UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2011


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 0-19673

AMERICA SERVICE GROUP INC.

(Exact name of registrant as specified in its charter)


Delaware		51-0332317
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

105 Westpark Drive, Suite 200
Brentwood, Tennessee		37027
(Address of principal executive offices)		(Zip Code)

(615) 373-3100
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed under 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 þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

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


Large Accelerated Filer o	Accelerated Filer þ	Non-Accelerated Filer o	Smaller Reporting Company o
		(Do not check if a smaller reporting company)

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

There were 9,297,566 shares of common stock, par value $0.01 per share, outstanding as of April 26, 2011.

AMERICA SERVICE GROUP INC.

QUARTERLY REPORT ON FORM 10-Q
INDEX


	Page
	Number
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets as of March 31, 2011 and December 31, 2010		3

Condensed Consolidated Statements of Income for the quarters ended March 31, 2011 and 2010		4

Condensed Consolidated Statements of Cash Flows for the quarters ended March 31, 2011 and 2010		5

Notes to Condensed Consolidated Financial Statements		6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		21

Item 3. Quantitative and Qualitative Disclosures About Market Risk		36

Item 4. Controls and Procedures		36

PART II. OTHER INFORMATION

Item 1. Legal Proceedings		37

Item 1A. Risk Factors		40

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		40

Item 3. Defaults Upon Senior Securities		40

Item 4. Reserved		40

Item 5. Other Information		40

Item 6. Exhibits		41

Signatures		42
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I:

FINANCIAL INFORMATION


ITEM 1.		FINANCIAL STATEMENTS

AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(shown in 000’s except share and per share amounts)
(UNAUDITED)


	March 31,		December 31,
	2011		2010
ASSETS
Current assets:
Cash and cash equivalents	$	41,606	$	39,584
Accounts receivable, net of allowance for doubtful accounts of $430 and $411, respectively		54,054		52,481
Inventories		2,870		2,868
Prepaid expenses and other current assets		14,048		13,750
Current deferred tax assets		—		3,359

Total current assets		112,578		112,042
Property and equipment, net		11,163		11,040
Goodwill		40,772		40,772
Contracts, net		1,588		1,658
Other assets		11,776		11,852
Noncurrent deferred tax assets		244		—

Total assets	$	178,121	$	177,364


LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	23,051	$	23,691
Accrued medical claims liability		20,310		23,750
Accrued expenses		42,561		38,810
Deferred revenue		12,377		10,053
Current deferred tax liabilities		1,576		—

Total current liabilities		99,875		96,304
Noncurrent portion of accrued expenses		20,744		20,460
Noncurrent deferred tax liabilities		—		4,836

Total liabilities		120,619		121,600

Commitments and contingencies (Note 19)
Stockholders’ equity:
Preferred stock, $0.01 par value, 2,000,000 shares authorized at March 31, 2011 and December 31, 2010; no shares issued or outstanding		—		—
Common stock, $0.01 par value, 20,000,000 shares authorized at March 31, 2011 and December 31, 2010; 9,297,566 and 9,280,382 shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively		93		93
Additional paid-in capital		40,553		40,015
Retained earnings		16,856		15,656

Total stockholders’ equity		57,502		55,764

Total liabilities and equity	$	178,121	$	177,364

The accompanying notes to condensed consolidated financial statements are an integral part
of these condensed consolidated balance sheets. The condensed consolidated balance sheet at
December 31, 2010 is taken from the audited financial statements at that date.

AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(shown in 000’s except share and per share amounts)
(UNAUDITED)


	Quarter ended
	March 31,
	2011		2010
Healthcare revenues	$	153,865	$	159,960
Healthcare expenses		139,761		144,628

Gross margin		14,104		15,332
Selling, general and administrative expenses		8,682		8,852
Merger expenses		1,339		—
Audit Committee investigation and related expenses		43		153
Depreciation and amortization		927		769

Income from operations		3,113		5,558
Interest income		5		20

Income from continuing operations before income tax provision		3,118		5,578
Income tax provision		1,365		2,328

Income from continuing operations		1,753		3,250
Income (loss) from discontinued operations, net of taxes		5		(53	)

Net income	$	1,758	$	3,197


Net income available to common shareholders (Note 20)	$	1,741	$	3,091


Net income (loss) available to common shareholders per common share — basic:
Continuing operations	$	0.19	$	0.36
Discontinued operations, net of taxes		—		—

Net income available to common shareholders per common share (Note 20)	$	0.19	$	0.36


Net income (loss) available to common shareholders per common share — diluted:
Continuing operations	$	0.19	$	0.36
Discontinued operations, net of taxes		—		(0.01	)

Net income available to common shareholders per common share (Note 20)	$	0.19	$	0.35


Weighted average common shares outstanding:
Basic		9,194,683		8,659,803

Diluted		9,323,272		8,743,774


Dividends declared per share	$	0.06	$	0.06

The accompanying notes to condensed consolidated financial statements are an
integral part of these condensed consolidated statements.

AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(shown in 000’s)
(UNAUDITED)


	Quarter ended
	March 31,
	2011			2010
Cash flows from operating activities:
Net income	$	1,758		$	3,197
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		928			771
Loss on retirement of fixed assets		—			1
Finance cost amortization		8			8
Deferred income taxes		(145	)		2,243
Share-based compensation expense		338			432
Changes in operating assets and liabilities:
Accounts receivable, net		(1,573	)		(6,023	)
Inventories		(2	)		141
Prepaid expenses and other current assets		(298	)		474
Other assets		69			1,355
Accounts payable		(640	)		6,019
Accrued medical claims liability		(3,440	)		1,542
Accrued expenses		3,477			(4,560	)
Deferred revenue		2,324			(665	)

Net cash provided by operating activities		2,804			4,935


Cash flows from investing activities:
Capital expenditures		(982	)		(1,319	)

Net cash used in investing activities		(982	)		(1,319	)


Cash flows from financing activities:
Share repurchases		—			(544	)
Issuance of common stock		200			186
Exercise of stock options		—			591

Net cash provided by financing activities		200			233


Net increase in cash and cash equivalents		2,022			3,849
Cash and cash equivalents at beginning of period		39,584			37,655

Cash and cash equivalents at end of period	$	41,606		$	41,504

The accompanying notes to condensed consolidated financial statements are an
integral part of these condensed consolidated statements.

AMERICA SERVICE GROUP INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2011
(unaudited)

1. Basis of Presentation

The interim condensed consolidated financial statements of America Service Group Inc. and its consolidated subsidiaries (collectively, the “Company”) as of March 31, 2011 and for the quarters ended March 31, 2011 and 2010 are unaudited, but in the opinion of management, have been prepared in conformity with United States generally accepted accounting principles (“U.S. GAAP”) applied on a basis consistent with those of the Company’s annual audited consolidated financial statements. Such interim condensed consolidated financial statements reflect all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of the financial position and the results of operations for the periods presented. The results of operations presented for the quarter ended March 31, 2011 are not necessarily indicative of the results to be expected for the year ending December 31, 2011. The interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the related notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission (“SEC”).

The preparation of the condensed consolidated financial statements in conformity with U. S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Some of the more significant areas requiring estimates in the financial statements include the Company’s accruals for unbilled medical services calculated based upon a claims payment lag methodology, realization of goodwill, estimated amortizable life of contract intangibles, reductions in revenue for contractual allowances, allowance for doubtful accounts, legal contingencies and share-based compensation as well as accruals associated with employee health, workers’ compensation and professional and general liability claims, for which the Company is substantially self-insured. Estimates change as new events occur, more experience is acquired, or additional information is obtained. A change in an estimate is accounted for in the period of change.

2. Description of Business

The Company provides and/or administers managed healthcare services to correctional facilities under contracts with state and local governments. The health status of inmates impacts the results of operations under such contractual arrangements. The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Prison Health Services, Inc. (“PHS”), Correctional Health Services, LLC (“CHS”) and Secure Pharmacy Plus, LLC (“SPP”). The Company has one reportable segment: correctional healthcare services.

3. Pending Merger

On March 2, 2011, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Valitás Health Services, Inc., a Delaware corporation (“Valitás”), and Whiskey Acquisition Corp., a Delaware corporation and a wholly owned subsidiary of Valitás (“Merger Sub”), providing for the acquisition of the Company by Valitás. Subject to the terms and conditions of the Merger Agreement, the Merger Sub will be merged with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly owned subsidiary of Valitás.

At the effective time of the Merger (the “Effective Time”), each share of common stock of the Company that is issued and outstanding as of immediately prior to the Effective Time (other than shares held by the Company, Valitás or any of their respective direct or indirect subsidiaries or shares held by stockholders who have properly exercised and perfected appraisal rights in accordance with Delaware law) will be automatically cancelled and converted into the right to receive $26.00 in cash, without interest and less any applicable withholding taxes (such per share amount, the “Merger Consideration”).

Prior to the Effective Time, each outstanding option to purchase shares of the Company’s common stock will vest and become exercisable in full. Each option to purchase shares of the Company’s common stock outstanding at the Effective Time will be canceled and converted into the right to receive, as soon as reasonably practicable after the Effective Time, an amount in cash equal to: (i) the number of shares subject to such option multiplied by (ii) the excess (if any) of the Merger Consideration over the exercise price per share of such option. As of the date of this Quarterly Report on Form 10-Q, the Company has no outstanding stock options with an exercise price per share in excess of the Merger Consideration. As of the Effective Time, the vesting restrictions on each outstanding share of restricted stock will be accelerated and will lapse and each such share of restricted stock will be automatically canceled and converted into the right to receive the Merger Consideration.

The Merger Agreement also contains certain termination rights in favor of each party, including rights allowing the Company to terminate the Merger Agreement in order to accept a Superior Proposal. Upon termination of the Merger Agreement under certain specified circumstances, the Company will be required to pay to Valitás a specified fee and to reimburse Valitás for up to $2.0 million in documented transaction expenses. While the Merger Agreement provided for a reduced fee of $4.5 million in connection with terminations based on the Company’s acceptance of a Superior Proposal made by an Excluded Party, because the No-Shop Period Start Date has passed and no third party qualifies as an Excluded Party, the Company will be required to pay to Valitás a fee in the amount of $8.0 million, plus documented transaction expenses, in connection with any termination that requires payment of a termination fee.

Completion of the Merger requires the fulfillment or waiver of a number of conditions, including: (i) the adoption of the Merger Agreement by the affirmative vote of the holders of a majority of the outstanding shares of the Company’s common stock entitled to vote thereon at the special meeting of the stockholders of the Company (or any adjournment or postponement thereof); (ii) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended; (iii) the absence of any law or governmental order prohibiting or making illegal the completion of the Merger; and (iv) subject to certain qualifications based on materiality thresholds, the accuracy of the parties’ representations and warranties and the parties’ compliance with the covenants and agreements set forth in the Merger Agreement.

The Company’s Board of Directors, unanimously approved the Merger Agreement and the Merger and determined that the Merger Agreement and the Merger are advisable, fair and in the best interest of the Company and its stockholders. The Merger is expected to be completed in the second quarter of 2011.

4. Audit Committee Investigation

On October 24, 2005, the Company announced that the Audit Committee had initiated an internal investigation into certain matters related to SPP. As disclosed in further detail in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, on March 15, 2006 the Company announced that the Audit Committee had concluded its investigation and reached certain conclusions with respect to findings of the investigation that resulted in an accrual of $3.7 million of aggregate refunds due to customers, including PHS, that were not charged by SPP in accordance with the terms of the respective contracts. In circumstances where SPP’s incorrect billings resulted in PHS billing its clients incorrectly, PHS passed the applicable amount through to its clients. This amount plus associated interest represented management’s best estimate of the amounts due to affected customers, based on the results of the Audit Committee’s investigation. As of March 31, 2011, the Company has paid all of these refunds plus associated interest to customers except for $0.4 million which has been tendered for payment to the Delaware Department of Corrections, which was serviced by a customer of SPP (see Note 19). The ultimate amounts paid could differ from the Company’s estimates; however, actual amounts to date have not differed materially from the estimated amounts. There can be no assurance that the Company, a customer or a third-party, including a governmental entity, will not assert that additional amounts, which may include penalties and/or associated interest, are owed to these customers. During the quarter ended March 31, 2011, the Company recognized additional expense totaling $43,000 relative to this matter which is primarily due to related litigation filed by the Company against one of its insurance carriers (see Note 19).

5. Restructuring Charge

On June 16, 2010, the former Senior Vice President, Chief Administrative Officer and Chief Compliance Officer of the Company, resigned his position, effective July 16, 2010. In connection with his resignation and this restructuring, his duties and responsibilities were reassigned to various members of management. The Company incurred a one-time termination charge related to the restructuring of approximately $0.3 million, comprised of $0.2

million in accrued compensation and benefits and a $0.1 million non-cash charge related to the accelerated vesting of remaining unvested restricted shares. The accrued compensation and benefits, which will be fully paid by July 16, 2011, are included in accrued expenses in the Company’s condensed consolidated balance sheet. The non-cash charge related to the stock based compensation is included in additional paid in capital in the Company’s condensed consolidated balance sheet.

A reconciliation of the related restructuring liability at March 31, 2011 is as follows (in thousands):


	One-time
	Termination
	Benefits
Balance at December 31, 2010	$	144
Plus: Costs incurred		—
Less: Amounts paid		(65	)

Balance at March 31, 2011	$	79

6. Share-Based Compensation

The Company has issued equity incentive awards to eligible employees and outside directors under the Amended and Restated Incentive Stock Plan, the Amended and Restated 1999 Incentive Stock Plan and the 2009 Equity Incentive Plan (“2009 Equity Plan”). The Company currently has two types of share-based awards outstanding under these plans: stock options and restricted stock. Additionally, the Company instituted an Employee Stock Purchase Plan during 1996. The Company accounts for share-based compensation in accordance with U.S. GAAP related to share-based payments. For the quarters ended March 31, 2011 and 2010, the Company recognized total share-based compensation costs of $0.3 million and $0.4 million, respectively.

No options were issued during the quarters ended March 31, 2011 and 2010. A summary of option activity and changes during the quarter ended March 31, 2011 is presented below:


				Weighted		Weighted Average		Aggregate Intrinsic
				Average		Remaining		Value (in
	Options			Exercise Price		Contractual Term		thousands) (1)
Outstanding, December 31, 2010		897,172		$	17.12
Granted		—			—
Exercised		(4,500	)		16.42
Canceled		—			—

Outstanding, March 31, 2011		892,672		$	17.13		5.65	$	7,599


Exercisable, March 31, 2011		638,672		$	18.05		4.19	$	4,847


Expected to vest, March 31, 2011 (2)		244,793		$	14.79		9.31	$	2,656


(1)		Based upon the difference between the closing market price of the Company’s common stock on the last trading day of the quarter and the exercise price of in-the-money options.

(2)		Amount represents options expected to vest, net of estimated forfeitures.

A summary of the nonvested shares of restricted stock and activity during the quarter ended March 31, 2011 is presented below:


				Weighted
	Restricted			Average Grant-
	Shares			Date Fair Value
Nonvested, December 31, 2010		91,065		$	13.53
Granted		—			—
Vested		(4,665	)		10.63
Forfeited		—			—

Nonvested, March 31, 2011		86,400		$	13.69

7. Discontinued Operations

Pursuant to U.S. GAAP related to discontinued operations, each of the Company’s correctional healthcare services contracts is a component of an entity whose operations can be distinguished from the rest of the Company. Therefore, when a correctional healthcare services contract terminates, the contract’s operations generally will be

eliminated from the ongoing operations of the Company and classified as discontinued operations. Accordingly, the operations of such contracts, net of applicable income taxes, have been presented as discontinued operations and prior period condensed consolidated statements of income have been reclassified.

The components of income (loss) from discontinued operations, net of taxes, are as follows (in thousands):


	Quarter ended
	March 31,
	2011			2010
Healthcare revenues	$	(139	)	$	4,121
Healthcare expenses		(149	)		4,209

Gross margin		10			(88	)
Depreciation and amortization		1			2

Income (loss) from discontinued operations before taxes		9			(90	)
Income tax provision (benefit)		4			(37	)

Income (loss) from discontinued operations, net of taxes	$	5		$	(53	)

8. Fair Value of Financial Instruments

Fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, the Company utilizes the U.S. GAAP fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumption about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).

The Company has available-for-sale securities and money market accounts totaling $13.4 million and $4.0 million at March 31, 2011 and December 31, 2010, respectively, that are classified as cash equivalents on the accompanying condensed consolidated balance sheet. These financial assets are recorded at fair value in accordance with the U.S. GAAP fair value hierarchy, classified as a Level 1 measurement. Inputs used to measure fair value in accordance with Level 1 are quoted market prices.

9. Accounts Receivable

Accounts receivable consist of the following (in thousands):


	March 31,			December 31,
	2011			2010
Billed accounts receivable	$	19,598		$	23,894
Unbilled accounts receivable		34,122			28,262
Other accounts receivable		1,006			943

		54,726			53,099
Less: Allowances		(430	)		(411	)

		54,296			52,688
Less: Receivables reclassified as noncurrent		(242	)		(207	)

	$	54,054		$	52,481

Unbilled accounts receivable generally represent additional revenue earned under shared-risk contracting models that remain unbilled at each balance sheet date, due to provisions within the contracts governing the timing for billing such amounts.

The Company and its clients will, from time to time, have disputes over amounts billed under the Company’s contracts. The Company records a reserve for contractual allowances in circumstances where it concludes that a loss from such disputes is probable.

As discussed more fully in Note 19, PHS is currently involved in a lawsuit with its former client, Baltimore County, Maryland (the “County”) involving the County’s lack of payment for services rendered. PHS has approximately $1.7 million of receivables due from the County, primarily related to services rendered between April 1, 2006 and September 14, 2006, the date the Company’s relationship with the County was terminated. The County has refused to pay PHS for these amounts and therefore, on October 27, 2006, PHS filed suit against the County in

the Circuit Court for Baltimore County, Maryland seeking collection of the outstanding receivables balance, damages for breach of contract, quantum meruit, and unjust enrichment as well as prejudgment interest. During February 2011, the parties agreed to resolve this matter through binding arbitration which is expected to occur during the third quarter of 2011. At March 31, 2011, the Company has classified these receivables as current assets in its condensed consolidated balance sheet.

As discussed more fully in Note 19, PHS believes, in the case of this lawsuit, that it has a valid and meritorious cause of action and, as a result, has concluded that the outstanding receivables, which represent services performed under the contractual relationship between the parties, are probable of collection. Although PHS believes it has valid contractual and legal arguments, an adverse result in this lawsuit could have a negative impact on the results of this matter and/or PHS’ ability to collect the outstanding receivables amount.

As stated above, the Company believes the recorded amount represents valid receivables which are contractually due from the County and expects full collection. However, due to the factors discussed above and more fully in Note 19, there is a heightened risk of uncollectibility of these receivables which may result in future losses. Nevertheless, the Company intends to take all necessary and available measures in order to collect these receivables.

Changes in circumstances related to the matter discussed above, or any other receivables, could result in a change in the allowance for doubtful accounts or the estimate of contractual adjustments in future periods. Such change, if it were to occur, could have a material adverse affect on the Company’s results of operations and financial position in the period in which the change occurs.

10. Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets are stated at amortized cost and comprised of the following (in thousands):


	March 31,		December 31,
	2011		2010
Prepaid insurance	$	6,990	$	6,303
Prepaid cash deposits for professional liability claims losses		4,974		5,524
Prepaid other		2,084		1,923

	$	14,048	$	13,750

11. Property and Equipment

Property and equipment are stated at cost and comprised of the following (in thousands):


	March 31,			December 31,			Estimated
	2011			2010			Useful Lives
Leasehold improvements	$	1,029		$	1,004		7 years
Equipment and furniture		11,089			10,635		5 years
Computer software		10,004			9,227		3-5 years
Medical equipment		1,009			980		5 years
Automobiles		44			44		5 years
Management information systems under development		505			689			—

		23,680			22,579
Less: Accumulated depreciation		(12,517	)		(11,539	)

	$	11,163		$	11,040

Depreciation expense for the quarters ended March 31, 2011 and 2010 was approximately $0.9 million and $0.7 million, respectively.

The Company capitalizes costs associated with internally developed software systems that have reached the application development stage. Capitalized costs include external direct costs of materials and services utilized in developing or obtaining internal-use software and payroll and payroll-related expenses for employees who are directly associated with and devote time to the internal-use software project. Capitalization of such costs begins when the preliminary project stage is complete and ceases no later than the point at which the project is substantially complete and ready for its intended purpose. In addition, the Company capitalizes costs associated with upgrades or enhancements to its internally developed software systems which result in additional functionality.

12. Other Assets

Other assets are stated at amortized cost or net realizable value and are comprised of the following (in thousands):


	March 31,			December 31,
	2011			2010
Deferred financing costs	$	68		$	68
Less: Accumulated amortization		(49	)		(42	)

		19			26
Prepaid cash deposits for professional liability claims losses		7,405			7,509
Prepaid insurance deposits		3,996			3,996
Noncurrent receivables		242			207
Other refundable deposits		114			114

	$	11,776		$	11,852

13. Contract Intangibles

The gross and net values of contract intangibles consist of the following (in thousands):


	March 31,			December 31,
	2011			2010
Gross contracts value	$	4,000		$	4,000
Less: Accumulated amortization		(2,412	)		(2,342	)

	$	1,588		$	1,658

The Company amortizes its contract intangibles on a straight-line basis over their estimated useful life. The Company evaluates the estimated remaining useful life of its contract intangibles on at least a quarterly basis, taking into account new facts and circumstances, including its retention rate for acquired contracts. If such facts and circumstances indicate the current estimated useful life is no longer reasonable, the Company adjusts the estimated useful life on a prospective basis.

Estimated aggregate amortization expense related to the above contract intangibles for the remainder of 2011 is $0.2 million and for each of the next four years is $0.3 million.

14. Accrued Expenses

Accrued expenses consist of the following (in thousands):


	March 31,			December 31,
	2011			2010
Salaries and employee benefits	$	21,429		$	22,230
Professional liability claims		24,287			22,646
Accrued workers’ compensation claims		7,284			6,469
Other		10,305			7,925

		63,305			59,270
Less: Noncurrent portion of deferred lease liability		(814	)		(844	)
Less: Noncurrent portion of professional liability and workers’ compensation claims		(19,930	)		(19,616	)

	$	42,561		$	38,810

15. Reserve for Loss Contracts

On a quarterly basis, the Company performs a review of its portfolio of contracts for the purpose of identifying potential loss contracts and developing a loss contract reserve for succeeding periods if any loss contracts are identified. The Company accrues losses under its fixed price contracts when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. The Company performs this loss accrual analysis on a specific contract basis taking into consideration such factors as the Company’s ability to terminate the contracts, future contractual revenue, projected future healthcare and maintenance costs, projected future stop-loss insurance recoveries and each contract’s specific terms related to future revenue increases as compared to increased healthcare costs. The projected future healthcare and maintenance costs are estimated based on historical trends and management’s estimate of future cost increases. These estimates are subject to the same adverse fluctuations and future claims experience as previously noted.

There are no loss contracts identified as of March 31, 2011.

In the course of performing its reviews in future periods, the Company might identify contracts which have become loss contracts due to a change in circumstances. Circumstances that might change and result in the identification of a contract as a loss contract in a future period include interpretations regarding contract termination or expiration provisions, unanticipated adverse changes in the healthcare cost structure, inmate population or the utilization of outside medical services in a contract, where such changes are not offset by increased healthcare revenues. Should a contract be identified as a loss contract in a future period, the Company would record, in the period in which such identification is made, a reserve for the estimated future losses that would be incurred under the contract. The identification of a loss contract in the future could have a material adverse effect on the Company’s results of operations in the period in which the reserve is recorded.

16. Banking Arrangements

On July 28, 2009, the Company entered into a Revolving Credit and Security Agreement which was subsequently amended on March 2, 2010 (the “Credit Agreement”) with CapitalSource Bank (“CapitalSource”). The Credit Agreement is set to mature on October 31, 2011 and includes a $40.0 million revolving credit facility, with a current facility cap of $20.0 million, under which the Company has available standby letters of credit up to $15.0 million. The Company may request an increase in the current facility cap of up to an additional $20.0 million subject to lender approval. The amount available to the Company for borrowings under the Credit Agreement is based on the Company’s collateral base, as determined under the Credit Agreement, and is reduced by the amount of each outstanding standby letter of credit. The Credit Agreement is secured by substantially all assets of the Company and its operating subsidiaries. At March 31, 2011 and December 31, 2010, the Company had no borrowings outstanding under the Credit Agreement. At March 31, 2011, the Company had $14.9 million available for borrowing, based on the current facility cap and the Company’s collateral base on that date and no standby letters of credit.

Borrowings under the Credit Agreement are limited to the lesser of (1) 85% of eligible receivables or (2) $20.0 million (the “Borrowing Capacity”). Interest under the Credit Agreement is payable monthly at an annual rate of one-month LIBOR plus 2%, subject to a minimum LIBOR rate of 3.14%. The Company is also required to pay a monthly collateral management fee equal to 0.042% on average borrowings outstanding under the Credit Agreement.

Under the terms of the Credit Agreement, the Company is required to pay a monthly unused line fee equal to 0.0375% on the Borrowing Capacity less the actual average borrowings outstanding under the Credit Agreement for the month and the balance of any outstanding letters of credit.

All amounts outstanding under the Credit Agreement will be due and payable on October 31, 2011. If the Credit Agreement is extinguished prior to July 31, 2011, the Company will be required to pay an early termination fee equal to $0.4 million.

expenses arising out of the Audit Committee investigation into matters at SPP including any expenses or charges incurred in the associated shareholder securities suit provided such amounts, net of insurance recoveries, do not exceed $4.5 million in the aggregate, minus gains on asset sales outside the normal course of business or other non-recurring gains. The Company was in compliance with the minimum level of EBITDA covenant requirement at March 31, 2011.

The Credit Agreement permits the Company to declare and pay cash dividends, but requires the Company to maintain both a pre-distribution fixed charge coverage ratio and a post-distribution fixed charge coverage ratio both calculated on a trailing twelve-month basis to be measured at the end of each calendar quarter. The Credit Agreement defines the pre-distribution fixed charge coverage ratio as EBITDA, as defined above, divided by the sum of principal payments on outstanding debt, cash interest expense on outstanding debt, capital expenditures and cash income taxes paid or accrued. The Credit Agreement requires that the Company maintain a minimum pre-distribution fixed charge coverage ratio of 1.75. The Credit Agreement defines the post-distribution fixed charge coverage ratio as EBITDA, as defined above, divided by the sum of principal payments on outstanding debt, cash interest expense on outstanding debt, capital expenditures, cash income taxes paid or accrued, and cash dividends paid or accrued or declared. The Credit Agreement requires a minimum post-distribution fixed charge coverage ratio of 1.25 if the Company’s average net cash (cash less outstanding debt) plus the average amount available for borrowing under the Credit Agreement is greater than or equal to $20.0 million for the most recent calendar quarter; or, a minimum post-distribution fixed charge coverage ratio of 1.50 if the Company’s average net cash (cash less outstanding debt) plus the average amount available for borrowing under the Credit Agreement is less than $20.0 million for the most recent calendar quarter. At March 31, 2011, the Company was in compliance with both the pre-distribution fixed charge coverage ratio and the post-distribution fixed charge coverage ratio. The Company is prohibited under the terms of the Merger Agreement from paying any additional dividends until the Merger closes or the Merger Agreement is terminated.

17. Income Taxes

The Company accounts for income taxes under the provisions of U.S. GAAP related to income taxes. Under the asset and liability method of U.S. GAAP related to income taxes, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.

The Company regularly reviews its deferred tax assets for recoverability taking into consideration such factors as historical losses, projected future taxable income and the expected timing of the reversals of existing temporary differences. U.S. GAAP requires the Company to record a valuation allowance when it is “more likely than not that some portion or all of the deferred tax assets will not be realized.” At March 31, 2011, the Company’s valuation allowance of approximately $0.2 million represents management’s estimate of state net operating loss carryforwards which will expire unused.

The Company’s estimated effective tax rate is based on expected pre-tax income, expected permanent book/tax differences, statutory tax rates and tax planning opportunities available in the various jurisdictions in which it operates. On an interim basis, management estimates the annual tax rate based on projected taxable income for the full year and records a quarterly income tax provision in accordance with the anticipated annual rate. As the year progresses, management refines the estimate of the year’s taxable income as new information becomes available, including year-to-date financial results. This continual estimation process often results in a change to the Company’s expected effective tax rate for the year. When this occurs, management adjusts the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision reflects the expected annual tax rate. The Company’s effective income tax rate on income from continuing operations before taxes for the quarter ended March 31, 2011 is 43.7%.

The Company accounts for tax contingency accruals under the provisions of U.S. GAAP related to accounting for uncertainty in income taxes. The Company’s tax contingency accruals are reviewed quarterly and can be adjusted in light of changing facts and circumstances, such as the progress of tax audits, case law and emerging legislation. Adjustments to the tax contingency accruals are recorded in the period in which the new facts or circumstances become known, therefore the accruals are subject to change in future periods and such change, if it were to occur, could have a material adverse effect on the Company’s results of operations.

It is the Company’s policy to recognize accrued interest and penalties related to its tax contingencies as income tax expense. The Company has no tax contingencies at March 31, 2011, and there is no accrued interest and penalties included in income tax expense for the quarters ended March 31, 2011 and 2010.

The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. The Company may be subject to examination by the Internal Revenue Service (“IRS”) for calendar years 2007 through 2010. The Company is currently under audit for the 2008 tax year. Additionally, open tax years related to state jurisdictions remain subject to examination.

18. Professional and General Liability Self-Insurance Retention

The Company maintains a primary professional liability insurance program, principally on a claims-made basis. For 2002 through 2006 and 2008 through 2011 with respect to the majority of its patients, the Company purchased commercial insurance coverage, but is effectively self-insured due to the terms of the coverage which include adjustable premiums. For 2002 through 2006 and 2008 through 2011, the Company is covered by separate policies, each of which contains a premium that is retroactively adjusted, with adjustment based on actual losses. The Company’s ultimate premium for its 2002 through 2006 and 2008 through 2011 policies will depend on the final incurred losses related to each of these separate policy periods. For 2007, the Company is insured through claims made policies subject to per event and aggregate coverage limits. In addition to the coverage described above, for 2010 and 2011, the Company has purchased excess liability policies which provide coverage on a claims made basis for indemnity losses in excess of $4.0 million up to a maximum coverage of $10.0 million per loss and in the aggregate. Any amounts ultimately incurred above these coverage limits would be the responsibility of the Company.

The Company records a liability for reported as well as unreported professional and general liability claims made against it, its directors and employees, and others who are indemnified by the Company. Amounts accrued were $24.3 million and $22.6 million at March 31, 2011 and December 31, 2010, respectively, and are included in accrued expenses and the non-current portion of accrued expenses in the condensed consolidated balance sheets. Changes in estimates of losses resulting from the continuous review process and differences between estimates and loss payments are recognized in the period in which the estimates are changed or payments are made. For the quarter ended March 31, 2011 and 2010, the Company recorded increases of approximately $1.5 million and $0.6 million, respectively, related to its prior years known claims reserves as a result of adverse developments on individual claims or matters. After considering the impact of earnings that would have been allocated to participating securities in calculating net income per common share (see Note 20), the Company’s net income available to common shareholders and basic and diluted earnings per common share were negatively impacted as a result of this adverse development by amounts totaling $0.9 million, or $0.10 per basic and diluted common share, for the quarter ended March 31, 2011 and $0.3 million, or $0.04 per basic common share and $0.03 per diluted common share, for the quarter ended March 31, 2010. Reserves for professional and general liability exposures are subject to fluctuations in frequency and severity and can fluctuate as a result of court decisions or as new facts become available. Given the inherent degree of variability in any such estimates, the reserves reported at March 31, 2011 represent management’s best estimate of the amounts necessary to discharge the Company’s self-insured professional and general liabilities. Any adverse developments on individual claims or matters in the future could have a material adverse effect on the Company’s financial position and its results of operations in the period in which the reserve for any adverse development is recorded.

19. Commitments and Contingencies

The Company is a party to various legal proceedings incidental to its business. With respect to all litigation matters, the Company considers the likelihood of a negative outcome typically in consultation with outside counsel handling the Company’s defense in these matters and estimates of the probable costs for resolution of these matters are based upon an estimated range of potential results, assuming a combination of litigation and settlement strategies. If the Company determines the likelihood of a negative outcome is probable and the amount of the loss can be reasonably estimated, the Company records an estimated loss for the expected outcome of the litigation. However, it is difficult to predict the outcome or estimate a possible loss or range of loss in some instances because litigation is subject to significant uncertainties. It is possible that future results of operations for any particular quarterly or annual period could be materially affected by changes in assumptions, new developments or changes in approach, such as a change in settlement strategy in dealing with litigation.

A discussion is provided below of significant outstanding matters for which there have been updates during 2011. For a discussion of all other significant outstanding matters, please refer to Note 21 of the Company’s 2010 Annual Report on Form 10-K filed on March 3, 2011.

Litigation and Claims

DeSantis Professional Liability Suit. On August 26, 2010, Theresa DeSantis and Julie Giangiolini, as guardians of the estate of Anthony DeSantis, Jr., filed a complaint in the Court of the Sixteenth Judicial Circuit in Kane County, Illinois alleging that PHS, by and through the actions of its medical staff committed medical negligence which caused Anthony DeSantis Jr. to suffer from significant injuries. Plaintiffs seek damages to recoup compensation for past and future pain and suffering, loss of income, medical bills incurred and for the cost of future medical treatment. This matter is currently in the discovery phase; however, the Company believes that a negative outcome is probable and has recorded significant reserves related to this matter. Such reserves are included in the Company’s reserves for professional liability claims which total $24.3 million at March 31, 2011. Should the ultimate resolution of this matter exceed the Company’s recorded reserves and available insurance coverage, such resolution could have a material adverse effect on the Company’s results of operations, financial position or cash flows in future periods.

Dawkins Professional Liability Suit. On September 18, 2009, Johnathan Dawkins, Sara H. Humphrey, guardian ad litem of Johnathan Dawkins, a mentally incapacitated person and Sara H. Humphrey, individually, filed a complaint in the U.S. District Court of New Jersey, against CHS, the New Jersey Counties of Essex and Union and a broad number of correctional personnel. The complaint alleges that in 2007 Johnathan Dawkins suffered permanent injuries while incarcerated at the Union County Jail as a result of actions of the defendants. This matter is currently in the discovery stage. Management currently believes this matter is covered under the policy limits of its 2007 professional liability insurance policy, however, should the ultimate resolution of this matter exceed such policy limits, such resolution could have a material adverse effect on the Company’s results of operations, financial position or cash flows in future periods.

Matters involving PHS and Baltimore County, Maryland. PHS is currently involved in a lawsuit with its former client, Baltimore County, Maryland (the “County”) in the Circuit Court for Baltimore County, Maryland seeking collection of outstanding receivable balances, damages for breach of contract, quantum meruit, and unjust enrichment as well as prejudgment interest (the “Collection Matter”). The outstanding receivable balances total approximately $1.7 million at March 31, 2011 and are primarily related to services performed by PHS between April 1, 2006 and September 14, 2006 while PHS and the County were jointly seeking a judicial interpretation of a contract dispute regarding whether the County had timely exercised its first renewal option under its contract with PHS.

PHS contended that the original term of its contract with the County expired on June 30, 2005, without the County exercising the first of three, two-year renewal options. On July 1, 2005, PHS sent a letter to the County stating its position that PHS’ contract to provide services expired on June 30, 2005 due to the County’s failure to provide such extension notice. The County disputed PHS’ contention asserting that it properly exercised the first renewal option and that the term of the contract therefore was through June 30, 2007, with extension options through June 30, 2011. In July 2005, the County and PHS agreed to have a judicial authority interpret the contract through formal judicial proceedings (the “Contract Matter”). At the written request of the County, PHS continued to provide healthcare services to the County from July 1, 2005 to September 14, 2006, under the terms and conditions of the contested contract, pending the judicial resolution of the Contract Matter, while reserving all of its rights. Finally, during September 2006, amid reciprocal claims of default, both PHS and the County took individual steps to terminate the relationship between the parties. PHS contends that it terminated the relationship effective September 14, 2006, due to various breaches by the County, including failure to remit payment of approximately $1.7 million primarily related to services rendered between April 1, 2006 and September 14, 2006. On October 27, 2006, PHS initiated the Collection Matter lawsuit against the County.

Prior to the trial date, preliminary settlement discussions were conducted without resolution. Subsequently, the parties agreed to forego the trial and resolve the Collection Matter through binding arbitration which is expected to occur during the third quarter of 2011. PHS believes, in the case of the Collection Matter, that it has a valid and meritorious cause of action and, as a result, has concluded that the outstanding receivables, which represent services performed under the relationship between the parties, continues to be probable of collection. However, although PHS believes it has valid contractual and legal arguments, an adverse result in the Collection Matter could have a negative impact on PHS’ ability to collect the outstanding receivable amount and result in losses in future periods.

During 2008, the Contract Matter, mentioned above, was resolved in the following manner. In November 2005, the Circuit Court for Baltimore County, Maryland ruled in favor of the County, with respect to the Contract Matter, ruling that the County properly exercised its first, two-year renewal option by sending a faxed written renewal amendment to PHS on July 1, 2005. PHS appealed this ruling. On December 6, 2006, the Maryland Court of Special Appeals (i) reversed this judgment; (ii) ruled that the County did not timely exercise its renewal option by its actions of July 1, 2005; and (iii) remanded the case to the Circuit Court to determine whether the County properly exercised the option by its conduct prior to June 30, 2005 — an issue not originally decided by the Circuit Court. On May 15, 2007, the Circuit Court, upon remand, held a hearing on the parties’ pending cross motions for summary judgment. The Court issued an oral opinion at the end of the hearing indicating its intention to rule in favor of the County’s motion for summary judgment and against PHS’ motion for summary judgment. On June 6, 2007, the Court filed its order memorializing the aforementioned ruling. In its order, the Court ruled that, by its actions, the County properly and timely exercised the first two-year renewal option. The Company filed a Notice of Appeal and on May 14, 2008, the Maryland Court of Special Appeals issued its ruling that the actions the County claimed constituted an exercise of renewal were ineffective. Accordingly, the Court of Special Appeals reversed the Circuit Court’s ruling and directed it to grant the Company’s motion for summary judgment in the lawsuit. On June 27, 2008, the County petitioned the Maryland Court of Appeals (the State’s highest appellate court) to review the May 14, 2008 Court of Special Appeals decision. By order dated August 26, 2008, the Court of Appeals denied the County’s request to review the decision, resulting in the ruling of the Court of Special Appeals in favor of the Company becoming final, thereby bringing closure to the Contract Matter.

Litigation Related to the Merger

On March 4, 2011, a purported class action lawsuit was filed on behalf of the Company’s stockholders in the Chancery Court for Davidson County, Tennessee, docketed as Colleen Witmer, individually and on behalf of all others similarly situated, v. America Service Group Inc., Valitás Health Services, Inc., Whiskey Acquisition Corp., Burton C. Einspruch, William M. Fenimore, Jr., John W. Gildea, Richard Hallworth, John C. McCauley, Michael W. Taylor, and Richard D. Wright, Case No. 11-0300-IV. The lawsuit alleges, among other things, that the Company’s Board of Directors (the “Board”) breached fiduciary duties owed to the Company’s stockholders by failing to take steps to maximize stockholder value or to engage in a fair sale process when approving the Merger. The complaint also alleges that the Company, Valitás and Merger Sub aided and abetted the members of the Board in the alleged breach of their fiduciary duties. The complaint seeks an order enjoining or rescinding the Merger, together with other relief.

Pursuant to the terms of the Merger Agreement, it is a condition to the completion of the Merger that there does not exist any law or governmental order prohibiting or making illegal the completion of the Merger. However, the Company believes the lawsuit is wholly without merit.

Matters Related to the Audit Committee Investigation and Shareholder Litigation

On March 15, 2006 the Company announced that its Audit Committee had concluded its investigation and reached certain conclusions with respect to findings of the investigation that resulted in the recording of amounts due to SPP’s customers that were not charged in accordance with the terms of their respective contracts.

Company’s business, forecasts and financial performance. The complaints sought certification as a class action, unspecified compensatory damages, attorneys’ fees and costs, and other relief. By order dated August 3, 2006, the district court consolidated the lawsuits into one consolidated action and on October 31, 2006, plaintiff filed an amended complaint adding SPP, Enoch E. Hartman III and Grant J. Bryson as defendants. Enoch E. Hartman III is a former employee of the Company and SPP and Grant J. Bryson is a former employee of SPP. The amended complaint also generally alleged that defendants made false and misleading statements concerning the Company’s business which caused the Company’s securities to trade at inflated prices during the class period. Plaintiff sought an unspecified amount of damages in the form of (i) restitution; (ii) compensatory damages, including interest; and (iii) reasonable costs and expenses. Defendants moved to dismiss the amended complaint on January 19, 2007, and the parties completed the briefs on the motion in May 2007. On March 31, 2009, the Court ruled on the defendants’ motion to dismiss, granting it in part and denying it in part. While the Court’s ruling dismissed significant portions of plaintiffs’ amended complaint and, as a result, narrowed the scope of plaintiffs’ claims, none of the defendants were dismissed from the case and several of plaintiffs’ claims under Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5 remained. The parties were not in agreement as to the scope of the Court’s order and defendants filed a motion to confirm which claims the Court dismissed in its March 31, 2009 ruling. The Court granted defendants’ motion to confirm the scope of the dismissal order on July 20, 2009, ruling that certain of Plaintiff’s claims had been in fact dismissed. The Court also confirmed, however, that certain other claims remained viable.

On July 22, 2009, the Court administratively closed the shareholder litigation case, while the parties pursued mediation of this matter. On February 19, 2010, the parties agreed to the terms of a mediator’s proposal to settle all of the claims in this lawsuit. At a hearing on October 15, 2010, the Court approved the settlement, entering a final judgment and dismissing with prejudice all claims against all defendant in the litigation. The settlement provided for payment by the Company of $10.5 million and issuance by the Company of 300,000 shares of common stock. The total value of the settlement, based upon the Company’s closing share price for its common stock of $15.12 per share on October 15, 2010, was approximately $15.0 million. The Company considers this matter closed.

In September 2009, the Company and its primary directors and officers liability (“D&O”) carrier reached an agreement under which the Company and the primary D&O carrier mutually released each other from future claims related to this matter and the primary D&O carrier remitted insurance proceeds to the Company totaling $8.0 million, less approximately $0.4 million in legal fees paid by the primary D&O carrier as of the settlement date.

In addition to its primary D&O carrier, with which the Company has settled all claims, the Company also maintains D&O insurance with an excess D&O carrier that provides for additional insurance coverage of up to $5.0 million for losses in excess of $10.0 million. The excess D&O carrier has denied coverage of this matter. After failing to reach agreement with the excess D&O carrier concerning the amount of their contribution to the settlement, the Company filed suit against the excess D&O carrier in the second quarter of 2010. This suit is currently in the discovery phase.

Delaware Department of Justice Inquiry. On April 4, 2006, the Company received a letter notifying it that the Office of the Attorney General, Delaware Department of Justice is conducting an inquiry into the indirect payment of claims by the Delaware Department of Correction to SPP beginning in July 2002 and ending in the spring of 2005 for pharmaceutical services. There can be no assurance that the Delaware Department of Justice inquiry will not result in the Company incurring additional investigation and related expenses; being required to make additional refunds; incurring criminal, or civil penalties, including the imposition of fines; or being debarred from pursuing future business in certain jurisdictions. Management of the Company is unable to predict the effect that any such actions may have on its business, financial condition, results of operations or stock price. During the second quarter of 2010, the Company received a written offer from the Delaware Department of Justice to settle the inquiry in exchange for a cash payment. The Company has reserves totaling $0.4 million related to this matter which is the Company’s estimate of refund and associated interest due to the Delaware Department of Corrections, which was serviced by a customer of SPP (see Note 4). This amount is recorded in accrued expenses in the Company’s consolidated balance sheet. The Company is continuing to cooperate with the Delaware Department of Justice during its inquiry.

Other Matters

The Company’s business results from time to time in labor and employment related claims and matters, actions for professional liability and related allegations of deliberate indifference in the provision of healthcare and other causes of action related to its provision of healthcare services. Therefore, in addition to the matters discussed above, the Company is a party to filed or pending legal and other proceedings incidental to its business. An estimate of the amounts payable on existing claims for which the liability of the Company is probable and estimable is included in accrued expenses. The Company is not aware of any unasserted claims that would have a material adverse effect on its consolidated financial position, results of operations or cash flows.

Performance Bonds

The Company is required under certain contracts to provide a performance bond and may also be required to post performance bonds for other business reasons. At March 31, 2011, the Company had outstanding performance bonds totaling $6.6 million. The performance bonds are renewed on an annual basis. The Company has no letters of credit at March 31, 2011 collateralizing these performance bonds. The Company is dependent on the financial health of the surety companies that it relies on to issue its performance bonds. An inability to obtain new or renew existing performance bonds could result in limitations on the Company’s ability to bid for new or renew existing contracts which could have a material adverse effect on the Company’s financial condition and results of operations.

20. Net Income (Loss) Per Common Share

Net income (loss) per common share is measured at two levels: basic income (loss) per common share and diluted income (loss) per common share. Basic income (loss) per common share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted income (loss) per common share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding after considering the additional dilution related to other dilutive non-participating securities. The Company’s other dilutive non-participating securities outstanding consist of options to purchase shares of the Company’s common stock. Unvested restricted shares of common stock are not considered outstanding common shares for purposes of calculating earnings per share available to common shareholders.

In June 2008, the FASB issued guidance which clarifies that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents, whether paid or unpaid, are participating securities and should be included in the computation of earnings per share under the “two class” method. In periods where the Company has income from continuing operations, the “two class” method allocates undistributed earnings between common shares and participating securities. In periods in which the Company has incurred a loss from continuing operations, the “two-class” method does not result in an allocation of such loss between the Company’s common shares and participating securities. Based on this clarification, the Company has determined that its unvested restricted stock awards are considered participating securities.

The following table presents information necessary to calculate basic and diluted earnings per common share (in thousands except for share and per share data):


	Quarter ended
	March 31,
	2011			2010
Numerator:
Income from continuing operations	$	1,753		$	3,250
Income (loss) from discontinued operations, net of taxes		5			(53	)

Net income		1,758			3,197
Less: Income allocated to participating securities (unvested restricted shares)		(17	)		(106	)

Net income allocated to common shareholders	$	1,741		$	3,091


Components of income allocated to participating securities (unvested restricted shares):
Income from continuing operations	$	17		$	107
Income (loss) from discontinued operations, net of taxes		—			(1	)

Income allocated to participating securities	$	17		$	106


Components of net income allocated to common shareholders — numerator for calculating net income (loss) available to common shareholders per common share:
Income from continuing operations	$	1,736		$	3,143
Income (loss) from discontinued operations, net of taxes		5			(52	)

Net income allocated to common shareholders	$	1,741		$	3,091


Denominator:
Denominator for basic net income loss) available to common shareholders per common share — weighted average shares		9,194,683			8,659,803
Effect of dilutive non-participating securities:
Employee stock options		128,589			83,971


Denominator for diluted net income (loss) available to common shareholders per common share — adjusted weighted average shares and assumed conversions		9,323,272			8,743,774


Net income (loss) available to common shareholders per common share — basic:
Continuing operations	$	0.19		$	0.36
Discontinued operations, net of taxes		—			—

Net income available to common shareholders per common share	$	0.19		$	0.36


Net income (loss) available to common shareholders per common share — diluted:
Continuing operations	$	0.19		$	0.36
Discontinued operations, net of taxes		—			(0.01	)

Net income available to common shareholders per common share	$	0.19		$	0.35

The table below sets forth information regarding options that have been excluded from the computation of diluted net income (loss) per common share because the average market price of the common shares for the periods shown and, therefore, the effect would be anti-dilutive.


	Quarter ended
	March 31,
	2011		2010
Options excluded from computation of diluted net income per common share as effect would be anti-dilutive		372,917		396,000

Weighted average exercise price of excluded options	$	20.07	$	21.82

21. Comprehensive Income

For the quarters ended March 31, 2011 and 2010, the Company’s comprehensive income was equal to net income.

22. Share Repurchases

On February 27, 2008, the Company’s Board of Directors approved a stock repurchase program to repurchase up to $15 million of the Company’s common stock through the end of 2009. On July 28, 2009, the Company’s Board of Directors authorized the extension of this program by two years through the end of 2011, while maintaining the total $15 million limit. This program is intended to be implemented through purchases made from time to time in either the open market or through private transactions, in accordance with SEC requirements. The Company may elect to

terminate or modify the program at any time. Under the stock repurchase program, no shares will be purchased directly from officers or directors of the Company. The timing, prices and sizes of purchases will depend upon prevailing stock prices, general economic and market conditions and other considerations. Funds for the repurchase of shares are expected to come primarily from cash provided by operating activities and also from funds on hand, including amounts available under the Company’s credit facility. There were no shares repurchased during the quarter ended March 31, 2011. As of March 31, 2011, the Company has repurchased and retired a total of 891,850 shares of common stock under the stock repurchase program at an aggregate cost of approximately $11.2 million. Under the terms of the Merger Agreement discussed in Note 3, the Company is prohibited from making any additional repurchases of its common stock until the Merger is completed, the Merger Agreement is terminated or the Company obtains prior written consent from Valitás.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

America Service Group Inc. (“ASG” or the “Company”) is a leading non-governmental provider and/or administrator of managed correctional healthcare services in the United States. The Company is a provider and/or administrator of managed healthcare services to county/municipal jails and detention centers and state correctional facilities. As of April 1, 2011, the Company provided and/or administered managed healthcare services under 57 contracts to approximately 161,000 inmates at over 140 sites in 19 states.

The Company operates through its subsidiaries, Prison Health Services, Inc. (“PHS”), Correctional Health Services, LLC (“CHS”) and Secure Pharmacy Plus, LLC (“SPP”). ASG was incorporated in 1990 as a holding company for PHS. Unless the context otherwise requires, the terms “ASG” or the “Company” refer to ASG and its direct and indirect subsidiaries. ASG’s executive offices are located at 105 Westpark Drive, Suite 200, Brentwood, Tennessee 37027. Its telephone number is (615) 373-3100.

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and accompanying notes included herein.

Pending Merger

The Company’s Board of Directors (the “Board of Directors”), unanimously approved the Merger Agreement and the Merger and determined that the Merger Agreement and the Merger are advisable, fair to and in the best interests of the Company and its stockholders. In connection with such approval, Oppenheimer & Co. Inc. rendered its opinion to the Board of Directors that, as of the date of the opinion and subject to the various assumptions limitations and qualifications set forth therein, the Merger Consideration to be received by the Company’s stockholders is fair, from a financial point of view, to such stockholders.

The Merger Agreement contains customary representations and warranties of the parties. The Merger Agreement also contains customary covenants, including covenants requiring: (i) each of the parties to use reasonable best efforts to cause the Merger to be consummated; and (ii) the Company to call and hold a special meeting of the Company’s stockholders at which the Board of Directors will recommend, subject to certain exceptions based on its fiduciary duties, that the stockholders approve the Merger Agreement and the transactions contemplated thereby, including the Merger. The Merger Agreement also requires the Company to conduct its operations in the ordinary course of business consistent with past practice during the period between the execution of the Merger Agreement and the Effective Time or the earlier termination of the Merger Agreement.

The Merger Agreement generally provided that until 11:59 p.m. (Eastern time) on April 16, 2011 (the “Go-Shop Period”) the Company was permitted to solicit, initiate and encourage other acquisition proposals and provide non-public information to third parties pursuant to confidentiality agreements not materially more favorable to such third parties than the Company’s confidentiality agreement with Valitás. After 12:00 a.m. (Eastern time) on April 17, 2011 (the “No-Shop Period Start Date”) and until the earlier of the Effective Time or the termination of the Merger Agreement, the Company became prohibited from soliciting, initiating or encouraging other acquisition proposals or providing non-public information to third parties that could reasonably be expected to lead to any acquisition proposal. Notwithstanding these restrictions, and subject to certain requirements set forth in the Merger Agreement, after the Go-Shop Period, the Company: (i) was entitled to provide confidential information, until 12:00 a.m. (Eastern time) on May 1, 2011, to any party (an “Excluded Party”) (A) who made a written acquisition proposal prior to the No-Shop Period Start Date (and did not withdraw, terminate or let such acquisition proposal expire) that the Board of Directors or a properly constituted committee thereof determined in good faith, after consultation with its independent financial advisor, is or would reasonably be expected to result in a Superior Proposal (as such term is defined in the Merger Agreement), (B) whom the Company identified to Valitás within 24 hours after the No-Shop Period Start Date to be an Excluded Party and (C) who continued to satisfy the criteria for remaining an Excluded Party as set forth in the Merger Agreement; and (ii) is entitled to provide confidential information to a third party in response to an unsolicited acquisition proposal, following which the Company is permitted to engage in discussions and negotiations with such third party if: (X) the Board of Directors or a properly constituted committee thereof determines in good faith, after consultation with outside legal counsel, that the failure to take such action would be inconsistent with its fiduciary duties; (Y) the Board of Directors or a properly constituted committee thereof determines in good faith, after consultation with its independent financial advisor, that the acquisition proposal is, or would reasonably be expected to result in, a Superior Proposal; and (Z) prior to taking such action, the Company gives Valitás four business days’ notice of the Company’s intent to do so, the identity of the third party and the terms of the acquisition proposal and the Company executes a confidentiality agreement with such third party with terms no less favorable than those contained in the Company’s confidentiality agreement with Valitás and containing customary “standstill” provisions. Following the expiration of the Go-Shop Period, there were no third parties that qualified as Excluded Parties, and as of the date of this Quarterly Report on Form 10-Q the Company has not received any alternative acquisition proposals.

Barclays Bank PLC and Bank of America, N.A. (collectively, the “Senior Lenders”) have provided customary senior debt commitments letters letter dated March 2, 2011, to provide Valitás with $360.0 million in senior secured credit facilities, comprised of: (i) a term loan facility of $285.0 million; and (ii) a revolving credit facility of $75.0 million (which Valitás will draw upon only in the event that the combined cash on hand of the Company and Valitás upon the completion of the Merger is less than approximately $73.0 million). In addition, funds managed by GSO Capital Partners LP and its affiliates (collectively with the Senior Lenders, the “Lenders”) have provided customary mezzanine financing commitment letters dated March 2, 2011, to provide Valitás with $100.0 million in gross proceeds from the issuance and sale by Valitás of unsecured senior subordinated notes pursuant to a private placement. The obligations of the Lenders to provide the debt financing under the respective debt commitment letters are subject to a number of conditions which the Company believes are customary for financings of this type or are otherwise similar to certain conditions in the Merger Agreement. The final termination date for the commitments under each debt commitment letter is August 31, 2011. Valitás, obligation to complete the Merger is not subject to any financing condition.

The Merger is expected to be completed in the second quarter of 2011.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements represent management’s current expectations regarding future events. All statements other than statements of current or historical fact contained in this quarterly report, including statements regarding the Company’s future financial position, business strategy, budgets, projected costs, and plans and objectives of management for future operations, are forward-looking statements. Forward-looking statements typically are identified by use of terms such as “may,” “will,” “should,” “plan,” “expect,” “anticipate,” “estimate,” “believe,” “continue,” “intend,” “project” and similar words, although some forward-looking statements are expressed differently. These statements are based on the Company’s current plans and anticipated future activities, and its actual results of operations may be materially different from those expressed or implied by the forward-looking statements. Some of the factors that may cause the Company’s actual results of operations or financial position to differ materially from those expressed or implied by the forward-looking statements include, among other things:

	•		the Company’s ability to obtain shareholder approval, regulatory approval and close the transaction discussed in the section titled “Pending Merger” above;

	•		the Company’s ability to retain existing client contracts and obtain new contracts at acceptable pricing levels;

	•		whether or not government agencies continue to privatize correctional healthcare services;

	•		risks arising from governmental budgetary pressures and funding;

	•		the possible effect of adverse publicity on the Company’s business;

	•		increased competition for new contracts and renewals of existing contracts;

	•		risks arising from the possibility that the Company may be unable to collect accounts receivable or that accounts receivable collection may be delayed;

	•		the Company’s ability to limit its exposure for inmate medical costs, catastrophic illnesses, injuries and medical malpractice claims in excess of amounts covered under contracts or insurance coverage;

	•		the Company’s ability to maintain and continually develop information technology and clinical systems;

	•		the outcome or adverse development of pending litigation, including professional liability litigation;

	•		the Company’s determination whether to continue the payment of quarterly cash dividends, and if so, at the current amount;

	•		the Company’s determination whether to repurchase shares under its stock repurchase program;

	•		the Company’s dependence on key management and clinical personnel;

	•		risks arising from potential weaknesses or deficiencies in the Company’s internal control over financial reporting;

	•		risks associated with the possibility that the Company may be unable to satisfy covenants under its credit facility;

	•		the risk that government or municipal entities (including the Company’s government and municipal customers) may bring enforcement actions against, seek additional refunds from, or impose penalties on, the Company or its subsidiaries as a result of the matters investigated by the Audit Committee in prior years; and

	•		the Company’s ability to expand its business beyond its traditional correctional health client base.

In addition to the factors referenced above and the other cautionary statements discussed in this report, you should also consider the risks included in Item 1A, “Risk Factors” contained in this Form 10-Q and Item 1A, “Risk Factors” contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 and in other documents that the Company files from time to time with the Securities and Exchange Commission. Because these risk factors could cause actual results or outcomes to differ materially from those expressed or implied in any forward-looking statements made by the Company or on the Company’s behalf, stockholders should not place undue reliance on any forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for the Company to predict which factors will arise. In addition, the Company cannot assess the impact of each factor on its business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in or implied by any forward-looking statements.

Critical Accounting Policies And Estimates

General

The Company’s discussion and analysis of its financial condition and results of operations are based upon its condensed consolidated financial statements, which have been prepared in accordance with United States generally

accepted accounting principles. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including, but not limited to, those related to:

	•		revenue (net of contractual allowances) and cost recognition (including the estimated cost of off-site medical claims);

	•		allowance for doubtful accounts;

	•		loss contracts;

	•		professional and general liability self-insurance retention;

	•		other self-funded insurance reserves;

	•		legal contingencies;

	•		impairment of intangible assets and goodwill;

	•		amortizable life of contract intangibles;

	•		income taxes; and

	•		share-based compensation.

The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The Company believes the following critical accounting policies are affected by its more significant judgments and estimates used in the preparation of its condensed consolidated financial statements.

Revenue and Cost Recognition

The Company’s contracts to provide healthcare services to correctional institutions are principally fixed price contracts with revenue adjustments for census fluctuations and risk sharing arrangements, such as stop-loss provisions and aggregate limits for off-site or pharmaceutical costs. Such contracts typically have a term of one to three years with subsequent renewal options and generally may be terminated by either party without cause upon proper notice. Revenues earned under contracts with correctional institutions are recognized in the period that services are rendered. Cash received in advance for future services is recorded as deferred revenue and recognized as income when the service is performed.

Revenues are calculated based on the specific contract terms and fall into one of three general categories: fixed fee, population based, or cost plus a fee.

For fixed fee contracts, revenues are recorded based on fixed monthly amounts established in the service contract irrespective of inmate population. Revenues for population-based contracts are calculated either on a fixed fee that is subsequently adjusted using a per diem rate for variances in the inmate population from predetermined population levels or by a per diem rate multiplied by the average inmate population for the period of service. For cost plus a fee contracts, revenues are calculated based on actual expenses incurred during the service period plus a contractual fee.

Generally, the Company’s contracts will also include additional provisions which mitigate a portion of the Company’s risk related to cost increases. Off-site utilization risk is mitigated in the majority of the Company’s contracts through aggregate pools or caps for off-site expenses, stop-loss provisions, cost plus a fee arrangements or, in some cases, the entire exclusion of certain or all off-site service costs. Pharmacy expense risk is similarly mitigated in certain of the Company’s contracts. Typically, under the terms of such provisions, the Company’s revenue under the contract increases to offset increases in specified cost categories such as off-site expenses or pharmaceutical costs. For contracts that include such provisions, the Company recognizes the additional revenues due from clients based on its estimates of applicable contract to date costs incurred as compared to the corresponding pro rata contractual limit for such costs. Because such provisions typically specify how often such additional revenue may be invoiced and require all such additional revenue to be ultimately settled based on actual expenses, the additional revenues are initially recorded as unbilled receivables until the time period for billing has been met and actual costs are known. Any differences between the Company’s estimates of incurred costs and the actual costs are recorded in the period in which such differences become known along with the corresponding adjustment to the amount of recorded additional revenues.

Under all contracts, the Company records revenues net of any estimated contractual allowances for potential adjustments resulting from a failure to meet performance or staffing related criteria. If necessary, the Company revises its estimates for such adjustments in future periods when the actual amount of the adjustment is determined.

The table below illustrates these revenue categories as a percentage of total revenues from continuing operations for the quarter ended March 31, 2011 and 2010.


	Percentage of Revenue from
	Continuing Operations
	Quarter Ended			Quarter Ended
Contract Category	March 31, 2011			March 31, 2010
Fixed Fee		12.9	%		12.0	%
Population Based		67.3	%		68.2	%
Cost Plus a Fee		19.8	%		19.8	%

Contracts under the population based and fixed fee categories generally have similar margins which are higher than margins for contracts under the cost plus a fee category. Cost plus a fee contracts generally have lower margins but with much less potential for variability due to the limited risk involved. The Company’s profitability under each of the three general contract categories discussed above varies based on the level of risk assumed under the contract terms with the most potential for variability being in contracts under the population based or fixed fee categories which do not contain the risk mitigating provisions related to off-site utilization described above.

Healthcare expenses include the compensation of physicians, nurses and other healthcare professionals and related benefits and all other direct costs of providing and/or administering the managed care, including the costs associated with services provided and/or administered by off-site medical providers, the costs of professional and general liability insurance and other self-funded insurance reserves discussed more fully below. Many of the Company’s contracts require the Company’s customers to reimburse the Company for all treatment costs or, in some cases, only treatment costs related to certain catastrophic events, and/or for specific disease diagnoses illnesses. Certain of the Company’s contracts do not contain such limits. The Company attempts to compensate for the increased financial risk when pricing contracts that do not contain individual, catastrophic or specific disease diagnosis-related limits. However, the occurrence of severe individual cases, specific disease diagnoses illnesses or a catastrophic event in a facility governed by a contract without such limitations could render the contract unprofitable and could have a material adverse effect on the Company’s operations. For certain of its contracts that do not contain catastrophic protection, the Company maintains stop loss insurance from an unaffiliated insurer with respect to, among other things, inpatient and outpatient hospital expenses (as defined in the policy) for amounts in excess of $375,000 per inmate up to an annual cap of $1.0 million per inmate and $3.0 million in total. Amounts reimbursable per claim under the policy are further limited to the lessor of billed charges, the amount paid or the contracted amounts in situations where the Company has negotiated rates with the applicable providers.

The cost of healthcare services provided, administered or contracted for are recognized in the period in which they are provided and/or administered based in part on estimates, including an accrual for estimated unbilled medical services rendered through the balance sheet date. The Company estimates the accrual for unbilled medical services using actual utilization data including hospitalization, one-day surgeries, physician visits and emergency room and ambulance visits and their corresponding costs, which are estimated using the average historical cost of such services. Additionally, the Company’s utilization management personnel perform a monthly review of inpatient hospital stays in order to identify any stays which would have a cost in excess of the historical average rates. Once identified, reserves for such stays are determined which take into consideration the specific facts of the stay. An actuarial analysis is also prepared at least quarterly as an additional tool to be considered by management in evaluating the adequacy of the Company’s total accrual related to contracts which have sufficient claims payment history. The analysis takes into account historical claims experience (including the average historical costs and billing lag time for such services) and other actuarial data.

Actual payments and future reserve requirements will differ from the Company’s current estimates. The differences could be material if significant fluctuations occur in the healthcare cost structure or the Company’s future claims experience. Changes in estimates of claims resulting from such fluctuations and differences between

actuarial estimates and actual claims payments are recognized in the period in which the estimates are changed or the payments are made.

Allowance for Doubtful Accounts

Accounts receivable are stated at estimated net realizable value. The Company recognizes allowances for doubtful accounts based on a variety of factors, including the length of time receivables are past due, significant one-time events, contractual rights, client funding and/or political pressures, discussions with clients and historical experience. If circumstances change, estimates of the recoverability of receivables would be further adjusted and such adjustments could have a material adverse effect on the Company’s results of operations in the period in which they are recorded.

As discussed more fully in Part II — Item 1. “Legal Proceedings,” PHS is currently involved in a lawsuit with its former client, Baltimore County, Maryland (the “County”) involving the County’s lack of payment for services rendered. PHS has approximately $1.7 million of receivables due from the County, primarily related to services rendered between April 1, 2006 and September 14, 2006, the date the Company’s relationship with the County was terminated. The County has refused to pay PHS for these amounts and therefore, on October 27, 2006, PHS filed suit against the County in the Circuit Court for Baltimore County, Maryland seeking collection of the outstanding receivables balance, damages for breach of contract, quantum meruit, and unjust enrichment as well as prejudgment interest. During February 2011, the parties agreed to resolve this matter through binding arbitration which is expected to occur during the third quarter of 2011. At March 31, 2011, the Company has classified these receivables as current assets in its consolidated balance sheet.

As discussed more fully in Part II — Item 1. “Legal Proceedings,” PHS believes, in the case of this lawsuit, that it has a valid and meritorious cause of action and, as a result, has concluded that the outstanding receivables, which represent services performed under the contractual relationship between the parties, continues to be probable of collection. Although PHS believes it has valid contractual and legal arguments, an adverse result in this lawsuit could have a negative impact on the results of this matter and/or PHS’ ability to collect the outstanding receivables amount.

As stated above, the Company believes the recorded amount represents valid receivables which are contractually due from the County and expects full collection. However, due to the factors discussed above and more fully in Part II — Item 1. “Legal Proceedings,” there is a heightened risk of uncollectibility of these receivables which may result in future losses. Nevertheless, the Company intends to take all necessary and available measures in order to collect these receivables.

Changes in circumstances related to the matter discussed above involving the County, or any other receivables, could result in a change in the allowance for doubtful accounts or the estimate of contractual adjustments in future periods. Such change, if it were to occur, could have a material adverse effect on the Company’s results of operations and financial position in the period in which the change occurs.

Loss Contracts

On a quarterly basis, the Company performs a review of its portfolio of contracts for the purpose of identifying potential loss contracts and developing a loss contract reserve for succeeding periods if any loss contracts are identified. The Company accrues losses under its fixed price contracts when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. The Company performs this loss accrual analysis on a specific contract basis taking into consideration such factors as the Company’s ability to terminate the contract, future contractual revenue, projected future healthcare and maintenance costs, projected future stop-loss insurance recoveries and the contract’s specific terms related to future revenue increases as compared to increased healthcare

costs. The projected future healthcare and maintenance costs are estimated based on historical trends and management’s estimate of future cost increases. These estimates are subject to the same adverse fluctuations and future claims experience as previously noted.

There are no loss contracts identified as of March 31, 2011 and 2010.

Professional and General Liability Self-Insurance Retention

As a healthcare provider, the Company’s business occasionally results in actions for negligence and other causes of action related to its provision of healthcare services with the attendant risk of substantial damage awards, or court ordered non-monetary relief such as, changes in operating practices or procedures, which may lead to the potential for substantial increases in the Company’s operating expenses. The most significant source of potential liability in this regard is the risk of suits brought by inmates alleging negligent healthcare services, deliberate indifference to their medical needs or the lack of timely or adequate healthcare services. The Company may also be liable, as employer, for the negligence of healthcare professionals it employs or healthcare professionals with whom it contracts. The Company’s contracts generally provide for the Company to indemnify the governmental agency for losses incurred related to healthcare provided by the Company and its agents.

To mitigate a portion of this risk, the Company maintains a primary professional liability insurance program, principally on a claims-made basis. For 2002 through 2006 and 2008 through 2011 with respect to the majority of its patients, the Company purchased commercial insurance coverage, but is effectively self-insured due to the terms of the coverage which include adjustable premiums. For 2002 through 2006 and 2008 through 2011, the Company is covered by separate policies, each of which contains a premium that is retroactively adjusted, with adjustment based on actual losses. The Company’s ultimate premium for its 2002 through 2006 and 2008 through 2011 policies will depend on the final incurred losses related to each of these separate policy periods. For 2007, the Company is insured through claims made policies subject to per event and aggregate coverage limits. In addition to the coverage described above, for 2010 and 2011, the Company has purchased excess liability policies which provide coverage on a claims made basis for indemnity losses in excess of $4.0 million up to a maximum coverage of $10.0 million per loss and in the aggregate. Any amounts ultimately incurred above these coverage limits would be the responsibility of the Company. Management establishes reserves for the estimated losses that will be incurred under these insurance policies after taking into consideration the Company’s professional liability claims department and external counsel evaluations of the merits of the individual claims, analysis of claim history, actuarial analysis and coverage limits where applicable. Any adjustments resulting from the review are reflected in current earnings.

Given the fact that many claims are not brought during the year of occurrence, in addition to its reserves for known claims, the Company maintains a reserve for incurred but not reported claims. The reserve for incurred but not reported claims is recorded on an undiscounted basis. The Company’s estimates of this reserve are supported by various analyses, including an actuarial analysis, which is performed on a quarterly basis.

At March 31, 2011, the Company’s reserves for both known as well as incurred but not reported claims totaled $24.3 million. Reserves for medical malpractice claims fluctuate because the number of claims and the severity of the underlying incidents change from one period to the next. Reserves for medical malpractice claims can also fluctuate as a result of court decisions or as new facts become available. Furthermore, payments with respect to previously estimated liabilities frequently differ from the estimated liability. Changes in estimates of losses resulting from such fluctuations and differences between management’s established reserves and actual loss payments are recognized by an adjustment to the reserve for medical malpractice claims in the period in which the estimates are changed or payments are made. For the quarter ended March 31, 2011 and 2010, the Company recorded increases of approximately $1.5 million and $0.6 million, respectively, related to its prior year known

claims reserves as a result of adverse developments. The reserves can also be affected by changes in the financial health of the third-party insurance carriers used by the Company. If a third party insurance carrier fails to meet its contractual obligations under the agreement with the Company, the Company would then be responsible for such obligations. Such changes could have a material adverse effect on the Company’s financial position and its results of operations in the period in which the changes occur.

Other Self-Funded Insurance Reserves

At March 31, 2011, the Company has approximately $8.8 million in accrued liabilities for employee health and workers’ compensation claims. Approximately $7.3 million of this amount is related to workers’ compensation claims, of which approximately $4.0 million is included within the noncurrent portion of accrued expenses as it is not expected to be paid within a year. The Company is essentially self-insured for employee health and workers’ compensation claims subject to certain individual case stop loss levels. As such, its insurance expense is largely dependent on claims experience and the ability to control claims. The Company accrues the estimated liability for employee health insurance based on its history of claims experience and estimated time lag between the incident date and the date of actual claim payment. The Company accrues the estimated liability for workers’ compensation claims based on evaluations of the merits of the individual claims and analysis of claims history. These estimated liabilities are recorded on an undiscounted basis. An actuarial analysis is prepared at least annually as an additional tool to be considered by management in evaluating the adequacy of the Company’s reserve for workers’ compensation claims. These estimates of self-funded insurance reserves could change in the future based on changes in the factors discussed above. Any adjustments resulting from such changes in estimates are reflected in current earnings.

Legal Contingencies

In addition to professional and general liability claims, the Company is also subject to other legal proceedings in the ordinary course of business. Such proceedings generally relate to labor, employment or contract matters. When estimable, the Company accrues an estimate of the probable costs for the resolution of these claims. Such estimates are developed in consultation with outside counsel handling the Company’s defense in these matters and are based upon an estimated range of potential results, assuming a combination of litigation and settlement strategies. It is possible that future results of operations for any particular quarterly or annual period could be materially affected by changes in assumptions, new developments or changes in approach, such as a change in settlement strategy in dealing with such litigation. See discussion of certain outstanding legal matters in Part II — Item 1. “Legal Proceedings.”

In addition to professional and general liability claims and other legal proceedings in the ordinary course of business, the Company is involved in other legal matters related to an Audit Committee investigation, which was announced by the Company on October 24, 2005. See Part II — Item 1. “Legal Proceedings” for further information regarding the Audit Committee investigation and related legal matters.

Impairment of Intangible Assets and Goodwill

Goodwill acquired is not amortized but is reviewed for impairment on an annual basis or more frequently whenever events or circumstances indicate that the carrying value may not be recoverable. U.S. GAAP requires that goodwill be tested at the reporting unit level, defined as an operating segment or one level below an operating segment (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired. The Company has determined that it has one operating, as well as one reportable, segment. The Company’s policy is to perform its annual goodwill impairment test as of the last day of each fiscal year, i.e. December 31.

In performing its annual goodwill impairment test, the Company uses a two-step process. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. The first step of the goodwill impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. The Company determined the fair value of its reporting unit to equal the market capitalization of its common stock as of the testing date. As of December 31, 2010, the indicated fair value of the Company’s reporting unit exceeded the carrying value of its reporting unit by a substantial amount, and, as such, the Company concluded that there was no indication of goodwill impairment.

Future events could cause the Company to conclude that impairment indicators exist and that the Company’s goodwill is impaired. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.

Important factors taken into consideration when evaluating the need for an impairment review, other than the annual impairment test, include the following:

	•		significant underperformance or loss of key contracts relative to expected historical or projected future operating results;

	•		significant changes in the manner of use of the Company’s assets or in the Company’s overall business strategy;

	•		significant negative industry or economic trends; and

	•		an adverse change in the Company’s market capitalization.

If the Company determines that the carrying value of goodwill may be impaired based upon the existence of one or more of the above or other indicators of impairment or as a result of its annual impairment review, the impairment will be measured using a fair-value-based goodwill impairment test. Fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties and may be estimated using a number of techniques, including quoted market prices or valuations by third parties, present value techniques based on estimates of cash flows, or multiples of earnings or revenues. The fair value of the asset could be different using different estimates and assumptions in these valuation techniques.

The Company’s other identifiable intangible assets represent customer contracts acquired in acquisitions and are amortized on the straight-line method over their estimated useful lives. The Company also assesses the potential impairment of its other identifiable intangibles whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

When the Company determines that the carrying value of other intangible assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, such impairment will be measured using an estimate of the asset’s fair value based on the projected net cash flows expected to result from that asset, including eventual disposition.

Amortizable Life of Contract Intangibles

Income Taxes

progresses, management refines the estimate of the year’s taxable income as new information becomes available, including year-to-date financial results. This continual estimation process often results in a change to the Company’s expected effective tax rate for the year. When this occurs, management adjusts the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision reflects the expected annual tax rate. The Company’s effective income tax rate on income from continuing operations before taxes for the quarter ended March 31, 2011 is 43.7%.

It is the Company’s policy to recognize accrued interest and penalties related to its tax contingencies as income tax expense. The Company has no tax contingencies at March 31, 2011 and there is no accrued interest and penalties included in income tax expense for the quarters ended March 31, 2011 and 2010.

Share-Based Compensation

The Company measures and recognizes compensation expense for all share-based payment awards based on estimated fair values at the date of grant. Determining the fair value of share-based awards at the grant date requires judgment in developing assumptions, which involve a number of variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards and expected stock option exercise behavior. In addition, the Company also uses judgment in estimating the number of share-based awards that are expected to be forfeited.

Results of Operations

The following table sets forth, for the periods indicated, the percentage relationship to healthcare revenues of certain items in the condensed consolidated statements of income.


	Quarter ended
	March 31,
Percentage of Healthcare Revenues	2011			2010
Healthcare revenues		100.0	%		100.0	%
Healthcare expenses		90.8			90.4

Gross margin		9.2			9.6
Selling, general and administrative expenses		5.7			5.5
Merger expenses		0.9			—
Audit Committee investigation and related expenses		—			0.1
Depreciation and amortization		0.6			0.5

Income from operations		2.0			3.5
Interest income		—			—

Income from continuing operations before income tax provision		2.0			3.5
Income tax provision		0.9			1.5

Income from continuing operations		1.1			2.0
Income (loss) from discontinued operations, net of taxes		—			—

Net income		1.1	%		2.0	%

Quarter Ended March 31, 2011 Compared to Quarter Ended March 31, 2010

Healthcare revenues. Healthcare revenues for the quarter ended March 31, 2011 decreased $6.1 million, or 3.8%, from $160.0 million for the quarter ended March 31, 2010 to $153.9 million for the quarter ended March 31, 2011. Correctional healthcare services contracts in place at January 1, 2010 and continuing beyond March 31, 2011 experienced negative revenue growth of 3.8% resulting in a reduction to revenue of $6.1 million during the first quarter of 2011. This revenue reduction is primarily the result of a reduction in risk sharing revenue on two large customers due to a reduction in off-site expenses combined with cost reductions on one large cost-plus contract resulting in revenue reductions. Additionally, the Company’s revenue related to contract base fees experienced slight negative growth due to customer budgetary pressures and contract renegotiations. There were no new correctional healthcare services contracts added subsequent to January 1, 2010. As discussed in the discontinued operations section below, the Company’s correctional healthcare services contracts that have expired or otherwise been terminated have been classified as discontinued operations.

Healthcare expenses. Healthcare expenses for the quarter ended March 31, 2011 decreased $4.9 million, or 3.4%, from $144.6 million, or 90.4% of revenues, for the quarter ended March 31, 2010 to $139.8 million, or 90.8% of revenues, for the quarter ended March 31, 2011. Correctional healthcare services contracts in place at January 1, 2010 and continuing beyond March 31, 2011 experienced a reduction in healthcare expenses of $4.6 million during the first quarter of 2011 primarily as a result of reductions in the off-site medical services associated with providing healthcare to inmates at existing contracts. Within this reduction is an offsetting increase in insurance expense of approximately $0.9 million during the first quarter of 2011 as a result of adverse development related to professional liability claims. There were no new correctional healthcare services contracts added subsequent to January 1, 2010. Also included in healthcare expenses for the quarter ended March 31, 2011 and 2010 is approximately $0.2 million and $0.5 million of accrued bonus expenses related to the Company’s 2011 incentive compensation plan and 2010 incentive compensation plan, respectively.

Selling, general and administrative expenses. Selling, general and administrative expenses were $8.7 million, or 5.7% of revenues, for the quarter ended March 31, 2011 as compared to $8.9 million, or 5.5% of revenues, for the quarter ended March 31, 2010. Included in selling, general and administrative expenses for the quarters ended March 31, 2011 and 2010 is approximately $0.3 million and $0.4 million, respectively, related to share-based compensation expense. Also included in selling, general and administrative expenses for the quarter ended March 31, 2011 is approximately $0.5 million of accrued bonus expense related to the Company’s 2011 incentive compensation plan. Included in selling, general and administrative expenses for the quarter ended March 31, 2010 is approximately $1.5 million of accrued bonus expense related to the Company’s 2010 incentive compensation plan.

Merger expenses. During the quarter ended March 31, 2011, the Company incurred $1.3 million of expenses related to the Merger discussed in Part I — Item 2. “Pending Merger.” There were no merger expenses incurred for the quarter ended March 31, 2010.

Audit Committee investigation and related expenses. Audit Committee investigation and related expenses were $43,000 for the quarter ended March 31, 2011 as compared to $0.2 million for the quarter ended March 31, 2010. The Audit Committee investigation and related expenses incurred in the quarter ended March 31, 2011, primarily related to legal expenses incurred due to litigation filed by the Company against one of its insurance carriers. The Audit Committee investigation and related expenses incurred in the quarter ended March 31, 2010, are primarily due to legal expenses. See Part II — Item 1. “Legal Proceedings” for further discussion of the Audit committee investigation and related legal matters.

Depreciation and amortization. Depreciation and amortization expense was $0.9 million and $0.8 million, respectively, for the quarters ended March 31, 2011 and 2010, respectively. The increase in depreciation and amortization is primarily due to an increase in capital expenditures.

Interest income. Interest income was $5,000 for the quarter ended March 31, 2011 compared to $20,000 for the quarter ended March 31, 2010. During the quarters ended March 31, 2011 and 2010, the Company had no borrowings outstanding on its Credit Agreement resulting in a reduction in interest expense. This reduction, combined with earnings on cash balances, resulted in net interest income for each period.

Income tax provision. The income tax provision for the quarter ended March 31, 2011 was $1.4 million as compared with $2.3 million for the quarter ended March 31, 2010. This decrease was the result of a decrease in income from continuing operations before income tax provision from $5.6 million for the quarter ended March 31, 2010 to $3.1 million for the quarter ended March 31, 2011.

Income from continuing operations. Income from continuing operations for the quarter ended March 31, 2011 was $1.8 million, as compared with $3.3 million for the quarter ended March 31, 2010 as the result of the factors discussed above.

Income (loss) from discontinued operations, net of taxes. Income from discontinued operations, net of taxes, for the quarter ended March 31, 2011 was $5,000 as compared with a loss of $53,000 for the quarter ended March 31, 2010. Income (loss) from discontinued operations, net of taxes, represents the operating results of the Company’s correctional healthcare services contracts that have expired or otherwise been terminated. The classification of these expired contracts is the result of the Company’s application of U.S. GAAP related to discontinued operations. See Note 7 of the Company’s condensed consolidated financial statements for further discussion of this application of U.S. GAAP.

Net income. Net income for the quarter ended March 31, 2011 was $1.8 million, or 1.1% of revenues, as compared with $3.2 million, or 2.0% of revenues, for the quarter ended March 31, 2010. This change in net income resulted from the factors discussed above.

Liquidity and Capital Resources

Overview

The Company had working capital of $12.7 million at March 31, 2011 compared to $15.7 million at December 31, 2010. At March 31, 2011, days sales outstanding in accounts receivable were 32, accounts payable days outstanding were 30 and accrued medical claims liability days outstanding were 45. At December 31, 2010, days sales outstanding in accounts receivable were 30, accounts payable days outstanding were 30 and accrued medical claims liability days outstanding were 48.

The Company had stockholders’ equity of $57.5 million at March 31, 2011 compared to $55.8 million at December 31, 2010. The Company had cash and cash equivalents of $41.6 million at March 31, 2011 compared to $39.6 million at December 31, 2010. The increase in cash and cash equivalents was primarily due to cash flows from operating activities less capital expenditures. The Company had no outstanding balance on its credit facility at March 31, 2011 or December 31, 2010.

Cash flows from operating activities represent the year to date net income plus adjustments for various non-cash charges, such as depreciation and amortization expense and share-based compensation expense, and changes in various components of working capital. Cash flows provided by operating activities during the quarter ended March 31, 2011 were $2.8 million, a decrease of $2.1 million from cash flows provided by operations during the quarter ended March 31, 2010 of $4.9 million.

Cash flows used in investing activities were $1.0 million and $1.3 million for the quarters ended March 31, 2011 and 2010, respectively, which represented capital expenditures, which were financed through working capital.

Cash flows provided by financing activities during the quarter ended March 31, 2011 were $0.2 million, which resulted from the issuance of common stock under the Company’s employee stock purchase plan. Cash flows provided by financing activities during the quarter ended March 31, 2010 were $0.2 million, which resulted from the issuance of common stock under the Company’s employee stock purchase plan of $0.2 million and cash receipts resulting from option exercises of $0.6 million, partially offset by dividends on common stock of $0.5 million.

Share Repurchases

On February 27, 2008, the Company’s Board of Directors approved a stock repurchase program to repurchase up to $15 million of the Company’s common stock through the end of 2009. On July 28, 2009, the Company’s Board of Directors authorized the extension of this program by two years through the end of 2011, while maintaining the total $15 million limit. As of March 31, 2011, the Company has repurchased and retired a total of 891,850 shares of common stock under the stock repurchase program at an aggregate cost of approximately $11.2 million. The Company is prohibited under the terms of the Merger Agreement from making any additional repurchases of its common stock until the Merger closes or the Merger Agreement is terminated. See Part I — Item 2. “Pending Merger.”

The stock repurchase program is intended to be implemented through purchases made from time to time in either the open market or through private transactions, in accordance with SEC requirements. The Company may elect to terminate or modify the program at any time. Under the stock repurchase program, no shares will be purchased directly from officers or directors of the Company. The timing, prices and sizes of purchases will depend upon prevailing stock prices, general economic and market conditions and other considerations. Funds for the repurchase of shares are expected to come primarily from cash provided by operating activities and also from funds on hand, including amounts available under the Company’s credit facility.

Dividends

On April 12, 2011, the Company paid a $0.06 cash dividend per share on the Company’s common stock for the quarter ended March 31, 2011.

The Board of Directors’ adoption of a dividend program reflects the Company’s intent to return capital to stockholders. The Company expects that any future quarterly cash dividends will be paid from cash generated by the Company’s business in excess of its operating needs, interest and principal payments on indebtedness, dividends on any future senior classes of the Company’s capital stock, if any, capital expenditures, taxes and future reserves, if any. Any future dividends will be authorized by the Board of Directors and declared by the Company based upon a variety of factors deemed relevant by directors of the Company. In addition, financial covenants in the Credit Agreement may restrict the Company’s ability to pay future quarterly dividends. The Board of Directors will continue to evaluate the Company’s dividend program each quarter and will make adjustments as necessary, based on a variety of factors, including, among other things, the Company’s financial condition, liquidity, earnings projections and business prospects, and no assurance can be given that this dividend program will not change in the future. The Company is prohibited under the terms of the Merger Agreement from paying any additional dividends until the Merger closes or the Merger Agreement is terminated. See Part I — Item 2. “Pending Merger.”

Credit Facility

$15.0 million. The Company may request an increase in the current facility cap of up to an additional $20.0 million subject to lender approval. The amount available to the Company for borrowings under the Credit Agreement is based on the Company’s collateral base, as determined under the Credit Agreement, and is reduced by the amount of each outstanding standby letter of credit. The Credit Agreement is secured by substantially all assets of the Company and its operating subsidiaries. At March 31, 2011 and December 31, 2010, the Company had no borrowings outstanding under the Credit Agreement. At March 31, 2011, the Company had $14.9 million available for borrowing, based on the current facility cap and the Company’s collateral base on that date and no standby letters of credit.

The Credit Agreement requires the Company to maintain a minimum level of EBITDA of $8.0 million on a trailing twelve-month basis to be measured at the end of each calendar quarter. The Credit Agreement defines EBITDA as net income plus interest expense, income taxes, depreciation expense, amortization expense, any other non-cash non-recurring expense, loss from asset sales outside of the normal course of business and charges and cash expenses arising out of the Audit Committee investigation into matters at SPP including any expenses or charges incurred in the associated shareholder securities suit provided such amounts, net of insurance recoveries, do not exceed $4.5 million in the aggregate, minus gains on asset sales outside the normal course of business or other non-recurring gains. The Company was in compliance with the minimum level of EBITDA covenant requirement at March 31, 2011.

Liquidity and Capital Resources Outlook

The Company currently believes that cash flows from operating activities, its available cash, and its expected available credit under the Amended Credit Agreement will continue to enable it to meet its contractual obligations and capital expenditure requirements for the foreseeable future. The Company may, from time to time, consider acquisitions involving other companies or assets. Such acquisitions or other opportunities may require the Company

to raise additional capital by expanding its existing credit facility and /or issuing debt or equity, as market conditions permit. If the Company is unable to obtain such additional capital on a timely basis, on favorable terms or at all, it could have inadequate capital to operate its business, meet its contractual obligations and capital expenditure requirements or fund potential acquisitions. Current market and economic conditions, including turmoil and uncertainty in the financial services industry and credit markets, have caused credit markets to tighten and led many lenders and institutional investors to reduce, and in some cases, cease to provide, funding to borrowers. Should the credit markets not improve, the Company can make no assurances that it would be able to secure additional financing if needed and, if such funds were available, whether the terms or conditions would be acceptable.

Other Financing Transactions

At March 31, 2011, the Company was contingently liable for $6.6 million of performance bonds.

Off-Balance Sheet Transactions

As of March 31, 2011, the Company did not have any off-balance sheet financing transactions or arrangements except for operating leases.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk represents the risk of loss that may impact the condensed consolidated financial statements of the Company due to adverse changes in financial market prices and rates. The Company’s exposure to market risk is primarily related to changes in the variable interest rate under the Company’s Credit Agreement. The Credit Agreement contains an interest rate based on the one-month LIBOR rate, subject to a minimum LIBOR rate of 3.14%; therefore the Company’s cash flow may be affected by changes in the one-month LIBOR rate. A hypothetical 10% change in the underlying interest rate for the quarter ended March 31, 2011 would have had no material effect on interest expense paid under the Credit Agreement. Net interest income represents less than 1% of the Company’s revenues for each of the quarters ended March 31, 2011 and 2010. The Company has no debt outstanding at March 31, 2011.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission (“SEC”) rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or furnishes under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, the Company evaluated under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, the effectiveness of the design and operation of the Company’s disclosure controls and procedures, pursuant to the Exchange Act. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the Company files or furnishes under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

There were no changes in the Company’s internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II:

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company is subject to legal proceedings in the ordinary course of business. A discussion is provided below of significant outstanding matters for which there have been updates during 2011. For a discussion of all other significant outstanding matters, please refer to Note 21 of the Company’s 2010 Annual Report on Form 10-K filed on March 3, 2011.

June 30, 2011. In July 2005, the County and PHS agreed to have a judicial authority interpret the contract through formal judicial proceedings (the “Contract Matter”). At the written request of the County, PHS continued to provide healthcare services to the County from July 1, 2005 to September 14, 2006, under the terms and conditions of the contested contract, pending the judicial resolution of the Contract Matter, while reserving all of its rights. Finally, during September 2006, amid reciprocal claims of default, both PHS and the County took individual steps to terminate the relationship between the parties. PHS contends that it terminated the relationship effective September 14, 2006, due to various breaches by the County, including failure to remit payment of approximately $1.7 million primarily related to services rendered between April 1, 2006 and September 14, 2006. On October 27, 2006, PHS initiated the Collection Matter lawsuit against the County.

The Collection Matter, although filed, was initially dormant, pending the resolution of the Contract Matter. As discussed in more detail below, the Contract Matter was resolved in favor of PHS on August 26, 2008, when the Maryland Court of Appeals (the State’s highest appellate court) denied the County’s request for a review of a Maryland Court of Special Appeals decision in favor of PHS. After the resolution of the Contract Matter, the parties, during 2009, commenced the discovery process on the Collection Matter. On March 30, 2010, the court held a scheduling conference in which the judge set February 8, 2011 as the trial date for the Collection Matter. Prior to the trial date, preliminary settlement discussions were conducted without resolution. Subsequently, the parties agreed to forego the trial and resolve the Collection Matter through binding arbitration which is expected to occur during the third quarter of 2011. PHS believes, in the case of the Collection Matter, that it has a valid and meritorious cause of action and, as a result, has concluded that the outstanding receivables, which represent services performed under the relationship between the parties, continues to be probable of collection. However, although PHS believes it has valid contractual and legal arguments, an adverse result in the Collection Matter could have a negative impact on PHS’ ability to collect the outstanding receivable amount and result in losses in future periods.

Litigation Related to the Merger

Matters Related to the Audit Committee Investigation and Shareholder Litigation

As disclosed in further detail in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, on March 15, 2006 the Company announced that its Audit Committee had concluded its investigation and reached certain conclusions with respect to findings of the investigation that resulted in the recording of amounts due to SPP’s customers that were not charged in accordance with the terms of their respective contracts.

Shareholder Litigation. On April 6, 2006, plaintiffs filed the first of four similar securities class action lawsuits in the United States District Court for the Middle District of Tennessee against the Company and the Company’s Chief Executive Officer, at that time, and Chief Financial Officer. Plaintiffs’ allegations in these class action lawsuits were substantially identical and generally alleged on behalf of a putative class of individuals who purchased the Company’s common stock between September 24, 2003 and March 16, 2006 that, prior to the Company’s announcement of the Audit Committee investigation, the Company and/or the Company’s Chief Executive Officer, at that time, and Chief Financial Officer violated Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5 by making false and misleading statements, or concealing information about the Company’s business, forecasts and financial performance. The complaints sought certification as a class action, unspecified compensatory damages, attorneys’ fees and costs, and other relief. By order dated August 3, 2006, the district court consolidated the lawsuits into one consolidated action and on October 31, 2006, plaintiff filed an amended complaint adding SPP, Enoch E. Hartman III and Grant J. Bryson as defendants. Enoch E. Hartman III is a former employee of the Company and SPP and Grant J. Bryson is a former employee of SPP. The amended complaint also generally alleged that defendants made false and misleading statements concerning the Company’s business which caused the Company’s securities to trade at inflated prices during the class period. Plaintiff sought an unspecified amount of damages in the form of (i) restitution; (ii) compensatory damages, including interest; and (iii) reasonable costs and expenses. Defendants moved to dismiss the amended complaint on January 19, 2007, and the parties completed the briefs on the motion in May 2007. On March 31, 2009, the Court ruled on the defendants’ motion to dismiss, granting it in part and denying it in part. While the Court’s ruling dismissed significant portions of plaintiffs’ amended complaint and, as a result, narrowed the scope of plaintiffs’ claims, none of the defendants were dismissed from the case and several of plaintiffs’ claims under Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5 remained. The parties were not in agreement as to the scope of the Court’s order and defendants filed a motion to confirm which claims the Court dismissed in its March 31, 2009 ruling. The Court granted defendants’ motion to confirm the scope of the dismissal order on July 20, 2009, ruling that certain of Plaintiff’s claims had been in fact dismissed. The Court also confirmed, however, that certain other claims remained viable.

Other Matters

The Company’s business ordinarily results in labor and employment related claims and matters, actions for professional liability and related allegations of deliberate indifference in the provision of healthcare and other causes of action related to its provision of healthcare services. Therefore, in addition to the matters discussed above, the Company is a party to a multitude of filed or pending legal and other proceedings incidental to its business. An estimate of the amounts payable on existing claims for which the liability of the Company is probable and estimable is included in accrued expenses. The Company is not aware of any unasserted claims that would have a material adverse effect on its consolidated financial position, results of operations or cash flows.

ITEM 1A. RISK FACTORS

The Company previously disclosed risk factors under “Item 1A. Risk Factors” in its Annual Report on Form 10-K for the year ended December 31, 2010. The risks discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 are not the only risks facing the Company. Additional risks and uncertainties not currently known to the Company or that the Company deems immaterial may materially adversely affect our business, financial condition and/or results of operations.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. RESERVED

ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS


2.1	—	Agreement and Plan of Merger, dated March 2, 2011 by and among Valitás Health Services, Inc., Whiskey Acquisition Corp. and America Service Group Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on March 3, 2011).

3.1	—	Amended and Restated Certificate of Incorporation of America Service Group Inc. (incorporated herein by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the three month period ended June 30, 2002).

3.2	—	Certificate of Amendment of Amended and Restated Certificate of Incorporation of America Service Group Inc. (incorporated herein by reference to Exhibit 3.4 to the Company’s Quarterly Report on Form 10-Q for the three month period ended June 30, 2004).

3.3	—	Amended and Restated By-Laws of America Service Group Inc. (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on March 3, 2009).

4.1	—	Specimen Common Stock Certificate (incorporated herein by reference to Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q for the three month period ended June 30, 2002).

4.2	—	Certificate of Designation of the Series A Convertible Preferred Stock (incorporated herein by reference to Exhibit 99.3 to the Company’s Current Report on Form 8-K filed on February 10, 1999).

11	—	Computation of Per Share Earnings.*

31.1	—	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2	—	Certification of the Chief Financial Officer pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1	—	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2	—	Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


*		Data required by U.S. GAAP related to earnings per share is provided in Note 20 to the condensed consolidated financial statements in this report.

SIGNATURES

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.


		AMERICA SERVICE GROUP INC.

		/s/ RICHARD HALLWORTH Richard Hallworth
		President & Chief Executive Officer
		(Duly Authorized Officer)


		/s/ MICHAEL W. TAYLOR Michael W. Taylor
		Executive Vice President & Chief Financial Officer
		(Principal Financial Officer)

Dated: May 2, 2011

AMERICA SERVICE GROUP INC /DE 10-Q