-----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, BEziwQUrgNF+YodZaf7F9Ne0/pRUHj9nRy6T9TXtzT40xBx/wpRGFK00T5innh98 i+ixlwO5LGl899SAiIYBfA== 0000950144-02-007327.txt : 20020712 0000950144-02-007327.hdr.sgml : 20020711 20020711160906 ACCESSION NUMBER: 0000950144-02-007327 CONFORMED SUBMISSION TYPE: S-4/A PUBLIC DOCUMENT COUNT: 16 FILED AS OF DATE: 20020711 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PMR CORP CENTRAL INDEX KEY: 0000829608 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-SPECIALTY OUTPATIENT FACILITIES, NEC [8093] IRS NUMBER: 232491707 STATE OF INCORPORATION: DE FISCAL YEAR END: 0430 FILING VALUES: FORM TYPE: S-4/A SEC ACT: 1933 Act SEC FILE NUMBER: 333-90372 FILM NUMBER: 02701156 BUSINESS ADDRESS: STREET 1: 501 WASHINGTON ST 5TH FL CITY: SAN DIEGO STATE: CA ZIP: 92103 BUSINESS PHONE: 6192952227 MAIL ADDRESS: STREET 1: 3990 OLD TOWN AVENUE SUITE 206A CITY: SAN DIEGO STATE: CA ZIP: 92110 FORMER COMPANY: FORMER CONFORMED NAME: ZARON CAPITAL INC DATE OF NAME CHANGE: 19891116 S-4/A 1 g76727a1sv4za.txt PMR CORPORATION AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JULY 11, 2002. REGISTRATION NO. 333-90372 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- AMENDMENT NO. 1 TO FORM S-4 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 --------------------- PMR CORPORATION (Exact name of registrant as specified in its charter) DELAWARE 8093 23-2491707 (State or other jurisdiction (Primary Standard Industrial (I.R.S. Employer of incorporation or organization) Classification Code Number) Identification Number)
--------------------- 1565 HOTEL CIRCLE SOUTH, 2ND FLOOR, SAN DIEGO, CALIFORNIA 92108, (619) 610-4001 (Address, including zip code, and telephone number, including area code, of registrant's principal executive offices) --------------------- FRED D. FURMAN PRESIDENT AND GENERAL COUNSEL, PMR CORPORATION 1565 HOTEL CIRCLE SOUTH, 2ND FLOOR, SAN DIEGO, CALIFORNIA 92108 (619) 610-4001 (Name, address, including zip code, and telephone number, including area code, of agent for service) --------------------- COPIES TO: THOMAS P. MASON, ESQ. LEE C. DILWORTH, ESQ. VINSON & ELKINS L.L.P. SUSAN V. SIDWELL, ESQ. THE TERRACE 7 HARWELL HOWARD HYNE GABBERT & MANNER, P.C. 2801 VIA FORTUNA, SUITE 100 315 DEADERICK STREET, SUITE 1800 AUSTIN, TEXAS 78746 NASHVILLE, TENNESSEE 37238 (512) 542-8400 (615) 256-0500
--------------------- APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as practicable after the registration statement becomes effective and the effective time of the proposed merger as described in the enclosed joint proxy statement/prospectus. --------------------- If the securities being registered on this Form are being offered in connection with the formation of a holding company and there is compliance with General Instruction G, check the following box. [ ] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] --------------------- THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE SECURITIES AND EXCHANGE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(a), MAY DETERMINE. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (PMR CORPORATION LOGO) (PSI LOGO) PROPOSED MERGER -- YOUR VOTE IS VERY IMPORTANT Dear stockholders: The boards of directors of PMR Corporation, a Delaware corporation, and Psychiatric Solutions, Inc., a Delaware corporation, have approved a merger between Psychiatric Solutions and a wholly-owned subsidiary of PMR. The merger agreement, as amended, provides for the merger of PMR Acquisition Corporation, a Delaware corporation and a wholly-owned subsidiary of PMR, with and into Psychiatric Solutions, pursuant to which: - each outstanding share of Psychiatric Solutions common stock will be converted into the right to receive 0.115125 shares of common stock of PMR; - each outstanding share of Psychiatric Solutions Series A preferred stock will be converted into the right to receive 0.246951 shares of common stock of PMR; and - each outstanding share of Psychiatric Solutions Series B preferred stock will be converted into the right to receive 0.312864 shares of common stock of PMR. In connection with and as a condition to the proposed merger, PMR is also proposing an amendment to its charter in order to effect a 1-for-3 reverse stock split. The foregoing exchange ratios give effect to this proposed reverse stock split. Except for the effect of the reverse stock split, each outstanding share of PMR common stock will remain outstanding as a share of PMR common stock. Psychiatric Solutions stockholders will have dissenters' rights under Delaware law in connection with the merger. After giving effect to the exercise of all outstanding options and warrants of Psychiatric Solutions into shares of PMR common stock following the merger, PMR and Psychiatric Solutions stockholders will own, respectively, approximately 28% and 72% of the common stock of PMR upon the completion of the merger. On May 3, 2002, the last full trading day prior to the public announcement of the proposed merger, PMR common stock closed at $2.38 per share, without giving effect to the reverse stock split. On July 10, 2002, the last trading day prior to the date of this joint proxy statement/prospectus, PMR common stock closed at $1.96 per share, without giving effect to the reverse stock split. PMR stockholders and Psychiatric Solutions stockholders are urged to obtain current market quotations for PMR common stock prior to making any decision with respect to the merger. The boards of directors of PMR and Psychiatric Solutions have unanimously determined that the merger is in the best interest of their stockholders, and each board recommends voting "FOR" approval of the merger agreement, as amended, and the transactions contemplated by the merger agreement. THE MERGER CANNOT BE COMPLETED UNLESS THE STOCKHOLDERS OF BOTH COMPANIES APPROVE THE MERGER AGREEMENT, AS AMENDED, AND THE PMR STOCKHOLDERS APPROVE AN AMENDMENT TO PMR'S CHARTER TO (I) INCREASE THE NUMBER OF AUTHORIZED SHARES OF PMR COMMON STOCK TO FACILITATE THE ISSUANCE OF PMR COMMON STOCK IN CONNECTION WITH THE MERGER, (II) EFFECT THE 1-FOR-3 REVERSE STOCK SPLIT, AND (III) CHANGE THE NAME OF PMR TO "PSYCHIATRIC SOLUTIONS, INC." WE HAVE EACH SCHEDULED SPECIAL MEETINGS FOR OUR STOCKHOLDERS TO VOTE ON THE MERGER AGREEMENT AND RELATED MATTERS. YOUR VOTE IS VERY IMPORTANT. You are cordially invited to attend the special meeting of stockholders of your respective company. In the material accompanying this letter, you will find a notice of special meeting of stockholders, the joint proxy statement/prospectus and a proxy card to allow you to vote your shares. We urge you to read carefully the joint proxy statement/prospectus which more fully describes the merger agreement, the merger and the transactions contemplated by the merger agreement. A copy of the merger agreement as amended is attached as Annex A to the joint proxy statement/prospectus. The date, times and places of the special meetings are as follows: For PMR stockholders: For Psychiatric Solutions stockholders: 9:00 a.m. local time, on Thursday, August 10:00 a.m. local time, on Thursday, August 5, 2002 5, 2002 PMR Corporation Harwell Howard Hyne Gabbert & Manner, P.C. 1565 Hotel Circle South, 2nd Floor 315 Deaderick Street, Suite 1800 San Diego, California 92108 Nashville, Tennessee 37238
WHETHER OR NOT YOU PLAN TO ATTEND YOUR COMPANY'S SPECIAL MEETING, IT IS IMPORTANT THAT YOU VOTE. PLEASE COMPLETE, SIGN, DATE AND RETURN THE PROXY CARD IN THE ENCLOSED POSTAGE-PAID ENVELOPE. If you attend the special meeting, you may vote in person, if you wish, even if you previously returned your proxy card. This document is a prospectus of PMR relating to the issuance of PMR common stock in connection with the merger and a proxy statement for both PMR and Psychiatric Solutions to use in soliciting proxies for our special stockholder meetings. It contains answers to frequently asked questions and a summary description of the merger (beginning on page 1), followed by a more detailed discussion of the merger and related matters. You should also review the "Risk Factors" beginning on page 31. We urge you to read this entire document carefully. /s/ Fred D. Furman /s/ Joey A. Jacobs Fred D. Furman Joey A. Jacobs President and General Counsel President and Chief Executive Officer PMR Corporation Psychiatric Solutions, Inc.
This joint proxy statement/prospectus is dated July 11, 2002, and is being first mailed to stockholders on or about July 12, 2002. PMR CORPORATION 1565 Hotel Circle South, 2nd Floor San Diego, California 92108 NOTICE OF SPECIAL MEETING OF STOCKHOLDERS TO BE HELD ON AUGUST 5, 2002 To the Stockholders of PMR Corporation: A special meeting in lieu of an annual meeting of the holders of common stock of PMR Corporation, a Delaware corporation ("PMR"), will be held at 9:00 a.m. local time, on Monday, August 5, 2002 at PMR Corporation, 1565 Hotel Circle South, 2nd Floor, San Diego, California 92108. At the PMR special meeting, the holders of common stock of PMR will: 1. Consider and vote upon a proposal to approve and adopt the Agreement and Plan of Merger, dated as of May 6, 2002, by and between Psychiatric Solutions, Inc., a Delaware corporation, PMR and PMR Acquisition Corporation, a Delaware corporation and a wholly-owned subsidiary of PMR ("Merger Sub"), as amended by Amendment No. 1 to Agreement and Plan of Merger dated as of June 10, 2002, and by Amendment No. 2 to Agreement and Plan of Merger dated as of July 9, 2002, pursuant to which, among other things, Merger Sub will merge with and into Psychiatric Solutions, Merger Sub will cease to exist and Psychiatric Solutions will survive as a wholly-owned subsidiary of PMR; 2. Consider and vote upon a proposal to approve and adopt an amendment to PMR's charter to (a) increase the number of authorized shares of PMR common stock to facilitate the issuance of PMR common stock in connection with the merger, (b) provide for a 1-for-3 reverse stock split of PMR common stock prior to the closing of the merger, and (c) change the name of PMR to "Psychiatric Solutions, Inc."; and 3. Transact any other business that may properly come before the special meeting or any adjournments of the special meeting. The board of directors has fixed the close of business on July 1, 2002, as the record date for determining which stockholders are entitled to notice of, and to vote at, the special meeting or any adjournments of the special meeting. THE BOARD OF DIRECTORS OF PMR UNANIMOUSLY RECOMMENDS THAT YOU VOTE "FOR" THE APPROVAL AND ADOPTION OF THE MERGER AGREEMENT, AS AMENDED, AND "FOR" THE PROPOSED AMENDMENT TO THE CHARTER. The affirmative vote of the holders of a majority of the outstanding shares of PMR common stock is required to approve and adopt the merger agreement and to approve and adopt the proposed amendment to the charter. If you do not send in your proxy or vote at the special meeting, it will have the same effect as if you voted against the merger and the amendment to the charter. Holders of PMR common stock, even if they expect to be present at the special meeting, are requested to sign, vote and date the enclosed proxy and return it promptly in the enclosed envelope. Any stockholder giving a proxy has the power to revoke it any time prior to the special meeting. Stockholders who are present at the special meeting may withdraw their proxies and vote in person. By Order of the Board of Directors, /s/ Fred D. Furman President and General Counsel San Diego, California July 12, 2002 PSYCHIATRIC SOLUTIONS, INC. 113 Seaboard Lane, Suite C-100 Franklin, Tennessee 37067 NOTICE OF SPECIAL MEETING OF STOCKHOLDERS TO BE HELD ON AUGUST 5, 2002 To the Stockholders of Psychiatric Solutions, Inc.: A special meeting of the holders of capital stock of Psychiatric Solutions, Inc., a Delaware corporation, will be held at 10:00 a.m. local time, on Monday, August 5, 2002, at Harwell Howard Hyne Gabbert & Manner, P.C., 315 Deaderick Street, Suite 1800, Nashville, Tennessee 37238. At the Psychiatric Solutions special meeting, the holders of capital stock of Psychiatric Solutions will: 1. Consider and vote upon a proposal to approve and adopt the Agreement and Plan of Merger, dated as of May 6, 2002, by and between Psychiatric Solutions, PMR Corporation, a Delaware corporation and PMR Acquisition Corporation, a Delaware corporation and a wholly-owned subsidiary of PMR ("Merger Sub"), as amended by Amendment No. 1 to Agreement and Plan of Merger dated as of June 10, 2002, and by Amendment No. 2 to Agreement and Plan of Merger dated as of July 9, 2002, pursuant to which, among other things, Merger Sub will merge with and into Psychiatric Solutions, Merger Sub will cease to exist and Psychiatric Solutions will survive as a wholly-owned subsidiary of PMR. As a result of the merger: - each outstanding share of Psychiatric Solutions common stock will be converted into the right to receive 0.115125 shares of common stock of PMR; - each outstanding share of Psychiatric Solutions Series A preferred stock will be converted into the right to receive 0.246951 shares of common stock of PMR; and - each outstanding share of Psychiatric Solutions Series B preferred stock will be converted into the right to receive 0.312864 shares of common stock of PMR. 2. Transact any other business that may properly come before the special meeting or any adjournments or postponements of the special meeting. The board of directors has fixed the close of business on July 1, 2002 as the record date for determining which stockholders are entitled to notice of, and to vote at, the special meeting or any adjournments of the special meeting. THE BOARD OF DIRECTORS OF PSYCHIATRIC SOLUTIONS UNANIMOUSLY RECOMMENDS THAT YOU VOTE "FOR" THE APPROVAL AND ADOPTION OF THE MERGER AGREEMENT, AS AMENDED. The affirmative vote of the holders of a majority of the outstanding shares of Psychiatric Solutions common stock and the holders of a majority of the outstanding shares of Psychiatric Solutions Series A preferred stock and Series B preferred stock, voting together as a single class, is required to approve and adopt the merger agreement. If you do not send in your proxy or vote at the special meeting, it will have the same effect as if you voted against the merger. Holders of Psychiatric Solutions capital stock, even if they expect to be present at the special meeting, are requested to sign, vote and date the enclosed proxy and return it promptly in the enclosed envelope. Any stockholder giving a proxy has the power to revoke it any time prior to the special meeting. Stockholders who are present at the special meeting may withdraw their proxies and vote in person. By Order of the Board of Directors, /s/ Joey A. Jacobs President and Chief Executive Officer Franklin, Tennessee July 12, 2002 (PMR CORPORATION LOGO) (PSI Logo) PROPOSED MERGER -- YOUR VOTE IS IMPORTANT The boards of directors of PMR Corporation and Psychiatric Solutions, Inc. have approved an agreement to merge PMR Acquisition Corporation, a Delaware corporation and a wholly-owned subsidiary of PMR, with and into Psychiatric Solutions, with Psychiatric Solutions surviving as a wholly-owned subsidiary of PMR. As a result of the merger, holders of Psychiatric Solutions common stock will receive 0.115125 shares of PMR common stock in exchange for each share of the Psychiatric Solutions common stock that they own. Holders of Psychiatric Solutions Series A preferred stock will receive 0.246951 shares of PMR common stock in exchange for each share of Psychiatric Solutions Series A preferred stock that they own. Holders of Psychiatric Solutions Series B preferred stock will receive 0.312864 shares of PMR common stock in exchange for each share of Psychiatric Solutions Series B preferred stock that they own. Following the merger, PMR stockholders will continue to own their existing shares of PMR common stock, as adjusted for the reverse stock split. Options to acquire Psychiatric Solutions common stock will be converted into options to purchase shares of PMR common stock based on the common stock exchange ratio used in the merger. Warrants and options of Psychiatric Solutions will entitle the holders to exercise these securities into shares of PMR common stock. After giving effect to the exercise of all outstanding options and warrants of Psychiatric Solutions following the merger, Psychiatric Solutions stockholders and PMR stockholders will own approximately 72% and 28% of the common of PMR, respectively, upon completion of the merger. PMR common stock trades on the Nasdaq National Market under the symbol "PMRP." PMR has applied to have the combined company's common stock listed on the Nasdaq National Market following the merger under the symbol "PSYS". In the alternative, PMR may apply to have the common stock listed on the Nasdaq SmallCap Market or the American Stock Exchange. This document is a prospectus of PMR relating to the issuance of shares of PMR's common stock in connection with the merger and a proxy statement for both PMR and Psychiatric Solutions to use in soliciting proxies for our special meetings. This document also constitutes a prospectus of PMR with respect to contingent value rights of PMR proposed to be issued to holders of PMR common stock prior to the merger. The contingent value rights represent the right to receive cash payments from PMR in connection with the collection of certain accounts receivable and other amounts of PMR following the merger. We can only complete the merger if the PMR stockholders and the Psychiatric Solutions stockholders approve the merger agreement, as amended. In addition, the PMR stockholders must also approve an amendment to the PMR charter to (i) increase the number of authorized shares of PMR common stock, (ii) effect a 1-for-3 reverse stock split, and (iii) change the name of PMR to "Psychiatric Solutions, Inc." In this document, all share and per share amounts of PMR common stock are on a post-split basis unless otherwise indicated. We have scheduled special meetings for the PMR stockholders and the Psychiatric Solutions stockholders to vote on these matters. YOUR VOTE IS VERY IMPORTANT. WHETHER OR NOT YOU PLAN TO ATTEND YOUR SPECIAL MEETING, PLEASE TAKE THE TIME TO VOTE BY COMPLETING AND MAILING THE ENCLOSED PROXY CARD TO US. Each of our boards of directors has unanimously determined that the terms of the merger agreement, as amended, are in the best interests of our stockholders and has approved and adopted the merger agreement, as amended. Accordingly, the PMR board of directors unanimously recommends that PMR stockholders vote "for" the approval and adoption of the merger agreement, as amended, and the amendment to the PMR charter. The board of directors of Psychiatric Solutions unanimously recommends that Psychiatric Solutions stockholders vote "for" the approval and adoption of the merger agreement, as amended. This document provides you with detailed information about the merger and related matters. It contains answers to frequently asked questions and a summary description of the merger (beginning on page 1), followed by a more detailed discussion of the merger and related matters. We encourage you to read this entire document carefully. You should also carefully consider the matters discussed under "Risk Factors" beginning on page 31 before voting on the merger. Neither the Securities and Exchange Commission nor any state securities regulators have approved the merger, the PMR common stock to be issued in the merger or the fairness or the merits of the merger or have determined whether the information contained in this document is accurate or adequate. Any representation to the contrary is a criminal offense. This joint proxy statement/prospectus is dated July 11, 2002, and is first being mailed to PMR stockholders and Psychiatric Solutions stockholders on or about July 12, 2002. REFERENCES TO ADDITIONAL INFORMATION This document incorporates important business and financial information about PMR that is not included in or delivered with this document. This information is available without charge to you upon written or oral request at PMR's address and telephone number listed on page 4. See also "Where You Can Find More Information" beginning on page 159. To obtain timely delivery, you must request the information no later than July 20, 2002. TABLE OF CONTENTS
PAGE ---- QUESTIONS AND ANSWERS ABOUT THE MERGER...................... 1 SUMMARY..................................................... 5 The Companies............................................. 5 Risks Associated with the Merger.......................... 6 The Merger................................................ 6 Reasons for the Merger.................................... 6 What PMR Stockholders Will Receive in the Merger.......... 7 What Psychiatric Solutions Stockholders Will Receive in the Merger............................................. 7 Recommendation of Each Company's Board of Directors to Stockholders........................................... 7 Fairness Opinions of Financial Advisors................... 8 Accounting Treatment...................................... 8 Material U.S. Federal Income Tax Consequences............. 8 Regulatory Approvals...................................... 8 Appraisal Rights.......................................... 9 Federal Securities Laws Consequences; Resale Restrictions........................................... 9 Interests of Certain Directors, Officers and Stockholders of Psychiatric Solutions and PMR in the Merger......... 9 The Merger Agreement...................................... 10 Stockholder Voting Agreements............................. 12 Contingent Value Rights................................... 12 Voting.................................................... 12 Directors and Officers of the Combined Company Following the Merger............................................. 13 How the Rights of Psychiatric Solutions Stockholders Will Differ as PMR Stockholders............................. 14 SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA OF PMR...... 15 SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA OF PSYCHIATRIC SOLUTIONS..................................... 17 UNAUDITED PRO FORMA CONDENSED COMBINED CONSOLIDATED FINANCIAL STATEMENTS OF PMR AND PSYCHIATRIC SOLUTIONS..... 18 NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED CONSOLIDATED FINANCIAL STATEMENTS...................................... 23 COMPARATIVE PER SHARE MARKET PRICE AND DIVIDEND INFORMATION............................................... 28 COMPARATIVE PER SHARE DATA.................................. 30 RISK FACTORS................................................ 31 Risks Related to the Merger............................... 31 Risks Related to the Business of Each of PMR and Psychiatric Solutions.................................. 36 Risks Related Solely to the Business of PMR............... 37 Risks Related Solely to the Business of Psychiatric Solutions.............................................. 37 FORWARD-LOOKING STATEMENTS.................................. 40 BUSINESS OF PMR............................................. 42 Health Services Programs.................................. 42 Regulatory Matters........................................ 44 Insurance................................................. 50 Properties................................................ 50
ii
PAGE ---- Legal Proceedings......................................... 50 Employees................................................. 51 Meetings of the Board..................................... 51 Directors of PMR.......................................... 51 Executive Officers of PMR................................. 53 Certain Relationships and Related Transactions............ 53 Section 16(a) Beneficial Ownership Reporting Compliance... 54 Audit Committee........................................... 54 Compensation of Directors and Executive Officers.......... 55 PMR's Independent Auditors................................ 60 PMR MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS....................... 62 Overview.................................................. 62 Sources of Revenue........................................ 63 Results of Continuing Operations.......................... 64 Fiscal Year Ended April 30, 2002 Compared to Fiscal Year Ended April 30, 2001................................... 64 Fiscal Year Ended April 30, 2001 Compared to Fiscal Year Ended April 30, 2000................................... 65 Liquidity and Capital Resources........................... 66 Impact of Inflation....................................... 68 Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.................... 68 Critical Accounting Policies.............................. 68 PMR's QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...................................................... 69 Interest Rate Sensitivity................................. 69 Exchange Rate Sensitivity................................. 69 BUSINESS OF PSYCHIATRIC SOLUTIONS........................... 70 Overview.................................................. 70 Industry Background....................................... 70 Business Strategy......................................... 71 Operations................................................ 72 Regulatory Matters........................................ 76 Sources of Revenue........................................ 83 Properties................................................ 83 Legal Proceedings and Insurance........................... 83 Employees................................................. 83 Competition............................................... 84 Recent Developments....................................... 84 Related Party Transactions................................ 86 PSYCHIATRIC SOLUTIONS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.......... 87 Overview.................................................. 87 Impact of Acquisitions.................................... 87 Sources of Revenue........................................ 88 Results of Continuing Operations.......................... 88 Liquidity and Capital Resources........................... 91 Impact of Inflation....................................... 93
iii
PAGE ---- Critical Accounting Policies.............................. 94 Changes in or Disagreements with Accountants on Accounting and Financial Disclosure............................... 95 THE MERGER.................................................. 95 General................................................... 95 Background of the Merger.................................. 95 Reasons for the Merger.................................... 97 Recommendation of Each Company's Board of Directors....... 100 Opinion of PMR's Financial Advisor........................ 101 Opinion of Psychiatric Solutions' Financial Advisor....... 107 Accounting Treatment...................................... 114 Material U.S. Federal Income Tax Consequences............. 114 Regulatory Matters; Legal Matters......................... 116 Nasdaq Market Quotation................................... 117 Appraisal Rights.......................................... 117 Federal Securities Laws Consequences; Resale Restrictions........................................... 119 INTERESTS OF CERTAIN DIRECTORS, OFFICERS AND STOCKHOLDERS IN THE MERGER................................................ 119 Director and Officer Positions with Combined Company...... 119 Acceleration of PMR Options............................... 120 Extension of Option Exercise Periods for Certain PMR Officers............................................... 120 Severance Arrangements for Certain PMR Officers........... 120 Payment of Preferential Amounts to Psychiatric Solutions Preferred Stockholders................................. 121 Amendments to Promissory Notes of Certain PMR Officers and Directors.............................................. 121 Certain Fees to be Paid to an Entity Owned and Controlled by PMR Director........................................ 121 Indemnification of Certain Persons........................ 121 Psychiatric Solutions Affiliate Letters................... 122 Allen Tepper Employment/Consulting Agreement.............. 122 Contingent Value Rights Representative.................... 122 THE MERGER AGREEMENT........................................ 122 Effective Time of the Merger.............................. 122 Psychiatric Solutions Stock Options....................... 124 Psychiatric Solutions Employee Benefits................... 124 Conditions to the Merger.................................. 125 Representations and Warranties of PMR and Psychiatric Solutions.............................................. 128 Conduct of the Business of PMR and Psychiatric Solutions Prior to the Merger.................................... 129 No Solicitation of Acquisition Transactions............... 131 Conduct of the Business of the Combined Company Following the Merger............................................. 132 Board, Committees and Officers of PMR..................... 133 Termination, Amendment or Waiver.......................... 133 Termination Fee........................................... 134 Expenses.................................................. 135 Indemnification and Insurance............................. 135
iv
PAGE ---- STOCKHOLDER VOTING AGREEMENTS............................... 135 Psychiatric Solutions Stockholder Voting Agreement........ 135 PMR Stockholder Voting Agreement.......................... 136 CONTINGENT VALUE RIGHTS AGREEMENT........................... 136 PMR SPECIAL MEETING......................................... 139 Time and Place; Purpose................................... 139 Amendment of PMR's Charter................................ 140 Record Date; Voting Rights and Proxies.................... 142 Solicitation of Proxies................................... 143 Quorum.................................................... 143 Required Vote; Failure to Vote and Broker Non-Votes....... 143 PSYCHIATRIC SOLUTIONS SPECIAL MEETING....................... 143 Time and Place; Purpose................................... 143 Record Date; Voting Rights and Proxies.................... 144 Solicitation of Proxies................................... 144 Quorum.................................................... 144 Required Vote and Failure to Vote......................... 144 BENEFICIAL OWNERSHIP OF PMR CAPITAL STOCK................... 145 BENEFICIAL OWNERSHIP OF PSYCHIATRIC SOLUTIONS CAPITAL STOCK..................................................... 148 DIRECTORS AND OFFICERS OF COMBINED COMPANY FOLLOWING THE MERGER.................................................... 149 Directors................................................. 149 Executive Officers........................................ 151 Executive Compensation.................................... 152 Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values...................... 152 COMPARISON OF STOCKHOLDER RIGHTS............................ 153 General................................................... 153 Number, Classification and Removal of Directors........... 154 Cumulative Voting......................................... 154 Power to Call Special Meeting............................. 154 Stockholder Vote Required for Certain Transactions........ 154 Action by Written Consent in Lieu of a Stockholder Meeting................................................ 155 Amendments to Certificates of Incorporation............... 155 Amendment to Bylaws....................................... 155 Preferred Stock........................................... 156 Preemptive Rights......................................... 156 DESCRIPTION OF PMR CAPITAL STOCK............................ 157 Authorized Capital Stock.................................. 157 Common Stock.............................................. 157 Preferred Stock........................................... 157 Transfer Agent and Registrar.............................. 157 Stock Exchange Listing.................................... 157 INDEPENDENT AUDITORS........................................ 157 LEGAL MATTERS............................................... 158
v
PAGE ---- EXPERTS..................................................... 158 STOCKHOLDER PROPOSALS....................................... 158 WHERE YOU CAN FIND MORE INFORMATION......................... 159 INDEX TO PMR CONSOLIDATED FINANCIAL STATEMENTS.............. FA-1 INDEX TO PSYCHIATRIC SOLUTIONS CONSOLIDATED FINANCIAL STATEMENTS................................................ FB-1 ANNEX A: AGREEMENT AND PLAN OF MERGER, AS AMENDED........... A-1 ANNEX B: AMENDMENT TO PMR AMENDED AND RESTATED CERTIFICATE OF INCORPORATION.......................................... B-1 ANNEX C: OPINION OF RAYMOND JAMES & ASSOCIATES, INC. ....... C-1 ANNEX D: OPINION OF BRENTWOOD CAPITAL ADVISORS LLC. ........ D-1 ANNEX E: DELAWARE GENERAL CORPORATION LAW SECTION 262 RELATING TO APPRAISAL RIGHTS.............................. E-1
vi QUESTIONS AND ANSWERS ABOUT THE MERGER Q: WHAT WILL HAPPEN IN THE MERGER? A: The merger will combine the businesses of PMR and Psychiatric Solutions. To combine the companies, a newly-formed, wholly-owned subsidiary of PMR will merge with and into Psychiatric Solutions. As a result, Psychiatric Solutions will become a wholly-owned subsidiary of PMR. Psychiatric Solutions stockholders will become PMR stockholders and will own approximately 72% of the PMR common stock outstanding immediately after the merger. Current PMR stockholders will own the remaining approximately 28%. The current officers of Psychiatric Solutions will manage the combined company, which will be renamed "Psychiatric Solutions, Inc." and is anticipated to trade on the Nasdaq National Market under the symbol "PSYS." The merger agreement, as amended, which is a contract among PMR, Psychiatric Solutions, and a subsidiary of PMR, is attached to this joint proxy statement/prospectus as Annex A. You should read the merger agreement carefully in its entirety because it is the legal document describing the parties' rights. Q: WHAT WILL I RECEIVE IN THE MERGER? A: In connection with the merger, holders of Psychiatric Solutions capital stock will receive varying amounts of PMR common stock depending on the class and number of shares of Psychiatric Solutions capital stock they hold. Each Psychiatric Solutions stockholder (other than Psychiatric Solutions stockholders who perfect their appraisal rights under Delaware law) will receive: - 0.115125 shares of PMR common stock in exchange for each share of Psychiatric Solutions common stock owned; - 0.246951 shares of PMR common stock in exchange for each share of Psychiatric Solutions Series A preferred stock owned; and - 0.312864 shares of PMR common stock in exchange for each share of Psychiatric Solutions Series B preferred stock owned. Following the merger, PMR stockholders will continue to own their existing shares of PMR common stock, as adjusted for the reverse stock split. Options to acquire Psychiatric Solutions common stock will be converted into options to purchase shares of PMR common stock based on the common stock exchange ratio used in the merger. Warrants and options of Psychiatric Solutions will entitle the holders to exercise these securities into shares of PMR common stock. After giving effect to the exercise of all outstanding options and warrants of Psychiatric Solutions following the merger, Psychiatric Solutions stockholders and PMR stockholders will own approximately 72% and 28% of the common of PMR, respectively, upon completion of the merger. Q: WHY ARE PMR AND PSYCHIATRIC SOLUTIONS PROPOSING THE MERGER? A: Our companies are proposing the merger because we believe that the combined businesses will be able to compete more effectively for and secure growth opportunities. We believe that the combined businesses will realize financial and operating synergies, offer more diverse services, allow us to better serve our constituencies, and have a stronger financial position. Please read the more detailed description of our reasons for the merger beginning on page 97. Q: WHAT WILL THE NEW COMPANY BE CALLED AND WHERE WILL IT BE HEADQUARTERED? A: The new company will be called "Psychiatric Solutions, Inc." and will be headquartered in Franklin, Tennessee. Q: WHAT WILL HAPPEN TO SHARES OF PMR COMMON STOCK IN CONNECTION WITH THE MERGER? A: A 1-for-3 reverse stock split of PMR common stock is a condition to the merger. As a result of the reverse stock split, the approximately 7,262,907 shares of PMR common stock outstanding on May 31, 2002 will become approximately 2,420,969 shares of common stock, not including the shares of PMR common stock issued to Psychiatric Solutions stockholders in the merger. Any other shares 1 issued before the effectiveness of the reverse stock split will be similarly adjusted. In addition, each option to purchase PMR common stock outstanding on the effective date will be adjusted so that the number of shares of PMR common stock issuable upon its exercise will be divided by 3, and the exercise price of each option will be multiplied by 3. Corresponding adjustments will be made to the number of shares vested under each outstanding option. Q: WHEN ARE THE SPECIAL STOCKHOLDERS' MEETINGS? A: Each company's special meeting of stockholders will take place on August 5, 2002. The time and location of each annual meeting is specified on the second page of this document. Q: WHAT WILL HAPPEN AT THE SPECIAL STOCKHOLDERS' MEETINGS? A: At the stockholder meeting, Psychiatric Solutions stockholders will vote on the merger agreement and the transactions contemplated by the merger agreement, as amended. At the PMR special meeting, PMR stockholders will vote on: - the merger agreement, as amended, and the transactions contemplated by the merger agreement; and - an amendment to PMR's charter to: - increase the number of authorized shares of PMR common stock; - effect a 1-for-3 reverse stock split of PMR's common stock; and - change the name of PMR to "Psychiatric Solutions, Inc." We cannot complete the merger unless, among other things: - stockholders of both companies vote to approve the merger agreement and the transactions contemplated by the merger agreement, as amended, including the merger; and - PMR stockholders vote to approve the amendment to PMR's charter. Q: HOW DO I VOTE? A: After reading this document, please fill out and sign your proxy card. Then mail your signed proxy card in the enclosed return envelope as soon as possible so that your shares will be represented at your special meeting. If you sign and send in your proxy card and do not indicate how you want to vote, your proxy will be counted as a vote in favor of the proposal(s) submitted at your special meeting. Q: WHAT HAPPENS IF I DO NOT RETURN A PROXY CARD? A: The failure to return a proxy card for Psychiatric Solutions stockholders will have the same effect as voting against the merger. For PMR stockholders, failure to return a proxy card will have the same effect as voting against the merger and the amendment to the charter. Q: MAY I VOTE IN PERSON? A: Yes. You may attend your special meeting and vote your shares in person, even if you sign and mail your proxy card. Q: MAY I CHANGE MY VOTE AFTER I HAVE MAILED MY SIGNED PROXY CARD? A: Yes. You can change your vote at any time before your proxy card is voted at the special meeting. You can do this in one of the following three ways: - you can send a written notice stating that you would like to revoke your proxy; - you can complete and submit a new proxy card; or 2 - you can attend the meeting and vote in person. Your attendance alone will not, however, revoke your proxy. If you have instructed a broker to vote your shares, you must follow directions received from your broker to change those instructions. Q: IF MY SHARES ARE HELD IN "STREET NAME" BY MY BROKER, WILL MY BROKER VOTE MY SHARES FOR ME? A: Your broker will vote your shares only if you provide instructions on how to vote. You should instruct your broker to vote your shares, following the directions provided by your broker. Q: WHAT ARE THE TAX CONSIDERATIONS OF THE MERGER? A: The merger generally will be tax free to the stockholders of each of PMR and Psychiatric Solutions for federal income tax purposes (other than with respect to cash that stockholders of Psychiatric Solutions may receive in the merger instead of fractional shares and payments received by stockholders of Psychiatric Solutions relating to the exercise of dissenters' appraisal rights). To review the tax considerations of the transaction in greater detail, see page 114. Q: ARE THERE RISKS ASSOCIATED WITH THE MERGER THAT I SHOULD CONSIDER IN DECIDING HOW TO VOTE? A: Yes. There are risks associated with all business combinations, including the merger. A number of risks are discussed in this document. Please read carefully the more detailed description of the risks associated with the merger beginning on page 31. Q: WHEN DO YOU EXPECT TO COMPLETE THE MERGER? A: We expect to complete the merger as quickly as possible once all the conditions to the merger, including obtaining the approvals of our stockholders, are fulfilled or waived. Fulfilling some of these conditions, such as receiving the consent of Psychiatric Solutions' senior lender, are not entirely within our control. We are working to complete the merger as soon as possible, and currently expect to complete the merger by the end of August 2002. In this document, we sometimes refer to the time we complete the merger as the effective time. Q: SHOULD I SEND IN MY STOCK CERTIFICATES NOW? A: No. After the merger is completed, we will send you written instructions that explain how to exchange your stock certificates for new stock certificates. You will not be required to pay transfer costs or other fees in connection with the exchange of your certificates. Please do not send in any stock certificates until you receive these written instructions and the letter of transmittal. Q: WHO WILL COUNT THE VOTES? A: The chairman of the board of directors of each company will select an inspector of the election for its stockholders meeting. The inspector will ascertain the number of shares outstanding and the voting power of the shares, determine the shares represented at the meeting, determine the validity of proxies and ballots, count all votes, and determine the results of the voting. Q: WILL PSYCHIATRIC SOLUTIONS STOCKHOLDERS BE ABLE TO TRADE THE PMR COMMON STOCK THAT THEY RECEIVE IN THE MERGER? A: Yes. We have applied to have the common stock listed under the symbol "PSYS" on the Nasdaq National Market. In the alternative, we may apply to have the common stock listed on the Nasdaq SmallCap Market or the American Stock Exchange. It is a condition to the obligation of Psychiatric Solutions to consummate the merger that the shares of PMR common stock to be issued in the merger have been approved for listing on either The Nasdaq National Market or the Nasdaq SmallCap Market. However, persons who are affiliates of Psychiatric Solutions will not be able to sell their shares received in the merger unless they comply with Rule 145 under the Securities Act of 1933, as amended. 3 Q: AM I ENTITLED TO APPRAISAL OR DISSENTERS' RIGHTS? A: Psychiatric Solutions stockholders have dissenters' rights, sometimes called appraisal rights, under Delaware law in connection with the merger. Under Delaware General Corporation Law, stockholders with dissenters' rights are entitled to dissent from the merger and obtain payment of the fair value of their shares if the transactions are consummated. The exercise of dissenters' rights will not be tax-free. Please review the information under the caption "Material U.S. Federal Income Tax Consequences -- Treatment of Dissenting Psychiatric Solutions Stockholders" beginning on page 116 for a description of the U.S. federal income tax consequences of exercising dissenters' rights. Attached as Annex E to this document is a copy of Section 262 of the Delaware General Corporation Law regarding appraisal rights. See "The Merger -- Appraisal Rights." Q: WILL THE RIGHTS OF A PSYCHIATRIC SOLUTIONS STOCKHOLDER CHANGE AS A RESULT OF THE MERGER? A: Yes. Psychiatric Solutions stockholders will become PMR stockholders as a result of the merger and, accordingly, their rights after the merger will be governed by PMR's charter and bylaws. Please read carefully the summary of the material differences between the rights of PMR stockholders and Psychiatric Solutions stockholders under the heading "Comparison of Stockholder Rights." Q: IF I HAVE MORE QUESTIONS ABOUT THE MERGER OR THE TWO COMPANIES, WHERE CAN I FIND ANSWERS? A: You can contact the companies at the following addresses if you have any questions regarding the merger or this document. For PMR stockholders: For Psychiatric Solutions stockholders: PMR Corporation Psychiatric Solutions, Inc. 1565 Hotel Circle South, 2nd Floor 113 Seaboard Lane, Suite C-100 San Diego, CA 92108 Franklin, TN 37067 (619) 610-4001 (615) 312-5700
In addition to reading this document and its annexes, you can find more information about the merger in PMR's filings with the SEC. 4 SUMMARY This summary, together with the preceding questions and answers section, highlights selected information from this document and may not contain all of the information that is important to you. To understand the merger fully and for a more detailed description of the legal terms of the merger, you should read carefully this entire document and the documents to which we have referred you, including the merger agreement, as amended, attached as Annex A, the proposed amendment to the amended and restated certificate of incorporation of PMR attached as Annex B, the opinion of Raymond James & Associates, Inc., attached as Annex C, the opinion of Brentwood Capital Advisors LLC attached as Annex D and the other documents to which we refer. See "Where You Can Find More Information" on page 159. We have included page references parenthetically to direct you to a more complete description of the topics presented in this summary. THE COMPANIES PMR CORPORATION 1565 Hotel Circle South, 2nd Floor San Diego, California 92108 Telephone: (619) 610-4001 Over the past fourteen years PMR has been a leader in the development and management of specialized mental health care programs and disease management services designed to treat individuals diagnosed with a serious mental illness. PMR currently manages, administers or provides consulting services for outpatient and community-based psychiatric services for serious mental illness patients, consisting of two outpatient programs and case management programs for a case management agency in and around the Nashville, Tennessee area. For the year ended April 30, 2002, PMR had net income of $5.8 million, or $0.81 per share on a pre-split basis. PMR generated earnings before interest, taxes, depreciation and amortization of $2.5 million for the year ended April 30, 2002, which includes the impact of a recovery of $3.4 million in the provision for doubtful accounts. PSYCHIATRIC SOLUTIONS, INC. 113 Seaboard Lane, Suite C-100 Franklin, Tennessee 37067 Telephone: (615) 312-5700 Psychiatric Solutions, Inc., based in Nashville, Tennessee, was founded in 1996 to become a leading provider of behavioral health care services in the United States. Through Psychiatric Solutions' freestanding specialty psychiatric hospitals and managed behavioral care facilities, Psychiatric Solutions offers a continuum of behavioral health programs to critically ill children, adolescents and adults. Its services include crisis stabilization, acute psychiatric services, acute chemical dependency services, partial hospitalization programs, intensive adolescent weekend services, outpatient services and support group services. Currently, Psychiatric Solutions is organized into two operating divisions: - ownership and operation of freestanding specialty psychiatric hospitals; and - management of psychiatric units in facilities owned by third parties. For the year ended December 31, 2001, Psychiatric Solutions had net income of $2.6 million, or $0.11 per fully diluted share. Psychiatric Solutions generated earnings before interest, taxes, depreciation and amortization of $6.2 million for the year ended December 31, 2001. 5 RISKS ASSOCIATED WITH THE MERGER (SEE PAGES 31 AND 84) In evaluating the merger agreement, you should carefully read this joint proxy statement/prospectus and especially consider the risks relating to the merger described under "Risk Factors" on page 31 and items included under "Business of Psychiatric Solutions -- Recent Developments" on page 84. THE MERGER (SEE PAGE 95) At the effective time of the merger, PMR Acquisition Corporation, a newly-formed, wholly-owned subsidiary of PMR, will merge with and into Psychiatric Solutions. Psychiatric Solutions will be the surviving corporation in the merger, and will become a wholly-owned subsidiary of PMR. In exchange for their outstanding shares of common stock or preferred stock in Psychiatric Solutions, stockholders of Psychiatric Solutions will receive newly-issued shares of PMR. Options to acquire Psychiatric Solutions common stock will be converted into options to purchase shares of PMR common stock based on the common stock exchange ratio used in the merger. Warrants of Psychiatric Solutions will enable the holders to exercise these securities into shares of PMR common stock. After giving effect to the exercise of all outstanding options and warrants of Psychiatric Solutions following the merger, Psychiatric Solutions stockholders and PMR stockholders will own approximately 72% and 28% of the common stock of PMR, respectively, upon completion of the merger. Immediately following the merger, PMR will change its name to "Psychiatric Solutions, Inc." Psychiatric Solutions will change its name to "Psychiatric Solutions Hospitals, Inc." The current senior management of Psychiatric Solutions will operate the combined entities. The following persons will serve as the seven directors of the combined company, representing the applicable company before the merger, and having the class and term, noted:
DIRECTOR COMPANY BEFORE MERGER CLASS TERM EXPIRES - -------- --------------------- ----- ------------ Christopher Grant, Jr............................. Psychiatric Solutions I 2003 Charles C. McGettigan............................. PMR I 2003 Mark P. Clein..................................... PMR II 2004 Joseph P. Donlan(1)............................... Psychiatric Solutions II 2004 Joey A. Jacobs.................................... Psychiatric Solutions III 2005 Edward K. Wissing................................. Psychiatric Solutions III 2005 David S. Heer..................................... Psychiatric Solutions III 2005
- --------------- (1) This director was designated by the purchasers of the senior subordinated notes issued by Psychiatric Solutions on June 28, 2002. The closing of the merger will occur as soon as practical after all conditions to the merger, other than those conditions that by their nature are to be satisfied at the closing, have been satisfied or waived, unless we agree on another time. As early as practicable on the closing date of the merger, we will file a certificate of merger with the Secretary of State of Delaware. The merger will become effective at or about the time we file the certificate of merger. We currently anticipate that we will complete the merger shortly after the PMR and Psychiatric Solutions special stockholder meetings, assuming our respective stockholders approve the merger and the other matters contemplated by the merger agreement, and that all other conditions to the merger have been satisfied or waived. The merger is conditioned upon approval by PMR's stockholders of an amendment to PMR's charter to (i) increase the number of authorized shares of PMR common stock, (ii) effect a 1-for-3 reverse stock split, and (iii) change the name of PMR to "Psychiatric Solutions, Inc." We will file the certificate of amendment to PMR's charter immediately before we file the certificate of merger. REASONS FOR THE MERGER (SEE PAGE 97) We believe that the merger will create a company with the strategic diversity and financial resources to enhance stockholder value in ways that are unlikely to be achieved by PMR or Psychiatric Solutions 6 alone. The merger will create a significant provider of diverse mental and behavioral health services, including disease management, brain injury, outpatient and inpatient programs. The combined company will be a substantially larger enterprise than either company is today, with combined pro forma 2001 revenues of approximately $135.4 million. The merger also accomplishes certain strategic goals of each company. For PMR, the merger concludes a lengthy process of terminating selected operations and participating in a strategic transaction it believes is more likely to achieve greater stockholder value. For Psychiatric Solutions, the transaction creates a more diversified operating company, consolidates its various classes of equity into a single class, and facilitates potential access to public equity markets. After the merger, the combined company expects to increase profitability through revenue enhancements, cost savings and operating efficiencies resulting from the elimination of redundant services, functions and facilities. The estimated cost savings reflect cost reduction opportunities and efficiencies through consolidating separate operations into a single enterprise. While the combined company expects that it will be able to realize the cost savings, no assurance can be given that it will actually be able to do so. Any cost savings realized will not result in a dollar-for-dollar increase in profitability. We also believe that after the merger, the combined company will be able to achieve additional long-term synergies but similarly can give no assurance in that regard. WHAT PMR STOCKHOLDERS WILL RECEIVE IN THE MERGER Each outstanding share of PMR common stock will remain outstanding after the merger, subject to being reduced by the proposed reverse stock split. PMR stockholders will own approximately 28% of the common stock of the combined company after the merger. WHAT PSYCHIATRIC SOLUTIONS STOCKHOLDERS WILL RECEIVE IN THE MERGER Except for Psychiatric Solutions stockholders who perfect their appraisal rights under Delaware law, Psychiatric Solutions stockholders will receive shares of PMR common stock in the merger in the following amounts. Holders of Psychiatric Solutions common stock will receive 0.115125 shares of PMR common stock in exchange for each share of Psychiatric Solutions common stock that they own. Holders of Psychiatric Solutions Series A preferred stock will receive 0.246951 shares of PMR common stock in exchange for each share of Psychiatric Solutions Series A preferred stock that they own. Holders of Psychiatric Solutions Series B preferred stock will receive 0.312864 shares of PMR common stock in exchange for each share of Psychiatric Solutions Series B preferred stock that they own. Options to acquire Psychiatric Solutions common stock will be converted into options to purchase shares of PMR common stock based on the common stock exchange ratio used in the merger. Warrants of Psychiatric Solutions will entitle the holders to exercise those securities into shares of PMR common stock. After giving effect to the exercise of all outstanding options and warrants of Psychiatric Solutions following the merger, Psychiatric Solutions stockholders and PMR stockholders will own 72% and 28% of the common stock of PMR, respectively, upon completion of the merger. RECOMMENDATION OF EACH COMPANY'S BOARD OF DIRECTORS TO STOCKHOLDERS (SEE PAGE 100) PMR BOARD The PMR board of directors believes that the merger is in your best interests and unanimously recommends that you vote "for": - approval of the merger agreement; and - approval of an amendment to the PMR charter to: - increase the number of authorized shares of PMR common stock, - effectuate a 1-for-3 reverse stock split of PMR common stock, and 7 - change the name of PMR to "Psychiatric Solutions, Inc." PSYCHIATRIC SOLUTIONS BOARD The Psychiatric Solutions board of directors believes that the merger is in your best interests and unanimously recommends that you vote "for" approval of the merger agreement. FAIRNESS OPINIONS OF FINANCIAL ADVISORS (SEE PAGES 101 AND 107) In deciding to approve the merger, we considered opinions from our financial advisors as to the fairness to you of the exchange ratios from a financial point of view. PMR received a written opinion dated April 29, 2002 of its financial advisor, Raymond James & Associates, Inc., to the effect that the exchange ratios are fair from a financial point of view to PMR stockholders. Psychiatric Solutions received a written opinion dated April 30, 2002 of its financial advisor, Brentwood Capital Advisors LLC, to the effect that the exchange ratios are fair from a financial point of view to Psychiatric Solutions stockholders and, in particular, to Psychiatric Solutions' common stockholders relative to Psychiatric Solutions' preferred stockholders. The full texts of these opinions describe the bases and assumptions on which they were rendered and are attached to this joint proxy statement/prospectus as Annexes C and D. We encourage you to read these opinions carefully before voting on the merger. ACCOUNTING TREATMENT (SEE PAGE 114) The merger will be accounted for by the combined company under the "purchase" method of accounting. MATERIAL U.S. FEDERAL INCOME TAX CONSEQUENCES (SEE PAGE 114) We have structured the merger so that neither the stockholders of PMR nor the stockholders of Psychiatric Solutions will recognize any gain or loss for U.S. federal income tax purposes as a result of the merger, except for taxes payable by each Psychiatric Solutions stockholder: - on the difference, if any, between cash received for fractional shares pursuant to the merger and the stockholder's adjusted tax basis in such fractional share interest; and - in connection with any exercise of dissenters' appraisal rights. As a condition to the merger, Psychiatric Solutions must receive an opinion from independent accountants that the merger will be tax free unless this condition is waived. Psychiatric Solutions does not intend to waive this condition. Tax matters are very complicated and the tax consequences of the merger to you will depend on the facts of your own situation. You should seek tax advice for a full understanding of the tax consequences of the merger to you. REGULATORY APPROVALS (SEE PAGE 116) Neither PMR nor Psychiatric Solutions is aware of any material governmental or regulatory approval required for completion of the merger, other than the effectiveness of the registration statement of which this joint proxy statement/prospectus is a part, approval for trading of the PMR common stock issuable to the Psychiatric Solutions stockholders on either the Nasdaq National Market, the Nasdaq SmallCap Market, or the American Stock Exchange, and compliance with applicable corporate law of Delaware. 8 APPRAISAL RIGHTS (SEE PAGE 117 AND ANNEX E) PSYCHIATRIC SOLUTIONS STOCKHOLDERS Under Delaware law, Psychiatric Solutions stockholders will be entitled to appraisal rights. Any holder of Psychiatric Solutions capital stock who does not wish to accept PMR common stock in the merger has the right under Delaware law to have the fair value of the holder's shares determined by the Delaware Court of Chancery. This right to appraisal is subject to a number of restrictions and technical requirements. Generally, in order to exercise appraisal rights, each holder of Psychiatric Solutions capital stock seeking appraisal: - must send a written demand to Psychiatric Solutions for appraisal in compliance with Delaware law before the vote on the merger; - must not vote in favor of the merger; and - must continuously hold the Psychiatric Solutions capital stock from the date of the holder's written demand for appraisal through the closing of the merger. Merely voting against the merger will not protect a holder's appraisal rights. Annex E to the joint proxy statement/prospectus contains a copy of the Delaware statute governing appraisal rights. A holder of Psychiatric Solutions capital stock that does not follow the steps required by Delaware law may lose appraisal rights. In addition to reading Annex E, see "Appraisal Rights" on page 117. PMR STOCKHOLDERS Under Delaware law, PMR stockholders do not have any right to an appraisal of the value of their shares in connection with the merger. FEDERAL SECURITIES LAWS CONSEQUENCES; RESALE RESTRICTIONS (SEE PAGE 119) All shares of PMR common stock received by Psychiatric Solutions stockholders in connection with the merger will be freely transferable except for any Psychiatric Solutions stockholder who is considered an affiliate of Psychiatric Solutions under the Securities Act of 1933. Shares of PMR common stock received by affiliates of Psychiatric Solutions at the time the merger is submitted to the stockholders for vote or consent may only be sold pursuant to Rule 145 of the Securities Act of 1933 or pursuant to a registration statement or exemption from the requirements of the Securities Act of 1933. INTERESTS OF CERTAIN DIRECTORS, OFFICERS AND STOCKHOLDERS OF PSYCHIATRIC SOLUTIONS AND PMR IN THE MERGER (SEE PAGE 119) When considering the recommendation of PMR's and Psychiatric Solutions' boards of directors, you should be aware that some of the directors, executive officers and stockholders of each company have interests in the merger that are different from, or are in addition to, yours. These interests include: - Continued Director Positions. Four directors of Psychiatric Solutions and two directors of PMR will become members of the board of directors of the combined company, and Joey A. Jacobs (currently the Chief Executive Officer of Psychiatric Solutions) will become the Chairman of the board of directors of the combined company upon the closing of the merger. - Accelerated Option Vesting. As a result of the merger, all option holders, including all officers and directors, of PMR will receive accelerated vesting of their outstanding stock options. In addition, in connection with the merger, PMR will extend the exercise periods under outstanding options held by certain officers and directors of PMR. - Severance Arrangements. In connection with the merger, certain officers of PMR will be entitled to cash severance payments and other benefits in connection with their resignation or termination of employment with PMR. 9 - Preferential Stockholder Treatments. In the merger, holders of Psychiatric Solutions' Series A preferred stock and Series B preferred stock will receive additional shares of PMR stock, relative to holders of Psychiatric Solutions common stock, in satisfaction of their preferential rights under Psychiatric Solutions' charter. - Amendment of Promissory Notes. In connection with the merger, the terms of certain outstanding promissory notes issued by certain officers and directors of PMR have been amended to provide for more favorable repayment terms. - Financial Advisor Fee. Upon the consummation of the merger, an entity owned and controlled by a director and significant stockholder of PMR will receive a fee from PMR for the provision of certain financial services to PMR in connection with the merger. - Indemnification and Insurance. The combined company will indemnify each present and former Psychiatric Solutions officer and director against liabilities arising out of such person's services as an officer or director and the transactions contemplated by the merger agreement, and PMR will maintain Psychiatric Solutions' officers' and directors' liability insurance to cover any such liabilities for the next six years (subject to certain limitations). - Potential Stock Liquidity. It is anticipated that the trading volume of the combined company will increase, which may facilitate the sale of an increased number of shares under Rule 144 of the Securities Act of 1933 for certain affiliates of PMR. - Engagement of PMR Chairman. In connection with the closing of the merger, Allen Tepper, currently the Chairman of the Board of Directors and Chief Executive Officer of PMR, will enter into an employment or consulting arrangement with the combined company pursuant to which he will receive monthly compensation and may be eligible for health benefits. - Engagement of PMR President. Fred D. Furman, the President and General Counsel of PMR, will serve as the representative of the holders of the contingent value rights pursuant to the contingent value rights agreement. As the representative, Mr. Furman will be entitled to certain compensation for services rendered. The board of directors of each of PMR and Psychiatric Solutions took into account these interests in considering whether the merger was in the best interests of the PMR and Psychiatric Solutions stockholders, as applicable. THE MERGER AGREEMENT (SEE PAGE 122) The merger agreement, as amended, is attached as Annex A to this document. For purposes of this joint proxy statement/prospectus, the term merger agreement includes amendments no. 1 and 2 to the merger agreement. We encourage you to read the merger agreement because it is the legal document that governs the merger. CONDITIONS TO THE MERGER (SEE PAGE 125) We will complete the merger only if the conditions of the merger agreement are satisfied or, if permitted, waived. These conditions include: - Approval of Merger Agreement. The adoption and approval of the merger agreement by the stockholders of PMR and Psychiatric Solutions; - Approval of PMR Charter Amendment. The amendment to PMR's charter to (i) increase the number of authorized shares of common stock, (ii) approve a 1-for-3 reverse stock split, and (iii) change the name of PMR to "Psychiatric Solutions, Inc."; - NASDAQ Listing. The approval for trading on either the Nasdaq National Market or Nasdaq Small Cap Market of the shares of PMR common stock to be issued in the merger, subject to official notice of issuance; 10 - Absence of Intervention. The absence of any law, court order, or proceeding that prohibits or threatens the merger; - Receipt of Consents. The receipt of material consents and approvals, including consent of Psychiatric Solutions' senior lender; - Effectiveness of Registration Statement. The registration statement on Form S-4 filed by PMR with the Securities and Exchange Commission being declared effective; - Covenants, Representations and Warranties. Both parties having complied with their covenants and agreements under the merger agreement and their representations and warranties being true and complete, in both cases in all material respects; - Tax Opinion. Psychiatric Solutions having received a tax opinion from independent accountants concerning the tax-free nature of the merger; and - Minimum PMR Cash Balance. PMR having on hand no less than $5.05 million in cash equivalents at the effective time of the merger. The party entitled to the benefit of these conditions may waive the conditions, provided that: - after the Psychiatric Solutions stockholders have approved the merger, no waiver or extension of the merger agreement which reduces or changes the consideration paid to the Psychiatric Solutions stockholders will be valid unless it is further approved by the Psychiatric Solutions stockholders; and - after the PMR stockholders have approved the merger, no waiver or extension of the merger agreement which increases or changes the consideration paid to the Psychiatric Solutions stockholders will be valid unless it is further approved by the PMR stockholders. Any such extension or waiver must be agreed to in writing by the party or parties to be bound thereby and must comply with law. NO SOLICITATION OF ACQUISITION TRANSACTIONS (SEE PAGE 131) The merger agreement contains detailed provisions prohibiting PMR and Psychiatric Solutions from seeking a competing business transaction. These no solicitation provisions prohibit PMR and Psychiatric Solutions, as well as their subsidiaries, officers, directors, employees and representatives, from taking any action to solicit a competing acquisition transaction proposal. TERMINATION OF THE MERGER AGREEMENT (SEE PAGE 133) We may jointly agree to terminate the merger agreement at any time, even after stockholder approval. In addition, either of us can terminate the merger agreement on our own without completing the merger under various circumstances, including the following: - No Closing by December 31, 2002. The merger is not completed by December 31, 2002, other than due to a breach of the merger agreement by the terminating party; - No Stockholder Approval. The stockholders of either PMR or Psychiatric Solutions fail to give the required approvals; - Legal Intervention. A court or other governmental authority permanently prohibits the merger; - Material Breach. Material breach or failure to perform by the other party which is incapable of being cured or is not cured within 30 days of notice of such breach or failure; or - Superior Proposal. The terminating company determines, under specific circumstances, to accept a superior offer from a third party, provides the other party with five business days' prior notice and complies with additional requirements, including payment of a termination fee. 11 TERMINATION FEE (SEE PAGE 134) If the merger agreement is terminated by either party in specific circumstances involving a business transaction with a third party, the party entering into the other transaction will be required to pay a termination fee of $750,000 and reimburse up to $250,000 of the other party's out-of-pocket expenses. STOCKHOLDER VOTING AGREEMENTS (SEE PAGE 135) As more fully described in this joint proxy statement/prospectus, a number of stockholders of each of PMR and Psychiatric Solutions have agreed to vote all of their shares of PMR or Psychiatric Solutions capital stock, as the case may be, in favor of the merger. The PMR voting agreements provide that certain PMR stockholders will vote their shares of PMR common stock in favor of the approval and adoption of the merger agreement and approval of the merger. The Psychiatric Solutions voting agreements provide that certain Psychiatric Solutions stockholders will vote their shares of Psychiatric Solutions capital stock in favor of the merger transaction. The PMR stockholders who have agreed with Psychiatric Solutions to vote in favor of the merger transaction collectively owned approximately 36% of the outstanding PMR common stock as of the PMR record date. The Psychiatric Solutions stockholders who have agreed with PMR to vote in favor of the merger transaction collectively owned over 80% of the outstanding Psychiatric Solutions capital stock as of the Psychiatric Solutions record date. CONTINGENT VALUE RIGHTS (SEE PAGE 136) The merger agreement permits PMR to issue Contingent Value Rights ("CVRs") prior to the effective time of the merger to each holder of outstanding PMR common stock pursuant to a CVR agreement to be entered into among PMR, Fred D. Furman, as representative of the CVR holders, and StockTrans, Inc., as trustee. In the event that PMR issues the CVRs, CVR holders would be entitled to receive: - a cash distribution within 90 days of the effective time of the merger equal to the amount of PMR's cash and cash equivalents in excess of $5.05 million as of the effective time of the merger; and - quarterly cash payments equal to the cash and cash equivalents collected on certain PMR accounts receivable during the two-year period following the effective time of the merger. Although PMR presently intends to issue the CVRs, it may determine not to issue the CVRs if the cash amount distributable in respect of the CVRs is not likely to be sufficient to justify the costs and expenses associated with the CVRs, due to (i) collection by PMR of the designated accounts receivable prior to the effective time of the merger, (ii) a determination by PMR that a significant amount of these accounts receivable are not likely to be collected, or (iii) a combination of these factors. VOTING TIME AND LOCATION OF SPECIAL MEETINGS (SEE PAGES 139 AND 143) PMR. The PMR special meeting will be held at 9:00 a.m. local time, on Monday, August 5, 2002, at PMR Corporation, 1565 Hotel Circle South, 2nd Floor, San Diego, California 92108. Psychiatric Solutions. The Psychiatric Solutions special meeting will be held at 10:00 a.m. local time, on Monday, August 5, 2002, at Harwell Howard Hyne Gabbert & Manner, P.C., 315 Deaderick Street, Suite 1800, Nashville, Tennessee 37238. RECORD DATE; VOTING POWER (SEE PAGES 142 AND 144) PMR. You may vote at the PMR special meeting if you owned shares as of the close of business on July 1, 2002, the PMR record date. You may cast one vote for each share of PMR common stock you own. 12 Psychiatric Solutions. You may vote at the Psychiatric Solutions special meeting if you owned shares as of the close of business on July 1, 2002, the Psychiatric Solutions record date. You may cast one vote for each share of Psychiatric Solutions capital stock you own. STOCKHOLDER VOTE REQUIRED TO APPROVE THE MERGER AND CERTAIN PMR CHARTER AMENDMENTS (SEE PAGES 143 AND 144) PMR. Approval of the merger agreement requires the favorable vote of a majority of the outstanding shares of PMR common stock. Approval of the amendment to PMR's charter requires the favorable vote of a majority of the outstanding shares of PMR common stock. Your failure to vote will have the effect of a vote against: - the merger; and - the proposed amendment to PMR's charter to (i) increase the number of authorized shares of PMR common stock, (ii) effectuate the 1-for-3 reverse stock split of PMR common stock, and (iii) change the name of PMR to "Psychiatric Solutions, Inc." Psychiatric Solutions. Approval of the merger agreement requires the favorable vote of the holders of a majority of the outstanding shares of Psychiatric Solutions common stock and the holders of a majority of the outstanding shares of Psychiatric Solutions Series A preferred stock and Series B preferred stock, voting together as a single class. Your failure to vote will have the effect of a vote against the merger. SHARE OWNERSHIP AND VOTING OF MANAGEMENT, DIRECTORS AND THEIR AFFILIATES PMR. As of the record date for the PMR special meeting, PMR directors, executive officers and their affiliates owned approximately 39.79% of the outstanding shares of PMR common stock. Mark P. Clein, Charles C. McGettigan and Allen Tepper, directors of PMR, and their affiliates have entered into voting agreements dated May 6, 2002, whereby they agreed to vote all shares of PMR common stock owned by them in favor of the merger agreement. See "PMR Stockholder Voting Agreement" on page 136. Psychiatric Solutions. As of the record date for the Psychiatric Solutions special meeting, Psychiatric Solutions' directors, executive officers and their affiliates owned approximately 81% of the outstanding shares of Psychiatric Solutions capital stock. Joey A. Jacobs and Dr. Richard Treadway, M.D., each a director of Psychiatric Solutions, as well as affiliates of other Psychiatric Solutions directors David Heer, Chris Grant, Eileen Moore and Bill Cook, executed voting agreements dated May 6, 2002, whereby they agreed to vote all their shares of Psychiatric Solutions capital stock in favor of the merger transaction. See "Psychiatric Solutions Stockholder Voting Agreement" on page 135. DIRECTORS AND OFFICERS OF THE COMBINED COMPANY FOLLOWING THE MERGER (SEE PAGE 149) At the effective time, PMR shall: - cause the board of directors to be comprised of: - Joey A. Jacobs, - Edward K. Wissing, - David S. Heer, - Christopher Grant, Jr., - Joseph P. Donlan, a representative of the holders of the senior subordinated convertible notes issued by Psychiatric Solutions on June 28, 2002, - Charles C. McGettigan, and - Mark P. Clein; and 13 - cause the executive officers of PMR to consist of: - Joey A. Jacobs, Chairman, Chief Executive Officer and President, - Steven T. Davidson, Chief Development Officer and Secretary, - Jack R. Salberg, Chief Operating Officer, and - Jack Polson, Controller. HOW THE RIGHTS OF PSYCHIATRIC SOLUTIONS STOCKHOLDERS WILL DIFFER AS PMR STOCKHOLDERS (SEE PAGE 153) When Psychiatric Solutions stockholders become PMR stockholders after the merger, their rights will be governed by PMR's certificate of incorporation and bylaws. Those rights differ from current rights of Psychiatric Solutions stockholders under Psychiatric Solutions' certificate of incorporation and bylaws. In general, preferential rights of the Psychiatric Solutions preferred stock will no longer apply, and all stockholders of the combined company will have the rights of holders of PMR common stock. 14 SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA OF PMR The following table sets forth selected historical consolidated financial data of PMR as of the dates and for the periods indicated. The historical consolidated financial data for each of the years ended April 30, 2002, 2001, 2000, 1999 and 1998 are derived from the audited consolidated financial statements of PMR and its predecessors. The following data should be read in conjunction with "PMR Management's Discussion and Analysis of Financial Condition and Results of Operations," the historical financial statements of PMR and the related notes thereto contained elsewhere in this joint proxy statement/ prospectus.
FISCAL YEAR ENDED APRIL 30, ----------------------------------------------- 2002 2001 2000 1999 1998 ------- ------- ------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Historical Consolidated Statements of Earnings Data: Revenues from continuing operations(1)............ $20,747 $17,682 $42,510 $55,823 $67,524 Net income (loss) from continuing operations(3)(4)(8)............................. 5,821 (10,770) (11,667) (46) 1,788 Net income (loss) from discontinued operations, net of gain on sale(2).......................... -- -- 664 (401) -- Net income (loss)(5).............................. 5,821 (10,770) (11,003) (447) 1,788 Net income (loss) per share from continuing operations(9): Basic........................................... 2.42 (4.55) (5.00) (0.19) 0.89 Diluted......................................... 2.42 (4.55) (5.00) (0.19) 0.80 Historical Consolidated Balance Sheets Data: Working capital(6)................................ $20,824 $15,430 $29,926 $52,233 $52,150 Total assets...................................... 24,802 21,359 40,736 67,052 70,449 Long-term debt.................................... -- 81 196 294 392 Total liabilities................................. 5,427 7,892 9,734 14,401 16,573 Stockholders' equity(6)(7)........................ 19,375 13,467 31,002 52,651 53,876
- --------------- (1) During fiscal year 2002, PMR recognized a reduction of approximately $1.7 million in contract settlement reserves due to estimated final settlement in provider cost reports. This reduction in contract settlement reserve was recorded as an increase in net revenues for the period. (2) During fiscal year 2000, PMR sold substantially all of its interest in Stadt Solutions LLC ("Stadt Solutions", a majority owned subsidiary partially-owned by Stadt Holdings (formerly Stadtlander Drug Distribution Co., Inc.). For fiscal years 2000 and 1999, PMR's revenues related to this discontinued business segment, which commenced in July 1998, were approximately $27 million and $30 million, respectively. (3) In fiscal year 1999, PMR wrote-off costs after income taxes of approximately $951,000 relating to a terminated acquisition. (4) In fiscal years 2002 and 2001, PMR incurred non-cash stock compensation expense of approximately $155,000 and $95,000, respectively. (5) In fiscal year 2002, PMR recognized $3.2 million in tax benefit resulting primarily from the economic recovery stimulus package approved by the 107th Congress of the United States of America, which allowed PMR to carryback the losses for a five-year period versus a two-year period, and various state tax refunds. In fiscal year 2001, PMR recognized an income tax benefit of approximately $929,000 resulting from federal and various state tax refunds for the fiscal year ended April 30, 2000. In the fourth quarter of fiscal year 2000, PMR established a tax asset valuation allowance of $5.9 million and reversed a current year net tax benefit of approximately $1.5 million to reserve fully for its deferred tax assets in conformity with SFAS No. 109, Accounting for Income Taxes. The reserve resulted in a total non-cash income tax of $7.4 million for the fiscal year ended April 30, 2000. 15 (6) In the third quarter of fiscal year 2001, PMR's Board of Directors declared a special cash dividend of $3.00 per share of common stock payable on December 29, 2000 to stockholders of record on December 21, 2000. The total amount of the dividend was approximately $7.3 million. In the third quarter of fiscal year 2000, PMR's Board of Directors declared a special cash dividend of $4.50 per share of common stock payable on January 31, 2000 to stockholders of record on January 26, 2000. The total amount of the dividend was approximately $10.6 million. (7) PMR's Stockholders' Equity includes notes receivable from employees and officers of approximately $373,000 at April 30, 2002 and $539,000 at April 30, 2001. Also included are unrealized gains (losses) on investments of approximately $32,000 at April 30, 2002 and $50,000 at April 30, 2001 and treasury shares of approximately $196,000 at April 30, 2002 and $28,000 at April 30, 2001. (8) In fiscal year 2002, PMR recovered $3.4 million in provision for doubtful accounts, which was primarily due to the collection of approximately $1.9 million of previously reserved accounts receivable relating to closed outpatient programs and a change in estimate on the collectability of certain other related receivables. (9) The basic and diluted income (loss) per share give effect to the proposed 1-for-3 reverse stock split in connection with and as a condition to the proposed merger with Psychiatric Solutions. 16 SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA OF PSYCHIATRIC SOLUTIONS The following table sets forth selected historical financial and operating data of Psychiatric Solutions for, or as of the end of, each of the five years ended December 31, 2001, and the three months ended March 31, 2002 and March 31, 2001. During 2000, the board of directors entered into a formal plan of disposal for its physician practice management, employee assistance program and ancillary business segments. Accordingly, the selected historical financial data has been restated to reflect these discontinued operations. The selected historical financial data as of and for each of the five years ended December 31, 2001 were derived from the audited consolidated financial statements of Psychiatric Solutions. The selected historical financial data as of March 31, 2002 and 2001 were derived from Psychiatric Solutions' unaudited consolidated financial statements. These unaudited consolidated financial statements include all adjustments necessary (consisting of normal recurring accruals) for a fair presentation of the financial position and the results of operations for these periods. Operating results for the three months ended March 31, 2002, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2002. The table should be read in conjunction with the Consolidated Financial Statements and notes thereto included elsewhere in this proxy statement/prospectus and "Psychiatric Solutions Management's Discussion and Analysis of Financial Condition and Results of Operations."
THREE MONTHS ENDED MARCH 31, FISCAL YEAR ENDED DECEMBER 31, ----------------- ----------------------------------------------- 2002 2001 2001 2000 1999 1998 1997 ------- ------- ------- ------- ------- ------- ------- (IN THOUSANDS) STATEMENT OF OPERATIONS DATA: Revenue.............................. $23,188 $ 7,219 $43,999 $23,502 $ 4,500 $ 1,533 $ 1,768 Salaries, wages and employee benefits........................... 13,970 4,272 26,183 15,256 4,350 2,819 2,016 Professional fees.................... 3,108 1,124 7,039 3,771 990 288 683 Provision for doubtful accounts...... 715 72 662 467 529 68 -- Other operating expenses............. 2,861 527 4,283 2,055 619 705 514 Depreciation and amortization........ 386 235 945 757 234 122 467 Interest expense..................... 1,372 405 2,660 1,723 371 98 13 ------- ------- ------- ------- ------- ------- ------- 22,412 6,635 41,772 24,029 7,093 4,100 3,693 Income (loss) from continuing operations before income taxes and extraordinary item................. 776 584 2,227 (527) (2,593) (2,567) (1,925) Provision for income taxes(1)........ 21 -- -- -- -- -- 39 ------- ------- ------- ------- ------- ------- ------- Income (loss) from continuing operations before extraordinary item............................... 755 584 2,227 (527) (2,593) (2,567) (1,964) Extraordinary loss on extinguishment of debt............................ -- -- (1,237) -- -- -- -- ------- ------- ------- ------- ------- ------- ------- Income (loss) from continuing operations......................... $ 755 $ 584 $ 990 $ (527) $(2,593) $(2,567) $(1,964) BALANCE SHEET DATA: Total assets......................... $55,901 $24,691 $54,294 $26,356 $13,154 $10,161 $ 9,770 Total liabilities.................... 45,516 17,976 45,056 20,120 7,338 3,106 795 Long term obligations, including current portion.................... 38,022 15,960 37,261 17,240 6,428 -- 95 Redeemable preferred stock........... 19,276 18,333 19,052 18,336 16,050 10,500 10,500
- --------------- (1) Psychiatric Solutions has recorded a valuation allowance against the deferred tax assets for each of the five years ended December 31, 2001 and the three month periods ended March 31, 2002 and 2001. The provision for income taxes for the year ended December 31, 1997 and the three months ended March 31, 2002 relates to current state income taxes. 17 UNAUDITED PRO FORMA CONDENSED COMBINED CONSOLIDATED FINANCIAL STATEMENTS OF PMR AND PSYCHIATRIC SOLUTIONS On May 6, 2002, PMR entered into the merger agreement with Psychiatric Solutions. Pursuant to the merger agreement, Psychiatric Solutions will merge with a newly created subsidiary of PMR. Immediately following the merger, after giving effect to the exercise of all outstanding options and warrants of Psychiatric Solutions into shares of PMR common stock, the former stockholders of Psychiatric Solutions will own approximately 72% of the common stock of PMR, and PMR stockholders will own approximately 28% of the common stock of PMR. Inasmuch as Psychiatric Solutions stockholders will own more than half of the surviving corporation's outstanding common stock immediately after the merger, Psychiatric Solutions will be treated as the acquiring company for accounting purposes. The acquisition will be accounted for using the purchase method of accounting, and accordingly, the purchase price will be allocated to the net tangible and intangible assets of PMR acquired and liabilities of PMR assumed in connection with the merger based on their fair values as of the acquisition date (see Note 1 to the unaudited pro forma condensed combined consolidated financial statements). The surviving company will use Psychiatric Solutions' fiscal year, which ends on December 31. The following unaudited pro forma condensed combined consolidated balance sheet as of March 31, 2002 is based on the following: - The historical balance sheet as of March 31, 2002 for each of PMR, Psychiatric Solutions, and Riveredge Hospital. - The unaudited pro forma balance sheet assumes the proposed merger occurred on March 31, 2002. - The unaudited pro forma balance sheet assumes the acquisition of Riveredge Hospital occurred on March 31, 2002. The unaudited pro forma condensed combined consolidated statement of earnings for the three months ended March 31, 2002 is based on the following: - The historical results of operations for the three months ended March 31, 2002 for each of PMR and Psychiatric Solutions; - The unaudited pro forma statement of earnings is presented as if the proposed merger occurred on January 1, 2002. - The results of operations of Riveredge Hospital as if such were acquired by Psychiatric Solutions on January 1, 2002 (actual acquisition date for this hospital was July 1, 2002). The unaudited pro forma condensed combined consolidated statement of operations for the year ended December 31, 2001 is based on the following: - The historical results of operations for the year ended December 31, 2001 for each of PMR and Psychiatric Solutions; - The results of operations of Cypress Creek Hospital and West Oaks Hospital, assuming both were acquired by Psychiatric Solutions on January 1, 2001 (actual acquisition date for both hospitals was September 1, 2001) (Note 2); - The results of operations of Texas NeuroRehab Hospital as if such were acquired by Psychiatric Solutions on January 1, 2001 (actual acquisition date for this hospital was on November 1, 2001) (Note 2); - The results of operations of Holly Hill Hospital as if such were acquired by Psychiatric Solutions on January 1, 2001 (actual acquisition date for Holly Hill Hospital was on December 1, 2001) (Note 2); and - The results of operations of Riveredge Hospital as if such were acquired by Psychiatric Solutions on January 1, 2001 (actual acquisition date for this hospital was July 1, 2002). - The unaudited pro forma statement of earnings assumes the proposed merger occurred on January 1, 2001. 18 The unaudited pro forma condensed combined consolidated financial statements should be read in conjunction with the historical consolidated financial statements and accompanying notes of PMR and Psychiatric Solutions included in this joint proxy statement/prospectus and the summary selected historical consolidated financial data included elsewhere in this joint proxy statement/prospectus. The unaudited pro forma condensed combined consolidated financial statements are not intended to represent or be indicative of the consolidated results of operations or financial condition that would have been reported had the merger been completed as of the dates presented, and should not be taken as representative of future consolidated results of operations or financial condition of the combined company. UNAUDITED PRO FORMA CONDENSED COMBINED CONSOLIDATED BALANCE SHEET OF PMR AND PSYCHIATRIC SOLUTIONS MARCH 31, 2002 (IN THOUSANDS)
HISTORICAL ----------------------------------------------------------------- PRO FORMA PSYCHIATRIC RIVEREDGE PURCHASE PSI PRO FORMA PRO FORMA SOLUTIONS HISTORICAL ADJUSTMENTS ADJUSTED PMR ADJUSTMENTS NOTES COMBINED ----------- ---------- ----------- -------- ---------- ----------- ----- --------- ASSETS Current assets: Cash and cash equivalents......... $ 1,157 $ 461 $ (461)(1) $ 1,157 $ 11,508 $ (6,449) (A),(D) $ 6,216 Short-term investments......... -- -- -- 8,093 (8,093) (A) -- Accounts receivable, net................. 19,192 4,599 -- 23,791 1,404 -- 25,195 Other current assets.............. 920 1,302 (278)(2) 1,944 435 -- 2,379 ------- ------- ------- ------- -------- -------- -------- Total current assets............ 21,269 6,362 (739) 26,892 21,440 (14,542) 33,790 Property, plant and equipment, net........ 17,858 4,463 -- 22,321 230 -- 22,551 Costs in excess of net assets acquired, net................... 15,042 -- 11,090(2) 26,132 -- 15,854 (B) 41,986 Amortizable intangible asset, net............ 1,620 157 743(3) 2,520 -- 2,520 Other assets............ 112 -- 112 570 -- 682 ------- ------- ------- ------- -------- -------- -------- Total assets............ $55,901 $10,982 $11,094 $77,977 $ 22,240 $ 1,312 $101,529 ======= ======= ======= ======= ======== ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Short-term borrowings.......... $16,393 $ 4,361 $(1,460)(2) $19,294 $ -- -- $ 19,294 Accounts payable...... 2,981 2,040 -- 5,021 184 1,000 Note 1 6,205 Accrued compensation and employee benefits............ 2,297 829 -- 3,126 1,405 -- 4,531 Other accrued liabilities......... 2,216 1,242 -- 3,458 1,921 -- 5,379 ------- ------- ------- ------- -------- -------- -------- Total current liabilities....... 23,887 8,472 (1,460) 30,899 3,510 1,000 35,409 Long-term debt.......... 20,624 400 12,110(2),(4) 33,134 -- -- 33,134 Other liabilities....... 1,004 565 -- 1,569 3,750 -- 5,319 ------- ------- ------- ------- -------- -------- -------- Total liabilities....... 45,515 9,437 10,650 65,602 7,260 1,000 73,862 Series A preferred stock................. 10,497 -- -- 10,497 -- (10,497) (C) -- Series B preferred stock................. 8,779 -- -- 8,779 -- (8,779) (C) -- Common stock............ 73 488 (488)(5) 73 73 (69) (E) 77 Additional paid-in capital............... 187 -- 1,989(4) 2,176 31,295 3,705 (F) 37,176 Notes receivable from employees and officers.............. -- -- -- -- (436) -- (436) Accumulated other comprehensive income................ -- -- -- -- 8 (8) (I) -- Accumulated (deficit) earnings.............. (9,150) 1,057 (1,057)(5) (9,150) (15,764) 15,764 (G) (9,150) Treasury stock.......... -- -- -- (196) 196 (H) -- ------- ------- ------- ------- -------- -------- -------- Total stockholders' equity................ 10,386 1,545 444 12,375 14,980 312 27,667 ------- ------- ------- ------- -------- -------- -------- Total liabilities and stockholders' equity.. $55,901 $10,982 $11,094 $77,977 $ 22,240 $ 1,312 $101,529 ======= ======= ======= ======= ======== ======== ========
19 - --------------- (1) Cash on hand to be used to pay off outstanding debt as of acquisition date. (2) Under the purchase method of accounting, the total estimated purchase price as shown in the table above is allocated to Riveredge's tangible and intangible assets acquired and liabilities assumed, based on their estimated fair values as of the date of the acquisition. The preliminary estimated purchase price is allocated as follows (in thousands): Total assets acquired by Psychiatric Solutions: Total assets at 3/31/02..................................... $ 10,982 Less valuation allowance against the net deferred tax asset..................................................... (278) Less intangible asset....................................... (157) Less cash to be used to retire existing debt (Note 1)....... (461) Less liabilities assumed by Psychiatric Solutions........... (5,076) Goodwill/unallocated purchase price......................... 11,090 --------- Total preliminary estimated purchase price.................. $ 16,100 Add estimated capitalized financing costs (note 3).......... 900 --------- Total required financing.................................... $ 17,000 =========
SHORT-TERM LONG-TERM PRO FORMA ADJUSTMENT ---------- --------- -------------------- Debt required to finance the Riveredge acquisition:......... 2,901 14,099 17,000 Less: Riveredge debt retired at acquisition............... 4,361 4,361 Less: warrant value associated with debt issuance......... 1,989 1,989 ------ ------ ------ Net adjustment to total debt................................ (1,460) 12,110 10,650 ====== ====== ======
(3) To eliminate the capitalized financing costs related to Riveredge debt, which will be retired at the acquisition date, and add estimated capitalized financing costs related to the acquisition of $900. (4) Adjustments to long-term debt related to issuance of warrants in conjunction with the mezzanine financing required for the Riveredge Hospital acquisition: Warrants issued............................................. 372,412 Assumed value per share less exercise price of $.09......... $ 5.34 --------- Assumed value of warrants................................... $ 1,989 =========
(5) To eliminate Riveredge's common stock and accumulated earnings. See accompanying notes to unaudited pro forma condensed combined consolidated financial statements 20 UNAUDITED PRO FORMA CONDENSED COMBINED CONSOLIDATED STATEMENT OF EARNINGS OF PMR AND PSYCHIATRIC SOLUTIONS THREE MONTHS ENDED MARCH 31, 2002 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
HISTORICAL ----------------------- PRO FORMA PSYCHIATRIC RIVEREDGE PURCHASE PSI PRO FORMA PRO FORMA SOLUTIONS HOSPITAL ADJUSTMENTS PRO FORMA PMR ADJUSTMENTS NOTES COMBINED ----------- --------- ----------- --------- ------- ----------- ------ --------- Revenue................... $23,188 $6,544 $ -- $29,732 $ 4,804 -- $34,536 ------- ------ ----- ------- ------- ----- ------- Expenses: Direct operating expenses.............. 19,037 5,588 -- 24,625 4,157 -- -- 28,782 Marketing, general and administrative........ 902 126 -- 1,028 660 -- -- 1,688 Provision for (recovery of) doubtful accounts.............. 715 44 -- 759 (1,931) -- -- (1,172) Depreciation and amortization.......... 386 80 -- 466 116 -- -- 582 Special charge.......... -- -- -- -- (18) -- -- (18) ------- ------ ----- ------- ------- ----- ------- Total expenses.... 21,040 5,838 -- 26,878 2,984 -- -- 29,862 Interest expense.......... (1,372) (139) (427)(1) (1,938) (2) -- -- (1,940) Other income -- interest...... -- -- -- -- 109 (73) (I) 36 ------- ------ ----- ------- ------- ----- ------- Earnings from continuing operations before taxes................... 776 567 (427) 916 1,927 (73) -- 2,770 Provision (benefit) for taxes................... 21 221 (187)(2) 55 (88) (J) (33) ------- ------ ----- ------- ------- ----- ------- Net earnings from continuing operations... $ 755 $ 346 $(240) $ 861 $ 2,015 $ (73) -- $ 2,803 ======= ====== ===== ======= ======= ===== ======= Net earnings per common share from continuing operations Basic................. $ 0.10 -- -- $ 0.13 $ 0.84 -- -- $ 0.37 ======= ======= ======= ======= Diluted............... $ 0.03 -- -- $ 0.03 $ 0.84 -- -- $ 0.33 ======= ======= ======= ======= Shares used in computing earnings per share: Basic................. 7,317 -- -- 7,317 2,390 -- Note 4 7,672 ======= ======= ======= ======= Diluted............... 27,025 -- -- 27,025 2,402 -- Note 4 8,702 ======= ======= ======= =======
- --------------- (1) Adjustments to interest to reflect financing of the Riveredge Hospital acquisition. (2) To eliminate federal income tax provision as a result of Psychiatric Solutions deferred tax asset valuation allowance. See accompanying notes to unaudited pro forma condensed combined consolidated financial statements 21 UNAUDITED PRO FORMA CONDENSED COMBINED CONSOLIDATED STATEMENT OF OPERATIONS OF PMR AND PSYCHIATRIC SOLUTIONS YEAR ENDED DECEMBER 31, 2001 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
PSYCHIATRIC SOLUTIONS --------------------------------------- PRO FORMA PRO HISTORICAL PRO FORMA PRO FORMA HISTORICAL ACQUISITIONS(2) FORMA PMR ADJUSTMENTS NOTES COMBINED ---------- --------------- -------- ---------- ----------- ------ --------- Revenue................. $43,999 $73,226 $117,225 $18,213 $135,438 ------- ------- -------- ------- -------- -------- Expenses: Direct operating expenses........... 35,477 62,696 98,173 15,208 113,381 Research and development........ -- -- -- 678 678 Marketing, general and administrative..... 2,028 1,943 3,971 5,326 9,297 Provision for (recovery of) doubtful accounts.. 662 2,368 3,030 (1,038) 1,992 Depreciation and amortization....... 945 891 1,836 1,144 2,980 Software development amortization....... -- -- -- 1,380 1,380 Special charge........ -- -- -- 2,083 2,083 ------- ------- -------- ------- -------- -------- Total expenses..... 39,112 67,898 107,010 24,781 131,791 Interest expense........ (2,660) (4,209) (6,869) (15) (6,884) Other income -- interest.... -- -- -- 804 (291) (I) 513 ------- ------- -------- ------- -------- -------- Earnings (loss) from continuing operations before taxes.......... 2,227 1,119 3,346 (5,779) (291) (2,724) Provision (benefit) for taxes................. -- 186 186 (929) (J) (743) ------- ------- -------- ------- -------- -------- Net earnings (loss) from continuing operations............ $ 2,227 $ 933 $ 3,160 $(4,850) $ (291) $ (1,981) ======= ======= ======== ======= ======== ======== Net earnings (loss) per common share from continuing operations Basic.............. $ 0.31 $ (2.01) $ (0.26) ======= ======= ======== Diluted............ $ 0.10 $ (2.01) $ (0.26) ======= ======= ======== Shares used in computing earnings (loss) per share: Basic.............. 7,291 2,407 Note 4 7,665 ======= ======= ======== Diluted............ 25,657 2,407 Note 4 7,665 ======= ======= ========
See accompanying notes to unaudited pro forma condensed combined consolidated financial statements 22 NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRO FORMA PRESENTATION For financial accounting purposes, Psychiatric Solutions is treated as the acquirer of PMR. Under that method, the purchase price for accounting purposes is established using the fair market value of 2,420,969 shares of outstanding PMR common stock of $6.15 per share (determined using the average of the closing prices of PMR stock after payment of the $5.10 per share cash dividend for each of the four days starting May 28, 2002 through May 31, 2002 as adjusted for the 1-for-3 reverse stock split), the fair value of assumed options to acquire 425,368 shares of PMR common stock and warrants to acquire 500 shares of PMR common stock as of May 31, 2002 (calculated using the Black-Scholes valuation model with the following assumptions: risk free interest rate of 5%, a volatility factor of 82.6%, a contractual life of three years and no dividend yield) and Psychiatric Solutions' estimated direct transaction costs, as follows (in thousands): Fair value of PMR common stock, 2,421 shares on May 31, 2002 at $6.15 per share........................................ $14,889 Fair value of PMR options and warrants assumed.............. 830 Estimated direct transaction cost........................... 1,000 ------- Estimated purchase price.................................... $16,719 =======
In connection with and as a condition to the proposed merger, PMR is also proposing an amendment to its charter in order to effect a proposed 1-for-3 reverse stock split. For purposes of the pro forma financial statements, the exchange ratios discussed below give effect to this proposed reverse stock split. Except for the effect of the reverse stock split, each outstanding share of PMR common stock will remain outstanding as a share of PMR common stock. PMR and Psychiatric Solutions stockholders will own, respectively, approximately 28% and 72% of the common stock of PMR after the merger. The unaudited pro forma condensed combined consolidated financial statements provide for the issuance of approximately 5.282 million shares of PMR common stock, based upon an exchange ratio (after a 1-for-3 reverse stock split) of 0.115125 shares of PMR common stock for each share of the Psychiatric Solutions common stock, 0.246951 shares of PMR common stock for each share of Psychiatric Solutions Series A preferred stock, and 0.312864 shares of PMR common stock for each share of Psychiatric Solutions Series B preferred stock. The actual number of shares of PMR common stock to be issued will be determined based on the actual number of shares of Psychiatric Solutions common stock outstanding at the completion of the merger. 23 2. PRO FORMA ACQUISITIONS BY PSYCHIATRIC SOLUTIONS The following table is an unaudited pro forma presentation of acquisitions made by Psychiatric Solutions during the year ended December 31, 2001 and 2002 as if such acquisitions occurred on January 1, 2001: UNAUDITED PRO FORMA ACQUISITIONS OF PSYCHIATRIC SOLUTIONS YEAR ENDED DECEMBER 31, 2001 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
CYPRESS WEST TEXAS HOLLY RIVEREDGE PRO FORMA PRO FORMA CREEK OAKS NEURO HILL HOSPITAL ADJUSTMENTS ACQUISITIONS ------- ------- ------- ------- --------- ----------- ------------ Revenue................... $10,465 $13,153 $14,539 $9,937 $ 25,132 -- $73,226 ------- ------- ------- ------ -------- -------- ------- Expenses: Direct operating expenses.............. 9,156 11,350 12,585 7,373 22,232 -- 62,696 Research and development........... -- -- -- -- -- -- -- Marketing, general and administrative........ 515 650 722 301 585 (830)(a) 1,943 Provision for doubtful accounts.............. 413 726 324 694 211 -- 2,368 Depreciation and amortization.......... 210 143 277 517 222 (478)(b) 891 Software development amortization.......... -- -- -- -- -- -- -- Special charge.......... -- -- -- 1,910 -- (1,910)(c) -- ------- ------- ------- ------ -------- -------- ------- Total expenses........ 10,294 12,869 13,908 10,795 23,250 (3,218) 67,898 Interest expense.......... (333) (564) (1,344) (23) (607) (1,338)(d) (4,209) Other income -- interest...... -- -- -- 80 37 (117)(e) -- ------- ------- ------- ------ -------- -------- ------- Earnings (loss) from continuing operations before taxes............ (162) (280) (713) (801) 1,312 1,763 1,119 Provision (benefit) for taxes................... -- -- -- -- 454 (268)(f) 186 ------- ------- ------- ------ -------- -------- ------- Net earnings (loss) from continuing operations... $ (162) $ (280) $ (713) $ (801) $ 858 $ 2,031 $ 933 ======= ======= ======= ====== ======== ======== =======
- --------------- (a) To eliminate management fees charged by previous owners, net of incremental overhead costs associated with the hospital acquisitions calculated as follows: Management fees charged by previous owners.................. $(2,188) Corporate overhead costs allocable to pre-acquisition financial statements based upon historical cost under Psychiatric Solutions ownership, capital structure, and budget estimates.......................................... 1,358 ------- Net adjustment.............................................. $ (830) =======
(b) Represents the change in depreciation expense as a result of the acquired assets at acquisition. (c) To eliminate an impairment charge incurred by Holly Hill Hospital in its pre-acquisition financial statements which was recorded based upon an excess of net book value of assets to be sold to Psychiatric Solutions over the purchase price negotiated with Psychiatric Solutions. The impairment charge is the subject of a pro forma adjustment as there were no indicators of impairment identified other than the proposed sale to Psychiatric Solutions (i.e. Holly Hill Hospital generated significant positive cash flows in the year of disposition). The sale of Holly Hill Hospital to Psychiatric Solutions was executed as part of a strategy of the previous owners to exit the psychiatric hospital business. 24 (d) The adjustment to interest expense is as follows: Interest expense prior to acquisition....................... $(2,871) Pro forma interest expense on debt related to acquisition... 4,209 ------- Net adjustment.............................................. $(1,338) =======
(e) To eliminate interest earned at Holly Hill Hospital and Riveredge related to cash retained by the prior owner. Psychiatric Solutions did not acquire the cash and cash equivalents of Holly Hill Hospital but intends to use Riveredge cash to pay existing debt. (f) To record state income tax expense as a result of the conversion of Holly Hill Hospital from a limited liability company to a corporation and to eliminate the federal tax provision for Riveredge as a result of Psychiatric Solutions deferred tax asset valuation allowance. 3. PRO FORMA ADJUSTMENTS The pro forma adjustments included in the unaudited pro forma condensed combined consolidated financial statements are as follows: (A) Pursuant to the merger agreement, PMR shall be entitled to declare and pay cash dividends in respect of PMR Common Stock, on one or more occasions, provided that, after giving pro forma effect to the declaration and payment of any such dividend, the aggregate amount of cash, cash equivalents and short-term investments of PMR at closing would not be less than $5.05 million. (B) Under the purchase method of accounting, the total estimated purchase price as shown in the table above is allocated to PMR's tangible and intangible assets acquired and liabilities assumed, based on their estimated fair values as of the date of the completion of the merger. The preliminary estimated purchase price is allocated as follows (in thousands): Total assets acquired by Psychiatric Solutions: Total assets at 3/31/02................................... $22,240 Less cash and short-term investments not acquired by Psychiatric Solutions (Note A)......................... 14,551 ------- Subtotal.................................................. 7,689 Add notes receivable from employees and officers.......... 436 ------- Total assets acquired by Psychiatric Solutions............ 8,125 PMR liabilities assumed..................................... (7,260) Goodwill/Unallocated purchase price......................... 15,854 ------- Total preliminary estimated purchase price.................. $16,719 =======
The allocation of the purchase price is preliminary. The actual purchase price allocation to reflect the fair values of assets acquired and liabilities assumed will be based upon the combined company's evaluation of such assets and liabilities upon completion of the merger. Accordingly, the adjustments included herein will change based upon the final allocation of the total purchase price, as adjusted to reflect the actual assets and liabilities in existence at the date upon which the merger is completed, stock values, value of the stock options and warrants assumed and transaction costs incurred. Deferred taxes have not been adjusted under the assumption that goodwill is the only asset subject to a purchase accounting adjustment. To the extent that assets other than goodwill are increased or decreased under the final purchase price allocation, adjustments to deferred taxes will be required to account for the disparity between book basis and tax basis of the assets acquired. A corresponding adjustment to goodwill will also be required to serve as an offset to any additional deferred tax assets or liabilities. That allocation may differ significantly from the preliminary allocation included in this joint proxy statement/prospectus. 25 (C) Conversion of 15.473 million shares of Psychiatric Solutions preferred stock into 4.149 million shares of PMR common stock and reclassification of amounts into common stock at par value and additional paid-in capital (Notes E and F). (D) Conversion of 928,000 shares of Psychiatric Solutions warrants into 928,000 shares of Psychiatric Solutions preferred stock immediately prior to the close of the merger, at an exercise price of $.01 per share. Such preferred shares shall subsequently convert into 290,400 shares of PMR common stock (Notes E and F). (E) Conversion of 7.328 million shares of Psychiatric Solutions common stock into 843,600 shares of PMR common stock. Adjustments to common stock are as follows (in thousands): Conversion of Psychiatric Solutions common stock into PMR common stock and reclassification of amounts into common stock at par and additional paid-in capital (Note F)...... $(73) Effect of 1-for-3 reverse split on outstanding PMR common stock..................................................... (49) Issuance of 5.282 million shares of PMR common stock, at $.01 par value (Notes C & D).............................. 53 ---- $(69) ====
(F) Adjustments to additional paid-in capital are as follows (in thousands): Conversion of Psychiatric Solutions preferred stock to PMR common stock (Note C)..................................... $ 19,276 Conversion of Psychiatric Solutions warrants to PMR common stock (Note D)............................................ 9 Conversion of Psychiatric Solutions common stock to PMR common stock (Note E)..................................... 73 Valuation of PMR common stock outstanding (Note 1).......... 14,889 $.01 par value of post-merger estimated common stock outstanding of 7,703 shares, (2,421 outstanding PMR shares after 1-for-3 reverse split plus 5,282 shares to be issued to Psychiatric Solutions)................................. (77) Fair value of PMR outstanding options and warrants to be assumed (Note 1).......................................... 830 Elimination of PMR additional paid-in capital............... (31,295) -------- Net adjustment to additional paid-in capital................ $ 3,705 ========
(G) To eliminate PMR's accumulated deficit. (H) To cancel PMR's treasury stock. (I) To reflect lost interest income due to reduction in cash, cash equivalents and short-term investments balances pursuant to item (A) above. (J) PMR tax net operating loss carryforwards will be subject to limitation under change in ownership provisions of Internal Revenue Code Section 382 and, as a result, the ability to recognize the tax net operating losses will be dependent upon future earnings of the company. 4. PRO FORMA EARNINGS PER SHARE The pro forma basic and diluted net earnings (loss) per share is computed by dividing the pro forma net earnings (loss) by the pro forma basic and diluted weighted average number of shares outstanding, assuming Psychiatric Solutions and PMR had merged at the beginning of each period presented. In addition, the basic and diluted PMR and combined common shares shown in the table below give effect to the proposed 1-for-3 reverse stock split. 26 The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts):
MARCH 31, 2002 DECEMBER 31, 2001 ------------------------------------ ------------------------------------ PSYCHIATRIC PSYCHIATRIC SOLUTIONS PMR PRO FORMA SOLUTIONS PMR PRO FORMA HISTORICAL HISTORICAL COMBINED HISTORICAL HISTORICAL COMBINED ----------- ---------- --------- ----------- ---------- --------- Numerator: Net earnings (loss) from continuing operations.... $ 755 $2,015 $ 2,803 $ 2,227 $(4,850) $(1,981) Interest expense on convertible debt outstanding..................................... 81 -- 81 324 -- 324 ------- ------ ------- ------- ------- ------- Net earnings (loss) available to common stockholders.................................... $ 836 $2,015 $ 2,884 $ 2,551 $(4,850) $(1,657) ------- ------ ------- ------- ------- ------- Denominator: Weighted-average common shares outstanding........ 7,317 2,390 7,672 7,291 2,407 7,665 Effect of dilutive employee stock options outstanding..................................... 1,422 12 174 492 Effect of dilutive warrants outstanding........... 1,268 372 856 Assumed converted preferred shares................ 15,473 15,473 Effect of dilutive conversion options related to debt outstanding................................ 1,545 484 1,545 ------- ------ ------- ------- ------- ------- Shares used in computing earnings (loss) per share........................................... 27,025 2,402 8,702 25,657 2,407 7,655 ------- ------ ------- ------- ------- ------- Basic earnings (loss) per share..................... $ 0.10 $ 0.84 $ .37 $ 0.31 $ (2.01) $ (.26) ======= ====== ======= ======= ======= ======= Diluted earnings (loss) per share................... $ 0.03 $ 0.84 $ .33 $ 0.10 $ (2.01) $ (.26) ======= ====== ======= ======= ======= ======= Pro forma weighted-average common shares outstanding: PMR weighted-average common shares outstanding after a 1-for-3 reverse split................... 2,390 2,407 Pro forma common shares to be issued to Psychiatric Solutions (Note F).................. 5,282 5,258 ------- ------- Total pro forma weighted average common shares outstanding....................................... 7,672 7,665 ======= =======
No dilutive common shares were included in the computation of diluted earnings per share under PMR Historical and Pro forma combined for the year ended December 31, 2001 because the inclusion thereof would have had an antidilutive effect. 27 COMPARATIVE PER SHARE MARKET PRICE AND DIVIDEND INFORMATION PMR PMR's common stock is listed on the Nasdaq National Market under the symbol "PMRP". The following table sets forth, for fiscal quarters indicated, the high and low sales prices for a share of PMR common stock as reported on the Nasdaq National Market. The stock prices have not been adjusted to reflect the proposed 1-for-3 reverse stock split.
HIGH LOW ----- ----- Quarters for the fiscal year ended April 30, 2002 First Quarter............................................. $1.75 $1.21 Second Quarter............................................ $2.03 $1.23 Third Quarter............................................. $2.14 $1.46 Fourth Quarter............................................ $2.56 $1.83 Quarters for the fiscal year ended April 30, 2001 First Quarter............................................. $4.00 $2.56 Second Quarter............................................ $2.84 $2.00 Third Quarter............................................. $3.00 $1.13 Fourth Quarter............................................ $1.97 $1.31
As of May 31, 2002, there were 102 holders of record of PMR's common stock. On May 3, 2002, the last full trading day prior to the public announcement of the proposed merger, PMR common stock closed at $2.38 per share, without giving effect to the reverse stock split. On July 10, 2002, the last trading day prior to the date of this joint proxy statement/prospectus, PMR common stock closed at $1.96 per share, without giving effect to the reverse stock split. PMR stockholders and Psychiatric Solutions stockholders are urged to obtain current market quotations for PMR common stock prior to making any decision with respect to the merger. In the third quarter of fiscal year 2000, PMR's board of directors declared a special dividend of $1.50 per share, without giving effect to the reverse stock split, of common stock payable to stockholders of record on January 26, 2000. The total amount of the dividend was approximately $10.6 million. In the third quarter of fiscal year 2001, PMR's board of directors declared a special cash dividend of $1.00 per share, without giving effect to the reverse stock split, of common stock payable on December 29, 2000 to stockholders of record on December 21, 2000. The total amount of the dividend was approximately $7.3 million. On May 6, 2002, PMR's board of directors declared a special cash dividend of $1.70 per share, without giving effect to the reverse stock split, of common stock payable on May 24, 2002 to the stockholders of record as of the close of business on May 17, 2002. The total amount of the dividend was approximately $12.3 million. PMR's board may declare an additional dividend prior to the closing of the merger, subject to the closing condition in the merger agreement requiring PMR to have on hand a minimum of $5.05 million in cash and cash equivalents at the effective time. PSYCHIATRIC SOLUTIONS Psychiatric Solutions common stock is not presently traded on an established public trading market. As of May 31, 2002, there were 7,327,627 shares of common stock outstanding, held by 62 holders. In addition, as of May 31, 2002, there were 10,497,000 shares of Series A preferred stock outstanding held by 41 holders and 4,975,736 shares of Series B preferred stock outstanding held by 18 holders. 28 Psychiatric Solutions has never declared or paid any cash dividends on its capital stock. Psychiatric Solutions and the combined company currently intend to retain any future earnings to finance the growth and development of the business and therefore do not anticipate paying any cash dividends in the foreseeable future. Any future determination to pay cash dividends will be at the discretion of the board of directors and will be dependent upon the combined company's financial condition, results of operations, capital requirements, general business conditions, and other factors that the board of directors deems relevant. 29 COMPARATIVE PER SHARE DATA The following table sets forth certain historical earnings (loss), dividend and book value per share data for PMR and Psychiatric Solutions and pro forma consolidated and equivalent pro forma earnings (loss) dividend, and book value per share data, excluding the effects of the conversion of Psychiatric Solutions preferred shares and other dilutive securities. The pro forma earnings (loss), dividend, and book value per share data are derived from the historical and pro forma financial data presented elsewhere in this document, which gives effect to the 1-for-3 stock split and the proposed merger under the purchase method of accounting at the estimated exchange ratio of 0.115125 of a share of PMR stock for each share of Psychiatric Solutions common stock at the beginning of the period presented. You should read the information set forth below along with the historical consolidated financial statements, including the notes to them and the Unaudited Pro Forma Condensed Combined Consolidated Financial Statements of PMR and Psychiatric Solutions including the notes to that data, included elsewhere in this document. The pro forma consolidated per share data in the table below are presented for information purposes. You should not rely on the pro forma amounts as indicating the financial position or results of operations of the consolidated company that would have actually occurred had the 1-for-3 stock split and the merger been effective during the periods presented or the future financial position or future results of operations of PMR and Psychiatric Solutions.
FOR THE YEAR ENDED FOR THE THREE MONTHS DECEMBER 31, 2001 ENDED MARCH 31, 2002 ------------------------------------ ------------------------------------ PRO FORMA PRO FORMA COMBINED COMBINED PMR/PSYCHIATRIC PMR/PSYCHIATRIC HISTORICAL SOLUTIONS EQUIVALENT(1) HISTORICAL SOLUTIONS EQUIVALENT(1) ---------- ----------------------- ---------- ----------------------- Psychiatric Solutions Common Stock: Earnings (loss) per share........ 0.31 (0.23) 0.10 0.10 Dividends per share.............. -- -- -- -- Book value per share............. (1.35) 0.35 (1.21) 0.42 PMR Corporation Common Stock(2): Earnings (loss) per share........ (2.01) (0.26) 0.84 0.84 Dividends per share.............. -- -- -- -- Book value per share............. 5.40 3.0 6.27 3.61
- --------------- (1) The Psychiatric Solutions per share equivalents were calculated by multiplying the pro forma combined per share amounts by the estimated exchange ratio of 0.115125 of a share of PMR Corporation common stock for each share of Psychiatric Solutions common stock pursuant to the merger agreement. (2) PMR has a fiscal year end of April 30. The above PMR information has been presented to coincide with Psychiatric Solutions' fiscal year end of December 31. 30 RISK FACTORS Following the merger, PMR and Psychiatric Solutions will operate as a combined company in a market environment that cannot be predicted and that involves significant risks, many of which will be beyond its control. In addition to the other information contained in, or incorporated by reference into, this joint proxy statement/prospectus, you should carefully consider the risks described below before deciding how to vote your shares. Additional risks and uncertainties not presently known to PMR and Psychiatric Solutions, or that are not currently believed to be important to you, if they materialize, also may adversely affect the merger and PMR and Psychiatric Solutions as a combined company. RISKS RELATED TO THE MERGER THE MARKET VALUE OF PMR COMMON STOCK THAT PSYCHIATRIC SOLUTIONS STOCKHOLDERS WILL RECEIVE IN THE MERGER MAY DECREASE PRIOR TO AND FOLLOWING THE MERGER. Psychiatric Solutions stockholders will not receive consideration in the merger with a set market value or a minimum market value. If the merger is completed, each Psychiatric Solutions stockholder (other than Psychiatric Solutions stockholders who perfect their appraisal rights under Delaware law) will receive: - 0.115125 shares of PMR common stock in exchange for each share of Psychiatric Solutions common stock owned; - 0.246951 shares of PMR common stock in exchange for each share of Psychiatric Solutions Series A preferred stock owned; and - 0.312864 shares of PMR common stock in exchange for each share of Psychiatric Solutions Series B preferred stock owned. No adjustment will be made to the number of shares of PMR common stock to be received by Psychiatric Solutions stockholders in the event of any increase or decrease in the market price of PMR common stock. The market price of PMR common stock when the merger takes place may vary from the market price on the date of this joint proxy statement/prospectus. On May 3, 2002 (the last trading day prior to the execution of the merger agreement), the closing market price of PMR common stock was $2.38 per share, without giving effect to the reverse stock split. During the twelve-month period ending on May 31, 2002, the closing market price of PMR common stock varied from a low of $1.25 to a high of $3.76 per share, without giving effect to the reverse stock split. In addition, the market value of the combined company stock may be volatile after the merger is completed for the reasons described under "-- The combined company's stock price could be volatile." INTEGRATING BUSINESS OPERATIONS MAY BE DISRUPTIVE TO THE COMBINED COMPANY'S BUSINESS. The combination of PMR and Psychiatric Solutions involves the integration of separate companies that prior to the closing of the merger transaction have operated independently. The process of combining the companies may be disruptive to our businesses and may cause an interruption of, or a loss of momentum in, these businesses as a result of the following difficulties, among others: - loss of key employees or consultants; - failures or delays in getting new contracts with present and potential customers of PMR or Psychiatric Solutions as a result of their concerns related to the integration of PMR and Psychiatric Solutions; - possible inconsistencies in standards, controls, procedures and policies between PMR and Psychiatric Solutions and the need to implement, integrate and harmonize various business-specific operating procedures and systems, as well as company-wide financial, accounting, information and other systems; and 31 - the diversion of management's attention from the day-to-day business of the combined company as a result of the need to deal with integration issues and the possible need to add management resources to do so. These disruptions and difficulties, if they occur, may cause material adverse short-term and long-term effects on the operating results and financial condition of the combined company. THE COMBINED COMPANY MAY BE OBLIGATED TO INDEMNIFY FORMER PMR CLIENTS FOR MATERIAL AMOUNTS. In connection with its outpatient programs, PMR maintains reserves on its financial books to cover the potential impact of two significant uncertainties: - PMR may be obligated to indemnify certain of its provider-clients for some portions of the management fee they paid PMR if any portion of such fee is disallowed, and therefore not reimbursed to the client, upon audit of the provider's cost report by fiscal intermediaries; and - PMR may not receive full payment of the management fees owed it by a provider if adjusted by fiscal intermediaries during the periodic review of the provider's claims. From time to time, PMR has recognized charges to its operating income as a result of particular uncertainties with the health care reimbursement rules as they apply to outpatient programs. Historically, a portion of PMR's revenue has been derived from managing outpatient programs. Because substantially all of the patients of outpatient programs are eligible for Medicare, collection of a significant component of PMR's management fees is dependent upon reimbursement of claims submitted to fiscal intermediaries by the hospitals or community mental health centers for which PMR managed these programs. Certain of PMR's management contracts with providers contain warranty obligations that require PMR to indemnify such providers for the portion of PMR's management fees, if any, disallowed for reimbursement by Medicare's fiscal intermediaries. In certain cases, PMR clients have made claims to PMR and PMR fulfilled its indemnity obligation. In other cases, PMR is aware that payors or fiscal intermediaries have disallowed claims from PMR's clients for amounts paid to PMR, yet the clients have not, to date, pursued a claim against PMR. In many cases, PMR has no knowledge of action by payors and fiscal intermediaries, although no claim has been made against PMR. In these events, claims may be made against PMR, and the combined company, after closing, should fiscal intermediaries or payors decline to reimburse PMR's client for fees and expenses paid to PMR. As of January 31, 2002, PMR had recorded approximately $3.8 million in contract settlement reserves to provide for such indemnity obligations. Subsequent to January 31, 2002, PMR reduced this reserve to $2.0 million based on an analysis of the estimated contract settlement reserve performed in the fourth quarter. PMR classifies these reserves as non-current since the ultimate determination of substantially all potential contract disallowances, if any, is not expected to occur in the current fiscal year. There can be no assurance that the amount of fees disallowed, and therefore owed by PMR, will not be greater than the amount of such reserves. Also, PMR's obligation to pay such amounts, if and when they become due, could have a material adverse effect on the short-term liquidity of the combined company. PMR believes that certain factors may lessen the impact of any such effect, including PMR's expectation that (i) if claims arise, they will likely arise on a periodic basis over several years, and (ii) disallowances may be offset, at least partially, by amounts owed to PMR by providers. In addition, PMR has been advised by the Centers for Medicare & Medicaid Services, formerly the Health Care Financing Administration, that certain program-related costs are not allowable for reimbursement. Thus, PMR may be obligated to reimburse amounts previously received from providers. Although PMR believes that the potential liability to satisfy such requirements has been adequately reserved in its financial statements, there can be no assurance that such reserves will be adequate. PMR's obligation to pay the amounts so reserved, if and when they become due, could have a material adverse effect on the cash flows and liquidity of the combined company and, if greater amounts become due, upon the combined company's business, financial condition and results of operations. 32 CURRENT PMR STOCKHOLDERS WILL NOT HAVE CONTROL OVER THE FUTURE DIRECTION OF THE COMBINED COMPANY. Immediately after the merger, PMR stockholders will hold approximately 28% of the outstanding shares of the combined company's common stock and, as a group, will not be able to elect a majority of the combined company's directors or control the future direction of the combined company. THE COMBINED COMPANY WILL HAVE A HIGHER DEBT LEVEL THAN PMR CURRENTLY HAS, WHICH MAY REQUIRE THE ALLOCATION OF A SUBSTANTIAL PORTION OF OPERATING CASH FLOW TO PAY INTEREST. The combined company will have higher levels of debt and interest expense after the merger than PMR on a stand-alone basis. The increased debt level will require us to use a substantial portion of the combined company's operating cash flow to pay interest on our debt instead of for other corporate purposes. The following table compares debt, leverage and interest coverage statistics for PMR and for the combined company on a pro forma basis:
PRO FORMA COMBINED PMR COMPANY --- --------- Total long-term debt as of March 31, 2002 (thousands)....... -- 33,134 Debt/capitalization ratio as of March 31, 2002.............. -- .54:1 Ratio of EBITDA to interest expense for the year ended December 31, 2001......................................... 1.31:1 1.04:1
The unaudited pro forma combined information should be read together with the historical consolidated financial statements of PMR and Psychiatric Solutions and the unaudited pro forma condensed combined financial statements contained elsewhere in this document. EBITDA represents income from continuing operations before interest expense (net of interest income), income taxes, depreciation, amortization and extraordinary items. Debt/capitalization ratio is calculated as long-term debt less current maturities divided by the sum of long-term debt less current maturities and total stockholders' equity. Ratio of EBITDA to interest expense is calculated as EBITDA, as defined above, divided by total interest expense. THE COMBINED COMPANY'S STOCK PRICE COULD BE VOLATILE. The market price of the combined company's common stock could fluctuate significantly in response to various factors, including: - problems relating to the integration of the companies; - problems in achieving revenue enhancements and operating efficiencies; - actual and estimated earnings and cash flows; - quarter-to-quarter variations in operating results; - changes in market conditions in the mental health or behavioral health care industries; - changes in general economic conditions; - fluctuations in the securities markets in general; - operating results differing from analysts' estimates; and - changes in analysts' earnings estimates. LOSS OF KEY PERSONNEL MAY HAVE A MATERIAL ADVERSE IMPACT ON THE COMBINED COMPANY. The operations of the combined company will be managed by a small number of key executive officers, the loss of any of whom could have a material adverse effect on the combined company. We cannot assure you that those individuals will remain with the combined company. 33 GENERAL UNCERTAINTY RELATED TO THE MERGER COULD HARM PMR AND PSYCHIATRIC SOLUTIONS. PMR's or Psychiatric Solutions' clients may, in response to the announcement of the proposed merger, delay or defer decisions to engage PMR's or Psychiatric Solutions' services. If PMR's or Psychiatric Solutions' clients delay or defer decisions to engage our services, the revenues of PMR and Psychiatric Solutions, respectively, could materially decline or any anticipated increase in revenue could be lower than expected. Also, speculation regarding the likelihood of the closing of the merger could increase the volatility of PMR's share price. CERTAIN OF PMR'S AND PSYCHIATRIC SOLUTIONS' OFFICERS, DIRECTORS AND STOCKHOLDERS HAVE CONFLICTS OF INTEREST THAT MAY INFLUENCE THEM TO SUPPORT OR APPROVE THE MERGER. Some of the directors and executive officers of PMR and Psychiatric Solutions, and certain stockholders of Psychiatric Solutions, participate in arrangements that provide them with interests in the merger that are different from yours, including, among other things, the following: - Continued Director Positions. Four directors of Psychiatric Solutions and two directors of PMR will become members of the board of directors of the combined company, and Joey A. Jacobs (currently the Chief Executive Officer of Psychiatric Solutions) will become the Chairman of the board of directors of the combined company upon the closing of the merger. - Accelerated Option Vesting. As a result of the merger, all option holders, including officers and directors, of PMR will receive accelerated vesting of their outstanding stock options. In addition, in connection with the merger, PMR will extend the exercise periods under outstanding options held by certain officers and directors of PMR. - Severance Arrangements. In connection with the merger, certain officers of PMR will be entitled to cash severance payments and other benefits in connection with their resignation or termination of employment. - Amendment of Promissory Notes. In connection with the merger, the terms of certain outstanding promissory notes issued by certain officers and directors of PMR have been amended to provide for more favorable repayment terms. - Financial Advisor Fee. Upon the consummation of the merger, an entity owned and controlled by a director and significant stockholder of PMR will receive a fee from PMR for the provision of certain financial services to PMR in connection with the merger. - Indemnification and Insurance. The combined company will indemnify each present and former Psychiatric Solutions officer and director against liabilities arising out of such person's services as an officer or director and the transactions contemplated by the merger agreement, and PMR will maintain Psychiatric Solutions' officers' and directors' liability insurance to cover any such liabilities for the next six years (subject to certain limitations). - Preferential Stockholder Treatment. In the merger, holders of Psychiatric Solutions' Series A preferred stock and Series B preferred stock will receive additional shares of PMR stock, relative to holders of Psychiatric Solutions common stock, in satisfaction of their preferential rights under Psychiatric Solutions' charter. - Potential Stock Liquidity. We anticipate that the trading volume of the combined company will increase, which may facilitate the sale of more shares under Rule 144 of the Securities Act of 1933 by the officers, directors and other affiliates of PMR. - Engagement of PMR Chairman. In connection with the closing of the merger, Allen Tepper, currently the Chairman of the Board of Directors and Chief Executive Officer of PMR, will enter into an employment or consulting arrangement with the combined company pursuant to which he will receive monthly compensation and may be eligible for health benefits. 34 - Engagement of PMR President. Fred D. Furman, the President and General Counsel of PMR, will serve as the representative of holders of contingent value rights pursuant to the contingent value rights agreement. As the representative, Mr. Furman will be entitled to certain compensation for services rendered. For a more detailed description of these interests, see "Interests of Certain Directors, Officers and Stockholders in the Merger" that begins on page 119 of this document. DURING THE PENDENCY OF THE MERGER, PMR AND PSYCHIATRIC SOLUTIONS MAY NOT BE ABLE TO ENTER INTO A MERGER OR BUSINESS COMBINATION WITH ANOTHER PARTY AT A FAVORABLE PRICE BECAUSE OF RESTRICTIONS IN THE MERGER AGREEMENT. Covenants in the merger agreement may impede the ability of PMR or Psychiatric Solutions to make acquisitions or complete other transactions that are not in the ordinary course of business pending completion of the merger. As a result, if the merger is not completed, the parties may be at a disadvantage to their competitors. In addition, while the merger agreement is in effect and subject to very narrowly defined exceptions, each party is prohibited from soliciting, initiating, encouraging or entering into certain extraordinary transactions, such as a merger, sale of assets or other business combinations, with any third party. FAILURE TO COMPLETE THE MERGER MAY RESULT IN PMR OR PSYCHIATRIC SOLUTIONS PAYING A TERMINATION FEE TO THE OTHER AND COULD HARM PMR'S COMMON STOCK PRICE AND PMR'S OR PSYCHIATRIC SOLUTIONS' FUTURE BUSINESS OPERATIONS. If the merger is not completed, PMR or Psychiatric Solutions may be subject to the following risks: - if the merger agreement is terminated under certain circumstances, PMR or Psychiatric Solutions will be required to pay the other a termination fee of $750,000 plus such other party's out of pocket expenses up to $250,000; - the price of PMR common stock may decline to the extent the current market price of PMR common stock reflects a market assumption that the merger will be completed, or to reflect PMR's cash dividend made to shareholders in contemplation of the merger; and - costs related to the merger, such as legal, accounting and certain financial advisory fees, must be paid even if the merger is not completed. In addition, if the merger agreement is terminated and PMR's or Psychiatric Solutions' board of directors, as the case may be, determines to seek another merger or business combination, there can be no assurance that it will be able to find a partner willing to pay an equivalent or more attractive price than the price to be paid in the merger. CHARGES TO EARNINGS RESULTING FROM THE APPLICATION OF THE PURCHASE METHOD OF ACCOUNTING MAY ADVERSELY AFFECT THE MARKET VALUE OF THE COMBINED COMPANY'S COMMON STOCK FOLLOWING THE MERGER. If the benefits of the merger are not achieved, the combined company's financial results, including earnings per share, could be adversely affected. In accordance with United States generally accepted accounting principles, the combined company will account for the merger using the purchase method of accounting. The combined company will allocate the total estimated purchase price to PMR's net tangible assets and amortizable intangible assets acquired and net liabilities assumed based on their fair values as of the date of completion of the merger, and record the excess of the purchase price of those fair values as goodwill. The combined company will incur amortization expense over the estimated useful lives of certain of the intangible assets acquired in connection with the merger. In addition, to the extent the value of goodwill or intangible assets with indefinite lives becomes impaired, the combined company may be required to incur material charges relating to the impairment of those assets. 35 RISKS RELATED TO THE BUSINESS OF EACH OF PMR AND PSYCHIATRIC SOLUTIONS THE HEALTH CARE INDUSTRY IN WHICH PMR AND PSYCHIATRIC SOLUTIONS OPERATE IS SUBJECT TO EXTENSIVE REGULATION; THE FAILURE TO COMPLY WITH SUCH REGULATIONS CAN HAVE A MATERIAL ADVERSE IMPACT ON EACH OF PMR AND PSYCHIATRIC SOLUTIONS. The health care industry is subject to extensive federal, state and local regulation relating to licensure, billing, privacy, conduct of operations, ownership of facilities, referrals, kickbacks, addition of facilities and services and prices for services. There can be no assurance that future regulatory changes will not have an adverse impact on PMR or Psychiatric Solutions. Many of these laws and regulations are expansive, and PMR and Psychiatric Solutions do not always have the benefit of significant regulatory or judicial interpretation. Different interpretations or enforcement of these laws and regulations could subject the current or past practices of each of PMR and Psychiatric Solutions to allegations of impropriety or illegality or could require each of PMR and Psychiatric Solutions to make changes in its respective facilities, equipment, personnel, services, capital expenditure programs, operating procedures, and contractual arrangements. If PMR or Psychiatric Solutions fails to comply with applicable laws and regulations, it could be subjected to liabilities, including: - criminal penalties, - civil penalties, including monetary penalties and the loss of licenses to operate one or more of its facilities, and - exclusion of one or more facilities from participation in the Medicare, Medicaid and other federal and state health care programs. A number of initiatives have been proposed during the past several years to reform various aspects of the health care system at the federal level. Current or future legislative initiatives or government regulation may have a material adverse effect on each of PMR and Psychiatric Solutions. OTHER COMPANIES WITHIN THE HEALTH CARE INDUSTRY CONTINUE TO BE THE SUBJECT OF FEDERAL AND STATE INVESTIGATIONS, WHICH INCREASES THE RISK THAT EACH OF PMR AND PSYCHIATRIC SOLUTIONS MAY BECOME SUBJECT TO INVESTIGATIONS IN THE FUTURE. Both federal and state government agencies as well as private payors have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of health care organizations. These investigations relate to a wide variety of topics, including: - cost reporting and billing practices, - quality of care, - financial relationships with referral sources, and - medical necessity of services provided. The Office of Inspector General of the Department of Health and Human Services and the U.S. Department of Justice have, from time to time, undertaken national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Moreover, health care providers are subject to civil and criminal false claims laws, including the federal False Claims Act, which allows private parties to bring whistleblower lawsuits against private companies doing business with or receiving reimbursement under government programs. Some states have adopted similar state whistleblower and false claims provisions. Publicity associated with the substantial amounts paid by other health care providers to settle these lawsuits may encourage current and former employees of PMR, Psychiatric Solutions and other health care providers to bring whistleblower lawsuits. Any investigations of PMR or Psychiatric Solutions or their respective executives or managers could result in significant liabilities or penalties as well as adverse publicity. 36 AS A PROVIDER OF HEALTH CARE SERVICES, EACH OF PMR AND PSYCHIATRIC SOLUTIONS IS SUBJECT TO CLAIMS AND LEGAL ACTIONS BY PATIENTS AND OTHERS. Hospitals acquired by Psychiatric Solutions may have unknown or contingent liabilities, including liabilities related to patient care and liabilities for failure to comply with health care laws and regulations, which could result in large claims and significant defense costs. Although Psychiatric Solutions generally seeks indemnification covering these matters from prior owners of hospitals it acquires, material liabilities for past activities of acquired hospitals may exist and such prior owners may not be able to satisfy their indemnification obligations. Each of PMR and Psychiatric Solutions is also susceptible of being named in claims brought related to patient care and other matters at facilities owned by third parties and operated by PMR or Psychiatric Solutions, as the case may be. To protect PMR and Psychiatric Solutions from the cost of these claims, professional malpractice liability insurance and general liability insurance coverage is maintained in amounts and with deductibles common in the industry. This insurance coverage may not cover all claims or continue to be available at a reasonable cost, especially given the significant increase in insurance premiums generally experienced in the health care industry. IF FEDERAL OR STATE HEALTH CARE PROGRAMS OR MANAGED CARE COMPANIES REDUCE REIMBURSEMENT FOR SERVICES PROVIDED, REVENUES MAY DECLINE. A large portion of each of PMR's and Psychiatric Solutions' revenues come from the Medicare and Medicaid programs. In recent years, federal and state governments made significant changes in these programs. These changes have, in certain instances, decreased the amount of money each of PMR and Psychiatric Solutions receive for services. Future federal and state legislation may further reduce the payments received for services provided. Insurance and managed care companies and other third parties from whom PMR and Psychiatric Solutions receive payment are increasingly attempting to control health care costs by requiring that hospitals discount their services in exchange for exclusive or preferred participation in their benefit plans. This trend may continue and may reduce the payments received by each of PMR and Psychiatric Solutions for its services. RISKS RELATED SOLELY TO THE BUSINESS OF PMR PMR DEPENDS ON ONE CUSTOMER FOR THE VAST MAJORITY OF ITS REVENUE, AND THE LOSS OF THIS CUSTOMER WOULD SIGNIFICANTLY REDUCE PMR'S REVENUE. Approximately 90% of PMR's revenue for the year ended April 30, 2002 was derived from two subsidiaries of Magellan Health Services, Inc. who receive funds under the Tennessee TennCare Partners State Medicaid Managed Care Program for the provision of mental health services, including case management services. PMR contracts with these subsidiaries to provide these services through a Nashville-based case management agency. It is anticipated that as of July 31, 2002 all of the covered patients of these two subsidiaries will be transferred to one of the subsidiaries. PMR's operating results in the foreseeable future will depend on this single customer. Therefore, the loss of this customer or the termination of PMR's agreement with the Nashville-based case management agency would significantly reduce PMR's revenue. RISKS RELATED SOLELY TO THE BUSINESS OF PSYCHIATRIC SOLUTIONS IF COMPETITION DECREASES THE ABILITY TO ACQUIRE ADDITIONAL HOSPITALS ON FAVORABLE TERMS, PSYCHIATRIC SOLUTIONS MAY BE UNABLE TO EXECUTE ITS ACQUISITION STRATEGY. Competition among hospitals and other health care providers in the United States has intensified in recent years due to cost containment pressures, changing technology, changes in government regulation and reimbursement, changes in practice patterns (such as shifting from inpatient to outpatient treatments), the impact of managed care organizations and other factors. An important part of the Psychiatric Solutions 37 business strategy is to acquire hospitals in growing urban markets. Some hospitals and health care providers that compete with Psychiatric Solutions have greater financial resources and larger, more experienced development staff focused on identifying and completing acquisitions. In addition, some competitors are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions, and can finance capital expenditures on a tax-exempt basis. Any or all of these factors may impede Psychiatric Solutions' business strategy. IF PSYCHIATRIC SOLUTIONS FAILS TO IMPROVE THE OPERATIONS OF ACQUIRED HOSPITALS, IT MAY BE UNABLE TO ACHIEVE ITS GROWTH STRATEGY. Some of the hospitals acquired or to be acquired had or may have operating losses prior to the time they were acquired. Psychiatric Solutions may be unable to operate profitably any hospital or other acquired facility, effectively integrate the operations of any acquisitions or otherwise achieve the intended benefit of its growth strategy. STATE EFFORTS TO REGULATE THE SALE OF HOSPITALS OPERATED BY NOT-FOR-PROFIT ENTITIES COULD PREVENT PSYCHIATRIC SOLUTIONS FROM ACQUIRING ADDITIONAL HOSPITALS AND EXECUTING ITS BUSINESS STRATEGY. Hospital acquisitions generally require a longer period to complete than acquisitions in many other industries and are subject to additional regulatory uncertainty. Many states have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the proceeds of the sale by the non-profit seller. In addition, the acquisition of hospitals in certain states requires advance regulatory approval under "certificate of need" or state licensure regulatory regimes. These state-level procedures could seriously delay or even prevent Psychiatric Solutions from acquiring hospitals, even after significant transaction costs have been incurred. PSYCHIATRIC SOLUTIONS DEPENDS ON ITS RELATIONSHIPS WITH PHYSICIANS WHO USE ITS FACILITIES. Psychiatric Solutions' business depends upon the efforts and success of the physicians who provide health care services at its facilities and the strength of the relationships with these physicians. The business of Psychiatric Solutions could be adversely affected if a significant number of physicians or a group of physicians: - terminate their relationship with, or reduce their use of, the facilities, - fail to maintain acceptable quality of care or to otherwise adhere to professional standards, - suffer damage to their reputation, or - exit the market entirely. PSYCHIATRIC SOLUTIONS DEPENDS ON ITS KEY MANAGEMENT PERSONNEL. Psychiatric Solutions is highly dependent on its senior management team, which has many years of experience addressing the broad range of concerns and issues relevant to the business of Psychiatric Solutions. Employment agreements are in place with Joey A. Jacobs, Chief Executive Officer, and Jack Salberg, Chief Operating Officer, and include non-competition and non-solicitation provisions, but key man life insurance policies are not maintained on any member of senior management other than Mr. Jacobs. The loss of key management or the inability to attract, retain and motivate sufficient numbers of qualified management personnel could have a material adverse effect on Psychiatric Solutions. Psychiatric Solutions' Chief Financial Officer position is currently vacant. 38 PSYCHIATRIC SOLUTIONS HAS A LIMITED OPERATING HISTORY. Psychiatric Solutions began operations in 1997 and acquired its first hospital in 2001. Because of its limited operating history, Psychiatric Solutions has limited insight into trends that may emerge in its industry and that affect its business. As a result, there can be no assurance that Psychiatric Solutions will achieve satisfactory operating results. ADDITIONAL FINANCING MAY BE NECESSARY TO FUND PSYCHIATRIC SOLUTIONS' ACQUISITION PROGRAM AND CAPITAL EXPENDITURES, AND ADDITIONAL FINANCING MAY NOT BE AVAILABLE WHEN NEEDED. Psychiatric Solutions' acquisition program requires substantial capital resources. Likewise, the operation of existing hospitals requires ongoing capital expenditures for renovation, expansion and the upgrade of equipment and technology. Psychiatric Solutions may not receive additional financing on satisfactory terms. In addition, Psychiatric Solutions' level of indebtedness at any time may restrict its ability to borrow additional funds. If Psychiatric Solutions is not able to obtain financing, then it may not be in a position to consummate acquisitions or undertake capital expenditures. RECENTLY ACQUIRED BUSINESSES OF PSYCHIATRIC SOLUTIONS AND BUSINESSES ACQUIRED BY THE COMBINED COMPANY IN THE FUTURE WILL EXPOSE THE COMBINED COMPANY TO INCREASED OPERATING RISKS. Psychiatric Solutions acquired four hospitals in 2001 and acquired a fifth hospital on July 1, 2002. This expansion exposes the combined company to additional business and operating risk and uncertainties, including: - our ability to effectively manage the expanded activities; - our ability to realize our investment in the expanded facilities; - our exposure to unknown liabilities; and - our ability to meet contractual obligations. If the combined company is unable to manage this expansion efficiently or effectively, or is unable to attract and retain additional qualified management personnel to run the expanded operations, this could result in a material adverse effect on the combined company. 39 FORWARD-LOOKING STATEMENTS This document and documents referred to in this document include "forward-looking statements" as defined by the SEC. "Forward-looking statements" are those concerning the companies' plans, synergies, expectations and objectives for future operations. When used or referred to in this document, forward-looking statements may be preceded by, followed by, or otherwise include words such as "believe," "expect," "anticipate," "intend," "plan," "estimate," "project," or similar expressions, or statements that some events or conditions "will" or "may" occur. All statements, other than statements of historical facts, included in this document that address activities, events or developments that the companies expect, believe or anticipate will or may occur in the future are forward-looking statements and include statements relating to the following matters: - completion of the proposed merger; - future financial performance; - future results of operations; - prospects for commercial or government contracts; - pro forma financial information; - financial position and liquidity; - labor and supply costs; and - selling, general and administrative costs. These statements occur in: - "Questions and Answers About the Merger"; - "Summary"; - "Selected Historical Consolidated Financial Data of PMR"; - "Selected Historical Consolidated Financial Data of Psychiatric Solutions"; - "Unaudited Pro Forma Condensed Combined Consolidated Financial Statements of PMR and Psychiatric Solutions"; - "Comparative Per Share Market Price and Dividend Information"; - "Comparative Per Share Data"; - "Risk Factors"; - "Business of PMR"; - "Business of Psychiatric Solutions"; - "The Merger -- Reasons for the Merger"; - "The Merger -- Recommendation of Each Company's Board of Directors"; - "The Merger -- Opinion of PMR's Financial Advisor"; - "The Merger -- Opinion of Psychiatric Solutions' Financial Advisor"; and - Statements contained elsewhere in this document concerning PMR's and Psychiatric Solutions' plans for their growth and future operations or financial position. 40 These forward-looking statements are based on assumptions, which the companies believe are reasonable, but which are subject to a wide range of uncertainties and business risks including: - risks related to the integration of the two companies; - risks arising from competition in the marketplace; - risks related to dependence on significant customers; - risks related to reimbursement rates; - risks related to regulatory matters; - the combined company's ability to manage its growth; and - additional risks identified in "Risk Factors." We cannot assure you that developments affecting PMR, Psychiatric Solutions, or the combined company will be those anticipated by us. "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995: Statements in this document regarding each company's business which are not historical facts are "forward-looking statements" that involve risks and uncertainties. For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see "Risk Factors" beginning on page 31 of this document. 41 BUSINESS OF PMR Over the past fourteen years PMR (and its subsidiaries) has been a leader in the development and management of specialized mental health care programs and disease management services designed to treat individuals diagnosed with a serious mental illness ("SMI"), primarily schizophrenia and bipolar disorder (i.e., manic-depressive illness). PMR currently manages, administers or provides consulting services for outpatient and community-based psychiatric services for SMI patients, consisting of two outpatient programs (the "Outpatient Programs") and case management programs for a case management agency in and around the Nashville, Tennessee area (the "Case Management Programs"). We refer to these programs in this document as "Health Services Programs". During the fiscal year ended April 30, 2002, PMR continued to focus on maximizing cash flow in the Health Services Programs. In July 2001, after exploring numerous strategic alternatives, PMR terminated the operations of its Infoscriber subsidiary and licensed the Infoscriber application to Conundrum Communications, Inc. on an exclusive and perpetual basis in the behavioral and social services areas. InfoScriber Corporation had a business plan to become a leading provider of strategic health information for pharmaceutical companies, medical device companies, managed care organizations and health care providers. PMR made significant progress in the completion of the software program, the signing and implementation of a group of select physicians as well as significant discussions with purchasers of the associated data. As anticipated, InfoScriber was using cash and PMR had hoped to seek additional third-party financing to fund the growth of the subsidiary. However, given the state of the capital markets and the need for significant additional investment to bring the InfoScriber subsidiary to profitability, it was determined in July 2001 that it would be in the stockholders' best interest to terminate the operations of InfoScriber. In addition, on July 30, 2001, PMR agreed to license the InfoScriber application to Conundrum. Conundrum will have the opportunity to grow the InfoScriber application in the behavioral health and social services areas while PMR's InfoScriber subsidiary will be eligible to receive royalties for a period of five years. PMR was incorporated in the State of Delaware in 1988. The operations of PMR include the operations of its wholly-owned subsidiaries, Psychiatric Management Resources, Inc., Collaborative Care Corporation, InfoScriber, and PMR Acquisition Corporation. The principal executive offices of PMR are located at 1565 Hotel Circle South, 2nd Floor, San Diego, California 92108. PMR's telephone number is (619) 610-4001. HEALTH SERVICES PROGRAMS OUTPATIENT PROGRAM MANAGEMENT SERVICES One aspect of PMR's historical business is the provision of management, administrative and consulting services to acute care hospitals, psychiatric hospitals and community mental health centers ("CMHCs") with respect to their outpatient programs, specifically Outpatient Programs for patients diagnosed with SMI ("Outpatient Program Management Services"). PMR does not render any medical or clinical services in connection with its Outpatient Program Management Services; all of these services are provided by the hospitals, CMHCs, and their personnel. The Outpatient Programs that PMR currently manages or administers consist primarily of psychiatric partial hospitalization programs. In these programs, the patient is ambulatory, but requires intensive, coordinated clinical services for SMI. In general, these programs are an alternative to inpatient care. They involve patients in crisis or recovering from crisis who, thus, require more intensive clinical services than those generally available in a traditional outpatient setting. As of June 1, 2002, PMR manages or provides consulting services to two Outpatient Programs. These services are provided under a contract, which has a remaining term of approximately two years, with an acute care hospital. This contract governs the method by which PMR provides consulting or management 42 services, the responsibility of the hospital provider for licensure, billing, staff, insurance and the provision of health care services and the manner in which PMR will be compensated. At each program location, PMR provides a program administrator, proprietary software and data systems, policies and procedures, clinical protocols and curricula and other technical and administrative information that enhance the quality of care and the efficiency of administration of the program. Effective March 8, 2002, this contract provides for payment of a fixed monthly fee by the hospital. Previously, the fees payable to PMR were based on the services that PMR provided. The hospital maintains responsibility for substantially all direct program costs under the contract. Historically, the costs incurred by the providers (hospitals or CMHCs) for PMR's Outpatient Program Management Services have been recovered by the provider through reimbursement by third party payors, typically Medicare and Medicaid. In that regard, the providers submitted invoices to the third party payors or requests for reimbursement in accordance with the regulations applicable to the governmental programs. The changing regulatory environment in recent years has resulted in the denial by Medicare or its fiscal intermediaries of claims for patient services rendered by the provider with respect to PMR's services and/or disallowance of reimbursement to the providers for portions of PMR's fees. Under the terms of some of PMR's terminated or expired contracts, PMR is required to indemnify the providers for some or all of PMR's fees if the fees were disallowed by Medicare or its fiscal intermediaries, or if the claims associated with PMR's fees for services rendered to patients were denied. In some instances, PMR is required to indemnify the hospital for certain of the hospital's direct costs if the claims associated with PMR's fees for services rendered to patients were denied. For further information regarding this matter, see "PMR Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources". The Outpatient Programs, after accounting for a $1.7 million reduction in contract settlement reserves, contributed revenues of $3.1 million for the fiscal year ended April 30, 2002, versus $3.3 million for fiscal year 2001. None of the Outpatient Programs that PMR administered during fiscal years 2002 and 2001 contributed more than 10% of PMR's consolidated revenues from continuing operations for the respective years. CASE MANAGEMENT PROGRAMS PMR acquired the model for its Case Management Programs in 1993. That model, as refined by PMR since then, constitutes a proprietary system for managing, in a managed care environment, treatment, rehabilitation and support for a limited population of individuals diagnosed with SMI. Specifically, PMR's Case Management Programs provide SMI patients with personalized, one-on-one services designed to stabilize their daily lives and to provide early intervention in crisis situations. In this fashion, PMR's programs limit the incurrence of the costs related to catastrophic events leading to inpatient hospitalization. Each program utilizes a case manager whose responsibilities include consumer education, crisis plan development, crisis event response, patient needs assessment, review of patient treatment plans, linking patients to emergency services and reviewing and authorizing services. Depending upon the needs of the specific case management population and the varying markets, these services may include 24-hour case management, crisis intervention, respite services, housing assistance, medication management and routine health screening. In providing case management services, PMR does not provide medical or clinical services; such services are performed by the case management agency with whom PMR contracts. PMR's Case Management Programs are located in and around Nashville, Tennessee. Prior to May 31, 2002, PMR also managed a Case Management Program in Memphis, Tennessee. In Tennessee, mental health care services for the Medicaid and qualified indigent population are provided under the Tennessee TennCare Partners State Medicaid Managed Care Program ("TennCare"). TennCare contracts with two behavioral health organizations ("BHOs") that are subsidiaries of Magellan Health Services, Inc. and that are at risk for the required services throughout the State of Tennessee. The BHOs in turn contract with various providers, including a wholly-owned subsidiary of PMR, for the provision of services to TennCare 43 enrollees. As of July 31, 2002, it is anticipated that all of the covered patients will be transferred to one of the BHOs. However, this should not have a material impact on PMR. The contracts between TennCare and the BHOs expire on or about December 31, 2003 and it is unknown whether the contracts will be extended or whether and how TennCare might initiate a bidding process for contracts after December 31, 2003, all of which creates uncertainty as to the future of the current arrangement. In general, PMR fulfills its contractual obligations to the BHOs pursuant to an exclusive agreement with the Nashville case management agency. The Nashville Case Management Program is administered pursuant to a management and affiliation agreement with the contracting case management agency. PMR is responsible for clinical systems, financial analysis, support services, contract development and other management and administrative services. Pursuant to the terms of the management and affiliation agreement, PMR manages and operates the delivery of case management and other covered psychiatric services. The case management agency is, however, responsible for staff personnel and program facilities, and retains final discretionary authority to approve the related policy manual, staffing issues and overall program operations. The term of the Nashville management and affiliation agreement has been extended to April 30, 2007 and may only be terminated upon the occurrence of events such as (i) a loss of accreditation or other required licensing or regulatory qualifications, (ii) material breach by either party, and (iii) certain legislative or administrative changes that may adversely affect the continued operation of the program. Through the Nashville Case Management Program, PMR currently provides case management services in and around Nashville to approximately 4,300 individuals residing primarily in the Nashville area. PMR had a second Case Management Program in Memphis, Tennessee, and the agreement with that case management agency expired on May 31, 2002. Case management contracts in Tennessee accounted for 92% and 82% of PMR's consolidated revenues from continuing operations for fiscal year 2002 and fiscal year 2001, respectively. COMPETITION In general, the operation of psychiatric programs is characterized by intense competition. General, community and specialty providers, including national companies and their subsidiaries, provide many different health care programs and services. Many other companies engaged in the management of outpatient psychiatric programs compete with PMR for the establishment of affiliations with acute care providers. Many of these present and future competitors are substantially more established and have greater financial and other resources than PMR does. In addition, PMR's current and potential providers may choose to manage mental health programs themselves rather than contract with PMR. There can be no assurance that PMR will be able to compete effectively with its present or future competitors, and any such inability could have a material adverse effect on PMR's business, financial condition and results of operations. REGULATORY MATTERS COMPLIANCE WITH MEDICARE GUIDELINES; REIMBURSEMENT FOR PARTIAL HOSPITALIZATION PROGRAMS With respect to PMR's revenues derived from payments made by providers to PMR for Outpatient Program Management Services, PMR bills its fees to the provider as a purchased management, administrative and consultative support service. Substantially all of the patients admitted to these programs are eligible for Medicare coverage and thus, the providers rely upon payment from Medicare for the services. Many of the patients are also eligible for Medicaid payments. As discussed below, there are at least three factors that will affect the revenue received by hospitals for Outpatient Programs managed by PMR: (i) coverage of services by third party payors, principally Medicare, i.e., payors will not pay any amount unless the services are covered; (ii) the amounts paid by third party payors, principally Medicare, for covered services; and (iii) the amounts paid by patients or their secondary payors for "coinsurance". To the extent that a hospital deems revenue for a program PMR 44 managed to be inadequate, it may seek to terminate its contract with PMR or not renew the contract. Similarly, PMR will not obtain new contracts for Outpatient Program Management Services if prospective customers do not believe that such programs will generate sufficient revenue. MEDICARE COVERAGE Medicare has published criteria limiting its coverage for partial hospitalization services to patients whose conditions are quite severe. The proper interpretation of Medicare's coverage criteria is often not clear. In addition, "intermediaries," or private contractors, who administer the Medicare program as contractors to the government, often interpret the Medicare coverage criteria in a very restrictive manner. Even when a patient should be found to meet the Medicare coverage, Medicare may deny coverage because the patient's condition was not documented adequately in the patient's medical record. Some adverse coverage determinations are made at the time the claim is presented. In such cases, Medicare does not pay for the services it deems not to be covered. In other instances, Medicare conducts coverage audits after claims have been paid. Often such audits are based on a sample of claims from a period, and the results of the sample are extrapolated to the universe of claims submitted for the entire period. In such instances, Medicare may demand repayment from the provider of several hundreds of thousands of dollars or more. Because the Office of the Inspector General of the Department of Health and Human Services ("OIG") as well as the Centers for Medicine and Medicinal Services ("CMS"), formerly the Health Care Financing Administration of the Department of Health and Human Services, have both identified partial hospitalization services as having often been billed to and paid by Medicare even though the services did not meet Medicare's coverage criteria, PMR expects the frequency and intensity of coverage reviews and audits of partial hospitalization services to continue or even to increase in the future. Coverage denials can have a direct adverse impact on PMR because some of its terminated contracts obligate PMR to refund to the provider fees paid to PMR, and in some instances certain of the hospital's direct costs, with respect to services for which coverage is denied. See "PMR Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." Depending on the basis for the denial of coverage, the provider may be able to appeal the coverage denial. PMR has assisted providers in appealing coverage denials and have, to date, prevailed in many of the cases PMR has pursued, resulting in restoration of PMR's fees previously not paid because of the denial. There can be no assurance that coverage denials for services managed by PMR will be overturned at that rate in the future. In addition, PMR does not undertake to appeal all services and may decide in the future not to pursue any such appeals. The appeal process can often extend for more than a year. MEDICARE PAYMENT RATES FOR COVERED SERVICES On or about August 1, 2000, under a new Medicare payment formula called the outpatient prospective payment system, Medicare began paying a pre-established rate to providers for outpatient services. Under the new formula, Medicare pays $206.82 per day (adjusted up or down for differences in wages from area to area) of partial hospitalization service, assuming that the services meet Medicare's coverage criteria (see "-- Medicare Coverage"). Medicare pays this amount regardless of whether it is more or less than a hospital's actual costs, although there is a three-year transition period during which hospitals whose aggregate costs for Medicare outpatients exceed the Medicare rates will receive some additional Medicare payments, but not up to the level of full costs. The Medicare rates for outpatient services should be updated annually, but in the past when Medicare has adjusted other rates similar to its new rates for hospital outpatient services, the updates have often been increases in amounts that were less than the increase in the "hospital market basket," i.e., the increase in costs of items and services purchased by hospitals. In some instances, Medicare has reduced rates in the updating process. 45 PATIENT COINSURANCE, MEDICAID COVERAGE OF MEDICARE COINSURANCE AMOUNTS, AND MEDICARE ALLOWABLE BAD DEBTS Although Medicare has established a rate for partial hospitalization services of $206.82 per day, Medicare will not pay that full amount to a hospital. It will deduct from that rate an amount for patient "coinsurance," or the amount that the patient is expected to pay. Most of the patients receiving services in partial hospitalization programs managed by PMR are unable to pay the coinsurance amount. If such patients are also covered by Medicaid, the Medicaid program usually will not pay the Medicare coinsurance amount in states where PMR furnishes Outpatient Program Management Services such as where PMR's two existing programs are located. Thus, the Medicare coinsurance amount will go uncollected by the provider except to the extent that the provider is partially reimbursed that amount as a Medicare "bad debt" as described in the following paragraph. To the extent that neither a Medicare patient nor any secondary payor for that patient pays the Medicare coinsurance amount after a documented reasonable collection effort or the patient's indigence is documented, the provider is entitled to be paid 70 percent of this "bad debt" by Medicare. However, there are many instances when Medicare denies reimbursement for all or part of claimed bad debts for coinsurance on Medicare patients on grounds that the provider did not engage in a reasonable collection effort or that the provider failed to maintain adequate documentation of its collection effort or of the patient's indigence. MEDICARE COST REIMBURSEMENT FOR PARTIAL HOSPITALIZATION FOR SERVICES FURNISHED PRIOR TO MEDICARE'S OUTPATIENT PROSPECTIVE PAYMENT SYSTEM Prior to the implementation of Medicare's outpatient prospective payment system, Medicare paid for partial hospitalization services on the basis of "reasonable cost," subject to coinsurance of 20 percent of the provider's charges. Medicare made interim payments to a provider based on an estimate of the provider's cost, and then made a final settlement based on an annual cost report filed by the provider. Providers claimed fees paid to PMR as part of their allowable costs for serving Medicare covered patients. Under the applicable Medicare principles of reimbursement, PMR's fees should be allowed if they are "reasonable" and relate to covered services. Medicare's policy directs that generally the reasonableness of PMR's fees should be evaluated by the market value of the services furnished by PMR. PMR believes that its fees are and have been fair market value for the services furnished. Nevertheless, there have been occasions when Medicare has disallowed a portion of PMR's fees, and that may occur in the future as Medicare conducts audits of cost reports for periods through July 31, 2000 (or such time as cost reimbursement ends for hospital outpatient services). In some instances, PMR has a contractual obligation to repay a provider the amount of PMR's fees, which are disallowed. MEDICARE CRITERIA FOR "PROVIDER-BASED" SITES In order for Medicare to cover partial hospitalization services, the services must be furnished by a hospital or a CMHC. In many instances, PMR has managed Outpatient Programs for a hospital or CMHC in which the program has been conducted away from the main campus of the provider. Such services have been covered by Medicare as the provider's services on the basis that the site where the services were furnished was a "provider-based" site. In 1996, Medicare published a policy that defined more narrowly than prior practice what was a "provider-based" site. In April 2000, Medicare published a final regulation that further defined what is a "provider-based" site. As a result of the Benefits Improvement and Protection Act of 2000, facilities treated as provider-based as of October 1, 2000 shall continue to be treated as provider-based until October 1, 2002, the effective date of the April 2000 final regulation. In addition, the April 2000 final regulation specifies instances when there may be retrospective recoveries of amounts previously paid by Medicare if a determination is made that a site was not "provider-based." On May 9, 2002, CMS published a rule that proposes to further extend the "grandfathering" of provider-based entities. Under the proposed rule, a facility will continue to be treated as provider based until the start of the hospital's first cost reporting period beginning on or after July 1, 46 2003. The proposed rule also specifies that in addition to possible recoupment of amounts previously paid, future payments may be adjusted to approximate the amounts that would be paid for the same services furnished by a freestanding facility. PMR is unable to predict when or if the provisions of this proposed rule will be adopted in final form. PMR believes that the sites it presently manages are provider-based within the meaning of the April 2000 final regulation, and PMR expects that its provider customers will obtain, or have obtained, determinations of such provider-based status from Medicare. However, it is possible that such sites will not obtain approval as provider-based sites or will lose such approval in the future. In such instances, there may be a loss of Medicare coverage for services furnished at that site and there may be a retrospective recovery by Medicare. There also is a risk that Medicare will determine that sites where PMR furnished Outpatient Program Management Services in the past were not provider-based. Such a determination would not necessarily trigger a demand for repayment from the provider because there is a "good faith" exception to demanding recoupment of amounts paid if the site: (i) was held out to the public as part of the provider; (ii) was part of the provider's licensed premises (if licensure was required); (iii) the provider billed Medicare a facility charge; and (iv) the physicians practicing at the site properly indicated the site of service on their bills to Medicare for professional services. PMR believes, but cannot assure, that the sites PMR managed met the good faith exception for retrospective recoveries. If a site managed by PMR in the past were found not to have been provider-based and the "good faith" exception not met, Medicare would demand repayment in full for the amounts it had paid for partial hospitalization services for all periods, which are subject to reopening at the time of the determination (generally the 5 preceding years, but it could be more in individual circumstances). If such demands were made upon providers that had contracted with PMR, it is possible that the providers would seek indemnity or damages from PMR. In some instances, it is possible that a court would interpret PMR's contract with a provider as requiring PMR to indemnify the provider asserting such a claim. COMPLIANCE WITH MEDICAID REGULATIONS AND POTENTIAL CHANGES PMR cannot predict the extent or scope of changes which may occur in the ways in which state Medicaid programs contract for and deliver services to Medicaid recipients. All Medicaid funding is generally conditioned upon financial appropriations to state Medicaid agencies by the state legislatures and there are political pressures on such legislatures in terms of controlling and reducing such appropriations. With respect to PMR's Case Management Programs reimbursed by behavioral health organizations, the overall trend is generally to impose lower reimbursement rates including incentives to assume risk not only by licensed managed care organizations with whom state Medicaid agencies contract, but by subcontracted providers, such as PMR. Consequently, any significant reduction in funding for Medicaid programs could have a material adverse effect on PMR's business, financial condition and results of operations. Some states may adopt substantial health care reform measures which could modify the manner in which all health services are delivered and reimbursed, especially with respect to Medicaid recipients and with respect to other individuals funded by public resources. The reduction in other public resources could have an impact upon the delivery of services to Medicaid recipients. SPECIFIC LICENSING OF PROGRAMS PMR's Outpatient Programs are operated as outpatient departments of providers, thus subjecting such programs to regulation by federal, state and local agencies. These regulations govern licensure and conduct of operations at the facilities, review of construction plans, addition of services and facilities and audit of cost allocations, cost reporting and capital expenditures. The facilities occupied by the programs must comply with the requirements of municipal building, health and fire codes. Inclusion of hospital space where the Outpatient Programs are furnished within the providers' license, when required under applicable state laws, is a prerequisite to participation in the Medicare programs. Additionally, the provider's premises and programs are subject to periodic inspection and recertification. 47 FALSE CLAIMS INVESTIGATIONS AND ENFORCEMENT OF HEALTH CARE FRAUD LAWS The OIG, as well as other federal, state, and private organizations, are aggressively enforcing their interpretation of Medicare and Medicaid laws and policies, and other applicable standards. Often in such enforcement efforts, the government has relied on the Federal Civil False Claims Act ("False Claims Act"). Under that law, if the government prevails in a case, it is entitled to treble damages plus not less than $5,000 nor more than $11,000 per claim, plus reasonable attorney fees and costs. In addition, a person found to have submitted false claims, or who caused the submission of false claims, can be excluded from governmental health care programs including Medicare and Medicaid. If a provider contracting with PMR were excluded from governmental health programs, no services furnished by that provider would be covered by any governmental health program. PMR could also be excluded from government health care programs if there were a finding that PMR had violated its obligations to those programs. If PMR were excluded, providers would as a practical matter, cease contracting for PMR's Outpatient Program Management Services. If PMR were excluded from governmental health programs, providers contracting with PMR could not be reimbursed for amounts paid to PMR. To prevail in a False Claims Act case, the government need show only that a person submitted, or "caused" to be submitted, incorrect claims with "reckless disregard" or in "deliberate ignorance" of the applicable Medicare law. The government does not have to prove that the claims were submitted with the intent to defraud a governmental or private health care payor. The qui tam provisions of the False Claims Act permit individuals also to bring suits under the False Claims Act. The incentive for an individual to do so is that he or she will usually be entitled to approximately 15% to 30% of any ultimate recovery. Under the False Claims Act, the Department of Justice has successfully made demands on thousands of providers to settle alleged improper billing disputes at double alleged damages or more. Although PMR does not bill governmental programs directly, PMR could possibly be liable under the False Claims Act to the extent that PMR is found to have "caused" false claims to have been presented. There are many other civil and criminal statutes at the federal and state levels that may penalize conduct related to submitting false claims for health care services. The penalties under many of those statutes are severe, and the government often need not prove intent to defraud in order to prevail. Management believes that PMR is in material compliance with applicable regulatory and industry standards. However, in light of the complexity of the policies governing governmental health care programs together with changing and uncertain interpretations of those policies, it is impossible to be absolutely assured that the government (or a qui tam relator in the name of the government) will not assert that some of PMR's conduct, or conduct by one of PMR's customers, has given rise to a potentially large liability. In the past, there have been occasions when Medicare fiscal intermediaries have denied coverage for all or substantially all of the claims submitted by the providers where PMR had a management or administrative services contract. Such denials have occurred even though a physician has certified that the Outpatient Program services were medically necessary. Notwithstanding PMR's ongoing efforts to assure that the Outpatient Program services furnished under contract are consistent with PMR's understanding of the Medicare coverage criteria, it is possible that there will be future occasions when a substantial number of services furnished at a site managed by PMR will be denied coverage. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") grants the U.S. Department of Health and Human Services broad authority to impose civil monetary penalties on providers for certain activities. Among those activities are the repeated submission of claims for services which are not medically necessary. If there were again to be occasions when a Medicare fiscal intermediary denied a large number of claims for a site managed by us, it is possible that the government would seek sanctions from the provider and possibly from PMR. While PMR believes that it would be inappropriate for the government to seek such sanctions for services for which the coverage criteria are interpreted differently at different times and which have been ordered by a physician, it is not clear at this time how the government will apply this new authority. 48 ANTI-REMUNERATION LAWS Medicare and Medicaid law prohibits an entity from paying or receiving, subject to certain exceptions and "safe harbors," any remuneration to induce the referral of Medicare or Medicaid beneficiaries, or the purchase or arranging for or recommending of the purchase of items or services that may receive payment under Medicare, Medicaid, or other federally-funded health care programs. Several states have similar laws, which are not limited to services for which Medicare or Medicaid payments are made. Sanctions for violating these federal and state anti-remuneration laws may include imprisonment, criminal and civil fines, and exclusion from participation in Medicare, Medicaid or other applicable programs. The courts, OIG and administrative agencies interpret the federal anti-remuneration law broadly. Because of the federal statute's broad scope, the regulations establish certain safe harbors from liability. Some of PMR's practices do not satisfy all of the requirements necessary to fall under the applicable safe harbor. A practice that does not fall under a safe harbor, although not necessarily unlawful, may be subject to scrutiny and challenge. PMR believes that it is in substantial compliance with the legal requirements imposed by these laws and regulations, but there can be no assurance that PMR will not be subject to scrutiny or challenge under such laws or regulations. Such scrutiny or challenge may have a material adverse effect on PMR's business, financial condition and results of operations. PRIVACY AND CONFIDENTIALITY LEGISLATION Most of PMR's activities require PMR to receive or use confidential medical information about individual patients. In addition, PMR has used aggregated unidentified patient data for research and analysis purposes and with respect to PMR's InfoScriber business. Federal and some state legislation restrict the use and disclosure of confidential medical information and the fact of treatment. There are specific requirements permitting disclosure, but inadequate or incorrect disclosure, even if inadvertent or negligent, can trigger substantial criminal and other penalties. To date, no such legislation has been enacted that adversely impacts PMR's ability to provide its services. HIPAA requires the Department of Health and Human Services ("HHS") to promulgate standards for health information privacy and security, as well as develop standards for electronic health transactions. These HIPAA rules, referred to collectively as Administrative Simplification, apply only to those entities defined as covered entities (health plans, "clearinghouses," and those providers who transmit any health information in electronic form in connection with a standard transaction). HHS has published final regulations to protect the privacy of individually identifiable health information, setting forth the rights of individuals who are the subject of protected health information, and establishing the permitted uses and disclosures of personally identifiable health information. The effective date of the privacy regulations for compliance purposes is April 14, 2003. HHS has also published standards for electronic transactions which are effective for compliance purposes on October 16, 2002. This compliance date may be extended by one year to October 16, 2003, if the provider files a compliance extension form with the Centers for Medicare and Medicaid Services ("CMS") by October 15, 2002. Additionally, HHS has issued a Notice of Proposed Rulemaking titled "Security and Electronic Signature Standards" to protect the security of health information when it is electronically maintained or transmitted. It is unknown at this time when these security regulations will be finalized. In connection with case management services PMR may electronically conduct activities, such as transmitting health care claims or equivalent encounter data, that may be classified as standard transactions under HIPAA. Therefore, PMR may need to convert its systems to adapt to the required HIPAA format to accommodate any covered entity clients that are directly subject to HIPAA rules and regulations. Under HIPAA, covered entities are obligated to enter into contractual agreements with any other entity to which they disclose protected health information and obligate such entities to protect the privacy and security of health information. Accessing the protected health information of its covered entity clients may make PMR the business associates of covered entities, or it is feasible that in certain circumstances PMR and/or its wholly-owned subsidiaries may be considered covered entities themselves. In either case, these HIPAA agreements may obligate PMR to install certain technical security 49 protections and to establish new policies and procedures to insure the confidentiality and integrity of health information. The HHS Office of Civil Rights is the enforcement agency for HIPAA Administrative Simplification and may assess civil penalties which range from $100 to $25,000 per year for each violation of an identical requirement or prohibition of the standards, to civil and criminal penalties of up to $250,000 and 10 years of prison for wrongful disclosure of health information for commercial advantage, personal gain, or malicious harm. Additionally, there are various state laws governing the protection of medical information, including certain statutes which may provide enhanced protections for sensitive health information, such as mental health records. HIPAA's civil and criminal sanctions apply only to covered entities. To the extent that PMR is not considered a covered entity itself, PMR's HIPAA liability under Administrative Simplification would be limited to any contractual agreements PMR makes. The costs of conforming PMR's systems to provide the privacy, security, and transaction standard conformance required by HIPAA Administrative Simplification and PMR's covered entity customers may require substantial cost investment in PMR's software, computers, policies and procedures, employee training, and other goods and services. UNLICENSED PRACTICE OF MEDICINE Many states prohibit physicians from splitting fees with non-physicians and prohibit non-physician entities from practicing medicine. These laws vary from state to state and are interpreted by courts and regulatory agencies with broad discretion. PMR believes that its contractual arrangements do not violate these laws. PMR's contractual arrangement and services, like InfoScriber, with some providers could possibly be challenged on the basis of being an alleged unlicensed practice of medicine, or the enforceability of provisions in that arrangement may be limited. In the event a regulatory authority limits or prohibits PMR or an affiliate from conducting PMR's business, PMR's contractual arrangements may require organizational modification or restructuring. INSURANCE Mental health care and information services are always subject to the risk of liability. In recent years, participants in the mental health care industry have become subject to an increasing number of lawsuits that allege malpractice or other related legal theories. These lawsuits often involve large claims and incur significant defense costs. PMR maintains liability insurance intended to cover such claims, which is renewable annually. PMR believes that its insurance coverage conforms to industry standards. There are no assurances, however, that PMR's insurance will cover all claims (e.g., claims for punitive damages), or that claims in excess of PMR's insurance coverage will not arise. A successful lawsuit against PMR that is not covered by, or is in excess of, PMR's insurance coverage may have a material adverse effect on PMR's business, financial condition and results of operations. There are no assurances that PMR will be able to obtain liability insurance coverage on commercially reasonable terms in the future or that such insurance will provide adequate coverage against potential claims. PROPERTIES PMR owns no real property. PMR currently subleases approximately 3,500 square feet comprised of a lease for its corporate headquarters at 1565 Hotel Circle South, 2nd Floor, San Diego, California expiring on September 30, 2002, with an option to renew for six months. PMR carries property and liability insurance as required by its sublessors. PMR believes that its facilities are adequate for its short-term needs. LEGAL PROCEEDINGS From time to time, PMR has been involved in routine litigation incidental to the conduct of its business. There are currently no material pending litigation proceedings to which PMR is a party. 50 EMPLOYEES As of May 31, 2002, PMR employed approximately 28 employees, of whom 24 are full-time employees. Approximately 13 are direct program employees and approximately 15 are in corporate management including finance, accounting, development, utilization review, training and education, information systems, member services, human resources and legal areas. None of PMR's employees is subject to a collective bargaining agreement and PMR believes that its employee relations are good. MEETINGS OF THE BOARD During the fiscal year ended April 30, 2002, PMR's Board of Directors met eight times. DIRECTORS OF PMR The following individuals currently serve on PMR's Board of Directors: Allen Tepper, Mark P. Clein, Charles C. McGettigan, Susan D. Erskine, Richard A. Niglio, Eugene D. Hill, III, and Satish Tyagi. Each of the current directors of PMR other than Charles C. McGettigan and Mark P. Clein will continue in office until the closing of the merger as described elsewhere in this joint proxy statement/prospectus. Messrs. McGettigan and Clein will become directors of the combined company. See "Directors and Officers of the Combined Company Following the Merger." ALLEN TEPPER Mr. Tepper, 54, was a co-founder of PMR in May 1988 and has served as Chairman of the Board of PMR since October 31, 1989. Mr. Tepper also currently serves as the Chief Executive Officer of PMR having been elected to such office on June 10, 2002. Previously, Mr. Tepper served as Chief Executive Officer of PMR from October 1989 to May 1999, and as President from October 1989 to April 1997. Mr. Tepper was a co-founder of Consolidated Medical Corp. in 1979, which was engaged in outpatient clinic management for acute care hospitals in the Philadelphia area. The company was sold to the Berwind Corporation in 1984 and Mr. Tepper remained with the company until December 1986 as Senior Vice President. Mr. Tepper serves as Chairman of the Board of Paidos Health Management Services, Inc., a privately-held neo-natal managed care company. Mr. Tepper holds a Masters of Business Administration degree from Northwestern University and a Bachelors degree from Temple University. MARK P. CLEIN Mark P. Clein, 42, has been a director of PMR since 1999. Mr. Clein presently serves as Executive Vice President and Chief Financial Officer of US Bioservices Corporation. Prior to joining US Bioservices Corporation, Mr. Clein served as Chief Executive Officer of PMR from May 14, 1999 to May 10, 2002, and previously served as Executive Vice President and Chief Financial Officer of PMR from May 1996 to May 1999. Prior to joining PMR, Mr. Clein was a Managing Director of Health Care Investment Banking for Jefferies & Co., an investment banking firm, from August 1995 to May 1996. Previously, Mr. Clein was a Managing Director of the investment banking firms of Rodman & Renshaw, Inc. (March 1995 to August 1995) and Mabon Securities Corp. (March 1993 to March 1995) and served as a Vice President with Sprout Group, an affiliate of Donaldson, Lufkin and Jenrette, Inc. (May 1991 to March 1993), and a Vice President and partner with Merrill Lynch Venture Capital, Inc. (1982 to February 1990 and August 1990 to February 1991). Mr. Clein holds a Masters of Business Administration degree from Columbia University and a Bachelors degree from the University of North Carolina. CHARLES C. MCGETTIGAN Mr. McGettigan, 57, has been a director of PMR since 1992. Mr. McGettigan was a co-founder in November 1988 and remains a Managing Director of McGettigan, Wick & Co., Inc., an investment banking firm. He is a general partner of Proactive Investment Managers, L.P., a limited partnership which, through its holdings, is a principal stockholder of PMR. See "Security Ownership of Certain Beneficial Owners and Management." Mr. McGettigan has previously served as an investment banker with Blyth 51 Eastman Dillon & Co. (1970-1980); Dillon, Read & Co. (1980-1982); Woodman, Kirkpatrick & Gilbreath (1983-1984); and Hambrecht & Quist (1984-1988). Mr. McGettigan serves on the Boards of Directors of Cuisine Solutions, Modtech, Onsite Energy, Sonex Research, and Tanknology. SUSAN D. ERSKINE Ms. Erskine, 50, was a co-founder of PMR in May 1988 and has been Executive Vice President, Secretary and a director of PMR since October 31, 1989. Ms. Erskine previously served in several operational and marketing management positions with acute care hospitals and health care management organizations. She holds a Master's degree in Health Science and completed post graduate work at Stanford University in Education and Psychology. She has extensive experience in program development, marketing and management of psychiatric programs, both inpatient and outpatient. RICHARD A. NIGLIO Mr. Niglio, 59, has been a director of PMR since 1992. In June 2000, Mr. Niglio was appointed as President, Chief Executive Officer and a Director of Chumbo Holdings, Inc., which has since been renamed Microgistix, Inc. From June 1998 until August 1999, he was Chairman and Chief Executive Officer of Equities Enterprises, Inc. From 1987 until May 1998, he was Chairman and Chief Executive Officer of Children's Discovery Centers of America, Inc. From 1982 until March 1987, he was President, Chief Executive Officer and a director of Victoria Station Incorporated. Prior to that time he held various executive positions with several major publicly held companies such as International Multifoods and Kentucky Fried Chicken Corporation. Mr. Niglio currently serves on the Boards of Directors of ShipExact.com, Inc., a private company providing fulfillment and other outsourcing services to the e-commerce industry, and VCExperts.com, Inc., a venture capital infoportal and services company. EUGENE D. HILL, III Mr. Hill, 50, has served as a director of PMR since 1995. Mr. Hill is a Partner with Schroder Ventures Life Sciences, a venture capital firm, since April 1999. Previously, Mr. Hill was with Accel Partners, a venture capital firm, since 1994 and a General Partner of the firm since 1995, where he focused on healthcare service investments. Prior to that time, he was President of Behavioral Health at United HealthCare Corporation from 1992 to 1994. From 1988 to 1992, he served as President and CEO of U.S. Behavioral Health, a managed behavioral healthcare company he built from a start-up to a national enterprise. Previously Mr. Hill was the President and Chairman of Sierra Health and Life Insurance Company. Prior to Sierra, he served as the Administrator of the Southern Nevada Memorial Hospital and the Boston City Hospital. He has been a managed healthcare consultant and venture capital advisor, and serves on the Boards of Directors of Interplan, Navix Radiology Systems, Phase Forward, Physicians Dialysis, MD Everywhere, EMED Technologies, and Cadent. He is a graduate of Middlebury College, received his M.B.A. in health care administration from Boston University and has completed Harvard University's Executive Program in Health Systems Management. SATISH K. TYAGI Mr. Tyagi, 46, has served as a director of PMR since 2000. Mr. Tyagi is currently Principal of Delta Capital & Research, a financial advisory and strategic consulting firm focused on healthcare IT, services, and medical technology. He is also currently engaged with Schroder Ventures Life Sciences, a venture capital firm, as Venture Partner. Previously, Mr. Tyagi was with investment banks SG Cowen Securities Corp., where he was Managing Director, Institutional Research since 1997, and Jefferies & Co., where he was Managing Director, Equity Research, since 1995. Mr. Tyagi serves on the Board of Directors of Superior Consultant Holdings Corp. Mr. Tyagi received his M.B.A. in Finance from New York University and a Bachelors degree in Economics from University of Delhi, New Delhi. 52 EXECUTIVE OFFICERS OF PMR The following individuals currently serve as executive officers of PMR.
NAME OFFICE(S) - ---- --------- Allen Tepper............................................ Chief Executive Officer Fred D. Furman.......................................... President & General Counsel Susan D. Erskine........................................ Secretary Reggie A. Roman......................................... Chief Financial Officer
Each of the current executive officers will continue in office until the closing of the merger. FRED D. FURMAN Fred D. Furman has served as President and General Counsel of PMR since April 1997. Previously, he held the position of Executive Vice President -- Administration and General Counsel from March 1995 to April 1997. Prior to joining PMR, Mr. Furman was a partner at Kleinbard, Bell and Brecker, a Philadelphia law firm from 1980 to March 1995. Mr. Furman is a member of the American Health Lawyers Association. He holds a Juris Doctor degree and a Bachelors degree from Temple University. REGGIE A. ROMAN Reggie Roman has served as Chief Financial Officer of PMR since October 2001. Previously, he held the position of Vice President of Finance, Strategic Planning and Reimbursement from May 1999 to October 2001. Mr. Roman started with PMR in February 1993 and served as the Manager and Director of the budget and reimbursement departments of PMR until April 1999. Prior to joining PMR, Mr. Roman has served in several finance, accounting and auditing positions with healthcare organizations. He holds dual degrees in Accountancy and Finance from the University of the Philippines. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS GRANT OF OPTIONS AND STOCK AWARD TO CERTAIN DIRECTORS AND EXECUTIVE OFFICERS Directors and members of PMR's management have been granted options to purchase PMR common stock. See "-- Compensation of Directors and Executive Officers -- Outside Directors' Non-Qualified Stock Option Plan of 1992," "-- Compensation of Directors and Executive Officers -- 1997 Equity Incentive Plan" and "-- Compensation of Directors and Executive Officers -- Stock Option Grants and Exercises." In April 2002 PMR's Board of Directors granted Reggie Roman 8,333 shares of PMR common stock. INDEBTEDNESS OF CERTAIN EXECUTIVE OFFICERS In January 2000, PMR loaned Messrs. Clein and Furman $467,500 and $684,750, respectively, pursuant to promissory notes for the purchase of stock from the exercise of stock options (the "Stock Notes"). The Stock Notes, due December 31, 2004, bear interest at the rate of 6.21% per annum and are with recourse in addition to being secured by stock under respective pledge agreements. PMR also received promissory notes from Messrs. Clein and Furman for up to $257,208 and $193,311, respectively, for tax liabilities related to the purchase of such stock (the "Tax Notes"). The Tax Notes, due December 31, 2004, bear interest at the rate of 6.21% and are secured by respective stock pledges, but are otherwise without recourse. In May 2002, the Stock Notes and Tax Notes for Mr. Clein were amended to include a provision that allows the principal and interest on the notes to be paid, at anytime prior to December 31, 2003, through the delivery to PMR of PMR common stock valued at the higher of (i) $7.92 or (ii) the average closing sales prices of PMR common stock for the five trading days prior to the delivery of such stock. Also in May 2002, the Stock Notes and Tax Notes for Mr. Furman were amended to included a provision that allows the principal and interest on the notes to be paid, at anytime prior to December 31, 2003, through the delivery to PMR of PMR common stock valued at the higher of 53 (i) $8.82 or (ii) the average closing sales prices of PMR common stock for the five trading days prior to the delivery of such stock. As of April 30, 2002, Messrs. Clein and Furman owed $59,554 and $256,624, respectively, under the Stock Notes and $278,505 and $209,317, respectively, under the Tax Notes. SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Exchange Act requires PMR's directors and executive officers, and persons who beneficially own more than ten percent of a registered class of PMR equity securities, to file with the Securities and Exchange Commission (the "SEC") initial reports of ownership and reports of changes in ownership of PMR common stock and other equity securities of PMR. PMR officers, directors and greater than ten percent beneficial owners are required by SEC regulation to furnish PMR with copies of all Section 16(a) reports they file. To PMR's knowledge, based solely on a review of the copies of such reports furnished to PMR and written representations that no other reports were required, (i) Jon D. Gruber and J. Patterson McBaine, beneficial owners of more than ten percent of PMR common stock, failed to file a required Form concerning the sale of 1,916 shares of PMR common stock during fiscal year ended April 30, 2002, and (ii) Reggie A. Roman failed to file a required Form when he became Chief Financial Officer of PMR in October 2001 but has since made an amended filing on the required Form. AUDIT COMMITTEE The Audit Committee of PMR's Board of Directors is responsible for supervising the integrity of PMR's financial reporting and selecting, evaluating, and, where appropriate, replacing PMR's independent auditors. PMR's Audit Committee consists of outside directors Messrs. McGettigan, Niglio, and Hill, each of whom is an independent director as such term is defined in Marketplace Rule 4200 of the Nasdaq Stock Market. During the fiscal year ended April 30, 2002, the Audit Committee met two times. Report of the Audit Committee(1) The following is the report of the PMR's Audit Committee with respect to PMR's audited financial statements for the fiscal year ended April 30, 2002, which are included elsewhere in this joint proxy statement/prospectus. The Audit Committee has reviewed and discussed these audited financial statements with management of PMR. The Audit Committee has discussed with PMR's independent auditors, Ernst & Young LLP, the matters required to be discussed by SAS 61 (Codification of Statements on Auditing Standards, AU Section 380) as amended, which includes, among other items, matters related to the conduct of the audit of the financial statements. The Audit Committee has received the written disclosures and the letter from Ernst & Young LLP required by Independence Standards Board Standard No. 1 ("Independence Discussions with Audit Committees") as amended, and has discussed with Ernst & Young LLP the independence of Ernst & Young LLP from PMR. The Audit Committee has also considered whether the provision of services by Ernst & Young LLP to PMR is compatible with maintaining the independence of Ernst & Young LLP. - --------------- 1 The material in this report is not "soliciting material," is not deemed "filed" with the SEC, and is not to be incorporated by reference into any filing of PMR under the Securities Act or the Exchange Act, whether made before or after the date hereof and irrespective of any general incorporation language contained in such filing. 54 Based on the review and discussions referred to above in this report, the Audit Committee recommended to PMR's Board of Directors that the audited financial statements be included in PMR's Annual Report on Form 10-K for the fiscal year ended April 30, 2002 for filing with the Securities and Exchange Commission. Submitted by the Audit Committee of the Board of Directors Charles C. McGettigan Eugene D. Hill, III Richard A. Niglio COMPENSATION OF DIRECTORS AND EXECUTIVE OFFICERS COMPENSATION OF DIRECTORS The employee-directors of PMR receive no fees or other compensation in connection with their services as directors. PMR has adopted an informal policy to pay a fee of $500 to each non-employee director who attends a regularly scheduled or special meeting of the Board of Directors and to pay expenses for attendance at any such meeting. For the fiscal year ended April 2002, Messrs. Hill and McGettigan, each received such payments in an aggregate amount of $2,000, Messrs. Tyagi and Niglio each received payments in an aggregate amount of $1,500, and PMR paid their expenses in connection with attendance at meetings. OUTSIDE DIRECTORS' NON-QUALIFIED STOCK OPTION PLAN OF 1992 Each non-employee director of PMR receives stock option grants under the Outside Directors' Non-Qualified Stock Option Plan of 1992 (the "Outside Directors' Plan"). Only non-employee directors of PMR are eligible to receive options under the Outside Directors' Plan. Options granted under the Outside Directors' Plan are intended by PMR not to qualify as incentive stock options under the Internal Revenue Code of 1986, as amended (the "Code"). Option grants under the Outside Directors' Plan are non-discretionary. As of the date of the regular meeting of PMR's Board of Directors closest to August 3rd of each year, each member of PMR's Board who is not an employee of PMR is automatically granted under the Outside Directors' Plan, without further action by PMR, the Board or the stockholders of PMR, an option to purchase 5,000 shares of common stock of PMR. The Board may also grant options at any other time under the Outside Directors' Plan. The exercise price of options granted under the Outside Directors' Plan must be at least 100% of the fair market value of the PMR common stock subject to the option on the date of the option grant. Options granted under the Outside Directors' Plan are immediately exercisable as to 30% of the option shares and the remaining 70% of the option shares become exercisable in equal installments on each of the first, second and third anniversary of the option grant date in accordance with the terms of the Outside Directors' Plan. In the event of certain mergers of PMR with or into another corporation or certain other consolidation, acquisition of assets or other change-in-control transactions involving PMR, the vesting period of each option will accelerate. On August 8, 2001, the Board granted options covering 5,000 shares of common stock of PMR to each of Messrs. McGettigan, Niglio, Hill, and Tyagi at the exercise price per share of $4.50 (the fair market value based on the closing sales price reported on the Nasdaq National Market on that date). 1997 EQUITY INCENTIVE PLAN Option grants under the 1997 Equity Incentive Plan (the "Incentive Plan") are discretionary by PMR's Board of Directors. The exercise price of options granted under the Incentive Plan must be at least 55 100% of the fair market value of the common stock subject to the option on the grant date for incentive stock options and at least 85% of the fair market value of the common stock subject to the option on the grant date for nonstatutory stock options and restricted stock purchases. Options granted under the Incentive Plan are exercisable as determined by PMR's Board of Directors. Options granted to an employee who is a director of PMR become immediately exercisable upon certain change in control transactions. Options granted to an employee who is not a director become immediately exercisable following certain change in control transactions if, within one year of the change in control of PMR, (i) the optionee's employment is terminated other than for cause or (ii) the optionee's employment is constructively terminated. During the last fiscal year, PMR granted stock options to Named Executive Officers (as defined below) and employee-directors of PMR. See "-- Compensation of Directors and Executive Officers -- Stock Option Grants and Exercises" and " -- Certain Relationships and Related Transactions -- Grant of Options to Certain Directors and Executive Officers" for a description of the terms of such stock options. COMPENSATION PURSUANT TO PLANS PMR maintains a tax-deferred retirement plan under Section 401(k) of the Code for the benefit of all employees meeting minimum eligibility requirements (the "401(k) Plan"). Under the 401(k) Plan, each employee may defer up to fifteen percent (15%) of pre-tax earnings, subject to certain limitations. PMR will match fifty percent (50%) of an employee's deferral to a maximum of three percent (3%) of an employee's gross salary. PMR's matching contribution vests over a five (5) year period. For the years ended April 30, 2002, 2001, and 2000, PMR contributed $39,000, $116,000, and $236,000, respectively, to match employee deferrals. Of these amounts, $24,700, $20,890, and $23,987, respectively, were contributed to match deferrals of the Named Executive Officers (as defined below) of PMR. SUMMARY OF COMPENSATION The following table shows for the fiscal years ended April 30, 2002, 2001, and 2000, compensation awarded or paid to, or earned by, PMR's Chief Executive Officer and its other four most highly compensated executive officers at April 30, 2002 (the "Named Executive Officers"): SUMMARY COMPENSATION TABLE
LONG TERM COMPENSATION ------------ ANNUAL COMPENSATION SECURITIES ALL OTHER ------------------------------- UNDERLYING COMPENSATION NAME AND PRINCIPAL POSITION YEAR SALARY ($)(1) BONUS($) OPTIONS(#) ($)(2) - --------------------------- ---- ------------- -------- ------------ ------------ Allen Tepper.......................... 2002 175,000 -- -- 5,100 Chairman of the Board 2001 175,000 -- -- 5,100 2000 175,000 -- -- 4,800 Mark P. Clein......................... 2002 200,000 -- -- 5,100 Chief Executive Officer(3) 2001 200,000 -- -- 5,350 2000 200,000 200,000 141,666 5,113 Fred D. Furman........................ 2002 192,000 -- -- 4,809 President and General Counsel 2001 192,000 -- -- 5,340 2000 192,000 192,000 66,666 4,914 Susan D. Erskine...................... 2002 180,000 -- -- 4,875 Executive Vice President -- 2001 180,000 -- 33,333 5,100 Development and Secretary 2000 180,000 -- 13,333 5,263 Reggie A. Roman(4).................... 2002 102,673 57,500 -- 3,080 Chief Financial Officer
56 - --------------- (1) In accordance with the rules of the SEC, the compensation described in this table does not include perquisites and other personal benefits received by the Named Executive Officers which do not exceed the lesser of $50,000 or 10% of any such officer's salary and bonus shown in the table. (2) Represents matching contributions by PMR under the 401(k) Plan. (3) Mr. Clein resigned as Chief Executive Officer effective as of May 10, 2002. On June 10, 2002 the Board of Directors of PMR appointed Mr. Tepper as the Chief Executive Officer. (4) Reggie A. Roman was appointed Chief Financial Officer in October 2001. STOCK OPTION GRANTS AND EXERCISES PMR grants options to its executive officers under the Incentive Plan. As of April 30, 2002, options to purchase 283,576 shares were outstanding under the Incentive Plan and 694,673 shares remained available for grant under the Incentive Plan. There were no options granted to the Named Executive Officers. The following table shows for the fiscal year ended April 30, 2002, certain information regarding options granted to, exercised by, and held at year end by, the Named Executive Officers. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR, AND FISCAL YEAR-END OPTION VALUES
NUMBER OF SECURITIES UNDERLYING UNEXERCISED VALUE OF UNEXERCISED OPTIONS AT FISCAL IN-THE-MONEY OPTIONS SHARES ACQUIRED ON VALUE REALIZED YEAR-END (#) AT FISCAL YEAR-END ($)(2) NAME EXERCISE (#) ($)(1) EXERCISABLE/UNEXERCISABLE EXERCISABLE/UNEXERCISABLE - ---- ------------------ -------------- ------------------------- ------------------------- Mr. Tepper........... 0 0 8,333/0 0/0 Ms. Erskine.......... 0 0 18,150/66,666 0/21,167 Mr. Furman........... 0 0 20,586/33,333 0/0 Mr. Clein............ 0 0 95,906/63,333 0/0 Mr. Roman............ 0 0 5,862/1,346 0/0
- --------------- (1) Based on the fair market value per share of PMR common stock (the closing sales price reported by the Nasdaq National Market) at the date of exercise, less the exercise price. (2) Based on the fair market value per share of PMR common stock ($6.78) at April 30, 2002, less the exercise price, multiplied by the number of shares underlying the option. EMPLOYMENT CONTRACTS PMR and each of Messrs. Clein and Furman and Ms. Erskine entered into agreements dated August 25, 1999 (the "Employment Agreements"), providing for, among other things, the employment of such Named Executive Officer until August 30, 2000. On August 30, 2000 and each year thereafter, the term of the Employment Agreements will automatically be extended by one year unless notice has been otherwise provided. The Employment Agreements provide for an annual salary, subject to such increases as the Board of Directors of PMR may from time to time determine, and permit PMR's Board of Directors, in its sole discretion, to provide a bonus to such Named Executive Officers. The Employment Agreements provide that during the term of such Named Executive Officer's employment thereunder and for a period of one year immediately following termination of such employment, such Named Executive Officer will not solicit or attempt to solicit any employee, consultant or independent contractor of PMR to terminate his or her relationship with PMR. The Employment Agreements provide that if such Named Executive Officer's employment is terminated (i) by PMR without Cause (as defined in the Employment Agreement), (ii) by such Named Executive Officer for Good Reason (as defined in the Employment Agreement) or (iii) by PMR's notification of non-renewal prior to the date of automatic renewal, such 57 Named Executive Officer is entitled to additional compensation upon termination in the form of a lump sum payment and, if eligible, periodic payments for a specified period of time or until such Named Executive Officer begins employment with another company or business. Pursuant to the terms of a Consulting Agreement dated May 10, 2002, Mr. Clein resigned as the Chief Executive Officer of PMR, terminated his employment with PMR and PMR's subsidiaries, as applicable, and waived any rights to benefits and severance under his employment agreement. In addition, pursuant to such Consulting Agreement, Mr. Clein has agreed to render consulting services to PMR until the earlier of (i) May 10, 2003 or (ii) the closing of the merger transaction described elsewhere in this joint proxy statement/prospectus. Under the terms of the Consulting Agreement, Mr. Clein will be considered an independent contractor and will not be eligible for benefits as an employee of PMR (other than any rights under COBRA and continuation of health insurance through June 30, 2002). In consideration for Mr. Clein's consulting services, PMR has agreed to pay Mr. Clein a fee in the total amount of $240,000 in two installments -- $120,000 on May 10, 2002 and $120,000 upon the closing of the merger transaction or May 10, 2003, whichever occurs first. The Consulting Agreement also provides for the amendment of certain option agreements, pursuant to which PMR granted to Mr. Clein options to purchase 159,240 of PMR's common stock, such that the exercise periods with respect to those options will be extended. COMPENSATION COMMITTEE The Compensation Committee of PMR's Board of Directors is responsible for developing and making recommendations to PMR's Board of Directors with respect to PMR's executive compensation policies. PMR's Compensation Committee consists of outside directors Messrs. Niglio and Hill each of whom is a non-employee director. During the fiscal year ended April 30, 2002, the Compensation Committee met four times. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION There were no Compensation Committee interlock relationships during the fiscal year ended April 30, 2002. All directors of PMR, including Messrs. Niglio and Hill, have options to purchase shares of PMR's common stock. See "-- Compensation of Directors and Executive Officers -- Outside Directors' Non- Qualified Stock Option Plan of 1992" and "-- Compensation of Directors and Executive Officers -- 1997 Equity Incentive Plan." COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION(1) Executive Officer Compensation Program PMR's executive compensation program is based on the following four objectives: (i) to link the interests of management with those of stockholders by encouraging stock ownership in PMR; (ii) to attract and retain superior executives by providing them with the opportunity to earn total compensation packages that are competitive with the industry; (iii) to reward individual results by recognizing performance through salary, annual cash incentives and long-term stock based incentives; and (iv) to manage compensation based on the level of skill, knowledge, effort and responsibility needed to perform the job successfully. The components of PMR's compensation program for its executive officers include (i) base salary, (ii) performance-based cash bonuses, (iii) incentive compensation in the form of stock options, and - --------------- 1 The material in this report is not "soliciting material," is not deemed "filed" with the SEC, and is not to be incorporated by reference into any filing of PMR under the Securities Act or the Exchange Act, whether made before or after the date hereof and irrespective of any general incorporation language contained in such filing. 58 (iv) participation in PMR's 401(k) Plan. An explanation of the 401(k) Plan appears at "-- Compensation of Directors and Executive Officers -- Compensation Pursuant to Plans." Base Salary. Base salary levels for the PMR's executive officers are determined, in part, through comparisons with companies in the outpatient service industry, other companies with which PMR competes for personnel, and general geographic market conditions. Additionally, PMR's Compensation Committee evaluates individual experience and performance and the overall performance of PMR. PMR's Compensation Committee reviews each executive's salary on an annual basis and may increase each executive's salary based on (i) the individual's increased contribution to PMR over the preceding year; (ii) the individual's increased responsibilities over the preceding year; and (iii) any increase in median competitive pay levels. Annual Cash Bonuses. PMR's Compensation Committee recommends the payment of bonuses from time-to-time to PMR's employees, including its executive officers, to provide an incentive to these persons to be productive over the course of each fiscal year. These bonuses are awarded only if PMR achieves or exceeds certain corporate performance objectives relating to net income and/or cash flow. Accrued monthly, depending on the earnings of PMR, is a cash bonus pool to be paid out after fiscal year end. The size of the cash bonus to each executive officer is based on the individual executive's performance during the preceding year. Stock Options. PMR believes that a key component to the compensation of its executive officers should be through stock options. Stock options utilized by PMR for this purpose have been designed to provide an incentive to these employees by allowing them to directly participate in any increase in the long-term value of PMR. This incentive is intended to reward, motivate and retain the services of executive employees. PMR has historically rewarded its executive employees through the grant of Incentive Stock Options and Nonstatutory Stock Options. Incentive Stock Options are allocated to both executive and non-executive employees on an annual basis by either the Committee or the Board. PMR's 1997 Equity Incentive Plan (the "Incentive Plan") provides for the grant of up to an aggregate 1,333,333 Options, of which 638,660 had been granted as of April 30, 2002. Incentive Stock Options are granted with exercise prices equal to the prevailing market value of PMR's common stock on the date of grant, have 10-year terms and are subject to vesting periods established from time to time by the Committee. Incentive Stock Options granted to holders of 10% or more of PMR's stock are granted with exercise prices equal to 110% of the prevailing market value of PMR's common stock on the date of grant and have terms of 5 years. PMR has also granted Nonstatutory Stock Options on occasion, generally, in circumstances where the grant of the option may not satisfy certain of the technical criteria for an Incentive Stock Option. Through April 30, 2002, PMR had granted 168,750 Nonstatutory Stock Options to executive personnel under the Incentive Plan. See "-- Compensation of Directors and Executive Officers -- 1997 Equity Incentive Plan." PMR's Compensation Committee employs no particular set of mechanical criteria in awarding stock options. Rather, it evaluates a series of factors including: (i) the overall performance of PMR for the fiscal year in question; (ii) the performance of the individual in question; (iii) the anticipated contribution by the individual to PMR on an overall basis; (iv) the historical level of compensation of the individual; (v) the level of compensation of similarly situated executives in PMR's industry; and (vi) that level of combination of cash compensation and stock options that would be required from a competitive point of view to retain the services of a valued executive officer. 59 CEO Compensation The base salary of PMR's Chief Executive Officer has been and will continue to be adjusted from time-to-time in accordance with the criteria for the determination of executive officer compensation as described above in the section captioned "Base Salary." In setting the compensation for Mr. Clein for fiscal year 2002, PMR sought to retain a key executive officer while continuing to tie a significant percentage of his compensation to company performance. By the Compensation Committee Richard A. Niglio Eugene D. Hill, III PERFORMANCE MEASUREMENT COMPARISON The following graph and table show the total stockholder return of an investment of $100 in cash on April 30, 1997 for PMR's Common Stock and the Nasdaq Stock Market (U.S.) Index. All values assume reinvestment of the full amount of all dividends and are calculated as of April 30, of each year: (PERFORMANCE GRAPH)
- -------------------------------------------------------------------------------------- FISCAL YEAR 4/97 4/98 4/99 4/00 4/2001 4/2002 - -------------------------------------------------------------------------------------- PMR Corporation $100.00 $75.47 $21.70 $25.16 $16.25 $ 24.48 Nasdaq Stock Market (U.S.) 100.00 148.20 201.69 306.22 167.85 133.91
PMR'S INDEPENDENT AUDITORS PMR has selected Ernst & Young LLP as its independent auditors for the fiscal year ending April 30, 2003. Representatives of Ernst & Young LLP are expected to be present at PMR's Special Meeting, will have an opportunity to make a statement if they so desire and will be available to respond to appropriate questions. Audit Fees: During the fiscal year ended April 30, 2002, Ernst & Young LLP billed PMR $114,143 for the audit of our annual financial statements and for review of the financial statements included in PMR's quarterly reports on Form 10-Q and other Securities and Exchange Commission filings. 60 Audit Related Fees: During the fiscal year ended April 30, 2002, Ernst & Young billed PMR $24,463 for accounting consultations and due diligence assistance. Financial Information Systems Design and Implementation Fees: PMR did not engage Ernst & Young LLP to provide it with advice regarding financial information systems design and implementation during the fiscal year ended April 30, 2002. All Other Fees: During the fiscal year ended April 30, 2002, for all other fees Ernst & Young billed PMR $45,854 for other non-audit services rendered to PMR, including tax related services. PMR's Audit Committee, as stated in its Audit Committee Report included elsewhere in this joint proxy statement/prospectus, has considered whether the provision of the services described in the preceding paragraphs is compatible with maintaining the independence of Ernst & Young LLP. 61 PMR MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with "Selected Historical Consolidated Financial Data of PMR" and the consolidated financial statements and related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties, such as statements of plans, objectives, expectations and intentions. The cautionary statements made in this joint proxy statement/prospectus should be read as applying to all related forward-looking statements wherever they appear in this joint proxy statement/prospectus. The actual results could differ materially from those anticipated in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed in "Risk Factors" and "Business of PMR" as well as those discussed elsewhere. OVERVIEW Management of PMR has undertaken significant changes to its business and operations during fiscal year 2002 including terminating its InfoScriber operations and reducing corporate overhead. As a direct result of these changes plus $3.4 million in recoveries of certain accounts receivable previously provided as doubtful accounts and $3.2 million in tax benefit resulting primarily from the economic recovery stimulus package approved by the 107th Congress of the United States of America, which allowed PMR to carryback the losses for a five-year period versus a two-year period, PMR significantly improved results from operations and its financial position for the fiscal year ended April 30, 2002 versus 2001. The recovery of provision for doubtful accounts was primarily due to the collection of approximately $1.9 million of previously reserved accounts receivable relating to closed outpatient programs and a change in estimate on the collectability of certain other related receivables. PMR had approximately $5.8 million in net income during the fiscal year ended April 30, 2002 versus a loss of approximately $10.8 million for the same period in the prior year. During fiscal year 2002, PMR continued to focus on maximizing cash flow. At April 30, 2002, PMR's cash and short-term investments totaled $22.6 million, as compared to $17.8 million at April 30, 2001. The increase in cash and short-term investments resulted primarily from the approximately $1.9 million collection of receivables from previously closed Outpatient Programs, a $2.6 million income tax refund, plus cash flow from operations. On July 30, 2001, PMR agreed to license the InfoScriber application to Conundrum Communications, Inc. Conundrum will have the opportunity to grow the InfoScriber application in the behavioral health and social service areas while PMR's InfoScriber subsidiary will be eligible to receive royalties for a period of five years. As of April 30, 2002, no royalties have been earned by PMR. Other than some transition services that were already reimbursed by Conundrum, and certain termination costs already accounted for as part of PMR's special charges for the fiscal year ended April 30, 2002, PMR does not anticipate incurring any further costs associated with the InfoScriber subsidiary. On February 15, 2001, PMR announced its intention to explore strategic alternatives to maximize stockholder value and currently retains Raymond James and Associates, Inc. to assist PMR in this process. PMR also engaged the firm of McGettigan, Wick & Co. to assist in an advisory role. A principal of McGettigan, Wick & Co. serves on PMR's Board of Directors. On May 6, 2002, PMR announced the execution of a definitive merger agreement dated May 6, 2002, providing for the merger of a wholly-owned subsidiary of PMR with and into Psychiatric Solutions, with Psychiatric Solutions being the surviving corporation and becoming a wholly-owned subsidiary of PMR. In connection with the merger, the stockholders of Psychiatric Solutions will exchange all preferred stock and common stock of Psychiatric Solutions for shares of PMR common stock, and outstanding options and warrants to acquire the common stock of Psychiatric Solutions will convert into the right to acquire the common stock of PMR. After giving effect to the exercise of all outstanding options and warrants of Psychiatric Solutions following the merger, stockholders of Psychiatric Solutions will own approximately 72% of the combined company and PMR stockholders will own approximately 28% of the common stock of PMR upon completion of the 62 merger. The transaction will be subject to PMR stockholder approval, regulatory approval, and other customary closing conditions. In connection with and as a condition of closing, PMR has also proposed an amendment to its charter in order to effect a proposed 1-for-3 reverse stock split. The reverse stock split will be subject to PMR stockholder approval. In this regard, all shares and per share amounts in this document, unless noted otherwise, have been retroactively restated for all periods presented to reflect this reverse stock split. SOURCES OF REVENUE OUTPATIENT PROGRAMS PMR continues to manage or administer two outpatient programs with one acute care hospital. PMR does not intend to continue to devote resources to develop additional outpatient programs. Prior to March 8, 2002, some of PMR's contracts with the acute care hospital provided for payment of fees by the hospital based on the services rendered by PMR. Effective March 8, 2002, the payment of fees was converted to a fixed amount per month. The hospital maintains responsibility for substantially all direct program costs under this contract. Under the terms of PMR's terminated or expired contracts, PMR is required to indemnify the providers for some or all of PMR's fees if the fees were disallowed by Medicare or its fiscal intermediaries, or if the claims associated with PMR's fees for services rendered to patients were denied. In some instances, PMR is required to indemnify the hospital for certain of the hospital's direct costs if the claims associated with PMR's fees for services rendered to patients were denied. As of April 30, 2002, PMR had recorded $2.0 million in contract settlement reserves to provide for an estimate of possible amounts ultimately owed to its provider customers resulting from disallowance of costs by Medicare and Medicare cost report settlement adjustments. Such reserves are classified as long-term liabilities because ultimate determination of substantially all of the potential contract disallowances, if any, is not anticipated to occur during the current fiscal year. The $2.0 million in contract settlement reserves at April 30, 2002, is net of a $1.7 million reduction in contract settlement reserves during fiscal year 2002 due to estimated final settlement in Provider cost reports. This reduction in contract settlement reserve was recorded as an increase to net revenues for the period. CASE MANAGEMENT PROGRAMS For its case management programs in Tennessee, PMR receives a monthly case rate fee from the managed care consortium responsible for managing the Tennessee TennCare Partners State Medicaid Managed Care Program ("TennCare"). Revenue under the TennCare program is recognized in the period in which the related service is to be provided and may fluctuate based on rates set by the managed care consortium as well as level of patient enrollment. 63 RESULTS OF CONTINUING OPERATIONS The following table sets forth, for the periods indicated, the percentage of revenue represented by the respective financial items:
YEARS ENDED APRIL 30, ----------------------- 2002 2001 2000 ----- ----- ----- Revenue from continuing operations.......................... 100.0% 100.0% 100.0% ----- ----- ----- Direct operating expenses................................... 78.2% 86.5% 81.5% Research and development.................................... 1.0% 5.6% 0.0% Marketing, general and administrative....................... 18.8% 46.9% 20.1% Provision for (recovery of) doubtful accounts............... (15.4%) 4.1% 12.1% Depreciation and amortization............................... 2.6% 7.7% 2.4% Software development amortization........................... 0.0% 15.6% 0.0% Special charge.............................................. 5.2% 7.0% 3.4% ----- ----- ----- Total expenses.............................................. 90.4% 173.4% 119.5% ----- ----- ----- Interest expense............................................ (0.1%) (0.1%) (0.1%) Interest income............................................. 3.0% 7.4% 3.5% Income (loss) from continuing operations before income taxes..................................................... 12.5% (66.1%) (16.1%) Income tax (benefit) expense................................ (15.6%) (5.3%) 11.5% ----- ----- ----- Net income (loss) from continuing operations................ 28.1% (60.8%) (27.6%) ===== ===== =====
FISCAL YEAR ENDED APRIL 30, 2002 COMPARED TO FISCAL YEAR ENDED APRIL 30, 2001 Revenues. Revenue from continuing operations increased from $17.7 million for the fiscal year ended April 30, 2001 to $20.7 million for the fiscal year ended April 30, 2002, an increase of $3.0 million, or 16.9%. The increase was primarily due to a $3.2 million increase in Case Management Program revenues and a $1.7 million reduction in contract settlement reserves during fiscal year 2002 due to estimated final settlement in Provider cost reports, offset by a $1.9 million decrease in Outpatient Program revenues due to the termination of numerous programs in fiscal year 2001. Direct Operating Expenses. Direct operating expenses from continuing operations consist of costs incurred at program sites and costs associated with field management responsible for administering the programs. Direct operating expenses increased from $15.3 million for the fiscal year ended April 30, 2001 to $16.2 million for the fiscal year ended April 30, 2002, an increase of $900,000 or 5.9%. As a percentage of revenues, however, direct operating expenses were 78.2%, down from 86.5% for the fiscal year ended April 30, 2001 as a result of better operating margins during fiscal year 2002. Research and Development. PMR stopped incurring research and development costs with the termination of the InfoScriber operations in July 2001. Marketing, General and Administrative. Marketing, general and administrative expenses decreased from $8.3 million for the fiscal year ended April 30, 2001 to $3.9 million for the fiscal year ended April 30, 2002, a decrease of $4.4 million or (53%). The decrease was primarily due to the reduction in corporate overhead costs resulting from the termination of the InfoScriber operations. Recovery of Provision for Doubtful Accounts. During the fiscal year ended April 30, 2002, PMR recovered $3.4 million in provision for doubtful accounts. The recovery was primarily due to the collection of approximately $1.9 million of previously reserved accounts receivable relating to closed outpatient programs and a change in estimate on the collectability of certain other related receivables. Depreciation and Amortization. Depreciation and amortization expense decreased from $1.4 million for the fiscal year ended April 30, 2001 to $500,000 for the fiscal year ended April 30, 2002, a decrease of 64 $900,000 or (64.3%). The decrease was primarily due to the disposal and write-off of assets in 2001 resulting from contract terminations or expirations. Special Charge. Special charges of approximately $1.1 million were recorded in fiscal year 2002 for lease termination costs, severance costs, and write-off of various assets primarily resulting from the termination of the InfoScriber operations and the associated corporate overhead reductions. The accruals for special charges included in the liabilities sections in the consolidated balance sheets at April 30, 2002 and 2001 were $203,000 and $265,000, respectively. Net Interest Income. Interest income, net of interest expense, decreased from $1.3 million for the fiscal year ended April 30, 2001 to $600,000 for the fiscal year ended April 30, 2002, a decrease of $700,000 or (53.8%). The decrease was primarily due to the lower interest rates and lower average balances in interest-bearing assets during fiscal year 2002 versus 2001. PMR paid cash dividends of approximately $7.3 million in December 2000. Income Tax (Benefit) Expense. For the fiscal year ended April 30, 2002, PMR recognized total income tax benefit of $3.2 million primarily resulting from the economic recovery stimulus package approved by the 107th Congress of the United States of America, which allowed PMR to carryback the losses for a five-year period versus a two-year period, and refunds from various State tax authorities. PMR has treated the entire $3.2 million as income tax benefit because PMR had previously recognized a valuation allowance against all of its deferred tax assets. The valuation allowance was originally established because realization of the deferred tax assets was uncertain in light of recurring net losses, changes in PMR's core business and associated business risks. FISCAL YEAR ENDED APRIL 30, 2001 COMPARED TO FISCAL YEAR ENDED APRIL 30, 2000 Revenues. Revenue from continuing operations decreased from $42.5 million for the fiscal year ended April 30, 2000 to $17.7 million for the fiscal year ended April 30, 2001, a decrease of $24.8 million, or (58.4%). The decrease was primarily due to the termination of numerous Outpatient Program contracts during fiscal year 2001. The Outpatient Programs recorded revenues of $3.3 million for the fiscal year ended April 30, 2001, a decrease of $23.6 million or (87.7%) as compared to fiscal year 2000. Case Management Program revenues remained relatively unchanged between fiscal years 2000 and 2001. Direct Operating Expenses. Direct operating expenses from continuing operations consist of costs incurred at program sites and costs associated with field management responsible for administering the programs. Direct operating expenses decreased from $34.6 million for the fiscal year ended April 30, 2000 to $15.3 million for the fiscal year ended April 30, 2001, a decrease of $19.3 million, or (55.8%). As a percentage of revenues, direct operating expenses were 86.5%, slightly up from 81.5% for the fiscal year ended April 30, 2000 as a result of lower revenues in fiscal year 2001. Research and Development. PMR incurred, in fiscal year 2001, approximately $1.0 million in research and development costs related to the development of Version 2 of its InfoScriber medication management system. PMR will not incur did not incur thereafter significant additional research and development costs for InfoScriber due to the termination of the operations of InfoScriber in July 2001. Marketing, General and Administrative. Marketing, general and administrative expenses for the fiscal year ended April 30, 2001 was relatively unchanged from that for the fiscal year ended April 30, 2000. Provision for Doubtful Accounts. Provision for doubtful accounts from continuing operations decreased from $5.1 million for the fiscal year ended April 30, 2000 to $700,000 for the fiscal year ended April 30, 2001, a decrease of approximately $4.4 million or (86.3%). As a percentage of revenues, the provision for doubtful accounts decreased to 4.1% in the fiscal year ended April 30, 2001 from 12.1% in fiscal year 2000. The decrease was due to lower revenues in fiscal year 2001 and the additional reserves taken in fiscal year 2000 due to anticipated difficulties in the collection of receivables related to Outpatient Program locations closed throughout fiscal year 2000. PMR expects the allowance for non-collectible accounts to fluctuate based on the amount of claims from our Outpatient Programs under review and the number of Health Services Programs that it manages. 65 Depreciation and Amortization. Depreciation and amortization expense increased from $1.0 million for the fiscal year ended April 30, 2000 to $1.4 million for the fiscal year ended April 30, 2001, an increase of $400,000 or 40.0%. This increase was primarily due to the addition of computer equipment for InfoScriber and the change in estimates of useful life of certain assets related to the Case Management Program. Software Development Amortization. Amortization of the InfoScriber medication management software commenced upon its completion and commercial release in August 2000. Research for and development of Version 2 of the software started immediately thereafter. Version 2 was expected to completely replace Version 1 and was anticipated to be technically feasible shortly after April 30, 2001. Accordingly, PMR amortized the total capitalized cost of Version 1 of approximately $2.8 million through April 30, 2001. In July 2001, PMR terminated the operations of InfoScriber. Special Charge. Special charges of approximately $1.2 million were recorded in fiscal year 2001 for lease termination costs, severance costs, and write-off of various assets related to closures of numerous Outpatient Program locations and the impairment charge incurred on InfoScriber's furniture, equipment, and certain other current assets under the provisions of SFAS No. 121. The accruals for special charges included in the liabilities sections in the consolidated balance sheets at April 30, 2001 and 2000 were $265,000 and $376,000, respectively. Net Interest Income. Interest income, net of interest expense, decreased from $1.5 million for the fiscal year ended April 30, 2000 to $1.3 million for the fiscal year ended April 30, 2001, a decrease of $200,000 or (13.3%). This decrease resulted from lower interest bearing cash, cash equivalent, and short- term investment balances primarily due to the negative cash flow from InfoScriber and a $7.3 million cash dividend payment at the end of the third quarter of fiscal year 2001. Income Tax (Benefit) Expense. The income tax benefit of $929,000 in fiscal year 2001 is related to the federal and various state tax refunds recognized for the fiscal year ended April 30, 2000. Income tax expense for fiscal year 2000 was $4.9 million as a result of establishing a non-cash valuation allowance to fully reserve for deferred tax assets in conformity with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. The valuation allowance was recognized in fiscal year 2000 because realization of the deferred tax assets was uncertain in light of the changes in PMR's core business and associated business risks, including an unproven history of earnings in InfoScriber. PMR continued to fully reserve for its tax assets in fiscal year 2001. Results from Discontinued Operation. In the third quarter of fiscal year 2000, PMR sold substantially all of its interest in Stadt Solutions. The transaction, which eliminated PMR's ownership interest, resulted in cash proceeds of $3.3 million and a gain of $664,000, net of operating losses related to Stadt Solutions during fiscal year 2000. There were no discontinued operations in fiscal year 2001. LIQUIDITY AND CAPITAL RESOURCES For the fiscal year ended April 30, 2002, net cash provided by operating activities was $5.2 million as compared to net cash used in operating activities of $1.5 million in fiscal year 2001. The increase in cash flows from operating activities was primarily due to the decrease in operating expenses resulting from the termination of the InfoScriber operations, $1.9 million in collection of previously reserved accounts receivable, and $2.6 million in income tax refunds, net of payments. Cash and cash equivalents and short-term investments at April 30, 2002 were $22.6 million, an increase of $4.8 million, or 27.0%, as compared to $17.8 million at April 30, 2001. Working capital at April 30, 2002 was $20.8 million, an increase of $5.4 million, or 35.1%, as compared to working capital of $15.4 million at April 30, 2001. The increase in working capital was primarily due to the increase in cash provided by operating activities discussed in the preceding paragraph and a change in estimate on the collectability of certain other related receivables. 66 Actual cash usage during fiscal year 2003 may fluctuate and vary depending upon PMR's cash flow from its existing operations, success in continued collection on accounts receivable balances from closed programs, and completion of the merger agreement with PSI. Working capital may also be used, from time to time, to pay dividends to PMR's stockholders. In connection with the execution of the merger agreement, on May 6, 2002, the Board of Directors of PMR declared a special cash dividend in the amount of $5.10 per share, payable on May 24, 2002, to the stockholders of record as of the close of business on May 17, 2002. The total amount of the dividend that was paid on May 24, 2002 was approximately $12.3 million. Additionally, the PMR board of directors has authorized the repurchase of up to 15% of PMR's outstanding common stock. Purchased shares will be used for corporate purposes including issuance under PMR's stock compensation plans. The purchases will be made from time to time in open market transactions. During fiscal year 2001, PMR repurchased 3,333 shares of its common stock at an average price of $8.26 per share or $27,500 in open market transactions. During the fiscal year ended April 30, 2002, PMR repurchased 33,191 shares of its common stock at an average price of $5.08 per share, or $168,007 in open market transactions. All shares repurchased are held in treasury. In connection with its outpatient programs, PMR maintains reserves to cover the potential impact of two significant uncertainties: (i) PMR may have an obligation to indemnify certain providers for some portions of its management fee which may be subject to disallowance upon audit of a provider's cost report by fiscal intermediaries; and (ii) PMR may not receive full payment of the management fees owed by a provider during the periodic review of the provider's claims by the fiscal intermediaries. From time to time, PMR recognizes charges to operations as a result of particular uncertainties associated with the healthcare reimbursement rules as they apply to the outpatient programs. During the fiscal years 2000, 2001, and 2002, a portion of PMR's revenue was derived from the management of the outpatient programs. Because substantially all of the patients of the outpatient programs are eligible for Medicare, collection of a significant component of PMR's management fees is dependent upon reimbursement of claims submitted to fiscal intermediaries by the hospitals or community mental health centers on whose behalf these programs are managed. Certain of PMR's contracts with providers contain warranty obligations that require PMR to indemnify such providers for the portion of PMR's management fees disallowed for reimbursement by Medicare's fiscal intermediaries. As of April 30, 2001 and 2002, PMR had recorded $4.2 million and $2.0 million, respectively, in contract settlement reserves to provide for such indemnity obligations. These reserves have been classified as non-current because the ultimate determination of substantially all potential contract disallowances, if any, is not anticipated to occur during the current fiscal year. Although PMR believes that its potential liability to satisfy such requirements has been adequately reserved in the financial statements, there can be no assurance that the amount of fees disallowed will not be greater than the amount of such reserves. Also, the obligation to pay such amounts, if and when they become due, could have a material adverse effect on PMR's short-term liquidity. Certain factors are, in management's view, likely to lessen the impact of any such effect, including the expectations that (i) if claims arise, they will arise on a periodic basis over several years and (ii) any disallowance may be offset against obligations already owed by the provider to PMR. In addition, PMR has been advised by the Centers for Medicare & Medicaid Services, formerly Health Care Financing Administration, that certain program-related costs are not allowable for reimbursement. Thus, PMR may be responsible for reimbursement of the amounts previously paid to PMR that are disallowed pursuant to obligations that exist with certain providers. Although PMR believes that the potential liability to satisfy such requirements has been adequately reserved in the financial statements, there can be no assurance that such reserves will be adequate. The obligation to pay the amounts so reserved, if and when they become due, could have a material adverse effect upon PMR's cash flows and liquidity and, if greater amounts became due, on PMR's business, financial condition, and results of operations. Management believes that PMR has the financial resources needed to meet its business requirements throughout fiscal year 2003. PMR will continue to evaluate the allocation of its financial resources 67 including, but not limited to, the merger with PSI, dividend distributions, and funding of on-going working capital requirements. PMR may also, from time to time, use working capital, issue debt or equity securities, or a combination thereof, to finance other selective acquisitions of assets or businesses or for general corporate purposes. PMR's ability to effect any such issuance will be dependent on its results of operations, its financial condition, current market conditions and other factors beyond its control. IMPACT OF INFLATION A substantial portion of PMR's revenue is subject to reimbursement rates that are regulated by the federal and state governments and that do not automatically adjust for inflation. As a result, increased operating costs due to inflation, such as labor and supply costs, without a corresponding increase in reimbursement rates, may adversely affect PMR's earnings in the future. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has not been any change of accountants or any disagreements with PMR's accountants on any matter of accounting practice or financial disclosure during the reporting periods. CRITICAL ACCOUNTING POLICIES PMR's consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing its financial statements, PMR is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses included in the financial statements. PMR bases its estimates on historical experience and other information currently available, the results of which form the basis of PMR's estimates and assumptions. While PMR believes its estimation processes are reasonable, actual results could differ from those estimates. The following represent the estimates that PMR considers most critical to its operating performance and involve the most subjective and complex assumptions and assessments. ALLOWANCE FOR DOUBTFUL ACCOUNTS PMR estimates the allowance for doubtful accounts for receivables under its management contracts primarily based upon the specific identification of potential collection issues. PMR continually monitors its accounts receivable balances and utilizes cash collection data to support its estimates of the provision for doubtful accounts. The allowance for doubtful accounts is approximately 69.4% of the accounts receivable balance at April 30, 2002. The primary collection risk is attributable to claim denials and contract disputes. CONTRACT SETTLEMENT RESERVES Revenue under Outpatient Programs is recognized when services are rendered based upon contractual arrangements with customers at the estimated net realizable amounts. Under certain management contracts, PMR is obligated under warranty provisions to indemnify the customers for all or some portions of PMR's management fees that may be disallowed as reimbursable to the providers by Medicare's fiscal intermediaries. PMR has recorded contract settlement reserves to provide for possible amounts ultimately owed to its customers resulting from disallowance of costs by Medicare and Medicare cost report settlement adjustments. Disallowance of costs by Medicare are pertinent only for services rendered through September 30, 2000 inasmuch as the Medicare program converted to the prospective payment methodology for the reimbursement of outpatient services effective October 1, 2000. 68 PMR'S QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE SENSITIVITY PMR's financial instruments include an equipment note payable and investments in debt securities, including U.S. Treasury securities, commercial paper and certificates of deposit. The equipment note payable, due in November 2002, has an effective interest rate of 8.36%. There was approximately $72,000 outstanding under this note at April 30, 2002 and approximately $188,000 outstanding under this note at April 30, 2001. At April 30, 2001, the fair market value of PMR's investment in debt securities was approximately $4.1 million, which includes an unrealized holding gain of approximately $50,000. These securities bear interest rates ranging from 4.57 percent to 7.55 percent and are generally short-term and readily marketable. At April 30, 2002, the fair market value of the investment in debt securities was approximately $7.8 million, which includes an unrealized gain of approximately $32,000. These securities bear interest rates ranging from 1.10% to 7.88% and are generally short-term and readily marketable. PMR does not and has not used derivative financial instruments for any purpose, including hedging or mitigating interest rate risk, and PMR believes the increase in the fair value of its investments in debt securities due to interest rate sensitivity is temporary in nature. This determination was based on the marketability of the instruments, PMR's ability to retain its investment in the instruments, past market movements and reasonably possible, near-term market movements. Therefore, PMR does not believe that potential, near-term gains or losses in future earnings, fair values, or cash flows from changes in interest rates are likely to be material. EXCHANGE RATE SENSITIVITY PMR does not currently have financial instruments that are sensitive to foreign currency exchange rates. 69 BUSINESS OF PSYCHIATRIC SOLUTIONS OVERVIEW Since its formation in 1996, Psychiatric Solutions has become a leading provider of behavioral health care services in the United States. Psychiatric Solutions initially developed a services-oriented, broad-based platform to provide both inpatient and outpatient behavioral health care services. These services included psychiatric physician practice management, outpatient treatment facilities, employee assistance plans and psychiatric contract management services to general acute care hospitals. During the first two years of operations, Psychiatric Solutions' management made select acquisitions, evaluated their primary business lines and witnessed dramatic change in the market for behavioral health providers. In 1999, management began to reposition Psychiatric Solutions to focus on inpatient hospital settings. To that end, two post-acute geropsychiatric unit management companies, Cornerstone Behavioral Health Management and Sunrise Behavioral Health, Ltd. were acquired in 1999 and 2000, respectively. Psychiatric Solutions discontinued its physician practice management unit and related activities during 2000 and sold its employee assistance plan division in 2001. In 2001, Psychiatric Solutions continued its focus on the ownership of inpatient facilities by acquiring four freestanding specialty hospitals. On July 1, 2002 Psychiatric Solutions acquired its fifth inpatient facility. Through its managed and freestanding psychiatric hospitals, Psychiatric Solutions now offers an extensive continuum of behavioral health programs to critically ill children, adolescents and adults. Psychiatric Solutions was incorporated in the State of Delaware in September 1996. The principal executive offices of Psychiatric Solutions are located at 113 Seaboard Lane, Suite C-100, Franklin, Tennessee 37067. Psychiatric Solutions' telephone number is (615) 312-5700. INDUSTRY BACKGROUND CMS estimates that total health expenditures were $1.3 trillion in 2000. This represents a compound annual growth rate of 8.6% since 1980. According to Mental Health: A Report of the Surgeon General, the direct cost to treat mental health disorders accounted for 7% of total U.S. health care expenditures in 1996, or approximately $69.0 billion. Assuming this same 7% as a percentage of total health care expenditures, Salomon Smith Barney estimates that the direct cost to treat mental health disorders was approximately $91.0 billion in 2000. This estimate includes the total direct cost to treat the most common manifestations of mental illness such as anxiety, psychosis and depression. According to the 2000 census, there are approximately 281 million people in the United States. Salomon Smith Barney estimates that approximately 245 million people have some form of health insurance coverage, either through the private sector or through government entitlement programs such as Medicare and Medicaid. According to Open Minds, a behavioral health research and consulting firm, approximately 209 million beneficiaries were covered by some form of behavioral managed health care plan as of July 2000. The Surgeon General estimates that approximately 21% of Americans, or roughly 59 million individuals, suffer from a diagnosable mental disorder in any given year, with the most common being disorders of anxiety and mood (i.e. depression and bipolar disorder). Approximately 10% of the U.S. adult population utilizes mental health services each year, with another 5% seeking such services from social service agencies, schools, religious groups or self-help groups. The American Psychiatric Association estimates that more than 5% of Americans, or nearly 15 million people, suffer from severe depression. Additionally, it is estimated that some form of mild depression affects 20% to 26% of women and 8% to 12% of men over the course of a lifetime. The freestanding psychiatric hospital industry underwent a significant correction during the 1990s, including a decrease in the number of beds, hospitals and average length of stay per admission. The decreases were attributable to managed care providers who drove down the average lengths of psychiatric stays from approximately 30 days in 1987 to 10 days in 1999. This trend created overcapacity in several psychiatric markets, resulting in numerous hospital closures. For example, in Houston, Psychiatric 70 Solutions operates two of the remaining five freestanding psychiatric hospitals. At one time, there were twenty-eight freestanding psychiatric hospitals in Houston. Psychiatric Solutions believes that this correction in over capacity has run its course and a rebound is underway. Key indicators include (i) average lengths of stay in the industry stabilizing at 10 days per admission for the past four years, (ii) increases during 2000 and 2001 in admissions and census, and (iii) increases during 2000 and 2001 in average reimbursement rates. Psychiatric Solutions believes that these increases parallel the improved results experienced by general acute care hospitals and reflect true increases in demand by patients and a stronger bargaining position by providers that have survived the correction. The combination of a large population of insured beneficiaries, increasing demand for acute psychiatric services and increasing reimbursement rates should create a favorable industry environment going forward. BUSINESS STRATEGY With the acquisition of five psychiatric hospitals in the past 12 months, Psychiatric Solutions initiated its consolidation plan for the freestanding psychiatric hospital industry. Psychiatric Solutions plans to continue to acquire additional hospitals at a significant rate, although no assurance can be given that Psychiatric Solutions will be able to successfully execute this plan. Psychiatric Solutions believes that there are a number of attractive freestanding hospital acquisition candidates available for purchase at attractive valuations. Psychiatric Solutions utilizes the following acquisition criteria: - Number one or two market position within growing, urban areas with low capital expenditure requirements; - Minimum licensed hospital beds of 50 to 75; - Positive EBITDA; and - Opportunity for revenue growth and margin improvement through introducing new programs, intensive marketing and recruiting additional inpatient psychiatrists. Psychiatric Solutions has developed a strong pipeline of potential specialty psychiatric hospital acquisitions in various stages of evaluation and negotiation. On July 1, 2002, Psychiatric Solutions acquired Riveredge Hospital, in Forest Park, Illinois. See "Business of Psychiatric Solutions -- Recent Developments" on page 84. Psychiatric Solutions' strategy upon acquiring an inpatient facility is to improve operations by focusing on continuing to provide high quality cost effective patient care. The focus on revenue growth is to maintain and grow that facility's admissions and revenues through improvements to marketing and community education. A key opportunity for revenue growth is renegotiating managed care agreements. Further organic growth occurs through adding capacity in existing programs. Psychiatric Solutions also increases the focus on reducing costs by challenging staffing ratios and benefits costs. Psychiatric Solutions also includes the acquired hospital into its group purchasing cooperative to reduce supplies expense. Psychiatric Solutions believes that substantial opportunities exist to provide psychiatric contract management services to general acute care hospitals in the U.S. General acute care hospitals are increasingly outsourcing key clinical departments to independent management companies because they lack the expertise to (i) manage and operate specialized clinical programs, (ii) assess the programs for effectiveness and results, (iii) market and develop programs, and (iv) design and operate programs that satisfy specialized regulatory, licensing, accreditation and reimbursement requirements. Psychiatric Solutions plans to continue to add new management contracts and increase the number of third-party operations it manages, although no assurance can be given that Psychiatric Solutions will be able to achieve this goal. 71 OPERATIONS Currently, Psychiatric Solutions is organized into two operating divisions: (i) owning and operating freestanding psychiatric inpatient hospitals and (ii) managing psychiatric units owned by third parties. Through its freestanding and managed psychiatric hospitals, Psychiatric Solutions offers an extensive continuum of behavioral health programs to critically ill children, adolescents and adults. FREESTANDING SPECIALTY HOSPITAL DIVISION. The freestanding specialty hospital division is currently comprised of five hospitals that offer a complement of behavioral health care treatment and crisis stabilization services for critically ill children, adolescents and adults with psychiatric, emotional, substance abuse and behavioral disorders. Psychiatric Solutions' hospitals work closely with mental health professionals, non-psychiatric physicians, emergency rooms and community agencies that interact with individuals who may need treatment for mental illness or substance abuse. A typical treatment program integrates physicians and other patient-care professionals. For those patients who do not have a personal psychiatrist or other specialist, Psychiatric Solutions' hospital will arrange for the patient to be seen by a member of its medical staff. Psychiatric Solutions' hospitals provide 24-hour skilled nursing observation, daily interventions and oversight by psychiatrists, and intensive, coordinated treatments by physician-led teams of mental health care professionals. In addition to traditional inpatient programs, the hospitals also offer less costly treatment alternatives such as residential treatment, intensive adolescent weekend services, and other intensive and non-intensive outpatient programs and support group services. Over the past 12 months, Psychiatric Solutions has acquired the following hospitals: WEST OAKS HOSPITAL, HOUSTON, TEXAS (SOUTHWEST HOUSTON). Psychiatric Solutions acquired West Oaks in September 2001. West Oaks is a 142-bed private acute care psychiatric facility licensed by the Texas Department of Health and accredited by the JCAHO, with 20 beds licensed by the Texas Commission on Alcohol and Drug Abuse. As a Medicare, Medicaid and managed care provider, West Oaks offers a comprehensive continuum of inpatient, day treatment and outpatient services and programs for critically ill children, adolescents and adults. West Oaks operates the following programs:
NUMBER OF PROGRAM LICENSED BEDS - ------- ------------- Adult Psychiatric Intensive Care............................ 20 beds Adult General Psychiatric Care.............................. 20 beds Substance Abuse Program..................................... 18 beds Adult Psychiatry Dual Diagnosis Program..................... 20 beds Adolescent Psychiatric Care................................. 32 beds Child Psychiatric Care...................................... 16 beds Texas Commission on Alcohol and Drug Abuse Adult Residential Treatment Center.......................................... 16 beds
West Oaks Demographics. According to 2000 census information, Houston is the seventh largest city in the U.S. with a population of more than 1.95 million. The population of Houston and surrounding counties is growing more than 1.6% annually. Between 1990 and 1999 the population of the Houston Metropolitan Service area grew approximately 20.4% as compared to the national average of 9.7%. West Oaks Hospital Strategy. Since acquiring this hospital, Psychiatric Solutions has established key objectives for fiscal year 2002. These objectives include: (i) achieving a substantial overall increase in managed care reimbursement rates, (ii) continuing to increase inpatient admission volume, (iii) recruiting additional psychiatrists to the facility, (iv) controlling operating expenses in a competitive labor environment, and (v) establishing both a new dual disorder unit and a second adolescent inpatient unit. 72 West Oaks Payor Mix. West Oaks' payor base for the fiscal year ended December 31, 2001 consisted of approximately 66% commercial and managed care, 26% Medicare and 8% Medicaid. CYPRESS CREEK HOSPITAL, HOUSTON, TEXAS (NORTHWEST HOUSTON). Psychiatric Solutions acquired Cypress Creek in September 2001. Cypress Creek is a 114-bed private acute care psychiatric facility licensed by the Texas Department of Health, the JCAHO and the Texas Commission on Alcohol and Drug Abuse. As a Medicare, Medicaid and managed care provider, Cypress Creek provides a comprehensive continuum of inpatient, day treatment and outpatient services and programs for critically ill children, adolescents and adults. Cypress Creek operates the following programs:
NUMBER OF PROGRAM LICENSED BEDS - ------- ------------- Adult Psychiatric Intensive Care............................ 16 beds Adult Intermediate Psychiatric Care......................... 14 beds Adult General Psychiatric Care.............................. 32 beds Adolescent Psychiatric Care................................. 24 beds Child Psychiatric Care...................................... 8 beds Substance Abuse Detoxification.............................. 20 beds
Cypress Creek Demographics. According to 2000 census information, Houston is the seventh largest city in the United States with a population of more than 1.95 million. The population of Houston and surrounding counties is growing more than 1.6% annually. Between 1990 and 1999 the population of the Houston Metropolitan Service area grew approximately 20.4% as compared to the national average of 9.7%. Cypress Creek Hospital Strategy. Since acquiring this hospital, Psychiatric Solutions has established key objectives for fiscal year 2002. These objectives include: (i) achieving a substantial overall increase in managed care reimbursement rates, (ii) increasing inpatient admission volume, (iii) recruiting additional psychiatrists to the facility, (iv) controlling operating expenses with specific emphasis on salary and benefit costs, and (v) opening a new detoxification unit. Cypress Creek Payor Mix. Cypress Creek's payor base for the fiscal year ended December 31, 2001 consisted of approximately 72% commercial and managed care, 23% Medicare and 5% Medicaid. TEXAS NEUROREHAB CENTER, AUSTIN, TEXAS (TRAVIS COUNTY). Psychiatric Solutions acquired Texas NeuroRehab in November 2001. Texas NeuroRehab is a 127-bed private specialty neuropsychiatric/ neurobehavioral hospital and residential treatment center which offers an extensive range of medical rehabilitation, brain injury and neurobehavioral treatment programs for children, adolescents and adults. Long term acute care ("LTAC") beds comprise 31 of the 127 beds at Texas NeuroRehab. Texas NeuroRehab is licensed by the Texas Department of Health and the Texas Department of Protective and Regulatory Services. Texas NeuroRehab operates the following programs:
NUMBER OF PROGRAM LICENSED BEDS - ------- ------------- LTAC Specialty Hospital..................................... 31 beds Neuropsychiatric/Neurobehavioral Hospital................... 28 beds Residential Treatment Center................................ 68 beds
Texas NeuroRehab Demographics. According to 2000 census information, the Austin metropolitan area is the fourth largest area in Texas, with a population of more than 1.1 million. Austin's population has increased 41.0% from 465,600 in 1990 to 657,000 in 2000. According to the census, historical data indicates that Austin's population has doubled every 20 years. 73 Texas NeuroRehab Growth Strategy. Since acquiring this hospital, Psychiatric Solutions has established key objectives for fiscal year 2002. These objectives include: (i) achieving increases in managed care reimbursement rates, (ii) recruiting additional management, (iii) controlling operating expenses, and (iv) identifying new product lines, such as youth based residential treatment facilities. Texas NeuroRehab Payor Mix. Texas NeuroRehab's payor base for the fiscal year ended December 31, 2001 consisted of approximately 44% commercial and managed care, 18% Medicare and 38% Medicaid. HOLLY HILL HOSPITAL, RALEIGH, NORTH CAROLINA (WAKE COUNTY). Psychiatric Solutions acquired Holly Hill in December 2001. Holly Hill is a 108-bed private acute care psychiatric and substance abuse facility that provides a comprehensive continuum of inpatient, day treatment, and intensive outpatient services and programs for children, adolescents and adults. Holly Hill operates the following programs:
NUMBER OF PROGRAM LICENSED BEDS - ------- ------------- Adult Psychiatric Care...................................... 28 beds Adult Chemical Dependency................................... 28 beds Adolescent Psychiatric Care................................. 25 beds Child Psychiatric Care...................................... 27 beds
Holly Hill Demographics. According to 2000 census information, the Raleigh metropolitan area is one of the fastest growing areas in North Carolina with a population of more than 1.13 million. Wake county's population has increased 17.0% from 518,466 in 1996 to 606,403 in 2000. Holly Hill Hospital Strategy. Since acquiring this hospital, Psychiatric Solutions has established key objectives for fiscal year 2002. These objectives include: (i) achieving a significant overall increase in managed care reimbursement rates, (ii) increasing inpatient admission volume, (iii) recruiting additional psychiatrists to the facility, (iv) controlling operating expenses and (v) improving service quality. Holly Hill Payor Mix. Holly Hill's payor base for the fiscal year ended December 31, 2001 consisted of approximately 60% commercial and managed care, 25% Medicare and 15% Medicaid. RIVEREDGE HOSPITAL, FOREST PARK, ILLINOIS (CHICAGO, COOK COUNTY). Psychiatric Solutions acquired Riveredge Hospital on July 1, 2002. Riveredge is a 210 licensed-bed inpatient psychiatric facility that offers a full continuum of behavioral health care. Riveredge Hospital currently operates the following programs:
NUMBER OF PROGRAM LICENSED BEDS - ------- ------------- Adult Geriatric Psychiatric Care............................ 36 beds Adult General and Dual Diagnosis Psychiatric Care........... 36 beds Adolescent Psychiatric Intensive Care....................... 25 beds Young Adult General Psychiatric Care........................ 18 beds Adolescent Psychiatric Care................................. 72 beds Child Psychiatric Care...................................... 18 beds
Riveredge Demographics. According to 2000 census information, Chicago and the surrounding area is estimated to have a population of approximately 8 million and Cook County's population is estimated at approximately 5 million. Riveredge Hospital Strategy. Psychiatric Solutions acquired this hospital on July 1, 2002 and has established key objectives for the remainder of fiscal year 2002. These objectives include: (i) achieving a substantial overall increase in managed care reimbursement rates, (ii) increasing inpatient admission 74 volume, (iii) recruiting additional psychiatrists to the facility, and (iv) stabilizing revenues and controlling operating expenses in a competitive labor environment. Riveredge Payor Mix. Riveredge's payor base for the fiscal year ended December 31, 2001 consisted of approximately 12.5% commercial and managed care, 44.6% Medicare and 42.8% Medicaid. For a description of this transaction, see "Business of Psychiatric Solutions -- Recent Developments" on page 84. PSYCHIATRIC UNIT MANAGEMENT DIVISION. The psychiatric unit management division develops, organizes and manages geriatric behavioral health care programs within general acute care hospitals owned and operated by third parties. The division's experienced team administers a broad range of psychiatric health services designed to meet specific hospital requirements. As of July 8, 2002, Psychiatric Solutions managed 46 behavioral health units, making Psychiatric Solutions the second largest provider of psychiatric contract management services in the United States. Psychiatric Solutions has four new management contracts to open programs in 2002, although none of these programs has opened yet. The psychiatric unit management division is dedicated to providing quality programs with integrity, innovation and sufficient flexibility to develop individual programs that meet specific facility requirements. The increased demand for better quality, lower costs and simplified systems places additional burdens on management teams and clinical departments within hospitals. As a result, many general acute care hospitals are increasing efficiency by outsourcing key clinical departments and functions to independent contract managers that can provide focused expertise. Psychiatric Solutions offers hospitals a complete menu of management options, including: - Clinical and management infrastructure; - Personnel recruitment, staff orientation and supervision; - Corporate consultation; and - Performance improvement plans. Psychiatric Solutions and the client hospital determine the programs and services to be offered by the hospital. Each contract is tailored to address the differing needs of the client hospital and its community. Under the contracts, the hospital is the actual provider of the mental health services and utilizes its own facilities (including beds for inpatient programs), support services (such as billing, dietary and housekeeping), and generally its own nursing staff in connection with the operation of its programs. Generally, Psychiatric Solutions provides the behavioral health unit of the client hospital with: - a psychiatric director who provides medico-administrative management services and professional direction in all psychiatric matters relating to patients admitted to the unit, and determines if patients meet the clinical criteria for admission to the unit. - a program manager, who maintains a direct reporting relationship to the chief executive officer of the client hospital with respect to the day-to-day operations of the unit. In addition, the program manager generally: - provides administrative and training services; - assists with the administrative and clinical criteria for admission to the unit; - determines whether a patient meets the administrative criteria for admission; - advises client hospital with respect to issues relating to compliance with licensing, certification, accreditation and survey requirements; 75 - establishes performance improvement standards in conjunction with the client hospital that are consistent with the hospital's standards; and - completes, in conjunction with the hospital, annual performance evaluations of all unit patient care staff. - A medical director who provides direction in all non-psychiatric phases of patient care and provides physician coverage, including medical care for patients who do not have a primary physician relationship. While each of the management contracts is tailored to the specific needs of the client hospital, in general the contracts have an initial term of two to five years and are extended for successive one year periods unless terminated by either party. Psychiatric Solutions has successfully retained over 80% of the management contracts since it acquired its contract management division in 1999 and 2000. Substantially all of the management contracts contain non-compete and confidentiality provisions. In addition, the management contracts typically prohibit the client hospital from soliciting employees of Psychiatric Solutions during term of the contract and for a specified period thereafter. MANAGEMENT CONTRACTS At July 9, 2002, Psychiatric Solutions had a total of 46 management contracts with general acute care hospitals located in 14 states as shown below:
NUMBER OF STATE CONTRACTS - ----- --------- Arkansas.................................................... 2 California.................................................. 1 Indiana..................................................... 4 Iowa........................................................ 3 Louisiana................................................... 3 Minnesota................................................... 4 Mississippi................................................. 4 Missouri.................................................... 4 Ohio........................................................ 5 Oklahoma.................................................... 4 Pennsylvania................................................ 4 Tennessee................................................... 6 Texas....................................................... 1 Washington.................................................. 1 -- Total Contracts........................................... 46 ==
REGULATORY MATTERS Psychiatric Solutions, as a participant in the health care industry, is affected by the numerous laws and regulations that govern the operations of its facilities and programs at the federal, state and local levels. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of patient care and Medicare and Medicaid fraud and abuse. Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs, budget cuts or other legislative, regulatory or judicial actions could have an unforeseen material adverse effect on the financial position, results of operations and cash flows of the company. 76 MEDICARE REVENUE Psychiatric Solutions' owned facilities each derive approximately 23% of their revenue from Medicare. As psychiatric hospitals, these facilities are exempt from the inpatient services prospective payment system ("PPS") applicable to general acute care hospitals. Services are cost reimbursed by Medicare, subject to a per discharge ceiling (see "-- Medicare Payment Rates for Covered Services" for further reimbursement discussion). Medicare pays for inpatient psychiatric services on the basis of actual cost, subject to a deductible and coinsurance of 20% of the provider's charges. Medicare makes interim payments to the provider based on an estimate of the provider's cost, and then makes a final settlement based on an annual cost report filed by the provider. With respect to revenues derived from psychiatric unit management services, Psychiatric Solutions bills its fees to the provider as a purchased management, administrative and consultative support service. Substantially all of the patients admitted to these programs are eligible for Medicare coverage. As a result, the providers rely upon payment from Medicare for the services. Many of the patients are also eligible for Medicaid payments. To the extent that a hospital deems revenue for a program Psychiatric Solutions manages to be inadequate, it may seek to terminate its contract with Psychiatric Solutions or not renew the contract. Similarly, Psychiatric Solutions may not necessarily solicit new unit management contracts if prospective customers do not believe that such programs will generate sufficient revenue. MEDICARE PAYMENT RATES FOR COVERED SERVICES In the mid-1980's, changes in reimbursement rates and procedures included the creation of the prospective payment system ("PPS") using predetermined reimbursement rates for diagnosis related groups ("DRGs"). Behavioral health facilities, such as Psychiatric Solutions' freestanding hospitals, are excluded from the inpatient services PPS, and are instead reimbursed by the Medicare program based on actual cost, generally subject to a per discharge ceiling. Capital related costs are not included, but are reimbursed separately at a rate of 85% of allowable costs. In the Balanced Budget Act of 1997 ("BBA-97"), Congress significantly revised the Medicare payment provisions for PPS-excluded hospitals, including psychiatric hospitals. Effective for Medicare cost reporting periods beginning on or after October 1, 1997, different caps are applied to psychiatric hospitals' target amounts depending upon whether a hospital was excluded from PPS before or after that date, with higher caps for hospitals excluded before that date. Consistent with reimbursement trends for other segments of the health care services industry, Medicare is expected to shift to PPS for inpatient psychiatric hospitals in the next several years, possibly as soon as October 2004. The PPS reimbursement system involves a determination by the federal government of an average, or fair price, for a fixed unit of health care services, adjusted for regional differences in cost. Psychiatric Solutions believes, although cannot guarantee, that it will benefit under a PPS system as a relatively low-cost provider of behavioral health care services. Mental health services provided by acute care hospitals which qualify for a PPS exemption are deemed to be Distinct Part Units ("DPUs") and are not included in the DRG system. Services provided by DPUs are reimbursed on an actual cost basis, subject to certain limitations. The mental health programs managed by Psychiatric Solutions which are eligible for reimbursement by the Medicare program currently meet the applicable requirements for designation as DPUs and are exempt from the DRG system. In the future, however, it is possible that Medicare reimbursement for mental health services, including those provided by programs managed by Psychiatric Solutions, could be under the PPS system or otherwise altered. On or about August 1, 2000, under a new Medicare payment formula called the "outpatient prospective payment system", Medicare began paying a pre-established rate to providers for outpatient services. Under the new final payment formula for year 2001, Medicare pays $206.82 per day (adjusted up or down for differences in wages from area to area) of partial hospitalization service, assuming that the services meet Medicare's coverage criteria (see "--Medicare Revenue"). Medicare pays this amount regardless of whether it is more or less than a hospital's actual costs, although there is a three-year transition period during which hospitals whose aggregate costs for Medicare outpatients exceed the 77 Medicare rates will receive some additional Medicare payments, but not up to the level of full costs. The Medicare rates for outpatient services should be updated annually, but in the past when Medicare has adjusted other rates similar to its new rates for hospital outpatient services, the updates have often been increases in amounts that were less than the increase in the "hospital market basket," i.e., the increase in costs of items and services purchased by hospitals. In some instances, Medicare has reduced rates in the updating process. PATIENT COINSURANCE, MEDICAID COVERAGE OF MEDICARE COINSURANCE AMOUNTS, AND MEDICARE ALLOWABLE BAD DEBTS Although Medicare uses a cost-based reimbursement formula for psychiatric hospital inpatient services, and has established a rate for partial hospitalization services of $206.82 per day, Medicare will not pay these full amounts to a hospital. It will deduct from that rate an amount for patient "coinsurance," or the amount that the patient is expected to pay. Many patients are unable to pay the coinsurance amount. Even if these patients are also covered by Medicaid, some states' Medicaid programs will not pay the Medicare coinsurance amount. As a result, the Medicare coinsurance amount will go uncollected by the provider except to the extent that the provider is partially reimbursed that amount as a Medicare "bad debt" as described in the following paragraph. To the extent that neither a Medicare patient nor any secondary payor for that patient pays the Medicare coinsurance amount after a reasonable collection effort or the patient's indigence is documented, the provider is entitled to be paid 70% of this "bad debt" by Medicare. However, there are instances when Medicare denies reimbursement for all or part of claimed bad debts for coinsurance on Medicare patients on grounds that the provider did not engage in a reasonable collection effort or that the provider failed to maintain adequate documentation of its collection effort or of the patient's indigence. MEDICARE CRITERIA FOR TREATING MANAGED UNITS AS "PROVIDER-BASED" SITES The services Psychiatric Solutions provides through psychiatric unit management contracts have historically been covered by Medicare, as if provided by the host provider on the basis that the site where the services were furnished was a "provider based" site. Historically, a site could assert provider based status simply by claiming the designation. In April 2000, CMS adopted new rules requiring a CMS determination that a facility has provider based status before a provider can bill Medicare for the services rendered at the facility. The new rules have been construed by CMS to apply to inpatient mental health units, and therefore they impact Psychiatric Solutions' psychiatric unit management operations. As a result of the Benefits Improvement and Protection Act of 2000, facilities treated as provider-based as of October 1, 2000 will be treated as provider-based until October 1, 2002, the effective date of the April 2000 final regulation. In addition, the April 2000 final regulation specifies instances when there may be retrospective recoveries of amounts previously paid if Medicare determines that a site was not "provider-based". The regulation also places significant restrictions on which personnel can be management employees if the provider based facility is operated under a management contract. On May 9, 2002, CMS published a rule that proposes to further extend the "grandfathering" of provider-based entities. Under the proposed rule, a facility will continue to be treated as provider based until the start of the hospital's first cost reporting period beginning on or after July 1, 2003. The proposed rule makes important changes to some of the management contract requirements that will ease the restrictions on management personnel imposed in the April 2001 final regulation. The proposed rule also specifies that in addition to possible recoupment of amounts previously paid, future payments may be adjusted to approximate the amounts that would be paid for the same services furnished by a freestanding facility. Psychiatric Solutions is unable to predict when or if the provisions of this proposed rule will be adopted, or if there will be further changes to the rule before it is adopted in final form. Psychiatric Solutions believes the sites it presently manages are provider-based within the meaning of the April 2000 final regulation, and Psychiatric Solutions expects that its provider customers will obtain, or have obtained, determinations of such provider-based status from Medicare. However, it is possible that 78 such sites will not obtain approval as provider-based sites or will lose such approval in the future. In such instances, there may be a loss of Medicare coverage for services furnished at that site and there may be a retrospective recovery by Medicare. It is also possible that the provider based rules could result in termination or non-renewal of management contracts if, under the rule as finally adopted, it is not possible for a provider to obtain a determination of provider-based status of an inpatient unit operated under a management contract. Further, adoption of a final rule that has restrictive management personnel provisions could have a material adverse impact on the structure and profitability of Psychiatric Solutions' inpatient programs as currently operated. COMPLIANCE WITH MEDICAID REGULATIONS AND POTENTIAL CHANGES Psychiatric Solutions cannot predict the extent or scope of changes which may occur in the ways in which state Medicaid programs contract for and deliver services to Medicaid recipients. All Medicaid funding is generally conditioned upon financial appropriations to state Medicaid agencies by the state legislatures and there are political pressures on such legislatures in terms of controlling and reducing such appropriations. With respect to both the freestanding specialty hospital and the psychiatric unit management divisions, the overall trend is generally to impose lower reimbursement rates and add risk- sharing incentives. Consequently, any significant reduction in funding for Medicaid programs could have a material adverse effect on Psychiatric Solutions' business, financial condition and results of operations. Some states may adopt substantial health care reform measures which could modify the manner in which all health services are delivered and reimbursed, especially with respect to Medicaid recipients and with respect to other individuals funded by public resources. The reduction in other public resources could have an impact on the delivery of services to Medicaid recipients. Any significant changes in Medicaid funding, the structure of a particular state's Medicaid program, the contracting process or reimbursement levels could have a material adverse impact on the combined company. SPECIFIC LICENSING OF PROGRAMS The hospitals Psychiatric Solutions owns and operates are subject to various federal, state and local regulations, including use, licensure and inspection requirements. The facilities are required to obtain annual licensure renewal and are subject to annual surveys and inspections in order to be certified for participation in the Medicare and Medicaid programs. In order to maintain their state operating license and certification for participation in Medicare and Medicaid programs, the facilities must meet certain statutory and administrative requirements. In granting and renewing a facility's licenses, government agencies generally consider, among other factors, the physical condition of the facility, the qualifications of the administrative and professional staff, the quality of professional and other services, and the continuing compliance of the facility with the laws and regulations applicable to its operations. Psychiatric Solutions assists its client hospitals in obtaining required approvals for new programs. Some approval processes may lengthen the time required for programs to begin operations. Such requirements are subjective and subject to change. Many states also have certificate of need laws intended to avoid the proliferation of unnecessary or under-utilized health care services and facilities. Additionally, certain of the personnel working at facilities owned and operated by Psychiatric Solutions are subject to state laws and regulations governing their particular area of professional practice. Psychiatric Solutions strives for its hospitals and personnel, as well as the mental health programs it manages and the facilities of the client hospitals used in the operation of such programs, to comply in all material respects with applicable licensing and certification requirements. FALSE CLAIMS INVESTIGATIONS AND ENFORCEMENT OF HEALTH CARE FRAUD LAWS The OIG, as well as other federal, state, and private organizations, are aggressively enforcing their interpretation of Medicare and Medicaid laws and policies, and other applicable standards. Often in such enforcement efforts, the government has relied on the Federal Civil False Claims Act ("False Claims Act"). Under that law, if the government prevails in a case, it is entitled to treble damages plus not less 79 than $5,000 nor more than $11,000 per violation, plus reasonable attorney fees and costs. In addition, a person found to have submitted false claims, or who caused the submission of false claims, can be excluded from governmental health care programs including Medicare and Medicaid. If a provider contracting with Psychiatric Solutions were excluded from government health programs, no services furnished by that provider would be covered by any government health program. Psychiatric Solutions could also be excluded from government health care programs if there were a finding that Psychiatric Solutions had violated its obligations to those programs. If Psychiatric Solutions were excluded from government health programs, owned facilities would not be eligible for reimbursement by any government-funded payors. In addition, providers would as a practical matter, cease contracting for Psychiatric Solutions' psychiatric unit management services because they could not be reimbursed for any management fee amounts they paid to Psychiatric Solutions. To prevail in a False Claims Act case, the government need show only that a person submitted, or "caused" to be submitted, incorrect claims with "reckless disregard" or in "deliberate ignorance" of the applicable Medicare law. The government does not have to prove that the claims were submitted with the intent to defraud a governmental or private health care payor. The qui tam provisions of the False Claims Act permit individuals also to bring suits under the False Claims Act. The incentive for an individual to do so is that he or she will usually be entitled to approximately 15% to 30% of any ultimate recovery. Under the False Claims Act, the Department of Justice has successfully made demands on thousands of providers to settle alleged improper billing disputes at double alleged damages or more. Psychiatric Solutions could possibly be liable under the False Claims Act to the extent that Psychiatric Solutions is found either to have presented false claims directly, or to have "caused" false claims to be presented. There are many other civil and criminal statutes at the federal and state levels that may penalize conduct related to submitting false claims for health care services. The penalties under many of those statutes are severe, and the government often need not prove intent to defraud in order to prevail. Management believes that Psychiatric Solutions is in material compliance with applicable regulatory and industry standards. However, in light of the complexity of the policies governing government health care programs together with changing and uncertain interpretations of those policies, it is impossible to be absolutely assured that the government (or a qui tam relator in the name of the government) will not assert that some of Psychiatric Solutions' conduct, or conduct by one of Psychiatric Solutions' clients, has given rise to a potentially large liability. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") grants the U.S. Department of Health and Human Services broad authority to impose civil monetary penalties on providers for certain activities. Among those activities are the repeated submission of claims for services which are not medically necessary. If there were to be occasions when a Medicare fiscal intermediary denied a large number of claims for a site owned or managed by Psychiatric Solutions, it is possible that the government would seek sanctions from Psychiatric Solutions or the host provider of the managed program. While Psychiatric Solutions believes it would be inappropriate for the government to seek such sanctions for services for which the coverage criteria are interpreted differently at different times and which have been ordered by a physician, it is not clear at this time how the government will apply this new authority. ANTI-REMUNERATION LAWS AND ENFORCEMENT OF HEALTH CARE FRAUD LAWS Various state and federal laws regulate the relationships between health care providers and referral sources, including federal and state fraud and abuse laws prohibiting individuals and entities from knowingly and willfully offering, paying, soliciting or receiving remuneration in order to induce referrals for the furnishing of health care services or items. These federal laws generally apply only to referrals for items or services reimbursed under the Medicare or Medicaid programs or any state health care program. The objective of these laws is generally to ensure that the purpose of a referral is not for monetary gain at the expense of a government reimbursed health care program. 80 Anti-Kickback. The Medicare and Medicaid anti-kickback statute, 42 U.S.C. Section I 320a-7b, prohibits the knowing and willful solicitation or receipt of any remuneration "in return for" referring an individual, or for recommending or arranging for the purchase, lease, or ordering, of any item or service for which payment may be made under Medicare or a state health care program. In addition, the statute prohibits the offer or payment of remuneration "to induce" a person to refer an individual, or to recommend or arrange for the purchase, lease, or ordering of any item or service for which payment may be made under the Medicare or state health care programs. The statute contains exceptions for certain practices defined in regulatory safe harbors. Psychiatric Solutions has entered into agreements with physicians to serve as medical directors at its owned hospitals, as well as at mental health programs and facilities it manages. These agreements generally provide for payments to such physicians by Psychiatric Solutions as compensation for their administrative services. These medical directors also generally provide professional services at these programs and facilities. Strictly construed, payments to physicians under these contracts could be viewed as "remuneration" within the meaning of the anti-kickback statute. However, regulations issued under federal fraud and abuse laws created certain "safe harbors" for relationships between health care providers and referral sources, including safe harbors for personal services arrangements and for management contracts. A relationship that fully satisfies the terms of the safe harbor is considered permitted. Failure to satisfy every element of a safe harbor, however, does not mean that the relationship is necessarily unlawful. Psychiatric Solutions strives for the contracts and relationships between Psychiatric Solutions and its client hospitals and medical directors to meet the elements to qualify for safe harbor protection. However, there can be no assurance that one or more of these contractual arrangements will not be challenged at some point by regulatory authorities. Stark. The Omnibus Budget Reconciliation Act of 1993 contains provisions ("Stark II") prohibiting physicians from referring Medicare and Medicaid patients to an entity with which the physician has a "financial relationship" for the furnishing of any "designated health services," including physical therapy, occupational therapy, hospital inpatient and outpatient services, and others. If a financial relationship exists, the entity is generally prohibited from claiming payment for such services under the Medicare or Medicaid programs. Compensation arrangements with physicians are generally exempted from Stark's prohibitions if, among other things, the compensation to be paid is set in advance, is at fair market value and is not determined in a manner that takes into account the volume or value of any referrals or other business generated between the parties. Unlike the anti-kickback statute however, Stark is absolute. If all elements of an exception are not met, then the statute is violated. Psychiatric Solutions strives for its contractual arrangements with physicians to meet the requirements of the Stark law and its applicable exceptions. HIPAA. HIPAA granted expanded enforcement authority to HHS and the U.S. Department of Justice ("DOJ"), and provided enhanced resources to support the activities and responsibilities of the Office of Inspector General ("OIG") of HHS and DOJ by authorizing large increases in funding for investigating fraud and abuse violations relating to health care delivery and payment. On January 24, 1997, the OIG issued guidelines for the Fraud and Abuse Control Program as mandated by the Act, and on February 19, 1997 issued an interim final rule establishing procedures for seeking advisory opinions on the application on the anti-kickback statute and certain other fraud and abuse laws. The 1997 Balanced Budget Act also includes numerous health fraud provisions, including expanded exclusion authority and penalties. Additional Regulation. In addition, federal and some state laws impose restrictions on referrals for certain designated health services by physicians and, in a few states, psychologists and other mental health care professionals to entities with which they have financial relationships. Psychiatric Solutions strives for its operations to comply with these restrictions to the extent applicable, although no assurance can be given regarding compliance in any particular factual situation. Federal legislation has been considered to expand current law from its application to Medicare and Medicaid business to all payors and to additional health services. Certain states are considering adopting similar restrictions or expanding the scope of existing restrictions. There can be no assurance that the federal government or other states in which 81 Psychiatric Solutions operates will not enact similar or more restrictive legislation or restrictions that could under certain circumstances adversely impact Psychiatric Solutions' operations. PRIVACY AND CONFIDENTIALITY LEGISLATION Most of Psychiatric Solutions' activities require Psychiatric Solutions to receive or use confidential medical information about individual patients. Federal and some state legislation restrict the use and disclosure of confidential medical information and the fact of treatment. There are specific requirements permitting disclosure, but inadequate or incorrect disclosure, even if inadvertent or negligent, can trigger substantial criminal and other penalties. To date, no such legislation has been enacted that adversely impacts Psychiatric Solutions' ability to provide its services. The Administrative Simplification Provisions of the Health Insurance Portability and Accountability Act of 1996 require the use of uniform electronic data transmission standards for health care claims and payment transactions submitted or received electronically. These provisions are intended to encourage electronic commerce in the health care industry. On August 17, 2000, CMS published final regulations establishing electronic data transmission standards that all health care providers must use when submitting or receiving certain health care transactions electronically. Compliance with these regulations is required by October 16, 2002, although the compliance date can be extended by one year if the provider submits a plan by October 16, 2002 showing how the provider plans to meet the transactions standards. The Administrative Simplification Provisions also require CMS to adopt standards to protect the security and privacy of health-related information. CMS proposed regulations containing security standards on August 12, 1998. These proposed security regulations have not been finalized, but as proposed, would require health care providers to implement organizational and technical practices to protect the security of electronically maintained or transmitted health-related information. CMS released final regulations containing privacy standards in December 2000. These privacy regulations are effective April 14, 2001, but compliance with these regulations is not required until April 14, 2003. In addition, on March 27, 2002, CMS proposed additional changes to the privacy regulations to remove consent requirements which were anticipated to hinder access to care, as well as to clarify other provisions related to oral communications, parental access to children's records and prohibition of certain marketing without patient authorization. The HHS Office of Civil Rights is the enforcement agency for HIPAA Administrative Simplification and may assess civil penalties which range from $100 to $25,000 per year for each violation of an identical requirement or prohibition of the standards, to civil and criminal penalties of up to $250,000 and 10 years of prison, for wrongful disclosure of health information for commercial advantage, personal gain, or malicious harm. Additionally, various state laws govern the protection of medical information, including certain statutes which may provide enhanced protections for sensitive health information, such as mental health records. Psychiatric Solutions will continue to remain subject to any Federal or state privacy-related laws that are more restrictive than the privacy regulations issued under the Administrative Simplification Provisions. These statutes vary and could impose additional penalties. The costs of conforming Psychiatric Solutions' systems to provide the privacy, security and transaction standard conformance required by HIPAA may require substantial cost investment in software, computers, policies and procedures, employee training and other goods and services. HIPAA gives the Department of Health and Human Services authority to make changes to the privacy rules prior to April 14, 2003. As a result, until the standards are implemented in final form, Psychiatric Solutions cannot know the full extent of these costs for implementing the requirements the regulations impose. UNLICENSED PRACTICE OF MEDICINE Many states prohibit physicians from splitting fees with non-physicians and prohibit non-physician entities from practicing medicine. These laws vary from state to state and are interpreted by courts and regulatory agencies with broad discretion. Psychiatric Solutions believes that its contractual arrangements do not violate these laws. Psychiatric Solutions' contractual arrangements and services with some providers could possibly be challenged on the basis of being an alleged unlicensed practice of medicine, or the 82 enforceability of provisions in that arrangement may be limited. In the event a regulatory authority limits or prohibits Psychiatric Solutions or an affiliate from conducting Psychiatric Solutions' business, Psychiatric Solutions' arrangements may require contractual or organizational modification or restructuring. SOURCES OF REVENUE In its freestanding psychiatric hospital division, Psychiatric Solutions receives payment for services rendered from private insurers, including managed care plans, the federal government under the Medicare program, state governments under their respective Medicaid programs and directly from patients. For the year ended December 31, 2001, approximately 60% of Psychiatric Solutions' revenues were generated from commercial providers and other sources, while federal and state Medicare and Medicaid programs comprised approximately 40%. The fees received by Psychiatric Solutions for its services under management contracts are paid directly by its client hospitals. The client hospitals receive reimbursement under either Medicare or Medicaid programs or from payments from insurers, self-funded benefit plans or third-party payors for the mental health services provided to patients of the programs managed by Psychiatric Solutions. Subject to certain recently enacted caps in reimbursement amounts, the Medicare program reimburses general acute care hospitals for the cost of providing mental health services to eligible patients. These costs include Psychiatric Solutions' management fee, as well as allocated overhead costs to the facility. PROPERTIES Other than the property acquired with the hospital acquisitions which is described above, Psychiatric Solutions leases approximately 7,745 square feet in an office building in Franklin, Tennessee for its executive offices. Psychiatric Solutions believes its executive offices and its hospital property and equipment are generally well maintained, in good operating condition and adequate for its present needs. LEGAL PROCEEDINGS AND INSURANCE Mental health services are always subject to the risk of liability. In recent years, participants in the mental health care industry have become subject to an increasing number of lawsuits that allege malpractice or other related legal theories. These lawsuits often involve large claims and incur significant defense costs. Psychiatric Solutions maintains liability insurance intended to cover such claims, which is renewable annually. Psychiatric Solutions believes that its insurance coverage conforms to industry standards. There are no assurances, however, that Psychiatric Solutions' insurance will cover all claims (e.g., claims for punitive damages), or that claims in excess of Psychiatric Solutions' insurance coverage will not arise. A successful lawsuit against Psychiatric Solutions that is not covered by, or is in excess of, its insurance coverage may have a material adverse effect on Psychiatric Solutions' business, financial condition and results of operations. There are no assurances that such insurance will provide adequate coverage against potential claims or that Psychiatric Solutions will be able to obtain liability insurance coverage on commercially reasonable terms, especially given the general increase in insurance premiums experienced by the health care industry. Psychiatric Solutions is subject to various claims and legal actions which arise in the ordinary course of business. In the opinion of management, Psychiatric Solutions is currently not a party to any proceeding which would have a material adverse effect on Psychiatric Solutions' business financial condition or results of operations. EMPLOYEES As of May 1, 2002, Psychiatric Solutions employed approximately 1,555 employees, of whom approximately 892 are full-time employees. Approximately 1,111 employees staff the freestanding Psychiatric hospitals, approximately 421 employees staff the management contracts and approximately 23 are in corporate management including finance, accounting, development, utilization review, training and education, information systems, member services, human resources and legal areas. None of Psychiatric 83 Solutions' employees is subject to a collective bargaining agreement and Psychiatric Solutions believes that its employee relations are good. COMPETITION The freestanding psychiatric hospital industry and the psychiatric unit management industry are both highly competitive and highly fragmented. The industry is subject to continual changes in the method in which services are provided and the types of companies providing such services. Psychiatric Solutions competes with several national competitors and many regional and local competitors, some of which have greater resources than Psychiatric Solutions. In addition, some of its competitors are owned by governmental agencies and supported by tax revenues, and others are owned by nonprofit corporations and may be supported to a large extent by endowments and charitable contributions. Such support is not available to Psychiatric Solutions' hospitals. The largest competitors in the freestanding psychiatric hospital and psychiatric unit management industry are: - Ardent Health Services, which operates 23 psychiatric facilities and two medical/surgical hospitals; - Universal Health Services (NYSE: UHS), which operates 38 psychiatric facilities and 35 acute care facilities; and - Horizon Health Corporation (NasdaqNM: HORC), which operates 124 psychiatric unit management contracts, 26 rehabilitation unit contracts and employee assistance programs covering 2.3 million lives. In addition, Psychiatric Solutions' freestanding psychiatric hospitals and managed psychiatric units compete for patients with other providers of mental health care services, including other freestanding psychiatric hospitals, general acute care hospitals, independent psychiatrists and psychologists. Psychiatric Solutions also competes with hospitals, nursing homes, clinics, physicians' offices and contract nursing companies for the services of registered nurses. Registered nurses are in limited supply and there can be no assurance that Psychiatric Solutions will be able to attract a sufficient number of registered nurses for its growing needs. RECENT DEVELOPMENTS Purchase of Riveredge Hospital. On June 20, 2002 Psychiatric Solutions entered into a definitive Stock Purchase Agreement with the shareholders of Aeries Healthcare Corporation for the purchase of Riveredge Hospital in Forest Park, Cook County, Illinois. The transaction closed on July 1, 2002. Pursuant to the stock purchase agreement, Psychiatric Solutions acquired 100% of the outstanding stock of Aeries for $16.1 million, prior to adjustments based on a measure of Aeries' net working capital. The stock purchase agreement contained representations and warranties customary of transactions of similar size and in the psychiatric health care industry segment. A portion of the purchase price was placed in escrow in part to secure certain contingent obligations of Aeries resulting from breaches of its representations and warranties in the Stock Purchase Agreement. A separate Indemnification Agreement was executed in conjunction with the transaction. It requires Psychiatric Solutions as well as the shareholders of Aeries to indemnify the other for certain liabilities arising under the agreement. Hospitals participating in Medicare, Medicaid or other government funded programs are required initially to obtain and continuously maintain certification that they meet all required conditions of participation to be reimbursed under these programs. Verification of compliance with the conditions of participation is made through periodic on-site survey visits to the facility. As part of an ongoing survey review, on May 22, 2002, CMS conducted a survey of Riveredge. Riveredge was later notified that it was found to be in compliance with all Medicare Conditions of Participation except the Condition of Physical Environment. If deficiencies in the Condition of Physical Environment are not satisfactorily corrected, CMS has advised Riveredge that its Medicare provider agreement could be terminated as of December 15, 84 2002. Riveredge has submitted a Plan of Correction in response to the cited deficiencies, and believes that it will be in compliance with all Medicare Conditions of Participation before December 15, 2002. However, there can be no assurance that satisfactory compliance with this or other conditions of participation will be achieved and that termination of Riveredge's Medicare provider agreement will not be invoked. Termination of Riveredge's Medicare provider status would have a material adverse impact on its operations. Amendment of Senior Credit Facility. In connection with its acquisition of Riveredge Hospital, Psychiatric Solutions amended its 2001 Senior Credit Facility as of June 28, 2002 to provide for an additional non-revolving term loan in the amount of $7.95 million. The additional term loan accrues interest at the Citibank, N.A. prime rate plus 4.75% and increases the total 2001 Senior Credit Facility to $41.15 million. Issuance of Senior Subordinated Notes and Warrants. On June 28, 2002, Psychiatric Solutions entered into a securities purchase agreement with 1818 Mezzanine Fund II, L.P. to issue up to $20 million of senior subordinated notes with detachable nominal warrants. At the closing on June 28, 2002, a total of $10 million of the senior subordinated notes were issued. Approximately $7.5 million of the proceeds were used to fund a portion of the acquisition of Riveredge Hospital, and approximately $2.5 million of the proceeds were used to reduce current indebtedness. The remaining $10 million of senior subordinated notes may be issued to fund additional acquisitions of free-standing psychiatric hospitals and for general working capital purposes, subject generally to approval by the 1818 Fund. The notes have a term of seven years and bear interest at 12% annually, payable quarterly. The notes provide for a prepayment penalty of 6%, 3% and 1% if the notes are prepaid prior to the first anniversary, second anniversary and third anniversary of the closing date, respectively. The notes grant the holders the right to require prepayment in the event of a change of control of Psychiatric Solutions, subject to a prepayment penalty of 1% if redeemed on or before the third anniversary of the closing date. The notes also require Psychiatric Solutions to comply with financial and other covenants. In connection with the initial $10 million of notes issued, Psychiatric Solutions also issued a warrant to purchase 1,502,140 shares of Psychiatric Solutions common stock at a nominal price and provide for an adjustment to allow the warrants to become exercisable initially into approximately 372,412 shares of common stock of the combined company at any time after the merger. Psychiatric Solutions will be required to issue additional warrants of up to 1,502,140 shares of common stock of Psychiatric Solutions from time to time upon the issuance of the remaining $10 million of senior subordinated notes. These warrants would also provide for an adjustment to allow the warrants to become exercisable into shares of common stock of the combined company after the merger on the same basis as the initial warrants. The warrants provide for anti-dilution protection, pre-emptive rights and registration rights. The securities purchase agreement also allows the holders of the notes to designate one director to the board of directors of Psychiatric Solutions. The holders have designated Joseph P. Donlan as their board representative. HUD Refinancing. Psychiatric Solutions is also in the process of refinancing a portion of its senior credit facility with various loans guaranteed by the U.S. Department of Housing and Urban Development (HUD). These loans are expected to be in the aggregate amount of approximately $25.0 million and would be secured by real estate and other fixed assets of West Oaks Hospital, Cypress Creek Hospital, Holly Hill Hospital and Texas NeuroRehab Center. This refinancing is expected to close in four installments (one per hospital) after September 1, 2002. Management anticipates that this refinancing will result in annual interest expense savings of approximately $420,000. These projected savings are not reflected in the Unaudited Pro Forma Condensed Combined Financial Statements of PMR and Psychiatric Solutions. The HUD refinancing is not contingent upon the merger, nor is the merger contingent upon the HUD refinancing. 85 RELATED PARTY TRANSACTIONS During 2001 and 2000, Psychiatric Solutions leased office space from a company whose chief executive officer is Dr. Richard Treadway, the chairman of Psychiatric Solutions' board of directors. The term of the lease was from March 16, 1999 to July 2002 and was terminated on December 7, 2001. Rent expense for this space totaled $142,154 for the year ended December 31, 2001. Psychiatric Solutions believes the terms of this lease were at fair market value. Currently Psychiatric Solutions leases 7,745 square feet of office space for its executive offices from a company in which Dr. Treadway is a minority investor. Affiliates of other Psychiatric Solutions stockholders are also investors. The lease was entered into in October 2001 and has a term of approximately six years. The annual rent under this lease is approximately $92,000. Psychiatric Solutions believes the terms of this lease are at fair market value. Joey Jacobs, Psychiatric Solutions' Chief Executive Officer, serves as a member of the board of directors of Stones River Hospital, a hospital in which Psychiatric Solutions manages a unit pursuant to a management agreement. The term of the third amendment to the management agreement is two years, and automatically renews for one year terms unless terminated by either party. Total revenue from this management agreement was $678,243 for the year ended December 31, 2001. Psychiatric Solutions believes the terms of the management agreement are consistent with management agreements negotiated at arms-length. Jack Salberg, Psychiatric Solutions' Chief Operating Officer, is a minority owner of the entity which owns Riveredge Hospital and is on Riveredge Hospital's board of directors. Riveredge Hospital is the hospital in Forest Park, Illinois recently acquired by Psychiatric Solutions. Mr. Salberg disclosed his interest to the board of directors and was not directly involved in the negotiation of the definitive agreements. Edward Wissing, a director of Psychiatric Solutions, occasionally provides advisory and consulting services to Brentwood Capital Advisors, Psychiatric Solutions' financial advisor. Mr. Wissing is also party to a consulting arrangement with Brentwood Capital pursuant to which he provides certain consulting services. According to the terms of this consulting arrangement, Mr. Wissing, will receive a fixed consulting fee of $5,000 per month beginning in August 2002 and ending in May 2003. 86 PSYCHIATRIC SOLUTIONS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with "Selected Historical Consolidated Financial Data of Psychiatric Solutions" and the consolidated financial statements and related notes thereto included in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties, such as statements of plans, objectives, expectations, and intentions. The cautionary statements made in this joint proxy statement/prospectus should be read as applying to all related forward-looking statements wherever they appear in this joint proxy statement/prospectus. The actual results could differ materially from those anticipated in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed in "Risk Factors", as well as those discussed elsewhere. See "Risk Factors" and "Forward-Looking Statements". OVERVIEW Psychiatric Solutions was organized in September 1996. It currently has two operating divisions: (i) the ownership and operation of freestanding inpatient psychiatric hospitals and (ii) the operation of psychiatric units in facilities owned by third parties. As of March 31, 2002, Psychiatric Solutions owned and operated four free-standing psychiatric hospitals which provided psychiatric services to patients in and around the Houston, Texas, Austin, Texas, and Raleigh, North Carolina areas and managed 44 psychiatric units for third party acute care hospitals in 14 states. Psychiatric Solutions' objective is to provide high-quality, cost-effective psychiatric services in the communities it serves. Through its managed and freestanding psychiatric hospitals, Psychiatric Solutions offers an extensive continuum of behavioral health programs to critically ill children, adolescents and adults. IMPACT OF ACQUISITIONS Acquiring free-standing psychiatric hospitals is a key part of Psychiatric Solutions' business strategy. Since Psychiatric Solutions has grown through acquisitions accounted for as purchases, it is difficult to make meaningful comparisons between its financial statements for the fiscal periods presented. In addition, since Psychiatric Solutions owns a relatively small number of hospitals, an individual acquisition may have a material effect on its overall operating performance. At the time a hospital is acquired, a number of measures to lower costs are implemented and significant investments may also be made in the facility. Therefore, the financial performance of a newly acquired hospital may adversely affect its overall performance in the short-term. On August 31, 1999 Psychiatric Solutions purchased all of the outstanding stock of Cornerstone Behavioral Health Services Inc. ("Cornerstone") for approximately $4.6 million. Cornerstone is the manager of approximately 20 geropsychiatric units in acute care hospitals situated primarily in suburban communities in the south and midwest. Effective May 1, 2000, Psychiatric Solutions acquired the equity of Sunrise Behavioral Health, Ltd. ("Sunrise"), a manager of inpatient psychiatric units in acute care hospitals, for approximately $15.1 million. The acquisition was financed through the assumption of certain liabilities, borrowings under a credit agreement, and the issuance of seller-financed subordinated convertible notes. On September 1, 2001, Psychiatric Solutions acquired the assets of Cypress Creek Hospital and West Oaks Hospital in Houston, Texas for approximately $14.2 million. The acquisition was financed through a seller-financed subordinated convertible note as well as other long-term borrowings. Effective November 1, 2001, Psychiatric Solutions acquired the assets of Texas NeuroRehab Hospital in Austin, Texas for approximately $8.4 million, which was financed through a seller-financed subordinated convertible note and additional long-term borrowings. 87 On December 1, 2001, Psychiatric Solutions acquired the assets of Holly Hill Hospital in Raleigh, North Carolina for approximately $8.4 million which was financed through long-term borrowings under a line of credit. On July 1, 2002, Psychiatric Solutions acquired all of the capital stock of Aeries Healthcare Corporation and its wholly owned subsidiary, Aeries Healthcare of Illinois, Inc. for $16.1 million, prior to certain adjustments. Aeries Healthcare of Illinois owns the assets and operations of Riveredge Hospital located near Chicago, Illinois. The acquisition was financed in part through an amendment to Psychiatric Solutions' Senior Credit Facility. SOURCES OF REVENUE PATIENT SERVICE REVENUE Patient service revenue is generated by Psychiatric Solutions' hospitals as a result of services provided to patients within the hospital setting. Patient service revenue is reported on the accrual basis in the period in which services are rendered, at established rates, regardless of whether collection in full is expected. Patient service revenue includes amounts estimated by management to be reimbursable by Medicare and Medicaid under provisions of cost or prospective reimbursement formulas in effect. Amounts received are generally less than the established billing rates of the facilities and the differences are reported as deductions from patient service revenue at the time the service is rendered. For the quarter ended March 31, 2002, patient service revenue comprised approximately 72.6% of total revenue. MANAGEMENT FEE REVENUE Management fee revenue is earned by Psychiatric Solutions' unit management division. The Psychiatric Unit Management division receives contractually determined management fees and director fees from hospitals and clinics for providing psychiatric management and development services. For the quarter ended March 31, 2002, management fee revenue comprised approximately 27.4% of total revenue. RESULTS OF CONTINUING OPERATIONS The following table sets forth, for the periods indicated, Psychiatric Solutions operating results:
UNAUDITED YEARS ENDED DECEMBER 31, THREE MONTHS ENDED MARCH 31, ---------------------------------------------------- -------------------------------- 2001 2000 1999 2002 2001 --------------- --------------- ---------------- --------------- -------------- AMOUNT % AMOUNT % AMOUNT % AMOUNT % AMOUNT % ------- ----- ------- ----- ------- ------ ------- ----- ------ ----- (DOLLARS IN THOUSANDS) Revenue............................ $43,999 100.0% $23,502 100.0% $ 4,500 100.0% $23,188 100.0% $7,219 100.0% Salaries, wages, and employee benefits......................... 26,183 59.5% 15,256 64.9% 4,350 96.7% 13,970 60.2% 4,272 59.1% Professional fees.................. 7,039 16.0% 3,771 16.1% 990 22.0% 3,108 13.4% 1,124 15.6% Provision for doubtful accounts.... 662 1.5% 467 2.0% 529 11.7% 715 3.1% 72 1.0% Other operating expenses........... 4,283 9.7% 2,055 8.7% 619 13.8% 2,861 12.3% 527 7.3% ------- ----- ------- ----- ------- ------ ------- ----- ------ ----- EBITDA(1).......................... 5,832 13.3% 1,953 8.3% (1,988) (44.2%) 2,534 11.0% 1,224 17.0% Depreciation and amortization...... 945 2.1% 757 3.2% 234 5.2% 386 1.7% 235 3.3% Interest expense................... 2,660 5.5% 1,723 7.3% 371 8.2% 1,372 4.6% 405 5.6% ------- ----- ------- ----- ------- ------ ------- ----- ------ ----- Income (loss) from continuing operations before income taxes and extraordinary items.......... 2,227 5.6% (527) (2.2%) (2,593) (57.6%) 776 4.7% 584 8.1% Provision for income taxes......... -- 0.0% -- 0.0% -- 0.0% 21 0.0% -- 0.0% ------- ----- ------- ----- ------- ------ ------- ----- ------ ----- Income (loss) from continuing operations before extraordinary items............................ 2,227 5.6% (527) (2.2%) (2,593) (57.6%) 755 4.7% 584 8.1% Extraordinary loss from early retirement of Debt............... (1,237) (2.8%) -- 0.0% -- 0.0% -- 0.0% -- 0.0% ------- ----- ------- ----- ------- ------ ------- ----- ------ ----- Net income (loss) from continuing operations....................... $ 990 2.8% $ (527) (2.2%) $(2,593) (57.6%) $ 755 4.7% $ 584 8.1% ======= ===== ======= ===== ======= ====== ======= ===== ====== =====
88 - --------------- (1) EBITDA is defined as income from continuing operations before interest expense (net of interest income), income taxes, depreciation, amortization, and extraordinary items. While you should not consider EBITDA in isolation or as a substitute for net income, operating cash flows or other cash flow statement data determined in accordance with accounting principles generally accepted in the United States, management understands that EBITDA is a commonly used analytical indicator within the health care industry and also serves as a measure of leverage capacity and debt service ability. EBITDA, as presented, may not be comparable to similarly titled measures of other companies. QUARTER ENDED MARCH 31, 2002 COMPARED TO QUARTER ENDED MARCH 31, 2001 Revenue. Revenue from continuing operations was $7.2 million for the quarter ended March 31, 2001 compared to $23.2 million for the quarter ended March 31, 2002, an increase of $16.0 million or 222.2%. Acquisitions during the third and fourth quarters of 2001 accounted for approximately $16.8 million of the increase in revenues for the quarter ended March 31, 2002. Salaries, wages, and employee benefits. Salaries, wages, and employee benefits were $4.3 million for the quarter ended March 31, 2001 compared to $14.0 million for the quarter ended March 31, 2002, an increase of $9.7 million or 225.6%. This increase is related to acquisitions completed during the third and fourth quarters of fiscal 2001. Professional fees. Professional fees were $1.1 million for the quarter ended March 31, 2001 compared to $3.1 million for the quarter ended March 31, 2002, an increase of $2.0 million or 181.8%. Acquisitions during the third and fourth quarters of fiscal 2001 account for approximately $2.1 million of the increase. Additionally, professional fees on the facilities acquired represent a lower percentage of net revenues than do professional fees on revenues from Psychiatric Solutions' unit management business. Provision for doubtful accounts. The provision for doubtful accounts was $72,000 for the quarter ended March 31, 2001, compared to $715,000 for the quarter ended March 31, 2002, an increase of $643,000 or 893.1%. The provision for doubtful accounts for the acquisitions during the third and fourth quarters of 2001 was approximately $400,000. The remaining increase is attributable to a change in the mix of accounts receivable from management contract receivables as of March 31, 2001 compared to a combination of management contract and patient accounts receivables as of March 31, 2002. Collection characteristics differ with regard to these two types of receivables. Other operating expenses. Other operating expenses were $527,000 for the quarter ended March 31, 2001 compared to $2.9 million for the quarter ended March 31, 2002, an increase of $2.4 million or 443%. Acquisitions during the third and fourth quarters of fiscal 2001 accounted for the increase. Depreciation and amortization. Depreciation and amortization expense was $235,000 for the quarter ended March 31, 2001, compared to $386,000 for the quarter ended March 31, 2002, an increase of approximately $151,000 or 64%. Acquisitions during the third and fourth quarters of fiscal 2001 accounted for substantially all of this increase. Interest expense. Interest expense was $405,000 for the quarter ended March 31, 2001, compared to $1.4 million for the quarter ended March 31, 2002, an increase of $997,000 or 246.2%. The increase in interest expense is due to borrowings under Psychiatric Solutions' line of credit as well as seller-financed convertible notes to fund acquisitions during the third and fourth quarters of fiscal 2001. FISCAL YEAR ENDED DECEMBER 31, 2001 COMPARED TO FISCAL YEAR ENDED DECEMBER 31, 2000 Revenue. Revenue from continuing operations was $23.5 million for the fiscal year ended December 31, 2000 compared to $44.0 million for the fiscal year ended December 31, 2001, an increase of $20.5 million or 87.2%. Acquisitions of hospitals during fiscal 2001 accounted for approximately $16.0 million of the increase in revenues during the fiscal year ended December 31, 2001. Additionally, the increase reflects the fact that the operations of Sunrise are included for eight months during 2000 as compared to twelve months for 2001. 89 Salaries, wages, and employee benefits. Salaries, wages, and employee benefits expense was $15.3 million for the fiscal year ended December 31, 2000, compared to $26.2 million for the fiscal year ended December 31, 2001, an increase of $10.9 million or 71.2%. Of this increase, $9.5 million related to additional personnel stemming from fiscal 2001 acquisitions. This increase is due to the fact that the acquired entities, which consist of psychiatric hospitals, are much more labor-intensive than that experienced under Psychiatric Solutions' management contracts. Professional fees. Professional fees were $3.8 million for the fiscal year ended December 31, 2000, compared to $7.0 million for the fiscal year ended December 31, 2001, an increase of $3.2 million or 84.2%. This increase relates to the acquisition of Sunrise in May 2000 and that the acquisition of Cornerstone in September 1999 represents only four months of operation in that year. Provision for doubtful accounts. The provision for doubtful accounts was $467,000 for the fiscal year ended December 31, 2000, compared to $662,000 for the fiscal year ended December 31, 2001, an increase of $195,000 or 41.8%. This increase is attributable to approximately $400,000 of provision for doubtful accounts related to hospital acquisitions which is offset by improved collections experience related to Psychiatric Solutions management contracts. The provision for doubtful accounts as a percentage of revenue increased from 1.1% for the fiscal year ended December 31, 2000 to 1.5% for the fiscal year ended December 31, 2001. Other operating expenses. Other operating expenses were approximately $2.1 million for the fiscal year ended December 31, 2000, compared to $4.3 million for the fiscal year ended December 31, 2001, an increase of $2.2 million or 108.5%. This increase is attributable to acquisitions during fiscal 2001. Depreciation and amortization. Depreciation and amortization expense was $757,000 for the fiscal year ended December 31, 2000, compared to $945,000 for the fiscal year ended December 31, 2001, an increase of $188,000 or 24.8%. This increase is attributable to acquisitions during fiscal 2001. Interest expense. Interest expense was $1.7 million for the fiscal year ended December 31, 2000, compared to $2.6 million for the fiscal year ended December 31, 2001, an increase of $937,000 or 54.4%. The increase in interest expense is due to borrowings under Psychiatric Solutions' line of credit as well as seller-financed convertible notes to fund 2001 acquisitions. FISCAL YEAR ENDED DECEMBER 31, 2000 COMPARED TO FISCAL YEAR ENDED DECEMBER 31, 1999 Revenue. Revenue from continuing operations were $4.5 million for the fiscal year ended December 31, 1999 compared to $23.5 million for the fiscal year ended December 31, 2000, an increase of $19.0 million or 422.2%. The acquisition of Sunrise during May 2000 accounted for approximately $13.3 million of the increase in revenues during the fiscal year ended December 31, 2000. Additionally, the operations of Cornerstone are included in Psychiatric Solutions results for four months in 1999 as compared to twelve months in 2000. Salaries, wages, and employee benefits. Salaries, wages, and employee benefits expense was $4.4 million for the fiscal year ended December 31, 1999, compared to $15.3 million for the fiscal year ended December 31, 2000, an increase of $10.9 million or 247.7%. Of this increase, $8.3 million related to the acquisition of Sunrise during May 2000. Professional fees. Professional fees were $1.0 million for the fiscal year ended December 31, 1999, compared to $3.8 million for the fiscal year ended December 31, 2000, an increase of $2.8 million or 280.0%. The Sunrise acquisition in May 2000 represents $1.7 million of this increase and the Cornerstone acquisition in September 1999 represents $1.0 million of this increase due to a full year reported in 2000. Provision for doubtful accounts. The provision for doubtful accounts was $529,000 for the fiscal year ended December 31, 1999, compared to $467,000 for the fiscal year ended December 31, 2000 an increase of $1.4 million or 233.3%. The provision for doubtful accounts as a percentage of revenue decreased from 11.8% for the fiscal year ended December 31, 1999 to 2.0% for the fiscal year ended December 31, 2000. This decrease is due to improved collection efforts and termination of unprofitable contracts. 90 Other operating expenses. Other operating expenses were approximately $619,000 for the fiscal year ended December 31, 1999, compared to $2.1 million for the fiscal year ended December 31, 2000, an increase of $1.4 million or 232.0%. The acquisition of Sunrise during May 2000 accounted for approximately $800,000 of the increase and the Cornerstone acquisition in September 1999 accounted for approximately $500,000 of the increase due to a full year reported in 2000. Depreciation and amortization. Depreciation and amortization expense was $234,000 for the fiscal year ended December 31, 1999, compared to $757,000 for the fiscal year ended December 31, 2000, an increase of $523,000 or 223.5%. The acquisition of Sunrise during May 2000 accounted for $300,000 of this increase. Interest expense. Interest expense was $371,000 for the fiscal year ended December 31, 1999, compared to $1.7 million for the fiscal year ended December 31, 2000, an increase of $1.3 million or 350.4%. The increase in interest expense is due to borrowings under Psychiatric Solutions' line of credit to fund the Sunrise acquisition during May 2000. LIQUIDITY AND CAPITAL RESOURCES As of March 31, 2002, Psychiatric Solutions had a working capital deficit of $2.7 million, including cash and cash equivalents of $1.2 million. The working capital deficit as of December 31, 2001 was $3.6 million. Included in the working capital deficit is $11.9 million and $11.1 million at March 31, 2002 and December 31, 2001, respectively, which is attributable to terms of Psychiatric Solutions' revolving credit agreement which requires that all non-governmental cash receipts be applied to reduce the outstanding balance under the revolving line of credit agreement. Such amounts can then be re-borrowed to the extent that borrowing capacity remains under the revolving line of credit. The decrease in the working capital deficit is due to a transitional and seasonal increase in accounts receivable. The working capital deficit at December 31, 2001 compares to $4.6 million at December 31, 2000. The decrease in the working capital deficit is due to cash flows from continuing operating activities during fiscal 2001 of approximately $6.8 million compared to cash used in continuing operating activities of approximately $200,000 in fiscal 2000. Cash provided by operating activities decreased from $200,000 for the three months ended March 31, 2001 to cash used in operating activities of $300,000 for the three months ended March 31, 2002. Cash provided by operating activities for the fiscal year ended December 31, 2001 was $6.8 million as compared to cash used in operating activities of $200,000 for the fiscal year ended December 31, 2000. The increase in cash flows from operating activities was due to the acquisition of the hospitals in the third and fourth quarters of 2001. Cash provided by investing activities decreased from approximately $1.3 million for the three months ended March 31, 2001 to cash used in investing activities of $300,000 for the three months ended March 31, 2002. This decrease was due to additional initial cash requirements needed to finance the hospital working capital, related to seasonal and transitional issues. Cash provided by investing activities for the fiscal year ended December 31, 2001 was $2.0 million compared to cash used in investing activities of approximately $8.7 million for the fiscal year ended December 31, 2000. The increase in cash provided by investing activities was due to proceeds on the disposition of the employee assistance program segment during fiscal 2001. Additionally, the 2001 acquisitions were funded via non-cash transactions (e.g. seller financed notes payable) while the 2000 acquisitions were financed by the use of cash. Cash used in financing activities decreased from $1.6 million for the three months ended March 31, 2001 to cash provided by financing activities of $500,000 for the three months ended March 31, 2002. This increase was due to additional financing required as a result of delays in receiving certain amounts due from The Brown Schools and North Carolina Medicaid as well as seasonal variations. Such amounts were subsequently collected in April 2002. Cash used in financing activities for the fiscal year ended December 31, 2001 was $7.8 million compared to cash provided by financing activities of $8.1 million for the fiscal year ended December 31, 2000. The increase in cash used in financing activities was due to the use of cash generated by operations to repay bank borrowings during 2001. Additionally, cash provided by financing activities in fiscal 2000 includes proceeds on long-term debt used to fund fiscal 2000 acquisitions. 91 In conjunction with its hospital acquisition in November 2001, Psychiatric Solutions entered into a senior credit facility of $33.2 million ("2001 Senior Credit Facility"). The 2001 Senior Credit Facility was amended on June 28, 2002 to provide for an additional $7.95 million pursuant to a new non-revolving term note. The 2001 Senior Credit Facility, as revised, includes two lines of credit for a total credit facility of $41.15 million, made up of $23.65 million of non-revolving term loans and a $17.5 million revolving working capital line of credit. Both lines are secured by substantially all of Psychiatric Solutions' assets and stock of its subsidiaries. The term loans accrue interest at the Citibank, N.A. prime rate plus 4.25% to 4.75%. The revolving line of credit accrues interest at the Citibank, N.A. prime rate plus 2% and is due in November 2004. At March 31, 2002, the interest rate was 7.25%. Until the due date, Psychiatric Solutions may borrow, repay and re-borrow an amount not to exceed the lesser of $17.5 million or the borrowing base (as defined in the 2001 Senior Credit Facility). As of December 31, 2001 there was $14.7 million available under the revolving line of credit compared to $3.4 million as of March 31, 2002. On July 1, 2002, Psychiatric Solutions drew $2.9 million on the revolving line of credit in connection with its purchase of Riveredge Hospital. Following the acquisition of Riveredge Hospital on July 1, 2002, there was $2.2 million available under the revolving line of credit. Under the revolving line of credit, all of Psychiatric Solutions' collections, except for Medicare and Medicaid payments, are deposited into lockbox accounts controlled by the lender. The funds deposited in the lockbox are applied to outstanding borrowings with the lender on a daily basis. As a result, the outstanding borrowings under the revolving line of credit are classified as short term as of December 31, 2001 and March 31, 2002. Psychiatric Solutions must pay an unused fee in the amount of 0.05% per month of the monthly unused portion of the 2001 Senior Credit Facility. Such fees were approximately $4,000 as of December 31, 2001. The 2001 Senior Credit Facility contains customary covenants which include (i) a specified monthly patient census for any owned, operated or leased hospitals, (ii) a limitation on capital expenditures, sales of assets, mergers, changes of ownership and management, new lines of business and dividends and (iii) various financial covenants. As of December 31, 2001 and March 31, 2002, Psychiatric Solutions was in compliance with all applicable debt covenant requirements. Should Psychiatric Solutions' results of operations or cash flows decline and result in violation of one or more of these covenants, amounts outstanding under the 2001 Senior Credit Facility could become immediately payable and additional borrowings could be restricted. As of March 31, 2002, approximately $11.9 million was outstanding with approximately $3.4 million available. In connection with the 2001 Senior Credit Facility, Psychiatric Solutions was required to expense the remaining deferred loan costs associated with its prior credit facility in the amount of $418,639 and incurred early termination penalties of $818,156. In October 2000 Psychiatric Solutions issued subordinated notes totaling $1.0 million with certain of its stockholders (the "Bridge Loan"). In connection with the Bridge Loan, Psychiatric Solutions issued warrants to purchase a total of 398,579 shares of its Series B preferred stock. These warrants expire in October 2005. The Bridge Loan was used to fund short-term working capital requirements and accrued interest at 10% per annum, payable monthly. The Bridge Loan was paid in full in April 2002. In connection with the acquisition of Sunrise in May 2000, Psychiatric Solutions issued subordinated convertible notes in the amount of $3.6 million. These convertible notes are due May 1, 2005 and accrue interest at 9% per annum. The principal amount of these convertible notes are convertible into shares of Psychiatric Solutions' Series B preferred stock based on conversion prices of $2.00 to $3.00 per share. Psychiatric Solutions also issued promissory notes totaling $4.5 million in connection with its acquisitions of three hospitals. One note in the amount of $2.5 million accrues interest at 9% per annum and matured on June 30, 2002. Psychiatric Solutions paid off this note in full with a portion of the proceeds of its subordinated debt offering described below. The remaining $2.0 million note accrues interest at 9% per annum and is due June 30, 2005. Among other customary covenants, both notes contain cross default covenants triggered by a default of any other indebtedness of at least $1.0 million. Psychiatric Solutions was in compliance with these covenants as of December 31, 2001 and March 31, 2002. 92 On June 28, 2002, Psychiatric Solutions entered into a securities purchase agreement with 1818 Mezzanine Fund II, L.P. to issue up to $20 million of senior subordinated notes with detachable nominal warrants. At the closing on June 28, 2002, a total of $10 million of the senior subordinated notes were issued. Approximately $7.5 million of the proceeds were used to fund a portion of the acquisition of Riveredge Hospital, and approximately $2.5 million of the proceeds were used to reduce current indebtedness. The remaining $10 million of senior subordinated notes may be issued to fund additional acquisitions of free-standing psychiatric hospitals and for general working capital purposes, subject generally to approval by the 1818 Fund. The notes have a term of seven years and bear interest at 12% annually, payable quarterly. The notes provide for a prepayment penalty of 6%, 3% and 1% if the notes are prepaid prior to the first anniversary, second anniversary and third anniversary of the closing date, respectively. The notes grant the holders the right to require prepayment in the event of a change of control of Psychiatric Solutions, subject to a prepayment penalty of 1% if redeemed on or before the third anniversary of the closing date. The notes also require Psychiatric Solutions to comply with financial and other covenants. Psychiatric Solutions believes that its working capital on hand and the availability under the existing line of credit are sufficient to meet operating and capital needs for the next 12 months. Psychiatric Solutions intends to acquire additional psychiatric hospitals and is actively seeking acquisitions that fit its corporate growth strategy. These acquisitions may, however, require financing in addition to the working capital on hand and future cash flows from operations. Management continually assesses its capital needs and may seek additional financing, including debt or equity, as considered necessary to fund potential acquisitions or for other corporate purposes.
PAYMENTS DUE BY PERIOD AS OF DECEMBER 31, 2001 ---------------------------------------------------- LESS THAN AFTER CONTRACTUAL CASH OBLIGATION: 1 YEAR 1-3 YEARS 4-5 YEARS 5 YEARS TOTAL - ---------------------------- --------- --------- --------- ------- ------ (IN THOUSANDS) Long term debt.......................... 15,387 3,316 5,473 12,163 36,339 Operating leases........................ 561 769 156 287 1,773 ------ ----- ----- ------ ------ Subtotal.............................. 15,948 4,085 5,629 12,450 38,112 ====== ===== ===== ====== ======
AMOUNT OF COMMITMENT EXPIRATION PER PERIOD ---------------------------------------------------- (IN THOUSANDS) LESS THAN AFTER OTHER COMMITMENTS: 1 YEAR 1-3 YEARS 4-5 YEARS 5 YEARS TOTAL - ------------------ --------- --------- --------- ------- ------ Letter of credit........................ 100 -- -- -- 100 ------ ----- ----- ------ ------ Subtotal.............................. 100 -- -- -- 100 ====== ===== ===== ====== ====== Total obligations and commitments..... 16,048 4,085 5,629 12,450 38,212 ====== ===== ===== ====== ======
The carrying amount of our total long-term debt, including current maturities, of $36.3 million and $16.6 million at December 31, 2001 and 2000, respectively, approximated fair value. We had $26.8 million of variable rate debt outstanding at December 31, 2001. At the December 31, 2001 borrowing level, a hypothetical 10% adverse change in interest rates, would have a $2.7 million decrease to net income and cash flows. IMPACT OF INFLATION Although inflation has not had a material impact on Psychiatric Solutions results of operations, the health care industry is very labor intensive and salaries and benefits are subject to inflationary pressures as are rising supply costs which tend to escalate as vendors pass on the rising costs through price increases. Some of Psychiatric Solutions' freestanding specialty psychiatric hospitals are experiencing the effects of the tight labor market, including a shortage of nurses, which has caused and may continue to cause an increase in its salaries, wages and benefits expense in excess of the inflation rate. Although Psychiatric 93 Solutions cannot predict its ability to cover future cost increases, management believes that through adherence to cost containment policies, labor management and reasonable price increases, the effects of inflation on future operating margins should be manageable. Psychiatric Solutions' ability to pass on increased costs associated with providing health care to Medicare and Medicaid patients is limited due to various federal, state and local laws which have been enacted that, in certain cases, limit its ability to increase prices. In addition, as a result of increasing regulatory and competitive pressures and a continuing industry wide shift of patients into managed care plans, Psychiatric Solutions' ability to maintain margins through price increases to non-Medicare patients is limited. The psychiatric health care industry is typically not directly impacted by periods of recession, erosions of consumer confidence or other general economic trends as most health care services are not considered a component of discretionary spending. However, Psychiatric Solutions' facilities may be indirectly negatively impacted to the extent such economic conditions result in decreased reimbursements by federal or state governments or managed care payers. Psychiatric Solutions is not aware of any economic trends that would lead it to believe that Psychiatric Solutions will not be able to remain in compliance with all debt covenants and meet all required obligations and commitments in the near future. CRITICAL ACCOUNTING POLICIES Psychiatric Solutions' consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing its financial statements, Psychiatric Solutions is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses included in the financial statements. Estimates are based on historical experience and other information currently available, the results of which form the basis of such estimates. While Psychiatric Solutions believes its estimation processes are reasonable, actual results could differ from those estimates. The following represent the estimates considered most critical to Psychiatric Solutions' operating performance and involve the most subjective and complex assumptions and assessments. ALLOWANCE FOR DOUBTFUL ACCOUNTS Psychiatric Solutions' ability to collect outstanding patient receivables from third party payors and receivables due under its management contracts is critical to its operating performance and cash flows. With regard to patient receivables, the allowance for doubtful accounts is approximately 19.7% of the accounts receivable balance net of contractual discounts as of March 31, 2002. The primary collection risk for these receivables lies with uninsured patient accounts or patient accounts for which primary insurance has paid but a patient portion remains outstanding. Psychiatric Solutions estimates the allowance for doubtful accounts primarily based upon the age of the accounts since patient discharge date. Psychiatric Solutions continually monitors its accounts receivable balances and utilizes cash collection data to support its estimates of the provision for doubtful accounts. Significant changes in payor mix or business office operations could have a significant impact on Psychiatric Solutions' results of operations and cash flows. With regard to receivables due under management contracts, the allowance for doubtful accounts is approximately 32.7% of the accounts receivable balance at March 31, 2002. The primary collection risk is attributable to contractual disputes. Psychiatric Solutions estimates the allowance for doubtful accounts for these receivables based primarily upon the specific identification of potential collection issues. As with its patient receivables, Psychiatric Solutions continually monitors its accounts receivable balances and utilizes cash collection data to support its estimates of the provision for doubtful accounts. ALLOWANCES FOR CONTRACTUAL DISCOUNTS For the three months ended March 31, 2002, Medicare and Medicaid revenues accounted for approximately 40.8% of total gross patient revenues. The Medicare regulations and various managed care contracts are often complex and may include multiple reimbursement mechanisms for different types of services provided in Psychiatric Solutions' facilities and cost settlement provisions requiring complex 94 calculations and assumptions subject to interpretation. Psychiatric Solutions estimates the allowance for contractual discounts on a payer-specific basis given its interpretation of the applicable regulations or contract terms. The services authorized and provided and related reimbursement are often subject to interpretation that could result in payments that differ from Psychiatric Solutions' estimates. Additionally, updated regulations and contract renegotiations occur frequently necessitating continual review and assessment of the estimation process by management. CHANGES IN OR DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Psychiatric Solutions has not experienced a change of accountants or any disagreements with its accountants on any matter of accounting practice or financial disclosure during the reporting periods. THE MERGER GENERAL The following summarizes the material terms of the merger agreement. A copy of the merger agreement is included in this joint proxy statement/prospectus as Annex A. The merger agreement is incorporated in this document by reference. We urge you to read the merger agreement in its entirety for a more complete description of the terms and conditions upon which the merger is to be effected. If the merger agreement is approved and adopted by the stockholders of PMR and Psychiatric Solutions and all conditions to the merger agreement are satisfied or waived, a wholly-owned subsidiary of PMR will be merged with and into a Psychiatric Solutions, with the wholly-owned subsidiary ceasing to exist and Psychiatric Solutions surviving as a wholly-owned subsidiary of PMR. BACKGROUND OF THE MERGER In pursuing strategies to enhance stockholder value, both PMR and Psychiatric Solutions have from time to time considered opportunities for acquisitions, dispositions and strategic alliances. The companies have remained aware of each other and have periodically met to discuss potential synergies in their operations. Toward that end, the companies executed a Confidentiality Agreement having a five-year term on June 6, 1999. At meetings of the board of directors of PMR held during the first several months of 2001, the board of directors of PMR discussed the possibility of exploring strategic alternatives for PMR, including a possible sale of the company or the possible acquisition of another company. To assist it in the process, on February 8, 2001, PMR engaged McGettigan, Wick & Co., Inc. and on May 18, 2001, PMR engaged Raymond James & Associates, Inc., in each case to render financial advising services related to the exploration of these strategic alternatives. On July 3, 2001, Mark Clein, a current director and then-officer of PMR, and Joey Jacobs, President & Chief Executive Officer of Psychiatric Solutions, met in Nashville to discuss the possibility of a transaction between the companies. Also in attendance were Riley Sweat and Burk Lindsey, representatives of PMR's financial advisor, Raymond James, as well as Psychiatric Solutions directors David Heer and Bill Cook. The participants discussed the background and current operations of each entity, as well as the possibility of a strategic transaction. Subsequent to that meeting, Mr. Clein presented to the PMR board of directors an overview of the business and operations of Psychiatric Solutions and reviewed with the PMR board the discussions held with Psychiatric Solutions regarding a potential strategic transaction. The PMR board determined not to pursue a transaction with Psychiatric Solutions at that time. On February 13, 2002, Mr. Jacobs again met with Messrs. Sweat and Lindsey at the Nashville offices of Raymond James. Mr. Jacobs provided an update regarding Psychiatric Solutions' operations and recent acquisitions and Mr. Sweat updated Mr. Jacobs on PMR's process of evaluating strategic alternatives. 95 On March 5, 2002, Messrs. Clein, Jacobs, Sweat and Lindsey, as well as PMR's President and General Counsel, Fred Furman, met at the Nashville offices of Raymond James. The principals agreed to consider the terms of a potential strategic transaction, and PMR's financial advisor provided a financial business analysis to the participants later that day. The PMR board of directors held a meeting on March 14, 2002 during which it discussed the structure of a potential acquisition transaction with Psychiatric Solutions. The Psychiatric Solutions board of directors held a meeting on March 21, 2002 in which it discussed the structure of a potential strategic transaction with PMR. Mr. Sweat of Raymond James joined a portion of the meeting by telephone and outlined potential benefits of the proposed transaction with Psychiatric Solutions. The PMR board of directors met again on March 25, 2002 to discuss and consider potential strategic acquisition alternatives. Mr. Sweat of Raymond James summarized for the PMR board the structure of the proposed transaction with Psychiatric Solutions. Over the following week, senior management of each company and their advisors negotiated a term sheet outlining a proposed transaction between the two companies. The boards of directors of PMR and Psychiatric Solutions reviewed this term sheet at meetings on April 1, 2002 and April 2, 2002, respectively, but took no action. The term sheet was further negotiated during the following week. On April 9, 2002, counsel for Psychiatric Solutions delivered a draft of a merger agreement to counsel for PMR. During the remainder of April, the senior management of each company and their legal and financial advisors conducted an extensive due diligence review of the other and negotiated a merger agreement and related documentation. During April 10-12, 2002, counsel to Psychiatric Solutions performed due diligence review on-site at PMR's offices in San Diego. During April 17-19, 2002, PMR's senior management and legal counsel performed due diligence review of Psychiatric Solutions in Nashville. On April 26, 2002, Psychiatric Solutions engaged its financial advisors, Brentwood Capital Advisors, to provide a fairness opinion in addition to the advisory services it had already been providing. On April 29, 2002, the PMR board of directors held a special meeting at which PMR's senior management and its financial and legal advisors were present. At this meeting, the PMR board of directors reviewed and considered the proposed transaction with Psychiatric Solutions. Raymond James made a presentation with respect to the financial aspects of the proposed merger with Psychiatric Solutions and delivered its oral opinion, subsequently confirmed in writing dated as of April 29, 2002, that the consideration to be paid by PMR in the merger was fair from a financial point of view to the stockholders of PMR. PMR's legal advisor then reviewed with the PMR board of directors the terms of the proposed merger agreement and the fiduciary duties of the PMR board of directors. PMR's legal advisor also reviewed the results of the due diligence review it had conducted with respect to Psychiatric Solutions on behalf of PMR. The PMR board of directors reconvened on May 1, 2002 and, during this meeting, PMR's financial and legal advisors updated the PMR board of directors on developments regarding the terms of the merger agreement and other matters. At the May 1, 2002 meeting, the PMR board of directors approved the merger agreement with Psychiatric Solutions and authorized the officers of PMR to finalize and execute the merger agreement. At this meeting, the PMR board of directors also authorized the payment of a dividend of $5.10 per share of its common stock to holders of record on May 17, 2002, payable on May 24, 2002. In addition, the PMR board of directors authorized the amendment of the employment agreements of Mr. Furman and Susan D. Erskine, PMR's Executive Vice President-Development and Secretary, that would entitle each to receive specified severance payments if their employment is terminated by either PMR or the employee in contemplation of a change of control of PMR, or within 180 days thereafter. The PMR board of directors also approved amendments to the promissory notes relating to amounts owed by each of Mr. Clein, Mr. Furman, and Ms. Erskine to permit the payment of the outstanding principal and interest through the delivery of shares of PMR common stock valued at the higher of the average closing price of PMR common stock for the five trading days prior to such delivery or a specified price which was $7.92, $8.82, and $6.00 for Mr. Clein, Mr. Furman, and Ms. Erskine, respectively. 96 On April 30, 2002, the Psychiatric Solutions board of directors reviewed the proposed transaction in detail and authorized Mr. Jacobs to finalize and execute the merger agreement. On May 2, 2002, Mr. Clein traveled to Nashville to facilitate finalizing the merger agreement. The merger agreement was signed by PMR, PMR Acquisition Corporation and Psychiatric Solutions on May 6, 2002, and the transaction was announced by PMR through a press release. During late May and early June 2002, legal counsel to both PMR and Psychiatric Solutions discussed the advisability of an amendment to the merger agreement that would require PMR, as a condition to the closing of the merger, to amend its charter in order to effect a reverse stock split and a name change. During the first week of June 2002, legal counsel to PMR presented to PMR's board of directors, PMR's management, and PMR's financial advisors a draft of amendment no. 1 to the merger agreement. On June 7, 2002, PMR's board of directors approved amendment no. 1 to the merger agreement by unanimous written consent and authorized the officers of PMR to finalize and execute such amendment. PMR, PMR Acquisition Corporation, and Psychiatric Solutions signed amendment no. 1 to the merger agreement on June 10, 2002. During late June and early July 2002, legal counsel to PMR and Psychiatric Solutions discussed the advisability of an amendment to the merger agreement that, among other things, provides for a 1-for-3 reverse stock split instead of the 1-for-2 1/2 reverse stock split provided for in amendment no. 1 to the merger agreement. During the first week of July 2002, legal counsel to PMR presented to PMR's board of directors, PMR's management and PMR's financial advisors a draft of amendment no. 2 to the merger agreement. On July 3, 2002, PMR's board of directors approved amendment no. 2 to the merger agreement by unanimous written consent and authorized officers of PMR to finalize and execute such amendment. PMR, PMR Acquisition Corporation and Psychiatric Solutions signed amendment no. 2 to the merger agreement on July 9, 2002. REASONS FOR THE MERGER PMR and Psychiatric Solutions believe that the merger will create significant value for their respective stockholders. Both boards of directors believe that the merger agreement and the terms of the merger are in the best interests of their respective stockholders and unanimously recommend that the stockholders vote "for" the adoption of the merger agreement. Each of PMR and Psychiatric Solutions believe that the combined company can achieve enhanced earnings by: - Potential Revenue Enhancement. The potential enhancement of revenues based on the combined company's attractiveness as a more comprehensive provider of mental health care services resulting from complementary capabilities, broader service offerings and strengthened financial base; - Potential Expense Efficiencies. Realizing annual cost savings through the merger, including through the consolidation of the corporate headquarters of the two companies, the elimination of duplicative staff and expenses, and potential access to capital and less expensive credit. Board of Director Considerations. In reaching their decision to recommend the merger to their stockholders, each company's board of directors consulted with their management, as well as their respective financial and legal advisors, and considered various factors, including without limitation: - Strategic Assessment of Merger Partner. Information regarding the financial performance and condition, business operations and prospects of each of PMR and Psychiatric Solutions, and each company's respective future performance and prospects as a separate entity and on a combined basis; - External Factors. Current industry, economic and market conditions and how each relates to business combinations or strategic alliances in the behavioral health care services industry; 97 - Market Valuations. Recent and historical prices of PMR's common stock and the value assigned to Psychiatric Solutions' common stock; - Potential Revenue Enhancement. The potential enhancement of revenues based on the combined company's attractiveness as a more comprehensive provider of mental health care services resulting from its complementary capabilities, broader service offerings and strengthened financial base; - Fairness Opinions. The financial analyses provided to them by their respective financial advisors, as described below, and the respective opinions of each company's financial advisors that the exchange ratio is fair from a financial point of view to their respective stockholders; - Potential Synergies. The potential consolidation benefits that are expected to be available to the combined entity, primarily in the form of improved efficiencies from operations and corporate cost reductions; - Due Diligence. Discussions with management and each company's advisors concerning the results of their due diligence investigation of the other company; - Likelihood of Closing. The likelihood that the merger would be completed; and - Transaction Structure and Terms. The proposed structure of the transaction and the other terms of the merger agreement and related agreements including: - Exchange Ratios. Exchange ratios for each class of Psychiatric Solutions capital stock that provide certainty about the number of shares of PMR common stock that will be issued in the merger; - Representations, Warranties and Covenants. The representations, warranties and covenants made by each company; - Tax-Free Reorganization. The expected treatment of the merger as a tax-free reorganization; - Flexibility Regarding Superior Proposals. The ability of each company to respond to unsolicited alternative acquisition proposals which the board of directors of that company determines, after consultation with its financial advisors, would result in a transaction more favorable to that company's stockholders than the merger; - Termination Fee Provisions. The provisions of the merger agreement that may require the party entering into another transaction, in circumstances involving the termination of the merger agreement, to pay the other party to the merger agreement a termination fee and reimburse the other party's out-of-pocket expenses; and - Limitations on Pre-Closing Activities. Restrictions on specified transactions by each of the companies during the period prior to the completion of the merger. Additional PMR Considerations. The board of directors of PMR considered these additional factors: - Leverage. The increased levels of debt and interest costs that the combined company would have compared to PMR on a stand-alone basis; - Board Composition. The continued board representation for the current PMR stockholders through the two seats on the combined company's board of directors; - Voting Agreements. The voting agreements entered into by the certain stockholders of PMR and Psychiatric Solutions supporting the merger; - Size. The greater size and diversification of the combined company; - Stockholder Distributions. The ability to make distributions to its stockholders prior to the closing of the merger, provided that PMR has not less than $5.05 million of cash and cash equivalents at the time of the closing of the merger, which provision allowed PMR to pay a cash dividend of $5.10 per share of its common stock on May 24, 2002; 98 - Contingent Value Rights. The ability of PMR to distribute contingent value rights to its stockholders prior to the closing of the merger that would, if issued, entitle the holders to receive additional cash payments based on any cash and cash equivalents of PMR in excess of $5.05 million as of the closing of the merger and based on the collection of specified accounts receivable of PMR after the closing of the merger relating to closed management contracts; - Comparable Benefits. The potential benefits of a merger with Psychiatric Solutions as compared to the potential distribution to PMR's stockholders if PMR were to wind down its existing business operations and subsequently dissolve; and - Certain Interests in the Merger. The interest that certain PMR executive officers and directors may have with respect to the merger in addition to their interests as stockholders of PMR. See "Interests of Certain Directors, Officers and Stockholders in the Merger." Additional Psychiatric Solutions Considerations. The board of directors of Psychiatric Solutions considered these additional factors: - PMR Stock Price. The then-current and historical market prices of PMR common stock; - Industry Leadership Position. The board's belief that the merger will position Psychiatric Solutions to become an industry leader in providing behavioral health care services; - Board Composition. The continued representation for current Psychiatric Solutions stockholders through the four seats on the combined company's board of directors and the continued role of Psychiatric Solutions' President and Chief Executive Officer as Chairman, President and Chief Executive Officer of the combined company, of Psychiatric Solutions' Chief Development Officer as Chief Development Officer and Secretary of the combined company, of Psychiatric Solutions' Chief Operating Officer as Chief Operating Officer of the combined company, and of Psychiatric Solutions' Controller as Controller of the combined company; - Continuation of PMR Contract. The likelihood that the combined company will be able to continue to service PMR's management and affiliation agreement with Mental Health Cooperative, Inc.; - Equity Structure. The simplification of Psychiatric Solutions' capital structure by reducing its three classes of capital stock into a single class; - Public Company Status. The potential benefits of being a public company, including possible access to equity markets and liquidity for stockholders; and - Name and Headquarters. The fact that after the merger PMR's name will be changed to "Psychiatric Solutions, Inc." and the consolidated headquarters will be in Franklin, Tennessee. Selected Risks and Disadvantages. Each board of directors also considered certain risks and potential disadvantages associated with the merger, including without limitation: - Potential Distraction. The potential disruptive effects of the merger on the business and operation on each of PMR and Psychiatric Solutions due to additional and competing demands on management; - Integration of Operations. The risk that operations of the two companies may not be successfully integrated; - Integration of Acquisitions. The risk that the operations of inpatient psychiatric hospitals recently acquired by Psychiatric Solutions will not be successfully integrated; - Unrealized Efficiencies. The risk that expected cost savings may not be realized to the degree anticipated; 99 - Failure to Close. The risk that the merger might not be completed as a result of a failure to satisfy the conditions to the merger agreement, including receiving the consent of Psychiatric Solutions' senior lender; - Public Company Status. The costs, disclosure obligations and other potential disadvantages of being a public company; - Adverse Effects of Failing to Close. The potential adverse effect on each company's business, operations and financial condition should it not be possible to complete the merger, as well as adverse effects resulting from the expenses incurred by each company in connection with the merger and the possibility of paying a termination fee to the other party; - Lack of Post-Closing Remedies. The absence of contractual indemnification and other meaningful post-merger remedies for breaches or inaccuracies regarding each company's representations and warranties; - Loss of Directors. The loss of guidance from longstanding directors of each company who will not continue as directors of the combined companies after the merger; - Unknown Liabilities. The risk that material unknown and/or contingent liabilities associated with the other company may arise after the merger; - Benefits Not Achieved. The risk that benefits sought from the merger might not be fully achieved; and - Other Risk Factors. Other matters described under "Risk Factors." Each board of directors determined that the potential advantages of the merger substantially outweigh the risks and disadvantages described above. The above discussion of factors considered by the boards of directors is not intended to be exhaustive but is believed to include material factors considered by each. In reaching its decision to approve the merger, each company's board of directors did not quantify or assign any relative weights to the factors considered, and individual directors may have given different weights to different factors. RECOMMENDATION OF EACH COMPANY'S BOARD OF DIRECTORS After considering all of the factors described above, at a meeting held on May 1, 2002, PMR's board of directors unanimously approved the merger agreement and the related transactions. At a meeting held on April 30, 2002, Psychiatric Solutions' board of directors approved the merger agreement and the related transactions. In considering the recommendation of the PMR board of directors and the Psychiatric Solutions board of directors with respect to the merger, the merger agreement and the related transactions, PMR and Psychiatric Solutions stockholders should be aware that some officers and directors of PMR and Psychiatric Solutions have interests in the proposed merger that are different from and in addition to the interests of PMR and Psychiatric Solutions stockholders generally. Each of the PMR and the Psychiatric Solutions board of directors was aware of these additional conflicts of interests and considered them in approving the merger and merger agreement. For a description of these interests, see "Interests of Certain Directors, Officers and Stockholders in the Merger" that begins on page 119 of this document. The PMR board of directors and the Psychiatric Solutions board of directors each believe that the merger agreement and the terms of the merger are in the best interests of PMR and Psychiatric Solutions stockholders, respectively, and recommend that the stockholders of PMR and Psychiatric Solutions, respectively, vote "for" the adoption of the merger agreement. 100 In addition to voting "for" the approval and adoption of the merger, the PMR board of directors also recommends that the stockholders for PMR vote "for" an amendment to PMR's charter to: - increase the authorized number of shares of PMR common stock to facilitate the issuance of PMR common stock pursuant to the merger; - effectuate a 1-for-3 reverse stock split pursuant to which each outstanding share of PMR common stock would be converted into one-third of a share of PMR common stock; and - change the name of PMR to "Psychiatric Solutions, Inc." OPINION OF PMR'S FINANCIAL ADVISOR INTRODUCTION AND SUMMARY PMR engaged Raymond James & Associates as financial advisor to PMR on May 18, 2001. In connection with that engagement, the PMR board of directors requested that Raymond James evaluate the fairness, from a financial point of view, to the stockholders of the outstanding common stock of PMR of the issuance of common stock, representing approximately 72.0% of the fully-diluted shares of PMR on a post-merger basis, to the stockholders of Psychiatric Solutions in connection with the proposed merger of Psychiatric Solutions and PMR pursuant and subject to the draft Agreement and Plan of Merger between PMR and Psychiatric Solutions dated April 29, 2002, after taking into account an assumed approximate $14.3 million one-time special dividend to be distributed to stockholders of PMR prior to the closing of the merger. On April 29, 2002, Raymond James delivered to the PMR board of directors its opinion, that as of that date and based on the assumptions made, matters considered, and limits of review set forth in Raymond James's written opinion, the issuance of common stock was fair to PMR from a financial point of view. Raymond James later delivered its written opinion, dated April 29, 2002, confirming its oral opinion. THE FORM OF THE FULL TEXT OF THE OPINION OF RAYMOND JAMES, DATED APRIL 29, 2002, WHICH SETS FORTH ASSUMPTIONS MADE, MATTERS CONSIDERED AND LIMITATIONS ON THE REVIEW UNDERTAKEN BY RAYMOND JAMES, IS ATTACHED AS ANNEX C TO THIS JOINT PROXY STATEMENT/PROSPECTUS AND SHOULD BE READ CAREFULLY AND IN ITS ENTIRETY BY PMR STOCKHOLDERS. THE FOLLOWING DESCRIPTION OF THE RAYMOND JAMES WRITTEN OPINION IS ONLY A SUMMARY OF THE RAYMOND JAMES WRITTEN OPINION AND IS QUALIFIED BY, AND NOT A SUBSTITUTE FOR, THE RAYMOND JAMES WRITTEN OPINION. PMR STOCKHOLDERS SHOULD NOTE THAT THE RAYMOND JAMES OPINION WAS PREPARED FOR THE PMR BOARD OF DIRECTORS AND ADDRESSES ONLY THE FAIRNESS OF THE TRANSACTION, IN THE AGGREGATE, TO THE COMMON STOCKHOLDERS OF PMR, FROM A FINANCIAL POINT OF VIEW, AND DOES NOT CONSTITUTE A RECOMMENDATION TO ANY STOCKHOLDER OF PMR AS TO HOW SUCH STOCKHOLDER SHOULD VOTE UPON THE PROPOSED MERGER. THE RAYMOND JAMES OPINION DOES NOT CONSTITUTE AN OPINION AS TO THE PRICE AT WHICH PMR COMMON STOCK WILL ACTUALLY TRADE AT ANY TIME. NO RESTRICTIONS OR LIMITATIONS WERE IMPOSED UPON RAYMOND JAMES WITH RESPECT TO THE INVESTIGATIONS MADE OR PROCEDURES FOLLOWED IN RENDERING ITS OPINION. Unless otherwise provided, references to shares of PMR stock and stock prices in this section do not give effect to the reverse stock split. In conducting its analysis and arriving at its opinion regarding the fairness, from a financial point of view, of the proposed merger to the common stockholders of PMR, Raymond James reviewed a draft of the merger agreement dated April 29, 2002. Raymond James also reviewed: - the audited financial statements of PMR as of and for the years ended April 30, 2001 and 2000 and the audited financial statements of Psychiatric Solutions as of and for the years ended December 31, 2001 and 2000; - PMR's Annual Reports filed on Form 10-K for the year ending April 30, 2001 and PMR's Quarterly Reports filed on Form 10-Q for the quarters ended July 30, 2001, October 31, 2001, and January 31, 2002; 101 - other financial and operating information, including projections, requested from and/or provided by PMR and Psychiatric Solutions; and - certain other publicly-available information on PMR. Raymond James also discussed with members of the senior management of PMR and Psychiatric Solutions certain information relating to the aforementioned and any other matters, which Raymond James has deemed relevant to its inquiry. Raymond James assumed and relied upon the accuracy and completeness of all information supplied or otherwise made available to it by PMR and Psychiatric Solutions, and Raymond James has not attempted to verify independently any of such information. Raymond James has not made or obtained an independent appraisal of the assets or liabilities (contingent or otherwise) of PMR or Psychiatric Solutions. The financial projections provided to Raymond James and used by Raymond James in the preparation of its opinion were prepared by the management of PMR and Psychiatric Solutions. Neither PMR nor Psychiatric Solutions publicly discloses financial projections of the type provided to Raymond James in connection with its review of the merger, and as a result, these financial projections were not prepared with a view towards public disclosure. The projections for the post-merger combined company were developed by combining the earnings projections for each company provided by its management, and by applying merger-related adjustments reviewed and approved only by the management of PMR. With respect to financial projections and other information and data provided to or otherwise reviewed by or discussed with Raymond James, Raymond James has assumed that such projections and other information and data have been reasonably prepared in good faith on bases reflecting the best currently available estimates and judgments of management, and Raymond James has relied upon each party to advise Raymond James promptly if any information previously provided became inaccurate or was required to be updated during the period of our review. Raymond James's opinion was based upon market, economic, financial and other circumstances and conditions existing and disclosed to Raymond James as of April 29, 2002 and any material change in such circumstances and conditions would require a reevaluation of this opinion, which Raymond James is under no obligation to undertake. Raymond James expressed no opinion as to the underlying business decision to effect the merger, the structure or tax consequences of the merger, or the availability or advisability of any alternatives to the merger. Raymond James did not express any opinion as to the likely trading range of the PMR's common stock following the merger, which may vary depending on numerous factors that generally impact the price of securities or on the financial condition of PMR at that time. The opinion of Raymond James is limited to the fairness, from a financial point of view, of the merger consideration to the stockholders of PMR. Raymond James expressed no opinion with respect to any other reasons, legal, business, or otherwise, that may support the decision of the board of directors to approve or consummate the merger. Raymond James believes that its analyses must be considered as a whole and that selecting portions of its analyses, without considering all analyses, would create an incomplete view of the process underlying its opinion. TRANSACTION TERMS Upon consummation of the merger, PMR will issue as consideration to Psychiatric Solutions 6,307,422 shares of PMR common stock (on a fully diluted basis taking into account the exercise of outstanding options and warrants of Psychiatric Solutions and giving effect to the proposed 1-for-3 reverse stock split of PMR common stock prior to closing), an amount representing approximately 72.0% of the pro forma common stock of PMR. PMR plans to distribute approximately $14.3 million of its cash on hand to its stockholders prior to the closing of the merger. Of PMR's remaining cash on hand, management has estimated that approximately $3.5 million will be used to satisfy severance and transaction-related expenses and that PMR will have sufficient cash on hand at closing to satisfy the closing condition that it not have less than $5.05 million of cash and cash equivalents on hand as of the closing. 102 DESCRIPTION OF ANALYTICAL APPROACH The analysis performed by Raymond James was affected significantly by two unusual factors: (i) the large amount of cash (approximately $22.8 million as of April 29, 2002) of PMR in relation to PMR's aggregate equity value of approximately $16.0 million as of April 29, 2002 based on the average closing sales price of PMR's common stock for the 60 days prior to such date and (ii) PMR's plan to dividend approximately $14.3 million to its stockholders prior to the closing of the merger. Given the small size of PMR's current operating business and the PMR's lack of research coverage, Raymond James believes that for some time the primary driver of PMR's stock value has been the cash on PMR's balance sheet. Because a majority of that cash will be distributed to PMR stockholders prior to the closing of the merger with Psychiatric Solutions, Raymond James believes the "value" of PMR stock could change, perhaps significantly, prior to the closing of the merger. Given that the consideration being paid by PMR consists entirely of PMR stock, the "transaction value" is therefore difficult to estimate with any degree of precision. Based upon (i) the large number of alternatives evaluated by PMR's board of directors and (ii) specific guidance from management and the board of directors, Raymond James assumed for its analysis two scenarios that were under consideration by the PMR board of directors: - completion of the business combination with Psychiatric Solutions; or - a winding-down of the operations of PMR. In both scenarios, Raymond James assumed a dividend of approximately $14.3 million would be paid to PMR stockholders. Relying upon guidance from management, Raymond James assumed that any winding-down of PMR would require that PMR leave approximately $5.0 million of net cash in PMR to fund ongoing obligations associated with PMR's remaining management contracts and to satisfy any legacy liabilities from closed management programs. AS A RESULT, A COMPONENT OF RAYMOND JAMES'S FOCUS WAS COMPARING THE PROSPECTIVE RESIDUAL VALUE OF PMR'S STOCK SUBSEQUENT TO THE ASSUMED DIVIDEND IN EACH OF THE TWO SCENARIOS. In analyzing the transaction, Raymond James utilized the following methodologies: - a capitalized contribution analysis; - an earnings-based pro forma valuation; - an earnings before interest, taxes, depreciation and amortization ("EBITDA")-based pro forma valuation; and - a discounted cash flow-based valuation. In the earnings-based and EBITDA-based pro forma valuations and in the discounted cash flow-based valuation, Raymond James utilized ranges of earnings and EBITDA multiples that were derived from, and informed by, a public comparable companies trading analysis and a selected acquisitions analysis. CAPITALIZED CONTRIBUTION ANALYSIS Raymond James analyzed the capitalized EBITDA contribution of each of PMR and Psychiatric Solutions adjusted for net outstanding indebtedness. To perform this analysis, Raymond James calculated a weighted average EBITDA multiple for Psychiatric Solutions of 5.7x by applying a 4.0x multiple to the EBITDA generated from Psychiatric Solutions' unit management business for the year ended December 31, 2001 (44.9% contribution) and a 7.0x multiple to the EBITDA generated from Psychiatric Solutions' freestanding psychiatric hospital business (55.1% contribution). The unit management multiple represented a 20.0% discount to the EBITDA multiple of Horizon Health Corp. (Nasdaq NM: HORC), the only publicly-traded contract behavioral health care manager. The 7.0x multiple applied to Psychiatric Solutions' freestanding psychiatric hospital business represents a 25.0% discount to Universal Health 103 Services (NYSE: UHS), the only publicly-traded hospital company with a meaningful portion of psychiatric facilities in its portfolio. Raymond James applied a slightly lower EBITDA valuation multiple of 3.5x to PMR's unit management business. The lower multiple reflects the small number of management contracts (PMR's two versus 44 for Psychiatric Solutions), as well as the projected value that likely could be obtained by PMR in a sale of those contracts. Raymond James used the capitalized contribution analysis as the primary methodology for evaluating the fairness of the transaction. Raymond James observed that the capitalized contribution analysis generated implied equity ownership levels of 28.8% and 71.2% for PMR and Psychiatric Solutions, respectively, and that those ownership levels compared favorably to the negotiated pro forma ownership of the two companies in the post-merger entity of approximately 28.0% and 72.0%, respectively. EARNINGS-BASED PRO FORMA VALUATION In this analysis, Raymond James developed a prospective residual value of PMR's stock, subsequent to the assumed dividend of approximately $14.3 million described above, in each of two scenarios, one involving a winding-down of operations of PMR without the merger and the other involving the merger with Psychiatric Solutions. The analysis in the merger scenario was based on the application of various multiples to the post-merger entity's projected 2002 earnings. Computation of Residual Per Share Equity Value in a Wind-Down Scenario. Relying upon guidance from management, Raymond James assumed that any winding-down of PMR would require that PMR leave approximately $5.0 million of net cash in PMR to fund ongoing obligations associated with the PMR's remaining management contracts and to satisfy any legacy liabilities from closed management programs. Raymond James derived a theoretical post-liquidating dividend per share equity value of $0.49 per PMR share by multiplying (i) the historical discount of PMR's common stock to the implied cash value per share -- 70.2%;(1) by (ii) the estimated cash value per share of PMR common stock post-liquidating dividend -- $0.70.(2) Computation of Residual Per Share Equity Value in the Merger Scenario. Raymond James derived theoretical per share equity values in the merger scenario by applying a range of earnings multiples of 7.5x to 20.0x to the post-merger entity's projected 2002 earnings. In determining the range of earnings multiples to be applied in this analysis, Raymond James utilized multiples implied by the Comparable Public Companies Trading Analysis (discussed below). As of April 29, 2002, the Comparable Public Companies were trading at implied multiples in a range of 9.3x to 27.4x earnings for the latest twelve months.(3) Raymond James noted that the resulting implied per share equity values in the merger scenario exceeded the theoretical per share value in a wind-down scenario across the entire range of multiples considered. EBITDA-BASED PRO FORMA VALUATION In this analysis, Raymond James developed a prospective residual value of PMR's stock, subsequent to the assumed dividend of approximately $14.3 million discussed above in each of two scenarios, one involving a winding-down of operations of PMR without the merger and the other involving the merger with Psychiatric Solutions. The analysis in the merger scenario was based on an application of various multiples to the post-merger entity's projections 2002 EBITDA. - --------------- (1) PMR's 60-day trailing average stock price as of April 29, 2002 of $2.23 divided by PMR's cash value per share as of that date of $3.18. Cash value per share was computed by dividing PMR's approximate cash balance of $22.8 million by PMR's common shares outstanding of 7.2 million. (2) Computed as (i) PMR's approximate post-liquidating dividend cash balance of $5.0 million ($22.8 million less the estimated total liquidating dividend of $14.3 million, less severance, transaction and related expenses of $3.5 million) divided by (ii) PMR's common shares outstanding of approximately 7.2 million. (3) As of April 29, 2002, there were no forward estimates available for any of the comparable companies with the exception of Universal Health Services. 104 Computation of Residual Per Share Equity Value in a Wind-Down Scenario. As in the earnings-based pro forma valuation analysis above, Raymond James derived a theoretical post-liquidating dividend per share equity value of $0.49 per PMR share. Computation of Residual Per Share Equity Value in the Merger Scenario. In this analysis, Raymond James derived theoretical enterprise values in the merger scenario by applying a range of EBITDA multiples of 4.0x to 8.0x to the post-merger entity's projected 2002 EBITDA. In determining the range of EBITDA multiples to be applied in this analysis, Raymond James utilized multiples implied by the Comparable Public Companies Trading Analysis (discussed below). As of April 29, 2002, the Comparable Public Companies were trading at implied multiples in a range of 5.1x to 9.5x EBITDA for the latest twelve months.(3) Raymond James then subtracted projected pro forma net debt to derive theoretical equity values in the merger scenario. These equity values were then divided by the projected pro forma common shares outstanding to derive theoretical per share equity values in the merger scenario. Raymond James noted that the resulting implied per share equity values in the merger scenario exceeded the theoretical per share value in a wind-down scenario across the entire range of multiples considered. DISCOUNTED CASH FLOW ANALYSIS Using a discounted cash flow analysis, Raymond James estimated the present value of the future cash flows that the post-merger entity could produce over a five-year period (2002 through 2006) without giving effect to potential operating or other efficiencies pro forma the merger, in accordance with forecasts developed by the PMR and Psychiatric Solutions management teams and certain variants of those forecasts. Raymond James determined certain equity market value reference ranges based upon the sum of the aggregate discounted value of the post-merger entity's free cash flows over a five-year investment horizon and the product of the final year's projected free cash flow multiplied by terminal values. To calculate free cash flow, Raymond James: - tax-affected the post-merger entity's projected earnings before interest, intangible amortization, and tax expense; - added back depreciation; - subtracted the estimated change in working capital; and - subtracted estimated capital expenditures. The estimated free cash flows over a five-year projection horizon were discounted to present values utilizing the post-merger entity's estimated weighted average cost of capital ("WACC"). Raymond James estimated the terminal value of the post-merger entity by assuming a sale of the company at the end of 2006 for a range of enterprise values computed by applying a range of theoretical EBITDA valuation multiples of 4.0x to 8.0x to the post-merger entity's projected terminal year (2006) EBITDA. The range of terminal multiples was determined by comparison to the EBITDA multiples of the Comparable Public Companies, which as of April 29, 2002 were trading at implied multiples of enterprise value in a range of 5.1x to 9.5x EBITDA for the latest twelve months. In determining the post-merger entity's WACC (the discount rate used in its discounted cash flow calculations), Raymond James relied upon the capital asset pricing model ("CAPM"). In utilizing the CAPM, Raymond James incorporated the following assumptions: - a risk-free rate of return equal to the then-current five-year treasury bond yield of 4.74%; - an average levered beta for the selected publicly-traded companies and the post-merger entity of 0.48 and 0.45, respectively; - a public equity risk premium (above the risk-free rate) of 8.4%; and 105 - an illiquidity premium of 30.0% given the projected sub-$100.0 million equity market capitalization of the post-merger entity. Raymond James noted that the resulting implied per share equity values in the merger scenario exceeded the theoretical per share value in a wind-down scenario across the entire range of multiples considered. COMPARABLE PUBLIC COMPANIES TRADING ANALYSIS To provide contextual data and comparative market information, Raymond James analyzed the operating performance of PMR and Psychiatric Solutions relative to certain companies whose securities are publicly traded and that were deemed by Raymond James to be reasonably similar to PMR pro forma for the merger with Psychiatric Solutions (facility-based behavioral health care providers). The selected companies chosen included: Horizon Health Corp.; Ramsay Youth Services, Inc.; Res-Care, Inc.; and Universal Health Services, Inc. (the "Comparable Public Companies"). Raymond James examined certain publicly available financial data of the Comparable Public Companies for the latest twelve months and was not able to analyze projected data as no forward year estimates were available for any Comparable Public Company other than Universal Health Services, Inc. The latest twelve months data analyzed included enterprise value (defined as the market value of common equity plus book value of total debt and preferred stock less cash) as a multiple of the latest twelve months revenues, latest twelve months EBITDA and latest twelve months earnings before interest and taxes ("EBIT"), and equity value as a multiple of latest twelve months pre-tax income and per share price to earnings ratios based upon latest twelve months earnings per share ("EPS"). Raymond James noted that as of April 29, 2002, the Comparable Public Companies were trading at implied multiples of enterprise value in a range of 0.4x to 1.3x (with a mean of 0.8x) for the latest twelve months revenues, a range of 5.1x to 9.5x (with a mean of 7.0x) for the latest twelve months EBITDA, and a range of 6.5x to 14.4x (with an average of 10.3x) for the latest twelve months EBIT. Raymond James noted that as of the same date, the Comparable Public Companies were trading at implied multiples of equity value in: - a range of 6.0x to 13.5x (with a mean of 9.8x) for the latest twelve months pre-tax income; and - a range of 9.3x to 27.4x (with a mean of 19.2x) for the latest twelve months EPS. Raymond James notes that no conclusions can be drawn by simply applying the mean multiples of the Comparable Public Companies to the implied valuation of the post-merger entity merger, as the value of the consideration being paid by PMR, which consists of 100.0% PMR common stock, may change, perhaps significantly, prior to the close of the merger given PMR's plan to distribute the majority of its major asset, cash, to its stockholders prior to the closing of the merger. SELECTED ACQUISITIONS ANALYSIS Raymond James performed an analysis based upon selected merger and acquisition transactions in the behavioral health care industry set forth below (the "Selected Transactions"). Multiples reviewed in the Selected Transactions analysis included (i) enterprise value (defined as the equity value of the offer plus book value of total debt and preferred stock less cash) as a multiple (when available) of the latest twelve months revenues, latest twelve months EBITDA, and latest twelve months EBIT. The Selected Transactions were comprised of the following six facility transactions and seven company transactions (Acquiror/Target): Psychiatric Solutions/Neuro Rehabilitation Center; Psychiatric Solutions/Holly Hill Hospital; Psychiatric Solutions/West Oaks Hospital; Investment AB Bure/Three Magellan Hospitals; Undisclosed Acquiror/Greenbriar Psychiatric Hospital; Ameris Acquisition Corporation/Children's Comprehensive Services, Inc.; Horizon Health Corp./FPM Behavioral Care; Youth & Family Centered Services/YSII Behavioral Health division; Res-Care/Communications Network; Children's Comprehensive Services/Vendell Healthcare; Crescent Real Estate Equities/90 Magellan Hospitals and Related Interests; and Behavioral Healthcare Corp./Transitional Hospital -- Psychiatric Operations. 106 Based upon the Selected Transactions, Raymond James noted the implied multiples of aggregate transaction value and aggregate purchase price, respectively, are in: - a range of 0.3x to 1.9x (with a mean of 0.7x) for the latest twelve months revenues; - a range of 2.9x to 8.5x (with a mean of 4.9x) for the latest twelve months EBITDA; and - a range of 3.9x to 23.8x (with a mean of 9.9x) for the latest twelve months EBIT. Raymond James notes that no conclusions can be drawn by simply applying the mean multiples of the Selected Transactions to the implied valuation of the post-merger entity, as the value of the consideration being paid by PMR, which consists of 100% PMR common stock, may change, perhaps significantly, prior to the closing of the merger given PMR's plan to distribute the majority of its major asset, cash, to its stockholders prior to the closing of the merger. CONCLUSION In performing its analyses, Raymond James made numerous assumptions with respect to industry performance, general business, economic, market, and financial conditions and other matters, many of which are beyond the control of PMR and Psychiatric Solutions. Any estimates contained in such analyses are not necessarily indicative of actual past or future results or values, which may be significantly more or less favorable than such estimates. Actual values will depend upon several factors, including events affecting the provider-based behavioral health care industry, general economic, market, and interest rate conditions, and other factors which generally influence the price of securities. Pursuant to the terms of Raymond James's engagement, PMR has agreed to pay Raymond James an aggregate fee of $900,000 for its services in connection with the merger, $700,000 of which is contingent upon the consummation of the merger. PMR has also agreed to reimburse Raymond James for its reasonable out-of-pocket expenses incurred in performing its services and to indemnify Raymond James and related persons against certain liabilities. Raymond James was selected to render an opinion in connection with the merger based upon Raymond James's qualifications as investment bankers, health care expertise and reputation, including the fact that Raymond James, as part of its health care investment banking services, is regularly engaged in the valuation of businesses and securities in connection with mergers, acquisitions, underwritings, sales and distributions of listed and unlisted securities, private placements, and valuations for corporate and other purposes. Raymond James & Associates is a nationally recognized investment banking firm that provides a full range of financial, advisory and brokerage services. Raymond James is currently serving as an advisor to PMR in connection with PMR's evaluation of strategic alternatives. Raymond James is a market maker in PMR common stock; accordingly, Raymond James may at any time hold a long or short position in such securities. OPINION OF PSYCHIATRIC SOLUTIONS' FINANCIAL ADVISOR On April 30, 2002, Brentwood Capital rendered its oral opinion to the Psychiatric Solutions' board of directors, later confirmed in writing in a fairness opinion letter dated April 30, 2002, that, as of the date of such opinion letter and based on and subject to the assumptions, limitations and qualifications described in such opinion letter, both (i) the aggregate merger consideration to be received by the holders of Psychiatric Solutions' capital stock in the merger and (ii) the merger consideration to be received by the holders of Psychiatric Solutions' common stock relative to the consideration to be received by the holders of Psychiatric Solutions' Series A preferred stock and Psychiatric Solutions' Series B preferred stock were fair from a financial point of view. THE FULL TEXT OF THE OPINION OF BRENTWOOD CAPITAL, WHICH SETS FORTH THE ASSUMPTIONS MADE, MATTERS CONSIDERED, AND QUALIFICATIONS AND LIMITATIONS ON THE REVIEW UNDERTAKEN BY BRENTWOOD CAPITAL, IS ATTACHED AS ANNEX D TO THIS JOINT PROXY STATEMENT/PROSPECTUS AND THIS SUMMARY OF THE OPINION IS QUALIFIED IN ITS 107 ENTIRETY BY REFERENCE TO THE FULL TEXT OF THE OPINION BY BRENTWOOD CAPITAL. PSYCHIATRIC SOLUTIONS' STOCKHOLDERS ARE URGED TO READ THE OPINION OF BRENTWOOD CAPITAL CAREFULLY AND IN ITS ENTIRETY. BRENTWOOD CAPITAL'S OPINION WAS PROVIDED FOR THE INFORMATION AND ASSISTANCE OF THE PSYCHIATRIC SOLUTIONS BOARD OF DIRECTORS AND IS DIRECTED ONLY TO THE FAIRNESS FROM A FINANCIAL POINT OF VIEW OF THE MERGER CONSIDERATION TO HOLDERS OF PSYCHIATRIC SOLUTIONS' CAPITAL STOCK. THE TERMS OF THE MERGER AGREEMENT AND THE MERGER CONSIDERATION, HOWEVER, WERE DETERMINED THROUGH NEGOTIATIONS BETWEEN PSYCHIATRIC SOLUTIONS AND PMR, AND WERE APPROVED BY THE PSYCHIATRIC SOLUTIONS BOARD OF DIRECTORS. BRENTWOOD CAPITAL'S OPINION DOES NOT ADDRESS THE RELATIVE MERITS OF THE MERGER AS COMPARED TO OTHER TRANSACTIONS OR BUSINESS STRATEGIES THAT MIGHT BE AVAILABLE TO PSYCHIATRIC SOLUTIONS, NOR DOES IT ADDRESS THE UNDERLYING BUSINESS DECISION OF THE PSYCHIATRIC SOLUTIONS BOARD OF DIRECTORS TO ENGAGE IN THE MERGER. BRENTWOOD CAPITAL'S OPINION AND PRESENTATION TO THE PSYCHIATRIC SOLUTIONS BOARD OF DIRECTORS WERE ONLY TWO OF MANY FACTORS TAKEN INTO CONSIDERATION BY THE PSYCHIATRIC SOLUTIONS BOARD OF DIRECTORS IN MAKING ITS DETERMINATION TO APPROVE THE MERGER AGREEMENT. BRENTWOOD CAPITAL'S OPINION DOES NOT CONSTITUTE A RECOMMENDATION TO PSYCHIATRIC SOLUTIONS' STOCKHOLDERS AS TO HOW THEY SHOULD VOTE WITH RESPECT TO THE PROPOSED MERGER. IN ADDITION, BRENTWOOD CAPITAL HAS NOT EXPRESSED ANY OPINION AS TO THE PRICES AT WHICH PMR'S COMMON STOCK WILL TRADE FOLLOWING THE ANNOUNCEMENT OR CONSUMMATION OF THE MERGER. In rendering its opinion, Brentwood Capital performed a variety of financial analyses, including those summarized below. These analyses were presented to Psychiatric Solutions' board of directors at a meeting held on April 30, 2002. The summary set forth below does not purport to be a complete description of the analyses underlying the Brentwood Capital fairness opinion or the presentation made by Brentwood Capital to Psychiatric Solutions' board of directors. The preparation of a fairness opinion is a complex analytical process involving various determinations as to the most appropriate and relevant methods of financial analysis and the application of these methods to the particular circumstances and, therefore, such an opinion is not readily susceptible to partial analysis or summary description. Accordingly, notwithstanding the separate analyses summarized below, Brentwood Capital believes that its analyses must be considered as a whole and that selecting portions of its analyses and factors considered by it, without considering all of its analyses and factors, or attempting to ascribe relative weights to some or all of its analyses and factors, could create an incomplete view of the evaluation process underlying its opinion. In performing its analyses, numerous assumptions were made with respect to industry performance, general business, economic, market and financial conditions and other matters, many of which are beyond the control of Brentwood Capital, Psychiatric Solutions or PMR. Any estimates contained in the analyses performed by Brentwood Capital are not necessarily indicative of actual values or future results, which may be significantly more or less favorable than suggested by the analyses. Additionally, estimates of the value of businesses or securities do not purport to be appraisals or to reflect the prices at which the businesses or securities might actually be sold. Accordingly, the analyses and estimates are inherently subject to substantial uncertainty. In connection with its opinion, Brentwood Capital, among other things: - Reviewed a draft of the merger agreement dated April 26, 2002 and related documents; - Reviewed certain historical and projected financial statements of both Psychiatric Solutions and PMR; - Compared certain financial and other information of Psychiatric Solutions with respect to certain other companies in the behavioral health care management contract and facilities-based behavioral health care services industries; - Reviewed the historical price and volume trading activity relating to the common stock of PMR; - Conducted extensive discussions with Psychiatric Solutions' management concerning the operations of both Psychiatric Solutions and PMR, their respective financial condition and prospects, as well as strategic and operating benefits anticipated from the merger; 108 - Conducted on-site visits to certain freestanding psychiatric hospitals of Psychiatric Solutions to inspect the physical characteristics of the properties, to assess the quality and range of services offered at these properties and to meet with on-site management of the facilities. In arriving at its opinion, in addition to reviewing the matters listed above, Brentwood Capital performed the following valuation analyses: - Compared the trading multiples for comparable publicly traded companies in the behavioral health care management contract and facilities-based behavioral health care services industries with Psychiatric Solutions' implied equity value of the per share merger consideration; - Compared completed precedent transaction multiples for control acquisitions in the behavioral health care management contract and facilities-based behavioral health care services industries with Psychiatric Solutions' implied equity value of the per share merger consideration; - Performed a discounted cash flow analysis for Psychiatric Solutions to analyze the net present value of: (i) Psychiatric Solutions' five-year annual projected cash flows and (ii) a terminal value for Psychiatric Solutions in fiscal year 2006 based upon a range of EBITDA multiples compared to Psychiatric Solutions' implied equity value of the per share merger consideration; - Performed a stand-alone leveraged buyout analysis for Psychiatric Solutions to analyze the maximum prices per share of Psychiatric Solutions' common stock that a third party financial buyer could pay in a competitive environment compared to Psychiatric Solutions' implied equity value of the per share merger consideration; - Performed an accretion/dilution analysis for the proposed transaction to analyze the projected pro forma effect of the merger on the combined company's earnings per share; and - Conducted such other financial studies, analyses and investigations and reviewed such other factors as Brentwood Capital deemed appropriate for purposes of its opinion. In rendering its opinion, Brentwood Capital assumed and relied on the accuracy and completeness of the financial, legal, tax, operating, and other information provided to it by Psychiatric Solutions and PMR, including, without limitation, the financial statements and related notes of Psychiatric Solutions and PMR. Brentwood Capital has not assumed any responsibility for independently verifying that information or undertaken an independent evaluation or appraisal of any of the assets or liabilities of Psychiatric Solutions or PMR or been furnished with any such evaluation or appraisal. With respect to the financial forecast information furnished to or discussed with Brentwood Capital by Psychiatric Solutions or PMR, Brentwood Capital assumed that they were reasonably prepared and reflected the best currently available estimates and judgment of Psychiatric Solutions' or PMR's management as to the expected future financial performance of Psychiatric Solutions or PMR, as the case may be. The opinion of Brentwood Capital speaks only as of the date it was rendered, is based on the conditions as they existed, and information supplied to Brentwood Capital, as of April 26, 2002 (the last trading day preceding the finalization of its analysis), and is without regard to any market, economic, financial, legal, or other circumstances or event of any kind or nature which may exist or occur after such date. Brentwood Capital assumed that in the course of obtaining the necessary regulatory or other consents or approvals (contractual or otherwise) for the merger, no restrictions, including any divestiture requirements or amendments or modifications, will be imposed that will have a material adverse effect on the contemplated benefits of the merger. Brentwood Capital further assumed that the merger will qualify as a tax-free reorganization for U.S. federal income tax purposes. The financial forecasts furnished to Brentwood Capital and used by it in some of its analyses were prepared by the management of either Psychiatric Solutions or PMR. Neither Psychiatric Solutions nor PMR publicly discloses financial forecasts of the type provided to Brentwood Capital in connection with its review of the merger, and as a result, these financial forecasts were not prepared with a view towards public disclosure. The financial forecasts were based on numerous variables and assumptions which are inherently uncertain, including, without limitation, factors related to general economic and competitive 109 conditions, and accordingly, actual results could vary significantly from those set forth in such financial forecasts. The following is a summary of the material analyses performed by Brentwood Capital in connection with its opinion. For this summary of Brentwood Capital's opinion, the term "EBITDA" means earnings before interest, taxes, depreciation and amortization, and the term "Enterprise Value" means the sum of (i) equity market capitalization, or market equity value, plus (ii) minority interest, (iii) preferred stock and (iv) net debt, which equals total debt less cash and cash equivalents. Future earnings for the comparable companies used in the analyses were based on publicly available estimates. At the time of its analyses, Brentwood Capital used $1.67 as the implied equity value of the per share merger consideration giving regard to the exchange ratio provisions of the merger agreement and the negotiated ownership levels in the combined company of 72.0% for Psychiatric Solutions and 28.0% for PMR. In order to calculate this implied equity value of the per share merger consideration, Brentwood Capital derived the relative equity contribution analysis of the two companies by: (i) applying a 6.0x EBITDA multiple to Psychiatric Solutions' pro forma EBITDA of $11.3 million less net debt of approximately $36.5 million and (ii) applying a 3.5x EBITDA multiple to PMR's pro forma EBITDA of $2.0 million plus cash of approximately $5.1 million. In performing the above analysis, Brentwood Capital calculated an implied equity valuation for Psychiatric Solutions of approximately $31.3 million, or approximately 72.1% of the combined company, while PMR generated an implied equity valuation of approximately $12.1 million, or approximately 27.9% of the combined company. Based on this analysis, Brentwood Capital noted that the relative equity contribution of the two companies is comparable to the negotiated merger ownership levels in the combined company. SELECTED COMPARABLE PUBLIC COMPANY ANALYSIS. Brentwood Capital compared certain financial and operating statistics to analyze Psychiatric Solutions' implied transaction valuation relative to a group of publicly-traded behavioral health care services companies that Brentwood Capital deemed to be comparable in whole or in part to Psychiatric Solutions. Using publicly available information, Brentwood Capital compared the enterprise value of Psychiatric Solutions implied by the per share merger consideration, expressed as a multiple of pro forma revenue and EBITDA in calendar year 2001, to the respective low, high, median and mean multiples of enterprise values of comparable companies implied by the public trading price of their respective common stock. Because Psychiatric Solutions may be reasonably considered, at least in part, both a behavioral health care management contract company and a facilities-based behavioral health care services company, Brentwood Capital conducted its comparable company analysis by examining both types of companies. The only behavioral health care management contract company Brentwood Capital considered comparable to Psychiatric Solutions was - Horizon Health Services Corp. The facility-based behavioral health care services companies Brentwood Capital considered comparable to Psychiatric Solutions were: - Ramsay Youth Services, Inc.; - Res-Care, Inc.; and - Universal Health Services, Inc. 110 The following table compares, as of April 26, 2002, the implied transaction multiples of Psychiatric Solutions for the transaction with the low, high, median and mean multiples for the selected comparable public companies as an aggregate group:
PSI COMPARABLE COMPANY ANALYSIS (AS IMPLIED BY THE --------------------------- PER SHARE MERGER LOW HIGH MEDIAN MEAN CONSIDERATION) ---- ---- ------ ---- ------------------ Enterprise Value as a Multiple of LTM: Net Revenue............................. 0.5x 1.3x 0.7x 0.8x 0.7x EBITDA.................................. 6.0x 9.4x 7.3x 7.5x 6.0x
For purposes of its analysis, Brentwood Capital compared the last twelve month ("LTM") trading multiples of the comparable companies to the pro forma 2001 results of Psychiatric Solutions. Brentwood Capital noted that analyzing Psychiatric Solutions' pro forma results was a more accurate comparison due to the acquisitions completed during the last four months of fiscal year 2001. Brentwood Capital also noted that certain risks and limitations associated with Psychiatric Solutions' current size and the illiquidity of its capital stock relative to several of the selected comparable publicly traded companies would suggest discounted trading multiples to those comparable companies. In addition, Brentwood Capital noted that the implied transaction value received by holders of Psychiatric Solutions' capital stock may change significantly based on PMR's plan to distribute a majority of its cash to its existing stockholders prior to the close of the contemplated merger. SELECTED COMPARABLE TRANSACTION ANALYSIS. Using publicly available information, Brentwood Capital reviewed the purchase prices and multiples paid in selected acquisitions of public and private behavioral health care companies that were deemed to be reasonably similar to Psychiatric Solutions in whole or in part. Specifically, Brentwood Capital reviewed the following behavioral health care company transactions:
TARGET ACQUIROR - ----------------------------------------- ----------------------------------------- - - Children's Comprehensive Services, Inc. - Ameris Acquisition, Inc. - - National Mentor - Management & Madison Dearborn Partners - - Charter Behavioral Manatee Palms - Ramsay Youth Services, Inc. - - FPM Behavioral Health - Horizon Health Services Corp. - - YSII Behavioral Health - Youth & Family Centered Services - - 90 Magellan Hospitals & Related - Crescent Real Estate Equities Operations - - Communications Network - Res-Care, Inc. - - Vendell Healthcare - Children's Comprehensive Services, Inc.
For each transaction, Brentwood Capital calculated transaction multiples at announcement based on the enterprise value over the LTM revenue and EBITDA for those transactions for which data was available and meaningful. It should be noted that none of the comparable precedent transactions are identical to the contemplated merger and that, therefore, there are numerous factors that may have impacted the resulting transaction multiples that would affect the implied valuation of Psychiatric Solutions. Financial data regarding the comparable precedent transactions was taken from filings with the SEC, press releases, industry reports and other sources. 111 The following table compares the implied transaction multiples of Psychiatric Solutions for the transaction with the low, high, median and mean multiples for the selected comparable transactions:
PSYCHIATRIC SOLUTIONS COMPARABLE TRANSACTION ANALYSIS (AS IMPLIED BY THE ------------------------------- PER SHARE MERGER LOW HIGH MEDIAN MEAN CONSIDERATION) ----- ----- ------- ----- --------------------- Enterprise Value as a Multiple of LTM: Net Revenue........................... 0.4x 1.9x 0.5x 0.9x 0.7x EBITDA................................ 2.9x 8.5x 5.0x 5.2x 6.0x
For purposes of its analysis, Brentwood Capital compared the LTM multiples of the comparable transactions to the pro forma 2001 results of Psychiatric Solutions. Brentwood Capital noted that analyzing Psychiatric Solutions' pro forma results was a more accurate comparison due to the acquisitions completed during the last four months of fiscal year 2001. In addition, Brentwood Capital noted that the implied transaction value received by holders of Psychiatric Solutions' capital stock may change significantly based on PMR's plan to distribute a majority of its cash to its existing stockholders prior to the close of the contemplated merger. DISCOUNTED CASH FLOW ANALYSIS. Using discounted cash flow analysis, based on information obtained from Psychiatric Solutions' management, Brentwood Capital discounted to present value the future cash flows that Psychiatric Solutions is projected to generate through fiscal year 2006. Brentwood Capital calculated terminal values for Psychiatric Solutions by applying multiples of EBITDA in the fiscal year 2006 of 5.0x to 7.0x. The cash flow streams and terminal values were then discounted to present values using discount rates of 16.0% to 20.0%, chosen to reflect different assumptions regarding the returns expected by potential equity holders and Psychiatric Solutions' weighted average cost of capital. Brentwood Capital's analysis of operating cash flows yielded an implied value per share ranging from $1.24 to $2.45 (based on Psychiatric Solutions' fully diluted shares outstanding prior to the merger). Brentwood Capital noted that these results were highly sensitive to the underlying financial projections provided by management, which showed strong revenue increases and margin improvement through 2006. LEVERAGED BUYOUT ANALYSIS. Utilizing the projections provided by Psychiatric Solutions' management, Brentwood Capital analyzed the value of Psychiatric Solutions as a stand-alone entity in a leveraged transaction. Based on Brentwood Capital's knowledge of the current lending environment for such transactions, Brentwood Capital assumed a financing based on a range of exit multiples and internal rates of return ("IRRs") on invested capital. Brentwood Capital calculated the five-year IRRs required by hypothetical mezzanine holders and equity investors, and analyzed the total indebtedness that could be reasonably incurred in connection with a transaction given current market conditions. Brentwood Capital calculated exit values for Psychiatric Solutions by applying multiples of EBITDA in fiscal year 2006 of 5.0x to 7.0x. Brentwood Capital projected an IRR to mezzanine holders of between 19% and 21% over the five-year period and to equity investors of between 25% and 35% over the five-year period. Based upon its experience in leveraged transactions, Brentwood Capital noted that these return levels are generally consistent with those required in such transactions given current market conditions. Brentwood Capital also noted that upon completion of such a transaction, Psychiatric Solutions' total indebtedness to pro forma 2001 EBITDA ratio would be approximately 4.5x. Brentwood Capital's analysis of a 6.0x hypothetical leveraged buyout yielded an implied equity value per share range of $0.84 to $1.18 (based on Psychiatric Solutions' fully diluted shares outstanding prior to the merger). ACCRETION/DILUTION ANALYSIS. Based on the financial projections provided by Psychiatric Solutions' and PMR, Brentwood Capital analyzed the pro forma impact of the transaction on the projected earnings per share of the combined 112 company for 2002 and 2003. Brentwood Capital prepared this analysis using the terms and exchange ratios agreed upon in the merger agreement. Assuming no synergies, Brentwood Capital noted that by using this exchange ratio, the combined company's pro forma earnings per share would be slightly dilutive in calendar year 2002 and accretive in calendar year 2003. Brentwood Capital also analyzed the impact of the merger on the combined company's balance sheet and noted that the merger would, among other effects, increase Psychiatric Solutions' cash balance by approximately $5.05 million, thereby improving Psychiatric Solutions' balance sheet from a financial leverage perspective. The actual impact of the merger on Psychiatric Solutions' balance sheet and income statement will depend upon a number of factors including: (i) the actual amount of expenses associated with the merger, (ii) the amount of synergies, if any, realized with the merger, (iii) the actual use of the $5.05 million excess cash balance towards the execution of Psychiatric Solutions' business strategy and (iv) the improved terms and availability, if any, of additional capital related to an improved balance sheet. TRANSACTION CONSIDERATION ANALYSIS. As part of its engagement with Psychiatric Solutions to provide a written opinion with respect to the fairness from a financial point of view, Brentwood Capital reviewed and analyzed the consideration to be received by the holders of Psychiatric Solutions' common stock relative to the consideration to be received by the holders of Psychiatric Solutions' Series A preferred stock and Psychiatric Solutions' Series B preferred stock. The distribution of PMR common stock among Psychiatric Solutions' stockholders was derived by applying the formulations outlined in the Series A preferred stock, Series B preferred stock, warrants to purchase Series B preferred stock and common stock stockholder agreements. Psychiatric Solutions' preferred stock issues are currently structured as participating preferred securities. As a result, holders of the Series A preferred stock, Series B preferred stock and warrants to purchase Series B preferred stock are entitled to receive a liquidation preference equal to their respective investments in Psychiatric Solutions' stock before dividing the remaining shares among all preferred and common stockholders on a pro rata basis. Management of Psychiatric Solutions derived the value ascribed to each share of PMR by applying a multiple of pro forma 2002 earnings per share of the combined company. Brentwood Capital noted that the multiple applied to the pro forma earnings per share was discounted from those of publicly traded comparable companies to adjust for differences in size and trading liquidity. The combination of shares allocated to holders of Psychiatric Solutions' capital stock is a result of (i) liquidation preferences and (ii) pro rata ownership determined in the final distribution of PMR stock among Psychiatric Solutions' stockholders. OTHER ANALYSES. Brentwood Capital conducted such other analyses as it deemed necessary, including: (i) performing a relative contribution analysis examining each of PMR's and Psychiatric Solutions' projected results; (ii) reviewing the relative post-merger ownership; and (iii) reviewing the stock price performance of PMR and other comparable publicly traded companies. BRENTWOOD CAPITAL FEE. Psychiatric Solutions retained Brentwood Capital to act as its exclusive financial advisor because Brentwood Capital's investment bankers have substantial experience in transactions similar to the contemplated merger and because its bankers are familiar with Psychiatric Solutions. Brentwood Capital, as part of its investment banking services, engages in the valuation of businesses and securities in connection with mergers and acquisitions, leveraged buyouts, private placements, and valuations for estate, corporate, and other purposes. In addition, Brentwood Capital is currently providing investment banking and other financial advisory services to Psychiatric Solutions and may continue to do so and may receive fees for the rendering of such services. Mr. Edward Wissing, a member of Psychiatric Solutions' board of directors, occasionally provides advisory and consulting services to Brentwood Capital. 113 In February 2002, Psychiatric Solutions retained Brentwood Capital to act as its financial advisor with respect to a potential private placement of subordinated debt securities. Psychiatric Solutions agreed to pay Brentwood Capital a monthly advisory fee for these services, until the consummation of the private placement or the termination of the Brentwood Capital engagement letter, as well as a fee equal to 2.5% of the total principal amount of the debt securities, less any advisory fees paid. In April 2002, Psychiatric Solutions retained Brentwood Capital to act as its financial advisor with respect to participating in and supervising the documentation in connection with the proposed merger. Under this agreement, Psychiatric Solutions agreed to pay Brentwood Capital an advisory fee of $35,000 for these services, payable upon the execution of the merger agreement. In addition, in April 2002, Psychiatric Solutions retained Brentwood Capital, in a separate letter agreement, to prepare and render a written opinion for the board of directors of Psychiatric Solutions with respect to the fairness, from a financial point of view, of (i) the aggregate consideration to be received by the holders of Psychiatric Solutions' capital stock in connection with the proposed transaction and (ii) the consideration to be received by the holders of Psychiatric Solutions' common stock relative to the consideration to be received by the holders of Series A and Series B Preferred Stock of Psychiatric Solutions in connection with the proposed transaction. Under this agreement, the Psychiatric Solutions' board of directors has agreed to pay Brentwood Capital a fee of $35,000 for these services on the date of the delivery of Brentwood Capital's opinion, and agreed to pay an additional advisory fee of $25,000 upon the consummation of the contemplated merger. Psychiatric Solutions also has agreed to indemnify Brentwood Capital and its affiliates, and their respective directors, officers, agents, and employees against certain losses, claims, damages or liabilities relating to or arising out of the proposed transaction, including liabilities under federal securities laws. ACCOUNTING TREATMENT The combined company intends to account for the merger as a purchase under United States generally accepted accounting principles. After the merger, the results of operations of PMR will be included in the consolidated financial statements of Psychiatric Solutions. The purchase price will be allocated based on the fair values of the assets acquired and the liabilities assumed. Pursuant to Statements of Financial Accounting Standards No. 141, "Business Combinations" and No. 142, "Goodwill and Other Intangible Assets," goodwill will no longer be subject to amortization over its estimated useful life. Rather, goodwill will be subject to at least annual assessment for impairment based on a fair value test. Identified intangible assets with finite lives will be amortized over those lives. A final determination of the intangible asset values and required purchase accounting adjustments, including the allocation of the purchase price of the assets acquired and liabilities assumed based on their respective fair values, has not been made. Psychiatric Solutions will determine the fair value of assets and liabilities and will make appropriate business combination accounting adjustments. However, for purposes of disclosing unaudited pro forma information in this joint proxy statement/prospectus, Psychiatric Solutions has made a preliminary determination of the purchase price allocation, based upon current estimates and assumptions, which is subject to revision upon consummation of the merger. MATERIAL U.S. FEDERAL INCOME TAX CONSEQUENCES The following sets forth a summary of the material U.S. federal income tax consequences that are expected to result from the merger. This summary does not deal with all aspects of federal income taxation that may affect particular Psychiatric Solutions stockholders in light of their individual circumstances and does not consider the effect of any applicable state, local or foreign tax laws. Further, this summary only applies to Psychiatric Solutions stockholders who hold shares of Psychiatric Solutions common stock as capital assets and does not deal with special classes of stockholders, such as: - insurance companies; - tax-exempt organizations; - financial institutions; 114 - broker-dealers; - foreign persons or entities; or - persons who acquired shares of Psychiatric Solutions common stock upon the exercise of employee options or otherwise as compensation. Accordingly, Psychiatric Solutions stockholders are urged to seek tax advice from their own tax advisors as to their particular circumstances. This summary is based upon current law. Future legislative, judicial or administrative changes or interpretations could alter or modify the following statements and conclusions, and any of these changes or interpretations could be retroactive and could affect the tax consequences to PMR, Psychiatric Solutions or the stockholders of PMR or Psychiatric Solutions. TAX OPINION REGARDING THE MERGER. Completion of the merger is conditioned upon the receipt by Psychiatric Solutions of an opinion of independent accountants in form and substance satisfactory to Psychiatric Solutions. This opinion, dated the effective time of the merger, will be based on the facts, representations and assumptions set forth in the opinion, and is expected to state that: - the merger will constitute a tax-free reorganization within the meaning of Section 368(a) of the Internal Revenue Code; - PMR and Psychiatric Solutions are each a "party to a reorganization" within the meaning of Section 368(b) of the Internal Revenue Code; and - no gain or loss will be recognized by PMR, Psychiatric Solutions or Psychiatric Solutions stockholders (except to the extent of any cash received) as a result of the merger. Neither PMR nor Psychiatric Solutions will seek a ruling from the IRS concerning the federal income tax consequences of the merger. The opinion of Psychiatric Solutions' independent accountants is not binding on the IRS or the courts. In rendering its opinion, Psychiatric Solutions' independent accountants will assume that the merger will be completed as contemplated by this document and will receive customary representations of facts from PMR and Psychiatric Solutions upon which they will rely. TREATMENT OF PMR AND PSYCHIATRIC SOLUTIONS. As a result of the merger qualifying as a tax-free reorganization for federal income tax purposes, neither PMR nor Psychiatric Solutions will recognize any gain or loss with respect to the merger. TREATMENT OF HOLDERS OF PSYCHIATRIC SOLUTIONS COMMON STOCK. Except for the federal income tax consequences described below under "-- Cash in Lieu of Fractional Shares" and "-- Treatment of Dissenting Psychiatric Solutions Stockholders", a Psychiatric Solutions stockholder who, under the merger, exchanges Psychiatric Solutions capital stock for PMR common stock generally will not recognize any gain or loss upon the exchange. A Psychiatric Solutions stockholder's aggregate tax basis in PMR common stock received in the merger will equal the holder's aggregate tax basis in Psychiatric Solutions common stock surrendered in the exchange, reduced by any tax basis allocable to fractional shares exchanged for cash. The holding period of the shares of PMR common stock received by a Psychiatric Solutions stockholder in the merger will include the holding period of the Psychiatric Solutions common stock surrendered in the exchange. CASH IN LIEU OF FRACTIONAL SHARES. We will not issue any fractional shares of PMR common stock in the merger. A Psychiatric Solutions stockholder who receives cash instead of fractional shares of PMR common stock will be treated as having received fractional shares in the merger and then as having received cash for these fractional shares in a redemption by PMR. Any gain or loss attributable to these fractional shares generally will be capital gain or loss. The amount of this gain or loss will equal the difference between the holder's tax basis of Psychiatric Solutions common stock surrendered in the merger that is allocated to fractional shares and the cash received instead of fractional shares. Any capital gain or loss will be treated as long-term capital gain or loss if a Psychiatric Solutions stockholder has held the Psychiatric Solutions common stock for more than one year at the effective time. Capital gain on assets 115 held for more than one year by an individual is generally subject to federal income tax at a maximum 20% capital gains rate. TREATMENT OF DISSENTING PSYCHIATRIC SOLUTIONS STOCKHOLDERS. A dissenting Psychiatric Solutions stockholder who receives cash for the fair value of shares in connection with the exercise of dissenters' appraisal rights may be treated as having received the payment in redemption of shares and recognize capital gain or loss equal to the difference between the amount of cash received and such stockholder's basis in the shares (except in respect of any amount constituting interest, which should be treated as ordinary income). A redemption of that type would be subject to the conditions and limitations of Section 302 of the Internal Revenue Code. If the dissenting Psychiatric Solutions stockholder owns, either actually or constructively under the provisions of Section 318 of the Internal Revenue Code, any PMR shares after the effective date of the merger, the payment made to the dissenting stockholder could be treated as a dividend and recognized as ordinary income. In general, under Section 318 of the Internal Revenue Code, a stockholder may be considered to own stock that is owned, and in some cases constructively owned, by certain related individuals or entities, as well as stock that the stockholder, or related individuals or entities, has the right to acquire by exercising an option or converting a convertible security. Each Psychiatric Solutions stockholder who contemplates exercising dissenters' appraisal rights should consult his or her own tax advisor as to the taxation of any gain or loss and the possibility that any payment to the stockholder will be treated as a dividend. This discussion is intended only to provide you with a general summary, and it is not intended to be a complete analysis or description of all potential United States federal income tax consequences or any other consequences of the merger. In addition, this discussion does not address tax consequences that may vary with, or are contingent on, your individual circumstances. Moreover, this discussion does not address any non-income tax, state or local tax consequences of the merger. Accordingly, we strongly urge you to consult with your tax advisor to determine the particular United States federal, state, local or foreign income or other tax consequences to you of the merger. BACKUP WITHHOLDING. Unless an exemption applies under the applicable law and regulations, the exchange agent may be required to withhold 31% of any cash payments to a Psychiatric Solutions stockholder in the merger unless the stockholder provides the appropriate form. Unless an applicable exemption exists and is proved in a manner satisfactory to the exchange agent, a stockholder should complete and sign the Substitute Form W-9 enclosed with the letter of transmittal sent by the exchange agent. This completed form provides the information, including the stockholder's taxpayer identification number, and certification necessary to avoid backup withholding. The foregoing summary does not address the particular facts and circumstances of any particular holder of Psychiatric Solutions common stock. In addition, the foregoing summary does not address any non-income tax or any foreign, state or local tax consequences of the merger nor does it address the tax consequences of any transactions other than the merger. Psychiatric Solutions stockholders are urged to seek tax advice to determine their particular U.S. federal, state, local or foreign income or other tax consequences. TREATMENT OF THE REVERSE STOCK SPLIT. The reverse stock split should not be taxable to stockholders of PMR or Psychiatric Solutions. Consequently, the holding period of shares of post-reverse split common stock should include the holding period for the shares of common stock exchanged, if those shares are held as a capital asset at the effectiveness of the charter amendment. In addition, the aggregate basis of the shares of post-reverse split common stock should be the same as the aggregate basis of the shares of common stock exchanged. PMR stockholders will not be entitled to receive cash for fractional shares resulting from the reverse stock split. Rather, fractional shares that would otherwise result from the reverse stock split will be rounded down to the nearest whole share. REGULATORY MATTERS; LEGAL MATTERS Neither PMR nor Psychiatric Solutions is aware of any material governmental or regulatory approval required for completion of the merger, other than the effectiveness of the registration statement of which 116 this joint proxy statement/prospectus is a part, approval for trading of the PMR common stock issuable to the Psychiatric Solutions stockholders on either the Nasdaq National Market, the Nasdaq SmallCap Market or the American Stock Exchange, and compliance with applicable corporate law of Delaware. NASDAQ MARKET QUOTATION It is a condition of the merger that the shares of PMR common stock issuable in the merger be approved for trading on either the Nasdaq National Market or Nasdaq SmallCap Market, subject to official notice of issuance. APPRAISAL RIGHTS PMR Under the laws of the state of Delaware, the state of incorporation of PMR, the common stockholders of PMR are not entitled to appraisal rights with respect to the merger. PSYCHIATRIC SOLUTIONS If the merger is consummated, a holder of record of Psychiatric Solutions capital stock on the date of making a demand for appraisal, as described below, who: - continues to hold those shares through the time of the merger; - strictly complies with the procedures set forth under Section 262 of the Delaware General Corporation Law ("Section 262"); and - has not voted in favor of the merger, will be entitled to have those shares appraised by the Delaware Court of Chancery under Section 262 and to receive payment for the "fair value" of these shares in lieu of the consideration provided for in the merger agreement. This joint proxy statement/prospectus is being sent to all holders of record of Psychiatric Solutions capital stock on the record date for the Psychiatric Solutions special meeting and constitutes notice of the appraisal rights available to those holders under Section 262. The statutory right of appraisal granted by Section 262 requires strict compliance with the procedures set forth in Section 262. Failure to follow any of such procedures may result in a termination or waiver of appraisal rights under Section 262. The following is a summary of the principal provisions of Section 262 and is not a complete statement of Section 262. The summary is qualified in its entirety by reference to Section 262 which is incorporated herein by reference, together with any amendments to the statute that may be adopted after the date of this joint proxy statement/prospectus. A copy of Section 262 is attached as Annex E to this joint proxy statement/prospectus. A holder of Psychiatric Solutions capital stock electing to exercise appraisal rights under Section 262 must deliver a written demand for appraisal of his or her shares prior to the vote on the merger. The written demand must identify the holder of record and state the holder's intention to demand appraisal of the shares. All demands should be delivered to Psychiatric Solutions, Inc., 113 Seaboard Lane, Suite C-100, Franklin, Tennessee 37067, Attention: Secretary, telephone: (615) 312-5700. Only a holder of shares of Psychiatric Solutions capital stock on the date of making a written demand for appraisal who continuously holds those shares through the time of the merger is entitled to seek appraisal. Demand for appraisal must be executed by or for the holder of record, fully and correctly, as that holder's name appears on the holder's stock certificates representing shares of Psychiatric Solutions capital stock. If Psychiatric Solutions capital stock is owned of record in a fiduciary capacity, such as by a trustee, guardian or custodian, the demand should be made in that capacity, and if Psychiatric Solutions capital stock is owned of record by more than one person, as in a joint tenancy or tenancy in common, the demand must be made by or for all owners of record. An authorized agent, including one or more joint owners, may execute the demand for appraisal for a holder of record; that agent, however, must identify 117 the record owner or owners and expressly disclose in the demand that such agent is acting as agent for the record owner or owners of the shares. A record holder such as a broker who holds shares of Psychiatric Solutions capital stock as a nominee for beneficial owners, some of whom desire to demand appraisal, must exercise appraisal rights on behalf of those beneficial owners with respect to the shares of Psychiatric Solutions capital stock held for those beneficial owners. In that case, the written demand for appraisal should set forth the number of shares of Psychiatric Solutions capital stock covered by it. Unless a demand for appraisal specifies a number of shares, the demand will be presumed to cover all shares of Psychiatric Solutions capital stock held in the name of the record owner. Beneficial owners of Psychiatric Solutions capital stock who are not record holders of such stock and who intend to exercise appraisal rights should instruct the record holder to comply with the statutory requirements with respect to the exercise of appraisal rights before the date of the Psychiatric Solutions special meeting. Within ten days after the time of the merger, the surviving corporation is required to send notice of the effectiveness of the merger to each holder who prior to the time of the merger has fully complied with the requirements of Section 262. Within 120 days after the time of the merger, the surviving corporation or any holder who has complied with the requirements of Section 262 may file a petition in the Delaware Court of Chancery demanding a determination of the fair value of the shares of Psychiatric Solutions capital stock held by all holders seeking appraisal. Each of these holders must serve a copy of the petition on the surviving corporation. If no petition is filed by either the surviving corporation or any such holder within the 120-day period, the rights of all holders to appraisal will cease. Holders seeking to exercise appraisal rights should not assume that the surviving corporation will file a petition with respect to the appraisal of the fair value of their shares or that the surviving corporation will initiate any negotiations with respect to the fair value of those shares. The surviving corporation is under no obligation to take any action in this regard. Accordingly, holders who wish to seek appraisal of their shares should initiate all necessary action with respect to the perfection of their appraisal rights within the time periods and in the manner prescribed in Section 262. Failure to file the petition on a timely basis will cause the holder's appraisal rights to cease. Any holder who has complied with subsections (a) and (d) of Section 262 is entitled, upon written request, to receive from the surviving corporation a statement setting forth the aggregate number of shares of Psychiatric Solutions capital stock not voted in favor of the merger with respect to which demands for appraisal have been received by Psychiatric Solutions and the number of holders of those shares. The surviving corporation must mail the statement within ten days after the written request has been received by Psychiatric Solutions or within ten days after expiration of the time for delivery of demands for appraisal under subsection (d) of Section 262, whichever is later. If a petition for an appraisal is filed in a timely manner, at the hearing on the petition, the Delaware Court of Chancery will determine which holders are entitled to appraisal rights and will appraise the shares of Psychiatric Solutions capital stock owned by those holders, determining the fair value of those shares, exclusive of any element of value arising from the accomplishment or expectation of the merger, together with a fair rate of interest, to be paid, if any, upon the amount determined to be the fair value. Holders considering seeking appraisal should consider that the fair value of their shares determined under Section 262 could be more than, the same as, or less than, the value of the consideration provided for in the merger agreement without the exercise of appraisal rights. The cost of the appraisal proceeding may be determined by the Court of Chancery and assessed against the parties as the Court deems equitable in the circumstances. Upon application of a holder seeking appraisal, the Court may order that all or a portion of the expenses incurred by any such holder in connection with the appraisal proceeding (including, without limitation, reasonable attorney's fees and the fees and expenses of experts) be charged pro rata against the value of all shares of Psychiatric Solutions capital stock entitled to appraisal. In the absence of such a determination or assessment, each party bears its own expenses. 118 Any holder that has demanded appraisal in compliance with Section 262 will not, after the time of the merger, be entitled to vote such stock for any purpose or receive payment of dividends or other distributions, if any, on the Psychiatric Solutions capital stock, except for dividends or distributions, if any, payable to holders of record at a date prior to the merger. A holder may withdraw a demand for appraisal and accept the PMR common stock at any time within 60 days after the time of the merger, or thereafter may withdraw such a demand with the written approval of the surviving corporation. If an appraisal proceeding is properly instituted, such proceeding may not be dismissed as to any holder without the approval of the Delaware Court of Chancery, and any such approval may be conditioned upon such terms as the Court of Chancery deems just. If, after the merger, a holder of Psychiatric Solutions capital stock who had demanded appraisal for the holder's shares fails to perfect, or loses the right to appraisal, those shares will be treated under the merger agreement as if they had been converted as of the time of the merger into PMR common stock. Any Psychiatric Solutions stockholder who wishes to exercise appraisal rights or wishes to preserve the right to do so should review carefully Annex E to this joint proxy statement/prospectus because failure to comply with the procedures of Section 262 in a proper and timely manner will result in the loss of appraisal rights. Because of the complexity of the procedures for exercising the right to seek appraisal of the Psychiatric Solutions common stock, Psychiatric Solutions recommends that Psychiatric Solutions stockholders who consider exercising these rights seek the advice of counsel. FEDERAL SECURITIES LAWS CONSEQUENCES; RESALE RESTRICTIONS This document does not cover resales of the PMR common stock to be received by the stockholders of Psychiatric Solutions upon completion of the merger, and no person is authorized to make any use of this document in connection with these resales. All shares of PMR common stock received by Psychiatric Solutions stockholders in the merger will be freely transferable, except that shares of PMR common stock received by persons who are deemed to be "affiliates" as defined under the Securities Act of 1933 of Psychiatric Solutions may be resold by them only in transactions permitted by the resale provisions of Rule 145 (or Rule 144 in the case of persons who become affiliates of PMR) or as otherwise permitted under the Securities Act of 1933. Persons who may be deemed to be affiliates of Psychiatric Solutions or PMR generally include individuals or entities that control, are controlled by, or are under common control with, these persons and may include officers and directors of Psychiatric Solutions or PMR as well as significant stockholders. The merger agreement requires Psychiatric Solutions to use its best efforts to cause each of its affiliates to execute a written agreement to the effect that the affiliate will not sell, transfer or otherwise dispose of any of the shares of PMR common stock issued to them in the merger in violation of the Securities Act of 1933 or the rules and regulations promulgated by the SEC. INTERESTS OF CERTAIN DIRECTORS, OFFICERS AND STOCKHOLDERS IN THE MERGER PMR and Psychiatric Solutions stockholders should note that some of the directors, executive officers and stockholders of PMR and Psychiatric Solutions have interests in the merger as employees, directors and preferred stockholders that are different from, or in addition to, the PMR and most Psychiatric Solutions stockholders, as described below. DIRECTOR AND OFFICER POSITIONS WITH COMBINED COMPANY PMR has designated two individuals who were directors of PMR on the date of the merger agreement to become directors of the combined company. These individuals are Mark P. Clein and Charles C. McGettigan. Additionally, Psychiatric Solutions has designated five individuals, four of whom were directors of Psychiatric Solutions on the date of the merger agreement, to become directors of the combined company. Psychiatric Solutions directors who will become directors of the combined entity are 119 Joey A. Jacobs, who will become the Chairman of the board of directors, Edward K. Wissing, David S. Heer, Christopher Grant, Jr. and Joseph P. Donlan. The directors of the combined company will be entitled to compensation for their services. Psychiatric Solutions will also cause the senior officers of the combined company to consist of: - Joey A. Jacobs as Chairman, Chief Executive Officer and President; - Steven T. Davidson as Chief Development Officer and Secretary; - Jack R. Salberg as Chief Operating Officer; and - Jack Polson as Controller. ACCELERATION OF PMR OPTIONS Pursuant to the provisions of the PMR 1997 Equity Incentive Plan, as amended, in the event of a change in control of PMR, all of the options granted pursuant to such plan will become fully vested and immediately exercisable unless otherwise provided in the option agreement related to such options. For purposes of the PMR 1997 Equity Incentive Plan, the merger will constitute a change in control. As of May 31, 2002, Mark P. Clein, Susan D. Erskine, Fred D. Furman and Reggie Roman, each an officer or director of PMR, held 63,333, 66,666, 33,333 and 1,346 unvested options to purchase shares of PMR common stock, respectively, subject to the PMR 1997 Equity Incentive Plan. Pursuant to the provisions of the PMR Outside Directors' Non-Qualified Stock Option Plan of 1992, in the event of a change in control, all of the options granted pursuant to such plan will become fully vested and immediately exercisable. For purposes of the PMR Outside Directors' Non-Qualified Stock Option Plan of 1992, the merger will constitute a change in control. As of May 31, 2002, Charles C. McGettigan, Eugene Hill, Richard Niglio and Satish Tyagi, each a director of PMR, held 7,000, 7,000, 7,000 and 5,833 unvested options to purchase shares of PMR common stock, respectively, subject to the PMR Outside Directors' Non-Qualified Stock Option Plan of 1992. EXTENSION OF OPTION EXERCISE PERIODS FOR CERTAIN PMR OFFICERS In connection with the closing of the merger, PMR's board of directors has extended or will extend the option exercise period for all options to purchase PMR common stock held by each of Mark P. Clein, Fred D. Furman, Susan D. Erskine, Reggie Roman, and Allen Tepper to a period that is three years from the date of such individual's termination of employment with PMR. SEVERANCE ARRANGEMENTS FOR CERTAIN PMR OFFICERS MARK P. CLEIN. In connection with the merger, Mark P. Clein, the Chief Executive Officer and member of the board of directors of PMR, entered into a consulting agreement with PMR to be effective as of May 10, 2002. Pursuant to the consulting agreement, Mr. Clein terminated his employment with PMR effective May 10, 2002 and waived any and all rights to cash severance payments pursuant to his employment agreement. Pursuant to the consulting agreement Mr. Clein also will provide management and strategic consulting to PMR until the closing of the merger for two lump-sum cash payments of $120,000 each, one of which was paid upon the execution of the consulting agreement and the other of which is payable upon the earlier of the closing of the merger or May 10, 2003. Finally, the consulting agreement provides for the extension of the exercise period of all PMR stock options held by Mr. Clein to a date that is 90 days following the earlier of the closing of the merger or May 10, 2003. FRED D. FURMAN. In connection with the merger, PMR and Fred D. Furman, PMR's President and General Counsel, entered into an amendment to his employment agreement effective as of May 1, 2002. Pursuant to the amendment, if Mr. Furman's employment with PMR is terminated by PMR or Mr. Furman in contemplation of, upon or within 180 days following the merger, then Mr. Furman is entitled to a lump-sum cash severance payment by PMR on the date of such termination equal to three times Mr. Furman's annual base salary plus three times his average annual bonus. 120 SUSAN D. ERSKINE. In connection with the merger, PMR and Susan D. Erskine, PMR's Executive Vice President -- Development and Secretary, entered into an amendment to her employment agreement effective as of May 1, 2002. Pursuant to the amendment, if Ms. Erskine's employment with PMR is terminated by PMR or Ms. Erskine in contemplation of, upon or within 180 days following the merger, then Ms. Erskine is entitled to a lump-sum cash severance payment by PMR on the date of such termination equal to three times Ms. Erskine's annual base salary plus three times her average annual bonus. PAYMENT OF PREFERENTIAL AMOUNTS TO PSYCHIATRIC SOLUTIONS PREFERRED STOCKHOLDERS In the merger, the Series A preferred stock and Series B preferred stock of Psychiatric Solutions will be treated as if converted into Psychiatric Solutions common stock immediately before the merger. As a consequence, holders of Psychiatric Solutions preferred stock will receive additional shares of PMR common stock, relative to Psychiatric Solutions common stockholders, in fulfillment of their preferential rights under Psychiatric Solutions' second amended and restated certificate of incorporation, as amended. To accomplish this preferential payment, the exchange ratio in the merger for Psychiatric Solutions' Series A preferred stockholders and Series B preferred stockholders is 0.246951 and 0.312864, respectively, compared to an exchange ratio of 0.115125 for Psychiatric Solutions' common stockholders. Certain of Psychiatric Solutions' directors are representatives of holders of the Series A preferred stock and Series B preferred stock of Psychiatric Solutions. AMENDMENTS TO PROMISSORY NOTES OF CERTAIN PMR OFFICERS AND DIRECTORS The outstanding promissory notes of each of Mark P. Clein, a director of PMR, Fred D. Furman, the President and General Counsel of PMR, and Susan D. Erskine, the Executive Vice President -- Development, Secretary and a director of PMR, payable to PMR were amended and restated on May 1, 2002, to: - permit the payment of all outstanding principal and interest thereon to be paid through the delivery of shares of PMR common stock and provide that each share delivered for such purpose would be valued at the higher of: - $7.92 in the case of Mr. Clein, $8.82 in the case of Mr. Furman and $6.00 in the case of Ms. Erskine, and - the average closing price of PMR common stock for the five trading days prior to any such delivery; and - eliminate the provision in each note which required any dividends received with respect to shares being purchased with the proceeds of such note to be immediately applied toward the payment of amounts outstanding under such note. CERTAIN FEES TO BE PAID TO AN ENTITY OWNED AND CONTROLLED BY PMR DIRECTOR PMR entered into an agreement with McGettigan, Wick & Co., Inc. on February 8, 2001 to provide financial services to the management and board of directors of PMR in connection with potential strategic alternatives for PMR. PMR paid McGettigan, Wick & Co., Inc. a $30,000 retainer fee and has agreed to reimburse all reasonable out-of-pocket expenses incurred by McGettigan, Wick & Co. In addition, upon the closing of the merger, PMR has agreed to pay McGettigan, Wick & Co., Inc. an advisory fee equal to $270,000 in cash. Charles C. McGettigan, a director and significant stockholder of PMR, and Myron A. Wick III, a significant stockholder of PMR, are each a founder, owner and managing director of McGettigan, Wick & Co., Inc. INDEMNIFICATION OF CERTAIN PERSONS PMR has agreed to indemnify Psychiatric Solutions' current officers and directors pursuant to terms no less favorable than those contained in Psychiatric Solutions' certificate of incorporation and bylaws. 121 PMR has agreed not to amend, repeal or otherwise modify these provisions for a period of six years from the effective time of the merger in any manner that would adversely affect the rights of Psychiatric Solutions' present directors and officers. PMR has agreed that, for six years after completion of the merger, it will maintain directors and officers liability insurance for PMR's current directors and officers comparable to the insurance provided to such persons immediately prior to the effective time of the merger, subject to certain limitations. PMR has also agreed that, for six years after completion of the merger, it will maintain directors and officers liability insurance for Psychiatric Solutions' current directors and officers comparable to the insurance provided to such persons immediately prior to the effective time of the merger, subject to certain limitations. PSYCHIATRIC SOLUTIONS AFFILIATE LETTERS Under the terms of the merger agreement, Psychiatric Solutions has agreed to use its best efforts to cause each person who is an affiliate of Psychiatric Solutions to execute and deliver to PMR and Psychiatric Solutions an affiliate letter, whereby each affiliate of Psychiatric Solutions will, among other things, agree that certificates representing the shares of PMR which he will receive in the merger will contain legends. The officers and directors of Psychiatric Solutions will be deemed affiliates of Psychiatric Solutions. ALLEN TEPPER EMPLOYMENT/CONSULTING AGREEMENT In connection with the merger, Allen Tepper, currently the Chairman of the Board of Directors and Chief Executive Officer of PMR, will enter into an employment or consulting agreement with the combined company pursuant to which he will receive monthly compensation of $5,000 and may be eligible for health benefits. The employment agreement would be for an initial term of 12 months and would include a non-competition provision restricting Mr. Tepper's ability to compete with the Tennessee Mental Health Cooperative for a period of one year following the effective time of the merger. CONTINGENT VALUE RIGHTS REPRESENTATIVE Fred D. Furman, the President and General Counsel of PMR, will serve as the representative of the holders of contingent value rights pursuant to the contingent value rights agreement. As the representative, Mr. Furman will be entitled to certain compensation for services rendered. See "Contingent Value Rights Agreement -- Legacy Receivables Representative" on page 137. THE MERGER AGREEMENT The following describes the material terms of the merger agreement, as amended. The full text of the merger agreement, as amended, is attached as Annex A to this joint proxy statement/prospectus. We encourage you to read the merger agreement in its entirety before you decide how to vote. EFFECTIVE TIME OF THE MERGER EFFECTIVE TIME. The merger will be effective upon the filing of a certificate of merger with the Secretary of State of the State of Delaware. This filing will be made simultaneously with, or as promptly as practicable following, the closing of the transactions contemplated by the merger agreement. See "-- Conditions to the Merger" on page 125. Share certificates should not be surrendered for exchange by stockholders of Psychiatric Solutions prior to approval of the merger and the receipt of a transmittal form. 122 At the effective time, upon completion of the merger: - each outstanding share of Psychiatric Solutions common stock will be converted into the right to receive 0.115125 shares of common stock of PMR; - each outstanding share of Psychiatric Solutions Series A preferred stock will be converted into the right to receive 0.246951 shares of common stock of PMR; and - each outstanding share of Psychiatric Solutions Series B preferred stock will be converted into the right to receive 0.312864 shares of common stock of PMR. The above exchange ratios give effect to the reverse stock split. The merger agreement also provides that a warrant to purchase 30,000 shares of Series B preferred stock of Psychiatric Solutions, warrants to purchase an aggregate of 1,682,519 shares of common stock of Psychiatric Solutions, options to acquire 249,446 shares of common stock of Psychiatric Solutions, and promissory notes in an aggregate principal amount of $3.6 million convertible into Series B preferred stock of Psychiatric Solutions, following the effective time of the merger, based on the exchange ratio specified in the merger agreement with respect to common stock or Series B preferred stock, will be exercisable or convertible, as the case may be, into shares of PMR common stock except that the warrants to purchase 1,502,140 shares of common stock of Psychiatric Solutions issued to 1818 Fund contain a provision which provides that, upon the completion of the merger, such warrants will purchase, in the aggregate, approximately 372,412 shares of common stock of the combined company. Psychiatric Solutions will be required to issue additional warrants of up to 1,502,140 shares of common stock of Psychiatric Solutions from time to time upon the issuance of an additional $10 million of senior subordinated notes that 1818 Fund is obligated to purchase from Psychiatric Solutions under certain circumstances. These warrants would also provide for an adjustment to allow the warrants to become exercisable into shares of common stock of the combined company after the merger on the same basis as the initial warrants. After giving effect to the exercise of all of these options and warrants, including the full amount of the additional warrants that may be issued to 1818 Fund, PMR and Psychiatric Solutions stockholders would own, respectively, approximately 28% and 72% of the common stock of PMR upon completion of the merger. No fractional shares of PMR common stock will be issued to any Psychiatric Solutions stockholder. In lieu of fractional shares, each holder of Psychiatric Solutions capital stock who would otherwise have been entitled to receive a fraction of a share will receive cash (rounded to the nearest whole cent) without interest in an amount equal to the fractional part of a share multiplied by the closing price for a share of PMR common stock on the Nasdaq National Market on the trading day on which the effective time occurs. No dividend or distribution with respect to PMR common stock will be payable with respect to any fractional share and fractional share interests will not entitle their owners to any rights of a stockholder of the combined company. Promptly after the effective time, transmittal forms and exchange instructions will be mailed to each holder of record of Psychiatric Solutions common stock to be used to exchange certificates formerly evidencing shares of Psychiatric Solutions capital stock for certificates of PMR common stock. After receipt and upon execution of the transmittal forms, each holder of certificates formerly representing Psychiatric Solutions capital stock will be able to surrender the certificates to the exchange agent, and each holder will receive certificates evidencing the number of whole shares of PMR common stock to which the holder is entitled, any cash which may be payable in lieu of a fractional share of PMR common stock and any dividends or other distributions with respect to PMR common stock with a record date after the effective time. Psychiatric Solutions stockholders should not send in their certificates until they receive a transmittal form. After the effective time, each certificate formerly representing shares of Psychiatric Solutions capital stock, until so exchanged, will be deemed, for all purposes, to evidence only the right to receive the number of whole shares of PMR common stock which the holder of the certificates is entitled to receive 123 in the merger, any cash payment in lieu of a fractional share of PMR common stock and any dividend or other distribution with respect to PMR common stock, as described above. The holders of these unexchanged certificates will not be entitled to receive any dividends or other distributions payable by the combined company until the certificates have been exchanged. Subject to applicable laws, following surrender of the certificates, the dividends and distributions, together with any cash payment in lieu of a fractional share of PMR common stock, will be paid without interest. PSYCHIATRIC SOLUTIONS STOCK OPTIONS The merger agreement provides that at the effective time, automatically and without any action on the part of the holder thereof (herein, an "optionholder"), each stock option granted under Psychiatric Solutions' stock option plan will be converted into an option to purchase that number of shares of PMR common stock determined by multiplying the number of shares subject to the Psychiatric Solutions stock option at the effective time by the common stock exchange ratio. In addition, the exercise price of the stock option will automatically be adjusted by dividing the exercise price per share by the common stock exchange ratio; provided, however, that any Psychiatric Solutions stock options which are "incentive stock options" (as defined in Section 422 of the Internal Revenue Code) or which are described in Section 423 of the Internal Revenue Code shall be effected in a manner consistent with the requirements of Section 424(a) of the Internal Revenue Code. If the foregoing calculation results in an exchanged Psychiatric Solutions stock option being exercisable for a fraction of a share of PMR common stock, then the number of shares of PMR common stock subject to such option will be rounded to the nearest whole number of shares. The term, exercisability, vesting schedule, and all other terms and conditions of the Psychiatric Solutions stock options will otherwise be unchanged by these provisions and will operate in accordance with their original terms. All shares of PMR common stock issued upon exercise of the exchanged Psychiatric Solutions stock options will be registered under an effective Form S-8 registration statement (or other comparable form) filed with the SEC. Based on the Psychiatric Solutions stock options outstanding at the record date and assuming none of such Psychiatric Solutions stock options is exercised prior to the effective time, and assuming an exchange ratio of 0.115125, PMR will be required at the effective time to reserve an aggregate of 249,447 shares of PMR common stock for issuance upon exercise of Psychiatric Solutions stock options assumed by PMR pursuant to the merger. This number is in addition to shares already reserved by PMR pursuant to options previously granted by PMR. PSYCHIATRIC SOLUTIONS EMPLOYEE BENEFITS The combined company will continue to honor the employee benefit plans of PMR and Psychiatric Solutions existing at the effective time until a joint committee creates replacement plans for the employees of the combined company that treat similarly situated employees of PMR and Psychiatric Solutions on a substantially equivalent basis. The combined company will provide all current and past employees of PMR, Psychiatric Solutions and their respective subsidiaries with compensation and benefits on terms which are, in the aggregate, substantially comparable to those provided under the respective PMR or Psychiatric Solutions benefit plans prior to the effective time until the replacement plans have been implemented or, if earlier, through the first anniversary of the effective time. Employees of PMR and Psychiatric Solutions will receive full credit for purposes of eligibility, vesting, benefit accrual and eligibility to receive benefits under any employee benefit plans or arrangements established or maintained by the combined company for the employees' service with PMR, Psychiatric Solutions or their subsidiaries prior to the effective time. However, this crediting of service will not duplicate any benefits to employees. 124 CONDITIONS TO THE MERGER CONDITIONS TO EACH PARTY'S OBLIGATIONS TO COMPLETE THE MERGER. The respective obligations of Psychiatric Solutions and PMR to effect the merger are subject to the fulfillment, at or prior to the effective time, of the following conditions, unless waived by the parties: - Effective Registration Statement. The registration statement on Form S-4 filed by PMR will be effective, and no stop order or proceeding shall have been initiated or, to the knowledge of either company, threatened by the SEC to suspend effectiveness of the registration statement. - Stockholder Approval. The merger agreement and the transactions contemplated, including, in the case of the PMR stockholders, the amendment to the PMR charter (i) authorizing a sufficient number of additional shares of PMR common stock to effectuate the merger, (ii) effecting a 1-for-3 reverse stock split, and (iii) changing the name of PMR to "Psychiatric Solutions, Inc.", will have been approved and adopted by the required vote of the stockholders of each company. - No Injunctions or Restraints; Illegality. No temporary restraining order, preliminary or permanent injunction or other order issued by any court of competent jurisdiction or other legal or regulatory restraint or prohibition preventing the consummation of the merger shall be in effect; nor shall any proceeding brought by an administrative agency or commission or other governmental authority or instrumentality, domestic or foreign, seeking any of the foregoing be pending; nor shall there be any action taken, or any statute, rule, regulation or order enacted, entered, enforced or deemed applicable to the merger, which makes the consummation of the merger illegal. - Nasdaq Listing. The shares of PMR common stock issuable in the merger will have been approved for trading on either the Nasdaq National Market or Nasdaq SmallCap Market, subject to official notice of issuance. - Consents and Approvals. All required governmental approvals, waivers or consents will have been obtained unless failure to do so would not have a materially adverse effect after the effective time. ADDITIONAL CONDITIONS TO THE OBLIGATIONS OF PSYCHIATRIC SOLUTIONS. The obligation of Psychiatric Solutions to effect the merger is further subject to the fulfillment, at or prior to the effective time, of the following additional conditions, unless waived by Psychiatric Solutions: - Performance of Agreements, Representations and Warranties. PMR will have performed and complied with all its agreements in the merger agreement in all material respects, and its representations and warranties will be true and correct in all material respects as of the effective time as if made on the effective time, and Psychiatric Solutions will have received an officer's certificate executed on PMR's behalf by an executive officer of PMR to that effect. - Third Party Consents. Psychiatric Solutions will have been furnished with evidence satisfactory to it of all consents and approvals required with respect to certain material contracts of PMR. - Injunctions or Restraints on Conduct of Business. No temporary restraining order, preliminary or permanent injunction or other order issued by any court of competent jurisdiction or other legal or regulatory restraint provision limiting or restricting PMR's conduct or operation of the business of Psychiatric Solutions and its subsidiaries following the merger shall be in effect, nor shall any proceeding brought by an administrative agency or commission or other governmental entity, domestic or foreign, seeking the foregoing be pending. - Legal Opinion. Psychiatric Solutions shall have received a legal opinion from PMR's legal counsel in substantially the form of Exhibit E to the merger agreement. - No Material Adverse Effect. There shall not have occurred any material adverse effect as to PMR, and PMR shall not have received any notice of termination or non-renewal with respect to any contract accounting for 10% or more of PMR's annual revenues. 125 - Resignation of Directors and Officers. All directors and officers of PMR (other than Mark P. Clein and Charles C. McGettigan in their capacity as a director) shall have resigned as directors and officers, as applicable, of PMR effective as of the effective time. - Tax Opinion. Psychiatric Solutions shall have received the written opinion of independent accountants in form and substance reasonably satisfactory to it, and dated on or about the closing date to the effect that: - the merger will constitute a reorganization within the meaning of Section 368(a) of the Internal Revenue Code; - each of PMR and Psychiatric Solutions are parties to the reorganization within the meaning of Section 368(b) of the Internal Revenue Code; and - no gain or loss will be recognized by PMR, Psychiatric Solutions or Psychiatric Solutions stockholders (except to the extent of any cash received) as a result of the merger, and such opinions shall not have been withdrawn. - Certificate of Good Standing. PMR shall have provided Psychiatric Solutions a certificate from the Secretary of State of Delaware (or other state of formation, as applicable), dated within ten days prior to the closing date, as to the good standing of and payment of taxes by PMR and its subsidiaries. - Consent of Senior Lender. Psychiatric Solutions shall have received, in form and substance reasonably satisfactory to Psychiatric Solutions, the consent of Psychiatric Solutions' senior lender with regard to the merger and the transactions contemplated by the merger agreement, which consent shall contain either amendments to covenants in Psychiatric Solutions' credit agreement with such lender or waivers thereof to enable Psychiatric Solutions not to be in default under such covenants at the effective time. - PMR Cash Equivalents. PMR will have on hand at the effective time no less than $5.05 million in cash equivalents, and Psychiatric Solutions shall be reasonably satisfied that payments of all severance resulting from the merger and PMR's transaction costs shall have been made, or provided for, without any effect on such $5.05 million in cash equivalents. - PMR Employee Non-Competition Agreements. Mark P. Clein, Fred D. Furman and Susan D. Erskine, each an employee or consultant to PMR, shall have entered into a non-competition agreement with PMR prior to the effective time of the merger. - Fairness Opinion. Psychiatric Solutions shall have received a written opinion from its financial advisor, Brentwood Capital Advisors, in form and substance reasonably satisfactory to it, that subject to factors and assumptions set forth in such opinion, the consideration and exchange ratio to be paid in the merger is fair from a financial point of view to the holders of Psychiatric Solutions capital stock and, in particular, fair from a financial point of view to holders of Psychiatric Solutions common stock relative to holders of Psychiatric Solutions preferred stock. - Accounts Receivable Credit Balances. PMR shall have settled certain accounts receivable credit balances. - Satisfaction of Certain PMR Contractual Obligations. PMR shall have satisfied, or made financial arrangements for the satisfaction of, certain contractual obligations to third parties described in the merger agreement. - Allen Tepper Non-Compete. Allen Tepper shall have entered into a non-competition agreement with PMR restricting his ability to compete with the Tennessee Mental Health Cooperative for a period of one year following the effective time. 126 ADDITIONAL CONDITIONS TO THE OBLIGATIONS OF PMR. The obligation of PMR to effect the merger is further subject to the fulfillment, at or prior to the effective time, of the following additional conditions, unless waived by PMR: - Performance of Agreements, Representations and Warranties. Psychiatric Solutions will have performed and complied with all its agreements in the merger agreement in all material respects, and its representations and warranties will be true and correct in all material respects as of the effective time as if made on the effective time, and PMR will have received an officer's certificate executed by the president of Psychiatric Solutions to that effect. - Third Party Consents. PMR will have been furnished with evidence satisfactory to it of all consents and approvals required with respect to certain material contracts of Psychiatric Solutions. - Injunctions or Restraints on Conduct of Business. No temporary restraining order, preliminary or permanent injunction or other order issued by any court of competent jurisdiction or other legal or regulatory restraint provision limiting or restricting PMR's conduct or operation of the business of Psychiatric Solutions and its subsidiaries, following the merger shall be in effect, nor shall any proceeding brought by an administrative agency or commission or other governmental entity, domestic or foreign, seeking the foregoing be pending. - Legal Opinion. PMR shall have received a legal opinion from Psychiatric Solutions' legal counsel in substantially the form of Exhibit F to the merger agreement. - No Material Adverse Effect. There shall not have occurred any material adverse effect as to Psychiatric Solutions, and Psychiatric Solutions shall not have received any notice of termination or non-renewal with respect to any contract accounting for 10% or more of Psychiatric Solutions' annual revenues. - Tax Certificates. Psychiatric Solutions shall, prior to the closing date of the merger, provide PMR with: - a properly executed FIRPTA notification letter stating that shares of capital stock of Psychiatric Solutions do not constitute "United States real property interests" under Section 897(c) of the Internal Revenue Code for purposes of satisfying PMR's obligations under Treasury Regulation Section 1.1445-2(c)(3), and - a form of notice to the IRS in accordance with the requirements of Treasury Regulation Section 1.897-2(h)(2), along with written authorization for PMR to deliver such notice form to the IRS on behalf of Psychiatric Solutions upon the closing of the merger. - Distribution of Contingent Value Rights. There shall not exist any legal or regulatory constraint or prohibition that would prevent PMR from making the distribution of contingent value rights to its stockholders pursuant to the contingent value rights agreement described under the heading "Contingent Value Rights Agreement." - Dissenters' Rights. Not more than 10% of the shares of Psychiatric Solutions capital stock outstanding immediately prior to the effective time shall be dissenting shares. - Certificates of Good Standing. Psychiatric Solutions shall have provided PMR a certificate from the Secretary of State of Delaware, dated as of a date within ten days prior to the closing date of the merger, as to Psychiatric Solutions' good standing and payment of all applicable taxes. - Warrants Exercised/Canceled Prior to Closing. Psychiatric Solutions shall have provided evidence of the exercise or cancellation, as applicable, of certain warrants to purchase Psychiatric Solutions capital stock. 127 REPRESENTATIONS AND WARRANTIES OF PMR AND PSYCHIATRIC SOLUTIONS The merger agreement contains various customary representations and warranties of Psychiatric Solutions and PMR relating to, among other things: - proper organization and good standing of Psychiatric Solutions, PMR and their respective subsidiaries; - the capitalization of Psychiatric Solutions and PMR; - the corporate authorization and enforceability of the merger agreement; - the absence of conflicts and consents; - possession of and compliance with permits; - with respect to PMR only, the filing of SEC reports; - the preparation of financial statements; - the absence of material adverse changes or events; - employee benefit matters; - labor controversies; - material contracts; - the absence of any undisclosed liabilities; - litigation; - restrictions on business activities; - title to property; - environmental matters; - intellectual property matters; - taxes; - conflicts of interest and related party transactions; - compliance with laws; - accounts receivable; - customers and suppliers; - third party consents; - regulatory matters; - Medicare/Medicaid participation; - minute books; - the opinion of a financial advisor; - the required stockholder vote for the approval of the merger; - board approval for the merger; - brokers and finders; and - insurance. 128 CONDUCT OF THE BUSINESS OF PMR AND PSYCHIATRIC SOLUTIONS PRIOR TO THE MERGER Pursuant to the merger agreement, Psychiatric Solutions and PMR have agreed that, prior to the effective time or earlier termination of the merger agreement and except to the extent expressly contemplated by the merger agreement or as consented to in writing, they will and will cause each of their subsidiaries: - Conduct Business in Ordinary Course. To conduct their respective businesses in the usual, regular and ordinary course of business and consistent with past practice; - Pay Expenses. To pay their respective debts, taxes and other obligations when due subject to good faith disputes; - Preserve Business. To use all reasonable efforts, in good faith, consistent with past practice and policies to preserve their respective business organizations, keep available the services of their respective present officers and key employees and preserve their respective relationships with customers, suppliers, distributors, licensors, licensees, and others having business dealings with them, to the end that their respective goodwill and ongoing business shall be unimpaired at the effective time; - Give Required Notices. To give all notices and other information required to be given to their respective employees and any applicable governmental authority under the WARN Act, the National Labor Relations Act, the Internal Revenue Code, the Consolidated Omnibus Budget Reconciliation Act, and other applicable law in connection with the merger; - Notice of Extraordinary Events. To promptly notify the other party of any event or occurrence not in the ordinary course of their respective business, and of any event which could reasonably be likely to have a material adverse effect; - No Amendments to Organizational Documents. To not amend or permit any amendments to their respective organizational documents, except as necessary for PMR to: - increase the authorized number of shares of PMR common stock to facilitate the issuance of PMR common stock pursuant to the merger, - effectuate the proposed 1-for-3 reverse stock split of PMR common stock, and - change the name of PMR to "Psychiatric Solutions, Inc."; - No Issuance of Securities. To not issue, deliver or sell or authorize or propose the issuance, delivery or sale of, or purchase or propose the purchase of, any shares of any class of capital stock, any options, other rights of any kind to acquire any shares of capital stock, or any other ownership interest, other than the issuance of shares of their respective common stock pursuant to the exercise of stock options or warrants or other rights therefore outstanding as of the date of the merger agreement; - No Dividends or Distributions. To not declare, set aside or pay any dividend or distribution payable in cash, stock, property or otherwise; provided, that PMR shall be entitled to declare a cash dividend so long as its cash equivalents at the effective time are at least $5.05 million and that PMR shall be entitled to distribute the CVRs to its stockholders; - No Capital Changes. To not split, combine or reclassify, repurchase or redeem their outstanding capital stock other than the proposed 1-for-3 reverse stock split of PMR common stock; - No Option Changes. To not accelerate, amend or change the period of exercisability or vesting of options or other rights granted under its stock plans or authorize cash payments in exchange for any options or for other rights granted under any of such plans; - No Material Obligations. To not enter into any material contract or commitment, or violate, amend or otherwise modify or waive any of the terms of any material contract; provided specifically 129 that neither PMR nor Psychiatric Solutions shall enter into any agreement or commitment for the purchase of products or supplies or the provision of services in an amount in excess of $50,000 in any one case or $100,000 in the aggregate, other than, in the case of Psychiatric Solutions, in connection with: - acquisitions permitted by the merger agreement, - the proposed HUD refinancing of each of its four freestanding specialty psychiatric hospitals (See "Business of Psychiatric Solutions -- Recent Developments"), and - Psychiatric Solutions' senior subordinated debt financing of up to $20,000,000 (See "Business of Psychiatric Solutions -- Recent Developments"); - No Extraordinary Acquisitions. To not acquire or agree to acquire by merging or consolidating with, or by purchasing a substantial portion of the assets of, or by any other manner, any business or any corporation, partnership, association or other business organization or division thereof, or otherwise acquire or agree to acquire any assets which are material, individually or in the aggregate, to their respective business taken as a whole, other than in the case of Psychiatric Solutions, acquisitions or purchases having a purchase price equal or less than five times the acquiree's trailing 12 months' earnings before interest, taxes, depreciation and amortization, as adjusted for nonrecurring items; - No Intellectual Property Transfers. To not transfer to any person or entity any rights to their respective intellectual property other than in the ordinary course of business consistent with past practice; - No Exclusive Arrangements. To not enter into or amend any agreements pursuant to which any other party is granted exclusive marketing or other exclusive rights of any type or scope with respect to any of their respective products or technology; - No Material Changes in Assets. To not sell, lease, license or otherwise dispose of or encumber any of their respective properties or assets which are material, individually or in the aggregate, to their businesses, taken as a whole, except for sales of services in the ordinary course; - No Incurrence of Material Debt. To not incur any indebtedness for borrowed money in excess of $50,000 in the case of Psychiatric Solutions, or $20,000 in the case of PMR, or guarantee any such indebtedness or issue or sell any debt securities or guarantee any debt securities of others other than indebtedness incurred by Psychiatric Solutions in connection with: - the proposed HUD refinancing of each of the four freestanding specialty psychiatric hospitals (See "Business of Psychiatric Solutions -- Recent Developments"), and - Psychiatric Solutions' senior subordinated debt financing of up to $20,000,000 (See "Business of Psychiatric Solutions -- Recent Developments"); - No Material Operating Leases. To not enter into any operating lease in excess of $50,000 in the case of Psychiatric Solutions, and $20,000 in the case of PMR; - No Extraordinary Discharge. To, in the case of Psychiatric Solutions, not pay, discharge or satisfy in an amount in excess of $50,000 in any one case or $100,000 in the aggregate, any claim, liability or obligation arising other than in the ordinary course of business other than the payment, discharge or satisfaction of liabilities reflected or reserved against in their respective financial statements; - No Material Capital Expenses. To not make any capital expenditures, capital additions or capital improvements except, in the case of Psychiatric Solutions, in the ordinary course of business and consistent with past practice and in the case of PMR, having a cost in excess of $20,000; - No Insurance Reductions. To not materially reduce the amount of any insurance coverage provided by existing insurance policies; 130 - No Material Waivers. To not terminate or waive any right of substantial value except, in the case of PMR, in connection with the settlement of legacy receivables subject to the contingent value rights agreement; - No Extraordinary Changes in Benefits. To not adopt or amend any employee benefit or stock purchase or option plan, except as required under ERISA or except as necessary to maintain the qualified status of such plan under the Internal Revenue Code; hire any new director level or officer level employee; pay any special bonus or special remuneration to any employee or director, except payments made pursuant to written agreements outstanding on the date hereof; or increase the salaries or wage rates of their respective employees (other than normal increases based on continued service consistent with historical practices), except, in the case of PMR, increases in salary made pursuant to PMR's customary practice of annual review of salary and wage levels provided such salaries or wage increases do not increase the aggregate employee compensation by more than five percent; - No Post-Closing Severance. To not grant any severance or termination pay (i) to any director or officer or (ii) to any other employee except payments made pursuant to written agreements outstanding on the date of the merger agreement, except, in the case of PMR, for payments made before the effective time of the merger; - No Extraordinary Litigation. To not commence a lawsuit other than (i) for the routine collection of bills, (ii) in such cases where it in good faith determines that failure to commence suit would result in the material impairment of a valuable aspect of its business, provided that it consults with the other party prior to the filing of such a suit, or (iii) for a breach of the merger agreement; - No Material Tax or Accounting Changes. To not make or change any material tax election, adopt or change any accounting method in respect of taxes or file any material tax return or settle any claim or assessment in respect of taxes; - No Revaluation of Assets. To, in the case of Psychiatric Solutions, not revalue any of its assets, including without limitation writing down the value of inventory or writing off notes or accounts receivable other than in the ordinary course of business, and, in the case of PMR, not revalue any of its assets except for any revaluation relating to writing off notes or accounts receivable reserved for in its consolidated balance sheet dated January 31, 2002; - Not Threaten Tax-Free Treatment. To not take any action that would cause the merger not to qualify as a reorganization under Section 368(a) of the Internal Revenue Code; - Not Breach Representations, Warranties, and Conditions. To not take any action that is reasonably likely to result in any of the representations and warranties being untrue in any material respect or any of the conditions not being satisfied; or - No Agreement To Do The Foregoing. To not take or agree in writing or otherwise to take any of the above actions. NO SOLICITATION OF ACQUISITION TRANSACTIONS The merger agreement provides that prior to the effective time or earlier termination of the merger agreement, Psychiatric Solutions and PMR will not (and will not permit any of their subsidiaries, directors, officers, employees, financial advisors, attorneys or accountants to) solicit, initiate, encourage, facilitate or provide confidential information to facilitate any acquisition proposals, including the following: - a merger, reorganization, consolidation, business combination, recapitalization, liquidation, dissolution or similar transaction involving it or any of its subsidiaries, or - a purchase or acquisition of their business that constitutes 15% or more of net revenues, net income or assets or 15% or more of their capital stock (pursuant to a tender offer or otherwise). 131 However, if the board of directors of either company determines in good faith, after consultation with outside counsel, that it is necessary to perform the actions described above to comply with its fiduciary duties, it may, in response to a superior acquisition proposal (described below): - furnish information about the company to any person making a superior acquisition proposal; and - participate in discussions or negotiations regarding the superior acquisition proposal. The board of directors of Psychiatric Solutions and PMR may not: - modify or withdraw, in a manner adverse to the other party, its recommendation of the merger agreement or the merger; - approve or recommend an acquisition proposal described above; or - enter into any letter of intent or agreement relating to any proposal. However, Psychiatric Solutions or PMR, as the case may be, may terminate the merger agreement after five business days' prior written notice to the other and enter into an acquisition agreement with a third party upon receipt of a superior acquisition proposal consisting of a proposal: - to acquire, by tender offer, merger, business combination, exchange offer, recapitalization, liquidation or dissolution, more than 50% of the combined voting power of their outstanding common stock or all or substantially all of their assets; - that is on terms which the board of directors determines in its good faith judgment (based upon the advice of a financial advisor of nationally recognized reputation) to be more favorable to its stockholders than the merger; - for which financing is, upon the good faith judgment of the board, reasonably obtainable; and - for which, in the good faith judgment of the board, no regulatory approvals are required that would not be reasonably obtainable. If Psychiatric Solutions or PMR terminates the merger agreement to accept a superior acquisition proposal, it must pay the other a termination fee. See "-- Termination Fee" on page 134. The merger agreement requires that the companies notify each other immediately after receipt of any acquisition proposal, including the material terms of the proposal and the identity of the person making the proposal, and they must update each other as necessary. Nothing described above prohibits PMR from taking and disclosing to its stockholders a position contemplated by Rule 14e-2(a) promulgated under the Securities Exchange Act of 1934, as amended, or from making any disclosures to PMR's stockholders if, in the good faith judgment of the board of directors of PMR, after consultation with outside counsel, failure to so disclose would be inconsistent with its obligations under applicable law. CONDUCT OF THE BUSINESS OF THE COMBINED COMPANY FOLLOWING THE MERGER At the effective time of the merger, a wholly-owned subsidiary of PMR will be merged with and into Psychiatric Solutions, with Psychiatric Solutions constituting the surviving entity in the merger. Therefore, following the merger, Psychiatric Solutions will be a wholly-owned subsidiary of PMR. Pursuant to the merger agreement, the charter of PMR's wholly-owned subsidiary, as in effect immediately prior to the effective time, will be the charter of the surviving PMR subsidiary corporation, and the charter of the PMR subsidiary will be amended to provide that the name of the surviving corporation will be "Psychiatric Solutions Hospitals, Inc." The charter of PMR will be amended to reflect the new name of Psychiatric Solutions, Inc. 132 BOARD, COMMITTEES AND OFFICERS OF PMR At the effective time, PMR shall: - cause the board of directors to be comprised of: - Joey A. Jacobs, - Edward K. Wissing, - David S. Heer, - Christopher Grant, Jr., - Joseph P. Donlan, the representative of the holders of the senior subordinated convertible notes issued by Psychiatric Solutions on June 28, 2002; - Charles C. McGettigan, and - Mark P. Clein; - cause the compensation committee of PMR to be comprised of: - Joey A. Jacobs, - David S. Heer, and - Christopher Grant, Jr.; - cause the audit committee of PMR to be comprised of: - Edward K. Wissing, - Christopher Grant, Jr., and - Charles C. McGettigan; and - cause the executive officers of PMR to consist of: - Joey A. Jacobs, Chief Executive Officer and President, - Steven T. Davidson, Chief Development Officer and Secretary, - Jack R. Salberg, Chief Operating Officer, and - Jack Polson, Controller. TERMINATION, AMENDMENT OR WAIVER Termination. The merger agreement may be terminated at any time prior to the effective time, whether before or after the approval by the stockholders of PMR or Psychiatric Solutions: - by the mutual written consent of PMR and Psychiatric Solutions; or - by either PMR or Psychiatric Solutions if; - the merger is not completed by December 31, 2002, so long as the delay or default was not on the part of the terminating party, - any required approval by the stockholders of PMR or Psychiatric Solutions is not obtained, - a court or other governmental authority permanently prohibits the merger, - the non-terminating party fails to perform or comply with any material representations, warranties, covenants or agreements in the merger agreement and does not cure the default in all material respects within 30 days or the default is incurable, or 133 - by PMR or Psychiatric Solutions, as the case may be, if, as a result of a superior acquisition proposal, its board of directors makes the determinations described in "-- No Solicitation of Acquisition Transactions" on page 131; provided that the termination will not be effective until the other party has received the termination fee and out-of-pocket expenses required to be paid pursuant to the merger agreement. Amendment. The merger agreement may not be amended except by action taken by the parties' respective boards of directors and then only by an instrument in writing signed on behalf of each party and in compliance with applicable law. The amendment may take place at any time prior to the effective time, and, subject to applicable law, whether before or after approval by the stockholders of Psychiatric Solutions and PMR, provided that: - if it occurs after Psychiatric Solutions stockholder approval, no amendment may be made which would reduce the amount or change the type of consideration into which each share of Psychiatric Solutions capital stock shall be converted pursuant to the merger agreement; and - if it occurs after PMR stockholder approval, no amendment may be made which would increase the amount or change the type of consideration into which each share of Psychiatric Solutions capital stock shall be converted pursuant to the merger agreement. Waiver. At any time prior to the effective time, either party to the merger agreement may, to the extent legally allowed: - extend the time for the performance of any of the obligations or other acts of the other party pursuant to the merger agreement; - waive any inaccuracies in the representations and warranties of the other party contained in the merger agreement or in any document delivered pursuant to the merger agreement; and - waive compliance by the other party with any of the agreements or conditions contained in the merger agreement. Notwithstanding the foregoing, no waiver may take place: - after the Psychiatric Solutions stockholder approval that reduces the amount or changes the type of consideration into which each share of Psychiatric Solutions capital stock shall be converted pursuant to the merger agreement, unless further approval of the Psychiatric Solutions stockholders is obtained, or - after the PMR stockholder approval that increases the amount or changes the type of consideration into which each share of Psychiatric Solutions capital stock shall be converted pursuant to the merger agreement, unless further approval of the PMR stockholders is obtained. TERMINATION FEE PMR has agreed that, in the event of a termination of the merger agreement, PMR will pay Psychiatric Solutions a termination fee equal to $750,000, plus out-of-pocket expenses of Psychiatric Solutions (not to exceed $250,000), if: - an acquisition proposal has been publicly announced or received by PMR and the merger agreement is terminated by either party based on the failure to complete the merger by December 31, 2002, without any fault of the terminating party; - an acquisition proposal has been publicly announced or received by PMR and the merger agreement is terminated by either party based on the failure of the stockholders of PMR to approve the merger; or - PMR terminates the merger agreement because its board of directors has received a superior acquisition proposal and has made the determinations described in "-- No Solicitation of Acquisition Transactions" on page 131. 134 Psychiatric Solutions has agreed that, in the event of a termination of the merger agreement, Psychiatric Solutions will pay PMR a termination fee equal to $750,000, plus out-of-pocket expenses of PMR (not to exceed $250,000), if: - an acquisition proposal has been publicly announced or received by Psychiatric Solutions and the merger agreement is terminated by either party based on the failure to complete the merger by December 31, 2002, without any fault of the terminating party; - an acquisition proposal has been publicly announced or received by Psychiatric Solutions and the merger agreement is terminated by either party based on the failure of the stockholders of Psychiatric Solutions to approve the merger; or - Psychiatric Solutions terminates the merger agreement because the board has received a superior acquisition proposal and has made the determinations described in "-- No Solicitation of Acquisition Transactions" on page 131. EXPENSES The merger agreement generally provides that all costs and expenses incurred in connection with the merger agreement and the transactions contemplated thereby will be paid by the party incurring the expenses, except that: - those costs and expenses (other than fees and expenses of attorneys) incurred in connection with the preparation, filing, printing and mailing of this joint proxy statement/prospectus, including SEC filing fees and fees and expenses of accountants, will be shared equally by PMR and Psychiatric Solutions; and - PMR's portion of such costs and expenses, whether paid before or after the effective time of the merger, shall not reduce the $5.05 million of cash and cash equivalents PMR is required to have on hand at the effective time. INDEMNIFICATION AND INSURANCE The combined company will indemnify each present and former Psychiatric Solutions officer and director against liabilities arising out of such person's services as an officer or director and the transactions contemplated by the merger agreement. The combined company will maintain directors and officers liability insurance for the current directors and officers of both PMR and Psychiatric Solutions comparable to the insurance provided to such persons immediately prior to the effective time of the merger, in each case, subject to certain limitations. See "Interests of Certain Directors, Officers and Stockholders in the Merger -- Indemnification of Certain Persons." STOCKHOLDER VOTING AGREEMENTS On May 6, 2002, simultaneously with entering into the merger agreement, certain stockholders of Psychiatric Solutions and PMR entered into voting agreements with Psychiatric Solutions and PMR. This section of the joint proxy statement/prospectus describes the material provisions of these voting agreements. The descriptions of these agreements in this joint proxy statement/prospectus are summaries and therefore they do not contain all the information that may be important to you. PSYCHIATRIC SOLUTIONS STOCKHOLDER VOTING AGREEMENT Under the Psychiatric Solutions stockholder voting agreement, each Psychiatric Solutions stockholder who became a party irrevocably agreed to vote at any meeting of stockholders of Psychiatric Solutions as follows: - in favor of the merger and in favor of the actions outlined in the merger agreement; and - against an alternative merger or combination between Psychiatric Solutions and any entity other than PMR. 135 Also, if and to the extent any executing Psychiatric Solutions stockholder owns any shares of Psychiatric Solutions Series A preferred stock or Psychiatric Solutions Series B preferred stock or was a party to the investors rights agreement, co-sale agreement and voting agreements relating to these Psychiatric Solutions securities, pursuant to the voting agreement such Psychiatric Solutions stockholder agreed to the exchange of such preferred shares for PMR common stock and the termination of each of these agreements as of the effective time. In addition, each Psychiatric Solutions stockholder who became a party to the voting agreement revoked all proxies granted to him with respect to the matters described above and appointed PMR as his attorney and proxy, with power to vote all voting securities owned by him, on the above matters. As of the date of the merger agreement, Psychiatric Solutions stockholders executing voting agreements beneficially owned approximately 20,172,261 shares of Psychiatric Solutions capital stock, which constitutes over 80% of the outstanding shares of capital stock of Psychiatric Solutions. Pursuant to the Psychiatric Solutions stockholder voting agreement, during the term of the voting agreement each stockholder executing the voting agreement further agreed not, directly or indirectly, to solicit or encourage any offer from any party concerning the possible disposition of all or any substantial portion of Psychiatric Solutions' business, assets or capital stock. The voting agreement will terminate with respect to the obligations of the Psychiatric Solutions stockholders relating to the merger upon the earlier to occur of: - the completion of the merger; and - the termination of the merger agreement in accordance with its terms. PMR STOCKHOLDER VOTING AGREEMENT Under the PMR stockholder voting agreement, each PMR stockholder who became a party irrevocably agreed to vote at any meeting of stockholders of PMR as follows: - in favor of the merger and in favor of the actions outlined in the merger agreement; and - against an alternative merger or combination between PMR and any entity other than Psychiatric Solutions. In addition, each PMR stockholder who became a party to the voting agreement revoked all proxies granted to him with respect to the matters described above and appointed PMR as his attorney and proxy, with power to vote all voting securities owned by him, on the above matters. As of the date of the merger agreement, PMR stockholders executing voting agreements beneficially owned approximately 858,731 shares of PMR common stock, which constitutes approximately 36% of the outstanding shares of capital stock of PMR. Pursuant to the PMR stockholder voting agreement, during the term of the voting agreement each stockholder executing the voting agreement further agreed not, directly or indirectly, to solicit or encourage any offer from any party concerning the possible disposition of all or any substantial portion of PMR's business, assets or capital stock. The voting agreement will terminate with respect to the obligations of the PMR stockholders relating to the merger upon the earlier to occur of: - the completion of the merger; and - the termination of the merger agreement in accordance with its terms. CONTINGENT VALUE RIGHTS AGREEMENT In connection with the transactions contemplated by the merger agreement, PMR expects to issue "contingent value rights" to the holders of its common stock prior to the effective time of the merger. As 136 a result, the holders of the capital stock of Psychiatric Solutions will not be entitled to receive any contingent value rights. If issued, the contingent value rights will have the characteristics described in the contingent value rights agreement attached as Exhibit D to the merger agreement. This section of the joint proxy statement/prospectus describes the material terms of the contingent value rights agreement. GENERAL. PMR expects to issue the contingent value rights ("CVRs") prior to the effective time of the merger to each holder of outstanding PMR common stock pursuant to the CVR agreement to be entered into among PMR, Fred D. Furman, as representative, and StockTrans, Inc., as trustee. Although PMR presently intends to issue the CVRs, it may determine not to issue the CVRs if the amount distributable in respect of the CVRs, due to collection by PMR of the designated accounts receivable prior to the effective time of the merger, due to determination by PMR that a significant amount of these accounts receivable are not likely to be collected, or a combination of these factors, is not likely to be sufficient to justify the costs and expenses associated with the CVRs. PAYMENT OF EXCESS CASH EQUIVALENTS AT EFFECTIVE TIME. The CVR agreement provides that, if the aggregate amount of cash and cash equivalents of PMR immediately prior to the effective time is greater than $5.05 million, then PMR shall pay such excess cash and cash equivalents to each CVR holder on or before the 90th date following the effective time; provided that, the aggregate amount of excess cash and cash equivalents must exceed $100,000 or it will be deemed a "legacy receivable" and be paid to CVR holders in accordance with the paragraph below entitled "Quarterly Payment of Legacy Receivables." However, there is no assurance that any payments will be made with respect to the CVRs, and the CVRs, therefore, may not have any value. LEGACY RECEIVABLES. The contingent value rights agreement provides that PMR will distribute to the holders of the CVRs cash collected on any and all accounts receivable of PMR that remain uncollected by PMR as of the effective time other than: - accounts receivable attributable to the following contracts: - Consulting Agreement with Alameda County Medical Center dated March 8, 2002, - Transportation Agreement with Alameda County Medical Center dated November 17, 1999, - License Agreement with Conundrum Communications, Inc. dated July 31, 2001, - Management and Affiliation Agreement dated April 13, 1995, between Mental Health Cooperative, Inc. and Tennessee Mental Health Cooperative, Inc. with Addendum, as amended, - Provider Agreement dated December 4, 1995, between Tennessee Behavioral Health, Inc. and Tennessee Mental Health Corporations, Inc., as amended, - Provider Participation Agreement dated February 13, 1996, among Green Spring Health Services, Inc., AdvoCare, Inc. and Tennessee Mental Health Cooperative, Inc., as amended, and - Management Agreement between PMR and New Center Community Health Services; and - notes payable from employees of PMR. PMR will retain the right to collect these excluded receivables. The remaining accounts receivable with respect to which the holders of CVRs will be entitled to a cash payment if such receivables are collected are referred to as "legacy receivables." LEGACY RECEIVABLES REPRESENTATIVE. The CVR agreement appoints a representative, initially Fred D. Furman, the current President and General Counsel of PMR, to act as an agent for PMR to assist in the collection of legacy receivables. PMR will provide the representative with accounting, legal and administrative support during the term of the CVR agreement. The representative will have the power and authority, subject to the prior written consent of PMR, to bring any action, suit or other legal proceeding with respect to any legacy receivable. 137 PMR will compensate the representative as follows: - $5,000 monthly following the execution of the CVR agreement for a 12-month period; - $3,500 monthly thereafter until the CVRs have expired by their terms; and - 10% of actual collections of the legacy receivables related to the management contracts of PMR with either Centennial Medical Center or Skyline Hospital (formerly Nashville Memorial Hospital). PMR also agrees to: - advance all reasonable expenses and disbursements incurred or to be incurred by the representative; and - indemnify the representative for any loss, liability or expense incurred without willful misconduct or bad faith on the part of the representative, arising out of or in connection with the exercise or performance of his duties under the CVR agreement. QUARTERLY PAYMENT OF LEGACY RECEIVABLES. The CVR agreement provides that within 30 days following the end of each fiscal quarter, PMR shall: - determine the aggregate amount of legacy receivables actually collected by PMR during that quarter; and - pay to each CVR holder such holder's pro rata amount of such cash collections based on the ratio of the amount of CVRs held by such holder divided by the total amount of outstanding CVRs, after deducting fees and expenses of third-parties incurred by PMR to collect the legacy receivables (other than of the legacy receivables representative) and a 15% accounts receivable collection fee to be retained by PMR. Notwithstanding the above paragraph, if the aggregate quarterly payment is less than $500,000, then such amount will not be paid to the CVR holders at that time but will be paid on the earlier of: - the next succeeding quarter in which the total quarterly payment exceeds $500,000; or - on or within 45 days of the expiration date of the CVRs. EXPIRATION OF CVRS. The CVRs terminate on the second anniversary of the effective time of the merger unless PMR is engaged in active litigation with respect to any legacy receivables, in which case the CVRs shall terminate on the final resolution of all such litigation. Notwithstanding the previous sentence, the CVRs shall terminate at any time following the first anniversary of the effective time of the merger upon the mutual determination of PMR and the representative if: - the legacy receivables relating to the following accounts or entities have been collected in full or settled: - Little Rock Community Mental Health Center, - Professional Counseling Associates, - Centennial Medical Center, - Skyline Hospital (formerly Nashville Memorial Hospital), and - Austin Travis Mental Health Mental Retardation; and - no event of default has occurred and is continuing. EVENTS OF DEFAULT. If an event of default occurs and is continuing, either the CVR trustee or CVR holders of not less than 25% of the outstanding CVRs, by notice in writing to PMR (and to the CVR trustee if given by CVR holders), may declare the CVRs to be due and payable immediately, and upon any such declaration, PMR shall pay to the CVR holders in cash for each CVR held by the CVR holders, 138 any payments owed to CVR holders with interest at 8% per annum, from the default payment date through the date payment is made to the CVR trustee. If, at any time after the CVRs shall have been so declared due and payable, and before any judgment or decree for the payment of the amounts due shall have been obtained or entered, PMR shall pay or shall deposit with the CVR trustee a sum sufficient to pay all amounts which shall have become due otherwise than by acceleration (with interest upon such overdue amount at 8% per annum to the date of such payment or deposit) and an amount sufficient to cover reasonable compensation to the CVR trustee, its agents, attorneys and counsel, and all other expenses and liabilities incurred and all advances made by the CVR trustee except as a result of negligence or bad faith. If any and all events of default, other than the nonpayment of the amounts which shall have become due by acceleration, have been cured, waived or otherwise remedied, then the CVR holders holding a majority of all the CVRs then outstanding, by written notice to PMR and to the CVR trustee, may waive all defaults with respect to the CVRs and rescind and annul such declaration and its consequences, but no such waiver or rescission and annulment shall extend to or shall affect any subsequent default or shall impair any right consequent thereof. CONSOLIDATION, MERGER AND SALE OF ASSETS. The contingent value rights agreement provides that PMR may, without the consent of the CVR holders, consolidate with or merge into any other person or entity or convey, transfer or lease its properties and assets substantially as an entirety to any corporation, partnership or trust organized under the laws of the United States of America, any state thereof or the District of Columbia, provided that: - the successor person or entity assumes PMR's obligations under the CVRs and the contingent value rights agreement; - immediately after giving pro forma effect to the transaction, there exists no event of default; and - PMR delivers to the CVR trustee an officer's certificate regarding compliance with the foregoing. Solely for purposes of this paragraph, "convey, transfer or lease its properties and assets substantially as an entirety" shall mean properties and assets contributing in the aggregate at least 80% of PMR's total revenues as reported in PMR's last available periodic financial report (quarterly or annual, as the case may be) filed with the SEC. PMR SPECIAL MEETING This document is furnished in connection with the solicitation of proxies from the holders of PMR common stock by the PMR board for use at the PMR special meeting in lieu of its 2002 annual meeting. This document and accompanying form of proxy are first being mailed to the stockholders of PMR on or about July 12, 2002. TIME AND PLACE; PURPOSE The PMR special meeting in lieu of annual meeting will be held at 9:00 a.m. local time, on Monday, August 5, 2002, at PMR Corporation, 1565 Hotel Circle South, 2nd Floor, San Diego, California 92108. At the PMR special meeting (and any adjournment or postponement of the PMR special meeting), the stockholders of PMR will be asked to consider and vote upon: - the approval and adoption of the merger agreement and the merger; - the approval of an amendment to the PMR charter to (i) increase the number of authorized shares of PMR common stock, (ii) effectuate a 1-for-3 reverse stock split prior to the merger, and (iii) change the name of PMR to "Psychiatric Solutions, Inc."; and - other matters as may properly come before the PMR special meeting. PMR stockholder approval and adoption of the merger agreement is required by the Delaware General Corporation Law and the rules of the Nasdaq Stock Market. 139 The PMR board of directors has unanimously approved the terms of the merger agreement, and unanimously believes that the terms of the merger agreement are fair to, and in the best interests of, PMR and its stockholders, and unanimously recommends that holders of PMR common stock vote "for": - approval and adoption of the merger agreement; and - approval and adoption of the amendment to the PMR charter (i) increasing the number of authorized shares of PMR common stock, (ii) effecting a 1-for-3 reverse stock split prior to the merger, and (iii) changing the name of PMR to "Psychiatric Solutions, Inc." AMENDMENT OF PMR'S CHARTER The board of directors of PMR has unanimously recommended for approval by the stockholders the proposal to amend the charter to: - increase the number of authorized shares of common stock of PMR to facilitate the issuance of new shares in the merger to Psychiatric Solutions' stockholders; - effect a 1-for-3 reverse stock split; and - change the name of PMR to "Psychiatric Solutions, Inc." Under the proposal, the PMR charter would be amended to restate Article I, so that it would read in its entirety as follows: "The name of this Corporation is Psychiatric Solutions, Inc." Under the proposal, the PMR charter would be further amended to restate Article V, so that it would read in its entirety as follows: "A. This Corporation is authorized to issue two classes of shares to be designated, respectively, "Common Stock" and "Preferred Stock." All of said shares shall be one cent ($0.01) par value each. The total number of shares of stock that the Corporation is authorized to issue is Fifty Million (50,000,000), of which Forty-Eight Million (48,000,000) shares shall be Common Stock, each having a par value of one cent ($0.01) per share, and Two Million (2,000,000) shares shall be Preferred Stock, each having a par value of one cent ($0.01) per share. B. The Preferred Stock may be issued from time to time in one or more series. The Board of Directors is hereby authorized, by filing a certificate (a "Preferred Stock Designation") pursuant to the Delaware General Corporation Law, to fix or alter from time to time the designation, powers, preferences and rights of the shares of each such series and the qualifications, limitations or restrictions of any wholly unissued series of Preferred Stock, and to establish from time to time the number of share constituting any such series or any of them; and to increase or decrease the number of shares of any series subsequent to the issuance of shares of that series, but not below the number of shares of such series then outstanding. In case the number of shares of any series shall be decreased in accordance with the foregoing sentence, the shares constituting such decrease shall resume the status that they had prior to the adoption of the resolution originally fixing the number of shares of such series. C. The Corporation may purchase, directly or indirectly, its own shares to the extent that may be allowed by law. D. Effective immediately upon filing of this Certificate of Amendment with the Secretary of State of the State of Delaware (the "Effective Time"), each share of Common Stock, par value $0.01 per share (the "Old Common Stock"), issued and outstanding immediately prior to such Effective Time shall, without any action on the part of the holder thereof, be converted and reclassified into, and immediately represent, one-third of one validly issued, fully paid and non-assessable share of Common Stock, par value $0.01 per share. Notwithstanding the foregoing, no fraction of a share of Common Stock shall be issued by virtue of such conversion and reclassification, and any fraction of a 140 share of Common Stock that would otherwise result pursuant to the preceding sentence (after aggregating all fractional shares to be received by such stockholder) shall automatically be rounded down to the nearest whole share. Each certificate representing shares of Old Common Stock shall thereafter represent that number of shares of Common Stock determined in accordance with the previous sentences; provided, however, that each person holding of record a stock certificate or certificates representing shares of Old Common Stock shall receive, upon surrender of such certificate or certificates, a new certificate or certificates evidencing and representing the number of shares of Common Stock to which such person is entitled. In addition, any options to acquire shares of Common Stock (each, an "Option") outstanding immediately prior to the Effective Time shall, without any action on the part of the holder thereof or the Corporation, be adjusted as follows: (i) the number of shares of Common Stock subject to such Option shall be divided by 3 (rounded down to the nearest whole share); and (ii) the per share exercise price set forth in such Option shall be multiplied by 3, subject to appropriate reduction on account of any fractions not issued as a result of rounding down; provided, however, that the foregoing adjustments shall not apply if the plan under which a particular Option was granted provides for adjustments similar to the foregoing. The provisions of this Paragraph D shall not change the par value of the Common Stock as set forth in Article V, Paragraph A hereof." The proposed amendment to PMR's charter is attached as Annex B to this joint proxy statement/ prospectus. The primary purpose of the increase in the number of authorized shares of common stock of PMR is to facilitate the issuance of new shares of common stock in the merger to the stockholders of Psychiatric Solutions. PMR currently has 19,000,000 shares of authorized common stock and 1,000,000 shares of authorized preferred stock. If the proposed amendment to the PMR charter is approved, PMR will have 48 million shares of authorized common stock and 2 million shares of authorized preferred stock. Pursuant to the merger, it is contemplated that PMR would issue approximately 6,307,422 shares of its common stock to the current stockholders of Psychiatric Solutions (on a fully diluted basis taking into account the exercise of conversion of outstanding options, warrants and convertible securities of Psychiatric Solutions). This amendment would also provide PMR the flexibility to issue additional shares of common stock or preferred stock to raise capital, to make acquisitions or for other general corporate purposes. The purpose of the reverse stock split is to adjust the trading price of PMR common stock to a higher price than PMR's common stock has been recently traded. On July 10, 2002, the closing sales price for PMR's common stock on the Nasdaq National Market was $1.96. For additional information regarding the ranges of historical closing prices for PMR's common stock, please read "Comparative Per Share Market Price and Dividend Information." Based on the number of shares of PMR common stock outstanding as of May 31, 2002, following the reverse stock split but without giving effect to the merger, PMR would have 2,420,969 shares of common stock outstanding (without giving effect to the cancellation of fractional shares that may result from the reverse stock split) and no shares of preferred stock outstanding. No fraction of a share shall be issued by virtue of the reverse stock split and any fraction of a share of PMR common stock that would otherwise result pursuant to the reverse stock split (after aggregating all fractional shares to be received by a stockholder) will automatically be rounded down to the nearest whole share of PMR common stock. With the limited exception of stockholders whose fractional share interests are rounded down to the nearest whole share after the reverse stock split, the proportionate ownership interests of stockholders will not be affected by the reverse stock split. Pursuant to the reverse stock split, each holder of a share of PMR common stock, par value $0.01 per share ("Old PMR Common Stock"), immediately prior to the effectiveness of the reverse stock split will become the holder of one-third of a share of PMR common stock, par value $0.01 per share ("New PMR Common Stock") after consummation of the reverse stock split. 141 Commencing on the effective date of the reverse stock split, each PMR common stock certificate will be deemed for all corporate purposes to evidence ownership of the reduced number of shares of common stock resulting from the reverse stock split. As soon as practicable after the effective date, PMR stockholders will be notified as to the effectiveness of the reverse stock split and instructed as to how and when to surrender their certificates representing shares of Old PMR Common Stock. The exercise prices and/or conversion ratios of PMR's outstanding stock options and securities having a conversion or redemption feature will be correspondingly adjusted upon the consummation of the reverse stock split. If approved, the reverse stock split will result in some stockholders of PMR owning odd lots of less than 100 shares of PMR common stock. Brokerage commissions and other costs of transactions in odd lots are generally somewhat higher than the costs of transactions in "round lots" of even multiples of 100 shares. PMR common stock is currently registered under the Securities Exchange Act of 1934 (the "Exchange Act"), and as a result, PMR is subject to the periodic reporting and other requirements of the Exchange Act. The proposed reverse stock split will not affect the registration of PMR common stock under the Exchange Act. The par value of PMR common stock will remain at $0.01 following the reverse stock split, and the number of shares of PMR common stock outstanding will be reduced by approximately 66.66% (without giving effect to the issuance of shares of PMR common stock pursuant to the merger). As a consequence, the aggregate par value of the outstanding PMR common stock will be reduced, while the aggregate capital in excess of par value attributable to the outstanding common stock for statutory and accounting purposes will be correspondingly increased. The resolution approving the reverse stock split provides that this increase in capital in excess of par value will be treated as capital for statutory purposes. The purpose of the proposed amendment to change the name of PMR to "Psychiatric Solutions, Inc." is to better identify the combined company resulting from the merger with the name previously identified with the largest operations of the combined company, which operations are currently conducted by Psychiatric Solutions. RECORD DATE; VOTING RIGHTS AND PROXIES Only holders of record of PMR common stock at the close of business on July 1, 2002 are entitled to notice of and to vote at the PMR special meeting. As of the PMR record date, there were 2,420,969 shares of PMR common stock outstanding, each of which entitled its holder to one vote. There were approximately 102 holders of record on the record date. All shares of PMR common stock represented by properly executed proxies will, unless these proxies have been previously revoked, be voted in accordance with the instructions indicated in these proxies. If no instructions are indicated, the shares of PMR common stock will be voted "for" approval and adoption of the merger agreement and the amendment to the charter increasing the number of authorized shares of common stock of PMR. PMR does not know of any matters other than the approval of the merger agreement, and the proposed amendment to the PMR charter that are to come before the PMR special meeting. If any other matter or matters are properly presented for action at the PMR special meeting, the persons named in the enclosed form of proxy and acting under the proxy will have the discretion to vote on those matters in accordance with their best judgment. A stockholder who has given a proxy may revoke it at any time prior to its exercise by giving written notice of revocation to PMR by signing and returning a later dated proxy, or by voting in person at the PMR special meeting. Votes cast by proxy or in person at the PMR special meeting will be tabulated by the inspector of election appointed for the meeting. 142 SOLICITATION OF PROXIES Proxies are being solicited by and on behalf of the PMR board. The cost of solicitation will be borne by PMR. In addition to solicitation by use of the mails, proxies may be solicited by directors, officers and employees of PMR in person or by telephone, telegram or other means of communication. Those directors, officers and employees will not be additionally compensated, but may be reimbursed for out-of-pocket expenses incurred in connection with the solicitation. Arrangements have also been made with brokerage firms, banks, custodians, nominees and fiduciaries for the forwarding of proxy solicitation materials to owners of PMR common stock held of record by those persons and in connection therewith the firms will be reimbursed for reasonable expenses incurred in forwarding those materials. QUORUM The presence in person or by properly executed proxy of a majority of the issued and outstanding shares of PMR common stock entitled to vote at the special meeting is necessary to constitute a quorum at the PMR special meeting. If there are not sufficient shares represented in person or by proxy at the special meeting to constitute a quorum, the special meeting may be postponed or adjourned in order to permit further solicitation of proxies by PMR. REQUIRED VOTE; FAILURE TO VOTE AND BROKER NON-VOTES Approval and adoption of the merger agreement requires the affirmative vote of a majority of the outstanding shares of PMR common stock. The approval of the proposed amendment to PMR's charter requires the affirmative vote of a majority of the outstanding shares of PMR common stock. Any failure to vote, or a vote to abstain, will have the effect of a vote against the merger agreement and the proposed amendment to PMR's charter. Under Nasdaq rules, brokers who hold shares in street name for customers have the authority to vote on some "routine" proposals when they have not received instructions from beneficial owners. However, these brokers are precluded from exercising their voting discretion with respect to the approval and adoption of non-routine matters such as the merger agreement and the proposed amendment to PMR's charter and, thus, absent specific instructions from the beneficial owner of the shares, brokers are not empowered to vote the shares with respect to the merger agreement and the proposed amendment to PMR's charter. These "broker non-votes" will therefore have the effect of a vote "against" the merger agreement and the proposed amendment to PMR's charter. PSYCHIATRIC SOLUTIONS SPECIAL MEETING This document is furnished in connection with the solicitation of proxies from the holders of Psychiatric Solutions capital stock by the Psychiatric Solutions board for use at the Psychiatric Solutions special meeting. This document and accompanying form of proxy are first being mailed to the stockholders of Psychiatric Solutions on or about July 12, 2002. TIME AND PLACE; PURPOSE The Psychiatric Solutions special meeting will be held at 10:00 a.m. local time, on Monday, August 5, 2002 at Harwell Howard Hyne Gabbert & Manner, P.C., 315 Deaderick Street, Suite 1800, Nashville, Tennessee 37238. At the Psychiatric Solutions special meeting (and any adjournment or postponement of the Psychiatric Solutions special meeting), the stockholders of Psychiatric Solutions will be asked to consider and vote upon the approval and adoption of the merger agreement and other matters as may properly come before the Psychiatric Solutions special meeting. Psychiatric Solutions stockholder approval and adoption of the merger agreement is required by the Delaware General Corporation Law. 143 The Psychiatric Solutions board of directors has approved the terms of the merger agreement and the completion of the merger contemplated by the merger agreement, believes that the terms of the merger agreement are fair to, and in the best interests of, Psychiatric Solutions and its stockholders, and unanimously recommends that holders of Psychiatric Solutions capital stock vote "for" the approval and adoption of the merger agreement. RECORD DATE; VOTING RIGHTS AND PROXIES Only holders of record of Psychiatric Solutions capital stock at the close of business on, July 1, 2002, are entitled to notice of and to vote at the Psychiatric Solutions special meeting. As of the record date, there were 22,800,363 shares of Psychiatric Solutions capital stock outstanding, each of which entitles its holder to one vote. There were approximately 102 registered holders of record on the record date. All shares of Psychiatric Solutions capital stock represented by properly executed proxies will, unless these proxies have been previously revoked, be voted in accordance with the instructions indicated in these proxies. If no instructions are indicated, these shares of Psychiatric Solutions capital stock will be voted "for" approval and adoption of the merger agreement. Psychiatric Solutions does not know of any matters other than the approval of the merger agreement that are to come before the Psychiatric Solutions special meeting. If any other matter or matters are properly presented for action at the Psychiatric Solutions special meeting, the persons named in the enclosed form of proxy and acting under the proxy will have the discretion to vote on those matters in accordance with their best judgment. A stockholder who has given a proxy may revoke it at any time prior to its exercise by giving written notice of revocation to Psychiatric Solutions by signing and returning a later dated proxy, or by voting in person at the Psychiatric Solutions special meeting. Votes cast by proxy or in person at the Psychiatric Solutions special meeting will be tabulated by the inspector of election appointed for the meeting. SOLICITATION OF PROXIES Proxies are being solicited by and on behalf of the Psychiatric Solutions board. The cost of solicitation will be borne by Psychiatric Solutions. In addition to solicitation by use of the mails, proxies may be solicited by directors, officers and employees of Psychiatric Solutions in person or by telephone, telegram or other means of communication. Those directors, officers and employees will not be additionally compensated but may be reimbursed for out-of-pocket expenses incurred in connection with the solicitation. Arrangements have also been made with brokerage firms, banks, custodians, nominees and fiduciaries for the forwarding of proxy solicitation materials to owners of Psychiatric Solutions capital stock held of record by these persons and in connection therewith these firms will be reimbursed for reasonable expenses incurred in forwarding those materials. Psychiatric Solutions stockholders should not send any certificates representing Psychiatric Solutions capital stock with their proxy cards. Following the effective time, Psychiatric Solutions stockholders will receive instructions for the surrender and exchange of their stock certificates. QUORUM The presence in person or by properly executed proxy of a majority of the issued and outstanding shares of Psychiatric Solutions capital stock entitled to vote at the special meeting is necessary to constitute a quorum at the Psychiatric Solutions special meeting. If there are not sufficient shares represented in person or by proxy at the special meeting to constitute a quorum, the special meeting may be postponed or adjourned in order to permit further solicitation of proxies by Psychiatric Solutions. Abstentions and "broker non-votes" are counted for purposes of determining whether a quorum is present. REQUIRED VOTE AND FAILURE TO VOTE Approval and adoption of the merger agreement requires the affirmative vote of (i) a majority of the outstanding shares of Psychiatric Solutions common stock, and (ii) a majority of the outstanding shares of Psychiatric Solutions Series A preferred stock and Series B preferred stock, voting as a single class. Any failure to vote, or a vote to abstain, will have the effect of a vote against the merger and the merger agreement. 144 BENEFICIAL OWNERSHIP OF PMR CAPITAL STOCK The following table presents information regarding beneficial ownership of PMR's common stock as of May 31, 2002, as adjusted to reflect the proposed 1-for-3 reverse stock split, by: - each person whom PMR knows beneficially owns more than 5 percent of PMR's common stock; - each of PMR's directors; - PMR's chief executive officer and each of our four other most highly compensated executive officers; and - all of PMR's executive officers and directors as a group. This table is based upon information supplied by officers, directors and principal stockholders and Schedules 13D and 13G (if any) filed with the Securities and Exchange Commission. Unless otherwise indicated in the footnotes to this table and subject to community property laws where applicable, PMR believes that each of the stockholders named in this table has sole voting and investment power with respect to the shares indicated as beneficially owned. Except as otherwise indicated, the address of each holder identified below is in care of PMR, 1565 Hotel Circle South, 2nd Floor, San Diego, California 92108.
BENEFICIAL OWNERSHIP(1) ---------------------------- NUMBER OF BENEFICIAL OWNER SHARES PERCENT OF TOTAL - ---------------- --------- ---------------- Persons and entities affiliated with Proactive Investment Managers, L.P.(2)(3)(4).................................. 462,233 19.09 50 Osgood Place, Penthouse San Francisco, CA 94133 Jon D. Gruber(2)(3)........................................ 416,650 17.21 50 Osgood Place, Penthouse San Francisco, CA 94133 J. Patterson McBaine(2)(4)................................. 412,817 17.05 50 Osgood Place, Penthouse San Francisco, CA 94133 J. P. Morgan Chase & Co.(5)................................ 218,820 9.04 270 Park Avenue New York, NY 10017 Myron A. Wick III(2)....................................... 176,635 7.30 50 Osgood Place, Penthouse San Francisco, CA 94133 Dimensional Fund Advisors Inc.(6).......................... 160,600 6.63 1299 Ocean Avenue, 11th Floor Santa Monica, CA 90401 Allen Tepper(7)............................................ 301,747 12.46 Charles C. McGettigan(2)................................... 199,860 8.26 50 Osgood Place, Penthouse San Francisco, CA 94133 Mark P. Clein.............................................. 198,573 8.20 Fred D. Furman............................................. 120,840 4.99 Susan D. Erskine(8)........................................ 60,639 2.50 Richard A. Niglio.......................................... 41,317 1.71 Reggie Roman............................................... 14,196 *
145
BENEFICIAL OWNERSHIP(1) ---------------------------- NUMBER OF BENEFICIAL OWNER SHARES PERCENT OF TOTAL - ---------------- --------- ---------------- Eugene D. Hill, III........................................ 22,000 * Satish Tyagi............................................... 4,166 * All executive officers and directors as a group............ 963,341 39.79
- --------------- * Less than one percent. (1) Applicable percentages of ownership are based on 2,420,969 shares of PMR Common Stock outstanding on May 31, 2002, as adjusted to reflect the proposed 1-for-3 reverse stock split, and adjusted as required by rules promulgated by the SEC. Under the rules, shares are deemed to be "beneficially owned" by a person if he or she directly or indirectly has or shares the power to vote or dispose of such shares, whether or not he or she has any pecuniary interest in such shares, or if he or she has the right to acquire the power to vote or dispose of such shares within 60 days, including any right to acquire such power through the exercise of any option, warrant or right. The shares beneficially owned by Ms. Erskine and Messrs. Tepper, McGettigan, Clein, Furman, Niglio, Roman, and Hill include 18,150, 8,333, 17,333, 87,351, 20,586, 12,333, 5,862, and 12,333 shares, respectively, that may be acquired by such persons within 60 days through the exercise of stock options. The shares owned by the executive officers and directors as a group include 182,284 shares that may be acquired by such persons within 60 days through the exercise of stock options. (2) Charles C. McGettigan, a director of PMR since 1992, Jon D. Gruber, J. Patterson McBaine, and Myron A. Wick III are general partners of Proactive Investment Managers, L.P. Proactive Investment Managers, L.P. is the general partner of Proactive Partners, L.P. and Fremont Proactive Partners, L.P. Shares beneficially owned include (i) 168,943 shares held by Proactive Partners, L.P., (ii) with respect to Mr. McGettigan, 13,583 shares held by Mr. McGettigan, (iii) with respect to Messrs. Gruber and McBaine, 219,565 shares held by entities controlled by Messrs. Gruber and McBaine (which include (A) 144,582 shares held by Lagunitas Partners L.P., a limited partnership of which an entity controlled by Messrs. Gruber and McBaine is the controlling general partner and (B) 74,983 shares held by entities controlled by Messrs. Gruber and McBaine and in various accounts managed by an investment advisor controlled by Messrs. Gruber and McBaine), (iv) with respect to Mr. Gruber, 28,083 shares held by Mr. Gruber, (v) with respect to Mr. McBaine, 24,308 shares held by Mr. McBaine, and (vi) with respect to Mr. Wick, 7,691 shares held by Mr. Wick. Proactive Investment Managers, L.P. and its general partners, Messrs. McGettigan, Gruber, McBaine and Wick, share voting and investment power of the shares and may be deemed to be beneficial owners of the shares held by Proactive Partners, L.P. Messrs. McGettigan, Gruber, McBaine and Wick disclaim beneficial ownership of any shares held by Proactive Investment Managers, L.P., Proactive Partners, L.P., or other entities they control or for which they exercise voting and investment power as described above, except to the extent of their respective interests in such shares arising from their pecuniary interest in such partnerships. (3) Includes 21,541 shares over which Mr. Gruber shares ownership with his wife, 2,066 shares over which Mr. Gruber has sole voting and investment power as a trustee for a foundation, 1,333 shares over which Mr. Gruber has sole voting and investment power as a trustee of accounts for the benefit of his children and 666 shares held by Mr. Gruber's wife. (4) Includes 1,833 shares over which Mr. McBaine has shared ownership with his wife, 1,333 shares over which Mr. McBaine and his wife share voting and investment power as trustees for a foundation, 666 shares held by Mr. McBaine's child who lives with Mr. McBaine and 1,333 shares held by Mr. McBaine's child, over which shares Mr. McBaine has voting and investment power. (5) Based solely on the Schedule 13G/A filed with the SEC on February 13, 2002, J.P. Morgan Chase & Co. is the beneficial owner of 218,820 shares. J.P. Morgan Chase & Co. has sole dispositive power over, and sole power to vote or to direct voting of, such shares. 146 (6) Based solely on the Schedule 13G filed with the SEC on February 12, 2002, Dimensional Fund Advisors Inc. is the beneficial owner of 160,600 shares as a result of acting as an investment advisor to certain investment companies, commingled group trusts and separate accounts (together, the "Funds"). Dimensional Fund Advisors Inc. possesses voting and/or investment power over the shares, all of which are owned by the Funds. Dimensional Fund Advisors Inc. disclaims beneficial ownership of such shares. (7) Includes 3,025 shares held by Mr. Tepper, 285,388 shares held by Mr. Tepper as Trustee FBO Tepper Family Trust and 5,333 shares held by Mr. Tepper and Ms. Tepper as Trustees FBO The Tepper 1996 Charitable Remainder Trust UA DTD 11/19/96. (8) Includes 40,156 shares held by the Erskine Family Trust and 2,333 shares held by Ms. Erskine's spouse, William N. Erskine, who has sole voting and dispositive power over such shares and as to which Ms. Erskine disclaims beneficial ownership. 147 BENEFICIAL OWNERSHIP OF PSYCHIATRIC SOLUTIONS CAPITAL STOCK The following table provides information, as of June 28, 2002, concerning the beneficial ownership of Psychiatric Solutions common stock and Series A preferred stock and Series B preferred stock by: (1) each person or entity known by Psychiatric Solutions to beneficially own more than 5% of Psychiatric Solutions outstanding capital stock; (2) each director; (3) each executive officer; and (4) all directors and executive officers as a group. Unless otherwise indicated, each of the stockholders has sole voting and investment power with respect to the shares shown as beneficially owned by them.
AMOUNT AND NATURE OF PERCENT OF BENEFICIAL OWNERSHIP CAPITAL STOCK ---------------------------------- OUTSTANDING COMMON SERIES A SERIES B (ON AN AS-IF NAME OF BENEFICIAL OWNER STOCK PREFERRED PREFERRED CONVERTED BASIS)(1) ------------------------ --------- ---------- --------- ------------------- Charles R. F. Treadway, M.D.(2)... 1,141,761 110,000 0 5.5% Christopher Grant, Jr.(3)......... 0 500,000 287,188 3.4% Joey A. Jacobs(4)................. 1,618,441 0 8,000 7.0% Edward K. Wissing (5)............. 55,000 0 5,000 * David S. Heer(6).................. 0 4,370,000 1,946,007 27.1% Joseph P. Donlan(7)............... 1,502,140 0 0 6.2% Eileen M. More(8)................. 0 4,500,000 1,946,007 27.6% Bill F. Cook(9)................... 1,018,441 500,000 1,882,562 14.8% Steven T. Davidson(10)............ 180,000 0 0 * Jack R. Salberg(11)............... 176,000 0 0 * Jack Polson(12)................... 62,500 0 0 * Acacia Venture Partners. L.P.(6)......................... 0 4,370,000 1,946,007 27.1% Oak Investment Partners(7)........ 0 4,500,000 1,946,007 27.6% Clayton Associates LLC(8)......... 1,018,441 500,000 1,882,562 14.8% 1818 Fund Mezzanine II L.P.(7).... 1,502,140 0 0 6.2% All directors and executive officers as a group (11 persons)(13).................... 5,754,283 9,980,000 6,074,764 82.4%
- --------------- * Less than one percent (1) The percentages shown are based on 22,800,363 shares of common stock outstanding on May 31, 2002 assuming the conversion of all Series A preferred stock and Series B preferred stock. Pursuant to Rule 13d-3 under the Securities Exchange Act of 1934, as amended, shares of common stock which a person has the right to acquire pursuant to the exercise of stock options and warrants held by such holder that are exercisable within sixty (60) days of such date are deemed outstanding for the purpose of computing the percentage ownership of such person, but are not deemed outstanding for computing the percentage ownership of any other person. (2) Includes options to purchase 20,000 shares of common stock. (3) Mr. Grant is the board designee for the CGJR Group and as such is deemed to beneficially own the shares owned by the CGJR Group. Mr. Grant disclaims such beneficial ownership. The CGJR Group consists of (i) CGJR Health Care Services Private Equities, L.P. which owns 250,000 shares of Series A preferred stock and 177,417 shares of Series B preferred stock and warrants to purchase 20,120 shares of Series B preferred stock; (ii) CGJR II, L.P. which owns 160,000 shares of Series A preferred stock and 57,251 shares of Series B preferred stock; and (iii) CGJR/MF III, L.P. which owns 90,000 shares of Series A preferred stock and 32,400 shares of Series B preferred stock. (4) Includes options to purchase 400,000 shares of common stock. (5) Includes options to purchase 25,000 shares of common stock. 148 (6) Includes capital stock held by Acacia Venture Partners, L.P. which owns 4,124,000 shares of Series A preferred stock and 1,395,732 shares of Series B preferred stock and warrants to purchase 523,133 shares of Series B preferred stock; shares held by South Park Venture Partners, L.P. which owns 246,000 shares of Series A preferred stock and 20,460 shares of Series B preferred stock and warrants to purchase 762 shares of Series B preferred stock and South Pointe Venture Partners, L.P. which owns 2,542 shares of Series B preferred stock and warrants to purchase 3,378 shares of Series B preferred stock. Mr. Heer is the board designee for Acacia Venture Partners and a managing director of Acacia Venture Partners. The address for Acacia Venture Partners is 101 California Street, Suite 3160, San Francisco, California 94111. (7) Mr. Donlan is the board designee of the 1818 Fund Mezzanine II L.P. which owns a warrant to purchase 1,502,140 shares of common stock. (8) Includes shares held by Oak Investment Partners VII Limited Partnership which owns 4,389,750 shares of Series A preferred stock and 1,383,976 shares of Series B preferred stock and warrants to purchase 523,645 shares of Series B preferred stock; Oak Investment Partners VII Affiliates Fund, Limited Partnership which owns 34,758 shares of Series B preferred stock and warrants to purchase 3,628 shares of Series B preferred stock; and Oak VII Affiliates Fund, Limited Partnership which owns 110,250 shares of Series A preferred stock. Mrs. More is the board designee of Oak Investment Partners. The address for Oak Investment Partners is One Gorham Island, Westpoint, Connecticut 06880. (9) Includes shares held by Clayton Associates, LLC which owns 1,018,441 shares of common stock, 100,000 shares of Series A preferred stock and 8,400 shares of Series B preferred stock and warrants to purchase 2,520 shares of Series B preferred stock; FCA Venture Partners I, L.P. which owns 400,000 shares of Series A preferred stock and 33,600 shares of Series B preferred stock and warrants to purchase 10,080 shares of Series B preferred stock; and FCA Venture Partners II, L.P. which owns 1,604,200 shares of Series B preferred stock and warrants to purchase 223,762 shares of Series B preferred stock. Mr. Cook is the board designee of Clayton Associates and FCA. The address for Clayton Associates is 113 Seaboard Lane, Suite B-200, Franklin, Tennessee 37067 and for FCA is One Burton Hill Boulevard, Suite 180, Nashville, Tennessee 37215. (10) Includes options to purchase 180,000 shares of common stock. (11) Includes options to purchase 176,000 shares of common stock. (12) Includes options to purchase 62,500 shares of common stock. (13) Includes warrants to purchase 1,311,028 shares of Series B preferred stock and options to purchase 863,500 shares of common stock and warrants to purchase 1,502,140 shares of common stock. DIRECTORS AND OFFICERS OF COMBINED COMPANY FOLLOWING THE MERGER The board of directors and the executive officers of PMR will change as a result of the merger. PMR and Psychiatric Solutions have designated two and four individuals, respectively, who were directors of one of the companies on the date of the merger agreement, to become directors of the combined company. A seventh director will be appointed by the holders of certain subordinated convertible notes issued by Psychiatric Solutions pursuant to its pending subordinated debt financing. (See "Business of Psychiatric Solutions -- Recent Developments"). The following individuals will be the directors and officers of the combined company following the merger: DIRECTORS
NAME AGE CURRENT BOARD MEMBERSHIP - ---- --- ------------------------ Christopher Grant, Jr................................... 47 Psychiatric Solutions Charles C. McGettigan................................... 57 PMR
149
NAME AGE CURRENT BOARD MEMBERSHIP - ---- --- ------------------------ Joseph P. Donlan(1)..................................... -- Psychiatric Solutions Mark P. Clein........................................... 42 PMR Joey A. Jacobs.......................................... 48 Psychiatric Solutions Edward K. Wissing....................................... 64 Psychiatric Solutions David S. Heer........................................... 42 Psychiatric Solutions
(1) Note: Mr. Donlan joined Psychiatric Solutions' board of directors on June 28, 2002 as the designee of the holders of Psychiatric Solutions' senior subordinated notes. Christopher Grant, Jr. Mr. Grant has been a director of Psychiatric Solutions since formation. Mr. Grant was a co-founder in 1997 and remains a General Partner of Salix Ventures, a venture capital firm. Prior to founding Salix, Mr. Grant managed CGJR Health Care Services Group, a Nashville-based health care venture fund since May 1995. Mr. Grant was chief operating officer of Surgical Health Corporation from January 1994 until May 1994. Mr. Grant had been chief operating officer and director of Heritage Surgical Corporation from March 1993 until it was acquired by Surgical Health in 1994. From 1985 until its acquisition in 1989, Mr. Grant served as chief financial officer and later as president and director of MediVision. Mr. Grant then served as senior vice president and treasurer of Medical Care International, the company that acquired MediVision, until March 1993. Mr. Grant received a bachelors degree from Williams College in 1976 and a JD from Boston University in 1979. Mr. Grant currently serves on the board of several Salix Ventures portfolio companies. Charles C. McGettigan. Mr. McGettigan has been a director of PMR since 1992. Mr. McGettigan was a co-founder in November 1988 and remains a Managing Director of McGettigan, Wick & Co., Inc., an investment banking firm. He is a general partner of Proactive Investment Managers, L.P., a limited partnership which, through its holdings, is a principal stockholder of PMR. Mr. McGettigan has previously served as an investment banker with Blyth Eastman Dillon & Co. (1970-1980); Dillon, Read & Co., Inc. (1980-1982); Woodman, Kirkpatrick & Gilbreath (1983-1984); and Hambrecht & Quist (1984-1988). Mr. McGettigan serves on the Boards of Directors of Cuisine Solutions, Inc., Modtech, Inc., Onsite Energy, Sonex Research, and Tanknology -- NDE. Joseph P. Donlan. Mr. Donlan became a director of Psychiatric Solutions on June 28, 2002. Mr. Donlan is a Managing Director of Brown Brothers Harriman & Co ("BBH"), and co-manager of its 1818 Mezzanine Fund, L.P. and 1818 Mezzanine Fund II, L.P. Mr. Donlan joined BBH in 1970 and has held a variety of positions, including head of U.S. Banking and as Senior Credit Officer. In addition to his responsibilities with the 1818 Mezzanine Funds, he is a member of BBH's credit committee. Mr. Donlan is a 1968 graduate of Georgetown University and received a Masters of Business Administration from Rutgers University in 1970. Mr. Donlan is a director of Fiber Composites Corporation, National Auto Receivables Liquidation, Inc., American Tire Distributors, Inc., One Call Medical, Inc., Ranpak Corp., and Wise Foods, Inc. Additionally, he holds a visitor seat on the board of Caliber Collision Corp. Mark P. Clein. Mr. Clein has been a director of PMR since 1999. Mr. Clein has served as Chief Executive Officer of PMR since May 14, 1999, and previously served as Executive Vice President and Chief Financial Officer of PMR from May 1996 to May 1999. Prior to joining PMR, Mr. Clein was a Managing Director of Health Care Investment Banking for Jefferies & Co., an investment banking firm, from August 1995 to May 1996. Previously, Mr. Clein was a Managing Director of the investment banking firms of Rodman & Renshaw, Inc. (March 1995 to August 1995) and Mabon Securities Corp. (March 1993 to March 1995) and served as a Vice President with Sprout Group, an affiliate of Donaldson, Lufkin and Jenrette, Inc. (May 1991 to March 1993), and a Vice President and partner with Merrill Lynch Venture Capital, Inc. (1982 to February 1990 and August 1990 to February 1991). Mr. Clein holds a Masters of Business Administration degree from Columbia University and a Bachelors degree from the University of North Carolina. Joey A. Jacobs, Chairman of the Board. Mr. Jacobs serves as President and Chief Executive Officer of Psychiatric Solutions and co-founded Psychiatric Solutions in April 1997. Prior to founding Psychiatric Solutions, Mr. Jacobs served for 21 years in various capacities with Hospital Corporation of America 150 ("HCA," also formerly known as Columbia and Columbia/HCA). Most recently at HCA, Mr. Jacobs was the president of the Tennessee Division. Mr. Jacobs' background at HCA also includes serving as president of the company's Central Group, vice president of the Western Group, assistant vice president of the Central Group and assistant vice president of the Salt Lake City Division. Edward K. Wissing. Mr. Wissing has been a director of Psychiatric Solutions since August 1997. Mr. Wissing served as President and Chief Executive Officer of American HomePatient, Inc., a national provider of home health care products and services, from May 1994 until May 1998. Mr. Wissing has been actively involved in the home health care industry and has twice chaired the Health Industry Distributor's Association. Mr. Wissing serves on the Boards of Directors of American Homecare Supply, a provider of home medical equipment products and services, Care Centric, a home health care software and home care consulting provider, and Pediatric Services of America, a pediatric home care services and equipment provider. David S. Heer. Mr. Heer has been a director of Psychiatric Solutions since November 1999. Mr. Heer joined Acacia Venture Partners, a venture capital firm, at its inception in 1995 and has been a managing director since that time. Prior to joining Acacia Venture Partners, Mr. Heer was an associate at First Century Partners where he focused on the health care services sector since 1987. Prior to joining First Century Partners, Mr. Heer was a financial analyst with Intel. Mr. Heer serves on the board of several Acacia Venture Partners portfolio companies. The merger agreement designates Mr. Grant, Mr. Wissing and Mr. McGettigan as members of the audit committee. The audit committee will review and evaluate the results and scope of the audit and other services provided by the combined company's independent accountants, as well as the combined company's accounting principles and system of internal accounting controls. The merger agreement designates Mr. Grant, Mr. Heer and Mr. Jacobs as the members of the compensation committee. The compensation committee will advise, recommend and approve compensation policies, strategies, and pay levels necessary to support organizational objectives. EXECUTIVE OFFICERS Executive officers of the combined company will be elected annually by the combined company's board of directors to serve in their respective capacities until their successors are duly elected and qualified or until their earlier resignation or removal. The following will initially serve as executive officers of the combined company:
CURRENT COMPANY NAME AGE POSITION IN COMBINED COMPANY AFFILIATION - ---- --- --------------------------------------- --------------------- Joey A. Jacobs.... 48 Chief Executive Officer and President Psychiatric Solutions Steven T. 44 Chief Development Officer and Secretary Psychiatric Solutions Davidson........ Jack R. Salberg... 54 Chief Operating Officer Psychiatric Solutions Jack Polson....... 36 Controller Psychiatric Solutions
Psychiatric Solutions' Chief Financial Officer position is currently vacant. Steven T. Davidson, Chief Development Officer. Mr. Davidson has served as Chief Development Officer of Psychiatric Solutions since August 1997 and has over 19 years of health care experience. Prior to joining Psychiatric Solutions, Mr. Davidson served as the Director of Development at Hospital Corporation of America ("HCA," formerly known as Columbia and Columbia/HCA) from 1991 until 1997. Mr. Davidson also served as a Senior Audit Supervisor and Hospital Controller during his term at HCA, which began in 1983, where he supervised audits of hospitals and other corporate functions. Prior to joining HCA, Mr. Davidson was employed by Ernst and Young as a Senior Auditor. Mr. Davidson is a Certified Public Accountant and a member of the American Institute of Certified Public Accountants. Jack Salberg, Chief Operating Officer. Mr. Salberg has served as Chief Operating Officer of Psychiatric Solutions since May 2000 and has more than 29 years of operational experience in both for- 151 profit and non-profit health care sectors. Prior to joining Psychiatric Solutions, Mr. Salberg served as president and chief executive officer of Sunrise Healthcare from 1996 to 2000. In addition, Mr. Salberg served for ten years in various capacities with American Healthcorp, most recently as senior vice president with specific responsibilities for multi-facility contract management. Mr. Salberg also spent three years as head of Health Group, Inc.'s psychiatric division. In addition, Mr. Salberg was employed for four years with Humana Corporation as a hospital executive director and seven years with Arden Hill Hospital, an independent hospital, as its associate executive director. Jack E. Polson. Mr. Polson has served as the Controller of Psychiatric Solutions since June 1997. From June 1995 until joining Psychiatric Solutions, Mr. Polson served as Controller for Columbia Healthcare Network, a risk-bearing physician health organization. From May 1992 until June 1995, Mr. Polson served as an internal audit supervisor for Columbia/HCA, a hospital corporation. EXECUTIVE COMPENSATION The following table provides information about the cash and non-cash compensation during 2001 earned by or awarded to Psychiatric Solutions' chief executive officer and the other three executive officers who will remain executive officers of the combined company and whose combined salary and bonus exceeded $100,000 during 2001.
LONG-TERM COMPENSATION ------------ ANNUAL COMPENSATION AWARDS ---------------------------------------- SECURITIES NAME AND OTHER ANNUAL UNDERLYING ALL OTHER PRINCIPAL POSITIONS YEAR SALARY($) BONUS($) COMPENSATION($) OPTIONS(#) COMPENSATION($) - ------------------- ---- --------- -------- --------------- ------------ --------------- Joey A. Jacobs...................... 2001 230,000 25,000 -- -- -- Chief Executive Officer and President Steven T. Davidson.................. 2001 155,000 25,000 -- -- -- Chief Development Officer and Secretary Jack R. Salberg..................... 2001 224,640 81,389 -- -- -- Chief Operating Officer Jack Polson......................... 2001 100,000 5,000 -- -- -- Controller
Option Grants. Psychiatric Solutions did not grant any stock options to the executive officers during the year ended December 31, 2001. Option Exercise and Values. The table below provides information as to exercise of options by the executive officers during the 2001 fiscal year under the option plans and the year-end value of unexercised options. AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES
NUMBER OF NUMBER OF UNDERLYING VALUE OF UNEXERCISED SECURITIES UNEXERCISED OPTIONS/SARS IN-THE-MONEY OPTIONS/SARS UNDERLYING AT FISCAL YEAR-END AT FISCAL YEAR-END($)(1) OPTIONS VALUE --------------------------- --------------------------- NAME EXERCISED(#) REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE - ---- ------------ -------- ----------- ------------- ----------- ------------- Joey A. Jacobs........... 0 N/A 400,000 0 $100,000 $ 0 Steven T. Davison........ 0 N/A 170,000 20,000 $ 37,500 $ 0 Jack R. Salberg.......... 0 N/A 174,667 87,333 $ 0 $ 0 Jack Polson.............. 0 N/A 60,000 5,000 $ 13,750 $ 0
- --------------- (1) This amount represents the aggregate of the number of "in-the-money" options multiplied by the difference between $0.35, the fair market value of the common stock at December 31, 2001 as determined by the board of directors of Psychiatric Solutions, and the exercise price for that option. Options are classified as "in-the-money" if the market value of the underlying common stock exceeds 152 the exercise price of the option. Actual values which may be realized, if any, upon the exercise of options will be based on the per share market price of the common stock at the time of exercise and are thus dependent upon future performance of the common stock. Effective January 1, 2002, Psychiatric Solutions entered into an Amended and Restated Employment Agreement with Mr. Jacobs. Mr. Jacobs' agreement provides for an annual base salary of $230,000 and an annual cash incentive compensation award tied to objective criteria as established by the Psychiatric Solutions board of directors. The employment agreement has an initial term of one year, subject to automatic annual renewals absent prior notice from either party. Mr. Jacobs' employment agreement provides for various payments to Mr. Jacobs upon cessation of employment, depending on the circumstances. If Psychiatric Solutions terminates Mr. Jacobs' employment "Without Cause" or if he resigns pursuant to a "Constructive Discharge," then: (i) all options scheduled to vest during the succeeding 18 month period will immediately vest; (ii) any restricted stock will immediately vest; (iii) Mr. Jacobs will receive a cash payment equal to 150% of his base salary and bonus earned during the 12 months prior to termination; and (iv) all benefits and perquisites will continue for 18 months. If Psychiatric Solutions terminates Mr. Jacobs' employment for "Cause" or if Mr. Jacobs resigns other than pursuant to a "Constructive Discharge" or "Change of Control," Mr. Jacobs will only receive his earned but unpaid base salary through the date of termination. If Mr. Jacobs resigns after a "Change in Control" of Psychiatric Solutions, his employment agreement provides for Psychiatric Solutions to pay him a cash amount equal to 150% of his base salary and bonus earned during the 12 months prior to termination and to continue all benefits and perquisites for 18 months. Effective May 1, 2000, Psychiatric Solutions entered into an Employment Agreement with Mr. Salberg. Mr. Salberg's agreement provides for an annual base salary of $216,000 and an annual cash incentive compensation award tied to objective criteria as established by the Psychiatric Solutions board of directors. The employment agreement has an initial term of one year, subject to automatic annual renewals absent prior notice from either party. Mr. Salberg's employment agreement provides for various payments to Mr. Salberg upon cessation of employment, depending on the circumstances. If Psychiatric Solutions terminates Mr. Salberg's employment "Without Cause" or if he resigns pursuant to a "Constructive Discharge," then: (i) all options scheduled to vest during the succeeding 18 month period will immediately vest; (ii) any restricted stock will immediately vest; (iii) Mr. Salberg will receive a cash payment equal to 150% of his base salary and bonus earned during the 12 months prior to termination; and (iv) all benefits and perquisites will continue for 18 months. If Psychiatric Solutions terminates Mr. Salberg's employment for "Cause" or if Mr. Salberg resigns other than pursuant to a "Constructive Discharge" or "Change of Control," Mr. Salberg will only receive his earned but unpaid base salary through the date of termination. If Mr. Salberg resigns after a "Change in Control" of Psychiatric Solutions, his employment agreement provides for Psychiatric Solutions to pay him a cash amount equal to 150% of his base salary and bonus earned during the 12 months prior to termination and to continue all benefits and perquisites for 18 months. COMPARISON OF STOCKHOLDER RIGHTS GENERAL If the merger is consummated, the stockholders of Psychiatric Solutions will become stockholders of PMR except for persons who exercise their dissenters' rights. The rights of the stockholders of both PMR and Psychiatric Solutions are governed by and subject to the provisions of the Delaware General Corporation Law. The rights of current Psychiatric Solutions stockholders following the merger will be governed by the PMR charter (as described under the heading "PMR Special Meeting -- Amendment of PMR's Charter") and bylaws rather than the provisions of the Psychiatric Solutions Second Amended and 153 Restated Certificate of Incorporation, as amended, and its bylaws. The following is a brief summary of certain differences between the rights of PMR stockholders and the rights of Psychiatric Solutions stockholders, and is qualified in its entirety by reference to the relevant provisions of the Delaware General Corporation Law, the PMR charter and bylaws and the Psychiatric Solutions amended and restated certificate of incorporation and bylaws. NUMBER, CLASSIFICATION AND REMOVAL OF DIRECTORS Under the PMR bylaws, the number of directors, which is presently set at seven, is determined by resolution of the PMR Board of Directors. The PMR bylaws further provide for three classes of directors with staggered terms of three years each. Newly created directorships resulting from any increase in the authorized number of directors and any vacant directorships may be filled by a majority of the directors then in office. Subject to certain exceptions, any director (or the entire PMR Board of Directors) may be removed only for cause and only by the affirmative vote of the holders of two-thirds of the combined voting power of the then outstanding shares of stock entitled to vote generally in the election of directors, voting together as a single class. The Psychiatric Solutions Second Amended and Restated Certificate of Incorporation, as amended, provides that a majority of the holders of the outstanding preferred stock, voting as a class, must approve an increase or decrease in the number of members of the Board of Directors. The number of directors presently authorized is nine. For so long as not less than 2,700,000 shares of preferred stock is outstanding and the number of authorized members of the Board of Directors is nine or more, the preferred stock, voting as a separate class, may elect five members of the Board of Directors. The holders of preferred stock further have the authority to elect, remove and fill vacancies for such directors. The remaining four directors are elected by the common stockholders by majority vote; and the common stockholders may remove and fill vacancies created by such board members. CUMULATIVE VOTING Neither PMR's charter nor Psychiatric Solutions Second Amended and Restated Certificate of Incorporation, as amended, provides for cumulative voting rights for the election of directors or otherwise. POWER TO CALL SPECIAL MEETING The PMR bylaws provide that a special meeting of stockholders may be called at any time by the Chairman of the Board, the Chief Executive Officer, the President, or a majority of the PMR Board of Directors. Upon written request of any person or persons entitled to call a special meeting, the Secretary shall call a special meeting to be held not less than ten nor more than sixty days after the receipt of such request. The Psychiatric Solutions bylaws provide that a special meeting of the stockholders may be called for any purpose or purposes upon (i) written request from the Chairman of the Board of Directors, (ii) written request from the Chief Executive Officer, (iii) a resolution approved by a majority of the total number of authorized directors, or (iv) written request from the holders of not less than ten percent of the shares entitled to vote at the special meeting. The special meeting shall be held not less than 35 nor more than 120 days after a resolution approved by the Board of Directors or receipt by the Chairman of the Board of Directors, the Chief Executive Officer or the Secretary of a written request for a special meeting. STOCKHOLDER VOTE REQUIRED FOR CERTAIN TRANSACTIONS The PMR charter and bylaws contain no provision that would require greater than a majority of stockholders to approve mergers, consolidations, sales of a substantial amount of assets or other similar transactions. The Psychiatric Solutions Second Amended and Restated Certificate of Incorporation, as amended, requires that a majority of the holders of preferred stock, voting as a class, approve (i) a transaction in 154 which all or substantially all of the assets of Psychiatric Solutions are transferred, (ii) a consolidation, merger or reorganization in which majority control of Psychiatric Solutions is transferred, or (iii) any transaction or series of transactions in which in excess of 50% of Psychiatric Solutions' voting power is transferred. ACTION BY WRITTEN CONSENT IN LIEU OF A STOCKHOLDER MEETING The PMR charter and bylaws are silent on the issue of action by written consent. The Delaware General Corporation Law provides that, unless otherwise specified in a corporation's certificate of incorporation, any action permitted or required by law may be taken without a meeting, without prior notice and without a vote, if a consent in writing, setting forth the action taken is signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a stockholder meeting. Prompt notice of the taking of any corporate action without a meeting by less than unanimous consent shall be given to those stockholders who have not consented in writing. The Psychiatric Solutions bylaws provide that any action permitted or required by law to be taken at an annual or special meeting may be taken without a meeting, without prior notice and without a vote, if a consent in writing, setting forth the action taken is signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a stockholder meeting. Prompt notice of the taking of any corporate action without a meeting by less than unanimous consent shall be given to those stockholders who have not consented in writing. AMENDMENTS TO CERTIFICATES OF INCORPORATION Section 242 of the Delaware General Corporation Law provides that an amendment to a corporation's certificate of incorporation must be approved by the board of directors and by the affirmative vote of the holders of at least a majority of the outstanding stock entitled to vote. PMR's charter generally requires the affirmative vote of the holders of two-thirds of the combined voting power of the then outstanding shares of stock entitled to vote on any proposed amendment to the charter. However, in the event that a resolution to amend the charter is adopted by the affirmative vote of at least 80% of PMR's Board of Directors, PMR's charter requires that approval of the amendment shall only require the affirmative vote of the holders of a majority of the combined voting power of the then outstanding shares of stock entitled to vote thereon, voting as a single class. In addition to approval by a majority of the board of directors as required by Section 242 of the Delaware General Corporation Law, an amendment to the Psychiatric Solutions certificate of incorporation requires the approval of a majority of common stock holders (which includes holders of preferred stock voting on an as-converted basis). Psychiatric Solutions' Second Amended and Restated Certificate of Incorporation, as amended, provides that in the event the proposed amendment (i) affects the power, preferences, or other special rights or privileges, qualifications, limitations, or restrictions of the preferred stock, (ii) adjusts the authorized number of shares of capital stock, or (iii) authorizes or designates a new class or series of capital stock or other securities ranking pari passu with or senior to the preferred stock, a majority of the holders of outstanding preferred stock, voting as a separate class, must approve such amendment in addition to approval by the common stock holders (which includes holders of preferred stock voting on an as-converted basis). AMENDMENT TO BYLAWS The PMR bylaws provide that the PMR Board of Directors shall have the power to adopt, amend, and repeal the bylaws, subject to the right of the stockholders in certain instances to vote with respect to any such amendments. The PMR bylaws further provide that the PMR stockholders may not adopt, alter, amend, or repeal the PMR bylaws without the affirmative vote of the holders of two-thirds of the combined voting power of the then outstanding shares of stock entitled to vote on any proposed amendment. 155 The Psychiatric Solutions bylaws provide that the Psychiatric Solutions stockholders may amend the bylaws by majority vote. Psychiatric Solutions' Second Amended and Restated Certificate of Incorporation, as amended, provides that the Board of Directors may amend the bylaws at any time; provided, however, the stockholders by majority vote may change or repeal any amendment by the Board of Directors; and, provided further, no amendment to the bylaws adopted by the Board of Directors may vary or conflict with any amendment adopted by the stockholders. The Psychiatric Solutions' Second Amended and Restated Certificate of Incorporation, as amended, further provides that any amendment to the bylaws that affects the power, preferences, or other special rights or privileges, qualifications, limitations, or restrictions of the preferred stock must be approved by a majority of the holders of the preferred stock, voting as a separate class. PREFERRED STOCK There are no outstanding shares of PMR preferred stock. Psychiatric Solutions has outstanding 10,497,000 shares of Series A Preferred Stock and 4,975,736 shares of Series B Preferred Stock. PREEMPTIVE RIGHTS The Delaware General Corporation Law does not affirmatively grant stockholders preemptive rights. PMR's charter does not grant stockholders preemptive rights. Psychiatric Solutions' Second Amended and Restated Certificate of Incorporation, as amended, grants preemptive rights only pursuant to written agreement. 156 DESCRIPTION OF PMR CAPITAL STOCK The following is a summary of the material terms of the charter and bylaws concerning the capital stock of PMR. Copies of the PMR charter and PMR bylaws will be sent to holders of shares of PMR common stock and Psychiatric Solutions capital stock upon request. See "Where You Can Find More Information" on page 159. For a comparison of provisions of the PMR charter and the Psychiatric Solutions second amended and restated certificate of incorporation, as amended, see "Comparison of Stockholder Rights" on page 153. AUTHORIZED CAPITAL STOCK PMR's authorized capital stock currently consists of 19,000,000 shares of PMR common stock, par value $0.01 per share, and 1,000,000 shares of PMR preferred stock, par value $0.01 per share. These share numbers do not take into account the proposed amendments to PMR's charter described on page 140 under the heading "PMR Special Meeting -- Amendment of PMR's Charter". If the proposed amendment to PMR's charter is approved by PMR's stockholders, PMR's authorized capital stock will consist of 48,000,000 shares of PMR common stock, par value $0.01, and 2,000,000 shares of PMR preferred stock, par value $0.01. COMMON STOCK The holders of PMR common stock are entitled to one vote for each share held of record on all matters submitted to a vote of stockholders. Subject to preferences that may be applicable to any outstanding PMR preferred stock, holders of PMR common stock are entitled to receive ratably dividends as they may be declared by the PMR board out of funds legally available for dividends. In the event of a liquidation or dissolution of PMR, holders of PMR common stock are entitled to share ratably in all assets remaining after payment of liabilities and the liquidation preference of any outstanding PMR preferred stock. Holders of PMR common stock have no cumulative voting rights, no preemptive rights and have no rights to convert their PMR common stock into any other securities. All of the outstanding shares of PMR common stock are, and the shares of PMR common stock issued pursuant to the merger will be, duly authorized, validly issued, fully paid and nonassessable. PREFERRED STOCK The PMR board is authorized to designate any series of PMR preferred stock and the powers, preferences and rights of the shares of the series and the qualifications, limitations or restrictions of the series of preferred stock without further action by the holders of the PMR common stock. As of the date of this document, there were no shares of preferred stock outstanding. TRANSFER AGENT AND REGISTRAR StockTrans, Inc. is the transfer agent and registrar for the PMR common stock. STOCK EXCHANGE LISTING It is a condition of the merger that the shares of PMR common stock issuable in the merger be approved for trading on either the Nasdaq National Market or Nasdaq SmallCap Market on or prior to the effective time, subject to official notice of issuance. PMR's stock symbol will be changed to "PSYS." INDEPENDENT AUDITORS It is expected that representatives of Ernst & Young LLP will be present at each of the Special Meetings to respond to appropriate questions of stockholders and to make a statement if they so desire. 157 LEGAL MATTERS The validity of the PMR common stock to be issued to Psychiatric Solutions stockholders pursuant to the merger will be passed upon by Vinson & Elkins L.L.P., counsel to PMR. Certain tax matters relating to the merger will be passed upon for Psychiatric Solutions by Kruse & Associates, P.C. See "The Merger -- Material U.S. Federal Income Tax Consequences" and "The Merger Agreement -- Conditions to the Merger" on pages 114 and 125, respectively. EXPERTS The consolidated financial statements and the related financial statement schedule of PMR Corporation at April 30, 2002 and 2001, and for each of the three years in the period ended April 30, 2002, included in this joint proxy statement/prospectus of PMR Corporation, which is referred to and made part of this prospectus and Registration Statement, have been audited by Ernst & Young LLP, independent auditors, as set forth in their report appearing elsewhere herein, and are included in reliance upon such report given on the authority of such firm as experts in accounting and auditing. The consolidated financial statements of Psychiatric Solutions, Inc. at December 31, 2001 and 2000, and for each of the three years in the period ended December 31, 2001, included in this joint proxy statement/prospectus of PMR Corporation, which is referred to and made part of this prospectus and Registration Statement, have been audited by Ernst & Young LLP, independent auditors, as set forth in their report appearing elsewhere herein, and are included in reliance upon such report given on the authority of such firm as experts in accounting and auditing. The financial statements of Sunrise Behavioral Health, Ltd., for the four months ended April 30, 2000, included in this joint proxy statement/prospectus of PMR Corporation, which is referred to and made part of this prospectus and Registration Statement, have been audited by Ernst & Young LLP, independent auditors, as set forth in their report appearing elsewhere herein, and are included in reliance upon such report given on the authority of such firm as experts in accounting and auditing. The combined financial statements of Cypress Creek Hospital, Inc., West Oaks Hospital, Inc. and Healthcare Rehabilitation Center Of Austin, Inc., for the years ended December 31, 2000, 1999 and 1998, included in this joint proxy statement/prospectus of PMR Corporation, which is referred to and made part of this prospectus and Registration Statement, have been audited by Ernst & Young LLP, independent auditors, as set forth in their report appearing elsewhere herein, and are included in reliance upon such report given on the authority of such firm as experts in accounting and auditing. The financial statements of Holly Hill/Charter Behavioral Health System, L.L.C. for the years ended September 30, 2001 and 2000, included in this joint proxy statement/prospectus of PMR Corporation, which is referred to and made part of this prospectus and Registration Statement, have been audited by Ernst & Young LLP, independent auditors, as set forth in their report appearing elsewhere herein, and are included in reliance upon such report given on the authority of such firm as experts in accounting and auditing. The consolidated financial statements of Aeries Healthcare Corporation and its subsidiary (d/b/a Riveredge Hospital), included in this joint proxy statement/prospectus of PMR Corporation, which is referred to and made part of this prospectus and Registration Statement, have been audited by BDO Seidman, LLP, independent certified public accountants to the extent and for the periods set forth in their report appearing elsewhere herein, and are included in reliance upon such report upon the authority of said firm as experts in auditing and accounting. STOCKHOLDER PROPOSALS Any proposals of holders of common stock intended to be presented at the annual meeting of stockholders of PMR or the combined company, as the case may be, to be held in 2003 must be received by PMR or the combined company, as the case may be, at its executive offices, a reasonable time before 158 the solicitation is made, to be considered for inclusion in the proxy statement and form of proxy relating to that meeting. WHERE YOU CAN FIND MORE INFORMATION PMR files annual, quarterly and special reports, proxy statements and other information with the SEC. You may read and copy any reports, statements or other information filed by PMR at the SEC's public reference room at 450 Fifth Street, N.W., Washington, D.C. 20549, or at the SEC's public reference rooms in New York, New York and Chicago, Illinois. Please call the SEC at 1-800-SEC-0330 for further information on the public reference rooms. The filings of PMR with the SEC are also available to the public from commercial document retrieval services and at the web site maintained by the SEC at http://www.sec.gov. PMR invites you to visit its web site at http://www.pmrcorp.com, and Psychiatric Solutions invites you to visit its web site at http://www.psysolutions.com. PMR filed a registration statement on Form S-4 to register with the SEC PMR common stock to be issued to Psychiatric Solutions stockholders in the merger. This document is a part of that registration statement and constitutes a prospectus of PMR in addition to being a proxy statement of each of Psychiatric Solutions and PMR. As allowed by SEC rules, this document does not contain all the information you can find in the registration statement or the exhibits to the registration statement. 159 INDEX TO PMR CONSOLIDATED FINANCIAL STATEMENTS PMR CORPORATION Report of Independent Auditors............................ FA-2 Consolidated Balance Sheets as of April 30, 2002 and 2001................................................... FA-3 Consolidated Statements of Operations for the years ended April 30, 2002, 2001 and 2000.......................... FA-4 Consolidated Statements of Stockholders' Equity for the years ended April 30, 2002, 2001 and 2000.............. FA-5 Consolidated Statements of Cash Flows for the years ended April 30, 2002, 2001 and 2000.......................... FA-6 Notes to Consolidated Financial Statements................ FA-7 Valuation and Qualifying Accounts......................... S-1
FA-1 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Stockholders PMR Corporation We have audited the accompanying consolidated balance sheets of PMR Corporation as of April 30, 2002 and 2001, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended April 30, 2002. Our audits also included the financial statement schedule listed in the index at item 21(b). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of PMR Corporation at April 30, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended April 30, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Ernst & Young LLP San Diego, California June 21, 2002 The foregoing report is in the form that will be signed upon completion of the restatement of the capital accounts described in Note 17 to the financial statements. /s/ Ernst & Young LLP San Diego, California July 3, 2002 FA-2 PMR CORPORATION CONSOLIDATED BALANCE SHEETS
APRIL 30, --------------------------- 2002 2001 ------------ ------------ ASSETS Current assets: Cash and cash equivalents................................. $ 14,847,153 $ 13,636,122 Short-term investments, available-for-sale................ 7,767,116 4,129,364 Accounts receivable, net of allowance for doubtful accounts of $2,060,000 in 2002 and $4,992,000 in 2001................................................... 909,605 794,549 Prepaid expenses and other current assets................. 679,295 453,768 ------------ ------------ Total current assets........................................ 24,203,169 19,013,803 Furniture and office equipment, net of accumulated depreciation of $1,617,000 in 2002 and $2,400,000 in 2001...................................................... 163,842 742,754 Long-term accounts and notes receivable, net of allowance for doubtful accounts of $91,000 in 2002 and $520,000 in 2001...................................................... 407,028 1,514,482 Other long-term assets...................................... 28,166 88,035 ------------ ------------ Total assets.............................................. $ 24,802,205 $ 21,359,074 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable.......................................... $ 194,038 $ 466,564 Accrued expenses.......................................... 928,438 1,274,788 Accrued compensation and employee benefits................ 311,851 530,646 Advances from case management agencies.................... 1,944,472 1,312,187 ------------ ------------ Total current liabilities.............................. 3,378,799 3,584,185 Contract settlement reserve................................. 2,048,597 4,199,146 Note payable, long-term portion............................. -- 81,284 Other long-term liabilities................................. -- 27,360 Stockholders' equity: Convertible preferred stock, $.01 par value, authorized shares -- 1,000,000; issued & outstanding shares -- none in 2002 and 2001........................ -- -- Common stock, $.01 par value, authorized shares -- 19,000,000; issued and outstanding shares -- 2,430,006 in 2002 and 2,418,339 in 2001...... 72,650 72,550 Additional paid-in capital................................ 31,365,808 31,259,688 Notes receivable from employees and officers, net......... (373,017) (539,260) Accumulated other comprehensive income.................... 31,829 49,747 Accumulated deficit....................................... (11,526,954) (17,348,126) Treasury stock, at cost................................... (195,507) (27,500) ------------ ------------ Total stockholders' equity.................................. 19,374,809 13,467,099 ------------ ------------ Total liabilities and stockholders' equity.................. $ 24,802,205 $ 21,359,074 ============ ============
See accompanying notes. FA-3 PMR CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED APRIL 30, ----------------------------------------- 2002 2001 2000 ----------- ------------ ------------ Revenues............................................ $20,746,624 $ 17,682,291 $ 42,510,179 ----------- ------------ ------------ Expenses: Direct operating expenses......................... 16,231,237 15,287,649 34,626,858 Research and development.......................... 210,851 997,117 -- Marketing, general and administrative............. 3,902,745 8,292,006 8,561,708 Provision for (recovery of) doubtful accounts..... (3,195,115) 723,376 5,128,847 Depreciation and amortization..................... 542,993 1,361,740 1,010,415 Software development amortization................. -- 2,759,942 -- Special charge.................................... 1,070,046 1,246,425 1,432,823 ----------- ------------ ------------ Total expenses................................. 18,762,757 30,668,255 50,760,651 ----------- ------------ ------------ Interest expense.................................... (11,326) (20,625) (26,908) Interest income..................................... 616,337 1,307,743 1,491,977 ----------- ------------ ------------ Income (loss) from continuing operations before income taxes...................................... 2,588,878 (11,698,846) (6,785,403) Income tax (benefit) expense........................ (3,232,294) (929,305) 4,881,927 ----------- ------------ ------------ Net income (loss) from continuing operations........ 5,821,172 (10,769,541) (11,667,330) Results from discontinued operation -- Stadt Solutions LLC..................................... -- -- 664,011 ----------- ------------ ------------ Net income (loss)................................... $ 5,821,172 $(10,769,541) $(11,003,319) =========== ============ ============ Earnings (loss) per common share from continuing operations: Basic............................................. $ 2.42 $ (4.55) $ (5.30) ----------- ------------ ------------ Diluted........................................... $ 2.42 $ (4.55) $ (5.30) ----------- ------------ ------------ Earnings per common share from discontinued operation: Basic............................................. $ -- $ -- $ 0.30 ----------- ------------ ------------ Diluted........................................... $ -- $ -- $ 0.30 ----------- ------------ ------------ Earnings (loss) per common share : Basic............................................. $ 2.42 $ (4.55) $ (5.00) ----------- ------------ ------------ Diluted........................................... $ 2.42 $ (4.55) $ (5.00) ----------- ------------ ------------ Dividend declared per share of common stock outstanding of 2,418,339 shares on December 29, 2000 and 2,351,230 shares on January 26, 2000..... $ -- $ 3.00 $ 4.50 =========== ============ ============ Shares used in computing per share amounts: Basic............................................. 2,400,745 2,366,000 2,202,107 =========== ============ ============ Diluted........................................... 2,403,962 2,366,000 2,202,107 =========== ============ ============
See accompanying notes. FA-4 PMR CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
NOTES RECEIVABLE CONVERTIBLE FROM PREFERRED STOCK COMMON STOCK ADDITIONAL EMPLOYEES RETAINED --------------- ------------------- PAID-IN AND EARNINGS TREASURY SHARES AMOUNT SHARES AMOUNT CAPITAL OFFICERS (DEFICIT) STOCK ------ ------ --------- ------- ----------- ----------- ------------ ----------- Balance at April 30, 1999.......... -- -- 2,329,626 $69,889 $48,123,385 $ -- $ 5,400,242 $ (942,500) Acquisition of treasury stock at cost........................... -- -- -- -- -- -- -- (1,786,406) Issuance of common stock under stock option plan.............. -- -- 23,046 691 250,342 -- -- -- Reissued treasury stock under stock option plan.............. -- -- -- -- -- -- 13,326 427,822 Reissued treasury stock in exchange of notes receivable... -- -- -- -- -- (1,312,250) (988,834) 2,301,084 Proceeds from payment of employees and officers......... -- -- -- -- -- 980,250 -- -- Stock compensation expense....... -- -- -- -- 202,790 -- -- -- Dividend paid on common stock.... -- -- -- -- (10,580,534) -- -- -- Net loss......................... -- -- -- -- -- -- (11,003,319) -- Unrealized loss on short-term investments.................... -- -- -- -- -- -- -- -- Comprehensive loss............... -- -- -- -- -- -- -- -- ------ ------ --------- ------- ----------- ----------- ------------ ----------- Balance at April 30, 2000.......... -- -- 2,352,672 70,580 37,995,983 (332,000) (6,578,585) -- Acquisition of treasury stock at cost........................... -- -- -- -- -- -- -- (27,500) Issuance of common stock under stock option plan.............. -- -- 65,667 1,970 423,353 (423,260) -- -- Proceeds from payments on notes receivable from employees and officers....................... -- -- -- -- -- 216,000 -- -- Stock compensation expense....... -- -- -- -- 95,368 -- -- -- Dividend paid on common stock.... -- -- -- -- (7,255,016) -- -- -- Net loss......................... -- -- -- -- -- -- (10,769,541) -- Unrealized gain on short-term investments.................... -- -- -- -- -- -- -- -- Comprehensive loss............... -- -- -- -- -- -- -- -- ------ ------ --------- ------- ----------- ----------- ------------ ----------- Balance at April 30, 2001.......... -- -- 2,418,339 72,550 31,259,688 (539,260) (17,348,126) (27,500) Acquisition of treasury stock at cost........................... -- -- -- -- -- -- -- (168,007) Issuance of common stock......... -- -- 11,667 100 71,150 -- -- -- Proceeds from payments on notes receivable from employees and officers....................... -- -- -- -- -- 103,510 -- -- Stock compensation expense....... -- -- -- -- 34,970 -- -- -- Allowance on notes receivable.... 62,733 Net income....................... -- -- -- -- -- -- 5,821,172 -- Unrealized gain on short-term investments.................... -- -- -- -- -- -- -- -- Comprehensive income............. -- -- -- -- -- -- -- -- ------ ------ --------- ------- ----------- ----------- ------------ ----------- Balance at April 30, 2002.......... -- -- 2,430,006 $72,650 $31,365,808 $ (373,017) $(11,526,954) $ (195,507) ====== ====== ========= ======= =========== =========== ============ =========== ACCUMULATED OTHER COMPREHENSIVE TOTAL INCOME STOCKHOLDER'S (LOSS) EQUITY ------------- ------------- Balance at April 30, 1999.......... $ -- $ 52,651,016 Acquisition of treasury stock at cost........................... -- (1,786,406) Issuance of common stock under stock option plan.............. -- 251,033 Reissued treasury stock under stock option plan.............. -- 441,148 Reissued treasury stock in exchange of notes receivable... -- -- Proceeds from payment of employees and officers......... -- 980,250 Stock compensation expense....... -- 202,790 Dividend paid on common stock.... -- (10,580,534) Net loss......................... -- (11,003,319) Unrealized loss on short-term investments.................... (154,274) (154,274) ------------ Comprehensive loss............... -- (11,157,593) --------- ------------ Balance at April 30, 2000.......... (154,274) 31,001,704 Acquisition of treasury stock at cost........................... -- (27,500) Issuance of common stock under stock option plan.............. -- 2,063 Proceeds from payments on notes receivable from employees and officers....................... -- 216,000 Stock compensation expense....... -- 95,368 Dividend paid on common stock.... -- (7,255,016) Net loss......................... -- (10,769,541) Unrealized gain on short-term investments.................... 204,021 204,021 ------------ Comprehensive loss............... -- (10,565,520) --------- ------------ Balance at April 30, 2001.......... 49,747 13,467,099 Acquisition of treasury stock at cost........................... -- (168,007) Issuance of common stock......... -- 71,250 Proceeds from payments on notes receivable from employees and officers....................... -- 103,510 Stock compensation expense....... -- 34,970 Allowance on notes receivable.... 62,733 Net income....................... -- 5,821,172 Unrealized gain on short-term investments.................... (17,918) (17,918) ------------ Comprehensive income............. -- 5,803,254 --------- ------------ Balance at April 30, 2002.......... $ 31,829 $ 19,374,809 ========= ============
See accompanying notes. FA-5 PMR CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED APRIL 30, ------------------------------------------ 2002 2001 2000 ------------ ------------ ------------ OPERATING ACTIVITIES Net income (loss).................................. $ 5,821,172 $(10,769,541) $(11,003,319) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization.................... 542,993 4,121,682 1,010,415 Special charge................................... 1,070,046 1,246,425 1,432,823 Provision for (recovery of) doubtful accounts.... (3,285,820) 723,376 5,128,847 Stock compensation expense....................... 155,203 95,368 202,790 Deferred income taxes, net of valuation allowance..................................... -- -- 8,071,815 Changes in operating assets and liabilities: Accounts and notes receivable................. 4,278,218 4,633,483 11,950,486 Prepaid expenses and other assets............. (176,598) 758,395 668,018 Accounts payable and accrued expenses......... (1,418,216) (1,051,777) (2,565,844) Accrued compensation and employee benefits.... (218,795) (305,220) (1,247,216) Advances from case management agencies........ 632,285 227,991 237,843 Payable to related party...................... -- -- (3,052,610) Contract settlement reserve................... (2,150,549) (1,113,909) (1,359,672) Minority interest............................. -- -- (1,921,057) Other long-term liabilities................... (27,360) (18,613) (7,466) ------------ ------------ ------------ Net cash provided by (used in) operating activities....................................... 5,222,579 (1,452,340) 7,545,853 ------------ ------------ ------------ INVESTING ACTIVITIES Proceeds from the sale and maturity of short-term investments...................................... 6,520,601 16,980,209 15,576,782 Purchases of short-term investments................ (10,176,271) (2,325,798) (6,801,256) Software development costs......................... -- (1,187,654) (1,572,288) Purchases of furniture and office equipment, net of disposals........................................ (223,847) (391,253) (205,393) ------------ ------------ ------------ Net cash (used in) provided by investing activities....................................... (3,879,517) 13,075,504 6,997,845 ------------ ------------ ------------ FINANCING ACTIVITIES Cash dividend paid................................. -- (7,255,016) (10,580,534) Acquisition of treasury stock...................... (86,757) (27,500) (1,786,406) Issuance of common stock........................... 13,750 2,063 251,033 Issuance of treasury stock......................... -- -- 441,148 Proceeds from payments of notes receivable from employees and officers........................... 22,260 216,000 980,250 Payments on note payable to bank................... (81,284) (114,843) (97,947) ------------ ------------ ------------ Net cash used in financing activities.............. (132,031) (7,179,296) (10,792,456) ------------ ------------ ------------ Net increase in cash and cash equivalents.......... 1,211,031 4,443,868 3,751,242 Cash and cash equivalents of discontinued operation........................................ -- -- 192,166 Cash and cash equivalents at beginning of period... 13,636,122 9,192,254 5,248,846 ------------ ------------ ------------ Cash and cash equivalents at end of period......... $ 14,847,153 $ 13,636,122 $ 9,192,254 ============ ============ ============ SUPPLEMENTAL INFORMATION: Tax refund, net.................................... $ (2,570,803) $ (938,706) $ (3,624,370) Interest paid...................................... $ 11,326 $ 20,625 $ 28,521 SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES: Cancellation of note receivable from officer for treasury shares.................................. $ 81,250 $ -- $ --
See accompanying notes. FA-6 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION, BUSINESS AND PRINCIPLES OF CONSOLIDATION PMR Corporation and its subsidiaries ("PMR" or the "Company") developed and managed specialized mental health care programs and disease management services designed to treat individuals diagnosed with a serious mental illness ("SMI"), primarily schizophrenia and bipolar disorder (i.e., manic-depressive illness). The Company currently manages, administers or provides consulting services for outpatient and community-based psychiatric services for SMI patients, consisting of two outpatient programs (the "Outpatient Programs") and case management programs for a case management agency in and around the Nashville, Tennessee area (the "Case Management Programs"). During the fiscal year ended April 30, 2002, the Company continued to focus on maximizing cash flow in the Health Services Programs as it evaluated its strategic alternatives. In fiscal year 2000, the Company launched a health information business through InfoScriber Corporation ("InfoScriber"), its wholly-owned subsidiary, whose mission was to become a strategic health information company that would provide critical disease-specific information to pharmaceutical companies, providers, managed care organizations, and other health care organizations. The Company made significant progress in the completion of the software program, the signing and implementation of a group of select physicians as well as significant discussions with purchasers of the associated data. As anticipated, InfoScriber was using cash and the Company had hoped to seek additional third-party financing to fund the growth of the subsidiary. However, given the state of the capital markets and the need for significant additional investment to bring the InfoScriber subsidiary to profitability, it was determined in July 2001 that it would be in the stockholders' best interest to terminate the operations of InfoScriber. In addition, on July 31, 2001, the Company agreed to license the InfoScriber application to Conundrum Communications, Inc. on an exclusive and perpetual basis in the behavioral and social services areas. Conundrum will have the opportunity to grow the InfoScriber application in the behavioral health and social services areas while the InfoScriber subsidiary will be eligible to receive royalties for a period of five years. The Company was incorporated in the State of Delaware in 1988. The consolidated financial statements include the accounts of PMR Corporation and its wholly-owned subsidiaries, Psychiatric Management Resources, Inc., Collaborative Care Corporation and InfoScriber Corporation. The Company accounted for its consolidation in accordance with Statement of Financial Accounting Standards No. 94, Consolidation of All Majority-Owned Subsidiaries. All inter-company balances have been eliminated in consolidation. The Company does not consolidate any of the organizations it manages as it does not have operating control as defined in Emerging Issues Task Force Statement No. 97-2, Application of FASB Statement No. 94 and APB Opinion No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual Management Arrangements (EITF 97-2). RECENT OPERATING RESULTS AND LIQUIDITY The Company experienced significant losses in fiscal years 2001 and 2000. Those losses reduced the Company's equity position at April 30, 2001. Management of the Company has undertaken significant changes to its business and operations including reducing the number of Outpatient Programs managed and exiting the InfoScriber business. As a direct result of these changes plus $3.4 million in recoveries of certain accounts receivable previously provided as doubtful accounts and $3.2 million in tax benefit resulting primarily from the economic recovery stimulus package approved by the 107th Congress of the United States of America, which allowed the Company to carryback the losses for a five-year period versus a two-year period, the Company significantly improved results from operations and its financial position during fiscal year 2002. FA-7 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In May 2002, the Company announced the execution of a definitive merger agreement dated May 6, 2002, providing for the merger of a wholly-owned subsidiary of PMR with and into Psychiatric Solutions, Inc., a privately-held Delaware corporation ("PSI"), with PSI being the surviving corporation and becoming a wholly-owned subsidiary of PMR, which will be subsequently renamed PSI. In connection with the merger, PSI stockholders will exchange all warrants, preferred stock, and common stock of PSI for shares of PMR common stock. Upon completion of the merger, PSI stockholders will own approximately 72% of the combined company and PMR shareholders will own approximately 28%. The transaction will be subject to PMR stockholder approval, regulatory approval, and other customary closing conditions. In connection with the execution of the merger agreement, on May 6, 2002, the Board of Directors of PMR declared a special cash dividend in the amount of $5.10 per share, payable on May 24, 2002, to the stockholders of record as of the close of business on May 17, 2002. The total amount of the dividend that was paid on May 24, 2002 was approximately $12.3 million on approximately 2,421,000 shares outstanding on that date. Although there can be no assurances, management believes that the Company has the financial resources needed to meet its liquidity needs throughout fiscal year 2003. LEGISLATION, REGULATIONS AND MARKET CONDITIONS The Company is subject to federal, state and local government regulation relating to licensure, conduct of operations, ownership of facilities, expansion of facilities and services, and reimbursement for services. As such, in the ordinary course of business, the Company's operations are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits, and surveys, some of which may be non-routine. The Company believes that it is in substantial compliance with the applicable laws and regulations. However, if the Company is ever found to have engaged in improper practices, it could be subjected to civil, administrative or criminal fines, penalties, or restitutionary relief. CONCENTRATION OF CREDIT RISK The Company grants credit to contracting providers in various states without collateral. At April 30, 2002, the Company has net current and long term receivables aggregating approximately $1,063,000 from two providers, each of which comprise more than 10% of total net consolidated receivables. The Company monitors the credit worthiness of these customers and believes the balances outstanding, net of allowances at April 30, 2002, are fully collectible. Substantially all of the Company's cash and cash equivalents are held at five financial institutions. The Company monitors the financial status of these banks and does not believe the deposits are subject to a significant degree of risk. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures at the date of the financial statements and the amounts of revenues and expenses reported during the period. Actual results could differ from those estimates. The Company's significant accounting estimates are the allowance for doubtful accounts and the contract settlement reserve. FA-8 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of highly liquid investments with maturities, when acquired, of three months or less. Investments with original maturities of three months or less that were classified as cash equivalents totaled approximately $3.9 million and $4.2 million as of April 30, 2002 and 2001, respectively. SHORT-TERM INVESTMENTS Marketable equity securities and debt securities are classified as available-for-sale because management has the intent and ability to sell the securities prior to maturity for use in current operations. Available-for-sale securities are carried at fair value, which approximates cost, with unrealized gains and losses reported as a separate component of stockholders' equity. The cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization along with realized gains and losses, interest and dividends are included in interest income. The cost of securities sold is based on the specific identification method. DIVIDEND PAID ON COMMON STOCK No dividends were paid in fiscal year 2002. In the third quarter of fiscal year 2001, the Board of Directors declared a dividend of $7,255,016, or $3.00 per share of common stock, payable to stockholders of record on December 21, 2000. In fiscal year 2000, the Board of Directors declared a dividend of $10,580,534, or $4.50 per share of common stock, payable to stockholders of record on January 26, 2000. In connection with the execution of the merger agreement, on May 6, 2002 (See Note 1), the Board of Directors of PMR declared a special cash dividend in the amount of $5.10 per share, payable on May 24, 2002, to the stockholders of record as of the close of business on May 17, 2002. The total amount of the dividend that was paid on May 24, 2002 was approximately $12.3 million. EARNINGS PER SHARE Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings per Share, requires dual presentation of basic and diluted earnings per share by entities with complex capital structures. Basic EPS includes no dilution and is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of the entity. The Company has calculated its earnings per share in accordance with SFAS No. 128 for all periods presented. FA-9 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the computation of basic and diluted earnings per share:
YEARS ENDED APRIL 30, ---------------------------------------- 2002 2001 2000 ---------- ------------ ------------ Numerator: Net income (loss) available to common stockholders............................ $5,821,172 $(10,769,541) $(11,003,319) ========== ============ ============ Denominator: Weighted average shares outstanding for basic earnings per share................ 2,400,745 2,366,000 2,202,107 Effects of dilutive stock options and warrants outstanding.................... 3,217 -- -- Shares used in computing diluted earnings per common share........................ 2,403,962 2,366,000 2,202,107 ========== ============ ============ Earnings (loss) per common share, basic...... $ 2.42 $ (4.55) $ (5.00) ========== ============ ============ Earnings (loss) per common share, diluted.... $ 2.42 $ (4.55) $ (5.00) ========== ============ ============
No dilutive stock options and warrants were included in the computation of diluted earnings per share for the fiscal years ended April 30, 2001 and 2000 because the inclusion thereof would have had an antidilutive effect. REVENUE RECOGNITION AND CONTRACT SETTLEMENT RESERVE The Outpatient Programs that the Company currently manages or administers consist primarily of psychiatric partial hospitalization programs. In these programs, the patient is ambulatory, but requires intensive, coordinated clinical services for SMI. In general, these programs are an alternative to inpatient care. They involve patients in crisis or recovering from crisis who, thus, require more intensive clinical services than those generally available in a traditional outpatient setting. Presently, the Company's Outpatient Program Management Services are provided under a contract, which has a remaining term of two years, with an acute care hospital. This contract governs the method by which the Company provides consulting or management services, the responsibility of the hospital provider for licensure, billing, staff, insurance and the provision of health care services and the manner in which the Company will be compensated. The Company provides a program administrator or consultant, proprietary software and data systems, policies and procedures, clinical protocols and curricula and other technical and administrative information that enhance the quality of care and the efficiency of administration of the program. Prior to March 8, 2002, this contract provided for payment of fees by the hospital based on the services that the Company provides. Effective March 8, 2002, the payment of fees was converted to a fixed monthly management fee. The hospital maintains responsibility for substantially all direct program costs under this contract. The Company has been retained to manage and provide the outpatient psychiatric portion of a managed health care program funded by the State of Tennessee ("TennCare"). Under the terms of its agreements, the Company receives a monthly case rate payment from the managed care consortium responsible for managing the TennCare program, and is responsible for planning, coordinating and managing psychiatric case management to residents of Tennessee who are eligible to participate in the TennCare program using the proprietary treatment programs developed by the Company. The Company offers its case management services through long-term exclusive management agreements with leading independent providers for case management services. Pursuant to those agreements, the Company contributes its proprietary protocols and management expertise and, when necessary, negotiates case FA-10 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) management rates and contracts on behalf of the Providers. The Company may also provide training, management information systems support, and accounting and fiscal services. Presently, the Company manages programs for a case management agency in and around the Nashville, Tennessee area. Revenues under these programs were approximately $17,201,000, $14,019,000, and $13,663,000 for the years ended April 30, 2002, 2001, and 2000, respectively. The Company does not employ or bill for any services rendered by psychiatrists or other professionals whose patients are enrolled in the programs managed by the Company. Revenue under the acute outpatient psychiatric programs is recognized when services are rendered based upon contractual arrangements with providers at the estimated net realizable amounts. Under certain management contracts, the Company is obligated under warranty provisions to indemnify the Providers for all or some portions of the Company's management fees that may be disallowed as reimbursable to the Providers by Medicare's fiscal intermediaries. The Company has recorded contract settlement reserves to provide for possible amounts owed to its Providers resulting from disallowance of costs by Medicare and Medicare cost report settlement adjustments. Such reserve is classified as a non-current liability in the accompanying balance sheets as payment of these reserves is not expected to occur during fiscal year 2003. Disallowance of costs by Medicare are pertinent only for services rendered through September 30, 2000 inasmuch as the Medicare program converted to the prospective payment methodology for the reimbursement of outpatient services effective October 1, 2000. Under provisions of the indemnification clause of the Company's management contracts, the Company indemnified providers approximately $1,240,000 and $2,874,000 for the years ended April 30, 2001 and 2000, respectively. The Company was not required to indemnify any provider during fiscal year 2002. In addition, during the fourth quarter of fiscal year 2002, the Company recognized a reduction of approximately $1.7 million in contract settlement reserves due to estimated final settlement in Provider cost reports. This reduction in contract settlement reserve was recorded as an increase to net revenues for the period. During the fiscal year ended April 30, 2002, the Company recorded $3.4 million in recoveries of certain accounts receivable previously provided as doubtful accounts. The recoveries were primarily due to the collection of approximately $1.9 of previously reserved accounts receivable relating to closed outpatient programs and a change in estimate on the collectability of certain other related receivables. Stadt Solutions LLC ("Stadt Solutions") recorded pharmaceutical revenue when the product was sold to customers at pharmacies, net of any estimated contractual allowances. A substantial portion of the net revenue for Stadt Solutions was derived directly from customers insured under Medicaid or other government-sponsored health care programs. The Company sold substantially all of its interest in Stadt Solutions in fiscal year 2000. Activity related to Stadt Solutions is presented in the Company's financial statements and footnotes as a discontinued operation for all fiscal years (see Note 2). INSURANCE The Company carries "occurrence basis" insurance to cover general liability, property damage and workers' compensation risks. Medical professional liability risk is covered by a "claims made" insurance policy that provides for guaranteed tail coverage. Loss reserves for incurred by not reported medical professional liability claims are not material. STOCK OPTIONS SFAS No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), establishes the use of the fair value based method of accounting for stock-based compensation arrangements, under which compensation cost is determined using the fair value of stock-based compensation determined as of the grant date, and is recognized over the periods in which the related services are rendered. In accordance FA-11 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) with the provisions of SFAS No. 123, the Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related Interpretations in accounting for its employee stock options. Under APB 25, when the purchase price of restricted stock or the exercise price of the Company's employee stock options equals or exceeds the fair value of the underlying stock on the date of issuance or grant, no compensation expense is recognized. In accordance with SFAS No. 123, the Company has presented pro forma disclosures of net income and earnings per share as if SFAS No. 123 had been applied. COMPREHENSIVE INCOME (LOSS) The Company follows SFAS No. 130, Reporting Comprehensive Income, which requires that all components of comprehensive income, including net income, be reported in the financial statements in the period in which they are recognized. Comprehensive income is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Net income (loss) and other comprehensive income (loss), including foreign currency translation adjustments and unrealized gains and losses on investments, shall be reported, net of their related tax effect, to arrive at comprehensive income (loss). The Company reports comprehensive income (loss) as a separate component of Stockholders' Equity. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the FASB issued SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are viewed annually for impairment, or more frequently if impairment indicators arise. Separable intangible assets that are not deemed to have indefinite lives will continue to be amortized over their useful lives. The Company had no acquired goodwill or intangible assets at April 30, 2002 or 2001 and, thus, the adoption of these new standards had no impact. In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which establishes one accounting model to be used for long-lived assets to be disposed of by sale and broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The Company does not believe the adoption of SFAS No. 144 will have a significant effect on its financial statements. 2. DISCONTINUED OPERATION During fiscal year 2000, the Company sold substantially all of its interest in Stadt Solutions, a majority owned subsidiary owned partially by Stadt Holdings (formerly Stadtlander Drug Distribution Co., Inc.). Stadt Solutions comprised the Company's entire pharmaceutical segment. The transaction, which effected the sale of the Company's ownership interest in Stadt Solutions, resulted in cash proceeds of FA-12 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) approximately $3.3 million and a gain of approximately $664,000, net of fiscal year 2000 operating losses. The operating results of the discontinued operation are summarized as follows:
YEAR ENDED APRIL 30, 2000 -------------- Net revenue................................................. $26,878,254 ----------- Loss before minority interest and income tax benefit........ (2,773,570) Minority interest........................................... 1,384,011 ----------- Net loss.................................................... $(1,389,559) ===========
Net current assets and net long-term liabilities of the discontinued operation have been reported as a separate component of the consolidated balance sheets for all years presented. Net results of operation for the discontinued operation have been reported as a separate component of the consolidated statements of operations for all years presented. There were no discontinued operations during fiscal years 2002 and 2001. 3. INVESTMENTS The following is a summary of available-for-sale securities, stated at fair value:
APRIL 30, ----------------------- 2002 2001 ---------- ---------- U.S. government securities.................................. $5,558,178 $3,876,999 Commercial paper............................................ 2,208,938 252,365 ---------- ---------- Total debt securities....................................... $7,767,116 $4,129,364 ========== ==========
At April 30, 2002 all investments contain contractual maturities of two years or less. The balance sheet classification as short-term available-for-sale securities is based on management's intentions rather than actual maturity dates. Therefore, classification of these securities may differ from stated maturities. As management has the ability and intent to sell these available-for-sale securities prior to maturity and views the portfolio as available for use in current operations, the investments are classified as current at April 30, 2002. Unrealized holding gains, reported as other comprehensive income in accordance with SFAS No. 130 (see Note 1), totaled approximately $32,000 and $50,000 at April 30, 2002 and 2001, respectively. 4. CAPITALIZED SOFTWARE DEVELOPMENT During the years ended April 30, 2001 and 2000, the Company recorded capitalized software development costs in accordance with FASB Statement No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, and related interpretations. Capitalized software development costs consist primarily of consulting fees and salaries and benefits for in-house programmers incurred by the newly established InfoScriber subsidiary. Amortization commenced upon completion and commercial release of the software in August 2000. Research for and development of Version 2 of the InfoScriber medication management software started immediately after completion of Version 1. Version 2 was expected to completely replace Version 1 and was anticipated to be technically feasible shortly after April 30, 2001. Accordingly, the Company amortized the total capitalized cost of Version 1 of approximately $2.8 million through April 30, 2001. In July 2001, after exploring numerous strategic alternatives, the Company terminated the operations of its InfoScriber subsidiary and licensed the InfoScriber application to Conundrum Communications, Inc. ("Conundrum") on an exclusive and perpetual basis in the behavioral and social services areas. FA-13 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 5. LONG TERM RECEIVABLES Long-term receivables consist of amounts due from certain officers for related tax liabilities (see Note 10). 6. FURNITURE AND OFFICE EQUIPMENT Furniture and office equipment consist of the following at April 30:
2002 2001 ----------- ----------- Furniture and equipment.................................... $ 1,573,680 $ 2,857,193 Leasehold improvements..................................... 206,849 285,448 ----------- ----------- 1,780,529 3,142,641 Accumulated depreciation................................... (1,616,687) (2,399,887) ----------- ----------- $ 163,842 $ 742,754 =========== ===========
Furniture and office equipment are stated at cost and are depreciated over their estimated useful lives using the straight-line method over terms of three to five years. Depreciation expense from continuing operations was approximately $532,000, $1,173,000, and $898,000 for the years ended April 30, 2002, 2001, and 2000, respectively. 7. OTHER LONG-TERM ASSETS Other long-term assets consist of the following at April 30:
2002 2001 --------- --------- Proprietary information and covenants not to compete........ $ 225,000 $ 225,000 Other....................................................... 178,268 227,197 --------- --------- 403,268 452,197 Amortization................................................ (375,102) (364,162) --------- --------- $ 28,166 $ 88,035 ========= =========
Other assets are amortized using the straight-line method over their estimated useful lives. The estimated useful life of proprietary information and covenants not to compete is five to ten years. Amortization expense from continuing operations was approximately $11,000, $189,000, and $112,000 for the fiscal years ended April 30, 2002, 2001, and 2000, respectively. 8. BORROWINGS EQUIPMENT NOTE PAYABLE The Company has a promissory note for the purchase of office furniture, fixtures, and equipment. The note is collateralized by all assets acquired with proceeds from the loan. The note matures in November 2002 and requires principal and interest payments due monthly with interest accruing at 8.36%. The balance outstanding under this note was approximately $72,000 and $188,000 at April 30, 2002 and 2001, respectively for which the current portion is included in accrued expenses and the long-term portion is included in other long-term liabilities. FA-14 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. STOCK OPTIONS AND WARRANTS The Company's 1997 Equity Incentive Plan, as amended (the "1997 Plan") provides for the granting of options to purchase up to 1,333,333 shares of common stock to eligible employees. Under the 1997 Plan, options may be granted for terms of up to ten years and are generally exercisable in cumulative annual increments of 20% each year, commencing one year after the date of grant. The 1997 Plan also provides for the full vesting of all outstanding options under certain change of control events. Option prices must equal or exceed the fair market value of the common shares on the date of grant. The termination date of the 1997 Plan is October 6, 2008. The Company has a non-qualified stock option plan for its outside directors (the "1992 Plan"). The 1992 Plan provides for the Company to grant each outside director options to purchase 5,000 shares of the Company's common stock annually at the fair market value at the date of grant. As amended, options for a maximum of 341,667 shares may be granted under this plan. The options vest 30% immediately and in ratable annual increments over the three-year period following the date of grant. In 1997, the Board of Directors amended the 1992 Plan to provide for full vesting of all outstanding options under certain change of control events. During fiscal year 2000, the Company recognized $142,500 compensation expense related to stock options issued to certain officers with exercise prices below fair market value. WARRANTS In September 1995, the Company granted rights to earn up to 16,667 warrants to a case management agency in connection with a Management and Affiliation Agreement. The warrants may be earned in each of the five years beginning May 1997 only if certain financial performance criteria are met. The exercise price is equal to the average closing price of the Company's common stock for the ten day period prior to April 30 for the year in which the warrants are earned. As of April 30, 2002, no warrants were earned under the agreement. Rights to earn 13,333 of the warrants were expired at April 30, 2001. In November 1996, the Company granted warrants to purchase a total of 10,000 shares of common stock to the case management agency discussed above. The warrants are exercisable in increments of 1,667 shares per year for six years beginning May 1997. The exercise price is equal to the average closing price of the Company's common stock for the ten day period prior to April 30 for the covered year. As of April 30, 2002, warrants to purchase 8,333 shares of the Company's stock were outstanding at prices ranging from $4.20 to $57.56. The warrants expire in September 2002. In March 2000, warrants to purchase 333 shares of the Company's common stock were issued to an outside party at an exercise price of $13.50. The warrants are immediately exercisable and expire in March 2005. None of the warrants were exercised as of April 30, 2002. In March 2000, the Company granted rights to an outside party to earn up to 3,333 warrants to purchase the Company's common stock. The exercise price of the warrants is $14.82. The warrants are earned only if certain criteria are met by the outside party. Upon being earned, the warrants are exercisable at a rate of 33.3% on the first day of the calendar quarter following each of the first, second and third anniversary of their respective effective dates. The warrants expire the earlier of five years from the date of grant or on the date the Membership Agreement with the outside party is terminated. Warrants to purchase 166 shares of the Company's common stock expired during fiscal year 2002. FA-15 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A summary of the Company's stock option and warrant activity and related information is as follows:
WEIGHTED-AVERAGE SHARES EXERCISE PRICE --------- ---------------- Outstanding April 30, 1999................................ 892,470 $20.04 Granted................................................. 354,333 7.53 Exercised............................................... (281,380) 7.14 Forfeited............................................... (304,158) 18.81 --------- Outstanding April 30, 2000................................ 661,265 19.14 Granted................................................. 187,033 6.57 Exercised............................................... (65,667) 6.48 Forfeited............................................... (133,778) 15.78 --------- Outstanding April 30, 2001................................ 648,853 17.49 Granted................................................. 21,667 4.48 Exercised............................................... (3,333) 4.13 Forfeited............................................... (196,971) 17.65 --------- Outstanding April 30, 2002................................ 470,216 16.92 =========
At April 30, 2002, options and warrants to purchase 259,787 and 8,666 shares of common stock, respectively, were exercisable. Shares available for future grant under the 1997 and 1992 Plans totaled 875,590 at April 30, 2002. The weighted-average fair value of options and warrants granted was $2.92, $4.59, and $5.10 for the fiscal years ended April 30, 2002, 2001, and 2000, respectively. A summary of options and warrants outstanding and exercisable at April 30, 2002 follows:
WEIGHTED- OPTIONS WEIGHTED- AVERAGE OPTIONS WEIGHTED- AND AVERAGE REMAINING AND AVERAGE WARRANTS EXERCISE PRICE EXERCISE CONTRACTUAL WARRANTS EXERCISE OUTSTANDING RANGE PRICE LIFE EXERCISABLE PRICE - ----------- --------------- --------- ----------- ----------- --------- 60,000 $ 4.20 - $ 6.00 $ 4.81 8.2 10,334 $ 4.83 89,917 7.32 - 10.50 9.24 6.4 45,267 9.18 74,869 11.25 - 14.25 14.04 3.6 74,169 14.04 197,070 14.81 - 24.00 21.63 5.4 90,323 22.05 45,026 29.25 - 30.00 30.00 3.7 45,026 30.00 3,334 46.39 - 57.56 51.98 0.3 3,334 51.98 - ----------- ------ --- ------- ------ 470,216 16.92 5.5 268,453 18.71 =========== =======
Adjusted pro forma information regarding net income and net income per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options and stock purchase plan under the fair value method of SFAS 123. The fair value for these options was FA-16 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) estimated at the date of grant using the "Black-Scholes" method for option pricing with the following weighted-average assumptions for fiscal years 2002, 2001, and 2000:
2002 2001 2000 ---- ---- ---- Expected life (years)....................................... 5.0 5.0 5.0 Risk-free interest rate..................................... 4.61% 5.75% 6.12% Annual dividend yield....................................... -- -- -- Volatility.................................................. 70.0% 82.6% 70.0%
For purposes of pro forma disclosures, the estimated fair value of the options granted is amortized to expense over the options' vesting period. The Company's pro forma information for the years ended April 30, 2002, 2001, and 2000 follows:
2002 2001 2000 ---------- ------------ ------------ Pro forma net income (loss).................. $4,934,200 $(12,162,678) $(11,712,350) Pro forma net earnings (loss) per share, basic...................................... 2.06 (5.14) (5.32) Pro forma net earnings (loss) per share, diluted.................................... 2.05 (5.14) (5.32)
10. NOTES RECEIVABLE FROM EMPLOYEES AND OFFICERS In fiscal year 2001 and 2000, the Company loaned approximately $423,000 and $1.3 million, respectively, to certain employees and officers of the Company for the purchase of stock pursuant to the exercise of stock options ("Stock Notes"). The notes receivable are recorded as a separate component of stockholders' equity in the accompanying balance sheets and totaled approximately $373,000 and $539,000 at April 30, 2002 and 2001, respectively. The notes for purchase of stock are with recourse in addition to being collateralized by stock under the respective pledge agreements. The Company also made available loans of approximately $451,000 to certain officers for related tax liabilities ("Tax Notes"). The notes receivable plus accrued interest are included in long-term accounts and notes receivable in the accompanying balance sheets and totaled approximately $407,000 and $451,000 at April 30, 2002 and 2001, respectively. The notes for related tax liabilities are without recourse. The notes are collateralized by stock under their respective pledge agreements. Effective May 1, 2002, the notes were amended to include a provision that allows the principal and interest on the notes to be paid, at anytime prior to December 31, 2003, through the delivery to the Company of PMR common stock valued at the higher of (i) a fixed amount or (ii) the average closing sales prices of PMR common stock for the five trading days prior to the delivery of such stock. As of April 30, 2002, the Company's stock price was below the fixed amount stated above. As such, the Company recorded allowances on the Stock Notes and Tax Notes of approximately $63,000 and $91,000, respectively, as of April 30, 2002. 11. INCOME TAXES Income tax (benefit) expense consists of the following:
2002 2001 2000 ----------- --------- ----------- Federal: Current...................................... $ (87,000) $(741,000) $(1,000,000) Deferred..................................... (3,379,000) -- 4,653,000 ----------- --------- ----------- (3,466,000) (741,000) 3,653,000 ----------- --------- -----------
FA-17 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2002 2001 2000 ----------- --------- ----------- State: Current...................................... -- (188,000) -- Deferred..................................... 234,000 -- 1,229,000 ----------- --------- ----------- 234,000 (188,000) 1,229,000 ----------- --------- ----------- $(3,232,000) $(929,000) $ 4,882,000 =========== ========= ===========
At April 30, 2002, the Company had federal and state tax net operating loss carryforwards of approximately $6,822,000 and $10,567,000, respectively. The federal and state tax loss carryforwards will begin to expire in 2020 and 2003, respectively, unless previously utilized. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance has been recognized in fiscal years 2002 and 2001 as realization of such assets is uncertain due primarily to changes in the Company's core business and associated business risks. Significant components of the Company's deferred tax assets and liabilities at April 30 are as follows:
2002 2001 ---------- ------------ Deferred tax assets: Allowance for bad debts.................................... $1,761,000 $ 2,388,000 Contract settlement reserve................................ 835,000 1,711,000 Other...................................................... 90,000 445,000 Depreciation and amortization.............................. 907,000 692,000 Net operating loss carryforwards........................... 2,996,000 7,899,000 Special charge............................................. 83,000 130,000 ---------- ------------ Total deferred tax assets.................................. 6,672,000 13,265,000 ---------- ------------ Deferred tax liabilities: Right to bill.............................................. -- 633,000 Non-accrual experience method.............................. 163,000 2,335,000 ---------- ------------ Total deferred tax liabilities............................. 163,000 2,968,000 ---------- ------------ Net deferred tax asset before valuation allowance.......... 6,509,000 10,297,000 Valuation allowance for deferred tax assets................ (6,509,000) (10,297,000) ---------- ------------ Net deferred tax asset..................................... $ -- $ -- ========== ============
FA-18 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A reconciliation between the federal income tax rate and the effective income tax rate is as follows:
YEAR ENDED APRIL 30, ---------------------- 2002 2001 2000 ---- ---- ---- Statutory federal income tax rate........................... 34% (41)% (35)% State income taxes, net of federal tax benefit.............. 0% (2)% (6)% Permanent differences....................................... 4% 0% 0% Net operating loss carryback................................ (125)% 0% 0% Change in valuation allowance............................... (38)% 35% 0% Net effect of valuation of deferred tax assets.............. 0% 0% 121% ---- --- --- (125)% (8)% 80% ==== === ===
12. CUSTOMERS The Company's consolidated revenues, net of the effect of a $1.7 million reduction in contract settlement reserve (see Note 1), was approximately $19.0 million for the fiscal year ended April 30, 2002. Approximately 90% of such revenues relate to programs for a case management agency in and around the Nashville, Tennessee area. Approximately 2% of this $19.0 million in consolidated revenues was for a case management contract in Memphis, Tennessee that terminated on June 1, 2002. Revenues from the two continuing outpatient psychiatric programs accounted for the balance of the Company's consolidated revenues. There were no outpatient psychiatric care providers responsible for 10% or more of the Company's consolidated revenues from continuing operations in fiscal years 2002 and 2001. Individual providers responsible for ten percent or more of the Company's consolidated revenues from continuing operations totaled 32% in fiscal year 2000. 13. EMPLOYEE BENEFITS The Company maintains a tax deferred retirement plan under Section 401(k) of the Internal Revenue Code for the benefit of all employees meeting minimum eligibility requirements. Under the plan, each employee may defer up to 15% of pre-tax earnings, subject to certain limitations. The Company will match 50% of an employee's deferral to a maximum of 3% of the employee's gross salary. The Company's matching contributions vest over a five-year period. For the years ended April 30, 2002, 2001, and 2000, the Company contributed approximately $39,000, $116,000, and $236,000, respectively, to match employee deferrals. 14. COMMITMENTS AND CONTINGENCIES LEASES The Company leases its corporate headquarters in San Diego under a non-cancelable leasing arrangement for $6,000 per month, which expires on September 30, 2002. The Company also leases certain equipment under operating lease agreements. At April 30, 2002, future minimum lease payments for all operating leases with initial terms of one year or more are approximately $30,000 for the fiscal year ended April 2003. Rent expense from continuing operations totaled approximately $283,000, $427,000, and $2,052,000 for the years ended April 30, 2002, 2001, and 2000, respectively. FA-19 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) LITIGATION The Company is a party to various potential litigation claims and legal proceedings arising in the normal course of business. In management's opinion, the outcome of these proceedings is not expected to have a material adverse effect on the Company's consolidated financial position, results of operations, or cash flows. 15. SPECIAL CHARGE (CREDIT) A summary of the special charge for the year ended April 30, 2002 is as follows: Severance................................................... $ 736,722 Write-off of property and equipment......................... 39,722 Other costs................................................. 293,602 ---------- Total special charge........................................ $1,070,046 ==========
The special charge in fiscal year 2002 resulted primarily from the termination of the InfoScriber operations and the related reduction in administrative overhead costs. The components of the special charge in fiscal year 2002 consist of severance for terminated employees, costs for non-cancelable facility lease commitments, write-offs of additional office furniture and equipment, and other miscellaneous charges. A summary of the special charge for the year ended April 30, 2001 is as follows: Severance................................................... $ 600,164 Write-off of property and equipment......................... 561,647 Other costs................................................. 84,614 ---------- Total special charge........................................ $1,246,425 ==========
The special charge in fiscal year 2001 resulted primarily from management's decision to close 14 programs, reduce administrative overhead during the fiscal year, and the impairment charge recognized on InfoScriber's furniture, equipment, and certain other current assets under the provisions of SFAS No. 121. The components of the exit costs resulting from closing Outpatient Program locations and reducing operations and administrative overhead consist of severance for terminated employees, costs for non-cancelable facility lease commitments, write-offs of office furniture and equipment, and other miscellaneous charges. A summary of the special charge for the year ended April 30, 2000 is as follows: Severance................................................... $ 800,349 Lease costs................................................. 371,166 Write-off of property and equipment......................... 177,826 Other costs................................................. 83,482 ---------- Total special charge........................................ $1,432,823 ==========
The special charge in fiscal year 2000 resulted primarily from management's decision to close 26 programs and reduce administrative overhead during the year. The components of the exit costs resulting from closing program locations and reducing administrative overhead consist of severance for terminated employees, costs for non-cancelable facility lease commitments, write-offs of office furniture and equipment, and other miscellaneous charges. FA-20 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Components of the accrued special charge at April 30, 2002 are as follows: Non-cancelable lease costs.................................. $117,000 Severance................................................... 38,000 Other costs................................................. 48,000 -------- Accrued special charges, April 30, 2002..................... $203,000 ========
Components of the accrued special charge at April 30, 2001 are as follows: Non-cancelable lease costs.................................. $ 95,000 Severance................................................... 148,000 Other costs................................................. 22,000 -------- Accrued special charges, April 30, 2001..................... $265,000 ========
Accruals for special charges are included in the accompanying balance sheets as a component of accrued expenses. An analysis of the accrual activity during fiscal year 2002 is as follows: Accrued special charges, April 30, 2001..................... $265,000 Lease costs, net.......................................... 22,000 Severance, net............................................ (110,000) Other, net................................................ 26,000 (62,000) -------- Accrued special charges, April 30, 2002..................... $203,000 ========
An analysis of the accrual activity during fiscal year 2001 is as follows: Accrued special charges, April 30, 2000..................... $ 376,000 Impaired long-term assets, net............................ (14,000) Lease costs, net.......................................... (97,000) Severance, net............................................ 15,000 Other, net................................................ (15,000) (111,000) --------- Accrued special charges, April 30, 2001..................... $ 265,000 =========
16. RELATED PARTY In January 2001, the Company retained McGettigan, Wick & Co. Inc., a principal of which holds a seat in the Company's Board of Directors, to provide financial advisory services to the management and Board of Directors of the Company relative to the structuring, evaluation, negotiation, documentation, and closing of strategic alternatives for the Company. The fee for providing such services was $10,000, payable for three months commencing in February 2001, plus out-of-pocket expenses. Also due and payable upon consummation of any sale or merger of, acquisition by, or third-party financing for the Company will be an advisory fee equal to 5% of the consideration received or paid by the Company. The aggregate retainer fee of $30,000 will be credited against the advisory fee. If the Company were the acquiror, the advisory fee of $270,000 will be paid upon closing of the transaction. FA-21 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 17. REVERSE STOCK SPLIT In connection with and as a condition to the proposed merger discussed in Note 1, the Company is also proposing an amendment to its charter in order to effect a proposed 1-for-3 reverse stock split. The reverse stock split will be subject to PMR stockholder approval. All shares and per share amounts have been retroactively restated for all periods presented to reflect this reverse stock split. 18. DISCLOSURES ABOUT REPORTABLE SEGMENTS In accordance with the criteria of SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company determined that it operates in two reportable segments: Health Services Business and Health Information Business. The Company's reportable segments are strategic business units that offer different services to a variety of inpatient and outpatient recipients and healthcare industry participants. The Health Services Business segment consists of two Outpatient Programs and two Case Management Programs. Under the Health Information Business, the Company has licensed its software application to Conundrum Communications, Inc. ("Conundrum") in exchange for eligibility to receive royalties for a period of five years. The Company does not anticipate incurring any further costs associated with the Health Information Business. Accounting policies of segments are the same as those described in Note 1. There are no intersegment revenues. All revenues are derived from services performed in the United States. Activities classified as Other in the following schedule relate primarily to unallocated home office items. Assets for Outpatient Programs, Case Management Programs, and Health Information segment consist primarily of cash, accounts receivable, furniture and office equipment, and intangible assets. The Company evaluates the performance of each reportable segment based on income (loss) from operations before income taxes.
CASE HEALTH OUTPATIENT MANAGEMENT INFORMATION PROGRAMS PROGRAMS BUSINESS OTHER TOTAL ----------- ----------- ----------- ------------ ----------- 2002 Revenues................. $ 3,106,813 $17,639,811 $ -- $ -- $20,746,624 Operating profit (loss)................ 2,458,442 1,917,519 (801,488) (3,172,682) 401,791 Depreciation and amortization.......... 4,273 235,096 -- 303,624 542,993 Special charge........... -- -- 658,223 411,823 1,070,046 Net interest income...... -- 48,069 56,346 500,596 605,011 Income (loss) from continuing operations before income taxes... 5,649,284 1,730,492 (1,403,365) (3,387,533) 2,588,878 Total assets.......... 725,358 1,105,944 1,763,524 21,207,379 24,802,205 ----------- ----------- ----------- ------------ -----------
FA-22 PMR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
CASE HEALTH OUTPATIENT MANAGEMENT INFORMATION PROGRAMS PROGRAMS BUSINESS OTHER TOTAL ----------- ----------- ----------- ------------ ----------- 2001 Revenues................. $ 3,265,169 $14,417,122 $ -- $ -- $17,682,291 Operating profit (loss)................ 1,629,151 1,321,783 (5,091,671) (4,753,744) (6,894,481) Depreciation and amortization.......... 33,361 648,758 2,817,217 622,346 4,121,682 Special charge........... 249,571 -- 851,592 145,262 1,246,425 Net interest income...... -- 112,063 382,228 792,827 1,287,118 Income (loss) from continuing operations before income taxes... 1,513,628 141,672 (8,378,252) (4,975,894) (11,698,846) Total assets.......... 3,502,460 1,681,523 3,707,182 12,467,909 21,359,074 ----------- ----------- ----------- ------------ ----------- 2000 Revenues................. $26,861,993 $14,298,819 $ -- $ 1,349,367 $42,510,179 Operating profit (loss)................ 7,412,352 1,693,444 (1,296,519) (8,487,664) (678,387) Depreciation and amortization.......... 232,162 266,109 7,617 504,527 1,010,415 Special credit........... 1,432,823 -- -- -- 1,432,823 Net interest income...... -- -- -- 1,465,069 1,465,069 Income (loss) from continuing operations before income taxes... 5,672,808 748,586 (1,304,136) (11,902,661) (6,785,403) Total assets.......... 4,788,180 2,601,569 1,691,066 31,654,747 40,735,562 ----------- ----------- ----------- ------------ -----------
19. UNAUDITED QUARTERLY FINANCIAL INFORMATION The following table presents unaudited quarterly financial information for the eight quarters ended April 30, 2002. Management believes this information reflects all adjustments (consisting of normal recurring adjustments) that they consider necessary for a fair presentation with accounting principles generally accepted in the United States. The results for any quarter are not necessarily indicative of results for any future period:
QUARTERS FOR THE YEARS ENDED, ------------------------------------------------------------------------------- APRIL 30, 2002 APRIL 30, 2001 -------------------------------------- -------------------------------------- UNAUDITED UNAUDITED -------------------------------------- -------------------------------------- 4/30/02 1/31/02 10/31/01 7/31/01 4/30/01 1/31/01 10/31/00 7/31/00 ------- ------- -------- ------- ------- ------- -------- ------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Revenues............... $6,422 $4,887 $4,933 $ 4,505 $ 4,137 $ 4,100 $ 4,263 $5,182 Net income (loss)...... 4,320 2,051 948 (1,498) (3,725) (2,869) (2,523) (1,653) Net income (loss) per share: Basic................ 1.81 0.86 0.39 (0.62) (1.53) (1.20) (1.08) (0.72) Diluted.............. 1.80 0.85 0.39 (0.62) (1.53) (1.20) (1.08) (0.72)
FA-23 SCHEDULE II PMR CORPORATION VALUATION AND QUALIFYING ACCOUNTS
COL. A COL. B COL. C COL. D COL. E ------ ------------ ---------- ------------- ---------- ADDITIONS BALANCE AT CHARGED TO BALANCE AT BEGINNING OF COSTS AND DEDUCTIONS -- END OF DESCRIPTION PERIOD EXPENSES DESCRIBE PERIOD - ----------- ------------ ---------- ------------- ---------- YEAR ENDED APRIL 30, 2002 Allowance for doubtful accounts........... $ 5,512,329 $ 389,340 $3,688,354(1) 2,213,315 Contract settlement reserve............... 4,199,146 -- 2,150,549(2) 2,048,597 YEAR ENDED APRIL 30, 2001 Allowance for doubtful accounts........... 7,142,662 723,376 2,353,709(1) 5,512,329 Contract settlement reserve............... 5,313,055 41,973 1,155,882(2) 4,199,146 YEAR ENDED APRIL 30, 2000 Allowance for doubtful accounts........... 10,781,138 5,128,847 8,767,323(1) 7,142,662 Contract settlement reserve............... 6,672,727 1,945,806 3,305,478(2) 5,313,055
- --------------- (1) Uncollectible accounts written-off, net of recoveries and reclassification of allowance from contract settlement reserve. (2) Contract settlement reserve written-off and reclassified to allowance for doubtful accounts. S-1 INDEX TO PSYCHIATRIC SOLUTIONS CONSOLIDATED FINANCIAL STATEMENTS PSYCHIATRIC SOLUTIONS, INC. Report of Independent Auditors............................ FB-2 Consolidated Balance Sheets as of December 31, 2001 and 2000 and as of March 31, 2002.......................... FB-3 Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999 and for the three months ended March 31, 2002 and 2001................... FB-4 Consolidated Statements of Stockholders' Deficit for the years ended December 31, 2001, 2000 and 1999 and the three months ended March 31, 2002...................... FB-5 Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999 and the three months ended March 31, 2002 and 2001.......................... FB-6 Notes to Consolidated Financial Statements................ FB-8 CYPRESS CREEK HOSPITAL, INC., WEST OAKS HOSPITAL, INC. AND HEALTHCARE REHABILITATION CENTER OF AUSTIN, INC. Report of Independent Auditors............................ FB-26 Combined Statements of Operations for the years ended December 31, 2000, 1999 and 1998 and for the six months ended June 30, 2001 and 2000........................... FB-27 Combined Statements of Cash Flows for the years ended December 31, 2000, 1999 and 1998 and the six months ended June 30, 2001 and 2000........................... FB-28 Notes to Combined Financial Statements.................... FB-29 HOLLY HILL/CHARTER BEHAVIORAL HEALTH SYSTEM, L.L.C. Report of Independent Auditors............................ FB-33 Statements of Operations for the years ended September 30, 2001 and 2000.......................................... FB-34 Statements of Cash Flows for the years ended September 30, 2001 and 2000.......................................... FB-35 Notes to Financial Statements............................. FB-36 SUNRISE BEHAVIORAL HEALTH, LTD. Report of Independent Auditors............................ FB-40 Statement of Operations for the four months ended April 30, 2000............................................... FB-41 Statement of Cash Flows for the four months ended April 30, 2000............................................... FB-42 Notes to Financial Statements............................. FB-43 RIVEREDGE/AERIES HEALTHCARE CORPORATION Report of Independent Certified Public Accountants........ FB-47 Consolidated Balance Sheets as of December 31, 2001 and 2000 and as of March 31, 2002.......................... FB-48 Consolidated Statements of Operations for the year ended December 31, 2001 and the ten months ended December 31, 2000 and for the three months ended March 31, 2002 and 2001................................................... FB-49 Consolidated Statements of Stockholders' Equity for the year ended December 31, 2001 and the ten months ended December 31, 2000 and for the three months ended March 31, 2002 and 2001...................................... FB-50 Consolidated Statements of Cash Flows for the year ended December 31, 2001 and the ten months ended December 31, 2000 and for the three months ended March 31, 2002 and 2001................................................... FB-51 Summary of Accounting Policies............................ FB-52 Notes to Consolidated Financial Statements................ FB-55
FB-1 REPORT OF INDEPENDENT AUDITORS Board of Directors and Stockholders Psychiatric Solutions, Inc. We have audited the accompanying consolidated balance sheets of Psychiatric Solutions, Inc., as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholders' deficit and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Psychiatric Solutions, Inc., at December 31, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States. /s/ Ernst & Young LLP Nashville, Tennessee April 5, 2002 FB-2 PSYCHIATRIC SOLUTIONS, INC. CONSOLIDATED BALANCE SHEETS
DECEMBER 31, -------------------------- MARCH 31, 2001 2000 2002 ----------- ------------ ----------- (UNAUDITED) ASSETS Current assets: Cash...................................................... $ 1,262,282 $ 335,596 $ 1,156,910 Accounts receivable, less allowance for doubtful accounts of $3,940,000, $2,443,000 and $2,484,652 (unaudited), respectively............................................ 17,477,022 6,423,906 19,191,632 Prepaids and other........................................ 818,975 203,612 920,464 ----------- ------------ ----------- Total current assets........................................ 19,558,279 6,963,114 21,269,006 Property and equipment: Land...................................................... 5,259,654 -- 5,259,654 Buildings................................................. 11,669,824 -- 11,669,824 Equipment................................................. 1,631,412 609,966 1,811,909 Less accumulated depreciation............................... (580,522) (301,955) (883,296) ----------- ------------ ----------- 17,980,368 308,011 17,858,091 Cost in excess of net assets acquired, net.................. 15,207,402 15,028,898 15,214,473 Contracts, net.............................................. 913,936 1,220,774 837,226 Other assets................................................ 558,295 268,583 610,539 Net assets of discontinued operations....................... 75,499 2,566,235 111,791 ----------- ------------ ----------- Total assets................................................ $54,293,779 $ 26,355,615 $55,901,126 =========== ============ =========== LIABILITIES AND STOCKHOLDERS' DEFICIT Current liabilities: Accounts payable.......................................... $ 2,641,232 $ 715,659 $ 2,980,845 Salaries and benefits payable............................. 2,531,596 651,637 2,297,305 Other accrued liabilities................................. 2,622,407 1,513,137 2,216,030 Revolving line of credit.................................. 11,149,815 6,826,155 11,899,600 Current portion of long-term debt......................... 4,237,199 1,827,712 4,475,256 ----------- ------------ ----------- Total current liabilities................................... 23,182,249 11,534,300 23,869,036 Long-term debt, less current portion........................ 20,951,397 7,987,410 20,624,482 Deferred tax liability...................................... 382,718 382,718 382,718 Other liabilities........................................... 540,000 216,000 621,000 Series A Preferred Stock, redeemable and convertible, 10,500,000 shares authorized; 10,497,000 and 10,500,000 issued and outstanding at December 31, 2001 and 2000 and March 31, 2002 (stated at liquidation preference value)... 10,497,000 10,500,000 10,497,000 Series B Preferred Stock, redeemable and convertible, 6,200,000 shares authorized; 4,975,736 shares issued and outstanding at December 31, 2001 and 2000 and March 31, 2002 (liquidation preference value of $7,463,604), respectively; 1,141,693, 662,720 and 1,337,348 warrants issued and outstanding at December 31, 2001 and 2000 and March 31, 2002............................................ 8,554,564 7,836,104 8,853,567 Stockholders' deficit: Common Stock, $.01 par value, 35,000,000 shares authorized; 7,295,628, 8,120,616 and 7,327,628 issued and outstanding at December 31, 2001 and 2000 and March 31, 2002, respectively.................................. 72,957 81,207 73,277 Additional paid-in capital................................ 74,368 356,977 186,811 Accumulated deficit....................................... (9,961,474) (12,539,101) (9,206,765) ----------- ------------ ----------- Total stockholders' deficit................................. (9,814,149) (12,100,917) (8,946,677) ----------- ------------ ----------- Total liabilities and stockholders' deficit................. $54,293,779 $ 26,355,615 $55,901,126 =========== ============ ===========
See accompanying notes. FB-3 PSYCHIATRIC SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, THREE MONTHS ENDED MARCH 31, --------------------------------------- ----------------------------- 2001 2000 1999 2002 2001 ----------- ----------- ----------- ------------- ------------ (UNAUDITED) Revenue..................... $43,998,677 $23,502,241 $ 4,500,341 $23,188,390 $7,218,518 Salaries, wages and employee benefits.................. 26,182,853 15,256,497 4,350,827 13,970,130 4,271,517 Professional fees........... 7,039,275 3,771,133 990,237 3,108,008 1,123,968 Rentals and leases.......... 327,729 375,693 215,806 189,930 16,833 Other operating expenses.... 3,955,443 1,679,325 403,262 2,671,332 510,394 Provision for bad debts..... 661,979 467,082 528,835 715,145 72,178 Depreciation and amortization.............. 944,645 757,014 233,742 385,989 234,849 Interest expense............ 2,660,100 1,723,462 371,401 1,372,147 405,268 ----------- ----------- ----------- ----------- ---------- 41,772,024 24,030,206 7,094,110 22,412,681 6,635,007 Income (loss) from continuing operations before income taxes....... 2,226,653 (527,965) (2,593,769) 775,709 583,511 Provision for income taxes.................. -- -- -- 21,000 -- ----------- ----------- ----------- ----------- ---------- Income (loss) from continuing operations..... 2,226,653 (527,965) (2,593,769) 754,709 583,511 ----------- ----------- ----------- ----------- ---------- Discontinued operations before extraordinary item Income (loss) from operations of discontinued lines of business......... 88,736 349,813 (4,283,394) -- (57,439) Gain (loss) on disposal of discontinued lines of business, net of income taxes of $223,000 for 2001................... 1,499,033 (1,738,278) -- -- -- ----------- ----------- ----------- ----------- ---------- Income (loss) from discontinued operations... 1,587,769 (1,388,465) (4,283,394) -- (57,439) ----------- ----------- ----------- ----------- ---------- Net income (loss) before extraordinary item........ 3,814,422 (1,916,430) (6,877,163) 754,709 526,072 Loss from early retirement of debt................... (1,236,795) -- -- -- -- ----------- ----------- ----------- ----------- ---------- Net income (loss)........... $ 2,577,627 $(1,916,430) $(6,877,163) $ 754,709 $ 526,072 =========== =========== =========== =========== ==========
See accompanying notes. FB-4 PSYCHIATRIC SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
COMMON STOCK ADDITIONAL ------------------- PAID-IN ACCUMULATED SHARES AMOUNT CAPITAL DEFICIT TOTAL --------- ------- ---------- ------------ ------------ Balance at December 31, 1999..... 7,962,991 $79,631 $ 309,604 $(10,622,671) $(10,233,436) Common Stock issued............ 157,625 1,576 47,373 -- 48,949 Net loss....................... -- -- -- (1,916,430) (1,916,430) --------- ------- --------- ------------ ------------ Balance at December 31, 2000..... 8,120,616 81,207 356,977 (12,539,101) (12,100,917) Common Stock issued............ 36,764 368 3,849 - 4,217 Reacquired common stock........ (861,752) (8,618) (286,458) - (295,076) Net income..................... -- -- -- 2,577,627 2,577,627 --------- ------- --------- ------------ ------------ Balance at December 31, 2001..... 7,295,628 $72,957 $ 74,368 $ (9,961,474) $ (9,814,149) Common Stock issued............ 32,000 320 3,380 -- 3,700 Issuance of stock options...... -- -- 109,063 -- 109,063 Net income..................... -- -- -- 754,709 754,709 --------- ------- --------- ------------ ------------ Balance at March 31, 2002 (unaudited).................... 7,327,628 $73,277 $ 186,811 $ (9,206,765) $ (8,946,677) ========= ======= ========= ============ ============
See accompanying notes. FB-5 PSYCHIATRIC SOLUTIONS, INC., CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED YEAR ENDED DECEMBER 31, MARCH 31, --------------------------------------- --------------------------- 2001 2000 1999 2002 2001 ----------- ----------- ----------- -------------- ---------- (UNAUDITED) OPERATING ACTIVITIES Net income (loss).............. $ 2,577,627 $(1,916,430) $(6,877,163) $ 754,709 $ 526,072 Adjustments to reconcile net income (loss) to net cash provided by (used in) continuing operating activities: Depreciation and amortization............... 944,645 757,014 233,742 385,989 234,849 Provision for doubtful accounts................... 661,979 467,082 528,835 715,145 72,178 Accretion of detachable warrants................... 704,339 165,556 -- 390,050 279,450 Issuance of stock options.... -- -- -- 109,063 -- Amortization of loan costs... 172,021 68,956 -- 51,142 32,073 Extraordinary loss on extinguishment of debt..... 1,236,795 -- -- -- -- Loss (income) from discontinued operations.... (1,587,769) 1,388,465 4,499,563 -- 57,439 Long-term interest accrued... 324,000 216,000 -- 81,000 81,000 Changes in operating assets and liabilities, net of effect of acquisitions: Accounts receivable........ 392,721 (641,504) (1,966,734) (2,429,755) 70,081 Prepaids and other current assets.................. (117,919) (73,769) (16,301) (101,489) (216,600) Accounts payable........... (246,992) 46,964 221,858 360,613 (535,424) Salaries and benefits payable................. 783,002 61,670 66,334 (234,291) (129,297) Accrued liabilities and other liabilities....... 946,848 (717,581) 33,242 (427,377) (200,033) ----------- ----------- ----------- ----------- ---------- Net cash provided by (used in) continuing operating activities................... 6,791,297 (177,577) (3,276,624) (345,201) 271,788 INVESTING ACTIVITIES Cash paid for acquisitions, net of cash acquired............. (304,707) (9,528,838) (4,913,262) -- -- Capital purchases of leasehold improvements, equipment and software..................... (115,618) (105,743) (127,399) (187,002) (39,103) Change in net assets of discontinued operations...... 2,387,867 939,352 (167,551) (36,292) 1,187,728 Other assets................... -- (23,517) 16,670 (48,357) -- ----------- ----------- ----------- ----------- ---------- Net cash provided by (used in) investing activities......... 1,967,542 (8,718,746) (5,191,542) (271,651) 1,148,625
(Continued) FB-6 PSYCHIATRIC SOLUTIONS, INC., CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED YEAR ENDED DECEMBER 31, MARCH 31, ---------------------------------------- ---------------------------- 2001 2000 1999 2002 2001 ------------ ----------- ----------- -------------- ----------- (UNAUDITED) FINANCING ACTIVITIES Proceeds from issuance of Series B Preferred Stock... $ -- $ 1,913,600 $ 5,550,004 $ -- $ -- Net payments of (proceeds from) long-term debt....... (6,955,998) 6,440,463 3,683,901 569,880 (1,640,543) Payment of loan costs........ (880,372) (289,530) -- (62,100) (544) Proceeds from issuance of Common Stock............... 4,217 3,449 65,159 3,700 -- ------------ ----------- ----------- ----------- ----------- Net cash (used in) provided by financing activities.... (7,832,153) 8,067,982 9,299,064 511,480 (1,641,087) Net (decrease) increase in cash....................... 926,686 (828,341) 830,898 (105,372) (220,674) Cash at beginning of the period..................... 335,596 1,163,937 333,039 1,262,282 335,596 ------------ ----------- ----------- ----------- ----------- Cash at end of the period.... $ 1,262,282 $ 335,596 $ 1,163,937 $ 1,156,910 $ 114,922 ============ =========== =========== =========== =========== SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid.............. $ 1,717,411 $ 1,401,170 $ 323,758 $ 953,946 $ 429,752 ============ =========== =========== =========== =========== EFFECT OF ACQUISITIONS: Assets acquired, net of cash acquired................... $ 30,978,310 $16,133,703 $ 5,163,466 $ -- $ -- Liabilities assumed.......... (3,661,159) (2,559,365) (226,165) -- -- Notes payable issued......... (4,500,000) (4,000,000) -- -- -- Common Stock issued.......... -- (45,500) (24,039) -- -- Long-term debt issued........ (22,512,444) -- -- -- -- ------------ ----------- ----------- ----------- ----------- Cash paid for acquisitions, net of cash acquired....... $ 304,707 $ 9,528,838 $ 4,913,262 $ -- $ -- ============ =========== =========== =========== =========== SIGNIFICANT NON-CASH TRANSACTIONS: Issuance of detachable stock warrants as consideration for Bridge Loan............ $ 718,460 $ 372,500 $ -- $ 299,003 $ -- ============ =========== =========== =========== =========== Financing of early debt termination fee............ $ 818,156 $ -- $ -- $ -- $ -- ============ =========== =========== =========== ===========
There were no acquisitions during the three months ended March 31, 2002 and 2001, respectively. See accompanying notes. FB-7 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2001 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DESCRIPTION OF BUSINESS Psychiatric Solutions, Inc. (the "Company" or "PSI") was formed on September 26, 1996 as a Delaware corporation with its corporate office in Nashville, Tennessee. The Company manages behavioral health units and owns psychiatric hospitals. The Company has formed two operating divisions: (1) Psychiatric Unit Management, and (2) Freestanding Specialty Hospitals. The Psychiatric Unit Management division provides psychiatric management and development services to behavioral health units in hospitals and clinics. The Freestanding Specialty Hospitals division includes owned psychiatric hospitals. As of December 31, 2001, the Company managed 48 behavioral health units and owned four psychiatric hospitals in two states. BASIS OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions are eliminated in consolidation. UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS The accompanying unaudited consolidated balance sheet as of March 31, 2002 and the related unaudited consolidated statements of operations and cash flows for the three months ended March 31, 2001 and March 31, 2002, and the unaudited consolidated statement of stockholders' deficit for the three months ended March 31, 2002 (interim financial statements) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim results have been included. The unaudited interim consolidated financial statements should be read in conjunction with the audited December 31, 2001 consolidated financial statements appearing herein. The results of the three months ended March 31, 2002 may not be indicative of operating results for the full year. CASH Cash consists of demand deposits held at financial institutions. The Company places its cash in financial institutions that are federally insured and limits the amount of credit exposure with any one financial institution. ACCOUNTS RECEIVABLE Accounts receivable vary according to the type of service being provided. Accounts receivable for the Psychiatric Unit Management division is comprised of contractually determined fees for services rendered. Such amounts are recorded net of estimated bad debts. Concentration of credit risk is limited by the number of customers. Accounts receivable for the Freestanding Specialty Hospitals division are comprised of patient service revenue and are recorded net of contractual adjustments and estimated bad debts. Such amounts are owed by various governmental agencies, insurance companies and private patients. Medicare and Medicaid comprised approximately 14% and 12%, respectively, of patient receivables at December 31, 2001. Concentration of credit risk from other payers is limited by the number of patients and payers. FB-8 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INCOME TAXES The Company accounts for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based upon differences between the financial statement carrying amounts and tax bases of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. LONG-LIVED ASSETS Property and Equipment Property and equipment are stated at cost and depreciated using the straight-line method over the useful lives of the assets, which range from 4 to 40 years. Leasehold improvements are amortized on a straight-line basis over the shorter of the lease term or estimated useful lives of the assets. Capitalized software consists primarily of costs incurred for external services and materials associated with the purchase and implementation of software systems. Depreciation expense was $278,567 and $214,141 for the years ended December 31, 2001 and 2000, respectively. Cost in Excess of Net Assets Acquired Cost in excess of net assets acquired (or goodwill) consists of the excess purchase price over the fair value of acquired tangible and identifiable intangible assets. Goodwill is amortized on a straight-line basis over 40 years. The amounts reported at December 31, 2001 and 2000 are net of accumulated amortization of $840,114 and $480,874, respectively. Amortization expense related to goodwill was $359,240 and $276,071 for the years ended December 31, 2001 and 2000, respectively. Contracts Contracts represent the fair value of management contracts and service contracts purchased and are being amortized using the straight-line method over five years. The amounts reported at December 31, 2001 and 2000 are net of accumulated amortization of $620,256 and $313,418, respectively. Amortization expense related to contracts was $306,256 and $263,007 for the years ended December 31, 2001 and 2000, respectively. Estimated amortization expense for the years ended December 31, 2002, 2003, 2004 and 2005 of contracts is $306,838, $306,838, $256,427 and $43,833. When events, circumstances and operating results indicate that the carrying values of certain long-lived assets and the related identifiable intangible assets might be impaired, the Company prepares projections of the undiscounted future cash flows expected to result from the use of the assets and their eventual disposition. If the projections indicate that the recorded amounts are not expected to be recoverable, such amounts are reduced to estimated fair value. Fair value is estimated based upon projections of discounted cash flows. OTHER ASSETS Other assets consist principally of loan costs which are deferred and amortized over the term of the related debt. The amounts reported at December 31, 2001 and 2000 are net of accumulated amortization of $85,229 and $68,956, respectively. STOCK-BASED COMPENSATION The Company accounts for its stock option plan in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense would be recorded on the date of grant only if the current FB-9 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) market price of the underlying stock exceeded the exercise price. Management of the Company has determined that the pro forma net income disclosures as required by Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," would not differ materially from net loss as shown on the accompanying Consolidated Statements of Operations. (See Note 9) USE OF ESTIMATES Management of the Company has made certain estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with accounting principles generally accepted in the United States. Actual results could differ from those estimates. RISK MANAGEMENT The Company carries general and professional liability insurance from an unrelated commercial insurance carrier for per occurrence losses up to $6,000,000 with policy limits of $8,000,000 in the aggregate, on a claims-made basis. Management is not aware of any claims against it or its affiliated physician groups. The Company also carries workers' compensation insurance from an unrelated commercial insurance carrier. The Company's experience with workers' compensation claims has been insignificant. The Company believes that adequate provision has been made for workers compensation and professional and general liability risks. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts reported in the accompanying Consolidated Balance Sheets for cash, accounts receivable, and accounts payable approximate their fair value given the short-term maturity of these instruments. Based upon the borrowing rates currently available to the Company, the carrying amounts reported in the accompanying Consolidated Balance Sheets for long-term debt approximate fair value. RECLASSIFICATIONS Certain prior period amounts have been reclassified in order to conform to current period presentation. RECENT PRONOUNCEMENTS During July 2001, the Financial Accounting Standards Board ("FASB") issued Statements of Financial Accounting Standards No. 141, Business Combinations ("SFAS 141") and No. 142, Goodwill and Other Intangible Assets ("SFAS 142"). SFAS 141 is effective for transactions completed subsequent to June 30, 2001 and SFAS 142 is effective for years beginning after December 15, 2001. Under the provisions of SFAS 142, goodwill will no longer be amortized but will be subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives. Goodwill recorded by the Company as a result of an acquisition completed subsequent to July 1, 2001, will not be amortized. Otherwise, the Company will apply the new rules on accounting for goodwill and other intangible assets beginning in 2002. During 2002, the Company will perform the first of the required impairment tests of goodwill and does not expect a material impact on the earnings and financial position of the Company. A FB-10 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) reconciliation of previously reported net income to the pro forma amounts adjusted for the exclusion of goodwill amortization follows:
THREE MONTHS ENDED YEAR ENDED DECEMBER 31 MARCH 31 --------------------------------------- ------------------- 2001 2000 1999 2002 2001 ----------- ----------- ----------- -------- -------- (UNAUDITED) Reported net income (loss) before extraordinary item............. $ 3,814,422 $(1,916,430) $(6,877,163) $754,709 $526,072 Extraordinary loss on extinguishment of debt......... (1,236,795) -- -- -- -- ----------- ----------- ----------- -------- -------- Reported net income (loss)....... 2,577,627 (1,916,430) (6,877,163) 754,709 526,072 Add: goodwill amortization....... 378,049 276,071 64,893 -- 94,512 ----------- ----------- ----------- -------- -------- Pro forma adjusted net income (loss)......................... $ 2,955,676 $(1,640,359) $(6,812,270) $754,709 $620,584
In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"), which supersedes SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS 144 removes goodwill from its scope and clarifies other implementation issues related to SFAS 121. SFAS 144 also provides a single framework for evaluating long-lived assets to be disposed of by sale. The Company does not expect SFAS 144 to have a material effect on its results of operations or financial position. In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). SFAS 145 prohibits the classification of gains or losses from debt extinguishments as extraordinary items unless the criteria outlined in APB Opinion No. 30, Reporting the Results of Operations -- Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, are met. SFAS 145 also eliminates an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS 145 is effective for fiscal years beginning after May 15, 2002, with early adoption encouraged. The Company intends to adopt the provisions of SFAS 145 during fiscal 2003 and restate its prior audited consolidated financial statements for the reclassification of extraordinary loss on extinguishment of debt. 2. REVENUE Revenue consists of the following amounts:
DECEMBER 31, ------------------------- 2001 2000 ----------- ----------- Patient service revenue.................................... $16,025,787 $ -- Management fee revenue..................................... 27,972,890 23,502,241 ----------- ----------- Total revenue.............................................. $43,998,677 $23,502,241 =========== ===========
NET PATIENT SERVICE REVENUE Patient service revenue is reported on the accrual basis in the period in which services are provided, at established rates, regardless of whether collection in full is expected. FB-11 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Net patient service revenue includes amounts estimated by management to be reimbursable by Medicare and Medicaid under provisions of cost or prospective reimbursement formulas in effect. Amounts received are generally less than the established billing rates of the facilities and the differences (contractual allowances) are reported as deductions from patient service revenue at the time the service is rendered. The effect of other arrangements for providing services at less than established rates is also reported as deductions from patient service revenue. Settlements under cost reimbursement agreements with third party payers are estimated and recorded in the period in which the related services are rendered and are adjusted in future periods as final settlements are determined. Final determination of amounts earned under the Medicare and Medicaid programs often occur in subsequent years because of audits by the programs, rights of appeal and the application of numerous technical provisions. MANAGEMENT FEE REVENUE Revenue is recorded as management fee revenue for the Psychiatric Unit Management division. The Psychiatric Unit Management division receives contractually determined management fees and director fees from hospitals and clinics for providing psychiatric management and development services. There were no individual or group of affiliated contracts in 2001 and 2000, which provided a significant concentration of management fee revenue. 3. DISCONTINUED OPERATIONS Included in discontinued operations are the operating results and estimated losses on the unwind of service agreements entered into with physicians, as well as the operating results and gain on disposal for the Employee Assistance Program. As part of the Company's Physician Practice Management Division, the Company had acquired certain net assets of psychiatric clinics, and had operated the clinics and managed the physician practices under long-term service agreements with the physicians that practiced exclusively through the clinics. The Company had not consolidated these clinics or the physician practices it managed, as it did not have operating control. Additionally, discontinued operations include the operating results and estimated losses on the closure of clinics owned by the Company. Such clinics provided group and individual therapy sessions to patients through partial hospitalization and intensive outpatient programs. The Company-owned clinics were all closed as of December 31, 2000. The Company's Employee Assistance Programs division contracted with employers to provide confidential assistance and counseling to their employees. The Company's implementation of plans during 2000 to exit these lines of business resulted in an estimated loss on disposal of discontinued operations of $1,738,278 during the year ended December 31, 2000. The December 31, 2000 loss on disposal consists primarily of lease termination costs and the write down of fixed assets and other assets directly resulting from the decision to exit the Physician Practice Management line of business. The December 31, 2000 loss on disposal also includes an estimate of losses from operations associated with the physician practice service agreements of approximately $359,000 through the disposal date. Such costs are recorded within net assets of discontinued operations in the accompanying Consolidated Balance Sheet. The December 31, 2001 income (loss) on disposal consists primarily of a gain on the sale of the Employee Assistance Programs division of $1,169,562 (net of taxes of $223,000), the operations of the Employee Assistance Programs division from the measurement date through the disposal date of $245,753 and final adjustments to the Company's 2000 loss on disposal of FB-12 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $83,718. Significant assets and liabilities of the discontinued lines of business included in the accompanying Consolidated Balance Sheets are as follows:
DECEMBER 31, ----------------------- 2001 2000 --------- ----------- Cash........................................................ $ (82,684) $ (27,595) Other current assets........................................ -- 37,504 Accounts receivable, net.................................... 358,903 2,202,640 Fixed assets, net........................................... 50,402 509,712 Other assets................................................ 195,934 2,086,451 Accounts payable............................................ -- (107,112) Accrued expenses............................................ (447,056) (1,784,887) Long-term debt.............................................. -- (350,478) --------- ----------- $ 75,499 $ 2,566,235 ========= ===========
Accounts receivable primarily include contractually determined fees for management services due under the service agreements. Such amounts are recorded net of estimated bad debts. Management fee revenue earned under the service agreements and net patient service revenue earned from the Company-owned clinics totaled $9,876,181 and $12,814,081 for the years ended December 31, 2001 and 2000, respectively. Management fee revenue earned under the service agreements includes reimbursement of clinic expenses incurred on behalf of the clinic facilities. These reimbursed clinic expenses do not include the salaries and benefits of physicians and therapists who provide medical service. 4. ACQUISITIONS 1999 ACQUISITIONS During 1999, the Company purchased all of the outstanding stock of Cornerstone Behavioral Health Services Inc. for approximately $4.6 million. Cornerstone is the manager of approximately 20 geropsychiatric units in acute care hospitals situated primarily in suburban communities in the south and midwest. 2000 ACQUISITIONS During 2000, the Company acquired various entities, which provided psychiatric management and development services and employee assistance and counseling services. Certain assets of these entities were acquired in exchange for Common Stock, cash, notes payable or a combination thereof. The Company issued 130,000 shares of Common Stock in connection with these acquisitions during 2000. FB-13 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table summarizes the allocation of the aggregate purchase price of the aforementioned acquisitions:
2000 SUNRISE EAP TOTAL - ---- ----------- -------- ----------- Assets acquired: Assets receivable............................. $ 4,640,317 $ 49,754 $ 4,690,071 Other current assets.......................... 80,695 -- 80,695 Fixed assets.................................. 97,534 18,519 116,053 Costs in excess of net assets acquired........ 9,789,957 930,950 10,720,907 Contracts..................................... 525,977 -- 525,977 ----------- -------- ----------- 15,134,480 999,223 16,133,703 Liabilities assumed........................... 2,177,642 381,723 2,559,365 Subordinated convertible notes issued......... 3,600,000 400,000 4,000,000 Common stock issued........................... -- 45,500 45,500 ----------- -------- ----------- Cash paid, net of cash acquired................. $ 9,356,838 $172,000 $ 9,528,838 =========== ======== ===========
2001 ACQUISITIONS During 2001, the Company acquired four free-standing psychiatric hospitals, three in Texas and one in North Carolina. All of the acquisitions were accounted for by the purchase method. The aggregate purchase price of these transactions was allocated to the assets acquired and liabilities assumed based upon their respective fair values. The consolidated financial statements include the accounts and operations of the acquired entities for periods subsequent to the respective acquisition dates. The goodwill associated with these acquisitions is deductible for federal income tax purposes. The following table summarizes the allocation of the aggregate purchase price of the aforementioned acquisitions:
WEST OAKS TEXAS AND NEURO CYPRESS REHAB 2001 CREEK HOLLY HILL CENTER TOTAL - ---- ----------- ---------- ---------- ----------- Assets acquired: Accounts receivable.............. $ 7,090,871 $1,616,944 $3,400,001 $12,107,816 Other current assets............. 243,548 99,499 154,397 497,444 Fixed assets..................... 6,833,333 6,264,340 4,737,633 17,835,306 Costs in excess of net assets acquired...................... - 402,833 134,911 537,744 ----------- ---------- ---------- ----------- 14,167,752 8,383,616 8,426,942 30,978,310 Liabilities assumed.............. 2,105,075 758,310 797,774 3,661,159 Subordinated convertible notes issued........................ 2,000,000 - 2,500,000 4,500,000 Long-term debt issued............ 9,908,091 7,542,413 5,061,940 22,512,444 ----------- ---------- ---------- ----------- Cash paid, net of cash acquired.... $ 154,586 $ 82,893 $ 67,228 $ 304,707 =========== ========== ========== ===========
FB-14 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) OTHER INFORMATION PRO FORMA RESULTS The following represents the unaudited pro forma results of consolidated operations as if the aforementioned acquisitions had occurred at the beginning of the immediate preceding period, after giving effect to certain adjustments, including the depreciation and amortization of the assets acquired based upon their fair values and changes in interest expense resulting from changes in consolidated debt:
2001 2000 1999 ----------- ----------- ----------- Revenue........................................ $92,093,000 $87,600,000 $25,577,000 Income before extraordinary items.............. 3,642,000 (2,671,000) (1,017,000) Net income..................................... 2,405,000 (2,671,000) (1,017,000)
The pro forma information given does not purport to be indicative of what the Company's results of operations would have been if the acquisitions had in fact occurred at the beginning of the periods presented, and is not intended to be a projection of the impact on future results or trends. 5. LONG-TERM DEBT Long-term debt consists of the following:
DECEMBER 31, ------------------------- 2001 2000 ----------- ----------- Debt payable to banks: Revolving line of credit, expiring on May 5, 2005 and bearing interest at the prime rate plus 1.25% (10.75% at December 31, 2000)................................. $ -- $ 6,826,155 Non-revolving line of credit, due on May 5, 2005 and bearing interest at the prime rate plus 2% (11.5% at December 31, 2000).................................... -- 4,950,000 Revolving line of credit, expiring on November 30, 2004 and bearing interest at the prime rate plus 2% (7% at December 31, 2001).................................... 11,149,815 -- Non-revolving line of credit, due on November 30, 2003 and bearing interest at the prime rate plus 4.75% (9.75% at December 31, 2001).......................... 15,656,305 -- Related party bridge loan (liquidation preference value of $1,000,000).............................................. 903,732 793,056 Subordinated convertible notes............................. 3,600,000 3,600,000 Subordinated promissory note............................... 4,880,338 400,000 Other...................................................... 273,018 72,066 ----------- ----------- 36,463,208 16,641,277 Less current portion....................................... 15,511,811 8,653,867 ----------- ----------- Long-term debt............................................. $20,951,397 $ 7,987,410 =========== ===========
FB-15 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DEBT PAYABLE TO BANKS 2000 Senior Credit Facility In conjunction with an acquisition in May 2000, the Amended Loan Agreement and the amounts outstanding thereunder were replaced with a $17,500,000 senior credit facility (2000 Senior Credit Facility). The 2000 Senior Credit Facility included two lines of credit: a $5,500,000 non-revolving term loan (2000 Term Loan) and a $12,000,000 revolving working capital line of credit (2000 Revolver). Both lines of credit were collateralized by the Company's assets and stock of the Company's subsidiaries. Until the maturity date of the 2000 Revolver, the Company could borrow, repay and re-borrow an amount not to exceed the lesser of $12,000,000 or the Borrowing Base (the estimated net value of eligible accounts receivable, as defined in the 2000 Senior Credit Facility, multiplied by 85%). The 2000 Revolver was due in full at maturity in May 2005, with the exception of an Interim Availability Balance (as defined in the 2000 Senior Credit Facility) of approximately $385,000, which was due during 2001. The available borrowings under the 2000 Revolver were $795,158 as of December 31, 2000. Under the 2000 Revolver, all of the Company's collections, except for Medicare and Medicaid, are deposited into lockbox accounts controlled by the lender. The funds deposited into the lockbox accounts were applied to outstanding borrowings with the lender on a daily basis. As such, the outstanding borrowings with the 2000 Revolver were classified as short term at December 31, 2000. The Company was required to pay an unused fee in the amount of .375% per year of the unused portion of the 2000 Senior Credit Facility. This fee was payable monthly in arrears on the first day of each calendar month. Such fees were $41,332 for the year ended December 31, 2000. In conjunction with the amendment dated August 31, 2001, the Company borrowed an additional $3,500,000 under the 2000 Term Loan and $1,500,000 under a new Term Loan B. The 2000 Term Loan was to be repaid in twenty equal quarterly installments commencing as of January 1, 2002. Prior to the amendment, the 2000 Term Loan was payable in twenty quarterly installments of $275,000 beginning on June 30, 2000. In addition to the quarterly principal payments of the 2000 Term Loan, the Company was required to make additional principal payments on the 2000 Term Loan in the amount of 30% of the Excess Cash Flow (as defined in the 2000 Senior Credit Facility) within ninety days of each fiscal year end. The Term Loan B was to be repaid in equal monthly installments commencing as of March 1, 2002, with final payment on August 1, 2003. Interest accrued on the 2000 Revolver was payable weekly. Interest accrued on the 2000 Term Loan and Term Loan B was payable monthly. 2001 Senior Credit Facility In conjunction with an acquisition in November 2001, the Amended Loan Agreement was replaced with a $33,156,305 senior credit facility (2001 Senior Credit Facility). The 2001 Senior Credit Facility includes two lines of credit: a $15,656,305 non-revolving term loan (2001 Term Loan) and a $17,500,000 revolving working capital line of credit (2001 Revolver). Both lines of credit are collateralized by the Company's assets and stock of the Company's subsidiaries. Until the maturity date of the 2001 Revolver, the Company may borrow, repay and re-borrow an amount not to exceed the lesser of $17,500,000 or the Borrowing Base (the estimated net collectible value of eligible receivables, as defined in the 2001 Senior Credit Facility, multiplied by 85%). The 2001 Revolver is due in full at maturity in November 2004. The available borrowings under the 2001 Revolver were $14,659,210 at December 31, 2001. The 2001 Term Loan is due in monthly installments of principal and interest, as well as an additional principle payment equal to 50% of the Company's excess cash flows for the year that is due within 30 days after preparation of the Company's audited financial statements, but in no event later than 145 days after year-end. FB-16 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Under the 2001 Revolver, all of the Company's collections, except for Medicare and Medicaid, are deposited into lockbox accounts controlled by the lender. The funds deposited into the lockbox accounts are applied to outstanding borrowings with the lender on a daily basis. As such, the outstanding borrowings under the 2001 Revolver are classified as short term at December 31, 2001. The Company must pay an unused fee in the amount of 0.05% per month of the monthly unused portion of the 2001 Senior Credit Facility. This fee is payable monthly is arrears on the first day of each calendar month. Such fees were approximately $4,000 at December 31, 2001. The 2001 Senior Credit Facility contains customary covenants which include (i) a specified monthly census required for any owned, operated or leased hospitals of the Company, (ii) a limitation on capital expenditures, sales of assets, mergers, changes of ownership and management, new lines of business and dividends, and (iii) various financial covenants. At December 31, 2001, the Company was in compliance with all applicable debt covenant requirements. EXTRAORDINARY ITEM Commensurate with the refinancing of the 2000 Senior Credit Facility, the Company expensed the remaining deferred loan costs associated with this debt of $418,639 and incurred early termination penalties of $818,156, resulting in an extraordinary loss on extinguishment of debt of $1,236,795 at December 31, 2001. RELATED PARTY BRIDGE LOAN In October 2000, the Company entered into subordinated notes totaling $1,000,000 with certain stockholders of the Company (collectively referred to as the Bridge Loan). The Bridge loan bears interest at 10% payable monthly. The proceeds were used to fund short-term working capital requirements. Based upon terms as amended on July 31, 2001, the subordinated notes and accrued but unpaid interest are payable upon the earlier of (i) 180 days after the July 31, 2001, amendment (i.e., January 31, 2002), or (ii) the availability under the Borrowing Base under the 2001 Revolver equals or exceeds $2,000,000 on a daily basis as of each day during the 45 day period immediately proceeding the maturity date, or (iii) the receipt of proceeds by the Company for any transaction having aggregate amounts of proceeds of at least $4,000,000, or (iv) a change of control of PSI. As consideration for the issuance of the Bridge Loan, the Company granted warrants ("Bridge Loan Warrants") to purchase 250,000 shares of the Company's Series B Preferred Stock at $0.01 per share. The Bridge Loan Warrants expire October 12, 2005. In 2000, the carrying value of the Bridge Loan was reduced and the carrying value of the Series B Preferred Stock was increased by $372,500, the fair market value of the Bridge Loan Warrants issued. The carrying value of the Bridge Loan is being accreted to its face value over its maximum life of six months. Accretion of the Bridge Loan was $206,944 and $165,556 for the years ended December 31, 2001 and 2000, respectively. In 2001, the Company granted additional Bridge Loan Warrants to purchase 478,973 shares of the Company's Series B Preferred Stock at $0.01 per share. The additional warrants expire October 12, 2005. The carrying value of the Bridge Loan was decreased by $469,500, the fair market value of the Bridge Loan Warrants issued. The carrying value of the additional Bridge Loan is being accreted over the life of the loan. Accretion of the additional Bridge Loan Warrants was $497,395 for December 31, 2001. FB-17 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUBORDINATED CONVERTIBLE NOTES In connection with an acquisition during May 2000, the Company issued subordinated convertible notes payable (Subordinated Convertible Notes). The Subordinated Convertible Notes mature and become immediately due and payable upon the earlier of (i) sale of the Company (ii) any change of control as defined in the Subordinated Convertible Notes, or (iii) the Company's initial public offering of common stock. Interest accrues on the Subordinated Convertible Notes at 9% and is payable May 1, 2005. As of December 31, 2001 and 2000, the Company has accrued $540,000 and $216,000 of interest, respectively, which is included in other liabilities on the accompanying consolidated balance sheets. Any time until April 30, 2004, holders of the Subordinated Convertible Notes may convert the unpaid principal balance, in increments of $1,000, into a number of shares of Series B Preferred Stock based upon the following conversion prices:
CONVERSION DATE CONVERSION PRICE - --------------- ---------------- May 1, 2000 -- April 30, 2001............................... $2.00 per share May 1, 2001 -- April 30, 2002............................... $2.33 per share May 1, 2002 -- April 30, 2003............................... $2.67 per share May 1, 2003 -- April 30, 2004............................... $3.00 per share
SUBORDINATED PROMISSORY NOTE In connection with an acquisition in 2000, the Company issued a promissory note payable (Subordinated Promissory Note) in the amount of $400,000 bearing interest at 9% for the year ended December 31, 2000. The Subordinated Promissory Note matures in five equal annual installments beginning April 1, 2001. Accrued interest is due and payable on the first day of each calendar quarter beginning July 1, 2000. In connection with two acquisitions in 2001, the Company issued promissory notes (Subordinated Promissory Notes) totaling $4,500,000. A $2,500,000 Subordinated Promissory Note bears interest at 9% per annum and matures June 30, 2002, with periodic interest payments due beginning December 31, 2001. The $2,000,000 Subordinated Promissory Note bears interest at 9% per annum and matures June 30, 2005, with periodic principal and interest payments due beginning September 30, 2002. Per the provisions of the $2,500,000 Subordinated Promissory Note, the entire principal amount plus accrued interest becomes immediately due and payable upon the receipt of at least $5,000,000 of proceeds by the Company from any sale of subordinated debt or equity securities. These Subordinated Promissory Notes contain customary covenants which include a cross default covenant with the occurrence of a default of any indebtedness of at least $1,000,000 held by any creditor of the Company. As of December 31, 2001, the Company was in compliance with these covenants. OTHER The aggregate maturities of long-term debt, are as follows: 2002........................................................ $15,511,811 2003........................................................ 1,392,983 2004........................................................ 1,923,151 2005........................................................ 5,472,649 2006 and thereafter......................................... 12,162,614 ----------- Total............................................. $36,463,208 ===========
FB-18 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. PREFERRED STOCK The Company is authorized to issue 10,500,000 shares of Series A Preferred Stock and had outstanding 10,497,000 and 10,500,000 at December 31, 2001 and 2000, respectively. The Company is authorized to issue 6,200,000 shares of Series B Preferred Stock and has outstanding 4,975,736 at December 31, 2001 and 2000. The Company issued 1,275,733 and 3,700,003 shares of Series B Preferred Stock at $1.50 per share during 2000 and 1999, for proceeds of $1,913,600 and $5,550,004, respectively. The proceeds from the issuance of the Series B Preferred Stock were used primarily to fund acquisitions and for working capital purposes. During 2001, the Company cancelled 3,000 shares of its Preferred Stock A in connection with the unwinding of a certain physician practice during the year. VOTING RIGHTS Shares of the Preferred Stock are generally voted equally with the shares of Common Stock, and not as a separate class, at any annual or special meeting of stockholders of the Company. Holders of Preferred Stock may act by written consent in the same manner as holders of Common Stock. A holder of Preferred Stock is entitled to one vote per share of Common Stock into which Preferred Stock held by such holder could then be converted. Among other required votes, the approval of the holders of at least a majority of the outstanding Preferred Stock is required to (i) amend any provision of the Certificate of Incorporation or Bylaws so as to adversely change any voting powers, preferences or other special right of the Preferred Stock; (ii) change the authorized number of shares of Common Stock or Preferred Stock; (iii) authorize or designate any new class or series of stock of the Company with rights equal or senior to the Preferred Stock; (iv) redeem, repurchase, pay dividends on or make other distributions with respect to any other stock of the Company, except in limited circumstances; (v) voluntarily dissolve or liquidate the Company; (vi) effect a change in control of the Company; (vii) sell, lease, or otherwise dispose of all or substantially all of the assets of the Company; (viii) take any action that results in the payment or declaration of a dividend on any shares of Common Stock or Preferred Stock; or (ix) change the size of the Board of Directors. DIVIDENDS Holders of the Preferred Stock, in preference to any other stock of the Company, are entitled to receive cash dividends at a rate of Eight Cents ($0.08) per annum on each outstanding share of Preferred Stock. Such dividends are payable only when and if declared by the Board of Directors and are non- cumulative. So long as Preferred Stock is outstanding, no distribution will be made on any other stock of the Company nor will any shares of any other stock of the Company be purchased, redeemed or otherwise acquired for value by the Company (except in limited circumstances) until all dividends on Preferred Stock have been paid or declared and set apart. CONVERSION FEATURES Any shares of Preferred Stock may, at the option of the holder, be converted at any time into fully paid and nonassessable shares of Common Stock. The number of shares of Common Stock to which a holder of Preferred Stock is entitled upon conversion is dependent upon the then effective "Series Conversion Rate" (as defined in the amended and restated Certificate of Incorporation [the "Certificate"]). The Series Conversion Rate is subject to an antidilution adjustment if the Company issues or sells, or is deemed to issue or sell, shares of Common Stock at a per share price less than the then "Effective Series Preferred Price" as defined in the Certificate. An adjustment to the Series Conversion Rate would FB-19 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) increase the voting power of the holders thereof. The Company is deemed to issue or sell shares of Common Stock if, among other things, the Company issues or sells options or other securities convertible into Common Stock. At December 31, 2001 and 2000, the Preferred Stock was convertible into 15,472,731 and 15,475,736 shares, respectively, of the Company's common stock. Each share of Preferred Stock will automatically be converted into shares of Common Stock, based on the then "Effective Series Preferred Price" (as defined in the Certificate) immediately upon the closing of a public offering under the Securities Act of 1933, as amended, covering the offer and sale of common stock in which (i) the per share price is at least four times the "Series B Preferred Price", and (ii) the gross cash proceeds to the Company (before underwriting discounts, commissions and fees) are at least $20,000,000. Upon such automatic conversion, any declared and unpaid dividends will be paid to the holder. REDEMPTION FEATURES The holders of at least 66 and 2/3% of the outstanding shares of Preferred Stock may require the Company, to the extent it may lawfully do so, to redeem the Preferred Stock in three equal annual installments beginning on the seventh anniversary of the original issue date, and ending three years from such first redemption rate. The Company will effectively redeem the Preferred Stock by paying in cash a sum equal to the original issue price per share of Preferred Stock plus declared and unpaid dividends with respect to such shares in exchange for the shares of Preferred Stock to be redeemed. LIQUIDATION PREFERENCES Holders of the Preferred Stock are entitled to a preference on liquidation. Upon any liquidation, dissolution, or winding up of the Company, the holders of Series A and Series B are entitled to receive $1.00 per share, and $1.50 per share, respectively, plus all declared and unpaid dividends. If, upon any liquidation, distribution or winding up, the assets of the Company are insufficient to make the payment of the full amount of such preference to all holders of Preferred Stock, then such assets will be distributed among the holders of Preferred Stock at the time outstanding, on a pro rata basis. 7. LEASES At December 31, 2001, future minimum lease payments under non-cancelable leases are as follows:
OPERATING LEASES ---------- 2002........................................................ $ 561,087 2003........................................................ 396,648 2004........................................................ 372,353 2005........................................................ 156,165 2006........................................................ 143,282 Thereafter.................................................. 143,282 ---------- Total minimum lease payments................................ $1,772,817 ==========
Rent expense totaled $535,631 and $1,967,958 for December 31, 2001 and 2000, respectively. 8. INCOME TAXES During the years ended December 31, 2001 and 2000, the Company generated net operating loss (NOL) carryforwards for federal and state income tax purposes. The NOL carryforwards are applicable to both discontinued and continuing operations. As a result of each period's loss and existing NOL carryforwards, the Company has not recorded a provision for current federal income tax for the years FB-20 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) ended December 31, 2001 and 2000. At December 31, 2001 and 2000, the Company has a cumulative NOL carryforward for federal income tax purposes of $6,996,448 and $2,536,100, respectively, which expires between 2012 and 2021. For financial reporting purposes, a valuation allowance has been recorded against the deferred tax assets related to these carryforwards. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the company's deferred tax assets and liabilities for continuing and discontinued operations are as follows:
2001 2000 ----------- ----------- Deferred tax assets: Net operating loss carryforwards......................... $ 2,655,852 $ 962,704 Allowance for doubtful accounts.......................... 1,044,659 1,638,335 Accrued vacation......................................... 370,420 183,284 Depreciation............................................. -- 56,105 Amortization............................................. -- 1,632,462 Other.................................................... 49,423 466,671 ----------- ----------- Total gross deferred tax assets............................ 4,120,354 4,939,561 Less: Valuation allowance................................ (3,890,289) (5,016,105) ----------- ----------- Total deferred tax assets.................................. 230,065 (76,544) Deferred tax liability: Depreciation............................................. (81,182) -- Amortization............................................. (438,115) (306,174) Other.................................................... (93,486) -- ----------- ----------- Net deferred tax asset (liability)......................... $ (382,718) $ (382,718) =========== ===========
The provision for income taxes for the years ended December 31, 2001 and 2000 differs from the amount computed by applying the statutory rate of 34% due to the following:
2001 2000 ----------- --------- Tax at federal statutory rate............................... $ 841,708 $ (7,871) State income taxes.......................................... 98,034 14,154 Nondeductible goodwill amortization......................... 87,030 31,866 Meals and entertainment..................................... 16,533 20,991 Change in valuation allowance............................... (1,043,305) 79,108 Other....................................................... -- (138,248) ----------- --------- $ -- $ -- =========== =========
The valuation allowance has changed by approximately $83,000 for the tax effect of discontinued operations. 9. STOCK OPTION PLANS During 1997, the Company and its stockholders adopted the 1997 Incentive and Nonqualified Stock Option Plan for Key Personnel (the "Plan"). The maximum aggregate number of shares of Common Stock to be issued under the Plan shall not exceed 2,200,000. FB-21 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Shares issued under the Plan may be in the form of incentive stock options or non-qualified options to officers, employers and directors. The exercise price per share determined by the Compensation Committee of the Board of Directors (the "Committee") generally is not less than fair market value of the Common Stock on the date of grant. Stock options shall become exercisable in whole or in part on such date or dates as determined by the Committee at the date of grant. Options granted generally vest and are exercisable ratably by the respective grantee over a four-year period beginning on the date of grant. Each option shall generally expire ten years from the grant date. In connection with an acquisition in 1997, the Company granted options to purchase 491,996 shares to the sellers. The 491,996 shares are subject to the same terms as shares under the Plan, but are not considered to be under the Plan. Stock option activity, including options granted for acquisitions, is as follows:
NUMBER OF OPTION WEIGHTED AVERAGE OPTIONS EXERCISE PRICE EXERCISE PRICE ----------------- -------------- ---------------- Balance at December 31, 1999........... 1,752,507 $0.10 to $0.35 $0.18 Granted.............................. 739,000 $0.35 $0.35 Canceled............................. (406,852) $0.10 to $0.35 $0.26 Exercised............................ (27,625) $0.10 to $0.35 $0.20 --------- -------------- ----- Balance at December 31, 2000........... 2,057,030 $0.10 to $0.35 $0.23 Granted.............................. 310,000 $0.35 $0.35 Canceled............................. (465,467) $0.10 to $0.35 $0.30 Exercised............................ (36,764) $0.10 to $0.35 $0.12 --------- -------------- ----- Balance at December 31, 2001........... 1,864,799 $0.10 to $0.35 $0.24 ========= ============== =====
The following table summarizes information concerning outstanding and exercisable options at December 31, 2001.
OPTIONS OUTSTANDING OPTIONS EXERCISABLE - -------------------------------------------------------------------- ------------------------- WEIGHTED NUMBER AVG. WEIGHTED NUMBER OUTSTANDING AT REMAINING AVERAGE EXERCISABLE AT DECEMBER 31, CONTRACTUAL EXERCISE DECEMBER 31, EXERCISE PRICES 2001 LIFE PRICE 2001 - --------------- -------------- ----------- -------- -------------- $0.10................................. 758,299 6.00 $0.10 758,299 $0.10................................. 35,000 7.00 $0.10 32,812 $0.35................................. 80,000 7.00 $0.35 64,999 $0.35................................. 151,500 8.00 $0.35 87,958 $0.35................................. 555,000 9.00 $0.35 196,563 $0.35................................. 285,000 10.00 $0.35 17,813 --------- ----- --------- $0.10 - 0.35.......................... 1,864,799 $0.24 1,158,444 ========= ===== =========
Pro forma information regarding net income and earnings per share is required by SFAS No. 123, "Accounting for Stock Based Compensation," and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. During 2001 and 2000, the Company granted 310,000 and 739,000 stock options, respectively. The fair value of these options was estimated at $0.05 and $0.08 per share for 2001 and 2000, respectively, on the date of grant using a minimum value option pricing model with the following weighted-average assumptions: risk free interest rate of 3.69% and 6.27%; dividend yield of 0%; and a weighted-average expected life of the options of approximately ten years. FB-22 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Option valuation models require the input of highly subjective assumptions. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the option's vesting period. The Company's pro forma information follows:
2001 2000 ---------- ----------- Net income (loss)........................................... $2,577,627 $(1,916,430) Pro forma compensation expense from stock options........... 12,234 19,081 ---------- ----------- Pro forma net income (loss)................................. $2,565,393 $(1,935,511) ========== ===========
10. EMPLOYEE BENEFIT PLANS The Company adopted the Psychiatric Solutions, Inc., Retirement Savings Plan (the "Plan"). The Plan is a tax-qualified profit sharing plan with a cash or deferred arrangement whereby employees who have completed two months of service and are age 21 or older are eligible to participate. The plan allows eligible employees to make contributions of 1% to 15% of their annual compensation. The plan includes a discretionary company matching contribution not to exceed 15% of eligible employee compensation. Employer contributions vest 20% after two years of service and continue vesting at 20% per year until fully vested. There were no employer contributions to the plan during 2000 or 2001. 11. CONTINGENCIES AND HEALTHCARE REGULATION CONTINGENCIES The Company is subject to various claims and legal actions which arise in the ordinary course of business. The Company has professional liability insurance to protect against such claims or legal actions. In the opinion of management, the ultimate resolution of such matters will be adequately covered by insurance and will not have a material adverse effect on the Company's financial position or results of operations. CURRENT OPERATIONS Final determination of amounts earned under prospective payment and cost-reimbursement activities is subject to review by appropriate governmental authorities or their agents. In the opinion of the Company's management, adequate provision has been made for any adjustments that may result from such reviews. Laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing. While no such regulatory inquiries have been made, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusion from the Medicare and Medicaid programs. The Company has acquired and may continue to acquire professional corporations with prior operating histories. Acquired corporations may have unknown or contingent liabilities for failure to comply with health care laws and regulations, such as billing and reimbursement, fraud and abuse and similar anti-referral laws. Although the Company attempts to assure itself that no such liabilities exist and obtains FB-23 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) indemnification from prospective sellers covering such matters, there can be no assurance that any such matter will be covered by indemnification or, if covered, that the liability sustained will not exceed contractual limits or the financial capacity of the indemnifying party. 12. RELATED PARTY TRANSACTIONS During 2001 and 2000, the Company leased office space from a company whose chief executive officer is Dr. Richard Treadway, the chairman of the Company's board of directors. The term of the lease was from May 16, 1999 to July 2002 and was terminated on December 7, 2001. Rent expense for this space totaled $142,154 for the year ended December 31, 2001. The Company believes the terms of this lease were at fair market value. Currently the Company leases 7,745 square feet of office space for its executive offices from a company in which Dr. Treadway is a minority investor. The lease was entered into in October 2001 and has a term of approximately six years. The annual rent under this lease is approximately $492,000. The Company believes the terms of this lease are at fair market value. Joey Jacobs, the Company's Chief Executive Officer, serves as a member of the board of directors of Stones River Hospital, a hospital in which the Company manages a unit pursuant to a management agreement. The term of the third amendment to the management agreement is two years, and automatically renews for one year terms unless terminated by either party. Total revenue from this management agreement was $678,243 for the year ended December 31, 2001. The Company believes the terms of the management agreement are consistent with management agreements negotiated at arms-length. 13. SEGMENT INFORMATION The Company's hospitals and management contracts comprising the Freestanding Specialty Hospitals and Psychiatric Unit Management divisions, respectively are each similar in their activities and the economic environments in which they operate. Accordingly, the Company's reportable operating segments consist of (1) Freestanding Specialty Hospitals and (2), Psychiatric Unit Management. Prior to the acquisitions of the Company's hospitals in fiscal 2001, management had determined that the Company did not have separately reportable segments as defined under Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information. The following is a financial summary by business segment for the periods indicated. EBITDA represents EBITDA, or net income before interest expense (net of interest income), income taxes, depreciation, amortization. EBITDA is commonly used as an analytical indicator within the healthcare industry and serves as a measure of leverage capacity and debt service ability. EBITDA should not be considered as a measure of financial performance under accounting principles generally accepted in the United States, and the items excluded in determining EBITDA are significant components in understanding and assessing financial performance. Because neither is a measurement determined in accordance with accounting principles generally accepted in the United States, it is susceptible to varying FB-24 PSYCHIATRIC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) calculations, and as a result our calculation of EBITDA as presented may not be comparable to EBITDA or other similarly titled measures used by the companies: YEAR ENDED DECEMBER 31, 2001
FREESTANDING PSYCHIATRIC SPECIALTY UNIT CORPORATE HOSPITALS MANAGEMENT AND OTHER CONSOLIDATED ------------ ----------- ----------- ------------ Revenue.................................. $16,020,097 $27,972,890 $ 5,690 $43,998,677 Salaries, wages and employee benefits.... 9,463,453 15,461,893 1,257,507 26,182,853 Professional fees........................ 2,609,511 4,114,796 314,968 7,039,275 Rentals and leases....................... 103,678 114,994 109,057 327,729 Other operating expenses................. 2,067,871 1,540,739 346,833 3,955,443 Provision for doubtful accounts.......... 384,781 277,198 -- 661,979 ----------- ----------- ----------- ----------- EBITDA................................... 1,390,803 6,463,270 (2,022,675) 5,831,398 Depreciation and amortization............ 170,485 717,985 56,175 944,654 Interest expense......................... 532,672 324,000 1,803,428 2,660,100 Inter-segment expenses................... 447,967 1,773,325 (2,221,292) -- ----------- ----------- ----------- ----------- Income (loss) from continuing operations before income taxes.................... $ 239,679 $ 3,647,960 $(1,660,986) $ 2,226,644 =========== =========== =========== =========== Segment assets........................... $31,471,318 $20,393,873 $ 2,428,588 $54,293,779 =========== =========== =========== =========== Capital expenditures..................... $18,373,050 $ -- $ 115,618 $18,488,668 =========== =========== =========== ===========
14. OTHER INFORMATION A summary of activity in the Company's allowance for doubtful accounts follows:
ADDITIONS ADDITIONS ACCOUNTS BALANCES AT CHARGED TO (1) CHARGED WRITTEN BALANCE AT BEGINNING COSTS AND TO OTHER OFF, NET OF END OF OF PERIOD EXPENSES ACCOUNTS RECOVERIES PERIOD ----------- ---------- ----------- ----------- ---------- Allowance for doubtful accounts Year ended December 31, 1999........ $ -- $528,835 $ -- $161,835 $ 367,000 Year ended December 31, 2000........ 367,000 467,082 1,818,000 209,082 2,443,000 Year ended December 31, 2001........ 2,443,000 661,979 921,458 86,437 3,940,000
- --------------- (1) Allowances as a result of acquisition. 15. SUBSEQUENT EVENT (UNAUDITED) Effective May 6, 2002, the boards of directors of PSI and PMR Corporation have approved an agreement to merge. PMR develops and manages specialized mental health programs and disease management services designed to treat individuals diagnosed with a serious mental illness. As a result of the merger holders of PSI common stock, Series A Preferred Stock and Series B preferred stock will receive 0.115125, 0.246951 and 0.312864 shares, respectively, of PMR common stock in exchange for each share of the PSI stock that they own. PSI shareholders will own approximately 72% of the combined company. The proposed merger is subject to customary closing conditions and approval of the shareholders of both companies. FB-25 REPORT OF INDEPENDENT AUDITORS The Board of Directors Cypress Creek Hospital, Inc., West Oaks Hospital, Inc. and Healthcare Rehabilitation Center Of Austin, Inc. We have audited the accompanying combined statements of operations and cash flows of Cypress Creek Hospital, Inc., West Oaks Hospital, Inc. and Healthcare Rehabilitation Center Of Austin, Inc. (collectively the "Brown Schools Facilities") for the years ended December 31, 2000, 1999 and 1998. These financial statements are the responsibility of the Brown Schools Facilities' management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the operations and cash flows of Cypress Creek Hospital, Inc., West Oaks Hospital, Inc. and Healthcare Rehabilitation Center Of Austin, Inc. for the years ended December 31, 2000, 1999 and 1998 in conformity with accounting principles generally accepted in the United States. /s/ Ernst & Young LLP Nashville, Tennessee May 31, 2002 FB-26 CYPRESS CREEK HOSPITAL, INC., WEST OAKS HOSPITAL, INC. AND HEALTHCARE REHABILITATION CENTER OF AUSTIN, INC. COMBINED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, SIX MONTHS ENDED JUNE 30, --------------------------------------- ------------------------- 2000 1999 1998 2001 2000 ----------- ----------- ----------- ----------- ----------- UNAUDITED Net patient service revenue................... $45,178,655 $38,014,253 $40,400,347 $28,167,521 $23,414,664 Other revenue............... 329,054 141,533 74,493 39,735 166,172 ----------- ----------- ----------- ----------- ----------- 45,507,709 38,155,786 40,474,840 28,207,256 23,580,836 Expenses: Salaries, wages and employee benefits...... 27,316,964 22,054,865 21,942,237 15,742,477 13,027,542 Supplies.................. 3,184,588 2,497,757 2,640,792 1,903,237 1,549,674 Professional fees......... 5,267,879 4,976,424 4,693,658 3,826,208 3,811,599 Provision for doubtful accounts............... 1,227,080 1,086,822 2,104,466 1,112,041 720,885 Other operating expenses............... 5,089,803 5,140,053 5,099,152 3,102,798 2,593,892 Depreciation and amortization........... 736,926 688,546 630,741 376,551 332,277 Management fees........... 2,321,766 1,959,794 1,980,428 1,360,485 1,167,418 Interest.................. 2,444,792 2,111,796 1,688,746 1,641,567 1,112,457 Impairment of long-lived assets................. 827,000 -- -- -- -- ----------- ----------- ----------- ----------- ----------- 48,416,798 40,516,057 40,780,220 29,065,364 24,315,744 ----------- ----------- ----------- ----------- ----------- Net loss.................... $(2,909,089) $(2,360,271) $ (305,380) $ (858,108) $ (734,908) =========== =========== =========== =========== ===========
See accompanying notes. FB-27 CYPRESS CREEK HOSPITAL, INC., WEST OAKS HOSPITAL, INC. AND HEALTHCARE REHABILITATION CENTER OF AUSTIN, INC. COMBINED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, SIX MONTHS ENDED JUNE 30, --------------------------------------- ------------------------- 2000 1999 1998 2001 2000 ----------- ----------- ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net loss.................... $(2,909,089) $(2,360,271) $ (305,380) $ (858,108) $ (734,908) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization........... 736,926 688,546 630,741 376,551 332,277 Impairment of long-lived assets................. 827,000 -- -- -- -- Provision for doubtful accounts............... 1,227,080 1,086,822 2,104,466 1,112,041 720,885 Changes in operating assets and liabilities: Accounts receivable.... (5,316,708) 373,039 (2,137,954) (2,477,461) (5,214,118) Prepaid expenses and other assets......... (28,447) (66,136) 104,136 (147,776) (28,446) Accounts payable and accrued expenses..... 1,363,716 (734,782) 1,037,204 (887,888) 850,965 Estimated payable under third-party reimbursement programs............. 789,527 (859,898) 309,629 784,116 942,947 Other liabilities.... (746,518) (5,347) (880,004) (38,268) 1,619,323 ----------- ----------- ----------- ----------- ----------- Net cash (used in) provided by operating activities... (4,056,513) (1,878,027) 862,838 (2,136,793) (1,511,075) CASH FLOWS FROM INVESTING ACTIVITIES Purchases of property and equipment, net............ (380,383) (1,076,685) (1,225,691) (109,317) 60,438 ----------- ----------- ----------- ----------- ----------- Net cash (used in) provided by investing activities... (380,383) (1,076,685) (1,225,691) (109,317) 60,438 CASH FLOWS FROM FINANCING ACTIVITIES Net transfers from parent... 4,436,621 2,818,179 496,487 2,249,152 1,450,362 ----------- ----------- ----------- ----------- ----------- Net cash flows from financing activities...... 4,436,621 2,818,179 496,487 2,249,152 1,450,362 (Decrease) increase in cash...................... (275) (136,533) 133,634 3,042 (275) Cash at beginning of period.................... 16,606 153,139 19,505 16,331 16,606 ----------- ----------- ----------- ----------- ----------- Cash at end of period....... $ 16,331 $ 16,606 $ 153,139 $ 19,373 $ 16,331 =========== =========== =========== =========== =========== SUPPLEMENTAL INFORMATION: Interest payments........... $ 2,444,792 $ 2,111,796 $ 1,688,746 $ 1,641,567 $ 1,112,457 =========== =========== =========== =========== ===========
See accompanying notes. FB-28 CYPRESS CREEK HOSPITAL, INC., WEST OAKS HOSPITAL, INC. AND HEALTHCARE REHABILITATION CENTER OF AUSTIN, INC. NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 2000 1. ORGANIZATION The accompanying combined financial statements include the accounts of the following entities (collectively, the Brown Schools Facilities). - Cypress Creek Hospital, Inc. (Cypress) owns and operates a 114-bed private acute care psychiatric facility located in Houston, Texas. Cypress provides inpatient, day treatment and outpatient services and programs for critically ill children, adolescents and adults. - Healthcare Rehabilitation Center of Austin, Inc. (HRC) owns and operates a 127-bed private specialty neuropsychiatry/neurobehavioral hospital and residential treatment center. HRC provides long-term acute care, medical rehabilitation, brain injury and neurobehavioral treatment programs for children, adolescents and adults. - West Oaks Hospital, Inc. (West Oaks) owns and operates a 142-bed private acute care psychiatric facility located in Houston, Texas. West Oaks provides inpatient, day treatment and outpatient services and programs for critically ill children, adolescents and adults. The Brown Schools Facilities were wholly-owned subsidiaries of The Brown Schools, Inc. (the Parent). Cypress and West Oaks were purchased by Psychiatric Solutions, Inc. (PSI) on October 1, 2001 for approximately $14 million. HRC was purchased on November 1, 2001 for approximately $8.4 million. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES UNAUDITED INTERIM COMBINED FINANCIAL STATEMENTS The accompanying unaudited combined statements of operations and cash flows for the six months ended June 30, 2001 and 2000 have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim results have been included. The unaudited interim combined financial statements should be read in conjunction with the audited December 31, 2000, 1999, and 1998 combined financial statements appearing herein. The results of the six months ended June 30, 2001 and 2000 may not be indicative of operating results for the full year. NET PATIENT SERVICE REVENUE The Brown Schools Facilities receive payment for patient services from the federal government primarily under the Medicare program, health maintenance organizations, preferred provider organizations and other private insurers and directly from patients. Patient service revenue is reported on the accrual basis in the period in which services are provided, at established rates, regardless of whether collection in full is expected. Net patient service revenue is based on established billing rates less allowances and discounts for patients covered by Medicare and various other discount arrangements. Payments received under these programs and arrangements, which are based on either predetermined rates or the cost of services, are generally less than the Brown Schools Facilities' customary charges, and the differences are recorded as contractual adjustments or policy discounts at the time service is rendered. FB-29 CYPRESS CREEK HOSPITAL, INC., WEST OAKS HOSPITAL, INC. AND HEALTHCARE REHABILITATION CENTER OF AUSTIN, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) Settlements under cost reimbursement agreements with third party payors are estimated and recorded in the period in which the related services are rendered and are adjusted in future periods as final settlements are determined. Final determination of amounts earned under the Medicare and Medicaid programs often occur in subsequent years because of audits by the programs, rights of appeal and the application of numerous technical provisions. Adjustments to estimated settlements increased net revenues approximately $94,000, $197,000 and $522,000 for the years ended December 31, 2000, 1999 and 1998, respectively. RELATED PARTY TRANSACTIONS Interest expense is allocated by the Parent to the Brown Schools Facilities based upon a percentage of the Brown Schools Facilities' fixed assets and working capital. Interest expense totaled approximately $2,445,000, $2,112,000 and $1,689,000 for the years ended December 31, 2000, 1999 and 1998, respectively. The Brown Schools Facilities are charged a management fee by the Parent equal to 5% of its unaudited revenues. Management fees were $2,322,000, $1,960,000 and $1,980,000 for the years ended December 31, 2000, 1999 and 1998, respectively. The Parent carries employee health and dental insurance from an unrelated commercial carrier on behalf of the Brown Schools Facilities. Premiums are allocated based on the number of enrolled employees and dependents at the individual facilities. Health and dental expenses were approximately $835,000, $649,000 and $734,000 for the years ended December 31, 2000, 1999 and 1998, respectively. CASH AND CASH EQUIVALENTS Cash and cash equivalents include all highly liquid investments with a remaining maturity of three months or less at date of acquisition. INVENTORIES Inventories, consist principally of supplies, are stated at the lower of cost (first-in, first-out) or market. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Depreciation is computed by the straight-line method over the estimated useful life of the assets. Depreciation expense was approximately $737,000, $689,000 and $631,000 for the years ended December 31, 2000, 1999 and 1998, respectively. When events, circumstances and operating results indicate that the carrying values of certain long-lived assets and the related identifiable intangible assets might be impaired, the Brown Schools Facilities prepares projections of the undiscounted future cash flows expected to result from the use of the assets and their eventual disposition. If the projections indicated that the recorded amounts are not expected to be recoverable, such amounts are reduced to estimated fair value. Fair value is estimated based upon projections of discounted cash flows for assets to be held and used. Fair value for assets expected to be sold is estimated based upon comparable sales values. INCOME TAXES The provision for income taxes for the years ended December 31, 2000, 1999, and 1998 differs from the amount computed by applying the statutory rate of 34% due primarily to a valuation allowance that FB-30 CYPRESS CREEK HOSPITAL, INC., WEST OAKS HOSPITAL, INC. AND HEALTHCARE REHABILITATION CENTER OF AUSTIN, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) has been recorded against the deferred taxes of the Brown Schools Facilities. A valuation allowance has been recognized to reflect the possible limitation in the ability to utilize net operating loss carryforwards and other tax benefits in future years. Additionally, at December 31, 2000, the Brown Schools Facilities have net operating loss carryforwards of approximately $7,600,000, which expire in various years through 2020. GENERAL AND PROFESSIONAL LIABILITY RISKS The Parent, on behalf of the Brown Schools Facilities, carries general and professional liability insurance from an unrelated commercial insurance carrier, on a claims-made basis, for per occurrence losses up to $1,000,000 in 1998 and $2,000,000 in 1999 and 2000 with policy limits of $3,000,000 in the aggregate in 1998 and $2,000,000 in 1999 and 2000. In addition, the Parent has an umbrella policy with an unrelated insurance carrier with coverage up to $9,000,000 per occurrence and in the aggregate in 1998 and $25 million per occurrence and in the aggregate in 1999 and 2000. The Parent also carries workers' compensation insurance from an unrelated commercial insurance carrier. The cost of general and professional liability and workers' compensation coverage is allocated to the Brown Schools Facilities based upon a percentage of the number of full time employees as compared to the consolidated total of the Parent. The cost for the years ended December 31, 2000, 1999 and 1998 was approximately $706,000, $729,000 and $735,000, respectively. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. 3. CONCENTRATIONS OF CREDIT RISK The Brown Schools Facilities' primary concentration of credit risk is patient accounts receivable, which consists of amounts owed by governmental agencies, insurance companies, and private patients. The Brown Schools Facilities manages the receivables by regularly reviewing its accounts and contracts and by providing appropriate allowances for uncollectible accounts. The Medicare and Medicaid programs comprised approximately 15% and 21% of patient receivables at December 31, 2000, respectively. Remaining receivables relate primarily to various commercial insurance carriers and HMO/PPO programs. Concentration of credit risk from other payers is limited by the number of patients and payors. 4. RETIREMENT PLAN The Brown Schools Facilities participates in the Parent's defined contribution retirement plan, The Brown Schools, Inc. 401(k) Plan (the Plan). The Plan covers substantially all employees. Retirement expense was approximately $55,000, $46,000 and $61,000 for the years ended December 31, 2000, 1999 and 1998, respectively. The Brown Schools Facilities make discretionary contributions to the Plan through the Parent. 5. IMPAIRMENT OF LONG-LIVED ASSETS The Brown Schools Facilities recognized an impairment related to the fixed assets of HRC of approximately $827,000 for the year ended December 31, 2000. The Brown Schools Facilities recorded these fixed assets at fair value based upon sales proceeds received from the sale of HRC to PSI. FB-31 CYPRESS CREEK HOSPITAL, INC., WEST OAKS HOSPITAL, INC. AND HEALTHCARE REHABILITATION CENTER OF AUSTIN, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) 6. COMMITMENTS AND CONTINGENCIES CURRENT OPERATIONS Final determination of amounts earned under prospective payment and cost-reimbursement activities is subject to review by appropriate governmental authorities or their agents. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. CONTINGENCIES Laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. The Brown Schools Facilities believe that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing. While no such regulatory inquiries have been made, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusion from the Medicare and Medicaid programs. The Brown Schools Facilities are subject to claims and suits arising in the ordinary course of business. In the opinion of management, the ultimate resolution of such pending legal proceedings will not have a material effect on the Brown Schools Facilities' results of operations. LEASES The Brown Schools Facilities lease office space and certain equipment under operating agreements. Total rent expense under operating leases was approximately $475,000, $481,000 and $550,000 for the years ended December 31, 2000, 1999 and 1998, respectively. FB-32 REPORT OF INDEPENDENT AUDITORS The Board of Directors Holly Hill/Charter Behavioral Health System, L.L.C. We have audited the accompanying statements of operations and cash flows of Holly Hill/Charter Behavioral Health System, L.L.C. (the Company) for the years ended September 30, 2001 and 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the operations and cash flows of Holly Hill/Charter Behavioral Health System, L.L.C. for the years ended September 30, 2001 and 2000 in conformity with accounting principles generally accepted in the United States. /s/ Ernst & Young LLP Nashville, Tennessee June 4, 2002 FB-33 HOLLY HILL/CHARTER BEHAVIORAL HEALTH SYSTEM, L.L.C. STATEMENTS OF OPERATIONS
YEARS ENDED SEPTEMBER 30, ------------------------- 2001 2000 ----------- ----------- Revenues.................................................... $10,666,452 $10,056,888 Expenses: Salaries, wages and employee benefits..................... 5,693,052 5,674,026 Professional fees......................................... 148,507 158,836 Supplies.................................................. 533,129 445,171 Provision for doubtful accounts........................... 658,376 300,222 Other operating expenses.................................. 1,818,320 1,836,067 Depreciation and amortization............................. 542,537 450,913 Management fees........................................... 201,123 300,000 Settlement of malpractice claim........................... -- 1,000,000 Impairment of long-lived assets........................... 1,910,166 -- ----------- ----------- 11,505,210 10,165,235 ----------- ----------- Net loss.................................................... $ (838,758) $ (108,347) =========== ===========
See accompanying notes. FB-34 HOLLY HILL/CHARTER BEHAVIORAL HEALTH SYSTEM, L.L.C. STATEMENTS OF CASH FLOWS
YEARS ENDED SEPTEMBER 30, -------------------------- 2001 2000 ----------- ------------ CASH FLOWS FROM OPERATING ACTIVITIES Net loss.................................................... $ (838,758) $ (108,347) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization............................. 542,537 450,913 Provision for doubtful accounts........................... 658,376 300,222 Impairment of long-lived assets........................... 1,910,166 -- Changes in operating assets and liabilities: Accounts receivable.................................... (852,299) 343,431 Prepaid expenses and other assets...................... 2,627 (9,727) Accounts payable and accrued expenses.................. (601,832) 372,860 Estimated payable under third-party reimbursement programs.............................................. 303,087 (127,710) ---------- ----------- Net cash provided by operating activities................... 1,123,904 1,221,642 CASH FLOWS FROM INVESTING ACTIVITIES Purchases of property and equipment, net.................... (185,602) (55,221) Other assets................................................ (500,000) -- ---------- ----------- Net cash used in investing activities....................... (685,602) (55,221) CASH FLOWS FROM FINANCING ACTIVITIES Distributions paid to partners.............................. -- (1,801,000) ---------- ----------- Net cash provided by (used in) financing activities......... -- (1,801,000) ---------- ----------- Increase (decrease) in cash................................. 438,302 (634,579) Cash at beginning of year................................... 2,411,134 3,045,713 ---------- ----------- Cash at end of year......................................... $2,849,436 $ 2,411,134 ========== =========== SUPPLEMENTAL INFORMATION: Interest payments........................................... $ 19,407 $ -- ========== =========== SIGNIFICANT NON-CASH TRANSACTION: Finance purchase of property through a capital lease arrangement............................................... $ 245,550 $ -- ========== ===========
See accompanying notes. FB-35 HOLLY HILL/CHARTER BEHAVIORAL HEALTH SYSTEM, L.L.C. NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30, 2001 1. ORGANIZATION Holly Hill/Charter Behavioral Health System, L.L.C. (the Company), a Tennessee limited liability company, was organized in July 1995 to provide psychiatric and mental health services to patients in and around the Raleigh, North Carolina area. The Company is 50% owned by HCA Inc. and 50% owned by Magellan Health Services, Inc (Magellan). Related profit and loss is allocated evenly based upon respective ownership percentages. Charter Behavioral Health System (Charter) was hired by the Company to manage operations. Charter filed a petition for bankruptcy in February 2000 and ceased management functions as of September 30, 2000. Subsequent to September 30, 2000, Magellan was hired as manager of operations. Effective November 30, 2001, the Company was purchased by Psychiatric Solutions, Inc. (PSI) for approximately $8.4 million (including the assumption of certain liabilities). 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES NET PATIENT SERVICE REVENUE The Company receives payment for patient services from the federal government primarily under the Medicare program, health maintenance organizations, preferred provider organizations and other private insurers and directly from patients. Patient service revenue is reported on the accrual basis in the period in which services are provided, at established rates, regardless of whether collection in full is expected. Net patient service revenue is based on established billing rates less allowances and discounts for patients covered by Medicare and various other discount arrangements. Payments received under these programs and arrangements, which are based on either predetermined rates or the cost of services, are generally less than the Company's customary charges, and the differences are recorded as contractual adjustments or policy discounts at the time service is rendered. Settlements under cost reimbursement agreements with third party payors are estimated and recorded in the period in which the related services are rendered and are adjusted in future periods as final settlements are determined. Final determination of amounts earned under the Medicare and Medicaid programs often occur in subsequent years because of audits by the programs, rights of appeal and the application of numerous technical provisions. Adjustments to estimated settlements that increased net revenues were approximately $27,000 and $385,000 for the years ended September 30, 2001 and 2000, respectively. RELATED PARTY TRANSACTIONS Information systems fees are provided by a related party and are allocated based on direct costs incurred. The costs for the years ended September 30, 2001 and 2000 was approximately $4,700 and $30,000, respectively. Management fees of $201,000 and $300,000 for 2001 and 2000, respectively, were paid to a related party for management services as specified by the management and control agreement. CASH AND CASH EQUIVALENTS Cash and cash equivalents include all highly liquid investments with a remaining maturity of three months or less at date of acquisition. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Depreciation is computed by the straight-line method over the estimated useful life of the assets. Depreciation expense was approximately $437,000 and FB-36 HOLLY HILL/CHARTER BEHAVIORAL HEALTH SYSTEM, L.L.C. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) $451,000 for the years ended September 30, 2001 and 2000, respectively. Amortization expense under capital leases was approximately $106,000 for the year ended September 30, 2001. When events, circumstances and operating results indicate that the carrying values of certain long-lived assets and the related identifiable intangible assets might be impaired, the Company prepares projections of the undiscounted future cash flows expected to result from the use of the assets and their eventual disposition. If the projections indicated that the recorded amounts are not expected to be recoverable, such amounts are reduced to estimated fair value. Fair value is estimated based upon projections of discounted cash flows for assets to be held and used. Fair value for assets expected to be sold is estimated based upon comparable sales values. INCOME TAXES The Company is not a tax paying entity. No provision is made in the accounts of the Company since such taxes are liabilities of individual members of the Company, and the amounts thereof depend on their respective tax situations. The Company's tax returns and tax amounts of distributable Company income or loss are subject to examination by the federal and state taxing authorities. In the event of an examination of the Company's tax return, the tax liability of the members could be changed if any adjustment to the Company income or loss is ultimately substained by the taxing authorities. GENERAL AND PROFESSIONAL LIABILITY RISKS For the year ended September 30, 2000, the Company participated in Charter's self insured program for general and professional liability. The cost was allocated by Charter based on actuarially determined estimates. The cost for the year ended September 30, 2000 was approximately $245,000. Charter filed for bankruptcy in February 2000. Due to the provisions in the petition, it was determined that the Company was subject to a risk of loss for all claims incurred during the periods covered under Charter's self-insurance program. A claim was asserted during 1999 and a settlement was paid by the Company in the amount of $1,000,000 during 2000. The Company also participated in Charter's workers' compensation insurance plan from an unrelated insurance carrier. The cost for the year ended September 30, 2000 was approximately $69,000. Subsequent to September 30, 2000, Magellan, on behalf of the Company, carries general and professional liability insurance from an unrelated commercial insurance carrier, on a claims-made basis, for per occurrence losses up to $1,000,000 with policy limits of $3,000,000 in the aggregate. In addition, Magellan has an umbrella policy with an unrelated insurance carrier with coverage up to $10 million per occurrence and in the aggregate. Magellan allocates the cost of general and professional liability coverage to the Company based upon a pro rata share of premiums. The cost for the year ended September 30, 2001 was approximately $217,000. Also, Magellan, on behalf of the Company, carries workers' compensation insurance from an unrelated carrier. Magellan allocated costs of approximately $168,000 to the Company for the year ended September 30, 2001. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. FB-37 HOLLY HILL/CHARTER BEHAVIORAL HEALTH SYSTEM, L.L.C. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) 3. CONCENTRATIONS OF CREDIT RISK The Company's primary concentration of credit risk is patient accounts receivable, which consists of amounts owed by governmental agencies, insurance companies, and private patients. The Company manages the receivables by regularly reviewing its accounts and contracts and by providing appropriate allowances for uncollectible accounts. The Medicare and Medicaid programs comprised approximately 19% and 17% of patient receivables at September 30, 2001, respectively. Remaining receivables relate primarily to various commercial insurance carriers and HMO/PPO programs. Concentration of credit risk from other payers is limited by the number of patients and payers. 4. RETIREMENT PLAN The Company participates in a defined contribution retirement plan through a related party. Benefits are discretionary and are determined as a percentage of a participant's salary and are vested over specified periods of employee service. Retirement expense was approximately $79,000 for the year ended September 30, 2000 and is included in the accompanying statement of operations as salaries and benefits. 5. IMPAIRMENT OF LONG-LIVED ASSETS The Company recognized an impairment of approximately $1.9 million related to its fixed assets. The Company recorded its fixed assets to fair value based upon sales proceeds received from the sale of the Company to PSI. 6. COMMITMENTS AND CONTINGENCIES CURRENT OPERATIONS Final determination of amounts earned under prospective payment and cost-reimbursement activities is subject to review by appropriate governmental authorities or their agents. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. CONTINGENCIES Laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing. While no such regulatory inquiries have been made, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusion from the Medicare and Medicaid programs. The Company is subject to claims and suits arising in the ordinary course of business. In the opinion of management, the ultimate resolution of such pending legal proceedings will not have a material effect on the Company's results of operations. FB-38 HOLLY HILL/CHARTER BEHAVIORAL HEALTH SYSTEM, L.L.C. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) LEASES The Company leases office space and certain equipment under both operating and capital lease agreements. Future minimum lease payments under noncancelable operating leases with terms greater than one year and capital leases at September 30, 2001, are as follows:
OPERATING CAPITAL LEASES LEASES ---------------- -------------- 2002..................................................... $14,265 $122,984 2003..................................................... 11,643 122,984 2004..................................................... 5,822 30,746 ------- -------- $31,730 276,714 Amounts representing interest............................ 31,164 -------- Present value of minimum lease payments.................. $245,550 ========
Total rent expense under operating leases was approximately $16,638 and $11,039 for the years ended September 30, 2001 and 2000, respectively. FB-39 REPORT OF INDEPENDENT AUDITORS Board of Directors Psychiatric Solutions, Inc. We have audited the accompanying statements of operations and cash flows of Sunrise Behavioral Health, Ltd. (the Partnership) for the four months ended April 30, 2000. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of the Partnership for the four months ended April 30, 2000, in conformity with accounting principles generally accepted in the United States. /s/ Ernst & Young LLP Nashville, Tennessee May 30, 2002 FB-40 SUNRISE BEHAVIORAL HEALTH, LTD. STATEMENT OF OPERATIONS FOR THE FOUR MONTHS ENDED APRIL 30, 2000 Management fee revenues:.................................... $7,082,691 Costs and expenses: Direct costs: Salaries and related costs of leased employees......... 4,188,046 Contract and consulting fees........................... 775,127 Provision for doubtful accounts........................ 1,284,285 Other direct costs..................................... 199,303 General and administrative................................ 833,570 Interest.................................................. 262,764 Depreciation and amortization............................. 200,076 ---------- Total costs and expenses.................................... 7,743,171 ---------- Net loss.................................................... $ (660,480) ==========
See accompanying notes. FB-41 SUNRISE BEHAVIORAL HEALTH, LTD. STATEMENT OF CASH FLOWS FOR THE FOUR MONTHS ENDED APRIL 30, 2000 OPERATING ACTIVITIES Net loss.................................................... $(660,480) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization............................. 200,076 Provision for doubtful accounts........................... 1,284,285 Amortization of discount on notes payable................. 19,958 Changes in operating assets and liabilities: Accounts receivable.................................... (446,308) Prepaid expenses and other current assets.............. 8,634 Accounts payable and accrued expenses.................. (398,878) Deferred revenue....................................... 264,707 --------- Net cash provided by operating activities................... 271,994 INVESTING ACTIVITIES Purchases of property and equipment......................... (13,940) Increase in other non-current assets........................ (400,000) --------- Net cash used in investing activities....................... (413,940) FINANCING ACTIVITIES Borrowings on long-term debt................................ 256,000 Repayments of long-term debt................................ (125,000) Distributions paid to partners.............................. (200,129) --------- Net cash used in financing activities....................... (69,129) --------- Net decrease in cash........................................ (211,075) Cash at beginning of period................................. 218,175 --------- Cash at end of period....................................... $ 7,100 ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid during the period for interest.................... $ 178,106 =========
See accompanying notes. FB-42 SUNRISE BEHAVIORAL HEALTH, LTD. NOTES TO FINANCIAL STATEMENTS APRIL 30, 2000 1. PARTNERSHIP Sunrise Behavioral Health, Ltd. (the Partnership or the Company), a Texas limited partnership, was organized in March 1995 to own and manage geriatric psychiatry units within rural general acute care hospitals. The Partnership has contracts with hospitals, generally for three or five years and on a year-to- year basis thereafter, to provide turnkey psychiatric care staffing and management services. Net income or loss of the Partnership is first allocated to the Class B limited partner in an amount equal to the Class B preferred return distribution through February 28, 1998, and the remainder is allocated to the Class A limited partners and the general partner in proportion to the respective partner's ownership percentage. In addition to Class B distributions, if any, the general partner intends to distribute annually, at a minimum, an amount that approximates the federal and state tax liability of the partners arising from the Partnership operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES MANAGEMENT FEE REVENUES Management fee revenues are recognized as earned based on a contracted fee per month or per patient discharge. Unbilled fees are accrued to recognize revenues earned for which billings have not yet been presented to the hospital. Deferred revenues represent amounts received from hospitals or included in accounts receivable which have not yet been earned. Management fee revenues from no single hospital represent more than 10% of the total management fee revenues for the four months ended April 30, 2000. PROPERTY AND EQUIPMENT Property and equipment are stated at cost less accumulated depreciation. Depreciation is provided over the estimated useful lives of the assets which range from five to seven years. INTANGIBLE AND OTHER ASSETS Intangible and other assets are amortized on a straight-line basis over the following periods: hospital contracts and relationships purchased, the estimated economic useful life of the relationships, primarily eight years; goodwill, twenty-five years; and debt issuance costs, over three years. When events, circumstances and operating results indicate that the carrying values of certain long-lived assets and the related identifiable intangible assets might be impaired, the Partnership prepares projections of the undiscounted future cash flows expected to result from the use of the assets and their eventual disposition. If the projections indicate that the recorded amounts are not expected to be recoverable, such amounts are reduced to estimated fair value. Fair value is estimated based upon projections of discounted cash flows. INCOME TAXES The Partnership is not a tax paying entity. No provision is made in the accounts of the Partnership since such taxes are liabilities of individual partners of the Partnership, and the amounts thereof depend on their respective tax situations. The Partnership's tax returns and tax amounts of distributable Partnership income or loss are subject to examination by the federal and state taxing authorities. In the event of an examination of the Partnership's tax return, the tax liability of the partners could be changed if any adjustment to the Partnership income or loss is ultimately sustained by the taxing authorities. FB-43 SUNRISE BEHAVIORAL HEALTH, LTD. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) EQUITY-BASED COMPENSATION Equity-based compensation arising from grants of partnership units is accounted for by the intrinsic value method under Accounting Principles Board Opinion No. 25 (APB No. 25). SFAS No. 123, "Accounting for Stock-Based Compensation," was effective for the Partnership beginning January 1, 1996. This statement requires expanded disclosures of stock-based or similar compensation arrangements with employees and encourages (but does not require) compensation cost to be measured based on the fair value of the equity instrument awarded. As permitted by SFAS No. 123, the Partnership continues to apply APB No. 25 to its equity-based compensation awards to employees and discloses the pro forma effect on net income. The fair value of options issued was estimated at the date of grant using an option pricing model with the following weighted-average assumptions: risk-free interest rate ranging from 5.0% to 5.8%, no dividend yield and an expected ten year life of the options. The estimated fair value for these options was calculated using the minimum value method and may not be indicative of the future impact since this model does not take into consideration volatility. The pro forma effects under SFAS No. 123's fair value based method were not materially different than from the corresponding APB No. 25 intrinsic value methodology because the weighted-average grant date fair value of options granted during the period was negligible. RISKS AND UNCERTAINTIES The Balanced Budget Act of 1997 (BBA), which is effective for all Medicare providers with fiscal years beginning on or after October 1, 1997, established a payment cap per discharge for Medicare-funded distinct part psychiatric programs. The BBA reduced reimbursement on a per discharge basis for certain hospitals, which has and may continue to further impact revenues of the Partnership. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates also affect the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. 3. DEBT AND CREDIT FACILITIES SENIOR TERM LOAN AND LINE OF CREDIT In August 1998, the Company entered into a new loan agreement with a bank under which the Company borrowed $2,500,000 under a senior term loan and may borrow up to $7,500,000 under a line of credit. The initial proceeds of $6,764,390 under these facilities were used to repay amounts outstanding under the Company's previous $10,000,000 line of credit. The new revolving line of credit and term loan are both subject to limitations on distributions and expenditures as well as maintenance of specified financial covenants generally related to net worth, liquidity, debt service coverage and cash flows, and are collateralized by accounts receivable, equipment and contract rights. The line of credit borrowings under the new loan agreement are limited to the lesser of $7,500,000 or an amount determined by a defined borrowing base. SUBORDINATED NOTES TO RELATED PARTY In August 1998, the Company issued $1,900,000 in subordinated notes due in August 2000 to the general partner and certain Class A limited partners at a rate of 9%. In conjunction with the issuance of FB-44 SUNRISE BEHAVIORAL HEALTH, LTD. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) the new subordinated notes, the Company issued to the holders of such notes warrants to purchase 844,445 partnership units of the Company at $2.25 per unit. The Company valued the warrants at $119,751, and such warrants were recorded as partners' equity and as a discount on the new subordinated notes which is amortized as additional interest expense over the term of the notes. CONVERTIBLE DEBT Convertible debt of $1,200,000 is payable to a Class A limited partner, bears interest at 9% payable quarterly, matures in 2000 and is convertible at any time through March 2000 into 240,845 Class A limited partner units. The convertible debt is subject to the maintenance of specified financial covenants generally related to interest coverage and cash flows and "excess cash flow" prepayment provisions as defined in the convertible debt agreement. At April 30, 2000, the Partnership was in violation of certain of these covenants. DEBT AND CREDIT FACILITIES RETIREMENT The Company's operations and substantially all net assets were sold to Psychiatric Solutions, Inc. effective May 1, 2000 (see Note 7). In connection with this transaction, the obligations referred to above were retired subsequent to April 30, 2000. 4. RELATED PARTY TRANSACTIONS AND CONSULTING AGREEMENTS The Partnership has a consulting agreement with a company owned by a Class A limited partner, who is a director and the sole owner of the entity that is the general partner. Under the agreement, which was amended in November 1997, the Partnership paid $40,000 during the four months ended April 30, 2000, for consulting services. The Partnership has a consulting agreement with a company owned by an officer and Class A limited partner of the Partnership. Under the agreement, which was amended in November 1997, the Partnership paid $28,335 during the four months ended April 30, 2000, for consulting services. 5. EMPLOYEE AND PHYSICIAN ARRANGEMENTS Physicians are retained under consulting contracts with the Partnership. Professional liability insurance is carried at several levels, including the hospital, the physician and the Partnership. Administrative, management and other health care personnel are contracted under an employee leasing arrangement with an outside company. Under this arrangement, the lessor receives a fee and reimbursement for labor costs, including taxes and benefits. The employee leasing arrangement can be terminated by either the lessee or lessor with a 30-day notice. All employee leasing costs are included in leased employee expenses, except for administrative employee leasing costs which are included in general and administrative expenses totaling $381,492 for the four months ended April 30, 2000. The Partnership has a profit sharing plan under Section 401(k) of the Internal Revenue Code, which covers substantially all employees, including personnel under employee leasing arrangements. The Partnership is required to match employee contributions to the Plan. Partnership contributions of $57,294 for the four months ended April 30, 2000, is included in salaries and related costs of leased employees. FB-45 SUNRISE BEHAVIORAL HEALTH, LTD. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) 6. COMMITMENTS AND CONTINGENCIES The Partnership leases office space and vehicles under noncancelable operating leases that expire through 2002. Future minimum lease payments under the operating leases are as follows: 2002........................................................ $ 64,948 2003........................................................ 70,954 2004........................................................ 20,411 -------- $156,313 ========
Rent expense was $44,760 for the four months ended April 30, 2000. The Partnership is subject to various claims and legal actions which arise in the ordinary course of business. The Partnership has an occurrence-based professional liability insurance policy to protect against such claims or legal actions. In the opinion of management, the ultimate resolution of such matters will be adequately covered by insurance and will not have a material adverse effect on the Partnership's financial position or results of operations. 7. SUBSEQUENT EVENT Effective May 1, 2000, Psychiatric Solutions, Inc. acquired substantially all of the net assets of the Partnership for cash for approximately $9.4 million and a subordinated convertible note of approximately $3.6 million. FB-46 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Aeries Healthcare Corporation and Subsidiary (d/b/a Riveredge Hospital) Forest Park, Illinois We have audited the accompanying consolidated balance sheets of Aeries Healthcare Corporation and Subsidiary (d/b/a Riveredge Hospital) as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholders' equity and cash flows for the year ended December 31, 2001 and the ten months ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Aeries Healthcare Corporation and Subsidiary (d/b/a Riveredge Hospital) at December 31, 2001 and 2000, and the consolidated results of their operations and cash flows for the year ended December 31, 2001 and the ten months ended December 31, 2000, in conformity with accounting principles generally accepted in the United States. /s/ BDO Seidman, LLP Chicago, Illinois February 14, 2002 except for notes 9c and 10 which are as of July 1, 2002 FB-47 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) CONSOLIDATED BALANCE SHEETS
DECEMBER 31, MARCH 31, ------------------------ ----------- 2001 2000 2002 ----------- ---------- ----------- (UNAUDITED) ASSETS CURRENT ASSETS Cash................................................. $ 1,337,093 $ -- $ 460,565 Accounts receivable, net of allowance of $583,000 and $379,000 and $869,000 (unaudited), respectively... 3,923,635 4,173,086 4,598,806 Other accounts receivable............................ 148,033 303,603 101,771 Inventory............................................ 90,000 78,329 90,000 Prepaid expenses..................................... 144,937 140,076 788,509 Deferred tax asset................................... 322,000 187,000 322,000 ----------- ---------- ----------- TOTAL CURRENT ASSETS................................... 5,965,698 4,882,094 6,361,651 ----------- ---------- ----------- PROPERTY AND EQUIPMENT, less accumulated depreciation and amortization..................................... 4,512,701 4,409,407 4,463,148 ----------- ---------- ----------- OTHER ASSETS Notes receivable..................................... -- 10,870 -- Deferred financing fees, net of accumulated amortization of $44,420, 0 and $91,571 (unaudited), respectively......................... 204,150 212,676 156,999 ----------- ---------- ----------- TOTAL OTHER ASSETS..................................... 204,150 223,546 156,999 ----------- ---------- ----------- $10,682,549 $9,515,047 $10,981,798 =========== ========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Line of credit....................................... -- -- $ 2,370,456 Current portion of long-term debt.................... $ 530,772 $ 300,000 1,990,383 Accounts payable..................................... 1,290,920 2,272,530 2,040,253 Accrued compensation................................. 691,397 741,179 829,083 Accrued expenses..................................... 416,194 509,794 308,623 Due to Medicare...................................... 410,800 1,019,000 682,693 Income taxes payable................................. 426,080 205,000 250,080 ----------- ---------- ----------- TOTAL CURRENT LIABILITIES.............................. 3,766,163 5,047,503 8,471,571 DEFERRED TAX LIABILITY................................. 44,000 142,000 44,000 LINE OF CREDIT......................................... 3,174,596 1,878,232 -- LONG-TERM DEBT, less current portion................... 1,592,304 1,200,000 -- CONVERTIBLE DEBT....................................... 400,000 400,000 400,000 PUT WARRANTS........................................... 521,000 521,000 521,000 ----------- ---------- ----------- TOTAL LIABILITIES...................................... 9,498,063 9,188,735 9,436,571 ----------- ---------- ----------- COMMITMENTS, CONTINGENCIES AND OTHER MATTERS STOCKHOLDERS' EQUITY Common stock -- $.01 par value; 2,500 shares authorized, 316 shares issued and outstanding at December 31, 2001 and 2000 and 324 shares issued and outstanding at March 31, 2002................. 3 3 3 Additional paid-in capital........................... 473,437 473,437 488,063 Retained earnings (accumulated deficit).............. 711,046 (147,128) 1,057,161 ----------- ---------- ----------- TOTAL STOCKHOLDERS' EQUITY............................. 1,184,486 326,312 1,545,227 ----------- ---------- ----------- $10,682,549 $9,515,047 $10,981,798 =========== ========== ===========
See accompanying summary of accounting policies and notes to consolidated financial statements. FB-48 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, YEAR ENDED TEN MONTHS ENDED ----------------------- DECEMBER 31, 2001 DECEMBER 31, 2000 2002 2001 ------------------ ----------------- ---------- ---------- (UNAUDITED) NET PATIENT SERVICE REVENUE......... $25,131,767 $18,005,765 $6,544,256 $6,393,878 ----------- ----------- ---------- ---------- EXPENSES Salaries and benefits............. 14,058,107 9,482,678 3,615,589 3,802,797 Supplies.......................... 1,928,567 1,072,623 448,369 471,596 Contract services................. 2,695,929 3,248,982 643,176 773,107 Professional fees................. 1,177,469 766,960 212,357 322,688 Insurance......................... 482,194 223,416 153,867 44,138 Utilities......................... 499,279 415,949 97,606 160,847 Real estate taxes................. 351,195 383,000 150,000 150,000 Depreciation...................... 221,914 161,645 80,000 55,488 Other............................. 1,834,510 881,314 437,031 427,853 ----------- ----------- ---------- ---------- Total expenses...................... 23,249,164 16,636,567 5,837,995 6,208,514 ----------- ----------- ---------- ---------- Income from operations.............. 1,882,603 1,369,198 706,261 185,364 ----------- ----------- ---------- ---------- OTHER INCOME (EXPENSE) Interest expense.................. (607,078) (1,406,099) (139,146) (148,370) Miscellaneous income.............. 36,630 49,773 -- -- ----------- ----------- ---------- ---------- Total other expense................. (570,448) (1,356,326) (139,146) (148,370) ----------- ----------- ---------- ---------- Income before income tax expense.... 1,312,155 12,872 567,115 36,994 INCOME TAX EXPENSE.................. 453,981 160,000 221,000 14,428 ----------- ----------- ---------- ---------- NET INCOME (LOSS)................... $ 858,174 $ (147,128) $ 346,115 $ 22,566 =========== =========== ========== ==========
See accompanying summary of accounting policies and notes to consolidated financial statements. FB-49 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
RETAINED ADDITIONAL EARNINGS COMMON STOCK PAID-IN (ACCUMULATED SHARES AMOUNT CAPITAL DEFICIT) TOTAL ------ ------ ---------- ------------ ---------- BALANCE, AT MARCH 1, 2000............... -- $ -- $ -- $ -- $ -- Cash paid for common stock.............. 72 1 99,999 -- 100,000 Common stock issued in exchange for services provided and other associated costs................................. 244 2 323,438 -- 323,440 Warrants issued in exchange for services rendered.............................. -- -- 50,000 -- 50,000 Net loss for the ten months ended December 31, 2000..................... -- -- -- (147,128) (147,128) --- ----- -------- ---------- ---------- BALANCE, AT DECEMBER 31, 2000........... 316 3 473,437 (147,128) 326,312 Net income for the year ended December 31, 2001.............................. -- -- -- 858,174 858,174 --- ----- -------- ---------- ---------- BALANCE, AT DECEMBER 31, 2001........... 316 3 473,437 711,046 1,184,486 Common Stock issued..................... 8 -- 14,626 -- 14,626 Net income for the three months ended March 31, 2002........................ -- -- -- 346,115 346,115 --- ----- -------- ---------- ---------- BALANCE, AT MARCH 1, 2002 (UNAUDITED)... 324 $ 3 $488,063 $1,057,161 $1,545,227 === ===== ======== ========== ==========
See accompanying summary of accounting policies and notes to consolidated financial statements. FB-50 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) CONSOLIDATED STATEMENTS OF CASH FLOWS
TEN THREE MONTHS YEAR ENDED MONTHS ENDED ENDED MARCH 31, DECEMBER 31, DECEMBER 31, ------------------------ 2001 2000 2002 2001 ------------ ------------ ---------- ----------- (UNAUDITED) CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss).................................. $ 858,174 $ (147,128) $ 346,115 $ 22,566 Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities Depreciation..................................... 221,914 161,645 80,000 55,488 Amortization of deferred financing fees.......... 44,420 350,000 47,151 7,400 Amortization of original issue discount.......... -- 521,000 -- -- Deferred taxes................................... (233,000) (45,000) -- -- Changes in operating assets and liabilities, net of effects of purchase of Riveredge Hospital in March 2000 Accounts receivable............................ 249,451 (2,638,876) (675,171) (1,282,965) Other accounts receivable...................... 155,570 (179,158) 46,262 32,441 Inventory...................................... (11,671) (19,538) -- (23,290) Prepaid expenses............................... (4,861) (96,856) (643,572) (83,646) Notes receivable............................... 10,870 20,149 -- 10,870 Accounts payable............................... (981,610) 1,984,814 749,333 1,534,351 Accrued expenses............................... (143,382) 439,252 30,115 (436,427) Due to Medicare................................ (608,200) 1,019,000 271,893 (19,000) Income taxes payable........................... 221,080 205,000 (176,000) (135,572) ---------- ----------- ---------- ----------- Net cash (used in) provided by operating activities......................................... (221,245) 1,574,304 76,126 (317,784) ---------- ----------- ---------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES Cash used in acquisition of Riveredge Hospital, including associated costs....................... -- (4,693,703) -- -- Capital expenditures............................... (325,208) (196,157) (30,447) (28,611) ---------- ----------- ---------- ----------- Net cash used in investing activities................ (325,208) (4,889,860) (30,447) (28,611) ---------- ----------- ---------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from term loans........................... 1,000,000 5,000,000 -- -- Repayment of term loan............................. (376,924) (3,500,000) (132,693) (75,000) Increase (decrease) in line of credit.............. 1,296,364 1,878,232 (804,140) 432,116 Proceeds from the issuance of convertible debt..... -- 400,000 -- -- Proceeds from the issuance of common stock......... -- 100,000 14,626 -- Cash paid for deferred financing fees.............. (35,894) (562,676) -- (10,722) ---------- ----------- ---------- ----------- Net cash provided by (used in) financing activities......................................... 1,883,546 3,315,556 (922,207) 346,395 ---------- ----------- ---------- ----------- NET INCREASE IN CASH................................. $1,337,093 $ -- $ (876,528) $ -- CASH, AT BEGINNING OF PERIOD......................... -- -- 1,337,093 -- ---------- ----------- ---------- ----------- CASH, AT END OF PERIOD............................... $1,337,093 $ -- $ 460,565 $ -- ========== =========== ========== =========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period for interest........... $ 514,121 $ 490,000 $ 151,000 $ 174,000 Cash paid during the period for income taxes....... 465,901 -- $ 397,000 $ 150,000 NONCASH INVESTING AND FINANCING ACTIVITIES In March 2000, the Company issued 244 shares of common stock and 36 warrants in exchange for services provided and other costs associated with the acquisition. As a result, $323,440 and $50,000, respectively, has been recorded as additional paid-in capital.
See accompanying summary of accounting policies and notes to consolidated financial statements. FB-51 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) SUMMARY OF ACCOUNTING POLICIES BUSINESS AND OPERATIONS Aeries Healthcare Corporation and Subsidiary was formed for the purpose of owning and operating healthcare facilities providing psychiatric and related mental health services. The Company currently owns and operates one facility, the Riveredge Hospital, through its wholly owned subsidiary, Aeries Healthcare of Illinois, Inc. BASIS OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. All significant intercompany balances and transactions are eliminated in consolidation. UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS The accompanying unaudited consolidated balance sheet as of March 31, 2002 and the related unaudited consolidated statements of operations and cash flows for the three months ended March 31, 2001 and March 31, 2002, and the unaudited consolidated statement of stockholders' equity for the three months ended March 31, 2002 (interim financial statements) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim results have been included. The unaudited interim consolidated financial statements should be read in conjunction with the audited December 31, 2001 and 2000 consolidated financial statements appearing herein. The results of the three months ended March 31, 2002 and 2001 may not be indicative of operating results for the full year. ACCOUNTS RECEIVABLE The Company's primary concentration of credit risk arises from patient accounts receivable which consist of amounts owed by various governmental agencies, insurance companies and private patients. The Company manages the risk by regularly reviewing its accounts and contracts and by providing appropriate allowances for uncollectible amounts. Receivables from Medicare and Medicaid programs account for approximately 80% of patient receivables at December 31, 2001 and 2000. Receivables from the Department of Mental Health and the Department of Children and Family Services account for approximately 9% of patient receivables at December 31, 2001 and 2000. Remaining receivables relate primarily to various HMO/PPO programs. Concentration of credit risk from other payers is limited by the number of patients and payers. REVENUE RECOGNITION Patient service revenue is reported on the accrual basis in the period in which services are provided, at established rates, as discussed below. Net patient service revenue includes amounts estimated by management to be reimbursable by Medicare and Medicaid under provisions of cost or prospective reimbursement formulas in effect. Amounts received are generally less than the established billing rates of the facilities and the differences (contractual allowances) are reported as deductions from patient service revenue at the time the service is rendered. The effect of other arrangements for providing services at less than established rates is also reported as deductions from patient service revenue. FB-52 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) SUMMARY OF ACCOUNTING POLICIES -- (CONTINUED) Settlements under cost reimbursement agreements with third-party payers are estimated and recorded in the period in which the related services are rendered and are adjusted in future periods as final settlements are determined. Final determination of amounts earned under the Medicare and Medicaid programs often occurs in subsequent years because of audits by the programs, rights of appeal and the application of numerous technical provisions. The adjustments to estimated settlements for prior years are not considered material. Due to Medicare at December 31, 2001 and 2000 represents overpayments received and cost reporting settlements. Net patient service revenue is net of contractual adjustments and policy discounts of approximately $41,924,000 and $31,668,000 for the year ended December 31, 2001 and the ten months ended December 31, 2000, respectively. The provision for doubtful accounts is included in operating expenses. INVENTORIES Inventories, consisting of hospital and medical-related supplies, are stated at the lower of cost or market. Cost is determined by the first-in, first-out method. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Routine maintenance and repairs are charged to expense as incurred. Expenditures that increase values, change capacities or extend useful lives are capitalized. Depreciation is computed by the straight-line method over the estimated useful lives of the assets which range from five to 25 years. DEFERRED FINANCING FEES Deferred financing fees relate to the Company's term loans and are being amortized over the term of this debt as additional interest. ESTIMATES Financial statements prepared by management in conformity with generally accepted accounting principles include estimated amounts and certain disclosures based on assumptions about future events. Accordingly, actual results could differ from those estimates. INCOME TAXES Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. RISK MANAGEMENT The Company carries general and professional liability insurance from an unrelated commercial insurance carrier for per-occurrence losses up to $1,000,000 with policy limits of $3,000,000 in the aggregate, on a claims-made basis. In addition, the Company has an umbrella policy with an unrelated insurance carrier with coverage up to $10,000,000 per occurrence and in the aggregate. The Company also carries workers' compensation insurance from an unrelated commercial insurance carrier. FB-53 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) SUMMARY OF ACCOUNTING POLICIES -- (CONTINUED) Management is aware of no potential professional liability or workers' compensation claims whose settlement, if any, would have a material adverse effect on the Company's consolidated financial position or results of operations. STOCK-BASED COMPENSATION In accordance with the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"), warrants and common stock issued to consultants in connection with the Company's acquisition of Riveredge Hospital have been recorded at fair value. The fair value has been reflected as an additional cost of the acquisition. The Company accounts for its employee stock options in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. FB-54 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ACQUISITIONS Effective March 1, 2000, the Company acquired substantially all of the assets of Riveredge Hospital, a psychiatric hospital previously owned by Illinois Psychiatric Hospital Company, Inc. This acquisition was accounted for using the purchase method of accounting. The aggregate purchase price was approximately $6,166,000 consisting of cash paid of approximately $4,261,000 and the assumption of liabilities of approximately $1,099,000, and direct acquisition costs of approximately $806,000 (of which approximately $433,000 was paid in cash). The preliminary allocation of the aggregate purchase price is as follows: Patient receivables......................................... $1,534,000 Other current assets........................................ 257,000 Property and equipment...................................... 4,375,000
2. PROPERTY AND EQUIPMENT Major classes of property and equipment consist of the following:
DECEMBER 31, ----------------------- 2001 2000 ---------- ---------- Land........................................................ $ 686,000 $ 686,000 Land improvements........................................... 96,025 88,037 Building.................................................... 3,383,050 3,383,050 Furniture and equipment..................................... 726,532 413,965 ---------- ---------- 4,891,607 4,571,052 Less accumulated depreciation and amortization.............. (378,906) (161,645) ---------- ---------- $4,512,701 $4,409,407 ========== ==========
3. LINE OF CREDIT At December 31, 2001, the Company has a line-of-credit agreement with Healthcare Business Credit Corporation. This agreement provides for advances of up to 85% of eligible accounts receivable up to a maximum of $3,500,000. This line of credit bears interest at a variable rate (ranging between prime plus 1% to prime plus 3%) based on certain financial ratios of the Company. The interest rate in effect at December 31, 2001 was 7.75%. The line of credit matures on February 28, 2003. The line of credit is collateralized by substantially all of the Company's assets, personally guaranteed by a shareholder of the Company, and requires adherence to a financial covenant. FB-55 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 4. LONG-TERM DEBT Long-term debt consists of the following:
DECEMBER 31, ----------------------- 2001 2000 ---------- ---------- First term loan, payable in monthly principal installments of $25,000 plus interest at prime plus 4% (8.75% at December 31, 2001) through January 2003 with a final balloon payment of the remaining unpaid principal amount of $875,000 due February 28, 2003............... $1,200,000 $1,500,000 Second term loan, payable in monthly principal installments of $19,231 plus interest at prime plus 4% through January 2003 with a final balloon payment of the remaining unpaid principal amount of $673,073 due February 28, 2003........ 923,076 -- ---------- ---------- 2,123,076 1,500,000 Less current maturities..................................... 530,772 300,000 ---------- ---------- Net long-term debt................................ $1,592,304 $1,200,000 ========== ==========
These term loans are collateralized by substantially all of the Company's assets, personally guaranteed by a shareholder of the Company, and require adherence to a financial covenant. Following is a schedule of maturities of long-term debt:
YEAR ENDING DECEMBER 31, AMOUNT - ------------------------ ---------- 2002........................................................ $ 530,772 2003........................................................ 1,592,304 ---------- Total............................................. $2,123,076 ==========
5. CONVERTIBLE DEBT In March 2000, the Company issued a $400,000 subordinated convertible note to Sunrise Behavioral Health, Ltd., a related party through common ownership. This debt bears interest at 7% and is due on March 1, 2010. This note is convertible at any time in whole or in part, at the holder's option, into shares of common stock of the Company at a conversion price of $1,389 per share. FB-56 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. INCOME TAXES The Company's net deferred tax asset as of December 31, 2001 and 2000 consists principally of differences in accounting for the allowance for doubtful accounts, certain accruals, and fixed assets. The provision for income taxes consists of the following for the year ended December 31, 2001 and the ten months ended December 31, 2000:
2001 2000 --------- -------- Current: Federal................................................... $ 584,000 $174,000 State..................................................... 102,981 31,000 --------- -------- 686,981 205,000 --------- -------- Deferred: Federal................................................... (198,000) (38,000) State..................................................... (35,000) (7,000) --------- -------- (233,000) (45,000) --------- -------- Total taxes on income....................................... $ 453,981 $160,000 ========= ========
The Company's effective tax rate varies from statutory federal income tax rates due to differences in the treatment of acquisition-related costs and a permanent difference relating to the put warrant liability. 7. STOCKHOLDERS' EQUITY SHARES ISSUED FOR CASH In connection with the formation of the Company in March 2000, the Company issued 72 shares of common stock in exchange for $100,000. SHARES ISSUED FOR SERVICES RENDERED In March 2000, the Company issued 244 shares of common stock in exchange for services provided and other associated costs in connection with the acquisition. As the fair value of these services was not readily determinable, these services were valued based on the fair value for the stock issued. As a result, $323,440 has been reflected as an additional cost of the acquisition. PUT WARRANTS In order to finance the purchase of Riveredge Hospital in March 2000 (see Note 1), the Company entered into a subordinated term loan in the amount of $3,500,000 with the Hillstreet Fund L.P., which was subsequently refinanced with another lender in December 2000. In connection with the Hillstreet debt financing, the Company issued warrants to purchase 186 shares of the Company's common stock at an exercise price of $.01 per share. There are put and call rights associated with these warrants. The put option period is any time subsequent to March 2, 2003 and the call option period is any time subsequent to March 2, 2005. The put/call price is the greater of the fair market value (per share) of the Company or a per-share price calculated using a formula defined in the warrant agreement which is based on earnings of the Company. The fair value of such warrants was determined to be $521,000. Such amount was recorded as a discount in the related debt and was amortized over the life of the debt using the interest method, resulting in additional interest expense of $521,000 for the ten months ended FB-57 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) December 31, 2000. At December 31, 2001 and 2000, there is an estimated liability of $521,000 for these put warrants. Because the formula is based upon estimated future levels of earnings and debt, it is likely that management's estimate of this obligation will change in future years. Future changes in the estimated liability will be recorded as an adjustment to interest. OTHER WARRANTS The Company also issued warrants to purchase 36 shares of the Company's common stock at an exercise price of $.01 per share in exchange for services rendered in connection with the acquisition. As the fair value of these services was not readily determinable, these services were valued based on the estimated fair value for the warrants issued which was $50,000. This amount has been reflected as an additional cost of the acquisition. The Company also issued warrants to stockholders to purchase 413 shares of the Company's common stock at an exercise price of $1,389 per share in exchange for services provided. The fair value of these warrants was determined to be immaterial and as a result, no value was recorded for these warrants. STOCK OPTIONS In December 2000, the Company established a long-term incentive plan which provides for the granting of options to key employees, directors, independent contractors and consultants. A total of 310 shares of the Company's common stock is authorized to be granted under this plan. During 2000, 158 options with an exercise price of $1,389 were granted to the chief executive officer of the Company. 71 of these options to purchase common stock of the Company vested in December 2000, 55 options vested in January 2001 and the remaining 32 options will vest in the event the Company is sold prior to November 30, 2002 and the sales price meets or exceeds certain specified levels. With the exception of the options contingent on the sale of the Company, which expire in November 2002, the options granted during 2000 must be exercised within 10 years of vesting. No compensation expense was recorded as a result of the stock options granted. The pro forma impact on net income for the stock options, assuming compensation cost was recognized based on the fair value in accordance with SFAS No. 123, is not material. 8. RELATED PARTIES For the year ended December 31, 2001 and the ten months ended December 31, 2000, the Company incurred expense of $550,000 and $601,000, respectively, for management services provided by both stockholders and entities affiliated through common ownership. $140,250 of these management fees are included in accounts payable at December 31, 2001. In addition, the Company paid rent of $36,000 and $30,000 for the year ended December 31, 2001 and the ten months ended December 31, 2000, respectively, to an affiliated entity. The Company has five management contracts with affiliated entities and stockholders. These contracts range from one to five years. Under the terms of these arrangements, the aggregate amount due in the future (excluding payments contingent upon certain future financial ratios of the Company) is approximately $767,000. 9. CONTINGENCIES AND HEALTHCARE REGULATION A) CONTINGENCIES The Company is presently, and from time to time, subject to other various claims and lawsuits arising in the normal course of business. In the opinion of management, the ultimate resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations. FB-58 AERIES HEALTHCARE CORPORATION AND SUBSIDIARY (D/B/A RIVEREDGE HOSPITAL) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) B) CURRENT OPERATIONS Final determination of amounts earned under prospective payment and cost-reimbursement activities is subject to review by appropriate governmental authorities or their agents. In the opinion of the Company's management, adequate provision has been made for any adjustments that may result from such reviews. C) UNCERTAINTIES The Company was the subject of two separate Medicare surveys during 2001. After each survey, the Medicare Program issued a Statement of Deficiencies and requested that the Company submit a plan of correction. The failure to submit a plan of correction acceptable to Medicare could result in the termination of the Company from the Medicare program. The Company has submitted plans of correction and is currently addressing comments received from the Centers for the Medicare and Medicaid Services. Laws and regulations governing the Medicare, Medicaid, and other federal healthcare programs are complex and subject to interpretation. The Company's management believes that the Company is in compliance with all applicable laws and regulations in all material respects. Compliance with laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusion from the Medicare, Medicaid and other federal program. 10. SUBSEQUENT EVENT Effective July 1, 2002, Psychiatric Solutions purchased 100% of the Company's outstanding common stock for a purchase price of approximately $16.1 million. In addition, as a result of the sale of the Company, the outstanding put warrant liability discussed in Note 7 increased to approximately $1.7 million of which $1.1 million will be paid in July 2002 and the remainder will be paid contingent upon certain future events. FB-59 ANNEX A AGREEMENT AND PLAN OF MERGER BY AND BETWEEN PMR CORPORATION, PMR ACQUISITION CORPORATION AND PSYCHIATRIC SOLUTIONS, INC. MAY 6, 2002 TABLE OF CONTENTS
PAGE ---- ARTICLE I THE MERGER................................................ A-2 1.1 The Merger.................................................. A-2 1.2 Closing; Effective Time..................................... A-2 1.3 Effect of the Merger........................................ A-2 1.4 Certificate of Incorporation; Bylaws........................ A-2 1.5 Board and Officers of the Surviving Corporation............. A-2 1.6 Board, Committees and Officers of PMR....................... A-3 1.7 Effect on Capital Stock..................................... A-3 1.8 Surrender of Certificates................................... A-5 1.9 No Further Ownership Rights in PSI Capital Stock............ A-6 1.10 Lost, Stolen or Destroyed Certificates...................... A-6 1.11 Tax Consequences............................................ A-6 1.12 Taking of Necessary Action; Further Action.................. A-6 1.13 Withholding................................................. A-6 1.14 Stock Transfer Books........................................ A-7 1.15 Pre-Closing Distribution to PMR Shareholders................ A-7 ARTICLE II REPRESENTATIONS AND WARRANTIES OF PSI.................... A-7 2.1 Organization, Standing and Power............................ A-7 2.2 Capital Structure........................................... A-8 2.3 Authority; No Conflict; Required Filings and Consents....... A-9 2.4 Financial Statements........................................ A-10 2.5 Absence of Certain Changes.................................. A-10 2.6 Absence of Undisclosed Liabilities.......................... A-11 2.7 Litigation.................................................. A-11 2.8 Restrictions on Business Activities......................... A-12 2.9 Governmental Authorization.................................. A-12 2.10 Title to Property........................................... A-12 2.11 Intellectual Property....................................... A-12 2.12 Environmental Matters....................................... A-13 2.13 Tax Matters................................................. A-14 2.14 Employee Benefit Plans...................................... A-16 2.15 Certain Agreements Affected by the Merger................... A-18 2.16 Employee Matters............................................ A-18 2.17 Conflicts of Interest; Related Party Transactions........... A-19 2.18 Insurance................................................... A-19 2.19 Compliance With Laws........................................ A-19 2.20 Accounts Receivable......................................... A-19 2.21 Customers and Suppliers..................................... A-19 2.22 Material Contracts.......................................... A-20 2.23 No Breach of PSI Material Contracts......................... A-20 2.24 Third Party Consents........................................ A-20 2.25 Certain Additional Regulatory Matters....................... A-20 2.26 Medicare/Medicaid Participation............................. A-21
A-i
PAGE ---- 2.27 Minute Books................................................ A-22 2.28 Complete Copies of Materials................................ A-22 2.29 Brokers' and Finders' Fees.................................. A-22 2.30 Vote Required............................................... A-22 2.31 Board Approval.............................................. A-22 2.32 State Takeover Statutes..................................... A-22 2.33 Programs.................................................... A-22 2.34 Representations Complete.................................... A-22 ARTICLE III REPRESENTATIONS AND WARRANTIES OF PMR AND MERGER SUB.... A-23 3.1 Organization, Standing; and Power........................... A-23 3.2 Capital Structure........................................... A-24 3.3 Authority; No Conflict; Required Filings and Consents....... A-24 3.4 SEC Documents; Financial Statements......................... A-25 3.5 Absence of Certain Changes.................................. A-25 3.6 Absence of Undisclosed Liabilities.......................... A-26 3.7 Litigation.................................................. A-27 3.8 Restrictions on Business Activities......................... A-27 3.9 Governmental Authorization.................................. A-27 3.10 Title to Property........................................... A-27 3.11 Intellectual Property....................................... A-27 3.12 Environmental Matters....................................... A-29 3.13 Tax Matters................................................. A-29 3.14 Employee Benefit Plans...................................... A-30 3.15 Certain Agreements Affected by the Merger................... A-33 3.16 Employee Matters............................................ A-33 3.17 Conflicts of Interest; Related Party Transactions........... A-34 3.18 Insurance................................................... A-34 3.19 Compliance With Laws........................................ A-34 3.20 Accounts Receivable......................................... A-34 3.21 Customers and Suppliers..................................... A-34 3.22 Material Contracts.......................................... A-35 3.23 No Breach of Material Contracts............................. A-35 3.24 Third Party Consents........................................ A-35 3.25 Certain Additional Regulatory Matters....................... A-35 3.26 Medicare/Medicaid Participation............................. A-36 3.27 Minute Books................................................ A-37 3.28 Complete Copies of Materials................................ A-37 3.29 Brokers' and Finders' Fees.................................. A-37 3.30 Vote Required............................................... A-37 3.31 PMR Board Approval; Merger Sub Approval..................... A-37 3.32 State Takeover Statutes..................................... A-37 3.33 Representations Complete.................................... A-37
A-ii
PAGE ---- ARTICLE IV CONDUCT PRIOR TO THE EFFECTIVE TIME...................... A-38 4.1 Conduct of Business of PSI.................................. A-38 4.2 Restriction on Conduct of Business of PSI................... A-38 4.3 Conduct of Business of PMR.................................. A-40 4.4 Restriction on Conduct of Business of PMR................... A-41 ARTICLE V ADDITIONAL AGREEMENTS..................................... A-43 5.1 Rule 145 Affiliates......................................... A-43 5.2 Registration Statement; Proxy Statement..................... A-43 5.3 Stockholders' Meetings...................................... A-44 5.4 Access to Information; Confidentiality...................... A-44 5.5 No Solicitation by PSI...................................... A-45 5.6 No Solicitation by PMR...................................... A-46 5.7 Best Efforts................................................ A-48 5.8 Stock Options and Other Stock Awards; Employee Benefit A-49 Plans....................................................... 5.9 Update Disclosure; Breaches................................. A-50 5.10 Public Announcements........................................ A-51 5.11 Nasdaq Listing.............................................. A-51 5.12 Indemnification of PSI and PMR Directors and Officers....... A-51 5.13 Plan of Reorganization...................................... A-52 5.14 Headquarters; Name.......................................... A-52 5.15 Obligations of Merger Sub................................... A-52 5.16 Financial Statements........................................ A-52 5.17 Appraisal Rights............................................ A-52 ARTICLE VI CONDITIONS TO THE MERGER................................. A-52 6.1 Conditions to Obligations of Each Party to Effect the A-52 Merger...................................................... 6.2 Additional Conditions to Obligations of PSI................. A-53 6.3 Additional Conditions to the Obligations of PMR............. A-55 ARTICLE VII TERMINATION, AMENDMENT AND WAIVER....................... A-56 7.1 Termination................................................. A-56 7.2 Effect of Termination....................................... A-57 7.3 Amendment................................................... A-57 7.4 Extensions; Waiver.......................................... A-57 7.5 Fees and Expenses; Termination Fees......................... A-57 ARTICLE VIII GENERAL PROVISIONS..................................... A-58 8.1 Non-Survival at Effective Time.............................. A-58 8.2 Notices..................................................... A-59 8.3 Definitions................................................. A-59 8.4 Interpretation.............................................. A-60 8.5 Counterparts................................................ A-61 8.6 Entire Agreement; Nonassignability; Parties in Interest..... A-61 8.7 Severability................................................ A-61 8.8 Remedies Cumulative......................................... A-61 8.9 Governing Law............................................... A-61 8.10 Rules of Construction....................................... A-61
A-iii SCHEDULES Schedule A PSI Stockholders Executing Voting Agreement Schedule B PMR Stockholders Executing Voting Agreement Schedule C Directors and Officers of the Surviving Corporation Following Effective Time Schedule D Directors and Officers of PMR Following Effective Time PSI DISCLOSURE SCHEDULE Schedule 2.1 PSI Subsidiaries Schedule 2.2 PSI Securityholders Schedule 2.5 Absence of Certain Changes Schedule 2.6(a) Absence of Undisclosed Liabilities Schedule 2.7 PSI Litigation Schedule 2.8 Restrictions on Business Activities Schedule 2.10 PSI Real Property Schedule 2.11 PSI Intellectual Property Schedule 2.12(b) Environmental Matters Schedule 2.13(a) Tax Return Matters Schedule 2.13(c) Tax Liability Matters Schedule 2.14 PSI Employee Plans Schedule 2.14(h) PSI Benefit Plans Schedule 2.16 Employee Matters Schedule 2.17(b) Related Party Transactions Schedule 2.22 PSI Material Contracts Schedule 2.24 Third Party Consents Schedule 2.29 Brokers' and Finders' Fees Schedule 4.2(j) Pending Additional Indebtedness Schedule 5.1 List of PSI Affiliates Schedule 6.3(h) Employees of PSI Entering into Non-Competition Agreements with PMR and PSI PMR DISCLOSURE SCHEDULE Schedule 3.1 PMR Subsidiaries Schedule 3.5 Absence of Certain Changes Schedule 3.6 Absence of Undisclosed Liabilities Schedule 3.7 PMR Litigation Schedule 3.8 Restrictions on Business Activities Schedule 3.10 PMR Real Property Schedule 3.11 PMR Intellectual Property Schedule 3.14 PMR Employee Plans Schedule 3.15 Certain Agreements Affected by the Merger Schedule 3.16 Employee Matters Schedule 3.17(b) Related Party Transactions Schedule 3.22 PMR Material Contracts Schedule 3.24 Third Party Consents
A-iv Schedule 3.29 Brokers' and Finders' Fees Schedule 4.4 Restrictions on Conduct of PMR Schedule 4.4(f) Intellectual Property Schedule 4.4(n) Employee Benefit Plans; New Hires; Pay Increases Schedule 6.2(g) Officers and Directors Resigning from PMR Schedule 6.2(l) Employees of PMR Entering into Non-Competition Agreements Schedule 6.2(n) PMR Accounts Receivable Credit Balances Schedule 6.2(o) PMR Contractual Obligations
EXHIBITS Exhibit A -- Voting Agreement (PSI) Exhibit B -- Voting Agreement (PMR) Exhibit C -- Form of Affiliate Letter Exhibit D -- Contingent Value Rights Agreement Exhibit E -- Legal Opinion (PMR) Exhibit F -- Legal Opinion (PSI) Exhibit G -- FIRPTA Notice Exhibit H -- IRS Notice Exhibit I -- Non-Competition Agreement
A-v INDEX OF DEFINED TERMS
DEFINED TERM SECTION ------------ ------- Affiliate................................................... 5.1 Agreement................................................... Introduction Books and Records........................................... 8.3 Canceled Warrants........................................... 2.2(a) Cash Equivalents............................................ 8.3 Certificate or Certificates................................. 1.7(b)(iv) Certificate of Merger....................................... 1.2 Closing..................................................... 1.2 Closing Date................................................ 1.2 COBRA....................................................... 2.14(c) Code........................................................ Recital G Confidential Information.................................... 2.11(g) Confidentiality Agreement................................... 5.4(b) Contingent Value Rights..................................... 4.4(b) Convertible Notes........................................... 2.2(a) Dissenting Shares........................................... 1.7(d) DGCL........................................................ Recital A Effective Time.............................................. 1.2 Encumbrances................................................ 8.3 Environmental and Safety Laws............................... 2.12(a)(i) ERISA....................................................... 2.14(a) Exchange Agent.............................................. 1.8(a) Exercised Warrants.......................................... 2.2(a) Federal Health Care Program................................. 2.26 Governmental Entity......................................... 2.3 Hazardous Materials......................................... 2.12(a)(ii) HSR Act..................................................... 2.3 Intellectual Property....................................... 2.11(a) Latest Audited PSI Balance Sheet............................ 2.5(b) Latest PMR Balance Sheet.................................... 3.5(b) Law......................................................... 2.3 Liability................................................... 8.3 Merger...................................................... Recital A Merger Consideration........................................ 1.7(b)(iv) Merger Sub.................................................. Introduction NASD........................................................ 3.3 Nasdaq...................................................... 3.3 Order....................................................... 5.7(a)(ii) PMR......................................................... Introduction PMR Acquisition Agreement................................... 5.6(b) PMR Applicable Period....................................... 5.6(a) PMR Authorizations.......................................... 3.9
A-vi
DEFINED TERM SECTION ------------ ------- PMR Balance Sheet Date...................................... 3.5 PMR Benefit Plans........................................... 3.14(h) PMR Common Stock............................................ Recital E PMR Director Plan........................................... 3.2 PMR Disclosure Schedule..................................... Article III PMR Employee Plans.......................................... 3.14(a) and 5.8(b) PMR ERISA Affiliate......................................... 3.14(a) PMR Facilities.............................................. 3.12(a)(ii) PMR Financial Statements.................................... 3.4 PMR Insurance Amount........................................ 5.12(d) PMR Material Adverse Effect................................. Article III PMR Material Contracts...................................... 3.22 PMR Meeting................................................. 5.3 PMR Notice.................................................. 5.6(a) PMR Option.................................................. 5.8(a) PMR Out-of-Pocket Expenses.................................. 7.5(b) PMR Property................................................ 3.12(a)(i) PMR SEC Documents........................................... 3.4 PMR Stockholder Approval.................................... 6.1(c) PMR Stock Plan.............................................. 3.2 PMR Subsidiary or PMR Subsidiaries.......................... 3.1 PMR Superior Proposal....................................... 5.6(b) PMR Takeover Proposal....................................... 5.6(a) PMR Tax Affiliate........................................... 3.13(a) PMR Termination Fee......................................... 7.5(b) PMR Third Party Intellectual Property Rights................ 3.11(b) PMR Voting Agreements....................................... Recital I Person...................................................... 8.3 Proceeding.................................................. 8.3 Proxy Statement............................................. 5.2(a) PSI......................................................... Introduction PSI Acquisition Agreement................................... 5.5(b) PSI Applicable Period....................................... 5.5(a) PSI Authorizations.......................................... 2.9 PSI Balance Sheet Date...................................... 2.5 PSI Benefit Plans........................................... 2.14(h) PSI Capital Stock........................................... Recital E PSI Common Stock............................................ 1.7(b)(i) and 2.2(a) PSI Disclosure Schedule..................................... Article II PSI Employee Plans.......................................... 2.14(a) PSI ERISA Affiliate......................................... 2.14(a) PSI Facilities.............................................. 2.12(a)(iv) PSI Financial Statements.................................... 2.4 PSI Indemnified Parties..................................... 5.12(b)
A-vii
DEFINED TERM SECTION ------------ ------- PSI Insurance Amount........................................ 5.12(c) PSI Material Adverse Effect................................. Article II PSI Material Contracts...................................... 2.22 PSI Meeting................................................. 5.3 PSI Notice.................................................. 5.5(a) PSI Out-of-Pocket Expenses.................................. 7.5(c) PSI Preferred Stock......................................... 1.7(b)(ii) PSI Property................................................ 2.12(a)(iii) PSI Series A Preferred Stock................................ 1.7(b)(ii) and 2.2(a) PSI Series B Preferred Stock................................ 1.7(b)(ii) and 2.2(a) PSI Stockholder Approval.................................... 6.1(b) PSI Stock Plan.............................................. 1.7(g) PSI Subsidiary or PSI Subsidiaries.......................... 2.1 PSI Superior Proposal....................................... 5.5(b) PSI Takeover Proposal....................................... 5.5(a) PSI Tax Affiliate........................................... 2.13(a) PSI Termination Fee......................................... 7.5(c) PSI Third Party Intellectual Property Rights................ 2.11(b) PSI Voting Agreements....................................... Recital H PSI Warrants................................................ 1.7(b)(iii) Registration Statement...................................... 5.2(a) Replacement Plans........................................... 5.8(b) Representatives............................................. 5.4(a) Reverse Stock Split......................................... 5.3 Rule 145.................................................... 5.1 Section 262................................................. 1.7(d) 1 Shareholders' Meetings.................................... 5.3 SSA......................................................... 2.25(a)(v) State Health Care Program................................... 2.26 Subsidiary.................................................. 8.3 Surviving Corporation....................................... 1.1 Tax, Taxes, Taxable and Tax Authority....................... 8.3 Tax Return.................................................. 8.3 TRICARE..................................................... 2.25(a)
A-viii AGREEMENT AND PLAN OF MERGER This AGREEMENT AND PLAN OF MERGER (this "AGREEMENT") is made and entered into as of May 6, 2002, by and between PMR Corporation, a Delaware corporation ("PMR"), PMR Acquisition Corporation, a Delaware corporation ("MERGER SUB"), and Psychiatric Solutions, Inc., a Delaware corporation ("PSI"). RECITALS A. Upon the terms and subject to the conditions of this Agreement and in accordance with the Delaware General Corporation Law (the "DGCL"), PMR and PSI will enter into a business combination transaction pursuant to which Merger Sub will merge with and into PSI (the "MERGER"). B. The Board of Directors of PSI has (i) determined that the Merger is consistent with and in furtherance of the long-term business strategy of PSI and is in the best interests of PSI and its stockholders, (ii) approved and adopted this Agreement, the Merger and the other transactions contemplated by this Agreement and (iii) determined to recommend that the stockholders of PSI adopt and approve this Agreement and the Merger. C. The Board of Directors of PMR has (i) determined that the Merger is consistent with and in furtherance of the long-term business strategy of PMR and is in the best interests of PMR and its stockholders, (ii) approved and adopted this Agreement, the Merger and the other transactions contemplated by this Agreement and (iii) determined to recommend that the stockholders of PMR adopt and approve this Agreement and the Merger. D. The Board of Directors of Merger Sub has determined that the Merger is in the best interests of Merger Sub and its sole stockholder and has approved and adopted this Agreement, the Merger and the other transactions contemplated by this Agreement, and PMR, as the sole stockholder of Merger Sub, has approved and adopted this Agreement, the Merger and the other transactions contemplated by this Agreement. E. Pursuant to the Merger, among other things, each outstanding share of capital stock of PSI ("PSI CAPITAL STOCK") shall be converted into shares of common stock of PMR, par value $0.01 per share ("PMR COMMON STOCK"), in the manner set forth herein. F. PSI, PMR and Merger Sub desire to make certain representations, warranties, covenants and other agreements in connection with the Merger as set forth herein. G. The parties intend, by executing this Agreement, to adopt a plan of reorganization within the meaning of Section 354(a)(1) of the Internal Revenue Code of 1986, as amended (the "CODE"), and to cause the Merger to qualify as a reorganization under the provisions of Section 368(a) of the Code. H. Concurrently with the execution of this Agreement and as a condition to the willingness of PMR to enter into this Agreement, each of the persons identified on Schedule A attached hereto have entered into voting agreements with PMR and PSI (the "PSI VOTING AGREEMENTS"), dated as of the date of this Agreement, which agreements are in the form of Exhibit A attached hereto, pursuant to which each such person has agreed, among other things, to vote all shares of PSI Capital Stock held by such person in favor of the adoption of this Agreement. I. Concurrently with the execution of this Agreement and as a condition to the willingness of PSI to enter into this Agreement, each of the persons identified on Schedule B attached hereto have entered into voting agreements with PMR and PSI (the "PMR VOTING AGREEMENTS"), dated as of the date of this Agreement, which agreements are in the form of Exhibit B attached hereto, pursuant to which each such person has agreed, among other things, to vote all shares of PMR Common Stock held by such person in favor of the adoption of this Agreement. A-1 NOW, THEREFORE, in consideration of the covenants and representations set forth herein, and for other good and valuable consideration, the parties agree as follows: ARTICLE I THE MERGER 1.1 The Merger. Upon the terms of this Agreement and subject to the conditions set forth in this Agreement, and in accordance with the DGCL, at the Effective Time (as defined in Section 1.2), Merger Sub shall be merged with and into PSI, and as a result of the Merger, the separate corporate existence of Merger Sub shall cease, and PSI shall continue as the surviving corporation of the Merger (the "SURVIVING CORPORATION"); provided, however, that at any time prior to the Effective Time, without any requirement to obtain approval of the stockholders of any of PMR, Merger Sub or PSI, the parties hereto, by written instrument executed and delivered by each such party, shall be permitted to change the direction of the Merger and in such event, as a result of the Merger, the separate corporate existence of PSI shall cease, and Merger Sub shall continue as the "Surviving Corporation." 1.2 Closing; Effective Time. As promptly as practicable following the satisfaction or, if permissible, waiver of the conditions set forth in Article VI (or such other date as may be agreed by each of the parties hereto), the parties hereto shall cause the Merger to be consummated by filing a certificate of merger (the "CERTIFICATE OF MERGER") with the Secretary of State of the State of Delaware in such form as is required by, and executed in accordance with, the relevant portions of the DGCL. The term "EFFECTIVE TIME" means the date and time of such filing (or such later time as may be agreed by each of the parties hereto and specified in the Certificate of Merger). Immediately prior to the filing of the Certificate of Merger, a closing (the "CLOSING") will be held at the offices of Harwell Howard Hyne Gabbert & Manner, P.C., 315 Deaderick Street, Suite 1800, Nashville, Tennessee 37238 (or such other place as the parties may agree). The date on which the Closing shall occur is referred to herein as the "CLOSING DATE." 1.3 Effect of the Merger. At the Effective Time, the effect of the Merger shall be as provided in the applicable provisions of the DGCL. Without limiting the generality of the foregoing, and subject thereto, at the Effective Time, all the property, rights, privileges, powers and franchises of each of PSI and Merger Sub shall vest in the Surviving Corporation, and all debts, liabilities, obligations, restrictions, disabilities and duties of each of PSI and Merger Sub shall become the debts, liabilities, obligations, restrictions, disabilities and duties of the Surviving Corporation. 1.4 Certificate of Incorporation; Bylaws. (a) At the Effective Time, the Certificate of Incorporation of PSI as the Surviving Corporation shall be amended and restated to read the same as the Certificate of Incorporation of Merger Sub as in effect immediately prior to the Effective Time, except that Section 1 of the amended and restated Certificate of Incorporation of the Surviving Corporation, instead of reading the same as Section 1 of the Certificate of Incorporation of Merger Sub, shall read as follows: "The name of this corporation is Psychiatric Solutions, Inc." (b) At the Effective Time, the Bylaws of PSI as the Surviving Corporation shall be amended to read the same as the Bylaws of Merger Sub as in effect immediately prior to the Effective Time, except that all references to Merger Sub in the Bylaws of the Surviving Corporation shall be changed to refer to Psychiatric Solutions, Inc. 1.5 Board and Officers of the Surviving Corporation. Immediately following the Effective Time, the Board of Directors and officers of the Surviving Corporation shall be as set forth in Schedule C hereto until the earlier of the resignation or removal of any individual set forth in Schedule C or until their respective successors are duly elected and qualified, as the case may be, it being agreed that if any director shall be unable to serve as a director at the Effective Time the party which designated such individual as indicated in Schedule C shall designate another individual to serve in such individual's place. If any officer A-2 set forth in Schedule C ceases to be a full-time employee of either PMR or PSI at or before the Effective Time, the parties will agree upon another person to serve in such person's stead. 1.6 Board, Committees and Officers of PMR. Immediately following the Effective Time, the Board of Directors of PMR, committees of the Board of Directors of PMR, composition of such committees (including chairpersons thereof) and officers of PMR shall be as set forth in Schedule D hereto until the earlier of the resignation or removal of any individual set forth in Schedule D or until their respective successors are duly elected and qualified, as the case may be, it being agreed that if any director shall be unable to serve as a director (including as a member or chairperson or any committee) at the Effective Time the party which designated such individual as indicated in Schedule D shall designate another individual to serve in such individual's place. If any officer set forth in Schedule D ceases to be a full-time employee of either PMR or PSI at or before the Effective Time, the parties will agree upon another person to serve in such person's stead until the Effective Time. 1.7 Effect on Capital Stock. By virtue of the Merger and without any action on the part of PMR, Merger Sub, PSI or the holders of any of PSI's securities: (a) Each issued and outstanding share of common stock, par value $0.01 per share, of Merger Sub shall be converted into and become one fully paid and nonassessable share of common stock, par value $0.01 per share, of the Surviving Corporation. (b) Conversion of PSI Capital Stock. (i) Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each share of common stock, par value $0.001 per share, of PSI (the "PSI COMMON STOCK") issued and outstanding immediately prior to the Effective Time (other than shares to be canceled in accordance with Section 1.7(e)) shall be converted into the right to receive 0.392263 shares of fully paid and nonassessable shares of PMR Common Stock; provided however, in the event that PMR has amended its Certificate of Incorporation prior to the Effective Time to effectuate the Reverse Stock Split (as defined in Section 5.3), such number shall be 0.196132. (ii) Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each issued and outstanding share of PSI's Series A Preferred Stock ("PSI SERIES A PREFERRED STOCK") shall be converted into the right to receive 0.840693 shares of fully paid and nonassessable shares of PMR Common Stock; provided, however, in the event that PMR has amended its Certificate of Incorporation prior to the Effective Time to effectuate the Reverse Stock Split, such number shall be 0.420347. Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each issued and outstanding share of PSI's Series B Preferred Stock ("PSI SERIES B PREFERRED STOCK") shall be converted into the right to receive 1.064909 shares of fully paid and nonassessable shares of PMR Common Stock; provided, however, in the event that PMR has amended its Certificate of Incorporation prior to the Effective Time to effectuate the Reverse Stock Split, such number shall be 0.532455. The PSI Series A Preferred Stock and the PSI Series B Preferred Stock may be referred to collectively as "PSI PREFERRED STOCK." (iii) The shares of PMR Common Stock into which the shares of PSI Capital Stock are converted into the right to receive pursuant to the Merger are referred to herein collectively as the "MERGER CONSIDERATION." At the Effective Time, all such shares of PSI Capital Stock shall no longer be outstanding and shall automatically be canceled and shall cease to exist, and each holder of a certificate or certificates that immediately prior the Effective Time represented any such shares (a "CERTIFICATE" or "CERTIFICATES") shall cease to have any rights with respect thereto, except the right to receive the Merger Consideration with respect thereto and any cash in lieu of fractional shares of PMR Common Stock to be issued in consideration therefor upon surrender of such Certificate in accordance with Section 1.8. Each share of PSI Common Stock or PSI Preferred Stock issued and outstanding immediately prior to the Effective Time that is restricted or not fully vested shall upon such conversion and exchange have the same restrictions or vesting arrangements applicable to such shares prior to the conversion. A-3 (c) Anti-Dilution Provisions. In the event that the capitalization of PMR (as set forth in Section 3.2) changes prior to the Effective Time (other than changes resulting from a Reverse Stock Split) or in the event that the capitalization of PSI (as set forth in Section 2.2) changes prior to the Effective Time, the exchange ratios set forth in Sections 1.7(a) and 1.7(b) shall be appropriately adjusted to reflect such changes in the capitalization of PSI or PMR, or both, as the case may be; provided, however, that in the event that (i) there are no changes to the capitalization of PMR (as set forth in Section 3.2) prior to the Effective Time (other than resulting from any Reverse Stock Split) and (ii) PSI issues any additional shares of PSI Common Stock or any option, warrant or other security exercisable for, exchangeable for or convertible into, directly or indirectly, any shares of PSI Common Stock prior to the Effective Time, then the exchange ratios set forth in Section 1.7(a) and Section 1.7(b) shall be adjusted in a manner that provides for (i) the issuance of an aggregate of 8,678,505 shares of PMR Common Stock to the holders of PSI Preferred Stock or, if PMR has effectuated the Reverse Stock Split, 4,339,253 shares (allocated between the holders of the PSI Series A Preferred Stock and PSI Series B Preferred Stock in the same proportions as set forth in Section 1.7(b)) and (ii) the issuance of an aggregate of 10,243,761 shares of PMR Stock allocated among the holders of shares of PSI Common Stock, holders of shares of PSI Preferred Stock and the holders of options, warrants and other securities exercisable for, exchangeable for or convertible into, directly or indirectly, shares of PSI Common Stock (other than the Cancelled Warrants and the Convertible Notes) upon the exercise, exchange or conversion thereof, with such allocation to be made on a pro rata basis in relation to the fully diluted capitalization of PSI immediately prior to the Effective Time, assuming that all shares of PSI Preferred Stock and all options, warrants and such other securities, other than the Cancelled Warrants and the Convertible Notes, are exercised, exchanged or converted into shares of PSI Common Stock immediately prior to the Effective Time. (d) Dissenters' Rights. Notwithstanding anything in this Agreement to the contrary, shares (the "DISSENTING SHARES") of PSI Capital Stock issued and outstanding immediately prior to the Effective Time that are held by any holder who is entitled to demand and properly demands appraisal of such Dissenting Shares pursuant to, and who complies in all respects with, the provisions of Section 262 of the DGCL ("SECTION 262") shall not be converted into the right to receive the Merger Consideration as provided in Section 1.7(b), but instead the holders of Dissenting Shares shall be entitled to payment of the fair value of such Dissenting Shares in accordance with the provisions of Section 262; provided, however, that if any such holder shall fail to perfect or otherwise shall waive, withdraw or lose the right to appraisal under Section 262 or a court of competent jurisdiction shall determine that such holder is not entitled to the relief provided by Section 262, then the right of such holder to be paid the fair value of such holder's Dissenting Shares under Section 262 shall cease and such Dissenting Shares shall be deemed to have been converted at the Effective Time into, and shall have become, the right to receive the appropriate portion of the Merger Consideration as provided in Section 1.7(b). At the Effective Time, all Dissenting Shares shall no longer be outstanding and shall automatically be canceled and shall cease to exist, and each holder of Dissenting Shares shall cease to have any rights with respect thereto, except, subject to the immediately preceding sentence, the right to receive the fair value of such shares in accordance with the provisions of Section 262. PSI shall serve prompt notice to PMR of any demands for appraisal of any shares of PSI Capital Stock, and PMR shall have the right to participate in and direct all negotiations and proceedings with respect to such demands. PSI shall not, without the prior written consent of PMR, make any payment with respect to, or settle or offer to settle, any such demands, or agree to do any of the foregoing. (e) Cancellation of PSI Capital Stock Owned by PSI. At the Effective Time, all shares of PSI Capital Stock that are owned by PSI as treasury stock, and each share of PSI Capital Stock owned by any direct or indirect wholly owned PSI Subsidiary immediately prior to the Effective Time shall be canceled and extinguished without any conversion thereof. (f) Fractional Shares. No fraction of a share of PMR Common Stock will be issued, but in lieu thereof each holder of shares of PSI Capital Stock who would otherwise be entitled to a fraction of a share of PMR Common Stock (after aggregating all fractional shares of PMR Common Stock to A-4 be received by such holder) shall receive from PMR an amount of cash (rounded to the nearest whole cent) equal to the product of (i) such fraction, multiplied by (ii) PMR Stock Price. (g) PSI Stock Option Plans. At the Effective Time, the Psychiatric Solutions, Inc. 1997 Incentive and Non-Qualified Stock Option Plan for Key Personnel (the "PSI STOCK PLAN") and all options to purchase PSI Common Stock then outstanding under the PSI Stock Plan shall be assumed by PMR in accordance with Section 5.8. 1.8 Surrender of Certificates. (a) Exchange Agent. PMR's transfer agent shall act as exchange agent (the "EXCHANGE AGENT") in the Merger. (b) PMR to Provide Common Stock and Cash. Within thirty (30) business days following the Closing Date, PMR shall make available to the Exchange Agent for exchange in accordance with this Article I, through such reasonable procedures as PMR may adopt, (i) the shares of PMR Common Stock issuable pursuant to Section 1.7(b) in exchange for shares of PSI Capital Stock outstanding immediately prior to the Effective Time and (ii) cash in an amount sufficient to permit payment of cash in lieu of fractional shares pursuant to Section 1.7(f). (c) Exchange Procedures. Within ten (10) business days after the date hereof, PMR shall deliver to PSI (i) a form of letter of transmittal (which shall specify that delivery shall be effected, and risk of loss and title to the Certificates (as defined below) shall pass, only upon receipt by the Exchange Agent of a Certificate or Certificates, which immediately prior to the Effective Time represented outstanding shares of PSI Capital Stock, whose shares were converted into the right to receive shares of PMR Common Stock (and cash in lieu of fractional shares) pursuant to Section 1.7, and shall be in such form and have such other provisions as PMR may reasonably specify) and (ii) instructions for use in effecting the surrender of the Certificates in exchange for certificates representing shares of PMR Common Stock (and cash in lieu of fractional shares). PSI shall mail or provide such letter of transmittal and such instructions to every holder of record of a Certificate. To the extent at Closing PMR shall have received Certificates, together with corresponding letters of transmittal, duly completed and validly executed in accordance with the instructions thereto, then within thirty (30) business days after the Closing (i) such holders of record submitting the same shall be entitled to receive a certificate representing the number of whole shares of PMR Common Stock and payment in lieu of fractional shares which such holder has the right to receive pursuant to Section 1.7, and (ii) such Certificates shall be canceled. (d) Distributions With Respect to Unexchanged Shares. No dividends or other distributions with respect to PMR Common Stock with a record date after the Effective Time will be paid to the holder of any unsurrendered Certificate with respect to the shares of PMR Common Stock represented thereby until the holder of record of such Certificate shall surrender such Certificate. Subject to applicable law, following surrender of any such Certificate, there shall be paid to the record holder of the certificates representing whole shares of PMR Common Stock issued in exchange therefor, without interest, at the time of such surrender, the amount of any such dividends or other distributions with a record date after the Effective Time theretofore payable (but for the provisions of this Section 1.8(d)) with respect to such shares of PMR Common Stock. (e) Transfers of Ownership. If any certificate for shares of PMR Common Stock is to be issued in a name other than that in which the Certificate surrendered in exchange therefor is registered, it will be a condition of the issuance thereof that the Certificate so surrendered will be properly endorsed and otherwise in proper form for transfer and that the person requesting such exchange will have paid to PMR or any agent designated by it any transfer or other taxes required by reason of the issuance of a certificate for shares of PMR Common Stock in any name other than that of the registered holder of the Certificate surrendered, or established to the satisfaction of PMR or any agent designated by it that such tax has been paid or is not payable. A-5 (f) No Liability. Notwithstanding anything to the contrary in this Section 1.8, none of the Exchange Agent, PMR, the Surviving Corporation or any party hereto shall be liable to any person for any amount properly paid to a public official pursuant to any applicable abandoned property, escheat or similar law. (g) Dissenting Shares. The provisions of this Section 1.8 shall also apply to Dissenting Shares that lose their status as such, except that the obligations of PMR under this Section 1.8 shall commence on the date of loss of such status and the holder of such shares shall be entitled to receive in exchange for such shares the number of shares of PMR Common Stock and cash in lieu of any fractional shares to which such holder is entitled pursuant to Section 1.7 hereof. (h) Unclaimed Shares. Any amounts of PMR Common Stock (and cash in lieu of fractional shares) delivered or made available to the Exchange Agent pursuant to this Section 1.8 and not exchanged for PSI Capital Stock within six (6) months after the Effective Time pursuant to this Section 1.8 shall be returned by the Exchange Agent to PMR, which thereafter shall act as Exchange Agent subject to the rights of holders of unsurrendered Certificates under this Article I. Thereafter such holders shall be entitled to look to the Surviving Corporation (subject to abandoned property, escheat and other similar laws) only as general creditors thereof with respect to any PMR Common Stock (and cash in lieu of fractional shares) that may be payable upon due surrender of the PSI Capital Stock held by them. 1.9 No Further Ownership Rights in PSI Capital Stock. All shares of PMR Common Stock issued upon the surrender for exchange of shares of PSI Capital Stock in accordance with the terms hereof (including any cash paid in lieu of fractional shares) shall be deemed to have been issued in full satisfaction of all rights pertaining to such shares of PSI Capital Stock, and there shall be no further registration of transfers on the records of the Surviving Corporation of shares of PSI Capital Stock which were outstanding immediately prior to the Effective Time. If, after the Effective Time, Certificates are presented to the Surviving Corporation for any reason, they shall be canceled and exchanged as provided in this Article I. 1.10 Lost, Stolen or Destroyed Certificates. In the event any Certificates shall have been lost, stolen or destroyed, the Exchange Agent shall issue in exchange for such lost, stolen or destroyed Certificates, upon the making of an affidavit of that fact by the holder thereof, such shares of PMR Common Stock (and cash in lieu of fractional shares) as may be required pursuant to Section 1.7; provided, however, that PMR may, in its discretion and as a condition precedent to the issuance thereof, require the owner of such lost, stolen or destroyed Certificates to deliver a bond in such sum as it may reasonably direct as indemnity against any claim that may be made against PMR, the Surviving Corporation or the Exchange Agent with respect to the Certificates alleged to have been lost, stolen or destroyed. 1.11 Tax Consequences. It is intended by the parties hereto that the Merger shall constitute a reorganization within the meaning of Section 368(a) of the Code. 1.12 Taking of Necessary Action; Further Action. If, at any time after the Effective Time, any further action is necessary or desirable to carry out the purposes of this Agreement and to vest the Surviving Corporation with full right, title and possession to all assets, property, rights, privileges, powers and franchises of PSI, the officers and directors of PSI and the Surviving Corporation are fully authorized in the name of their respective corporations or otherwise to take, and will take, all such lawful and necessary action, so long as such action is not inconsistent with this Agreement. 1.13 Withholding. PMR or the Exchange Agent shall be entitled to deduct and withhold from the consideration otherwise payable pursuant to this Agreement to any holder of PSI Capital Stock such amounts as PMR or the Exchange Agent are required to deduct and withhold under the Code, or any provision of state, local or foreign tax law, with respect to the making of such payment. To the extent that amounts are so withheld by PMR or the Exchange Agent, such withheld amounts shall be treated for all purposes of this Agreement as having been paid to the holder of PSI Capital Stock in respect of whom such deduction and withholding was made by PMR or the Exchange Agent. A-6 1.14 Stock Transfer Books. At the Effective Time, the stock transfer books of PSI shall be closed and there shall be no further registration of transfers of shares of PSI Capital Stock thereafter on the records of PSI. From and after the Effective Time, the holders of Certificates representing shares of PSI Capital Stock outstanding immediately prior to the Effective Time shall cease to have any rights with respect to such shares of PSI Capital Stock except as otherwise provided herein or by Law. On or after the Effective Time, any Certificates presented to the Exchange Agent or PMR for any reason shall be converted into the shares of PMR Common Stock, any cash in lieu of fractional shares of PMR Common Stock to which holders thereof are entitled pursuant to Section 1.7(g) and any dividends or other distributions to which the holders thereof are entitled pursuant to Section 1.7(c). 1.15 Pre-Closing Distribution to PMR Shareholders. Prior to the Effective Time, PMR shall distribute to holders of PMR Common Stock: PMR Cash Equivalents in excess of $5.05 million pursuant to Section 6.2(k) and Contingent Value Rights pursuant to the Contingent Value Rights Agreement described in Section 4.4(b). ARTICLE II REPRESENTATIONS AND WARRANTIES OF PSI In this Agreement, any reference to any event, change, condition or effect being "material" with respect to any entity or group of entities means any material event, change, condition or effect related to the condition (financial or otherwise), properties, assets (including intangible assets), liabilities, business, operations or results of operations of such entity or group of entities. In this Agreement, any reference to a "PSI MATERIAL ADVERSE EFFECT" means any event, change, condition or effect that is materially adverse to the condition (financial or otherwise), properties, assets, liabilities, business, operations or results of operations of PSI and the PSI Subsidiaries (as defined in Section 2.1), taken as a whole, other than any event, change, condition or effect relating to (i) this Agreement or the transactions contemplated hereby or the announcement thereof, (ii) the failure to obtain applicable regulatory or third party consents that may be required in connection with this Agreement or the transactions contemplated hereby, (iii) the United States economy in general, or (iv) the behavioral healthcare industry in general; provided, however, that a PSI Material Adverse Effect shall include any change in or effect on the business of PSI and the PSI Subsidiaries that is, or is reasonably likely to be, materially adverse to the condition (financial or otherwise), properties, assets, liabilities, business, operations or results of operations of PSI and the PSI Subsidiaries taken as a whole, if such change or effect is significantly more adverse to PSI and the PSI Subsidiaries, taken as a whole, than to the behavioral healthcare industry in general. In this Agreement, any reference to a party's "knowledge" means actual knowledge of such party's officers and directors, provided that such persons shall make due and diligent inquiry of those employees of such party whom such officers or directors reasonably believe would have actual knowledge of the matters represented. Except as disclosed in a document of even date herewith attached as an exhibit to this Agreement and delivered by PSI to PMR prior to the execution and delivery of this Agreement and referring to the representations and warranties in this Agreement (the "PSI DISCLOSURE SCHEDULE", PSI represents and warrants to PMR and Merger Sub as follows: 2.1 Organization, Standing and Power. Each of PSI and the PSI Subsidiaries is a corporation duly organized, validly existing and in good standing under the laws of its jurisdiction of organization. Each of PSI and the PSI Subsidiaries has the corporate power to own its properties and to carry on its business as now being conducted and as currently proposed to be conducted and is duly qualified to do business and is in good standing in each jurisdiction in which the failure to be so qualified and in good standing would have a Material Adverse Effect on PSI. PSI has made available to PMR a true and correct copy of the Certificate of Incorporation and Bylaws or other charter documents, as applicable, of PSI and each of the PSI Subsidiaries, each as amended to date. Neither PSI nor any of the PSI Subsidiaries is in violation of any of the provisions of its Certificate of Incorporation or Bylaws or equivalent organizational documents. A-7 Set forth in Schedule 2.1 of the PSI Disclosure Schedule is a complete and accurate list of all Subsidiaries of PSI (the entities identified in Schedule 2.1 are referred to collectively as the "PSI SUBSIDIARIES" and individually a "PSI SUBSIDIARY"). PSI is the owner of all outstanding shares of capital stock of each of the PSI Subsidiaries, and all such shares are duly authorized, validly issued, fully paid and nonassessable. All of the outstanding shares of capital stock of each such PSI Subsidiary are owned by PSI free and clear of all liens, charges, claims or encumbrances or rights of others. There are no outstanding subscriptions, options, warrants, puts, calls, rights, exchangeable or convertible securities or other commitments or agreements of any character relating to the issued or unissued capital stock or other securities of any such PSI Subsidiary, or otherwise obligating PSI or any such PSI Subsidiary to issue, transfer, sell, purchase, redeem or otherwise acquire any such securities. Except as set forth in Schedule 2.1 to the PSI Disclosure Schedule, PSI does not directly or indirectly own any equity or similar interest in, or any interest convertible or exchangeable or exercisable for, any equity or similar interest in, any corporation, partnership, joint venture or other business association or entity. 2.2 Capital Structure. (a) The authorized capital stock of PSI immediately prior to the Effective Time consists of 53,500,000 shares of capital stock, consisting of (i) 35,000,000 shares of Common Stock, par value $.01 per share (the "PSI COMMON STOCK"), 7,327,627 shares of which are issued and outstanding on the date of this Agreement, (ii) 10,500,000 shares of Series A preferred stock, $.01 par value per share (the "PSI SERIES A PREFERRED STOCK") of which 10,497,000 shares are issued and outstanding on the date of this Agreement, and (iii) 8,000,000 shares of Series B preferred stock $.01 par value per share (the "PSI SERIES B PREFERRED STOCK") of which 4,975,736 shares are issued and outstanding on the date of this Agreement. As of the date of this Agreement, there are outstanding warrants to purchase 1,341,028 shares of PSI Series B Preferred Stock and 180,379 shares of PSI Common Stock. Warrants to purchase 928,308 shares of PSI Series B Preferred Stock will be exercised prior to the Effective Time (the "EXERCISED WARRANTS"). The remaining warrants to purchase 412,720 shares of PSI Series B Preferred Stock will be canceled prior to the Effective Time (the "CANCELED WARRANTS"). There are no other outstanding shares of capital stock or voting securities and no outstanding commitments to issue any shares of capital stock or voting securities, other than as set forth in this Section 2.2. Attached to or as set forth in Schedule 2.2 to the PSI Disclosure Schedule is a true and correct list of PSI's stockholders and any persons with rights to acquire PSI securities, which list will be promptly updated from time to time prior to Closing to reflect any changes thereto (which changes are in any event subject to the restrictions imposed under Section 5.9). All outstanding shares of PSI Capital Stock are duly authorized, validly issued, fully paid and nonassessable and are free of any liens or encumbrances other than any liens or encumbrances created by or imposed upon the holders thereof, and are not subject to preemptive rights or rights of first refusal created by statute, the Certificate of Incorporation or Bylaws of PSI or any agreement to which PSI is a party or by which it is bound. PSI has reserved (i) sufficient shares of PSI Common Stock for issuance upon conversion of the PSI Preferred Stock, and (ii) 3,373,313 shares of PSI Common Stock for issuance to employees and consultants pursuant to the PSI Stock Plan, of which 709,886 shares have been issued pursuant to option exercises or direct stock purchases, 2,205,499 shares are subject to outstanding, unexercised options, and 457,928 shares are available for issuance thereunder. PSI has outstanding subordinated notes with an aggregate principal amount of $3,564,000.14 which are convertible into PSI Series B Preferred Stock (the "CONVERTIBLE NOTES"). Except for (i) the rights created pursuant to this Agreement, (ii) PSI's right to repurchase any unvested shares under the PSI Stock Plan, (iii) outstanding warrants to purchase 1,341,028 shares of PSI Series B Preferred Stock and 180,379 shares of PSI Common Stock, and (iv) the Convertible Notes, there are no other options, warrants, calls, rights, commitments or agreements of any character to which PSI is a party or by which it is bound obligating PSI to issue, deliver, sell, repurchase or redeem, or cause to be issued, delivered, sold, repurchased or redeemed, any shares of capital stock of PSI or obligating PSI to grant, extend, accelerate the vesting of, change the price of, or otherwise amend or enter into any such option, warrant, call, right, commitment or agreement. Except for the agreements contemplated by this Agreement, there are no contracts, commitments or agreements A-8 relating to voting, purchase or sale of PSI's capital stock (i) between or among PSI and any of its securityholders and (ii) to PSI's knowledge, between or among any of PSI's securityholders. The terms of the PSI Stock Plan and the applicable stock option agreements permit the assumption or substitution of options to purchase PMR Common Stock as provided in this Agreement, without the consent or approval of the holders of such securities, the PSI stockholders, or otherwise. None of the outstanding options permit any accelerated vesting or exercisability of those options by reason of the Merger or any other transactions contemplated by this Agreement. True and complete copies of all agreements and instruments relating to or issued under the PSI Stock Plan have been provided to PMR and such agreements and instruments have not been amended, modified or supplemented, and there are no agreements to amend, modify or supplement such agreements or instruments in any case from the form provided to PMR. All outstanding shares of PSI Common Stock and PSI Preferred Stock were issued in compliance with all applicable federal and state securities laws. (b) Each of the PSI stockholders and/or optionholders is the registered and beneficial owner of that number of shares of PSI Capital Stock and/or PSI options set forth opposite its name in Schedule 2.2. The number of shares of PSI Capital Stock and/or PSI options set forth opposite such person's name in Schedule 2.2 constitutes the entire interest of such person in the outstanding capital stock or voting securities of PSI. No other person or entity not disclosed in Schedule 2.2 has a beneficial interest in or a right to acquire any PSI Capital Stock or PSI options. In addition, the shares of PSI Capital Stock and/or PSI Options disclosed in Schedule 2.2 are and will, at all times during the term of this Agreement and through and including the Closing, be free and clear of any liens, pledges, options, charges, restrictions or other encumbrances. (c) Notwithstanding anything in the foregoing to the contrary, the exercise of options by any PSI option holder between the date of this Agreement and the Effective Time shall not cause a breach of this Section 2.2. 2.3 Authority; No Conflict; Required Filings and Consents. PSI has all requisite corporate power and authority to enter into this Agreement and to consummate the transactions contemplated hereby. The execution and delivery of this Agreement and the consummation of the transactions contemplated hereby have been duly authorized by all necessary corporate action on the part of PSI. This Agreement has been duly executed and delivered by PSI and constitutes the valid and binding obligation of PSI enforceable against PSI in accordance with its terms. The execution and delivery of this Agreement by PSI does not, and the consummation of the transactions contemplated hereby will not, conflict with, or result in any violation of, or default under (with or without notice or lapse of time, or both), or give rise to a right of termination, cancellation or acceleration of any obligation or loss of any benefit under (i) any provision of the Certificate of Incorporation or Bylaws of PSI or the Certificate of Incorporation or Bylaws (or similar instruments) of any of the PSI Subsidiaries, as amended, (ii) any foreign or domestic law, statute, code ordinance, rule, regulation, order, judgment, writ, stipulation, award, injunction or decree ("LAW") applicable to PSI or any of the PSI Subsidiaries or any of their properties or assets or (iii) any material mortgage, indenture, lease, contract or other agreement or instrument, permit, franchise, or license applicable to PSI or any of the PSI Subsidiaries or any of their properties or assets. No consent, approval, order or authorization of, or registration, declaration or filing with, any court, administrative agency or commission or other governmental authority or instrumentality ("GOVERNMENTAL ENTITY") is required by or with respect to PSI or any of the PSI Subsidiaries in connection with the execution and delivery of this Agreement or the consummation of the transactions contemplated hereby, except for (i) the filing of the Certificate of Merger as provided in Section 1.2 ; (ii) such consents, approvals, orders, authorizations, registrations, declarations and filings as may be required under applicable state securities laws and the securities laws of any foreign country; (iii) such filings as may be required under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the "HSR ACT"); and (iv) such other consents, authorizations, filings, approvals and registrations which, if not obtained or made, would not have a PSI Material Adverse Effect and would not prevent, or materially alter or delay any of the transactions contemplated by this Agreement. A-9 2.4 Financial Statements. PSI has delivered to PMR its audited consolidated financial statements (including balance sheet, statement of operations and statement of cash flows) as at and for the twelve-month periods ended December 31, 1999, 2000 and 2001 (collectively, the "PSI FINANCIAL STATEMENTS"). The PSI Financial Statements have been prepared in accordance with generally accepted accounting principles applied on a consistent basis throughout the periods indicated and with each other. The PSI Financial Statements fairly present the consolidated financial condition and operating results of PSI as of the dates, and for the periods, indicated therein, subject to normal year-end audit adjustments. PSI and the PSI Subsidiaries maintain adequate systems of internal controls established and administered in accordance with generally accepted accounting principles. 2.5 Absence of Certain Changes. Since December 31, 2001 (the "PSI BALANCE SHEET DATE"), except as set forth in Schedule 2.5 of the PSI Disclosure Schedule, and except for changes that are not prohibited by Section 4.2 or changes as otherwise contemplated by this Agreement, PSI and the PSI Subsidiaries conducted their respective businesses in the ordinary course consistent with past practice and there has not occurred: (a) any change, event or condition (whether or not covered by insurance) that has resulted in, or might reasonably be expected to result in, a PSI Material Adverse Effect; (b) any discharge or satisfaction of any Encumbrance other than those then required to be discharged or satisfied prior to the Closing Date pursuant to the existing terms of any agreement between PSI or any of the PSI Subsidiaries and a party unaffiliated with PSI or any of the PSI Subsidiaries, or payment of any obligation or Liability, other than current Liabilities shown on the consolidated balance sheet of PSI as of December 31, 2001 included in the PSI Financial Statements (the "LATEST AUDITED PSI BALANCE SHEET") and current Liabilities incurred in the ordinary course of business consistent with prior practice, or any cancellation, forgiveness or compromise by PSI or any of the PSI Subsidiaries of any debts or claims other than in the ordinary course of business or any waiver or release of any right of substantial value to PSI and the PSI Subsidiaries; (c) any declaration, setting aside or payment of any dividend or other distribution of any assets of any kind whatsoever with respect to any shares of the capital stock of PSI or the PSI Subsidiaries, or any direct or indirect redemption, purchase or other acquisition of any such shares of the capital stock of PSI or the PSI Subsidiaries; (d) any stock split, reverse stock split, combination, reclassification or recapitalization of any capital stock of PSI or the PSI Subsidiaries, or any issuance of any other security in respect of or in exchange for, any shares of any capital stock of PSI or the PSI Subsidiaries; (e) any issuance by PSI or the PSI Subsidiaries of any shares of their capital stock or any debt security or securities, rights, options or warrants convertible into or exercisable or exchangeable for any shares of such capital stock or debt security; (f) any license, sale, transfer, pledge, mortgage or other disposition of any tangible or intangible asset of PSI or the PSI Subsidiaries, except for inventory sold in the ordinary course of business; (g) any termination or receipt by PSI or the PSI Subsidiaries of any notice of termination or non-renewal of any Contract between PSI or the PSI Subsidiaries and any other Person involving payments by or to PSI or any of the PSI Subsidiaries in excess of $100,000 in the aggregate; (h) any write-down or write-up of the value of any asset of PSI or the PSI Subsidiaries, or, other than in the ordinary course of business, any write-off of any accounts receivable or notes receivable of PSI or the PSI Subsidiaries or any portion thereof in excess of $50,000 in the aggregate; (i) any increase in or modification of compensation payable or to become payable to any officer, employee, consultant or agent of PSI or the PSI Subsidiaries, other than any such increases in the ordinary course of business, consistent with past practice, or the entering into of any employment contract with any officer or employee; A-10 (j) any increase in or modification or acceleration of any benefits payable or to become payable under any bonus, pension, severance, insurance or other benefit plan, payment or arrangement (including, but not limited to, the granting of stock options, restricted stock awards or stock appreciation rights) made to, for or with any officer, employee, consultant or agent of PSI or the PSI Subsidiaries; (k) the making of any loan, advance or capital contribution to or investment in any Person or the engagement in any transaction with any employee, officer, director or stockholder of PSI or the PSI Subsidiaries, other than advances to employees in the ordinary course of business for travel and similar business expenses; (l) any change in the accounting methods or practices followed by PSI or the PSI Subsidiaries or any change in depreciation or amortization policies or rates theretofore adopted; (m) any material deterioration in the aging of PSI's or the PSI Subsidiaries' accounts payable or material acceleration in the aging of PSI's or the PSI Subsidiaries' accounts receivable or other change in PSI's or the PSI Subsidiaries' working capital management practices; (n) any material change in the manner in which PSI or the PSI Subsidiaries extend discounts or credit or otherwise deal with third party payors, patients or other customers; (o) any termination of employment of any officer or key employee of PSI or the PSI Subsidiaries; (p) except as contemplated hereby, any amendments or changes in PSI's or the PSI Subsidiaries' articles or certificate of incorporation or bylaws (or other governing documents); (q) any labor disputes or any union organizing campaigns; (r) the commencement of any litigation or other action by or against PSI or the PSI Subsidiaries; or (s) any agreement, understanding, or authorization, whether in writing or otherwise, for PSI or the PSI Subsidiaries to take any of the actions specified in items (a) through (r) above. 2.6 Absence of Undisclosed Liabilities. Except as set forth in Schedule 2.6(a), neither PSI nor any of the PSI Subsidiaries have any Liability, except for (i) Liabilities reflected or reserved against in the Latest Audited PSI Balance Sheet, and (ii) Liabilities that have arisen since the date of the Latest Audited PSI Balance Sheet in the ordinary course of business (none of which arise from any breach of Contract, breach of warranty, tort, infringement, violation of Law, or any action, suit or Proceeding (including any Liability under any Environmental and Safety Laws)). There are no loss contingencies (as such term is used in Statement of Financial Accounting Standards No. 5 issued by the Financial Accounting Standards Board in March 1975) that are not adequately provided for on the Latest Audited PSI Balance Sheet. Except as set forth in Schedule 2.6(a), neither PSI nor any of the PSI Subsidiaries have, either expressly or by operation of Law, assumed or undertaken any Liability of any other Person, including, without limitation, any obligation for corrective or remedial action relating to or required under any Environmental and Safety Laws. The reserves reflected on the Latest Audited PSI Balance Sheet for Liabilities that were incurred but not reported are adequate to cover such Liabilities. 2.7 Litigation. Except as set forth in Schedule 2.7 of the PSI Disclosure Schedule, there is no Proceeding pending before any agency, court or tribunal, foreign or domestic, or, to the knowledge of PSI or any of the PSI Subsidiaries, threatened against PSI or any of the PSI Subsidiaries or any of their respective properties or any of their respective officers or directors (in their capacities as such). There is no judgment, decree or order against PSI or any of the PSI Subsidiaries, or, to the knowledge of PSI and the PSI Subsidiaries, any of their respective directors or officers (in their capacities as such), that could prevent, enjoin, or materially alter or delay any of the transactions contemplated by this Agreement, or that could reasonably be expected to have a PSI Material Adverse Effect. Schedule 2.7 of the PSI Disclosure Schedule also lists all litigation that PSI has pending against other parties. A-11 2.8 Restrictions on Business Activities. Except as set forth on Schedule 2.8, there is no agreement, judgment, injunction, order or decree binding upon PSI or any of the PSI Subsidiaries which has or could reasonably be expected to have the effect of prohibiting or impairing any current or future business practice of PSI or any of the PSI Subsidiaries, any acquisition of property by PSI or any of the PSI Subsidiaries or the conduct of business by PSI or any of the PSI Subsidiaries as currently conducted or as proposed to be conducted by PSI or any of the PSI Subsidiaries. 2.9 Governmental Authorization. PSI and each of the PSI Subsidiaries have obtained each federal, state, county, local or foreign governmental consent, license, permit, grant, or other authorization of a Governmental Entity (i) pursuant to which PSI or any of the PSI Subsidiaries currently operates or holds any interest in any of its properties or (ii) that is required for the operation of PSI's or any of the PSI Subsidiaries' business or the holding of any such interest ((i) and (ii) herein collectively called "PSI AUTHORIZATIONS"), and all of such PSI Authorizations are in full force and effect, except where the failure to obtain or have any such PSI Authorizations could not reasonably be expected to have a PSI Material Adverse Effect. PSI and the PSI Subsidiaries are in material compliance with the terms and conditions of the PSI Authorizations. 2.10 Title to Property. PSI and the PSI Subsidiaries have good and marketable title to all of their respective properties, interests in properties and assets, real and personal, reflected in the PSI Balance Sheet or acquired after the PSI Balance Sheet Date (except properties, interests in properties and assets sold or otherwise disposed of since the PSI Balance Sheet Date in the ordinary course of business), or with respect to leased properties and assets, valid leasehold interests in, free and clear of all mortgages, liens, pledges, charges or encumbrances of any kind or character, except (i) the lien of current taxes not yet due and payable, (ii) such imperfections of title, liens and easements as do not and will not materially detract from or interfere with the use of the properties subject thereto or affected thereby, or otherwise materially impair business operations involving such properties and (iii) liens securing debt which is reflected on the PSI Balance Sheet. The plants, property and equipment of PSI and the PSI Subsidiaries that are used in the operations of their businesses are in good operating condition and repair, subject to normal wear and tear. All properties used in the operations of PSI and the PSI Subsidiaries are reflected in the PSI Balance Sheet to the extent generally accepted accounting principles require the same to be reflected. Schedule 2.10 identifies each parcel of real property owned or leased by PSI or any of the PSI Subsidiaries. 2.11 Intellectual Property. (a) PSI and the PSI Subsidiaries own, or are licensed or otherwise possess legally enforceable rights to use all patents, trademarks, trade names, service marks, copyrights, and any applications therefor, maskworks, net lists, schematics, technology, know-how, trade secrets, inventions, ideas, algorithms, processes, computer software programs or applications (in source code and/or object code form), and tangible or intangible proprietary information or material ("INTELLECTUAL PROPERTY") that are used or proposed to be used in the business of PSI and the PSI Subsidiaries as currently conducted or as proposed to be conducted by PSI and the PSI Subsidiaries. PSI has not (i) licensed any of its Intellectual Property in source code form to any party or (ii) entered into any exclusive agreements relating to its Intellectual Property with any party. (b) Schedule 2.11 lists (i) all patents and patent applications and all registered and unregistered trademarks, trade names and service marks, registered and unregistered copyrights, registered domain names, and maskworks, included in the Intellectual Property, including the jurisdictions in which each such Intellectual Property right has been issued or registered or in which any application for such issuance and registration has been filed, (ii) all licenses, sublicenses and other agreements as to which PSI is a party and pursuant to which any person is authorized to use any Intellectual Property (other than computer software licenses which are used by PSI in the ordinary course of business), and (iii) all licenses, sublicenses and other agreements as to which PSI is a party and pursuant to which PSI is authorized to use any third party patents, trademarks or copyrights ("PSI THIRD PARTY INTELLECTUAL PROPERTY RIGHTS") which are incorporated in, are, or form a part of any PSI product. A-12 (c) There is no unauthorized use, disclosure, infringement or misappropriation of any Intellectual Property rights of PSI or any of the PSI Subsidiaries, or any PSI Third Party Intellectual Property Rights, by any third party, including any employee or former employee of PSI or any of the PSI Subsidiaries. Neither PSI nor any of the PSI Subsidiaries has entered into any agreement to indemnify any other person against any charge of infringement of any Intellectual Property, other than indemnification provisions contained in purchase orders or license agreements arising in the ordinary course of business. (d) PSI is not, nor will it be as a result of the execution and delivery of this Agreement or the performance of its obligations under this Agreement, in material breach of any license, sublicense or other agreement relating to the Intellectual Property or PSI Third Party Intellectual Property Rights. (e) All patents, registered trademarks, service marks and copyrights held by PSI are valid and subsisting. PSI has not been sued in any suit, action or proceeding which involves a claim of infringement of any patents, trademarks, service marks, copyrights or violation of any trade secret or other proprietary right of any third party. The manufacturing, marketing, licensing or sale of PSI's products do not infringe any patent, trademark, service mark, copyright, trade secret or other proprietary right of any third party. PSI has not brought any action, suit or proceeding for infringement of Intellectual Property or breach of any license or agreement involving Intellectual Property against any third party. (f) PSI has secured valid written assignments from all consultants and employees who contributed to the creation or development of Intellectual Property of the rights to such contributions that PSI does not already own by operation of law. (g) PSI has taken all necessary and appropriate steps to protect and preserve the confidentiality of all Intellectual Property not otherwise protected by patents, patent applications or copyright ("CONFIDENTIAL INFORMATION"). All use, disclosure or appropriation of Confidential Information owned by PSI by or to a third party has been pursuant to the terms of a written agreement between PSI and such third party. All use, disclosure or appropriation of Confidential Information not owned by PSI has been pursuant to the terms of a written agreement between PSI and the owner of such Confidential Information, or is otherwise lawful. (h) As of the date of this Agreement, there are no actions that must be taken by PSI or any PSI Subsidiary within sixty (60) days of the Closing Date that, if not taken, will result in the loss of any Intellectual Property, including the payment of any registration, maintenance or renewal fees or the filing of any responses to PTO office actions, documents, applications or certificates for the purposes of obtaining, maintaining, perfecting or preserving or renewing any Intellectual Property. 2.12 Environmental Matters. (a) The following terms shall be defined as follows: (i) "ENVIRONMENTAL AND SAFETY LAWS" shall mean any federal, state or local laws, ordinances, codes, regulations, rules, policies and orders that are intended to assure the protection of the environment, or that classify, regulate, call for the remediation of, require reporting with respect to, or list or define air, water, groundwater, solid waste, hazardous or toxic substances, materials, wastes, pollutants or contaminants, or which are intended to assure the safety of employees, workers or other persons, including the public. (ii) "HAZARDOUS MATERIALS" shall mean any toxic or hazardous substance, material or waste or any pollutant or contaminant, or infectious or radioactive substance or material, including without limitation, those substances, materials and wastes defined in or regulated under any Environmental and Safety Laws. (iii) "PSI PROPERTY" shall mean all real property leased or owned by PSI or any PSI Subsidiaries either currently or in the past. A-13 (iv) "PSI FACILITIES" shall mean all buildings and improvements on PSI Property. (b) Except as set forth on Schedule 2.12(b), PSI represents and warrants as follows: (i) no methylene chloride is contained in or has been used at or released from the PSI Facilities by PSI or PSI Subsidiaries; (ii) all Hazardous Materials and wastes, if disposed of by PSI or PSI Subsidiaries, have been disposed of in accordance with all Environmental and Safety Laws; and (iii) PSI and the PSI Subsidiaries have received no notice (verbal or written) of any noncompliance of the PSI Facilities or PSI's past or present operations with Environmental and Safety Laws; (iv) no notices, administrative actions or suits are pending or threatened against PSI or PSI Subsidiaries relating to a violation of any Environmental and Safety Laws; (v) there are no polychlorinated biphenyls (PCBs) deposited, stored, disposed of or located on the PSI Property or PSI Facilities or any equipment on the PSI Property containing PCBs at levels in excess of 50 parts per million; (vi) PSI's and the PSI Subsidiaries' uses and activities of the PSI Facilities have at all times complied with all Environmental and Safety Laws; (vii) PSI and the PSI Subsidiaries have all the permits and licenses required to be issued under federal, state or local laws regarding Environmental and Safety Laws and are in full compliance with the terms and conditions of those permits; neither PSI nor any PSI Subsidiary are a potentially responsible party under the federal Comprehensive Environmental Response Compensation and Liability Act (CERCLA), or state analog statute, arising out of events occurring prior to the Closing Date; (viii) there have not been in the past, during the period of time in which PSI or any PSI Subsidiary owned or controlled the applicable PSI Property or PSI Facilities, and are not now, any Hazardous Materials on, under or migrating to or from any PSI Facilities or PSI Property, other than in compliance with Environmental and Safety Laws; and (ix) there have not been in the past, during the period of time in which PSI or any PSI Subsidiary owned or controlled the applicable PSI Property, and are not now, any underground tanks or underground improvements at, on or under the PSI Property, including without limitation, treatment or storage tanks, sumps, or water, gas or oil wells, that are not currently maintained in compliance with Environmental and Safety Laws. 2.13 Tax Matters. (a) Except as set forth in Schedule 2.13(a), PSI and each other Person included in any consolidated or combined Tax Return and part of an affiliated group, within the meaning of Section 1504 of the Code, of which PSI is or has been a member ("PSI TAX AFFILIATE"), for the years that it was a PSI Tax Affiliate of PSI: (i) has timely paid or caused to be paid all Taxes required to be paid by it through the date hereof and as of the Closing Date (including any Taxes shown due on any Tax Return); (ii) has filed or caused to be filed in a timely and proper manner (within any applicable extension periods) all Tax Returns required to be filed by it with the appropriate Governmental Entities in all jurisdictions in which such Tax Returns are required to be filed, and all Tax Returns filed on behalf of PSI and each PSI Tax Affiliate were complete and correct in all material respects; and (iii) has not requested or caused to be requested any extension of time within which to file any Tax Return, which Tax Return has not since been filed if due. (b) PSI has previously made available to PMR for review true, correct and complete copies of all Tax Returns filed by or on behalf of PSI through the Closing Date for the periods ending after December 31, 1994. (c) Except as set forth in Schedule 2.13(c): (i) neither PSI nor any PSI Tax Affiliate (for the years that it was a PSI Tax Affiliate of PSI) has been notified by the Internal Revenue Service or any other taxing authority that any issues have been raised (and no such issues are currently pending) by the Internal Revenue Service or any other taxing authority in connection with any Tax Return filed by or on behalf of A-14 PSI or any PSI Tax Affiliate; there are no pending Tax audits and no waivers of statutes of limitations have been given or requested with respect to PSI or any PSI Tax Affiliate (for the years that it was a PSI Tax Affiliate of PSI); no Tax Encumbrances have been filed against PSI or any PSI Tax Affiliate (for the years that it was a tax of PSI) except for Encumbrances for current Taxes not yet due and payable for which adequate reserves have been provided for in the Latest PSI Balance Sheet or the Latest Audited PSI Balance Sheet; no unresolved deficiencies or additions to Taxes have been proposed, asserted, or assessed against PSI or any PSI Tax Affiliate (for the years that it was a PSI Tax Affiliate of PSI); (ii) full and adequate provision (at assumed tax rates) has been made (A) on the Latest PSI Balance Sheet and the Latest Audited PSI Balance Sheet, and the Books and Records of PSI for all deferred Taxes not yet due and payable by PSI for all periods on or prior to the Closing Date, and (B) on the Books and Records of PSI for all deferred Taxes payable by PSI for all periods beginning on or after the Latest Audited PSI Balance Sheet Date; (iii) neither PSI nor any PSI Subsidiaries have incurred any Liability for Taxes from and after the Latest Audited PSI Balance Sheet Date other than Taxes incurred in the ordinary course of business and consistent with past practices; (iv) PSI has not (A) made an election (or had an election made on its behalf by another Person) to be treated as a "consenting corporation" under Section 341(f) of the Code or (B) been a "personal holding company" within the meaning of Section 542 of the Code; (v) PSI and each PSI Tax Affiliate has complied with all applicable Laws relating to the collection or withholding of Taxes (such as sales Taxes or withholding of Taxes from the wages of employees) in all material respects; (vi) neither PSI nor the PSI Subsidiaries have any Liability in respect of any Tax sharing agreement with any Person and all Tax sharing agreements to which either PSI or the PSI Subsidiaries have been bound have been terminated; (vii) neither PSI nor the PSI Subsidiaries have incurred any Liability to make or possibly make any payments either alone or in conjunction with any other payments that: (A) shall be non-deductible under, or would otherwise constitute a "parachute payment" within the meaning of Section 280G of the Code (or any corresponding provision of state, local or foreign income Tax Law); or (B) are or may be subject to the imposition of an excise Tax under Section 4999 of the Code; (viii) neither PSI nor the PSI Subsidiaries have agreed to (nor has any other Person agreed to on its behalf) and is not required to make any adjustments or changes either on, before or after the Closing Date, to its accounting methods pursuant to Section 481 of the Code, and the Internal Revenue Service has not proposed any such adjustments or changes in the accounting methods of such Persons; (ix) no claim has been made within the last three years by any taxing authority in a jurisdiction in which PSI and the PSI Subsidiaries do not file Tax Returns that PSI or the PSI Subsidiaries are or may be subject to taxation by that jurisdiction; (x) the consummation of the transactions hereunder will not trigger the realization or recognition of intercompany gain or income to PSI or the PSI Subsidiaries under the federal consolidated return regulations with respect to federal, state, or local taxes; and (xi) PSI is not currently, nor has it been at any time during the previous five years, a "U.S. real property holding corporation." A-15 2.14 Employee Benefit Plans. (a) Schedule 2.14 lists, with respect to PSI, any PSI Subsidiary and any trade or business (whether or not incorporated) which is treated as a single employer with PSI (a "PSI ERISA AFFILIATE") within the meaning of Section 414(b), (c), (m) or (o) of the Code, (i) all material employee benefit plans (as defined in Section 3(3) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), (ii) each loan to a non-officer employee in excess of $10,000, each loan to any officer or director and any stock option, stock purchase, phantom stock, stock right, supplemental retirement, severance, sabbatical, medical, dental, vision care, disability, employee relocation, cafeteria benefit (Code Section 125) or dependent care (Code Section 129), life insurance or accident insurance plans, programs or arrangements, (iii) all bonus, pension, profit sharing, savings, deferred compensation or incentive plans, programs or arrangements, (iv) other fringe or employee benefit plans, programs or arrangements that apply to senior management of PSI and that do not generally apply to all employees, and (v) any current or former employment or executive compensation or severance agreements, written or otherwise, as to which unsatisfied obligations of PSI of greater than $10,000 remain for the benefit of, or relating to, any present or former employee, consultant or director of PSI (together, the "PSI EMPLOYEE PLANS"). (b) PSI has made available to PMR a copy of each of the PSI Employee Plans and related plan documents (including trust documents, insurance policies or contracts, employee booklets, summary plan descriptions and other authorizing documents, and any material employee communications relating thereto) and has, with respect to each PSI Employee Plan which is subject to ERISA reporting requirements, provided copies of the Form 5500 reports filed for the last three plan years. Any PSI Employee Plan intended to be qualified under Section 401(a) of the Code has either obtained from the Internal Revenue Service a favorable determination letter as to its qualified status under the Code, including all amendments to the Code effected by the Tax Reform Act of 1986 and subsequent legislation, or has applied (or has time remaining in which to apply) to the Internal Revenue Service for such a determination letter prior to the expiration of the requisite period under applicable Treasury Regulations or Internal Revenue Service pronouncements in which to apply for such determination letter and to make any amendments necessary to obtain a favorable determination or has been established under a standardized prototype plan for which an Internal Revenue Service opinion letter has been obtained by the plan sponsor and is valid as to the adopting employer. PSI has also furnished PMR with the most recent Internal Revenue Service determination or opinion letter issued with respect to each such PSI Employee Plan, and nothing has occurred since the issuance of each such letter which could reasonably be expected to cause the loss of the tax-qualified status of any PSI Employee Plan subject to Code Section 401(a). PSI has also furnished PMR with all registration statements and prospectuses prepared in connection with each PSI Employee Plan. (c) (i) None of the PSI Employee Plans promises or provides retiree medical or other retiree welfare benefits to any person other than as required under the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA"); (ii) there has been no "prohibited transaction," as such term is defined in Section 406 of ERISA and Section 4975 of the Code, with respect to any PSI Employee Plan, which could reasonably be expected to have, in the aggregate, a PSI Material Adverse Effect; (iii) each PSI Employee Plan has been administered in accordance with its terms and in compliance with the requirements prescribed by any and all statutes, rules and regulations (including ERISA and the Code), except as would not have, in the aggregate, a PSI Material Adverse Effect, and PSI and each PSI Subsidiary or PSI ERISA Affiliate have performed all obligations required to be performed by them under, are not in any material respect in default under or violation of, and have no knowledge of any material default or violation by any other party to, any of the PSI Employee Plans; (iv) neither PSI nor any PSI Subsidiary or PSI ERISA Affiliate is subject to any liability or penalty under Sections 4976 through 4980 of the Code or Title I of ERISA with respect to any of the PSI Employee Plans; (v) all material contributions required to be made by PSI or any PSI Subsidiary or PSI ERISA Affiliate to any PSI Employee Plan have been made on or before their due dates and a reasonable amount has been accrued for contributions to each PSI A-16 Employee Plan for the current plan years; (vi) with respect to each PSI Employee Plan, no "reportable event" within the meaning of Section 4043 of ERISA (excluding any such event for which the thirty (30) day notice requirement has been waived under the regulations to Section 4043 of ERISA) nor any event described in Section 4062, 4063 or 4041 of ERISA has occurred; (vii) no PSI Employee Plan is covered by, and neither PSI nor any PSI Subsidiary or PSI ERISA Affiliate has incurred or expects to incur any liability under Title IV of ERISA or Section 412 of the Code; and (viii) each PSI Employee Plan can be amended, terminated or otherwise discontinued after the Effective Time in accordance with its terms, without liability to PMR (other than ordinary administrative expenses typically incurred in a termination event). With respect to each PSI Employee Plan subject to ERISA as either an employee pension plan within the meaning of Section 3(2) of ERISA or an employee welfare benefit plan within the meaning of Section 3(1) of ERISA, PSI has prepared in good faith and timely filed all requisite governmental reports (which were true and correct as of the date filed) and has properly and timely filed and distributed or posted all notices and reports to employees required to be filed, distributed or posted with respect to each such PSI Employee Plan. No suit, administrative proceeding, action or other litigation has been brought, or to the knowledge of PSI is threatened, against or with respect to any such PSI Employee Plan, including any audit or inquiry by the Internal Revenue Service or United States Department of Labor. No payment or benefit which will or may be made by PSI to any employee of PSI or any PSI Subsidiary will be characterized as an "excess parachute payment" within the meaning of Section 280G(b)(1) of the Code. (d) With respect to each PSI Employee Plan, PSI and each of its United States PSI Subsidiaries have complied with (i) the applicable health care continuation and notice provisions of COBRA and the regulations (including proposed regulations) thereunder except to the extent that such failure to comply would not, in the aggregate, have a PSI Material Adverse Effect, (ii) the applicable requirements of the Family Medical and Leave Act of 1993 and the regulations thereunder, except to the extent that such failure to comply would not, in the aggregate, have a PSI Material Adverse Effect and (iii) the applicable requirements of the Health Insurance Portability and Accountability Act of 1996 and the regulations (including proposed regulations) thereunder, except to the extent that such failure to comply would not, in the aggregate, have a PSI Material Adverse Effect. (e) There has been no amendment to, written interpretation or announcement (whether or not written) by PSI, any PSI Subsidiary or other PSI ERISA Affiliate relating to, or change in participation or coverage under, any PSI Employee Plan which would materially increase the expense of maintaining such PSI Employee Plan above the level of expense incurred with respect to that PSI Employee Plan for the most recent fiscal year included in PSI's financial statements. (f) PSI does not currently maintain, sponsor, participate in or contribute to, nor has it ever maintained, established, sponsored, participated in, or contributed to, any pension plan (within the meaning of Section 3(2) of ERISA) which is subject to Part 3 of Subtitle B of Title I of ERISA, Title IV of ERISA or Section 412 of the Code. (g) Neither PSI nor any PSI Subsidiary or other PSI ERISA Affiliate is a party to, or has made any contribution to or otherwise incurred any obligation under, any "multiemployer plan" as defined in Section 3(37) of ERISA. (h) Each compensation and benefit plan required to be maintained or contributed to by the law or applicable custom or rule of the relevant jurisdiction outside of the United States (the "PSI BENEFIT PLANS") is listed in Schedule 2.14(h) of the Disclosure Schedule. As regards each such PSI Benefit Plan, unless disclosed in Schedule 2.14(h) of the PSI Disclosure Schedule (i) each of the PSI Benefit Plans is in material compliance with the provisions of the laws of each jurisdiction in which each such PSI Benefit Plan is maintained, to the extent those laws are applicable to the PSI Benefit Plans; (ii) all material contributions to, and material payments from, the PSI Benefit Plans which may have been required to be made in accordance with the terms of any such PSI Benefit A-17 Plan, and, when applicable, the law of the jurisdiction in which such PSI Benefit Plan is maintained, have been timely made or shall be made by the Closing Date, and all such contributions to the PSI Benefit Plans, and all payments under the PSI Benefit Plans, for any period ending before the Closing Date that are not yet, but will be, required to be made, are reflected as an accrued liability on the PSI Balance Sheet, or disclosed to PMR within fifteen (15) days following the date hereof in Schedule 2.14(h) of the Disclosure Schedule; (iii) PSI and the PSI Subsidiaries and ERISA Affiliates have materially complied with all applicable reporting and notice requirements, and all of the PSI Benefit Plans have obtained from the governmental body having jurisdiction with respect to such plans any required determinations, if any, that such PSI Benefit Plans are in compliance with the laws of the relevant jurisdiction if such determinations are required in order to give effect to the PSI Benefit Plan; (iv) each of the PSI Benefit Plans has been administered in all material respects at all times in accordance with its terms and applicable law and regulations; (v) to the knowledge of PSI, there are no pending investigations by any governmental body involving the PSI Benefit Plans, and no pending claims (except for claims for benefits payable in the normal operation of the PSI Benefit Plans), suits or proceedings against any PSI Benefit Plan or asserting any rights or claims to benefits under any PSI Benefit Plan; and (vi) the consummation of the transactions contemplated by this Agreement will not by itself create or otherwise result in any liability with respect to any PSI Benefit Plan other than the triggering of payment to participants. 2.15 Certain Agreements Affected by the Merger. Neither the execution and delivery of this Agreement nor the consummation of the transactions contemplated hereby will (i) result in any payment (including, without limitation, severance, unemployment compensation, golden parachute, bonus or otherwise) becoming due to any director, employee or consultant of PSI or any of the PSI Subsidiaries, (ii) materially increase any benefits otherwise payable by PSI or (iii) result in the acceleration of the time of payment or vesting of any such benefits except as required under Code Section 411(d)(3). 2.16 Employee Matters. PSI and each of the PSI Subsidiaries are in compliance in all material respects with all currently applicable laws and regulations respecting employment, discrimination in employment, terms and conditions of employment, wages, hours and occupational safety and health and employment practices, and is not engaged in any unfair labor practice. PSI has withheld all amounts required by law or by agreement to be withheld from the wages, salaries, and other payments to employees and is not liable for any arrears of wages or any taxes or any penalty for failure to comply with any of the foregoing. PSI is not liable for any payment to any trust or other fund or to any governmental or administrative authority, with respect to unemployment compensation benefits, social security or other benefits or obligations for employees (other than routine payments to be made in the normal course of business and consistent with past practice). Except as set forth on Schedule 2.16, there are no pending claims against PSI or any of the PSI Subsidiaries under any workers compensation plan or policy or for long term disability. There are no controversies pending or, to the knowledge of PSI or any of the PSI Subsidiaries, threatened, between PSI or any of the PSI Subsidiaries and any of their respective employees, which controversies have or could reasonably be expected to result in an action, suit, proceeding, claim, arbitration or investigation before any agency, court or tribunal, foreign or domestic. Neither PSI nor any of the PSI Subsidiaries is a party to any collective bargaining agreement or other labor union contract nor does PSI nor any of the PSI Subsidiaries know of any activities or proceedings of any labor union or to organize any such employees. To PSI's knowledge, no employees of PSI or any of the PSI Subsidiaries are in violation of any term of any employment contract, patent disclosure agreement, enforceable noncompetition agreement, or any enforceable restrictive covenant to a former employer relating to the right of any such employee to be employed by PSI or any of the PSI Subsidiaries because of the nature of the business conducted or presently proposed to be conducted by PSI or to the use of trade secrets or proprietary information of others. No employees of PSI or any of the PSI Subsidiaries have given notice to PSI or any of the PSI Subsidiaries, nor is PSI otherwise aware, that any such employee intends to terminate his or her employment with PSI or any of the PSI Subsidiaries. Except as set forth in Schedule 2.16, the employment of each of the employees of PSI and each of the PSI Subsidiaries is "at will" and PSI and each of the PSI Subsidiaries does not have any obligation to provide any particular form or period of notice prior to terminating the employment of any of their employees. A-18 2.17 Conflicts of Interest; Related Party Transactions. (a) None of PSI, the PSI Subsidiaries or any officer nor, to the knowledge of the officers of PSI, any employee, agent or other Person acting on behalf of PSI or the PSI Subsidiaries has, directly or indirectly, given or agreed to give any money, gift or similar benefit (other than legal price concessions to customers in the ordinary course of business) to any physician, psychologist, counselor, or other direct or indirect referral source, or any family member or agent of the foregoing, or official or employee of any Governmental Entity or other Person who was or is in a position to help or hinder the business of PSI or the PSI Subsidiaries (or assist in connection with any actual or proposed transaction) that (i) might subject PSI or the PSI Subsidiaries to any material damage or material penalty in any Proceeding before any agency, court or tribunal, foreign or domestic, (ii) if not given in the past, could have resulted in a PSI Material Adverse Effect, (iii) if not continued in the future, could result in a PSI Material Adverse Effect; or (iv) is in material violation of any Laws, including the federal illegal remuneration statute, 42 U.S.C. sec. 1320a-76. (b) Except as set forth in Schedule 2.17(b), and except for compensation to regular employees of PSI or the PSI Subsidiaries, no current or former Affiliate of PSI, or the PSI Subsidiaries or any associate of such Person (as defined in Rule 12b-2 promulgated under the Exchange Act thereof, is now, or has been during the last five fiscal years, (i) a party to any transaction or agreement with PSI or any of the PSI Subsidiaries, or (ii) the direct or indirect owner of an interest in any Person which is a present or potential competitor, supplier or customer of PSI or the PSI Subsidiaries (other than non-affiliated holdings in publicly-held companies), nor does any such Person receive income from any source other than PSI or the PSI Subsidiaries which should properly accrue to PSI or the PSI Subsidiaries. Except as set forth in Schedule 2.17, neither PSI nor the PSI Subsidiaries are a guarantor or otherwise liable for any actual or potential Liability or obligation, whether direct or indirect, of any of its Affiliates. Except as set forth in Schedule 2.17, there are no intercompany loans or open account balances between PSI and the PSI Subsidiaries. 2.18 Insurance. PSI and each of the PSI Subsidiaries have policies of insurance and bonds of the type and in amounts customarily carried by persons conducting businesses or owning assets similar to those of PSI and the PSI Subsidiaries. There is no material claim pending under any of such policies or bonds as to which coverage has been questioned, denied or disputed by the underwriters of such policies or bonds. All premiums due and payable under all such policies and bonds have been paid and PSI and the PSI Subsidiaries are otherwise in compliance with the terms of such policies and bonds. PSI has no knowledge of any threatened termination of, or material premium increase with respect to, any of such policies. 2.19 Compliance With Laws. Each of PSI and the PSI Subsidiaries has complied with, are not in violation of, and have not received any notices of violation with respect to, any Law with respect to the conduct of the PSI business, or the ownership or operation of its business, except for such violations or failures to comply as could not be reasonably expected to have a PSI Material Adverse Effect. 2.20 Accounts Receivable. Subject to any reserves set forth in the PSI Financial Statements, the accounts receivable shown on the PSI Financial Statements represent bona fide claims against debtors for services rendered, sales and other charges, and are not subject to discount except for normal cash and immaterial trade discounts. The amount carried for doubtful accounts and allowances disclosed in the PSI Financial Statements was calculated in accordance with generally accepted accounting principles and in a manner consistent with prior periods. 2.21 Customers and Suppliers. No third party payor or customer which individually accounted for more than five percent (5%) of PSI's gross revenues during the 12-month period preceding the date hereof, and no hospital, health care provider or supplier of PSI, has canceled or otherwise terminated, or made any written threat to PSI to cancel or otherwise terminate its relationship with PSI, or has decreased materially its services or supplies to PSI in the case of any such hospital, health care provider or supplier, or its usage of the services or products of PSI in the case of such third party payor or customer, and to PSI's knowledge, no such hospital, health care provider, supplier, third party payor or customer intends to A-19 cancel or otherwise terminate its relationship with PSI or to decrease materially its services or supplies to PSI or its usage of the services or products of PSI, as the case may be. PSI has not knowingly breached, so as to provide a benefit to PSI that was not intended by the parties, any agreement with, or engaged in any fraudulent conduct with respect to, any third party payor, customer, hospital, health care provider or supplier of PSI. 2.22 Material Contracts. Except for the contracts and agreements described in Schedule 2.22 (collectively, the "PSI MATERIAL CONTRACTS"), neither PSI nor any PSI Subsidiary is a party to or bound by any material contract, including without limitation: (a) any distributor, sales, advertising, agency or manufacturer's representative contract; (b) any continuing contract for the purchase of materials, supplies, equipment or services involving in the case of any such contract more than $50,000 annually; (c) any trust indenture, mortgage, promissory note, loan agreement or other contract for the borrowing of money, any currency exchange, commodities or other hedging arrangement or any leasing transaction of the type required to be capitalized in accordance with generally accepted accounting principles; (d) any contract for capital expenditures in excess of $50,000 in the aggregate; (e) any contract limiting the freedom of PSI to engage in any line of business or to compete with any other Person as that term is defined in the Exchange Act or any confidentiality, secrecy or non-disclosure contract; (f) any contract with any person with whom PSI does not deal at arm's length; (g) any agreement of guarantee, support, indemnification, assumption or endorsement of, or any similar commitment with respect to, the obligations, liabilities (whether accrued, absolute, contingent or otherwise) or indebtedness of any other Person; or (h) any contracts or commitments providing for payments based in any manner on the revenues or profits of the business of PSI or the PSI Subsidiaries; provided, however that PSI Material Contracts comprised of managed care contracts, management service/unit management agreements and Medical Director Agreements are not required to be disclosed on Schedule 2.22. 2.23 No Breach of PSI Material Contracts. All PSI Material Contracts are in written form. PSI has performed all of the obligations required to be performed by it and is entitled to all benefits under, and is not alleged to be in default in respect of any PSI Material Contract. Each of the PSI Material Contracts is in full force and effect, unamended, and there exists no default or event of default or event, occurrence, condition or act, with respect to PSI or to PSI's knowledge with respect to the other contracting party, which, with the giving of notice, the lapse of time or the happening of any other event or conditions, would become a default or event of default under any PSI Material Contract. True, correct and complete copies of all PSI Material Contracts have been made available to PMR. 2.24 Third Party Consents. Except as set forth in Schedule 2.24, the execution and delivery of this Agreement and the consummation of the transactions contemplated hereby will not require the consent, approval, order or authorization of any third party under the PSI Material Contracts. 2.25 Certain Additional Regulatory Matters. (a) Except where such activities have not had and will not have a PSI Material Adverse Effect, neither PSI, the PSI Subsidiaries, nor any officer, director or managing employee of such Person (within the meaning of 42 U.S.C. (sec. 1320a-5(b)) has engaged in any activities which constitute violations of, or are cause for imposition of civil penalties upon PSI or the PSI Subsidiaries or mandatory or permissive exclusion of such Persons from Medicare or Medicaid, under sec.sec. 1320a-7, 1320a-7a, 1320a-7b, or 1395nn of Title 42 of the United States Code, sec. 3727 et seq. of Title 51 of the A-20 United States Code ("TRICARE"), any other state or federal health care program, or the regulations promulgated pursuant to such statutes or regulations or related state or local statutes or which constitute violations of or deficiencies under the standards of any private accrediting organization from which PSI or any of the PSI Subsidiaries is accredited or seeks accreditation, including the following activities: (i) making or causing to be made a false statement or representation of a material fact in any application for any benefit or payment; (ii) making or causing to be made any false statement or representation of a material fact for use in determining rights to any benefit or payment; (iii) presenting or causing to be presented a claim for reimbursement under TRICARE, Medicare, Medicaid or any other State Health Care Program or Federal Health Care Program (each as defined below) that is (A) for an item or service that the person presenting or causing to be presented knows or should know was not provided as claimed, or (B) for an item or service where the person presenting knows or should know that the claim is false or fraudulent; (iv) offering, paying, soliciting or receiving any remuneration (including any kickback, bribe or rebate), directly or indirectly, overtly or covertly, in cash or in kind (A) in return for referring, or to induce the referral of, an individual to a person for the furnishing or arranging for the furnishing of any item or service for which payment may be made in whole or in part by TRICARE, Medicare or Medicaid, or any other State Health Care Program or any Federal Health Care Program, or (B) in return for, or to induce, the purchase, lease, or order, or the arranging for or recommending of the purchase, lease, or order, of any good, facility, service, or item for which payment may be made in whole or in part by TRICARE, Medicare or Medicaid or any other State Health Care Program or any Federal Health Care Program; (v) making or causing to be made or inducing or seeking to induce the making of any false statement or representation (or omitting to state a material fact required to be stated therein or necessary to make the statements contained therein not misleading) of a material fact with respect to (A) the conditions or operations of a facility in order that the facility may qualify for TRICARE, Medicare, Medicaid or any other State Health Care Program certification or any Federal Health Care Program certification, or (B) information required to be provided under sec. 1124(A) of the Social Security Act ("SSA") (42 U.S.C. sec. 1320a-3); or (vi) failing substantially to provide medically necessary items or services, if the failure adversely affects individuals covered by Medicare or Medicaid. (b) Each of the facilities operated by PSI and the PSI Subsidiaries has a Medicaid number and a participating provider agreement in each state, as applicable, to which it bills directly to such states' Medicaid agency for services provided by it. 2.26 Medicare/Medicaid Participation. Neither PSI, the PSI Subsidiaries, any officer, director, or managing employee (as defined in SSA sec. 1126(b) or any regulations promulgated thereunder): (x) have had a civil monetary penalty assessed against him, her or it under sec. 1128A of the SSA or any regulations promulgated thereunder; (y) have been excluded from participation under the Medicare program or a state health care program as defined in SSA sec. 1128(h) or any regulations promulgated thereunder ("STATE HEALTH CARE PROGRAM") or a federal health care program as defined in SSA sec. 1128B(f) ("FEDERAL HEALTH CARE PROGRAM"); or (z) have been convicted (as that term is defined in 42 C.F.R. sec. 1001.2) of any of the following categories of offenses as described in SSA sec.sec. 1128(a) and (b)(1), (2), (3) or any regulations promulgated thereunder: (i) criminal offenses relating to the delivery of an item or service under Medicare or any State Health Care Program or any Federal Health Care Program; (ii) criminal offenses under federal or state law relating to patient neglect or abuse in connection with the delivery of a health care item or service; A-21 (iii) criminal offenses under federal or state law relating to fraud, theft, embezzlement, breach of fiduciary responsibility, or other financial misconduct in connection with the delivery of a health care item or service or with respect to any act or omission in a program operated by or financed in whole or in part by any federal, state or local governmental agency; (iv) federal or state laws relating to the interference with or obstruction of any investigation into any criminal offense; or (v) criminal offenses under federal or state law relating to the unlawful manufacture, distribution, prescription or dispensing of a controlled substance. 2.27 Minute Books. The minute books of PSI and the PSI Subsidiaries made available to PMR contain a complete and accurate summary of all meetings of directors and stockholders or actions by written consent since the time of incorporation of PSI and the respective PSI Subsidiaries through the date of this Agreement, and reflect all transactions referred to in such minutes accurately in all material respects. 2.28 Complete Copies of Materials. PSI has delivered or made available true and complete copies of each document which has been requested by PMR or its counsel in connection with their legal and accounting review of PSI and the PSI Subsidiaries. 2.29 Brokers' and Finders' Fees. Except as set forth on Schedule 2.29, PSI has not incurred, nor will it incur, directly or indirectly, any liability for brokerage or finders' fees or agents' commissions or investment bankers' fees or any similar charges in connection with this Agreement or any transaction contemplated hereby. 2.30 Vote Required. The affirmative vote of the holders of greater than 50% of the PSI Common Stock and 50% of the PSI Preferred Stock outstanding on the record date set for the PSI Meeting is the only vote of the holders of any of PSI's Capital Stock necessary to approve this Agreement and the transactions contemplated hereby. 2.31 Board Approval. The Board of Directors of PSI has (i) approved this Agreement and the Merger, (ii) determined that the Merger is in the best interests of the stockholders of PSI and is on terms that are fair to such stockholders and (iii) recommended that the stockholders of PSI approve this Agreement and the Merger. 2.32 State Takeover Statutes. The Board of Directors of PSI has approved this Agreement, the agreements entered into or proposed to be entered into as contemplated by this Agreement and the transactions contemplated hereby and thereby (including the Merger), and such approval is sufficient to render inapplicable to such agreements and transactions the provisions of any "fair price," "moratorium," "control share," "interested shareholders," "affiliated transaction" or other anti-takeover statute or regulation and any applicable anti-takeover or other restrictive provisions of PSI's Certificate of Incorporation, Bylaws or other governing documents. 2.33 Programs. Each facility where behavioral health, substance abuse, and human service programs provided by PSI or the PSI Subsidiaries are offered to Medicare or Medicaid beneficiaries, are eligible to receive payment under Titles XVIII and XIX of the Social Security Act and are "providers" under existing provider agreements with the Medicare and Medicaid programs through the applicable carriers. Each facility is in substantial compliance with the conditions of participation in the Medicare and Medicaid programs and have received all approvals or qualifications necessary for reimbursement through the Medicare and Medicaid programs. 2.34 Representations Complete. None of the representations or warranties made by PSI herein or in any Schedule hereto, including the PSI Disclosure Schedule, or certificate furnished by PSI pursuant to this Agreement, when all such documents are read together in their entirety, contains or will contain at the Effective Time any untrue statement of a material fact, or omits or will omit at the Effective Time to state any material fact necessary in order to make the statements contained herein or therein, in the light of the circumstances under which made, not misleading. A-22 ARTICLE III REPRESENTATIONS AND WARRANTIES OF PMR AND MERGER SUB In this Agreement, any reference to any event, change, condition or effect being "material" with respect to any entity or group of entities means any material event, change, condition or effect related to the condition (financial or otherwise), properties, assets (including intangible assets), liabilities, business, operations or results of operations of such entity or group of entities. In this Agreement, any reference to a "PMR MATERIAL ADVERSE EFFECT" means any event, change, condition or effect that is materially adverse to the condition (financial or otherwise), properties, assets, liabilities, business, operations or results of operations of PMR and the PMR Subsidiaries, taken as a whole, other than any event, change, condition or effect relating to (i) this Agreement or the transactions contemplated hereby or the announcement thereof, (ii) the failure to obtain applicable regulatory or third party consents that may be required in connection with this Agreement or the transactions contemplated hereby, (iii) the United States economy in general, (iv) the behavioral healthcare industry in general, or (v) the termination of employment of any senior management employee of PMR prior to the Effective Time; provided, however, that a PMR Material Adverse Effect shall include any change in or effect on the business of PMR and the PMR Subsidiaries that is, or is reasonably likely to be, materially adverse to the condition (financial or otherwise), properties, assets, liabilities, business, operations or results of operations of PMR and the PMR Subsidiaries, taken as a whole, if such change or effect is significantly more adverse to PMR and the PMR Subsidiaries, taken as a whole, than to the human services industry in general. In this Agreement, any reference to a party's "knowledge" means actual knowledge of such party's officers or directors, provided that such persons shall make due and diligent inquiry of those employees of such party whom such officers and directors reasonably believe would have actual knowledge of the matters represented. Except as disclosed in a document of even date herewith and delivered by PMR and Merger Sub to PSI prior to the execution and delivery of this Agreement and referring to the representations and warranties in this Agreement (the "PMR DISCLOSURE SCHEDULE"), PMR and Merger Sub represent and warrant to PSI as follows: 3.1 Organization, Standing; and Power. Each of PMR and the PMR Subsidiaries is a corporation duly organized, validly existing and in good standing under the laws of its jurisdiction of organization. PMR has the corporate power to own its properties and to carry on its business as now being conducted and as proposed to be conducted and is duly qualified to do business and is in good standing in each jurisdiction in which the failure to be so qualified and in good standing would have a PMR Material Adverse Effect. PMR has made available to PSI a true and correct copy of the Certificate of Incorporation and Bylaws or other charter documents, as applicable, of PMR and each of the PMR Subsidiaries, each as amended to date. Neither PMR nor any of the PMR Subsidiaries is in violation of any of the provisions of its Certificate of Incorporation or Bylaws or equivalent organizational documents. PMR is the owner of all outstanding shares of capital stock of each of the entities set forth in Schedule 3.1 of the PMR Disclosure Schedule (collectively, the "PMR SUBSIDIARIES" and each a "PMR SUBSIDIARY") and all such shares are duly authorized, validly issued, fully paid and nonassessable. Schedule 3.1 is a complete and accurate list of all subsidiaries of PMR. All of the outstanding shares of capital stock of each such PMR Subsidiary are owned by PMR free and clear of all liens, charges, claims or encumbrances or rights of others. There are no outstanding subscriptions, options, warrants, puts, calls, rights, exchangeable or convertible securities or other commitments or agreements of any character relating to the issued or unissued capital stock or other securities of any such PMR Subsidiary, or otherwise obligating PMR or any such PMR Subsidiary to issue, transfer, sell, purchase, redeem or otherwise acquire any such securities of any such PMR Subsidiary. Except as set forth in Schedule 3.1 to the PMR Disclosure Schedule, PMR does not directly or indirectly own any equity or similar interest in, or any interest convertible or exchangeable or exercisable for, any equity or similar interest in, any corporation, partnership, joint venture or other business association or entity. A-23 3.2 Capital Structure. The authorized capital stock of PMR consists of 19,000,000 shares of PMR Common Stock, of which there are 7,180,442 shares issued and outstanding. The shares of PMR Common Stock to be issued pursuant to the Merger will be duly authorized, validly issued, fully paid and nonassessable. There are no other outstanding shares of capital stock or voting securities and no outstanding commitments to issue any shares of capital stock or voting securities, other than pursuant to (i) the exercise of outstanding warrants to purchase shares of PMR Common Stock and (ii) the exercise of options outstanding as of such date under PMR's 1997 Equity Incentive Plan (the "PMR STOCK PLAN") and PMR's Outside Directors' Non-Qualified Stock Option Plan of 1992 (the "PMR DIRECTOR PLAN"). All outstanding shares of PMR Common Stock are duly authorized, validly issued, fully paid and nonassessable and are free of any liens or encumbrances other than any liens or encumbrances created by or imposed upon the holders thereof, and are not subject to preemptive rights or rights of first refusal created by statute, the Certificate of Incorporation or Bylaws of PMR or any agreement to which PMR is a party or by which it is bound. PMR has reserved sufficient shares of PMR Common Stock for issuance to employees and consultants pursuant to the PMR Stock Plan, of which 1,248,651 shares have been issued pursuant to option exercises or direct stock purchases, 1,147,401 shares are subject to outstanding, unexercised options, and 1,603,948 shares are available for issuance thereunder. PMR has reserved sufficient shares of PMR Common Stock for issuance to directors of PMR pursuant to the PMR Director Plan, of which 219,000 shares have been issued pursuant to option exercises or direct stock purchases, 287,250 shares are subject to outstanding, unexercised options, and 518,750 shares are available for issuance thereunder. Notwithstanding anything in the foregoing to the contrary, the exercise of options by any PMR option holder between the date of this Agreement and the Effective Time shall not cause a breach of this Section 3.2. 3.3 Authority; No Conflict; Required Filings and Consents. Each of PMR and Merger Sub has all requisite corporate power and authority to enter into this Agreement and to consummate the transactions contemplated hereby. The execution and delivery of this Agreement and the consummation of the transactions contemplated hereby have been duly authorized by all necessary corporate action on the part of PMR and Merger Sub. This Agreement has been duly executed and delivered by each of PMR and Merger and constitutes the valid and binding obligation of PMR and Merger Sub enforceable against each of PMR and Merger Sub in accordance with its terms. The execution and delivery of this Agreement do not, and the consummation of the transactions contemplated hereby will not, conflict with, or result in any violation of, or default under (with or without notice or lapse of time, or both), or give rise to a right of termination, cancellation or acceleration of any obligation or loss of a benefit under (i) any provision of the Articles of Incorporation or Bylaws of PMR or Merger Sub, as amended, (ii) any Law applicable to PMR, Merger Sub or their respective properties or assets or (iii) any material mortgage, indenture, lease, contract or other agreement or instrument, permit, franchise, or license applicable to PMR, Merger Sub or their respective properties or assets. No consent, approval, order or authorization of, or registration, declaration or filing with, any Governmental Entity, is required by or with respect to PMR or Merger Sub in connection with the execution and delivery of this Agreement by PMR or Merger Sub or the consummation by PMR or Merger Sub of the transactions contemplated hereby, except for (i) the filing of the Certificate of Merger, together with the required officers' certificates, as provided in Section 1.2, (ii) the filing of a Form 8-K with the SEC and National Association of Securities Dealers ("NASD") within 15 days after the Closing Date, (iii) the filing and effectiveness of a registration statement on Form S-4 with the SEC, (iv) any filings as may be required under applicable state securities laws and the securities laws of any foreign country, (v) such filings as may be required under the HSR Act, (vi) the filing with The Nasdaq National Market (the "NASDAQ") of a Notification Form for Listing of Additional Shares with respect to the shares of PMR Common Stock issuable upon conversion of the PSI Capital Stock in the Merger and upon exercise of the options under the PSI Stock Plan assumed by PMR, (vii) the filing of a registration statement on Form S-8 with the SEC, or other applicable form covering the shares of PMR Common Stock issuable pursuant to outstanding options under the PSI Stock Plan assumed by PMR and (viii) such other consents, authorizations, filings, approvals and registrations which, if not obtained or made, would not have a Material Adverse Effect on PMR and would not prevent, materially alter or delay any of the transactions contemplated by this Agreement. A-24 3.4 SEC Documents; Financial Statements. PMR has made available to PSI each statement, report, registration statement (with the prospectus in the form filed pursuant to Rule 424(b) of the Securities Act), definitive proxy statement, and other filing filed with the SEC by PMR since April 30, 2001 (collectively, the "PMR SEC DOCUMENTS"). In addition, PMR has made available to PSI all exhibits to the PMR SEC Documents filed prior to the date hereof, and will promptly make available to PSI all exhibits to any additional PMR SEC Documents filed prior to the Effective Time. Except as set forth in any PMR SEC Document, as of their respective filing dates, the PMR SEC Documents complied in all material respects with the requirements of the Exchange Act and the Securities Act, and none of the PMR SEC Documents contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements made therein, in light of the circumstances in which they were made, not misleading, except to the extent corrected by a subsequently filed PMR SEC Document. Except as set forth in any PMR SEC Document, the financial statements of PMR, including the notes thereto, included in the PMR SEC Documents (the "PMR FINANCIAL STATEMENTS") were complete and correct in all material respects as of their respective dates, complied as to form in all material respects with applicable accounting requirements and with the published rules and regulations of the SEC with respect thereto as of their respective dates, and have been prepared in accordance with generally accepted accounting principles applied on a basis consistent throughout the periods indicated and consistent with each other (except as may be indicated in the notes thereto or, in the case of unaudited statements included in Quarterly Reports on Form 10-Q, as permitted by Form 10-Q of the SEC). The PMR Financial Statements fairly present the consolidated financial condition and operating results of PMR at the dates and during the periods indicated therein (subject, in the case of unaudited statements, to normal, recurring year-end adjustments). 3.5 Absence of Certain Changes. Since April 30, 2001 (the "PMR BALANCE SHEET DATE"), except as set forth in Schedule 3.5 or as disclosed in the PMR SEC Documents or as contemplated by this Agreement, PMR and the PMR Subsidiaries conducted their respective businesses in the ordinary course consistent with past practice and there has not occurred: (a) any change, event or condition (whether or not covered by insurance) that has resulted in, or might reasonably be expected to result in, a PMR Material Adverse Effect; (b) any discharge or satisfaction of any Encumbrance other than those then required to be discharged or satisfied prior to the Closing Date pursuant to the existing terms of any agreement between PMR or any of the PMR Subsidiaries and a party unaffiliated with PMR or any of the PMR Subsidiaries, or payment of any obligation or Liability, other than current Liabilities shown on the consolidated balance sheet of PMR as of January 31, 2002 (the "LATEST PMR BALANCE SHEET") included in the PMR Financial Statements and current Liabilities incurred in the ordinary course of business consistent with prior practice, or any cancellation, forgiveness or compromise by PMR or any of the PMR Subsidiaries of any debts or claims other than in the ordinary course of business or any waiver or release of any right of substantial value to PMR and the PMR Subsidiaries; (c) except as expressly permitted by Section 4.4(b), any declaration, setting aside or payment of any dividend or other distribution of any assets of any kind whatsoever with respect to any shares of the capital stock of PMR or the PMR Subsidiaries, or any direct or indirect redemption, purchase or other acquisition of any such shares of the capital stock of PMR or the PMR Subsidiaries; (d) any stock split, reverse stock split, combination, reclassification or recapitalization of any capital stock of PMR or the PMR Subsidiaries, or any issuance of any other security in respect of or in exchange for, any shares of any capital stock of PMR or the PMR Subsidiaries; (e) any issuance by PMR or the PMR Subsidiaries of any shares of their capital stock or any debt security or securities, rights, options or warrants convertible into or exercisable or exchangeable for any shares of such capital stock or debt security; (f) any license, sale, transfer, pledge, mortgage or other disposition of any tangible or intangible asset of PMR or the PMR Subsidiaries, except for inventory sold in the ordinary course of business; A-25 (g) any termination or receipt by PMR or the PMR Subsidiaries of any notice of termination or non-renewal of any Contract between PMR or the PMR Subsidiaries and any other Person involving payments by or to PMR or any of the PMR Subsidiaries in excess of $100,000 in the aggregate; (h) any write-down or write-up of the value of any asset of PMR or the PMR Subsidiaries, or, other than in the ordinary course of business, any write-off of any accounts receivable or notes receivable of PMR or the PMR Subsidiaries or any portion thereof in excess of $50,000 in the aggregate; (i) any increase in or modification of compensation payable or to become payable to any officer, employee, consultant or agent of PMR or the PMR Subsidiaries, (other than (i) increases not more than 5% different from the aggregate compensation prior to the increase, or (ii) any severance benefit or bonus which is completely paid prior to the Effective Time), or the entering into of any employment contract with any officer or employee; (j) any increase in or modification or acceleration of any benefits payable or to become payable under any pension, insurance or other benefit plan, payment or arrangement (including, but not limited to, the granting of stock options, restricted stock awards or stock appreciation rights) made to, for or with any officer, employee, consultant or agent of PMR or the PMR Subsidiaries; (k) the making of any loan, advance or capital contribution to or investment in any Person or the engagement in any transaction with any employee, officer, director or stockholder of PMR or the PMR Subsidiaries, other than advances to employees in the ordinary course of business for travel and similar business expenses; (l) any change in the accounting methods or practices followed by PMR or the PMR Subsidiaries or any change in depreciation or amortization policies or rates theretofore adopted; (m) any material deterioration in the aging of PMR's or the PMR Subsidiaries' accounts payable or material acceleration in the aging of PMR's or the PMR Subsidiaries' accounts receivable or other change in PMR's or the PMR Subsidiaries' working capital management practices; (n) any material change in the manner in which PMR or the PMR Subsidiaries extend discounts or credit to or otherwise deal with third party payors, patients or other customers; (o) any termination of employment of any officer or key employee of PMR or the PMR Subsidiaries; (p) except as contemplated hereby, any amendments or changes in PMR's or the PMR Subsidiaries' articles or certificate of incorporation or bylaws (or other governing documents); (q) any labor disputes or any union organizing campaigns; (r) the commencement of any litigation or other action by or against PMR or the PMR Subsidiaries; or (s) any agreement, understanding, or authorization, whether in writing or otherwise, for PMR or the PMR Subsidiaries to take any of the actions specified in items (a) through (r) above. 3.6 Absence of Undisclosed Liabilities. Except as set forth in Schedule 3.6, neither PMR nor any of the PMR Subsidiaries have any Liability, except for (i) Liabilities reflected or reserved against in the consolidated balance sheet of PMR as of January 31, 2002, and (ii) Liabilities that have arisen since the date of the Latest PMR Balance Sheet in the ordinary course of business (none of which arise from any breach of Contract, breach of warranty, tort, infringement, violation of Law, or any action, suit or Proceeding (including any Liability under any Environmental and Safety Laws)). There are no loss contingencies (as such term is used in Statement of Financial Accounting Standards No. 5 issued by the Financial Accounting Standards Board in March 1975) that are not adequately provided for on the Latest PMR Balance Sheet. Except as set forth in Schedule 3.6, neither PMR nor any of the PMR Subsidiaries have, either expressly or by operation of Law, assumed or undertaken any Liability of any other Person, A-26 including, without limitation, any obligation for corrective or remedial action relating to or required under any Environmental and Safety Laws. The reserves reflected on the Latest PMR Balance Sheet for Liabilities that were incurred but not reported are adequate to cover such Liabilities. 3.7 Litigation. Except as set forth in Schedule 3.7 of the PMR Disclosure Schedule, there is no Proceeding pending before any agency, court or tribunal, foreign or domestic, or, to the knowledge of PMR or any of the PMR Subsidiaries, threatened against PMR or any of the PMR Subsidiaries or any of their respective properties or any of their respective officers or directors (in their capacities as such). There is no judgment, decree or order against PMR or any of the PMR Subsidiaries, or, to the knowledge of PMR and the PMR Subsidiaries, any of their respective directors or officers (in their capacities as such), that could prevent, enjoin, or materially alter or delay any of the transactions contemplated by this Agreement, or that could reasonably be expected to have a PMR Material Adverse Effect. Schedule 3.7 of the PMR Disclosure Schedule also lists all litigation that PMR has pending against other parties. 3.8 Restrictions on Business Activities. Except as set forth in Schedule 3.8, there is no agreement, judgment, injunction, order or decree binding upon PMR or any of the PMR Subsidiaries which has or could reasonably be expected to have the effect of prohibiting or impairing any current or future business practice of PMR or any of the PMR Subsidiaries, any acquisition of property by PMR or any of the PMR Subsidiaries or the conduct of business by PMR or any of the PMR Subsidiaries as currently conducted or as proposed to be conducted by PMR or any of the PMR Subsidiaries. 3.9 Governmental Authorization. PMR and each of the PMR Subsidiaries have obtained each federal, state, county, local or foreign governmental consent, license, permit, grant, or other authorization of a Governmental Entity (i) pursuant to which PMR or any of the PMR Subsidiaries currently operates or holds any interest in any of its properties or (ii) that is required for the operation of PMR's or any of the PMR Subsidiaries' business or the holding of any such interest ((i) and (ii) herein collectively called "PMR AUTHORIZATIONS"), and all of such PMR Authorizations are in full force and effect, except where the failure to obtain or have any such PMR Authorizations could not reasonably be expected to have a PMR Material Adverse Effect. 3.10 Title to Property. PMR and the PMR Subsidiaries have good and marketable title to all of their respective properties, interests in properties and assets, real and personal, reflected in the Latest PMR Balance Sheet or acquired after the PMR Balance Sheet Date (except properties, interests in properties and assets sold or otherwise disposed of since the PMR Balance Sheet Date in the ordinary course of business), or with respect to leased properties and assets, valid leasehold interests in, free and clear of all mortgages, liens, pledges, charges or encumbrances of any kind or character, except (i) the lien of current taxes not yet due and payable, (ii) such imperfections of title, liens and easements as do not and will not materially detract from or interfere with the use of the properties subject thereto or affected thereby, or otherwise materially impair business operations involving such properties and (iii) liens securing debt which is reflected on the Latest PMR Balance Sheet. The plants, property and equipment of PMR and the PMR Subsidiaries that are used in the operations of their businesses are in good operating condition and repair, subject to normal wear and tear. All properties used in the operations of PMR and the PMR Subsidiaries are reflected in the Latest PMR Balance Sheet to the extent generally accepted accounting principles require the same to be reflected. Schedule 3.10 identifies each parcel of real property owned or leased by PMR or any of the PMR Subsidiaries. 3.11 Intellectual Property. (a) PMR and the PMR Subsidiaries own, or are licensed or otherwise possess legally enforceable rights to use all Intellectual Property that are used or proposed to be used in the business of PMR and the PMR Subsidiaries as currently conducted or as proposed to be conducted by PMR and the PMR Subsidiaries. Except as set forth in Schedule 3.11, PMR has not (i) licensed any of its Intellectual Property in source code form to any party or (ii) entered into any exclusive agreements relating to its Intellectual Property with any party. A-27 (b) Schedule 3.11 lists (i) all patents and patent applications and all registered and unregistered trademarks, trade names and service marks, registered and unregistered copyrights, registered domain names, and maskworks, included in the Intellectual Property, including the jurisdictions in which each such Intellectual Property right has been issued or registered or in which any application for such issuance and registration has been filed, (ii) all licenses, sublicenses and other agreements as to which PMR is a party and pursuant to which any person is authorized to use any Intellectual Property (other than computer software licenses used by PMR in the ordinary course of business), and (iii) all licenses, sublicenses and other agreements as to which PMR is a party and pursuant to which PMR is authorized to use any third party patents, trademarks or copyrights ("PMR THIRD PARTY INTELLECTUAL PROPERTY RIGHTS") which are incorporated in, are, or form a part of any PMR product. (c) There is no unauthorized use, disclosure, infringement or misappropriation of any Intellectual Property rights of PMR or any of the PMR Subsidiaries, or any PMR Third Party Intellectual Property Rights, by any third party, including any employee or former employee of PMR or any of the PMR Subsidiaries. Neither PMR nor any of the PMR Subsidiaries has entered into any agreement to indemnify any other person against any charge of infringement of any Intellectual Property, other than indemnification provisions contained in purchase orders or license agreements arising in the ordinary course of business. (d) PMR is not, nor will it be as a result of the execution and delivery of this Agreement or the performance of its obligations under this Agreement, in material breach of any license, sublicense or other agreement relating to the Intellectual Property or PMR Third Party Intellectual Property Rights. (e) All patents, registered trademarks, service marks and copyrights held by PMR are valid and subsisting. PMR has not been sued in any suit, action or proceeding which involves a claim of infringement of any patents, trademarks, service marks, copyrights or violation of any trade secret or other proprietary right of any third party. The manufacturing, marketing, licensing or sale of PMR's products do not infringe any patent, trademark, service mark, copyright, trade secret or other proprietary right of any third party. PMR has not brought any action, suit or proceeding for infringement of Intellectual Property or breach of any license or agreement involving Intellectual Property against any third party. (f) PMR has secured valid written assignments from all consultants and employees who contributed to the creation or development of Intellectual Property of the rights to such contributions that PMR does not already own by operation of law. (g) PMR has taken all necessary and appropriate steps to protect and preserve the confidentiality of all Intellectual Property not otherwise protected by patents, patent applications or copyright Confidential Information. All use, disclosure or appropriation of Confidential Information owned by PMR by or to a third party has been pursuant to the terms of a written agreement between PMR and such third party. All use, disclosure or appropriation of Confidential Information not owned by PMR has been pursuant to the terms of a written agreement between PMR and the owner of such Confidential Information, or is otherwise lawful. (h) As of the date of this Agreement, except as set forth in Schedule 3.11, there are no actions that must be taken by PMR or any PMR Subsidiary within sixty (60) days of the Closing Date that, if not taken, will result in the loss of any Intellectual Property, including the payment of any registration, maintenance or renewal fees or the filing of any responses to PTO office actions, documents, applications or certificates for the purposes of obtaining, maintaining, perfecting or preserving or renewing any Intellectual Property. A-28 3.12 Environmental Matters. (a) The following terms shall be defined as follows: (i) "PMR PROPERTY" shall mean all real property leased or owned by PMR or the PMR Subsidiaries either currently or in the past. (ii) "PMR FACILITIES" shall mean all buildings and improvements on PMR Property. (b) PMR represents and warrants as follows: (i) no methylene chloride is contained in or has been used at or released from the PMR Facilities by PMR or PMR Subsidiaries; (ii) all Hazardous Materials and wastes if disposed of by PSI or PSI Subsidiaries have been disposed of in accordance with all Environmental and Safety Laws; and (iii) PMR and the PMR Subsidiaries have received no notice (verbal or written) of any noncompliance of the PMR Facilities or its past or present operations with Environmental and Safety Laws; (iv) no notices, administrative actions or suits are pending or threatened relating to a violation of any Environmental and Safety Laws; (v) there are no polychlorinated biphenyls (PCBs) deposited, stored, disposed of or located on the PMR Property or PMR Facilities or any equipment on the PMR Property containing PCBs at levels in excess of 50 parts per million; (vi) PMR and the PMR Subsidiaries' uses and activities of the PMR Facilities have at all times complied with all Environmental and Safety Laws; and (vii) PMR and the PMR Subsidiaries have all the permits and licenses required to be issued under federal, state or local laws regarding Environmental and Safety Laws and are in full compliance with the terms and conditions of those permits; neither PMR nor any PMR Subsidiary are a potentially responsible party under the federal Comprehensive Environmental Response Compensation and Liability Act (CERCLA), or state analog statute, arising out of events occurring prior to the Closing Date. 3.13 Tax Matters. (a) Except as set forth in Schedule 3.13(a), PMR and each other Person included in any consolidated or combined Tax Return and part of an affiliated group, within the meaning of Section 1504 of the Code, of which PMR is or has been a member ("PMR TAX AFFILIATE"), for the years that it was a PMR Tax Affiliate of PMR: (i) has timely paid or caused to be paid all Taxes required to be paid by it through the date hereof and as of the Closing Date (including any Taxes shown due on any Tax Return) other than as fully reserved for in the PMR Financial Statements; (ii) has filed or caused to be filed in a timely and proper manner (within any applicable extension periods) all Tax Returns required to be filed by it with the appropriate Governmental Entities in all jurisdictions in which such Tax Returns are required to be filed, and all Tax Returns filed on behalf of PMR and each PMR Tax Affiliate were complete and correct in all material respects; and (iii) has not requested or caused to be requested any extension of time within which to file any Tax Return, which Tax Return has not since been filed if due. (b) PMR has previously made available to PSI for review true, correct and complete copies of all Tax Returns filed by or on behalf of PMR through the Closing Date for the periods ending after December 31, 1994. (c) Except as set forth in Schedule 3.13(c): (i) neither PMR nor any PMR Tax Affiliate (for the years that it was a PMR Tax Affiliate of PMR) has been notified by the Internal Revenue Service or any other taxing authority that any issues have been raised (and no such issues are currently pending) by the Internal Revenue Service or any other taxing authority in connection with any Tax Return filed by or on behalf of PMR or any PMR Tax Affiliate; there are no pending Tax audits and no waivers of statutes of limitations have been given or requested with respect to PMR or any PMR Tax Affiliate (for the years that it was a PMR Tax Affiliate of PMR); no Tax Encumbrances have been filed against A-29 PMR or any PMR Tax Affiliate (for the years that it was a tax of PMR) except for Encumbrances for current Taxes not yet due and payable for which adequate reserves have been provided for in the Latest PMR Balance Sheet or the Latest Audited PMR Balance Sheet; no unresolved deficiencies or additions to Taxes have been proposed, asserted, or assessed against PMR or any PMR Tax Affiliate (for the years that it was a PMR Tax Affiliate of PMR); (ii) full and adequate provision (at assumed tax rates) has been made (A) on the Latest PMR Balance Sheet and the Latest Audited PMR Balance Sheet, and the Books and Records of PMR for all deferred Taxes not yet due and payable by PMR for all periods on or prior to the Closing Date, and (B) on the Books and Records of PMR for all deferred Taxes payable by PMR for all periods beginning on or after the Latest Audited PMR Balance Sheet Date; (iii) neither PMR nor any PMR Subsidiaries have incurred any Liability for Taxes from and after the Latest Audited PMR Balance Sheet Date other than Taxes incurred in the ordinary course of business and consistent with past practices; (iv) PMR has not (A) made an election (or had an election made on its behalf by another Person) to be treated as a "consenting corporation" under Section 341(f) of the Code or (B) been a "personal holding company" within the meaning of Section 542 of the Code; (v) PMR and each PMR Tax Affiliate has complied with all applicable Laws relating to the collection or withholding of Taxes (such as sales Taxes or withholding of Taxes from the wages of employees) in all material respects; (vi) neither PMR nor the PMR Subsidiaries have any Liability in respect of any Tax sharing agreement with any Person and all Tax sharing agreements to which either PMR or the PMR Subsidiaries have been bound have been terminated; (vii) neither PMR nor the PMR Subsidiaries have incurred any Liability to make or possibly make any payments either alone or in conjunction with any other payments that: (A) shall be non-deductible under, or would otherwise constitute a "parachute payment" within the meaning of Section 280G of the Code (or any corresponding provision of state, local or foreign income Tax Law); or (B) are or may be subject to the imposition of an excise Tax under Section 4999 of the Code; (viii) neither PMR nor the PMR Subsidiaries have agreed to (nor has any other Person agreed to on its behalf) and is not required to make any adjustments or changes either on, before or after the Closing Date, to its accounting methods pursuant to Section 481 of the Code, and the Internal Revenue Service has not proposed any such adjustments or changes in the accounting methods of such Persons; (ix) no claim has been made within the last three years by any taxing authority in a jurisdiction in which PMR and the PMR Subsidiaries do not file Tax Returns that PMR or the PMR Subsidiaries are or may be subject to taxation by that jurisdiction; (x) the consummation of the transactions hereunder will not trigger the realization or recognition of intercompany gain or income to PMR or the PMR Subsidiaries under the federal consolidated return regulations with respect to federal, state, or local taxes; and (xi) PMR is not currently, nor has it been at any time during the previous five years, a "U.S. real property holding corporation." 3.14 Employee Benefit Plans. (a) Schedule 3.14(a) lists, with respect to PMR, any PMR Subsidiary and any trade or business (whether or not incorporated) which is treated as a single employer with PMR (a "PMR ERISA AFFILIATE") within the meaning of Section 414(b), (c), (m) or (o) of the Code, (i) all material A-30 employee benefit plans (as defined in Section 3(3) of the ERISA, (ii) each loan to a non-officer employee in excess of $10,000, each loan to any officer or director and any stock option, stock purchase, phantom stock, stock right, supplemental retirement, severance, sabbatical, medical, dental, vision care, disability, employee relocation, cafeteria benefit (Code Section 125) or dependent care (Code Section 129), life insurance or accident insurance plans, programs or arrangements, (iii) all bonus, pension, profit sharing, savings, deferred compensation or incentive plans, programs or arrangements, (iv) other fringe or employee benefit plans, programs or arrangements that apply to senior management of PMR and that do not generally apply to all employees, and (v) any current or former employment or executive compensation or severance agreements, written or otherwise, as to which unsatisfied obligations of PMR of greater than $10,000 remain for the benefit of, or relating to, any present or former employee, consultant or director of PMR (together, the "PMR EMPLOYEE PLANS"). (b) PMR has made available to PSI a copy of each of the PMR Employee Plans and related plan documents (including trust documents, insurance policies or contracts, employee booklets, summary plan descriptions and other authorizing documents, and any material employee communications relating thereto) and has, with respect to each PMR Employee Plan which is subject to ERISA reporting requirements, provided copies of the Form 5500 reports filed for the last three plan years. Any PMR Employee Plan intended to be qualified under Section 401(a) of the Code has either obtained from the Internal Revenue Service a favorable determination letter as to its qualified status under the Code, including all amendments to the Code effected by the Tax Reform Act of 1986 and subsequent legislation, or has applied (or has time remaining in which to apply) to the Internal Revenue Service for such a determination letter prior to the expiration of the requisite period under applicable Treasury Regulations or Internal Revenue Service pronouncements in which to apply for such determination letter and to make any amendments necessary to obtain a favorable determination or has been established under a standardized prototype plan for which an Internal Revenue Service opinion letter has been obtained by the plan sponsor and is valid as to the adopting employer. PMR has also furnished PSI with the most recent Internal Revenue Service determination or opinion letter issued with respect to each such PMR Employee Plan, and nothing has occurred since the issuance of each such letter which could reasonably be expected to cause the loss of the tax-qualified status of any PMR Employee Plan subject to Code Section 401(a). PMR has also furnished PSI with all registration statements and prospectuses prepared in connection with each PMR Employee Plan. (c) Except as set forth on Schedule 3.14(c), (i) None of the PMR Employee Plans promises or provides retiree medical or other retiree welfare benefits to any person other than as required under COBRA; (ii) there has been no "prohibited transaction," as such term is defined in Section 406 of ERISA and Section 4975 of the Code, with respect to any PMR Employee Plan, which could reasonably be expected to have, in the aggregate, a PMR Material Adverse Effect; (iii) each PMR Employee Plan has been administered in accordance with its terms and in compliance with the requirements prescribed by any and all statutes, rules and regulations (including ERISA and the Code), except as would not have, in the aggregate, a PMR Material Adverse Effect, and PMR and each PMR Subsidiary or PMR ERISA Affiliate have performed all obligations required to be performed by them under, are not in any material respect in default under or violation of, and have no knowledge of any material default or violation by any other party to, any of the PMR Employee Plans; (iv) neither PMR nor any PMR Subsidiary or PMR ERISA Affiliate is subject to any liability or penalty under Sections 4976 through 4980 of the Code or Title I of ERISA with respect to any of the PMR Employee Plans; (v) all material contributions required to be made by PMR or any PMR Subsidiary or PMR ERISA Affiliate to any PMR Employee Plan have been made on or before their due dates and a reasonable amount has been accrued for contributions to each PMR Employee Plan for the current plan years; (vi) with respect to each PMR Employee Plan, no "reportable event" within the meaning of Section 4043 of ERISA (excluding any such event for which the thirty (30) day notice requirement has been waived under the regulations to Section 4043 of ERISA) nor any event described in Section 4062, 4063 or 4041 of ERISA has occurred; (vii) no PMR Employee Plan is covered by, and neither PMR nor any PMR Subsidiary or PMR ERISA Affiliate has incurred A-31 or expects to incur any liability under Title IV of ERISA or Section 412 of the Code; and (viii) each PMR Employee Plan can be amended, terminated or otherwise discontinued after the Effective Time in accordance with its terms, without liability to PMR (other than ordinary administrative expenses typically incurred in a termination event). With respect to each PMR Employee Plan subject to ERISA as either an employee pension plan within the meaning of Section 3(2) of ERISA or an employee welfare benefit plan within the meaning of Section 3(1) of ERISA, PMR has prepared in good faith and timely filed all requisite governmental reports (which were true and correct as of the date filed) and has properly and timely filed and distributed or posted all notices and reports to employees required to be filed, distributed or posted with respect to each such PMR Employee Plan. No suit, administrative proceeding, action or other litigation has been brought, or to the knowledge of PMR is threatened, against or with respect to any such PMR Employee Plan, including any audit or inquiry by the Internal Revenue Service or United States Department of Labor. Except as set forth on Schedule 3.14(c), no payment or benefit which will or may be made by PMR to any employee of PMR or any PMR Subsidiary will be characterized as an "excess parachute payment" within the meaning of Section 280G(b)(1) of the Code. (d) With respect to each PMR Employee Plan, PMR and each of its United States PMR Subsidiaries have complied with (i) the applicable health care continuation and notice provisions of COBRA and the regulations (including proposed regulations) thereunder except to the extent that such failure to comply would not, in the aggregate, have a PMR Material Adverse Effect, (ii) the applicable requirements of the Family Medical and Leave Act of 1993 and the regulations thereunder, except to the extent that such failure to comply would not, in the aggregate, have a PMR Material Adverse Effect and (iii) the applicable requirements of the Health Insurance Portability and Accountability Act of 1996 and the regulations (including proposed regulations) thereunder, except to the extent that such failure to comply would not, in the aggregate, have a PMR Material Adverse Effect. (e) Except as set forth on Schedule 3.14(e), there has been no amendment to, written interpretation or announcement (whether or not written) by PMR, any PMR Subsidiary or other PMR ERISA Affiliate relating to, or change in participation or coverage under, any PMR Employee Plan which would materially increase the expense of maintaining such PMR Employee Plan above the level of expense incurred with respect to that PMR Employee Plan for the most recent fiscal year included in PMR's financial statements. (f) PMR does not currently maintain, sponsor, participate in or contribute to, nor has it ever maintained, established, sponsored, participated in, or contributed to, any pension plan (within the meaning of Section 3(2) of ERISA) which is subject to Part 3 of Subtitle B of Title I of ERISA, Title IV of ERISA or Section 412 of the Code. (g) Neither PMR nor any PMR Subsidiary or other PMR ERISA Affiliate is a party to, or has made any contribution to or otherwise incurred any obligation under, any "multiemployer plan" as defined in Section 3(37) of ERISA. (h) Each compensation and benefit plan required to be maintained or contributed to by the law or applicable custom or rule of the relevant jurisdiction outside of the United States (the "PMR BENEFIT PLANS") is listed in Schedule 3.14(h) of the Disclosure Schedule. As regards each such PMR Benefit Plan, unless disclosed in Schedule 3.14(h) of the PMR Disclosure Schedule (i) each of the PMR Benefit Plans is in material compliance with the provisions of the laws of each jurisdiction in which each such PMR Benefit Plan is maintained, to the extent those laws are applicable to the PMR Benefit Plans; (ii) all material contributions to, and material payments from, the PMR Benefit Plans which may have been required to be made in accordance with the terms of any such PMR Benefit Plan, and, when applicable, the law of the jurisdiction in which such PMR Benefit Plan is maintained, have been timely made or shall be made by the Closing Date, and all such contributions to the PMR Benefit Plans, and all payments under the PMR Benefit Plans, for any period ending before the Closing Date that are not yet, but will be, required to be made, are reflected as an accrued liability on A-32 the PMR Balance Sheet, or disclosed to PSI within fifteen (15) days following the date hereof in Schedule 3.14(h) of the PMR Disclosure Schedule; (iii) PMR and the PMR Subsidiaries and PMR ERISA Affiliates have materially complied with all applicable reporting and notice requirements, and all of the PMR Benefit Plans have obtained from the governmental body having jurisdiction with respect to such plans any required determinations, if any, that such PMR Benefit Plans are in compliance with the laws of the relevant jurisdiction if such determinations are required in order to give effect to the PMR Benefit Plan; (iv) each of the PMR Benefit Plans has been administered in all material respects at all times in accordance with its terms and applicable law and regulations; (v) to the knowledge of PMR, there are no pending investigations by any governmental body involving the PMR Benefit Plans, and no pending claims (except for claims for benefits payable in the normal operation of the PMR Benefit Plans), suits or proceedings against any PMR Benefit Plan or asserting any rights or claims to benefits under any PMR Benefit Plan; and (vi) the consummation of the transactions contemplated by this Agreement will not by itself create or otherwise result in any liability with respect to any PMR Benefit Plan other than the triggering of payment to participants. 3.15 Certain Agreements Affected by the Merger. Except as set forth in Schedule 3.15, neither the execution and delivery of this Agreement nor the consummation of the transactions contemplated hereby will (i) result in any payment (including, without limitation, severance, unemployment compensation, golden parachute, bonus or otherwise) becoming due to any director, employee or consultant of PMR or any of the PMR Subsidiaries, (ii) materially increase any benefits otherwise payable by PMR or (iii) result in the acceleration of the time of payment or vesting of any such benefits except as required under Code Section 411(d)(3). 3.16 Employee Matters. PMR and each of the PMR Subsidiaries are in compliance in all material respects with all currently applicable laws and regulations respecting employment, discrimination in employment, terms and conditions of employment, wages, hours and occupational safety and health and employment practices, and is not engaged in any unfair labor practice. PMR has withheld all amounts required by law or by agreement to be withheld from the wages, salaries, and other payments to employees; and is not liable for any arrears of wages or any taxes or any penalty for failure to comply with any of the foregoing. PMR is not liable for any payment to any trust or other fund or to any governmental or administrative authority, with respect to unemployment compensation benefits, social security or other benefits or obligations for employees (other than routine payments to be made in the normal course of business and consistent with past practice). Except as set forth on Schedule 3.16, there are no pending claims against PMR or any of the PMR Subsidiaries under any workers compensation plan or policy or for long term disability. There are no controversies pending or, to the knowledge of PMR or any of the PMR Subsidiaries, threatened, between PMR or any of the PMR Subsidiaries and any of their respective employees, which controversies have or could reasonably be expected to result in an action, suit, proceeding, claim, arbitration or investigation before any agency, court or tribunal, foreign or domestic. Neither PMR nor any of the PMR Subsidiaries is a party to any collective bargaining agreement or other labor union contract nor does PMR nor any of the PMR Subsidiaries know of any activities or proceedings of any labor union or to organize any such employees. To PMR's knowledge, no employees of PMR or any of the PMR Subsidiaries are in violation of any term of any employment contract, patent disclosure agreement, enforceable noncompetition agreement, or any enforceable restrictive covenant to a former employer relating to the right of any such employee to be employed by PMR or any of the PMR Subsidiaries because of the nature of the business conducted or presently proposed to be conducted by PMR or to the use of trade secrets or proprietary information of others. No employees of PMR or any of the PMR Subsidiaries have given notice to PMR or any of the PMR Subsidiaries, nor is PMR otherwise aware, that any such employee intends to terminate his or her employment with PMR or any of the PMR Subsidiaries. Except as set forth in Schedule 3.16, the employment of each of the employees of PMR and each of the PMR Subsidiaries is "at will" and PMR and each of the PMR Subsidiaries does not have any obligation to provide any particular form or period of notice prior to terminating the employment of any of their employees. A-33 3.17 Conflicts of Interest; Related Party Transactions. (a) None of PMR, the PMR Subsidiaries or any officer, employee, agent or other Person acting on behalf of PMR or the PMR Subsidiaries has, directly or indirectly, given or agreed to give any money, gift or similar benefit (other than legal price concessions to customers in the ordinary course of business) to any physician, psychologist, counselor, or other direct or indirect referral source, or any family member or agent of the foregoing, or official or employee of any Governmental Entity or other Person who was or is in a position to help or hinder the business of PMR or the PMR Subsidiaries (or assist in connection with any actual or proposed transaction) that (i) might subject PMR or the PMR Subsidiaries to any material damage or material penalty in any Proceeding before any agency, court or tribunal, foreign or domestic, (ii) if not given in the past, could have resulted in a PMR Material Adverse Effect, (iii) if not continued in the future, could result in a PMR Material Adverse Effect, or (iv) is in material violation of any Laws, including the federal illegal remuneration statute, 42 U.S.C. sec. 1320a-76. (b) Except as set forth in Schedule 3.17(b), and except for compensation to regular employees of PMR or the PMR Subsidiaries, no current or former Affiliate of PMR, or the PMR Subsidiaries or any associate of such Person (as defined in Rule 12b-2 promulgated under the Exchange Act thereof, is now, or has been during the last five fiscal years, (i) a party to any transaction or agreement with PMR or any of the PMR Subsidiaries, or (ii) the direct or indirect owner of an interest in any Person which is a present or potential competitor, supplier or customer of PMR or the PMR Subsidiaries (other than non-affiliated holdings in publicly-held companies), nor does any such Person receive income from any source other than PMR or the PMR Subsidiaries which should properly accrue to PMR or the PMR Subsidiaries. Except as set forth in Schedule 3.17(b), neither PMR nor the PMR Subsidiaries are a guarantor or otherwise liable for any actual or potential Liability or obligation, whether direct or indirect, of any of its Affiliates. Except as set forth in Schedule 3.17(b), there are no intercompany loans or open account balances between PMR and the PMR Subsidiaries. 3.18 Insurance. PMR and each of the PMR Subsidiaries have policies of insurance and bonds of the type and in amounts customarily carried by persons conducting businesses or owning assets similar to those of PMR and the PMR Subsidiaries. There is no material claim pending under any of such policies or bonds as to which coverage has been questioned, denied or disputed by the underwriters of such policies or bonds. All premiums due and payable under all such policies and bonds have been paid and PMR and the PMR Subsidiaries are otherwise in compliance with the terms of such policies and bonds. PMR has no knowledge of any threatened termination of, or material premium increase with respect to, any of such policies. 3.19 Compliance With Laws. Each of PMR and the PMR Subsidiaries has complied with, are not in violation of, and have not received any notices of violation with respect to, any federal, state, local or foreign statute, law or regulation with respect to the conduct of its business, or the ownership or operation of its business, except for such violations or failures to comply as could not be reasonably expected to have a PMR Material Adverse Effect. 3.20 Accounts Receivable. Subject to any reserves set forth in the PMR Financial Statements, the accounts receivable reflected as current assets on the PMR Financial Statements represent bona fide claims against debtors for services rendered, sales and other charges, and are not subject to discount except for normal cash and immaterial trade discounts. The amount carried for doubtful accounts and allowances disclosed in the PMR Financial Statements was calculated in accordance with generally accepted accounting principles and in a manner consistent with prior periods. 3.21 Customers and Suppliers. No third party payor or customer which individually accounted for more than 1% of PMR's gross revenues during the 12-month period preceding the date hereof, and no hospital, health care provider or supplier of PMR, has canceled or otherwise terminated, or made any written threat to PMR to cancel or otherwise terminate its relationship with PMR, or has decreased materially its services or supplies to PMR in the case of any such hospital, health care provider or supplier, or its usage of the services or products of PMR in the case of such third party payor or customer, A-34 and to PMR's knowledge, no such hospital, health care provider, supplier, third party payor or customer intends to cancel or otherwise terminate its relationship with PMR or to decrease materially its services or supplies to PMR or its usage of the services or products of PMR, as the case may be. PMR has not knowingly breached, so as to provide a benefit to PMR that was not intended by the parties, any agreement with, or engaged in any fraudulent conduct with respect to, any third party payor, customer, hospital, health care provider or supplier of PMR. 3.22 Material Contracts. Except for the contracts and agreements described in Schedule 3.22 (collectively, the "PMR MATERIAL CONTRACTS"), neither PMR nor any PMR Subsidiary is a party to or bound by any material contract, including without limitation: (a) any distributor, sales, advertising, agency or manufacturer's representative contract; (b) any continuing contract for the purchase of materials, supplies, equipment or services involving in the case of any such contract more than $50,000 annually; (c) any trust indenture, mortgage, promissory note, loan agreement or other contract for the borrowing of money, any currency exchange, commodities or other hedging arrangement or any leasing transaction of the type required to be capitalized in accordance with generally accepted accounting principles; (d) any contract for capital expenditures in excess of $50,000 in the aggregate; (e) any contract limiting the freedom of PMR to engage in any line of business or to compete with any other Person as that term is defined in the Exchange Act or any confidentiality, secrecy or non-disclosure contract; (f) any contract with any person with whom PMR does not deal at arm's length; (g) any agreement of guarantee, support, indemnification, assumption or endorsement of, or any similar commitment with respect to, the obligations, liabilities (whether accrued, absolute, contingent or otherwise) or indebtedness of any other Person; provided, however, that PMR Material Contracts comprised of Management Services Contracts for which the program under PMR management no longer provides clinical services to patients and contracts related to Infoscriber are not required to be disclosed on Schedule 3.22 (provided, however, that PMR will disclose the Infoscriber License Agreement with Conundrum Communication, Inc. on such schedule); or (h) any contracts or commitments providing for payments based in any manner on the revenues or profits of the business of PMR or the PMR Subsidiaries. 3.23 No Breach of Material Contracts. All PMR Material Contracts are in written form. PMR has performed all of the obligations required to be performed by it and is entitled to all benefits under, and is not alleged to be in default in respect of any PMR Material Contract. Each of the PMR Material Contracts is in full force and effect, unamended, and there exists no default or event of default or event, occurrence, condition or act, with respect to PMR or to PMR's knowledge with respect to the other contracting party, which, with the giving of notice, the lapse of time or the happening of any other event or conditions, would become a default or event of default under any PMR Material Contract. True, correct and complete copies of all PMR Material Contracts have been made available to PMR. 3.24 Third Party Consents. Except as set forth in Schedule 3.24, the execution and delivery of this Agreement and the consummation of the transactions contemplated hereby will not require the consent, approval, order or authorization of any third party under the PMR Material Contracts. 3.25 Certain Additional Regulatory Matters. (a) Except where such activities have not had and will not have a PMR Material Adverse Effect, neither PMR, the PMR Subsidiaries, nor any officer, director or managing employee of such Person (within the meaning of 42 U.S.C. (sec. 1320a-5(b)) has engaged in any activities which constitute violations of, or are cause for imposition of civil penalties upon PMR or the PMR A-35 Subsidiaries or mandatory or permissive exclusion of such Persons from Medicare or Medicaid, under sec.sec. 1320a-7, 1320a-7a, 1320a-7b, or 1395nn of Title 42 of the United States Code, TRICARE, any other state or federal health care program, or the regulations promulgated pursuant to such statutes or regulations or related state or local statutes or which constitute violations of or deficiencies under the standards of any private accrediting organization from which PMR or any of the PMR Subsidiaries is accredited or seeks accreditation, including the following activities: (i) making or causing to be made a false statement or representation of a material fact in any application for any benefit or payment; (ii) making or causing to be made any false statement or representation of a material fact for use in determining rights to any benefit or payment; (iii) presenting or causing to be presented a claim for reimbursement under TRICARE, Medicare, Medicaid or any other State Health Care Program or Federal Health Care Program that is (A) for an item or service that the person presenting or causing to be presented knows or should know was not provided as claimed, or (B) for an item or service where the person presenting knows or should know that the claim is false or fraudulent; (iv) offering, paying, soliciting or receiving any remuneration (including any kickback, bribe or rebate), directly or indirectly, overtly or covertly, in cash or in kind (A) in return for referring, or to induce the referral of, an individual to a person for the furnishing or arranging for the furnishing of any item or service for which payment may be made in whole or in part by TRICARE, Medicare or Medicaid, or any other State Health Care Program or any Federal Health Care Program, or (B) in return for, or to induce, the purchase, lease, or order, or the arranging for or recommending of the purchase, lease, or order, of any good, facility, service, or item for which payment may be made in whole or in part by TRICARE, Medicare or Medicaid or any other State Health Care Program or any Federal Health Care Program; (v) making or causing to be made or inducing or seeking to induce the making of any false statement or representation (or omitting to state a material fact required to be stated therein or necessary to make the statements contained therein not misleading) of a material fact with respect to (A) the conditions or operations of a facility in order that the facility may qualify for TRICARE, Medicare, Medicaid or any other State Health Care Program certification or any Federal Health Care Program certification, or (B) information required to be provided under sec. 1124(A) of the SSA (42 U.S.C. sec. 1320a-3); or (vi) failing substantially to provide medically necessary items or services, if the failure adversely affects individuals covered by Medicare or Medicaid. 3.26 Medicare/Medicaid Participation. Neither PMR, the PMR Subsidiaries, any officer, director, or managing employee (as defined in SSA sec. 1126(b) or any regulations promulgated thereunder): (x) have had a civil monetary penalty assessed against him, her or it under sec. 1128A of the SSA or any regulations promulgated thereunder; (y) have been excluded from participation under the Medicare program or a State Health Care Program or Federal Health Care Program; or (z) have been convicted (as that term is defined in 42 C.F.R. sec. 1001.2) of any of the following categories of offenses as described in SSA sec.sec. 1128(a) and (b)(1), (2), (3) or any regulations promulgated thereunder: (i) criminal offenses relating to the delivery of an item or service under Medicare or any State Health Care Program or any Federal Health Care Program; (ii) criminal offenses under federal or state law relating to patient neglect or abuse in connection with the delivery of a health care item or service; (iii) criminal offenses under federal or state law relating to fraud, theft, embezzlement, breach of fiduciary responsibility, or other financial misconduct in connection with the delivery of a health care item or service or with respect to any act or omission in a program operated by or financed in whole or in part by any federal, state or local governmental agency; A-36 (iv) federal or state laws relating to the interference with or obstruction of any investigation into any criminal offense; or (v) criminal offenses under federal or state law relating to the unlawful manufacture, distribution, prescription or dispensing of a controlled substance. 3.27 Minute Books. The minute books of PMR and the PMR Subsidiaries made available to PMR contain a complete and accurate summary of all meetings of directors and stockholders or actions by written consent since the time of incorporation of PMR and the respective PMR Subsidiaries through the date of this Agreement, and reflect all transactions referred to in such minutes accurately in all material respects. 3.28 Complete Copies of Materials. PMR has delivered or made available true and complete copies of each document which has been requested by PMR or its counsel in connection with their legal and accounting review of PMR and the PMR Subsidiaries. 3.29 Brokers' and Finders' Fees. Except as set forth in Schedule 3.29, PMR has not incurred, nor will it incur, directly or indirectly, any liability for brokerage or finders' fees or agents' commissions or investment bankers' fees or any similar charges in connection with this Agreement or any transaction contemplated hereby. 3.30 Vote Required. The affirmative vote of the holders of at least a majority of the PMR Common Stock outstanding on the record date set for the PMR Meeting is the only vote of the holders of any of PMR's Common Stock necessary to approve (i) an amendment to PMR's Certificate of Incorporation to increase in the number of shares of PMR Common Stock authorized to be issued by PMR, (ii) an amendment to PMR's Certificate of Incorporation to effectuate the Reverse Stock Split, and (iii) the issuance of PMR Common Stock pursuant to the Merger, and no other vote of the holders of PMR Common Stock is necessary to approve either this Agreement or the transactions contemplated hereby. 3.31 PMR Board Approval; Merger Sub Approval. The Board of Directors of PMR has (i) approved this Agreement and the Merger, (ii) determined that the Merger is in the best interests of the stockholders of PMR and (iii) recommended that the stockholders of PMR approve this Agreement and the Merger. The Board of Directors of Merger Sub has determined that the Merger is in the best interests of Merger Sub and its sole stockholder and has approved and adopted this Agreement, the Merger and the other transactions contemplated by this Agreement, and PMR, as the sole stockholder of Merger Sub, has approved and adopted this Agreement, the Merger and the other transactions contemplated by this Agreement. 3.32 State Takeover Statutes. The Boards of Directors of PMR and Merger Sub have approved this Agreement, the agreements entered into or proposed to be entered into as contemplated by this Agreement and the transactions contemplated hereby and thereby (including the Merger), and such approvals are sufficient to render inapplicable to such agreements and transactions the provisions of any "fair price," "moratorium," "control share," "interested shareholders," "affiliated transaction" or other anti-takeover statute or regulation and any applicable anti-takeover or other restrictive provisions of the Certificate of Incorporation, Bylaws or other governing documents of each of PMR and Merger Sub. 3.33 Representations Complete. None of the representations or warranties made by PMR herein or in any Schedule hereto, including the PMR Disclosure Schedule, or certificate furnished by PMR pursuant to this Agreement, when all such documents are read together in their entirety, contains or will contain at the Effective Time any untrue statement of a material fact, or omits or will omit at the Effective Time to state any material fact necessary in order to make the statements contained herein or therein, in the light of the circumstances under which made, not misleading. A-37 ARTICLE IV CONDUCT PRIOR TO THE EFFECTIVE TIME 4.1 Conduct of Business of PSI. (a) During the period from the date of this Agreement and continuing until the earlier of the termination of this Agreement or the Effective Time, PSI agrees (except to the extent expressly contemplated by this Agreement or as consented to in writing by PMR, which consent will not unreasonably be withheld or delayed): (i) to carry on its and the PSI Subsidiaries' business in the usual, regular and ordinary course in substantially the same manner as heretofore conducted; (ii) to pay and to cause the PSI Subsidiaries to pay debts and Taxes when due subject to good faith disputes over such debts or Taxes; (iii) to pay or perform other obligations when due; (iv) to use all reasonable efforts, in good faith, consistent with past practice and policies to preserve intact its and the PSI Subsidiaries' present business organizations, keep available the services of its and the PSI Subsidiaries' present officers and key employees and preserve its and the PSI Subsidiaries' relationships with customers, suppliers, distributors, licensors, licensees, and others having business dealings with it or the PSI Subsidiaries, to the end that its and the PSI Subsidiaries' goodwill and ongoing businesses shall be unimpaired at the Effective Time; and (v) to give all notices and other information required to be given to the employees of PSI and any applicable government authority under the WARN Act, the National Labor Relations Act, the Code, the Consolidated Omnibus Budget Reconciliation Act, and other applicable law in connection with the transactions provided for in this Agreement. (b) PSI agrees to promptly notify PMR of any event or occurrence not in the ordinary course of its or the PSI Subsidiaries' business, and of any event which could reasonably be likely to have a PSI Material Adverse Effect. 4.2 Restriction on Conduct of Business of PSI. During the period from the date of this Agreement and continuing until the earlier of the termination of this Agreement or the Effective Time, except as set forth in the PSI Disclosure Schedule and as expressly contemplated by this Agreement, PSI shall not do, cause or permit any of the following, or allow, cause or permit any of the PSI Subsidiaries to do, cause or permit any of the following, without the prior written consent of PMR, which consent will not be unreasonably withheld or delayed: (a) Charter Documents. Cause or permit any amendments to its Certificate of Incorporation or Bylaws; (b) Dividends; Changes in Capital Stock. Declare or pay any dividends on or make any other distributions (whether in cash, stock or property) in respect of any of its capital stock, or split, combine or reclassify any of its capital stock or issue or authorize the issuance of any other securities in respect of, in lieu of or in substitution for shares of its capital stock, or repurchase or otherwise acquire, directly or indirectly, any shares of its capital stock except from former employees, directors and consultants in accordance with written agreements providing for the repurchase of shares in connection with any termination of service to it or the PSI Subsidiaries; (c) Stock Option Plans, Etc. Accelerate, amend or change the period of exercisability or vesting of options or other rights granted under its stock plans or authorize cash payments in exchange for any options or for other rights granted under any of such plans; (d) Material Contracts. Enter into any material contract or commitment, or violate, amend or otherwise modify or waive any of the terms of any PSI Material Contract; provided specifically that PSI shall not enter into any agreement or commitment for the purchase of products or supplies or the A-38 provision of services to PSI in an amount in excess of $50,000 in any one case or $100,000 in the aggregate, other than in connection with the acquisitions permitted by Section 4.2(e) and the transactions described in Schedule 4.2(j); (e) Acquisitions. Acquire or agree to acquire by merging or consolidating with, or by purchasing a substantial portion of the assets of, or by any other manner, any business or any corporation, partnership, association or other business organization or division thereof, or otherwise acquire or agree to acquire any assets which are material, individually or in the aggregate, to its and the PSI Subsidiaries' business taken as a whole, other than acquisitions or purchases having a purchase price equal or less than five (5) times the acquiree's trailing twelve (12) months' earnings before interest, taxes, depreciation and amortization (EBITDA), as adjusted for nonrecurring items. PSI shall notify PMR of any such permitted transactions within two (2) business days of any signed letters of intent. (f) Issuance of Securities. Issue, deliver or sell or authorize or propose the issuance, delivery or sale of, or purchase or propose the purchase of, any shares of its capital stock or securities convertible into, or subscriptions, rights, warrants or options to acquire, or other agreements or commitments of any character obligating it to issue any such shares or other convertible securities, other than the issuance of shares of its Common Stock pursuant to the exercise of stock options, warrants or other rights therefor outstanding as of the date of this Agreement; (g) Intellectual Property. Transfer to any person or entity any rights to its Intellectual Property other than in the ordinary course of business consistent with past practice; (h) Exclusive Rights. Enter into or amend any agreements pursuant to which any other party is granted exclusive marketing or other exclusive rights of any type or scope with respect to any of its products or technology; (i) Dispositions. Sell, lease, license or otherwise dispose of or encumber any of its properties or assets which are material, individually or in the aggregate, to its and its Subsidiaries' businesses, taken as a whole except for sales of products in the ordinary course; (j) Indebtedness. Incur any indebtedness for borrowed money in excess of $50,000 or guarantee any such indebtedness or issue or sell any debt securities or guarantee any debt securities of others other than indebtedness described in Schedule 4.2(j) provided that the indebtedness is incurred on substantially the same terms; (k) Leases. Enter into any operating lease in excess of $50,000; (l) Payment of Obligations. Pay, discharge or satisfy in an amount in excess of $50,000 in any one case or $100,000 in the aggregate, any claim, liability or obligation (absolute, accrued, asserted or unasserted, contingent or otherwise) arising other than in the ordinary course of business other than the payment, discharge or satisfaction of liabilities reflected or reserved against in the PSI Financial Statements; (m) Capital Expenditures. Make any capital expenditures, capital additions or capital improvements except in the ordinary course of business and consistent with past practice; (n) Insurance. Materially reduce the amount of any insurance coverage provided by existing insurance policies; (o) Termination or Waiver. Terminate or waive any right of substantial value; (p) Employee Benefit Plans; New Hires; Pay Increases. Adopt or amend any employee benefit or stock purchase or option plan, except as required under ERISA or except as necessary to maintain the qualified status of such plan under the Code; hire any new director level or officer level employee; pay any special bonus or special remuneration to any employee or director, except payments made pursuant to written agreements outstanding on the date hereof; or increase the salaries or wage rates A-39 of its employees (other than normal increases based on continued service consistent with historical practices); (q) Severance Arrangements. Grant any severance or termination pay (i) to any director or officer or (ii) to any other employee except payments made pursuant to written agreements outstanding on the date hereof; (r) Lawsuits. Commence a lawsuit other than (i) for the routine collection of bills, (ii) in such cases where it in good faith determines that failure to commence suit would result in the material impairment of a valuable aspect of its business, provided that it consults with PMR prior to the filing of such a suit, or (iii) for a breach of this Agreement; (s) Taxes. Make or change any material election in respect of Taxes, adopt or change any accounting method in respect of Taxes, file any material Tax Return or any amendment to a material Tax Return, enter into any closing agreement, settle any claim or assessment in respect of Taxes, or consent to any extension or waiver of the limitation period applicable to any claim or assessment in respect of Taxes; (t) Revaluation. Revalue any of its assets, including without limitation writing down the value of inventory or writing off notes or accounts receivable other than in the ordinary course of business; or (u) Other. Take or agree in writing or otherwise to take, any of the actions described in Sections 4.4(a) through 4.4(s) above, or any action which would make any of its representations or warranties contained in this Agreement untrue or incorrect or prevent it from performing or cause it not to perform its covenants hereunder. 4.3 Conduct of Business of PMR. (a) During the period from the date of this Agreement and continuing until the earlier of the termination of this Agreement or the Effective Time, PMR agrees (except to the extent expressly contemplated by this Agreement or as consented to in writing by PSI, which consent will not unreasonably be withheld or delayed): (i) to carry on its and the PMR Subsidiaries' business in the usual, regular and ordinary course in substantially the same manner as heretofore conducted; (ii) to pay and to cause the PMR Subsidiaries to pay debts and Taxes when due subject (A) to good faith disputes over such debts or Taxes and (B) to PSI's consent to the filing of material Tax Returns (which consent shall not be unreasonably withheld or delayed); (iii) to pay or perform other obligations when due; (iv) to use all reasonable efforts, in good faith, consistent with past practice and policies to preserve intact its and the PMR Subsidiaries' present business organizations, keep available the services of its and the PMR Subsidiaries' present officers and key employees and preserve its and the PMR Subsidiaries' relationships with customers, suppliers, distributors, licensors, licensees, and others having business dealings with it or the PMR Subsidiaries, to the end that its and the PMR Subsidiaries' goodwill and ongoing businesses shall be unimpaired at the Effective Time; (v) to give all notices and other information required to be given to the employees of PMR and any applicable government authority under the WARN Act, the National Labor Relations Act, the Code, the Consolidated Omnibus Budget Reconciliation Act, and other applicable law in connection with the transactions provided for in this Agreement; and (vi) to continue to pay and to cause the PMR Subsidiaries to pay current liabilities in the ordinary course of business and consistent with past practices such that the consolidated current liabilities of PMR and the PMR Subsidiaries at the Effective Time shall not exceed the total Current Liabilities reflected on the Latest PMR Balance Sheet by more than one percent (1%). A-40 (b) PMR agrees to promptly notify PSI of any event or occurrence not in the ordinary course of its or the PMR Subsidiaries' business, and of any event which could have a PMR Material Adverse Effect. 4.4 Restriction on Conduct of Business of PMR. During the period from the date of this Agreement and continuing until the earlier of the termination of this Agreement or the Effective Time, except as set forth in the PMR Disclosure Schedule and as expressly contemplated by this Agreement, PMR shall not do, cause or permit any of the following, or allow, cause or permit any of the PMR Subsidiaries to do, cause or permit any of the following, without the prior written consent of PSI, which consent will not unreasonably be withheld or delayed: (a) Charter Documents. Cause or permit any amendments to its Certificate of Incorporation or Bylaws, except as necessary to (i) increase the authorized number of shares of PMR Common Stock to facilitate the issuance of PMR Common Stock pursuant to the Merger, or (ii) effectuate the Reverse Stock Split; (b) Dividends; Changes in Capital Stock. Declare or pay any dividends on or make any other distributions (whether in cash, stock or property) in respect of any of its capital stock, or split, combine or reclassify any of its capital stock or issue or authorize the issuance of any other securities in respect of, in lieu of or in substitution for shares of its capital stock, or repurchase or otherwise acquire, directly or indirectly, any shares of its capital stock except from former employees, directors and consultants in accordance with written agreements providing for the repurchase of shares in connection with any termination of service to it or the PMR Subsidiaries; provided, however, that notwithstanding the foregoing, (i) PMR shall be entitled to declare and pay cash dividends in respect of PMR Common Stock, on one or more occasions, if with respect to any such dividend, after giving pro forma effect to the declaration and payment of any such dividend the aggregate amount of Cash Equivalents (as defined in Section 8.3) of PMR at Closing would not be less than $5.05 million, and (ii) PMR shall be entitled to declare and make a distribution in respect of PMR Common Stock of contingent value rights having the term specified in the form of Contingent Value Rights Agreement attached to this Agreement as Exhibit D (the "CONTINGENT VALUE RIGHTS"); (c) Stock Option Plans, Etc. Except as set forth in Schedule 4.4(c), accelerate, amend or change the period of exercisability or vesting of options or other rights granted under its stock plans or authorize cash payments in exchange for any options or other rights granted under any of such plans; (d) Material Contracts. Except as set forth on Schedule 4.4(d), enter into any material contract or commitment, or violate, amend or otherwise modify or waive any of the terms of any of its material contracts; provided however, that PMR shall not enter into any agreement or commitment for the purchase of products or supplies or the provision of services in an amount in excess of $50,000 in any one case or $100,000 in the aggregate; (e) Issuance of Securities. Except as set forth in Schedule 4.4(e), issue, deliver or sell or authorize or propose the issuance, delivery or sale of, or purchase or propose the purchase of, any shares of its capital stock or securities convertible into, or subscriptions, rights, warrants or options to acquire, or other agreements or commitments of any character obligating it to issue any such shares or other convertible securities, other than the issuance of shares of its Common Stock pursuant to the exercise of stock options, warrants or other rights therefor outstanding as of the date of this Agreement; (f) Intellectual Property. Except as set forth in Schedule 4.4(f), transfer to any person or entity any rights to its Intellectual Property other than in the ordinary course of business consistent with past practice; (g) Exclusive Rights. Enter into or amend any agreements pursuant to which any other party is granted exclusive marketing or other exclusive rights of any type or scope with respect to any of its products or technology; A-41 (h) Dispositions. Sell, lease, license or otherwise dispose of or encumber any of its properties or assets which are material, individually or in the aggregate, to PMR's and the PMR Subsidiaries' businesses, taken as a whole except for sales of assets relating to PMR's management and administration functions at PMR's corporate headquarters; (i) Indebtedness. Incur any indebtedness for borrowed money in excess of $20,000 or guarantee any such indebtedness or issue or sell any debt securities or guarantee any debt securities of others; (j) Leases. Enter into any operating lease in excess of $20,000; (k) Capital Expenditures. Make any capital expenditures, capital additions or capital improvements having a cost in excess of $20,000; (l) Insurance. Materially reduce the amount of any insurance coverage provided by existing insurance policies; (m) Termination or Waiver. Except in connection with the settlement of the Legacy Receivables (as defined in the Contingent Value Rights Agreement), terminate or waive any right of substantial value; (n) Employee Benefit Plans; New Hires; Pay Increases. Except as set forth in Schedule 4.4(n), adopt or amend any employee benefit or stock purchase or option plan, except as required under ERISA or except as necessary to maintain the qualified status of such plan under the Code, or hire any new director level or officer level employee, or increase the salaries or wage rates of its employees, except for any salary or wage increase made pursuant to PMR's customary practice of annual review of salary and wage levels provided that any such salary or wage increases to not increase the aggregate employee compensation expense, on an annualized basis, by more than 5% from the aggregate employee compensation expense immediately prior to any such increase; (o) Severance Arrangements. Grant any severance or termination pay (i) to any director or officer or (ii) to any other employee except, in both instances, payments made before the Effective Time; (p) Lawsuits. Commence a lawsuit other than (i) for the routine collection of bills, (ii) in such cases where it in good faith determines that failure to commence suit would result in the material impairment of a valuable aspect of its business, provided that it consults with PSI prior to the filing of such a suit, or (iii) for a breach of this Agreement; (q) Acquisitions. Acquire or agree to acquire by merging or consolidating with, or by purchasing a substantial portion of the assets of, or by any other manner, any business or any corporation, partnership, association or other business organization or division thereof, or otherwise acquire or agree to acquire any assets which are material, individually or in the aggregate, to its and the PMR Subsidiaries' business, taken as a whole; (r) Taxes. Make or change any material election in respect of Taxes, adopt or change any accounting method in respect of Taxes, file any material Tax Return or any amendment to a material Tax Return, enter into any closing agreement, settle any claim or assessment in respect of Taxes (except for the settlement of any claim or assessment in an amount not to exceed the amount reserved for such claim or assessment in the Latest PMR Balance Sheet), or consent to any extension or waiver of the limitation period applicable to any claim or assessment in respect of Taxes; (s) Revaluation. Revalue any of its assets except for any revaluation relating to writing off notes or accounts receivable reserved for in the Latest PMR Balance Sheet; or (t) Other. Take or agree in writing or otherwise to take, any of the actions described in Sections 4.4(a) through 4.4(s) above, or any action which would make any of its representations or A-42 warranties contained in this Agreement untrue or incorrect or prevent it from performing or cause it not to perform its covenants hereunder. ARTICLE V ADDITIONAL AGREEMENTS 5.1 Rule 145 Affiliates. Schedule 5.1 sets forth those persons who may be deemed affiliates ("AFFILIATES") of PSI within the meaning of Rule 145 promulgated under the Securities Act ("RULE 145"). PSI shall provide PMR such information and documents as PMR shall reasonably request for purposes of reviewing such list. PSI shall use its best efforts to deliver or cause to be delivered to PMR on or prior to the Effective Time a duly executed affiliates letter in the form of Exhibit C attached hereto for each such "affiliate" of PSI. PMR shall be entitled to place appropriate legends on the certificates evidencing any PMR Common Stock to be received by such affiliates pursuant to the terms of this Agreement and to issue appropriate stock transfer instructions to the transfer agent for PMR Common Stock. 5.2 Registration Statement; Proxy Statement. (a) As promptly as practicable after the execution of this Agreement, (i) PMR and PSI shall prepare, and PMR shall file with the SEC, a joint proxy statement relating to the meeting of PSI's stockholders and PMR's stockholders to be held in connection with the Merger (together with any amendments thereof or supplements thereto, the "PROXY STATEMENT") and (ii) PMR shall prepare and file with the SEC a registration statement on Form S-4 (together with all amendments thereto, the "REGISTRATION STATEMENT") in which the Proxy Statement shall be included as a prospectus in connection with the registration under the Securities Act of the shares of PMR Common Stock to be issued to the stockholders of PSI pursuant to the Merger. Each of PMR and PSI will use all reasonable efforts to cause the Registration Statement to become effective as promptly as practicable, and, prior to the effective date of the Registration Statement, PMR shall take all or any action required under any applicable federal or state securities laws in connection with the issuance of shares of PMR Common Stock in the Merger. Each of PMR and PSI shall furnish all information concerning it and the holders of its capital stock as the other may reasonably request in connection with such actions and the preparation of the Registration Statement and Proxy Statement. As promptly as practicable after the Registration Statement shall have become effective, each of PMR and PSI shall mail the Proxy Statement to its respective stockholders and, if necessary, after the Proxy Statement shall have been so mailed, promptly circulate amended, supplemental or supplemented proxy materials and, if required in connection therewith, resolicit proxies. The Proxy Statement shall include the recommendation of the Board of Directors of each of PMR and PSI in favor of the Merger, except as otherwise provided in Section 5.5(b) or Section 5.7(b). No amendment or supplement to the Proxy Statement or the Registration Statement will be made by PMR or PSI without the approval of the other party (which approval shall not be unreasonably withheld or delayed). PMR and PSI each will advise the other, promptly after it receives notice thereof, of the time when the Registration Statement has become effective or any supplement or amendment has been filed, the issuance of any stop order, the suspension of the qualification of the PMR Common Stock issuable in connection with the Merger for offering or sale in any jurisdiction, or any request by the SEC for amendment of the Proxy Statement or the Registration Statement or comments thereon and responses thereto or requests by the SEC for additional information. (b) The information supplied by PMR for inclusion in the Registration Statement and the Proxy Statement shall not, at (i) the time the Registration Statement is declared effective, (ii) the time the Proxy Statement (or any amendment thereof or supplement thereto) is first mailed to the stockholders of PMR and PSI, (iii) the time of each of the Stockholders' Meetings (as defined in Section 5.3), and (iv) the Effective Time, contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary in order to make the statements A-43 therein not misleading. If at any time prior to the Effective Time any event or circumstance relating to PMR or any of its Subsidiaries, or their respective officers or directors, should be discovered by PMR which should be set forth in an amendment or a supplement to the Registration Statement or Proxy Statement, PMR shall promptly inform PSI and an appropriate amendment or supplement describing such information shall be promptly filed with the SEC and, to the extent required by law or regulation, disseminated to the stockholders of PMR and PSI. All documents that PMR is responsible for filing with the SEC in connection with the transactions contemplated herein will comply as to form and substance in all material respects with the applicable requirements of the Securities Act and the rules and regulations thereunder and the Exchange Act and the rules and regulations thereunder. (c) The information supplied by PSI for inclusion in the Registration Statement and the Proxy Statement shall not, at (i) the time the Registration Statement is declared effective, (ii) the time the Proxy Statement (or any amendment thereof or supplement thereto) is first mailed to the stockholders of PSI and PMR, (iii) the time of each of the Stockholders' Meetings, and (iv) the Effective Time, contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary in order to make the statements therein not misleading. If at any time prior to the Effective Time any event or circumstance relating to PSI or any PSI Subsidiary, or their respective officers or directors, should be discovered by PSI which should be set forth in an amendment or a supplement to the Registration Statement or Proxy Statement, PSI shall promptly inform PMR and an appropriate amendment or supplement describing such information shall be promptly filed with the SEC and, to the extent required by law or regulation, disseminated to the stockholders of PMR and PSI. All documents that PSI is responsible for providing to PMR for filing with the SEC in connection with the transactions contemplated herein will comply as to form and substance in all material respects with the applicable requirements of the Securities Act and the rules and regulations thereunder and the Exchange Act and the rules and regulations thereunder. 5.3 Stockholders' Meetings. PSI shall collect proxies and/or call and hold a meeting of its stockholders (together, the "PSI MEETING") and PMR shall call and hold a meeting of its stockholders (the "PMR Meeting" and, together with PSI Meeting, the "STOCKHOLDERS' MEETINGS") as promptly as practicable for the purpose of obtaining the PSI Stockholder Approval (as defined in Section 6.1), the PMR Stockholder Approval (as defined in Section 6.1) and approval of an amendment to PMR's Certificate of Incorporation to provide for a "reverse stock split" pursuant to which each outstanding share of PMR Common Stock would be converted into one-half of a share of PMR Common Stock (the "REVERSE STOCK SPLIT"), and PMR and PSI shall use their best efforts to hold the Stockholders' Meetings on the same day and as soon as practicable after the date on which the Registration Statement becomes effective. 5.4 Access to Information; Confidentiality. (a) Except as required pursuant to any confidentiality agreement or similar agreement or arrangement to which PSI or PMR or any of their respective Subsidiaries is a party or pursuant to applicable Law or the regulations or requirements of any stock exchange or other regulatory organization with whose rules the parties are required to comply, from the date of this Agreement to the Effective Time, PSI and PMR shall (and shall cause their respective Subsidiaries to): (i) provide to the other party (and the other party's officers, directors, employees, accountants, consultants, legal counsel, agents and other representatives, collectively, "REPRESENTATIVES") access, at reasonable times upon prior notice, to its and its Subsidiaries' officers, employees, agents, properties, offices, facilities, books and records and (ii) furnish promptly such information concerning its and its Subsidiaries' business, properties, contracts, assets, liabilities and personnel as the other party or its Representatives may reasonably request. No investigation conducted pursuant to this Section 5.4 shall affect or be deemed to modify any representation or warranty made in this Agreement. (b) The parties shall comply with, and shall cause their respective Representatives to comply with, all of their respective obligations under the Confidentiality Agreement dated as of July 26, 2001, A-44 between PSI and PMR (the "CONFIDENTIALITY AGREEMENT") with respect to the information disclosed pursuant to this Section 5.4. 5.5 No Solicitation by PSI. (a) PSI shall not, nor shall it permit any of its Subsidiaries to, nor shall it authorize or permit any of its directors, officers or employees or any investment banker, financial advisor, attorney, accountant or other representative retained by it or any of its Subsidiaries to, directly or indirectly through another person, (i) solicit, initiate or encourage (including by way of furnishing information), or take any other action designed to facilitate, any inquiries or the making of any proposal which constitutes any PSI Takeover Proposal (as defined below) or (ii) participate in any discussions or negotiations regarding any PSI Takeover Proposal; provided, however, that if the Board of Directors of PSI determines in good faith, after consultation with outside counsel, that it is necessary to do so in order to comply with its fiduciary duties to PSI's stockholders under applicable law, PSI may, in response to a PSI Superior Proposal (as defined in Section 5.5(b)) which was not solicited by it or which did not otherwise result from a breach of this Section 5.5(a), and subject to providing prior written notice of its decision to take such action to PMR (the "PSI NOTICE") and compliance with Section 5.5(c), for a period of five business days following delivery of the PSI Notice (x) furnish information with respect to PSI and its Subsidiaries to any person making a PSI Superior Proposal pursuant to a customary confidentiality agreement (as determined by PSI after consultation with its outside counsel) and (y) participate in discussions or negotiations regarding such PSI Superior Proposal. For purposes of this Agreement, a "PSI TAKEOVER PROPOSAL" means any inquiry, proposal or offer from any person relating to any direct or indirect acquisition or purchase of a business that constitutes 15% or more of the net revenues, net income or the assets of PSI and its Subsidiaries, taken as a whole, or 15% or more of any class of equity securities of PSI or any of its Subsidiaries, any tender offer or exchange offer that if consummated would result in any person beneficially owning 15% or more of any class of equity securities of PSI or any of its Subsidiaries, or any merger, consolidation, business combination, recapitalization, liquidation, dissolution or similar transaction involving PSI or any of its Subsidiaries, other than the transactions contemplated by this Agreement. (b) Except as expressly permitted by this Section 5.5, neither the Board of Directors of PSI nor any committee thereof shall (i) withdraw or modify, or propose publicly to withdraw or modify, in a manner adverse to PMR, the approval or recommendation by such Board of Directors or such committee of the Merger or this Agreement, (ii) approve or recommend, or propose publicly to approve or recommend, any PSI Takeover Proposal, or (iii) cause PSI to enter into any letter of intent, agreement in principle, acquisition agreement or other similar agreement (each, a "PSI ACQUISITION AGREEMENT") related to any PSI Takeover Proposal. Notwithstanding the foregoing, in the event that the Board of Directors of PSI determines in good faith that there is a substantial probability that the adoption of this Agreement by holders of PSI Capital Stock will not be obtained due to the existence of a PSI Superior Proposal, the Board of Directors of PSI may (subject to this and the following sentences) terminate this Agreement (and concurrently with or after such termination, if it so chooses, cause PSI to enter into any PSI Acquisition Agreement with respect to any PSI Superior Proposal), but only at a time that is after the fifth business day following PMR' receipt of written notice advising PMR that the Board of Directors of PSI is prepared to accept a PSI Superior Proposal, specifying the material terms and conditions of such PSI Superior Proposal and identifying the person making such PSI Superior Proposal. For purposes of this Agreement, a "PSI SUPERIOR PROPOSAL" means any proposal made by a third party (i) to acquire, directly or indirectly, including pursuant to a tender offer, exchange offer, merger, consolidation, business combination, recapitalization, liquidation, dissolution or similar transaction, for consideration consisting of cash and/or securities, more than 50% of the combined voting power of the shares of PSI Capital Stock then outstanding or all or substantially all the assets of PSI, (ii) that is otherwise on terms which the Board of Directors of PSI determines in its good faith judgment (based on the advice of a financial advisor of nationally recognized reputation) to be more favorable to PSI's stockholders than the Merger, (iii) for which financing, to the extent required, is then committed or which, in the good A-45 faith judgment of the Board of Directors of PSI, is reasonably capable of being obtained by such third party and (iv) for which, in the good faith judgment of the Board of Directors of PSI, no regulatory approvals are required, including antitrust approvals, that could not reasonably be expected to be obtained. (c) In addition to the obligations of PSI set forth in paragraphs (a) and (b) of this Section 5.5, PSI shall immediately advise PMR orally and in writing of any request for nonpublic information or of any PSI Takeover Proposal, including the material terms and conditions of such request or PSI Takeover Proposal and the identity of the person making such request or PSI Takeover Proposal. PSI will keep PMR reasonably informed on as prompt a basis as is practicable of the status and details of any such PSI Takeover Proposal or request and any related discussions or negotiations, including by forwarding copies of any material written communications relating thereto. PSI agrees not to release any third party from, or waive any provisions of, any confidentiality or standstill agreement to which it (or its Subsidiaries) is a party. PSI shall use commercially reasonable efforts to ensure that the officers, directors and employees of PSI and its Subsidiaries and any investment banking firm or other advisor or representative retained by such party are aware of and instructed to comply with the restrictions described in this Section 5.5. (d) Nothing contained in this Section 5.5 shall prohibit PSI from taking and disclosing to its stockholders a position contemplated by Rule 14e-2(a) promulgated under the Exchange Act or from making any disclosure to PSI's stockholders if, in the good faith judgment of the Board of Directors of PSI, after consultation with outside counsel, failure so to disclose would be inconsistent with its obligations under applicable law. (e) PSI will immediately cease and cause its Subsidiaries, and its and their officers, directors, agents, representatives and advisors, to cease any and all existing activities, discussions or negotiations with any parties conducted prior to the date of this Agreement with respect to any PSI Takeover Proposal, provided, however, that nothing in this Section 5.5(e) shall limit or restrict PSI's ability to take any actions otherwise permitted by subparagraphs (a) through (d) of Section 5.5. 5.6 No Solicitation by PMR. (a) PMR shall not, nor shall it permit any of its Subsidiaries to, nor shall it authorize or permit any of its directors, officers or employees or any investment banker, financial advisor, attorney, accountant or other representative retained by it or any of its Subsidiaries to, directly or indirectly through another person, (i) solicit, initiate or encourage (including by way of furnishing information), or take any other action designed to facilitate, any inquiries or the making of any proposal which constitutes any PMR Takeover Proposal (as defined below) or (ii) participate in any discussions or negotiations regarding any PMR Takeover Proposal; provided, however, that if the Board of Directors of PMR determines in good faith, after consultation with outside counsel, that it is necessary to do so in order to comply with its fiduciary duties to PMR' stockholders under applicable law, PMR may, in response to a PMR Superior Proposal (as defined in Section 5.6(b)) which was not solicited by it or which did not otherwise result from a breach of this Section 5.6(a), and subject to providing prior written notice of its decision to take such action to PSI (the "PMR NOTICE") and compliance with Section 5.6(c), for a period of five business days following delivery of the PMR Notice (x) furnish information with respect to PMR and its Subsidiaries to any person making a PMR Superior Proposal pursuant to a customary confidentiality agreement (as determined by PMR after consultation with its outside counsel) and (y) participate in discussions or negotiations regarding such PMR Superior Proposal. For purposes of this Agreement, "PMR TAKEOVER PROPOSAL" means any inquiry, proposal or offer from any person relating to any direct or indirect acquisition or purchase of a business that constitutes 15% or more of the net revenues, net income or the assets of PMR and its Subsidiaries, taken as a whole, or 15% or more of any class of equity securities of PMR or any of its Subsidiaries, any tender offer or exchange offer that if consummated would result in any person beneficially owning 15% or more of any class of equity securities of PMR or any of its Subsidiaries, or any merger, consolidation, business combination, recapitalization, liquidation, dissolution or similar transaction A-46 involving PMR or any of its Subsidiaries, other than the transactions contemplated by this Agreement. (b) Except as expressly permitted by this Section 5.6, neither the Board of Directors of PMR nor any committee thereof shall (i) withdraw or modify, or propose publicly to withdraw or modify, in a manner adverse to PSI, the approval or recommendation by such Board of Directors or such committee of the Merger, this Agreement or the issuance of PMR Common Stock in connection with the Merger, (ii) approve or recommend, or propose publicly to approve or recommend, any PMR Takeover Proposal, or (iii) cause PMR to enter into any letter of intent, agreement in principle, acquisition agreement or other similar agreement (each, a "PMR ACQUISITION AGREEMENT") related to any PMR Takeover Proposal. Notwithstanding the foregoing, in the event that the Board of Directors of PMR determines in good faith that there is a substantial probability that the PMR Stockholder Approval will not be obtained due to the existence of a PMR Superior Proposal, the Board of Directors of PMR may (subject to this and the following sentences) terminate this Agreement (and concurrently with or after such termination, if it so chooses, cause PMR to enter into any PMR Acquisition Agreement with respect to any PMR Superior Proposal), but only at a time that is after the fifth business day following PSI's receipt of written notice advising PSI that the Board of Directors of PMR is prepared to accept a PMR Superior Proposal, specifying the material terms and conditions of such PMR Superior Proposal and identifying the person making such PMR Superior Proposal. For purposes of this Agreement, a "PMR SUPERIOR PROPOSAL" means any proposal made by a third party (i) to acquire, directly or indirectly, including pursuant to a tender offer, exchange offer, merger, consolidation, business combination, recapitalization, liquidation, dissolution or similar transaction, for consideration consisting of cash and/or securities, more than 50% of the combined voting power of the shares of PMR Common Stock then outstanding or all or substantially all of the assets of PMR, (ii) that is otherwise on terms which the Board of Directors of PMR determines in its good faith judgment (based on the advice of a financial advisor of nationally recognized reputation) to be more favorable to PMR' stockholders than the Merger, (iii) for which financing, to the extent required, is then committed or which, in the good faith judgment of the Board of Directors of PMR, is reasonably capable of being obtained by such third party and (iv) for which, in the good faith judgment of the Board of Directors of PMR, no regulatory approvals are required, including antitrust approvals, that could not reasonably be expected to be obtained. (c) In addition to the obligations of PMR set forth in paragraphs (a) and (b) of this Section 5.6, PMR shall immediately advise PSI orally and in writing of any request for nonpublic information or of any PMR Takeover Proposal, the material terms and conditions of such request or PMR Takeover Proposal and the identity of the person making such request or PMR Takeover Proposal, forwarding a copy of any written communications relating thereto. PMR will keep PSI reasonably informed on as prompt a basis as is practicable of the status and details of any such PMR Takeover Proposal or request and any related discussions or negotiations, including by forwarding copies of any material written communications relating thereto. PMR agrees not to release any third party from, or waive any provisions of, any confidentiality or standstill agreement to which it (or its Subsidiaries) is a party. PMR shall use commercially reasonable efforts to ensure that the officers, directors and employees of PMR and its Subsidiaries and any investment banking firm or other advisor or representative retained by such party are aware of and instructed to comply with the restrictions described in this Section 5.6. (d) Nothing contained in this Section 5.6 shall prohibit PMR from taking and disclosing to its stockholders a position contemplated by Rule 14e-2(a) promulgated under the Exchange Act or from making any disclosure to PMR' stockholders if, in the good faith judgment of the Board of Directors of PMR, after consultation with outside counsel, failure so to disclose would be inconsistent with its obligations under applicable law. (e) PMR will immediately cease and cause its Subsidiaries, and its and their officers, directors, agents, representatives and advisors, to cease any and all existing activities, discussions or negotiations with any parties conducted prior to the date of this Agreement with respect to any PMR Takeover A-47 Proposal, provided, however, that nothing in this Section 5.6(e) shall limit or restrict PMR's ability to take any action otherwise permitted by subparagraphs (a) through (d) of Section 5.6. 5.7 Best Efforts. (a) Appropriate Actions. (i) Subject to the provisions of Sections 5.5 and 5.6 regarding superior proposals, PSI and PMR shall use their reasonable best efforts to (A) take, or cause to be taken, all appropriate action, and do, or cause to be done, all things necessary, proper or advisable under applicable Law or otherwise to consummate and make effective the transactions contemplated by this Agreement as promptly as practicable, (B) obtain from any Governmental Entities any consents, licenses, permits, waivers, approvals, authorizations or orders required to be obtained or made by PMR or PSI or any of their Subsidiaries, or to avoid any action or proceeding by any Governmental Entity (including, without limitation, those in connection with the HSR Act), in connection with the authorization, execution and delivery of this Agreement and the consummation of the transactions contemplated herein, including, without limitation, the Merger, and (iii) make all necessary filings, and thereafter make any other required submissions, with respect to this Agreement and the Merger required under (x) the Securities Act and the Exchange Act, and any other applicable federal or state securities Laws, (y) the HSR Act and (z) any other applicable Law; provided that PMR and PSI shall cooperate with each other in connection with the making of all such filings, including providing copies of all such documents to the non-filing party and its advisors prior to filing and, if requested, to accept all reasonable additions, deletions or changes suggested in connection therewith. PSI and PMR shall furnish to each other all information required for any application or other filing to be made pursuant to the rules and regulations of any applicable Law (including all information required to be included in the Proxy Statement and the Registration Statement) in connection with the transactions contemplated by this Agreement. PSI and PMR shall not take any action, or refrain from taking any action, the effect of which would be to delay or impede the ability of PSI and PMR to consummate the transactions contemplated by this Agreement. (ii) Each of the parties hereto agrees, and shall cause each of its respective Subsidiaries to cooperate and to use their respective reasonable best efforts to obtain any government clearances required for completion of the transactions (including compliance with the HSR Act), to respond to any government requests for information, and to contest and resist any action, including any legislative, administrative or judicial action, and to have vacated, lifted, reversed or overturned any decree, judgment, injunction or other order (whether temporary, preliminary or permanent) (an "ORDER") that restricts, prevents or prohibits the consummation of the Merger or any other transactions contemplated by this Agreement. Each of the parties hereto also agrees to take any and all of the following actions to the extent necessary to obtain the approval of any Governmental Entity with jurisdiction over the enforcement of any applicable laws regarding the Merger: entering into negotiations; providing information; substantially complying with any second request for information pursuant to the HSR Act; making proposals; and entering into and performing agreements or submitting to judicial or administrative orders. The parties hereto will consult and cooperate with one another, and consider in good faith the views of one another, in connection with any analyses, appearances, presentations, memoranda, briefs, arguments, opinions and proposals made or submitted by or on behalf of any party hereto in connection with proceedings under or relating to the HSR Act or any other federal, state or foreign antitrust or fair trade law. Each party shall promptly notify the other party of any communication to that party from any Governmental Entity in connection with any required filing with, or approval or review by, such Governmental Entity in connection with the Merger and permit the other party to review in advance any such proposed communication to any Governmental Entity. Neither party shall agree to participate in any meeting with any Governmental Entity in respect of any such filings, investigation or other inquiry unless it consults with the other party in advance and, A-48 to the extent permitted by such Governmental Entity, gives the other party the opportunity to attend and participate thereat. (b) Third Party Consents; Minimize Adverse Effects. (i) PSI and PMR shall give (or shall cause their respective Subsidiaries to give) any notices to third parties, and use, and cause their respective Subsidiaries to use, all reasonable efforts to obtain any third party consents, (A) necessary, proper or advisable to consummate the transactions contemplated in this Agreement, (B) disclosed or required to be disclosed in the PSI Disclosure Schedule or the PMR Disclosure Schedule, as the case may be, or (C) required to prevent a PSI Material Adverse Effect or a PMR Material Adverse Effect from occurring prior to or after the Effective Time. (ii) In the event that either party shall fail to obtain any third party consent described in subsection (b)(i) above, such party shall use all reasonable efforts, and shall take any such actions reasonably requested by the other party hereto, to minimize any adverse effect upon PSI and PMR, their respective Subsidiaries, and their respective businesses resulting, or which could reasonably be expected to result after the Effective Time, from the failure to obtain such consent. (c) Notices. From the date of this Agreement until the Effective Time, PSI and PMR shall each promptly notify the other in writing of any pending or, to the knowledge of such party, threatened action, proceeding or investigation by any Governmental Entity or any other person (i) challenging or seeking material damages in connection with the Merger or the conversion of PSI Capital Stock into PMR Common Stock, or the issuance of PMR stock to PSI's Stockholders, pursuant to the Merger or (ii) seeking to restrain or prohibit the consummation of the Merger or otherwise limit the right of PMR or the PMR Subsidiaries to own or operate all or any portion of the businesses or assets of PSI or the PSI Subsidiaries, which in either case is reasonably likely to have a PSI Material Adverse Effect prior to or after the Effective Time, or a PMR Material Adverse Effect after the Effective Time. 5.8 Stock Options and Other Stock Awards; Employee Benefit Plans. (a) Prior to the Effective Time, PSI and PMR shall take such action as may be necessary to cause each PSI Option under the PSI Stock Plan, copies of which (as amended through the date hereof) have heretofore been made available to PMR by PSI, to be automatically converted at the Effective Time into an option (a "PMR OPTION") to purchase a number of shares of PMR Common Stock equal to the number of shares of PSI Common Stock that could have been purchased under such PSI Option multiplied by the common stock exchange ratio in Section 1.7(b)(i) (rounded to the nearest whole number of shares of PMR Common Stock), at a price per share of PMR Common Stock equal to the per-share option exercise price specified in such PSI Option divided by the common stock exchange ratio in Section 1.7(b)(i) (rounded down to the nearest whole cent); provided, however, that with respect to any options which are "incentive stock options" (as defined in Section 422 of the Code) or which are described in Section 423 of the Code shall be affected in a manner that is consistent with the requirements of Section 424(a) of the Code. Pursuant to the terms of the PSI Stock Plan, each such option shall be subject to the same terms and conditions as the related PSI Option. The date of grant of the substituted PMR Option shall be the date on which the corresponding PSI Option was granted. As promptly as practicable after the Effective Time, PMR shall issue to each holder of an outstanding PSI Option a document evidencing the foregoing assumption by PMR. In addition, PMR shall take all necessary actions to amend the PMR Stock Plan to authorize the issuance of a sufficient number of shares of PMR Common Stock to cover the PMR Options to be granted pursuant to the Merger. As soon as practicable after the Effective Time, to the extent necessary to provide for registration of shares of PMR Common Stock subject to such substituted PMR Options, PMR shall file a registration statement on Form S-8 (or any successor form) with respect to such shares of PMR Common Stock and shall use its best efforts to maintain such registration statement (or any successor form), including the current status of any related prospectus or prospectuses, for so long as such options remain outstanding. The conversion feature A-49 contained in the Convertible Notes shall be adjusted to account for the Merger based upon the provisions contained in the Convertible Notes. (b) From and after the Effective Time, all employee benefit plans of PMR (the "PMR EMPLOYEE PLANS") and the PSI Employee Plans in effect as of the Effective Time shall, subject to applicable law, the terms of this Agreement and the terms of such plans, remain in effect with respect to the employees of PMR or PSI (or their respective Subsidiaries), as the case may be, until such time as PMR shall amend its, or adopt new, employee benefit plans and arrangements with respect to employees of the Surviving Corporation and its Subsidiaries (the "REPLACEMENT PLANS"). From and after the Effective Time, subject to the terms and conditions of the Replacement Plans PMR shall, and shall cause its Subsidiaries to, honor in accordance with their terms all PMR Employee Plans and PSI Employee Plans, respectively, as amended as permitted hereunder, and all other contracts, arrangements and commitments that apply to current or former employees or directors of PMR, PSI or their respective Subsidiaries. (c) Prior to the Effective Time, a committee (consisting of the Chief Executive Officer of PSI and the Chief Executive Officer of PMR and an equal number of representatives from PSI and PMR as they shall appoint) shall be formed to conduct a review of PMR's and PSI's respective employee benefit and compensation plans and programs in order to coordinate the provision of benefits and compensation to the employees of PMR and its Subsidiaries after the Effective Time and to eliminate duplicative benefits, including, without limitation, through the establishment of the Replacement Plans. The Replacement Plans shall, in all material respects, (i) treat similarly situated employees of PMR and PSI and their respective Subsidiaries on a substantially equivalent basis, taking into account all relevant factors, including, without limitation, duties, geographic location, tenure, qualifications and abilities, and (ii) not discriminate between employees who were covered by the PMR Employee Plans, on the one hand, and those covered by the PSI Employee Plans, on the other, at the Effective Time. Notwithstanding the foregoing, the employee benefit plans and arrangements maintained for current and former employees of PMR, PSI and their respective Subsidiaries following the Effective Time shall provide, until any applicable Replacement Plan has been implemented (or, if earlier, through the first anniversary of the Effective Time), a level of compensation and benefits that is substantially comparable in the aggregate to that provided under the PMR Employee Plans or the PSI Employee Plans, as the case may be, as in effect immediately prior to the date of this Agreement; provided, however, that changes may be made to such plans to the extent necessary to comply with applicable law. (d) Employees of PMR, PSI and their respective Subsidiaries shall receive credit for purposes of eligibility to participate, vesting, benefit accrual and eligibility to receive benefits under any employee benefit plan, program or arrangement established or maintained by the Surviving Corporation or any of its Subsidiaries for service accrued or deemed accrued prior to the Effective Time with PMR, PSI or any of their respective Subsidiaries, as the case may be; provided, however, that such crediting of service shall not operate to duplicate any benefit or the funding of any such benefit. 5.9 Update Disclosure; Breaches. From and after the date of this Agreement until the Effective Time, each party hereto shall promptly notify the other party hereto by written update to its Disclosure Schedule of (i) the occurrence, or non-occurrence, of any event that would be likely to cause any condition to the obligations of any party to effect the Merger and the other transactions contemplated by this Agreement not to be satisfied, or (ii) the failure of PSI or PMR, as the case may be, to comply with or satisfy any covenant, condition or agreement to be complied with or satisfied by it pursuant to this Agreement which would be likely to result in any condition to the obligations of any party to effect the Merger and the other transactions contemplated by this Agreement not to be satisfied; provided, however, that the delivery of any notice pursuant to this Section 5.9 shall not cure any breach of any representation or warranty requiring disclosure of such matter prior to the date of this Agreement or otherwise limit or affect the remedies available hereunder to the party receiving such notice. A-50 5.10 Public Announcements. PMR and PSI shall consult with each other before issuing any press release or otherwise making any public statements with respect to the Merger and shall not issue any such press release or make any such public statement prior to such consultation, except as may be required by Law or any listing agreement with the Nasdaq. 5.11 Nasdaq Listing. PMR shall promptly prepare and submit to the Nasdaq a listing application covering the shares of PMR Common Stock to be issued in the Merger, and shall use all reasonable efforts to cause such shares to be approved for listing on the Nasdaq, subject to official notice of issuance, prior to the Effective Time. 5.12 Indemnification of PSI and PMR Directors and Officers. (a) PMR and the Surviving Corporation agree that the indemnification obligations set forth in PSI's Certificate of Incorporation and PSI's Bylaws, in each case as of the date of this Agreement, shall survive the Merger (and, prior to the Effective Time, PMR shall cause the Certificate of Incorporation and Bylaws of Merger Sub to reflect such provisions) and shall not be amended, repealed or otherwise modified for a period of six years after the Effective Time in any manner that would adversely affect the rights thereunder of the individuals who on or prior to the Effective Time were directors, officers, employees or agents of PSI or its Subsidiaries. (b) PSI shall, to the fullest extent permitted under applicable Law and regardless of whether the Merger becomes effective, indemnify and hold harmless, and, after the Effective Time, PMR and the Surviving Corporation shall, to the fullest extent permitted under applicable Law, indemnify and hold harmless, each present and former director, officer, trustee, fiduciary, employee or agent of PSI and each PSI Subsidiary and each such person who served at the request of PSI or any PSI Subsidiary as a director, officer, trustee, partner, fiduciary, employee or agent of another corporation, partnership, joint venture, trust, pension or other employee benefit plan or enterprise (collectively, the "PSI INDEMNIFIED PARTIES") against all costs and expenses (including reasonable attorneys' fees), judgments, fines, losses, claims, damages, liabilities and settlement amounts paid in connection with any claim, action, suit, proceeding or investigation (whether arising before or after the Effective Time), whether civil, administrative or investigative, arising out of or pertaining to any action or omission in their capacity as an officer or director, in each case occurring before the Effective Time (including the transactions contemplated by this Agreement). Without limiting the foregoing, in the event of any such claim, action, suit, proceeding or investigation, (i) PSI or PMR and the Surviving Corporation, as the case may be, shall pay the fees and expenses of counsel selected by any PSI Indemnified Party, which counsel shall be reasonably satisfactory to PSI or to PMR and the Surviving Corporation, as the case may be, promptly after statements therefor are received (unless the Surviving Corporation shall elect to defend such action) and (ii) PSI and PMR and the Surviving Corporation shall cooperate in the defense of any such matter. (c) For six years from the Effective Time, the Surviving Corporation shall use its best efforts to provide to PSI's current directors and officers liability insurance protection of the same kind and scope as that provided by PSI's directors' and officers' liability insurance policies (copies of which have been made available to PMR) immediately prior to the Effective Time; provided, however, that in no event shall the Surviving Corporation be required to expend more than 200% of the current amount expended by PSI (the "PSI INSURANCE AMOUNT") to maintain or procure insurance coverage pursuant hereto and further provided that if PMR is unable to maintain or obtain the insurance called for by this Section 5.12(c), PMR shall use its best efforts to obtain as much comparable insurance as available for the PSI Insurance Amount. (d) For six years from the Effective Time, the Surviving Corporation shall use its best efforts to provide to PMR's current directors and officers liability insurance protection of the same kind and scope as that provided by PMR's directors' and officers' liability insurance policies (copies of which have been made available to PSI) immediately prior to the Effective Time; provided, however, that in no event shall the Surviving Corporation be required to expend more than 200% of the current amount expended by PMR (the "PMR INSURANCE AMOUNT") to maintain or procure insurance A-51 coverage pursuant hereto and further provided that if the Surviving Corporation is unable to maintain or obtain the insurance called for by this Section 5.12(c), the Surviving Corporation shall use its best efforts to obtain as much comparable insurance as available for the PMR Insurance Amount. (e) In the event PMR or any of their respective successors or assigns (i) consolidates with or merges into any other person or shall not be the continuing or surviving corporation or entity in such consolidation or merger or (ii) transfers all or substantially all its properties and assets to any person, then, and in each case, proper provision shall be made so that the successors and assigns of PMR, as the case may be, honor the indemnification obligations set forth in this Section 5.12. (f) The obligations of PSI, PMR and the Surviving Corporation under this Section 5.12 shall not be terminated or modified in such a manner as to adversely affect any director, officer, employee, agent or other person to whom this Section 5.12 applies without the consent of such affected director, officer, employees, agents or other persons (it being expressly agreed that each such director, officer, employee, agent or other person to whom this Section 5.12 applies shall be third party beneficiaries of this Section 5.12). 5.13 Plan of Reorganization. The Agreement is intended to constitute a "plan of reorganization" within the meaning of section 1.368-2(g) of the income tax regulations promulgated under the Code. From and after the date hereof and until the Effective Time, each party hereto shall use its reasonable best efforts to cause the Merger to qualify, and will not knowingly take any actions or cause any actions to be taken which could prevent the Merger from qualifying, as a reorganization under the provisions of section 368(a) of the Code. Following the Effective Time, neither the Surviving Corporation, PMR nor any of their affiliates shall knowingly take any action or knowingly cause any action to be taken which would cause the Merger to fail to qualify as a reorganization under section 368(a) of the Code. 5.14 Headquarters; Name. As promptly as reasonably practicable after the Effective Time, PMR and PSI shall take all action necessary such that their combined headquarters shall be located at Nashville, Tennessee. Effective as of the Effective Time, PMR shall amend its Certificate of Incorporation such that its name shall be changed to Psychiatric Solutions, Inc. 5.15 Obligations of Merger Sub. PMR shall take all action necessary to cause Merger Sub to perform its obligations under this Agreement and to consummate the Merger on the terms and conditions set forth in this Agreement. 5.16 Financial Statements. PSI shall use its best efforts to cause to be prepared all financial statement information relating to PSI and the PSI Subsidiaries (including their predecessors) as is required to be included in the Registration Statement pursuant to Article 3-05 of Regulation S-X promulgated under the Securities Act. 5.17 Appraisal Rights. PSI shall use its reasonable best efforts to ensure that the condition set forth in Section 6.3(j) is satisfied. If (i) a PSI Takeover Proposal shall have been announced or otherwise publicly disclosed (or disclosed to the PSI stockholders generally) and (ii) the Merger is not consummated because of a failure of the condition set forth in Section 6.3(j) to be satisfied, then PSI shall pay PMR the PMR Termination Fee and the PMR Out-of-Pocket Expenses in immediately available funds promptly upon PSI's receipt of a written demand therefor from PMR. ARTICLE VI CONDITIONS TO THE MERGER 6.1 Conditions to Obligations of Each Party to Effect the Merger. The respective obligations of each party to this Agreement to consummate and effect this Agreement and the transactions contemplated A-52 hereby shall be subject to the satisfaction at or prior to the Effective Time of each of the following conditions, any of which may be waived, in writing, by agreement of all the parties hereto: (a) Effectiveness of the Registration Statement. The Registration Statement shall have been declared effective by the SEC under the Securities Act. No stop order suspending the effectiveness of the Registration Statement shall have been issued by the SEC and no proceedings for that purpose shall have been initiated or, to the knowledge of PMR or PSI, threatened by the SEC. (b) PSI Stockholder Approval. This Agreement and the Merger shall have been approved and adopted by the requisite vote of the PSI stockholders ("PSI STOCKHOLDER APPROVAL"). Any agreements or arrangements that may result in the payment of any amount that would not be deductible by reason of Section 2806 of the Code shall have been approved by such number of stockholders of PSI as is required by the terms of Section 280G(b)(5)(B) and shall be obtained in a manner which satisfies all applicable requirements of such Code Section 280(G)(b)(5) (B) and the proposed Treasury Regulations thereunder, including (without limitation) Q-7 of Section 1.280G-1 of such proposed regulations. (c) PMR Stockholder Approval. This Agreement, the Merger and an amendment to PMR's Certificate of Incorporation authorizing a sufficient number of additional shares of PMR Common Stock to provide for the issuance of the Merger Consideration shall have been approved and adopted by the requisite vote of the PMR stockholders ("PMR STOCKHOLDER APPROVAL"). (d) No Injunctions or Restraints; Illegality. No temporary restraining order, preliminary or permanent injunction or other order issued by any court of competent jurisdiction or other legal or regulatory restraint or prohibition preventing the consummation of the Merger shall be in effect, nor shall any proceeding brought by an administrative agency or commission or other governmental authority or instrumentality, domestic or foreign, seeking any of the foregoing be pending; nor shall there be any action taken, or any statute, rule, regulation or order enacted, entered, enforced or deemed applicable to the Merger, which makes the consummation of the Merger illegal. In the event an injunction or other order shall have been issued, each party agrees to use its reasonable efforts to have such injunction or other order lifted. (e) Blue Sky Filings. There shall have been obtained any and all material permits, approvals and consents of securities or "blue sky" authorities of any jurisdiction that are necessary so that the consummation of the Merger and the transactions contemplated thereby will be in compliance with applicable laws, the failure to comply with which would be reasonably likely to have, individually or in the aggregate, a PMR Material Adverse Effect or a PSI Material Adverse Effect. (f) Nasdaq. The shares of PMR Common Stock issuable to PSI's shareholders pursuant to the Merger shall have been approved for trading on either the Nasdaq National Market or Nasdaq SmallCap Market, subject to official notice of issuance. (g) Additional Governmental Approvals. PMR and PSI and their respective Subsidiaries shall have timely obtained from each Governmental Entity all approvals, waivers and consents, if any, necessary for consummation of or in connection with the Merger and the several transactions contemplated hereby, including such additional approvals, waivers and consents as may be required under the Securities Act, under state Blue Sky laws, and under the HSR Act. 6.2 Additional Conditions to Obligations of PSI. The obligations of PSI to consummate and effect this Agreement and the transactions contemplated hereby shall be subject to the satisfaction at or prior to the Effective Time of each of the following conditions, any of which may be waived, in writing, by PSI: (a) Representations, Warranties and Covenants. Except as disclosed in the PMR Disclosure Schedule dated the date of this Agreement, (i) the representations and warranties of PMR in this Agreement shall be true and correct in all material respects (except for such representations and warranties that are qualified by their terms by a reference to materiality which representations and warranties as so qualified shall be true in all respects) on and as of the date of this Agreement and on A-53 and as of the Effective Time as though such representations and warranties were made on and as of such time and (ii) PMR shall have performed and complied in all material respects with all covenants, obligations and conditions of this Agreement required to be performed and complied with by it as of the Effective Time. (b) Certificate of PMR. PSI shall have been provided with a certificate executed on behalf of PMR by an executive officer of PMR to the effect set forth in Section 6.2(a). (c) Third Party Consents. PSI shall have been furnished with evidence satisfactory to it of the consent or approval of those persons whose consent or approval shall be required in connection with the Merger under the PMR Material Contracts set forth in Schedule 3.24 hereto. (d) Injunctions or Restraints on Conduct of Business. No temporary restraining order, preliminary or permanent injunction or other order issued by any court of competent jurisdiction or other legal or regulatory restraint provision limiting or restricting PMR's conduct or operation of the business of PSI and its Subsidiaries, following the Merger shall be in effect, nor shall any proceeding brought by an administrative agency or commission or other Governmental Entity, domestic or foreign, seeking the foregoing be pending. (e) Legal Opinion. PSI shall have received a legal opinion from PMR's legal counsel in substantially the form of Exhibit E. (f) No Material Adverse Effect. There shall not have occurred any PMR Material Adverse Effect; PMR shall not have received any notice of termination or non-renewal with respect to any contract accounting for ten percent (10%) or more of PMR's annual revenues. (g) Resignation of Directors and Officers. The directors and officers of PMR set forth in Schedule 6.2(g) shall have resigned as directors and officers, as applicable, of PMR effective as of the Effective Time. (h) Tax Opinion. PSI shall have received the written opinion of independent accountants in form and substance reasonably satisfactory to it, and dated on or about the Closing Date to the effect that (i) the Merger will constitute a reorganization within the meaning of Section 368(a) of the Code, (ii) each of PMR and PSI are parties to the reorganization within the meaning of Section 368(b) of the Code, and (iii) no gain or loss will be recognized by PMR, PSI or PSI shareholders (except to the extent of any cash received) as a result of the Merger, and such opinions shall not have been withdrawn. In rendering such opinion, the opining party shall be entitled to rely upon, among other things, reasonable assumptions as well as representations of PMR and PSI. (i) Certificate of Good Standing. PMR shall have provided PSI a certificate from the Secretary of State of Delaware (or other state of formation, as applicable), dated as of a date within ten (10) days prior to the Closing Date, as to the good standing of and payment of all applicable taxes by PMR and each of the PMR Subsidiaries. (j) Consent of Senior Lender. PSI shall have received, in form and substance reasonably satisfactory to PSI, the consent of PSI's senior lender with regard to the Merger and the transactions contemplated by this Agreement, which consent shall contain either amendments to covenants in PSI's credit agreement with such lender or waivers thereof to enable PSI not to be in default under such covenants at the Effective Time. (k) Parent Cash Equivalents. PMR will have on hand at the Effective Time no less than $5.05 million in Cash Equivalents, and PSI shall be reasonably satisfied that payments of all severance resulting from the Merger, PMR's transaction costs shall have been made, or provided for, without any effect on such $5.05 million in Cash Equivalents. (l) Parent Employee Non-Competition Agreements. The employees of PMR set forth in Schedule 6.2(l) shall have entered into a Non-Competition Agreement in the form attached as Exhibit I. A-54 (m) Fairness Opinion. PSI shall have received a written opinion from its financial advisor, in form and substance reasonably satisfactory to it, that subject to factors and assumptions set forth in such opinion, the consideration and exchange ratio to be paid in the Merger is fair from a financial point of view to the holders of PSI Capital Stock. (n) Accounts Receivable Credit Balances. PMR shall have settled the accounts receivable credit balances set forth on Schedule 6.2(n). (o) Satisfaction of Certain PMR Contractual Obligations. PMR shall have satisfied, or made financial arrangements for the satisfaction of, certain contractual obligations to third parties described on Schedule 6.2(o). (p) Allen Tepper Non-Compete. Allen Tepper shall have entered into a non-competition agreement with PMR restricting his ability to compete with the Tennessee Mental Health Cooperative for a period of one year following the Effective Time. 6.3 Additional Conditions to the Obligations of PMR. The obligations of PMR to consummate and effect this Agreement and the transactions contemplated hereby shall be subject to the satisfaction at or prior to the Effective Time of each of the following conditions, any of which may be waived, in writing, by PMR: (a) Representations, Warranties and Covenants. Except as disclosed in the PSI Disclosure Schedule dated the date of this Agreement (i) the representations and warranties of PSI in this Agreement shall be true and correct in all material respects (except for such representations and warranties that are qualified by their terms by a reference to materiality which representations and warranties as so qualified shall be true in all respects) on and as of the date of this Agreement and on and as of the Effective Time as though such representations and warranties were made on and as of such time and (ii) PSI shall have performed and complied in all material respects with all covenants, obligations and conditions of this Agreement required to be performed and complied with by it as of the Effective Time. (b) Certificate of PSI. PMR shall have been provided with a certificate executed on behalf of PSI by its President to the effect set forth in Section 6.3(a). (c) Third Party Consents. PMR shall have been furnished with evidence satisfactory to it of the consent or approval of those persons whose consent or approval shall be required in connection with the Merger under the PSI Material Contracts set forth in Schedule 2.24 hereto. (d) Injunctions or Restraints on Conduct of Business. No temporary restraining order, preliminary or permanent injunction or other order issued by any court of competent jurisdiction or other legal or regulatory restraint provision limiting or restricting PMR's conduct or operation of the business of PSI and its Subsidiaries, following the Merger shall be in effect, nor shall any proceeding brought by an administrative agency or commission or other Governmental Entity, domestic or foreign, seeking the foregoing be pending. (e) Legal Opinion. PMR shall have received a legal opinion (pursuant to the American Bar Association Legal Opinion Accord) from PSI's legal counsel in substantially the form of Exhibit F. (f) No Material Adverse Effect. There shall not have occurred any PSI Material Adverse Effect; PSI shall not have received any notice of termination or non-renewal with respect to any contract accounting for ten percent (10%) or more of PSI's annual revenues. (g) Tax Certificates. PSI shall, prior to the Closing Date, provide PMR with a properly executed FIRPTA Notification Letter, substantially in the form of Exhibit G attached hereto, which states that shares of capital stock of PSI do not constitute "United States real property interests" under Section 897(c) of the Code, for purposes of satisfying PMR's obligations under Treasury Regulation Section 1.1445-2(c)(3). In addition, simultaneously with delivery of such Notification Letter, PSI shall have provided to PMR, as agent for PSI, a form of notice to the Internal Revenue A-55 Service in accordance with the requirements of Treasury Regulation Section 1.897-2(h)(2) and substantially in the form of Exhibit H attached hereto along with written authorization for PMR to deliver such notice form to the Internal Revenue Service on behalf of PSI upon the Closing of the Merger. (h) PSI Employee Non-Competition Agreements. The employees of PSI set forth in Schedule 6.3(h) shall have accepted employment with PMR and shall have entered into a Non-Competition Agreement in the form attached hereto as Exhibit I. (i) Distribution of Contingent Value Rights. There shall not exist any legal or regulatory constraint or prohibition that would prevent PMR from making the distribution of Contingent Value Rights to its stockholders. (j) Dissenters' Rights. Not more than 10% of the shares of PSI Capital Stock outstanding immediately prior to the Effective Time shall be Dissenting Shares. (k) Certificates of Good Standing. PSI shall have provided PMR a certificate from the Secretary of State of Delaware, dated as of a date within 10 days prior to the Closing Date, as to PSI's good standing and payment of all applicable taxes. (l) Warrants Exercised/Canceled Prior to Closing. PSI shall have provided evidence of the exercise of the Exercised Warrants and the cancellation of the Canceled Warrants. ARTICLE VII TERMINATION, AMENDMENT AND WAIVER 7.1 Termination. This Agreement may be terminated at any time prior to the Effective Time, whether before or after the PSI Stockholder Approval or the PMR Stockholder Approval: (a) by mutual written consent of PMR, Merger Sub and PSI; (b) by either PMR or PSI: (i) if the Merger shall not have been consummated by December 31, 2002; provided, however, that the right to terminate this Agreement pursuant to this Section 7.1(b)(i) shall not be available to any party whose failure to perform any of its obligations under this Agreement results in the failure of the Merger to be consummated by such time; (ii) if the approval of the PSI Stockholder Approval shall not have been obtained at the PSI Meeting duly convened therefor or at any adjournment or postponement thereof; (iii) if the PMR Stockholder Approval shall not have been obtained at the PMR Meeting duly convened therefor or at any adjournment or postponement thereof; or (iv) if any court of competent jurisdiction or any governmental entity shall have issued an order, decree or ruling or taken any other action permanently enjoining, restraining or otherwise prohibiting the Merger. (c) by PMR, if PSI shall have breached or failed to perform in any material respect any of its representations, warranties, covenants or other agreements contained in this Agreement, which breach or failure to perform (A) would give rise to the failure of a condition set forth in Section 6.3(a) or (b), and (B) is incapable of being cured by PSI or is not cured within 30 days of notice of such breach or failure; (d) by PMR in accordance with Section 5.6(b); provided that, in order for the termination of this Agreement pursuant to this paragraph (d) to be deemed effective, PMR shall have complied with all provisions contained in Section 5.6, including the notice provisions therein, and with applicable requirements, including the payment of the Termination Fee and PSI Out-of Pocket Expenses, of Section 7.5; A-56 (e) by PSI, if PMR shall have breached or failed to perform in any material respect any of its representations, warranties, covenants or other agreements contained in this Agreement, which breach or failure to perform (A) would give rise to the failure of a condition set forth in Section 6.2(a) or (b), and (B) is incapable of being cured by PMR or is not cured within 30 days of notice of such breach or failure; or (f) by PSI in accordance with Section 5.5(b); provided that, in order for the termination of this Agreement pursuant to this paragraph (f) to be deemed effective, PSI shall have complied with all provisions of Section 5.5, including the notice provisions therein, and with applicable requirements, including the payment of the Termination Fee and PMR Out-of-Pocket Expenses, of Section 7.5. 7.2 Effect of Termination. In the event of termination of this Agreement by either PSI or PMR as provided in Section 7.1, this Agreement shall forthwith become void and have no effect, without any liability or obligation on the part of PMR, Merger Sub or PSI, other than the provisions of Section 2.29, Section 3.29, Section 5.4(b), this Section 7.2, Section 7.5 and Article VIII, which provisions will survive such termination. Any termination of this Agreement pursuant to Section 7.1 hereof shall not relieve any party hereto for liabilities related to any breach of any of its representations, warranties, covenants or agreements in this Agreement, which right to recover damages shall be in addition to (and not exclusive of) any other remedy at law or in equity available to any party. 7.3 Amendment. This Agreement may be amended by the parties hereto by action taken by or on behalf of their respective Boards of Directors at any time prior to the Effective Time; provided, however, that, (i) after the PSI Stockholder Approval is obtained, no amendment may be made which would reduce the amount or change the type of consideration into which each share of PSI Common Stock shall be converted pursuant to this Agreement upon consummation of the Merger; and (ii) after the PMR Stockholder Approval is obtained, no amendment may be made which would increase the amount or change the type of consideration into which each share of PSI Common Stock shall be converted pursuant to this Agreement upon consummation of the Merger. This Agreement may not be amended except by an instrument in writing signed by the parties hereto. 7.4 Extensions; Waiver. At any time prior to the Effective Time, any party hereto may (a) extend the time for the performance of any of the obligations or other acts of the other party hereto, (b) waive any inaccuracies in the representations and warranties of the other party contained herein or in any document delivered pursuant hereto and (c) waive compliance by the other party with any of the agreements or conditions contained herein; provided, however, that (i) after the PSI Stockholder Approval is obtained, there may not be, without further approval of such stockholders, any extension or waiver of this Agreement or any portion thereof which reduces the amount or changes the form of the consideration to be delivered to the holders of PSI Common Stock hereunder other than as contemplated by this Agreement and (ii) after the PMR Stockholder Approval is obtained, there may not be, without further approval of such stockholders, any extension or waiver of this Agreement or any portion thereof which increases the amount or changes the form of the consideration to be delivered to the holders of PSI Common Stock hereunder other than as contemplated by this Agreement. Any such extension or waiver shall be valid only if set forth in an instrument in writing signed by the party or parties to be bound thereby, but such extension or waiver or failure to insist on strict compliance with an obligation, covenant, agreement or condition shall not operate as a waiver of, or estoppel with respect to, any subsequent or other failure. 7.5 Fees and Expenses; Termination Fees. (a) Except as provided in this Section 7.5, all fees and expenses incurred in connection with the Merger, this Agreement, and the transactions contemplated by this Agreement shall be paid by the party incurring such fees or expenses, whether or not the Merger is consummated; provided, however, that (i) each of PMR and PSI shall bear 50% of the costs and expenses (other than fees and expenses of attorneys) incurred in connection with the preparation, filing, printing and mailing of the Registration Statement and the Proxy Statement, including SEC filing fees and fees and expenses of accountants, and (ii) PMR's portion of such costs and expenses, whether paid before or after the A-57 Effective Time, shall not reduce the $5.05 million of Cash Equivalents PMR is required to have on hand at the Effective Time pursuant to Sections 4.4(b) and 6.2(k). (b) In the event that (i) a PSI Takeover Proposal shall have been made known to PSI or any of the PSI Subsidiaries or has been made directly to its stockholders generally or any person shall have publicly announced an intention (whether or not conditional) to make a PSI Takeover Proposal and thereafter this Agreement is terminated by either PMR or PSI pursuant to Section 7.1(b)(i) or (ii), or (ii) this Agreement is terminated by PSI pursuant to Sections 7.1(f) and 5.5(b) based on a PSI Superior Proposal, then PSI shall promptly, but in no event later than five (5) days after the date of such termination, pay PMR a fee equal to the sum of $750,000 (the "PMR TERMINATION FEE") and the PMR Out-of-Pocket Expenses payable by wire transfer of same day funds. "PMR OUT-OF-POCKET EXPENSES" means the lesser of (A) all documented out-of-pocket expenses and fees incurred by PMR (including, without limitation, fees and expenses payable to all legal, accounting, financial, public relations and other professional advisers and expenses related to printing and mailing the Proxy Statement) arising out of, in connection with or related to this Agreement and the transactions contemplated herein and (B) $250,000. PSI acknowledges that the agreements contained in this Section 7.5(b) are an integral part of the transactions contemplated by this Agreement, and that, without these agreements, PMR would not enter into this Agreement; accordingly, if PSI fails promptly to pay the amount due pursuant to this Section 7.5(b), and, in order to obtain such payment, PMR commences a suit which results in a judgment against PSI for the fee set forth in this Section 7.5(b), PSI shall pay to PMR its costs and expenses (including connection with such suit, together with interest on the amount of the fee at the prime rate of Citibank N.A. in effect on the date such payment was required to be made. (c) In the event that (i) a PMR Takeover Proposal shall have been made known to PMR or any of the PMR Subsidiaries or has been made directly to its stockholders generally or any person shall have publicly announced an intention (whether or not conditional) to make a PMR Takeover Proposal and thereafter this Agreement is terminated by either PMR or PSI pursuant to Section 7.1(b)(i) or (iii), or (ii) this Agreement is terminated by PMR pursuant to Sections 7.1(d) and 5.6(b) based on a PMR Superior Proposal then PMR shall promptly, but in no event later than five (5) days after the date of such termination, pay PSI the sum of $750,000 (the "PSI TERMINATION FEE") and the PSI Out-of-Pocket Expenses, payable by wire transfer of same day funds. "PSI OUT-OF-POCKET EXPENSES" means the lesser of (A) all documented out-of-pocket expenses and fees incurred by PSI (including, without limitation, fees and expenses payable to all legal, accounting, financial, public relations and other professional advisers and expenses relating to printing and mailing the Proxy Statement) arising out of, in connection with or related to this Agreement and the transactions contemplated herein and (B) $250,000. PMR acknowledges that the agreements contained in this Section 7.5(c) are an integral part of the transactions contemplated by this Agreement, and that, without these agreements, PSI would not enter into this Agreement; accordingly, if PMR fails promptly to pay the amount due pursuant to this Section 7.5(c), and, in order to obtain such payment, PSI commences a suit which results in a judgment against PMR for the fee set forth in this Section 7.5(c), PMR shall pay to PSI its costs and expenses (including attorneys' fees and expenses) in connection with such suit, together with interest on the amount of the fee at the prime rate of Citibank N. A. in effect on the date such payment was required to be made. ARTICLE VIII GENERAL PROVISIONS 8.1 Non-Survival at Effective Time. The representations and warranties set forth in Article III shall not survive the Effective Time. The agreements set forth in this Agreement shall terminate at the Effective Time, except that the agreements set forth in Article I, Section 5.4 (Access to Information; Confidentiality), Section 5.8 (Stock Options and Other Stock Awards; Employee Benefit Plans), A-58 Section 5.10 (Public Announcements), Section 5.12 (Indemnification of Directors and Officers), Section 7.3 (Amendment), Section 7.4 (Waiver), Section 7.5 (Fees and Expenses) and this Article VIII shall survive the Effective Time and the Closing. The exhibits to this Agreement shall survive the Effective Time and the Closing. 8.2 Notices. All notices and other communications hereunder shall be in writing and shall be deemed given if delivered personally or by commercial delivery service, or mailed by registered or certified mail (return receipt requested) or sent via facsimile (with confirmation of receipt) to the parties at the following address (or at such other address for a party as shall be specified by like notice): (a) if to PMR, to: PMR Corporation 1565 Hotel Circle South, 2nd Floor San Diego, CA 92108 Attention: Chief Executive Officer Facsimile No.: (619) 610-4184 Telephone No.: (619) 610-4001 with a copy to: Vinson & Elkins L.L.P. One American Center 600 Congress Avenue Austin, TX 78701 Attention: Thomas P. Mason Facsimile No.: (512) 236-3250 Telephone No.: (512) 495-8439 (Effective 5/27/02, the address will be: The Terrace 7 2801 Via Fortuna, Suite 100 Austin, Texas 78746 Facsimile No.: (512) 236-3250 Telephone No.: (512) 542-8439) (b) if to PSI, to: Psychiatric Solutions, Inc. 113 Seaboard Lane, Suite C-100 Franklin, TN 37067 Attention: Chief Executive Officer Facsimile No.: (615) 312-5711 Telephone No.: (615) 312-5700 with a copy to: Harwell Howard Hyne Gabbert & Manner, P.C. 315 Deaderick Street, Suite 1800 Nashville, TN 37238 Attn: Lee C. Dilworth Facsimile No.: (615) 251-1059 Telephone No.: (615) 251-1076 8.3 Definitions. For purposes of this Agreement: "BOOKS AND RECORDS" shall mean all books of account, tax records, sales and purchase records, customer and supplier lists, computer software, formulae, business reports, plans and projections and all other documents, files, correspondence and other information (whether in written, printed, electronic or computer printout form). A-59 "CASH EQUIVALENTS" means (i) United States dollars, (ii) securities issued or directly and fully guaranteed or insured by the full faith and credit of the United States government or any agency or instrumentality thereof having maturities of not more than one year from the date of acquisition, (iii) demand or time deposits, certificates of deposit and eurodollar time deposits with maturities of one year or less from the date of acquisition, bankers' acceptances with maturities not exceeding one year and overnight bank deposits, in each case with any domestic commercial bank having capital and surplus in excess of $500 million and a Keefe Bank Watch Rating of "B" or better, (iv) repurchase obligations with a term of not more than seven days for underlying securities of the types described in clauses (ii) and (iii) above entered into with any financial institution meeting the qualifications specified in clause (iii) above, (v) commercial paper having the highest rating obtainable from Moody's Investors Service, Inc. or Standard & Poor's Corporation and in each case maturing within one year after the date of acquisition, and (vi) investments in money market or other mutual funds at least 95% of whose assets comprise securities described in clauses (ii) through (v) above. "ENCUMBRANCES" shall mean security interests, mortgages, liens, pledges, charges, easements, reservations, restrictions, rights of way, options, rights of first refusal and all other encumbrances of record or contract, whether or not relating to the extension of credit or the borrowing of money. "LIABILITY" shall mean any liability or obligation (including as related to Taxes), whether known or unknown, asserted or unasserted, absolute or contingent, accrued or unaccrued, liquidated or unliquidated and whether due or to become due, regardless of when asserted. "PERSON" shall be construed broadly and shall include any individual, a partnership, a corporation, a limited liability company, an association, a joint stock company, a trust, a joint venture, an unincorporated organization or a governmental entity (or any department, agency or political subdivision thereof). "PROCEEDING" shall mean a private or governmental action, suit, proceeding, claim, arbitration or investigation. "SUBSIDIARY" shall mean any corporation, partnership, joint venture or other legal entity of which such person (either alone or through or together with any other subsidiary) owns, directly or indirectly, more than 50% of the stock or other equity interests, the holders of which are generally entitled to vote for the election of the board of directors or other governing body of such corporation or other legal entity. "TAX" (and, with correlative meaning, "TAXES" and "TAXABLE") shall mean (i) any net income, alternative or add-on minimum tax, gross income, gross receipts, sales, use, ad valorem, transfer, franchise, profits, license, withholding, payroll, employment, excise, severance, stamp, occupation, premium, property, environmental or windfall profit tax, custom duty or other tax, governmental fee or other like assessment or charge of any kind whatsoever, together with any interest or any penalty, addition to tax or additional amount imposed by any governmental entity (a "TAX AUTHORITY") responsible for the imposition of any such tax (domestic or foreign), (ii) any liability for the payment of any amounts of the type described in (i) as a result of being a member of an affiliated, consolidated, combined, unitary or aggregate group for any Taxable period, and (iii) any liability for the payment of any amounts of the type described in (i) or (ii) as a result of being a transferee of or successor to any person or as a result of any express or implied obligation to indemnify any other person. "TAX RETURN" shall mean any return, statement, report or form (including, without limitation, estimated tax returns and reports, withholding tax returns and reports and information returns and reports) required to be filed with respect to Taxes. 8.4 Interpretation. When a reference is made in this Agreement to Exhibits, such reference shall be to an Exhibit to this Agreement unless otherwise indicated. The words "include," "includes" and "including" when used herein shall be deemed in each case to be followed by the words "without limitation." The phrase "made available" in this Agreement shall mean that the information referred to has been made available if requested by the party to whom such information is to be made available. The phrases "the date of this Agreement," "the date hereof," and terms of similar import, unless the context otherwise requires, shall be deemed to refer to May 6, 2002. The table of contents and headings contained A-60 in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement. 8.5 Counterparts. This Agreement may be executed in one or more counterparts, all of which shall be considered one and the same agreement and shall become effective when one or more counterparts have been signed by each of the parties and delivered to the other parties, it being understood that all parties need not sign the same counterpart. 8.6 Entire Agreement; Nonassignability; Parties in Interest. This Agreement and the documents and instruments and other agreements specifically referred to herein or delivered pursuant hereto, including the Exhibits, the Schedules, including the PSI Disclosure Schedule and the PMR Disclosure Schedule (a) constitute the entire agreement among the parties with respect to the subject matter hereof and supersede all prior agreements and understandings, both written and oral, among the parties with respect to the subject matter hereof, except for the Confidentiality Agreement, which shall continue in full force and effect, and shall survive any termination of this Agreement or the Closing, in accordance with its terms; (b) are not intended to confer upon any other person any rights or remedies hereunder, except as set forth in Sections 1.7(b), 1.7(c), 1.7(d), 1.7(e), 1.7(g), 1.8 and 5.8; and (c) shall not be assigned by operation of law or otherwise except as otherwise specifically provided. 8.7 Severability. In the event that any provision of this Agreement, or the application thereof, becomes or is declared by a court of competent jurisdiction to be illegal, void or unenforceable, the remainder of this Agreement will continue in full force and effect and the application of such provision to other persons or circumstances will be interpreted so as reasonably to effect the intent of the parties hereto. The parties further agree to replace such void or unenforceable provision of this Agreement with a valid and enforceable provision that will achieve, to the extent possible, the economic, business and other purposes of such void or unenforceable provision. 8.8 Remedies Cumulative. Except as otherwise provided herein, any and all remedies herein expressly conferred upon a party will be deemed cumulative with and not exclusive of any other remedy conferred hereby, or by law or equity upon such party, and the exercise by a party of any one remedy will not preclude the exercise of any other remedy. 8.9 Governing Law. This Agreement shall be governed by and construed in accordance with the laws of Delaware without reference to such state's principles of conflicts of law. Each of the parties hereto irrevocably consents to the exclusive jurisdiction of any court located within the State of Delaware, in connection with any matter based upon or arising out of this Agreement or the matters contemplated herein, agrees that process may be served upon them in any manner authorized by the laws of the State of Delaware for such persons and waives and covenants not to assert or plead any objection which they might otherwise have to such jurisdiction and such process. 8.10 Rules of Construction. The parties hereto agree that they have been represented by counsel during the negotiation, preparation and execution of this Agreement and, therefore, waive the application of any law, regulation, holding or rule of construction providing that ambiguities in an agreement or other document will be construed against the party drafting such agreement or document. A-61 IN WITNESS WHEREOF, PMR, Merger Sub and PSI have caused this Agreement to be executed and delivered by their respective officers thereunto duly authorized, all as of the date first written above. PMR: PMR Corporation By: /s/ MARK CLEIN ------------------------------------ Name: Mark Clein ---------------------------------- Title: Chief Executive Officer ----------------------------------- MERGER SUB: PMR Acquisition Corporation By: /s/ MARK CLEIN ------------------------------------ Name: Mark Clein ---------------------------------- Title: Chief Executive Officer ----------------------------------- PSI: Psychiatric Solutions, Inc. By: /s/ JOEY A. JACOBS -------------------------------------- Name: Joey A. Jacobs Title: President & Chief Executive Officer [Signature page to Agreement and Plan of Merger] A-62 SCHEDULE A TO AGREEMENT AND PLAN OF MERGER PSI STOCKHOLDERS EXECUTING VOTING AGREEMENT Acacia Venture Partners, L.P. South Park Venture Partners, L.P. South Pointe Venture Partners, L.P. CGJF Health Care Services Private Equities, L.P. CGJR II, L.P. CGJR/MF III, L.P. Oak Investment Partners VII Limited Partnership Oak Investment Partners VII Affiliates Fund, Limited Partnership Oak VII Affiliates Fund, Limited Partnership Clayton Associates, LLC FCA Venture Partners I, L.P. FCA Venture Partners II, L.P. Joey Jacobs Charles R.F. Treadway, M.D. K. Bryce DeHaven Douglas B. Lewis SCHEDULE B TO AGREEMENT AND PLAN OF MERGER PMR STOCKHOLDERS EXECUTING VOTING AGREEMENT Proactive Investment Managers Jon D. Gruber J. Patterson McBaine Myron Wick Allen Tepper Charles McGettigan Mark Clein SCHEDULE C TO AGREEMENT AND PLAN OF MERGER DIRECTORS AND OFFICERS OF THE SURVIVING CORPORATION FOLLOWING EFFECTIVE TIME Board of Directors Joey A. Jacobs Steven T. Davidson Officers Joey A. Jacobs, Chief Executive Officer and President Steven T. Davidson, Chief Development Officer and Secretary Jack R. Salberg, Chief Operating Officer Jack Polson, Controller A-63 SCHEDULE D TO AGREEMENT AND PLAN OF MERGER DIRECTORS AND OFFICERS OF PMR FOLLOWING EFFECTIVE TIME Board of Directors Class One (1-year initial term): Christopher Grant, Jr. Charles McGettigan Class Two (2-year initial term): [REPRESENTATIVE OF PSI SUBORDINATED NOTEHOLDERS] Mark Clein Class Three (3-year initial term): Joey A. Jacobs, Chairman of the Board Edward K. Wissing David S. Heer Officers Joey A. Jacobs, Chief Executive Officer and President Steven T. Davidson, Chief Development Officer and Secretary Jack R. Salberg, Chief Operating Officer Jack Polson, Controller Audit Committee Christopher Grant, Jr. Edward K. Wissing Charles McGettigan Compensation Committee Christopher Grant, Jr. David S. Heer Joey A. Jacobs A-64 AMENDMENT NO. 1 TO AGREEMENT AND PLAN OF MERGER This Amendment No. 1 to Agreement and Plan of Merger (this "AMENDMENT") is made and entered into as of June 10, 2002 by and among PMR Corporation, a Delaware corporation ("PMR"), PMR Acquisition Corporation, a Delaware corporation and a wholly-owned subsidiary of PMR ("MERGER SUB"), and Psychiatric Solutions, Inc., a Delaware corporation ("PSI"). WHEREAS, PMR, Merger Sub, and PSI are parties to that certain Agreement and Plan of Merger dated as of May 6, 2002 (the "MERGER AGREEMENT"); WHEREAS, Section 7.3 of the Merger Agreement permits the Merger Agreement to be amended by a signed, written instrument upon action taken by or on behalf of the respective Boards of Directors of the parties thereto at any time prior to the Effective Time; and WHEREAS, PMR, Merger Sub, and PSI now desire to amend the Merger Agreement. NOW, THEREFORE, for and in consideration of the premises and the mutual benefits to the parties arising out of this Amendment, the receipt and sufficiency of which are hereby acknowledged by the parties' execution and delivery hereof, the parties hereto agree as follows: 1. Definitions. Capitalized terms not defined in this Amendment shall have the meanings ascribed thereto in the Merger Agreement. 2. Amendments to the Merger Agreement. 2.1. Amendments to Index of Defined Terms. The Index of Defined Terms is hereby amended as follows: (a) So as to add the following to the alphabetical list of terms defined and used in the Merger Agreement: "PMR Stock Price Section 1.7(f)" (b) So as to change the cross-reference to the section of the Merger Agreement in which the following is defined: "Reverse Stock Split Section 3.30" 2.2. Amendment to Section 1.4. Section 1.4 of the Merger Agreement is hereby amended so as to read in its entirety as follows: "1.4 Certificate of Incorporation; Bylaws. (a) At the Effective Time, the Certificate of Incorporation of PSI as the Surviving Corporation shall be amended and restated to read the same as the Certificate of Incorporation of Merger Sub as in effect immediately prior to the Effective Time, except that Section 1 of the amended and restated Certificate of Incorporation of the Surviving Corporation, instead of reading the same as Section 1 of the Certificate of Incorporation of Merger Sub, shall read as follows: "The name of this corporation is Psychiatric Solutions Hospitals, Inc." (b) At the Effective Time, the Bylaws of PSI as the Surviving Corporation shall be amended to read the same as the Bylaws of Merger Sub as in effect immediately prior to the Effective Time, except that all references to Merger Sub in the Bylaws of the Surviving Corporation shall be changed to refer to Psychiatric Solutions Hospitals, Inc." A-65 2.3. Amendment to Section 1.7(b). Section 1.7(b) of the Merger Agreement is hereby amended so as to read in its entirety as follows: "(b) Conversion of PSI Capital Stock. (i) Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each share of common stock, par value $0.001 per share, of PSI (the "PSI COMMON STOCK") issued and outstanding immediately prior to the Effective Time (other than shares to be canceled in accordance with Section 1.7(e)) shall be converted into the right to receive 0.156648 shares of fully paid and nonassessable shares of PMR Common Stock. (ii) Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each issued and outstanding share of PSI's Series A Preferred Stock ("PSI SERIES A PREFERRED STOCK") shall be converted into the right to receive 0.336020 shares of fully paid and nonassessable shares of PMR Common Stock. Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each issued and outstanding share of PSI's Series B Preferred Stock ("PSI SERIES B PREFERRED STOCK") shall be converted into the right to receive 0.425707 shares of fully paid and nonassessable shares of PMR Common Stock. The PSI Series A Preferred Stock and the PSI Series B Preferred Stock may be referred to collectively as "PSI PREFERRED STOCK." (iii) The shares of PMR Common Stock into which the shares of PSI Capital Stock are converted into the right to receive pursuant to the Merger are referred to herein collectively as the "MERGER CONSIDERATION." At the Effective Time, all such shares of PSI Capital Stock shall no longer be outstanding and shall automatically be canceled and shall cease to exist, and each holder of a certificate or certificates that immediately prior the Effective Time represented any such shares (a "CERTIFICATE" or "CERTIFICATES") shall cease to have any rights with respect thereto, except the right to receive the Merger Consideration with respect thereto and any cash in lieu of fractional shares of PMR Common Stock to be issued in consideration therefor upon surrender of such Certificate in accordance with Section 1.8. Each share of PSI Common Stock or PSI Preferred Stock issued and outstanding immediately prior to the Effective Time that is restricted or not fully vested shall upon such conversion and exchange have the same restrictions or vesting arrangements applicable to such shares prior to the conversion." 2.4 Amendment to Section 1.7(c). Section 1.7(c) of the Merger Agreement is hereby amended so as to read in its entirety as follows: "(c) Anti-Dilution Provisions. In the event that the capitalization of PMR (as set forth in Section 3.2) changes prior to the Effective Time (other than changes resulting from the Reverse Stock Split) or in the event that the capitalization of PSI (as set forth in Section 2.2) changes prior to the Effective Time, the exchange ratios set forth in Sections 1.7(a) and 1.7(b) shall be appropriately adjusted to reflect such changes in the capitalization of PSI or PMR, or both, as the case may be; provided, however, that in the event that (i) there are no changes to the capitalization of PMR (as set forth in Section 3.2) prior to the Effective Time (other than resulting from the Reverse Stock Split) and (ii) PSI issues any additional shares of PSI Common Stock or any option, warrant or other security exercisable for, exchangeable for or convertible into, directly or indirectly, any shares of PSI Common Stock prior to the Effective Time, then the exchange ratios set forth in Section 1.7(a) and Section 1.7(b) shall be adjusted in a manner that provides for (1) the issuance of an aggregate of 3,479,474 shares of PMR Common Stock to the holders of PSI Preferred Stock (allocated between the holders of the PSI Series A Preferred Stock and PSI Series B Preferred Stock in the same proportions as set forth in Section 1.7(b)), and (2) the issuance of an aggregate of 4,089,432 shares of PMR Stock allocated among the holders of shares of PSI Common Stock, holders of shares of PSI Preferred Stock and the holders of options, warrants and other securities exercisable for, exchangeable for or convertible into, directly or indirectly, shares of PSI Common Stock (other than the Cancelled Warrants and the Convertible Notes) upon the exercise, exchange or conversion thereof, with such allocation to be made on a pro rata basis in relation to the fully diluted capitalization of PSI immediately prior to the Effective Time, assuming that all shares of PSI A-66 Preferred Stock and all options, warrants and such other securities, other than the Cancelled Warrants and the Convertible Notes, are exercised, exchanged or converted into shares of PSI Common Stock immediately prior to the Effective Time." 2.5 Amendment to Section 1.7(f). Section 1.7(f) of the Merger Agreement is hereby amended so as to read in its entirety as follows: "(f) Fractional Shares. No fraction of a share of PMR Common Stock will be issued, but in lieu thereof each holder of shares of PSI Capital Stock who would otherwise be entitled to a fraction of a share of PMR Common Stock (after aggregating all fractional shares of PMR Common Stock to be received by such holder) shall receive from PMR an amount of cash (rounded to the nearest whole cent) equal to the product of (i) such fraction, multiplied by (ii) the closing price for a share of PMR Common Stock on the Nasdaq National Market on the trading day on which the Effective Time occurs (the "PMR STOCK PRICE")." 2.6. Amendment to Section 1.15. Section 1.15 of the Merger Agreement is hereby amended so as to read in its entirety as follows: "1.15 Pre-Closing Distribution to PMR Shareholders. Prior to the Effective Time, PMR shall be entitled to distribute to holders of PMR Common Stock (i) PMR Cash Equivalents in excess of $5.05 million pursuant to Section 6.2(k) and (ii) Contingent Value Rights pursuant to the Contingent Value Rights Agreement described in Section 4.4(b)." 2.7. Amendment to Section 2.2(a). Section 2.2(a) of the Merger Agreement is hereby amended so as to read in its entirety as follows: "(a) The authorized capital stock of PSI immediately prior to the Effective Time consists of 53,500,000 shares of capital stock, consisting of (i) 35,000,000 shares of Common Stock, par value $.01 per share (the "PSI COMMON STOCK"), 7,327,627 shares of which are issued and outstanding on the date of this Agreement, (ii) 10,500,000 shares of Series A preferred stock, $.01 par value per share (the "PSI SERIES A PREFERRED STOCK") of which 10,497,000 shares are issued and outstanding on the date of this Agreement, and (iii) 8,000,000 shares of Series B preferred stock $.01 par value per share (the "PSI SERIES B PREFERRED STOCK") of which 4,975,736 shares are issued and outstanding on the date of this Agreement. As of the date of this Agreement, there are outstanding warrants to purchase 1,341,028 shares of PSI Series B Preferred Stock and 180,379 shares of PSI Common Stock, of which warrants to purchase 928,308 shares of PSI Series B Preferred Stock will be exercised prior to the Effective Time (the "EXERCISED WARRANTS"), warrants to purchase 382,720 shares of PSI Series B Preferred Stock will be canceled prior to the Effective Time (the "CANCELED WARRANTS"), and warrants to purchase 30,000 shares of PSI Series B Preferred Stock will remain outstanding at the Effective Time. There are no other outstanding shares of capital stock or voting securities and no outstanding commitments to issue any shares of capital stock or voting securities, other than as set forth in this Section 2.2. Attached to or as set forth in Schedule 2.2 to the PSI Disclosure Schedule is a true and correct list of PSI's stockholders and any persons with rights to acquire PSI securities, which list will be promptly updated from time to time prior to Closing to reflect any changes thereto (which changes are in any event subject to the restrictions imposed under Section 5.9). All outstanding shares of PSI Capital Stock are duly authorized, validly issued, fully paid and nonassessable and are free of any liens or encumbrances other than any liens or encumbrances created by or imposed upon the holders thereof, and are not subject to preemptive rights or rights of first refusal created by statute, the Certificate of Incorporation or Bylaws of PSI or any agreement to which PSI is a party or by which it is bound. PSI has reserved (i) sufficient shares of PSI Common Stock for issuance upon conversion of the PSI Preferred Stock, and (ii) 3,373,313 shares of PSI Common Stock for issuance to employees and consultants pursuant to the PSI Stock Plan, of which 709,886 shares have been issued pursuant to option exercises or direct stock purchases, 2,166,749 shares are subject to outstanding, unexercised options, and 496,678 shares are available for issuance thereunder. PSI has outstanding subordinated notes with an aggregate principal amount of $3,600,000 which are convertible into PSI Series B Preferred Stock (the "CONVERTIBLE NOTES"). A-67 Except for (i) the rights created pursuant to this Agreement, (ii) PSI's right to repurchase any unvested shares under the PSI Stock Plan, (iii) outstanding warrants to purchase 1,341,028 shares of PSI Series B Preferred Stock and 180,379 shares of PSI Common Stock, and (iv) the Convertible Notes, there are no other options, warrants, calls, rights, commitments or agreements of any character to which PSI is a party or by which it is bound obligating PSI to issue, deliver, sell, repurchase or redeem, or cause to be issued, delivered, sold, repurchased or redeemed, any shares of capital stock of PSI or obligating PSI to grant, extend, accelerate the vesting of, change the price of, or otherwise amend or enter into any such option, warrant, call, right, commitment or agreement. Except for the agreements contemplated by this Agreement, there are no contracts, commitments or agreements relating to voting, purchase or sale of PSI's capital stock (i) between or among PSI and any of its securityholders and (ii) to PSI's knowledge, between or among any of PSI's securityholders. The terms of the PSI Stock Plan and the applicable stock option agreements permit the assumption or substitution of options to purchase PMR Common Stock as provided in this Agreement, without the consent or approval of the holders of such securities, the PSI stockholders, or otherwise. None of the outstanding options permit any accelerated vesting or exercisability of those options by reason of the Merger or any other transactions contemplated by this Agreement. True and complete copies of all agreements and instruments relating to or issued under the PSI Stock Plan have been provided to PMR and such agreements and instruments have not been amended, modified or supplemented, and there are no agreements to amend, modify or supplement such agreements or instruments in any case from the form provided to PMR. All outstanding shares of PSI Common Stock and PSI Preferred Stock were issued in compliance with all applicable federal and state securities laws." 2.8. Amendment to Section 3.30. Section 3.30 of the Merger Agreement is hereby amended so as to read in its entirety as follows: "3.30 Vote Required. The affirmative vote of the holders of at least a majority of the PMR Common Stock outstanding on the record date set for the PMR Meeting is the only vote of the holders of any of PMR's Common Stock necessary to approve (a) an amendment to PMR's Certificate of Incorporation to (i) increase in the number of shares of PMR Common Stock authorized to be issued by PMR, (ii) effectuate a "reverse stock split" pursuant to which each outstanding share of PMR Common Stock would be converted into four-tenths of a share of PMR Common Stock (the "REVERSE STOCK SPLIT"), and (iii) change the name of PMR to "Psychiatric Solutions, Inc.", and (b) the issuance of PMR Common Stock pursuant to the Merger, and no other vote of the holders of PMR Common Stock is necessary to approve either this Agreement or the transactions contemplated hereby." 2.9. Amendment to Section 5.3. Section 5.3 of the Merger Agreement is hereby amended so as to read in its entirety as follows: "5.3 Stockholders' Meetings. PSI shall collect proxies and/or call and hold a meeting of its stockholders (together, the "PSI MEETING") and PMR shall call and hold a meeting of its stockholders (the "PMR MEETING" and, together with PSI Meeting, the "STOCKHOLDERS' MEETINGS") as promptly as practicable for the purpose of obtaining the PSI Stockholder Approval (as defined in Section 6.1) and the PMR Stockholder Approval (as defined in Section 6.1), and PMR and PSI shall use their best efforts to hold the Stockholders' Meetings on the same day and as soon as practicable after the date on which the Registration Statement becomes effective." 2.10. Amendment to Section 6.1(c). Section 6.1(c) of the Merger Agreement is hereby amended so as to read in its entirety as follows: "(c) PMR Stockholder Approval. This Agreement, the Merger, and an amendment to PMR's Certificate of Incorporation for the purpose of (i) authorizing a sufficient number of additional shares of PMR Common Stock to provide for the issuance of the Merger Consideration, (ii) effecting the Reverse Stock Split, and (iii) changing the name of PMR to "Psychiatric Solutions, Inc.", shall have been approved and adopted by the requisite vote of the PMR stockholders ("PMR STOCKHOLDER APPROVAL")." A-68 3. No Other Changes/Promises. Except as specifically set forth in this Amendment, the terms and provisions of the Merger Agreement shall remain unmodified and the Merger Agreement is hereby confirmed by the parties as being in full force and effect as amended herein. This Amendment and the Merger Agreement constitute the entire understanding of the parties with respect to the subject matter thereof, and no other covenants have been made by either party to the to the other. 4. Counterparts. This Amendment may be executed in one or more counterparts, all of which shall be considered one and the same agreement and shall become effective when one or more counterparts have been signed by each of the parties and delivered to the other parties, it being understood that all parties need not sign the same counterpart. * * * [SIGNATURE PAGE FOLLOWS] A-69 IN WITNESS WHEREOF, PMR, Merger Sub and PSI have caused this Amendment No. 1 to Agreement and Plan of Merger to be executed and delivered by their respective officers thereunto duly authorized, all as of the date first written above. PMR: PMR CORPORATION By: /s/ FRED D. FURMAN ------------------------------------ Name: Fred D. Furman Title: President & General Counsel MERGER SUB: PMR ACQUISITION CORPORATION By: /s/ FRED D. FURMAN ------------------------------------ Name: Fred D. Furman Title: President & Secretary PSI: PSYCHIATRIC SOLUTIONS, INC. By: /s/ JOEY A. JACOBS ------------------------------------ Name: Joey A. Jacobs Title: President & Chief Executive Officer A-70 AMENDMENT NO. 2 TO AGREEMENT AND PLAN OF MERGER This Amendment No. 2 to Agreement and Plan of Merger (this "AMENDMENT") is made and entered into as of July 9, 2002 by and among PMR Corporation, a Delaware corporation ("PMR"), PMR Acquisition Corporation, a Delaware corporation and a wholly-owned subsidiary of PMR ("MERGER SUB"), and Psychiatric Solutions, Inc., a Delaware corporation ("PSI"). WHEREAS, PMR, Merger Sub, and PSI are parties to that certain Agreement and Plan of Merger dated as of May 6, 2002 (the "MERGER AGREEMENT"); WHEREAS, PMR, Merger Sub, and PSI amended the Merger Agreement pursuant to Amendment No. 1 dated as of June 10, 2002 (the "FIRST AMENDMENT"); WHEREAS, Section 7.3 of the Merger Agreement permits the Merger Agreement to be amended by a signed, written instrument upon action taken by or on behalf of the respective Boards of Directors of the parties thereto at any time prior to the Effective Time; and WHEREAS, PMR, Merger Sub, and PSI now desire to further amend the Merger Agreement, as previously amended. NOW, THEREFORE, for and in consideration of the premises and the mutual benefits to the parties arising out of this Amendment, the receipt and sufficiency of which are hereby acknowledged by the parties' execution and delivery hereof, the parties hereto agree as follows: 1. Definitions. Capitalized terms not defined in this Amendment shall have the meanings ascribed thereto in the Merger Agreement or the First Amendment. 2. Amendments to the Merger Agreement. 2.1. Amendment to Section 1.7(b). Section 1.7(b) of the Merger Agreement is hereby amended so as to read in its entirety as follows: "(b) Conversion of PSI Capital Stock. (i) Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each share of common stock, par value $0.01 per share, of PSI (the "PSI COMMON STOCK") issued and outstanding immediately prior to the Effective Time (other than shares to be canceled in accordance with Section 1.7(e)) shall be converted into the right to receive 0.115125 shares of fully paid and nonassessable shares of PMR Common Stock. (ii) Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each issued and outstanding share of PSI's Series A Preferred Stock ("PSI SERIES A PREFERRED STOCK") shall be converted into the right to receive 0.246951 shares of fully paid and nonassessable shares of PMR Common Stock. Subject to Sections 1.7(c), 1.7(d), 1.7(e), 1.7(f) and 1.8(d), each issued and outstanding share of PSI's Series B Preferred Stock ("PSI SERIES B PREFERRED STOCK") shall be converted into the right to receive 0.312864 shares of fully paid and nonassessable shares of PMR Common Stock. The PSI Series A Preferred Stock and the PSI Series B Preferred Stock may be referred to collectively as "PSI PREFERRED STOCK." (iii) The shares of PMR Common Stock into which the shares of PSI Capital Stock are converted into the right to receive pursuant to the Merger are referred to herein collectively as the "MERGER CONSIDERATION." At the Effective Time, all such shares of PSI Capital Stock shall no longer be outstanding and shall automatically be canceled and shall cease to exist, and each holder of a certificate or certificates that immediately prior the Effective Time represented any such shares (a "CERTIFICATE" or "CERTIFICATES") shall cease to have any rights with respect thereto, except the right to receive the Merger Consideration with respect thereto and any cash in lieu of fractional shares of PMR Common Stock to be issued in consideration therefor upon surrender of such Certificate in accordance with Section 1.8. Each share of PSI Common Stock or PSI A-71 Preferred Stock issued and outstanding immediately prior to the Effective Time that is restricted or not fully vested shall upon such conversion and exchange have the same restrictions or vesting arrangements applicable to such shares prior to the conversion." 2.2. Amendment to Section 1.7(c). Section 1.7(c) of the Merger Agreement is hereby amended so as to read in its entirety as follows: "(c) Anti-Dilution Provisions. In the event that the capitalization of PMR (as set forth in Section 3.2) changes prior to the Effective Time (other than changes resulting from the Reverse Stock Split) or in the event that the capitalization of PSI (as set forth in Section 2.2) changes prior to the Effective Time, the exchange ratios set forth in Sections 1.7(a) and 1.7(b) shall be appropriately adjusted to reflect such changes in the capitalization of PSI or PMR, or both, as the case may be; provided, however, that in the event that (i) there are no changes to the capitalization of PMR (as set forth in Section 3.2) prior to the Effective Time (other than resulting from the Reverse Stock Split) and (ii) PSI issues, or agrees to issue, any additional shares of PSI Common Stock or any option, warrant or other security exercisable for, exchangeable for or convertible into, directly or indirectly, any shares of PSI Common Stock prior to the Effective Time, then the exchange ratios set forth in Section 1.7(a) and Section 1.7(b) shall be adjusted in a manner that provides for (1) the issuance of an aggregate of 2,557,170 shares of PMR Common Stock to the holders of PSI Preferred Stock (allocated between the holders of the PSI Series A Preferred Stock and PSI Series B Preferred Stock in the same proportions as set forth in Section 1.7(b)), and (2) the issuance of an aggregate of 3,750,249 shares of PMR Stock allocated among the holders of shares of PSI Common Stock, holders of shares of PSI Preferred Stock and the holders of options, warrants and other securities, or contractual rights exercisable for, exchangeable for or convertible into, directly or indirectly, shares of PSI Common Stock (other than the Cancelled Warrants and the Convertible Notes) upon the exercise, exchange or conversion thereof, with such allocation to be made on a pro rata basis in relation to the fully diluted capitalization of PSI immediately prior to the Effective Time, assuming that all shares of PSI Preferred Stock and all options, warrants and such other securities, other than the Cancelled Warrants and the Convertible Notes, are exercised, exchanged or converted into shares of PSI Common Stock immediately prior to the Effective Time." 2.3 Amendment to Section 1.7. A new Section 1.7(h) is hereby added to the Merger Agreement which shall read in its entirety as follows: "(h) 1818 Fund Warrants. At the Effective Time, all obligations relating to the warrants (the "1818 FUND WARRANTS") as required under the 1818 Fund Securities Purchase Agreement (as defined in Section 2.2(a)) (whether such 1818 Fund Warrants are then or thereafter issued and including, without limitation, the obligation to issue additional warrants on the terms set forth in the 1818 Fund Securities Purchase Agreement) shall be assumed by PMR such that each holder of an 1818 Fund Warrant shall thereafter have the right to exercise such Warrant for the number of shares of PMR Common Stock as provided in such 1818 Fund Warrant." 2.4 Amendment to Section 2.2(a). Section 2.2(a) of the Merger Agreement is hereby amended so as to read in its entirety as follows: "(a) The authorized capital stock of PSI immediately prior to the Effective Time consists of 53,500,000 shares of capital stock, consisting of (i) 35,000,000 shares of Common Stock, par value $.01 per share (the "PSI COMMON STOCK"), 7,327,627 shares of which are issued and outstanding on the date of this Agreement, (ii) 10,500,000 shares of Series A preferred stock, $.01 par value per share (the "PSI SERIES A PREFERRED STOCK") of which 10,497,000 shares are issued and outstanding on the date of this Agreement, and (iii) 8,000,000 shares of Series B preferred stock $.01 par value per share (the "PSI SERIES B PREFERRED STOCK") of which 4,975,736 shares are issued and outstanding on the date of this Agreement. As of the date of this Agreement, there are outstanding warrants to purchase 1,341,028 shares of PSI Series B Preferred Stock and 180,379 shares of PSI Common Stock, of which warrants to purchase 928,308 shares of PSI Series B Preferred Stock will be exercised prior to the Effective Time (the "EXERCISED WARRANTS"), warrants to purchase 382,720 A-72 shares of PSI Series B Preferred Stock will be canceled prior to the Effective Time (the "CANCELED WARRANTS"), and warrants to purchase 30,000 shares of PSI Series B Preferred Stock will remain outstanding at the Effective Time. As of the date of this Agreement there are also outstanding warrants to purchase 1,502,140 shares of PSI Common Stock that have been issued pursuant to, and have the terms specified in Exhibit B attached to the Securities Purchase Agreement (the "1818 FUND SECURITIES PURCHASE AGREEMENT"), dated June 28, 2002, between PSI and the 1818 Mezzanine Fund II, L.P. (the "1818 FUND"), a copy of which has been provided to PMR, and that will remain outstanding and as of the Effective Time will become exercisable into 372,412 shares of PMR Common Stock. In addition, PSI has an obligation to issue additional warrants to purchase up to an additional 1,502,140 shares of PSI Common Stock upon the occurrence of certain events, which additional warrants, if issued, will have the terms specified in Exhibit B to the 1818 Fund Securities Purchase Agreement and will become exercisable into up to 372,412 shares of PMR Common Stock. There are no other outstanding shares of capital stock or voting securities and no outstanding commitments to issue any shares of capital stock or voting securities, other than as set forth in this Section 2.2. Attached to or as set forth in Schedule 2.2 to the PSI Disclosure Schedule is a true and correct list of PSI's stockholders and any persons with rights to acquire PSI securities, which list will be promptly updated from time to time prior to Closing to reflect any changes thereto (which changes are in any event subject to the restrictions imposed under Section 5.9). All outstanding shares of PSI Capital Stock are duly authorized, validly issued, fully paid and nonassessable and are free of any liens or encumbrances other than any liens or encumbrances created by or imposed upon the holders thereof, and are not subject to preemptive rights or rights of first refusal created by statute, the Certificate of Incorporation or Bylaws of PSI or any agreement to which PSI is a party or by which it is bound. PSI has reserved (i) sufficient shares of PSI Common Stock for issuance upon conversion of the PSI Preferred Stock, and (ii) 3,373,313 shares of PSI Common Stock for issuance to employees and consultants pursuant to the PSI Stock Plan, of which 709,886 shares have been issued pursuant to option exercises or direct stock purchases, 2,166,749 shares are subject to outstanding, unexercised options, and 496,678 shares are available for issuance thereunder. PSI has outstanding subordinated notes with an aggregate principal amount of $3,600,000 which are convertible into PSI Series B Preferred Stock (the "CONVERTIBLE NOTES"). Except for (i) the rights created pursuant to this Agreement, (ii) PSI's right to repurchase any unvested shares under the PSI Stock Plan, (iii) outstanding warrants to purchase 1,341,028 shares of PSI Series B Preferred Stock and 180,379 shares of PSI Common Stock, (iv) the outstanding warrants to purchase 1,502,140 shares of PSI Common Stock and the obligation to issue additional warrants to purchase up to an additional 1,502,140 shares of PSI Common Stock upon the occurrence of certain events, and (v) the Convertible Notes, there are no other options, warrants, calls, rights, commitments or agreements of any character to which PSI is a party or by which it is bound obligating PSI to issue, deliver, sell, repurchase or redeem, or cause to be issued, delivered, sold, repurchased or redeemed, any shares of capital stock of PSI or obligating PSI to grant, extend, accelerate the vesting of, change the price of, or otherwise amend or enter into any such option, warrant, call, right, commitment or agreement. Except for the agreements contemplated by this Agreement, there are no contracts, commitments or agreements relating to voting, purchase or sale of PSI's capital stock (i) between or among PSI and any of its securityholders and (ii) to PSI's knowledge, between or among any of PSI's securityholders. The terms of the PSI Stock Plan and the applicable stock option agreements permit the assumption or substitution of options to purchase PMR Common Stock as provided in this Agreement, without the consent or approval of the holders of such securities, the PSI stockholders, or otherwise. None of the outstanding options permit any accelerated vesting or exercisability of those options by reason of the Merger or any other transactions contemplated by this Agreement. True and complete copies of all agreements and instruments relating to or issued under the PSI Stock Plan have been provided to PMR and such agreements and instruments have not been amended, modified or supplemented, and there are no agreements to amend, modify or supplement such agreements or instruments in any case from the form provided to PMR. All outstanding shares of PSI Common Stock and PSI Preferred Stock were issued in compliance with all applicable federal and state securities laws." A-73 2.5 Amendment to Section 3.30. Section 3.30 of the Merger Agreement is hereby amended so as to read in its entirety as follows: "3.30 Vote Required. The affirmative vote of the holders of at least a majority of the PMR Common Stock outstanding on the record date set for the PMR Meeting is the only vote of the holders of any of PMR's Common Stock necessary to approve (a) an amendment to PMR's Certificate of Incorporation to (i) increase in the number of shares of PMR Common Stock authorized to be issued by PMR, (ii) effectuate a "reverse stock split" pursuant to which each outstanding share of PMR Common Stock would be converted into one-third of a share of PMR Common Stock (the "REVERSE STOCK SPLIT"), and (iii) change the name of PMR to "Psychiatric Solutions, Inc.", and (b) the issuance of PMR Common Stock pursuant to the Merger, and no other vote of the holders of PMR Common Stock is necessary to approve either this Agreement or the transactions contemplated hereby." 2.6 Amendment to Article V. A new Section 5.18 is hereby added to Article V of the Merger Agreement which shall read in its entirety as follows: "5.17 PMR Guarantee. Concurrently with the Effective Time, PMR shall execute and deliver to PSI and 1818 Fund a guarantee of the obligations of PSI to the 1818 Fund under the 1818 Fund Securities Purchase Agreement, which PMR Guarantee shall be in substantially the form attached to the 1818 Fund Securities Purchase Agreement." 3. No Other Changes/Promises. Except as specifically set forth in this Amendment, the terms and provisions of the Merger Agreement shall remain unmodified and the Merger Agreement is hereby confirmed by the parties as being in full force and effect as amended herein. This Amendment and the Merger Agreement constitute the entire understanding of the parties with respect to the subject matter thereof, and no other covenants have been made by either party to the to the other. 4. Counterparts. This Amendment may be executed in one or more counterparts, all of which shall be considered one and the same agreement and shall become effective when one or more counterparts have been signed by each of the parties and delivered to the other parties, it being understood that all parties need not sign the same counterpart. * * * [SIGNATURE PAGE FOLLOWS] A-74 IN WITNESS WHEREOF, PMR, Merger Sub and PSI have caused this Amendment No. 2 to Agreement and Plan of Merger to be executed and delivered by their respective officers thereunto duly authorized, all as of the date first written above. PMR: PMR CORPORATION By: /s/ FRED D. FURMAN ------------------------------------ Name: Fred D. Furman Title: President & General Counsel MERGER SUB: PMR ACQUISITION CORPORATION By: /s/ FRED D. FURMAN ------------------------------------ Name: Fred D. Furman Title: President & Secretary PSI: PSYCHIATRIC SOLUTIONS, INC. By: /s/ JOEY A. JACOBS ------------------------------------ Name: Joey A. Jacobs Title: President & Chief Executive Officer A-75 ANNEX B AMENDMENT TO PMR AMENDED AND RESTATED CERTIFICATE OF INCORPORATION CERTIFICATE OF AMENDMENT TO AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF PMR CORPORATION (Incorporated on January 8, 1988) (Pursuant to Section 242 of the General Corporation Law of the State of Delaware) - -------------------------------------------------------------------------------- PMR Corporation, a corporation organized and existing under and by virtue of the General Corporation Law of the State of Delaware (the "Corporation"), hereby certifies: FIRST: The name of the Corporation is PMR Corporation. SECOND: The Amended and Restated Certificate of Incorporation of the Corporation was filed with the Secretary of State of the State of Delaware on March 9, 1998. THIRD: The Amended and Restated Certificate of the Corporation is hereby amended so that ARTICLE I reads in its entirety as follows: "The name of this Corporation is Psychiatric Solutions, Inc." FOURTH: The Amended and Restated Certificate of the Corporation is hereby amended so that ARTICLE V reads in its entirety as follows: "A. This Corporation is authorized to issue two classes of shares to be designated, respectively, "Common Stock" and "Preferred Stock." All of said shares shall be one cent ($0.01) par value each. The total number of shares of stock that the Corporation is authorized to issue is Fifty Million (50,000,000), of which Forty-Eight Million (48,000,000) shares shall be Common Stock, each having a par value of one cent ($0.01) per share, and Two Million (2,000,000) shares shall be Preferred Stock, each having a par value of one cent ($0.01) per share. B. The Preferred Stock may be issued from time to time in one or more series. The Board of Directors is hereby authorized, by filing a certificate (a "Preferred Stock Designation") pursuant to the Delaware General Corporation Law, to fix or alter from time to time the designation, powers, preferences and rights of the shares of each such series and the qualifications, limitations or restrictions of any wholly unissued series of Preferred Stock, and to establish from time to time the number of share constituting any such series or any of them; and to increase or decrease the number of shares of any series subsequent to the issuance of shares of that series, but not below the number of shares of such series then outstanding. In case the number of shares of any series shall be decreased in accordance with the foregoing sentence, the shares constituting such decrease shall resume the status that they had prior to the adoption of the resolution originally fixing the number of shares of such series. C. The Corporation may purchase, directly or indirectly, its own shares to the extent that may be allowed by law. B-1 D. Effective immediately upon filing of this Certificate of Amendment with the Secretary of State of the State of Delaware (the "Effective Time"), each share of Common Stock, par value $0.01 per share (the "Old Common Stock"), issued and outstanding immediately prior to such Effective Time shall, without any action on the part of the holder thereof, be converted and reclassified into, and immediately represent, one-third of one validly issued, fully paid and non-assessable share of Common Stock, par value $0.01 per share. Notwithstanding the foregoing, no fraction of a share of Common Stock shall be issued by virtue of such conversion and reclassification, and any fraction of a share of Common Stock that would otherwise result pursuant to the preceding sentence (after aggregating all fractional shares to be received by such stockholder) shall automatically be rounded down to the nearest whole share. Each certificate representing shares of Old Common Stock shall thereafter represent that number of shares of Common Stock determined in accordance with the previous sentences; provided, however, that each person holding of record a stock certificate or certificates representing shares of Old Common Stock shall receive, upon surrender of such certificate or certificates, a new certificate or certificates evidencing and representing the number of shares of Common Stock to which such person is entitled. In addition, any options to acquire shares of Common Stock (each, an "Option") outstanding immediately prior to the Effective Time shall, without any action on the part of the holder thereof or the Corporation, be adjusted as follows: (i) the number of shares of Common Stock subject to such Option shall be divided by 3 (rounded down to the nearest whole share); and (ii) the per share exercise price set forth in such Option shall be multiplied by 3, subject to appropriate reduction on account of any fractions not issued as a result of rounding down; provided, however, that the foregoing adjustments shall not apply if the plan under which a particular Option was granted provides for adjustments similar to the foregoing. The provisions of this Paragraph D shall not change the par value of the Common Stock as set forth in Article V, Paragraph A hereof." FIFTH: The above amendments to the Restated Certificate of Incorporation of the Corporation were duly adopted by the unanimous approval of the Board of Directors of the Corporation and have been duly approved by the stockholders of the Corporation in accordance with the provisions of Section 242 of the General Corporation Law of the State of Delaware and the Restated Certificate of Incorporation of the Corporation, or otherwise. * * * IN WITNESS WHEREOF, the undersigned has executed this Certificate this day of , 2002. PMR CORPORATION By: ------------------------------------ Fred Furman President and General Counsel B-2 ANNEX C OPINION OF RAYMOND JAMES & ASSOCIATES, INC. April 29, 2002 Board of Directors PMR Corporation 1565 Hotel Circle South Second Floor San Diego, California 92108 Members of the Board: You have requested our opinion as to the fairness, from a financial point of view, to the shareholders of the outstanding common stock, par value $0.01 per share (the "Common Stock") of PMR Corporation (the "Company") of the issuance of Common Stock, representing approximately 72.0% of the fully-diluted shares of the Company on a post-merger basis, to the shareholders of Psychiatric Solutions, Inc. ("Psychiatric Solutions") (the "Transaction Consideration") in connection with the proposed merger (the "Merger") of Psychiatric Solutions with a subsidiary of the Company pursuant and subject to the draft Agreement and Plan of Merger between the Company, PMR Acquisition Corporation and Psychiatric Solutions dated as of April 29, 2002 (the "Agreement") after taking into account an assumed approximate $14.3 million one-time special dividend (the "Liquidating Dividend") to be distributed to shareholders of the Company prior to the closing of the Merger. In connection with our review of the proposed Merger and the preparation of our opinion, we have, among other things: 1. reviewed the financial terms and conditions as stated in the draft Agreement; 2. reviewed the audited financial statements of the Company as of and for the years ended April 30, 2001 and 2000 and the audited financial statements of Psychiatric Solutions as of and for the years ended December 31, 2001 and 2000; 3. reviewed the Company's Annual Reports filed on Form 10-K for the year ending April 30, 2001 and the Company's Quarterly Reports filed on 10-Q for the quarters ended July 30, 2001, October 31, 2001, and January 31, 2002; 4. reviewed other financial and operating information, including projections, requested from and/or provided by the Company and Psychiatric Solutions; 5. reviewed certain other publicly available information on the Company; and 6. discussed with members of the senior management of the Company and Psychiatric Solutions certain information relating to the aforementioned and any other matters which we have deemed relevant to our inquiry. We have assumed and relied upon the accuracy and completeness of all information supplied or otherwise made available to us by the Company, Psychiatric Solutions, or any other party and have not attempted to verify independently any of such information. We have not made or obtained an independent appraisal of the assets or liabilities (contingent or otherwise) of the Company or Psychiatric Solutions. With respect to financial projections and other information and data provided to or otherwise reviewed by or discussed with us, we have assumed that such projections and other information and data have been reasonably prepared in good faith on bases reflecting the best currently available estimates and judgments of management, and we have relied upon each party to advise us promptly if any information previously provided became inaccurate or was required to be updated during the period of our review. Under the terms of the Merger, PMR and Psychiatric Solutions intend to adopt a plan of reorganization within the meaning of Section 354(a)(1) of the Internal Revenue Code of 1986, as amended (the "Code"), and to cause the Merger to qualify as a reorganization under the provisions of Section 368(a) of the Code. C-1 Our opinion is based upon market, economic, financial and other circumstances and conditions existing and disclosed to us as of April 29, 2002 and any material change in such circumstances and conditions would require a reevaluation of this opinion, which we are under no obligation to undertake. We express no opinion as to the underlying business decision to effect the Merger, the structure or tax consequences of the Agreement, or the availability or advisability of any alternatives to the Merger. This letter does not express any opinion as to the likely trading range of the Company's common stock following the Merger, which may vary depending on numerous factors that generally impact the price of securities or on the financial condition of the Company at that time. Our opinion is limited to the fairness, from a financial point of view, of the Transaction Consideration to the shareholders of the Company. We express no opinion with respect to any other reasons, legal, business, or otherwise, that may support the decision of the Board of Directors to approve or consummate the Merger. In conducting our investigation and analyses and in arriving at our opinion, we have taken into account such accepted financial and investment banking procedures and considerations as we have deemed relevant, including the review of (i) historical and projected revenues, operating earnings, net income, and capitalization of the Company and of Psychiatric Solutions and certain other publicly-held companies in businesses we believe to be comparable to the Company and to Psychiatric Solutions; (ii) the current and projected financial position and results of operations of the Company and Psychiatric Solutions; (iii) the historical market prices and trading activity of the Common Stock of the Company; (iv) financial and operating information concerning selected business combinations which we deemed comparable in whole or in part; and (v) the general condition of the securities markets. In arriving at this opinion, Raymond James & Associates, Inc. ("Raymond James") did not attribute any particular weight to any analysis or factor considered by it, but rather made qualitative judgments as to the significance and relevance of each analysis and factor. Accordingly, Raymond James believes that its analyses must be considered as a whole and that selecting portions of its analyses, without considering all analyses, would create an incomplete view of the process underlying this opinion. Raymond James is actively engaged in the health care investment banking business and regularly undertakes the valuation of investment securities in connection with public offerings, private placements, business combinations, and similar transactions. Raymond James has been engaged to render financial advisory services to the Company in connection with the proposed Merger and will receive a fee for such services, which fee is contingent upon consummation of the Merger. Raymond James will also receive a fee upon the delivery of this opinion. In addition, the Company has agreed to indemnify us against certain liabilities arising out of our engagement. In the ordinary course of our business, Raymond James may trade in the securities of the Company for our own account or for the accounts of our customers and, accordingly, may at any time hold a long or short position in such securities. It is understood that this letter is for the information of the Board of Directors of the Company in evaluating the proposed Merger and does not constitute a recommendation to any shareholder of the Company regarding how said shareholder should vote on the proposed Merger. The Company may include the full text of this letter in any proxy statement or offering memorandum prepared by the Company in connection with and describing the Merger. Except for such uses, this opinion is not to be quoted or referred to, in whole or in part, without our prior written consent, which will not be unreasonably withheld. Based upon and subject to the foregoing, it is our opinion that, as of April 29, 2002, the Transaction Consideration is fair, from a financial point of view, to the holders of the Company's outstanding Common Stock. Very truly yours, /s/ Raymond James & Associates, Inc. RAYMOND JAMES & ASSOCIATES, INC. C-2 ANNEX D OPINION OF BRENTWOOD CAPITAL ADVISORS LLC April 30, 2002 Board of Directors Psychiatric Solutions, Inc. 113 Seaboard Lane, Suite C-100 Franklin, TN 37067 Ladies and Gentlemen: PMR Corporation, a Delaware corporation ("Acquiror"), and Psychiatric Solutions, Inc., a Delaware corporation ("Target"), are contemplating a transaction pursuant to which Target will be merged with a wholly-owned subsidiary of Acquiror with Target as the surviving corporation (the "Transaction"). The terms of the Transaction are set forth in an Agreement and Plan of Merger, as amended, between Acquiror, Target and PMR Acquisition Corporation, a Delaware corporation (the "Agreement"). You have requested our opinion as to the fairness, from a financial point of view, of (i) the aggregate Merger Consideration to the stockholders of Target and (ii) the Merger Consideration to be received by the holders of common stock, par value $.01 per share (the "Common Stock"), of Target relative to the consideration to be received by the holders of Series A preferred stock, par value $.01 per share (the "Series A Preferred"), of Target and Series B preferred stock, par value $.01 per share (the "Series B Preferred"), of Target. The Series A Preferred and the Series B Preferred are collectively referred to herein as the "Preferred Stock." The Agreement provides for, among other things, (i) each share of Common Stock to be converted into the right to receive 0.115125 shares of common stock, par value $.01 per share, of Acquiror (the "PMR Common Stock"), (ii) each share of Series A Preferred to be converted into the right to receive 0.246951 shares of PMR Common Stock and (iii) each share of Series B Preferred and bridge loan warrants to be converted into the right to receive 0.312864 shares of PMR Common Stock. Capitalized terms used but not defined herein have the meanings ascribed to those terms in the Agreement. Brentwood Capital Advisors LLC, as part of its investment banking business, engages in the valuation of businesses and securities in connection with mergers and acquisitions, private placements, and valuations for estate, corporate, and other purposes. We have been engaged by the Board of Directors of Target to render this opinion in connection with the Transaction and have received and will receive a fee from Target for our services. We have acted as an investment banker to Target with respect to a potential private placement of subordinated debt securities and have received and are entitled to receive an advisory fee each month until consummation of the private placement or termination of our engagement as well as a fee equal to 2.5% of the total principal amount of the debt securities, less any advisory fees paid. We will receive a fee upon delivery of this opinion and upon the closing of the Transaction. In conducting our analysis and arriving at our opinion, we have considered such financial and other information as we deemed appropriate including, among other things, the following: the Agreement, certain historical and current financial information with respect to Target and Acquiror, certain projected financial information of Acquiror and Target, certain historical financial information and other information with respect to other companies in the unit management and behavioral healthcare industries and certain historical price and volume trading information with respect to PMR Common Stock. We also have held discussions with members of the senior management of Target regarding the strategic rationale for, and the potential benefits of, the transactions contemplated by the Agreement and the past and current business operations, financial condition, and future prospects of Acquiror and Target, respectively. As part of such discussions, we have been advised by management of Target that the Transaction significantly advances the Target's overall strategic and operational goals in the unit management and behavioral healthcare industries. We have taken into account our assessment of general economic, market, and financial and other conditions and our experience in other transactions, as well as our experience in securities valuation and D-1 our knowledge of the industries in which Acquiror and Target operate generally. Our opinion is necessarily based on the information made available to us and conditions as they exist and can be evaluated as of the date hereof. We have relied upon the accuracy and completeness of all of the financial and other information reviewed by us for purposes of our opinion and have not assumed any responsibility for, nor undertaken an independent verification of, such information. With respect to the internal operating data and financial analyses and forecasts supplied to us (including forecasts of estimated cost savings as a result of the Transaction), we have assumed that such data, analyses and forecasts were reasonably prepared on bases reflecting the best currently available estimates and judgments of Acquiror's and Target's senior management as to the recent and likely future performance of Acquiror and Target, respectively. Accordingly, we express no opinion with respect to such analyses of forecasts or the assumptions on which they are based. We have assumed that the Transaction will be consummated in accordance with the terms set forth in the Agreement, including, among other things, that the Transaction will qualify as a reorganization under the provisions of Section 368(a) of the Internal Revenue Code of 1986, as amended, and that the other conditions to consummation of the Transaction set forth in the Agreement will be met. In addition, we have assumed that 412,700 warrants to purchase Series B Preferred with an exercise price of $1.50 per share will be cancelled. We have also assumed that without the payment of a liquidation preference valued at $1.00 per share and $1.50 per share for the holders of Series A Preferred and Series B Preferred, respectively, such holders would not vote in favor of the Transaction. We were not asked to consider and our opinion does not address the relative merits of the Transaction as compared to any alternative business strategies that might exist for Target or the effect of any other transactions in which Target might engage. Furthermore, we have not made an independent evaluation or appraisal of the assets or liabilities of Acquiror or Target or any of their subsidiaries or affiliates and have not been furnished with any such evaluation or appraisal. In arriving at our opinion, we were not authorized to solicit, and did not solicit, interest from any party with respect to the acquisition of Target. Target is entitled to reproduce this opinion, in whole but not in part, in the proxy statement/prospectus as required by applicable law or where otherwise appropriate; provided, however, that any excerpt or reference to this opinion (including any summary thereof) in such document must be approved by us in advance in writing. Notwithstanding the foregoing, this opinion does not constitute a recommendation to any holder of Target Preferred Stock or Common Stock to vote in favor of the Transaction. We were engaged by the Board of Directors of Target to render this opinion in connection with the Board's discharge of its fiduciary obligations. We have advised the Board of Directors that we do not believe that any person (including a stockholder of Target) other than the Board of Directors has the legal right to rely upon this opinion for any claim arising under state law and that, should any such claim be brought against us, this assertion will be raised as a defense. In the absence of governing authority, this assertion will be resolved by the final adjudication of such issue by a court of competent jurisdiction. Resolution of this matter under state law, however, will have no effect on the rights and responsibilities of any person under the federal securities laws or on the rights or responsibilities of Target's Board of Directors under applicable state law. Based upon and subject to the foregoing, and based upon such other matters we consider relevant, it is our opinion that, as of the date hereof and based on conditions as they currently exist, (i) the aggregate Merger Consideration is fair, from a financial point of view, to the stockholders of Target and (ii) the Merger Consideration is fair, from a financial point of view, to the holders of Common Stock of Target relative to the Merger Consideration to be received by the holders of Preferred Stock of Target. Very truly yours, /s/ Brentwood Capital Advisors LLC BRENTWOOD CAPITAL ADVISORS LLC D-2 ANNEX E DELAWARE GENERAL CORPORATION LAW SEC. 262 APPRAISAL RIGHTS. (a) Any stockholder of a corporation of this State who holds shares of stock on the date of the making of a demand pursuant to subsection (d) of this section with respect to such shares, who continuously holds such shares through the effective date of the merger or consolidation, who has otherwise complied with subsection (d) of this section and who has neither voted in favor of the merger or consolidation nor consented thereto in writing pursuant to Section 228 of this title shall be entitled to an appraisal by the Court of Chancery of the fair value of the stockholder's shares of stock under the circumstances described in subsections (b) and (c) of this section. As used in this section, the word "stockholder" means a holder of record of stock in a stock corporation and also a member of record of a nonstock corporation; the words "stock" and "share" mean and include what is ordinarily meant by those words and also membership or membership interest of a member of a nonstock corporation; and the words "depository receipt" mean a receipt or other instrument issued by a depository representing an interest in one or more shares, or fractions thereof, solely of stock of a corporation, which stock is deposited with the depository. (b) Appraisal rights shall be available for the shares of any class or series of stock of a constituent corporation in a merger or consolidation to be effected pursuant to Section 251 (other than a merger effected pursuant to Section 251(g) of this title), Section 252, Section 254, Section 257, Section 258, Section 263 or Section 264 of this title: (1) Provided, however, that no appraisal rights under this section shall be available for the shares of any class or series of stock, which stock, or depository receipts in respect thereof, at the record date fixed to determine the stockholders entitled to receive notice of and to vote at the meeting of stockholders to act upon the agreement of merger or consolidation, were either (i) listed on a national securities exchange or designated as a national market system security on an interdealer quotation system by the National Association of Securities Dealers, Inc. or (ii) held of record by more than 2,000 holders; and further provided that no appraisal rights shall be available for any shares of stock of the constituent corporation surviving a merger if the merger did not require for its approval the vote of the stockholders of the surviving corporation as provided in subsection (f) of Section 251 of this title. (2) Notwithstanding paragraph (1) of this subsection, appraisal rights under this section shall be available for the shares of any class or series of stock of a constituent corporation if the holders thereof are required by the terms of an agreement of merger or consolidation pursuant to Sections 251, 252, 254, 257, 258, 263 and 264 of this title to accept for such stock anything except: a. Shares of stock of the corporation surviving or resulting from such merger or consolidation, or depository receipts in respect thereof; b. Shares of stock of any other corporation, or depository receipts in respect thereof, which shares of stock (or depository receipts in respect thereof) or depository receipts at the effective date of the merger or consolidation will be either listed on a national securities exchange or designated as a national market system security on an interdealer quotation system by the National Association of Securities Dealers, Inc. or held of record by more than 2,000 holders; c. Cash in lieu of fractional shares or fractional depository receipts described in the foregoing subparagraphs a. and b. of this paragraph; or d. Any combination of the shares of stock, depository receipts and cash in lieu of fractional shares or fractional depository receipts described in the foregoing subparagraphs a., b. and c. of this paragraph. E-1 (3) In the event all of the stock of a subsidiary Delaware corporation party to a merger effected under Section 253 of this title is not owned by the parent corporation immediately prior to the merger, appraisal rights shall be available for the shares of the subsidiary Delaware corporation. (c) Any corporation may provide in its certificate of incorporation that appraisal rights under this section shall be available for the shares of any class or series of its stock as a result of an amendment to its certificate of incorporation, any merger or consolidation in which the corporation is a constituent corporation or the sale of all or substantially all of the assets of the corporation. If the certificate of incorporation contains such a provision, the procedures of this section, including those set forth in subsections (d) and (e) of this section, shall apply as nearly as is practicable. (d) Appraisal rights shall be perfected as follows: (1) If a proposed merger or consolidation for which appraisal rights are provided under this section is to be submitted for approval at a meeting of stockholders, the corporation, not less than 20 days prior to the meeting, shall notify each of its stockholders who was such on the record date for such meeting with respect to shares for which appraisal rights are available pursuant to subsection (b) or (c) hereof that appraisal rights are available for any or all of the shares of the constituent corporations, and shall include in such notice a copy of this section. Each stockholder electing to demand the appraisal of such stockholder's shares shall deliver to the corporation, before the taking of the vote on the merger or consolidation, a written demand for appraisal of such stockholder's shares. Such demand will be sufficient if it reasonably informs the corporation of the identity of the stockholder and that the stockholder intends thereby to demand the appraisal of such stockholder's shares. A proxy or vote against the merger or consolidation shall not constitute such a demand. A stockholder electing to take such action must do so by a separate written demand as herein provided. Within 10 days after the effective date of such merger or consolidation, the surviving or resulting corporation shall notify each stockholder of each constituent corporation who has complied with this subsection and has not voted in favor of or consented to the merger or consolidation of the date that the merger or consolidation has become effective; or (2) If the merger or consolidation was approved pursuant to Section 228 or Section 253 of this title, then, either a constituent corporation before the effective date of the merger or consolidation; or the surviving or resulting corporation within ten days thereafter, shall notify each of the holders of any class or series of stock of such constituent corporation who are entitled to appraisal rights of the approval of the merger or consolidation and that appraisal rights are available for any or all shares of such class or series of stock of such constituent corporation, and shall include in such notice a copy of this section. Such notice may, and, if given on or after the effective date of the merger or consolidation, shall, also notify such stockholders of the effective date of the merger or consolidation. Any stockholder entitled to appraisal rights may, within 20 days after the date of mailing of such notice, demand in writing from the surviving or resulting corporation the appraisal of such holder's shares. Such demand will be sufficient if it reasonably informs the corporation of the identity of the stockholder and that the stockholder intends thereby to demand the appraisal of such holder's shares. If such notice did not notify stockholders of the effective date of the merger or consolidation, either (i) each such constituent corporation shall send a second notice before the effective date of the merger or consolidation notifying each of the holders of any class or series of stock of such constituent corporation that are entitled to appraisal rights of the effective date of the merger or consolidation or (ii) the surviving or resulting corporation shall send such a second notice to all such holders on or within 10 days after such effective date; provided, however, that if such second notice is sent more than 20 days following the sending of the first notice, such second notice need only be sent to each stockholder who is entitled to appraisal rights and who has demanded appraisal of such holder's shares in accordance with this subsection. An affidavit of the secretary or assistant secretary or of the transfer agent of the corporation that is required to give either notice that such notice has been given shall, in the absence of fraud, be prima facie evidence of the facts stated therein. For purposes of determining the stockholders entitled to receive either notice, each constituent corporation may fix, in advance, a record date that shall be not more than 10 days prior to the date the notice is given, E-2 provided, that if the notice is given on or after the effective date of the merger or consolidation, the record date shall be such effective date. If no record date is fixed and the notice is given prior to the effective date, the record date shall be the close of business on the day next preceding the day on which the notice is given. (e) Within 120 days after the effective date of the merger or consolidation, the surviving or resulting corporation or any stockholder who has complied with subsections (a) and (d) hereof and who is otherwise entitled to appraisal rights, may file a petition in the Court of Chancery demanding a determination of the value of the stock of all such stockholders. Notwithstanding the foregoing, at any time within 60 days after the effective date of the merger or consolidation, any stockholder shall have the right to withdraw such stockholder's demand for appraisal and to accept the terms offered upon the merger or consolidation. Within 120 days after the effective date of the merger or consolidation, any stockholder who has complied with the requirements of subsections (a) and (d) hereof, upon written request, shall be entitled to receive from the corporation surviving the merger or resulting from the consolidation a statement setting forth the aggregate number of shares not voted in favor of the merger or consolidation and with respect to which demands for appraisal have been received and the aggregate number of holders of such shares. Such written statement shall be mailed to the stockholder within 10 days after such stockholder's written request for such a statement is received by the surviving or resulting corporation or within 10 days after expiration of the period for delivery of demands for appraisal under subsection (d) hereof, whichever is later. (f) Upon the filing of any such petition by a stockholder, service of a copy thereof shall be made upon the surviving or resulting corporation, which shall within 20 days after such service file in the office of the Register in Chancery in which the petition was filed a duly verified list containing the names and addresses of all stockholders who have demanded payment for their shares and with whom agreements as to the value of their shares have not been reached by the surviving or resulting corporation. If the petition shall be filed by the surviving or resulting corporation, the petition shall be accompanied by such a duly verified list. The Register in Chancery, if so ordered by the Court, shall give notice of the time and place fixed for the hearing of such petition by registered or certified mail to the surviving or resulting corporation and to the stockholders shown on the list at the addresses therein stated. Such notice shall also be given by 1 or more publications at least 1 week before the day of the hearing, in a newspaper of general circulation published in the City of Wilmington, Delaware or such publication as the Court deems advisable. The forms of the notices by mail and by publication shall be approved by the Court, and the costs thereof shall be borne by the surviving or resulting corporation. (g) At the hearing on such petition, the Court shall determine the stockholders who have complied with this section and who have become entitled to appraisal rights. The Court may require the stockholders who have demanded an appraisal for their shares and who hold stock represented by certificates to submit their certificates of stock to the Register in Chancery for notation thereon of the pendency of the appraisal proceedings; and if any stockholder fails to comply with such direction, the Court may dismiss the proceedings as to such stockholder. (h) After determining the stockholders entitled to an appraisal, the Court shall appraise the shares, determining their fair value exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with a fair rate of interest, if any, to be paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into account all relevant factors. In determining the fair rate of interest, the Court may consider all relevant factors, including the rate of interest which the surviving or resulting corporation would have had to pay to borrow money during the pendency of the proceeding. Upon application by the surviving or resulting corporation or by any stockholder entitled to participate in the appraisal proceeding, the Court may, in its discretion, permit discovery or other pretrial proceedings and may proceed to trial upon the appraisal prior to the final determination of the stockholder entitled to an appraisal. Any stockholder whose name appears on the list filed by the surviving or resulting corporation pursuant to subsection (f) of this section and who has submitted such stockholder's certificates of stock to the Register in Chancery, if such is required, may E-3 participate fully in all proceedings until it is finally determined that such stockholder is not entitled to appraisal rights under this section. (i) The Court shall direct the payment of the fair value of the shares, together with interest, if any, by the surviving or resulting corporation to the stockholders entitled thereto. Interest may be simple or compound, as the Court may direct. Payment shall be so made to each such stockholder, in the case of holders of uncertificated stock forthwith, and the case of holders of shares represented by certificates upon the surrender to the corporation of the certificates representing such stock. The Court's decree may be enforced as other decrees in the Court of Chancery may be enforced, whether such surviving or resulting corporation be a corporation of this State or of any state. (j) The costs of the proceeding may be determined by the Court and taxed upon the parties as the Court deems equitable in the circumstances. Upon application of a stockholder, the Court may order all or a portion of the expenses incurred by any stockholder in connection with the appraisal proceeding, including, without limitation, reasonable attorney's fees and the fees and expenses of experts, to be charged pro rata against the value of all the shares entitled to an appraisal. (k) From and after the effective date of the merger or consolidation, no stockholder who has demanded appraisal rights as provided in subsection (d) of this section shall be entitled to vote such stock for any purpose or to receive payment of dividends or other distributions on the stock (except dividends or other distributions payable to stockholders of record at a date which is prior to the effective date of the merger or consolidation); provided, however, that if no petition for an appraisal shall be filed within the time provided in subsection (e) of this section, or if such stockholder shall deliver to the surviving or resulting corporation a written withdrawal of such stockholder's demand for an appraisal and an acceptance of the merger or consolidation, either within 60 days after the effective date of the merger or consolidation as provided in subsection (e) of this section or thereafter with the written approval of the corporation, then the right of such stockholder to an appraisal shall cease. Notwithstanding the foregoing, no appraisal proceeding in the Court of Chancery shall be dismissed as to any stockholder without the approval of the Court, and such approval may be conditioned upon such terms as the Court deems just. (l) The shares of the surviving or resulting corporation to which the shares of such objecting stockholders would have been converted had they assented to the merger or consolidation shall have the status of authorized and unissued shares of the surviving or resulting corporation. E-4 PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 20. INDEMNIFICATION OF DIRECTORS AND OFFICERS Section 145 of the Delaware General Corporation Law, Articles VII and VIII of PMR's Amended and Restated Certificate of Incorporation and Article VII of PMR's Amended and Restated Bylaws provide for the indemnification of officers, directors, employees and agents under certain circumstances. Set forth below are Articles VII and VIII of PMR's Amended and Restated Certificate of Incorporation pertaining to indemnification of officers, directors, employees and agents and insurance: ARTICLE VII A. No director shall be personally liable to the Corporation or its stockholders for monetary damages for any breach of fiduciary duty by such director as a director, except (i) for breach of the director's duty of loyalty to the Corporation or its stockholders, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) pursuant to Section 174 of the Delaware General Corporation Law, or (iv) for any transaction from which the director derived an improper personal benefit. If the Delaware General Corporation Law is amended after approval by the stockholders of this Article VII to authorize corporate action further eliminating or limiting the personal liability of the directors, then the liability of a director shall be eliminated or limited to the fullest extent permitted by Delaware General Corporation Law, as so amended. B. Any repeal or modification of this Article VII shall be prospective and shall not affect the rights under this Article VII in effect at the time of the alleged occurrence of any act or omission to act giving rise to liability or indemnification. ARTICLE VIII The Corporation may indemnify any person who is or was a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that the person is or was a director, officer, employee or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against any and all expenses (including attorneys' fees), judgments, fines and amounts paid in settlement or incurred in connection with the investigation, preparation to defend or defense of such action, suit, proceeding or claim, to the fullest extent permitted by the Delaware General Corporation Law, as amended from time to time. The Corporation may purchase and maintain insurance, at its expense, to protect itself and any director, officer, employee or agent of the Corporation or another corporation, partnership, joint venture, trust or other enterprise, against any such expense, liability or loss, to the fullest extent permitted by the Delaware General Corporation Law. Set forth below is Article VII of PMR's Amended and Restated Bylaws: ARTICLE VII INDEMNIFICATION OF DIRECTORS, OFFICERS, AGENTS AND EMPLOYEES SECTION 1. Indemnification in Suits and Proceedings With Others. The Corporation shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than an action by or in the right of the Corporation) by reason of the fact that he is or was a director, officer, employee or agent of the Corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, II-1 trust or other enterprise, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the Corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. The termination of any action, suit or proceeding by judgment, order, settlement, conviction, or upon a plea of nolo contendere or its equivalent, shall not, of itself, create a presumption that the person did not act in good faith and in a manner which he reasonably believed to be in or not opposed to the best interests of the Corporation, and, with respect to any criminal action or proceeding, had reasonable cause to believe that his conduct was unlawful. SECTION 2. Indemnification in Derivative Suits. The Corporation shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the Corporation to procure a judgment in its favor by reason of the fact that he is or was a director, officer, employee or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against expenses (including attorneys' fees) actually and reasonably incurred by him in connection with the defense or settlement of such action or suit if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the Corporation, except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable for negligence or misconduct in the performance of his duty to the Corporation unless and only to the extent that the Court of Chancery or the court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Court of Chancery or such other court shall deem proper. SECTION 3. Reasonable Defense Expenses. To the extent that a director, officer, employee or agent of the Corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in Sections 1 and 2 of this Article, or in defense of any claim, issue or matter therein, he shall be indemnified against expenses (including attorney's fees) actually and reasonably incurred by him in connection therewith. SECTION 4. Standard of Conduct and Determination. Any indemnification under Sections 1 and 2 of this Article (unless ordered by a court) shall be made by the Corporation only as authorized in the specific case upon a determination that indemnification of the director, officer, employee or agent is proper in the circumstances because he has met the applicable standard of conduct set forth in Sections 1 and 2 of this Article. Such determination shall be made (1) by the Board of Directors by a majority vote of a quorum consisting of directors who were not parties to such action, suit or proceeding, or (2) if such quorum is not obtainable, or, even if obtainable a quorum of disinterested directors so directs, by independent legal counsel in a written opinion, or (3) by the stockholders. SECTION 5. Advance of Defense Expenses. Expenses incurred in defending a civil or criminal action, suit or proceeding may be paid by the Corporation in advance of the final disposition of such action, suit or proceeding as authorized by the Board of Directors in the manner provided in Section 4 of this Article upon receipt of an undertaking by or on behalf of the director, officer, employee or agent to repay such amount unless it shall ultimately be determined that he is entitled to be indemnified by the Corporation as authorized in this Section. SECTION 6. Nonexclusivity of Indemnification. The indemnification provided by this Section shall not be deemed exclusive of any other rights to which those indemnified may be entitled under any bylaw, agreement, vote of stockholders or disinterested directors or otherwise, both as to action in his official capacity and as to action in another capacity while holding such office, and shall continue II-2 as to a person who has ceased to be a director, officer, employee or agent and shall inure to the benefit of the heirs, executors and administrators of such person. SECTION 7. Insurance Authorization. The Corporation may purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against any liability asserted against him and incurred by him in any such capacity, or arising out of his status as such, whether or not the Corporation would have the power to indemnify him against such liability under the provisions of this Section. SECTION 8. Definition of "Corporation" in Mergers. For purposes of this Section, references to "the Corporation" shall include, in the case of a merger or consolidation, in addition to the resulting Corporation, any constituent corporation (including any constituent of a constituent) absorbed in a consolidation or merger which, if its separate existence had continued, would have had power and authority to indemnify its directors, officers and employees or agents, so that any person who is or was a director, officer, employee or agent of such constituent corporation, or is or was serving at the request of such constituent corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, shall stand in the same position under the provisions of this Section with respect to the resulting or supervising corporation as he would have with respect to such constituent corporation if its separate existence had continued. SECTION 9. Other Definitions. For references to "fines" shall include any excise taxes assessed on a person with respect to an employee benefit plan; and references to "serving at the request of the Corporation" purposes of this Section, reference to "other enterprises" shall include employee benefit plans; shall include any service as a director, officer, employee or agent of the Corporation which imposes duties on, or involves services by, such director, officer, employee or agent with respect to an employee benefit plan, its participants or beneficiaries; and a person who acted in good faith and in a manner he reasonably believed to be in the interest of the participants and beneficiaries of an employee benefit plan shall be deemed to have acted in a manner "not opposed to the best interests of the Corporation" as referred to in this Section. PMR has also purchased liability insurance policies covering directors and officers of PMR. ITEM 21. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Exhibits. The following exhibits are filed as part of this Registration Statement:
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 2.1 Agreement and Plan of Merger by and between PMR Corporation, PMR Acquisition Corporation and Psychiatric Solutions, Inc. dated May 6, 2002, as amended by Amendment No. 1 dated as of June 10, 2002 and Amendment No. 2 dated as of July 9, 2002 (included as Annex A to this registration statement). 3.1 PMR's Amended and Restated Certificate of Incorporation, filed with the Delaware Secretary of State on March 9, 1998 (incorporated by reference to Exhibit 3.1 to PMR's Annual Report on Form 10-K for the fiscal year ended April 30, 1998). 3.2 PMR's Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended April 30, 1997). 4.1 Reference is made to Exhibits 3.1 and 3.2. 4.2 Common Stock Specimen Certificate (incorporated by reference to Exhibit 4.1 to PMR's Registration Statement on Form S-18 (Reg. No. 23-20095-A)). 5.1 Opinion of Vinson & Elkins L.L.P. regarding legality. 8.1 Opinion of Kruse & Associates, P.C. regarding tax matters.
II-3
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 10.1* Amended and Restated Promissory Note between Mark P. Clein and PMR Corporation in the amount of $59,554, dated as of May 1, 2002. 10.2* Amended and Restated Promissory Note between Mark P. Clein and PMR Corporation in the amount of $278,504.82, dated as of May 1, 2002. 10.3* Amended and Restated Promissory Note between Fred D. Furman and PMR Corporation in the amount of $256,623.60, dated as of May 1, 2002. 10.4* Amended and Restated Promissory Note between Fred D. Furman and PMR Corporation in the amount of $209,317.15, dated as of May 1, 2002. 10.5* Amended and Restated Promissory Note between Susan Erskine and PMR Corporation in the amount of $20,414, dated as of May 1, 2002. 10.6* Consulting Agreement between Mark P. Clein and PMR Corporation dated as of May 10, 2002. 10.7* Employment Agreement between Fred D. Furman and PMR Corporation dated as of August 25, 1999. 10.8* Employment Agreement between Susan D. Erskine and PMR Corporation dated as of August 25, 1999. 10.9* Amendment to Employment Agreement between Fred D. Furman and PMR Corporation dated as of May 1, 2002. 10.10* Amendment to Employment Agreement between Susan Erskine and PMR Corporation dated as of May 1, 2002. 10.11* Amended and Restated Employment Agreement between Joey Jacobs and Psychiatric Solutions, Inc. dated as of January 1, 2002. 10.12* Employment Agreement between Jack Salberg and Psychiatric Solutions, Inc. dated as of May 1, 2000. 10.13* Revolving Credit and Term Loan Agreement between Psychiatric Solutions, Inc., certain of its related entities, CapitalSource Finance, LLC, and the lenders thereunder, dated as of November 30, 2001. 10.14 Stock Purchase Agreement, dated as of June 20, 2002, is by and among the shareholders of Aeries Healthcare Corporation, a Delaware corporation and Psychiatric Solutions, Inc., a Delaware corporation and/or its designated affiliate. 10.15 Indemnification Agreement, dated as of June 28, 2002, is by and among the shareholders of Aeries Healthcare Corporation, a Delaware corporation, and Psychiatric Solutions, Inc., a Delaware corporation and/or its designated affiliate. 10.16 Subordinated Promissory Note to Brown Schools Inc. dated August 31, 2001 in the original principal amount of $2 million. 10.17 Form of Convertible Subordinated Note dated May 5, 2000 to the sellers of Sunrise Behavioral Health in the original aggregate principal amount of $3.6 million. 10.18 Securities Purchase Agreement between Psychiatric Solutions and The 1818 Mezzanine Fund II, L.P. dated as of June 28, 2002. 10.19 Warrant to purchase shares of common stock issued by Psychiatric Solutions to The 1818 Mezzanine Fund II L.P. dated June 28, 2002. 10.20 Second Amendment to Revolving Credit and Term Loan Agreement dated June 28, 2002 by and among Psychiatric Solutions and certain of its related entities, Capital Source Finance, LLC and the lenders thereunder. 10.21 Term Note dated June 28, 2002 in the original principal amount of $7,950,000 payable to Capital Source Finance, LLC issued by Psychiatric Solutions and certain of its related entities. 21.1* List of Subsidiaries. 23.1 Consent of Ernst & Young LLP, Independent Auditors on behalf of PMR Corporation. 23.2 Consent of Ernst & Young LLP, Independent Auditors on behalf of Psychiatric Solutions. 23.3 Consent of Kruse & Associates, P.C. (set forth in Exhibit 8.1).
II-4
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 23.4 Consent of Vinson & Elkins L.L.P. (set forth in Exhibit 5.1). 23.5 Consent of Raymond James & Associates, Inc. (set forth in Exhibit 99.3). 23.6 Consent of Brentwood Capital Advisors LLC. (set forth in Exhibit 99.4). 23.7 Consent of BDO Seidman, LLP 24.1* Powers of Attorney (set forth on signature page). 99.1 Form of PMR Proxy. 99.2 Form of Psychiatric Solutions Proxy. 99.3 Opinion of Raymond James & Associates, Inc. (included as Annex C to this registration statement). 99.4 Opinion of Brentwood Capital Advisors LLC (included as Annex D to this registration statement).
- --------------- * Filed with initial registration statement. (b) Financial Statements Schedules:
TITLE PAGE ----- ---- Schedule II -- Valuation and Qualifying Accounts S-1
ITEM 22. UNDERTAKINGS. The undersigned registrant hereby undertakes: (1) To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement: (i) To include any prospectus required by section 10(a)(3) of the Securities Act of 1933; (ii) To reflect in the prospectus any facts or events arising after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of a prospectus filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the changes in volume and price represent no more than 20 percent change in the maximum aggregate offering price set forth in the "Calculation of Registration Fee" table in the effective registration statement. (iii) To include any material information with respect to the plan of distribution not previously disclosed in the registration statement or any material change to such information in the registration statement; (2) That, for the purpose of determining any liability under the Securities Act of 1933, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (3) To remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering. (4) That, for purposes of determining any liability under the Securities Act of 1933, each filing of its annual report pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (and, where applicable, each filing of an employee benefit plan's annual report pursuant to Section 15(d) of the Securities Exchange Act of 1934) that is incorporated by reference in the registration statement II-5 shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (5) That prior to any public reoffering of the securities registered hereunder through use of a prospectus which is a part of this registration statement, by any person or party who is deemed to be an underwriter within the meaning of Rule 145(c), the issuer undertakes that such reoffering prospectus will contain the information called for by the applicable registration form with respect to reofferings by persons who may be deemed underwriters, in addition to the information called for by the other items of the applicable form. (6) That every prospectus: (i) that is filed pursuant to paragraph (5) immediately preceding, or (ii) that purports to meet the requirements of Section 10(a)(3) of the Act and is used in connection with an offering of securities subject to Rule 415, will be filed as part of an amendment to the registration statement and will not be used until such amendment is effective, and that, for purposes of determining any liability under the Securities Act of 1933, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (7) To respond to requests for information that is incorporated by reference into the prospectus pursuant to Item 4, 10(b), 11, or 13 of this form, within one business day of receipt of such request, and to send the incorporated documents by first class mail or other equally prompt means. This includes information contained in documents filed subsequent to the effective date of the registration statement through the date of responding to the request. (8) To supply by means of a post-effective amendment all information concerning a transaction, and the company being acquired involved therein, that was not the subject of and included in the registration statement when it became effective. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to the directors, officers and controlling persons of PMR pursuant to the foregoing provisions, or otherwise, PMR has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by PMR of expenses incurred or paid by a director, officer or controlling person of PMR in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, PMR will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. II-6 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, as amended, the registrant has duly caused this amendment to the Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in San Diego, California, on the 11th day of July, 2002. PMR CORPORATION By: /s/ FRED D. FURMAN ------------------------------------ Fred D. Furman President and General Counsel Pursuant to the requirements of the Securities Act of 1933, this registration statement has been signed by the following persons in the capacities indicated on the 11th day of July, 2002.
SIGNATURE TITLE --------- ----- * Chairman of the Board of Directors ------------------------------------------------ and Chief Executive Officer Allen Tepper (Principal Executive Officer) * Director ------------------------------------------------ Mark P. Clein /s/ FRED D. FURMAN President and General Counsel ------------------------------------------------ Fred D. Furman * Executive Vice President, ------------------------------------------------ Secretary and Director Susan D. Erskine * Director ------------------------------------------------ Satish Tyagi * Director ------------------------------------------------ Charles C. McGettigan * Director ------------------------------------------------ Eugene D. Hill * Director ------------------------------------------------ Richard Niglio * Chief Financial Officer ------------------------------------------------ (Principal Financial Officer) Reggie A. Roman *By/s/ FRED D. FURMAN ------------------------------------------------ attorney-in-fact
II-7 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 2.1 Agreement and Plan of Merger by and between PMR Corporation, PMR Acquisition Corporation and Psychiatric Solutions, Inc. dated May 6, 2002, as amended by Amendment No. 1 dated as of June 10, 2002 and Amendment No. 2 as of July 9, 2002 (included as Annex A to this registration statement). 3.1 PMR's Amended and Restated Certificate of Incorporation, filed with the Delaware Secretary of State on March 9, 1998 (incorporated by reference to Exhibit 3.1 to PMR's Annual Report on Form 10-K for the fiscal year ended April 30, 1998). 3.2 PMR's Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended April 30, 1997). 4.1 Reference is made to Exhibits 3.1 and 3.2. 4.2 Common Stock Specimen Certificate (incorporated by reference to Exhibit 4.1 to PMR's Registration Statement on Form S-18 (Reg. No. 23-20095-A)). 5.1 Opinion of Vinson & Elkins L.L.P. regarding legality. 8.1 Opinion of Kruse & Associates, P.C. regarding tax matters. 10.1* Amended and Restated Promissory Note between Mark P. Clein and PMR Corporation in the amount of $59,554, dated as of May 1, 2002. 10.2* Amended and Restated Promissory Note between Mark P. Clein and PMR Corporation in the amount of $278,504.82, dated as of May 1, 2002. 10.3* Amended and Restated Promissory Note between Fred D. Furman and PMR Corporation in the amount of $256,623.60, dated as of May 1, 2002. 10.4* Amended and Restated Promissory Note between Fred D. Furman and PMR Corporation in the amount of $209,317.15, dated as of May 1, 2002. 10.5* Amended and Restated Promissory Note between Susan Erskine and PMR Corporation in the amount of $20,414, dated as of May 1, 2002. 10.6* Consulting Agreement between Mark P. Clein and PMR Corporation dated as of May 10, 2002. 10.7* Employment Agreement between Fred D. Furman and PMR Corporation dated as of August 25, 1999. 10.8* Employment Agreement between Susan D. Erskine and PMR Corporation dated as of August 25, 1999. 10.9* Amendment to Employment Agreement between Fred D. Furman and PMR Corporation dated as of May 1, 2002. 10.10* Amendment to Employment Agreement between Susan Erskine and PMR Corporation dated as of May 1, 2002. 10.11* Amended and Restated Employment Agreement between Joey Jacobs and Psychiatric Solutions, Inc. dated as of January 1, 2002. 10.12* Employment Agreement between Jack Salberg and Psychiatric Solutions, Inc. dated as of May 1, 2000. 10.13* Revolving Credit and Term Loan Agreement between Psychiatric Solutions, Inc., certain of its related entities, CapitalSource Finance, LLC, and the lenders thereunder, dated as of November 30, 2001. 10.14 Stock Purchase Agreement, dated as of June 20, 2002, is by and among the shareholders of Aeries Healthcare Corporation, a Delaware corporation and Psychiatric Solutions, Inc., a Delaware corporation and/or its designated affiliate. 10.15 Indemnification Agreement, dated as of June 28, 2002, is by and among the shareholders of Aeries Healthcare Corporation, a Delaware corporation, and Psychiatric Solutions, Inc., a Delaware corporation and/or its designated affiliate.
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 10.16 Subordinated Promissory Note to Brown Schools Inc. dated August 31, 2001 in the original principal amount of $2 million. 10.17 Form of Convertible Subordinated Note dated May 5, 2000 to the sellers of Sunrise Behavioral Health in the original aggregate principal amount of $3.6 million. 10.18 Securities Purchase Agreement between Psychiatric Solutions and The 1818 Mezzanine Fund II, L.P. dated as of June 28, 2002. 10.19 Warrant to purchase shares of common stock issued by Psychiatric Solutions to The 1818 Mezzanine Fund II L.P. dated June 28, 2002. 10.20 Second Amendment to Revolving Credit and Term Loan Agreement dated June 28, 2002 by and among Psychiatric Solutions, Inc. certain of its related entities, CapitalSource Finance, LLC and the lenders thereunder. 10.21 Term Note dated June 28, 2002 in the original principal amount of $7,950,000 payable to CapitalSource Finance LLC issued by Psychiatric Solutions and certain of its related entities. 21.1* List of Subsidiaries. 23.1 Consent of Ernst & Young LLP, Independent Auditors on behalf of PMR Corporation. 23.2 Consent of Ernst & Young LLP, Independent Auditors on behalf of Psychiatric Solutions. 23.3 Consent of Kruse & Associates, P.C. (set forth in Exhibit 8.1). 23.4 Consent of Vinson & Elkins L.L.P. (set forth in Exhibit 5.1). 23.5 Consent of Raymond James & Associates, Inc. (set forth in Exhibit 99.3). 23.6 Consent of Brentwood Capital Advisors LLC. (set forth in Exhibit 99.4). 23.7 Consent of BDO Seidman, LLP 24.1* Powers of Attorney (set forth on signature page). 99.1 Form of PMR Proxy. 99.2 Form of Psychiatric Solutions Proxy. 99.3 Opinion of Raymond James & Associates, Inc. (included as Annex C to this registration statement). 99.4 Opinion of Brentwood Capital Advisors LLC (included as Annex D to this registration statement).
- --------------- * Filed with initial Registration Statement. EX-5.1 3 g76727a1exv5w1.txt OPINION OF VINSON & ELKINS EXHIBIT 5.1 [VINSON & ELKINS LETTERHEAD] July 11, 2002 PMR Corporation 1565 Hotel Circle South, 2nd Floor San Diego, California 92108 Ladies and Gentlemen: We acted as counsel for PMR Corporation, a Delaware corporation ("PMR"), in connection with PMR's Form S-4 registration statement (the "Registration Statement"), including the Prospectus included therein at the time the Registration Statement is declared effective (the "Prospectus"), relating to: (i) the offering, issuance and sale of shares of PMR's common stock, par value $0.01 per share (the "Shares"), pursuant to the proposed merger of PMR Acquisition Corp., a Delaware corporation and wholly-owned subsidiary of PMR, with and into Psychiatric Solutions, Inc., a Delaware corporation, and (ii) the issuance of the contingent value rights (the "CVRs") pursuant to a contingent value rights agreement (the "CVR Agreement") among PMR, StockTrans, Inc., as CVR trustee, and Fred Furman, as representative of the CVR holders, as described in the Registration Statement. In connection with rendering our opinion, we examined certain of the corporate records of PMR, including its Amended and Restated Certificate of Incorporation (as amended), certain resolutions of the Board of Directors of PMR, the Registration Statement and the exhibits thereto, the CVR Agreement and such certificates of corporate officers of PMR and governmental officials as we deemed necessary for the purposes of this opinion. As to matters of fact relevant to the opinions expressed herein, and as to factual matters arising in connection with our examination of the above described documents, we relied upon certificates and other communications of corporate officers of PMR and governmental officials without further investigation as to the facts set forth therein. We are rendering this opinion as of the effective date of the Registration Statement. Based upon the foregoing, we are of the opinion that: 1. assuming that the Certificate of Amendment to the Amended and Restated Certificate of Incorporation of PMR, in the form included as Annex A in the joint proxy statement/prospectus contained in the Registration Statement, is approved by the holders of a majority of the outstanding shares of common stock of PMR at a meeting duly called and held for such purpose and is filed with the Secretary of State of the State of Delaware in accordance with the provisions of the Delaware General Corporation of Law, the Shares have been validly authorized for issuance and, upon issuance as described in the Registration Statement, will be validly issued, fully paid and nonassessable; 2. the CVR Agreement has been duly authorized by PMR; and 3. when (a) the CVR Agreement has been duly executed and delivered by the parties thereto, (b) the CVRs have been duly authorized, executed and issued in accordance with the provisions of the CVR Agreement (including the provisions of the CVR Agreement regarding establishment of the form of CVRs), (c) such CVRs have been authenticated by the CVR trustee under the CVR agreement, and (d) such CVRs have been delivered in the manner and on the terms described in the Prospectus, such CVRs will have been validly issued and will constitute valid and binding obligations of PMR, enforceable against PMR in accordance with their terms and entitled to the benefits of the CVR Agreement, subject to (i) the effect of any applicable bankruptcy, insolvency (including, without limitation, all laws relating to fraudulent transfers), reorganization, moratorium or similar laws affecting creditors' rights generally and (ii) the effect of general principles of equity (regardless of whether considered in a proceeding in equity or at law). We hereby consent to the filing of this letter as an exhibit to the Registration Statement. By giving such consent, we do not admit that we are within the category of persons whose consent is required under Section 7 of the Securities Act of 1933, as amended, or the rules and regulations of the Securities and Exchange Commission issued thereunder. For purposes of the foregoing opinions, we assumed that the Shares will be offered, issued and sold in compliance with all applicable state securities or Blue Sky laws. Very truly yours, /s/ VINSON & ELKINS L.L.P. EX-8.1 4 g76727a1exv8w1.txt OPINION OF KRUSE & ASSOCIATES, P.C. EXHIBIT 8.1 July 2, 2002 Mr. Steven Davidson Vice President Psychiatric Solutions, Inc. Dear Mr. Davidson: This letter states our opinions regarding certain U.S. federal income tax consequences(1) to PMR Corporation, ("PMR"), Psychiatric Solutions, Inc. ("PSI"), and Psychiatric Solutions, Inc. stockholders ("PSI stockholders") associated with the "Agreement and Plan of Merger" ("Agreement") described below. The opinions stated in this letter memorialize our conclusions concerning the Merger, and are based upon existing provisions of the Internal Revenue Code of 1954 and the Internal Revenue Code of 1986, as amended ("the Code"), the Treasury Department regulations promulgated thereunder (final, temporary and proposed), published Revenue Rulings and Revenue Procedures of the Internal Revenue Service ("IRS") and judicial decisions as were in effect on July 1, 2002. All such authorities are subject to change at any time, either prospectively or retroactively, and any such changes could significantly modify the opinions stated in this letter. In rendering our opinion, we undertake no responsibility to advise you of any such changes or of any developments in the application or interpretation of the federal income tax laws. The opinions stated in this letter may not be relied upon to the extent that there are changes or material developments in the application or interpretation of the federal income tax laws that relate to the transactions that are the subject of this letter. A number of issues raised by the matters addressed in this letter, including matters upon which we have stated opinions, are complex and have not been definitely resolved by the tax laws. The opinions stated in this letter are based on our interpretation of existing law and our belief regarding what a court would reasonably conclude if presented with relevant issues. However, we cannot assure that our interpretations will prevail if the issues become the subjects of judicial or administrative proceedings. Realization of the tax consequences set forth in this letter is subject to the significant risk that the IRS may challenge the tax treatment and that a court could sustain such challenge. (1) With respect to the Merger, we have not addressed any state or local or non-U.S. tax consequences. (1) Because taxpayers generally bear the burden of proof required to support items challenged by the IRS, the opinions stated in this letter are based upon the assumption that the appropriate taxpayer will undertake the appropriate effort and expense to fully present the case in support of any IRS challenges. No ruling has been requested from the IRS with respect to the Merger, and no assurance can be given that the IRS will accept the treatment described below. I) REPRESENTATIONS AND ASSUMPTIONS The opinions stated in this letter are based upon our understanding of the facts related to the Merger, as described herein. In the event that there is a difference between the actual facts related to the Merger and our understanding of the facts, as detailed in this letter, it is likely that the opinions stated in this letter could become inapplicable, in whole or in part. II) THE MERGER With regard to the Merger, we have assumed the following based on the terms, conditions and other provisions of the Agreements as well as any amendments thereto, all of the factual information, descriptions, representations and assumptions set forth in your representation letter dated July 3, 2002, and in the Proxy Statement/Prospectus dated June 12, 2002, and mailed to shareholders of both companies in connection with the special meetings of shareholders to approve the Merger. An Agreement And Plan Of Merger ("Agreement") was made and entered into as of May 6, 2002, by and between PMR Corporation, a Delaware corporation ("PMR"), PMR Acquisition Corporation, a Delaware corporation ("Merger Sub"), and Psychiatric Solutions, Inc., a Delaware corporation ("PSI"). Upon the terms and subject to the conditions of the Agreement and in accordance with the Delaware General Corporation Law ("DGCL"), PMR and PSI will enter into a business combination transaction pursuant to which Merger Sub will merge with and into PSI ("Merger"). Pursuant to the Merger, among other things, each outstanding share of capital stock of PSI ("PSI Capital Stock") shall be converted into shares of common stock of PMR, par value $0.01 per share ("PMR Common Stock"). The parties intend, by executing the Agreement, to adopt a plan of reorganization within the meaning of Section 354(a)(1) of the Code and to cause the Merger to qualify as a reorganization under the provisions of Section 368(a) of the Code. (2) At the Effective Time (as defined in the Agreement), Merger Sub shall be merged with and into PSI, and as a result of the Merger, the separate corporate existence of Merger Sub shall cease, and PSI shall continue as the surviving corporation of the Merger ("Surviving Corporation"). As promptly as practicable, the parties shall cause the Merger to be consummated by filing a certificate of merger (the "Certificate of Merger") with the Secretary of State of the State of Delaware in such form as is required by, and executed in accordance with, the relevant portions of the DGCL. At the Effective Time, the effect of the Merger shall be as provided in the applicable provisions of the DGCL. In general, this means that all the property, rights, privileges, powers and franchises of each of PSI and Merger Sub shall vest in the Surviving Corporation, and all debts, liabilities, obligations, restrictions, disabilities and duties of each of PSI and Merger Sub shall become the debts, liabilities, obligations, restrictions, disabilities and duties of the Surviving Corporation. At the Effective Time, the Certificate of Incorporation of PSI as the Surviving Corporation shall be amended and restated to read the same as the Certificate of Incorporation of Merger Sub as in effect immediately prior to the Effective Time, except that the amended and restated Certificate of Incorporation of the Surviving Corporation, shall read as follows: "The name of this corporation is Psychiatric Solutions Hospitals, Inc." At the Effective Time, the Bylaws of PSI as the Surviving Corporation shall be amended to read the same as the Bylaws of Merger Sub as in effect immediately prior to the Effective Time, except that all references to Merger Sub in the Bylaws of the Surviving Corporation shall be changed to refer to Psychiatric Solutions Hospitals, Inc. As promptly as practicable, the Certificate of Incorporation of PMR shall be amended and restated to read as follows: "The name of this corporation is Psychiatric Solutions, Inc." By virtue of the Merger and without any action on the part of PMR, Merger Sub, PSI or the holders of any of PSI's securities, each issued and outstanding share of common stock, par value $0.01 per share, of Merger Sub shall be converted into and become one fully paid and nonassessable share of common stock, par value $0.01 per share, of the Surviving Corporation. Each share of common stock, par value $0.01 per share, of PSI (the "PSI Common Stock") issued and outstanding immediately prior to the Effective Time (other than shares to be canceled) shall be converted into the right to receive 0.115125 shares of fully paid and nonassessable shares of PMR Common Stock. Each issued and outstanding share of PSI's Series A Preferred Stock ("PSI Series A Preferred Stock") shall be converted into the right to receive 0.246951 shares of fully paid and nonassessable shares of PMR Common Stock. (3) Each issued and outstanding share of PSI's Series B Preferred Stock ("PSI Series B Preferred Stock") shall be converted into the right to receive 0.312864 shares of fully paid and nonassessable shares of PMR Common Stock. At the Effective Time, all shares of PSI Capital Stock shall no longer be outstanding and shall automatically be canceled and shall cease to exist, and each holder of a certificate or certificates that immediately prior the Effective Time represented any such shares (a "Certificate" or "Certificates") shall cease to have any rights with respect thereto, except the right to receive the PMR Common Stock and any cash in lieu of fractional shares of PMR Common Stock to be issued in consideration therefor upon surrender of such Certificate. Each share of PSI Common Stock or PSI Preferred Stock issued and outstanding immediately prior to the Effective Time that is restricted or not fully vested shall upon such conversion and exchange have the same restrictions or vesting arrangements applicable to such shares prior to the conversion. At the Effective Time, all shares of PSI Capital Stock that are owned by PSI as treasury stock, and each share of PSI Capital Stock owned by any direct or indirect wholly owned PSI Subsidiary immediately prior to the Effective Time shall be canceled and extinguished without any conversion thereof. No fraction of a share of PMR Common Stock will be issued, but in lieu thereof each holder of shares of PSI Capital Stock who would otherwise be entitled to a fraction of a share of PMR Common Stock (after aggregating all fractional shares of PMR Common Stock to be received by such holder) shall receive from PMR an amount of cash in lieu of such fractional shares. Prior to the Effective Time, PMR shall distribute to holders of PMR Common Stock: PMR Cash Equivalents in excess of $5.05 million, provided that its Cash and Equivalents at the Effective Time are in excess of $5.05 Million. In addition to the foregoing assumptions, you have represented the following regarding the Merger: 1. The Merger will be a statutory merger in accordance with the applicable provisions of the DGCL. 2. It is intended by the parties that the Merger shall constitute a reorganization within the meaning of Section 368(a) of the Code. 3. Following the transaction, PSI will hold at least 90 percent of the fair market value of its net assets and at least 70 percent of the fair market value of its gross assets and at least 90 percent of the fair market value of Merger Sub's net assets and at least 70 percent of the fair market value of Merger Sub's gross assets held immediately prior to the transaction, excluding assets transferred from PMR to Merger Sub in pursuance of the (4) plan of reorganization. For purposes of this representation, amounts paid by PSI or Merger Sub to dissenters, amounts paid by PSI or Merger Sub to shareholders who receive cash or other property, amounts used by PSI or Merger Sub to pay reorganization expenses, and all redemptions and distributions (except for regular, normal dividends) made by PSI will be included as assets of PSI or Merger Sub, respectively, immediately prior to the transaction. 4. Prior to the transaction, PMR will be in control of Merger Sub within the meaning of Section 368(c) of the Code. 5. No two parties to the Merger are investment companies as defined in Sections 368(a)(2)(F)(iii) and (iv) of the Code. 6. PSI is not under the jurisdiction of a court in a title 11 or similar case within the meaning of Section 368(a)(3)(A) of the Code. 7. Except as described in the Proxy Statement/Prospectus, no dividends or distributions, other than regular or normal dividends or distributions, will be made with respect to any PSI stock prior to the Merger. After the Merger, no dividends or distributions will be made to the former PSI shareholders by PMR, other than regular or normal dividend distributions made with regard to all shares of PMR Common Stock. 8. The Merger is being effected for bona fide business reasons as described in the Agreement. 9. PSI has no intention to issue additional shares of stock that would result in PMR losing control of PSI within the meaning of Section 368(c) of the Code. 10. PSI has no intention to cause PMR to liquidate PSI, to merge PSI with or into another corporation, to sell or otherwise dispose of the stock of PSI except for transfers of stock to corporations controlled by PMR, or to cause PSI to sell or otherwise dispose of any of its assets or of any of the assets acquired from Merger Sub, except for dispositions made in the ordinary course of business or transfers of assets to corporations controlled by PSI. 11. The liabilities of Merger Sub, if any, assumed by PSI and the liabilities to which the transferred assets of Merger Sub are subject, if any, were incurred in the ordinary course of its business. 12. Following the transaction, PSI will continue its historic business or use a significant portion of its historic business assets in a business. 13. There is no intercorporate indebtedness existing between PMR and PSI or between Merger Sub and PSI that was issued, acquired, or will be settled at a discount. (5) 14. In the transaction, shares of PSI stock representing control of PSI, as defined in Section 368(c) of the Code, will be exchanged solely for voting stock of PMR. For purposes of this representation, shares of PSI stock exchanged for cash or other property originating with PMR will be treated as outstanding PSI stock on the date of the transaction. 15. At the time of the transaction, PSI will not have outstanding any warrants, options, convertible securities, or any other type of right, except those listed in the Agreement, pursuant to which any person could acquire stock in PSI that, if exercised or converted, would affect PMR's acquisition or retention of control of PSI, as defined in Section 368(c) of the Code. 16. The payment of cash in lieu of fractional shares of PMR stock is solely for the purpose of avoiding the expense and inconvenience to PMR of issuing fractional shares and does not represent separately bargained for consideration. 17. Excluding the payment of cash in lieu of fractional shares, the payment of cash in lieu of PMR shares to dissenting PSI shareholders, and the payment of cash in lieu of continued ownership in PMR to dissenting PMR shareholders is solely for the purpose of complying with state law dissenter's rights, and does not represent separately bargained for consideration. III) ISSUES With regard to the Merger, we have been asked to opine on the following issues: 1) Will the Merger constitute a reorganization within the meaning of Section 368(a) of the Code? 2) Are PMR and Psychiatric Solutions each a "party to a reorganization" within the meaning of Section 368(b) of the Code? 3) Will any gain or loss be recognized by PMR, Psychiatric Solutions or Psychiatric Solutions stockholders (except to the extent of any cash received) as a result of the Merger? IV) SUMMARY OF OPINIONS Subject to the analysis set out in Part V below, it is our opinion that the material federal income tax consequences described below should result with regard to the following issues, and that each such opinion is supported by a good faith belief that such opinions are warranted in existing law or can be supported by a good faith argument for extension, modification, or reversal of existing law. In addition, it is our opinion that the appropriate taxpayer should succeed if the matter is litigated or if the issues become subjects of judicial or administrative proceedings. (6) 1) The Merger should constitute a reorganization within the meaning of Section 368(a) of the Code. 2) PMR and Psychiatric Solutions should each be considered a "party to a reorganization" within the meaning of Section 368(b) of the Code. 3) No gain or loss should be recognized by PMR, Psychiatric Solutions or Psychiatric Solutions stockholders (except to the extent of any cash received) as a result of the Merger. V) DISCUSSION 1) SECTION 354 OF THE CODE: Section 354 of the Code provides the following in pertinent part: (a) General rule. (1) In general. No gain or loss shall be recognized if stock or securities in a corporation a party to reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization. 2) SECTION 361 OF THE CODE: Section 361 of the Code provides the following in pertinent part: (a) General rule. No gain or loss shall be recognized to a corporation if such corporation is a party to a reorganization and exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization. 3) SECTION 368 OF THE CODE: Section 368 of the Code provides the following in pertinent part: (A) REORGANIZATION. (1) In general. For purposes of parts I and II and this part, the term "reorganization" means-- (A) a statutory merger or consolidation; (F) a mere change in identity, form, or place of organization of one corporation, however effected; or (7) (2) Special rules relating to paragraph (1). (E) Statutory merger using voting stock of corporation controlling merged corporation. A transaction otherwise qualifying under paragraph (1)(A) shall not be disqualified by reason of the fact that stock of a corporation (referred to in this subparagraph as the "controlling corporation") which before the merger was in control of the merged corporation is used in the transaction, if-- (i) after the transaction, the corporation surviving the merger holds substantially all of its properties and of the properties of the merged corporation (other than stock of the controlling corporation distributed in the transaction); and (ii) in the transaction, former shareholders of the surviving corporation exchanged, for an amount of voting stock of the controlling corporation, an amount of stock in the surviving corporation which constitutes control of such corporation. (B) PARTY TO A REORGANIZATION. For purposes of this part, the term "a party to a reorganization" includes-- (1) a corporation resulting from a reorganization, and (2) both corporations, in the case of a reorganization resulting from the acquisition by one corporation of stock or properties of another. In the case of a reorganization qualifying under paragraph (1)(B) or (1)(C) of subsection (a), if the stock exchanged for the stock or properties is stock of a corporation which is in control of the acquiring corporation, the term "a party to a reorganization" includes the corporation so controlling the acquiring corporation. In the case of a reorganization qualifying under paragraph (1)(A), (1)(B), (1)(C), or (1)(G) of subsection (a) by reason of paragraph (2)(C) of subsection (a), the term "a party to a reorganization" includes the corporation controlling the corporation to which the acquired assets or stock are transferred. In the case of a reorganization qualifying under paragraph (1)(A) or (1)(G) of subsection (a) by reason of paragraph (2)(D) of that subsection , the term "a party to a reorganization" includes the controlling corporation referred to in such paragraph (2)(D). In the case of a reorganization qualifying under subsection (a)(1)(A) by reason of subsection (a)(2)(E), the term "party to a reorganization" includes the controlling corporation referred to in subsection (a)(2)(E). (C) CONTROL DEFINED. For purposes of part I (other than Section 304), part II, this part, and part V, the term "control" means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation. (8) 4) TREASURY REGULATION SECTION 1.368-2: Treasury Regulation Section 1.368-2 provides the following in pertinent part: (A) The application of the term "reorganization" is to be strictly limited to the specific transactions set forth in Section 368(a). The term does not embrace the mere purchase by one corporation of the properties of another corporation. ... (B) (1) In order to qualify as a reorganization under Section 368(a)(1)(A) the transaction must be a merger or consolidation effected pursuant to the corporation laws of the United States or a State or territory, or the District of Columbia. (F) The term "a party to a reorganization" includes a corporation resulting from a reorganization, and both corporations, in a transaction qualifying as a reorganization where one corporation acquires stock or properties of another corporation. If a transaction otherwise qualifies as a reorganization, a corporation remains a party to the reorganization even though stock or assets acquired in the reorganization are transferred in a transaction described in paragraph (k) of this Section. If a transaction otherwise qualifies as a reorganization, a corporation shall not cease to be a party to the reorganization solely by reason of the fact that part or all of the assets acquired in the reorganization are transferred to a partnership in which the transferor is a partner if the continuity of business enterprise requirement is satisfied. See ss. 1.368-1(d). The preceding three sentences apply to transactions occurring after January 28, 1998, except that they do not apply to any transaction occurring pursuant to a written agreement which is binding on January 28, 1998, and at all times thereafter. A corporation controlling an acquiring corporation is a party to the reorganization when the stock of such controlling corporation is used in the acquisition of properties. Both corporations are parties to the reorganization if, under statutory authority, Corporation A is merged into Corporation B. All three of the corporations are parties to the reorganization if, pursuant to statutory authority, Corporation C and Corporation D are consolidated into Corporation E. Both corporations are parties to the reorganization if Corporation F transfers substantially all its assets to Corporation G in exchange for all or a part of the voting stock of Corporation G. All three corporations are parties to the reorganization if Corporation H transfers substantially all its assets to Corporation K in exchange for all or a part of the voting stock of Corporation L, which is in control of Corporation K. Both corporations are parties to the reorganization if Corporation M transfers all or part of its assets to Corporation N in exchange for all or a part of the stock and securities of Corporation N, but only if (1) (9) immediately after such transfer, Corporation M, or one or more of its shareholders (including persons who were shareholders immediately before such transfer), or any combination thereof, is in control of Corporation N, and (2) in pursuance of the plan, the stock and securities of Corporation N are transferred or distributed by Corporation M in a transaction in which gain or loss is not recognized under Section 354 or 355, or is recognized only to the extent provided in Section 356. Both Corporation O and Corporation P, but not Corporation S, are parties to the reorganization if Corporation O acquires stock of Corporation P from Corporation S in exchange solely for a part of the voting stock of Corporation O, if (1) the stock of Corporation P does not constitute substantially all of the assets of Corporation S, (2) Corporation S is not in control of Corporation O immediately after the acquisition, and (3) Corporation O is in control of Corporation P immediately after the acquisition. (J) (1) This paragraph (j) prescribes rules relating to the application of Section 368(a)(2)(E). (2) Section 368(a)(2)(E) does not apply to a consolidation. (3) A transaction otherwise qualifying under Section 368(a)(1)(A) is not disqualified by reason of the fact that stock of a corporation (the controlling corporation) which before the merger was in control of the merged corporation is used in the transaction, if the conditions of Section 368(a)(2)(E) are satisfied. Those conditions are as follows: (i) In the transaction, shareholders of the surviving corporation must surrender stock in exchange for voting stock of the controlling corporation. Further, the stock so surrendered must constitute control of the surviving corporation. Control is defined in Section 368(c). The amount of stock constituting control is measured immediately before the transaction. For purposes of this subdivision (i), stock in the surviving corporation which is surrendered in the transaction (by any shareholder except the controlling corporation) in exchange for consideration furnished by the surviving corporation (and not by the controlling corporation of the merged corporation) is considered not to be outstanding immediately before the transaction. For effect on "substantially all" test of consideration furnished by the surviving corporation, see paragraph (j)(3)(iii) of this Section. (ii) Except as provided in paragraph (k)(2) of this Section, the controlling corporation must control the surviving corporation immediately after the transaction. (iii) After the transaction, except as provided in paragraph (k)(2) of this Section, the surviving corporation must hold substantially all of its own properties and substantially all of the properties of the merged corporation (other than stock of the controlling corporation distributed in the transaction). The term "substantially all" has the same meaning as in Section 368(a)(1)(C). The "substantially all" test applies separately to the merged corporation and to the surviving corporation. In applying the "substantially all" test to the (10) surviving corporation, consideration furnished in the transaction by the surviving corporation in exchange for its stock is property of the surviving corporation which it does not hold after the transaction. In applying the "substantially all" test to the merged corporation, assets transferred from the controlling corporation to the merged corporation in pursuance of the plan of reorganization are not taken into account. Thus, for example, money transferred from the controlling corporation to the merged corporation to be used for the following purposes is not taken into account for purposes of the "substantially all" test: (A) To pay additional consideration to shareholders of the surviving corporation; (B) To pay dissenting shareholders of the surviving corporation; (C) To pay creditors of the surviving corporation; (D) To pay reorganization expenses; or (E) To enable the merged corporation to satisfy state minimum capitalization requirements (where the money is returned to the controlling corporation as part of the transaction). (iv) Paragraphs (j)(3)(ii) and (iii) of this Section apply to transactions occurring after January 28, 1998, except that they do not apply to any transaction occurring pursuant to a written agreement which is binding on January 28, 1998, and at all times thereafter. (4) The controlling corporation may assume liabilities of the surviving corporation without disqualifying the transaction under Section 368(a)(2)(E). An assumption of liabilities of the surviving corporation by the controlling corporation is a contribution to capital by the controlling corporation to the surviving corporation. If, in pursuance of the plan of reorganization, securities of the surviving corporation are exchanged for securities of the controlling corporation, or for other securities of the surviving corporation, see Sections 354 and 356. (5) In applying Section 368(a)(2)(E), it makes no difference if the merged corporation is an existing corporation, or is formed immediately before the merger, in anticipation of the merger, or after preliminary steps have been taken to otherwise acquire control of the surviving corporation. ... 5) SECTION 1032 OF THE CODE: Section 1032 of the Code provides the following in pertinent part: (a) Nonrecognition of gain or loss. No gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation. No gain or loss shall be recognized by a corporation with respect to any lapse or acquisition of an option, or with respect to a securities futures (11) contract (as defined in Section 1234B), to buy or sell its stock (including treasury stock). 6) SECTION 302 OF THE CODE: Section 302 of the Code provides the following in pertinent part: (a) General rule. If a corporation redeems its stock (within the meaning of Section 317(b)), and if paragraph (1), (2), (3), or (4) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock. (b) Redemptions treated as exchanges. (1) redemptions not equivelant to dividends. Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend. (2) Substantially disproportionate redemption of stock. (A) In general. Subsection (a) shall apply if the distribution is substantially disproportionate with respect to the shareholder. (B) Limitation. This paragraph shall not apply unless immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote. (C) Definitions. For purposes of this paragraph, the distribution is substantially disproportionate if-- (i) the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of the voting stock of the corporation at such time, is less than 80 percent of-- (ii) the ratio which the voting stock of the corporation owned by the shareholder immediately before the redemption bears to all of the voting stock of the corporation at such time. For purposes of this paragraph, no distribution shall be treated as substantially disproportionate unless the shareholder's ownership of the common stock of the corporation (whether voting or nonvoting) after and before redemption also meets the 80 percent requirement of the preceding sentence. For purposes of the preceding sentence, if there is more than one class of common stock, the determinations shall be made by reference to fair market value. (D) Series of redemptions. This paragraph shall not apply to any redemption made pursuant to a plan the purpose or effect of which is a series of redemptions resulting in a distribution which (in the aggregate) is not substantially disproportionate with respect to the shareholder. (3) Termination of shareholder's interest. Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder. (12) (4) Redemption from noncorporate shareholder in partial liquidation. Subsection (a) shall apply to a distribution if such distribution is-- (A) in redemption of stock held by a shareholder who is not a corporation, and (B) in partial liquidation of the distributing corporation. VII) CONCLUSIONS 1) THE MERGER SHOULD CONSTITUTE A REORGANIZATION WITHIN THE MEANING OF SECTION 368(A) OF THE CODE. As provided in Section 368(a)(1)(A) of the Code, a reorganization means a statutory merger or consolidation, such as a statutory merger under the DGCL. Further, as provided in Section 368(a)(2)(E) of the Code, a transaction otherwise qualifying under Section 368(a)(1)(A) shall not be disqualified by reason of the fact that stock of a corporation controlling the merged corporation, such as PMR stock, is used in the transaction, if the other requirements of Section 368(a)(2)(E) are satisfied. Due to the fact that the Merger will be considered a statutory merger under DGCL, it should constitute a reorganization within the meaning of Section 368(a) of the Code. The Merger's qualification as a reorganization will not be disqualified by reason of the fact that the stock of PMR, which is a corporation, which will be in control of Merger Sub immediately before the transaction, will be used in the transaction. The use of PMR stock will qualify under Section 368(a)(2)(E) of the Code because after the transaction, PSI will hold substantially all of its properties and the properties of Merger Sub(2); and in the transaction, former shareholders of PSI will exchange, for approximately 72 percent of PMR, the controlling corporation, 100 percent of the stock of PSI, which is an amount of stock in PSI which constitutes control of the corporation. Finally, when PMR changes its name to Psychiatric Solutions, Inc, this should also constitute a reorganization within the meaning of Section 368(a) of the Code as a mere change in identity under Section 368(a)(1)(F). 2) PMR AND PSYCHIATRIC SOLUTIONS SHOULD EACH BE CONSIDERED A "PARTY TO A REORGANIZATION" WITHIN THE MEANING OF SECTION 368(B) OF THE CODE. As provided in Section 368(b) of the Code, "a party to a reorganization" includes both corporations in the case of a reorganization resulting from the acquisition by one corporation of (2) While there is no exact definition of "substantially all", for Private Letter Ruling purposes, Rev. Proc. 86-42, 1986-2 C.B. 722, 724 amplifying Rev. Proc. 77-37, 1977-2 C.B. 568, holds that the transfer of 70 percent of the fair market value of gross assets and 90 percent of the fair market value of net assets will be deemed "substantially all". You have represented that both PSI and Merger Sub will meet this test. (13) stock or properties of another. Further the term "party to a reorganization" also includes a controlling corporation referred to in Section 368(a)(2)(E). Therefore, by nature of the fact that the Merger should constitute a reorganization within the meaning of Section 368(a) of the Code, PSI, as the acquiring corporation of Merger Sub's properties should be considered a party to a reorganization. Further, due fact that the Merger should qualify as a reorganization by reason of Section 368(a)(2)(E), PMR as the controlling corporation in the Merger should also be considered a party to a reorganization. 3) NO GAIN OR LOSS SHOULD BE RECOGNIZED BY PMR, PSYCHIATRIC SOLUTIONS, OR PSYCHIATRIC SOLUTIONS STOCKHOLDERS (EXCEPT TO THE EXTENT OF ANY CASH RECEIVED) AS A RESULT OF THE MERGER. PMR: As provided in Section 354(a)(1) of the Code, no gain or loss should be recognized by PMR upon the receipt of PSI common stock solely in exchange for stock of Merger Sub. PSI: As provided in Section 1032(a) of the Code, no gain or loss should be recognized by PSI upon the receipt of the assets of Merger Sub under Delaware state law, in exchange for shares of Psychiatric Solutions stock. PSI stockholders: As provided in Section 354(a)(1) of the Code, no gain or loss should be recognized by PSI stockholders (except to the extent of any cash received) upon the exchange of their PSI stock solely for PMR stock. The payment of cash in lieu of fractional share interests in PMR stock should be treated as if the fractional shares were distributed as part of the exchange and then were redeemed by PMR. These cash payments should be treated as having been received as distributions in full payment in exchange for the stock redeemed as provided in Section 302(a) of the Code. If solely cash is received by dissenting PSI stockholders in exchange for their PSI stock, the cash payment should be treated as received by the stockholder as a distribution in redemption of the stockholder's stock subject to the provisions and limitations of Section 302(a) of the Code. (14) SCOPE OF THE OPINION The foregoing opinion addresses only those items set forth in the "Issues" section of this letter and, therefore, no opinion is hereby expressed regarding any other federal, state, local, or foreign tax issue or on any other matter not specifically described herein. The opinion is being furnished only to you and solely for your benefit, and may not be used or relied upon for any other purpose, and may not be circulated, quoted, or otherwise referred to for any other purpose without our express written consent. Notwithstanding the foregoing, we hereby consent to the filing of this opinion as an exhibit to the Registration Statement and reference to this firm under the heading "Legal Matters" in the joint proxy statement/prospectus. If you wish to discuss any of this information further please contact John Campbell or Matthew Joffe at (615) 360-5500. Very Truly Yours, /s/ Kruse & Associates, P.C. Kruse & Associates, P.C. EX-10.14 5 g76727a1exv10w14.txt STOCK PURCHASE AGREEMENT EXHIBIT 10.14 STOCK PURCHASE AGREEMENT AMONG THE SHAREHOLDERS OF AERIES HEALTHCARE CORPORATION NAMED ON THE SIGNATURE PAGE AS SELLERS AND PSYCHIATRIC SOLUTIONS, INC., AS PURCHASER DATED: JUNE 20, 2002 TABLE OF CONTENTS Section 1. Sale of Assets and Certain Related Matters.........................................................1 1.1 Sale of Purchased Assets................................................................................1 1.2 Purchase Price..........................................................................................1 1.3 Capital Contribution....................................................................................2 1.4 Payment of Purchase Price...............................................................................2 1.5 Post-Closing Reconciliation.............................................................................2 Section 2. Closing............................................................................................2 2.1 Closing.................................................................................................2 2.2 Actions of Sellers at Closing...........................................................................3 2.3 Actions of Purchaser at Closing.........................................................................3 2.4 Additional Acts.........................................................................................4 Section 3. Representations and Warranties of Seller...........................................................4 3.1 Incorporation, Qualification and Capacity...............................................................4 3.2 Capitalization of Aeries and Aeries Illinois............................................................5 3.3 Ownership of Stock of Aeries and Aeries Illinois........................................................5 3.4 No Outstanding Rights...................................................................................5 3.5 Binding Agreement.......................................................................................5 3.6 Financial Information...................................................................................6 3.7 Permits and Approvals...................................................................................6 3.8 Intellectual Property...................................................................................7 3.9 Medicare Participation/Accreditation....................................................................7 3.10 Regulatory Compliance...................................................................................9 3.11 Title to Properties/Condition...........................................................................9 3.12 Insurance...............................................................................................9 3.13 Employee Benefit Plans.................................................................................10 3.14 Employees and Employee Relations.......................................................................11 3.15 Litigation or Proceedings..............................................................................11 3.16 Tax Matters............................................................................................12 3.17 Environmental Matters..................................................................................12 3.18 Immigration Act........................................................................................13 3.19 OSHA...................................................................................................13 3.20 Inventory..............................................................................................13 3.21 Absence of Changes.....................................................................................13 3.22 Statements True and Correct............................................................................14 3.22 Statements True and Correct............................................................................14 Section 4. Representations and Warranties of Purchaser.......................................................14 4.1 Corporate Capacity.....................................................................................14 4.2 Corporate Powers; Consents; Absence of Conflicts With Other Agreements, Etc............................14 4.3 Binding Effect.........................................................................................15 4.4 Litigation.............................................................................................15 4.5 Availability of Funds..................................................................................15 4.6 Exclusion and Modification of Warranties...............................................................15
i 4.7 Investment Representations.............................................................................15 4.8 Hart-Scott-Rodino......................................................................................16 4.9 Statements True and Correct............................................................................16 Section 5. Covenants of Seller and Purchaser.................................................................16 5.1 Information Concerning Hospital........................................................................16 5.2 Operations of Hospital.................................................................................17 5.3 Negative Covenants of Sellers..........................................................................18 5.4 Notification of Certain Matters........................................................................19 5.5 Approvals..............................................................................................19 5.6 Additional Financial Information of Seller.............................................................19 5.7 Maintenance of Books and Records by Purchaser..........................................................20 5.8 Liability Insurance Continuation.......................................................................20 5.9 Closing................................................................................................20 Section 6. Conditions Precedent to Obligations of Purchaser..................................................20 6.1 Compliance With Covenants..............................................................................21 6.2 Opinion of Seller's Counsel............................................................................21 6.3 Opinion of Aeries' Counsel.............................................................................21 6.4 Action/Proceeding.....................................................................................21 6.5 Representations and Warranties.........................................................................21 6.6 Indemnification Agreement..............................................................................21 6.7 Escrow Agreement.......................................................................................21 6.8 Agency Agreement.......................................................................................21 6.9 Management Agreements Terminated.......................................................................21 6.10 Transitional Assistance................................................................................21 6.11 Redemption of Options..................................................................................22 6.12 Subordination Agreements...............................................................................22 6.13 Provider Leases........................................................................................22 Section 7. Conditions Precedent to Obligations of Seller.....................................................22 7.1 Compliance with Covenants..............................................................................22 7.2 Opinion of Purchaser's Counsel.........................................................................22 7.3 Action/Proceeding......................................................................................22 7.4 Representations and Warranties.........................................................................22 7.5 Indemnification Agreement..............................................................................23 7.6 Escrow Agreement.......................................................................................23 7.7 Agency Agreement.......................................................................................23 7.8 HBCC Loan..............................................................................................23 Section 8. Hospital Cost Reports.............................................................................23 Section 9. Additional Agreements.............................................................................23 9.1 Acknowledgement........................................................................................23 9.2 Termination Prior to Closing...........................................................................24 9.3 Post-Closing Access to Information.....................................................................24 9.4 Preservation and Access to Records After the Closing...................................................24 9.5 Capital Expenditures...................................................................................25 9.6 Reproduction of Documents..............................................................................25 9.7 Cooperation on Tax Matters.............................................................................25 9.8 Noncompetition Agreement...............................................................................26 9.9 Sole Remedy............................................................................................26 Section 10. Definitions.......................................................................................27 10.1 Definitions............................................................................................27
ii 10.2 Interpretation.........................................................................................31 Section 11. General...........................................................................................32 11.1 Consents; Approvals and Discretion.....................................................................32 11.2 Legal Fees and Costs...................................................................................32 11.3 Choice of Law..........................................................................................32 11.4 Benefit; Assignment....................................................................................32 11.5 Accounting Date........................................................................................32 11.6 No Brokerage...........................................................................................32 11.7 Cost of Transaction....................................................................................33 11.8 Waiver of Breach.......................................................................................33 11.9 Notice.................................................................................................33 11.10 Severability........................................................................................34 11.11 No Inferences.......................................................................................34 11.12 Divisions and Headings..............................................................................34 11.13 No Third-Party Beneficiaries........................................................................34 11.14 Tax and Medicare Advice and Reliance................................................................34 11.15 Entire Agreement; Amendment.........................................................................35 11.16 Counterparts........................................................................................35 11.17 Authority to Sign...................................................................................35 11.18 Time of Essence.....................................................................................35
iii SCHEDULE NUMBER SCHEDULE MATTER 3.3 Stock Ownership and Capitalization 3.6 Historical Financial Information 3.7 Healthcare Permits and Approvals 3.8 Intellectual Property 3.9 Medicare Participation/Accreditation 3.10 Regulatory Compliance 3.11 Title to Properties/Conditions 3.12 Insurance 3.13 Employee Benefit Plans 3.14 Employment Contracts 3.15 Litigation 3.16 Tax Matters 3.17 Environmental Matters 3.21 Absence of Changes 5.2 Operations of Hospital 5.3 Negative Covenants Exhibit 1.2 Example of Purchase Price Calculation Methodology Exhibit 1.3 Form of Escrow Agreement Exhibit 6.2 Form of Opinion of Sellers' Counsel Exhibit 6.6 Form of Indemnification Agreement Exhibit 6.8 Form of Agency Agreement Exhibit 7.2 Form of Opinion of Purchaser's Counsel iv STOCK PURCHASE AGREEMENT THIS STOCK PURCHASE AGREEMENT (the "Agreement"), dated as of June 20, 2002, is by and among the shareholders of AERIES HEALTHCARE CORPORATION ("Aeries"), a Delaware corporation, named on the signature page hereto (collectively, whether one or more, "Sellers"), and PSYCHIATRIC SOLUTIONS, INC., a Delaware corporation and/or its designated affiliate ("Purchaser"). Except as otherwise defined herein, capitalized terms shall have the meanings ascribed to them in Section 10 of this Agreement. RECITALS: Aeries is authorized to issue 2,500 shares of its $0.01 par value voting common stock, of which 624.64 shares are presently issued and outstanding. Aeries also has outstanding two classes of warrants to acquire an aggregate of 624.89 shares of its voting common stock (such issued and outstanding voting common stock and the warrants to acquire such stock being hereafter referred to as the "Stock"). Sellers are the sole owners of all of the Stock. In addition, Aeries has outstanding Options to acquire 147.05 shares of its voting common stock, which Options shall be redeemed by Aeries prior to Closing. Aeries, in turn, is the sole owner of all of the issued and outstanding voting common stock of Aeries Healthcare of Illinois, Inc., an Illinois corporation ("Aeries Illinois"), its sole class of stock. Aeries Illinois owns and operates Riveredge Hospital located in Forest Park, Illinois. Sellers now desire to sell, and the Purchaser desires to purchase, all of the Stock of Aeries, all on the terms and conditions set out herein. NOW, THEREFORE, consideration of the premises and of the mutual agreements, covenants, representations, and warranties contained herein and other good and valuable consideration, the receipt, adequacy, and sufficiency of which are hereby acknowledged, the parties hereto agree as follows: SECTION 1. SALE OF STOCK; PURCHASE PRICE; PAYMENT. 1.1 SALE OF STOCK. At the "Closing" (as such term is defined herein) Sellers shall sell, assign, transfer, convey, and deliver, or cause to be delivered, to Purchaser the Stock, and the Purchaser shall purchase, accept, and pay for the Stock as set out in Section 1.2. 1.2 PURCHASE PRICE. The full Purchase Price for the Stock shall be $16,100,000.00 less Net Debt immediately following the Closing, subject to adjustment as follows: The Purchase Price shall be subject to adjustment upward or downward at Closing based upon the difference between Aeries' March 31, 2002, Net Working Capital of $1,706,139 and its Net Working Capital as of June 30, 2002. For purposes of this Agreement, "Net Working Capital" is defined as (1) total current assets (including accounts receivable for Hospital's Cost Reports for the years 2000 and 2001) less cash, minus (2) total current liabilities less accrued interest, all determined in a manner consistent with the March 31, 2002, financial statements. Any adjustment made pursuant to this Section shall be deemed an adjustment in the Cash to Sellers component of the Purchase Price described 1 below. An example of the methodology of the computation of the Purchase Price is set out in Exhibit 1.2, hereto. 1.3 CAPITAL CONTRIBUTION. The parties recognize that the redemption of Aeries Options required in Section 6.11, below, by Aeries prior to Closing will serve to reduce the Purchase Price paid directly by Purchaser by the amount required to effect the redemption. To assure the payment of the full, agreed upon Purchase Price - including the equity component of the Aeries Options - simultaneously with Closing Purchaser shall contribute to Aeries an amount of cash equal to the compensation income paid to the Aeries' Option holders in exchange for termination of their Option rights. 1.4 PAYMENT OF PURCHASE PRICE. The Purchase Price shall be payable at the Closing as follows: 1.4.1 ESCROW PAYMENT. Purchaser shall deposit $4,500,000.00 with Escrow Agent pursuant to the terms of the Escrow Agreement in substantially the form attached hereto as Exhibit 1.3 (the "Escrow Payment") to secure any contingent obligations of Sellers for breaches of their representations and warranties; and 1.4.2 CASH TO SELLERS. The balance of the Purchase Price, adjusted as provided in Sections 1.2 and 5.8 hereof ("Cash to Sellers"), shall be paid by Purchaser to Sellers at Closing by wire transfer to an account or accounts designated by Sellers in immediately available funds, for subsequent distribution to Sellers and shall be allocated among Sellers proportionately to their holdings of Stock. Sellers shall provide the Purchaser with Sellers' wire transfer instructions no less than two (2) business days prior to the Closing Date. 1.5 POST-CLOSING RECONCILIATION. The Purchase Price shall be subject to a post-closing adjustment in the following manner within thirty (30) days following Closing: For purposes of Closing, the Purchase Price is being calculated based upon Aeries financial statements as of May 31, 2002. As soon as Aeries financial statements for June 30, 2002, are prepared, the Purchase Price as of that date shall be calculated. To the extent the June 30 Purchase Price exceeds the May 31 Purchase Price, Purchaser shall, within three (3) business days, pay over to Sellers' Agent designated in that certain Agency Agreement by and among Purchaser, Sellers, and Escrow Agent of even date herewith, the amount by which the June 30 Purchase Price exceeds the May 31 Purchase Price. However, in the event the June 30 Purchase Price is less than the May 31 Purchase Price, Sellers shall, within three (3) business days, pay to Purchaser the amount by which the June 30 Purchase Price is less than the May 31 Purchase Price. All payments due hereunder shall bear interest at the rate of six percent (6%) per annum until paid. SECTION 2. CLOSING. 2.1 CLOSING. Subject to the satisfaction or waiver by the appropriate party of all the conditions precedent to Closing specified in Sections 6 and 7 hereof, the consummation of the sale and purchase of the Stock and the other transactions contemplated by and described in this Agreement (the "Closing") shall take place at the offices of Harwell Howard Hyne Gabbert & 2 Manner, P.C., 315 Deaderick Street, Suite 1800, Nashville, Tennessee, at 10:00 a.m. local time, on June 28, 2002, or at such other date and/or at such other location as the parties hereto may mutually designate in writing (the "Closing Date"). The parties shall use commercially reasonable efforts to cause the conditions set forth in Sections 6 and 7 to be satisfied so that the Closing will occur on or before June 28, 2002. 2.2 ACTIONS OF SELLERS AT CLOSING. At the Closing and unless otherwise waived in writing by Purchaser, Sellers shall deliver to Purchaser the following: 2.2.1 A stock certificate or stock certificates and warrant certificates or other conveyances representing not less than all of the Stock duly endorsed or accompanied by appropriate stock powers duly endorsed in blank. 2.2.2 The Escrow Agreement to be delivered pursuant to Sections 6.5 and 7.5 fully-executed by all Sellers. 2.2.3 The Indemnification Agreement to be delivered pursuant to Sections 6.6 and 7.6 fully-executed by all Sellers. 2.2.4 A certificate of Sellers certifying that the conditions set forth in Section 6.5 have been satisfied; 2.2.5 Certificates of existence for each of Aeries and Aeries Illinois, from their respective states of incorporation dated the most recent practical date prior to Closing; 2.2.6 The opinion of Sellers' counsel as described in and provided by Section 6.2 hereof; 2.2.7 Such other instruments and documents as are reasonably necessary to satisfy the conditions precedent to Purchaser's obligations hereunder. 2.3 ACTIONS OF PURCHASER AT CLOSING. At the Closing and unless otherwise waived in writing by Sellers, Purchaser shall deliver to Sellers the following: 2.3.1 The Cash to Sellers component of the Purchase Price in immediately available funds; 2.3.2 The Escrow Agreement to be delivered pursuant to Sections 6.7 and 7.5 fully-executed by Purchaser. 2.3.3 The Indemnification Agreement to be delivered pursuant to Sections 6.6 and 7.6 fully-executed by Purchaser. 2.3.4 Copies of resolutions duly adopted by the board of directors of Purchaser, authorizing and approving Purchaser's performance of the transactions contemplated hereby and the execution and delivery of this Agreement and the documents described 3 herein, certified as true and in full force as of Closing by an appropriate officer of Purchaser; 2.3.5 A certificate of Purchaser certifying that the conditions set forth in Section 7.4 have been satisfied; 2.3.6 Certificates of incumbency for the respective officers of Purchaser executing this Agreement and any other agreements or instruments contemplated herein dated as of the Closing Date; 2.3.7 Certificates of existence and good standing of Purchaser from its state of organization or incorporation and the State of Tennessee, each dated the most recent practical date prior to Closing; 2.3.8 The opinion of Purchaser's counsel as described in and provided by Section 7.2; and 2.3.9 Such other instruments and documents as are reasonably necessary to satisfy the conditions precedent to Sellers' obligations hereunder. 2.4 ADDITIONAL ACTS. From time to time after Closing, Sellers shall execute and deliver such other instruments of conveyance and transfer, and take such other actions as Purchaser reasonably may request, to convey and transfer full right, title and interest to, vest in, and place Purchaser in legal and actual possession of, Hospital. In the case of rights that cannot be transferred effectively without the consent of third parties, Purchaser and Sellers shall each use commercially reasonable efforts to obtain such consents prior to the Closing and, if not so obtained, then promptly thereafter. Sellers shall also furnish Purchaser with such information and documents in their possession or under their control, or that Sellers can execute or cause to be executed, as will enable Purchaser to prosecute any and all petitions, applications, claims and demands relating to or constituting a part of Hospital. SECTION 3. REPRESENTATIONS AND WARRANTIES OF SELLERS. As of the date hereof and as of the Closing Date (except to the extent any of the following speaks as of a specific date, such as the date hereof), Sellers jointly and severally represent and warrant to Purchaser the following: 3.1 INCORPORATION, QUALIFICATION AND CAPACITY. Each of Aeries and Aeries Illinois is a corporation duly organized, validly existing, and in good standing under the Laws of its state of incorporation. Each of Aeries and Aeries Illinois is duly authorized, qualified to do business and in good standing under all applicable Laws of any Governmental Entity having jurisdiction over the business and operation of Hospital to own its properties and conduct its business in the place and manner now conducted, except to the extent that failure to be so qualified has not had a material adverse effect on the operations of Hospital. 4 3.2 CAPITALIZATION OF AERIES AND AERIES ILLINOIS. 3.2.1 AERIES. The authorized capital stock of Aeries consists of: (i) 2,500 shares of voting common stock, $0.01 par value per share, of which 624.64 shares are issued and outstanding; (ii) warrants to acquire 211.89 shares of Aeries voting common stock for an exercise price of $0.01 per share; (iii) warrants to acquire 413 shares of Aeries' voting common stock for an exercise price of $1,388.89 per share; and (iv) Options to acquire 147.05 shares of Aeries voting common stock for an exercise price of $1,389.00 per share. Immediately prior to Closing, Aeries shall redeem and cancel all of the issued and outstanding Options, and none shall be outstanding at Closing. 3.2.2 AERIES ILLINOIS. The authorized capital stock of Aeries Illinois consists of 100,000 shares of voting common stock, $0.01 par value, of which 100 shares are issued and outstanding. Except as set out above, there are no outstanding (a) securities convertible into or exchangeable for Aeries or Aeries Illinois stock or (b) options, warrants or preemptive or other rights to acquire any shares of capital stock of Aeries or Aeries Illinois. 3.3 OWNERSHIP OF STOCK OF AERIES AND AERIES ILLINOIS. All issued and outstanding Stock is duly authorized and validly issued, fully-paid and non-assessable, with no personal liability attaching to the ownership thereof and is free and clear of any taxes, liens or other encumbrances. Sellers have been advised that the sale of the Stock as contemplated herein is exempt from registration under the Securities Act of 1933, as amended (the "Act"). Each Seller is the sole record and beneficial owner of the shares of Stock set forth opposite his, her or its name on Schedule 3.3. Upon delivery by such Sellers of the certificates representing the Stock and payment therefor by Purchaser as provided herein, Purchaser will acquire valid and marketable title to the Stock free and clear of any Encumbrances except for restrictions on transfer imposed by the Act and state securities laws. Except as set forth in Schedule 3.3, other than Sellers, there are no holders of any equity interest in Aeries. All issued and outstanding shares of the common stock of Aeries Illinois are duly authorized and validly issued, fully-paid and non-assessable, with no personal liability attaching to the ownership thereof and are free and clear of any taxes, liens or other encumbrances. Aeries is the sole record and beneficial owner of all of the issued and outstanding shares of Aeries Illinois' voting common stock. The only subsidiary of Aeries is Aeries Illinois, and Aeries Illinois has no subsidiaries. 3.4 NO OUTSTANDING RIGHTS. Except as set forth on Schedule 3.3, there are no outstanding rights (including any right of first refusal), options, agreements or other commitments giving any Person any current or future right to require Sellers or, following the Closing Date, Purchaser, to sell or transfer to such Person or to any third party any material interest in any of the Stock or any material assets of Hospital. 3.5 BINDING AGREEMENT. Assuming necessary Permits and Approvals (if any) are obtained, this Agreement and all agreements to which Sellers will become a party hereunder are and will constitute the valid and legally binding obligations of each Seller and are and will be enforceable against each in accordance with the respective terms hereof or thereof, except as 5 enforceability may be restricted, limited or delayed by applicable bankruptcy or other laws affecting creditors' rights generally and except as enforceability may be subject to general principles of equity. 3.6 FINANCIAL INFORMATION. Schedule 3.6 hereto contains the following financial statements and financial information (collectively, the "Historical Financial Information"): 3.6.1 Audited consolidated balance sheets of Aeries and Aeries Illinois for the year ended December 31, 2001, and for the ten months ended December 31, 2000; 3.6.2 Audited consolidated statement of operations of Aeries and Aeries Illinois for the year ended December 31, 2001, and for the ten months ended December 31, 2000; and 3.6.3 Unaudited consolidated financial statements of Aeries and Aeries Illinois for the three-month period ended on the Balance Sheet Date and on April 30, 2002, and the one-month period ended April 30, 2002. Except as disclosed on Schedule 3.6, the financial statements included in the Historical Financial Information have been prepared in accordance with GAAP, applied on a consistent basis throughout the periods indicated, and Aeries and Aeries Illinois have not changed any accounting policy or methodology in determining the obsolescence of inventory or in calculating reserves (including reserves for uncollected accounts receivable) throughout all periods presented except that such statements: (i) with respect to unaudited statements, may be subject to cost report and other year-end audit adjustments, (ii) with respect to unaudited statements, may not contain footnotes, (iii) with respect to unaudited statements, may be prepared without physical inventories, (iv) may not contain an unaudited statement of cash flow, (v) may be restated for subsequent events, and (vi) may include allowances for doubtful accounts recorded in compliance with Hospital's policy of maintaining the allowance for doubtful accounts based upon an amount equal to all accounts aged greater than 150 days. Except as set forth on Schedule 3.6, the balance sheets contained in the Historical Financial Information present fairly in all material respects the financial condition of Aeries and Hospital as of the dates indicated thereon, and the income statements contained in the Historical Financial Information present fairly in all material respects the results of operations of Hospital for the periods covered. The accounts receivable of Aeries Illinois identified in the Historical Financial Information have all arisen from the provision of services and sale of goods billed in the normal course of Hospital's operation and, to the knowledge of the Sellers, are collectible in the ordinary course of business consistent with Hospital's historical collection experience and subject to the reserves on the financial statements. 3.7 PERMITS AND APPROVALS. 3.7.1 Set forth on Schedule 3.7 is a true and complete description of all material Permits and Approvals (other than Environmental Approvals and Permits) issued or granted by a Governmental Entity and owned or held by or issued to Hospital currently ( "General Permits and Approvals"). Such General Permits and Approvals constitute all material General Permits and Approvals necessary for the conduct of the business and operation 6 of Hospital as currently conducted. Each of Aeries and Aeries Illinois, as the case may be, has been during its operation of Hospital the duly authorized holder of such General Permits and Approvals, all of which are in full force and effect and unimpaired. Hospital's pharmacies, laboratories and all other material ancillary departments located at Hospital or operated for the benefit of Hospital and included within Hospital, which are required to be specially licensed, have been licensed by the appropriate Governmental Entity during Aeries Illinois' ownership of Hospital, as set forth on Schedule 3.7. 3.7.2 During Aeries Illinois' ownership of Hospital, Hospital has been in compliance in all material respects with all General Permits and Approvals. There are no provisions in, or agreements relating to, any such General Permits and Approvals that preclude or limit in any material respect Aeries Illinois from operating Hospital as it is currently operated. There is not now pending nor, to the knowledge of Sellers, threatened, any action by or before any Governmental Entity of which Sellers have notice to revoke, cancel, rescind, modify or refuse to renew any of the General Permits and Approvals, and all of the material General Permits and Approvals are and shall be in good standing as of the Closing. 3.7.3 Hospital is in compliance in all material respects with all applicable fire code regulations. Sellers have identified on Schedule 3.7 the most recent state licensing reports and lists of deficiencies, if any, and the most recent fire marshal surveys and lists of deficiencies, if any, for Hospital. 3.8 INTELLECTUAL PROPERTY. 3.8.1 Schedule 3.8 sets out a complete list of all Intellectual Property used by Aeries, Aeries Illinois, or Sellers and material to the operation of Hospital. Aeries Illinois has owned, or has been licensed or will be licensed or has otherwise possessed all necessary rights to use, all Intellectual Property material to the operation of Hospital. 3.8.2 Except as set forth on Schedule 3.15, Aeries, Aeries Illinois, or Sellers have not been served with process in any suit, action or proceeding that involves a claim of infringement of any Intellectual Property. To the knowledge of Sellers, the business of Hospital does not infringe any Intellectual Property or other proprietary right of any third party. Neither Aeries, Aeries Illinois, nor Sellers has brought any action, suit or proceeding for infringement of Intellectual Property or breach of any license or agreement involving Intellectual Property related to any of Hospital against any third party. 3.9 MEDICARE PARTICIPATION/ACCREDITATION. 3.9.1 Except as set forth on Schedule 3.9, Hospital is eligible to receive payment without restriction under Title XVIII of the Social Security Act ("Medicare") and Title XIX of the Social Security Act ("Medicaid"), and is a "provider" with valid and current provider agreements and with one or more provider numbers with Medicare, all applicable Medicaid, and successor programs (the "Government Programs") through 7 intermediaries. Except as set forth on Schedule 3.9, Hospital is in compliance with the conditions of participation for the Government Programs in all material respects. Except as set forth on Schedule 3.9, there is not pending nor to the knowledge of Sellers threatened, any proceeding or investigation of which Sellers have notice under the Government Programs involving Sellers or Hospital. Except as disclosed on Schedule 3.9, Hospital is in material compliance with filing requirements with respect to cost reports of Hospital and such reports do not claim, and Sellers have not received payment or reimbursement in excess of, the amount provided by Law or any applicable agreement, except where excess reimbursement was noted on the cost report. Except as disclosed on Schedule 3.9 and except for claims, actions and appeals in the ordinary course of business, there are no claims, actions or appeals pending before any Governmental Entity, including any fiscal intermediary or carrier, Governmental Entity or the Administrator of the Center for Medicare and Medicaid Services with respect to any Government Program cost reports or claims filed on behalf of Hospital or Aeries Illinois on or before the date of this Agreement, or any disallowances by any commission, board or agency in connection with any audit of such cost reports. Except as disclosed on Schedule 3.9 and except for those in the ordinary course of business, no validation review or program integrity review related to the operation of Hospital or the consummation of the transactions contemplated by this Agreement has been conducted by any commission, board, agency or Government Entity in connection with the Government Programs, and to the knowledge of Sellers, no such reviews are scheduled, pending or threatened against Hospital. 3.9.2 To Sellers' knowledge and except as set for the on Schedule 3.9, accounts receivable billing practices of Aeries Illinois with respect to Hospital to all private insurance companies have been in compliance with all applicable Laws in all material respects, and neither Aeries Illinois nor Hospital has billed to or received from any such payer payment or reimbursement in excess of amounts allowed by Law. 3.9.3 Hospital is fully accredited by the Joint Commission on Accreditation of Healthcare Organizations ("JCAHO"). Sellers have provided Purchaser or have made available to Purchaser copies of each such JCAHO accreditation survey report and deficiency list, if any, and Hospital's most recent statement of deficiencies and plan of correction. 3.9.4 Neither Hospital, Aeries, Aeries Illinois, Aeries Healthcare Management Services, LLC, nor any partner, member, director, officer or employee of Hospital, Aeries, Aeries Illinois, Aeries Healthcare Management Services, LLC, nor, to Sellers' knowledge, any agent acting on behalf of or for the benefit of any of the foregoing, has directly or indirectly in connection with Hospital: (i) offered or paid any remuneration, in cash or in kind, to, or made any financial arrangements with, any past, present or potential customers, past or present suppliers, patients, medical staff members, contractors or third party payers of Sellers or Hospital in order to obtain business or payments from such Persons other than in the ordinary course of business; (ii) given or agreed to give, or has knowledge that there has been made or that there is any agreement to make, any gift or gratuitous payment of any kind, nature or description (whether in money, property or 8 services) to any customer or potential customer, supplier or potential supplier, contractor, third party payor or any other Person other than in connection with promotional or entertainment activities in the ordinary course of business; (iii) made or agreed to make, or has knowledge that there has been made or that there is any agreement to make, any contribution, payment or gift of funds or property to, or for the private use of, any governmental official, employee or agent where either the contribution, payment or gift or the purpose of such contribution, payment or gift is or was illegal under the Laws of the United States or under the Laws of any state or any other Governmental Entity having jurisdiction over such payment, contribution or gift; (iv) established or maintained any unrecorded fund or asset for any purpose or made any materially misleading, false or artificial entries on any of its books or records for any reason; or (v) made, or agreed to make, or has knowledge that there has been made or that there is any agreement to make, any payment to any Person with the intention or understanding that any part of such payment would be used for any purpose other than that described in the documents supporting such payment. 3.9.5 Neither Hospital, Aeries, Aeries Illinois, Aeries Healthcare Management Services, LLC, nor any partner, member, director, officer or employee of Hospital, is a party to any contract, lease agreement or other arrangement (including any joint venture or consulting agreement) related to Hospital with any physician, health care facility, hospital, nursing facility, home health agency or other Person who is in a position to make or influence referrals to or otherwise generate business for Hospital with respect to Hospital, to provide services, lease space, lease, equipment or engage in any other venture or activity, to the extent that any of the foregoing is prohibited by Law. 3.10 REGULATORY COMPLIANCE. Except as set forth on Schedule 3.10, Hospital is in compliance in all material respects with all applicable statutes, rules, regulations and requirements of Government Entities having jurisdiction over Hospital. Hospital has timely filed all material forms, applications, reports, statements, data and other information required to be filed with Government Entities. 3.11 TITLE TO PROPERTIES/CONDITION. Except as disclosed on Schedule 3.11, Aeries Illinois or Hospital has good, valid and marketable or merchantable title to all its properties and assets used in or relating to its business, whether real, personal and mixed, tangible and intangible, other than those that are leased, free and clear of any Encumbrance. Excluding ordinary wear and tear consistent with their age, the tangible assets of Hospital are in good operating condition and repair and are adequate and suitable for the purpose for which they are being utilized. Excluding ordinary wear and tear consistent with their age, no physical condition of Hospital real property and improvements thereon could reasonably be expected to have a material adverse effect on the operation of Hospital. 3.12 INSURANCE. Schedule 3.12 sets forth a true and complete list of all loss and/or casualty insurance policies or self-insurance funds maintained with respect to Hospital as of the date of this Agreement covering the ownership and operation of Hospital. Sellers will maintain all of such policies or substantially similar policies until the Closing in full force and effect on a claims made basis with no premium arrearages. 9 3.13 EMPLOYEE BENEFIT PLANS. 3.13.1 Schedule 3.13 contains a true and complete list of all the following agreements, plans or other arrangements, covering any employee of Aeries Illinois, which are presently in effect: (i) employee benefit plans within the meaning of Section 3(3) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and (ii) any other employee benefit plan, program, policy or arrangement, whether written or unwritten, formal or informal, which Sellers currently sponsor on behalf of any employee of Aeries Illinois, or to which they have any outstanding present or future obligations to contribute or other liability, whether voluntary, contingent or otherwise (collectively, the "Plans"). 3.13.2 Neither Hospital nor its assets are, and Sellers do not reasonably expect them to become, subject to a lien imposed under the Code or under Title I or Title IV of ERISA including liens arising by virtue of Aeries Illinois being considered to be aggregated with another entity pursuant to Section 414 of the Code ("ERISA Controlled Group"). 3.13.3 Neither Aeries Illinois nor any member of any ERISA Controlled Group has sponsored, contributed to or had an "obligation to contribute" (as defined in ERISA Section 4212) to a "multi-employer plan" (as defined in ERISA Sections 4001(a)(3) or 3(37)) on or after March 1, 2000, on behalf of any employees of Aeries Illinois. 3.13.4 Neither Aeries Illinois nor any member of any ERISA Controlled Group has at any time sponsored or contributed to a "single employer plan" (as defined in ERISA Section 4001(a)(14)) in which at least two or more of the "contributing sponsors" (as defined in ERISA Section 4001(a)(13)) are not part of the same ERISA Controlled Group. 3.13.5 Except as set forth on Schedule 3.13, there are no material actions, audits or claims pending or, to Sellers' knowledge, threatened against Aeries Illinois or Hospital with respect to Hospital's and Aeries Illinois' maintenance of the Plans, other than routine claims for benefits and other claims that are not material. 3.13.6 Aeries Illinois and any ERISA Controlled Group have complied in all material respects with all of the continuation coverage requirements of Section 1001 of the Consolidated Omnibus Budget Reconciliation Act of 1985, as amended, and ERISA Sections 601 through 608 and with the requirements of Section 5000 of the Code. 3.13.7 All of Sellers' Plans that are intended to satisfy Section 401 of the Code ("Retirement Plans") from which assets may be involved in a "direct rollover" (as defined in Section 401(a)(31) of the Code) or other transfer to Purchaser's Retirement Plans have complied in all material respects with the requirements of Section 401(a) or of the Code. 10 3.14 EMPLOYEES AND EMPLOYEE RELATIONS. 3.14.1 Except as set forth on Schedule 3.14, employees deployed at Hospital are employed by Aeries Illinois. No changes in the basis for remuneration of employees of Aeries Illinois have been made, promised or authorized by Aeries, Aeries Illinois or Hospital since the Balance Sheet Date, except in the ordinary and usual course. Except as set forth on Schedule 3.14, Sellers have no written employment contracts, and no agreement of any nature that provides for employment for any particular period of time or that provides any restrictions upon Hospital's right to terminate employment without any post-termination payment obligation, with any Person whomsoever relating to Hospital. Other than in the ordinary course of business, no binding agreements have been made or entered into between Aeries Illinois and any employee regarding changes in compensation, promotion or any other change in status. 3.14.2 Except as set forth on Schedule 3.14: (i) there is no pending or, to the best of Sellers' knowledge, threatened employee strike, work stoppage or labor dispute, (ii) no union representation question exists respecting any employees of Aeries Illinois, no demand has been made for recognition by a labor organization by or with respect to any employees of Aeries Illinois, no union is actively seeking to organize the employees of Aeries Illinois are taking place, and none of the employees of Aeries Illinois is represented by any labor union or organization , (iii) no collective bargaining agreement exists or is currently being negotiated by Aeries Illinois, (iv) there is no unfair practice claim against Aeries Illinois or Hospital before the National Labor Relations Board, or any strike, dispute, slowdown, or stoppage pending or, to the best of Sellers' knowledge, threatened against or involving Hospital and none has occurred, (v) Aeries Illinois and Hospital are in compliance in all material respects with all Laws and contracts respecting employment and employment practices, labor relations, terms and conditions of employment, and wages and hours, (vi) to the best of Sellers' knowledge, Aeries Illinois and Hospital are not engaged in any unfair labor practices, (vii) there are no pending or, to the best of Sellers' knowledge, threatened complaints or charges before any Governmental Entity regarding employment discrimination, safety or other employment-related charges or complaints, wage and hour claims, unemployment compensation claims, workers' compensation claims or the like, and (viii) except as otherwise provided in this Agreement, Purchaser will not be subject to any claim or liability for severance pay as a result of the consummation of the transactions contemplated by this Agreement through the Closing. Except as set forth on Schedule 3.14, no claims, injuries, fact, event or condition exists which could give rise to a material claim by employees or former employees (including dependents and spouses) with respect to Hospital under any workers compensation Laws, requirements or programs or for any other medical costs and expenses. 3.15 LITIGATION OR PROCEEDINGS. Aeries Illinois and Hospital are not in violation in any material respect under any Law relating to the operation of Hospital, or under any order of any court or federal, state, municipal or other Governmental Entity wherever located. Except to the extent set forth on Schedule 3.15, there are no claims, actions, suits, audits, compliance reports or information requests, proceedings or investigations pending, or to the knowledge of 11 Sellers, threatened, against or affecting Sellers or Hospital that are not adequately insured against. Other than as set forth on Schedule 3.15, Hospital is not subject to any outstanding judgment, order or decree. 3.16 TAX MATTERS. Except as set forth on Schedule 3.16: 3.16.1 Any tax returns, including income tax returns, sales tax returns, employee unemployment tax returns and franchise tax returns, for periods prior to and including Closing that are or were required to be filed by Aeries or Aeries Illinois (collectively "Returns") have been filed or will be filed within the time (including any valid extensions thereof) and in the manner provided by Law, and all Returns are or will be true and correct in all material respects and accurately reflect the tax liabilities of Aeries or Aeries Illinois in all material respects, and all amounts shown due on such Returns have been or will be paid on a timely basis; 3.16.2 No notice of a claim or pending investigation has been received or, to the knowledge of Sellers, has been threatened, by any state, local or other jurisdiction, alleging that Aeries or Aeries Illinois has a duty to file tax returns and pay taxes or is otherwise subject to the taxing authority of any jurisdiction, nor have Aeries, Aeries Illinois, or Sellers received any notice from any jurisdiction that asserts that Aeries or Aeries Illinois has a duty to file such returns and pay such taxes, or otherwise is subject to the taxing authority of such jurisdiction. 3.17 ENVIRONMENTAL MATTERS. Except as set forth on Schedule 3.17 or in any environmental report listed therein: 3.17.1 Hospital has materially complied and is in material compliance with all Environmental Laws. 3.17.2 To the best of Sellers' knowledge, neither Aeries nor Aeries Illinois has liability under any Environmental Law with respect to Hospital nor is Aeries or Aeries Illinois responsible for any liability of any other Person under any Environmental Law with respect to Hospital. There are no pending or, to the knowledge of Sellers threatened, actions, suits, orders, claims, legal proceedings or other proceedings based on, and Sellers have received no formal or informal notice from any Governmental Entity that would reasonably be expected to form the basis for any such actions or notices arising out of or attributable to any Environmental Condition. 3.17.3 To the best of Sellers' knowledge, Hospital has been duly issued and currently has and will maintain through the Closing Date, all material Approvals and Permits required under any Environmental Law with respect to Hospital (the "Environmental Approvals and Permits"). A true and complete list of such Environmental Approvals and Permits, 12 all of which are valid and in full force and effect, is set forth in Schedule 3.17. Hospital is in material compliance with all Environmental Approvals and Permits. 3.17.4 No Encumbrance in favor of any Person relating to or in connection with any claim under any Environmental Law has been filed with respect to Hospital. 3.18 IMMIGRATION ACT. Aeries and Aeries Illinois are in compliance in all material respects with the terms and provisions of the Immigration Act with respect to Hospital. For each employee of Aeries Illinois for whom compliance with the Immigration Act is required, Aeries Illinois have obtained and retained a complete and true copy of each such employee's Form I9 (Employment Eligibility Verification Form) and all other records or documents prepared, procured or retained by Aeries Illinois pursuant to the Immigration Act to the extent Aeries Illinois is required to do so under the Immigration Act and the failure to comply with such requirement would have a material adverse effect on the operations of Hospital. Hospital has not been cited, fined, served with a Notice of Intent to Fine or with a Cease and Desist Order (as such terms are defined in the Immigration Act) at Hospital nor, to the knowledge of Sellers, has any action or administrative proceeding been initiated or threatened against Hospital or Aeries Illinois by reason of any actual or alleged failure to comply with the Immigration Act. 3.19 OSHA. Hospital has complied with all applicable laws relating to employee health and safety in all material respects and neither Aeries, Aeries Illinois, nor Sellers has received any written notice from any Governmental Entity that past or present conditions of Hospital violate any of such applicable legal requirements or otherwise will be made the basis of any claim, proceeding or investigation, based on OSHA violations or otherwise related to employee health and safety. 3.20 INVENTORY. All of the Inventory existing on the date hereof will exist on the Closing Date except for Inventory exhausted or added in the ordinary course of business between the date of this Agreement and the Closing Date. All of the Inventory on hand on the date of this Agreement and to be on hand on the Closing Date consists and will consist in all material respects of items of a quality usable or saleable in the ordinary and usual course of business. The quantities of all Inventory are reasonable and justified under the normal operations of Hospital. 3.21 ABSENCE OF CHANGES. Except as set forth in Schedule 3.21 or otherwise in the ordinary course of business, between the Balance Sheet Date and the date hereof, there has not been any transaction or occurrence in which Hospital has: 3.21.1 suffered any material damage, destruction or loss with respect to or affecting any of its property; 3.21.2 written down or written up in any material amount the value of any Inventory (including write-downs by reason of shrinkage or markdowns), determined as collectible any material account receivable or any portion thereof that was previously considered uncollectible, or written off as uncollectible any material account receivable or any portion thereof, except for write-downs, write-ups, and write-offs in the ordinary course of business; 13 3.21.3 disposed of or permitted to lapse any right to the use of any material Intellectual Property; 3.21.4 made any material capital expenditure or commitment for additions to property, plant, equipment, intangible or capital assets or for any other purpose; 3.21.5 sold, transferred or otherwise disposed of any material asset; 3.21.6 granted or incurred any obligation for any increase in the compensation of any employee who is employed at Hospital (including any increase pursuant to any bonus, pension, profit-sharing, retirement or other plan or commitment) except in the ordinary course of business; 3.21.7 made any change in any method of accounting or accounting principle, practice, or policy; or 3.21.8 taken any other action neither in the ordinary course of business nor provided for in this Agreement. 3.22 EARN OUT. Hospital's aggregate EBITDA (calculated in the same manner as calculated for Hospital prior to Closing) for the months of July, August, September, and October, 2002 ("Aggregate EBITDA"), shall equal or exceed $1,115,000, provided Mark R. Russell is designated the chief executive officer of Hospital and is allowed to operate Hospital as he operated it prior to Closing through-out the entire four-month period and consistent with applicable law.. 3.23 STATEMENTS TRUE AND CORRECT. The representations and warranties of Sellers set out in this Agreement and the Schedules hereto (whenever delivered), taken together, do not contain, as of the date hereof, any untrue statement of a material fact or omit to state any material fact necessary to make the statements made in this Agreement or the Schedules provided by Sellers not misleading. SECTION 4. REPRESENTATIONS AND WARRANTIES OF PURCHASER. As of the date hereof and as of the Closing Date (except to the extent any of the following speaks as of a specific date, such as the date hereof), Purchaser represents and warrants to Sellers the following: 4.1 CORPORATE CAPACITY. Purchaser is a validly existing corporation duly organized under the laws of the State of Delaware. 4.2 CORPORATE POWERS; CONSENTS; ABSENCE OF CONFLICTS WITH OTHER AGREEMENTS, ETC. The execution, delivery and performance of this Agreement by Purchaser and all other agreements referenced in or ancillary hereto to which Purchaser is a party and the consummation of the transactions contemplated herein by Purchaser: 14 4.2.1 are within its corporate powers and are not in contravention of the terms of Purchaser's articles or certificate of incorporation or bylaws and have been approved by all requisite corporate action; 4.2.2 except as otherwise expressly herein provided, do not require any Approval or Permit of, or filing with, any Governmental Entity bearing on the validity of this Agreement that is required by Law; and 4.2.3 will neither conflict with nor result in any material breach or contravention of, or the creation of any Encumbrance under, any indenture, agreement, lease, instrument or understanding to which Purchaser is a party or by which Purchaser is bound. 4.3 BINDING EFFECT. This Agreement and all other agreements to which Purchaser will become a party hereunder are and will constitute the valid and legally binding obligations of Purchaser and are and will be enforceable against Purchaser in accordance with the respective terms hereof and thereof, except as enforceability against Purchaser may be restricted, limited or delayed by applicable bankruptcy or other laws affecting creditors' rights generally and except as enforceability may be subject to general principles of equity. 4.4 LITIGATION. There is no claim, action, suit, proceeding or investigation pending or, to the knowledge of Purchaser, threatened against or affecting Purchaser that has or would reasonably be expected to have a material adverse effect on Purchaser's ability to perform this Agreement or any aspect of the transactions contemplated hereby. 4.5 AVAILABILITY OF FUNDS. Purchaser has the ability to obtain funds in cash in amounts equal to the Purchase Price by means of credit facilities or otherwise and will at Closing have immediately available funds in cash that are sufficient to pay the Purchase Price and to pay any other amounts payable pursuant to this Agreement and to consummate the transactions contemplated by this Agreement. 4.6 EXCLUSION AND MODIFICATION OF WARRANTIES. Except as otherwise set out herein, Purchaser acknowledges that there are no warranties, express or implied, as to the merchantability or fitness of any furniture, fixtures or equipment (as defined in the Uniform Commercial Code in effect in the State of Illinois) owned or utilized by Hospital. 4.7 INVESTMENT REPRESENTATIONS. 4.7.1 LACK OF REGISTRATION. Purchaser acknowledges that the Stock has not been registered under the Federal Securities Act of 1933, as amended (the "Act"), or under the securities laws of any other jurisdiction and that this transaction has not been reviewed by, passed on or submitted to the United States Securities and Exchange Commission or the state agency, neither has any agency made any finding or determination as to the fairness of this investment or any recommendation or endorsement of the Stock. 15 4.7.2 INVESTMENT INTENT. The Stock is being acquired for the Purchaser's own account for investment and not with a view toward dividing its interests therein with others or reselling or otherwise disposing of all or any part of the same or toward the distribution thereof within the meaning of the Act, the Securities Exchange Act of 1934, as amended or applicable securities laws of any other jurisdiction. 4.8 HART-SCOTT-RODINO. Based upon the information available to Purchaser, the transaction contemplated herein is not subject to premerger notification under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, 15 U.S.C. ss.18a, and the Premerger Notification Rules, 16 C.F.R. Parts 801, 802, and 803, thereunder. 4.9 STATEMENTS TRUE AND CORRECT. The representations and warranties of Purchaser set out in this Agreement and the Schedules hereto do not include, as of the date hereof, any untrue statement of a material fact or omit to state any material fact necessary to make the statements made in this Agreement not misleading. SECTION 5. COVENANTS OF SELLERS AND PURCHASER. 5.1 INFORMATION CONCERNING HOSPITAL. Between the date of this Agreement and the Closing Date, to the extent permitted by Law, Sellers shall afford to the authorized representatives and agents of Purchaser reasonable access to and the right to inspect the plants, properties, books and records of Aeries, Aeries Illinois, and Sellers relating to Hospital and will furnish Purchaser with such additional financial and operating data and other information as to the business and properties of Aeries, Aeries Illinois, and Sellers relating to Hospital as Purchaser may from time to time reasonably request including all items set forth on Schedules under Section 3 of this Agreement. Purchaser's right of access and inspection shall be exercised in such a manner as not to interfere unreasonably with the operation of Hospital. In this regard, Purchaser agrees that such inspection shall not take place, and no employees or other personnel at Hospital shall be contacted by Purchaser's representatives, without first coordinating such contact or inspection with Mark R. Russell or his designee. The term "Information" shall mean and refer to the information obtained by Purchaser (whether directly or through Sellers' legal counsel) in the course of its due diligence review of Hospital. Purchaser acknowledges that the Information, together with analyses, compilations, studies or other documents or records prepared by Purchaser based upon the Information or that contain or are generated from such Information, may be used only to consider the transactions contemplated in this Agreement, and will be kept confidential and disclosed only to those agents of Purchaser (including, without limitation, consultants, lenders, issuers or other participants in any financing Purchaser is undertaking in connection with the transactions contemplated within this Agreement) reasonably having a need to know the Information in connection with the transactions contemplated within this Agreement or pursuant to any court or administrative order or legal subpoena. Purchaser shall: (a) inform all persons, including its representatives, who receive the Information of the confidential nature of the Information and require all such persons to treat the Information confidentially and not use it other than for the purpose of analyzing and evaluating the transactions contemplated within this Agreement, (b) be responsible in any event for any breach of this Agreement by any person to whom the Information is delivered by Purchaser; and (c) make all reasonable and appropriate efforts to safeguard the Information from disclosure to 16 anyone other than as permitted hereby. In the event the transactions contemplated within this Agreement are not consummated, Purchaser shall return the Information and all copies thereof (including any analyses, compilations, studies or other documents or records prepared by Purchaser based upon the Information or which contain or otherwise reflect or are generated from such Information, and regardless of the format (whether paper, photographic, film, electronic, digital or otherwise)) to Sellers immediately or destroy it and certify to Sellers its destruction. The foregoing restrictions with respect to the Information shall not apply to any information that: (i) on the date hereof is or thereafter becomes generally available to the public other than as a result of a disclosure, directly or indirectly, by the party receiving the Information or its representatives, (ii) was available to such party on a non-confidential basis prior to its disclosure, or (iii) becomes available to such party on a non-confidential basis from a source other than the other party or its representatives, which source was not itself bound by a confidentiality agreement with a party hereto or its representatives and did not receive such information, directly or indirectly, from a person or entity so bound. Nothing in this Section shall prohibit the use of such confidential information, documents or information for the purpose of securing financing to enable Purchaser to effect the purchase contemplated herein or such governmental filings as in the opinion of Purchaser's counsel or Sellers' counsel, as appropriate, are required by Law or governmental regulations. Nothing in this Section shall prohibit the disclosure by Purchaser or Sellers of any information, instruments or documents that are reasonably determined to be required to be filed with Governmental Entities by Sellers or Purchaser under applicable securities laws, rules and regulations. Any statement in this Agreement to the contrary notwithstanding, either Sellers or Purchaser may issue a customary press release regarding this Agreement and the transactions contemplated herein upon execution of this Agreement or at any other time if either party reasonably determines that such a release is necessary in order to comply with applicable securities laws or listing requirements. Each party shall have the right to review and consent to any proposed release, which consent shall not be unreasonably withheld. 5.2 OPERATIONS OF HOSPITAL. From the date hereof until the Closing Date, except as set forth in Schedule 5.2 or in the ordinary course of business, Sellers shall, with respect to Hospital, cause Aeries Illinois and Hospital to: 5.2.1 carry on business related to Hospital in substantially the same manner as heretofore and not make any material change in personnel operations, finance, accounting policies or Hospital operation other than in the ordinary course of business; 5.2.2 use commercially reasonable efforts to maintain Hospital and all parts thereof in as good working order and condition as at present, ordinary wear and tear excepted; 5.2.3 use commercially reasonable efforts to perform in all material respects all contractual obligations relating to or affecting Hospital and Hospital's business and operation; 5.2.4 keep in full force and effect present insurance policies or other comparable insurance on Hospital; 17 5.2.5 use commercially reasonable efforts to maintain and preserve the business organization of Hospital intact, retain present employees at Hospital, and maintain relationships with physicians, medical staff, suppliers, customers and others having business relations with Hospital; 5.2.6 comply in all material respects with all Laws applicable to the conduct of the business and operation of Hospital; 5.2.7 maintain the levels and quality of Inventory existing on the date hereof; 5.2.8 continue to collect accounts receivable and pay accounts payable with respect to Hospital in the ordinary course of business; 5.2.9 use commercially reasonable efforts to maintain all Approvals and Permits relating to Hospital in good standing; and 5.2.10 promptly notify Purchaser of any material and adverse change to Hospital. 5.3 NEGATIVE COVENANTS OF SELLERS. From the date hereof to the Closing Date, except as set forth in Schedule 5.3, Sellers will cause Aeries, Aeries Illinois, and Aeries Healthcare Management Services, LLC, with respect to the business or operation of Hospital or otherwise regarding Hospital, without the prior written consent of Purchaser, which shall not be unreasonably withheld or delayed, not to: 5.3.1 enter into any material contract or commitment or incur or shall incur any material liability, except (i) in the ordinary course of business, (ii) for those of the foregoing that are terminable without cause or penalty within ninety (90) days following Closing, and (iii) to procure an extended reporting endorsement on Sellers' current insurance policies insuring officers' and directors' against potential liability for their acts as such; 5.3.2 increase compensation payable or to become payable or make a bonus payment to or otherwise enter into one or more bonus agreements with any employee or agent or under any personal services contract, except in the ordinary course of business in accordance with existing personnel policies; 5.3.3 sell, assign or otherwise transfer or dispose of any assets except in the ordinary course of business; 5.3.4 (i) by action or inaction, abandon, terminate, cancel, forfeit, waive or release Aeries', Aeries Illinois', or Sellers' material rights, in whole or in part, with respect to Hospital or encumber any assets of Hospital; (ii) effect any corporate merger, business combination, reorganization or similar transaction or take any other action, corporate or otherwise, which could reasonably be expected materially and adversely to affect Sellers' ability to perform in accordance with this Agreement; or (iii) settle any dispute or threatened dispute with any Governmental Entity regarding Hospital in a manner that 18 materially and adversely affects Purchaser (it being understood that the maintenance of record retention programs with respect to Hospital shall be deemed not to materially and adversely affect Purchaser); 5.3.5 create, assume or permit to exist any new Encumbrance upon any asset of Hospital that materially affects the value or use of such asset; 5.3.6 take any other action materially outside the ordinary course of business except as otherwise permitted hereunder; or 5.3.7 make any capital expenditure commitment in excess of $25,000 for additions to property, plant, equipment, intangible, or capital assets or for any other purpose, other than for emergency repairs or replacement. 5.4 NOTIFICATION OF CERTAIN MATTERS. 5.4.1 At any time from the date of this Agreement to the Closing Date, Sellers shall give prompt written notice to Purchaser of (i) the occurrence, or failure to occur, of any event that has caused any representation or warranty of Sellers contained in this Agreement to be untrue in any material respect and (ii) any failure of Sellers to comply with or satisfy, in any material respect, any covenant, condition or agreement to be complied with or satisfied by it under this Agreement. Such notice shall provide a reasonably detailed description of the relevant circumstances and shall include the amount that Sellers believe, based on facts known to them, would be payable by Sellers pursuant to the Indemnification Agreement. 5.4.2 At any time from the date of this Agreement to the Closing Date, Purchaser shall give prompt notice to Sellers of (i) the occurrence, or failure to occur, of any event that has caused any representation or warranty of Purchaser contained in this Agreement to be untrue in any material respect and (ii) any failure of Purchaser to comply with or satisfy, in any material respect, any covenant, condition or agreement to be complied with or satisfied by it under this Agreement. Such notice shall provide a reasonably detailed description of the relevant circumstances and shall include the amount that Purchaser believes, based on facts known to it, would be payable by Purchaser pursuant to the Indemnification Agreement. 5.5 APPROVALS. Between the date of this Agreement and the Closing Date, each of Purchaser and Sellers will (i) cooperate with one another and take all reasonable steps to obtain, as promptly as practicable, all Approvals and Permits of any Governmental Entities required of either party to consummate the transactions contemplated by this Agreement, if any, and (ii) provide such other information and communications to any Governmental Entity as may be reasonably requested. 5.6 ADDITIONAL FINANCIAL INFORMATION OF SELLER. Within thirty (30) days following the end of each calendar month prior to the Closing Date, Sellers will deliver to Purchaser copies of the unaudited balance sheets and the related unaudited income statements of Aeries Illinois for 19 each month then ended. Such financial statements shall have been prepared in a manner consistent with the preparation of the Historical Financial Information, the balance sheets contained therein shall fairly present in all material respects the financial position of Aeries Illinois at the dates of such balance sheets and the income statements contained therein shall present fairly in all material respects the results of operations of Hospital for the period indicated. 5.7 MAINTENANCE OF BOOKS AND RECORDS BY PURCHASER. Until the later to occur of (i) the final adjudication of any dispute or investigation involving liabilities, federal state or local taxes or under the Medicare or Medicaid programs arising out of the business, operations or affairs of Sellers relating to Hospital before the Closing Date or (ii) the running of applicable statutes of limitations, Purchaser will maintain in the ordinary course of business all books and records of Aeries and Aeries Illinois that are delivered to Purchaser at Closing and that relate to the pre-Closing business, operations, and affairs of Sellers relating to Hospital to the extent reasonably necessary in connection with any tax, Medicare or Medicaid liability or other matter reasonably relating to Hospital for any period ending at or before the Closing Date. 5.8 LIABILITY INSURANCE CONTINUATION. Aeries and/or Aeries Illinois currently maintains one or more claims made policies insuring it against claims for negligence in the delivery of medical services at or by Hospital in the amounts of $1 million per occurrence, $3 million in the aggregate per year with a $10 million umbrella policy, all issued by AIG. Purchaser shall continue such policies in full force and effect and shall renew such policies upon their expiration unless Purchaser and Sellers agree that to do so would be impracticable. If this determination is made, Purchaser shall obtain quotations for the cost of (i) acquiring an extended reporting endorsement for the current policies or (ii) having Aeries Illinois' and Hospital's prior acts covered under a new policy or policies put into place by Purchaser. Purchaser and Sellers shall mutually agree upon the most appropriate of these options once such quotations are obtained and Purchaser and Sellers shall participate in the cost of such agreed upon coverage in the following manner: Sellers shall be responsible for the first $100,000 of premium associated with obtaining the agreed upon coverage, Purchaser shall be responsible for the next $100,000 of premium, and all premiums over $200,000 shall be borne equally by Purchaser and Sellers. If such a determination is made prior to Closing, Sellers' portion of the cost thereof, if any, shall be paid by adjustment to the Purchase Price. The provisions of this Section shall survive Closing for a period of one (1) year. 5.9 CLOSING. Each of Sellers and Purchaser shall use their respective commercially reasonable efforts to satisfy all of the conditions precedent to Closing set forth in this Agreement to the extent that Sellers' or Purchaser's respective action or inaction can control or influence the satisfaction of such conditions. Each of Sellers and Purchaser shall proceed to Closing upon the terms and conditions set out in this Agreement upon the fulfillment or waiver by the other party of the conditions precedent. SECTION 6. CONDITIONS PRECEDENT TO OBLIGATIONS OF PURCHASER. The obligations of Purchaser hereunder are subject to the satisfaction, on or prior to the Closing Date, of the following conditions unless waived in writing by Purchaser: 20 6.1 COMPLIANCE WITH COVENANTS. Sellers shall have in all material respects performed all obligations and complied with all covenants and conditions required by this Agreement to be performed or complied with by them at or prior to the Closing Date; provided that this condition will be deemed to be satisfied unless both (i) Sellers were given written notice of such failure to perform or comply and did not or could not cure such failure to perform or comply within fifteen (15) days after receipt of such notice and (ii) the respects in which such covenants and obligations that have not been performed have a material adverse effect on the business, financial condition or results of operations of Hospital, taken as a whole. 6.2 OPINION OF SELLERS' COUNSEL. Purchaser shall have received the opinion, dated the Closing Date, of Sherrard & Roe, PLC, counsel for Sellers, in substantially the form of Exhibit 6.2 hereto. 6.3 OPINION OF AERIES' COUNSEL. Purchaser shall have received the opinion, dated the Closing Date, of Gardner Carton & Douglas, Chicago, Illinois, counsel to Aeries, addressing Illinois regulatory matters, in form and substance reasonably satisfactory to Purchaser. 6.4 ACTION/PROCEEDING. No court or any other Governmental Entity shall have issued an order restraining or prohibiting the transactions herein contemplated; and no Governmental Entity shall have commenced or threatened in writing to commence any action or suit before any court of competent jurisdiction or other Governmental Entity that seeks to restrain or prohibit the consummation of the transactions herein contemplated or otherwise seeks a remedy that would materially and adversely affect the ability of Purchaser to enjoy the full use and enjoyment of Hospital; and neither the Justice Department nor the FTC shall have requested, orally or in writing, that Purchaser delay or postpone the Closing. 6.5 REPRESENTATIONS AND WARRANTIES. All Sellers' representations and warranties shall be true and correct in all material respects on the Closing Date. 6.6 INDEMNIFICATION AGREEMENT. Sellers shall have executed and delivered the Indemnification Agreement in the form attached hereto as Exhibit 6.6. 6.7 ESCROW AGREEMENT. Sellers shall have executed and delivered the Escrow Agreement in the form attached hereto as Exhibit 1.3. 6.8 AGENCY AGREEMENT. Sellers and Escrow Agent shall have executed and delivered the Agency Agreement in the form attached hereto as Exhibit 6.8. 6.9 MANAGEMENT AGREEMENTS TERMINATED. That certain Management Agreement between Aeries Illinois and Aeries Healthcare Management Services, LLC, and the certain Amended and Restated Management Agreement between Aeries Illinois and Best, Patterson & Crothers, Ltd., dated April 27, 2000, shall each have been terminated and Aeries Illinois and Hospital shall have no further obligations under such agreements. 6.10 TRANSITIONAL ASSISTANCE. Purchaser shall have entered into an agreement with Aeries HealthCare Management Services, LLC, and Mark R. Russell, pursuant to which Mr. Russell shall serve as the chief executive officer of Hospital with sole responsibility for its operation through October 31, 2002. 21 6.11 REDEMPTION OF OPTIONS. Aeries shall have redeemed and cancelled in full, without any obligation of Aeries or Aeries Illinois remaining post-Closing, all outstanding Options and any other unexercised contractual rights to acquire any equity interest in Aeries or Aeries Illinois. 6.12 SUBORDINATION AGREEMENTS. Sellers shall have caused each of Sunrise Holdings, Inc., Randy Best, Michael Crothers, Jack Salberg, Paul Yeoman, Stan Kantanie, and Gail Thoma Patterson to amend their respective Subordination Agreements with Purchaser and Purchaser's lender dated May 5, 2000, in form and manner reasonably acceptable to Purchaser. 6.13 PROVIDER LEASES. All leases for space between Aeries Illinois or Hospital, as lessor, and individual providers, as lessees, shall be reduced to writing in a manner that conforms with applicable federal and state law. SECTION 7. CONDITIONS PRECEDENT TO OBLIGATIONS OF SELLERS. The obligations of Sellers hereunder are subject to the satisfaction, on or prior to the Closing Date, of the following conditions unless waived in writing by Sellers: 7.1 COMPLIANCE WITH COVENANTS. Purchaser shall have in all material respects performed all obligations and complied with all covenants and conditions required by this Agreement to be performed or complied with by it at or prior to the Closing Date; provided that, except for Purchaser's obligation to pay the Purchase Price at Closing, this condition will be deemed to be satisfied unless both (i) Purchaser was given written notice of such failure to perform or comply and did not or could not cure such failure to perform or comply within fifteen (15) days after receipt of such notice and (ii) the respects in which such covenants have not been performed have a material adverse effect on Purchaser's ability to perform this Agreement or any aspect of the transactions contemplated hereby. 7.2 OPINION OF PURCHASER'S COUNSEL. Sellers shall have received the opinion, dated the Closing Date, of Harwell Howard Hyne Gabbert & Manner, P.C., counsel for Purchaser, in substantially the form of Exhibit 7.2 hereto. 7.3 ACTION/PROCEEDING. No court or any other Governmental Entity shall have issued an order restraining or prohibiting the transactions herein contemplated; no Governmental Entity shall have commenced or threatened in writing to commence any action or suit before any court of competent jurisdiction or other Governmental Entity that seeks to restrain or prohibit the consummation of the transactions contemplated hereby or impose material damages or penalties in connection therewith; and neither the Justice Department nor the FTC shall have requested, orally or in writing, that Sellers delay or postpone the Closing. 7.4 REPRESENTATIONS AND WARRANTIES. All Purchaser's representations and warranties shall be true and correct in all material respects on the Closing Date. 22 7.5 INDEMNIFICATION AGREEMENT. Purchaser shall have executed and delivered the Indemnification Agreement in the form attached hereto as Exhibit 6.6. 7.6 ESCROW AGREEMENT. Purchaser shall have executed and delivered the Escrow Agreement in the form attached hereto as Exhibit 1.3. 7.7 AGENCY AGREEMENT. Purchaser and Escrow Agent shall have executed and delivered the Agency Agreement in the form attached hereto as Exhibit 6.8. 7.8 HBCC LOAN. Purchaser shall have retired Aeries Illinois' indebtedness to Healthcare Business Credit Corporation under the terms of that certain Loan and Security Agreement dated December 4, 2000, between HBCC and Aeries Illinois or, failing that, HBCC shall have consented to the transaction or otherwise waived its right to claim an event of default as a result of the transaction is and related documents. SECTION 8. HOSPITAL COST REPORTS. Sellers have or shall timely prepare and file all cost reports relating to Hospital for periods ending on or prior to the Closing Date or required as a result of the consummation of the transactions set forth herein (the "Hospital's Cost Reports"). Purchaser shall forward to Sellers any and all correspondence relating to Hospital's Cost Reports or other third-party payer within five (5) business days after receipt by Purchaser. Purchaser, upon reasonable notice, at Sellers' expense and during normal business hours, will cooperate with Sellers in regard to the preparation, filing, handling, and appeals of all cost reports relating to Hospital for periods ending on or prior to the Closing Date or required as a result of the transactions described herein. Purchaser shall remit any funds received by it relating to Hospital's Cost Reports in excess of $365,000.00 for the year ending December 31, 2000, and $491,693.00 for the year ending December 31, 2001, but not any subsequent period, within three (3) business days after receipt by Purchaser. If, on the other hand, the refund received by Purchaser relating to Hospital's Cost Reports is less than $365,000 for the year ending December 31, 2000, and/or less than $491,693 for the year ending December 31, 2001, Purchaser shall be entitled to recoup the amount of such deficiency out of the Escrow Payment subject to the requirements of the Indemnification Agreement and Escrow Agreement. Sellers shall retain the right to appeal any Medicare determinations relating to settlements and Hospital's Cost Reports. Sellers shall retain the originals of Hospital's Cost Reports, correspondence, work papers and other documents relating to Hospital's Cost Reports and the settlements. Sellers will furnish copies of such documents to Purchaser prior to the Closing to the extent then existing. In the event of any subsequent sale of Aeries, Aeries Illinois or Hospital by Purchaser, Purchaser shall use commercially reasonable efforts to make sure that Sellers have a right of access for such purposes for as long as is necessary after the closing date. SECTION 9. ADDITIONAL AGREEMENTS. 9.1 ACKNOWLEDGEMENT. Purchaser hereby expressly acknowledges that the operations of HCA - The Healthcare Company (and its predecessor Columbia/HCA Healthcare Corporation) and its Affiliates are currently under review by the U.S. Department of Justice and 23 the U.S. Center for Medicare and Medicaid Services (hereinafter the "DOJ/CMS"). Upon reasonable notice, during normal business hours, and consistent with otherwise applicable legal requirements relating to patient rights, Purchaser shall afford to representatives of the DOJ/CMS full and complete access to the originals of the records that have been transferred to Purchaser, as well as the right to make copies of those records. In addition, Purchaser shall afford the DOJ/CMS the right to remove original records upon reasonable notice and the substitution of copies for any records to be removed at Sellers' or the DOJ/CMS's expense. 9.2 TERMINATION PRIOR TO CLOSING. 9.2.1 Anything herein to the contrary notwithstanding, this Agreement and the transactions contemplated by this Agreement may be terminated at any time before the Closing as follows and in no other manner: (i) by mutual consent in writing of Purchaser and Sellers owning a majority of the Stock; (ii) by Sellers any time after June 30, 2002, if the Closing shall not have occurred by such date; (iii) by Purchaser by written notice to Sellers if any event occurs or condition exists that causes Sellers to be unable to satisfy, in all material respects, one or more conditions to the obligations of Sellers to consummate the transactions contemplated by this Agreement as set forth in Sections 6 of this Agreement; and (iv) by Sellers by written notice to Purchaser if any event occurs or condition exists that causes Purchaser to be unable to satisfy, in all material respects, one or more conditions to the obligations of Purchaser to consummate the transactions contemplated by this Agreement as set forth in Section 7. 9.2.2 In the event that this Agreement shall be terminated pursuant to Section 9.2.1, all further obligations of the parties under this Agreement shall terminate without further liability of any party to another; provided that the obligations of the parties contained in Sections 5.1 and 9.3 shall survive any such termination. 9.3 POST-CLOSING ACCESS TO INFORMATION. Purchaser and Sellers acknowledge that subsequent to the Closing Purchaser and Sellers may each need access to information, documents or computer data in the control or possession of the other, and Sellers may need access to Hospital for purposes of preparing and filing cost reports, concluding the transactions contemplated herein, and for audits, appeals, investigations, compliance with governmental requirements, regulations and requests, and the prosecution or defense of third party claims. Accordingly, Purchaser shall make available to Sellers and their agents, independent auditors and/or Governmental Entities such documents and information as may be available relating to Hospital in respect of periods prior to Closing and will permit Sellers to make copies of such documents and information. Sellers' rights granted pursuant to this section shall be exercised only in such a manner as not to interfere unreasonably with the operation of Hospital. 9.4 PRESERVATION AND ACCESS TO RECORDS AFTER THE CLOSING. After the Closing and for the time period necessary to comply with this section, Purchaser shall keep and preserve in their original form all medical and other records of Hospital existing as of the Closing. For purposes of this Agreement, the term "records" includes all documents, electronic data, and other compilations of information in any form. Purchaser acknowledges that as a result of entering into this Agreement and operating Hospital it and its Affiliates will gain access to patient and 24 other information that are subject to rules and regulations regarding confidentiality. Purchaser shall abide by any such rules and regulations relating to the confidential information that it acquires. Purchaser shall maintain the patient records held at Hospital or delivered to Purchaser at Closing at Hospital after Closing in accordance with applicable Law (including, if applicable, Section 1861(v)(i)(I) of the Social Security Act (42 U.S.C. ss. 1395(V)(1)(i)), and requirements of relevant insurance carriers, all in a manner consistent with the maintenance of patient records generated at Hospital after Closing. Purchaser shall give Sellers notice of its intent to destroy any of the above records at least ten (10) business days prior to doing so and Sellers shall have the right, for fifteen (15) business days from receipt of such notice, to remove such records from Purchaser's possession at Sellers' expense. Upon reasonable notice, during normal business hours and upon Purchaser's receipt of appropriate consents and authorizations, Purchaser shall afford to representatives of Sellers, including their counsel and accountants, full and complete access to, and the right to make copies of, the records transferred to Purchaser at the Closing (including, without limitation, access to patient records in respect of patients treated by Affiliates of Sellers at Hospital). In addition, Sellers shall be entitled to remove from Hospital any such patient records, but only for purposes of pending litigation involving a patient to whom such records refer, as certified in writing prior to removal by counsel retained by Sellers in connection with such litigation. Any patient records so removed from Hospital shall be promptly returned to Purchaser following the use thereof by Sellers. 9.5 CAPITAL EXPENDITURES. This Agreement shall not be deemed to be an acquisition or obligation of a capital expenditure or of funds within the meaning of the certificate of need statute of any state until the appropriate Governmental Entities shall have granted a certificate of need or the appropriate approval or ruled that no certificate of need or other approval is required. 9.6 REPRODUCTION OF DOCUMENTS. This Agreement and all documents relating hereto including (a) consents, waivers and modifications that may hereafter be executed, (b) the documents delivered at the Closing, and (c) financial statements, certificates and other information previously or hereafter furnished to Sellers or to Purchaser, may, subject to the provisions of Section 5.1 hereof, be reproduced by Sellers and Purchaser by any photographic, photostatic, microfilm, micro-card, miniature photographic or other similar process and Sellers and Purchaser may destroy any original documents so reproduced. Sellers and Purchaser stipulate that any such reproduction shall be admissible in evidence as the original itself in any judicial, arbitral or administrative proceeding (whether or not the original is in existence and whether or not such reproduction was made by Sellers or Purchaser in the regular course of business) and that any enlargement, facsimile or further reproduction of such reproduction shall likewise be admissible in evidence. 9.7 COOPERATION ON TAX MATTERS. Following the Closing, the parties shall cooperate fully with each other and shall make available to the other, as reasonably requested and at the expense of the requesting party, and to any taxing authority, all information, records or documents relating to tax liabilities or potential tax liabilities of Aeries or Aeries Illinois for all periods on or prior to the Closing and any information that may be relevant to determining the amount payable under this Agreement, and shall preserve all such information, records and documents (to the extent a part of Hospital delivered to Purchaser at Closing) at least until the expiration of any applicable statute of limitations or extensions thereof. 25 9.8 NONCOMPETITION AGREEMENT. 9.8.1 NONCOMPETITION AGREEMENT. Sellers and their respective affiliates hereby covenant and agree with Purchaser that during the "Noncompete Period" within the "Noncompete Area" they shall not directly or indirectly, (i) acquire, lease, manage, consult for, finance or own any part of (as member, shareholder or partner) any in-patient psychiatric facility that provides services that are the same or similar to the services provided by Hospital, or (ii) solicit for employment or employ any person who at Closing became an employee of Purchaser (other than general media advertisements of employment opportunities), or (iii) disrupt or attempt to disrupt any past, present or reasonably foreseeable future relationship, contractual or otherwise between Purchaser, on the one hand, and any physician, physician group, or other healthcare provider with whom Aeries contracts with in connection with Hospital, on the other hand (other than general media advertisements of employment opportunities). The "Noncompete Period" shall commence at the Closing and terminate on the third (3rd) anniversary of the Closing Date. The "Noncompete Area" shall mean the area within a twenty-five (25) mile radius of Hospital and each of the following facilities: Cypress Creek Hospital, 17750 Cali Drive, Houston, Texas 77090; Texas NeuroRehab Center, 1106 West Dittmar, Austin, Texas 78745; West Oaks Hospital, 6500 Hornwood, Houston, Texas 77074; and Holly Hill Hospital, 3019 Falstaff Road, Raleigh, North Carolina 27610. Ownership of less than five percent (5%) of the stock of a publicly held company shall not be deemed a breach of this covenant. 9.8.2 ENFORCEABILITY OF NONCOMPETE. In the event of a breach of this Section 9.8, Sellers recognize that monetary damages shall be inadequate to compensate Purchaser and Purchaser shall be entitled, without the posting of a bond, to an injunction restraining such breach, with the costs including attorneys fees of securing such injunction to be borne by Sellers, jointly and severally. Nothing herein contained shall be construed as prohibiting Purchaser from pursuing any other remedy available to it for such breach or threatened breach. The parties recognize that the restrictions contained in Section 9.8 are reasonable and necessary. All parties hereto hereby acknowledge the necessity of protection against the competition of Sellers and their respective affiliates and that the nature and scope of such protection has been carefully considered by the parties. The period provided and the area covered are expressly represented and agreed to be fair, reasonable and necessary. The consideration provided for herein is deemed to be sufficient and adequate to compensate for agreeing to the restrictions contained in this Section 9.8. If, however, any court determines that the forgoing restrictions are not reasonable, such restrictions shall be modified, rewritten or interpreted to include as much of their nature and scope as will render them enforceable. 9.8.3 ALLOCATION OF PURCHASE PRICE. $100,000 of the Purchase Price shall be allocated to the foregoing noncompete agreement. The parties shall be bound by this allocation for federal income tax purposes, and shall report their tax liabilities in accordance with this allocation. 9.9 SOLE REMEDY. Purchaser acknowledges that its sole remedy for breaches by Sellers, Aeries or Aeries Illinois of any his, her or its representations, warranties, and other 26 obligations under this Agreement, other than those set out in Section 9.8, shall be those set out in the Indemnification Agreement and the Escrow Agreement an no other. SECTION 10. DEFINITIONS. 10.1 DEFINITIONS. As used herein the terms below shall have the following meanings: "ACCOUNTS PAYABLE" means, as of any date, the accounts payable of any specified Person on such date determined in accordance with GAAP, applied in a manner consistent with the historical practices of such Person. "AFFILIATE" means, as to the Person in question, any Person that directly or indirectly controls, is controlled by, or is under common control with, the Person in question; and the term "control" means possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a Person whether through ownership of voting securities, by contract or otherwise. "AGREEMENT" means this Agreement, as amended or supplemented, together with all Exhibits and Schedules attached or delivered with respect hereto or expressly incorporated herein by reference. "APPROVAL" means any approval, authorization, consent, notice, qualification or registration, or any extension, modification, amendment or waiver of any of the foregoing, of or from, or any notice, statement, filing or other communication to be filed with or delivered to, any Governmental Entity. "BALANCE SHEET DATE" means March 31, 2002. "CERCLA" has the meaning set forth in the definition of Environmental Laws. "CLOSING" has the meaning set forth in Section 2.1 hereto. "CLOSING DATE" has the meaning set forth in Section 2.1. "CODE" means the United States Internal Revenue Code of 1986, as amended, and the rules and regulations promulgated thereunder. "EBITDA" does not mean EBITDA according to generally accepted accounting principles. For purposes of this Agreement, "EBITDA" means net revenue less direct operating expenses, each as historically characterized by Hospital. "Direct operating expenses" do not include any allocated parent or affiliate overhead or expense, any management fees, the expenses of any employee(s) not hired by Mark Russell, or any other expense allocation not historically charged to Hospital's operating income. "EEOC" means the United States Equal Employment Opportunity Commission. 27 "ENCUMBRANCE" means any claim, charge, easement, encroachment, security interest, mortgage, lien, pledge or restriction, whether imposed by agreement, understanding, Law, equity or otherwise. "ENVIRONMENTAL CONDITION" means any event, circumstance or conditions related in any manner whatever to: (i) the current or past presence or spill emission, discharge, disposal, release or threatened release of any hazardous, infectious or toxic substance or waste (as defined by any applicable Environmental Laws) or any chemicals, pollutants, petroleum, petroleum products or oil ("Hazardous Materials"), into the environment; or (ii) the on-site or off-site treatment, storage, disposal or other handling of any Hazardous Material originating on or from Hospital; or (iii) the placement of structures or materials into waters of the United States; or (iv) the presence of any Hazardous Substance, including, but not limited to, friable asbestos, in any building, structure or workplace or on any portion of Hospital; or (v) any violation of Environmental Laws at or on any part of Hospital or arising from the activities of Hospital involving Hazardous Materials. "ENVIRONMENTAL LAWS" means all Laws relating to pollution or the environment, including but not limited to the Comprehensive Environmental Response, Compensation, and Liability Act, as amended, 42 U.S.C. ss. 9601, et seq. ("CERCLA"), the Resource Conservation and Recovery Act, as amended, 42 U.S.C. ss. 6901, et seq. ("RCRA"), the Clean Air Act, 42 U.S.C. ss. 7401, the Occupational Safety and Health Act, 29 U.S.C. ss. 600, et seq. ("OSHA"), and similar state Laws, and all other Laws and regulations relating to emissions, discharges, releases, or threatened releases of pollutants, contaminants, chemicals, pesticides, or industrial, infectious, toxic or hazardous substances or wastes into the environment (including, without limitation, ambient air, surface water, groundwater, land surface or subsurface strata) or otherwise relating to the processing, generation, distribution, use, treatment, storage, disposal, transport, or handling of pollutants, contaminants, chemicals, or industrial, infectious, toxic, or hazardous substances or wastes. "ERISA" has the meaning set forth in Section 3.13. "ESCROW AGREEMENT" means that certain Escrow Agreement of even date herewith by and among Purchaser, Sellers, and the escrow agent named therein. "FTC" means the United States Federal Trade Commission. "FURNITURE AND EQUIPMENT" means all equipment (including movable equipment), vehicles, furniture or furnishings reflected in the March Balance Sheet or acquired since the Balance Sheet Date that are held or used by Aeries Illinois in or ancillary to the business or operation of Hospital , including all such equipment, vehicles, furniture or furnishings that have been fully depreciated for accounting purposes. "GAAP" means United States generally accepted accounting principles and practices as in effect from time to time, as modified and/or as described in Schedule 3.6 and applied consistently by Aeries throughout the periods involved. 28 "GOVERNMENT PROGRAMS" has the meaning set forth in Section 3.9. "GOVERNMENTAL ENTITY" means any government or any agency, bureau, board, directorate, commission, court, department, official, political subdivisions tribunal or other instrumentality of any government, whether federal, state or local. "HAZARDOUS MATERIALS" has the meaning set forth in the definition of Environmental Condition. "HISTORICAL FINANCIAL INFORMATION" has the meaning set forth in Section 3.6. "HOSPITAL" means Riveredge Hospital, 8311 West Roosevelt, Forest Park, Illinois. "HOSPITAL'S COST REPORTS" has the meaning set forth in Section 8. "IMMIGRATION ACT" means the Immigration Reform and Control Act of 1986. "INDEMNIFICATION AGREEMENT" means that certain Indemnification Agreement by and among Purchaser and Sellers. "INFORMATION" has the meaning set forth in Section 5.1. "INTELLECTUAL PROPERTY" means, to the extent held or used in operation of Hospital, patents, trademarks, trade names, service marks, copyrights and any applications therefor, mask works, net lists, schematics, technology, know-how, trade secrets, ideas, algorithms, processes, and tangible or intangible proprietary information or material except as set forth on Schedule 3.8. "INVENTORY" means all inventory and supplies held or used in the business or operation of Hospital. "JCAHO" has the meaning set forth in Section 3.9.3. "JUSTICE DEPARTMENT" or "DOJ" means the United States Department of Justice. "KNOWLEDGE": whenever any statement herein or in any schedule, exhibit, certificate or other documents delivered to any party pursuant to this Agreement is made "to [its] knowledge" or words of similar intent or effect of any party or his, her or its representative, such person shall make such statement only as to such facts and other information which, as of the date the representation is given, are actually known or reasonably should be known by the party making such statement in the exercise of such party's duties, which, with respect to Persons that are corporations, means the knowledge of its executive officers that is or should reasonably be known to them in the exercise of their offices. References to "Knowledge of Sellers" or phrases of similar import, shall be construed to mean knowledge of any of the Sellers. "LAW" means any constitutional provision, statute, ordinance or other law, rule, regulation or order of any Governmental Entity. 29 "MARCH BALANCE SHEET" means the balance sheet of Aeries and/or Aeries Illinois as of March 31, 2002. "MEDICAID" has the meaning set forth in Section 3.9.1. "MEDICARE" has the meaning set forth in Section 3.9.1. "NET DEBT" means (x) Sellers' total long-term debt that is retired by Purchaser in connection with the transaction contemplated herein or that remains following Closing, plus accrued interest thereon and plus any prepayment penalty actually paid on account of the prepayment of any amounts due, less (y) cash on hand. "NET WORKING CAPITAL" has the meaning set forth in Section 1.2. "OPTIONS" means outstanding options to acquire 147.05 shares of Aeries Healthcare Corporation's voting common stock for an exercise price of $1,389.00 per share. "OSHA" has the meaning set forth in the definition of Environmental Laws. "PERMIT" means any license, permit or certificate of need required to be issued by any Governmental Entity. "PERSON" means an association, a corporation, a limited liability company, any individual, a partnership, a limited liability partnership, a trust or any other entity or organization. "PLANS" has the meaning set forth in Section 3.13. "PURCHASE PRICE" has the meaning set forth in Section 1.2. "PURCHASER" means Psychiatric Solutions, Inc., a Delaware corporation, or its permitted assignee. "RCRA" has the meaning set forth in the definition of Environmental Laws. "RETIREMENT PLANS" has the meaning set forth in Section 3.13. "RETURNS" has the meaning set forth in Section 3.16.1. "SELLERS" means the shareholders of Aeries Healthcare Corporation, a Delaware corporation, set forth on the signature page to this Agreement. "STOCK" has the meaning ascribed to it the first paragraph of the Recitals. 30 "TRICARE" means the successor to the Civilian Health and Medical Programs of the Uniformed Services. 10.2 INTERPRETATION. In this Agreement, unless the context otherwise requires: 10.2.1 References to this Agreement are references to this Agreement and to the Exhibits and Schedules (as hereinafter defined); 10.2.2 References to Sections are references to sections of this Agreement; 10.2.3 References to any party to this Agreement shall include references to his, her or its legal representatives, successors, and permitted assigns; 10.2.4 References to a judgment shall include references to any order, writ, injunction, decree, determination or award of any court or tribunal; 10.2.5 The terms "hereof," "herein," "hereby," and derivative or similar words will refer to this entire Agreement; 10.2.6 References to any document (including this Agreement) are references to that document as amended, consolidated, supplemented, novated or replaced by the parties from time to time and as in existence on the date hereof; 10.2.7 Unless the context requires otherwise, references to any Law are references to that Law as of the Closing Date, and shall also refer to all rules and regulations promulgated thereunder; 10.2.8 The word "including" means including without limitation; 10.2.9 References to time are references to Central Standard or Daylight time in the city in which the Closing is to occur (as in effect on the applicable day) unless otherwise specified herein; 10.2.10 The gender of all words herein include the masculine, feminine and neuter, and the number of all words herein include the singular and plural; 10.2.11 Provisions of this Agreement shall be interpreted in such a manner so as not to inequitably benefit or burden any party through "double counting" of assets or liabilities or failing to recognize benefits that may result from any matters that impose losses or burdens on any party, including in connection with the calculation of losses on casualty claims; and 10.2.12 The terms "date hereof," "date of this Agreement" and similar terms shall mean the date first set out in the first paragraph of this Agreement. 31 SECTION 11. GENERAL. 11.1 CONSENTS; APPROVALS AND DISCRETION. Except as herein expressly provided to the contrary, whenever this Agreement requires any consent or approval to be given by either party or either party must or may exercise discretion, but such consent or approval shall not be unreasonably withheld or delayed and such discretion shall be reasonably exercised. 11.2 LEGAL FEES AND COSTS. If any attorney is employed by any party with regard to any legal action, arbitration or other proceeding brought by any party for the enforcement of this Agreement, or because of an alleged dispute, breach, default or misrepresentation in connection with any of the provisions of this Agreement, then the prevailing party, whether at trial or upon appeal, and in addition to any other relief to which the prevailing party may be granted, shall be entitled to recover from the losing party all costs, expenses, and a reasonable sum for attorneys' fees incurred by the prevailing party in bringing or defending such action, arbitration, or proceeding, and in enforcing any judgment granted therein. Any judgment or order entered in such matter shall contain a specific provision providing for the recovery by the prevailing party of attorneys' fees, costs, and expenses incurred in enforcing such judgment. For purposes of this Section, attorneys' fees shall include, without limitation, fees incurred in the following: post-judgment motions; contempt proceedings; garnishment, levy, and debtor and third party examinations; discovery; and bankruptcy litigation. 11.3 CHOICE OF LAW. This Agreement shall be governed by and construed in accordance with the laws of the State of Tennessee. This Agreement and its subject matter have substantial contacts with Tennessee, and all actions, suits, or other proceedings with respect to this Agreement shall be brought only in a court of competent jurisdiction sitting in Davidson County, Tennessee, or in the United States District Court having jurisdiction over that County. In any such action, suit, or proceeding, such court shall have personal jurisdiction of all of the parties hereto, and service of process upon them under any applicable statutes, laws, and rules shall be deemed valid and good. 11.4 BENEFIT; ASSIGNMENT. Subject to provisions herein to the contrary, this Agreement shall inure to the benefit of and be binding upon the parties hereto and their respective legal representatives, successors and assigns. No party may assign this Agreement without the prior written consent of the other party, which consent shall not be unreasonably withheld; provided, however, that a party hereto may assign his, her or its interest in this Agreement to an Affiliate, but in such event, the assignor shall be required to remain obligated hereunder in the same manner as if such assignment had not been effected. 11.5 ACCOUNTING DATE. The transactions contemplated hereby shall be effective for accounting purposes as of 00:01 a.m. on July 1, 2002, unless otherwise agreed in writing by Sellers and Purchaser. The parties will use commercially reasonable efforts to cause the Closing to be effective as of a month end. 11.6 NO BROKERAGE. Except for a certain Fee Agreement between Aeries, Aeries Illinois, Mark R. Russell, Stan Kantanie, and Jack Salberg dated January 1, 2002, Sellers and Purchaser each represent to each other that no broker has in any way been contracted in connection with the transactions contemplated hereby. Each of Sellers and Purchaser shall 32 indemnify the other party from and against all loss, cost, damage or expense arising out of claims for fees or commissions of brokers employed or alleged to have been employed by such indemnifying party. 11.7 COST OF TRANSACTION. Whether or not the transactions contemplated hereby shall be consummated and except as otherwise provided herein: 11.7.1 Sellers will pay the fees, expenses and disbursements of Sellers and their agents, representatives, accountants, and counsel, and sales taxes incident upon them, incurred in connection with the subject matter hereof and any amendments hereto; and 11.7.2 Purchaser shall pay the fees, expenses and disbursements of Purchaser and its agents, representatives, accountants, and counsel incurred in connection with the subject matter hereof and any amendments hereto, together with any recording and transfer fees or taxes. 11.8 WAIVER OF BREACH. The waiver by either party of breach or violation of any provision of this Agreement shall not operate as, or be construed to constitute, a waiver of any subsequent breach of the same or other provision hereof. 11.9 NOTICE. All notices, offers, requests, demands, and other communications pursuant to this Agreement shall be given in writing by personal delivery, by prepaid first class registered or certified mail properly addressed with appropriate postage paid thereon, by facsimile transmission, or by UPS, FedEx or other recognized, reputable overnight courier and shall be deemed to be duly given and received on the date of delivery if delivered personally, on the second day after the deposit in the United States Mail if mailed, upon acknowledgment of receipt of electronic transmission if sent by facsimile transmission, or upon delivery if by UPS, FedEx or other recognized, reputable overnight courier. Notices shall be sent to the parties at the following address: Sellers: Mark R. Russell, Sellers' Representative c/o Sherrard & Roe, PLC 424 Church Street, Suite 2000 Nashville, Tennessee 37219-3304 Attention: Michel G. Kaplan, Esq. Facsimile: (615) 742-4539 with copies to: Sherrard & Roe, PLC 424 Church Street, Suite 2000 Nashville, Tennessee 37219-3304 Attention: Michel G. Kaplan, Esq., or John R. Voigt, Esq. Facsimile: (615) 742-4539 mkaplan@sherrardroe.com or jvoigt@sherrardroe.com 33 Purchaser: Psychiatric Solutions, Inc. 113 Seaboard Lane, Suite C-100 Franklin, Tennessee 37067 Attention: President & CEO Facsimile: (615) 312-5700 jjacobs@psysolutions.com with copies to: Harwell Howard Hyne Gabbert & Manner, P.C. 315 Deaderick Street, Suite 1800 Nashville, Tennessee 37238 Attention: Lee C. Dilworth, Esq. Facsimile: (615) 251-1059 lcd@h3gm.com or to such other address, and to the attention of such other person or officer as any party may hereafter designate in writing. 11.10 SEVERABILITY. If any term, provision, condition or covenant of this Agreement or the application thereof to any party or circumstance shall be held to be invalid or unenforceable to any extent in any jurisdiction, then the remainder of this Agreement and the application of such term, provision, condition or covenant in any other jurisdiction or to persons or circumstances other than those as to whom or which it is held to be invalid or unenforceable, shall not be affected thereby, and each term, provision, condition and covenant of this Agreement shall be valid and enforceable to the fullest extent permitted by law. 11.11 NO INFERENCES. Inasmuch as this Agreement is the result of negotiations between sophisticated parties of equal bargaining power represented by counsel, no inference in favor of or against, either party shall be drawn from the fact that any portion of this Agreement has been drafted by or on behalf of such party. 11.12 DIVISIONS AND HEADINGS. The divisions of this Agreement into sections and subsections and the use of captions and headings in connection therewith are solely for convenience and shall have no legal effect in construing the provisions of this Agreement. 11.13 NO THIRD-PARTY BENEFICIARIES. This Agreement has been made and is solely for the benefit of the parties hereto and their respective successors and permitted assigns. Nothing in this Agreement is intended to confer any rights or remedies under or by reason of this Agreement on any Persons other than the parties to it and their respective successors and permitted assigns or to relieve or discharge the obligation or liability of any third Persons to any party to this Agreement. 11.14 TAX AND MEDICARE ADVICE AND RELIANCE. None of the parties (nor any of the parties' respective counsel, accountants or other representatives) has made or is making any representations to any other party (or to any other party's counsel, accountants or other representatives) concerning the consequences of the transactions contemplated hereby under applicable tax laws or under the laws governing the Medicare program. Each party has relied 34 solely upon the tax and Medicare advice of its own employees or of representatives engaged by such party and not on any such advice provided by any other party hereto. 11.15 ENTIRE AGREEMENT; AMENDMENT. This Agreement, the Indemnification Agreement, the Escrow Agreement, the Agency Agreement, and ancillary documents related to each, all executed contemporaneously herewith or at Closing, merge and supersede all previous discussions and agreements and constitute the entire agreement of whatever kind or nature existing between or among the parties representing the within subject matter and no party shall be entitled to benefits other than those specified herein or therein. As between or among the parties, no oral statement or prior written material not specifically incorporated herein shall be of any force and effect. The parties specifically acknowledge that in entering into and executing this Agreement, the parties rely solely upon the representations and agreements contained in this Agreement and no others. All prior representations or agreements, whether written or verbal not expressly incorporated herein are superseded unless and until made in writing and signed by all parties hereto. This Agreement may not be amended or modified in any respect except in a writing signed by all of parties hereto. 11.16 COUNTERPARTS. This Agreement may be executed in two or more counterparts, each of which shall be deemed to be an original document and all of which, taken together, shall be deemed to constitute but a single original document. 11.17 AUTHORITY TO SIGN. Each individual executing this Agreement on behalf of a corporation or other entity having limited liability represents and warrants that he or she is duly authorized to execute and deliver this Agreement on behalf of said entity in accordance with a resolution of the governing body of that entity duly adopted in accordance with the governing documents of said entity; that this Agreement is binding on said entity in accordance with its terms; and that this Agreement is not in violation of or inconsistent with or contrary to provisions of any other agreement to which such entity is a party. 11.18 TIME OF ESSENCE. With regard to all dates and time periods set out or referred to herein, time is of the essence. [SIGNATURE PAGES FOLLOW.] 35 IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed in multiple originals by themselves or their authorized officers, all as of the day and year first written above. PURCHASER: SELLERS: PSYCHIATRIC SOLUTIONS, INC. AERIES HEALTHCARE MANAGEMENT SERVICES, L.L.C. By: /s/ Steven T. Davidson By: /s/ Mark R. Russell --------------------------------- ------------------------------- Its: Vice President Mark R. Russell, Sole Member -------------------------------- THE HILLSTREET FUND, L.P., A DELAWARE LIMITED PARTNERSHIP BY: HILLSTREET CAPITAL, INC., ITS INVESTMENT MANAGER By: /s/ Christian L. Meininger ------------------------------- Christian L. Meininger, President /s/ Mike Crothers ---------------------------------- Mike Crothers /s/ Stanley J. Kantanie ---------------------------------- Stanley J. Kantanie XYRX ASSET INVESTMENT FUND, LLC By: /s/ Dan E. Patterson ------------------------------- Dan E. Patterson, President /s/ Mark R. Russell ---------------------------------- Mark R. Russell /s/ Jack R. Salberg ---------------------------------- Jack R. Salberg /s/ Paul Yeoham ---------------------------------- Paul Yeoham 36 EX-10.15 6 g76727a1exv10w15.txt INDEMNIFICATION AGREEMENT EXHIBIT 10.15 INDEMNIFICATION AGREEMENT THIS INDEMNIFICATION AGREEMENT (the "Indemnification Agreement"), dated as of June 28, 2002, is by and among the shareholders of AERIES HEALTHCARE CORPORATION ("Aeries"), a Delaware corporation, named on the signature page hereto (collectively, whether one or more, "Sellers"), and PSYCHIATRIC SOLUTIONS, INC., a Delaware corporation and/or its designated affiliate ("Purchaser"). Capitalized terms used in this Indemnification Agreement, if not otherwise defined herein, shall have the respective meanings ascribed to such terms in the Stock Purchase Agreement (as defined herein). RECITALS: Effective as of the date first set out above, Purchaser acquired all of the issued and outstanding common stock and warrants to acquire common stock of Aeries, pursuant to the terms and conditions of a certain Stock Purchase Agreement dated as of June 20, 2002, by and among Purchaser and Sellers (the "Stock Purchase Agreement"). As a condition precedent to the closing of the Stock Purchase Agreement, Purchaser deposited $4,500,000 of the cash proceeds of the Purchase Price (the "Escrowed Funds") in an interest-bearing escrow account established pursuant to an Escrow Agreement of even date herewith by and among Purchaser, Sellers, and escrow agent to secure any contingent obligations of Sellers for breaches of their representations and warranties under the Stock Purchase Agreement. The Escrow Funds are to be used to indemnify Purchaser pursuant to the terms and conditions of this Indemnification Agreement. NOW, THEREFORE, in consideration of the foregoing and of the mutual promises and covenants contained herein and other good and valuable consideration the receipt, adequacy, and sufficiency of which are hereby acknowledged, it is agreed as follows: SECTION 1. REPRESENTATIONS AND WARRANTIES OF SELLERS. As an inducement to the other party to enter into this Indemnification Agreement, each signatory hereby represent and warrant to the others the following matters. 1.1 AUTHORITY; VALIDITY; NO BREACH BY SELLERS. 1.1.1 Each of the Sellers has the power and authority to execute and deliver this Indemnification Agreement and to perform his, her or its obligations under this Indemnification Agreement. All actions required to be taken by each of the Sellers to authorize the execution, delivery and performance of this Indemnification Agreement have been duly and properly taken. 1.1.2 This Indemnification Agreement is the lawful, valid and legally binding obligation of Sellers, enforceable against each in accordance with its respective terms, except as enforceability may be restricted, limited, or delayed by applicable bankruptcy or other laws affecting creditors' rights generally and except as enforceability may be subject to general principles of equity or public policy. 1 1.1.3 The execution and delivery of this Indemnification Agreement by Sellers will neither conflict with nor result in any material breach or contravention of, or the creation of any encumbrance under, any indenture, agreement, lease, instrument or understanding to which any Seller is a party or by which any Seller is bound. 1.2 AUTHORITY; VALIDITY; NO BREACH BY PURCHASER. 1.2.1 Purchaser has the power and authority to execute and deliver this Indemnification Agreement and to perform its obligations under this Indemnification Agreement. All actions required to be taken by Purchaser to authorize the execution, delivery and performance of this Indemnification Agreement have been duly and properly taken. 1.2.2 This Indemnification Agreement is the lawful, valid and legally binding obligation of Purchaser, enforceable against Purchaser in accordance with its respective terms, except as enforceability may be restricted, limited, or delayed by applicable bankruptcy or other laws affecting creditors' rights generally and except as enforceability may be subject to general principles of equity or public policy. 1.2.3 The execution and delivery of this Indemnification Agreement by Purchaser will neither conflict with nor result in any material breach or contravention of, or the creation of any encumbrance under, any indenture, agreement, lease, instrument or understanding to which Purchaser is a party or by which Purchaser is bound. 1.3 NO UNTRUE OR INACCURATE REPRESENTATIONS OR WARRANTIES. The representations and warranties of each party contained in this Indemnification Agreement are true, accurate, correct, and complete in all material respects, and do not contain any untrue statement of material fact or omit to state a material fact necessary in order to make the statements and information contained therein not misleading. SECTION 2. INDEMNIFICATION; SURVIVAL; LIMITATIONS. 2.1 INDEMNIFICATION BY SELLERS. From and after the Closing Date, Sellers shall indemnify and hold harmless, on a joint and several basis, Purchaser, its subsidiaries and Affiliates, and its and their respective officers, directors, principals, attorneys, agents, employees or other representatives (each a "Purchaser Indemnified Party" and all, collectively, "Purchaser Indemnified Parties") from and against: (i) any and all losses, liabilities, damages, costs (including court costs and costs of appeal) and expenses (including reasonable attorneys' fees) that such Purchaser Indemnified Party incurs as a result of, or with respect to, any inaccuracy in any of the representations or warranties made by Sellers in the Stock Purchase Agreement except that indemnification of Purchaser Indemnified Parties for inaccuracies in the Historical Financial Information shall be limited to the sum of all inaccuracies in such statements (positive and negative) on a dollar-for-dollar basis, and (ii) claims for refunds pursuant to Section 8 of the Stock Purchase Agreement. 2 2.2 INDEMNIFICATION BY PURCHASER. Purchaser shall indemnify and hold harmless Sellers and their respective officers, directors, principals, attorneys, agents, heirs, executors, assigns or other representatives (each a "Seller Indemnified Parties" and all, collectively, "Seller Indemnified Party") from and against: (i) any and all losses, liabilities, damages, costs (including court costs and costs of appeal) and expenses (including reasonable attorneys' fees) that such Seller Indemnified Party incurs as a result of, or with respect to, any inaccuracy in any of the representations or warranties made by Purchaser in the Stock Purchase Agreement, and (ii) claims for additional funds due Purchaser pursuant to Section 8 of the Stock Purchase Agreement. 2.3 THE ESCROWED FUNDS. The Escrowed Funds consist of four (4) separate funds of in the following amounts: The Earn Out Fund, $1,500,000; the One-Year Warranty Fund, $1,000,000; the Two-Year Warranty Fund, $1,000,000; and the Cost Report Fund, $1,000,000. 2.4 LIMITATIONS. The foregoing indemnities by Sellers are subject to the following limitations: 2.4.1 EARN OUT WARRANTIES. Claims for breach of warranties made pursuant to Section 3.22 (Earn Out) of the Stock Purchase Agreement may be made on the following basis: In the event Aggregate EBITDA is less than $1,115,000, Purchaser shall be entitled to recover from the Earn Out Fund an amount calculated by multiplying the number of whole dollars by which Aggregate EBITDA is less than $1,115,000 by 2.6785714. If Aggregate EBITDA is $555,000 or less, Purchaser shall be entitled to all amounts in the Earn Out Fund and shall have no further remedy for claims for breach of Section 3.22 (Earn Out). Provided, however, that if Mark Russell ceases to be able to function as the chief executive officer of Hospital (whether called by that title or not) in an unfettered manner as the result of any action or inaction by Purchaser or its agents or representatives and provided further that Mark Russell gives written notice to Purchaser specifying such action or inaction within three (3) days of such, and following such notice Purchaser shall have three (3) days to either (i) cure the alleged action or inaction, or (ii) notify Mark Russell that Purchaser contends its action or inaction does not prevent Mark Russell from functioning as the Hospital's chief executive officer in an unfettered manner, the warranty contained in Section 3.22 shall be deemed to be satisfied and Sellers shall be entitled to the entire $1,500,000. Claims for breach of warranties made pursuant to Section 3.22 of the Stock Purchase Agreement may be brought, if at all, only before December 1, 2002, after which all warranties with regard to Section 3.22 of the Stock Purchase Agreement shall expire. All amounts in the Earn Out Fund not claimed by Purchaser under this Indemnification Agreement shall be delivered to Sellers in accordance with the terms of the Escrow Agreement. 2.4.2 ONE-YEAR WARRANTIES. Claims for breach of warranties made pursuant to Section 3.6 (Financial Information) of the Stock Purchase Agreement may be brought, if at all, only before the end of the 365th day following the Closing Date and only against the amounts remaining in the One-Year Warranty Fund, after which all warranties under Section 3.6 of the Stock Purchase Agreement shall expire. All amounts in the One-Year Warranty Fund 3 not claimed by Purchaser under this Indemnification Agreement shall be delivered to Sellers in accordance with the terms of the Escrow Agreement. 2.4.3 TWO-YEAR WARRANTIES. Claims for breach of warranties made in any Subsection of Section 3, Representations and Warranties of Sellers, of the Stock Purchase Agreement, other than Section 3.6 (Financial Information), Section 3.9 (Medicare Participation/Accreditation), and Section 3.22 (Earn Out), may be brought, if at all, only before the end of the 730th day following the Closing Date and only against the amounts remaining in the Two-Year Warranty Fund, after which all warranties under the Stock Purchase Agreement shall expire. All amounts in the Two-Year Warranty Fund not claimed by Purchaser under this Indemnification Agreement shall be delivered to Sellers in accordance with the terms of the Escrow Agreement. 2.4.4 COST REPORT WARRANTIES. Claims for breach of warranties made pursuant to Section 3.9 (Medicare Participation/Accreditation) of the Stock Purchase Agreement and claims for amounts due pursuant to Section 8 of the Stock Purchase Agreement may be brought, if at all, only before the end of the 30th day following receipt by Purchaser of the Final Notice of Program Reimbursement from Medicare for calendar year 2000 or 2001, as appropriate, by Purchaser, after which all warranties with regard to such Cost Report shall expire. All amounts in the Cost Report Fund not claimed by Purchaser under this Indemnification Agreement shall be delivered to Sellers in accordance with the terms of the Escrow Agreement. 2.5 GENERAL LIMITATIONS. Purchaser's sole recourse against Sellers for indemnification under this Indemnification Agreement shall be recovery from the designated Escrowed Fund and shall be limited to the aggregate amount originally placed into each respective fund. Moreover, Sellers shall not be required to make any indemnification payment pursuant to this Indemnification Agreement from either the One-Year Warranty Fund or the Two-Year Warranty Fund unless and until the aggregate of all amounts for which indemnity would be payable from either or both Funds exceeds $25,000 (the "Basket Amount"), in which event Sellers shall then be responsible for all amounts including the Basket Amount. 2.6 NOTICE AND CONTROL OF LITIGATION. 2.6.1 If any claim or liability is asserted in writing against a Person entitled to indemnification under this Indemnification Agreement (the "Indemnified Party') that would give rise to a claim under this Indemnification Agreement, the Indemnified Party shall notify the Person giving the indemnity ("Indemnifying Party") in writing of the same within twenty (20) business days of receipt of such written assertion of a claim or liability; provided, however, that the failure to provide such notice as so indicated shall not affect the Indemnifying Party's obligation to indemnify and the Indemnifying Party shall have no remedy by reason of such failure except to the extent of any actual prejudice resulting from such delay. The Indemnifying Party shall have the right to defend any such claim, select the counsel, and control the defense, settlement, and prosecution of any litigation. If the Indemnifying Party fails, within ten (10) business days after notice of such claim, to initiate the defense of such claim, the Indemnified 4 Party will (upon further notice to the Indemnifying Party) have the right to undertake the defense, compromise or settlement of such claim on behalf of and for the account and risk of the Indemnifying Party; provided, however, that such claim shall not be compromised or settled without the consent of the Indemnifying Party, which consent shall not be unreasonably withheld or delayed. 2.6.2 The Indemnified Party shall cooperate in all reasonable respects with the Indemnifying Party in the investigation, trial and defense of any lawsuit or action that may be subject to this Indemnification Agreement and any appeal arising therefrom; provided, however, that the Indemnified Party may, at its own cost, participate in the investigation, trial and defense of such lawsuit or action any appeal arising therefrom. The parties shall cooperate with each other in any notifications to insurers. 2.7 EXCLUSIVE REMEDY. EXCEPT FOR CLAIMS FOR BREACH OF THIS INDEMNIFICATION AGREEMENT, THE SOLE AND EXCLUSIVE REMEDY FOR ANY BREACH OF ANY COVENANT OR AGREEMENT OR THE INACCURACY OF ANY REPRESENTATION OR WARRANTY, OR ALLEGED BREACH OR INACCURACY OF ANY COVENANT, AGREEMENT, REPRESENTATION OR WARRANTY, RESPECTIVELY, MADE IN THE STOCK PURCHASE AGREEMENT OR IN ANY AGREEMENT EXECUTED AND DELIVERED PURSUANT THERETO, OR FOR ANY OTHER ALLEGED OR ACTUAL BREACH OR VIOLATION OF THE STOCK PURCHASE AGREEMENT OR ANY AGREEMENT EXECUTED AND DELIVERED PURSUANT THERETO, SHALL BE THE INDEMNIFICATION REMEDY PROVIDED IN THIS INDEMNIFICATION AGREEMENT. 2.8 MITIGATION. The Indemnified Party shall take all reasonable steps to mitigate all liabilities and claims, including availing itself as reasonably directed by Indemnifying Party of any defenses, limitations, rights of contribution, claims against third parties and other rights at law, and shall provide such evidence and documentation of the nature and extent of any liability as may be reasonably requested by the Indemnifying Party. Each party shall act in a commercially reasonable manner in addressing any liabilities that may provide the basis for an indemnifiable claim (that is, each party shall respond to such liability in the same manner that it would respond to such liability in the absence of the indemnification provided for in this Indemnification Agreement). Any request for indemnification of specific costs shall include invoices and supporting documents containing reasonably detailed information about the costs and/or damages for which indemnification is being sought. SECTION 3. MISCELLANEOUS PROVISIONS. 3.1 SUCCESSORS AND ASSIGNS. All of the terms and provisions of this Indemnification Agreement shall be binding upon and shall inure to the benefit of and be enforceable by the respective successors and assigns of the parties hereto. No party hereto may assign any of its rights or delegate any of its duties under this Indemnification Agreement without the prior written consent of the other parties. 5 3.2 GOVERNING LAW. This Agreement shall be governed by and construed in accordance with the laws of the State of Tennessee. This Agreement and its subject matter have substantial contacts with Tennessee, and all actions, suits, or other proceedings with respect to this Agreement shall be brought only in a court of competent jurisdiction sitting in Davidson County, Tennessee, or in the United States District Court having jurisdiction over that County. In any such action, suit, or proceeding, such court shall have personal jurisdiction of all of the parties hereto, and service of process upon them under any applicable statutes, laws, and rules shall be deemed valid and good. 3.3 AMENDMENTS. This Indemnification Agreement may not be amended or modified other than by written instrument signed by the parties hereto. 3.4 NOTICES. All notices, offers, requests, demands, and other communications pursuant to this Indemnification Agreement shall be given in writing by personal delivery, by prepaid first class registered or certified mail properly addressed with appropriate postage paid thereon, by facsimile transmission, or by UPS, FedEx or other recognized, reputable overnight courier and shall be deemed to be duly given and received on the date of delivery if delivered personally, on the second day after the deposit in the United States Mail if mailed, upon acknowledgment of receipt of electronic transmission if sent by facsimile transmission, or upon delivery if by UPS, FedEx or other recognized, reputable overnight courier. Notices shall be sent to the parties at the following address: Sellers: Mark R. Russell, Sellers' Representative c/o Sherrard & Roe, PLC 424 Church Street, Suite 2000 Nashville, Tennessee 37219-3304 Attention: Michel G. Kaplan, Esq. Facsimile: (615) 742-4539 with copies to: Sherrard & Roe, PLC 424 Church Street, Suite 2000 Nashville, Tennessee 37219-3304 Attention: Michel G. Kaplan, Esq., or John R. Voigt, Esq. Facsimile: (615) 742-4539 mkaplan@sherrardroe.com or jvoigt@sherrardroe.com Purchaser: Psychiatric Solutions, Inc. 113 Seaboard Lane, Suite C-100 Franklin, Tennessee 37067 Attention: President Facsimile: (615) 312-5700 jjacobs@psysolutions.com 6 with copies to: Harwell Howard Hyne Gabbert & Manner, P.C. 315 Deaderick Street, Suite 1800 Nashville, Tennessee 37238 Attention: Lee C. Dilworth, Esq. Facsimile: (615) 251-1059 lcd@h3gm.com or to such other address, and to the attention of such other person or officer as any party may hereafter designate in writing. 3.5 HEADINGS. The section and other headings contained in this Indemnification Agreement are included for the purpose of convenient reference only and shall not restrict, amplify, modify or otherwise affect in any way the meaning or interpretation of this Indemnification Agreement. 3.6 GENDER AND NUMBER. All references to the neuter gender shall include the feminine or masculine gender and vice versa, where applicable, and all references to the singular shall include the plural and vice versa, where applicable. 3.7 THIRD PARTY BENEFICIARY. This Agreement has been made and is solely for the benefit of the parties hereto and their respective successors and permitted assigns. Nothing in this Agreement is intended to confer any rights or remedies under or by reason of this Agreement on any persons other than the parties to it and their respective successors and permitted assigns or to relieve or discharge the obligation or liability of any third persons to any party to this Agreement. 3.8 COUNTERPARTS; EXECUTION BY FACSIMILE. This Indemnification Agreement may be executed in several counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same Agreement, binding on all of the parties hereto. 3.9 SEVERABILITY. If any term, provision, condition or covenant of this Indemnification Agreement or the application thereof to any party or circumstance shall be held to be invalid or unenforceable to any extent in any jurisdiction, then the remainder of this Indemnification Agreement and the application of such term, provision, condition or covenant in any other jurisdiction or to persons or circumstances other than those as to whom or which it is held to be invalid or unenforceable, shall not be affected thereby, and each term, provision, condition and covenant of this Indemnification Agreement shall be valid and enforceable to the fullest extent permitted by law. 3.10 ENTIRE AGREEMENT. This Indemnification Agreement, and the Stock Purchase Agreement and the Escrow Agreement executed contemporaneously herewith, set forth the entire agreement and understanding of the parties hereto with respect to the matters covered herein and therein, and supersede all prior agreements, arrangements and understandings relating to the subject matter of this Indemnification Agreement and the Stock Purchase Agreement. 7 IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed in multiple originals by themselves or their authorized officers, all as of the day and year first written above. PURCHASER: SELLERS: PSYCHIATRIC SOLUTIONS, INC. AERIES HEALTHCARE MANAGEMENT SERVICES, L.L.C. By: /s/ Steven T. Davidson By: /s/ Mark R. Russell --------------------------------- ------------------------------- Its: Vice President Mark R. Russell, Sole Member -------------------------------- THE HILLSTREET FUND, L.P., A DELAWARE LIMITED PARTNERSHIP BY: HILLSTREET CAPITAL, INC., ITS INVESTMENT MANAGER By: /s/ Christian L. Meininger ------------------------------- Christian L. Meininger, President /s/ Mike Crothers ---------------------------------- Mike Crothers /s/ Stanley J. Kantanie ---------------------------------- Stanley J. Kantanie XYRX ASSET INVESTMENT FUND, LLC By: /s/ Dan E. Patterson ------------------------------- Dan E. Patterson, President /s/ Mark R. Russell ---------------------------------- Mark R. Russell /s/ Jack R. Salberg ---------------------------------- Jack R. Salberg /s/ Paul Yeoham ---------------------------------- Paul Yeoham 8 EX-10.16 7 g76727a1exv10w16.txt SUBORDINATED PROMISSORY NOTE EXHIBIT 10.16 PROMISSORY NOTE THE PAYMENT OF THIS INSTRUMENT, BOTH PRINCIPAL AND INTEREST, AND ALL OTHER INDEBTEDNESS EVIDENCED HEREBY, IS SUBORDINATE, SUBJECT AND MADE JUNIOR IN RIGHT OF PAYMENT TO THE RIGHTS OF HEALTHCARE BUSINESS CREDIT CORPORATION, ITS SUCCESSORS AND ASSIGNS PURSUANT TO THE TERMS OF THE SUBORDINATION AGREEMENT ("SENIOR SECURED LENDER"). PSYCHIATRIC SOLUTIONS, INC. SUBORDINATED NOTE $2,000,000 AUGUST 31, 2001 PSYCHIATRIC SOLUTIONS, INC., a Delaware corporation ("PSI"), promises to pay to the order of BROWN SCHOOLS, INC. (together with each assignee, donee, successor or transferee thereof, the "HOLDER") at the address listed on the signature page hereto, or at such other address as the Holder of this Note may designate in writing to PSI, or its assigns, the principal sum of Two Million Dollars ($2,000,000) (the "PRINCIPAL AMOUNT"). Notwithstanding, the Principal Amount is subject to adjustment as set forth in Section 3.1(b) of that certain Asset Purchase Agreement dated July __, 2001 between, among others, Cypress Creek Hospital, Inc., West Oaks Hospital, Inc., and PSI Hospitals, Inc. (the "APA"). The Principal Amount, as adjusted, shall be paid together with interest on the adjusted Principal Amount from the date of this Note until such Principal Amount is paid in full, at the rate equal to nine percent (9%) per annum as provided herein (the "NOTE"). Interest will be computed on the basis of a 360-day year of twelve 30-day months for the actual number of days elapsed, and be payable as set forth below. The Note shall mature and all principal and accrued but unpaid interest shall be and become immediately due and payable on August 31, 2005. Notwithstanding, principal and interest on the Note shall be payable as follows: (a) no payment of principal or interest shall be paid prior to September 30, 2002 (provided, however, that interest on the Note shall accrete on a quarterly basis from the date hereof as additional principal of the Note in an aggregate principal amount equal to the amount of interest accrued but unpaid with respect to such quarter), (b) on September 30, 2002, and again on the final day of each subsequent calendar quarter through the quarter ending June 30, 2003, PSI shall pay the Holder an amount equal to the accrued but unpaid interest with respect to such quarter on the Note, and (c) on September 30, 2003, and again on the final day of each subsequent calendar quarter through the quarter ending June 30, 2005, PSI shall pay the Holder an amount equal to (i) the accrued but unpaid interest with respect to such quarter on the Note, plus (ii) one-eighth of the Principal Amount (as adjusted). This note is unsecured. This Note shall be prepayable, in part or whole. 1. SUBORDINATION. 1.1 The payment of this Note, both principal and interest, is subordinate, subject to and made junior in right of payment to the rights of Senior Secured Lender pursuant to the terms and conditions of that certain Subordination Agreement dated as of even date herewith by and among Senior Secured Lender, PSI, and Holder. 2. DEFAULT. 2.1 The entire unpaid balance of the Principal Amount (as adjusted) and all interest accrued and unpaid on this Note shall, at the election of the Holder, be and become immediately due and payable upon the occurrence of any of the following events (each a "DEFAULT EVENT"): 2.1.1 The non-payment by PSI when due of principal or interest as provided in this Note, unless such delinquent payment is cured within five (5) days following delivery of written notice from the Holder. 2.1.2 Any breach by PSI of any representation, warranty, or covenant contained in this Note (including but not limited to a breach of Section 4 of this Note); unless such breach is cured within five (5) days following delivery of written notice from Holder. 2.1.3 Default with respect to indebtedness of at least One Million Dollars ($1,000,000) held by any creditor of PSI that results in the holder accelerating such indebtedness. 2.1.4 A Change of Control of PSI or its successor if and only if such Change of Control occurs after February 28, 2003. For purposes of this Section 2.1.4, a "Change of Control" shall include (i) the merger or consolidation with or into any person or entity in a transaction whereby (a) the shareholders of PSI (or its successor) immediately prior to the transaction do not continue to own at least fifty-one percent (51%) of the outstanding voting securities of the surviving company following the transaction, or (b) the shareholders of PSI (or its successor) immediately prior to the transaction do not collectively have the ability to appoint at least a majority of the Board of Directors of the surviving company following the transaction, or (ii) the sale, lease or other disposition of all or substantially all the assets of PSI and its subsidiaries to any person. 2.1.5 If PSI (i) applies for or consents to the appointment of, or if there shall be a taking of possession by, a receiver, custodian, trustee or liquidator for PSI or any of its property; (ii) adopts a plan of liquidation; (iii) becomes generally unable to pay its debts as they become due; (iv) makes a general assignment for the benefit of creditors or becomes insolvent; (v) files or is served with any petition for relief under the Bankruptcy Code or any similar federal or state statute; or (vi) has any attachment or levy made to or against any of its property or assets, and such judgment remains undischarged, unstayed or unreleased, as applicable for a period of forty-five (45) days. 2.2 Upon the occurrence of a Default Event, the indebtedness evidenced by this Note shall bear interest at the lesser of two percentage points (2%) in excess of the applicable interest rate 2 on the Note per annum or the Highest Lawful Rate (as defined below). The Holder shall be entitled to collect all costs and expenses of collection and/or suit including, but not limited to, reasonable attorneys' fees. 2.3 Each right, power or remedy of the Holder upon the occurrence of any Default Event as provided for in this Note or now or hereafter existing at law or in equity or by statute shall be cumulative and concurrent and shall be in addition to every other right, power or remedy provided for in this Note or now or hereafter existing at law or in equity or by statute, and the exercise or beginning of the exercise by the Holder or transferee hereof of any one or more of such rights, powers or remedies shall not preclude the simultaneous or later exercise by the Holder of any or all such other rights, powers or remedies. 3. CHANGE OF CONTROL. In the event of a merger, consolidation, sale/lease of assets, or any other type of transaction such that a person or entity other than PSI becomes the successor to all or substantially all of the assets of PSI, PSI shall cause its successor to execute an Assumption Agreement (in form reasonably satisfactory to Holder) whereby such successor will assume the obligations of PSI under this Note. 4. DIVIDENDS. Prior to September 30, 2002, PSI (or its successor) will not declare or pay any dividends unless such declaration or payment is approved by the Senior Secured Lender. During the term of this Note after such date, PSI (or its successor) will not declare or pay any dividends unless PSI (or its successor) is current in all payments of principal and interest required by this Note. 5. FAILURE TO ACT AND WAIVER. No failure or delay by the Holder to insist upon the strict performance of any term of this Note or to exercise any right, power or remedy consequent upon a default hereunder shall constitute a waiver of any such term or of any such breach, or preclude the Holder from exercising any such right, power or remedy at any later time or times. By accepting payment after the due date of any amount payable under this Note, the Holder shall not be deemed to waive the right to require payment when due of all other amounts payable under this Note, or to declare a default for failure to effect such payment of any such other amount. The failure of the Holder of this Note to give notice of any failure or breach of PSI under this Note shall not constitute a waiver of any right or remedy in respect of such continuing failure or breach or any subsequent failure or breach. 6. NOTICES. All notices and communications under this Note shall be in writing and shall be either delivered via facsimile or in person or accompanied by a signed receipt therefore or mailed first-class United States certified mail, return receipt requested, postage prepaid, and addressed to PSI at its principal executive office and to Holder at the address listed on the signature page hereto or such other actual address of Holder known to PSI's Chief Financial Officer. Any notice of communication shall be deemed given and received as of the date of such delivery or mailing. 7. USURY. Regardless of any provisions contained in this Note or in any other documents and instruments referred to herein, Holder shall never be deemed to have contracted for or be entitled to receive, collect, or apply as interest on this Note any amount in excess of the Highest Lawful 3 Rate, and in the event Holder ever receives, collects or applies as interest any such excess, such amount which would be excessive interest shall be applied to the reduction of the unpaid principal balance of this Note, and, if the principal balance of this Note is paid in full, any remaining excess shall forthwith be paid to PSI. "HIGHEST LAWFUL RATE" shall mean the maximum non-usurious interest rate, if any, at any time or from time to time may be contracted for, taken, reserved, charged or received on the total indebtedness due under this Note under the Laws of the United States and the State of Texas applicable thereto which are presently in effect or, to the extent allowed by such applicable laws of the United States or the state of Texas, which may hereafter be in effect and which allow a higher maximum non-usurious interest rate than applicable laws now allow. In determining whether or not interest paid or payable, under any specific contingency, exceeds the Highest Lawful Rate, PSI and Holder shall, to the maximum extent permitted under applicable law, (a) characterize any non-principal payment as an expense, fee, or premium rather than as interest, (b) exclude voluntary prepayments and the effect thereof, and (c) amortize, prorate, allocate and spread, in equal parts, the total amount of interest throughout the entire contemplated term of this Note so that the interest is uniform throughout the entire term hereof. 8. AMENDMENT. No amendment, alteration or modification of this Note shall be valid unless in each instance such amendment, alteration or modification is expressed in a written instrument duly executed by each of the parties hereto. 9. GOVERNING LAW; VENUE. This Note shall be governed by an construed and enforced in accordance with the laws of the State of Texas. The parties expressly agree that this Note is entered into in Austin, Texas, and that all performance required hereunder is significantly connected therewith. Accordingly, venue for any action at law or equity arising or related to this Note shall be in a court of appropriate jurisdiction in Austin, Travis County, Texas. 10. WAIVER OF NOTICE. PSI hereby waives notice, presentment, demand, protect and notice of dishonor. IN WITNESS WHEREOF, PSI has caused this Note to be duly executed. PSYCHIATRIC SOLUTIONS, INC. By: /s/ Steven T. Davidson ------------------------------------------------ Its: Vice President ------------------------------------------------ 4 EX-10.17 8 g76727a1exv10w17.txt FORM OF CONVERTIBLE SUBORDINATED NOTE EXHIBIT 10.17 NEITHER THIS SUBORDINATED CONVERTIBLE NOTE NOR THE SERIES B PREFERRED STOCK INTO WHICH IT IS CONVERTIBLE HAS BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933 (THE "ACT") OR APPLICABLE STATE SECURITIES LAWS (THE "STATE ACTS"), AND MAY NOT BE SOLD, PLEDGED, HYPOTHECATED, DONATED, OR OTHERWISE TRANSFERRED (WHETHER OR NOT FOR CONSIDERATION) BY THE HOLDER EXCEPT UPON THE ISSUANCE TO THE MAKER OF A FAVORABLE OPINION OF ITS COUNSEL, OR SUBMISSION TO THE MAKER OF SUCH OTHER EVIDENCE AS MAY BE REASONABLY SATISFACTORY TO COUNSEL FOR THE MAKER, TO THE EFFECT THAT ANY SUCH TRANSFER SHALL NOT BE IN VIOLATION OF THE ACT AND THE STATE ACTS. THE PAYMENT OF THIS INSTRUMENT, BOTH PRINCIPAL AND INTEREST, AND ALL OTHER INDEBTEDNESS EVIDENCED HEREBY, IS SUBORDINATE, SUBJECT AND MADE JUNIOR IN RIGHT OF PAYMENT TO THE RIGHTS OF OTHER LENDERS TO THE MAKER, INCLUDING COPELCO/AMERICAN HEALTHFUND, INC., ITS SUCCESSORS AND ASSIGNS ("COPELCO"), IN THE MANNER AND TO THE EXTENT PROVIDED FOR IN THE RELATED SUBORDINATION AGREEMENT EXECUTED ON OR ABOUT THE DATE HEREOF BETWEEN THE HOLDER AND COPELCO (THE "SUBORDINATION AGREEMENT"). PSYCHIATRIC SOLUTIONS, INC. CONVERTIBLE SUBORDINATED NOTE $____________ May 5, 2000 Psychiatric Solutions, Inc., a Delaware corporation ("PSI"), promises to pay to the order of Sunrise Holdings, Inc., a corporation (together with each assignee, donee, successor or transferee thereof, the "HOLDER") at the address listed on the signature page hereto, or at such other address as the Holder of this Note may designate in writing to PSI, or its assigns, the principal sum of ___________________ and __/100 Dollars ($_________) (the "PRINCIPAL AMOUNT") together with interest on the outstanding Principal Amount at the rate of nine percent (9%) per annum as provided herein (the "NOTE"). Unless sooner redeemed or converted, all principal and accrued interest shall be paid on May 1, 2005 (the "DUE DATE"). Interest will be computed on the basis of a 360-day year of twelve 30-day months. In the event of any conversions of this Note, as specified herein, accrued interest will be converted or paid in cash at the discretion of PSI. Notwithstanding the stated Due Date and subject to the Subordination Agreement with the holders of the Senior Indebtedness; at the option of the Holder, the Note shall mature and all principal and accrued interest shall be and become immediately due and payable upon the happening of any of the following events: (a) the sale, exchange, lease, or other disposition of all or substantially all of the assets or stock of PSI in one transaction or a series of related transactions; (b) any "change of control," or (c) an initial public offering by PSI of its securities. A "change of control" shall be deemed to have occurred upon the acquisition of at least fifty percent (50%) of the equity interest in PSI by a person or entity and its respective affiliates other than a presently existing officer and/or his affiliates of PSI or a presently existing director and/or his affiliates of PSI. This Note shall not be prepayable, in part or whole, to the extent provided for in the Subordination Agreement. 1. CONVERSION. 1.1 The Holder of this Note shall have the right, at such Holder's option, at any time until April 30, 2004, to convert, in whole or in part, the unpaid principal balance of this Note, in increments of $1,000 Principal Amount, into that number of fully paid and nonassessable shares of Series B Preferred Stock of PSI based on the following conversion prices:
Conversion Date "Conversion Price" --------------- ------------------ May 1, 2000 - April 30, 2001 $2.00 per share May 1, 2001 - April 30, 2002 $2.33 per share May 1, 2002 - April 30, 2003 $2.67 per share May 1, 2003 - April 30, 2004 $3.00 per share
1.2 The Holder of this Note may exercise the conversion right provided in this Section by giving written notice ten (10) days prior to conversion (the "CONVERSION NOTICE") to PSI of the exercise of such right and stating the Principal Amount being converted and the name or names in which the stock to be issued and the address to which such stock shall be delivered. 1.3 Conversion shall be deemed to have been effected on the tenth (10th) day following the date the Conversion Notice is given (the "CONVERSION DATE"). 1.4 In the event of the issuance by PSI of any Series B Preferred Stock with proceeds to PSI of less than One and 50/100 Dollars ($1.50) per share, or any recapitalization, stock split or stock dividend of PSI, at such time as this Note, or any portion hereof, remains convertible, appropriate adjustment shall be made in the Conversion Price per share to be paid so as to maintain the proportionate interest represented herein. 1.5 In case of any capital reorganization, or reclassification of the capital stock of PSI (other than a change in par value or from par value to no par value or from no par value to par value or as a result of a stock distribution or split, or the consolidation or merger of PSI with or into another person or entity (other than a consolidation or merger in which PSI is the continuing entity)) or of the sale, exchange, lease, transfer or other disposition of all or substantially all of the properties and assets of PSI, this Note shall (effective on the opening of business on the date after the effective date of such reorganization, reclassification, consolidation, merger, sale or exchange, lease, transfer or other disposition or share exchange) be convertible into the kind and number of shares of stock 2 or other securities or property of PSI or of the entity resulting from such consolidation or surviving such merger or to which such properties and assets shall have been sold, exchanged, leased, transferred or otherwise disposed or which was the entity whose securities were exchanged for those of PSI to which the Holder of the number of shares of stock deliverable (at the close of business on the date immediately preceding the effective date of such reorganization, reclassification, consolidation, merger, sale, exchange, lease, transfer or other disposition or share exchange) upon conversion of this Note would have been entitled upon such reorganization, reclassification, consolidation, merger, sale, exchange, lease transfer or other disposition or share exchange. The provisions of this Section 1.5 shall similarly apply to successive reorganizations, reclassifications, consolidations, mergers, sales, exchanges, leases, transfers or other dispositions. 1.6 Whenever the Conversion Price shall be adjusted as provided herein, PSI shall prepare and send to the Holder of this Note a statement, signed by the chief financial officer of PSI, certifying the facts requiring such adjustment and the Conversion Price that shall be in effect after such adjustment. 1.7 In the event PSI shall propose to take any action of the types described in Section 1.5 hereof, PSI shall give notice to the Holder of this Note, which notice shall specify the record date, if any, with respect to any such action and the date on which such action is to take place. Such notice shall be given on or prior to the earlier of ten (10) days prior to the record date or the date which such action shall be taken. Such notice shall also set forth such facts with respect thereto as shall be reasonably necessary to indicate the effect of such action (to the extent such effect may be known at the date of such notice) on the Conversion Price and the number, kind or class of shares or other securities or property which shall be deliverable or purchasable upon the occurrence of such action or deliverable upon conversion of this Note. 1.8 PSI shall pay all documentary, stamp or other transactional taxes (excluding any federal, state or local income tax) and charges attributable to the issuance or delivery of PSI stock upon conversion; provided, however, that PSI shall not be required to pay any taxes which may be payable in respect of any transfer involved in the issuance or delivery of any certificate for such stock in a name other than the record Holder of this Note. 1.9 PSI shall at all times authorize the issuance of PSI stock and the admission, with full voting rights, or the Holder as a shareholder of PSI upon any conversion of this Note. 2. SUBORDINATION; RESTRICTION ON SERIES B PREFERRED STOCK DIVIDENDS AND DISTRIBUTIONS. 2.1 The payment of this Note, both principal and interest, is subordinate, subject to and made junior in right of payment to the rights of Copelco in the manner and to the extent provided for in the Subordination Agreement. 2.2 PSI shall make no distributions or dividends of cash or property to holders of its Series A or B Preferred Stock, common stock, or any other class of equity, so long as any amount of principal or interest remains due and payable to Holder pursuant to the terms of this Note; 3 provided that this Section 2.2 is not intended and shall not be construed to preclude any events described in, and in conformance with, Sections 1.4 or 1.5 above. 3. DEFAULT. 3.1 The entire unpaid balance of the Principal Amount and all interest accrued and unpaid on this Note shall, at the election of the Holder, be and become immediately due and payable upon the occurrence of any of the following events (each a "DEFAULT EVENT"): 3.1.1 The non-payment by PSI when due of principal and interest or of any other payment as provided in this Note, unless such delinquent payment is cured within ten (10) days following delivery of notice from the Holder. 3.1.2 Default with respect to Copelco or any other secured creditor of PSI unless any such monetary default is cured within thirty (30) days or any nonmonetary default is cured within forty-five (45) days. Provided, however, PSI shall have the right to dispute in good faith any such claims of default but such dispute will not affect the Default Event hereunder. 3.1.3 If PSI (i) applies for or consents to the appointment of, or if there shall be a taking of possession by, a receiver, custodian, trustee or liquidator for PSI or any of its property; (ii) becomes generally unable to pay its debts as they become due; (iii) makes a general assignment for the benefit of creditors or becomes insolvent; (iv) files or is served with any petition for relief under the Bankruptcy Code or any similar federal or state statute; (v) has any judgment entered against it in excess of One Hundred Thousand Dollars ($100,000) in any one instance or in the aggregate during any consecutive twelve (12) month period or has any attachment or levy made to or against any of its property or assets, and such judgment is final and all appeals have been exhausted; or (vi) has assessed or imposed against it, or if there shall exist any general or specific lien for any federal, state or local taxes or charges against any of its property or assets. 3.1.4 Any failure by PSI to issue and deliver shares of its Series B Preferred Stock as provided herein upon conversion of this Note. 3.2 Upon the occurrence of a Default Event, the indebtedness evidenced by this Note shall bear interest at the lesser of three percentage points (3%) in excess of the applicable interest rate on the Note per annum or the highest lawful rate. The Holder shall be entitled to collect all costs and expenses of collection and/or suit, including, but not limited to reasonable attorneys' fees. 3.3 Each right, power or remedy of the Holder hereof upon the occurrence of any Default Event as provided for in this Note or now or hereafter existing at law or in equity or by statute shall be cumulative and concurrent and shall be in addition to every other right, power or remedy provided for in this Note or now or hereafter existing at law or in equity or by statute, and the exercise or beginning of the exercise by the Holder or transferee hereof of any one or more of such rights, powers or remedies shall not preclude the simultaneous or later exercise by the Holder hereof of any or all such other rights, powers or remedies. Notwithstanding the foregoing, in the event PSI 4 and/or its affiliates have or pursue a claim against Holder, PSI shall not be entitled to set off the amount of such claim against any amounts due and owing Holder hereunder absent Holder's prior consent or the entry of a final judgment, decree or order of a court of competent jurisdiction over such matter. 4. FAILURE TO ACT AND WAIVER. No failure or delay by the Holder hereof to insist upon the strict performance of any term of this Note or to exercise any right, power or remedy consequent upon a default hereunder shall constitute a waiver of any such term or of any such breach, or preclude the Holder hereof from exercising any such right, power or remedy at any later time or times. By accepting payment after the due date of any amount payable under this Note, the Holder hereof shall not be deemed to waive the right either to require payment when due of all other amounts payable under this Note, or to declare a default for failure to effect such payment of any such other amount. The failure of the Holder of this Note to give notice of any failure or breach of PSI under this Note shall not constitute a waiver of any right or remedy in respect of such continuing failure or breach or any subsequent failure or breach. 5. TRANSFER. This Note may be transferred by the Holder without the consent of PSI, but subject to the restrictive legend contained herein. In the event of any said transfer, the Note shall be transferred on the books of PSI only by the registered Holder hereof or by its attorney duly authorized in writing or by delivery to PSI of a duly executed assignment. PSI shall be entitled to treat any Holder of record of the Note as the Holder in fact thereof and shall not be bound to recognize any equitable or other claim to or interest in this Note in the name of any other person, whether or not it shall have express or other notice thereof, save as expressly provided by the laws of Texas. No transfer shall be made, however, unless the transferee expressly acknowledges to the holders of the Senior Indebtedness, in writing, that it agrees to be bound by all of the terms hereof. 6. NOTICES. All notices and communications under this Note shall be in writing and shall be either delivered via facsimile or in person or accompanied by a signed receipt therefore or mailed first-class United States certified mail, return receipt requested, postage prepaid, and addressed to PSI at its principal executive office and to Holder at the address listed on the signature page hereto or such other actual address of Holder known to PSI's Chief Financial Officer. Any notice of communication shall be deemed given and received as of the date of such delivery or mailing. 7. USURY. Regardless of any provisions contained in this Note or in any other documents and instruments referred to herein, Holder shall never be deemed to have contracted for or be entitled to receive, collect, or apply as interest on this Note any amount in excess of the Highest Lawful Rate, and in the event Holder ever receives, collects or applies as interest any such excess, such amount which would be excessive interest shall be applied to the reduction of the unpaid principal balance of this Note, and, if the principal balance of this Note is paid in full, any remaining excess shall forthwith be paid to PSI. "HIGHEST LAWFUL RATE" shall mean the maximum non-usurious interest rate, if any, at any time or from time to time may be contracted for, taken, reserved, charged or received on the total indebtedness due under this Note under the Laws of the United States and the State of Tennessee applicable thereto which are presently in effect or, to the extent allowed by such applicable laws of the United States or the state of Tennessee, which may hereafter be in effect 5 and which allow a higher maximum non-usurious interest rate than applicable laws now allow. In determining whether or not interest paid or payable, under any specific contingency, exceeds the Highest Lawful Rate, PSI and Holder shall, to the maximum extent permitted under applicable law, (a) characterize any non-principal payment as an expense, fee, or premium rather than as interest, (b) exclude voluntary prepayments and the effect thereof, and (c) amortize, prorate, allocate and spread, in equal parts, the total amount of interest throughout the entire contemplated term of this Note so that the interest is uniform throughout the entire term hereof. 8. HOLDER'S REPRESENTATIVE. 8.1 In order to administer efficiently the implementation of this Note by the Holder, the Holder hereby designates Hunt Capital Group, LLC as its representative (the "HOLDER'S REPRESENTATIVE"). 8.2 The Holder hereby authorizes the Holder's Representative (i) to take all action necessary in connection with the implementation of this Note on behalf of Holder or the settlement of any dispute, (ii) to give and receive all notices required to be given under this Note, and (iii) to take any and all additional action as is contemplated to be taken by or on behalf of the Holder by the terms of this Note. 8.3 By its execution of this Note, the Holder agrees that: 8.3.1 PSI shall be able to rely conclusively on the instructions and decisions of the Holder's Representative as to any actions required or permitted to be taken by the Holder or the Holder's Representative under this Note, and no party hereunder shall have any cause of action against PSI for any action taken by PSI in reliance upon such instructions or decisions of the Holder's Representative; and 8.3.2 all actions, decisions and instructions of the Holder's Representative shall be conclusive and binding upon Holder and Holder shall have no cause of action against Holder's Representative for any action taken, decision made or instruction given by the Holder's Representative under this Note except for fraud or willful breach of this Note by the Holder's Representative. 9. GOVERNING LAW; VENUE. This Note shall be governed by an construed and enforced in accordance with the laws of the State of Tennessee. Further, as a specifically bargained inducement for the holders of the Senior Indebtedness to extend credit to PSI, and after having the opportunity to consult counsel, the parties agree that the courts located in Davidson County, Tennessee shall have subject matter and personal jurisdiction to enforce the terms of this Note and venue to enforce the terms of this Note shall be proper in Nashville, Davidson County, Tennessee. 6 IN WITNESS WHEREOF, PSI has caused this Note to be duly executed. PSYCHIATRIC SOLUTIONS, INC. By: /s/ Steven T. Davidson --------------------------------------- Steven T. Davidson, Vice President TERMS OF SUBORDINATION ACKNOWLEDGED AND AGREED: SUNRISE HOLDINGS, INC. By: -------------------------------- Holder's Address: - ------------------------------------ - ------------------------------------ - ------------------------------------ 7 EX-10.18 9 g76727a1exv10w18.txt SECURITIES PURCHASE AGREEMENT EXHIBIT 10.18 SECURITIES PURCHASE AGREEMENT between PSYCHIATRIC SOLUTIONS, INC., and THE 1818 MEZZANINE FUND II, L.P. ------------------------------ Dated as of: June 28, 2002 ------------------------------ TABLE OF CONTENTS
Page ---- ARTICLE I DEFINITIONS..............................................................1 1.1 Definitions....................................................1 1.2 Accounting Terms; Financial Covenants.........................16 ARTICLE II PURCHASE AND SALE......................................................16 2.1 Purchase and Sale of Note and Initial Warrants................16 2.2 Additional Loans..............................................17 2.3 Fees..........................................................17 2.4 Initial Closing...............................................17 2.5 Additional Closings...........................................17 ARTICLE III CONDITIONS TO THE OBLIGATION OF THE PURCHASER TO CLOSE................20 3.1 Representations and Warranties True...........................20 3.2 Compliance with this Agreement................................20 3.3 Officers' Certificate.........................................20 3.4 Secretary's Certificates......................................20 3.5 Documents.....................................................20 3.6 Purchase Permitted by Applicable Laws; Legal Investment.......21 3.7 Opinion of Counsel............................................21 3.8 Approval of Counsel to the Purchaser..........................21 3.9 Consents and Approvals........................................21 3.10 No Material Adverse Change....................................21 3.11 Investor Rights Agreement.....................................21 3.12 Co-Sale Agreement.............................................21 3.13 Voting Agreement..............................................21 3.14 Subsidiaries' Guarantee.......................................21 3.15 Subordination Agreement.......................................21 3.16 Market Conditions.............................................22 3.17 No Litigation.................................................22 3.18 No Default or Breach..........................................22 3.19 Repayment of Promissory Notes.................................22 3.20 Credit Agreement..............................................22 3.21 Amendment to Credit Agreement.................................23 3.22 PMR Letter Agreement..........................................23 3.23 Aeries Healthcare.............................................23 3.24 Junior Subordination Agreements...............................23 3.25 Amending Agreement............................................23 3.26 PMR Consent...................................................23 3.27 Amendment to By-laws..........................................23
i
Page ---- 3.28 Waiver of Rights..............................................23 3.29 Fees and Expenses.............................................23 ARTICLE IV CONDITIONS TO THE OBLIGATION OF THE COMPANY TO CLOSE..................24 4.1 Representations and Warranties True...........................24 4.2 Compliance with this Agreement................................24 4.3 Consents and Approvals........................................24 ARTICLE V REPRESENTATIONS AND WARRANTIES OF THE COMPANY...........................24 5.1 Corporate Existence and Power.................................24 5.2 Corporate Authorization; No Contravention.....................25 5.3 Governmental Authorization; Third Party Consents..............25 5.4 Binding Effect................................................25 5.5 No Legal Bar..................................................26 5.6 Litigation....................................................26 5.7 No Default or Breach..........................................26 5.8 Title to Properties...........................................26 5.9 Investment Company............................................26 5.10 Subsidiaries..................................................27 5.11 Financial Condition; No Undisclosed Liabilities...............27 5.12 No Material Adverse Change....................................28 5.13 Capitalization................................................28 5.14 Solvency......................................................30 5.15 Private Offering..............................................30 5.16 Broker's, Finder's or Similar Fees............................30 5.17 Full Disclosure...............................................30 5.18 Anti-Dilution Protection; Preemptive Rights...................30 5.19 Investor Rights Agreements....................................31 5.20 Projections...................................................31 5.21 Labor Relations...............................................31 5.22 ERISA and Employee Benefit Plans..............................31 5.23 Environmental Matters.........................................32 5.24 Taxes.........................................................34 5.25 Intellectual Property.........................................34 5.26 Potential Conflicts of Interest...............................35 5.27 Trade Relations...............................................35 5.28 Outstanding Borrowing.........................................36 5.29 Material Contracts............................................36 5.30 Insurance.....................................................36 5.31 Compliance with Laws..........................................37 5.32 Assets, Licenses, Etc.........................................37 5.33 Aeries Healthcare Acquisition.................................37 5.34 Regulatory Matters............................................37
ii
Page ---- ARTICLE VI REPRESENTATIONS AND WARRANTIES OF THE PURCHASER........................42 6.1 Existence and Power...........................................42 6.2 Authorization; No Contravention...............................43 6.3 Binding Effect................................................43 6.4 No Legal Bar..................................................43 6.5 Purchase for Own Account......................................43 6.6 Accredited Investor...........................................44 6.7 Broker's, Finder's or Similar Fees............................44 ARTICLE VII INDEMNIFICATION.......................................................44 7.1 Indemnification by the Company................................44 7.2 Notification..................................................45 7.3 Investor Rights Agreement.....................................45 ARTICLE VIII FINANCIAL COVENANTS..................................................46 8.1 Minimum Census. ..............................................46 8.2 Total Consolidated Leverage Ratio.............................46 8.3 Senior Consolidated Leverage Ratio............................46 8.4 Consolidated Interest Coverage Ratio..........................46 8.5 Consolidated Fixed Charge Ratio...............................47 ARTICLE IX AFFIRMATIVE COVENANTS..................................................47 9.1 Financial Statements..........................................47 9.2 Certificates; Other Information...............................49 9.3 Preservation of Corporate Existence...........................49 9.4 Payment of Obligations........................................49 9.5 Compliance with Laws..........................................49 9.6 Notices.......................................................50 9.7 Issue Taxes...................................................50 9.8 Inspection; Confidentiality...................................50 9.9 Use of Proceeds...............................................51 9.10 Payment of the Note...........................................51 9.11 Subsidiaries' Guarantee.......................................51 9.12 PMR Guarantee.................................................51 9.13 No Inconsistent Agreements....................................51 9.14 Reservations of Shares........................................52 9.15 Registration and Listing......................................52 9.16 Allocation for Tax Purposes...................................52 9.17 Register of the Note..........................................52 9.18 Payment Upon Liquidation......................................53 9.19 Right of First Refusal........................................53 ARTICLE X NEGATIVE COVENANTS......................................................54 10.1 Restrictions on Indebtedness..................................54
iii
Page ---- 10.2 Restrictions on Liens.........................................55 10.3 Investments...................................................57 10.4 Disposition of Assets.........................................57 10.5 Mergers, Etc. ...............................................57 10.6 Assumptions, Guaranties, Etc. of Indebtedness of Other Persons.......................................................57 10.7 ERISA.........................................................58 10.8 Distributions.................................................58 10.9 Sale and Leaseback............................................58 10.10 Transactions with Affiliates..................................58 10.11 Change in Business............................................59 10.12 PMR Merger Agreement..........................................59 10.13 Drawdown Acquisition Documents................................59 10.14 Stock Option Plan.............................................59 10.15 Organizational Documents; Etc.................................59 10.16 Payment on Subordinated Debt..................................60 ARTICLE XI DEFAULTS AND REMEDIES..................................................60 11.1 Events of Default.............................................60 11.2 Rights and Remedies...........................................62 11.3 Rights and Remedies not Exclusive.............................63 ARTICLE XII REDEMPTION OF THE NOTES...............................................63 ARTICLE XIII REDEMPTION OF WARRANTS...............................................64 13.1 Holder's Right to Require Redemption..........................64 ARTICLE XIV SUBORDINATION.........................................................66 ARTICLE XV MISCELLANEOUS..........................................................66 15.1 Survival of Provisions........................................66 15.2 Notices.......................................................66 15.3 Successors and Assigns........................................67 15.4 Assignments...................................................68 15.5 Amendment and Waiver..........................................68 15.6 Counterparts..................................................69 15.7 Headings......................................................69 15.8 Determinations................................................69 15.9 Governing Law.................................................69 15.10 Jurisdiction..................................................69 15.11 Severability..................................................70 15.12 Rules of Construction.........................................70 15.13 Remedies......................................................70 15.14 Entire Agreement..............................................70 15.15 Attorneys' Fees...............................................70
iv
Page ---- 15.16 Publicity.....................................................71 15.17 Expenses......................................................71 15.18 Further Assurances............................................71
v EXHIBITS Exhibit A Form of Note Exhibit B Form of Warrant Certificate Exhibit C Form of Opinion Exhibit D Form of Second Amended and Restated Investor Rights Agreement Exhibit E Form of Second Amended and Restated Co-Sale Agreement Exhibit F Form of Second Amended and Restated Voting Agreement Exhibit G Form of Subsidiaries' Guarantee Exhibit H Form of PMR Guarantee Exhibit I Form of Subordination Agreement Exhibit J Form of PMR Letter Agreement Exhibit K Form of Junior Subordination Agreements Exhibit L Form of Amending Agreement SCHEDULES Schedule 3.14 Subsidiaries' Guarantee Schedule 3.19 Promissory Notes Schedule 3.24 Junior Subordination Agreements Schedule 5.6 Litigation Schedule 5.10 Subsidiaries Schedule 5.11 Pro Forma Financials Schedule 5.13(a) Capitalization Schedule 5.13(b) Common Stock Equivalents Schedule 5.16 Broker's, Finder's or Similar Fees Schedule 5.18 Anti-Dilution Protection; Preemptive Rights Schedule 5.20 Projections Schedule 5.22 ERISA Schedule 5.23 Environmental Matters Schedule 5.25(a) Intellectual Property Schedule 5.25(d) Software Schedule 5.26 Conflicts of Interest Schedule 5.28 Outstanding Borrowings Schedule 5.29 Material Contracts Schedule 5.30 Insurance Schedule 5.32 Assets, Licenses, Etc. Schedule 5.34 Regulatory Matters Schedule 8.1 Facilities Schedule 10.3 Investments in Subsidiaries Schedule 10.10 Transactions with Affiliates vi SECURITIES PURCHASE AGREEMENT SECURITIES PURCHASE AGREEMENT (this "Agreement"), dated as of June 28, 2002, between PSYCHIATRIC SOLUTIONS, Inc., a Delaware corporation (the "Company"), and THE 1818 MEZZANINE FUND II, L.P., a Delaware limited partnership (the "Purchaser"). WHEREAS, the Company proposes to issue and sell to the Purchaser (i) a senior subordinated promissory note with a final maturity of June 28, 2009 in the aggregate principal amount of up to $20,000,000 (together with all notes issued in connection with the substitution, replacement or transfer thereof, the "Note") and (ii) detachable warrants (the "Warrants") exercisable to purchase in the aggregate up to 3,004,280 shares of Common Stock (as hereinafter defined) (subject to adjustment as set forth in the Warrant Certificate), at an exercise price of $.01 per share of Common Stock. NOW, THEREFORE, in consideration of the mutual covenants and agreements set forth herein and for good and valuable consideration, the receipt and adequacy of which is hereby acknowledged, the parties hereto agree as follows: ARTICLE I DEFINITIONS 1.1 Definitions. As used in this Agreement, and unless the context requires a different meaning, the following terms have the meanings indicated: "Additional Closing" has the meaning assigned to that term in Section 2.5(a). "Additional Closing Date" has the meaning assigned to that term in Section 2.5(a). "Additional Loan" and "Additional Loans" have the meanings assigned to those terms in Section 2.2. "Additional Purchase Price" has the meaning assigned to that term in Section 2.5(a). "Additional Warrant" and "Additional Warrants" have the meaning assigned to those terms in Section 2.5(a). "Advances" shall mean, individually and/or collectively, borrowings under the Credit Agreement. Any amounts paid by any agent or lender party to the Credit Agreement on behalf of the Company or any Subsidiary or any guarantor under any Loan Document (as defined in the Credit Agreement) shall be an Advance for purposes of this Agreement. "Aeries Companies" has the meaning assigned to that term in Section 5.34(a). "Aeries Healthcare" means Aeries Healthcare Corporation, a Delaware corporation. "Aeries Purchase Agreement" means the Stock Purchase Agreement, dated as of June 20, 2002, by and among the Company, Aeries Healthcare and the other parties thereto. "Affiliate" has the meaning assigned to that term in Rule 12b-2 of the Exchange Act. "Agreement" means this Agreement, as the same may be amended or modified from time to time in accordance with the terms hereof. "Amending Agreement" means the Amending Agreement, substantially in the form attached hereto as Exhibit L, as the same may be amended, amended and restated, or modified from time to time in accordance with its terms. "BBH & Co." means Brown Brothers Harriman and Co., a New York limited partnership. "Benefit Plans" has the meaning assigned to those terms in Section 5.22(a). "Business" and "Businesses" have the meanings assigned to those terms in Section 5.34(a). "Business Day" means any day other than a Saturday, Sunday or other legal holiday on which commercial banks in New York City are authorized or required by law or executive order to close. "Businesses" has the meaning assigned to that term in Section 5.34(a). "Capital Expenditures" shall mean, for any Test Period, the sum (without duplication) of all expenditures (whether paid in cash or accrued as liabilities) during the Test Period that are or should be treated as capital expenditures under GAAP. "Capitalized Lease" shall mean, as to any Person, a lease of any interest in any kind of property or asset by that Person as lessee that is, should be or should have been recorded as a "capital lease" in accordance with GAAP. "Capitalized Lease Obligations" shall mean all obligations of any Person under Capitalized Leases, in each case, taken at the amount thereof accounted for as a liability in accordance with GAAP. 2 "CapitalSource" means CapitalSource Finance LLC, a Delaware limited liability company, or its assignee or successor as senior secured lender to the Company as permitted by the terms of the Subordination Agreement. "Capital Stock" of any Person means any and all shares, interests, participations or other equivalents (however designated) of such Person's capital stock (or equivalent ownership interests or membership interests) whether now outstanding or hereafter issued, including, without limitation, all common stock, preferred stock and other securities which are exercisable for or convertible into such Person's capital stock and any rights, warrants, options or other subscription or purchase rights to purchase such Person's capital stock. "Cash Equivalents" shall mean (a) securities issued, or directly and fully guaranteed or insured, by the United States or any agency or instrumentality thereof (provided, that the full faith and credit of the United States is pledged in support thereof) having maturities of not more than six months from the date of acquisition, (b) U.S. dollar denominated time deposits, certificates of deposit and bankers' acceptances of (i) any domestic commercial bank of recognized standing having capital and surplus in excess of $500,000,000, or (ii) any bank (or the parent company of such bank) whose short-term commercial paper rating from Standard & Poor's Ratings Services ("S&P") is at least A-2 or the equivalent thereof or from Moody's Investors Service, Inc. ("Moody's") is at least P-2 or the equivalent thereof in each case with maturities of not more than six months from the date of acquisition (any bank meeting the qualifications specified in clauses (b)(i) or (ii), an "Approved Bank"), (c) repurchase obligations with a term of not more than seven days for underlying securities of the types described in clause (a), above, entered into with any Approved Bank, (d) commercial paper issued by any Approved Bank or by the parent company of any Approved Bank and commercial paper issued by, or guaranteed by, any industrial or financial company with a short-term commercial paper rating of at least A-2 or the equivalent thereof by S&P or at least P-2 or the equivalent thereof by Moody's, or guaranteed by any industrial company with a long term unsecured debt rating of at least A or A2, or the equivalent of each thereof, from S&P or Moody's, as the case may be, and in each case maturing within six months after the date of acquisition and (e) investments in money market funds substantially all of whose assets are comprised of securities of the type described in clauses (a) through (d) above. "CERCLA" has the meaning assigned to that term in Section 5.23(b). "Closing" means the Initial Closing or any Additional Closing, as the case may be. "Closing Date" means the Initial Closing Date or any Additional Closing Date, as the case may be. "Code" means the Internal Revenue Code of 1986, as amended, or any successor statute thereto. 3 "Commission" means the Securities and Exchange Commission or any similar agency then having jurisdiction to enforce the Securities Act. "Common Stock" means shares of common stock, par value $0.01 per share, of the Company. "Company" has the meaning assigned to that term in the preamble of this Agreement. "Contractual Obligation" means, as to any Person, any provision of any security issued by such Person or of any agreement, undertaking, contract, indenture, mortgage, deed of trust or other instrument to which such Person is a party or by which it or any of its property is bound. "Co-Sale Agreement" means the Second Amended and Restated Co-Sale Agreement, substantially in the form attached hereto as Exhibit E, as the same may be amended, amended and restated or modified from time to time in accordance with its terms. "Credit Agreement" means the Revolving Credit and Term Loan Agreement, dated as of November 30, 2001, by and among CapitalSource, the Company, and the other parties thereto, as amended, modified, supplemented, restated, refinanced or replaced from time to time in accordance with its terms and the terms of this Agreement and the Subordination Agreement. "Debtor Relief Law" means the Bankruptcy Code of the United States of America and all other applicable liquidation, conservatorship, bankruptcy, moratorium, rearrangement, receivership, insolvency, reorganization or similar debtor relief laws from time to time in effect affecting the rights of creditors generally, as amended from time to time. "Default" means an event or condition which with the passage of time or giving of notice, or both, would become an Event of Default. "Demand Notice" has the meaning assigned to that term in Section 13.1(a). "Distribution" means, as to any Person: (a) the declaration or payment of any dividend on or in respect of any shares of any class of Capital Stock of such Person, other than dividends payable solely in shares of common stock of such person; (b) the purchase, redemption, or other acquisition or retirement of any shares of any class of Capital Stock of such Person directly or indirectly; (c) any other distribution on or in respect of any shares of any class of Capital Stock of such Person; (d) any setting apart or allocating any sum for the payment of any dividend or distribution, or for the purchase, redemption or retirement of any shares of Capital Stock of such Person; and (e) any fee, payment, bonus or other remuneration of any kind, and any replacement of or debt service on any loans or other Indebtedness other than to the Purchaser. 4 "Drawdown Acquisition" means an acquisition of all or substantially all of the assets or shares of stock of a Person by the Company or a wholly-owned Subsidiary, provided, however: (i) the total consideration for such assets or stock does not exceed $5,000,000 without the prior written consent of the Purchaser; (ii) such Person must be engaged in the same line of business as the Company and the Subsidiaries; (iii) any notes payable by the Company or any wholly-owned Subsidiary to such Person or its designee as part of the purchase price for such acquisition shall be unsecured and subordinated to the Note in form and substance satisfactory to the Purchaser; (iv) prior to the closing of each such acquisition, the Company shall deliver to the Purchaser an officer's certificate, as well as evidence satisfactory to the Purchaser establishing that: (1) immediately prior to such acquisition and immediately after such acquisition, the Purchaser is in compliance with all of the covenants and agreements hereunder and under the Credit Agreement; and (2) the calculation of the financial covenants required by Section 2.5(c) and this definition shall include the notes payable referenced in paragraph (iii) of this definition; (v) such acquisition is approved in writing by the Board of Directors of such Person to be acquired and the Company; and (vi) if the Purchaser does not advance funds to the Company in accordance with Section 2.5 simultaneously with the closing of such acquisition, then such acquisition shall not constitute a Drawdown Acquisition. "Drawdown Acquisition Documents" means, with respect to any Drawdown Acquisition, any and all documents, together with the exhibits and schedules thereto, related to such Drawdown Acquisition, including, without limitation, the documents governing such Drawdown Acquisition and any documents and certificates delivered in connection therewith. "Due Diligence Requests" has the meaning assigned to that term in Section 5.34(i). "EBITDA" shall mean, for any Test Period, the sum, without duplication, of the following for the Company and the Subsidiaries, on a consolidated and consolidating basis: Net Income determined in accordance with GAAP, plus, (a) Interest Expense, (b) taxes on income, whether paid, payable or accrued, (c) depreciation expense, (d) amortization expense, (e) all other non-cash, non-recurring charges and 5 expenses, excluding accruals for cash expenses made in the ordinary course of business, and (f) gain or loss from any sale of assets, other than sales in the ordinary course of business, all of the foregoing determined in accordance with GAAP. "Environment" means navigable waters, waters of the contiguous zone, ocean waters, natural resources, surface waters, ground water, drinking water supply, land surface, subsurface strata, ambient air, both inside and outside of buildings and structures, man-made buildings and structures, and plant and animal life on earth. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended. "ERISA Affiliate" has the meaning assigned to that term in Section 5.22(c). "Event of Default" has the meaning assigned to that term in Section 11.1. "Exchange Act" means the Securities Exchange Act of 1934, as amended, and the rules and regulations of the Commission thereunder. "Fair Market Value" has the meaning assigned to that term in Section 13.1(c). "Financials" has the meaning assigned to that term in Section 5.11(a). "Fixed Charge Ratio" shall mean, at any date of determination, for the Company and each Subsidiary, individually and collectively, on a consolidated and consolidating basis, the ratio of (a) EBITDA for the Monthly Test Period most recently ended before such date, to (b) Fixed Charges for the Monthly Test Period most recently ended before such date, in each case taken as one accounting period. "Fixed Charges" shall mean, on any calculation date, for any Monthly Test Period, the sum of the following for the Company and each Subsidiary, individually and collectively, on a consolidated and consolidating basis: (a) Total Debt Service for such period, (b) Capital Expenditures and management and services fees during such period, (c) income taxes paid in cash or accrued during such period, (d) dividends paid or accrued or declared during such period and (e) principal payments made by the Company or any Subsidiary pursuant to a HUD Financing. Any principal payments by the Company and the Subsidiaries made pursuant to the Revolving Facility shall be excluded from this definition. "GAAP" means generally accepted accounting principles in the United States of America in effect from time to time as applied by nationally recognized accounting firms. "Government Programs" has the meaning assigned to that term in Section 5.34(a). 6 "Governmental Authority" means the government of any nation, state, city, locality or other political subdivision of any thereof, any entity exercising executive, legislative, judicial, regulatory or administrative functions of or pertaining to government, and any corporation or other entity owned or controlled, through stock or capital ownership or otherwise, by any of the foregoing. "Guaranty" or "Guarantee" or "Guaranties" means any arrangement whereby a Person is or becomes liable in respect of any Indebtedness or other obligation of another and any other arrangement whereby credit is extended to another obligor on the basis of any promise of a guarantor, whether that promise is expressed in terms of an obligation to pay the Indebtedness of such obligor, or to purchase or lease assets under circumstances that would enable such obligor to discharge one or more of its obligations, or to maintain the capital, the working capital, solvency or general financial condition of such obligor, whether or not such arrangement is listed in the balance sheet of the guarantor or referred to in a footnote thereto. "Hazardous Substance" has the meaning assigned to that term in Section 5.23(b). "Holder" means the Purchaser and any subsequent direct or indirect transferee of the Note or Warrants or shares of Common Stock issuable upon exercise of the Warrants, other than a transferee who has acquired Warrants or shares of Common Stock issuable upon exercise of Warrants that have been (a) the subject of a distribution pursuant to a registered public offering or (b) transferred to a transferee who has acquired such securities after such securities have been the subject of a distribution to the public pursuant to Rule 144 under the Securities Act or otherwise distributed under circumstances not requiring a legend. "HUD" has the meaning assigned to that term in Section 10.1(b). "HUD Financings" means any type of financing to or for the Company or any Subsidiary from HUD. "Indebtedness" means, with respect to any Person, without duplication, (a) all indebtedness of such Person for borrowed money or for the deferred purchase price of property, but excluding obligations to trade creditors incurred in the ordinary course of business that are unsecured and not overdue by more than six months unless being contested in good faith, (b) all reimbursement and other obligations with respect to letters of credit, bankers' acceptances and surety bonds, whether or not matured, (c) all obligations evidenced by notes, bonds, debentures or similar instruments, (d) all indebtedness created or arising under any conditional sale or other title retention agreement with respect to property acquired by such Person (even though the rights and remedies of the seller or lender under such agreement in the event of default are limited to repossession or sale of such property), (e) all Capitalized Lease Obligations and the present value (discounted at the Index Rate as in effect on the Closing Date) of future rental payments under all synthetic leases, (f) all obligations of such Person under commodity purchase or option agreements or other commodity price hedging 7 arrangements, in each case whether contingent or matured, measured on a mark-to-market basis, (g) all obligations of such Person under any foreign exchange contract, currency swap agreement, interest rate swap, cap or collar agreement or other similar agreement or arrangement designed to alter the risks of that Person arising from fluctuations in currency values or interest rates, in each case whether contingent or matured, measured on a mark-to-market basis, (h) all Indebtedness referred to above secured by (or for which the holder of such Indebtedness has an existing right, contingent or otherwise, to be secured by) any Lien upon or in property or other assets (including accounts and contract rights) owned by such Person, even though such Person has not assumed or become liable for the payment of such Indebtedness and (i) with respect to the Company, the Obligations. The amount of Indebtedness of the Note shall be deemed to be an amount equal to the stated or determinable amount of such Indebtedness. "indemnified party" has the meaning assigned to that term in Section 7.1. "Initial Closing" has the meaning assigned to that term in Section 2.4. "Initial Closing Date" has the meaning assigned to that term in Section 2.4. "Initial Purchase Price" has the meaning assigned to that term in Section 2.1. "Initial Warrants" has the meaning assigned to that term in Section 2.1. "Intellectual Property" shall mean all of the following as they exist in all jurisdictions throughout the world, in each case, to the extent owned by, licensed to, or otherwise used by the Company and the Subsidiaries: (i) patents, patent applications, and other patent rights (including any divisions, continuations, continuations-in-part, substitutions, or reissues thereof, whether or not patents are issued on any such applications and whether or not any such applications are modified, withdrawn, or resubmitted); (ii) trademarks, service marks, trade dress, trade names, brand names, Internet domain names, designs, logos, or corporate names, whether registered or unregistered, and all registrations and applications for registration thereof; (iii) copyrights, including all renewals and extensions thereof, copyright registrations and applications for registration thereof, and non-registered copyrights; (iv) trade secrets, concepts, ideas, designs, research, processes, procedures, techniques, methods, know-how, data, mask works, discoveries, inventions, modifications, extensions, improvements, and other proprietary rights (whether or not patentable or subject to copyright, mask work, or trade secret protection); and 8 (v) computer software programs, including, without limitation, all source code, object code, and documentation related thereto. "Interest Coverage Ratio" shall mean, at any date of determination, for the Company and each Subsidiary individually and on a consolidated and consolidating basis, without duplication, the ratio of (a) EBITDA for the Monthly Test Period most recently ended before such date (taken as one accounting period), to (b) Interest Expense for the Monthly Test Period most recently ended before such date (taken as one accounting period). "Interest Expense" shall mean, for any Test Period, total interest expense (including attributable to Capitalized Leases in accordance with GAAP) of the Company and each Subsidiary, individually and collectively, on a consolidated and consolidating basis with respect to all outstanding Indebtedness, including, without limitation, (i) the Interest Expense on the aggregate outstanding amount of the Term Loan on such date, (ii) the Interest Expense on the aggregate amount of all Advances outstanding under the Revolving Facility on such date, (iii) the Interest Expense on the aggregate amount of all Capitalized Lease Obligations on such date, (iv) the Interest Expense on the aggregate outstanding amount of all Indebtedness to the Purchaser under this Agreement on such date, (v) the Interest Expense on the aggregate outstanding amount of all Seller Notes, excluding all non-cash interest expenses related to such Seller Notes, (vi) the Interest Expense on any other Indebtedness on such date, (vii) the Interest Expense on the aggregate outstanding amount of any HUD Financing and (viii) capitalized interest, but excluding commissions, discounts and other fees owed with respect to letters of credit and bankers' acceptance financing and net costs under Interest Rate Agreements. "Interest Rate Agreements" shall mean any interest rate swap, cap or collar agreement or other similar agreement or arrangement designed to hedge the position with respect to interest rates. "Interim Financials" has the meaning assigned to that term in Section 5.11(a). "Inventory" means all inventory of whatever name, nature, kind or description, all goods held for sale or lease or to be furnished under contracts of service, finished goods, work in process, raw materials, materials used or consumed, parts, supplies, all wrapping, packaging, advertising, labeling, and shipping materials, devices, names and marks, all contracts rights and documents relating to any of the foregoing, whether any of the foregoing be now existing or hereafter arising, wherever located, now owned or hereafter acquired. "Investment" means (i) the ownership or acquisition (whether for cash, property, services, securities or otherwise) of stock, bonds, notes, debentures, partnership or other ownership interests or other securities of any other Person and (ii) the making of any advance, loan, other extension of credit or capital contribution to any Person. 9 "Investor Rights Agreement" means the Second Amended and Restated Investor Rights Agreement, substantially in the form attached hereto as Exhibit D, as the same may be amended, amended and restated, or modified from time to time in accordance with its terms. "Junior Subordination Agreements" means the Subordination Agreements, substantially in the forms attached hereto as Exhibit K, as the same may be amended, amended and restated, or modified from time to time in accordance with their terms. "Leverage Test Period" shall mean a period ending on the last calendar day of each month and including the twelve most recent calendar months then ended (taken as one accounting period), or such other period as specified in this Agreement. "Liability Event" means any event, fact, condition or circumstance or series thereof (a) in or for which the Company or any Subsidiary becomes liable or otherwise responsible for any amount owed or owing to any Medicare or Medicaid program by a provider under common ownership with the Company or such Subsidiary or any provider owned by the Company or such Subsidiary pursuant to any applicable law, ordinance, rule, decree, order or regulation of any Governmental Authority after the failure of any such provider to pay any such amount when owed or owing, (b) in which Medicaid or Medicare payments to the Company or any Subsidiary are lawfully set-off against payments to the Company or any Subsidiary to satisfy any liability of or for any amounts owed or owing to any Medicare or Medicaid program by a provider under common ownership with the Company or such Subsidiary or any provider owned by the Company or such Subsidiary pursuant to any applicable law, ordinance, rule, decree, order or regulation of any Governmental Authority, excluding any cost report liability which has been appropriately recorded in the Company's or such Subsidiary's financial statements in accordance with GAAP and appropriately reserved with respect to any Borrowing Base (as defined in the Credit Agreement) calculation, or (c) any of the foregoing under clauses (a) or (b) in each case pursuant to statutory or regulatory provisions that are similar to any applicable law, ordinance, rule, decree, order or regulation of any Governmental Authority referenced in clauses (a) and (b) above or successor provisions thereto. "Lien" means any mortgage, pledge, hypothecation, assignment, deposit arrangement, encumbrances, lien (statutory or other), charge or other security interest of any preference, priority or other security agreement or preferential arrangement of any kind or nature whatsoever (including, without limitation, any conditional sale or other title retention agreement and any Capitalized Lease having substantially the same economic effect as any of the foregoing). "Losses" has the meaning assigned to that term in Section 7.1. "Medical Waste Laws" has the meaning assigned to that term in Section 5.34(b). 10 "Medicare and Medicaid programs" has the meaning assigned to that term in Section 5.34(a). "Monthly Test Period" shall mean a period ending on the last calendar day of each month and including the three most recent calendar months then ended (taken as one accounting period), or such other period as specified in this Agreement. "Nasdaq" means the National Market System of The Nasdaq Stock Market, Inc. "Net Income" shall mean, for any Test Period, the net income (or loss) of the Company and each Subsidiary, individually and collectively, on a consolidated and consolidating basis for such period taken as a single accounting period determined in conformity with GAAP; provided, that there shall be excluded (i) the income (or loss) of any Person in which any other Person (other than the Company or any Subsidiary) has a joint interest, except to the extent of the amount of dividends or other distributions actually paid to the Company or any Subsidiary by such Person during such period, (ii) the income (or loss) of any Person accrued prior to the date it becomes a borrower under the Notes or a Subsidiary or is merged into or consolidated with the Company or any Subsidiary or that Person's assets are acquired by the Company or any Subsidiary, (iii) the income of the Company or any Subsidiary to the extent that the declaration or payment of dividends or similar distributions of that income by that Subsidiary is not at the time permitted by operation of the terms of the charter or any agreement, instrument, judgment, decree, order, statute, rule or governmental regulation applicable to that Subsidiary, (iv) compensation expense resulting from the issuance of capital stock, stock options or stock appreciation rights issued to former or current employees, including officers, of the Company or any Subsidiary, or the exercise of such options or rights, in each case to the extent the obligation (if any) associated therewith is not expected to be settled by the payment of cash by the Company or any Subsidiary or any affiliate thereof, and (v) compensation expense resulting from the repurchase of capital stock, options and rights described in clause (iv) of this definition of Net Income. "Nonparticipating Holders" has the meaning assigned to that term in Section 13.1(a). "Note" has the meaning assigned to that term in the recitals of this Agreement. "NYSE" means the New York Stock Exchange, Inc. "Obligations" means the obligation of the Company to the Purchaser for the prompt payment when due (whether by scheduled maturity, required prepayment, acceleration, demand or otherwise) and performance of (a) the Note and any premium and all interest and other sums in respect thereof, and (b) all other liabilities, obligations and indebtedness, direct or indirect, matured or unmatured, primary or secondary, absolute or contingent, due or to become due, secured or unsecured of the Company to 11 the Purchaser, now or hereafter owing or incurred, accrued in each case to the date of payment thereof. "Pension Plan" means an employee benefit plan or other plan maintained for the employees of the Company or any Subsidiary as described in Section 4021(a) of ERISA. "Permits" has the meaning assigned to that term in Section 5.34(a). "Person" means an individual, corporation, partnership, joint venture, association, estate, joint stock company, trust, organization, business, or a government or agency or political subdivision thereof. "Plan" has the meaning assigned to that term in Section 5.13(c). "PMR Common Stock" has the meaning assigned to that term in Section 5.13(f) "PMR Companies" has the meaning assigned to that term in Section 5.34(a). "PMR Corporation" means PMR Corporation, a Delaware corporation. "PMR Guarantee" has the meaning assigned to that term in Section 9.12. "PMR Letter Agreement" means the letter agreement, substantially in the form attached hereto as Exhibit J, as the same may be amended, amended and restated or modified from time to time in accordance with its terms. "PMR Merger" means the merger contemplated by the PMR Merger Agreement. "PMR Merger Agreement" means the Agreement and Plan of Merger, dated as of May 6, 2002, by and between PMR Corporation, PMR Acquisition Corporation, a Delaware corporation, and the Company, as amended by Amendment No. 1 to Agreement and Plan of Merger, dated as of June 10, 2002, and as further amended or modified in accordance with its terms. "Prepayment Event" has the meaning assigned to that term in the Note. "Private Programs" has the meaning assigned to that term in Section 5.34(a). "Projections" has the meaning assigned to that term in Section 5.20. "PSI Companies" has the meaning assigned to that term in Section 5.34(a). 12 "Purchaser" has the meaning assigned to that term in the recitals of this Agreement and shall include its successors and assigns. "Put Price" has the meaning assigned to that term in Section 13.1(a). "Put Price Notes" has the meaning assigned to that term in Section 13.1(b). "PWRW&G" has the meaning assigned to that term in Section 2.4. "Redemption Date" has the meaning assigned to that term in Section 13.1(a). "Register" has the meaning assigned to that term in Section 9.17. "Regulated Company" and "Regulated Companies" have the meanings assigned to those terms in Section 5.34(a). "Regulations" has the meaning assigned to that term in Section 5.34(a). "release" has the meaning assigned to that term in Section 5.23(b). "Required Redemption Notice" has the meaning assigned to that term in Section 13.1(a). "Requirements of Law" means, as to any Person, any law, treaty, rule or regulation or determination of an arbitrator or a court or other Governmental Authority, or any guidance or manual of any Governmental Authority, in each case applicable or binding upon such Person or any of its property or to which such Person or any of its property is subject. "Revolving Facility" shall mean a revolving credit facility provided by the lenders under the Credit Agreement pursuant to the Credit Agreement. "Safety and Environmental Laws" means all Requirements of Law relating to pollution, protection of the Environment, protection of worker health and safety, or the emission, discharge, release or threatened release of Hazardous Substances into the Environment or otherwise relating to the manufacture, processing, distribution, use, treatment, storage, disposal, transport or handling of Hazardous Substances including the Comprehensive Environmental Response, Compensation and Liability Act, 42 U.S.C. ss. 9601 et seq., the Resource Conservation and Recovery Act, 42 U.S.C. ss. 6901 et seq., the toxic Substances Control Act, 15 U.S.C. ss. 2601 et seq., the Federal Water Pollution Control Act, 33 U.S.C. ss. 1251 et seq., the Clean Air Act, 42 U.S.C. ss. 7401 et seq., the Federal Insecticide, Fungicide and Rodenticide Act, 7 U.S.C. ss. 121 et seq., the Occupational Safety and Health Act, 29 U.S.C. ss. 651 et seq., the Asbestos Hazard Emergency Response Act, 15 U.S.C. ss. 2601 et seq., the Safe Drinking Water Act, 42 U.S.C. ss. 300f et seq., the Oil Pollution Act of 1990, 33 U.S.C. ss. 2701 et seq., and analogous state acts. 13 "Securities Act" means the Securities Act of 1933, as amended, and the rules and regulations of the Commission promulgated thereunder. "Seller Notes" shall mean the Indebtedness owing to the shareholders of Aeries Healthcare pursuant to the Aeries Purchase Agreement and the Indebtedness under the Junior Subordination Agreements. "Senior Debt Documents" has the meaning assigned to that term in the Subordination Agreement. "Senior Leverage Ratio" shall mean, at any date of determination, for the Company and each Subsidiary, individually and collectively, on a consolidated and consolidating basis, the ratio of (i) the aggregate outstanding amount of (A) the aggregate outstanding amount of the Term Loan on such date, (B) the aggregate amount of all Advances outstanding under the Revolving Facility on such date, (C) the aggregate amount of all Capitalized Lease Obligations on such date, and (D) the aggregate outstanding amount of all HUD Financings to (ii) EBITDA (including overhead without duplication to overhead allocated to the Unit Management Division). "Series A Stock" has the meaning assigned to that term in Section 5.13(a). "Series B Stock" has the meaning assigned to that term in Section 5.13(a). "Solvent" means, as to any Person, that the fair salable value on a going concern basis of the assets and property of such Person is, on the date of determination, greater than the total amount of liabilities (including contingent and unliquidated liabilities) of such Person as of such date and that, as of such date, such Person is able to pay all liabilities of such Person as such liabilities mature. In computing the amount of contingent or unliquidated liabilities at any time, such liabilities will be computed as the amount which, in light of all the facts and circumstances existing at such time, represents the amount that is probable to become an actual or matured liability. "Subordinated Debt" means any Indebtedness of the Company that is expressly subordinated to the Obligations, in form and substance satisfactory to the Purchaser. "Subordination Agreement" means the Subordination and Intercreditor Agreement, substantially in the form attached hereto as Exhibit I, as the same may be amended or modified from time to time in accordance with its terms. "Subsidiaries' Guarantee" means that guaranty agreement, substantially in the form attached hereto as Exhibit G, as the same may be amended or modified from time to time in accordance with its terms. "Subsidiary" means any Person in which more than 50% of all equity, membership, partnership or other ownership interests is owned directly or indirectly by the Company or one or more of the Company's Subsidiaries. 14 "Tax" or "Taxes" means all federal, state, county, local, foreign and other taxes (including, without limitation, income, profits, premium, estimated, excise, sales, use, occupancy, gross receipts, franchise, ad valorem, severance, capital levy, production, transfer, withholding, employment, unemployment compensation, payroll-related and property taxes, import duties and other governmental charges and assessments), whether or not measured in whole or in part by net income, and including deficiencies, interest, additions to tax or interest, and penalties with respect thereto, and including expenses associated with any proposed adjustment relating to any of the foregoing (including advice in connection with contesting such adjustment). "Term Loan" shall mean a term loan facility provided by the lenders under the Credit Agreement pursuant to the Credit Agreement. "Test Period" means, individually and/or collectively, the Monthly Test Period and the Leverage Test Period. "Total Debt" shall mean, at any date of determination, for the Company and the Subsidiaries, individually and collectively, on a consolidated and consolidating basis, the sum of (without duplication) (i) the aggregate outstanding amount of the Term Loan on such date, (ii) the aggregate amount of all Advances outstanding under the Revolving Facility on such date, (iii) the aggregate amount of all Capitalized Lease Obligations on such date, (iv) the aggregate outstanding amount of all Indebtedness to the Purchaser under this Agreement on such date, (v) the aggregate amount of all Indebtedness under the Junior Subordination Agreements, (vi) the aggregate amount of all Indebtedness pursuant to the Seller Notes, (vii) the aggregate outstanding amount of all HUD Financings, and (viii) any other Indebtedness on such date, less (ix) cash held on such date and (ix) Cash Equivalents held on such date. "Total Debt Service" shall mean for any period, for the Company and the Subsidiaries, individually and collectively, on a consolidated and consolidating basis, the sum of (i) scheduled or other required payments of principal on Indebtedness, and (ii) Interest Expense, in each case for such period. "Total Leverage Ratio" shall mean, at any date of determination, for the Company and each Subsidiary, individually and collectively, on a consolidated and consolidating basis, the ratio of (i) Total Debt on such date, to (ii) EBITDA (including overhead without duplication to overhead allocated to the Unit Management Division). "Transaction Documents" means, collectively, this Agreement, the Note, the Warrant Certificates, the Investor Rights Agreement, the Co-Sale Agreement, the Voting Agreement, the Amending Agreement, the Subsidiaries' Guarantee, the PMR Guarantee (if any), the PMR Letter Agreement, the PMR Merger Agreement, the Drawdown Acquisition Documents (if any), the Subordination Agreement, the Junior Subordination Agreements and the Credit Agreement. "Unit Management Division" shall mean the Company's business unit (which operates under Sunstone Behavioral Health, Inc. and Persons in which more than 15 50% of all equity, membership, partnership and other ownership interests is owned directly or indirectly by Sunstone Behavioral Health, Inc.) which provides management services to the psychiatric units of medical/surgical hospitals pursuant to management contracts. "Voting Agreement" means the Second Amended and Restated Voting Agreement, substantially in the form attached hereto as Exhibit F, as the same may be amended, amended and restated or modified from time to time in accordance with its terms. "Warrant Certificate" means the Warrant Certificate representing the Warrants, substantially in the form attached hereto as Exhibit B. "Warrants" has the meaning assigned to that term in the recitals of this Agreement. 1.2 Accounting Terms; Financial Covenants. All accounting terms used herein not expressly defined in this Agreement shall have the respective meanings given to them in accordance with sound accounting practice. The term "sound accounting practice" means such accounting practice as, in the opinion of the independent accountants regularly retained by the Company, conforms at the time to GAAP applied on a consistent basis. If any changes in accounting principles are hereafter occasioned by promulgation of rules, regulations, pronouncements or opinions by or are otherwise required by the Financial Accounting Standards Board or the American Institute of Certified Public Accountants (or successors thereto or agencies with similar functions), and any of such changes results in a change in the method of calculation of, or affects the results of such calculation of, any of the financial covenants, standards or terms found herein, then the parties hereto agree to enter into and diligently pursue negotiations in order to amend such financial covenants, standards or terms so as to reflect fairly and equitably such changes, with the desired result that the criteria for evaluating the Company's financial condition and results of operations shall be the same after such changes as if such changes had not been made. ARTICLE II PURCHASE AND SALE 2.1 Purchase and Sale of Note and Initial Warrants. Upon the terms and subject to the conditions set forth herein, the Company agrees that it will issue to the Purchaser, and the Purchaser agrees that it will acquire from the Company on the Initial Closing Date, (a) a Note in the aggregate principal amount of up to $20,000,000 with $10,000,000 advanced thereunder, with such Note being substantially in the form attached hereto as Exhibit A, appropriately completed in conformity herewith and (b) a Warrant Certificate representing Warrants to purchase initially 1,502,140 shares of Common Stock (subject to adjustment as set forth in the Warrant Certificate) (the "Initial Warrants"), all for an aggregate purchase price of $10,000,000 (the "Initial Purchase Price") in cash, by wire transfer of immediately available funds to an account designated 16 by the Company in a written notice delivered to the Purchaser not later than two Business Days prior to the Initial Closing Date. 2.2 Additional Loans. Upon the terms and subject to the conditions set forth herein, the Company has the option of requiring the Purchaser, from time to time on or before December 29, 2003, to advance additional loans to the Company pursuant to the Note (each, an "Additional Loan" and, collectively, the "Additional Loans") to be used to pay the purchase price of any Drawdown Acquisition; provided, that, in no event shall the Purchaser have any obligation to advance more than an aggregate principal amount of $20,000,000 under the Note and this Agreement. The Company shall give the Purchaser written notice of its election to borrow Additional Loans under the Note on a date specified in such notice (which date shall be a Business Day occurring at least 15 Business Days after the date of such notice and prior to December 29, 2003, and such notice shall specify the amount of the Additional Loans to be made under the Note (which must be at least $5,000,000 and, if greater, in $1,000,000 multiples thereof). 2.3 Fees. The Company hereby agrees that it will pay to the Purchaser at the Initial Closing a facility fee equal to $400,000. The Purchaser shall deduct such amount from the Initial Purchase Price for the payment of such facility fee. 2.4 Initial Closing. The closing (the "Initial Closing") of the purchase and sale of the Note and the Initial Warrants shall take place at the offices of Paul, Weiss, Rifkind, Wharton & Garrison ("PWRW&G"), 1285 Avenue of the Americas, New York, New York 10019-6064, at 10:00 a.m., New York City time, on the date hereof or on such other date and at such other time as the Purchaser and the Company may mutually agree (the "Initial Closing Date"). At the Initial Closing, upon the terms and subject to the conditions set forth herein, the Company shall sell the Note and the Initial Warrants to the Purchaser by delivering to the Purchaser the Note and the Warrant Certificate representing the Initial Warrants, registered in the name of the Purchaser, with appropriate issue stamps, if any, affixed at the expense of the Company, free and clear of any Lien, and the Purchaser shall purchase the Note and the Initial Warrants for the Initial Purchase Price. 2.5 Additional Closings. (a) The closing (each, an "Additional Closing") of each Additional Loan and the purchase of Additional Warrants shall occur on the date and at the location and time specified in the written notice delivered by the Company to the Purchaser pursuant to the last sentence of Section 2.2 (each, an "Additional Closing Date"). At each Additional Closing, upon the terms and subject to the conditions set forth herein, the Company shall borrow the Additional Loans on such date pursuant to the Note and issue to the Purchaser a Warrant Certificate representing Warrants to purchase 150,214 shares of Common Stock (subject to adjustment as set forth in the Warrant Certificate) for each $1,000,000 of Additional Loans being advanced by the Purchaser on such date (each, an "Additional Warrant" and, collectively, the "Additional Warrants"), registered in the name of the Purchaser, with appropriate issue stamps, if any, affixed at the expense of the Company, free and clear of any Lien, and the Purchaser shall deliver an amount equal to 17 the Additional Loans advanced by the Purchaser on such date (the "Additional Purchase Price"). (b) The obligation of the Purchaser at each Additional Closing to make Additional Loans and purchase Additional Warrants, to pay the Additional Purchase Price and to perform any of its obligations hereunder shall be subject to the satisfaction or waiver of the following conditions on or before such Additional Closing Date: (i) A Drawdown Acquisition (meeting all the requirements of such set forth in the definition of such term in Section 1.1) is simultaneously being consummated on such Additional Closing Date; (ii) The proceeds of the Additional Loans to be advanced on such Additional Closing Date shall be used to pay part or all of the purchase price of such Drawdown Acquisition; (iii) The representations and warranties of the seller or sellers in the Drawdown Acquisition Documents (relating to such Drawdown Acquisition) shall be true and correct in all respects at and as of such Additional Closing Date as if made as of such Additional Closing Date (unless such representations and warranties relate to matters only as of a particular date, in which case such representations and warranties shall be true and correct in all respects as of such date); (iv) The Company and each other Person shall have performed and complied with all of its agreements and conditions set forth or contemplated in such Drawdown Acquisition Documents that are required to be performed or complied with by it on or before the closing of the transactions contemplated by such Drawdown Acquisition Documents; (v) The Purchaser shall have received true, complete and correct copies of such Drawdown Acquisition Documents and any other documents it may reasonably request in connection with the transactions contemplated by such Drawdown Acquisition Documents; (vi) The transactions contemplated by such Drawdown Acquisition Documents are simultaneously being consummated in accordance with the terms of such Drawdown Acquisition Documents, and all conditions to the Company's obligations to consummate the transactions contemplated by such Drawdown Acquisition Documents shall have been satisfied or waived with the prior consent of the Purchaser; (vii) Any Person acquired by the Company in connection with such Drawdown Acquisition shall execute and deliver to the Purchaser the Subsidiaries' Guarantee; (viii) The representations and warranties of (A) each Subsidiary in the Subsidiaries' Guarantee and (B) PMR Corporation in the PMR Guarantee (if any), shall be true and correct in all respects at and as of such Additional Closing Date as if made as of such Additional Closing Date and after giving effect to the 18 transactions contemplated by Section 2.2 and such Drawdown Acquisition Documents (unless such representations and warranties relate to matters only as of a particular date, in which case such representations and warranties shall be true and correct in all respects as of such date); and (ix) The terms and conditions of such Drawdown Acquisition are acceptable to the Purchaser. (c) In addition to the conditions to each Additional Closing set forth in Section 2.5(b), on each Additional Closing Date, (i) the Purchaser shall deliver to the Company a certificate signed by a General Partner of the Purchaser stating that the representations and warranties of the Purchaser contained in Article VI are true and correct in all respects at and as of such Additional Closing Date as if made as of such Additional Closing Date (unless such representations and warranties relate to matters only as of a particular date, in which case such representations and warranties shall be true and correct in all respects as of such date) and (ii) the Chairman, President, Chief Financial Officer, Chief Development Officer or Controller of the Company shall deliver to the Purchaser a certificate stating that (A) the representations and warranties of the Company contained in Article V are true and correct in all respects at and as of such Additional Closing Date as if made as of such Additional Closing Date and after giving effect to the transactions contemplated by Section 2.2 and the applicable Drawdown Acquisition Documents (unless such representations and warranties relate to matters only as of a particular date in which case such representations and warranties shall be true and correct in all respects as of such date) and (B) the Company is, and after giving effect to the transactions contemplated by Section 2.2 and the applicable Drawdown Acquisition Documents will be, in compliance in all respects with its obligations in Articles VIII, IX and X (such financial covenants to be calculated on a pro forma basis in a manner to be agreed upon by the Company and the Purchaser); provided, that, (x) the reference in Section 5.11 to "the audited consolidated financial statements of the Company and the Subsidiaries for the fiscal year ended December 31, 2001" shall instead be to "the audited consolidated financial statements of the Company and the Subsidiaries for the most recently completed fiscal year," (y) the reference in Section 5.11 to "the unaudited consolidated balance sheet of the Company and the Subsidiaries as of March 31, 2002 and the related consolidated statements of operations and accumulated deficit and cash flows, together with the notes thereto, for the three-month period then ended" shall instead be to "the unaudited consolidated financial statements of the Company and the Subsidiaries for each completed fiscal quarter ending March 31, June 30 and September 30 since the most recently completed fiscal year," and (z) the Company shall deliver a supplemental schedule to the Purchaser updating the capitalization and material contracts representations and warranties contained in Sections 5.13 and 5.29, respectively; provided, further, that the Company shall also satisfy and certify that the conditions contained in Sections 3.6, 3.7, 3.9, 3.10, 3.17, 3.18 and 3.20 shall be satisfied as of the Additional Closing Date and after giving effect to the transactions contemplated by Section 2.2 and the applicable Drawdown Acquisition Documents, and the Company shall reimburse the Purchaser on such Additional Closing Date for all fees and expenses set forth in Section 15.17(c)(i). 19 ARTICLE III CONDITIONS TO THE OBLIGATION OF THE PURCHASER TO CLOSE The obligation of the Purchaser to purchase the Note and the Initial Warrants, to pay the Initial Purchase Price and to perform any of its obligations hereunder shall be subject to the satisfaction or waiver of the following conditions on or before the Initial Closing Date: 3.1 Representations and Warranties True. The representations and warranties of the Company contained in Article V hereof shall be true and correct in all respects (a) at and as of the Closing Date as if made as of the Closing Date and (b) after giving effect to the transactions contemplated by the Transaction Documents (unless, in either case, such representations and warranties relate to matters only as of a particular date, in which case such representations and warranties shall be true and correct in all respects as of such date). 3.2 Compliance with this Agreement. The Company shall have performed and complied with all of its agreements and conditions set forth or contemplated herein that are required to be performed or complied with by it on or before the Closing Date. 3.3 Officers' Certificate. The Purchaser shall have received a certificate, dated the Closing Date and signed by the Chairman, President, Chief Financial Officer, Chief Development Officer or Controller of the Company, certifying that the conditions set forth in Sections 3.1 and 3.2 hereof have been satisfied on and as of such date. 3.4 Secretary's Certificates. The Purchaser shall have received a certificate, dated the Closing Date and (a) signed by the Secretary or an Assistant Secretary of the Company, attaching a good standing certificate from the Secretary of State of the State of Delaware with respect to the Company and certifying the truth and correctness of attached copies of the Certificate of Incorporation and By-laws of the Company and resolutions of the Board of Directors of the Company approving this Agreement, the other Transaction Documents and the transactions contemplated hereby and thereby and (b) signed by the Secretary or an Assistant Secretary of each Subsidiary, attaching a good standing certificate from the Secretary of State of the jurisdiction of organization of such Subsidiary with respect to such Subsidiary and certifying the truth and correctness of attached copies of the organizational or governing documents of such Subsidiary and resolutions of the Board of Directors of such Subsidiary approving the Subsidiaries' Guarantee and the transactions contemplated thereby. 3.5 Documents. The Purchaser or its counsel shall have received copies of such documents as it reasonably may request in connection with the sale of the Note and the Warrants and the transactions contemplated hereby, all in form and substance reasonably satisfactory to the Purchaser. 20 3.6 Purchase Permitted by Applicable Laws; Legal Investment. The acquisition of and payment for the Note and the Warrants and the consummation of the transactions contemplated by the Transaction Documents (a) shall not be prohibited by any applicable law or governmental regulation, (b) shall not subject the Purchaser to any penalty or, in its reasonable judgment, other onerous condition under or pursuant to any applicable law or governmental regulation and (c) shall be permitted by the laws and regulations of the jurisdictions to which it is subject. 3.7 Opinion of Counsel. The Purchaser shall have received the opinion of Harwell Howard Hyne Gabbert & Manner, P.C., counsel to the Company, dated the Closing Date, substantially in the form attached hereto as Exhibit C. 3.8 Approval of Counsel to the Purchaser. All actions and proceedings hereunder and all documents required to be delivered by the Company hereunder or in connection with the consummation of the transactions contemplated by the Transaction Documents, and all other related matters, shall have been reasonably acceptable to PWRW&G, counsel to the Purchaser, as to their form and substance. 3.9 Consents and Approvals. All consents, waivers, exemptions, authorizations, or other actions by, or notices to, or filings with, Governmental Authorities and other Persons (including, without limitation, CapitalSource) necessary or required in connection with the execution, delivery or performance by the Company or enforcement against the Company of this Agreement or any other Transaction Document shall have been obtained and be in full force and effect, and the Purchaser shall have been furnished with satisfactory evidence thereof. 3.10 No Material Adverse Change. Since December 31, 2001, there shall have been no material adverse change, nor shall any such change be threatened, in the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole. 3.11 Investor Rights Agreement. The Company and each other party thereto (other than the Purchaser) shall have duly executed and delivered to the Purchaser the Investor Rights Agreement. 3.12 Co-Sale Agreement. The Company and each other party thereto (other than the Purchaser) shall have duly executed and delivered to the Purchaser the Co-Sale Agreement. 3.13 Voting Agreement. The Company and each other party thereto (other than the Purchaser) shall have duly executed and delivered the Voting Agreement. 3.14 Subsidiaries' Guarantee. Each of the Subsidiaries set forth on Schedule 3.14 shall have duly executed and delivered to the Purchaser the Subsidiaries' Guarantee. 3.15 Subordination Agreement. The Company and CapitalSource shall have duly executed and delivered to the Purchaser the Subordination Agreement. 21 3.16 Market Conditions. At any time after the date hereof and prior to the Initial Closing Date, (a) trading in securities generally on the NYSE shall not have been suspended or limited or minimum or maximum prices shall not have been generally established on such exchange, or additional material governmental restrictions, not in force on the date of this Agreement, shall not have been imposed upon trading in securities generally by such exchange or by order of the Commission or any court or other Governmental Authority, (b) a general banking moratorium shall not have been declared by United States Federal or New York State authorities or (c) any material adverse change in the financial or securities markets in the United States or in political, financial or economic conditions in the United States or any outbreak or material escalation of hostilities or declaration by the United States of a national emergency or war or other calamity or crisis shall not have occurred. 3.17 No Litigation. No action, suit, proceeding, claim or dispute shall have been brought or otherwise arisen at law, in equity, in arbitration or before any Governmental Authority against the Company or any Subsidiary which would, if adversely determined, in the reasonable judgment of the Purchaser, (a) after giving effect to the transactions contemplated hereby, have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole, or (b) have a material adverse effect on the ability of the Company or any Subsidiary to perform its respective obligations under any Transaction Document. 3.18 No Default or Breach. The Company shall not have been in default under or with respect to this Agreement or any other Transaction Document and, after giving effect to the transactions contemplated hereby and thereby, the Company will not be in default under any of the Transaction Documents. Neither the Company nor the Subsidiaries shall be in default and, after giving effect to the transactions contemplated by the Transaction Documents, the Company and the Subsidiaries will not be in default, under or with respect to any of its Contractual Obligations in any respect, which, individually or together with all such defaults, would have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole, or which could materially adversely affect the ability of the Company or any Subsidiary to perform its respective obligations under any Transaction Document. 3.19 Repayment of Promissory Notes. Simultaneously with the Initial Closing, the aggregate principal amount and all accrued interest on the promissory notes listed on Schedule 3.19 and all other amounts due thereunder shall be paid in full, and satisfactory evidence thereof shall have been delivered to the Purchaser. 3.20 Credit Agreement. No Default or Event of Default (each as defined in the Credit Agreement) shall have occurred and be continuing at and as of the Closing Date and after giving effect to the transactions contemplated by the Transaction Documents. 22 3.21 Amendment to Credit Agreement. The parties to the Credit Agreement shall have duly executed and delivered an amendment thereto in respect of, among other things, the issuance of the Note, the Put Price Notes and the Warrants, the payment of interest on the Note and certain other payments in respect of the Note, the Warrants and this Agreement, in form and substance satisfactory to the Purchaser. 3.22 PMR Letter Agreement. The Company and PMR Corporation shall have duly executed and delivered to the Purchaser the PMR Letter Agreement. 3.23 Aeries Healthcare. Aeries Healthcare shall have duly executed and delivered to the Purchaser the Subsidiaries' Guarantee. 3.24 Junior Subordination Agreements. The Company, CapitalSource and each of the Persons listed on Schedule 3.24 shall have duly executed and delivered to the Purchaser the Junior Subordination Agreements. 3.25 Amending Agreement. The Company, PMR Corporation and each other party to those certain Voting Agreements, dated on or about April 30, 2002, by and between PMR Corporation, the Company and the other parties thereto shall have duly executed and delivered to the Purchaser the Amending Agreement. 3.26 PMR Consent. PMR Corporation shall have duly executed and delivered a consent to any actions taken by the Company or any Subsidiary prior to the consummation of the PMR Merger necessitating or requiring the consent of PMR Corporation under the PMR Merger Agreement, and such consent shall be in full force and effect, and the Purchaser shall have been furnished with satisfactory evidence thereof. 3.27 Amendment to By-laws. The Company shall have amended its By-laws to remove the right of first refusal or any other similar restrictions on the ability of the Purchaser to transfer securities of the Company, and the Purchaser shall have been furnished with satisfactory evidence thereof. 3.28 Waiver of Rights. All anti-dilution, preemptive and first offer rights and other similar rights, if any, to which any Person is entitled in connection with the transactions contemplated by the Transaction Documents, including, without limitation, the issuance of the Note and Warrants (including, without limitation, any adjustment in the number of shares of Common Stock issued or issuable upon exercise thereof), shall be waived in writing, and the terms of the Series A Stock and Series B Stock shall be amended to delete the rights of any holders thereof to receive upon the events described in Section 3 of the Company's Certificate of Incorporation, as amended, any amounts in excess of the liquidation preference plus all declared and unpaid dividends on the Series A Stock or Series B Stock, and satisfactory evidence of the foregoing shall have been delivered to the Purchaser. 3.29 Fees and Expenses. The Company shall have paid to the Purchaser the fees provided for in Section 2.3 and the expenses provided for in Section 15.17. 23 ARTICLE IV CONDITIONS TO THE OBLIGATION OF THE COMPANY TO CLOSE The obligation of the Company to issue and sell the Note and the Initial Warrants and to perform any of its other obligations hereunder shall be subject to the satisfaction or waiver of the following conditions on or before the Closing Date: 4.1 Representations and Warranties True. The representations and warranties of the Purchaser contained in Article VI hereof shall be true and correct in all material respects at and as of the Closing Date as if made as of the Closing Date (unless such representations and warranties relate to matters only as of a particular date, in which case such representations and warranties shall be true and correct as of such date). 4.2 Compliance with this Agreement. The Purchaser shall have performed and complied with all of its agreements and conditions set forth or contemplated herein that are required to be performed or complied with by the Purchaser on or before the Closing Date. 4.3 Consents and Approvals. All consents, waivers, exemptions, authorizations or other actions by, or notices to, or filings with, Governmental Authorities and other Persons necessary or required in connection with the execution, delivery or performance by the Purchaser or enforcement against the Purchaser of this Agreement shall have been obtained and be in full force and effect, and the Company shall have been furnished with satisfactory evidence thereof. ARTICLE V REPRESENTATIONS AND WARRANTIES OF THE COMPANY The Company hereby represents and warrants to the Purchaser as follows: 5.1 Corporate Existence and Power. The Company and each of the Subsidiaries: (a) is, and after giving effect to the transactions contemplated by the Transaction Documents will be, duly organized, validly existing and in good standing under the laws of the jurisdiction of its organization; (b) has, and after giving effect to the transactions contemplated by the Transactions Documents will have, (i) full corporate power and authority and (ii) all governmental licenses, authorizations, consents and approvals to own and operate its property, to lease the property it operates as lessee and to conduct the business in which it is currently, or is currently proposed to be, engaged; 24 (c) is, and after giving effect to the transactions contemplated by the Transactions Documents will be, duly qualified as a foreign corporation, licensed and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification; and (d) is, and after giving effect to the transactions contemplated by the Transactions Documents will be, in compliance with (i) its organizational or governing documents and (ii) all Requirements of Law; except, in the case of (b)(ii), (c) or (d)(ii) of this Section 5.1, to the extent that the failure to do so would not have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole. 5.2 Corporate Authorization; No Contravention. The execution, delivery and performance by the Company of this Agreement and each other Transaction Document to which it is a party, and the transactions contemplated hereby and thereby, including, without limitation, the issuance of the Note and the Warrants: (a) is within the Company's corporate power and authority and has been duly authorized by all necessary corporate action; (b) does not, and will not after giving effect to the transactions contemplated by the Transaction Documents, contravene the terms of the certificate of incorporation, by-laws or organizational or governing documents or any amendment thereof of the Company or any Subsidiary; and (c) does not, and will not after giving effect to the transactions contemplated by the Transactions Documents, violate, conflict with or result in any breach of, contravention of or the creation of any Lien under, any Contractual Obligation of the Company or any Subsidiary or any order or decree directly relating to the Company or any Subsidiary. 5.3 Governmental Authorization; Third Party Consents. No approval, consent, exemption, authorization, or other action by, or notice to, or filing with, any Governmental Authority or any other Person, is necessary or required in connection with the execution, delivery or performance by the Company or enforcement against the Company of this Agreement or any other Transaction Document to which the Company is a party or the transactions contemplated hereby or thereby. As of the Closing Date, the issuance of the Note, the Put Price Notes and the Warrants, the payment of interest on the Note and all other payments permitted by the Subordination Agreement, will not be prohibited by the terms of the Credit Agreement. 5.4 Binding Effect. This Agreement, the Note, the Warrant Certificates, the Investor Rights Agreement, the Co-Sale Agreement, the Voting Agreement and each other Transaction Document to which the Company is a party have been duly executed and delivered by the Company, and this Agreement and the other Transaction Documents to which the Company is a party constitute, and after giving 25 effect to the transactions contemplated by the Transaction Documents will constitute, the legal, valid and binding obligations of the Company enforceable against the Company in accordance with their respective terms, subject to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and other laws of general applicability relating to or affecting creditors' rights and to general equity principles. 5.5 No Legal Bar. The execution, delivery and performance by the Company of this Agreement and the other Transaction Documents to which the Company is a party will not violate any Requirements of Law. 5.6 Litigation. Except as set forth on Schedule 5.6, there are no, and after giving effect to the transactions contemplated by the Transaction Documents there will not be any, actions, suits, proceedings, claims or disputes pending, or to the knowledge of the Company, threatened, at law, in equity, in arbitration or before any Governmental Authority against the Company or any Subsidiary (or any of their respective officers or directors), that if determined adversely, would be reasonably expected to have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole, or could have a material adverse effect on the ability of the Company or any Subsidiary to perform its respective obligations under any Transaction Document to which it is a party. No injunction, writ, temporary restraining order, decree or any order of any nature has been issued by any court or other Governmental Authority purporting to enjoin or restrain the execution, delivery and performance by the Company of this Agreement or any other Transaction Document. 5.7 No Default or Breach. No event has occurred and is continuing or would result from the incurring of obligations by the Company under this Agreement or any other Transaction Document to which it is a party which constitutes a Default or Event of Default under or breach of any of the provisions hereof or of the Note or the Warrant Certificates, and no such event will occur or will be continuing after giving effect to the transactions contemplated by the Transaction Documents. Neither the Company nor any Subsidiary is, and after giving effect to the transactions contemplated by the Transaction Documents will not be, in default under or with respect to any Contractual Obligation in any material respect. 5.8 Title to Properties. The Company and each of the Subsidiaries has, and after giving effect to the transactions contemplated by the Transaction Documents will have, good record and marketable title to, or hold leases in full force and effect in all their real property, except for Liens in favor of CapitalSource in connection with the Credit Agreement and such defects in title as could not reasonably, individually or in the aggregate, have a materially adverse effect on the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole, or the ability of the Company or any Subsidiary to perform its respective obligations under any Transaction Document to which it is a party. 5.9 Investment Company. Neither the Company nor any Person controlling the Company is, and no such Person after giving effect to the transactions 26 contemplated by the Transaction Documents will be, an "investment company" within the meaning of the Investment Company Act of 1940, as amended. 5.10 Subsidiaries. The Company has no Subsidiaries except for those listed on Schedule 5.10. All of the issued and outstanding capital stock of each Subsidiary listed (or required to be listed) on Schedule 5.10 is owned of record and beneficially as set forth in Schedule 5.10, free and clear of any Liens, except for Liens in favor of CapitalSource in connection with the Credit Agreement. There are no outstanding options, warrants, subscriptions, calls, rights, convertible securities or other agreements or commitments obligating any Subsidiary to issue, transfer or sell any of its securities. 5.11 Financial Condition; No Undisclosed Liabilities. (a) The Company heretofore has delivered to the Purchaser true and correct copies of (i) the audited consolidated financial statements of the Company and the Subsidiaries for the fiscal year ended December 31, 2001 (the "Financials") and (ii) the unaudited consolidated balance sheet of the Company and the Subsidiaries as of March 31, 2002 and the related consolidated statements of operations and accumulated deficit and cash flows, together with notes thereto, for the three-month period then ended (the "Interim Financials"), certified by the President, Chief Financial Officer, Chief Development Officer or Controller of the Company. The Financials and the Interim Financials have been prepared in accordance with GAAP applied consistently throughout the periods covered thereby, present fairly the consolidated financial condition of the Company and the Subsidiaries as of the dates thereof and the consolidated results of operations and cash flows of the Company and the Subsidiaries for the periods then ended, and are true, correct and complete as of the date thereof. (b) The pro forma consolidated balance sheet of the Company and the Subsidiaries attached hereto as Schedule 5.11(b) fairly presents in all material respects the assets and liabilities of the Company and the Subsidiaries on a pro forma basis as of May 31, 2002, after taking into account the consummation of the transactions contemplated by the Transaction Documents, including, without limitation the issuance of the Note, the repayment of the promissory notes listed on Schedule 3.19 and the payment of all material fees and expenses in connection with the Transaction Documents, subject to ordinary course audit adjustments. (c) The Company and the Subsidiaries do not have, and after giving effect to the transactions contemplated by the Transaction Documents will not have, any direct or indirect Indebtedness, liability (including, without limitation, product liability or warranty claim), obligation, fixed or unfixed, contingent or otherwise, other than (i) as fully and adequately reflected on the Financials or the Interim Financials, (ii) those incurred since December 31, 2001 in the ordinary course of business or pursuant to the Credit Agreement, (iii) those incurred pursuant to this Agreement and (iv) other liabilities incurred in the ordinary course of business which, individually or in the aggregate, are not material to the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole. 27 5.12 No Material Adverse Change. Since December 31, 2001, there has not been, and after giving effect to the transactions contemplated by the Transaction Documents there will not be, any material adverse change, nor to the knowledge of the Company, is any such change threatened, in the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole. 5.13 Capitalization. (a) As of the Closing Date, after giving effect to the transactions contemplated by the Transaction Documents (other than the PMR Merger): (i) the authorized capital of the Company will consist of 35,000,000 shares of Common Stock, 10,500,000 shares of Series A preferred stock, par value $0.01 per share (the "Series A Stock"), and 8,000,000 shares of Series B preferred stock, par value $0.01 per share (the "Series B Stock"); (ii) 7,327,627 shares of Common Stock will be issued and outstanding, 10,497,000 shares of Series A Stock will be issued and outstanding and 4,975,736 shares of Series B Stock will be issued and outstanding, all of which will be owned of record by the Persons listed on Schedule 5.13(a) in the amounts listed next to the name of each such Person; and (iii) except as listed on Schedule 5.13(a), no shares of Common Stock will be held in the Company's treasury. (b) Except for the Series A Stock, the Series B Stock, the warrants listed on Schedule 5.13(b), the convertible notes listed on Schedule 5.13(b), the Warrants and the options issued under the Plan listed on Schedule 5.13(b), or as otherwise set forth on Schedule 5.13(b), there are no outstanding options, warrants, conversion privileges, subscription or purchase rights or other rights to purchase or otherwise acquire shares of Capital Stock or other securities of the Company, and the Company is not obligated in any manner to issue shares of Capital Stock or other securities. Except as contemplated hereby or by the Investor Rights Agreement, or pursuant to relevant state and federal securities laws, there are no restrictions on the Company's ability to transfer shares of Capital Stock. (c) Except for (i) 10,497,000 shares of Common Stock issuable upon conversion of the Series A Stock, (ii) 4,975,736 shares of Common Stock issuable upon conversion of the Series B Stock, (iii) 1,341,028 shares of Series B Stock issuable upon exercise of warrants listed on Schedule 5.13(b) and the 1,341,028 shares of Common Stock issuable upon conversion of such shares of Series B Stock, (iv) 1,348,315 shares of Series B Stock issuable upon conversion of the convertible notes listed on Schedule 5.13(b) and the 1,348,315 shares of Common Stock issuable upon conversion of such shares of Series B Stock, (v) 1,502,140 shares of Common Stock issuable upon exercise of the Initial Warrants, and (vi) 3,373,313 shares of Common Stock reserved for issuance under the Company's 1997 Incentive and Nonqualified Stock Option Plan for Key Personnel (the "Plan"), there are no shares of Capital Stock of the Company reserved for issuance. The shares of Capital Stock of the Company to be issued upon exercise or conversion of any of the foregoing (including, without limitation, all shares of Common Stock to be issued upon exercise of the Warrants) have been duly authorized (or, with respect to the shares of Common Stock to be issued upon exercise of the Warrants, will, 28 at the Closing, be authorized) and, when issued and paid for in accordance with the provisions of the applicable governing documents, will be validly issued, fully paid and non-assessable, will be free and clear of any Liens, will not be subject to any preemptive or similar rights that have not been waived and will be issued in compliance with the registration and qualification requirements of all applicable securities laws. (d) The Note and the Warrants are duly authorized, and when issued and sold to the Purchaser after the payment therefor, will be validly issued, free and clear of any Liens, not subject to any preemptive or similar rights that have not been waived, and will be issued in compliance with the qualification and registration requirements of all applicable securities laws. All shares of Capital Stock of the Company have been duly authorized and all of the issued and outstanding shares of Capital Stock of the Company are validly issued, fully paid and non-assessable, are free and clear of any Liens, are not subject to any preemptive or similar rights that have not been waived and have been issued in compliance with the registration and qualification requirements of all applicable securities laws. (e) Assuming all Warrants that may be issued to the Purchaser hereunder are issued on the Initial Closing Date, the Warrants may be exercisable initially into not less than 10.0% of the outstanding shares of Common Stock on a fully diluted basis as of the Initial Closing Date and after giving effect to the transactions contemplated by the Transaction Documents (other than the PMR Merger) and assuming, for purposes of this calculation, (i) the exercise of all options under the Plan, (ii) the grant and exercise of options to purchase up to 550,000 shares of Common Stock to be granted to existing senior management of the Company, and (iii) the conversion, exercise or exchange of all outstanding securities and securities that have been approved for issuance into shares of Common Stock, including, without limitation, the Series A Stock, the Series B Stock, the warrants listed on Schedule 5.13(b), the convertible notes listed on Schedule 5.13(b) and the Warrants. (f) Assuming all Warrants that may be issued to the Purchaser hereunder are issued on or prior to consummation of the PMR Merger, the Warrants may be exercisable initially into not less than 8.0% of the outstanding shares, par value $0.01 per share, of common stock of PMR Corporation (the "PMR Common Stock") on a fully diluted basis as of the consummation of the PMR Merger and after giving effect to the transactions contemplated by the Transaction Documents (including, without limitation, the PMR Merger) and assuming, without duplication, for purposes of this calculation, (i) the exercise, immediately prior to the consummation of the PMR Merger, of all options under the Plan, (ii) the grant and exercise, immediately prior to the consummation of the PMR Merger, of the options to be granted to existing senior management of the Company to purchase up to 550,000 shares of Common Stock, (iii) the exercise of all options granted under PMR Corporation's 1997 Equity Incentive Plan and PMR Corporation's Outside Directors' Non-Qualified Stock Option Plan of 1992 as of the consummation of the PMR Merger (but excluding 979,788 options (such number being determined without giving effect to the reverse stock split contemplated to be undertaken by PMR Corporation prior to the PMR Merger), all of which have an exercise price per share of PMR Common Stock in excess of $4.00 (such number being determined without 29 giving effect to the reverse stock split contemplated to be undertaken by PMR Corporation prior to the PMR Merger)) and (iv) the conversion, exercise or exchange of all outstanding securities and securities that have been approved for issuance into shares of PMR Common Stock as of the consummation of the PMR Merger, including, without limitation, the Warrants. 5.14 Solvency. After giving effect to the transactions contemplated by the Transaction Documents, the Company will be Solvent. 5.15 Private Offering. No form of general solicitation or general advertising was used by the Company or, to the knowledge of the Company, any of the Company's representatives in connection with the offer or sale of the Note or the Warrants. Subject to the accuracy of the representations of the Purchaser set forth in Article VI below, no registration of the Note or the Warrants pursuant to the provisions of the Securities Act or any state securities or "blue sky" laws will be required by the offer, sale or issuance of any such securities pursuant to the transactions contemplated by the Transaction Documents. The Company agrees that neither the Company, nor anyone acting on the Company's behalf, will offer or sell the Note, the Warrants or any other security so as to require the registration of the Note or the Warrants or any other security pursuant to the provisions of the Securities Act or any state securities or "blue sky" laws, unless such securities are so registered. 5.16 Broker's, Finder's or Similar Fees. Except as disclosed on Schedule 5.16 and for the facility fee payable to the Purchaser pursuant to Section 2.3, there are no brokerage commissions, finder's fees or similar fees or commissions payable in connection with the offer or sale of the Note or the Warrants based on any agreement, arrangement or understanding with the Company or any action taken by the Company. 5.17 Full Disclosure. No statement by the Company contained in any Transaction Document or any other document, certificate, notice or consent related to any of the foregoing delivered to the Purchaser in connection with the purchase and sale of the Note and the Warrants at or prior to the Closing contains or will contain an untrue statement of a material fact or omits or will omit to state a material fact required to be stated therein or necessary to make the statements made, in light of the circumstances in which made, not materially false or misleading. 5.18 Anti-Dilution Protection; Preemptive Rights. Except as set forth on Schedule 5.18, no Person has any rights to purchase or receive additional shares of Capital Stock or other securities of the Company as a result of or relating to the transactions contemplated by this Agreement, the Note, the Warrant Certificates (including, without limitation, as a result of or relating to any adjustment in the number of shares of Common Stock issued or issuable upon exercise of any Warrants) or the other Transaction Documents. Except for the Investor Rights Agreement, the Co-Sale Agreement and the Voting Agreement, as of the Closing Date, the Company is not a party to or bound by, and no holder of any Capital Stock of the Company is a party to or bound by, any agreement relating to shareholder actions or the voting or transfer of Capital Stock of the Company, and except for the Purchaser and as set forth on 30 Schedule 5.18, no Person is entitled to participate in any anti-dilution rights or preemptive rights with respect to the Capital Stock of the Company. 5.19 Investor Rights Agreements. As of the Closing Date, the Company will not be a party to or bound by any agreement, other than the Investor Rights Agreement, granting any registration rights to any Person or any other rights which conflict with the rights of the Purchaser under the Investor Rights Agreement. 5.20 Projections. Prior to the date hereof, the Company delivered to the Purchaser financial projections attached as Schedule 5.20 (the "Projections"). The assumptions used in preparation of the Projections were reasonable when made and continue to be reasonable as of the Closing Date. The Projections have been prepared in good faith and the Projections give effect to the transactions contemplated by the Transaction Documents. The Purchaser acknowledges that the Projections contain assumptions about future events and that actual results during the period or periods covered may differ materially from the data and results contained in such Projections. 5.21 Labor Relations. Neither the Company nor any Subsidiary is engaged in any unfair labor practice. There is (a) no unfair labor practice complaint pending or, to the knowledge of the Company, threatened against the Company or any Subsidiary before the National Labor Relations Board, and no grievance or arbitration proceeding arising out of or under any collective bargaining agreement is so pending or, to the knowledge of the Company, threatened, (b) no strike, labor dispute, slowdown or stoppage pending or, to the knowledge of the Company, threatened against the Company or any Subsidiary, and (c) no union representation question existing with respect to the employees of the Company or any Subsidiary and, to the knowledge of the Company, no union organizing activities are taking place. 5.22 ERISA and Employee Benefit Plans. (a) There are no employee benefit plans, as defined in Section 3(2) of ERISA, maintained by the Company or any Subsidiary, or with respect to which the Company or any Subsidiary has or could have any direct or indirect material liability, other than those described in Schedule 5.22 ("Benefit Plans"). (b) Accurate and complete copies of all Benefit Plan text and agreements, the most recent annual report, the most recent annual and periodic accounting of Benefit Plan assets, and the most recent actuarial valuation with respect to each Benefit Plan have been delivered or made available to the Purchaser. (c) No Benefit Plan is subject to Title IV of ERISA or section 412 of the Code. Except as set forth on Schedule 5.22, no Benefit Plan is a "multiple employer plan" within the meaning of the Code or ERISA. With respect to any Benefit Plan that is a "multi-employer plan," as such term is defined in Section 3(37) of ERISA, (i) neither the Company nor any Subsidiary, nor any entity which is treated as a single employer with any of them pursuant to Section 414(b), (c), (m) or (o) of the Code (an "ERISA Affiliate") has, since the date on which the Company or any Subsidiary first began 31 contributing to any multi-employer plan, made or suffered a "complete withdrawal" or a "partial withdrawal," as such terms are respectively defined in Sections 4203 and 4205 of ERISA, (ii) no event has occurred that presents a material risk of a partial withdrawal, (iii) neither the Company, nor any Subsidiary, nor any ERISA Affiliate has any contingent liability under Section 4204 of ERISA, and (iv) there would be no withdrawal liability of the Company, any Subsidiary and any ERISA Affiliates, computed as if a complete withdrawal by each such entity had occurred under each such Benefit Plan on the date hereof if each such entity ceased contributions thereto. (d) With respect to each Benefit Plan: (i) if it is intended to qualify under section 401(a) of 403(a) of the Code, the Company has no knowledge of any circumstance that could be reasonably expected to result in such Benefit Plan's failure to be so qualified; (ii) such Benefit Plan has been maintained and administered at all times in substantial compliance with its terms and applicable laws and regulations; (iii) no event has occurred and there exists no circumstances under which the Company or any Subsidiary could be reasonably expected to incur material liability under ERISA, the Code or otherwise (other than routine claims for benefits) with respect to such Benefit Plan or with respect to any other entity's employee benefit plan; and (iv) all contributions and premiums due with respect to such Benefit Plan have been made on a timely basis. (e) With respect to each "welfare plan" (as defined in ERISA section 3(1)) which is maintained or contributed to by the Company or any Subsidiary or with respect to which the Company or any Subsidiary has or could have any direct or indirect liability as of the Closing Date: (i) no such plan provides medical or death benefits with respect to current or former employees of the Company or any Subsidiary beyond their termination of employment (other than as required to avoid an excise tax under Code section 4980B); and (ii) the Company and each Subsidiary has substantially complied with the requirements of Code section 4980B. (f) The consummation of the transactions contemplated by this Agreement and the other Transaction Documents will not: (i) entitle any individual to severance or termination pay; (ii) accelerate the time of payment or vesting, or increase the amount of compensation due to any individual; or (iii) result in the payment that will be taken into account in determining whether there is an "excess parachute payment" under Code section 280G(b)(1). 5.23 Environmental Matters. Except as set forth in Schedule 5.23: (a) To the knowledge of the Company, none of the Company, any Subsidiary or any operator of any of their respective properties is in violation, or to the knowledge of the Company, is in alleged violation, of any Safety and Environmental Law. (b) None of the Company, any Subsidiary or any operator of any of their respective properties has received written notice from any third party, including, without limitation, any federal, state, county, or local governmental authority, (i) that it has been identified as a potentially responsible party under the Comprehensive 32 Environmental Response, Compensation and Liability Act of 1980 as amended ("CERCLA") or any equivalent state law, with respect to any site or location, (ii) that any hazardous waste, as defined in 42 U.S.C. ss. 6903(5), any hazardous substances, as defined in 42 U.S.C. ss. 9601(14), any pollutant or contaminant, as defined in 42 U.S.C. ss. 9601(33), or any toxic substance, oil or hazardous materials or other chemicals or substances regulated by any Safety and Environmental Laws ("Hazardous Substances") which it has generated, transported or disposed of, has been found at any site at which a federal, state, county, or local agency or other third party has conducted or has ordered the Company, any Subsidiary or another third party or parties (e.g., a committee of potentially responsible parties) to conduct a remedial investigation, removal or other response action pursuant to any Safety and Environmental Law, or (iii) that it is or shall be a named party to any claim, action, cause of action, complaint (contingent or otherwise) or legal or administrative proceeding arising out of any actual or alleged release or threatened release of Hazardous Substances. For purposes of this Section 5.23 and the definition of "Safety and Environmental Laws," "release" means any past or present releasing, spilling, leaking, pumping, pouring, emitting, emptying, discharging, injecting, escaping, disposing or dumping of Hazardous Substances into the environment. (c) (i) To the knowledge of the Company, the Company, each Subsidiary and each operator of any real property owned or operated by the Company and any Subsidiary is in compliance in all material respects with all provisions of the Safety and Environmental Laws relating to the handling, manufacturing, processing, generation, storage or disposal of any Hazardous Substances; (ii) to the knowledge of the Company, no portion of property owned, operated or controlled by the Company or any Subsidiary has been used for the handling, manufacturing, processing, generation, storage or disposal of Hazardous Substances except in accordance with applicable Safety and Environmental Laws; (iii) to the knowledge of the Company, there have been no releases or threatened releases of Hazardous Substances on, upon, into or from any property owned, operated or controlled by the Company or any Subsidiary, which releases could have a material adverse effect on the value of such properties or adjacent properties or the environment; (iv) to the knowledge of the Company, there have been no releases of Hazardous Substances on, upon, from or into any real property in the vicinity of the real properties owned, operated or controlled by the Company or any Subsidiary which, through soil or groundwater contamination, may have come to be located on the properties of the Company or any Subsidiary; and (v) to the knowledge of the Company, there have been no releases of Hazardous Substances on, upon, from or into any real property formerly but no longer owned, operated or controlled by the Company or any Subsidiary. (d) To the knowledge of the Company, none of the properties of the Company or any Subsidiary is subject to any applicable environmental cleanup responsibility law or environmental restrictive transfer law or regulation by virtue of the transactions set forth herein and contemplated hereby. 33 5.24 Taxes. (a) The Company and the Subsidiaries have timely filed (or obtained appropriate extensions for filing) all material returns with respect to Taxes required to be filed through the date hereof in a manner consistent with prior years and applicable laws and regulations and all such Tax returns are true and complete in all material respects. The Company and the Subsidiaries have timely paid all material Taxes that are due through the date thereof, or that are claimed or asserted by any taxing authority to be due through the date hereof, except for those Taxes that are being contested in good faith by appropriate proceedings and with respect to which adequate reserves have been set aside. With respect to any period for which Tax returns have not yet been filed, or for which Taxes are not yet due or owing, the Company and the Subsidiaries have no material liability for Taxes in each case other than Taxes incurred in the ordinary course of business or for which accruals are reflected in the Financial and Interim Financials. (b) No audit or other proceeding by any court, taxing authority, or similar person is pending or, to the knowledge of the Company, threatened with respect to any Taxes due from or with respect to the operations of the Company or any Subsidiary, or any Tax return filed by or with respect to the operations of the Company or any Subsidiary. No assessment of Taxes is proposed in writing against the Company, any Subsidiary or their respective assets. 5.25 Intellectual Property. (a) Schedule 5.25(a) sets forth all United States and foreign patents and patent applications, registered trademarks and service marks and applications therefor, Internet domain name registrations and applications, and registered copyrights and applications therefor owned or licensed by the Company or any Subsidiary, specifying as to each item, as applicable: the nature of the item, including the title; the owner of the item; the jurisdictions in which the item is issued or registered or in which an application for issuance or registration has been filed; and the issuance, registration, or application numbers and dates. (b) The Company and each Subsidiary owns, free and clear of all Liens (other than permitted Liens pursuant to Section 10.2), or has the right to use, pursuant to a valid license or permission, all Intellectual Property that is material to and used in the conduct of the business of the Company and such Subsidiary. (c) Neither the Company nor any Subsidiary has been a party to any claim or action and, to the knowledge of the Company, there is no claim or action threatened, that challenges the validity, enforceability, ownership, or right to use, sell, or license any Intellectual Property. To the knowledge of the Company, no third party is infringing upon any Intellectual Property. (d) All material software used or licensed by the Company or any Subsidiary, other than off-the-shelf software which is commercially available on a retail basis and used solely on the computers of the Company and the Subsidiaries, is described in Schedule 5.25(d). Such software is held by the Company and the Subsidiaries legitimately, and to the knowledge of the Company, (i) is free from any significant 34 software defect, (ii) performs in conformance with its documentation, and (iii) does not contain any bugs or viruses or any code or mechanism that could be used to interfere with the operation of the software. The Company has made available to the Purchaser all documentation requested by the Purchaser relating to the use, maintenance, and operation of such software, all of which, to the knowledge of the Company, is true and accurate. (e) The Company and each Subsidiary has taken all commercially reasonable steps to maintain and protect each item of Intellectual Property owned by them. (f) The Company and the Subsidiaries are not, and after giving effect to the transactions contemplated by the Transaction Documents will not be, in violation of any agreement relating to any Intellectual Property, and the Company and the Subsidiaries will own all right, title, and interest in and to or have a license to use all Intellectual Property on identical terms and conditions as they enjoyed immediately prior to such transactions except to the extent that such violation or lack would not have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole. 5.26 Potential Conflicts of Interest. Except as set forth on Schedule 5.26, no officer, member, manager or Affiliate of the Company or any Subsidiary, and to the knowledge of the Company, no parent, child, sibling or spouse of any such officer, member, manager or Affiliate: (a) owns, directly or indirectly, any interest in (excepting less than 2% stock holdings for investment purposes in securities of publicly held and traded companies), or is an officer, member, director, employee or consultant of, any Person which is or is engaged in business as, a competitor, lessor, lessee, supplier, distributor, sales agent or customer of, or lender to or borrower from, the Company or any Subsidiary; (b) owns, directly or indirectly, in whole or in part, any tangible or intangible property that the Company or any Subsidiary uses in the conduct of its business; or (c) has any cause of action or other claim whatsoever against, or owes any amount to, the Company or any Subsidiary, except for claims in the ordinary course of business such as for accrued vacation pay, accrued benefits under employee benefit plans, and similar matters and agreements arising in the ordinary course of business. 5.27 Trade Relations. There exists no actual, or to the knowledge of the Company threatened, termination, cancellation or limitation of, or any adverse modification or change in, the business relationship or business of the Company and the Subsidiaries, taken as a whole, or their business with any customer or any group of customers whose use of their services are individually or in the aggregate material to the business of the Company and the Subsidiaries, taken as a whole, or with any material supplier, and, to the knowledge of the Company, there exists no condition or state of facts or circumstances that would materially adversely affect the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole, or would prevent the Company or any Subsidiary from conducting its business after the consummation of the transactions contemplated by the Transaction Documents in substantially the same manner in which it heretofore has been conducted. 35 5.28 Outstanding Borrowing. Schedule 5.28 sets forth (a) the amount of all Indebtedness of the Company and the Subsidiaries for money borrowed (other than the Note), (b) the Liens that relate to such Indebtedness and that encumber the assets of the Company or any Subsidiary and (c) the name of each lender thereof. 5.29 Material Contracts. Neither the Company nor any Subsidiary is a party to any Contractual Obligation or is subject to any charge, corporate restriction, judgment, injunction, decree or Requirement of Law materially adversely affecting, or which may adversely affect, the assets, business, properties, prospects, operations or financial or other condition of the Company and the Subsidiaries, taken as a whole. Except for the contracts, agreements and commitments, whether written or oral, described on Schedule 5.29, neither the Company nor any Subsidiary is a party to or bound by any material contract, agreement or commitment, whether written or oral, including, without limitation, (a) any distributor, sales, advertising, agency or manufacturer's representative contract, (b) any continuing contract for the purchase of materials, supplies, equipment or services involving in the case of any such contract more than $50,000 annually, (c) any trust indenture, mortgage, promissory note, loan agreement or other contract for the borrowing of money, any currency exchange, commodities or other hedging arrangement or any leasing transaction of the type required to be capitalized in accordance with GAAP, (d) any contract for capital expenditures in excess of $50,000 in the aggregate, (e) any contract limiting the freedom of the Company or any Subsidiary to engage in any line of business or to compete with any other Person or any confidentiality, secrecy or non-disclosure contract, (f) any contract with any Person with whom the Company or any Subsidiary does not deal at arm's length, (g) any agreement of guarantee, support, indemnification, assumption or endorsement of, or any similar commitment with respect to, the obligations, liabilities (whether accrued, absolute, contingent or otherwise) or Indebtedness of any other Person, or (h) any contracts or commitments providing for payments based in any manner on the revenues or profits of the business of the Company or any Subsidiary; provided, however, that managed care contracts and Medical Director Agreements are not required to be disclosed on Schedule 5.29. All of the contracts, agreements and commitments of the Company and the Subsidiaries are in full force and effect and binding upon the parties thereto in accordance with their terms. Neither the Company nor any Subsidiary, nor, to the knowledge of the Company, any other party to such contracts, agreements or commitments, is in default thereunder, nor does any condition exist that with notice or lapse of time or both would constitute a default thereunder. The Company has no knowledge of any proposed, pending, or likely cancellation or termination of any such contract, agreement or commitment. 5.30 Insurance. Schedule 5.30 sets forth a description of all policies or binders of fire, liability, workman's compensation, keyman, vehicular, life or other insurance held by or on behalf of the Company and the Subsidiaries, specifying the insurer, the policy number of covering note numbers with respect to binders and describing each pending claim thereunder of more than $50,000. Such insurance is in full force and effect. Neither the Company nor any Subsidiary is in default in any material respect with respect to any provision contained in any such policy or binder and has not failed to give any notice or present any claim under such policy or binder in due and timely fashion. 36 5.31 Compliance with Laws. The Company and each Subsidiary has the lawful authority and all material state, federal, special or local governmental authorizations, licenses or permits required to conduct their respective businesses as such businesses are presently being conducted. There are no pending, or to the knowledge of the Company threatened, actions, notices, or proceedings by any state, federal, special or local government or any subdivision thereof or any public or private group against the Company or any Subsidiary. The Purchaser has been provided with a list and brief description of all licenses, including those granted or derived from governmental sources, issued or granted to the Company or any Subsidiary which are material to its business. 5.32 Assets, Licenses, Etc. The Company and each Subsidiary has good and marketable title to, or valid leasehold interests in, all of its assets, real and personal, including the assets carried on its books and reflected in the Financials and the Interim Financials, subject to no Liens, except for (i) Liens described in Schedule 5.32 or permitted by Section 10.2, and (ii) assets sold, abandoned or otherwise disposed of in the ordinary course of business. 5.33 Aeries Healthcare Acquisition. The Company heretofore has delivered to the Purchaser true, correct and complete copies of the Aeries Purchase Agreement and all documents and certificates related thereto. To the knowledge of the Company, the representations and warranties made by the sellers in the Aeries Purchase Agreement and the related documents and certificates are true and correct in all respects at and as of the date hereof and after giving effect to the transactions contemplated by the Transaction Documents as if such representations and warranties were made at and as of such dates (unless such representations and warranties relate to matters only as of a particular date, in which case such representations and warranties shall be true and correct in all respects as of such date). 5.34 Regulatory Matters. Except as set forth in Schedule 5.34, the Company represents and warrants to the Purchaser as follows: (a) Licenses, Permits, Authorizations and Payor Programs. (i) (A) The Company and each entity directly or indirectly controlled by it (the "PSI Companies"), (B) if the PMR Merger is consummated, PMR Corporation and each entity directly or indirectly controlled by it (the "PMR Companies") and (C) if the acquisition contemplated by the Aeries Purchase Agreement (as in effect on the date hereof) is consummated, Aeries Healthcare and each entity directly or indirectly controlled by it (the "Aeries Companies," and together with the PSI Companies and the PMR Companies, the "Regulated Companies," and each, a "Regulated Company") each hold all licenses and other rights, accreditations, permits, approvals and authorizations ("Permits") required by law, ordinance, regulation or ruling guidance or manual of any governmental regulatory authority necessary to operate each line of business or facility presently conducted and presently proposed to be conducted by each of the Regulated Companies (each such line or facility, a "Business" and collectively, the "Businesses"), except for Permits, the absence of which would not reasonably be expected to have a material adverse effect on the assets, business, 37 properties, prospects, operations or financial or other condition of any Business. Each Regulated Company that directly receives reimbursement or payments under Titles XVIII and XIX of the Social Security Act (the "Medicare and Medicaid programs") is certified for participation and reimbursement under the Medicare and Medicaid programs. Each Regulated Company that directly or indirectly receives reimbursement or payments under the Medicare and Medicaid programs, the CHAMPUS and TriCare programs and such other similar federal, state or local reimbursement or governmental programs (collectively the "Government Programs") has current provider numbers and provider agreements required for each of such Government Programs. Each Regulated Company that directly or indirectly receives payments under any non-governmental program, including without limitation any private insurance program (collectively, the "Private Programs") has all provider agreements and provider numbers that are required under such Private Programs. (ii) True, correct and complete copies or descriptive listing of the aforementioned Permits (including the name of the issuing agency and the expiration date) and provider numbers and provider agreements under all Government Programs and Private Programs, have been provided to the Purchaser. True, complete and correct copies or descriptive listing of all surveys, reviews and/or audits of any Regulated Company or any Business or its predecessors in interest conducted during the past two years in connection with any Government Program, Private Program or licensing or accrediting body have been provided to the Purchaser. (iii) No violation, default, order or legal or administrative proceeding exists with respect to any of the aforementioned Permits, Medicare or Medicaid certifications, provider agreements or provider numbers, except for any of the foregoing that would not reasonably be expected to have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of any Business. Except as disclosed on Schedule 5.34, none of the Regulated Companies has received any notice of any action pending or recommended by any state or federal agency having jurisdiction with respect to any of the aforementioned Permits, Medicare or Medicaid certifications, provider agreements, or provider numbers, either to revoke, withdraw or suspend any such Permit, certification, provider agreements or provider number, or to terminate the participation of any Business in any Government Program or Private Program. Except as disclosed on Schedule 5.34, no event has occurred that, with the giving of notice, the passage of time, or both, would constitute grounds for a material violation, order or deficiency with respect to any such Permit, certification, provider agreement or provider number, or to revoke, withdraw or suspend any such Permit, certification, provider agreements or provider number, or to terminate or modify the participation of any Business in any Government Program or Private Program. There has been no decision not to renew any provider number or provider agreement or third-party payor agreement of any Regulated Company or Business. No consent or approval of, prior filing with or notice to, or any action by, any governmental body or agency or any other third party is required in connection with any such Permit, or Government Program or Private Program, by reason of the transactions contemplated hereby, and the continued operation of any Business thereafter on a basis consistent with past practices (other than the renewal of current approvals, licenses and Permits). 38 (iv) Each Regulated Company and/or Business has timely filed all reports and billings required to be filed by it prior to the date hereof with respect to the Government Programs and Private Programs, all fiscal intermediaries and other insurance carriers and all such reports and billings are complete and accurate in all material respects and have been prepared in compliance with all applicable laws, regulations, rules, manuals and guidance governing reimbursement and claims. True, correct and complete copies of such reports and billings for the most recent year have previously been made available to the Purchaser. Each Regulated Company has paid or caused to be paid all known and undisputed refunds, overpayments, discounts or adjustments which have become due pursuant to such reports and billings, has not claimed or received reimbursements from Government Programs or Private Programs in excess of amounts permitted by law, and has no liability under any Government Program or Private Program (known or unknown, contingent or otherwise) for any refund, overpayment, discount or adjustment. With respect to such prior reports or billings, there are no pending appeals, adjustments, challenges, audits, inquiries, litigation or notices of intent to audit, and, other than the routine review of cost reports, during the last two years none of the Business has been audited, or otherwise examined by any Government Program or Private Program. There are no other reports required to be filed by any Business in order to be paid under any Government Program or Private Program for services rendered, except for reports not yet due. (v) All activities of each Business of the PSI Companies, and, to the knowledge of the PSI Companies after due and reasonable inquiry, of each Business of each other Regulated Company and of any officers, directors, agents and employees of any of the Regulated Companies undertaken on behalf of any Business, have been, and are currently being, conducted in compliance in all respects with all applicable Requirements of Law, permits, licenses, certificates, governmental requirements, Government Program manuals and guidance, orders and other similar items of any Governmental Entity including, without limitation, all Requirements of Law pertaining to confidentiality of patient information, occupational safety and health, workers' compensation, unemployment, building and zoning codes (collectively, "Regulations"), other than any non-compliance that does not or would not have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of any Business. Neither the Business of any PSI Company nor, to the knowledge of the PSI Companies after due and reasonable inquiry, of any other Regulated Company, has violated or become liable for, or received a notice or charge asserting any such violation or liability with respect to, any Regulation, nor are there any facts or circumstances that are known or that reasonably should be known to the Regulated Companies that could form the basis for any such violation or liability. None of the Regulated Companies or Businesses is relying on any exemption from or deferral of any Regulation that would not be available to such Regulated Company or Business after the Closing. (vi) There are no pending changes in applicable law or regulations that would prevent any of the Businesses from conducting its business in substantially the same manner as the business is currently conducted. 39 Notwithstanding anything to the contrary, statements in subsections (iii), (iv) and (v) of this Section 5.34(a) as to any of the PMR Companies, Aeries Companies or their respective Businesses are made to the knowledge of the Company after due and reasonable inquiry. (b) Medical Waste Laws. None of the Regulated Companies and none of the Businesses is in violation of, or the subject of, any enforcement action by any Governmental Authority under the Medical Waste Tracking Act, 42 U.S.C. ss. 6992 et seq., or any other applicable federal, state or local governmental law dealing with the disposal of medical wastes (the "Medical Waste Laws"). None of the Regulated Companies has, within the last two years, received any written or oral notice of any investigation or inquiry by any Governmental Authority under the Medical Waste Laws. The Regulated Companies and the Businesses have obtained and are in compliance with any permits related to medical waste disposal required by the Medical Waste Laws, other than any non-compliance that does not or would not have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of any Business, and have taken reasonable steps to determine, and have determined, that all disposal of medical waste by them has been in compliance with the Medical Waste Laws. (c) No Changes in Suppliers and Third-Party Payors. None of the suppliers supplying products, materials or drugs to any Business of the PSI Companies or, to the knowledge of the PSI Companies after due and reasonable inquiry, any other Regulated Company, has provided any notice (written or oral) to any Regulated Company that it intends to cease selling such products, materials or drugs to such Regulated Company or Business or to limit or reduce such sales of the products to any such Regulated Company or Business or increase prices and there is no fact that indicates that any third-party payor of any Regulated Company or any Business intends to terminate, limit or reduce its business relations with such Regulated Company or Business in the event of a sale of any Regulated Company or Business, or otherwise, other than any of the foregoing acts that do not or would not have a material adverse effect on the assets, business, properties, prospects, operations or financial or other condition of any Business. (d) Inspections and Investigations. No Regulated Company or Business, no licensed professional or other individual affiliated with the PSI Companies or any Business of the PSI Companies, and, to the knowledge of the PSI Companies after due and reasonable inquiry, no licensed professional or other individual affiliated with the other Regulated Companies or any Business of such Regulated Companies, has had its, his or her right to receive reimbursements pursuant to any Government Program or Private Program terminated or otherwise adversely affected as a result of any investigation or action whether by any federal or state governmental regulatory authority or other third party. Except as described on Schedule 5.34, no Regulated Company or Business, and, to the knowledge of the PSI Companies after due and reasonable inquiry, no licensed professional or other individual who is a party to a contract with any Regulated Company, has, during the past three years, been the subject of any inspection, investigation, survey, audit, monitoring or other form of review by any governmental regulatory entity, trade association, professional review organization, accrediting 40 organization or certifying agency based upon any alleged improper activity on the part of such Regulated Company, Business or individual, and no Regulated Company has received any notice of deficiency during the past three years in connection with the operation of the Business. Except as described on Schedule 5.34, there are no presently, and at the Closing there will not be, any outstanding deficiencies or work orders of any Governmental Authority having jurisdiction over any Business, or requiring conformity to any applicable agreement, statute, regulation, ordinance bylaw, including but not limited to, the Government Programs and Private Programs. Except as described on Schedule 5.34, there is not any notice of any claim, requirement or demand of any licensing or certifying agency or other third party supervising or having authority over any Business to rework or redesign any part thereof or to provide additional furniture, fixtures, equipment, appliances or inventory so as to conform to or comply with any existing law, code, rule, regulation or standard. (e) Fraud and Abuse; Stark Act; False Claims. Neither the PSI Companies, nor, to the knowledge of the PSI Companies after due and reasonable inquiry, any other Regulated Company, nor any officer, director or managing employee of the PSI Companies or, to the knowledge of the PSI Companies after due and reasonable inquiry, of any other Regulated Company, and, to the knowledge of the PSI Companies after due and reasonable inquiry, no person or entity providing professional services in connection with any Business, has engaged in any activities that are prohibited, or cause for the imposition of penalties or mandatory or permissive exclusion, under 42 U.S.C. s. 1320a-7, 1320a-7a, 1320a-7b, 1395nn, or 1396b, 31 U.S.C. s. 3729-3733, or the federal CHAMPUS/TRICARE statute (or other federal or state statutes related to false or fraudulent claims) or the regulations promulgated thereunder pursuant to such statutes, or related state or local statutes or regulations, or under any criminal laws, statutes, ordinances, regulations or rulings or manuals of any governmental regulatory authority relating to health care services or payments, or that are prohibited by rules of professional conduct, including but not limited to the following: (i) knowingly and willfully making or causing to be made a false statement or representation of a fact in any application for any benefit or payment; (ii) knowingly and willfully making or causing to be made any false statement or representation of a fact for use in determining rights to any benefit or payment; (iii) failing to disclose knowledge by a claimant of the occurrence of any event affecting the initial or continued right to any benefit or payment on its own behalf or on behalf of another, with intent to fraudulently secure such benefit or payment; and (iv) knowingly and willfully soliciting or receiving any remuneration (including any kickback, bribe or rebate), directly or indirectly, overtly or covertly, in cash or in kind or offering to pay or receive such remuneration (A) in return for referring an individual to a person for the furnishing or arranging for the furnishing of any item or service for which payment may be made in whole or in part by Medicare or Medicaid, or (B) in return for purchasing, leasing, or ordering or arranging for or recommending purchasing, leasing, or ordering any good, facility, service or item for which payment may be made in whole or in part by Medicare or Medicaid, or under any Private Program. (f) Rates and Reimbursement Policies. Except as described on Schedule 5.34, no Regulated Company has any reimbursement or payment rate appeals, 41 disputes or contested positions currently pending before any Governmental Authority or any administrator of any Private Programs with respect to any Business. (g) Controlled Substances. Each Regulated Company and its officers, directors and employees and, to the knowledge of the PSI Companies after due and reasonable inquiry, persons who provide professional services under agreements (whether oral or written) with such Regulated Company in connection with any Business has not, in connection with its, his or her activities directly or indirectly related to any Business, engaged in any activities which are prohibited under the Federal Controlled Substances Act, 21 U.S.C. ss. 801 et seq. or the regulations promulgated pursuant to such statute or any related state or local statutes or regulations concerning the dispensing and sale of controlled substances. (h) Intermediate Sanctions. No PSI Company or Business of any PSI Company and, to the knowledge of the PSI Companies after due and reasonable inquiry, no other Regulated Company or Business of any other Regulated Company has (i) engaged in any transaction with any entity that is tax-exempt under Section 501(c)(3) or (4) of the Code that has resulted in the imposition on such Regulated Company or Business of any tax under Section 4958 of the Code or (ii) engaged in an "excess benefit transaction" (as defined in such Section 4958 of the Code) with any such tax-exempt entity. (i) Due Diligence Disclosures. Each of the PSI Companies has truly, correctly and completely answered all questions in the initial due diligence request submitted to it on behalf of the Purchaser, dated May 7, 2002, and all supplements thereto, including those dated May 17, 2002, May 23, 2002, June 5, 2002 and June 10, 2002 (collectively, the "Due Diligence Requests") and has provided the Purchaser true, correct and complete copies of all existing documents that were requested in the Due Diligence Requests. ARTICLE VI REPRESENTATIONS AND WARRANTIES OF THE PURCHASER The Purchaser represents and warrants to the Company as follows: 6.1 Existence and Power. The Purchaser: (a) is duly organized and validly existing under the laws of the jurisdiction of its organization; and (b) has the power and authority to own and operate its property, to lease the property it operates as lessee and to conduct the business in which it is currently, or is currently proposed to be, engaged. 42 6.2 Authorization; No Contravention. The execution, delivery and performance by the Purchaser of this Agreement and each other Transaction Document to which it is a party: (a) is within the Purchaser's power and authority and has been duly authorized by all necessary action; (b) does not contravene the terms of the Purchaser's organizational or governing documents or any amendment thereof; (c) will not violate, conflict with or result in any breach or contravention of or the creation of any Lien under, any Contractual Obligation of the Purchaser, or any order or decree directly relating to the Purchaser; and (d) does not require approval, consent, exemption, authorization or other action by, or notice to, or filing with, any Governmental Authority or any other Person, other than those that have been obtained or made on or prior to the Closing. 6.3 Binding Effect. This Agreement and each other Transaction Document to which the Purchaser is a party has been duly executed and delivered by the Purchaser, and constitutes the legal, valid and binding obligation of the Purchaser enforceable against it in accordance with its terms, subject to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and other laws of general applicability relating to or affecting creditors' rights and to general equity principles. 6.4 No Legal Bar. The execution, delivery and performance by the Purchaser of this Agreement or any other Transaction Document to which the Purchaser is a party will not violate any Requirements of Law. 6.5 Purchase for Own Account. The Note and the Warrants (including, for purposes of this Section 6.5, the shares of Common Stock issuable upon exercise of the Warrants) to be acquired by the Purchaser pursuant to this Agreement are being acquired for its own account and with no intention of distributing or reselling such securities or any part thereof in any transaction that would be in violation of the securities laws of the United States of America, or any state, without prejudice, however, to the rights of such Purchaser at all times to sell or otherwise dispose of all or any part of the Note and the Warrants and any shares of Common Stock issuable upon exercise of the Warrants. If the Purchaser should in the future decide to dispose of the Note or the Warrants, the Purchaser understands and agrees that it may do so only in compliance with the Securities Act and applicable state securities laws, as then in effect, and that stop-transfer instructions to that effect, where applicable, will be in effect with respect to such securities. The Purchaser agrees to the imprinting, so long as required by law, of a legend on certificates representing all of the Warrants to the following effect: THIS WARRANT AND THE SECURITIES ISSUABLE UPON EXERCISE HEREOF HAVE BEEN TAKEN FOR INVESTMENT AND HAVE NOT BEEN REGISTERED 43 UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"), OR ANY APPLICABLE STATE SECURITIES LAWS AND MAY NOT BE SOLD OR OTHERWISE TRANSFERRED BY ANY PERSON, EXCEPT PURSUANT TO AN EFFECTIVE REGISTRATION STATEMENT UNDER THE SECURITIES ACT AND APPLICABLE STATE SECURITIES LAWS OR AN APPLICABLE EXEMPTION TO THE REGISTRATION REQUIREMENTS OF THE SECURITIES ACT OR SUCH STATE SECURITIES LAWS. 6.6 Accredited Investor. The Purchaser is an "accredited investor" as such term is defined under Rule 501 under the Securities Act. 6.7 Broker's, Finder's or Similar Fees. Except for the facility fee payable to the Purchaser pursuant to Section 2.3, there are no brokerage commissions, finder's fees or similar fees or commissions payable in connection with the offer or sale of the Note or the Warrants based on any agreement, arrangement or understanding with the Purchaser or any action taken by the Purchaser. ARTICLE VII INDEMNIFICATION 7.1 Indemnification by the Company. In addition to all other sums due hereunder or provided for in this Agreement and each other Transaction Document, the Company agrees to indemnify and hold harmless the Purchaser and its Affiliates (including, without limitation, BBH & Co.) and their respective officers, directors, agents, employees, partners and controlling persons (each, an "indemnified party") to the fullest extent permitted by law from and against any and all losses, claims, damages, expenses (including reasonable fees, disbursements and other charges of counsel) or other liabilities ("Losses") resulting from any breach of any representation or warranty, covenant or agreement of the Company contained in this Agreement or any other Transaction Document or any legal, administrative or other actions (including actions brought by the Company or any equity holders of the Company or derivative actions brought by any Person claiming through the Company or in the Company's name), proceedings or investigations (whether formal or informal), or written threats thereof, based upon, relating to or arising out of this Agreement or any other Transaction Document, the transactions contemplated hereby or thereby, or any indemnified person's role herein or therein; provided, however, that the Company shall not be liable under this Section 7.1: (a) for any amount paid in settlement of claims without the Company's consent (which consent shall not be unreasonably withheld), or (b) to the extent that it is finally judicially determined that such Losses resulted primarily from the willful misconduct, bad faith or gross negligence of such indemnified party; provided, further, that if and to the extent that such indemnification is unenforceable for any reason, the 44 Company shall make the maximum contribution to the payment and satisfaction of such indemnified liability which shall be permissible under applicable laws. In connection with the obligation of the Company to indemnify for expenses as set forth above, the Company further agrees to reimburse each indemnified party for all such expenses (including reasonable fees, disbursements and other charges of counsel) as they are incurred by such indemnified party; provided, however, that if an indemnified party is reimbursed hereunder for any expenses, such reimbursement of expenses shall be refunded to the extent it is finally judicially determined that the Losses in question resulted primarily from the willful misconduct, bad faith or gross negligence of such indemnified party. 7.2 Notification. Each indemnified party under this Article VII will, promptly after the receipt of notice of the commencement of any action or other proceeding against such indemnified party in respect of which indemnity may be sought from the Company under this Article VII, notify the Company in writing of the commencement thereof. The omission of any indemnified party so to notify the Company of any such action shall not relieve the Company from any liability which it may have to such indemnified party other than pursuant to this Article VII or, unless, and only to the extent that, such omission results in the Company's forfeiture of substantive rights or defenses. In case any such action or other proceeding shall be brought against any indemnified party and it shall notify the Company of the commencement thereof, the Company shall be entitled to participate therein and, to the extent that it may wish, to assume the defense thereof, with counsel reasonably satisfactory to such indemnified party; provided, however, that any indemnified party may, at its own expense, retain separate counsel to participate in such defense. Notwithstanding the foregoing, in any action or proceeding in which each of the Company and an indemnified party is, or is reasonably likely to become, a party, such indemnified party shall have the right to employ separate counsel at the Company's expense and to control its own defense of such action or proceeding if, in the reasonable opinion of counsel to such indemnified party, (a) there are or may be legal defenses available to such indemnified party or to other indemnified parties that are different from or additional to those available to the Company or (b) any conflict or potential conflict exists between the Company and such indemnified party that would make such separate representation advisable; provided, however, that in no event shall the Company be required to pay fees and expenses under this Article VII for more than one firm of attorneys in any jurisdiction in any one legal action or group of related legal actions. The Company shall not, without the consent of the indemnified party (which consent shall not be unreasonably withheld), consent to the entry of any judgment or enter into any settlement which does not include as an unconditional term thereof the giving by the claimant or plaintiff to such indemnified party of a release from all liability in respect to such claim or litigation or which requires action other than the payment of money by the Company. The rights accorded to indemnified parties hereunder shall be in addition to any rights that any indemnified party may have at common law, by separate agreement or otherwise. 7.3 Investor Rights Agreement. Notwithstanding anything to the contrary in this Article VII, the indemnification and contribution provisions of the 45 Investor Rights Agreement shall govern any claim made with respect to registration statements filed pursuant thereto or sales made thereunder. ARTICLE VIII FINANCIAL COVENANTS On and after the date hereof, until all of the Obligations of the Company to the Purchaser have been satisfied, the Company shall, and shall cause the Subsidiaries to, observe the following covenants: 8.1 Minimum Census. As of the last day of each Monthly Test Period, (a) the aggregate combined census levels at the facilities owned, operated or leased by the Company and the Subsidiaries and (b) the census level at each facility, shall be not less than 72.5% of the census levels for such applicable calendar months for the facilities listed on Schedule 8.1. 8.2 Total Consolidated Leverage Ratio. As of the last day of each Leverage Test Period beginning on June 30, 2002 through and including December 31, 2002, the Total Leverage Ratio shall not exceed 4.50:1.00. As of the last day of each Leverage Test Period beginning on January 1, 2003 through and including March 31, 2003, the Total Leverage Ratio shall not exceed 4.25:1.00. As of the last day of each Leverage Test Period beginning on April 1, 2003 through and including December 31, 2003, the Total Leverage Ratio shall not exceed 4.00:1.00. As of the last day of each Leverage Test Period beginning on January 1, 2004 through and including December 31, 2004, the Total Leverage Ratio shall not exceed 3.75:1.00. As of the last day of each Leverage Test Period beginning on January 1, 2005 through and including December 31, 2005, the Total Leverage Ratio shall not exceed 3.50:1.00. As of the last day of each Leverage Test Period after January 1, 2006, the Total Leverage Ratio shall not exceed 3.25:1.00. 8.3 Senior Consolidated Leverage Ratio. As of the last day of each Leverage Test Period beginning on June 30, 2002 through and including March 31, 2003, the Senior Leverage Ratio shall not exceed 3.50:1.00. As of the last day of each Leverage Test Period beginning on April 1, 2003 through and including December 31, 2003, the Senior Leverage Ratio shall not exceed 3.25:1.00. As of the last day of each Leverage Test Period beginning on January 1, 2004 through and including December 31, 2004, the Senior Leverage Ratio shall not exceed 3.00:1.00. As of the last day of each Leverage Test Period after January 1, 2005, the Senior Leverage Ratio shall not exceed 2.75:1.00. 8.4 Consolidated Interest Coverage Ratio. As of the last day of each Monthly Test Period beginning on June 30, 2002 through and including March 31, 2003, the Interest Coverage Ratio shall not be less than 2.00:1.00. As of the last day of each Monthly Test Period beginning on April 1, 2003 through and including March 31, 2004, the Interest Coverage Ratio shall not be less than 2.25:1.00. As of the last day of each 46 Monthly Test Period after April 1, 2004, the Interest Coverage Ratio shall not be less than 2.50:1.00. 8.5 Consolidated Fixed Charge Ratio. As of the last day of each Monthly Test Period beginning June 30, 2002 through and including March 31, 2003, the Fixed Charge Ratio shall be a minimum of 1.20:1.00. As of the last day of each Monthly Test Period after April 1, 2003, the Fixed Charge Ratio shall not be less than 1.33:1.00. For purposes of this financial covenant only, the following shall be excluded from calculation of the Fixed Charge Ratio: (a) the aggregate amount of all principal payments made in an aggregate amount not to exceed $2,500,000 by the Company and the Subsidiaries to The Brown Schools, Inc. in accordance with the provisions of the note evidencing such Indebtedness, (b) all non-cash interest expenses related to such Seller Notes and (c) such other non-occurring charges as the Purchaser may consent to in its sole discretion (e.g., computer conversions). ARTICLE IX AFFIRMATIVE COVENANTS On and after the date hereof, until all of the Obligations of the Company to the Purchaser have been satisfied, the Company shall, and shall cause the Subsidiaries to, observe the following covenants: 9.1 Financial Statements. The Company shall deliver to the Purchaser and any other Holder: (a) (i) as soon as available and in any event within 90 days after the end of each fiscal year of the Company, audited annual consolidated and consolidating financial statements of the Company and the Subsidiaries, including the notes thereto, consisting of a consolidated and consolidating balance sheet at the end of such completed fiscal year and the related consolidated and consolidating statements of income, retained earnings, cash flows and owners' equity for such completed fiscal year, which financial statements shall be prepared and certified without qualification by an independent certified public accounting firm satisfactory to the Purchaser and accompanied by related management letters, if available, and (ii) as soon as available and in any event within 30 days after the end of each calendar month, unaudited consolidated and consolidating financial statements of the Company and the Subsidiaries consisting of a balance sheet and statements of income, retained earnings, cash flows and owners' equity as of the end of the immediately preceding calendar month. All such financial statements shall be prepared in accordance with GAAP consistently applied with prior periods. With each such financial statement, the Company shall also deliver a certificate of its Chief Financial Officer, stating that (A) such Person has reviewed the relevant terms of this Agreement and the Note and the condition of the Company and the Subsidiaries, (B) no Default or Event of Default has occurred or is continuing, or, if any of the foregoing has occurred or is continuing, specifying the nature and status and period of existence thereof and the steps taken or proposed to be taken with respect thereto, and (C) the Company and the Subsidiaries are in compliance with all financial covenants set forth in Article 47 VIII. Such certificate shall be accompanied by the calculations necessary to show compliance with the financial covenants in a form satisfactory to the Purchaser. (b) as soon as available, and in any event within 10 days after the preparation or issuance thereof or at such other time as set forth below: (i) copies of such financial statements (other than those required to be delivered pursuant to Section 9.1(a)) prepared by, for or on behalf of the Company and the Subsidiaries, and any other notes, reports and other materials related thereto, including, without limitation, any pro forma financial statements; (ii) any reports, returns, information, notices and other materials that the Company or any Subsidiary shall send to its stockholders, members, partners or other equity owners at any time; (iii) all Medicare and Medicaid cost reports and other document and materials filed by the Company or any Subsidiary and any other reports, materials or other information regarding or otherwise relating to Medicaid or Medicare prepared by, for or on behalf of the Company or any Subsidiary; (iv) any other reports, materials or other information regarding or otherwise relating to Medicaid or Medicare prepared by, for, or on behalf of, the Company or any Subsidiary, including, without limitation, (A) copies of licenses and permits required by any applicable federal, state, foreign or local law, statute ordinance or regulation or Governmental Authority for the operation of its business, (B) Medicare and Medicaid provider numbers and agreements, (C) state surveys pertaining to any healthcare facility operated or owned or leased by the Company or any Subsidiary or any of their respective Affiliates, and (D) participating agreements relating to medical plans; (v) within 15 days after the end of each calendar month for such month, (A) a report of the status of all payments, denials and appeals of all Medicare and/or Medicaid Accounts, (B) a sales and collection report and accounts receivable and accounts payable aging schedule, including a report of sales, credits issued and collections received, all such reports showing a reconciliation to the amounts reported in the monthly financial statements, and (C) a report of census and occupancy percentage by payor type; (vi) promptly upon receipt thereof, copies of any reports submitted to the Company or any Subsidiary by its independent accountants in connection with any interim audit of the books of such Person or any of its Affiliates and copies of each management control letter provided by such independent accountants; and (vii) such additional information, documents, statements, reports and other materials as the Purchaser may reasonably request from a credit or security perspective or otherwise from time to time. (c) for each fiscal year of the Company thereafter not less than 30 days prior to the commencement of such fiscal year, consolidated and consolidating month by month projected operating budgets, annual projections, profit and loss statements, balance sheets and cash flow reports of and for the Company and the Subsidiaries for such upcoming fiscal year (including an income statement for each month and a balance sheet as at the end of the last month in each fiscal quarter), in each case prepared in accordance with GAAP consistently applied with prior periods; and (d) management reports, documentation of material financial transactions, projections, operating reports, acquisition analyses, presentations to banks, financial institutions or potential investors, consultants' reports and such other financial 48 and operating data of the Company and the Subsidiaries as the Purchaser reasonably may request. 9.2 Certificates; Other Information. The Company shall furnish to the Purchaser and any other Holder: (a) any notice of default in respect of any Indebtedness of the Company or any Subsidiary for borrowed money promptly upon receipt thereof; and (b) any material amendment, supplement, modification or waiver of the agreements or arrangements of the Company or any Subsidiary for Indebtedness promptly upon execution thereof. 9.3 Preservation of Corporate Existence. The Company shall, and shall cause each Subsidiary to: (a) preserve and maintain in full force and effect its corporate existence and good standing under the laws of its jurisdiction of incorporation or organization; (b) preserve and maintain in full force and effect all material rights, privileges, qualifications, licenses and franchises necessary in the normal conduct of its business; and (c) use its reasonable efforts to preserve its business organization. 9.4 Payment of Obligations. The Company shall, and shall cause the Subsidiaries to, pay and discharge as the same shall become due and payable, all their respective obligations and liabilities, including without limitation: (a) all Tax liabilities, assessments and governmental charges or levies upon it or its properties or assets, unless the same are being contested in good faith by appropriate proceedings and adequate reserves in accordance with GAAP are being maintained by the Company or any Subsidiary; (b) all lawful claims which the Company or any Subsidiary is obligated to pay, which are due and which, if unpaid, might by law become a Lien (to the extent not permitted under Section 10.2 of this Agreement) upon its property; and (c) all payments of principal and interest when due (giving effect to any grace periods relating thereto) on Indebtedness of the Company or any Subsidiary. 9.5 Compliance with Laws. The Company shall comply, and shall cause each Subsidiary to comply, with its certificate of incorporation and by-laws or other organizational or governing documents and all Requirements of Law and with the directions of any Governmental Authority having jurisdiction over it or its business, except to the extent such failure to comply would not have a material adverse effect on the assets, business, operations, properties, prospects or financial or other condition the 49 Company and the Subsidiaries, taken as a whole. The Company hereby covenants and agrees that all offerings of securities of the Company or any Subsidiary shall be either (a) registered pursuant to the provisions of the Securities Act and any applicable state securities or "blue sky" laws or (b) exempt from registration under the Securities Act and any applicable state securities or "blue sky" laws. 9.6 Notices. Upon knowledge of the Chief Executive Officer, the President, the Chief Financial Officer, the Chief Development Officer or the Controller of the Company of any of the events described below, the Company shall give prompt written notice (but in any event within 10 days) to the Purchaser and any other Holder: (a) of the occurrence of any default under, or breach of, any of the provisions of Articles VIII, IX or X accompanied by a certificate specifying the nature of such default or breach, the period of existence thereof and the action that the Company has taken or proposes to take with respect thereto; (b) of any (i) default or event of default under any material Contractual Obligation of the Company or any Subsidiary, including, without limitation, the Credit Agreement and the Senior Debt Documents, or (ii) dispute, litigation, investigation, proceeding or suspension which may exist at any time between the Company or any Subsidiary and any Governmental Authority; and (c) each notice pursuant to this Section 9.6 shall be accompanied by a statement by the Chief Executive Officer, President, Chief Financial Officer, Chief Development Officer or the Controller of the Company, setting forth details of the occurrence referred to therein and stating what action the Company proposes to take with respect thereto. 9.7 Issue Taxes. The Company shall pay, or cause to be paid, all documentary and similar Taxes levied under the laws of any applicable jurisdiction in connection with the issuance of the Note (including all loans made thereunder) and the Warrants and the execution and delivery of the other agreements and documents contemplated hereby and any modification of the Note and the Warrants and such other agreements and documents, and will hold the Holder harmless, without limitation as to time, against any and all liabilities with respect to all such Taxes. 9.8 Inspection; Confidentiality. (a) The Company shall permit, and shall cause each Subsidiary to permit, representatives of the Purchaser to visit and inspect any of its properties, to examine its corporate, financial and operating records and make copies thereof or abstracts therefrom, and to discuss its affairs, finances and accounts with their respective managers, officers and independent public accountants, all at such reasonable times during normal business hours and as often as may be reasonably requested, upon reasonable advance notice to the Company. (b) The Purchaser will utilize reasonable good faith efforts to maintain as confidential any confidential information obtained from the Company and the 50 Subsidiaries pursuant to Section 9.8(a) (other than information which (i) at the time of disclosure or thereafter is generally available to and known by the public (other than as a result of a disclosure directly or indirectly by the Purchaser or any of its representatives), (ii) is available to the Purchaser on a non-confidential basis from a source other than the Company or the Subsidiaries, provided that such source was not known by the Purchaser to be bound by a confidentiality agreement with the Company or any Subsidiary, (iii) has been independently developed by the Purchaser or (iv) was obtained more than one year prior to such disclosure), and shall not disclose any such information required to be maintained as confidential pursuant hereto, except (A) to BBH & Co. and its advisors, representatives, agents, partners and employees, (B) to its advisors, representatives, agents, partners (and their representatives and advisors) and employees, (C) to any prospective transferee of the Note, the Warrants or shares of Common Stock issued upon the exercise of the Warrants or of an interest in the Purchaser or in a successor fund sponsored by BBH & Co., provided such prospective transferee agrees to maintain such information in confidence, (D) as may be required by law (including a court order, subpoena or other administrative order or process) or applicable regulations to which the Purchaser is or becomes subject, (E) in connection with any litigation arising out of or related to this Agreement, (F) to the executive officers of the Company or any Subsidiary, or (G) with the consent of the Company. 9.9 Use of Proceeds. The Company shall use the proceeds of the loan made at the Initial Closing and the sale of the Initial Warrants (a) to repay at the Initial Closing the aggregate principal amount and all accrued interest on the promissory notes listed on Schedule 3.19 and all other amounts due thereunder, (b) to finance at the Initial Closing the acquisition of the outstanding Capital Stock of Aeries Healthcare pursuant to the terms of the Aeries Purchase Agreement and (c) for working capital purposes. The Company shall use the proceeds of any Additional Loans and the sale of any Additional Warrants to finance at the Additional Closing at which such Additional Loans are made and Additional Warrants are sold a Drawdown Acquisition. 9.10 Payment of the Note. The Company shall pay the principal of, interest on and all other amounts due in respect of, the Note on the dates and in the manner provided herein and in the Note. 9.11 Subsidiaries' Guarantee. The Company shall cause each Subsidiary (whether newly formed, presently in existence, subsequently acquired, including, without limitation, in connection with a Drawdown Acquisition, or otherwise), to execute and deliver to the Purchaser the Subsidiaries' Guarantee. 9.12 PMR Guarantee. Simultaneously with the consummation of the transactions contemplated under the PMR Merger Agreement, the Company shall require PMR to execute and deliver to the Purchaser a guarantee (the "PMR Guarantee") of the obligations of the Company to the Purchaser under this Agreement and the Note, in substantially the form attached hereto as Exhibit H. 9.13 No Inconsistent Agreements. Neither the Company nor any Subsidiary shall (a) enter into any loan or other agreement after the date hereof or 51 (b) amend or modify any currently existing loan or other agreement, including, without limitation, the Credit Agreement and the Senior Debt Documents, which by its terms restricts or prohibits the ability of the Company to pay the principal of or interest on the Note or restricts or prohibits the ability of the Company to issue Common Stock upon exercise of the Warrants or to issue Put Price Notes, except to the extent contemplated by the Subordination Agreement as in effect on the date hereof. 9.14 Reservations of Shares. The Company shall reserve and keep available out of its authorized Common Stock, solely for the purpose of issue and delivery upon exercise of the Warrants, such number of shares of Common Stock as shall then be issuable or deliverable upon exercise of the Warrants (assuming, for these purposes, that the maximum number of Warrants issuable under this Agreement are issued and outstanding). Such shares of Common Stock shall, when issued or delivered, be duly and validly issued, fully paid and non-assessable, shall be free and clear of any Liens and shall not be subject to any preemptive or similar rights that have not been waived. 9.15 Registration and Listing. If any shares of Common Stock required to be reserved for purposes of exercise of the Warrants as provided in the Warrants, require registration with or approval of any Governmental Authority under any federal or state or other applicable law before such shares of Common Stock may be issued or delivered upon exercise of the Warrants, the Company will in good faith and as expeditiously as possible endeavor to cause such shares of Common Stock to be duly registered or approved. In the event that, and so long as, the shares of Common Stock (or any series or class of Capital Stock into which the shares of Common Stock are reorganized, reclassified, reconstituted or otherwise changed) are listed on the NYSE or quoted or listed on any other national securities exchange or Nasdaq, the Company will, if permitted by the rules of such system or exchange, quote or list and keep quoted or listed on such exchange or Nasdaq, upon official notice of issuance, all shares of Common Stock issuable or deliverable upon exercise of the Warrants. In addition, the Company will in good faith and as expeditiously as possible endeavor to obtain private placement numbers for the Note, the Warrants and the shares of Common Stock issued pursuant to the exercise thereof, assigned by the CUSIP Service Bureau of Standard & Poor's Corporation. 9.16 Allocation for Tax Purposes. The Company hereby covenants and agrees that it shall allocate $1,502,140 of the Initial Purchase Price to the purchase by the Purchaser of the Initial Warrants, and, with respect to each Additional Closing, the Company covenants and agrees to allocate a percentage of the Additional Purchase Price to the Additional Warrants sold at such Additional Closing, as agreed to by the Company and the Purchaser at or prior to such Additional Closing. 9.17 Register of the Note. The Company will maintain at its principal office a register (the "Register") for the purpose of registering the beneficial owner of the Note and registering transfers and exchanges of the Note. The entries in the Register shall be conclusive, in the absence of manifest error, and the Company may treat each Person whose name is recorded in the Register as the owner of the Note recorded therein. 52 No transfer or exchange of the Note by the Holder of the Note shall be effective unless it has been recorded in the Register as provided in this Section 9.17. Upon notice from the registered owner of the Note of any sale or transfer thereof, the Company shall register such sale or transfer in the Register. The Register shall be available for inspection by the Holder of the Note and its successors and assigns at any reasonable time and from time to time upon reasonable prior notice. 9.18 Payment Upon Liquidation. In the event that, at anytime on or prior to the consummation of the PMR Merger, there is a liquidation, dissolution or winding up of the Company or any other event that is considered a "liquidation" under the Company's Certificate of Incorporation, including, without limitation, an Acquisition (as defined in the Certificate of Incorporation) or an Asset Transfer (as defined in the Certificate of Incorporation), but specifically excluding the PMR Merger, the Company agrees to make a payment to the Purchaser upon the occurrence of any such event, in addition to any other payments the Company is required to make to the Purchaser, in an aggregate amount of $99,860 for each $1,000,000 of loans advanced by the Purchaser as of such date pursuant to this Agreement. 9.19 Right of First Refusal. (a) In the event the Company or any Subsidiary (a "ROFR Borrower") receives an offer, term sheet or commitment or makes a proposal (including, without limitation, any application filed in connection with a HUD Financing accepted by any Person (each, an "Offer") which provides for any type of Qualified Debt Financing (as defined below) to or for any ROFR Borrower, the Company shall, or shall cause such ROFR Borrower, to notify the Purchaser of the Offer in writing (including all material terms of the Offer), and the Purchaser shall have 30 calendar days after receipt of such notice (the "Option Period") to agree to provide similar debt financing in the place of such Person upon substantially the same terms and conditions (or terms more favorable to such ROFR Borrower) as set forth in the Offer. For purposes of this Agreement, a "Qualified Debt Financing" means any debt financing which is subordinated to the Credit Agreement. This Section 9.19 shall expire once the ROFR Borrowers have made Offers to the Purchaser in respect of $20 million principal amount of Qualified Debt Financing. (b) The Fund shall notify the Company in writing of its acceptance of the Offer pursuant hereto (the "Acceptance Notice"), in which case the Company shall cause the ROFR Borrower to obtain such debt financing, subject to the terms herein, from the Fund and not accept such Offer from such other Person. If no Acceptance Notice has been received by the ROFR Borrower within the Option Period, the ROFR Borrower may consummate the Offer with the other Person on the terms and conditions set forth in the Offer (the "Transaction"); provided, however, that none of the foregoing or any failure by the Fund to issue an Acceptance Notice shall be construed as a waiver of any of the terms, covenants or conditions of the Securities Purchase Agreement or any other Transaction Document. If any transaction described in an Offer is not consummated on the terms set forth in the Offer or with the Person providing the Offer or during the 90 calendar day period following the expiration of the Option Period, the Company shall not 53 permit the ROFR Borrower to consummate the transaction without again complying with this Section 9.19. ARTICLE X NEGATIVE COVENANTS On the date hereof, until all of the Obligations of the Company to the Purchaser have been satisfied, the Company covenants and agrees that neither it nor any Subsidiary will: 10.1 Restrictions on Indebtedness. Create, incur, suffer or permit to exist, or assume or guarantee, either directly or indirectly, or otherwise become or remain liable with respect to, any Indebtedness, except the following: (a) Indebtedness outstanding at the date of this Agreement as set forth on Schedule 5.28 but no amendments or refinancings thereof; provided that all Indebtedness set forth on Schedule 5.28 owing to any seller in connection with the acquisition by the Company or any Subsidiary of any business (whether by asset purchase, stock purchase or otherwise) shall be Subordinated Debt, except as specifically indicated otherwise on Schedule 5.28. (b) Indebtedness to the United States Department of Housing and Urban Development ("HUD") in connection with the refinancing of a portion of the Indebtedness under the Credit Agreement in an aggregate amount not to exceed $35,000,000 (including, for purposes of this cap, any Indebtedness to HUD set forth on Schedule 5.28), but no amendments or refinancings thereof. (c) Indebtedness owing by any wholly-owned Subsidiary to the Company or to another wholly-owned Subsidiary; provided, that such Indebtedness shall be evidenced by a note and shall be Subordinated Debt. (d) Borrowings incurred in the ordinary course of business and not exceeding $100,000 individually or in the aggregate outstanding at any one time; provided, however, that such Indebtedness shall be Subordinated Debt. (e) Indebtedness in an amount not to exceed $100,000 in respect of purchase money security interests permitted under Section 10.2(c), including, for purposes of this cap, any Indebtedness in respect of purchase money security interests set forth on Schedule 5.28. (f) Indebtedness to the Purchaser incurred in connection with a Drawdown Acquisition as set forth in paragraph (iii) of the definition of "Drawdown Acquisition." (g) Indebtedness to the Purchaser. 54 (h) Capitalized Lease Obligations of the Company in an amount not to exceed $100,000 including, for purposes of this cap, any Capitalized Lease Obligations set forth on Schedule 5.28. (i) Indebtedness under the Credit Agreement (including letters of credit issued under the Credit Agreement) in an aggregate principal amount outstanding not in excess of the current maximum commitment under the Credit Agreement and any additional advances or increases thereunder, so long as, after giving effect to such advances or increases, the Company does not exceed the Total Leverage Ratio; provided, however, that the Company agrees that it shall not permit any amendment, supplement, modification or waiver or refinancing of the Credit Agreement, except as provided in the Subordination Agreement. (j) Indebtedness in connection with advances made by a stockholder in order to cure any default of the financial covenants set forth in Article VIII; provided, however, that such Indebtedness shall be Subordinated Debt. (k) Indebtedness to any seller of any business incurred in connection with the acquisition by the Company or any wholly-owned Subsidiary of such business (whether by asset purchase, stock purchase or otherwise), but no amendments or refinancings thereof; provided, that such Indebtedness shall be Subordinated Debt; provided, however, that no Indebtedness shall be permitted under this Section 10.1 unless at the time such Indebtedness is created, incurred, suffered or permitted to exist, or assumed or guaranteed, either directly or indirectly, and after giving effect to such Indebtedness, no Default or Event of Default shall have occurred and be continuing. Neither the Company nor any Subsidiary shall make prepayments on any existing or future Indebtedness to any Person other than under the Credit Agreement or to the Purchaser or to the extent specifically permitted by this Agreement. 10.2 Restrictions on Liens. Create or incur or suffer to be created or incurred or to exist any encumbrance, mortgage, pledge, Lien, charge or other security interest of any kind upon any of its property or assets of any character, whether now owned or hereafter acquired, or transfer any of such property or assets for the purposes of subjecting the same to the payment of Indebtedness or performance of any other obligation in priority to payment of its general creditors, or grant any person (other than CapitalSource under the Credit Agreement) a negative pledge or other similar restriction with respect to any of its property or assets, or acquire or agree or have an option to acquire any property or assets upon conditional sale or other title retention agreement, device or arrangement (including, without limitation, Capitalized Leases) or suffer to exist for a period of more than 30 days after the same shall have been incurred any Indebtedness against it which if unpaid might by law or upon bankruptcy or insolvency, or otherwise, be given any priority whatsoever over its general creditors, or sell, assign, pledge or otherwise transfer for security any of its accounts, contract rights, general intangibles, or chattel paper (as those terms are defined in the New York Uniform 55 Commercial Code) with or without recourse; provided, however, that the Company or any Subsidiary may create or incur or suffer to be created or incurred or to exist: (a) Liens in favor of CapitalSource pursuant to the terms of the Senior Debt Documents; (b) Existing Liens and security interests described in Schedule 5.32 securing presently outstanding Indebtedness permitted by Section 10.1. (c) Purchase money security interests (which term shall include mortgages, conditional sale contracts, Capitalized Leases and all other title retention or deferred purchase devices) to secure the purchase price of property acquired hereafter by the Company or any Subsidiary, or to secure Indebtedness incurred solely for the purpose of financing such acquisitions, in each case to the extent permitted by Section 10.1; provided, however, that no such purchase money security interests shall extend to or cover any property other than the property the purchase price of which is secured by it, and that the principal amount of Indebtedness (whether or not assumed) with respect to each item of property subject to such a security interest shall not exceed the fair value of such item on the date of its acquisition. (d) (i) Deposits or pledges made in connection with, or to secure payment of, workmen's compensation, professional liability insurance, unemployment insurance, old age pensions or other social security or to secure the performance of tenders, bids, leases, contracts (other than for the repayment of Indebtedness), statutory obligations and other similar obligations; (ii) arising as a result of progress payments under government contracts; and (iii) Liens for Taxes, assessments or governmental charges or levies and Liens to secure claims for labor, material or supplies to the extent that payment thereof shall not at the time be required to be made in accordance with Section 9.4(a). (e) Encumbrances in the nature of zoning restrictions, easements, and rights or restrictions of record on the use of real property which do not materially detract from the value of such property or impair its use in the business of the owner or lessee. (f) Liens (other than judgments and awards) created by or resulting from any litigation or legal proceeding, provided the execution or other enforcement thereof is effectively stayed and the claims secured thereby are being actively contested in good faith by appropriate proceedings reasonably satisfactory to the Purchaser. (g) Liens arising by operation of law to secure landlords, lessors or renters under leases or rental agreements made in the ordinary course of business and confined to the premises or property rented. (h) Judgment Liens in an aggregate amount not to exceed (i) $250,000, if such amount is covered by insurance or (ii) $50,000, if such amount is not covered by insurance. 56 (i) Liens necessary and desirable for the operation of such Person's business; provided, that the Purchaser has consented to such Liens in writing before their creation and existence and the debt secured thereby is both subject and subordinate in all respects to the Obligations and all of the rights and remedies of the Purchaser, all in form and substance satisfactory to the Purchaser in its sole discretion. (j) Liens in favor of HUD to secure Indebtedness to HUD permitted by Section 10.1(b); Nothing contained in this Section 10.2 shall permit the Company or any Subsidiary to incur any Indebtedness or take any other action or permit to exist any other condition which would be in contravention of any other provision of this Agreement. 10.3 Investments. Have outstanding or hold or acquire or make or commit itself to acquire or make any Investment, or acquire any interest in, or all or substantially all of the assets of, any Person or joint venture, except the following: (a) Investments having a maturity of less than one year from the date thereof by the Company in: (i) obligations of the United States of America or any agency or instrumentality thereof; or (ii) repurchase agreements involving securities described in clause (i) with the Purchaser; and (iii) commercial paper which is rated not less than prime-one or A-1 or their equivalents by Moody's Investor Service, Inc. or Standard & Poor's Corporation, respectively, or their successors. (b) Existing Investments of the Company in any Subsidiary, as described on Schedule 10.3. (c) Investments consisting of reasonable and customary travel and similar advances to employees of the Company and the Subsidiaries. (d) Investments or acquisitions by the Company or any wholly-owned Subsidiary constituting a Drawdown Acquisition. 10.4 Disposition of Assets. Sell, lease or otherwise dispose of any assets except for the sale, lease or other disposition of Inventory or other property in the ordinary course of business. 10.5 Mergers, Etc. Without the prior written consent of the Purchaser, enter into any merger or consolidation with or acquire all or substantially all of the assets of any Person, or sell, assign, lease or otherwise dispose of (whether in one transaction or in a series of transactions) all or substantially all of its assets (whether now owned or hereafter acquired) to any Person, except that (a) any wholly-owned Subsidiary may merge into the Company or any other wholly-owned Subsidiary and (b) the Company may merge with PMR Acquisition Corporation, a Delaware corporation, pursuant to the PMR Merger Agreement as in effect on the date hereof. 10.6 Assumptions, Guaranties, Etc. of Indebtedness of Other Persons. Except as permitted by the Credit Agreement or the Transaction Documents, assume, 57 guarantee, endorse or otherwise be or become directly or contingently liable (including, without limitation, by way of agreement, contingent or otherwise, to purchase, provide funds for payment, supply funds to or otherwise invest in any Person or otherwise assure the creditors of any such Person against loss) in connection with any Indebtedness of any other Person, except for (i) trade credit extended in the ordinary course of business, (ii) advances for business travel and similar temporary advances made in the ordinary course of business to officers, directors and employees and (iii) guaranties by endorsement of negotiable instruments for deposit or collection, or similar transactions in the ordinary course of business. 10.7 ERISA. At any time while the Company or any Subsidiary has a Pension Plan, permit any accumulated funding deficiency to occur with respect to any Pension Plan or other employee benefit plans established or maintained by the Company or any Subsidiary or to which contributions are made by the Company or any Subsidiary, and which are subject to the "Pension Reform Act" and the rules and regulations thereunder or to Section 412 of the Code, and at all times comply in all material respects with the provisions of the Pension Reform Act and Code which are applicable to such plans. The Company will not, and will cause the Subsidiaries not to, permit the Pension Benefit Guaranty Corporation to cause the termination of any Pension Plan under circumstances which would cause the lien provided for in Section 4068 of the Pension Reform Act to attach to the assets of the Company or any Subsidiary. 10.8 Distributions. Make (i) any Distributions or make any other payment on account of the purchase, acquisition, redemption, or other retirement of any shares of stock, whether now or hereafter outstanding, (ii) any payments or Distributions to any stockholder, member, partner or other equity owner in such Person's capacity as such, or (iii) any payment of any management, service or related or similar fee to any Person or with respect to any facility owned, operated or leased by the Company or any Subsidiary, except (A) any Subsidiary may make a Distribution to the Company, (B) the Company or any wholly-owned Subsidiary may enter into a Drawdown Acquisition in accordance with the terms and conditions set forth herein, (C) the Company may make a payment in connection with the redemption of the Warrants pursuant to Article XIII, and (D) the Company may make any payment to the Purchaser permitted under this Agreement, the Note or the Warrants. 10.9 Sale and Leaseback. Sell or transfer any of its properties with the intention of taking back a lease of the same property or leasing other property for substantially the same use as the property being sold or transferred. 10.10 Transactions with Affiliates. Enter into or amend, modify or renew any transaction, including, without limitation, the purchase, sale or exchange of property or the rendering of any service, with any Affiliate, except (i) as disclosed on Schedule 10.10, and (ii) that the Company and the Subsidiaries may pay salaries and bonuses to its directors and officers as are usual and customary in the Company's or the Subsidiaries' business; provided, that no payment of any bonus shall be permitted if a Default or Event of Default has occurred and remains in effect or would be caused by or result from such payment. 58 10.11 Change in Business. Engage in any business, or permit any Subsidiary thereof so to do, other than the business of owning and operating freestanding specialty psychiatric hospitals and managing psychiatric units owned by third parties and any other business reasonably related to the foregoing business. 10.12 PMR Merger Agreement. Amend, supplement, modify or waive any provision of the PMR Merger Agreement or the documents related thereto without the prior written consent of the Purchaser; provided, however, that prior to the consummation of the PMR Merger, the Company shall cause PMR Corporation to amend the PMR Merger Agreement in order to provide that, upon consummation of the PMR Merger, PMR Corporation shall assume the Company's obligations relating to the Warrants (whether then or thereafter issued and including, without limitation, the obligation to issue Additional Warrants on the terms set forth in this Agreement) such that each holder of a Warrant shall thereafter have the right to exercise such Warrant for the number of shares of PMR Common Stock that would have been received by a holder of the number of shares of Common Stock into which such Warrant could have been exercised immediately prior to the PMR Merger (subject to further adjustment as set forth in the Warrants). 10.13 Drawdown Acquisition Documents. Amend, supplement, modify or waive any provision of any Drawdown Acquisition Documents or the Aeries Purchase Agreement and the documents related thereto, without the prior written consent of the Purchaser. 10.14 Stock Option Plan. Issue, without the consent of the Purchaser, any equity securities, options, warrants or other rights to purchase shares of Capital Stock of the Company or stock appreciation rights, to any director, officer, employee or consultant of the Company or any Subsidiary, other than pursuant to (i) the Plan, without regard to any amendment or modification thereof, other than any amendment or modification thereof approved by the Board of Directors of the Company, (ii) an amendment of the Plan approved by the Purchaser or (iii) a plan adopted with the consent of the Purchaser. 10.15 Organizational Documents; Etc. (i) Amend its Certificate of Incorporation or By-laws or equivalent organizational or governing documents without the prior written consent of the Purchaser; (ii) change its fiscal year unless the Company demonstrates to the Purchaser's satisfaction compliance with the covenants contained herein for both the fiscal year in effect prior to any change and the new fiscal year period by delivery to the Purchaser of appropriate interim and annual pro forma, historical and current compliance certificates for such periods and such other information as the Purchaser may reasonably request; (iii) amend, alter or suspend or terminate or make provisional in any material way, any license, lease, power, permit, franchise, certificate, authorization, approval, certificate of need, provider number or other rights without the prior written consent of the Purchaser, which consent shall not be unreasonably withheld; (iv) wind up, liquidate or dissolve (voluntarily or involuntarily) or commence or suffer any proceedings seeking or that would result in any of the foregoing; or (v) use any proceeds of any loans hereunder for "purchasing" or "carrying" "margin stock" as 59 defined in Regulations U, T or X of the Board of Governors of the Federal Reserve System. 10.16 Payment on Subordinated Debt. Neither the Company nor any Subsidiary shall (a) make any prepayment of any part or all of any Subordinated Debt, (b) repurchase, redeem or retire any instrument evidencing any such Subordinated Debt prior to maturity, or (c) enter into any agreement (oral or written) which could in any way be construed to amend, modify, alter or terminate any one or more instruments or agreements evidencing or relating to any Subordinated Debt. ARTICLE XI DEFAULTS AND REMEDIES 11.1 Events of Default. The occurrence of any one or more of the following shall constitute an "Event of Default" hereunder: (a) The Company shall fail to pay any amount on the Obligations or provided for in this Agreement or the Note when due (whether on any payment date, at maturity, by reason of acceleration, by notice of intention to prepay, by required prepayment or otherwise); provided, that, if the Company shall fail to pay any amount on the Obligations when due, there shall be a one-day grace period after receipt by the Company of written notice from the Purchaser or any Holder of the Note of such nonpayment; (b) Any representation, statement or warranty made or deemed made by (i) the Company in this Agreement (including the representations and warranties made pursuant to Section 2.5) or the Note or in any other certificate, document, report or opinion delivered in conjunction therewith, (ii) any Subsidiary in the Subsidiaries' Guarantee or in any certificate, document, report or opinion delivered in conjunction therewith, or (iii) PMR Corporation in the PMR Guarantee (if any) or in any other certificate, document, report or opinion delivered in conjunction therewith, shall not be true and correct in all material respects or shall have been false or misleading in any material respect on the date when made or deemed to have been made (except to the extent already qualified by materiality, in which case it shall be true and correct in all respects and shall not be false or misleading in any respect); (c) The Company, any Subsidiary or PMR Corporation or other party thereto, other than the Purchaser or any Holder of any Warrant or the Note, shall be in violation, breach or default of, or shall fail to perform, observe or comply with any covenant, obligation or agreement set forth in, this Agreement, the Note, the Subsidiaries' Guarantee or the PMR Guarantee (if any), and such violation, breach, default or failure shall not be cured within the applicable period set forth in the applicable document; provided that, with respect to the affirmative covenants set forth in Article IX (other than Sections 9.3, 9.4, 9.9, 9.10, 9.11, 9.12 and 9.17 for which there shall be no cure period), there shall be a 30 day cure period commencing from the earlier of (i) receipt by such Person of written notice of such breach, default, violation or failure, and (ii) the time at 60 which such Person or any authorized officer thereof knew or became aware, or should have known or been aware, of such failure, violation, breach or default; (d) This Agreement, the Note, the Subsidiaries' Guarantee or the PMR Guarantee (if any) ceases to be in full force and effect; (e) One or more judgments or decrees is rendered against the Company or any Subsidiary in an amount in excess of (i) $300,000, if such amount is covered by insurance or (ii) $100,000, if such amount is not covered by insurance, which is/are not satisfied, stayed, vacated or discharged of record within 30 calendar days of being rendered; (f) (i) Any default occurs, which is not cured or waived, in the payment of any amount with respect to any Indebtedness (other than the Obligations) of the Company or any Subsidiary in excess of $100,000, and such default continues for more than any applicable grace period, or (ii) any Indebtedness of the Company or any Subsidiary in excess of $100,000 is declared to be due and payable or is required to be prepaid (other than by a regularly scheduled payment) prior to the stated maturity thereof, or any obligation of such Person for the payment of Indebtedness (other than the Obligations) is not paid when due or within any applicable grace period, or any such obligation becomes or is declared to be due and payable before the expressed maturity thereof; (g) The Company or any Subsidiary shall (i) be unable to pay its debts generally as they become due, (ii) file a petition under any insolvency statute, (iii) make a general assignment for the benefit of its creditors, (iv) commence a proceeding for the appointment of a receiver, trustee, liquidator or conservator of itself or of the whole or any substantial part of its property, or (v) file a petition seeking reorganization or liquidation or similar relief under any Debtor Relief Law or any other applicable law or statute; (h) (i) A court of competent jurisdiction shall (A) enter an order, judgment or decree appointing a custodian, receiver, trustee, liquidator or conservator of the Company or any Subsidiary or the whole or any substantial part of any such Person's properties, which shall continue unstayed and in effect for a period of 60 days, (B) approve a petition filed against the Company or any Subsidiary seeking reorganization, liquidation or similar relief under the any Debtor Relief Law or any applicable law or statute, which is not dismissed within 60 days or, (C) under the provisions of any Debtor Relief Law or other applicable law or statute, assume custody or control of the Company or any Subsidiary or of the whole or any substantial part of any such Person's properties, which is not irrevocably relinquished within 60 days, or (ii) there is commenced against the Company or any Subsidiary any proceeding or petition seeking reorganization, liquidation or similar relief under any Debtor Relief Law or any other applicable law or statute, which (A) is not unconditionally dismissed within 60 days after the date of commencement, or (B) is with respect to which the Company or such Subsidiary takes any action to indicate its approval of or consent to; 61 (i) (i) Any event, condition or circumstance or set of events, conditions or circumstances or any change has occurred or is reasonably expected to occur which (A) has or could reasonably be expected to have a material adverse effect upon or change in the validity or enforceability of this Agreement, the Note, the Subsidiaries' Guarantee or the PMR Guarantee (if any), (B) has been or could reasonably be expected to be material and adverse to the business, operations, prospects, properties, assets, liabilities or condition of the Company and/or any Subsidiary, either individually or taken as a whole, or (C) has materially impaired or could reasonably be expected to materially impair the ability of the Company, any Subsidiary or PMR Corporation, as the case may be, to perform the Obligations or to consummate the transactions under this Agreement, the Note, the Subsidiary and the PMR Guarantee (if any), as the case may be, (ii) any Liability Event occurs or is reasonably expected to occur, which results or is reasonably expected to result in a liability of the Company or any Subsidiary in excess of $100,000, or (iii) the Company or any Subsidiary ceases any portion of its business operations as currently conducted; (j) The Purchaser or any Holder receives any indication or evidence that the Company or any Subsidiary may have directly or indirectly been engaged in any type of activity which, in the Purchaser's judgment, might result in forfeiture of any property to any Governmental Authority which shall have continued unremedied for a period of 10 days after written notice from the Purchaser; (k) The issuance of any process for levy, attachment or garnishment or execution in an aggregate amount in excess of $100,000 upon or prior to any judgment against the Company or any Subsidiary or any of their property or assets; or (l) The Company or any Subsidiary does, or enters into or becomes a party to any agreement or commitment to do, or cause to be done, any of the things described in this Article XI or otherwise prohibited by this Agreement, the Note, the Subsidiaries' Guarantee or the PMR Guarantee (if any) (subject to any cure periods set forth therein); then, and in any such event, notwithstanding any other provision of this Agreement, the Note, the Subsidiaries' Guarantee and the PMR Guarantee (if any), the Purchaser and any Holder of the Note may, by notice to the Company (i) terminate their obligations to make Additional Loans hereunder, whereupon the same shall immediately terminate, (ii) declare all or any of the loans made under the Note, all interest thereon and all other Obligations to be due and payable immediately (except in the case of an Event of Default under Section 11.1(d), (g), (h) or (i)(ii), in which event all of the foregoing shall automatically and without further act by the Purchaser be due and payable), in each case without presentment, demand, protest or further notice of any kind, all of which are hereby expressly waived by the Company, and (iii) prohibit any action permitted to be taken under Article X. 11.2 Rights and Remedies. In addition to the acceleration provisions set forth in Section 11.1, upon the occurrence and continuation of an Event of Default, the Purchaser and any Holder of the Note shall have the right to exercise any and all rights, 62 options and remedies provided for in this Agreement, the Note, the Subsidiaries' Guarantee and the PMR Guarantee (if any) at law or in equity and/or in any other appropriate proceeding either for specific performance or in aid of the exercise of any power granted in this Agreement, the Note, the Subsidiaries' Guarantee or the PMR Guarantee (if any), including, without limitation, the right to (i) apply any property of the Company held by the Purchaser, for the benefit of any Holder of the Note, to reduce the Obligations, and (ii) reduce or otherwise change the maximum aggregate principal amount of Additional Loans under the Note which have not yet been made hereunder. Notwithstanding any provision of this Agreement, the Note, the Subsidiaries' Guarantee or the PMR Guarantee (if any), the Purchaser and any Holder of the Note, in their sole discretion, shall have the right, at any time that the Company fails to do so, and from time to time, without prior notice, to pay for the performance of any of the Obligations. Such expenses and advances shall be added to the Obligations until reimbursed to the Purchaser and any Holder of the Note, and such payments by the Purchaser and any Holder of the Note shall not be construed as a waiver by the Purchaser and any Holder of the Note of any Event of Default or any other rights or remedies of the Purchaser and any Holder of the Note. 11.3 Rights and Remedies not Exclusive. The Purchaser and any Holder of the Note shall have the right in their sole discretion to determine which rights and/or remedies they may at any time pursue, relinquish, subordinate or modify, and such determination will not in any way modify or affect any of the Purchaser's or any other Holder's rights or remedies under this Agreement, the Note, the Subsidiaries' Guarantee or the PMR Guarantee (if any), applicable law or equity. The enumeration of any rights and remedies in this Agreement, the Note, the Subsidiaries' Guarantee and the PMR Guarantee (if any) is not intended to be exhaustive, and all rights and remedies of the Purchaser and the Holder of the Note described in this Agreement, the Note, the Subsidiaries' Guarantee and the PMR Guarantee (if any) are cumulative and are not alternative to or exclusive of any other rights or remedies which the Purchaser and any Holder of the Note otherwise may have. The partial or complete exercise of any right or remedy shall not preclude any other further exercise of such or any other right or remedy. ARTICLE XII REDEMPTION OF THE NOTES The Company shall redeem the entire outstanding principal (together with accrued interest and premium), if any, on the Note in accordance with the "Mandatory Redemption at the Option of the Holder" and "Mandatory Redemption at Maturity" provisions set forth in Sections 3 and 5 of the Note. The Company may prepay outstanding principal (together with accrued interest) on the Note only if the Note is prepaid in accordance with the "Optional Redemption" provisions set forth in Section 4 of the Note. 63 ARTICLE XIII REDEMPTION OF WARRANTS 13.1 Holder's Right to Require Redemption. The Company hereby covenants and agrees with the Purchaser and each Holder of Warrants or the shares of Common Stock issued upon the exercise of the Warrants that: (a) Upon the earliest to occur of (i) a Prepayment Event, (ii) all or any portion of the Obligations becoming due and payable pursuant to Section 11.2 and (iii) the sixth anniversary of the Initial Closing Date, the Purchaser, on behalf of the Holders of Warrants, may at any time by notice to the Company (a "Demand Notice") require the Company to redeem (unless otherwise prevented by law) all of the outstanding Warrants, and the shares of Common Stock issued upon exercise of the Warrants, held by the Holders at a purchase price equal to the Fair Market Value per share of Common Stock (less, in the case of the Warrants, the Exercise Price (as defined in the Warrants) for each such share) at the time multiplied by the number of such shares of Common Stock issuable or issued upon the exercise of the Warrants (the "Put Price") in cash, in immediately available funds payable upon actual delivery to the Company or the Company's transfer agent of the Warrants and the share certificates representing the shares of Common Stock issued upon exercise of the Warrants, as the case may be; provided, however, that the Company's payment of the Put Price in cash is approved by CapitalSource under the Credit Agreement. The Company shall promptly notify all Holders as to whether such approval of CapitalSource under the Credit Agreement has been obtained. Within 20 days following receipt of a Demand Notice, the Company shall give notice (a "Required Redemption Notice") to all registered holders of Warrants and shares of Common Stock issued upon the exercise of the Warrants who did not participate in the Demand Notice (the "Nonparticipating Holders") that the Company has received a Demand Notice and shall inform each such Nonparticipating Holder that it has the right under this Section 13.1(a) to include in the redemption any or all of its Warrants and shares of Common Stock issued upon exercise of the Warrants held by such holder by giving the Company written notice of its desire to participate within 15 days following receipt of the Company's Required Redemption Notice. Notice of a request for redemption pursuant to this Section 13.1 shall be sent in accordance with Section 15.2. If the Company is obligated pursuant to this Section 13.1 to redeem Warrants and/or shares of Common Stock issued upon exercise of the Warrants, the Company shall redeem the Warrants and/or shares of Common Stock issued upon exercise of the Warrants participating in such demand no later than 10 Business Days after completion of the valuation procedure described in Section 13.1(c) (the "Redemption Date"). At any time on or after the Redemption Date, the participating holders of Warrants and shares of Common Stock issued upon exercise of the Warrants shall be entitled to receive payment of the Put Price in cash in immediately available funds upon the actual delivery to the Company or its transfer agent of their Warrants or share certificates representing the shares of Common Stock issued upon exercise of the Warrants. Notice of a Prepayment Event shall be mailed no more than 20 Business Days prior to the occurrence of a Prepayment Event to each Holder of Warrants and shares of Common Stock issued upon exercise of the Warrants, at such Holder's address as it appears on the transfer books of 64 the Company. The Redemption Date shall be fixed by the Company in the notice and shall be on or prior to the consummation of the Prepayment Event; provided, however, that the Company shall not be required to redeem the Warrants and the shares of Common Stock issued upon exercise of the Warrants, unless such Prepayment Event shall be consummated, in which case the Company shall be required to redeem the Warrants and shares of Common Stock issued upon exercise of the Warrants immediately prior to or simultaneously with the consummation of such transaction. (b) If the Company fails to pay the Put Price in cash because under applicable law it is prevented from making such payment or because it does not obtain the requisite approval of CapitalSource under the Credit Agreement to make such payment, the Company's obligation to pay the Put Price shall remain in full force and effect as a senior subordinated obligation of the Company payable on the earlier of (i) the first anniversary of the Demand Notice or (ii) the Maturity Date (as defined in the Note purchased pursuant hereto), accruing interest at the rate of 18% per annum, compounded quarterly, calculated using twelve thirty day months and a 360 day year, payable-in-kind quarterly in arrears, prepayable at any time without premium, and otherwise on terms substantially similar to the terms of the Note (the "Put Price Notes"). The Put Price Notes shall be unconditionally guaranteed by PMR Corporation if the PMR Merger has been consummated; provided, however, that the Put Price Notes and the guarantee thereof by PMR Corporation shall be subordinated to the Indebtedness under the Credit Agreement on the terms set forth in the Subordination Agreement. The form and substance of the Put Price Notes and the guarantee thereof by the Company shall be reasonably acceptable to the Purchaser. The Company shall use reasonable best efforts (i) to obtain the approval of CapitalSource under the Credit Agreement to payment of the Put Price in cash and (ii) to overcome any legal obstacle to making payment of the Put Price. Neither the Company nor any Subsidiary shall enter into any loan or other agreement which contains provisions that, or amend or modify any loan or other agreement to include provisions that restrict or prohibit the ability of the Company to issue the Put Price Notes. (c) As used in this Section 13.1, "Fair Market Value" shall mean the amount which a willing buyer, under no compulsion to buy, would pay a willing seller, under no compulsion to sell, in an arm's-length transaction to a third party which is not an Affiliate of the Company treating the Company and the Subsidiaries as a going concern and without regard to (i) the lack of liquidity of Common Stock due to any restrictions or other limitations contained in this Agreement, the Investor Rights Agreement, the Co-Sale Agreement, the Voting Agreement, the Warrants or otherwise, (ii) any discount for minority interests, (iii) the fact that some of the issued and outstanding shares of Common Stock may not have any voting rights or may not have full voting rights, (iv) the fact that one or more of the holders of Common Stock may be unable to exercise in full any of its voting rights due to regulatory, contractual or other restrictions, or (v) the fact that contractual or regulatory approvals, consents, waivers, licenses, permits or notifications may need to be obtained in connection with such sale and the time required to obtain the same and without any reduction to such price attributable to management fees, option costs and other similar fees and expenses. The Fair Market Value shall be determined, in the first instance, by a negotiation between the 65 Company and the Holders affected by such determination, and if such negotiation has not reached a determination acceptable to all negotiating parties within 10 Business Days after commencing such negotiation (or such other period as all the negotiating parties agree), then the Fair Market Value shall be determined by an independent, national recognized valuation expert selected by the Holders of a majority of the shares of Common Stock issued or issuable that are being put to the Company under this Section 13.1 (and reasonably acceptable to the Company), acting in a diligent and prompt manner and at the Company's expense. Upon the determination of Fair Market Value by a valuation expert, the Company shall promptly give notice thereof to all Holders of Warrants and Common Stock issued upon exercise of the Warrants, setting forth in reasonable detail the method and basis of determination of such Fair Market Value. Such determination shall be binding on the Company and the Holders. The Company shall provide the valuation expert with all information about the Company and the Subsidiaries which such valuation expert reasonably deems necessary for determining the Fair Market Value. ARTICLE XIV SUBORDINATION The payment obligations under this Agreement and the Note shall at all times be wholly subordinate and junior in right of payment to the Indebtedness under the Senior Debt Documents to the extent and in the manner provided in the Subordination Agreement. ARTICLE XV MISCELLANEOUS 15.1 Survival of Provisions. All of the representations and warranties made herein shall survive the execution and delivery of this Agreement, any investigation by or on behalf of the Purchaser or any Affiliate, acceptance of the Note, the Warrants and shares of Common Stock issued pursuant to the exercise of the Warrants and payment therefor, payment of the Note upon redemption, prepayment or otherwise, exercise of the Warrants and the termination of this Agreement. 15.2 Notices. All notices, demands and other communications provided for or permitted hereunder shall be made in writing and shall be by registered or certified first-class mail, return receipt requested, telecopier, courier services or personal delivery to the following addresses, or to such other addresses as shall be designated from time to time by a party in accordance with this Section 15.2: 66 (a) if to the Purchaser: The 1818 Mezzanine Fund II, L.P. c/o Brown Brothers Harriman & Co. 59 Wall Street New York, New York 10005 Attention: Joseph P. Donlan Telecopier No.: (212) 493-8429 with a copy to: Paul, Weiss, Rifkind, Wharton & Garrison 1285 Avenue of the Americas New York, New York 10019-6064 Attention: Marilyn Sobel, Esq. Telecopier No.: (212) 757-3990 (b) if to the Company: Psychiatric Solutions, Inc. 113 Seaboard Lane, Suite C-100 Franklin, TN 37067 Attention: Chief Executive Officer Telecopier No.: (615) 312-5711 with a copy to: Harwell Howard Hyne Gabbert & Manner, P.C. 315 Deaderick Street, Suite 1800 Nashville, TN 37238 Attention: Lee C. Dilworth, Esq. Telecopier No.: (615) 251-1059 All such notices and communications shall be deemed to have been duly given: when delivered by hand, if personally delivered; when delivered to a courier, if delivered by commercial overnight courier service; five Business Days after being deposited in the mail, postage prepaid, if mailed; and when receipt is acknowledged, if telecopied. 15.3 Successors and Assigns. This Agreement shall inure to the benefit of and be binding upon the successors and permitted assigns and permitted transferees of the parties hereto. Except as provided in Article VII, no Person other than the parties hereto and their successors and permitted assigns is intended to be a beneficiary of this Agreement, the Note and the Warrants. 67 15.4 Assignments. (a) The Company may not assign any of its rights or obligations under this Agreement without the written consent of the Purchaser. (b) The Purchaser and any subsequent Holder of the Note or any Warrants may, at any time or from time to time, sell, agree to sell or assign to one or more other Persons who agree to be bound by all of the terms of this Agreement and the terms of the Note or Warrant Certificates, as the case may be, all or any portion of the Note or any Warrant Certificate. In the event of any such sale or assignment of the Note, upon surrender for exchange of the Note at the office of the Company designated for notices in accordance with Section 15.2, the Company shall execute and deliver in exchange therefor, without expense to the holder, one or more new Notes in the same aggregate principal amount as the then unpaid principal amount of the Note so surrendered as such holder shall specify, dated as of the date to which interest has been paid on the Note so surrendered (or, if no interest has been paid, the date of such surrendered Note), in the name of such Person or Persons as may be designated by such holder in writing, and otherwise of the same form and tenor as the Note so surrendered for exchange. Every Note surrendered for transfer shall be duly endorsed, or accompanied by a written instrument of transfer duly executed by the holder of such Note or its attorney duly authorized in writing. Any sale or assignment of a Warrant Certificate shall be in accordance with the provisions of Section 7 of the Warrant Certificate. 15.5 Amendment and Waiver. (a) No failure or delay on the part of any Holder, in exercising any right, power or remedy hereunder shall operate as a waiver thereof, nor shall any single or partial exercise of any such right, power or remedy preclude any other or further exercise thereof or the exercise of any other right, power or remedy. The remedies provided for herein are cumulative and are not exclusive of any remedies that may be available to any Holder of the Note or any Warrant at law, in equity or otherwise. (b) Any amendment, supplement or modification of or to any provision of this Agreement, any waiver of any provision of this Agreement and any consent to any departure by the Company from the terms of any provision of this Agreement, shall be effective (i) only if it is made or given in writing and signed by the Company and (x) holders of a majority of the aggregate principal amount of the loans made under the Note and (y) holders of a majority of the shares of Common Stock issued or issuable upon the exercise of the Warrants, and (ii) only in the specific instance and for the specific purpose for which made or given. (c) Any amendment, supplement or modification of or to any provision of the Note, any waiver of any provision of the Note, and any consent to any departure by the Company from the terms of any provision of the Note, shall be effective (i) only if it is made or given in writing and signed by the Company and the holders of a majority of the aggregate principal amount of the loans made under the Note, and 68 (ii) only in the specific instance and for the specific purpose for which made or given; provided, however, that without the consent of each holder of the Note affected, an amendment may not: (A) reduce the rate of or extend the time for payment of interest on the Note; (B) reduce the principal of or extend the maturity of the Note; (C) change the time at which the Note shall or may be prepaid in accordance with the terms of the Note; (D) make the Note payable in money other than that stated in the Note; or (E) make any change to this Section 15.5(c). Except where notice is specifically required by this Agreement, no notice to or demand on the Company in any case shall entitle the Company to any other or further notice or demand in similar or other circumstances. 15.6 Counterparts. This Agreement may be executed in any number of counterparts and by the parties hereto in separate counterparts, each of which when so executed shall be deemed to be an original and all of which taken together shall constitute one and the same agreement. 15.7 Headings. The headings in this Agreement are for convenience of reference only and shall not limit or otherwise affect the meaning hereof. 15.8 Determinations. Except to the extent that any provision herein expressly requires that a determination be reasonable or a consent not be unreasonably withheld, or be subject to qualifications to a similar effect, all determinations to be made by the Company, the Purchaser or any Holder hereunder in its opinion or judgment or with its approval or otherwise shall be made by it in its sole discretion. 15.9 Governing Law. This Agreement has been negotiated, executed and delivered in the State of New York, and shall be governed by and construed in accordance with the law of the State of New York, without regard to principles of conflicts of law thereof. 15.10 Jurisdiction. Each party to this Agreement hereby irrevocably agrees that any legal action or proceeding arising out of or relating to this Agreement or any agreements or transactions contemplated hereby may be brought in the courts of the State of New York located in New York City or of the United States of America for the Southern District of New York and hereby expressly submits to the personal jurisdiction and venue of such courts for the purposes thereof and expressly waives any claim of improper venue and any claim that such courts are an inconvenient forum. Each party hereby irrevocably consents to the service of process of any of the aforementioned courts pursuant to a contractual provision in any such suit, action or proceeding by the mailing of copies thereof by registered or certified mail, postage prepaid, to the address set forth in Section 15.2, such service to become effective 10 days after such mailing. TO THE EXTENT NOT PROHIBITED BY APPLICABLE LAW WHICH CANNOT BE WAIVED, EACH PARTY HEREBY WAIVES, AND COVENANTS THAT IT WILL NOT ASSERT (WHETHER AS PLAINTIFF, DEFENDANT OR OTHERWISE), ANY RIGHT TO TRIAL BY JURY IN ANY FORUM IN RESPECT OF ANY ISSUE, CLAIM, DEMAND, ACTION, OR CAUSE OF ACTION ARISING OUT OF OR 69 BASED UPON THIS AGREEMENT OR THE SUBJECT MATTER HEREOF OR ANY FUNDAMENTAL DOCUMENT, IN EACH CASE WHETHER NOW EXISTING OR HEREAFTER ARISING OR WHETHER IN CONTRACT OR TORT OR OTHERWISE. 15.11 Severability. In the event that any one or more of the provisions contained herein, or the application thereof in any circumstance, is held invalid, illegal or unenforceable in any respect for any reason, the validity, legality and enforceability of any such provision in every other respect and of the remaining provisions hereof shall not be in any way impaired, unless the provisions held invalid, illegal or unenforceable shall substantially impair the benefits of the remaining provisions hereof. 15.12 Rules of Construction. Unless the context otherwise requires, "or" is not exclusive, and references to sections or subsections refer to sections or subsections of this Agreement. 15.13 Remedies. If a breach of this Agreement, the Note or the Warrant Certificates by the Company occurs and is continuing, the Purchaser or any Holder of the Note or any Warrant Certificate may pursue any available remedy by proceeding at law or in equity to enforce the performance (including, without limitation, the specific performance) of any provision of this Agreement or the Note or Warrant Certificate. The Purchaser or any Holder of the Note or Warrant Certificate may maintain a proceeding even if it does not possess the Note or Warrant Certificate or does not produce any of them in the proceeding. Except as otherwise provided by law, a delay or omission by the Purchaser or any Holder of the Note or any Warrant Certificate in exercising any right or remedy accruing upon any such breach shall not impair the right or remedy or constitute a waiver of or acquiescence in any such breach. No remedy is exclusive of any other remedy. All available remedies are cumulative. 15.14 Entire Agreement. This Agreement, together with the exhibits and schedules hereto, and the other Transaction Documents are intended by the parties as a final expression of their agreement and intended to be a complete and exclusive statement of the agreement and understanding of the parties hereto and thereto in respect of the subject matter contained herein and therein. There are no restrictions, promises, warranties or undertakings, other than those set forth or referred to herein or therein. This Agreement, together with the exhibits and schedules hereto, and the other Transaction Documents supersede all prior agreements and understandings among the parties with respect to such subject matter. 15.15 Attorneys' Fees. In any action or proceeding brought to enforce any provision of this Agreement or any other of the Transaction Documents or any other document or instrument contemplated hereby or thereby, or where any provision hereof or thereof is validly asserted as a defense, the successful party shall be entitled to recover reasonable attorneys' fees, charges and disbursements in addition to any other available remedy. 70 15.16 Publicity. Except as may be required by applicable law, no party hereto shall issue a publicity release or announcement or otherwise make any public disclosure concerning this Agreement or the transactions contemplated hereby, without prior approval by the other parties hereto. If any announcement is required by law to be made by a party hereto, prior to making such announcement such party will deliver a draft of such announcement to the other parties and shall give the other parties an opportunity to comment thereon. 15.17 Expenses. The Company acknowledges and agrees that whether or not the transactions contemplated by the Transaction Documents are consummated, it shall reimburse (a) the Purchaser for (i) all reasonable legal fees, expenses and disbursements of PWRW&G and Benesch, Friedlander, Coplan & Aronoff LLP, (ii) all of its reasonable out-of-pocket expenses and (iii) all reasonable expenses of accounting and/or other advisors to the Purchaser relating to its review of the Company's accounting and management information systems, incurred in connection with the due diligence process and the negotiation, execution and delivery of this Agreement and the other Transaction Documents, (b) the Purchaser for all reasonable out-of-pocket expenses of the Purchaser in connection with monitoring the transactions contemplated by the Transaction Documents following the Initial Closing and (c) the Purchaser for all reasonable out-of-pocket expenses and the reasonable legal fees and expenses of legal counsel in connection with any (i) Additional Closing and (ii) amendment, supplement, modification or waiver of or to any provision of this Agreement and the other Transaction Documents following the Initial Closing. The fees and expenses set forth in Sections 15.17(a) and 15.7(c)(i) shall be paid by the Company at the Initial Closing or Additional Closing, as applicable, and the fees and expenses set forth in Sections 15.17(b) and 15.17(c)(ii) shall be paid by the Company as incurred by the Purchaser. 15.18 Further Assurances. Each of the parties hereto agrees that, except as otherwise provided in this Agreement and subject to its legal obligations, it will use its reasonable best efforts to fulfill all conditions precedent specified herein, and to do all things reasonably necessary to consummate the transactions contemplated hereby. [Remainder of page intentionally left blank.] 71 IN WITNESS WHEREOF, the parties hereto have caused this Securities Purchase Agreement to be executed and delivered as an instrument under seal by their respective officers or partners hereunto duly authorized as of the date first above written. PSYCHIATRIC SOLUTIONS, INC. By: /s/ Steven T. Davidson ----------------------------------- Name: Steven T. Davidson Title: Chief Development Officer THE 1818 MEZZANINE FUND II, L.P. By: Brown Brothers Harriman & Co., General Partner By: /s/ Joseph P. Donlan ----------------------------------- Name: Joseph P. Donlan Title: Managing Director 72 EX-10.19 10 g76727a1exv10w19.txt WARRANT TO PURCHASE SHARES EXHIBIT 10.19 THIS WARRANT AND THE SECURITIES ISSUABLE UPON EXERCISE HEREOF HAVE BEEN TAKEN FOR INVESTMENT AND HAVE NOT BEEN REGISTERED, UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"), OR ANY APPLICABLE STATE SECURITIES LAWS AND MAY NOT BE SOLD OR OTHERWISE TRANSFERRED BY ANY PERSON, INCLUDING A PLEDGEE, UNLESS (1) EITHER (A) A REGISTRATION STATEMENT WITH RESPECT THERETO SHALL BE EFFECTIVE UNDER THE SECURITIES ACT, OR (B) AN EXEMPTION FROM REGISTRATION UNDER THE SECURITIES ACT IS THEN AVAILABLE AND (2) THERE SHALL HAVE BEEN COMPLIANCE WITH ALL APPLICABLE STATE SECURITIES OR "BLUE SKY" LAWS. WARRANT NO. 1 June 28, 2002 WARRANT TO PURCHASE SHARES OF COMMON STOCK, PAR VALUE $.01 PER SHARE, OF PSYCHIATRIC SOLUTIONS, INC. THIS IS TO CERTIFY THAT THE 1818 MEZZANINE FUND II, L.P., a Delaware limited partnership, or its permitted registered assigns (the "Holder"), is the owner of One Million Five Hundred Two Thousand One Hundred Forty (1,502,140) Warrants (the "Warrants"), each of which entitles the registered holder thereof to purchase from Psychiatric Solutions, Inc., a Delaware corporation (the "Company"), one fully paid, duly authorized and nonassessable share of Common Stock (as defined in Section 13 hereof) of the Company, at any time or from time to time on or before 5:00 p.m., New York City time, on the tenth anniversary of the Issue Date (the "Warrant Expiration Date"), at an exercise price of $.01 per share (the "Exercise Price"), all on the terms and subject to the conditions hereinafter set forth. The number of shares of Common Stock issuable upon exercise of each such Warrant (the "Number Issuable"), which is initially one (1) share, is subject to adjustment from time to time pursuant to the provisions of Section 2 of this Warrant Certificate. Capitalized terms used herein but not otherwise defined shall have the meanings given to such terms in Section 13 hereof. Section 1. Exercise of Warrant. The Warrants evidenced hereby may be exercised, in whole or in part, by the Holder hereof at any time or from time to time on or before 5:00 p.m., New York City time, on the Warrant Expiration Date, upon delivery to the Company at the principal executive office of the Company in the United States of America, of (a) this Warrant Certificate, (b) a written notice stating that such Holder elects to exercise the Warrants evidenced hereby in accordance with the provisions of this Section 1 and specifying the number of Warrants being exercised and the name or names in which such Holder wishes the certificate or certificates for shares of Common Stock to be issued and (c) payment of the Exercise Price for the shares of Common Stock issuable upon such exercise of such Warrants, which shall be payable by any one or any combination of (i) cash, (ii) certified or official bank check payable to the order of the Company, (iii) the surrender (which surrender shall be evidenced by cancellation of the number of Warrants represented by any Warrant Certificate presented in connection with a Cashless Exercise (as defined below)) of Warrants (represented by one or more relevant Warrant Certificates), without the payment of the Exercise Price in cash, in return for the delivery to the surrendering holder of such number of shares of Common Stock equal to the number of shares of Common Stock for which such Warrant is requested to be exercised (if the Exercise Price were being paid in cash or certified or official bank check) reduced by that number of shares of Common Stock equal to the quotient obtained by dividing (x) the aggregate Exercise Price to be paid by (y) the Market Price of one share of Common Stock on the Business Day which next precedes the day of exercise of the Warrants, or (iv) by the delivery of shares of Common Stock having a value (as defined by the next sentence) equal to the aggregate Exercise Price to be paid that are either held by the Holder or are acquired in connection with such exercise, and without payment of the Exercise Price in cash. Any share of Common Stock delivered as payment of the Exercise Price in connection with an In-Kind Exercise (as defined below) shall be deemed to have a value equal to the Market Price of one share of Common Stock on the Business Day which next precedes the day of exercise of the Warrants. An exercise of the Warrants in accordance with clause (iii) above is herein referred to as a "Cashless Exercise" and an exercise of the Warrants in accordance with clause (iv) is herein referred to as an "In Kind Exercise." The documentation and consideration, if any, delivered in accordance with subsections (a), (b) and (c) above are collectively referred to herein as the "Warrant Exercise Documentation." As promptly as practicable, and in any event within five Business Days after receipt of the Warrant Exercise Documentation, the Company shall deliver or cause to be delivered (a) certificates representing the number of validly issued, fully paid and nonassessable shares of Common Stock specified in the Warrant Exercise Documentation, (b) if applicable, cash in lieu of any fraction of a share, as hereinafter provided, and (c) if less than the full number of Warrants evidenced hereby are being exercised or used in a Cashless Exercise, a new Warrant Certificate or Certificates, of like tenor, for the number of Warrants evidenced by this Warrant Certificate, less the number of Warrants then being exercised or used in a Cashless Exercise. Such exercise shall be deemed to have been made at the close of business on the date of delivery of the Warrant Exercise Documentation so that the Person entitled to receive shares of Common Stock upon such exercise shall be treated for all purposes as having become the record holder of such shares of Common Stock at such time. No such surrender shall be effective to constitute the person entitled to receive such shares as the record holder thereof while the transfer books of the Company for the Common Stock are closed for any purpose (but not 2 for any period in excess of five days); but any such surrender of this Warrant Certificate for exercise during any period while such books are so closed shall become effective for exercise immediately upon the reopening of such books, as if the exercise had been made on the date this Warrant Certificate was surrendered and for the Number Issuable of Common Stock specified in the Warrant Exercise Documentation and at the Exercise Price. The Company shall pay all expenses in connection with, and all taxes and other governmental charges (other than income taxes of the holder) that may be imposed in respect of, the issue or delivery of any shares of Common Stock issuable upon the exercise of the Warrants evidenced hereby. The Company shall not be required, however, to pay any tax or other charge imposed in connection with any transfer involved in the issue of any certificate for shares of Common Stock in any name other than that of the registered holder of the Warrants evidenced hereby. In connection with the exercise of any Warrants evidenced hereby, no fractions of shares of Common Stock shall be issued, but in lieu thereof the Company shall pay a cash adjustment in respect of such fractional interest in an amount equal to such fractional interest multiplied by the Current Market Price per share of Common Stock on the Business Day which next precedes the day of exercise. If more than one such Warrant shall be exercised by the Holder thereof at the same time, the number of full shares of Common Stock issuable on such exercise shall be computed on the basis of the total number of Warrants so exercised. All certificates representing the shares of Common Stock issued upon exercise of the Warrants shall bear legends substantially as follows: THE SECURITIES REPRESENTED BY THIS CERTIFICATE HAVE BEEN TAKEN FOR INVESTMENT AND HAVE NOT BEEN REGISTERED, UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"), OR ANY APPLICABLE STATE SECURITIES LAWS AND MAY NOT BE SOLD OR OTHERWISE TRANSFERRED BY ANY PERSON, INCLUDING A PLEDGEE, UNLESS (1) EITHER (A) A REGISTRATION STATEMENT WITH RESPECT THERETO SHALL BE EFFECTIVE UNDER THE SECURITIES ACT, OR (B) AN EXEMPTION FROM REGISTRATION UNDER THE SECURITIES ACT IS THEN AVAILABLE AND (2) THERE SHALL HAVE BEEN COMPLIANCE WITH ALL APPLICABLE STATE SECURITIES OR "BLUE SKY" LAWS. Section 2. Adjustments. (a) Adjustment of Number Issuable. The Number Issuable shall be subject to adjustment from time to time as follows: 3 (i) In case the Company shall at any time or from time to time after the Issue Date: (A) issue shares of the Capital Stock of the Company as a dividend or other distribution on the outstanding shares of Common Stock; (B) subdivide the outstanding shares of Common Stock into a larger number of shares; (C) combine the outstanding shares of Common Stock into a smaller number of shares; or (D) issue any shares of its Capital Stock in a reclassification of the Common Stock; then, and in each such case, the Number Issuable in effect immediately prior to such event shall be adjusted (and any other appropriate actions shall be taken by the Company) so that the holder of any Warrants evidenced hereby thereafter exercised shall be entitled to receive the number of shares of Common Stock or other securities of the Company which such holder would have owned or had been entitled to receive upon or by reason of any of the events described above, had such Warrants been exercised immediately prior to the happening of such event. An adjustment made pursuant to this clause (i) shall be effective (x) in the case of any such dividend or distribution, on the date immediately following the close of business on the record date for the determination of holders of shares of Common Stock entitled to receive such dividend or distribution, or (y) in the case of any such subdivision, combination or reclassification, at the close of business on the date upon which such corporate action becomes effective. (ii) If after the Issue Date, the Company shall at any time or from time to time issue or sell (x) shares of Common Stock or (y) securities convertible into or exchangeable for shares of Common Stock, or any options, warrants or other rights to acquire shares of Common Stock (excluding any additional warrants issued in connection with any Additional Closing (as defined in the Securities Purchase Agreement) pursuant to the terms of the Securities Purchase Agreement), at a price per share that is less than the Current Market Price per share of Common Stock then in effect as of the record date or issue date, as the case may be, referred to in the following sentence (the "Relevant Date") (treating the price per share of Common Stock, in the case of the issuance of any security convertible into, or exchangeable or exercisable for, shares of Common Stock as equal to (x) the sum of the price for such security convertible into, or, exchangeable or exercisable for, shares of Common Stock plus any additional consideration payable (without regard to any anti-dilution adjustments) upon the conversion, exchange or exercise of such security into shares of Common Stock divided by (y) the number of shares of Common Stock initially underlying such convertible, exchangeable or exercisable security), in each case, other than issuances or sales for which an adjustment is made pursuant to another paragraph of this Section 2, then, and in each such case, the Number Issuable then in effect shall be adjusted by multiplying the 4 Number Issuable in effect on the day immediately prior to the Relevant Date by a fraction, (1) the numerator of which shall be the sum of the number of shares of Common Stock outstanding on the Relevant Date, plus the number of additional shares of Common Stock issued or to be issued (or the maximum number into which such convertible or exchangeable securities initially may convert or exchange or for which such options, warrants or other rights initially may be exercised), and (2) the denominator of which shall be the sum of the number of shares of Common Stock outstanding on the Relevant Date, plus the number of shares of Common Stock which the aggregate consideration (plus the aggregate amount of any additional consideration initially payable upon conversion, exchange or exercise of such security) for the total number of such additional shares of Common Stock so issued (or into which such convertible or exchangeable securities may convert or exchange or for which such options, warrants or other rights may be exercised) would purchase at the Current Market Price per share of Common Stock on the Relevant Date. Such adjustment shall be made whenever such shares, securities, options, warrants or other rights are issued, and shall become effective retroactively to a date immediately following the close of business (x) in the case of an issuance to the stockholders of the Company, as such, on the record date for the determination of stockholders entitled to receive such shares, securities, options, warrants or other rights and (y) in all other cases, on the date (the "issue date") of such issuance. Solely for purposes of this clause (ii), (I) Common Stock shall include the Common Stock, par value $.01 per share, of the Company and each other class of Capital Stock of the Company that does not have a preference over any other class of Capital Stock of the Company as to dividends or upon liquidation, dissolution or winding up of the Company and, in each case, shall include any other class of Capital Stock of the Company into which such stock is reclassified or reconstituted and (II) if the provisions of any securities convertible into or exchangeable for shares of Common Stock or options, warrants or other rights to acquire shares of Common Stock are amended after the date of issuance so as to (directly or indirectly) reduce the applicable conversion price, exchange price or exercise price such amendment shall be deemed to be a new issuance of such securities as of the date of such amendment. (iii) In case the Company shall at any time or from time to time after the Issue Date distribute to any holder of shares of its Common Stock in respect of such shares (including any such distribution made in connection with a consolidation or merger in which the Company is the resulting or surviving corporation and the Common Stock is not changed or exchanged) cash, evidences of indebtedness of the Company or another issuer, securities of the Company or another issuer or other assets (excluding dividends or other distributions of shares of Common Stock or other Capital Stock for which adjustment is made under Section 2(a)(i) or dividends or other distributions received by or set aside for the benefit of the holders of Common Stock pursuant to Section 2(c) below) or rights or warrants to subscribe for or purchase securities of the Company (excluding those in respect of which adjustments in the Number Issuable is made pursuant to Section 2(a)(i) or Section 2(a)(ii)), then, and in each such case, the Number Issuable then in effect shall be adjusted by multiplying the Number Issuable in effect immediately prior to the date of such distribution by a fraction (x) the numerator of which shall be the Current Market Price per share of Common Stock on the record date referred to below and (y) the denominator of which shall be such Current Market Price 5 per share of Common Stock less the then Fair Market Value (as determined in good faith by the Board of Directors of the Company, a certified resolution with respect to which shall be mailed to the holder of the Warrants evidenced hereby) of the portion of the cash, evidences of indebtedness, securities or other assets so distributed or of such subscription rights or warrants applicable to one share of Common Stock (but such denominator shall in no event be zero). Such adjustment shall be made whenever any such distribution is made and shall become effective retroactively to a date immediately following the close of business on the record date for the determination of stockholders entitled to receive such distribution. (iv) In case the Company at any time or from time to time shall take any action which could have a dilutive effect on the number of shares of Common Stock that may be issued upon exercise of the Warrants, other than an action described in any of Section 2(a)(i) through 2(a)(iii), inclusive, or Section 2(b) or 2(c), then, the Number Issuable shall be adjusted in such manner and at such time as the Board of Directors of the Company reasonably determines to be equitable under the circumstances (such determination to be evidenced in a resolution, a certified copy of which shall be mailed to the holder of the Warrants evidenced hereby). (v) Notwithstanding anything herein to the contrary, no adjustment under this Section 2(a) need be made to the Number Issuable unless such adjustment would require an increase or decrease of at least 1% of the Number Issuable then in effect. Any lesser adjustment shall be carried forward and shall be made at the time of and together with the next subsequent adjustment, which, together with any adjustment or adjustments so carried forward, shall amount to an increase or decrease of at least 1% of such Number Issuable. Any adjustment to the Number Issuable carried forward and not theretofore made shall be made immediately prior to the exercise of any Warrants pursuant hereto. (vi) The Company promptly shall deliver to each registered holder of Warrants at least five Business Days prior to effecting any transaction which would result in an increase or decrease in the Number Issuable pursuant to this Section 2 a notice thereof, together with a certificate, signed by the President or the Chief Executive Officer and by the Treasurer or an Assistant Treasurer or the Secretary or an Assistant Secretary of the Company, setting forth in reasonable detail the event requiring the adjustment and the method by which such adjustment was calculated and specifying the increased or decreased Number Issuable then in effect following such adjustment. (vii) Notwithstanding anything contrary contained in this Section 2(a), the Company shall be entitled to make such upward adjustments in the Number Issuable, in addition to those otherwise required by this Section 2(a), as the Board of Directors of the Company in their discretion shall determine to be advisable in order that any stock dividend, subdivision or combination of shares, distribution of rights or warrants to purchase stock or securities, or distribution of securities convertible into or exchangeable for Common Stock, hereafter made by the Company to its shareholders shall not be taxable; provided, however, that any such adjustment shall be made, as 6 nearly as practicable, in a manner which treats all holders of Warrants with similar protections on an equal basis. (b) Reorganization, Reclassification, Consolidation, Merger or Sale of Assets. In case of any capital reorganization or reclassification or other change of outstanding shares of Common Stock (other than a change in par value, or from par value to no par value, or from no par value to par value, or as a result of a subdivision or combination), or in case of any consolidation or merger of the Company with or into another Person (including without limitation, the PMR Merger), or in case of any sale or other disposition to another Person of all or substantially all of the assets of the Company (any of the foregoing, a "Transaction"), the Company, or such successor or purchasing Person (including, in the case of the PMR Merger, PMR), as the case may be, shall execute and deliver to each holder of the Warrants evidenced hereby, simultaneously with effecting any of the foregoing Transactions, a certificate that such holder of Warrants then outstanding shall have the right thereafter to exercise such Warrants into the kind and amount of shares of stock or other securities (of the Company or another issuer and, in the case of the PMR Merger, of PMR) or property or cash receivable upon such Transaction by a holder of the number of shares of Common Stock into which such Warrants could have been exercised immediately prior to such Transaction. Such certificate shall provide for adjustments which shall be as nearly equivalent as may be practicable to the adjustments provided for in this Section 2 and shall contain other terms substantially identical to the terms hereof. If, in the case of any such Transaction, the stock, other securities, cash or property receivable thereupon by a holder of Common Stock includes shares of stock or other securities of a Person other than the successor or purchasing Persons and other than the Company, which controls or is controlled by the successor or purchasing Person or which, in connection with such Transaction, issues stock, securities, other property or cash to holders of Common Stock, then such certificate also shall be executed by such Person, and such Person shall, in such certificate, specifically assume the obligations of such successor or purchasing Person and acknowledge its obligations to issue such stock, securities, other property or cash to holders of the Warrants upon exercise thereof as provided above. Simultaneously with the consummation of the PMR Merger, the Company shall cause PMR to deliver the certificate referred to in the immediately preceding sentence to each holder of the Warrants evidenced hereby. The provisions of this Section 2(b) similarly shall apply to successive Transactions. (c) PMR Merger. In the event that after the Issue Date the PMR Merger shall occur, the Number Issuable in effect immediately prior to the PMR Merger shall be adjusted so that the holder of any Warrants evidenced hereby thereafter exercised shall be entitled to receive a number of shares, par value $0.01 per share, of common stock of PMR (the "PMR Common Stock") (subject to further adjustment pursuant to the terms of this Warrant Certificate) equal to (x) such holder's Proportionate Percentage (as defined below) multiplied by (y) the number of shares of PMR Common Stock, representing 8.0% of the outstanding shares of PMR Common Stock on a fully diluted basis after giving effect to the transactions contemplated by the Transaction Documents (as defined in the Securities Purchase Agreement), including, without limitation, the PMR Merger, and assuming, without duplication, for purposes of this calculation, (i) the 7 exercise, immediately prior to the consummation of the PMR Merger, of all options under the Company's 1997 Incentive and Nonqualified Stock Option Plan for Key Personnel, (ii) the grant and exercise, immediately prior to the consummation of the PMR Merger, of the options to be granted to existing senior management of the Company to purchase up to 550,000 shares of Common Stock, (iii) the exercise of all options granted under PMR's 1997 Equity Incentive Plan and PMR's Outside Directors' Non-Qualified Stock Option Plan of 1992 as of the consummation of the PMR Merger (but excluding 979,788 options (such number being determined without giving effect to the reverse stock split contemplated to be undertaken by PMR prior to the PMR Merger), all of which have an exercise price per share of PMR Common Stock in excess of $4.00 (such number being determined without giving effect to the reverse stock split contemplated to be undertaken by PMR prior to the PMR Merger) and (iv) the conversion, exercise or exchange of all outstanding securities and securities that have been approved for issuance into shares of PMR Common Stock as of the consummation of the PMR Merger, including, without limitation, all warrants that may be issued under the Securities Purchase Agreement. The "Proportionate Percentage" means, with respect to the holder of any Warrants evidenced hereby, a fraction, the numerator of which equals the number of shares of Common Stock issuable upon exercise of such Warrants immediately prior to the PMR Merger and the denominator of which equals the number of shares of Common Stock issuable upon exercise immediately prior to the PMR Merger of all warrants issuable under the Securities Purchase Agreement (assuming that all such warrants are issued immediately prior to the PMR Merger). (d) Special Distributions. In the event that after the Issue Date the Company shall declare a dividend or make any other distribution (including, without limitation, in cash, in Capital Stock (which shall include, without limitation, any options, warrants or other rights to acquire Capital Stock) of the Company, whether or not pursuant to a shareholder rights plan, "poison pill" or similar arrangement) in other property or assets, to holders of Common Stock (a "Special Distribution"), then the Board of Directors shall, if the holder so elects by sending a Special Notice to the Company, set aside the amount of such dividend or distribution that any holder of Warrants would have been entitled to receive had it exercised such Warrants prior to the record date for such dividend or distribution. Upon the exercise of Warrants evidenced hereby, such electing holder or such holder's subsequent permitted transferee shall be entitled to receive, such dividend or distribution that such holder would have received had such Warrants been exercised immediately prior to the record date for such dividend or distribution. Prior to any Special Distribution described in this Section 2(c), the Company shall as provided in Section 4 hereof notify each holder (not less than ten Business Days prior to the occurrence of such Special Distribution) of its intent to make such Special Distribution and such holder, if it elects to have such distribution set aside the amount thereof rather than have an adjustment to the Number Issuable as provided in Section 2(a)(i) or (iii), shall notify the Company by sending to the Company a Special Notice not less than three (3) Business Days prior to the date of any such Special Distribution. 8 Section 3. Redemption. The Warrants and the shares of Common Stock for which the Warrants are exercisable are subject to the Holder's put right set forth in Article XIII of the Securities Purchase Agreement. Section 4. Notice of Certain Events. In case at any time or from time to time after the Issue Date the Company shall declare any dividend or any other distribution to the holders of its Common Stock, or shall authorize the granting to the holders of its Common Stock of rights or warrants to subscribe for or purchase any additional shares of stock of any class or any other right, or shall authorize the issuance or sale of any other shares or rights which would result in an adjustment to the Number Issuable pursuant to Section 2(a)(i), (ii) or (iii) or would result in a Special Distribution pursuant to Section 2(c) hereof, or there shall be any capital reorganization or reclassification of the Common Stock of the Company or consolidation or merger of the Company with or into another Person, or any sale or other disposition of all or substantially all the assets of the Company, or there shall be a voluntary or involuntary dissolution, liquidation or winding up of the Company, then, in any one or more of such cases the Company shall mail to each holder of the Warrants evidenced hereby at such holder's address as it appears on the transfer books of the Company, as promptly as practicable but in any event at least 15 days prior to the applicable date hereinafter specified, a notice stating (a) the date on which a record is to be taken for the purpose of such dividend, distribution, rights or warrants or, if a record is not to be taken, the date as of which the holders of Common Stock of record to be entitled to such dividend, distribution, rights or warrants are to be determined, (b) the issue date (as defined in Section 2(a)(ii) hereof) or (c) the date on which such reclassification, consolidation, merger, sale, conveyance, dissolution, liquidation or winding up is expected to become effective; provided that in the case of any event to which Section 2(b) applies, the Company shall give at least ten Business Days' prior written notice as aforesaid. Such notice also shall specify the date as of which it is expected that the holders of Common Stock of record shall be entitled to exchange their Common Stock for shares of stock or other securities or property or cash deliverable upon such reorganization, reclassification, consolidation, merger, sale, conveyance, dissolution, liquidation or winding up. Section 5. Certain Covenants. (a) The Company covenants and agrees that all shares of Capital Stock of the Company which may be issued upon the exercise of the Warrants evidenced hereby will be duly authorized, validly issued and fully paid and nonassessable, will be free and clear of any Liens (as defined in the Securities Purchase Agreement) and will not be subject to any preemptive or similar rights that have not been waived. (b) The Company shall at all times reserve and keep available for issuance upon the exercise of the Warrants, such number of its authorized but unissued shares of Common Stock as will from time to time be sufficient to permit the exercise of all outstanding Warrants, and shall take all action required to increase the authorized number of shares of Common Stock if at any time there shall be insufficient authorized but unissued shares of Common Stock to permit such reservation or to permit the exercise of all outstanding Warrants. 9 (c) In the event of a contemplated sale of all or substantially all of the assets or of the Capital Stock of the Company (by way of sale, merger or otherwise, specifically excluding the PMR Merger), the Company, if requested in writing by holders of outstanding Warrants representing a majority of the shares of Common Stock issuable upon the exercise of all outstanding Warrants, shall use its reasonable efforts to cause such transaction to be structured in a manner that requires the purchaser(s) to purchase the outstanding Warrants from such holders at a price equal to the consideration such holders would have received had they had exercised their Warrants immediately prior to the consummation of such sale transaction less the exercise price of such Warrants. Section 6. Registered Holder. The person in whose name this Warrant Certificate is registered shall be deemed the owner hereof and of the Warrants evidenced hereby for all purposes. The registered holder of this Warrant Certificate, in its capacity as such, shall not be entitled to any rights whatsoever as a stockholder of the Company, except as herein provided. Section 7. Transfer of Warrants. Any transfer of the rights represented by this Warrant Certificate shall be effected by the surrender of this Warrant Certificate, along with the form of assignment attached hereto, properly completed and executed by the registered holder hereof, at the principal executive office of the Company in the United States of America, together with an appropriate investment letter, if deemed reasonably necessary by counsel to the Company to assure compliance with applicable securities laws. Thereupon, the Company shall issue in the name or names specified by the registered holder hereof and, in the event of a partial transfer, in the name of the registered holder hereof, a new Warrant Certificate or Certificates evidencing the right to purchase such number of shares of Common Stock as shall be equal to the number of shares of Common Stock then purchasable hereunder. Section 8. Denominations. The Company covenants that it will, at its expense, promptly upon surrender of this Warrant Certificate at the principal executive office of the Company in the United States of America, execute and deliver to the registered holder hereof a new Warrant Certificate or Certificates in denominations specified by such holder for an aggregate number of Warrants equal to the number of Warrants evidenced by this Warrant Certificate. Section 9. Amendments. Any amendment, supplement or modification of or to any provision of the Warrant Certificates, any waiver of any provision of the Warrant Certificates, and any consent to any departure by the Company from the terms of any provision of the Warrant Certificates, shall be effective (i) only if it is made or given in writing and signed by the Company and holders of at least a majority of the shares of Common Stock issuable upon the exercise of all of the Warrants issued pursuant to the Securities Purchase Agreement, and (ii) only in the specific instance and for the specific purpose for which made or given. Any such amendment, supplement or modification made in accordance with the previous sentence of this Section 9, shall be deemed effective for all Warrants issued pursuant to the Securities Purchase Agreement. However, without the consent of each holder of a Warrant Certificate affected, an 10 amendment may not: (1) reduce the number of shares of Common Stock issuable pursuant to such Warrant Certificate; or (2) make any change to this Section 9. Section 10. Replacement of Warrants. Upon receipt of evidence satisfactory to the Company of the loss, theft, destruction or mutilation of this Warrant Certificate and, in the case of loss, theft or destruction, upon delivery of an indemnity reasonably satisfactory to the Company (in the case of an insurance company or other institutional investor, its own unsecured indemnity agreement shall be deemed to be reasonably satisfactory), or, in the case of mutilation, upon surrender and cancellation thereof, the Company will issue a new Warrant Certificate of like tenor for a number of Warrants equal to the number of Warrants evidenced by this Warrant Certificate. Section 11. Governing Law. THIS WARRANT CERTIFICATE SHALL BE CONSTRUED AND ENFORCED IN ACCORDANCE WITH, AND THE RIGHTS OF THE PARTIES SHALL BE GOVERNED BY, THE LAW OF THE STATE OF NEW YORK APPLICABLE TO AGREEMENTS MADE AND TO BE PERFORMED ENTIRELY WITHIN SUCH STATE. Section 12. Rights Inure to Registered Holder. The Warrants evidenced by this Warrant Certificate will inure to the benefit of and be binding upon the registered holder thereof and the Company and their respective successors and permitted assigns. Nothing in this Warrant Certificate shall be construed to give to any Person other than the Company and the registered holder thereof any legal or equitable right, remedy or claim under this Warrant Certificate, and this Warrant Certificate shall be for the sole and exclusive benefit of the Company and such registered holder. Nothing in this Warrant Certificate shall be construed to give the registered holder hereof any rights as a holder of shares of Common Stock until such time, if any, as the Warrants evidenced by this Warrant Certificate are exercised in accordance with the provisions hereof. Section 13. Definitions. For the purposes of this Warrant Certificate, the following terms shall have the meanings indicated below: "Business Day" means any day other than a Saturday, Sunday or other legal holiday on which commercial banks in the City of New York are authorized or required by law or executive order to close. "Capital Stock" of any Person means any and all shares, interests, participation or other equivalents (however designated) of such Person's capital stock (or equivalent ownership interests in a Person not a corporation) whether now outstanding or hereafter issued, including, without limitation, all common stock and preferred stock and any rights, warrants or options to purchase such Person's capital stock. "Commission" means the Securities and Exchange Commission. "Common Stock" shall mean the Common Stock, par value $.01 per share, of the Company. 11 "Current Market Price" per share shall mean, on any date specified herein for the determination thereof, (a) the average daily Market Price of the Common Stock for those days during the period of 30 days, ending on such date, on which the national securities exchanges were open for trading, and (b) if the Common Stock is not then listed or admitted to trading on any national securities exchange or quoted in the over-the-counter market, the Market Price on such date. "Exercise Price" shall have the meaning given it in the first paragraph hereof. "Fair Market Value" shall mean the amount which a willing buyer, under no compulsion to buy, would pay a willing seller, under no compulsion to sell, in an arm's-length transaction assuming (i) that the Company's Common Stock is valued "as if fully distributed" and (ii) no consideration is given for minority interest discounts, or discounts related to illiquidity or restrictions on transferability. "Issue Date" shall mean the Initial Closing Date (as defined in the Securities Purchase Agreement). "Market Price" shall mean, per share of Common Stock on any date specified herein: (a) the closing price per share of the Common Stock on such date published in The Wall Street Journal or, if no such closing price on such date is published in The Wall Street Journal, the average of the closing bid and asked prices on such date, as officially reported on the principal national securities exchange on which the Common Stock is then listed or admitted to trading; (b) if the Common Stock is not then listed or admitted to trading on any national securities exchange but is designated as a national market system security, the last trading price of the Common Stock on such date; or (c) if there shall have been no trading on such date or if the Common Stock is not so designated, the average of the reported closing bid and asked prices of the Common Stock on such date as shown by NASDAQ and reported by any member firm of the NYSE, selected by the Company. If neither (a), (b) or (c) is applicable, Market Price shall mean the Fair Market Value per share determined in good faith by the Board of Directors of the Company which shall be deemed to be Fair Market Value unless holders of at least 15% of Common Stock issued or issuable upon exercise of the Warrants request that the Company obtain an opinion of a nationally recognized investment banking firm chosen by the Company (who shall bear the expense) and reasonably acceptable to such requesting holders of the Warrants, in which event Fair Market Value shall be as determined by such investment banking firm. "NASDAQ" shall mean the National Market System of the Nasdaq Stock Market. "Number Issuable" shall have the meaning given it in the second paragraph hereof. "NYSE" shall mean the New York Stock Exchange, Inc. 12 "Person" shall mean any individual, corporation, partnership, joint venture, association, estate, joint stock company, trust, organization, business, or a government or an agency or political subdivision thereof. "PMR" shall mean PMR Corporation, a Delaware corporation, and its successors. "PMR Merger" shall mean the merger of Psychiatric Solutions, Inc. with PMR Acquisition Corporation, a subsidiary of PMR, with Psychiatric Solutions, Inc. being the surviving corporation, pursuant to the Agreement and Plan of Merger, dated as of May 6, 2002, as amended, by and between PMR, PMR Acquisition Corporation and the Company. "Securities Act" shall mean the Securities Act of 1933, as amended, and the rules and regulations of the Commission promulgated thereunder. "Securities Purchase Agreement" shall mean that certain Securities Purchase Agreement, dated as of the Issue Date, between the Company and The 1818 Mezzanine Fund II, L.P., as the same may be amended or modified from time to time in accordance with its terms. "Special Notice" shall mean the notice sent by a holder to the Company indicating its preference to have any special distribution set aside for its benefit upon exercise of the Warrant. "Warrant Exercise Documentation" shall have the meaning given it in Section 1 hereof. Section 14. Notices. All notices, demands and other communications provided for or permitted hereunder shall be made in writing and shall be by registered or certified first-class mail, return receipt requested, courier services or personal delivery, (a) if to the holder of a Warrant, at such holder's last known address appearing on the books of the Company; and (b) if to the Company, at its principal executive office in the United States located at the address designated for notices in the Securities Purchase Agreement, or such other address as shall have been furnished to the party given or making such notice, demand or other communication. All such notices and communications shall be deemed to have been duly given: when delivered by hand, if personally delivered; one Business Day after delivered to a courier if delivered by commercial overnight courier service; and five Business Days after being deposited in the mail, postage prepaid, if mailed. [Remainder of page intentionally left blank.] 13 IN WITNESS WHEREOF, the Company has caused this Warrant Certificate to be duly executed as of the Issue Date. PSYCHIATRIC SOLUTIONS, INC. By: /s/ Steven T. Davidson ---------------------- Name: Steven T. Davidson Title: Vice President 14 [Form of Assignment Form] [To be executed upon assignment of Warrants] The undersigned hereby assigns and transfers this Warrant Certificate to ____________________ whose Social Security Number or Tax ID Number is _________________ and whose record address is _________________________________, and irrevocably appoints ________________ as agent to transfer this security on the books of the Company. Such agent may substitute another to act for such agent. Signature: ------------------------------- Signature Guarantee: -------------------------------- Date: ___________________________ 15 EX-10.20 11 g76727a1exv10w20.txt 2ND AMENDMENT TO REVOLVING CREDIT & TERM LOAN EXHIBIT 10.20 SECOND AMENDMENT TO REVOLVING CREDIT AND TERM LOAN AGREEMENT THIS SECOND AMENDMENT TO REVOLVING CREDIT AND TERM LOAN AGREEMENT (this "Amendment") is made and entered into as of June 28, 2002, by and among PSYCHIATRIC SOLUTIONS, INC., a Delaware corporation ("PSI"), PSYCHIATRIC SOLUTIONS OF ALABAMA, INC., a Tennessee corporation ("PS ALABAMA"), PSYCHIATRIC SOLUTIONS OF FLORIDA, INC., a Tennessee corporation ("PS FLORIDA"), PSYCHIATRIC SOLUTIONS OF TENNESSEE, INC., a Tennessee corporation ("PS TENNESSEE"), SOLUTIONS CENTER OF LITTLE ROCK, INC., a Tennessee corporation ("LITTLE ROCK"), PSYCHIATRIC SOLUTIONS OF NORTH CAROLINA, INC., a Tennessee corporation ("PS NORTH CAROLINA"), PSI COMMUNITY MENTAL HEALTH AGENCY MANAGEMENT, INC., a Tennessee corporation ("PSI COMMUNITY"), PSI-EAP, INC., a Delaware corporation ("PSI-EAP"), SUNSTONE BEHAVIORAL HEALTH, INC., a Tennessee corporation ("SUNSTONE"), THE COUNSELING CENTER OF MIDDLE TENNESSEE, INC., a Tennessee corporation ("COUNSELING CENTER"), PSI HOSPITALS, INC., a Delaware corporation ("PSI HOSPITALS"), PSI TEXAS HOSPITALS, LLC, a Texas limited liability company ("TEXAS HOSPITALS"), PSYCHIATRIC PRACTICE MANAGEMENT OF ARKANSAS, INC., a Tennessee corporation ("PPM ARKANSAS"), TEXAS CYPRESS CREEK HOSPITAL, L.P., a Texas limited partnership ("CYPRESS CREEK"), TEXAS WEST OAKS HOSPITAL, L.P., a Texas limited partnership ("WEST OAKS"), NEURO INSTITUTE OF AUSTIN, L.P., a Texas limited partnership ("NEURO INSTITUTE") (individually and collectively, the "ORIGINAL BORROWER"), AERIES HEALTHCARE CORPORATION, a Delaware corporation ("AERIES"), AERIES HEALTHCARE OF ILLINOIS, INC., an Illinois corporation ("AERIES ILLINOIS"), HOLLY HILL REAL ESTATE, LLC, a North Carolina limited liability company ("HOLLY HILL REAL ESTATE"), CYPRESS CREEK REAL ESTATE, L.P., a Texas limited partnership ("CYPRESS CREEK REAL ESTATE"), WEST OAKS REAL ESTATE, L.P., a Texas limited partnership ("WEST OAKS REAL ESTATE"), NEURO REHAB REAL ESTATE, L.P., a Texas limited partnership ("NEURO REHAB REAL ESTATE") (individually and collectively with Original Borrower, "BORROWER"), CAPITALSOURCE FINANCE LLC, a Delaware limited liability company ("CAPITALSOURCE"), as administrative agent and collateral agent for Lenders (in such capacities, the "AGENT"), and the Lenders. RECITALS A. WHEREAS, pursuant to the terms and subject to the conditions of that certain Revolving Credit and Term Loan Agreement, dated as of November 30, 2001 by and among Agent, the Lenders and Original Borrower, as amended by that certain First Amendment to Revolving Credit and Term Loan Agreement, dated as of April 30, 2002 by and among Agent, the Lenders and Original Borrower (such Revolving Credit and Term Loan Agreement, as the same is hereby amended and may hereafter be amended from time to time, being hereinafter referred to as the "LOAN AGREEMENT"), Borrower was provided a Term Loan in the amount of $15,656,305, a Revolving Loan Facility in an aggregate amount not to exceed $17,500,000 and a 1 Bridge Facility as a sub-facility of the Revolving Loan Facility in an aggregate amount not to exceed $1,200,000; B. WHEREAS, Borrower has requested, among other things, the Lenders add a term loan in the amount of $7,950,000; and C. WHEREAS, in furtherance of the foregoing and to evidence the agreements of the parties hereto in relation thereto the parties hereto desire to amend the Loan Agreement as hereinafter provided. AGREEMENT NOW, THEREFORE, in consideration of the premises herein contained and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties, intending to be legally bound, agree as follows: ARTICLE I DEFINITIONS 1.01 Capitalized terms used in this Amendment are defined in the Loan Agreement, as amended hereby, unless otherwise stated. ARTICLE II AMENDMENTS TO LOAN AGREEMENT The Loan Agreement is hereby amended as follows: 2.01 AMENDMENT TO THE PREAMBLE. Effective as of the date of this Amendment, the preamble shall be amended and restated as follows: "THIS REVOLVING CREDIT AND TERM LOAN AGREEMENT (the "AGREEMENT") dated as of November 30, 2001, is entered into among PSYCHIATRIC SOLUTIONS, INC., a Delaware corporation ("PSI"), PSYCHIATRIC SOLUTIONS OF ALABAMA, INC., a Tennessee corporation ("PS ALABAMA"), PSYCHIATRIC SOLUTIONS OF FLORIDA, INC., a Tennessee corporation ("PS FLORIDA"), PSYCHIATRIC SOLUTIONS OF TENNESSEE, INC., a Tennessee corporation ("PS TENNESSEE"), SOLUTIONS CENTER OF LITTLE ROCK, INC., a Tennessee corporation ("LITTLE ROCK"), PSYCHIATRIC SOLUTIONS OF NORTH CAROLINA, INC., a Tennessee corporation ("PS NORTH CAROLINA"), PSI COMMUNITY MENTAL HEALTH AGENCY MANAGEMENT, INC., a Tennessee corporation ("PSI COMMUNITY"), PSI-EAP, INC., a Delaware corporation ("PSI-EAP"), SUNSTONE BEHAVIORAL HEALTH, INC., a Tennessee corporation ("SUNSTONE"), THE COUNSELING CENTER OF MIDDLE TENNESSEE, INC., a Tennessee corporation ("COUNSELING CENTER"), PSI HOSPITALS, INC., a Delaware corporation ("PSI HOSPITALS"), PSI TEXAS HOSPITALS, LLC, a Texas limited liability company ("TEXAS HOSPITALS"), 2 PSYCHIATRIC PRACTICE MANAGEMENT OF ARKANSAS, INC., a Tennessee corporation ("PPM ARKANSAS"), TEXAS CYPRESS CREEK HOSPITAL, L.P., a Texas limited partnership ("CYPRESS CREEK"), TEXAS WEST OAKS HOSPITAL, L.P., a Texas limited partnership ("WEST OAKS"), NEURO INSTITUTE OF AUSTIN, L.P., a Texas limited partnership ("NEURO INSTITUTE"), AERIES HEALTHCARE CORPORATION, a Delaware corporation ("AERIES"), AERIES HEALTHCARE OF ILLINOIS, INC., an Illinois corporation ("AERIES ILLINOIS"), HOLLY HILL REAL ESTATE, LLC, a North Carolina limited liability company ("HOLLY HILL REAL ESTATE"), CYPRESS CREEK REAL ESTATE, L.P., a Texas limited partnership ("CYPRESS CREEK REAL ESTATE"), WEST OAKS REAL ESTATE, L.P., a Texas limited partnership ("WEST OAKS REAL ESTATE"), NEURO REHAB REAL ESTATE, L.P., a Texas limited partnership ("NEURO REHAB REAL ESTATE") (individually and collectively, the "BORROWER"), CAPITALSOURCE FINANCE LLC, a Delaware limited liability company ("CAPITALSOURCE"), as administrative agent and collateral agent for Lenders (in such capacities, the "AGENT"), and the Lenders." 2.02 DELETION OF WHEREAS CLAUSE. Effective as of the date of this Amendment, the fourth "WHEREAS" clause shall be deleted in its entirety. 2.03 AMENDMENT TO SECTION 2.6. Effective as of the date of this Amendment, Section 2.6 shall be amended and restated as follows: "2.6 TERM LOAN. Subject to the terms and conditions set forth in this Agreement, each Lender agrees to loan to Borrower its Pro Rata Share of the Term Loan, which is in the aggregate original principal amount equal to the Maximum Loan Amount. The Term Loan shall be evidenced by Term Notes, payable to the order of each Lender in the principal amount of the Commitment of the applicable Lender, duly executed and delivered by Borrower. On the Closing Date, Borrower will authorize (a) the assignment by Healthcare to CapitalSource of Term Note A, Term Note B and Term Note C and the modification of each note pursuant to the Modification of Notes and Liens and (b) the issuance of Term Note D, which shall be in the original principal amount of $4,531,305 payable to the order of CapitalSource, duly executed and delivered by Borrower and dated the Closing Date (the "TERM NOTE D"). On the date of the Second Amendment, Borrower will authorize the issuance of Term Note E, which shall be in the original principal amount of $7,950,000 payable to the order of CapitalSource, duly executed and delivered by Borrower and dated as of the date of the Second Amendment (the "TERM NOTE E" and collectively with Term Note A, Term Note B, Term Note C and Term Note D, the "TERM NOTES"). Each Lender agrees to loan to Borrower on the Closing Date or the date of the Second Amendment, as applicable, the Maximum Loan Amount, in an amount not to exceed its Pro Rata Share, in the form of the Term Loan equal to such Maximum Loan Amount to be disbursed to (x) Healthcare, pursuant to the General Assignment and (y) the 3 appropriate Borrower's account(s) as set forth on Schedule 2.4. The Term Loan is not a revolving credit facility, and any repayments of principal shall be applied to permanently reduce the Term Loan. The Term Loan shall be evidenced by the Term Notes." 2.04 AMENDMENT TO SECTION 2.8. Effective as of the date of this Amendment, Section 2.8 shall be amended and restated as follows: "2.8 REPAYMENT OF TERM LOAN; MATURITY Payment of principal (in addition to the interest payments in Section 2.7) and all other amounts outstanding under the Term Loan shall be made monthly as follows: (a) (i) $98,360 per month shall be due and payable, beginning July 1, 2002 and continuing on the 1st day of each month thereafter through the last month of the Term Loan Term or (ii) upon the payment of such amount required pursuant to Section 2.11(d), $94,190 per month shall be due and payable, beginning on the earlier to occur of (A) the PMR Merger Date and (B) September 1, 2002 and continuing on the 1st day of each month thereafter through the last month of the Term Loan Term; and (b) the unpaid principal of the Term Loan and all other Obligations under the Term Loan shall be due and payable in full, and the Term Notes shall mature, if not earlier in accordance with this Agreement, on the earlier of (i) the occurrence of an Event of Default if required pursuant hereto or Agent's demand upon an Event of Default, and (ii) the last day of the Term Loan Term (such earlier date being the "TERM LOAN MATURITY DATE")." 2.05 AMENDMENT TO SECTION 2.11. Effective as of the date of this Amendment, Section 2.11 shall be amended by amending and restating subsection (c) in its entirety, and adding new subsections (d) and (e), which subsections shall read in their entirety as follows: "(c) until such time as the Obligations relating to the Term Loan are indefeasibly paid in full in cash and fully performed, 50% of Borrower's Excess Cash Flow for each fiscal quarter shall be paid by Borrower to Agent, for the benefit of Lenders, and shall be applied by Agent to reduce the Obligations relating to the Term Loan. Such payments shall be made no later than sixty (60) calendar days after the end of the fiscal quarter to which such Cash Flow relates, but in any event, if any Borrower is public, not later than fifteen (15) calendar days after the required delivery to the Securities and Exchange Commission of Borrower's quarterly financial statements; provided, however, that such payments are to be applied to the Obligations relating to the Term Loan at such time and in such manner and order as Agent shall decide in its sole discretion. Borrower shall provide Agent with a year-end reconciliation report of Borrower's quarterly Excess Cash Flow sweeps for each fiscal year, which reconciliation report shall be 4 based on Borrower's audited financial statements for such fiscal year and which shall be delivered not later than thirty (30) days after preparation of Borrower's audited financial statements for such fiscal year; (d) on or before the earlier to occur of (i) the PMR Merger Date and (ii) August 30, 2002, Borrower shall pay to Agent, for the benefit of Lenders, an aggregate amount equal to (A) $1,200,000 which amount shall be applied by Agent to reduce the Obligations relating to the Bridge Facility and (B) $1,000,000, which amount shall be applied by Agent to reduce the Obligations relating to Term Note E; and (e) until such time as Term Loan E is indefeasibly paid in full in cash, an amount each month (if positive) equal to (i) the aggregate amount outstanding on the Term Loan E minus (ii) (A) 2.5 multiplied by (B) as of the end of such month, the twelve-month rolling average of EBITDA on the Riveredge Hospital Facility minus (iii) the aggregate amount of principal paid on Term Loan E for such month pursuant to Section 2.8(a). For purposes of Subsection 2.11(e)(ii) only, (x) for any month prior to and including April 2002, such EBITDA shall be deemed to be $241,670 per month, and (y) for any month after April 2002, such EBITDA shall be as provided by Borrower and approved by Lender." 2.06 AMENDMENT TO SECTION 6.13. Effective as of the date of this Amendment, Section 6.13 shall be amended and restated as follows: "6.13 RIGHT OF FIRST REFUSAL. If at any time Borrower receives from a third party an offer, term sheet or commitment or makes a proposal (including without limitation any application filed in connection with a HUD Financing) accepted by any Person (each, an "OFFER") which provides for any type of debt financing to or for Borrower, Borrower shall notify Agent and Lenders of the Offer in writing (including all material terms of the Offer) and Agent and Lenders shall have 30 calendar days after Receipt of such notice (the "OPTION PERIOD") to agree to provide similar debt financing in the place of such Person upon substantially the same terms and conditions (or terms more favorable to such Borrower) as set forth in the Offer. Agent shall notify Borrower in writing of Agent's and Lenders' acceptance of the Offer pursuant hereto (the "ACCEPTANCE NOTICE"), in which case Borrower shall obtain such debt financing from Agent and Lenders and shall not accept the Offer from such other Person. If no Acceptance Notice has been Received from Agent within the Option Period, Borrower may consummate the Offer with the other Person on the terms and conditions set forth in the Offer (the "TRANSACTION"); provided, however, that none of foregoing or any failure by Agent to issue an Acceptance Notice shall be construed as a waiver of any of the terms, covenants or conditions of any of the Loan Documents. If the Transaction is not consummated on the terms set forth in the Offer or with the Person providing the Offer or during the ninety (90) calendar day period following the expiration of the 5 Option Period, Borrower shall not be permitted to consummate the Transaction without again complying with this Section 6.13. The provisions of this Section 6.13 shall survive the payment in full of the Obligations and termination of this Agreement for a period of six months. For purposes of this Section 6.13, "Lender" shall include CapitalSource Finance LLC and any of its parents, subsidiaries or affiliates. Notwithstanding anything to the contrary contained in this Section 6.13, the provisions of this Section 6.13 shall not include the offer of 1818 Mezzanine Fund, and acceptance by PSI, of the 1818 Mezzanine Fund Subordinated Indebtedness." 2.07 AMENDMENT TO SECTION 7.1. Effective as of the date of this Amendment, Section 7.1 shall be amended and restated as follows: "7.1 INDEBTEDNESS Borrower shall not create, incur, assume or suffer to exist any Indebtedness, except the following (collectively, "PERMITTED INDEBTEDNESS"): (a) Indebtedness under the Loan Documents, (b) any Indebtedness set forth on Schedule 7.1; provided, that any refinancing of the Indebtedness set forth on Schedule 7.1 shall have the following terms: (i) the stated applicable pre-default or post-default interest rate (or the margin thereon if based on a variable rate) on such Indebtedness shall not be greater than the stated applicable pre-default or post-default interest rate (or the margin thereon if based on a variable rate) as in effect on the date hereof; (ii) the maximum principal amount outstanding under such Indebtedness as so refinanced does not exceed the maximum principal amount permitted to be outstanding on the date hereof; and (iii) no advances under such Indebtedness may be made on or after the date hereof, (c) Capitalized Lease Obligations incurred after the Closing Date and Indebtedness incurred pursuant to purchase money Liens permitted by Section 7.3(e); provided, that the aggregate amount thereof outstanding at any time shall not exceed $75,000, (d) Indebtedness in connection with advances made by a stockholder in order to cure any default of the financial covenants set forth on Annex I; provided, however, that such Indebtedness shall be on an unsecured basis, subordinated in right of repayment and remedies to all of the Obligations and to all of Agent's and Lenders' rights and in form and substance satisfactory to Agent; (e) accounts payable to trade creditors and current operating expenses (other than for borrowed money) which are not aged more than 120 calendar days from the billing date or more than 30 days from the due date, in each case incurred in the ordinary course of business and paid within such time period, unless the same are being contested in good faith and by appropriate and lawful proceedings and such reserves, if any, with respect thereto as are required by GAAP and deemed adequate by Borrower's independent accountants shall have been reserved; (f) Indebtedness owing by any Borrower to another Borrower; provided, that such Indebtedness shall be (i) evidenced by a note, (ii) on an unsecured basis, subordinated in right of repayment and remedies to all of the Obligations and to all of Agent's and Lenders' rights 6 and in form and substance satisfactory to Agent, and (iii) pledged to Agent, for the benefit of itself and Lenders, (g) borrowings incurred in the ordinary course of business and not exceeding $10,000 individually or in the aggregate outstanding at any one time and (h) the 1818 Mezzanine Fund Subordinated Indebtedness; provided, however, that such Indebtedness shall be on an unsecured basis, subordinated in right of repayment and remedies to all of the Obligations and to all of Agent's and Lenders' rights and in form and substance satisfactory to Agent. Borrower shall not make prepayments on any existing or future Indebtedness to any Person other than to Agent, for the benefit of Lenders, or to the extent specifically permitted by this Agreement or any subsequent agreement between Borrower, Agent and Lenders. 2.08 AMENDMENT TO SECTION 7.4. Effective as of the date of this Amendment, Section 7.4 shall be amended and restated as follows: "7.4 INVESTMENTS; NEW FACILITIES OR COLLATERAL; SUBSIDIARIES Borrower, directly or indirectly, shall not (a) purchase, own, hold, invest in or otherwise acquire obligations or stock or securities of, or any other interest in, or all or substantially all of the assets of, any Person or any joint venture; provided, however, Borrower may consummate the Aeries Acquisition, or (b) make or permit to exist any loans, advances or guarantees to or for the benefit of any Person or assume, guarantee, endorse, contingently agree to purchase or otherwise become liable for or upon or incur any obligation of any Person (other than those created by the Loan Documents and Permitted Indebtedness set forth on Schedule 7.1 and other than (i) trade credit extended in the ordinary course of business, (ii) advances for business travel and similar temporary advances made in the ordinary course of business to officers, directors and employees, and (iii) the endorsement of negotiable instruments for deposit or collection or similar transactions in the ordinary course of business. Borrower, directly or indirectly, shall not purchase, own, operate, hold, invest in or otherwise acquire any facility, property or assets or any Collateral that is not located at the locations set forth on Schedule 5.18B, unless Borrower shall provide to Agent at least thirty (30) Business Days prior written notice. Borrower shall have no Subsidiaries other than Borrowers hereunder." 2.09 AMENDMENT TO SECTION 7.5. Effective as of the date of this Amendment, Section 7.5 shall be amended and restated as follows: "7.5 DIVIDENDS; REDEMPTIONS Borrower shall not (a) declare, pay or make any dividend or distribution on any shares of capital stock or other securities or interests (other than dividends or distributions payable in its stock, or split-ups or reclassifications of its stock), (b) apply any of its funds, property or assets to the acquisition, 7 redemption or other retirement of any capital stock or other securities or interests or of any options to purchase or acquire any of the foregoing (provided, however, that Borrower may redeem its capital stock from terminated employees pursuant to, but only to the extent required under, the terms of the related employment agreements as long as no Default or Event of Default has occurred and is continuing or would be caused by or result therefrom), (c) otherwise make any payments or Distributions to any stockholder, member, partner or other equity owner in such Person's capacity as such, or (d) make any payment of any management, service or related or similar fee to any Person or with respect to any facility owned, operated or leased by Borrower; provided, that nothing contained in this Section 7.5 shall prevent Borrower from making any payments and/or consummating any transactions permitted pursuant to the Intercreditor Agreement." 2.10 AMENDMENT TO SECTION 7.6. Effective as of the date of this Amendment, Section 7.6 shall be amended and restated as follows: "7.6 TRANSACTIONS WITH AFFILIATES Borrower shall not enter into or consummate any transaction of any kind with any of its affiliates or any Guarantor or any of their respective affiliates other than: (a) salary, bonus, employee stock option and other compensation and employment arrangements with directors or officers in the ordinary course of business; provided, that no payment of any bonus shall be permitted if a Default or Event of Default has occurred and remains in effect or would be caused by or result from such payment, (b) distributions and dividends permitted pursuant to Section 7.5, (c) transactions on overall terms at least as favorable to Borrower as would be the case in an arm's-length transaction between unrelated parties of equal bargaining power, (d) transactions with Agent or Lenders or any affiliate of Agent or Lenders, (e) payments permitted under and pursuant to written agreements entered into by and between Borrower and one or more of its affiliates that both (i) reflect and constitute transactions on overall terms at least as favorable to Borrower as would be the case in an arm's-length transaction between unrelated parties of equal bargaining power, and (ii) are subject to such terms and conditions as determined by Agent in its sole discretion; provided, that notwithstanding the foregoing Borrower shall not (A) enter into or consummate any transaction or agreement pursuant to which it becomes a party to any mortgage, note, indenture or guarantee evidencing any Indebtedness of any of its affiliates or otherwise to become responsible or liable, as a guarantor, surety or otherwise, pursuant to agreement for any Indebtedness of any such affiliate, or (B) make any payment to any of its affiliates in excess of $10,000 without the prior written consent of Agent or (f) payments and/or transactions permitted pursuant to the Intercreditor Agreement." 8 2.11 AMENDMENT TO SECTION 7.9. Effective as of the date of this Amendment, Section 7.9 shall be amended and restated as follows: "7.9 PAYMENT ON SUBORDINATED DEBT. Borrower shall not (a) make any prepayment of any part or all of any Subordinated Debt, (b) repurchase, redeem or retire any instrument evidencing any such Subordinated Debt prior to maturity, or (c) enter into any agreement (oral or written) which could in any way be construed to amend, modify, alter or terminate any one or more instruments or agreements evidencing or relating to any Subordinated Debt; provided, however, that Borrower may make payments on any Subordinated Debt in accordance with the provisions of the note evidencing such Subordinated Debt, or if more restrictive, the provisions of any Subordination Agreement or the Intercreditor Agreement, each as in effect on the date hereof. Notwithstanding the foregoing, Borrower shall not make any payments on any Subordinated Debt if a Default or Event of Default shall have occurred and be continuing or would occur as a result of any payment on such Subordinated Debt (unless, with respect to the 1818 Mezzanine Fund Subordinated Indebtedness, such payment is permitted pursuant to the Intercreditor Agreement)." 2.12 ADDITION OF SECTION 7.10. Effective as of the date of this Amendment, the Loan Agreement shall be amended by adding a new Section 7.10 which shall read in its entirety as follows: "7.10 AMENDMENT OF THE 1818 MEZZANINE FUND SUBORDINATED DEBT DOCUMENTS. Borrower shall not, without the prior written consent of Agent, agree to any amendment, modification or supplement to the 1818 Mezzanine Fund Subordinated Debt Documents the effect of which is to (a) increase the maximum principal amount of the 1818 Mezzanine Fund Subordinated Indebtedness or rate of interest on any of the 1818 Mezzanine Fund Subordinated Indebtedness, (b) change the dates upon which payments of principal or interest on the 1818 Mezzanine Fund Subordinated Indebtedness are due, (c) change or add any event of default or any covenant with respect to the 1818 Mezzanine Fund Subordinated Indebtedness, (d) change any redemption or prepayment provisions of the 1818 Mezzanine Fund Subordinated Indebtedness, (e) alter the subordination provisions with respect to the 1818 Mezzanine Fund Subordinated Indebtedness, including, without limitation, subordinating the 1818 Mezzanine Fund Subordinated Indebtedness to any other indebtedness, (f) take any liens or security interests in any assets of Borrower or any guarantor of the 1818 Mezzanine Fund Subordinated Indebtedness or (g) change or amend any other term of the 1818 Mezzanine Fund Subordinated Debt Documents if such change or amendment would result in an Event of Default, increase the obligations of Borrower or any guarantor of the 1818 Mezzanine Fund Subordinated Indebtedness or confer 9 additional material rights on 1818 Mezzanine Fund or any other holder of the 1818 Mezzanine Fund Subordinated Indebtedness in a manner adverse to Borrower, any such guarantor or Agent." 2.13 ADDITION OF DEFINITIONS TO APPENDIX A. Effective as of the date of this Amendment, Appendix A shall be amended by adding the following definitions thereto in alphabetical order: "1818 Mezzanine Fund" shall mean The 1818 Mezzanine Fund II, L.P., a Delaware limited partnership. "1818 Mezzanine Fund Subordinated Indebtedness" shall mean the subordinated indebtedness owing by PSI (and any other Borrower who is a party or obligor thereunder) to 1818 Mezzanine Fund pursuant to the Securities Purchase Agreement. "1818 Mezzanine Fund Subordinated Debt Documents" shall mean the Securities Purchase Agreement and all other documents, agreements and instruments now existing or hereinafter entered into evidencing or pertaining to all or any portion of the 1818 Mezzanine Fund Subordinated Indebtedness. "Aeries Acquisition" shall mean the acquisition contemplated by the Stock Purchase Agreement. "HUD Financing" shall mean any type of financing to or for Borrower from the U.S. Department of Housing and Urban Development. "Intercreditor Agreement" shall mean that certain Subordination and Intercreditor Agreement, dated as June 28, 2002, by and among Agent, 1818 Mezzanine Fund and Borrower, as amended, supplemented, restated or otherwise modified from time to time as permitted thereunder. "PMR Acquisition" shall mean PMR Acquisition Corporation, a Delaware corporation. "PMR Corporation" shall mean PMR Corporation, a Delaware corporation. "PMR Merger" shall mean the merger contemplated by the PMR Merger Agreement. "PMR Merger Agreement" shall mean the Agreement and Plan of Merger, dated as of May 6, 2002, by and between PMR Corporation, PMR Acquisition and PSI, as amended by Amendment No. 1 to Agreement and Plan of Merger, dated as of June 28, 2002, and as further amended or modified in accordance with its terms. 10 "PMR Merger Date" shall mean the date the PMR Merger is consummated. "Riveredge Hospital Facility" shall mean that certain property located at 8311 West Roosevelt Road, Forest Park, Illinois 60130. "Second Amendment" shall mean that certain Second Amendment to Revolving Credit and Term Loan Agreement, dated as of June 28, 2002, by and among Agent, Lenders and Borrower. "Securities Purchase Agreement" shall mean that certain Securities Purchase Agreement, dated as of June 28, 2002 by and between PSI and 1818 Mezzanine Fund, as amended, supplemented, restated or otherwise modified from time to time as permitted hereunder. "Seller Notes" shall mean the indebtedness owing to the Shareholders of Aeries Corporation pursuant to the Aeries Stock Purchase Agreement and the Indebtedness identified in each Subordination Agreement. "Stock Purchase Agreement" shall mean that certain Stock Purchase Agreement, dated as of June 20, 2002 by and between PSI and the Shareholders of Aeries Corporation (as identified therein), as amended, supplemented, restated or otherwise modified from time to time as permitted hereunder. 2.14 AMENDMENT TO DEFINITIONS IN APPENDIX A. Effective as of the date of this Amendment, the following definitions contained in Appendix A to the Loan Agreement shall be amended and restated as follows: "Facility Cap" shall mean the lesser of (i) $17,500,000, or (ii) $40,000,000 minus the aggregate outstanding amount of the Term Loan. "Liability Event" shall mean any event, fact, condition or circumstance or series thereof (i) in or for which any Borrower becomes liable or otherwise responsible for any amount owed or owing to any Medicaid or Medicare program by a provider under common ownership with such Borrower or any provider owned by such Borrower pursuant to any applicable law, ordinance, rule, decree, order or regulation of any Governmental Authority after the failure of any such provider to pay any such amount when owed or owing, (ii) in which Medicaid or Medicare payments to any Borrower are lawfully set-off against payments to such or any other Borrower to satisfy any liability of or for any amounts owed or owing to any Medicaid or Medicare program by a provider under common ownership with such Borrower or any provider owned by such Borrower pursuant to any applicable law, ordinance, rule, decree, order or regulation of any Governmental Authority, excluding any cost report liability which has been appropriately recorded in Borrower's financial statements in accordance with GAAP and appropriately reserved with respect to any Borrowing Base calculation, or (iii) any 11 of the foregoing under clauses (i) or (ii) in each case pursuant to statutory or regulatory provisions that are similar to any applicable law, ordinance, rule, decree, order or regulation of any Governmental Authority referenced in clauses (i) and (ii) above or successor provisions thereto. "Loan Documents" shall mean, collectively and each individually, the Agreement, the Notes, the Security Documents, the Guarantees, the Stock Pledge Agreements, the Assignment of Liens, the General Assignment, the Modification of Notes and Liens, the Assignment of Representations, Warranties, Covenants and Indemnities, the Lockbox Agreements, the Participation Agreement, the Uniform Commercial Code Financing Statements, the Subordination Agreements, the Intercreditor Agreement, the Landlord Waiver and Consents, the Borrowing Certificates, the Warrant Agreement and the Warrant and all other agreements, documents, instruments and certificates heretofore or hereafter executed or delivered to Agent in connection with any of the foregoing or the Loans, as the same may be amended, modified or supplemented from time to time. "Maximum Loan Amount" shall mean $23,606,305. "Minimum Termination Fee" shall mean (for the time period indicated) the amount equal to (i) 4% of the Facility Cap, if the date of notice of such termination by Borrower is after the Closing Date but before the second anniversary of the Closing Date; and (ii) 3% of the Facility Cap, if the date of notice of such termination by Borrower is on or after the second anniversary of the Closing Date. "Real Property" shall mean shall mean that certain property located at (a) 17750 Cali Drive, Houston, Texas 77090 (Cypress Creek Hospital), (b) 6500 Hornwood Drive, Houston, Texas 77074 (West Oaks Hospital), (c) 3019 Falstaff Road, Raleigh, North Carolina (Holly Hill Hospital), (d) 1106 W. Dittmar Road, Austin, Texas 78745 (Texas NeuroRehab Center) and (e) 8311 West Roosevelt Road, Forest Park, Illinois 60130 (Riveredge Hospital), each as more particularly described in its respective Mortgage. "Revolving Facility" shall mean a revolving credit facility provided by Lenders to Borrower pursuant to Section 2.1. "Stock Pledge Agreement" shall mean, collectively and each individually, (i) that certain Stock Pledge Agreement, as amended by that certain First Amendment to Stock Pledge Agreement, executed by PSI in favor of Agent, for the benefit of itself and Lenders, (ii) that certain Stock Pledge Agreement executed by PS Tennessee in favor of Agent, for the benefit of itself and Lenders, (iii) that certain Stock Pledge Agreement executed by PSI Hospitals in favor of Agent, for the benefit of itself and Lenders, (iv) that certain Stock Pledge Agreement executed by Texas Hospitals in favor of Agent, for the benefit of itself and Lenders, (v) that certain Stock Pledge Agreement executed by Aeries 12 Corporation in favor of Agent, for the benefit of itself and Lenders, and (vi) any additional stock pledge agreements executed by a Borrower or Guarantor in favor of Agent, for the benefit of itself and Lenders, as the same may be modified, amended or supplemented from time to time. "Subordinated Debt" shall mean any Indebtedness of Borrower that is expressly subordinated to the Obligations, including, without limitation, (i) the Indebtedness identified in each Subordination Agreement, (ii) the 1818 Mezzanine Fund Subordinated Indebtedness and (iii) the Seller Notes. "Term Loan" shall mean a term loan facility provided by Lenders to Borrower pursuant to Section 2.6. "Term Note(s)" shall mean, collectively and each individually, Term Note A, Term Note B, Term Note C, Term Note D, Term Note E and any additional promissory note(s) payable to the order of each Lender executed by Borrower evidencing the Term Loan, as the same may be modified, amended or supplemented from time to time. 2.15 AMENDMENT TO ANNEX I. Effective as of the date of this Amendment, Annex I shall be amended and restated to read as set forth on Annex I attached hereto. 2.16 AMENDMENT TO SCHEDULE 5.3. Effective as of the date of this Amendment, Schedule 5.3 shall be amended and restated to read as set forth on Schedule 5.3 attached hereto. 2.17 AMENDMENT TO SCHEDULE 5.4. Effective as of the date of this Amendment, Schedule 5.4 shall be amended and restated to read as set forth on Schedule 5.4 attached hereto. 2.18 AMENDMENT TO SCHEDULE 5.15. Effective as of the date of this Amendment, Schedule 5.15 shall be amended and restated to read as set forth on Schedule 5.15 attached hereto. 2.19 AMENDMENT TO SCHEDULE 5.16. Effective as of the date of this Amendment, Schedule 5.16 shall be amended and restated to read as set forth on Schedule 5.16 attached hereto. 2.20 AMENDMENT TO SCHEDULE 5.17. Effective as of the date of this Amendment, Schedule 5.17 shall be amended and restated to read as set forth on Schedule 5.17 attached hereto. 2.21 AMENDMENT TO SCHEDULE 5.18A. Effective as of the date of this Amendment, Schedule 5.18A shall be amended and restated to read as set forth on Schedule 5.18A attached hereto. 2.22 AMENDMENT TO SCHEDULE 5.18B. Effective as of the date of this Amendment, Schedule 5.18B shall be amended and restated to read as set forth on Schedule 5.18B attached hereto. 13 2.23 AMENDMENT TO SCHEDULE 7.1. Effective as of the date of this Amendment, Schedule 7.1 shall be amended and restated to read as set forth on Schedule 7.1 attached hereto. 2.24 AMENDMENT TO SCHEDULE A-1. Effective as of the date of this Amendment, Schedule A-1 shall be amended and restated to read as set forth on Schedule A-1 attached hereto. ARTICLE III CONDITIONS PRECEDENT 3.01 CONDITIONS TO EFFECTIVENESS. The effectiveness of this Amendment is subject to the satisfaction of the following conditions precedent in a manner satisfactory to Agent, unless specifically waived in writing by Lender: (a) Agent shall have received each of the following, each in form and substance satisfactory to Agent, in its sole discretion, and, where applicable, each duly executed by each party thereto: (i) this Amendment, duly executed by Borrower; (ii) Term Note E, duly executed by Borrower; (iii) that certain First Amendment to Stock Pledge Agreement, duly executed by PSI in favor of Agent, for the benefit of itself and Lenders, together with all appropriate stock powers and stock certificates; (iv) that certain Stock Pledge Agreement duly executed by Aeries Corporation in favor of Agent, for the benefit of itself and Lenders, together with all appropriate stock powers and stock certificates; (v) the Joinder Agreement, duly executed by Aeries Corporation and Aeries Acquisition; (vi) a Borrowing Certificate for the June 28, 2002 requested Advance; (vii) a Secretary's Incumbency Certificate from each Borrower (except Aeries Corporation and Aeries Acquisition) certified by the secretary of each Borrower with specimen signatures of the officers of such Borrower who are authorized to sign such documents attaching (A) copies of amendments, if any, to such Borrower's constituent organizational documents, (B) certified copies of the resolutions of the Board of Directors of Borrower authorizing the execution, delivery and performance of this Amendment and any and all other Loan Documents executed by Borrower in connection herewith, and (C) true and correct copies of applicable certificates of existence, good standing and/or authority to transact business issued by the appropriate governmental official in the state in which such Borrower is incorporated or organized, as applicable, and in each other state in which such Borrower is required to be qualified; 14 (viii) a Secretary's Incumbency Certificate from each of Aeries Corporation and Aeries Acquisition certified by the secretary of each Borrower with specimen signatures of the officers of such Borrower who are authorized to sign such documents attaching (A) a copy of such Borrower's constituent organizational documents, (B) certified copies of the resolutions of the Board of Directors of Borrower authorizing the execution, delivery and performance of this Amendment and any and all other Loan Documents executed by Borrower in connection herewith, and (C) true and correct copies of applicable certificates of existence, good standing and/or authority to transact business issued by the appropriate governmental official in the state in which such Borrower is incorporated or organized, as applicable, and in each other state in which such Borrower is required to be qualified; (ix) the written legal opinion of counsel for Borrower and Guarantors, including local Chicago, Illinois counsel, in form and substance satisfactory to Agent and its counsel; (x) the Subordination Agreements, duly executed by each such holder of Subordinated Debt, each in form and substance satisfactory to Agent; (xi) the Intercreditor Agreement, duly executed by 1818 Mezzanine Fund and Borrower, in form and substance satisfactory to Agent; (xii) each other applicable Loan Document, each duly executed, each in form and substance satisfactory to Agent in its sole discretion; (xiii) (A) a report of Uniform Commercial Code financing statement, tax and judgment lien searches performed with respect to each Borrower and Guarantor in each jurisdiction determined by Agent in its sole discretion, and such report shall show no Liens on the Collateral (other than Permitted Liens), (B) each document (including, without limitation, any Uniform Commercial Code financing statement) required by any Loan Document or under law or requested by Agent to be filed, registered or recorded to create, in favor of Agent, for the benefit of Lenders, a perfected first priority security interest upon the Collateral, and (C) evidence of each such filing, registration or recordation and of the payment by Borrower of any necessary fee, tax or expense relating thereto; (xiv) all in form and substance satisfactory to Agent in its sole discretion, such consents, approvals and agreements, including, without limitation, any applicable Landlord Waivers and Consents with respect to any and all leases pertaining to the Riveredge Hospital Facility, from such third parties as Agent and its counsel shall determine are necessary or desirable with respect to (A) the Loan Documents and/or the transactions contemplated thereby, and/or (B) claims against any Borrower or Guarantor or the Collateral; 15 (xv) a mortgagee title insurance policy on the Riveredge Hospital Facility (or binding commitment therefor) in form and substance and from Chicago Title Insurance Company or such other title insurer reasonably acceptable to Agent, on an A.L.T.A. 1970 form designated by Agent, which title insurance policy shall (A) specifically contain no exception as to survey matters or creditors rights, (B) contain affirmative coverage against mechanics', contractors', suppliers' and/or materialmen's liens, which may be filed or unfiled, (C) must affirmatively insure that the mortgage or deed of trust is a valid first lien against the fee simple, marketable estate, insuring Agent and Lenders for a sum not less than the maximum principal amount of the Term Loan, (D) insure any easements or leases necessary to access the Riveredge Hospital Facility and such easements or leases shall not be subject to any prior liens, encumbrances, covenants or restrictions and (E) contain such endorsements as may be reasonably required by Agent; provided, however, that such mortgagee title insurance policy may contain the usual "pending disbursements" clause, if applicable; (xvi) evidence that Borrower has a fee simple title to the Riveredge Hospital Facility and to the material fixtures, equipment, furniture and personal property encumbered by the Loan Documents, and such title shall be marketable, and free and clear of all defects, liens, encumbrances, security interests, assessments, restrictions and easements, unless otherwise approved in writing by Agent; (xvii) in form and substance reasonably satisfactory to Agent, evidence that the Riveredge Hospital Facility and all improvements (to the extent required) (i) comply with applicable codes, regulations and ordinances, (ii) are zoned for their current use, (iii) are adequately served by public utilities, (iv) are completed free of mechanics and materialmens liens, (v) are not the subject to any pending or threatened litigation, (vi) are not the subject of any pending or threatened condemnation proceeding, (vii) have not been damaged by fire or other casualty and (viii) are not within a special flood hazard area and are not eligible for flood insurance under the U.S. Flood Disaster Protection Act of 1973, as amended, or such other flood insurance which in Agent's reasonable opinion adequately protects against the risk of damage by flood; (xviii) in form and substance reasonably satisfactory to Agent, evidence that all taxes and assessments on all Real Property owned by Borrower and Guarantors have currently been paid, settlement copies of all recent real estate tax bills, with proof of payment, together with evidence that the mortgaged premises is a separately identifiable tax lot; (xix) in form and substance reasonably satisfactory to Agent, a report of a search of the public records performed against the Riveredge Hospital Facility, Borrower and Guarantor in each state and local jurisdiction, and such report shall show no conditional sales contracts, chattel mortgages, leases of personalty, financing statements or title retention agreements filed and/or recorded against the 16 Riveredge Hospital Facility, Borrower and Guarantor, other than liens which are specifically permitted under this Agreement; (xx) each in form and substance satisfactory to Agent, any and all property as-built A.L.T.A. surveys, environmental reports and other third party reports as Agent shall deem necessary or appropriate; provided, that the environmental report must address such matters as Agent shall request in its sole and absolute discretion, including, without limitation, confirmation of the absence of asbestos in any form that is or could become friable and confirmation of the absence of underground storage tanks; (xxi) copies of all licenses and permits required for Borrower to conduct the business in which it is currently engaged or is contemplated pursuant to the Loan Documents or shall have received an opinion from licensure counsel verifying that all approvals for licensure have been granted; (xxii) copies of all material agreements between Borrower and any healthcare management consultants and/or agents, including documents relating to borrowed money, capital leases and occupancy leases; (xxiii) copies of all participation agreements relating to medical plans of Borrower; (xxiv) the 1818 Mezzanine Fund Subordinated Debt Documents, duly executed by PSI and 1818 Mezzanine Fund and in form and substance satisfactory to Agent; (xxv) that certain Stock Purchase Agreement, duly executed by PSI and the Shareholders of Aeries Corporation and in form and substance satisfactory to Agent; and (xxvi) all other documents Agent may request with respect to any matter relevant to this Amendment or the transactions contemplated hereby. (b) If access to the Riveredge Hospital Facility is by means of easements or leases, said easements or leases shall be satisfactory in form and substance to Agent, shall be covered by the mortgagee title insurance policy. (c) All streets necessary to serve the Riveredge Hospital Facility for the use represented by Borrower shall have been completed and shall be serviceable and all streets to be dedicated shall have been dedicated and accepted for public use and maintenance. (d) The representations and warranties contained herein and in the Loan Agreement and the other documents executed in connection with the Loan Agreement (herein referred to as "LOAN DOCUMENTS"), as each is amended hereby, shall be true and 17 correct as of the date hereof, as if made on the date hereof, except for such representations and warranties as are by their express terms limited to a specific date. (e) Agent shall have completed its due diligence examinations of Borrower, each Subsidiary and each Guarantor, the results of which shall be satisfactory in form and substance to Agent. (f) No Default or Event of Default shall have occurred and be continuing, unless such Default or Event of Default has been otherwise specifically waived in writing by Lender. (g) On or before the Closing Date, Borrower shall pay to Agent, for the ratable benefit of Lenders, $39,750, as a nonrefundable commitment fee. Borrower shall pay Agent a structuring fee as provided in the letter agreement between Agent and Borrower dated as of the date of the Second Amendment. (h) The 1818 Mezzanine Fund Subordinated Debt Documents shall have been duly executed and delivered by the parties thereto and shall be on terms and conditions satisfactory to Agent in its sole discretion, and all conditions precedent contemplated by those agreements shall have been satisfied or waived. (i) The Stock Purchase Agreement and all documents related thereto shall have been duly executed and delivered by the parties thereto and shall be on terms and conditions satisfactory to Agent in its sole discretion, and all conditions precedent contemplated by those agreements shall have been satisfied or waived. (j) All corporate proceedings taken in connection with the transactions contemplated by this Amendment and all documents, instruments and other legal matters incident thereto shall be satisfactory to Lender. ARTICLE IV LIMITED WAIVER By execution of this Amendment, Agent and Lenders hereby waive any Event of Default that would otherwise occur or exist under Section 7.4 of the Loan Agreement solely as a result of Borrower's creation of Holly Hill Real Estate, Cypress Creek Real Estate, West Oaks Real Estate and Neuro Rehab Real Estate. Except as specifically provided in this Article IV, nothing contained herein shall be construed as a consent or waiver by Agent or Lenders of any covenant or provision of the Loan Agreement (including, but not limited to, the consummation of the PMR Merger), the other Loan Documents, this Amendment or any other contract or instrument among the Borrower, Agent and Lenders, and the failure of Agent or Lenders at any time or times hereafter to require strict performance by the Borrower of any provision thereof shall not waive, affect or diminish any right of Agent or Lenders to thereafter demand strict compliance therewith. 18 ARTICLE V RATIFICATIONS, REPRESENTATIONS AND WARRANTIES 5.01 RATIFICATIONS. The terms and provisions set forth in this Amendment shall modify and supersede all inconsistent terms and provisions set forth in the Loan Agreement and the other Loan Documents, and, except as expressly modified and superseded by this Amendment, the terms and provisions of the Loan Agreement and the other Loan Documents are ratified and confirmed and shall continue in full force and effect. The Borrower, the Agent and Lenders agree that the Loan Agreement and the other Loan Documents, as amended hereby, shall continue to be legal, valid, binding and enforceable in accordance with their respective terms. 5.02 REPRESENTATIONS AND WARRANTIES. The Borrower hereby represents and warrants to Lenders that (a) the execution, delivery and performance of this Amendment and any and all other Loan Documents executed and/or delivered in connection herewith have been authorized by all requisite corporate or limited partnership or limited liability company action (as applicable) on the part of the Borrower and will not violate the Articles (or Certificates) of Incorporation or Bylaws of the Borrower that are corporations or the limited partnership agreements or certificates of limited partnership of the Borrower that are limited partnerships or the articles of formation/organization, regulations or limited liability company agreements of the Borrower that are limited liability companies; (b) each of the Borrower's Board of Directors (or the general partner of the applicable limited partnership) or the members or the Board of Managers of the applicable limited liability company has authorized the execution, delivery and performance of this Amendment and any and all other Loan Documents executed and/or delivered in connection herewith; (c) the representations and warranties contained in the Loan Agreement, as amended hereby, and any other Loan Document are true and correct on and as of the date hereof and on and as of the date of execution hereof as though made on and as of each such date; (d) no Default or Event of Default under the Loan Agreement, as amended hereby, has occurred and is continuing, unless such Default or Event of Default has been specifically waived in writing by Lenders; (e) the Borrower is in full compliance with all covenants and agreements contained in the Loan Agreement and the other Loan Documents, as amended hereby; and (f) the Borrower has not amended their Articles (or Certificates) of Incorporation or their Bylaws or similar organizational documents since the date of the Loan Agreement, except as otherwise disclosed to Agent. ARTICLE VI MISCELLANEOUS PROVISIONS 6.01 SURVIVAL OF REPRESENTATIONS AND WARRANTIES. All representations and warranties made in the Loan Agreement or any other Loan Document, including, without limitation, any document furnished in connection with this Amendment, shall survive the execution and delivery of this Amendment and the other Loan Documents, and no investigation by Agent and Lenders or any closing shall affect the representations and warranties or the right of Agent and Lenders to rely upon them. 6.02 REFERENCE TO LOAN AGREEMENT. Each of the Loan Agreement and the other Loan Documents, and any and all other Loan Documents, documents or instruments now or hereafter executed and delivered pursuant to the terms hereof or pursuant to the terms of the Loan Agreement, as amended hereby, are hereby amended so that any reference in the Loan Agreement 19 and such other Loan Documents to the Loan Agreement shall mean a reference to the Loan Agreement, as amended hereby. 6.03 EXPENSES OF AGENT AND LENDERS. As provided in the Loan Agreement, Borrower agrees to pay on demand all costs and expenses incurred by Agent and Lenders, or their Affiliates, in connection with the preparation, negotiation, and execution of this Amendment and the other Loan Documents executed pursuant hereto and any and all amendments, modifications, and supplements thereto, including, without limitation, the costs and fees of legal counsel, and all costs and expenses incurred by Agent and Lenders in connection with the enforcement or preservation of any rights under the Loan Agreement, as amended hereby, or any other Loan Documents, including, without, limitation, the costs and fees of legal counsel. 6.04 SEVERABILITY. Any provision of this Amendment held by a court of competent jurisdiction to be invalid or unenforceable shall not impair or invalidate the remainder of this Amendment and the effect thereof shall be confined to the provision so held to be invalid or unenforceable. 6.05 SUCCESSORS AND ASSIGNS. This Amendment is binding upon and shall inure to the benefit of Agent, Lenders and Borrower and their respective successors and assigns, except that Borrower may not assign or transfer any of their rights or obligations hereunder without the prior written consent of Agent and Lenders. 6.06 COUNTERPARTS. This Amendment may be executed in one or more counterparts, each of which when so executed shall be deemed to be an original, but all of which when taken together shall constitute one and the same instrument. This Amendment may be executed by facsimile transmission, which facsimile signatures shall be considered original executed counterparts for purposes of this Section 6.06, and each party to this Amendment agrees that it will be bound by its own facsimile signature and that it accepts the facsimile signature of each other party to this Amendment. 6.07 EFFECT OF WAIVER. No consent or waiver, express or implied, by Agent or Lenders to or for any breach of or deviation from any covenant or condition by Borrower shall be deemed a consent to or waiver of any other breach of the same or any other covenant, condition or duty. 6.08 HEADINGS. The headings, captions, and arrangements used in this Amendment are for convenience only and shall not affect the interpretation of this Amendment. 6.09 APPLICABLE LAW. THIS AMENDMENT AND ALL OTHER LOAN DOCUMENTS EXECUTED PURSUANT HERETO SHALL BE DEEMED TO HAVE BEEN MADE AND TO BE PERFORMABLE IN AND SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF MARYLAND. 6.10 FINAL AGREEMENT. THE LOAN AGREEMENT AND THE OTHER LOAN DOCUMENTS, EACH AS AMENDED HEREBY, REPRESENT THE ENTIRE EXPRESSION OF THE PARTIES WITH RESPECT TO THE SUBJECT MATTER HEREOF ON THE DATE THIS AMENDMENT IS EXECUTED. THE LOAN AGREEMENT AND THE OTHER LOAN 20 DOCUMENTS, AS AMENDED HEREBY, MAY NOT BE CONTRADICTED BY EVIDENCE OF PRIOR, CONTEMPORANEOUS OR SUBSEQUENT ORAL AGREEMENTS OF THE PARTIES. THERE ARE NO UNWRITTEN ORAL AGREEMENTS BETWEEN THE PARTIES. NO MODIFICATION, RESCISSION, WAIVER, RELEASE OR AMENDMENT OF ANY PROVISION OF THIS AMENDMENT SHALL BE MADE, EXCEPT BY A WRITTEN AGREEMENT SIGNED BY BORROWER AND LENDER. 6.11 RELEASE BY THE BORROWER. THE BORROWER HEREBY ACKNOWLEDGES THAT THEY HAVE NO DEFENSE, COUNTERCLAIM, OFFSET, CROSS-COMPLAINT, CLAIM OR DEMAND OF ANY KIND OR NATURE WHATSOEVER THAT CAN BE ASSERTED TO REDUCE OR ELIMINATE ALL OR ANY PART OF ITS LIABILITY TO REPAY THE "OBLIGATIONS" OR TO SEEK AFFIRMATIVE RELIEF OR DAMAGES OF ANY KIND OR NATURE FROM AGENT OR LENDERS. THE BORROWER HEREBY VOLUNTARILY AND KNOWINGLY RELEASES AND FOREVER DISCHARGES AGENT AND LENDERS AND THEIR PREDECESSORS, AGENTS, EMPLOYEES, SUCCESSORS AND ASSIGNS (COLLECTIVELY, THE "RELEASED PARTIES"), FROM ALL POSSIBLE CLAIMS, DEMANDS, ACTIONS, CAUSES OF ACTION, DAMAGES, COSTS, EXPENSES, AND LIABILITIES WHATSOEVER, KNOWN OR UNKNOWN, ANTICIPATED OR UNANTICIPATED, SUSPECTED OR UNSUSPECTED, FIXED, CONTINGENT, OR CONDITIONAL, AT LAW OR IN EQUITY, ORIGINATING IN WHOLE OR IN PART ON OR BEFORE THE DATE THIS AMENDMENT IS EXECUTED, WHICH THE BORROWER MAY NOW OR HEREAFTER HAVE AGAINST THE RELEASED PARTIES, IF ANY, AND IRRESPECTIVE OF WHETHER ANY SUCH CLAIMS ARISE OUT OF CONTRACT, TORT, VIOLATION OF LAW OR REGULATIONS, OR OTHERWISE, AND ARISING FROM ANY "LOANS", INCLUDING, WITHOUT LIMITATION, ANY CONTRACTING FOR, CHARGING, TAKING, RESERVING, COLLECTING OR RECEIVING INTEREST IN EXCESS OF THE HIGHEST LAWFUL RATE APPLICABLE, THE EXERCISE OF ANY RIGHTS AND REMEDIES UNDER THE LOAN AGREEMENT OR OTHER LOAN DOCUMENTS, AND NEGOTIATION FOR AND EXECUTION OF THIS AMENDMENT. [The Remainder of this Page Intentionally Left Blank] 21 IN WITNESS WHEREOF, this Amendment has been executed and is effective as of the date first above-written. BORROWER: PSYCHIATRIC SOLUTIONS, INC. PSYCHIATRIC SOLUTIONS OF ALABAMA, INC. PSYCHIATRIC SOLUTIONS OF FLORIDA, INC. PSYCHIATRIC SOLUTIONS OF TENNESSEE, INC. SOLUTIONS CENTER OF LITTLE ROCK, INC. PSYCHIATRIC SOLUTIONS OF NORTH CAROLINA, INC. PSI COMMUNITY MENTAL HEALTH AGENCY MANAGEMENT, INC. PSI-EAP, INC. SUNSTONE BEHAVIORAL HEALTH, INC. THE COUNSELING CENTER OF MIDDLE TENNESSEE, INC. PSI HOSPITALS, INC. PSI TEXAS HOSPITALS, LLC PSYCHIATRIC PRACTICE MANAGEMENT OF ARKANSAS, INC. AERIES HEALTHCARE CORPORATION AERIES HEALTHCARE OF ILLINOIS HOLLY HILL REAL ESTATE, LLC By: /s/ Steven T. Davidson --------------------------------------------- Name: Steven T. Davidson -------------------------------------------- Title: Vice President ------------------------------------------ TEXAS CYPRESS CREEK HOSPITAL, L.P. TEXAS WEST OAKS HOSPITAL, L.P. NEURO INSTITUTE OF AUSTIN, L.P. CYPRESS CREEK REAL ESTATE, L.P. WEST OAKS REAL ESTATE, L.P. NEURO REHAB REAL ESTATE, L.P. By: PSI Texas Hospitals, LLC, general partner for each By: /s/ Steven T. Davidson ----------------------------------------- Name: Steven T. Davidson --------------------------------------- Title: Vice President -------------------------------------- AGENT AND LENDER: CAPITALSOURCE FINANCE LLC By: /s/ Kathleen M. Miko -------------------------------------------------- Name: Kathleen M. Miko ------------------------------------------------ Title: Vice President & Deputy General Counsel ---------------------------------------------- ANNEX I FINANCIAL COVENANTS 1) MINIMUM CENSUS As of the last day of each Monthly Test Period, (a) the aggregate combined census levels at the facilities owned, operated or leased by Borrower and (b) the census level at each facility, shall be not less than 85% of the census levels for such applicable calendar months for the facilities listed on Schedule A-1. 2) NET LEVERAGE RATIO (TERM LOAN/EBITDA) As of the last day of each Leverage Test Period, the Net Leverage Ratio shall not exceed 3.00:1.00. 3) TOTAL LEVERAGE RATIO (TOTAL DEBT/EBITDA) As of the last day of each Leverage Test Period beginning on June 30, 2002 through and including December 31, 2002, the Total Leverage Ratio shall not exceed 3.94:1.00. As of the last day of each Leverage Test Period beginning on January 1, 2003 through and including March 31, 2003, the Total Leverage Ratio shall not exceed 3.72:1.00. As of the last day of each Leverage Test Period beginning on April 1, 2003 through and including December 31, 2003, the Total Leverage Ratio shall not exceed 3.50:1.00. As of the last day of each Leverage Test Period beginning on January 1, 2004 through and including December 31, 2004, the Total Leverage Ratio shall not exceed 3.28:1.00. As of the last day of each Leverage Test Period beginning on January 1, 2005 through and including December 31, 2005, the Total Leverage Ratio shall not exceed 3.06:1.00. As of the last day of each Leverage Test Period after January 1, 2006, the Total Leverage Ratio shall not exceed 2.84:1.00. 4) SENIOR LEVERAGE RATIO As of the last day of each Leverage Test Period beginning on June 30, 2002 through and including March 31, 2003, the Senior Leverage shall not exceed 3.06:1.00. As of the last day of each Leverage Test Period beginning on April 1, 2003 through and including December 31, 2003, the Senior Leverage shall not exceed 2.84:1.00. As of the last day of each Leverage Test Period beginning on January 1, 2004 through and including December 31, 2004, the Senior Leverage shall not exceed 2.63:1.00. As of the last day of each Leverage Test Period after January 1, 2005, the Senior Leverage shall not exceed 2.41:1.00. 5) INTEREST COVERAGE RATIO (EBITDA/INTEREST EXPENSE) As of the last day of each Monthly Test Period beginning on June 30, 2002 through and including March 31, 2003, the Interest Coverage Ratio shall not be less than 2.25:1.00. As of the last day of each Monthly Test Period beginning on April 1, 2003 through and including March 31, 2004, the Interest Coverage Ratio shall not be less than 2.53:1.00. As of the last day of each Monthly Test Period after April 1, 2004, the Interest Coverage Ratio shall not be less than 2.81:1.00. 6) FIXED CHARGE RATIO (EBITDA/FIXED CHARGES) As of the last day of each Monthly Test Period beginning June 30, 2002 through and including July 31, 2002, the Fixed Charge Ratio shall be a minimum of 1.50:1.00. As of the last day of each Monthly Test Period beginning August 1, 2002 through and including March 31, 2003, the Fixed Charge Ratio shall be a minimum of 1.35:1.00. As of the last day of each Monthly Test Period after April 1, 2003, the Fixed Charge Ratio shall not be less than 1.50:1.00. For purposes of this financial covenant only, the following shall be excluded from calculation of the Fixed Charge Ratio: (a) the aggregate amount of all principal payments made in an aggregate amount not to exceed $2,500,000 by Borrower to The Brown Schools, Inc. in accordance with the provisions of the note evidencing such Subordinated Debt, (b) all non-cash interest expenses related to such Seller Notes and (c) such other non-occurring charges as Agent may consent to in its sole discretion (e.g., computer conversions). 7) MINIMUM DEBT SERVICE COVERAGE RATIO As of the last day of each Monthly Test Period, the Debt Service Coverage Ratio shall not exceed 1.90:1.00. 8) MINIMUM UNIT MANAGEMENT DIVISION EBITDA As of the last day of each Monthly Test Period after June 30, 2002, Borrower shall not permit its EBITDA for each Monthly Test Period, to be less than an annualized amount equal to $3,500,000; provided, however, that beginning June 30, 2002 through and including the earlier to occur of the PMR Merger and (b) August 31, 2002, Borrower shall not permit its EBITDA for each Monthly Test Period to be less than an annualized amount equal to $5,500,000. For purposes of this financial covenant, the term "EBITDA" of any Person shall relate solely to the Unit Management Division and shall be calculated giving effect to overhead allocated to the Unit Management Division. For purposes of the covenants set forth in this Annex I, the terms listed below shall have the following meanings: "Capital Expenditures" shall mean, for any Test Period, the sum (without duplication) of all expenditures (whether paid in cash or accrued as liabilities) during the Test Period that are or should be treated as capital expenditures under GAAP. "Cash Equivalents" shall mean (a) securities issued, or directly and fully guaranteed or insured, by the United States or any agency or instrumentality thereof (provided, that the full faith and credit of the United States is pledged in support thereof) having maturities of not more than six months from the date of acquisition, (b) U.S. dollar denominated time deposits, certificates of deposit and bankers' acceptances of (i) any domestic commercial bank of recognized standing having capital and surplus in excess of $500,000,000, or (ii) any bank (or the parent company of such bank) whose short-term commercial paper rating from Standard & Poor's Ratings Services ("S&P") is at least A-2 or the equivalent thereof or from Moody's Investors Service, Inc. ("MOODY'S") is at least P-2 or the equivalent thereof in each case with maturities of not more than six months from the date of acquisition (any bank meeting the qualifications specified in clauses (b)(i) or (ii), an "Approved Bank"), (c) repurchase obligations with a term of not more than seven days for underlying securities of the types described in clause (a), above, entered into with any Approved Bank, (d) commercial paper issued by any Approved Bank or by the parent company of any Approved Bank and commercial paper issued by, or guaranteed by, any industrial or financial company with a short-term commercial paper rating of at least A-2 or the equivalent thereof by S&P or at least P-2 or the equivalent thereof by Moody's, or guaranteed by any industrial company with a long term unsecured debt rating of at least A or A2, or the equivalent of each thereof, from S&P or Moody's, as the case may be, and in each case maturing within six months after the date of acquisition and (e) investments in money market funds substantially all of whose assets are comprised of securities of the type described in clauses (a) through (d) above. "Debt Service Coverage Ratio" shall mean, at any date of determination, for Borrower individually and on a consolidated and consolidating basis, without duplication, the ratio of (a) EBITDA for the Monthly Test Period most recently ended before such date (taken as one accounting period), to (b) Total Debt Service for the Monthly Test Period most recently ended before such date (taken as one accounting period). "EBITDA" shall mean, for any Test Period, the sum, without duplication, of the following for Borrower, on a consolidated and consolidating basis: Net Income determined in accordance with GAAP, plus, (a) Interest Expense, (b) taxes on income, whether paid, payable or accrued, (c) depreciation expense, (d) amortization expense, (e) all other non-cash, non-recurring charges and expenses, excluding accruals for cash expenses made in the ordinary course of business, and (f) gain or loss from any sale of assets, other than sales in the ordinary course of business, all of the foregoing determined in accordance with GAAP. "Fixed Charge Ratio" shall mean, at any date of determination, for Borrower individually and collectively on a consolidated and consolidating basis, the ratio of (a) EBITDA for the Monthly Test Period most recently ended before such date, to (b) Fixed Charges for the Monthly Test Period most recently ended before such date, in each case taken as one accounting period. "Fixed Charges" shall mean, on any calculation date, for any Monthly Test Period, the sum of the following for Borrower, individually and collectively, on a consolidated and consolidating basis: (a) Total Debt Service for such period, (b) Capital Expenditures and management and services fees during such period, (c) income taxes paid in cash or accrued during such period, (d) dividends paid or accrued or declared during such period and (e) and principal payments made by Borrower pursuant to a HUD Financing. Any principal payments by Borrower made pursuant to the Revolving Facility shall be excluded from this definition. "Interest Coverage Ratio" shall mean, at any date of determination, for Borrower individually and on a consolidated and consolidating basis, without duplication, the ratio of (a) EBITDA for the Monthly Test Period most recently ended before such date (taken as one accounting period), to (b) Interest Expense for the Monthly Test Period most recently ended before such date (taken as one accounting period). "Interest Expense" shall mean, for any Test Period, total interest expense (including attributable to Capital Leases in accordance with GAAP) of Borrower individually and collectively, on a consolidated and consolidating basis with respect to all outstanding Indebtedness, including, without limitation, (i) the Interest Expense on the aggregate outstanding amount of the Term Loan on such date, (ii) the Interest Expense on the aggregate amount of all Advances outstanding under the Revolving Facility on such date, (iii) the Interest Expense on the aggregate amount of all Capitalized Lease Obligations on such date, (iv) the Interest Expense on the aggregate outstanding amount of all 1818 Mezzanine Fund Subordinated Indebtedness on such date, (v) the Interest Expense on the aggregate outstanding amount of the Seller Notes, excluding all non-cash interest expenses related to such Seller Notes, (vi) Interest Expense on any other Indebtedness on such date, (vii) the Interest Expense on the aggregate outstanding amount of any HUD Financing and (vii) capitalized interest, but excluding commissions, discounts and other fees owed with respect to letters of credit and bankers' acceptance financing and net costs under Interest Rate Agreements. "Interest Rate Agreement" shall mean any interest rate swap, cap or collar agreement or other similar agreement or arrangement designed to hedge the position with respect to interest rates. "Leverage Test Period" shall mean a period ending on the last calendar day of each month, including the twelve most recent calendar months then ended (taken as one accounting period), or such other period as specified in the Agreement or any Annex thereto. "Monthly Test Period" shall mean a period ending on the last calendar day of each month, including the three most recent calendar months then ended (taken as one accounting period), or such other period as specified in the Agreement or any Annex thereto. "Net Income" shall mean, for any Test Period, the net income (or loss) of Borrower individually and collectively on a consolidated and consolidating basis for such period taken as a single accounting period determined in conformity with GAAP; provided, that there shall be excluded (i) the income (or loss) of any Person in which any other Person (other than Borrower) has a joint interest, except to the extent of the amount of dividends or other distributions actually paid to a Borrower by such Person during such period, (ii) the income (or loss) of any Person accrued prior to the date it becomes a Borrower or is merged into or consolidated with a Borrower or that Person's assets are acquired by a Borrower, (iii) the income of any Subsidiary of Borrower to the extent that the declaration or payment of dividends or similar distributions of that income by that Subsidiary is not at the time permitted by operation of the terms of the charter or any agreement, instrument, judgment, decree, order, statute, rule or governmental regulation applicable to that Subsidiary, (iv) compensation expense resulting from the issuance of capital stock, stock options or stock appreciation rights issued to former or current employees, including officers, of a Borrower, or the exercise of such options or rights, in each case to the extent the obligation (if any) associated therewith is not expected to be settled by the payment of cash by a Borrower or any affiliate thereof, and (v) compensation expense resulting from the repurchase of capital stock, options and rights described in clause (iv) of this definition of Net Income. "Net Leverage Ratio" shall mean, at any date of determination, for Borrower individually and collectively on a consolidated and consolidating basis, the ratio of (i) the Term Loan balance on such date, to (ii) EBITDA (including overhead without duplication to overhead allocated to the Unit Management Division) generated from the operation of Borrower owned Real Property. "Senior Leverage Ratio" shall mean, at any date of determination, for Borrower individually and collectively on a consolidated and consolidating basis, the ratio of (i) the aggregate outstanding amount of (A) the aggregate outstanding amount of the Term Loan on such date, (B) the aggregate amount of all Advances outstanding under the Revolving Facility on such date, (C) the aggregate amount of all Capitalized Lease Obligations on such date, and (D) the aggregate outstanding amount of all HUD Financings to (ii) EBITDA (including overhead without duplication to overhead allocated to the Unit Management Division). "Test Period" means, individually and/or collectively, Monthly Test Period and Leverage Test Period. "Total Debt" shall mean, at any date of determination, for Borrower individually and collectively on a consolidated and consolidating basis, the sum of (i) the aggregate outstanding amount of the Term Loan on such date, (ii) the aggregate amount of all Advances outstanding under the Revolving Facility on such date, (iii) the aggregate amount of all Capitalized Lease Obligations on such date, (iv) the aggregate outstanding amount of all Subordinated Debt on such date, (v) the aggregate outstanding amount of all Seller Notes, and (vi) any other Indebtedness on such date, (vii) the aggregate outstanding amount of all HUD Financings, less (viii) cash held on such date and (ix) Cash Equivalents held on such date. "Total Debt Service" shall mean for any period, for Borrower individually and collectively on a consolidated and consolidating basis, the sum of (i) scheduled or other required payments of principal on Indebtedness, and (ii) Interest Expense, in each case for such period. "Total Leverage Ratio" shall mean, at any date of determination, for Borrower individually and collectively on a consolidated and consolidating basis, the ratio of (i) Total Debt on such date, to (ii) EBITDA (including overhead without duplication to overhead allocated to the Unit Management Division). "Unit Management Division" shall mean Borrower's business unit (which operates under Sunstone Behavioral Health, Inc. and its Subsidiaries) which provides management services to the psychiatric units of medical/surgical hospitals pursuant to management contracts. EX-10.21 12 g76727a1exv10w21.txt TERM NOTE DATED 6/28/02 EXHIBIT 10.21 TERM NOTE E U.S. $7,950,000 Dated: June 28, 2002 FOR VALUE RECEIVED, the undersigned, PSYCHIATRIC SOLUTIONS, INC., a Delaware corporation, PSYCHIATRIC SOLUTIONS OF ALABAMA, INC., a Tennessee corporation, PSYCHIATRIC SOLUTIONS OF FLORIDA, INC., a Tennessee corporation, PSYCHIATRIC SOLUTIONS OF TENNESSEE, INC., a Tennessee corporation, SOLUTIONS CENTER OF LITTLE ROCK, INC., a Tennessee corporation, PSYCHIATRIC SOLUTIONS OF NORTH CAROLINA, INC., a Tennessee corporation, PSI COMMUNITY MENTAL HEALTH AGENCY MANAGEMENT, INC., a Tennessee corporation, PSI-EAP, INC., a Delaware corporation, SUNSTONE BEHAVIORAL HEALTH, INC., a Tennessee corporation, THE COUNSELING CENTER OF MIDDLE TENNESSEE, INC., a Tennessee corporation, PSI HOSPITALS, INC., a Delaware corporation, PSI TEXAS HOSPITALS, LLC, a Texas limited liability company, PSYCHIATRIC PRACTICE MANAGEMENT OF ARKANSAS, INC., a Tennessee corporation, TEXAS CYPRESS CREEK HOSPITAL, L.P., a Texas limited partnership, TEXAS WEST OAKS HOSPITAL, L.P., a Texas limited partnership, NEURO INSTITUTE OF AUSTIN, L.P., a Texas limited partnership, AERIES HEALTHCARE CORPORATION, a Delaware corporation, AERIES HEALTHCARE OF ILLINOIS, INC., an Illinois corporation, HOLLY HILL REAL ESTATE, LLC, a North Carolina limited liability company, CYPRESS CREEK REAL ESTATE, L.P., a Texas limited partnership, WEST OAKS REAL ESTATE, L.P., a Texas limited partnership, and NEURO REHAB REAL ESTATE, L.P., a Texas limited partnership (individually and collectively, "BORROWER"), hereby promises to pay to CAPITALSOURCE FINANCE LLC ("LENDER") the unpaid principal amount at any time outstanding, which shall not exceed SEVEN MILLION NINE HUNDRED FIFTY THOUSAND DOLLARS ($7,950,000) (the "TERM LOAN"), with interest thereon and all other Obligations under the Revolving Credit and Term Loan Agreement dated as of November 30, 2001, between Borrower, Agent and Lenders (as those terms are defined therein) (as heretofore and may hereafter be amended, supplemented or otherwise modified from time to time, the "LOAN AGREEMENT"), on the Term Loan Maturity Date (as defined below) or otherwise at the times and in the manner set forth in the Loan Agreement. Capitalized terms used but not defined herein shall have the meanings given them in the Loan Agreement. 1. INTEREST PAYMENTS. (a) Borrower promises to pay interest on the outstanding principal amount of the Term Loan from the date of funding of the Term Loan until such principal amount is irrevocably paid in full in cash. Interest on the outstanding principal amount of the Term Loan under this Term Note E (the "TERM NOTE") shall be due and payable monthly in arrears on the first calendar day of each calendar month, commencing July 1, 2002, at an annual rate of the Prime Rate, plus 4.75%; provided, however, that, notwithstanding any other provision of this Agreement or any other Loan Document, the interest on the outstanding principal balance of the Term Loan under this Term Note E shall be not less than 10.0%, in each case calculated on the basis of a 360-day year and for the actual number of calendar days elapsed in each interest calculation period. (b) Advances under the Revolving Facility shall be made automatically for the payment of interest on the Term Loan and other Obligations on the date when due to the extent available and as provided for in the Loan Agreement. Any payments of principal or interest or other amounts on or payments under this Term Note not paid automatically through Advances under the Revolving Facility as provided in the Loan Agreement shall be paid to Lender only by wire transfer on the date when due, without offset or counterclaim, in dollars in immediately available funds as required in the Loan Agreement. Notwithstanding and without limiting or being limited by any other provision of this Term Note, any payments or prepayments received upon termination or otherwise under this Term Note shall be credited and applied in such manner and order as Lender shall decide in its sole discretion. 2. PRINCIPAL PAYMENT AND MATURITY. Unless earlier due and payable or accelerated under the Loan Agreement, this Term Note shall mature, and the outstanding principal balance hereunder and other Obligations under the Term Loan, together with all other outstanding amounts due hereunder and under the Loan Agreement, shall be made monthly pursuant to the Loan Agreement beginning July 1, 2002 and continuing on the 1st day of each month thereafter through the last month of the Term Loan Term; and (b) the unpaid principal of the Term Loan and all other Obligations under the Term Loan shall be due and payable in full, and this Term Note shall mature, if not earlier in accordance with the Loan Agreement, on the earlier of (i) the occurrence of an Event of Default if required pursuant to the Loan Agreement or Lender's demand upon an Event of Default, and (ii) the last day of the Term Loan Term (such earlier date being the "TERM LOAN MATURITY DATE"). Until such time as the Obligations relating to the Term Loan are indefeasibly paid in full in cash and fully performed, fifty percent (50%) of Borrower's Excess Cash Flow for each fiscal year shall be paid by Borrower to Lender and shall be applied by Lender to reduce the outstanding balance of the Obligations relating to the Term Loan all in accordance with the Loan Agreement. 3. LATE FEE; DEFAULT RATE. (a) Notwithstanding any other provision of this Term Note or the Loan Agreement or any Loan Document, if any payment, interest, Obligation, fee, charge or other amount due hereunder or under any other Loan Document is not received by Lender within three (3) Business Days of the day such payment is due and payable, then Borrower shall pay to Lender a late charge equal to fifteen percent (15.0%) of the amount of such interest or other payment not timely made. (b) Upon the occurrence of an Event of Default and during the continuation thereof, the Applicable Rate of interest in effect at such time with respect to the Obligations shall be increased by five percent (5.0%) per annum. 4. LOAN AGREEMENT AND SECURITY AGREEMENT. (a) This Term Note is referred to in, made pursuant to, and entitled to the benefits of, the Loan Agreement. The Loan Agreement, among other things, (i) provides for the making of the Term Loan by Lender to Borrower in the dollar amount first mentioned above, (ii) contains provisions for acceleration of the maturity hereof upon the happening of certain stated events upon the terms and conditions therein specified, and (iii) contains provisions defining an Event of Default and the rights and remedies of Lender upon the occurrence of an Event of Default. (b) This Term Note is a secured note, entitled to the benefits of and security interests granted in, among other things, that certain Security Agreement dated as of even date herewith, between Borrower and Agent, and the other Security Documents (as such Security Agreement and other Security Documents have been heretofore and may hereafter be amended, supplemented or otherwise modified from time to time). 5. PREPAYMENTS. This Term Note may be prepaid in whole or in part upon notice to Lender and shall be prepaid in whole, in each case as provided or required in the Loan Agreement and upon payment of all fees and other Obligations set forth therein. No payment or 2 prepayment of any amount shall entitle any Person to be subrogated to the rights of Lender hereunder or under the Loan Agreement unless and until the Obligations have been performed in full and paid irrevocably in full in cash and the Loan Agreement has been terminated. 6. PAYMENTS DUE ON A DAY OTHER THAN A BUSINESS DAY. If any payment to be made on or under this Term Note is stated to be due or becomes due and payable on a day other than a Business Day, the due date thereof shall be extended to, and such payment shall be made on, the next succeeding Business Day, and such extension of time in such case shall be included in the computation of payment of any interest (at the interest rate then in effect during such extension) and/or fees, as the case may be. 7. WAIVERS. The Borrower hereby waives demand, presentment, protest, notice of dishonor or non-payment, as well as all defenses with respect to this Term Note, the Loan Agreement and/or any Obligation, notice of acceptance hereof, notice of loans or Advances made, credit extended, collateral received or delivered, or any other action taken in reliance hereon, and all other demands and notices of any description, except such as are expressly provided for herein. The pleading of any statute of limitations as a defense to any demand against Borrower hereunder is expressly waived by Borrower. No cause of action or dealing, renewal or extension of this Term Note or any Loan Document or any rights hereunder or thereunder, release of Borrower or any Guarantor, or delay, failure or omission on Lender's part in enforcing this Term Note or any other Loan Document or in exercising or enforcing any right, remedy, option or power hereunder or under any other Loan Document shall affect the liability of Borrower or any Guarantor or operate as a waiver of such or any other right, remedy, power or option or of any default, nor shall any single or partial exercise of any right, remedy, option or power hereunder or under any other Loan Document affect the liability of Borrower or any Guarantor or preclude any other or further exercise of such or any other right, remedy, power or option. No waiver of any one or more defaults in the performance of any of the provisions of this Term Note shall operate or be construed as a waiver of any future default or defaults, whether of a like or different nature. 8. EXERCISE OF RIGHTS. (a) Lender shall have the right in its sole discretion to determine which rights, powers, Liens, security interests or remedies Lender may at any time pursue, relinquish, subordinate or modify or to take any other action with respect thereto, and such determination will not in any way modify or affect any of Lender's rights, powers, Liens, security interests or remedies hereunder or under any of the Loan Documents, under applicable law or at equity. (b) The enumeration of the foregoing rights and remedies is not intended to be exhaustive. The rights and remedies of Lender described herein are cumulative and are not alternative to or exclusive of any other rights or remedies which Lender otherwise may have by contract or at law or in equity, and the partial or complete exercise of any right or remedy shall not preclude any other further exercise of such or any other right or remedy. 9. LAWFUL LIMITS. This Term Note is expressly limited so that in no contingency or event whatsoever, whether by reason of acceleration or otherwise, shall the interest and other charges paid or agreed to be paid to Lender for the use, forbearance or detention of money hereunder exceed the maximum rate permissible under applicable law which a court of competent jurisdiction shall, in a final determination, deem applicable hereto. If, due to any circumstance whatsoever, fulfillment of any provision hereof, at the time performance of such provision shall be due, shall exceed any such limit, then the obligation to be so fulfilled shall be reduced to such lawful limit, and, if Lender shall have received interest or any other charges of any kind which 3 might be deemed to be interest under applicable law in excess of the maximum lawful rate, then such excess shall be applied first to any unpaid fees and charges hereunder, then to unpaid principal balance owed by Borrower hereunder, and if the then remaining excess interest is greater than the previously unpaid principal balance hereunder, Lender shall promptly refund such excess amount to Borrower and the provisions hereof shall be deemed amended to provide for such permissible rate. The terms and provisions of this Section 9 shall control to the extent any other provision of this Term Note or any Loan Document is inconsistent herewith. 10. GOVERNING LAW. This Term Note shall be governed by and construed in accordance with the internal laws of the State of Maryland without giving effect to its choice of laws provisions. [REMAINDER OF THIS PAGE INTENTIONALLY LEFT BLANK] 4 Executed as of the date first written above. PSYCHIATRIC SOLUTIONS, INC. PSYCHIATRIC SOLUTIONS OF ALABAMA, INC. PSYCHIATRIC SOLUTIONS OF FLORIDA, INC. PSYCHIATRIC SOLUTIONS OF TENNESSEE, INC. SOLUTIONS CENTER OF LITTLE ROCK, INC. PSYCHIATRIC SOLUTIONS OF NORTH CAROLINA, INC. PSI COMMUNITY MENTAL HEALTH AGENCY MANAGEMENT, INC. PSI-EAP, INC. SUNSTONE BEHAVIORAL HEALTH, INC. THE COUNSELING CENTER OF MIDDLE TENNESSEE, INC. PSI HOSPITALS, INC. PSI TEXAS HOSPITALS, LLC PSYCHIATRIC PRACTICE MANAGEMENT OF ARKANSAS, INC. AERIES HEALTHCARE CORPORATION AERIES HEALTHCARE OF ILLINOIS, INC. HOLLY HILL REAL ESTATE, LLC By: /s/ Steven T. Davidson ------------------------------------------- Name: Steven T. Davidson ------------------------------------------- Title: Vice President ------------------------------------------- TEXAS CYPRESS CREEK HOSPITAL, L.P. By: PSI Texas Hospitals, LLC, its general partner By: /s/ Steven T. Davidson --------------------------------------- Name: Steven T. Davidson --------------------------------------- Title: Vice President --------------------------------------- TEXAS WEST OAKS HOSPITAL, L.P. By: PSI Texas Hospitals, LLC, its general partner By: /s/ Steven T. Davidson -------------------------------------- Name: Steven T. Davidson -------------------------------------- Title: Vice President -------------------------------------- NEURO INSTITUTE OF AUSTIN, L.P. By: PSI Texas Hospitals, LLC, its general partner By: /s/ Steven T. Davidson ----------------------------------------- Name: Steven T. Davidson ------------------------------------- Title: Vice President ---------------------------------- CYPRESS CREEK REAL ESTATE, L.P. By: PSI Texas Hospitals, LLC, its general partner By: /s/ Steven T. Davidson ----------------------------------------- Name: Steven T. Davidson --------------------------------------- Title: Vice President -------------------------------------- WEST OAKS REAL ESTATE, L.P. By: PSI Texas Hospitals, LLC, its general partner By: /s/ Steven T. Davidson ----------------------------------------- Name: Steven T. Davidson --------------------------------------- Title: Vice President -------------------------------------- NEURO REHAB REAL ESTATE, L.P. By: PSI Texas Hospitals, LLC, its general partner By: /s/ Steven T. Davidson ---------------------------------------- Name: Steven T. Davidson -------------------------------------- Title: Vice President ------------------------------------- 2 EX-23.1 13 g76727a1exv23w1.txt CONSENT OF ERNST & YOUNG LLP EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the reference to our firm under the caption "Experts" and to the use of our report dated June 21, 2002 included in the joint proxy statement of PMR Corporation that is made a part of the Registration Statement (Amendment No. 1 to Form S-4) and prospectus of PMR Corporation for the registration of 6,307,422 shares of its common stock and 2,420,969 of contingent value rights. Ernst & Young LLP San Diego, California The foregoing consent is in the form that will be signed upon the completion of the restatement of capital accounts described in Note 17 to the financial statements. /s/ Ernst & Young LLP San Diego, California July 3, 2002 EX-23.2 14 g76727a1exv23w2.txt CONSENT OF ERNST & YOUNG LLP EXHIBIT 23.2 CONSENT OF INDEPENDENT AUDITORS We consent to the reference to our firm under the caption "Experts" in the joint proxy statement of PMR Corporation that is made part of Amendment No. 1 to Registration Statement (Form S-4 No. 333-90372) and prospectus of PMR Corporation for the registration of 6,307,422 shares of its common stock and 2,420,969 of contingent value rights and to the use of our reports therein dated (i) April 5, 2002, with respect to the consolidated financial statements of Psychiatric Solutions, Inc.; (ii) May 30, 2002, with respect to the financial statements of Sunrise Behavioral Health, Ltd.; (iii) June 4, 2002, with respect to the financial statements of Holly Hill/Charter Behavioral Health System, L.L.C.; and (iv) May 31, 2002, with respect to the combined financial statements of Cypress Creek Hospital, Inc., West Oaks Hospital, Inc., and Healthcare Rehabilitation of Austin, Inc. /s/ Ernst & Young LLP Nashville, Tennessee July 8, 2002 EX-23.7 15 g76727a1exv23w7.txt CONSENT OF BDO SEIDMAN Exhibit 23.7 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS We hereby consent to the use in the Prospectus constituting a part of this Registration Statement of our report dated February 14, 2002, (except for Notes 9c and 10 which are as of July 1, 2002) relating to the consolidated financial statements of Aeries Healthcare Corporation (d/b/a Riveredge Hospital), which is contained in that Prospectus. We also consent to the reference to us under the caption "Experts" in the Prospectus. BDO SEIDMAN, LLP Chicago, Illinois July 10, 2002 EX-99.1 16 g76727a1exv99w1.txt FORM OF PRM PROXY EXHIBIT 99.1 PMR CORPORATION SPECIAL MEETING OF STOCKHOLDERS TO BE HELD AUGUST 5, 2002 THIS PROXY IS SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS. The undersigned hereby: (i) acknowledges receipt of the Notice of Special Meeting of Stockholders of PMR Corporation, to be held at 9:00 a.m., local time, on August 5, 2002 at PMR Corporation, 1565 Hotel Circle South, 2nd Floor, San Diego, California 92108; (ii) acknowledges receipt of the joint proxy statement/prospectus in connection therewith, dated July 11, 2002; (iii) appoints Fred D. Furman or Reggie Roman, or either of them, as the Proxy of the undersigned; and (iv) authorizes the Proxy to represent and vote, as designated on the reverse side hereof, all the shares of common stock that the undersigned would be entitled to vote if personally present at the special meeting. The undersigned hereby revokes any proxy to vote any shares of common stock held by the undersigned previously given to the extent such proxy permits the holder thereof to vote on the matter covered by this Proxy. THE UNDERSIGNED ACKNOWLEDGES THAT THIS PROXY, WHEN PROPERLY EXECUTED, WILL BE VOTED IN THE MANNER DIRECTED BY THE UNDERSIGNED STOCKHOLDER ON THE REVERSE SIDE OF THIS PROXY CARD. THE PROXIES MAY VOTE IN THEIR DISCRETION ON ANY OTHER MATTER WHICH MAY PROPERLY COME BEFORE THE SPECIAL MEETING. IF YOU SIGN, DATE, AND MAIL THIS PROXY WITHOUT INDICATING HOW YOU WANT TO VOTE, THIS PROXY WILL BE TREATED AS A VOTE FOR THE RESOLUTION DESCRIBED ON THE REVERSE SIDE OF THIS PROXY CARD. IF YOU FAIL TO RETURN THIS PROXY, OR IF YOU RETURN THIS PROXY UNSIGNED, THEN THIS PROXY WILL BE TREATED AS A VOTE AGAINST THE RESOLUTION. You may revoke this proxy at any time before it is voted by either (i) notifying the corporate secretary, in writing, of your intent to revoke this proxy, (ii) attending the special meeting and voting in person or (iii) delivering to the corporate secretary a later-dated proxy. (CONTINUED AND TO BE SIGNED ON THE REVERSE SIDE.) SEE REVERSE SIDE The following issues will be presented to our stockholders for a vote at the special meeting: 1. Approval of the Agreement and Plan of Merger, dated as of May 6, 2002, by and between PMR Corporation, PMR Acquisition Corporation, and Psychiatric Solutions, Inc., as amended by Amendment No. 1 and No. 2 dated as of June 10, 2002 and July 9, 2002, respectively, each as set forth in Annex A attached to the joint proxy statement/prospectus. [ ] FOR [ ] AGAINST [ ] ABSTAIN 2. Approval of an amendment to PMR Corporation's Amended and Restated Certificate of Incorporation that (a) increases the number of authorized shares of PMR Corporation common stock, (b) effects a 1-for-3 reverse stock split, and (c) changes the name of PMR Corporation to "Psychiatric Solutions, Inc." [ ] FOR [ ] AGAINST [ ] ABSTAIN 3. In their discretion, the Proxies are authorized to vote upon such other business as may properly be brought before the meeting or any adjournment or postponement thereof. Dated: , 2002 -------------------------------- --------------------------------------------- --------------------------------------------- Signature(s) of Stockholder(s) (Executors, administrators, guardians, trustees, attorneys, and officers signing for corporations or other organizations should give full title. If a partnership or jointly owned, each owner should sign.)
PLEASE MARK, DATE, AND SIGN THIS PROXY AND RETURN IT IN THE ACCOMPANYING POSTPAID ENVELOPE. EX-99.2 17 g76727a1exv99w2.txt FORM OF PSYCHIATRIC SOLUTION PROXY EXHIBIT 99.2 PROXY PSYCHIATRIC SOLUTIONS, INC. PROXY SPECIAL MEETING OF SHAREHOLDERS, AUGUST 5, 2002 THIS PROXY IS SOLICITED BY THE BOARD OF DIRECTORS The undersigned hereby appoints Joey A. Jacobs and Steven T. Davidson, or either of them, as proxies, with power of substitution, to vote all shares of the undersigned at the special meeting of the shareholders of Psychiatric Solutions, Inc., to be held on August 5, 2002, at 10:00 a.m. local time, at Harwell Howard Hyne Gabbert & Manner, P.C., 315 Deaderick Street, Suite 1800, Nashville, Tennessee 37238 and at any adjournments or postponements thereof, upon the matters described in the accompanying Notice of Special Meeting of Shareholders and the accompanying joint proxy statement/prospectus, receipt of which is acknowledged, and upon any other business that may properly come before the meeting or any adjournment in accordance with the following instructions: 1. PROPOSAL to approve the Agreement and Plan of Merger as amended, by and between Psychiatric Solutions, Inc., PMR Corporation ("PMR"), and PMR Acquisition Corporation, a wholly-owned subsidiary of PMR, and the transactions contemplated by the Agreement and Plan of Merger, as amended. [ ] FOR [ ] AGAINST [ ] ABSTAIN 2. IN THEIR DISCRETION, Joey A. Jacobs and Steven T. Davidson may act upon such other matters as may properly come before the meeting. [ ] FOR DISCRETION [ ] AGAINST DISCRETION [ ] ABSTAIN THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR BOTH PROPOSALS. THE SHARES REPRESENTED HEREBY WILL BE VOTED AS SPECIFIED. IF NO SPECIFICATION IS MADE, THE SHARES WILL BE VOTED FOR APPROVAL OF THE MERGER AND, IN THE DISCRETION OF THE PROXIES, ON SUCH OTHER MATTERS AS MAY PROPERLY COME BEFORE THE MEETING. A FAILURE TO RETURN THIS PROXY CARD OR AN ABSTENTION WILL HAVE THE SAME EFFECT AS VOTING AGAINST THE MERGER. PLEASE SIGN AND DATE BELOW AND RETURN PROMPTLY, USING THE ENCLOSED ENVELOPE. Dated: ---------------------------, 2002 --------------------------------------------- Signature --------------------------------------------- Signature Signatures of shareholder(s) should correspond exactly with the name printed hereon. Joint owners should each sign personally. Executors, administrators, trustees, etc., should give full title and authority.
PSYCHIATRIC SOLUTIONS, INC. 113 SEABOARD LANE, SUITE C-100 FRANKLIN, TENNESSEE 37067 -----END PRIVACY-ENHANCED MESSAGE-----