Use these links to rapidly review the document
TABLE OF CONTENTS
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS



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


FORM 10-K


ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003

o

TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                             to                              

Commission File No. 1-6639


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

Delaware
(State or other jurisdiction of
incorporation or organization)
  58-1076937
(I.R.S. Employer
Identification No.)

16 Munson Road, Farmington, Connecticut
(Address of principal executive offices)

 

06032
(Zip Code)

Registrant's telephone number, including area code: (860) 507-1900

Securities registered pursuant to Section 12(b) of the Act: None.

Securities registered pursuant to Section 12(g) of the Act: Ordinary Common Stock
($0.01 per share par value).

        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 twelve 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 ý    No o

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes o    No ý

        The aggregate market value of the pre-petition common stock held by non-affiliates of the registrant as of June 30, 2003 (the last business day of the registrant's most recently completed second fiscal quarter) was approximately $1.4 million.

        The number of shares of reorganized Magellan Health Services, Inc.'s Ordinary Common Stock and Multi-Vote Common Stock outstanding as of March 4, 2004 was 26,900,268 and 8,469,846, respectively.

APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

        Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ý    No o

DOCUMENTS INCORPORATED BY REFERENCE

        None.




MAGELLAN HEALTH SERVICES, INC.
REPORT ON FORM 10-K
For the Fiscal Year Ended December 31, 2003

Table of Contents

 
   
PART I
Item 1.   Business
Item 2.   Properties
Item 3.   Legal Proceedings
Item 4.   Submission of Matters to a Vote of Security Holders

PART II
Item 5.   Market for Registrant's Common Equity and Related Stockholder Matters
Item 6.   Selected Financial Data
Item 7.   Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk
Item 8.   Financial Statements and Supplementary Data
Item 9.   Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Item 9A.   Controls and Procedures

PART III
Item 10.   Directors and Executive Officers of the Registrant
Item 11.   Executive Compensation
Item 12.   Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
Item 13.   Certain Relationships and Related Transactions
Item 14.   Principal Accountant Fees and Services

PART IV
Item 15.   Exhibits, Financial Statement Schedule and Reports on Form 8-K

2



PART I

        This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are set forth under the heading "Cautionary Statements" in Item 1 and elsewhere in this Form 10-K. When used in this Form 10-K, the words "estimate", "anticipate", "expect", "believe", "should" and similar expressions are intended to be forward-looking statements.


Item 1. Business

        Magellan Health Services, Inc. ("Magellan") was incorporated in 1969 under the laws of the State of Delaware. The Company's executive offices are located at 16 Munson Road, Farmington, Connecticut 06032, and its telephone number at that location is (860) 507-1900.

        Magellan, directly and through its subsidiaries (collectively, the "Company") coordinates and manages the delivery of behavioral healthcare treatment services that are provided through its contracted network of third-party treatment providers, which includes psychiatrists, psychologists, other behavioral health professionals, psychiatric hospitals, residential treatment centers and other treatment facilities. See "Business—Provider Network" for further discussion of the Company's managed behavioral healthcare network. The treatment services provided through the Company's provider network include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and crisis intervention services. The Company, however, generally does not directly provide, or own any provider of, treatment services. The Company provides its management services primarily through: (i) risk-based products, where the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) administrative services only ("ASO") products, where the Company provides services such as utilization review, claims administration and/or provider network management but does not assume responsibility for the cost of the treatment services, (iii) employee assistance programs ("EAPs") and (iv) products which combine features of some or all of the Company's risk-based, ASO or EAP products. At December 31, 2003, the Company managed the behavioral healthcare benefits of approximately 58.6 million individuals.

        In May 2003, the Company's board of directors approved a change in the Company's fiscal year. Instead of a fiscal year ending on September 30, the Company has adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. On August 12, 2003, the Company filed with the Securities and Exchange Commission ("SEC") a Transition Report on Form 10-K for the three-month period ended December 31, 2002. Throughout this Report on Form 10-K, references to the Company's historical financial information prior to December 31, 2002 will refer to the Company's former fiscal year end of September 30. For example, fiscal years 2001 and 2002 correspond to the twelve-month periods ended September 30, 2001 and 2002, respectively. References to fiscal 2003 relate to the Company's fiscal year ended December 31, 2003.

Emergence From Chapter 11

        On January 5, 2004 (the "Effective Date"), Magellan and 88 of its subsidiaries consummated their Third Joint Amended Plan of Reorganization, as modified and confirmed (the "Plan"), under

3



chapter 11 of title 11 of the United States Bankruptcy Code (the "Bankruptcy Code"), which had been confirmed by order of the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") on October 8, 2003, and accordingly the Plan became fully effective and the companies emerged from the protection of their chapter 11 proceedings. Magellan and these subsidiaries had filed voluntary petitions for relief under the Bankruptcy Code in the Bankruptcy Court on March 11, 2003.

        The following is a summary of the transactions which became effective on the Effective Date pursuant to or in connection with the consummation of the Plan. The distributions to which the Company's former creditors and shareholders became entitled under the Plan were made by the Company on the Effective Date or were disbursed in accordance with the Plan soon thereafter, except for certain immaterial distributions that were subsequently made or will be made in the future as provided for by the Plan upon certain conditions being satisfied. This summary only highlights certain of the substantive provisions of the Plan and the documents implementing the Plan and is qualified in its entirety by reference to (i) the full text of the Plan, a copy of which was filed as Exhibit 2(a) to Magellan's Quarterly Report on Form 10-Q filed with the SEC on August 19, 2003, as first supplemented by the modification filed as Exhibit 99.2 to Magellan's Current Report on Form 8-K filed with the SEC on September 30, 2003 and further supplemented by the modification filed as Exhibit 2.3 to Magellan's Current Report on Form 8-K filed with the SEC on October 9, 2003 and as to be implemented pursuant to the confirmation order, a copy of which was filed as Exhibit 2.4 to Magellan's Current Report on Form 8-K filed with the SEC on October 9, 2003, and (ii) the implementing documents, which are referred to below in this summary, filed as Exhibits 2.2 – 2.15 to Magellan's Current Report on Form 8-K filed with the SEC on January 6, 2004, and as amended in certain instances by Magellan's Current Reports on Form 8-K and Form 8-K/A filed with the SEC on January 7, 2004.

        Giving effect to the Plan, Magellan and its subsidiaries continued, in their previous organizational form, to conduct their business as previously conducted, with the same assets in all material respects (except for cash to be distributed under the Plan to former creditors of the Company), but the Company was recapitalized. Specifically, the Company's secured bank loans, as existing before the Effective Date, were paid in full, and other then existing indebtedness (i.e., two classes of notes and general unsecured creditor claims) and the then existing equity interests in Magellan were cancelled as of the Effective Date in exchange for the distributions provided for by the Plan, as further described below, all as of the Effective Date.

        On the Effective Date, the Company entered into a credit agreement with Deutsche Bank, as lender and administrative agent, and other lenders providing for a $100.0 million term loan, an $80.0 million letter of credit facility and a $50.0 million revolving credit facility (collectively, the "Credit Agreement"). The interest rate on term loan and revolving credit borrowings will fluctuate and will be at a rate equal to the higher of (i) the prime rate established by Deutsche Bank or (ii) one-half of one percent in excess of the overnight "federal funds" rate, as from time to time in effect, plus in either case two and one-half percent per year, subject to the Company's election to have interest calculated based on the "Eurodollar rate" offered by Deutsche Bank plus three and one-half percent per year. The interest rate on letter of credit-related borrowings will be fixed at 3.5 percent. However, in each case the interest rate could be reduced upon achievement of certain conditions. Borrowings under the Credit Agreement will mature on August 15, 2008 and certain quarterly principal payments on the term loan are also required. The Credit Agreement is guaranteed by substantially all of the subsidiaries of Magellan and is secured by substantially all of the assets of Magellan and the subsidiary guarantors. The proceeds of the term loan, together with other existing funds, were used on the Effective Date to repay in full in accordance with the Plan the Company's senior secured bank indebtedness under its previous credit agreement (the "Old Credit Agreement") of approximately $161 million, to make other cash payments contemplated by the Plan, to pay fees and expenses related to the chapter 11 cases, and

4



for general working capital purposes. In addition, the letter of credit facility has been utilized to back letters of credit outstanding on the Effective Date and to provide additional letters of credit when needed for the Company's business. For a further discussion of the Credit Agreement, see Note 7—"Long-Term Debt and Capital Lease Obligations" to the audited consolidated financial statements set forth elsewhere herein.

        As of the Effective Date, in satisfaction of the $250 million of principal owed on the 9.375% senior notes due 2007 (the "Old Senior Notes") and all accrued and unpaid interest thereon, the Company issued to the holders of such notes approximately $233.5 million in original principal amount of Series A notes of a new issue of senior notes due November 15, 2008 (the "Series A Notes", together with the Series B Notes (see below), the "Senior Notes") and made a cash payment of approximately $46.1 million. The terms of the Senior Notes are substantially similar to those of the Old Senior Notes, except that they mature on November 15, 2008. For a further discussion of the Senior Notes, see Note 7—"Long-Term Debt and Capital Lease Obligations" to the audited consolidated financial statements set forth elsewhere herein.

        Under the Plan, holders of the Company's previous 9% Senior Subordinated Notes due 2008 in the principal amount of $625.0 million (the "Old Subordinated Notes") and holders of general unsecured creditor claims (other than claims on the Old Senior Notes and Old Subordinated Notes) ("Other GUCs") were to receive in the aggregate approximately 97 percent of the Ordinary Common Stock (or approximately 22.3 million shares) of the reorganized Company (before giving effect to the Cash-Out Elections discussed below). The actual number of shares allocated between these two classes of creditors, as well as the number of shares allocated to each individual creditor in such creditor classes, is dependent upon the final, total aggregate value of claims for the two creditor classes, as discussed further below.

        As of the Effective Date, the Company estimated that the holders of the Old Subordinated Notes would receive in satisfaction of their claims (including all accrued and unpaid interest), approximately 20.5 million shares of Ordinary Common Stock of Magellan (before giving effect to the Cash-Out Elections discussed below). Accordingly, the Company distributed, as of the Effective Date, approximately 32.83 shares per $1,000 of principal amount of such notes (although no fractional shares or cash in lieu thereof were issued or paid). The share distribution amount is subject to adjustments as set forth below.

        As of the Effective Date, the Company estimated that total claims of Other GUCs, would be approximately $78 million (including unresolved disputed claims). Under the Plan, and based upon this total estimated claim value, such creditor class was estimated to receive in satisfaction of their claims (including any unpaid interest accrued thereon) the following consideration for each $1,000 of claim value: (i) $50.34 in cash, (ii) $254.99 of Series B of the Senior Notes ("Series B Notes"), and (iii) 22.41 shares of Ordinary Common Stock (although no fractional shares or cash in lieu thereof were or will be issued or paid), for an aggregate of 1.8 million shares (before giving effect to the Cash-Out Elections discussed below). As of March 4, 2004, the Company has issued approximately $5.1 million of Series B Notes for the settled claims of Other GUCs. The Series B Notes portions of certain other claims of Other GUCs were settled for cash, based upon claim settlement terms between the Company and such individual general unsecured creditors. The Ordinary Common Stock share distribution amount is subject to adjustment as set forth below.

        The Company currently estimates that the total claim value for Other GUCs will ultimately be resolved for approximately $55.0 million, of which $50.5 million has been settled as of March 4, 2004. If the claims of Other GUCs are ultimately resolved for the Company's current estimate of $55.0 million, the Other GUCs would receive additional consideration of approximately 0.53 shares of Ordinary Common Stock per $1,000 of claim value (although no fractional shares or cash in lieu thereof will be issued or paid) and the holders of claims on the Old Subordinated Notes would receive an additional

5



0.77 shares of Ordinary Common Stock per $1,000 of principal amount of such notes (although no fractional shares or cash in lieu thereof will be issued or paid).

        Also on the Effective Date, the previously outstanding shares of Common Stock and Preferred Stock of Magellan were cancelled, three new classes of capital stock were authorized and Magellan's certificate of incorporation and bylaws were amended and restated. Specifically, 100 million shares of Ordinary Common Stock, $0.01 par value per share ("Ordinary Common Stock"), and 40 million shares of Multiple and Variable Vote Restricted Convertible Common Stock, $0.01 par value per share ("Multi-Vote Common Stock") were authorized, as were 10 million shares of Preferred Stock, $0.01 par value per share, that are issuable at the discretion of the Board of Directors in the manner provided by law in one or more series with such powers, privileges and rights as may be determined by the Board (except that no non-voting shares shall be issued). No shares of Preferred Stock were issued or are to be issued under the Plan. Shares of the Multi-Vote Common Stock may only be issued to, and held by, Onex Corporation, a Canadian corporation, or an affiliate thereof (collectively, "Onex"). As described below, Onex, in connection with the Plan, invested in the equity of Magellan in the form of shares of Multi-Vote Common Stock. Upon transfer of any shares of Multi-Vote Common Stock to any party other than Onex, the shares of Multi-Vote Common Stock will automatically convert on a share-for-share basis into shares of Ordinary Common Stock. In addition, any shares of Ordinary Common Stock that Onex may come to own at any time when the Multi-Vote Common Stock is outstanding will automatically convert into shares of Multi-Vote Common Stock.

        In general, the Multi-Vote Common Stock and Ordinary Common Stock have the same powers, privileges and rights, and each share represents an equivalent interest in Magellan's equity, except that the shares of Multi-Vote Common Stock will have the number of votes per share from time to time sufficient so that all the outstanding shares of Multi-Vote Common Stock will have an equal number of votes as all the outstanding shares of Ordinary Common Stock (i.e., the Multi-Vote Common Stock will be entitled to exercise 50 percent of the voting power of all the common stock of Magellan). The Multi-Vote Common Stock and Ordinary Common Stock also differ in that each class has different voting rights in the election of directors and certain other voting rights and other special rights and privileges. The Multi-Vote Common Stock will cease to have any special voting rights or any other special rights or powers in the event the outstanding shares of Multi-Vote Common Stock cease to represent at least 15.33 percent of the total number of shares of common stock (both Ordinary Common Stock and Multi-Vote Common Stock) issued on the Effective Date (approximately 35.1 million shares) or at least 10 percent of the total number of shares of common stock outstanding at any time (the "Minimum Hold Condition"). For further information regarding the voting rights of the Ordinary Common Stock and the Multi-Vote Common Stock, see Item 10—"Directors and Executive Officers of the Registrant—Director Election and Terms of Office".

        As part of the Plan, Magellan offered to holders of its Old Subordinated Notes, its general unsecured creditors and one holder of an administrative claim the opportunity to purchase, on the effective date of the Plan, shares of common stock equivalent to 6,052,632 shares of Ordinary Common Stock for a total purchase price of $75 million ($12.39 per share). The Company also received as part of the Plan a commitment from Onex to purchase on the same terms any shares not purchased in the Equity Offering by the creditors to whom such shares were offered. Pursuant to the equity offering included in the Plan, creditors purchased 5,111,019 shares and Onex purchased 941,613 shares.

        Onex also purchased, pursuant to an additional commitment under the Plan, 6,052,632 shares of common stock for a total purchase price of $75 million (the "Onex Investment"), or $12.39 per share. In addition, Onex committed, under the Plan, to fund an offer made by Magellan pursuant to the Plan to holders of its Old Subordinated Notes and to the Company's other general unsecured creditors permitting them to elect to receive $9.78 in cash per share in lieu of the shares of Ordinary Common Stock they would otherwise receive under the Plan (the "Cash-Out Election"). Onex committed to fund the Cash-Out Election by purchasing that amount of shares of Multi-Vote Common Stock at $9.78 per

6



share equal to the amount of shares of Ordinary Common Stock cashed out pursuant to the Cash-Out Election. As of the Effective Date, Onex purchased 1,421,335 shares pursuant to this commitment. Also pursuant to this commitment, Onex committed to purchase, subsequent to the Effective Date, up to an additional 137,120 shares as a result of the settlement of claims that had elected the Cash-Out Election but were disputed and unresolved at the Effective Date. Onex has purchased and will purchase 8,552,700 shares in the aggregate (in the Equity Offering, pursuant to the Onex Investment and to fund the Cash-Out Election), all of which are shares of Multi-Vote Common Stock. These shares represented approximately 24.2 percent of the shares of common stock outstanding on the Effective Date and 21.2 percent of the common stock on a fully diluted basis as of the Effective Date. As stated above, the allocation of stock among creditors will change based on the value of all claims as ultimately resolved. If all claims are ultimately resolved for the amount of the Company's current estimate, 36,592 additional shares would be allocated to claims that had elected the Cash-Out Election, which would result in Onex acquiring an additional 36,592 shares at $9.78 per share (for a total of 8,589,292 shares).

        The previously outstanding Series A Redeemable Preferred Stock of Magellan was cancelled on the Effective Date and the holders thereof were issued 456,660 shares of Ordinary Common Stock, representing approximately 1.3 percent of the common stock of Magellan as of the Effective Date on a fully diluted basis (giving effect to all shares outstanding or subject to options or warrants outstanding as of the Effective Date), as well as warrants to purchase until January 5, 2011 for $30.46 per share, 456,660 shares of Ordinary Common Stock. The previously outstanding common stock of Magellan also was cancelled on the Effective Date and the holders thereof received 114,165 shares of Ordinary Common Stock, representing approximately 0.3 percent of the common stock of Magellan on the Effective Date on a fully diluted basis (calculated on the same basis as described above), as well as warrants to purchase at any time until January 5, 2011 for $30.46 per share, 114,165 shares of Ordinary Common Stock, which equals approximately one share of Ordinary Common Stock and a warrant to purchase one share of Ordinary Common Stock for every 310 shares of the previously outstanding common stock. For further information regarding the warrants issued under the Plan, see Note 8—"Stockholders' Equity" to the audited consolidated financial statements set forth elsewhere herein. Pursuant to the Plan, on the Effective Date all previously outstanding options and warrants to purchase common stock of Magellan were cancelled.

        As part of the consummation of the Plan, an agreement became effective between Aetna, Inc. ("Aetna") and the Company to renew their behavioral health services contract. Under the renewed agreement, the Company will continue to manage the behavioral health care of members of Aetna's healthcare programs through December 31, 2005, with an option for Aetna at that time to either extend the agreement or to purchase certain assets of the Company used solely in the management of the behavioral healthcare of Aetna members (the "Aetna-Dedicated Assets"). Pursuant to the Plan, on the Effective Date, the Company paid $15.0 million to Aetna, out of a debt obligation allowed under the Plan of $60.0 million plus accrued interest, and issued to Aetna an interest-bearing note (the "Aetna Note") for the balance of $48.9 million, which will mature on December 31, 2005. The Aetna Note is guaranteed by substantially all of the subsidiaries of Magellan and is secured by a second lien on substantially all of the assets of Magellan and the subsidiary guarantors. Additionally, if the behavioral health services contract is extended by Aetna at its option through at least December 31, 2006, one-half of the Aetna Note would be payable on December 31, 2005, and the remainder would be payable on December 31, 2006. If Aetna opts to purchase the Aetna-Dedicated Assets, the purchase price could be offset against any amounts owing under the Aetna Note. In addition, pursuant to the Plan, the Company issued to Aetna a warrant to purchase 230,000 shares of Ordinary Common Stock from January 1, 2006 to January 5, 2009 at a purchase price of $10.48 per share. For further information regarding the Company's agreement with Aetna, the Aetna Note and the warrant issued to Aetna under the Plan, see Note 7—"Long-Term Debt and Capital Lease Obligations" and Note 8—"Stockholders' Equity" to the audited consolidated financial statements set forth elsewhere herein.

7



        On the Effective Date, Magellan's Board of Directors was reconstituted to consist of nine members, as specified in accordance with the Plan. Information on the members of the Magellan Board of Directors is disclosed in Part III herein.

        The Company's senior executive officers before the Effective Date (Steven J. Shulman, Dr. Rene Lerer and Mark S. Demilio) entered into employment agreements with Magellan as of the Effective Date in a form provided by the Plan and providing for them to continue in their current positions. In general, the Company's other senior officers continued in Magellan's employ in substantially the same positions after the Effective Date and entered into employment agreements with Magellan in a form provided by the Plan. A Management Incentive Plan became effective on the Effective Date in accordance with the Plan, under which restricted stock awards, stock options and other equity incentives may be issued to members of the Company's management and other employees. The Company's employment agreements with its senior executive officers provided for the purchase by Mr. Shulman of certain shares of Ordinary Common Stock and for the grant to each such officer pursuant to the Management Incentive Plan of certain restricted shares of Ordinary Common Stock, all as of the Effective Date, and for certain cash payments to such officers related to the income taxes incurred by them in connection with such transactions. Options for a total of 4.3 million shares of Ordinary Common Stock were issued under the Management Incentive Plan in January and February of 2004. Information on the Company's executive officers', their compensation and the Management Incentive Plan, as required to be disclosed in Part III of Form 10-K, will be reported in an amendment to this Annual Report on Form 10-K, filed no later than April 29, 2004. See Note 8—"Stockholders' Equity" to the audited consolidated financial statements set forth elsewhere herein for a discussion of charges to be recorded by the Company related to stock grants, stock options and cash payments pursuant to the employment agreements and stock options under the Management Incentive Plan. Such charges will be recorded in the first quarter of fiscal 2004 and in future periods corresponding to the vesting or life of the options.

        Before the Effective Date, the common stock of the Company was registered pursuant to Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). On the Effective Date, the Ordinary Common Stock of Magellan, as issued in accordance with the Plan, was deemed registered under Section 12(g) of the Exchange Act as a successor issue, and Magellan as reorganized was deemed a successor issuer, in relation to the previously registered common stock in accordance with SEC Rule 12g-3(a). In addition, the warrants issued to former common and preferred stockholders as referred to above became registered under Section 12(g) of the Exchange Act pursuant to a registration statement on Form 8-A. The Ordinary Common Stock of the Company, including shares that may be issued upon conversion of shares of Multi-Vote Common Stock and upon exercise of the warrants and options referred to above, became listed on the Nasdaq Stock Market under the ticker symbol "MGLN" on January 6, 2004. On the Effective Date, in accordance with the Plan, Magellan also entered into a Registration Rights Agreement with Onex and Aetna, providing them rights with respect to the registration of their shares for public sale under the Securities Act of 1933, as amended, in certain circumstances.

Accounting for Consummation of the Plan

        In connection with the consummation of the Plan, the Company adopted the "fresh start reporting" provisions of AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), with respect to its financial reports, which requires the Company to restate its assets and liabilities to their fair values based upon the provisions of the Plan and certain valuations which the Company will make in connection with the implementation of the Plan. Under the provisions of SOP 90-7, fresh start reporting should not be applied until all material conditions of the reorganization plan are satisfied. All material conditions to the Company were satisfied as of December 29, 2003 (the "Material Conditions Date"). Due to the proximity of the

8



Material Conditions Date to year end and the immateriality of the results of operations for the intervening two-day period, the Company applied fresh start reporting as if the material conditions were satisfied as of December 31, 2003. All adjustments and reorganization expenses as a result of the application of fresh start reporting are reflected in the audited consolidated financial statements as of and for the year ended December 31, 2003 included elsewhere herein. See "Critical Accounting Policies and Estimates" in Item 7 and Note 2—"Fresh Start Reporting" to the audited consolidated financial statements elsewhere herein for further discussion of fresh start reporting and adjustments recorded pursuant to the application of SOP 90-7 by the Company.

        As a result of the application of the fresh start reporting provision of SOP 90-7, the consolidated balance sheets of the Company prior to December 31, 2003 are not comparable with the consolidated balance sheet as of December 31, 2003. Therefore, all balance sheet data as of December 31, 2003 have been disclosed herein as balances of the Reorganized Company, and all balance sheet data prior to December 31, 2003 have been disclosed as balances of the Predecessor Company. Statement of operations and statement of cash flows data for all periods presented herein represents the results of the Predecessor Company. Accordingly, all references to the Company with respect to disclosures of amounts recorded (i) through or prior to December 31, 2003 in relation to income statement or cash flow items; and (ii) prior to December 31, 2003 in relation to balance sheet items, relate to the Predecessor Company. All references to the Company with respect to disclosures of amounts recorded or to be recorded (i) after December 31, 2003 in relation to income statement or cash flow items; and (ii) on or after December 31, 2003 in relation to balance sheet items, relate to the Reorganized Company.

History

        Prior to June 1997, the Company's primary business was the operation of psychiatric hospitals. In addition, the Company operated, through its human services segment, specialty home-based healthcare services. In June 1997, the Company sold substantially all of its domestic psychiatric hospitals and residential treatment facilities (collectively, the "Psychiatric Hospital Facilities") to Crescent Real Estate ("Crescent"), and, with Crescent Operating, Inc. ("COI"), an affiliate of Crescent, formed Charter Behavioral Health Systems, LLC ("CBHS") to conduct the operations of the Psychiatric Hospital Facilities through a franchising arrangement with the Company. The Company maintained a 50.0 percent ownership of CBHS; the other 50.0 percent of the ownership interest of CBHS was owned by COI.

        In December 1995, the Company acquired a 61.0 percent ownership interest in Green Spring Health Services, Inc. ("Green Spring"), a managed behavioral healthcare company specializing in mental health and substance abuse/dependence services, and in January 1998, acquired the remaining 39.0 percent. In December 1997, the Company purchased from Aetna, Human Affairs International, Incorporated ("HAI"), which managed behavioral healthcare programs primarily through EAPs and other managed behavioral healthcare plans. In February 1998, the Company acquired Merit Behavioral Care Corporation ("Merit"), which managed behavioral healthcare programs across all segments of the healthcare industry, including health maintenance organizations ("HMOs"), Blue Cross/Blue Shield organizations and other insurance companies, corporations and labor unions, federal, state and local governmental agencies and various state Medicaid programs.

        In April 1999, the Company sold its European psychiatric provider operations, and in September 1999, completed its exit from the healthcare provider and franchising businesses by transferring certain assets and other interests pursuant to a Letter Agreement with Crescent, COI and CBHS (the "CBHS Transaction"). See Note 5—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. The CBHS Transaction, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999 (the measurement date), represented the disposal of the Company's healthcare provider and healthcare

9



franchising business segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30").

        On October 4, 2000, the Company adopted a formal plan to exit from the businesses included in the Company's specialty managed healthcare segment through the sale and/or abandonment of these businesses and related assets. The specialty managed healthcare segment included the businesses acquired in conjunction with the purchase of Vivra, Inc. ("Vivra"), which was consummated in February 2000 and Allied Specialty Care Services, Inc. ("Allied"), which was consummated in December 1997. The Company exited the specialty managed healthcare business via sale and/or abandonment of businesses and related assets, certain of which activities had already occurred in the normal course prior to October 4, 2000. See Note 5—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        On January 18, 2001, the Board of Directors approved, and the Company entered into a definitive agreement for, the sale of the stock of National Mentor, Inc. ("Mentor"), which represented the business and interests that comprised the Company's human services segment. The human services the Company provided through Mentor included specialty home-based healthcare services provided through "mentor" homes, as well as residential and day treatment services for individuals with acquired brain injuries and for individuals with developmental disabilities. See Note 5—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        As a result of these transactions, the Company's sole business is the managed behavioral healthcare business.

        Due primarily to the debt-financed acquisitions noted above, and the subsequent disposal activities, the Company had amassed over $1.0 billion in total debt as of September 30, 2002. Although the Company believed it had sufficient cash on hand to meet its then current operating obligations, the Company did not believe it had sufficient cash on hand or capacity to borrow under the Old Credit Agreement to pay scheduled interest and to make contingent purchase price payments. Based on market trends and forecasted level of operations, the Company concluded that it could no longer support the existing capital structure. Therefore, the Company's management determined to restructure its debt to levels that were more in line with its operations. On March 11, 2003, the Company and 88 of its subsidiaries filed voluntary petitions for relief under the Bankruptcy Code in order to accomplish such restructuring.

Industry

        According to the final report, Achieving the Promise: Transforming Mental Health Care in America, from the President's New Freedom Commission on Mental Health (established on April 29, 2002 by Executive Order 13263) (the "Commission Report"), approximately 5 percent to 7 percent of adults in a given year have a "serious mental illness", defined as any diagnosable mental disorder that affects work, home or other areas of social functioning; and approximately 5 percent to 9 percent of children have a "serious emotional disturbance" defined as any diagnosable mental disorder (in a child under 18) that severely disrupts social, academic and emotional functioning. In addition, according to the Commission Report, mental illness ranks first among all diseases in terms of causing disability in the United States, Canada and Western Europe. In 1997, the latest year for which comparable data is available, spending in the United States on the treatment of mental illness totaled almost $71 billion. In addition, the Commission Report states that the annual economic, indirect cost of mental illness is estimated to be $79 billion, of which approximately $63 billion represents the loss of productivity as a result of illnesses.

        Managed behavioral healthcare companies such as the Company were formed to address the behavioral health needs of society. Managed behavioral healthcare companies focus on matching an

10



appropriate level of specialist and treatment setting with the behavioral health treatment needs of the patient to provide care in a cost-efficient manner while improving early access to care and utilizing the most modern and effective treatments. As the growth of managed behavioral healthcare increased, there was a significant decrease in occupancy rates and average lengths of stay for inpatient psychiatric facilities and an increase in outpatient treatment and alternative care services.

        According to an industry trade publication entitled "Open Minds Yearbook of Managed Behavioral Health Market Share in the United States 2002-2003" published by Open Minds, Gettysburg, Pennsylvania (hereinafter referred to as "Open Minds"), as of January 2002, some form of managed behavioral healthcare plan covered approximately 227.1 million beneficiaries. Open Minds divides the managed behavioral healthcare industry as of January 2002 into the following categories of care, based on services provided, extent of care management and level of risk assumption:

Category of Care

  Beneficiaries (In Millions)
  Percent of Total
 
Risk-Based Network Products   58.6   25.8 %
EAPs   62.8   27.7  
Integrated Products   17.4   7.6  
Utilization Review/Care Management Products   42.9   18.9  
Non-Risk-Based Network Products   45.4   20.0  
   
 
 
  Total   227.1   100.0 %
   
 
 

        The following is a summary of each of these categories of care as defined by Open Minds:

        Risk-Based Network Products.    Under risk-based network products, the managed behavioral healthcare company manages the delivery of behavioral healthcare treatment services through a contracted network of behavioral healthcare providers and assumes all or a portion of the responsibility for the cost of providing such services. Most of these programs have payment arrangements in which the managed care company receives a fixed fee per member per month (that varies depending on the profile of the beneficiary population). Under these products, the managed behavioral healthcare company not only reviews and monitors a course of treatment, but also arranges and pays for the provision of patient care, usually through a network of specialized providers and facilities that is contracted and managed by the managed care company. This product generally provides higher revenue for the managed behavioral healthcare company, due to the fact that it bears the financial responsibility for the cost of delivering care. The Company's risk-based products are risk-based network products as defined by Open Minds.

        Employee Assistance Programs.    An EAP is a product sold directly to employers that is designed to assist in the early identification and resolution of productivity problems associated with behavioral conditions or other personal concerns of employees and their dependants. Under an EAP, staff or network providers or other affiliated clinicians provide assessment and referral services to employee beneficiaries and their dependants. These services consist of evaluating a beneficiary's needs and, if indicated, providing limited counseling and/or identifying an appropriate provider, treatment facility or other resource for more intensive treatment services. The EAP industry developed largely out of employers' efforts to combat alcoholism and substance abuse problems afflicting workers. Many businesses have expanded alcoholism and drug abuse treatment programs in the workplace to cover a wider spectrum of personal problems experienced by workers and their families, such as depression and anxiety disorders. As a result, EAP products now typically include consultation services, evaluation and referral services and employee education and outreach services and employers increasingly regard EAPs as an important component in the continuum of behavioral healthcare services. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as defined by Open Minds) as risk-based products.

11



        Integrated EAP/Managed Behavioral Healthcare Products.    Integrated Products combine the preventive and early intervention EAP products with the more comprehensive managed behavioral healthcare programs. Integrated products offer employers comprehensive management and treatment of all aspects of behavioral healthcare. The managed behavioral healthcare program component of the Integrated Product can be risk-based or non-risk-based. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as defined by Open Minds) as risk-based products.

        Utilization Review/Care Management Products.    Under utilization review/care management products, a managed behavioral healthcare company manages and often arranges for treatment, but does not maintain a network of providers or assume any of the responsibility for the cost of providing treatment services. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as it is defined by Open Minds) as ASO products.

        Non-Risk-Based Network Products.    Under non-risk-based network products, the managed behavioral healthcare company manages the delivery of behavioral healthcare treatment services through a contracted network of behavioral healthcare providers but does not assume any of the responsibility for the cost of providing such services. Under these products, the managed care company provides a full array of managed care services, including selecting, credentialing and managing a network of providers, and performs utilization review, claims administration and care management functions. However, the customer remains responsible for the cost of providing the treatment services rendered. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as it is defined by Open Minds) as ASO products.

Company Overview

        The Company is engaged in the managed behavioral healthcare business. Within this managed behavioral healthcare business, the Company operates in the following four segments, based on the services it provides and/or the customers that it serves: (i) Magellan Health Plan Solutions ("Health Plan Solutions"); (ii) Magellan Employer Solutions ("Employer Solutions"); (iii) Magellan Public Sector Solutions ("Public Sector Solutions") and (iv) Corporate and Other. See "Business—Segments" for a discussion of the Company's segments.

        According to enrollment data reported in Open Minds, the Company is the nation's largest provider of managed behavioral healthcare services. As of December 31, 2003, the Company had approximately 58.6 million covered lives under managed behavioral healthcare contracts and managed behavioral healthcare programs for approximately 1,900 customers. The Company's managed behavioral healthcare network consists of over 63,000 behavioral healthcare professionals, including facility locations providing various levels of care nationwide.

        The Company coordinates and manages the delivery of behavioral healthcare treatment services that are provided through its contracted network of third-party treatment providers, which includes psychiatrists, psychologists, other behavioral health professionals, psychiatric hospitals, residential treatment centers and other treatment facilities. See "Business—Provider Network" for further discussion of the Company's managed behavioral healthcare network. The treatment services provided through the Company's provider network include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and crisis intervention services. The Company, however, generally does not directly provide, or own any provider of, treatment services.

Business Strategy

        Continued Focus on Improving Operating Efficiency and Margins.    The Company believes that it can reduce administrative costs and improve customer service by consolidating service centers, creating

12


more efficiency in corporate overhead, consolidating systems, improving call center technology and instituting other operational and business efficiencies implementing best practices across the organization and by standardizing and consolidating processes as appropriate. In early 2003, the Company formulated performance improvement plans ("PIP") to achieve these cost efficiencies. The Company began implementing these multi-year initiatives in 2003. The Company has incurred approximately $9.8 million to date related to PIP activities, of which approximately $3.3 million has been paid with cash from operations as of December 31, 2003 and the remainder was accrued as of December 31, 2003. The Company expects to fund future amounts with cash from operations. There can be no assurance that the Company will be able to continue to successfully fund or implement these initiatives or realize the anticipated savings.

        Leverage the Company's Market Position to Grow Revenue and Increase Earnings.    The Company believes it is positioned to grow membership and revenues over the long term as a result of its economies of scale, solid customer base and proven behavioral health expertise. Furthermore, as the industry leader, the Company believes it is also positioned to benefit from proposed changes in federal and state parity legislation, which propose to reduce and in some cases eliminate the difference in coverage limits for mental health coverage as compared to medical health coverage. The Company's membership has decreased during the last two years. There can be no assurance that the Company will be able to reverse the membership decreases in future periods.

        New Product Development.    The Company is exploring opportunities to expand its business including the enhancement of existing products and the development of new products within current business lines and the possible development of new products outside of its current business line.

13


Managed Behavioral Healthcare Products and Services

        General.    The following table sets forth the approximate number of covered lives as of September 30, 2001 and 2002, and December 31, 2001, 2002 and 2003. The table also shows revenue for the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, and for the three months ended December 31, 2001 and 2002, for the types of managed behavioral healthcare programs offered by the Company:

 
  Predecessor Company
Programs

  Covered Lives
  Percent
  Revenue
  Percent
 
  (in millions, except percentages)

Fiscal Year ended September 30, 2001                  
Risk-Based products (1)   36.5   56.8%   $ 1,540.7   87.8%
ASO products   27.7   43.2     214.8   12.2
   
 
 
 
  Total   64.2   100.0%   $ 1,755.5   100.0%
   
 
 
 

Fiscal Year ended September 30, 2002

 

 

 

 

 

 

 

 

 
Risk-Based products (1)   34.5   55.3%   $ 1,537.9   87.7%
ASO products   27.9   44.7     215.2   12.3
   
 
 
 
  Total   62.4   100.0%   $ 1,753.1   100.0%
   
 
 
 

Fiscal Year ended December 31, 2003

 

 

 

 

 

 

 

 

 
Risk-Based products (1)   29.5   50.3%     1,292.5   85.6%
ASO products   29.1   49.7     218.2   14.4
   
 
 
 
  Total   58.6   100.0%   $ 1,510.7   100.0%
   
 
 
 

Three Months ended December 31, 2001 (unaudited)

 

 

 

 

 

 

 

 

 
Risk-Based products (1)   37.1   57.4%   $ 390.3   87.7%
ASO products   27.5   42.6     54.5   12.3
   
 
 
 
  Total   64.6   100.0%   $ 444.8   100.0%
   
 
 
 

Three Months ended December 31, 2002

 

 

 

 

 

 

 

 

 
Risk-Based products (1)   33.6   54.1%   $ 388.7   87.2%
ASO products   28.5   45.9     57.2   12.8
   
 
 
 
  Total   62.1   100.0%   $ 445.9   100.0%
   
 
 
 

(1)
Includes Risk-Based Network Products, EAPs and Integrated Products.

        The number of covered lives fluctuates based on several factors, including the number of contracts entered into by the Company and changes in the number of employees, subscribers or enrollees of the Company's customers covered by such contracts.

Segments

        General.    The following table sets forth the approximate number of covered lives as of September 30, 2001 and 2002, and December 31, 2001, 2002 and 2003 and the revenue for the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, and for the three months ended December 31, 2001 and 2002, in each of the Company's behavioral customer segments. The Company's behavioral customer segments are defined below. In certain limited cases, customer contracts that would otherwise meet the definition of one segment are managed and reported internally in another segment, in which cases the membership and financial results of such contracts are reflected in the segment in which it is reported internally. In fiscal 2003, the internal reporting of certain of these

14


contracts was transferred between segments. Accordingly, the Company has reclassified the membership and financial results of such contracts for all periods into the corresponding segments consistent with its internal reporting. This restatement did not affect consolidated membership or financial results for any period presented. In fiscal 2003, management also changed the name of its "Workplace" segment to the "Employer Solutions" segment. All periods presented were adjusted to conform with the fiscal 2003 restatement.

 
  Predecessor Company
 
  Covered Lives
  Percent
  Revenue
  Percent
 
  (in millions, except percentages)

Fiscal Year ended September 30, 2001                  
Health Plan Solutions   39.9   62.2%   $ 1,079.6   61.5%
Employer Solutions   21.8   33.9     189.6   10.8
Public Sector Solutions   2.5   3.9     486.3   27.7
   
 
 
 
  Total   64.2   100.0%   $ 1,755.5   100.0%
   
 
 
 

Fiscal Year ended September 30, 2002

 

 

 

 

 

 

 

 

 
Health Plan Solutions   37.0   59.3%   $ 1,013.1   57.8%
Employer Solutions   22.2   35.6     188.7   10.8
Public Sector Solutions   3.2   5.1     551.3   31.4
   
 
 
 
  Total   62.4   100.0%   $ 1,753.1   100.0%
   
 
 
 

Fiscal Year ended December 31, 2003

 

 

 

 

 

 

 

 

 
Health Plan Solutions   36.0   61.4%   $ 870.5   57.6%
Employer Solutions   19.9   34.0     159.0   10.5
Public Sector Solutions   2.7   4.6     481.2   31.9
   
 
 
 
  Total   58.6   100.0%   $ 1,510.7   100.0%
   
 
 
 

Three Months ended December 31, 2001 (unaudited)

 

 

 

 

 

 

 

 

 
Health Plan Solutions   39.3   60.9%   $ 270.1   60.7%
Employer Solutions   22.3   34.5     45.9   10.3
Public Sector Solutions   3.0   4.6     128.8   29.0
   
 
 
 
  Total   64.6   100.0%   $ 444.8   100.0%
   
 
 
 

Three Months ended December 31, 2002

 

 

 

 

 

 

 

 

 
Health Plan Solutions   36.5   58.7%   $ 245.6   55.1%
Employer Solutions   22.2   35.7     46.7   10.5
Public Sector Solutions   3.4   5.6     153.6   34.4
   
 
 
 
  Total   62.1   100.0%   $ 445.9   100.0%
   
 
 
 

        See Note 16—"Business Segment Information" to the Company's audited consolidated financial statements set forth elsewhere herein for additional segment financial information, such as segment profit.

        Health Plan Solutions.    The Company's Health Plan Solutions segment generally reflects managed behavioral healthcare services provided under contracts with managed care companies, health insurers and other health plans. This segment's contracts encompass both risk-based and ASO contracts. Although certain health plans provide their own managed behavioral healthcare services, many health plans "carve out" behavioral healthcare from their general healthcare services and subcontract such services to managed behavioral healthcare companies such as the Company. In the Health Plan Solutions segment, the Company's members are the beneficiaries of the health plan (the employees and

15



dependents of the customer of the health plan), for which the behavioral healthcare services have been carved out to the Company.

        Employer Solutions.    The Company's Employer Solutions segment generally reflects the provision of EAP services, managed behavioral healthcare services and integrated products under contracts with employers, including corporations and governmental agencies, and labor unions. This segment's managed behavioral healthcare services are primarily ASO products.

        Public Sector Solutions.    The Company's Public Sector Solutions segment generally reflects managed behavioral healthcare services provided to Medicaid recipients under contracts with state and local governmental agencies. This segment's contracts encompass both risk-based and ASO contracts. See "Cautionary Statements—Dependence on Government Spending for Managed Healthcare"; "—Possible Impact of Healthcare Reform" and "—Regulation".

Customer Contracts

        The Company's contracts with customers typically have terms of one to three years, and in certain cases contain renewal provisions (at the customer's option) for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts may be immediately terminated with cause and many are terminable without cause by the customer or the Company either upon the giving of requisite notice and the passage of a specified period of time (typically between 60 and 180 days) or upon the occurrence of other specified events. In addition, the Company's contracts with federal, state and local governmental agencies generally are conditioned on legislative appropriations. These contracts, notwithstanding terms to the contrary, generally can be terminated or modified by the customer if such appropriations are not made. The Company's contracts generally provide for payment of a per member per month fee to the Company. See "Cautionary Statements—Risk-Related Products" and "—Reliance on Customer Contracts".

Provider Network

        The Company's managed behavioral healthcare and EAP treatment services are provided by a network of third-party providers, including behavioral healthcare professionals and facilities. The number and type of providers in a particular area depend upon customer preference, site, geographic concentration and demographic make-up of the beneficiary population in that area. Network behavioral healthcare professionals include a variety of specialized behavioral healthcare personnel, such as psychiatrists, psychologists, licensed clinical social workers, substance abuse counselors and other professionals. Network facilities include psychiatric hospitals, residential treatment facilities and other treatment facilities.

        The Company's managed behavioral healthcare network consists of over 63,000 behavioral healthcare professionals, including facility locations, providing various levels of care nationwide. The Company's network providers are almost exclusively independent contractors located throughout the local areas in which the Company's customers' beneficiary populations reside. Network providers work out of their own offices, although the Company's personnel are available to assist them with consultation and other needs. Network providers include both individual practitioners, as well as individuals who are members of group practices or other licensed centers or programs. Network providers typically execute standard contracts with the Company under which they are paid on a fee-for-service basis. In some limited cases, network providers are paid on a "case rate" basis, whereby the provider is paid a set rate for an entire course of treatment, or on a subcapitation or other risk sharing arrangements.

        The Company's managed behavioral healthcare network also includes contractual arrangements with third-party treatment facilities, including inpatient psychiatric and substance abuse hospitals, intensive outpatient facilities, partial hospitalization facilities, community health centers and other community-based facilities, rehabilitative and support facilities and other intermediate care and

16



alternative care facilities or programs. This variety of facilities enables the Company to offer patients a full continuum of care and to refer patients to the most appropriate facility or program within that continuum. Typically, the Company contracts with facilities on a per diem or fee-for-service basis and, in some limited cases, on a "case rate" or capitated basis. The contracts between the Company and inpatient and other facilities typically are for one-year terms and are terminable by the Company or the facility upon 30 to 120 days' notice.

Joint Ventures

        Prior to October 29, 2002, the Company was a 50.0 percent partner with Value Options, Inc. in the Choice Behavioral Health Partnership ("Choice"), a managed behavioral healthcare company. Choice derived all of its revenues from a subcontract with a health plan under which it provided managed behavioral healthcare services to TRICARE beneficiaries. TRICARE was formerly known as the Civilian Health and Medical Program of the Uniformed Services (CHAMPUS). The Company accounted for its investment in Choice using the equity method of accounting with the Company's share of net income or loss of Choice recognized in the statement of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations", and Note 4—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein for additional discussion of Choice.

        The Company currently owns a 50.0 percent interest in Premier Behavioral Systems of Tennessee, LLC ("Premier"), which was formed to manage behavioral healthcare benefits for a certain portion of the State of Tennessee's TennCare program. In addition, the Company contracts with Premier to provide certain services to the joint venture. Through fiscal 2003, the Company accounted for its investment in Premier using the equity method. Effective December 31, 2003, in connection with the implementation of fresh start reporting, the Reorganized Company early adopted the Financial Accounting Standards Board's ("FASB") Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51 ("FIN 46"), under which the Reorganized Company has consolidated the balance sheet of Premier in its consolidated balance sheet as of December 31, 2003. Beginning in fiscal 2004, the Reorganized Company will consolidate the results of operations of Premier in its consolidated statement of operations. See further discussion of FIN 46 in "Management's Discussion and Analysis of Financial Condition and Results of Operations—Recent Accounting Pronouncements". See Note 4—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein for further information on Premier.

        The Company currently owns a 36.3 percent interest in Royal Health Care, LLC ("Royal"). Royal is a managed services organization that receives management fees for the provision of administrative, marketing, management and support services to five managed care organizations. Royal does not provide any services to the Company. The Company accounts for its investment in Royal using the equity method. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Off Balance Sheet Arrangements" and Note 4—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein for further information on Royal.

Competition

        The Company's business is highly competitive. The Company competes with other managed behavioral healthcare organizations as well as with insurance companies, HMOs, PPOs, third-party administrators ("TPAs"), independent practitioner associations ("IPAs"), multi-disciplinary medical groups and other managed care companies. Many of the Company's competitors, particularly certain insurance companies and HMOs, are significantly larger and have greater financial, marketing and other resources than the Company, and some of the Company's competitors provide a broader range of services. The Company may also encounter competition in the future from new market entrants. Many of the Company's customers that are managed care companies may seek to provide managed behavioral healthcare services directly to their subscribers, rather than by contracting with the Company

17



for such services. Because of these factors, the Company does not expect to be able to rely solely on price increases to achieve revenue growth and expects to continue experiencing pricing pressures. Also, the Company was adversely affected in its ability to successfully compete in certain circumstances during its financial restructuring process.

        The Company believes it benefits from the competitive strengths described below:

        Industry Leadership.    The Company is the largest provider of managed behavioral healthcare services in the United States, according to enrollment data reported in Open Minds. The Company believes, based on data reported in Open Minds, that it also has the number one market position in each of the major managed behavioral healthcare product markets in which it competes. The Company believes this leadership position provides it with a base of treatment experience and expertise that is unmatched by any competitor and provides a value proposition that customers are seeking. The Company also believes there are certain economies of scale resulting from its large membership base and the Company continues to strive to achieve operating efficiencies in order to better capitalize on such economies. See "Cautionary Statements—Competition", for a discussion of the risks associated with the highly competitive nature of the managed behavioral healthcare industry.

        Broad Product Offering and Nationwide Provider Network.    The Company offers managed behavioral care products that can be designed to meet specific customer needs, including risk-based and partial risk-based products, integrated EAPs, stand-alone EAPs and ASO products. The Company's managed behavioral healthcare network consists of over 63,000 behavioral healthcare providers, including professionals at all levels of care, such as psychiatrists, psychologists, licensed clinical social workers, substance abuse counselors and other professionals, and facilities at all points of the spectrum of behavioral heath services such as psychiatric hospitals, residential treatment centers and other treatment facilities. The Company believes the breadth and depth of its provider network is a competitive asset. See "Cautionary Statements—Risk-Related Products", for a discussion of the risks associated with risk-based products, which are the Company's primary source of revenue.

        Broad Base of Customer Relationships.    The Company's customers include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs and other mid-sized insurers; (iii) large corporations; (iv) state and local governmental agencies and (v) certain agencies of the federal government. The Company believes that its broad base of customer relationships provides the Company with opportunities for additional business from these customers. The Company also believes it has a unique array of customers that demonstrates credibility when competing for new business. See "Cautionary Statements—Reliance on Customer Contracts", for a discussion of the risks associated with the Company's reliance on certain contracts with payors of behavioral healthcare benefits.

Insurance

        The Company maintains a program of insurance coverage for a broad range of risks in its business. As part of this program of insurance, the Company is self-insured for a portion of its general and current professional liability risks. The Company maintained general, professional and managed care liability insurance policies with unaffiliated insurers covering the two-year period from June 17, 2000 to June 16, 2002. The policies were written on a "claims-made" basis, subject to a $0.25 million per claim and $1.0 million annual aggregate self-insured retention for general and professional liability, and also subject to a $0.5 million per claim and $2.5 million annual aggregate self-insured retention for managed care liability. The Company renewed its general, professional and managed care liability insurance policies with unaffiliated insurers for the one-year period from June 17, 2002 to June 16, 2003. These policies were also written on a "claims-made" basis, and were subject to a $1.0 million per claim ($5.0 million per class action claim) un-aggregated self-insured retention for managed care liability and a $0.25 million per claim un-aggregated self-insured retention for general and professional liability. The Company currently maintains general, professional and managed care liability insurance policies with unaffiliated insurers for a one-year period from June 17, 2003 to June 17, 2004. The policies are

18



written on a "claims-made" basis, subject to a $1.25 million per claim ($10.0 million per class action claim) un-aggregated self-insured retention for managed care liability, and a $0.25 million per claim un-aggregated self-insured retention for general and professional liability. The Company also purchases excess liability coverage in an amount deemed reasonable by management for the size and profile of the organization. The Company is responsible for claims within its self-insured retentions, for those claims, or portions thereof, that exceed the Company's policy limits and for claims reported after the expiration date of the policies if they are not renewed. See "Cautionary Statements—Professional Liability and Other Insurance", for a discussion of the risks associated with the Company's insurance coverage.

Regulation

        General.    The managed behavioral healthcare industry is subject to extensive and evolving state and federal regulation. The Company is subject to certain state laws and regulations, including those governing the licensing of insurance companies, HMOs, PPOs, TPAs and companies engaged in utilization review. In addition, the Company is subject to regulations concerning the licensing of healthcare professionals, including restrictions on business corporations from providing, controlling or exercising excessive influence over behavioral healthcare services through the direct employment of psychiatrists or, in a few states, psychologists and other behavioral healthcare professionals. These laws and regulations vary considerably among states and the Company may be subject to different types of laws and regulations depending on the specific regulatory approach adopted by each state to regulate the managed care business and the provision of behavioral healthcare treatment services. In addition, the Company is subject to certain federal laws as a result of the role it assumes in connection with managing its customers' employee benefit plans. The regulatory scheme generally applicable to the Company's managed behavioral healthcare operations is described in this section. The subjects of these regulations include Medicare and Medicaid fraud and abuse.

        The Company believes its operations are structured to comply with applicable laws and regulations in all material respects and that it has received all licenses and approvals that are material to the operation of the business. However, regulation of the managed healthcare industry is constantly evolving, with new legislative enactments and regulatory initiatives at the state and federal levels being implemented on a regular basis. Consequently, it is possible that a court or regulatory agency may take a position under existing or future laws or regulations, or as a result of a change in the interpretation thereof, that such laws or regulations apply to the Company in a different manner than the Company believes such laws or regulations apply. Moreover, any such position may require significant alterations to the Company's business operations in order to comply with such laws or regulations, or interpretations thereof. Expansion of the Company's business to cover additional geographic areas, to serve different types of customers, to provide new services or to commence new operations could also subject the Company to additional license requirements and/or regulation.

        Licenses.    Certain regulatory agencies having jurisdiction over the Company possess discretionary powers when issuing or renewing licenses or granting approval of proposed actions such as mergers, a change in ownership, transfer or assignment of licenses and certain intra-corporate transactions. One or multiple agencies may require as a condition of such license or approval that the Company cease or modify certain of its operations or modify the way it operates in order to comply with applicable regulatory requirements or policies. In addition, the time necessary to obtain a license or approval varies from state to state, and difficulties in obtaining a necessary license or approval may result in delays in the Company's plans to expand operations in a particular state and, in some cases, lost business opportunities. In recent years, in response to governmental agency inquiries or discussions with regulators, the Company has determined to seek licensing as a single service HMO, TPA or utilization review agent in one or more jurisdictions. Compliance activities, mandated changes in the Company's operations, delays in the expansion of the Company's business or lost business opportunities as a result of regulatory requirements or policies could have a material adverse effect on the Company.

19



        Insurance, HMO and PPO Activities.    To the extent that the Company operates or is deemed to operate in one or more states as an insurance company, HMO, preferred provider organization ("PPO") or similar entity, it may be required to comply with certain laws and regulations that, among other things, may require the Company to maintain certain types of assets and minimum levels of deposits, capital, surplus, reserves or net worth. In many states, entities that assume risk under contracts with licensed insurance companies or HMOs have not been considered by state regulators to be conducting an insurance or HMO business. As a result, the Company has not sought licenses as either an insurer or HMO in certain states. The National Association of Insurance Commissioners (the "NAIC") has undertaken a comprehensive review of the regulatory status of entities arranging for the provision of healthcare services through a network of providers that, like the Company, may assume risk for the cost and quality of healthcare services, but that are not currently licensed as an HMO or similar entity. As a result of this review, the NAIC developed a "health organizations risk-based capital" formula, designed specifically for managed care organizations, that establishes a minimum amount of capital necessary for a managed care organization to support its overall operations, allowing consideration for the organization's size and risk profile. The NAIC also adopted a model regulation in the area of health plan standards, which could be adopted by individual states in whole or in part, and could result in the Company being required to meet additional or new standards in connection with its existing operations. Certain states, for example, have adopted regulations based on the NAIC initiative, and as a result, the Company has been subject to certain minimum capital requirements in those states. Certain other states, such as Maryland, Texas, New York and New Jersey, have also adopted their own regulatory initiatives that subject entities such as the Company's subsidiaries to regulation under state insurance laws. This includes, but is not limited to, requiring adherence to specific financial solvency standards. State insurance laws and regulations may limit the Company's ability to pay dividends, make certain investments and repay certain indebtedness. Being licensed as an insurance company, HMO or similar entity could also subject the Company to regulations governing reporting and disclosure, mandated benefits, rate setting and other traditional insurance regulatory requirements. PPO regulations to which the Company may be subject may require the Company to register with a state authority and provide information concerning its operations, particularly relating to provider and payor contracting. The imposition of such requirements could increase the Company's cost of doing business and could delay the Company's conduct or expansion of its business in some areas. The licensing process under state insurance laws can be lengthy and, unless the applicable state regulatory agency allows the Company to continue to operate while the licensing process is ongoing, the Company could experience a material adverse effect on its operating results and financial condition while its license application is pending. In addition, failure to obtain and maintain required licenses typically also constitutes an event of default under the Company's contracts with its customers. The loss of business from one or more of the Company's major customers as a result of such an event of default or otherwise could have a material adverse effect on the Company.

        Regulators may impose operational restrictions on entities granted licenses to operate as insurance companies or HMOs. For example, the California Department of Corporations imposed certain restrictions on the Company in connection with the issuance of an approval of the Company's acquisitions of HAI and Merit, including restrictions on the ability of the California subsidiaries of HAI and Merit to fund the Company's operations in other states and on the Company's ability to make certain operational changes with respect to the subsidiaries of HAI and Merit in California.

        In addition, regulators of certain of the Company's subsidiaries may exercise certain discretionary rights under regulations including increasing its supervision of such entities, requiring additional restricted cash or other security or seizing or otherwise taking control of the assets and operations of such subsidiaries. In particular, the State of California has taken certain actions to increase its supervision of the Company's regulated subsidiaries in California due primarily to the Company's financial condition prior to the bankruptcy filing.

20



        Utilization Review and Third-Party Administrator Activities.    Numerous states in which the Company does business have adopted, or are expected to adopt, regulations governing entities engaging in utilization review and TPA activities. Utilization review regulations typically impose requirements with respect to the qualifications of personnel reviewing proposed treatment, timeliness and notice of the review of proposed treatment and other matters. TPA regulations typically impose requirements regarding claims processing and payments and the handling of customer funds. Utilization review and TPA regulations may increase the Company's cost of doing business in the event that compliance requires the Company to retain additional personnel to meet the regulatory requirements and to take other required actions and make necessary filings. Although compliance with utilization review regulations has not had a material adverse effect on the Company, there can be no assurance that specific regulations adopted in the future would not have such a result, particularly since the nature, scope and specific requirements of such provisions vary considerably among states that have adopted regulations of this type.

        There is a trend among states to require licensing or certification of entities performing utilization review or TPA activities. However, certain federal courts have held that such licensing requirements are preempted by the Employment Retirement Income Security Act of 1974 ("ERISA"). ERISA preempts state laws that mandate employee benefit structures or their administration, as well as those that provide alternative enforcement mechanisms. The Company believes that its TPA activities performed for its self-insured employee benefit plan customers are exempt from otherwise applicable state licensing or registration requirements based upon federal preemption under ERISA and have relied on this general principle in determining not to seek licenses for certain of the Company's activities in many states. Existing case law is not uniform on the applicability of ERISA preemption with respect to state regulation of utilization review or TPA activities. There can be no assurance that additional licenses will not be required with respect to utilization review or TPA activities in certain states.

        Licensing of Healthcare Professionals.    The provision of behavioral healthcare treatment services by psychiatrists, psychologists and other providers is subject to state regulation with respect to the licensing of healthcare professionals. The Company believes that the healthcare professionals who provide behavioral healthcare treatment on behalf of or under contracts with the Company and the case managers and other personnel of the health services business are in compliance with the applicable state licensing requirements and current interpretations thereof. However, there can be no assurance that changes in such state licensing requirements or interpretations thereof will not adversely affect the Company's existing operations or limit expansion. With respect to the Company's crisis intervention program, additional licensing of clinicians who provide telephonic assessment or stabilization services to individuals who are calling from out-of-state may be required if such assessment or stabilization services are deemed by regulatory agencies to be treatment provided in the state of such individual's residence. The Company believes that any such additional licenses could be obtained. However, there can be no assurance that such licensing requirements will not adversely affect the Company's existing operations or limit expansion.

        Prohibition on Fee Splitting and Corporate Practice of Professions.    The laws of some states limit the ability of a business corporation to directly provide, control or exercise excessive influence over behavioral healthcare services through the direct employment of psychiatrists, psychologists, or other behavioral healthcare professionals, who are providing direct clinical services. In addition, the laws of some states prohibit psychiatrists, psychologists, or other healthcare professionals from splitting fees with other persons or entities. These laws and their interpretations vary from state to state and enforcement by the courts and regulatory authorities may vary from state to state and may change over time. The Company believes that its operations as currently conducted are in material compliance with the applicable laws. However, there can be no assurance that the Company's existing operations and its contractual arrangements with psychiatrists, psychologists and other healthcare professionals will not be successfully challenged under state laws prohibiting fee splitting or the practice of a profession by an unlicensed entity, or that the enforceability of such contractual arrangements will not be limited. The

21



Company believes that it could, if necessary, restructure its operations to comply with changes in the interpretation or enforcement of such laws and regulations, and that such restructuring would not have a material adverse effect on its operations.

        Direct Contracting with Licensed Insurers.    Regulators in several states in which the Company does business have adopted policies that require HMOs or, in some instances, insurance companies, to contract directly with licensed healthcare providers, entities or provider groups, such as IPAs, for the provision of treatment services, rather than with unlicensed intermediary companies. In such states, the Company's customary model of contracting directly with its customers may need to be modified so that, for example, the IPAs (rather than the Company) contract directly with the HMO or insurance company, as appropriate, for the provision of treatment services. The Company intends to work with a number of these HMO customers to restructure existing contractual arrangements, upon contract renewal or in renegotiations, so that the entity, which contracts with the HMO directly, is an IPA. The Company does not expect this method of contracting to have a material adverse effect on its operations.

        HIPAA.    Confidentiality and patient privacy requirements are particularly strict in the field of behavioral healthcare. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") requires the Secretary of the Department of Health and Human Services ("HHS") to adopt standards relating to the transmission, privacy and security of health information by healthcare providers and healthcare plans. HIPAA calls for HHS to create regulations in several different areas to address the following: electronic transactions and code sets, privacy, security, provider IDs, employer IDs, health plan IDs and individual IDs. At present, all but the health plan IDs and individual IDs have been released in final form. The Company commissioned a dedicated HIPAA Project Management Office ("PMO") to coordinate participation from its customers, providers and business partners in achieving compliance with these regulations. The Company, through the PMO, put together a dedicated HIPAA Project Team to develop, coordinate and implement the compliance plan. The PMO has been phased out as a separate department and these HIPAA compliance activities are now contained in the Company's Corporate Compliance Department. Additionally, the Company has identified business area leads and work group chairpersons to support and lead compliance efforts related to their areas of responsibility and expertise.

        The Transactions and Code Sets regulation is final and was effective October 16, 2003 for companies that filed for a one-year deferral that was permitted by law. The Company filed for the extension as permitted by law. This regulation establishes standard data content and formats for the submission of electronic claims and other administrative and health transactions. This regulation only applies to electronic transactions, and healthcare providers will still be able to submit paper documents without being subject to this regulation. In addition, health plans must be prepared to receive these various transactions. The Company has completed the development of a new electronic data interchange ("EDI") strategy, which it believes will significantly enhance its HIPAA compliance efforts. The Company has signed an agreement with an external EDI tool vendor to expand the Company's usage of EDI technology, developed a project plan and an accompanying resource requirements rationale and identified anomalies through mapping of the HIPAA standard transactions to the Company's various clinical, claim and provider systems.

        The final regulation on privacy was published on December 28, 2000 and accepted by Congress on February 16, 2001. This regulation, which became effective on April 14, 2001 with a compliance date of April 14, 2003, requires patient authorization to release healthcare information in certain situations, creates rules about how much and when information may be released and creates rights for patients to review and amend their health records, creates a requirement to notify members of privacy practices and also requires that entities contract with their downstream business associates using standards required by the regulation. This regulation applies to both electronic and paper transactions. A new proposed modification to this rule was published on March 27, 2002 in the federal register with a 30-day comment period. This proposal sought to change some of the areas of the privacy regulation

22



that had an unintended adverse effect on the provision of care. The final modification to the privacy regulation was published in the August 14, 2002 Federal Register. The compliance date for the privacy regulation, including these changes was April 14, 2003. The Company has developed and implemented various measures to address areas such as confidential communications, accounting of disclosures, right of access and amendment, identifying and contracting with business associates, creation of HIPAA compliant policies and information technology upgrades. The Company believes that its business and operations are structured to comply with all applicable provisions of the privacy regulations.

        The draft version of the regulation on security was published on August 12, 1998. The final version of this rule was published on February 20, 2003 with a compliance date of April 21, 2005. This regulation creates safeguards for physical and electronic storage of, maintenance and transmission of, and access to, individual health information. Although the final security regulation was just released this year, the Company began compliance efforts over two years ago by taking steps to address the requirements of the draft regulation through the implementation of technical, physical and administrative safeguards to enhance physical, personnel and information systems security. The Company has completed its review of the final regulation and an extensive gap analysis, and is addressing the remaining compliance issues. The Company expects that it will be fully compliant with the security regulation by the compliance date.

        The provider ID and employer ID regulations are similar in concept. The provider ID regulation was published in draft form on May 7, 1998 and would create a unique number for healthcare providers that will be used by all health plans. The employer ID regulation was published in draft form on June 16, 1998 and calls for using the Employer Identification Number (the taxpayer identifying number for employers that is assigned by the Internal Revenue Service) as the identifying number for employers that will be used by all health plans. The final regulation on employer IDs was published on May 31, 2002 with a compliance date of July 30, 2004. The final regulation on Provider IDs was published on January 23, 2004 with a compliance date of May 23, 2005. The health plan ID and individual ID regulations have not been released in draft form.

        Management is currently assessing and acting on the wide reaching implications of these regulations to ensure the Company's compliance by the respective implementation dates. Management has identified HIPAA as a major initiative impacting the Company's systems, business processes and business relationships. This issue extends beyond the Company's internal operations and requires active participation and coordination with the Company's customers, providers and business partners. Management has commissioned a dedicated HIPAA project team to develop, coordinate and implement our compliance plan. With respect to the final regulations on security and privacy, the Company has hired personnel dedicated to physical and information security issues, appointed an officer who will be responsible for privacy issues, commissioned separate security and privacy workgroups which identified and assessed the potential impact of the regulations and reviewed current policies and drafted new policies to comply with the new requirements.

        Other Significant Privacy Regulation.    The privacy regulation under HIPAA generally does not preempt state law except under the following limited circumstances: (i) the privacy rights afforded under state law are contrary to those provided by HIPAA so that compliance with both standards is not possible and (ii) HIPAA's privacy protections are more stringent than the state law in question. Because many states have privacy laws that either provide more stringent privacy protections than those imposed by HIPAA or laws that can be followed in addition to HIPAA, the Company must address privacy issues under HIPAA and state law as well. While the Company has always been required to follow state privacy laws, the Company now has had to review these state laws against HIPAA to determine whether it must comply with standards established by both HIPAA and state law. In addition, HIPAA has created an increased awareness of the issues surrounding privacy, which may generate more state regulatory scrutiny in this area.

23


        Regulation of Customers.    Regulations imposed upon the Company's customers include, among other things, benefits mandated by statute, exclusions from coverages prohibited by statute, procedures governing the payment and processing of claims, record keeping and reporting requirements, requirements for and payment rates applicable to coverage of Medicaid and Medicare beneficiaries, provider contracting and enrollee rights and confidentiality requirements. Although the Company believes that such regulations do not at present materially impair its operations, there can be no assurance that such indirect regulation will not have a material adverse effect on the Company in the future.

        ERISA.    Certain of the Company's services are subject to the provisions of ERISA. ERISA governs certain aspects of the relationship between employer-sponsored healthcare benefit plans and certain providers of services to such plans through a series of complex laws and regulations that are subject to periodic interpretation by the IRS and the U.S. Department of Labor. In some circumstances, and under certain customer contracts, the Company may be expressly named as a "fiduciary" under ERISA, or be deemed to have assumed duties that make it an ERISA fiduciary, and thus be required to carry out its operations in a manner that complies with ERISA requirements in all material respects. Although the Company believes that it is in material compliance with the applicable ERISA requirements and that such compliance does not currently have a material adverse effect on its operations, there can be no assurance that continuing ERISA compliance efforts or any future changes to the applicable ERISA requirements will not have a material adverse effect on the Company.

        Other Proposed Legislation.    In the last five years, legislation has periodically been introduced at the state and federal levels providing for new healthcare regulatory programs and materially revising existing healthcare regulatory programs. Legislation of this type, if enacted, could materially adversely affect the Company's business, financial condition or results of operations. Such legislation could include both federal and state bills affecting the Medicaid programs which may be pending in, or recently passed by, state legislatures and which are not yet available for review and analysis. Such legislation could also include proposals for national health insurance and other forms of federal regulation of health insurance and healthcare delivery. It is not possible at this time to predict whether any such legislation will be adopted at the federal or state level, or the nature, scope or applicability to the Company's business of any such legislation, or when any particular legislation might be implemented. No assurance can be given that any such federal or state legislation will not have a material adverse effect on the Company.

        Other Regulation of Healthcare Providers.    The Company's business is affected indirectly by regulations imposed upon healthcare providers. Regulations imposed upon healthcare providers include provisions relating to the conduct of, and ethical considerations involved in, the practice of psychiatry, psychology, social work and related behavioral healthcare professions, accreditation, government healthcare program participation requirements, reimbursements for patient services, Medicare and Medicaid fraud and abuse and, in certain cases, the common law duty to warn others of danger or to prevent patient self-injury.

Cautionary Statements

        This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are set forth below and elsewhere in this Form 10-K. When used in this Form 10-K, the words "estimate", "anticipate", "expect", "believe", "should" and similar expressions are intended to be forward-looking statements.

24



        Fresh Start Reporting.    Due to the Reorganized Company's emergence from bankruptcy pursuant to the Plan of Reorganization, the Reorganized Company has implemented the "fresh start" reporting provisions of SOP 90-7, effective December 31, 2003. Fresh start reporting requires the Company to restate all assets and liabilities to reflect their respective fair values. As a result, the consolidated balance sheet as of December 31, 2003 and the statement of operations for periods after the Reorganized Company's emergence from bankruptcy will not be comparable to the consolidated financial statements for the periods prior to the Company's emergence from bankruptcy, which were prepared on a historical basis. The application of "fresh start" reporting may make it more difficult to compare the Reorganized Company's post-emergence operations and results to those in pre-emergence periods. For further information on fresh start reporting, including the adjustments recorded by the Company as of December 31, 2003, see Note 2—"Fresh Start Reporting" to the audited consolidated financial statements set forth elsewhere herein.

        Significant Stockholder.    Onex, through its affiliate, Magellan Holdings, L.P., beneficially owns all of the outstanding shares of the Multi-Vote Common Stock and thereby possesses the right to elect four of the nine members of the Company's Board of Directors and to exercise 50 percent of voting power for all other matters that come before Magellan's stockholders (other than with respect to the election of three of the nine members of the Board) until such time as the ownership of Multi-Vote Common Stock by Onex and affiliated parties decreases below certain pre-determined levels. This voting power of the Multi-Vote Common Stock is in excess of its interest in Magellan's outstanding common stock of approximately 24.2 percent as of the Effective Date. Onex's interests in the Company may conflict with the interests of the holders of the Ordinary Common Stock. As a result of Onex's substantial equity interest in and voting power over Magellan, Onex could have significant influence over the management and affairs of the Company, and a significant and potentially controlling influence on all matters submitted to the Company's stockholders for approval, including any merger, consolidation or sale of all or substantially all of the Company's assets. While Onex is restricted in its ability to sell the shares of Multi-Vote Common Stock it owns, it is entitled to convert its shares of Multi-Vote Common Stock into shares of Ordinary Common Stock and sell such shares and, in many conditions, in doing so will not reduce its voting power. For further information regarding Onex's rights as a stockholder, see "Business—Emergence from Chapter 11". Onex has certain rights to sell publicly the shares of Ordinary Common Stock that it may receive upon conversion of its shares of Multi-Vote Common Stock. See Item 12—"Security Ownership of Certain Beneficial Owners and Management". The market for the Ordinary Common Stock may be affected as a result of Onex's substantial position as a stockholder of Magellan.

        Restrictive Covenants in Debt Agreements.    On the Effective Date, the Company entered into an indenture governing the terms of the Senior Notes (the "Indenture"), as well as a new senior secured credit agreement (the "Credit Agreement"). In general, the Credit Agreement and the Indenture contain a number of covenants that limit management's discretion in the operations of the Company and its subsidiaries by restricting or limiting the Company's ability to, among other things:

25


        These restrictions may adversely affect the Company's ability to finance its future operations or capital needs or engage in other business activities that may be in its interest.

        The Credit Agreement also requires the Company to comply with specified financial ratios and tests (as defined), including minimum consolidated EBITDA, interest coverage ratios and maximum leverage ratios. Failure to comply with such covenants, without waiver, would result in an event of default under the Credit Agreement and, in the event the indebtedness under the Credit Agreement were accelerated, would give rise to defaults under substantially all of the Company's other debt agreements. The Credit Agreement is guaranteed by substantially all of the subsidiaries of the Company and is secured by substantially all of the assets of the Company and the subsidiary guarantors.

        Risk-Related Products.    The Company's revenues come primarily from arrangements under which it assumes all or a portion of the responsibility for the cost of providing a full or specified range of behavioral healthcare treatment services (excluding at present the cost of pharmaceuticals or other medication) to a specified beneficiary population in exchange, generally, for a fixed per member per month fee. The Company refers to such arrangements as "risk-related contracts" or "risk-related products". Revenues from such arrangements accounted for approximately 87.8 percent, 87.7 percent and 85.6 percent of the Company's net revenue in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively. For the three months ended December 31, 2001 and 2002, risk-related products accounted for approximately 87.7 percent and 87.2 percent, respectively, of the Company's net revenue. In order for such contracts to be profitable, the Company must accurately estimate the rate of service utilization by members enrolled under such contracts in order to obtain the appropriate pricing and control the unit cost of such services. If the aggregate cost of behavioral healthcare treatment services provided to members under a contract together with the administrative costs incurred by the Company to operate such contract, exceeds the aggregate of the per member per month fees received by the Company under such contract, the Company will incur a loss with respect to such contract. The Company's assumptions as to the utilization of services by rates and costs may not accurately and adequately reflect actual utilization rates and costs, many aspects of which are beyond the control of the Company.

        In addition, adjustments may be required to the estimates, particularly those regarding cost of care, made in reporting historical financial results. See Note 3—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein. Medical claims payable, in the Company's financial statements, includes reserves for incurred but not reported ("IBNR") claims, which are estimated by the Company. The Company determines the amount of such reserves based on past claims payment experience, including the average interval between the date services are rendered and the date claims are paid and between the date services are rendered and the date the claims are received, enrollment data, utilization statistics, adjudication decisions, authorized healthcare services and other factors. This data is incorporated into contract specific reserve models. The estimates for submitted claims and IBNR claims are made on an accrual basis and adjusted in future periods as required. However, changes in assumptions for medical costs caused by changes in actual experience (such as changes in the delivery system, changes in utilization patterns, unforeseen fluctuations in claims backlogs and others) may ultimately prove these estimates inaccurate. During fiscal 2001, the Company recorded an adjustment (and corresponding income statement charge) of $15.0 million to its estimate of claims incurred in prior years based on the results of the reduction in claims inventory and other claims processing improvements. During fiscal 2002, the Company experienced net unfavorable prior fiscal year medical claims development of $6.4 million (unfavorable development of $8.6 million for the Health Plan Solutions segment partially offset by favorable development of $2.2 million for the Public Sector Solutions segment). During the three months ended December 31, 2002, the Company experienced net favorable prior fiscal year medical claims development of $3.7 million (composed of Health Plan Solutions segment of $1.3 million, Employer Solutions segment of $0.8 million and Public Sector Solutions segment of $1.6 million). During fiscal 2003, the Company experienced net favorable prior fiscal year medical claims development of

26



$11.9 million (composed of Health Plan Solutions segment of $11.4 million and Employer Solutions segment of $0.5 million). As of December 31, 2003, the Company believes that its medical claims payable balance of $177.1 million is adequate in order to satisfy ultimate claim liabilities incurred through December 31, 2003. Any adjustments to such estimates could adversely affect the Company's results of operations in future periods.

        If the Company's membership in risk-based business grows, its exposure to potential losses from risk-related products will also be increased. Furthermore, certain of these contracts and certain state regulations limit the profits that the Company may earn on risk-related business and may require refunds if the loss experience is more favorable than that originally anticipated. Although experience varies on a contract-by-contract basis, historically, the Company's risk-related contracts have been profitable in the aggregate. However, the degree of profitability varies significantly from contract to contract. For example, the Company's Medicaid contracts with governmental entities generally tend to have direct profit margins that are lower than its other contracts. The most significant factor affecting the profitability of risk-related contracts is the ability to control direct service costs in relation to contract pricing.

        Certain of the contracts of the Company and certain state regulations may also require the Company or certain of its subsidiaries to reserve a specified amount of cash or to maintain a letter of credit as financial assurance that it can meet its obligations under such contracts. As of December 31, 2003, the Reorganized Company had restricted cash and investments of approximately $161.9 million and letters of credit of approximately $56.2 million pursuant to such contracts and regulations. Such amounts are not available to the Company for general corporate purposes. Furthermore, certain state regulations restrict the ability of subsidiaries that offer risk-related products to pay dividends to the Company. Additional state regulations could be promulgated which would increase the amount of restricted cash or other security the Company would be required to maintain. In addition, the Company's customers may require additional restricted cash or other security with respect to the Company's obligations under its contracts, including unpaid medical claims.

        Reliance on Customer Contracts.    All of the Company's net revenue is derived from contracts with payors of behavioral healthcare benefits. The Company's managed behavioral healthcare contracts typically have terms of one to three years, and in certain cases contain renewal provisions (at the customer's option) providing for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts are immediately terminable with cause and many, including some of the Company's most significant contracts, are terminable without cause by the customer upon the provision of requisite notice and the passage of a specified period of time (typically between 60 and 180 days), or upon the occurrence of certain other specified events. The Company's ten largest customers accounted for approximately 59.1 percent, 57.6 percent and 61.6 percent of the Company's net revenue for the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively. These customers represented approximately 58.9 percent and 58.2 percent of the Company's net revenue during the three months ended December 31, 2001 and 2002, respectively. Loss of all of these contracts or customers would, and loss of any one of these contracts or customers could, have a material adverse effect on the Company. One of these contracts is a subcontract with a health plan under which the Company manages the mental health and substance abuse services for certain of the beneficiaries of TRICARE, which subcontract expires on September 30, 2004 and will not be renewed. The Company recognized net revenue from this subcontract of $61.5 million, $48.0 million and $47.3 million in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively. The Company recognized net revenue from this contract of $12.7 million and $14.0 million during the three months ended December 31, 2001 and 2002, respectively.

        The Company's two largest customer contracts are with Aetna and the State of Tennessee's TennCare program. The Company's managed behavioral contract with Aetna accounted for approximately $315.6 million, $250.3 million and $193.6 million of consolidated net revenue in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively. The Company

27



recognized net revenue from Aetna of $78.8 million and $54.8 million during the three months ended December 31, 2001 and 2002, respectively. The declines in Aetna revenue of approximately $56.7 million in fiscal 2003 compared to fiscal 2002, approximately $65.3 million in fiscal 2002 compared to fiscal 2001, and of approximately $24.0 million for the three months ended December 31, 2002 as compared to the three months ended December 31, 2001, were mainly due to decreased membership as a result of Aetna intentionally reducing its membership levels in an effort to exit less profitable businesses.

        As described above in "Business—Emergence from Chapter 11," as part of the consummation of the Plan, Aetna and Magellan have renewed their contract, under which the Company will continue to manage the behavioral health care of Aetna's members through December 31, 2005, with an option for Aetna to either extend the agreement at that time or to purchase the assets used in the operation of the Aetna contract.

        Both the Company, through its wholly owned subsidiary, Tennessee Behaviorial Health ("TBH"), and Premier, a joint venture in which the Company has a 50.0 percent interest, separately contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program. In addition, the Company contracts with Premier to provide certain services to the joint venture. The Company's direct TennCare contract (exclusive of Premier's contract with TennCare) accounted for approximately $248.9 million, $237.5 million and $157.3 million of consolidated net revenue in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and approximately $60.0 million and $63.0 million of consolidated net revenue for the three months ended December 31, 2001 and 2002, respectively. Such revenue amounts include revenue recognized by the Company associated with services performed on behalf of Premier totaling $102.0 million, $134.9 million and $39.8 million for fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and $33.6 million and $34.6 million for the three months ended December 31, 2001 and 2002, respectively.

        In September 2003, the State of Tennessee issued a request for proposal ("RFP") relating to the TennCare program under which the program will be divided into three regions. The Company, through TBH, submitted a proposal for the East region only and was awarded the contract. The new contract with respect to the East region will become effective July 1, 2004. When contract negotiations between the State and the vendor that had been awarded the contracts for the Middle and West regions were discontinued, the State asked TBH and Premier to continue with their current contracts for those regions through December 31, 2004. The East region contract has an initial term that runs through December 31, 2005, and includes a provision for extensions at the State's option through December 31, 2008.

        The Aetna and TennCare contracts may not be extended or successfully renegotiated or, if renewed or renegotiated, the terms of any new contracts may not be comparable to those of existing contracts.

        The Company derives a significant portion of its revenue from contracts with various counties in the state of Pennsylvania (the "Pennsylvania Counties"). Although these are separate contracts with individual counties, they all pertain to the Pennsylvania Medicaid program. Revenues from the Pennsylvania Counties in the aggregate totaled approximately $121.1 million, $181.9 million and $189.6 million in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and approximately $36.0 million and $56.2 million for the three months ended December 31, 2001 and 2002, respectively. The Company's contract with one of the counties was terminated as December 31, 2003. Revenue related to this particular county totaled approximately $19.6 million, $22.8 million and $24.0 million in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and approximately $5.1 million and $6.4 million for the three months ended December 31, 2001 and 2002, respectively.

        Changes in the Medical Managed Care Industry.    Substantially all of the Company's revenues in its Health Plan segment are derived from customers in the medical managed care industry including

28



managed care companies, health insurers and other health plans. Certain changes in the business practices of this industry could negatively impact the Company. For example, if the managed care companies that the Company serves seek to provide managed behavioral healthcare services directly to their subscribers, rather than by contracting with the Company for such services, the Company could be adversely affected. See "Reliance on Customer Contracts" for a discussion of the potential impact of lost revenues associated with certain significant health plan customers of the Company

        In addition, the company has a significant number of contracts with Blue Cross and Blue Shield health plans and other regional health plans. Consolidation of the industry through acquisitions and mergers could impact this sector of the industry and could potentially result in the loss of contracts for the Company.

        Competition.    The Company's business is highly competitive. The Company competes with other managed behavioral healthcare organizations as well as with insurance companies, HMOs, PPOs, TPAs, IPAs, multi-disciplinary medical groups and other managed care companies. Many of the Company's competitors, particularly certain insurance companies and HMOs, are significantly larger and have greater financial, marketing and other resources than the Company. The entrance or expansion of these larger companies in the managed behavioral healthcare industry could increase the competitive pressures the Company faces.

        Integration of Operations.    The Company is in the process of implementing initiatives aimed at reducing operating costs and improving operating efficiencies (see "Business—Business Strategy" above). These initiatives include consolidating service centers, creating more efficiency in corporate overhead, consolidating systems, improving call center technology and instituting other operational and business efficiencies. The Company believes that it can reduce administrative costs and improve customer service through these measures. The Company expects to fund these costs with internally generated funds. However, there can be no assurance that the Company will be able to successfully implement these initiatives or realize the anticipated savings.

        In addition, the Company could experience disruptions in its computer systems or other operations during the implementation of these initiatives, which disruptions could adversely affect the Company's relationships with many of its contracted providers and customers, and its business and results of operations.

        Fluctuation in Operating Results.    The Company's quarterly operating results have varied in the past and may fluctuate significantly in the future due to a combination of factors, including:


        These factors may affect the Company's quarterly and annual revenues, expenses and results of operations in the future. Accordingly, reliance should not be placed on quarter-to-quarter or year-to-year comparisons of the Company's results of operations as an indication of future performance.

        Dependence On Government Spending For Managed Healthcare. A significant portion of the Company's revenue is derived, directly or indirectly, from federal, state and local governmental agencies, including state Medicaid programs. Contract rates vary from state to state, are subject to periodic negotiation and may limit the Company's ability to maintain or increase rates. The Company is

29



unable to predict the impact on its operations of future regulations or legislation affecting Medicaid programs, or the healthcare industry in general, and future regulations or legislation may have a material adverse effect on the Company. Moreover, any reduction in government spending for such programs could also have a material adverse effect. In addition, the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements, generally are conditioned upon financial appropriations by one or more governmental agencies, especially with respect to state Medicaid programs. These contracts generally can be terminated or modified by the customer if such appropriations are not made. Finally, some of the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements, require the Company to perform additional services if federal, state or local laws or regulations imposed after the contract is signed so require, in exchange for additional compensation to be negotiated by the parties in good faith. Government and other third-party payors are generally seeking to impose lower contract rates and to renegotiate reduced contract rates with service providers in a trend toward cost control. See "Business—Industry" and "—Business Strategy".

        Possible Impact of Healthcare Reform.    The U.S. Congress is considering legislation which, among other things, would place limits on healthcare plans and methods of operations, limit employers' and healthcare plans' ability to define medical necessity and permit employers and healthcare plans to be sued in state courts for coverage determinations. It is uncertain whether the Company could recoup, through higher revenues or other measures, the increased costs of federally mandated benefits or other increased costs caused by such legislation or similar legislation. In addition, if any federal parity legislation is adopted and the difference in coverage limits for mental health coverage and medical health coverage is reduced or eliminated, any increase in revenue the Company derives following such legislation may not be sufficient to cover the increase in costs that would result from a greater utilization of mental healthcare services. The Company cannot predict the effect of this legislation, nor other legislation that may be adopted by Congress, and such legislation may have an adverse effect on the Company.

        Regulation.    The managed behavioral healthcare industry and the provision of behavioral healthcare services are subject to extensive and evolving state and federal regulation. The Company is subject to certain state laws and regulations and federal laws as a result of the role the Company assumes in connection with managing its customers' employee benefit plans.

        The regulatory issues that may affect operations include:

30


        The imposition of additional license requirements and other regulatory requirements may, among other things, increase the Company's equity requirements, increase the cost of doing business or force changes in the Company's operations significantly to comply with these requirements.

        Onex Corporation is a non-U.S. company and has the right to elect one or more directors of the Company. See "Significant Stockholder" above. Therefore, federal law considers the Company to be under the ownership, control or influence of a foreign entity. As a result, the Company must comply with additional requirements in order to obtain a federal facility security clearance issued by the Defense Security Service. Such security clearance is a requirement of one of the Company's contracts with an agency of the federal government and may be a requirement of any new contracts the Company attempts to enter into with agencies of the federal government.

        Risks Related To Realization of Goodwill and Intangible Assets.    The Company's total assets at December 31, 2003 reflects goodwill of approximately $450.2 million, representing approximately 34.8 percent of total assets. There can be no assurance that such goodwill will be realizable. The application of the fresh start reporting provisions of SOP 90-7, as discussed above (see "Cautionary Statements—Fresh Start Reporting"), require the Company to value its assets and liabilities at fair market value. In accordance with the fresh start reporting provisions of SOP 90-7, implemented as of December 31, 2003, the reorganization value of the Company was allocated to the Company's tangible and identified intangible assets. Under SOP 90-7, if any portion of the reorganization value of the Company cannot be attributable to specific assets, such amount should be reported as goodwill. As a result of the application of fresh start reporting, the Predecessor Company's balance of goodwill was written-off at December 31, 2003. See Note 2—"Fresh Start Reporting" to the audited consolidated financial statements set forth elsewhere herein for further discussion of adjustments recorded under fresh start reporting. Pursuant to Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), the Company will test goodwill as of October 1 for impairment based upon fair values.

        At December 31, 2003, identifiable intangible assets (customer lists, contracts and provider networks) totaled approximately $58.1 million. Intangible assets are amortized over their estimated remaining useful lives which range from approximately two to eighteen years. The amortization periods used may differ from those used by other entities. In addition, the Company may be required to shorten the amortization period for intangible assets in future periods based on changes in the Company's business. The Company may not ever realize the value of such assets.

        The Company evaluates, on a regular basis, whether events and circumstances have occurred that indicate that all or a portion of the carrying value of intangible assets and other long lived assets may no longer be recoverable, in which case a charge to earnings for impairment losses could become necessary. When events or changes in circumstances are present that indicate the carrying amount of long lived assets may not be recoverable, the Company assesses the recoverability of long lived assets other than goodwill by determining whether the carrying value of such intangible assets will be recovered through the future cash flows expected from the use of the asset and its eventual disposition.

        Any event or change in circumstances which leads to a future determination requiring additional write-offs of a significant portion of unamortized intangible assets or goodwill would adversely affect the Company's results of operations.

        Claims for Professional Liability.    The management and administration of the delivery of managed behavioral healthcare services, and the direct provision of behavioral healthcare treatment services, entail significant risks of liability. From time to time, the Company is subject to various actions and claims of professional liability for alleged negligence in performing utilization review activities, as well as for the acts or omissions of the Company's employees, network providers or other parties. In the normal course of business, the Company receives reports relating to suicides and other serious incidents

31



involving patients enrolled in the Company's programs. Such incidents occasionally give rise to malpractice, professional negligence and other related actions and claims against the Company or its network providers. As the number of lives covered by the Company grows and the number of providers under contract increases, actions and claims against the Company (and, in turn, possible legal liability) predicated on malpractice, professional negligence or other related legal theories can be expected to increase. The Company is also subject to actions and claims for the costs of services for which payment was denied. Many of these actions and claims seek substantial damages and require the Company to incur significant fees and costs related to its defense. Pending or future actions or claims for professional liability (including any judgments, settlements or costs associated therewith) may have a material adverse effect on the Company.

        Professional Liability and Other Insurance.    The Company maintains a program of insurance coverage for a broad range of risks in its business. As part of this program of insurance, the Company carries professional liability insurance, subject to certain deductibles and self-insured retentions. Such insurance may not be sufficient to cover any judgments, settlements or costs relating to present or future claims, suits or complaints. Upon expiration of the Company's insurance policies, sufficient insurance may not be available on favorable terms, if at all. To the extent the Company's customers are entitled to indemnification under their contracts with the Company relating to liabilities they incur arising from the operation of the Company's programs, such indemnification may not be covered under the Company's insurance policies. To the extent that certain actions and claims seek punitive and compensatory damages arising from alleged intentional misconduct by the Company, such damages, if awarded, may not be covered, in whole or in part, by the Company's insurance policies. The Company also has certain potential liabilities relating to the self-insurance program the Company maintained with respect to its provider business prior to the Crescent Transactions. If the Company is unable to secure adequate insurance in the future, or if the insurance the Company carries is not sufficient to cover any judgments, settlements or costs relating to any present or future actions or claims, such judgments, settlements or costs may have a material adverse effect on the Company. In addition, the Company obtains surety bonds from insurance companies to meet requirements under the laws and regulations of states in which the Company operates. As of March 17, 2004, the Company has approximately $11.8 million of surety bonds outstanding. The surety bond carriers have collateral in the form of letters of credit in the amount of $13.2 million. If the Company is unable to obtain adequate surety bonds or make alternative arrangements to satisfy the requirements for such bonds, it may no longer be able to operate in those states, which would have a material adverse effect on the Company.

        Class Action Suits and Other Legal Proceedings.    Certain managed healthcare companies, including the Company, have been targeted as defendants in national class action lawsuits regarding their business practices. The Company is also subject to certain lawsuits and legal proceedings in conducting its business. See Item 3—"Legal Proceedings" elsewhere herein. Such lawsuits may have a material adverse effect on the Company.

        Government Investigations.    From time to time, the Company receives notifications from and engages in discussions with various government agencies concerning the Company's respective managed care businesses and operations. As a result of these contacts with regulators, the Company may, as appropriate, implement changes to its operations, revise its filings with such agencies and/or seek additional licenses to conduct its business. See Item 3—"Legal Proceedings" elsewhere herein. The Company's inability to cooperate with these government investigations and inquiries and comply with the various requirements imposed on the Company as a result of these proceedings may have a material adverse effect on the Company's business. In addition, the healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations cover, but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, information privacy and security, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Over the past several years, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or

32



regulations by healthcare organizations. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed services. A violation of such laws and regulations may have a material adverse effect on the Company.

        Use of Prior Audit Reports Prepared by Arthur Andersen LLP.    Arthur Andersen LLP, the Predecessor Company's accounting firm that audited the Predecessor Company's financial statements for the fiscal year ended September 30, 2001, was found guilty by a jury on June 15, 2002 of federal obstruction of justice charges in connection with the government's investigation of Enron Corp. Arthur Andersen ceased practicing before the Commission effective August 31, 2002. It is possible that events arising out of this conviction or the cessation of Arthur Andersen's practice may adversely affect the ability of Arthur Andersen to satisfy any claims arising from its provision of auditing and other services to clients, including claims that may arise out of Arthur Andersen's audit of the Company's financial statements.

        In addition, should the Company seek to access the public capital markets, it would need to satisfy certain requirements of the Commission relating to the Company's audited financial statements for fiscal years which were audited by Arthur Andersen. The Commission's current rules require the inclusion or incorporation by reference of three years of audited financial statements in any prospectus for a public offering of securities of the Company, which would require the Company to present audited financial statements for one or more fiscal years audited by Arthur Andersen until the Company's audited financial statements for the fiscal year ending December 31, 2004 become available in the first quarter of the Company's fiscal year 2005. The Commission has adopted rules exempting certain issuers filing Securities Act registration statements containing financial statements audited by Arthur Andersen from having to comply with the provisions of its rules that would otherwise require issuers to present with such financial statements manually signed reissued accountants' reports and written consents issued by Arthur Andersen. Although the Company believes that it currently meets the requirements for such exemptions, if the Commission ceases accepting financial statements audited by Arthur Andersen pursuant to such exemptions, it is possible that the Company's financial statements for the year ended September 30, 2001 audited by Arthur Andersen might not satisfy the Commission's requirements. If this occurs, the Company would not be able to access the public capital markets unless Ernst & Young LLP, the Company's current independent accounting firm, or another independent accounting firm, is able to audit the financial statements originally audited by Arthur Andersen. Any delay or inability to access the public capital markets caused by circumstances of such nature could have a material adverse effect on the Company.

Employees of the Registrant

        At December 31, 2003, the Company had approximately 4,700 full-time and part-time employees. The Company believes it has satisfactory relations with its employees.

Available Information

        The Company makes its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and Section 16 filings available on the Company's Internet website at http://www.magellanhealth.com as soon as practicable after the Company has electronically filed such material with, or furnished it to, the SEC. The information on the Company's website is not part of or incorporated by reference in this report on Form 10-K.

33



Item 2. Properties

        The Company currently leases approximately 1.1 million square feet of office space comprising 62 offices in 28 states and Puerto Rico with terms expiring between April 2004 and January 2013. The Company's principal executive offices are located in Farmington, Connecticut, which lease expires in May 2005. The Company believes that its current facilities are suitable for and adequate to support the level of its present operations.


Item 3. Legal Proceedings

        The management and administration of the delivery of managed behavioral healthcare services entail significant risks of liability. From time to time, the Company is subject to various actions and claims arising from the acts or omissions of its employees, network providers or other parties. In the normal course of business, the Company receives reports relating to suicides and other serious incidents involving patients enrolled in its programs. Such incidents occasionally give rise to malpractice, professional negligence and other related actions and claims against the Company or its network providers. See also "Cautionary Statements—Claims for Professional Liability". Many of these actions and claims received by the Company seek substantial damages and therefore require the defendant to incur significant fees and costs related to their defense. To date, claims and actions against the Company alleging professional negligence have not resulted in material liabilities and the Company does not believe that any such pending action against it will have a material adverse effect on the Company. However, there can be no assurance that pending or future actions or claims for professional liability (including any judgments, settlements or costs associated therewith) will not have a material adverse effect on the Company.

        The Company is subject to or party to certain class action suits, litigation and claims relating to its operations and business practices. Litigation asserting claims against the Company and its subsidiaries that were parties to the chapter 11 proceedings for pre-petition obligations (the "Pre-petition Litigation") were enjoined as a consequence of the commencement of the Company's chapter 11 proceedings. The Company believes that the Pre-petition Litigation claims constitute pre-petition general unsecured claims and, to the extent allowed by the Bankruptcy Court, would be resolved as Other General Unsecured Claims under the Plan. See "Business—Emergence from Chapter 11".

        In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company, and for which the outcome is probable and reasonably estimable. Management believes that the resolution of such litigation and claims will not have a material adverse effect on the Company's financial position or results of operations; however, there can be no assurance in this regard.


Item 4. Submission of Matters to a Vote of Security Holders

        None.

34




PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters

        Since January 6, 2004, shares of the Reorganized Company's Ordinary Common Stock, $0.01 par value per share ("Ordinary Common Stock") have traded on the Nasdaq Stock Market under the symbol "MGLN". From January 6, 2004 through March 4, 2004, the high and low closing bid prices of the Reorganized Company's Ordinary Common Stock, as reported by the Nasdaq National Market, were $29.01 and $26.25, respectively. For further information regarding the Reorganized Company's Ordinary Common Stock, see Note 8—"Stockholders' Equity" to the audited consolidated financial statements set forth elsewhere herein. Warrants to purchase shares of the Reorganized Company's Ordinary Common Stock have traded on the Over-the-Counter Bulletin Board ("OTCBB") under the ticker symbol MGLNW since February 2, 2004.

        From October 9, 2002 to January 5, 2004, the Predecessor Company's previously authorized Class A common stock was listed for trading on the OTCBB under the ticker symbol "MGLHQ.OB". As of the Effective Date, trading of the Predecessor Company's pre-petition Class A common stock was halted on the OTCBB and the Company's Class A common stock was cancelled. Prior to October 9, 2002, the Class A Common Stock was traded on the New York Stock Exchange ("NYSE") under the ticker symbol "MGL" until such date, when it was de-listed from that market. The following table sets forth the high and low closing bid prices of the Predecessor Company's previously authorized Class A common stock as reported by the NYSE and the OTCBB from January 1, 2002 through December 31, 2003:

 
  Common Stock
Sales Prices

Calendar Year

  High
  Low
2002        
First Quarter   6.75   5.20
Second Quarter   8.65   1.00
Third Quarter   1.75   0.26
Fourth Quarter   0.24   0.03

2003

 

 

 

 
First Quarter   0.19   0.03
Second Quarter   0.06   0.03
Third Quarter   0.20   0.05
Fourth Quarter   0.11   0.06

        On the Effective Date, all interests in the Reorganized Company's pre-petition Common Stock and Preferred Stock were cancelled and three new classes of capital stock were authorized. Specifically, 100 million shares of Ordinary Common Stock and 40 million shares of Multiple and Variable Vote Restricted Convertible Common Stock, $0.01 par value per share ("Multi-Vote Common Stock") were authorized, as were 10 million shares of Preferred Stock, $0.01 par value per share, that are issuable at the discretion of the Board of Directors in the manner provided by law in one or more series with such powers, privileges and rights as may be determined by the Board (except that no non-voting shares shall be issued). No shares of Preferred Stock were issued or are to be issued under the Plan. Shares of the Multi-Vote Common Stock may only be issued to, and held by, Onex Corporation, a Canadian corporation, or (as determined in accordance with Magellan's amended and restated certificate of incorporation) an affiliate thereof (collectively, "Onex"). Onex, in connection with the Plan, invested in the equity of Magellan, which equity is to be in the form of shares of Multi-Vote Common Stock. Upon transfer of any shares of Multi-Vote Common Stock to any party other than Onex, the shares of Multi-Vote Common Stock will automatically convert on a share-for-share basis into shares of the Ordinary Common Stock. In addition, any shares of Ordinary Common Stock that Onex may come to

35



own at any time when the Multi-Vote Common Stock is outstanding will automatically convert into shares of Multi-Vote Common Stock.

        As of March 4, 2004, the approximate number of stockholders of record of the Ordinary Common Stock and the Multi-Vote Common Stock was 263 and 1, respectively. The stockholders of record data for the Ordinary Common Stock does not reflect stockholders whose stock was held on that date by the Depository Trust Company or other intermediaries. The Company's Multi-Vote Common Stock is held 100.0 percent by Onex, but upon sale of any such shares by Onex to any non-affiliate, such sold shares automatically convert to and become Ordinary Common Stock.

Dividends

        The Company did not declare any cash dividends on its pre-petition Class A common stock during either the fiscal years ended September 30, 2002 or December 31, 2003 nor during the three months ended December 31, 2002. The Company has not declared any cash dividends on the Ordinary Common Stock. The Company is prohibited from paying dividends on the Ordinary Common Stock under the terms of the Credit Agreement, except in very limited circumstances. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Outlook—Liquidity and Capital Resources—Restrictive Covenants in Debt Agreements".

Securities Authorized for Issuance Under Equity Compensation Plans

        As of December 31, 2003, the Company maintained stock option and incentive plans under which employees and non-employee directors could be granted options to purchase shares of Company common stock or awarded shares of common stock and, in addition, the Company maintained its 2000 Employee Stock Purchase Plan, all of which had previously been approved by the Company's stockholders. No options or shares were granted or issued under any of these plans in the year ended December 31, 2003. All options related to the previously authorized common stock of the Company remaining outstanding under these plans were cancelled on the Effective Date and no consideration was issued in exchange therefor. Any shares of the previously authorized common stock issued under these plans (including shares issued under the 2003 Employee Stock Purchase Plan) that were outstanding on the Effective Date were converted into shares of Ordinary Common Stock and Warrants in accordance with the provisions of the Plan. Each of these plans was cancelled as of the Effective Date (except to the extent that provisions of the plans might continue to apply to shares of Ordinary Common Stock or warrants issued under the Plan in respect of shares of the previously common stock issued under such plans and remaining outstanding immediately before the Effective Date). Accordingly, securities may no longer be issued by the Company under any of these plans.

        The Plan provided for the creation of a Management Incentive Plan, under which restricted stock awards, stock options and other equity incentives may be issued to members of the Company's management and other employees. The Plan also provided for employment agreements with certain senior executives of the Company which in turn provide for issuances of shares of the Company's Ordinary Common Stock or options to acquire such shares in certain circumstances. The Management Incentive Plan and these agreements became effective on the Effective Date. Information regarding securities issued and which may be issued under these plans and agreements is contained in Note 1—"General" and in Note 8—"Stockholders' Equity" to the audited consolidated financial statements set forth elsewhere herein.

36



Item 6. Selected Financial Data

        In May 2003, the Company's board of directors approved a change in the Company's fiscal year. Instead of a fiscal year ending on September 30, the Company has adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. The following table sets forth selected historical consolidated financial information of the Company as of and for each of the four fiscal years ended September 30, 1999, 2000, 2001 and 2002, as of and for the fiscal year ended December 31, 2003, and as of and for the three-month transition period ended December 31, 2002. The table also presents unaudited comparable data as of and for the three months ended December 31, 2001.

        As a result of the Company's financial restructuring under chapter 11 of the U.S. Bankruptcy Code commenced in March 2003 and consummated on the Effective Date and the Company's implementation of fresh start reporting effective December 31, 2003, the selected financial data as of and for the year ended December 31, 2003 are not comparable to the prior periods presented. Selected financial data as of and for the fiscal year ended December 31, 2003 includes the following significant unusual items:

        See Note 2—"Fresh Start Reporting" to the audited consolidated financial statements elsewhere herein for discussion of fresh start adjustments recorded by the Company.

        Net loss for fiscal 2002 includes the effect of the adoption of SFAS 142. Adoption of SFAS 142 resulted in the Company recognizing an impairment loss of $207.8 million before taxes ($191.6 million after taxes), in the first quarter of fiscal 2002, recorded as a cumulative effect of a change in accounting principle, separate from operating results. Adoption of SFAS 142 also resulted in goodwill impairment charges of $415.9 million and $28.8 million in fiscal 2002 and fiscal 2003, respectively. In accordance with SFAS 142, the Company did not record goodwill amortization, which would have amounted to approximately $31.1 million and $31.8 million in fiscal 2002 and 2003, respectively, and $7.9 million (unaudited) and $7.8 million during the three months ended December 31, 2001 and 2002, respectively,

37



had SFAS 142 not been adopted. See Note 3—"Summary of Significant Accounting Policies—Goodwill" to the audited consolidated financial statements set forth elsewhere herein for further discussion of the impact to the Company of the adoption of SFAS 142 in fiscal 2002. In addition, the Company's capital restructuring activities and financial condition resulted in uncertainty as of September 30, 2002 as to the Company's ability to realize its net operating loss carryforwards and other deferred tax assets. Accordingly, as of September 30, 2002, the Company recorded an increase to its valuation allowance of $200.5 million, resulting in a total valuation allowance covering all of its net deferred tax assets. See Note 10—"Income Taxes" to the audited consolidated financial statements set forth elsewhere herein.

        The operating results for fiscal 2001 were positively impacted by settlements of certain contract appeals related to subcontracts with respect to TRICARE. For fiscal 2001, net revenue and equity in earnings of unconsolidated subsidiaries included $30.3 million and $22.6 million, respectively, related to such settlements. For fiscal 2001, income from continuing operations and net income each included approximately $31.7 million related to the positive impact of these settlements. Additionally, in the fourth quarter of fiscal 2002, the Company adopted SFAS 145, which led to the reclassification of losses due to early extinguishment of debt in fiscal 2001 from extraordinary losses to losses from operations.

        On September 2, 1999, the Company's Board of Directors approved a formal plan to dispose of the Company's businesses and interests included in the Company's healthcare provider and healthcare franchising segments and on September 10, 1999, the Company consummated such disposal. On October 4, 2000, the Company adopted a formal plan to dispose of the business included in the Company's specialty managed healthcare segment. On January 18, 2001, the Company adopted a formal plan to dispose of the business representing the Company's human services segment, and on March 9, 2001, the Company consummated such disposal. Accordingly, the statement of operations data has been restated to reflect the healthcare provider, healthcare franchising, specialty managed healthcare and human services business segments as discontinued operations.

        Selected consolidated financial information for the years ended September 30, 2001 and 2002 and December 31, 2003, and for the three months ended December 31, 2002, and as of December 31, 2002 and 2003 presented below, have been derived from, and should be read in conjunction with, the audited consolidated financial statements and the notes thereto included elsewhere herein. Selected consolidated financial information for the fiscal years ended September 30, 1999 and 2000 and as of September 30, 1999, 2000, 2001 and 2002 has been derived from the Company's audited consolidated financial statements not included in this Form 10-K. The selected consolidated financial information as of and for the three months ended December 31, 2001 is unaudited. The selected financial data set forth below also should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere herein.

38




MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

 
  Predecessor Company
 
 
   
   
   
   
   
  Three Months Ended
December 31,

 
 
  Fiscal Year Ended September 30,
   
 
 
  Fiscal Year Ended
December 31,
2003

 
 
  1999
  2000
  2001
  2002
  2001 (1)
  2002
 
Statement of Operations Data:                                            
Net revenue   $ 1,465,918   $ 1,640,933   $ 1,755,512   $ 1,753,058   $ 1,510,746   $ 444,842   $ 445,890  
Salaries, cost of care and other operating expenses     1,282,064     1,442,082     1,557,042     1,585,314     1,324,886     395,093     391,433  
Equity in earnings of unconsolidated subsidiaries     (20,442 )   (9,792 )   (36,566 )   (13,006 )   (6,202 )   (3,177 )   (2,138 )
Depreciation and amortization     62,408     68,261     68,294     47,558     48,047     11,190     14,380  
Interest expense (Contractual interest of $106,328 in fiscal 2003)     104,156     106,711     110,423     97,596     61,016     23,719     25,333  
Interest income     (10,404 )   (9,425 )   (10,121 )   (5,365 )   (2,873 )   (1,310 )   (1,010 )
Reorganization benefit, net                     (438,217 )        
Goodwill impairment charges                 415,880     28,780          
Managed care integration costs     6,238                          
Special charges     4,441     25,398     3,340     15,729     9,528     4,485     3,907  
Income (loss) from continuing operations before income taxes and minority interest     37,457     17,698     63,100     (390,648 )   485,781     14,842     13,985  
Income tax provision (benefit)     21,674     8,994     33,732     151,609     33,813     6,086     3,129  
Income (loss) from continuing operations before minority interest     15,783     8,704     29,368     (542,257 )   451,968     8,756     10,856  
Minority interest     630     114     78     47     253     16     27  
Income (loss) from continuing operations     15,153     8,590     29,290     (542,304 )   451,715     8,740     10,829  
Income (loss) from discontinued operations (2)     36,958     (56,736 )   4,624     4,894     (25,028 )   158     803  
Income (loss) on disposal of discontinued operations (2)     (47,423 )   (17,662 )   (9,359 )   (92 )   4,756     820     97  
Reorganization benefit, net (2) (See Note 3)                     20,327          
Income (loss) before cumulative effect of change in accounting principle     4,688     (65,808 )   24,555     (537,502 )   451,770     9,718     11,729  
Cumulative effect of change in accounting principle (2)                 (191,561 )       (191,561 )    
Net income (loss)     4,688     (65,808 )   24,555     (729,063 )   451,770     (181,843 )   11,729  
Preferred dividends (Contractual dividends of $4,788 in fiscal 2003)         3,401     4,527     4,657     883     1,075     1,243  
Amortization of redeemable preferred stock issuance costs, and other         401     522     540     172     143     136  
Preferred stock reorganization items, net (2)                     2,668          
Income (loss) available to common stockholders   $ 4,688   $ (69,610 ) $ 19,506   $ (734,260 ) $ 448,047   $ (183,061 ) $ 10,350  
Income (loss) per common share available to common stockholders — basic:                                            
Income (loss) from continuing operations before extraordinary items   $ 0.48   $ 0.15   $ 0.72   $ (15.71 ) $ 12.69   $ 0.22   $ 0.27  
Income (loss) from discontinued operations     (0.33 )   (2.32 )   (0.14 )   0.14         0.03     0.02  
Cumulative effect of change in accounting principle                 (5.50 )       (5.53 )    
Net income (loss)   $ 0.15   $ (2.17 ) $ 0.58   $ (21.07 ) $ 12.69   $ (5.28 ) $ .029  
Income (loss) per common share available to common stockholders — diluted:                                            
Income (loss) from continuing operations before extraordinary items   $ 0.48   $ 0.15   $ 0.69   $ (15.71 ) $ 10.86   $ 0.21   $ 0.26  
Income (loss) from discontinued operations     (0.33 )   (2.30 )   (0.13 )   0.14         0.02     0.02  
Cumulative effect of change in accounting principle                 (5.50 )       (4.55 )    
Net income (loss)   $ 0.15   $ (2.15 ) $ 0.56   $ (21.07 ) $ 10.86   $ (4.32 ) $ 0.28  
 
 
Predecessor Company

 
Reorganized
Company

 
Predecessor Company

 
 
  September 30,
   
  December 31,
 
 
  December 31,
2003

 
 
  1999
  2000
  2001
  2002
  2001 (1)
  2002
 
Balance Sheet Data:                                            
Current assets   $ 374,927   $ 325,532   $ 274,011   $ 283,730   $ 630,223   $ 293,276   $ 286,131  
Current liabilities     474,268     475,758     430,285     1,494,412     523,531     425,182     1,477,999  
Property and equipment, net     120,667     112,612     94,322     86,773     122,082     90,369     85,659  
Total assets     1,881,615     1,809,666     1,666,705     1,004,080     1,292,017     1,667,730     998,917  
Total debt and capital lease obligations     1,144,308     1,098,047     1,006,356     1,049,354     493,699     1,005,369     1,048,158  
Stockholders' equity (deficit)   $ 196,696   $ 128,464   $ 162,188   $ (570,672 ) $ 387,911   $ 170,729   $ (560,322 )

(1)
Amounts are unaudited.
(2)
Net of income taxes.

39



Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

        This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are set forth under the heading "Cautionary Statements" in Item 1 and elsewhere in this Form 10-K. When used in this Form 10-K, the words "estimate", "anticipate", "expect", "believe", "should" and similar expressions are intended to be forward-looking statements.

Business Overview

        Magellan, directly and through its subsidiaries (collectively, the "Company") coordinates and manages the delivery of behavioral healthcare treatment services that are provided through its contracted network of third-party treatment providers, which includes psychiatrists, psychologists, other behavioral health professionals, psychiatric hospitals, residential treatment centers and other treatment facilities. See "Business—Provider Network" for further discussion of the Company's managed behavioral healthcare network. The treatment services provided through the Company's provider network include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and crisis intervention services. The Company, however, generally does not directly provide, or own any provider of, treatment services. The Company provides its management services primarily through: (i) risk-based products, where the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) administrative services only ("ASO") products, where the Company provides services such as utilization review, claims administration and/or provider network management but does not assume responsibility for the cost of the treatment services, (iii) employee assistance programs ("EAPs") and (iv) products which combine features of some or all of the Company's risk-based, ASO or EAP products. At December 31, 2003, the Company managed the behavioral healthcare benefits of approximately 58.6 million individuals.

        Within the managed behavioral healthcare business, the Company operates in the following four segments, based on the services it provides and/or the customers that it serves: (i) Magellan Health Plan Solutions ("Health Plan Solutions"); (ii) Magellan Employer Solutions ("Employer Solutions"); (iii) Magellan Public Sector Solutions ("Public Sector Solutions") and (iv) Corporate and Other.

        Health Plan Solutions.    The Company's Health Plan Solutions segment generally reflects managed behavioral healthcare services provided under contracts with managed care companies, health insurers and other health plans. This segment's contracts encompass both risk-based and ASO contracts. Although certain health plans provide their own managed behavioral healthcare services, many health plans "carve out" behavioral healthcare from their general healthcare services and subcontract such services to managed behavioral healthcare companies such as the Company. In the Health Plan Solutions segment, the Company's members are the beneficiaries of the health plan (the employees and dependents of the customer of the health plan), for which the behavioral healthcare services have been carved out to the Company. During the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, the Company derived approximately $315.6 million, $250.3 million and $193.6 million, respectively, of consolidated net revenue from its contracts with Aetna, Inc. ("Aetna"). The Company recognized net revenues from Aetna of $78.8 million and $54.8 million during the three months ended December 31, 2001 and 2002, respectively. The declines in Aetna revenue of

40



approximately $56.7 million in fiscal 2003 compared to fiscal 2002, approximately $65.3 million in fiscal 2002 compared to fiscal 2001, and of approximately $24.0 million for the three months ended December 31, 2002 as compared to the three months ended December 31, 2001, were mainly due to decreased membership as a result of Aetna intentionally reducing its membership levels in an effort to exit less profitable businesses.

        As described in "Business—Emergence from Chapter 11," as part of the consummation of the Plan, Aetna and Magellan have renewed their contract, under which the Company will continue to manage the behavioral health care of Aetna's members through December 31, 2005, with an option for Aetna to either extend the agreement at that time or to purchase the assets used in the operation of the Aetna contract.

        The Company manages the mental health and substance abuse services for certain of the beneficiaries of TRICARE, formerly the Civilian Health and Medical Program of the Uniformed Services (CHAMPUS), under a subcontract with a health plan that contracts with TRICARE. The Company recognized net revenues from this subcontract of $61.5 million, $48.0 million, and $47.3 million in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and $12.7 million and $14.0 million during the three months ended December 31, 2001 and 2002, respectively. This subcontract expires on September 30, 2004 and will not be renewed. The Company previously had a second subcontract with another health plan that contracted with TRICARE. This second subcontract expired on April 30, 2003. The Company recognized net revenues from the second TRICARE subcontract of $39.3 million, $31.2 million and $9.9 million for the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and $8.3 million and $8.9 million during the three months ended December 31, 2001 and 2002, respectively.

        The Company receives fixed fees under its TRICARE subcontract, which are subject to certain bid-price adjustments (BPAs). The BPAs are calculated in accordance with contractual provisions and actual healthcare utilization from the data collection period, as defined. The BPAs are recorded when measurable, based upon information available from both the TRICARE program and the Company's information systems.

        Employer Solutions.    The Company's Employer Solutions segment (formerly "Workplace") generally reflects the provision of EAP services, managed behavioral healthcare services and integrated products under contracts with employers, including corporations and governmental agencies, and labor unions. This segment's managed behavioral healthcare services are primarily ASO products.

        Public Sector Solutions.    The Company's Public Sector Solutions segment generally reflects managed behavioral healthcare services provided to Medicaid recipients under contracts with state and local governmental agencies. This segment's contracts encompass both risk-based and ASO contracts. The Company provides managed behavioral healthcare services to the State of Tennessee's TennCare program, both through a direct contract held by the Company's wholly owned subsidiary Tennessee Behavioral Health, Inc. ("TBH"), and through a contract held by Premier Behavioral Systems of Tennessee, LLC ("Premier"), a joint venture in which the Company owns a 50.0 percent interest. In addition, the Company contracts with Premier to provide certain services to the joint venture. Through fiscal 2003, the Predecessor Company accounted for its investment in Premier using the equity method. Effective December 31, 2003, the Reorganized Company early adopted the Financial Accounting Standards Board's ("FASB") Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51 ("FIN 46"), under which the Reorganized Company has consolidated the balance sheet of Premier in its consolidated balance sheet as of December 31, 2003. Beginning in fiscal 2004, the Reorganized Company will consolidate the results of operations of Premier, including revenue and cost of care of the joint venture, in its consolidated statement of operations. See further discussion of FIN 46 in "Management's Discussion and Analysis of Financial Condition and Results of Operations—Recent Accounting Pronouncements".

41



        The Company's direct TennCare contract (exclusive of Premier's contract with TennCare) accounted for approximately $248.9 million, $237.5 million and $157.3 million of consolidated net revenue in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and approximately $60.0 million (unaudited) and $63.0 million of consolidated net revenue for the three months ended December 31, 2001 and 2002, respectively. Such revenue amounts include revenue recognized by the Company associated with services performed on behalf of Premier totaling $102.0 million, $134.9 million and $39.8 million for fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and $33.6 million (unaudited) and $34.6 million for the three months ended December 31, 2001 and 2002, respectively. The decline in revenue associated with the TennCare program was primarily the result of the reduction in revenue associated with services no longer performed on behalf of Premier due to a program change, which reduction was partially offset by increases in rates.

        In September 2003, the State of Tennessee issued a request for proposal ("RFP") relating to the TennCare program under which the program will be divided into three regions. The Company, through TBH, submitted a proposal for the East region only and was awarded the contract. The new contract with respect to the East region will become effective July 1, 2004. When contract negotiations between the State and the vendor that had been awarded the contracts for the Middle and West regions were discontinued, the State asked TBH and Premier to continue with their current contracts for those regions through December 31, 2004. The East region contract has an initial term that runs through December 31, 2005, and includes a provision for extensions at the State's option through December 31, 2008.

        The Company's Public Sector Solutions segment derives a significant portion of its revenue from contracts with various counties in the state of Pennsylvania (the "Pennsylvania Counties"). Although these are separate contracts with individual counties, they all pertain to the Pennsylvania Medicaid program. Revenues from the Pennsylvania Counties in the aggregate totaled approximately $121.1 million, $181.9 million and $189.6 million in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and approximately $36.0 million and $56.2 million for the three months ended December 31, 2001 and 2002, respectively. The Company's contract with one of the counties was terminated as December 31, 2003. Revenue related to this particular county totaled approximately $19.6 million, $22.8 million and $24.0 million in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and approximately $5.1 million and $6.4 million for the three months ended December 31, 2001 and 2002, respectively.

        Risk contracts in the Public Sector Solutions segment generally have higher per member premiums, cost and (to some degree) more volatility than risk contracts in either the Health Plan Solutions and Employer Solutions segments due to the nature of populations, benefits provided and other matters. See "Cautionary Statements—Dependence on Government Spending for Managed Healthcare", "—Possible Impact of Healthcare Reform" and "—Regulation".

        Corporate and Other.    This segment of the Company is comprised primarily of operational support functions such as claims administration, network services, sales and marketing and information technology, as well as corporate support functions such as executive, finance and legal. Discontinued operations activity is not included in the Corporate and Other segment operating results.

Fiscal Year Change

        In May 2003, the Company's board of directors approved a change in the Company's fiscal year. Instead of a fiscal year ending on September 30, the Company has adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. On August 12, 2003, the Company filed with the Securities and Exchange Commission ("SEC") a Transition Report on Form 10-K for the three-month period ended December 31, 2002. Throughout this Report on Form 10-K, references to the Company's

42



historical financial information for fiscal years prior to December 31, 2002 will refer to the Company's former fiscal year end of September 30. For example, fiscal years 2001 and 2002 correspond to the twelve-month periods ending September 30, 2001 and 2002, respectively. References to fiscal 2003 relate to the Company's fiscal year ending December 31, 2003.

Emergence from Chapter 11

        On January 5, 2004 (the "Effective Date"), Magellan and 88 of its subsidiaries consummated their Third Joint Amended Plan of Reorganization, as modified and confirmed (the "Plan"), under chapter 11 of title 11 of the United States Bankruptcy Code (the "Bankruptcy Code"), which had been confirmed by order of the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") on October 8, 2003, and accordingly the Plan became fully effective and the companies emerged from the protection of their chapter 11 proceedings. Magellan and these subsidiaries had filed voluntary petitions for relief under the Bankruptcy Code in the Bankruptcy Court on March 11, 2003.

        The following is a summary of the transactions which became effective on the Effective Date pursuant to or in connection with the consummation of the Plan. The distributions to which the Company's former creditors and shareholders became entitled under the Plan were made by the Company on the Effective Date or were disbursed in accordance with the Plan soon thereafter, except for certain immaterial distributions that were subsequently made or will be made in the future as provided for by the Plan upon certain conditions being satisfied. This summary only highlights certain of the substantive provisions of the Plan and the documents implementing the Plan and is qualified in its entirety by reference to (i) the full text of the Plan, a copy of which was filed as Exhibit 2(a) to Magellan's Quarterly Report on Form 10-Q filed with the SEC on August 19, 2003, as first supplemented by the modification filed as Exhibit 99.2 to Magellan's Current Report on Form 8-K filed with the SEC on September 30, 2003 and further supplemented by the modification filed as Exhibit 2.3 to Magellan's Current Report on Form 8-K filed with the SEC on October 9, 2003 and as to be implemented pursuant to the confirmation order, a copy of which was filed as Exhibit 2.4 to Magellan's Current Report on Form 8-K filed with the SEC on October 9, 2003, and (ii) the implementing documents, which are referred to below in this summary, filed as Exhibits 2.2 – 2.15 to Magellan's Current Report on Form 8-K filed with the SEC on January 6, 2004, and as amended in certain instances by Magellan's Current Reports on Form 8-K and Form 8-K/A filed with the SEC on January 7, 2004.

        Giving effect to the Plan, Magellan and its subsidiaries continued, in their previous organizational form, to conduct their business as previously conducted, with the same assets in all material respects (except for cash to be distributed under the Plan to former creditors of the Company), but the Company was recapitalized. Specifically, the Company's secured bank loans, as existing before the Effective Date, were paid in full, and other then existing indebtedness (i.e., two classes of notes and general unsecured creditor claims) and the then existing equity interests in Magellan were cancelled as of the Effective Date in exchange for the distributions provided for by the Plan, as further described below, all as of the Effective Date.

        On the Effective Date, the Company entered into a credit agreement with Deutsche Bank, as lender and administrative agent, and other lenders providing for a $100.0 million term loan, an $80.0 million letter of credit facility and a $50.0 million revolving credit facility (collectively, the "Credit Agreement"). The interest rate on term loan and revolving credit borrowings will fluctuate and will be at a rate equal to the higher of (i) the prime rate established by Deutsche Bank or (ii) one-half of one percent in excess of the overnight "federal funds" rate, as from time to time in effect, plus in either case two and one-half percent per year, subject to the Company's election to have interest calculated based on the "Eurodollar rate" offered by Deutsche Bank plus three and one-half percent per year. The interest rate on letter of credit-related borrowings will be fixed at 3.5 percent. However, in each

43



case the interest rate could be reduced upon achievement of certain conditions. Borrowings under the Credit Agreement will mature on August 15, 2008 and certain quarterly principal payments on the term loan are also required. The Credit Agreement is guaranteed by substantially all of the subsidiaries of Magellan and is secured by substantially all of the assets of Magellan and the subsidiary guarantors. The proceeds of the term loan, together with other existing funds, were used on the Effective Date to repay in full in accordance with the Plan the Company's senior secured bank indebtedness under its previous credit agreement (the "Old Credit Agreement") of approximately $161 million, to make other cash payments contemplated by the Plan, to pay fees and expenses related to the chapter 11 cases, and for general working capital purposes. In addition, the letter of credit facility has been utilized to back letters of credit outstanding on the Effective Date and to provide additional letters of credit when needed for the Company's business. For a further discussion of the Credit Agreement, see Note 7—"Long-Term Debt and Capital Lease Obligations" to the audited consolidated financial statements set forth elsewhere herein.

        As of the Effective Date, in satisfaction of the $250 million of principal owed on the 9.375% senior notes due 2007 (the "Old Senior Notes") and all accrued and unpaid interest thereon, the Company issued to the holders of such notes approximately $233.5 million in original principal amount of Series A notes of a new issue of senior notes due November 15, 2008 (the "Series A Notes", together with the Series B Notes (see below), the "Senior Notes") and made a cash payment of approximately $46.1 million. The terms of the Senior Notes are substantially similar to those of the Old Senior Notes, except that they mature on November 15, 2008. For a further discussion of the Senior Notes, see Note 7—"Long-Term Debt and Capital Lease Obligations" to the audited consolidated financial statements set forth elsewhere herein.

        Under the Plan, holders of the Company's previous 9% Senior Subordinated Notes due 2008 in the principal amount of $625.0 million (the "Old Subordinated Notes") and holders of general unsecured creditor claims (other than claims on the Old Senior Notes and Old Subordinated Notes) ("Other GUCs") were to receive in the aggregate approximately 97 percent of the Ordinary Common Stock (or approximately 22.3 million shares) of the reorganized Company (before giving effect to the Cash-Out Elections discussed below). The actual number of shares allocated between these two classes of creditors, as well as the number of shares allocated to each individual creditor in such creditor classes, is dependent upon the final, total aggregate value of claims for the two creditor classes, as discussed further below.

        As of the Effective Date, the Company estimated that the holders of the Old Subordinated Notes would receive in satisfaction of their claims (including all accrued and unpaid interest), approximately 20.5 million shares of Ordinary Common Stock of Magellan (before giving effect to the Cash-Out Elections discussed below). Accordingly, the Company distributed, as of the Effective Date, approximately 32.83 shares per $1,000 of principal amount of such notes (although no fractional shares or cash in lieu thereof were issued or paid). The share distribution amount is subject to adjustments as set forth below.

        As of the Effective Date, the Company estimated that total claims of Other GUCs, would be approximately $78 million (including unresolved disputed claims). Under the Plan, and based upon this total estimated claim value, such creditor class was estimated to receive in satisfaction of their claims (including any unpaid interest accrued thereon) the following consideration for each $1,000 of claim value: (i) $50.34 in cash, (ii) $254.99 of Series B of the Senior Notes ("Series B Notes"), and (iii) 22.41 shares of Ordinary Common Stock (although no fractional shares or cash in lieu thereof were or will be issued or paid), for an aggregate of 1.8 million shares (before giving effect to the Cash-Out Elections discussed below). As of March 4, 2004, the Company has issued approximately $5.1 million of Series B Notes for the settled claims of Other GUCs. The Series B Notes portions of certain other claims of Other GUCs were settled for cash, based upon claim settlement terms between

44



the Company and such individual general unsecured creditors. The Ordinary Common Stock share distribution amount is subject to adjustment as set forth below.

        The Company currently estimates that the total claim value for Other GUCs will ultimately be resolved for approximately $55.0 million, of which $50.5 million has been settled as of March 4, 2004. If the claims of Other GUCs are ultimately resolved for the Company's current estimate of $55.0 million, the Other GUCs would receive additional consideration of approximately 0.53 shares of Ordinary Common Stock per $1,000 of claim value (although no fractional shares or cash in lieu thereof will be issued or paid) and the holders of claims on the Old Subordinated Notes would receive an additional 0.77 shares of Ordinary Common Stock per $1,000 of principal amount of such notes (although no fractional shares or cash in lieu thereof will be issued or paid).

        Also on the Effective Date, the previously outstanding shares of Common Stock and Preferred Stock of Magellan were cancelled, three new classes of capital stock were authorized and Magellan's certificate of incorporation and bylaws were amended and restated. Specifically, 100 million shares of Ordinary Common Stock, $0.01 par value per share ("Ordinary Common Stock"), and 40 million shares of Multiple and Variable Vote Restricted Convertible Common Stock, $0.01 par value per share ("Multi-Vote Common Stock") were authorized, as were 10 million shares of Preferred Stock, $0.01 par value per share, that are issuable at the discretion of the Board of Directors in the manner provided by law in one or more series with such powers, privileges and rights as may be determined by the Board (except that no non-voting shares shall be issued). No shares of Preferred Stock were issued or are to be issued under the Plan. Shares of the Multi-Vote Common Stock may only be issued to, and held by, Onex Corporation, a Canadian corporation, or an affiliate thereof (collectively, "Onex"). As described below, Onex, in connection with the Plan, invested in the equity of Magellan in the form of shares of Multi-Vote Common Stock. Upon transfer of any shares of Multi-Vote Common Stock to any party other than Onex, the shares of Multi-Vote Common Stock will automatically convert on a share-for-share basis into shares of Ordinary Common Stock. In addition, any shares of Ordinary Common Stock that Onex may come to own at any time when the Multi-Vote Common Stock is outstanding will automatically convert into shares of Multi-Vote Common Stock.

        In general, the Multi-Vote Common Stock and Ordinary Common Stock have the same powers, privileges and rights, and each share represents an equivalent interest in Magellan's equity, except that the shares of Multi-Vote Common Stock will have the number of votes per share from time to time sufficient so that all the outstanding shares of Multi-Vote Common Stock will have an equal number of votes as all the outstanding shares of Ordinary Common Stock (i.e., the Multi-Vote Common Stock will be entitled to exercise 50 percent of the voting power of all the common stock of Magellan). The Multi-Vote Common Stock and Ordinary Common Stock also differ in that each class has different voting rights in the election of directors and certain other voting rights and other special rights and privileges. The Multi-Vote Common Stock will cease to have any special voting rights or any other special rights or powers in the event the outstanding shares of Multi-Vote Common Stock cease to represent at least 15.33 percent of the total number of shares of common stock (both Ordinary Common Stock and Multi-Vote Common Stock) issued on the Effective Date (approximately 35.1 million shares) or at least 10 percent of the total number of shares of common stock outstanding at any time the (the "Minimum Hold Condition"). For further information regarding the voting rights of the Ordinary Common Stock and the Multi-Vote Common Stock, see Item 10—"Directors and Executive Officers of the Registrant—Director Election and Terms of Office".

        As part of the Plan, Magellan offered to holders of its Old Subordinated Notes, its general unsecured creditors and one holder of an administrative claim the opportunity to purchase, on the effective date of the Plan, shares of common stock equivalent to 6,052,632 shares of Ordinary Common Stock for a total purchase price of $75 million ($12.39 per share). The Company also received as part of the Plan a commitment from Onex to purchase on the same terms any shares not purchased in the

45



Equity Offering by the creditors to whom such shares were offered. Pursuant to the equity offering included in the Plan, creditors purchased 5,111,019 shares and Onex purchased 941,613 shares.

        Onex also purchased, pursuant to an additional commitment under the Plan, 6,052,632 shares of common stock for a total purchase price of $75 million (the "Onex Investment"), or $12.39 per share. In addition, Onex committed, under the Plan, to fund an offer made by Magellan pursuant to the Plan to holders of its Old Subordinated Notes and to the Company's other general unsecured creditors permitting them to elect to receive $9.78 in cash per share in lieu of the shares of Ordinary Common Stock they would otherwise receive under the Plan (the "Cash-Out Election"). Onex committed to fund the Cash-Out Election by purchasing that amount of shares of Multi-Vote Common Stock at $9.78 per share equal to the amount of shares of Ordinary Common Stock cashed out pursuant to the Cash-Out Election. As of the Effective Date, Onex purchased 1,421,335 shares pursuant to this commitment. Also pursuant to this commitment, Onex committed to purchase, subsequent to the Effective Date, up to an additional 137,120 shares pursuant to this commitment as a result of the settlement of claims that had elected the Cash-Out Election but were disputed and unresolved at the Effective Date. Onex has purchased and will purchase 8,552,700 shares in the aggregate (in the Equity Offering, pursuant to the Onex Investment and to fund the Cash-Out Election), all of which are shares of Multi-Vote Common Stock. These shares represented approximately 24.2 percent of the shares of common stock outstanding on the Effective Date and 21.2 percent of the common stock on a fully diluted basis as of the Effective Date. As stated above, the allocation of stock among creditors will change based on the value of all claims as ultimately resolved. If all claims are ultimately resolved for the amount of the Company's current estimate, 36,592 additional shares would be allocated to claims that had elected the Cash-Out Election, which would result in Onex acquiring an additional 36,592 shares at $9.78 per share (for a total of 8,589,282 shares).

        The previously outstanding Series A Redeemable Preferred Stock of Magellan was cancelled on the Effective Date and the holders thereof were issued 456,660 shares of Ordinary Common Stock, representing approximately 1.3 percent of the common stock of Magellan as of the Effective Date on a fully diluted basis (giving effect to all shares outstanding or subject to options or warrants outstanding as of the Effective Date), as well as warrants to purchase until January 5, 2011 for $30.46 per share, 456,660 shares of Ordinary Common Stock. The previously outstanding common stock of Magellan also was cancelled on the Effective Date and the holders thereof received 114,165 shares of Ordinary Common Stock, representing approximately 0.3 percent of the common stock of Magellan on the Effective Date on a fully diluted basis (calculated on the same basis as described above), as well as warrants to purchase at any time until January 5, 2011 for $30.46 per share, 114,165 shares of Ordinary Common Stock, which equals approximately one share of Ordinary Common Stock and a warrant to purchase one share of Ordinary Common Stock for every 310 shares of the previously outstanding common stock. For further information regarding the warrants issued under the Plan, see Note 8—"Stockholders' Equity" to the audited consolidated financial statements set forth elsewhere herein. Pursuant to the Plan, on the Effective Date all previously outstanding options and warrants to purchase common stock of Magellan were cancelled.

        As part of the consummation of the Plan, an agreement became effective between Aetna, Inc. ("Aetna") and the Company to renew their behavioral health services contract. Under the renewed agreement, the Company will continue to manage the behavioral health care of members of Aetna's healthcare programs through December 31, 2005, with an option for Aetna at that time to either extend the agreement or to purchase certain assets of the Company used solely in the management of the behavioral healthcare of Aetna members (the "Aetna-Dedicated Assets"). Pursuant to the Plan, on the Effective Date, the Company paid $15.0 million to Aetna, out of a debt obligation allowed under the Plan of $60.0 million plus accrued interest, and issued to Aetna an interest-bearing note (the "Aetna Note") for the balance of $48.9 million, which will mature on December 31, 2005. The Aetna Note is guaranteed by substantially all of the subsidiaries of Magellan and is secured by a second lien

46



on substantially all of the assets of Magellan and the subsidiary guarantors. Additionally, if the behavioral health services contract is extended by Aetna at its option through at least December 31, 2006, one-half of the Aetna Note would be payable on December 31, 2005, and the remainder would be payable on December 31, 2006. If Aetna opts to purchase the Aetna-Dedicated Assets, the purchase price could be offset against any amounts owing under the Aetna Note. In addition, pursuant to the Plan, the Company issued to Aetna a warrant to purchase 230,000 shares of Ordinary Common Stock from January 1, 2006 to January 5, 2009 at a purchase price of $10.48 per share. For further information regarding the Company's agreement with Aetna, the Aetna Note and the warrant issued to Aetna under the Plan, see Note 7—"Long-Term Debt and Capital Lease Obligations" and Note 8—"Stockholders' Equity" to the audited consolidated financial statements set forth elsewhere herein.

        On the Effective Date, Magellan's Board of Directors was reconstituted to consist of nine members, as specified in accordance with the Plan. Information on the members of the Magellan Board of Directors is disclosed in Part III herein.

        The Company's senior executive officers before the Effective Date (Steven J. Shulman, Dr. Rene Lerer and Mark S. Demilio) entered into employment agreements with Magellan as of the Effective Date in a form provided by the Plan and providing for them to continue in their current positions. In general, the Company's other senior officers continued in Magellan's employ in substantially the same positions after the Effective Date and entered into employment agreements with Magellan in a form provided by the Plan. A Management Incentive Plan became effective on the Effective Date in accordance with the Plan, under which restricted stock awards, stock options and other equity incentives may be issued to members of the Company's management and other employees. The Company's employment agreements with its senior executive officers provided for the purchase by Mr. Shulman of certain shares of Ordinary Common Stock and for the grant to each such officer pursuant to the Management Incentive Plan of certain restricted shares of Ordinary Common Stock, all as of the Effective Date, and for certain cash payments to such officers related to the income taxes incurred by them in connection with such transactions. Options for a total of 4.3 million shares of Ordinary Common Stock were issued under the Management Incentive Plan in January and February 2004. Information on the Company's executive officers, their compensation and the Management Incentive Plan, as well as information regarding such grants under the employment agreements and Management Incentive Plan, is disclosed in Part III herein. See Note 8—"Stockholders' Equity" to the audited consolidated financial statements set forth elsewhere herein for a discussion of charges to be recorded by the Company related to stock grants, stock options and cash payments pursuant to the employment agreements and stock options under the Management Incentive Plan. Such charges, which total $58.4 million, will be recorded in future periods corresponding to the vesting or life of the options.

        Before the Effective Date, the common stock of the Company was registered pursuant to Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). On the Effective Date, the Ordinary Common Stock of Magellan, as issued in accordance with the Plan, was deemed registered under Section 12(g) of the Exchange Act as a successor issue, and Magellan as reorganized was deemed a successor issuer, in relation to the previously registered common stock in accordance with SEC Rule 12g-3(a). In addition, the warrants issued to former common and preferred stockholders as referred to above became registered under Section 12(g) of the Exchange Act pursuant to a registration statement on Form 8-A. The Ordinary Common Stock of the Company, including shares that may be issued upon conversion of shares of Multi-Vote Common Stock and upon exercise of the warrants and options referred to above, became listed on the Nasdaq Stock Market under the ticker symbol "MGLN" on January 6, 2004. On the Effective Date, in accordance with the Plan, Magellan also entered into a Registration Rights Agreement with Onex and Aetna, providing them rights with respect to the registration of their shares for public sale under the Securities Act of 1933, as amended, in certain circumstances.

47


Critical Accounting Policies and Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The Company considers the following to be its critical accounting policies and estimates:

        Fresh Start Reporting.    In connection with the consummation of the Plan, the Company adopted the "fresh start reporting" provisions of AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), with respect to its financial reports, which requires the Company to restate its assets and liabilities to their fair values based upon the provisions of the Plan and certain valuations which the Company will make in connection with the implementation of the Plan. The Company is required to apply the fresh-start provisions of SOP 90-7 to its financial statements, because it has concluded that (a) the reorganization value of the assets of the emerging entity immediately before the date of confirmation was less than the total of all post-petition liabilities and allowed claims, and (b) the holders of existing voting shares of the Company immediately before confirmation (i.e., the holders of shares of Magellan's pre-petition common stock that were issued and outstanding prior to the commencement of the chapter 11 proceedings) received less than 50 percent of the voting shares of the emerging entity. SOP 90-7 sets forth the principles regarding the date at which a company that has emerged from a chapter 11 proceeding should apply fresh start reporting to account for the effects of the plan of reorganization. Under SOP 90-7, application of fresh start reporting is permitted as early as the date on which the plan of reorganization is confirmed by the bankruptcy court, but SOP 90-7 further provides that fresh start reporting should not be applied until all material conditions are satisfied. All material conditions to the Plan were satisfied as of December 29, 2003 (the "Material Conditions Date"). Due to the proximity of the Material Conditions Date to year end and the immateriality of the results of operations for the intervening two-day period through December 31, 2003, the Company applied fresh start reporting as if the material conditions were satisfied as of December 31, 2003. All adjustments and reorganization expenses as a result of the application of fresh start reporting are reflected in the audited consolidated financial statements as of and for the year ended December 31, 2003 included elsewhere herein. See Note 2—"Fresh Start Reporting" to the audited consolidated financial statements set forth elsewhere herein for adjustments recorded by the Company pursuant to the application of SOP 90-7.

        Upon adoption of fresh start reporting as of December 31, 2003, the Company created, in substance, per SOP 90-7, a new reporting entity. The Reorganized Company has adopted the same accounting policies as the Predecessor Company with the exception of the date on which the Reorganized Company intends to perform its annual goodwill impairment test under SFAS No. 142. The Reorganized Company will perform its annual impairment test on October 1, as opposed to September 1.

        As a result of the application of the fresh start reporting provision of SOP 90-7, the consolidated balance sheets of the Company prior to December 31, 2003 are not comparable with the consolidated balance sheet as of December 31, 2003. Therefore, all balance sheet data as of December 31, 2003 have been disclosed herein as balances of the Reorganized Company, and all balance sheet data prior to December 31, 2003 have been disclosed as balances of the Predecessor Company. Statement of operations and statement of cash flows data for all periods presented herein represents the results of the Predecessor Company. Accordingly, all references to the Company with respect to disclosures of amounts recorded (i) through or prior to December 31, 2003 in relation to income statement or cash flow items; and (ii) prior to December 31, 2003 in relation to balance sheet items, relate to the Predecessor Company. All references to the Company with respect to disclosures of amounts recorded or to be recorded (i) after December 31, 2003 in relation to income statement or cash flow items; and

48



(ii) on or after December 31, 2003 in relation to balance sheet items, relate to the Reorganized Company.

        Managed Care Revenue.    Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members. Managed care risk revenues earned for the fiscal years ended September 30, 2001 and 2002 and December 31, 2003 approximated $1,540.7 million, $1,537.9 million and $1,292.5 million, respectively. Managed care risk revenues for the three months ended December 31, 2001 and 2002 were approximately $390.3 million (unaudited) and $388.7 million, respectively.

        The Company has the ability to earn performance-based revenue, primarily under certain non-risk contracts. Performance-based revenue generally is based on the ability of the Company to manage care for its ASO clients below specified targets. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue is recognized on an interim basis pursuant to the rights and obligations of each party upon termination of the contracts. The Company recognized performance revenue of approximately $22.7 million, $13.0 million and $7.7 million in the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively. For the three months ended December 31, 2001 and 2002, the Company recognized performance-based revenue of approximately $3.4 million (unaudited) and $1.0 million, respectively.

        The Company provides mental health and substance abuse services to the beneficiaries of TRICARE, under a subcontract with a health plan that contracts with TRICARE. See discussion of this subcontract in "Health Plan Solutions" above. The Company receives fixed fees under its TRICARE subcontract, which are subject to certain BPAs. The BPAs are calculated in accordance with contractual provisions and are based on actual healthcare utilization from historical periods as well as changes in certain factors during the contract period. The Company has information to record, on a quarterly basis, for reasonable estimates of the BPAs as part of its managed care risk revenues. These estimates are based upon information available, on a quarterly basis, from both the TRICARE program and the Company's information systems. Under the contract, the Company settles the BPAs at set intervals over the term of the contracts.

        The Company recorded estimated receivables of approximately $3.6 million and $2.5 million as of December 31, 2002 and 2003, respectively, based upon the Company's interim calculations of the estimated BPAs. Such amounts were recorded as adjustments to revenues. While management believes that the estimated TRICARE adjustments are adequate, ultimate settlement resulting from adjustments and available appeal processes may vary from the amounts provided.

        Prior to fiscal 2001, the Company and its contractors under its TRICARE contracts filed joint appeals regarding incorrect data provided and contractual issues related to the initial bidding process. These contingent claims were settled in fiscal 2001, resulting in the Company recording approximately $30.3 million in additional revenues in fiscal 2001.

        Cost of Care and Medical Claims Payable.    Cost of care, recorded as a component of operating expenses, is recognized in the period in which members receive behavioral health services. In addition to actual benefits paid, cost of care includes the impact of accruals for estimates of medical claims payable. Medical claims payable in the Company's audited consolidated financial statements represent the liability for healthcare claims reported but not yet paid and claims incurred but not yet reported ("IBNR") related to the Company's managed healthcare business. The IBNR portion of medical claims payable is estimated based on past claims payment experience for member groups, enrollment data, utilization statistics, authorized healthcare services and other factors. This data is incorporated into contract-specific actuarial reserve models. The estimates for submitted claims and IBNR claims are made on an accrual basis and adjusted in future periods as required. However, changes in assumptions for medical costs caused by changes in actual experience (such as changes in the delivery system,

49



changes in utilization patterns, unforeseen fluctuations in claims backlogs, etc.) may ultimately prove these estimates inaccurate. As of December 31, 2003, the Company believes that its medical claims payable balance of $177.1 million is adequate in order to satisfy ultimate claim liabilities incurred through December 31, 2003. Medical claims payable balances are continually monitored and reviewed. Changes in assumptions for cost of care caused by changes in actual experience could cause the estimates to change in the near term.

        Long-lived Assets.    Long-lived assets, including property and equipment and intangible assets to be held and used, are currently reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be addressed pursuant to SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144") which superseded SFAS No. 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Disposed Of" ("SFAS 121"). Pursuant to this guidance, impairment is determined by comparing the carrying value of these long-lived assets to management's best estimate of the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The cash flow projections used to make this assessment are consistent with the cash flow projections that management uses internally to assist in making key decisions. In the event an impairment exists, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the asset, which is generally determined by using quoted market prices or the discounted present value of expected future cash flows.

        Goodwill.    Goodwill is accounted for in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142, goodwill is no longer amortized over its estimated useful life. Instead, goodwill is tested for impairment based upon fair values at least on an annual basis. In accordance with SFAS 142, the book value of goodwill is assigned to the Company's reporting units. See Note 3—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein.

        Deferred Taxes.    The Company files a consolidated federal income tax return for the Company and its wholly owned consolidated subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect of a change in tax rates on deferred taxes is recognized in income in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on the Company's assessment of the realizability of such amounts.

        The Company notes that for federal income tax purposes, the cancellation of indebtedness event takes place on the date of the Company's emergence from bankruptcy (January 5, 2004) and the actual attribute reduction calculation as set forth under Internal Revenue Code Section 108 occurs at or immediately after December 31, 2004 (the taxable year of discharge), and generally after determining the income tax liability for 2004. The Company plans to change its income tax reporting year to a calendar year basis in conformity with its financial reporting year effective December 31, 2003. For financial reporting purposes, the emergence from bankruptcy is deemed to occur in 2003; however, since the Company did not emerge from bankruptcy until January 5, 2004, for federal income tax purposes, the emergence from bankruptcy is a 2004 event.

        After consideration of the effect of bankruptcy emergence, including the effect of cancellation of indebtedness income and the related attribute reduction effects as provided under Internal Revenue Code Section 108, as of December 31, 2003, the Company has estimated tax net operating loss ("NOL") carryforwards of approximately $507.3 million available to reduce future federal taxable income. These estimated NOL carryforwards expire in 2006 through 2019.

        Valuation allowances on deferred tax assets are estimated based on the Company's assessment of the realizability of such amounts. As discussed in "Business—Emergence from Bankruptcy", the

50



Company's history of recent operating losses (prior to reorganization benefits) and financial restructuring activities have created uncertainty as to the Company's ability to realize its NOL carryforwards and other deferred tax assets. In addition, the Company's utilization of NOL carryforwards will be subject to limitation under Internal Revenue Code Section 382 upon emergence from bankruptcy, which may affect the timing of the use of, or ultimate realization of, NOL carryforwards. Accordingly, as of December 31, 2003 and 2002, the Company has a total valuation allowance covering all of the Company's net deferred tax assets.

        The Company recognized current tax expense attributable to estimated, current taxable income for the three months ended December 31, 2002 and for the year ended December 31, 2003. This expense was recorded due to the estimated utilization of NOL carryforwards generated prior to a previous bankruptcy filing in 1992 and prior to the occurrence of certain other events that may cause limitation on its NOL carryforwards. The Company's current tax expense in fiscal 2003 also includes changes in estimates regarding the Company's utilization of the above-referenced NOL carryforwards due to amendments of prior year tax returns.

Results of Operations

        The Company's significant accounting policies are discussed in Note 3—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein.

        The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation, amortization, interest (net), goodwill impairment charges, special charges, income taxes and minority interest ("Segment Profit"). See Note 16—"Business Segment Information" to the Company's audited consolidated financial statements set forth elsewhere herein. The Company's behavioral customer segments are defined below. In certain limited cases, customer contracts that would otherwise meet the definition of one segment are managed and reported internally in another segment, in which cases the membership and financial results of such contracts are reflected in the segment in which it is reported internally. In fiscal 2003, the internal reporting of certain of these contracts was transferred between segments. Accordingly, the Company has reclassified the membership and financial results of such contracts for all periods into the corresponding segments consistent with its internal reporting. This restatement did not affect consolidated membership or financial results for any period presented. In fiscal 2003, management also changed the name of its "Workplace" segment to the "Employer Solutions" segment. All periods presented were adjusted to conform with the fiscal 2003 restatement. For comparative purposes, the Company has presented results of operations below for the twelve-month period ended December 31, 2002, which information is unaudited.

51


        The table below summarizes, for the periods indicated, operating results and other financial information, by business segment (in thousands). Given the Company's change in year-end during fiscal year 2003, the Company believes the period comparisons below present the most useful comparison for readers:

 
  Predecessor Company
 
 
  Health
Plan
Solutions

  Employer
Solutions

  Public
Sector
Solutions

  Corporate
and
Other

  Consolidated
 
Fiscal Year Ended September 30, 2001                                
Net revenue   $ 1,079,549   $ 189,625   $ 486,338   $   $ 1,755,512  
Cost of care     621,817     64,649     410,982         1,097,448  
Direct service costs     179,836     73,363     38,225         291,424  
Other operating expenses                 168,170     168,170  
Equity in (earnings) loss of unconsolidated subsidiaries     (39,103 )       2,537         (36,566 )
   
 
 
 
 
 
Segment profit (loss)   $ 316,999   $ 51,613   $ 34,594   $ (168,170 ) $ 235,036  
   
 
 
 
 
 

Fiscal Year Ended September 30, 2002

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Net revenue   $ 1,013,033   $ 188,703   $ 551,322   $   $ 1,753,058  
Cost of care     596,811     72,446     456,497         1,125,754  
Direct service costs     174,926     76,752     41,423         293,101  
Other operating expenses                 166,459     166,459  
Equity in (earnings) loss of unconsolidated subsidiaries     (15,537 )       2,531         (13,006 )
   
 
 
 
 
 
Segment profit (loss)   $ 256,833   $ 39,505   $ 50,871   $ (166,459 ) $ 180,750  
   
 
 
 
 
 

Twelve Months Ended December 31, 2002 (unaudited) (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Net revenue   $ 988,465   $ 189,533   $ 576,108   $   $ 1,754,106  
Cost of care     581,882     72,352     477,559         1,131,793  
Direct service costs     164,024     75,692     42,149         281,865  
Other operating expenses                 167,996     167,996  
Equity in (earnings) loss of unconsolidated subsidiaries     (13,699 )       1,732         (11,967 )
   
 
 
 
 
 
Segment profit (loss)   $ 256,258   $ 41,489   $ 54,668   $ (167,996 ) $ 184,419  
   
 
 
 
 
 

Fiscal Year Ended December 31, 2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Net revenue   $ 870,540   $ 159,034   $ 481,172   $   $ 1,510,746  
Cost of care     464,128     44,858     397,498         906,484  
Direct service costs     130,731     68,135     28,759         227,625  
Other operating expenses                 190,777     190,777  
Equity in (earnings) loss of unconsolidated subsidiaries     (6,560 )       358         (6,202 )
   
 
 
 
 
 
Segment profit (loss)   $ 282,241   $ 46,041   $ 54,557   $ (190,777 ) $ 192,062  
   
 
 
 
 
 

(1)
The results of operations for the twelve months ended December 31, 2002 represent the amalgamation of the results of operations for the nine-month period ended September 30, 2002 (unaudited) and the three-month period ended December 31, 2002 (audited) previously reported in the Company's Form 10-Q for the quarterly period ended September 30, 2003 filed with the SEC on November 19, 2003 and the Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002 filed with the SEC on August 12, 2003, respectively.

52


        The following table reconciles segment profit as calculated in the table above to consolidated net income (loss):

 
  Predecessor Company
 
 
  Fiscal Year Ended
September 30,

  Twelve Months Ended
December 31,

  Fiscal Year Ended
December 31,

 
 
  2001
  2002
  2002 (1)
  2003
 
 
   
   
  (unaudited)

   
 
Segment profit   $ 235,036   $ 180,750   $ 184,419   $ 192,062  
Depreciation and amortization     (68,294 )   (47,558 )   (50,748 )   (48,047 )
Interest expense     (110,423 )   (97,596 )   (99,210 )   (61,016 )
Interest income     10,121     5,365     5,065     2,873  
Reorganization benefit                 438,217  
Special charges     (3,340 )   (15,729 )   (15,151 )   (9,528 )
Goodwill impairment charges         (415,880 )   (415,880 )   (28,780 )
   
 
 
 
 
Income (loss) from continuing operations before provision for income taxes and minority interest     63,100     (390,648 )   (391,505 )   485,781  
Provision for income taxes     33,732     151,609     148,652     33,813  
   
 
 
 
 
Income (loss) from continuing operations before minority interest     29,368     (542,257 )   (540,157 )   451,968  
Minority interest     78     47     58     253  
   
 
 
 
 
Income (loss) from continuing operations     29,290     (542,304 )   (540,215 )   451,715  
Discontinued operations:                          
  Income (loss) from discontinued operations (2)     4,624     4,894     5,539     (25,028 )
  Income (loss) on disposal of discontinued operations (2)     (9,359 )   (92 )   (815 )   4,756  
  Reorganization benefit (2)                 20,327  
   
 
 
 
 
      (4,735 )   4,802     4,724     55  
   
 
 
 
 
Income (loss) before cumulative effect of change in accounting principle     24,555     (537,502 )   (535,491 )   451,770  
Cumulative effect of change in accounting principle (2)         (191,561 )        
   
 
 
 
 
Net income (loss)   $ 24,555   $ (729,063 ) $ (535,491 ) $ 451,770  
   
 
 
 
 

(1)
The results of operations for the twelve months ended December 31, 2002 represent the amalgamation of the results of operations for the nine-month period ended September 30, 2002 (unaudited) and the three-month period ended December 31, 2002 (audited) previously reported in the Company's Form 10-Q for the quarterly period ended September 30, 2003 filed with the SEC on November 19, 2003 and the Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002 filed with the SEC on August 12, 2003, respectively. The following two tables reconcile the results of operations for the twelve months ended December 31, 2002 to the amounts reported in the Company's previous filings, as noted above (in thousands).

(2)
Net of related income taxes.

53


 
  Predecessor Company
 
 
  Health
Plan
Solutions

  Employer
Solutions

  Public
Sector
Solutions

  Corporate
and
Other

  Consolidated
 
Net Revenue                                
Nine months ended September 30, 2002 (unaudited)   $ 742,884   $ 142,833   $ 422,499   $   $ 1,308,216  
Three months ended December 31, 2002     245,581     46,700     153,609         445,890  
   
 
 
 
 
 
Twelve Months ended December 31, 2002 (unaudited)   $ 988,465   $ 189,533   $ 576,108   $   $ 1,754,106  
   
 
 
 
 
 

Cost of Care

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Nine months ended September 30, 2002 (unaudited)   $ 444,381   $ 54,984   $ 350,718   $   $ 850,083  
Three months ended December 31, 2002     137,501     17,368     126,841         281,710  
   
 
 
 
 
 
Twelve Months ended December 31, 2002 (unaudited)   $ 581,882   $ 72,352   $ 477,559   $   $ 1,131,793  
   
 
 
 
 
 

Direct Service Costs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Nine months ended September 30, 2002 (unaudited)   $ 127,790   $ 57,385   $ 31,226   $   $ 216,401  
Three months ended December 31, 2002     36,234     18,307     10,923         65,464  
   
 
 
 
 
 
Twelve Months ended December 31, 2002 (unaudited)   $ 164,024   $ 75,692   $ 42,149   $   $ 281,865  
   
 
 
 
 
 

Other Operating Expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Nine months ended September 30, 2002 (unaudited)   $   $   $   $ 123,737   $ 123,737  
Three months ended December 31, 2002                 44,259     44,259  
   
 
 
 
 
 
Twelve Months ended December 31, 2002 (unaudited)   $   $   $   $ 167,996   $ 167,996  
   
 
 
 
 
 

Equity in Unconsolidated Subsidiaries

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Nine months ended September 30, 2002 (unaudited)   $ (11,706 ) $   $ 1,877   $   $ (9,829 )
Three months ended December 31, 2002     (1,993 )       (145 )       (2,138 )
   
 
 
 
 
 
Twelve Months ended December 31, 2002 (unaudited)   $ (13,699 ) $   $ 1,732   $   $ (11,967 )
   
 
 
 
 
 

Segment Profit (Loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Nine months ended September 30, 2002 (unaudited)   $ 182,419   $ 30,464   $ 38,678   $ (123,737 ) $ 127,824  
Three months ended December 31, 2002     73,839     11,025     15,990     (44,259 )   56,595  
   
 
 
 
 
 
Twelve Months ended December 31, 2002 (unaudited)   $ 256,258   $ 41,489   $ 54,668   $ (167,996 ) $ 184,419  
   
 
 
 
 
 

54


 
  Predecessor Company
 

 

 

Nine Months Ended
September 30,
2002


 

Three Months Ended
December 31,
2002


 

Twelve Months Ended
December 31,
2002


 
 
  (unaudited)

   
  (unaudited)

 
Depreciation and amortization   $ 36,368   $ 14,380   $ 50,748  
Interest expense     73,877     25,333     99,210  
Interest income     (4,055 )   (1,010 )   (5,065 )
Special charges     11,244     3,907     15,151  
Goodwill impairment charges     415,880         415,880  
Provision for income taxes     145,523     3,129     148,652  
Minority interest     31     27     58  
Income from discontinued operations, net     4,736     803     5,539  
Income (loss) on disposal of discontinued operations, net     (912 )   97     (815 )

Fiscal year ended December 31, 2003 ("Current Year"), compared to the twelve months ended December 31, 2002 (unaudited) ("Prior Year")

Health Plan Solutions

        Net Revenue.    Net revenue related to the Health Plan Solutions segment decreased by 11.9 percent or $118.0 million to $870.5 million for the Current Year from $988.5 million for the Prior Year. The decrease in revenue is mainly due to terminated contracts of $109.2 million, a reduction in revenue under the Company's contract with Aetna (primarily due to decreased membership) of $30.2 million, contract changes (mainly risk to non-risk) of $23.3 million, and lower performance revenue of $2.7 million (see below), which decreases were partially offset by net increased membership from existing and new customers (excluding Aetna) of $24.6 million (mainly related to non-risk membership), net increases in rates of $17.8 million, and other net increases of $5.0 million.

        Performance-based revenues for the Health Plan Solutions segment were $9.3 million and $6.6 million for the Prior Year and Current Year, respectively. The decrease is primarily due to the Prior Year including performance revenue for a contract that no longer has performance revenue terms.

        Cost of Care.    Cost of care decreased by 20.2 percent or $117.8 million to $464.1 million for the Current Year from $581.9 million for the Prior Year. The decrease in cost of care is primarily due to terminated contracts of $77.9 million, net contract changes (mainly risk to non-risk) of $24.0 million, favorable prior year medical claims development recorded during fiscal 2003 of $11.4 million (which has a year over year impact of $22.8 million), a reduction in care under the Company's contract with Aetna (mainly due to decreased risk membership) of $15.2 million, and net favorable settlements of $6.7 million related to claims paid by clients, which decreases were partially offset by net increased membership from existing and new customers of $8.2 million and estimated higher costs due to care trends and other net changes of $20.6 million. Excluding the impact in the Current Year of favorable Prior Year care development, cost of care decreased as a percentage of risk revenue from 70.8 percent in the Prior Year to 69.9 percent in the Current Year, mainly due to changes in business mix.

        Direct Service Costs.    Direct service costs decreased by 20.3 percent or $33.3 million to $130.7 million for the Current Year from $164.0 million for the Prior Year. The decrease in direct service costs is primarily due to cost reduction efforts undertaken by the Company including the shutdown of several regional service centers, as well as lower costs required to support the decrease in net membership in the Health Plan Solutions segment. Direct service costs decreased as a percentage of revenue from 16.6 percent for the Prior Year to 15.0 percent for the Current Year. The decrease in

55



the percentage of direct service costs in relationship to revenue is mainly due to the aforementioned cost reduction efforts undertaken by the Company and rate increases since the Prior Year.

        Equity in (Earnings) Loss of Unconsolidated Subsidiaries.    Equity in (earnings) loss of unconsolidated subsidiaries decreased 51.8 percent or $7.1 million to $(6.6) million for the Current Year from $(13.7) million for the Prior Year. The decrease primarily relates to the Company's withdrawal from the Choice partnership as of the end of October 2002, with equity in (earnings) of Choice totaling $(9.0) million for the Prior Year. Partially offsetting this reduction is an increase of $1.9 million in equity in (earnings) related to the Royal Health Care, LLC joint venture (in which the Company has a 36.3 percent ownership interest).

Employer Solutions

        Net Revenue.    Net revenue related to the Employer Solutions segment decreased by 16.1 percent or $30.5 million to $159.0 million for the Current Year from $189.5 million for the Prior Year. The decrease in revenue is mainly due to terminated contracts of $23.6 million, net decreased membership from existing customers of $8.3 million, and contract changes (mainly risk to non-risk) of $3.0 million, which decreases were partially offset by other net changes of $4.4 million.

        Cost of Care.    Cost of care decreased by 38.0 percent or $27.5 million to $44.9 million for the Current Year from $72.4 million for the Prior Year. The decrease in cost of care is mainly due to terminated contracts of $16.4 million, net contract changes (mainly risk to non-risk) of $3.1 million, favorable care trends and other net changes of $6.3 million, and costs associated with net membership reduction of $1.7 million. The favorable care trends are partially due to the closure of several staff offices which had higher per cost visits than that incurred by utilizing the Company's contracted network of outpatient providers. Cost of care decreased as a percentage of risk revenue from 40.2 percent in the Prior Year to 29.9 percent in the Current Year, mainly due to favorable care trends experienced in the Current Year and changes in business mix.

        Direct Service Costs.    Direct service costs decreased by 10.0 percent or $7.6 million to $68.1 million for the Current Year from $75.7 million for the Prior Year. The decrease in direct service costs is mainly due to lower costs required to support the decrease in net membership in the Employer Solutions segment. As a percentage of revenue, direct service costs increased from 39.9 percent for the Prior Year to 42.8 percent for the Current Year. The increase in the percentage of direct service costs in relationship to revenue is mainly due to the reduction in revenue due to terminated contracts and decreased membership from existing customers (as described above), for which the direct service costs are not reduced proportionally, or such reductions are accomplished on a delayed basis.

Public Sector Solutions

        Net Revenue.    Net revenue related to the Public Sector Solutions segment decreased by 16.5 percent or $94.9 million to $481.2 million for the Current Year from $576.1 million for the Prior Year. The decrease in revenue is mainly due to a net reduction in revenue with respect to the TennCare program of $83.3 million, primarily as a result of a program change (as described above), a contract change with respect to the Pennsylvania Counties of $42.9 million and terminated contracts of $4.9 million, which decreases were partially offset by net increased membership from other existing customers of $30.4 million, net rate increases (other than from TennCare) of $4.9 million and other net increases of $0.9 million.

        Cost of Care.    Cost of care decreased by 16.8 percent or $80.1 million to $397.5 million for the Current Year from $477.6 million for the Prior Year. The decrease in cost of care is mainly due to a net reduction in cost of care with respect to the TennCare program of $79.5 million, primarily as a result of a program change (as described above), and a contract change with respect to the Pennsylvania Counties of $31.6 million, which decreases were partially offset by net increased

56



membership from other existing customers of $24.3 million and higher costs due to care trends (other than with respect to TennCare) and other net changes of approximately $6.7 million. Cost of care as a percentage of risk revenue was relatively consistent for both periods at 86.6 percent in the Prior Year and 86.3 percent in the Current Year.

        Direct Service Costs.    Direct service costs decreased by 31.6 percent or $13.3 million to $28.8 million for the Current Year from $42.1 million for the Prior Year. The decrease in direct service costs is primarily due to cost reduction efforts undertaken by the Company and a contract change with respect to the Pennsylvania Counties contracts, partially offset by higher costs required to support the increase in net membership in the Public Sector Solutions segment. As a percentage of revenue, direct service costs decreased from 7.3 percent for the Prior Year to 6.0 percent for the Current Year.

        Equity in (Earnings) Loss of Unconsolidated Subsidiaries.    Equity in loss of unconsolidated subsidiaries decreased $(1.3) million to $0.4 million for the Current Year from $1.7 million for the Prior Year. The investment in unconsolidated subsidiary relates to Premier. The year-to-date improvement is primarily due to increased risk share revenue, favorable runout of prior period IBNR and favorable rate changes, which changes were partially offset by decreased membership.

Corporate and Other

        Other Operating Expenses.    Other operating costs related to the Corporate and Other Segment increased by 13.6 percent or $22.8 million to $190.8 million for the Current Year from $168.0 million for the Prior Year. The increase is mainly due to higher discretionary employee benefit costs of $21.5 million (the Prior Year included a change in estimate to reduce certain discretionary employee benefit cost accruals of $2.0 million), insurance premiums of $7.5 million with respect to coverage after the Company's emergence from bankruptcy for acts occurring prior to emergence, and the inclusion in the Prior Year of the favorable impact of changes in estimates of the reserves previously recorded for employee health benefits, self-insurance and litigation totaling approximately $3.5 million. Such increases in other operating expenses were partially offset by the Company's cost reduction efforts undertaken in the Current Year. As a percentage of total net revenue, other operating expenses increased from 9.6 percent for the Prior Year to 12.6 percent for the Current Year due to the lower revenue in the Current Year (as described above) and the increase in other operating expenses.

        Depreciation and Amortization.    Depreciation and amortization decreased by 5.3 percent or $2.7 million to $48.0 million for the Current Year from $50.7 million for the Prior Year. The decrease is primarily due to a reduction in depreciation expense mainly related to certain capitalized software assets that became fully depreciated at March 31, 2003, partially offset by an increase in amortization expense related to an adjustment of the remaining useful lives of certain intangible assets as of October 1, 2002.

        Interest Expense.    Interest expense decreased by 38.5 percent or $38.2 million to $61.0 million for the Current Year from $99.2 million for the Prior Year. The decrease is mainly due to the fact that the Company did not accrue interest after March 11, 2003 of approximately $45.3 million for the Old Subordinated Notes as a result of the chapter 11 filing, in accordance with SOP 90-7. Such decrease was partially offset by increased interest expense incurred under the Old Credit Agreement of approximately $2.9 million, mainly related to higher borrowing levels on the Company's Old Revolving Facility and higher overall interest rates charged for all loans under the Old Credit Agreement, $3.9 million related to the Aetna Note and other net increases of $0.3 million.

        Other Items.    The Company recorded a net reorganization benefit from continuing operations of approximately $438.2 million during the Current Year. This amount is mainly composed of a $479.7 million net fresh start reorganization gain, partially offset by the write-off of deferred financing costs and professional fees and expenses associated with the Company's financial restructuring process and chapter 11 proceedings. For further discussion, see Note 3—"Summary of Significant Accounting

57



Policies—Financial Reporting Under the Bankruptcy Code" to the audited consolidated financial statements set forth elsewhere herein.

        The Company recorded special charges of $9.5 million and $15.2 million in the Current Year and the Prior Year, respectively. The special charges primarily relate to restructuring plans that have resulted in the elimination of certain positions and the closure of certain offices, partially offset by income recorded to special charges related to the collection of a previously reserved note receivable. The charges related to restructuring plans primarily consist of employee severance and termination benefits, lease termination costs and consulting fees. See Note 12—"Special Charges" to the audited consolidated financial statements set forth elsewhere herein for further discussion.

        The Company recorded goodwill impairment charges of $28.8 million and $415.9 million in the Current Year and the Prior Year, respectively. The Current Year charge represents impairments to the Employer Solutions and Public Sector Solutions reporting units, based on the comparison between the carrying value and the fair market value of the segments, as estimated by an independent appraisal firm. The Current Year write-down was attributable to the Company's financial performance and its business outlook as of September 1, 2003 (the annual measurement date), and resulted in the complete write-down of goodwill related to the Employer Solutions and Public Sector Solutions reporting units. In the Prior Year, the Company recorded an impairment charge to write-down the balance of goodwill related to the Health Plan Solutions, Employer Solutions and Public Sector Solutions reporting units to estimated fair value, based on independently appraised values. The Prior Year write-down occurred due to changes in the Company's financial performance and its business outlook from the beginning of the year through September 1, 2002, which decreased the estimated fair value of the Company's reporting units.

        Income Taxes.    The Company's effective income tax rate was 7.0 percent for the Current Year as compared to (38.8) percent for the Prior Year. The Current Year effective rate varies substantially from federal statutory rates because the Company's effective rate is based only on current expense due to full valuation allowances against net deferred tax assets and the estimated utilization of net operating loss ("NOL") carryforwards generated prior to a previous bankruptcy filing in 1992 and prior to the occurrence of certain other events which may cause limitations on its NOL carryforwards. In addition, the Company notes that its Current Year taxable income is affected by the non-taxable impact of the fresh start reporting gain and non-deductible goodwill included in the Current Year goodwill impairment charge. Under SOP 90-7, the deferred tax benefit related to the realization of the pre-1992 bankruptcy NOL carryforwards is not reflected in the consolidated statements of operations. The income tax provision in the Current Year also considers certain changes in estimates regarding the Company's anticipated utilization of pre-1992 bankruptcy NOL carryforwards due to amendments of prior year tax returns.

        The Prior Year effective rate varies substantially from federal statutory rates primarily due to the impact of non-deductible goodwill included in the prior year goodwill impairment charge and a valuation allowance adjustment to reduce the Company's deferred tax asset balance to zero due to the uncertainty as to the Company's ability to realize its net operating loss carryforwards and other deferred tax assets.

        Discontinued Operations.    The following table summarizes, for the periods indicated, income (loss) from discontinued operations, net of tax (in thousands):

 
  2002
  2003
 
Healthcare provider and franchising segments   $ 5,341   $ (24,482 )
Specialty managed healthcare segment     198     (546 )
   
 
 
    $ 5,539   $ (25,028 )
   
 
 

58


        The loss for the Current Year in the healthcare provider and franchising segments is primarily the result of the settlement of a significant claim, which resulted in an adjustment to discontinued operations legal expense of $24.0 million, for which there was no tax effect. Income from the healthcare provider and franchising segments for the Prior Year includes a reduction of estimates of reserves pertaining to the former psychiatric hospital facilities of $4.3 million (before taxes) and the positive settlement of outstanding Medicare and Medicaid cost reports of $4.3 million (before taxes), partially offset by the cost of collections, legal fees and other costs.

        The loss for the Current Year in the specialty managed healthcare segment is a result of an increase in estimates of certain reserves for the segment. Income from the specialty managed healthcare segment for the Prior Year is a result of a change in estimate of certain lease reserves of $0.3 million (before taxes) related to the settlement of a lease obligation. See Note 5—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        The following table summarizes, for the periods indicated, the income (loss) on disposal of discontinued operations, net of tax (in thousands):

 
  2002
  2003
Healthcare provider and franchising segments   $ 47   $ 2,751
Specialty managed healthcare segment     (1,642 )   1,953
Human services segment     780     52
   
 
    $ (815 ) $ 4,756
   
 

        The Current Year income on disposal in the healthcare provider and franchising segments is attributable to changes in estimates of previously recorded liabilities related to the disposal of the segment. Additionally, the Current Year income on disposal includes gains on the sale of a hospital facility of $0.7 million (before taxes) and cash received as a final distribution associated with a discontinued provider joint venture of $0.8 million (before taxes).

        The Current Year income on disposal in the specialty managed healthcare segment is primarily the result of cash received as a partial payment on a note receivable held by the Company that the Company had fully reserved in fiscal 2001, resulting in a gain of $1.3 million (before taxes), and a favorable change in estimated lease reserves of $0.5 million (before taxes). Loss on disposal in the specialty managed healthcare segment in the Prior Year is primarily the result of an increase in lease reserves of approximately $(2.3) million (before taxes) to reflect changes in estimates, which loss is offset by $0.7 million (before taxes) in cash received as partial payment on a note receivable held by the Company that the Company had fully reserved in fiscal 2001.

        The Prior Year income on disposal in the human services segment is the result of a change in estimate of self-insurance and other reserves.

        The following table summarizes, for the periods indicated, the net reorganization benefit included in discontinued operations (in thousands):

 
  2002
  2003
Healthcare provider and franchising segments   $   $ 15,268
Specialty managed healthcare segment         5,059
   
 
    $   $ 20,327
   
 

        Included in the net reorganization benefit is $15.4 million representing the net fresh start reorganization gain. In addition, as part of its financial restructuring plan and chapter 11 proceedings, the Company has rejected certain leases for closed offices. To the extent that the estimated cost to the

59



Company as a result of rejecting such leases was different than the liability previously recorded, such difference has been recorded as reorganization (expense) benefit in accordance with SOP 90-7.

Fiscal 2002 compared to fiscal 2001

Health Plan Solutions

        Net Revenue.    Net revenue related to the Health Plan Solutions segment decreased by 6.2 percent or $66.5 million to $1,013.0 million in fiscal 2002 from $1,079.5 million in fiscal 2001. During fiscal 2001, the Company settled certain contract appeals related to two subcontracts with respect to TRICARE that resulted in additional revenues of $30.3 million. The decrease in revenue is mainly due to TRICARE settlements of $30.3 million, the decrease in revenue under the Company's contract with Aetna (mainly due to decreased membership) of $65.2 million, terminated contracts in fiscal 2001 and fiscal 2002 of $38.7 million, contract changes (mainly risk to non-risk) of $16.1 million, decreased performance-based revenue of $7.6 million (see below) and the effect of the fiscal 2001 sale of Group Practice Affiliates, Inc. ("GPA"), a staff model physician practice, of $2.2 million, which decreases were partially offset by net increases in rates of $41.4 million, net increased membership from existing customers (excluding Aetna) of $38.4 million, new business of $11.0 million and other net changes.

        The Company earns performance-based fees as part of certain of its health plan contracts. Performance-based revenues are recorded when earned and estimable. Performance-based revenues for the Health Plan Solutions segment were $19.9 million and $12.3 million in fiscal 2001 and 2002, respectively. The decrease is primarily due to the inclusion in fiscal 2001 of positive changes in estimates regarding fiscal 2000 amounts and other positive contractual developments in fiscal 2001 under certain arrangements for which no contract periods had been settled in fiscal 2000.

        Cost of Care.    Cost of care decreased by 4.0 percent or $25.0 million to $596.8 million in fiscal 2002 from $621.8 million in fiscal 2001. The decrease in cost of care is primarily due to decreased membership from Aetna of $46.6 million, terminated contracts in fiscal 2001 and fiscal 2002 of $24.1 million, net contract changes (mainly risk to non-risk) of $16.1 million and unfavorable prior fiscal year medical claims development during fiscal 2001 of $15.0 million, which decreases were partially offset by higher care trends over the prior year of $31.6 million, net increased membership from existing customers (excluding Aetna) of $22.7 million, unfavorable prior fiscal year medical claims development during fiscal 2002 of $8.6 million (which entirely relates to fiscal 2001), new business of $5.2 million and other net changes. Cost of care increased as a percentage of risk revenue to 71.8 percent in fiscal 2002 from 69.4 percent in fiscal 2001, mainly due to higher care trends experienced in fiscal 2002 and the inclusion of revenue from the TRICARE settlement in fiscal 2001, partially offset by rate and other revenue increases in fiscal 2002.

        Direct Service Costs.    Direct service costs decreased by 2.7 percent or $4.9 million to $174.9 million in fiscal 2002 from $179.8 million in fiscal 2001. As a percentage of revenue, direct service costs increased to 17.3 percent for fiscal 2002 from 16.7 percent for fiscal 2001. The decrease in direct service costs is primarily due to the sale of GPA and cost reduction efforts undertaken by the Company including the shutdown of several regional service centers. The increase in the percentage of direct service costs in relationship to revenue is mainly due to the inclusion of revenue from the TRICARE settlement in fiscal 2001, partially offset by rate and other revenue increases in fiscal 2002.

        Equity in Earnings of Unconsolidated Subsidiaries.    Equity in earnings of unconsolidated subsidiaries decreased by 60.3 percent or $23.6 million to $15.5 million in fiscal 2002 from $39.1 million in fiscal 2001. During fiscal 2001, the Company recorded $22.6 million of earnings in connection with the settlement of certain appeals related to the Choice partnership's subcontract with respect to TRICARE. These settlements increased the Company's fiscal 2001 income from continuing operations and net income by approximately $13.5 million. The decrease in equity in earnings is primarily due to the fiscal 2001 TRICARE settlement, lower revenue from Choice due to decreased rates in the current

60



option year and higher care trends for Choice of approximately $1.7 million, partially offset by a favorable $0.7 million retroactive adjustment recorded in fiscal 2002 associated with a change in the operating agreement for Royal.

Employer Solutions

        Net Revenue.    Net revenue related to the Employer Solutions segment decreased by 0.5 percent or $0.9 million to $188.7 million in fiscal 2002 from $189.6 million in fiscal 2001. The decrease in revenue is mainly due to terminated contracts in fiscal 2001 and fiscal 2002 of $10.4 million, the effect of the fiscal 2001 sale of the Company's Canadian operations, which contributed $3.3 million of revenue in fiscal 2001 and other net decreases of $1.8 million, which decreases were partially offset by net increased membership from existing customers of $10.5 million and new business of $4.1 million.

        Cost of Care.    Cost of care increased by 12.1 percent or $7.8 million to $72.4 million in fiscal 2002 from $64.6 million in fiscal 2001. The increase in cost of care is mainly due to higher care trends of $8.7 million, net increased membership from existing customers of $3.4 million and new business of $0.3 million, partially offset by terminated contracts of $4.0 million and the sale of the Company's Canadian operations of $0.6 million. As a percentage of risk revenue, cost of care increased to 40.3 percent for fiscal 2002 from 36.7 percent for fiscal 2001, mainly due to higher care trends experienced in fiscal 2002.

        Direct Service Costs.    Direct service costs increased by 4.6 percent or $3.4 million to $76.8 million in fiscal 2002 from $73.4 million in fiscal 2001. As a percentage of revenue, direct service costs increased to 40.7 percent for fiscal 2002 from 38.7 percent for fiscal 2001. The aforementioned changes are mainly due to a change in the mix of business to include more ASO and cost-plus contracts in fiscal 2002.

Public Sector Solutions

        Net Revenue.    Net revenue related to the Public Sector Solutions segment increased by 13.4 percent or $65.0 million to $551.3 million in fiscal 2002 from $486.3 million in fiscal 2001. The increase in revenue is mainly due to new business of $44.1 million and net rate increases of $28.5 million, partially offset by net decreased membership from existing customers of $7.6 million and terminated contracts of $1.2 million and other net changes.

        Cost of Care.    Cost of care increased by 11.1 percent or $45.5 million to $456.5 million in fiscal 2002 from $411.0 million in fiscal 2001. As a percentage of risk revenue, cost of care decreased to 86.6 percent for fiscal 2002 from 87.7 percent for fiscal 2001. The increase in cost of care is mainly due to new business of $35.0 million and higher care trends of $24.6 million, partially offset by net decreased membership from existing customers of $9.4 million, favorable prior fiscal year medical claims development during fiscal 2002 of $2.2 million (which entirely relates to fiscal 2001), terminated contracts of $0.2 million and other net changes.

        Direct Service Costs.    Direct service costs increased by 8.4 percent or $3.2 million to $41.4 million in fiscal 2002 from $38.2 million in fiscal 2001. The increase in direct service costs is primarily due to costs associated with new business. As a percentage of revenue, direct service costs decreased from 7.9 percent for fiscal 2001 to 7.5 percent for fiscal 2002. This change is primarily due to favorable rate changes, which increased revenue but had no effect on direct service costs.

        Equity in Loss of Unconsolidated Subsidiaries.    Equity in loss of unconsolidated subsidiaries was $(2.5) million for both fiscal 2002 and 2001. The Public Sector Solutions segment's investment in unconsolidated subsidiary relates to Premier, in which the Company maintains a 50.0 percent interest. Results for fiscal 2002 as compared to fiscal 2001 reflect higher care trends which were entirely offset by rate increases and the inclusion in fiscal 2001 of an expense of $3.1 million for certain legal actions.

61


Corporate and Other

        Other Operating Expenses.    Other operating costs related to the Corporate and Other Segment decreased by 1.0 percent or $1.7 million to $166.5 million in fiscal 2002 from $168.2 million in fiscal 2001. As a percentage of total revenue, other operating costs decreased to 9.5 percent for fiscal 2002 from 9.6 percent for fiscal 2001. The decrease in other operating expenses is mainly due to lower headcount in various corporate departments of $0.4 million, reduction in discretionary employee benefit costs of $1.3 million, changes in estimates for certain employee benefit related costs recorded in the prior fiscal year of $0.4 million and certain self insurance and legal reserves of approximately $4.0 million, partially offset by fees incurred in conjunction with migration of operating systems of $1.3 million and other net changes.

        Depreciation and Amortization.    Depreciation and amortization decreased by 30.3 percent or $20.7 million to $47.6 million in fiscal 2002 from $68.3 million in fiscal 2001. The decrease is primarily attributable to the implementation of SFAS 142 in fiscal 2002. Had the Company adopted SFAS 142 effective October 1, 2000, the Company would not have recorded approximately $30.2 million of amortization expense related to continuing operations during fiscal 2001. Partially offsetting this decrease is $5.7 million of increased depreciation expense related to revisions to the estimated useful lives of certain assets and increased depreciation expense associated with fixed asset additions in fiscal 2002. See Note 3—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein for further discussion of the impact of the adoption of SFAS 142.

        Interest, Net.    Net interest expense decreased by 8.1 percent or $8.1 million to $92.2 million for fiscal 2002 from $100.3 million in fiscal 2001. Fiscal year 2001 interest expense includes approximately $6.6 million to write-off deferred loan costs related to the issuance of the Old Senior Notes. The charge of $6.6 million was previously reported as an extraordinary loss on early extinguishment of debt, net of the tax benefit of $2.6 million. The fiscal 2001 write-off of the deferred loan costs was reclassified to interest expense due to the adoption of SFAS No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections" ("SFAS 145") in the fourth quarter of fiscal 2002. Fiscal year 2001 also benefited from $2.1 million of interest income received in conjunction with a retroactive pricing adjustment related to a customer contract. In fiscal 2002, the Company incurred approximately $1.9 million in penalty interest due to non-registration of the Old Senior Notes. Excluding the items above, net interest expense decreased by approximately $5.5 million from fiscal 2001. The decrease is primarily the result of lower average outstanding debt and lower average interest rates in fiscal 2002 versus fiscal 2001. The lower average outstanding debt is due to scheduled payments of principal on the Term Loans under the Old Credit Agreement as well as unscheduled payments under the Old Credit Agreement with the proceeds from the sale of the Company's human services segment in fiscal 2001.

        Other Items.    The Company recorded special charges of $3.3 million in fiscal 2001 related to the loss on the sale of the Company's Canadian subsidiary. The Company recorded special charges of $15.7 million in fiscal 2002 related to restructuring plans that have resulted in the elimination of certain positions and the closure of certain offices. These charges primarily consist of severance, lease and consulting fees. See Note 12—"Special Charges" to the audited consolidated financial statements set forth elsewhere herein for further discussion. During fiscal 2002, the Company recorded goodwill impairment charges of $415.9 million related to its annual impairment test of goodwill in accordance with SFAS 142. This impairment charge was a result of writing down the balance of goodwill related to the Health Plan Solutions, Employer Solutions and Public Sector Solutions reporting units to estimated fair value, based upon independently appraised values. For further discussion, see Note 3—"Summary of Significant Accounting Policies" to the Company's audited consolidated financial statements set forth elsewhere herein.

        Income Taxes.    The Company's financial restructuring activities and financial condition result in uncertainty as to the Company's ability to realize its net operating loss carryforwards and other

62



deferred tax assets. Accordingly, as of September 30, 2002, the Company recorded an increase to its valuation allowance of $200.5 million, resulting in a total valuation allowance covering all of the Company's net deferred tax assets. Excluding the impact of this valuation allowance adjustment, the Company's effective income tax rate was approximately (12.5) percent for fiscal 2002 as compared to 53.5 percent for fiscal 2001. The effective rate varies substantially from statutory rates due primarily to the impact of non-deductible goodwill included in the fiscal 2002 goodwill impairment charge, non-deductible goodwill amortization in fiscal 2001 and non-deductible intangible asset amortization resulting primarily from acquisitions.

        Discontinued Operations.    The following table summarizes, for the periods indicated, income (loss) from discontinued operations, net of tax (in thousands):

 
  2001
  2002
Healthcare provider and franchising segments   $ (287 ) $ 4,696
Specialty managed healthcare segment     3,160     198
Human services segment     1,751    
   
 
    $ 4,624   $ 4,894
   
 

        Income from the healthcare provider and franchising segments in fiscal 2002 includes a reduction of estimates of regulatory reserves pertaining to the former psychiatric hospitals of approximately $5.2 million, before taxes. Additionally, the Company recorded positive settlements of outstanding Medicare and Medicaid cost reports of $7.4 million in fiscal 2002, offset by the cost of collections, legal fees and other costs of exiting the business. Loss from the healthcare provider and franchising segments for fiscal 2001 is a result of the positive settlement of outstanding Medicare and Medicaid cost reports of $6.3 million and collection of certain receivables previously written off of $1.0 million, offset by the cost of collections, lease termination payments and other costs of exiting the business.

        Income from the specialty managed healthcare segment for fiscal 2001 represents the settlement of obligations for less than the amount previously estimated. See Note 5—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        Income from the human services segment of $1.8 million for fiscal 2001 is primarily the result of operating results prior to the sale of the segment in the second fiscal quarter of 2001. See Note 5—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. The following table summarizes, for the periods indicated, the income (loss) on disposal of discontinued operations, net of tax (in thousands):

 
  2001
  2002
 
Healthcare provider and franchising segments   $ 2,744   $ 867  
Specialty managed healthcare segment         (1,642 )
Human services segment     (12,103 )   683  
   
 
 
    $ (9,359 ) $ (92 )
   
 
 

        In fiscal 2002, the Company and its joint venture partner sold the operations and assets of the remaining provider joint venture ("Provider JV"), resulting in the Company receiving $3.5 million in cash and recording a pre-tax gain of approximately $1.3 million. In conjunction with the Charter Behavioral Health Systems, LLC ("CBHS") settlement consummated in fiscal 2001, the Company was released from certain liabilities and therefore determined that certain liabilities recorded as a result of certain transactions with CBHS during fiscal 1999 were no longer needed. The reversal of these liabilities, net of tax, was recorded during the third quarter of fiscal 2001, resulting in a change in estimate related to the loss on disposal of the healthcare provider and franchising segments of $2.7 million.

63



        The loss on disposal of the specialty managed healthcare segment in fiscal 2002 is primarily attributable to net changes in estimates of certain future lease obligations and other reserves of approximately $2.5 million.

        Income from disposal of the human services segment in fiscal 2002 represents changes in estimates regarding previously recorded liabilities related to the disposal of the segment. The Company recorded an estimated loss on disposal of the human service segment of approximately $12.1 million during fiscal 2001. This loss is comprised of an estimated pre-tax loss of $2.8 million and tax provision of $9.3 million. The tax provision is related to the tax gain on the sale which results from a lower tax basis, primarily due to approximately $26.1 million of goodwill that has no tax basis. See Note 5—"Discontinued Operations" to the Company's audited condensed consolidated financial statements set forth elsewhere herein.

        Cumulative Effect of Change in Accounting Principle.    As of October 1, 2001, the Company early adopted SFAS 142. The initial goodwill impairment charge of $207.8 million, before taxes ($191.6 million after taxes), was recorded as a cumulative effect of a change in accounting principle during such fiscal quarter. This impairment charge was a result of writing down the balance of goodwill related to the Employer Solutions reporting unit to estimated fair value as of October 1, 2001, based upon independently appraised values. For further discussion, see Note 3—"Summary of Significant Accounting Policies" to the Company's audited consolidated financial statements set forth elsewhere herein.

Outlook—Results of Operations

        The Company's Segment Profit and net income are subject to significant fluctuations on a quarterly basis. These fluctuations may result from: (i) changes in utilization levels by enrolled members of the Company's risk-based contracts, including seasonal utilization patterns; (ii) performance-based contractual adjustments to revenue, reflecting utilization results or other performance measures; (iii) contractual adjustments and settlements; (iv) retrospective membership adjustments; (v) timing of implementation of new contracts, enrollment changes and contract terminations; (vi) pricing adjustments upon contract renewals (and price competition in general) and (vii) changes in estimates regarding medical costs and incurred but not yet reported medical claims.

        A portion of the Company's business is subject to rising care costs due to an increase in the number and frequency of covered members seeking behavioral care services, and higher costs per inpatient day or outpatient visit. Many of these factors are beyond the Company's control. Future results of operations will be heavily dependent on management's ability to obtain customer rate increases that are consistent with care cost increases and/or to reduce operating expenses.

        The Company is a market leader in a mature market with many viable competitors. The Company is continuing its attempts to increase its market share in the managed behavioral healthcare industry through aggressive marketing and development of new products; however, due to the amount of competition, the Company believes that the probability of losing market share to these competitors may be greater than the probability of increasing market share. The Company anticipates a reduction in the fiscal year ending December 31, 2004 revenue compared to fiscal 2003 due to contracts that had been terminated effective in 2003 and contracts that have been terminated with an effective date in 2004, as well as potential additional contract terminations in 2004. Such terminations include the two subcontracts with respect to TRICARE discussed above, one of which expired as of April 30, 2003, and the other of which will expire on September 30, 2004. In addition, it is possible that the Company's customers that are managed care companies may, in the future, seek to provide managed behavioral healthcare services directly to their subscribers, rather than by contracting with the Company for such services.

        Stock Compensation.    Pursuant to employee agreements entered into as part of the Plan, on the Effective Date, the Company granted a total of 167,926 shares of Ordinary Common Stock to the

64


Company's Chief Executive Officer, Chief Operating Officer and Chief Financial Officer (the "Senior Executives"). Pursuant to his employment agreement, the Chief Executive Officer purchased 83,963 fully-vested shares of Ordinary Common Stock on the Effective Date. Under such agreements, the Company also granted an aggregate of 2,891,022 stock options to the Senior Executives on the Effective Date and made cash payments to the Senior Executives to approximate the tax liability associated with the compensation expense resulting from the stock grants, the stock purchase and the cash payments, as defined below. Also on the Effective Date, pursuant to the consummation of the Plan, a Management Incentive Plan became effective under which 1,376,400 stock options were awarded to other members of the Company's management and other employees. All of these awards were contingent upon the Company's emergence from its chapter 11 proceedings, relate to underlying common stock that was not authorized until the Effective Date and relate to services to be performed by the employees subsequent to the Effective Date.

        Beginning in the first quarter of fiscal 2004, the Company will recognize the following charges related to stock compensation:

        The Company estimates that the total amount of such charges will be $58.4 million, before taxes. Based upon a seven year vesting schedule for the two Senior Executive tranches, as discussed above, the Company estimates that it will recognize approximately $18.7 million, $10.6 million, $10.6 million $7.4 million and $11.1 million of such charges in fiscal years 2004, 2005, 2006, 2007 and 2008 and beyond, respectively. However, certain of these charges may be accelerated depending on the market price performance of the Ordinary Common Stock, as discussed above.

        Interest Rate Risk.    Changes in interest rates affect interest income earned on the Company's cash equivalents and restricted cash and investments, as well as interest expense on variable interest rate borrowings under the Credit Agreement. Based on the borrowing levels under the Credit Agreement as of the Effective Date, a hypothetical 10 percent increase in the interest rate, with all other variables held constant, would not materially affect the Company's future earnings and cash outflows.

        Operating Restructuring Activities.    In April 2003, the Company implemented a new business and performance initiative, named Performance Improvement Plan ("PIP"). PIP is focused on further consolidating service centers, creating more efficiencies in corporate overhead, consolidating systems, improving call center technology and instituting other operational and business efficiencies while

65



maintaining or improving service to customers. During the fiscal year ended December 31, 2003, PIP resulted in the recognition of special charges of (a) $7.5 million to terminate 463 employees that represented both operational and corporate personnel, and (b) $2.4 million to downsize and close excess facilities, and other associated activities. The employee termination costs of $7.5 million, which are provided under an ongoing benefit arrangement, include severance and related termination benefits, including payroll taxes. All terminations are expected to be completed by June 30, 2004 and termination costs associated with such employees are expected to be paid in full by January 31, 2005. Termination liabilities attributable to ongoing benefit arrangements have been accrued when probable in accordance with SFAS No. 112, "Employers' Accounting for Postemployment Benefits". The other special charges of $2.4 million represent costs to downsize and close seven leased facilities and other associated costs. Lease termination costs are accounted for under SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"). In accordance with SFAS 146, the liability for lease termination costs is accrued at the time that all employees have vacated the leased property. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. At December 31, 2003, outstanding liabilities of approximately $4.8 million related to PIP are included in the consolidated balance sheet set forth elsewhere herein in "Accrued liabilities".

        Implementation of PIP resulted in additional incremental costs that were expensed as incurred. Special charges for the year ended December 31, 2003 includes $0.6 million for the cost of outside consultants. Also included in special charges for the year ended December 31, 2003 is income of $1.4 million, primarily related to the collection of a previously reserved note receivable. The note receivable was related to the sale of a subsidiary sold by the Company in fiscal 2001.

        The Company intends to continue implementing PIP initiatives throughout fiscal 2004. Management estimates that the Company will incur approximately $5 million to $10 million of costs related to PIP activities in fiscal 2004. The Company expects to fund these costs with internally generated funds. However, there can be no assurance that the Company will be able to successfully fund or implement these initiatives or realize the anticipated savings.

Historical Liquidity and Capital Resources

Fiscal year ended December 31, 2003 ("Current Year"), compared to the twelve months ended December 31, 2002 ("Prior Year")

        The following table calculates condensed cash flows from operating activities, investing activities and financing activities for the twelve months ended December 31, 2002 (unaudited), by adding previously reported amounts for the nine months ended September 30, 2002, as reported in the quarterly report on Form 10-Q for the quarter ended September 30, 2003, and the three months ended

66



December 31, 2002, as reported in the transition report on Form 10-K for the three month period ended December 31, 2002.

 
  Predecessor Company

 
 
  Nine Months
Ended September 30,
2002

  Three Months
Ended December 31,
2002

  Twelve Months
Ended December 31,
2002

 
 
  (unaudited)

   
  (unaudited)

 
Net cash provided by operating activities   $ 42,605   $ 28,001   $ 70,606  
   
 
 
 
 
Capital expenditures

 

 

(21,585

)

 

(8,421

)

 

(30,006

)
  Acquisitions and investments in businesses, net of cash acquired     (63,731 )       (63,731 )
   
 
 
 
Net cash used in investing activities     (85,316 )   (8,421 )   (93,737 )
   
 
 
 
 
Proceeds from issuance of debt, net of issuance costs

 

 

105,000

 

 


 

 

105,000

 
  Payments on debt and capital lease obligations     (64,853 )   (1,196 )   (66,049 )
  Other financing activities     1,159     (1,909 )   (750 )
   
 
 
 
Net cash provided by (used in) financing activities     41,306     (3,105 )   38,201  
   
 
 
 
Net increase (decrease) in cash and cash equivalents   $ (1,405 ) $ 16,475   $ 15,070  
   
 
 
 
Supplemental cash flow information:                    
Income taxes paid   $ 593   $ 71   $ 664  
   
 
 
 
Interest paid   $ 76,463   $ 16,175   $ 92,638  
   
 
 
 

        Operating Activities.    The Company's net cash provided by operating activities was $70.6 million and $178.3 million for the Prior Year and Current Year, respectively. The increase in cash provided by operating activities from the Prior Year to the Current Year is primarily due to a reduction in cash interest payments. Cash interest payments in the Prior Year totaled $92.6 million, as compared to $15.8 million in the Current Year, a reduction of approximately $76.8 million. The decrease in interest payments is mainly due to the fact that the Company did not pay interest on the Old Senior Notes and Old Subordinated Notes totaling $79.7 million during the period beginning on the date the Company filed for bankruptcy protection, March 11, 2003, through the end of the Current Year. Also contributing to the increase in operating cash flows from the Prior Year to the Current Year are higher cash flows attributable to increased segment profit year over year, lower net cash outflows with respect to discontinued operations and improved working capital. The Company's segment profit for the Prior Year was $184.4 million, as compared to $192.1 million in the Current Year. Net cash outflows with respect to discontinued operations were $5.8 million and $0.1 million in the Prior Year and Current Year, respectively.

        Investing Activities.    The Company utilized $30.0 million and $29.8 million in funds during the Prior Year and Current Year, respectively, for capital expenditures. The majority of the Company's capital expenditures relate to management information systems and related equipment. These expenditures have remained relatively constant year over year and are reduced from prior years as the result of the Company's focus on cost reduction through the ABI and PIP restructuring initiatives.

        The Company used $63.7 million and $3.7 million in funds during the Prior Year and Current Year, respectively, for acquisitions and investments in businesses. Included in the Prior Year is a contingent purchase price payment of $60.0 million to Aetna related to the acquisition of HAI. Included in the Prior Year and Current Year are the final two earn-out payments of $3.7 million each with respect to the acquisition in 1998 of Inroads, a managed behavioral healthcare company, by Merit Behavioral Care Corporation ("Merit") (which was later acquired by the Company).

67



        Financing Activities.    The Company borrowed approximately $105.0 million and $0.1 million during the Prior Year and Current Year, respectively. The borrowings in the Prior Year were primarily draws under the revolving credit facility for short-term capital needs.

        In the Prior Year, the Company made repayments of approximately $66.0 million and $3.0 million on debt and capital lease obligations during the Prior Year and Current year, respectively. The Prior Year repayments included scheduled term loan repayments, term loan repayments with cash received from asset sales during the year, scheduled capital lease payments and revolving facility repayments primarily with cash generated from operations. The Current Year repayments include payments on capital lease obligations.

Fiscal year ended September 30, 2002 ("fiscal 2002"), compared to the fiscal year ended September 30, 2001 ("fiscal 2001")

        Operating Activities.    The Company's net cash provided by operating activities was $85.7 million and $66.7 million for fiscal 2001 and 2002, respectively. The decrease in operating cash flows from fiscal 2001 to fiscal 2002 is primarily due to the fact that fiscal 2001 benefited from approximately $30.0 million of settlements of contract appeals with respect to TRICARE in fiscal 2001 and $25.0 million in distributions from Choice related to its settlements of contract appeals in fiscal 2001 with respect to TRICARE, partially offset by the payment of approximately $44.0 million related to discontinued operations obligations during fiscal 2001. Operating cash flows for fiscal 2002 were negatively impacted by $5.4 million of cash outflows related to discontinued operations.

        Investing Activities.    The Company utilized $34.7 million and $27.6 million in funds during fiscal 2001 and 2002, respectively, for capital expenditures. Capital expenditures decreased 20.5 percent, or $7.1 million, from fiscal 2001 to fiscal 2002. The majority of the Company's capital expenditures relate to management information systems and related equipment. These expenditures decreased from fiscal 2001 to fiscal 2002 primarily as the result of the Company's focus on cost reduction through the ABI restructuring initiative. Also contributing to this decrease were capital leases of $3.8 million entered into by the Company during fiscal 2002 that would have otherwise required a capital expenditure.

        The Company used $87.7 million and $63.7 million in funds during fiscal 2001 and 2002, respectively, net of cash acquired, for acquisitions and investments in businesses. Included in each year is a contingent purchase price payment of $60.0 million to Aetna related to the acquisition of HAI and an earn-out payment of $3.7 million with respect to the acquisition in 1998 of Inroads, a managed behavioral healthcare company, by Merit Behavioral Care Corporation ("Merit") (which was later acquired by the Company). In fiscal 2001, the Company also paid the remaining contingent purchase price of $24.0 million to the shareholders of CMG Health, Inc. ("CMG"), a managed behavioral healthcare company acquired by Merit in September 1997.

        The Company received proceeds from the sale of assets, net of transaction costs and cash conveyed, of $110.6 million and $3.5 million in fiscal 2001 and 2002, respectively. The sales proceeds were generated primarily from: (i) the sale in fiscal 2001 of Mentor, two of the three remaining Provider JVs of the discontinued healthcare provider segment, assets of the psychiatric practice management business and the Company's Canadian operations and (ii) the sale of the remaining Provider JV in fiscal 2002.

        Financing Activities.    The Company borrowed approximately $356.6 million and $105.0 million during fiscal 2001 and 2002, respectively. The borrowings in fiscal 2002 were primarily draws under the revolving credit facility for short-term capital needs. The borrowings in fiscal 2001 represent draws under the revolving facility for short-term capital needs and the issuance of $250.0 million of Old Senior Notes, less issuance costs.

        The Company made repayments of approximately $458.2 million and $65.9 million on debt and capital lease obligations during fiscal 2001 and 2002, respectively. Fiscal 2001 repayments included

68



scheduled term loan repayments, scheduled capital lease payments, term loan and revolving facility repayments made with the proceeds from the sale of Mentor and term loan repayments made with proceeds from issuance of the Old Senior Notes and the sale of the Company's Canadian operations. Fiscal 2002 repayments included scheduled term loan repayments, term loan repayments with cash received from asset sales during the year, scheduled capital lease payments and revolving facility repayments primarily with cash generated from operations.

        In fiscal 2001, the Company issued $250.0 million of Old Senior Notes. The gross proceeds from the issuance and sale of the Old Senior Notes were used to repay indebtedness outstanding under the Company's term loans.

Outlook—Liquidity and Capital Resources

        During fiscal 2004, the Company will have significant cash inflows and outflows related to the consummation of the Plan, as well as with the refinancing of the Old Credit Agreement. In particular, the Company will record in 2004: (i) the receipt of net cash from the Equity Offering and from the Onex Investment of approximately $146.9 million (total additional equity of $150.0 million less approximately $3.1 million of issuance costs); (ii) the receipt of net cash of approximately $92.6 million from term loans as part of the new senior secured credit agreement with Deutsche Bank (the "Credit Agreement") (total term loans of $100.0 million less approximately $7.4 million of loan acquisition costs); (iii) the payment of approximately $31.6 million for debt related to the Old Senior Notes and the Aetna Note; (iv) estimated payments of approximately $74.2 million for liabilities related to the chapter 11 proceedings, including professional fees and claim settlements; and (v) the payment of $160.8 million of debt outstanding under the Old Credit Agreement.

        In addition, during fiscal 2004, the Company expects to pay its current obligations as noted in the commitments table reflected below, and fund its capital expenditures with cash from operations. The Company estimates that its capital expenditures will be approximately $35 million to $40 million in fiscal 2004. The Company does not anticipate that it will need to draw on amounts available under the Revolving Loan Facility for its operations, capital needs or debt service in fiscal 2004.

        The following table sets forth the future financial commitments of the Company as of the Effective Date, after giving effect to the debt and other liabilities to be paid upon consummation of the plan (in thousands):

 
  Payments due by period

Contractual Obligations

  Total
  Less than
1 year

  1-3
years

  3-5
years

  More than
5 years

Long-term debt (1)   $ 389,261   $ 15,000   $ 96,415   $ 277,846   $
Interest on long-term debt (2)     144,134     30,411     61,487     52,236    
Capital lease obligations     12,056     9,785     2,271        
Operating leases (3)     71,556     16,706     20,110     14,523     20,217
   
 
 
 
 
    $ 617,007   $ 71,902   $ 180,283   $ 344,605   $ 20,217
   
 
 
 
 

(1)
Pursuant to the Plan, and on the Effective Date, the Company refinanced its long-term debt. See Note 7—"Long-term Debt and Capital Lease Obligations" to the audited consolidated financial statements set forth elsewhere herein for discussion of the new debt financing of the Company as of the Effective Date. Long-term debt amounts in the table above reflects future obligations under the Credit Agreement, the Senior Notes and the Aetna Note. See discussion of the Credit Agreement and amounts outstanding thereunder as of the Effective Date below.

(2)
Interest payments have been estimated based upon current interest rates, and include commitment fees associated with certain borrowings under the Credit Agreement.

69


(3)
Operating lease obligations include estimated future lease payments for both open and closed offices. Such future lease amounts reflect the estimated impact of leases that have been rejected through December 31, 2003 as part of the Company's chapter 11 proceedings.

        Credit Agreement.    The Company's new senior secured credit agreement (the "Credit Agreement") provides for a Term Loan Facility in an original aggregate principal amount of $100.0 million, a Revolving Loan Facility providing for loans of up to $50.0 million and a Credit-Linked Facility for the issuance of letters of credit for the account of the Company in an aggregate principal amount of $80.0 million. Borrowings under the Credit Agreement will mature on August 15, 2008 and certain quarterly principal payments on the Term Loan Facility are also required. As of the Effective Date, the Company had outstanding $100.0 million under the Term Loan Facility. The Company had not drawn on the Revolving Loan Facility, resulting in unutilized commitments of $50.0 million. As of the Effective Date, the Company had issued letters of credit in the amount of $62.7 million, resulting in unutilized commitments under the Credit-Linked Facility of $17.3 million.

        Restrictive Covenants in Debt Agreements.    On the Effective Date, the Company entered into an indenture governing the terms of the Senior Notes (the "Indenture"), in addition to the Credit Agreement, as discussed above. In general, the Credit Agreement and the Indenture contain a number of covenants that limit management's discretion in the operations of the Company and its subsidiaries by restricting or limiting the Company's ability to, among other things:

        These restrictions may adversely affect the Company's ability to finance its future operations or capital needs or engage in other business activities that may be in its interest.

        The Credit Agreement also requires the Company to comply with specified financial ratios and tests (as defined), including minimum consolidated EBITDA, interest coverage ratios and maximum leverage ratios. Failure to comply with such covenants, without waiver, would result in an event of default under the Credit Agreement and, in the event the indebtedness under the Credit Agreement were accelerated, would give rise to defaults under substantially all of the Company's other debt agreements. The Credit Agreement is guaranteed by substantially all of the subsidiaries of the Company and is secured by substantially all of the assets of the Company and the subsidiary guarantors. As of the date of filing of this Form 10-K, the Company believes that it is in compliance with its debt covenants.

        Net Operating Loss Carryforwards.    During fiscal 2000, the Company reached an agreement (the "IRS Agreement") with the Internal Revenue Service ("IRS") related to its federal income tax returns for the fiscal years ended September 30, 1992 and 1993. The IRS had originally proposed to disallow approximately $162.0 million of deductions related primarily to interest expense in fiscal 1992. Under the IRS Agreement, the Company paid approximately $1.0 million in taxes and interest to the IRS in

70



the second quarter of fiscal 2001 to resolve the assessment specifically relating to taxes due for these open years, although no concession was made by either party as to the Company's ability to utilize these deductions through net operating loss carryforwards. While any IRS assessment related to these deductions is not expected to result in a material cash payment for income taxes related to prior years, the Company's federal net operating loss carryforwards could be reduced if the IRS later successfully challenges these deductions. The Company's history of recent operating losses (prior to reorganization benefits) and financial restructuring activities continue to create uncertainty as to the Company's ability to realize its NOL carryforwards and other deferred tax assets. In addition, the Company's utilization of NOL carryforwards will be subject to limitation under Internal Revenue Code Section 382 upon emergence from bankruptcy, which may affect the timing of the use of, or the ultimate realization of, NOL carryforwards. Accordingly, as of December 31, 2003 and 2002, the Company maintains a total valuation allowance covering all of the Company's net deferred tax assets. See Note 10—"Income Taxes" to the audited consolidated financial statements set forth elsewhere herein.

        Discontinued Operations.    APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. The operating results of the discontinued segments have been disclosed, net of income tax, in a separate income statement caption "Discontinued operations—Income (loss) from discontinued operations". The losses the Company incurred to exit the discontinued operations are reflected, net of income tax, in the caption "Discontinued operations—Loss on disposal of discontinued operations". The assets, liabilities and cash flows related to discontinued operations have not been segregated from continuing operations.

        As of December 31, 2003, the Company has disposed of its human services segment in its entirety, and has taken the majority of the actions necessary to complete the disposal of or shutting down of its healthcare provider and franchising segments and its specialty managed healthcare segment, but still has certain estimated liabilities for various obligations as follows:

        As part of its financial restructuring plan and chapter 11 proceedings, the Company rejected certain leases for closed offices. As leases for closed offices were rejected, the net liability arising from such rejections was compared to the net liability already recorded by the Company, and the difference was recorded as a component of "Reorganization expense" in the Company's statement of operations, in accordance with SOP 90-7.

        The remaining assets and liabilities of these discontinued segments are described more fully in Note 5—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. There can be no assurance that the reserves established will prove to be

71



adequate. In the event that any future losses or expenses exceed the amount of reserves on the balance sheet, the Company will be required to record additional losses on disposal of discontinued operations or losses from discontinued operations in the consolidated statement of operations.

Recent Accounting Pronouncements

        In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51 ("FIN 46"). FIN 46 requires consolidation of entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Currently, entities are generally consolidated by an enterprise when it has a controlling financial interest through ownership of a majority voting interest in the entity. The Reorganized Company early adopted the provisions of FIN 46 effective December 31, 2003. Early adoption of new accounting pronouncements is required by companies implementing the fresh start reporting provisions of SOP 90-7. Based on the guidance of FIN 46, the Reorganized Company has determined that it is the primary beneficiary of Premier, a variable interest entity for which the Reorganized Company maintains a 50 percent voting interest. Concurrent with the provisions of FIN 46, the Reorganized Company has consolidated the balance sheet of Premier into the Reorganized Company's balance sheet as of December 31, 2003. Through December 31, 2003, the Predecessor Company accounted for Premier under the equity method, whereby the Predecessor Company included its portion of Premier's earnings or loss in its consolidated statement of operations under the caption "Equity in (earnings) loss of unconsolidated subsidiaries". In 2004, the Reorganized Company will consolidate the results of operations of Premier in its consolidated statement of operations. See further discussion of the adoption of FIN 46, including disclosures required by FIN 46, in Note 3—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein.

        In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF No. 94-3"). SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002. The January 1, 2003 implementation of SFAS 146 has not had a material impact upon the Company's financial position or results of operations.


Item 7A. Quantitative and Qualitative Disclosures About Market Risk

        Changes in interest rates affect interest income earned on the Company's cash equivalents and restricted cash and investments, as well as interest expense on variable interest rate borrowings under the Credit Agreement. Based on the borrowing levels under the Credit Agreement as of the Effective Date, a hypothetical 10 percent increase in the interest rate, with all other variables held constant, would not materially affect the Company's future earnings and cash outflows. See "Business—Cautionary Statements—Restrictive Covenants in Debt Agreements", "Management's Discussion and Analysis of Financial Condition and Results of Operations—Outlook—Results of Operations", "—Outlook—Liquidity and Capital Resources" and Note 7—"Long-Term Debt and Capital Lease Obligations" to the Company's audited consolidated financial statements set forth elsewhere herein for discussion of the Company's Credit Agreement and the interest rates thereunder.


Item 8. Financial Statements and Supplementary Data

        Information with respect to this item is contained in the Company's audited consolidated financial statements set forth elsewhere herein and financial statement schedule indicated in the Index on Page F-1 of this Report on Form 10-K, and is incorporated herein by reference.

72




Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

        On May 22, 2002, the Company's Audit Committee approved the dismissal of its independent auditors, Arthur Andersen LLP ("Arthur Andersen"), and engaged Ernst & Young LLP to serve as its new independent auditors for fiscal year 2002. The Company filed a current report on Form 8-K with the SEC on May 24, 2002, the same date that the change in auditors became effective.

        Arthur Andersen's report on the Predecessor Company's consolidated financial statements for the fiscal year ended September 30, 2001, as included elsewhere herein, did not contain an adverse opinion or disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit scope or accounting principles.

        During the fiscal year ended September 30, 2001 and the interim period between September 30, 2001 and May 24, 2002, there were no disagreements between the Company and Arthur Andersen on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure which, if not resolved to Arthur Andersen's satisfaction, would have caused them to make reference to the subject matter of the disagreement in connection with their report for such year; and there were no reportable events as defined in Item 304(a)(1)(v) of Regulation S-K.


Item 9A. Controls and Procedures

73



PART III

        On the Effective Date, Magellan and 88 of its subsidiaries consummated the Plan under chapter 11 of title 11 of the Bankruptcy Code, which had been confirmed by order of the Bankruptcy Court on October 8, 2003, and accordingly the Plan became fully effective and the companies emerged from the protection of their chapter 11 proceedings. Magellan and these subsidiaries had filed voluntary petitions for relief under the Bankruptcy Code in the Bankruptcy Court on March 11, 2003.


Item 10. Directors and Executive Officers of the Registrant

Directors

        Under the Company's certificate of incorporation, as amended and restated on the Effective Date, the number of directors is currently fixed at nine. The directors of the Company were appointed in accordance with the Plan and the Confirmation Order as of the Effective Date (except for Mr. McBride as noted below), and are divided into three classes: (i) Class 1, consisting of four directors, (ii) Class 2, consisting of two directors, and (iii) Class 3, consisting of three directors.

        The Company's bylaws require a majority of directors to be independent in accordance with the Nasdaq Stock Market's ("NASDAQ") listing standards. The Company's Board of Directors has determined that except for those directors who are members of management of the Company or are affiliated with Onex, all directors are independent as that term is defined by the NASDAQ listing standards.

Class 1 Directors

        Steven J. Shulman, 52, is the Chairman of the Board and Chief Executive Officer of the Company. He became Chief Executive Officer of the Company in December 2002 and Chairman of the Board on the Effective Date. Prior to joining the Company, Mr. Shulman founded Internet HealthCare Group (IHCG), an early stage healthcare technology venture fund, and served as its Chairman and Chief Executive Officer from 2000 to 2002. Prior to IHCG, he was employed by Prudential Healthcare, Inc. as its Chairman, President and Chief Executive Officer from 1997 to 1999. Prior thereto, Mr. Shulman co-founded Value Health, Inc., and served as President of its Pharmacy and Disease Management Group and Director from 1987 to 1996. From 1983 to 1986, Mr. Shulman was employed by CIGNA Healthplans as President of its East Central Division. Prior thereto, he served as Director of Medical Economics for Kaiser Permanente from 1974 to 1982. Mr. Shulman is a member of the board of directors of Lumenos, Digital Insurance, RealMed, BenefitPoint Inc. and NDCHealth.

        Mark L. Hilson, 46, is a Managing Director for Onex Corporation. Prior to joining Onex in 1988, he was an Associate in the Mergers and Acquisitions Group at Merrill Lynch and a Brand Manager at Procter & Gamble. Mr. Hilson is a director of ClientLogic, ONCAP and Vincor International. Mr. Hilson also serves as a governor of the Shaw Festival.

        Robert Haft, 51, is the Principal Manager of Morgan Noble LLC, a healthcare investment firm. He has also been Chairman of National Pharmacies Group LLC since December 2001. Previously he was President/CEO of national drug chain Phar-Mor from 1994 to 1997. Prior thereto, he was President/CEO of Dart Group from 1983 to 1993. In addition, Mr. Haft founded four companies including Crown Books, Trak Auto, Vitamin Superstore, and Morgan Noble, LLC.

        William J. McBride, 59, was appointed to the Board on January 21, 2004. Mr. McBride is currently retired. Prior to his retirement in 1995, Mr. McBride had been a director of Value Health, Inc. a NYSE specialty managed care company which included Value Behavioral Health, one of the largest behavioral health managed care companies at the time. From 1987 to 1995, Mr. McBride served as president and chief operating officer of Value Health, Inc., overseeing all operational activities of the company and its subsidiaries. Prior to his tenure at Value Health, Mr. McBride spent 15 years in a variety of positions with INA Corporation and its successor, CIGNA Corporation, including serving as

74



president and chief executive officer of CIGNA Healthplan, Inc., vice president and controller of INA's Life and Healthcare Group and vice president of finance for CIGNA's Affiliated Business Group. Mr. McBride currently serves on the board of directors of AMERIGROUP Corporation, a managed health care company focused on providing services to Medicaid recipients, VistaCare Inc., and IHCG.

Class 2 Directors

        Robert M. LeBlanc, 37, the Board's Lead Director, is a Managing Director for Onex Corporation. Prior to joining Onex in 1999, Mr. LeBlanc was with Berkshire Hathaway for seven years. He also worked for five years at GE Capital in a variety of positions, including corporate finance and corporate strategy. Mr. LeBlanc is a director of InsLogic and First Berkshire Hathaway Life. He held several other directorships during his tenure at Berkshire Hathaway.

        René Lerer, M.D., 48, became President and Chief Operating Officer of the Company in October 2003. He previously served as Chief Operating Officer of the Company since January 2003. Prior to joining the Company, Dr. Lerer co-founded IHCG and served as its President from 1999 to 2002. Prior to IHCG, Dr. Lerer was employed by Prudential Healthcare, Inc. as its Chief Operating Officer from 1997 to 1999. Prior thereto, Dr. Lerer was employed by Value Health, Inc., and served as Senior Vice President—Operations of its Pharmacy and Disease Management Group from 1995 to 1997. Prior thereto, Dr. Lerer was employed by Value Health Sciences as Senior Vice President of Corporate Development from 1992 to 1994. Dr. Lerer is a member of the board of directors of IHCG, Digital Insurance, Lumenos and RealMed.

Class 3 Directors

        Michael P. Ressner, 55, currently holds the position of Adjunct Professor of Finance & Accounting at North Carolina State University and is an advisor at Southeast Interactive Technology Fund. He previously spent 22 years in a variety of positions at Nortel Networks, holding leadership positions within operations and finance. Mr. Ressner currently serves on the boards of Entrust, Inc., Proxim Corporation, Riverstone Networks and Arsenal Digital Solutions.

        Michael Diament, 35, is a Portfolio Manager and Director of Bankruptcies and Restructurings for Renegade Swish, LLC which, through various contractual agreements, provides personnel services to Amalgamated Gadget, LP, the investment manager for R2 Investments, LDC. From January 2001 to December 2002, Mr. Diament served as Portfolio Manager for Acme Widget, LP. From February 2000 until January 2001, Mr. Diament was a Senior Research Analyst for Sandell Asset Management, an investment management firm and served as Vice President of Havens Advisors, an investment management firm, from July 1998 to January 2000.

        Saul E. Burian, 40, is a Director in the New York office of Houlihan, Lokey, Howard & Zukin ("Houlihan") and splits his practice between Restructuring Advisory and Distressed M&A. Mr. Burian has served as a Director of Houlihan since March 2001 and he presently manages its Distressed M&A Northeast Region. From November 1988 through February 2001, Mr. Burian was a Partner of the New York law firm, Kramer Levin Naftalis & Frankel LLP and specialized in the area of creditors' rights and bankruptcy. He has been a member of the committee on bankruptcy and corporate reorganization of the Association of the Bar of the City of New York and has been approved by the chief bankruptcy judge of the Southern District of New York to serve as a court-certified bankruptcy mediator. Mr. Burian is a member of the City of New Rochelle Waterfront Commission, and a director of the New York Chapter of the Turnaround Management Association and of S/A/R Academy of Riverdale.

Director Election and Terms of Office

        Messrs. Shulman, Ressner, Diament and Burian will serve for a three-year term to extend until the 2007 annual meeting of stockholders. Messrs. Lerer and Hilson will serve for a two-year term to extend until the 2006 annual meeting of stockholders. Messrs. Haft, McBride and LeBlanc will serve for a

75



one-year term to extend to the 2005 annual meeting of stockholders. In each case, the term of their successors will extend for three years and until the election and qualification of their respective successors, or in any case their earlier death, incapacity, resignation or removal.

        Upon the expiration of their initial terms, the seats held by the Class 1 directors will be filled by election by vote of the holders of the Multi-Vote Common Stock only, voting as a separate class; the seats of the Class 3 directors will be filled by election by vote of the holders of the Ordinary Common Stock only, voting as a separate class; and the seats of the Class 2 directors and their successors will be filled by election by vote of the holders of the Multi-Vote Common Stock and the Ordinary Common Stock, voting together as though one class, in which vote the Multi-Vote Common Stock will be entitled to cast 50 percent of the entire vote. In addition, directors assigned to these classes can be removed, with or without cause, only by the vote of the holders of the class or classes of common stock entitled to participate in their election, except that the Class 3 directors may be so removed before the third anniversary of the Effective Date only for cause. Moreover, the filing of vacancies in these classes by the Board before the end of a director's term requires approval of the other directors of the class, subject to certain qualifications and provisions of Magellan's certificate of incorporation and bylaws. The holders of the Multi-Vote Common Stock and the Ordinary Common Stock are also entitled to a separate class vote on any amendment of these voting rights or any other amendment of Magellan's certificate of incorporation that would adversely affect their special rights or privileges. When the Minimum Hold Condition is no longer satisfied, the special voting powers of the Multi-Vote Common Stock and Ordinary Common Stock will terminate at such time and all the directors will then be elected by all the common stockholders voting together on the basis of one vote per share.

Arrangements Regarding the Nomination of Directors

        The individuals selected as directors of the Company as of the Effective Date were selected in accordance with provisions of the Plan by agreement of parties in interest in the chapter 11 proceedings and as approved by the Bankruptcy Court pursuant to the Confirmation Order. To the best of the Company's knowledge, there is no agreement or arrangement whereby any such director will be re-nominated or any other individual will be nominated or selected to serve as a director of Magellan. However, certain provisions of the Company's certificate of incorporation and bylaws govern the nomination and election of Magellan's directors. In accordance with the Company's bylaws, Magellan's Board of Directors is required to nominate for election at each annual meeting of stockholders candidates who, if elected, will cause a majority of the members of the Board of Directors of the Company to be independent directors, as determined in accordance with the listing standards of NASDAQ (and to meet certain other requirements regarding independence for membership on the audit and executive compensation committee of the Board, as also as specified in the bylaws). Nominations may also be made by stockholders in accordance with certain procedures established by the bylaws and nominations not made in compliance with the requirements established thereby may not be given effect. Such provisions regarding stockholder nominations do not, however, limit nominations made by a holder of Multi-Vote Common Stock. Class 1 Directors may only be elected by the holders of Multi-Vote Common Stock and Class 3 Directors may only be elected by holders of Ordinary Common Stock. For further information regarding the selection of directors, see Item 1. "Business—Emergence from Chapter 11" and "—Cautionary Factors—Significant Stockholder."

Nominations of Candidates for Election as Directors

        The Company does not currently have a Nominating Committee. As previously disclosed above, the current directors' terms extend until the 2005 Annual Shareholders' Meeting at the earliest. In addition to the nomination by the Board of candidates for election to the Board, candidates may be nominated by any shareholder of the Corporation entitled to notice of, and to vote at, any meeting called for the election of directors. Shareholder nominations are required to be in writing and to be sent to the Secretary of the Company.

76



Audit Committee

        The Company has appointed a separately-designated standing audit committee established in accordance with section 3(a)(58)(A) of the Exchange Act. The members of the audit committee are Michael Ressner (Committee Chairman), Robert Haft and William McBride. The Company's Board of Directors has determined that each of Messrs. Ressner, Haft and McBride is independent as that term is defined by the NASDAQ listing standards. The Company's Board of Directors has identified Michael P. Ressner as its Audit Committee Financial Expert, as defined by Item 401 of Regulation S-K. Mr. Ressner is an independent Board member, as defined by Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act. The Audit Committee has adopted a written charter pursuant to which the Audit Committee, among other things, provides assistance to the Company's Board of Directors in its oversight of the Company's accounting and financial reporting processes, and is responsible for the appointment, compensation, retention and oversight of the Company's independent auditors.

Executive Officers of the Registrant

Name

  Age
  Position
Steven J. Shulman   52   Chairman and Chief Executive Officer
René Lerer, M.D.   48   President and Chief Operating Officer
Mark S. Demilio   48   Executive Vice President, Chief Financial Officer
Megan M. Arthur   41   Executive Vice President, General Counsel
Anthony M. Kotin   51   Executive Vice President, Chief Marketing and
Strategy Officer
Jeff D. Emerson   56   Executive Vice President, Chief Information Officer

        Information for Steven J. Shulman and René Lerer, M.D. is presented above under "Directors".

        Mark S. Demilio became Chief Financial Officer of the Company in October 2001. Mr. Demilio served as Executive Vice President, General Counsel of the Company from July 1999 and as Executive Vice President, Finance and Legal from December 2000. Prior thereto, Mr. Demilio was with Youth Services International, Inc., a publicly traded company that managed residential treatment centers for behaviorally troubled youth and behavioral treatment programs in juvenile correction facilities, serving as Executive Vice President, Business Development and General Counsel from March 1997 and Chief Financial Officer from June 1998. Prior thereto, Mr. Demilio was a partner with Miles & Stockbridge, a Baltimore, Maryland-based law firm.

        Megan M. Arthur became Executive Vice President, General Counsel in October 2001. Ms. Arthur served as General Counsel, Magellan Behavioral Health, Inc. from July 2000 to September 2001 and as Deputy General Counsel, Magellan Behavioral Health from February 1998 to June 2000. Prior thereto, Ms. Arthur was an attorney with Magellan Behavioral Health and one of its predecessor organizations from November 1994 to January 1998.

        Anthony M. Kotin became Executive Vice President, Chief Marketing and Strategy Officer in October 2003. Mr. Kotin previously served in various positions with Mercer Human Resource Consulting, most recently as the National Leader for Knowledge and Service Development for the health and group practice from April 2001 to September 2003, and also as Principle from August 1999 to June 2000. Mr. Kotin served as Senior Vice President of Operations at IHCG from July 2000 to March 2001. Prior thereto, he served as National Chief Medical Officer for Prudential Healthcare, Inc. from July 1997 to July 1999. Before joining Prudential, Mr. Kotin served as the National Practice Leader for Clinical Operations and Analysis in the integrated healthcare consulting practice of Towers Perrin from October 1994 to June 1997.

        Jeff D. Emerson became Executive Vice President, Chief Information Officer in March 2003. Prior to joining the Company, Mr. Emerson served as President of CIGNA HealthCare's Mid-Atlantic Region from 2001 to 2002. Before joining CIGNA, he was Chief Operating Officer of Digital

77



Insurance, a start-up Internet broker of health and related insurance plans that he helped found from 1999 to 2001. Prior thereto, Mr. Emerson served as President and Chief Executive Officer of NYLCare Health Plans of the Mid-Atlantic from 1987-1999. Prior thereto, he served as Chief Executive Officer for the start-up operations of SkyTel, Inc. from 1986 to 1987. Mr. Emerson has also served previously in a variety of leadership positions with Informatics General Corporation, Stentran Systems, Inc. and Boeing Computer Services.

Code of Ethics

        In March 2004, the Company adopted a code of ethics that applies to its chief executive officer, chief financial officer and controller. The Company has posted the text of such code of ethics on its website at http://www.magellanhealth.com. The Company intends to post on its website any amendments to, or waivers from, its Code of Ethics applicable to its senior officers.

Section 16(a) Beneficial Ownership Reporting Compliance

        Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's directors, certain officers and persons who own more than 10.0 percent of the common stock of the Company to file reports of ownership and changes in ownership with the SEC and furnish copies of such reports to the Company. Based solely on a review of the copies of such forms furnished to the Company during fiscal 2003, or written representations that no other reports were required, the Company believes that all persons who are required to comply with the Section 16(a) filing requirements during fiscal 2003 with respect to the Company's common stock have complied with such filing requirements on a timely basis, other than as described below. Magellan's reorganization proceeding occasioned uncertainties concerning the status of certain executives as officers required to make such reports, resulting in their making Section 16(a) filings late when such uncertainties were resolved in connection with the consummation of the Plan, as follows:

         In addition, commencing with the Effective Date and until the date of this report, certain Section 16(a) reports have been filed late. These reports were required with respect to the consummation of the Plan and related stock ownership transactions and clarification of the impact of the filing requirements on these transactions and the need to obtain EDGAR filings codes by persons not previously required to have such codes in order to file such reports resulted in the following late filings:


Item 11. Executive Compensation

Executive Compensation

        The following table sets forth, for the fiscal year ended December 31, 2003, the two preceding fiscal years ended September 30, 2002 and 2001, respectively, and the three-month transition period ended December 31, 2002, the compensation paid by the Company to the Company's Chief Executive

78



Officer and the Company's four next most highly compensated executive officers serving at December 31, 2003 (collectively, the "Named Executive Officers").

Summary Compensation Table

 
   
  Annual Compensation
  Long-Term Compensation
   
 
   
   
   
   
  Awards
  Payouts
   
Name and Principal Position

  Period
  Salary
  Bonus
  Other Annual
Compensation

  Restricted
Stock
Awards

  Securities
Underlying
Options/
SARS(#)(1)

  LTIP
Payouts

  All Other
Compensation(2)

Steven J. Shulman (3)
Chief Executive Officer and Chairman of the Board
  12-03
12-02
9-02
9-01
  $





  $





  $





 


 


  $





  $






René Lerer, M.D. (4)
President and Chief Operating Officer

 

12-03
12-02
9-02
9-01

 

 





 

 





 

 





 





 





 

 





 

 





Mark S. Demilio (5)
Executive Vice President,
Chief Financial Officer

 

12-03
12-02
9-02
9-01

 

 

400,000
105,417
324,375
310,333

 

 

66,660
25,000
50,000
30,000

 

 





 





 





 

 





 

 

5,981

38,000
38,630

Henry T. Harbin, M.D. (6)
former Chairman of the Board

 

12-03
12-02
9-02
9-01

 

 

516,667
150,000
600,000
800,000

 

 





 

 





 





 



—100,000

 

 





 

 

5,837

103,000
159,195

Megan M. Arthur (7)
Executive Vice President, General Counsel

 

12-03
12-02
9-02
9-01

 

 

260,000
65,000
245,417
200,833

 

 

21,665


7,374

 

 





 





 




12,000

 

 





 

 

5,958

31,929
21,771

(1)
Represents the number of stock options granted during the period under the Company's pre-petition stock option plans.

(2)
For the year ended December 31, 2003, includes contributions to the Company's 401(k) plans.


For the year ended September 30, 2002, includes: (i) contributions to the Company's 401(k) plans of $5,500, $5,500 and $6,079 for Mr. Demilio, Dr. Harbin and Ms. Arthur, respectively, and (ii) contributions by the Company deposited in trust pursuant to the Company's SAP of $97,500, $32,500 and $25,850 for Dr. Harbin, Mr. Demilio and Ms. Arthur, respectively, for the calendar year 2002.


For the year ended September 30, 2001, includes: (i) contributions to the Company's 401(k) plans of $3,195, $6,130 and $5,571 for Dr. Harbin, Mr. Demilio and Ms. Arthur, respectively and (ii) contributions by the Company deposited in trust pursuant to the Company's SAP of $156,000, $32,500 and $16,200 for Dr. Harbin, Mr. Demilio and Ms. Arthur, respectively, for the calendar year 2001.

(3)
Mr. Shulman became Chief Executive Officer in December 2002. In fiscal 2003, he was compensated by HPI, which in turn was paid by the Company via a consulting agreement. See further discussion of the HPI consulting agreement below under Item 13—"Certain Relationships and Related Transactions". Mr. Shulman entered into an employment agreement with the Company on the Effective Date. See "Employment Agreements" below.

(4)
Dr. Lerer became Chief Operating Officer in January 2003 and President in October 2003. In fiscal 2003, he was compensated by HPI, which in turn was paid by the Company via a consulting agreement. See further discussion of the HPI consulting agreement below under Item 13—"Certain Relationships and Related Transactions". Dr. Lerer entered into an employment agreement with the Company on the Effective Date. See "Employment Agreements" below.

(5)
Mr. Demilio became Executive Vice President, Chief Financial Officer in October 2001.

(6)
Dr. Harbin's tenure as Chairman of the Board of Directors extended until the Effective Date.

(7)
Ms. Arthur became Executive Vice President, General Counsel in October 2001.

Option/SAR Grants in Last Fiscal Year

        There were no options to purchase pre-petition common stock granted by the Company in fiscal 2003. All outstanding options to purchase pre-petition common stock were canceled as of the Effective

79



Date. In January and February of 2004, options to purchase shares of the Ordinary Common Stock of the Company were granted as follows:

Individual Grants

 
   
   
   
   
  Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation for Option Term ($)(1)
 
  Number of Securities
Underlying
Options/SARs
Granted (#)

  Percentage of
Total Options
Granted to
Employees (%)

   
   
Name

  Exercise
of Base Price
Per Share ($)

  Expiration
Date

  5%
  10%
Steven J. Shulman   413,002
619,505
413,004
(2)
(3)
(4)
9.7
14.5
9.7
  11.91
10.43
11.91
  1/5/2014
1/5/2014
1/5/2014
  10,890,863
17,253,214
10,890,915
  20,253,618
31,297,393
20,253,716

René Lerer, M.D.

 

247,802
371,703
247,802

(2)
(3)
(4)

5.8
8.7
5.8

 

11.91
10.43
11.91

 

1/5/2014
1/5/2014
1/5/2014

 

6,534,539
10,351,929
6,534,539

 

12,152,210
18,778,436
12,152,210

Mark S. Demilio

 

165,201
247,802
165,201

(2)
(3)
(4)

3.9
5.8
3.9

 

11.91
10.43
11.91

 

1/5/2014
1/5/2014
1/5/2014

 

4,356,350
6,901,286
4,356,350

 

8,101,457
12,518,957
8,101,457

Megan M. Arthur

 

26,664
13,336

(5)
(6)

0.6
0.3

 

12.39
23.52

 

1/5/2014
2/4/2014

 

838,050
270,721

 

1,529,980
616,790

(1)
The Company is required by the Securities and Exchange Commission to use a 5.0 percent and 10.0 percent assumed rate of appreciation over the ten-year option term. This does not represent the Company's estimate or projection of the future Common Stock price. If the Common Stock does not appreciate, the Named Executive Officers will receive no benefit from the options.

(2)
Options vest in 33 percent increments on January 5 of each of 2005, 2006 and 2007. Options are exercisable only if the market price of the common stock has increased from January 5, 2004 through the determination date at a cumulative rate of 16 percent per annum, with daily compounding, over $11.91 per share. The determination of whether these options are exercisable shall be determined on each trading day occurring on or after a vesting date and shall be based on the average closing prices of the common stock for each of the 20 consecutive trading days ending on each such determination date. In all events, the options fully vest and are exercisable on January 5, 2011.

(3)
Options vest in 33 percent increments on January 5 of each of 2005, 2006 and 2007. Options are exercisable only if the market price of the common stock has increased from January 5, 2004 through the determination date at a cumulative rate of 10 percent per annum, with daily compounding, over $11.91 per share. The determination of whether these options have become exercisable shall be determined on each trading day occurring on or after a vesting date and shall be based on the average closing prices of the common stock for each of the 20 consecutive trading days ending on each such determination date. In all events, options shall become fully vested and exercisable on January 5, 2011.

(4)
Options vest, and become exercisable, in 33 percent increments on January 5, of each of 2005, 2006 and 2007.

(5)
Options vest, and become exercisable, as follows: 25 percent on each of January 5, 2006 and 2007, and 50 percent on January 5, 2008.

(6)
Options vest, and become exercisable, in 25 percent increments on January 5, of each of 2005, 2006, 2007 and 2008.

80


Aggregated Option/SAR Exercises in Fiscal 2003, and Option/SAR Values at December 31, 2003

        No Named Executive Officer exercised options to purchase shares of pre-petition common stock of the Company during the fiscal year ended December 31, 2003. The pre-petition common stock and all outstanding options to purchase shares of stock were canceled as of the Effective Date. The following table sets forth the number and value of outstanding options to purchase pre-petition common stock as of December 31, 2003. No options held by any Named Executive Officer were "In-the-Money Options" as of December 31, 2003.

 
   
   
  Number of Securities Underlying Unexercised Options/SARs at December 31, 2003
  Value of Unexercised
In-the-Money
Options/SARs at
December 31, 2003 ($)(1)

Name

  Shares
Acquired on
Exercise (#)

  Value
Realized ($)

  Exercisable
  Unexercisable
  Exercisable
  Unexercisable
Steven J. Shulman            
René Lerer, M.D.            
Mark S. Demilio       205,000      
Henry T. Harbin, M.D.       563,068      
Megan M. Arthur       49,664      

(1)
The closing per share price for the pre-petition common stock of the Company as reported on the Over-the-Counter Bulletin Board on December 31, 2003 was $0.08.

Aggregated Option/SAR Exercises since the Effective Date, and Option/SAR Values as of March 4, 2004

        No Named Executive Officer has exercised options to purchase shares of the Ordinary Common Stock of the Company since the Effective Date. The following table sets forth the number and value of outstanding options to purchase shares of the Ordinary Common Stock at March 4, 2004.

 
   
   
  Number of Securities
Underlying Unexercised
Options/SARs at
March 4, 2004

  Value of Unexercised
In-the-Money
Options/SARs at
March 4, 2004 ($)(1)

Name

  Shares
Acquired on
Exercise (#)

  Value
Realized ($)

  Exercisable
  Unexercisable
  Exercisable
  Unexercisable
Steven J. Shulman         1,445,511     23,307,833
René Lerer, M.D.         867,307     13,984,706
Mark S. Demilio         578,204     9,323,127
Henry T. Harbin, M.D.            
Megan M. Arthur         40,000     451,970

(1)
The closing per share price for the Ordinary Common Stock as reported on the Nasdaq National Market on March 4, 2004 was $27.40.

Compensation of Directors

        Pursuant to a January 5, 2004 Board resolution, in return for their services on behalf of the Company as directors, the individuals who serve as members of the Board of Directors after the Effective Date will receive the compensation listed below; provided however, that no compensation shall be given to those members who are employees of either the Company or Onex (or its affiliates):

81


        In addition, on January 5, 2004 the Board approved, as further compensation for the services of those directors commencing service on the Board in 2004 (as of January 21, 2004) who are not members of management and not associated with Onex, a grant of 2,152 shares of Ordinary Common Stock plus the number of additional shares of Ordinary Common Stock equivalent to $13,333 divided by 85 percent of the average closing price of the shares in Nasdaq trading for the 20 consecutive trading days following the Effective Date, which was 567 shares, for a total grant of 2,719 shares. Such shares may not be sold by a director until January 5, 2006 or the earlier termination of a director's service and in compliance with certain regulatory requirements. This action did not provide for (nor does it prohibit) a grant of stock compensation for service as a director in any future year (i.e., after the 2005 annual meeting of shareholders).

Employment Agreements

        Steven J. Shulman and René Lerer, M.D. The Company entered into a consulting agreement with HPI, a newly formed entity whose principals are Steven J. Shulman and René Lerer, M.D., on December 4, 2002, as described in Item 13 below. This consulting agreement remained in effect through fiscal 2003 and until the Effective Date. Upon the Effective Date, the following employment agreements were entered into by Mr. Shulman and Dr. Lerer as described below.

        Steven J. Shulman. Under the Employment Agreement between Mr. Shulman and Magellan Health Services, Inc., effective January 5, 2004, Mr. Shulman will serve as Chairman and Chief Executive Officer and member of the Board of Directors of the Company. The Agreement is for a three-year term beginning on the Effective Date, with automatic renewals for additional one-year terms, unless sooner terminated as provided in the Agreement. The Company will pay Mr. Shulman a base salary of $1,000,000 per year, with annual review for increase by the Board or a duly authorized committee thereof. Mr. Shulman is entitled to an annual target bonus opportunity of 100 percent of base salary, subject to achievement of performance targets fixed by the Board or a duly authorized committee thereof. Under the Agreement, the Company granted Mr. Shulman 83,963 fully-vested shares of Ordinary Common Stock on the Effective Date. The Agreement also provided for Mr. Shulman to purchase on the Effective Date for $1,000,000 in cash 83,963 fully-vested shares of Ordinary Common Stock for $11.91 per share in cash, the average price paid by Onex for all of the shares of common stock it acquired in connection with the Plan. Mr. Shulman will receive a cash payment equal to a portion of the income taxes that he may incur as a result of such purchase. Additionally, under the Agreement, the Company granted to Mr. Shulman options to purchase a total of 1,445,511 shares of Ordinary Common Stock with a ten-year term as noted in the "Individual Grants" table above. The Agreement provides for benefits commensurate with Mr. Shulman's position. The Agreement also provides for severance payments upon termination by the Company as follows:

82


        René Lerer, M.D. Under the Employment Agreement between Dr. Lerer and Magellan Health Services, Inc., effective January 5, 2004, Dr. Lerer will serve as President and Chief Operating Officer and member of the Board of Directors of the Company. The Agreement is for a three-year term beginning on the Effective Date, with automatic renewals for additional one-year terms, unless sooner terminated as provided in the Agreement. The Company will pay Dr. Lerer a base salary of $600,000 per year, with annual review for increase by the Chief Executive Officer, subject to approval of the Board or a duly authorized committee thereof. Dr. Lerer is entitled to an annual target bonus opportunity of 75 percent of base salary, subject to achievement of performance targets fixed by the Board or a duly authorized committee thereof. Under the Agreement, the Company granted Dr. Lerer 50,378 fully-vested shares of Ordinary Common Stock on the Effective Date. Additionally, under the Agreement, the Company granted to Dr. Lerer options to purchase a total of 867,307 shares of Ordinary Common Stock with a ten-year term as noted in the "Individual Grants" table above. The Agreement provides for benefits commensurate with Dr. Lerer's position. The Agreement also provides for severance payments upon termination by the Company as follows:

        Mark S. Demilio. Under the Employment Agreement between Mr. Demilio and Magellan Health Services, Inc., effective January 5, 2004, Mr. Demilio will serve as Executive Vice President and Chief Financial Officer of the Company. The Agreement is for a three-year term beginning on the Effective Date, with automatic renewals for additional one-year terms, unless sooner terminated as provided in the Agreement. The Company will pay Mr. Demilio a base salary of $500,000 per year, with annual review for increase by the Chief Executive Officer, subject to approval of the Board or a duly authorized committee thereof. Mr. Demilio is entitled to an annual target bonus opportunity of 60 percent of base salary, subject to achievement of performance targets fixed by the Board or a duly authorized committee thereof. Under the Agreement, the Company granted Mr. Demilio 33,585 fully-vested shares of Ordinary Common Stock on the Effective Date. Additionally, under the Agreement, the Company granted to Mr. Demilio options to purchase a total of 578,204 shares of Ordinary Common Stock with a ten-year term as noted in the "Individual Grants" table above. The Agreement

83



provides for benefits commensurate with Mr. Demilio's position. The Agreement also provides for severance payments upon termination by the Company as follows:

        Henry T. Harbin, M.D.    As of the Effective Date, Dr. Harbin was replaced as Chairman of the Board by Mr. Shulman. Dr. Harbin remained an employee of the Company from that time up to the termination date of his employment agreement, which expired on March 17, 2004. The Company and Dr. Harbin have entered into a consulting agreement, effective as of March 18, 2004, under which Dr. Harbin will provide services on behalf of the Company on an as-needed basis.

        Megan M. Arthur.    The Company has an Employment Agreement with Ms. Arthur effective November 1, 2003 for a term extending to May 22, 2004, unless terminated earlier in accordance with terms of the agreement. Thereafter the agreement will automatically renew for thirty-day periods, unless terminated sooner as provided in the agreement, until January 31, 2005. Under the agreement, Ms. Arthur will serve the Company as General Counsel or Deputy General Counsel, or a comparable position as the Company determines from time to time. The agreement provides for a base salary of $270,000 per year and benefits commensurate with Ms. Arthur's position.

Benefit Plans

        Annual Incentive Plan.    In fiscal year 2003, the executive officers were eligible for participation in the Short-Term Incentive Plan ("STIP"), which was designed to award officers (and other employees) for meeting or exceeding specific financial targets approved by the Compensation Committee for fiscal year 2003. The Target Bonus Award levels for the executive officers range from 50.0 percent to 60.0 percent of base salary, and based on performance in relation to goals, the amount of bonus can range from 0 percent to 200 percent of target percentage. Incentive Awards are funded based on meeting or exceeding threshold goals and are awarded based on corporate and individual performance. Based on the financial results attained for fiscal year 2003, the STIP was funded at 120 percent and bonuses were paid in the first quarter of 2004.

        2003 Management Incentive Plan.    This plan replaces the Company's former 1994, 1996, 1997 and 1998 Stock Option Plans and the 2000 Long-Term Incentive Plan, all of which were terminated as of the Effective Date. The 2003 Management Incentive Plan (the "MIP"), which is administered by the Compensation Committee of the Board, allows approval of several types of long-term incentives including stock options, stock appreciation rights, restricted stock awards and stock units. A total of 6,373,689 shares of Ordinary Common Stock have been reserved for issuance pursuant to the MIP over a period not to exceed ten years after the Effective Date. Pursuant to the MIP and their employment

84


agreements, as of the Effective Date, options to purchase 2,891,022 shares of Ordinary Common Stock and restricted stock awards for 167,926 shares of Ordinary Common Stock were issued to the three senior executive officers of the Company (Mr. Shulman, Dr. Lerer and Mr. Demilio). Stock options covering 1,376,400 additional shares were issued to other members of management of the Company in connection with the consummation of the Plan, leaving 2,106,267 options issuable under the MIP. The options to executive officers were granted with exercise prices ranging from the reorganization value under the Plan, as set forth in the Plan's disclosure statement ($10.43 per share), to the average price paid by Onex for all of the shares it acquired in connection with the Plan ($11.91 per share). The options granted to other members of management have exercise prices ranging from the price paid in the Onex Investment ($12.39 per share) to the price that is 85 percent of the average closing price of the common stock over the first 20 trading days ($23.52 per share).

        The maximum number of shares of Ordinary Common Stock that may be granted or measured to any individual participant under the MIP in any one calendar year may not exceed 2,000,000. The MIP allows the Compensation Committee flexibility in developing appropriate long-term incentive strategies to retain the Company's key executive officers. The Compensation Committee is authorized, subject to the provisions of the MIP, to make and administer grants under the MIP, and to establish such rules as it deems necessary for the proper administration of the MIP.

        Executive Benefits Plan.    The Magellan Health Services, Inc. Supplemental Accumulation Plan (the "SAP"), was approved by the Compensation Committee for plan year 2000. The SAP, a calendar year based plan, is funded through a fixed component that has been structured to provide an incentive for executive officers to remain with the Company. It may also be funded by the executive officers through voluntary deferrals of base and/or incentive compensation. Annually, the Compensation Committee approves the fixed percentage contribution for the Executive Officers. For calendar 2003, the Chief Executive Officer and other executive officers were each eligible for a Company contribution of 11 percent of base salary. Both Company and voluntary contributions are paid to a trust and invested in one or more mutual funds selected by the respective executive officer.

        The fixed percentage amount contributed to the trust and any appreciation thereon is paid to the executive officer on a date at least two years from the date of funding, if such officer is still employed at that time, or two years following the date of termination from the Company, provided that the executive officer has complied with covenants not to compete with the Company during that time period and the termination was not "for cause".

        The terms of the SAP provide that the amounts deposited in the trust on behalf of executive officers are to be immediately and fully vested upon a change of control of the Company (as defined in the SAP document).

        Key Employee Retention Plan.    Subsequent to the Commencement Date, the Board of Directors adopted and the Bankruptcy Court approved the Key Employee Retention Plan ("KERP"). The purpose of KERP is to provide supplemental compensation to certain employees, including certain executive members of management, in order to retain such employees through the Company's financial restructuring process. KERP does not include individuals retained by the Company pursuant to the consulting agreement with HPI. KERP supplemental compensation awards range up to 50.0 percent of base salary and were paid 33 percent on July 31, 2003, and the remainder on February 19, 2004, 45 days after consummation of the plan of reorganization.

Certain Compensation Expenses

        Based on the terms established for certain of the stock and option compensation arrangements provided for members of management under the Plan and implemented on the Effective Date and shortly thereafter, as described above, the related compensation expense will be charged against the Company's income periodically over subsequent periods as described in Note 8—"Stockholders Equity—Stock Option Plans" to the accompanying audited consolidated financial statements set forth elsewhere herein.

85


Compensation Committee Interlocks and Insider Participation

        During fiscal 2003, the Compensation Committee was comprised of former Board members, Gerald L. McManis and James B. Williams, each a non-employee director. Mr. Williams was affiliated with the Texas Pacific Group, which previously engaged in certain transactions with the Company. Neither Mr. McManis nor Mr. Williams engaged in related party transactions with the Company.

        The new Compensation Committee, effective as of the Effective Date and as of the date hereof, consists of Messrs. Burian, Diament and Haft, each a non-employee director. Mr. Burian and Mr. Haft are affiliated with entities that have engaged in certain transactions with the Company or the Company's affiliates. Mr. Diament has not engaged in related party transactions with the Company or its affiliates.

        None of the Company's executive officers serves as a member of a board of directors or compensation committee of any entity that has one or more executive officers who serves on the Company's Board or on the Compensation Committee.


Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters

Security Ownership of Management

        Information with respect to securities authorized for issuance under equity compensation plans is provided in Item 5 of Part I of this Form 10-K, and is incorporated herein by reference.

        The following table sets forth information concerning the beneficial ownership of Ordinary Common Stock by: (i) directors, (ii) Named Executive Officers and (iii) directors and executive officers as a group, as of March 4, 2004.

Name of Beneficial Owner

  Amount and Nature
of Beneficial
Ownership (1) (2)

  Percent of
Class (3)

 
Steve Shulman (4)   167,926   *  
René Lerer, M.D. (5)   50,378   *  
Robert M. LeBlanc (6)   5,166   *  
Mark L. Hilson (6)   4,583   *  
Saul E. Burian (7)   2,719   *  
Michael Diament (7)   2,719   *  
Michael P. Ressner (7)   2,719   *  
William J. McBride (7)   2,719   *  
Robert Haft (8)   85,573   *  
Mark Demilio (9)   33,617   *  
Henry Harbin (10)   206   *  
Megan Arthur (11)   6   *  
All directors and executive officers as a group (14 persons) (12)   358,395   1.3 %

*
Less than 1.0 percent of total outstanding.

(1)
Unless otherwise indicated in the footnotes to this table and subject to community property laws where applicable, the Company believes that each of the stockholders named in this table has sole voting and investment power with respect to the shares indicated as beneficially owned. This table is based upon information supplied by the directors and executive officers.

(2)
Shares shown as beneficially owned do not include any stock options, as no options held by such individuals are exercisable within 60 days of March 4, 2004.

86


(3)
Based on an aggregate of 26,900,268 shares of Ordinary Common Stock issued and outstanding as of March 4, 2004 plus, in determining percentage ownership, shares that are considered to be beneficially owned as a result of the ability to exercise warrants and in respect of the conversion of shares of Multi-Vote Common Stock into Ordinary Common Stock by the individuals involved.

(4)
Represents 83,963 shares of restricted stock granted to Mr. Shulman under the MIP, and an additional 83,963 shares purchased by Mr. Shulman, as stipulated in his employment agreement.

(5)
Represents restricted stock granted to Dr. Lerer under the MIP, as stipulated in his employment agreement.

(6)
Represents the shares of Ordinary Common Stock considered beneficially owned by reason of a pecuniary interest held by Messrs. Hilson and LeBlanc in shares of Multi-Vote Common Stock owned by Onex. Excludes shares of Multi-Vote Common Stock beneficially owned by Onex, of which Messrs. Hilson and LeBlanc may be considered beneficial owners by virtue of their positions as executives of Onex. See below.

(7)
Represents shares granted to directors whom are neither employees of the Company nor affiliated with Onex as additional compensation for their services on behalf of the Company.

(8)
Robert Haft is the Principal Manager of Morgan Noble LLC, which acquired 82,854 shares of Multi-Vote Common Stock from Magellan Holdings LP ("Holdings") in January 2004. The Multi-Vote Common Stock automatically converted to Ordinary Common Stock upon the sale. Mr. Haft maintains a 95 percent economic interest in Morgan Noble LLC, and his spouse has an economic interest in the remaining 5 percent of Morgan Noble LLC. As Principal Manager, Mr. Haft maintains voting and dispositive power with respect to these shares.

(9)
Represents 33,585 shares of restricted stock granted to Mr. Demilio under the MIP, as stipulated in his employment agreement, plus 32 shares acquired as part of the Plan in respect of shares of pre-petition common stock converted into Ordinary Common Stock, plus 32 additional shares which Mr. Demilio has the right to purchase pursuant to the warrants he received under the Plan in respect of shares of pre-petition common stock. The shares subject to such warrants were added to the issued and outstanding shares as of March 4, 2004 in order to determine the percentage of the class beneficially owned by Mr. Demilio.

(10)
Although a Named Executive Officer in 2003, as of the Effective Date, Dr. Harbin was replaced as Chairman of the Board of Directors. On the Effective Date, the shares of the Company's previously authorized common stock owned by Dr. Harbin were converted in accordance with the Plan into 103 shares of Ordinary Common Stock and warrants to purchase another 103 shares of Ordinary Common Stock. The shares subject to the warrants were added to the issued and outstanding shares as of March 4, 2004 in order to determine the percentage of the class beneficially owned by Dr. Harbin.

(11)
Represents shares and a like number of warrants for shares acquired as part of the Plan in respect of shares of pre-petition common stock converted into three shares of Ordinary Common Stock. The shares subject to the warrants were added to the issued and outstanding shares as of March 4, 2004 in order to determine the percentage of the class beneficially owned by Ms. Arthur.

(12)
Includes the shares listed above plus 16 shares and a like number of warrants for shares acquired by an officer as part of the Plan in respect of pre-petition common stock. The shares subject to the warrants and the shares of Ordinary Common Stock convertible into the shares of Multi-Vote Common Stock were added to the issued and outstanding shares as of March 4, 2004 in order to determine the percentage of the class beneficially owned by such directors and officers as a group.

87


        The following table sets forth information concerning the beneficial ownership of Multi-Vote Common Stock by: (i) directors, (ii) Named Executive Officers and (iii) directors and executive officers as a group, as of March 4, 2004.

Name of Beneficial Owner

  Amount and Nature
of Beneficial
Ownership (1) (2)

  Percent of
Class (3)

Steve Shulman    
René Lerer, M.D.    
Robert M. LeBlanc (4)   5,166   *
Mark L. Hilson (4)   4,583   *
Saul E. Burian    
Michael Diament    
Michael P. Ressner    
William J. McBride    
Robert Haft    
Mark Demilio    
Henry Harbin    
Megan Arthur    
All directors and executive officers as a group (14 persons)   9,749   *

*
Less than 1.0 percent of total outstanding.

(1)
Unless otherwise indicated in the footnotes to this table and subject to community property laws where applicable, the Company believes that each of the stockholders named in this table has sole voting and investment power with respect to the shares indicated as beneficially owned. This table is based upon information supplied by the directors and executive officers.

(2)
No options to purchase Multi-Vote Common Stock have been granted.

(3)
Based on an aggregate of 8,469,846 shares of Multi-Vote Common Stock issued and outstanding as of March 4, 2004.

(4)
Represents the shares of Multi-Vote Common Stock considered beneficially owned by reason of a pecuniary interest held by Messrs. Hilson and LeBlanc in shares of Multi-Vote Common Stock owned by Onex. Excludes additional shares of Multi-Vote Common Stock beneficially owned by Onex, of which Messrs. Hilson and LeBlanc are executives. See below.

88


Security Ownership of Certain Beneficial Owners

        The following table sets forth certain information as of March 4, 2004 (except as otherwise noted) with respect to any person known by the Company to be the beneficial owner of more than 5.0 percent of the outstanding Ordinary Common Stock or the Multi-Vote Common Stock:

Title of Class

  Name of Beneficial Owner
  Amount and Nature
of Beneficial
Ownership (1)

  Percent of
Class (1)


Multi-Vote Common Stock

 

Magellan Holdings LP
712 Fifth Avenue
New York, NY 10019

 

8,469,846

 

100.0%

Ordinary Common Stock

 

Magellan Holdings LP (2)
712 Fifth Avenue
New York, NY 10019

 

8,469,846

 

23.9%

Ordinary Common Stock

 

Amalgamated Gadget LP (3)
301 Commerce Street
Suite 2975
Fort Worth, TX 76102

 

2,459,431

 

9.1%

Ordinary Common Stock

 

Paul Tudor Jones (4)
c/o Tudor Investment Corporation
1275 King Street
Greenwich, CT 06831

 

2,457,283

 

9.1%

Ordinary Common Stock

 

Third Point Management Co LLC (5)
360 Madison Avenue
24th Floor
New York, NY 10017

 

2,047,443

 

7.6%

(1)
The information regarding the beneficial ownership of Common Stock by such individual or entity is included herein in reliance on its report filed with the United States Securities and Exchange Commission (the "SEC"), except that the percentage of Common Stock beneficially owned is based upon the Company's calculations made in reliance upon the number of shares of Common Stock reported to be beneficially owned by such person or entity in such report and 26,900,268 shares of Ordinary Common Stock and 8,469,846 shares of Multi-Vote Common Stock issued and outstanding as of March 4, 2004.

(2)
Based upon information set forth in a Schedule 13D filed with the SEC on January 16, 2004. Shares of Ordinary Common Stock are issuable upon conversion of shares of Multi-Vote Common Stock. Onex is the general partner of Onex Partners GP, Inc. ("Partners GP"), which is the general partner of Onex Partners GP LP ("Partners GP LP"), which is the general partner of Onex Partners LP ("Partners"), which is the general partner of Holdings. All of the shares beneficially owned by Holdings may be deemed beneficially owned by each of Partners, Partners GP LP, Partners GP and Onex. Mr. Gerald W. Schwartz is the Chairman of the Board, President and Chief Executive Officer of Onex. Mr. Schwartz, as with the entities above (collectively, the "Reporting Persons"), may be deemed a beneficial owner of the shares of the Ordinary Common Stock beneficially owned by the other Reporting Persons, but disclaims beneficial ownership of such shares. These converted shares were added to the amount of currently issued and outstanding Ordinary Common Stock noted above in (1) in order to determine the percent of class beneficially owned by Holdings. Holdings shares voting and dispositive power of all shares with the other Reporting Persons.

89


(3)
Based upon information set forth in a Schedule 13G filed with the SEC on January 8, 2004. Amalgamated Gadget LP has sole voting and dispositive power of all shares.

(4)
Based upon information set forth in a Schedule 13G filed with the SEC on January 12, 2004. Amount includes 181,003 shares owned directly by Tudor Proprietary Trading, LLC ("TPT"), 10,582 shares owned by The Altar Rock Fund LP ("Altar Rock"), 1,932,805 shares owned by The Raptor Global Portfolio, Ltd. ("Raptor Portfolio") and 332,893 shares owned by The Tudor BVI Global Portfolio, Ltd. ("BVI Portfolio"). Tudor Investment Corporation ("TIC") is the sole general partner of Altar Rock and provides investment advisory services to Raptor Portfolio and BVI Portfolio. As such, TIC may be deemed to beneficially own the shares of Ordinary Common Stock owned by each of Altar Rock, Raptor Portfolio and BVI Portfolio. TIC expressly disclaims such beneficial ownership. In addition, because Paul Tudor Jones is the controlling shareholder of TIC and the indirect controlling shareholder of TPT, Mr. Jones may be deemed to beneficially own the shares of Ordinary Common Stock deemed beneficially owned by TIC and TPT. Mr. Jones expressly disclaims such beneficial ownership.

(5)
Based upon information set forth in a Schedule 13D filed with the SEC on January 13, 2004. Third Point Management Company LLC shares voting and dispositive power of all shares with Daniel S. Loeb, the managing member of the management company.

        In accordance with a registration rights agreement dated as of January 5, 2004 that was entered into in connection with the consummation of the Plan (the "Registration Rights Agreement"), Holdings (and a permitted transferee) is entitled to have Magellan, subject to certain terms and conditions, register under the Securities Act for public sale the shares of Ordinary Common Stock it may acquire upon conversion of the shares of Multi-Vote Common Stock it owns. Such shares, when registered, may be sold in an underwritten public offering or from time to time in the NASDAQ trading market or by other means, as Holdings may elect, and as is provided in the applicable registration statement. In accordance with the Registration Rights Agreement, Magellan currently expects to register shares of Ordinary Common Stock for sale in the NASDAQ trading market by Holdings commencing in the Spring of 2004, permitting such sales, on the conditions permitted by the agreement, at such time, if ever, and in such amount, if any, as Holdings may choose from time to time. Based solely upon the information contained in Holding's Schedule 13D report dated January 15, 2004 referred to above, the Company has no reason to believe that Holdings (or any permitted transferee thereof) presently intends to so sell publicly any shares of Ordinary Common Stock pursuant to such contemplated registration statement (or otherwise), but Magellan has no control over the timing or amount of any shares that Holdings (or a permitted transferee thereof) may decide to sell.

Equity Compensation Plan Information

        The following table sets forth certain information as of March 4, 2004 with respect to the Management Incentive Plan.

Plan category

  Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights

  Weighted average
exercise price of
outstanding options,
warrants and rights

  Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
column (a))

Equity compensation plans approved by security holders   4,267,422   $ 12.83   2,106,267
Equity compensation plans not approved by security holders        
   
 
 
  Total   4,267,422   $ 12.83   2,106,267
   
 
 

90



Item 13. Certain Relationships and Related Transactions

        On December 4, 2002, the Company entered into a consulting agreement with Healthcare Partners, Inc. ("HPI"), a newly formed entity whose principals are Steven J. Shulman and René Lerer, M.D. (the "HPI Agreement"). Pursuant to the HPI Agreement, HPI, Mr. Shulman and Dr. Lerer, as well as Danna Mezin and Keith Kudla (the "Officers"), became part of the management of the Company, with Mr. Shulman becoming the chief executive officer of the Company. All of the Officers have devoted substantially all of their time to the management of the Company. For such services, the Company has paid to HPI, per the agreement, $250,000 per month for every month or portion thereof from December 2002 through the Effective Date and a bonus payment of $1.95 million based upon the achievement of certain targets under the agreement. This agreement terminated on the Effective Date, at which time Mr. Shulman and Dr. Lerer entered into employment agreements with the Company, as discussed above and Ms. Mezin and Mr. Kudla became employees of the Company.

        Robert M. LeBlanc and Mark L. Hilson are affiliated with Onex. Pursuant to the Plan, Magellan Holdings LP, an affiliate of Onex, purchased 8,552,700 shares of Multi-Vote Common Stock of the Company. In January 2004, Onex sold 82,854 of these shares to Morgan Noble LLC.

        Michael Diament is a Portfolio Manager and Director of Bankruptcies and Restructurings for Renegade Swish, LLC which, through various contractual agreements, provides investment management services to Amalgamated Gadget, LP, the investment manager for R2 Investments, LDC. On the Effective Date, Amalgamated Gadget, LP, for and on behalf of R2 Investments, LDC, acquired beneficial ownership of 3,198,106 shares of Ordinary Common Stock of the Company. On January 6, 2004, Amalgamated LP sold 738,675 shares, leaving it with beneficial ownership of 2,459,431 shares or approximately 9.1 percent of the total shares outstanding as of that date.

        Saul E. Burian is a Director in the New York office of Houlihan, Lokey, Howard & Zukin ("Houlihan"). Houlihan represented the Pre-Petition Unofficial Committee of the Company's Unsecured Noteholders and the Official Committee of Unsecured Creditors of the Company in connection with the Company's financial restructuring process. The Company estimates that the total compensation to be paid to Houlihan for services rendered to the Committees as financial advisor will be approximately $2.9 million in cash, 166,966 shares of Ordinary Common Stock, and $1.8 million of Series B Notes, subject to finalization when the recoveries under the Plan by general unsecured creditors are finalized. In addition, Mr. Burian, as a Director of Houlihan, received an economic interest in 4,000 shares Houlihan received pursuant to the Plan. Mr. Burian did not have record ownership, nor did he possess either investment or dispositive power over the shares; however, Mr. Burian did, as a Director of Houlihan, possess the economic risk and benefit of the ownership of these shares. Such shares were sold by Houlihan shortly following the consummation of the Plan.

        Robert Haft, a Director of the Company, is the Principal Manager of Morgan Noble LLC, which purchased 82,854 shares of Multi-Vote Common Stock from Magellan Holdings LP in January 2004 at $12.07 per share. The Multi-Vote Common stock immediately converted to Ordinary Common Stock upon the transfer of the shares.


Item 14. Principal Accountant Fees and Services

        On May 22, 2002, the Company determined to dismiss its independent auditors, Arthur Andersen LLP, and to engage Ernst & Young LLP to serve as its new independent auditors. The change in auditors became effective May 24, 2002. The determination was approved by Magellan's Audit Committee of the Board of Directors. All fees disclosed below relate to Ernst & Young LLP services.

91



Audit Fees

        Aggregate fees totaled $1,519,272, $1,076,291 million and $2,871,029 for services such as audits of the consolidated annual financial statements, review of interim consolidated financial statements and audits of various subsidiaries, contracts and joint ventures due to regulatory requirements relating to the fiscal year ended September 30, 2002, the three months ended December 31, 2002 and the year ended December 31, 2003, respectively.

Audit-Related Fees

        Aggregate fees totaled $191,824, $9,500 and $817,933 for audit-related services during the fiscal year ended September 30, 2002, the three months ended December 31, 2002 and the year ended December 31, 2003, respectively. Audit-related services included benefit plan audits, and assurance and advisory services including assistance with internal control documentation related to Section 404 of the Sarbanes-Oxley Act of 2002 and assistance with a proposed debt offering in the fiscal year ended September 30, 2002.

Tax Fees

        Aggregate fees totaled $0, $62,080 and $469,413 for tax compliance, tax advice and tax planning services during the fiscal year ended September 30, 2002, the three months ended December 31, 2002 and the year ended December 31, 2003, respectively. Such services included federal and state and local tax advisory services.

All Other Fees

        Aggregate fees totaled $0, $30,854 and $233,256 for certain services provided in connection with the Company's financial restructuring under chapter 11 of the U.S. Bankruptcy Code, and for unclaimed property advisory services during the fiscal year ended September 30, 2002, the three months ended December 31, 2002 and the year ended December 31, 2003, respectively.

        The Company's Audit Committee pre-approves all services provided by Ernst & Young LLP. The Company has been advised by Ernst & Young LLP that substantially all of the work done in conjunction with the audit of the Company's financial statements for the year ended December 31, 2003, was performed by permanent full time employees and partners of Ernst & Young LLP.

92



PART IV

Item 15. Exhibits, Financial Statement Schedule and Reports on Form 8-K

1.     Financial Statements

        Information with respect to this item is contained on Pages F-1 to F-68 of this Report on Form 10-K.

2.     Financial Statement Schedule

        Information with respect to this item is contained on page S-1 of this Report on Form 10-K.

3.     Exhibits

Exhibit No.

  Description of Exhibit
2.1   Master Service Agreement, dated August 5, 1997, between the Company, Aetna U.S. Healthcare, Inc. and Human Affairs International, Incorporated, which was filed as Exhibit 2(b) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference.
2.2   First Amendment to Master Services Agreement, dated December 4, 1997, between the Company, Aetna U.S. Healthcare, Inc. and Human Affairs International, Incorporated, which was filed as Exhibit 2(d) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference.
2.3   Asset Purchase Agreement, dated October 16, 1997, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D. and Lawrence Schimmel, M.D., which was filed as Exhibit 2(e) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference.
2.4   First Amendment to Asset Purchase Agreement, dated December 5, 1997, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence Schimmel, M.D., which was filed as Exhibit 2(f) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference.
2.5   Second Amendment to Asset Purchase Agreement, dated November 18, 1998, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence Schimmel, M.D., which was filed as Exhibit 2(m) to the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 1998, and is incorporated herein by reference.
2.6   Third Amendment to Asset Purchase agreement, dated December 31, 1998, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D.; and Lawrence Schimmel, M.D., which was filed as Exhibit 2(b) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1998, and is incorporated herein by reference.
     

93


2.7   Agreement and Plan of Merger, dated October 24, 1997, among the Company; Merit Behavioral Care Corporation; and MBC Merger Corporation, which was filed as Exhibit 2(g) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference.
2.8   Share Purchase Agreement, dated April 2, 1999, by and among the Company; Charter Medical International; S.A., Inc. (a wholly owned subsidiary of the Company); Investment AB Bure; and CMEL Holding Limited (a wholly owned subsidiary of Investment AB Bure), filed as Exhibit 2(a) to the Company's current report on Form 8-K, which was filed on April 12, 1999, and is incorporated herein by reference.
2.9   Stock Purchase Agreement, dated April 2, 1999, by and among the Company; Charter Medical International S.A., Inc. (a wholly owned subsidiary of the Company); Investment AB Bure; and Grodrunden 515 AB (a wholly owned subsidiary of Investment AB Bure), filed as Exhibit 2(b) to the Company's current report on Form 8-K, which was filed on April 12, 1999, and is incorporated herein by reference.
2.10   First Amendment to Share Purchase Agreement, dated April 8, 1999, by and among the Company; Charter Medical International S.A., Inc. (a wholly owned subsidiary of the Company); Investment AB Bure; and CMEL Holding Limited (a wholly owned subsidiary of Investment AB Bure), filed as Exhibit 2(c) to the Company's current report on Form 8-K, which was filed on April 12, 1999, and is incorporated herein by reference.
2.11   First Amendment to Stock Purchase Agreement, dated April 8, 1999, among the Company; Charter Medical International S.A., Inc. (a wholly owned subsidiary of the Company); Investment AB Bure; and CMEL Holding Limited (a wholly owned subsidiary of Investment AB Bure), filed as Exhibit 2(d) to the Company's current report on Form 8-K, which was filed on April 12, 1999, and is incorporated herein by reference.
2.12   Letter Agreement dated August 10, 1999 by and among the Company; Charter Behavioral Health Systems, LLC; Crescent Real Estate Equities Limited Partnership; and Crescent Operating, Inc., which was filed as Exhibit 2(a) to the Company's current report on Form 8-K, which was filed on September 24, 1999, and is incorporated herein by reference.
2.13   Debtors' Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code, which was filed as Exhibit 2.1 to the Company's current report on Form 8-K, which was filed on March 12, 2003, and is incorporated herein by reference.
2.14   Second Amendment to the Aetna Master Services Agreement, dated as of March 11, 2003 which was filed as Exhibit 10.1 to the Company's current report on Form 8-K, which was filed on March 12, 2003, and is incorporated herein by reference.
2.15   Debtors' First Amended Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code, which was filed as Exhibit 99.1 to the Company's current report on Form 8-K, which was filed on March 27, 2003, and is incorporated herein by reference.
2.16   Disclosure Statement for the Debtors' First Amended Joint Plan of Reorganization, which was filed as Exhibit 99.2 to the Company's current report on Form 8-K, which was filed on March 27, 2003, and is incorporated herein by reference.
2.17   Debtors' Second Amended Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code, which was filed as Exhibit 99.1 to the Company's current report on Form 8-K, which was filed on July 29, 2003, and is incorporated herein by reference.
2.18   Disclosure Statement for the Debtors' Second Amended Joint Plan of Reorganization, which was filed as Exhibit 99.2 to the Company's current report on Form 8-K, which was filed on July 29, 2003, and is incorporated herein by reference.
2.19   Debtors' Third Amended Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code, which was filed as Exhibit 2(a) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003, and is incorporated herein by reference.
     

94


2.20   Disclosure Statement for the Debtors' Third Amended Joint Plan of Reorganization, which was filed as Exhibit 2(b) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003, and is incorporated herein by reference.
2.21   Modifications to Debtors' Third Amended Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code, dated September 25, 2003, which was filed as Exhibit 99.2 to the Company's current report on Form 8-K, which was filed September 30, 2003, and is incorporated herein by reference.
2.22   Modifications to Debtors' Third Amended Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code, dated October 8, 2003, which was filed as Exhibit 2.3 to the Company's current report on Form 8-K, which was filed October 9, 2003, and is incorporated herein by reference.
2.23   Confirmation of Debtors' Third Amended Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code, as Modified, which was filed as Exhibit 2.4 to the Company's current report on Form 8-K, which was filed October 9, 2003, and is incorporated herein by reference.
2.24   Third Amendment to the Aetna Master Services Agreement, dated as of January 5, 2004 which was filed as Exhibit 2.7 to the Company's current report on Form 8-K, which was filed on January 6, 2004, and is incorporated herein by reference.
2.25   Stock Purchase Agreement, dated December 18, 2003, among the Company and Magellan Holdings LP, which was filed as Exhibit 2.4 to the Company's current report on Form 8-K/A, which was filed on January 7, 2004, and is incorporated herein by reference.
3.1   Certificate of Ownership and Merger merging Magellan Health Services, Inc. (a Delaware corporation) into Charter Medical Corporation (a Delaware corporation), as filed in Delaware on December 21, 1995, which was filed as Exhibit 3(c) to the Company's Annual Report on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference.
#3.2   Amended and Restated Certificate of Incorporation of the Company.
3.3   Bylaws of the Company, as in effect on January 5, 2004, which were filed as Exhibit 2.10 to the Company's current report on Form 8-K, which was filed on January 6, 2004, and is incorporated herein by reference.
4.1   Credit Agreement, dated January 5, 2004, among the Company, various lenders listed therein and Deutsche Bank AG, New York Branch, as administrative agent, which was filed as Exhibit 2.2 to the Company's current report on Form 8-K, which was filed January 6, 2004, and is incorporated herein by reference.
4.2   Indenture, dated as of January 5, 2004, between the Company and HSBC Bank USA, as trustee, relating to the 93/8% Series A Senior Notes due 2008 and the 93/8% Series B Senior Notes due 2008 of the Company, which was filed as Exhibit 2.3 to the Company's current report on Form 8-K, which was filed January 6, 2004 and is incorporated herein by reference.
4.3   Warrant Agreement, dated as of January 5, 2004, between the Company and Wachovia Bank, National Association, as Warrant Agent, which was filed as Exhibit 2.5 to the Company's current report on Form 8-K, which was filed January 6, 2004, and is incorporated herein by reference.
4.4   Amendment No. 1 to the Warrant Agreement, dated as of January 7, 2004, between the Company and Wachovia Bank, National Association, as Warrant Agent, which was filed as Exhibit 10.1 to the Company's current report on Form 8-K, which was filed January 7, 2004, and is incorporated herein by reference.
     

95


4.5   Amended and Restated Warrant Agreement, dated as of January 5, 2004, between the Company and Wachovia Bank, National Association, as Warrant Agent, which was filed as Exhibit 10.2 to the Company's current report on Form 8-K, which was filed January 7, 2004, and is incorporated herein by reference.
4.6   New Aetna Note, dated as of January 5, 2004, issued by the Company to Aetna, Inc., with a final maturity date of December 31, 2005, which was filed as Exhibit 2.6 to the Company's current report on Form 8-K/A, which was filed January 7, 2004, and is incorporated herein by reference.
4.7   New Aetna Warrant to purchase 1.0% of the common stock of the Company, exerciseable on or after January 1, 2006, dated as of January 5, 2004, which was filed as Exhibit 2.8 to the Company's current report on Form 8-K, which was filed January 6, 2004, and is incorporated herein by reference.
4.8   Registration Rights Agreement, dated as of January 5, 2004, between the Company and Magellan Holdings LP and Aetna, Inc., filed as Exhibit 2.15 to the Company's current report on Form 8-K, which was filed on January 6, 2004, and is incorporated herein by reference.
*10.1   Employment Agreement, dated February 11, 1999, between the Company and Clarissa C. Marques, Ph.D., Executive Vice President of the Company, which was filed as Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999, and is incorporated herein by reference.
10.2   Agreement and Plan of Merger by and among Merit Behavioral Care Corporation; Merit Merger Corp.; and CMG Health, Inc. dated as of July 14, 1997, which was filed as Exhibit 10(ah) to the Company's Annual Report on Form 10-K for the year ended September 30, 1998, and is incorporated herein by reference.
10.3   Stock Purchase Agreement, dated as of January 28, 2000, by and among Magellan Health Services, Inc.; Allied Specialty Care Services, Inc.; and Vivra Holdings, Inc., which was filed as Exhibit 2 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2000, and is incorporated herein by reference.
10.4   Share Purchase Agreement, dated December 4, 2000 among Green Spring Health Services of Canada Co.; Green Spring Canadian Holding, Inc.; Green Spring Health Services, Inc.; and Family Guidance Group, Inc., which was filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2000 and is hereby incorporated herein by reference.
10.5   Stock Purchase Agreement, dated as of January 15, 2001, by and among National Mentor, Inc.; Magellan Public Network, Inc.; Magellan Health Services, Inc.; and National Mentor Holdings, Inc., which was filed as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2000 and is hereby incorporated herein by reference.
*10.6   Employment Agreement, dated April 15, 2002 between the Company and Jay J. Levin, Executive Vice President and Chief Operating Officer of the Company, which was filed as Exhibit 10(am) to the Company's Annual Report on Form 10-K for the year ended September 30, 2002, and is incorporated herein by reference.
*10.7   Engagement Letter, dated December 3, 2002, between and among the Company; Healthcare Partners, Inc.; Steven J. Shulman, Chief Executive Officer of the Company; and Dr. Rene Lerer, which was filed as Exhibit 10(au) to the Company's Annual Report on Form 10-K for the year ended September 30, 2002, and is incorporated herein by reference.
*10.8   Magellan Health Services, Inc. — Key Employee Retention Program for the year ended December 31, 2003, which was filed as Exhibit 10(aw) to the Company's Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002, which was filed August 12, 2003, and is incorporated herein by reference.
     

96


*10.9   Employment Agreement, dated January 5, 2004, between the Company and Steven J. Shulman, Chairman and Chief Executive Officer of the Company, which was filed as Exhibit 2.11 to the Company's current report on Form 8-K/A, which was filed January 7, 2004, and is incorporated herein by reference.
*10.10   Employment Agreement, dated January 5, 2004, between the Company and Dr. Rene Lerer, President and Chief Operating Officer of the Company, which was filed as Exhibit 2.12 to the Company's current report on Form 8-K/A, which was filed January 7, 2004, and is incorporated herein by reference.
*10.11   Employment Agreement, dated January 5, 2004, between the Company and Mark S. Demilio, Executive Vice President and Chief Financial Officer of the Company, which was filed as Exhibit 2.13 to the Company's current report on Form 8-K/A, which was filed January 7, 2004, and is incorporated herein by reference.
*10.12   Magellan Health Services, Inc. — 2003 Management Incentive Plan, effective as of January 5, 2004, which was filed as Exhibit 2.14 to the Company's current report on Form 8-K, which was filed January 6, 2004, and is incorporated herein by reference.
#*10.13   Employment Agreement, dated March 15, 2004, between the Company and Megan M. Arthur, Executive Vice President and General Counsel of the Company.
#*10.14   Magellan Health Services, Inc. — 2003 Short-Term Incentive Plan, effective as of March 26, 2004.
16   Letter regarding change in the Company's certifying accountant dated May 24, 2002, which was filed as Exhibit 16 to the Company's current report on Form 8-K, which was filed on May 24, 2002, and is incorporated herein by reference.
#21   List of subsidiaries of the Company.
#31.1   Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
#31.2   Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
.1 †32   Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
.2 †32   Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*
Constitutes a management contract or compensatory plan arrangement.

#
Filed herewith.

Furnished herewith.

97



Date of Report

  Item Reported and Description

  Financial
Statements
as Filed

October 2, 2003   The Company reported under Item 9 the filing of a monthly operating report for Magellan and its debtor-in-possession subsidiaries for the month of August 2003 with the United States Bankruptcy Court of the Southern District of New York   no
October 8, 2003   The Company reported under Item 3 the confirmation of the Third Joint Amended Plan of Reorganization, as modified, by order of the United States Bankruptcy Court of the Southern District of New York   no
November 12, 2003   The Company reported under Item 5 that it had received a new ticker symbol from the OTC Bulletin Board   no
November 21, 2003   The Company reported under Item 5 that one of its wholly-owned subsidiaries was the winning bidder on a new contract to provide behavioral health services   no
November 21, 2003   The Company reported under Item 9 the filing of a monthly operating report for Magellan and its debtor-in-possession subsidiaries for the month of September 2003 with the United States Bankruptcy Court of the Southern District of New York   no
December 5, 2003   The Company reported under Item 9 the filing of a monthly operating report for Magellan and its debtor-in-possession subsidiaries for the month of October 2003 with the United States Bankruptcy Court of the Southern District of New York   no

        Exhibits required to be filed by the Company pursuant to Item 601 of Regulation S-K are contained in a separate volume.

98



SIGNATURES

        Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.

  MAGELLAN HEALTH SERVICES, INC.
(Registrant)

Date: March 30, 2004

/s/  
MARK S. DEMILIO      
Mark S. Demilio
Executive Vice President and Chief Financial Officer

Date: March 30, 2004

/s/  
JEFFREY N. WEST      
Jeffrey N. West Senior Vice President and Controller

        Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the Registrant and in the capacities and on the dates indicated have signed this Report below.

Signature
  Title
  Date
/s/  STEVEN J. SHULMAN      
Steven J. Shulman
  Chief Executive Officer and Chairman of the Board of Directors   March 30, 2004

/s/  SAUL E. BURIAN      
Saul E. Burian

 

Director

 

March 30, 2004

/s/  MICHAEL DIAMENT      
Michael Diament

 

Director

 

March 30, 2004

/s/  ROBERT HAFT      
Robert Haft

 

Director

 

March 30, 2004

/s/  MARK L. HILSON      
Mark L. Hilson

 

Director

 

March 30, 2004

/s/  ROBERT M. LE BLANC      
Robert M. Le Blanc

 

Director

 

March 30, 2004

/s/  RENE LERER      
Rene Lerer

 

Chief Operating Officer and Director

 

March 30, 2004
         

99



/s/  WILLIAM J. MCBRIDE      
William J. McBride

 

Director

 

March 30, 2004

/s/  MICHAEL P. RESSNER      
Michael P. Ressner

 

Director

 

March 30, 2004

100



MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS

        The following consolidated financial statements of the registrant and its subsidiaries are submitted herewith in response to Item 8 and Item 15(a)1:

 
Magellan Health Services, Inc.
  Audited Consolidated Financial Statements
    Reports of independent auditors
    Consolidated balance sheets as of December 31, 2002 and 2003 for the Predecessor Company and the Reorganized Company, respectively
    Consolidated statements of operations for the Predecessor Company for the fiscal years ended December 31, 2003, September 30, 2002 and 2001 and the three-month transition period ended December 31, 2002
    Consolidated statements of changes in stockholders' equity (deficit) for the Company for the fiscal years ended December 31, 2003, September 30, 2002 and 2001, and the three-month transition period ended December 31, 2002
    Consolidated statements of cash flows for the Predecessor Company for the fiscal years ended December 31, 2003, September 30, 2002 and 2001 and the three-month transition period ended December 31, 2002
    Notes to consolidated financial statements

        The following financial statement schedule of the registrant and its subsidiaries is submitted herewith in response to Item 15(a)2:

  Schedule II — Valuation and qualifying accounts   S-1

        All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.

F-1



REPORT OF INDEPENDENT AUDITORS

Board of Directors
Magellan Health Services, Inc.

        We have audited the accompanying consolidated balance sheet of Predecessor Magellan Health Services, Inc. and subsidiaries ("Predecessor Company") as of December 31, 2002, the accompanying consolidated balance sheet of Reorganized Magellan Health Services, Inc. and subsidiaries ("Reorganized Company") as of December 31, 2003, and the related consolidated statements of operations, stockholders' equity and cash flows of Predecessor Company for the year ended September 30, 2002, the three months ended December 31, 2002 and the year ended December 31, 2003. Our audits also included the financial statement schedule of Magellan Health Services, Inc. ("Magellan") for the year ended September 30, 2002, the three months ended December 31, 2002 and the year ended December 31, 2003 listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of Magellan's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. The consolidated financial statements and schedule of Predecessor Company for the year ended September 30, 2001 were audited by other auditors, who have ceased operations, and whose report dated December 6, 2001 (except with respect to the matters discussed in Note 14, as to which the date was December 27, 2001) expressed an unqualified opinion on those statements before the restatement adjustments described in Note 3 and Note 16.

        We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 Predecessor Company at December 31, 2002, the consolidated financial position of Reorganized Company at December 31, 2003, and the consolidated results of Predecessor Company's operations and its cash flows for the year ended September 30, 2002, the three months ended December 31, 2002 and the year ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule for the year ended September 30, 2002, the three months ended December 31, 2002 and the year ended December 31, 2003, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

        As discussed in Note 3 to the consolidated financial statements, effective October 1, 2001, Predecessor Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS No. 142"), which resulted in Predecessor Company changing the method in which it accounts for goodwill.

        As discussed in Note 1 to the consolidated financial statements, effective December 29, 2003, Magellan received final clearance of significant contingencies related to the implementation of its plan of reorganization, which had been confirmed on October 8, 2003 by the United States Bankruptcy Court for the Southern District of New York. Magellan officially emerged from bankruptcy as of January 5, 2004. In connection with its reorganization, Magellan applied fresh start reporting as of December 31, 2003. As more fully discussed in Note 2, the accompanying consolidated balance sheet of Reorganized Company as of December 31, 2003, reflects the adjustments required under fresh start

F-2



reporting. As a result, the December 31, 2003 balance sheet of Reorganized Company is presented on a basis different from that of Predecessor Company and, therefore, is not comparable to prior periods.

        As discussed in Note 3 to the consolidated financial statements, in connection with the application of fresh start reporting as of December 31, 2003, Reorganized Company early adopted Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51, which requires consolidation of certain variable interest entities.

        As discussed above, the consolidated financial statements of Predecessor Company as of September 30, 2001, and for the year then ended were audited by other auditors who have ceased operations. As described in Note 3, these financial statements have been revised to include the transitional disclosures required by SFAS No. 142, which was adopted by Predecessor Company as of October 1, 2001. Our audit procedures with respect to the disclosures in Note 3 with respect to 2001 included (a) agreeing the previously reported net income to the previously issued financial statements and the adjustments to reported net income representing amortization expense (including any related tax effects) recognized in those periods related to goodwill that is no longer being amortized to Predecessor Company's underlying records obtained from management, and (b) testing the mathematical accuracy of the reconciliation of adjusted net income to reported net income, and the related earnings-per-share amounts. In our opinion, the disclosures for 2001 in Note 3 are appropriate. However, we were not engaged to audit, review, or apply any procedures to the 2001 consolidated financial statements of Predecessor Company other than with respect to such disclosures and, accordingly, we do not express an opinion or any other form of assurance on the 2001 consolidated financial statements taken as a whole.

        As discussed above, the consolidated financial statements of Predecessor Company as of September 30, 2001, and for the year then ended were audited by other auditors who have ceased operations. As described in Note 16, Predecessor Company changed the composition of its reportable segments in 2003, and the amounts in the 2001 consolidated financial statements relating to reportable segments have been restated to conform to the 2003 composition of reportable segments. We audited the adjustments that were applied to restate the disclosures for reportable segments reflected in the 2001 consolidated financial statements. Our procedures included (a) agreeing the adjusted amounts of segment revenues, segment profit and assets to Predecessor Company's underlying records obtained from management, and (b) testing the mathematical accuracy of the reconciliations of segment amounts to the consolidated financial statements. In our opinion, such adjustments are appropriate and have been properly applied. However, we were not engaged to audit, review, or apply any procedures to the 2001 consolidated financial statements of Predecessor Company other than with respect to such adjustments and, accordingly, we do not express an opinion or any other form of assurance on the 2001 consolidated financial statements taken as a whole.

/s/ Ernst & Young LLP
Baltimore, Maryland
March 19, 2004

F-3


        The following report is a copy of a report previously issued by Arthur Andersen LLP ("Andersen"), which report has not been reissued by Andersen. Certain financial information for the year ended September 30, 2001 was not reviewed by Andersen and includes: (i) reclassifications to conform to the Company's September 30, 2002, December 31, 2002 and December 31, 2003 financial statement presentation and (ii) additional disclosures to conform with new accounting pronouncements and SEC rules and regulations issued during such fiscal periods. The Andersen report reflected below is dual dated with a reference to Note 14 from the fiscal 2001 Annual Report on Form 10-K. See Item 1—"Business—Cautionary Statements" for discussion of risks.


REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors of Magellan Health Services, Inc.:

        We have audited the accompanying consolidated balance sheets of Magellan Health Services, Inc. (a Delaware corporation) and subsidiaries as of September 30, 2000 and 2001, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended September 30, 2001. These consolidated financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 financial position of Magellan Health Services, Inc. and subsidiaries as of September 30, 2000 and 2001 and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2001 in conformity with accounting principles generally accepted in the United States.

        Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule II is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.

/s/ Arthur Andersen LLP
Baltimore, Maryland
December 6, 2001,
Except with respect to the matters discussed in Note 14, as to which the date is
December 27, 2001

F-4



MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

 
  Predecessor
Company

  Reorganized
Company

 
  December 31,
2002

  December 31,
2003

ASSETS
Current Assets:            
Cash and cash equivalents   $ 62,488   $ 206,948
Stock subscriptions receivable         146,871
Accounts receivable, less allowance for doubtful accounts of $3,749 at December 31, 2002 (Predecessor Company) and $5,178 at December 31, 2003 (Reorganized Company)     81,228     83,919
Restricted cash, investments and deposits     127,318     161,923
Refundable income taxes     1,966    
Other current assets     13,131     30,562
   
 
        Total Current Assets     286,131     630,223

Property and equipment, net

 

 

85,659

 

 

122,082
Investments in unconsolidated subsidiaries     12,183     13,034
Other long-term assets     43,840     18,334
Goodwill     502,334     450,244
Other intangible assets, net     68,770     58,100
   
 
    $ 998,917   $ 1,292,017
   
 
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities:            
Accounts payable   $ 15,897   $ 23,355
Accrued liabilities     217,837     205,868
Medical claims payable     205,331     177,141
Current maturities of long-term debt (and debt in default in 2002)     1,038,934     24,785
Debt paid upon consummation of the Plan         92,382
   
 
        Total Current Liabilities     1,477,999     523,531
   
 
Long-term debt and capital lease obligations     9,224     376,532
   
 
Deferred credits and other long-term liabilities     2,290     1,802
   
 
Minority interest     683     2,241
   
 
Commitments and Contingencies            

Redeemable preferred stock

 

 

69,043

 

 

   
 
Stockholders' Equity (Deficit):            
  Predecessor Company Preferred stock, without par value            
    Authorized — 9,793 shares at December 31, 2002 — Issued and outstanding — none at December 31, 2002        
  Reorganized Company Preferred stock, par value $.01 per share            
    Authorized — 10,000 shares at December 31, 2003 — Issued and outstanding — none at December 31, 2003        
  Predecessor Company Common stock, par value $.25 per share            
    Authorized — 80,000 shares at December 31, 2002 — Issued — 37,428 shares at December 31, 2002 — Outstanding — 35,139 shares at December 31, 2002     9,356    
  Reorganized Company Ordinary common stock, par value $.01 per share            
    Authorized — 100,000 shares at December 31, 2003 — Issued and outstanding — 26,552 shares at December 31, 2003         265
  Reorganized Company Multi-Vote common stock, par value $.01 per share            
    Authorized — 40,000 shares at December 31, 2003 — Issued and outstanding — 8,553 shares at December 31, 2003         86
 
Other Stockholders' Equity (Deficit):

 

 

 

 

 

 
    Additional paid-in capital     352,718     379,067
    Accumulated deficit     (903,137 )  
    Warrants outstanding     25,050     8,493
    Predecessor Company Common stock in treasury, 2,289 shares at December 31, 2002     (44,309 )  
   
 
        Total Stockholders' Equity (Deficit)     (560,322 )   387,911
   
 
    $ 998,917   $ 1,292,017
   
 

        See accompanying notes.

F-5



MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)

 
  Predecessor Company
 
 
  Fiscal Year Ended
September 30,

  Fiscal Year
Ended
December 31,

  Three Months Ended
December 31,

 
 
  2001
  2002
  2003
  2001
  2002
 
 
   
   
   
  (unaudited)

   
 
Net revenue   $ 1,755,512   $ 1,753,058   $ 1,510,746   $ 444,842   $ 445,890  
   
 
 
 
 
 
Costs and expenses:                                
Salaries, cost of care and other operating expenses     1,557,042     1,585,314     1,324,886     395,093     391,433  
Equity in earnings of unconsolidated subsidiaries     (36,566 )   (13,006 )   (6,202 )   (3,177 )   (2,138 )
Depreciation and amortization     68,294     47,558     48,047     11,190     14,380  
Interest expense (Contractual interest of $106,328 in fiscal 2003)     110,423     97,596     61,016     23,719     25,333  
Interest income     (10,121 )   (5,365 )   (2,873 )   (1,310 )   (1,010 )
Reorganization benefit, net (See Note 2)             (438,217 )        
Goodwill impairment charges         415,880     28,780          
Special charges     3,340     15,729     9,528     4,485     3,907  
   
 
 
 
 
 
      1,692,412     2,143,706     1,024,965     430,000     431,905  
   
 
 
 
 
 
Income (loss) from continuing operations before income taxes and minority interest     63,100     (390,648 )   485,781     14,842     13,985  
Provision for income taxes     33,732     151,609     33,813     6,086     3,129  
   
 
 
 
 
 
Income (loss) from continuing operations before minority interest     29,368     (542,257 )   451,968     8,756     10,856  
Minority interest     78     47     253     16     27  
   
 
 
 
 
 
Income (loss) from continuing operations     29,290     (542,304 )   451,715     8,740     10,829  
   
 
 
 
 
 
Discontinued operations:                                
Income (loss) from discontinued operations (1)     4,624     4,894     (25,028 )   158     803  
Income (loss) on disposal of discontinued operations (2)     (9,359 )   (92 )   4,756     820     97  
Reorganization benefit, net (3) (See Note 2)             20,327          
   
 
 
 
 
 
      (4,735 )   4,802     55     978     900  
   
 
 
 
 
 
Income (loss) before cumulative effect of change in accounting principle     24,555     (537,502 )   451,770     9,718     11,729  
Cumulative effect of change in accounting principle, net of income tax benefit of $16,249 in fiscal 2002 (Note 3)         (191,561 )       (191,561 )    
   
 
 
 
 
 
Net income (loss)     24,555     (729,063 )   451,770     (181,843 )   11,729  
Preferred dividends (Contractual dividends of $4,788 for the fiscal year ended December 31, 2003)     4,527     4,657     883     1,075     1,243  
Amortization of redeemable preferred stock issuance costs, and other     522     540     172     143     136  
Preferred stock reorganization items, net             2,668          
   
 
 
 
 
 
Income (loss) available to common stockholders     19,506     (734,260 )   448,047     (183,061 )   10,350  
Other comprehensive loss     (68 )                
   
 
 
 
 
 
Comprehensive income (loss)   $ 19,438   $ (734,260 ) $ 448,047   $ (183,061 ) $ 10,350  
   
 
 
 
 
 
Weighted average number of common shares outstanding — basic     33,448     34,854     35,305     34,670     35,139  
   
 
 
 
 
 
Weighted average number of common shares outstanding — diluted     34,935     34,854     41,605     42,075     41,439  
   
 
 
 
 
 
Income (loss) per common share available to common stockholders — basic:                                
Income (loss) from continuing operations   $ 0.72   $ (15.71 ) $ 12.69   $ 0.22   $ 0.27  
   
 
 
 
 
 
Income (loss) from discontinued operations     (0.14 )   0.14         0.03     0.02  
   
 
 
 
 
 
Cumulative effect of change in accounting principle         (5.50 )       (5.53 )    
   
 
 
 
 
 
Net income (loss)   $ 0.58   $ (21.07 ) $ 12.69   $ (5.28 ) $ 0.29  
   
 
 
 
 
 
Income (loss) per common share available to common stockholders — diluted:                                
Income (loss) from continuing operations   $ 0.69   $ (15.71 ) $ 10.86   $ 0.21   $ 0.26  
   
 
 
 
 
 
Income (loss) from discontinued operations     (0.13 )   0.14         0.02     0.02  
   
 
 
 
 
 
Cumulative effect of change in accounting principle         (5.50 )       (4.55 )    
   
 
 
 
 
 
Net income (loss)   $ 0.56   $ (21.07 ) $ 10.86   $ (4.32 ) $ 0.28  
   
 
 
 
 
 

(1)
Net of income tax provision (benefit) of $2,921, $2,635 and $(1,341) for the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and $82 and $433 for the three months ended December 31, 2001 and 2002, respectively.

(2)
Net of income tax provision (benefit) of $10,781, $(49) and $1,347 for the fiscal years ended September 30, 2001 and 2002 and December 31, 2003, respectively, and $442 and $52 for the three months ended December 31, 2001 and 2002, respectively.

(3)
Net of income tax benefit of $(817) for the fiscal year ended December 31, 2003.

See accompanying notes.

F-6



MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)
(In thousands)

 
  Predecessor
Company
Common
Stock

  Reorganized
Company
Ordinary
common
stock

  Reorganized
Company
Multi-Vote
common
stock

  Additional
paid-in
capital

  Accumulated
Deficit

  Warrants
outstanding

  Predecessor
Company
Common
stock in
treasury

  Predecessor
Company
Cumulative
foreign currency
adjustments
included in other
comprehensive
income

  Total
Stockholders'
Equity (Deficit)

 
Predecessor Company:                                                        
  Balance at September 30, 2000   $ 8,733   $   $   $ 349,541   $ (210,358 ) $ 25,050   $ (44,309 ) $ (193 ) $ 128,464  
  Exercise of options and warrants     505             7,980                     8,485  
  Stock option expense                 636                     636  
  Tax benefit on exercise of stock options                 4,799                     4,799  
  Preferred dividend requirement and amortization of redeemable preferred stock issuance costs                 (5,049 )                   (5,049 )
  Net income (loss)                     24,555                 24,555  
  Other                 366                     366  
  Other comprehensive loss:                                                        
    Unrealized foreign currency translation loss                                 (113 )   (113 )
    Benefit from income taxes                                 45     45  
   
 
 
 
 
 
 
 
 
 
  Balance at September 30, 2001     9,238             358,273     (185,803 )   25,050     (44,309 )   (261 )   162,188  
  Exercise of options and warrants     118             1,185                     1,303  
  Preferred dividend requirement and amortization of redeemable preferred stock issuance costs                 (5,197 )                   (5,197 )
  Other                 (164 )                   (164 )
  Net income (loss)                     (729,063 )               (729,063 )
  Other comprehensive loss — other                                 261     261  
   
 
 
 
 
 
 
 
 
 
  Balance at September 30, 2002     9,356             354,097     (914,866 )   25,050     (44,309 )       (570,672 )
  Preferred dividend requirement and amortization of redeemable preferred stock issuance costs                 (1,379 )                   (1,379 )
  Net income (loss)                     11,729                 11,729  
   
 
 
 
 
 
 
 
 
 
  Balance at December 31, 2002     9,356             352,718     (903,137 )   25,050     (44,309 )       (560,322 )
  Employee stock purchase plan activity     45             (19 )                   26  
  Preferred dividend requirement and amortization of redeemable preferred stock issuance costs                 (1,055 )                   (1,055 )
  Preferred stock reorganization items                 (2,668 )                   (2,668 )
  Net income (loss), excluding reorganization adjustments gain                     (43,372 )               (43,372 )
   
 
 
 
 
 
 
 
 
 
  Subtotal     9,401             348,976     (946,509 )   25,050     (44,309 )       (607,391 )
Fresh Start Adjustments:                                                        
  Net reorganization fresh start gain (Note 2) — Predecessor Company                     495,142                 495,142  
  Other reorganization adjustments (Note 2) — Predecessor Company     (9,401 )           (348,976 )       (25,050 )   44,309         (339,118 )
  Accumulated deficit reorganization adjustments (Note 2)                     451,367                 451,367  
  Issuance of common stock and warrants under Plan of Reorganization — Reorganized Company         265     86     379,067         8,493             387,911  
   
 
 
 
 
 
 
 
 
 
  Balance at December 31, 2003,
Reorganized Company
  $   $ 265   $ 86   $ 379,067   $   $ 8,493   $   $   $ 387,911  
   
 
 
 
 
 
 
 
 
 

See accompanying notes.

F-7



MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

 
  Predecessor Company
 
 
  Fiscal Year Ended
   
  Three Months Ended
 
 
  Fiscal Year
Ended
December 31,
2003

 
 
  September 30,
2001

  September 30,
2002

  December 31,
2001

  December 31,
2002

 
 
   
   
   
  (unaudited)

   
 
Cash Flows From Operating Activities:                                
Net income (loss)   $ 24,555   $ (729,063 ) $ 451,770   $ (181,843 ) $ 11,729  
   
 
 
 
 
 
Adjustments to reconcile net income (loss) to net cash provided by operating activities:                                
(Gain) loss on sale of assets     1,918     (1,262 )   (4,460 )   (1,262 )    
Depreciation and amortization     70,277     47,558     48,047     11,190     14,380  
Goodwill impairment charges         415,880     28,780          
Cumulative effect of change in accounting principle         191,561         191,561      
Equity in earnings of unconsolidated subsidiaries     (36,566 )   (13,006 )   (6,202 )   (3,177 )   (2,138 )
Stock option expense     636                  
Non-cash fresh start reorganization gain             (495,142 )        
Other non-cash reorganization expense             6,902          
Other non-cash interest expense     11,718     5,424     4,662     1,231     1,642  
Cash flows from changes in assets and liabilities, net of effects from sales and acquisitions of businesses:                                
Accounts receivable, net     (6,881 )   3,156     11,650     (572 )   13,896  
Restricted cash, investments and deposits     (4,725 )   (2,291 )   (39 )   (8,861 )   (2,578 )
Net cash flows related to unconsolidated subsidiaries     38,353     10,685     (3,881 )   2,828     3,175  
Income taxes payable and deferred income taxes     45,042     153,731     1,966     6,760     129  
Other assets     2,754     4,980     (837 )   7,265     3,424  
Accounts payable and accrued liabilities     (37,739 )   (20,796 )   178,355     4,817     (19,257 )
Medical claims payable     (11,310 )   (2,088 )   (47,403 )   (6,988 )   3,568  
Other liabilities     (13,402 )   257     (450 )   (148 )   (21 )
Minority interest, net of dividends paid     130     78     352     26     42  
Other     926     1,856     4,223     1,228     10  
   
 
 
 
 
 
Total adjustments     61,131     795,723     (273,477 )   205,898     16,272  
   
 
 
 
 
 
  Net cash provided by operating activities     85,686     66,660     178,293     24,055     28,001  
   
 
 
 
 
 
Cash Flows From Investing Activities:                                
Capital expenditures     (34,709 )   (27,596 )   (29,773 )   (6,011 )   (8,421 )
Acquisitions and investments in businesses     (87,731 )   (63,731 )   (3,731 )        
Proceeds from sale of assets     110,551     3,500     2,588     3,500      
   
 
 
 
 
 
  Net cash used in investing activities     (11,889 )   (87,827 )   (30,916 )   (2,511 )   (8,421 )
   
 
 
 
 
 
Cash Flows From Financing Activities:                                
Payments on long-term debt and capital lease obligations     (458,221 )   (65,840 )   (3,018 )   (987 )   (1,196 )
Proceeds from issuance of long-term debt, net of issuance costs     356,648     105,000     76          
Credit agreement amendment fees and other         (1,499 )       (1,403 )   (1,909 )
Proceeds from exercise of stock options and warrants and employee stock purchase plan     8,485     1,303     25     48      
   
 
 
 
 
 
  Net cash provided by (used in) financing activities     (93,088 )   38,964     (2,917 )   (2,342 )   (3,105 )
   
 
 
 
 
 
Net increase (decrease) in cash and cash equivalents     (19,291 )   17,797     144,460     19,202     16,475  
Cash and cash equivalents at beginning of period     47,507     28,216     62,488     28,216     46,013  
   
 
 
 
 
 
Cash and cash equivalents at end of period   $ 28,216   $ 46,013   $ 206,948   $ 47,418   $ 62,488  
   
 
 
 
 
 

See accompanying notes.

F-8



MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2003
(All information pertaining to December 31, 2001 or the
three months ended December 31, 2001 is unaudited.)

1. General

Basis of Presentation

        The consolidated financial statements as of December 31, 2002 and for the years ended September 30, 2001, September 30, 2002 and December 31, 2003, and for the three months ended December 31, 2002 of Magellan Health Services, Inc., a Delaware corporation ("Magellan" or the "Company"), include the accounts of the Company and its majority owned subsidiaries. The consolidated financial statements as of December 31, 2003, also include all variable interest entities ("VIEs") for which the Company is the primary beneficiary. The Company's principal offices and operations are in the United States. All significant intercompany accounts and transactions have been eliminated in consolidation.

        As discussed further in Note 2—"Fresh Start Reporting," the Company applied the fresh start reporting provisions of American Institute of Certified Public Accountants ("AICPA") Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7") as of December 31, 2003. Accordingly, the consolidated balance sheets of the Company prior to December 31, 2003 are not comparable with the consolidated balance sheet as of December 31, 2003. Therefore, all balance sheet data as of December 31, 2003 has been disclosed herein as balances of the Reorganized Company, and all balance sheet data prior to December 31, 2003 has been disclosed as balances of the Predecessor Company. Statement of operations and statement of cash flows data for all periods presented herein represents the results of the Predecessor Company. Accordingly, all references to the Company with respect to disclosures of amounts recorded (i) through or prior to December 31, 2003 in relation to income statement or cash flow items; and (ii) prior to December 31, 2003 in relation to balance sheet items, relate to the Predecessor Company. All references to the Company with respect to disclosures of amounts recorded or to be recorded (i) after December 31, 2003 in relation to income statement or cash flow items; and (ii) on or after December 31, 2003 in relation to balance sheet items, relate to the Reorganized Company.

Change in Fiscal Year

        In May 2003, the Predecessor Company's board of directors approved a change in the Predecessor Company's fiscal year. Instead of a fiscal year ending on September 30, Magellan has adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. On August 12, 2003, the Predecessor Company filed with the Securities and Exchange Commission ("SEC") a Transition Report on Form 10-K for the three-month period ended December 31, 2002. As a result of this change, the audited consolidated statements of operations, changes in stockholders' equity and cash flows presented herein include the three-month transition period ended December 31, 2002 and each of the two previous fiscal years ended September 30, 2001 and 2002. The accompanying consolidated financial statements and notes to the consolidated financial statements also include comparative, unaudited financial information for the three months ended December 31, 2001. Throughout these financial statements, references to the Predecessor Company's historical financial information prior to December 31, 2002 will refer to the Predecessor Company's former fiscal year end of September 30. For example, fiscal years 2001 and 2002 correspond to the twelve-month periods ended September 30, 2001 and 2002, respectively. References to fiscal 2003 relate to the Predecessor Company's fiscal year ended December 31, 2003.

F-9



Emergence From Chapter 11

        On January 5, 2004 (the "Effective Date"), Magellan and 88 of its subsidiaries consummated their Third Joint Amended Plan of Reorganization, as modified and confirmed (the "Plan"), under chapter 11 of title 11 of the United States Bankruptcy Code (the "Bankruptcy Code"), which had been confirmed by order of the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") on October 8, 2003, and accordingly the Plan became fully effective and the companies emerged from the protection of their chapter 11 proceedings. Magellan and these subsidiaries had filed voluntary petitions for relief under the Bankruptcy Code in the Bankruptcy Court on March 11, 2003.

        The following is a summary of the transactions which became effective on the Effective Date pursuant to or in connection with the consummation of the Plan. The distributions to which the Company's former creditors and shareholders became entitled under the Plan were made by the Company on the Effective Date or were disbursed in accordance with the Plan soon thereafter, except for certain immaterial distributions that were subsequently made or will be made in the future as provided for by the Plan upon certain conditions being satisfied. This summary only highlights certain of the substantive provisions of the Plan and the documents implementing the Plan.

        Giving effect to the Plan, Magellan and its subsidiaries continued, in their previous organizational form, to conduct their business as previously conducted, with the same assets in all material respects (except for cash to be distributed under the Plan to former creditors of the Company), but the Company was recapitalized. Specifically, the Company's secured bank loans, as existing before the Effective Date, were paid in full, and other then existing indebtedness (i.e., two classes of notes and general unsecured creditor claims) and the then existing equity interests in Magellan were cancelled as of the Effective Date in exchange for the distributions provided for by the Plan, as further described below, all as of the Effective Date.

        On the Effective Date, the Company entered into a credit agreement with Deutsche Bank, as lender and administrative agent, and other lenders providing for a $100.0 million term loan, an $80.0 million letter of credit facility and a $50.0 million revolving credit facility (collectively, the "Credit Agreement"). The proceeds of the term loan, together with other existing funds, were used on the Effective Date to repay in full the Company's senior secured bank indebtedness under its previous credit agreement (the "Old Credit Agreement") of approximately $161 million, to make other cash payments contemplated by the Plan, to pay fees and expenses related to the chapter 11 cases, and for general working capital purposes. In addition, the letter of credit facility has been utilized to back letters of credit outstanding on the Effective Date and to provide additional letters of credit when needed for the Company's business. For a further discussion of the Credit Agreement, see Note 7—"Long-Term Debt and Capital Lease Obligations".

        As of the Effective Date, in satisfaction of the $250 million of principal owed on the 9.375% senior notes due 2007 (the "Old Senior Notes") and all accrued and unpaid interest thereon, the Company issued to the holders of such notes approximately $233.5 million in original principal amount of Series A notes of a new issue of senior notes due November 15, 2008 (the "Series A Notes", together with the Series B Notes (see below), the "Senior Notes") and made a cash payment of

F-10



approximately $46.1 million. The terms of the Senior Notes are substantially similar to those of the Old Senior Notes, except that they mature on November 15, 2008. For a further discussion of the Senior Notes, see Note 7—"Long-Term Debt and Capital Lease Obligations".

        Under the Plan, holders of the Company's previous 9% Senior Subordinated Notes due 2008 in the principal amount of $625.0 million (the "Old Subordinated Notes") and holders of general unsecured creditor claims (other than claims on the Old Senior Notes and Old Subordinated Notes) ("Other GUCs") were to receive in the aggregate approximately 97 percent of the Ordinary Common Stock (or approximately 22.3 million shares) of the reorganized Company (before giving effect to the Cash-Out Elections discussed below). The actual number of shares allocated between these two classes of creditors, as well as the number of shares allocated to each individual creditor in such creditor classes, is dependent upon the final, total aggregate value of claims for the two creditor classes, as discussed further below.

        As of the Effective Date, the Company estimated that the holders of the Old Subordinated Notes would receive in satisfaction of their claims (including all accrued and unpaid interest), approximately 20.5 million shares of Ordinary Common Stock of Magellan (before giving effect to the Cash-Out Elections discussed below). Accordingly, the Company distributed, as of the Effective Date, approximately 32.83 shares per $1,000 of principal amount of such notes (although no fractional shares or cash in lieu thereof were issued or paid). The share distribution amount is subject to adjustment as set forth below.

        As of the Effective Date, the Company estimated that total claims of Other GUCs, would be approximately $78 million (including unresolved disputed claims). Under the Plan, and based upon this total estimated claim value, such creditor class was estimated to receive in satisfaction of their claims (including any unpaid interest accrued thereon) the following consideration for each $1,000 of claim value: (i) $50.34 in cash, (ii) $254.99 of Series B of the Senior Notes ("Series B Notes"), and (iii) 22.41 shares of Ordinary Common Stock (although no fractional shares or cash in lieu thereof were or will be issued or paid), for an aggregate of 1.8 million shares (before giving effect to the Cash-Out Elections discussed below). As of March 4, 2004, the Company has issued approximately $5.1 million of Series B Notes for the settled claims of Other GUCs. The Series B Notes portions of certain other claims of Other GUCs were settled for cash, based upon claim settlement terms between the Company and such individual general unsecured creditors. The Ordinary Common Stock share distribution amount is subject to adjustment as set forth below.

        The Company currently estimates that the total claim value for Other GUCs will ultimately be resolved for approximately $55.0 million, of which $50.5 million has been settled as of March 4, 2004. If the claims of Other GUCs are ultimately resolved for the Company's current estimate of $55.0 million, the Other GUCs would receive additional consideration of approximately 0.53 shares of Ordinary Common Stock per $1,000 of claim value (although no fractional shares or cash in lieu thereof will be issued or paid) and the holders of claims on the Old Subordinated Notes would receive an additional 0.77 shares of Ordinary Common Stock per $1,000 of principal amount of such notes (although no fractional shares or cash in lieu thereof will be issued or paid).

F-11



        Also on the Effective Date, the previously outstanding shares of Common Stock and Preferred Stock of Magellan were cancelled, three new classes of capital stock were authorized and Magellan's certificate of incorporation and bylaws were amended and restated. Specifically, 100 million shares of Ordinary Common Stock, $0.01 par value per share ("Ordinary Common Stock"), and 40 million shares of Multiple and Variable Vote Restricted Convertible Common Stock, $0.01 par value per share ("Multi-Vote Common Stock") were authorized, as were 10 million shares of Preferred Stock, $0.01 par value per share, that are issuable at the discretion of the Board of Directors in the manner provided by law in one or more series with such powers, privileges and rights as may be determined by the Board (except that no non-voting shares shall be issued). No shares of Preferred Stock were issued or are to be issued under the Plan. Shares of the Multi-Vote Common Stock may only be issued to, and held by, Onex Corporation, a Canadian corporation, or an affiliate thereof (collectively, "Onex"). As described below, Onex, in connection with the Plan, invested in the equity of Magellan in the form of shares of Multi-Vote Common Stock. Upon transfer of any shares of Multi-Vote Common Stock to any party other than Onex, the shares of Multi-Vote Common Stock will automatically convert on a share-for-share basis into shares of Ordinary Common Stock. In addition, any shares of Ordinary Common Stock that Onex may come to own at any time when the Multi-Vote Common Stock is outstanding will automatically convert into shares of Multi-Vote Common Stock.

        In general, the Multi-Vote Common Stock and Ordinary Common Stock have the same powers, privileges and rights, and each share represents an equivalent interest in Magellan's equity, except that the shares of Multi-Vote Common Stock will have the number of votes per share from time to time sufficient so that all the outstanding shares of Multi-Vote Common Stock will have an equal number of votes as all the outstanding shares of Ordinary Common Stock (i.e., the Multi-Vote Common Stock will be entitled to exercise 50 percent of the voting power of all the common stock of Magellan). The Multi-Vote Common Stock and Ordinary Common Stock also differ in that each class has different voting rights in the election of directors and certain other voting rights and other special rights and privileges. The Multi-Vote Common Stock will cease to have any special voting rights or any other special rights or powers in the event the outstanding shares of Multi-Vote Common Stock cease to represent at least 15.33 percent of the total number of shares of common stock (both Ordinary Common Stock and Multi-Vote Common Stock) issued on the Effective Date (approximately 35.1 million shares) or at least 10 percent of the total number of shares of common stock outstanding at any time (the "Minimum Hold Condition").

        As part of the Plan, Magellan offered to holders of its Old Subordinated Notes, its general unsecured creditors and one holder of an administrative claim the opportunity to purchase, on the effective date of the Plan, shares of common stock equivalent to 6,052,632 shares of Ordinary Common Stock for a total purchase price of $75 million ($12.39 per share). The Company also received as part of the Plan a commitment from Onex to purchase on the same terms any shares not purchased in the Equity Offering by the creditors to whom such shares were offered. Pursuant to the equity offering included in the Plan, creditors purchased 5,111,019 shares and Onex purchased 941,613 shares.

        Onex also purchased, pursuant to an additional commitment under the Plan, 6,052,632 shares of common stock for a total purchase price of $75 million (the "Onex Investment"), or $12.39 per share. In addition, Onex committed, under the Plan, to fund an offer made by Magellan pursuant to the Plan

F-12



to holders of its Old Subordinated Notes and to the Company's other general unsecured creditors permitting them to elect to receive $9.78 in cash per share in lieu of the shares of Ordinary Common Stock they would otherwise receive under the Plan (the "Cash-Out Election"). Onex committed to fund the Cash-Out Election by purchasing that amount of shares of Multi-Vote Common Stock at $9.78 per share equal to the amount of shares of Ordinary Common Stock cashed out pursuant to the Cash-Out Election. As of the Effective Date, Onex purchased 1,421,335 shares pursuant to this commitment. Also pursuant to this commitment, Onex committed to purchase, subsequent to the Effective Date, up to an additional 137,120 shares pursuant to this commitment as a result of the settlement of claims that had elected the Cash-Out Election but were disputed and unresolved at the Effective Date. Onex has purchased and will purchase 8,552,700 shares in the aggregate (in the Equity Offering, pursuant to the Onex Investment and to fund the Cash-Out Election), all of which are shares of Multi-Vote Common Stock. As stated above, the allocation of stock among creditors will change based on the value of all claims as ultimately resolved. If all claims are ultimately resolved for the amount of the Company's current estimate, 36,592 additional shares would be allocated to claims that had elected the Cash-Out Election, which would result in Onex acquiring an additional 36,592 shares at $9.78 per share (for a total of 8,589,292 shares). Issuance costs of approximately $3.1 million were incurred in relation to the Onex transactions.

        The previously outstanding Series A Redeemable Preferred Stock of Magellan was cancelled on the Effective Date and the holders thereof were issued 456,660 shares of Ordinary Common Stock, as well as warrants to purchase until January 5, 2011 for $30.46 per share, 456,660 shares of Ordinary Common Stock. The previously outstanding common stock of Magellan also was cancelled on the Effective Date and the holders thereof received 114,165 shares of Ordinary Common Stock, as well as warrants to purchase at any time until January 5, 2011 for $30.46 per share, 114,165 shares of Ordinary Common Stock, which equals approximately one share of Ordinary Common Stock and a warrant to purchase one share of Ordinary Common Stock for every 310 shares of the previously outstanding common stock. For further information regarding the warrants issued under the Plan, see Note 8—"Stockholders' Equity". Pursuant to the Plan, on the Effective Date all previously outstanding options and warrants to purchase common stock of Magellan were cancelled.

        As part of the consummation of the Plan, an agreement became effective between Aetna, Inc. ("Aetna") and the Company to renew their behavioral health services contract. Under the renewed agreement, the Company will continue to manage the behavioral health care of members of Aetna's healthcare programs through December 31, 2005, with an option for Aetna at that time to either extend the agreement or to purchase certain assets of the Company used solely in the management of the behavioral healthcare of Aetna members (the "Aetna-Dedicated Assets"). Pursuant to the Plan, on the Effective Date, the Company paid $15.0 million to Aetna, out of a debt obligation allowed under the Plan of $60.0 million plus accrued interest, and issued to Aetna an interest-bearing note (the "Aetna Note") for the balance of $48.9 million, which will mature on December 31, 2005. The Aetna Note is guaranteed by substantially all of the subsidiaries of Magellan and is secured by a second lien on substantially all of the assets of Magellan and the subsidiary guarantors. Additionally, if the behavioral health services contract is extended by Aetna at its option through at least December 31, 2006, one-half of the Aetna Note would be payable on December 31, 2005, and the remainder would

F-13



be payable on December 31, 2006. If Aetna opts to purchase the Aetna-Dedicated Assets, the purchase price could be offset against any amounts owing under the Aetna Note. In addition, pursuant to the Plan, the Company issued to Aetna a warrant to purchase 230,000 shares of Ordinary Common Stock from January 1, 2006 to January 5, 2009 at a purchase price of $10.48 per share. For further information regarding the Company's agreement with Aetna, the Aetna Note and the warrant issued to Aetna under the Plan, see Note 7—"Long-Term Debt and Capital Lease Obligations" and Note 8—"Stockholders' Equity".

        The Company's senior executive officers and other key officers entered into employment agreements as of the Effective Date in a form provided by the Plan. A Management Incentive Plan became effective on the Effective Date in accordance with the Plan, under which restricted stock awards, stock options and other equity incentives may be issued to members of the Company's management and other employees. The Company's employment agreements with its senior executive officers provided for the purchase by the Company's Chief Executive Officer of certain shares of Ordinary Common Stock and for the grant to each such officer (pursuant to the Management Incentive Plan) of certain restricted shares of Ordinary Common Stock, all as of the Effective Date, and for certain cash payments to such officers related to the income taxes incurred by them in connection with such transactions. Options for a total of 4.3 million shares of Ordinary Common Stock were issued under the Management Incentive Plan in January and February 2004. See Note 8—"Stockholders' Equity" for a discussion of charges anticipated to be recorded by the Company related to stock grants, stock options and related cash payments.

2. Fresh Start Reporting

        In connection with the consummation of the Plan, the Company adopted the fresh start reporting provisions SOP 90-7, with respect to its financial reports, which requires the Company to restate its assets and liabilities to their fair values based upon the provisions of the Plan and certain valuations which the Company has made in connection with the implementation of the Plan. The Company is required to apply the fresh-start provisions of SOP 90-7 to its financial statements because it has concluded that (a) the reorganization value of the assets of the emerging entity immediately before the date of confirmation was less than the total of all post-petition liabilities and allowed claims and (b) the holders of existing voting shares of the Company immediately before confirmation (i.e., the holders of shares of Magellan's pre-petition common stock that were issued and outstanding prior to the commencement of the chapter 11 proceedings) received less than 50 percent of the voting shares of the emerging entity. SOP 90-7 sets forth the principles regarding the date at which a company that has emerged from a chapter 11 proceeding should apply fresh start reporting to account for the effects of the plan of reorganization. Under SOP 90-7, application of fresh start reporting is required on the date on which the plan of reorganization is confirmed by the bankruptcy court, but SOP 90-7 further provides that fresh start reporting should not be applied until all material conditions are satisfied. All material conditions to the Plan were satisfied as of December 29, 2003 (the "Material Conditions Date"). Due to the proximity of the Material Conditions Date to year end and the immateriality of the results of operations for the intervening two-day period through December 31, 2003, the Company applied fresh start reporting as if the material conditions were satisfied on December 31, 2003.

F-14



        The fair value of the Reorganized Company, or the reorganization value, of approximately $675.0 million, prior to $146.9 million of net proceeds from new equity in the Company as discussed in Note 1—"General", was allocated to long-term debt and equity in accordance with SOP 90-7. The reorganization value was estimated by independent appraisers utilizing comparable-company trading multiples and discounted cash-flow methodologies. Based on the Plan, the Company's reorganization value, excluding debt, resulted in equity reorganization value, as disclosed in the Plan, of $241.0 million (prior to the aforementioned new equity transactions). Fresh start reporting requires that the reorganization value be allocated to the entity's net assets in conformity with procedures specified by Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations," ("SFAS 141"). The Company engaged another independent appraiser to assist in the allocation of the reorganization value to the Reorganized Company's assets and liabilities by determining the fair market value of the Company's property and equipment and intangible assets. The fair value adjustments primarily impacted goodwill, intangible assets, fixed assets and certain liabilities. A reconciliation of the adjustments to be recorded in connection with the reorganization of debt and equity and the adoption of fresh start reporting is presented below (in thousands):

 
  Predeccesor
Company
December 31, 2003

  Reorganization of Debt and Equity (1)
  Issuance
of New
Securities (2)

  Fresh
Start
Adjustments (3)

  Reorganized
Company
December 31, 2003

ASSETS                              
Current Assets:                              
Cash and cash equivalents   $ 206,948   $   $   $   $ 206,948
Stock subscriptions receivable             146,871         146,871
Accounts receivable, net     83,775     144             83,919
Restricted cash, investments and deposits     161,923                 161,923
Other current assets     15,317     15,245             30,562
   
 
 
 
 
  Total current assets     467,963     15,389     146,871         630,223

Property and equipment, net

 

 

83,860

 

 


 

 


 

 

38,222

(4)

 

122,082
Investments in unconsolidated subsidiaries     13,034                 13,034
Other long-term assets     19,513             (1,179 )(4)   18,334
Goodwill, predecessor     472,818             (472,818 )(4)  
Goodwill, reorganized                 450,244     450,244
Other intangible assets     51,261             6,839 (4)   58,100
   
 
 
 
 
    $ 1,108,449   $ 15,389   $ 146,871   $ 21,308   $ 1,292,017
   
 
 
 
 
                               

F-15


LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)                              
Current Liabilities:                              
Accounts payable   $ 22,006   $ 1,349   $   $   $ 23,355
Accrued liabilities     110,756     157,313         (62,201 )(4)   205,868
Medical claims payable     172,700     4,441             177,141
Current maturities of long-term debt     170,623     (145,838 )           24,785
Debt paid upon consummation of the Plan         92,382             92,382
Current liabilities subject to compromise     1,160,675     (1,160,675 )          
   
 
 
 
 
  Total current liabilities     1,636,760     (1,051,028 )       (62,201 )   523,531
   
 
 
 
 
Long-term debt and capital lease obligations     2,271     374,261             376,532
   
 
 
 
 
Deferred credits and other long-term liabilities     1,175     627             1,802
   
 
 
 
 
Minority interest     2,241                 2,241
   
 
 
 
 
Long-term liabilities subject to compromise     627     (627 )          
   
 
 
 
 
Predecessor Company redeemable preferred stock subject to compromise     72,766     (72,766 )          
   
 
 
 
 
Stockholders' Equity:                              
Predecessor Company common stock and warrants     339,118     (339,118 )          
Reorganized Company common stock, warrants and additional paid-in capital         242,163     146,871     (1,123 )   387,911
Accumulated deficit     (946,509 )   861,877 (4)       84,632    
   
 
 
 
 
  Total Stockholders' Equity (Deficit)     (607,391 )   764,922     146,871     83,509     387,911
   
 
 
 
 
    $ 1,108,449   $ 15,389   $ 146,871   $ 21,308   $ 1,292,017
   
 
 
 
 

(1)
To record the reorganization of debt and equity in accordance with the Plan, including the discharge of pre-petition liabilities comprised principally of $625.0 million of Old Subordinated Notes accrued interest on Old Subordinated Notes of $32.2 million, redeemable preferred stock of $72.8 million and estimated other general unsecured claims of $55.0 million.

F-16


(2)
To reflect stock subscription for issuance of new equity in the Reorganized Company as discussed in Note 1—"General." Net proceeds of $146.9 million from the issuance of such new equity were received on the Effective Date.

(3)
To adjust the carrying value of assets, liabilities and stockholders' equity to fair value, and record Reorganized Company goodwill in accordance with the fresh start reporting requirements of SOP 90-7.

(4)
Net reorganization fresh start gain as of December 31, 2003 consisted of the following:

Net gain resulting from reorganization of debt, preferred stock and equity   $ 861,877  
Net loss resulting from fresh start value adjustments to assets and liabilities, excluding Reorganized Company goodwill     (366,735 )
   
 
  Net fresh start reorganization gain   $ 495,142  
   
 

        Certain transactions that occurred on the Effective Date, while consummated in connection with the Plan, were not required by the Plan and thus, pursuant to SOP 90-7, are not recorded as part of the fresh start reporting as of December 31, 2003. Accordingly, these transactions will be recorded in the first quarter of 2004. In addition, cash transfers related to various transactions associated with the Plan occurred on the Effective Date, or shortly thereafter, and also are not recorded until 2004. These transactions and cash transfers include, among others, the entering into of the Credit Agreement and the repayment of the amounts outstanding under the Old Credit Agreement; the receipt of cash from the sale of equity to creditors pursuant to the Equity Offering and to Onex pursuant to the Onex Investment, the Equity Offering and the Cash-Out Election; the issuance of stock and options to management and other employees and other cash payments to management pursuant to their employment agreements entered into on the Effective Date; and cash payments related to certain liabilities incurred in the chapter 11 proceedings, including professional fees and success fees.

        Net proceeds from new equity in the Company received on the Effective Date are reflected as stock subscriptions receivable at December 31, 2003.

3. Summary of Significant Accounting Policies

Review of Significant Accounting Policies

        As discussed in Note 2, the Company adopted fresh start reporting as of December 31, 2003, creating, in substance, per SOP 90-7, a new reporting entity. The Reorganized Company has adopted the same acounting policies as the Predecessor Company with the exception of the date on which the Reorganized Company intends to perform its annual goodwill impairment test under SFAS No. 142. The Reorganization Company will perform its annual goodwill impairment test on October 1, as opposed to September 1.

F-17



Use of Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates of the Company include, among other things, accounts receivable realization, valuation allowances for deferred tax assets, valuation of goodwill and intangible assets, medical claims payable and legal liabilities. Actual results could differ from those estimates.

Financial Reporting Under the Bankruptcy Code

        From March 11, 2003 (the "Commencement Date") to December 31, 2003, the Company accounted for its operations under SOP 90-7. In accordance with SOP 90-7, certain expenses incurred and benefits realized by the Company during the bankruptcy period were recorded as "Reorganization benefit, net" in the accompanying audited consolidated statements of operations. In order to record its debt instruments at the amount of claim expected to be allowed by the Bankruptcy Court in accordance with SOP 90-7, as of the Commencement Date, Magellan wrote off as reorganization expense its capitalized deferred financing fees associated with the Old Senior Notes and Old Subordinated Notes. Reorganization expense also includes professional fees and other expenses directly associated with the bankruptcy process. As part of its financial restructuring plan, the Company rejected certain leases for closed offices. To the extent the estimated cost to the Company as a result of rejecting such leases was different than the liability previously recorded, such difference was recorded as a component of reorganization benefit, net, in accordance with SOP 90-7. Furthermore, in accordance with SOP 90-7, reorganization benefit, net includes the estimated interest income that the Company earned attributable to additional unrestricted cash balances that accumulated as a result of the chapter 11 proceedings.

F-18



        The following table summarizes reorganization expense (benefit) for the fiscal year ended December 31, 2003 (in thousands):

 
  Predecessor
Company