-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, U+i57fLL0i1B/TfWNEdvhRy8Mga/SFlR+MYdmb21oFmCtjyprxJTOB2YfCe2VsnT N6g/f718kHaXEkX4ZKJhfA== 0000936392-99-000882.txt : 19990729 0000936392-99-000882.hdr.sgml : 19990729 ACCESSION NUMBER: 0000936392-99-000882 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 19990430 FILED AS OF DATE: 19990728 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PMR CORP CENTRAL INDEX KEY: 0000829608 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-SPECIALTY OUTPATIENT FACILITIES, NEC [8093] IRS NUMBER: 232491707 STATE OF INCORPORATION: DE FISCAL YEAR END: 0430 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-20488 FILM NUMBER: 99671678 BUSINESS ADDRESS: STREET 1: 501 WASHINGTON ST 5TH FL CITY: SAN DIEGO STATE: CA ZIP: 92103 BUSINESS PHONE: 6192952227 MAIL ADDRESS: STREET 1: 3990 OLD TOWN AVENUE SUITE 206A CITY: SAN DIEGO STATE: CA ZIP: 92110 FORMER COMPANY: FORMER CONFORMED NAME: ZARON CAPITAL INC DATE OF NAME CHANGE: 19891116 10-K 1 FORM 10-K 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED APRIL 30, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] FOR THE TRANSITION PERIOD FROM __________ TO ___________ COMMISSION FILE NO. 0-20488 ---------------- PMR CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) ----------------
DELAWARE 23-2491707 STATE OR OTHER JURISDICTION OF I.R.S. EMPLOYER IDENTIFICATION NO. INCORPORATION OR ORGANIZATION 501 WASHINGTON STREET, 5TH FLOOR 92103 SAN DIEGO, CALIFORNIA (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) (619) 610-4001 ---------------- SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, PAR VALUE $.01 PER SHARE Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10K or any amendment to this Form 10K [ ] As of June 30, 1999, the approximate aggregate market value of the Common Stock held by non-affiliates of the registrant was $15,399,922, based upon the closing price of the Common Stock reported on the Nasdaq National Stock Market of $3.3125 per share. See footnote (1) below. The number of shares of Common Stock outstanding as of June 30, 1999 was 6,988,878. -1- 2 - ------------ (1) The information provided shall in no way be construed as an admission that any person whose holdings are excluded from the figure is not an affiliate or that any person whose holdings are included is an affiliate and any such admission is hereby disclaimed. The information provided is included solely for record keeping purposes of the Securities and Exchange Commission. ================================================================================ -2- 3 PART I Except for the historical information contained herein, the following discussion contains forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include without limitation, those discussed in the description of the Company's business below and the section entitled "Risk Factors," in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this Annual Report, as well as those discussed in documents incorporated herein by reference. ITEM 1. BUSINESS GENERAL PMR Corporation and its subsidiaries ("PMR" or the "Company") is a leading manager of specialized mental health care programs and disease management services designed to treat individuals diagnosed with a serious mental illness ("SMI"), primarily schizophrenia and bi-polar disorder (i.e., manic-depressive illness). PMR manages and administers the delivery of a broad range of outpatient and community-based psychiatric services for SMI patients, consisting of 37 intensive outpatient programs (the "Outpatient Programs"), two case management programs (the "Case Management Programs") and four chemical dependency and substance abuse programs (the "Chemical Dependency Programs"). In July, 1998, the Company and Stadt Holdings (formerly, Stadtlander Drug Distribution Co., Inc.) ("Stadtlander") formed a new company called Stadt Solutions, LLC ("Stadt Solutions"). Stadt Solutions offers a specialty pharmacy program for individuals with an SMI. Stadt Solutions presently serves approximately 7,500 individuals through fifteen pharmacies in fourteen states. In October, 1998, PMR, in conjunction with two California-based HMOs and a California professional corporation (the "Medical Group"), launched a fully capitated managed care product for SMI individuals that have Medicare as their primary insurer. The product is a pilot project which will be expanded if enrollment and profitability targets are met. PMR, including Stadt Solutions, operates in approximately twenty-five states and employs or contracts with more than 400 mental health and pharmaceutical professionals and administers or provides services to approximately 11,000 individuals diagnosed with SMI. A four-decade old public policy trend of de-institutionalizing the mentally ill from long-term care hospitals into the community has resulted in a deterioration in SMI patient care and a fragmented and disjointed system of care which typically fails to adequately provide the patient management or coordination of benefits required by the medically complex SMI patient population. Coordination and monitoring of patient services is essential to avoid the debilitating effects of fragmented care delivered by diverse outpatient providers which are reimbursed by disparate, uncoordinated funding sources. PMR's clinical philosophy focuses on improving outcomes and lowering costs by utilizing intensive, community-based treatment of the SMI population in outpatient settings. PMR-managed or administered Outpatient Programs serve as a comprehensive alternative to inpatient hospitalization and include partial hospitalization and lower intensity outpatient services. The Case Management Programs provide an intensive, individualized primary care service which consists of a proprietary case management model utilizing clinical protocols for delivering care to SMI patients. The most rapidly growing segment of the Company's business is the Stadt Solutions specialty pharmacy venture. This service provides pharmacy distribution directly to patients or to the community institutions that provide mental health services to such patients. Stadt Solutions will provide additional value-added services to physicians and clients relating to compliance, proper dosing, drug interactions and side effects. PMR's objective is to be the leader in the management of cost-effective programs which provide quality care and foster the successful recovery of individuals from the devastating effects of SMI. The Company intends to achieve this objective by (i) expanding Stadt Solutions' specialty pharmaceutical services to individuals with SMI as well as providing clinical information services to pharmaceutical companies, health care providers and public sector purchasers; (ii) selectively obtaining new contracts for Outpatient and Case Management Programs in existing markets (iii) establishing new programs and ancillary services, and (iv) expanding its coordinated care pilot project -3- 4 within current markets and rolling out new markets if the project achieves profitability and revenue targets during this fiscal year. PMR was incorporated in the State of Delaware in 1988. The operations of the Company include the operations of its wholly owned subsidiaries, Psychiatric Management Resources, Inc., Collaborative Care Corporation, Collaborative Care, Inc., and Twin Town Corporation, and its majority owned subsidiary Stadt Solutions. The principal executive offices of the Company are located at 501 Washington Street, 5th Floor, San Diego, California 92103. The Company's telephone number is (619) 610-4001. THE MARKET AND INDUSTRY BACKGROUND According to the National Institute of Mental Health (the "NIMH") and its National Advisory Mental Health Council (the "NAMHC"), serious mental illnesses are neurobiological disorders of the brain and include schizophrenia, schizoaffective disorder, manic-depressive illness and autism, as well as severe forms of other disorders such as major depression, panic disorder and obsessive-compulsive disorder. These diseases are chronic and represent one of the highest cost segments of the health care system. Industry sources indicate that approximately 2.8% of the adult population and 3.2% of children ages 9-17 are affected by SMI, for a total SMI population in the United States of approximately 5.6 million people. According to industry sources, in 1995, individuals diagnosed with SMI consumed $27 billion in direct medical costs relating to the provision of mental health services and consumed more than $74 billion in total costs, including estimates of lost productivity. Based on the industry data, the Company estimates that the direct medical expenditures associated with SMI represent in excess of 25% of total direct mental health care costs. However, the potential costs of direct medical care may exceed these levels due to the approximately 2.2 million Americans estimated to be suffering from untreated SMI. Substantially all costs of treating and managing the SMI population are borne by federal, state and local programs, including Medicare and Medicaid. The SMI population accesses care primarily through community mental health centers ("CMHCs") and other community-based health care facilities such as psychiatric and acute care hospitals and nursing homes. CMHCs typically are not-for-profit organizations which lack access to capital, sophisticated management information and financial systems, and comprehensive programs for treating SMI patients. Since 1955, the SMI population in the United States has experienced extensive de-institutionalization resulting in the public psychiatric hospital census declining from approximately 560,000 individuals in 1955 to approximately 72,000 individuals in 1994. The effect of de-institutionalization is exacerbated by the fact that the general population grew 58% over this same period, while the SMI incidence rate remained stable. Industry sources estimate that there are approximately 763,000 individuals in the United States currently diagnosed with SMI who otherwise would have received inpatient treatment prior to de-institutionalization, of which 60%-75% are patients with schizophrenia or bi-polar disorder. The result of this trend has been increased rates of transinstitutionalism and homelessness among SMI patients. Transinstitutionalism is a term utilized to describe the mechanism by which de-institutionalized individuals receive care in one or more alternate settings such as nursing homes, general hospitals, jails and prisons. Industry estimates indicate that 23% of nursing home residents have a mental disorder and that more than 98,000 acute care hospital beds are occupied by SMI patients. Furthermore, approximately 10% of all prison and jail inmates are diagnosed with SMI and 35% of the approximately 350,000 homeless individuals in the United States are currently suffering from SMI disorders. The most frequently occurring primary diagnosis of the SMI population treated by PMR is schizophrenia, an incurable biological disorder which affects approximately 1% of the general population. Approximately 70% of the patients treated at the Company's programs are diagnosed with schizophrenia or schizoaffective disorder. The remainder are afflicted with bi-polar disorder, major depression, or other personality disorders. Industry sources indicate that up to 50% of patients suffering from schizophrenia receive no treatment for symptoms. In addition, due to the stigma and social constraints that accompany schizophrenia, it is estimated approximately 25% of schizophrenics attempt to end their lives through suicide. In general, each year a significant percentage of individuals with schizophrenia are admitted for an inpatient hospitalization and virtually all of the diagnosed population is prescribed a chronic medication regimen. It is not uncommon that these individuals also suffer from a substance abuse or chemical dependency diagnosis. Based on industry data, the Company estimates that treatment -4- 5 for schizophrenia consumes approximately $20 billion in annual mental health care expenditures. The direct medical costs of schizophrenia are consumed primarily in CMHCs, nursing homes and acute care hospitals. Since the introduction of Clozaril in the United States in 1989, several pharmaceutical products have been developed for SMI patients that have resulted in significant improvements in treatment. Although the specific biological causes of SMI remain unknown, the efficacy of many treatment regimens has been found to be comparable to that in other branches of medicine. For example, with the exception of autism, medications exist which generate medical responses in 60%-90% of patients with SMI. For schizophrenia and schizoaffective disorder, research has shown that standard anti-psychotic medication will reduce psychotic symptoms in 60% of patients and in 70%-85% of those experiencing symptoms for the first time. These newer medications, with proper use and compliance, offer significant potential for recovery to individuals afflicted with SMI. PROGRAMS AND OPERATIONS OUTPATIENT PROGRAMS PMR's Outpatient Programs are operated under management, administrative or consulting contracts with acute care hospitals, psychiatric hospitals and CMHCs, and consist principally of intensive outpatient programs which serve as alternatives to inpatient care. These programs target patients in crisis or those recovering from crisis and thus provide more intensive clinical services than those generally available in a traditional outpatient setting. The Company currently manages 37 Outpatient Programs in Arizona, Arkansas, California, Colorado, Hawaii, Idaho, Kentucky, Michigan, Missouri, Nevada, North Carolina, Ohio, Tennessee, Texas and West Virginia. The Company contracts with 32 separate providers including Scripps Health, St. Mary's Health Center of the SSM Health Care System, University of California, Irvine, and Presbyterian Hospital, North Carolina. Typically, the Company's contracts are two to five years in length. While contract expirations occur from time to time in the ordinary course of business, the Company vigorously attempts to extend and renew existing profitable contracts and to maintain its market share through the addition of new contracts. The Outpatient Programs consist principally of psychiatric partial hospitalization programs which are ambulatory in nature and provide intensive, coordinated clinical services to patients diagnosed with SMI. In 1996, the Company introduced its structured outpatient clinic, which is a lower intensity "step-down" outpatient service designed to continue the care, maintain the gains achieved and prevent the relapse of patients who have completed the partial hospitalization program. To further expand the Company's potential client population, the Company broadened its structured outpatient program in August 1997 to include clients who are at a lower level of clinical risk. Patients admitted to the Outpatient Programs undergo a complete assessment and treatment planning process that includes psychiatric, psycho-social, medical and other specialized evaluations under the care and supervision of a psychiatrist. Each SMI individual is assigned a care coordinator responsible for managing the comprehensive treatment available to the patient, which includes specialty services for geriatric and dually diagnosed patients. All Outpatient Programs provide programming five or six days a week. Treatments include daily group psychotherapy and individual therapy conducted by therapists, nurses and mental health specialists who are supervised by the appropriate department of the hospital or CMHC and by senior clinical managers in the programs. In Outpatient Programs where the Company retains designated staffing responsibilities, the Company provides program administrators and medical directors, and may provide nurses, community liaisons and other clinical personnel. In these cases, the program administrator generally has a degree in psychology or social work and several years of experience in health care administration. Typically, the medical director is a board-eligible or certified psychiatrist and the other professionals have various levels of training in nursing, psychology or social work. Through its Outpatient Programs, the Company brings management expertise to the health care provider with respect to the establishment, development and operation of an outpatient program for SMI patients that is not usually available on an in-house basis. Services provided under Outpatient Program management contracts include complete program design and administration from start-up through ongoing program operation. These programs are -5- 6 intended to enhance the delivery of outpatient mental health services by introducing proprietary clinical protocols and procedures, conducting quality assurance and utilization reviews, identifying or supplying highly trained personnel, and expanding the range of services provided. In addition, the programs also enhance the management of financial and administrative services by providing support to the providers and performing budget, financial and statistical analyses designed to monitor facility performance. The Company believes these comprehensive features enhance the efficiency and quality of care provided by its Outpatient Programs. During the first quarter of fiscal year 2000, the Company has closed six Outpatient Program locations in Chicago, Illinois; Bellevue, Washington; and San Francisco, Santa Ana, Riverside and San Bernardino, California; and has opened three Outpatient Program locations in Corona, California; Reno, Nevada; and Charleston, West Virginia. CASE MANAGEMENT PROGRAMS PMR's Case Management Programs were created in 1993 to treat the SMI population in a managed care environment. The case management model was developed in part from proprietary clinical protocols and assessment tools which were acquired in 1993 from leading researchers in the field of psychiatric rehabilitation. Specifically, the Company's programs provide SMI patients with personalized, one-on-one services designed to stabilize their daily lives and provide early intervention in crisis situations, thereby limiting the catastrophic events which lead to inpatient hospitalizations. The Case Management Programs utilize comprehensive protocols based upon a specific model of intensive service coordination in conjunction with a case manager whose responsibilities include consumer education, the development of crisis plans, responding to crisis events, linking patients to emergency services, assessing patient needs, reviewing patient treatment plans, and authorizing and reviewing services. Case management services vary by market and need of the population and may include 24-hour case management, crisis intervention, respite services, housing assistance, medication management and routine health screening. PMR believes that its Case Management Programs represent the core clinical tools for managing the SMI population in either a capitated or fee-for-service environment and enable its patients to live more healthy, independent, productive and satisfying lives in the community. PMR offers its case management services through long-term exclusive management agreements with leading independent providers of case management services. Pursuant to those agreements, the Company contributes its proprietary protocols and/or management expertise and, when necessary, negotiates case management rates and contracts on behalf of the providers. The Company may also provide training, management information systems support, and accounting and financial services. Presently, the Company has agreements with two case management agencies in Tennessee. PMR provides its Case Management services principally in Davidson County, Tennessee, presently serving approximately 3,000 individuals located primarily in Nashville, Tennessee. The Company also provides case management services through a case management agency in Memphis, Tennessee as well as case management services in Southern California as part of its managed care effort. In 1998, the Company introduced its Urgent Care service in Nashville, Tennessee. Urgent Care is a high acuity, crisis intervention service designed for triage and stabilization of a patient at the time of highest clinical need. The service involves physician intervention and combines a medical model for crises and assessment and a case management model for on-going maintenance. STADT SOLUTIONS In July 1998, the Company and Stadtlander, a leading specialty pharmacy company, formed Stadt Solutions, a Delaware limited liability company, to offer specialty pharmaceutical services to individuals with SMI. Stadt Solutions also offers site management and clinical information services to pharmaceutical companies, health care providers and public sector purchasers. The ownership of Stadt Solutions is held 50.1% by PMR and 49.9% by Stadtlander. Through December 31, 2000, Stadtlander is entitled to receive a priority distribution approximately equivalent to the operating income Stadtlander expected to be generated by Stadtlander's contributed base of approximately 6,000 clients. The incremental operating income in excess of this base, if any, will be distributed based on proportional ownership to the Company and Stadtlander through this period. Beginning with calendar -6- 7 year 2001, the preferred payment to Stadtlander becomes a fixed amount which is determined primarily based on the financial results in 2000. The venture commenced business with approximately 6,000 clients receiving the drug Clozaril, an anti-psychotic for schizophrenia, as well as blood monitoring services through thirteen Stadtlander pharmacies in twelve states. Stadt Solutions has opened two of its own pharmacies since its inception in July 1998. Stadt Solutions will seek to offer patients expanded services, including dispensing of all of the pharmaceuticals needed by these individuals and providing disease management services to improve compliance and education for the patient, the physician and family members. The Company believes that Stadt Solutions is the first specialty pharmacy company devoted to serving the needs of individuals with SMI. In January 1999, Stadtlander Operating Company, L.L.C., a subsidiary of Bergen Brunswig Corporation ("BBC") purchased the stock of Stadtlander Drug Distribution Co., Inc. BBC is one of the nation's largest independent wholesale drug distributors. In May 1999, BBC acquired PharMerica, Inc., a pharmacy services company. Prior to consummation of the acquisition, the Company and Stadt Solutions unsuccessfully sought a temporary restraining order to prevent consummation of the acquisition alleging the acquisition would result in the violation of certain non-competition and confidentiality provisions contained in the Stadt Solutions Operating Agreement. The litigation is continuing. See "Item 3. Legal Proceedings". SITE MANAGEMENT AND CLINICAL INFORMATION In January 1997, the Company began the development of a site management and clinical information division. This division was established to participate in clinical trials and collect clinical information related to pharmaceutical and non-pharmaceutical clinical practice. The Company's objective was to build a business model that contributes to the Company's revenues and earnings and to develop an information asset that can improve and define "best practices" for the SMI patient population. In April 1998, the Company entered into reciprocal enabling agreements with Vanderbilt University where the Company is able to enter into project-specific research agreements with the University to develop and carry out funded research projects. The current research network includes six locations with qualified investigators and study coordinators. PMR contributed the site management and clinical information initiative to Stadt Solutions as part of Stadt Solutions' formation in July 1998. MANAGED CARE In October 1998, the Company, in conjunction with Universal Care, a Knox-Keene licensed health care service plan, HealthNet, a large HMO with Medicare risk contracting capability, and the Medical Group launched a managed care pilot project in Southern California. The pilot project is designed to appeal to individuals who are deemed as disabled due to their SMI and therefore have Medicare as their primary insurance. HealthNet holds the Medicare risk contract and the individuals with SMI are enrolled in HealthNet's health plan. Universal Care contracts with HealthNet to sub-capitate risk and provides substantially all of the non-psychiatric care and case management network. The Medical Group primarily provides and arranges for behavioral health services for the SMI enrollees. The Company furnishes certain administrative services through an agreement with Medical Group. The Company's services to the Medical Group include, but are not limited to, billing and collection, member services, utilization review, quality assurance, quality management, financing and credentialing services. In addition, the Company also provides case management services to the Medical Group's enrolled patients. CHEMICAL DEPENDENCY PROGRAMS Through a wholly-owned subsidiary, the Company operates and manages programs devoted exclusively to substance abuse and rehabilitation in ambulatory settings, primarily to patients of managed care organizations in Southern California. The Company's Chemical Dependency Programs are operated either as free-standing treatment services or as part of a Management Services Agreement with health care providers. All programs have received accreditation by the Joint Commission of American Health Organizations ("JCAHO"). -7- 8 The Company operates four outpatient Chemical Dependency Programs in Southern California under the name of Twin Town Treatment. The Company has decided that its Chemical Dependency Programs are no longer a core strategic asset of the Company and is currently evaluating alternatives with respect to the future of such Programs. PROGRAM LOCATIONS
STATE CITY SERVICE PROVIDED ----- ---- ---------------- California San Diego Outpatient; Clinical Research Culver City Outpatient El Cajon Outpatient Los Angeles Outpatient Ventura Outpatient Oakland Outpatient Walnut Creek Outpatient Vista Outpatient Union City Outpatient Garden Grove Managed Care Rosemead Outpatient Sacramento Clinical Research Orange Outpatient; Chemical Dependency San Jose Outpatient La Jolla Outpatient North Hollywood Chemical Dependency Los Alamitos Chemical Dependency Torrance Chemical Dependency Encinitas Clinical Research Alabama Birmingham Pharmacy* Arizona Phoenix Outpatient Tempe Outpatient Arkansas Little Rock Outpatient (2); Clinical Research Colorado Denver Outpatient Georgia Atlanta Pharmacy* Hawaii Honolulu Outpatient; Pharmacy* Waipahu Outpatient Idaho Boise Outpatient Kentucky Bowling Green Outpatient Mayfield Outpatient Lexington Outpatient Louisville Outpatient Maine Portland Pharmacy* Massachusetts Boston Pharmacy* Michigan Detroit Outpatient; Clinical Research
-8- 9
STATE CITY SERVICE PROVIDED ----- ---- ---------------- Minnesota Minneapolis Pharmacy* Missouri St. Louis Outpatient; Pharmacy* Nevada Reno Outpatient New York Long Island Pharmacy* North Carolina Charlotte Outpatient Ohio Cleveland Outpatient Columbus Outpatient; Pharmacy Dayton Outpatient Pennsylvania Pittsburgh Pharmacy* Philadelphia Pharmacy* South Carolina Columbia Pharmacy* Tennessee Kingsport Outpatient Madison Outpatient Nashville Outpatient; Case Management; Clinical Research; Pharmacy Memphis Case Management Texas Austin Outpatient; Clinical Research Utah Salt Lake City Pharmacy* Washington Seattle Pharmacy* West Virginia Charleston Outpatient
------------ * Pharmacy licensed through Stadtlander. CONTRACTS OUTPATIENT PROGRAMS Each Outpatient Program is generally administered and operated pursuant to the terms of written management, administrative or consulting contracts with providers. These contracts generally govern the term of the program, the method by which the program is to be managed by the Company, the responsibility of the provider for licensure, billing, insurance and the provision of health care services, and the methods by which the Company will be compensated. The contracts are generally for a stated term between two and five years. Generally, contracts may only be terminated with cause or upon the occurrence of certain material events including changes in applicable laws, rules or regulations. Revenues derived by the Company under these contracts generally fit within three types of arrangements: (i) all-inclusive fee arrangements based on fee-for-service rates (based on units of service provided) under which the Company is responsible for substantially all direct program costs; (ii) fee-for-service arrangements under which the provider maintains responsibility for a large extent of direct program costs; and (iii) fixed fee arrangements where the Company's fee is a fixed monthly sum and the provider assumes responsibility for substantially all program costs. The all-inclusive arrangements were in effect at 33 of the 39 Outpatient Programs operated during fiscal -9- 10 1999 and constituted approximately 69.4% of the Company's consolidated revenues for the year ended April 30, 1999. These contractual agreements are with hospitals or CMHCs and require the Company to provide, at its own expense, specific management personnel for each program site. Regardless of the type of arrangement with the provider, all medical services rendered in the programs are provided by the provider. A significant number of the Company's contracts require the Company to indemnify the provider for some or all of the fee paid to the Company if either third-party reimbursement for mental health services provided to patients of the programs is denied or if the fee paid to the Company is not reimbursable by Medicare. See "Risk Factors -- Dependence Upon Medicare Reimbursement," "-- Sufficiency of Existing Reserves to Cover Reimbursement Risks," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business -- Regulatory Matters." In order for the services furnished to Medicare beneficiaries in Outpatient Programs managed by the Company to be reimbursable to the provider, the program must be deemed to be "provider-based." In fiscal year 1998, HCFA's Region IX office challenged the "provider-based" designation of certain outpatient programs operated by Scripps Health a provider to which the Company provided management services. In July 1998, HCFA's Region IX office notified Scripps Health of its determination that certain of its programs were approved as "provider-based" and that certain other of its program locations were not "provider-based" because they did not meet HCFA's service area requirements. As a result of HCFA's challenge and determination, the Company and Scripps Health amended their contract, Scripps Health reconfigured certain of its partial hospitalization programs, two locations were closed and one of the locations was taken over by another provider who engaged the Company to manage the program. One other program managed by the Company received notice that it did not meet provider-based designation requirements because the Company was prohibited from employing any personnel involved in the program furnished by the provider, except as a consultant to the provider. This issue was never finally resolved because the provider hospital closed for reasons unrelated to the notice. Because the proper interpretation and application of the "provider-based" criteria are not entirely clear, are applied on a case by case basis, and are currently the subject of an ongoing rule making process, it is possible that these challenges will emerge with other providers and that the Company may not be able to amend its contracts to satisfy HCFA or its provider customers. See "Regulatory Matters - Compliance with Medicare Guidelines; Reimbursement for Partial Hospitalization Programs." No Company Outpatient Program with a provider accounted for more than 10% of the Company's revenues for fiscal 1999. As the Company-managed Outpatient Programs mature and increase in number, the Company anticipates that as a matter of normal business development, contract terminations may occur on a periodic basis. There can be no assurance that the Company will be able to successfully replace such terminated contracts or programs in the future. CASE MANAGEMENT PROGRAMS In the Fall of 1995, the Company commenced the operation of its Case Management Programs with two case management agencies in Nashville, Tennessee and Memphis, Tennessee. Commencing in July 1996, two managed care consortiums became the payors for mental health care services under the Tennessee TennCare Partners State Medicaid Managed Care Program ("TennCare"), and the Company had contracts with both behavioral health organizations for case management programs in Nashville and Memphis. These consortiums, known as Tennessee Behavioral Health ("TBH") and Premier Behavioral Health ("Premier"), were fully at-risk for the approximately 1.2 million individuals who qualified for coverage based on Medicaid eligibility or indigency standards. The Company received notice of termination of its contract with TBH effective December 10, 1997, but the Company continued to provide services to, and receive payments from, TBH at reduced rates. In February 1998, Magellan Health Services, Inc. acquired Merit Behavioral Health Care, Inc., thereby becoming the managing shareholder of TBH. Magellan, through its Green Spring subsidiary, is also the managing shareholder of Premier. Beginning, July 1998, Magellan managed both Premier and TBH and as of that date the Company has been paid the -10- 11 identical rates by both consortiums. Some uncertainty exists as to the future structure of TennCare. See "Risk Factors -- Concentration of Revenues." The Nashville Case Management Program is administered pursuant to a management and affiliation agreement with the contracting provider and operates through a wholly owned subsidiary of the Company. The Company is responsible for developing and implementing detailed operating protocols relating to training procedures, management information systems, utilization review, coordination of quality assurance, contract development and other management and administrative services, and the provision of mental health services. Pursuant to the terms of the management and affiliation agreement, the Company manages and operates the delivery of case management and other covered psychiatric services. The case management provider is responsible for staff personnel and program facilities, and retains final discretionary authority to approve the related policy manual, staffing issues and overall program operations. The Nashville management and affiliation agreement has a term of six years (ending April 30, 2002) and may only be terminated for cause upon the occurrence of such events as (i) a loss of accreditation or other required licensing or regulatory qualifications, (ii) material breach by either party, (iii) certain legislative or administrative changes that may adversely affect the continued operation of the program and (iv) failure to achieve certain performance targets after designated notice and cure periods. The Memphis Case Management Program is also administered through a wholly owned subsidiary of the Company which entered into a management and affiliation agreement with a case management agency substantially similar to the agreement entered into with the Nashville case management agency. Effective June 1, 1998, the Memphis management and affiliation agreement was terminated and the parties entered into a Provider Services Agreement for a term of four years pursuant to which the Company provides billing, contract development, quality assurance and liaison services and allows the agency to utilize the Company's protocols. Case management contracts in Tennessee accounted for 12.3% and 21.6% of the Company's consolidated revenues for fiscal 1999 and fiscal 1998, respectively. In May 1998, the Company closed its remaining Case Management programs in Arkansas with its CMHC providers after previously anticipated changes to Arkansas' reimbursement for case management services did not occur. MARKETING AND DEVELOPMENT PMR intends to focus increasing marketing and development efforts to the expansion of the specialty pharmacy services to individuals with SMI as well as clinical information services to pharmaceutical companies, health care providers and public sector purchasers. The market is growing rapidly due to the number of new drugs that have been introduced over the past five years for the indication of schizophrenia. Numerous other drugs are in pre-approval development for this indication as well as for bipolar disorder and major depression. According to industry sources, in 1998 alone, pharmaceutical companies invested approximately $4.8 billion to discover and develop medicines acting on the central nervous system, including drugs for mental illnesses. The Company, through Stadt Solutions, plans to develop new pharmacies to support community-based agencies that employ prescribing physicians and assist the SMI population in medication management and compliance. PMR's principal marketing effort with respect to its Outpatient and Case Management Programs is concentrated in the Company's existing markets in the identification of prospective hospitals, CMHCs and case management agencies which may be suitable providers for new programs or expansion of services. Providers that may contract for the Company's services are identified through an analysis of market need, discussions with key individuals in the prospective area, and an assessment of the financial and clinical profile of the provider. The Company also markets the benefits of its Outpatient, Case Management and Urgent Care programs to managed care organizations and their provider networks as public sector contracts are awarded. The Case Management Program is also available to entities at risk for managed care for SMI patients. The Company has decided that its Chemical Dependency Programs are no longer a core strategic asset of the Company and is currently evaluating the need to continue related marketing efforts related to those programs. -11- 12 The Company's marketing efforts with providers are undertaken by its own marketing and development personnel who focus upon the dissemination of information about the benefits of the Company's programs. The Company believes that its ability to secure new contracts with providers is based on its reputation for quality and the uniqueness of its services in its market areas. REGULATORY MATTERS COMPLIANCE WITH MEDICARE GUIDELINES; REIMBURSEMENT FOR PARTIAL HOSPITALIZATION PROGRAMS A significant component of the Company's revenues are derived from payments made by providers to the Company for the management and administration by the Company of Outpatient Programs managed for providers. The Company bills its fees to the provider as a purchased management, administrative and consultative support service. Substantially all of the patients admitted to these programs are eligible for Medicare coverage and thus, the providers rely upon payment from Medicare for the services. The providers are reimbursed their costs on an interim basis by Medicare fiscal intermediaries and the providers submit annual cost reimbursement reports to the fiscal intermediaries for audit and payment reconciliation. The providers seek reimbursement of the Company's fees from these fiscal intermediaries as part of their overall payments from Medicare. Under certain of the Company's contracts the Company is obligated to indemnify the provider for all or some portion of the Company's fees that may be disallowed to the provider. In the event a significant amount of such fees are disallowed for providers, there could be a material adverse effect upon the Company's financial condition and results of operations. In addition, to the extent that providers who contract with the Company for management services suffer material losses in Medicare payments, there is a greater risk of non-payment by the providers and a risk that the providers will terminate or not renew their contracts with the Company. Thus, even though the Company is not paid by Medicare, it may be adversely affected by reductions in Medicare payments or other Medicare policies. See "Risk Factors-Dependence Upon Third Party Reimbursement" below and "Item 7. Management's Discussion And Analysis Of Financial Condition And Results Of Operations." The Medicare Program was created in 1965 as part of the federal social security system. It is administered by the U.S. Department of Health and Human Services which has established the Health Care Financing Administration ("HCFA") to administer and interpret the rules and regulations governing the Medicare program and the benefits associated therewith. Applicable Medicare guidelines permit the reimbursement of contracted management services provided that, among other things, the associated fees are "reasonable." As a general rule, Medicare guidelines indicate that the costs incurred by a provider for contract management services relating to furnishing Medicare-covered services are deemed "reasonable" if the costs incurred are comparable with marketplace prices for similar services. Although management believes that the Company's fees for its services are comparable with marketplace prices for similar services, the determination of reasonableness may be interpreted by HCFA or a fiscal intermediary in a manner inconsistent with the Company's belief. Notwithstanding the Company's belief, a determination that the Company's fees may not be "reasonable" may have a material adverse effect on the Company's business, financial condition and results of operations. HCFA has published criteria which partial hospitalization services must meet in order to qualify for Medicare funding. In transmittal number 1303 (effective January 2, 1997) and in subsequent criteria published in Section 230.5 of the Medicare Hospital Manual, HCFA requires partial hospitalization services to be: (i) incident to a physician's service; (ii) reasonable and necessary for the diagnosis or treatment of the patient's conditions; and (iii) provided by a physician with a reasonable expectation of improvement of the patient from the treatment. The Medicare criteria for coverage, specifically what is "reasonable and necessary" in particular cases is a subjective determination on which health care professionals may disagree. Moreover, the fiscal intermediaries which administer the Medicare program and evaluate and process claims for payment, establish local medical review policies which the affect of such policies may have a material adverse effect on the Company's results of operations. How Medicare applies its "reasonable and necessary" standard is not always consistent, and that standard may be interpreted in the future in a manner which is more restrictive than currently prevailing interpretations. The Company and its providers have quality assurance and utilization review programs to monitor partial hospitalization programs managed or administered by the Company to ensure that such programs operate in compliance with the Company's understanding of all Medicare coverage requirements. -12- 13 Further, the partial hospitalization programs managed by the Company are required under HCFA's current interpretation of the Medicare regulations, to be "provider-based" programs. This designation is important since partial hospitalization services are covered only when furnished by or "under arrangement" with, a "provider", i.e., a hospital or a CMHC. To the extent that any particular partial hospitalization program is not deemed by HCFA to be "provider based" under HCFA's current interpretation of the Medicare regulations, there would not be Medicare coverage for the services furnished at that site under Medicare's partial hospitalization benefit. HCFA has published criteria for determining when programs operated in facilities separate from a hospital's or CMHC's main premises may be deemed to be "provider-based" programs. The proper interpretation and application of these criteria are not entirely clear, and there is a risk that some or substantially all of the sites managed by the Company may be found not to be "provider-based". If such a determination is made and the Company is unable to satisfactorily restructure its contract with the provider, HCFA may cease reimbursing for the services at the provider, and HCFA may, in some situations, seek retrospective recoveries from providers. Any such cessation of reimbursement for services or retrospective recoveries could result in non-payment by providers, possibly trigger indemnity claims, and have a material adverse effect on the Company's business, financial condition and results of operations. In September, 1998, HCFA published a proposed rule that would add to the existing standards that must be met to obtain provider-based status. The comment period is open until July 31, 1999, and the Company does not expect a final rule on provider-based status to be effective prior to sometime in 2000, although it would be possible for HCFA to publish a final rule effective earlier. The standards in the proposed rule are similar to existing standards, although the proposed rule would mandate that retrospective recoveries would ensue in most instances when HCFA or its agents determined that a program or site was not "provider-based." See "Risk Factors - Dependence Upon Third Party Reimbursement." In fiscal year, 1998, HCFA's Region IX office challenged the "provider-based" designation of certain outpatient programs operated by Scripps Health a provider to which the Company provided management services. In July 1998, HCFA notified Scripps Health that certain of its programs were approved as "provider-based" and that certain other of its program locations were not "provider-based" because they did not meet HCFA's service area requirements. As a result of HCFA's challenge and determination, the Company and Scripps Health amended their contract, Scripps Health reconfigured certain of its partial hospitalization programs, two locations were closed and one of the locations was taken over by another provider who engaged the Company to manage the program. In other instances, when the Company's customers have sought provider-based status determinations from HCFA upon establishing a program, HCFA's Region IX Office has interpreted the provider-based standards so as to prevent the Company from employing any personnel involved in the programs furnished by the provider except for "consultants" from the Company. This interpretation makes it more difficult for the Company to furnish the services upon which the Company has built its reputation and which its customers want. If the interpretation of provider-based standards applied by HCFA's Region IX Office are applied by other HCFA regional offices, or are adopted nationally as the correct interpretation, PMR would have to re-negotiate the vast majority of its contracts to administer partial hospitalization and other outpatient mental health programs. It is also possible that if provider-based challenges emerge with other providers, the Company may not be able to amend its contracts to satisfy HCFA or its provider customers. In addition, there can be no assurance that HCFA will not challenge the "provider-based" status of the Scripps Health program or any other Program in the future. If the Company is unable to amend its contracts to satisfy any "provider based" challenge in the future, the potential termination of any such contracts could have a material adverse effect upon the Company's business, financial condition and results of operations. "See "Business - Contracts - Outpatient Programs." Historically, CMHCs, unlike hospitals, were not surveyed by Medicare before being permitted to participate in the Medicare program. However, HCFA now requires prospective approval of all new CMHCs to confirm that they meet all applicable Medicare conditions for furnishing partial hospitalization services. In addition, HCFA will monitor existing CMHCs to assure compliance with applicable conditions of furnishing partial hospitalization services. Because the proper interpretation and application of such Medicare conditions are not entirely clear, it is possible that these challenges may emerge with CMHCs contracted with the Company and, if not found in compliance with the applicable requirements, such CMHCs may be terminated from the Medicare program. It is also possible that the government will attempt to recover payments made to such CMHCs for services which had been furnished by the Company and paid for by Medicare, which could possibly trigger indemnity claims -13- 14 which could be material. There may also be significant delays or suspension of payments made to CMHCs contracted with the Company due to such increased scrutiny and reviews by Medicare. The Office of Inspector General ("OIG") of the United States Department of Health and Human Services has reported that the vast majority of partial hospitalization services furnished by CMHCs do not satisfy Medicare's coverage criteria and that many CMHCs were not properly participating in the Medicare program because they did not meet the statutory and regulatory definition of a CMHC. Consequently, HCFA has implemented a program to review all partial hospitalization services even more intensely for meeting Medicare coverage criteria and to assure that all CMHCs meet the requirements for participation in the Medicare program. This more intensive review and auditing of claims for partial hospitalization services furnished by CMHCs to Medicare patients may result in a greater number of claims being denied for the Company's customers. The Company also expects more intensive reviews of claims, and increased audits by HCFA and OIG, of Hospital outpatient mental health services and partial hospitalization services including, the allowability of claims, medical necessity issues and reasonableness of fees. Presently, one CMHC provider and one hospital provider with whom the Company contracts are undergoing such audits. The more intensive review of claims for partial hospitalization or other outpatient mental health services furnished to Medicare patients may result in a greater number of claims being denied for the Company's customers, or disallowance of Company fees, which, as described above, may have a material adverse effect on the Company's business, financial condition and results of operations. In addition, if the scrutiny of CMHCs results in termination of provider agreements between Medicare and CMHCs with which the Company has contracts, there may be a material adverse effect on the Company's business, financial condition and results of operations. CHANGES IN MEDICARE'S PAYMENT FOR PARTIAL HOSPITALIZATION SERVICES The Balanced Budget Act of 1997 requires the implementation of a prospective payment system ("PPS") for all outpatient hospital services, including partial hospitalization, for the calendar year beginning January 1, 1999. The initial date for publishing the proposed PPS rates was May 1998. However, concerns over HCFA's compliance with year 2000 computer issues have caused significant delays in the implementation of PPS. Under such a system, a predetermined rate would be paid to providers regardless of the provider's reasonable costs. The proposed rate is $206.71 per diem, subject to adjustment up or down for wage levels in the area where the services are furnished. This rate may be changed in the final regulation or a basis for payment other than per diem, may be established. While the actual reimbursement rates have not been determined and thus their effect, positive or negative, is unknown, the Company anticipates that it will need to negotiate modifications to its contracts with providers if PPS is implemented. The uncertainty regarding PPS has negatively affected the Company's marketing of new programs due to providers' uncertainty regarding the economic impact of the new rates. While the Company cannot predict the impact of continued delays on the Company's marketing program, it could have a material adverse effect on the Company's ability to sign new contracts and retain existing contracts. The Medicare partial hospitalization benefit has a coinsurance feature, which means that the amount paid by Medicare is the provider's reasonable cost less "coinsurance" which is ordinarily to be paid by the patient. The coinsurance amount is 20% of the charges for the services and must be charged to the patient by the provider unless the patient is indigent. If the patient is indigent or if the patient does not pay the provider the billed coinsurance amounts after reasonable collection efforts, the Medicare program has historically paid those amounts as "allowable Medicare bad debts." The allowability of Medicare bad debts to providers for whom the Company manages partial hospitalization programs is significant since most of the patients in programs managed by the Company are indigent or have very limited resources. The Balanced Budget Act of 1997 reduces the amount of Medicare allowable bad debts payable to hospital providers, as follows: a reduction by 40% for provider fiscal years beginning on or after October 1, 1998; and by 45% for provider fiscal years beginning on or after October 1, 1999. The Clinton Administration has proposed an additional reduction to 55% for the budget year commencing October 1, 1999, and also proposes extending this bad debt reduction to community mental health centers. The reduction in "allowable Medicare bad debts", as well as any future reductions that may be authorized, could have a material adverse effect on Medicare reimbursement to the Company's hospital providers and could further result in the restructuring or loss of provider contracts with the Company. -14- 15 COMPLIANCE WITH MEDICAID REGULATIONS AND POTENTIAL CHANGES Since the Company is involved with state Medicaid agencies and with providers whose clients are covered by Medicaid, the programs managed by the Company must be in compliance with the laws and regulations governing such reimbursement. Likewise, Stadt Solutions' pharmacies must comply with Medicaid criteria for its pharmacy services which are predominantly paid for by Medicaid. Medicaid is a joint state and federally funded program established as part of the Social Security Act in the mid-1960s to provide certain defined health care benefits to poor, indigent or otherwise eligible general welfare recipients. As states consider methods to control the cost of health care services generally, and behavioral health services specifically, to Medicaid recipients, and because such recipients are, as a group, heavy users of the type of services which the Company offers, the effect of Medicaid reimbursement and regulatory compliance with its rules could be material to the Company's financial condition and results of operations. Medicaid funding and the methods by which services are supplied to recipients are changing rapidly. Many states have "carved out" behavioral health services from the delivery of other health services to Medicaid recipients and are separately procuring such services on a capitated basis requiring the contractor, and permitting subcontracted providers, to assume financial risk for the cost of providing care. The Company cannot predict the extent or scope of changes which may occur in the ways in which state Medicaid programs contract for and deliver services to Medicaid recipients. All Medicaid funding is generally conditioned upon financial appropriations to state Medicaid agencies by the state legislatures and there are ever-increasing uncertain political pressures on such legislatures in terms of controlling and reducing such appropriations. With respect to the Company's case management programs reimbursed by behavioral health organizations, the overall trend is generally to impose lower reimbursement rates including incentives to assume risk not only by licensed managed care organizations with whom state Medicaid agencies contract, but by subcontracted providers, such as the Company. Consequently, any significant reduction in funding for Medicaid programs could have a material adverse effect on the Company's business, financial condition and results of operations. The United States Congress continues to consider legislation to substantially alter the overall Medicaid program, to give states greater flexibility in the design and operation of their individual Medicaid program, and to stabilize federal spending for such benefits. Various states are also considering substantial health care reform measures which could modify the manner in which all health services are delivered and reimbursed, especially with respect to Medicaid recipients and with respect to other individuals funded by public resources. The reduction in other public resources could have an impact upon the delivery of services to Medicaid recipients. Many of the patients served in the Outpatient Programs managed by the Company are indigent or have very limited resources. Accordingly, many of those patients have Medicaid coverage in addition to Medicare coverage. In some of the states where the Company furnishes services, the state Medicaid plans have paid the Medicare coinsurance amount. However, under the Balanced Budget Act of 1997, states will no longer have to pay such amounts if the amount paid by Medicare for the service equals or exceeds what Medicaid would have paid had it been the primary insurer. To the extent that states take advantage of this new legislation and refuse to pay the Medicare coinsurance amounts on behalf of the Outpatient Program patients to the extent that they had in the past, it will have an adverse effect on the providers with whom the Company contracts, and thus, may have a material adverse effect on the Company's business, financial condition and results of operations. -15- 16 COMPLIANCE WITH OTHER STATE REGULATORY CONSIDERATIONS The Company is also sensitive to the particular nature of the delivery of behavioral health services and various state and federal requirements with respect to confidentiality and patient privacy. Indeed, federal and state laws require providers of certain behavioral health services to maintain strict confidentiality as to treatment records and, the fact of treatment. There are specific requirements permitting disclosure, but inadequate or incorrect disclosure, even if inadvertent or negligent, can trigger substantial criminal and other penalties. See "Risk Factors-Privacy and Confidentiality Legislation" below. SPECIFIC LICENSING OF PROGRAMS AND PHARMACY SERVICES The Company's Outpatient Programs are operated as outpatient departments of hospitals or CMHCs, thus subjecting such programs to regulation by federal, state and local agencies. These regulations govern licensure and conduct of operations at the facilities, review of construction plans, addition of services and facilities and audit of cost allocations, cost reporting and capital expenditures. The facilities occupied by the programs must comply with the requirements of municipal building, health and fire codes. Inclusion of hospital space where the Outpatient Programs are furnished within the hospitals' license, when required under applicable state laws, is a prerequisite to participation in the Medicare programs. Additionally, the provider's premises and programs are subject to periodic inspection and recertification. Stadt Solutions' pharmacies are licensed and subject to all applicable State Board of Pharmacy and United States Drug Enforcement Administration rules, regulations and requirements and other applicable state and federal statutes and regulations governing pharmacy services. Many of the pharmacy locations are licensed through Stadlander, the minority shareholder. See "Risk Factors - Pharmacy Services Regulations." FALSE CLAIMS INVESTIGATIONS AND ENFORCEMENT OF HEALTH CARE FRAUD LAWS The Office of the Inspector General within the U.S. Department of Health and Human Services, as well as other federal, state, and private organizations, are aggressively enforcing their interpretation of Medicare and Medicaid laws and policies, and other applicable standards. Often in such enforcement efforts, the government has relied on the Federal False Claims Act. Under that law, if the government prevails in a case, it is entitled to treble damages plus not less than $5,000 nor more than $10,000 per claim, plus reasonable attorney fees and costs. In addition, a person found to have submitted false claims can be excluded from governmental health care programs including Medicare and Medicaid. If a provider contracting with the Company were excluded from governmental health programs, no services furnished by that provider would be covered by any governmental health program. Some of the providers contracting with the Company are reported to be under active investigation for health care fraud, although the Company is not aware of those investigations relating to programs with which the Company is involved. If the Company were excluded from governmental health programs, providers contracting with the Company could not be reimbursed for amounts paid to the Company. To prevail in a False Claims Act case, the government need show only that incorrect claims were submitted with "reckless disregard" or in "deliberate ignorance" of the applicable Medicare law. The government does not have to prove that the claims were submitted with the intent to defraud a governmental or private health care payor. The qui tam provisions of the Federal False Claims Act permit individuals also to bring suits under the False Claims Act. The incentive for an individual to do so is that he or she will usually be entitled to approximately 15% to 30% of any ultimate recovery. Under the Federal False Claims Act, the Office of the Inspector General, in conjunction with the Department of Justice, have successfully made demands on thousands of providers to settle alleged improper billing disputes at double alleged damages or more. Although the Company does not bill governmental programs directly, it could possibly be liable under the False Claims Act to the extent that it is found to have "caused" false claims to have been presented. There are many other civil and criminal statutes at the federal and state levels that may penalize conduct related to submitting false claims for health care services or for offering or receiving anything of value in exchange for the referral of patients. The penalties under many of those statutes are severe, and the government often need -16- 17 not prove intent to defraud in order to prevail. Management believes that the Company is in material compliance with applicable regulatory and industry standards. However, in light of the complexity of the policies governing governmental health care programs together with changing and uncertain interpretations of those policies, it is impossible to be absolutely assured that the government (or a qui tam relator in the name of the government) will not assert that some conduct by the Company, or conduct by one of the Company's customers, has given rise to potentially a large liability. See "Risk Factors - Anti-Remuneration Laws." In the past, there have been occasions when Medicare fiscal intermediaries have denied coverage for all or substantially all of the claims submitted by the providers where the Company had a management or administrative services contract. Such denials have occurred even though a physician has certified that the Outpatient Program services were medically necessary. Notwithstanding the Company's ongoing efforts to assure that the Outpatient Program services furnished by it under contract are consistent with its understanding of the Medicare coverage criteria, it is possible that there will be future occasions when a substantial number of services furnished at a site managed by the Company will be denied coverage. The Health Insurance Portability and Accountability Act of 1996 grants the U.S. Department of Health and Human Services broad authority to impose civil monetary penalties on providers for certain activities. Among those activities are the repeated submission of claims for services which are not medically necessary. If there were again to be occasions when a Medicare fiscal intermediary denied a large number of claims for a site managed by the Company, it is possible that the government would seek sanctions from the provider and possibly from the Company. While the Company believes that it would be inappropriate for the government to seek such sanctions for services for which the coverage criteria are interpreted differently at different times and which have been ordered by a physician, it is not clear at this time how the government will apply this new authority. COMPETITION In general, the operation of psychiatric programs is characterized by intense competition. General, community and specialty hospitals, including national companies and their subsidiaries, provide many different health care programs and services. The Company anticipates that competition will increase as pressure to contain the rising costs of health care continues to intensify, particularly as programs such as those operated by the Company are perceived to help contain mental health care costs. Many other companies engaged in the management of outpatient psychiatric programs compete with the Company for the establishment of affiliations with acute care hospitals. Furthermore, while the Company's existing competitors in the case management business are predominantly not-for-profit CMHCs and case management agencies, the Company anticipates that other health care management companies will eventually compete for this business. Many of these present and future competitors are substantially more established and have greater financial and other resources than the Company. In addition, the Company's current and potential providers may choose to manage mental health programs themselves rather than contract with the Company. There can be no assurance that the Company will be able to compete effectively with its present or future competitors, and any such inability could have a material adverse effect on the Company's business, financial condition and results of operations. The Company believes that the proprietary nature of its policy and procedures manuals and the level of service it provides and the expertise of its management and field personnel provide it with a leading position in the development and management of Outpatient Programs. The Company believes that the Case Management Programs provide the means to effectively control costs in a managed, public-sector mental health system by reducing the costs for the population that consumes the largest portion of the treatment dollars, the SMI population. In addition, the Company believes that the Company's case management model provides state-of-the-art treatment and rehabilitation services which serve to upgrade the existing provider network in a community. The Company believes the benefits of its case management model are recognized as a distinguishing feature for public-sector managed care efforts. The Company's primary existing competitors in the case management business are predominantly not-for-profit CMHCs and case management agencies. The Company anticipates that mental health managed care companies will eventually compete for this business. There can be no assurances that the Company will be able to compete successfully with its present or future competitors. -17- 18 The specialty pharmacy business is intensely competitive. There are numerous local, regional and national companies which can dispense pharmaceuticals locally or through the mail. There are also numerous companies which provide lab work and analysis services necessary for blood monitoring. Many of these companies have substantially greater resources than Stadt Solutions. While the Company believes that Stadt Solutions is the first specialty pharmacy company to focus on SMI and further believes that Stadt Solutions offers value added disease management services not typically provided by competitors, there can be no assurance that Stadt Solutions will be able to compete successfully with its present or future competitors. EMPLOYEES As of June 30, 1999, the Company employed approximately 794 employees, of which 406 are full-time employees. Approximately 685 employees staff the clinical programs and approximately 109 are in corporate management including finance, accounting, development, utilization review, training and education, information systems, human resources and legal areas. None of the Company's employees are subject to a collective bargaining agreement and the Company believes that its employee relations are good. As of June 30, 1999, Stadt Solutions employed approximately 115 employees of which 84 are full-time employees. Approximately 74 employees staff the pharmacies and approximately 41 are in corporate management. RISK FACTORS The Company's business is subject to a number of risks, including the risks described in this section and elsewhere in this Annual Report on Form 10-K. The Company's actual results could differ materially from the results projected in this Report or in any other forward-looking statements presented by management from time to time, due to some or all of such risks. Dependence Upon Medicare Reimbursement. The Company's business could be materially and adversely affected if HCFA or fiscal intermediaries deny reimbursement or challenge reimbursement claims by providers who obtain services from the Company. A significant component of the Company's revenues is derived from payments made by providers to the Company for managing and administering Outpatient Programs for providers. Substantially all of the patients admitted to the Outpatient Programs are Medicare beneficiaries for whom Medicare payments may be made if Medicare's coverage criteria are satisfied. A provider's Medicare payments can be adversely affected if HCFA or fiscal intermediaries deny coverage or claims for services furnished to Medicare eligible patients or disallow costs claimed on the basis that such costs are unreasonable, relate to uncovered services or are otherwise non-allowable. In addition, Medicare payments are subject to changes in the law or interpretation of the law governing Medicare coverage and payment. In certain instances, providers are not obligated to pay the Company's fee if coverage for claims submitted by the provider related to services furnished by the Company are denied by Medicare's fiscal intermediary. In other instances, the Company may be obligated to indemnify a provider to the extent the Company's fee charged to the provider is disallowed by Medicare's fiscal intermediary for reimbursement. The occurrence of either of these events with respect to a significant number of providers or a significant amount of fees could have a material adverse effect upon the Company's business, financial condition and results of operations. See "Business -- Regulatory Matters -- Compliance With Medicare Guidelines; Reimbursement For Partial Hospitalization Programs." The Company's programs have in the past, and may in the future, from time to time, be subject to Focused Medical Reviews or similar intensive audits. A "Focused Medical Review" consists of an intensive review by fiscal intermediaries of HCFA, on an industry-wide basis, of certain targeted claims. Focused Medical Reviews may occur for a number of reasons including, without limitation, an intermediary's concern about coverage for claims at a specific site or because HCFA has identified certain services as being at risk of inappropriate program payment. This generally occurs when HCFA identifies significant industry-wide increases in payments for certain types of services, as had been the case with partial hospitalization benefits. -18- 19 The Office of Inspector General ("OIG") of the United States Department of Health and Human Services has reported that the vast majority of partial hospitalization services furnished by CMHCs do not satisfy Medicare's coverage criteria and that many CMHCs were not properly participating in the Medicare program because they did not meet the statutory and regulatory definition of a CMHC. Consequently, HCFA has implemented a program to review all partial hospitalization services even more intensely for meeting Medicare coverage criteria and to assure that all CMHCs meet the requirements for participation in the Medicare program. This more intensive review and audits of claims for partial hospitalization services furnished by CMHCs to Medicare patients may result in a greater number of claims being denied for the Company's customers. The Company also expects more intensive reviews of claims, and increased audits by HCFA and OIG, of Hospital outpatient mental health services and partial hospitalization services including, the allowability of claims, medical necessity issues and reasonableness of fees, and presently one CMHC provider and one hospital provider is undergoing such audits. The more intensive review of claims for partial hospitalization or other outpatient mental health services furnished to Medicare patients may result in a greater number of claims being denied for the Company's customers, or disallowance of Company fees, which, as described above, may have an adverse effect on the Company's business, financial condition and results of operations. In addition, if the scrutiny of CMHCs results in termination of provider agreements between Medicare and CMHCs with which the Company has contracts, there may be an adverse effect on the Company's business, financial condition and results of operations. A CMHC outpatient program the Company formerly managed in Dallas, Texas, was the subject of a civil investigation conducted by the OIG and U.S. Attorney's Office in Dallas, Texas (previously disclosed in the Company's Annual Report on Form 10-K/A for the year ended April 30, 1998 and the Quarterly Report on Form 10-Q for the quarter ended October 31, 1998). Although the investigations were terminated, it is still possible that the outpatient program could be subject to recoupment of possible overpayment by Medicare. Further, the partial hospitalization programs managed by the Company are required under HCFA's current interpretation of the Medicare regulations, to be "provider-based" programs. This designation is important since partial hospitalization services are covered only when furnished by or "under arrangement" with, a "provider", i.e., a hospital or a CMHC. To the extent that any particular partial hospitalization program is not deemed by HCFA to be "provider based" under HCFA's current interpretation of the Medicare regulations, there would not be Medicare coverage for the services furnished at that site under Medicare's partial hospitalization benefit. HCFA has published criteria for determining when programs operated in facilities separate from a hospital's or CMHC's main premises may be deemed to be "provider-based" programs. The proper interpretation and application of these criteria are not entirely clear, and there is a risk that some or substantially all of the sites managed by the Company will be found not to be "provider-based". If such a determination is made and the Company is unable to satisfactorily restructure its contract with the provider, HCFA may cease reimbursing for the services at the provider, and HCFA may, in some situations, seek retrospective recoveries from providers. Any such cessation of reimbursement for services or retrospective recoveries could result in non-payment by providers, possibly trigger indemnity claims, and have a material adverse effect on the Company's business, financial condition and results of operations. In July 1998, HCFA notified Scripps Health that certain of its programs were approved as "provider based" and that certain other of its program locations were not "provider based" because they did not meet HCFA's service area requirements. As a result of HCFA's challenge and determination, the Company and Scripps Health amended their contract, Scripps Health reconfigured certain of its partial hospitalization programs, two locations were closed and one of the locations was taken over by another provider who engaged the Company to manage the program. In other instances, when the Company's customers have sought provider-based status determinations from HCFA upon establishing a program, HCFA's Region IX Office has interpreted the provider-based standards so as to prevent the Company from employing any personnel involved in the programs furnished by the provider except for "consultants" from the Company. This interpretation makes it more difficult for the Company to furnish the services customers want and which the Company has made its reputation furnishing. If the interpretation of provider-based standards applied by HCFA's Region IX Office are applied by other HCFA regional offices, or are adopted nationally as the correct interpretation, PMR would have to re-negotiate the vast majority of its contracts to administer partial hospitalization and other outpatient mental health programs. It is also possible that if provider-based challenges emerge with other providers, the Company may not be able to amend its contracts to satisfy HCFA or its provider customers. In addition, there can be no assurance that HCFA will not challenge the "provider based" -19- 20 status of the Scripps Health program in the future. If the Company is unable to amend its contracts to satisfy any "provider based" challenge in the future, the potential termination of any such contracts could have a material adverse effect upon the Company's business, financial condition and results of operations. See "Business -- Contracts -- Outpatient Programs," "-- Regulatory Matters -- Compliance with Medicare Guidelines; Reimbursement for Partial Hospitalization Programs." Anti-Remuneration Laws. Medicare and Medicaid law prohibits, among other things, an entity from paying or receiving, subject to certain exceptions and "safe harbors", any remuneration to induce the referral of Medicare or Medicaid beneficiaries or the purchase (or the arranging for or recommending of the purchase) of items or services for which payment may be made under Medicare, Medicaid, or other federally-funded healthcare programs. Several states have similar laws which are not limited to services for which Medicare or Medicaid payment is made. Sanctions for violating these federal and state anti-remuneration laws may include imprisonment, criminal and civil fines, and exclusion from participation in the Medicare or Medicaid programs or other applicable programs. The federal anti-remuneration law has been interpreted broadly by courts, the OIG and administrative bodies. Because of the federal statute's broad scope, the federal regulations establish certain safe harbors from liability. Some of the Company's practices do not satisfy all of the requirements necessary to fall within the applicable safe harbor. Nonetheless, a practice that does not fall within a safe harbor is not necessarily unlawful, but may be subject to scrutiny and challenge. Although the Company believes that it is in substantial compliance with the legal requirements imposed by such laws and regulations, there can be no assurance that the Company will not be subject to scrutiny or challenge under such laws or regulations, or that any such challenge would not have a material adverse effect upon the Company. Privacy and Confidentiality Legislation. Most of the Company's activities involve receipt or use by the Company of confidential medical information concerning individual clients or members. In addition, the Company uses aggregated (anonymous) data for research and analysis purposes. Legislation has been proposed at the federal level and in several states to restrict the use and disclosure of confidential medical information. To date, no such legislation has been enacted that adversely impacts the Company's ability to provide its services. However, confidentiality provisions of the Health Insurance Portability and Accountability Act of 1996 require the Secretary of Health and Human Services to establish health information privacy standards. In September 1997, the Secretary submitted recommendations to Congress to implement these standards. If Congress does not enact health information privacy legislation by August, 1999, the Secretary will be required to issue regulations on the subject. Such federal legislation could have a material adverse effect on the Company's operations. Corporate Practice of Medicine Prohibitions. The laws of many states prohibit physicians from splitting fees with non-physicians and prohibit non-physician entities from practicing medicine. These laws vary from state to state and are enforced by courts and regulatory agencies with varying and broad discretion. The Company believes that its administrative and management services with respect to its contractual arrangements do not violate such laws; however, there can be no assurance that the Company's contractual arrangements would not be successfully challenged as constituting the unlicensed practice of medicine or that the enforceability of the provisions of such arrangements will not be limited. In the event of action by any regulatory authority limiting or prohibiting the Company or any affiliate from carrying on its business, organizational modification of the Company or restructuring of its contractual arrangements may be required. Stark Laws. The Omnibus Budget Reconciliation Act of 1993 substantially broadened the scope of the federal physician self-referral act commonly known as "Stark I." "Stark II," which became effective in 1995, prohibits physicians from referring Medicare or Medicaid patients for "designated health services" to an entity with which the physician or an immediate family member of the physician has a financial relationship. The Stark laws contain certain exceptions for physician financial arrangements, and HCFA has published Stark II proposed regulations which describe the parameters of these exceptions in more detail. While Stark laws and regulations may apply to certain contractual arrangements between the Company and physicians who may refer patients to or write prescriptions ultimately filled by Stadt Solutions, the Company believes it is in compliance with such laws and -20- 21 regulations. Any determination by a court or regulatory agency that the Company's arrangements violate the Stark laws could have a material adverse effect on the Company's operating results and financial condition. State Self-Referral Laws. The Company may be subject to state statutes and regulations that prohibit payments for referral of patients and referrals by physicians to healthcare providers with whom the physicians have a financial relationship. Some state statutes and regulations apply to services reimbursed by governmental as well as private payors. Violation of these laws may result in prohibition of payment for services rendered, loss of licenses, fines and criminal penalties. The laws and exceptions or safe harbors may vary from the federal Stark laws and vary significantly from state to state. The laws are often vague, and, in many cases, have not been widely interpreted by courts and regulatory agencies. The Company believes that it is in substantial compliance with the legal requirements imposed by such laws and regulations, however there can be no assurance that the Company will not be subject to scrutiny or challenge under such laws or regulations, or that any such challenge would not have a material adverse effect upon the Company. Pharmacy Services Regulations. Various federal and state regulations govern the purchase, distribution and management of prescription drugs and affect or may affect Stadt Solutions. The Company believes that Stadt Solutions' operations are in substantial compliance with existing laws which are material to Stadt Solutions' operations. Any failure or alleged failure to comply with applicable laws and regulations could have a material adverse effect on the Company's operating results and financial condition. Stadt Solutions' services are subject to state and federal statutes and regulations governing the operation of pharmacies, repackaging of drug products, dispensing of controlled substances, medical waste disposal, labeling, advertising and adulteration of prescription drugs. Federal controlled substance laws require Stadt Solutions to register its pharmacies and repackaging facility with the United States Drug Enforcement Administration and to comply with security, recordkeeping, inventory control and labeling standards in order to dispense controlled substances. State controlled substance laws require registration and compliance with state pharmacy licensure, registration or permit standards promulgated by the state pharmacy licensing authority. Such standards often address the qualifications of an applicant's personnel, the adequacy of its prescription fulfillment and inventory control practices and the adequacy of its facilities. In general, pharmacy licenses are renewed annually. Pharmacists employed by each branch must also satisfy applicable state licensing requirements. Any failure to comply with licensing requirements of any applicable regulatory agency could impair Stadt Solutions' business and have a material adverse effect on the Company's operating results and financial condition. Pharmacy Reimbursement. A substantial portion of the revenue for Stadt Solutions is derived directly from Medicaid or other government-sponsored healthcare programs. Should there be material changes to federal or state reimbursement methodologies, regulations or policies, Stadt Solutions' reimbursement from government sponsored programs could be adversely affected. See "Compliance with Medicaid Regulations and Potential Changes" and see "Business - Stadt Solutions." Dependence on Pharmaceutical Industry. Stadt Solutions' business is dependent on research, development, manufacturing and marketing expenditures of pharmaceutical companies and the ability of such companies to develop, supply and generate demand for drugs that meet Stadt Solutions' service model. Stadt Solutions would be materially and adversely affected by unfavorable developments in the pharmaceutical industry that related to psychiatric medications including, among other things, supply shortages, adverse drug reactions, drug recalls, government or private initiative to regulate the manner in which drug manufacturers, health care providers or pharmacies promote or sell their products and services. In addition, certain drugs pertaining to Stadt Solutions' business could be rendered obsolete or uneconomical by the development of new drugs and other technological advances, which could result in a material adverse effect on Stadt Solutions' business, financial condition and results of operations. Dependence on Stadtlander. Stadt Solutions is dependent on Stadtlander for various services including, but not limited to, management information services, reimbursement services, and fulfillment services such as, purchasing, receipt and delivery of materials to Stadt Solutions. Although Stadtlander is obligated to provide such services to Stadt Solutions, there can be no assurance that Stadtlander will be able to provide adequate or timely -21- 22 services or products, or that Stadtlander will remain in business, or be able to comply with applicable government regulations or be able to maintain its applicable licenses, permits or contracts with third parties necessary to provide services to Stadt Solutions. Impact of Health Care Reform and the Balanced Budget Act of 1997. Political, economic and regulatory influences are subjecting the health care industry in the United States to fundamental change. Changes in the law, new interpretations of existing laws, or changes in payment methodology or amounts may have a dramatic effect on the relative costs associated with doing business and the amount of reimbursement provided by government or other third-party payors. In addition to specific health care legislation, both the Clinton Administration and various federal legislators have considered health care reform proposals intended to control health care costs and to improve access to medical services for uninsured individuals. These proposals have included cutbacks to the Medicare and Medicaid programs and steps to permit greater flexibility in the administration of the Medicaid program. In addition, some states in which the Company operates are considering various health care reform proposals. The Company anticipates that federal and state governments will continue to review and assess alternative health care delivery systems and payment methodologies, and that public debate on these issues will likely continue in the future. Due to uncertainties regarding the ultimate features of reform initiatives and their enactment, implementation and interpretation, the Company cannot predict which, if any, of such reform proposals will be adopted, when they may be adopted or what impact they may have on the Company. Accordingly, there can be no assurance that future health care legislation or other changes in the administration or interpretation of governmental health care programs will not have an adverse effect on the Company's business, financial condition and results of operations. The Balanced Budget Act of 1997 has adversely affected reimbursements to certain providers and payments to the Company. The Medicare benefit for partial hospitalization and outpatient mental health services has a coinsurance feature, which means that the amount payable by Medicare is reduced by the "coinsurance" amount which is ordinarily to be paid by the patient. The Medicare program has historically paid amounts designated as the patient's coinsurance obligation where the patient is indigent or if the patient does not pay the provider the billed coinsurance amounts after reasonable collection efforts. Those amounts are characterized as "allowable Medicare bad debts." The allowability of bad debts to providers is significant because most of the patients in programs managed by the Company are indigent or have very limited resources. The reduction in "allowable Medicare bad debts" under the Balanced Budget Act, as well as any future reductions that may be authorized, could have a material adverse impact on Medicare reimbursement to the Company's hospital Providers and could further result in the restructuring or loss of provider contracts with the Company. The Clinton Administration's proposal for an additional reduction to 55% for the budget year commencing October 1, 1999, and its proposal for extending this bad debt reduction to CMHCs could have an adverse effect on Medicare reimbursement to the Company's hospital providers, on reimbursement to CMHC providers, and could have a material adverse effect upon the Company's business, financial condition and results of operations. See "Business -- Regulatory Matters -- Compliance With Medicare Guidelines; Reimbursement For Partial Hospitalization Programs." In addition, under the Balanced Budget Act of 1997, state Medicaid plans that have historically paid the Medicare coinsurance amount will no longer have to pay such amounts if the amount paid by Medicare for the service equals or exceeds what Medicaid would have paid had it been the primary insurer. Some states where the Company does business have taken advantage of this new legislation and refuse to pay the Medicare coinsurance amounts on behalf of the Outpatient Program patients to the degree that they had in the past. To the extent that additional states take advantage of this law, it will have an adverse impact on the providers with whom the Company contracts, and thus may have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Regulatory Matters -- Changes In Medicare's Cost Based Reimbursement For Partial Hospitalization Services" and "-- Compliance With Medicaid Regulations and Potential Changes." The outpatient prospective payment system ("PPS") to be implemented under the Balanced Budget Act of 1997 could have an adverse effect on the business of certain providers and the Company. As presented in a proposed rule in September, 1998, Medicare would pay for $206.71 for a day of partial hospitalization services, subject to adjustment for wage costs in the provider's area. In the proposed rule, HCFA specifically solicited -22- 23 comments on the appropriate rate for partial hospitalization services. It is possible that the rate published in the final rule will differ from the proposed rate, and may be lower. The payment for outpatient mental health services furnished by hospitals will also be subject to a rate methodology and there may be changes in the proposed rates and methodology for payment in the final rule. The implementation of outpatient PPS is projected by HCFA to occur on July 1, 2000, but the actual effective date may differ. Both in contemplation of and in reaction to PPS, the Company may need to negotiate modifications to its contracts with providers, which could have a material adverse effect on the Company's business, financial condition and results of operations. The uncertainty regarding PPS has negatively effected the Company's marketing of new programs due to provider's uncertainty regarding the economic impact of the new rates. See "Business -- Regulatory Matters -- Changes in Medicare's Cost Based Reimbursement For Partial Hospitalization Services." Sufficiency of Existing Reserves to Cover Reimbursement Risks. The Company maintains significant reserves to cover the potential impact of two primary uncertainties: (i) the Company may have an obligation to indemnify certain providers for some portions of its fee which may be subject to disallowance upon audit of a provider's cost report by fiscal intermediaries; and (ii) the Company may not receive full payment of the fees owed to it by a provider during the periodic review of the provider's claims by the fiscal intermediaries. The Company has been advised by HCFA that certain program-related costs are not allowable for reimbursement. Although the Company believes that its potential liability to satisfy requirements for potential indemnity obligations or payment shortfalls has been adequately reserved in its financial statements, there can be no assurance that such reserves will be adequate. The obligation to pay the amounts estimated within the Company's financial statements (or such greater amounts as are due), if and when they become due, could have a material adverse effect upon the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business - Regulatory Matters - Compliance with Medicare Guidelines; Reimbursement for Partial Hospitalization Programs. Continuity of Management, Administrative Services and Consulting Contracts. Substantially all of the revenues of the Company are derived from contracts with providers, behavioral health organizations and case management agencies. The continued success of the Company is subject to its ability to maintain, renew, extend or replace existing management, administrative services and consulting contracts and obtain new management, administrative services and consulting contracts. These contracts generally have defined terms of duration and many have automatic renewal provisions. The contracts often provide for early termination either by the provider if specified performance criteria are not satisfied or by the Company under various other circumstances. Contract renewals and extensions are likely to be subject to competing proposals from other contract management companies as well as consideration by certain providers to terminate their mental health programs or convert their mental health programs from independently managed programs to programs operated internally. There can be no assurance that any provider or case management agency will continue to do business with the Company following expiration of its management contract or that such management contracts will not be terminated prior to expiration. In addition, any changes in the Medicare or Medicaid program which have the effect of limiting or reducing reimbursement levels for mental health services provided by programs managed by the Company could result in the early termination of existing management contracts and could adversely affect the ability of the Company to renew or extend existing management contracts and to obtain new management contracts. The termination or non-renewal of a significant number of management contracts could result in a significant decrease in the Company's net revenues and could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Contracts." Concentration of Revenues. For fiscal 1999, no Company Outpatient Program with a provider accounted for more than 10% of the Company's revenue. In addition, although not attributed to a particular "customer," the Case Management Programs accounted for 12.3% of the Company's revenue for fiscal 1999. These programs were largely operated under contracts with two managed care consortiums in the State of Tennessee and management agreements with two case management agencies. A termination or non-renewal of any of these contracts could have a material adverse effect on the Company's business, financial condition and results of operations. Further, the TennCare program has undergone significant changes since its inception and has been subjected to substantial criticism, which could result in additional structural changes which the Company cannot predict with any degree of -23- 24 certainty, and which could have a material adverse effect on the Company's business, financial condition and results of operations. For fiscal 1999, Stadt Solutions' pharmacy services accounted for 34.7% of Company's total revenue. See " -- Concentration of Revenues," "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business --Programs and Operations" -- Case Management Programs" and "Contracts -- Case Management Programs." Government Regulation. Mental health care is an area subject to extensive regulation and frequent changes in those regulations. Changes in the laws or new interpretations of existing laws can have a significant effect on the methods of doing business, costs of doing business and amounts of reimbursement available from governmental and other payors. In addition, a number of factors, including changes in the healthcare industry and the availability of investigatory resources, have resulted in increased scrutiny, inquiry and investigations by various federal and state regulatory agencies relating to the operation of healthcare companies, including the Company. The Company is and will continue to be subject to varying degrees of regulation, licensing, inquiry and investigation by health or social service agencies and other regulatory and enforcement authorities in the various states and localities in which it operates or intends to operate. The Company's business is subject to a broad range of federal, state and local requirements including, but not limited to, fraud and abuse laws, licensing and certification standards, and regulations governing the scope and quality of care. Violations of these requirements may result in civil and criminal penalties and exclusions from participation in federal and state-funded programs. The Company at all times attempts to comply with all such laws including applicable Medicare and Medicaid regulations; however, there can be no assurance that the expansion or interpretation of existing laws or regulations, or the imposition of new laws or regulations, will not have a material adverse effect on the Company's provider relationships or the Company's business, financial condition and results of operations. Risks Associated with Acquisitions. The Company currently intends as part of its business strategy to pursue acquisitions of complementary businesses as it seeks to compete in the rapidly changing healthcare industry. Acquisitions involve numerous risks, including difficulties in assimilation of the operations and personnel of the acquired business, the integration of management information and accounting systems of the acquired business, the diversion of management's attention from other business concerns, risks of entering markets in which the Company has no direct prior experience, and the potential loss of key employees of the acquired business. The Company's management will be required to devote substantial time and attention to the integration of any such businesses and to any material operational or financial problems arising as a result of any such acquisitions. There can be no assurance that operation or financial problems will not occur as a result of any such acquisitions. Failure to effectively integrate acquired businesses could have a material adverse effect on the Company's business, financial condition and results of operations. The Company intends to continue to evaluate potential acquisitions of, or investments in, companies which the Company believes will complement or enhance its existing business. Future acquisitions by the Company may result in potentially dilutive issuances of equity securities, the incurrence of additional debt and amortization expenses related to goodwill and other intangible assets which could adversely affect the Company's business, financial condition and results of operations. There can be no assurance that the Company will consummate any acquisition in the future or if consummated, that any such acquisition will ultimately be beneficial to the Company. Management of Growth. The Company expects that the Stadt Solutions pharmacy services business and its Outpatient and Case Management Programs may increase significantly as the Company pursues its growth strategy. If it materializes, this growth will place significant demands on the Company's management resources. The Company's ability to manage its growth effectively will require it to continue to expand its operational, financial and management information systems, and to continue to attract, train, motivate, manage and retain key employees. If the Company is unable to manage its growth effectively, its business, financial condition and results of operations could be adversely affected. Dependence on Key Personnel. The Company depends, and will continue to depend, upon the services of its current senior management for the management of the Company's operations and the implementation of its business strategy. In addition, the Company's success is also dependent upon its ability to attract and retain additional qualified management personnel to support the Company's growth. The loss of the services of any or all -24- 25 such individuals or the Company's inability to attract additional management personnel in the future may have a material adverse effect on the Company's business, financial condition and results of operations. The Company's success and growth strategy also will depend on its ability to attract and retain qualified clinical, marketing and other personnel. The Company competes with general acute care hospitals and other health care providers for the services of psychiatrists, psychologists, social workers, therapists and other clinical personnel. Demand for such clinical personnel is high and they are often subject to competing offers. There can be no assurance that the Company will be able to attract and retain the qualified personnel necessary to support its business in the future. Any such inability may have a material adverse effect on the Company's business, financial condition and results of operations. Psychiatric services competition. In general, the operation of psychiatric programs is characterized by intense competition. General, community and specialty hospitals, including national companies and their subsidiaries, provide many different health care programs and services. The Company anticipates that competition will become more intense as pressure to contain the rising costs of health care continues to intensify, particularly as programs such as those operated by the Company are perceived to help contain mental health care costs. Many other companies engaged in the management of outpatient psychiatric programs compete with the Company for the establishment of affiliations with acute care hospitals. Furthermore, while the Company's existing competitors in the case management business are predominantly not-for-profit CMHCs and case management agencies, the Company anticipates that other health care management companies will eventually compete for this business. Many of these present and future competitors are substantially more established and have greater financial and other resources than the Company. In addition, the Company's current and potential providers may choose to operate mental health programs themselves rather than contract with the Company. There can be no assurance that the Company will be able to compete effectively with its present or future competitors, and any such inability could have a material adverse effect on the Company's business, financial condition and results of operations. Specialty pharmacy services competition. There are numerous local, regional and national companies which can dispense pharmaceuticals locally or through the mail. There are also numerous companies which provide lab work and analysis services necessary for blood monitoring. Many of these companies have substantially greater resources than Stadt Solutions. While the Company believes that Stadt Solutions is the first specialty pharmacy company to focus on SMI and that Stadt Solutions offers value added disease management services not typically provided by competitors, there can be no assurance that Stadt Solutions will be able to compete successfully with its present or future competitors. Availability and adequacy of insurance. The provision of mental health care services entails an inherent risk of liability. In recent years, participants in the industry have become subject to an increasing number of lawsuits alleging malpractice or related legal theories, many of which involve large claims and significant defense costs. The Company currently maintains annually renewable liability insurance intended to cover such claims and the Company believes that its insurance is in conformity with industry standards. There can be no assurance, however, that claims in excess of the Company's insurance coverage or claims not covered by the Company's insurance coverage (e.g., claims for punitive damages) will not arise. A successful claim against the Company not covered by, or in excess of, the Company's insurance coverage could have a material adverse effect upon the Company's business, financial condition and results of operations. In addition, claims asserted against the Company, regardless of their merit or eventual outcome, could have a material adverse effect upon the Company's reputation and ability to expand its business, and could require management to devote time to matters unrelated to the operation of the Company's business. There can be no assurance that the Company will be able to obtain liability insurance coverage on commercially reasonable terms in the future or that such insurance will provide adequate coverage against potential claims. Shares Eligible For Sale. Sales by holders of substantial amounts of Common Stock could adversely affect the prevailing market price of the Common Stock. The number of shares of Common Stock available for sale in the public market is limited by restrictions under the Securities Act of 1933, as amended (the "Securities Act"), including Rule 144 ("Rule 144") under the Securities Act. As of June 30, 1999, the Company had 6,988,878 shares of Common Stock outstanding. Of these shares, the officers and directors of the Company and their affiliates own -25- 26 2,339,845 shares and may acquire up to 1,466,018 shares that may be issued upon the exercise of outstanding stock options and warrants. These outstanding shares and shares issued upon the exercise of the options and warrants are considered "restricted securities" and may be sold, subject to the volume limitations under Rule 144. Possible Volatility of Stock Price. The market price of the Company's Common Stock could be subject to significant fluctuations in response to various factors and events, including, but not limited to, the liquidity of the market for the Common Stock, variations in the Company's quarterly results of operations, revisions to existing earnings estimates by research analysts and new statutes or regulations or changes in the interpretation of existing statutes or regulations or market conditions affecting the health care industry generally or mental health services in particular, some of which are unrelated to the Company's operating performance. In addition, the stock market in recent years has generally experienced significant price and volume fluctuations that often have been unrelated to the operating performance of particular companies. These market fluctuations also may adversely affect the market price of the Common Stock. Concentration of Ownership, Anti-Takeover Provisions. The officers and directors of the Company and their affiliates own over 20% of the Company's issued and outstanding Common Stock (and over 30% including shares issuable upon currently exercisable stock options and warrants). Although the officers and directors do not have any arrangements or understandings among themselves with respect to the voting of the shares of Common Stock beneficially owned by such persons, such persons acting together could elect a majority of the Company's Board of Directors and control the Company's policies and day-to-day management. The Company's Board of Directors has the authority, without action by the stockholders, to issue shares of preferred stock and to fix the rights and preferences of such shares. The ability to issue shares of preferred stock, together with certain provisions of Delaware law and certain provisions of the Company's Restated Certificate of Incorporation, such as staggered terms for directors, limitations on the stockholders' ability to call a meeting or remove directors and the requirement of a two-thirds vote of stockholders for amendment of certain provisions of the Restated Certificate of Incorporation or approval of certain business combinations, may delay, deter or prevent a change in control of the Company, may discourage bids for the Common Stock at a premium over the market price of the Common Stock and may adversely affect the market price of, and the voting and other rights of the holders of, the Common Stock. Year 2000 Compliance. The year 2000 issue is the result of computer applications being written using two digits rather than four to define the applicable year. Computer applications may recognize a date using "00" as the year 1900 rather than the year 2000, resulting in system failures or miscalculations causing disruption of operations. The Company has reviewed its material computer applications for year 2000 compliance and is working with vendors and suppliers to make its computer applications year 2000 compliant. However, if any such corrections cannot be completed on a timely basis, the year 2000 issue could have a material adverse impact on the Company's business, financial condition and results of operations. Because of the many uncertainties associated with year 2000 compliance issues, and because the Company's assessment is necessarily based on information from third party vendors and suppliers, there can be no assurance that the Company's assessment is correct or as to the materiality or effect of any failure of such assessment to be correct. The Company has surveyed its contract providers to verify that their computer applications are year 2000 compliant with respect to Medicare's April 5, 1999 requirement for providers to establish a four digit "birth date" field for electronic data interface with the Medicare payor. Although over 90% of the contract providers have indicated to the Company that their software complies with Medicare's requirements, there can be no assurance that remaining vendors will assert their compliance or that any claimed compliance does not in fact prove to be incorrect. Any disruption in the reimbursement process, or the billing practices of providers or the payment practices of Medicare or other payors, could have a substantial adverse impact on Medicare or Medicaid payments to providers and, in turn, payments to the Company and upon the Company's business, financial condition and results of operations. See "Management's Discussion And Analysis of Financial Condition And Results of Operations -- Impact of Year 2000 Computer Issues." -26- 27 ITEM 2. PROPERTIES The Company owns no real property, but currently leases and subleases approximately 185,000 square feet comprised of (i) a lease for the Company's corporate headquarters at 501 Washington Street, San Diego, California expiring on April 3, 2002, (ii) a lease for its regional administration office in Nashville, Tennessee expiring in November 2001, and (iii) approximately fifty (50) leases for sites, averaging three years duration, none of which extend beyond 2003. The Company carries property and liability insurance where required by lessors and sublessors. The Company believes that its facilities are adequate for its short term needs. Leases and sub-leases, other than the short-term and month-to-month leases, generally provide for annual rental adjustments which are either indexed to inflation or have been agreed upon, and typically provide for termination on not less than ninety (90) days' written notice. ITEM 3. LEGAL PROCEEDINGS The Company is engaged in disputes with TBH regarding certain payments made to the Company for case management services. TBH has made a claim based on a sample review for approximately $4.2 million relating to payments made to the Company for case management services. TBH later, based on a subsequent sample review, reduced the claim to approximately $2.3 million. On April 8, 1999, TBH sent Company formal notice of the dispute, triggering the dispute resolution provisions of its contract. The Company provided a response denying liability for the claim and believes that the claim is without merit. TBH has the right to submit the dispute to binding arbitration, which has not occurred. A qui tam suit was filed by Anastasios Giorgiadis, a former employee of the Company, against a subsidiary of the Company in Federal District Court in the Southern District of California. This suit was filed under seal and the Company was first informed of it on July 20, 1998. Under the False Claims Act, the Department of Justice must inform the court whether it will intervene and take control of the qui tam suit. In September, 1998, the U.S. Attorney for the Southern District of California filed a Notice of Election of the United States to Decline Intervention relating to its decision not to intervene in the qui tam suit filed by the former employee of the Company. The Department of Justice decided not to intervene in this qui tam suit. On June 25, 1999, the Federal District Court for the Southern District of California granted the Company's Motion for Summary Judgment and dismissed the case. The United States gave notice that it did not oppose the dismissal, and the Company's Motion was unopposed by the relator. In January 1999, Stadtlander Operating Company, L.L.C., a subsidiary of Bergen Brunswig Corporation ("BBC") purchased the stock of Stadtlander Drug Distribution Co., Inc. In May 1999, BBC acquired PharMerica, Inc. Prior to consummation of the acquisition, the Company and Stadt Solutions unsuccessfully sought a temporary restraining order to prevent consummation of the acquisition alleging the acquisition would result in the violation of the non-compete provisions and confidentiality requirements underlying the formation of Stadt Solutions. The litigation is continuing. From time to time, the Company has been involved in routine litigation incidental to the conduct of its business. There are currently no material pending litigation proceedings to which the Company is a party. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. On March 4, 1999, the Company held its Annual Meeting of Stockholder where Susan Erskine and Richard Niglio were re-elected as directors of the Company. The following directors continued in office after the meeting: Allen Tepper, Daniel Frank, Charles McGettigan and Eugene Hill. In addition, the Company's stockholders approved an amendment to the Company's 1997 Equity Incentive Plan to increase the number of shares of common stock reserved for issuance under the plan by 1,000,000, and ratified the selection of Ernst & Young LLP as the Company's auditors for the fiscal year ending April 30, 1999. The re-election of each of Susan Erskine and Richard Niglio as directors of the Company was approved with 4,044,934.56 and 4,046,924.56 votes, respectively, in favor and 29,800 and 27,800 votes, respectively, against. The Amendment to the plan was approved with 2,284,224.56 -27- 28 votes in favor, 505,598 votes against, and 311,860 abstentions. The ratification of the selection of the auditors was approved with 4,070,924.56 votes in favor, 2,700 votes against, and 1,100 abstentions. ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY The executive officers of the Company and their ages and positions at June 30, 1999, are as follows:
NAME AGE POSITION ---- --- -------- Allen Tepper ............... 51 Chairman of the Board Mark P. Clein .............. 40 Chief Executive Officer Fred D. Furman ............. 51 President Susan D. Erskine ........... 47 Executive Vice President-Development, Secretary and Director Daniel L. Frank ............ 42 President of Disease Management Division Charles E. Galetto ......... 48 Senior Vice President-Finance and Treasurer
Allen Tepper co-founded the Company in 1988, has served as Chairman of the Board since October 1989, and served as Chief Executive Officer of the Company from October 1989 to May 1999, and President from October 1989 to April 1997. Mr. Tepper co-founded Consolidated Medical Corp., which was engaged in out-patient clinic management for acute care hospitals in the Philadelphia area. The company was subsequently sold to the Berwind Corporation in 1984 and Mr. Tepper remained with the company until December 1986 as Senior Vice President. Mr. Tepper holds a Masters of Business Administration degree from Northwestern University and a Bachelors degree from Temple University. Mark P. Clein has served as Chief Executive Officer of the Company since May 1999, and served as Executive Vice President and Chief Financial Officer of the Company from May 1996 to May 1999. Prior to joining the Company, Mr. Clein was a Managing Director of Health Care Investment Banking for Jefferies & Co., an investment banking firm, from August 1995 to May 1996, a Managing Director of Rodman & Renshaw, Inc., an investment banking firm, from March 1995 to August 1995, a Managing Director of Mabon Securities Corp., an investment banking firm, from March 1993 to March 1995, a Vice President with Sprout Group, an affiliate of Donaldson, Lufkin and Jenrette, Inc., from May 1991 to March 1993, and a Vice President and partner with Merrill Lynch Venture Capital, Inc. from 1982 to February 1990 and from August 1990 to February 1991. Mr. Clein holds a Masters of Business Administration degree from Columbia University and a Bachelors degree from the University of North Carolina. Fred D. Furman has served as President of the Company since April 1997. Previously, he held the position of Executive Vice President -- Administration and General Counsel from March 1995 to April 1997. Prior to joining the Company, Mr. Furman was a partner at Kleinbard, Bell and Brecker, a Philadelphia law firm from 1980 to March 1995. Mr. Furman is a member of the National Health Lawyers Association. He holds a Juris Doctor degree and a Bachelors degree from Temple University. Susan D. Erskine co-founded the Company in 1988 and has served as Executive Vice President, Secretary and a director of the Company since October 1989. Ms. Erskine previously served in several operational and marketing management positions with acute care hospitals and health care management organizations. Ms. Erskine holds a Masters in Health Science degree and completed post-graduate work at Stanford University in Education and Psychology, and she holds a Bachelors degree from the University of Miami. Daniel L. Frank has served as President of the Disease Management division of the Company since April 1998. This division is responsible for the development of Stadt Solutions and its integrated managed care initiative. Mr. Frank has also served as a director of the Company since 1992. Previously, Mr. Frank was President of Coram -28- 29 Healthcare's Lithotripsy division from 1996 until its sale in 1997. Prior to that, Mr. Frank was Chief Executive Officer of Western Medical Center - Anaheim and Santa Ana Health, Inc. from 1993 to 1996. From 1991 to 1993, he was President of Summit Ambulatory Network. Charles E. Galetto has served as Senior Vice President-Finance and Treasurer of the Company since August 1997. Prior to joining the Company, Mr. Galetto was Vice President-Corporate Controller of Medtrans, a medical transportation company, from June 1996 to July 1997 and Vice President, Chief Financial Officer, Treasurer and Secretary of Data/Ware Development, Inc., a computer hardware and software developer, from 1989 to May 1996. Mr. Galetto holds a Bachelors degree from Wayne State University. Mr. Galetto will resign as an officer and employee of the Company effective July 31, 1999. -29- 30 PART II ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) MARKET INFORMATION The Company's Common Stock (NASDAQ symbol "PMRP") is traded publicly through the NASDAQ National Market. The following table represents quarterly information on the price range of the Company's Common Stock. This information indicates the high and low sale prices reported by the NASDAQ National Market. These prices do not include retail markups, markdowns or commissions:
HIGH LOW ------ ------ Quarters for the year ended April 30, 1999 First Quarter ........................ $15.25 $ 8.88 Second Quarter ....................... $10.31 $ 5.50 Third Quarter ........................ $ 8.88 $ 6.75 Fourth Quarter ....................... $ 8.88 $ 4.19 Quarters for the year ended April 30, 1998 First Quarter ........................ $24.13 $16.88 Second Quarter ....................... $24.50 $19.13 Third Quarter ........................ $23.63 $17.00 Fourth Quarter ....................... $19.50 $10.50
(b) HOLDERS As of July 15, 1999 there were 103 holders of record of the Company's Common Stock. (c) DIVIDENDS It is the policy of the Company's Board of Directors to retain earnings to support operations and to finance continued growth of the Company rather than to pay dividends. The Company has never paid or declared any cash dividends on its Common Stock and does not anticipate paying any cash dividends in the foreseeable future. The Company's credit facility contains certain restrictions and limitations, including the prohibition against payment of dividends on Common Stock. (d) RECENT SALES OF UNREGISTERED SECURITIES From May 1, 1998 to April 30, 1999, the Company has not sold any unregistered securities. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with the Company's consolidated financial statements and the accompanying notes included elsewhere herein.
YEARS ENDED APRIL 30, --------------------------------------------------------------------- 1999 1998 1997 1996 1995 -------- -------- -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) INCOME STATEMENT INFORMATION Revenues (1) ......................... $ 85,489 $ 67,524 $ 56,637 $ 36,315 $ 21,747 Net Income (loss)(2)(3) .............. (447) 1,788 3,107 918 (2,352) Net Income (loss) per share Basic .............................. (.06) .30 .66 .26 (.71) Diluted ............................ (.06) .27 .55 .23 (.71) WEIGHTED SHARES OUTSTANDING Basic .............................. 6,924 6,053 4,727 3,484 3,336 Diluted ............................ 7,300 6,695 5,646 4,471 3,336
-30- 31 PRO FORMA INFORMATION Pro forma net income and earnings per share as if cumulative change had occurred for all periods presented: Pro forma net income (loss) available to common stock shareholders ......... 146 1,422 2,869 960 (2,360) Pro forma earnings (loss) per share: Basic ............................. .02 .24 .61 .28 (.71) Diluted ........................... .02 .21 .51 .22 (.71)
AS OF APRIL 30, --------------------------------------------------------------------- 1999 1998 1997 1996 1995 -------- -------- -------- -------- -------- (in thousands) BALANCE SHEET INFORMATION Working Capital ...................... $ 52,233 $ 52,150 $ 17,036 $ 10,911 $ 8,790 Total Assets ......................... 70,966 70,449 32,450 21,182 14,811 Long Term Debt ....................... 294 392 0 0 126 Total Liabilities .................... 18,315 16,573 16,202 12,070 7,749 Stockholders' Equity ................. 52,651 53,876 16,248 9,112 7,062
(1) In fiscal 1999, approximately $30 million of revenues were attributable to a new product line in pharmaceuticals, which commenced in July 1998 through the formation of Stadt Solutions. (2) In fiscal 1999, the Company had a write-off of costs after income taxes of $951,000 relating to a terminated acquisition. (3) In fiscal 1999 and 1998, the Company had a special charge (credit) after income taxes of ($154,000) and $1,194,000, respectively.
QUARTERS FOR THE YEARS ENDED, -------------------------------------------------------------------------------------------------- APRIL 30, 1999 APRIL 30, 1998 --------------------------------------------- --------------------------------------------- 7/31/98 10/31/98 1/31/99 4/30/99 7/31/97 10/31/97 1/31/98 4/30/98 ------- -------- ------- ------- ------- -------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Revenues ............ 17,851 22,417 21,989 23,232 16,177 17,561 16,522 17,264 Net income (loss) ... 478 89 178 (1,192) 970 1,162 1,327 (1,671) Net income (loss) per Share Basic ............. .07 .01 .03 (.17) .19 .22 .19 (.24) Diluted ........... .07 .01 .02 (.17) .17 .19 .18 (.22)
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the more detailed information and consolidated financial statements and accompanying notes, as well as the other financial information appearing elsewhere in this document. Except for historical information, the following discussion contains forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Risk Factors," as well as those discussed elsewhere in this document. -31- 32 OVERVIEW PMR is a leading manager of specialized mental health care programs and disease management services designed to treat individuals diagnosed with SMI. PMR manages and administers the delivery of a broad range of outpatient and community-based psychiatric services for SMI patients, consisting of 37 Outpatient Programs, two Case Management Programs and four Chemical Dependency Programs. Stadt Solutions, the Company's majority owned subsidiary with Stadtlander, offers a specialty pharmacy program for individuals with SMI, which presently serves approximately 7,500 individuals through fifteen pharmacies in fourteen states. Stadt Solutions received the Company's clinical research and information business upon formation. PMR, including Stadt Solutions, operates in approximately twenty-five states and employs or contracts with more than 400 mental health and pharmaceutical professionals and provide services to approximately 11,000 individuals diagnosed with SMI. SOURCES OF REVENUE Outpatient Programs. Outpatient Programs managed or administered by PMR are the Company's primary source of revenue. Revenue under these programs is derived primarily from services provided under three types of agreements: (i) all-inclusive fee arrangements based on fee-for-service rates (based on units of service provided) under which the Company is responsible for substantially all direct program costs; (ii) fee-for-service arrangements under which the provider maintains responsibility for a large extent of direct program costs; and (iii) fixed fee arrangements where the Company's fee is a fixed monthly sum and the provider assumes substantially all program costs. The all-inclusive arrangements are in effect at 33 of the 39 Outpatient Programs operated during fiscal 1999 and constituted 69.4% of the Company's psychiatric care revenue for the year ended April 30, 1999. These contractual agreements are with hospitals or CMHCs, and require the Company to provide, at its own expense, specific management personnel for each program site. Patients served by the Outpatient Programs typically are covered by Medicare. Revenue under the Outpatient Program is recognized at estimated net realizable amounts when services are rendered based upon contractual arrangements with providers. Under certain of the Company's contracts, the Company is obligated to indemnify the provider for all or some portion of the Company's fees that may not be deemed reimbursable to the provider by Medicare's fiscal intermediaries. As of April 30, 1999, the Company had recorded $6.7 million in contract settlement reserves to provide for possible amounts ultimately owed to its provider customers resulting from disallowance of costs by Medicare and Medicare cost report settlement adjustments. Such reserves are classified as non-current liabilities because ultimate determination of substantially all of the potential contract disallowances is not anticipated to occur during fiscal 1999. See "Risk Factors -- Dependence Upon Medicare Reimbursement" and "-- Sufficiency of Existing Reserves to Cover Reimbursement Risks." Case Management Programs. For its Case Management Programs in Tennessee, the Company receives a monthly case rate fee from the managed care consortiums responsible for managing the TennCare program and is responsible for planning, coordinating and managing psychiatric case management services for its consumers who are eligible to participate in the TennCare program. The Company also is responsible for providing a portion of the related outpatient clinical care under certain of the agreements. Revenue under the TennCare program is recognized in the period in which the related service is to be provided. These revenues represent substantially all of the Company's case management revenues. The urgent care program receives interim payments which are adjusted based on inpatient utilization statistics which are compared to a baseline. Revenues are recognized based on the quarterly calculation of the statistical trends. See "Risk Factors -- Concentration of Revenues," "-- Concentration of Revenues" and "--Limited Operating History of Case Management Programs." Chemical Dependency Programs. In Southern California, the Company contracts primarily with managed care companies and commercial insurers to provide its outpatient chemical dependency services. The contracts are structured as fee-for-service or case rate reimbursement and revenue is recognized in the period in which the related service is delivered. Pharmaceuticals. Through Stadt Solutions, the Company offers specialty pharmaceutical services to individuals with SMI. Stadt Solutions also offers site management and clinical information services to -32- 33 pharmaceutical companies, health care providers and public sector purchasers. Stadt Solutions serves clients through a variety of pharmacies offering anti-psychotic or other medications for individuals with schizophrenia or other serious mental illnesses as well as offering blood monitoring services. Stadt Solutions will seek to offer patients expanded services, including dispensing of all of the pharmaceuticals needed by these individuals and providing disease management services to improve compliance and education for the patient, the physician and family members. Stadt Solutions records pharmaceutical revenue when the product is sold to customers at pharmacies, net of any estimated contractual allowances. See "Risk Factors - Pharmacy Services Regulations" "- Pharmacy Reimbursement." RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, the percentage of revenue represented by the respective financial items:
YEAR ENDED APRIL 30, --------------------------------- 1999 1998 1997 ----- ----- ----- Revenue .......................................... 100.0% 100.0% 100.0% ----- ----- ----- Operating expenses ............................... 75.7 71.5 73.7 Marketing, general and administrative ............ 14.4 13.6 10.7 Provision for bad debts .......................... 9.4 7.6 5.4 Depreciation and amortization .................... 1.3 1.6 1.2 Acquisition expense .............................. 1.9 -- -- Special Charge ................................... (.3) 3.0 -- Interest (income), expense ....................... (1.9) (1.8) (0.4) ----- ----- ----- Total expenses ................................... 100.5 95.5 90.6 ----- ----- ----- Income (loss) before minority interest, income taxes and cumulative change ...................... (.5) 4.5 9.4 Minority interest ................................ .8 -- -- ----- ----- ----- Income before income taxes and cumulative change.. .3 4.5 9.4 Income tax expense ............................... .1 1.9 3.9 ----- ----- ----- Net income before cumulative change .............. .2 2.6 5.5 Cumulative change, net of income tax benefit ..... .7 -- -- ----- ----- ----- Net income (loss) ................................ (.5%) 2.6% 5.5% ===== ===== =====
YEAR ENDED APRIL 30, 1999 COMPARED TO YEAR ENDED APRIL 30, 1998 Revenue - Psychiatric Care. Revenues from psychiatric care decreased from $67.5 million for the year ended April 30, 1998 to $55.8 million for the year ended April 30, 1999, a decrease of $11.7 million, or 17.3%. The Outpatient Programs recorded revenues of $43.7 million, a decrease of $5.7 million or 11.5% as compared to fiscal 1998. The decrease in revenues was due to a net reduction of five outpatient programs versus a year ago. This reduction was partially offset by same site revenue growth of 8.6% in the Outpatient Programs. The Outpatient Programs operated under an all-inclusive fee arrangement had operating margins of 34.2% in the year ended April 30, 1999 as compared to 35.7% in the year ended April 30, 1998. The Company's Case Management Programs recorded revenues of $10.5 million, a decrease of $4.6 million, or 30.5%, from the year ended April 30, 1998. The decrease in revenues was due to the restructuring of the Company's relationship with Case Management, Inc. and the termination of two Case Management Programs in Arkansas. Revenues from the Company's Chemical Dependency and other programs not included as outpatient or case management were $1.3 million, a decrease of 46.7% from the year ended April 30, 1998. The decrease in revenues was associated primarily with the Company's termination of two Chemical Dependency Programs in Arkansas. -33- 34 Revenue - Pharmaceuticals. Revenues of $29.7 million from pharmaceutical care represent sales of pharmaceutical products to approximately 7,500 individuals with SMI through 15 pharmacies serving Stadt Solutions since its formation in July 1998. Direct Operating Expenses - Psychiatric Care. Direct operating expenses consist of costs incurred at the program sites and costs associated with the field management responsible for administering the programs. Direct operating expenses decreased from $48.2 million for the year ended April 30, 1998 to $38.6 million for the year ended April 30 ,1999, a decrease of $9.6 million, or 19.9%. As a percentage of psychiatric care revenues, psychiatric care operating expenses were 69.1%, down from 71.5% for the year ended April 30, 1998. The overall decrease in direct operating expenses and the improvement in the operating expense ratio was primarily due to the net closing of five Outpatient Programs, three Case Management Programs and two Chemical Dependency Programs, which in the aggregate, had lower patient volume and higher expense ratios than the remaining programs. The Company also restructured its agreement with Case Management, Inc., which reduced recognized revenue but improved operating margins. Cost of Sales - Pharmaceuticals. Cost of sales of pharmaceutical products of $22.0 million represent the cost of providing such products since the formation of Stadt Solutions in July 1998. The costs represent 74.1% of pharmaceutical revenue and includes product costs. Direct Operating Expenses - Pharmaceuticals. Direct operating expenses of pharmaceutical care of $4.2 million consist of the operating costs incurred at the 15 pharmacies serving Stadt Solutions and related billing costs since the formation of Stadt Solutions in July 1998. Marketing, General and Administrative. Marketing, general and administrative expenses increased from $9.2 million for the year ended April 30, 1998 to $12.3 million for the year ended April 30, 1999, an increase of $3.1 million or 33.7%. The increase was related to investment in the corporate headquarters to support existing and anticipated programs, including the Stadt Solutions venture and a coordinated care initiative in Southern California. As a percentage of total revenues, marketing, general and administrative expenses were 14.4% for the year ended April 30, 1999, as compared to 13.6% for fiscal year 1998. The increase in marketing, general and administrative expenses as a percent of revenue was due to an increase in support costs related to the coordinated care initiative without a proportionate increase in coordinated care revenue, partially offset by a significant increase in pharmaceutical revenues without proportionate increases in administrative expenses. Provision for Bad Debts. Expenses related to the provision for bad debts increased from $5.1 million for the year ended April 30, 1998 to $8.1 million for the year ended April 30, 1999, an increase of $3.0, or 58.8%. The increase was due to reserve against revenue from sales of the new product segment pharmaceutical products and to a higher provision rate for bad debt associated with a less than expected collection experience in pharmaceutical products and certain Outpatient Programs that were subject to a high level of review from fiscal intermediaries. As a percentage of revenues, the provision for bad debts increased to 9.4% of revenues for the year ended April 30, 1999 from 7.6% in fiscal 1998. The Company expects this accrual to fluctuate based on the amount of claims under review in its Outpatient Programs and the number of programs that the Company operates which serve a significant indigent population. Depreciation and Amortization. Depreciation and amortization expenses increased from $1,065,000 for the year ended April 30, 1998 to $1,117,000 for the year ended April 30, 1999, an increase of $52,000, or 4.9%. The increase was due to additional capital expenditures associated with new Outpatient Programs and increased capital expenditures for information systems. Write-off of Costs Related to Terminated Acquisition. Acquisition expenses consist of legal, advisory, accounting, consulting, and other costs related to the terminated definitive merger agreement with Behavioral Health Corporation. Previously capitalized acquisition expenses written-off for the year ended April 30, 1999 were $1.6 million. No Acquisition expenses were recorded in the year ended April 30, 1998. -34- 35 Special Charge Credit in Fiscal 1999. The special charge credit relates primarily to a favorable settlement of disputes and the restructuring of the relationship with Case Management, Inc. ("CMI"). The Company had incurred a special charge relating to the closing of several programs identified in the year ended April 30, 1998, which included a special charge relating to CMI. The outcome of the dispute in August 1998, which was better than anticipated as of April 30, 1998, involved the return of common stock that was previously issued to CMI as part of the consideration for a restrictive covenant, a cash settlement and the release of claims against the Company for certain liabilities. The Company has reflected the return of common stock as treasury stock in the statement of stockholders' equity at a fair market value of $418,750, at the date of settlement. At the time of original issuance, an intangible asset for the common stock was valued at fair market value of $256,250 and was amortized over the term of the restrictive covenant of 72 months. At April 30, 1998, the net book value of the intangible asset was $158,000 and was fully reserved in the special charge. The other components of the special charge credit were a cash settlement of $150,000 for accounts receivable which were fully reserved, the release of certain liabilities relating to unemployment taxes of $94,000, and other items of $15,542. Additional components of the special charge credit include a charge of $416,000 to write down certain goodwill and certain property and equipment. The charges relate to goodwill at the Company's chemical dependency program and property and equipment at the Company's chemical dependency program and several additional sites. The write down of these assets resulted from a failure of the chemical dependency business to provide sufficient cash flow to recover the Company's investment in this line of business. Net Interest Income. Interest income, net of interest expense, increased from $1,187,000 for the year ended April 30, 1998 to $1,610,000 for the year ended April 30, 1999, an increase of $423,000, or 35.6%. This increase resulted from higher cash and cash equivalent and short-term investment balances resulting from the completion of the Company's follow-on common stock offering in October 1997, partially offset by non-recurring interest expense on income taxes of $358,000. Income (Loss) Before Minority Interest, Income Taxes and Cumulative Change. Income (loss) before minority interest, income taxes and cumulative change decreased from $3.0 million for the year ended April 30, 1998 to a loss of $.4 million for the year ended April 30, 1999, a decrease of $3.4 million. Minority Interest. Minority interest of $677,000 represents the allocation of the operating losses of Stadt Solutions during the year ended April 30, 1999 to the minority shareholder as required by the Stadt Solutions Operating Agreement. Cumulative Change. The cumulative change of $593,000 represents the effect, net of income tax benefit of $411,000, of writing off previously capitalized start-up costs. The Company adopted this change in accounting principle in the first quarter of fiscal 1999 consistent with the requirements of Accounting Standards Executive Committee's Statement of Position 98-5, Reporting on Costs of Start-up Activities. YEAR ENDED APRIL 30, 1998 COMPARED TO YEAR ENDED APRIL 30, 1997 Revenue. Revenue increased from $56.6 million for the year ended April 30, 1997 to $67.5 million for the year ended April 30, 1998, an increase of $10.9 million, or 19.2%. The Outpatient Programs recorded revenue of $49.4 million, an increase of 23.5% as compared to fiscal 1997. The growth in Outpatient Programs was the result of the addition of nine new programs in fiscal 1998 and increases in "same-site" revenues of 11.7% compared to fiscal 1997. The remainder of the increase in revenue came from the growth in Case Management Programs in Tennessee and Arkansas, which recorded revenue of $15.1 million, an increase of $1.4 million or 10.4% as compared to fiscal 1997. Revenue from the Chemical Dependency Programs was $3.0 million, an increase of 1.0% as compared to fiscal 1997. The Company is currently in the process of terminating or restructuring its relationship with a Tennessee case management agency and during fiscal 1998 terminated its Arkansas Case Management Programs. See "Business -- Programs and Operations --Case Management Programs." The all-inclusive -35- 36 Outpatient Programs operated during fiscal 1998 had an operating margin for the year ended April 30, 1998 of 35.7% as compared to 31.9% for the year ended April 30, 1997. Operating Expenses. Operating expenses consist of costs incurred at the program sites and costs associated with the field management responsible for the administering the programs. Operating expenses increased from $41.7 million for the year ended April 30, 1997 to $48.2 million for the year ended April 30, 1998, an increase of $6.5 million, or 15.6%. As a percentage of revenue, operating expenses were 71.5%, down from 73.7% for the year ended April 30, 1997. The improvement in the operating expense ratio was due to reductions in bonus expenses of $680,000 as well as operating leverage realized as a result of revenue growth in the Outpatient and Case Management Programs which was spread across existing fixed and semi-variable cost structures. Marketing, General and Administrative. Marketing, general and administrative expenses increased from $6.0 million for the year ended April 30, 1997 to $9.2 million for the year ended April 30, 1998, an increase of $3.2 million, or 53.3%. The increase was due to investment in both the regional and home offices to support existing and anticipated programs. As a percentage of revenue, marketing, general and administrative expenses were 13.6% for the year ended April 30, 1998, as compared to 10.7% for the year ended April 30, 1997. Provision for Bad Debts. Provision for bad debt expense increased from $3.1 million for the year ended April 30, 1997 to $5.1 million for the year ended April 30, 1998, an increase of $2.0 million, or 64.5%. The increase was due to anticipated difficulties associated with collection of receivables relating to program locations closed in the fourth quarter of fiscal 1998. As part of a special charge in the fourth quarter of fiscal 1998, the Company recorded approximately $2.4 million in additional bad debt expenses associated with the closed programs. Special Charge. A Special Charge of $4.4 million was recorded in the fourth quarter to provide for costs associated with closing several programs, resolving the provider based status associated with the Scripps Health programs and resolving other regulatory matters. Included in this charge is a $2.4 million bad debt expense which was recorded in provision for bad debts. The remaining $2.0 million was allocated to program closing costs which were $1.4 million and costs associated with noncancelable contract obligations which were $600,000. Depreciation and Amortization. Depreciation and amortization expense increased from $701,000 for the year ended April 30, 1997 to $1,065,000 for the year ended April 30, 1998, an increase of $364,000 or 51.9%. The increase was due to additional capital expenditures associated with the start-up of new programs during fiscal 1998 and as well as equipment and leasehold improvements associated with the Company's corporate office. Net Interest Income. Interest income increased from $217,000 for the year ended April 30, 1997 to $1,187,000 for the year ended April 30, 1998, an increase of $970,000 or 447.0%. This increase resulted from higher cash and cash equivalent and short-term investment balances resulting from the completion of the Company's common stock offering in October 1997. Income Before Income Taxes. Income before income taxes decreased from $5.3 million for the year ended April 30, 1997 to $3.0 million for the year ended April 30, 1998, a decrease of $2.3 million, or 43.4%. Income before income taxes as a percentage of revenue decreased from 9.4% to 4.5% over this period of time. LIQUIDITY AND CAPITAL RESOURCES For the year ended April 30, 1999, net cash used in operating activities was $6.8 million. Working capital at April 30, 1999 was $52.2 million, an increase of $83,000, as compared to working capital at April 30, 1998. Cash and cash equivalents and short-term investments at April 30, 1999 were $33.0 million, a decrease of $5.8 million or 14.9% as compared to April 30, 1998. The Company experienced growth in accounts receivable due to significant revenue increases partially offset by a decrease in days revenue outstanding from 88 at April 30, 1998 to 76 at April 30, 1999. The decrease in days revenue outstanding was due to a reclassification of approximately $3.0 million in current accounts receivable to notes and long term receivables and a change in the receivables mix, with pharmacy related receivables, which -36- 37 experience shorter payment cycles comprising a larger portion of the base. The largest source of accounts receivable growth has been from pharmaceutical services, which has accumulated $6.9 million in accounts receivable since the commencement of operations on July 1, 1998. The other significant use of cash was leasehold improvements associated with recently opened sites and investment in information technology. Working capital available to finance fiscal 2000 obligations is expected to be provided principally from operations, as well as from a $10 million line of credit from Sanwa Bank. Interest is payable under this line of credit at either the bank's reference rate or the Eurodollar rate plus 2%. As of April 30, 1999, no balance was outstanding under the line of credit. Working capital is anticipated to be utilized during fiscal 2000 to continue expansion of the Company's Outpatient and Case Management Programs, for expansion of Stadt Solutions' pharmacy services, and for the development of a risk based coordinated care project. Pursuant to the terms of the Stadt Solutions Subscription Agreement and Operating Agreement, the Company invested approximately $2.5 million into Stadt Solutions during the year ended April 30, 1999 to fund the second closing and provide sufficient working capital for operations. The Company also anticipates using working capital and, if necessary, incurring indebtedness in connection with, selective acquisitions. In December 1998, the Board of Directors authorized the Company to repurchase up to 350,000 shares of its common stock, approximately 5% of the Company's outstanding common stock. Purchased shares will be used for corporate purposes including issuance under PMR's stock compensation plans. The purchases will be made from time to time in open market transactions. As of April 30, 1999, the Company repurchased 90,000 shares of its common stock at an average price of $5.81 per share, or $523,750, in open market transactions. In May 1999, the Company repurchased an additional 200,000 shares of its common stock at a price of $3.75 per share, or $750,000, in open market transactions. These shares were held in treasury. The opening of a new Outpatient Program site typically requires $45,000 to $150,000 for office equipment, supplies, lease deposits, leasehold improvements and the hiring and training of personnel prior to opening. These programs generally experience operating losses through an average of the first four months of operation. The Company expects to provide cash for the start up of the site management and clinical information business as part of the growth strategy of Stadt Solutions. From time to time, the Company recognizes charges to operations as a result of particular uncertainties associated with the health care reimbursement rules as they apply to the Outpatient Programs. During fiscal 1998 and 1999, a majority of the Company's psychiatric care revenue was derived from the management of its Outpatient Programs. Since substantially all of the patients of the Outpatient Programs are eligible for Medicare, collection of a significant component of the Company's management fees is dependent upon reimbursement of claims submitted to fiscal intermediaries by the hospitals or CMHCs on whose behalf these programs are managed. Certain of the Company's contracts with its providers contain warranty obligations that require the Company to indemnify such providers for the portion of the Company's management fee disallowed for reimbursement. Although the Company believes that its potential liability to satisfy such requirements has been adequately reserved in its financial statements, the obligation to pay such amounts, if and when they become due, could have a material adverse effect on the Company's short term liquidity. Certain factors are, in management's view, likely to lessen the impact of any such effect, including the expectation that, if claims arise, they will arise on a periodic basis over several years and that any disallowance will merely be offset against obligations already owed by the provider to the Company. The Company maintains significant reserves to cover the potential impact of two primary uncertainties: (i) the Company may have an obligation to indemnify certain providers for some portions of its management fee which may be subject to disallowance upon audit of a provider's cost report by fiscal intermediaries; and (ii) the Company may not receive full payment of the management fees owed to it by a provider during the periodic review of the provider's claims by the fiscal intermediaries. The Company has been advised by Health Care Financing Administration that certain program-related costs are not allowable for reimbursement. The Company may be responsible for reimbursement of the amounts previously paid to the Company that are disallowed pursuant to indemnity obligations that exist with certain -37- 38 providers. Although the Company believes that its potential liability to satisfy such requirements has been adequately reserved in its financial statements, there can be no assurance that such reserves will be adequate. The obligation to pay the amounts estimated within the Company's financial statements (or such greater amounts as are due), if and when they become due, could have a material adverse effect upon the Company's business, financial condition and results of operations. In the first quarter of fiscal year 2000, the Company has closed six outpatient psychiatric program locations. In addition, in July, 1999, the Company determined to restructure certain departments company-wide in an effort to streamline functions and improve efficiencies. The restructuring will involve the reduction in force and consolidation of responsibilities. The Company anticipates that it will incur a charge related to such site closures and restructure due to severance and lease obligations. IMPACT OF INFLATION A substantial portion of the Company's revenue is subject to reimbursement rates that are regulated by the federal and state governments and that do not automatically adjust for inflation. As a result, increased operating costs due to inflation, such as labor and supply costs, without a corresponding increase in reimbursement rates, may adversely affect the Company's earnings in the future. IMPACT OF YEAR 2000 COMPUTER ISSUES The year 2000 issue is the result of computer applications being written using two digits rather than four to define the applicable year. The Company's computer applications (and computer applications used by any of the Company's customers, vendors, payors or other business partners) may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations causing disruption of operations. The Company has completed a thorough review of its material computer applications and has identified and scheduled necessary corrections for its computer applications. Corrections are currently being made and are expected to be substantially implemented by the second quarter of fiscal 2000. The Company expects that the total cost associated with these revisions will not be material. These costs were primarily incurred during fiscal 1999 and charged to expense as incurred. For externally maintained systems, the Company has begun working with vendors to ensure that each system is currently year 2000 compliant or will be made year 2000 compliant during 1999. The cost to be incurred by the Company related to externally maintained systems is expected to be minimal. The Company believes that by completing its planned corrections to its computer applications, the year 2000 issue with respect to the Company's systems can be mitigated. However, if such corrections cannot be completed on a timely basis, the year 2000 issue could have a material adverse impact on the Company's business, financial condition and results of operations. Because of the many uncertainties associated with year 2000 compliance issues, and because the Company's assessment is necessarily based on information from third party vendors and suppliers, there can be no assurance that the Company's assessment is correct or as to the materiality, worst case scenario or effect of any failure of such assessment to be correct. The Company has initiated a program to determine whether the computer applications of its significant payors and contract providers will be upgraded in a timely manner. The Company has not completed this review and it is unknown whether computer applications of contract providers and Medicare and other payors will be year 2000 compliant. The Company has not determined the extent to which any disruption in the billing practices of providers or the payment practices of Medicare or other payors caused by the year 2000 issues will affect the Company's operations. However, any such disruption in the billing or reimbursement process could have a substantial adverse impact on Medicare or Medicaid payments to providers and, in turn, payments to the Company. Any such disruption could have a material adverse effect upon the Company's business, financial condition and results of operations. The Company has not established a contingency plan in the event of any such disruption or worst case scenario. Stadt Solutions has completed a review and assessment of its applications and systems and is expected to complete all required remediation. The cost to be incurred by Stadt Solutions related to such remediation, and the -38- 39 extent of such remediation, is expected to be minimal. Stadt Solutions believes that by completing the planned corrections to its applications and systems, the year 2000 issue with respect to its applications and systems can be mitigated. However, if such corrections cannot be completed on a timely basis, the year 2000 issue could have a material adverse impact on Stadt Solutions' business, financial condition and results of operations. Because of the many uncertainties associated with year 2000 compliance issues, including uncertainties or disruption in the payment practices of Medicaid or other payors, and because Stadt Solutions' assessment is necessarily based on information from third party vendors and suppliers and Stadtlander, there can be no assurance that the Company's assessment is correct or as to the materiality, worst case scenario or effect of any failure of such assessment to be correct. Stadt Solutions has not established a contingency plan in the event of any such disruption or worst case scenario. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK. The Company does not and did not invest in market risk sensitive instruments in fiscal 1999. The Company had and has no exposure to market risk with regard to changes in interest rates. The Company does not and has not used derivative financial instruments for any purposes, including hedging or mitigating interest rate risk. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements and supplementary data of the Company are provided at the pages indicated in Item 14(a). ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has not been any change of accountants or any disagreements with the Company's accountants on any matter of accounting practice or financial disclosure during the reporting periods. -39- 40 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS Information with regard to this item is incorporated by reference to the definitive 1999 Proxy Statement to be filed with the Securities and Exchange Commission within 120 days of April 30, 1999, under the caption "Election of Directors." See "Item 4. Executive Officers of the Company" with regard to Executive Officers. ITEM 11. EXECUTIVE COMPENSATION Information with regard to this item is incorporated by reference to the definitive 1999 Proxy Statement to be filed with the Securities and Exchange Commission within 120 days of April 30, 1999, under the caption "Additional Information - Management Compensation." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information with regard to this item is incorporated by reference to the definitive 1999 Proxy Statement to be filed with the Securities and Exchange Commission within 120 days of April 30, 1999, under the caption "Principal Stockholders." ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information with regard to this item is incorporated by reference to the definitive 1999 Proxy Statement to be filed with the Securities and Exchange Commission within 120 days of April 30, 1999, under the caption "Additional Information - Certain Transactions." -40- 41 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS ANNUAL REPORT ON FORM 10K: 1. Financial Statements: The financial statements of PMR are included as Appendix F of this report. See Table of Contents to Financial Statements in Appendix F. 2. Financial Statement Schedules: Schedule II-PMR Corporation Valuation and Qualifying Accounts is included in Appendix F of this report. See Table of Contents to Financial Statements in Appendix F. 3. The exhibits which are filed with this Report or which are incorporated herein by reference are set forth in the Exhibit Index on page 41. (b) REPORTS ON FORM 8-K: The Company did not file any reports on Form 8-K during the fourth quarter of fiscal 1999. (c) EXHIBITS:
EXHIBIT NUMBER DESCRIPTION ------ ----------- 3.1 The Company's Restated Certificate of Incorporation, filed with the Delaware Secretary of State on March 9, 1998.+ 3.2 The Company's Amended and Restated Bylaws.* 4.1 Common Stock Specimen Certificate.** 10.1 The Company's 1997 Equity Incentive Plan (filed as Exhibit 10.1).* 10.2 Form of Incentive Stock Option Agreement under the 1997 Plan (filed as Exhibit 10.2).* 10.3 Form of Nonstatutory Stock Option Agreement under the 1997 Plan (filed as Exhibit 10.).* 10.4 Outside Directors' Non-Qualified Stock Option Plan of 1992 (the "1992 Plan") (filed as Exhibit 10.4).* 10.5 Form of Outside Directors' Non-Qualified Stock Option Agreement (filed as Exhibit 10.5).* 10.6 Amended and Restated Stock Option Agreement dated April 30, 1996, evidencing award to Allen Tepper (filed as Exhibit 10.6).* 10.7 Amended and Restated Stock Option Agreement dated April 30, 1996, evidencing award to Susan Erskine (filed as Exhibit 10.7).* 10.8 Amended and Restated Stock Option Agreement dated February 1, 1996, evidencing award to Mark Clein (filed as Exhibit 10.8).* 10.9 Amended and Restated Stock Option Agreement dated February 1, 1996, evidencing award to Mark Clein (filed as Exhibit 10.9).* 10.10 Amended and Restated Warrant dated July 9, 1997, evidencing award to Fred Furman (filed as Exhibit 10.11).* 10.11 Restated Management Agreement dated April 11, 1997 with Scripps Health (filed as Exhibit 10.12).* 10.12 Amendment to Restated Management Agreement dated July 15, 1998 with Scripps Health.+ 10.13 Sublease dated April 1, 1997 with CMS Development and Management Company, Inc. (filed as Exhibit
-41- 42
EXHIBIT NUMBER DESCRIPTION ------ ----------- 10.13).* 10.14 Management and Affiliation Agreement dated April 13, 1995, between Mental Health Cooperative, Inc. and Tennessee Mental Health Cooperative, Inc. with Addendum (filed as Exhibit 10.14). (Tennessee Mental Health Cooperative, Inc. subsequently changed its name to Collaborative Care Corporation.)* 10.15 Second Addendum to Management and Affiliation Agreement dated November 1, 1996 between Mental Health Cooperative, Inc. and Collaborative Care Corporation (filed as Exhibit 10.15).*** 10.16 Provider Services Agreement dated April 13, 1995, between Tennessee Mental Health Cooperative, Inc. and Mental Health Cooperative, Inc. (filed as Exhibit 10.15). (Tennessee Mental Health Cooperative, Inc. subsequently changed its name to Collaborative Care Corporation.)* 10.19 Provider Agreement dated December 4, 1995, between Tennessee Behavioral Health, Inc. and Tennessee Mental Health Corporations, Inc.+ 10.20 Addendum No. 1 to Provider Agreement dated December 4, 1995, between Tennessee Behavioral Health, Inc. and Tennessee Mental Health Cooperative, Inc.+ 10.21 Addendum No. 2 to Provider Agreement dated February 4, 1996, between Tennessee Behavioral Health, Inc. and Tennessee Mental Health Cooperative, Inc.+ 10.22 Provider Participation Agreement dated December 1, 1995, among Green Spring Health Services, Inc., AdvoCare, Inc. and Tennessee Mental Health Cooperative, Inc.+ 10.23 Amendment to Provider Participation Agreement dated February 13, 1996, among Green Spring Health Services, Inc., AdvoCare of Tennessee, Inc. and Tennessee Mental Health Cooperative, Inc.+ 10.24 Subscription Agreement dated June 8, 1998, between the Company and Stadtlander Drug Distribution Co., Inc.+ 10.25 Sanwa Bank California Credit Agreement dated February 2, 1996, as amended on October 31, 1996.*** 10.26 Transition and Services Agreement dated July 1, 1998, between Stadt Solutions LLC, PMR Corporation and Stadtlander Drug Distribution Company, Inc. 10.27 Operating Agreement dated July 1, 1998, between PMR Corporation and Stadtlander Drug Distribution Company, Inc. 10.28 Stock Option dated September 8, 1998 granted to Daniel Frank. 10.29 Stock Option dated September 8, 1998 granted to Daniel Frank. 10.30 Form of Stock Option granted to Mark P. Clein, Fred D. Furman and Susan Erskine, dated December 3, 1998. 21.1 List of Subsidiaries. 23.1 Consent of Ernst & Young LLP. 27.1 Financial Data Schedule.
- ------------ * Incorporated by reference to exhibits filed with the SEC in the Company's Annual Report on Form 10-K for the year ended April 30, 1997. ** Incorporated by reference to the Company's Registration Statement on Form S-18 (Reg. No. 23-20095-A). *** Incorporated by reference to exhibits filed with the SEC in the Company's Registration Statement on Form S-2 (Reg. No. 333-36313). + Previously filed. -42- 43 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on July 26, 1999. PMR Corporation By: /s/ MARK P. CLEIN ----------------------------------- Mark P. Clein Chief Executive Officer (Principal Executive Officer) KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Mark P. Clein and Fred D. Furman, and each or any one of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitutes or substitute, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- /s/ ALLEN TEPPER Chairman of the Board of Directors July 26, 1999 - ------------------------------------ Allen Tepper /s/ MARK P. CLEIN Chief Executive Officer July 26, 1999 - ------------------------------------ and Director (Principal Executive Officer) Mark P. Clein /s/ FRED D. FURMAN President July 26, 1999 - ------------------------------------ Fred D. Furman /s/ SUSAN D. ERSKINE Executive Vice President, Secretary and Director July 26, 1999 - ------------------------------------ Susan D. Erskine /s/ DANIEL L. FRANK President of Disease Management Division July 26, 1999 - ------------------------------------ and Director Daniel L. Frank /s/ CHARLES E. GALETTO Senior Vice President - Finance & Treasurer July 26, 1999 - ---------------------------- (Principal Accounting Officer) Charles E. Galetto
-43- 44 Consolidated Financial Statements and Schedule PMR Corporation Years ended April 30, 1999 and 1998 with Report of Independent Auditors 45 PMR Corporation Consolidated Financial Statements and Schedule Years ended April 30, 1999 and 1998 CONTENTS Report of Independent Auditors........................................ F-1 Consolidated Financial Statements Consolidated Balance Sheets........................................... F-2 Consolidated Statements of Operations................................. F-3 Consolidated Statements of Stockholders' Equity....................... F-4 Consolidated Statements of Cash Flows................................. F-5 Notes to Consolidated Financial Statements............................ F-6 Schedule Schedule II - Valuation and Qualifying Accounts....................... S-1
46 Report of Ernst & Young LLP, Independent Auditors The Board of Directors and Stockholders PMR Corporation We have audited the accompanying consolidated balance sheets of PMR Corporation and subsidiaries as of April 30, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended April 30, 1999. Our audits also included the financial statement schedule listed in the index at item 14(a). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of PMR Corporation and subsidiaries at April 30, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended April 30, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respect the information set forth therein. As discussed in Note 1 to the financial statements, in 1999 the Company changed its method of accounting for start-up and organizational costs. San Diego, California June 18, 1999 F-1 47 PMR Corporation Consolidated Balance Sheets
APRIL 30, ---------------------------- 1999 1998 ---------------------------- ASSETS Current assets: Cash and cash equivalents $ 5,441,012 $ 18,522,859 Short-term investments, available for sale 27,509,554 20,257,045 Accounts receivable, net of allowance for uncollectible amounts of $10,664,000 in 1999 and $8,182,000 in 1998 20,002,894 16,655,759 Prepaid expenses and other current assets 1,787,859 1,192,144 Income taxes receivable 2,212,815 -- Deferred income tax benefit 4,653,000 4,136,000 ---------------------------- Total current assets 61,607,134 60,763,807 Furniture and office equipment, net of accumulated depreciation of $1,532,000 in 1999 and $1,727,000 in 1998 2,863,934 3,492,449 Long-term receivables, net of allowance for uncollectible amounts of $4,087,000 in 1999 and $900,000 in 1998 4,742,329 2,976,918 Deferred income tax benefit 1,206,000 2,080,000 Other assets 546,621 1,135,880 ---------------------------- Total assets $ 70,966,018 $ 70,449,054 ============================ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,539,327 $ 469,462 Accrued expenses 1,852,335 2,974,400 Accrued compensation and employee benefits 2,083,082 2,178,693 Advances from case management agencies 846,353 1,686,477 Income taxes payable -- 1,304,353 Payable to related party 3,052,610 -- ---------------------------- Total current liabilities 9,373,707 8,613,385 Note payable 294,073 392,024 Deferred rent expense 53,438 87,566 Contract settlement reserve 6,672,727 7,479,993 Minority Interest 1,921,057 -- Commitments Stockholders' equity: Convertible preferred stock, $.01 par value, authorized shares - 1,000,000; issued and outstanding shares - none in 1999 and 1998 -- -- Common stock, $.01 par value, authorized shares - 19,000,000; issued and outstanding shares - 6,988,878 in 1999 and 6,949,650 in 1998 69,889 69,496 Additional paid-in capital 48,123,385 47,959,557 Retained earnings 5,400,242 5,847,033 Treasury stock, 140,000 shares of common stock at cost (942,500) -- ---------------------------- Total stockholders' equity 52,651,016 53,876,086 ---------------------------- $ 70,966,018 $ 70,449,054 ============================
See accompanying notes. F-2 48 PMR Corporation Consolidated Statements of Operations
YEAR ENDED APRIL 30, -------------------------------------------- 1999 1998 1997 -------------------------------------------- Revenue - psychiatric care $ 55,822,568 $ 67,523,950 $ 56,636,902 Revenue - pharmaceuticals 29,666,887 -- -- -------------------------------------------- Total revenue 85,489,455 67,523,950 56,636,902 Costs and expenses: Direct operating expenses - psychiatric care 38,574,192 48,255,459 41,738,298 Cost of sales - pharmaceuticals 21,969,451 -- -- Direct operating expenses - pharmaceuticals 4,162,558 -- -- Marketing, general and administrative 12,305,721 9,186,401 6,034,960 Provision for bad debts 8,051,576 5,148,580 3,084,166 Depreciation and amortization 1,116,769 1,064,873 700,734 Write-off of costs related to terminated 1,612,240 -- -- acquisition Special charge (credit) (262,408) 2,022,889 -- Net interest income (1,610,242) (1,186,637) (217,297) -------------------------------------------- 85,919,857 64,491,565 51,340,861 Income (loss) before minority interest, income taxes and cumulative change (430,402) 3,032,385 5,296,041 Minority interest 676,729 -- -- -------------------------------------------- Income before income taxes and cumulative change 246,327 3,032,385 5,296,041 Income tax expense 100,429 1,244,000 2,172,000 -------------------------------------------- Net income before cumulative change 145,898 1,788,385 3,124,041 Cumulative change, net of income tax benefit (592,689) -- -- -------------------------------------------- Net income (loss) (446,791) 1,788,385 3,124,041 -------------------------------------------- Less dividends on: Series C convertible preferred stock -- -- 17,342 -------------------------------------------- Net income (loss) available to common shareholders $ (446,791) $ 1,788,385 $ 3,106,699 ============================================ Earnings (loss) per common share before cumulative change: Basic $ .02 $ .30 $ .66 ============================================ Diluted $ .02 $ .27 $ .55 ============================================ Earnings (loss) per common share: Basic $ (.06) $ .30 $ .66 ============================================ Diluted $ (.06) $ .27 $ .55 ============================================ Shares used in computing earnings (loss) per share: Basic 6,923,916 6,053,243 4,727,124 ============================================ Diluted 6,923,916 6,695,321 5,645,947 ============================================ Pro forma net income and earnings per share as if cumulative change had occurred for all periods presented: Pro forma net income available to common shareholders $ 145,898 $ 1,422,152 $ 2,868,566 ============================================ Pro forma earnings per share: Basic $ .02 $ .24 $ .61 ============================================ Diluted $ .02 $ .21 $ .51 ============================================
See accompanying notes. F-3 49 PMR Corporation Consolidated Statements of Stockholders' Equity
SERIES C PREFERRED COMMON CONVERTIBLE STOCK STOCK ADDITIONAL ------------------------------------------------ PAID-IN SHARES AMOUNT SHARES AMOUNT CAPITAL --------------------------------------------------------------- Balance at April 30, 1996 700,000 $ 7,000 3,577,917 $35,778 $ 8,259,243 Issuance of common stock under stock option plans including realization of income tax benefit of $369,000 -- -- 96,016 960 729,189 Dividend payable on Series C preferred stock -- -- -- -- -- Proceeds from payment of stockholder notes -- -- -- -- -- Exercise of warrants to purchase common stock -- -- 657,524 6,575 3,104,801 Issuance of common stock for consulting services -- -- 2,050 21 45,336 Conversion of Series C convertible preferred stock (700,000) (7,000) 700,000 7,000 -- Net income -- -- -- -- -- --------------------------------------------------------------- Balance at April 30, 1997 -- -- 5,033,507 50,334 12,138,569 Issuance of common stock under stock option plans including realization of income tax benefit of $1,687,355 -- -- 226,143 2,262 2,717,694 Issuance of common stock in follow-on offering, net of offering costs of $637,556 -- -- 1,690,000 16,900 33,103,294 Net income -- -- -- -- -- --------------------------------------------------------------- Balance at April 30, 1998 -- -- 6,949,650 69,496 47,959,557 Issuance of common stock under stock option plans -- -- 37,228 373 148,598 Issuance of common stock for compensation -- -- 2,000 20 15,230 Acquisition of treasury stock at cost -- -- -- -- -- Net loss -- -- -- -- -- =============================================================== Balance at April 30, 1999 -- $ -- 6,988,878 $69,889 $48,123,385 ===============================================================
NOTES RECEIVABLE TOTAL FROM RETAINED TREASURY STOCKHOLDERS' STOCKHOLDERS EARNINGS STOCK EQUITY ----------------------------------------------------------- Balance at April 30, 1996 $(141,547) $ 951,949 $ -- $ 9,112,423 Issuance of common stock under stock option plans including realization of income tax benefit of $369,000 -- -- -- 730,149 Dividend payable on Series C preferred stock -- (17,342) -- (17,342) Proceeds from payment of stockholder notes 141,547 -- -- 141,547 Exercise of warrants to purchase common stock -- -- -- 3,111,376 Issuance of common stock for consulting services -- -- -- 45,357 Conversion of Series C convertible preferred stock -- -- -- -- Net income -- 3,124,041 -- 3,124,041 ----------------------------------------------------------- Balance at April 30, 1997 -- 4,058,648 -- 16,247,551 Issuance of common stock under stock option plans including realization of income tax benefit of $1,687,355 -- -- -- 2,719,956 Issuance of common stock in follow-on offering, net of offering costs of $637,556 -- -- -- 33,120,194 Net income -- 1,788,385 -- 1,788,385 ----------------------------------------------------------- Balance at April 30, 1998 -- 5,847,033 -- 53,876,086 Issuance of common stock under stock option plans -- -- -- 148,971 Issuance of common stock for compensation -- -- -- 15,250 Acquisition of treasury stock at cost -- -- (942,500) (942,500) Net loss -- (446,791) -- (446,791) =========================================================== Balance at April 30, 1999 $ -- $ 5,400,242 $(942,500) $ 52,651,016 ===========================================================
See accompanying notes. F-4 50 PMR Corporation Consolidated Statements of Cash Flows
YEARS ENDED APRIL 30, 1999 1998 1997 ---------------------------------------------- OPERATING ACTIVITIES Net income (loss) $ (446,791) $ 1,788,385 $ 3,124,041 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Write-off of costs related to terminated acquisition 1,612,240 -- -- Special charge (credit) (262,408) 2,022,889 -- Depreciation and amortization 1,116,769 1,064,873 700,734 Issuance of stock for consulting services -- -- 45,357 Provision for bad debts 8,051,576 5,148,580 3,084,166 Cumulative effect of change in accounting principle 592,689 -- -- Loss applicable to minority interest (676,729) -- -- Deferred income taxes 357,000 (782,000) (3,834,000) Changes in operating assets and liabilities: Accounts and notes receivable (13,164,122) (11,151,423) (4,980,050) Prepaid expenses and other assets (364,550) (620,008) (250,630) Accounts payable and accrued expenses (1,820,782) (404,697) 212,937 Accrued compensation and employee benefits (95,611) (773,174) 675,058 Advances from case management agencies (840,124) 759,765 (86,135) Payable to related party 3,052,610 -- -- Other liabilities -- -- (127,213) Contract settlement reserve (807,266) (1,311,935) 3,292,908 Income taxes receivable/payable (3,105,300) 1,288,715 1,394,511 Deferred rent expense (34,128) (5,256) (56,709) ---------------------------------------------- Net cash (used in) provided by operating activities (6,834,927) (2,975,286) 3,194,975 INVESTING ACTIVITIES Proceeds from the sale and maturity of short term investments 24,159,504 -- -- Purchases of short-term investments (31,412,013) (20,257,045) -- Purchases of furniture and office equipment (1,134,717) (2,927,837) (958,685) ---------------------------------------------- Net cash used in investing activities (8,387,226) (23,184,882) (958,685) FINANCING ACTIVITIES Proceeds from follow-on offering, net of offering costs -- 33,120,194 -- Proceeds from sale of common stock and notes receivable from stockholders 164,221 1,032,601 3,983,072 Investment by related party in subsidiary 2,597,786 -- -- Proceeds from note payable to bank -- 517,397 -- Payments on note payable to bank (97,951) (35,368) -- Acquisition of treasury stock (523,750) -- -- Cash dividend paid -- -- (89,081) ---------------------------------------------- Net cash provided by financing activities 2,140,306 34,634,824 3,893,991 ---------------------------------------------- Net (decrease) increase in cash (13,081,847) 8,474,656 6,130,281 Cash at beginning of year 18,522,859 10,048,203 3,917,922 ---------------------------------------------- Cash at end of year $ 5,441,012 $ 18,522,859 $ 10,048,203 ============================================== SUPPLEMENTAL INFORMATION: Taxes paid $ 3,806,563 $ 1,330,725 $ 4,611,489 ============================================== Interest paid $ 396,170 $ 20,936 $ 17,612 ==============================================
See accompanying notes. F-5 51 PMR Corporation Notes to Consolidated Financial Statements April 30, 1999 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Organization, Business and Principles of Consolidation PMR Corporation ("the Company") and its subsidiaries is a leading manager of specialized mental health care programs and disease management services designed to treat individuals diagnosed with a serious mental illness ("SMI"), primarily schizophrenia and bi-polar disorder (i.e. manic-depressive illness). The Company manages and administers the delivery of a broad range of outpatient and community-based psychiatric services for SMI patients, consisting of intensive outpatient programs, case management programs, chemical dependency and substance abuse programs and a specialty pharmacy program for individuals with SMI. The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries, Psychiatric Management Resources, Inc., Collaborative Care Corporation, and Twin Town Corporation, and its majority-owned subsidiary Stadt Solutions, LLC ("Stadt Solutions"). The Company has accounted for its consolidation in accordance with Statement of Financial Accounting Standards No. 94, Consolidation of All Majority-Owned Subsidiaries. All intercompany balances have been eliminated in consolidation. The Company does not consolidate any of the organizations it manages as it does not have operating control as defined in Emerging Issues Task Force Statement No. 97-2, Application of FASB Statement No. 94 and APB Opinion No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual Management Arrangements (EITF 97-2). Legislation, Regulations and Market Conditions The Company is subject to extensive federal, state and local government regulation relating to licensure, conduct of operations, ownership of facilities, expansion of facilities and services and reimbursement for services. As such, in the ordinary course of business, the Company's operations are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which may be non-routine. The Company believes that it is in substantial compliance with applicable laws and regulations. However, if the Company is ever found to have engaged in improper practices, it could be subjected to civil, administrative or criminal fines, penalties or restitutionary relief. F-6 52 PMR Corporation Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Cash and Cash Equivalents Cash and cash equivalents consist of highly liquid investments with maturities, when acquired, of three months or less. Investments with original maturities of three months or less that were classified as cash equivalents totaled $1,863,000 and $7,817,000 as of April 30, 1999 and 1998, respectively. Short-Term Investments Marketable equity securities and debt securities are classified as available-for-sale because management has the intent and ability to sell the securities prior to maturity for use in current operations. Available-for-sale securities are carried at fair value, which approximates cost, with unrealized gains and losses reported as a separate component of stockholders' equity. The cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization along with realized gains and losses, interest and dividends are included in interest income. The cost of securities sold is based on the specific identification method. Concentration of Credit Risk The Company grants credit to contracting providers in various states without collateral. Losses resulting from bad debts have traditionally not exceeded management's estimates. At April 30, 1999, the Company has net current and long term receivables aggregating $6,002,000 from two providers, each of which comprise more than 10% of total net consolidated receivables. The Company monitors the credit worthiness of these customers and believes the balances outstanding, net of allowance at April 30, 1999, are fully collectible. Through its Stadt Solutions subsidiary, the Company sells pharmaceutical products and services to various customers and clients throughout the United States. At April 30, 1999, no single pharmaceutical customer comprised more than 10% of total net consolidated receivables, although a substantial portion of the pharmaceutical receivables are funded by Medicaid and other government-sponsored healthcare programs. Stadt Solutions obtains pharmaceutical products from one primary manufacturer and two primary distributors. The Company believes there are alternative manufacturers and distributors available for the supply and distribution of their products. F-7 53 PMR Corporation Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Substantially all of the Company's cash and cash equivalents is held at five financial institutions. The Company monitors the financial status of these institutions and does not believe the deposits are subject to a significant degree of risk. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures at the date of the financial statements and the amounts of revenues and expenses reported during the period. Actual results could differ from those estimates. The Company's significant accounting estimates are the allowance for uncollectible accounts and the contract settlement reserve. Earnings Per Share Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings per Share, requires dual presentation of basic and diluted earnings per share by entities with complex capital structures. Basic EPS includes no dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of the entity. The Company has calculated its earnings per share in accordance with SFAS No. 128 for all periods presented. F-8 54 PMR Corporation Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The following table sets forth the computation of basic and diluted earnings per share:
YEARS ENDED APRIL 30, ---------------------------------------- 1999 1998 1997 ---------------------------------------- Numerator: Net income (loss) available to common stockholders $ (446,791) $1,788,385 $3,106,699 Preferred stock dividends -- -- 17,342 ---------------------------------------- Net income (loss) available to common stockholders after assumed conversion of preferred stock $ (466,791) $1,788,385 $3,124,041 ======================================== Denominator: Weighted average shares outstanding for basic earnings per share 6,923,916 6,053,243 4,727,124 ---------------------------------------- Effects of dilutive securities: Employee stock options -- 596,008 707,368 Warrants -- 46,070 119,825 Convertible preferred stock -- -- 91,630 ---------------------------------------- Dilutive potential common shares -- 642,078 918,823 Shares used in computing diluted earnings per common share 6,923,916 6,695,321 5,645,947 ======================================== Earnings (loss) per common share, basic $ (.06) $ .30 $ .66 ======================================== Earnings (loss) per common share, diluted $ (.06) $ .27 $ .55 ========================================
At April 30, 1999, the Company had outstanding stock options under its stock option plan and warrants. However, since the Company had a net loss, these potentially dilutive securities were not included in the calculation of diluted earnings per share as their effect was anti-dilutive. Revenue Recognition and Contract Settlement Reserve - Psychiatric Care The Company's outpatient psychiatric program customers are hospitals or community mental health centers (the "providers"). Typical contractual agreements with providers require the Company to provide, at its own expense, specific management personnel for each program site. Revenue under these programs is primarily derived from services provided under three types of agreements: 1) all inclusive fee arrangements based on fee-for-service rates (based on units of service provided) under which the Company is responsible for substantially all direct program costs; 2) fee-for-service arrangements under which the provider maintains responsibility for a larger extent of direct program costs; and 3) fixed fee arrangements where the Company's fee is a fixed monthly sum F-9 55 PMR Corporation Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) and the provider assumes responsibility for substantially all program costs. Through the Outpatient Programs, the Company provides management and clinical expertise to the providers with respect to the administration of an outpatient program for SMI patients. Services provided under outpatient program management contracts include specialized program design and administration from start-up through the term of the contract. These programs managed or administered by the Company are intended to enhance the delivery of outpatient mental health services by introducing proprietary clinical protocols and procedures, assisting in quality assurance and utilization review, assisting in training of personnel, and coordinating a continuum of care for persons with serious mental illness. In all cases, the Company provides on-site managerial or consultative personnel. Patients served by the acute outpatient psychiatric programs are typically covered by the Medicare program. The Company has been retained to manage and provide the outpatient psychiatric portion of a managed health care program funded by the State of Tennessee ("TennCare"). Under the terms of its agreements, the Company receives a monthly case rate payment from the managed care consortium responsible for managing the TennCare program, and is responsible for planning, coordinating and managing psychiatric case management to residents of Tennessee who are eligible to participate in the TennCare program using the proprietary treatment programs developed by the Company. The Company offers its case management services through long-term exclusive management agreements with leading independent providers of case management services. Pursuant to those agreements, the Company contributes its proprietary protocols and management expertise and, when necessary, negotiates case management rates and contracts on behalf of the Providers. The Company may also provide training, management information systems support, and accounting and financial services. Presently, the Company has agreements with two case management agencies in Tennessee. Revenue under this program was approximately $10,534,000, $14,607,000 and $13,429,000 for the years ended April 30, 1999, 1998 and 1997, respectively. The Company also operates and manages chemical dependency rehabilitation programs. Revenue from these programs was $1,104,000, $2,828,000 and $1,673,000 for the years ended April 30, 1999, 1998 and 1997, respectively. The Company does not employ or bill for any services rendered by psychiatrists or other professionals whose patients are enrolled in the programs managed by the Company. F-10 56 PMR Corporation Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Revenue under the acute outpatient psychiatric programs is recognized when services are rendered based upon contractual arrangements with providers at the estimated net realizable amounts. Under certain management contracts, the Company is obligated under warranty provisions to indemnify the providers for all or some portions of the Company's fees that may be disallowed as reimbursable to the providers by Medicare's fiscal intermediaries. The Company has recorded contract settlement reserves to provide for possible amounts ultimately owed to its providers resulting from disallowance of costs by Medicare and Medicare cost report settlement adjustments. Such reserve is classified as a non-current liability as ultimate resolution of substantially all of these issues is not expected to occur during fiscal 2000. Under the provisions of the indemnification clause of the Company's management contracts, the Company indemnified providers $3,661,000 and $634,000 for the years ended April 30, 1998 and 1997, respectively. The Company was not required to indemnify any providers during fiscal 1999. Revenue - Pharmaceuticals Through its Stadt Solutions subsidiary, the Company offers specialty pharmaceutical services to individuals with SMI. Stadt Solutions also offers site management and clinical information services to pharmaceutical companies, health care providers and public sector purchasers. Stadt Solutions serves clients through a variety of pharmacies offering the drug, Clorazil, an anti-psychotic for schizophrenia, as well as blood monitoring services. Stadt Solutions records pharmaceutical revenue when the product is sold to customers at pharmacies, net of any estimated contractual allowances. A substantial portion of the net revenue for Stadt Solutions is derived directly from customers insured under Medicaid or other government-sponsored healthcare programs. Insurance The Company carries "occurrence basis" insurance to cover general liability, property damage and workers' compensation risks. Medical professional liability risk is covered by a "claims made" insurance policy that provides for guaranteed tail coverage. Loss reserves for incurred but not reported medical professional liability claims are not material. F-11 57 PMR Corporation Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Stock Options SFAS No. 123, Accounting for Stock-Based Compensation, establishes the use of the fair value based method of accounting for stock-based compensation arrangements, under which compensation cost is determined using the fair value of stock-based compensation determined as of the grant date, and is recognized over the periods in which the related services are rendered. In accordance with the provisions of SFAS No. 123, the Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related Interpretations in accounting for its employee stock options. Under APB 25, when the purchase price of restricted stock or the exercise price of the Company's employee stock options equals or exceeds the fair value of the underlying stock on the date of issuance or grant, no compensation expense is recognized. In accordance with SFAS No. 123, the Company has presented pro forma disclosures of net income and earnings per share as if SFAS No. 123 had been applied. Comprehensive Income In 1999, the Company adopted SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 requires that all components of comprehensive income, including net income, be reported in the financial statements in the period in which they are recognized. Comprehensive income is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Net income (loss) and other comprehensive income (loss), including foreign currency translation adjustments and unrealized gains and losses on investments, shall be reported, net of their related tax effect, to arrive at comprehensive income (loss). Comprehensive income (loss) was not materially different than net income (loss) for the years presented. Change in Accounting Principal In April 1998, the Accounting Standards Executive Committee issued Statement of Position 98-5, Reporting on Costs of Start-Up Activities (SOP 98-5) which is effective for fiscal years beginning after December 15, 1998. SOP 98-5 requires costs of start-up activities and organization costs to be expensed as incurred. In addition, all start-up costs and organization costs previously capitalized must be written off. Initial application of SOP 98-5 is reported as the cumulative effect of a change in accounting principle. In May 1999, the Company incurred a charge of $593,000 representing the effect, net of income tax benefits of $411,000 of writing off previously capitalized start-up costs. F-12 58 PMR Corporation Notes to Consolidated Financial Statements (continued) 2. INVESTMENTS At April 30, 1999, the fair market value of marketable securities approximates cost. The following is a summary of available-for-sale securities:
APRIL 30, 1999 1998 -------------------------- U.S. government securities $23,346,448 $16,752,478 U. S. corporate securities 3,663,106 2,005,187 Commercial paper 500,000 1,000,000 Certificate of deposit -- 499,380 -------------------------- Total debt securities $27,509,554 $20,257,045 ==========================
At April 30, 1999, all investments contain contractual maturities of two years or less. The balance sheet classification of available-for-sale securities is based on management's intentions rather than actual maturity dates, therefore classification of these securities may differ from stated maturities. As management has the ability and intent to sell these available-for-sale securities prior to maturity and views the portfolio as available for use in current operations, the investments are classified as current at April 30, 1999. 3. LONG TERM RECEIVABLES Long-term receivables at April 30, 1999 consist primarily of amounts due from contracting Providers for which the Company has established specific payment terms for receivable amounts which were past due or for which payment, due to contract terms, is expected to exceed one year. Management expects to receive payment on the long-term receivables as contract terms are met, none of which are expected to exceed two years. 4. FURNITURE AND OFFICE EQUIPMENT Furniture and office equipment consisted of the following at April 30:
1999 1998 --------------------------- Furniture and fixtures $ 2,796,010 $ 1,975,766 Leasehold improvements 1,056,145 1,133,641 Software 543,548 365,625 Start-up costs -- 1,744,457 --------------------------- 4,395,703 5,219,489 Accumulated depreciation (1,531,769) (1,727,040) --------------------------- $ 2,863,934 $ 3,492,449 ===========================
F-13 59 PMR Corporation Notes to Consolidated Financial Statements (continued) 4. FURNITURE AND OFFICE EQUIPMENT (CONTINUED) Furniture and office equipment are stated at cost and are depreciated over their estimated useful lives using the straight-line method over terms of three to five years. Depreciation expense was $762,000, $710,000 and $344,000 for the years ended April 30, 1999, 1998 and 1997, respectively. 5. OTHER ASSETS Other assets consisted of the following at April 30:
1999 1998 --------------------------- Proprietary information and covenants not to compete $ 862,503 $ 1,118,753 Goodwill -- 978,858 Other 234,659 282,176 --------------------------- 1,097,162 2,379,787 Accumulated amortization (550,541) (1,243,907) --------------------------- $ 546,621 $ 1,135,880 ===========================
Other assets are being amortized using the straight-line method over their estimated useful lives. The estimated useful life of proprietary information and covenants not to compete is five to ten years and goodwill is fifteen years. Amortization expense was $355,000, $355,000 and $357,000 for the years ended April 30, 1999, 1998 and 1997, respectively. Goodwill related to the Company's chemical dependency programs of approximately $312,000 was written-off as a Special Charge in 1999 related to an impairment under the provisions of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, due to the failure of this business to provide sufficient cash flows. See Note 14. 6. BORROWINGS Line of Credit The Company has a credit agreement with a bank that permits borrowings of up to the lesser of 50% of the aggregate amount of eligible accounts receivable of the Company or $10,000,000 for working capital needs. The credit agreement expires on August 30, 2000 and is secured by substantially all of the Company's assets. Interest on borrowings is payable monthly at either the Bank's reference rate or at the Bank's Eurodollar rate plus 2%. There were no borrowings outstanding at April 30, 1999 and 1998. F-14 60 PMR Corporation Notes to Consolidated Financial Statements (continued) 6. BORROWINGS (CONTINUED) Equipment Note Payable The Company has a promissory note for the purchase of office furniture, fixtures and equipment. The note is secured by the assets acquired with proceeds from the loan. The note matures in November 2002 and requires principal and interest payments due monthly with interest accruing at 8.36%. There was $392,000 and $482,000 outstanding under this note at April 30, 1999 and 1998, respectively. 7. STOCK OPTIONS AND WARRANTS The Company's 1997 Equity Incentive Plan, as amended (the "1997 Plan") provides for the granting of options to purchase up to 3,000,000 shares of common stock to eligible employees. Under the 1997 Plan, options may be granted for terms of up to ten years and are generally exercisable in cumulative annual increments of 20 percent each year, commencing one year after the date of grant. The 1997 Plan also provides for the full vesting of all outstanding options under certain change of control events. Option prices must equal or exceed the fair market value of the common shares on the date of grant. The termination date of the 1997 Plan is October 6, 2008. The Company has a non qualified stock option plan for its outside directors (the "1992 Plan"). The 1992 Plan provides for the Company to grant each outside director options to purchase 15,000 shares of the Company's common stock annually, at the fair market value at the date of grant. Options for a maximum of 525,000 shares may be granted under this plan. The options vest 30% immediately and in ratable annual increments over the three year period following the date of grant. In 1997, the board of directors amended the 1992 Plan to provide for full vesting of all outstanding options under certain change of control events. Warrants to purchase shares of the Company's common stock were issued in each of the two years in the period ended April 30, 1997 to brokers in connection with financing transactions. As of April 30, 1999, broker warrants to purchase 53,000 shares of the Company's common stock at $2.50 per share were outstanding. These warrants expire on October 31, 1999. Warrants to purchase shares of the Company's common stock were issued to a case management agency in connection with a Management and Affiliation Agreement. On September 1, 1995, the Company granted warrants to the case management agency to purchase up to an aggregate of 550,000 shares of common stock at fair market value over a seven year period if certain performance criteria are met. On November 1, 1996, the F-15 61 PMR Corporation Notes to Consolidated Financial Statements (continued) 7. STOCK OPTIONS AND WARRANTS (CONTINUED) Company granted additional warrants to the case management agency to purchase a total of 30,000 shares of common stock (5,000 shares per year over six years beginning May 1, 1997) at fair market value. As of April 30, 1999, warrants to purchase 15,000 shares of the Company's common stock were outstanding at prices ranging from $15.46 to $19.19. The warrants expire on September 1, 2002. A summary of the Company's stock option and warrant activity and related information is as follows:
WEIGHTED-AVERAGE SHARES EXERCISE PRICE --------------------------- Outstanding April 30, 1996 1,555,053 $ 6.63 --------- Granted 486,837 20.50 Exercised (96,016) 5.17 Forfeited (160,268) 8.44 --------- Outstanding April 30, 1997 1,785,606 14.72 Granted 105,000 19.78 Exercised (226,143) 4.42 Forfeited (60,855) 13.00 --------- Outstanding April 30, 1998 1,603,608 10.86 Granted 2,091,582 7.25 Exercised (37,230) 4.13 Forfeited (980,550) 14.90 --------- Outstanding April 30, 1999 2,677,410 $ 6.68 =========
At April 30, 1999 options and warrants to purchase approximately 1,119,000 and 68,000 shares of common stock, respectively, were exercisable and 833,149 shares and 120,000 shares were available for future grant under 1997 Plan and the 1992 Plan, respectively. The weighted-average fair value of options granted was $2.84, $12.37 and $15.21 in fiscal years 1999, 1998 and 1997, respectively. F-16 62 PMR Corporation Notes to Consolidated Financial Statements (continued) 7. STOCK OPTIONS AND WARRANTS (CONTINUED) A summary of options outstanding and exercisable as of April 30, 1999 follows:
WEIGHTED- WEIGHTED- AVERAGE AVERAGE REMAINING OPTIONS EXERCISE EXERCISE CONTRACTUAL OPTIONS WEIGHTED-AVERAGE OUTSTANDING PRICE RANGE PRICE LIFE EXERCISABLE EXERCISE PRICE - ------------------------------------------------------------------------------------------ 156,247 $2.37-$3.50 $ 3.45 5.8 156,247 $ 3.45 476,786 $3.75-$4.75 $ 4.24 4.7 444,783 $ 4.26 1,804,526 $6.00-$8.00 $ 6.92 8.5 425,751 $ 7.07 199,045 $9.75-$11.38 $10.00 6.1 134,076 $10.02 40,806 $15.46-$23.38 $22.59 7.4 26,001 $22.42 --------- --------- 2,677,410 $2.37-$23.38 $ 6.68 7.5 1,186,858 $ 6.12 ========= =========
Adjusted pro forma information regarding net income and net income per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options and stock purchase plan under the fair value method of SFAS 123. The fair value for these options was estimated at the date of grant using the "Black-Scholes" method for option pricing with the following weighted-average assumptions for fiscal 1999, 1998 and 1997:
1999 1998 1997 ------- ------- ------- Expected life (years) 5.0 5.0 6.0 Risk-free interest rate 4.71% 6.34% 6.5% Annual dividend yield -- -- -- Volatility 69% 69% 88%
F-17 63 PMR Corporation Notes to Consolidated Financial Statements (continued) 7. STOCK OPTIONS AND WARRANTS (CONTINUED) For purposes of pro forma disclosures, the estimated fair value of the options granted is amortized to expense over the options' vesting period. The Company's pro forma information for the years ended April 30, 1999, 1998 and 1997, follows:
1999 1998 1997 ------------- ------------- ------------- Pro forma net income (loss) $ (2,747,903) $ 354,343 $ 1,967,939 Pro forma earnings (loss) per share, basic $ (.40) $ .06 $ .42 Pro forma earnings (loss) per share, diluted $ (.40) $ .05 $ .35
8. INCOME TAXES Income tax expense (benefit) consists of the following:
YEAR ENDED APRIL 30 1999 1998 1997 ------------------------------------------- Federal: Current $ (524,000) $ 1,583,000 $ 4,868,000 Deferred 231,000 (612,000) (3,009,000) ------------------------------------------- (293,000) 971,000 1,859,000 State: Current (146,000) 443,000 1,138,000 Deferred 128,000 (170,000) (825,000) ------------------------------------------- (18,000) 273,000 313,000 ------------------------------------------- $ (311,000) $ 1,244,000 $ 2,172,000 ===========================================
The fiscal year 1999 income tax benefit is composed of approximately $100,000 of income tax expense related to current operations and a $411,000 income tax benefit relating to the cumulative effect of a change in accounting principal (see Note 1). The cumulative effect of a change in accounting principal is reported net of taxes in the consolidated statement of operations. F-18 64 PMR Corporation Notes to Consolidated Financial Statements (continued) 8. INCOME TAXES (CONTINUED) Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
APRIL 30, 1999 1998 ------------------------- Deferred tax assets: Allowance for bad debts $ 4,518,000 $3,704,000 Contract settlement reserve 2,719,000 3,048,000 Other 907,000 234,000 Depreciation and amortization 725,000 254,000 Net operating loss carryforwards 494,000 -- Accrued compensation and employee benefits 362,000 405,000 Special Charge 320,000 885,000 ------------------------- Total deferred tax assets 10,045,000 8,530,000 Deferred tax liabilities: Right to bill 3,059,000 1,401,000 Non-accrual experience method 1,127,000 913,000 ------------------------- Total deferred tax liabilities 4,186,000 2,314,000 ------------------------- Net deferred tax assets $ 5,859,000 $6,216,000 =========================
At April 30, 1999, the Company has federal and California net operating loss carryforwards of approximately $1,281,000 and $793,000, respectively. The federal and California tax loss carryforwards will begin expiring in 2019 and 2014, respectively, unless previously utilized. Pursuant to Internal Revenue Code Section 382, the use of the Company's net operating loss carryforwards may be limited if a cumulative change in ownership of more than 50% occurs within any three year period. A reconciliation between the federal income tax rate and the effective income tax rate is as follows:
YEAR ENDED APRIL 30, 1999 1998 1997 -------------------------------- Statutory federal income tax rate 35% 35% 35% State income taxes, net of federal tax 6 6 6 benefit -------------------------------- Effective income tax rate 41% 41% 41% --------------------------------
F-19 65 PMR Corporation Notes to Consolidated Financial Statements (continued) 9. CUSTOMERS Approximately 30% of the Company's consolidated revenue for the year ended April 30, 1999 is derived from contracts with psychiatric care providers in the State of California. Providers responsible for ten percent or more of the Company's consolidated revenues at April 30, 1999 accounted for 12%, 22% and 23% of revenue for the years ended April 30, 1999, 1998 and 1997, respectively. No single pharmaceutical customer comprised more than 10% of the Company's total consolidated revenue for the period ended April 30, 1999. A substantial portion of the Company's pharmaceutical revenue is directly funded by Medicaid and other government-sponsored healthcare programs. 10. EMPLOYEE BENEFITS The Company maintains a tax deferred retirement plan under Section 401(k) of the Internal Revenue Code for the benefit of all employees meeting minimum eligibility requirements. Under the plan, each employee may defer up to 15% of pre-tax earnings, subject to certain limitations. The Company will match 50% of an employee's deferral to a maximum of 3% of the employee's gross salary. The Company's matching contributions vest over a five year period. The Company maintains a similar retirement plan for employees of the Stadt Solutions subsidiary. Subject to minimum eligibility requirements, each employee may defer up to 15% of pre-tax earnings, subject to certain limitations. The Company will match 100% of an employee's deferral to a maximum of 3% of the employee's gross salary, and 50% of an employee's deferral on the next 2% of the employee's gross salary. The Company's matching contributions vest immediately. The Company contributed $272,000, $265,000 and $186,000 to match employee deferrals for the years ended April 30, 1999, 1998 and 1997, respectively. 11. RELATED PARTY In July 1998, the Company and Stadtlander Drug Distribution Company (Stadlander) formed Stadt Solutions to offer specialty pharmaceutical services to individuals with SMI and also offer site management and clinical information services to pharmaceutical companies, healthcare providers, and public sector purchasers. In return for initial contributions of approximately $2.6 million by both the Company and Stadtlander to fund the start-up of Stadt Solutions, the Company received a 50.1% interest in and Stadtlander received a 49.9% interest in Stadt Solutions. The Company consolidates the accounts of Stadt Solutions and records a minority interest on their balance sheet for the respective ownership by Stadtlander. F-20 66 PMR Corporation Notes to Consolidated Financial Statements (continued) 11. RELATED PARTY (CONTINUED) Based on the provisions of the Operating Agreement, profits and losses of Stadt Solutions are allocated between the Company and Stadtlanders based upon their respective proportional ownership percentages. This allocation is subject to certain priority distributions to Stadtlander approximately equivalent to the operating income Stadtlander expected to be generated by their contributed base of approximately 6,000 clients. In addition, Stadt Solutions is required to reimburse both the Company and Stadtlander for certain costs associated with the business such as marketing, general and administrative expenses and cost of sales related to the pharmaceutical products. Approximately $22.0 million of costs and expenses were recorded in fiscal 1999 to Stadlander under the Operating Agreement of which approximately $3.0 million is payable at April 30, 1999 and reflected as a related party payable in the accompanying balance sheet. 12. COMMITMENTS AND CONTINGENCIES Leases The Company leases its administrative facilities and certain program site facilities under both cancelable and non-cancelable leasing arrangements. Certain non-cancelable lease agreements call for annual rental increases based on the consumer price index or as otherwise provided in the lease. The Company also leases certain equipment under operating lease agreements. At April 30, 1999, future minimum lease payments for all leases with initial terms of one year or more are $2,219,000, $1,639,000, $1,065,000, $227,000, $46,000 and $4,000 for the years ended April 30, 2000, 2001, 2002, 2003, 2004 and thereafter, respectively. Rent expense totaled $2,716,000, $3,140,000 and $2,690,800 for the years ended April 30, 1999, 1998 and 1997, respectively. Litigation The Company is engaged in disputes with Tennessee Behavioral Health ("TBH") regarding certain payments made to the Company for case management services. TBH has made a claim, based on a sample review, for approximately $4.2 million relating to payments made to the Company for case management services. TBH later, based on a subsequent sample review, reduced the claim to approximately $2.3 million. On April 8, 1999, TBH sent the Company formal notice of the dispute, triggering the dispute resolution provisions of its contract. The Company provided a response denying liability for the claim and believes the claim is without merit. TBH has the right to submit the dispute to binding arbitration, which has not occurred. F-21 67 PMR Corporation Notes to Consolidated Financial Statements (continued) 12. COMMITMENTS AND CONTINGENCIES (CONTINUED) The Company is also a party to various legal proceedings arising in the normal course of business. In management's opinion, the outcome of these proceedings is not expected to have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows. 13. WRITE-OFF OF COSTS RELATED TO TERMINATED ACQUISITION The Company wrote-off acquisition costs of $1.6 million related to a terminated definitive merger agreement between the Company and Behavioral Health Corporation in the second quarter of fiscal 1999. 14. SPECIAL CHARGE (CREDIT) A summary of the special charge (credit) for the year ended April 30, 1999 is as follows: CMI settlement: Return of common stock $(418,750) Cash settlement (150,000) Release of liabilities and other (109,542) --------- (678,292) Write off of goodwill 311,884 Write off of property and equipment 104,000 --------- $(262,408) =========
The special charge (credit) relates primarily to a favorable settlement of disputes and the restructuring of the relationship with Case Management, Inc. ("CMI"). The Company incurred a special charge relating to the closing of several programs identified in the year ended April 30, 1998, which included a special charge relating to CMI. During the second quarter of fiscal 1999, the Company resolved its dispute with CMI. The ultimate outcome of the dispute involved the return of common stock that was previously issued to CMI as part of the consideration for a restrictive covenant, a cash settlement, and the release of claims against the Company for certain liabilities. The Company has reflected the return of common stock as treasury stock in the statement of stockholders' equity at a fair market value of $418,750, at the date of settlement. At the time of original issuance, an intangible asset for the common stock was recorded at the fair market value of $256,250 of the stock and was to be amortized over the term of the restrictive covenant of 72 months. At April 30, 1998, the net book value of the intangible asset was $158,000 and was fully reserved in the special charge. The other components of the special charge (credit) were a cash settlement of $150,000 for accounts receivable which were fully reserved, the release of certain liabilities relating to unemployment taxes of $94,000, and other items of $15,542. Additional components of the special charge (credit) include a charge of $311,884 to write down certain goodwill and a charge of $104,000 to establish a reserve for the write off of certain property and equipment. The charges relate to goodwill at the Company's chemical dependency program and property and equipment at the Company's chemical dependency program and several additional sites (see Note 15). A summary of the special charge for the year ended April 30, 1998 is as follows: Site closure costs: Estimated costs to resolve claims and related legal costs incurred $ 720,693 Equipment and intangibles 250,651 Lease costs 167,462 Severance 97,886 Other costs 166,204 ---------- 1,402,896 Loss contract charge 619,993 ---------- $2,022,889 ==========
The special charge in 1998 resulted primarily from management's decision to close ten program locations in the Mid-America Region, costs to be incurred in connection with noncancelable operating commitments resulting from the HCFA withdrawal of provider status for the Company's largest partial hospitalization program, and costs related to the resolution of claims associated with locations in the Company's Mid-America Region that were scheduled for closure. The components of the impairment and exit costs resulting from closing program locations consisted of severance, noncancelable facility lease commitments, related legal costs, write-off of furniture and office equipment and intangible assets, and other related costs. F-22 68 PMR Corporation Notes to Consolidated Financial Statements (continued) 14. SPECIAL CHARGE (CREDIT) (CONTINUED) At April 30, 1999 and 1998, accruals for special charges of approximately $786,000 and $1,670,000, respectively, were included in accrued liabilities in the consolidated balance sheet. An analysis of the accrual activity during 1999 is as follows: Accrued special charges, April 30, 1998: $1,670,000 Site closure costs: Estimated costs to resolve claims and related legal costs (225,000) Equipment and intangibles (251,000) Lease costs (48,000) Severance (57,000) (581,000) --------- Loss contract charge (407,000) Impairment of long term asset 104,000 (884,000) --------- ---------- ACCRUED SPECIAL CHARGES, APRIL 30, 1999: $ 786,000 ==========
The components of the accrued special charges as of April 30, 1999 relate to: Estimated costs to resolve claims and related legal costs $350,000 Lease costs 119,000 Loss contract charge 213,000 Long-term assets 104,000 --------- $786,000 =========
F-23 69 PMR Corporation Notes to Consolidated Financial Statements (continued) 14. SPECIAL CHARGE (CREDIT) (CONTINUED) In February 1998, the Company announced that the outpatient program that it formerly managed in Dallas, Texas was subject to a civil investigation being conducted by the U.S. Department of Health and Human Services' Office of Inspector General and the U.S. Attorney's office in Dallas, Texas (collectively, the "Agencies"). The Dallas program was operational from January 1996 to February 1998. In October 1998, the U.S. Attorney's office in Dallas, Texas confirmed that it declined prosecution of any claims it may have against the Company under the False Claims Act arising from Company management of the Outpatient Program in Dallas. It is still possible, however, that the Outpatient Program could be subject to recoupment of possible overpayments by Medicare. Under the Company's management agreement with the Dallas program, the Company was contractually responsible for resolving reimbursement issues and for indemnification of certain costs incurred by the program if reimbursement was not received for patient care provided. As of April 30, 1999, $350,000 was included in accrued special charges. 15. SUBSEQUENT EVENTS In May 1999, the Company repurchased 200,000 shares of its common stock at a price of $3.75 per share, for a total of $750,000. In May and June 1999, the Company closed five outpatient psychiatric program locations. Plans have been implemented to close one additional site in July 1999 and two additional sites in August 1999. In accordance with the guidelines under EITF 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity, the Company intends to take a charge of approximately $500,000 related to these programs in the first quarter of fiscal year 2000, primarily for severance and lease termination costs. 16. DISCLOSURES ABOUT REPORTABLE SEGMENTS In accordance with the criteria of SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company determined that it operates in three reportable segments: Outpatient Programs, Case Management Programs and Pharmaceuticals. The Company's reportable segments are strategic business units that offer different services to a variety of inpatient and outpatient recipients (see Note 1). F-24 70 PMR Corporation Notes to Consolidated Financial Statements (continued) 16. DISCLOSURES ABOUT REPORTABLE SEGMENTS (CONTINUED) Accounting policies for segments are the same as those described in Note 1. There are no intersegment revenues. All revenues are derived from services performed in the United States. Activities classified as Other in the following schedule relate primarily to unallocated home office items and activity from the Company's chemical dependency program. Assets for Outpatient Programs, Case Management Programs and Pharmaceuticals consist primarily of cash, accounts receivable, furniture and office equipment and intangible assets. The Company evaluates the performance of each reportable segment based on income (loss) from operations before income taxes and before the cumulative effect of a change in accounting principal. F-25 71 ' PMR Corporation Notes to Consolidated Financial Statements (continued) 16. DISCLOSURES ABOUT REPORTABLE SEGMENTS (CONTINUED) A summary of reportable segments is as follows:
CASE OUTPATIENT MANAGEMENT PROGRAMS PROGRAMS PHARMACEUTICALS OTHER TOTAL -------------------------------------------------------------------------------- 1999 Revenues $ 43,662,377 $ 10,534,204 $ 29,666,887 $ 1,625,987 $ 85,489,455 Operating profit 14,603,771 1,268,794 2,275,262 (9,670,294) 8,477,533 Depreciation and amortization 283,438 199,827 9,039 624,465 1,116,769 Acquisition expense -- -- -- 1,612,240 1,612,240 Special charge (credit) (262,408) -- -- -- (262,408) Net interest (income) expense -- -- (1,221) (1,609,021) (1,610,242) Minority interest -- -- 676,729 -- 676,729 Income (loss) before income taxes and cumulative change 11,861,117 488,685 (679,441) (11,424,034) 246,327 Total assets 17,254,231 2,892,900 7,716,292 43,102,595 70,966,018 - ------------------------------------------------------------------------------------------------------------ 1998 Revenues 49,449,846 15,133,568 -- 2,940,536 67,523,950 Operating profit 19,506,154 1,251,869 -- (10,675,933) 10,082,090 Depreciation and amortization 502,277 143,976 -- 418,620 1,064,873 Special charge 2,022,889 -- -- -- 2,022,889 Net interest (income) expense -- -- -- (1,186,637) (1,186,637) Income (loss) before income taxes 13,318,473 267,633 -- (10,553,721) 3,032,385 Total assets 19,710,939 2,634,273 -- 48,103,842 70,449,054 - ------------------------------------------------------------------------------------------------------------ 1997 Revenues 40,000,000 13,690,251 -- 2,946,651 56,636,902 Operating profit (loss) 7,743,913 (561,133) -- 1,680,864 8,863,644 Depreciation and amortization 324,070 120,650 -- 256,014 700,734 Net interest (income) expense -- -- -- (217,297) (217,297) Income (loss) before income taxes 6,936,482 (44,462) -- (1,595,979) 5,296,041 Total assets 13,788,876 2,794,289 -- 15,866,373 32,449,538 - ------------------------------------------------------------------------------------------------------------
Revenues from one provider, which are included in the case management segment, are greater than 10% of consolidated revenues for the year ended April 30, 1999 (see Note 9) and totaled approximately $10.5 million, $15.1 million, and $13.7 million for the years ended April 30, 1999, 1998 and 1997, respectively. F-26 72 Schedule II 73 Schedule II PMR Corporation Valuation and Qualifying Accounts
----------------------------------- -------------- -------------- --------------- --------------- COL. A COL. B COL. C COL. D COL. E ----------------------------------- -------------- -------------- --------------- --------------- ADDITIONS -------------- DESCRIPTION BALANCE AT CHARGED TO BALANCE AT BEGINNING OF COSTS AND DEDUCTIONS - END OF PERIOD PERIOD EXPENSES DESCRIBE ----------------------------------- -------------- -------------- --------------- --------------- Year ended April 30, 1999 Allowance for doubtful accounts $9,081,610 $8,051,576 $2,381,832(1) $14,751,354 Contract settlement reserve 7,479,993 1,983,123 2,790,389(2) 6,672,727 Year ended April 30, 1998 Allowance for doubtful accounts 5,081,177 5,148,580 1,148,147(3) 9,081,610 Contract settlement reserve 8,791,928 2,349,382 3,661,317(4) 7,479,993 Year ended April 30, 1997 Allowance for doubtful accounts 1,759,182 3,084,166 (237,829)(3) 5,081,177 Contract settlement reserve 5,499,020 3,927,371 634,463(4) 8,791,928
(1) Uncollectible accounts written off, net of recoveries and reclassification of allowance from contractual settlement reserve (2) Contract settlement reserve reclassified to allowance for doubtful accounts (3) Uncollectible accounts written off, net of recoveries (4) Write off of hospital receivables based on disallowance of the Company's fee on Provider's cost reimbursement report and the Company's indemnity obligation S-1 EX-10.26 2 EXHIBIT 10.26 1 Exhibit 10.26 TRANSITION AND SERVICES AGREEMENT THIS TRANSITION AND SERVICES AGREEMENT (this "Agreement"), is effective as of July 1, 1998 (the "Effective Date"), by and between STADT SOLUTIONS, LLC, a Delaware limited liability company ("Company"), PMR CORPORATION, a Delaware corporation ("PMR") and STADTLANDER DRUG DISTRIBUTION COMPANY, INC., a Delaware corporation ("Stadtlander"). Together, PMR and Stadtlander are hereinafter referred to as the "Service Providers" or individually, each a "Service Provider." RECITALS WHEREAS, Company requires certain support in the conduct of its business; and WHEREAS, PMR and Stadtlander each wish to offer and provide such support to Company, and Company wishes to accept such support, upon the terms and conditions set forth herein. NOW, THEREFORE, in consideration of the foregoing premises and the mutual covenants and obligations contained herein, the parties agree as follows: 1. SCOPE OF AGREEMENT. Each Service Provider severally, and not jointly, hereby agrees to provide or make available certain support and related services to Company ("Services") in accordance with the terms and conditions of this Agreement. Each Service Provider shall also provide such additional support or services to Company pursuant to this Agreement as such Service Provider and Company may mutually agree. The Services shall be performed in the manner, to the extent and at a time substantially consistent with the manner in which each Service Provider performs administrative or other services for its own benefit. 2. SERVICES. 2.1 TYPES OF SUPPORT SERVICES. Upon Company's request, the Service Providers shall provide the Services as described below: (a) ACCOUNTING SERVICES. Stadtlander shall provide bookkeeping and accounting services relating to the maintenance of books and records of Company's financial operations, including, for example, bank balances, loan balances and cash management services. If requested, Stadtlander shall assist Company in the gathering and maintenance of records and information to be provided to Company's independent certified accountants in connection with the calculation of taxes owed by Company and the preparation of Company's tax returns. Company agrees that so long as Stadtlander is providing fulfillment and accounting services under this Agreement, Company's independent certified accountants shall be Stadtlander's independent certified accountants. 1. 2 (b) GENERAL AND ADMINISTRATIVE SERVICES; USE OF EQUIPMENT AND FACILITIES. Each Service Provider agrees that it shall provide such other general and administrative support to Company necessary for or relating to the proper functioning of Company as a commercial entity, as the parties shall agree. Such support includes, but is not limited to, general office services, including use of telephone(s) and other office equipment, and providing necessary insurance coverage for and access to utilities at the portion of the facilities provided by the Service Provider and used by Company. (c) PAYROLL AND PERSONNEL SERVICES. Each Service Provider agrees that it shall provide the following payroll and personnel services to Company: maintenance of employee files, assistance in recruiting, hiring and dismissing employees, administration of reasonable employee payroll matters and maintenance of general employee insurance obligations. (d) MIS SERVICES. Each Service Provider agrees that it shall provide reasonable management information services to Company relating to Services provided to Company hereunder, including coordination of network services between the Service Provider and Company, and information technology planning services. A Service Provider may provide additional management information services as are mutually agreed between the Service Provider and Company. (e) REIMBURSEMENT SERVICES. (i) Stadtlander shall provide reimbursement services, including billing, coordination of reimbursement and collection services relating to the provision of phlebotomy and case management services associated with the drug Clozaril and any generic equivalents ("Case Management Services"). (ii) With respect to each of the states in which Stadtlander's customers and patients are located immediately prior to the Effective Date (the "Initial States"), Stadtlander shall provide reimbursement services, including billing, coordination of reimbursement and collection services relating to the fulfillment and distribution of pharmaceutical products. (f) FULFILLMENT SERVICES. Stadtlander shall provide to Company the following services with respect to Company's business: enrollment of patients and customers, entry of purchase orders, purchasing, receipt of materials purchased, and delivery of materials received on behalf of Company directly to Company's customers. Stadtlander agrees that it shall take all necessary steps to Company's satisfaction to keep any and all accounts, funds, materials, inventory and any other assets of Company free from claims of Stadtlander's creditors pursuant to any lien, security interest or any other encumbrance or claim. In addition, Stadtlander acknowledges and agrees that the economic value of all discounts, rebates, concessions or other customer incentives or accommodations relating to Company's customers will inure to the benefit of Company. Stadtlander further agrees that it will involve Company in all discussions and negotiations with any pharmaceutical manufacturers relating to rebates or pricing of Clozaril or its generic alternatives and that it will use its commercially reasonable efforts to include the Company in any purchasing agreement entered into with respect to Clozaril or its generic alternatives. 2. 3 (g) CONSULTING SERVICES. PMR shall provide consulting services relating to its knowledge, experience and expertise in the areas of mental illness, case management and medical informatics. 2.2 PERFORMANCE OF SERVICES. (a) PERFORMANCE. Each Service Provider shall perform the Services for which it is obligated above on an ongoing basis during the Term (as defined in Section 6.1 below), as reasonably required or requested by Company. (b) THIRD PARTY PROVISION OF SERVICES. Each Service Provider may, upon the written consent of Company, provide any of the Services by contracting with a third party to provide such services. In such event, Company shall continue to pay such Service Provider directly for the services in accordance with Section 2.3 of this Agreement. 2.3 CHARGE FOR SERVICES. (a) Company shall pay to each Service Provider such Service Provider's "Costs" in providing Services, monthly in arrears, within thirty (30) days of the date the Service Provider's invoice is received by Company. A Service Provider's "Costs," for purposes of this Agreement, shall include (i) the Service Provider's direct costs, (ii) directly attributed overhead costs of dispensing locations, and (iii) the cost of assets purchased for use solely on behalf of Company. Direct costs and directly attributed overhead costs shall not include corporate overhead costs or allocations. Schedule B to that certain Operating Agreement dated as of the date hereof, by and between PMR and Stadtlander, as it may be amended from time to time (the "Operating Agreement") contains a list of representative Costs relating to certain Services. In addition to the Services described herein, Company shall pay a Service Provider for its costs in providing any other services which are requested by Company and agreed upon by the Service Provider but which are not otherwise contemplated in this Agreement, such costs to be agreed to between the Company and the Service Provider. (b) Notwithstanding the foregoing, so long as Stadtlander is providing purchasing and fulfillment services hereunder, the cost of pharmaceuticals to be billed to Company by Stadtlander will be the Costs thereof (as defined above) plus the lower of (i) seventeen percent (17%) of such Costs or (ii) Stadtlander's actual gross margin from such services (such 17% of Costs or actual gross margin is hereinafter referred to as the "Gross Margin"). Payments of all amounts representing Gross Margin hereunder shall be due and payable on the 30th day following the end of each month and shall be payable only to the extent the Company's net cash flow from operations for such month is greater than or equal to the Gross Margin payable for such month. If the amount of Gross Margin payable in any month exceeds the amount of net cash flow from operations for the month, then payments of such excess Gross Margin shall be payable with the next monthly payment to the extent such Gross Margin may be paid in accordance with the net cash flow requirement set forth in the preceding sentence. All Gross Margin paid to Stadtlander in a fiscal year shall be credited first against the Net Income Base distribution, and second, against other amounts or distributions payable to Stadtlander for such fiscal year, to the extent of the Net Income Base. If the Gross Margin amount paid to Stadtlander in a fiscal year exceeds the total amounts credited under the 3. 4 preceding sentence, then such excess amount shall be rebated to Company in the form of a reduction of the cost of services charged by Stadtlander to Company. 3. DUTIES OF COMPANY. 3.1 MEDICAID PROVIDER NUMBERS AND PHARMACY LICENSES. Company will use its commercially reasonable efforts to secure Medicaid provider numbers and/or pharmacy licenses to facilitate its business. 3.2 COOPERATION. Company shall fully cooperate with the Service Providers to permit the Service Providers to perform their duties and obligations under this Agreement in a timely manner. Company shall direct its officers, managers, employees, and agents ("Representatives") to (i) properly respond to requests by any Service Provider for information, and (ii) if requested by a Service Provider, meet with or consult with the Service Provider regarding any manner related to the Services. Company shall also promptly provide a Service Provider with copies of any agreements, instruments or documents in possession of Company as are reasonably requested by such Service Provider, and promptly provide a Service Provider with any notices or other communications that Company may receive that may have any effect on the Service Provider's performance of the Services. 3.3 ACCURACY OF INFORMATION. Company shall be responsible for the completeness and accuracy of all information furnished to a Service Provider by Company and Representatives of Company in connection with the Service Provider's performance of Services. 4. LIMITATION OF LIABILITY. Company acknowledges that the Service Providers are not in the business of providing Services and that Services are being provided pursuant to this Agreement as an accommodation to Company. Company's sole and exclusive remedy and each Service Provider's sole and exclusive liability for any breach of by such Service Provider of its obligations under Section 2, and for any damages of Company suffered or incurred directly or indirectly in connection with the provision of Services by such Service Provider (whether any claim related to such damages arises in contract, in tort, by statute or otherwise), shall be the reperformance by the Service Provider of Services at the Service Provider's expense. No Service Provider makes any warranty, express or implied, including any implied warranty of merchantability or fitness for a particular purpose or as to the performance of the Services furnished hereunder, nor any implied warranty arising from course of performance, course of dealing or usage of trade, all of which are hereby expressly disclaimed. 5. INDEMNITY. 5.1 INDEMNIFICATION. Each party hereby agrees to save, defend and hold each other party and its directors, officers, stockholders, members, employees, and agents harmless from and against any and all claims, suits, actions, demands, liabilities, expenses and/or loss, including reasonable legal expense and attorneys' fees (collectively, "Claims") for damage to persons or property resulting directly or indirectly from its negligence or willful or reckless misconduct in connection with this Agreement; provided, however, that no party shall be required to indemnify or hold any party harmless (either directly or pursuant to any subrogation of rights) for any 4. 5 portion of any Claim that is covered and paid for by any applicable insurance policy or contract maintained by the party seeking indemnification or seeking to be held harmless and which coverage under such insurance contract is not invalidated by a waiver of subrogation rights. 5.2 CONTROL OF DEFENSE. Any entity entitled to indemnification under this Section 5 shall give notice to the indemnifying party of any Claims that may be subject to indemnification, promptly after learning of such Claim, and the indemnifying party shall assume the defense of such Claims with counsel reasonably satisfactory to the indemnified party. If such defense is assumed by the indemnifying party with counsel so selected, the indemnifying party will not be subject to any liability for any settlement of such Claims made by the indemnified party without its consent (but such consent will not be unreasonably withheld or delayed), and will not be obligated to pay the fees and expenses of any separate counsel retained by the indemnified party with respect to such Claims. 6. TERM AND TERMINATION. 6.1 TERM. This Agreement shall begin as of the Effective Date and shall continue until the earlier of (i) termination of the Operating Agreement, (ii) termination by unanimous written consent of the parties, or (iii) termination pursuant to Section 6.2 below. 6.2 RIGHT TO TERMINATE FOR BREACH. In the event any party shall commit a material breach of any term or condition of this Agreement, any aggrieved party may terminate this Agreement upon written notice to the other parties, and such termination shall be effective unless the breach has been remedied within 60 days from notice thereof. 6.3 SUSPENSION OF SERVICES. To suspend or terminate all or part of the Services, either Company or any Service Provider that is obligated to perform such Services may at any time during the Term deliver to the other party a 90-day prior written notice that any of such services will be suspended or terminated. 6.4 EFFECT OF TERMINATION. If this Agreement is terminated pursuant to this Section 6, all further obligation of the parties with respect to such Services under this Agreement shall terminate; provided, however, that: (a) no party shall be relieved of any obligation or liability arising from any prior breach by such party of the provisions of this Agreement; (b) the parties shall, in all events, remain bound by and continue to be subject to the terms set forth in Sections 5 and 6; and (c) Company shall remain liable for payment under Section 2.3 for any Services performed on or prior to the date of termination. 7. CONFIDENTIALITY, RECORDS. 7.1 PROPRIETARY INFORMATION. (a) All information furnished or disclosed by one party (a "Disclosing Party") to any other party (a "Receiving Party") in connection with the negotiation or performance of this Agreement, including but not limited to trade secrets, cost and pricing information, computer programs, techniques, designs, drawings, prototypes, formula or test data, data relating to any research project, work in process, future development, engineering, manufacturing, marketing, servicing, financing or personnel matter shall be deemed "Proprietary Information." Provided, 5. 6 however, that the term "Proprietary Information" shall not be deemed to include information which the Receiving Party can demonstrate by competent written proof: (a) is now, or hereafter becomes, through no act or failure to act on the part of the Receiving Party, generally known or available to the public; (b) is known by the Receiving Party at the time of receiving such information, as evidenced by its records; (c) is hereafter furnished to the Receiving Party by a third party without restriction on disclosure; or (d) is the subject of a written permission to disclose by the Disclosing Party. (b) For purposes of clarification and subject to the provisions of the last sentence of Section 7.1(a) (information excluded from the definition of Proprietary Information), the following are examples of (and do not constitute an exhaustive list of) Proprietary Information of the Company: all information relating to clinical practices information, pharmaceutical usage and outcomes information relating to patients with a serious mental illness who are customers of Company. All such Proprietary Information shall be property solely of Company, regardless of the location or system on which such information is located, and each Service Provider agrees to maintain and provide Company with unlimited and unrestricted access to such information that is within the control of such Service Provider. 7.2 USE AND HANDLING OF PROPRIETARY INFORMATION. The Receiving Party shall maintain all Proprietary Information in trust and confidence and shall use at least the same degree of care regarding this information as it uses with respect to its own Proprietary Information to prevent its unauthorized disclosure, use or publication. The Receiving Party may use such Proprietary Information only to the extent required to accomplish the intent of this Agreement. The Receiving Party shall not use the Proprietary Information for any purpose or in any manner which would constitute a violation of any laws or regulations, including without limitation the export control laws of the United States. 7.3 OWNERSHIP OF PROPRIETARY INFORMATION. All Proprietary Information (including all copies thereof) of a party hereto shall at all times remain the property of such Disclosing Party. No rights or licenses to trademarks, inventions, copyrights or patents are implied or granted under this Agreement. 7.4 PERMITTED DISCLOSURE. A party may disclose Proprietary Information to its professional advisors, and may disclose such information if such disclosure is in response to a valid order of a court or other governmental body of the United States or any political subdivision thereof, provided, however, that the Receiving Party shall first have given notice to the Disclosing Party and shall have made a reasonable effort to obtain a protective order requiring that the Proprietary Information so disclosed be used only for the purposes for which the order was issued; or is otherwise required by law. 7.5 INJUNCTIVE RELIEF. Each party hereby acknowledges and agrees that in the event of any breach of this Section 7 of this Agreement by a Receiving Party, including, without limitation, the actual or threatened disclosure of Proprietary Information without the prior express written consent of the Disclosing Party, the Disclosing Party will suffer an irreparable injury, such that no remedy at law will afford it adequate protection against, or appropriate compensation for, such injury. Accordingly, in the event of any breach or threatened breach by a Receiving Party of any provisions of this Section 7, the Disclosing Party shall, in addition to all 6. 7 other remedies available to it, be entitled to injunctive relief in connection with a breach by Receiving Party under this Agreement. 8. MISCELLANEOUS. 8.1 TAXES. Company shall pay any and all direct or indirect taxes arising out of payments made or due pursuant to this Agreement. 8.2 GOVERNING LAW. This Agreement shall be governed by and construed under the internal laws of the State of California. 8.3 ARBITRATION. The parties agree that they shall submit any disputes arising under this Agreement to binding arbitration pursuant to Section 14.1 of the Operating Agreement, which section is incorporated herein by reference. 8.4 ENTIRE AGREEMENT; AMENDMENT. This Agreement, the Operating Agreement, and that certain Subscription Agreement dated June 8, 1998, by and between PMR and Stadtlander including any and all attachments or exhibits hereto or thereto, constitute the entire, final and exclusive understanding and agreement between the parties with respect to the subject matter hereof. This Agreement may be amended, waived, discharged or terminated only by written agreement of the parties. 8.5 COUNTERPARTS. This Agreement may be executed in counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 8.6 SEVERABILITY. In the event that any provision of this Agreement becomes or is declared by a court of competent jurisdiction to be illegal, unenforceable or invalid, this Agreement shall continue in full force and effect without said provision. 8.7 FORCE MAJEURE. In the event that a party's performance under this Agreement, other than Company's obligation to make payments, shall be interrupted or delayed by the occurrence of any event beyond the reasonable control of such party, then such party shall be excused from performance during the period of time when the interruption occurred. 8.8 CAPTIONS. The captions and heading to Sections of this Agreement have been inserted for identification and reference purposes only and shall not be used to construe the meaning or the interpretation of this Agreement. 8.9 PARTIES IN INTEREST. This Agreement shall inure to the benefit of and be binding upon each Service Provider, Company and their successors and assigns. 8.10 NOTICES. Unless otherwise provided, any notice required or permitted under this Agreement shall be given in writing and shall be deemed effectively given upon personal delivery to the party to be notified or upon deposit with the United States Post Office, by registered or certified mail, postage prepaid and addressed to the party to be notified at the address indicated for such party on the signature page hereof, or at such other address as such party may designate by ten (10) days' advance written notice to the other parties. 7. 8 IN WITNESS WHEREOF, this Agreement has been duly executed and delivered by the respective parties as of the respective dates set forth below. COMPANY: STADT SOLUTIONS, LLC a Delaware limited liability company By: /s/ Mark Clein ------------------------------------ Name: Mark Clein --------------------------------- Title: Manager --------------------------------- Address: 501 Washington Street 5th Floor San Diego, CA 92103 PMR: PMR CORPORATION a Delaware corporation By: /s/ Mark Clein ------------------------------------ Name: Mark Clein --------------------------------- Title: C.F.O. --------------------------------- Address: 501 Washington Street 5th Floor San Diego, CA 92103 STADTLANDER: STADTLANDER DRUG DISTRIBUTION COMPANY, INC. a Delaware corporation By: /s/ James J. Sas Name: James J. Sas Title: Chief Financial Officer Address: 600 Penn Center Boulevard Pittsburgh, PA 15235 8. EX-10.27 3 EXHIBIT 10.27 1 Exhibit 10.27 STADT SOLUTIONS, LLC OPERATING AGREEMENT THIS OPERATING AGREEMENT (the "Operating Agreement") is made as of July 1, 1998, by and between PMR CORPORATION, a Delaware corporation ("PMR") and STADTLANDER DRUG DISTRIBUTION COMPANY, INC., a Delaware corporation ("Stadtlander") (collectively, the "Initial Members") with respect to the operation of STADT SOLUTIONS, LLC, a Delaware limited liability company (the "Company"). WHEREAS, the Company was formed, pursuant to the provisions of the Delaware Limited Liability Company Act, upon the filing of a certificate of formation (the "Certificate of Formation") with the Delaware Secretary of State on June 19, 1998; and WHEREAS, the Initial Members of the Company wish to set forth their respective ownership interests in the Company and the principles by which the Company will be operated and governed. NOW, THEREFORE, in consideration of mutual covenants and other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties hereby agree as follows: ARTICLE 1 DEFINITIONS 1.1 DEFINITIONS. The following terms used in this Operating Agreement shall have the following meanings (unless otherwise expressly provided herein): (a) "ACCOUNTING PERIOD" shall be (i) the Company's Fiscal Year if there are no changes in the Members' respective interests in Company income, gain, loss or deductions during such Fiscal Year except on the first day thereof, or (ii) any other period beginning on the first day of a Fiscal Year, or any other day during a Fiscal Year upon which there occurs a change in such respective interests, and ending on the last day of a Fiscal Year, or on the day preceding an earlier day upon which any change in such respective interest shall occur. (b) "ADDITIONAL CAPITAL COMMITMENT" shall mean Capital Contributions to the capital of the Company in excess of Initial Capital Contributions. (c) "ADDITIONAL MEMBER" shall mean any Person who or which is admitted to the Company as an Additional Member pursuant to Article 9 hereof. (d) "ADJUSTED ASSET VALUE" with respect to any asset shall be the asset's adjusted basis for federal income tax purposes, except as follows: 1 2 (i) The initial Adjusted Asset Value of any asset contributed by a Member to the Company shall be the gross fair market value of such asset at the time of contribution, as determined by the contributing Member and all of the Managers. (ii) In the discretion of the Managers, the Adjusted Asset Values of all Company assets may be adjusted to equal their respective gross fair market values, as determined by the Managers, and the resulting unrecognized profit or loss allocated to the Capital Accounts of the Members pursuant to Article 7, as of the following times: (i) the acquisition of an additional interest in the Company by any new or existing Member in exchange for more than a de minimis capital contribution; and (ii) the distribution by the Company to a Member of more than a de minimis amount of Company assets, unless all Members receive simultaneous distributions of either undivided interests in the distributed property or identical Company assets in proportion to their interests in Company distributions as provided in Section 7.1. (iii) The Adjusted Asset Values of all Company assets shall be adjusted to equal their respective gross fair market values, as determined by the Managers, and the resulting unrecognized profit or loss allocated to the Capital Accounts of the Members pursuant to Article 7, as of the following times: (i) the termination of the Company for federal income tax purposes pursuant to Code Section 708(b)(1)(B); and (ii) a Dissolution Event, as defined in Section 10.1. (e) "ADJUSTED CAPITAL ACCOUNT," with respect to any Member, shall mean the Member's Capital Account as adjusted by the items described in Sections 1.704-2(g)(3), 1.704-2(i)(5) and 1.704-1(b)(2)(ii)(d)(4), (5) and (6) of the Treasury Regulations. (f) "AFFILIATE" of any Person shall mean any Person that directly, or indirectly through one (1) or more intermediaries, controls, or is controlled by or is under common control with the Person specified. (g) "BANKRUPTCY" of a Person shall mean (i) the filing by a Person of a voluntary petition seeking liquidation, reorganization, arrangement or readjustment, in any form, of its debts under the U.S. Bankruptcy Code (or corresponding provisions of future laws) or any other federal, state or foreign insolvency law, or a Person's filing an answer consenting to or acquiescing in any such petition; (ii) the making by a Person of any assignment for the benefit of its creditors or the admission by a Person of its inability to pay its debts as they mature; or (iii) the expiration of sixty (60) days after the filing of an involuntary petition under the Bankruptcy Code (or corresponding provisions of future laws) seeking an application for the appointment of a receiver for the assets of a Person, or an involuntary petition seeking liquidation, reorganization, arrangement or readjustment of its debts under any other federal, state or foreign insolvency law, unless the same shall have been vacated, set aside or stayed within such 60-day period. (h) "BANKRUPT MEMBER" shall mean a Member that becomes the subject of a Bankruptcy. (i) "BUY-SELL PRICE" shall have the meaning ascribed thereto in Section 13.1(b). 2 3 (j) "CAPITAL ACCOUNT" as of any given date shall mean the Capital Contribution to the Company by a Member as adjusted up to the date in question pursuant to Article 6. (k) "CAPITAL CONTRIBUTION" shall mean any contribution to the capital of the Company in cash or property by a Member whenever made. Any reference to a capital contribution of a Member shall include the Capital Contribution made by a predecessor holder of any Units held by such Member with respect to such Units. (l) "CODE" shall mean the Internal Revenue Code of 1986, as amended, or corresponding provisions of subsequent superseding federal revenue laws. (m) "COMPANY" shall refer to Stadt Solutions, LLC. (n) "COMPANY MINIMUM GAIN" shall mean with respect to any taxable year of the Company, the minimum gain of the Company computed strictly in accordance with the principles of Section 1.704-2(d) of the Treasury Regulations. Subject to the previous sentence, Company Minimum Gain shall mean the sum for all Company assets of the amounts of taxable income or gain that would be recognized if the asset were disposed of for the amount of Nonrecourse Liabilities secured by the asset. For this purpose, where the asset is subject to multiple secured liabilities of unequal priority, the adjusted basis of the asset shall be allocated among the liabilities in order of priority from most senior first to least senior last. Where two or more secured liabilities are of equal priority, basis shall be allocated among the liabilities pro rata in accordance with the amounts of the liabilities. For purposes of computing Company Minimum Gain, the Adjusted Asset Value of an asset shall be substituted for its adjusted tax basis if the two differ, but otherwise Company Minimum Gain shall be determined in accordance with federal income tax principles. (o) "COMPANY NONRECOURSE DEDUCTIONS" shall mean an amount of Company deductions, losses and Section 705(a)(2)(B) expenditures, as the case may be (all as computed for "book" purposes), equal to the increase in Company Minimum Gain during the Company taxable year. If the net increase in Company Minimum Gain during the taxable year exceeds the total amount of items of Company loss, deduction and Section 705(a)(2)(B) expenditures for the year, then the excess shall carry over and be treated as Company Minimum Gain of the immediately subsequent year and all following years until cumulative Company Nonrecourse Deductions shall equal the sum of the increases in Company Minimum Gain for all Company taxable years ending on or after the date of this Operating Agreement. This amount shall be comprised of Company items as provided in Section 1.704-2(c) of the Treasury Regulations: (i) First, depreciation or cost recovery deductions (as determined for "book" purposes) with respect to items of Company Property subject to one or more Nonrecourse Liabilities to the extent of the increase in Minimum Gain attributable to the Nonrecourse Liabilities to which each item is subject. 3 4 (ii) Thereafter, a pro rata portion of the Company's other items (as determined for "book" purposes) of deduction, loss and Code Section 705(a)(2)(B) expenditures for the year. (p) "COMPANY PROPERTY" shall mean any tangible and intangible personal property now owned or hereafter acquired by the Company, including, without limitation, all cash, cash equivalents, deposits, accounts receivable, work-in-progress, inventory, equipment, materials, supplies, prototypes, vehicles, real property, fixtures, permits, approvals, licenses, patents, consents, contracts, agreements, applications for permits, approvals, licenses, development rights, development agreements, trade names and warranties, or any other property. (q) "CONVERSION PERCENTAGE LOAN AMOUNT" and "CONVERTED LOAN AMOUNT" shall have the meanings ascribed thereto in Section 6.1(d). (r) "DELAWARE ACT" shall mean the Delaware Limited Liability Company Act at 6 Del. C. Sections 18-101, et seq., as amended. (s) "DISSOLUTION EVENT" shall mean those events defined as such in Section 10.1. (t) "DISTRIBUTABLE CASH" shall mean all cash, receipts and funds received by the Company from Company operations (except for Capital Contributions), less the sum of the following to the extent paid or set aside by the Company: (i) all principal and interest payments on indebtedness of the Company and all other sums paid to lenders; (ii) all cash expenditures incurred incident to the normal operation of the Company's business; (iii) such Reserves as the Managers deem reasonably necessary to the proper operation of the Company's business. (u) "ECONOMIC RISK OF LOSS" shall have the meaning defined in Treasury Regulations Section 1.704-2(b)(4). (v) "ELECTION DAY" shall have the meaning ascribed thereto in Section 13.1(b). (w) "ELECTING MEMBER" and "ELECTION NOTICE" shall have the meanings ascribed thereto in Section 13.1. (x) "ELECTION PERIOD" shall have the meaning ascribed thereto in Section 13.1(d). (y) "FISCAL YEAR" shall mean the Company's fiscal year. The Company's fiscal year shall be the taxable year required by Section 706 of the Code. (z) [INTENTIONALLY OMITTED.] (aa) "IMPASSE" shall have the meaning ascribed thereto in Section 14.1. 4 5 (bb) "INITIAL CAPITAL CONTRIBUTION" shall mean the initial contribution to the capital of the Company pursuant to this Operating Agreement in connection with the initial issuance of Units. (cc) "INTEREST" shall mean the proportion that a Member's Units bears to the aggregate outstanding Units of all Members. (dd) "MANAGER" shall mean each of the Members or other persons designated by this Operating Agreement to act as managers of the Company. (ee) "MEMBER" shall mean each of the Initial Members and Additional Members who are, as of a given time, a member of the Company. (ff) "MEMBER MINIMUM GAIN" shall mean, with respect to each Member Nonrecourse Debt, an amount equal to the Company Minimum Gain that would result if such Member Nonrecourse Debt were treated as a Nonrecourse Liability, determined in accordance with Treasury Regulations Section 1.704-2(i). (gg) "MEMBER NONRECOURSE DEBT" shall mean any nonrecourse debt to the Company for which any Member bears the Economic Risk of Loss. (hh) "MEMBER NONRECOURSE DEDUCTIONS" shall mean, with respect to a Member Nonrecourse Debt, the excess, if any, of the net increase, if any, in the amount of Member Minimum Gain attributable to such Member Nonrecourse Debt during an Accounting Period over the aggregate amount of any distributions during such Accounting Period to such Member that bears the Economic Risk of Loss for such Member Nonrecourse Debt to the extent such distributions are from the proceeds of such Member Nonrecourse Debt and are allocable to an increase in Member Minimum Gain attributable to such Member Nonrecourse Debt, determined in accordance with Treasury Regulations Section 1.704-2(i)(2). (ii) "NET INCOME BASE" shall have the meaning ascribed thereto in Section 7.1(a). (jj) "NET PROFITS OR NET LOSSES" shall be an amount computed for each Accounting Period as of the last day thereof that is equal to the Company's taxable income or loss for such Accounting Period, determined in accordance with Section 703(a) of the Code (for this purpose, all items of income, gain, loss, or deduction required to be stated separately pursuant to Code Section 703(a)(1) shall be included in taxable income or loss), with the following adjustments: (i) Any income of the Company that is exempt from federal income tax and not otherwise taken into account in computing Net Profits or Net Losses pursuant to this Section 1.1(jj) shall be added to such taxable income or loss; (ii) Any expenditures of the Company described in Code Section 705(a)(2)(B) or treated as Code Section 705(a)(2)(B) expenditures pursuant to Treasury Regulations Section 1.704-1(b)(2)(iv)(i) and not otherwise taken into account in computing Net 5 6 Profits or Net Losses pursuant to this Section 1.1(jj) shall be subtracted from such taxable income or loss; (iii) Gain or loss resulting from any disposition of Company Property with respect to which gain or loss is recognized for federal income tax purposes and depreciation or amortization with respect to Company Property, shall be computed by reference to the Adjusted Asset Value of such property rather than its adjusted tax basis; (iv) The difference between the gross fair market value of all Company assets and their respective Adjusted Asset Values shall be added to such taxable income or loss in the circumstances described in Section 1.1(d); (v) In the event of a distribution in kind of Company Property to the Members, the gain or loss that would result from a sale of such Company Property at fair market value shall be added to or subtracted from such taxable income or loss; and (vi) Items that are specially allocated pursuant to Section 7.3 hereof shall not be taken into account in computing Net Profits or Net Losses. (kk) "NET STATED EQUITY" shall have the meaning ascribed thereto in Section 13.2. (ll) "NONRECOURSE LIABILITIES" shall mean "nonrecourse liabilities" as characterized under Section 1.704-2(b)(3) of the Treasury Regulations. Subject to the foregoing sentence, Nonrecourse Liabilities means liabilities of the Company (or a portion thereof) with respect to which none of the Members bears the Economic Risk of Losses (other than through the Member's indirect interest as a Member in the Company assets subject to the liability). Any liability of the Company to a Member and any liability guaranteed by a Member or with respect to which a Member has pledged personal assets (to the extent the Member may bear the burden of an economic loss attributable to the liability) shall not be classified as a Nonrecourse Liability. (mm) "NOTICE MEMBER" shall mean a Member who receives an Election Notice pursuant to Section 13.1. (nn) "OPERATING AGREEMENT" shall mean this Operating Agreement as originally executed and as amended from time to time. (oo) "PERSON" shall mean any individual or entity, and the heirs, executors, administrators, legal representatives, successors, and assigns of such "Person" where the context so admits. (pp) "PMR MANAGERS" shall mean the Managers appointed by PMR pursuant to Section 4.2. (qq) "PURCHASE MEMBER" and "PURCHASE NOTICE" shall have the meanings ascribed thereto in Section 13.1(c). 6 7 (rr) "REGULATORY ALLOCATIONS" shall mean the allocations pursuant to Sections 7.2(a) through 7.2(d) of this Operating Agreement. (ss) "RESERVES" shall mean, with respect to any Fiscal Year, funds set aside or amounts allocated during such Fiscal Year to reserves that shall be maintained in amounts deemed sufficient by the Managers for working capital and to pay taxes, insurance, debt service or other costs or expenses incident to the ownership or operation of the Company's business. (tt) "SECOND CAPITAL CONTRIBUTION" shall have the meaning ascribed thereto in Section 6.1(a). (uu) "SELLING MEMBER" shall have the meaning ascribed thereto in Section 13.1(d). (vv) "STADTLANDER MANAGERS" shall mean the Managers appointed by Stadtlander pursuant to Section 4.2. (ww) "STATED AMOUNT" shall mean the amount stated in an Election Notice which represents and shall be used as the value of the Company's assets in computing the Net Stated Equity. (xx) "TOTAL UNITS" shall have the meaning ascribed thereto in Section 6.1. (yy) "TREASURY REGULATIONS" shall mean the Income Tax Regulations, including temporary regulations, promulgated under the Code, as amended from time to time. (zz) "UNITS" shall mean the capital units issued by the Company to its Members, in exchange for contributions or as otherwise determined by the Managers, which represent the Member's Interest in the Company. ARTICLE 2 FORMATION OF COMPANY 2.1 FORMATION. On June 19, 1998, the Company was organized as a Delaware limited liability company under and pursuant to the Delaware Act. 2.2 NAME. The name of the Company is Stadt Solutions, LLC. 2.3 PRINCIPAL PLACE OF BUSINESS. The principal place of business of the Company shall be 501 Washington Street, 5th Floor, San Diego, California 92103. The Company may locate its places of business and registered office at any other place or places as the Managers may from time to time deem advisable. 2.4 REGISTERED OFFICE AND REGISTERED AGENT. The Company's registered office in the state of Delaware shall be at the office of its registered agent at 9 East Loockerman Street, Dover, Delaware 19901, County of Kent, and the name of its initial registered agent at such address shall be National Registered Agents, Inc. 7 8 2.5 TERM. The Company's existence commenced June 19, 1998 upon the filing with the Secretary of the State of Delaware of the Company's Certificate of Formation and shall continue for a period of thirty (30) years, unless the Company is earlier dissolved in accordance with either the provisions of this Operating Agreement or the Delaware Act. ARTICLE 3 PURPOSES OF COMPANY 3.1 COMPANY PURPOSES. The purpose of the Company is to (a) operate a specialty pharmaceutical business to provide services to patients diagnosed with a serious mental illness, and to record and use information relating to health care informatics, clinical practices, pharmaceutical usage and patient outcomes, clinical research site management and information services and (b) engage in any other lawful act or activity for which a limited liability company may be organized under the laws of the state of Delaware, incident, necessary, advisable or desirable to carry out the foregoing. The Company shall have the power to make and perform all contracts and to engage in all actions and transactions necessary or advisable to carry out the purposes of the Company, and all other powers available to limited liability companies under the Delaware Act. ARTICLE 4 RIGHTS AND DUTIES OF THE MANAGERS AND OFFICERS 4.1 MANAGEMENT. The business and affairs of the Company shall be managed by the Managers in accordance with this Article 4. 4.2 NUMBER AND TERM OF THE MANAGERS. The number of Managers of the Company shall be fixed at four (4) Managers. PMR shall be entitled to appoint two (2) Managers (the "PMR Managers") and Stadtlander shall be entitled to appoint two (2) Managers (the "Stadtlander Managers"). The initial PMR Managers shall be Mark P. Clein and Daniel L. Frank and the initial Stadtlander Managers shall be Allan Silber and Morris Perlis. Each Manager shall hold office until a successor shall have been elected and qualified. No Member shall appoint a Manager that is not an employee of such Member or one of its Affiliates. 4.3 RESIGNATION. A Manager may resign at any time by giving written notice to the Members of the Company. The resignation of a Manager shall take effect upon receipt of notice thereof or at such later time as shall be specified in such notice; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. 4.4 REMOVAL. Only the Member entitled to appoint a Manager pursuant to Section 4.2 shall be entitled to remove such a Manager. 4.5 VACANCIES. Any vacancy in the position of Manager occurring for any reason shall be filled by the written consent of the Member entitled to appoint the Manager (pursuant to Section 4.2) for which a vacancy exists. 8 9 4.6 CERTAIN POWERS OF THE MANAGERS. (a) EXCLUSIVE MANAGEMENT BY THE MANAGERS. The business, property and affairs of the Company shall be managed exclusively by the Managers. Except for situations in which the approval of the Members is expressly required by the Delaware Act or this Operating Agreement, the Managers shall have full, complete and exclusive authority, power, and discretion to manage and control the business, property and affairs of the Company, to make all decisions regarding those matters and to perform any and all other acts or activities customary or incident to the management of the Company's purposes, business, property and affairs. The Managers may adopt such rules and regulations for the management of the Company not inconsistent with this Operating Agreement or the Delaware Act. Subject to Section 5.4 below, the Managers shall have all necessary powers to manage and carry out the purposes, business, property, and affairs of the Company, including, without limitation, the power to exercise on behalf and in the name of the Company all of the powers described in Delaware Act Section 18-106. (b) AGENCY AUTHORITY OF THE MANAGERS. Subject to Section 5.4, the Managers are authorized to execute on behalf of the Company all instruments and documents, including, without limitation, checks, drafts, notes and other negotiable instruments, mortgages or deeds of trust, security agreements, financing statements, documents providing for the acquisition, mortgage or disposition of Company Property, assignments, bills of sale, leases, partnership agreements, and any other instruments or documents necessary, in the opinion of the Managers, to the business of the Company. (c) VOTING POWER. Each Manager shall have the number of votes ("Manager Votes") equal to the number of Units then held by the Member who appointed such Manager. 4.7 MANAGERS HAVE NO EXCLUSIVE DUTY TO COMPANY. The Managers shall not be required to manage the Company as their sole and exclusive function and they may have other business interests and may engage in other activities in addition to those relating to the Company. Neither the Company nor any Member shall have any right, by virtue of this Operating Agreement, to share or participate in such other investments or activities of the Managers or to the income or proceeds derived therefrom. 4.8 BANK ACCOUNTS. The Managers may from time to time open bank accounts in the name of the Company. 4.9 INDEMNIFICATION. (a) The Company agrees to indemnify, out of the assets of the Company only, each Manager and each Manager's members, partners, employees and Affiliates (each, an "Indemnitee") to the fullest extent permitted by law and to save and hold them harmless from and in respect of all (a) reasonable fees, costs, and expenses paid in connection with or resulting from any claim, action, or demand against an Indemnitee that arises out of or in any way relates to the Company, its properties, business, or affairs and (b) such claims, actions, and demands and any losses or damages resulting form such claims, actions, and demands, including amounts paid in settlement or compromise (if recommended by attorneys for the Company) of any such claim, action or demand; provided, however, that this indemnity shall not extend to (i) conduct not undertaken in good faith to promote the best interests of the Company or (ii) conduct which is 9 10 reckless, intentionally wrongful or grossly negligent. In addition to the indemnification conferred in this Section 4.9, the Indemnitee shall also be entitled to have paid directly by the Company the expenses reasonably incurred in defending any such proceeding against such Indemnitee in advance of its final disposition, to the fullest extent not prohibited by the Delaware Act, as the same exists or may hereafter be amended. The right to indemnification conferred in this Section 4.9 shall be a contract right. (b) The Company may, by action of the Managers, provide indemnification to such of the officers, employees and agents of the Company to such extent and to such effect as the Managers shall determine to be appropriate and authorized under Section 18-108 of the Delaware Act, as the same exists or may hereafter be amended. (c) The rights and authority conferred in this Section 4.9 shall not be exclusive of any other right which any person may have or hereafter acquire under any statute, agreement, or otherwise. (d) The Company may purchase and maintain insurance on behalf of one or more Indemnitees and other Persons against any liability which may be asserted against, or expense which may be incurred by, any such Person in connection with the Company's activities (and the Company shall use its commercially reasonable efforts to purchase and maintain such insurance on behalf of the Managers), whether or not the Company would have the power to indemnify such Person against such liability under the provisions of this Operating Agreement. 4.10 APPOINTMENT OF OFFICERS. The Managers may appoint officers of the Company, which may include, but shall not be limited to: (a) a president; (b) one or more vice presidents; (c) a secretary; and (d) a treasurer or chief financial officer. The Managers may delegate their day-to-day management responsibilities to any such officers, and such officers shall have the authority to contract for, negotiate on behalf of and otherwise represent the interests of the Company as authorized by the Managers in any job description created by the Managers. All officers shall hold office at the pleasure of the Managers and until their successors shall have been duly elected and qualified, unless sooner removed. Any officer may be removed at any time by the Managers. If the office of any officer becomes vacant for any reason, the vacancy may be filled by the Managers. 4.11 MANAGER APPROVAL; DEADLOCK. Unless otherwise expressly provided for in this Operating Agreement, any action or approval of the Managers shall require the vote, consent or approval of Managers holding a majority of the Manager Votes. ARTICLE 5 RIGHTS AND OBLIGATIONS OF MEMBERS 5.1 LIMITATION OF LIABILITY. Each Member's liability shall be limited as set forth in the Delaware Act and other applicable law. Except as otherwise provided by the Delaware Act, the debts, obligations and liabilities of the Company, whether arising in contract, tort or otherwise, shall be the debts, obligations and liabilities solely of the Company, and the Members of the Company shall not be obligated personally for any of such debts, obligations or liabilities solely by reason of being a Member of the Company. 10 11 5.2 MEMBER ACCESS TO RECORDS. Upon written request of any Member, setting forth the purpose for such request, each Member shall have the right, during regular business hours, to inspect and copy such Company documents at the Member's expense as set forth in Section 7.9. 5.3 MEMBERS HAVE NO MANAGERIAL AUTHORITY. Pursuant to Section 4.1, the management of the Company is vested in the Managers. The Members shall have no power to participate in the management of the Company except as expressly authorized by this Operating Agreement and except as expressly required by the Delaware Act. Unless expressly and duly authorized in writing to do so by the Managers, no Member shall have any power or authority to act as an agent of the Company, to bind or act on behalf of the Company in any way, to pledge its credit, or to render it liable for any purpose. 5.4 VOTING RIGHTS. Except as required by the Delaware Act, Members shall have no voting, approval or consent rights except the right to approve or disapprove the following: (a) APPROVAL BY MEMBERS HOLDING TWO-THIRDS OF THE INTERESTS. The following matters shall require the vote, approval or consent of Members holding at least two-thirds of the Interests: (i) Any operating budget for the Company which provides for capital expenditures that exceeds the previous Fiscal Year's budget for capital expenditures by more than twenty percent (20%); (ii) The issuance of additional Units or other equity securities or rights or securities convertible into Units or other equity securities of the Company; (iii) Any agreement (or modification of an agreement) or transaction between the Company and any Member or its Affiliate or any director or executive officer thereof; (iv) Any liquidation or dissolution of the Company or the decision to cause the Company to enter into Bankruptcy; (v) Any amendment of the Certificate of Formation or this Operating Agreement; provided, however, that this Operating Agreement shall not be amended to create any obligation to contribute capital to the Company without the consent of each affected Member; (vi) The sale, exchange or other disposition of more than twenty percent (20%) of the Company Property as part of a single transaction or plan, except in the orderly liquidation and winding up of the business of the Company upon its duly authorized dissolution; and (vii) The merger of the Company with another limited liability company, a limited partnership, a general partnership, or a corporation; provided in no event shall a Member be required to become a general partner in a merger with a limited partnership or a general partnership without his express written consent or unless the agreement of merger provides each Member with the dissenter's rights described in the Delaware Act. 11 12 5.5 MEMBER HAS NO EXCLUSIVE DUTY TO COMPANY. Subject to the provisions of Section 12.1, Members may have other business interests and engage in other activities in addition to those relating to the Company. ARTICLE 6 CONTRIBUTIONS TO THE COMPANY, CAPITAL UNITS AND CAPITAL ACCOUNTS 6.1 CAPITAL CONTRIBUTIONS. (a) REQUIRED CAPITAL CONTRIBUTIONS. Each Member shall contribute within 60 days following the date of this Operating Agreement such amount as is set forth in Schedule A hereto as such Member's share of the Initial Capital Contribution and will receive a credit to such Member's Capital Account in the amount set fort in Schedule A. At the Second Closing (as defined in that certain Subscription Agreement by and between the Members, dated as of June 8, 1998 (the "Subscription Agreement")), each Member shall contribute such assets as is set forth in Schedule A hereto as such Member's Second Capital Contribution and will receive a credit to such Member's Capital Account in the amount of the value as set forth in Schedule A. (b) ADDITIONAL CAPITAL CONTRIBUTIONS. No Member shall be required to make any additional Capital Contribution to the Company. Members may make additional Capital Contributions only upon agreement of all Members and, unless all Members otherwise agree in writing, pro rata in proportion to the Units held by each Member. Without in any way limiting the generality of the foregoing, no additional capital contribution shall be required pursuant to an arbitration under Section 14.1. (c) LOANS. In the event that less than all Members agree to make additional Capital Contributions, any Member shall have the right, but not the obligation, to make a loan (to the extent funds are reasonably required by the Company for a bona fide purpose, including for operations or to pay debts or liabilities) to the Company with interest at the rate of prime plus two percent (2%), with principal and interest payable not less than quarterly, and on such other then prevailing commercially reasonable terms. 6.2 UNITS. Each Member's Interest in the Company shall be represented by Units of membership interest each having identical rights and privileges. An unlimited number of Units is hereby authorized. In consideration for their respective Initial and Second Capital Contributions, the Initial Members shall receive the number of Units set forth on Schedule A (the "Initial Units"). 6.3 CAPITAL ACCOUNTS. (a) A separate Capital Account will be maintained for each Member. Each Member's Capital Account will be increased by (1) the amount of money contributed by such Member to the Company; (2) the fair market value of property contributed by such Member to the Company (net of liabilities secured by such contributed property that the Company is considered to assume or take subject to under Section 752 of the Code); and (3) the amount of Net Profits or other items of income or gain allocated to such Member. Each Member's Capital 12 13 Account will be decreased by (1) the amount of money distributed to such Member by the Company; (2) the fair market value of property distributed to such Member by the Company (net of liabilities secured by such distributed property that such Member is considered to assume or take subject to under Section 752 of the Code); and (3) the amount of Net Losses or other items of deduction or loss allocated to such Member. (b) In the event of a permitted sale or transfer of all or part of a Member's Interest in the Company, the Capital Account of the transferor shall become the Capital Account of the transferee to the extent it relates to the transferred Interest. (c) The manner in which Capital Accounts are to be maintained pursuant to this Section 6.3 is intended, and shall be construed so as, to comply with the requirements of Code Section 704(b) and the Treasury Regulations promulgated thereunder. (d) Upon liquidation of the Company (or any Member's Interest), liquidating distributions will be made in accordance with the positive Capital Account balances of the Members, as determined after taking into account all Capital Account adjustments for the Company's taxable year during which the liquidation occurs. Liquidation proceeds will be paid within sixty (60) days of the end of the taxable year (or, if later, within ninety (90) days after the date of the liquidation). 6.4 WITHDRAWAL OR REDUCTION OF MEMBERS, CONTRIBUTIONS TO CAPITAL. (a) A Member shall not receive out of the Company Property any part of its contributions to capital until all liabilities of the Company, except liabilities to Members on account of their contributions to capital, have been paid or there remains property of the Company sufficient to pay them. (b) A Member shall not be entitled to demand or receive from the Company the liquidation of its interest in the Company until the Company is dissolved in accordance with the provisions hereof or other applicable provisions of the Delaware Act. ARTICLE 7 DISTRIBUTIONS, ALLOCATIONS, INCOME TAX, ELECTIONS AND REPORTS 7.1 DISTRIBUTIONS OF PROFITS AND LOSSES. (a) DISTRIBUTION OF PROFITS. Until such time as the total cumulative Net Income Base (as defined below) amounts paid to Stadtlander hereunder equals the amount of the Aggregate Net Income Base Obligation (i.e., when the Aggregate Net Income Base Obligation is satisfied), the cash available for distribution shall be distributed as follows: Stadtlander will receive, and the Company will be obligated to pay (subject to any limitation contained herein) annually within 30 days following the completion of the annual audit of the financial results of the Company, Distributable Cash equal to at least the full amount of the Net Income Base for the Fiscal Year as set forth in this Section 7.1(a) reduced by the amount of Gross Margin previously paid by Company to Stadtlander under that certain Transition and Services Agreement dated as of even date herewith, among Company, PMR and Stadtlander (the "Transition and Services 13 14 Agreement"). Any deficit in a Net Income Base distribution shall accrue interest at the same rate of interest as the senior debt of the Company plus 1% (or if there is no senior debt outstanding, the Wall Street Journal prime rate plus one percent (1%)) and subject to Section 7.1(a)(iii) shall be payable with the Net Income Base Payment for the Fiscal Year ended December 31, 2000 or, at the Company's option, at any earlier time. Any Distributable Cash in excess of the Net Income Base shall then be distributed between the Members in accordance with their Interests. All Distributable Cash shall be distributed between the Members in accordance with their Interests after the Aggregate Net Income Base Obligation is satisfied. Notwithstanding anything herein to the contrary, the Managers shall not make (i) for the Fiscal Year ended December 31, 1998, any distribution in excess of consolidated net cash flow from operations (determined in accordance with generally accepted accounting principles consistently applied ("GAAP")), or (ii) for each of the Fiscal Years ended December 31, 1999 and 2000, any distribution in excess of consolidated net cash flow from operations determined (in accordance with GAAP) as of December 31, 1999 or December 31, 2000, as the case may be, as adjusted for certain capital expenditures to be agreed upon by the parties. (i) The following terms shall have the definitions set forth below: (1) "Aggregate Net Income Base Obligation" shall mean the greater of $48,000,000 or the product of the Net Income Base for the Fiscal Year ended December 31, 2000 multiplied by ten (10). (2) "Clozaril Base Overhead" shall be the sum of $5,375,000, which is the Company's estimated operating and overhead expenses for pharmaceutical fulfillment and case management services during each full Fiscal Year relating solely to the sales of Clozaril and Clozapine (and any of their successor products) by the Company, and which is determined as set forth in Schedule B attached hereto. (3) Subject to the provisions of this subsection 7.1(a)(i)(3), "Clozaril Gross Profit" shall mean for a Fiscal Year, the product of (i) the average gross profit per patient participating in the Company's Clozaril and Clozapine (or successor product) program ("Clozaril Customer") (determined in accordance with GAAP), multiplied by (ii) 6,000. For purposes of this subsection, so long as there are at least 6,000 Clozaril Customers in the Initial States (as defined in the Transition and Services Agreement), the average gross profit described in clause (i) above shall be calculated based only on the Clozaril Customers in such Initial States. If there are less than 6,000 Clozaril Customers in the Initial States, the Clozaril Gross Profit shall be calculated using gross profit for the actual number of Clozaril Customers in the Initial States plus the blended average gross profit per customer for all other Clozaril Customers multiplied by the difference between the number of Clozaril Customers in the Initial States and 6,000. (ii) Net Income Base for a Fiscal Year shall be determined as set forth below: (1) For the Fiscal Year ending December 31, 1998, the Net Income Base shall be the greater of (A) $2,000,000 or (B) the result of Clozaril Gross Profit minus fifty percent (50%) of the Clozaril Base Overhead. In the event the Company begins operations after July 1, 1998, the dollar amount set forth in (A) and the portion of the Clozaril 14 15 Base Overhead set forth in (B) shall be pro-rated for the remainder of the Fiscal Year based on the number of days of operations divided by 180. (2) For the Fiscal Year ending December 31, 1999, the Net Income Base shall be the greater of (A) $4,000,000 or (B) the result of Clozaril Gross Profit minus Clozaril Base Overhead. (3) For the Fiscal Year ending December 31, 2000, the Net Income Base shall be the greater of (A) $4,000,000 or (B) the result of Clozaril Gross Profit minus Clozaril Base Overhead, and the Net Income Base distribution shall be accompanied by a payment of all outstanding deficits of previous Net Income Base distribution obligations (plus accrued interest) as described in Section 7.1(a). (4) Subject to Section 7.1(a)(iii), for each subsequent Fiscal Year beginning with the Fiscal Year ending December 31, 2001, the Net Income Base shall be the greater of (A) $4,000,000 or (B) the amount of the Net Income Base for the Fiscal Year ended December 31, 2000. (iii) If for the Fiscal Year ended December 31, 2000 (1) the result of gross profit from all sales of Clozaril and Clozapine (and successor products) (determined in accordance with GAAP) is less than $4,000,000 and (2) the Company's earnings before interest and taxes (exclusive of any allocations of corporate overhead or other expenses not in the ordinary course of business), determined in accordance with GAAP ("EBITDA"), is less than $7,600,000, then Stadtlander and PMR shall negotiate in good faith and shall agree to appropriately adjust the amount of the Net Income Base distribution for each subsequent Fiscal Year downward to an equitable amount and defer the payment of any accrued deficit of Net Income Base distributions then outstanding. (b) TAX WITHHOLDING. All amounts withheld pursuant to the Code or any provisions of state or local tax law with respect to any income allocable to or payment or distribution to the Members from the Company shall be treated as amounts distributed to the relevant Member or Members pursuant to the applicable subparagraph of this Section 7.1. 7.2 ALLOCATIONS OF NET PROFITS AND NET LOSSES. For each Accounting Period, Net Profits and Net Losses (and, to the extent necessary, items thereof) shall be allocated as follows: (a) First, to Stadtlander until its Adjusted Capital Account balance is equal to the amount that Stadtlander would have been entitled to receive pursuant to the first two sentences of Section 7.1(a) had the Company sold all of its assets as of the end of such Account Period for an amount that generated no Net Profit or Net Loss (or any other item of income, gain, loss or deduction) and immediately thereafter distributed all of such assets in liquidation of the Company pursuant to Section 7.1. (b) Second, to all Members in accordance with their Interests. 15 16 7.3 SPECIAL ALLOCATIONS. (a) LIMITATIONS ON LOSSES ALLOCATIONS. Notwithstanding Section 7.2(b) above, no loss shall be allocated to a Member if such allocation would cause such Member's Adjusted Capital Account to become negative or to increase the negative balance thereof. (b) QUALIFIED INCOME OFFSET. In the event any Member unexpectedly receives any adjustments, allocations or distributions described in Section 1.704-l(b)(2)(ii)(d)(4), (5) or (6) of the Treasury Regulations, items of Company income and gain shall be specially allocated to each such Member in an amount and manner sufficient to eliminate, to the extent required by the Treasury Regulations, the deficit balance of the Adjusted Capital Account of such Member as possible, provided that an allocation pursuant to this Section 7.3(b) shall only be made if and to the extent such Member would have a deficit balance in its Adjusted Capital Account after all other allocations provided for in Section 7.2 and Section 7.3 have been made as if this Section 7.3(b) were not in this Operating Agreement. (c) GROSS INCOME ALLOCATION. In the event any Member has a deficit Capital Account at the end of any Accounting Period which is in excess of the sum of (i) the amount such Member is obligated to restore pursuant to any provision of this Operating Agreement, if any, and (ii) the amount such Member is deemed to be obligated to restore pursuant to the penultimate sentence of Treasury Regulations Sections l.704-2(g)(1) and 1.704-2(i)(5), each such Member shall be specially allocated items of Company income and gain in the amount of such excess as quickly as possible, provided that an allocation pursuant to this Section 7.3(c) shall be made only if and to the extent that such Member would have a deficit Capital Account in excess of such sum after all other allocations provided for in Section 7.2 and Section 7.3 have been made as if Section 7.3(b) hereof and this Section 7.3(c) were not in this Operating Agreement. (d) CODE SECTION 754 ADJUSTMENTS. To the extent an adjustment to the adjusted tax basis of any Company asset purchase to Code Section 734(b) or Code Section 743(b) is required, pursuant to Treasury Regulations Section l.704-l(b)(2)(iv)(m), to be taken into account in determining Capital Accounts, the amount of such adjustment to the Capital Accounts shall be treated as an item of gain (if the adjustment increases the basis of the asset) or loss (if the adjustment decreases such basis) and such gain or loss shall be specially allocated to the Members in a manner consistent with the manner in which their Capital Accounts are required to be adjusted pursuant to such Section of the Treasury Regulations. (e) CURATIVE ALLOCATIONS. Notwithstanding any other provision of this Operating Agreement, the Regulatory Allocations shall be taken into account in allocating items of income, gain, loss and deduction among the Members so that, to the extent possible, the net amount of such allocations of other items and the Regulatory Allocations to each Member shall be equal to the net amount that would have been allocated to each such Member if the Regulatory Allocations had not occurred. For purposes of applying the foregoing sentence, allocations pursuant to this Section 7.3(e) shall only be made with respect to allocations pursuant to Section 7.3(d) hereof to the extent the Managers reasonably determine that such allocations will otherwise be inconsistent with the economic agreement among the parties to this Operating Agreement. 16 17 7.4 ALLOCATION OF NONRECOURSE ITEMS. (a) COMPANY NONRECOURSE DEDUCTIONS. Any Company Nonrecourse Deductions for any Fiscal Year or Accounting Period shall be allocated to the Members in accordance with their respective Interests. (b) MEMBER NONRECOURSE DEDUCTIONS. Any Member Nonrecourse Deductions for any Fiscal Year or Accounting Period shall be specially allocated to the Member who bears the Economic Risk of Losses with respect to the Member Nonrecourse Debt to which such Member Nonrecourse Deductions are attributable in accordance with Treasury Regulations Section 1.704-2(i). (c) COMPANY MINIMUM GAIN CHARGEBACK. Notwithstanding any other provision of this Article 7, if there is a net decrease in Company Minimum Gain during any Fiscal Year, each Member shall be specially allocated items of Company income and gain for such year (and, if necessary, subsequent years) in an amount equal to the greater of (i) the portion of such Member's share of the net decrease in Company Minimum Gain, determined in accordance with Treasury Regulations Section 1.704-2(g), that is allocable to the disposition of Company Property subject to such Nonrecourse Liability, determined in accordance with Treasury Regulations Section 1.704-2(f), or (ii) the negative balance standing in such Member's Capital Account. Allocations pursuant to the previous sentence shall be made in proportion to the respective amounts required to be allocated to each Member pursuant thereto. The items to be so allocated shall be determined in accordance with Treasury Regulations Section 1.704-2(f)(6). This Section 7.4(c) is intended to comply with the minimum gain chargeback requirements set forth in Treasury Regulations Section 1.704-2(f)(6) and shall be interpreted consistently therewith. (d) MEMBER MINIMUM GAIN CHARGEBACK. Notwithstanding any other provision of this Article 7 (except Section 7.4(c), which shall be applied first), if there is a net decrease in Member Minimum Gain attributable to a Member Nonrecourse Debt during any Fiscal Year or Accounting Period, each Member who has a share of the Member Minimum Gain attributable to such Member Nonrecourse Debt, determined in accordance with Treasury Regulations Section 1.704-2(i)(5), shall be specially allocated items of Company income and gain for such year (and if necessary, subsequent years) in an amount equal to the greater of (i) the portion of such Member's share of the net decrease in Member Minimum Gain attributable to such Member Nonrecourse Debt, determined in accordance with Treasury Regulations Section 1.704-2(i)(5), that is allocable to the disposition of Company Property subject to such Member Nonrecourse Debt, determined in accordance with Treasury Regulations Section 1.704-2(i)(4) or (ii) the negative balance standing in such Member's Capital Account. Allocations pursuant to the previous sentence shall be made in proportion to the respective amounts required to be allocated to each Member pursuant thereto. The items to be so allocated shall be determined in accordance with Treasury Regulations Section 1.704-2(i)(4). This Section 7.4(d) is intended to comply with the minimum gain chargeback requirements set forth in Treasury Regulations Section 1.704-2(i)(4) and shall be interpreted consistently therewith. 7.5 LIMITATION UPON DISTRIBUTIONS. 17 18 (a) No distribution shall be declared and paid to a Member to the extent that at the time of distribution, after giving effect to the distribution, all liabilities of the Company, other than liabilities to Members on account of their Interests and liabilities for which the recourse of creditors is limited to specific property of the Company, exceed the fair market value of the assets of the Company, except that the fair market value of property that is subject to a liability for which the recourse of creditors is limited shall be included in the assets of the Company only to the extent that the fair market value of the property exceeds that liability. (b) A Member who receives a distribution in violation of Section 7.5(a), and who knew at the time of the distribution that the distribution violated Section 7.5(a), shall be liable to the Company for the amount of the distribution. A Member who receives a distribution in violation of Section 7.5(a), and who did not know at the time of the distribution that such distribution violated Section 7.5(a) and shall have made a good faith effort to return as much as possible of the improper distribution shall not be liable for the amount of the distribution. (c) A Member who receives a distribution from the Company shall have no liability under this Section 7.5 or other applicable law for the amount of the distribution after the expiration of three (3) years from the date of the distribution unless an action to recover the distribution from such Member is commenced prior to the expiration of the said three (3) year period and an adjudication of liability against such Member is made in the said action. 7.6 ACCOUNTING PRINCIPLES. The profits and losses of the Company shall be determined in accordance with generally accepted accounting principles applied on a consistent basis. 7.7 INTEREST ON AND RETURN OF CAPITAL CONTRIBUTIONS. No Member shall be entitled to interest on its Capital Contribution or to return of its Capital Contribution, except as otherwise specifically provided for herein. 7.8 LOANS TO COMPANY. Nothing in this Operating Agreement shall prevent any Member from making secured or unsecured loans to the Company by agreement with the Managers on behalf of the Company. 7.9 RECORDS AND REPORTS. At the expense of the Company, the Managers shall maintain records and accounts of all operations and expenditures of the Company and shall keep the following records: (a) A current list of the full name and last known business address of the Managers and each Member; (b) A copy of the Certificate of Formation and all amendments thereto, together with executed copies of any written powers of attorney pursuant to which this Operating Agreement and any certificate and all amendments thereto have been executed; (c) Copies of the Company's federal, foreign, state and local income tax returns and reports, if any, for the three (3) most recent years; (d) Copies of this Operating Agreement and all amendments thereto; 18 19 (e) True and full information regarding the status of the business and financial condition of the Company, including financial statements of the Company since the date of formation of the Company; and (f) True and full information regarding the amount of cash and a description and statement of the agreed value of any other property or services contributed by each Member and which each Member has agreed to contribute in the future, and the date on which each became a Member. 7.10 RETURNS AND OTHER ELECTIONS. The Managers shall cause the preparation and timely filing of all tax returns required to be filed by the Company pursuant to the Code and all other tax returns deemed necessary and required in each jurisdiction in which the Company does business. Copies of such returns, or pertinent information therefrom, shall be furnished to the Members within a reasonable time after the end of the Company's Fiscal Year. All elections permitted to be made by the Company under federal or state laws shall be made by the Managers in their discretion. 7.11 TAX MATTERS PARTNER. Stadtlander is hereby designated the "tax matters partner" of Company for purposes of Chapter 63 of the Code and the Treasury Regulations thereunder. The tax matters partner may be changed by the Managers. ARTICLE 8 TRANSFERABILITY 8.1 TRANSFER. Except as provided in this Section 8.1, Section 8.2 or Section 8.4 or Article 13 below or with the prior written consent of Members holding at least two-thirds of the Interests (which consent shall not be withheld in the event of a proposed transfer pursuant to a sale of all or substantially all of the assets of a Member), no Member may shall sell, assign, give, pledge, hypothecate, encumber or otherwise transfer ("transfer") its Interest, or any portion thereof, or any other right or interest in all or any of the assets of the Company. 8.2 PERMITTED TRANSFERS. Notwithstanding the provisions of Section 8.1, a Member may, without the consent of the Managers, transfer all or any portion of its Interest to an Affiliate that is the sole owner of or is wholly owned and controlled by such Member. 8.3 CONDITIONS OF TRANSFER. Subject to the provisions of Sections 8.1 and 8.2, no Member shall sell, assign or otherwise transfer all or less than all of his Interest. No sale, assignment or other transfer of an Interest shall be effective unless: (a) The transferee on or prior to the date of transfer agrees in writing to become a Member in the Company bound by all the terms and conditions of this Operating Agreement; (b) The transferee on or prior to the date of transfer agrees in writing to assume all obligations and liabilities of the Member with respect to the transferred Interest; 19 20 (c) Such transfer is completed in accordance with all the provisions of this Article 8 and all applicable state or federal securities or other laws; and (d) The transfer of the entire Interest of the transferor Member is made to not more than one transferee (unless this condition is waived by the Managers). No transferee shall become a substituted Member without the consent of Members holding at least two-thirds of the Interests which may be withheld or granted in their sole discretion. 8.4 RIGHT TO ACQUIRE INTEREST. Notwithstanding the foregoing or anything else herein to the contrary, upon the occurrence of a Bankruptcy with respect to a Member, the trustee, receiver or similar representative for the Bankrupt Member will notify each other Member in writing of such Bankruptcy within 10 days after his or her appointment, or if no such representative is appointed for the Bankrupt Member, such notice will be given by the Bankrupt Member within such period of time. Notwithstanding the obligation to deliver any such notice, the occurrence of any such Bankruptcy shall immediately subject the Bankrupt Member to the Buy-Sell provisions of Article 13. 8.5 RIGHTS OF ASSIGNEE. Any assignee who is not a Member at the time of the assignment will be entitled to the allocations and distributions attributable to the interest assigned to such assignee and will be subject to the transfer, assignment and withdrawal provisions of this Operating Agreement applicable to Members; however, such assignee will not be entitled to the other rights of a Member (including, for example and without limitation, the right to appoint Managers) until such assignee becomes a substituted Member with the consent of Members holding at least two-thirds of the Interests, which consent may be granted or withheld in the Members' sole discretion. The assignee will be subject to the obligations of a Member hereunder, including, without limitation, this Article 8. Notwithstanding the above, neither the Company nor the Managers will incur liability for allocations and distributions made in good faith to the transferring Member until the written instrument of assignment has been received by the Company and recorded on its books, any documents required by the Company pursuant to Article 8 have been executed and received by the Company and the effective date of the transfer has passed. 8.6 EFFECT OF TRANSFER. The transfer of a Member's Interest or any part thereof will not be cause for dissolution of the Company. ARTICLE 9 ADDITIONAL MEMBERS 9.1 ADMISSION OF NEW MEMBERS. From the date of the formation of the Company, with the written consent of the Managers and in accordance with the approval of Members pursuant to Section 5.4, any Person acceptable to the Managers may, subject to the terms and conditions of this Operating Agreement, become an Additional Member of the Company by the acquisition of new Units for such consideration, if any, as the Managers shall determine. 20 21 9.2 ALLOCATIONS TO NEW MEMBERS. No Additional Member shall be entitled to any retroactive allocation of losses, income or expense deductions incurred by the Company. The Net Profits and Net Losses of the Company for each Accounting Period shall be allocated among the Members in accordance with Article 7, with the Accounting Period being subject to adjustment pursuant to Section 1.1(a) upon the addition of an Additional Member. ARTICLE 10 DISSOLUTION AND TERMINATION 10.1 DISSOLUTION. The Company shall be dissolved upon the occurrence of any of the following events (a "Dissolution Event"): (a) the period fixed for the duration of the Company shall expire; (b) subject to Section 5.4, by the approval of Members holding at least two-thirds of the Interests; or (c) the entry of a decree of judicial dissolution under Section 18-802 of the Delaware Act. 10.2 EFFECT OF FILING OF CERTIFICATE OF CANCELLATION. The Company shall cease to carry on its business, except insofar as may be necessary for the winding up of its business, upon the occurrence of a final dissolution event, but its separate existence shall continue until a Certificate of Cancellation has been filed with the Secretary of State of Delaware or until a decree dissolving the Company has been entered by a court of competent jurisdiction. 10.3 DISTRIBUTION OF ASSETS UPON DISSOLUTION. In settling accounts after dissolution, the liabilities of the Company shall be entitled to payment in the following order: (a) those to creditors, in the order of priority as provided by law and those to Members who have made loans to the Company pursuant to Section 6.1(c), but except those to Members of the Company on account of their Capital Contributions; and (b) those to Members of the Company, with respect to their Capital Accounts in accordance with Section 6.3(d). 10.4 WINDING UP. Except as provided by law, upon dissolution, each Member shall look solely to the assets of the Company for the return of its Capital Contribution. If the Company Property remaining after the payment or discharge of the debts and liabilities of the Company is insufficient to return the Capital Contribution of each Member, such Member shall have no recourse against any other Member. The winding up of the affairs of the Company and the distribution of its assets shall be conducted exclusively by the Managers, who are hereby authorized to take all actions necessary to accomplish such distribution, including without limitation, selling any Company assets the Managers deem necessary or appropriate to sell. 21 22 10.5 FILING OF CERTIFICATE OF CANCELLATION. (a) When all debts, liabilities and obligations have been paid and discharged or adequate provisions have been made therefor and all of the remaining property and assets have been distributed to the Members, a Certificate of Cancellation shall be executed in duplicate and verified by the person signing the certificate, which certificate shall set forth the information required by the Delaware Act. Duplicate originals of such Certificate of Cancellation shall be delivered to the Delaware Secretary of State. (b) Upon the acceptance of the Certificate of Cancellation, the existence of the Company shall cease, except for the purpose of suits, other proceedings and appropriate action as provided in the Delaware Act. The Managers shall thereafter be trustee for the Members and creditors of the Company and as such shall have authority to distribute any Company Property discovered after dissolution, convey real estate and take such other action as may be necessary on behalf of and in the name of the Company. ARTICLE 11 MERGER OR CONSOLIDATION 11.1 MERGER OR CONSOLIDATION. The Company may, upon a vote of the Members holding at least two-thirds of the Interests, merge or consolidate pursuant to an agreement of merger or consolidation with or into one or more entities formed or organized under the laws of the State of Delaware or any other state of the United States or any foreign country or other foreign jurisdiction, with such entity as the agreement shall provide being the surviving or resulting entity. 11.2 EXCHANGE RELATING TO MERGER OR CONSOLIDATION. Rights or securities of, or Interests in, the Company or other entity that is a constituent party to the merger or consolidation may be exchanged for or converted into cash, property, rights or securities of, or Interests in, the surviving or resulting entity or, in addition to or in lieu thereof, may be exchanged for or converted into cash, property, rights or securities of, or Interests in, an entity which is not the surviving or resulting entity in the merger or consolidation. 11.3 FILING AND EFFECT OF CERTIFICATE OF MERGER OR CONSOLIDATION. If the Company enters into an agreement of merger or consolidation, the surviving entity shall file a Certificate of Merger or Consolidation in the Office of the Secretary of State of the State of Delaware containing the information required by Section 18-209(c) of the Delaware Act. Unless a future date is provided for in such Certificate of Merger or Consolidation, the effective date shall be the date of filing with the Secretary of State of the State of Delaware. Such Certificate of Merger or Consolidation shall act as a Certificate of Cancellation for the Company if it is not the surviving or resulting entity in the merger or consolidation. 11.4 AMENDMENT OF OLD OR ADOPTION OF NEW OPERATING AGREEMENT. An agreement of merger or consolidation approved in accordance with Section 5.4(a)(vii) may effect any amendment to the Company's Operating Agreement or effect the adoption of a new Operating Agreement for the Company or the surviving entity, as the case may be. Any amendment of this 22 23 Operating Agreement or adoption of a new Operating Agreement shall be effective at the effective time or date of the merger or consolidation. 11.5 ASSUMPTION OF ASSETS AND LIABILITIES. When any merger or consolidation shall have become effective under this Article 11, for all purposes of the laws of the State of Delaware, all of the rights, privileges and powers of the Company and each of the other entities that have merged or consolidated, and all property, real, personal and mixed, and all debts due or incurred to or by any of the constituent parties, as well as all other things and causes of action belonging to each of such parties to the merger or consolidation, shall be vested in the surviving or resulting entity, and shall thereafter be the property or obligation of the surviving or resulting entity, and the title to any real property vested by deed or otherwise shall not revert or be in any way impaired. 11.6 NET INCOME BASE OBLIGATION ACCELERATION. In addition to the foregoing provisions of this Article 11, in the event of any merger or consolidation pursuant to which the Members hold less than a controlling ownership and voting interest of any successor or surviving entity, the Company's obligation to make all remaining Net Income Base distributions (up to the balance of the outstanding Aggregate net Income Base Obligation) shall be accelerated and shall be payable to Stadtlander upon the consummation of such merger or consolidation, discounted at the rate of the Wall Street Journal prime rate as of the date of such event plus 1.5% per year. ARTICLE 12 NONCOMPETITION, CONFIDENTIALITY AND PROPRIETARY INFORMATION 12.1 NONCOMPETITION; CONFIDENTIALITY. As an inducement for each of the parties to enter into this Operating Agreement, to purchase and sell membership interests in the Company, and in order to preserve the goodwill to be developed by and acquired by Company in its business the parties agree as follows: (a) MEMBERS' COVENANT NOT TO COMPETE. During the term of this Operating Agreement and for a period of three (3) years from the termination of this Operating Agreement or with respect to a Member that has transferred all of its Interest, three (3) years from the date of the transfer of all of that Member's Interest, no Member nor any Affiliate thereof will directly or indirectly engage in any Competitive Activities. The term "Competitive Activities" as used herein shall mean: (i) directly or indirectly engaging in, continuing in or carrying on any business involved in providing specialty pharmaceutical services to patients diagnosed with a serious mental illness or conducting clinical research or site management and information services relating to healthcare informatics, clinical practices, pharmaceutical usage and patient outcomes relating to patients with a serious mental illness, or any business that is substantially similar thereto, including owning or controlling any financial interest in any corporation, partnership, firm or other form of business organization which competes with or is engaged in or carries on any aspect of such business or any business substantially similar thereto; (ii) serving as a shareholder, officer, director, member, manager, trustee or partner of, or consulting with, advising or assisting in any way, whether or not for 23 24 consideration, any corporation, partnership, firm, proprietorship or other business organization which is now, becomes or may become a competitor of Company in any aspect with respect to the Company's business, including, but not limited to, advertising or otherwise endorsing the services of any such competitor; soliciting customers, providers or otherwise serving as an intermediary for any such competitor; loaning money or rendering any other form of financial assistance to or engaging in any form of business transaction on other than an arm's length basis with any such competitor; (iii) engaging in any practice the purpose of which is to evade the provisions of this covenant not to compete or to commit any act which is detrimental to the successful continuation of Company's business by Company or which adversely affects its business. The term "Competitive Activities" shall not include (A) the ownership of securities of corporations which are listed on a national securities exchange or traded in the national over-the-counter market in an amount which shall not exceed 5% of the outstanding shares of any such corporation, (B) acquiring a business that is competitive with the Company pursuant to the acquisition of an entity or group of affiliated entities whose principal business is not in competition with the Company, provided that in no event shall revenues of such Member derived from the business that is directly competitive with the Company's business exceed twenty-five percent (25%) of the Company's revenues, or (C) any activities of Counsel Corporation or its Affiliates that would otherwise be deemed Competitive Activities above other than, so long as Counsel Corporation holds a controlling interest in Stadtlander, initiating or creating any business or entity which competes with the Company or acquiring any business or entity whose principal business is in competition with the Company, or whose principal business is not in competition with the Company but the revenues derived from the business directly competitive with the Company exceeds fifty percent (50%) of the Company's revenues. The parties agree that the geographic scope of this covenant not to compete shall extend throughout the United States. The parties agree that Company may sell, assign or otherwise transfer this covenant not to compete, in whole or in part, to any person, corporation, firm or entity that purchases all or part of the capital stock or all or substantially all of the assets of the Company. In the event a court of competent jurisdiction determines that the provisions of this covenant not to compete are excessively broad as to duration, geographical scope or activity, it is expressly agreed that this covenant not to compete shall be construed so that the remaining provisions shall not be affected, but shall remain in full force and effect, and any such over broad provisions shall be deemed, without further action on the part of any person, to be modified, amended and/or limited, but only to the extent necessary to render the same valid and enforceable in such jurisdiction. (b) COMPANY'S COVENANT NOT TO COMPETE. During the term of this Operating Agreement and for a period of three (3) years from the termination of this Operating Agreement or with respect to a Member that has transferred all of its Interest, three (3) years from the date of the transfer of all of that Member's Interest, neither the Company nor any subsidiary of the Company will directly or indirectly engage in any activity which is competitive with the principal business of any Member or its Affiliates. Prohibited activity hereunder includes: 24 25 (i) owning or controlling any financial interest in any corporation, partnership, firm or other form of business organization which competes with or is engaged in or carries on any aspect of a Member's business or any business substantially similar thereto; (ii) serving as a shareholder, officer, director, member, manager, trustee or partner of, or consulting with, advising or assisting in any way, whether or not for consideration, any corporation, partnership, firm, proprietorship or other business organization which is now, becomes or may become a competitor of a Member in any aspect with respect to the Member's business, including, but not limited to, advertising or otherwise endorsing the services of any such competitor; soliciting customers, providers or otherwise serving as an intermediary for any such competitor; loaning money or rendering any other form of financial assistance to or engaging in any form of business transaction on other than an arm's length basis with any such competitor; and (iii) engaging in any practice the purpose of which is to evade the provisions of this covenant not to compete or to commit any act which is detrimental to the successful continuation of a Member's business by such Member or which adversely affects its business; provided, however, that the prohibited activities hereunder shall not include the ownership of securities of corporations which are listed on a national securities exchange or traded in the national over-the-counter market in an amount which shall not exceed 5% of the outstanding shares of any such corporation. The parties agree that the geographic scope of this covenant not to compete shall extend throughout the United States. The parties agree that any Member may sell, assign or otherwise transfer this covenant not to compete, in whole or in part, to any person, corporation, firm or entity that purchases all or part of the capital stock or all or substantially all of the assets of such Member. In the event a court of competent jurisdiction determines that the provisions of this covenant not to compete are excessively broad as to duration, geographical scope or activity, it is expressly agreed that this covenant not to compete shall be construed so that the remaining provisions shall not be affected, but shall remain in full force and effect, and any such over broad provisions shall be deemed, without further action on the part of any person, to be modified, amended and/or limited, but only to the extent necessary to render the same valid and enforceable in such jurisdiction. (c) COVENANT OF CONFIDENTIALITY. During the term of this Operating Agreement and for a period of three (3) years from the termination of this Operating Agreement, no Member shall, except as explicitly permitted under any other agreement between Company and any Member, (i) use for any purpose, (ii) disclose to any person, or (iii) keep or make copies of documents, tapes, discs or programs containing, any confidential information concerning Company's business. For purposes hereof, "confidential information" shall mean and include, without limitation, all intellectual property, trade secrets, reports, financial information, business plans, customer and/or provider lists and customer and/or provider information, and all other information concerning Company's business and marketing methods used in connection with its business, not previously disclosed to the public directly by Company. The provisions of this Section 12.1(c) shall not supercede, modify or affect in any way any similar confidentiality provisions in any other agreement between Company and any Member(s), including the Transition and Services Agreement, and so long as any such agreement is in effect, the 25 26 confidentiality provisions therein shall govern in the event of a conflict with the provisions of this Section 12.1(c). (d) COMPANY PROPRIETARY INFORMATION. Notwithstanding the nature of any assets or information contributed to Company by any Member, all patient and customer information developed by Company shall be proprietary to Company and no Member will have any ownership interest in such proprietary information (except to the extent such Member may have an interest in such assets upon the liquidation of Company by virtue of the Member's Interest). (e) EQUITABLE RELIEF FOR VIOLATIONS. The parties agree that the provisions and restrictions contained in this Section 12.1 are necessary to protect the legitimate continuing interests of Company and each Member, and that any violation or breach of these provisions will result in irreparable injury to Company or such Member for which a remedy at law would be inadequate and that, in addition to any relief at law which may be available to such party for such violation or breach and regardless of any other provision contained in this Operating Agreement, such party shall be entitled to injunctive and other equitable relief as a court may grant after considering the intent of this Section 12.1. ARTICLE 13 BUY-SELL 13.1 BUY-SELL. Upon the earlier of any Bankruptcy of a Member or January 1, 2001 (the "Buy-Sell Right Inception"), Members shall have the rights of purchase and sale provided by this Section 13.1, to be exercised by delivering a notice (an "Election Notice"). A Member giving an Election Notice as provided herein is referred to as an "Electing Member," a Member receiving an Election Notice is referred to as a "Notice Member." (a) INVOCATION OF BUY-SELL PROCEDURE. At any time after the Buy-Sell Right Inception, this buy-sell procedure may be invoked by the giving of an Election Notice by any Member. Such Election Notice, to be valid, shall include the Stated Amount of the Members' interests and shall be given to the Notice Member. The date of such notice shall be referred to as the "Election Day." (b) EFFECT OF ELECTION NOTICE; BUY-SELL PRICE. An Election Notice shall constitute an irrevocable offer by the Electing Member either to (1) purchase all, and not less than all, of the Interest of the Notice Member, or (2) sell all, but not less than all, of its Interest to the Notice Member. The price at which the Interest of any Member is purchased and sold under this Section 13.1 (the "Buy-Sell Price" of such Interest) shall be a price determined by the Electing Member, which shall not be less than the Net Stated Equity thereof, determined as of the Election Day plus full repayment of any loans to the Company (plus accrued interest) outstanding and payable to the Member. The cost of determining Net Stated Equity shall be borne by the Company and shall be treated as an expense for purposes of such determination. (c) NOTICE MEMBER'S ELECTION TO PURCHASE OR SELL. For a period (the "Election Period") ending at 11:59 P.M. (local time at the Company's principal place of business) on the sixtieth day following the Election Day, the Notice Member shall have the right to elect to (i) 26 27 purchase all, and not less than all, of the Interest of the Electing Member, by giving notice thereof (the "Purchase Notice") to the Electing Member which Purchase Notice shall not be valid unless it states such Member (the "Purchasing Member") is electing to purchase all of the Electing Member's Interest (as the "Selling Member"); or (ii) obtain a commitment from a nationally recognized investment banker to act as an underwriter in a public offering of the Company's securities for an aggregate value that is at least as beneficial to the Member who delivered the Election Notice as the price of the Interest. A Purchasing Member, upon sending a Purchase Notice, shall be obligated to purchase all of the Electing Member's Interest. If the Notice Member elects to obtain an investment banker commitment to offer the Company's securities in a public offering, the public offering shall be consummated within 150 days of the date of such election. If (i) no Purchase Notice is sent, (ii) no investment banker commitment is obtained, or (iii) if an investment banker commitment is obtained but the public offering is not consummated within the 150-day period, the Electing Member shall become the Purchasing Member and shall be obligated to purchase all of the Interest of the Notice Member in accordance with the Election Notice, who shall become the Selling Member and shall be obligated to sell all of its interest to the Purchasing Member. (d) TERMS OF PURCHASE; CLOSING. The closing of the purchase and sale of the Selling Member's Interest shall occur on a date and time mutually agreeable to the Purchasing Member and the Selling Member, which shall not be later than 10:00 A.M. (local time at the place of the closing) on the first business day occurring on or after the sixtieth day following the Election Day and at such place as is mutually agreeable to the Purchasing Member and Selling Member, or upon the failure to agree, at the Company's principal place of business. At the closing the Purchasing Member shall pay to the Selling Member, by cash or other immediately available funds, the Buy-Sell Price of such Selling Member's Interest, and the Selling Member shall deliver to the Purchasing Member good title, free and clear of any liens, claims, encumbrances, security interests or options (other than those granted by this Agreement) to the Selling Member's Interest thus purchased. At the closing the Members shall execute such documents and instruments of conveyance as may be necessary or appropriate to confirm the transactions contemplated hereby, including, without limitation, the transfer of the Company Interest of the Selling Member to the Purchasing Member and the assumption by the Purchasing Member of the Selling Member's obligations with respect to the Selling Member's Interest transferred to the Purchasing Member. The reasonable costs of such Transfer and closing, including, without limitation, attorneys' fees and filing fees, shall be divided equally between the Selling Member and the Purchasing Member. 13.2 NET EQUITY. The "Net Stated Equity" of a Member's Interest in the Company, as of any day, shall be the amount that would be distributed to such Member in dissolution of the Company pursuant to Article 10 hereof if (1) all of the Company's assets were sold for the Stated Amount, (2) the Company paid its accrued, but unpaid, liabilities and established reserves for the payment of reasonably anticipated contingent or unknown liabilities, and (3) the Company distributed the remaining proceeds to the Members in liquidation, all as of such day. The Net Stated Equity of a Member's Interest in the Company shall be determined, without audit or certification, from the books and records of the Company by the firm of independent certified public accountants regularly employed by the Company. The Net Stated Equity of a Member's interest shall be determined within thirty (30) days of the day upon which such 27 28 accountants are apprised in writing of the Stated Amount and the amount of such Net Stated Equity shall be disclosed to the Company and each of the Members by written notice. The Net Stated Equity determination of such accountants shall be final and binding in the absence of a showing of gross negligence or willful misconduct. ARTICLE 14 ADDITIONAL COVENANTS 14.1 ARBITRATION. In the event of a dispute under this Operating Agreement, including any Impasse (as defined below) or any dispute raised by a Member claiming that the actions or omissions of the Managers are detrimental to the Member as a holder of a minority interest, the Members agree that they will submit the resolution of any such dispute or Impasse to binding arbitration in accordance with the then-current commercial arbitration rules of the American Arbitration Association. The arbitration shall be conducted in San Diego County, California. The decision of the arbitrator(s) shall be in accordance with the best interests of the Company and in no event shall any decision by an arbitrator(s) conflict with the provisions of this Agreement. The decision of the arbitrator(s) shall be binding on the parties, and judgment in accordance with that decision may be entered in any court having jurisdiction thereof. The arbitrator(s) shall be empowered to award specific performance, injunctive relief and damages (but not exemplary damage). An "Impasse" shall be deemed to occur if at any time: (i) a disagreement between the Members or among the Managers occurs with respect to any significant business matter or the consideration of a proposal by either Member to sell all or substantially all of the assets of the Company or to enter into a merger or consolidation; or (ii) the Managers otherwise become deadlocked. ARTICLE 15 MISCELLANEOUS PROVISIONS 15.1 NOTICES. Any notice, demand or communication required or permitted to be given by any provision of this Operating Agreement shall be deemed to have been sufficiently given or served for all purposes if delivered personally to the party or to an executive officer of the party to whom the same is directed or, if sent by registered or certified mail, postage and charges prepaid, addressed to the Managers', Members' and/or Company's address as it appears in the Company's records, as appropriate. Except as otherwise provided herein, any such notice shall be deemed to be given five (5) business days after the date on which the same was deposited in a regularly maintained receptacle for the deposit of United States mail, addressed and sent as aforesaid. 15.2 APPLICATION OF DELAWARE LAW. This Operating Agreement, and the application of interpretation hereof, shall be governed by the Delaware Act. 15.3 WAIVER OF ACTION FOR PARTITION. Each Member irrevocably waives during the term of the Company any right that it may have to maintain any action for partition with respect to the property of the Company. 28 29 15.4 AMENDMENTS. Any amendment to this Operating Agreement may be proposed to the Members by the Managers or Members holding majority of the Interests. A vote on an amendment to this Operating Agreement shall be taken within thirty (30) days after notice thereof has been given to the Members unless such period is otherwise extended by applicable laws, regulations, or agreement of the Members. A proposed amendment shall become effective at such time as it has been approved by Members holding two-thirds of the Interests. 15.5 EXECUTION OF ADDITIONAL INSTRUMENTS. Each Member hereby agrees to execute such other and further statements of interest and holdings, designations, powers of attorney and other instruments necessary to comply with any laws, rules or regulations. 15.6 CONSTRUCTION. Whenever the singular number is used in this Operating Agreement and when required by the context, the same shall include the plural, and the masculine gender shall include the feminine and neuter genders and vice versa. 15.7 HEADINGS. The headings in this Operating Agreement are inserted for convenience only and are in no way intended to describe, interpret, define, or limit the scope, extent or intent of this Operating Agreement or any provision hereof. 15.8 WAIVERS. The failure of any party to seek redress for violation of or to insist upon the strict performance of any covenant or condition of this Operating Agreement shall not prevent a subsequent act, which would have originally constituted a violation, from having the effect of an original violation. 15.9 RIGHTS AND REMEDIES CUMULATIVE. The rights and remedies provided by this Operating Agreement are cumulative, and the use of any one right or remedy by any party shall not preclude or waive the right to use any or all other remedies. Such rights and remedies are given in addition to any other rights the parties may have by law, statute, ordinance or otherwise. 15.10 SEVERABILITY. If any provision of this Operating Agreement or the application thereof to any person or circumstance shall be invalid, illegal or unenforceable to any extent, the remainder of this Operating Agreement and the application thereof shall not be affected and shall be enforceable to the fullest extent permitted by law. 15.11 HEIRS, SUCCESSORS AND ASSIGNS. Each and all of the covenants, terms, provisions and agreements herein contained shall be binding upon and inure to the benefit of the parties hereto and, to the extent permitted by this Operating Agreement, their respective heirs, legal representatives, successors and assigns. 15.12 CREDITORS. None of the provisions of this Operating Agreement shall be for the benefit of or enforceable by any creditor of the Company. 15.13 COUNTERPARTS. This Operating Agreement may be executed in counterparts, each of which shall be deemed an original but all of which shall constitute one and the same instrument. 29 30 [THIS SPACE INTENTIONALLY LEFT BLANK] 30 31 IN WITNESS WHEREOF, the parties hereto have executed this Operating Agreement as of the date first written above. PMR CORPORATION a Delaware corporation By: /s/ Mark Clein --------------------------------- Title: C.F.O. --------------------------------- STADTLANDER DRUG DISTRIBUTION COMPANY, INC. a Delaware corporation By: /s/ James J. Sas --------------------------------- Title: Chief Financial Officer --------------------------------- [EXHIBITS EXCLUDED] 31 EX-10.28 4 EXHIBIT 10.28 1 EXHIBIT 10.28 PMR CORPORATION INCENTIVE STOCK OPTION DANIEL L. FRANK, Optionee: PMR CORPORATION (the "Company"), pursuant to its 1997 Equity Incentive Plan (the "Plan"), has granted to you, the optionee named above, an option to purchase shares of the common stock of the Company ("Common Stock"). This option is intended to qualify as an "incentive stock option" to the extent possible within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"). The grant hereunder is in connection with and in furtherance of the Company's compensatory benefit plan for participation of the Company's employees (including officers), directors or consultants. Defined terms not explicitly defined in this agreement but defined in the Plan shall have the same definitions as in the Plan. The details of your option are as follows: 1. TOTAL NUMBER OF SHARES SUBJECT TO THIS OPTION. The total number of shares of Common Stock subject to this option is One Hundred Thousand (100,000). 2. VESTING. Subject to the limitations contained herein, the shares subject to this option will vest (become exercisable) upon the earlier to occur of (i) September 8, 2005 or (ii) on the first day following the ten consecutive trading days over which the average closing price of the Company's Common Stock quoted on the Nasdaq National Market or listed on any national securities exchange is at least $27.50 per share. Notwithstanding anything herein to the contrary, all of the shares subject to this option shall vest and become immediately exercisable as described in the attached Change in Control Vesting Policy. 3. EXERCISE PRICE AND METHOD OF PAYMENT. (a) EXERCISE PRICE. The exercise price of this option is six and 63/100 dollars ($6.63) per share, being not less than one hundred percent (100%) of the fair market value of the Common Stock on the date of grant of this option. (b) METHOD OF PAYMENT. Payment of the exercise price per share is due in full upon exercise of all or any part of each installment which has accrued to you. You may elect, to the extent permitted by applicable statutes and regulations, to make payment of the exercise price under one of the following alternatives: (i) Payment of the exercise price per share in cash (including check) at the time of exercise; 1. 2 (ii) Payment pursuant to a program developed under Regulation T as promulgated by the Federal Reserve Board which, prior to the issuance of Common Stock, results in either the receipt of cash (or check) by the Company or the receipt of irrevocable instructions to pay the aggregate exercise price to the Company from the sales proceeds; (iii) Provided that at the time of exercise the Company's Common Stock is publicly traded and quoted regularly in the Wall Street Journal, payment by delivery of already-owned shares of Common Stock, held for the period required to avoid a charge to the Company's reported earnings, and owned free and clear of any liens, claims, encumbrances or security interests, which Common Stock shall be valued at its fair market value on the date of exercise; or (iv) Payment by a combination of the methods of payment permitted by subparagraph 3(b)(i) through 3(b)(iii) above. 4. WHOLE SHARES. This option may only be exercised for whole shares. 5. SECURITIES LAW COMPLIANCE. Notwithstanding anything to the contrary contained herein, this option may not be exercised unless the shares issuable upon exercise of this option are then registered under the Securities Act or, if such shares are not then so registered, the Company has determined that such exercise and issuance would be exempt from the registration requirements of the Securities Act. 6. TERM. The term of this option commences on September 8, 1998, the date of grant, and expires on September 7, 2008 (the "Expiration Date"), which date shall be no more than ten (10) years from the date this option is granted, unless this option expires sooner as set forth below or in the Plan. In no event may this option be exercised on or after the Expiration Date. This option shall terminate prior to the Expiration Date as follows: three (3) months after the termination of your Continuous Status as an Employee, Director or Consultant with the Company or an Affiliate of the Company unless one of the following circumstances exists: (a) Your termination of Continuous Status as an Employee, Director or Consultant is due to your disability. This option will then expire on the earlier of the Expiration Date set forth above or twelve (12) months following such termination of Continuous Status as an Employee, Director or Consultant. (b) Your termination of Continuous Status as an Employee, Director or Consultant is due to your death or your death occurs within three (3) months following your termination of Continuous Status as an Employee, Director or Consultant for any other reason. This option will then expire on the earlier of the Expiration Date set forth above or twelve (12) months after your death. 2. 3 (c) If during any part of such three (3)-month period you may not exercise your option solely because of the condition set forth in paragraph 5 above, then your option will not expire until the earlier of the Expiration Date set forth above or until this option shall have been exercisable for an aggregate period of three (3) months after your termination of Continuous Status as an Employee, Director or Consultant. (d) If your exercise of the option within three (3) months after termination of your Continuous Status as an Employee, Director or Consultant with the Company or with an Affiliate of the Company would result in liability under section 16(b) of the Securities Exchange Act of 1934, then your option will expire on the earlier of (i) the Expiration Date set forth above, (ii) the tenth (10th) day after the last date upon which exercise would result in such liability or (iii) six (6) months and ten (10) days after the termination of your Continuous Status as an Employee, Director or Consultant with the Company or an Affiliate of the Company. However, this option may be exercised following termination of Continuous Status as an Employee, Director or Consultant only as to that number of shares as to which it was exercisable on the date of termination of Continuous Status as an Employee, Director or Consultant under the provisions of paragraph 2 of this option. In order to obtain the federal income tax advantages associated with an "incentive stock option," the Code requires that at all times beginning on the date of grant of the option and ending on the day three (3) months before the date of the option's exercise, you must be an employee of the Company or an Affiliate of the Company, except in the event of your death or permanent and total disability. The Company has provided for continued vesting or extended exercisability of your option under certain circumstances (for example, disability) for your benefit, but cannot guarantee that your option will necessarily be treated as an "incentive stock option" if you provide services to the Company or an Affiliate of the Company as a consultant or exercise your option more than three (3) months after the date your employment with the Company and all Affiliates of the Company terminates. 7. EXERCISE. (a) This option may be exercised, to the extent specified above, by delivering a notice of exercise (in a form designated by the Company) together with the exercise price to the Secretary of the Company, or to such other person as the Company may designate, during regular business hours, together with such additional documents as the Company may then require pursuant to subsection 11(e) of the Plan. (b) By exercising this option you agree that, as a precondition to the completion of any exercise, the Company may require you to enter an arrangement providing for the payment by you to the Company of any tax withholding obligation of the Company arising by reason of (1) the exercise of this option; (2) the lapse of any substantial risk of forfeiture to which the shares are subject at the time of exercise; or (3) the disposition of shares acquired upon such exercise. You also agree that the exercise of this option has not been completed and that the Company is under no obligation to issue any shares of Common Stock to you until such an arrangement is established or the Company's tax withholding obligations are satisfied, as determined by the Company. 3. 4 8. TRANSFERABILITY. This option is not transferable, except by will or by the laws of descent and distribution, and is exercisable during your life only by you. Notwithstanding the foregoing, by delivering written notice to the Company, in a form satisfactory to the Company, you may designate a third party who, in the event of your death, shall thereafter be entitled to exercise this option. 9. REDUCTION FOR DISQUALIFIED INDIVIDUALS. (a) If this option becomes fully vested in connection with Optionee's termination following a Change in Control as described in the Plan, and if Optionee is deemed to be a "disqualified individual" as defined in Section 280G of the Code (which includes certain officers and highly compensated employees of the Company), then if the aggregate of the Optionee's gain upon the exercise of the option with respect to shares that became fully vested because of a Change in Control and all other payments made to Optionee in connection with a Change in Control would constitute a "parachute payment" within the meaning of Section 280G of the Code and would, but for this subsection (a), subject Optionee to liability for the twenty percent (20%) excise tax imposed by Section 4999 of the Code (the "Excise Tax"), then, subject to the provisions of subsection (b) hereof, the option exercise shall be reduced to the largest amount which the Company determines would result in no portion of such exercise being subject to the Excise Tax (but in no event shall the option exercise be reduced below the number of shares vested prior to acceleration in connection with a Change in Control). The Company's determination of any required deduction pursuant to this subsection (a) shall be conclusive and binding upon Optionee. However, if the Internal Revenue Service ("IRS") nevertheless determines that an exercise is subject to the Excise Tax, then subsection (b) hereof shall apply. (b) If notwithstanding the reduction described in subsection (a) hereof (or in the absence of any such reduction), the IRS determines that Optionee is liable for the Excise Tax as a result of the exercise, then Optionee shall be obligated to rescind within thirty (30) days after final IRS determination, the exercise of shares that subject the Optionee to the Excise Tax; provided, however, that Optionee shall not be obligated to rescind the exercise of shares that were vested prior to acceleration in connection with a Change in Control. The rescinded amount shall be the smallest such amount, if any, as shall be required so that no portion of Optionee's exercise shall be subject to the Excise Tax. In the event of any rescission hereunder, the Company shall return to Optionee the full exercise price paid by Optionee for the shares being rescinded. 10. OPTION NOT A SERVICE CONTRACT. This option is not an employment contract and nothing in this option shall be deemed to create in any way whatsoever any obligation on your part to continue in the employ of the Company, or of the Company to continue your employment with the Company. In addition, nothing in this option shall obligate the Company or any Affiliate of the Company, or their respective shareholders, Board of Directors, officers or employees to continue any relationship which you might have as a Director or Consultant for the Company or Affiliate of the Company. 11. NOTICES. Any notices provided for in this option or the Plan shall be given in writing and shall be deemed effectively given upon receipt or, in the case of notices delivered by the Company to you, five (5) days after deposit in the United States mail, postage prepaid, 4. 5 addressed to you at the address specified below or at such other address as you hereafter designate by written notice to the Company. 12. GOVERNING PLAN DOCUMENT. This option is subject to all the provisions of the Plan, a copy of which is attached hereto and its provisions are hereby made a part of this option, including without limitation the provisions of Section 6 of the Plan relating to option provisions, and is further subject to all interpretations, amendments, rules and regulations which may from time to time be promulgated and adopted pursuant to the Plan. In the event of any conflict between the provisions of this option and those of the Plan, the provisions of the Plan shall control. Dated the 8th day of September, 1998. Very truly yours, PMR CORPORATION By: /s/ Allen Tepper ------------------------------- Title: Chief Executive Officer ATTACHMENTS: 1997 Equity Incentive Plan Notice of Exercise Change in Control Vesting Policy 5. 6 The undersigned: (a) Acknowledges receipt of the foregoing option and the attachments referenced therein and understands that all rights and liabilities with respect to this option are set forth in the option and the Plan; and (b) Acknowledges that as of the date of grant of this option, it sets forth the entire understanding between the undersigned optionee and the Company and its Affiliates regarding the acquisition of stock in the Company and supersedes all prior oral and written agreements on that subject with the exception of (i) the options previously granted and delivered to the undersigned under stock option plans of the Company, and (ii) the following agreements only: NONE DLF (Initial) OTHER ------------------------------- ------------------------------- ------------------------------- /s/ Daniel L. Frank ------------------------------- DANIEL L. FRANK Address: 10231 Bothwell Northridge, CA 91324 6. 7 NOTICE OF EXERCISE PMR Corporation 501 Washington Street Fifth Floor San Diego, CA 92103 Date of Exercise: ___________ Ladies and Gentlemen: This constitutes notice under my incentive stock option that I elect to purchase the number of shares for the price set forth below. Stock option dated: ___________ Number of shares as to which option is exercised: ___________ Certificates to be issued in name of: ___________ Total exercise price: $__________ Cash payment delivered herewith: $__________ Value of ______ shares of common stock delivered herewith1: $__________
By this exercise, I agree (i) to provide such additional documents as you may require pursuant to the terms of the Company's 1997 Equity incentive Plan and (ii) to provide for the payment by me to you (in the manner designated by you) of your withholding obligation, if any, relating to the exercise of this option. Very truly yours, ------------------------------- - -------- 1 Shares must meet the public trading requirements set forth in the option. Shares must be valued in accordance with the terms of the option being exercised, must have been owned for the minimum period required in the option, and must be owned free and clear of any liens, claims, encumbrances or security interests. Certificates must be endorsed or accompanied by an executed assignment separate from certificate. 8 PMR CORPORATION CHANGE IN CONTROL VESTING POLICY (THE "POLICY") In the event the employment or relationship as a consultant to the Company of a person holding an option under the 1997 Equity Incentive Plan (the "Optionee") is, within one (1) year following a "Change in Control," (i) terminated by the Company other than for "Cause," or (ii) terminated in a "Constructive Termination," then the option held by such Optionee shall be fully vested. Moreover, all options held by directors shall become fully vested immediately upon the occurrence of a Change in Control. For purposes of this Policy, the following definitions shall apply: "CHANGE IN CONTROL" shall mean the occurrence of any of the following events: (a) The Company is merged, consolidated or reorganized into or with another corporation, partnership, limited liability company, or other entity or person, and as a result of such merger, consolidation or reorganization less than 70% of the combined voting power of the then-outstanding securities of such corporation, partnership, limited liability company, or other entity or person immediately after such transaction are held in the aggregate by holders of voting securities of the Company immediately prior to such transaction; (b) The Company sells all or substantially all of its assets to any other corporation, partnership, limited liability company, or other entity or person, and thereafter, less than 70% of the combined voting power of the then-outstanding voting securities of the acquiring or consolidated entity are held in the aggregate by the holders of voting securities of the Company immediately prior to such sale; (c) There is a report filed after the date on which the option is granted on Schedule 13D or Schedule 14D-1 (or any successor schedule, form or report), each as promulgated pursuant to the Securities Exchange Act of 1934 (the "Exchange Act") disclosing that any person (as the term "person" is used in Section 13(d)(3) or Section 14(d)(2) of the Exchange Act) has become the beneficial owner (as the term "beneficial owner" is defined under Rule 13d-3 or any successor rule or regulation promulgated under the Exchange Act) representing 30% or more of the combined voting power of the then-outstanding voting securities of the Company; (d) The Company shall file a report or proxy statement with the Securities and Exchange Commission pursuant to the Exchange Act disclosing in response to Item 1 of Form 8-K thereunder or Item 5(b) or Item 14 of Schedule 14A thereunder (or any successor schedule, form or report or item therein) that a change in control of the Company has or may have occurred or will or may occur in the future pursuant to any then-existing contract or transaction; or (e) During any period of two (2) consecutive years, individuals who at the beginning of any such period constitute the directors of the Company cease for any reason to constitute at least a majority of the Board of Directors of the Company unless the election or the nomination for election by the Company's shareholders of each director of the Company first 1. 9 elected during such period was approved by a vote of at least two-thirds of the directors of the Company then still in office who were directors of the Company at the beginning of such two (2)-year period. "CAUSE" shall mean termination due to the occurrence of any of the following: (a) any intentional action or intentional failure to act by Optionee which was performed in bad faith and to the material detriment of the Company; (b) Optionee intentionally refuses or intentionally fails to act in accordance with any lawful direction or order of the Company; (c) Optionee willfully and habitually neglects his duties of employment; (d) Optionee's engaging or participating in any activity which is competitive with or injurious to the Company in the judgment of the Board of Directors; (e) Optionee's commission of any fraud against the Company or use or appropriation for his personal use and benefit of any funds, assets or properties of the Company not authorized by the Company to be so used or appropriated; or (f) Optionee is convicted of a felony crime involving moral turpitude. "CONSTRUCTIVE TERMINATION" means that the Optionee voluntarily terminates his or her employment with the Company after any of the following are undertaken, following a Change in Control, without Optionee's express written consent: (a) the assignment to Optionee of any duties or responsibilities which are inconsistent with, or result in any diminution or adverse change of, Optionee's position, status or circumstances of employment as in effect immediately prior to a Change in Control; an adverse change in Optionee's titles, offices, benefits and/or perquisites as in effect immediately prior to a Change in Control; any removal of Optionee from or any failure to re-elect Optionee to any offices held by Optionee immediately prior to a Change in Control, including, but not limited to, Optionee's membership on the Board, except in connection with the termination of his employment for death, disability, retirement, Cause, or any voluntary termination of employment by Optionee other than a Constructive Termination; (b) a reduction by the Company in Optionee's annual base salary by greater than five percent (5%) from that which was in effect immediately prior to a Change in Control; (c) a relocation of Optionee, or the Company's principal executive offices if Optionee's principal office is at such offices, to a location more than forty (40) miles from the location at which Optionee was performing his duties prior to a Change in Control, except for required travel by Optionee on the Company's business to an extent substantially consistent with Optionee's business travel obligations at the time of a Change in Control; (d) any material breach by the Company of any material provision of Optionee's Stock Award Agreement following a Change in Control; or (e) any failure by the Company to obtain the assumption of Optionee's Stock Award Agreement by any successor or assign of the Company. 2. EX-10.29 5 EXHIBIT 10.29 1 EXHIBIT 10.29 PMR CORPORATION INCENTIVE STOCK OPTION DANIEL L. FRANK, Optionee: PMR CORPORATION (the "Company"), pursuant to its 1997 Equity Incentive Plan (the "Plan"), has granted to you, the optionee named above, an option to purchase shares of the common stock of the Company ("Common Stock"). This option is intended to qualify as an "incentive stock option" to the extent possible within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"). The grant hereunder is in connection with and in furtherance of the Company's compensatory benefit plan for participation of the Company's employees (including officers), directors or consultants. Defined terms not explicitly defined in this agreement but defined in the Plan shall have the same definitions as in the Plan. The details of your option are as follows: 1. TOTAL NUMBER OF SHARES SUBJECT TO THIS OPTION. The total number of shares of Common Stock subject to this option is One Hundred Fifty Thousand (150,000). 2. VESTING. Subject to the limitations contained herein, all of the shares subject to this option will vest (become exercisable) on September 8, 2003; provided, however, that portions of the shares subject to this option will vest immediately on the date of each event set forth below, in the corresponding number of shares set forth below: (a) Fifty Thousand (50,000) shares will vest and become exercisable upon the enrollment in any managed care program operated by the Company of any patient suffering from a serious mental illness. (b) Fifty Thousand (50,000) shares will vest and become exercisable on the first day following the ten consecutive trading days over which the average closing price of the Company's Common Stock quoted on the Nasdaq National Market or listed on any national securities exchange is at least $25.00 per share. (c) Fifty Thousand (50,000) shares will vest and become exercisable on the first day following the delivery of the audited financial statements for the first fiscal year of the Company in which the division of the Company which operates its managed care programs has a positive gross margin for such fiscal year as reflected in the Company's audited financial statements for such year (as determined in accordance with generally accepted accounting principles consistently applied). The Company shall notify you of the satisfaction of any of the events set forth above within five (5) business days of the occurrence of such event. The Company's determination that any such event is satisfied shall be conclusive. Notwithstanding anything herein to the contrary, all of the 2 shares subject to this option shall vest and become immediately exercisable as described in the attached Change in Control Vesting Policy. 3. EXERCISE PRICE AND METHOD OF PAYMENT. (a) EXERCISE PRICE. The exercise price of this option is six and 63/100 dollars ($6.63) per share, being not less than one hundred percent (100%) of the fair market value of the Common Stock on the date of grant of this option. (b) METHOD OF PAYMENT. Payment of the exercise price per share is due in full upon exercise of all or any part of each installment which has accrued to you. You may elect, to the extent permitted by applicable statutes and regulations, to make payment of the exercise price under one of the following alternatives: (i) Payment of the exercise price per share in cash (including check) at the time of exercise; (ii) Payment pursuant to a program developed under Regulation T as promulgated by the Federal Reserve Board which, prior to the issuance of Common Stock, results in either the receipt of cash (or check) by the Company or the receipt of irrevocable instructions to pay the aggregate exercise price to the Company from the sales proceeds; (iii) Provided that at the time of exercise the Company's Common Stock is publicly traded and quoted regularly in the Wall Street Journal, payment by delivery of already-owned shares of Common Stock, held for the period required to avoid a charge to the Company's reported earnings, and owned free and clear of any liens, claims, encumbrances or security interests, which Common Stock shall be valued at its fair market value on the date of exercise; or (iv) Payment by a combination of the methods of payment permitted by subparagraph 3(b)(i) through 3(b)(iii) above. 4. WHOLE SHARES. This option may only be exercised for whole shares. 5. SECURITIES LAW COMPLIANCE. Notwithstanding anything to the contrary contained herein, this option may not be exercised unless the shares issuable upon exercise of this option are then registered under the Securities Act or, if such shares are not then so registered, the Company has determined that such exercise and issuance would be exempt from the registration requirements of the Securities Act. 6. TERM. The term of this option commences on September 8, 1998, the date of grant, and expires on September 7, 2008 (the "Expiration Date"), which date shall be no more than ten (10) years from the date this option is granted, unless this option expires sooner as set forth below or in the Plan. In no event may this option be exercised on or after the Expiration Date. This option shall terminate prior to the Expiration Date as follows: three (3) months after the termination of your Continuous Status as an Employee, Director or Consultant with the Company or an Affiliate of the Company unless one of the following circumstances exists: 2. 3 (a) Your termination of Continuous Status as an Employee, Director or Consultant is due to your disability. This option will then expire on the earlier of the Expiration Date set forth above or twelve (12) months following such termination of Continuous Status as an Employee, Director or Consultant. (b) Your termination of Continuous Status as an Employee, Director or Consultant is due to your death or your death occurs within three (3) months following your termination of Continuous Status as an Employee, Director or Consultant for any other reason. This option will then expire on the earlier of the Expiration Date set forth above or twelve (12) months after your death. (c) If during any part of such three (3)-month period you may not exercise your option solely because of the condition set forth in paragraph 5 above, then your option will not expire until the earlier of the Expiration Date set forth above or until this option shall have been exercisable for an aggregate period of three (3) months after your termination of Continuous Status as an Employee, Director or Consultant. (d) If your exercise of the option within three (3) months after termination of your Continuous Status as an Employee, Director or Consultant with the Company or with an Affiliate of the Company would result in liability under section 16(b) of the Securities Exchange Act of 1934, then your option will expire on the earlier of (i) the Expiration Date set forth above, (ii) the tenth (10th) day after the last date upon which exercise would result in such liability or (iii) six (6) months and ten (10) days after the termination of your Continuous Status as an Employee, Director or Consultant with the Company or an Affiliate of the Company. However, this option may be exercised following termination of Continuous Status as an Employee, Director or Consultant only as to that number of shares as to which it was exercisable on the date of termination of Continuous Status as an Employee, Director or Consultant under the provisions of paragraph 2 of this option. In order to obtain the federal income tax advantages associated with an "incentive stock option," the Code requires that at all times beginning on the date of grant of the option and ending on the day three (3) months before the date of the option's exercise, you must be an employee of the Company or an Affiliate of the Company, except in the event of your death or permanent and total disability. The Company has provided for continued vesting or extended exercisability of your option under certain circumstances (for example, disability) for your benefit, but cannot guarantee that your option will necessarily be treated as an "incentive stock option" if you provide services to the Company or an Affiliate of the Company as a consultant or exercise your option more than three (3) months after the date your employment with the Company and all Affiliates of the Company terminates. 7. EXERCISE. (a) This option may be exercised, to the extent specified above, by delivering a notice of exercise (in a form designated by the Company) together with the exercise price to the Secretary of the Company, or to such other person as the Company may designate, during 3. 4 regular business hours, together with such additional documents as the Company may then require pursuant to subsection 11(e) of the Plan. (b) By exercising this option you agree that, as a precondition to the completion of any exercise, the Company may require you to enter an arrangement providing for the payment by you to the Company of any tax withholding obligation of the Company arising by reason of (1) the exercise of this option; (2) the lapse of any substantial risk of forfeiture to which the shares are subject at the time of exercise; or (3) the disposition of shares acquired upon such exercise. You also agree that the exercise of this option has not been completed and that the Company is under no obligation to issue any shares of Common Stock to you until such an arrangement is established or the Company's tax withholding obligations are satisfied, as determined by the Company. 8. TRANSFERABILITY. This option is not transferable, except by will or by the laws of descent and distribution, and is exercisable during your life only by you. Notwithstanding the foregoing, by delivering written notice to the Company, in a form satisfactory to the Company, you may designate a third party who, in the event of your death, shall thereafter be entitled to exercise this option. 9. REDUCTION FOR DISQUALIFIED INDIVIDUALS. (a) If this option becomes fully vested in connection with Optionee's termination following a Change in Control as described in the Plan, and if Optionee is deemed to be a "disqualified individual" as defined in Section 280G of the Code (which includes certain officers and highly compensated employees of the Company), then if the aggregate of the Optionee's gain upon the exercise of the option with respect to shares that became fully vested because of a Change in Control and all other payments made to Optionee in connection with a Change in Control would constitute a "parachute payment" within the meaning of Section 280G of the Code and would, but for this subsection (a), subject Optionee to liability for the twenty percent (20%) excise tax imposed by Section 4999 of the Code (the "Excise Tax"), then, subject to the provisions of subsection (b) hereof, the option exercise shall be reduced to the largest amount which the Company determines would result in no portion of such exercise being subject to the Excise Tax (but in no event shall the option exercise be reduced below the number of shares vested prior to acceleration in connection with a Change in Control). The Company's determination of any required deduction pursuant to this subsection (a) shall be conclusive and binding upon Optionee. However, if the Internal Revenue Service ("IRS") nevertheless determines that an exercise is subject to the Excise Tax, then subsection (b) hereof shall apply. (b) If notwithstanding the reduction described in subsection (a) hereof (or in the absence of any such reduction), the IRS determines that Optionee is liable for the Excise Tax as a result of the exercise, then Optionee shall be obligated to rescind within thirty (30) days after final IRS determination, the exercise of shares that subject the Optionee to the Excise Tax; provided, however, that Optionee shall not be obligated to rescind the exercise of shares that were vested prior to acceleration in connection with a Change in Control. The rescinded amount shall be the smallest such amount, if any, as shall be required so that no portion of Optionee's exercise shall be subject to the Excise Tax. In the event of any rescission hereunder, the 4. 5 Company shall return to Optionee the full exercise price paid by Optionee for the shares being rescinded. 10. OPTION NOT A SERVICE CONTRACT. This option is not an employment contract and nothing in this option shall be deemed to create in any way whatsoever any obligation on your part to continue in the employ of the Company, or of the Company to continue your employment with the Company. In addition, nothing in this option shall obligate the Company or any Affiliate of the Company, or their respective shareholders, Board of Directors, officers or employees to continue any relationship which you might have as a Director or Consultant for the Company or Affiliate of the Company. 11. NOTICES. Any notices provided for in this option or the Plan shall be given in writing and shall be deemed effectively given upon receipt or, in the case of notices delivered by the Company to you, five (5) days after deposit in the United States mail, postage prepaid, addressed to you at the address specified below or at such other address as you hereafter designate by written notice to the Company. 12. GOVERNING PLAN DOCUMENT. This option is subject to all the provisions of the Plan, a copy of which is attached hereto and its provisions are hereby made a part of this option, including without limitation the provisions of Section 6 of the Plan relating to option provisions, and is further subject to all interpretations, amendments, rules and regulations which may from time to time be promulgated and adopted pursuant to the Plan. In the event of any conflict between the provisions of this option and those of the Plan, the provisions of the Plan shall control. Dated the 8th day of September, 1998. Very truly yours, PMR CORPORATION By: /s/ Allen Tepper ------------------------------- Title: Chief Executive Officer ATTACHMENTS: 1997 Equity Incentive Plan Notice of Exercise Change in Control Vesting Policy 5. 6 The undersigned: (a) Acknowledges receipt of the foregoing option and the attachments referenced therein and understands that all rights and liabilities with respect to this option are set forth in the option and the Plan; and (b) Acknowledges that as of the date of grant of this option, it sets forth the entire understanding between the undersigned optionee and the Company and its Affiliates regarding the acquisition of stock in the Company and supersedes all prior oral and written agreements on that subject with the exception of (i) the options previously granted and delivered to the undersigned under stock option plans of the Company, and (ii) the following agreements only: NONE (Initial) OTHER ------------------------------- ------------------------------- ------------------------------- /s/ Daniel L. Frank ------------------------------- DANIEL L. FRANK Address: 10231 Bothwell ------------------------------- Northridge, CA 91324 ------------------------------- ------------------------------- 6. 7 NOTICE OF EXERCISE PMR Corporation 501 Washington Street Fifth Floor San Diego, CA 92103 Date of Exercise: ___________ Ladies and Gentlemen: This constitutes notice under my incentive stock option that I elect to purchase the number of shares for the price set forth below. Stock option dated: ___________ Number of shares as to which option is exercised: Certificates to be issued in name of: ___________ Total exercise price: $__________ Cash payment delivered herewith: $__________ Value of ______ shares of common stock delivered herewith1: $__________
By this exercise, I agree (i) to provide such additional documents as you may require pursuant to the terms of the Company's 1997 Equity incentive Plan and (ii) to provide for the payment by me to you (in the manner designated by you) of your withholding obligation, if any, relating to the exercise of this option. Very truly yours, ------------------------------- - -------- 1 Shares must meet the public trading requirements set forth in the option. Shares must be valued in accordance with the terms of the option being exercised, must have been owned for the minimum period required in the option, and must be owned free and clear of any liens, claims, encumbrances or security interests. Certificates must be endorsed or accompanied by an executed assignment separate from certificate. 8 PMR CORPORATION CHANGE IN CONTROL VESTING POLICY (THE "POLICY") In the event the employment or relationship as a consultant to the Company of a person holding an option under the 1997 Equity Incentive Plan (the "Optionee") is, within one (1) year following a "Change in Control," (i) terminated by the Company other than for "Cause," or (ii) terminated in a "Constructive Termination," then the option held by such Optionee shall be fully vested. Moreover, all options held by directors shall become fully vested immediately upon the occurrence of a Change in Control. For purposes of this Policy, the following definitions shall apply: "CHANGE IN CONTROL" shall mean the occurrence of any of the following events: (a) The Company is merged, consolidated or reorganized into or with another corporation, partnership, limited liability company, or other entity or person, and as a result of such merger, consolidation or reorganization less than 70% of the combined voting power of the then-outstanding securities of such corporation, partnership, limited liability company, or other entity or person immediately after such transaction are held in the aggregate by holders of voting securities of the Company immediately prior to such transaction; (b) The Company sells all or substantially all of its assets to any other corporation, partnership, limited liability company, or other entity or person, and thereafter, less than 70% of the combined voting power of the then-outstanding voting securities of the acquiring or consolidated entity are held in the aggregate by the holders of voting securities of the Company immediately prior to such sale; (c) There is a report filed after the date on which the option is granted on Schedule 13D or Schedule 14D-1 (or any successor schedule, form or report), each as promulgated pursuant to the Securities Exchange Act of 1934 (the "Exchange Act") disclosing that any person (as the term "person" is used in Section 13(d)(3) or Section 14(d)(2) of the Exchange Act) has become the beneficial owner (as the term "beneficial owner" is defined under Rule 13d-3 or any successor rule or regulation promulgated under the Exchange Act) representing 30% or more of the combined voting power of the then-outstanding voting securities of the Company; (d) The Company shall file a report or proxy statement with the Securities and Exchange Commission pursuant to the Exchange Act disclosing in response to Item 1 of Form 8-K thereunder or Item 5(b) or Item 14 of Schedule 14A thereunder (or any successor schedule, form or report or item therein) that a change in control of the Company has or may have occurred or will or may occur in the future pursuant to any then-existing contract or transaction; or (e) During any period of two (2) consecutive years, individuals who at the beginning of any such period constitute the directors of the Company cease for any reason to constitute at least a majority of the Board of Directors of the Company unless the election or the nomination for election by the Company's shareholders of each director of the Company first 9 elected during such period was approved by a vote of at least two-thirds of the directors of the Company then still in office who were directors of the Company at the beginning of such two (2)-year period. "CAUSE" shall mean termination due to the occurrence of any of the following: (a) any intentional action or intentional failure to act by Optionee which was performed in bad faith and to the material detriment of the Company; (b) Optionee intentionally refuses or intentionally fails to act in accordance with any lawful direction or order of the Company; (c) Optionee willfully and habitually neglects his duties of employment; (d) Optionee's engaging or participating in any activity which is competitive with or injurious to the Company in the judgment of the Board of Directors; (e) Optionee's commission of any fraud against the Company or use or appropriation for his personal use and benefit of any funds, assets or properties of the Company not authorized by the Company to be so used or appropriated; or (f) Optionee is convicted of a felony crime involving moral turpitude. "CONSTRUCTIVE TERMINATION" means that the Optionee voluntarily terminates his or her employment with the Company after any of the following are undertaken, following a Change in Control, without Optionee's express written consent: (a) the assignment to Optionee of any duties or responsibilities which are inconsistent with, or result in any diminution or adverse change of, Optionee's position, status or circumstances of employment as in effect immediately prior to a Change in Control; an adverse change in Optionee's titles, offices, benefits and/or perquisites as in effect immediately prior to a Change in Control; any removal of Optionee from or any failure to re-elect Optionee to any offices held by Optionee immediately prior to a Change in Control, including, but not limited to, Optionee's membership on the Board, except in connection with the termination of his employment for death, disability, retirement, Cause, or any voluntary termination of employment by Optionee other than a Constructive Termination; (b) a reduction by the Company in Optionee's annual base salary by greater than five percent (5%) from that which was in effect immediately prior to a Change in Control; (c) a relocation of Optionee, or the Company's principal executive offices if Optionee's principal office is at such offices, to a location more than forty (40) miles from the location at which Optionee was performing his duties prior to a Change in Control, except for required travel by Optionee on the Company's business to an extent substantially consistent with Optionee's business travel obligations at the time of a Change in Control; (d) any material breach by the Company of any material provision of Optionee's Stock Award Agreement following a Change in Control; or (e) any failure by the Company to obtain the assumption of Optionee's Stock Award Agreement by any successor or assign of the Company. 2. EX-10.30 6 EXHIBIT 10.30 1 EXHIBIT 10.30 PMR CORPORATION INCENTIVE STOCK OPTION ____________________, Optionee: PMR CORPORATION (the "Company"), pursuant to its 1997 Equity Incentive Plan (the "Plan"), and subject to the Company's stockholders' approval of an increase of the shares authorized for issuance under the Plan to 3,000,000, has granted to you, the optionee named above, an option to purchase shares of the common stock of the Company ("Common Stock"). This option is intended to qualify as an "incentive stock option" within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"). The grant hereunder is in connection with and in furtherance of the Company's compensatory benefit plan for participation of the Company's employees (including officers), directors or consultants. Defined terms not explicitly defined in this agreement but defined in the Plan shall have the same definitions as in the Plan. The details of your option are as follows: 1. TOTAL NUMBER OF SHARES SUBJECT TO THIS OPTION. The total number of shares of Common Stock subject to this option is one hundred thousand (100,000). 2. VESTING. (a) Subject to the limitations contained herein (including the condition that the Company's stockholders approve the increase of the shares available for issuance under the Plan as described in the introductory paragraph above), the shares subject to this option will vest (become exercisable) upon the earlier to occur of (i) December 3, 2005 or (ii) on the first day following the ten consecutive trading days over which the average closing price of the Company's Common Stock quoted on the Nasdaq National Market or listed on any national securities exchange is at least $27.50 per share. (b) Notwithstanding the provisions of subsection 2(a) above, but subject to the provisions of subsection 2(c) below, all of the shares subject to this option shall vest and become immediately exercisable upon the consummation of a "Change in Control." For purposes of this option, "Change in Control" shall mean the occurrence of any of the following events: (i) The Company is merged, consolidated or reorganized into or with another corporation, partnership, limited liability company, or other entity or person, and as a result of such merger, consolidation or reorganization less than 70% of the combined voting power of the then-outstanding securities of such corporation, partnership, limited liability company, or other entity or person immediately after such transaction are held in the aggregate by holders of voting securities of the Company immediately prior to such transaction; (ii) The Company sells all or substantially all of its assets to any other corporation, partnership, limited liability company, or other entity or person, and thereafter, less 1. 2 than 70% of the combined voting power of the then-outstanding voting securities of the acquiring or consolidated entity are held in the aggregate by the holders of voting securities of the Company immediately prior to such sale; (iii) There is a report filed after the date on which the option is granted on Schedule 13D or Schedule 14D-1 (or any successor schedule, form or report), each as promulgated pursuant to the Securities Exchange Act of 1934 (the "Exchange Act") disclosing that any person (as the term "person" is used in Section 13(d)(3) or Section 14(d)(2) of the Exchange Act) has become the beneficial owner (as the term "beneficial owner" is defined under Rule 13d-3 or any successor rule or regulation promulgated under the Exchange Act) representing 30% or more of the combined voting power of the then-outstanding voting securities of the Company; (iv) The Company shall file a report or proxy statement with the Securities and Exchange Commission pursuant to the Exchange Act disclosing in response to Item 1 of Form 8-K thereunder or Item 5(b) or Item 14 of Schedule 14A thereunder (or any successor schedule, form or report or item therein) that a change in control of the Company has or may have occurred or will or may occur in the future pursuant to any then-existing contract or transaction; or (v) During any period of two (2) consecutive years, individuals who at the beginning of any such period constitute the directors of the Company cease for any reason to constitute at least a majority of the Board of Directors of the Company unless the election or the nomination for election by the Company's shareholders of each director of the Company first elected during such period was approved by a vote of at least two-thirds of the directors of the Company then still in office who were directors of the Company at the beginning of such two (2)-year period. (c) Notwithstanding anything herein to the contrary, in the event all of the following occur: (i) a contemplated Change in Control is proposed by the Company; (ii) this option would by itself cause a contemplated Change in Control, that would otherwise be eligible to be accounted for as a "pooling of interests" accounting transaction, to become ineligible for such accounting treatment; and (iii) the Company and the other party(ies) to the Change in Control transaction desire to account for such contemplated Change in Control as a "pooling of interests" transaction, then the provisions of this option may be modified by the Board of Directors to the furthest extent possible to permit the contemplated Change in Control transaction to be accounted for as a "pooling of interests" accounting transaction. In addition, the Board of Directors shall, to the extent reasonably possible subject to the foregoing, modify this option to remain consistent with the intent of the Company in granting this option as it relates to shares exercisable and vesting. Accounting issues will be determined by the independent auditors of the parties to the Change in Control transaction applying generally accepted accounting principles and any requirements imposed by regulatory authorities. 2. 3 3. EXERCISE PRICE AND METHOD OF PAYMENT. (a) EXERCISE PRICE. The exercise price of this option is seven and 125/1000 dollars ($7.125) per share, being not less than one hundred percent (100%) of the fair market value of the Common Stock on the date of grant of this option. (b) METHOD OF PAYMENT. Payment of the exercise price per share is due in full upon exercise of all or any part of each installment which has accrued to you. You may elect, to the extent permitted by applicable statutes and regulations, to make payment of the exercise price under one of the following alternatives: (i) Payment of the exercise price per share in cash (including check) at the time of exercise; (ii) Payment pursuant to a program developed under Regulation T as promulgated by the Federal Reserve Board which, prior to the issuance of Common Stock, results in either the receipt of cash (or check) by the Company or the receipt of irrevocable instructions to pay the aggregate exercise price to the Company from the sales proceeds; (iii) Provided that at the time of exercise the Company's Common Stock is publicly traded and quoted regularly in the Wall Street Journal, payment by delivery of already-owned shares of Common Stock, held for the period required to avoid a charge to the Company's reported earnings, and owned free and clear of any liens, claims, encumbrances or security interests, which Common Stock shall be valued at its fair market value on the date of exercise; or (iv) Payment by a combination of the methods of payment permitted by subparagraph 3(b)(i) through 3(b)(iii) above. 4. WHOLE SHARES. This option may only be exercised for whole shares. 5. SECURITIES LAW COMPLIANCE. Notwithstanding anything to the contrary contained herein, this option may not be exercised unless the shares issuable upon exercise of this option are then registered under the Securities Act or, if such shares are not then so registered, the Company has determined that such exercise and issuance would be exempt from the registration requirements of the Securities Act. 6. TERM. The term of this option commences on December 3, 1998, the date of grant, and expires on December 2, 2008 (the "Expiration Date"), which date shall be no more than ten (10) years from the date this option is granted, unless this option expires sooner as set forth below or in the Plan. In no event may this option be exercised on or after the Expiration Date. This option shall terminate prior to the Expiration Date as follows: three (3) months after the termination of your Continuous Status as an Employee, Director or Consultant with the Company or an Affiliate of the Company unless one of the following circumstances exists: (a) Your termination of Continuous Status as an Employee, Director or Consultant is due to your disability. This option will then expire on the earlier of the Expiration 3. 4 Date set forth above or twelve (12) months following such termination of Continuous Status as an Employee, Director or Consultant. (b) Your termination of Continuous Status as an Employee, Director or Consultant is due to your death or your death occurs within three (3) months following your termination of Continuous Status as an Employee, Director or Consultant for any other reason. This option will then expire on the earlier of the Expiration Date set forth above or twelve (12) months after your death. (c) If during any part of such three (3)-month period you may not exercise your option solely because of the condition set forth in paragraph 5 above, then your option will not expire until the earlier of the Expiration Date set forth above or until this option shall have been exercisable for an aggregate period of three (3) months after your termination of Continuous Status as an Employee, Director or Consultant. (d) If your exercise of the option within three (3) months after termination of your Continuous Status as an Employee, Director or Consultant with the Company or with an Affiliate of the Company would result in liability under section 16(b) of the Securities Exchange Act of 1934, then your option will expire on the earlier of (i) the Expiration Date set forth above, (ii) the tenth (10th) day after the last date upon which exercise would result in such liability or (iii) six (6) months and ten (10) days after the termination of your Continuous Status as an Employee, Director or Consultant with the Company or an Affiliate of the Company. However, this option may be exercised following termination of Continuous Status as an Employee, Director or Consultant only as to that number of shares as to which it was exercisable on the date of termination of Continuous Status as an Employee, Director or Consultant under the provisions of paragraph 2 of this option. In order to obtain the federal income tax advantages associated with an "incentive stock option," the Code requires that at all times beginning on the date of grant of the option and ending on the day three (3) months before the date of the option's exercise, you must be an employee of the Company or an Affiliate of the Company, except in the event of your death or permanent and total disability. The Company has provided for continued vesting or extended exercisability of your option under certain circumstances (for example, disability) for your benefit, but cannot guarantee that your option will necessarily be treated as an "incentive stock option" if you provide services to the Company or an Affiliate of the Company as a consultant or exercise your option more than three (3) months after the date your employment with the Company and all Affiliates of the Company terminates. 7. EXERCISE. (a) This option may be exercised, to the extent specified above, by delivering a notice of exercise (in a form designated by the Company) together with the exercise price to the Secretary of the Company, or to such other person as the Company may designate, during regular business hours, together with such additional documents as the Company may then require pursuant to subsection 11(e) of the Plan. 4. 5 (b) By exercising this option you agree that, as a precondition to the completion of any exercise, the Company may require you to enter an arrangement providing for the payment by you to the Company of any tax withholding obligation of the Company arising by reason of (1) the exercise of this option; (2) the lapse of any substantial risk of forfeiture to which the shares are subject at the time of exercise; or (3) the disposition of shares acquired upon such exercise. You also agree that the exercise of this option has not been completed and that the Company is under no obligation to issue any shares of Common Stock to you until such an arrangement is established or the Company's tax withholding obligations are satisfied, as determined by the Company. 8. TRANSFERABILITY. This option is not transferable, except by will or by the laws of descent and distribution, and is exercisable during your life only by you. Notwithstanding the foregoing, by delivering written notice to the Company, in a form satisfactory to the Company, you may designate a third party who, in the event of your death, shall thereafter be entitled to exercise this option. 9. REDUCTION FOR DISQUALIFIED INDIVIDUALS. (a) If this option becomes fully vested in connection with Optionee's termination following a Change in Control as described in the Plan, and if Optionee is deemed to be a "disqualified individual" as defined in Section 280G of the Code (which includes certain officers and highly compensated employees of the Company), then if the aggregate of the Optionee's gain upon the exercise of the option with respect to shares that became fully vested because of a Change in Control and all other payments made to Optionee in connection with a Change in Control would constitute a "parachute payment" within the meaning of Section 280G of the Code and would, but for this subsection (a), subject Optionee to liability for the twenty percent (20%) excise tax imposed by Section 4999 of the Code (the "Excise Tax"), then, subject to the provisions of subsection (b) hereof, the option exercise shall be reduced to the largest amount which the Company determines would result in no portion of such exercise being subject to the Excise Tax (but in no event shall the option exercise be reduced below the number of shares vested prior to acceleration in connection with a Change in Control). The Company's determination of any required deduction pursuant to this subsection (a) shall be conclusive and binding upon Optionee. However, if the Internal Revenue Service ("IRS") nevertheless determines that an exercise is subject to the Excise Tax, then subsection (b) hereof shall apply. (b) If notwithstanding the reduction described in subsection (a) hereof (or in the absence of any such reduction), the IRS determines that Optionee is liable for the Excise Tax as a result of the exercise, then Optionee shall be obligated to rescind within thirty (30) days after final IRS determination, the exercise of shares that subject the Optionee to the Excise Tax; provided, however, that Optionee shall not be obligated to rescind the exercise of shares that were vested prior to acceleration in connection with a Change in Control. The rescinded amount shall be the smallest such amount, if any, as shall be required so that no portion of Optionee's exercise shall be subject to the Excise Tax. In the event of any rescission hereunder, the Company shall return to Optionee the full exercise price paid by Optionee for the shares being rescinded. 5. 6 10. OPTION NOT A SERVICE CONTRACT. This option is not an employment contract and nothing in this option shall be deemed to create in any way whatsoever any obligation on your part to continue in the employ of the Company, or of the Company to continue your employment with the Company. In addition, nothing in this option shall obligate the Company or any Affiliate of the Company, or their respective shareholders, Board of Directors, officers or employees to continue any relationship which you might have as a Director or Consultant for the Company or Affiliate of the Company. 11. NOTICES. Any notices provided for in this option or the Plan shall be given in writing and shall be deemed effectively given upon receipt or, in the case of notices delivered by the Company to you, five (5) days after deposit in the United States mail, postage prepaid, addressed to you at the address specified below or at such other address as you hereafter designate by written notice to the Company. 12. GOVERNING PLAN DOCUMENT. This option is subject to all the provisions of the Plan, a copy of which is attached hereto and its provisions are hereby made a part of this option, including without limitation the provisions of Section 6 of the Plan relating to option provisions, and is further subject to all interpretations, amendments, rules and regulations which may from time to time be promulgated and adopted pursuant to the Plan. In the event of any conflict between the provisions of this option and those of the Plan, the provisions of the Plan shall control. Dated the 3rd day of December, 1998. Very truly yours, PMR CORPORATION By: ------------------------------- Title: ---------------------------- ATTACHMENTS: 1997 Equity Incentive Plan Notice of Exercise 6. 7 The undersigned: (a) Acknowledges receipt of the foregoing option and the attachments referenced therein and understands that all rights and liabilities with respect to this option are set forth in the option and the Plan; and (b) Acknowledges that as of the date of grant of this option, it sets forth the entire understanding between the undersigned optionee and the Company and its Affiliates regarding the acquisition of stock in the Company and supersedes all prior oral and written agreements on that subject with the exception of (i) the options previously granted and delivered to the undersigned under stock option plans of the Company, and (ii) the following agreements only: NONE ------------------------------- (Initial) OTHER ------------------------------- ------------------------------- ------------------------------- ------------------------------- [optionee signature] ------------------------------- Address: ------------------------------- ------------------------------- 7. 8 NOTICE OF EXERCISE PMR Corporation 501 Washington Street Fifth Floor San Diego, CA 92103 Date of Exercise: ___________ Ladies and Gentlemen: This constitutes notice under my incentive stock option that I elect to purchase the number of shares for the price set forth below. Stock option dated: ___________ Number of shares as to which option is exercised: ___________ Certificates to be issued in name of: ___________ Total exercise price: $__________ Cash payment delivered herewith: $__________ Value of ______ shares of common stock delivered herewith1: $__________
By this exercise, I agree (i) to provide such additional documents as you may require pursuant to the terms of the Company's 1997 Equity incentive Plan and (ii) to provide for the payment by me to you (in the manner designated by you) of your withholding obligation, if any, relating to the exercise of this option. Very truly yours, ------------------------------- - -------- 1 Shares must meet the public trading requirements set forth in the option. Shares must be valued in accordance with the terms of the option being exercised, must have been owned for the minimum period required in the option, and must be owned free and clear of any liens, claims, encumbrances or security interests. Certificates must be endorsed or accompanied by an executed assignment separate from certificate. 8. EX-21.1 7 EXHIBIT 21.1 1 EXHIBIT 21.1 SUBSIDIARIES The following are subsidiaries of PMR Corporation and their state of incorporation or organization.
Name State - ---- ----- Neuroscience Pharmaceutical Network, Inc. Delaware Twin Town Corporation California Psychiatric Management Resources, Inc. California Collaborative Care, Inc. California Collaborative Care Corporation Tennessee Business Office Solutions Corporation Delaware Stadt Solutions, LLC Delaware (PMR Corporation owns a 50.1% interest in Stadt Solutions, LLC)
1. EX-23.1 8 EXHIBIT 23.1 1 EXHIBIT 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 File No. 333-38419) pertaining to the 1997 Equity Incentive Plan, 1995 Warrant Grant, and the 1996 Stock Grants and the Registration Statements (Forms S-3 File No. 033-97202 and File No. 333-34473) of PMR Corporation of our report dated June 18, 1999, with respect to the consolidated financial statements and schedule of PMR Corporation included in its Annual Report (Form 10-K) for the year ended April 30, 1999. ERNST & YOUNG LLP San Diego, California July 27, 1999 EX-27.1 9 EXHIBIT 27.1
5 YEAR APR-30-1999 MAY-01-1998 APR-30-1999 5,441,012 27,509,554 30,666,894 10,664,000 0 61,607,134 4,395,934 1,532,000 70,966,018 9,373,707 0 0 0 69,889 52,581,127 70,966,018 29,666,887 85,489,455 21,969,451 64,706,201 1,116,769 8,051,576 (1,610,242) 246,327 100,429 0 0 0 592,689 (446,791) (.06) (.06)
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