MAGELLAN HEALTH SERVICES INC - 10-Q Quarterly Report

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

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

The number of shares of the registrant's common stock outstanding as of July 31, 2003 was 35,318,926.

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

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

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

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2003

(Unaudited)

The accompanying unaudited condensed consolidated financial statements of Magellan Health Services, Inc., a Delaware Corporation, and its subsidiaries ("Magellan" or the "Company") have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the Securities and Exchange Commission's (the "SEC") instructions to Form 10-Q. 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, have been included. The results of operations for the three-month and six-month periods ended June 30, 2003, are not necessarily indicative of the results to be expected for the full year.

The accompanying unaudited condensed consolidated financial statements of the Company have been presented on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business. As more fully described below, the Company has violated certain financial covenants on its debt obligations and is facing pending liquidity shortfalls. In addition, the Company has filed for voluntary relief under chapter 11 of the U.S. Bankruptcy Code. These conditions raise substantial doubt about the Company's ability to continue as a going concern. The ability of the Company, both during and after the Chapter 11 Cases (as defined below), to continue as a going concern is dependent upon, among other things, (i) the ability of the Company to confirm a plan of reorganization under the Bankruptcy Code and obtain emergence financing; (ii) the ability of the Company to successfully achieve required cost savings to complete its restructuring; (iii) the ability of the Company to maintain adequate cash on hand; (iv) the ability of the Company to generate cash from operations; (v) the ability of the Company to maintain its customer base; and (vi) the Company's ability to achieve profitability. There can be no assurance that the Company will be able to successfully achieve these objectives in order to continue as a going concern. The accompanying unaudited condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern.

These unaudited condensed consolidated financial statements should be read in conjunction with the Company's audited consolidated financial statements for the transition period from October 1, 2002 to December 31, 2002 and the notes thereto, which are included in the Company's Transition Report on Form 10-K filed with the SEC on August 12, 2003.

On May 14, 2003, the Company's Board of Directors approved a change in the Company's fiscal year. Instead of a fiscal year ending on September 30, the Company adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. Throughout these unaudited condensed consolidated financial statements, references to the Company's historical financial information prior to December 31, 2002 will refer to the Company's former fiscal year end of September 30. For example, fiscal 2001 and 2002 correspond to the twelve-month periods ending September 30, 2001 and 2002,

respectively. References to fiscal 2003 relate to the Company's fiscal year ending December 31, 2003. Certain reclassifications have been made to fiscal 2002 amounts to conform to fiscal 2003 presentation.

On March 11, 2003 (the "Commencement Date"), Magellan and 88 of its subsidiaries (the "Debtors") filed voluntary petitions for relief under chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") (the "Chapter 11 Cases"). Magellan's Chapter 11 Cases have been assigned to the Honorable Prudence Carter Beatty under Case Nos. 03-40514 through 03-40602. Magellan remains in possession of its assets and properties, and continues to operate its business and manage its properties as "debtors-in-possession" pursuant to sections 1107(a) and 1108 of the Bankruptcy Code.

On the Commencement Date, the Bankruptcy Court entered an order authorizing Magellan to pay, among other claims, the pre-petition claims of the Company's behavioral health providers and customers. Also on the Commencement Date, the Bankruptcy Court entered an order authorizing Magellan to pay certain pre-petition wages, salaries, benefits and other employee obligations, as well as to continue in place Magellan's various employee compensation programs and procedures. Since the Commencement Date, the Company has remained in possession of its properties and businesses and has continued to pay such pre-petition claims of behavioral health providers, customers and employees and its post-petition claims in the ordinary course of business.

Chapter 11 is the principal business reorganization chapter of the Bankruptcy Code. Under chapter 11, a debtor is authorized to continue to operate its business in the ordinary course and to reorganize its business for the benefit of its creditors. A debtor-in-possession under chapter 11 may not engage in transactions outside the ordinary course of business without the approval of the Bankruptcy Court, after notice and an opportunity for a hearing. In addition to permitting the rehabilitation of the debtor, section 362 of the Bankruptcy Code generally provides for an automatic stay of substantially all judicial, administrative and other actions or proceedings against a debtor and its property, including all attempts to collect claims or enforce liens that arose prior to the commencement of the debtor's case under chapter 11. Also, the debtor may assume or reject pre-petition executory contracts and unexpired leases pursuant to section 365 of the Bankruptcy Code and other parties to executory contracts or unexpired leases being rejected may assert rejection damage claims as permitted thereunder.

The United States Trustee has appointed an unsecured creditors committee (the "Official Committee"). The Official Committee and their legal representatives have a right to be heard on all matters that come before the Bankruptcy Court, and are the primary entities with which Magellan will negotiate the treatment of the claims of general unsecured creditors. The Official Committee comprises five members, with whom, among others, the Company negotiated the terms of a financial restructuring as embodied in a plan of reorganization filed with the Bankruptcy Court on August 18, 2003 (the "Plan"). The Company believes that approval of the Plan maximizes the recovery to creditors and equity holders. However, there can be no assurance that the Company will be able to obtain the votes necessary to approve the Plan, and disagreements between Magellan and the Official Committee or the lenders could protract the bankruptcy proceedings, could negatively impact Magellan's ability to operate during bankruptcy and could delay Magellan's emergence from bankruptcy. One creditor has informed the Company that it owns sufficient Senior Subordinated Notes (as defined below) to block such class of creditors' acceptance of the Plan, and has notified the Company that it intends to vote against the Plan.

Confirmation and consummation of a plan of reorganization are the principal objectives of a chapter 11 reorganization case. On August 18, 2003, the Company filed with the Bankruptcy Court its Third Amended Plan of Reorganization and the related Disclosure Statement (the "Disclosure Statement").

Under the Plan, holders of the Company's $625.0 million of 9% Senior Subordinated Notes due 2008 (the "Senior Subordinated Notes") will receive, in satisfaction of their claims, which include all accrued and unpaid interest, approximately 88.0% of the new common stock of reorganized Magellan (the "New Common Stock") or approximately 9.0 million shares of New Common Stock. Holders of the Company's $250.0 million of 9³/8% Senior Notes due 2007 (the "Senior Notes') will exchange their Senior Notes and all accrued and unpaid interest thereon for new unsecured notes (the "New Notes") in an amount equal to the face amount of the Senior Notes plus cash equal to the accrued and unpaid interest thereon. As a result of the chapter 11 filing, no cash interest payments will be made regarding either the Senior Subordinated Notes or the Senior Notes during the course of the bankruptcy proceedings. The New Notes will contain terms substantially similar to the existing Senior Notes, will have a maturity of November 15, 2008 and an interest rate of 9³/8% per annum. Holders of general unsecured claims (other than Senior Notes claims and Senior Subordinated Notes claims) will receive, in satisfaction of their claims, cash, New Common Stock equal to approximately 9.5% of reorganized Magellan or approximately 680,000 shares of New Common Stock, and New Notes as set forth in the Plan. The existing Series A redeemable preferred stock of the Company will be cancelled and the holders thereof will receive approximately 2.0% of the New Common Stock or approximately 200,000 shares of New Common Stock, as well as warrants to purchase a like number of shares of New Common Stock. The existing common stock of the Company will also be cancelled and the holders thereof will receive approximately 0.5% of the New Common Stock of the reorganized entity or approximately 50,000 shares of New Common Stock, as well as warrants to purchase a like number of shares of New Common Stock. The distributions of New Common Stock under the Plan will be subject to the dilutive effects of the amount of New Common Stock issued in respect of a rights offering and a direct equity investment for approximately 34.4% of the reorganized entity (see below). Pursuant to the Plan, all outstanding options and warrants to purchase existing common stock will be cancelled, and will not be replaced with options or warrants to purchase New Common Stock.

Under the Plan, it is estimated that 49,637 shares of New Common Stock will be issued to the holders of the 35,318,926 shares of existing common stock or a ratio of approximately 1 share of New Common Stock for every 712 shares of existing common stock. No fractional shares or cash in lieu thereof will be issued or paid. For every share of New Common Stock received, holders of existing common stock will receive a warrant to purchase one additional share of New Common Stock at a purchase price that is approximately 2.9 times the estimated value of the New Common Stock upon emergence. The proposed distributions to the holders of existing preferred stock and common stock are conditioned on all classes of creditors accepting the Plan. The Company has been informed that one creditor who owns sufficient Senior Subordinated Notes to block such class from accepting the Plan intends to vote against the Plan. Under such circumstances, no distribution of New Common Stock will be made to holders of existing preferred stock or common stock, and such New Common Stock will be distributed to holders of general unsecured claims (other than Senior Notes claims). In light of the foregoing, as well as the uncertainty regarding the confirmation of the Plan by the Bankruptcy Court, the Company considers the value of the common stock to be highly speculative and cautions equity holders that the stock may ultimately have no value. Accordingly, the Company urges that appropriate caution be exercised with respect to existing and future investments in the existing common stock.

annum of the face amount of letters of credit. The Company would pay the lenders a fee of one percent of the New Facilities on the effective date of the Plan. The New Facilities would be guaranteed by substantially all of the subsidiaries of Magellan and would be secured by substantially all of the assets of Magellan and the subsidiary guarantors. It is anticipated that the New Facilities will not be used and instead, the Credit Agreement will be refinanced as described below.

On August 1, 2003, the Company entered into a commitment letter with Deutsche Bank (the "DB Commitment Letter") to provide an exit facility (the "Exit Facility") that would provide $100.0 million in term loans, an $80.0 million letter of credit facility and a $50.0 million revolving credit facility. The interest rate on the Exit Facility would be lower than the rates of interest on the New Facilities. Borrowings under the Exit Facility would have a term of five years. The Exit Facility would be guaranteed by substantially all of the subsidiaries of Magellan and would be secured by substantially all of the assets of Magellan and the subsidiary guarantors. The proceeds of the Exit Facility, together with cash on hand, would be used to repay the obligations under the existing Credit Agreement, to pay fees and expenses related to the Chapter 11 Cases, to make other cash payments contemplated by the Chapter 11 Cases, and for general working capital purposes. The DB Commitment Letter is subject to a number of conditions, the satisfaction or waiver of which is necessary prior to Deutsche Bank's obligations thereunder. There is no assurance that the Company will satisfy such conditions or have such conditions waived and therefore no assurance can be given that the Company will be able to borrow under the Exit Facility.

The Plan provides for an option for holders of Senior Subordinated Notes and general unsecured creditors to elect to receive cash in lieu of New Common Stock that they would otherwise be entitled to receive (up to an aggregate maximum of $50 million) at a price of $22.50 per share (the "Partial Cash Out Election"). If such election is oversubscribed, those holders electing such option would be entitled to participate on a pro rata basis and would receive shares of New Common Stock for the portion of the shares of New Common Stock that is not fully cashed out. Under the Plan, this $50 million cash out election would be funded by the purchase of equity by Onex Corporation (the "Equity Investor") as set forth below. If the entire $50 million is subscribed for, approximately 13.6% of the equity of reorganized Magellan would not be issued to creditors, but would be issued to the Equity Investor as set forth below.

The Plan also provides, in accordance with a commitment letter between the Company and the Equity Investor, for reorganized Magellan to issue shares of common stock representing approximately 34.4% of the reorganized Magellan for a purchase price of $150 million in the aggregate. The terms of such offering are as follows: (i) approximately 2.63 million shares, representing approximately 17.2% of reorganized Magellan would be offered to holders of the existing Senior Subordinated Notes and general unsecured creditors for $75 million in the aggregate (or $28.50 per share); (ii) to the extent the holders of the Senior Subordinated Notes and general unsecured creditors elect not to participate in such offering, the Equity Investor would purchase the unsubscribed equity at the same price; and (iii) approximately 2.63 million shares, representing approximately 17.2% of the reorganized Magellan would be purchased by the Equity Investor for a purchase price of $75 million in the aggregate (or $28.50 per share). In addition, up to 13.6% of reorganized Magellan would be purchased by the Equity Investor at an aggregate purchase price of $50 million (or $22.50 per share) solely to the extent necessary to fully fund the Partial Cash-Out Election.

pursuant to the penultimate sentence of this section) shall convert shares of New Common Stock that they may acquire into the same number of shares of MVS Securities unless no MVS Securities are then outstanding. Pursuant to the terms of the Plan, the Equity Investor shall receive shares of MVS Securities on the effective date of the Plan, which MVS Securities shall be entitled to exercise 50% of the voting rights pertaining to all of reorganized Magellan's outstanding common stock (including the New Common Stock and the MVS Securities). The MVS Securities shall be convertible into the same number of shares of New Common Stock upon the transfer of the MVS Securities to any person other than the Equity Investor, Onex, Onex Partners LP, a Delaware limited partnership ("Onex Partners") or an entity controlled by Onex or Onex Partners (including a change of control of any entity other than Onex or Onex Partners owning the MVS Securities so that it is no longer controlled by Onex or Onex Partners).

As part of, and subject to, consummation of the Plan, Aetna Inc. ("Aetna") and Magellan have agreed to renew their behavioral health services contract. Under this agreement, the Company will continue to manage the behavioral health care of Aetna's members through December 31, 2005, with an option for Aetna to either purchase the business or to extend the agreement at that time. Pursuant to the Plan, upon emergence from chapter 11, the Company would pay $15.0 million of its obligation to Aetna of $60.0 million plus accrued interest, and provide Aetna with an interest-bearing note (the "Aetna Note") for the balance, which would mature on December 31, 2005. The Aetna Note would be guaranteed by substantially all of the subsidiaries of Magellan and would be secured by a second lien on substantially all of the assets of Magellan and the subsidiary guarantors. Additionally, if the contract is extended by Aetna at its option through at least December 31, 2006, one-half of the Aetna Note would be payable on December 31, 2005, and the remainder would be payable on December 31, 2006. If Aetna opts to purchase the business, the purchase price could be offset against any amounts owing under the Aetna Note. The Bankruptcy Court approved the renewal of the Aetna agreement on April 23, 2003.

Although the Company has filed the Plan with the Bankruptcy Court, there can be no assurance that the Company will (i) obtain Bankruptcy Court approval of the Plan and the Disclosure Statement; (ii) obtain the approval of the Bankruptcy Court for the transactions referred to above that have not already been approved; (iii) obtain the acceptances from its creditors necessary to confirm and consummate the Plan; and/or (iv) obtain any other requisite approvals to confirm and consummate the Plan. If the Company is not successful in its financial restructuring efforts, the Company will not be able to continue as a going concern.

Certain defaults exist under the Credit Agreement and the indentures governing the Senior Notes and Senior Subordinated Notes that have resulted in acceleration of all indebtedness thereunder. The Company's current liquidity is not sufficient to satisfy the obligations under such acceleration. However, under Section 362 of the Bankruptcy Code, the lenders under the Credit Agreement and the holders of the Senior Notes and Senior Subordinated Notes are prohibited from attempting to collect payment of any of such indebtedness. As a result of such defaults, the Company is unable to access additional borrowings or letters of credit under the Credit Agreement.

The accompanying interim condensed consolidated financial statements have been prepared in accordance with AICPA Statement of Position No. (SOP) 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"), and on a going concern basis as discussed above.

Liabilities subject to compromise in the accompanying condensed consolidated balance sheets refer to certain of the liabilities of the Debtors incurred prior to the Commencement Date that are owed to unrelated parties. In accordance with SOP 90-7, liabilities subject to compromise are recorded at the estimated amount that is expected to be allowed as pre-petition claims in the chapter 11 proceedings and are subject to future adjustments. Adjustments may result from negotiations, actions of the Bankruptcy Court, further developments with respect to disputed claims, rejection of executory contracts and unexpired leases, proofs of claim, implementation of the Plan, or other events. Liabilities subject to compromise consisted of the following as of June 30, 2003 (in thousands):

Current liabilities subject to compromise:
	Senior Subordinated Notes, in default	$	625,000
	Senior Notes, in default		250,000
	Accrued interest on Senior Subordinated Notes		32,188
	Accrued interest on Senior Notes		8,348
	Contingent purchase price payable to Aetna (including accrued interest through Commencement Date)		60,296
	Medical claims payable		35,519
	Other current liabilities		110,560

		$	1,121,911

	Non-current liabilities subject to compromise — other	$	2,876

In order to record its debt instruments at the amount of claim expected to be allowed by the Bankruptcy Court in accordance with SOP 90-7, as of the Commencement Date, Magellan wrote off as reorganization expense its capitalized deferred financing fees associated with the Senior Notes and Senior Subordinated Notes. Reorganization expense also includes professional fees and other expenses directly associated with the bankruptcy process. As part of its financial restructuring plan, the Company has rejected certain leases for closed offices. To the extent the estimated cost to the Company as a result of rejecting such leases is different than the liability previously recorded, such difference has been recorded as a component of reorganization expense, in accordance with SOP 90-7. Furthermore, in accordance with SOP 90-7, reorganization expense includes the estimated interest income that the Company earned attributable to additional unrestricted cash balances that have accumulated as a result of the chapter 11 proceeding.

The following table summarizes reorganization expense (benefit) for the periods indicated (in thousands):

		Three Months Ended June 30, 2003			Six Months Ended June 30, 2003
Continuing operations:
	Deferred financing costs	$	—		$	18,459
	Professional fees and expenses		5,276			9,907
	Interest income		(353	)		(393	)
	Net benefit from lease rejections		(372	)		(268	)

		$	4,551		$	27,705

Discontinued operations:
	Net benefit from lease rejections	$	(132	)	$	(3,167	)

Magellan is required to accrue interest expense during the chapter 11 proceedings only to the extent that it is probable that such interest will be paid pursuant to the proceedings. Based on the

structure of the Plan, Magellan recognized interest expense subsequent to the Commencement Date with respect to the loans and letters of credit under its Credit Agreement, and its capital lease obligations.

Magellan obtained approval from the Bankruptcy Court to pay or otherwise honor certain of its pre-petition obligations, including claims of the Company's behavioral health providers, customers, and employee wages, salaries, benefits and certain other employee obligations. The Company has been paying, and intends to continue to pay, such pre-petition claims in the ordinary course of business. However, in accordance with SOP 90-7, these pre-petition liabilities of the Debtors are classified as "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet at June 30, 2003 to the extent such liabilities have not been paid at that time.

In accordance with SOP 90-7, Magellan is required to record its preferred stock at the amount expected to be allowed as a claim by the Bankruptcy Court. Accordingly, as of the Commencement Date the Company recorded a net $2.7 million adjustment in the three month period ended March 31, 2003, which is mainly composed of the write-off of unamortized issuance costs related to its redeemable preferred stock. Such amount is reflected in "Preferred stock reorganization items, net" in the accompanying condensed consolidated statements of operations for the six months ended June 30, 2003. In addition, the Company stopped accruing preferred stock dividends subsequent to the Commencement Date.

Based on the current terms of the Plan, the Company believes it would qualify for and be required to implement the "Fresh Start" accounting provisions of SOP 90-7 upon emergence from bankruptcy, which would establish a "fair value" basis for the carrying value of the assets and liabilities of reorganized Magellan. The application of "Fresh Start" accounting on the Company's consolidated financial statements may result in material changes in the amounts and classifications of the Company's non-current assets (including property and equipment and intangible assets); however, the potential impact cannot be determined at this time.

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

Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members. Managed care risk revenues earned for the three months ended June 30, 2002 and 2003 approximated $383.6 million and $331.1 million, respectively, and approximated $762.7 million and $683.1 million for the six months ended June 30, 2002 and 2003, respectively.

upon termination of the contracts. The Company recognized performance revenue of approximately $4.3 million and $2.2 million, for the three months ended June 30, 2002 and 2003, respectively, and approximately $8.3 million and $4.3 million during the six months ended June 30, 2002 and 2003, respectively.

The Company provides mental health and substance abuse services to the beneficiaries of TRICARE, formerly the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS"), under two separate subcontracts with health plans that contract with TRICARE. One of these subcontracts associated with TRICARE expired on April 30, 2003. See discussion of these subcontracts in "Significant Customers" below. The Company receives fixed fees for the management of the services, which are subject to certain bid price adjustments ("BPAs"). The BPAs are calculated in accordance with contractual provisions and are based on actual healthcare utilization from historical periods as well as changes in certain factors during the contract period. The Company has information to record, on a quarterly basis, reasonable estimates of the BPAs as part of its managed care risk revenues. These estimates are based upon information available, on a quarterly basis, from both the TRICARE program and the Company's information systems. Under the contracts, the Company settles the BPAs at set intervals over the term of the contracts.

The Company recorded estimated receivables of approximately $3.6 million and $0.3 million as of December 31, 2002 and June 30, 2003, respectively, based upon the Company's interim calculations of the estimated BPAs and certain other settlements. Such amounts were recorded as adjustments to revenues. While management believes that the estimated TRICARE adjustments are reasonable, ultimate settlement resulting from adjustments and available appeal processes may vary from the amounts provided.

Net revenues from two of the Company's customers each exceeded ten percent of consolidated net revenues in each of the six-month periods ended June 30, 2002 and 2003.

Net revenue from Aetna approximated $55.8 million and $46.9 million for the three months ended June 30, 2002 and 2003, respectively, and $117.1 million and $96.7 million for the six months ended June 30, 2002 and 2003, respectively. The current Aetna contract extends through December 31, 2005. See Note A—"General" for discussion of the contract extension with Aetna.

Both the Company, through its wholly owned subsidiary Tennessee Behavioral Health, Inc. ("TBH"), and Premier Behavioral Systems of Tennessee, LLC ("Premier"), an unconsolidated joint venture in which the Company has a fifty percent interest, separately contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program. In addition, the Company contracts with Premier to provide certain services to the joint venture. The Company recognized approximately $59.6 million and $35.4 million of consolidated net revenue for the three months ended June 30, 2002 and 2003, respectively, and approximately $114.5 million and $85.2 million for the six months ended June 30, 2002 and 2003, respectively, in connection with the TennCare program. Such revenue amounts include revenue recognized by the Company associated with services performed on behalf of Premier totaling approximately $34.6 million and $5.3 million for the three months ended June 30, 2002 and 2003, respectively, and approximately $65.8 million and $29.0 million for the six months ended June 30, 2002 and 2003, respectively. TBH and Premier are each operating under an agreed notice of administrative supervision. Under such agreements, the State may exercise additional supervision over the affairs of such entities.

the State of Tennessee exercised its option to delay the transfer of Premier's TennCare membership to TBH for up to six months. In December 2002, Premier signed a contract amendment under which the Premier contract was extended through June 30, 2003. On May 9, 2003, Premier and the State of Tennessee executed an extension of the Premier agreement through December 31, 2003, which agreement required the consent of Magellan's joint venture partner in Premier. The joint venture partner agreed to give such consent provided that Magellan made a capital contribution of approximately $0.9 million into Premier and Premier made a non-pro rata distribution of a like amount to the joint venture partner. Such capital contribution and distribution were completed in May 2003. It is uncertain as to what will happen to the Premier and/or TBH membership after December 31, 2003; however, the State of Tennessee has indicated that it plans to issue a request for proposals ("RFP") relating to the TennCare program. The State has also indicated that if the Company has not emerged from bankruptcy prior to the due date for the RFP, the Company will be precluded from participating in the selection process.

The Company has had a significant concentration of business related to two separate subcontracts with health plans that contract with TRICARE. One of these contracts expired on April 30, 2003. The Company recognized net revenues from this TRICARE contract of $7.0 million and $1.9 million in the quarters ended June 30, 2002 and 2003, respectively. During the six months ended June 30, 2002 and 2003, the Company derived approximately $14.7 million and $9.6 million, respectively, of net revenue from this contract. The Company recognized net revenues from the second TRICARE contract of $11.6 million and $12.2 million in the quarters ended June 30, 2002 and 2003, respectively. During the six months ended June 30, 2002 and 2003, the Company derived approximately $23.6 million and $22.6 million, respectively, of net revenue from this contract. This contract extends through March 31, 2004. The health plan with which the Company has this contract has not included the Company as a subcontractor in its bid to the government for a contract beyond such date.

In addition, the Company derives a significant portion of its revenue from contracts with various counties in the state of Pennsylvania (the "Pennsylvania Counties"). Although these are separate contracts with individual counties, they all pertain to the Pennsylvania Medicaid program. Revenues from the Pennsylvania Counties in the aggregate totaled approximately $51.3 million and $59.4 million for the quarters ended June 30, 2002 and 2003, respectively, and approximately $94.5 million and $115.7 million for the six months ended June 30, 2002 and 2003, respectively. The Company has been notified that its contract with one of the counties will be terminated effective December 31, 2003. Revenue related to this one county totaled approximately $6.0 million and $6.9 million for the quarters ended June 30, 2002 and 2003, respectively, and approximately $11.8 million and $13.5 million for the six months ended June 30, 2002 and 2003, respectively.

Goodwill represents the excess of the cost of businesses acquired over the fair value of the net identifiable assets at the date of acquisition In the first quarter of fiscal 2002, the Company early adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142, the Company no longer amortizes goodwill over its estimated useful life. Instead, the Company is required to test the goodwill for impairment based upon fair values at least on an annual basis. In accordance with the early adoption of SFAS 142, the Company assigned the book value of goodwill to its reporting units. The Company has determined that its reporting units are identical to its reporting segments. The Company selected September 1 as its annual measurement date under SFAS 142. The Company believes that no events have occurred during the quarter ended June 30, 2003 that would require re-evaluation of impairment during such quarter.

At June 30, 2003, the Company had identifiable intangible assets (primarily customer agreements and lists, provider networks, and trademarks and copyrights) of approximately $60.1 million, net of accumulated amortization of approximately $60.3 million. During the three-month transition period ended December 31, 2002, management reevaluated the estimated useful lives of the Company's intangible assets, which resulted in the Company changing the remaining useful lives of certain customer agreements and lists and provider networks. Such changes reflected management's updated best estimates, given the Company's current business environment. The effect of these changes in remaining useful lives was to increase amortization expense for the three-month and six-month periods ended June 30, 2003 by $0.7 million and $2.5 million, respectively. Net income for such periods has been reduced by the same amounts, or $0.02 and $0.07 per diluted share for the three-month and six-month periods ended June 30, 2003, respectively. The remaining estimated useful lives at June 30, 2003 of the customer agreements and lists, provider networks, and trademarks and copyrights range from one to seventeen years.

Long-lived assets, including property and equipment and intangible assets to be held and used, are currently reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be addressed pursuant to SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), which superseded SFAS No. 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"). Pursuant to this guidance, impairment is determined by comparing the carrying value of these long-lived assets to management's best estimate of the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The cash flow projections used to make this assessment are consistent with the cash flow projections that management uses internally to assist in making key decisions, including the development of the proposed financial restructuring. In the event an impairment exists, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the asset, which is generally determined by using quoted market prices or the discounted present value of expected future cash flows. The Company believes that no such impairment existed as of June 30, 2003. In the event that there are changes in the planned use of the Company's long-term assets or its expected future undiscounted cash flows are reduced significantly, the Company's assessment of its ability to recover the carrying value of these assets would change. In addition, upon emergence from bankruptcy, the Company believes that it would be required to apply "Fresh Start" accounting, which could result in a significant change to the recorded values of the Company's long-lived assets.

Medical claims payable represent the liability for healthcare claims reported but not yet paid and claims incurred but not yet reported ("IBNR") related to the Company's managed healthcare businesses. The IBNR portion of medical claims payable is estimated based on past claims payment experience for member groups, enrollment data, utilization statistics, authorized healthcare services and other factors. This data is incorporated into contract-specific actuarial reserve models. Although considerable variability is inherent in such estimates, management believes the liability for medical claims payable is adequate. Medical claims payable balances are continually monitored and reviewed. Changes in assumptions for care costs caused by changes in actual experience could cause these estimates to change in the near term.

The Company files a consolidated federal income tax return for the Company and its wholly owned consolidated subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect of a change in tax rates on deferred taxes is recognized in income in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on the Company's assessment of the realizability of such amounts. The Company's financial restructuring activities and financial condition result in uncertainty as to the Company's ability to realize its net operating loss carryforwards and other deferred tax assets. Accordingly, the Company's deferred tax assets were fully reserved at December 31, 2002 and June 30, 2003.

The Company's effective income tax rate increased to 366.8 percent for the six months ended June 30, 2003 from 42.3 percent for the six months ended June 30, 2002. The current year effective rate exceeds federal statutory rates primarily due to changes in estimates regarding the Company's anticipated utilization of net operating loss carryforwards that existed prior to its emergence from bankruptcy in 1992. Such changes in estimates occurred in the quarter ended June 30, 2003, due to the Company's finalization and amending of certain prior year income tax returns. Because the utilization of such pre-bankruptcy net operating loss carryforwards is subject to continued review and adjustment by the Internal Revenue Service, the Company fully reserves for any utilization of these carryforwards. The prior year effective rate exceeds federal statutory rates primarily due to the state income tax provision.

Under SFAS No. 123, "Accounting for Stock-Based Compensation", ("SFAS 123") which established new financial accounting and reporting standards for stock-based compensation plans, entities are allowed to measure compensation cost for stock-based compensation under SFAS 123 or Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees". Entities electing to remain with the accounting in APB 25 are required to make pro forma disclosures of net income and income per share as if the provisions of SFAS 123 had been applied. The Company has adopted SFAS on a pro forma disclosure basis.

The Company discloses stock-based compensation under the requirements of SFAS 123 and SFAS No. 148, "Accounting for Stock-Based Compensation, Transition and Disclosure". At June 30, 2003, the Company had stock-based employee incentive plans, which are described more fully in Note 7 in the Company's Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002. The following table illustrates pro forma net income and pro forma net income per share as if the fair value-based method of accounting for stock options had been applied in measuring compensation cost for stock-based awards.

Reported and pro forma net income and net income per share amounts are set forth below (in thousands, except per share data):

		Three Months Ended June 30,		Six Months Ended June 30,
		2002		2003		2002		2003
Net income, as reported		$	4,309		$	14,439		$	10,624		$	2,037
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects			—			—			—			—
Deduct: Total stock-based employee compensation expense determined under fair value method, net of related tax effects			(893	)		(265	)		(1,785	)		(530	)
Pro forma net income		$	3,416		$	14,174		$	8,839		$	1,507
Earnings (loss) per share:
	Basic — as reported		$	0.09		$	0.41		$	0.23		$	(0.05	)
	Basic — pro forma		$	0.06		$	0.40		$	0.18		$	(0.06	)
	Diluted — as reported		$	0.08		$	0.35		$	0.23		$	(0.05	)
	Diluted — pro forma		$	0.06		$	0.34		$	0.18		$	(0.06	)

Below is supplemental cash flow information related to the six months ended June 30, 2002 and 2003 (in thousands):

	Six Months Ended June 30,
	2002		2003
Income tax paid (refunds received)	$	748	$	(579	)

Interest paid	$	45,545	$	8,139

The following tables reconcile income (numerator) and shares (denominator) used in the Company's computations of income from continuing operations per common share (in thousands):

Conversion of the redeemable preferred stock (see Note I—"Redeemable Preferred Stock") was not presumed for the three-month periods or the six-month periods ended June 30, 2002 or the six-month period ended June 30, 2003 due to its anti-dilutive effect. Certain stock options and warrants which were outstanding during the three-month period or the six-month period ended June 30, 2002 were not included in the computation of diluted earnings per share because of their anti-dilutive effect. Because the Company has reported a loss from continuing operations during the six months ended June 30, 2003, no common stock equivalents have been included in the computation of weighted average common shares outstanding for the six months ended June 30, 2003.

During fiscal 1997, the Company sold substantially all of its domestic acute-care psychiatric hospitals and residential treatment facilities (collectively, the "Psychiatric Hospital Facilities") to Crescent Real Estate Equities ("Crescent") for $417.2 million in cash and certain other consideration (the "Crescent Transactions"). Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company and Crescent Operating, Inc. ("COI"), an affiliate of Crescent, formed Charter Behavioral Health Systems, LLC ("CBHS") to conduct the operations of the Psychiatric Hospital Facilities and

certain other facilities transferred to CBHS by the Company. The Company retained a 50 percent ownership of CBHS; the other 50 percent ownership interest of CBHS was owned by COI.

On September 10, 1999, the Company transferred certain assets and other interests and forgave certain receivables pursuant to an agreement with Crescent, COI and CBHS that effected the Company's exit from its healthcare provider and healthcare franchising businesses (the "CBHS Transactions"). The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999 (the measurement date), represented the disposal of the Company's healthcare provider and healthcare franchising business segments.

On October 4, 2000, the Company adopted a formal plan to dispose of the business and interest comprised by the Company's specialty managed healthcare segment. The Company exited the specialty managed healthcare business through the sale and/or abandonment of businesses and related assets, certain of which activities had already occurred in the normal course prior to October 4, 2000. The Company has exited all operating contracts entered into in connection with the specialty managed healthcare segment; however, the Company is obligated to satisfy lease agreements, subject to the Chapter 11 proceedings, for which the Company believes it has adequate reserves at June 30, 2003.

On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of National Mentor, Inc. ("Mentor"), which represented the business and interest comprised by the Company's human services segment. On March 9, 2001, the Company consummated the sale of the stock of Mentor for approximately $113.5 million, net of approximately $2.0 million in transaction costs. The Company's consideration consisted of $103.5 million in cash and $10.0 million in the form of an interest-bearing note. Additionally, the Company assumed liabilities of approximately $3.0 million. Approximately $50.2 million of the proceeds were used to retire loans under the Term Loan Facility as required by the Credit Agreement with the remainder of the cash proceeds used to reduce amounts outstanding under the Revolving Facility.

The Company has accounted for the disposal of the discontinued segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. All activity related to the healthcare provider and franchising segments, the specialty managed healthcare segment and the human services segment are reflected as discontinued operations for the three-month and six-month periods ended June 30, 2002 and 2003. As permitted, the assets, liabilities and cash flows related to discontinued operations have not been segregated from those related to continuing operations.

The summarized results of the discontinued operations segments are as follows (in thousands):

During the quarter ended June 30, 2003, the Company sold a hospital facility that resulted in a gain of $0.7 million, net of tax, and received cash as a final distribution associated with a discontinued provider joint venture that resulted in a gain of $0.8 million, net of tax. The remaining assets and liabilities of the healthcare provider and franchising segments at June 30, 2003 include, among other

things, (i) cash and cash equivalents of $0.7 million; (ii) restricted cash of $2.0 million; (iii) accounts receivable of $0.1 million; (iv) investment in provider joint ventures of $1.2 million; (v) hospital-based real estate of $2.4 million; (vi) debt of $6.4 million related to the hospital-based real estate that has been classified as current given a default; and (vii) accounts payable and accrued liabilities of $6.5 million (of which approximately $4.8 million is included in "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet in accordance with SOP 90-7).

The Company is also subject to inquiries and investigations from governmental agencies and other legal contingencies related to the operating and business practices of the healthcare provider segment prior to June 17, 1997. See Note F—"Commitments and Contingencies".

The remaining assets and liabilities of the specialty managed healthcare segment at June 30, 2003 include, among other things, (i) reserve related to the discontinuance of operations of $1.9 million and (ii) accounts payable and accrued liabilities of $0.6 million. These liabilities are included in "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet in accordance with SOP 90-7.

The following table provides a roll-forward of reserves related to the discontinuance of the specialty managed healthcare segment (in thousands):

Type of Cost		Balance December 31, 2002		Payments		Reorganization Expense (Benefit)(1)		Balance June 30, 2003
Lease exit costs		$	5,809		$	(371	)	$	(3,511	)	$	1,927

The Company maintains a program of insurance coverage for a broad range of risks in its business. As part of this program of insurance, the Company is self-insured for a portion of its general and current professional liability risks. Prior to July 1999, the Company maintained certain reserves related primarily to the professional liability risks of the Company's healthcare provider segment prior to the Crescent Transactions. On July 2, 1999, the Company transferred its remaining medical malpractice claims portfolio (the "Loss Portfolio Transfer") to a third-party insurer for approximately $22.3 million. The Loss Portfolio Transfer was funded from assets restricted for settlement of unpaid claims. The insurance limit obtained through the Loss Portfolio Transfer for future medical malpractice claims is $26.3 million. The Company continually evaluates the adequacy of this insured limit and management believes such amount is sufficient; however, there can be no assurance in that regard.

The Company maintained general, professional and managed care liability insurance policies with unaffiliated insurers covering the two-year period from June 17, 2000 to June 16, 2002. The policies were written on a "claims-made" basis, subject to a $0.25 million per claim and $1.0 million annual aggregate self-insured retention for general and professional liability, and also subject to a $0.5 million per claim and $2.5 million annual aggregate self-insured retention for managed care liability. The Company renewed its general, professional and managed care liability insurance policies with unaffiliated insurers for the one-year period from June 17, 2002 to June 16, 2003. These policies were

also written on a "claims-made" basis, and were subject to a $1.0 million per claim ($5.0 million per class action claim) un-aggregated self-insured retention for managed care liability and a $0.25 million per claim un-aggregated self-insured retention for general and professional liability. The Company renewed its general, professional and managed care liability insurance policies with unaffiliated insurers for a one-year period from June 17, 2003 to June 16, 2004. The policies are also written on a "claims-made" basis, subject to a $1.25 million per claim ($10.0 million per class action claim) un-aggregated self-insured retention for managed care liability, and a $0.25 million per claim un-aggregated self-insured retention for general and professional liability. The Company also purchases excess liability coverage in an amount deemed reasonable by management for the size and profile of the organization. The Company is responsible for claims within its self-insured retentions, as well as portions of claims reported after the expiration date of the policies if they are not renewed, or if policy limits are exceeded.

The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations cover, but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, information privacy and security, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Over the past several years, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or regulations by healthcare organizations. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services ("OIG") and the United States Department of Justice ("Department of Justice") and certain other federal and state governmental agencies are currently conducting inquiries and/or investigations regarding the compliance by the Company and certain of its subsidiaries with such laws and regulations. Certain of the inquiries relate to the operations and business practices of the Psychiatric Hospital Facilities prior to the consummation of the Crescent Transactions in June 1997. The Department of Justice has indicated that its inquiries are based on its belief that the federal government has certain civil and administrative causes of action under the Civil False Claims Act, the Civil Monetary Penalties Law, other federal statutes and the common law arising from the participation in federal health benefit programs of the Psychiatric Hospital Facilities nationwide. The Department of Justice inquiries relate to the following matters: (i) Medicare cost reports; (ii) Medicaid cost statements; (iii) supplemental applications to CHAMPUS/TRICARE (as defined) based on Medicare cost reports; (iv) medical necessity of services to patients and admissions; (v) failure to provide medically necessary treatment or admissions; and (vi) submission of claims to government payors for inpatient and outpatient psychiatric services. No amounts related to such proposed causes of action have yet been specified. Subsequent to the Commencement Date, the Company began settlement negotiations with the Department of Justice concerning its inquiries. The Company believes that it will reach a settlement with the Department of Justice, which will include a release from all claims related to its inquiries, prior to the conclusion of the Chapter 11 Cases. As of June 30, 2003, the Company has recorded reserves related to this matter at an amount that it believes is adequate based upon the nature of the aforementioned inquires and based upon the status of the settlement discussions.

In addition, the Company's financial condition could cause regulators of certain of the Company's subsidiaries to exercise certain discretionary rights under regulations including increasing its supervision of such entities, requiring additional restricted cash or other security or seizing or otherwise taking control of the assets and operations of such subsidiaries. The State of California has taken certain actions to increase its supervision of one of the Company's subsidiaries in California. In addition, TBH, Premier and one of the Company's subsidiaries in Iowa are each operating under an agreed notice of

administrative supervision. Under such agreements, the State of Tennessee and the State of Iowa may exercise additional supervision over the affairs of such entities.

Confidentiality and patient privacy requirements are particularly strict in the field of behavioral healthcare. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") requires the Secretary of the Department of Health and Human Services ("HHS") to adopt standards relating to the transmission, privacy and security of health information by healthcare providers and healthcare plans. HIPAA calls for HHS to create regulations in several different areas to address the following: electronic transactions and code sets, privacy, security, provider IDs, employer IDs, health plan IDs and individual IDs. At present, regulations relating to electronic transactions and code sets, privacy, employer IDs and security have been released in final form subject to various implementation dates beginning in April 2003. The Company has commissioned a dedicated HIPAA Project Management Office ("PMO") to coordinate participation from its customers, providers and business partners in achieving compliance with these regulations. The Company, through the PMO, has put together a dedicated HIPAA Project Team to develop, coordinate and implement the compliance plan. Additionally, the Company has identified business area leads and work group chairpersons to support and lead compliance efforts related to their areas of responsibility and expertise.

On or about August 4, 2000, the Company was served with a lawsuit filed by Wachovia Bank, N.A. ("Wachovia") in the Court of Common Pleas of Richland County, South Carolina, seeking recovery under the indemnification provisions of an Engagement Letter between South Carolina National Bank (now Wachovia) and the Company and the Employee Stock Ownership Plan ("ESOP") Trust Agreement between South Carolina National Bank (now Wachovia) and the Company for losses sustained in a settlement entered into by Wachovia with the United States Department of Labor ("DOL") in connection with the ESOP's purchase of stock of the Company in 1990 while Wachovia served as ESOP Trustee. The participants of the ESOP were primarily employees who worked in the Company's healthcare provider and franchising segments. The Company subsequently removed the case to the United States District Court for the District of South Carolina (Case No. 3:00-CV-02664). Wachovia also alleges fraud, negligent misrepresentation and other claims, and asserts losses of $30 million from the settlement with the DOL (plus costs and interest which amount to approximately $10 million as of the date of filing of this Form 10-Q). During the second quarter of fiscal 2001, the court entered an order dismissing all of the claims asserted by Wachovia, with the exception of the contractual indemnification portion of the claim. The Company disputes Wachovia's claims and has been vigorously contesting such claims. During November 2002, the Company's Board of Directors rejected a proposed settlement of this claim that had been reached as a result of court-ordered mediation. As a result, the Company has not recorded any reserves relating to this matter. No trial date has been set by the Court. As part of the Company's bankruptcy proceedings, Wachovia has filed

a proof of claim against the Company for approximately the aforementioned amounts. The Company believes that Wachovia's claims constitute pre-petition general unsecured claims and, to the extent allowed by the Bankruptcy Court, would be resolved as Other General Unsecured Claims under the Plan in the Chapter 11 Cases.

On October 26, 2000, two class action complaints (the "Class Actions") were filed against Magellan Health Services, Inc. and Magellan Behavioral Health, Inc. (the "Defendants") in the United States District Court for the Eastern District of Missouri under the Racketeer Influenced and Corrupt Organizations Act ("RICO") and ERISA. The class representatives purport to bring the actions on behalf of a nationwide class of individuals whose behavioral health benefits have been provided, underwritten and/or arranged by the Defendants since 1996 (RICO class) and 1994 (ERISA class). The complaints allege violations of RICO and ERISA arising out of the Defendants' alleged misrepresentations with respect to and failure to disclose its claims practices, the extent of the benefits coverage and other matters that cause the value of benefits to be less than the value represented to the members. The complaints seek unspecified compensatory damages, treble damages under RICO and an injunction barring the alleged improper practices, plus interest, costs and attorneys' fees. During the third quarter of fiscal 2001, the court transferred the Class Actions to the United States District Court for the District of Maryland (Case No. L-01-01786). These actions are similar to suits filed against a number of other health care organizations, elements of which have already been dismissed by various courts around the country, including the Maryland court where the Class Actions are now pending. While the Class Actions are in the initial stages and an outcome cannot be determined, the Company believes that the claims are without merit and intends to defend them vigorously. The Company has not recorded any reserves related to these matters. The Class Actions have been stayed as a consequence of the commencement of the Company's Chapter 11 Cases. The Company believes that the claims in the Class Actions constitute pre-petition general unsecured claims and, to the extent allowed by the Bankruptcy Court, would be resolved as Other General Unsecured Claims under the Plan in the Chapter 11 Cases. The plaintiffs did not file a timely proof of claim with the Bankruptcy Court and therefore the Company believes that there will be no allowed claim with respect thereto in the Chapter 11 Cases.

The Company is also subject to or party to other class action suits, litigation and claims relating to its operations and business practices. Litigation asserting claims against the Company for pre-petition obligations (the "Pre-petition Litigation") has been stayed as a consequence of the commencement of the Chapter 11 Cases. The Company believes that the Pre-petition Litigation claims constitute pre-petition general unsecured claims and, to the extent allowed by the Bankruptcy Court, would be resolved as Other General Unsecured Claims under the Plan in the Chapter 11 Cases.

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

Several states have initiated audits of the Company's filings related to unclaimed property under escheat laws. A single firm that specializes in unclaimed property audits is conducting the audits on behalf of such states. In general, state escheat statutes allow the examination of unclaimed property filings to extend back ten years or more. The Company has recorded estimated reserves for potential unclaimed property liabilities pertaining to its continuing operations. The Company is also analyzing its potential unclaimed property exposure related to discontinued operations. However, such amounts are not considered probable and estimable at this time, and no discontinued operations reserves related to unclaimed property have been recorded at June 30, 2003.

During fiscal 2000 the Company incurred special charges related to the closure of certain provider offices and restructuring of the corporate function and certain managed behavioral healthcare office sites. At June 30, 2003, outstanding liabilities of approximately $0.8 million related to such activities are included in "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet, in accordance with SOP 90-7.

The following table provides a roll-forward of remaining liabilities resulting from these special charges (in thousands):

Type of Cost		Balance December 31, 2002		Payments		Adjustments		Reorganization Expense (Benefit) (1)		Balance June 30, 2003
Lease termination and other costs		$	1,890		$	(299	)	$	(22	)	$	(781	)	$	788

As of December 31, 2001, management committed the Company to a restructuring plan to eliminate certain duplicative functions and facilities (the "2002 Restructuring Plan") primarily related to the Health Plans segment. The Company's 2002 Restructuring Plan resulted in the recognition of special charges of approximately $8.2 million during fiscal 2002, with special charges of $3.7 million being recorded during the six months ended June 30, 2002. The special charges for fiscal 2002 consisted of (a) $6.3 million to terminate 277 employees, the majority of which were field operational personnel in the Health Plans segment, and (b) $1.9 million to downsize and close excess facilities, and other associated activities. The employee termination costs included severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees in fiscal 2002, with the majority of the terminations completed by September 30, 2002. The remaining employee termination costs are expected to be paid in full by April 30, 2004. The special charges of $1.9 million represent costs to downsize and close 14 leased facilities. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. At June 30, 2003, outstanding liabilities of approximately $0.7 million related to the 2002 Restructuring Plan are included in "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet, in accordance with SOP 90-7.

The following table provides a roll-forward of remaining liabilities resulting from these special charges (in thousands):

In June 2002, the Company implemented a new business improvement initiative named Accelerated Business Improvement ("ABI"). ABI was instituted to expand the initiatives of the 2002 Restructuring Plan to the Company as a whole, and is focused on reducing operational and administrative costs while maintaining or improving service to customers. During fiscal 2002, ABI resulted in recognition of costs of (a) $2.9 million to terminate 228 employees, the majority of which were field operational personnel, and (b) $1.0 million to downsize and close excess facilities and other associated activities. Of the $3.9 million of special charges recognized during fiscal 2002, $0.5 million were recognized during the three months ended June 30, 2002.

During the three months ended December 31, 2002, the Company's ABI initiative resulted in the recognition of special charges of (a) $2.0 million to terminate 172 employees that comprised both field operational and corporate personnel, and (b) $0.5 million to downsize and close excess facilities and other associated activities. At December 31, 2002, outstanding liabilities related to ABI totaled $3.1 million.

During the six months ended June 30, 2003, the Company continued the ABI initiative, which resulted in the recognition of special charges of (a) $1.9 million to terminate an additional 73 employees that represented both field operational and corporate personnel, and (b) $0.1 million to downsize and close additional excess facilities and other associated activities. The employee termination costs of $1.9 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees during the six months ended June 30, 2003, with all of the terminations completed by June 30, 2003. All employee termination costs accrued and unpaid as of June 30, 2003 are expected to be paid in full by September 30, 2004. The other special charges primarily represent costs to downsize and close one additional leased facility. These closure and exit costs include payments required under the lease contract (less any applicable existing or estimated sublease income) after the property was abandoned, write-offs of leasehold improvements related to the facility and other related expenses. At June 30, 2003, outstanding liabilities of approximately $1.5 million related to ABI are included in the accompanying condensed consolidated balance sheet, with liabilities of $0.1 million included in "accrued liabilities" and $1.4 million in "current liabilities subject to compromise" in accordance with SOP 90-7.

The following table provides a roll-forward of liabilities resulting from the special charges incurred in the implementation of this plan (in thousands):

In April 2003, the Company implemented a new business and performance initiative, named Performance Improvement Plan ("PIP"). PIP is focused on further consolidating service centers, creating more efficiencies in corporate overhead, consolidating systems, improving call center technology and instituting other operational and business efficiencies while maintaining or improving service to customers. During the three months ended June 30, 2003, PIP resulted in the recognition of special charges of (a) $1.2 million to terminate 224 employees that represented both field operational and corporate personnel, and (b) $0.1 million to downsize and close one facility. The employee termination costs of $1.2 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees during the three months ended June 30, 2003, with all terminations expected to be completed by January 2004. All termination costs associated with those employees terminated during the three months ended June 30, 2003 are expected to be paid in full by August 2004. In accordance with SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," the liability for termination costs for those employees required to render service until they are terminated that exceeds the minimum retention period (defined as 60 days) is being recognized ratably over the future service period. The Company has estimated that additional termination costs of $1.7 million related to those employees terminated during the three months ended June 30, 2003 will be recognized throughout the remainder of fiscal 2003. The other special charges of $0.1 million represent costs to downsize and close one leased facility. These closure and exit costs include payments required under the lease contract (less any applicable existing and/or estimated sublease income) after the property is abandoned, write-off of leasehold improvements related to the facility and other related expenses. At June 30, 2003, outstanding liabilities of approximately $1.2 million related to PIP are included in the accompanying June 30, 2003 condensed consolidated balance sheet, with the liability for employee severance and termination benefits included in "accrued liabilities" and the liability for lease termination and other costs included in "current liabilities subject to compromise" in accordance with SOP 90-7.

The following table provides a roll-forward of liabilities resulting from these special charges (in thousands):

Implementation of PIP resulted in additional incremental costs that were expensed as incurred. Special charges for the six months ended June 30, 2003 includes $0.2 million for the cost of outside consultants. Also included in special charges for the six months ended June 30, 2003 is income of $1.4 million, primarily related to the collection of a previously reserved note receivable. The note receivable was related to the sale of a subsidiary sold by the Company in fiscal 2001.

The Company operates solely in the managed behavioral healthcare business. The Company provides managed behavioral healthcare services to health plans, insurance companies, corporations, labor unions and various governmental agencies. Within the managed behavioral healthcare business, the Company is further divided into the following four segments, based on the services it provides and/or the customers that it serves, as described below.

The Company provides managed behavioral healthcare services primarily to beneficiaries of managed care companies, health insurers and other health plans. Health Plans' contracts encompass both risk-based and ASO contracts. Although certain large health plans provide their own managed behavioral healthcare services, many health plans "carve out" behavioral healthcare from their general healthcare services and subcontract such services to managed behavioral healthcare organizations such as the Company. In the Health Plans segment, the Company's members are the beneficiaries of the health plan (the employees and dependents of the customer of the health plan), for which the behavioral healthcare services have been carved out to the Company.

Workplace. The Company's Workplace segment mainly provides EAP services and integrated products primarily to employers, including corporations and governmental agencies. In addition, the Workplace segment provides ASO products to certain health plan customers, including Aetna.

Public. The Company provides managed behavioral healthcare services to Medicaid recipients through direct contracts with state and local governmental agencies. Public's contracts encompass both risk-based and ASO contracts. The Company provides managed behavioral healthcare services to the State of Tennessee's TennCare program, both through a direct contract and through Premier, a joint venture in which the Company owns a 50 percent interest.

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

The accounting policies of these segments are the same as those described in the summary of significant accounting policies included in the Company's Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002. The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation, amortization, interest (net), goodwill impairment charges, special charges, reorganization expense, income taxes and minority interest ("Segment Profit"). Intersegment sales and transfers are not significant.

The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):

The following tables reconcile Segment Profit to consolidated income from continuing operations before provision for income taxes and minority interest (in thousands):

On December 5, 1999, TPG Magellan, LLC, an affiliate of the investment firm Texas Pacific Group ("TPG") purchased approximately $59.1 million of the Company's Series A Cumulative Convertible Preferred Stock (the "Series A Preferred Stock") and an Option (the "Option") to purchase approximately $21.0 million of additional Series A Preferred Stock (the "TPG Investment"). The Option expired, without being exercised, on August 19, 2002. Net proceeds from issuance of the Series A Preferred Stock were $54.8 million. Approximately 50 percent of the net proceeds received from the issuance of the Series A Preferred Stock was used to reduce debt outstanding under the Term Loan Facility with the remaining 50 percent of the proceeds being used for general corporate purposes. The Series A Preferred Stock carries a dividend of 6.5 percent per annum, payable in quarterly installments in cash or common stock, subject to certain conditions. Dividends not paid in cash or common stock accumulate. Accumulated dividends are payable only in cash. No dividends have been paid to the holders of Series A Preferred Stock. The Series A Preferred Stock is convertible at any time into the Company's common stock at a conversion price of $9.375 per share (which would result in approximately 6.3 million shares of common stock if all of the currently issued Series A Preferred Stock were to convert) and carries "as converted" voting rights. The Company must redeem the Series A Preferred Stock, plus accrued and unpaid dividends thereon on December 15, 2009.

TPG has the right to nominate three representatives to the Company's Board of Directors. As of August 1, 2003, TPG had two representatives on the Company's seven-member Board of Directors.

Under the Plan, the redeemable preferred stock is subject to compromise. In accordance with SOP 90-7, the Company ceased accruing preferred stock dividends as of the Commencement Date. Also, in accordance with SOP 90-7, in order to record the Series A Preferred Stock at the claim amount that the Company expects will be allowed by the Bankruptcy Court, Magellan reclassified into additional paid-in capital the net deferred issuance costs associated with the Series A Preferred Stock.

The TPG Investment is reflected under the caption "redeemable preferred stock, including accrued dividends (subject to compromise)" in the Company's condensed consolidated balance sheets as follows (in thousands):

MAGELLAN HEALTH SERVICES, INC. AND DEBTOR SUBSIDIARIES
DEBTORS IN POSSESSION
CONDENSED COMBINED BALANCE SHEET
(Unaudited)
(In thousands)

In accordance with SOP 90-7, presented below are the condensed combined financial statements as of June 30, 2003 of the Debtors (Magellan Health Services, Inc. and 88 of its subsidiaries) that filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. Such financial statements have been prepared using standards consistent with the Company's condensed consolidated financial statements.

MAGELLAN HEALTH SERVICES, INC. AND DEBTOR SUBSIDIARIES
DEBTORS IN POSSESSION
CONDENSED COMBINED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands)

MAGELLAN HEALTH SERVICES, INC. AND DEBTOR SUBSIDIARIES
DEBTORS IN POSSESSION
CONDENSED COMBINED STATEMENT OF CASH FLOWS
(Unaudited)
(In thousands)

Subsequent to June 30, 2003, the Board of Directors adopted and the Bankruptcy Court approved the Key Employee Retention Program ("KERP"). The purpose of KERP is to provide supplemental compensation to certain employees, including certain executive members of management, in order to retain such employees through the Company's financial restructuring process. KERP supplemental compensation awards range up to fifty percent of base salary and will be paid 33 percent on July 31, 2003, and the remainder 45 days after consummation of the plan of reorganization.

Item 2.—Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the financial condition and results of operations of Magellan should be read together with the Consolidated Financial Statements and the notes to the Consolidated Financial Statements included elsewhere in this quarterly report and in the Company's Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002.

This Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements include:

Further discussion of factors currently known to management that could cause actual results to differ materially from those in forward-looking statements is set forth under the heading "Cautionary Statements" in Item 1 of Magellan's Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002. When used in this Form 10-Q, the words "estimate," "anticipate," "expect," "believe," "should," and similar expressions are intended to be forward-looking statements. Magellan undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time.

The United States Trustee has appointed an unsecured creditors committee (the "Official Committee"). The Official Committee and their legal representatives have a right to be heard on all matters that come before the Bankruptcy Court, and are the primary entities with which Magellan will negotiate the treatment of the claims of general unsecured creditors. The Official Committee comprises five members, with whom, among others, the Company negotiated the terms of a financial restructuring as embodied in a plan of reorganization filed with the Bankruptcy Court on August 18, 2003 (the "Plan"). Prior to the commencement date of its Chapter 11 Cases, the Company negotiated the terms of a financial restructuring which was incorporated in the original plan of reorganization filed with the Bankruptcy Court on March 11, 2003 ("Original Plan"). Prior to the commencement date of the Chapter 11 Cases, the Company entered into lock-up and voting agreements for the support of the

Original Plan that the Company executed with holders of 52% of the 9³/8% Senior Notes due 2007 (the "Senior Notes"), 35% of the 9% Senior Subordinated Notes due 2008 (the "Senior Subordinated Notes") and 47.5% of its senior secured debt. In connection with the execution of an equity commitment letter with Onex Corporation (the "Equity Investor"), as described below, which was supported by the Official Committee and the agent for the Company's senior lenders, certain modifications were made to the Original Plan as incorporated in the Plan. As a result, the counterparties may terminate such lock-up and voting agreements thereto because certain conditions have not been met. The Official Committee has stated that they support the Plan. The Company believes that approval of the Plan maximizes the recovery to creditors and equity holders. Notwithstanding the foregoing, there can be no assurance that the Company will be able to obtain the votes necessary to approve the Plan, and disagreements between Magellan and the Official Committee or the lenders could protract the bankruptcy proceedings, could negatively impact Magellan's ability to operate during bankruptcy and could delay Magellan's emergence from bankruptcy. One creditor has informed the Company that it owns sufficient Senior Subordinated Notes to block such class of creditors' acceptance of the Plan, and has notified the Company that it intends to vote against the Plan. If the class of claims holders of Senior Subordinated Notes does not vote to accept the Plan, the Company believes that it will be able to confirm the Plan under the applicable provisions of the Bankruptcy Code. There can be no assurance, however, that the Company will be able to do so.

As part of its Chapter 11 Cases, the Debtors routinely file pleadings, documents and reports with the Bankruptcy Court, which may contain updated, additional or more detailed information about the Company, its assets and liabilities or financial performance. Copies of the filings for Magellan's Chapter 11 Cases are available, for a fee, during regular business hours at the office of the Clerk of the Bankruptcy Court or at the Bankruptcy Court's internet site at: http://www.nysb.uscourts.gov.

Under the Plan, holders of the Company's $625.0 million of Senior Subordinated Notes will receive, in satisfaction of their claims, which include all accrued and unpaid interest, approximately 88.0% of the new common stock of reorganized Magellan (the "New Common Stock") or approximately 9.0 million shares of New Common Stock. Holders of the Company's $250.0 million of Senior Notes will exchange their Senior Notes and all accrued and unpaid interest thereon for new unsecured notes (the "New Notes") in an amount equal to the face amount of the Senior Notes plus cash equal to the accrued and unpaid interest thereon. As a result of the chapter 11 filing, no cash interest payments will be made regarding either the Senior Subordinated Notes or the Senior Notes during the course of the bankruptcy proceedings. The New Notes will contain terms substantially similar to the existing Senior Notes, will have a maturity of November 15, 2008 and an interest rate of 9³/8% per annum. Holders of general unsecured claims (other than Senior Notes claims and Senior Subordinated Notes claims) will receive, in satisfaction of their claims, cash, New Common Stock equal to approximately 9.5% of reorganized Magellan or approximately 680,000 shares of New Common Stock, and New Notes as set forth in the Plan. The existing Series A redeemable preferred stock of the Company will be cancelled and the holders thereof will receive approximately 2.0% of the New Common Stock or approximately 200,000 shares of New Common Stock, as well as warrants to purchase a like number of shares of New Common Stock. The existing common stock of the Company will also be cancelled and the holders thereof will receive approximately 0.5% of the New Common Stock of the reorganized entity or approximately 50,000 shares of New Common Stock, as well as warrants to purchase a like number of shares of New Common Stock. The distributions of New Common Stock under the Plan will be subject to the dilutive effects of the amount of New Common Stock issued in respect of a rights offering and a direct equity investment for approximately 34.4% of the reorganized entity (see below). Pursuant to the Plan, all outstanding options and warrants to

purchase existing common stock will be cancelled, and will not be replaced with options or warrants to purchase New Common Stock.

Also pursuant to the Plan, the Company's senior secured bank credit agreement dated February 12, 1998, as amended (the "Credit Agreement"), consisting of term loans of approximately $115.8 million and a revolver under which there are outstanding borrowings of $45.0 million and outstanding letters of credit of approximately $73.5 million, will be either repaid in full (as discussed further below) or will be paid $50.0 million in cash and the remaining balance will be converted to secured term loans (and letter of credit commitments with respect to outstanding letters of credit and renewals thereof) having maturities through November 30, 2005 (the "New Facilities"). The New Facilities would bear interest at a rate equal to the prime rate plus 3.25 percent and the Company would pay letter of credit fees equal to 4.25 percent per annum plus a fronting fee of 0.125 percent per annum of the face amount of letters of credit. The Company would pay the lenders a fee of one percent of the New Facilities on the effective date of the Plan. The New Facilities would be guaranteed by substantially all of the subsidiaries of Magellan and would be secured by substantially all of the assets of Magellan and the subsidiary guarantors. It is anticipated that the New Facilities will not be used and instead, the Credit Agreement will be refinanced as described below.

portion of the shares of New Common Stock that is not fully cashed out. Under the Plan, this $50 million cash out election would be funded by the purchase of equity by Onex Corporation (the "Equity Investor") as set forth below. If the entire $50 million is subscribed for, approximately 13.6% of the equity of reorganized Magellan would not be issued to creditors, but would be issued to the Equity Investor as set forth below.

All purchases made by the Equity Investor would be of a separate class of common stock (the "MVS Securities"), which would be shares of multiple voting common stock of reorganized Magellan. The MVS Securities will be issued to the Equity Investor pursuant to the terms of the Plan. Each share of MVS Securities and each share of the New Common Stock will be identical in all respects, except with respect to voting and except that (a) the MVS Securities will be convertible into New Common Stock, as provided in the Amended Certificate of Incorporation and (b) the Equity Investor and its affiliates (including any entity to which MVS Securities could be transferred without conversion pursuant to the penultimate sentence of this section) shall convert shares of New Common Stock that they may acquire into the same number of shares of MVS Securities unless no MVS Securities are then outstanding. Pursuant to the terms of the Plan, the Equity Investor shall receive shares of MVS Securities on the effective date of the Plan, which MVS Securities shall be entitled to exercise 50% of the voting rights pertaining to all of reorganized Magellan's outstanding common stock (including the New Common Stock and the MVS Securities). The MVS Securities shall be convertible into the same number of shares of New Common Stock upon the transfer of the MVS Securities to any person other than the Equity Investor, Onex, Onex Partners LP, a Delaware limited partnership ("Onex Partners") or an entity controlled by Onex or Onex Partners (including a change of control of any entity other than Onex or Onex Partners owning the MVS Securities so that it is no longer controlled by Onex or Onex Partners). Onex shall be deemed to control any entity controlled by Mr. Gerald W. Schwartz so long as Mr. Schwartz controls Onex. All MVS Securities shall cease to have any special voting rights (i.e., each share of MVS Securities and New Common Stock shall have one vote per share and shall vote together on all matters submitted to stockholders, including the election of all members of the Board of Directors of reorganized Magellan, as a single class) if at any time either (i) the number of outstanding MVS Securities is less than 15.33% of the total number of MVS Securities and shares of New Common Stock issued on the Effective Date or (ii) the number of outstanding MVS Securities is less than 10% of the aggregate number of MVS Securities and shares of New Common Stock then outstanding.

guaranteed by substantially all of the subsidiaries of Magellan and would be secured by a second lien on substantially all of the assets of Magellan and the subsidiary guarantors. Additionally, if the contract is extended by Aetna at its option through at least December 31, 2006, one-half of the Aetna Note would be payable on December 31, 2005, and the remainder would be payable on December 31, 2006. If Aetna opts to purchase the business, the purchase price could be offset against any amounts owing under the Aetna Note. The Bankruptcy Court approved the renewal of the Aetna agreement on April 23, 2003.

Due to Magellan's chapter 11 filing, the condensed consolidated financial statements in this Form 10-Q have been prepared in accordance with AICPA Statement of Position 90-7 "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"). As such, the consolidated financial statements for the periods presented distinguish transactions and events that are directly associated with the reorganization from the Company's ongoing operations. In accordance with SOP 90-7, the Company has presented "liabilities subject to compromise" at the estimated amount that is expected to be allowed as pre-petition claims in the chapter 11 proceedings. Such amounts are subject to future adjustments. Also, the Company has recorded as "reorganization expense" the write-off of deferred financing fees associated with the Senior Notes and the Senior Subordinated Notes, as well as certain professional fees and expenses and other amounts directly associated with the bankruptcy process. Magellan plans to continue to operate in the ordinary course of business during the reorganization process under chapter 11 of the Bankruptcy Code; however, there can be no assurance in this regard. Bankruptcy Court approval of the Company's Plan could materially change the amounts and classifications reported in the condensed consolidated financial statements. Additionally, the Company may, subject to Bankruptcy Court approval, if required, or as permitted in the normal course of business, sell or otherwise dispose of assets and liquidate or settle liabilities for amounts other than those reflected in the accompanying condensed consolidated financial statements. Based on the current terms of the Plan, the Company believes it would qualify for and be required to implement the "Fresh Start" accounting provisions of SOP 90-7 upon emergence from bankruptcy, which would establish a "fair value" basis for the carrying value of the assets and liabilities of reorganized Magellan. The application of "Fresh Start" accounting on the Company's consolidated financial statements may result in material changes in the amounts and classifications of the Company's non-current assets (including property and equipment and intangible assets); however, the potential impact cannot be determined at this time.

On May 14, 2003, the Board of Directors of Magellan approved a change in the Company's fiscal year end. Instead of a fiscal year ending September 30, the Company adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. As a result of this change, Magellan filed a Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002 on August 12, 2003.

Over the past three years, the Company has exited non-core businesses and focused on its core managed behavioral healthcare business. APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of

discontinued operations. The operating results of the discontinued segments have been disclosed, net of income tax, in a separate income statement caption "Discontinued operations—Income (loss) from discontinued operations". The income (loss) the Company incurred to exit the discontinued operations is reflected, net of income tax, in the caption "Discontinued operations—Income (loss) on disposal of discontinued operations". Adjustments to recorded liabilities (mainly lease run-out accruals for closed offices) that result from the chapter 11 process have been disclosed, net of income tax, in a separate income statement caption "Discontinued operations—Reorganization (expense) benefit, net". The assets, liabilities and cash flows related to discontinued operations have not been segregated from continuing operations.

The Company currently is engaged in the managed behavioral healthcare business. The Company coordinates and manages the delivery of behavioral healthcare treatment services through its network of providers, which includes psychiatrists, psychologists and other behavioral health professionals. The Company's managed behavioral healthcare network also includes contractual arrangements with certain third-party treatment facilities. The treatment services provided through these provider networks include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and crisis intervention services. The Company provides these services primarily through: (i) risk-based products, where the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) Administrative Services Only ("ASO") products, where the Company provides services such as utilization review, claims administration and/or provider network management, (iii) Employee Assistance Programs ("EAP") and (iv) products which combine features of some or all of the Company's risk-based, ASO, or EAP products.

At June 30, 2003, the Company managed behavioral healthcare benefits of approximately 59.5 million covered lives, which is a decline of 6.9 million covered lives from March 31, 2003. The reduction in covered lives is mainly attributable to the implementation of the new Aetna contract that resulted in the Company changing the way that its reports the Aetna membership it serves. Aetna pays the Company for ASO members on a per product basis based on estimates of the number of its members that receive various ASO products. In certain instances, there are members that are served with more than one product, and the Company received more than one payment with respect to such members. Under the new agreement with Aetna, the Company will be reimbursed on a per ASO member basis with blended rates that reflect the product use, which results in substantially equivalent revenue but lower membership counts. Beginning with the quarter ended June 30, 2003 the Company has started reporting the lower membership totals related to Aetna based on current estimates, which has resulted in a 5.5 million reduction in covered lives reported by the Company. This reduction in reported Aetna membership does not result in lower revenue.

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

The Company provides managed behavioral healthcare services primarily to beneficiaries of managed care companies, health insurers and other health plans. Health Plans' contracts encompass both risk-based and ASO contracts. Although certain large health plans provide their own managed behavioral healthcare services, many health plans "carve out" behavioral healthcare from their general healthcare services and subcontract such services to managed behavioral healthcare organizations such as the Company. In the Health Plans segment, the Company's members are the beneficiaries of the health plan (the employees and dependents of the customer of the health plan) for which the behavioral healthcare services have been carved out to the Company.

During the three months ended June 30, 2002 and 2003 the Company derived approximately $55.8 million and $46.9 million, respectively, of net revenue from its contract with Aetna, Inc. ("Aetna"), with the majority of such revenue associated with the Health Plans segment. During the six months ended June 30, 2002 and 2003 the Company derived approximately $117.1 million and $96.7 million, respectively, of net revenue from its contract with Aetna. The decline in Aetna revenue of approximately $20.4 million in the six months ended June 30, 2003 compared to the six months ended June 30, 2002 was mainly due to decreased membership as a result of Aetna intentionally reducing its membership levels during calendar 2002 and the first six months of 2003 in an effort to exit less profitable businesses.

As described above, as part of, and subject to, consummation of the Plan, Aetna and Magellan have agreed to renew their contract, under which the Company will continue to manage the behavioral health care of Aetna's members through December 31, 2005.

The Company has had a significant concentration of business related to two separate subcontracts with health plans that contract with TRICARE. One of these contracts expired on April 30, 2003. The Company recognized net revenues from this TRICARE contract of $7.0 million and $1.9 million in the quarters ended June 30, 2002 and 2003, respectively. During the six months ended June 30, 2002 and 2003, the Company derived approximately $14.7 million and $9.6 million, respectively, of net revenue from this contract. The decline in revenue associated with this TRICARE contract of approximately $5.1 million in the six months ended June 30, 2003 compared to the six months ended June 30, 2002 is mainly due to the expiration of this contract on April 30, 2003. The Company recognized net revenues from the second TRICARE contract of $11.6 million and $12.2 million in the quarters ended June 30, 2002 and 2003, respectively. During the six months ended June 30, 2002 and 2003, the Company derived approximately $23.6 million and $22.6 million, respectively, of net revenue from this contract. This contract extends through March 31, 2004. The health plan with which the Company maintains this contract has not included the Company as a subcontractor in its bid to the government for a contract beyond such date.

Choice Behavioral Health Partnership ("Choice"), in which the Company previously had a fifty percent interest, also is a subcontractor with respect to TRICARE. All of Choice's revenues are derived from its subcontract with respect to TRICARE. Such subcontract expired on June 30, 2003. Effective October 29, 2002, the Company withdrew from the Choice partnership on the following terms: (i) the Company is to receive or pay, as the case may be, fifty percent of all bid price adjustments, change order and other pricing adjustments finalized subsequent to October 31, 2002 but relating to the period prior to November 1, 2002; (ii) the Company would continue to share in fifty percent of all profits or losses from Choice for the period from November 1, 2002 through June 30, 2003; and (iii) if Choice's subcontract is extended beyond June 30, 2003, the Company would be paid $150,000 per month for the extension period up to a maximum of twelve months. Choice's subcontract has been extended on a monthly basis at least through August 2003.

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

The Company's Workplace segment mainly provides EAP services and integrated products primarily to employers, including corporations and governmental agencies. In addition, the Workplace segment provides ASO products to certain Health Plan customers, including Aetna.

The Company provides managed behavioral healthcare services to Medicaid recipients through direct contracts with state and local governmental agencies. Public's contracts encompass both risk-based and ASO contracts. Public risk contracts generally have higher per member premiums, cost and (to some degree) more volatility than both Health Plans and Workplace, due to the nature of populations, benefits provided and other matters.

Both the Company, through its wholly owned subsidiary Tennessee Behavioral Health, Inc. ("TBH"), and Premier Behavioral Systems of Tennessee, LLC ("Premier"), an unconsolidated joint venture in which the Company has a fifty percent interest, separately contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program. In addition, the Company contracts with Premier to provide certain services to the joint venture. The Company recognized approximately $59.6 million and $35.4 million of consolidated net revenue for the three months ended June 30, 2002 and 2003, respectively, and approximately $114.5 million and $85.2 million for the six months ended June 30, 2002 and 2003, respectively, in connection with the TennCare program. Such revenue amounts include revenue recognized by the Company associated with services performed on behalf of Premier totaling approximately $34.6 million and $5.3 million for the three months ended June 30, 2002 and 2003, respectively, and approximately $65.8 million and $29.0 million for the six months ended June 30, 2002 and 2003, respectively. The decline in revenue associated with the TennCare program was primarily the result of the reduction in revenue associated with services no longer performed on behalf of Premier due to a program change, which reduction was partially offset by increases in rates. TBH and Premier are each operating under an agreed notice of administrative supervision. Under such agreements, the State may exercise additional supervision over the affairs of such entities.

In May 2002, the Company signed a contract with the State of Tennessee under which the Company was to provide all services under the TennCare program through a direct contract with TBH. Such TennCare contract covers the period from July 1, 2002 through December 31, 2003. Accordingly, Premier was to cease providing services upon the expiration of its contract on June 30, 2002; however, the State of Tennessee exercised its option to delay the transfer of Premier's TennCare membership to TBH for up to six months. In December 2002, Premier signed a contract amendment under which the Premier contract was extended through June 30, 2003. On May 9, 2003, Premier and the State of Tennessee executed an extension of the Premier agreement through December 31, 2003, which agreement required the consent of Magellan's joint venture partner in Premier. The joint venture partner agreed to give such consent provided that Magellan made a capital contribution of approximately $0.9 million into Premier and Premier made a non-pro rata distribution of a like amount to the joint venture partner. Such capital contribution and distribution were completed in May 2003. It is uncertain as to what will happen to the Premier and/or TBH membership after December 31, 2003; however, the State of Tennessee has indicated that it plans to issue a request for proposals ("RFP") relating to the TennCare program. The State has also indicated that if the Company has not emerged from bankruptcy prior to the due date for the RFP, the Company will be precluded from participating in the selection process.

ended June 30, 2002 and 2003, respectively, and approximately $11.8 million and $13.5 million for the six months ended June 30, 2002 and 2003, respectively.

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

The Company has the ability to earn performance-based revenue, primarily under certain non-risk contracts. Performance-based revenue generally is based on the ability of the Company to manage care for its ASO clients below specified targets. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue is recognized on an interim basis pursuant to the rights and obligations of each party upon termination of the contracts. The Company recognized performance revenue of approximately $4.3 million and $2.2 million, for the three months ended June 30, 2002 and 2003, respectively, and approximately $8.3 million and $4.3 million during the six months ended June 30, 2002 and 2003, respectively.

The Company provides mental health and substance abuse services to the beneficiaries of TRICARE, formerly the Civilian Health and Medical Program of the Uniformed Services (CHAMPUS), under two separate subcontracts with health plans that contract with TRICARE. One of these subcontracts associated with TRICARE expired on April 30, 2003. See discussion of these subcontracts in "Health Plans" above. The Company receives fixed fees for the management of the services, which are subject to certain BPAs. The BPAs are calculated in accordance with contractual provisions and are based on actual healthcare utilization from historical periods as well as changes in certain factors during the contract period. The Company has information to record, on a quarterly basis, for reasonable estimates of the BPAs as part of its managed care risk revenues. These estimates are based upon information available, on a quarterly basis, from both the TRICARE program and the Company's information systems. Under the contracts, the Company settles the BPAs at set intervals over the term of the contracts.

Property and equipment are stated at cost, except for assets that have been impaired, for which the carrying amount is reduced to estimated fair value. Expenditures for renewals and improvements are capitalized to the property accounts. Replacements and maintenance and repairs that do not improve or extend the life of the respective assets are expensed as incurred. Internal-use software is capitalized in accordance with American Institute of Certified Public Accountants ("AICPA") Statement of Position 98-1, "Accounting for Cost of Computer Software Developed or Obtained for Internal Use." Amortization of capital lease assets is included in depreciation expense. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets, which is generally two to ten years for buildings and improvements, three to ten years for equipment and three to five years for capitalized internal-use software.

Goodwill represents the excess of the cost of businesses acquired over the fair value of the net identifiable assets at the date of acquisition. In the first quarter of fiscal 2002, the Company early adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142, the Company no longer amortizes goodwill over its estimated useful life. Instead, the Company is required to test the goodwill for impairment based upon fair values at least on an annual basis. In accordance with the early adoption of SFAS 142, the Company assigned the book value of goodwill to its reporting units. The Company has determined that its reporting units are identical to its reporting segments. The Company selected September 1 as its annual measurement date under SFAS 142. The Company believes that no events have occurred during the quarter ended June 30, 2003 that would require re-evaluation of impairment during such quarter.

At June 30, 2003, the Company had identifiable intangible assets (primarily customer agreements and lists, provider networks and trademarks and copyrights) of approximately $60.1 million, net of accumulated amortization of approximately $60.3 million. During the quarter ended December 31, 2002, management reevaluated the estimated useful lives of the Company's intangible assets, which resulted in the Company changing the remaining useful lives of certain customer agreements and lists and provider networks. Such changes reflected management's updated best estimates, given the Company's current business environment. The effect of these changes in remaining useful lives was to increase amortization expense for the three-month and six-month periods ended June 30, 2003 by $0.7 million and $2.5 million, respectively. Net income for such periods has been reduced by the same amounts, or $0.02 and $0.07 per diluted share for the three-month and six-month periods ended June 30, 2003, respectively. The remaining estimated useful lives at June 30, 2003 of the customer agreements and lists, provider networks, and trademarks and copyrights range from one to seventeen years.

this assessment are consistent with the cash flow projections that management uses internally to assist in making key decisions, including the development of the proposed financial restructuring. In the event an impairment exists, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the asset, which is generally determined by using quoted market prices or the discounted present value of expected future cash flows. The Company believes that no such impairment existed as of June 30, 2003. In the event that there are changes in the planned use of the Company's long-term assets or its expected future undiscounted cash flows are reduced significantly, the Company's assessment of its ability to recover the carrying value of these assets would change. In addition, upon emergence from bankruptcy, the Company believes that it would be required to apply "Fresh Start" accounting, which could result in a significant change to the recorded values of the Company's long-lived assets.

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51" (the "Interpretation"). The Interpretation requires consolidation of entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Currently, entities are generally consolidated by an enterprise when it has a controlling financial interest through ownership of a majority voting interest in the entity. The Company is required to adopt the provisions of the Interpretation effective July 1, 2003. The Company is currently evaluating the effects of the issuance of the Interpretation on the Company's financial statements.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"). This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3,

"Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF No. 94-3"). SFAS 146 is effective for exit or disposal activities initiated after December 31, 2002, and therefore the Company has applied the provisions of SFAS 146 to its exit activities subsequent to that date.

The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation, amortization, interest (net), goodwill impairment charges, special charges, reorganization expense, income taxes and minority interest ("Segment Profit"). See Note H—"Business Segment Information" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in millions):

Quarter ended June 30, 2003 ("Current Year Quarter"), compared to the quarter ended June 30, 2002 ("Prior Year Quarter")

Net revenue related to the Health Plans segment decreased by 9.6 percent or $22.7 million to $214.5 million for the Current Year Quarter from $237.2 million for the Prior Year Quarter. The decrease in revenue is mainly due to a reduction in revenue under the Company's contract with Aetna (mainly due to decreased membership) of $8.2 million, terminated contracts of $27.9 million, lower performance revenue of $2.4 million (see below), contract changes (mainly risk to non-risk) of $7.9 million, which decreases were partially offset by net increases in rates of $6.3 million, net increased membership from existing customers (excluding Aetna) of $5.7 million, the recognition of $6.9 million of revenue from the Company's agreement with respect to its withdrawal from the Choice partnership, new business of $4.7 million and other net changes.

Performance-based revenues for the Health Plans segment were $4.0 million and $1.6 million for the quarters ended June 30, 2002 and 2003, respectively. The decrease is primarily due to the Prior Year Quarter including performance revenue for a contract that no longer has performance revenue terms.

Cost of care decreased by 4.5 percent or $6.3 million to $135.0 million for the Current Year Quarter from $141.3 million for the Prior Year Quarter. The decrease in cost of care is primarily due to a reduction in care under the Company's contract with Aetna (mainly due to decreased membership) of $5.6 million, terminated contracts of $19.0 million and net contract changes (mainly risk to non-risk) of $6.5 million, which decreases were partially offset by net increased membership from existing customers (excluding Aetna) of $0.9 million, estimated higher costs due to care trends and other net changes of $23.2 million and new business of $0.7 million. Cost of care increased as a percentage of risk revenue from 70.6 percent in the Prior Year Quarter to 79.2 percent in the Current Year Quarter, mainly due to unfavorable care trends.

Direct service costs decreased by 27.4 percent or $11.6 million to $30.8 million for the Current Year Quarter from $42.4 million for the Prior Year Quarter. The decrease in direct service costs is primarily due to cost reduction efforts undertaken by the Company including the shutdown of several regional service centers, as well as lower costs required to support the Company's decrease in net membership. Direct service costs decreased as a percentage of revenue from 17.9 percent for the Prior Year Quarter to 14.4 percent for the Current Year Quarter. The decrease in the percentage of direct service costs in relationship to revenue is mainly due to the aforementioned cost reduction efforts undertaken by the Company and rate and other revenue increases since the Prior Year Quarter.

Equity in (earnings) loss of unconsolidated subsidiaries decreased 62.8 percent or $2.7 million to $(1.6) million for the Current Year Quarter from $(4.3) million for the Prior Year Quarter. The decrease relates to the Company's withdrawal from the Choice partnership as of the end of October 2002, with equity in earnings of Choice totaling $(2.7) million for the Prior Year Quarter.

Net revenue related to the Workplace segment decreased by 14.9 percent or $8.5 million to $48.7 million for the Current Year Quarter from $57.2 million for the Prior Year Quarter. The decrease in revenue is mainly due to net decreased membership from existing customers (excluding Aetna) of $1.8 million, terminated contracts of $6.8 million, and a reduction in revenue under the Company's contract with Aetna (mainly due to decreased membership) of $0.7 million, which decreases were partially offset by changes in estimates of performance penalties and other net changes.

Cost of care decreased by 36.3 percent or $7.0 million to $12.3 million for the Current Year Quarter from $19.3 million for the Prior Year Quarter. The decrease in cost of care is mainly due to net decreased membership from existing customers (excluding Aetna) of $0.6 million, net terminated contracts of $5.0 million and estimated lower costs due to care trends and other net changes of $1.4 million. The lower costs due to care trends for the Workplace segment are due to the closure of several staff offices which had higher per visit costs than that incurred by utilizing the Company's network of outpatient providers. Cost of care decreased as a percentage of risk revenue from 41.5 percent in the Prior Year Quarter to 31.8 percent in the Current Year Quarter, mainly due to lower care trends experienced in the Current Year Quarter and changes in business mix.

Direct service costs decreased by 10.0 percent or $2.1 million to $18.9 million for the Current Year Quarter from $21.0 million for the Prior Year Quarter. The decrease in direct service costs is mainly due to cost reduction efforts undertaken by the Company. As a percentage of revenue, direct service costs increased from 36.7 percent for the Prior Year Quarter to 38.8 percent for the Current Year Quarter. The increase in the percentage of direct service costs in relationship to revenue is mainly due to the reduction in revenue due to terminated contracts and decreased membership from existing customers (as described above), for which there is a delayed impact to direct service costs.

Net revenue related to the Public segment decreased by 10.9 percent or $15.6 million to $127.1 million for the Current Year Quarter from $142.7 million for the Prior Year Quarter. The decrease in revenue is mainly due to a net reduction in revenue with respect to the TennCare program of $25.5 million, primarily as a result of a program change (as described above) and terminated contracts of $1.0 million, which decreases were partially offset by net increased membership from other existing customers of $2.8 million, net rate increases (other than from TennCare) and other net changes of $8.1 million.

Cost of care decreased by 13.7 percent or $16.4 million to $103.3 million for the Current Year Quarter from $119.7 million for the Prior Year Quarter. The decrease in cost of care is mainly due to a net reduction in cost of care with respect to the TennCare program of $26.8 million, primarily as a result of a program change (as described above), which decrease was partially offset by net increased membership from other existing customers of $1.9 million and higher costs due to care trends (other than with respect to TennCare) and other net changes of approximately $8.5 million. As a percentage

of risk revenue, cost of care decreased from 87.5 percent for the Prior Year Quarter to 84.6 percent for the Current Year Quarter, mainly due to contract changes in the Current Year Quarter.

Direct service costs were $10.3 million for both the Current Year Quarter and the Prior Year Quarter. The Company experienced a decrease in direct service costs primarily due to cost reduction efforts undertaken by the Company, which decrease was offset by higher costs required to support the increase in net membership. As a percentage of revenue, direct service costs increased from 7.2 percent for the Prior Year Quarter to 8.1 percent for the Current Year Quarter, primarily due to lower revenue for the Current Year Quarter with respect to the TennCare program.

Equity in loss of unconsolidated subsidiaries decreased $3.8 million to $0.4 million for the Current Year Quarter from $4.2 million for the Prior Year Quarter. The investment in unconsolidated subsidiary relates to Premier. The decrease in loss is primarily due to favorable rate changes and other contractual changes, which increases were partially offset by decreased membership.

Other operating costs related to the Corporate and Other Segment increased by 2.2 percent or $0.9 million to $41.0 million for the Current Year Quarter from $40.1 million for the Prior Year Quarter. This increase is mainly due to higher discretionary employee benefit costs of $2.9 million, partially offset by the Company's cost reduction efforts. As a percentage of total net revenue, other operating costs increased from 9.2 percent for the Prior Year Quarter to 10.5 percent for the Current Year Quarter primarily due to the lower revenue in the Current Year Quarter (as described above) and the higher discretionary employee benefit costs.

Depreciation and amortization decreased by 9.8 percent or $1.2 million to $11.0 million for the Current Year Quarter from $12.2 million for the Prior Year Quarter. The decrease is due to a reduction in depreciation expense mainly related to certain capitalized software assets that became fully depreciated at March 31, 2003, partially offset by an increase in amortization expense related to an adjustment of the remaining useful lives of certain intangible assets as of October 1, 2002.

Interest expense decreased by 80.1 percent or $19.7 million to $4.9 million for the Current Year Quarter from $24.6 million for the Prior Year Quarter. The decrease is mainly due to the Company not accruing interest after the Commencement Date of approximately $14.1 million and $6.5 million for the Senior Subordinated Notes and the Senior Notes, respectively, as a result of the chapter 11 filing, in accordance with SOP 90-7. In addition, there was a decrease in the amortization of deferred financing fees of $0.4 million mainly due to the write-off of deferred financing fees associated with the Senior Subordinated Notes and Senior Notes in March 2003, in accordance with SOP 90-7. Such decrease was partially offset by increased Credit Agreement interest expense of approximately $0.9 million, mainly related to higher borrowing levels on the Company's revolving line of credit and higher overall interest rates charged for all loans under the Credit Agreement, increased letter of credit fees of $0.3 million and increased other fees of $0.1 million.

The Company recorded net reorganization expense from continuing operations of $4.6 million during the Current Year Quarter. Such amount is mainly composed of professional fees and expenses associated with the Company's financial restructuring process and chapter 11 proceedings. For further discussion, see Note A—"General" to the unaudited condensed consolidated financial statements set forth elsewhere herein. The Company recorded special charges of $0.4 million and $1.3 million in the Current Year Quarter and the Prior Year Quarter, respectively. The special charges primarily relate to restructuring plans that have resulted in the elimination of certain positions and the closure of certain offices, partially offset by income recorded to special charges related to the collection of a previously reserved note receivable. The charges related to restructuring plans primarily consist of employee severance and termination benefits, lease termination costs and consulting fees. See Note G—"Managed Care Integration Plan and Special Charges" to the unaudited condensed consolidated financial statements set forth elsewhere herein for further discussion.

The Company's effective income tax rate decreased to 31.3 percent for the Current Year Quarter from 43.5 percent for the Prior Year Quarter. The income tax provision in the Current Year Quarter includes estimates regarding the Company's utilization of net operating loss carryforwards that existed prior to its emergence from bankruptcy in 1992. The Prior Year Quarter effective rate exceeds federal statutory rates primarily due to the state income tax provision.

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

	Three Months Ended June 30,
	2002		2003
Healthcare provider and franchising segments	$	1,711	$	(854	)
Specialty managed healthcare segment		—		—

	$	1,711	$	(854	)

The loss for the Current Year Quarter related to the healthcare provider and franchising segments is primarily the result of changes in estimates of certain accrued liabilities of $0.4 million, the cost of finalizing cost reports and other costs of exiting the business. Income from the healthcare provider and franchising segments for the Prior Year Quarter represents a reduction of estimates of regulatory reserves pertaining to the former psychiatric hospital facilities of approximately $3.1 million, before taxes, partially offset by the excess of expenses incurred in collection of previously written off Medicare and Medicaid receivables over cash collected. See Note E—"Discontinued Operations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

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

	Three Months Ended June 30,
	2002			2003
Healthcare provider and franchising segments	$	34		$	1,462
Specialty managed healthcare segment		(819	)		310

	$	(785	)	$	1,772

The Current Year Quarter income on disposal related to the healthcare provider and franchising segments is attributable to the sale of a hospital facility that resulted in a gain of $0.7 million, net of taxes, and cash received as a final distribution associated with a previously discontinued provider joint venture that resulted in a gain of $0.8 million, net of taxes.

The Current Year Quarter income on disposal related to the specialty managed healthcare segment is the result of cash received as a partial payment on a note receivable held by the Company that the Company had fully reserved in fiscal 2001. The Prior Year Quarter loss on disposal related to the specialty managed healthcare segment is attributable to the Company's reevaluation of the lease reserve balance, which resulted in an increase to the reserve of approximately $1.3 million, before taxes, to reflect changes in estimates.

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

	Three Months Ended June 30,
	2002		2003
Healthcare provider and franchising segments	$	—	$	(87	)
Specialty managed healthcare segment		—		219

	$	—	$	132

As part of its financial restructuring plan and chapter 11 proceedings, the Company has rejected certain leases for closed offices. The estimated cost to the Company as a result of rejecting such leases is different than the liability recorded. In accordance with SOP 90-7, such difference has been recorded as reorganization (expense) benefit.

Six months ended June 30, 2003 ("Current Year Period"), compared to the six months ended June 30, 2002 ("Prior Year Period")

Net revenue related to the Health Plans segment decreased by 11.0 percent or $53.3 million to $433.4 million for the Current Year Period from $486.7 million for the Prior Year Period. The decrease in revenue is mainly due to a reduction in revenue under the Company's contract with Aetna (mainly due to decreased membership) of $17.7 million, terminated contracts of $52.1 million, lower performance revenue of $4.0 million (see below), contract changes (mainly risk to non-risk) of $16.1 million, and other net changes, which decreases were partially offset by net increases in rates of $13.7 million, net increased membership from existing customers (excluding Aetna) of $11.9 million, the recognition of $9.6 million of revenue under the Company's agreement to withdraw from the Choice partnership and new business of $7.0 million.

Performance-based revenues for the Health Plans segment were $7.6 million and $3.6 million for the Prior Year Period and Current Year Period, respectively. The decrease is primarily due to the Prior Year Period including performance revenue for a contract that no longer has performance revenue terms.

Cost of care decreased by 11.6 percent or $34.7 million to $265.3 million for the Current Year Period from $300.0 million for the Prior Year Period. The decrease in cost of care is primarily due to a reduction in care under the Company's contract with Aetna (mainly due to decreased membership) of $11.7 million, terminated contracts of $35.7 million, net contract changes (mainly risk to non-risk) of $14.2 million, and net favorable settlements of $5.1 million related to claims paid by clients, which decreases were partially offset by estimated higher costs due to care trends and other net changes of $26.2 million, net increased membership from existing customers of $4.1 million and new business of $1.7 million. Cost of care increased as a percentage of risk revenue from 73.2 percent in the Prior Year Period to 76.3 percent in the Current Year Period, mainly due to higher care trends experienced in the Current Year Period, partially offset by rate and other revenue increases and net favorable settlements related to claims paid by clients in the Current Year Period.

Direct service costs decreased by 23.8 percent or $20.1 million to $64.4 million for the Current Year Period from $84.5 million for the Prior Year Period. The decrease in direct service costs is primarily due to cost reduction efforts undertaken by the Company including the shutdown of several regional service centers, as well as lower costs required to support the Company's decrease in net membership. Direct service costs decreased as a percentage of revenue from 17.4 percent for the Prior Year Period to 14.9 percent for the Current Year Period. The decrease in the percentage of direct service costs in relationship to revenue is mainly due to the aforementioned cost reduction efforts undertaken by the Company and rate and other revenue increases since the Prior Year Period.

Equity in (earnings) loss of unconsolidated subsidiaries decreased 61.0 percent or $4.7 million to $(3.0) million for the Current Year Period from $(7.7) million for the Prior Year Period. The decrease mainly relates to the Company's withdrawal from the Choice partnership as of the end of October 2002, with equity in (earnings) of Choice totaling $(5.5) million for the Prior Year Period. Partially offsetting this reduction is an increase in equity in (earnings) related to Royal Health Care.

Net revenue related to the Workplace segment decreased by 13.6 percent or $15.8 million to $100.2 million for the Current Year Period from $116.0 million for the Prior Year Period. The decrease in revenue is mainly due to a reduction in revenue under the Company's contract with Aetna (mainly due to decreased membership) of $2.7 million, net decreased membership from existing customers (excluding Aetna) of $3.5 million, terminated contracts of $8.3 million and contract changes (mainly risk to non-risk) of $3.0 million, which decreases were partially offset by other net changes of $1.7 million.

Cost of care decreased by 31.4 percent or $12.1 million to $26.4 million for the Current Year Period from $38.5 million for the Prior Year Period. The decrease in cost of care is mainly due to terminated contracts of $5.9 million, net contract changes (mainly risk to non-risk) of $3.1 million, favorable care trends and other net changes of $2.3 million and costs associated with net membership reduction of $0.8 million. Cost of care decreased as a percentage of risk revenue from 41.6 percent in the Prior Year Period to 32.9 percent in the Current Year Period, mainly due to changes in business mix.

Direct service costs decreased by 7.2 percent or $3.0 million to $38.8 million for the Current Year Period from $41.8 million for the Prior Year Period. The decrease in direct service costs is mainly due to cost reduction efforts undertaken by the Company. As a percentage of revenue, direct service costs increased from 36.0 percent for the Prior Year Period to 38.7 percent for the Current Year Period. The increase in the percentage of direct service costs in relationship to revenue is mainly due to the reduction in revenue due to terminated contracts and decreased membership from existing customers (as described above), for which there is a delayed impact to direct service costs. Such increase was partially offset by cost reduction efforts undertaken by the Company.

Net revenue related to the Public segment decreased by 2.4 percent or $6.6 million to $265.7 million for the Current Year Period from $272.3 million for the Prior Year Period. The decrease in revenue is mainly due to a net reduction in revenue with respect to the TennCare program of $29.3 million, primarily as a result of a program change (as described above) and terminated contracts of $1.6 million, which decreases were partially offset by net increased membership from other existing customers of $17.8 million and net rate increases (other than from TennCare) of $6.5 million.

Cost of care decreased by 3.3 percent or $7.5 million to $219.0 million for the Current Year Period from $226.5 million for the Prior Year Period. The decrease in cost of care is mainly due to a net reduction in cost of care with respect to the TennCare program of $29.1 million, primarily as a result of a program change (as described above), which decrease was partially offset by net increased membership from other existing customers of $14.1 million and higher costs due to care trends (other than with respect to TennCare) and other net changes of approximately $7.5 million. As a percentage of risk revenue, cost of care decreased from 86.9 percent for the Prior Year Period to 85.9 percent for the Current Year Period, mainly due to contract changes in the Current Year Period.

Direct service costs increased by 2.5 percent or $0.5 million to $20.9 million for the Current Year Period from $20.4 million for the Prior Year Period. The increase in direct service costs is primarily due to higher costs required to support the increase in net membership, partially offset by cost reduction efforts undertaken by the Company. As a percentage of revenue, direct service costs increased from 7.5 percent for the Prior Year Period to 7.9 percent for the Current Year Period, primarily due to lower revenue for the Current Year Period with respect to the TennCare program.

Equity in loss of unconsolidated subsidiaries decreased $(2.0) million to $1.2 million for the Current Year Period from $3.2 million for the Prior Year Period. The investment in unconsolidated subsidiary relates to Premier. The decrease in loss is primarily due to favorable rate changes and other contractual changes, which increases were partially offset by decreased membership.

Other operating costs related to the Corporate and Other Segment increased by 9.7 percent or $7.6 million to $85.7 million for the Current Year Period from $78.1 million for the Prior Year Period. The increase is mainly due to higher discretionary employee benefit costs of $7.7 million (the Prior Year included a change in estimate to reduce certain discretionary employee benefit cost accruals of $2.0 million), higher legal fee expenses of $0.7 million due to the timing of litigation activity, and the inclusion in the Prior Year Period of the favorable impact of changes in estimates of the reserves previously recorded for employee health benefits, self-insurance and litigation totaling approximately $3.5 million. Such increases in other operating expenses were partially offset by the Company's cost reduction efforts. As a percentage of total net revenue, other operating expenses increased from 8.9 percent for the Prior Year Period to 10.7 percent for the Current Year Period primarily due to the lower revenue in the Current Year Period (as described above) and the increases in other operating expenses.

Depreciation and amortization increased by 6.0 percent or $1.4 million to $24.7 million for the Current Year Period from $23.3 million for the Prior Year Period. The increase is primarily due to additional amortization expense related to an adjustment of the remaining useful lives of certain intangible assets as of October 1, 2002, partially offset by the effect of certain capitalized software assets that became fully depreciated at March 31, 2003.

Interest expense decreased by 45.6 percent or $22.4 million to $26.7 million for the Current Year Period from $49.1 million for the Prior Year Period. The decrease is mainly due to the Company not accruing interest after the Commencement Date of approximately $17.2 million and $7.9 million for the Senior Subordinated Notes and the Senior Notes, respectively, as a result of the chapter 11 filing, in accordance with SOP 90- 7. In addition, there was a decrease in the amortization of deferred financing fees of $0.2 million mainly due to the write off of deferred financing fees associated with the Senior Subordinated Notes and Senior Notes in March 2003, in accordance with SOP 90-7, and a decrease in other fees of $0.1 million. Such decrease was partially offset by increased Credit Agreement interest expense of approximately $2.1 million, mainly related to higher borrowing levels on the Company's revolving line of credit and higher overall interest rates charged for all loans under the Credit Agreement, $0.6 million of increased letter of credit fees and $0.3 million related to the Aetna Note.

The Company recorded net reorganization expense from continuing operations of $27.7 million during the Current Year Period. Such amount is mainly composed of the write-off of deferred financing costs and professional fees and expenses associated with the Company's financial restructuring process and chapter 11 proceedings. For further discussion, see Note A—"General" to the unaudited condensed consolidated financial statements set forth herein. The Company recorded special charges of $2.1 million and $4.7 million in the Current Year Period and the Prior Year Period, respectively. The special charges primarily relate to restructuring plans that have resulted in the elimination of certain positions and the closure of certain offices, partially offset by income recorded to special charges related to the collection of a previously reserved note receivable. The charges related to restructuring plans primarily consist of employee severance and termination benefits, lease termination costs and consulting fees. See Note G—"Managed Care Integration Plan and Special Charges" to the unaudited condensed consolidated financial statements set forth elsewhere herein for further discussion.

The Company's effective income tax rate increased to 366.8 percent for the Current Year Period from 42.3 percent for the Prior Year Period. The Current Year Period effective rate exceeds federal statutory rates primarily due to changes in estimates regarding the Company's anticipated utilization of net operating loss carryforwards that existed prior to its emergence from bankruptcy in 1992. Such changes in estimates occurred in the quarter ended June 30, 2003, due to the Company's finalization and amending of certain prior year income tax returns. Because the utilization of such pre-bankruptcy net operating loss carryforwards is subject to continued review and adjustment by the Internal Revenue Service, the Company fully reserves for any utilization of these carryforwards. The Prior Year Period effective rate exceeds federal statutory rates primarily due to state income tax provision.

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

	Six Months Ended June 30,
	2002		2003
Healthcare provider and franchising segments	$	2,535	$	(616	)
Specialty managed healthcare segment		198		—

	$	2,733	$	(616	)

The loss for the Current Year Period related to the healthcare provider and franchising segments is primarily the result of changes in estimates of certain accrued liabilities of $0.4 million, the cost of finalizing cost reports and other costs of exiting the business, partially offset by a change in estimate related to the tax provision of $0.4 million. Income from the healthcare provider and franchising segments for the Prior Year Period includes a reduction of estimates of regulatory reserves pertaining to the former psychiatric hospital facilities of $3.1 million, before taxes, and the positive settlement of outstanding Medicare and Medicaid cost reports of $2.4 million, before taxes, partially offset by the cost of collections, legal fees and other costs.

Income from the specialty managed healthcare segment for the Prior Year Period is a result of a change in estimate of certain lease reserves of $0.3 million, before taxes, related to the settlement of a lease obligation. See Note E—"Discontinued Operations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.

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

	Six Months Ended June 30,
	2002			2003
Healthcare provider and franchising segments	$	34		$	1,462
Specialty managed healthcare segment		(616	)		636
Human services segment		—			52

	$	(582	)	$	2,150

The Current Year Period income on disposal related to the healthcare provider and franchising segments is attributable to the sale of a hospital facility that resulted in a gain of $0.7 million and cash received as a final distribution associated with a discontinued provider joint venture that resulted in a gain of $0.8 million.

The Current Year Period income on disposal related to the specialty managed healthcare segment is the result of cash received as a partial payment on a note receivable held by the Company that the Company had fully reserved in fiscal 2001. Loss on disposal related to the specialty managed healthcare segment in the Prior Year Period represents an increase in lease reserves of approximately $1.3 million to reflect changes in estimates, reduced by $0.3 million in cash received as partial payment on a note receivable held by the Company that the Company had fully reserved in fiscal 2001.

The following table summarizes, for the periods indicated, reorganization (expense) benefit related to discontinued operations (in thousands):

	Six Months Ended June 30,
	2002		2003
Healthcare provider and franchising segments	$	—	$	(344	)
Specialty managed healthcare segment		—		3,511

	$	—	$	3,167

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

The Company's business is subject to rising care costs in certain portions of its business. Future results of operations will be heavily dependent on management's ability to obtain customer rate increases that are consistent with care cost increases and/or to reduce operating expenses.

Based upon the Company's financial condition and due to the status of its financial restructuring activities, the Company anticipates a reduction in the fiscal year ending December 31, 2003 revenue from lost customer contracts at a higher rate than it has experienced in prior fiscal years. Such anticipated losses include one of the TRICARE contracts and one of the Pennsylvania Counties contracts as previously discussed. In addition, it is possible that the Company's customers that are managed care companies may, in the future, seek to provide managed behavioral healthcare services directly to their subscribers, rather than by contracting with the Company for such services. Furthermore, the Company's financial condition is expected to result in limited opportunities for the Company to sell new business until at least such time as its financial restructuring and chapter 11 activities would be completed.

The Company had $160.8 million of total debt outstanding under the Credit Agreement at June 30, 2003. Currently, the Company's interest rates for the loans under the Credit Agreement are based on the prime rate plus a borrowing margin of 2.50 percent for Revolving Loans, 3.25 percent for the Tranche B Loans and 3.50 percent for Tranche C Loans. The prime rate was 4.75 percent on June 30, 2002 and 4.00 percent on June 30, 2003. Based on the June 30, 2003 borrowing levels under the Credit Agreement, a 0.25 percent increase in interest rates would cost the Company approximately $0.4 million per year in additional interest expense. The Company's earnings could be adversely affected by increases in interest rates.

The Company continues to conduct certain operating restructuring activities that impact results of operations. As of December 31, 2001, management committed the Company to a restructuring plan to eliminate certain duplicative functions and facilities (the "2002 Restructuring Plan") primarily related to the Health Plans segment. The Company's 2002 Restructuring Plan resulted in the recognition of special charges of approximately $8.2 million during fiscal 2002, with special charges of $3.7 million being recorded during the six months ended June 30, 2002. The special charges for fiscal 2002 consisted of (a) $6.3 million to terminate 277 employees, the majority of which were field operational personnel in the Health Plans segment, and (b) $1.9 million to downsize and close excess facilities, and other associated activities. The employee termination costs included severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees in fiscal 2002, with the majority of the terminations completed by September 30, 2002. The remaining employee termination costs are expected to be paid in full by April 30, 2004. The special charges of $1.9 million represent costs to downsize and close 14 leased facilities. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. The remaining leased facilities terminate at various dates through March 2004. At June 30, 2003, outstanding liabilities of $0.7 million related to the 2002 Restructuring Plan are included in "current liabilities subject to compromise" in the accompanying unaudited condensed consolidated balance sheets.

were field operational personnel, and (b) $1.0 million to downsize and close excess facilities, and other associated activities. Of the $3.9 million of special charges recognized during fiscal 2002, $0.5 million were recognized during the three months ended June 30, 2002.

During the six months ended June 30, 2003, the Company continued the ABI initiative, which resulted in the recognition of special charges of (a) $1.9 million to terminate an additional 73 employees that represented both field operational and corporate personnel, and (b) $0.1 million to downsize and close additional excess facilities and other associated activities. The employee termination costs of $1.9 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees during the six months ended June 30, 2003, with all of the terminations completed by June 30, 2003. All employee termination costs accrued and unpaid as of June 30, 2003 are expected to be paid in full by September 30, 2004. The other special charges primarily represent costs to downsize and close one additional leased facility. These closure and exit costs include payments required under the lease contract (less any applicable existing or estimated sublease income) after the property was abandoned, write-offs of leasehold improvements related to the facility and other related expenses. The leased facilities closed due to the ABI initiative have lease termination dates ranging from fiscal 2003 through fiscal 2008. Certain of these leases were rejected as part of the Company's financial restructuring. In accordance with SOP 90-7, the liabilities under such leases are recorded at the estimated cost as a result of such rejections. At June 30, 2003, outstanding liabilities of approximately $1.5 million related to ABI are included in the accompanying June 30, 2003 unaudited condensed consolidated balance sheets, with $0.1 million included in "accrued liabilities" and $1.4 million in "current liabilities subject to compromise".

In April 2003, the Company implemented a new business and performance initiative, named Performance Improvement Plan ("PIP"). PIP is focused on further consolidating service centers, creating more efficiencies in corporate overhead, consolidating systems, improving call center technology and instituting other operational and business efficiencies, while maintaining or improving service to customers. During the three months ended June 30, 2003, PIP resulted in the recognition of special charges of (a) $1.2 million to terminate 224 employees that represented both field operational and corporate personnel, and (b) $0.1 million to downsize and close one facility. The employee termination costs of $1.2 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees during the three months ended June 30, 2003, with all terminations expected to be completed by January 2004. All termination costs associated with those employees terminated during the three months ended June 30, 2003 are expected to be paid in full by August 2004. In accordance with SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", the liability for termination costs for those employees required to render service until they are terminated that exceeds the minimum retention period (defined as 60 days) is being recognized ratably over the future service period. The Company has estimated that additional termination costs of $1.7 million related to those employees terminated during the three months ended June 30, 2003 will be recognized throughout the remainder of fiscal 2003. The other special charges of $0.1 million represent costs to downsize and close one leased facility. These closure and exit costs include payments required under the lease contract (less any applicable existing and/or estimated sublease income) after the property is abandoned, write-off of leasehold improvements related to the facility and other related expenses. Such leased facility has a lease termination date of March 31, 2004. At June 30, 2003, outstanding liabilities of approximately $1.2 million related to PIP are included in the accompanying June 30, 2003 unaudited condensed

consolidated balance sheets, with the liability for employee severance and termination benefits of $1.1 million included in "accrued liabilities" and the liability for lease termination and other costs of $0.1 million included in "current liabilities subject to compromise".

As part of PIP, the Company has identified eight other leased facilities, including regional service centers and staff offices, which will be closed during the remainder of fiscal 2003. The Company anticipates rejecting certain of these leases as part of the bankruptcy proceedings. In accordance SFAS 146, the Company will accrue as special charges the estimated cost incurred in exiting these excess leased facilities at the time such facilities are vacated. The Company estimates total cost to be incurred in relation to exiting these leases will range from $2.5 million to $3.5 million. Implementation of PIP also resulted in additional costs of $0.2 million during the six months ended June 30, 2003 for the cost of outside consultants. Also included in special charges for the six months ended June 30, 2003 is income of $1.4 million related to the collection of a previously reserved note receivable.

The Company intends to continue implementing PIP initiatives throughout the remainder of fiscal 2003. Management estimates that the Company will incur approximately $6 million to $14 million of costs related to PIP activities during the remaining six months of its fiscal year ended December 31, 2003. The Company expects to fund these costs with internally generated funds. However, there can be no assurance that the Company will be able to successfully fund or implement these initiatives or realize the anticipated savings.

The Transactions and Code Sets regulation is final and was originally scheduled to become effective on October 16, 2002; however, companies may now elect a one-year deferral. The Company has filed for the extension as permitted by law. This regulation establishes standard data content and formats for the submission of electronic claims and other administrative and health transactions. This regulation only applies to electronic transactions, and healthcare providers will still be able to submit paper documents without being subject to this regulation. In addition, health plans must be prepared to receive these various transactions. The Company has completed the development of a new electronic data interchange ("EDI") strategy, which it believes will significantly enhance its HIPAA compliance efforts. The Company has signed an agreement with an external EDI tool vendor to expand the Company's usage of EDI technology, developed a project plan and an accompanying resource requirements rationale and identified anomalies through mapping of the HIPAA standard transactions to the Company's various clinical, claim and provider systems.

The final regulation on privacy was published on December 28, 2000 and accepted by Congress on February 16, 2001. This regulation, which became effective on April 14, 2001 with a compliance date of

April 14, 2003, requires patient authorization to release healthcare information in certain situations, creates rules about how much and when information may be released and creates rights for patients to review and amend their health records, creates a requirement to notify members of privacy practices and also requires that entities contract with their downstream business associates using standards required by the regulation. This regulation applies to both electronic and paper transactions. A new proposed modification to this rule was published on March 27, 2002 in the federal register with a 30-day comment period. This proposal sought to change some of the areas of the privacy regulation that had an unintended adverse effect on the provision of care. The final modification to the privacy regulation was published in the August 14, 2002 Federal Register. The compliance date for the privacy regulation, including these changes was April 14, 2003. The Company has developed and implemented various measures to address areas such as confidential communications, accounting of disclosures, right of access and amendment, identifying and contracting with business associates, creation of HIPAA compliant policies and information technology upgrades. The Company believes that its business and operations are structured to comply with all applicable provisions of the privacy regulations.

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

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

Management is currently assessing and acting on the wide reaching implications of these regulations to ensure the Company's compliance by the respective implementation dates. Management has identified HIPAA as a major initiative impacting the Company's systems, business processes and business relationships. This issue extends beyond the Company's internal operations and requires active participation and coordination with the Company's customers, providers and business partners. Management has commissioned a dedicated HIPAA project team to develop, coordinate and implement our compliance plan. With respect to the final regulations on security and privacy, the Company has hired personnel dedicated to physical and information security issues, appointed an officer who will be responsible for privacy issues, commissioned separate security and privacy workgroups which identified and assessed the potential impact of the regulations and reviewed current policies and drafted new policies to comply with the new requirements. The Company incurred approximately $0.9 million in operating costs during both the three months ended June 30, 2002 and 2003, and approximately $2.1 million and $1.8 million during the six months ended June 30, 2002 and 2003, respectively. Capital expenditures related to HIPAA were approximately $0.6 million for both the three months ended June 30, 2002 and 2003, and approximately $1.1 million for both the six months ended June 30, 2002 and 2003. Management estimates that the Company will incur approximately $1.7 million to $2.7 million in operating expenditures and approximately $1.4 million to $2.4 million in capital

expenditures related to these efforts during the remaining six months of its fiscal year ended December 31, 2003.

The Company's net cash provided by operating activities was $49.1 million and $95.4 million for the six months ended June 30, 2002 and 2003, respectively. The approximately $46.3 million increase in operating cash flows from the Prior Year Period to the Current Year Period is primarily due to a reduction in cash interest payments, lower cash outflows with respect to discontinued operations and improved working capital attributable to pre-petition liabilities resulting from the Company's chapter 11 filing, partially offset by lower cash flows attributable to a decrease in segment profit.

During the Current Year Period, the Company made cash interest payments of $8.1 million, which is a reduction of $37.4 million from the Prior Year Period amount of $45.5 million. This decrease is primarily due to the Company not making scheduled interest payments of $28.1 million in February 2003 associated with the Senior Subordinated Notes and $11.7 million in May 2003 associated with the Senior Notes given the Company's chapter 11 filing and its proposed treatment of the Senior Subordinated Notes and Senior Notes in the Plan. The Prior Year Period includes $6.1 million of net cash outflows and the Current Year Period includes $0.1 million of net cash inflows with respect to discontinued operations. The Company reported segment profit of $89.7 million and $80.6 million for the Prior Year Period and Current Year Period, respectively.

The Company utilized $13.5 million and $8.8 million in funds during the Prior Year Period and the Current Year Period, respectively, for capital expenditures, which is a decrease of $4.7 million, or 34.8 percent. The majority of the Company's capital expenditures relate to management information systems and related equipment. These expenditures have decreased over the Prior Year Period as the Company has focused on cost reductions through the ongoing restructuring initiatives of ABI and PIP.

The Company used $62.4 million and $3.7 million during the Prior Year Period and the Current Year Period, respectively, for acquisitions and investments in businesses. The amount for the Prior Year Period includes a contingent purchase price payment of $60.0 million to Aetna and an earn-out payment of $2.4 million with respect to the acquisition in 1998 of Inroads, a managed behavioral healthcare company. The amount for the Current Year Period relates to the final earn-out payments with respect to the acquisition in 1998 of Inroads.

The Company received proceeds of $2.6 million from the sale of assets, net of transaction costs, during the Current Year Period, which resulted in a gain of $1.7 million, net of taxes. Proceeds of $2.4 million were received related to the Company's discontinued healthcare provider and franchising segments, with $1.6 million from the sale of a hospital facility and $0.8 million as a final distribution associated with a discontinued provider joint venture. The Company also sold the assets of one of its subsidiaries for $0.2 million.

During the six months ended June 30, 2002, the Company had net borrowings of $15.0 million on the Revolving Facility, received proceeds of $0.6 million related to the exercise of stock options, made payments on capital lease obligations of $1.4 million and repaid $0.7 million of indebtedness outstanding under the Term Loan Facility.

During the six months ended June 30, 2003, the Company made payments on capital lease obligations of $1.7 million and had other net financing activities of $0.1 million.

In light of its current financial condition, the Company has undertaken an effort to restructure its debt, which totals approximately $1.0 billion, and to improve its liquidity. Because of the Company's belief that its operations could no longer support its existing capital structure and that it must restructure its debt to levels that are more in line with its operations, the Company and 88 of its subsidiaries filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code on March 11, 2003.

The United States Trustee has appointed an unsecured creditors committee (the "Official Committee"). The Official Committee and their legal representatives have a right to be heard on all matters that come before the Bankruptcy Court, and are the primary entities with which Magellan will negotiate the treatment of the claims of general unsecured creditors. The Official Committee comprises five members, with whom, among others, the Company negotiated the terms of a financial restructuring as embodied in a plan of reorganization filed with the Bankruptcy Court on August 18, 2003 (the "Plan"). Prior to the commencement date of its Chapter 11 Cases, the Company negotiated the terms of a financial restructuring which was incorporated in the original plan of reorganization filed with the Bankruptcy Court on March 11, 2003 ("Original Plan"). Prior to the commencement date of the Chapter 11 Cases, the Company entered into lock-up and voting agreements for the support of the Original Plan that the Company executed with holders of 52% of the 9³/8% Senior Notes due 2007 (the "Senior Notes"), 35% of the 9% Senior Subordinated Notes due 2008 (the "Senior Subordinated Notes") and 47.5% of its senior secured debt. In connection with the execution of an equity

commitment letter with Onex Corporation (the "Equity Investor"), as described below, which was supported by the Official Committee and the agent for the Company's senior lenders, certain modifications were made to the Original Plan as incorporated in the Plan. As a result, the counterparties may terminate such lock-up and voting agreements thereto because certain conditions have not been met. The Official Committee has stated that they support the Plan. The Company believes that approval of the Plan maximizes the recovery to creditors and equity holders. Notwithstanding the foregoing, there can be no assurance that the Company will be able to obtain the votes necessary to approve the Plan, and disagreements between Magellan and the Official Committee or the lenders could protract the bankruptcy proceedings, could negatively impact Magellan's ability to operate during bankruptcy and could delay Magellan's emergence from bankruptcy. One creditor has informed the Company that it owns sufficient Senior Subordinated Notes to block such class of creditors' acceptance of the Plan, and has notified the Company that it intends to vote against the Plan. If the class of claims holders of Senior Subordinated Notes does not vote to accept the Plan, the Company believes that it will be able to confirm the Plan under the applicable provisions of the Bankruptcy Code. There can be no assurance, however, that the Company will be able to do so.

$50 million cash out election would be funded by the purchase of equity by Onex Corporation (the "Equity Investor") as set forth below. If the entire $50 million is subscribed for, approximately 13.6% of the equity of reorganized Magellan would not be issued to creditors, but would be issued to the Equity Investor as set forth below.

Certain defaults exist under the Credit Agreement and the indentures governing the Senior Notes and Senior Subordinated Notes that have resulted in acceleration of all indebtedness thereunder. The Company's current liquidity is not sufficient to satisfy the obligations under such acceleration. However, under Section 362 of the Bankruptcy Code, the lenders under the Credit Agreement and the holders of the Senior Notes and Senior Subordinated Notes are prohibited from attempting to collect payment of such indebtedness. As a result of such defaults, the Company is unable to access additional borrowings or letters of credit under the Credit Agreement.

The ability of the Company, both during and after the Chapter 11 Cases, to continue as a going concern is dependent upon, among other things, (i) the ability of the Company to confirm a plan of reorganization under the Bankruptcy Code and obtain emergence financing; (ii) the ability of the Company to successfully achieve required cost savings to complete its restructuring; (iii) the ability of the Company to maintain adequate cash on hand; (iv) the ability of the Company to generate cash from operations; (v) the ability of the Company to maintain its customer base; and (vi) the Company's ability to achieve profitability. There can be no assurance that the Company will be able to successfully achieve these objectives in order to continue as a going concern. The Company's condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern.

The Company had a working capital deficit of approximately $1.2 billion as of June 30, 2003. The June 30, 2003 working capital deficit includes approximately $1.0 billion of long-term debt, which has been classified as a current liability due to certain of the Company's debt agreement defaults. As of June 30, 2003, the Company had unrestricted cash of approximately $146.3 million. As a result of certain defaults existing under the Credit Agreement, the Company is unable to access additional borrowings or letters of credit under the Credit Agreement.

During the remaining six months of its fiscal year ended December 31, 2003, the Company estimates it will have non-operating cash outflows related to (among other things) capital expenditures of approximately $24 to $34 million (the majority of the Company's capital expenditures relate to management information systems and related equipment, including improvements to its computer systems in conjunction with the Company's on-going integration plan and efforts to comply with HIPAA), liabilities with respect to its discontinued operations and costs associated with the financial restructuring activities. During the pendency of the Company's chapter 11 process, from which the

Company plans to emerge in October, 2003, the Company will not pay cash interest on the Senior Notes or the Senior Subordinated Notes or pay certain other liabilities subject to compromise. The Company believes that its cash on hand and its operating cash flows will be sufficient to satisfy its non-operating cash requirements for the remainder of its fiscal year ended December 31, 2003, however there can be no assurance in this regard.

The Company's letter of credit requirements may increase as a result of (i) customers seeking security for the medical claims payable to providers for services rendered to members covered under the customers' risk-based contracts with the Company, (ii) potential new regulations which would require the Company to post security for its risk-based business and (iii) the need to replace or collateralize surety bonds with letters of credit due to the current conditions of the surety bond market. As of June 30, 2003, the Company had outstanding letters of credit and surety bonds totaling $73.5 million and $14.1 million respectively. The surety bond carriers have collateral in the form of letters of credit in the amount of $13.2 million (which are included in the total letters of credit of $73.5 million). If the Company is unable to obtain adequate surety bonds or make alternative arrangements to satisfy the requirements for such bonds, it may no longer be able to operate in certain states, which would have a material adverse effect on the Company. The beneficiaries of letters of credit generally require such letters of credit to have a one-year term, and to renew annually. Because the Company is unable to issue or increase letters of credit under the Credit Agreement, Magellan could lose customers, which would have a material adverse effect on the Company.

The Company is highly leveraged with indebtedness and other future commitments that are substantial in relation to its stockholders' deficit and in relation to its earnings. Notwithstanding the classification of all long-term debt as current due to certain defaults under the Credit Agreement and the indentures governing the Senior Notes and the Subordinated Notes, the Company will not pay principal on the Credit Agreement, cash interest on the Senior Notes or the Senior Subordinated Notes or certain other liabilities subject to compromise, including the final contingent purchase price payment of $60 million to Aetna during the course of the bankruptcy proceedings. Under the Company's proposed Plan of Reorganization, the Company would emerge with a revised capital structure as described above. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Voluntary Chapter 11 Filing".

Magellan and 88 of its subsidiaries (the "Debtors") are operating its business and managing its properties as debtors-in-possession subject to the provisions of the Bankruptcy Code. Pursuant to the provisions of the Bankruptcy Code, the Debtors are not permitted to pay any claims or obligations that arose prior to the Commencement Date (pre-petition claims) unless specifically authorized by the Bankruptcy Court. Similarly, claimants may not enforce any claims against any of the Debtors that arose prior to the Commencement Date unless specifically authorized by the Bankruptcy Court. In addition, as a debtor-in-possession, each of the Debtors has the right, subject to the Bankruptcy Court's approval, to assume or reject any executory contracts and un-expired leases in existence at the Commencement Date. Parties having claims as a result of any such rejection may file claims with the Bankruptcy Court, which will be dealt with as part of the Chapter 11 Cases. Pursuant to the terms of the Bankruptcy Code, the Debtors may only operate their business in the ordinary course. Therefore any transactions outside the ordinary course (e.g., asset sales and purchases, compromise or settlement of claims, incurrence of indebtedness, payment of any pre-petition indebtedness, and creation of liens) would require Bankruptcy Court approval prior to the Company's ability to enter into such transactions. An official committee of unsecured creditors of the Debtors (the "Official Committee") has been appointed in the Debtors' chapter 11 case. In accordance with the provisions of the Bankruptcy Code, the Official Committee, as well as any other party in interest, has the right to be

heard on matters that come before the Bankruptcy Court in the Debtors' chapter 11 case. The restrictions imposed by the Bankruptcy Code (to the extent relief is not granted by the Bankruptcy Court) may adversely affect the Company's ability to finance its future operations or capital needs or engage in other business activities that may be in its interest. Furthermore, as a result of the restrictions described above, the ability of the Company to respond to changing business and economic conditions may be significantly restricted, and the Company may be prevented from engaging in transactions that might otherwise be considered beneficial.

In addition, as part of the Debtors' Plan, as filed with the Bankruptcy Court, the Debtors contemplate entering into an indenture governing the terms of the New Notes of the reorganized Magellan (the "New Notes Indenture") on the effective date of the Plan, as well as a new senior secured credit agreement with respect to either the New Facilities or the Exit Facility (the "New Credit Agreement") also on the effective date of the Plan. The anticipated terms of the New Credit Agreement and the New Notes Indenture are summarized in the Plan and the Disclosure Statement. In general, the New Credit Agreement and the New Note Indenture will contain a number of covenants that limit management's discretion in the operations of the Company and its subsidiaries by restricting the Company's ability to:

These restrictions may adversely affect the Company's ability, after the effective date of the Plan, to finance its future operations or capital needs or engage in other business activities that may be in its interest. In addition, it is anticipated that the New Credit Agreement, as amended, will include other and more restrictive covenants and will prohibit the Company from prepaying certain of its other indebtedness.

During fiscal 2000, the Company reached an agreement (the "IRS Agreement") with the Internal Revenue Service ("IRS") related to its federal income tax returns for the fiscal years ended September 30, 1992 and 1993. The IRS had originally proposed to disallow approximately $162 million of deductions related primarily to interest expense in fiscal 1992. Under the IRS Agreement, the Company paid approximately $1 million in taxes and interest to the IRS in the second quarter of fiscal 2001 to resolve the assessment specifically relating to taxes due for these open years, although no concession was made by either party as to the Company's ability to utilize these deductions through net operating loss carryforwards. As a result of the IRS Agreement, the Company recorded a reduction in deferred tax reserves of approximately $9.1 million as a change in estimate during the fourth quarter of fiscal 2000. While any IRS assessment related to these deductions is not expected to result in a material cash payment for income taxes related to prior years, the Company's federal net operating loss carryforwards could be reduced if the IRS later successfully challenges these deductions. In addition,

the Company's financial restructuring activities and financial condition result in uncertainty as to the Company's ability to realize its net operating loss carryforwards and other deferred tax assets. Accordingly, as of September 30, 2002, the Company recorded an increase to its valuation allowance of $200.5 million, resulting in a total valuation allowance covering all of its net deferred tax assets. The Company's net deferred tax assets were fully reserved as of December 31, 2002 and June 30, 2003.

In fiscal 1999 through 2001, the Company disposed of its healthcare provider and healthcare franchising segments, specialty managed healthcare segment and human services segments.

Although the Company has formally exited these businesses, it maintains certain estimated liabilities for various obligations as follows:

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

The Company has significant interest rate risk related to its variable rate debt outstanding under the Credit Agreement. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Outlook—Liquidity and Capital Resources."

The Company's management evaluated, with the participation of the Company's chief executive officer ("CEO") and chief financial officer ("CFO"), the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), as of June 30, 2003. Based on their evaluation, the Company's CEO and CFO concluded that the Company's disclosure controls and procedures were effective as of June 30, 2003.

There has been no change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company's fiscal quarter ended June 30, 2003, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

On March 11, 2003, the Company and 88 of its subsidiaries filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code in the Bankruptcy Court (Case Nos. 03-40514 through 03-40602). The Company continues to operate its business and manage its property as a debtor-in-possession pursuant to sections 1107 and 1108 of the Bankruptcy Code. As a result of the filing, attempts to collect, secure or enforce remedies with respect to pre-petition claims against the Company are subject to the automatic stay provisions of section 362(a) of the Bankruptcy Code. The Company's Chapter 11 Cases are discussed in greater detail in Note A—"General" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein and in "Management's Discussion and Analysis of Financial Condition and Results of Operations—Voluntary Chapter 11 Filing".

The management and administration of the delivery of managed behavioral healthcare services, and the direct provision of behavioral healthcare treatment services, entail significant risks of liability. From time to time, the Company is subject to various actions and claims arising from the acts or omissions of its employees, network providers or other parties. In the normal course of business, the Company receives reports relating to suicides and other serious incidents involving patients enrolled in its programs. Such incidents occasionally give rise to malpractice, professional negligence and other related actions and claims against the Company or its network providers. See "Cautionary Statements—Claims for Professional Liability" in Item 1 of Magellan's Transition Report on Form 10-K for the transition period from October 1, 2002 to December 31, 2002. Many of these actions and claims received by the Company seek substantial damages and therefore require the defendant to incur significant fees and costs related to their defense. To date, claims and actions against the Company alleging professional negligence have not resulted in material liabilities and the Company does not believe that any such pending action against it will have a material adverse effect on the Company. However, there can be no assurance that pending or future actions or claims for professional liability (including any judgments, settlements or costs associated therewith) will not have a material adverse effect on the Company.

To the extent the Company's customers are entitled to indemnification under their contracts with the Company relating to liabilities they incur arising from the operation of the Company's programs, such indemnification may not be covered under the Company's insurance policies. In addition, to the extent that certain actions and claims seek punitive and compensatory damages arising from alleged intentional misconduct by the Company, such damages, if awarded, may not be covered, in whole or in part, by the Company's insurance policies.

From time to time, the Company receives notifications from and engages in discussions with various governmental agencies concerning its respective managed care businesses and operations. As a result of these contacts with regulators, the Company in many instances implements changes to its operations, revises its filings with such agencies and/or seeks additional licenses to conduct its business. In recent years, in response to governmental agency inquiries or discussions with regulators, the Company has determined to seek licensure as a single service health maintenance organization, third-party administrator or utilization review agent in one or more jurisdictions.

government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services ("OIG") and the United States Department of Justice ("Department of Justice") and certain other federal and state governmental agencies are currently conducting inquiries and/or investigations regarding the compliance by the Company and certain of its subsidiaries with such laws and regulations. Certain of the inquiries relate to the operations and business practices of the Psychiatric Hospital Facilities prior to the consummation of the Crescent Transactions in June 1997. The Department of Justice has indicated that its inquiries are based on its belief that the federal government has certain civil and administrative causes of action under the Civil False Claims Act, the Civil Monetary Penalties Law, other federal statutes and the common law arising from the participation in federal health benefit programs of the Psychiatric Hospital Facilities nationwide. The Department of Justice inquiries relate to the following matters: (i) Medicare cost reports; (ii) Medicaid cost statements; (iii) supplemental applications to CHAMPUS/TRICARE (as defined) based on Medicare cost reports; (iv) medical necessity of services to patients and admissions; (v) failure to provide medically necessary treatment or admissions; and (vi) submission of claims to government payors for inpatient and outpatient psychiatric services. No amounts related to such proposed causes of action have yet been specified. Subsequent to the Commencement Date, the Company began settlement negotiations with the Department of Justice concerning its inquiries. The Company believes that it will reach a settlement with the Department of Justice, which will include a release from all claims related to its inquiries, prior to the conclusion of the Chapter 11 Cases. As of June 30, 2003, the Company has recorded reserves related to this matter at an amount that it believes is adequate based upon the nature of the aforementioned inquires and based upon the status of the settlement discussions.

holders of the Senior Notes and Senior Subordinated Notes are prohibited from attempting to collect payment of such indebtedness.

The Company filed or furnished the following current reports related to the quarter ended June 30, 2003, on Form 8-K with the Securities and Exchange Commission.

Date of Report	Item Reported and Description	Financial Statements as Filed
May 14, 2003	Item 8. Change in Fiscal Year — Announcement of Board of Directors' approval to change fiscal year end from September 30 to December 31	no
May 27, 2003	Item 5. Other Events and Regulation FD Disclosure — Commitment letter and press release of Onex Corporation's investment commitment in the equity of Magellan, Registrant's press release dated May 28, 2003	no
May 30, 2003	Item 9. Regulation FD Disclosure — Monthly operating reports for Magellan and its debtor-in-possession subsidiaries for the period March 11, 2003 through March 31, 2003, and for the month of April 2003 filed with the United States Bankruptcy Court for the Southern District of New York	no
June 25, 2003	Item 9. Regulation FD Disclosure — Monthly operating report for Magellan and its debtor-in-possession subsidiaries for the month of May 2003 filed with the United States Bankruptcy Court for the Southern District of New York	no
June 26, 2003	Item 5. Other Events and Regulation FD Disclosure — Revised commitment letter and press release of Onex Corporation's investment commitment in the equity of Magellan, Registrant's press release dated June 30, 2003	no

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2003
or
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to

Delaware (State of other jurisdiction of incorporation or organization)		58-1076937 (IRS Employer Identification No.)
6950 Columbia Gateway Drive Suite 400 Columbia, Maryland (Address of principal executive offices)		21046 (Zip code)


PART I — Financial Information:
	Item 1: Financial Statements
		Condensed Consolidated Balance Sheets — December 31, 2002 and June 30, 2003
		Condensed Consolidated Statements of Operations — For the Three Months and Six Months ended June 30, 2002 and 2003
		Condensed Consolidated Statements of Cash Flows — For the Six Months ended June 30, 2002 and 2003
		Notes to Condensed Consolidated Financial Statements
	Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations
	Item 3: Quantitative and Qualitative Disclosures About Market Risk
	Item 4: Controls and Procedures
PART II — Other Information:
	Item 1: Legal Proceedings
	Item 2: Changes in Securities and Use of Proceeds
	Item 3: Default Upon Senior Securities
	Item 4: Submission of Matters to a Vote of Security Holders
	Item 5: Other Information
	Item 6: Exhibits and Reports on Form 8-K
	Signatures
	Exhibits

				December 31, 2002			June 30, 2003
							(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents			$	62,488		$	146,325
	Accounts receivable, less allowance for doubtful accounts of $3,749 at December 31, 2002 and $3,922 at June 30, 2003				81,228			68,547
	Restricted cash, investments and deposits				127,318			123,914
	Refundable income taxes				1,966			1,575
	Other current assets				13,131			28,743

		Total current assets			286,131			369,104
Property and equipment					85,659			75,993
Investments in unconsolidated subsidiaries					12,183			14,110
Other long-term assets					43,840			21,124
Goodwill, net					502,334			501,937
Intangible assets, net					68,770			60,086

				$	998,917		$	1,042,354

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Liabilities not subject to compromise:
	Accounts payable			$	15,897		$	9,848
	Accrued liabilities				217,837			44,324
	Medical claims payable				205,331			180,365
	Debt in default and current maturities of capital lease obligations				1,038,934			169,622

		Total current liabilities not subject to compromise			1,477,999			404,159
		Current liabilities subject to compromise (See Note A)			—			1,121,911

			Total current liabilities		1,477,999			1,526,070

Long-term capital lease obligations, not subject to compromise					9,224			1,829

Deferred credits and other long-term liabilities, not subject to compromise					2,290			—

Minority interest, not subject to compromise					683			795

Long-term liabilities subject to compromise (See Note A)					—			2,876

Commitments and contingencies (See Note F)
Redeemable preferred stock, including accrued dividends (subject to compromise) (See Note I)					69,043			72,766

Stockholders' equity:
	Preferred stock, without par value; Authorized — 9,793 shares Issued and outstanding — none				—			—
	Common stock, par value $0.25 per share; Authorized — 80,000 shares Issued 37,428 shares and outstanding 35,139 shares at December 31, 2002 and issued 37,608 shares and outstanding 35,319 shares at June 30, 2003				9,356			9,401
Other stockholders' equity:
	Additional paid-in capital				352,718			348,976
	Accumulated deficit				(903,137	)		(901,100	)
	Warrants outstanding				25,050			25,050
	Common stock in treasury, 2,289 shares at December 31, 2002 and June 30, 2003				(44,309	)		(44,309	)

		Total stockholders' equity			(560,322	)		(561,982	)

				$	998,917		$	1,042,354

		For the Three Months Ended June 30,						For the Six Months Ended June 30,
		2002			2003			2002			2003
Net revenue		$	437,066		$	390,270		$	874,985		$	799,244

Cost and expenses:
	Salaries, cost of care and other operating expenses		394,165			351,576			789,781			720,415
	Equity in earnings of unconsolidated subsidiaries		(140	)		(1,184	)		(4,487	)		(1,799	)
	Depreciation and amortization		12,192			11,020			23,320			24,672
	Interest expense (Contractual interest of $26,605 and $53,218 for the three and six months ended June 30, 2003)		24,625			4,938			49,059			26,726
	Interest income		(1,042	)		(676	)		(2,088	)		(1,503	)
	Reorganization expense, net (See Note A)		—			4,551			—			27,705
	Special charges		1,329			387			4,705			2,092

			431,129			370,612			860,290			798,308

Income from continuing operations before income taxes and minority interest			5,937			19,658			14,695			936
Provision for income taxes			2,581			6,162			6,219			3,433

Income (loss) from continuing operations before minority interest			3,356			13,496			8,476			(2,497	)
Minority interest			(27	)		107			3			167

Income (loss) from continuing operations			3,383			13,389			8,473			(2,664	)

Discontinued operations, net of tax (See Note E):
	Income (loss) from discontinued operations (1)		1,711			(854	)		2,733			(616	)
	Income (loss) on disposal of discontinued operations (2)		(785	)		1,772			(582	)		2,150
	Reorganization benefit, net (See Note A)		—			132			—			3,167

			926			1,050			2,151			4,701

Net income			4,309			14,439			10,624			2,037
Preferred dividends (Contractual dividends of $1,184 and $2,336 for the three and six months ended June 30, 2003)			1,110			—			2,190			883
Amortization of redeemable preferred stock issuance costs, and other			217			—			434			172
Preferred stock reorganization items, net			—			—			—			2,668

Income (loss) available to common stockholders			2,982			14,439			8,000			(1,686	)
Other comprehensive loss			—			—			—			—

Comprehensive income (loss)		$	2,982		$	14,439		$	8,000		$	(1,686	)

Weighted average number of common shares outstanding — basic			34,897			35,319			34,830			35,290

Weighted average number of common shares outstanding — diluted			35,473			41,619			35,444			35,290

Income (loss) per common share available to common stockholders — basic:
	Income (loss) from continuing operations	$	0.06		$	0.38		$	0.17		$	(0.18	)

	Income from discontinued operations	$	0.03		$	0.03		$	0.06		$	0.13

Net income (loss)		$	0.09		$	0.41		$	0.23		$	(0.05	)

Income (loss) per common share available to common stockholders — diluted:
	Income (loss) from continuing operations	$	0.06		$	0.32		$	0.17		$	(0.18	)

	Income from discontinued operations	$	0.02		$	0.03		$	0.06		$	0.13

Net income (loss)		$	0.08		$	0.35		$	0.23		$	(0.05	)

				For the Six Months Ended June 30,
				2002			2003
Cash flows from operating activities:
	Net income			$	10,624		$	2,037
	Adjustments to reconcile net income to net cash provided by operating activities:
		Gain on sale of assets			—			(1,672	)
		Depreciation and amortization			23,320			24,672
		Equity in earnings of unconsolidated subsidiaries			(4,487	)		(1,799	)
		Non-cash reorganization expense			—			15,002
		Non-cash interest expense			2,779			2,674
		Cash flows from changes in assets and liabilities, net of effects from sales and acquisitions of businesses:
			Accounts receivable, net		(680	)		12,629
			Restricted cash, investments and deposits		15,675			3,404
			Other assets		6,718			(14,245	)
			Accounts payable and other accrued liabilities		(24,129	)		40,036
			Medical claims payable		7,632			10,553
			Income taxes payable and deferred income taxes		6,630			391
			Net cash flows related to unconsolidated subsidiaries		5,592			(128	)
			Other liabilities		(924	)		590
			Minority interest, net of dividends paid		5			112
			Other		390			1,176

	Total adjustments				38,521			93,395

	Net cash provided by operating activities				49,145			95,432

Cash flows from investing activities:
	Capital expenditures				(13,471	)		(8,805	)
	Acquisitions and investments in businesses, net of cash acquired				(62,371	)		(3,731	)
	Proceeds from sale of assets, net of transaction costs				—			2,588

	Net cash used in investing activities				(75,842	)		(9,948	)

Cash flows from financing activities:
	Proceeds from issuance of debt, net of issuance costs				75,000			24
	Payments on debt and capital lease obligations				(62,150	)		(1,696	)
	Proceeds from exercise of stock options and warrants				616			25

	Net cash provided by (used in) financing activities				13,466			(1,647	)

Net (decrease) increase in cash and cash equivalents					(13,231	)		83,837
Cash and cash equivalents at beginning of period					47,418			62,488

Cash and cash equivalents at end of period				$	34,187		$	146,325

Type of Cost	Balance December 31, 2002		Payments			Adjustments			Reorganization Expense (Benefit)(1)			Balance June 30, 2003
Employee severance and termination benefits	$	823	$	(487	)	$	—		$	—		$	336
Lease termination and other costs		436		(101	)		(3	)		(3	)		329

	$	1,259	$	(588	)	$	(3	)	$	(3	)	$	665

Type of Cost	Balance December 31, 2002		Additions		Payments			Reorganization Expense (Benefit)(1)			Balance June 30, 2003
Employee severance and termination benefits	$	1,963	$	1,874	$	(2,979	)	$	—		$	858
Lease termination and other costs		1,116		132		(414	)		(202	)		632

	$	3,079	$	2,006	$	(3,393	)	$	(202	)	$	1,490

Type of Cost	Balance December 31, 2002		Additions		Payments			Balance June 30, 2003
Employee severance and termination benefits	$	—	$	1,257	$	(150	)	$	1,107
Lease termination and other costs		—		65		(4	)		61

	$	—	$	1,322	$	(154	)	$	1,168

		Health Plans			Workplace		Public		Corporate and Other			Consolidated
Three Months Ended June 30, 2002
	Net revenue	$	237,187		$	57,212	$	142,667	$	—		$	437,066
	Cost of care		141,322			19,311		119,710		—			280,343
	Direct service costs		42,423			21,029		10,255		—			73,707
	Other operating expenses		—			—		—		40,115			40,115
	Equity in (earnings) loss of unconsolidated subsidiaries		(4,327	)		—		4,187		—			(140	)
	Segment profit (loss)	$	57,769		$	16,872	$	8,515	$	(40,115	)	$	43,041
Three Months Ended June 30, 2003
	Net revenue	$	214,547		$	48,655	$	127,068	$	—		$	390,270
	Cost of care		135,050			12,283		103,276		—			250,609
	Direct service costs		30,845			18,889		10,242		—			59,976
	Other operating expenses		—			—		—		40,991			40,991
	Equity in (earnings) loss of unconsolidated subsidiaries		(1,603	)		—		419		—			(1,184	)
	Segment profit (loss)	$	50,255		$	17,483	$	13,131	$	(40,991	)	$	39,878
Six Months Ended June 30, 2002
	Net revenue	$	486,670		$	115,984	$	272,331	$	—		$	874,985
	Cost of care		299,958			38,537		226,519		—			565,014
	Direct service costs		84,501			41,784		20,422		—			146,707
	Other operating expenses		—			—		—		78,060			78,060
	Equity in (earnings) loss of unconsolidated subsidiaries		(7,672	)		—		3,185		—			(4,487	)
	Segment profit (loss)	$	109,883		$	35,663	$	22,205	$	(78,060	)	$	89,691
Six Months Ended June 30, 2003
	Net revenue	$	433,385		$	100,202	$	265,657	$	—		$	799,244
	Cost of care		265,310			26,417		218,930		—			510,657
	Direct service costs		64,337			38,807		20,923		—			124,067
	Other operating expenses		—			—		—		85,691			85,691
	Equity in (earnings) loss of unconsolidated subsidiaries		(2,954	)		—		1,155		—			(1,799	)
	Segment profit (loss)	$	106,692		$	34,978	$	24,649	$	(85,691	)	$	80,628

		December 31, 2002			June 30, 2003
Redeemable convertible preferred stock:
	Series A — stated value $1, 87 shares authorized, 59 shares issued and outstanding	$	59,063		$	59,063
	Series B — stated value $1, 60 shares authorized, none issued and outstanding		—			—
	Series C — stated value $1, 60 shares authorized, none issued and outstanding		—			—

			59,063			59,063
	Accumulated unpaid dividends on Series A Preferred Stock		12,819			13,703
	Issuance costs (net of accumulated amortization), and other		(2,839	)		—

		$	69,043		$	72,766

		For the Three Months Ended June 30, 2003			For the Period March 11, 2003 Through June 30, 2003
Net revenue		$	233,007		$	288,056

Cost and expenses:
	Salaries, cost of care and other operating expenses		189,833			241,145
	Equity in earnings of unconsolidated subsidiaries		(1,184	)		(1,605	)
	Depreciation and amortization		10,965			14,091
	Interest expense		4,017			5,019
	Interest income		(314	)		(404	)
	Reorganization expense, net		4,551			24,791
	Special charges		387			1,003

			208,255			284,040

Income from continuing operations before income taxes			24,752			4,016
Provision for income taxes			7,759			7,804

Income (loss) from continuing operations			16,993			(3,788	)
Discontinued operations:
	Loss from discontinued operations		(916	)		(890	)
	Income on disposal of discontinued operations		960			1,181
	Reorganization benefit, net		132			3,167

			176			3,458

Net income (loss)		$	17,169		$	(330	)

				For the Period March 11, 2003 Through June 30, 2003
Cash flows from operating activities:
	Net loss			$	(330	)
	Adjustments to reconcile net loss to net cash provided by operating activities:
		Gain on sale of assets			(861	)
		Depreciation and amortization			14,091
		Equity in earnings of unconsolidated subsidiaries			(1,605	)
		Non-cash reorganization expense			15,002
		Non-cash interest expense			1,307
		Cash flows from changes in assets and liabilities, net of effects from sales and acquisitions of businesses:
			Accounts receivable, net		7,874
			Restricted cash, investments and deposits		(90	)
			Other assets		(15,743	)
			Accounts payable and other accrued liabilities		26,307
			Medical claims payable		19,215
			Income taxes payable and deferred income taxes		453
			Net cash flows related to unconsolidated subsidiaries		(870	)
			Net cash flows related to non-Debtor subsidiaries		(320	)
			Other liabilities		101
			Other		1,153

	Total adjustments				66,014

	Net cash provided by operating activities				65,684

Cash flows from investing activities:
	Capital expenditures				(5,322	)
	Acquisitions and investments in businesses, net of cash acquired				(1,360	)
	Proceeds from sale of assets, net of transaction costs				1,776

	Net cash used in investing activities				(4,906	)

Cash flows from financing activities:
	Proceeds from issuance of debt, net of issuance costs				24
	Payments on debt and capital lease obligations				(1,375	)
	Net transfers from related parties				8,794

	Net cash provided by financing activities				7,443

Net increase in cash and cash equivalents					68,221
Cash and cash equivalents at beginning of period					56,951

Cash and cash equivalents at end of period				$	125,172

	Health Plans			Workplace		Public		Corporate and Other			Consolidated
Three Months Ended June 30, 2002
Net revenue	$	237.2		$	57.2	$	142.7	$	—		$	437.1
Cost of care		141.3			19.3		119.7		—			280.3
Direct service costs		42.4			21.0		10.3		—			73.7
Other operating expenses		—			—		—		40.1			40.1
Equity in (earnings) loss of unconsolidated subsidiaries		(4.3	)		—		4.2		—			(0.1	)
Segment profit (loss)	$	57.8		$	16.9	$	8.5	$	(40.1	)	$	43.1
Three Months Ended June 30, 2003
Net revenue	$	214.5		$	48.7	$	127.1	$	—		$	390.3
Cost of care		135.0			12.3		103.3		—			250.6
Direct service costs		30.8			18.9		10.3		—			60.0
Other operating expenses		—			—		—		41.0			41.0
Equity in (earnings) loss of unconsolidated subsidiaries		(1.6	)		—		0.4		—			(1.2	)
Segment profit (loss)	$	50.3		$	17.5	$	13.1	$	(41.0	)	$	39.9
Six Months Ended June 30, 2002
Net revenue	$	486.7		$	116.0	$	272.3	$	—		$	875.0
Cost of care		300.0			38.5		226.5		—			565.0
Direct service costs		84.5			41.8		20.4		—			146.7
Other operating expenses		—			—		—		78.1			78.1
Equity in (earnings) loss of unconsolidated subsidiaries		(7.7	)		—		3.2		—			(4.5	)
Segment profit (loss)	$	109.9		$	35.7	$	22.2	$	(78.1	)	$	89.7
Six Months Ended June 30, 2003
Net revenue	$	433.4		$	100.2	$	265.7	$	—		$	799.3
Cost of care		265.3			26.4		219.0		—			510.7
Direct service costs		64.4			38.8		20.9		—			124.1
Other operating expenses		—			—		—		85.7			85.7
Equity in (earnings) loss of unconsolidated subsidiaries		(3.0	)		—		1.2		—			(1.8	)
Segment profit (loss)	$	106.7		$	35.0	$	24.6	$	(85.7	)	$	80.6

Date: August 19, 2003		MAGELLAN HEALTH SERVICES, INC. (Registrant)
		/s/ MARK S. DEMILIO Mark S. Demilio Executive Vice President and Chief Financial Officer