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Advanzeon Solutions, Inc. – ‘10-KT’ for 12/31/06

On:  Thursday, 8/9/07, at 4:08pm ET   ·   For:  12/31/06   ·   Accession #:  1193125-7-177463   ·   File #:  1-09927

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 8/09/07  Advanzeon Solutions, Inc.         10-KT      12/31/06    7:1.1M                                   RR Donnelley/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-KT       Form 10-K Transition Report                         HTML   1.04M 
 2: EX-21       List of Company's Active Subsidiaries               HTML      9K 
 3: EX-23.1     Consent                                             HTML      7K 
 4: EX-31.1     Certification of CEO Pursuant to Section 302        HTML     11K 
 5: EX-31.2     Certification of CFO Pursuant to Section 302        HTML     11K 
 6: EX-32.1     Certification of CEO Pursuant to Section 906        HTML      9K 
 7: EX-32.2     Certification of CFO Pursuant to Section 906        HTML      9K 

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

For the fiscal year ended                     

or

For the transition period from June 1, 2006 to December 31, 2006

Commission file number 1-9927

COMPREHENSIVE CARE CORPORATION

(Exact name of Registrant as specified in its charter)

(813) 288-4808

(Registrant’s telephone number, including area code)

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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  x    No  ¨

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

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer  ¨                    Accelerated Filer  ¨                    Non-Accelerated Filer  x

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ¨    No  x

The aggregate market value of voting stock held by non-affiliates of the Registrant on November 30, 2006 was approximately $9,400,000 based on the closing price of $1.90 of the Common Stock on November 30, 2006, as reported on the Over-The-Counter Bulletin Board. This amount excludes approximately 2,800,000 shares of common stock held by officers, directors, and persons owning 5% or more of our outstanding common stock. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

On August 6, 2007, the Registrant had 7,702,781 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None.

Table of Contents

TABLE OF CONTENTS

Table of Contents

PART I

ITEM 1. BUSINESS

CAUTIONARY STATEMENT FOR THE PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: Certain information included in this transition report and in our other reports, Securities and Exchange Commission (SEC) filings, statements, and presentations is forward looking within the meaning of the Private Securities Litigation Reform Act of 1995, including, but not limited to, statements concerning our anticipated operating results, financial resources, increases in revenues, increased profitability, interest expense, growth and expansion, and the ability to obtain new behavioral healthcare contracts. Such forward-looking information involves important risks and uncertainties that could significantly affect actual results and cause them to differ materially from expectations expressed herein and in our other reports, SEC filings, statements, and presentations. These risks and uncertainties include the effect of governmental regulation, competitive market conditions, varying trends in member utilization, our ability to manage healthcare operating expenses, the profitability of our capitated contracts, cost of care, seasonality, the risk that any definitive agreements or additional business will result from letters of intent entered into by us, and other risks detailed from time to time in our SEC reports.

OVERVIEW

We are a Delaware corporation organized in 1969. Unless the context otherwise requires, all references to us include our wholly owned operating subsidiary, Comprehensive Behavioral Care, Inc.^{SM (1 )} (CBC) and subsidiary corporations.

Primarily through CBC, we provide managed care services in the behavioral health and psychiatric fields, which is our only operating segment. We coordinate and manage the delivery of a continuum of psychiatric and substance abuse services to:

on behalf of:

Our customer base includes both private and governmental entities. We provide services primarily by a contracted network of providers that includes:

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The services provided through our provider network include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), and inpatient and crises intervention services. We do not directly provide treatment or own any provider of treatment services.

We typically enter into contracts with our clients on an annual basis to provide managed behavioral healthcare and substance abuse services to our clients’ members. Our arrangements with our clients fall into two broad categories: capitation arrangements, where our clients pay us a fixed fee per member, and fee-for-service and administrative service arrangements where we may manage behavioral healthcare programs or perform various managed care services. Under capitation arrangements, the number of covered members reported by our clients determines the amount of premiums we receive, which is independent of the cost of services rendered to members. The amount of premiums we receive for each member is fixed at the beginning of the contract term. These premiums may be subsequently adjusted, up or down, generally at the commencement of each renewal period.

The following table sets forth our operating revenue and covered lives, segregated by category, for the seven months ended December 31, 2006 and 2005 and for the fiscal years ended May 31, 2006, 2005, and 2004:

Over the last several years we have experienced a trend with our clients to contract for services more on a capitated basis than on a non-capitated basis. In addition, several of our large clients have determined to establish their own behavioral health units.

Our largest expense is the cost of behavioral health services that we provide, which is based primarily on our arrangements with healthcare providers. Since we are subject to increases in healthcare operating expenses based on an increase in the number and frequency of our members seeking behavioral care services, our profitability depends on our ability to predict and effectively manage healthcare operating expenses in relation to the fixed premiums we receive under capitation arrangements. Providing services on a capitation basis exposes us to the risk that our contracts may ultimately be unprofitable if we are unable to anticipate or control healthcare costs. Estimation of healthcare operating expense is our most significant critical accounting estimate. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Estimates.”

We manage programs through which services are provided to recipients in fifteen states. Our programs and services include:

We also provide prior and concurrent authorization for physician-prescribed psychotropic medications for a Medicaid health maintenance organization (“HMO”) in Michigan. Members are generally directed to us by their employer, health plan, or physician and receive an initial authorization for an assessment. Based upon the initial assessment, a treatment plan is established for the member.

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Our objective is to provide easily accessible, high quality behavioral healthcare services and products and to manage costs through measures such as the monitoring of hospital inpatient admissions and the review of authorizations for various types of outpatient therapy. Our goal is to combine access to quality behavioral healthcare services with effective management controls in order to ensure the most cost-effective use of healthcare resources.

RECENT DEVELOPMENTS

On December 8, 2006, we entered into a contract with a health plan to provide behavioral healthcare services to approximately 250,000 Medicaid recipients in Indiana. The contract started on January 1, 2007, and is estimated to generate approximately $14 to $15 million in annual revenues, or approximately 41% of our anticipated annual revenues of between $35 and $36 million.

On January 12, 2007, Hythiam, Inc., a healthcare services management company focusing on solutions for those suffering from alcoholism and other substance dependencies, gained a majority controlling interest in us by purchasing the membership interests of Woodcliff Healthcare Investment Partners, LLC, (“Woodcliff”) now a wholly owned subsidiary of Hythiam. Since February 2006, we have had a marketing agreement with Hythiam under which we have the right to offer its PROMETA^® treatment programs as part of a disease management offering to our customers and other mutually agreed parties on an exclusive basis.

Hythiam owns 1,739,130 shares of our common stock and 14,400 shares of our Series A Convertible Preferred Stock. The Preferred Stock is convertible into 4,235,328 shares of our common stock. Assuming conversion, Hythiam has the ability to control 5,974,458 shares or 50.05% of our common stock based on shares outstanding at August 6, 2007. Hythiam has dividend and liquidation preferences, anti-dilution protection, and the right to appoint a majority of our board of directors. In addition, we are required to obtain Hythiam’s consent for a sale or merger involving a material portion of our assets or business, and prior to entering into any single or series of related transactions exceeding $500,000 or incurring any debt in excess of $200,000. After Hythiam acquired Woodcliff, our board appointed three new directors proposed by Hythiam, and three of our existing board members resigned.

On January 18, 2007, we entered into an Agreement and Plan of Merger (“the Merger Agreement”) with Hythiam, as amended on January 26, 2007, whereby we would merge with a newly formed, wholly-owned subsidiary of Hythiam, with CompCare surviving the merger as a wholly-owned subsidiary of Hythiam. Our board of directors approved the merger subject to approval by a majority interest of our stockholders. To complete the merger, Hythiam would acquire our remaining outstanding shares in exchange for Hythiam common stock. Two stockholder class action lawsuits were filed January 23, 2007 and February 1, 2007, respectively, seeking to enjoin the proposed merger. See Part I, Item 3 “Legal Proceedings” for a discussion of these lawsuits.

On May 21, 2007, our Board of Directors approved a change in our fiscal year end from May 31 to December 31, effective December 31, 2006, to align our fiscal year end with that of Hythiam to obtain reporting efficiencies and cost reductions. In addition, a calendar year end will coincide with that of a new client that is estimated to provide approximately 41% of our annual revenues during the 2007 calendar year. The seven months ended December 31, 2006 is our transition period and our new fiscal year began January 1, 2007 and will end December 31, 2007.

On May 25, 2007, we mutually agreed to terminate the Merger Agreement, releasing all parties from any and all liabilities and further obligations arising under the agreement. For the foreseeable future we will continue as a majority-owned, controlled subsidiary of Hythiam, which has publicly indicated that it has determined that it can effectuate substantially all of the benefits of its relationship with us under the current operational structure.

On July 19, 2007, we received from an existing client in Texas a notice of termination, which, if we are not successful in reinstating or obtaining an extension, will result in termination of our contract effective November 30, 2007. This client accounted for 14.5%, or $1.5 million, of our revenues for the seven months ended December 31, 2006 and has been a customer since 1998.

On August 1, 2007, we began providing behavioral healthcare services to approximately 23,000 Medicare members from an existing client in Pennsylvania. Such services are estimated to generate between $4.5 and $5.0 million in annual revenues.

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SOURCES OF REVENUE

We provide managed behavioral healthcare and substance abuse services to recipients, primarily through subcontracts with HMOs who have historically carved out these functions to managed behavioral healthcare organizations like us. We generally receive a negotiated amount on a per member per month or capitated basis in exchange for providing these services. We then contract directly with behavioral healthcare providers who receive a pre-determined, fee-for-service rate or case rate. Our behavioral healthcare providers include:

As of December 31, 2006, we had approximately 7,000 behavioral healthcare practitioners in our network who are primarily located in the seven states in which we have principal contracts:

Under such full-risk capitation arrangements, profit is a function of utilization and the amount of claims payments made to our network providers. We perform periodic reviews of our current client contracts to determine profitability. In the event a contract is not profitable, we may seek to revise the terms of the contract or to terminate the agreement in accordance with the specific contract terms.

For the seven months ended December 31, 2006, we provided services under capitated arrangements for commercial, Medicare, Medicaid, and CHIP patients in Texas; commercial, Medicaid, and Medicare patients in Florida; commercial patients in Georgia, Alabama, and Indiana; Medicare patients in the District of Columbia, Maryland, Connecticut and Pennsylvania; and Medicaid patients in California and Michigan. Our Medicare, Medicaid and CHIP contracts are subject to agreements with our HMO clients whose contracts with the various governmental agencies may be subject to renegotiation at the election of the specific agency.

For the seven months ended December 31, 2006 and December 31, 2005, a significant portion of our operating revenue was concentrated in contracts with six and seven health plans, respectively, to provide behavioral healthcare services under commercial, Medicare, Medicaid, and CHIP plans. These combined contracts represented approximately 81.5% and 82.6% of our operating revenue for the seven months ended December 31, 2006 and December 31, 2005, respectively. For the fiscal years ended May 31, 2006 and 2005, eight contracts represented approximately 87.0% and 78.3% of our operating revenues, respectively. The terms of each contract are generally for one-year periods and are automatically renewable for additional one-year periods unless terminated by either party. The loss of one or more of these clients, without replacement by new business, would negatively affect our financial condition.

GROWTH STRATEGY

Our objective is to expand our presence in both existing and new managed behavioral healthcare markets by enhancing our product offerings and identifying new business development partners. We have expanded our disease management approach to include behavioral health pharmacy management, integration of behavioral health with medical care that targets primary care physician support, substance abuse disease management with cutting edge medical technology, and other chronic disease coordination programs.

We will continue to provide our core product, carve-out behavioral healthcare management to health plans, government entities, employers and other entities. In addition, the Medicare market is growing rapidly with new Medicare Advantage Plans being approved by the Centers for Medicare and Medicaid Services (CMS). Persons over the age of 65 and younger persons who are deemed disabled are eligible to receive Medicare benefits. The

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shifting demographics of the U.S. population signal increasing Medicare enrollment as the baby boom generation ages. Mental health disorders have been diagnosed in 6% of elderly enrollees and 37% of disabled enrollees. For those enrollees who are disabled and also eligible for Medicaid, 59% have a mental health disability. Mental health expertise is critical to successful management of these populations.

We have developed product, marketing and distribution relationships with external companies to maximize our offerings. We have entered into relationships with Health Alliance Network, Inc. for commercial and Medicare sales, Comprehensive Neuroscience, Inc. for pharmacy data analytics and Hythiam to provide the Prometa^® Treatment Program for our Substance Abuse product offering. We will continue to seek and explore relationships with partners that offer strategic synergies.

PROVIDER NETWORK

Our managed behavioral healthcare services are provided by contracted providers, including behavioral healthcare professionals and facilities. Our behavioral healthcare professionals include a variety of specialized behavioral healthcare personnel, such as:

Our facilities include:

Outpatient providers include both individual practitioners as well as individuals who are members of group practices or other licensed centers or programs. Outpatient providers typically execute contracts with the company under which they are generally paid on a fee-for-service basis.

Our provider network also includes contractual arrangements with intensive outpatient facilities, partial hospitalization facilities, community health centers and other community-based facilities. Our contracts with facilities are on a per diem or fee-for-service basis and, in some cases, on a “case rate” basis, whereby a fixed amount is paid, irrespective of the amount of services provided.

COMPETITION

The behavioral healthcare industry is very competitive and provides products and services that are price sensitive. We believe that there are approximately 150 managed behavioral healthcare organizations (“MBHOs”) providing services for an estimated 227 million covered lives in the United States. Competitors include both freestanding MBHOs as well as HMOs with internal behavioral health units or subsidiaries. Many of these competitors have revenues, financial resources, and membership substantially larger than ours. The extent of competition results in significant pricing pressures which limits our revenue growth. Accordingly, we expect our future growth to come mainly from additional contracts.

SEASONALITY OF BUSINESS

Historically, we have experienced increased member utilization during the months of March, April and May, and consistently low utilization by members during the months of June, July, and August. Such variations in member utilization impact our costs of care during these months, generally having a positive impact on our gross margins and operating profits during the June through August period and a negative impact on our gross margins and operating profits during the months of March through May. During the period September 2006 through December 2006, we experienced higher than expected member utilization costs as compared to the similar period of the previous year. We have attempted to address the high utilization costs incurred through rate increases with certain of our clients. We may continue to experience increased utilization costs in subsequent periods.

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GOVERNMENT REGULATION

We are subject to extensive and evolving state and federal regulations relating to the nation’s mental health system as well as changes in Medicaid and Medicare reimbursement that could have an effect on our profitability. These regulations range from licensure and compliance with regulations related to insurance companies and other risk-assuming entities, to licensure and compliance with regulations related to healthcare providers. These laws and regulations may vary considerably among states. As a result, we may be subject to the specific regulatory approach adopted by each state for regulation of managed care companies and for providers of behavioral healthcare treatment services. We hold licenses or certificates to perform utilization review and third party administrator (“TPA”) services in certain states. Certain of the services provided by our managed behavioral healthcare subsidiaries may be subject to such licensing requirements in other states. There can be no assurance that additional utilization review or TPA licenses will not be required or, if required, that we will qualify to obtain such licenses. In many states, entities that assume risk under contract with licensed insurance companies or health plans that retain ultimate financial responsibility have not been considered by state regulators to be conducting an insurance or HMO business. As a result, we have not sought licensure as either an insurer or HMO in certain states. If the regulatory positions of these states were to change, our business could be materially affected until such time as we meet the regulatory requirements. We cannot quantify the potential effects of additional regulation of the managed care industry, but such costs will have an adverse effect on future operations to the extent that they are not able to be recouped in future managed care contracts.

As of December 31, 2006, we managed approximately 545,000 lives in connection with behavioral and substance abuse services covered through Medicare, Medicaid and CHIP programs in Texas, Medicare and Medicaid in Florida, Medicaid in California and Michigan, and Medicare in Maryland and Pennsylvania. On January 1, 2007 we began serving approximately 250,000 Medicaid recipients in the state of Indiana. Any changes in Medicare, Medicaid or CHIP funding would ultimately affect our reimbursement and overall profitability.

We are subject to the requirements of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”). One of the purposes of HIPAA is to improve the efficiency and effectiveness of the healthcare system through standardization of the electronic data interchange of certain administrative and financial transactions and, also, to protect the security and privacy of protected health information. Entities subject to HIPAA include some healthcare providers and all healthcare plans.

ACCREDITATION

To develop standards that effectively evaluate the structure and function of medical and quality management systems in managed care organizations, the National Committee on Quality Assurance (“NCQA”) has developed an extensive review and development process in conjunction with the managed care industry, healthcare purchasers, state regulators, and consumers. The Standards for Accreditation of MBHOs used by NCQA reviewers to evaluate an MBHO address the following areas: quality improvement; utilization management; credentialing; members’ rights and responsibilities; and preventative care. These standards validate that an MBHO is founded on principles of quality and is continuously improving the clinical care and services it provides. NCQA utilizes Health Plan Employer Data and Information Set (“HEDIS”), which is a core set of performance measurements developed to respond to complex but clearly defined employer needs as standards for patient care and customer satisfaction. In May 2005 we were awarded Full Accreditation extending to July 22, 2008. Full Accreditation is granted for a period of three years to those plans that have, according to the NCQA, excellent programs for continuous quality improvement and that meet NCQA’s rigorous standards.

We believe our NCQA accreditation is beneficial to our clients and their members we serve. Additionally, NCQA accreditation is required by several of our client contracts and is frequently an important consideration to our prospective clients.

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MANAGEMENT INFORMATION SYSTEMS

All of our health plan information technology and systems operate on a single platform. This approach avoids the costs associated with maintaining multiple systems and improves productivity. The open architecture of the systems gives us the ability to transfer data from other systems thereby facilitating the integration of new health plan business. We use our information system for claims processing, utilization management, reporting, cost trending, planning, and analysis. The system also supports member and provider service functions, including:

We have decided to implement significant enhancements to our existing healthcare information system with recently made available technology from our current vendor to best meet our future information system needs and comply with all HIPAA requirements. These enhancements include advanced software to facilitate patient case management and provide our healthcare providers with self-serve capabilities through the Internet. We expect all parties involved to benefit from the efficiencies of our improved information systems.

MARKETING AND SALES

Our Marketing and Sales efforts are led by the Chief Development Officer under the direction of the Chief Executive Officer. In addition, we utilize Health Alliance Network for consultation and direct sales to commercial and Medicare prospective clients. We have further expanded our sales capacity through a contract with Hythiam, which funds two additional sales positions dedicated to Substance Abuse Disease Management utilizing the PROMETA Treatment Program. We also recently entered into a sales referral and cooperative marketing relationship with Adaptis, Inc., a company that offers integrated business process solutions for health payers. We will continue to dedicate our resources to expand sales staff and marketing efforts.

Sales strategy focuses on matching our solutions to the needs identified by our potential clients. Sales are highly technical and complex, involving many stakeholders within an organization. The sales cycle is typically 12-18 months. Sales leads may be generated by our Business Development staff, our operations staff, consultants, cold calls, prior business relationships or from recommendations by existing clients. We attend trade shows within geographic areas in which we conduct business and reach out to contacts known to us, our consultants and our investors. Proposals in response to Requests for Proposals from prospective commercial and public sector clients are prepared by our sales staff and presented by our Chief Development Officer. In addition, we maintain permanent marketing outreach through our website, www.compcare.com.

ADMINISTRATION AND EMPLOYEES

Our executive and administrative offices are located in Tampa, Florida, where we maintain operations, business development, accounting, reporting and information systems, and provider and member service functions. Provider management, account management, and certain clinical and utilization management functions are also performed in our Texas and Indiana offices. At December 31, 2006 we employed 77 full-time and 9 part-time employees.

AVAILABLE INFORMATION

Our stockholder website is www.compcare-shareholders.com. We make available free of charge, through a link to the SEC Internet site, our annual, quarterly, and current reports, and any amendments to these reports, as well as any beneficial ownership reports of officers and directors filed electronically on Forms 3, 4, and 5. Information contained on our website or linked through our website is not part of this report on Form 10-K.

CODE OF ETHICS

We have adopted a code of ethics applicable to all of our employees, including our principal executive officer, principal financial officer, principal accounting officer and persons performing similar functions. The text of this code of ethics can be found on our website at www.compcare-shareholders.com. We intend to post notice of any waiver from, or amendment to, any provision of our code of ethics on our website.

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ITEM 1A. RISK FACTORS

Important Factors Related to Forward-Looking Statements and Associated Risks

This Transition Report on Form 10-K contains certain forward-looking statements that are based on our current expectations and plans. Although we believe our expectations and plans are reasonable and made in good faith, we can provide no assurance that they will be achieved. Our forward-looking statements are not guarantees of future performance and would be significantly affected by the material risk factors set forth below and other risks described in our public filings with the SEC.

Risks related to our business

We may not be able to accurately predict utilization of our full-risk contracts, which could result in contracts priced at levels insufficient to ensure profitability.

Managed care operations are at risk for costs incurred to provide agreed upon levels of service. Failure to anticipate or control costs could have material, adverse effects on our business. Providing services on a full-risk capitation basis exposes us to the additional risk that contracts negotiated and entered into may ultimately be unprofitable if utilization levels require us to provide services at capitation rates which do not account for or factor in such utilization levels.

Because providers are responsible for claims submission, the timing of which is uncertain, we must estimate the amount of claims incurred but not reported.

Our costs of care include estimated amounts for claims incurred but not reported (“IBNR”). The IBNR is estimated using an actuarial paid completion factor methodology and other statistical analyses that we continually review and adjust, if necessary, to reflect any change in the estimated liability. These estimates are subject to the effects of trends in utilization and other factors. Our estimates of IBNR may be inadequate in the future, which would negatively affect results of operations. Although considerable variability is inherent in such estimates, we believe that our unpaid claims liability is adequate. However, actual results may differ materially from the estimated amounts reported.

We are subject to fines and penalties being assessed to us by our clients.

Many of our contracts contain provisions stating that if our clients are assessed penalties or fines by a regulatory agency due to our noncompliance with a contractual requirement, we will be responsible for paying the assessed fine or penalty.

Failure to maintain effective internal controls over financial reporting could have a material adverse effect on our operating results.

The Sarbanes-Oxley Act of 2002 requires that we maintain effective internal control over financial reporting. As a result of the change in our fiscal year, we will be required to comply with its requirements for our annual report for the year ended December 31, 2007, which will be a significant and unanticipated expense. Our future testing or the subsequent testing by our independent registered public accounting firm may reveal deficiencies in our internal controls over financial reporting that are deemed to be material weaknesses, which would require additional financial and management resources.

A failure of our information systems would significantly impair our ability to serve our customers and manage our business.

An effective and secure information system, available at all times, is vital to our health plans and their members. We depend on our computer systems for significant service and management functions, such as providing membership verification, monitoring utilization, processing provider claims, and providing regulatory data and other client and managerial reports. Any loss of availability of our current information system would cause a disruption in operations and impact our performance.

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We are subject to intense competition that may prevent us from gaining new customers or pricing our contracts at levels to achieve sufficient gross margins to ensure profitability.

We are continually pursuing new business. However, the smaller size and financial condition of our company has proved a deterrent to some prospective customers. Additionally, we will likely have difficulty in matching the financial resources expended on marketing characteristic of our competitors. As a result, we may not be able to realize our forecasted short and long-term growth plans.

As a result of our dependence on a limited number of customers, the loss of any one of these customers, or a reduction in business from any one of them, could have a material adverse effect on our working capital and future results of operations.

At December 31, 2006, we provided behavioral healthcare services to the members of six health plans under contracts that on a combined basis represented approximately 81.5% of our operating revenue for the seven months ended December 31, 2006. For the seven months ended December 31, 2005, seven contracts accounted for 82.6 % of our operating revenue. The terms of each contract are generally for one-year periods and are automatically renewable for additional one-year periods unless terminated by either party. The contracts may be terminated immediately with cause and in most cases, in 60 to 120 days without cause. The loss of one or more of these clients, without replacement by new business, would negatively affect our financial condition.

We have noted an annual seasonality in the usage of our provider network. Our financial results may suffer to the extent we cannot adequately manage periods of increased utilization.

Historically we have generally experienced increased utilization during the months of March, April and May. Such a variation in utilization impacts our costs of care during these months, generally having a negative impact on our gross margins and operating profits.

We are dependent on our executive officers and other key employees.

Our operations are highly dependent on the efforts of our senior executive officers. The loss of their leadership, knowledge and experience could negatively impact our operations.

We may be unsuccessful in managing our new Indiana Medicaid contract, or the contract may be significantly more costly than anticipated.

We may be unsuccessful in managing our new Indiana Medicaid contract that started January 1, 2007. We expect this contract to provide approximately 41% of our revenue in 2007. Providing services under a new contract for populations at risk that have not been managed before exposes us to the risk it may be unprofitable. There is a limited historical basis for the actuarial assumptions about the utilization of benefits by members covered under this new managed care behavioral program, and premiums based on these assumptions may be insufficient to cover the benefits provided and we may be unable to obtain offsetting rate increases. Contract premiums have been set based on anticipated significant savings and on types of utilization management that may not be possible, which may cause disagreements with providers, diverting management resources and having an adverse impact on our financial results.

We are dependent on our provider network to provide services to our members.

We contract with providers as a means to assure access to behavioral health services for our members. Some providers could refuse to contract with us, demand higher payments, or take other actions which could result in higher healthcare operating expenses. In addition, certain providers may have significant market position, which could cause disruption to provider access in a particular geographic area for our members and affect our contractual requirements with our customers of maintaining an adequate network.

Risks related to our industry

Our existing and potential managed care clients operate in a highly competitive environment and may be subject to a higher rate of merger, acquisition and regulation than in other industries.

We typically contract with small to medium sized HMO’s which may be adversely affected by the continuing efforts of governmental and third party payers to contain or reduce the costs of healthcare through various means. Our clients may also determine to manage the behavioral healthcare benefits “in house” and, as a result, discontinue contracting with us. Additionally, our clients may be acquired by larger HMOs, in which case there can be no assurance that the acquiring company would renew our contract.

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Many managed care companies, including nine of our existing clients, provide services to groups covered by Medicare, Medicaid and/or CHIP programs. Such federal and state controlled programs are susceptible to annual changes in reimbursement rates and eligibility requirements that could ultimately affect companies such as CompCare.

As of December 31, 2006, we managed approximately 545,000 lives in connection with behavioral and substance abuse services covered through Medicare, Medicaid and CHIP programs in Texas, Medicare and Medicaid in Florida, Medicaid in California and Michigan, and Medicare in Maryland and Pennsylvania. In addition, on January 1, 2007 we began serving approximately 250,000 Medicaid recipients in Indiana. Any changes in Medicare, Medicaid and/or CHIP reimbursement could ultimately affect us through contract bidding and cost structures with the health plans first impacted by such changes. Benefits available to Texas CHIP recipients were significantly reduced for the five-month period from September 1, 2003 to January 31, 2004 as a result of legislative bills passed by the Texas State legislature. Although subsequent legislation restored the majority of benefits available to CHIP recipients effective February 1, 2004, the temporary reduction in revenues had a negative impact on our results of operations for the twelve months ended May 31, 2004. Such changes, if implemented in the future, could have a material, adverse impact on our operations. Additionally, we cannot predict which states in which we operate may pass legislation that would reduce our revenue through changes in the reimbursement rates or in the number of eligible participants. In either case, we may be unable to reduce our costs to a level that would allow us to maintain current gross margins specific to our Medicare, Medicaid and CHIP programs.

The industry is subject to extensive state and federal regulations, as well as diverse licensure requirements varying by state. Changes in regulations could affect the profitability of our contracts or our ability to retain clients or to gain new customers.

We hold licenses or certificates to perform utilization review and TPA services in certain states. There can be no assurance that additional utilization review or TPA licenses will not be required or, if required, that we will qualify to obtain such licenses. In many states, entities that assume risk under contract with licensed insurance companies or health plans have not been considered by state regulators to be conducting an insurance or HMO business. As a result, we have not sought licensure as either an insurer or HMO in any state. If the regulatory positions of these states were to change, our business could be materially affected until such time as we are able to meet the regulatory requirements, if at all. Additionally, some states may determine to contract directly with companies such as ours for managed behavioral healthcare services in which case they may also require us to maintain financial reserves or net worth requirements that we may not be able to meet. Currently, we cannot quantify the potential effects of additional regulation of the managed care industry, but such costs will have an adverse effect on future operations to the extent that they are not able to be recouped in future managed care contracts.

We are subject to the requirements of HIPAA. The purpose of the HIPAA is to improve the efficiency and effectiveness of the healthcare system through standardization of the electronic data interchange of certain administrative and financial transactions and to protect the security and privacy of protected health information. We have implemented policies and practices to achieve compliance with HIPAA, and believe we are fully compliant with all HIPAA regulations. However, any lack of compliance with HIPAA regulations may result in penalties and have a material adverse effect on our ability to retain our customers or to gain new business.

Risks related to our common and preferred stock

Currently, our Series A Preferred Shareholder is able to exercise decisive influence over our major corporate decisions.

In June 2005, Woodcliff purchased 14,400 shares of our Series A Convertible Preferred Shares. Such shares are convertible into 4,235,328 common shares, which when combined on an “as-converted” basis with 1,739,130 common shares purchased by Woodcliff in October 2006, resulted in beneficial ownership of capital stock representing approximately 50.2% of the Company’s voting power as of December 31, 2006. Hythiam acquired Woodcliff’s interest in January 2007 and has the right to designate a majority of the members of our Board of Directors. As a result, holders of our common stock are subject to the following risks, among others:

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Our Series A Preferred Shareholder has significant rights and preferences over the holders of our common stock.

The holder of our Series A Preferred Shares is entitled to receive dividends when declared by our Board of Directors. The payment of these dividends will take priority over any payment of dividends on our common stock. The holder of our Series A Shares will have a claim against our assets senior to the claim of the holders of our common stock in the event of our liquidation, dissolution or winding-up. The aggregate amount of that senior claim is approximately $3.6 million, which represents the Series A Preferred shareholder investment in our Company as of December 31, 2006 and will increase thereafter if such preferred stock accrues dividends and if we issue additional shares of such preferred stock to Hythiam pursuant to the terms of the Securities Purchase Agreement for the Series A Preferred Shares. There have been no dividends declared or paid by us to our Series A Preferred shareholder.

The holder of our Series A Preferred Shares has other rights and preferences, including the following:

The price of our common stock may be adversely affected by our small public capitalization.

The size of our public market capitalization is relatively small, and the volume of our shares that are traded is low. These factors could cause significant fluctuation in the trading of our stock, which may adversely affect the price of our common stock.

Our stock is a “penny stock” which makes it more difficult for us to raise needed funds, and for our stockholders to sell their shares.

The SEC has adopted regulations which generally define “penny stock” to be an equity security that has a market price of less than $5.00 per share or an exercise price of less than $5.00 per share, subject to specific exemptions. The market price of our common stock is currently approximately $1.00 per share, which is substantially less than the $5.00 per share threshold. This designation requires any broker or dealer selling these securities to disclose specified information concerning the transaction, obtain a written agreement from the purchaser and determine that the purchaser is reasonably suitable to purchase the securities. These rules may restrict the ability of brokers or dealers to sell our common stock and may affect the ability of stockholders to sell their shares. In addition, since our common stock is currently not traded on any stock exchange, but instead is only quoted on the Over-The-Counter Bulletin Board, stockholders may find it difficult to obtain accurate quotations for our common stock and may experience a lack of buyers to purchase our shares or a lack of market makers to support the stock price.

There may be ongoing legal challenges to our relationship with Hythiam, which could adversely affect our results of operations.

On May 25, 2007, we entered into a Termination Agreement with Hythiam terminating the proposed merger with Hythiam. There are potential legal and economic risks associated with terminating the merger agreement and continuing with our ongoing relationship with Hythiam, including challenges from public minority shareholders concerning the procedural and financial fairness of our existing agreements, and any future agreements or arrangement between us. Current or future litigation may be expensive and time consuming, and may impede or restrict our ability to operate effectively, which could negatively impact our results of operations.

Errors in estimates may have a significant negative impact on our financial condition and results of operations.

Assumptions relating to the foregoing involve judgments that are difficult to predict accurately and are subject to many factors that can materially affect results. Budgeting and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our budgets which may in turn affect our results. In light of the factors that can materially affect the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives or plans will be achieved.

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ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

We do not own any real property. We lease our corporate office and regional offices. The following table sets forth certain information regarding our leased properties as of December 31, 2006. The Texas lease is a full service lease under which we bear only those costs of operations and property taxes exceeding the base-year expenses. The Florida lease is a sublease for which the monthly base rent covers all services and property taxes. We believe our current office space is suitable and adequate to meet our existing needs and that additional facilities will be available for lease to meet our future needs.

ITEM 3. LEGAL PROCEEDINGS

We and nine current and former board members were named as defendants in two class action lawsuits filed by two shareholders on January 23, 2007 and February 1, 2007, respectively. In the similar complaints, filed in the Chancery Court of Delaware, the plaintiffs seek permanent injunctive and other equitable relief to prevent Hythiam from acquiring 49.95% of our outstanding common shares that it does not currently own (either directly or through its wholly owned subsidiary, Woodcliff) from the remaining minority shareholders. The plaintiffs allege that the consideration being proposed to the minority shareholders by Hythiam is inadequate, through coercive means, without fair process and through material misleading information.

On May 25, 2007, we mutually terminated the Agreement and Plan of Merger. The plaintiffs’ counsel has acknowledged that the lawsuits are now moot and has agreed to dismiss them, but has not yet done so.

On June 15, 2007, a complaint was filed against us by two stockholders in the Delaware Court of Chancery. The complaint seeks an order compelling us to deliver copies of requested books and records pursuant to Section 220 of the Delaware General Corporation Law. In addition, the complaint seeks payment of reasonable fees and expenses to the plaintiffs and such other further relief that the Court may deem just and proper. We filed an answer to the complaint on July 11, 2007, in which we contend that the demand made by the plaintiffs does not comply with the form and manner of making a demand for inspection under Section 220, that the plaintiffs failed to set forth or establish a proper purpose for inspection, and that the documents the plaintiffs seek to inspect are overly broad. We have offered to produce appropriate documents pursuant to a reasonable protective order, to which the plaintiffs have refused to agree.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On November 17, 2006, we held our 2006 annual meeting of stockholders for the purpose of electing seven directors. Record holders as of the September 22, 2006 record date were entitled to notice of the annual meeting and to vote at such meeting. As of the record date, there were 5,904,207 shares of common stock and 14,400 shares of Convertible Preferred Stock entitled to vote at the meeting. The 14,400 shares of Convertible Preferred Stock represented 4,235,328 common shares on an as converted basis. Stockholders holding 4,995,079 shares of common stock and 14,400 shares of Convertible Preferred Stock, representing a majority of the common stock and preferred stock and a quorum (approximately 84.6% and 100%, respectively, of the total shares entitled to vote), were represented at the meeting either in person or by proxy.

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RESULTS OF ELECTION OF DIRECTORS

Common and preferred stockholders were asked to elect three directors to our Board of Directors. Set forth below are the names of the persons nominated for and elected as well as the results of the voting for the nominees. The results include common shares and preferred shares on an as converted basis.

The preferred stockholder, Woodcliff, was asked to elect four directors to our Board of Directors. Set forth below are the names of the persons nominated for and elected as well as the results of the voting for the nominees.

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PART II

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

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ITEM 6. SELECTED FINANCIAL DATA

Prior to fiscal 1993, we principally engaged in the ownership, operation, and management of psychiatric and substance abuse programs in Company owned, leased, or unaffiliated hospitals. During fiscal 1999, we completed our plan to dispose of our hospital business segment. Fiscal 2004 results include a $387,000 charge related to such discontinued operations (see Note 10 – “Discontinued Operations” to the audited, consolidated financial statements).

Fiscal 2003 results include a $7.7 million, non-operating gain related to a settlement with the Internal Revenue Service (IRS). Additionally, fiscal 2003 results include a $470,000 gain included in discontinued operations, related to the settlement of one matter, covering our fiscal years 1983 through 1986, involving Medi-Cal reimbursements paid to Brea Neuropsychiatric Hospital, a facility we owned until its disposal in fiscal year 1991.

The selected consolidated financial data that follows should be read in conjunction with the consolidated financial statements and accompanying notes appearing elsewhere in this report.

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This report on includes forward-looking statements, the realization of which may be impacted by certain important factors discussed previously under Item 1A “Risk Factors — Important Factors Related to Forward-Looking Statements and Associated Risks.”

OVERVIEW

We manage the delivery of a continuum of psychiatric and substance abuse services to commercial, Medicare, and Medicaid members on behalf of employers, health plans, government organizations, third-party claims administrators, and commercial and other group purchasers of behavioral healthcare services. Our managed care operations include administrative service agreements, fee-for-service agreements, and capitation contracts. The customer base for our services includes both private and governmental entities. Our services are provided primarily by unrelated vendors on a subcontract or subcapitated basis.

The following table sets forth our operating income (loss) for the seven months ended December 31, 2006 and 2005 and the fiscal years ended May 31, 2006, 2005 and 2004:

RESULTS OF OPERATIONS – SEVEN MONTHS ENDED DECEMBER 31, 2006 AS COMPARED TO THE SEVEN MONTHS ENDED DECEMBER 31, 2005.

The decrease in capitated contract revenue is primarily attributable to the termination of our Connecticut contract, the loss of which accounted for $3.4 million less revenue for the seven months ended December 31, 2006 versus 2005 and the termination of a Texas contract, the loss of which accounted for $3.2 million less revenue for the same periods. This was partially offset by additional business from existing clients in Pennsylvania, Texas, Michigan and Maryland. The decrease in non-capitated revenue is primarily attributable to the loss of a management services only customer in Michigan offset by additional business in Texas and Florida and a new client in Connecticut.

Claims expense on capitated contracts decreased approximately $3.2 million or 30.0% for the seven months ended December 31, 2006 as compared to the seven months ended December 31, 2005. The reduction is due to the

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loss of capitated revenue as mentioned above. Claims expense as a percentage of capitated revenues increased from 74.0% for the period ended December 31, 2005 to 77.1% for the period ended December 31, 2006. Other healthcare operating expenses, which are incurred to service both capitated and non-capitated contracts, decreased approximately $456,000, or 17.6%, due to staff reductions in response to the loss of revenues in Michigan, Connecticut and Texas. As a percentage of total revenue, other healthcare operating expenses increased from 17.0% for the period ended December 31, 2005 to 20.7% for the period ended December 31, 2006.

General and administrative expenses decreased by $192,000, or 9.8%, for the seven months ended December 31, 2006 as compared to the seven months ended December 31, 2005. This decrease is primarily attributable to indirect costs of the June 2005 sale of Series A Preferred Stock, increased costs for marketing consultants engaged to obtain additional commercial business, and legal expenses associated with our 2005 Annual Meeting and changes to the corporate charter in the period ended December 31, 2005. General and administrative expense as a percentage of operating revenue increased from 12.8% for the period ended December 31, 2005 to 17.1% for the period ended December 31, 2006.

RESULTS OF OPERATIONS –YEAR ENDED MAY 31, 2006 AS COMPARED TO THE YEAR ENDED MAY 31, 2005.

Capitated contract revenues increased 4.5% or approximately $1.0 million to $23.0 million for the year ended May 31, 2006 compared to $22.0 million for the year ended May 31, 2005. This increase in revenue is primarily attributable to additional business from existing clients in Indiana and new customers in Pennsylvania and Maryland, but was partially offset by the termination of our Connecticut contract, the loss of which accounted for $1.9 million less revenue in fiscal 2006 than in fiscal 2005. Non-capitated revenue declined 62.2%, or $1.5 million, to $0.9 million for the fiscal year ended May 31, 2006, compared to $2.4 million for the fiscal year ended May 31, 2005. The decrease is primarily attributable to the loss of two management services only customers in Michigan and an ASO client in Texas.

Claims expense on capitated contracts decreased approximately $129,000 or 0.8% for the fiscal year ended May 31, 2006 as compared to the fiscal year ended May 31, 2005. The reduction is due to decreased utilization of covered services. Claims expense as a percentage of capitated revenues decreased from 74.2% for the fiscal year ended May 31, 2005 to 70.5% for the fiscal year ended May 31, 2006. Other healthcare operating expenses, which are incurred to service both capitated and non-capitated contracts, decreased approximately $607,000, or 12.3% for the fiscal year ended May 31, 2006 as compared to the fiscal year ended May 31, 2005, due to staff reductions in response to the loss of revenues in Michigan, Connecticut and Texas. As a percentage of total revenue, other healthcare operating expenses decreased from 20.1% for fiscal 2005 to 18.0% for fiscal 2006.

General and administrative expenses increased by $238,000, or 7.7%, for the fiscal year ended May 31, 2006 as compared to the fiscal year ended May 31, 2005. This increase is primarily attributable to indirect costs of the June 2005 sale of Series A Preferred Stock, increased costs for marketing consultants engaged to obtain additional commercial business, and legal expenses associated with our 2005 Annual Meeting and changes to the corporate charter. General and administrative expense as a percentage of operating revenue increased from 12.6% for the fiscal year ended May 31, 2005 to 13.8% for the fiscal year ended May 31, 2006.

RESULTS OF OPERATIONS –YEAR ENDED MAY 31, 2005 AS COMPARED TO THE YEAR ENDED MAY 31, 2004.

Capitated contract revenues decreased by 6.4%, or approximately $1.5 million, to $22.1 million for the fiscal year ended May 31, 2005 compared to $23.6 million for the fiscal year ended May 31, 2004. This decrease is primarily attributable to the loss of one major customer in Florida that accounted for $4.4 million of revenue during the fiscal year ended May 31, 2004, offset partially by increased revenues primarily in Connecticut and Texas. Non-capitated revenue declined 39.8% or approximately $1.6 million to $2.4 million for the fiscal year ended May 31, 2005, compared to $4.0 million for the same period of fiscal 2004. This decrease is attributable to the loss of ASO clients in Michigan and Texas.

Claims expense on capitated contracts decreased approximately $1.8 million or 9.9% for the fiscal year ended May 31, 2005 as compared to the fiscal year ended May 31, 2004, due to a reduction in capitated revenues and the loss of one major contract in Florida that consistently returned a high medical loss ratio. Claims expense as a percentage of capitated revenues decreased from 77.1% for the fiscal year ended May 31, 2004 to 74.2% for the fiscal year ended May 31, 2005. Other healthcare operating expenses, which are incurred to service both capitated and non-capitated contracts, decreased approximately $1.1 million, or 18.1%. This decrease is attributable to lower personnel costs resulting from restructuring our regional and corporate operations. As a percentage of total revenue, other healthcare operating expenses decreased from 21.8% for fiscal 2004 to 20.1% for fiscal 2005.

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General and administrative expenses decreased by $307,000, or 9.1%, for the fiscal year ended May 31, 2005 as compared to the fiscal year ended May 31, 2004. This decrease is primarily attributable to a decrease in salaries and benefits resulting from our restructuring of regional and corporate operations and less usage of outside professional services. General and administrative expense as a percentage of operating revenue increased slightly from 12.3% for the fiscal year ended May 31, 2004 to 12.6% for the fiscal year ended May 31, 2005.

SEASONALITY OF BUSINESS

Historically, we have experienced increased member utilization during the months of March, April and May, and consistently low utilization by members during the months of June, July, and August. Such variations in member utilization impact our costs of care during these months, generally having a positive impact on our gross margins and operating profits during the June through August period and a negative impact on our gross margins and operating profits during the months of March through May. During the period September 2006 through December 2006, we experienced higher than expected member utilization costs as compared to the similar period of the previous year. We have attempted to address the high utilization costs incurred through rate increases with certain of our clients. We may continue to experience increased utilization costs in subsequent periods.

LIQUIDITY AND CAPITAL RESOURCES

During the seven months ended December 31, 2006, our cash and cash equivalents increased by $80,000. Net cash used by continuing operations amounted to $539,000. Cash used in investing activities totaled $113,000, which is comprised primarily of $160,000 in additions to property and equipment offset by $35,000 in proceeds from a property insurance claim. Cash provided by financing activities consists primarily of $785,000 in net proceeds from the exercise of a Put Option to Woodcliff in exchange for 1,739,130 shares of our common stock in October of 2006. At December 31, 2006, cash and cash equivalents amounted to $5.5 million. We believe we have sufficient working capital to sustain current operations and meet our current obligations during the next twelve months.

Our unpaid claims liability is estimated using an actuarial paid completion factor methodology and other statistical analyses. These estimates are subject to the effects of trends in utilization and other factors. Any significant increase in member utilization that falls outside of our estimations would increase healthcare operating expenses and may impact our ability to achieve and sustain profitability and positive cash flow. Although considerable variability is inherent in such estimates, we believe that our unpaid claims liability is adequate. However, actual results could differ from the $2.7 million accrued claims payable amount reported as of December 31, 2006.

COMMITMENTS AND CONTRACTUAL OBLIGATIONS

The following is a schedule at December 31, 2006 of our long-term contractual commitments, future minimum lease payments under non-cancelable operating lease arrangements, and other long-term obligations:

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CRITICAL ACCOUNTING ESTIMATES

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make significant estimates and judgments to develop the amounts reflected and disclosed in the consolidated financial statements, most notably our estimate for claims incurred but not yet reported (“IBNR”). On an on-going basis, we evaluate the appropriateness of our estimates and we maintain a thorough process to review the application of our accounting policies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

We believe our accounting policies specific to our revenue recognition, accrued claims payable and claims expense, premium deficiencies, goodwill, and stock compensation expense involve our most significant judgments and estimates that are material to our consolidated financial statements (see Note 2 – “Summary of Significant Accounting Policies” to the audited, consolidated financial statements).

REVENUE RECOGNITION

We provide managed behavioral healthcare and substance abuse services to recipients, primarily through subcontracts with HMOs. Revenue under the vast majority of these agreements is earned and recognized monthly based on the number of covered members as reported to us by our clients regardless of whether services actually provided are lesser or greater than anticipated when we entered into such contracts (generally referred to as capitation arrangements). The information regarding the number of covered members is supplied by our clients and we review membership eligibility records and other reported information to verify its accuracy in calculating the amount of revenue to be recognized. Consequently, the vast majority of our revenue is determined by the monthly receipt of covered member information and the associated payment from the client, thereby removing uncertainty and precluding us from needing to make assumptions to estimate monthly revenue amounts.

We may experience adjustments to our revenues to reflect changes in the number and eligibility status of members subsequent to when revenue is recognized. Subsequent adjustments to our revenue have not been material in the past.

ACCRUED CLAIMS PAYABLE AND CLAIMS EXPENSE

Healthcare operating expenses are composed of claims expense and other healthcare expenses. Claims expense includes amounts paid to hospitals, physician groups and other licensed behavioral healthcare professionals. Other healthcare operating expenses include items such as information systems, provider contracting, case management and quality assurance, attributable to both capitated and non-capitated contracts.

The cost of behavioral health services is recognized in the period in which an eligible member actually receives services and includes an estimate of IBNR (as defined below). We contract with various healthcare providers including hospitals, physician groups and other managed care organizations either on a discounted fee-for-service or a per-case basis. We determine that a member has received services when we receive a claim within the contracted timeframe with all required billing elements correctly completed by the service provider. We then determine whether (1) the member is eligible to receive such services, (2) the service provided is medically necessary and is covered by the benefit plan’s certificate of coverage, and (3) the service has been authorized by one of our employees. If all of these requirements are met, the claim is entered into our claims system for payment and the associated cost of behavioral health services is recognized. If the claim is denied, the service provider is notified and has appeal rights under their contract with us.

Accrued claims payable consists primarily of reserves established for reported claims and claims incurred but not reported (“IBNR”) which are unpaid through the respective balance sheet dates. Our policy is to record management’s best estimate of IBNR. The IBNR liability is estimated monthly using an actuarial paid completion factor methodology and is continually reviewed and adjusted, if necessary, to reflect any change in the estimated liability as more information becomes available. In deriving a range of estimates, management considers qualitative factors, authorization information, and an actuarial model that incorporates past claims payment experience, enrollment data and key assumptions such as trends in healthcare costs and seasonality. The accrued claims payable ranges were between $2.6 and $2.9 million at December 31, 2006, between $2.6 and $2.8 million at May 31, 2006, and between $3.5 and $3.8 million at May 31, 2005. To determine the best estimates, management reviews

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utilization statistics, authorized healthcare service data, calculated completion factors and other data available at and subsequent to the balance sheet dates. The best estimates at December 31, 2006, May 31, 2006 and 2005 were $2.7 million, $2.8 million and $3.7 million respectively. We have used the same methodology and assumptions for estimating the IBNR portion of the accrued claims liability for the last three years.

The following table provides a reconciliation of the beginning and ending balance of accrued claims payable for the seven months ended December 31, 2006 and fiscal years ended May 31, 2006, and 2005:

Changes in prior year claims expense were primarily due to changes in utilization patterns and changes in claim submission timeframes by providers. Management considers these changes in claims expenses to be immaterial when compared to the total claims expenses incurred in prior years

Accrued claims payable at December 31, 2006 and May 31, 2006 and 2005 comprises approximately $0.7 million, $1.1 million and $1.8 million, respectively, of submitted and approved claims which had not yet been paid, and $2.0 million, $1.7 million and $1.9 million for IBNR claims, respectively.

Many aspects of our business are not predictable with consistency, and therefore, estimating IBNR claims involves a significant amount of management judgment. Actual claims incurred could differ from the estimated accrued claims payable amount presented. The following are factors that would have an impact on our future operations and financial condition:

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A 5% increase in assumed healthcare cost trends from those used in our calculations of IBNR at December 31, 2006 could increase our claims expense by approximately $80,000 as illustrated in the table below:

Change in Healthcare Costs:

PREMIUM DEFICIENCIES

We accrue losses under our capitated contracts when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. We perform this loss accrual analysis on a specific contract basis taking into consideration such factors as future contractual revenue, projected future healthcare and maintenance costs, and each contract’s specific terms related to future revenue increases as compared to expected increases in healthcare costs. The projected future healthcare and maintenance costs are estimated based on historical trends and our estimate of future cost increases.

At any time prior to the end of a contract or contract renewal, if a capitated contract is not meeting its financial goals, we generally have the ability to cancel the contract with 60 to 90 days’ written notice. Prior to cancellation, we will usually submit a request for a rate increase accompanied by supporting utilization data. Although our clients have historically been generally receptive to such requests, no assurance can be given that such requests will be fulfilled in the future in our favor. If a rate increase is not granted, we have the ability, in most cases, to terminate the contract and limit our risk to a short-term period.

On a quarterly basis, we perform a review of our portfolio of contracts for the purpose of identifying loss contracts (as defined in the American Institute of Certified Public Accountants Audit and Accounting Guide – Health Care Organizations) and developing a contract loss reserve, if applicable, for succeeding periods. During the seven months ended December 31, 2006, we identified one contract that was not meeting its financial goals and in May 2007, entered into an agreement to obtain a rate increase of approximately 20% from the client. At December 31, 2006, we believe no contract loss reserve for future periods is necessary for this contract. Annual revenues from the contract are approximately $1.2 million.

GOODWILL

We evaluate at least annually the amount of our recorded goodwill by performing an impairment test that compares the carrying amount to an estimated fair value. In estimating the fair value, management makes its best assumptions regarding future cash flows and a discount rate to be applied to the cash flows to yield a present, fair value of equity. As a result of such tests, management believes there is no material risk of loss from impairment of goodwill. However, actual results may differ significantly from management’s assumptions, resulting in potentially adverse impact to our consolidated financial statements.

STOCK COMPENSATION EXPENSE

We issue stock-based awards to our employees and members of our board of directors. Effective June 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R “Share-Based Payment” and elected to apply the modified-prospective method to measure compensation cost for stock options at fair value on the grant date and recognize compensation cost on a straight-line basis over the service period for those options expected to vest. We use the Black-Scholes option pricing model, which requires certain variables for input to calculate the fair value of a stock award on the grant date. These variables include the expected volatility of our stock price, award exercise behaviors, the risk free interest rate, and expected dividends. We use significant judgment in estimating expected volatility of the stock, exercise behavior and forfeiture rates.

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Expected Volatility

We estimate the volatility of the share price by using historical data of our traded stock in combination with our expectation of the extent of fluctuation in future stock prices. We believe our historical volatility is more representative of future stock price volatility and as such it has been given greater weight in estimating future volatility.

Expected Term

A variety of factors are considered in determining the expected term of options granted. Options granted are grouped by their homogeneity based on the optionees’ position, whether managerial or clerical, and length of service and turnover rate. Where possible, we analyze exercise and post-vesting termination behavior. For any group without sufficient information, we estimate the expected term of the options granted by averaging the vesting term and the contractual term of the options.

Expected Forfeiture Rate

We generally separate our option awards into two groups: employee and non-employee awards. The historical data of each group are analyzed independently to estimate the forfeiture rate of options at the time of grant. These estimates are revised in subsequent periods if actual forfeitures differ from estimated forfeitures.

RECENT ACCOUNTING PRONOUNCEMENTS

Effective June 1, 2006, we adopted the fair value recognition provisions of SFAS 123R, as previously discussed in “Critical Accounting Estimates” immediately preceding.

In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”) which clarifies the accounting for uncertainty in income taxes. FIN 48 requires that companies recognize in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 effective January 1, with no impact on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” (“SFAS 157”) which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently evaluating the statement to determine what, if any, impact it will have on our consolidated financial statements.

In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 provides that companies may elect to measure many financial instruments and certain other items at fair value on a contract-by-contract basis, with changes in fair value recognized in earnings each reporting period. The election, called the “fair value option,” will enable some companies to reduce the variability in reported earnings caused by measuring related assets and liabilities differently. SFAS 159 is effective as of the beginning of a company’s first fiscal year that begins after November 15, 2007. We are in the process of evaluating the impact adoption of SFAS 159 will have on our consolidated financial statements.

LEGAL PROCEEDINGS

From time to time, we may be party to, and our property may be subject to, ordinary, routine litigation incidental to our business. Claims may exceed insurance policy limits and we may have exposure to a liability that is not covered by insurance. Management is not aware of any such lawsuits that could have a material adverse impact on our consolidated financial statements.

CAUTIONARY STATEMENT FOR THE PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: Certain information included in this transition report on Form 10-K and in our other reports, Securities and Exchange Commission (SEC) filings, statements, and presentations is forward looking within the meaning of the Private Securities Litigation Reform Act of 1995, including, but not limited to, statements concerning our anticipated operating results, financial resources,

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increases in revenues, increased profitability, interest expense, growth and expansion, and the ability to obtain new behavioral healthcare contracts. Such forward-looking information involves important risks and uncertainties that could significantly affect actual results and cause them to differ materially from expectations expressed herein and in our other reports, SEC filings, statements, and presentations. These risks and uncertainties include, but are not limited to, changes in local, regional, and national economic and political conditions, the effect of governmental regulation, competitive market conditions, varying trends in member utilization, our ability to manage healthcare operating expenses, the profitability of our capitated contracts, cost of care, seasonality, the risk that any definitive agreements or additional business will result from letters of intent entered into by us, and other risks detailed from time to time in our SEC reports.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

While we currently have market risk sensitive instruments, we have no significant exposure to changing interest rates as the interest rate on our long-term debt is fixed. Additionally, we do not use derivative financial instruments for investment or trading purposes and our investments are generally limited to cash deposits.

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ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Consolidated Financial Statements

Seven Months Ended December 31, 2006 and 2005, and

Years Ended May 31, 2006, 2005, and 2004

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

Comprehensive Care Corporation

We have audited the accompanying consolidated balance sheets of Comprehensive Care Corporation and Subsidiaries as of December 31, 2006, May 31, 2006, and May 31, 2005, and the related consolidated statements of operations, stockholders’ deficit and cash flows for the seven months ended December 31, 2006, and the years ended May 31, 2006, 2005 and 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Comprehensive Care Corporation and Subsidiaries as of December 31, 2006, May 31, 2006, and May 31, 2005, and the consolidated results of their operations and their cash flows for the seven months ended December 31, 2006, and the years ended May 31, 2006, 2005 and 2004, in conformity with U.S. generally accepted accounting principles.

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CONSOLIDATED BALANCE SHEETS