Advanzeon Solutions, Inc. - Quarter Report: 2008 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2008

Commission File Number 1-9927

COMPREHENSIVE CARE CORPORATION

(Exact name of registrant as specified in its charter)

3405 W. Dr. Martin Luther King Jr. Blvd, Suite 101, Tampa, FL 33607

(Address of principal executive offices and zip code)

(813) 288-4808

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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

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

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

As of November 4, 2008, there were 8,327,766 shares of registrant’s common stock, $0.01 par value, outstanding.

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COMPREHENSIVE CARE CORPORATION AND SUBSIDIARIES

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PART I – FINANCIAL INFORMATION

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands)

See accompanying notes to condensed consolidated financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Amounts in thousands, except per share amounts)

See accompanying notes to condensed consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Amounts in thousands)

See accompanying notes to condensed consolidated financial statements.

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NOTE 1 — DESCRIPTION OF THE COMPANY’S BUSINESS AND BASIS OF PRESENTATION

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements for Comprehensive Care Corporation (referred to herein as the “Company,” “CompCare,” “we,” “us” or “our”) and its subsidiaries have been prepared in accordance with the Securities and Exchange Commission (“SEC”) rules for interim financial information and do not include all information and notes required for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the consolidated financial statements and the notes thereto in our most recent report on Form 10-K, from which the December 31, 2007 balance sheet has been derived.

Going Concern

The Company’s financial statements are presented on the basis that it is a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. We have incurred significant operating losses and negative cash flows from operating activities, which raise substantial doubt as to our ability to continue as a going concern. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recovery and classification of assets or the amount and classification of liabilities that may result from the outcome of these uncertainties, including those described in Note 3 - “Liquidity and Management Plans Regarding Going Concern.”

Consolidation

Our consolidated financial statements include the accounts of the Company and our wholly-owned subsidiary Comprehensive Behavioral Care, Inc. (“CBC”) and subsidiaries. The Company, primarily through CBC, provides managed care services in the behavioral health and psychiatric fields, which is its only operating segment. We manage the delivery of a continuum of psychiatric and substance abuse services to commercial, Medicare, Medicaid and Children’s Health Insurance Program (“CHIP”) members on behalf of employers, health plans, government organizations, third-party claims administrators, and commercial and other group purchasers of behavioral healthcare services. We also provide prior and concurrent authorization for physician-prescribed psychotropic medications for a major Medicaid health maintenance organization (“HMO”) in Indiana and Michigan. The managed care operations include administrative services only (ASO) agreements, fee-for-service agreements, and capitation contracts. The customer base for our services includes both private and governmental entities. Our services are provided primarily by unrelated vendors on a subcontract basis.

Change in Fiscal Year End

Our Board of Directors approved on May 21, 2007 a change in the Company’s fiscal year end from May 31 to December 31, effective December 31, 2006. The purpose of the change was to align the Company’s fiscal year end with that of Hythiam, Inc., which purchased a majority controlling interest in the Company through its purchase of Woodcliff Healthcare Investment Partners LLC (“Woodcliff”) in January 2007. In addition, a calendar year end coincides with that of our major Indiana client that provided approximately 48.6% of our revenues during the nine months ended September 30, 2008. The seven months ended December 31, 2006 was our transition period for financial reporting purposes.

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition

Our managed care activities are performed under the terms of agreements with health maintenance organizations, preferred provider organizations, and other health plans or payers to provide contracted behavioral healthcare services to subscribing participants. Revenue under a substantial portion of these agreements is earned monthly based on the number of qualified participants regardless of services actually provided (generally referred to as capitation arrangements). The information regarding qualified participants is supplied by our clients and we review member eligibility records and other reported information to verify its accuracy to determine the amount of revenue to be recognized. Such agreements accounted for 97.0%, or $26.5 million, of revenue for the nine months ended September 30, 2008 and 97.0%, or $26.8 million, of revenue for the nine months ended September 30, 2007. The remaining balance of our revenues is earned on a fee-for-service basis and is recognized as services are rendered.

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Under our major Indiana contract, approximately $200,000 of our monthly revenue is dependent on our satisfaction of various monthly performance criteria. On a monthly basis we review our performance against the criteria and recognize the revenue monthly if all the specified performance targets were achieved.

Healthcare Expense Recognition

Healthcare operating expense is recognized in the period in which an eligible member actually receives services and includes an estimate of the cost of behavioral health services that have been incurred but not yet reported. See “Accrued Claims Payable” for a discussion of claims incurred but not yet reported. We contract with various healthcare providers including hospitals, physician groups and other licensed behavioral healthcare professionals either on a discounted fee-for-service or a per-case basis. We determine that a member has received services when we receive a claim within the contracted timeframe with all required billing elements correctly completed by the service provider. We then determine whether the member is eligible to receive such services, the service provided is medically necessary and is covered by the benefit plan’s certificate of coverage, and in most cases, whether the service is authorized by one of our employees. If the applicable requirements are met, the claim is entered into our claims system for payment.

Accrued Claims Payable

The accrued claims payable liability represents the estimated ultimate net amounts owed for all behavioral healthcare services provided through the respective balance sheet dates, including estimated amounts for claims incurred but not yet reported (IBNR) to the Company. The unpaid claims liability is estimated using an actuarial paid completion factor methodology and other statistical analyses and is continually reviewed and adjusted, if necessary, to reflect any change in the estimated liability. These estimates are subject to the effects of trends in utilization and other factors. However, actual claims incurred could differ from the estimated claims payable amount reported. Although considerable variability is inherent in such estimates, management believes that the unpaid claims liability is adequate.

Premium Deficiencies

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

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

On a quarterly basis, we perform a review of our portfolio of contracts for the purpose of identifying loss contracts (as defined in the American Institute of Certified Public Accountants Audit and Accounting Guide – Health Care Organizations) and developing a contract loss reserve, if applicable, for succeeding periods. Other than our Indiana contract, which was determined to be a loss contract at June 30, 2008, we did not identify any additional contracts for which it is probable that a loss will be incurred during the remaining contract term at September 30, 2008. Of the $300,000 reserve established for our Indiana contract at June 30, 2008, $235,000 remains at September 30, 2008 as a reserve for the remainder of the contract, which terminates December 31, 2008.

Fair Value Measurements

Effective January 1, 2008, we adopted Statement of Financial Accounting Standard No. 157, “Fair Value Measurements,” (“SFAS 157”) which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. During the three months ended September 30, 2008, we had no assets or liabilities that are required to be measured at fair value on a recurring basis. Therefore, the adoption of SFAS 157 did not impact our financial position or results of operations.

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On January 1, 2008 we adopted SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 provides that companies may elect to measure many financial instruments and certain other items at fair value on a contract-by-contract basis, with changes in fair value recognized in earnings each reporting period. The election, called the “fair value option,” will enable some companies to reduce the variability in reported earnings caused by measuring related assets and liabilities differently. We chose not to measure at fair value our eligible financial assets and liabilities existing at September 30, 2008. Consequently, the adoption of SFAS No. 159 had no impact on our consolidated financial statements.

Income Taxes

Under the asset and liability method of SFAS No. 109, “Accounting for Income Taxes,” deferred tax assets and liabilities are recognized for the future tax consequences attributable to net operating loss carryforwards and to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect of a change in tax rates on deferred tax assets or liabilities is recognized in the consolidated statements of operations in the period that included the enactment. A valuation allowance is established for deferred tax assets unless their realization is considered more likely than not.

In June 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes. FIN 48 requires that companies recognize in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 on January 1, 2007, the beginning of our 2007 fiscal year, with no impact on our consolidated financial statements.

In June 2005, we completed a private placement transaction with Woodcliff that constituted a “change of ownership” under IRS Section 382 rules, which impose limitations on the ability to deduct prior period net operating losses on current federal tax returns. As a result, our ability to use our net operating losses incurred prior to June 14, 2005 is limited to approximately $400,000 per year.

On January 12, 2007, the sale of Woodcliff’s majority interest in the Company to Hythiam constituted another “change of ownership” under IRS Section 382 rules. In the event that the Company has two or more ownership changes, Section 1.382-5(d) also describes a potential impact on the limitation for any losses attributable to the period preceding the earlier ownership change. We have determined that the latest change of ownership does not change the limitation of approximately $400,000 per year for net operating losses incurred prior to June 14, 2005, the date of the first change in control. Furthermore, our ability to use net operating losses incurred between June 15, 2005 and January 12, 2007 is limited to approximately $490,000 per year. Net operating losses for periods prior to June 15, 2005 and for the subsequent period of June 15, 2005 to January 12, 2007 may be deducted simultaneously subject to the applicable limitations. Any unused portion of such limitations can be carried forward to the following year. We may be subject to further limitation in the event that we issue or agree to issue substantial amounts of additional equity.

Stock Options

We issue stock options to our employees and non-employee directors allowing optionees to purchase the Company’s common stock pursuant to shareholder-approved stock option plans. We currently have two incentive plans, the 1995 Incentive Plan and the 2002 Incentive Plan, that provide for the granting of stock options, stock appreciation rights, limited stock appreciation rights, and restricted stock grants to eligible employees and consultants. Grants issued under the plans may qualify as incentive stock options (ISOs) under Section 422A of the Internal Revenue Code. Options for ISOs may be granted for terms of up to ten years and are generally exercisable in cumulative increments of 50% each six months. The exercise price for ISOs must equal or exceed the fair market value of the shares on the date of grant. The plans also provide for the full vesting of all outstanding options under certain change of control events. The maximum number of shares authorized for issuance is 1,000,000 under the 2002 Incentive Plan and 1,000,000 under the 1995 Incentive Plan. As of September 30, 2008, under the 2002 Incentive Plan, there were 384,500 options available for grant and there were 575,500 options outstanding, of which 295,500

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were exercisable. Additionally, as of September 30, 2008, under the 1995 Incentive Plan, there were 257,025 options outstanding and exercisable. Effective August 31, 2005, the 1995 Incentive Plan terminated such that there are no further options available for grant under this plan.

We also have a non-qualified stock option plan for our non-employee directors. Each non-qualified stock option is exercisable at a price equal to the average of the closing bid and asked prices of the common stock in the over-the-counter market for the most recent preceding day there was a sale of the stock prior to the grant date. Grants of options vest in accordance with vesting schedules established by our Board of Director’s Compensation and Stock Option Committee. Upon joining the Board, directors receive an initial grant of 25,000 options. Annually, directors are granted 15,000 options on the date of the Company’s annual meeting. As of September 30, 2008, under the directors’ plan, there were 776,668 shares available for option grants and there were 125,000 options outstanding, of which 112,500 were exercisable.

A summary of activity throughout the three months ended September 30, 2008 is as follows:

The following table summarizes information about options granted, exercised, and vested for the three and nine months ended September 30, 2008 and 2007.

A total of 295,000 options were granted to directors and employees during the nine months ended September 30, 2008. No stock options were exercised during the three months ended September 30, 2008. During the nine months ended September 30, 2008, 125,000 stock options were exercised. Total intrinsic value (the difference between the exercise price of the option and the market value of our stock on the day of exercise) of exercised options during the nine months ended September 30, 2008 was $50,080. For the nine months ended September 30, 2007, 37,500 options with a total intrinsic value of $13,160 were exercised. Cash received from option exercise under all plans for the nine months ended September 30, 2008 and 2007 was approximately $32,000 and $19,000, respectively. During the three months ended September 30, 2008, 12,850 stock options granted to employees expired.

At September 30, 2008, unrecognized compensation expense related to unvested stock options totaled approximately $85,000, which we expect to recognize over the next nine months. The net tax benefit attributable to stock-based compensation recorded during the three months ended September 30, 2008 was approximately $19,000, and was fully offset by a valuation allowance of the same amount due to the likelihood of future realization.

The following table lists the assumptions utilized in applying the Black-Scholes valuation model. We use historical data and management judgment to estimate the expected term of the option. Expected volatility is based on

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the historical volatility of our traded stock. We did not declare dividends in the past nor do we expect to do so in the near future, and as such we assume no expected dividend. The risk-free rate is based on the U.S. Treasury yield curve with the same expected term as that of the option at the time of grant. In the event that there is no risk-free rate with the same expected term, we extrapolate the rate from the U.S. Treasury yield curve. We did not grant any stock options during the three months ended September 30, 2008.

Per Share Data

In calculating basic income (loss) per share, net income (loss) is divided by the weighted average number of common shares outstanding for the period. Diluted income (loss) per share reflects the assumed exercise or conversion of all dilutive securities, such as options, warrants, and convertible debt instruments. No such exercise or conversion is assumed where the effect is antidilutive, such as when there is a loss. The following table sets forth the computation of basic and diluted income (loss) per share in accordance with SFAS No. 128, “Earnings Per Share” (amounts in thousands, except per share data):

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Authorized shares of common stock reserved for possible issuance for convertible debentures, convertible preferred stock, a convertible promissory note, stock options, and warrants are as follows at September 30, 2008:

NOTE 3 – LIQUIDITY AND MANAGEMENT PLANS REGARDING GOING CONCERN

During the nine months ended September 30, 2008, net cash used in operations totaled $5.5 million, attributable primarily to payment of claims on our Indiana, Pennsylvania, and Maryland contracts which have experienced high utilization of services by members. Approximately $1.5 million of the total cash usage was due to a timing difference in the monthly capitation remittance from our Indiana client, which was received in October 2008. In addition, approximately $0.7 million in cash was used to pay accrued claims payable relating to three contracts that terminated during the quarter ended December 31, 2007, and a contractually required severance payment of $410,000 was made to our former Chief Executive Officer. Cash used in investing activities is comprised of $41,000 in additions to property and equipment offset by $20,000 in proceeds from payments received on notes receivable. In September 2008 we completed private placements of our common stock generating $125,000 in cash proceeds and issued a convertible promissory note in the amount of $200,000, providing additional funds for working capital purposes. Other cash flows from financing activities consist of repayment of debt of $41,000. At September 30, 2008, cash and cash equivalents amounted to $1.1 million.

At September 30, 2008, we had a working capital deficit of $5.2 million and a stockholders’ deficit of $8.7 million. During June and July of 2008, we reduced our usage of consultants and temporary employees as well as eliminated permanent staffing positions. In addition we implemented a 10% salary reduction for employees at the vice president level and above and have reduced outside directors’ fees by 10%. We have also requested rate increases from several of our existing clients.

The significant decrease in our cash position is primarily attributable to our major Indiana contract, which ends December 31, 2008. To reduce the claim expenses of this contract, we have implemented additional utilization and case management procedures. We are also in the process of negotiating a rate increase. If the rate increase is realized we would also receive a lump sum payment to offset past contract expenses. Management believes the combination of the rate increase and lump sum payment would provide sufficient cash to cover the claims run-out after the contract ends. We can provide no assurance that we will be successful in our negotiations with this client. If we are unsuccessful, we will need to raise additional equity capital or seek additional debt financing to fund the claims run-out from this contract.

Hythiam is under no obligation to provide us with any form of financing, and we do not currently anticipate receiving a cash investment from Hythiam. Failure to obtain sufficient debt or equity financing and, ultimately to achieve profitable operations and positive cash flows from operations during the remaining period in 2008 would adversely affect the Company’s ability to achieve its business objectives and continue as a going concern. There can

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be no assurance as to the availability of any additional debt or equity financing and, if available, that the source of the financing would be available on terms and conditions acceptable to us, or that we will be able to achieve profitable operations and positive cash flows. These conditions raise doubt about our ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments that may result from the outcome of this uncertainty.

During the nine months ended September 30, 2007, our cash and cash equivalents increased by $1.5 million, primarily due to timing differences of monies received from our Indiana contract that started January 1, 2007 and claims received for payment from our providers related to this contract. Cash flows attributed to investing activities consist primarily of $55,000 in outflows for additions to property and equipment offset by $30,000 in cash provided by proceeds from sales of available-for-sale securities.

NOTE 4 – SOURCES OF REVENUE

Our revenue can be segregated into the following significant categories (amounts in thousands):

Capitated revenues include contracts under which we assume the financial risk for the costs of member behavioral healthcare services in exchange for a fixed, per member per month fee. For non-capitated contracts, we may manage behavioral healthcare programs or perform various managed care functions, such as clinical care management, provider network development, and claims processing without assuming financial risk for member behavioral healthcare costs.

NOTE 5 — MAJOR CUSTOMERS/CONTRACTS

(1)We currently provide behavioral health services to approximately 11,000 members of a Medicare Advantage HMO in the state of Maryland. We previously served 39,000 of this HMO’s members in Pennsylvania until the contract for the membership in this state ended on July 31, 2008, due to the HMO’s selection of another behavioral health vendor. Services provided to members in both states accounted for $5.6 million, or 20.5%, and $3.4 million, or 12.3%, of our operating revenues for the nine-month periods ending September 30, 2008 and 2007, respectively. The Pennsylvania contract provided $4.2 million, or 15.4%, of our operating revenues for the nine months ended September 30, 2008.

In August 2008 our client notified us that it had selected the same behavioral health vendor for its Maryland membership as it had selected for its Pennsylvania membership, and that our contract would end December 31, 2008. Services provided under this contract accounted for $1.4 million, or 5.1% or our revenues for the nine-month period ended September 30, 2008. The loss of this client, unless replaced by new business, may require us to delay or reduce operating expenses and curtail our operations.

(2) On January 1, 2007, we began providing behavioral healthcare services to approximately 250,000 Medicaid recipients in Indiana under a contract with an initial term of two years. The contract generated $13.3 million, or 48.6% of our revenues for the nine months ended September 30, 2008, and $11.4 million, or 41.2%, of our revenues for the nine months ended September 30, 2007. Our contract is not going to be renewed and accordingly will end December 31, 2008. The loss of this client, unless replaced by new business, may require us to delay or reduce operating expenses and curtail our operations.

(3) We currently furnish behavioral healthcare services to approximately 242,000 members of a health plan providing Medicaid, Medicare, and CHIP benefits in Michigan, Texas and California. Services are provided on a fee-for-service and ASO basis. The contracts accounted for $2.8 million, or 10.3%, and $3.3 million, or 12.0%, of our revenues for the nine-month periods ended September 30, 2008 and 2007, respectively. The health plan has been a customer since June of 2002. The initial contract was for a one-year period and has been automatically renewed on an annual basis. Termination by either party may occur with 90 days written notice to the other party.

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In general, our contracts with our customers are typically for initial one-year terms, with automatic annual extensions. Such contracts generally provide for cancellation by either party with 60 to 90 days written notice.

NOTE 6 – PREFERRED STOCK

As of September 30, 2008, there were 4,340 remaining shares of preferred stock authorized and available to issue, and 14,400 outstanding shares of Series A Preferred Stock. All outstanding shares were issued in June 2005 as a result of the sale of Series A Preferred Stock to Woodcliff for approximately $3.4 million in net cash proceeds. The Series A Preferred Stock, acquired by Hythiam in January 2007, is convertible into 4,553,136 shares of common stock at a conversion rate of 316.19 common shares for each preferred share. Hythiam has the right to designate the majority of our Board of Directors, has dividend and liquidation preferences, and anti-dilution protection. In addition, we need Hythiam’s consent for a sale or merger involving a material portion of our assets or business, any single or series of related transactions exceeding $500,000, and prior to incurring any debt in excess of $200,000.

We are authorized to issue shares of Preferred Stock, $50.00 par value, in one or more series, each series to have such designation and number of shares as the Board of Directors may fix prior to the issuance of any shares of such series. Each series may have such preferences and relative participation, optional or special rights with such qualifications, limitations or restrictions stated in the resolution or resolutions providing for the issuance of such series as may be adopted from time to time by the Board of Directors prior to the issuance of any such series.

NOTE 7— COMMITMENTS AND CONTINGENCIES

(1) We provided behavioral healthcare services to the members of a Connecticut HMO from 2001 to 2005 under a contract that provided that we would also receive funds directly from a state reinsurance program for the purpose of paying providers. At September 30, 2008, $2.5 million of reinsurance claims payable remains and is attributable to providers having submitted claims for authorized services having incorrect service codes or otherwise incorrect information that has caused payment to be denied by us. In such cases, there are statutory provisions that allow the provider to appeal a denied claim. If no appeal is received by the Company within the prescribed amount of time, it is probable that we will be required to remit the reinsurance funds back to the appropriate party.

(2) In connection with our Indiana contract that started January 1, 2007, we maintain a performance bond in the amount of $1 million. In addition, a $25,000 performance bond is maintained in relation to a Third Party Administrator license in Maryland.

(3) Related to our discontinued hospital operations, Medicare guidelines allow the Medicare fiscal intermediary to re-open previously filed cost reports. Our cost report for our 1999 fiscal year, the final year we were required to file a cost report, is being reviewed in which case the intermediary may determine that additional amounts are due to or from Medicare. Management believes cost reports for fiscal years prior to fiscal 1999 are closed and considered final.

(4) We have insurance for a broad range of risks as it relates to our business operations. We maintain managed care errors and omissions, professional and general liability coverage. These policies are written on a claims-made basis and are subject to a $10,000 per claim self-insured retention. The managed care errors and omissions and professional liability policies include limits of liability of $1 million per claim and $3 million in the aggregate. The general liability has a limit of liability of $5 million per claim and $5 million in the aggregate. We are responsible for claims within the self-insured retentions or if the policy limits are exceeded. Management is not aware of any claims that could have a material adverse impact on our consolidated financial statements.

(5) Relating to our major Indiana contract, our client and the state of Indiana have required us to reconsider payment of claims billing codes that our client previously instructed us to deny. To reevaluate these claims, we formulated “reconsideration criteria,” which were approved by our client and the state of Indiana. In September 2008, we were notified by our client that other health care entities may be responsible for these claims. Due to the uncertainty relating to this matter, we are not able to estimate the amount of claims to be paid, if any, and have not accrued any amounts in our accrued claims payable in the accompanying consolidated balance sheet at September 30, 2008. If it is ultimately determined that we are required to pay these claims, our consolidated financial statements could be materially and adversely impacted.

NOTE 8 – RELATED PARTY TRANSACTIONS

In August 2005, the Company’s principal operating subsidiary, Comprehensive Behavioral Care, Inc., entered into a marketing agreement with Health Alliance Network, Inc. (“HAN”) whereby CBC appointed HAN as its

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primary representative and marketing agent for commercial business. Two shareholders of HAN held membership interests in Woodcliff, the owner of a controlling interest in the Company. On January 12, 2007, the members of Woodcliff sold 100% of their outstanding membership interests in Woodcliff to Hythiam. For the three and nine months ended September 30, 2008, CBC paid HAN consulting fees of $0 and $9,000, respectively, and $12,000 and $48,000 for the three and nine months ended September 30, 2007, respectively. In March 2008, CBC terminated the marketing agreement.

In February 2006, CBC entered into an agreement with Hythiam whereby CBC would have the exclusive right to market Hythiam’s substance abuse disease management program to its current and certain mutually agreed upon prospective clients. The program is an integrated disease management approach designed to offer less restrictive levels of care in order to minimize repeat detoxifications. Under the agreement, CBC will pay Hythiam license and service fees for each enrollee who is treated. As of September 30, 2008, there have been no material transactions resulting from this agreement.

In late 2007, CBC contracted with Integra Health Management, Inc. (“IHM”), a company that provides behavioral and medical health management and consultative services to healthcare payers. IHM was founded by one of our directors, Michael Yuhas, who also serves as its current Chief Executive Officer. During the three and nine months ended September 30, 2008, CBC paid IHM $27,300 and $82,700, respectively, for monitoring and care coordination of intensive case management patients. In addition, for the three and nine months ended September 30, 2008, IHM provided $27,000 and $113,250, respectively, of information technology consulting services to CBC.

As a subsidiary of Hythiam, we have worked in conjunction with Hythiam to achieve cost savings on the combined purchase of certain services and insurance coverages. In addition, the consolidation of our financial results into those of Hythiam required us in 2007 to accelerate our Sarbanes-Oxley Act compliance efforts, an expense paid for by Hythiam but for which we will be partially responsible. To cover expected reimbursements to Hythiam for these costs, approximately $173,000 is included in accounts payable and accrued liabilities in the accompanying consolidated balance sheet at September 30, 2008.

In addition to historical information, the following information contains forward-looking statements as defined under federal securities laws. Such statements include, but are not limited to, statements concerning our anticipated operating results, financial resources, increases in revenues, increased profitability, interest expense, growth and expansion, and the ability to obtain new behavioral healthcare contracts. These statements are based on current expectations, estimates and projections about the industry and markets in which we operate, and management’s beliefs and assumptions. Forward-looking statements are not guarantees of future performance and involve certain known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Such risks and uncertainties include, but are not limited to, changes in local, regional, and national economic and political conditions, the effect of governmental regulation, competitive market conditions, varying trends in member utilization, our ability to manage healthcare operating expenses, our ability to achieve expected results from new business, the profitability of our capitated contracts, cost of care, seasonality, our ability to obtain additional financing, and other risks detailed herein and from time to time in our SEC reports. The following discussion should be read in conjunction with the accompanying consolidated financial statements and notes thereto of CompCare appearing elsewhere herein.

OVERVIEW

GENERAL

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

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

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on behalf of:

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

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

We typically enter into contracts on an annual basis to provide managed behavioral healthcare and substance abuse treatment to our clients’ members. Our arrangements with our clients fall into two broad categories:

or perform various managed care services.

Under capitation arrangements, the number of covered members as reported to us by our clients determines the amount of premiums we receive, which is independent of the cost of services rendered to members. The amount of premiums we receive for each member is fixed at the beginning of the contract term. These premiums may be subsequently adjusted, up or down, generally at the commencement of each renewal period.

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

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

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RECENT DEVELOPMENTS

In October 2008 we were awarded Full Accreditation by the National Committee on Quality Assurance (NCQA). NCQA accreditation validates that we meet managed behavioral healthcare organization (MBHO) accreditation standards that govern quality improvement, utilization management, provider credentialing, members’ rights and responsibilities, and preventative care. These standards confirm that an MBHO is founded on principles of quality and is continuously improving the clinical care and services it provides. Full Accreditation is granted for a period of three years to those plans that meet the NCQA’s rigorous standards.

In October 2008, we signed a letter of agreement to provide behavioral health and psychotropic pharmaceutical management services for a health plan with approximately 10,000 Medicare members in Puerto Rico. Services under the contract are expected to generate $1.0 million of annual revenue and will be provided through our newly formed, majority owned subsidiary, CompCare de Puerto Rico, Inc. Managed behavioral health services are expected to begin December 1, 2008 while pharmaceutical management services are anticipated to commence January 1, 2009.

At the end of September 2008, we became aware that our major Indiana client had decided to manage its plan membership through its own provider delivery system. Consequently our contract will not be renewed beyond its initial two-year term and will end December 31, 2008. Revenues for this client accounted for $13.3 million, or 48.6%, and $11.4 million, or 41.2%, of our operating revenues for the nine-month periods ending September 30, 2008 and 2007, respectively. To offset the loss of this contract, we have increased our sales and marketing efforts, which has increased our sales pipeline of potential new business. Our new contract in Puerto Rico is a result of these efforts and will partially replace the business lost in Indiana.

In August 2008, our HMO client in Maryland notified us that our contract for the HMO’s Maryland membership would not be renewed and would end December 31, 2008. Services provided under this contract accounted for approximately $1.4 million, or 5.1%, and $1.0 million, or 3.6% our revenues for the nine-month periods ended September 30, 2008 and 2007, respectively.

On June 19, 2008 the court awarded $325,000 in fees and expenses to attorneys for plaintiffs that had filed two class action lawsuits against the Company in January 2007 seeking to prevent Hythiam from acquiring outstanding common shares it did not own pursuant to a plan of merger between CompCare and Hythiam. The merger was terminated in May 2007 rendering the lawsuits moot, but plaintiffs’ attorneys’ claims for fees and expenses remained, resulting in the judgment against us for $325,000. Our claim for coverage of the judgment by our directors’ and officers’ insurance policy was initially denied, necessitating the accrual of $325,000 of expense in our June 30, 2008 financial statements. However, after appeal of the determination, the insurance carrier agreed to cover the judgment. We have accordingly accrued in our financial statements as of September 30, 2008 a reduction in expense of $300,000 representing management’s estimate of the reimbursable amount of the judgment and related legal fees, less the $100,000 policy deductible, which has previously been paid. We are currently covered under Hythiam’s directors’ and officers’ insurance policy and have not experienced any increases in our premiums. See Part II, Item 1, “Legal Proceedings.”

In March 2008, we signed an amendment to our agreement with our major Indiana client, which accounted for 48.6% of our total revenue for the nine months ended September 30, 2008. Effective January 1, 2008, we became eligible to receive a 15.9% rate increase, or approximately $200,000 per month, subject to meeting monthly performance measures. We met or exceeded all performance measures for the nine months ended September 30, 2008.

RESULTS OF OPERATIONS

For the nine months ended September 30, 2008, we reported a net loss of $4.8 million, or $0.62 loss per share (basic and diluted). In comparison, we reported a net loss of $2.7 million, or $0.35 loss per share (basic and diluted), for the nine months ended September 30, 2007.

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The following tables summarize the Company’s operating results from continuing operations for the three and nine months ended September 30, 2008 and 2007 (amounts in thousands):

THE THREE MONTHS ENDED SEPTEMBER 30, 2008 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 2007:

Operating revenues from capitated contracts decreased 13.8%, or $1.3 million, to $8.2 million for the three months ended September 30, 2008 compared to $9.5 million for the three months ended September 30, 2007. The decrease is attributable to the loss of four contracts accounting for $2.2 million of business in Pennsylvania, Texas and Indiana, partially offset by increased business from five clients in Indiana, Maryland, Texas and Michigan accounting for approximately $0.9 million of revenue. Non-capitated revenue decreased 17.6% or approximately $51,000, to $239,000 for the three months ended September 30, 2008, compared to $290,000 for the three months ended September 30, 2007.

Claims expense on capitated contracts decreased approximately $1.7 million or 21.4% for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 due to lower capitated revenues. Claims expense as a percentage of capitated revenues decreased from 81.3% for the three months ended September 30, 2007 to 74.1% for the three months ended September 30, 2008 due to seasonal fluctuations in medical loss ratios. Other healthcare operating expenses, attributable to servicing both capitated contracts and non-capitated contracts, decreased 15.4%, or approximately $257,000 due primarily to the elimination of temporary personnel services as well as a general reduction in the number of employees during the current quarter. In addition, the loss reserve related to our Indiana contract was reduced by $65,000.

General and administrative expenses decreased by 56.0%, or approximately $672,000 for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007. The change is primarily attributable to a reduction in legal fees of $266,000 and the recognition in the quarter ended September 30, 2007 of $416,000 in severance costs incurred as a result of the retirement of the Company’s CEO, who was due a payment equal to two years salary upon resignation within one year following a change of ownership of the Company. General and administrative expense as a percentage of operating revenue decreased from 12.3% for the three months ended September 30, 2007 to 6.3% for the three months ended September 30, 2008.

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THE NINE MONTHS ENDED SEPTEMBER 30, 2008 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 2007:

Operating revenues from capitated contracts decreased 1.0%, or approximately $279,000 to $26.5 million for the nine months ended September 30, 2008 compared to $26.8 million for the nine months ended September 30, 2007. The change is primarily attributable to $4.5 million of additional business from four existing customers in Pennsylvania, Maryland, Michigan, Texas and Indiana, offset by the loss of three clients in Indiana and Texas accounting for approximately $4.4 million of revenue, as well as a decrease in revenues from one customer in Texas accounting for approximately $277,000. Non-capitated revenue decreased 3.1% or approximately $26,000, to $809,000 for the nine months ended September 30, 2008, compared to $835,000 for the nine months ended September 30, 2007.

Claims expense on capitated contracts increased approximately $1.8 million or 8.1% for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 due to a higher medical loss ratios related to clients in Indiana, Pennsylvania, and Maryland. Accordingly, claims expense as a percentage of capitated revenues increased from 82.7% for the nine months ended September 30, 2007 to 90.4% for the nine months ended September 30, 2008. Other healthcare expenses, attributable to servicing both capitated contracts and non-capitated contracts, increased 3.0%, or approximately $143,000 due primarily to a loss reserve of $300,000 that was established at June 30, 2008 for our Indiana contract, which accounted for 48.6% of our revenue for the nine months ended September 30, 2008. The contract was determined to have a premium deficiency, which exists when the present value of future benefits payments and healthcare expenses are greater than the present value of expected future premiums. Of the $300,000 reserve established for our Indiana contract at June 30, 2008, $235,000 remains at September 30, 2008 as a reserve for the remainder of the contract, which terminates December 31, 2008 as a result of the client’s decision to manage the membership using its own delivery system.

General and administrative expenses decreased by 6.8%, or approximately $218,000 for the nine months ended September 30, 2008 when compared to the nine months ended September 30, 2007. The decrease is primarily due to a $143,000 reduction in director’s fees and a $320,000 decrease in salaries expense resulting from the recognition in August 2007 of $416,000 in severance costs due to the retirement of the Company’s CEO. These decreases were offset by increased consulting fees of $262,000 for compliance and information system management services and $45,000 in additional compensation expense from stock options due to option grants subsequent to September 30, 2007. General and administrative expense as a percentage of operating revenue decreased from 11.6% for the nine months ended September 30, 2007 to 11.0% for the nine months ended September 30, 2008.

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SEASONALITY OF BUSINESS

Historically, we have experienced increased member utilization during the months of March, April and May, and consistently low utilization by members during the months of June, July, and August. Such variations in member utilization impact our costs of care during these months, generally having a positive impact on our gross margins and operating profits during the June through August period and a negative impact on our gross margins and operating profits during the months of March through May.

CONCENTRATION OF RISK

For the nine months ended September 30, 2008, 88.3% of our operating revenue was concentrated in contracts with four health plans to provide behavioral healthcare services under commercial, Medicare, Medicaid, and CHIP plans. Our contracts with two of these health plans, constituting 69.1% of our operating revenue, will end December 31, 2008. For the nine months ended September 30, 2007, 86.7% of our operating revenue was concentrated in contracts with six health plans. The term of each contract is generally for one year and is automatically renewable for additional one-year periods unless terminated by either party by giving the requisite written notice. The loss of one or more of these clients, unless replaced by new business, would negatively affect our financial condition.

LIQUIDITY AND CAPITAL RESOURCES

During the nine months ended September 30, 2008, net cash used in operations totaled $5.5 million, attributable primarily to payment of claims on our Indiana, Pennsylvania, and Maryland contracts which have experienced high utilization of services by members. Approximately $1.5 million of the total cash usage was due to a timing difference in the monthly capitation remittance from our large Indiana client, which was received in October 2008. In addition, approximately $0.7 million in cash was used to pay accrued claims payable relating to three contracts that terminated during the quarter ended December 31, 2007, and $410,000 was used to make a contractually required severance payment to our former Chief Executive Officer. Cash used in investing activities is comprised of $41,000 in additions to property and equipment offset by $20,000 in proceeds from payments received on notes receivable. In September 2008 private placements of our common stock were completed generating $125,000 in cash proceeds and a convertible promissory note was issued in the amount of $200,000, providing additional funds for working capital purposes. Other cash flows from financing activities consist of repayment of debt of $41,000. At September 30, 2008, cash and cash equivalents were approximately $1.1 million.

At September 30, 2008, we had a working capital deficit of $5.2 million and a stockholders’ deficit of $8.7 million. During June and July of 2008, we reduced our usage of consultants and temporary employees as well as eliminated permanent staffing positions. In addition we implemented a 10% salary reduction for employees at the vice president level and above and have reduced outside directors fees by 10%. We have also requested rate increases from several of our existing clients.

The significant decrease in our cash position is primarily attributable to our major Indiana contract, which ends December 31, 2008. To reduce the claim expenses of this contract, we have implemented additional utilization and case management procedures. We are also in the process of negotiating a rate increase. If the rate increase is realized we would also receive a lump sum payment to offset past contract expenses. Management believes the combination of the rate increase and lump sum payment would provide sufficient cash to cover the claims run-out after the contract ends. We can provide no assurance that we will be successful in our negotiations with this client. If we are unsuccessful, we will need to raise additional equity capital or seek additional debt financing to fund the claims run-out from this contract.

During the nine months ended September 30, 2007, our cash and cash equivalents increased by $1.5 million, primarily due to timing differences of monies received from our Indiana contract that started January 1, 2007 and claims received for payment from our providers related to this contract. Cash flows attributed to investing activities consist primarily of $55,000 in outflows for additions to property and equipment offset by $30,000 in cash provided by proceeds from sales of available-for-sale securities.

Our unpaid claims liability is estimated using an actuarial paid completion factor methodology and other statistical analyses. These estimates are subject to the effects of trends in utilization and other factors. Any significant increase in member utilization that falls outside of our estimations would increase healthcare operating expenses and may impact our ability to achieve and sustain profitability and positive cash flow. Although considerable variability is inherent in such estimates, we believe that our unpaid claims liability is adequate. However, actual results could differ from the $6.4 million claims payable amount reported as of September 30, 2008.

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LIMITED CASH AVAILABILITY

As of October 31, 2008, we had net cash on hand of approximately $1.1 million. Excluding non-current accrued liability payments, our current plans call for expending cash at a rate of approximately $300,000 to $400,000 per month. At presently anticipated rates, we will need to obtain additional funds within the next two to three months to avoid ceasing or drastically curtailing our operations.

If we are not able to obtain a rate increase or significant additional payment from our major Indiana client within that time frame, it is likely we will need to raise additional equity capital, sell all or a portion of our assets, or seek additional debt financing to fund our operations during the fourth quarter of 2008. Any equity financing may result in substantial dilution of existing stockholders, and financing may not be available on acceptable terms, or at all. In addition, we need Hythiam’s consent for any single or series of related transactions exceeding $500,000, and prior to incurring any debt in excess of $200,000. Hythiam is under no obligation to provide us with any form of financing, and we do not currently anticipate receiving a cash investment from it. We may not be successful in obtaining needed funds, and if funding is obtained it may be on terms considered unfavorable to us or our existing shareholders.

SPECIAL COMMITTEE

In October 2007, our board of directors formed a special committee currently comprised solely of independent directors, which together with professional advisors, has been evaluating and pursuing available strategic alternatives for enhancing stockholder value, including a possible sale of the company.

GOING CONCERN

We have incurred significant operating losses and negative cash flows from operating activities, and have limited available cash, which raises substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to obtain a rate increase from our major Indiana client, reduce expenditures and attain further operating efficiencies, and, ultimately, to generate greater revenue. There can be no assurance that we will be successful in our efforts to obtain a rate increase from our major Indiana client, generate, increase, or maintain revenue, or raise additional capital on terms acceptable to us, or at all, or that we will be able to continue as a going concern.

Failure to obtain sufficient cash to fund ongoing operations and, ultimately to achieve profitable operations and positive cash flows from operations during the remaining period in 2008 would adversely affect our ability to achieve any business objectives and to continue as a going concern. There can be no assurance as to the availability of needed funding and, if available, that the source of funds would be available on terms and conditions acceptable to us, or that we will be able to achieve profitable operations and positive cash flows. The inability or failure to raise funds before our available cash is depleted will have a material adverse effect on our business and may result in discontinuation of operations.

CRITICAL ACCOUNTING ESTIMATES

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

We believe our accounting policies specific to revenue recognition, accrued claims payable, premium deficiencies, goodwill, and stock compensation expense involve our most significant judgments and estimates that are material to our consolidated financial statements (see Note 1 – “Description of the Company’s Business and Basis of Presentation” to the unaudited, consolidated financial statements).

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REVENUE RECOGNITION

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

Under our major Indiana contract, which will end December 31, 2008, approximately $200,000 of our monthly revenue is dependent on our satisfaction of various monthly performance criteria. The revenue is recognized only after verification that the specified performance targets have been achieved.

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

ACCRUED CLAIMS PAYABLE AND CLAIMS EXPENSE

Healthcare operating expenses are composed of claims expense, other healthcare expenses, and reserves for loss contracts. Claims expense includes amounts paid to hospitals, physician groups and other managed care organizations under capitated contracts. Other healthcare expenses include items such as information systems, case management and quality assurance, attributable to both capitated and non-capitated contracts. Reserves for loss contracts is the present value of future benefits payments and healthcare expenses less the present value of expected future premiums (see – “Premium Deficiencies”).

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

Accrued claims payable consists primarily of reserves established for reported claims and IBNR claims, which are unpaid through the respective balance sheet dates. Our policy is to record management’s best estimate of IBNR. The IBNR liability is estimated monthly using an actuarial paid completion factor methodology and is continually reviewed and adjusted, if necessary, to reflect any change in the estimated liability as more information becomes available. In deriving an initial range of estimates, we use an industry accepted actuarial model that incorporates past claims payment experience, enrollment data and key assumptions such as trends in healthcare costs and seasonality. Authorization data, utilization statistics, calculated completion percentages and qualitative factors are then combined with the initial range to form the basis of management’s best estimate of the accrued claims payable balance.

At September 30, 2008, the range of accrued claims payable was between $6.1 million and $6.9 million. Based on the information available, we determined our best estimate of the accrued claims liability to be $6.4 million. Approximately $3.0 million of the $6.4 million accrued claims payable balance at September 30, 2008 is attributable to our major Indiana client. At December 31, 2007, the accrued claims payable range was between $4.9 and $5.5 million, and our best estimate was determined to be $5.5 million. We have used the same methodology and assumptions for estimating the IBNR portion of the accrued claims liability for each quarter-end.

Accrued claims payable at September 30, 2008 and December 31, 2007 is comprised of approximately $1.8 million and $1.1 million, respectively, of submitted and approved claims, which had not yet been paid, and $4.6 million and $4.4 million for IBNR claims, respectively.

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

A 5% increase in assumed healthcare cost trends from those used in our calculations of IBNR at September 30, 2008, could increase our claims expense by approximately $129,000 and reduce our net results per share by $0.02 per share as illustrated in the table below:

PREMIUM DEFICIENCIES

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

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

On a quarterly basis, we perform a review of our portfolio of contracts for the purpose of identifying loss contracts (as defined in the American Institute of Certified Public Accountants Audit and Accounting Guide – Health Care Organizations) and developing a contract loss reserve, if applicable, for succeeding periods. Other than our Indiana contract, which was determined to be a loss contract at June 30, 2008, we did not identify any additional contracts for which it is probable that a loss will be incurred during the remaining contract term at September 30, 2008. Of the $300,000 reserve established for our Indiana contract at June 30, 2008, $235,000 remains at September 30, 2008 as a reserve for the remainder of the contract, which terminates December 31, 2008.

GOODWILL

We evaluate at least annually the amount of our recorded goodwill by performing an impairment test that compares the carrying amount to an estimated fair value. In estimating the fair value, management makes its best assumptions regarding future cash flows and a discount rate to be applied to the cash flows to yield a present, fair value of equity. We most recently performed an impairment test as of June 30, 2008 and determined that no impairment of goodwill had occurred as of such date. However, actual results may differ significantly from management’s assumptions, resulting in potentially adverse impact to our consolidated financial statements.

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STOCK COMPENSATION EXPENSE

We issue stock-based awards to our employees and members of our Board of Directors. Effective June 1, 2006, we adopted SFAS 123R and elected to apply the modified-prospective method to measure compensation cost for stock options at fair value on the grant date and recognize compensation cost on a straight-line basis over the service period for those options expected to vest. We use the Black-Scholes option pricing model, which requires certain variables for input to calculate the fair value of a stock award on the grant date. These variables include the expected volatility of our stock price, award exercise behaviors, the risk free interest rate, and expected dividends. We use significant judgment in estimating expected volatility of the stock, exercise behavior and forfeiture rates.

Expected Volatility

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

Expected Term

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

Expected Forfeiture Rate

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

LEGAL PROCEEDINGS

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business. Aside from the prior litigation described in Part II, Item 1, “Legal Proceedings,” as of the date of this report, we are not currently involved in any legal proceeding that we believe would have a material adverse effect on our business, financial condition or operating results.

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

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report (September 30, 2008), as is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Our disclosure controls and procedures are intended to ensure that the information we are required to disclose in the reports that we file or submit under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as the principal executive and financial officers, to allow timely decisions regarding required disclosures.

Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective. Our management has concluded that the financial statements included in this report present fairly, in all material respects our financial position, results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles.

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It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system will be met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events.

Changes in Internal Control

There have been no changes in our internal control over financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.

PART II – OTHER INFORMATION

We and nine current and former board members were named as defendants in two class action lawsuits filed by two shareholders on January 23, 2007 and February 1, 2007, respectively, regarding a proposed merger between CompCare and Hythiam. On May 25, 2007, we mutually terminated the Agreement and Plan of Merger. The lawsuits were subsequently dismissed as moot, but requests for attorney fees by plaintiffs remained pending. On June 19, 2008, the Chancery Court awarded $325,000 in fees and expenses to plaintiff’s counsel. Our claim for coverage of the judgment under our directors’ and officers’ insurance policy was initially denied necessitating the accrual of $325,000 of expense in our June 30, 2008 financial statements. However, after appeal of the determination, the insurance carrier agreed to cover the judgment. We have accordingly accrued in our consolidated financial statements as of September 30, 2008 a reduction in expense of $300,000 representing management’s estimate of the reimbursable amount of the judgment and related legal fees, less the $100,000 policy deductible, which has previously been paid. We are currently covered under Hythiam’s directors’ and officers’ insurance policy and have not experienced any increases in our premiums.

The Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2007 have not materially changed.

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SIGNATURES

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

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