-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, AraE1BsmzcaYXTviSoVGny48W6i94qKHnm3xoat4BBhV3DcQbQ3Ogd39Cz+dZ+Vn UEH9juxP//q5V66bBzARaA== 0000892569-99-001021.txt : 19990416 0000892569-99-001021.hdr.sgml : 19990416 ACCESSION NUMBER: 0000892569-99-001021 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990415 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SAFEGUARD HEALTH ENTERPRISES INC CENTRAL INDEX KEY: 0000727303 STANDARD INDUSTRIAL CLASSIFICATION: HOSPITAL & MEDICAL SERVICE PLANS [6324] IRS NUMBER: 521528581 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-12050 FILM NUMBER: 99595225 BUSINESS ADDRESS: STREET 1: 95 ENTERPRISE T CITY: ALISO VIEJO STATE: CA ZIP: 92656-2601 BUSINESS PHONE: 9494254110 10-K405 1 FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 1998 1 - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------- Form 10-K ANNUAL REPORT Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 1998 Commission File Number 0-12050 --------------- SAFEGUARD HEALTH ENTERPRISES, INC. (Exact name of registrant as specified in its charter) Delaware 52-1528581 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 95 Enterprise Aliso Viejo, California 92656 (Address of principal offices) (Zip Code) Registrant's telephone number, including area code: 949.425.4300 Fax telephone number, including area code: 949.425.4586 --------------- Securities registered to Section 12(b) of the Act: None Securities registered to Section 12(g) of the Act: Common Stock, $0.01 par value Listed on the NASDAQ Stock Market(R) - National Market System (Name of exchange on which listed) --------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filer 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. [X] The aggregate market value of the voting stock held by non-affiliates of the registrant as of April 12, 1999, was $12,596,072. The number of shares outstanding of the registrant's $0.01 par value common stock as of April 12, 1999, was 4,747,498 (not including 3,247,788 shares held in treasury). - -------------------------------------------------------------------------------- 2 SAFEGUARD HEALTH ENTERPRISES, INC. 1998 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS
Page ---- PART 1 Item 1. Business..................................................................1 Item 2. Properties...............................................................20 Item 3. Legal Proceedings........................................................20 Item 4. Submission of Matters to a Vote of Security Holders......................20 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters................................................................21 Item 6. Selected Financial Data..................................................22 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations..............................................23 Item 8. Financial Statements and Supplementary Data..............................32 Item 9. Changes in and Disagreements with Independent Accountants on Accounting and Financial Disclosure.................................32 PART III Item 10. Directors and Executive Officers of the Registrant.......................32 Item 11. Executive Compensation...................................................35 Item 12. Security Ownership of Certain Beneficial Owners and Management...........37 Item 13. Certain Relationships and Related Transactions...........................39 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K..........40 Signatures ........................................................................40
------------------------------------- (i) 3 PART I ITEM 1. BUSINESS In addition to historical information, the description of business below includes certain forward-looking statements, including those related to SafeGuard Health Enterprises, Inc., a Delaware corporation's (the "Company") growth and strategies, future operating results and financial position as well as economic and market events and trends. The Company's actual results and financial position could differ materially from those anticipated in the forward-looking statements as a result of various factors, including competition, changes in health care regulations, levels of utilization of dental health care services, new technologies, rising dental care costs, risks of acquisitions and sale of assets, ability to resell assets or notes of dental offices, waivers and/or extensions from lenders, and other risks and uncertainties as described below under "RISK FACTORS." The following should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto. (a) GENERAL DEVELOPMENT OF BUSINESS. The Company owns and operates one of the largest publicly traded dental benefits companies in the United States. The Company was founded in California in 1974 and is licensed to operate managed care dental plans in Arizona, California, Colorado, Florida, Illinois, Kansas, Kentucky, Missouri, Nevada, Ohio, Oklahoma, Oregon, Texas, Utah and Washington D.C., with significant operations in California, Colorado, Florida, Missouri and Texas. The Company's predecessor, SafeGuard Health Plans, Inc., a California corporation (the "California Plan"), commenced operations in 1974 as a nonprofit corporation. The California Plan converted from nonprofit status in December 1982 and is currently a wholly-owned subsidiary of the Company. The Company was incorporated in California in November 1982 and acquired the California Plan in December of that year. Wholly-owned subsidiaries conduct business in other states. On August 24, 1987, the Company reincorporated in Delaware. In September 1992, the Company acquired a California domiciled life insurance company and renamed it SafeHealth Life Insurance Company ("SafeHealth Life"). In August 1996, the Company acquired a Texas based managed dental care company, named First American Dental Benefits, Inc. In May 1997, the Company acquired a Florida based managed dental care company and renamed it SafeGuard Health Plans, Inc., which company also operates in Georgia, Illinois, Kansas, Missouri, Ohio, and Washington, D.C. In August 1997, the Company acquired a North Carolina domiciled life and health indemnity insurance company, redomesticated it to the State of Texas and renamed it SafeHealth Life Insurance Company, Inc. This Company is licensed to operate in the states of Alabama, Arizona, Arkansas, Delaware, Florida, Georgia, Indiana, Kentucky, Louisiana, Mississippi, North Carolina, Oklahoma, South Carolina, Tennessee, Texas, and Virginia. Unless the context otherwise requires, all references to the "Company" or "SafeGuard" mean SafeGuard Health Enterprises, Inc., a Delaware corporation, its predecessor California corporation, and its subsidiaries. In September 1996, the Company initiated a strategic plan to sell the general dental practices of the Company's dental office subsidiary, Guards Dental, Inc. ("Guards"). Guards dental offices were primarily formed for the purpose of supplementing, in geographic areas where needed, plan coverage provided by independent contracting dental offices. All of the general dental practices owned by Guards were sold during the period of September 30, 1996 through September 30, 1997. As of April 1, 1998, the Company sold the orthodontic practices operated by Guards to Pacific Coast Dental, Inc., Associated Dental Services, Inc., and their affiliated dentists. Pursuant to the terms of the definitive Master Asset Purchase Agreement (the "Agreement") dated and effective as of April 1, 1998, by and among Guards and the Purchasers, the orthodontic practices were sold for total consideration of $15,000,000, paid by an 8 1/2% 30-year Promissory Note, secured by all current and future assets of the Purchasers, including those assets transferred under the Agreement made by the Purchasers and payable to Guards. The principal followed in determining the amount of consideration was the fair market value of the assets. Among other provisions, the Agreement details the sale of associates assets and liabilities of the practices and a long term commitment to continue to provide orthodontic services to the members of SafeGuard Health Plans, Inc. In the fourth quarter of 1998 and as part of an ongoing review process, the Company ascertained that some of the Promissory Notes ("Notes") granted to the Company by the Purchasers of these practices were not performing at currently stated levels and therefore, unable to service such Notes pursuant to the terms and conditions thereof. As a result, the Company reduced the value of the Notes on its books so that they reflect management's current estimate of their market value. Rather than the Company exercising its right to foreclose on the Notes, Guards entered into a -1- 4 Default Forbearance Agreement and an Irrevocable Power of Attorney with the Purchasers, which will enable the Company to either resell the assets or Notes relating to the practices. The Company's executive offices are located at 95 Enterprise, Aliso Viejo, California 92656; its telephone number is 949.425.4300 and FAX number is 949.425.4586. DENTAL CARE MARKETPLACE According to the United States Office of National Health Statistics, the total expenditures for dental care in the United States grew from approximately $14 billion in 1980 to an estimated $48 billion in 1996. The United States Health Care Financing Administration reports that expenditures for dental services account for approximately 5% of total national health care expenditures. According to the United States Department of Labor ("DOL"), the cost of dental services has been rising at a rate higher than that for consumer goods. The DOL statistics reported that, from 1982 to 1998, the consumer price index for all urban consumers for dental services increased 136%, whereas this index for all items increased 63%. As a result, the Company believes that there has been an increased interest by employers in managing dental care costs. Employer-sponsored dental benefits are one of the most common employee welfare benefits. The National Association of Dental Plans ("NADP") estimates that approximately 147 million persons, representing approximately 55% of the total United States population, are covered by some form of dental benefit coverage at the end of 1997. The NADP estimates that managed care enrollment has grown from 18 million covered lives in 1994, to approximately 26 million covered lives by the end of 1997. This compares to over 50 million Americans who were enrolled in medical HMOs in 1997, according to the Group Health Association of America. The Company believes that the relatively high growth rate for Dental HMO plans, is attributable to (i) the greater acceptance of managed care by employers and employees; (ii) the significant price advantage relative to traditional fully-insured open panel fee-for-service or reimbursement plans; (iii) the cost effectiveness to employers of Dental HMO plans as an employee benefit; and (iv) the growing acceptance of dental health maintenance organization ("Dental HMO") plans by dentists throughout the country, resulting in improved accessibility and convenience for members. At the end of 1997, members of Dental HMO plans represent approximately 18% of the population with dental care coverage, and approximately 10% of the total United States population. As a result of these factors, the Company believes that there will continue to be significant growth opportunity in the Dental HMO benefits industry. It has been the Company's experience that larger employers have been more likely to offer dental benefit coverage to their employees. Additionally, according to the 1995 Foster Higgins Survey of Employee Sponsored Health Plans, nationally, approximately 89% of employers with more than 500 employees offer some type of dental benefits to some or all employees, and approximately 79% of these employers have a stand-alone dental plan, distinct and separate from other health and welfare benefits offered to employees. By comparison, this survey reported that approximately 54% of employers that had less than 500 employees, offer dental benefits. About 62% of all employers who offer dental benefits have distinct stand-alone plans. It has been the Company's experience that many employers in the small to mid-size range, that do not offer dental benefits, are willing to consider offering a plan, initially in which the employee pays the full cost or substantially the full cost of such benefits through payroll deductions collected by the employer. Consequently, it is the Company's current intent to target its marketing efforts on the small to mid-size range of employers to help increase growth. The Dental HMO industry as a whole, is currently fragmented and characterized by participation of several large, national insurance companies and numerous independent organizations. As of December 31, 1996, the NADP estimated that there were over 150 Dental HMO companies in the United States, with no dominant market leader. The increase in the number of dentists nationally during the last two decades, has exceeded the rate of population growth. According to the American Dental Association ("ADA"), the number of practicing dentists in the United States has increased to approximately 151,000, while the rate per 100,000 population, has increased from 53 in 1980 to 60 in 1991. In addition, the dental delivery marketplace is highly fragmented with approximately 96% of all practicing dentists, working in a one or two-dentist office, according to the ADA. Also, according to a survey of dental practices published by Dental Economics in 1994, the median of staff and other costs that are part of total overhead expenses for practicing dentists were approximately 60% of the gross revenue of solo and group dental practices. The significant increase in the number of dentists as a proportion of the population, the fragmented dental delivery marketplace, the high proportion of overhead costs for dentists and an improved level of overall dental health in the country, has created a highly competitive environment among dentists, particularly in major metropolitan areas where it is believed that there is a greater than 25% vacancy rate in the average dentist's office. The Company believes that these factors have contributed to the increased willingness of qualified dentists to participate in Dental HMO and preferred provider -2- 5 organization networks, such as those maintained by the Company, as dentists seek alternative methods to increase practice revenues. Under a traditional fee-for-service indemnity plan, coverage is provided based on a reimbursement formula of the usual and customary charges submitted by the dentist. Compared to medical coverage, the average cost of dental services is lower and the utilization of services is more predictable. Unlike medical coverage, dental coverage generally does not cover catastrophic risks. Dental care is provided almost exclusively on an outpatient basis and, according to a 1990 ADA survey, over 81% of all dental services are performed by general dentists. Also, dental plans generally do not include coverage for hospitalization, typically the most expensive component of medical services. Common features of dental indemnity plans include deductibles, maximum annual benefits of less than $2,000 per person and significant patient cost-sharing. Patient cost-sharing typically varies by type of dental procedure ranging from no cost sharing for preventive procedures to 50% cost-sharing for dentures and even greater cost-sharing for orthodontic care. This high patient cost-sharing and the relatively predictable nature of dental expenditures substantially limits the underwriting risk of a dental plan when compared to the underwriting risk of a medical plan which covers catastrophic illness and injuries. Furthermore, since most dental problems are neither life threatening nor represents serious impairments to overall health, there is a higher degree of patient cost sensitivity and discretion associated with obtaining dental services. Many dental conditions also have a range of appropriate courses of treatment, each of which has a different out-of-pocket cost for patients. For example, a deteriorated amalgam filling may be replaced with another amalgam filling (a low-cost alternative) a pin-retained crown build-up (a more costly alternative) or a crown with associated periodontal treatment (the most costly alternative). The level of coverage provided to the patient and the dental plan's reimbursement methodology may influence the type of services selected by the patient or rendered by the dentist. Under a traditional indemnity insurance plan or fee-for-service arrangement, the insurer and the patient each pays a percentage of the fee charged by the dentist, subject to cost-sharing, maximum benefit allowances and usual and customary limits. Under such an indemnity plan, dentists have little incentive to reduce total charges because they are compensated on a fee-for-service basis. By contrast, under a Dental HMO plan capitation payments are fixed and co-payments for additional services are pre-negotiated by the Company. The co-payments generally are designed to exceed the dentist's variable costs, but are typically less than the dentist's usual and customary fee. Fixed capitation payments that do not vary with the frequency of services provided create an incentive for dentists to emphasize preventive care, control costs and maintain a long-term patient relationship that generates consistent capitation revenue. Fixed capitation payments also substantially reduce the underwriting risk to the Company associated with the high utilization of dental services. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. The Company operates in a single industry segment providing Dental HMO and indemnity dental benefits. (c) NARRATIVE DESCRIPTION OF BUSINESS. GENERAL DESCRIPTION OF THE COMPANY The Company contracts with large and medium sized governmental or private sector employers, and multiple employer trusts. In addition, over the last several years the Company has focused its marketing efforts on mid-sized and small employer groups, usually with less than 1,000 employees. At the end of 1998, dental care under the Company's Dental HMO and preferred provider plans is provided by a panel of approximately 5,600 independent dental offices consisting of approximately 6,700 dentists. As of December 31, 1998, the Company had contracts with approximately 6,300 employer clients providing benefits to approximately 1,018,000 members, representing a 12.6% decrease in membership from 1,165,000 at December 31, 1997. This decrease in membership resulted primarily from the anticipated loss of a large private label HMO relationship in the first quarter of this year together with a decline in the Company's indemnity dental insurance membership as a result of the certain policy holders choosing not to renew their coverage when renewal rates were offered. The Company's Dental HMO contracts with its clients generally require the client to pay a monthly per capita fee that is usually fixed for a period of one to two years. The typical fee for a Dental HMO program for an employee and his or her dependents varies depending on the level of dental benefits, dependent coverage and member co-payment requirements stipulated in the contract. Each employee or dependent member receives covered services from a dental -3- 6 office selected by the member or dependent which is on the Company's panel of providers, whereas the individual is ordinarily free to select any dentist under a traditional indemnity insurance program. The Company's Dental HMO plans do not require the member to pay deductibles, file claim forms, or be subject to an annual dollar limitation on the amount of dental care for which they are eligible. Under the Company's indemnity dental insurance programs, members are required to pay small deductibles and copayments which are traditionally higher than that which are required by the Company's Dental HMO products. However, members may select any dentist of their choice for their dental care under these plans. The typical fee for an indemnity dental program for an employee and his or her dependents depends upon the level of dental benefits provided in the contract. The Company utilizes a local market strategy which establishes local offices responsible for sales, client services and provider relations, staffed by up to twelve individuals who are responsible to the local office executive director. Each local office is a separate profit center and has profitability responsibility and decision-making process. Some larger metropolitan areas may have more than one local office, depending upon the needs of the geographic territory. The Company also uses regional offices as training and support for the local office's sales, provider relations, client services and market management activities. Regional offices also provide claims and provider administration, member and provider services, underwriting, financial analysis, quality improvement and dental policy administration. The Company has established three regional offices which are responsible to provide support and training to the local offices in those regions. The Company's corporate office provides corporate governance, corporate finance, legal and regulatory services, processing policy and compliance activities, obtaining regulatory approval of new product market research, product development and management, public relations, information systems, corporate quality improvement policy and compliance activities, large case support, brokerage relationships, alternative distribution programs and business planning. The Company's stated goal is to move as much as possible of the decision-making process to the various constituencies of the Company, to better serve the member, the client and the producer by adopting the local office strategy. It is the Company's primary goal to be the leading dental benefits company in each of the markets in which it operates. Presently, the Company is licensed to provide Dental HMO benefits in fifteen states and the District of Columbia and indemnity benefits in twenty-seven states. It is the Company's belief that by targeting a specific segment of each of the markets in which the Company operates, it can attain and maintain market leadership by offering a full gamut of Dental HMO and indemnity dental products more particularly described below. To implement its strategy, the Company offers a comprehensive range of dental benefit plans utilizing specific standard plan designs which are available in each of the markets in which the Company operates. By standardizing the dental plans the Company offers, it can attain market share and excellence in service through the consistent application of policies and procedures, and administrative functions. Such standardizing also allows employers to offer substantially the same benefits in all states in which the Company is licensed to operate. The Company utilizes multiple distribution methods to sell its products. Its sales force focusing on its target market, allows the Company to attain growth in its core business areas, working with independent insurance brokers and agents who market the Company's plans. The Company also works with large national brokerage firms who provide consultative advice to large employers on the selection of dental benefit plans. The Company also sells to third party HMOs that offer its plans as an additional benefit to members of the medical HMOs. The Company also utilizes a general agency relationship in several of the markets in which it operates, targeting small employers and individuals. The Company is committed to ensuring quality dental care through a panel of accessible dentists. By providing multiple types of reimbursement programs, the Company is able to contract with and maintain significant provider panels in the markets in which it operates by providing a broad spectrum of patients to dentists through various funding mechanisms. The Company's provider relations representatives in each of its local market offices provide a valuable service in assisting to maintain the provider relationships. Local knowledge and expertise provided through these local representatives enable the Company to develop highly accessible dental networks convenient for plan members which is an important factor to employers in selecting a Dental HMO plan. Local efforts are supported by the Company's regional and corporate activities. An important factor in the Company's strategy is to provide an integrated approach to member services. Regional member service representatives provide support and assistance to local market offices by responding to member inquiries, requests for change in provider facilities, claims questions and payment information. Specific 800 telephone numbers accessible throughout the country are maintained with the objective of providing consistent, reliable, responsive and efficient member services. -4- 7 PRODUCTS Dental HMO Plans. The Company offers a variety of Dental HMO plans under the names SafeGuard Health Plans(R), SafeGuard Dental Plans(TM) and American Dental Corporation(R). The Company's Dental HMO plans operate similarly in each state in which business is conducted. Under the Company's Dental HMO plans, a premium is paid to the Company on behalf of the subscriber by the employer from the date the subscriber enrolls in the plan. A portion of this contribution is used by the Company to "prepay" for dental care for members through regular monthly capitation payments by the Company to a specific selected primary care dentist. The capitation rate does not vary with the nature or the extent of services utilized, but is variable based on plan design. In exchange for the capitation payments, the selected provider is obligated to provide specific dental services to plan members. Members covered under the Company's Dental HMO plans obtain certain basic dental procedures, such as examinations, x-rays, cleanings and fillings, at no additional charge, other than, in some cases, a small per office visit copayment. The plan's established copayments for more complicated procedures provided by the selected primary care dentist, such as root canals and crowns, vary in accordance with the complexity of the service and the level of benefits provided. Most of the Company's Dental HMO plans also cover services provided by specialists participating in the panel rather than the primary care dentists selected by the subscriber, including oral surgery, endodontics, periodontics, orthodontics, and pedodontics. The Company assumes responsibility under its Dental HMO plans for such specialty care arrangements and is responsible for such payments, usually at a discounted fee-for-service basis. Dual Choice Plans. The Company's products also include dual choice dental plans which allow subscribers to choose between a Dental HMO plan and an indemnity dental insurance plan. The Company believes that its ability to offer dual choice plans is an important element of its business success because it enables the Company to offer prospective customers flexibility, particularly when there are potential subscribers outside the area served by the Company's Dental HMO panel. Certain states, such as Nevada and Oklahoma, require that Dental HMO plans be offered only as part of a dual choice plan and other states may do so in the future. Dual choice plans are particularly effective as part of the Company's growth strategy in areas in which the Company's dental panel is less well developed and members may value the ability to choose non-panel dentists. The Company also believes that securing customers through dual choice arrangements provides an opportunity to cross sell Dental HMO plans. Preferred Provider Organizations. The Company's products also include a dental plan which provides for an increased level of benefits in the event a member utilizes a dentist participating on its Preferred Provider Organization ("PPO") panel. The level of benefits provided to members who select a PPO dentist is usually increased by at least 10% and usually provides for a waiver of annual deductibles required to be paid by plan members. In exchange, the dentist has contracted to provide dental benefits to plan members at a fee which is usually discounted by at least 30% off of the dentist's usual and customary fee or the Company's fee allowance, whichever is less. Additionally, the cost savings through reduced fees charged by PPO dentists are shared equally between the Company and the member. In the event the member utilizes a PPO dentist, the member also receives the same level of discount off of the provider's usual and customary fee, as applied to the member's coinsurance. The Company believes that its PPO is an excellent way to enter into new markets or areas that have been traditionally difficult areas to recruit dentists into a managed care plan, since the PPO acts as a traditional step for dentists between the traditional fee-for-service plans and the Dental HMO plans offered by the Company. The indemnity insurance portion of the Company's Dual Choice and PPO dental plan is underwritten by SafeHealth Life, a subsidiary of the Company. These plans subject the Company to underwriting risks associated with over utilization and pricing variances which are different from those pricing and reimbursement mechanisms utilized by the Company's Dental HMO plans. Other Dental Products. For self-insured employers, the Company provides claims administration under an Administrative Services Organization ("ASO") arrangement whereby the Company does not assume the underwriting risk for the indemnity claims. The Company receives an administrative fee to process claims and the underwriting risk is retained by the employer sponsoring the self-insured plan. The Company also provides access to its PPO network for a fee to clients. Under this program, the PPO network providers offer a reduced fee schedule for services performed. Eligible participants pay reduced fees when they receive dental services from a PPO network provider. The Company charges its PPO network clients a monthly fee for each participant eligible to access the Company's PPO fee arrangements. The Company does not make any payment to its PPO network providers on behalf of the participant eligible to access the reduced fee arrangement. Orthodontic Services. On February 26, 1998, the Company announced the discontinuance of its orthodontic practices. On April 1, 1998, the Company completed the sale of its orthodontic practices to Pacific Coast Dental, Inc./Associated Dental Services, Inc., and affiliated dentists. The practices were sold for $15 million in 8.5% long-term notes, -5- 8 discounted for up to $2.5 million for early cash payment by December 31, 1998. The transaction includes the sale of all assets and associated liabilities of the orthodontic practices and a long-term commitment from the purchaser to continue to provide orthodontic services to SafeGuard members. The assets of the orthodontic practices sold consist of accounts receivable, supply inventory and dental equipment. The Company recorded a gain on the disposal of the discontinued orthodontic practices of $3.7 million, net of taxes of $2.3 million. The Company also recognized a loss of $620 on operations to be disposed of, net of taxes. In the fourth quarter of 1998, and as part of an ongoing review process, the Company ascertained that some of the Promissory Notes ("Notes") granted to the Company by the Purchasers of these practices were not performing at currently stated levels and therefore, unable to service such Notes pursuant to the terms and conditions thereof. As a result, the Company reduced the value of the Notes on its books so that they reflect management's current estimate of their market value. Rather than the Company exercising its right to foreclose on the Notes, Guards entered into a Default Forbearance Agreement and an Irrevocable Power of Attorney with the Purchasers, which will enable the Company to either resell the assets or Notes relating to the practices. PROVIDER RELATIONS The Company believes that the most essential element in its enrollment growth is a stable panel of quality focused dentists in convenient locations. The Company also requires that all Dental HMO and PPO providers meet all Quality Assessment program standards. The program includes current professional license verification, current liability insurance, and a risk management review of the dental facility to ensure that all OSHA and regulatory requirements are met, an inspection of the office's sterilization practices, and a review of the facilities location, including parking availability and handicap access. See "QUALITY MANAGEMENT AND IMPROVEMENT." The Company believes that dental providers on the Company's Dental HMO and PPO panels are willing to provide their services at a lower capitated (fixed) rate per month in exchange for the relatively steady, extended stream of revenue generated by panel participation. Furthermore, this contractual revenue source for the provider is free from the collection problems and administrative costs sometimes associated with other forms of dental coverage. Thus, qualified dentists and/or dental groups have generally been available and willing to participate on the Company's panels and supplement their fee-for-service practice. The Company compensates each panel dental office on its Dental HMO plans on a monthly capitation rate for each member who selects that office, regardless of the amount or character of service provided during the month. The capitation rate does not vary with the nature or extent of services utilized, however it is variable based upon plan design. The total amount paid to each dental office is determined by the capitation rate per each client contract applicable thereto, and the number of eligible members served by the participating dental office. The Company provides additional compensation to its Dental HMO providers for specified dental procedures. The Company believes that this compensation program provides for a higher level of member and provider satisfaction through increased compensation to the provider. For dentists who provide services to the Company's insured members, compensation is based upon a percentage of the provider's usual and customary fee based upon established tables of allowances utilized by the Company in its claims paying processing systems. Benefits are provided in accordance with percentages that are established for each member's benefit program. Providers who participate in the Company's PPO program are compensated at a fee which is less than the provider's usual and customary fee, usually at a discount of up to 30 percent, or 30 percent off of the Company's usual and customary fee for the area, whichever is less. The Company currently employs provider relations representatives in each local market. All have extensive dental office management backgrounds and act as consultants to assist our panel providers with the administration of the plan in the day-to-day operation of their offices. Should a dental office terminate its contract with the Company, if necessary a new provider will be recruited in a timely manner to meet the needs of the members assigned to that office, and so there will be no delay in the member's care. No individual dental office provided service to more than 10 percent of the Company's members at December 31, 1998. The Company's panel dental offices are free to contract with other dental plans and both they and the Company can terminate the contract at any time upon 60 days prior written notice. In accordance with the contract, the Company may also terminate the contract "for cause" upon 15 days prior written notice. The Company may also, at anytime, -6- 9 change the terms, rates, benefits and conditions of the various plans serviced by its providers with ten (10) days notice to the provider. The Company's contracts with panel dental offices require them to maintain their own professional liability insurance for a minimum of $200,000 per claim, and $600,000 per annual aggregate and to indemnify the Company for claims arising from the dentist's acts or omissions. At December 31, 1998, approximately 5,000 primary care and specialty care dental offices, consisting of approximately 6,000 dentists were participating panel providers on the Company's Dental HMO plans. General dentists are required to render all basic dental care and refer members to specialists only as required. Under its policy, the Company offers nearly all specialty dental services, including oral surgery, endodontics, periodontics, orthodontics, and pediatric dentistry. If the specialty care falls within the Company's guidelines, all or a substantial portion of the specialists fees are paid by the Company. Such payments were 10.3 percent and 9.6 percent of the Company's dental health care services expenses in 1998 and 1997, respectively. At December 31, 1998, the Company contracted with approximately 11,790 primary care and specialty care dentists on the Company's PPO panel. MANAGEMENT INFORMATION SYSTEMS During 1998, the Company continued to enhance its proprietary management information system to better manage its operational resources and analysis of data. These changes focused on reporting mechanisms to track regulatory compliance and data interface with clients. The Company's goal is to continue to enhance technologies to better equip the Company to compete while ultimately reducing the Company's administrative expenses. The Company also continued its development of various operating systems based upon software source code purchased in 1996 for its business operations system, which are being adapted to the specific needs of the Company. This software allows the Company to develop, in-house, a system which is used to expand the Company's management information system to all Company regional offices. This system takes advantage of the power of personal computers in the workplace. The system provides a much easier and more efficient interface using Windows-based screens. Individual users are able to quickly customize data queries for their specific needs with results directed to the screen, printer or downloaded into a word processor and/or spreadsheet. The system also has integrated accounts receivable and accounts payable components that allow the Company to more easily track, report and perform analysis on revenue and expense. The Company employs a personal computer network-based general ledger system providing reporting and analysis tools which allows for the extraction and download of data to word processors and spreadsheets for further analysis. The Company also expanded the use of its electronic mail system to all its regional and sales offices. As the Company's client base continues to grow in all areas, the Company has upgraded its current network server to handle the increased activity. The Dental HMO plan, indemnity and PPO plans, and electronic mail environments are now interconnected. With the implementation of these new and upgraded systems, the entire network is tightly integrated. These systems demonstrate the Company's proactive position in automating its computer operations and allowing it to remain competitive in the marketplace. COMPANY-OWNED DENTAL FACILITIES In October 1996, the Company initiated a strategic plan to sell all of the general dental practices owned by the Company. The assets of the general dental practices sold pursuant to the Company's plan, consisted primarily of leasehold improvements, equipment, accounts receivable and supply inventories. Four general dental practices were sold during 1996 and the remaining twenty-seven general dental practices were sold during the nine month period ended September 30, 1997. In August 1997, the Company sold all of the tangible assets of its then remaining fifteen general dental practices to a non-affiliated entity. The aggregate purchase price of all of the assets sold relating to the general dental practices of the Company was $14.24 million in 1997 and $3.28 million in 1996. All transactions were wholly financed by the Company pursuant to various promissory notes which have an effective interest rate of 8.5 percent and 30 year term, secured by the assets sold. The Company recorded the completion of the sale of its remaining general dental practices in the third quarter of 1997. The Company also recorded a loss from the general dental practices disposed of net of income taxes in the fourth quarter, primarily relating to reserves for under performing notes and receivables, litigation expenses and other related transaction costs. On April 1, 1998, the Company sold all the orthodontic practices operated by a subsidiary of the Company to Pacific Coast Dental, Inc., Associated Dental Services, Inc., and their affiliated dentists. The Company recorded a gain on the disposal of the discounted orthodontic practices of $3.7 million, net of taxes of $2.3 million. The Company also recognized a loss of $620 on operations to be disposed of, net of taxes. Pursuant to the terms of the definitive Master Asset Purchase Agreement (the "Agreement") dated and effective as of April 1, 1998, by and among Guards and the Purchasers, the orthodontic practices were sold for total consideration of $15,000,000, paid by an 8 1/2% 30-year Promissory Note, secured by all current and future assets of the Purchasers, including those assets transferred under the Agreement made by the Purchasers and payable to Guards. The principal -7- 10 followed in determining the amount of consideration was the fair market value of the assets. Among other provisions, the Agreement details the sale of associates assets and liabilities of the practices and a long term commitment to continue to provide orthodontic services to the members of SafeGuard Health Plans, Inc. In the fourth quarter of 1998 and as part of an ongoing review process, the Company ascertained that some of the Promissory Notes ("Notes") granted to the Company by the Purchasers of these practices were not performing at currently stated levels and therefore, unable to service such Notes pursuant to the terms and conditions thereof. As a result, the Company reduced the value of the Notes on its books so that they reflect management's current estimate of their market value. Rather than the Company exercising its right to foreclose on the Notes, Guards entered into a Default Forbearance Agreement and an Irrevocable Power of Attorney with the Purchasers, which will enable the Company to either resell the assets or Notes relating to the practices. QUALITY MANAGEMENT AND IMPROVEMENT The Company's commitment to quality is supported throughout the entire organization. The program is fully encompassing to include the quality of care management process, provider selection, accreditation, maintenance assessment, utilization management, provider network corrective action and counseling management, grievance management functions, member satisfaction survey functions, accessibility monitoring, and ongoing improvement studies. The Company's quality management program objectives include quality assessment of the credentials and qualifications of dentists to become and/or remain affiliated providers, quality assessment of the affiliated network, dentist's compliance with Company standards, analysis and measurement of network and provider behavior, and continuous improvement of affiliated network dentist performance through constructive and continuous feedback. Under the direction of the Company, each affiliated dentist's office undergoes regular assessments to determine appropriateness of care and treatment outcomes. The Company outsources the onsite review process to several firms dedicated to this process. This policy is similar to the concept of using independent accountants to verify financial statements. By using an outside source, the Company is able to maintain a significant level of independence not always found when using employees to conduct the on-site assessments. The Company also maintains a credentialing committee and credentialing verification process through an outside source which is utilized to verify the provider's licensing status, insurance, compliance with applicable federal and state regulations, peer review society status, and other related processes with an objective approach for consistency, effectiveness, and risk management review. The Company's Member Satisfaction Assessment Program is designed to provide the Company with valid and reliable information on members' perceptions of the value of the dental services provided, as well as how expectations are being met. The program is a fully integrated approach to monitoring and responding to customer needs, and evaluating member satisfaction The specific functions of this program are to establish an understanding of customer expectations, assess the performance of the dentist's care relative to members' perceptions and levels of satisfaction, link member complaints with satisfaction for appropriate actionable network management, provide regular and accurate feedback to providers on members' perceptions and levels of satisfaction, and provide comparison levels for perception and levels of satisfaction measurements between different dental products. The Company maintains a comprehensive accessibility monitoring program which tracks appointment availability with affiliated dentist offices through standards including the availability of new patient appointments; the availability of hygienist appointments; the availability of restorative appointments; the availability of emergency appointments; the wait times upon arrival at the dental offices; and arrival in the operatory room. The Company conducts accessibility monitoring on a quarterly basis by mail, and results are then compared to findings of the on-site quality review, member satisfaction surveys, grievances, and Provider Relations visits. The Company continues to improve its review system to assure members are receiving quality care and providers are receiving training and guidance as needed. The Company employs a team concept, combining its Quality Review, Member Services and Provider Relations departments, to benefit both the member and provider. UTILIZATION REVIEW The Company uses computerized analysis to monitor the dental treatment provided to members. The analysis of provider utilization and cost data enable the Company and its clients to determine the type of procedures performed by plan contracted dental offices and ascertain the savings to both clients and members compared to competitive dental indemnity insurance coverage. The analyses are also used by the Company to identify unusual patterns of dental care utilization or complaints which may trigger special or comprehensive dental reviews. The computer system greatly -8- 11 enhances the Company's ability to monitor member utilization and appropriate dental treatment and to provide essential statistical information. The Company is also expanding its use of its indemnity claims paying processing system to include utilization review and case management for its indemnity insurance subsidiary. As part of the expansion of its PPO activities, the Company has developed a sophisticated reporting system to demonstrate cost savings for clients and members when PPO dentists are utilized. These reports compare practice patterns that vary from established norms, identify patient costs trends, provide detailed claims and group experience, and case and claims management through a thorough preauthorization process. Repricing services are also provided through the Company's PPO program. The Company compares utilization patterns for dentists rendering dental services to the Company's insureds to determine whether such dentists are over-utilizing the benefits provided. In the event that an unusual practice pattern is ascertained, the Company conducts a review of the dentist's facility to determine the basis for such practice patterns and reviews its findings with the dentist on a regular basis to eliminate any potential for abuse. MEMBER SERVICES The Company maintains a comprehensive Member Services and Grievance Resolution System designed to assist members with simple inquiries and resolution of dissatisfactions. The Company consistently monitors service statistics to ensure continued ability to exceed the members' expectations. Eighty percent of all dissatisfactions (grievances) received concerning eligibility or professional services are resolved completely within 48 hours. The Company makes every attempt to resolve more complex situations within 5 working days, but no longer than 30 days following the receipt of the grievance. The Company's Grievance Monitoring Committee, provides oversight of the grievance process with particular attention paid to emerging patterns and trends, nature and volume of complaints, financial implication for the disposition of complaints, and quality of care issues. The monitoring process is enhanced through the involvement of the Quality Management and Public Policy Committees. The Quality Management Committee, at quarterly scheduled meetings, reviews grievances at the provider level and has the responsibility to make corrective action recommendations to the Company's Board of Directors based upon grievance volume, trends and/or patterns. The Public Policy Committee, at quarterly scheduled meetings, reviews grievances based on volume and type of complaints, emergent patterns and trends, and has the responsibility to make administrative, policy or plan change recommendations to the Company's Board of Directors. Both committees also review specific complaints that have exhausted the standard grievance resolution process. All grievances receive a written disposition of the resolution within 30 days of receipt of the grievance. The Company's arbitration policy is designed as a final resort for members or providers that are dissatisfied with the results of the appeals, Quality Management or Public Policy processes. Arbitration may not be initiated until the grievance, Quality Management, or Public Policy processes have been exhausted. The arbitration is conducted according to the American Arbitration Association rules and regulations. The Company utilizes an automated call distribution ("ACD") system for customer call management. The Company provides toll-free customer telephone service with automated 24-hours per day, 7 days per week access. Automated service features are available for simple inquires such as provider selection, identification card requests, and eligibility verification. The Company also provides customer service telephone support during regularly scheduled business hours. The Company's call volume averages 45,000 calls per month, with approximately 30 percent handled via automated selection features. The ACD system has the capability to prioritize customer calls, and provide service update standards per guidelines reports on a predetermined basis. The Company strives to maintain a service standard of answering all customer calls within an average of 40 seconds, with an abandonment rate of approximately 2 percent to 4 percent monthly. RISK MANAGEMENT The Company has sufficient general and professional liability insurance coverage to manage the ordinary exposure of operating its Dental HMO plan business and its indemnity dental plans. Generally, the Company is indemnified against professional liability claims by its independently contracted providers. In addition, each dentist is required to maintain professional liability insurance with specified minimums of coverage. The Company also maintains arbitration provisions in its contracts with providers. Considering the Company's exposure to future claims for failure to provide coverage in addition to the secondary risk to professional liability claims, the Company carries its own professional liability insurance coverage in the amount of -9- 12 $10,000,000, which it views as being adequate. However, no guarantee is made that sufficient general and/or professional liability insurance coverage will be available to the Company at an acceptable cost. During 1998 as a result of its favorable claims history, the Company continued to lower its risk management costs. CLIENTS AND CONTRACTS Substantially all of the Company's 1,018,000 members at December 31, 1998, participate through over 6,300 group plans paid for by governmental and private sector employers, multiple-employer trusts and educational institutions or, to a minor extent, through individual plans. The Company's 10 largest clients accounted for approximately 18 percent of the Company's health care revenues for 1998 and 19 percent in 1997. Significant clients served in 1998 by the Company include the City of Dallas, City of Los Angeles, Southern California Edison, County of Los Angeles, Dallas Independent School District, Health Net, Foundation, several contracts with McDonnell Douglas Corporation, Southern California Gas Company, and the Joint Council #42 Welfare Trust. In the opinion of management, the loss of any single client would not have a material adverse effect on the Company's financial condition or results of operations. The Company takes a proactive approach to better service its clients and members. The Company maintains a multi-faceted plan to address the specific needs of its clients by assigning a client services representative to all clients. Each client services representative has dental care and field experience. The Company's customer service complaint system also has been enhanced by the Company's computer network which provides each representative with full access to client, member and provider records. The Company's provider network also benefits its multi-state clients. Given the increasingly competitive nature of the dental care market, it is not unusual for the Company to obtain a new client from competing indemnity insurers or other dental HMO plans, or to lose an existing client to others. The Company is also sensitive to the requirement that there be adequate levels of compensation to its panel of participating providers so as to ensure that there is an adequate panel of providers from which the client's members may select. As a result, the Company has been obtaining price increases of up to 10 percent per year. See "MARKETING" and "COMPETITION." The Company's contracts generally provide for a defined dental benefit program to be delivered to plan members for a period of one to two years at a fixed monthly per-capita rate to the client. The contracts normally allow the client the right to terminate on 60 days written notice of a deficiency in performance; the Company has the right to extend the 60-day period to correct the deficiency. ACQUISITIONS In 1996, the Company completed the acquisition of all of the outstanding shares of First American Dental Benefits, Inc., dba, American Dental Corporation ("First American"), a privately held Dental HMO company based in Dallas, Texas, and an affiliated marketing entity, for a total consideration of approximately $23.6 million. Of the purchase price, $20 million was paid at closing and the Company is obligated to pay an aggregate sum of $3.6 million over 3 years to satisfy certain payment obligations pursuant to non-competition agreements entered into between the Company and the former owners of First American. The Company financed the acquisition of First American through a credit agreement with a bank. First American provides managed dental care services through a network of approximately 1,100 dental care providers to approximately 175,000 members in Texas. The acquisition of First American was accounted for using the purchase method of accounting with the results of operations of the businesses acquired included from the effective date of the acquisition. In May 1997, the Company completed the acquisition of all of the outstanding shares of common stock of Advantage Dental HealthPlans, Inc. ("Advantage"), a privately held Dental HMO company based in Fort Lauderdale, Florida, for a total value of approximately $10.0 million consisting of cash and debt. As of December 31, 1998, Advantage provided benefits to approximately 125,000 members through approximately 700 dental care providers in Florida. The acquisition of Advantage was accounted for using the purchase method of accounting with the results of operations of the business acquired included from the effective date of the acquisition. In October 1997, the Company renamed Advantage to SafeGuard Health Plans, Inc. In January 1998, the Company merged one of the Advantage affiliates, Advantage Dental HealthPlans, Inc., a Missouri corporation, into its affiliate, SafeGuard Health Plans, Inc., a Missouri corporation. -10- 13 In August 1997, the Company completed the acquisition of all of the outstanding shares of common stock of Consumers Life Insurance Company of North Carolina ("Consumers"), a privately held dental indemnity insurance company with licenses in sixteen states. The Company purchased the licenses and obtained all the statutory deposits held on behalf of Consumers for a cash payment of $3.2 million and capitalized Consumers with total capital and surplus of $4.6 million. In connection with the acquisition of Consumers, it was redomesticated from North Carolina to Texas and renamed SafeHealth Life Insurance Company, Inc.("SafeHealth, Inc.") No active business was acquired in connection with the acquisition of Consumers by the Company. In May 1998, the Company initiated the merger of SafeHealth, Inc. into its affiliate, SafeHealth Life Insurance Company, a California corporation ("SafeHealth"), as part of a strategic plan to simplify business operations from an administrative, financial and legal perspective. The merger of SafeHealth, Inc. into SafeHealth will also release surplus requirements of the no longer existing entity, SafeHealth, Inc. The Company has received regulatory approval for the merger from both the California and Texas Departments of Insurance. It is anticipated that the merger will be completed during the second quarter of 1999. MARKETING In the past, the Company's primary marketing strategy has been to contract with large employer groups. While this strategy has served the Company well in the past, several years ago the Company broadened its market strategy to seek out and contract with employers with between 100 and 1,000 employees. While in the past, the Company's Dental HMO plan had been offered as an alternative to the primary dental insurance included in the employer's health care benefit program, with the acquisition of the Company's indemnity insurance subsidiary, the Company is now able to contract with the employer to provide both the Dental HMO plan and the indemnity dental insurance program through one relationship. By targeting the smaller and mid-sized employer groups described above, and by offering both the Dental HMO and indemnity dental products to the employer, the Company is able to obtain a higher per member per month rate than it could previously by only offering its Dental HMO plan. Before submitting a proposal to a prospective employer-client, the Company analyzes a demographic profile of the potential new plan members, the current and desired dental benefit levels, availability of adequate provider coverage and timely access, and other factors. The Company markets its dental benefit plans through a network of over 1,500 independent insurance agents and brokers and an employee sales force. This distribution system is designed to reach group purchasers of all sizes in an efficient and cost effective manner. The Company believes that its marketing strategy provides it with a competitive advantage by enabling it to market to a wider range of potential groups more effectively than companies relying upon a single distribution system. The Company's sales force targets employers and groups, which are more likely to contribute towards the cost of dental benefits for their employees. In marketing to such groups, the Company's sales force focuses on selling both the Dental HMO plan and an indemnity/PPO product. The Company pays its sales force through a combination of salary and incentive compensation based upon the number of members enrolled for new groups. As part of its growth strategy, the Company intends to increase its sales staff during 1999. The Company's independent insurance agent and broker network focuses on offering Dental HMO and indemnity/PPO products to medium and smaller sized employers which may or may not contribute towards or offer dental benefit plans to their employees. The Company believes that there are significant opportunities for the Company to expand Dental HMO and indemnity coverage to medium and smaller sized employers by expanding its network of independent brokers who can effectively sell dental benefit programs to the medium and smaller sized market. Brokers and agents typically do not market the Company's dental plans on an exclusive basis. Brokers and agents generally receive a flat percentage of premium collected as commission for the initial sale and for each renewal thereafter. Brokerage commissions paid by the Company were 6.3 percent and 5.7 percent of health care revenues for 1998 and 1997, respectively. Once plan participation is to be made available to employees, the Company's marketing efforts shift to the potential plan members. During a designated annual open enrollment period, participants may elect the Company's dental plans or opt for the other form(s) of dental benefits being offered, generally dental indemnity insurance, either offered by the Company or another insurance carrier. Generally, participating employees can enroll into or drop out of the Company's plans only during this enrollment period. Management believes that with most of its group clients, an average of approximately 10 percent to 15 percent of eligible employees select the Company's Dental HMO plan during the first open enrollment period in which it is offered and that with smaller group clients, an average of approximately 20 percent with voluntary plans select the Company's Dental HMO plan, and an average of approximately 30 percent of eligible employees with employer paid plans select the Company's Dental HMO plan during the first open enrollment period in which it is offered. -11- 14 The Company believes that it has an opportunity to obtain new contracts from employers with between 100 and 1,000 employees in the markets in which the Company operates. The Company believes that this represents a significant under penetrated market segment for the products offered by the Company. The Company intends to build upon its current market position and increase its sales activities by applying market segmentation and quality management principles to identify the highest potential of customers and proactively anticipating their needs in the marketing process. The Company intends to accomplish this by identifying its core capabilities and competitive advantages that it has over its competitors. By adding incremental service levels provided by the Company, and applying technological advances to the marketing process, the Company's goal is to lower per member acquisition costs, and eliminate unnecessary sales and administrative expenses while increasing production capabilities of the Company's marketing forces. In the situation where the Company is successful in selling its multi-choice products to the employer, all employees are enrolled in one of the plan's offered by the Company. The Company believes that the ability to offer a multi-choice option program increases the amount of revenue generated from each sale by providing the employer with the entire insurance program which may be available to its employees. This has the effect of increasing the overall per member per month rate paid by the employer for each employee since the per member per month premium for the Company's indemnity dental program is significantly higher than that which the Company charges for its Dental HMO plans. This has the overall effect of increasing the revenue generated from each dollar of expense associated with the selling of the Company's products. In 1998, approximately 60 percent of the Company's enrollment originated in the State of California, while approximately 19 percent originated in the State of Texas. No other state contributed more than 10% of the Company's enrollment during 1998. The Company provides a vision plan known as Premier Vision Care Plan (the "Premier Plan"). The Company developed the Premier Plan with the intention of enhancing the vision care component of its benefit programs. The Premier Plan also features a convenient open provider option that allows members to select any optometrist under contract with the Company at the time they seek care. This open panel option is underwritten by the Company's indemnity insurance subsidiary in California. The entire Premier Plan is underwritten by this subsidiary in all other states in which it is provided. No provider preselection is required. There are no cards to mail or forms to present before receiving care so members can enjoy immediate access. The Premier Plan also allows members to obtain services from any vision care professional and receive reimbursement from the Company according to a set schedule of benefits. While the vision plan did not generate significant revenues during 1998, it is anticipated that the vision plans will continue to contribute to net income. Smaller group employers find especially attractive the Company's ability to offer one-stop shopping with its multi-choice dental package of indemnity dental insurance and Dental HMO plans, its vision plans and its life insurance plans. The Company continues to increase its efforts to expand its business through strategic alliances. As a result, the Company maintains a relationship with several Health Maintenance Organizations ("HMOs") to provide dual choice indemnity and Dental HMO plans to segments of members enrolled in the HMO. INDEMNITY INSURANCE PLANS - INDEMNITY INSURANCE BENEFITS As a result of its desire to respond to the changing marketplace, the Company expanded its business to include indemnity dental plans. In September 1992, the Company acquired a California domiciled life and health insurance company and renamed it SafeHealth Life Insurance Company ("SafeHealth Life"). SafeHealth Life is regulated by the California Department of Insurance and currently holds a Certificate of Authority as a life, health and disability insurer in the states of Arizona, California, Colorado, Illinois, Kansas, Maryland, Missouri, Nevada, New Mexico, Ohio, Oregon, Texas, Utah and Wisconsin. In August 1997, the Company also acquired a North Carolina domiciled life and health insurance company known as Consumers Life Insurance Company of North Carolina, redomesticated it to the State of Texas and renamed it SafeHealth Life Insurance Company, Inc. ("SafeHealth, Inc."). SafeHealth, Inc. is licensed to transact the business of a life, health and disability insurance carrier in the states of Alabama, Arizona, Arkansas, Delaware, Florida, Georgia, Indiana, Kentucky, Louisiana, Mississippi, North Carolina, Oklahoma, South Carolina, Tennessee, Texas, and Virginia. No active insurance business was acquired in connection with the acquisition of SafeHealth Inc. The Company is in the process of merging SafeHealth Inc. into and with SafeHealth Life, and has received all required regulatory approvals to do so. The merger is anticipated to be completed during the second quarter of 1999. -12- 15 SafeHealth Life has collaborated with other subsidiaries of the Company to develop certain innovative marketing concepts with the intent of offering consumers a multiple choice product consisting of a flexible indemnity plan, a PPO plan, and a comprehensive Dental HMO plan in the states where it holds a Certificate of Authority. The ability to offer fee-for-service dental plans along with Dental HMO benefits, better serves new and existing clients. The Company also offers a vision plan through SafeGuard in California, and SafeHealth Life in Colorado, Illinois, Missouri, Nevada and Texas. SafeHealth Life utilizes independent agents and brokers who specialize in the employee benefits area and appreciate the ability of SafeHealth Life to custom design plans as needed. SafeHealth's client base includes small employer groups as well as governmental agencies and political subdivisions. During 1998, the number of insured members covered by SafeHealth stood at 114,000. SafeHealth anticipates increasing production of its multiple choice dental programs in other states in which it is admitted to do business. SafeHealth is also offering group term life insurance as a participant in a reinsurance pool. In late 1996, the Company purchased an indemnity dental claims processing system capable of auto-adjudicating significant number of claims filed. In 1997, the Company acquired the source code for its indemnity dental processing claim system so as to allow the Company better utilize the features of this system so as to maximize the technological advantages that are available with this system. This system and its modifications will allow the Company to expand its indemnity dental programs without necessarily incurring significant additional administrative expense. In 1998, over 65 percent of claims filed were auto adjudicated by this system. The ownership of an indemnity insurance company exposes the Company to risk for over utilization and claims costs in excess of premium revenue. To minimize its risks, the Company conducts thorough claims review and develops lag studies through the computer system purchased by the Company for its indemnity insurance business. The Company also maintains a full-time actuary department which is utilized to assist the Company in developing its benefit programs, rates and payment schedules. PREFERRED PROVIDER ORGANIZATION Since 1993, SafeHealth Life has developed its PPO Network program in response to the market demands to offer a more cost-effective alternative to traditional indemnity insurance, and more freedom of choice than the Dental HMO network/product alternatives. The PPO Network program was developed to complement and also be used as a cost containment mechanism for current and future indemnity dental plan clients. The negotiated fee arrangements enable the Company to offer indemnity dental and SafeHealth PPO Network Plans that reduce benefit costs for participating client groups and members. SafeHealth PPO Network Plans are designed to encourage a greater level of participation from participating network dentists due to lower levels of benefits for the out-of-network option. The Company also offers PPO Network Lease Services which offer the network as a stand alone option for a per-member per-month fee. The Network Lease Service is intended to be an option that is marketed to Health and Welfare Trusts, Third-Party Administrators and Self-funded Employer Groups, again promoting the cost containment features of the negotiated discounts. The Company assumes no risk for clients that lease the PPO Network. At December 31, 1998, SafeHealth had contracted with approximately 11,790 participating general and specialty dentists in the markets in which it operates. The overall geographical distribution of the dental network was developed to allow members easy access to network dentists to take advantage of negotiated discounts. All participating dentists have passed a strict qualification process and undergo annual quality assessment reviews as part of ongoing compliance with network participation. The Company continues to actively recruit dentists for its PPO plan, and intends to add substantially more dentists to its PPO panel throughout 1999. The PPO Network offers savings to the Company in the form of lower dollar levels of claims costs, and savings to the insured in lower out-of-pocket costs due to the PPO Network contracted fees. Administrative review protocol that utilizes a sophisticated case management system insures that the individual needs of a member are matched to treatment plans. The necessity and appropriateness of the treatment plans are continually monitored to assure a professional and appropriate treatment conclusion. The combination of the waiver of deductibles, negotiated provider fees and case management review system can result in significant member and claim costs savings. GEOGRAPHIC EXPANSION The Company's strategy regarding geographic expansion is presently undergoing a strategic review to identify and capitalize upon opportunities that may exist in states in which the Company is not presently operating. In the past, the Company's strategy generally has been to enter new states only after obtaining a major contract, either by expanding the -13- 16 geographic scope of service to existing clients, by entering into contracts with new clients, or by establishing marketing agreements with other organizations. Geographic expansion will also be accomplished through acquisition of other Dental HMO or indemnity insurance organizations, such as the Advantage acquisition that was completed in May 1997 which facilitated the establishment of a regional office in Florida and allowed the Company to commence operations in Florida, Georgia, and Washington, D.C. While the Company generally prefers not to expand into new states until an adequate base of client business exists to help defray the start-up costs of operations in those new states, the Company is currently reviewing its strategic opportunities to provide Dental HMO and dental indemnity benefits in other states and markets in which the Company does not presently operate. A number of opportunities exist through strategic affiliations which the Company is pursuing. Once a decision to expand has been made, the Company usually establishes a local market office to provide sales, marketing and provider services support in the local market. Basic administrative services are provided by the Company at its various regional offices. By using strategically located local market offices and regional support offices, the Company has better controlled administrative expenses associated with new plan start-ups, and can more efficiently and effectively service a greater number of members in each market. GOVERNMENT REGULATION Many states have laws establishing the requirements for, and regulating the conduct of, the Company and other Dental HMO plans. Such laws vary from state to state and they generally require a state license, frequently prescribe requirements for contracts, establish minimum benefit levels, impose financial tests and maintain standards for management and other personnel. There is currently no regulation of the Company's plans at the federal level. Since some states will only license full service health plans, the Company cannot enter those states except in conjunction with SafeHealth Life, its indemnity insurance subsidiary, or with a full service HMO. Other states permit only nonprofit corporations to become licensed as Dental HMO plans, again limiting the Company's access. The heavily regulated nature of the Company's industry imposes a variety of potential obstacles to management's plans for further geographic expansion and could limit the Company's future growth. On the other hand, this regulatory environment also governs the conduct and expansion prospects of existing and new competitors, thereby providing a niche in the marketplace for the Company. The Company's Dental HMO plans are licensed and regulated by pertinent state authorities. Among the areas regulated, although not necessarily by each state, are the scope of benefits available to members, the content of all contracts with clients, providers and others, tests of financial resources, including maintenance of minimum stipulated financial reserves for the benefit of plan members, procedures for review of quality assurance, enrollment requirements, minimum loss ratios, "any willing provider" requirements which may limit the Company's right to restrict the size of its provider network, the relationship between the plan and its providers, procedures for resolving grievances, and the manner in which premiums are determined or structured. The Company's indemnity insurance operations through SafeHealth Life are regulated by the California Department of Insurance, and the Department of Insurance of the other states in which SafeHealth Life is licensed to transact insurance business. The Company's indemnity insurance operations through SafeHealth Life, Inc. are regulated by the Texas Department of Insurance and the Department of Insurance in the other states in which SafeHealth Life, Inc. is licensed to transact business. These regulations include specific requirements with regard to minimum capital and surplus, permitted investments, advertising, policy forms and claims processing requirements. The Company's insurance operations are also licensed to transact business in other states which traditionally follow the compliance requirements of the insurance company's domiciled state, while sometimes imposing minimal specific policy and deposit requirements for the Company's operations in those states. Insurance companies are heavily regulated and require significant cash deposits for capital and surplus. The Company's ability to expand its insurance operations into states in which it is not currently licensed is dependent for the most part on the regulatory review process which is conducted by the Department of Insurance in each state in which the Company is applying. Such reviews may take anywhere from six to twenty-four months. TRADEMARKS, SERVICE MARKS AND TRADENAMES The Company has filed, received approval and has obtained renewal protection from the United States Patent and Trademark office for certain trademarks and tradenames for names and products used by the Company in its ordinary course of business. The Company has received a trademark, service mark or tradename for the following words and phrases used with and without distinctive logos maintained by the Company: -14- 17 o SafeGuard(R) used with a distinctive logo depicting a modified smile used in connection with its Dental HMO plans; o SafeGuard Health Plans(R) used in descriptive material to describe the products offered by the Company; o SafeGuard Dental Plans(TM) used to describe the various Dental HMO plans offered by the Company; o SafeHealth Life(R) used with a descriptive logo depicting a modified smile used by the Company to describe its indemnity insurance and PPO products; and o American Dental Corporation(R) adjacent to a flag of the State of Texas used in connection with its Dental HMO plans. Collectively, these trademarks, service marks and tradenames were first used in commerce in 1984 and have been continuously used thereafter. In addition, the Company has nearly completed and is about to receive trademark/service mark protection from the United States Assistant Commissioner for Trademarks of its distinctive logo depicting a smile that the Company is currently utilizing in interstate commerce. COMPETITION The Company operates in a highly competitive environment with numerous competitors wherever the Company conducts business. The Company's competitors include large insurance companies that offer both Dental HMO benefits and traditional dental indemnity insurance, HMOs that offer dental benefits, self-funded employer-sponsored dental programs, dental PPOs, discounted fee-for-service dental plans and other local or regional companies which offer dental benefit programs. Many of the Company's competitors are significantly larger and have substantially greater financial and other resources, than the Company. The Company believes that key factors in selecting a particular dental benefits company include the comprehensiveness and range of benefit plans offered, the quality, accessibility and convenience of the plans' dental networks, the responsiveness of customer service, and the premium rates charged. The Company's competitors compete aggressively in all of the markets in which the Company operates on all of these factors, including situations where the selection of a dental plan is made through a competitive bidding process. Some markets in which the Company operates also have intense price competition, which could occur in all of the markets in which the Company operates in the future. The Company has seen increasing competition from all competitive sectors and the Company anticipates that this trend will continue in the future. Larger, national indemnity insurance companies that offer both Dental HMO and indemnity dental benefits may have a competitive advantage over independent dental plans due to the availability of multiple product lines, established business relationships, better name recognition and greater financial and information system resources. The Company believes that it can effectively compete with these insurance companies due to the comprehensiveness of its management team and resources directed towards developing competitive dental benefit plans at premium rates, which are generally lower than such large national indemnity insurance companies. Some medical HMOs offer their own dental benefit plans and others contract with independent Dental HMO plans for those services. The Company believes that it can compete with HMOs that offer dental benefit plans and the Company intends to continue to pursue opportunities to form relationships with HMOs to offer dental benefit plans to HMO members. Other than for technological expenses associated with the provision of Dental HMO and indemnity dental benefit programs, the Company's business does not require substantial amounts of capital. Other than government regulation and the related operating costs of start-up, there are no significant barriers to new companies entering into the market. There can be no assurance that the Company will be able to compete successfully with new market entrants. Any such additional competition could adversely impact the Company's revenues, net income and growth prospects through fee reductions, loss of providers or clients, and/or market share. EMPLOYEES At December 31, 1998, the Company had 269 employees, of whom 12 were executives and 257 were administrative and clerical personnel. Regional administrative services are provided in Aliso Viejo, California, Dallas, Texas and Fort Lauderdale, Florida. Corporate administrative services are provided at the Corporate office in Aliso Viejo, California. Approximately 45 clerical and auxiliary employees are represented by a labor union. No other employees are union members. The Company considers its relations with its employees to be good. -15- 18 The Company maintains a 401(k) plan which allows for a pre-tax contribution from an employee's earnings. Employees are eligible to participate in the 401(k) plan upon completion of six months of service with the Company. Under the 401(k) plan, an employee may defer up to 15 percent of his or her gross compensation each pay period and the Company may, at its option, make an additional discretionary contribution to be allocated among employees in the plan in proportion to the compensation deferred. Employees are 100 percent vested in their interest in the 401(k) plan at all times. The Company also maintains a pre-tax medical insurance option within the meaning of Paragraph 106 of Section 125 of the Internal Revenue Code for its employees insuring dependents. RISK FACTORS The Company's business and competitive environment involve certain factors that expose us to risk and uncertainty. Some risks relate to the managed dental care industry in general and other risks relate to ourselves. As a result of the risks and uncertainties described below as well as other risks presented elsewhere in this report, there is no assurance that we will maintain our current market position. Some of the below-referenced risk factors have affected our operating results in the past, and all of these risk factors could affect our future operating results. Waivers and/or Extensions from Lender. Our financial position may be negatively affected in the event we are unable to obtain waivers and/or extensions from our senior note lender and line of credit lender concerning specific covenant compliance requirements. Although there is an agreement in principal to restructure the Company's debt to our senior note holder and line of credit lender, no assurance can be given that the parties will execute definitive and binding agreements with respect to such debt restructure by the agreed upon date of April 28, 1999. See "RECENT DEVELOPMENTS" and "CREDIT FACILITIES." Government Regulation. The health and dental care industry is subject to extensive federal, state and local laws, rules and regulations. Due to significant regulation of our business, a variety of potential obstacles to our plans for further geographic expansion could limit our future growth. Additionally, dental care practice standards and related federal and state regulations may change. We cannot predict what changes may be enacted which may affect our business and future growth. Ability to Sell Dental Offices and/or Promissory Notes. Our financial position may be negatively affected by our inability to consummate the proposed sale of our dental practices represented by underperforming promissory notes. We received promissory notes for all of the purchase price of some of the asset sale transactions related to our discontinued operations. In the fourth quarter of fiscal 1997, we established a reserve for underperformance of some of these notes. The non-performance of such notes may have a negative effect on our financial results if any charges exceed the reserves established. The sales may also expose us to additional transition costs. The sales may expose us to the time and costs of litigation. In the fourth quarter of 1998, and as part of an ongoing review process, the Company ascertained that some of the Promissory Notes ("Notes") granted to the Company by the Purchasers of these practices were not performing at currently stated levels and therefore, unable to service such Notes pursuant to the terms and conditions thereof. As a result, the Company reduced the value of the Notes on its books so that they reflect management's current estimate of their market value. Rather than the Company exercising its right to foreclose on the Notes, Guards entered into a Default Forbearance Agreement and an Irrevocable Power of Attorney with the Purchasers, which will enable the Company to either resell the assets or Notes relating to the practices. Risk of Acquisitions. We completed three acquisitions in the past few years. The acquisitions entail risks that we may be unable to successfully integrate the acquired businesses into our existing operations. Also, the acquisitions may fail to perform as expected. In addition, the acquisitions may require significant amounts of our time to assimilate. As a result, occurrence of any of the risks listed could have a material negative effect on our operating and financial results. Possible Volatility of Stock Price. Our stock price is subject to fluctuations. The stock price volatility can be a response to actual or anticipated variations in operating results, announcements of our new developments or our competitors, developments in relationships with clients and other events or factors. Even our modest underperformance against the expectations of the investment community can lead to a significant decline in our stock price. Broad stock market fluctuations, which may be unrelated to our operating performance may have a negative affect on the price of our stock. Competitive Market. We operate in a highly competitive environment. Our ability to expand is affected by existing and increasing competition and dental product choices and number of competitors in the areas that we offer products. There can be no assurance that we will be able to compete successfully with new market entrants. Any additional competition could have a negative impact on our revenues, net income and growth prospects through premium reductions, loss of providers or clients, or market share. We expect the level of competition to remain high. In addition, we recognize that competitive pricing pressures may have a negative effect on our operating margin. -16- 19 Ability to Continue Company Growth. We have grown in recent years through expansion in new small and mid-size clients. We also had an increase in the number of persons covered under indemnity insurance products offered by our insurance subsidiary. Also, we experienced an increase in the number of members covered as a result of strategic relationships with other health care providers with our September 1996 acquisition of First American, the May 1997 acquisition of Advantage, and the August 1997 acquisition of SafeHealth, Inc. Although we desire and intend to continue to expand, we are not sure that we will be able to maintain or continue to expand our market presence in our current locations or successfully enter other markets. The ability to continue our growth will depend on a number of factors, including existing and emerging competition. In addition, our ability to maintain effective control over dental care costs, secure cost effective contracts with additional dentists, introduce new technologies, and availability of working capital to support our growth. Levels of Utilization and Dental Care Services. Our dental indemnity and PPO dental plans are underwritten by one of our subsidiaries. These plans subject us to underwriting risks associated with over utilization and pricing variances in excess of premium revenues. To minimize these risks, we conduct thorough claims review and lag studies and maintain an actuary department. However, if underwriting risks are not accurately assessed, rates charged to clients may not cover costs. As a result, a material negative effect on our operating and financial results may occur. In addition, dental care provided by specialists is made available to members under many of our Dental HMO plans. We assume responsibility under such plans for such specialty care arrangements. We are responsible for payments to specialists, usually at a discounted, fee-for-service basis and not on a capitated basis. Accordingly, we retain the risk for the payment of specialty dental care claims. If the utilization of specialty dental care increases under our outstanding Dental HMO plans, operating and financial results could be negatively impacted. Effect of Adverse Economic Conditions. Our business may be negatively affected by periods of economic slowdown or recession which, among other things, may be accompanied by layoffs by client organizations reducing the number of members served by us, and increased pricing pressure from our clients and competitors. Relationships with Dental Providers. Our success is dependent upon our continued maintenance of a large network of quality dentists in each of our markets. Generally, we and network dentists enter into non-exclusive contracts that may be terminated by either party with limited notice. Our operating results may be negatively affected if we are unable to establish and maintain contracts with an adequate number of quality dentists in any market in which we operate. See "BUSINESS-PROVIDER RELATIONS." Dependence on Key Personnel. We believe that our success is largely dependent upon the abilities and experience of our senior management team. The loss of the services of one or more of these senior executives could negatively affect our operating and financial results. We have entered into employment agreements with key senior executives, including the Chief Executive Officer and the Chief Operating Officer. -17- 20 RECENT DEVELOPMENTS The Company reached an agreement in principle with its Senior Note Holder to restructure the debt owed by the Company. The senior notes due September 30, 2005 ("Note") will be modified to provide for an interest rate increase from 7.91% to 9.91% from the date that the Company and the Note holders execute definitive documents. Thereafter, the interest rate will decrease to 8.91% and then to 7.91% after the Company has satisfied certain conditions. The Company will also be responsible for all reasonable out-of-pocket attorneys' fees and costs and consultant's fee incurred by the Note holder after January 1, 1999, in connection with this debt, to be paid on the closing date. In -18- 21 consideration of this agreement, the Note holder has waived all existing defaults or events of defaults through April 28, 1999, or such mutually agreed to extended date thereafter and extended to April 29, 1999, the payment of interest due March 30, 1999. The sale of certain assets of the Company will also not be considered an event of default under the agreement with the Notes holder so long as the proceeds are used to repay the note holder in accordance with the amendments to the agreement. Various technical terms, covenants and provisions of the Note holder agreement relating to consolidated net worth, interest expense coverage and limitation on consolidated total debt will be amended. New provisions will include a requirement for the Company to provide the Note holder notice of any notice of intent to audit received by the Company from any regulatory agency, copies of correspondence from any regulatory agency and the Company's response thereto. In addition, the Company is not to declare dividends or other distributions, and not incur any liens on the Company's subsidiary's voting stock. The Company is also required to provide consolidated financial reports and cash flows at regular intervals. The Company is also required to pay from the proceeds of certain sales of assets owned by the Company specified amounts to the Note holder on a prorata basis, including the sale of the Company's former headquarters building, and certain promissory notes owned by the Company. The agreement in principal also provides that prior to December 31, 1999, the Company may satisfy all of the financial obligations due to the Notes holder without prepayment penalty. The Company's also responsible for issuing to the Note holder non-transferable and cancelable Warrants representing the right to acquire 382,000 shares of the Company's common stock, which are exercisable at any time after January 1, 2000, and prior to December 31, 2003, at a price per share equal to $1 above the twenty day weighted average of the NASDAQ closing price for the Company's stock for such twenty days prior to and including the closing date. However, the warrants will be automatically canceled on the date the Company's debt to the senior note holders is satisfied in full by December 31, 1999. Certain "piggyback" and demand registration rights with respect to the Warrants have been granted to the Note holder. Additional principal and collateral payments are required under the restructuring agreement including payment of a portion of the proceeds from the sale of the Company's former headquarters building in Anaheim, California, and with all appropriate regulatory approval, the payment of funds derived from the sale of certain promissory notes granted to the dental office subsidiary of the Company in connection with the sale of the general dental and orthodontic practices previously owned by the Company and a portion of the Company's 1998 federal tax refund. The Company also granted to the senior notes holder and the line of credit lender a first priority deed of trust on the Anaheim, California building, delivery of any promissory notes given to the Company in connection with the sale of the building and certain other promissory notes owned by the Company, to a collateral agent for the benefit of the senior notes holder. Additionally, the senior note holder has agreed not to exercise any and all rights or remedies under the original agreement through and including April 28, 1999, subject to certain events of default. The Company has also reached an agreement, in principle, with its line of credit lender to extend the maturity date of the existing obligation to January 29, 2000. The interest rate which shall be paid by the Company to the Lender from and after the closing date will be equal to the prime interest rate plus 4%. Thereafter, the rate shall be prime plus 3% and then the rate shall be prime plus 1.5% thereafter until paid in full upon the Company satisfying certain conditions. The Company is also required to make certain principal payment reductions during specified periods and in specified amounts, consisting of the payment of proceeds received from the sale of certain promissory notes owned by the Company, and certain promissory notes, after appropriate regulatory approval is received, owned by a subsidiary of the Company relating to previously sold general dental and orthodontic dental practices, the payment of a portion of the 1998 federal tax refund, and a portion of the net cash proceeds of the sale of the Anaheim, California building. -19- 22 The Agreement in Principal also provides that prior to the extended maturity date, the Company may repay the line of credit lender in full without penalty. Additionally, the line of credit lender has agreed not to exercise any and all rights and remedies under the original loan agreement through and including April 28, 1999, subject to certain events of default. Additional collateral provided to both the senior note holder and line of credit lender, shall be that as previously described. The Company is also obligated to pay reasonable out-of-pocket attorneys' fees and costs by line of credit lender through the closing date, and certain consulting fees for consultants required to be hired by The Company. The Company is also obligated to comply with certain operating covenants which are the same as previously described above. In consideration of the agreement, the line of credit lender waives all existing defaults and extends to April 29, 1999, the payment of outstanding principal and interest due to the line of credit lender while definitive documents are prepared. Additionally, the Company will provide credit lender with monthly consolidated financial statements and covenants compliance certificates, all Securities and Exchange Commissions filings, and other financial documents as they may reasonably request, and the same notice requirements as described above. Certain standard conditions are required as a condition of closing. The Company has also agreed to modify the various loan documents in accordance with Definitive Documents to be executed consistent with the Agreement in Principal. Although there is an agreement in principal to restructure the Company's debt to the Company's senior note holder and line of credit lender, no assurance can be given that the parties will execute definitive and binding agreements with respect to such debt restructure by the agreed upon date of April 28, 1999. ITEM 2. PROPERTIES During 1997, the Company entered into an agreement to lease office space consisting of approximately 68,000 square feet in Aliso Viejo, California. The Company moved its corporate headquarters and executive offices from its previous location in Anaheim, California to Aliso Viejo, California during the third quarter of 1998. The Company also owns a 60,000 square foot building in Anaheim, California, which it previously utilized as its corporate headquarters and executive offices. Currently, the Company is in the process of selling such building and intends on completing that transaction during 1999. However, no assurances can be given that such building will be sold during 1999 or that a suitable buyer willing to purchase the building under terms and conditions which are satisfactory to the Company will be found during 1999. In addition, the Company leases offices in Phoenix, Arizona; Walnut Creek, California; Denver, Colorado; Fort Lauderdale, Florida; St. Louis, Missouri; Austin, Dallas, and Houston, Texas. The Company leased all of its previously owned Guards practices, which leases have been assigned to the persons and/or entities who purchased the dental practices, but for which the Company remains secondarily liable. Those leases expire on dates ranging through July 2005. In the opinion of management, the Company's facilities are adequate for its current needs. ITEM 3. LEGAL PROCEEDINGS The Company is subject to various claims and legal actions in the ordinary course of business. The Company believes all pending claims either are adequately covered by insurance maintained by panel providers or the Company, or will not have a material adverse effect on the Company's results of operations or financial position. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1998. -20- 23 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS (a) Market Information The Company's common stock is traded on the NASDAQ National Market System under the symbol SFGD. The following table sets forth the high and low prices at which the Company's common stock traded as reported. The bid quotations represent inter-dealer prices, without retail markups or commissions, and do not necessarily represent actual transactions.
High Low -------- -------- Fiscal Year ended December 31, 1998 First Quarter...................................................$13.50 $ 8.25 Second Quarter..................................................$ 9.375 $ 6.00 Third Quarter...................................................$ 7.1875 $ 3.6875 Fourth Quarter..................................................$ 5.50 $ 3.3125 Fiscal Year ended December 31, 1997 First Quarter...................................................$18.375 $11.125 Second Quarter..................................................$12.75 $ 9.625 Third Quarter...................................................$14.00 $10.50 Fourth Quarter..................................................$14.875 $12.50
Approximate Number of Equity Security Holders
Approximate Number of Record Holders Title of Class (as of December 31, 1998) -------------- --------------------------- Common Stock, $.01 Par Value 1,000
Dividends No cash dividends have been paid on the Company's common stock. It is the policy of the Board of Directors to retain the Company's earnings for use in its operations and expansion of its business, and the Company does not anticipate paying cash dividends in the foreseeable future. The Company's credit arrangements prohibit dividends. Stockholder Rights Plan In March 1996, the Company's Board of Directors declared a dividend of one right to purchase fractions of the shares of its Series A Junior Participating Preferred Stock, par value $.01 per share having rights, preferences, privileges and restrictions under certain circumstances, other securities, for each outstanding share of the Company's common stock, par value $.01 per share distributed to stockholders of record at the close of business on April 12, 1996. The description and terms of the Rights are set forth in a Rights Agreement, dated as of March 22, 1996, between the Company and American Stock Transfer and Trust Company, as Rights Agent. (b) Use of Proceeds N/A -21- 24 ITEM 6. SELECTED FINANCIAL DATA The financial data included in the table as of December 31, 1998 and 1997 and for the three years ended December 31, 1998, have been derived from financial statements audited by the Company's independent accountants, Deloitte & Touche, LLP. This data was reclassified in prior years to reflect the discontinuation of the Company's general dental and orthodontic practices (see Note 2 of the Consolidated Financial Statements). This data should be read in conjunction with such financial statements and notes thereto, and Item 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS." Selected Operating, Statistical and Balance Sheet Data
Year Ended December 31, 1998 1997 1996 1995 1994 - ----------------------- --------- --------- --------- --------- --------- Operating Data (in $000's except income per share): Health care revenues $ 97,449 $ 95,350 $ 72,709 $ 60,736 $ 53,921 --------- --------- --------- --------- --------- Expenses: Health care services 66,020 65,702 54,534 45,285 39,203 Selling, general and administrative 37,492 25,103 16,292 13,451 12,178 --------- --------- --------- --------- --------- Total expenses 103,512 90,805 70,826 58,736 51,381 --------- --------- --------- --------- --------- Operating income (6,063) 4,545 1,883 2,000 2,540 Other income 2,341 1,632 984 1,286 1,026 Loss on impairment of assets (11,165) -- -- -- -- Interest expense (4,311) (2,871) (485) -- (3) --------- --------- --------- --------- --------- Income (loss) from continuing operations before (benefit) provision for income taxes and discontinued operations (19,198) 3,306 2,382 3,286 3,563 Provision for income taxes (6,638) 1,495 980 1,251 1,390 --------- --------- --------- --------- --------- Income (loss) before discontinued operations (12,560) 1,811 1,402 2,035 2,173 Income (loss) from discontinued operations to be disposed of, net (620) (3,555) (852) 353 (881) Income (loss) on disposal of dental practices, net 2,086 (605) 1,678 -- -- Cumulative effect of change in accounting principle, net -- -- 824 -- -- --------- --------- --------- --------- --------- Income (loss) from discontinued operations, net 1,466 (4,160) 1,650 353 (881) --------- --------- --------- --------- --------- Net income (loss) $ (11,094) $ (2,349) $ 3,052 $ 2,388 $ 1,292 ========= ========= ========= ========= ========= Basic income per share: Net income from continuing operations $ (2.66) $ 0.38 $ 0.30 $ 0.45 $ 0.47 Net income (loss) from discontinued operations, net 0.31 (0.88) 0.34 0.08 (0.19) --------- --------- --------- --------- --------- Net income (loss) $ (2.35) $ (0.50) $ 0.65 $ 0.53 $ 0.28 ========= ========= ========= ========= ========= Weighted average shares outstanding (000's) -- Basic 4,747 4,723 4,711 4,523 4,613 ========= ========= ========= ========= ========= Diluted income per share: Net income from continuing operations $ (2.66) $ 0.37 $ 0.28 $ 0.43 $ 0.45 Net income (loss) from discontinued operations, net 0.31 (0.85) 0.34 0.08 (0.18) --------- --------- --------- --------- --------- Net income (loss) $ (2.35) $ (0.48) $ 0.62 $ 0.51 $ 0.27 ========= ========= ========= ========= ========= Weighted average shares outstanding (000's) -- Diluted 4,747 4,899 4,940 4,725 4,852 ========= ========= ========= ========= ========= Membership (000's): 1,018 1,165 983 761 721 Clients 6,306 5,550 4,922 2,661 2,086 Employees 269 249 461 458 432 Contracted managed care dental offices 5,600 5,000 4,200 3,291 2,902 PPO dental offices 11,800 9,100 9,600 9,706 5,765 Company owned dental offices -- -- 27 33 30 Balance Sheet Data (in $000's): Cash and short-term investments $ 6,215 $ 12,906 $ 9,807 $ 14,746 $ 8,661 Current assets 32,945 26,403 27,622 23,576 12,378 Current liabilities 25,379 20,193 11,633 5,941 3,043 Long-term debt 32,500 33,894 19,086 -- -- Stockholders' equity 21,754 32,759 35,200 31,929 27,469 Total assets 79,944 88,518 68,116 38,343 30,792
-22- 25 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995 The Private Securities Litigation Reform Act of 1995 (the "1995 Act") provides a "safe harbor" for forward-looking statements, so long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed in the statement. The Company desires to take advantage of these safe harbor provisions. The statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations concerning growth and strategies, future operating results and financial position, as well as economic and market events and trends, any future premium pricing levels, future dental health care expense levels, the Company's ability to control health care, selling, general and administrative expenses, items discussed under heading "Year 2000" and all other statements that are not historical facts, are forward looking statements. Words such as expects, projects, anticipates, intends, plans, believes, seeks or estimates, or variations of such words and similar expressions are also intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties and contingencies, many of which are beyond the control of the Company. Actual results may differ materially from those projected in the forward-looking statements, if any, which statements involve risks and uncertainties. The Company's ability to expand is affected by competition not only in benefit program choices, but also the number of dental plan competitors in the markets in which the Company operates. Certain large employer groups and other purchasers of commercial dental health care services continue to demand minimal premium rate increases, while limiting the number of choices offered to employees. In addition, changes in dental health care regulations, securing cost effective contracts with dentists may become more difficult in part due to the increased competition among dental plans for dentist contracts. The Company's ability to obtain waivers and/or extensions from its lenders, whether or not the Company enters into any extraordinary transaction, changes in the Company's operating or expansion strategy, or failure to consummate proposed resale of dental offices and/or promissory notes. The Company's profitability depends, in part, on its ability to maintain effective control over health care costs, while providing members with quality dental care. Factors such as levels of utilization of dental health care services, new technologies, specialists costs, and numerous other external influences may effect the Company's operating results. Any critical unresolved Year 2000 issues at the Company or its vendors could have a material adverse effect on the Company's results of operations, liquidity or financial condition. In addition, the Company's expectations about the future costs and timely and successful completion of its Year 2000 Program are subject to uncertainties that could cause actual results to differ materially from what has been discussed under the heading "Year 2000". Factors that could influence the amount of future costs and the completion dates and effectiveness of remediation testing and certification and contingency planning efforts include the Company's success in identifying IT systems and embedded systems that contain two-digit year codes, the nature and amount of required reprogramming, testing and certification, the rate and magnitude of related labor and consulting costs, the availability of qualified personnel and the success of the Company's external relationships in addressing their own Year 2000 issues. The Company's expectations for the future are based on current information and evaluation of external influences. Changes in any one factor could materially impact the Company's expectations relating to premium rates, benefits plans offered, membership growth, the percentage of health care expenses, and as a result, profitability and therefore, effect the forward-looking statements which may be included in these reports. In addition, past financial performance is not necessarily a reliable indicator of future performance. An investor should not use historical performance alone to anticipate future results or future period trends. The following should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto.
Results of operations (000's omitted except percentages) 1998 Versus 1997 1997 Versus 1996 1996 Versus 1995 - ---------------------------------------------------------------------------------------------------- Membership enrollment (147) 182 222 Percentage change (12.6%) 18.5% 29.2% - ---------------------------------------------------------------------------------------------------- Health care revenues $ 2,099 $ 22,641 $ 11,973 Percentage change 2.2% 31.1% 19.7% - ---------------------------------------------------------------------------------------------------- Health care expenses $ 318 $ 11,168 $ 9,249 Percentage change 0.5% 20.5% 20.4% Percent of revenues 67.7% 68.9% 75.0% - ----------------------------------------------------------------------------------------------------
-23- 26
Results of operations (000's omitted except percentages) 1998 Versus 1997 1997 Versus 1996 1996 Versus 1995 - ---------------------------------------------------------------------------------------------------- Selling, general and administrative expenses $ 12,389 $ 8,811 $ 2,841 Percentage change 49.4% 54.1% 21.1% Percent of revenues 38.5% 26.3% 22.4% - ---------------------------------------------------------------------------------------------------- Other income, net $ 709 $ 648 $ (302) Percentage change 43.5% 65.9% (23.5)% Percent of revenues 2.4% 1.7% 1.4% - ---------------------------------------------------------------------------------------------------- Interest expense $ 1,440 $ 2,386 $ 485 Percentage change 50.2% 492.0% N/A Percent of revenues 4.4% 3.0% 0.7% - ---------------------------------------------------------------------------------------------------- Income (loss) from continuing operations before Discontinued operations $ (14,371) $ 409 $ (633) Percentage change (793.5)% 29.2% (31.1)% - ---------------------------------------------------------------------------------------------------- Income (loss) from discontinued operations, net $ 5,626 $ (5,810) $ 1,297 Percentage change 135.2% (352.1)% 367.4% - ---------------------------------------------------------------------------------------------------- Net income (loss) $ (8,745) $ (5,401) $ 664 Percentage change (372.3)% (177.0)% 27.8% - ----------------------------------------------------------------------------------------------------
1998 Versus 1997 The Company's revenues for twelve months ended December 31, 1998 increased 2.2% from $95,350 to $97,449 on a membership decrease of 12.6%. The 1997 basis of comparison, however, includes the acquisition of Advantage in May 1997. On a pro forma basis, including the effect of the Advantage acquisition for the entire year, revenues for the same period increased $202 on a membership decrease of 12.6%. Notwithstanding the membership losses, largely in the first quarter of 1998, new business was acquired during the balance of the year that incorporated improved pricing strategies that generated a recovery of revenues that would have otherwise been lost. Additionally, cross selling of offerings to clients, moderate price increases to the existing customer base and increases in sales to small and mid-size clients contributed to the revenue stability. Health care expenses increased 0.5% or $318 for the twelve months ended December 31, 1998. As a percent of revenues, health care expenses improved 1.2% from 68.9% of revenues for the twelve months ended December 31, 1997 to 67.7% for the same period in 1998. Including the Advantage acquisition for twelve months of 1997, health care expenses for the period would have been $66,452 or 68.2% of revenues. The comparison to 1998 then shows a decrease of $432 in health care expenses and a decrease of 0.6% of revenues. The Company continues to improve the health care cost ratios in its existing business, including the business provided by its recent acquisitions, as well as improvements to cost control measures. Selling, general and administrative expenses increased $12,389 or 49.4%. Including the Advantage acquisition for all of 1997, such increase is $11,819 on an increase of 11.6% of revenues. The increase experienced in 1998 is attributable to certain transitional costs the Company experienced during the year, including a charge for uncollectible accounts receivable, the Company's relocation of its corporate headquarters from Anaheim, CA to Aliso Viejo, CA, and the associated operating leases, the costs associated with the elimination of various job functions at year-end, and the continuing increases in costs associated with telecommunications and computer networks. Other income increased $709 for the twelve months ended December 31, 1998 from $1,632 in 1997 to $2,341, an increase of 43.4%. This is primarily due to the interest bearing notes receivable as a result of the sale of the discontinued general dentist and orthodontic practices. Loss on impairment of assets in the amount of $11,165 for the twelve months ended December 31, 1998 primarily represents a pre-tax charge against under-performing notes. Interest expense increased $1,440 for the twelve months ended December 31, 1998 from $2,871 in 1997 to $4,311 in 1998, an increase of 50.2%. Such increase is a result of the interest associated with the working capital credit facility which was entered into in 1998 and the private placement long-term debt, which was entered into during 1997. -24- 27 The operating results of the discontinued orthodontic and general dental practices for the twelve months ended December 31, 1998 reflect a gain of $1,466 after a tax provision of $937 versus a loss of $4,160 for the same period in the prior year, an increase of $5,626. Net loss of $11,094 for the twelve months ended December 31, 1998 was an increase of $8,745 over the loss of $2,349 reported for the same period a year ago. This was primarily due to the year-end discontinued and transitional charges discussed above. 1997 Versus 1996 As a result of the Company's discontinuation of its orthodontic practices in 1997, the financial statements have been reclassified for all comparative years to reflect these changes (see Note 2 of the Consolidated Financial Statements). The Company's revenues for the twelve months ended December 31, 1997, increased 31.1 percent, from $72,709 to $95,350, on a membership increase of 18.5 percent. This includes the contribution from the acquisition of First American in September 1996, as well as the acquisition of Advantage in May 1997. Excluding the impact of the two acquisitions, revenues for the same period indicated above increased 13.1 percent on a 5.9 percent increase in membership. These increases were attributable to cross selling of product offerings to existing clients, moderate price increases to renewing clients and increases in sales to small and mid-size clients. Health care expenses increased 20.5 percent, or $11,168 for the twelve months ended December 31, 1997. As a percentage of revenues, health care expenses improved by 6.1 percent, from 75.0 percent of revenues for the twelve months ended December 31, 1996, to 68.9 percent for the same period in 1997. This was primarily due to the acquisitions of both First American and Advantage, which have a lower health care cost as a percent of revenues. The Company also realized improvements in health care cost ratios for its existing business, excluding the two acquisitions, from 76.2 percent for the twelve months ended December 31, 1996, to 74.5 percent for the same period in 1997, an improvement of 1.7 percentage points. This improvement is due to improved pricing as well as continued improvement in control of costs. Selling, general and administrative expenses increased $8,811, or 54.1 percent, for the twelve months ended December 31, 1997. This was primarily due to the acquisitions of First American and Advantage with the related selling, general and administrative costs of those businesses. Goodwill and intangible amortization expense related to the acquisitions was $1,525 for the twelve months ending December 31, 1997 compared to $312 for same period in 1996. Excluding the effect of the two acquisitions, the ratio of selling, general and administrative expenses to revenues increased to 23.0 percent from 21.3 percent for the twelve months ended December 31, 1997, compared to the same period of 1996. This was as a result of increases in telecommunications and computer network systems costs, as well as increases in management staffing levels. Other income increased by $648 for the twelve months ending December 31, 1997, from $984 in 1996, to $1,632, an increase of 65.9 percent. This was due to an increase in interest bearing notes receivable resulting from the sale of the discontinued general dental practices. Interest expense of $2,871 for the twelve months ending December 31, 1997, is primarily a result of the borrowings obtained for the acquisition of both First American and Advantage. This represents an increase of $2,386 from $485 in 1996. The operating results, net of taxes, of the discontinued orthodontic and general dental practices for the twelve months ended December 31, 1997, reflect a net loss of $4,160 for the twelve months ending December 31, 1997, an increase in losses of $5,810 over the same period in 1996. This includes a pre-tax charge of $8,550 for under-performing notes and receivables ($5,600), litigation costs ($750), and other transition costs ($2,200). Net loss of $2,349 for the twelve months ended December 31, 1997, was a decrease of $5,401 in net income over the same period in the prior year. This was primarily due to the impact of the discontinued charge discussed above, as well as the other above factors. 1996 Versus 1995 After restating the Company's financial statements to reflect the discontinuation of the Company's general dental practices, and for the adoption of a change in accounting principle (see Notes 1 and 2 of the Consolidated Financial -25- 28 Statement), the Company's revenues for the twelve months ended December 31, 1996, were $72,709, or a 19.7 percent increase on a 29.2 percent membership increase over the corresponding period a year ago. These increases included the impact on revenues and membership for the acquisition of First American, completed September 27, 1996. Excluding the impact of the acquisition, revenues for the same period indicated above increased 14.8 percent on a 6.0 percent increase in membership. The increase in revenue was attributable to new small and mid-size clients, cross-selling of product offerings to existing clients and moderate price increases to renewing clients. Health care expenses for the twelve months ended December 31, 1996 increased $9,249 or 20.4 percent. Health care expense as a percentage of health care revenues increased by 0.4 percent from 74.6 percent of revenues for the twelve months ended December 31, 1995, to 75.0 percent for the same period in 1996. This was primarily due to an increase in the estimated liability for claim costs processed through the Company's indemnity dental system, as well as the selected disenrollment of less profitable clients based on actuarial reviews of plan designs and utilization. General and administrative expenses for the twelve months ended December 31, 1996, increased $2,841 or 21.1 percent. This was due primarily to the acquisition of First American. The acquisition had a slightly higher ratio of general and administrative expenses to revenues than the Company had prior to the acquisition. In addition, the goodwill expense of $312 attributable to the acquisition, for the period following the purchase on September 27, 1996, is included in general and administrative expenses. Excluding the impact of the acquisition and the associated goodwill expense, the ratio of general and administrative expenses to revenues improved slightly to 19.0 percent, from 20.1 percent for the twelve months ended December 31, 1996, compared to the same period of 1995. Other income declined to $984 from $1,286 due to lower balances of cash and investments. The Company entered into a credit agreement during 1996 to facilitate the acquisition of First American, resulting in interest expense of $485. Proforma operating results, net of taxes, of the discontinued general dental and orthodontic practices for the twelve months ended December 31, 1996, reflect a net income of $1,650 net of an after tax deferred loss of $621. This compares to a net after tax income of $353 for the same period in 1995. The income amount for 1996 included an after tax gain of $1,678 on the sale of four general dental practices during 1996 as well as the cumulative effect, after taxes, of the change in accounting principle which increased income by $824 and was adopted as of January 1, 1996. Net income increased due to the above factors. General The Company's California dental plan contributes substantially to the Company's operating revenues. Additionally, in 1998, the dental plans in each state all contributed positively towards operating revenues. Management believes that each state plan is capable of being profitable once targeted enrollment levels are attained and stable provider panels are in place. The Company's indemnity insurance subsidiary also contributed positively towards operating earnings. The Company's ability to attract clients is affected by revisions in employee benefit programs, fluctuations in employment levels, increasing market competition and other factors. The Company's ability to increase revenues depends on many factors, including existing and emerging competition. There can be no assurance that the Company's revenues will continue to increase. Liquidity and Capital Resources The Company's capital and operational cash requirements have been met principally from operating cash flows, and corporate borrowings, and this is expected to continue. At December 31, 1998 and December 31, 1997, the current ratio was 1.3 to 1.0 and 1.3 to 1.0, respectively. The Company's net worth was $21.8 million at December 31, 1998, compared to $32.8 million the previous year. The Company had $6.2 million and $12.9 million of cash and short-term investments as of December 31, 1998 and December 31, 1997, respectively. As a result of its regulated nature, the Company is required to maintain various regulatory bank accounts in an aggregate amount of approximately $9.0 million to satisfy depository requirements imposed by state regulatory agencies. The Company believes that cash flow from continuing operations, together with the existing cash and short-term investments on hand and other available sources of financing, should be adequate to meet operating capital and regulatory needs for the foreseeable future. See discussion of credit facilities below. -26- 29 Credit Facilities In September 1996, the Company established a $30 million bank loan which provided for a $22 million reducing revolving acquisition sub-facility and an $8 million revolving working capital sub-facility. This agreement was terminated in September 1997. On September 30, 1997, the Company completed a private placement of $32.5 million in long-term debt consisting of eight-year notes through John Hancock Mutual Life Insurance Company ("Hancock"). The Company used the proceeds to repay all of its long-term indebtedness and for general corporate purposes. The senior notes have a principal payment of $6.5 million due on September 30, of each year starting in 2001. The interest rate for the loan is fixed at 7.91 percent. The notes are unsecured senior notes. In connection with the senior notes, the Company is subject to certain financial and operational debt covenants. As of December 31, 1998, the Company was in compliance, or has obtained a waiver, with respect to these covenants. On May 9, 1997, the Company completed the acquisition of Advantage Dental HealthPlans, Inc. The Company financed part of the acquisition through an unsecured $8.5 million promissory note with the seller, with an interest rate which averaged 8.5 percent during 1998. The promissory note was paid in full in April 1998. On January 29, 1998, the Company entered into a $8,000,000 revolving working capital credit facility with Silicon Valley Bank (the "Bank"), all of which is currently being utilized by the Company. The loan had a maturity date of January 28, 1999, and is currently due and payable. The interest rate for the facility, as amended, was established at the Bank's Prime rate, plus 1.5 percent or at the Company's option, LIBOR plus 2.25 percent. The loan is secured by a first priority security interest in all the personal property of the Company, including accounts receivable, fixed assets and intangibles and a negative pledge on the stock of the Company's subsidiaries and on the real property owned by the Company. In connection with the Bank and Hancock loan, the Company is subject to certain financial and operational debt covenants. As a result of underperforming notes related to the sale of the dental offices that were previously sold and discontinued, reduction in the value of the Company's former headquarters building in Anaheim, California, which the Company is in the process of selling, severance payments to a number of former employees who left the Company in the fourth quarter as a result of the Company's continuing efforts to streamline its operations, and expenses for a reduction in its account receivable balances which may be uncollectable, as ascertained after the Company completed its systems conversion in October 1998, as of the end of the fourth quarter of 1998 the Company was not within compliance with such covenant requirements. See also the section entitled Recent Developments for a description of restructuring of credit facilities in April 1999. -27- 30 Year 2000 Compliance The Year 2000 issue results from computer programs using two digits rather than four to define the applicable year. Any of the Company's computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruption of operations, including among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. Company's State of Readiness The Company relies heavily upon information technology ("IT") systems and other systems and facilities such as telephones, building access control systems and heating and ventilation equipment ("embedded systems") to conduct its business. The Company also has business relationships with dental health care providers, financial institutions and other third parties ("Vendors") as well as regulators and customers who are themselves reliant upon IT and embedded systems to conduct their business. As part of the Company's proactive approach to automation, the Company began planning an awareness activity as early as January 1996 and incorporated Year 2000 compliance into its business continuity plans. As a result, the Company purchased and is in the final implementation process of upgrading any and all information systems software and hardware. The implementation of such new and upgraded computer information systems will recognize the Year 2000 and process date data correctly, including the Company's manipulation of data when dates are in the 20th or 21st century. The Company executed its initial steps in 1996 when it continued to enhance its information systems, including all hardware and software products, individually and in combination, to better manage operational resources and analysis of data. A review was also performed to determine the future needs of the Company and to enhance technology to better enable the Company to provide its services. In addition, as a foundation for developing and executing its Year 2000 compliance program, SafeGuard utilized and integrated Year 2000 compliance programs developed by both Federal and State governments and corporate industry leaders. Moreover, SafeGuard developed a comprehensive five-phase approach for all of its Year 2000 program activities and management processes. The five phases are included in the following table that indicates the percentage completed as of November 1998.
- ---------------------------------------------------------------------------------------------- ANTICIPATED PROGRAM GOALS START DATE DATE COMPLETED COMPLETION DATE - ---------------------------------------------------------------------------------------------- Planning and Awareness 1 Jan 1996 1 Jun 1997 N/A - ---------------------------------------------------------------------------------------------- Assessment 1 Jun 1996 1 Jan 1998 N/A - ---------------------------------------------------------------------------------------------- Renovation 1 Dec 1996 1 Jan 1999 N/A - ---------------------------------------------------------------------------------------------- Validation 1 Jan 1997 In Process 1 Jun 1999 - ---------------------------------------------------------------------------------------------- Implementation 1 Jun 1996 In Process 1 Jun 1999 - ----------------------------------------------------------------------------------------------
The Company's five-phase comprehensive approach is as follows: (1) Phase 1: Planning and Awareness - identify all IT and other systems and facilities and risk rate each according to its potential business impact; -30- 31 (2) Phase 2: Assessment - identify IT and other systems and facilities that utilize date functions and assessing them for Year 2000 functionality; (3) Phase 3: Renovation - reprogram or replace when necessary, inventoried items to ensure that they are Year 2000 compliant; (4) Phase 4: Validation - test the code modifications and new inventory of other associated systems, including extensive date testing and performing quality assurance testing to ensure successful operation in a post-1999 environment; and (5) Phase 5: Implementation of Year 2000 Compliant IT and other systems. As indicated in the above-referenced chart, the Company completed Phase 1 Planning and Awareness on or about June 1, 1997, Phase 2 Assessment on or about January 1, 1998 and Phase 3 Renovation of all of its IT and other systems and related facilities on or about January 1, 1999. The Company anticipates completing Phase 4 Validation and beginning Phase 5 Implementation of such Year 2000 Compliant IT and other systems and facilities by June 1999. The Company has inventoried and risk rated substantially all of its embedded systems. The results of these processes indicate that embedded systems should not present a material Year 2000 risk to the Company. The Company's remaining steps include testing selected embedded systems and remediating through replacement and/or repair and certifying systems that exhibit Year 2000 issues. The Company is focusing its testing and facilities such as data centers, service centers and communication centers. The Company plans to complete the testing, validation and implementation of these systems by June 1999. The Company has also inventoried and risk rated its systems. Substantially all of the tested systems have been found to be compliant. As part of the Company's Year 2000 Compliance Program Planning/Awareness and Assessment phases, the Company documented the state and condition of existing systems and processes and conducted a thorough analysis of inventory and vendor supplied systems and subsystems. The Company included information technology systems and non-information technology systems. The Company also faces the risk that one or more of its Vendors will not be able to interact with the Company due to the Vendor's inability to resolve its own Year 2000 issues, including those associated with its own external relationships. The Company has completed its inventory of Vendors and risk rated each external relationship based upon the potential business impact, available alternatives and cost of substitution. Although the Company is diligently working with its vendors regarding Year 2000 compliance, there can be no guarantee that all of the Company's vendors will be Year 2000 compliant. The Company has previously compiled a comprehensive list of any and all Vendors and Vendor products, which was included in a Vendor identification matrix. Although the Company does not currently rely upon external Vendors for proprietary software or data services, all other Vendors have been identified and have either stated their full compliance or partial compliance with contingent solutions to Year 2000 issues. The Company believes that its Vendors with which it has a material relationship are Year 2000 Compliant, based upon such vendor's assurances. Nonmaterial Vendors of the Company currently have provided either full and/or partial certification of compliance with the Year 2000 issue. The Company will continue to monitor such nonmaterial Vendor compliance activity in order to determine the risk to overall company operations. As a result of the anticipated execution of the Renovation, Validation and Implementation phases of the Company's Year 2000 Compliance Program, the Company believes the Year 2000 issue will not have a material impact on the Company's results or operations. Cost to Address Company's Year 2000 Issues The cost the Company incurred to address Year 2000 Compliance issues from a historical perspective is approximately $2.5 million. Whereas, the estimated cost of the Company's completion of the final phases of renovation, validation and implementation is estimated to be approximately $0.5 million. A large majority of these costs are expected to be incremental expenses that will not recur in Year 2000 or thereafter. The Company's current estimates primarily reflect increased remediation and testing efforts. The source of funds for the Year 2000 Compliance Program costs, including the percentage of the information technology budget utilized for the program was $3.0 million. Year 2000 Compliance -31- 32 is critical to the Company. Therefore, the Company has redeployed some resources from non-critical system enhancements to address Year 2000 issues. Due to the importance of IT systems to the Company's business, management has not deferred the decision to make non-critical systems enhancements Year 2000 ready. The Company does not expect these redeployments to have a material impact on the Company's financial condition or result of operations. Risk and Contingency/Recovery Planning The Company reasonably believes that its Year 2000 Compliance Program, which involves the phases of planning and awareness, assessment, renovation, validation and implementation should prevent the Year 2000 from having a material effect on the Company's business or financial condition. However, if the Company's Year 2000 issues were unresolved, potential consequences would include, among other possibilities, the inability to accurately and timely process benefits claims, update client groups' accounts, process financial transactions, bill client groups, report accurate data to management, shareholders, customers, regulators and others as well as business interruptions or shutdowns, financial losses, reputational harm, increased scrutiny by regulators and litigation related to Year 2000 issues. The Company is attempting to limit the potential impact of the Year 2000 by monitoring the progress of its own Year 2000 project and those of its critical Vendors by developing contingency/recovery plans. The Company has begun to develop contingency/recovery plans aimed at ensuring the continuity of critical business functions before and after December 31, 1999. As part of that process, the Company has begun to develop reasonably likely failure scenarios for its critical IT systems and external relationships and the embedded systems. Once these scenarios are identified, the Company will develop plans that are designed to reduce the impact on the Company, and provide methods of returning to normal operations, if one or more of those scenarios occur. The Company expects contingency/recovery planning to be substantially complete by June 1999. To reduce the risk of the Company presented by the Year 2000, the Company has also increased its on-hand supplies of inventory for printed documents and materials that are provided to client groups, and has identified alternative Vendors, whether such Vendors have previously provided assurances that they are fully Year 2000 Compliant or are in the process of becoming Year 2000 Compliant. Therefore, based upon the Company's proactive Year 2000 Compliance Program, the Company anticipates that the Year 2000 issue will not have a material impact on the Company's results or operations. Impact of Inflation Management believes that the Company's operations are not materially affected by inflation. The Company believes that a majority of its costs are capitated or fixed in nature and are directly related to membership levels, and therefore related to premium levels. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and the related Notes and Schedules thereto filed as part of this 1998 Annual Report on Form 10-K are listed on the accompanying Index to Financial Statements on page F-1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE During the two (2) most recent fiscal years, there have been no changes in the Company's independent auditors or disagreements with such auditors on accounting principles or practices or financial statement disclosures. PART III ITEM 10. DIRECTORS AND/OR EXECUTIVE OFFICERS OF THE COMPANY The current directors and/or executive officers of the Company are as follows:
Name Age Position - ---- --- -------- Steven J. Baileys, D.D.S. 45 Chairman of the Board of Directors and Chief Executive Officer(2) John E. Cox 47 President, Chief Operating Officer and Director(2) Ronald I. Brendzel, J.D. 49 Senior Vice President, General Counsel, Secretary and Director(2) Herb J. Kaufman, D.D.S. 47 Senior Vice President and Chief Dental Officer Kenneth E. Keating 35 Western Regional Vice President
-32- 33
Name Age Position - ---- --- -------- Ronald B. Bolden 33 Central Regional Vice President Gordon W. Spiering 42 Eastern Regional Vice President Judy M. Deal 47 Vice President-Provider Relations Thomas J. Fluegel 32 Vice President-Regional Support Carlos Ferrera 35 Vice President-Information Technologies Robert J. Pommersheim 50 Interim Chief Financial Officer Nancy Stokes 61 Vice President-Quality Improvement Programs Michael M. Mann, Ph.D. 59 Director(1)(2) William E. McKenna 79 Director(1)(2) George H. Stevens 45 Director(1)(2) Bradford M. Boyd, D.D.S. 47 Director(1)(2)
- ---------- (1) Member, Compensation and Stock Option Committee, Audit Committee, and Nominating Committee. (2) Directors hold office from the Annual Meeting of Stockholders for staggered terms of three years (until re-elected or until successors are elected and qualified), as follows: Dr. Baileys and Mr. Stevens Class III May, 1999 Mr. McKenna and Mr. Cox Class I May, 2000 Mr. Brendzel, Dr. Mann and Dr. Boyd Class II May, 2001
Officers are elected annually and serve at the pleasure of the Board of Directors, subject to all rights, if any, under certain contracts of employment. Dr. Baileys is Chairman of the Board of Directors and Chief Executive Officer. He was President from 1981 until March 1997, Chief Executive Officer since May 1995, and Chairman of the Board of Directors since September 1995. He was Chief Operating Officer from 1981 until May 1995. From 1975 until 1981, Dr. Baileys served in a variety of executive and administrative capacities with the Company. From September 30, 1996 through March 31, 1998, Dr. Baileys was an officer, director and 50% shareholder in the Islas Professional Dental Corporation, which operated a dental practice under contract to a subsidiary of the Company. Dr. Baileys is also licensed to practice dentistry in the State of California. He is also a member of the Southern California chapter of the Young Presidents' Organization. Dr. Baileys is the brother-in-law of Mr. Brendzel. Mr. Cox was appointed President and Chief Operating Officer, and was named as a Director of the Company in March 1997. He was Executive Vice President and Chief Operating Officer from May 1995 to March 1997. From 1985 to 1995, he served in various executive capacities for CIGNA Dental Health, including Vice President, National Sales and Account Services, Western Regional President, Chief Financial Officer, and Controller. From 1981 to 1985, Mr. Cox served in various financial capacities for Southeastern Health Services/Prucare-Prudential Insurance Company's group model HMO in Atlanta, Georgia. He is the Company's representative to the National Association of Dental Plans, and served on the Board of Directors the California Association of Dental Plans. Mr. Brendzel is Senior Vice President, General Counsel, Secretary and a Director of the Company. He was Chief Financial Officer from April 1988 to May 1996, Vice President-Corporate Development from August 1980 until April 1986, and held various executive and administrative positions from 1978 until 1980. Mr. Brendzel is a member of the California State Bar and is licensed to practice law in the state of California. He is also a member of the Knox-Keene Health Care Service Plan Advisory Committee, which assists the California Department of Corporations in regulating managed care health plans. Mr. Brendzel is also a former member of the Texas Health Maintenance Organization Solvency Surveillance Committee which assists the Texas Department of Insurance in regulating health maintenance organizations. Dr. Kaufman was appointed Senior Vice President and Chief Dental Officer for the Company in January 1997. From January 1995 to January 1997, he was National Dental Director for CIGNA. From January 1996 to January 1997, Dr. Kaufman was Chief Executive Officer of CIGNA Dental Health of Arizona, Inc. Preceding that, he was Regional Dental Director for the western region for CIGNA from February 1990 to January 1995. Prior thereto, Dr. Kaufman was CIGNA's Dental Director for the State of Arizona from April 1989 to February 1990. From September 1984 to April 1989, he was Dental Director and Dental Department Chair for CIGNA Healthcare of Arizona, Inc. Dr. Kaufman was in private dental practice from August 1979 to August 1984. Prior thereto, Dr. Kaufman was a general dentist in the United States Air Force from July 1976 to June 1979. Dr. Kaufman is licensed to practice dentistry in the States of Arizona, California and Colorado. He is a member of the American Dental Association, Arizona Dental Association, National Association of Dental Professionals, and California Association of Dental Plans. He serves on the advisory -33- 34 board for Procter and Gamble, Health Services Advisory Group, the Academy for Managed Care Dentistry Counsel, and on the faculty at Northern Arizona University. Mr. Keating is the Western Regional Vice President responsible for all administrative activities of the Company for its Western region. He was Vice President-Imprimis and Guards Office Operations for the Company from October 1995 until October 1997. He was Vice President-SafeHealth Life Operations from August 1995 until October 1995 when he was appointed to his present position. From March 1987 to July 1995, Mr. Keating served in various executive capacities for CIGNA Dental Health, including Director of Sales and Account Services, Director of Network Development and Director of Staff Model Operations. Mr. Bolden has been the Central Regional Vice President for the Company's Central region operations since April 1996. Prior to that, he served as New Business Manager for CIGNA Healthcare of California. From 1990 to 1994, Mr. Bolden served in various operational capacities for CIGNA Dental Health-Western Region, including Director, Provider Relations, Regional Sales Support Director and Provider Relations Manager. He obtained a Bachelor of Science degree in Biology from Morehouse College in 1987. Mr. Spiering has been the Eastern Regional Vice President for the Company since February 1998. Prior thereto, he was a Vice President for Lee Hecht Harrison from 1994 until 1998. From 1993 to 1994, he was President of Gordon Spiering & Associates. Preceding that, he was the Marketing/Contracting Manager for National Consulting Group from 1990 until 1993. He served as a Case Manager for Anon Anew of Boca Raton, Inc. from 1986 to 1989. From 1985 to 1986, he was Vice President for Trial Consultant, Inc. Ms. Deal was appointed Vice President-Provider Relations in October 1997. Prior thereto, she was Vice President-Member and Provider Services for the Company from January 1996 until October 1997. From January 1995 until January 1996, she was Vice President-Provider Relations. Prior to joining the Company, Ms. Deal was the Director of Provider Relations for CIGNA Dental Health from November 1988 to January 1995. Preceding that, Ms. Deal was the Dental Office Manager of a large group dental practice from November 1974 to November 1988. Mr. Fluegel was appointed Vice President-Regional Support in April 1998. He was Director, Acquisition & Business Integration from September 1996 to April 1998. From 1988 to 1996, he served in various managerial capacities for CIGNA Dental Health, including Director- Sales and Account Services, Director- Group Administration, Assistant Director-Administrative Development and Manager-Quality Control. Mr. Pommersheim was appointed Interim Chief Financial Officer in December 1998. He joined the Company in February 1997 as Controller Eastern Region and also served as Director Eastern Regional Operations until December 1998. From March 1995 until February 1997, he was the Controller for General Rental, Inc. Prior thereto, he was self-employed from September 1989 to March 1995. From February 1980 until September 1989, he served as Regional Vice President and Vice President, Finance for CIGNA Dental Health. Preceding that, he was the Operations Manager for John Wanamaker Company from November 1974 to February 1980. Mr. Ferrera was appointed Vice President-Information Technologies for the Company in October 1997. Prior thereto, he was Vice President-SafeHealth Life Operations for the Company. He joined the Company in October 1995. From March 1988 to October 1995, Mr. Ferrera served as Director of Provider Relations and Product Consultant for CIGNA Dental Health. Preceding that, he was a Staff Sergeant in the United States Air Force. Ms. Stokes joined the company in September 1997 as Vice President-Quality Improvement Programs. From August 1996 until September 1997, she was employed as a Health Planning Consultant, Quality Improvement Manager for the Arizona Department of Health Services, Office of Oral Health, responsible for designing, conducting, coordinating and documenting quality improvement reviews and program evaluations for all licensed prepaid dental plans operating in Arizona. Program oversight included conducting site visits, tracking, analyzing, monitoring and reporting quality improvement efforts and outcomes. From September 1991 until June 1996, Ms. Stokes was employed by CIGNA Dental Health where she was, at various times, responsible for provider recruitment, specialty referral processing, claim analysis and adjudication, and was director of member services. Dr. Mann has been a Director of the Company since May 1987. He is also Chairman of Blue Marble Partners, and Chairman, President and Chief Executive Officer of Blue Marble Development Group, Inc. international corporate development and consulting firms, and an Adjunct Professor of Industrial and Systems Engineering at the University of Southern California. He also serves as a member of the Board of Examiners for the Malcolm Baldrige National Quality Award. During the period from September 1987 to July 1988, Dr. Mann was a Senior Consultant of Arthur D. Little, Inc. From August 1986 until September 1987, Dr. Mann was a Partner of Mann, Kavanaugh, Chernove & Associates, a -34- 35 business development firm. He was President, Chief Executive Officer and a Director of Helionetics, Inc., a defense, energy and signal information processing company, from December 1984 to July 1986, and Executive Vice President from April to December 1984. Dr. Mann is a Director of Datum, Inc. and Management Technology, Inc. Mr. McKenna has been a Director of the Company since September 1983. Since December 1977, Mr. McKenna has been a general partner of MCK Investment Company, a private investment company. Mr. McKenna was Chairman of the Board of Technicolor, Inc. from 1970 to 1976 and was formerly Chairman of the Board and Chief Executive Officer of Hunt Foods & Industries, Inc. and its successor, Norton Simon, Inc. From 1960 to 1967, Mr. McKenna was associated with Litton Industries, Inc. as a Director and in various executive capacities. He is currently a Director of California Amplifier, Inc., Midway Games, Inc., Drexler Technology Corporation, and WMS Industries, Inc. Mr. Stevens has been a Director of the Company since May 1989. Since 1982, he has been President of Belle Haven Marina, Inc., a privately held leisure and recreational organization located in Virginia. He is also President of Kingfish Corporation, a privately held corporation which is engaged in the business of chartering pleasure yachts in the mid-Atlantic region. Mr. Stevens is also the owner of Mariner Sailing School located in Virginia. Mr. Stevens' combined organization is the largest operator of recreational vessels in the Washington D.C. area. Dr. Boyd has been a Director of the Company since May 1995. He has been licensed to practice dentistry in the State of California since 1983, and has been the sole proprietor of Bradford M. Boyd, D.D.S., located in Lancaster, California. Dr. Boyd also is a private investor. He is a member of the American Dental Association, California Dental Association, and San Fernando Valley Dental Society. Dr. Boyd is also an officer of the Dental Foundation of California and is also a member of the Board of Directors of High Desert Children's Dental, a charity organization providing free dental services to underprivileged children ITEM 11. EXECUTIVE COMPENSATION COMPENSATION OF EXECUTIVE OFFICERS The following table discloses compensation received by the Company's Chief Executive Officer and the four (4) remaining most highly paid executive officers who received total compensation in excess of $100,000 for the previous years ended December 31, 1998, 1997 and 1996. SUMMARY COMPENSATION TABLE
Long Term Annual Compensation Compensation Awards ----------------------------------------------------- Other Stock Name and Principal Position Year Salary($) Bonus($) ($)(2) Options - --------------------------------------------------------------------------------------------- Steven J. Baileys, D.D.S., 1998 400,000 * 1,260 70,000 Chairman of the Board of 1997 400,000 * 1,260 50,000 Directors and 1996 400,000 * 1,260 25,000 Chief Executive Officer John E. Cox, President and Chief 1998 275,000 * * 25,000 Operating Officer 1997 258,221 * * 25,000 1996 200,000 * * 25,000 Ronald I. Brendzel, J.D., Senior 1998 185,000 * 900 5,000 Vice President, General Counsel 1997 185,000 * 900 5,000 and Secretary 1996 185,000 * 900 10,000 Herb J. Kaufman, D.D.S., Senior 1998 165,530 * 249 7,500 Vice President and Chief Dental 1997 153,907 * 249 25,000 Officer(1) Kenneth E. Keating, Western 1998 150,000 * * 5,000 Regional Vice President 1997 150,000 * * 2,500 1996 170,823 * * 7,500
- ---------- * None. (1) Joined the Company on January 5, 1997. -35- 36 (2) Represents premiums paid for life insurance policies for the named individuals. - ---------- EMPLOYMENT AGREEMENTS AND TERMINATION OF EMPLOYMENT ARRANGEMENTS The Company has written employment agreements with Steven J. Baileys, D.D.S., John E. Cox, Ronald I. Brendzel, J.D., and Herb J. Kaufman, D.D.S. The employment agreements for Dr. Baileys, Mr. Cox and Mr. Brendzel are for a term through May 31, 2000, and provide for an annual salary of $400,000, $275,000, and $185,000, respectively. The employment agreement for Dr. Kaufman is for a term through January 5, 2002, and provides for an annual salary of $170,000. The Company may terminate the agreements for cause. The employee may terminate his agreement for any reason. Should there be a change in control of the Company in that more than fifty percent (50%) of the Company's then outstanding common stock is purchased by a then non-existing stockholder, and newly elected Directors constitute a majority of the Company's Board of Directors, the employee, at his option, may terminate his employment. In such event, the Company would be obligated to pay Dr. Baileys, Mr. Cox and Mr. Brendzel an amount equal to three (3) times, and in the case of Dr. Kaufman, one (1) times the employee's then current salary and bonus, paid on or before the fifth (5th) day following such change in control, along with the continuance of all employee benefits for the length of the employment agreement. STOCK OPTIONS The following table contains information concerning the grant of stock options pursuant to the Stock Option Plan (the "Plan") during the fiscal year ended December 31, 1998, to the named executives: STOCK OPTION GRANTS IN LAST FISCAL YEAR
Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation Individual Grants for Option Term(2) - ---------------------------------------------------------------------------------------------------------------- Percent of Number of Total Securities Options/SARs Exercise or Underlying Granted to Base Options/SARs Employees Price Expiration Name Granted(#)(1) In Fiscal Year ($/Share) Date 5%($) 10%($) - ---------------------------------------------------------------------------------------------------------------- Steven J. Baileys, D.D.S 70,000 39.2 10.038 3/27/03 194,132 428,981 John E. Cox 25,000 13.1 9.125 3/27/08 143,467 363,572 Herb J. Kaufman, D.D.S 7,500 3.9 9.125 3/27/08 43,040 109,072 Ronald I. Brendzel, J.D 5,000 2.6 9.125 3/27/08 28,693 72,714 Kenneth E. Keating 5,000 2.6 9.125 3/27/08 28,693 72,714
- ---------- (1) All options were granted under the Plan. The options described in this column vest in equal one-third (1/3) amounts over a three (3) year period following the date of grant. Unvested options terminate upon the employee's termination from the Company, for any reason. (2) Potential realizable value is based on an assumption that the market price of the common stock of $3.3125 as of December 31, 1998, appreciates at the stated rate, compounded annually, from the date of grant to the expiration date. These values are calculated based on requirements promulgated by the Securities and Exchange Commission and do not reflect the Company's estimate of future stock price appreciation. Actual gains, if any, are dependent on the future market price of the Company's common stock. STOCK OPTION EXERCISES AND HOLDINGS The following information is with respect to the named executive officers and indicated groups concerning the exercise of options during fiscal year December 31, 1998, and unexercised options held as of December 31, 1998. -36- 37 AGGREGATED STOCK OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR END OPTION VALUES
Shares Number of Securities Value of Unexercised Acquired Value Underlying Unexercised In-the-Money Name on Exercise(#) Realized($) Options at FY-End(#) Options at FY-End($)(1)(2) - ------------------------------------------------------------------------------------------------------------------------- Exercisable Unexercisable Exercisable Unexercisable Steven J. Baileys, D.D.S * * 183,333 111,667 0 0 John E. Cox * * 75,000 50,000 0 0 Ronald I. Brendzel, J.D * * 33,333 11,667 0 0 Herb J. Kaufman, D.D.S * * 8,333 24,167 0 0 Kenneth E. Keating * * 5,833 9,167 0 0 All executive officers as a group (10) persons) * * 339,833 242,667 0 0 All directors who are not executive * * 81,333 26,667 0 0 Officers as a group (4 persons) All employees who are not executive * * 15,067 35,733 0 0 Officers as a group (29 persons)
- ---------- * None. (1) Assumes a price per share of common stock of $3.3125 as of December 31, 1998. Gains are reported net of the option exercise price, but before any taxes associated with exercise. Actual gains, if any, on stock option exercises are dependent on future performance of the common stock, as well as the optionee's continued employment throughout the vesting period. (2) No stock appreciation rights were outstanding at the end of the 1998 fiscal year or exercised during that year. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT SECURITY OWNERSHIP OF MANAGEMENT The following table sets forth the beneficial ownership of the common stock of as of April 1, 1999, by each director, each executive officer named in the Summary Compensation Table below and all current directors and officers as a group. All shares of common stock are subject to the named person's sole voting and investment power, except where otherwise indicated.
SHARES BENEFICIALLY APPROXIMATE PERCENT NAME OWNED(1) OF CLASS - ---- ------------------- ------------------- Steven J. Baileys, D.D.S.(2) 1,982,099 41.8 Ronald I. Brendzel, J.D.(3) 136,573 2.9 John E. Cox(4) 85,000 1.8 William E. McKenna(5) 36,500 * Michael M. Mann, Ph.D.(6) 29,000 * George H. Stevens(7) 24,350 * Herb J. Kaufman, D.D.S.(8) 16,768 * Bradford M. Boyd, D.D.S.(9) 11,080 * Kenneth E. Keating(10) 5,833 * All current directors and officers as a group (12 persons) 2,346,202 49.4
- ---------- * Less than one percent (1%). (1) Some of the stockholders included in this table reside in states having community property laws under which the spouse of a stockholder in whose name securities are registered may be entitled to share in the management of their community property which may include the right to vote or dispose of such shares, and includes options to purchase 334,834 shares of common stock exercisable as of April 1, 1999, or within sixty (60) days thereafter. (2) The shares indicated include options to purchase 183,333 shares of common stock, 700,767 shares of common stock representing 14.8% owned by the Baileys Family Trust, 303,000 shares of common stock representing 6.4% held in various trusts for relatives of Dr. Baileys, for both of which Dr. Baileys is Trustee and for which Dr. Baileys has sole power to vote the securities, but for both of which Dr. Baileys disclaims beneficial ownership, and 150,000 shares of common stock representing 3.2% held by the Alvin and Geraldine Baileys -37- 38 Foundation, for which Dr. Baileys is an officer and director and for which Dr. Baileys has shared power to vote the securities, but for which Dr. Baileys disclaims beneficial ownership. (3) Includes options to purchase 25,000 shares of common stock. (4) Includes options to purchase 75,000 shares of common stock. (5) Includes options to purchase 29,000 shares of common stock. (6) Represents options to purchase 29,000 shares of common stock. (7) Includes options to purchase 24,000 shares of common stock. (8) Includes options to purchase 16,666 shares of common stock (9) Includes options to purchase 10,000 shares of common stock. (10) Represents options to purchase 5,833 shares of common stock. PRINCIPAL STOCKHOLDERS The following table sets forth information with respect to those persons who, to the Company's knowledge, beneficially owned five percent (5%) or more of common stock as of April 1, 1999, except with respect to the Baileys Family Trust, FMR Corp., Brinson Partners, Inc., Dimensional Fund Advisors, Inc., and T. Rowe Price Associates, Inc., which are stated as of December 31, 1998, based on filings made with the Securities and Exchange Commission. For purposes of this Annual Report on Form 10-K, beneficial ownership of securities is defined in accordance with the rules and regulations of the Securities and Exchange Commission and generally means the power to vote or dispose of securities regardless of any economic interest therein.
APPROXIMATE AMOUNT AND NATURE NAME OF BENEFICIAL OWNER OF BENEFICIAL OWNERSHIP(1) PERCENT OF CLASS - ------------------------ -------------------------- ---------------- Steven J. Baileys, D.D.S.(2) 1,982,099 41.8 Baileys Family Trust(3) 700,767 14.8 FMR Corp.(4) 462,700 9.8 Brinson Partners, Inc.(5) 403,755 8.5 Dimensional Fund Advisors, Inc.(6) 288,100 6.1 T. Rowe Price Associates, Inc.(7) 264,100 5.6 All Principal Stockholders 4,101,521 86.4
- ---------- (1) Except as otherwise stated herein, the persons and entities named in the table have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them, subject to community property laws where applicable, and include all shares held of record on April 1, 1999, and shares subject to options outstanding and exercisable within sixty (60) days thereafter. (2) Steven J. Baileys, D.D.S., an officer and director of the Company, located at 95 Enterprise, Aliso Viejo, California 92656, has sole voting and investment power with respect to the shares indicated. The shares indicated include options to purchase 183,332 shares of common stock, 700,767 shares of common stock representing 14.8% owned by the Baileys Family Trust, 303,000 shares of common stock representing 6.4% held in various trusts for relatives of Dr. Baileys, for both of which Dr. Baileys is Trustee and for which Dr. Baileys has sole power to vote the securities, but for both of which Dr. Baileys disclaims beneficial ownership, and 150,000 shares of common stock representing 3.2% held by the Alvin and Geraldine Baileys Foundation, for which Dr. Baileys is an officer and director, and for which Dr. Baileys has shared power to vote the securities, but for which Dr. Baileys disclaims beneficial ownership. (3) The Baileys Family Trust of which Steven J. Baileys, D.D.S., is Trustee, owns 700,767 shares of the Company's common stock and has sole voting and investment power with respect to the shares indicated. The shares indicated do not include 303,000 shares of common stock representing 6.4% held in various trusts for -38- 39 relatives of Dr. Baileys, for which Dr. Baileys is Trustee and for which Dr. Baileys has sole power to vote the securities, but for which Dr. Baileys disclaims beneficial ownership, and 150,000 shares of common stock representing 3.2%, held by the Alvin and Geraldine Baileys Foundation, for which Dr. Baileys is an officer and director, and for which Dr. Baileys has shared power to vote the securities, but which Dr. Baileys disclaims beneficial ownership. The address of the Baileys Family Trust is P.O. Box 9109, Newport Beach, California 92658. A Schedule 13G dated February 10, 1999, was filed with the Securities and Exchange Commission with respect to such shares. (4) These securities are owned by various individual and institutional investors including Fidelity Low-Priced Stock Fund, which owns the shares indicated, for which Fidelity Management and Research Company ("Fidelity") serves as investment advisor with power to direct investments and/or sole has the power to vote the securities. For purposes of the reporting requirements of the Securities Exchange Act of 1934, Fidelity is deemed to be a beneficial owner of such securities; however, Fidelity expressly disclaims that it is, in fact, the beneficial owner of such securities. The address of FMR Corp. is 82 Devonshire Street, Boston, Massachusetts 02109. A Schedule 13G dated February 12, 1999, was filed with the Securities and Exchange Commission with respect to such shares. (5) Brinson Partners, Inc. ("BPI"), a wholly owned subsidiary of Brinson Holdings, Inc. ("BHI") and Brinson Trust Company ("BTC"), a wholly owned subsidiary of BPI, 209 South La Salle, Chicago, Illinois 60604-1295 have the sole voting and dispositive power of the shares indicated. A Schedule 13G dated February 3, 1999, was filed with the Securities and Exchange Commission with respect to such shares. (6) These securities are owned by four institutional investment companies for which Dimensional Fund Advisors, Inc. ("Dimensional") serves as investment advisor with power to direct investments and/or has the sole power to vote the securities. For purposes of the reporting requirements of the Securities Exchange Act of 1934, Dimensional is deemed to be a beneficial owner of such securities; however Dimensional expressly disclaims that it is, in fact, the beneficial owner of such securities. The address of Dimensional Fund Advisors, Inc. is 1299 Ocean Avenue, 11th Floor, Santa Monica, California 90401. A Schedule 13G dated February 11, 1999, was filed with the Securities and Exchange Commission with respect to such shares. (7) These securities are owned by various individual and institutional investors including T. Rowe Price Small Cap Value Fund, Inc., and T. Rowe Price Associates, Inc. which collectively own the shares indicated for which T. Rowe Price Associates, Inc. ("Price Associates") serves as investment advisor with power to direct investments and/or has the sole power to vote the securities. For purposes of the reporting requirements of the Securities Exchange Act of 1934, Price Associates is deemed to be a beneficial owner of such securities; however, Price Associates expressly disclaims that it is, in fact, the beneficial owner of such securities. The address of T. Rowe Price Associates, Inc. is 100 E. Pratt Street, Baltimore, Maryland 21202. A Schedule 13G dated February 11, 1999, was filed with the Securities and Exchange Commission with respect to such shares. - ------------------------------ ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS On September 30, 1996, the Company sold to Islas Professional Dental Corporation ("Islas"), a dental practice (the "Practice") owned by a subsidiary of the Company in the aggregate amount of $1,131,000. Steven J. Baileys, D.D.S., the Company's Chairman of the Board of Directors and Chief Executive Officer, owned a fifty percent (50%) interest in Islas, which secured two (2) promissory notes from a subsidiary of the Company in the amount of the purchase price. Said notes are payable in equal monthly installments over a thirty (30) year period and a five (5) year period, respectively, and bear interest at eight and one half percent (8.5%). The Practice is also under contract to provide services to a subsidiary of the Company. During fiscal year 1998, the Company paid Islas $205,262.57 under said contract. The sale of the Practice was reviewed and approved by the independent members of the Board of Directors on September 27, 1996, which took into consideration information provided to it by the Company's independent accountants and outside counsel concerning the value of the Practice as an ongoing business owned by the Company contrasted to being owned by an independent dentist, the sale price of dental practices of similar size and scope, and the sale of other dental practices owned by the Company to unrelated parties. The action of the independent members of the Board of Directors in approving the sale of the Practice was ratified by the full Board of Directors of the Company on September 27, 1996. The Practice was sold to an unrelated third party effective on March 31, 1998, for the assumption of the obligation referred to above. -39- 40 PART IV EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ITEM 14(A) (1) - (2) AND (D). FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE The consolidated financial statements and financial statement schedule of SafeGuard Health Enterprises, Inc. filed as part of this 1998 Annual Report on Form 10-K are listed in the accompanying Index to Financial Statements on Page F-1. ITEM 14(A) (3) AND (C). EXHIBITS An "Exhibit Index" has been filed as part of this 1998 Annual Report on Form 10-K beginning on Page E-1. All Exhibits are either attached hereto or are on file with the Securities and Exchange Commission. ITEM 14(B). REPORTS ON FORM 8-K Reports on Form 8-K concerning the Company's wholly-owned subsidiary completed the sale of all of its thirty-four (34) orthodontic practices and related assets and liabilities and the appointment of Robert J. Pommersheim as Interim Chief Financial Officer, replacing Thomas C. Tekulve, C.P.A., who resigned to pursue other interests, were filed with the Securities and Exchange Commission on or about April 1, 1998 and December 14, 1998, respectively. The Reports on Form 8-K mentioned in this Item 14(b), are hereby incorporated herein to this 1998 Annual Report on Form 10-K for the period ended December 31, 1998, as is set forth in full herein. - -------------------------------------------------------------------------------- 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, in the City of Aliso Viejo, State of California, on the 15th day of April, 1999. SAFEGUARD HEALTH ENTERPRISES, INC. /s/ STEVEN J. BAILEYS, D.D.S. ---------------------------------------- STEVEN J. BAILEYS, D.D.S., Chairman of the Board and Chief Executive Officer (Principal Executive Officer) /s/ ROBERT J. POMMERSHEIM ---------------------------------------- ROBERT J. POMMERSHEIM Interim Chief Financial Officer (Principal Financial Officer) -40- 41 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. POWER OF ATTORNEY We, the undersigned directors and officers of SafeGuard Health Enterprises, Inc., and each of us, do hereby constitute and appoint Steven J. Baileys, D.D.S. and/or Ronald I. Brendzel, as our true and lawful attorneys and/or agents, each with power of substitution, to do any and all acts and things in our name and behalf in our capacities as directors and officers and to execute any and all instruments for us and in our names in the capacities indicated above, which said attorneys and/or agents, or any one of them, may deem necessary or advisable to enable said corporation to comply with the Securities Exchange Act of 1934, as amended, and any rules, regulations, and requirements of the Securities and Exchange Commission, in connection with this 1998 Annual Report on Form 10-K, including specifically but without limitation, power and authority to sign for us or any of us in our names in the capacities indicated below, any and all amendments hereto; and we do hereby ratify and confirm all that the said attorneys and/or agents, or their substitute or substitutes, or any one of them, shall do or cause to be done by virtue hereof.
Signature Title Date --------- ----- ---- STEVEN J. BAILEYS, D.D.S. Chairman of the Board and April 15, 1999 - ------------------------- Chief Executive Officer STEVEN J. BAILEYS, D.D.S. JOHN E. COX President, Chief Operating April 15, 1999 - ------------------------- Officer And Director JOHN E. COX RONALD I. BRENDZEL Senior Vice President, April 15, 1999 - ------------------ General Counsel, RONALD I. BRENDZEL Secretary and Director MICHAEL M. MANN Director April 15, 1999 - --------------- MICHAEL M. MANN WILLIAM E. MCKENNA Director April 15, 1999 - ------------------ WILLIAM E. MCKENNA GEORGE H. STEVENS Director April 15, 1999 - ----------------- GEORGE H. STEVENS BRADFORD M. BOYD, D.D.S. Director April 15, 1999 - ------------------------ BRADFORD M. BOYD, D.D.S.
-41- 42 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS
Page ---------- Independent Auditors' Report...................................................F-2 Financial Statements Consolidated Statements of Financial Position..........................F-3 Consolidated Statements of Operations..................................F-4 Consolidated Statements of Stockholders' Equity........................F-5 Consolidated Statements of Cash Flows..................................F-6 Notes to Consolidated Financial Statements.........................F-7 to F-22 Financial Statement Schedule Schedule II - Valuation and Qualifying Accounts........................F-23
All other schedules are omitted where they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. F-1 43 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of SafeGuard Health Enterprises, Inc.: We have audited the accompanying consolidated statements of financial position of SafeGuard Health Enterprises, Inc. and subsidiaries (the "Company") as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of SafeGuard Health Enterprises, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for recognizing revenue relating to providing orthodontic health care services in 1996. DELOITTE & TOUCHE LLP Costa Mesa, California April 15, 1999 F-2 44 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL POSITION ($000'S OMITTED, EXCEPT FOR SHARE DATA)
December 31, 1998 1997 - --------------------------------------------------------------------------------------------------------- ASSETS Current assets: Cash $ 3,256 $ 3,652 Investments available for sale, at estimated fair value 2,959 5,557 Investments held to maturity, at amortized cost -- 3,697 Accounts receivable, net of allowances of $2,954 in 1998 and $1,061 in 1997 4,641 5,349 Notes receivable, net of allowances of $17,305 in 1998 and $0 in 1997 10,892 1,878 Income taxes receivable 485 132 Prepaid expenses and other current assets 478 1,029 Deferred income taxes 6,672 1,047 Assets held for sale 3,562 -- Net assets of discontinued operations -- 4,062 -------- -------- Total current assets 32,945 26,403 Property and equipment, net 6,105 9,351 Investments available for sale, at estimated fair value 4,225 -- Investments held to maturity, at amortized cost -- 5,656 Notes receivable - long-term, net of allowances of $2,601 in 1998 and $3,595 in 1997 4,083 12,327 Goodwill, net of accumulated amortization of $1,563 in 1998 and $815 in 1997 27,914 29,556 Intangibles and covenant not to compete, net of accumulated amortization of $2,059 in 1998 and $2,297 in 1997 3,893 4,978 Deferred income taxes - long-term 539 -- Other assets 240 247 -------- -------- $ 79,944 $ 88,518 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Short-term debt $ 8,000 $ 8,500 Current portion of note payable 1,894 1,692 Accounts payable and accrued expenses 10,905 5,193 Reserves for dental claims 3,558 3,631 Deferred revenue 1,022 1,177 -------- -------- Total current liabilities 25,379 20,193 Long-term debt 32,500 32,500 Note payable -- 1,394 Deferred income taxes -- 1,289 Accrued compensation agreement 311 383 Commitments and contingencies (Notes 6 and 11) Stockholders' equity: Preferred stock - $.01 par value; 1,000,000 shares authorized, no shares issued or outstanding -- -- Common stock - $.01 par value; 30,000,000 shares authorized; 4,747,000 in 1998 and in 1997 shares issued and outstanding, Stated at 21,509 21,509 Retained earnings 18,722 29,816 Accumulated other comprehensive income (354) (443) Treasury stock, at cost (18,123) (18,123) -------- -------- Total stockholders' equity 21,754 32,759 -------- -------- $ 79,944 $ 88,518 ======== ========
See accompanying Notes to Consolidated Financial Statements. F-3 45 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS ($000'S OMITTED, EXCEPT PER SHARE DATA)
Year ended December 31, 1998 1997 1996 - ---------------------------------------------------------------------------------------------------- Health care revenues $ 97,449 $ 95,350 $ 72,709 Expenses: Health care services 66,020 65,702 54,534 Selling, general and administrative 37,492 25,103 16,292 --------- --------- --------- Total expenses 103,512 90,805 70,826 --------- --------- --------- (Loss) income from operations (6,063) 4,545 1,883 Other income 2,341 1,632 984 Loss on impairment of assets (11,165) -- -- Interest expense (4,311) (2,871) (485) --------- --------- --------- (Loss) income from continuing operations before (benefit) provision for income taxes, discontinued operations and cumulative effect (19,198) 3,306 2,382 (Benefit) provision for income taxes (6,638) 1,495 980 --------- --------- --------- (Loss) income from continuing operations before discontinued operations and cumulative effect (12,560) 1,811 1,402 --------- --------- --------- Discontinued operations and cumulative effect: Loss from operations to be disposed of (net of income tax benefit of $396 in 1998, $2,267 in 1997 and $616 in 1996 and net of after tax deferred loss of $621 in 1996) (620) (3,555) (852) Income (loss) on disposal of dental practices (net of income tax expense of $1,333 in 1998, income tax benefit of $367 in 1997 and income tax expense of $1,088 in 1996) 2,086 (605) 1,678 Cumulative effect of change in accounting principle- orthodontic operations, net of tax of $536 in 1996 -- -- 824 --------- --------- --------- Gain (loss) from discontinued operations and cumulative effect 1,466 (4,160) 1,650 --------- --------- --------- Net (loss) income $ (11,094) $ (2,349) $ 3,052 ========= ========= ========= Basic (loss) earnings per share: (Loss) income from continuing operations before discontinued operations $ (2.66) $ 0.38 $ 0.30 Income (loss) from discontinued operations 0.31 (0.88) 0.17 Cumulative effect of change in accounting principle -- -- 0.17 --------- --------- --------- Net (loss) income $ (2.35) $ (0.50) $ 0.64 ========= ========= ========= Diluted earnings per share: Income from continuing operations before discontinued operations $ (2.66) $ 0.37 $ 0.28 Income (loss) from discontinued operations 0.31 (0.85) 0.17 Cumulative effect of change in accounting principle -- -- 0.17 --------- --------- --------- Net (loss) income $ (2.35) $ (0.48) $ 0.62 ========= ========= =========
See accompanying Notes to Consolidated Financial Statements. F-4 46 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ($000'S OMITTED)
Accumulated Number of Shares Other ----------------- Common Retained Comprehensive Treasury Common Treasury Stock Earnings Income Stock Total - ----------------------------------------------------------------------------------------------------------------- January 1, 1996 7,979 (3,275) $21,092 $29,113 $ (153) $(18,123) $ 31,929 Comprehensive income: Net income 3,052 Net unrealized gain on investment securities available for sale, net of tax of $36 56 56 -------- Total comprehensive income (3,108) Exercise of stock options (includes $33 tax benefits) 12 163 3,052 ----- ------ ------- -------- ------- -------- -------- December 31, 1996 7,991 (3,275) 21,255 32,165 (97) (18,123) 35,200 Comprehensive income: Net loss (2,349) (2,349) Net unrealized loss on investment securities available for sale, net of tax benefit of $221 (346) (346) -------- Total comprehensive loss 2,695 Exercise of stock options (includes $121 tax benefits) 31 254 254 ----- ------ ------- -------- ------- -------- -------- December 31, 1997 8,022 (3,275) 21,509 29,816 (443) (18,123) 32,759 Comprehensive income: Net loss (11,094) (11,094) Net unrealized gain on investment securities available for sale, net of tax of $57 89 89 -------- Total comprehensive loss (11,005) ----- ------ ------- -------- ------- -------- -------- December 31, 1998 8,022 (3,275) $21,509 $ 18,722 $ (354) $(18,123) $ 21,754 ===== ====== ======= ======== ======= ======== ========
See accompanying Notes to Consolidated Financial Statements. F-5 47 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS ($000'S OMITTED)
Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net (loss) income $ (11,094) $ (2,349) $ 3,052 Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: (Gain) Loss from discontinued operations (2,043) 6,794 4,719 Gain on disposal of discontinued dental practices (8,092) (2,577) (2,766) Gain on sale of property and equipment -- -- (7) Loss on valuation of assets 12,269 -- -- Depreciation and amortization 2,839 2,284 2,350 Deferred income taxes (7,453) (1,256) 1,408 Changes in operating assets and liabilities, net of effects of acquisitions: Accounts and current notes receivable, net 8,306 (351) (1,478) Income taxes receivable (353) (88) 34 Prepaid expenses and other current assets 558 (299) (419) Accounts payable and accrued expenses 5,676 234 (111) Deferred revenue (155) 625 357 Reserves for incurred but not reported claims (73) 801 1,067 --------- -------- -------- Net cash provided by continuing operations 385 3,818 8,206 Net cash used in discontinued operations (2,778) (5,183) (7,336) --------- -------- -------- Net cash (used in) provided by operating activities (2,393) (1,365) 870 --------- -------- -------- Cash flows from investing activities: Purchase of investments available for sale (10,169) (9,386) (14,218) Proceeds from sales/maturity of investments available for sale 11,319 9,903 21,892 Purchase of investments held to maturity -- (8,104) (5,977) Proceeds from maturity of investments held to maturity 4,906 5,063 3,940 Purchases of property and equipment (2,449) (2,118) (3,029) Proceeds from sale of property and equipment -- -- 7 Payments received on notes receivable 54 38 -- Cash paid for business acquired, net of cash acquired -- (1,203) (20,320) Additions to intangibles and other assets 64 (2,109) (127) --------- -------- -------- Net cash used in investing activities - continuing operations 3,725 (7,916) (17,832) Net cash used in discontinued operations -- (684) (1,670) --------- -------- -------- Net cash used in investing activities 3,725 (8,600) (19,502) --------- -------- -------- Cash flows from financing activities: Proceeds from long-term debt 8,000 40,500 19,000 Proceeds from exercise of stock options -- 133 130 Payments on accrued compensation agreement (36) (30) Payments on bank debt -- (27,000) Payments on notes payable (9,692) (692) (298) --------- -------- -------- Net cash provided by financing activities (1,728) 12,911 18,832 --------- -------- -------- Net increase in cash (396) 2,946 200 Cash at beginning of year 3,652 706 506 --------- -------- -------- Cash at end of year $ 3,256 $ 3,652 $ 706 ========= ======== ======== Supplemental disclosure of non-cash activities: Tax benefit from exercise of stock options $ -- $ 121 $ 33 Supplementary information: Cash paid during the year for: Interest $ 4,008 $ 2,872 $ 485 Income taxes $ -- $ -- $ 619 Purchase of businesses acquired (Notes 1 and 3): Fair value of assets acquired $ -- $ 17,342 $ 25,697 Less: cash acquired -- (5,455) (201) Less: note payable issued -- (9,500) (3,576) Less: liabilities assumed -- (1,184) (1,600) --------- -------- -------- Cash paid for business acquired $ -- $ 1,203 $ 20,320 ========= ======== ========
See accompanying Notes to Consolidated Financial Statements. F-6 48 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES SafeGuard Health Enterprises, Inc., a Delaware corporation (the "Company"), is a holding company that manages what is, collectively, one of the largest publicly-traded Dental HMO plans in the United States. The Company provides managed care and indemnity dental benefits for approximately 1,018,000 members, through a panel of independent primary care dental offices and specialists, and a preferred provider organization panel. Operations are conducted through wholly-owned subsidiaries in twenty-seven states and the District of Columbia. The Company was founded as a non-profit entity in California in 1974, and converted to a for-profit entity at the end of 1982. In 1992, the Company acquired a California-based indemnity insurance company licensed to transact insurance business and currently holds a certificate of authority in 14 states. In 1996, the Company acquired a Texas-based managed dental care company and in 1997 the company acquired a Florida based managed dental care company. In 1997, the Company acquired Consumers Life Insurance Company of North Carolina, renamed it SafeHealth Life Insurance Company, Inc., and redomesticated it to Texas. That company is licensed in 16 states. In January 1998, the Company merged one of the Advantage affiliates, Advantage Dental HealthPlans, Inc., a Missouri corporation into SafeGuard Health Plans, Inc. a Missouri corporation. In May 1998, the Company initiated the merger of SafeHealth, Inc., into its affiliate, SafeHealth Life Insurance Company, a California corporation ("SafeHealth"), as part of a strategic plan to simplify business operations from an administrative, financial and legal perspective. The merger of SafeHealth, Inc. into SafeHealth will also release surplus requirements of the no longer existing entity, SafeHealth, Inc. The merger is subject to regulatory approval from both the California and Texas Departments of Insurance. In December 1998, the Company received approval from the California Department of Insurance and in March 1999, regulatory approval from the Texas Department of Insurance. As indicated in the accompanying consolidated statements of operations, the Company incurred a net loss of approximately $11 million during 1998. A significant component of this loss was the loss on impairment of assets of approximately $11.1 million, comprised primarily of reduction in value of notes received upon the sale of various discontinued operations, and the reduction in value of land and building held for sale to its estimated net realized value. Management's plans to return to profitability and positive cash flow from operations include restructuring of the Company's debt (see Note 14), disposition of non-core assets, reduction of selected costs, and the consideration of various strategic alternatives. Basis of Consolidation The consolidated financial statements include all the accounts of the Company and its subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. Revenue and Cost Recognition Premiums collected for health care revenues are recognized in the period for which the member is entitled to service. Related costs for health care services are expensed in the period the Company provides such service. On January 1, 1996, the Company changed its method of recognizing revenues relating to providing orthodontic health care services to the proportional performance method. This change in method of revenue recognition resulted in orthodontic practice revenues being recognized based on the ratio of costs incurred to total estimated costs, which better matches revenues and expenses over the life of an orthodontic contract. Previously, the Company recognized revenue ratably over the life of the contract on a straight-line basis. The Company believes the proportional performance method provides for a better matching of expenses to revenues over the life of each individual orthodontic contract. As a result, the Company recorded a total earned but unbilled receivable of approximately $1.9 million in 1997 and $2.6 million in 1996. Of the $2.6 million in 1996, $1.35 million represented cumulative effect, ($824,000 net of taxes, or $.17 per share) as of January 1, 1996. The orthodontic practices were disposed of on April 1, 1998. (See Note 2). Investments In accordance with Statement of Financial Accounting Standards No. 115 ("FAS 115"), Accounting for Certain Investments in Debt and Equity Securities, the Company has classified its investment portfolio into "available for sale" and "held to maturity" categories. Investments classified as available-for-sale are carried at fair value and unrealized gains or losses, net of applicable income taxes, are reported in a separate caption of stockholders' equity. Investments classified as held to maturity are carried at amortized cost. At December 31, 1998, the Company recorded net unrealized losses of $567,000 and decreased stockholders' equity by $354,000 (net unrealized losses, less deferred income taxes of $213,000). Investments consist principally of variable rate interest-bearing tax-exempt investments, taxable bonds, equity securities, treasury bills and notes, and certificates of deposit with original maturities greater than three months. The adjusted cost of specific securities sold is used to compute the gain or loss on sale of investments. F-7 49 During 1998, the Company transferred approximately $4.2 million of securities from the held to maturity category to the available for sale category. This amount represented the amortized cost of the securities at the date of transfer. The estimated fair value of those securities was approximately $4.4 million resulting in a net after tax unrealized gain of $0.1 million, which was reflected as a direct increase to equity. The change in classification was a result of a change in management's intent with respect to these securities related to a change in the Company's liquidity as discussed above, which could not have been predicted when the held to maturity investments were purchased. In order to have the flexibility to respond to changes in interest rates and to take advantage of changes in the availability of and the yield on alternative investments, management determined that the reclassification of these securities as available for sale was appropriate. Fair Value of Financial Instruments The Company's balance sheet includes the following financial instruments: cash, investments, accounts and notes receivable, accounts payable, short and long-term debt. The Company considers the carrying amounts in the financial statements to approximate the fair value for these financial instruments because of the relatively short period of time between origination of the instruments and their expected realization for current items. Due to current payment trends, notes receivable have been written down to management's estimate of net realizable value which approximates fair value (see Note 10). The fair value of the Company's long-term debt approximated its carrying value. Property and Equipment Property and equipment are recorded at cost. Depreciation and amortization are calculated using the straight-line method over the estimated useful lives of the respective property and equipment as follows: leasehold and building improvements - 5 to 25 years; furniture, fixtures and other equipment - 3 to 10 years. Expenditures for maintenance and repairs are expensed as incurred, while major improvements which extend the estimated useful life of an asset are capitalized. Upon the sale or other retirement of assets, the accounts are relieved of the cost and related accumulated depreciation and amortization, and any resultant gain or loss is recognized. In March 1995, the FASB issued Statement of Financial Accounting Standards No. 121 ("FAS 121"), Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, which became effective for fiscal years beginning after December 15, 1995. FAS 121 requires impairment losses to be recognized for long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows are not sufficient to recover the assets' carrying amount. The impairment loss is measured by comparing the fair value of the assets to their carrying amount. The statement also requires that assets to be disposed of be written down to fair value, less selling costs. The Company adopted this statement in fiscal year 1996 as required, and its adoption did not have a significant effect on the Company's financial position or results of operations. Intangibles License acquisition costs associated with the purchase of an indemnity insurance company in October 1992 and another in August 1997 are amortized over a 20 year period. Goodwill related to the acquisition of First American Dental Benefits, Inc. ("First American") in September 1996 and Advantage Dental HealthPlans ("Advantage") in May 1997 is being amortized over a period of 40 years. The covenants not to compete related to the acquisition of First American and Advantage are being amortized over a 5 year period. The Company periodically evaluates whether events and circumstances have occurred which may affect the estimated useful lives or the recoverability of the remaining balance of its intangibles. At December 31, 1998, the Company's management believed that no material impairment of goodwill or other intangible assets existed. Income Taxes The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards No. 109 ("FAS 109"), Accounting for Income Taxes. This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in the Company's financial statements or tax returns. The measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting basis and the tax basis of the Company's assets and liabilities result in a deferred tax asset, FAS 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized. F-8 50 401(k) Plan The Company maintains a 401(k) plan which allows for a pre-tax contribution from an employee's earnings. Employees are eligible to participate in the 401(k) plan upon completion of six months of service with the Company. Under the 401(k) plan, an employee may defer up to 15 percent of his or her gross compensation each pay period and the Company may, at its option, make an additional discretionary contribution to be allocated among employees in the plan in proportion to the compensation deferred. Employees are 100 percent vested in their interest in the 401(k) plan at all times. The Company did not make contributions in 1998 or 1997. The Company also maintains a pre-tax medical insurance option within the meaning of Section 125 of the Internal Revenue Code for its employees insuring dependents. Use of Estimates in Preparation of Financial Statements The preparation of financial statements in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Net (Loss) Income Per Share (Loss) earnings per share have been restated to conform with the provisions of Statement of Financial Accounting Standards No. 128, "Earnings Per Share". Basic earnings per share excludes the effect of all potentially dilutive securities. Diluted earnings per share includes the effect of all potentially dilutive common securities (see Note 9). The potentially dilutive securities were excluded from the calculation of diluted loss per share for 1998 because they were anti-dilutive. The weighted average number of basic and dilutive shares outstanding and the related earnings per share for the years ended December 31, were as follows:
For the year ended December 31, 1998 1997 1996 - ------------------------------- ------------------------------ ----------------------------- ----------------------------- Number Per-share Number Per-share Number Per-share Amount of shares amount Amount of shares amount Amount of shares amount -------- --------- --------- ------- --------- --------- ------- --------- --------- Basic earnings per share Net (loss) income available to common stockholders $(11,094) 4,747 $(2.35) $(2,349) 4,723 $(0.50) $(3,052) 4,711 $(0.65) Effect of Dilutive Securities Options -- -- -- 176 -- 229 Diluted earnings per share Income available to common stockholders and assumed conversions $(11,094) 4,747 $(2.35) $(2,349) 4,899 $(0.48) $(3,052) 4,940 $(0.62)
Regulatory Requirements and Restricted Deposits Pursuant to various state regulations, certain of the Company's subsidiaries are required to hold restricted deposits. As of December 31, 1998 and December 31, 1997, the Company held restricted deposits of $6.0 million and $9.0 million, respectively. Additionally, the Company is required to maintain minimum capital and surplus balances. As of December 31, 1998 and December 31, 1997, these subsidiaries were in compliance with all regulatory requirements. Reclassifications Certain amounts have been reclassified in prior years to conform with the financial statement presentation for the year ended December 31, 1998. Stock Options In October 1995, the Financial Accounting Standards Board issued SFAS No. 123, Accounting for Stock-Based Compensation, which requires adoption of the disclosure provisions no later than years beginning after December 15, 1995, and adoption of the recognition and measurement provisions for non-employee transactions no later than after December 15, 1995. The new standard defines a fair value method of accounting for stock options and other equity instruments. Under the fair value method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period which is usually the vesting period. F-9 51 Pursuant to the new accounting standard, companies are encouraged, but are not required, to adopt the fair value method of accounting for employee stock-based transactions. Companies are also permitted to continue to account for such transactions under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, but are required to disclose in a note to the financial statements pro forma net income and earnings per share as if the company had applied the new method of accounting. The Company has determined that it will not change to the fair value method and will continue to use Accounting Principles Board Opinion No. 25 for measurement and recognition of employee stock-based transaction. (See Note 9). Recent Accounting Pronouncements In June 1997, FASB issued Statement of Financial Accounting Standards No. 130 ("FAS 130"), Reporting Comprehensive Income, which becomes effective for fiscal years ending after December 15, 1997. FAS 130 requires that all components of comprehensive income be displayed with the same prominence as other financial statements. In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131 ("FAS 131"), Disclosure About Segments of an Enterprise and Related Information, which becomes effective for fiscal years ending after December 15, 1997. FAS 131 requires that future financial statements contain disclosures about products and services, geographic areas and major customers related to its reportable operating segments. The adoption of FAS 130 and 131 did not have a significant effect on the Company's financial position or results of operations. In June 1998, the Financial Accounting Standards Board (FASB) issued statement of Financial Accounting Standard No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities, which becomes effective for fiscal years beginning after June 15, 1999. FAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The Company does not expect the adoption of FAS 133 to have a significant impact on the Company's financial position or results of operations. NOTE 2: DISCONTINUED OPERATIONS General Dental Practices On October 21, 1996, the Company implemented a strategic plan to sell all of the general dental practices owned by the Company. Four of the general dental practices were sold during 1996, the remaining were sold during 1997. The assets of the general dental practices sold pursuant to the Company's plan, consisted primarily of accounts receivable, supply inventories, equipment and leasehold improvements. Each general dental practice sold could enter into a contract with the Company's practice management subsidiary, at the time of sale, whereby the Company would provide certain services to support the dentists in the operation of their practices, including administrative support. The Company discontinued operating its practice management subsidiary and terminated these agreements in 1998. The Company projected a gain on the disposal of the discontinued operations that offset the operating losses of the dental practices during the phase-out period ended September 30, 1997. In the fourth quarter 1997, the Company recorded a pretax charge of $8.5 million related to discontinued operations for both dental and orthodontic practices. This charge included reserves for under-performing notes and receivables ($5.6 million), litigation costs ($0.7 million) and other transition costs ($2.2 million). In 1996, year to date operating losses for discontinued dental operations prior to the measurement date of October 21, 1996, were $2.3 million net of a tax benefit of $1.5 million. The operating losses subsequent to the measurement date in 1996 were recognized in the consolidated statements of income up to the amount of the net gain on disposal of the discontinued dental practices which was $550 net of taxes as of December 31, 1996. The remaining losses of $621 net of taxes for December 31, 1996, were deferred as an asset until the completion of the sale of all the dental practices as of September 30, 1997. The income statement for prior years has been restated and operating results of the dental and orthodontic practices are also shown as discontinued operations. Net revenue generated by the discontinued dental practices for the twelve months ended December 31, 1997 and 1996, were $4.6 million and $18.6 million, respectively. These amounts are not included in revenue in the accompanying statements of operations. Orthodontic Practices On February 26, 1998, the Company announced the discontinuance of its orthodontic practices. The assets of the orthodontic practices which were sold on April 1, 1998, pursuant to the Company's plan, consisted primarily of accounts receivable, supply inventory and dental equipment. F-10 52 Pursuant to the terms of the definitive Master Asset Purchase Agreement (the "Agreement") dated and effective as of April 1, 1998, by and among Guards and the Purchasers, the orthodontic practices were sold for total gross consideration of $15 million, paid by an 8 1/2% 30-year promissory note, secured by all current and future assets of the Purchasers, including those assets transferred under the Agreement made by the Purchasers and payable to Guards. Among other provisions, the Agreement details the sale of associated assets and liabilities of the practices and a long term commitment to continue to provide orthodontic services to the members of SafeGuard Health Plans, Inc. The Company recorded a gain on disposal of the orthodontic practices of $3.7 million, net of taxes of $2.3 million. The operating results of the orthodontic practices for the three months ended March 31, 1998, and twelve months ended December 31, 1997 and 1996, are included in the accompanying consolidated statement of operations under the term "Discontinued Operations". Net revenue generated by the discontinued orthodontic practices for the three months ended March 31, 1998, and the years ended December 31, 1997 and 1996, were $1.9 million, $8.16 million and $8.28 million, respectively. These amounts are not included in revenue in the accompanying statements of operations. Assets of the discontinued general dental and orthodontic practices to be disposed of, shown at their net book value (in $000's), consisted of the following:
April 1, 1998 December 31, 1997 December 31, 1996 ------------- ----------------- ----------------- Accounts receivable, net $ 1,896 $ 1,896 $ 3,462 Supplies inventory 265 270 639 Leasehold improvements and equipment, net 2,413 2,478 7,571 Intangible assets 1,000 -- -- Deferred operating loss of discontinued operations, net 1,246 -- 1,036 Other 171 168 439 Legal reserves -- (750) -- ------- -------- ------- $ 6,991 $ 4,062 $13,147 ======= ======== =======
Net assets to be disposed of, at their book values, have been separately classified in the accompanying consolidated balance sheet at December 31, 1997 and 1996. NOTE 3: BUSINESS ACQUISITIONS Effective September 27, 1996, the Company completed the acquisition of all of the outstanding shares of First American, a privately-held managed dental care company based in Dallas, Texas, and a related marketing entity, for a total consideration of $23.6 million, plus assumed liabilities of $1.6 million, acquisition costs of $0.3 million and acquired cash of $0.2 million. Of the purchase price, $20 million was paid at closing (which included a $1 million holdback account) and an aggregate sum of $3.6 million over three years pursuant to non-competition agreements entered into between the Company and the former owners of First American. The Company financed the acquisition of First American through a credit agreement with Bank of America. First American provides managed dental care services through a network of approximately 1,100 dental care providers to approximately 175,000 members in Texas. The acquisition of First American was accounted for using the purchase method of accounting with the results of operations of the businesses acquired included from the effective date of the acquisition. The acquisition resulted in excess cost over fair market value of net assets acquired of $21.5 million. The acquisition is included as part of the Company's consolidated financial statements, subsequent to September 27, 1996. Effective May 9, 1997 the Company completed the acquisition of all of the outstanding shares of Advantage, a privately held managed dental care company based in Fort Lauderdale, Florida for a total consideration of $10 million plus assumed liabilities of $2.3 million, and acquired cash of $0.8 million. Of the purchase price, cash was paid at closing consisting of a $0.5 million holdback account and the Company is obligated to pay an aggregate sum of $1 million over two years pursuant to a non-competition agreement entered into between the Company and the former owner of Advantage. The Company financed the acquisition of Advantage through a note from the seller for $8.5 million which had a due date, with extensions, of April 2, 1998. Advantage provides managed dental care services through a network of approximately 800 dental care providers to approximately 125,000 members in Florida, Missouri and several other southeastern states. The acquisition of Advantage was accounted for using the purchase method of accounting with the results of operations of the businesses acquired included from the effective date of the acquisition. The acquisition resulted in excess cost over fair market value of net assets acquired of $9.2 million. The acquisition is included as part of the Company's consolidated financial statements, subsequent to May 9, 1997. F-11 53 Effective August 1997, the Company completed the acquisition of all of the outstanding shares of Consumers Life Insurance Company of North Carolina ("Consumers"), a privately held dental indemnity insurance company with licenses in sixteen states. The Company purchased the licenses and obtained all the statutory deposits held on behalf of Consumers for a cash payment of $3.2 million and capitalized Consumers with total capital and surplus of $5 million. The acquisition of Consumers was accounted for using the purchase method of accounting with the results of operations of the businesses acquired included from the effective date of the acquisition. Unaudited pro forma results (in $000's) of operations of the Company for the twelve months ended December 31, 1997 and December 31, 1996, are included below. Such pro forma presentation has been prepared assuming that the acquisitions had occurred as of January 1, of each period.
1997 1996 ---------- ---------- Revenues $ 97,808 $ 77,990 Net income (loss) (1,879) 1,705 Net (loss) income diluted common share $ (0.38) $ 0.35 Net (loss) income per diluted common share $ (0.47) $ 0.68
The pro forma results include, (1) the historical accounts of the Company and of the acquired businesses; (2) and pro forma adjustments, including the amortization of the excess purchase price over the fair value of the net assets acquired, the amortization for the non-compete agreements entered into between the Company and the former owners of First American and Advantage, interest on related debt, and the applicable income tax effects of these adjustments. The pro forma results for the year ended December 31, 1997, include the effect of adjustments recorded subsequent to the purchase of First American by the Company. Substantially all of the adjustments were one-time in nature. Such adjustments will be applied to the applicable holdback funds maintained by the Company in connection with this acquisition. The pro forma results of operations are not necessarily indicative of actual results which may have occurred had the operations of the acquired companies been combined in prior years. NOTE 4: COMPOSITION OF CERTAIN BALANCE SHEET ACCOUNTS Investments The following table summarizes the Company's investments as of December 31, 1998 (in $000's). The estimated fair value of investments is based on quoted market prices.
Gross Gross Estimated Cost/Amortized Unrealized Unrealized Fair Cost Gains Losses Value - ---------------------------------------------------------------------------------------------- Classified as available for sale: U.S. government and its agencies $3,538 $101 $ -- $3,638 State obligations 674 32 -- 706 Corporate bonds 376 -- (57) 319 Equity securities 2,715 -- (665) 2,050 Funds and other short-term Municipal obligations 448 23 -- 471 ------ ---- ----- ------ Total available for sale $7,751 $155 $(722) $7,184 ====== ==== ===== ======
The contractual maturities of investments as of December 31, 1998, are shown below (in $000's). Expected maturities may differ from contractual maturities:
Cost/Amortized Cost Estimated Fair Value - ----------------------------------------------------------------------------------------------- Classified as available for sale: Due in one year or less $ 904 $ 909 Due after one year through five years 2,642 2,731 Due after five years through ten years 873 833 Due after ten years 616 661 Equity securities 2,715 2,049 ------ ------ Total available for sale $7,751 $7,184 ====== ======
F-12 54 The following table summarizes the Company's investments as of December 31, 1997 (in $000's). The estimated fair value of investments is based on quoted market prices.
Cost/ Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value - -------------------------------------------------------------------------------------------- Classified as available for sale: U.S. government and its agencies $ 553 $ 8 $ -- $ 561 State obligations 1,000 -- 1,000 Corporate bonds 184 -- (60) 124 Equity securities 3,885 132 (806) 3,211 Funds and other short-term Municipal obligations 661 -- -- 661 ------- ---- ------- ------- Total available for sale 6,283 140 (866) 5,557 ------- ---- ------- ------- Classified as held to maturity: U.S. Government and its agencies 7,847 39 (2) 7,884 State obligations 702 24 -- 726 Municipal obligations 449 20 -- 469 Corporate bonds 353 -- -- 353 Funds and other short-term obligations 2 -- -- 2 ------- ---- ------- ------- Total held to maturity 9,353 83 (2) 9,434 ------- ---- ------- ------- Total $15,636 $223 $ (868) $14,991 ======= ==== ======= =======
The Company computes its realized gains and losses from sales of investments based on a specific identification. Property and Equipment The Company's property and equipment consist of the following:
December 31, 1998 1997 - --------------------------------------------------------------------------------- Land $ -- $ 644 Buildings and improvements 165 5,579 Leasehold improvements 520 402 Furniture, fixtures and other equipment 9,203 10,050 Construction in progress -- 265 -------- -------- $ 9,888 16,940 Less - accumulated depreciation and amortization (3,783) (7,589) -------- -------- $ 6,105 $ 9,351 ======== ========
Accounts Payable and Accrued Expenses The Company's accounts payable and accrued expenses consist of the following (in $000's):
December 31, 1998 1997 - --------------------------------------------------- Accounts payable $ 4,918 $1,457 Accrued compensation 296 71 Accrued interest 984 681 Other accrued expenses 4,707 2,984 ------- ------ $10,905 $5,193 ======= ======
F-13 55 NOTE 5: NOTES PAYABLE AND LONG-TERM DEBT Notes payable and long-term debt consisted of the following (in $000's):
December 31, 1998 1997 - --------------------------------------------------------------- Bank line of credit $ 8,000 $ -- Note payable -- 8,500 Senior notes payable 32,500 32,500 Less: current portion (8,000) (8,500) -------- -------- ng-term debt $ 32,500 $ 32,500 ======== ========
On May 13, 1997, under the terms of the Company's acquisition of Advantage (see Note 3), the Company issued an unsecured $8.5 million promissory note to the seller. This note was repaid during April 1998. On September 30, 1997, the Company completed a private placement of $32.5 million in long-term debt consisting of eight-year unsecured senior notes. The Company used the proceeds to repay all of its long-term indebtedness and for general corporate purposes. The senior notes have a principal payment of $6.5 million due each year starting on September 30, 2001. The interest rate for the loan was fixed at 7.91% at December 31, 1998. In connection with the senior notes, the Company is subject to certain financial and operational debt covenants (see Note 15). On January 29, 1998, the Company entered into an $8 million revolving working capital credit facility with Silicon Valley Bank (the "Bank"). The interest rate for the facility, as amended, was established at the bank's prime rate plus 1.5 percent (7.75% at December 31, 1998). The loan is secured by a first priority security interest in all of the personal property of the Company, including accounts receivable, fixed assets and intangibles and a negative pledge on the stock of the Company's subsidiaries and on the real property owned by the Company. In connection with the bank loan, the Company is subject to certain financial and operational debt covenants. (See Note 15) NOTE 6: LEASE OBLIGATIONS The Company leases administrative offices under various non-cancelable operating leases. Rental expense (in 000's) for these offices was $1,501, $1,217 and $2,201 in 1998, 1997 and 1996, respectively. Additionally, the Company also leases various computer equipment and furniture under other operating leases. Future minimum rental payments required under operating leases that have the initial or remaining lease terms in excess of one year as of December 31, 1998, are as follows (in 000's): Year ending December 31, 1998: 1999 $ 3,682 2000 3,624 2001 3,351 2002 2,522 2003 1,993 Thereafter 8,436
F-14 56 NOTE 7: INCOME TAXES The Company's (benefit from) provision for federal and state income taxes is as follows (in $000's):
Year ended December 31, 1998 1997 1996 - ----------------------------------------------------------------------------------------------------------------- (Benefit) provision for income taxes due to continuing operations: Taxes currently payable: Federal $ (22) $ 1,585 $ 936 State 11 407 343 Tax effect of timing differences: Difference in depreciation and amortization methods 92 22 75 Difference in accounting method for revenue adjustments (4,834) (282) (116) Difference in accounting method for specialist cost 258 (343) (275) Deferred state taxes (986) 36 (11) Net operating loss (1,929) -- -- Other (242) 70 28 ------- ------- ------- $(7,652) $ 1,495 $ 980 ======= ======= ======= (Benefit) provision due to: Continuing operations $(6,638) $ 1,495 $ 980 Discontinued operations 936 (2,634) 1,008 ------- ------- ------- $(5,700) $(1,139) $ 1,988 ======= ======= =======
A reconciliation of the federal income tax (benefit) provision at the expected statutory rate compared to the actual income tax provision is as follows (in $000's):
Year ended December 31, 1998 1997 1996 - -------------------------------------------------- ------------------------------------------ Expected $(7,628) (35.0%) $ 1,157 35.0% $ 834 35.0% State taxes, net of Federal effect (1,011) (4.6) 175 5.3 181 7.6 Tax-free income (19) (0.1) (35) (1.1) (99) (4.2) Non-deductible 254 1.2 186 5.6 47 2.0 amortization Transaction lost 531 2.4 Other 221 1.0 12 0.4 (17) 0.7 ------- ----- ------- ---- ----- ---- $(7,652) (35.1%) $ 1,495 45.2% $ 980 41.1% ======= ===== ======= ==== ===== ====
The major components of the Company's deferred taxes are as follows (in $000's):
December 31, 1998 1997 - ------------------------------------------------------------------------------------ Current deferred tax assets (liabilities): Accrued specialist costs and policy reserves $ 459 $ 784 Reserve for revenue adjustments 6,605 515 Amortization of prepaid expenses (23) (87) State income taxes (501) (100) Other 132 (65) ------- ------- Net current deferred tax asset 6,672 1,047 ------- ------- Non-current deferred tax assets (liabilities): Book versus tax basis in property, including Depreciation and amortization (875) (748) Deferred gain on sale of dental offices (979) (979) Unrealized loss on investments 97 283 Amortization of intangibles 43 30 Net operating loss carry forward 2,253 -- Other -- 125 ------- ------- Net non-current deferred tax asset/liability 539 (1,289) ------- ------- Net deferred tax asset/liability $ 7,211 $ (242) ======= =======
F-15 57 As of December 31, 1998, the Company has not recorded a valuation allowance against deferred tax assets. The Company has net operating loss carry forwards for federal and state purposes of $5,674 and $3,667 which begin to expire in 2018 and 2003, respectively. NOTE 8: OTHER INCOME Other income consists principally of interest income and dividends earned on investments, as follows (in $000's):
Year ended December 31, 1998 1997 1996 - ---------------------------------------------------------------- Interest income $1,985 $ 1,642 $809 Dividend income -- 12 61 Other 356 (22) 114 ------ ------- ---- $2,341 $ 1,632 $984 ====== ======= ====
NOTE 9: CAPITAL STOCK Stock Information Thirty million shares of common stock, $.01 par value, have been authorized since the Company's reincorporation in Delaware in August 1987. One million shares of Preferred Stock, $.01 par value, are authorized but no preferred stock has been issued. The Board of Directors may, without stockholder approval, establish rights, terms, preferences and privileges for these preferred shares. Stock Transactions Since October 1986, the Company has, at various times, announced plans to repurchase up to a total of 4,510,888 shares of its common stock through open market or private transactions. As of December 31, 1998, a total of 3,819,088 shares had been acquired. A total of 544,300 shares acquired prior to August 24, 1987, have been retired as required by California law. Shares acquired after the August 24, 1987 reincorporation in Delaware are being held as treasury stock, at an average cost of $5.54 per share. The Company has a current authorization for the repurchase of up to an additional 691,800 shares of the Company's common stock which may be made from time to time in either open market or private transactions. Stock Plans The Company's Stock Option Plan (the "Plan") authorizes both incentive and non-qualified stock options to be granted in an aggregate amount up to 1,700,000 shares of common stock. Options may be granted to executive officers or other key employees of the Company; non-employee directors of the Company are also eligible but only for nonqualified options. The option price must, at least, equal fair market value on the date the option is granted. The Plan is divided into a discretionary program for key employees and an automatic program for non-employee directors. The Plan is administered by the Compensation and Stock Option Committee of the Board of Directors. All stock options granted by the Company to employees through December 31, 1998 were incentive stock options. The following is a summary of stock option transactions:
Year ended December 31, 1998 1997 1996 - ----------------------------------------------------------------------------------------- Outstanding at beginning of year 638,017 510,817 397,500 Granted 184,000 168,000 132,300 Canceled (52,217) (10,134) (6,987) Exercised -- (30,666) (11,996) ------------ ------------- ------------- Outstanding at end of year 769,800 638,017 510,817 ============ ============= ============= Exercisable at end of year 455,066 363,228 303,389 ============ ============= ============= Price range of options granted $5.00-$10.04 $10.81-$18.00 $15.75-$20.75 Price range of options canceled $9.00-$15.75 $ 9.00-$15.75 $ 9.00-$15.75 Price range of options exercised -- $ 4.25-$ 9.00 $ 9.00-$11.88 Price range of options outstanding $4.25-$20.75 $ 4.67-$20.75 $ 4.25-$20.75
F-16 58 The following table summarizes information concerning stock options at December 31, 1998:
Number Weighted Average Number Range of Outstanding Remaining Weighted Average Exercisable Weighted Average Exercise Price 12/31/98 Contractual Life Exercise Price 12/31/98 Exercise Price - --------------------------------------------------------------------------------------------------- $ 4.25-$ 7.25 150,000 2.74 $ 4.80 134,000 $ 4.77 9.00- 10.38 228,500 8.14 9.57 73,000 9.66 10.25- 13.06 251,400 7.05 11.25 163,133 11.01 15.75- 15.75 61,400 7.23 15.75 40,933 15.75 17.33- 20.75 78,500 7.65 18.35 44,000 18.24 ------- ------- 769,800 6.90 $ 10.58 455,066 $ 10.10 ======= =======
The estimated fair value of options granted during 1998, 1997, and 1996, was $5.93, $4.56, and $4.84 per share, respectively. The Company applies Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for the Plan. No compensation cost has been recognized for the Plan. Had compensation cost for the Plan been determined based on the fair value at the grant dates for awards under the Plan consistent with the method of FAS 123, the Company's net income (loss) and earnings (loss) per share for the years ended December 31, 1998, 1997 and 1996, would have been reduced to the pro forma amounts indicated below:
1998 1997 1996 ---------- --------- --------- Net income (loss) (in $000's) As reported $ (11,094) $ (2,349) $ 3,052 Pro forma (11,481) (2,702) 2,855 Net income (loss) per common and common equivalent share As reported $ (2.35) $ (.48) $ .62 Pro forma $ (2.42) $ (.55) $ .58
Under FAS 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company's stock option awards. These models also require subjective assumptions, including future stock volatility and expected time to exercise, which greatly affect the calculated values. The fair value of options granted under the Plan was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used: no dividend yield, expected volatility of 50% in 1998, 38% in 1997, and 25% in 1996, risk free interest rate of approximately 6%, and an average expected life of four (4) years. NOTE 10: IMPAIRMENT OF ASSETS During the fourth quarter of 1998, the Company was notified by a major debtor that their obligation to the Company would not be able to be fully met as of December 31, 1998, and thereafter. As a result, the Company determined that notes and interest receivable from the sale of the orthodontic practices and general dental offices were impaired and not fully collectible. Therefore, the Company increased the allowances relates to these Notes and interest receivable related to these notes by $10,596, which was charged to continuing operations. As of the date of impairment, the Company ceased all recognition of interest revenue on all nonperforming Notes. During the third quarter of 1998, the Company moved its corporate and western region operations from its fully-owned building in Anaheim, CA to a leased facility in Aliso Viejo, CA. As a result of this relocation, the Company has been actively marketing the building and its related assets in Anaheim. Those assets include the land, building, and various building improvements. During the first quarter of 1999, the Company received a written offer for these assets. Based on this offer and as required by FAS 121, the Company wrote down the value of the building by $570 and accrued closing costs of $188. The book value of these assets was $3,562 at December 31, 1998. The sale of these assets is expected to be completed by the third quarter of 1999. NOTE 11: COMMITMENTS AND CONTINGENCIES The Company is a defendant in various litigation arising in the normal course of business. In the opinion of Management, the ultimate outcome of such litigation or any other contingencies would not have a material effect on the Company's consolidated financial position or results of operations. F-17 59 The Company has employment agreements with various executive officers requiring an annual payment of the following (in $000's):
Year ending December 31, 1999 $1,140 2000 551 2001 155 2002 39 2003 --
NOTE 12: RESERVES FOR INCURRED BUT NOT REPORTED CLAIMS Activity in the liability for dental indemnity insurance policy reserves and specialists claims expense is summarized as follows (in $000's):
Policy Reserves Specialist Total - -------------------------------------------------------------------------------------- Balance at January 1, 1997 $ 2,120 $ 1,010 $ 3,130 Incurred related to: Current year -- 1997 18,100 8,126 26,225 Prior years (13) (22) (34) -------- ------- -------- Total incurred 18,087 8,104 26,191 Paid related to: Current year -- 1997 15,950 6,645 22,595 Prior years 2,107 988 3,095 -------- ------- -------- Total paid 18,057 7,633 25,690 -------- ------- -------- Balance at December 31, 1997 $ 2,150 $ 1,481 $ 3,631 ======== ======= ======== Incurred related to: Current year -- 1998 $ 16,909 $ 7,251 $ 24,160 Prior years 794 (338) 456 -------- ------- -------- Total incurred 17,703 6,913 $ 24,616 Paid related to: Current year -- 1998 14,636 5,966 20,601 Prior years 2,944 1,143 4,088 -------- ------- -------- Total paid 17,580 7,109 24,689 -------- ------- -------- Balance at December 31, 1998 $ 2,273 $ 1,285 $ 3,558 ======== ======= ========
NOTE 13: BUSINESS SEGMENT INFORMATION The Company is engaged in the operation of Dental HMO and indemnity/PPO dental plans. The operation of the Dental Practices and the Orthodontic Practices have both been discontinued. The last of the discontinued operations were sold effective April 1, 1998. The identifiable assets for the discontinued operations have been segregated on the Consolidated Statements of Financial Position. (See Note 2: Discontinued Operations). Following the April 1, 1998 sale, the Company's sole line of business is providing dental benefits to employer groups, associations and individuals. NOTE 14: UNAUDITED SELECTED QUARTERLY INFORMATION Unaudited quarterly results of operations for the years ended December 31, 1998 and 1997 are set forth in the table below ($000's omitted, except per share data). The quarterly results should be read in conjunction with the audited Consolidated Financial Statements of the Company. Restatement: Subsequent to the issuance of the Company's 1998 quarterly results of operations for each of the three quarters ended September 30, 1998, the Company's management determined that certain prepaid expenses, fixed assets, accrued liabilities and deferred revenue balances were not properly stated. As a result, these balances have been restated from the amounts previously reported and income (loss) from continuing operations has been reduced by $469,000, $390,000, and $1,423,000. The tax affect of these adjustments on income (loss) from continuing operations were $206,000, $168,000, and $463,000 for the three months ended March 31, 1998, June 30, 1998 and September 30, 1998, respectively. These adjustments also resulted in a decrease in basic earnings per common share from continuing operations of .06 and .05 for the three months ended March 31, 1998 and June 30, 1998, respectively and an increase in the basic loss per common share from continuing operations of .20 for the three months ended September 30, 1998. In addition, management also determined that the gain on sale of discontinued operations for the three months ended June 30, 1998 was not properly stated. As a result, this gain has been reduced by $1,895,000 (tax affect of $739,000). The basic earnings per common share from discontinued operations was also reduced by .27 for the three months ended June 30, 1998. Fourth Quarter Adjustment: During its year end evaluation, the Company determined that the notes and interest receivable from the sale of the orthodontic practices and general dental offices were impaired and not fully collectible. As a result, the Company increased its allowances related to these notes and interest receivable by approximately $10,516,000 (tax affect of $3,709,000) which was charged to continuing operations during the quarter ended December 31, 1998. In addition, the Company determined that certain aged accounts receivable balances were uncollectible and accordingly recorded an increase to its reserves for doubtful accounts in the amount of $3,500,000 (tax affect of $1,225,000) during the fourth quarter of 1998. F-18 60 The results for 1998 were restated for changes to the results previously recorded:
First Second Third Year ended December 31, 1998 Quarter First Quarter Second Quarter Third As Quarter As Quarter As Quarter previously As previously As previously As Fourth reported restated reported restated reported restated Quarter - ------------------------------------------------------ -------- ---------- -------- ---------- ---------- ---------- Current assets: Cash $ 1,851 $ 1,851 $ 3,884 $ 3,884 $ 2,187 $ 2,187 $ 3,256 Investments available for sale 4,860 4,860 3,205 3,205 3,716 3,716 2,959 Investments held to maturity 4,272 4,272 1,249 1,249 -- -- -- Accounts and notes receivable, net 7,894 7,894 9,477 9,477 11,235 11,235 15,533 Income tax receivable 132 132 133 133 475 475 485 Prepaids and other current assets 1,378 1,021 1,361 923 1,003 565 478 Net assets of discontinued operations 5,143 5,143 -- -- -- -- -- Deferred income taxes 1,608 1,608 1,829 1,829 705 705 6,672 Assets available for sale -- -- -- 3,562 ------- ------- ------- ------- ------- ------- ------- Total current assets 27,138 26,781 21,138 20,700 19,321 18,883 32,945 Long-term assets: Property & equipment, net $ 9,729 $ 9,684 $10,184 $9,998 $10,598 $ 9,557 $ 6,105 Investments available for sale-long-term -- -- -- 4,225 Investments held to maturity-long-term 5,182 5,182 5,600 5,600 3,363 3,363 -- Notes receivable - long-term 12,389 12,389 21,753 21,753 22,778 22,778 4,083 Other assets 247 247 245 245 246 246 240 Intangibles and Goodwill, net 34,111 34,111 32,710 32,710 32,264 32,264 31,807 -- -- -- 539 ------- ------- ------- ------- ------- ------- ------- Total long-term assets 61,658 61,613 70,492 70,306 69,249 68,208 46,999 ======= ======= ======= ======= ======= ======= ======= Total Assets 88,796 88,394 91,630 91,006 88,570 87,091 79,944 ======= ======= ======= ======= ======= ======= ======= Liabilities and Stockholders' Equity Current liabilities: Short-term notes payable 10,500 10,500 8,000 8,000 8,000 8,000 8,000 Current portion of note payable 1,692 1,692 1,692 1,692 1,692 1,692 1,894 Accounts payable and accrued expenses 3,484 3,552 5,907 6,043 3,751 4,455 10,905 Income taxes payable 427 221 -- (374) -- (837) -- Reserve for dental claims 3,331 3,331 3,306 3,306 3,561 3,561 3,558 Deferred Revenues 1,198 1,198 1,341 1,441 949 1,049 1,022 ------- ------- ------- ------- ------- ------- ------- Total current liabilities 20,632 20,494 20,246 20,108 17,953 17,920 25,379 Long-Term Liabilities: Long-term debt 32,500 32,500 32,500 32,500 33,000 33,000 32,500 Note payable 1,096 1,096 798 798 -- -- -- Deferred income taxes 1,000 1,000 2,789 2,789 2,837 2,837 -- Accrued compensation agreement 374 374 365 365 356 356 311 ------- ------- ------- ------- ------- ------- ------- Total long-term liabilities 34,970 34,970 36,452 36,452 36,193 36,193 32,811 Stockholders' Equity: Common stock 21,509 21,509 21,509 21,509 21,509 21,509 21,509 Retained Earnings 30,479 30,215 32,401 31,915 31,778 30,332 18,722 Accumulated other comprehensive income (671) (671) (855) (855) (740) (740) (354) Treasury stock, at cost (18,123) (18,123) (18,123) (18,123) (18,123) (18,123) (18,123) ------- ------- ------- ------- ------- ------- ------- Total stockholders' equity 33,194 32,930 34,932 34,446 34,424 32,978 21,754 ------- ------- ------- ------- ------- ------- ------- Total Liabilities and Stockholders' Equity 88,796 88,394 91,630 91,006 88,570 87,091 79,944 ======= ======= ======= ======= ======= ======= =======
F-19 61
First Second Third Year ended December 31, 1998 Quarter Quarter Quarter - --------------------------------------------------------------------------------------- As previously reported Health care revenues $24,395 $24,540 $24,004 Health care expense 16,431 16,288 16,539 Selling, general and administrative 6,830 6,567 7,567 ------- ------- ------- Total expenses 23,261 22,855 24,106 Other income 970 534 199 Interest expense (922) (973) (1,020) ------- ------- ------- Income (loss) from continuing operations before tax 1,182 1,246 (923) Provision (benefit) for income taxes 519 538 (300) ------- ------- ------- Income (loss) from operations before discontinued operations 663 708 (623) Income from discontinued operations -- 1,214 -- ------- ------- ------- Net income $ 663 $ 1,922 $ (623) ======= ======= ======= Basic Earnings (Loss) Per Share Income from continuing operations per share $ 0.14 $ 0.15 $ (0.13) Income from discontinued operations per share -- 0.26 -- ------- ------- ------- Net income (loss) per share 0.14 0.40 (0.13) ------- ------- ------- Weighted average shares 4,747 4,747 4,747 Diluted Earnings Per Share Income from continuing operations per share $ 0.14 $ 0.15 $ (0.13) Income from discontinued operations per share -- 0.26 -- ------- ------- ------- Net income (loss) per share 0.14 0.40 (0.13) ------- ------- ------- Weighted average shares 4,747 4,747 4,747
F-21 62
First Second Third Fourth Year ended December 31, 1998 Quarter Quarter Quarter Quarter - --------------------------------------------------------------------------------------------------------------------- As restated Health care revenues 24,396 24,440 23,504 25,109 Health care expense 16,431 16,288 16,539 16,762 Selling, general and administrative 7,300 6,857 7,920 15,415 Other income 970 534 (371) 1,208 Loss on impaired assets -- -- -- (11,165) Interest expense (922) (973) (1,020) (1,396) ------- ------- ------- ------- Income (loss) from continuing operations before tax 713 856 (2,346) (18,421) Provision for income taxes 313 370 (763) (6,558) ------- ------- ------- ------- Income (loss) from continuing operations before discontinued operations 400 486 (1,583) (11,863) Income from discontinued operations -- (58) -- 1,524 ------- ------- ------- ------- Net income $ 400 $ 428 $(1,583) $(10,339) ======= ======= ======= ======= Basic Earnings (Loss) Per Share Income from continuing operations per share $ 0.08 $ 0.10 $ (0.33) $ (2.51) Income from discontinued operations per share -- (0.01) -- 0.32 ------- ------- ------- ------- Net income (loss) per share $ 0.08 $ 0.09 $ (0.33) $ (2.19) Weighted average shares 4,747 4,747 4,747 4,747 Diluted Earnings Per Share Income from continued operations per share $ 0.08 $ 0.10 $ (0.33) $ (2.51) Income from discontinued operations per share -- (0.01) -- $ .32 ------- ------- ------- ------- Net income (loss) per share $ 0.08 $ 0.09 $ (0.33) $ 2.19 Weighted average shares 4,747 4,747 4,747 4,747
NOTE 15. SUBSEQUENT EVENTS On April 14, 1999, the Company and its primary lenders (Silicon Valley Bank and John Hancock Mutual Life Insurance Company) agreed to modifications with respect to the working capital credit facility and the eight-year notes, respectively. This agreement provides for changes in interest rates, modifications to the financial covenants and reporting requirements, as well as specific principal repayments. In connection with the agreement, the Company, has obtained waivers for all prior and existing defaults and events of default under the related credit agreements through the date that definitive documents incorporating the agreed-upon terms are executed. F-22 63 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31, 1998, 1997 AND 1996 (in $000's)
Balance at Charged to Charged to Balance at Beginning Cost and Beginning Cost and Other End Classification of Year Expenses Accounts(1) Write Offs Of Year - ----------------------------------------------------------------------------------------------------------- 1996: Allowance for doubtful accounts: Accounts $ 260 $ 615 $ 62 $ (406) $ 531 1997: Allowance for doubtful accounts: Accounts $ 531 $ 1,058 $ -- $ (528) $ 1,061 Long-term notes receivable $ -- $ 3,595 $ -- $ -- $ 3,595 1998: Allowance for doubtful accounts: Accounts receivable $1,061 $ 2,745 $ -- $(851) $ 2,954 Current notes receivable $ -- $14,910 $ 2,395 $ -- $17,305 Long-term notes receivable $3,595 $ 1,401 $(2,395) $ -- $ 2,601
(1) Represents balance forward from First American, which was charged to the opening goodwill balance and reclasses between long-term and short-term. S-1 64 EXHIBIT INDEX
NUMBER EXHIBIT OF NUMBER COLUMNS DESCRIPTION - ------ ------- ----------- 2.1 One Plans of Acquisition(8) 3.1 One Articles of Incorporation(4) 3.2 One Bylaws(4) 10.1 One 1984 Stock Option Plan(3) 10.2 One Stock Option Plan Amendment(1) 10.3 One Stock Option Plan Amendment(5) 10.4 One Stock Option Plan Amendment(6) 10.5 One Amended Stock Option Plan(10) 10.6 One Corporation Grant Deed, dated December 21, 1984, relating to a property located at 505 North Euclid Avenue, Anaheim, California(2) 10.7 One Employment Agreement, as Amended, dated May 25, 1995, between Steven J. Baileys, D.D.S. and the Company.(7) 10.8 One Employment Agreement, as Amended, dated May 25, 1995, between Ronald I. Brendzel and the Company.(7) 10.9 One Employment Agreement dated May 25, 1995, between John E. Cox and the Company.(7) 10.10 One Form of Rights Agreement, dated as of March 22, 1996, between the Company and American Stock Transfer and Trust Company, as Rights Agent.(7) 10.11 One Employment Agreement dated January 5, 1997, between Herb J. Kaufman, D.D.S. and the Company.(10) 10.12 One Credit Agreement dated September 25, 1996, between Bank of America National Trust and Savings Association and the Company.(9) 10.13 One Stock Purchase Agreement between Consumers Life Insurance Company and SafeGuard Health Enterprises, Inc. dated March 6, 1997(11) 10.14 One Purchase Agreement between Associated Dental Services, Inc. and Guards Dental, Inc. dated August 1, 1997(11) 10.15 One Purchase agreement between Pacific Coast Dental, Inc. and Guards Dental, Inc. dated August 1, 1997(11) 10.16 One Form of Note Purchase Agreement dated as of September 30, 1997, and form of Promissory Note(12) 10.17 One Form of Master Asset Purchase Agreement effective as of April 1, 1998, and Form of Promissory Note without exhibits.(13) 10.18 One Default Forbearance Agreement and Irrevocable Power of Attorney(14) 10.19 One Credit Agreement dated January 29, 1998, between Silicon Valley Bank and the Company.(15) 21.1 One Subsidiaries of the Company 23.1 One Independent Auditor's Consent 24.1 One Power of Attorney (Reference is made to Page 41 of the Report) 27.1 One Financial Data Schedule
- ---------- (1) Incorporated by reference herein to the exhibit of the same number filed as an exhibit to the Company's Registration Statement on Form S- filed on September 12, 1983 (File No. 2-86472). (2) Incorporated by reference herein to the exhibit of the same number filed as an exhibit to the Company's Registration Statement on Form S-1 filed on August 22, 1985 (File No. 2-99663). (3) Incorporated by reference herein to the exhibit of the same number filed as an exhibit to the Company's Registration Statement on Form S-1 filed on July 3, 1984 (File No. 2-92013). (4) Incorporated by reference herein to the exhibit of the same number filed as an exhibit to the Company's Annual Report of Form 10-K for the period ended December 31, 1987. (5) Incorporated by reference herein to the exhibit of the same number filed as an exhibit to the Company's Annual Report of Form 10-K for the period ended December 31, 1989. (6) Incorporated by reference herein to the exhibit of the same number filed as an exhibit to the Company's Annual Report of Form 10-K for the period ended December 31, 1992. (7) Incorporated by reference herein to the exhibit of the same number filed as an exhibit to the Company's Annual Report of Form 10-K for the period ended December 31, 1995. (8) Incorporated by reference herein to Exhibit D filed as an exhibit to the Company's Report on Form 8-K dated September 27, 1996. (9) Incorporated by reference herein to Exhibit E filed as an exhibit to the Company's Report on Form 8-K dated September 27, 1996. (10) Incorporated by reference herein to the exhibit of the same number filed as an exhibit to the Company's Annual Report on Form 10-K for the period ended December 31, 1996. (11) Incorporated by reference to the exhibit of the same number filed as an exhibit to the Company's quarterly statement on Form 10-Q for the period ended June 30, 1997. (12) Incorporated by reference herein to Exhibit 99.1 filed as an exhibit to the Company's Report on Form 8-K dated October 7, 1997. (13) Incorporated by reference herein to Exhibit F filed as an exhibit to the Company's Report on Form 8-K dated April 1, 1998. 14 Referenced, disclosed and filed as an exhibit to Company's Annual Report on Form 10-K for the period ended December 31, 1998. (14) Referenced, disclosed and filed as an exhibit to Company's Annual Report on Form 10-K for the period ended December 31, 1998. (15) Referenced and disclosed in the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1998 and filed as an exhibit to the Company's Annual Report on Form 10-K for the period ended December 31, 1998. E-1 EX-10.18 2 DEFAULT FORBEARANCE AGREEMENT 1 EXHIBIT 10.18 DEFAULT FORBEARANCE AGREEMENT This Default Forbearance Agreement (this "AGREEMENT") is dated as of February 12, 1999, and is executed and delivered by and among Associated Dental Services, Inc., a California corporation ("ADS"), Pacific Coast Dental, Inc., a California corporation and a wholly-owned subsidiary of ADS, ("PCD") (ADS and PCD together, "BORROWERS"), The Pellkofer Family Trust (40% owner of ADS), Eric F. Pellkofer (10% owner of ADS), Frank G. Pellkofer (president of ADS), The Stalcup Family Trust (40% owner of ADS), and Robert W. Stalcup, D.D.S. (10% owner of ADS) ( the "SHAREHOLDERS") and Guards Dental, Inc., a California corporation ("LENDER"), with respect to the following facts: R E C I T A L S A. Lender is the holder of (i) a Promissory Note and Security Interest dated August 1, 1997, executed by ADS and payable to Lender, in the original principal amount of Four Million, Five Hundred Thousand Dollars ($4,500,000) (the "ADS NOTE"); (ii) a Promissory Note and Security Interest dated August 1, 1997, executed by PCD and payable to Lender, in the original principal amount of Three Million, Five Hundred Thousand Dollars ($3,500,000) (the "PCD NOTE"); (iii) a Promissory Note and Security Interest dated April 1, 1998, executed by ADS and PCD and payable to Lender, in the original principal amount of Fifteen Million Dollars ($15,000,000) (the "ADS/PCD NOTE"); (iv) a Promissory Note and Security Interest dated September 30, 1996, and assumed by ADS and PCD pursuant to an Assignment and Assumption of Note Agreement dated April 1, 1998 and payable to Lender, in the original principal amount of One Million Dollars ($1,000,000) (the "GLENDALE NOTE"); (v) a Promissory Note and Security Interest dated March 31, 1997, and assumed by ADS and PCD pursuant to an Assignment and Assumption of Note Agreement dated April 1, 1998 and payable to Lender, in the original principal amount of One Hundred Thirty One Thousand Dollars ($131,000) (the "EQUIPMENT NOTE"); (vi) a Promissory Note and Security Interest dated December 30, 1996, and assumed by ADS and PCD pursuant to an Assignment and Assumption of Note Agreement dated April 1, 1998 and payable to Lender, in the original principal amount of Six Hundred Thousand Dollars ($600,000) (the "RANCHO CUCAMONGA NOTE"); (vii) a Promissory Note and Security Interest dated June 23, 1997, and assumed by ADS and PCD pursuant to an Assignment and Assumption of Note Agreement dated April 1, 1998 and payable to Lender, in the original principal amount of Six Hundred Twenty Five Thousand Dollars ($625,000) (the "KEARNY MESA NOTE"); each as modified by that certain Master Asset Purchase Agreement dated April 1, 1998 among Lender, ADS and PCD; and (viii) a Promissory Note and Security Interest dated December 1, 1998 and assumed by ADS and PCD pursuant to an Assignment and Assumption of Note Agreement dated January 1, 1999, in the original principal amount of Three Hundred Thirty Five Thousand Dollars ($335,000) (the "MORENO VALLEY NOTE"). The ADS Note, PCD Note, ADS/PCD Note, Glendale Note, Equipment Note, Rancho Cucamonga Note, Kearny Mesa Note and Moreno Valley Note shall be referred to herein collectively as the "NOTES". 2 B. ADS's obligations under the ADS Note are secured pursuant to the terms of the ADS Note by all tangible, nonorthodontics-related assets of ADS existing on the date of the ADS Note or thereafter acquired and/or accrued, including any proceeds or replacements relating to the same. PCD's obligations under the PCD Note are secured pursuant to the terms of the PCD Note by all assets of PCD existing on the date of the PCD Note or thereafter acquired and/or accrued, including any proceeds or replacements relating to the same. Borrowers' obligations under the ADS/PCD Note are secured pursuant to the terms of the ADS/PCD Note by all of ADS's assets and PCD's assets related to or associated with the dental practices located on Schedule 3 attached thereto, or any other dental practices owned by PCD and ADS existing on the date of the PCD/ADS Note or thereafter acquired and/or accrued, including any proceeds or replacements relating to the same. Borrowers' obligations under the Glendale Note are secured pursuant to the terms of the Glendale Note by all of Borrowers' assets existing on the date of the Glendale Note or thereafter acquired and/or accrued, including any proceeds or replacements relating to the same. Borrowers' obligations under the Equipment Note are secured pursuant to the terms of the Equipment Note by all of Borrowers' assets existing on the date of the Equipment Note or thereafter acquired and/or accrued, including any proceeds or replacements relating to the same. Borrowers' obligations under the Rancho Cucamonga Note are secured pursuant to the terms of the Rancho Cucamonga Note by all of Borrowers' assets existing on the date of the Rancho Cucamonga Note or thereafter acquired and/or accrued, including any proceeds or replacements relating to the same. Borrowers' obligations under the Kearny Mesa Note are secured pursuant to the terms of the Kearny Mesa Note by all of Borrowers' assets existing on the date of the Kearny Mesa Note or thereafter acquired and/or accrued, including any proceeds or replacements relating to the same. Borrowers' obligations under the Moreno Valley Note are secured pursuant to the terms of the Moreno Valley Note by all of Borrowers' assets existing on the date of the Moreno Valley Note or thereafter acquired and/or accrued, including any proceeds or replacements relating to the same. C. Borrowers acknowledge that Borrowers have failed to pay and will not pay the full amount owing on the Notes for the months of January 1999 through the date of termination of this Agreement, such monthly deficit equaling $41,716.41 for the ADS Note, $32,446.09 for the PCD Note, $115,037.02 for the ADS/PCD Note, $9,309.08 for the Glendale Note, $3,874.46 for the Equipment Note, $5,570.64 for the Rancho Cucamonga Note, $5,988.87 for the Kearny Mesa Note, and $2,575.86 for the Moreno Valley Note, for a total deficit per month of $207,073.33 ("PAYMENT DEFICIT"), and as a result, Borrowers have accrued late fees in the amounts specified in the Notes ("LATE FEES"). Such failure to pay the Payment Deficit is referred to herein as the "SPECIFIED DEFICIT." 2 3 D. Borrowers have asked Lender, and Lender is willing to agree, to forbear temporarily from exercising its rights and remedies with respect to the Specified Deficit, on the terms and conditions set forth in this Agreement. E. The Dental Practice Asset Purchase Agreement dated August 1, 1997 between ADS and Lender, the Dental Practices Purchase Agreement dated August 1, 1997 between PCD and Lender, the Master Asset Purchase Agreement dated April 1, 1998 among ADS, PCD and Lender, the Assumption of Note Agreements described above for the Glendale Note, the Equipment Note, The Rancho Cucamonga Note, the Kearny Mesa Note, and the Moreno Valley Note, this Agreement, and the Notes, together with all modifications and amendments thereto and any documents required thereunder, are referred to herein collectively as the "LOAN DOCUMENTS" and each individually is referred to as a "LOAN DOCUMENT." Capitalized terms not otherwise defined herein shall have the respective meanings set forth in the Notes. F. All of the parties agree that it is in their best interest to market and sell the businesses operated by ADS and PCD (the "BUSINESSES") by causing ADS, PCD and the Shareholders to sign an irrevocable power of attorney in favor of Lender in the form attached hereto as Exhibit A. NOW, THEREFORE, FOR VALUABLE CONSIDERATION, the receipt and sufficiency of which are hereby acknowledged, Borrowers, Shareholders and Lender agree as follows: A G R E E M E N T 1. Forbearance. Subject to strict compliance by Borrowers with every covenant, condition and obligation set forth in this Agreement and in each and all of the other Loan Documents, Lender hereby agrees, until the earliest to occur of (i) August 12, 1999; (ii) the occurrence of any default (other than the Specified Deficit), following the expiration of applicable notice and grace periods, if any, under any of the Loan Documents, or (iii) any other event allowing Lender to declare the Notes immediately due and payable; to forbear from exercising Lender's rights and remedies under the Loan Documents arising out of or with respect to the Specified Deficit. Borrowers hereby agree and acknowledge that this forbearance by Lender does not constitute a waiver of the Specified Deficit or a waiver of Lender's right to assert and enforce its rights and remedies with respect to any default under the Loan Documents which may already have occurred (other than the Specified Deficit) or which may occur in the future. Borrowers further agree that, upon the occurrence of a default under any of the Loan Documents (other than the Specified Deficit), Lender may exercise any of its rights and remedies with respect to such default as well as with respect to the Specified Deficit. 2. Representations and Warranties. ADS, PCD, The Pellkofer Family Trust, Eric F. Pellkofer, Frank G. Pellkofer, The Stalcup Family Trust and Robert W. Stalcup, D.D.S., jointly and severally, represent and warrant to Lender, and agree with Lender, as follows: 3 4 (a) Defaults. Except for the Specified Deficit and the "Specified Deficit" as defined in the Forbearance Agreement entered into on the date hereof by and among SafeGuard Enterprises, Inc., ADS and the Shareholders, no event, omission, breach or failure of condition has occurred that is a default or, with the giving of notice or the passage of time or both, would constitute a default under any Loan Document. (b) Authority and Enforceability. Borrowers have all requisite power and authority to execute, deliver and perform their obligations under this Agreement, and this Agreement is a valid and binding obligation of Borrowers. The Pellkofer Family Trust, Eric F. Pellkofer, The Stalcup Family Trust and Robert W. Stalcup, D.D.S. are the sole shareholders of ADS. ADS is the sole shareholder of PCD. Frank G. Pellkofer represents and warrants that he has been duly authorized to enter into this Agreement on behalf of ADS, The Pellkofer Family Trust and Eric F. Pellkofer and has full and complete authority to do so. Robert W. Stalcup, D.D.S. represents and warrants that he has been duly authorized to enter into this Agreement on behalf of PCD and The Stalcup Family Trust, and has full and complete authority to do so. (c) Power of Sale. Borrowers have all requisite power and authority to execute, deliver and perform their obligations under agreements to sell the Businesses. (d) Obligations. As of January 1, 1999, (i) the amounts of the unpaid principal plus accrued interest balances are $4,500,000 for the ADS Note (plus accrued interest), $3,500,000 for the PCD Note (plus accrued interest), $15,000,000 for the ADS/PCD Note (plus accrued interest), $1,060,324.50 for the Glendale Note, $134,558.40 for the Equipment Note, $636,750.25 for the Rancho Cucamonga Note, $674,997.06 for the Kearny Mesa Note, and $335,000 for the Moreno Valley Note, and the total unpaid principal balance on the Notes is $25,841,630.21; and (iii) each and all of such amounts are payable to Lender. (e) No Conflicts. The execution and delivery of, and the performance of Borrowers' obligations under, this Agreement do not (i) require the consent of, or filing of any document with, any individual, entity, court, governmental agency or other person in order to be binding on Borrowers; (ii) violate any law, regulation, order or decree applicable to ADS or PCD; or (iii) conflict with the terms of any deed of trust, lease, loan, credit agreement, articles of incorporation, bylaws or other agreement or instrument to which ADS, PCD or any Affiliate of ADS or PCD is a party or by which they, any of their Affiliates or the collateral described in the Notes (the "PROPERTY") may be bound or affected. The term "AFFILIATE" means any person or entity which controls, is controlled by, or is under common control with, a specified person or entity. 4 5 3. Sale of Businesses. In consideration of Lender's agreement to forbear temporarily from exercising its rights and remedies with respect to the Specified Deficit on the terms and conditions set forth in this Agreement, ADS, PCD, the Shareholders and Lender agree to cooperate with each other in an effort to market and sell the Businesses as follows: (a) Trenwith Securities, Inc., as agent for and acting under authority granted by Lender ("AGENT"), shall control the marketing of the Businesses for sale to one or more third parties. Borrowers shall cooperate with Lender in the marketing and sale of the Businesses by, among other things, (i) sharing financial and other information pertaining to the Businesses (ii) providing access to facilities of the Businesses, and (iii) referring all interested parties to Agent rather than showing the Businesses for sale independently. Lender shall cooperate with Borrowers by, among other things, sharing information about the progress of any sale efforts and the terms of any offers that are submitted. (b) Lender shall have sole authority to negotiate and determine the terms of the transaction in which the Businesses are sold, including, but not limited to, the sales price and the structure of the sales transaction. Lender may accept or reject any offer and Lender may or may not agree to sell the Businesses during the term of this Agreement. Borrowers shall not enter into any transaction for the sale of the Businesses which has not been approved by Lender and any attempt to do so shall constitute a default under this Agreement. As a condition to Lender entering into this Agreement, ADS, PCD and the Shareholders shall execute an irrevocable power of attorney in favor of Lender in the form attached hereto as Exhibit A. (c) Notwithstanding subsection (b) above, any final sales transaction must (i) provide for the sale of either all the issued and outstanding stock of ADS and PCD or the sale of all or substantially all of the assets of ADS and PCD, and (ii) provide for the payment or assumption of all of the outstanding trade payables, payroll and payroll taxes of the Businesses. (d) The current management teams of ADS and PCD shall retain control over the day to day operations and management of the Businesses. However, failure to operate the Businesses in the ordinary course shall constitute a default under this Agreement. In particular but without limitation, any increases in salaries, distributions to the Shareholders or transactions between ADS or PCD and the Shareholders or their Affiliates shall constitute a default under this Agreement. (e) The Shareholders acknowledge and agree that they will make commercially reasonable representations and warranties to the purchaser(s) of the Businesses in their individual capacities. 5 6 (f) Proceeds from any sale of the Businesses pursuant to this Agreement shall be divided as follows: (i) The Shareholders shall receive a minimum of $500,000 in cash at the time of closing, regardless of the final sales price for the Businesses. Allocation among the Shareholders of funds payable to the Shareholders under this Agreement shall be pursuant to their respective shareholdings. (ii) Additional proceeds shall be payable to the Shareholders in cash at the time of closing based upon the average of the following two formulas: (A) 7.5% of the Net Sales Proceeds (as defined below) under $10 million plus 15% of the Net Sales Proceeds over $10 million; and (B) a minimum payment of $500,000 for any Net Sales Proceeds under $10 million plus 12.5% of any Net Sales Proceeds over $10 million. Amounts payable to the Shareholders at various assumed amounts of Net Sales Proceeds under the foregoing formula are illustrated in the chart below.
AMOUNT PAYABLE NET SALES PROCEEDS TO SHAREHOLDER ------------------ -------------- \ $15,000,000 $1,312,500 14,000,000 1,175,000 13,000,000 1,037,500 12,000,000 900,000 11,000,000 762,500 10,000,000 625,000 9,000,000 587,500 8,000,000 550,000 7,000,000 512,500 6,000,000 500,000 5,000,000 500,000
6 7 (iii) All Net Sales Proceeds not payable to the Shareholders pursuant to this Agreement shall be payable to Lender. The term "NET SALES PROCEEDS" means the gross sale price of the Businesses, less the direct costs of the sale (commissions to Agent, escrow fees, attorneys' fees... etc.), less any of the Businesses' gross liabilities (other than liabilities owing to Lender or its Affiliates), paid either (i) by Lender or (ii) by the purchaser of the Businesses where payment or assumption of such liabilities by the purchaser reduces the amount of the gross sale price available for distribution to Lender, less all costs and expenses incurred by Lender in connection with: (1) the preparation of this Agreement and any and all other sales agreements contemplated hereby; (2) the administration of this Agreement and the other sales agreements; and (3) the enforcement or satisfaction by Lender of any of Borrowers' obligations under this Agreement or any sales agreement. For all purposes of this Agreement, Lender's costs and expenses shall include, without limitation, all appraisal fees, legal fees, accounting fees and auditor fees. (iv) On the closing date of the sale of the Businesses, an amount equal to the lesser of (i) 25% of the total proceeds payable to the Shareholders or (ii) $250,000 shall be held back from distribution to the Shareholders and placed into an interest bearing escrow account for a period of six months to cover any claims made under the representations, warranties or guaranties of Borrowers or Shareholders which Lender or its Affiliates pays within six months of the closing date. The amount of escrowed funds needed to cover any claim of Lender will be released to the Lender upon proof of payment of the liability. If Lender has made no claims by the date three months from the closing date of the sale, one half of the escrowed amount will be distributed to the Shareholders. Any remaining escrowed funds will be distributed to the Shareholders on the date six months from the closing date of the sale. (v) Commissions payable to Agent for the sale of the Businesses are (i) $250,000 of the Transaction Value, as defined in the Agreement between SafeGuard Health Enterprises, Inc. and Agent, up to $10 million, plus (ii) two and one half percent (2.5%) per million thereafter. 4. Mutual Release. (a) In consideration of Lender's agreements set forth herein, Borrowers and Shareholders, for themselves, their Affiliates, and the respective successors, heirs and assigns of each of the foregoing (collectively, some or all of such persons and entities shall be referred to herein as the "BORROWER RELEASORS" and each reference to a "BORROWER RELEASOR" herein shall refer to each such person or entity individually), do hereby fully, forever 7 8 and irrevocably release, discharge and acquit Lender, and its respective past and present Affiliates, and the respective past and present officers, directors, shareholders, agents, and employees of each and all of the foregoing entities, and its and their respective successors, heirs, and assigns, and any other person or entity now, previously, or hereafter affiliated with any or all of the foregoing entities (Lender, together with each and all said Affiliates, officers, directors, shareholders, agents and employees shall be referred to collectively hereinbelow as the "BORROWER RELEASED PARTIES" and each such reference shall refer jointly and severally to each and all of Lender and such other persons and entities) of and from any and all rights, claims, demands, obligations, liabilities, indebtedness, breaches of contract, breaches of duty or any relationship, acts, omissions, misfeasance, malfeasance, cause or causes of action, debts, sums of money, accounts, compensations, contracts, controversies, promises, damages, costs, losses and expenses of every type, kind, nature, description or character, and irrespective of how, why, or by reason of what facts, whether heretofore or now existing, or that could, might, or may be claimed to exist, of whatever kind or name, whether known or unknown, suspected or unsuspected, liquidated or unliquidated, claimed or unclaimed, whether based on contract, tort, breach of any duty, or other legal or equitable theory of recovery, each as though fully set forth herein at length (collectively, a "CLAIM" or the "CLAIMS") arising from or out of, connected with, or relating to this Agreement, the transactions contemplated hereby, or the administration hereof. (b) In consideration of Borrowers' and Shareholders' agreements set forth herein, Lender, for itself, its Affiliates, and the respective successors, heirs and assigns of each of the foregoing (collectively, some or all of such persons and entities shall be referred to herein as the "LENDER RELEASORS" and each reference to a "LENDER RELEASOR" herein shall refer to each such person or entity individually), does hereby fully, forever and irrevocably release, discharge and acquit Borrowers and Shareholders, and their respective past and present Affiliates, and the respective past and present officers, directors, shareholders, agents, and employees of each and all of the foregoing entities, and their respective successors, heirs, and assigns, and any other person or entity now, previously, or hereafter affiliated with any or all of the foregoing entities (Borrowers and Shareholders, together with each and all said Affiliates, officers, directors, shareholders, agents and employees shall be referred to collectively hereinbelow as the "LENDER RELEASED PARTIES" and each such reference shall refer jointly and severally to each and all of Borrowers, Shareholders and such other persons and entities) of and from any and all Claims arising from or out of, connected with, or relating to this Agreement, the transactions contemplated hereby, or the administration hereof. 8 9 (c) Borrower Releasors and Lender Releasors (together, the "RELEASORS"), and each of them, irrevocably covenant and agree that each of them shall forever refrain from initiating, filing, instituting, maintaining, or proceeding upon, or encouraging, advising or voluntarily assisting any other person or entity to initiate, institute, maintain or proceed upon any Claim of any nature whatsoever released in paragraphs 4(a) and 4(b) above. (d) Releasors, and each of them, represent and warrant that each of them is the owner of and has not assigned, sold, transferred, or otherwise disposed of any of the Claims released in paragraphs 4(a) and 4(b) above. (e) Releasors, and each of them, represent and warrant that each of them has the authority and capacity to execute this Agreement. (f) Releasors, and each of them, for themselves, their successors and their assigns, hereby agree, represent, and warrant that the matters released herein are not limited to matters that are known or disclosed, and Releasors, and each of them, hereby waive any and all rights and benefits that they now have, or in the future may have, conferred upon them by virtue of the provisions of Section 1542 of the Civil Code of the State of California (or any other statute or common law principles of similar effect), which Section provides as follows: A GENERAL RELEASE DOES NOT EXTEND TO CLAIMS WHICH THE CREDITOR DOES NOT KNOW OR SUSPECT TO EXIST IN HIS FAVOR AT THE TIME OF EXECUTING THE RELEASE, WHICH IF KNOWN BY HIM MUST HAVE MATERIALLY AFFECTED HIS SETTLEMENT WITH THE DEBTOR. In this connection, (i) Borrower Releasors, and each of them, hereby agree, represent, and warrant that they realize and acknowledge that factual matters now unknown to them may have given or may hereafter give rise to causes of action, claims, demands, debts, controversies, damages, costs, losses, and expenses that are presently unknown, unanticipated, and unsuspected, and they further agree, represent, and warrant that paragraphs 4(a)-(f) have been negotiated and agreed upon in light of that realization and that they nevertheless hereby intend to release, discharge and acquit the Borrower Released Parties from any such unknown causes of action, claims, demands, debts, controversies, damages, costs, losses, and expenses that are in any way related to this Agreement, the transactions contemplated hereby, or the administration hereof; and 9 10 (ii) Lender Releasors, and each of them, hereby agree, represent, and warrant that they realize and acknowledge that factual matters now unknown to them may have given or may hereafter give rise to causes of action, claims, demands, debts, controversies, damages, costs, losses, and expenses that are presently unknown, unanticipated, and unsuspected, and they further agree, represent, and warrant that paragraphs 4(a)-(f) have been negotiated and agreed upon in light of that realization and that they nevertheless hereby intend to release, discharge and acquit the Lender Released Parties from any such unknown causes of action, claims, demands, debts, controversies, damages, costs, losses, and expenses that are in any way related to this Agreement, the transactions contemplated hereby, or the administration hereof. (g) The provisions of paragraphs 4(a)-(f) shall survive payment in full of the Notes, termination of this Agreement, and full performance of this Agreement and the other Loan Documents. INITIAL: ------------------------ ---------------------- ------------------------ ---------------------- ----------------------- 5. Waiver of Anti-Deficiency Protection. Borrowers hereby expressly and irrevocably disclaim and renounce any right and hereby irrevocably waive any defense, protection or right under: (a) California Code of Civil Procedure ("CCP") Section 580d concerning the bar against rendition of a deficiency judgment after foreclosure under a power of sale; (b) CCP Section 580a purporting to limit the amount of a deficiency judgment which may be obtained following exercise of a power of sale under a deed of trust; (c) CCP Section 726 concerning exhaustion of collateral, the form of foreclosure proceedings with respect to real property security located in California and otherwise limiting the amount of a deficiency judgment which may be recovered following completion of a judicial foreclosure by reference to the "fair value" of the foreclosure collateral; and (d) any duty on the part of Lender to conduct a commercially reasonable sale under California Uniform Commercial Code ("CUCC") Section 9504(3) to the extent any portion of the collateral for the obligations of Borrowers to Lender consists of personal property or fixtures, including, without limitation, the making of any election under CUCC Section 9501(4) in respect of any such personal property or fixtures. INITIAL: -------------------- -------------------- 6. Non-Impairment. Except as expressly provided herein, nothing in this Agreement shall alter or affect any provision, condition or covenant contained in the Notes or in any other Loan Documents or affect and impair any rights, powers or remedies of Lender, it being the intent of the parties hereto that the provisions of the Notes and the other Loan Documents shall continue in full force and effect except as expressly modified hereby. The breach of any representation or warranty hereunder shall constitute a "DEFAULT" under the Loan Documents. 10 11 7. Miscellaneous. This Agreement and the other Loan Documents shall be governed by and interpreted in accordance with the laws of the State of California, unless and to the extent preempted by Federal law, in which case this Agreement and the other Loan Documents shall be governed by and interpreted in accordance with Federal law to such extent. In any action brought or arising out of this Agreement or the Loan Documents, Borrowers, and the Affiliates of Borrowers, hereby consent to the jurisdiction of any Federal or State Court having proper venue within the State of California and also consent to the service of process by any means authorized by California or Federal law. The headings used in this Agreement are for convenience only and shall be disregarded in interpreting the substantive provisions of this Agreement. Except as expressly provided otherwise herein, all capitalized terms used herein shall have the respective meanings given to them in the other Loan Documents. Time is of the essence of each term of the Loan Documents, including this Agreement. The parties and their attorneys have cooperated in drafting and preparing this Agreement; consequently, the presumption that ambiguities are resolved against the drafting party shall be inapplicable, and any such ambiguities shall not be construed against any party. If any provision of this Agreement or any of the other Loan Documents shall be determined by a court of competent jurisdiction to be invalid, illegal or unenforceable, that portion shall be deemed severed from this Agreement and the remaining parts shall remain in full force as though the invalid, illegal, or unenforceable portion had never been a part thereof. 8. Knowing, Free, Voluntary Execution. The parties represent that they have carefully read and understand each of the provisions in this Agreement, know its contents, and have freely and voluntarily signed it. 9. Advice of Counsel. Each of the parties, by the execution of this Agreement, represents that it has reviewed each term of this Agreement with its legal counsel, and that hereafter it shall not deny the validity of the Agreement on the grounds that it did not have advice of counsel. 10. Integration; Interpretation. This Agreement contains or expressly incorporates by reference the entire agreement of the parties with respect to the matters contemplated herein and supersedes all prior negotiations. Clerical errors, if any, in computing dollar amounts relating to the Notes shall be corrected as soon as practicable by a written addendum to this Agreement executed by all the parties. This Agreement shall not be modified except by written instrument executed by all parties. Any reference in this Agreement to the Property shall include all or any part of the Property. 11. Authorization. Borrowers expressly waive any defense to this Agreement based on any lack of authority to enter into and be bound by the terms of this Agreement. 12. Execution in Counterpart. This Agreement may be executed in any number of counterparts, each of which when executed and delivered will be deemed to be an original and all of which, taken together, will be deemed to be one and the same instrument. 11 12 IN WITNESS WHEREOF, Borrowers, Shareholders and Lender have caused this Agreement to be duly executed as of the date first above written. "LENDER" GUARDS DENTAL, INC., a California corporation By:_________________________________ Its:________________________________ By:_________________________________ Its:________________________________ "BORROWERS" ASSOCIATED DENTAL SERVICES, INC. a California corporation By: /s/ FRANK G. PELLKOFER --------------------------------- Frank G. Pellkofer, President PACIFIC COAST DENTAL, INC. a California corporation By: /s/ ROBERT W. STALCUP, D.D.S. --------------------------------- Robert W. Stalcup, D.D.S., President "SHAREHOLDERS" THE PELLKOFER FAMILY TRUST By: /s/ FRANK G. PELLKOFER --------------------------------- Frank G. Pellkofer, Trustee ERIC F. PELLKOFER By: /s/ FRANK G. PELLKOFER --------------------------------- Frank G. Pellkofer, Attorney-in-fact /s/ FRANK G. PELLKOFER --------------------------------- Frank G. Pellkofer THE STALCUP FAMILY TRUST By: /s/ ROBERT W. STALCUP, D.D.S. --------------------------------- Robert W. Stalcup, D.D.S., Trustee /s/ ROBERT W. STALCUP, D.D.S. --------------------------------- Robert W. Stalcup, D.D.S. 12 13 IRREVOCABLE POWER OF ATTORNEY KNOW ALL BY THESE PRESENTS that in consideration of Guards Dental, Inc. entering into that certain Default Forbearance Agreement dated as of February 12, 1999 by and among Guards Dental, Inc., Pacific Coast Dental, Inc., Associated Dental Services, Inc., The Pellkofer Family Trust, Eric F. Pellkofer, Frank G. Pellkofer, The Stalcup Family Trust, and Robert W. Stalcup, D.D.S. (the "Forbearance Agreement") each of the undersigned hereby irrevocably constitutes and appoints GUARDS DENTAL, INC. as the undersigned's true and lawful attorney-in-fact and agent, with full power of substitution, for and in the undersigned's name, place and stead, in any and all capacities, to execute and deliver any and all agreements, notices, certificates and other documents arising from and/or relating to the undersigneds' purpose of allowing Guards Dental, Inc. to control a sale of the businesses of Pacific Coast Dental, Inc. and Associated Dental Services, Inc. (the "Businesses"), including but not limited to, the selling of the Businesses, setting of terms, hiring of agents, marketing the Businesses, establishing a price and any and all other items contemplated by the Forbearance Agreement to which this Irrevocable Power of Attorney is attached as such attorney-in-fact, in its sole discretion, deems advisable. Each of the undersigned hereby grants to such attorney-in-fact full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or proper to be done in the exercise of any of the rights and powers herein granted, as fully to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that such attorney-in-fact, or his substitute or substitutes, shall lawfully do or cause to be done by virtue of this Irrevocable Power of Attorney and the rights and powers herein granted; provided, however, that this Irrevocable Power of Attorney does not grant to the attorney-in-fact authority to agree to any individual or trust representations or warranties made by The Pellkofer Family Trust, Eric F. Pellkofer, Frank G. Pellkofer, The Stalcup Family Trust, or Robert W. Stalcup, D.D.S. in their individual or trust capacities. The rights, powers and authority of said attorney-in-fact to exercise any and all of the rights and powers herein shall commence and be in full effect on the date hereof and shall continue thereafter and shall only terminate and be of no further force and effect as of the date of termination of the Forbearance Agreement. 14 IN WITNESS WHEREOF, the undersigned have executed this Irrevocable Power of Attorney as of this 12th day of February 1999. PACIFIC COAST DENTAL, INC. /s/ ROBERT W. STALCUP, D.D.S. --------------------------- Robert W. Stalcup, D.D.S., President ASSOCIATED DENTAL SERVICES, INC. /s/ FRANK G. PELLKOFER ---------------------------- Frank G. Pellkofer, President THE PELLKOFER FAMILY TRUST /s/ FRANK G. PELLKOFER ---------------------------- Frank G. Pellkofer, Trustee ERIC F. PELLKOFER /s/ FRANK G. PELLKOFER ---------------------------- Frank G. Pellkofer, Attorney-in-fact /s/ FRANK G. PELLKOFER ---------------------------- Frank G. Pellkofer THE STALCUP FAMILY TRUST /s/ ROBERT W. STALCUP, D.D.S ---------------------------- Robert W. Stalcup, D.D.S., Trustee /s/ ROBERT W. STALCUP, D.D.S ---------------------------- Robert W. Stalcup 2 EX-10.19 3 CREDIT AGREEMENT DATED JANUARY 29, 1998 1 EXHIBIT 10.19 SILICON VALLEY BANK AMENDMENT TO LOAN AND SECURITY AGREEMENT AND CONSENT AGREEMENT BORROWER: SAFEGUARD HEALTH ENTERPRISES, INC DATE: JUNE 22, 1998 THIS AMENDMENT TO LOAN AGREEMENT is entered into between SILICON VALLEY BANK ("Bank") and the borrower named above (the "Borrower"). The Parties agree to amend, effective as of the date hereof, the Loan and Security Agreement between them, dated January 29, 1998, as amended by that Amendment to Loan and Security Agreement dated March 23, 1998, and as otherwise amended or modified from time to time (the "Loan Agreement"), as follows. (Capitalized terms used but not defined in this Amendment, shall have the meanings set forth in the Loan Agreement.) Reference is also to the Interest Rate Supplement to Agreement of even date with the Loan Agreement between Bank and Borrower (the "Supplement"). 1. REVISED DEFINITION. The definition of the term "Interest Rate" as set forth in the Supplement and as referred to in the Loan Agreement, is hereby amended, effective as of July 1, 1998, to read as follows: "Interest Rate" shall mean (I) if the Borrower attains a Current Ratio of less than 1.25 to 1 with respect to the period ending June 30, 1998, then as to: (a) Prime Rate Advances, the Interest Rate shall be equal to the Prime Rate plus .50%; and (b) LIBOR Rate Advances, the Interest Rate shall be equal to a rate of 2.50% per annum in excess of the LIBOR Rate (based on the LIBOR Rate applicable for the Interest Period selected by the Borrower) and (II) otherwise if the Borrower attains a Current Ratio of 1.25 to 1 or greater with respect to the period ending June 30, 1998, as to: (a) Prime Rate Advances, the Interest Rate shall be equal to a rate equal to the Prime Rate plus .25%; and (b) LIBOR Rate Advances, the Interest Rate shall be equal to a rate of 2.25% per annum in excess of the LIBOR Rate (based on the LIBOR Rate applicable for the Interest Period selected by the Borrower)." 2. REVISED SECTION 6.8. Section 6.8 of the Loan Agreement is hereby amended to read as follows: "6.8 Current Ratio. Borrower shall, on a consolidated basis, maintain, as of the last day of each fiscal quarter, a ratio of Current Assets to Current Liabilities of at least 1.00 to 1.0 for the period ending June 30, 1998. Thereafter, Borrower shall maintain, as of the last day of each calendar quarter, a ratio of Current Assets to Current Liabilities of at least 1.25 to 1.0." 3. CONSENT. Borrower owns real property commonly known as 505 North Euclid Street, Anaheim, California 92801, and is entering into a sale thereof (such Sale being the "Sale"). As such property is subject to a negative pledge agreement, as more fully set forth in the Loan Agreement, the Borrower has requested that the Bank consent to the Sale and waive any and all provisions in the Loan Agreement that restrict the Sale (such provisions being the -1- 2 "Sale Restriction Provisions"). The Bank is agreeable to such request and hereby consents to the Sale and waives the Sale Restriction Provisions, for the sole and specific purpose of effectuating the Sale. Such waiver does not waive, diminish or otherwise affect any other term or provision of the Loan Agreement, all of which shall remain in full force and effect. 4. REPRESENTATIONS TRUE. Borrower represents and warrants to Bank that all representations and warranties set forth in the Loan Agreement, as amended hereby, are true and correct. 5. GENERAL PROVISIONS. This Amendment and Consent, the Loan Agreement, any prior written amendments to the Loan Agreement signed by Bank and the Borrower, and the other written documents and agreements between Bank and the Borrower set forth in full all of the representations and agreements of the parties with respect to the subject matter hereof and supersede all prior discussions, representations, agreements and understandings between the parties with respect to the subject hereof. Except as herein expressly amended, all of the terms and provisions of the Loan Agreement, and all other documents and agreements between Bank and the Borrower shall continue in full force and effect and the same are hereby ratified and confirmed. This Agreement and Consent may be executed in any number of counterparts, which when taken together shall constitute one and the same agreement. BORROWER: BANK: SAFEGUARD HEALTH ENTERPRISES, INC. SILICON VALLEY BANK BY /s/ THOMAS C. TEKULVE, CPA BY -------------------------------- --------------------------------- TITLE: Vice President, TITLE Chief Financial Officer ------------------------------ BY /s/ STEVEN J. BAILEYS, DDS -------------------------------- TITLE: Chairman and CEO APPROVED AS TO FORM AND CONTENT BY /s/ RONALD I. BRENDZEL, JD -------------------------------- TITLE: Senior Vice President and Secretary -2- 3 - -------------------------------------------------------------------------------- SILICON VALLEY BANK AMENDMENT TO LOAN AND SECURITY AGREEMENT AND CONSENT AGREEMENT BORROWER: SAFEGUARD HEALTH ENTERPRISES, INC. DATE: NOVEMBER 19, 1998 THIS AMENDMENT TO LOAN AGREEMENT is entered into between SILICON VALLEY BANK ("Bank") and the borrower named above (the "Borrower"). The Parties agree to amend, effective as of the date hereof, the Loan and Security Agreement between them, dated January 29, 1998, as amended by that Amendment to Loan and Security Agreement dated March 23, 1998, that Amendment to Loan and Security Agreement dated June 22, 1998, and as otherwise amended or modified from time to time (the "Loan Agreement"), as follows. (Capitalized terms used but not defined in this Amendment, shall have the meanings set forth in the Loan Agreement.) Reference is also made to the Interest Rate Supplement to Agreement of even date with the Loan Agreement between Bank and Borrower (the "Supplement"). 1. REVISED DEFINITION. The definition of the term "Interest Rate" as set forth in the Supplement and as referred to in the Loan Agreement, is hereby amended to read as follows: ""Interest Rate" shall mean the Prime Rate plus 1.5%." 2. REVISED SECTION 6.3. Section 6.3 of the Loan Agreement is hereby amended to read as follows: "6.3 Financial Statements, Reports, Certificates. Borrower shall deliver to Bank: (a) within five (5) days of filing, copies of all statements, reports and notices sent or made available generally by Borrower to its security holders or to any holders of Subordinated Debt and all reports on Form 10-K, 10-Q and 8-K filed with the Securities and Exchange Commission (collectively, the "SEC Reports"); (b) on or before the last day of each month, the consolidated balance sheet and income statement for the immediately preceding month; (c) promptly upon receipt of notice thereof, a report of any legal actions pending or threatened against Borrower or any Subsidiary that could result in damages or costs to Borrower or any Subsidiary of One Hundred Thousand Dollars ($100,000) or 4 more; and (d) such budgets, sales projections, operating plans or other financial information as Bank may reasonably request from time to time. On or before the last day of each month, for the immediately preceding month, Borrower shall deliver to Bank a Compliance Certificate signed by a Responsible Officer in substantially the form of Exhibit D to the Loan Agreement. Bank shall have a right from time to time hereafter to audit Borrower's Accounts at Borrower's expense, provided that such audits will be conducted no more often than every six (6) months unless an Event of Default has occurred and is continuing." 3. AMENDMENT FEE. In consideration of Bank's execution of this Amendment and that certain Waiver of Default dated November 19, 1998, Borrower shall pay to Bank an amendment fee in the amount of $20,000.00 on or before November 19, 1998. 4. INFORMATION REQUEST. Borrower shall provide to Bank the information and documents set forth on Exhibit A hereto on or before November 23, 1998. 5. REPRESENTATIONS TRUE. Borrower represents and warrants to Bank that all representations and warranties set forth in the Loan Agreement, as amended hereby, are true and correct. 6. GENERAL PROVISIONS. This Amendment, the Loan Agreement, any prior written amendments to the Loan Agreement signed by Bank and the Borrower, and the other written documents and agreements between Bank and the Borrower set forth in full all of the representations and agreements of the parties with respect to the subject matter hereof and supersede all prior discussions, representations, agreements and understandings between the parties with respect to the subject hereof. Except as herein expressly amended, all of the terms and provisions of the Loan Agreement, and all other documents and agreements between Bank and the Borrower shall continue in full force and effect and the same are hereby ratified and confirmed. This Agreement and Consent may be executed in any number of counterparts, which when taken together shall constitute one and the same agreement. BORROWER: BANK: SAFEGUARD HEALTH ENTERPRISES, INC. SILICON VALLEY BANK BY /s/ STEVEN J. BAILEYS, DDS BY /s/ KITTRIDGE CHAMBERLIN ------------------------------------ ----------------------------- TITLE: Chairman & Chief Executive Officer TITLE SVP ---------------------------------- --------------------------- BY /s/ THOMAS C. TEKULVE, CPA ------------------------------------ TITLE: Vice Pres, Chief Financial Officer ---------------------------------- -2- 5 [LOGO] SILICON VALLEY BANK LOAN AND SECURITY AGREEMENT by and between SILICON VALLEY BANK as Lender and SAFEGUARD HEALTH ENTERPRISES, INC. as Borrower Dated: January 29, 1998 6 TABLE OF CONTENTS
PAGE ---- 1. DEFINITIONS AND CONSTRUCTION.................................................. 1 1.1 Definitions........................................................ 1 1.2 Accounting and Other Terms......................................... 6 2. LOAN AND TERMS OF PAYMENT..................................................... 6 2.1 Credit Extensions.................................................. 6 2.2 Overadvances....................................................... 7 2.3 Interest Rates, Payments, and Calculations......................... 7 2.4 Crediting Payments................................................. 8 2.5 Fees............................................................... 8 2.6 Additional Costs................................................... 8 2.7 Term............................................................... 9 3. CONDITIONS OF LOANS........................................................... 9 3.1 Conditions Precedent to Initial Credit Extension................... 9 3.2 Conditions Precedent to all Credit Extensions...................... 9 4. CREATION OF SECURITY INTEREST................................................. 10 4.1 Grant of Security Interest......................................... 10 4.2 Delivery of Additional Documentation Required...................... 10 4.3 Right to Inspect................................................... 10 5. REPRESENTATIONS AND WARRANTIES................................................ 10 5.1 Due Organization and Qualification................................. 10 5.2 Due Authorization.................................................. 10 5.3 No Prior Encumbrances.............................................. 11 5.4 [Reserved]......................................................... 11 5.5 Merchantable Inventory............................................. 11 5.6 [Reserved]......................................................... 11 5.7 Name............................................................... 11 5.8 Litigation......................................................... 11 5.9 No Material Adverse Change in Financial Statements................. 11 5.10 Solvency........................................................... 11 5.11 Regulatory Compliance.............................................. 11 5.12 Environmental Condition............................................ 11 5.13 Taxes.............................................................. 12 5.14 Subsidiaries....................................................... 12 5.15 Government Consents................................................ 12 5.16 Full Disclosure.................................................... 12 6. AFFIRMATIVE COVENANTS......................................................... 12 6.1 Good Standing...................................................... 12 6.2 Government Compliance.............................................. 12 6.3 Financial Statements, Reports, Certificates........................ 12 6.4 Inventory.......................................................... 13 6.5 Taxes.............................................................. 13 6.6 Insurance.......................................................... 13 6.7 Principal Depository............................................... 13 6.8 Current Ratio...................................................... 14 6.9 Debt-Net Worth Ratio............................................... 14 6.10 Stated Net Worth................................................... 14 6.11 EBITA/Interest Expense Ratio....................................... 14 6.12 Clean Up Period.................................................... 14 6.13 Further Assurances................................................. 14 7. NEGATIVE COVENANTS............................................................ 14
-i- 7 TABLE OF CONTENTS (CONTD)
PAGE ---- 7.1 Dispositions....................................................... 14 7.2 Changes in Business, Ownership, or Management, Business Locations................................................. 14 7.3 Mergers or Acquisitions............................................ 14 7.4 Indebtedness....................................................... 15 7.5 Encumbrances....................................................... 15 7.6 Distributions...................................................... 15 7.7 Investments........................................................ 15 7.8 Transactions with Affiliates....................................... 15 7.9 [Reserved]......................................................... 15 7.10 Subordinated Debt.................................................. 15 7.11 Inventory.......................................................... 15 7.12 Compliance......................................................... 15 8. EVENTS OF DEFAULT............................................................. 16 8.1 Payment Default ................................................... 16 8.2 Covenant Default................................................... 16 8.3 Material Adverse Change............................................ 16 8.4 Attachment ........................................................ 16 8.5 Insolvency......................................................... 16 8.6 Other Agreements................................................... 16 8.7 Subordinated Debt.................................................. 17 8.8 Judgments.......................................................... 17 8.9 Misrepresentations................................................. 17 8.10 Guaranty........................................................... 17 9. BANK'S RIGHTS AND REMEDIES.................................................... 17 9.1 Rights and Remedies................................................ 17 9.2 Power of Attorney.................................................. 18 9.3 Accounts Collection................................................ 18 9.4 Bank Expenses...................................................... 19 9.5 Bank's Liability for Collateral.................................... 19 9.6 Remedies Cumulative................................................ 19 9.7 Demand............................................................. 19 10. NOTICES ................................................................... 19 11. CHOICE OF LAW AND VENUE....................................................... 20 12. GENERAL PROVISIONS............................................................ 20 12.1 Successors and Assigns............................................. 20 12.2 Indemnification.................................................... 20 12.3 Time of Essence.................................................... 20 12.4 Severability of Provisions......................................... 20 12.5 Amendments in Writing, Integration................................. 20 12.6 Counterparts....................................................... 21 12.7 Survival........................................................... 21
-ii- 8 LOAN AND SECURITY AGREEMENT This LOAN AND SECURITY AGREEMENT is entered into as of January 29, 1998 by and between SILICON VALLEY BANK ("Bank") and SAFEGUARD HEALTH ENTERPRISES, INC., a Delaware corporation ("Borrower"). RECITALS Borrower wishes to obtain credit from time to time from Bank, and Bank desires to extend credit to Borrower. This Agreement sets forth the terms on which Bank will advance credit to Borrower, and Borrower will repay the amounts owing to Bank. AGREEMENT The parties agree as follows: 1. DEFINITIONS AND CONSTRUCTION 1.1 Definitions. As used in this Agreement, the following terms shall have the following definitions: "Accounts" means all presently existing and hereafter arising accounts, contract rights, and all other forms of obligations owing to Borrower arising out of the sale or lease of goods (including, without limitation, the licensing of software and other technology) or the rendering of services by Borrower, whether or not earned by performance, and any and all credit insurance, guaranties, and other security therefor, as well as all merchandise returned to or reclaimed by Borrower and Borrower's Books relating to any of the foregoing. "Advance" or "Advances" means a loan advance under the Committed Revolving Line. "Affiliate" means, with respect to any Person, any Person that owns or controls directly or indirectly such Person, any Person that controls or is controlled by or is under common control with such Person, and each of such Person's senior executive officers, directors, partners and, for any Person that is a limited liability company, such Persons, managers and members. "Bank Expenses" means all reasonable costs or expenses (including reasonable attorneys' fees and expenses) incurred in connection with the preparation, negotiation, administration, and enforcement of the Loan Documents; and Bank's reasonable attorneys' fees and expenses incurred in amending, enforcing or defending the Loan Documents, (including fees and expenses of appeal or review, or those incurred in any Insolvency Proceeding) whether or not suit is brought. "Borrower's Books" means all of Borrower's books and records including, without limitation: ledgers; records concerning Borrower's assets or liabilities, the Collateral, business operations or financial condition; and all computer programs, or tape files, and the equipment, containing such information. "Business Day" means any day that is not a Saturday, Sunday, or other day on which banks in the State of California are authorized or required to close, provided that with respect to all transactions involving LIBOR Rate Advances (as defined in the Supplement), "Business Day" shall have the meaning set forth in the Supplement. "Closing Date" means the date of this Agreement. -1- 9 "Code" means the California Uniform Commercial Code. "Collateral" means the property described on Exhibit A attached hereto. "Committed Revolving Line" means a credit extension of up to $8,000,000. "Consolidated EBITA" means for any period the amount of which is to be determined, Consolidated Net Income for such period plus (but only to the extent such amounts were deducted in the computation of Consolidated Net Income) (i) Consolidated Interest Expense, (ii) income tax expense (including deferred income tax expense) and (iii) amortization expense of the Consolidated Group for such period, determined on a consolidated basis in accordance with GAAP, consistently applied. "Consolidated Group" means the Borrower and each of its Subsidiaries and if the context so requires, the Borrower and its Subsidiaries, taken as a whole. "Consolidated Interest Expense" means for any period the amount of which is to be determined, the aggregate interest charges of the Consolidated Group (including without limitation that portion of any obligation under capitalized leases allocable to interest expense) on any Obligations for such period (without regard to any limitation on the payment thereof) as determined in accordance with GAAP, consistently applied. "Consolidated Net Income" means for any period the amount of which is to be determined, the net income of the Consolidated Group determined on a consolidated basis in accordance with GAAP, consistently applied. "Contingent Obligation" means, as applied to any Person, any direct or indirect liability, contingent or otherwise, of that Person with respect to (i) any indebtedness, lease, dividend, letter of credit or other obligation of another, including, without limitation, any such obligation directly or indirectly guaranteed, endorsed, co-made or discounted or sold with recourse by that Person, or in respect of which that Person is otherwise directly or indirectly liable; (ii) any obligations with respect to undrawn letters of credit issued for the account of that Person; and (iii) all obligations arising under any interest rate, currency or commodity swap agreement, interest rate cap agreement, interest rate collar agreement, or other agreement or arrangement designated to protect a Person against fluctuation in interest rates, currency exchange rates or commodity prices; provided, however, that the term "Contingent Obligation" shall not include endorsements for collection or deposit in the ordinary course of business. The amount of any Contingent Obligation shall be deemed to be an amount equal to the stated or determined amount of the primary obligation in respect of which such Contingent Obligation is made or, if not stated or determinable, the maximum reasonably anticipated liability in respect thereof as determined by such Person in good faith; provided, however, that such amount shall not in any event exceed the maximum amount of the obligations under the guarantee or other support arrangement. "Credit Extension" means each Advance, Letter of Credit or any other extension of credit by Bank for the benefit of Borrower hereunder. "Current Assets" means, as of any applicable date, all amounts that should, in accordance with GAAP, be included as current assets on the consolidated balance sheet of Borrower and its Subsidiaries as at such date. "Current Liabilities" means, as of any applicable date, all amounts that should, in accordance with GAAP, be included as current liabilities on the consolidated balance sheet of Borrower and its Subsidiaries, as at such date, plus, to the extent not already included therein, all outstanding Credit Extensions made under this Agreement, including all Indebtedness that is -2- 10 payable upon demand or within one year from the date of determination thereof unless such Indebtedness is renewable or extendable at the option of Borrower or any Subsidiary to a date more than one year from the date of determination, but excluding Subordinated Debt. "Equipment" means all present and future machinery, equipment, tenant improvements, furniture, fixtures, vehicles, tools, parts and attachments in which Borrower has any interest. "ERISA" means the Employment Retirement Income Security Act of 1974, as amended, and the regulations thereunder. "GAAP" means generally accepted accounting principles as in effect in the United States from time to time. "Indebtedness" means (a) all indebtedness for borrowed money or the deferred purchase price of property or services, including without limitation reimbursement and other obligations with respect to surety bonds and letters of credit, (b) all obligations evidenced by notes, bonds, debentures or similar instruments, (c) all capital lease obligations and (d) all Contingent Obligations. "Insolvency Proceeding" means any proceeding commenced by or against any person or entity under any provision of the United States Bankruptcy Code, as amended, or under any other bankruptcy or insolvency law, including assignments for the benefit of creditors, formal or informal moratoria, compositions, extension generally with its creditors, or proceedings seeking reorganization, arrangement, or other relief. "Interest Rate" shall have the meaning set forth in the Supplement. "Inventory" means all present and future inventory in which Borrower has any interest, including merchandise, raw materials, parts, supplies, packing and shipping materials, work in process and finished products intended for sale or lease or to be furnished under a contract of service, of every kind and description now or at any time hereafter owned by or in the custody or possession, actual or constructive, of Borrower, including such inventory as is temporarily out of its custody or possession or in transit and including any returns upon any accounts or other proceeds, including insurance proceeds, resulting from the sale or disposition of any of the foregoing and any documents of title representing any of the above. "Investment" means any beneficial ownership of (including stock, partnership interest or other securities) any Person, or any loan, advance or capital contribution to any Person. "IRC" means the Internal Revenue Code of 1986, as amended, and the regulations thereunder. "Letter of Credit" means a letter of credit or similar undertaking issued by Bank pursuant to Section 2.1.2. "Letter of Credit Reserve" has the meaning set forth in Section 2.1.2. "Lien" means any mortgage, lien, deed of trust, charge, pledge, security interest or other encumbrance. "Loan Documents" means, collectively, this Agreement, any note or notes executed by Borrower, and any other present or future agreement entered into between Borrower and/or for -3- 11 the benefit of Bank in connection with this Agreement, all as amended, extended or restated from time to time. Material Adverse Effect" means a material adverse effect on (i) the business operations or condition (financial or otherwise) of Borrower and its Subsidiaries taken as a whole or (ii) the ability of Borrower to repay the Obligations or otherwise perform its obligations under the Loan Documents. "Maturity Date" means the Revolving Maturity Date. "Negotiable Collateral" means all of Borrower's present and future letters of credit of which it is a beneficiary, notes, drafts, instruments, securities, documents of title, and chattel paper. "Obligations" means all debt, principal, interest, Bank Expenses and other amounts owed to Bank by Borrower pursuant to this Agreement or any other agreement, whether absolute or contingent, due or to become due, now existing or hereafter arising, including any interest that accrues after the commencement of an Insolvency Proceeding and including any debt, liability, or obligation owing from Borrower to others that Bank may have obtained by assignment or otherwise. "Payment Date" means the first calendar day of each month commencing on the first such date after the Closing Date and ending on the Revolving Maturity Date. "Permitted Indebtedness" means: (a) Indebtedness of Borrower in favor of Bank arising under this Agreement or any other Loan Document; (b) Indebtedness existing on the Closing Date and disclosed in the Schedule; (c) Subordinated Debt; (d) Indebtedness to trade creditors incurred in the ordinary course of business; and (e) Indebtedness secured by Permitted Liens. "Permitted Investment" means: (a) Investments existing on the Closing Date disclosed in the Schedule; (b) (i) marketable direct obligations issued or unconditionally guaranteed by the United States of America or any agency or any State thereof maturing within one (1) year from the date of acquisition thereof, (ii) commercial paper maturing no more than one (1) year from the date of creation thereof and currently having the highest rating obtainable from either Standard & Poor's Corporation or Moody's Investors Service, Inc., and (iii) certificates of deposit maturing no more than one (1) year from the date of investment therein issued by Bank; and (c) those Investments set forth on Exhibit C attached hereto. "Permitted Liens" means the following: -4- 12 (a) Any Liens existing on the Closing Date and disclosed in the Schedule or arising under this Agreement or the other Loan Documents; (b) Liens for taxes, fees, assessments or other governmental charges or levies, either not delinquent or being contested in good faith by appropriate proceedings and as to which adequate reserves are maintained on Borrower's Books in accordance with GAAP, provided the same have no priority over any of Bank's security interests; (c) Liens (i) upon or in any Equipment acquired or held by Borrower or any of its Subsidiaries to secure the purchase price of such Equipment or indebtedness incurred solely for the purpose of financing the acquisition of such Equipment, or existing on such equipment at the time of its acquisition, provided that the Lien is confined solely to the property so acquired and improvements thereon, and the proceeds of such equipment; and (d) Liens incurred in connection with the extension, renewal or refinancing of the indebtedness secured by Liens of the type described in clauses (a) through (c) above, provided that any extension, renewal or replacement Lien shall be limited to the property encumbered by the existing Lien and the principal amount of the indebtedness being extended, renewed or refinanced does not increase. "Person" means any individual, sole proprietorship, partnership, limited liability company, joint venture, trust, unincorporated organization, association, corporation, institution, public benefit corporation, firm, joint stock company, estate, entity or governmental agency. "Prime Rate" means the variable rate of interest, per annum, most recently announced by Bank, as its "prime rate," whether or not such announced rate is the lowest rate available from Bank. "Responsible Officer" means each of the Chief Executive Officer, the President and the Chief Financial Officer. "Revolving Maturity Date" means one day prior to the first anniversary of the date of this Agreement. "Schedule" means the schedule of exceptions attached hereto, if any. "SEC Reports" shall have the meaning set forth in Section 6.3(a) hereof. "Stated Net Worth" means as of any applicable date, the stated net worth of the Borrower determined in accordance with GAAP, consistently applied. "Subordinated Debt" means any debt incurred by Borrower that is subordinated to the debt owing by Borrower to Bank on terms acceptable to Bank (and identified as being such by Borrower and Bank). "Subsidiary" means with respect to any Person, corporation, partnership, company association, joint venture, or any other business entity of which more than fifty percent (50%) of the voting stock or other equity interests is owned or controlled, directly or indirectly, by such Person or one or more Affiliates of such Person. "Supplement" shall mean the Interest Rate Supplement to Agreement of even date herewith between Bank and Borrower attached hereto and forming a part of this Agreement. -5- 13 "Total Liabilities" means as of any applicable date, any date as of which the amount thereof shall be determined, all obligations that should, in accordance with GAAP be classified as liabilities on the consolidated balance sheet of Borrower, including in any event all Indebtedness, but specifically excluding Subordinated Debt. 1.2 Accounting and Other Terms. All accounting terms not specifically defined herein shall be construed in accordance with GAAP and all calculations and determinations made hereunder shall be made in accordance with GAAP. When used herein, the term "financial statements" shall include the notes and schedules thereto. The terms "including"/ "includes" shall always be read as meaning "including (or includes) without limitation", when used herein or in any other Loan Document. 2. LOAN AND TERMS OF PAYMENT 2.1 Credit Extensions. Borrower promises to pay to the order of Bank, in lawful money of the United States of America, the aggregate unpaid principal amount of all Credit Extensions made by Bank to Borrower hereunder. Borrower shall also pay interest on the unpaid principal amount of all Credit Extensions at rates in accordance with the terms hereof. 2.1.1 Advances. (a) Subject to and upon the terms and conditions of this Agreement, Bank agrees to make Advances to Borrower in an aggregate outstanding amount not to exceed (i) the Committed Revolving Line minus (ii) the face amount of all outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit). Subject to the terms and conditions of this Agreement, amounts borrowed pursuant to this Section 2.1 may be repaid and reborrowed at any time during the term of this Agreement. (b) Whenever Borrower desires an Advance, Borrower will notify Bank by facsimile transmission or telephone no later than 3:00 p.m. Pacific time, on the Business Day that the Advance is to be made, provided that a LIBOR Rate Advances (as defined in the Supplement) shall be subject to the Advance request provisions set forth in the Supplement. Each such notification shall be promptly confirmed by a Payment/Advance Form in substantially the form of Exhibit B hereto. Bank is authorized to make Advances under this Agreement, based upon instructions received from a Responsible Officer, or without instructions if in Bank's discretion such Advances are necessary to meet Obligations which have become due and remain unpaid. Bank shall be entitled to rely on any telephonic notice given by a person who Bank reasonably believes to be a Responsible Officer or a designee thereof, and Borrower shall indemnify and hold Bank harmless for any damages or loss suffered by Bank as a result of such reliance. Bank will credit the amount of Advances made under this Section 2.1 to Borrower's deposit account. (c) The Committed Revolving Line shall terminate on the Revolving Maturity Date, at which time all Advances under this Section 2.1 and other amounts due under this Agreement (except as otherwise expressly specified herein) shall be immediately due and payable. 2.1.2 Letters of Credit. (a) Subject to the terms and conditions of this Agreement, Bank agrees to issue or cause to be issued Letters of Credit for the account of Borrower in an aggregate -6- 14 outstanding face amount not to exceed (i) the Committed Revolving Line minus (ii) the then outstanding principal balance of the Advances; provided that the face amount of outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit and any Letter of Credit Reserve) shall not in any case exceed $1,000,000. Each Letter of Credit shall have an expiry date no later than the Revolving Maturity Date. All Letters of Credit shall be, in form and substance, acceptable to Bank in its sole discretion and shall be subject to the terms and conditions of Bank's form of standard Application and Letter of Credit Agreement. (b) The obligation of Borrower to immediately reimburse Bank for drawings made under Letters of Credit shall be absolute, unconditional and irrevocable, and shall be performed strictly in accordance with the terms of this Agreement and such Letters of Credit, under all circumstances whatsoever. Borrower shall indemnify, defend, protect, and hold Bank harmless from any loss, cost, expense or liability, including,. without limitation, reasonable attorneys' fees, arising out of or in connection with any Letters of Credit. (c) Borrower may request that Bank issue a Letter of Credit payable in a currency other than United States Dollars. If a demand for payment is made under any such Letter of Credit, Bank shall treat such demand as an Advance to Borrower of the equivalent of the amount thereof (plus cable charges) in United States currency at the then prevailing rate of exchange in San Francisco, California, for sales of that other currency for cable transfer to the country of which it is the currency. (d) Upon the issuance of any letter of credit payable in a currency other than United States Dollars, Bank shall create a reserve under the Committed Revolving Line for letters of credit against fluctuations in currency exchange rates, in an amount equal to ten percent (10%) of the face amount of such letter of credit. The amount of such reserve may be amended by Bank from time to time to account for fluctuations in the exchange rate. The availability of funds under the Committed Revolving Line shall be reduced by the amount of such reserve for so long as such letter of credit remains outstanding. 2.2 Overadvances. If, at any time or for any reason, the amount of Obligations owed by Borrower to Bank pursuant to Section 2.1.1 or 2.1.2 of this Agreement is greater than the Committed Revolving Line, Borrower shall immediately pay to Bank, in cash, the amount of such excess. 2.3 Interest Rates, Payments, and Calculations. (a) Interest Rate. Except as set forth in Section 2.3(b), any Advances shall bear interest, on the average daily balance thereof, at a per annum rate equal to the applicable Interest Rate. (b) Default Rate. All Obligations shall bear interest, from and after the occurrence of an Event of Default, at a rate equal to five (5) percentage points above the interest rate applicable immediately prior to the occurrence of the Event of Default, provided that LIBOR Rate Advances (as defined in the Supplement) shall first be subject to conversion to Prime Rate Advances (as defined in the Supplement) as more fully set forth in the Supplement. (c) Payments. Interest hereunder shall be due and payable on each Payment Date. Borrower hereby authorizes Bank to debit any accounts with Bank, including, without limitation, Account Number ____________________ for payments of principal and interest due on the Obligations and any other amounts owing by Borrower to Bank. Bank will notify -7- 15 Borrower of all debits which Bank has made against Borrower's accounts within the next customary bank statement reporting period. Any such debits against Borrower's accounts in no way shall be deemed a set-off. Any interest not paid when due shall be compounded by becoming a part of the Obligations, and such interest shall thereafter accrue interest at the rate then applicable hereunder. (d) Computation. In the event the Prime Rate is changed from time to time hereafter, the applicable rate of interest with respect to Prime Rate Advances (as defined in the Supplement) shall be increased or decreased effective as of 12:01 a.m. on the day the Prime Rate is changed, by an amount equal to such change in the Prime Rate. All interest chargeable under the Loan Documents shall be computed on the basis of a three hundred sixty (360) day year for the actual number of days elapsed. 2.4 Crediting Payments. Prior to the occurrence of an Event of Default, Bank shall credit a wire transfer of funds, check or other item of payment to such deposit account or Obligation as Borrower specifies. After the occurrence of an Event of Default, the receipt by Bank of any wire transfer of funds, check, or other item of payment, whether directed to Borrower's deposit account with Bank or to the Obligations or otherwise, shall be immediately applied to conditionally reduce Obligations, but shall not be considered a payment in respect of the Obligations unless such payment is of immediately available federal funds or unless and until such check or other item of payment is honored when presented for payment. Notwithstanding anything to the contrary contained herein, any wire transfer or payment received by Bank after 12:00 noon Pacific time shall be deemed to have been received by Bank as of the opening of business on the immediately following Business Day. Whenever any payment to Bank under the Loan Documents would otherwise be due (except by reason of acceleration) on a date that is not a Business Day, such payment shall instead be due on the next Business Day, and additional fees or interest, as the case may be, shall accrue and be payable for the period of such extension. 2.5 Fees. Borrower shall pay to Bank the following: (a) Facility Fee. A Facility Fee equal to $40,000, which fee shall be due on the Closing Date and shall be fully earned and non-refundable; (b) Financial Examination and Appraisal Fees. Bank's customary fees and reasonable out-of-pocket expenses for Bank's audits and appraisals of Collateral and financial analysis and examination of Borrower performed from time to time by Bank or its agents; and (c) Bank Expenses. Upon demand from Bank, including, without limitation, upon the date hereof, all reasonable Bank Expenses incurred through the date hereof, including reasonable attorneys' fees and expenses, and, after the date hereof, all reasonable Bank Expenses, including reasonable attorneys' fees and expenses, as and when they become due. 2.6 Additional Costs. In case any law, regulation, treaty or official directive or the interpretation or application thereof by any court or any governmental authority charged with the administration thereof or the compliance with any guideline or request of any central bank or other governmental authority (whether or not having the force of law): (a) subjects Bank to any tax with respect to payments of principal or interest or any other amounts payable hereunder by Borrower or otherwise with respect to the transactions contemplated hereby (except for taxes on the overall net income of Bank imposed by the United States of America or any political subdivision thereof); -8- 16 (b) imposes, modifies or deems applicable any deposit insurance, reserve, special deposit or similar requirement against assets held by, or deposits in or for the account of, or loans by, Bank; or (c) imposes upon Bank any other condition with respect to its performance under this Agreement, and the result of any of the foregoing is to increase the cost to Bank, reduce the income receivable by Bank or impose any expense upon Bank with respect to any loans, Bank shall notify Borrower thereof. Borrower agrees to pay to Bank the amount of such increase in cost, reduction in income or additional expense as and when such cost, reduction or expense is incurred or determined, upon presentation by Bank of a statement of the amount and setting forth Bank's calculation thereof, all in reasonable detail, which statement shall be deemed true and correct absent manifest error. 2.7 Term. Except as otherwise set forth herein, this Agreement shall become effective on the Closing Date and, subject to Section 12.7, shall continue in full force and effect for a term ending on the Maturity Date. Notwithstanding the foregoing, Bank shall have the right to terminate its obligation to make Credit Extensions under this Agreement immediately and without notice upon the occurrence and during the continuance of an Event of Default. Notwithstanding termination of this Agreement, Bank's lien on the Collateral shall remain in effect for so long as any Obligations are outstanding. 3. CONDITIONS OF LOANS 3.1 Conditions Precedent to Initial Credit Extension. The obligation of Bank to make the initial Credit Extension is subject to the condition precedent that Bank shall have received, in form and substance satisfactory to Bank, the following: (a) this Agreement; (b) a certificate of the Secretary of Borrower with respect to its certificate of incorporation, bylaws, incumbency and resolutions authorizing the execution and delivery of this Agreement; (c) financing statements (Forms UCC-1); (d) insurance certificate; (e) payment of the fees and Bank Expenses then due specified in Section 2.5 hereof; (f) Certificate of Foreign Qualification (if applicable); (g) review and approval by the Bank of the Note Purchase Agreement dated as of September 30, 1997 regarding the issuance of certain senior notes by the Borrower and all exhibits and all other documents relating thereto; and (h) such other documents, and completion of such other matters, as Bank may reasonably deem necessary or appropriate. 3.2 Conditions Precedent to all Credit Extensions. The obligation of Bank to make each Credit Extension, including the initial Credit Extension, is further subject to the following conditions: -9- 17 (a) timely receipt by Bank of the Payment/Advance Form as provided in Section 2.1; and (b) the representations and warranties contained in Section 5 shall be true and correct in all material respects on and as of the date of such Payment/Advance Form and on the effective date of each Credit Extension as though made at and as of each such date, and no Event of Default shall have occurred and be continuing, or would result from such Credit Extension. The making of each Credit Extension shall be deemed to be a representation and warranty by Borrower on the date of such Credit Extension as to the accuracy of the facts referred to in this Section 3.2(b). 4. CREATION OF SECURITY INTEREST 4.1 Grant of Security Interest. Borrower grants and pledges to Bank a continuing security interest in all presently existing and hereafter acquired or arising Collateral in order to secure prompt payment of any and all Obligations and in order to secure prompt performance by Borrower of each of its covenants and duties under the Loan Documents. Except as set forth in the Schedule, such security interest constitutes a valid, first priority security interest in the presently existing Collateral, and will constitute a valid, first priority security interest in Collateral acquired after the date hereof. Borrower acknowledges that Bank may place a "hold" on any Deposit Account pledged as Collateral to secure the Obligations. Notwithstanding termination of this Agreement, Bank's Lien on the Collateral shall remain in effect for so long as any Obligations are outstanding. 4.2 Delivery of Additional Documentation Required. Borrower shall from time to time execute and deliver to Bank, at the request of Bank, all Negotiable Collateral, all financing statements and other documents that Bank may reasonably request, in form satisfactory to Bank, to perfect and continue perfected Bank's security interests in the Collateral and in order to fully consummate all of the transactions contemplated under the Loan Documents. 4.3 Right to Inspect. Bank (through any of its officers, employees, or agents) shall have the right, upon reasonable prior notice, from time to time during Borrower's usual business hours, to inspect Borrower's Books and to make copies thereof and to check, test, and appraise the Collateral in order to verify Borrower's financial condition or the amount, condition of, or any other matter relating to, the Collateral. 5. REPRESENTATIONS AND WARRANTIES Borrower represents and warrants as follows: 5.1 Due Organization and Qualification. Borrower and each Subsidiary is a corporation duly existing and in good standing under the laws of its state of incorporation and qualified and licensed to do business in, and is in good standing in, any state in which the conduct of its business or its ownership of property requires that it be so qualified. 5.2 Due Authorization; No Conflict. The execution, delivery, and performance of the Loan Documents are within Borrower's powers, have been duly authorized, and are not in conflict with nor constitute a breach of any provision contained in Borrower's Articles/Certificate of Incorporation or Bylaws, nor will they constitute an event of default under any material agreement to which Borrower is a party or by which Borrower is bound. Borrower is not in default under any agreement to which it is a party or by which it is bound, which default could have a Material Adverse Effect. -l0- 18 5.3 No Prior Encumbrances. Borrower has good and indefeasible title to the Collateral, free and clear of Liens, except for Permitted Liens. 5.4 [Reserved] 5.5 Merchantable Inventory. All Inventory is in all material respects of good and marketable quality, free from all material defects. 5.6 [Reserved] 5.7 Name; Location of Chief Executive Office. Except as disclosed in the Schedule, Borrower has not done business and will not without at least thirty (30) days prior written notice to Bank do business under any name other than that specified on the signature page hereof. The chief executive office of Borrower is located at the address indicated in Section 10 hereof. 5.8 Litigation. Except as set forth in the Schedule, there are no actions or proceedings pending, or, to Borrower's knowledge, threatened by or against Borrower or any Subsidiary before any court or administrative agency in which an adverse decision could have a Material Adverse Effect or a material adverse effect on Borrower's interest or Bank's security interest in the Collateral. 5.9 No Material Adverse Change in Financial Statements. All consolidated financial statements related to Borrower and any Subsidiary that have been delivered by Borrower to Bank fairly present in all material respects Borrower's consolidated financial condition as of the date thereof and Borrower's consolidated results of operations for the period then ended. There has not been a material adverse change in the consolidated financial condition of Borrower since the date of the most recent of such financial statements submitted to Bank on or about the Closing Date. 5.10 Solvency. The fair saleable value of Borrower's assets (including goodwill minus disposition costs) exceeds the fair value of its liabilities; the Borrower is not left with unreasonably small capital after the transactions contemplated by this Agreement; and Borrower is able to pay its debts (including trade debts) as they mature. 5.11 Regulatory Compliance. Borrower and each Subsidiary has met the minimum funding requirements of ERISA with respect to any employee benefit plans subject to ERISA. No event has occurred resulting from Borrower's failure to comply with ERISA that is reasonably likely to result in Borrower's incurring any liability that could have a Material Adverse Effect. Borrower is not an "investment company" or a company "controlled" by an "investment company" within the meaning of the Investment Company Act of 1940. Borrower is not engaged principally, or as one of its important activities, in the business of extending credit for the purpose of purchasing or carrying margin stock (within the meaning of Regulations G, T and U of the Board of Governors of the Federal Reserve System). Borrower has complied with all the provisions of the Federal Fair Labor Standards Act. Borrower has not violated any statutes, laws, ordinances or rules applicable to it, violation of which could have a Material Adverse Effect. 5.12 Environmental Condition. None of Borrower's or any Subsidiary's properties or assets has ever been used by Borrower or any Subsidiary or, to the best of Borrower's knowledge, by previous owners or operators, in the disposal of, or to produce, store, handle, treat, release, or transport, any hazardous waste or hazardous substance other than in accordance with applicable law; to the best of Borrower's knowledge, none of Borrower's properties or assets has ever been designated or identified in any manner pursuant to any environmental protection statute as a hazardous waste or hazardous substance disposal site, or a candidate for closure pursuant to any environmental protection statute; no lien arising under any environmental protection statute has attached to any revenues or to any real or personal property owned by -11- 19 Borrower or any Subsidiary; and neither Borrower nor any Subsidiary has received a summons, citation, notice, or directive from the Environmental Protection Agency or any other federal, state or other governmental agency concerning any action or omission by Borrower or any Subsidiary resulting in the release, or other disposition of hazardous waste or hazardous substances into the environment. 5.13 Taxes. Borrower and each Subsidiary has filed or caused to be filed all tax returns required to be filed on a timely basis, and has paid, or has made adequate provision for the payment of, all taxes reflected therein. 5.14 Subsidiaries. Borrower does not own any stock, partnership interest or other equity securities of any Person, except for Permitted Investments. 5.15 Government Consents. Borrower and each Subsidiary has obtained all consents, approvals and authorizations of, made all declarations or filings with, and given all notices to, all governmental authorities that are necessary for the continued operation of Borrower's business as currently conducted. 5.16 Full Disclosure. No representation, warranty or other statement made by Borrower in any certificate or written statement furnished to Bank contains any untrue statement of a material fact or omits to state a material fact necessary in order to make the statements contained in such certificates or statements not misleading. 6. AFFIRMATIVE COVENANTS Borrower covenants and agrees that, until payment in full of all outstanding Obligations, and for so long as Bank may have any commitment to make a Credit Extension hereunder, Borrower shall do all of the following: 6.1 Good Standing. Borrower shall maintain its and each of its Subsidiaries' corporate existence and good standing in its jurisdiction of incorporation and maintain qualification in each jurisdiction in which the failure to so qualify could have a Material Adverse Effect. Borrower shall maintain, and shall cause each of its Subsidiaries to maintain, to the extent consistent with prudent management of Borrower's business, in force all licenses, approvals and agreements, the loss of which could have a Material Adverse Effect. 6.2 Government Compliance. Borrower shall meet, and shall cause each Subsidiary to meet, the minimum funding requirements of ERISA with respect to any employee benefit plans subject to ERISA. Borrower shall comply, and shall cause each Subsidiary to comply, with all statutes, laws, ordinances and government rules and regulations to which it is subject, noncompliance with which could have a Material Adverse Effect or a material adverse effect on the Collateral or the priority of Bank's Lien on the Collateral. 6.3 Financial Statements, Reports, Certificates. Borrower shall deliver to Bank: (a) within five (5) days of filing, copies of all statements, reports and notices sent or made available generally by Borrower to its security holders or to any holders of Subordinated Debt and all reports on Form 10-K, 10-Q and 8-K filed with the Securities and Exchange Commission (collectively, the "SEC Reports"); (b) promptly upon receipt of notice thereof, a report of any legal actions pending or threatened against Borrower or any Subsidiary that could result in damages or costs to Borrower or any Subsidiary of One Hundred Thousand Dollars ($100,000) or more; and (c) such budgets, sales projections, operating plans or other financial information as Bank may reasonably request from time to time. -12- 20 Within FIVE (5) days after the filing of the SEC Reports, Borrower shall deliver to Bank with a Compliance Certificate signed by a Responsible Officer substantially the form of Exhibit D hereto for the period then ended. Bank shall have a right from time to time hereafter to audit Borrower's Accounts at Borrower's expense, provided that such audits will be conducted no more often than every six (6) months unless an Event of Default has occurred and is continuing. 6.4 Inventory; Returns. Borrower shall keep all Inventory in good and marketable condition, free from all material defects. Returns and allowances, if any, as between Borrower and its account debtors shall be on the same basis and in accordance with the usual customary practices of Borrower, as they exist at the time of the execution and delivery of this Agreement. Borrower shall promptly notify Bank of all returns and recoveries and of all disputes and claims, where the return, recovery, dispute or claim involves more than Fifty Thousand Dollars ($50,000). 6.5 Taxes. Borrower shall make, and shall cause each Subsidiary to make, due and timely payment or deposit of all material federal, state, and local taxes, assessments, or contributions required of it by law, and will execute and deliver to Bank, on demand, appropriate certificates attesting to the payment or deposit thereof; and Borrower will make, and will cause each Subsidiary to make, timely payment or deposit of all material tax payments and withholding taxes required of it by applicable laws, including, but not limited to, those laws concerning F.I.C.A., F.U.T.A., state disability, and local, state, and federal income taxes, and will, upon request, furnish Bank with proof satisfactory to Bank indicating that Borrower or a Subsidiary has made such payments or deposits; provided that Borrower or a Subsidiary need not make any payment if the amount or validity of such payment is (i) contested in good faith by appropriate proceedings, (ii) is reserved against (to the extent required by GAAP) by Borrower and (iii) no lien other than a Permitted Lien results. 6.6 Insurance. (a) Borrower, at its expense, shall keep the Collateral insured against loss or damage by fire, theft, explosion, sprinklers, and all other hazards and risks, and in such amounts, as ordinarily insured against by other owners in similar businesses conducted in the locations where Borrower's business is conducted on the date hereof. Borrower shall also maintain insurance relating to Borrower's ownership and use of the Collateral in amounts and of a type that are customary to businesses similar to Borrower's. (b) All such policies of insurance shall be in such form, with such companies rated A-1, and in such amounts as are reasonably satisfactory to Bank, and that the current insurance amount of $5,000,000 regarding personal property is acceptable as of the date hereof, with the understanding that future events affecting the Borrower may cause the Bank to reevaluate such amount from time to time. All such policies of property insurance shall contain a lender's loss payable endorsement, in a form satisfactory to Bank, showing Bank as an additional loss payee thereof and all liability insurance policies shall show the Bank as an additional insured, and shall specify that the insurer must give at least twenty (20) days notice to Bank before canceling its policy for any reason. At Bank's request, Borrower shall deliver to Bank certified copies of such policies of insurance and evidence of the payments of all premiums therefor. All proceeds payable under any such policy shall, at the option of Bank, be payable to Bank to be applied on account of the Obligations. 6.7 Principal Depository. Borrower shall maintain its principal depository and operating accounts with Bank, no later than June 1, 1998. -13- 21 6.8 Current Ratio. Borrower shall, on a consolidated basis, maintain, as of the last day of each fiscal quarter, a ratio of Current Assets to Current Liabilities of at least 1.25 to 1.0 for the period ending December 31, 1997. Thereafter, Borrower shall maintain, as of the last day of each calendar quarter, a ratio of Current Assets to Current Liabilities of at least 1.50 to 1.0. 6.9 Debt-Net Worth Ratio. Borrower shall, on a consolidated basis, maintain, as of the last day of each fiscal quarter, a ratio of Total Liabilities less Subordinated Debt to Stated Net Worth plus Subordinated Debt of not more than 1.75 to 1.0. 6.10 Stated Net Worth. Borrower shall, on a consolidated basis, maintain, as of the last day of each fiscal quarter, a Stated Net Worth of not less than $30,000,000 plus 50% of the Borrower's positive, quarterly consolidated net income starting with the period ending December 31, 1996. 6.11 EBITA/Interest Expense Ratio. Borrower shall, on a consolidated basis, maintain, as of the last day of each fiscal quarter, a ratio of Consolidated EBITA to Consolidated Interest Expense, with respect to the most recent four fiscal quarter period, of not less than 2.00 to 1.0. 6.12 Clean Up Period. During each fiscal year of the Borrower, Borrower shall maintain a period of no less than 30 consecutive calendar days during which no Advances shall be outstanding. 6.13 Further Assurances. At any time and from time to time Borrower and Bank shall execute and deliver such further instruments and take such further action as may reasonably be requested by Bank and the Borrower, respectively, to effect the purposes of this Agreement. 7. NEGATIVE COVENANTS Borrower covenants and agrees that, so long as any Credit Extension hereunder shall be available and until payment in full of the outstanding Obligations or for so long as Bank may have any commitment to make any Advances, Borrower will not do any of the following, without the written consent of the Bank (and in connection therewith the Bank agrees to use reasonable efforts to respond to any such consent request by the Borrower within a reasonable time period with the understanding that such agreement does not mean or imply that such consent will be granted). 7.1 Dispositions. Convey, sell, lease, transfer or otherwise dispose of (collectively, a "Transfer"), or permit any of its Subsidiaries to Transfer, all or any part of its business or property, other than Transfers: (i) of inventory in the ordinary course of business, (ii) of non-exclusive licenses and similar arrangements for the use of the property of Borrower or its Subsidiaries in the ordinary course of business; (iii) that constitute payment of normal and usual operating expenses in the ordinary course of business; or (iii) of worn-out or obsolete Equipment. 7.2 Changes in Business, Ownership, or Management, Business Locations. Engage in any business, or permit any of its Subsidiaries to engage in any business, other than the businesses currently engaged in by Borrower and any business substantially similar or related thereto (or incidental thereto), or suffer a change in Borrower's ownership of greater than 40% or the Chairman of the Board and the President and Chief Executive Officer of the Borrower change after the date hereof. Borrower will not, without at least thirty (30) days prior written notification to Bank, relocate its chief executive office or add any new offices or business locations. 7.3 Mergers or Acquisitions. Merge or consolidate, or permit any of its Subsidiaries to merge or consolidate, with or into any other business organization, or acquire, or permit any of its Subsidiaries to acquire, all or substantially all of the capital stock or property of another Person, except that the Borrower or any of its Subsidiaries may merge or consolidate with another -14- 22 corporation if the Borrower or the Borrower's Subsidiary is the surviving corporation in the merger and the aggregate value of the assets acquired in the merger does not exceed 25% of Borrower's tangible net worth or the Subsidiary's tangible net worth, as applicable, as of the end of the month prior to the effective date of the merger, and the assets of the corporation acquired in the merger are not subject to any liens or encumbrances, except Permitted Liens. Tangible net worth shall be determined in accordance with GAAP, consistently applied. 7.4 Indebtedness. Create, incur, assume or be or remain liable with respect to any Indebtedness, or permit any Subsidiary so to do, other than Permitted Indebtedness. 7.5 Encumbrances. Create, incur, assume or suffer to exist any Lien with respect to any of its property, including, without limitation, (A) the real property of the Borrower commonly known as at 505 North Euclid Street, Anaheim, California 92801 or (B) any stock or other equity interest of any of the Subsidiaries of the Borrower; or assign or otherwise convey any right to receive income, including the sale of any Accounts, or permit any of its Subsidiaries to do so, except for Permitted Liens. 7.6 Distributions. Pay any dividends or make any other distribution or payment on account of or in redemption, retirement or purchase of any capital stock. 7.7 Investments; Loans; Guarantees. Directly or indirectly acquire or own, or make any Investment in or to any Person, or permit any of its Subsidiaries so to do, other than Permitted Investments, or make any loans of any money or any other assets to any Person, or guarantee or otherwise become liable with respect to the obligations of any other Person. 7.8 Transactions with Affiliates. Directly or indirectly enter into or permit to exist any material transaction with any Affiliate of Borrower except for transactions that are in the ordinary course of Borrower's business, upon fair and reasonable terms that are no less favorable to Borrower than would be obtained in an arm's length transaction with a non affiliated Person. 7.9 [Reserved] 7.10 Subordinated Debt. Make any payment in respect of any Subordinated Debt, or permit any of its Subsidiaries to make any such payment, except in compliance with the terms of such Subordinated Debt, or amend any provision contained in any documentation relating to the Subordinated Debt without Bank's prior written consent. 7.11 Inventory. Store the Inventory with a bailee, warehouseman, or similar party unless Bank has received a pledge of any warehouse receipt covering such Inventory. Except for Inventory sold in the ordinary course of business and except for such other locations as Bank may approve in writing, Borrower shall keep the Inventory only at the location set forth in Section 10 hereof and such other locations of which Borrower gives Bank prior written notice and as to which Borrower signs and files a financing statement where needed to perfect Bank's security interest. 7.12 Compliance. Become an "investment company" or a company controlled by an "investment company," within the meaning of the Investment Company Act of 1940, or become principally engaged in, or undertake as one of its important activities, the business of extending credit for the purpose of purchasing or carrying margin stock, or use the proceeds of any Advance for such purpose; fail to meet the minimum funding requirements of ERISA; permit a Reportable Event or Prohibited Transaction, as defined in ERISA, to occur; fail to comply with the Federal Fair Labor Standards Act or violate any other law or regulation, which violation could have a Material Adverse Effect or a material adverse effect on the Collateral or the priority of Bank's Lien on the Collateral; or permit any of its Subsidiaries to do any of the foregoing. -15- 23 8. EVENTS OF DEFAULT Any one or more of the following events shall constitute an Event of Default by Borrower under this Agreement: 8.1 Payment Default. If Borrower fails to pay, when due, any of the Obligations. 8.2 Covenant Default. (a) If Borrower fails to perform any obligation under Sections 6.3, 6.6, 6.7, 6.8, 6.9, 6.10, 6.11, 6.12 or 6.13 or violates any of the covenants contained in Article 7 of this Agreement, or (b) If Borrower fails or neglects to perform, keep, or observe any other material term, provision, condition, covenant, or agreement contained in this Agreement, in any of the Loan Documents, or in any other present or future agreement between Borrower and Bank and as to any default under such other term, provision, condition, covenant or agreement that can be cured, has failed to cure such default within ten (10) days after the occurrence thereof; provided, however, that if the default cannot by its nature be cured within the ten (10) day period or cannot after diligent attempts by Borrower be cured within such ten (10) day period, and such default is likely to be cured within a reasonable time, then Borrower shall have an additional reasonable period (which shall not in any case exceed thirty (30) days) to attempt to cure such default, and within such reasonable time period the failure to have cured such default shall not be deemed an Event of Default (provided that no Advances will be required to be made during such cure period); 8.3 Material Adverse Change. If there (i) occurs a material adverse change in the business, operations, or condition (financial or otherwise) of the Borrower, or (ii) is a material impairment of the prospect of repayment of any portion of the Obligations or (iii) is a material impairment of the value or priority of Bank's security interests in the Collateral; 8.4 Attachment. If any material portion of Borrower's assets is attached, seized, subjected to a writ or distress warrant, or is levied upon, or comes into the possession of any trustee, receiver or person acting in a similar capacity and such attachment, seizure, writ or distress warrant or levy has not been removed, discharged or rescinded within ten (10) days, or if Borrower is enjoined, restrained, or in any way prevented by court order from continuing to conduct all or any material part of its business affairs, or if a judgment or other claim becomes a lien or encumbrance upon any material portion of Borrower's assets, or if a notice of lien, levy, or assessment is filed of record with respect to any of Borrower's assets by the United States Government, or any department, agency, or instrumentality thereof, or by any state, county, municipal, or governmental agency, and the same is not paid within ten (10) days after Borrower receives notice thereof, provided that none of the foregoing shall constitute an Event of Default where such action or event is stayed or an adequate bond has been posted pending a good faith contest by Borrower (provided that no Credit Extensions will be required to be made during such cure period); 8.5 Insolvency. If Borrower becomes insolvent, or if an Insolvency Proceeding is commenced by Borrower, or if an Insolvency Proceeding is commenced against Borrower and is not dismissed or stayed within 30 days (provided that no Advances will be made prior to the dismissal of such Insolvency Proceeding); 8.6 Other Agreements. If there is a default in any agreement to which Borrower is a party with a third party or parties resulting in a right by such third party or parties, whether or not exercised, to accelerate the maturity of any Indebtedness in an amount in excess of Five Hundred Thousand Dollars ($500,000) or that could have a Material Adverse Effect; -16- 24 8.7 Subordinated Debt, If Borrower makes any payment on account of Subordinated Debt, except to the extent such payment is allowed under any subordination agreement entered into with Bank; 8.8 Judgments. If a judgment or judgments for the payment of money in an amount, individually or in the aggregate, of at least Two Hundred Fifty Thousand Dollars ($250,000) shall be rendered against Borrower and shall remain unsatisfied and unstayed for a period of ten (10) days (provided that no Credit Extensions will be made prior to the satisfaction or stay of such judgment); 8.9 Misrepresentations. If any material misrepresentation or material misstatement exists now or hereafter in any warranty or representation set forth herein or in any certificate or writing delivered to Bank by Borrower or any Person acting on Borrower's behalf pursuant to this Agreement or to induce Bank to enter into this Agreement or any other Loan Document; or 8.10 Guaranty. Any guaranty of all or a portion of the Obligations ceases for any reason to be in full force and effect, or any Guarantor fails to perform any obligation under any guaranty of all or a portion of the Obligations, or any material misrepresentation or material misstatement exists now or hereafter in any warranty or representation set forth in any guaranty of all or a portion of the Obligations or in any certificate delivered to Bank in connection with such guaranty, or any of the circumstances described in Sections 8.4, 8.5 or 8.8 occur with respect to any Guarantor. 9. BANKS RIGHTS AND REMEDIES 9.1 Rights and Remedies. Upon the occurrence and during the continuance of an Event of Default, Bank may, at its election, without notice of its election and without demand, do any one or more of the following, all of which are authorized by Borrower: (a) Declare all Obligations, whether evidenced by this Agreement, by any of the other Loan Documents, or otherwise, immediately due and payable (provided that upon the occurrence of an Event of Default described in Section 8.5 all Obligations shall become immediately due and payable without any action by Bank); (b) Cease advancing money or extending credit to or for the benefit of Borrower under this Agreement or under any other agreement between Borrower and Bank; (c) Demand that Borrower (i) deposit cash with Bank in an amount equal to the amount of any Letters of Credit remaining undrawn, as collateral security for the repayment of any future drawings under such Letters of Credit, and Borrower shall forthwith deposit and pay such amounts, and (ii) pay in advance all Letters of Credit fees scheduled to be paid or payable over the remaining term of the Letters of Credit; (d) [Reserved]; (e) Settle or adjust disputes and claims directly with account debtors for amounts, upon terms and in whatever order that Bank reasonably considers advisable; (f) Without notice to or demand upon Borrower, make such payments and do such acts as Bank considers necessary or reasonable to protect its security interest in the Collateral. Borrower agrees to assemble the Collateral if Bank so requires, and to make the Collateral available to Bank as Bank may designate. Borrower authorizes Bank to enter the premises where the Collateral is located, to take and maintain possession of the Collateral, or any part of it, and to pay, purchase, contest, or compromise any encumbrance, charge, or lien which in Bank's determination -17- 25 appears to be prior or superior to its security interest and to pay all expenses incurred in connection therewith. With respect to any of Borrower's premises, Borrower hereby grants Bank a license to enter such premises and to occupy the same, without charge in order to exercise any of Bank's rights or remedies provided herein, at law, in equity, or otherwise; (g) Without notice to Borrower set off and apply to the Obligations any and all (i) balances and deposits of Borrower held by Bank, or (ii) indebtedness at any time owing to or for the credit or the account of Borrower held by Bank; (h) Ship, reclaim, recover, store, finish, maintain, repair, prepare for sale, advertise for sale, and sell (in the manner provided for herein) the Collateral. Bank is hereby granted a non-exclusive, royalty-free license or other right, solely pursuant to the provisions of this Section 9.1, to use, without charge, Borrower's labels, patents, copyrights, mask works, rights of use of any name, trade secrets, trade names, trademarks, service marks, and advertising matter, or any property of a similar nature, as it pertains to the Collateral, in completing production of, advertising for sale, and selling any Collateral and, in connection with Bank's exercise of its rights under this Section 9.1, Borrower's rights under all licenses and all franchise agreements shall inure to Bank's benefit; (i) Sell the Collateral at either a public or private sale, or both, by way of one or more contracts or transactions, for cash or on terms, in such manner and at such places (including Borrower's premises) as Bank determines is commercially reasonable, and apply the proceeds thereof to the Obligations in whatever manner or order it deems appropriate; (j) Bank may credit bid and purchase at any public sale, or at any private sale as permitted by law; and (k) Any deficiency that exists after disposition of the Collateral as provided above will be paid immediately by Borrower. 9.2 Power of Attorney. Effective only upon the occurrence and during the continuance of an Event of Default, Borrower hereby irrevocably appoints Bank (and any of Bank's designated officers, or employees) as Borrower's true and lawful attorney to: (a) send requests for verification of Accounts or notify account debtors of Bank's security interest in the Accounts; (b) endorse Borrower's name on any checks or other forms of payment or security that may come into Bank's possession; (c) sign Borrower's name on any invoice or bill of lading relating to any Account, drafts against account debtors, schedules and assignments of Accounts, verifications of Accounts, and notices to account debtors; (d) make, settle, and adjust all claims under and decisions with respect to Borrower's policies of insurance; and (e) settle and adjust disputes and claims respecting the accounts directly with account debtors, for amounts and upon terms which Bank determines to be reasonable; provided Bank may exercise such power of attorney to sign the name of Borrower on any of the documents described in Section 4.2 regardless of whether an Event of Default has occurred. The appointment of Bank as Borrower's attorney in fact, and each and every one of Bank's rights and powers, being coupled with an interest, is irrevocable until all of the Obligations have been fully repaid and performed and Bank's obligation to provide advances hereunder is terminated. 9.3 Accounts Collection. Upon the occurrence and during the continuance of an Event of Default, Bank may notify any Person owing funds to Borrower of Bank's security interest in such funds and verify the amount of such Account. Borrower shall collect all amounts owing to Borrower for Bank, receive in trust all payments as Bank's trustee, and if requested or required by Bank, immediately deliver such payments to Bank in their original form as received from the account debtor, with proper endorsements for deposit. -18- 26 9.4 Bank Expenses. If Borrower fails to pay any amounts or furnish any required proof of payment due to third persons or entities, as required under the terms of this Agreement, then Bank may do any or all of the following: (a) make payment of the same or any part thereof; (b) set up such reserves under the Committed Revolving Line as Bank deems necessary to protect Bank from the exposure created by such failure; or (c) obtain and maintain insurance policies of the type discussed in Section 6.6 of this Agreement, and take any action with respect to such policies as Bank deems prudent. Any amounts so paid or deposited by Bank shall constitute Bank Expenses, shall be immediately due and payable, and shall bear interest at the then applicable rate hereinabove provided, and shall be secured by the Collateral. Any payments made by Bank shall not constitute an agreement by Bank to make similar payments in the future or a waiver by Bank of any Event of Default under this Agreement. 9.5 Bank's Liability for Collateral. So long as Bank complies with reasonable banking practices, Bank shall not in any way or manner be liable or responsible for: (a) the safekeeping of the Collateral; (b) any loss or damage thereto occurring or arising in any manner or fashion from any cause; (c) any diminution in the value thereof; or (d) any act or default of any carrier, warehouseman, bailee, forwarding agency, or other person whomsoever. All risk of loss, damage or destruction of the Collateral shall be borne by Borrower. 9.6 Remedies Cumulative. Bank's rights and remedies under this Agreement, the Loan Documents, and all other agreements shall be cumulative. Bank shall have all other rights and remedies not expressly set forth herein as provided under the Code, by law, or in equity. No exercise by Bank of one right or remedy shall be deemed an election, and no waiver by Bank of any Event of Default on Borrower's part shall be deemed a continuing waiver. No delay by Bank shall constitute a waiver, election, or acquiescence by it. No waiver by Bank shall be effective unless made in a written document signed on behalf of Bank and then shall be effective only in the specific instance and for the specific purpose for which it was given. 9.7 Demand; Protest. Borrower waives demand, protest, notice of protest, notice of default or dishonor, notice of payment and nonpayment, notice of any default, nonpayment at maturity, release, compromise, settlement, extension, or renewal of accounts, documents, instruments, chattel paper, and guarantees at any time held by Bank on which Borrower may in any way be liable. 10. NOTICES Unless otherwise provided in this Agreement, all notices or demands by any party relating to this Agreement or any other agreement entered into in connection herewith shall be in writing and (except for financial statements and other informational documents which may be sent by first-class mail, postage prepaid) shall be personally delivered or sent by a recognized overnight delivery service, by certified mail, postage prepaid, return receipt requested, or by telefacsimile to Borrower or to Bank, as the case may be, at its addresses set forth below: If to Borrower SafeGuard Health Enterprises, Inc. 505 North Euclid Street Anaheim, California 92803 Attn: Ronald I. Brendzel, Esq. FAX: 714-758-4383 If to Bank Silicon Valley Bank 18872 MacArthur Boulevard, Suite 100 Irvine, CA 92715 Attn: Manager FAX: 714-474-7892 -19- 27 The parties hereto may change the address at which they are to receive notices hereunder, by notice in writing in the foregoing manner given to the other. 11. CHOICE OF LAW AND VENUE; JURY WAIVER The Loan Documents shall be governed by, and construed in accordance with, the internal laws of the State of California, without regard to principles of conflicts of law. Each of Borrower and Bank hereby submits to the exclusive jurisdiction of the state and Federal courts located in the County of Orange, State of California. BORROWER AND BANK EACH HEREBY WAIVE THEIR RESPECTIVE RIGHTS TO A JURY TRIAL OF ANY CLAIM OR CAUSE OF ACTION BASED UPON OR ARISING OUT OF ANY OF THE LOAN DOCUMENTS OR ANY OF THE TRANSACTIONS CONTEMPLATED THEREIN, INCLUDING CONTRACT CLAIMS, TORT CLAIMS, BREACH OF DUTY CLAIMS, AND ALL OTHER COMMON LAW OR STATUTORY CLAIMS. EACH PARTY RECOGNIZES AND AGREES THAT THE FOREGOING WAIVER CONSTITUTES A MATERIAL INDUCEMENT FOR IT TO ENTER INTO THIS AGREEMENT. EACH PARTY REPRESENTS AND WARRANTS THAT IT HAS REVIEWED THIS WAIVER WITH ITS LEGAL COUNSEL AND THAT IT KNOWINGLY AND VOLUNTARILY WAIVES ITS JURY TRIAL RIGHTS FOLLOWING CONSULTATION WITH LEGAL COUNSEL. 12. GENERAL PROVISIONS 12.1 Successors and Assigns. This Agreement shall bind and inure to the benefit of the respective successors and permitted assigns of each of the parties; provided, however, that neither this Agreement nor any rights hereunder may be assigned by Borrower without Bank's prior written consent, which consent may be granted or withheld in Bank's sole discretion. Bank shall have the right without the consent of or notice to Borrower to sell, transfer, negotiate, or grant participation in all or any part of, or any interest in, Bank's obligations, rights and benefits hereunder. 12.2 Indemnification. Borrower shall, indemnify, defend, protect and hold harmless Bank and its officers, employees, and agents against: (a) all obligations, demands, claims, and liabilities claimed or asserted by any other party in connection with the transactions contemplated by the Loan Documents; and (b) all losses or Bank Expenses in any way suffered, incurred, or paid by Bank as a result of or in any way arising out of, following, or consequential to transactions between Bank and Borrower whether under the Loan Documents, or otherwise (including without limitation reasonable attorneys fees and expenses), except for losses caused by Bank's gross negligence or willful misconduct. 12.3 Time of Essence. Time is of the essence for the performance of all obligations set forth in this Agreement. 12.4 Severability of Provisions. Each provision of this Agreement shall be severable from every other provision of this Agreement for the purpose of determining the legal enforceability of any specific provision. 12.5 Amendments in Writing, Integration. This Agreement cannot be amended or terminated except by a writing signed by Borrower and Bank. All prior agreements, understandings, representations, warranties, and negotiations between the parties hereto with respect to the subject matter of this Agreement, if any, are merged into this Agreement and the Loan Documents. -20- 28 12.6 Counterparts. This Agreement may be executed in any number of counterparts and by different parties on separate counterparts, each of which, when executed and delivered, shall be deemed to be an original, and all of which, when taken together, shall constitute but one and the same Agreement. 12.7 Survival. All covenants, representations and warranties made in this Agreement shall continue in full force and effect so long as any Obligations remain outstanding. The obligations of Borrower to indemnify Bank with respect to the expenses, damages, losses, costs and liabilities described in Section 12.2 shall survive until all applicable statute of limitations periods with respect to actions that may be brought against Bank have run. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed as of the date first above written. SAFEGUARD HEALTH ENTERPRISES, INC. By: /s/ THOMAS C. TEKULVE, CPA --------------------------------------- Title: Vice President and CFO ------------------------------------ By: /s/ JOHN E. COX --------------------------------------- Title: President and COO ------------------------------------ SILICON VALLEY BANK By: /s/ KITTRIDGE CHAMBERLIN --------------------------------------- Title: Vice President ------------------------------------ -21- EX-21.1 4 SUBSIDIARIES OF THE COMPANY 1 Exhibit 21.1 SAFEGUARD HEALTH ENTERPRISES, INC. SUBSIDIARIES OF THE COMPANY The wholly owned subsidiaries of SafeGuard Health Enterprises, Inc., a Delaware corporation, are as follows: 1. SafeGuard Health Plans, Inc., an Arizona corporation 2. SafeGuard Health Plans, Inc., a California corporation 3. SafeGuard Health Plans, Inc., a Colorado corporation 4. SafeGuard Health Plans, Inc., a Florida corporation 5. SafeGuard Health Plans, Inc., an Illinois corporation 6. SafeGuard Health Plans, Inc., a Kansas corporation 7. SafeGuard Health Plans, Inc., a Kentucky corporation 8. SafeGuard Health Plans, Inc., a Missouri corporation 9. SafeGuard Health Plans, Inc., a Nevada corporation 10. SafeGuard Health Plans, Inc., an Ohio corporation 11. SafeGuard Health Plans, Inc., an Oklahoma corporation 12. SafeGuard Health Plans, Inc., an Oregon corporation 13. SafeGuard Health Plans, Inc., a Texas corporation 14. SafeGuard Health Plans, Inc., a Utah corporation 15. SafeHealth Life Insurance Company, Inc., a Texas corporation 16. Advantage Dental HealthPlans, Inc., a Delaware corporation 17. ADH Marketing, Inc., a Florida Corporation 18. ADH Plans, Inc., a Delaware corporation 19. Advantage Dental Plans, Inc., a Delaware corporation 20. Guards Dental, Inc., a California corporation (A wholly owned subsidiary of SafeGuard Health Plans, Inc., a California corporation) 21. SafeHealth Life Insurance Company, a California corporation 22. First American Dental Benefits, Inc., a Texas corporation 23. Imprimis Practice Management Company, Inc., a Delaware corporation EX-23.1 5 INDEPENDENT AUDITOR'S CONSENT 1 EXHIBIT 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement No. 33-2226 of SafeGuard Health Enterprises, Inc. on form S-8 of our report dated April 15, 1999, appearing in this Annual Report on Form 10-K of SafeGuard Health Enterprises, Inc. for the year ended December 31, 1998. Deloitte & Touche LLP Costa Mesa, California April 15, 1999 EX-27.1 6 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM BALANCE SHEET AND INCOME STATEMENT AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH 1998 10-K FILING. 12-MOS DEC-31-1998 JAN-01-1998 DEC-31-1998 3,256 2,959 32,804 (17,721) 0 32,945 13,450 (3,782) 79,944 25,379 0 0 0 21,509 245 79,944 97,449 99,790 66,020 103,512 0 (13,764) (4,311) (21,796) (7,652) (14,144) 3,050 0 0 (11,094) (2.35) (2.35)
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