-----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, VB8SWXEL3HGkS8Xf1dFo448CqxzfDHAoNsihkXVyRWcwMRV8i53HmWp4xAzj4oq/ gcvdqQ5ebr4rCFNYZWPPgw== 0001017062-97-000579.txt : 19970401 0001017062-97-000579.hdr.sgml : 19970401 ACCESSION NUMBER: 0001017062-97-000579 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: NASD 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: 1934 Act SEC FILE NUMBER: 000-12050 FILM NUMBER: 97568821 BUSINESS ADDRESS: STREET 1: 505 N EUCLID ST STREET 2: PO BOX 3210 CITY: ANAHEIM STATE: CA ZIP: 92803-3210 BUSINESS PHONE: 7147781005 10-K405 1 FORM 10-K405 / DATED DECEMBER 31, 1996 - -------------------------------------------------------------------------------- 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, 1996 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) 505 North Euclid Street P.O. Box 3210 Anaheim, California 92803-3210 (Address of principal offices) (Zip Code) Registrant's telephone number, including area code: (714) 778-1005 Fax telephone number, including area code: (714) 758-4383 _______________ 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 NASDAQ - 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 March 26, 1997, was $48,985,350. The number of shares outstanding of the registrant's $0.01 par value common stock as of March 26, 1997, was 4,716,832 (not including 3,274,788 shares held in treasury). ______________ DOCUMENTS INCORPORATED BY REFERENCE Part III incorporates information by reference to the registrant's Proxy Statement for the next Annual Meeting of Stockholders, to be held on May 22, 1997. _______________________________________________________________________________ SAFEGUARD HEALTH ENTERPRISES, INC. 1996 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS
Page PART 1 Item 1. Business.................................................................................. 1 Item 2. Properties................................................................................ 19 Item 3. Legal Proceedings......................................................................... 19 Item 4. Submission of Matters to a Vote of Security Holders....................................... 19 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters.................... 20 Item 6. Selected Financial Data..................................................................... 24 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....... 25 Item 8. Financial Statements and Supplementary Data................................................. 28 Item 9. Changes in and Disagreements With Independent Accountants on Accounting and Financial Disclosure................................................................... 28 PART III Item 10. Directors and Executive Officers of the Registrant.......................................... 29* Item 11. Executive Compensation...................................................................... 29* Item 12. Security Ownership of Certain Beneficial Owners and Management.............................. 29* Item 13. Certain Relationships and Related Transactions.............................................. 29* PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K............................. 30 Signatures ............................................................................................ 30
_____________________________________ * Incorporated by reference from the 1997 Proxy Statement for the Company's Annual Meeting of Stockholders, scheduled for May 22, 1997. (i) PART I ITEM 1. BUSINESS In addition to historical information, the description of business below includes certain forward-looking statements, including those related to the Company's 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 care services, new technologies, rising dental care costs 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. SafeGuard Health Enterprises, Inc. owns and operates one of the largest publicly traded managed dental care plans in the United States. The Company was founded in California in 1974 and since 1982 has expanded its operations into Arizona, Colorado, Illinois, Kansas, Missouri, Nevada, Ohio, Oklahoma, Oregon, Texas, Utah and Washington. The Company also has regulatory approval to operate similar managed dental care programs in Kentucky and is pursuing opportunities in other states. The Company also owns and operates a California based life and health indemnity insurance company primarily writing dental indemnity insurance which is licensed to transact insurance business in Arizona, California, Colorado, Illinois, Kansas, Maryland Missouri, Nevada, Ohio, Oregon, Texas and Wisconsin and is pursuing opportunities in other states. 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. 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. As of December 31, 1996, the Company operated 27 Company-owned dental offices in California which operate under the name of Guards Dental, Inc. ("Guards"). Guard's dental offices are primarily for the purpose of supplementing, in geographical areas where needed, plan coverage provided by independent dental offices. Guards dental offices have been in operation since 1983. In 1996, the Company initiated a strategic plan to sell all of the General Dental Practices owned by the Company. See "DENTAL OFFICE OPERATIONS - COMPANY-OWNED DENTAL FACILITIES." The Company's executive offices are located at 505 North Euclid Street, P.O. Box 3210, Anaheim, California 92803-3210; its telephone number is (714) 778-1005 and FAX number is (714) 758-4383. 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 $43 billion in 1995. 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 1995, the consumer price index for all urban consumers for dental services increased 115%, whereas this index for all items increased 54%. 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 125 million persons, representing approximately 48% of the total United States population, are covered by some form of dental benefit coverage at the end of 1995. The NADP estimates that managed care enrollment has grown from 7.8 million covered lives in 1992, to approximately 22 million covered lives by the end of 1995. This compares to over 50 million Americans who were enrolled in medical HMOs in 1995, according to the Group Health Association of America. The Company believes that the relatively high growth rate for managed dental care 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 1 reimbursement plans; (iii) the cost effectiveness to employers of managed dental care plans as an employee benefit; and (iv) the growing acceptance of managed care dental plans by dentists throughout the country, resulting in improved accessibility and convenience for members. At the end of 1995, members of managed dental benefit plans represent approximately 17% of the population with dental care coverage, and approximately 7% 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 managed dental 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 managed dental care 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, 1995, the NADP estimated that there were over 150 managed dental care 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 managed care and preferred provider 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. 2 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 managed dental care 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 two industry segments, providing managed care dental benefits, and orthodontic services. (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 1996, dental care under the Company's managed care plans, is provided by a panel of approximately 4,200 independent dental offices (including 27 Company-owned dental offices) consisting of approximately 4,700 dentists. As of December 31, 1996, the Company had contracts with approximately 5,000 employer clients providing benefits to approximately 983,000 members, representing a 29.2% increase in membership from 761,000 at December 31, 1995. This increase in membership resulted primarily from an acquisition made by the Company in September 1996, from the growth in new small and mid-size clients, an increase in the number of persons covered under indemnity insurance products offered by the Company's insurance subsidiary, and an increase in the number of members covered as a result of strategic relationships with other health care providers. The Company's managed care 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 three years. The typical fee for a managed care 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 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 managed care 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 managed care dental 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 also operates orthodontic practices at 31 dental offices owned or previously owned by the Company. As a result of the Company's decision in October 1996 to sell its general dental practices (the "General Practices"), the Company decided to retain its orthodontic practices in operation at many of the Company-owned dental offices. These orthodontic practices provide services to members of the Company's plans and non-plan members. Revenues from the Company's orthodontic practices represented 10.2% of the Company's total revenue in 1996 and increased 30.5% in 1996 over 1995. PRODUCTS Managed Dental Plans. The Company offers a variety of managed dental care plans under the name SafeGuard Health Plans(R), SafeGuard Dental Plans(TM) and First American Dental Benefits. The Company's managed dental care plans operate similarly in each state in which business is conducted. Under the Company's managed dental care 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 3 is used by the Company to "prepay" for dental care for members through regular monthly capitation payment 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. In exchange for the capitation payments, the selected provider is obligated to provide all necessary dental services to plan members. Members covered under the Company's managed dental care 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. The Company's managed dental care 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 managed dental care 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 managed dental care 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 managed dental care panel. Certain states, such as Nevada, require that managed dental care 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 managed dental care 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 managed care 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 managed dental care plans. 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. The Company also operates orthodontic practices at 31 dental offices owned or previously owned by the Company. As a result of the Company's decision in October 1996 to sell its General Practices, the Company decided to retain its orthodontic practices in operation at many of the Company- owned dental offices. These orthodontic practices provide services to members of the Company's plans and non-plan members. Revenues from the Company's orthodontic practices represented 10.2% of the Company's total revenue in 1996 and increased 30.5% in 1996 over 1995. 4 PROVIDER RELATIONS The Company believes that the most essential element in its managed care enrollment growth is a stable panel of quality focused dentists in convenient locations. The Company also requires that all managed care and PPO providers meet all Quality Assessment program standards. The program includes current 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 managed care 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 managed care 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. 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. In June 1996, the Company modified its compensation program to its managed care providers by implementing a program to provide for additional compensation for specified dental procedures. The Company believes that this compensation program will provide 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 on 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%, or 30% off of the Company's usual and customary fee for the area, whichever is less. The Company currently employs 14 Provider Relations representatives nationally. 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 dental office, other than the 27 Guards dental offices as a group, provided service to more than 10% of the Company's members at December 31, 1996. 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 120 days notice. In accordance with the contract, the Company may also terminate the contract "for cause" upon 15 days written notice. The Company may also, at anytime, 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 their acts or omissions. At December 31, 1996, approximately 4,200 primary care and specialty care dental offices, consisting of approximately 4,700 dentists were participating panel providers on the Company's managed care 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 is paid by the Company. Such payments were 5.9% and 5.5% of the Company's health care services expenses in 1996 and 1995, respectively. At December 31, 1996, the Company contracted with approximately 8,600 primary care and specialty care dentists on the Company's PPO panel. 5 MANAGEMENT INFORMATION SYSTEMS During 1996 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. A review was also performed to determine the future needs of the Company and to enhance technologies to better equip the Company to compete while ultimately reducing the Company's administrative expenses. In 1996, the Company purchased software source code for its business operations system which are being adapted to the specific needs of the Company. This new software allowed the Company to develop, in-house, a system which will be 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 will provide a much easier and more efficient interface using Windows-based screens. Individual users will be 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 will have 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 networked-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 regional offices. In addition to the new operational systems, the general ledger system, and the expanded electronic mail, the Company has purchased and developed an independent dental office information system which allows the Company's practice management subsidiary to monitor dental offices under management and those owned by the Company. This system facilitates tracking, reporting and analysis of revenue and expenses under a unified system, and enhances communications and better patient treatment. 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 managed dental plan, indemnity and PPO plans, and electronic mail environments are now interconnected. These connections have been extended to some regional and dental offices and it is anticipated that all offices shall be interconnected in 1997. With the implementation of these new and upgraded systems, and as the Company installs connections to the regional and dental offices, the entire network will be tightly integrated. These newly purchased and upgraded systems demonstrate the Company's proactive position in automating its computer operations and allowing it to remain competitive in the marketplace. DENTAL OFFICE OPERATIONS - COMPANY-OWNED DENTAL FACILITIES On December 31, 1996, the Company owned 27 dental offices located throughout California. Guards dental offices were originally established primarily for the purpose of supplementing, where needed, plan coverage provided by independent panel offices. These dental offices are included on the Company's panel providing general dental care, selected specialty care and, to a lesser extent, fee-for-service dental care to non-plan patients. Ownership of the Guards dental offices directly exposes the Company to the risks inherent in having to meet fixed costs and provide necessary levels of dental care service, which the Company normally transfers to independent dental providers on the panel. These risks include the possibility of incurring significant losses from operations, if the dental offices operated by the Company do not attain significant enrollment and revenue to offset fixed operating expenses. In October 1996, the Company initiated a strategic plan to sell all of the General Practices owned by the Company. The assets of the General Practices to be sold pursuant to the Company's plan, consist primarily of leasehold improvements, equipment, accounts receivable and supply inventories. It is anticipated that each General Practice sold may enter into a long-term contract with the Company's newly formed practice management subsidiary, whereby the Company will provide ongoing services to support the dentists in the operation of their practices, including marketing and administrative support. The Company intends to retain the orthodontic practice in each of the General Practices and intends to continue to operate the orthodontic practice in the other dental offices as they are sold. Under agreements with the dentists who purchased the General Practices, 4 of these General Practices were sold as of December 31, 1996. During the fourth quarter of 1996, the Company also established a practice management subsidiary known as Imprimis Practice Management Company, Inc. (the "Practice Management Company"). The purpose of this subsidiary is to provide ongoing support to dentists in the operation of their practices, including management services, accounting services, payroll services, financial analysis and reporting, benefits administration, marketing and advertising, supply and equipment purchasing, laboratory negotiations, computer services and systems training, human resources coordination and facility management. In exchange for the services provided by the Practice Management Company, the dentist is obligated to pay the subsidiary a set contracted amount plus a percentage of the dentist's collections. As 6 of December 31, 1996, the subsidiary had 4 clients. See Part II, Item 7- "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and Item 8-"FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." 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, implemented in January 1996, 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's credentialing verification is currently administered in-house. In 1997, the Company plans to outsource this arrangement which will ensure an objective approach for consistency, effectiveness, and risk management purposes. 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 insure 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. In addition, the Company provides its panel providers with specifications of new laws affecting the 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 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 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 7 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 inquires and resolution of dissatisfactions. The Company consistently monitors service statistics to ensure continued ability to exceed the members' expectations. Eighty percent (80%) 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 35,000 calls per month, with approximately 30% handled via automated selection features. The ACD system has the capability to prioritize customer calls, and provide service reports on a predetermined basis. The Company strives to answer over 90% of customer calls within 45 seconds of entering the selected queue, with an abandonment rate of approximately 2% to 4% monthly. RISK MANAGEMENT The Company has sufficient general and professional liability insurance coverage to manage the ordinary exposure of operating its managed care dental plan business and its indemnity dental plans. Generally, the Company is indemnified against professional liability claims by its contracting providers and the independently contracted dentists practicing at the Guards dental offices. 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 $5,000,000, which it views as being adequate. However, no guarantee is made that sufficient professional liability insurance coverage will be available to the Company at an acceptable cost. During 1996, as a result of its favorable claims history, the Company continued to lower its risk management costs. 8 CLIENTS AND CONTRACTS Substantially all of the Company's 983,000 members at December 31, 1996, participate through over 5,000 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 20% of the Company's health care revenues for both 1996 and 1995. Significant clients served in 1996 by the Company include the Bank of America, City of Dallas, City of Los Angeles, County of Los Angeles, several contracts with McDonnell Douglas Corporation, Southern California Edison Company, Southern California Gas Company, Rockwell International Corporation, Joint Council #42 Welfare Trust, the State of California, and the California State University. 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 sophisticated multi-faceted plan to address the specific needs of its clients by assigning a specialty trained client services representative to all clients. Each client services representative has dental care and field experience. The Company also provides a customized service plan to its clients. The Company also maintains multiple benefits services teams, comprising 26 individuals, each one cross-trained to serve clients, members and providers. Scheduling has been adjusted to maximize telephone coverage, with special consideration to peak times of the day. Most teams are provided with a Registered Dental Assistant leader for technological support and each supervisor is trained in both technological support and customer service. The Company's customer service complaint system 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 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 managed care dental 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 for managed dental care benefits. As a result, the Company has been obtaining price increases of up to 10% 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 three 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. ACQUISITION Effective September 27, 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 managed dental care 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 the 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. PENDING ACQUISITIONS On October 23, 1996, the Company announced that it had signed a letter of intent to acquire all of the issued and outstanding shares of Advantage Dental HealthPlans, Inc. ("Advantage"), a privately held dental managed care company based in Ft. Lauderdale, Florida, operating in 5 states and the District of Columbia. Advantage provides managed care dental benefits to approximately 60,000 members and the acquisition is expected to be completed during the first half of 1997. Subsequent to the announcement and prior to filing of this Annual Report, the Company entered into a definitive agreement to acquire Advantage. 9 On November 22, 1996, the Company announced that it had signed of a letter of intent to acquire all of the issued and outstanding shares of a privately held indemnity insurance company, licensed to operate in 16 states, primarily in the southeastern part of the United States. It is anticipated that this acquisition will be completed within 120 days. Subsequent to the announcement and prior to the filing of this Annual Report, the Company entered into a definitive agreement to acquire this privately held indemnity insurance company. The acquisition of Advantage and of the privately held indemnity insurance company, are subject to the satisfaction of certain conditions, including receipt of regulatory approvals. 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 managed care dental 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 managed care dental 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 managed care 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 managed dental care 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 a direct sales force of 22 employees. This dual 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 direct 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 managed care dental plan and an indemnity/PPO product. The Company pays its direct sales force through a combination of salary and incentive based upon the number of members enrolled for new groups. As part of its growth strategy, the Company intends to increase its internal sales and marketing staff during 1997. The Company's independent insurance agent and broker network focuses on offering managed dental care 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 managed dental care 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 3.9% and 2.4% of health care revenues for 1996 and 1995, respectively. The Company also works with "in- house" employee benefits managers in its marketing efforts. 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, usually lasting one month, participants may elect the Company's managed care dental plan 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% to 15% of eligible employees select the Company's managed care dental plan during the first open enrollment period in which it is offered and that with smaller group clients, an average of approximately 20% with voluntary plans select the Company's managed dental care plan, and an average of approximately 50% of eligible employees with employer paid plans select the Company's managed dental care plan during the first open enrollment period in which it is offered. The net percentage of participation in the Company's managed dental care plan tends to increase each year thereafter within most employer groups. 10 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 managed dental care 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 recent years, the Company has obtained contracts with employers that offer what are known as flexible benefits plans or cafeteria type benefit programs. Typically, such arrangements provide for the employer to establish a dollar value for all benefits to be provided to the employee who is then requested to select the program of benefits desired and designate whether dependent coverage is needed. The premium cost is then deducted from the employer's set contribution to benefits expenses. By making the employee more aware of the actual premium cost of the benefits provided, there appears to be a greater attractiveness of the lower cost programs, such as the Company's managed care dental plans. No assurance, however, can be given that such benefit programs will result in increased enrollment in the Company's plans. In 1996, approximately 70% of the Company's enrollment originated in the state of California, while approximately 24% originated in the state of Texas. No other state contributed more than 10% of the Company enrollment during 1996. During 1995, approximately 86% of the Company's enrollment originated in the state of California with no other state contributing more than 10% of the Company's total enrollment. The Company has provided a vision plan in California since the early 1980's, now known as the 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 1996, it is anticipated that the vision plans will continue to contribute to net income. 11 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 managed care dental 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 managed dental care 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, Ohio, Oregon, Texas and Wisconsin. SafeHealth Life has applied for a certificate of authority in the states of Georgia, Indiana, New Mexico, Oklahoma and Utah. 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 managed care plan in the states where it holds a Certificate of Authority. The ability to offer fee-for-service dental plans along with managed care 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 Life's client base includes small employer groups as well as governmental agencies and political subdivisions. During 1996, the number of insured members covered by SafeHealth Life grew 31.0% from 84,000 to 110,000. SafeHealth Life anticipates increasing production of its multiple choice dental programs in other states in which it is admitted to do business, with a majority of business to continue to be in California for the foreseeable future. SafeHealth Life is also offering group term life insurance as a participant in a reinsurance pool. In late 1996, the Company purchased a state-of-the-art indemnity dental claims processing system capable of auto-adjudicating over 60% of claims filed. This system will allow the Company to expand its indemnity dental programs without necessarily incurring significant additional administrative expense. 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. Additionally in 1996, the Company established a full-time actuary department which is utilized to assist the Company in developing its benefit programs, rates and payment schedules. As a result of the computer system enhancements, the establishment of an in-house actuary department and thorough review of the Company's indemnity insurance claims paying processing system, in the first quarter of 1997 the Company ascertained that it was going to experience a shortfall in its reserve for incurred but not reported ("IBNR") indemnity dental insurance claims for the period ended December 31, 1996. This information was developed as a result of the above factors which also included an analysis of claims costs by year. The Company ascertained that a significant portion of the IBNR shortfall resulted from claims for clients that originated their relationship with the Company prior to 1996 when the Company made the various operational changes to its indemnity insurance operations referred to above. As a result of this situation, the Company expensed approximately $1.0 million in the fourth quarter of 1996 to increase this reserve. The Company has also established a regular monthly review of the IBNR reserve so as to monitor the fluctuations that may occur within this reserve. Moreover, as a result of the more comprehensive data now available to the Company as a result of its new indemnity dental claims processing system, the Company is in the process of appropriately adjusting its premium rates on dental indemnity insurance business written prior to 1996, and renewing in 1997. PREFERRED PROVIDER ORGANIZATION During 1993, SafeHealth Life began development of it's 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 managed dental care 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 12 enable the Company to offer indemnity dental and SafeHealth Life PPO Network Plans that reduce benefit costs for participating client groups and members. SafeHealth Life 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, 1996, SafeHealth Life had contracted with approximately 8,600 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 1997. 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. During 1996, the Company continued recruitment efforts to develop an alternative dental network, the "Choice Dental Plan" in the State of Texas that would offer clients the option of greater discounts similar to those under the PPO Network, but not part of a PPO program. Approximately 600 dentists were contracted in this plan as of December 31, 1996. The Choice Dental Plan is not an insured product, but simply a discount program, whereby members receive a discount for services from participating providers. The Company assumes no risk for this product, and there is no out of network coverage. While recruitment activities are ongoing, this plan has not yet been activated. 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 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 managed care or indemnity insurance organizations. 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 managed care 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 sales and marketing office to provide sales, marketing and provider services support in the local market. All basic administrative services are provided by the Company at its corporate headquarters, with the exception of the Company's Texas operations which, due to regulatory constraints, requires that administrative services also be provided in the Company's Texas facilities. By using strategically located regional sales and marketing offices instead of separate full-service offices in each state, 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. The Company's managed care dental plans are operating or have been granted regulatory approval to operate in Arizona, California, Colorado, Illinois, Kansas, Kentucky, Missouri, Nevada, Ohio, Oklahoma, Oregon, Texas, Utah and Washington. The Company's indemnity insurance subsidiary has been granted a Certificate of Authority in Arizona, California, Colorado, Illinois, Kansas, Maryland, Missouri, Nevada, Ohio, Oregon, Texas and Wisconsin. The Company also has pending applications for a Certificate of Authority in several other states. The Company will most likely seek regulatory approvals in additional areas. 13 GOVERNMENT REGULATION Many states have laws establishing the requirements for, and regulating the conduct of, the Company and other managed care dental 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 managed care dental 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. The Company's managed dental care 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 are regulated by the California Department of Insurance, and the Department of Insurance of the other states in which the Company is licensed to transact insurance 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 and received approval 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: . SafeGuard(R) used with a distinctive logo depicting three superimposed figures used in connection with its managed care dental plans; . SafeGuard Health Plans(R) used in descriptive material to describe the products offered by the Company; . SafeGuard Dental Plans(TM) used to describe the various managed care dental plans offered by the Company; . SafeHealth Life(R) used with a descriptive logo depicting three superimposed figures used by the Company to describe its indemnity insurance and PPO products; and . American Dental Corporation(R) adjacent to a flag of the State of Texas used in connection with its managed dental care plans. Collectively, these trademarks, service marks and tradenames were first used in commerce in 1984 and have been continuously used thereafter. 14 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 managed dental 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 managed care 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 managed dental care 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 managed care 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, or market share. EMPLOYEES At December 31, 1996, the Company had 307 employees, of whom 12 were executives, 3 were Executive Directors of Regional offices, 22 were sales personnel, and 181 were administrative and clerical personnel. As of that date, the Company also had 154 employees in its Guards offices, and had 89 independent dentists under contract. The Company also utilized 40 temporary personnel assisting in administrative and clerical functions. Most all administrative services are provided at the corporate offices in Anaheim, California, with the exception of certain administrative functions which are performed in the Company's Dallas, Texas office, as required by applicable Texas statutes and regulations. Billing and other paperwork processing for Guards is also centralized at the corporate offices. Approximately 200 clerical and auxiliary employees are represented by two labor unions. No other employees or dentists are union members. The Company considers its relations with its employees to be good. 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% 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% 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. 15 RISK FACTORS Among the risks affecting the Company are the following: Government Regulation. The health and dental care industry is subject to extensive federal, state and local laws, rules and regulations. 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. Additionally, the standards of practice of dental care and related federal and state regulations are subject to change. The Company cannot predict what changes may be enacted which may affect its business and could limit the Company's future growth. Competitive Market. The Company operates a highly competitive environment. The Company's ability to expand is affected by its existing competition as well as increasing competition, not only in dental product choices, but also in the number of competitors in the areas that the Company offers its products. 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 premium reductions, loss of providers or clients, or market share. The Company expects the level of competition to remain high and recognizes that competitive pricing pressures may have an adverse effect on the Company's operating margin. Ability to Continue Company Growth. The Company has grown in recent years through expansion in new small and mid-size clients, an increase in the number of persons covered under indemnity insurance products offered by the Company's insurance subsidiary, an increase in the number of members covered as a result of strategic relationships with other health care providers, and the September 1996 acquisition of First American. There can be no assurance that the Company will continue to be able to maintain or expand its market presence in its current locations or to successfully enter other markets. The ability of the Company to continue its growth will depend on a number of factors including existing and emerging competition, the Company's ability to maintain effective control over dental care costs, the Company's ability to secure cost effective contracts with additional dentists, the introduction of new technologies, and availability of working capital to support the Company's growth. 16 DIRECTORS AND/OR EXECUTIVE OFFICERS OF THE REGISTRANT The current directors and/or executive officers of the Company are as follows:
Name Age Position - ---- --- -------- Steven J. Baileys, D.D.S. 43 Chairman of the Board of Directors and Chief Executive Officer (2) John E. Cox 45 President, Chief Operating Officer and Director (2) Ronald I. Brendzel, J.D. 47 Senior Vice President, General Counsel, Secretary and Director (2) Herb J. Kaufman, D.D.S. 45 Senior Vice President and Chief Dental Officer Wayne K. Butts 43 Senior Vice President-Regional Operations Judy M. Deal 45 Vice President-Provider and Member Services Thomas C. Tekulve, C.P.A. 45 Vice President and Chief Financial Officer Kenneth E. Keating 33 Vice President-Guards Dental Office Operations John D. Lyon 48 Vice President-Marketing and Sales Carlos Ferrera 33 Vice President-SafeHealth Life Operations Susan M. Klarner 42 Vice President-Quality and Service Programs Jacob J. Rausch 37 Vice President-Business Development Michael M. Mann, Ph.D. 57 Director (1)(2) William E. McKenna 77 Director (1)(2) George H. Stevens 43 Director (1)(2) Bradford M. Boyd, D.D.S. 45 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: Mr. McKenna and Mr. Cox Class I May, 1997 Mr. Brendzel and Dr. Mann Class II May, 1998 Dr. Baileys, Mr. Stevens and Dr. Boyd Class III May, 1999
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. See Part III, Item 11-"EXECUTIVE COMPENSATION." Dr. Baileys is the brother-in- law of Mr. Brendzel. 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. Dr. Baileys is also an officer, director and 50% shareholder in the Islas Professional Dental Corporation, which operates 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. 17 Mr. Cox was appointed President and Chief Operating Officer in March 1997, 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 the California Association of Prepaid 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 July 1978 until August 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 California Knox-Keene Health Care Service Plan Advisory Committee, which assists the California Department of Corporations (the "California Department") in regulating managed care health plans, and is the chairman of the Dental Quality of Care Task Force established by the California Department. From 1989 to 1991, Mr. Brendzel was also a 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 Health Maintenance Organizations. He serves on the advisory board for Procter and Gamble, Health Services Advisory Group, the Academy for Managed Care Dentistry Counsel, and serves on the faculty at Northern Arizona University. Mr. Butts was appointed Senior Vice President - Regional Operations in December 1995. Prior thereto, he was Vice President-National Sales Director since February 1988. Prior to joining the Company, he was a Senior Account Executive with Equicor-Equitable HCA Corporation in Los Angeles from November 1985 to February 1988. Preceding that, Mr. Butts was a Senior Sales Representative with the Company from February 1983 to November 1985. Mr. Butts' background in the insurance/benefits area began in 1978 with Blue Cross of California. Ms. Deal was appointed Vice President-Provider and Member Services in January 1996. 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. Tekulve was appointed Vice President and Chief Financial Officer in May of 1996. From April 1995 until April 1996, he was Vice President, Accounting, Finance and Information Systems for the Company when he was appointed to his present position. Prior to joining the Company, Mr. Tekulve was Director of Finance, International Operations for Beckman Instruments, Inc. from 1992 to 1995. During the period from 1984 to 1992, he also served as corporate Controller and Director of Corporate Accounting and Planning for Beckman Instruments, Inc. Mr. Tekulve is also a Certified Public Accountant. Mr. Keating is the Vice President-Guards Dental Office Operations for the Company. 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. Lyon is the Vice President-Marketing and Sales for the Company. He joined the Company in July 1995. From September 1993 to April 1995, Mr. Lyon was Vice President-Marketing of Scan Health Plan. From October 1990 to July 1993, he was Associate Vice President-Marketing of FHP Health Care. Preceding that, he was Vice President-Project Director of Fessel International from February 1989 to September 1990. Mr. Ferrera is the 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. 18 Ms. Klarner is the Vice President-Quality and Service Programs for the Company. From November 1993 to February 1996, she was Vice President-Network Programs for the Company's indemnity insurance subsidiary. From May 1989 until October 1993, she was the Company's Director of Provider Relations. Prior to joining the Company, Ms. Klarner was Manager of Provider Relations for a managed dental care company from July 1986 to April 1989. Mr. Rausch was appointed Vice President-Business Development in November 1996. From July 1996 until October 1996, he was the Company's Director of Business Development when he was appointed to his present position. Mr. Rausch joined the Company in July 1996. Prior to that he has held the positions of Regional Vice President for CIGNA Dental Health, Vice President and Health Plan Manager for CIGNA Healthplan, Regional Director of Contracting for Kaiser Health Plans, Assistant Vice President for Kemper National Services and Managing Consultant for Future Health, Inc., a health care consulting company. 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. From August 1986 until September 1987, Dr. Mann was a Partner of Mann, Kavanaugh, Chernove & Associates, a 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 currently the Chairman of the Board of Encompass Technologies, Inc., and 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, WMS Industries, Inc., and Williams Hospitality Group, Inc. Mr. Stevens has been a Director of the Company since May 1989. He has been President of Belle Haven Marina, Inc., a privately held leisure and recreational organization located in Virginia, since 1982. 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 is 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 private investor. He is a member of the American Dental Association, California Dental Association, and San Fernando Valley Dental Society. He 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 2. PROPERTIES The Company owns a 60,000 square foot building in Anaheim, California which it utilizes as its corporate headquarters and executive offices. In addition, the Company leases offices in Phoenix, Arizona; San Diego, California; Walnut Creek, California; Denver, Colorado; St. Louis, Missouri; Austin, Texas; Dallas, Texas; and Houston, Texas. The Company leases all of its Guards dental offices. 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, 1996. 19 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, 1996 First Quarter......................... $15.88 $11.50 Second Quarter........................ $19.25 $16.00 Third Quarter......................... $22.38 $17.50 Fourth Quarter........................ $20.75 $16.00 Fiscal Year ended December 31, 1995 First Quarter......................... $ 9.75 $ 8.25 Second Quarter........................ $11.50 $ 8.88 Third Quarter......................... $12.25 $10.50 Fourth Quarter........................ $13.25 $11.25 (b) Approximate Number of Equity Security Holders ---------------------------------------------
Approximate Number of Record Holders Title of Class (as of December 31, 1996) - -------------- ------------------------- Common Stock, $.01 Par Value 1,000
(c) 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. (d) Stockholder Rights Plan ----------------------- On March 22, 1996 ("RIGHTS DIVIDEND DECLARATION DATE"), the Company's Board of Directors declared a dividend of one right (a "RIGHT") to purchase fractions of the shares of its Series A Junior Participating Preferred Stock, par value $.01 per share having the rights, preferences, privileges and restrictions described below ("PREFERRED STOCK"), and, under certain circumstances, other securities, for each outstanding share of the Company's common stock, par value $.01 per share ("COMMON STOCK"), to be distributed to stockholders of record at the close of business on April 12, 1996 ("RECORD DATE"). The description and terms of the Rights are set forth in a Rights Agreement (the "RIGHTS AGREEMENT"), dated as of March 22, 1996, between the Company and American Stock Transfer and Trust Company, as Rights Agent. The following is a brief description of the Rights. It is intended to provide a general description only and is qualified in its entirety by reference to the Rights Agreement which has been filed as an exhibit to the Company's Registration Statement on Form 8-A filed with the Securities and Exchange Commission. ISSUANCE OF THE RIGHTS Each share of Common Stock outstanding at the close of business on the Record Date will receive one Right. In addition, prior to the earliest of the Distribution Date, a Section 13 Event or the Expiration Date (as each is hereinafter defined), one additional Right (as such number may be adjusted pursuant to the provisions of the Rights Agreement) shall be issued with each share of Common Stock issued after the Record Date. Following the Distribution Date and prior to the expiration or redemption of the Rights, the Company will issue one Right (as such number may be adjusted pursuant to the provisions of the Rights Agreement) for each share of Common Stock issued pursuant to the exercise of stock options or under employee plans or upon the exercise, conversion or exchange of securities issued by the 20 Company prior to the Distribution Date. A "SECTION 13 EVENT" shall mean any event in which (i) the Company merges or consolidates with another and the Company is not the surviving corporation; (ii) the Company merges or consolidates with another, the Company is the surviving corporation, and all or part of the Company's common stock is exchanged for other securities, cash or property; or (iii) the Company sells or transfers more than 50% of its assets or earning power. The "EXPIRATION DATE" shall mean the earliest of (i) March 21, 2006; (ii) the date of redemption of the Rights; (iii) the date the Board orders an exchange of Rights; or (iv) the date of consummation of a tender offer approved as fair to and in the best interests of the Company and its stockholders, and adequately priced with each stockholder receiving the same consideration per share in the same manner. COMMON STOCK CERTIFICATES REPRESENT THE RIGHTS PRIOR TO THE DISTRIBUTION DATE Prior to the Distribution Date (as hereinafter defined), no separate Rights certificates will be issued. Instead, the Rights will be evidenced by the certificates for the Common Stock to which they are attached and will be transferred with and only with such Common Stock certificates. The surrender for transfer of any certificates for Common Stock outstanding will also constitute the transfer of the Rights associated with the Common Stock represented by such certificate. New Common Stock certificates issued after the Record Date will contain a legend incorporating the Rights Agreement by reference. DISTRIBUTION DATE; ISSUANCE OF RIGHTS CERTIFICATES The Rights will separate from the Common Stock and become exercisable and a Distribution Date will occur ("DISTRIBUTION DATE") upon the earlier of ten days after (i) public announcement that a person or group of affiliated or associated persons has acquired beneficial ownership of 15% or more of the outstanding shares of Common Stock (an "ACQUIRING PERSON") or such earlier date as a majority of the Directors shall become aware of the existence of an Acquiring Person ("STOCK ACQUISITION DATE"); or (ii) the commencement of a tender or exchange offer by any person or group, if upon consummation thereof, such person or group of affiliated or associated persons would be the beneficial owner of 15% or more of the shares of Common Stock then outstanding. As soon as practicable after the Distribution Date, Rights certificates will be mailed to holders of record of the Common Stock as of the close of business on the Distribution Date and, thereafter, the separate Rights certificates alone will represent the Rights. EXERCISE OF THE RIGHTS Rights Initially Not Exercisable. Prior to the Distribution Date, the Rights - --------------------------------- are not exercisable. Exercise of the Rights to Purchase Preferred Stock of the Company. At any time - ------------------------------------------------------------------ after the Distribution Date but prior to the earlier of the expiration or redemption of the Rights, each Right may be exercised at the stated purchase of $75.00 (subject to adjustment, the "EXERCISE PRICE") for one one-thousandth of a share of the Preferred Stock, provided, however, that upon the occurrence of any of the events described below the Rights may no longer be exercised for the Preferred Stock and may only be exercised for certain other securities described below. Exercise of the Rights to Purchase Common Stock of the Company. In the event - --------------------------------------------------------------- that at any time following the Rights Dividend Declaration Date, a person, alone or with affiliates, becomes the beneficial owner of 15% or more of the then outstanding shares of the Company's Common Stock (except pursuant to an offer for all outstanding shares of Common Stock which is determined by both (i) the Board of Directors acting by Special Vote, and (ii) a majority of the Directors who are not associated with an Acquiring Person ("CONTINUING DIRECTORS") and who are also not employees of the Company, to be fair to and otherwise in the best interests of the Company and its stockholders (a "PERMITTED OFFER"), then each holder of a Right will thereafter have the right to exercise the Right for Common Stock (or, in certain circumstances, cash, property or other securities of the Company) having a value equal to two times the Exercise Price of the Right. If the Company does not have sufficient Common Shares available for all Rights to be exercised, the Company may substitute for all or any portion of the Common Stock that would be issuable upon exercise of the Rights, cash, assets, or other securities having the same aggregate value as such Common Stock. The Rights are exercisable as described in this paragraph only after the Company's right of redemption (as described below) has expired. Notwithstanding any of the foregoing, following the occurrence of the event set forth in this paragraph (a "SECTION 11(A)(II) EVENT"), all Rights that are, or under certain circumstances specified in the Rights Agreement were, beneficially owned by an Acquiring Person will be null and void. A "SPECIAL VOTE" of the Board of Directors is approval by both a majority of the Continuing Directors and a majority of the entire Board, including the Continuing Directors. 21 Exercise of the Rights to Purchase Common Stock of An Acquiring Company. In the - ------------------------------------------------------------------------ event that, at any time following the Stock Acquisition Date, (i) the Company is merged or consolidated with another company in a business combination transaction in which the Company is not the surviving corporation or in which the Company is the surviving corporation and all or part of the Common Stock of the Company is exchanged for stock of any other person, cash or any other property (other than a merger which follows an offer described in the preceding paragraph), or (ii) more than 50% of the assets or earning power of the Company and its subsidiaries (taken as a whole) is sold or transferred, then each holder of a Right (except Rights which previously have been voided as set forth above) shall thereafter have the right to exercise the Right for common stock of the acquiring company having a value equal to two times the Exercise Price of the Right. (An event described in this paragraph is a "SECTION 13 EVENT.") Adjustment of Number of Rights, Purchase Price and Number of Units of Preferred - ------------------------------------------------------------------------------- Stock. The Exercise Price payable and/or the number of shares of Preferred - ----- Stock or other securities or property issuable upon exercise of the Rights are subject to proportionate adjustment from time to time to prevent dilution (i) in the event of a stock dividend on, or a subdivision, combination or reclassification of the Preferred Stock, (ii) in the event holders of the Preferred Stock are granted certain rights or warrants to subscribe for Preferred Stock or convertible securities at less than the current market price of the Preferred Stock, or (iii) upon the distribution to holders of the Preferred Stock of evidences of indebtedness or assets (excluding regular quarterly cash dividends) or of subscription rights or warrants (other than those referred to above). If at any time after the Rights Dividend Declaration Date and prior to the Distribution Date the Company declares a stock dividend on, subdivides or combines the outstanding shares of Common Stock, the number of Rights associated with each share of Common Stock shall be proportionately adjusted. FRACTIONAL RIGHTS AND FRACTIONAL SHARES The Company is generally not required to issue fractional Rights, fractions of shares of Preferred Stock (other than fractions which are integral multiples of one one-thousandth share), or fractions of shares of Common Stock and, in lieu thereof, an adjustment in cash will be made on the market price of the Rights, Preferred Stock, or Common Stock, respectively. REDEMPTION OF THE RIGHTS In general, the Company may redeem all (but not less than all) of the Rights at a price of $0.01 per Right (subject to adjustment to reflect stock splits, stock dividends, or similar transactions), at any time until the earlier of the tenth day following the Stock Acquisition Date or March 21, 2006 (provided that any redemption after any person becomes an Acquiring Person may be effected only by the Board of Directors acting by Special Vote). This redemption period may be extended by the Board of Directors by amending the Rights Agreement as described below prior to the time when the Rights become nonredeemable. The redemption price may be paid in cash, shares of Common Stock, or any other consideration the Board of Directors deems appropriate. Immediately upon the action of the Board of Directors ordering redemption of the Rights, the Rights will terminate and the only right of the holders of Rights will be to receive the $0.01 redemption price. EXCHANGE OF THE RIGHTS At any time after a Section 11(a)(ii) Event or a Section 13 Event and before any person or group acquires 50% or more of the outstanding Common Stock, the Board of Directors of the Company, acting by Special Vote, may cause the Company to exchange some or all of the outstanding and exercisable Rights for Common Stock at a one-to-one exchange ratio (appropriately adjusted to reflect stock splits, dividends or similar transactions). Rights may not be exercised after the Board orders their exchange. If there is not sufficient authorized unissued Common Stock to fund an exchange, the Board, acting by Special Vote, may fund the exchange through other consideration, including issuance of debt and/or equity. In addition, at any time before any person or group becomes an Acquiring Person, the Board, acting by Special Vote, may exchange some or all of the Rights for rights of substantially equivalent value. AMENDMENTS Other than those provisions relating to the redemption price or the final expiration date of the Rights, any of the provisions of the Rights Agreement may be supplemented or amended by the Board of Directors of the Company prior to the Distribution Date, without approval of the Rights holders, whether or not a supplement or amendment is adverse to the Rights holders. After the Distribution Date, any provisions of the Rights Agreement (other than those provisions relating to the redemption price or the final expiration date of the Rights) may be amended by the Board of Directors acting by Special Vote in order to (i) cure any ambiguous, defective or inconsistent provision, (ii) shorten or lengthen any time period hereunder, or (iii) otherwise change a provision which the Board of Directors acting by Special Vote 22 may deem necessary or desirable and which does not materially and adversely affect the interests of holders of Rights (other than any Acquiring Person); provided, the Rights Agreement may not be amended to (A) make the Rights again redeemable after the Rights have ceased to be redeemable, or (B) change any other time period unless such change is for the purpose of protecting, enhancing or clarifying the rights of, and/or the benefits to the holders of the Rights (other than any Acquiring Person). EXPIRATION The Rights will expire upon the earliest to occur of the close of business on March 21, 2006, the exchange or redemption of the Rights by the Company, or the consummation of a Permitted Offer transaction followed by a merger or consolidation of the Company with another company in which all stockholders of the Company receive the same consideration and terms as in the Permitted Offer. NO STOCKHOLDER RIGHTS PRIOR TO EXERCISE Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends. TERMS OF THE PREFERRED STOCK The Company has initially reserved 30,000 shares of Preferred Stock for issuance upon exercise of the Rights, such number to be subject to adjustment from time to time in accordance with the Rights Agreement. The Preferred Stock will be nonredeemable. The dividend, liquidation and voting rights, and the rights upon consolidation or merger of the Preferred Stock are designed so that the value of the one one-thousandth interest in a share of Preferred Stock purchasable with each Right will approximate the value of one share of Common Stock. Each whole share of Preferred Stock will be entitled to receive a quarterly preferential dividend of 1,000 times the dividend declared on the Common Stock. In the event of liquidation, the holders of the Preferred Stock will be entitled to receive a preferential liquidation payment of $1,000 per share plus the amount of accrued unpaid dividends thereon, the holders of the Common Stock will then be entitled to receive a liquidation payment equal to $1.00 per share (subject to proportionate adjustment to reflect stock splits, dividends or combinations), and the holders of the Preferred Stock and Common Stock will then share ratably in all assets remaining available for distribution to stockholders. Each share of Preferred Stock will have 1,000 votes (subject to proportionate adjustment to reflect stock splits, dividends and combinations), and will generally vote together with the Common Stock. Finally, in the event of any merger, consolidation or other transaction in which shares of Common Stock are exchanged for or changed into other stock or securities, cash and/or other property, each share of Preferred Stock will be entitled to receive 1,000 times the amount received per share of Common Stock (subject to proportionate adjustment to reflect stock splits, dividends and combinations). ANTI-TAKEOVER EFFECTS The Rights are designed to protect and maximize the value of stockholders' interests in the Company in the event of an unsolicited attempt to take control of the Company in a manner or on terms not approved by the Board of Directors. Attempts to take control of a company frequently include coercive tactics to deprive the Board of Directors and stockholders of any real opportunity to determine the destiny of the Company. The Rights have been declared by the Board in order to deter such tactics, including a gradual accumulation in the open market of a 15% or greater position, followed by a merger or a partial, or two-tier tender offer that does not treat all stockholders equally. These tactics can unfairly pressure stockholders, squeeze them out of their investment without giving them any real choice, and deprive them of the full value of their shares. The Rights are not intended to prevent a takeover of the Company and will not do so. The rights may be redeemed by the Company as described above, and accordingly, the Rights should not interfere with any merger or business combination approved by the Board of Directors. Issuance of the Rights does not weaken the Company or interfere with its business plans. The issuance of the Rights themselves has no dilutive effect, will not affect reported earnings per share, should not be taxable to the Company or to its stockholders, and will not change the way in which the Company's shares are presently traded. The Company's Board of Directors believes that the Rights represent a sound and reasonable means of addressing the complex issues of corporate policy created by the current takeover environment. 23 However, the Rights may have the effect of rendering more difficult or discouraging an acquisition of the Company deemed undesirable by the Board of Directors. The Rights may cause substantial dilution to a person or group that attempts to acquire the Company on terms or in a manner not approved by the Company's Board of Directors, except pursuant to an offer conditioned upon the negation, purchase or redemption of the Rights. ITEM 6. SELECTED FINANCIAL DATA The financial data included in the table for the five years ended December 31, 1996 have been derived from financial statements audited by the Company's independent accountants, Deloitte & Touche LLP. This data was restated for prior years to reflect the discontinuation of the Company's General Dental Practices (see Note 2 of the Consolidated Financial Statements). Additionally, effective January 1, 1996, the Company adopted a preferable method of recognizing orthodontic revenues which better matches revenues and expenses over the life of an orthodontic contract (see Note 1 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 1996 1995 1994 1993 1992 - ---------------------------------------------------------------------------------------------- Operating data (in $000's except income per share): - ------------------------------------ Health care revenues $80,990 $67,082 $60,114 $56,354 $55,842 ------- ------- ------- ------- ------- Expenses: Health care services 59,566 49,743 43,155 38,705 38,844 Selling, general and administrative 16,292 13,451 12,178 11,573 10,189 ------- ------- ------- ------- ------- Total expenses 75,858 63,194 55,333 50,278 49,033 ------- ------- ------- ------- ------- Operating income 5,132 3,888 4,781 6,076 6,809 Other income 984 1,286 1,026 690 811 Interest expense (485) - (3) - - ------- ------- ------- ------- ------- Income from continuing operations before provision for income taxes, cumulative effect and discontinued operations 5,631 5,174 5,804 6,766 7,620 Income taxes 2,218 1,968 2,262 2,456 2,972 ------- ------- ------- ------- ------- Income from continuing operations before cumulative effect of a change in accounting principle and discontinued operations 3,413 3,206 3,542 4,310 4,648 Cumulative effect of change in accounting principle, net 824 - - - - ------- ------- ------- ------- ------- Income before discontinued operations 4,237 3,206 3,542 4,310 4,648 Loss from discontinued operations (1,185) (818) (2,250) (348) (727) ------- ------- ------- ------- ------- Net income $ 3,052 $ 2,388 $ 1,292 $ 3,962 $ 3,921 ======= ======= ======= ======= ======= Income per share Income from continuing operations before cumulative effect of a change in accounting principle and discontinued operations $0.69 $ 0.68 $ 0.73 $ 0.90 $ 0.99 Cumulative effect of change in accounting principle 0.17 0.00 0.00 0.00 0.00 Loss from discontinued operations (0.24) (0.17) (0.46) (0.07) (0.16) ------- ------- ------- ------- ------- Net income $0.62 $ 0.51 $ 0.27 $ 0.83 $ 0.83 ======= ======= ======= ======= ======= Weighted average shares outstanding (000's) Primary 4,939 4,623 4,852 4,793 4,711 ======= ======= ======= ======= ======= Fully Diluted 4,940 4,725 4,852 4,793 4,711 ======= ======= ======= ======= ======= Statistical Data: - ----------------- Membership (000's) 983 761 721 664 648 Clients 5,000 2,661 2,086 1,665 1,250 Employees 461 458 432 387 333 Managed dental offices 4,200 3,291 2,902 2,532 2,274 PPO dental offices 8,600 9,706 5,765 - - Guards dental offices 27 33 30 29 23
24 Selected Operating, Statistical and Balance Sheet Data (continued) - ------------------------------------------------------------------
Year Ended December 31 1996 1995 1994 1993 1992 - ------------------------------------------------------------------------------------- Balance Sheet Data (in $000's): - ------------------------------- Cash and short-term investments $ 9,807 $14,746 $ 8,661 $17,869 $14,771 Current assets 23,751 23,576 12,378 20,903 17,456 Current liabilities 11,633 5,941 3,043 2,107 1,362 Long-term debt 19,086 - - - - Stockholder's equity 35,200 31,929 27,469 27,224 22,763 Total assets 68,116 38,343 30,792 29,917 24,808
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In addition to historical information, management's discussion and analysis below includes certain forward-looking statements, including those related to the Company's 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 care services, new technologies, rising dental care costs and other risks and uncertainties as described above under "RISK FACTORS." The following should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto.
1996 1995 1994 Versus Versus Versus Results of operations (000's omitted) 1995 1994 1993 - ----------------------------------------------------------------------------- Health care revenues $13,908 $ 6,968 $ 3,760 Percentage change 20.7% 11.6% 6.7% - ----------------------------------------------------------------------------- Membership enrollment 222 40 57 Percentage change 29.2% 5.5% 8.6% - ----------------------------------------------------------------------------- Health care expenses $ 9,823 $ 6,588 $ 4,450 Percentage change 19.7% 15.3% 11.5% Percent of revenues 73.5% 74.2% 71.8% - ----------------------------------------------------------------------------- Selling, general and administrative expenses $ 2,841 $ 1,273 $ 605 Percentage change 21.1% 10.5% 5.2% Percent of revenues 20.1% 20.1% 20.3% - ----------------------------------------------------------------------------- Other income, net $ (302) $ 260 $ 336 Percentage change (23.5%) 25.3% 48.7% Percent of revenues 1.2% 1.9% 1.7% - ----------------------------------------------------------------------------- Interest expense $ 485 $ (3) $ 3 Percentage change N/A (100.0%) N/A Percent of revenues 0.6% -- -- - ----------------------------------------------------------------------------- Income from continuing operations before cumulative effect of a change in accounting principle and discontinued operations $ 207 $ (336) $ (768) Percentage change 6.5% (9.5%) (17.8%) - -----------------------------------------------------------------------------
25
1996 1995 1994 Versus Versus Versus Results of operations (000's omitted) 1995 1994 1993 - ------------------------------------------------------------------------------- Loss from discontinued operations, net of gain on sale of dental offices, net $ (367) $ 1,432 $(1,902) Percentage change (44.9%) 63.6% (546.6%) - ------------------------------------------------------------------------------- Net income $ 664 $ 1,096 $(2,670) Percentage change 27.8% 84.8% (67.4%) - -------------------------------------------------------------------------------
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 Statement), the Company's revenues for the twelve months ended December 31, 1996, were $80,990, or a 20.7% increase on a 29.2% 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 16.3% on a 6.0% increase in membership. The revenue increases were a result of the following two elements. First is the managed care growth attributable to new small and mid-size clients, cross-selling of product offerings to existing clients and moderate price increases to renewing clients. The second area of revenue growth is from the Company's orthodontic practices, which grew by 30.5% due primarily to an increase in orthodontic starts which was greater in 1996 than in 1995, as well as the impact in the current year of the change in accounting principle for recognizing orthodontic revenues. The cumulative effect of the change in accounting principle as of January 1, 1996 was not reflected as an element of revenues in 1996. Health care expenses for the twelve months ended December 31, 1996 increased $9,823, or 19.7%. Health care expense as a percentage of health care revenues improved by 0.7% from 74.2% of revenues for the twelve months ended December 31, 1995, to 73.5% for the same period in 1996. This was primarily due to the acquisition of First American on September 27, 1996, which has a lower health care cost as a percent of revenues. The Company also realized improvements in health care cost ratios for the managed care business, prior to acquisition, offset by 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. The orthodontic practices reflected an improvement in health care cost ratios due primarily to the effect of the change in accounting principle on revenues. General and administrative expenses for the twelve months ended December 31, 1996, increased $2,841, or 21.1%. 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% from 20.1% for the twelve months ended December 31, 1996, compared to the same period of 1995. Interest 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. The operating results, net of taxes, of the discontinued General Dental Practices for the twelve months ended December 31, 1996, reflect a net loss of $2,863, net of an after tax deferred loss of $621. This compares to a net after tax loss of $818 for the same period in 1995. This loss was offset by an after tax gain of $1,678 on the sale of four General Dental Practices during 1996, for a net after tax loss of $1,185 for 1996. The cumulative effect, after taxes, of the change in accounting principle, adopted as of January 1, 1996, increased net income by $824. Net income increased due to the above factors. 26 1995 Versus 1994 - ---------------- Health care revenues increased as a result of sales to new small and mid-size clients and increased revenue from the Company's indemnity insurance subsidiary. Membership enrollment increased to 761,000 primarily from sales to new small and mid-size group clients and an increase in the number of persons covered under various dental indemnity insurance products offered by the Company's insurance subsidiary. Health care expense increased primarily due to increased capitation and increased indemnity benefits paid to insureds directly related to increased premium revenue. Health care expense also increased due to increased claims and claims reserve costs associated with the implementation of a number of new indemnity benefit programs offered by the Company's indemnity insurance subsidiary, geographic expansion, and to a lesser extent, the expansion of the Company's Preferred Provider Organization operations. General and administrative expenses increased at a lower rate due to increased operating efficiencies. Selling expenses increased primarily due to higher costs in the distribution of the Company's products through insurance related sources. Pro forma operating losses for the discontinued General Dental Practices for the twelve months ended December 31, 1995, decreased due primarily to increases in revenues and more favorable costs related to the increased revenues in the dental offices. Other income increased due to the favorable disposition by the Company of certain equity investments and dividend income. Net income increased due to the above factors. 1994 Versus 1993 - ---------------- Health care revenues increased as a result of sales to new small and mid-sized clients, the Company's indemnity insurance subsidiary, and a slowing of layoffs at the Company's major clients in the aerospace, defense and retailing industries. Membership enrollment increased primarily due to sales to new group indemnity clients and an increase in the number of persons covered under indemnity insurance products offered by the Company's indemnity insurance subsidiary. Enrollment increases as a result of sales to new groups offset entirely the continued workforce reduction in a number of the Company's major group clients. Health care expenses increased primarily due to increases in capitation payments to participating providers in direct correlation with the increase in premium revenues. Health care expenses, as a percentage of revenues, increased primarily due to the increase in payments made to providers of care under the Company's indemnity insurance program, along with an increase in the reserve established for incurred but not reported claims. General and administrative expenses remain virtually the same notwithstanding an increase in revenue and the number of persons to whom benefits were provided. Selling expenses increased primarily due to an increase in sales and marketing activities, along with an increase in the number of persons employed by the Company in sales and marketing positions. Selling, general and administrative expenses declined as a percentage of revenue due to increased efficiencies within the Company's administrative operations. Pro forma operating losses for the discontinued General Dental Practices for the twelve months ended December 31, 1994, increased due to increased costs associated with the opening of new company-owned general dental offices. Other income increased as a result of an increase in the Company's investment portfolio which was realized in 1994. Net income declined as a result of the above factors. General - ------- Both the Company's California dental plan and the orthodontic practices contribute substantially all of the Company's operating earnings. Additionally, in 1996, the dental plans in each state all contributed positively towards operating earnings. 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 experienced a loss in 1996 primarily due to the increase in the estimated liability for claims costs. 27 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 orthodontic practices ability to bolster revenue from non-plan patients is dependent upon continued quality care, marketing efforts and their ability to compete in the orthodontic dental care environment. 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 business has not been capital intensive. The Company's operational cash requirements have been met principally from operating cash flows and this is expected to continue. At December 31, 1996 and December 31, 1995, the current ratio was 2.0 to 1.0 and 4.0 to 1.0, respectively. The Company's net worth was $35.2 million compared to $31.9 million the previous year. The Company had $9.8 million and $14.7 million of cash and short-term investments as of December 31, 1996 and December 31, 1995, respectively. As a result of its regulated nature, the Company is required to maintain various regulatory bank accounts in an aggregate amount of approximately $6.3 million to satisfy depository requirements imposed by state regulatory agencies. Due to the significant cash and short-term investments maintained by the Company, these requirements do not pose a significant liquidity burden on the Company. 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. Credit Facilities - ----------------- In September 1996, the Company established a $30 million bank loan with Bank of America which provides for a $22 million reducing revolving acquisition sub- facility and an $8 million revolving working capital sub-facility. The Company utilized $19 million of the reducing revolving acquisition sub-facility to fund the acquisition of First American. The reducing revolving acquisition sub- facility may also be used to fund other acquisitions while the working capital sub-facility may be used for ongoing working capital needs of the Company. The loan has a maturity date of March 31, 2002, and requires that the acquisition sub-facility commitment amount be reduced quarterly in accordance with a set schedule. The interest rate for the loan was established at the LIBOR rate plus between 1.75% and 2%, depending upon the total funded debt compared to the trailing four quarters EBITDA. The loan is secured by a first priority security interest in all of the personal property, including accounts receivable, fixed assets and intangibles of the Company, a pledge of the stock of all of the Company's subsidiaries now owned or hereafter formed or acquired, a negative pledge on all of the assets of the Company's subsidiaries, and a negative pledge on the real property owned by the Company. 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 1996 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. 28 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by Item 10 set forth in the table, the notes thereto and the paragraphs thereunder, under the caption "ELECTION OF DIRECTORS" in the Company's Proxy Statement for its Annual Meeting of Stockholders, set for May 22, 1997, is incorporated herein by reference. Additional information related to Item 10 appears in Part I (c) of this 1996 Annual Report on Form 10-K under the caption "DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT," which is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated by reference from the section "COMPENSATION OF EXECUTIVE OFFICERS" in the Company's Proxy Statement for its Annual Meeting of Stockholders, set for May 22, 1997. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated by reference from the section "SECURITY OWNERSHIP OF MANAGEMENT", and "PRINCIPAL STOCKHOLDERS" in the Company's Proxy Statement for its Annual Meeting of Stockholders, set for May 22, 1997 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated by reference from "Certain Transactions" in the Company's Proxy Statement for its Annual Meeting of Stockholders, set for May 22, 1997. 29 PART IV EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ITEM 14(a) (1) - (2) AND (d). FINANCIAL STATEMENTS AND FINANCIAL SCHEDULE The consolidated financial statements and financial statement schedules of SafeGuard Health Enterprises, Inc. filed as part of this 1996 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 1996 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 acquisition of First American were filed with the Securities and Exchange Commission on August 26, 1996 and October 9, 1996, respectively. The Reports on Form 8-K mentioned in this Item 14(b), are hereby incorporated herein to this 1996 Annual Report on Form 10-K for the period ended December 31, 1996, 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 Anaheim, State of California, on the 26th day of March, 1997. SAFEGUARD HEALTH ENTERPRISES, INC. STEVEN J. BAILEYS,D.D.S. ------------------------ STEVEN J. BAILEYS,D.D.S., Chairman of theBoard and Chief Executive Officer (Principal Executive Officer) THOMAS C. TEKULVE ----------------- THOMAS C. TEKULVE Vice President and Chief Financial Officer (Principal Accounting and Financial Officer) 30 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 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 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 1996 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 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 March 26, 1997 - -------------------------- Chief Executive Officer STEVEN J. BAILEYS, D.D.S. JOHN E. COX President, Chief Operating March 26, 1997 - -------------------------- Officer and Director JOHN E. COX RONALD I. BRENDZEL Senior Vice President, General March 26, 1997 - -------------------------- Counsel, Secretary and Director RONALD I. BRENDZEL MICHAEL M. MANN Director March 26, 1997 - -------------------------- MICHAEL M. MANN WILLIAM E. MCKENNA Director March 26, 1997 - -------------------------- WILLIAM E. MCKENNA GEORGE H. STEVENS Director March 26, 1997 - -------------------------- GEORGE H. STEVENS BRADFORD M. BOYD, D.D.S Director March 26, 1997 - -------------------------- BRADFORD M. BOYD, D.D.S.
31 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 2.1 Plans of Acquisition# 3.1 Articles of Incorporation**** 3.2 Bylaws**** 10.1 1984 Stock Option Plan*** 10.2 Stock Option Plan Amendment* 10.3 Stock Option Plan Amendment+ 10.4 Stock Option Plan Amendment++ 10.5 Amended Stock Option Plan 10.6 Corporation Grant Deed, dated December 21, 1984, relating to a property located at 505 North Euclid Avenue, Anaheim, California** 10.7 Employment Agreement, as Amended, dated May 25, 1995, between Steven J. Baileys, D.D.S. and the Company.+++ 10.8 Employment Agreement, as Amended, dated May 25, 1995, between Ronald I. Brendzel and the Company.+++ 10.9 Employment Agreement dated May 25, 1995, between John E. Cox and the Company.+++ 10.10 Employment Agreement dated May 25, 1995, between Wayne K. Butts and the Company.+++ 10.11 Form of Rights Agreement, dated as of March 22, 1996, between the Company and American Stock Transfer and Trust Company, as Rights Agent.+++ 10.12 Employment Agreement dated January 5, 1997, between Herb J. Kaufman, D.D.S. and the Company. 10.13 Credit Agreement dated September 25, 1996, between Bank of America National Trust and Savings Association and the Company.# 18.0 Independent Auditors' Preferability Letter for Change in Accounting Method 21.1 Subsidiaries of the Company 23.1 Independent Auditors' Consent 24.1 Power of Attorney (Reference is made to Page 31 of the Report) 27.1 Financial Data Schedule
_____________ * 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 September 12, 1983 (File No. 2-86472). ** 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). *** 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). **** 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. + 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. ++ 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. +++ 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. # Incorporated by reference herein to Exhibit D filed as an exhibit to the Company's Report on Form 8-K dated September 27, 1996. ## Incorporated by reference herein to Exhibit E filed as an exhibit to the Company's Report on Form 8-K dated September 27, 1996. E-1 32 SAFEGUARD HEALTH ENTERPRISES, INC. SUBSIDIARIES OF THE COMPANY The 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., an Illinois corporation 5. SafeGuard Health Plans, Inc., a Kansas corporation 6. SafeGuard Health Plans, Inc., a Kentucky corporation 7. SafeGuard Health Plans, Inc., a Missouri corporation 8. SafeGuard Health Plans, Inc., a Nevada corporation 9. SafeGuard Health Plans, Inc., an Ohio corporation 10. SafeGuard Health Plans, Inc., an Oklahoma corporation 11. SafeGuard Health Plans, Inc., an Oregon corporation 12. SafeGuard Health Plans, Inc., a Texas corporation 13. SafeGuard Health Plans, Inc., a Utah corporation 14. SafeGuard Health Plans, Inc., a Washington corporation 15. Guards Dental, Inc., a California corporation (A wholly owned subsidiary of SafeGuard Health Plans, Inc., a California corporation) 16. SafeHealth Life Insurance Company, a California corporation 17. First American Dental Benefits, Inc., a Texas corporation 18. Imprimis Practice Management Company, Inc., a Delaware corporation Exhibit 21.1 33 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 Income....................... 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-20 Financial Statement Schedule Schedule I - Valuation and Qualifying Accounts... F-21
All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. F-1 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 as of December 31, 1996 and 1995, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. 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, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996 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. DELOITTE & TOUCHE LLP Costa Mesa, California March 28, 1997 F-2 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL POSITION ($000'S OMITTED, EXCEPT FOR SHARE DATA)
December 31, 1996 1995 - --------------------------------------------------------------- ASSETS Current assets: Cash $ 706 $ 506 Investments available for sale, at estimated fair value 6,420 14,038 Investments held to maturity, at cost 2,681 202 Accounts and notes receivable, net of allowances of $531 in 1996 and $260 in 1995 6,375 3,419 Income taxes receivable 44 45 Prepaid expenses and other current assets 1,110 723 Deferred income taxes 165 262 Net assets of discontinued operations 6,250 4,381 -------- -------- Total current assets 23,751 23,576 -------- -------- Property and equipment, net 11,841 10,221 Investments held to maturity, at amortized cost 3,631 4,073 Notes receivable - long-term 3,125 - Other assets 231 226 Goodwill, net of accumulated amortization of $134 in 1996 21,786 - Intangibles and covenant not to compete, net of accumulated amortization of $1,431 in 1996 and $1,237 in 1995 3,751 247 -------- -------- $ 68,116 $ 38,343 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of long-term debt $ 2,000 $ - Current portion of note payable 1,192 - Accounts payable and accrued expenses 4,759 3,683 Reserves for incurred but not reported claims 3,130 2,063 Deferred revenue 552 195 -------- -------- Total current liabilities 11,633 5,941 -------- -------- Long-term debt 17,000 - Note payable 2,086 - Deferred income taxes 1,784 473 Accrued compensation agreement 413 - Commitments and contingencies (Notes 6 and 10) 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; 4,707,000 in 1996 and 4,695,000 in 1995 shares outstanding, stated at 21,255 21,092 Retained earnings 32,165 29,113 Net unrealized loss on investments available for sale, net of deferred taxes (97) (153) Treasury stock, at cost (18,123) (18,123) Total stockholders' equity 35,200 31,929 -------- -------- $ 68,116 $ 38,343 ======== ========
See accompanying Notes to Consolidated Financial Statements. F-3 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME ($000'S OMITTED, EXCEPT PER SHARE DATA)
Year ended December 31, 1996 1995 1994 - ------------------------------------------------------------------------ Health care revenues $80,990 $67,082 $60,114 Expenses: Health care services 59,566 49,743 43,155 Selling, general and administrative 16,292 13,451 12,178 ------- ------- ------- Total expenses 75,858 63,194 55,333 ------- ------- ------- Operating income 5,132 3,888 4,781 Other income 984 1,286 1,026 Interest expense (485) - (3) ------- ------- ------- Income from continuing operations before provision for income taxes, cumulative effect and discontinued operations 5,631 5,174 5,804 Provision for income taxes 2,218 1,968 2,262 ------- ------- ------- Income from continuing operations before cumulative effect of a change in accounting principle and discontinued operations 3,413 3,206 3,542 Cumulative effect of change in accounting principle, net of income taxes of $536 in 1996 824 - - ------- ------- ------- Income before discontinued operations 4,237 3,206 3,542 ------- ------- ------- Discontinued operations: Loss from dental operations to be disposed of (net of after tax deferred loss of $621 and net of income tax benefits of $1,861 in 1996, $522 in 1995, and $1,437 in 1994) (2,863) (818) (2,250) Gain on disposal of dental practices (net of income taxes of $1,095 in 1996) 1,678 - - ------- ------- ------- Loss from discontinued operations (1,185) (818) (2,250) ------- ------- ------- Net income $ 3,052 $ 2,388 $ 1,292 ======= ======= ======= Earnings per share: Income from continuing operations before cumulative effect of a change in accounting principle and discontinued operations $ 0.69 $ 0.68 $ 0.73 Cumulative effect of change in accounting principle 0.17 0.00 0.00 Loss from discontinued operations (0.24) (0.17) (0.46) ------- ------- ------- Net income $ 0.62 $ 0.51 $ 0.27 ======= ======= =======
See accompanying Notes to Consolidated Financial Statements. F-4 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ($000's OMITTED)
Net Unrealized Loss on Investment Number of Shares Securities ---------------- Common Retained Treasury Available Common Treasury Stock Earnings Stock For Sale Total - ----------------------------------------------------------------------------------------------------------------------------------- January 1, 1994 7,669 (3,128) $18,536 $25,433 $(16,745) $ - $27,224 Net income 1,292 1,292 Stock repurchases for treasury (146) (1,378) (1,378) Exercise of stock options (including tax benefits of $270) 70 676 676 Net unrealized loss on investment securities available for sale (345) (345) ----- ------ ------- ------- -------- ---------- ------- December 31, 1994 7,739 (3,274) 19,212 26,725 (18,123) (345) 27,469 Net income 2,388 2,388 Exercise of stock options (including tax benefits of $595) 230 1,880 1,880 Net unrealized gain on investment securities available for sale 192 192 ----- ------ ------- ------- -------- ---------- ------- December 31, 1995 7,969 (3,274) 21,092 29,113 (18,123) (153) 31,929 Net income 3,052 3,052 Exercise of stock options (including tax benefits of $33) 12 163 163 Net unrealized gain on investment securities available for sale 56 56 ----- ------ ------- ------- -------- ---------- ------- December 31, 1996 7,981 (3,274) $21,255 $32,165 $(18,123) $ (97) $35,200 ===== ====== ======= ======= ======== ========== =======
See accompanying Notes to Consolidated Financial Statements. F-5 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS ($000's OMITTED)
Year ended December 31, 1996 1995 1994 - ----------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 3,052 $ 2,388 $ 1,292 Adjustments to reconcile net income to net cash provided by continuing operations: Loss from discontinued operations 4,719 1,334 3,686 Gain on disposal of discontinued dental practices (2,766) - - Gain on sale of property and equipment (7) (23) - Depreciation and amortization 2,350 1,602 1,440 Deferred income taxes 1,408 178 (116) Changes in operating assets and liabilities: Accounts and current notes receivable, net (3,199) (1,245) (380) Income taxes receivable 34 805 167 Prepaid expenses and other current assets (419) 12 (57) Accounts payable and accrued expenses (111) 1,717 563 Deferred revenue 357 (33) (103) Reserves for incurred but not reported claims 1,067 1,214 476 -------- -------- -------- Net cash provided by continuing operations 6,485 7,949 6,968 Net cash used in discontinued operations (5,615) (2,411) (3,798) -------- -------- -------- Net cash provided by operating activities 870 5,538 3,170 -------- -------- -------- Cash flows from investing activities: Purchase of investments available for sale (14,218) (11,913) (20,070) Proceeds from sales/maturity of investments available for sale 21,892 2,965 25,855 Purchase of investments held to maturity (5,977) (2,680) (4,532) Proceeds from maturity of investments held to maturity 3,940 8,174 510 Purchases of property and equipment (2,672) (1,446) (378) Capital expenditures of discontinued operations (2,027) (1,953) (3,905) Proceeds from sale of property and equipment 7 33 - Cash paid for business acquired (20,320) - - Additions to intangibles and other assets (127) - (48) -------- -------- -------- Net cash used in investing activities (19,502) (6,820) (2,568) -------- -------- -------- Cash flows from financing activities: Stock repurchases - - (1,378) Proceeds from long-term debt 19,000 - - Proceeds from exercise of stock options 130 1,285 406 Payments on notes payable (298) - - -------- -------- -------- Net cash provided by (used in) financing activities 18,832 1,285 (972) -------- -------- -------- Net increase (decrease) in cash 200 3 (370) Cash at beginning of year 506 503 873 -------- -------- -------- Cash at end of year $ 706 $ 506 $ 503 ======== ======== ======== Supplemental disclosure of non-cash activities: Tax benefit from exercise of stock options $ 33 $ 595 $ 270 Conversion of debt securities to equity securities $ - $ 348 $ - Supplementary information: Cash paid during the year for: Interest $ 485 $ - $ 3 Income taxes $ 619 $ 586 $ 823 Purchase of business acquired (Note 1): Fair value of assets acquired $ 25,697 - - Less: cash acquired (201) - - Less: note payable issued (3,576) - - Less: liabilities assumed (1,200) - - -------- -------- -------- Cash paid for business acquired $ 20,320 - - ======== ======== ========
See accompanying Notes to Consolidated Financial Statements. F-6 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 managed care dental plans in the United States. Operations are conducted through wholly-owned subsidiaries in thirteen states. The Company was founded as a nonprofit entity in California in 1974 and converted to a for-profit entity at the end of 1982. Since then, the Company has expanded its operations into Arizona, Colorado, Illinois, Kansas, Missouri, Nevada, Ohio, Oklahoma, Oregon, Texas, Utah and Washington. The Company is also authorized to operate in Kentucky. In 1992, the Company acquired a California-based indemnity insurance company licensed to transact insurance business in the states of Arizona, California, Colorado, Missouri, Oregon and Texas. Since then, the Company expanded its operations by qualifying its indemnity insurance company to transact the business of insurance in the states of Illinois, Kansas, Maryland, Nevada, Ohio and Wisconsin. In 1996, the Company acquired a Texas-based managed dental care company. The Company provides managed care and indemnity dental benefits for approximately 983,000 members, through a panel of primary care dental offices and specialists, and a Preferred Provider Organization panel. At December 31, 1996, the Company also operates 27 dental offices in California under the name Guards Dental, Inc. ("Guards"). Guards offices are part of the Company's panel of dental providers and offer dental services to plan members and non-plan patients. (See Note 2). 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. Change in Revenue Recognition for Orthodontic Services - -------------------------------------------------------- On January 1, 1996, the Company changed its method of recognizing revenues relating to providing orthodontic healthcare services to the proportional performance method. This change in method of revenue recognition results in 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 on a contracted basis. The Company believes this method provides for a better matching of expenses to revenues over the life of each individual orthodontic contract. As a result, the Company has recorded a total earned but unbilled receivable of approximately $2.6 million, which is included in accounts and notes receivable on the accompanying consolidated statements of financial position. Of this amount, $1.35 million represents a cumulative effect, ($824,000 net of taxes, or $.17 per share) as of January 1, 1996. Due to changes in the Company's orthodontic business practices, estimation of the effect of the change in accounting principle for recognition of orthodontic revenue is not determinable for the years ended December 31, 1995 and 1994. Investments - ----------- In accordance with the 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. In 1996, the Company recorded net unrealized gains of $92,000 and increased stockholders' equity by $56,000 (net unrealized gains less deferred income taxes of $36,000) at December 31, 1996. F-7 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. Fair Value of Financial Instruments - ----------------------------------- The Company's balance sheet includes the following financial instruments: cash, accounts and notes receivable, accounts payable 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 and the yields on long-term notes reflect estimated current market yields. The fair value of the Company's bank loan 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: buildings - 30 years; leasehold and building improvements - 5 to 25 years; furniture, fixtures, dental equipment 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. Intangibles - ----------- License acquisition costs associated with the purchase of an indemnity insurance company in October 1992 are amortized over a 20 year period. Goodwill related to the acquisition of First American Dental Benefits, Inc. ("First American") in September 1996 is being amortized over a period of 40 years. The covenant not to compete related to the acquisition of First American is being amortized over a five 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, 1996, 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 bases and the tax bases 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. 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% 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% 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. 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 and 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. F-8 Net Income Per Share - -------------------- Primary and fully diluted earnings per share for the years ended December 31, 1996, 1995, and 1994 were computed by dividing net income by 4,940,000, 4,725,000 and 4,852,000 shares, respectively, which were the weighted average numbers of outstanding common shares and common share equivalents (stock options using the treasury stock method) during the respective periods. 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, 1996 and December 31, 1995, the Company held restricted deposits of $6.3 million and $6.1 million, respectively. Additionally, the Company is required to maintain minimum capital and surplus balances. As of December 31, 1996 and December 31, 1995, 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, 1996. Recent Accounting Pronouncements - -------------------------------- 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 asset to its carrying amount. The statement also requires that assets to be disposed of should 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. In October 1995, the FASB issued Statement of Financial Accounting Standards No. 123 ("FAS 123"), Accounting for Stock-Based Compensation, which requires adoption of the disclosure provisions no later than years beginning after December 15, 1995 and the 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. Pursuant to the new 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 transactions (See Note 9). In February 1997, the FASB issued Statement of Financial Accounting Standards No. 128 ("FAS 128"), Earnings Per Share, which becomes effective for fiscal years ending after December 15, 1997. FAS 128 specifies the computation, presentation and disclosure requirements for earnings per share, and its objective is to simplify the computation of earnings per share, and to make the U.S. standard for computing earnings per share more compatible with the standards of other countries. The statement requires that all prior period earnings per share data presented shall be restated. The Company will adopt FAS 128 in fiscal year 1997 as required, and its adoption is not expected to have a significant effect on the Company's financial position or results of operations. NOTE 2: DISCONTINUED OPERATIONS - -------------------------------- On October 21, 1996, the Company implemented a strategic plan to sell all of the general dental practices owned by the Company ("General Practices"). Four of the General Practices were sold during 1996. The Company anticipates that the remaining General Practices should be sold by September 30, 1997. F-9 One of the General Practices that was sold during the third quarter of 1996, was sold to Islas Professional Dental Corporation, a California corporation ("Islas Corporation"). Steven J. Baileys, D.D.S., an Officer and Director of the Company, is an owner of Islas Corporation. The sale of such General Practice to Islas Corporation was unanimously approved by the Independent Members of the Board of Directors of the Company, after a review by such Independent Directors found the transaction to be fair to all parties involved. The assets of the General Practices to be sold, pursuant to the Company's plan, consist primarily of accounts receivable and supply inventories. Each General Practice sold may also enter into a long-term contract with the Company's newly formed practice management subsidiary, whereby the Company will provide certain services to support the dentists in the operation of their practices, including administrative support. The Company will retain the orthodontic practice in each of the General Practices, and intends to operate the orthodontic practice in the other General Practices as they are sold. The Company projects a gain on the disposal of the discontinued operations that should offset the expected operating losses of the General Practices during the phase-out period through September 30, 1997. Due to the estimated gain on the sale of these offices, actual gains will be recorded at the time of such sales, and any losses generated will be recognized up to the amount of any gains and any excess losses will be deferred. No net deferred gain will be recognized until the completion of the sales of all the practices. The operating results of the General Practices for the twelve months ended December 31, 1996, are shown separately in the accompanying consolidated income statement, net of deferred losses from operations, under the term "Discontinued Operations". The 1996 year-to-date operating losses for discontinued operations prior to the measurement date of October 21, 1996 were $2,313 net of a tax benefit of $1,490. The operating losses subsequent to the measurement date were recognized in the consolidated statements of income up to the amount of the net gain on disposal of the discontinued General Practices ($550 net of taxes), which were sold during the fourth quarter 1996. The remaining loss of $621 net of taxes is being deferred as an asset until the completion of the sales of all the General Practices. The income statement for prior years has been restated and operating results of the General Practices are also shown separately. Net revenue (in $000's) generated by the discontinued General Practices for the twelve months ended December 31, 1996 and 1995, were $18,573 and $20,616, respectively. These amounts are not included in the net revenue in the accompanying income statements. Assets of the General Practices (in $000's), shown at their net book values, to be disposed of consisted of the following:
December 31, 1996 December 31, 1995 ----------------- ----------------- Leasehold improvements and equipment, net $3,700 $2,834 Accounts receivable, net 816 925 Supplies inventories 427 458 Intangibles, net 271 164 Deferred operating losses of discontinued operations 1,036 - ------ ------ Total $6,250 $4,381 ====== ======
Net assets to be disposed of, at their book values, have been separately classified in the accompanying consolidated balance sheet at December 31, 1996. The prior year balance sheet has been restated to conform with the current year's presentation. NOTE 3: BUSINESS ACQUISITION - ------------------------------ 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 the Company is obligated to pay an aggregate sum of $3.6 million over three (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 the 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 F-10 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. Unaudited pro forma results (in $000's) of operations of the Company for the twelve months ended December 31, 1996 and December 31, 1995, are included below. Such pro forma presentation has been prepared assuming that the acquisition had occurred as of January 1, of each period.
1996 1995 ------- ------- Revenues $90,076 $78,540 Net income before cumulative effect and discontinued operations 2,814 3,066 Net income before cumulative effect and discontinued operations per common share $ 0.57 $ 0.65 Net income per common share $ 0.50 $ 0.48
The pro forma results include, (1) the historical accounts of the Company, and of the acquired businesses; and (2) pro forma adjustments, as may be required, 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 the applicable income tax effects of these adjustments. The pro forma results for the year ended December 31, 1996, 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, 1996 (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 $ 410 $ - $ (1) $ 409 State obligations 2,835 4 (2) 2,837 Corporate bonds 812 4 (143) 673 Equity securities 269 6 (28) 247 Funds and other short-term municipal obligations 2,254 - - 2,254 ------- --- ----- ------- Total available for sale 6,580 14 (174) 6,420 ------- --- ----- ------- Classified as Held to Maturity: U.S. Government and its agencies 5,034 13 (18) 5,019 State obligations 600 7 (2) 605 Municipal obligations 448 10 - 458 Corporate bonds 194 - - 194 Funds and other short-term obligations 36 - - 36 ------- --- ----- ------- Total held to maturity 6,312 30 (20) 6,322 ------- --- ----- ------- Total $12,892 $44 $(194) $12,732 ======= === ===== =======
F-11 The contractual maturities of investments at December 31, 1996, are shown below (in $000's). Expected maturities may differ from contractual maturities:
Cost/ Estimated Amortized Cost Fair Value - ---------------------------------------------------------------------- Classified as available for sale: Due in one year or less $ 4,403 $ 4,404 Due after one year through five years 1,359 1,366 Due after five years through ten years 326 279 Due after ten years 223 124 ------- ------- 6,311 6,173 Equity securities 269 247 ------- ------- Total available for sale 6,580 6,420 ------- ------- Classified as held to maturity: Due in one year or less 2,681 2,678 Due after one year through five years 2,080 2,092 Due after five years through ten years 939 926 Due after ten years 612 626 ------- ------- Total held to maturity 6,312 6,322 ------- ------- Total $12,892 $12,742 ======= =======
The following table summarizes the Company's investment as of December 31, 1995 (in $000's). The estimated fair value of investments is based on quoted market prices.
Cost/Amortized Gross Unrealized Gross Unrealized Estimated Fair Cost Gains Losses Value - ----------------------------------------------------------------------------------------------------------------- Classified as Available for Sale: State obligations $ 840 $ 5 $ (9) $ 836 Corporate bonds 1,050 17 (153) 914 Equity securities 1,204 47 (158) 1,093 Funds and other short-term municipal obligations 11,195 - - 11,195 ------- ------ -------- -------- Total available for sale 14,289 69 (320) 14,038 ------- ------ -------- -------- Classified as Held to Maturity: U.S. Government and its agencies 3,127 25 (-) 3,152 State obligations 700 7 (6) 701 Municipal obligations 448 7 (1) 454 ------- ------ -------- -------- Total held to maturity 4,275 39 (7) 4,307 ------- ------ -------- -------- Total $18,564 $ 108 $ (327) $ 18,345 ======= ====== ======== ========
Property and Equipment - ---------------------- The Company's property and equipment consist of (in $000's):
December 31, 1996 1995 - ----------------------------------------------------------------------------------------------------------------- Land $ 702 $ 692 Buildings and improvements 5,970 5,909 Leasehold improvements 3,842 3,931 Dental equipment 3,306 3,381 Furniture, fixtures and other equipment 9,277 6,777 Construction in progress 471 143 -------- -------- 23,568 20,833 Less - accumulated depreciation and amortization (11,727) (10,612) -------- -------- $ 11,841 $ 10,221 ======== ========
Year ended December 31, 1996 1995 1994 - ----------------------------------------------------------------------------------------------- Depreciation and amortization expense (in $000's) $ 1,904 $1,511 $ 1,358
F-12 Accounts Payable and Accrued Expenses - ------------------------------------- The Company's accounts payable and accrued expenses consist of (in $000's):
December 31, 1996 1995 - ------------------------------------------------------------ Accounts payable $ 1,263 $2,862 Accrued compensation 156 97 Other accrued expenses 3,340 724 ------- ------ $ 4,750 $3,683 ======= ======
NOTE 5: LONG-TERM DEBT - ----------------------- Long-term debt consisted of the following (in $000's):
December 31, 1996 1995 - ------------------------------------------------------------ Bank credit agreement $19,000 $ - Less: current portion 2,000 - ------- ------ Long-term debt $17,000 - ======= ======
In September 1996, the Company established a $30 million bank loan with Bank of America which provides for a $22 million reducing revolving acquisition sub- facility and an $8 million revolving working capital sub-facility. The Company has utilized $19 million of the reducing revolving acquisition sub-facility. The loan has a maturity date of March 31, 2002, and requires that the acquisition sub-facility commitment amount be reduced quarterly in accordance with a set schedule. Scheduled aggregate annual payments of long-term debt (in $000's) are $2,000 for 1997, $13,500 for 1998 and $3,500 for 1999. The interest rate for the loan was established at the LIBOR rate plus between 1.75% and 2%, depending upon the total funded debt compared to the trailing four quarters EBITDA. The Company's interest rate on the loan at December 31, 1996, was 8.5%. 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, a pledge of the stock of all of the Company's subsidiaries, and a negative pledge on the real property owned by the Company. In connection with the bank loan, as amended, the Company is subject to certain financial and operational debt covenants. As of December 31, 1996, the Company was in compliance, or has obtained a waiver, with respect to these covenants. NOTE 6: LEASE OBLIGATIONS - -------------------------- The Company leases administrative and dental office space under various non- cancelable operating leases. Rental expense (in $000's) was $2,201, $1,609 and $1,401 in 1996, 1995 and 1994, respectively. Future minimum rental payments required under operating leases that have initial or remaining lease terms in excess of one year as of December 31, 1996 are (in $000's):
Year ending December 31: 1997 $2,063 1998 1,879 1999 1,815 2000 1,747 2001 1,668 Thereafter 4,552
The Company incurred rent expense (in $000's) to a related party of $10 in 1996, $12 in 1995 and $12 in 1994. F-13 NOTE 7: INCOME TAXES - --------------------- The Company's provision for federal and state income taxes is (in $000's):
Year ended December 31, 1996 1995 1994 - ---------------------------------------------------------------------- Provision for income taxes: Taxes currently payable: Federal $ 510 $1,084 $ 688 State 236 302 253 Tax effect of timing differences: Difference in accounting method for recognizing gain on sale of dental offices 1,177 - - Difference in accounting methods for recognizing deferred loss on discontinued operations 441 - - Difference in depreciation methods 75 61 (80) Difference in accounting method for revenue adjustments (116) (23) (22) Difference in accounting method for specialist cost (275) 37 (103) Deferred state taxes (134) (32) 124 Other 74 17 (35) ------ ------ ------ $1,988 $1,446 $ 825 ====== ====== ====== Provision due to: Continuing operations $2,754 $1,968 $2,262 Discontinued operations (766) (522) (1,437) ------ ------ ------ $1,988 $1,446 $ 825 ====== ====== ======
A reconciliation of the Federal income tax provision at the expected statutory rate compared to the actual income tax provision is as follows (in $000's):
Year ended December 31, 1996 1995 1994 - ----------------------------------------------------------------------------------------------- Expected $1,763 35.0% $1,342 35.0% $ 741 35.0% State taxes, net of federal effect 348 6.9 208 5.4 126 6.0 Tax-free income (99) (2.0) (159) (4.1) (111) (5.3) Non-deductible amortization 47 0.9 - - - - Other (71) (1.4) 55 1.4 69 3.3 ------ ---- ------ ----- ----- ------ $1,988 39.4% $1,446 37.7% $ 825 39.0% ====== ==== ====== ===== ===== ====== The major components of the Company's deferred taxes are as follows (in $000's):
December 31, 1996 1995 - ----------------------------------------------------------------------------------------------- Current deferred tax assets (liabilities): Accrued specialist costs and policy reserves $ 437 $ 157 Loss on discontinued operations (448) - Reserve for revenue adjustments 230 112 Amortization of prepaid expenses (119) (108) State income taxes 94 90 Other (29) 11 ----- ---- Net current deferred tax asset 165 262 ----- ---- Noncurrent deferred tax assets (liabilities): Book versus tax basis in property, including depreciation and amortization (726) (605) Deferred gain on sale of dental offices (1,189) - Unrealized loss on investments 62 98 Amortization of intangibles 32 34 Other 37 - ------- ------ Net noncurrent deferred tax liability (1,784) (473) ------- ------ Net deferred tax liability $(1,619) $ (211) ======= ======
F-14 As of December 31, 1996, the Company has not recorded a valuation allowance against deferred tax assets. 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, 1996 1995 1994 - ---------------------------------------------------- Interest income $ 809 $ 796 $ 744 Dividend income 61 233 - Other 114 257 282 ----- ------ ------ $ 984 $1,286 $1,026 ===== ====== ======
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 ever 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, 1996, 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. 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 1,200,000 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, 1996 were incentive stock options. The following is a summary of stock option transactions:
Year ended December 31, 1996 1995 1994 - -------------------------------------------------------------------------------------------------- Outstanding at beginning of year 397,500 538,000 623,669 Granted 132,300 285,000 6,000 Canceled (6,987) (195,167) (21,668) Exercised (11,996) (230,333) (70,001) --------------- --------------- --------------- Outstanding at end of year 510,817 397,500 538,000 =============== =============== =============== Exercisable at end of year 303,389 240,000 421,662 =============== =============== =============== Price range of options outstanding $ 4.25 - $20.75 $ 4.25 - $13.06 $ 4.25 - $13.06 Price range of options exercised $ 9.00 - $11.88 $ 4.63 - $11.88 $ 4.25 - $11.87 Price range of options granted $15.75 - $20.75 $ 9.00 - $11.50 $ 9.00 - $ 9.00 Price range of options canceled $ 9.00 - $15.75 $ 9.00 - $11.88 $ 4.24 - $11.88
F-15 The following table summarizes information concerning stock options at December 31, 1996:
Weighted Number Average Weighted Number Weighted Range of Outstanding Remaining Average Exercise Exercisable Average Exercise Exercise Price 12/31/96 Contractual Life Price 12/31/96 Price - ------------------------------------------------------------------------------------------------------------------------------ $ 4.25 - $ 7.25 164,000 3.87 $ 4.67 164,000 $ 4.67 9.00 - 9.90 77,167 7.84 9.62 33,722 9.53 10.25 - 13.06 139,000 5.71 11.09 105,667 11.35 15.75 - 15.75 77,150 9.22 15.75 0 0 17.33 - 20.75 53,500 9.50 18.52 0 0 ------- ---- ------ ------- ------ 510,817 6.37 $10.29 303,389 $ 7.54
The estimated fair value of options granted during 1996 and 1995, was $4.84 and $2.74 per share, respectively. The Company applies Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for the Plan. Accordingly, 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 and earnings per share for the year ended December 31, 1996 and 1995, would have been reduced to the pro forma amounts indicated below:
1996 1995 1994 ------ ------ ------ Net income (in $000's) As reported $3,052 $2,388 $1,292 Pro forma 2,730 2,274 1,262 Net income per common and common equivalent share As reported $ .62 $ .51 $ .27 Pro forma $ .55 $ .48 $ .26
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 divided yield, expected volatility of 25%, risk free interest rate of 6.0%, and an average expected life of four (4) years. NOTE 10: COMMITMENTS AND CONTINGENCIES - --------------------------------------- The Company is a defendant in various litigations 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. The Company has employment agreements with various executive officers requiring an annual payment of (in $000's): Year ending December 31, 1997 $1,140 1998 1,140 1999 1,140 2000 551 2001 155
F-16 NOTE 11: RESERVES FOR INCURRED BUT NOT REPORTED CLAIMS - -------------------------------------------------------- Activity in the liability for dental indemnity insurance policy reserves, specialists claims, and claim adjustment expenses is summarized as follows (in $000's):
Policy Reserves Specialist Total - ------------------------------------------------------------------------ Balance at January 1, 1995 $ 400 $ 449 $ 849 Incurred related to: Current year - 1995 6,015 3,464 9,479 Prior years - 55 55 ------- ------ ------- Total incurred 6,015 3,519 9,534 Paid related to: Current year - 1995 4,353 3,101 7,454 Prior years 362 504 866 ------- ------ ------- Total paid 4,715 3,605 8,320 ------- ------ ------- Balance at December 31, 1995 $ 1,700 $ 363 $ 2,063 ======= ====== ======= Incurred related to: Current year - 1996 13,298 4,828 18,126 Prior years 63 18 81 ------- ------ ------- Total incurred 13,361 4,846 18,207 Paid related to: Current year - 1996 11,180 3,821 15,001 Prior years 1,761 378 2,139 ------- ------ ------- Total paid 12,941 4,199 17,140 ------- ------ ------- Balance at December 31, 1996 $ 2,120 $1,010 $ 3,130 ======= ====== =======
NOTE 12: BUSINESS SEGMENT INFORMATION - -------------------------------------- The Company is engaged primarily in two distinct businesses: the operation of managed care dental programs and the operation of orthodontic practices. Summarized financial information by business segment for 1996, 1995 and 1994 is as follows (in $000's):
1996 1995 1994 - ------------------------------------------------------------------------ Health care revenues Managed care $72,709 $60,736 $53,921 Orthodontic 8,281 6,346 6,193 ------- ------- ------- $80,990 $67,082 $60,114 Health care expenses Managed care $54,534 $45,285 $39,203 Orthodontic 5,032 4,458 3,952 ------- ------- ------- $59,566 $49,743 $43,155 Pretax income before cumulative effect and discontinued operations 1996 1995 1994 - ------------------------------------------------------------------------ Managed care $ 5,034 $ 4,704 $ 5,965 Orthodontic 3,249 1,888 2,241 Other income (net) 499 1,286 1,023 Corporate (3,151) (2,704) (3,425) ------- ------- ------- $ 5,631 $ 5,174 $ 5,804 Identifiable assets 1996 1995 1994 - ------------------------------------------------------------------------ Managed care $52,973 $28,992 $23,190 Orthodontic 2,851 205 178 Corporate 6,042 4,765 4,880 Discontinued operations 6,250 4,381 2,544 ------- ------- ------- $68,116 $38,343 $30,792
F-17 NOTE 13: UNAUDITED SELECTED QUARTERLY INFORMATION - --------------------------------------------------- Unaudited quarterly results of operations for the years ended December 31, 1996 and 1995 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.
First Second Third Fourth Year ended December 31, 1996 Quarter Quarter Quarter Quarter - ----------------------------------------------------------------------------------- As previously reported: Health care revenue $21,901 $22,375 $19,543 Health care expense 17,435 17,576 14,176 Selling, general and administrative 3,467 3,588 3,869 Operating income 999 1,211 1,498 Income from continuing operations 999 1,211 1,017 Income from discontinued operations - - 99 Net income 760 927 1,116 Net income per share Net income from continuing $ 0.16 $ 0.19 $ 0.21 operations per share Net income from discontinued - - .02 operations per share Weighted average shares 4,889 4,937 4,950 As restated due to accounting change and discontinued operations: Health care revenue $18,535 $19,447 $19,937 $23,071 Health care expense 14,121 14,592 14,408 16,445 Selling, general and administrative 3,267 3,388 3,669 5,968 Operating income 1,367 1,786 2,030 448 Income from continuing operations before cumulative effect of change in accounting principle and discontinued operations 834 1,072 1,238 269 Cumulative effect of change in accounting principle 824 - - - Loss from discontinued operations (416) (426) (343) - Net income 1,242 646 895 269 Income per share Income from continuing operations before a change in accounting principle and discontinued operations $ 0.17 $ 0.22 $ 0.25 $ 0.06 Cumulative effect of change in accounting principle 0.17 - - - Loss from discontinued operations 0.09 0.09 .07 - Net income $ 0.25 $ 0.13 $ 0.18 $ 0.06 Weighted average shares 4,889 4,937 4,950 4,940 The quarterly results were restated due to the accounting change for orthodontic revenue recognition and for the discontinued operations of the General Practices. During the fourth quarter of 1996, as a result of the discontinued operations, the Company deferred loses of $621, net of taxes. Additionally, the Company recorded an increase of approximately $950 in the estimated liability for claim costs processed through the Company's indemnity dental system.
F-18
First Second Third Fourth Year ended December 31, 1995 Quarter Quarter Quarter Quarter - --------------------------------------------------------------------------------- As previously reported: Health care revenue $19,423 $20,042 $20,834 $21,278 Health care expense 15,472 16,142 16,773 17,191 Selling, general and administrative 3,349 3,247 3,476 3,379 Operating income 602 653 585 708 Net income 485 550 649 704 Net income per share $ 0.10 $ 0.12 $ 0.14 $ 0.15 Weighted average shares 4,656 4,668 4,777 4,820 As restated due to discontinued operations Health care revenue $15,810 $16,166 $17,383 $17,723 Health care expense 11,403 11,991 12,752 13,597 Selling, general and administrative 3,361 3,260 3,451 3,379 Operating income 1,238 1,166 1,583 1,187 Income from continuing operations 751 704 1,023 728 Loss from discontinued operations (266) (154) (374) (24) Net income 485 550 649 704 Income per share Net income from continuing operations per share $ 0.16 $ 0.15 $ 0.22 $ 0.15 Net loss from discontinued operations per share 0.06 0.03 0.08 $ 0.00 Net income $ 0.10 $ 0.12 $ 0.14 $ 0.15 Weighted average shares 4,656 4,668 4,777 4,820
F-19 NOTE 14: SUBSEQUENT EVENTS - --------------------------- On October 23, 1996, the Company announced that it would acquire all of the outstanding shares of common stock of Advantage Dental HealthPlans, Inc., a privately-held dental managed care company based in Fort Lauderdale, Florida. Additionally, on November 22, 1996, the Company also announced that it will acquire all of the outstanding shares of common stock of a privately-held dental indemnity insurance company, including licenses to operate in sixteen (16) states, primarily in the southeastern portion of the United States. The acquisitions are subject to the satisfaction of certain conditions and regulatory approval, and are expected to close in the first half of 1997. Other details of the transactions have not yet been disclosed by the Company. F-20 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE I VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31, 1996, 1995 and 1994 (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 - -------------------------------------------------------------------------------------------------------- 1994: - ---- Allowance for doubtful accounts: Accounts and notes receivable $ 156 $ 179 $ - $(129) $206 1995: - ---- Allowance for doubtful accounts: Accounts and notes receivable $ 206 $ 278 $ - $(224) $260 1996: - ---- Allowance for doubtful accounts: Accounts and notes receivable $ 260 $ 615 $ 62 $(406) $531
(1) Represents balance forward from American Dental Corporation, which was charged to the opening goodwill balance. F-21 EX-10.5 2 STOCK OPTION PLAN / DATED FEBRUARY 7, 1997 EXHIBIT 10.5 STOCK OPTION PLAN OF SAFEGUARD HEALTH ENTERPRISES, INC. (As Amended Through February 7, 1997) SAFEGUARD HEALTH ENTERPRISES, INC., a corporation organized under the laws of the State of Delaware, hereby adopts the following Amended Stock Option Plan of SafeGuard Health Enterprises, Inc., as is attached hereto, marked Exhibit A and incorporated by this reference herein. We hereby certify that the attached Amended Stock Option Plan was duly adopted by the Board of Directors of SafeGuard Health Enterprises, Inc., a Delaware corporation, at a duly called, authorized and convened meeting of the Board of Directors held on February 7, 1997. Date: 2/7/97 /s/ STEVEN J. BAILEYS, D.D.S ---------- ----------------------------- STEVEN J. BAILEYS, D.D.S. Chairman, President and Chief Executive Officer /s/ RONALD I. BRENDZEL, J.D. ---------------------------- RONALD I. BRENDZEL, J.D. Senior Vice President and Secretary STOCK OPTION PLAN OF SAFEGUARD HEALTH ENTERPRISES, INC. (As amended and restated through February 7, 1997) SAFEGUARD HEALTH ENTERPRISES, INC., a corporation organized under the laws of the State of Delaware, hereby adopts this Stock Option Plan of Safeguard Health Enterprises, Inc. The purposes of this Plan are as follows: (1) To further the growth, development and financial success of the Company by providing additional incentives to certain of its Directors and executive and other key Employees who have been or will be given responsibility for the management or administration of the Company's business affairs, by assisting them to become owners of capital stock of the Company and thus to benefit directly from its growth, development and financial success. (2) To enable the Company to obtain and retain the services of the type of Directors and professional, technical and managerial Employees considered essential to the long range success of the Company by providing and offering them an opportunity to become owners of capital stock of the Company under options, some of which are intended to qualify as "incentive stock options" under Section 422 of the Internal Revenue Code. The Plan shall be divided into two separate components: the Discretionary Option Grant Program described in Articles III through VI and the Automatic Option Grant Program described in Article VII. Under the Discretionary Option Grant Program, eligible individuals may, at the discretion of the Plan Administrator, be granted stock options to purchase shares of Common Stock in accordance with the provisions of Articles III through VI. Under the Automatic Option Grant Program, each eligible member of the Board will automatically receive periodic option grants to purchase shares of Common Stock in accordance with the provisions of Article VII. Unless the context clearly indicates otherwise, the provisions of Articles I, II and VIII of the Plan shall apply to both the Discretionary Option Grant Program and the Automatic Option Grant Program and shall accordingly govern the interests of all individuals under the Plan. ARTICLE I DEFINITION ---------- Section 1.1 - General - ----------- ------- Whenever the following terms are used in this Plan, they shall have the meaning specified below unless the context clearly indicates to the contrary. -1- Section 1.2 - Board - ----------- ----- "Board" shall mean the Board of Directors of the Company. Section 1.3 - Code - ----------- ---- "Code" shall mean the Internal Revenue Code of 1986, as amended from time to time. Section 1.4 - Committee - ----------- --------- "Committee" shall mean the committee appointed by the Board pursuant to Section 6.1(a) to administer the provisions of the Discretionary Stock Option Grant Program. Section 1.5 - Company - ----------- ------- "Company" shall mean Safeguard Health Enterprises, Inc. Section 1.6 - Director - ----------- -------- "Director" shall mean a member of the Board. Section 1.7 - Employee - ----------- -------- "Employee" shall mean any employee (as defined in accordance with the Regulations and Revenue Rulings then applicable under Section 3401(c) of the Code) of the Company or of any corporation which is then a Parent or Subsidiary, whether such employee is so employed at the time this Plan is adopted or becomes so employed subsequent to the adoption of this Plan. Section 1.8 - Incentive Stock Option - ----------- ---------------------- "Incentive Stock Option" shall mean an Option qualifying under Section 422 of the Code and designated as such by the Plan Administrator. Section 1.9 - Non-Employee Director - ----------- --------------------- "Non-Employee Director" shall mean any Director who qualifies as a "non-employee director" within the meaning of Rule 16b-3 promulgated by the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended. Section 1.10 - Non-Qualified Stock Option - ------------- -------------------------- "Non-Qualified Stock Option" shall mean an Option which is not an Incentive Stock Option and which is designated as a Non-Qualified Stock Option by the Plan Administrator. -2- Section 1.11 - Officer - ------------ ------- "Officer" shall mean an officer of the Company or of any Parent or Subsidiary. Section 1.12 - Option - ------------ ------ "Option" shall mean an option to purchase capital stock of the Company, granted under the Plan. "Options" includes both Incentive Stock Options and Non-Qualified Stock Options, except that for purposes of Article VII, such term shall refer solely to Non-Qualified Stock Options. Section 1.13 - Optionee - ------------ -------- "Optionee" shall mean an Employee or non-Employee member of the Board to whom an Option is granted under the Plan. Section 1.14 - Parent Corporation - ------------ ------------------ "Parent" shall mean any corporation in an unbroken chain of corporations ending with the Company if each of the corporations in the unbroken chain (other than the Company) owns at the time of determination stock possessing fifty percent (50%) or more of the total combined voting power of all classes of stock in one of the other corporations in such chain. Section 1.15 - Plan - ------------ ---- The "Plan" shall mean this Stock Option Plan of Safeguard Health Enterprises, Inc. Section 1.16 - Plan Administrator - ------------ ------------------ "Plan Administrator" shall mean the Board or the Committee appointed to administer the Discretionary Option Grant provisions of the Plan, to the extent such entity is carrying out its administrative functions under the Plan in accordance with the provisions of Article VI. Section 1.17 - Pronouns - ------------ -------- The masculine pronoun shall include the feminine and neuter and the singular shall include the plural, where the context so indicates. Section 1.18 - Secretary - ------------ --------- "Secretary" shall mean the Secretary of the Company. Section 1.19 - Subsidiary - ------------ ---------- "Subsidiary" shall mean any corporation in an unbroken chain of corporations beginning with the Company if each of the corporations other than the last corporation in the -3- unbroken chain owns at the time of determination stock possessing fifty percent (50%) or more of the total combined voting power of all classes of stock in one of the other corporations in such chain. Section 1.20 - Termination of Employment - ------------ ------------------------- "Termination of Employment" shall mean the time when the employee- employer relationship between the Optionee and the Company or any Parent or Subsidiary corporation, is terminated for any reason, with or without cause, at any time, including, but not by way of limitation, a termination by resignation, discharge, death or retirement, but excluding terminations where there is a simultaneous reemployment by the Company or any Parent or Subsidiary corporation. The Plan Administrator, in its absolute discretion, shall determine the effect of all other matters and questions relating to the Optionee's Termination of Employment, including, but not by way of limitation, the question of whether a Termination of Employment resulted from a discharge for good cause, and all questions of whether particular leaves of absence constitute Terminations of Employment; provided, however, that, with respect to Incentive Stock Options, a leave of absence shall constitute a Termination of Employment if, and to the extent that, such leave of absence interrupts employment for the purposes of Section 422(a)(2) of the Code and then applicable Treasury Regulations and other administrative authority under said Section. ARTICLE II SHARES SUBJECT TO PLAN ---------------------- Section 2.1 - Shares Subject to the Plan - ----------- -------------------------- The shares of stock subject to Options shall be shares of the Company's authorized common stock ("Common Stock"). The aggregate number of such shares which may be issued over the term of the Plan shall not exceed 1,700,000. The total number of shares issuable from time to time under the Plan shall be subject to periodic adjustment in accordance with the provisions of Section 2.3 below. Should an Option expire or terminate for any reason prior to exercise or surrender in full, the shares subject to the portion of the Option not so exercised or surrendered shall be available for subsequent Option grants under the Plan. Shares subject to any Option or portion thereof surrendered in accordance with Section 7.10 of the Plan and all share issuances under the Plan, whether or not such shares are subsequently repurchased by the Company pursuant to its repurchase rights under the Plan, shall reduce on a share-for-share basis the number of shares of Common Stock available for subsequent Option grants under this Plan. In addition, should the option price of an outstanding Option under the Plan be paid with shares of Common Stock, then the number of shares of Common Stock subsequently available for issuance under the Plan shall be reduced by the gross number of shares for which the Option is exercised, and not by the net number of shares of Common Stock actually issued to the Optionee. -4- Section 2.2 - Limitation on Incentive Stock Option Grants - ----------- ------------------------------------------- The aggregate fair market value (determined as of the respective date or dates of grant) of the shares of Common Stock for which one or more Incentive Stock Options granted to any Employee under the Plan (or any other stock option plan of the Company or its Parent or Subsidiary corporations) may for the first time become exercisable as Incentive Stock Options under the Federal tax laws during any one (1) calendar year shall not exceed the sum of One Hundred Thousand Dollars ($100,000) or such greater amount as may be permitted under subsequent amendments to Section 422 of the Internal Revenue Code. To the extent the Employee holds two (2) or more such Options which become exercisable for the first time in the same calendar year, the foregoing limitation on the exercisability thereof as Incentive Stock Options under the Federal tax laws shall be applied on the basis of the order in which such Options are granted. In the event the applicable $100,000 limitation is in fact exceeded in any calendar year, the Option may nevertheless be exercised for those excess shares as a Non-Qualified Stock Option. Section 2.3 - Changes in Company's Shares - ----------- --------------------------- In the event that the outstanding shares of Common Stock of the Company are hereafter changed into or exchanged for a different number or kind of shares or other securities of the Company, or of another corporation, by reason of reorganization, merger, consolidation, recapitalization, reclassification, stock split-up, stock dividend or combination of shares, appropriate adjustments shall be made by the Stock Option Committee in the number and kind of shares for the purchase of which Options may be granted, including adjustments of the limitations in Sections 2.1 and 2.2 on the maximum number and kind of shares which may be issued on exercise of Options. ARTICLE III GRANTING OF DISCRETIONARY OPTIONS --------------------------------- Section 3.1 - Eligibility for Option Grants - ----------- ----------------------------- (a) The persons eligible to receive Option grants pursuant to the Discretionary Option Grant Program shall be limited to the following individuals: (i) such Employee-members of the Board as the Committee shall select from time to time; and (ii) such other key Employees (including officers who are not Directors) as the Plan Administrator shall select from time to time. (b) The Plan Administrator shall have the sole and exclusive authority, within the scope of its administrative functions under the Plan, to select the eligible individuals who are to receive Option grants under the Discretionary Option Grant Program and to determine the number of shares to be covered by each such Option grant, the status of the granted Option as either an -5- Incentive Stock Option or a Non-Qualified Stock Option, the time or times at which such Option is to become exercisable and the maximum term for which the Option is to remain outstanding. (c) Non-Employee members of the Board (including members of the Committee) shall not be eligible to participate in the Discretionary Option Grant Program. However, non-Employee members of the Board shall be eligible to receive periodic Option grants pursuant to the Automatic Option Grant provisions of Article VII. (d) Upon the selection of an eligible individual to receive an Option grant under the Discretionary Option Grant Program, the Plan Administrator shall instruct the Secretary to issue such Option and may impose such conditions on the grant of such Option as it deems appropriate. Without limiting the generality of the preceding sentence, the Plan Administrator may, in its discretion and on such terms as it deems appropriate, require as a condition to the grant of the Option that the Optionee surrender for cancellation some or all of the unexercised Options which have been previously granted to him. Any Option the grant of which is unconditioned upon such surrender may have an option price lower (or higher) than the option price of the surrendered Option, may cover the same (or a lesser or greater) number of shares as the surrendered Option, may contain such other terms as the Plan Administrator deems appropriate and shall be exercisable in accordance with its terms, without regard to the number of shares, price, option period or any other term or condition of the surrendered Option. ARTICLE IV TERMS OF DISCRETIONARY OPTION GRANTS ------------------------------------ Section 4.1 - Option Agreement - ----------- ---------------- Each Option issued under the Discretionary Option Grant Program shall be evidenced by a written Stock Option Agreement, which shall be executed by the Optionee and authorized Officers of the Company and which shall contain such terms and conditions as the Plan Administrator shall determine, consistent with the Plan. Stock Option Agreements evidencing Incentive Stock Options shall contain such terms and conditions as may be necessary to qualify such Options as "incentive stock options" under Section 422 of the Code. Section 4.2 - Option Price - ----------- ------------ (a) The price of the shares subject to each Option shall be set by the Plan Administrator; provided, however, that the price per share shall be not less than one hundred percent (100%) of the fair market value of such shares on the date such Option is granted; provided, further, that, in the case of an Incentive Stock Option granted to an individual then owning (within the meaning of Section 424(d) of the Code) more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or any Subsidiary or any Parent corporation (a "10% Stockholder"), the price per share shall not be less than one hundred ten percent (110%) of the fair market value of such shares on the date such Option is granted. -6- (b) For the purpose of Section 4.2(a) and all other valuation purposes under the Plan, the fair market value of a share of the Company's stock on the date the Option is granted shall be: (i) the closing price of a share of the Company's Stock on the principal exchange on which shares of the Company's stock are then trading, if any, on such date, or, if shares were not traded on such date, then on the next preceding trading day during which a sale occurred; or (ii) if such stock is not traded on an exchange but quoted on NASDAQ or a successor quotation system, (1) the last sale price (if the stock is then listed as a National Market Issue) or (2) the mean between the closing representative bid and asked prices (in all other cases) for the stock on such date as reported by NASDAQ or such successor quotation system; or (iii) if such stock is not publicly traded on an exchange and not quoted on NASDAQ or a successor quotation system, the mean between the closing bid and asked prices for the stock on such date as determined in good faith by the Committee effecting the Option grant; or (iv) if the Company's stock is not publicly traded, the fair market value established by such Plan Administrator acting in good faith. Section 4.3 - Commencement of Exercisability - ----------- ------------------------------ (a) No Option may be exercised in whole or in part during the first year after such Option is granted. Thereafter the Optionee may, within the specified term of the Option and pursuant to the provisions of this Agreement, purchase the Optioned Shares in accordance with the following schedule: (i) One-third of the Optioned Shares at any time after the expiration of twelve (12) months measured from the date of grant. (ii) An additional one-third of the Optioned Shares at any time after the expiration of twenty-four (24) months measured from the date of grant. (iii) The final one-third of the Optioned Shares at any time after the expiration of thirty-six (36) months measured from the date of grant. Within the limitations provided in this Section 4.3 but subject to the other provisions of this Agreement, an Optionee may, on any two (2) occasions in each fiscal year during the term of the Option, purchase any or all of the Optioned Shares for which the Option is at the time exercisable; provided however, that each exercise shall be for not less than twenty-five (25) shares or the minimum installment set forth in this Section 4.3, if a smaller number of shares. In no event, however, shall an Option be exercisable for any fractional shares. (b) Subject to the provisions of Sections 4.3(a) and 4.3(c), Options shall become exercisable at such times and in such installments (which may be cumulative) as the Plan Administrator shall provide in the terms of the individual Option; provided, however, that by a resolution adopted after an Option is granted, the Plan Administrator may, on such terms and conditions as it may determine to be appropriate and subject to Sections 4.3(a) and 4.3(c), accelerate the time at which such Option or any portion thereof may be exercised. -7- (c) No portion of an Option which is unexercisable at Termination of Employment shall thereafter become exercisable. Section 4.4 - Expiration of Options - ----------- --------------------- (a) No Incentive Stock Option may be exercised to any extent by anyone after the first to occur of the following events: (i) The expiration of ten (10) years from the date the Option was granted; (ii) In the case of a 10% Stockholder, the expiration of five (5) years from the date that the Option was granted; (iii) Except in the case of any Optionee who is disabled (within the meaning of Section 22(e)(3) of the Code) at the time Employee status terminates, the expiration of thirty (30) days from the date of the Optionee's Termination of Employment for any reason other than such Optionee's death unless the Optionee dies within said thirty (30) days; (iv) In the case of an Optionee who is disabled (within the mean of Section 22(e)(3) of the Code) at the time Employee status terminates, the expiration of six (6) months from the date of the Optionee's Termination of Employment for any reason other than such Optionee's death unless the Optionee dies within said six (6) month period; (v) The expiration of ninety (90) days from the date of the Optionee's death. No Non-Qualified Stock Option may be exercised to any extent by anyone after the expiration of ten (10) years and one (1) day from the date the Option was granted. (b) Subject to the provisions of Section 4.4(a), the Plan Administrator shall provide, as part of the terms of the Option, when such Option expires and becomes unexercisable; and (without limiting the generality of the foregoing) the Plan Administrator may provide as part of the terms of the Option that such Option is to expire immediately upon a Termination of Employment for any reason. Section 4.5 - Consideration - ----------- ------------- In consideration of the granting of the Option, the Optionee shall agree, in the written Stock Option Agreement, to remain in the employ of the Company or a Parent or Subsidiary corporation for a period of at least one (1) year after the Option is granted. Nothing in this Plan or in any Stock Option Agreement hereunder shall confer upon any Optionee any right to continue in the employ of the Company or any Parent or Subsidiary corporation or shall interfere with or restrict -8- in any way the rights of the Company and any such Parent or Subsidiary corporation, which are hereby expressly reserved, to discharge any Optionee at any time for any reason whatsoever, with or without good cause. Section 4.6 - Adjustments in Outstanding Options - ----------- ---------------------------------- In the event that the outstanding shares of the stock subject to Options are changed into or exchanged for a different number or kind of shares of the Company or other securities of the Company by reason of merger, consolidation, recapitalization, reclassification, stock split-up, stock dividend or combination of shares, the Plan Administrator shall make an appropriate and equitable adjustment in the number and kind of shares as to which all outstanding Options, or portions thereof then unexercised, shall be exercisable, to the end that after such event the Optionee's proportionate interest (vis-a-vis the other stockholders of the Company) shall be maintained as before the occurrence of such event. Such adjustment in an outstanding Option shall be made without change in the total price applicable to the Option or the unexercised portion of the Option (except for any change in the aggregate price resulting from rounding-off of share quantities or prices) and with any necessary corresponding adjustment in option price per share; provided, however, that, in the case of Incentive Stock Options, each such adjustment shall be made in such manner as not to constitute a "modification" within the meaning of Section 424(h) (3) of the Code. Any such adjustment made by the Primary Committee (or the Board) shall be final and binding upon all Optionees, the Company and all other interested persons. Section 4.7 - Merger, Consolidation, Exchange, Acquisition, Liquidation or - ----------- ------------------------------------------------------------ Dissolution - ----------- In its absolute discretion, and on such terms and conditions as it deems appropriate, the Plan Administrator may provide as part of the terms of the Option that such Option cannot be exercised after the merger or consolidation of the Company into another corporation, the acquisition by another corporation of all or substantially all of the Company's assets or eighty percent (80%) or more of the Company's then outstanding voting stock or the liquidation or dissolution of the Company; and if the Plan Administrator so provides, it may, in its absolute discretion and on such terms and conditions as it deems appropriate, also provide either by the terms of such Option or by a resolution adopted prior to the occurrence of such merger, consolidation, exchange, acquisition, liquidation or dissolution, that, for some period of time prior to such event, such Option shall be exercisable as to all shares covered thereby, notwithstanding anything to the contrary in Section 4.3(a), Section 4.3(b) and/or in any installment provisions of such Option. ARTICLE V EXERCISE OF DISCRETIONARY OPTIONS --------------------------------- Section 5.1 - Persons Eligible to Exercise - ----------- ---------------------------- During the lifetime of the Optionee, only he may exercise an Option granted to him, or any portion thereof. After the death of the Optionee, any exercisable portion of an Option may, prior to the time when such portion becomes unexercisable under Section 4.4 or Section 4.7, be -9- exercised by his personal representative or by any person empowered to do so under the deceased Optionee's Will or under the then applicable laws of descent and distribution. Section 5.2 - Partial Exercise - ----------- ---------------- At any time and from time to time prior to the time when any exercisable Option or exercisable portion thereof becomes unexercisable under Section 4.4 or Section 4.7, such Option or portion thereof may be exercised in whole or in part; provided, however, that the Company shall not be required to issue fractional shares and the Plan Administrator may, as part of the terms of the Option, require any partial exercise to be with respect to a specified minimum number of shares. Section 5.3 - Manner of Exercise - ----------- ------------------ An exercisable Option, or any exercisable portion thereof, may be exercised solely by delivery to the Secretary or his office of all of the following prior to the time when such Option or such portion becomes unexercisable under Section 4.4 or Section 4.7: (a) Notice in writing signed by the Optionee or other person then entitled to exercise such Option or portion, stating that such Option or portion is exercised, such notice complying with all applicable rules established by the Plan Administrator; and (b) Payment of the option price for the purchased shares in any of the following forms: (i) full payment in a cashiers' check or wire transfer payable to the Company's order; or (ii) full payment in shares of Common Stock held for the requisite period necessary to avoid a charge to the Company's reported earnings and valued at fair market value on the Exercise Date (as such term is defined below); or (iii) payment effected through a broker-dealer sale and remittance procedure pursuant to which the Optionee shall provide irrevocable written instruction (I) to the designated brokerage firm to effect the immediate sale of the purchased shares and to remit to the Company, out of the sale proceeds available on the settlement date, an amount equal to the aggregate option price payable for the purchased shares plus all applicable federal and state income and employment taxes required to be withheld by the Company in connection with such purchase and sale and (II) to the Company to deliver the certificates for the purchased shares directly to such brokerage firm in order to complete the sale transaction; or (iv) any combination of the consideration provided in the foregoing subsections (i), (ii) and (iii). -10- For purposes of this subsection 5.3(b), the Exercise Date shall be the date on which written notice of the Option exercise is received by the Company. Except to the extent the sale and remittance procedure is utilized in connection with the Option exercise, payment of the option price for the purchased shares must accompany such exercise notice; and (c) Such representations and documents as the Plan Administrator may, in its absolute discretion, deem necessary or advisable to effect compliance with all applicable provisions of the Securities Act of 1933, as amended, and any other federal or state securities laws or regulations. The Plan Administrator may, in its absolute discretion, also take whatever additional actions it deems appropriate to effect such compliance including, without limitation, placing legends on share certificates and issuing stop-transfer orders to transfer agents and registrars; and (d) In the event that the Option or portion thereof shall be exercised pursuant to Section 5.1 by any person or persons other than the Optionee, appropriate proof of the right of such person or persons to exercise the Option or portion thereof. Section 5.4 - Conditions to Issuance of Stock Certificates - ----------- -------------------------------------------- The shares of stock issuable and deliverable upon the exercise of an Option, or any portion thereof, may be either previously authorized but unissued shares or issued shares which have then been reacquired by the Company. The Company shall not be required to issue or deliver any certificate or certificates for shares of stock purchased upon the exercise of any Option or portion thereof prior to fulfillment of all of the following conditions: (a) The admission of such shares to listing on all stock exchanges on which such class of stock is then listed; and (b) The completion of any registration or other qualification of such shares under any state or federal law or under the rulings or regulations of the Securities and Exchange Commission or any other governmental regulatory body, which the Plan Administrator shall, in its absolute discretion, deem necessary or advisable; and (c) The obtaining of any approval or other clearance from any state or federal governmental agency which the Plan Administrator shall, in its absolute discretion, determine to be necessary or advisable; and (d) The payment to the Company of all amounts which it is required to withhold under federal, state or local law in connection with the exercise of the Option; and (e) The lapse of such reasonable period of time following the exercise of the Option as the Plan Administrator may establish from time to time for reasons of administrative convenience. -11- Section 5.5 - Rights as Stockholders - ----------- ---------------------- The holders of Options shall not be, nor have any of the rights or privileges of, stockholders of the Company in respect of any shares purchasable upon the exercise of any part of an Option unless and until certificates representing such shares have been issued by the Company to such holders. Section 5.6 - Transfer Restrictions - ----------- --------------------- The Plan Administrator, in its absolute discretion, may impose such restrictions on the transferability of the shares purchasable upon the exercise of the Option as it deems appropriate, and any such restriction shall be set forth in the respective Stock Option Agreement and may be referred to on the certificates evidencing such shares. The Plan Administrator may require an Optionee to give the Company prompt notice of any disposition of shares of stock, acquired by exercise of an Incentive Stock Option, within two (2) years from the date of granting such Option or one (1) year after the transfer of such shares to such Optionee. The Plan Administrator may direct that the certificates evidencing shares acquired by exercise of an Option refer to such requirement to give prompt notice of disposition. ARTICLE VI ADMINISTRATION -------------- Section 6.1 - Administration of Plan - ----------- ---------------------- The Plan shall be administered in accordance with the following standards: (a) The Discretionary Option Grant Program shall be administered by the Plan Administrator, which shall be the Board or, in the discretion of the Board, a Committee appointed by the Board and composed solely of two (2) or more Non-Employee Directors. Members of the Committee shall serve for such term as the Board may determine and shall be subject to removal by the Board at any time. Subject to the provisions of the Plan, the Plan Administrator shall have the sole and exclusive authority to grant Options under the Discretionary Option Grant Program, to accelerate the exercisability of such Options, and to make all determinations necessary or advisable for the administration of the Discretionary Option Grant Program. (b) The Plan Administrator shall have full power and authority (subject to the express provisions of the Plan) to establish such rules and regulations as it may deem appropriate for the proper administration of the Plan functions within the scope of its administrative authority and to make any and all determinations with respect to those functions which it may deem necessary or advisable. All decisions of the Plan Administrator taken in good faith and within the scope of its administrative authority under the Plan shall be final and binding on the Optionee, the Company and all other parties who have an interest in any outstanding Option granted pursuant to such authority. -12- (c) Administration of the Automatic Option Grant provisions of Article VII shall be self-executing in accordance with the express terms and conditions of such Article VII, and the Plan Administrator shall exercise no discretionary functions with respect to the Option grants made pursuant to such Article VII. Section 6.2 - Compensation; Professional Assistance; Good Faith Actions - ----------- --------------------------------------------------------- Individuals serving as Plan Administrator shall not receive compensation for their services as such, but all expenses and liabilities they incur in connection with the administration of the Plan shall be borne by the Company. The Plan Administrator may, with the approval of the Board, employ attorneys, consultants, accountants, appraisers, brokers or other persons. The Plan Administrator, together with the Company and its Officers and Directors, shall be entitled to rely upon the advice, opinions or valuations of any such persons. No individual serving as Plan Administrator shall be personally liable for any action, determination or interpretation made in good faith with respect to the Plan or the Options, and such individuals shall be fully protected by the Company with respect to any such action, determination or interpretation. ARTICLE VII AUTOMATIC OPTION GRANT PROGRAM ------------------------------ Section 7.1 - Eligible Optionees - ----------- ------------------ (a) Each individual serving as a non-Employee member of the Board at any time on or after November 9, 1992, shall be eligible to receive periodic automatic Option grants pursuant to the provisions of this Article VII. However, in no event will any non-Employee Board member be eligible to receive Option grants under this Article VII program, if such individual has previously served as an Employee of the Company or any Parent or Subsidiary corporation. (b) Except for the Option grants to be made pursuant to the provisions of this Article VII, non-Employee Board members shall not be eligible to receive any additional Option grants under this Plan. Section 7.2 - Grant Dates - ----------- ----------- Option grants will be made under this Article VII on the dates specified below: (i) On November 9, 1992, each individual who is at the time serving as a non-Employee member of the Board shall automatically be granted on that date a Non-Qualified Stock Option to purchase two thousand (2,000) shares of Common Stock upon the terms and conditions of this Article VII. (ii) On the second Monday of November of each subsequent year, commencing with the 1993 calendar year, each member of the Board shall automatically be granted on that date a Non-Qualified Stock Option to purchase two -13- thousand (2,000) shares of Common Stock upon the terms and conditions of this Article VII, or such other number of shares of Common Stock as may be fixed by the Board from time to time. There shall be no limit on the number of such share Option grants any one non-Employee Board member may receive over his period of service on the Board. The number of shares subject to each automatic Option grant (including grants to be made in the future) shall be subject to periodic adjustment pursuant to the applicable provisions of Section 4.7. Section 7.3 - Option Price - ----------- ------------ The option price per share shall be equal to one hundred percent (100%) of the fair market value per share of Common Stock on the automatic grant date. Section 7.4 - Payment - ----------- ------- The option price shall be payable in one of the alternative forms specified below: (i) full payment in a cashiers check or wire transfer payable to the Company's order; or (ii) full payment in shares of Common Stock held for the requisite period necessary to avoid a charge to the Company's reported earnings and valued at fair market value on the Exercise Date (as such term is defined below); or (iii) payment effected through a broker-dealer sale and remittance procedure pursuant to which the Optionee shall provide irrevocable written instructions (I) to the designated brokerage firm to effect the immediate sale of the purchased shares and to remit to the Company, out of the sale proceeds available on the settlement date, an amount equal to the aggregate option price payable for the purchased shares and (II) to the Company to deliver the certificates for the purchased shares directly to such brokerage firm in order to complete the sale transaction; or (iv) any combination of the consideration provided in the foregoing subsections (i), (ii), and (iii). For purposes of this subsection 7.4, the Exercise Date shall be the date on which written notice of the Option exercise is received by the Company. Except to the extent the sale and remittance procedure is utilized in connection with the Option exercise, payment of the option price for the purchased shares must accompany such exercise notice. Section 7.5 - Option Term - ----------- ----------- Each automatic grant under this Article VII shall have a maximum term of ten (10) years measured from the automatic grant date. -14- Section 7.6 - Exercisability - ----------- -------------- Each automatic Option shall become exercisable for the Option shares one (1) year after the grant date. Section 7.7 - Termination of Board Service - ----------- ---------------------------- (a) Should the Optionee cease service as a Board member for any reason while holding one or more automatic Option grants under this Article VII, then such options granted hereunder not exercised by the Board member at the time of termination of Board membership, shall terminate and cease to be exercisable as of such date. (b) In no event shall any automatic grant under this Article VII remain exercisable after the specified expiration date of the ten (10) year Option term. Upon the expiration of the applicable exercise period in accordance with subparagraph (a) above or (if earlier) upon the expiration of the ten (10) year Option term, the automatic Option grant shall terminate and cease to be exercisable. Section 7.8 - Stockholder Rights - ----------- ------------------ The holder of an automatic Option grant under this Article VII shall have no stockholder rights with respect to any shares covered by such Option until such individual shall have exercised the Option, paid the option price for the purchased shares and been issued a stock certificate for such shares. Section 7.9 - Corporate Transaction - ----------- --------------------- In the event of any of the following stockholder-approved transactions to which the Company is a party (a "Corporate Transaction"): any merger or consolidation of the Company into another corporation, the acquisition by another corporation of all or substantially all of the Company's assets or the liquidation or dissolution of the Company, the exercisability of each automatic Option grant at the time outstanding under this Article VII shall automatically accelerate so that each such option shall, immediately prior to the specified effective date for the Corporate Transaction, become fully exercisable with respect to the total number of shares of Common Stock at the time subject to such Option and may be exercised for all or any portion of such shares. Upon the consummation of the Corporate Transaction, all automatic Option grants under this Article VII shall terminate and cease to be outstanding. Section 7.10 - Change in Control - ------------ ----------------- In connection with any Change in Control of the Company, the exercisability of each automatic Option grant at the time outstanding under this Article VII shall automatically accelerate so that each such Option shall, immediately prior to the specified effective date for the Change in Control, become fully exercisable with respect to the total number of shares of Common Stock at -15- the time subject to such Option and may be exercised for all or any portion of such shares. For purposes of this Article VII, a Change in Control shall be deemed to occur when any person or related group or persons (other than the Company or a person that directly or indirectly controls, is controlled by, or is under common control with, the Company) directly or indirectly acquires beneficial ownership [within the meaning of Rule 13d-3 of the Securities Exchange Act of 1934, as amended (the "1934 Act")] of securities possessing more than eighty percent (80%) of the total combined voting power of the Company's outstanding securities pursuant to a tender or exchange offer made directly to the Company's stockholders which the Board does not recommend such stockholders to accept. The shares of Common Stock subject to each Option surrendered in connection with the Change in Control shall not be available for subsequent issuance under this Plan. The automatic Option grants outstanding under this Article VII shall in no way affect the right of the Company to adjust, reclassify, reorganize or otherwise change its capital or business structure or to merge, consolidate, dissolve, liquidate or sell or transfer all or any part of its business or assets. Section 7.11 - Remaining Terms - ------------ --------------- The remaining terms and conditions of each automatic Option grant shall be as set forth in the prototype Directors Automatic Option Grant Agreement. Section 7.12 - Amendment of the Automatic Grant Provisions - ------------ ------------------------------------------- The provisions of this Automatic Option Grant Program, including any automatic Option grants outstanding under this Article VII, may not be amended at intervals more frequently than once every six (6) months, other than to the extent necessary to comply with applicable federal income tax laws and regulations. ARTICLE VIII MISCELLANEOUS PROVISIONS ------------------------ Section 8.1 - Options Not Transferable - ----------- ------------------------ During the lifetime of the Optionee, Options granted under either the Discretionary Option Grant Program or the Automatic Option Grant Program (and any stock appreciation rights attaching thereto) shall be exercisable only by the Optionee and shall not be assignable or transferable by the Optionee other than by a transfer of the Option effected by the Optionee's will or by the laws of descent and distribution following the Optionee's death. Accordingly, except for such permitted transfer, the Option (or any interest or right therein or part thereof) shall not be subject to disposition by transfer, alienation, anticipation, pledge, encumbrance, assignment or any other means whether such disposition be voluntary or involuntary or by operation of law by -16- judgment, levy, attachment, garnishment or any other legal or equitable proceedings (including bankruptcy), and any such attempted disposition thereof shall be null and void and of no effect. Section 8.2 - Amendment, Suspension or Termination of the Plan - ----------- ------------------------------------------------ (a) The Plan may be wholly or partially amended or otherwise modified, suspended or terminated at any time or from time to time by the Board; provided, however, that (I) no such amendment or modification shall, without the consent of the Option holders, adversely affect their rights and obligations under their Options and (II) any amendment to the Automatic Option Grant program shall be effected in compliance with the limitations of Section 7.12. In addition, the Board shall not, without the approval of the Company's stockholders, (i) materially increase the maximum number of shares issuable under the Plan, except for permissible adjustments under Section 2.3, (ii) materially modify the eligibility requirements for the grant of Options under the Plan, (iii) materially increase the benefits accruing to participants under the Plan or (iv) increase the maximum number of shares for which Automatic Option Grants may be periodically made pursuant to the provisions of Article VII. (b) No Option may be granted during any period of suspension nor after termination of the Plan, and in no event may any Option be granted under this Plan after the earlier of the following events: (i) December 31, 2006; or (ii) the date on which all shares available for issuance under the Plan shall have been issued or canceled pursuant to the exercise or surrender of the Options granted hereunder. If the date of termination is determined under clauses (i) above, then options outstanding on such date shall thereafter continue to have force and effect in accordance with the provisions of the instruments evidencing such options. Section 8.3 - Effective Date of Plan - ----------- ---------------------- (a) The Plan was initially adopted by the Board on April 25, 1984, and approved by the Company's stockholders on May 22, 1984. On November 9, 1992, the Board approved a restatement of the Plan, effective as of such date, to (i) increase the number of shares of Common Stock reserved for issuance under the Plan by an additional 450,000 shares, (ii) bring the Plan in compliance with the applicable requirements of SEC Rule 16b-3, as amended May 1, 1991, under the 1934 Act, (iii) revise the Incentive Stock Option provisions of the Plan to conform to applicable changes in the federal tax laws, (iv) establish the Automatic Option Grant Program for non-Employee Board members and (v) extend the term of the Plan to December 31, 2002. The November 1992 restatement was approved by the Company's stockholders on May 26, 1993. On February 7, 1997, the Board approved an Amendment to the Plan, effective as of such date, to (i) increase the number of shares of Common Stock reserved for issuance under the Plan by an additional 500,000 shares, and (ii) extend the term of the Plan to December 31, 2006. The February -17- 1997 Amendment will be submitted to stockholder approval at the 1997 Annual Meeting and no options granted on the basis of the 500,000 share increase shall become exercisable in whole or in part unless and until such stockholder approval shall have been obtained at the 1997 Annual Meeting. The November 1992 restatement shall apply only to options granted under the Plan from and after the November 9, 1992, effective date. Each option issued and outstanding under the Plan immediately prior to such effective date shall continue to be governed by the terms and conditions of the Plan (and the instrument evidencing such option) as in effect on the date such option was previously granted, and nothing in the November 1992 restatement shall be deemed to affect or otherwise modify the rights or obligations of the holders of such options with respect to the acquisition of shares of Common Stock thereunder. (b) The sale and remittance procedure for the exercise of outstanding options shall be available for all options granted under the Plan after November 9, 1992, and for all Non-Qualified Stock Options outstanding under the Plan on such date. The Plan Administrator may also allow such procedure to be utilized in connection with one or more disqualifying dispositions of Incentive Stock Option shares effected after such date. (c) Options may be granted under this Plan to purchase shares of Common Stock in excess of the number of shares then available for issuance under the Plan, provided (i) an amendment to increase the maximum number of shares issuable under the Plan is adopted by the Board prior to the initial grant of any such option and is thereafter submitted to the Company's stockholders for approval and (ii) each option so granted is not to become exercisable, in whole or in part, at any time prior to the obtaining of such stockholder approval. Section 8.4 - Effect of Plan Upon Other Options and Compensation Plans - ----------- -------------------------------------------------------- The adoption of this Plan shall not affect any other compensation or incentive plans in effect for the Company or any Parent or Subsidiary corporation. Nothing in this Plan shall be construed to limit the right of the Company or any Parent or Subsidiary corporation (a) to establish any other forms of incentives or compensation for employees of the Company or any Parent or Subsidiary corporation or (b) to grant or assume options otherwise than under this Plan in connection with any proper corporate purpose, including, but not by way of limitation, the grant or assumption of options in connection with the acquisition by purchase, lease, merger, consolidation or otherwise, of the business, stock or assets of any corporation, firm or association. Section 8.5 - Titles - ----------- ------ Titles are provided herein for convenience only and are not to serve as a basis for interpretation or construction of the Plan. -18- EX-10.12 3 EMPLOYMENT AGREEMENT EXHIBIT 10.12 EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement") is entered into as of January 6, 1997, by and between Safeguard Health Enterprises, Inc., a Delaware Corporation ("Company") and Herb Kaufman, D.D.S. ("Employee"). The Company desires to have the benefits of Employee's knowledge and experience as a full-time employee and considers such employment a vital element to protecting and enhancing the best interests of the Company, and Employee desires to be employed full time by the Company. The Company and Employee desire to enter into an agreement reflecting the terms under which the Company will employ Employee as its Senior Vice President-Chief Dental Officer ("SVP") until January 5, 2002. Therefore, the Company and Employee agree to the following terms and conditions under which Employee will serve as SVP of the Company: 1. EMPLOYMENT SERVICES AND DUTIES The Company agrees to employ and retain the services of Employee as SVP and Employee hereby agrees to continue employment with the Company as its SVP for the term of this Agreement. During the term of this Agreement, Employee agrees to perform his duties as SVP faithfully, to the best of his ability and in the best interests of the Company, to perform both his regular duties and other projects as requested by the Board of Directors, the Chief Executive Officer and the Chief Operating Officer of the Company, and assume such other additional reasonable duties or capacities as the Board of Directors, the Chief Executive Officer and the Chief Operating Officer of the Company may provide. 2. TERM OF EMPLOYMENT The Company agrees to employ Employee, and Employee agrees to serve, as SVP for the period commencing with the effective date of this Agreement until the earlier of January 5, 2002, the date of Employee's death, or the date of termination pursuant to Sections 6 and 7 of this Agreement. 3. COMPENSATION TERMS The Company agrees to compensate Employee for his services rendered as SVP under this Agreement as follows: (a) Base Salary. Effective January 6, 1997, and for the remainder of ------------ the term of employment, Employee shall receive a base salary of $155,000 per year. -1- (b) Bonuses. Employee shall receive such bonuses, if any, as -------- determined by the appropriate committee of the Board of Directors of the Company, in its sole and absolute discretion. (c) Benefits. Subject to satisfaction of all eligibility --------- requirements, Employee and his dependents shall be entitled to and shall receive any and all benefits generally available to executive employees of the Company, including participation in health, dental, vision and life insurance programs and retirement plans. (d) Indemnification. The Company shall indemnify Employee in ---------------- accordance with the terms and conditions of its then current indemnification agreements with directors and/or officers of the Company. 4. EXPENSES (a) Business Expenses. The Company authorizes Employee to incur the ------------------ reasonable and necessary expenses for promoting the business of the Company and its subsidiaries according to the policies of the Company with respect thereto and as may be determined from time to time by the Board of Directors of the Company. The Company agrees to reimburse Employee for any such reasonable and necessary expenses paid out of Employee's own fund. The Company also agrees to reimburse Employee for all reasonable professional dues and licensing fees required of Employee in connection with Employee's license to practice dentistry. (b) Transportation. During the term of this Agreement, the Company --------------- shall furnish to Employee an automobile, or an automobile expense allowance of not less than $650 per month and a cellular telephone allowance of not less than $100 per month, as may be determined by the Company's Chief Operating Officer. During such time when the Company furnishes an automobile to Employee, the Company shall be responsible for the insurance and non-routine expenses associated with the operation of the automobile and the Employee shall be responsible for gasoline, oil and routine expenses for such automobile. 5. VACATION Unless otherwise agreed to orally or by written agreement between Employee and the Company, Employee shall be entitled to four weeks of paid vacation during any fiscal year. Such vacation may be taken at such times as are mutually agreed upon by Employee and the Company, and pursuant to the Company's vacation policy then in effect. -2- 6. TERMINATION BY COMPANY (a) Termination. The Company may terminate Employee for "Cause." ------------ (b) "Cause" shall mean: ------- (i) The failure of Employee to render services to the Company in accordance with his employment duties, as determined by all of the independent directors of the Company's Board of Directors; (ii) The commission by Employee of an act of fraud or embezzlement against Company or an act which Employee knew to be in violation of his duties to the Company (including, but not limited to, the unauthorized disclosure of confidential information); (iii) The death or "permanent disability" of Employee. Permanent disability shall occur if, during the term of this Agreement, Employee becomes physically or mentally disabled such that he is substantially unable to perform his duties hereunder and such disability continues for six (6) continuous months; or (iv) Good cause as determined by all of the independent directors of the Company's Board of Directors to be a material breach justifying termination of Employee. (c) Notice of Termination. Any termination of Employee by the Company ---------------------- shall be communicated by a written Notice of Termination to Employee. For purposes of this Agreement, a Notice of Termination shall specify the termination provision of this Agreement relied upon to effect such termination and shall set forth in reasonable detail the specific facts and circumstances claimed to provide a basis for termination of Employee. 7. TERMINATION BY EMPLOYEE (a) Termination. Upon thirty (30) days advance written notice ------------ delivered to the Company, Employee may terminate his employment with the Company; or upon written notice delivered to the Company in accordance with Section 6(c), Employee may terminate his employment hereunder for "Good Reason" as is herein defined. (b) "Good Reason" means; ------------- (i) the occurrence of a "Change in Control" of the Company (as defined herein); -3- (ii) a failure by the Company to comply with any material provision of this Agreement that has not been cured within thirty (30) days after notice of such noncompliance has been given by Employee to the Company; or (iii) any purported termination of Employee's employment which is not effected pursuant to a Notice of Termination as set forth in Paragraph 6(c). (c) "Change in Control" occurs if (i) substantially all the assets of ----------------- the Company are sold to, or the Company is merged with, any "person," as that term is used in Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934, other than a then existing shareholder or group of shareholders of the Company (or affiliate thereof) owning fifty percent (50%) or more of the combined voting power of the Company's then outstanding securities, or (ii) any person or group becomes or is discovered to be a beneficial owner (as defined in Rule 13d-3 under the Exchange Act as in effect on the date hereof) directly of securities of the Company representing twenty-five percent (25%) or more of the combined voting power of Company's then outstanding securities (unless such person or group owns at least twenty-five percent (25%) of such voting power on the effective date of this Agreement), and in connection with such change in ownership the individuals who constitute the Board of Directors of Company immediately prior to such change cease to constitute at least a majority of the Board of Directors thereafter. 8. PAYMENT UPON TERMINATION (a) Date. The "Termination Date" shall be the effective date ----- specified in the Notice of Termination as provided for in Paragraphs 6(c) or 7(a). (b) Termination by Company. In the event the Company terminates ----------------------- Employee pursuant to Paragraphs 6(b)(i), 6(b)(ii), or 6(b)(iv), the Company shall pay to Employee his full salary through the Termination Date after which the Company shall have no further obligation to Employee under this Agreement. (c) Death. The Company shall maintain a life insurance policy owned ------ by the Employee which provides for payment to Employee's estate or designated beneficiary, a death benefit of $100,000. (d) Permanent Disability. In the event the Company terminates --------------------- Employee due to permanent disability pursuant to Paragraph 6(b)(iii), the Company shall pay to Employee fifty percent (50%) of Employee's annual salary then in effect, payable in equal amounts over a period of six (6) months following termination. Such payments shall begin no later than thirty (30) days following the Termination Date. -4- (e) Wrongful Termination or Termination by Employee for Good Reason. -------------------- ----------------------------------------- If, in breach of this Agreement, the Company terminates Employee's employment other than pursuant to Section 6 (it being understood that a termination purported to be pursuant to Section 6 hereof which is disputed by Employee and finally determined not to have been proper, shall be a termination by the Company in breach of this Agreement) or if Employee terminates his employment for Good Reason, then; (i) The Company shall pay Employee his full salary through the Termination Date at the rate in effect at the time the Notice of Termination is given; and (ii) In lieu of any further compensation payments to Employee for periods subsequent to the Termination Date, the Company shall pay as severance pay to Employee an amount equal to one (1) times Employee's average total compensation for the five (5) full taxable years preceding the Change in Control, as applicable, as determined in accordance with the "parachute payments" provisions of the Internal Revenue Code in effect on the date of this Agreement. If resulting from a termination based on a Change in Control of the Company, such payments shall be made in a lump sum on or before the thirtieth (30th) day following the Termination Date. If resulting from any other cause, such payments shall be made in substantially equal semimonthly installments on the fifteenth and last days of each month commencing with the month in which the Termination Date occurs and continuing for twenty-four (24) consecutive semimonthly payment dates (including the first such date as aforesaid); and (iii) If termination of Employee's employment arises out of a breach by the Company of this Agreement, the Company shall pay all other damages to which Employee may be entitled as a result of such breach, including damages for any and all loss of benefits to Employee under the Company's employee benefit plans that Employee would have received if the Company had not breached this Agreement and had Employee's employment continued for the full term as set forth in Section 2 and including all legal fees and expenses incurred by Employee as a result of such termination including, but not limited to, all such fees expended in enforcement of this Agreement. If Employee resigns for Good Reason and the Company contests its obligations, as hereunder, Employee shall be entitled to recover as damages the amount of his legal fees and expenses, including costs of investigation, related to his enforcement of the Agreement. (f) No Duty to Mitigate. Employee shall not be required to mitigate -------------------- the amount of any payment provided for in this Agreement by seeking other employment or otherwise. -5- 9. SEVERABILITY The provisions of this Agreement are severable. If a court of competent jurisdiction determines that any one or more provisions of this Agreement is invalid, void, or unenforceable, in whole or in part, it will be severed therefrom. The remaining provisions of this Agreement shall then continue in full force without being impaired or invalidated in any way. 10. ASSIGNMENT; BINDING EFFECT (a) Assignability. This Agreement may be assigned by the Company to -------------- any successor to all or substantially all of the business and/or assets of the Company. (b) Company's Obligation Upon Assignment or Succession. The Company --------------------------------------------------- shall require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and/or assets of the Company or assignee of this Agreement, by agreement in form and substance satisfactory to Employee, to expressly assume and agree to perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession had taken place. Failure of the Company to obtains such agreement prior to the effectiveness of any such succession or assignment shall be a breach of this Agreement and shall entitle Employee to compensation from the Company in the same amount and on the same terms as he would be entitled to hereunder if he terminated his employment for Good Reason, except that for purposes of implementing the foregoing, the date on which any such succession becomes effective shall be deemed the Termination Date. As used in this Agreement, "Company" shall mean the Company as herein before defined and any successor to its business and/or assets as aforesaid which executes and delivers the agreement provided for in this Section 10, or which otherwise becomes bound by all the terms and provision of this Agreement by operations of law. (c) Successors and Assigns. This Agreement shall inure to the benefit ----------------------- of and be binding on the parties and their respective successors and assigns. If Employee should die while any amounts would still be payable to him hereunder if he had continued to live, all such amounts, unless otherwise provided for herein, shall be paid in accordance with the terms of this Agreement to Employee's devisee, legatee, or other designee or, if there be no such designee, to Employee's estate. -6- 11. CONFIDENTIAL INFORMATION Employee agrees that he shall not, during the term of this Agreement, and for a period of five (5) years following its termination, absent the Company's consent, disclose to any person, or otherwise use or exploit any non- public proprietary or confidential information of material significance to the Company and/or its affiliates, including without limitation trade secrets, customer lists, records of research, memoranda, proposals, reports, methods, processes, techniques, non-public financial information, contracts, negotiations, business plans and strategies, marketing data or other non-public information regarding the Company and/or any of its affiliates, their business, properties or affairs ("Confidential Information") obtained by him at any time prior to or subsequent to the execution of this Agreement, except to the extent required by his performance of his assigned duties for the Company (including its affiliates). Upon termination of employment, Employee shall surrender all Confidential Information and all other property belonging to the Company and its subsidiaries, it being understood by Employee that such documents are the sole property of the Company and that Employee shall not make any copies thereof. Additionally, the terms and conditions of this Agreement shall constitute Confidential Information and shall not be disclosed by Employee except in accordance with this Section 11. 12. CONFLICTING INVESTMENTS During the term of this Agreement and for one (1) year after termination of this Agreement, Employee shall not make or cause to be made on his behalf, or maintain an investment in any business which is engaged, either in whole or in part, in any business which is competitive with or detrimental to any businesses of the Company, or its subsidiaries, except that Employee may make or maintain an investment of no more than five percent (5%) of any outstanding class of capital stock of any publicly traded company, provided such class of capital stock is regularly traded by the public, without prior written permission of the Company. 13. ENTIRE AGREEMENT This Agreement constitutes the entire understanding between the parties concerning the subject matter hereof. This Agreement supersedes all negotiations, prior discussions, and preliminary agreements. This Agreement may not be amended except in a writing executed by the Employee and the Company. 14. GOVERNING LAW This Agreement shall be governed by and construed in accordance with the laws of the State of California, regardless of the application of conflicts of laws principles. -7- 15. NOTICES All notices, requests, demands and other communication required or contemplated under this Agreement, shall be in writing and shall be deemed to have been duly given when delivered personally or when enclosed in a properly sealed and addressed envelope, registered or certified, return receipt requested, and deposited (postage prepaid) in a post office or branch post office regularly maintained by the United States Government. Any notice given to the Company under the terms of this Agreement shall be addressed to the Company at the following address: Safeguard Health Enterprises, Inc. Attention: Secretary 505 North Euclid Street P.O. Box 3210 Anaheim, California 92803-3210 Any notice to be given to Employee shall be addressed to him at his home address last shown on the Company's records, or at such other address as either party may hereafter designate in writing to the other. 16. WAIVER No waiver of any of the provisions of this Agreement shall be deemed, or shall constitute, a waiver of any other provision, whether or not similar, nor shall any waiver constitute a continuing waiver. No waiver shall be binding unless executed in writing by the party making the waiver. 17. COUNTERPARTS This Agreement may be executed in counterparts, and such counterparts may be transmitted by facsimile, and all counterparts, taken together, will constitute one and the same document. 18. ARBITRATION Any dispute regarding any aspect of this Agreement or any act that allegedly has or would violate any provision of this Agreement must be submitted to arbitration in Orange County, California, in accordance with the rules of the Judicial Arbitration and Mediations Service ("JAMS") as the exclusive remedy for such claim or dispute. Either party may invoke this clause by serving on the other, in writing, a request to arbitrate. -8- Within thirty (30) days thereafter, either party may institute proceedings in superior court to enforce this clause by way of reference pursuant to Section 638 of the California Code of Civil Procedure. If the parties cannot mutually select a judge from the JAMS panel, the superior court shall make the selection. The decision of JAMS will be final and binding. If Employee alleges in good faith that he has resigned for Good Reason, then the Company is required to advance to him any amounts necessary for legal fees and expenses, including costs of investigation, related to the dispute, subject to the Company's receipt of his undertaking to repay such amounts if it is ultimately determined by JAMS that he is not entitled to keep such amounts as damages under Section 8(e)(iii). IN WITNESS WHEREOF, the parties have duly executed this Agreement effective January 6, 1997. EMPLOYEE SAFEGUARD HEALTH ENTERPRISES, INC. /s/ HERB KAUFMAN, D.D.S. By: /s/ JOHN E. COX - ------------------------ ------------------------------ HERB KAUFMAN, D.D.S. JOHN E. COX Executive Vice President and Chief Operating Officer By: /s/ RONALD I. BRENDZEL, J.D. ---------------------------- RONALD I. BRENDZEL, J.D. Senior Vice President and Secretary
-9- EX-18.0 4 INDEPENDENT AUDITORS PREFERABILITY LETTER EXHIBIT 18.0 Independent Auditors' Preferability Letter for Change in Accounting Method March 28, 1997 Safeguard Health Enterprises, Inc. 505 North Euclid Street Anaheim, California 92803 Gentlemen: We have audited the consolidated financial statements of Safeguard Health Enterprises, Inc. as of December 31, 1996 and 1995, and for each of the three years in the period ended December 31, 1996 included in your Annual Report on Form 10-K to the Securities and Exchange Commission and have issued our report thereon dated March 28, 1997. Note 1 to such consolidated financial statements contains a description of your change during the year ended December 31, 1996 of accounting for recognizing revenue relating to providing orthodontic health care services. In our judgment, such change is to an alternative accounting principle that is preferable under the circumstances. /s/ DELOITTE & TOUCHE LLP Costa Mesa, California EX-23.1 5 INDEPENDENT AUDITORS CONSENT 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 March 28, 1997, appearing in this Annual Report on Form 10-K of Safeguard Health Enterprises, Inc. for the year ended December 31, 1996. /s/ Deloitte & Touche LLP Costa Mesa, California March 28, 1997 EX-27 6 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM STATEMENTS OF FINANCIAL POSITION AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR YEAR DEC-31-1996 DEC-31-1995 JAN-01-1996 JAN-01-1995 DEC-31-1996 DEC-31-1995 706 506 9,101 14,240 6,906 3,679 531 260 210 205 23,751 23,576 23,568 20,833 11,727 10,612 67,716 38,343 11,233 5,941 19,086 0 0 0 0 0 21,255 21,092 13,945 10,837 67,716 38,343 80,990 67,082 81,974 68,368 59,566 49,743 75,858 63,194 0 0 615 278 485 0 5,631 5,174 2,218 1,968 3,413 3,206 (1,185) (818) 0 0 824 0 3,052 2,388 0.62 0.51 0.62 0.51
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