**UNITEDSTATES********SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM10-Q**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND  EXCHANGE ACT OF 1934**                                                                                                                                |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                       |
| ** ** | ** ** | **For  the quarterly period ended March 31, 2006**                                                                                                                                                                                    |
|       |       |                                                                                                                                                                                                                                       |
| **OR**     |
|       |       |                                                                                                                                                                                                                                       |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934**                                                                                                                                |
|       |       |                                                                                                                                                                                                                                       |
| ** ** | ** ** | **For  the transition period from                    to                 ** |

 

**Commission file number 0-27444**

 

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**SOURCECORP,INCORPORATED**

(Exact name of registrant as specified in its charter)

 
| **DELAWARE**                                                                | ** ** | **75-2560895**                       |
|-----------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization)              |       | (I.R.S. Employer Identification No.) |
|                                                                        |       |                                 |
| **3232 MCKINNEY AVENUE, SUITE 1000  DALLAS, TEXAS**                         | ** ** | **75204**                            |
| (Address of principal executive offices)                                    |       | (Zip code)                           |
|                                                                        |       |                                 |
| REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: **(214) 740-6500** |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes  ý  No  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.  (CheckOne):

 
| Large  Accelerated Filer o |   | Accelerated  Filer ý |   | Non-Accelerated  Filer o |
|----------------------------|--------|---------------------------|--------|--------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

Yeso No  ý

 

Asof****April 30, 2006, 15,684,952 shares ofthe registrant’s Common Stock, $.01 par value per share, were outstanding(excluding 516,599 shares of unvested restricted stock).

 

 

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**FORM 10-Q FOR THE PERIOD ENDED MARCH 31, 2006**

 

**INDEX**

 
| **PART I.  FINANCIAL INFORMATION** |                                                                                                                 |
|-----------------------------------------|----------------------------------------------------------------------------------------------------------------------|
|                                    |                                                                                                                 |   |
| Item 1                                  | Financial Statements                                                                                                 |   |
|                                    |                                                                                                                 |   |
|                                    | Condensed Consolidated  Balance Sheets — December 31, 2005 and March 31, 2006 (unaudited)             |   |
|                                    |                                                                                                                 |   |
|                                    | Condensed Consolidated  Statements of Operations — Three months ended March 31, 2005 and 2006  (unaudited) |   |
|                                    |                                                                                                                 |   |
|                                    | Condensed Consolidated  Statements of Cash Flows — Three months ended March 31, 2005 and 2006  (unaudited) |   |
|                                    |                                                                                                                 |   |
|                                    | Notes to Condensed  Consolidated Financial Statements (unaudited)                                                    |   |
|                                    |                                                                                                                 |   |
| Item 2                                  | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                          |   |
|                                    |                                                                                                                 |   |
| Item 3                                  | Quantitative and Qualitative  Disclosures about Market Risk                                                          |   |
|                                    |                                                                                                                 |   |
| Item 4                                  | Controls and Procedures                                                                                              |   |
|                                    |                                                                                                                 |   |
| **PART II.  OTHER INFORMATION**    |                                                                                                                 |
|                                    |                                                                                                                 |   |
| Item 1                                  | Legal Proceedings                                                                                                    |   |
|                                    |                                                                                                                 |   |
| Item 2                                  | Unregistered Sales of Equity  Securities and Use of Proceeds                                                         |   |
|                                    |                                                                                                                 |   |
| Item 6                                  | Exhibits                                                                                                             |   |
|                                    |                                                                                                                 |   |
| ** **                              | **SIGNATURES**                                                                                                       |   |
|                                    |                                                                                                                 |   |
| ** **                              | **Index to Exhibits**                                                                                                |   |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item 1.**                   **Financial Statements**

 

**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(IN THOUSANDS, EXCEPT SHARE DATA)**

 
| ** **                                                                                                                                                                                                              | ** ** | **December 31,  2005** | ** ** | **March 31,  2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                                                              | ** ** | **(Unaudited)**             | ** ** |
| **ASSETS**                                                                                                                                                                                                              |       |                        |       |                     |       |
| **CURRENT ASSETS:**                                                                                                                                                                                                     |       |                        |       |                     |       |
| Cash and cash equivalents                                                                                                                                                                                               |       | $                           | 2,317      |                     | $          | 1,990 |   |
| Accounts and notes receivable, less  allowance for doubtful accounts of $10,219 and $12,680, respectively                                                                                                               |       | 68,444                      |       | 79,741                   |       |
| Inventories                                                                                                                                                                                                             |       | 640                         |       | 616                      |       |
| Deferred income taxes                                                                                                                                                                                                   |       | 7,835                       |       | 7,528                    |       |
| Prepaid expenses and other current assets                                                                                                                                                                               |       | 6,921                       |       | 6,356                    |       |
| Total current assets                                                                                                                                                                                                    |       | 86,157                      |       | 96,231                   |       |
| **PROPERTY, PLANT AND EQUIPMENT,**net  of accumulated depreciation of $49,292 and $51,737, respectively                                                                                                                 |       | 39,939                      |       | 37,437                   |       |
| **GOODWILL**                                                                                                                                                                                                            |       | 286,101                     |       | 286,101                  |       |
| **INTANGIBLES,** net  of amortization of $2,525 and $2,731, respectively                                                                                                                                                |       | 4,079                       |       | 3,873                    |       |
| **OTHER NONCURRENT ASSETS**                                                                                                                                                                                             |       | 2,360                       |       | 2,343                    |       |
| Total assets                                                                                                                                                                                                            |       | $                           | 418,636    |                     | $          | 425,985 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                          |       |                        |       |                     |       |
| **CURRENT LIABILITIES:**                                                                                                                                                                                                |       |                        |       |                     |       |
| Accounts payable and accrued liabilities                                                                                                                                                                                |       | $                           | 48,982     |                     | $          | 45,874 |   |
| Current maturities of long-term obligations                                                                                                                                                                             |       | 128                         |       | 109                      |       |
| Income tax payable                                                                                                                                                                                                      |       | 242                         |       | 2,902                    |       |
| Total current liabilities                                                                                                                                                                                               |       | 49,352                      |       | 48,885                   |       |
| **LONG-TERM OBLIGATIONS,**  net of current maturities                                                                                                                                                                   |       | 37,924                      |       | 40,032                   |       |
| **DEFERRED INCOME TAXES**                                                                                                                                                                                               |       | 26,064                      |       | 25,981                   |       |
| **OTHER LONG-TERM OBLIGATIONS**                                                                                                                                                                                         |       | 935                         |       | 1,023                    |       |
| Total liabilities                                                                                                                                                                                                       |       | 114,275                     |       | 115,921                  |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                                                                       |       |                        |       |                     |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                                                                          |       |                        |       |                     |       |
| Preferred stock, $.01 par value, 1,000,000  shares authorized, no shares issued or outstanding                                                                                                                          |       | —                      |       | —                   |       |
| Common stock, $.01 par value, 26,000,000  shares authorized, 15,659,348 and 15,720,122 shares issued and 15,622,678 and  15,683,452 shares outstanding at December 31, 2005 and March 31,  2006, respectively |       | 157                         |       | 157                      |       |
| Additional paid-in-capital                                                                                                                                                                                              |       | 197,684                     |       | 192,857                  |       |
| Retained earnings                                                                                                                                                                                                       |       | 113,023                     |       | 117,551                  |       |
|                                                                                                                                                                                                                    |       | 310,864                     |       | 310,565                  |       |
| Less— Treasury stock, at cost, 36,670  shares                                                                                                                                                                      |       | (501                        | )          | (501                     | )          |
| Less— Deferred compensation                                                                                                                                                                                        |       | (6,002                      | )          | —                   |       |
| Total stockholders’ equity                                                                                                                                                                                         |       | 304,361                     |       | 310,064                  |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                         |       | $                           | 418,636    |                     | $          | 425,985 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

3

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(IN THOUSANDS, EXCEPT PER SHARE DATA)**

 
| ** **                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                             | ** ** | **2005**                               | ** ** | **2006** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                        | ** ** |
| **REVENUE**                                            |       | $                                      | 105,932    |   | $ | 105,283 |   |
| **COST OF  SERVICES EXCLUSIVE OF DEPRECIATION**        |       | 58,536                                 |       | 58,765 |   |
| **DEPRECIATION**                                       |       | 3,423                                  |       | 3,652 |   |
| Gross profit                                           |       | 43,973                                 |       | 42,866 |   |
| **SELLING,  GENERAL AND ADMINISTRATIVE EXPENSES**      |       | 30,221                                 |       | 34,309 |   |
| **AMORTIZATION**                                       |       | 206                                    |       | 206 |   |
| Operating income                                       |       | 13,546                                 |       | 8,351 |   |
| **OTHER  (INCOME) EXPENSE:**                           |       |                                   |       |   |   |
| Interest expense                                       |       | 1,211                                  |       | 511 |   |
| Interest income                                        |       | (45                                    | )          | (85 | ) |
| Other (income) expense, net                            |       | 315                                    |       | 217 |   |
| Income from continuing operations before  income taxes |       | 12,065                                 |       | 7,708 |   |
| **PROVISION  FOR INCOME TAXES**                        |       | 4,710                                  |       | 3,071 |   |
| **INCOME  FROM CONTINUING OPERATIONS**                 |       | 7,355                                  |       | 4,637 |   |
| **LOSS  FROM DISCONTINUED OPERATIONS, NET OF TAX**     |       | (221                                   | )          | — |   |
| **NET  INCOME**                                        |       | $                                      | 7,134      |   | $ | 4,637 |   |
| **NET  INCOME PER COMMON SHARE**                       |       |                                   |       |   |   |
| **BASIC**                                              |       |                                   |       |   |   |
| **Continuing  Operations**                             |       | $                                      | 0.47       |   | $ | 0.30 |   |
| **Discontinued  Operations**                           |       | (0.01                                  | )          | — |   |
| **Total**                                              |       | $                                      | 0.46       |   | $ | 0.30 |   |
| **DILUTED**                                            |       |                                   |       |   |   |
| **Continuing  Operations**                             |       | $                                      | 0.46       |   | $ | 0.29 |   |
| **Discontinued  Operations**                           |       | (0.01                                  | )          | — |   |
| **Total**                                              |       | $                                      | 0.45       |   | $ | 0.29 |   |
| **WEIGHTED  AVERAGE COMMON SHARES OUTSTANDING**        |       |                                   |       |   |   |
| **BASIC**                                              |       | 15,670                                 |       | 15,675 |   |
| **DILUTED**                                            |       | 15,963                                 |       | 16,169 |   |
|                                                        |            |                                        |            |  |  |  |  |  |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

4

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(IN THOUSANDS)**

 
| ** **                                                                                                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                                                   | ** ** | **2005**                               | ** ** | **2006** | ** ** |
| ** **                                                                                                                                                   | ** ** | **(Unaudited)**                        | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                                                                                   |       |                                   |       |   |   |
| Income from continuing operations                                                                                                                            |       | $                                      | 7,355      |   | $ | 4,637 |   |
| Adjustments to reconcile income to net cash  provided by (used in) operating activities:                                                                     |       |                                   |       |   |   |
| Depreciation and amortization                                                                                                                                |       | 3,629                                  |       | 3,858 |   |
| Deferred income tax provision (benefit)                                                                                                                      |       | (1,900                                 | )          | 223 |   |
| Stock based compensation expense                                                                                                                             |       | 631                                    |       | 961 |   |
| Loss on sale of property, plant and  equipment                                                                                                               |       | 15                                     |       | 210 |   |
| Change in operating assets and liabilities:                                                                                                                  |       |                                   |       |   |   |
| Accounts and notes receivable                                                                                                                                |       | (8,303                                 | )          | (11,092 | ) |
| Inventories, prepaid expenses and other  assets                                                                                                              |       | (1,441                                 | )          | 605 |   |
| Accounts payable and accrued liabilities                                                                                                                     |       | (4,435                                 | )          | 1,180 |   |
| Excess tax benefit from exercise of stock  options                                                                                                           |       | —                                 |       | (40 | ) |
| Net cash provided by (used in) operating  activities from continuing operations                                                                              |       | (4,449                                 | )          | 542 |   |
| Net cash provided by (used in) operating  activities from discontinued operations                                                                            |       | (171                                   | )          | — |   |
| Net cash provided by (used in) operating  activities                                                                                                         |       | (4,620                                 | )          | 542 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                                                                                   |       |                                   |       |   |   |
| Net proceeds received from divestitures                                                                                                                      |       | 224                                    |       | 45 |   |
| Purchase of property, plant and equipment                                                                                                                    |       | (5,705                                 | )          | (2,581 | ) |
| Proceeds from disposition of property,  plant and equipment                                                                                                  |       | 3                                      |       | 64 |   |
| Cash paid for acquisitions, net of cash  acquired                                                                                                            |       | (34                                    | )          | (1,000 | ) |
| Net cash used in investing activities from  continuing operations                                                                                            |       | (5,512                                 | )          | (3,472 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                                                                                   |       |                                   |       |   |   |
| Proceeds from exercise of common stock  options                                                                                                              |       | —                                 |       | 475 |   |
| Excess tax benefit from exercise of stock  options                                                                                                           |       | —                                 |       | 40 |   |
| Proceeds from long-term obligations                                                                                                                          |       | 52,975                                 |       | 57,782 |   |
| Principal payments on long-term obligations                                                                                                                  |       | (46,321                                | )          | (55,694 | ) |
| Net cash provided by financing activities  from continuing operations                                                                                        |       | 6,654                                  |       | 2,603 |   |
|                                                                                                                                                         |       |                                   |       |   |   |
| **NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**                                                                                                    |       | (3,478                                 | )          | (327 | ) |
| **CASH AND  CASH EQUIVALENTS,** beginning of period                                                                                                          |       | 3,722                                  |       | 2,317 |   |
| **CASH AND  CASH EQUIVALENTS,** end of period                                                                                                                |       | $                                      | 244        |   | $ | 1,990 |   |
| **SUPPLEMENTAL  DATA:**                                                                                                                                      |       |                                   |       |   |   |
| Cash paid for:                                                                                                                                               |       |                                   |       |   |   |
| Income taxes, net of income tax refunds                                                                                                                      |       | $                                      | 11         |   | $ | 146 |   |
| Interest                                                                                                                                                     |       | $                                      | 1,209      |   | $ | 521 |   |
| **NONCASH OPERATING  AND INVESTING TRANSACTIONS:**                                                                                                           |       |                                   |       |   |   |
| Common stock retained and retired related  to employee payroll tax obligations associated with restricted stock vesting  (0 and 16,726 shares, respectively) |       | $                                      | —     |   | $ | (411 | ) |
| Accrued proceeds from disposition of property,  plant and equipment                                                                                          |       | $                                      | —     |   | $ | (250 | ) |
| Accrued capital expenditures                                                                                                                                 |       | $                                      | —     |   | $ | (908 | ) |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

5

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**1. Basis of Presentation**

 

Theaccompanying condensed consolidated financial statements and related notes tothe condensed consolidated financial statements include the accounts ofSOURCECORP, Incorporated and subsidiaries (collectively, the “Company”).  All significant intercompany accounts andtransactions have been eliminated in consolidation. These condensedconsolidated financial statements have been prepared by the Company, withoutaudit, pursuant to the rules and regulations of the Securities andExchange Commission (the “Commission”). Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to such rules and regulations.However, the Company believes that all disclosures are adequate to make theinformation presented not misleading. These condensed consolidated financial statements should be read inconjunction with the Company’s consolidated financial statements and therelated notes thereto in the Annual Report on Form 10-K filed with theCommission on March 31, 2006 as amended by Form 10-K/A filed with theCommission on April 26, 2006.

 

Inthe opinion of management, all adjustments necessary to fairly present theCompany’s financial position at March 31, 2006, and results of operationsand cash flows for the three months ended March 31, 2006 and 2005 havebeen included. The results of operations for the three months endedMarch 31, 2006 are not necessarily indicative of the results to beexpected for the full fiscal year or for any future periods.

 

TheCompany uses estimates and assumptions required for preparation of thefinancial statements. The estimates are primarily based on historicalexperience and business knowledge and are revised as circumstances change.However, actual results could differ from the estimates.

 

**2. Reserves and Other Loss Contingencies**

 

**Self-Insurance Liabilities and Reserves.**  TheCompany is self-insured for workmen’s compensation liabilities and asignificant portion of its employee medical costs. The Company accounts for itsself-insurance programs based on actuarial estimates of the amount of lossinherent in that period’s claims, including losses for which claims have notbeen reported. These loss estimates rely on actuarial observations of ultimateloss experience for similar historical events. The Company limits its risk bycarrying stop-loss policies for significant claims incurred for both workmen’scompensation liabilities and medical costs. The Company’s exposure under thestop-loss policies for workmen’s compensation and medical costs is limitedbased on fixed dollar amounts.  Forworkman’s compensation, the fixed dollar amount of stop-loss coverage is$500,000 per occurrence.  For medicalcosts, the fixed dollar amount of stop-loss coverage was $100,000 per coveredparticipant for the fiscal plan year ended June 30, 2005.  The stop-loss policy was renewed for oneyear, effective July 1, 2005.  The fixeddollar amount of stop-loss coverage under the new policy is $200,000 per coveredparticipant with a lifetime limit of liability per covered participant of $1,800,000.

 

Accrual balances related to workmen’s compensationand medical costs, included in accrued liabilities in the CondensedConsolidated Balance Sheets, are as follows (in thousands):

 
| ** **                   | ** ** | **December 31,  2005** | ** ** | **March 31,  2006** | ** ** |
|------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Workmen’s  Compensation |       | $                           | 2,288      |                     | $          | 2,410 |   |
| Employee  Medical Insurance  |       | 1,734                       |       | 2,103                    |       |
| Total                        |       | $                           | 4,022      |                     | $          | 4,513 |   |

 

**Other Loss Contingencies.**  TheCompany records liabilities when it is probable that a liability has beenincurred and the amount of the loss is reasonably estimable in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 5, *Accounting for Contingencies*.  Disclosure is required when there is areasonable possibility that the ultimate loss will exceed the recordedprovision. Contingent liabilities are often resolved over long periods of time.Estimating probable losses requires analysis of multiple forecasts that oftendepend on judgments about potential actions by third parties such asregulators. The Company’s loss contingencies consist primarily of estimatesrelated to the probable outcome of pending litigation.  See Note 8, Litigation.

 

**3. Stockholders’ Equity and Stock-Based Compensation**

 

*Stock-Based Compensation*

 

In2002, the Board of Directors and Shareholders of the Company approved theSOURCECORP, Incorporated 2002 Long-Term Incentive Plan (the “2002 Plan”), whichreplaced the 1995 Stock Option Plan, as amended (the “1995 Plan”). The 2002Plan 

 

6

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authorizesawards of options to purchase common stock and may include incentive stockoptions (“ISOs”) and/or non-qualified stock options (“NQSOs”), stockappreciation rights, restricted stock, deferred stock, bonus stock and awardsin lieu of cash obligations, dividend equivalents and other stock based awards.

 

TheBoard of Directors has appointed a committee (the “Committee”), which iscomposed of independent, non-employee directors, to administer the 2002 Plan.Persons eligible to receive awards under the plan include directors, officers,employees of the Company and its subsidiaries, and persons who provideconsulting services to the Company deemed by the Committee, or the Board as awhole, to be of substantial value to the Company, persons who have been offeredemployment by the Company or its subsidiaries, and persons employed by anentity that the Committee reasonably expects to become a subsidiary of theCompany. Awards granted under the 2002 Plan may, at the discretion of theCommittee, be granted either alone or in addition to, in tandem with or insubstitution for any other award granted under the 2002 Plan or any other planof the Company, any subsidiary or any business entity to be acquired by theCompany or one of its subsidiaries. The Committee determines vesting in awardsgranted under the 2002 Plan.

 

Prior to January 1, 2006, the Company accounted for its stock-basedcompensation plans under the provisions of Accounting Principles Board Opinion (“APB”)No. 25, *Accounting for Stock Issued toEmployees*, andrelated interpretations and applied the disclosure-only provisions of SFAS No123, *Accounting for Stock-Based Compensation*.   Accordingly, the Company recognizedcompensation expense related to grants of restricted stock awards, but nocompensation expense was recognized for grants of stock option and warrantawards as the exercise price of the stock option and warrant awards was equalto the market price of the common stock on the date of grant.

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issued SFASNo. 123(R), *Share-Based Payment*, which eliminatesthe alternative to account for employee stock options under APB No. 25 andrequires the fair value of all share-based payments to employees, including thefair value of grants of employee stock options, be recognized in the condensedconsolidated statements of operations, generally over the vesting period.  The pro-forma disclosures previouslypermitted under SFAS No. 123 are no longer an alternative to financialstatement recognition.

 

OnJanuary 1, 2006, the Company adopted SFAS No. 123(R) using the modifiedprospective transition method.  Underthis method, the Company will, on a prospective basis, recognize compensationexpense in the condensed consolidated statements of operations for (i) allstock-based awards granted prior to, but not yet vested as of January 1, 2006based on the grant date fair value estimated in accordance with the originalprovisions of SFAS No. 123 and (ii) all stock –based awards granted or modifiedsubsequent to January 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS No. 123(R).  Results from prior period have not beenrestated.

 

During the first quarter of 2006, the Company recognized approximately$0.2 million of compensation expense, included in Selling, General andAdministrative expenses in the Condensed Consolidated Statements of Operations,related to stock option and warrants awards granted prior to, but not yetvested as of January 1, 2006 as a result of adopting SFAS No. 123(R).  There were no grants or modifications tostock option or warrant awards during the three months ended March 31, 2006.

 

Priorto the adoption of SFAS No. 123(R), the Company presented all tax benefits fromdeductions resulting from the exercise of stock options as operating cash flowsin the its Condensed Consolidated Statements of Cash Flows.  SFAS No. 123(R) requires that the portion ofbenefits resulting from tax deductions in excess of recognized compensation(the “excess tax benefits”) be presented as financing cash flows.  The excess tax benefits were approximately$0.04 million for the first quarter of 2006 and would have been presented as anoperating cash inflow prior to the adoption of SFAS No. 123(R).  In addition, the Company previously presenteddeferred compensation as a separate component of Stockholders’ Equity.  In accordance with the provisions of SFAS No.123(R), the Company reclassified the deferred compensation balance toadditional paid-in-capital on its accompanying Condensed Consolidated Balance Sheets.

 

7

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The following table illustrates the effects on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS No. 123 to stock-based awards in the first quarter of 2005 (in thousands,except per share

information):

 
| ** **                                                                                                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2005**                               | ** ** |
| Net income as reported                                                                                                               |       | $                                      | 7,134      |   |
| Add: Deferred compensation expense included  in reported net income, net of related tax effect                                       |       | 385                                    |       |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of tax effect |       | (768                                   | )          |
| Proforma net income                                                                                                                  |       | $                                      | 6,751      |   |
|                                                                                                                                 |       |                                   |       |
| Earnings per share:                                                                                                                  |       |                                   |       |
| Reported basic earnings per share                                                                                                    |       | $                                      | 0.46       |   |
| Proforma basic earnings per share                                                                                                    |       | $                                      | 0.43       |   |
|                                                                                                                                 |       |                                   |       |
| Reported diluted earnings per share                                                                                                  |       | $                                      | 0.45       |   |
| Proforma diluted earnings per share                                                                                                  |       | $                                      | 0.42       |   |

 

During 2003, the Company awarded 164,300 shares of restricted stockunder the 2002 Plan. The restricted shares were issued at no cost to therecipients; therefore, the Company recorded deferred compensation ofapproximately $2.9 million based on the market value of the stock at thedate of issuance. Subsequent to the grant date, certain forfeitures ofrestricted stock occurred resulting in a total award of 154,000 shares andtotal deferred compensation of $2.8 million. The deferred compensationcharge is being amortized to expense over the vesting period of a three-yearperiod ending July 1, 2006, with acceleration of the vesting periodoccurring if a certain stock price or performance target is achieved.

 

During 2004, the Company awarded 182,550 shares of restricted stockunder the 2002 Plan. The restricted shares were issued at no cost to therecipients; therefore, the Company recorded deferred compensation ofapproximately $4.6 million based on the market value of the stock at thedate of issuance. Subsequent to the grant date, certain forfeitures ofrestricted stock occurred resulting in a total award of 177,300 shares and totaldeferred compensation of $4.5 million. The deferred compensation charge isbeing amortized to expense over the vesting period of the restricted stock. Therestricted shares vest on January 10, 2007 and May 26, 2007, withacceleration of the vesting period for certain shares occurring if certainperformance targets are achieved.

 

During 2005, the Company awarded 251,959 shares of restricted stockunder the 2002 Plan. The restricted shares were issued at no cost to therecipients; therefore, the Company recorded deferred compensation ofapproximately $4.8 million based on the market value of the stock at thedate of issuance. The deferred compensation charge is being amortized toexpense over the vesting period of the restricted stock. The restricted shares veston May 23, 2008, August 2, 2008 and December 18, 2009, withacceleration of the vesting period for certain shares occurring if certainperformance targets are achieved.

 

Deferredcompensation amortized to expense, included in Selling, General and Administrativeexpenses in the Condensed Consolidated Statements of Operations, related to therestricted stock grants discussed above is as follows (in thousands):

 
| ** **               | ** ** | **Three months ended  March 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| ** **               | ** ** | **2005**                               | ** ** | **2006** | ** ** |
| May 2003  grant     |       | $                                      | 238        |   | $ | 156 |   |
| January 2004  grant |       | 276                                    |       | 268 |   |
| May 2004  grant     |       | 117                                    |       | 104 |   |
| May 2005  grant          |       | —                                 |       | 247 |   |
| August 2005  grant       |       | —                                 |       | 5 |   |
| September  2005 grant    |       | —                                 |       | 6 |   |
| Total                    |       | $                                      | 631        |   | $ | 786 |   |

 

8

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*Net Income Per Share*

 

Basicand diluted net income per common share were computed in accordance with SFASNo. 128, *Earnings Per Share*.The differences between basic weighted average common shares and dilutedweighted average common shares and potentially dilutive common shares are asfollows (in thousands):

 
| ** **                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                               | ** ** | **2005**                               | ** ** | **2006** | ** ** |
| Basic  weighted average common shares                    |       | 15,670                                 |       | 15,675 |   |
| Weighted  average options, warrants and restricted stock |       | 293                                    |       | 494 |   |
| Diluted  weighted average common shares                  |       | 15,963                                 |       | 16,169 |   |

 

Approximately3.0 million and 2.3 million shares issuable under outstanding stock option andwarrant awards were not included in the diluted earnings per share calculationat March 31, 2005 and 2006, respectively, because they were anti-dilutive.  These common share equivalents may bedilutive in future earnings per share calculations.

 

**4.Discontinued Operations**

 

The condensedconsolidated statements of operations include loss from discontinuedoperations, net of tax, related to the divestitures in 2005 and 2004 asdiscussed below.

 

*2005 Divestiture*

 

During the first quarter of 2005, the Company formally committed to aplan of divestiture for a non-strategic asset group related to its litigationservice operations reported in the Healthcare, Regulatory and Legal Compliancesegment in prior periods.  Thenon-strategic asset group is accounted for as discontinued operations.  As such, the results associated with thisoperation are presented in the condensed consolidated statements of operationsas Loss from Discontinued Operations, net of tax.

 

During the first quarter of 2005, the Company completed the sale ofthis non strategic asset group, resulting in the recognition of a pre-tax lossof approximately $0.2 million.  Inconnection with this transaction, the Company received approximately $0.2million of cash proceeds and a promissory note of approximately $0.1 million.

 

9

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Summarizedselected financial information for the 2005 divestiture discussed above is asfollows (in thousands):

 
| ** **                                             | ** ** | **Three Months  Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                         | ** ** |
| **REVENUE**                                            |       | $                                       | 260        |   |
| **COST OF  SERVICES**                                  |       | 194                                     |       |
| **DEPRECIATION**                                       |       | 6                                       |       |
| Gross profit                                           |       | 60                                      |       |
| **SELLING,  GENERAL AND ADMINISTRATIVE EXPENSES**      |       | 191                                     |       |
| Operating loss                                         |       | (131                                    | )          |
| **OTHER  (INCOME) EXPENSE:**                           |       |                                    |       |
| Loss on sale of asset group                            |       | 168                                     |       |
| Loss from discontinued operations before  income taxes |       | (299                                    | )          |
| **PROVISION  (BENEFIT) FOR INCOME TAXES**              |       | (117                                    | )          |
| **LOSS  FROM DISCONTINUED OPERATIONS**                 |       | $                                       | (182       | ) |

 

*2004Divestitures*

 

During the first quarterof 2004, the Company completed a strategic evaluation of its operations basedon certain criteria, such as strategic and financial fit, and future growthprospects. As a result, on May 6, 2004, the Company formally committed toa plan of divestiture for certain non-strategic asset groups related to itsDirect Mail operations reported in the Information Management and Distributionsegment in prior periods, and two medical records management operationsreported in the Healthcare, Regulatory and Legal Compliance segment in priorperiods. The Direct Mail operations and the two medical records managementoperations are accounted for as discontinued operations. As such, the resultsassociated with these operations are presented in the condensed consolidatedstatements of operations as Loss from Discontinued Operations, net of tax.

 

Summarizedselected financial information for the 2004 divestitures discussed above is asfollows (in thousands):

 
| ** **                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                             | ** ** | **2005**                               | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                        | ** ** |
| **REVENUE**                                            |       | $                                      | 7          |   |
| **COST OF  SERVICES**                                  |       | 49                                     |       |
| **DEPRECIATION**                                       |       | —                                 |       |
| Gross profit                                           |       | (42                                    | )          |
| **SELLING,  GENERAL AND ADMINISTRATIVE EXPENSES**      |       | 4                                      |       |
| Operating loss                                         |       | (46                                    | )          |
| **OTHER  (INCOME) EXPENSE:**                           |       |                                   |       |
| Loss on sale of asset group                            |       | 17                                     |       |
| Loss from discontinued operations before  income taxes |       | (63                                    | )          |
| **PROVISION  (BENEFIT) FOR INCOME TAXES**              |       | (24                                    | )          |
| **LOSS  FROM DISCONTINUED OPERATIONS**                 |       | $                                      | (39        | ) |

 

10

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**5. Business Combinations**

 

*Intangibles*

 

The components of intangibles are as follows (inthousands):

 
| ** **             | ** ** | **December 31, 2005** | ** ** | **March 31, 2006**       | ** ** |
|------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Customer relationships |       | $                          | 4,283      |                          | $          | (1,350 | ) | $ | 4,283 |   | $ | (1,417 | ) |
| Non-compete agreements |       | 2,321                      |       | (1,175                        | )          | 2,321 |   | (1,314 | ) |
| Total                  |       | $                          | 6,604      |                          | $          | (2,525 | ) | $ | 6,604 |   | $ | (2,731 | ) |
|                        |            |                            |            |                               |            |  |  |  |  |  |  |  |  |  |

 

Aggregateamortization expense related to intangibles for the three months endedMarch 31, 2005 and 2006 was approximately $0.2 million and $0.2 million,respectively.  Estimated amortizationexpense for the years ending December 31, 2006 through December 31,2010 and thereafter is presented in the table below.

 

| **Years  Ending December 31,** | ** ** | **Estimated Amortization  Expense** | ** ** |
|-------------------------------------|------------|-------------------------------------|------------|
| ** **                          | ** ** | **(in thousands)**                  | ** ** |
| 2006                                |       | $                                   | 825        |   |
| 2007                                |       | 737                                 |       |
| 2008                                |       | 384                                 |       |
| 2009                                |       | 267                                 |       |
| 2010                                |       | 267                                 |       |
| Thereafter                          |       | 1,599                               |       |
| Total                               |       | $                                   | 4,079      |   |

* *

*Contingent Consideration*

 

Certainof the Company’s acquisitions were subject to adjustments in overallconsideration and recorded goodwill based upon the achievement of specifiedrevenue and/or earnings targets generally over one to three year periods. Incertain agreements, the Company reserves the right to change the payment mix touse common stock versus cash in satisfying contingent considerationliabilities.

 

Management’sevaluation of the cumulative earnings of acquired companies indicated that anacquired company met specified earnings targets beyond a reasonable doubt.  As result, at December 31, 2004, inconnection with the 2002 purchase of United Information Services, Inc. (“UIS”),approximately $5.3 million of additional consideration was accrued andclassified as other current liabilities in the consolidated balance sheet.  Pursuant to the terms of the UIS purchaseagreement, approximately $4.3 million of additional contingent considerationwas paid in cash to the former shareholders during the second quarter of 2005and approximately $1.0 million of additional contingent consideration was paidin cash to the former shareholders during the first quarter of 2006.

 

Asof December 31, 2004, all periods applicable for earnout targets of pastacquisitions were completed.  As of March31, 2006, all amounts due under earnout agreements of past acquisitions havebeen paid and there are no further amounts due.

 

**6. Segment Reporting**

 

TheCompany aggregates its service offerings and operations into two reportablesegments: (i) Information Management and

Distribution,and (ii) Healthcare, Regulatory, and Legal Compliance. The Company’sreportable segments are organized around customer types and service offeringspossessing similar economic characteristics. Management evaluates segmentperformance based on revenue and income before income taxes. All centrallyincurred corporate costs are allocated to the segments based principally onoperating income of the reportable segments. The reporting segments follow the same accounting policies used for theCompany’s consolidated financial statements.

 

Theidentified segments are as follows:

 

**Information Management and Distribution.**  Thissegment offers Business Process Outsourcing (“BPO”) solutions that help itscustomers manage the *Document In-flow*,*Workflow Processing* and *Statement Out-flow* of their missioncritical business document processes. This segment’s BPO solutions enablecustomers to automate their complex workflow processes by digitizing largevolumes of documents, capturing information from the documents, hostingelectronic documents on the Company’s Web-based repository, and preparingstatements that customers mail or present electronically to their end users.

 

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**Healthcare, Regulatory and Legal Compliance.**  Thissegment offers specialized knowledge-based processing and consulting servicesthat include medical records release, record management services for healthcareinstitutions, temporary staffing for healthcare institutions, providing managedcare compliance reviews, class action claims administration services, andprofessional economic research and litigation services.

 

TheCompany measures segment profit as income from continuing operations beforeincome taxes. Information on the segments follows (in thousands):

 
| ** **                                                    | ** ** | **THREE MONTHS ENDED MARCH 31, 2006**     | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                       |       | $                                              | 52,996     |   | $ | 52,287 |   | $ | 105,283 |   |
| Income (loss) from continuing operations  before income taxes |       | 3,271                                          |       | 4,437 |   | 7,708 |   |
|                                                               |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                             | ** ** | **THREE MONTHS ENDED MARCH 31, 2005**     | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 56,295     |   | $ | 49,637 |   | $ | 105,932 |   |
| Income from continuing operations before  income taxes |       | 5,816                                          |       | 6,249 |   | 12,065 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 

**7.  Potential Merger**

 

On March 8, 2006, the Company announced that it had entered intoan Agreement and Plan of Merger, dated as of March 7, 2006 (the “MergerAgreement”), among the Company, CorpSource Holdings, LLC (“Purchaser”) andCorpSource MergerSub, Inc. (“Merger Sub”). Purchaser and Merger Sub areentities affiliated with Apollo Management, L.P. (“Apollo”). The MergerAgreement contemplates that Merger Sub will be merged with and into the Company(the “Merger”) and each outstanding share of common stock of the Company willbe converted into the right to receive $25.00 per share in cash, withoutinterest. The consummation of the Merger is subject to various customaryconditions, including adoption of the Merger Agreement by the Company’sstockholders, expiration of the antitrust waiting period (which has expired),the absence of a material adverse change in the Company’s business and thereceipt of committed debt financing by Purchaser. No assurance can be giventhat such conditions will be satisfied or waived.  In the event the potential Merger closes, theCompany will incur additional transaction costs and expenses related toinvestment banker fees, outside legal counsel fees, change of control paymentsand acceleration of stock-based compensation vesting.

 

The Merger Agreement contains representations and warranties by theCompany, Purchaser and Merger Sub. The representations and warranties reflectnegotiations between the parties to the Merger Agreement and, in certain cases,merely represent allocation decisions among the parties and may not bestatements of fact. As such, the representations and warranties are solely forthe benefit of the parties to the Merger Agreement and may be limited ormodified by a variety of factors, including: subsequent events, informationincluded in public filings, disclosures made during negotiations,correspondence between the parties and disclosure schedules to the MergerAgreement. Accordingly, the representations and warranties may not describe theactual state of affairs at the date they were made or at any other time and youshould not rely on them as statements of fact.

 

**8.Litigation**

 

TheCompany is, from time to time, a party to litigation. The following is adescription of the most significant legal matters that the Company is involvedin.  In the event of an adverse outcomein one or more of the legal proceedings the Company’s business, financialcondition, results of operations or cash flows could be materially adverselyaffected.

 

*DavidcoLitigation*

 

OnMarch 8, 2006, a purported class action complaint (the “Davidco Complaint”)challenging the proposed Merger with entities affiliated with Apollo was filedby a putative stockholder of the Company in an action styled *Davidco Investments, on behalf of itself and all others similarlysituated v. Ed H. Bowman, Jr., et al.*, C.A. No. 1982-N (the “DavidcoAction”), pending in the Court of the Chancery of the State of Delaware, Countyof New Castle, against the Company, certain of its officers and directors (the “DavidcoIndividual Defendants”) and Apollo.  SeeNote 7, Potential Merger.  The DavidcoComplaint alleges a claim for breach of fiduciary duties against the DavidcoIndividual Defendants, alleging, among other things, that the consideration tobe paid to the stockholders of the Company in the Merger is unfair andinadequate and was not the result of a full and fair sale process or adequatemarket check.  The Davidco Complaint alsoasserts a claim against Apollo for allegedly aiding and abetting such purportedbreaches of fiduciary duties.

 

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The DavidcoComplaint seeks, among other relief, class certification, an injunctionpreventing completion of the Merger (or rescinding the Merger if it iscompleted prior to the receipt of such relief), compensatory and/or rescissorydamages to the class, attorneys’ fees and expenses, and such other relief asthe court might find just and proper. Defendants have moved to dismiss the Davidco Complaint and the motion isstill being briefed by the parties.

 

This matterhas been settled in principle.  See *Settlement of Litigation*, below.

 

*KabotaLitigation*

 

A purportedstockholder derivative action was filed on December 28, 2004, in an actionstyled *Howard Kabota, Derivatively on Behalf ofSourcecorp, Incorporated v. Thomas c. Walker, et al.*, CauseNo. 04-12854, pending in the District Court of the State of Texas, Countyof Dallas, 14th Judicial District, against certain of the Company’scurrent and former officers and directors as individual defendants and theCompany as a nominal defendant (the “Kabota I Action”).  In an amended petition (the “Kabota IPetition”), plaintiff alleges breach of fiduciary duty, abuse of control, grossmismanagement, waste of assets and unjust enrichment related to the allegationsunderlying a separate securities fraud action styled *In reSOURCECORP, Inc. Securities Litigation*, CaseNo. 3:04-CV-2351-N, pending in the United States District Court for theNorthern District of Texas, Dallas Division (the “Securities Litigation”)(further discussed below).  All of theseclaims are asserted derivatively on behalf of the Company and seek unspecifieddamages against those individuals.

 

Upon motion bythe defendants, the court entered an order staying the case datedSeptember 27, 2005, which stays all proceedings in the action forsuccessive sixty day periods while the special committee of the board ofdirectors (discussed below) considers the allegations raised in the Kabota IPetition.  At the end of each successivesixty day period, any party may file a motion requesting that the court reviewthe continued necessity of the stay.

 

In addition,on March 8, 2006, a shareholder derivative petition for breach offiduciary duty (the “Kabota II Petition”) was filed by a putative stockholderof the Company in an action styled *Howard Kabota,Derivatively On Behalf of Sourcecorp, Incorporated v. Thomas C. Walker, et al.*,Cause No. 06-02446 (the “Kabota II Action”) pending in the District Courtof the State of Texas, County of Dallas, D-95th Judicial District,against the Company and certain of its officers and directors (the “KabotaIndividual Defendants”).  The Kabota IIPetition alleges, among other things, that the consideration contemplated underthe Merger Agreement to be paid to the Company’s stockholders is unfair andinadequate.  See Note 7, PotentialMerger.  In addition, the Kabota IIPetition alleges a claim for breach of fiduciary duties against the KabotaIndividual Defendants, asserting, among other things, that the KabotaIndividual Defendants failed to properly value the Company, ignored or did notprotect against purported conflicts of interest of certain Kabota IndividualDefendants in connection with the Merger, and agreed to the Merger in awrongful attempt to insulate themselves from potential personal liabilityalleged in the Kabota I Action (discussed above).

 

The Kabota IIPetition seeks, among other relief, an injunction preventing completion of theMerger (or rescinding the Merger if it is completed prior to the receipt ofsuch relief), a direction that the Kabota Individual Defendants exercise theirfiduciary duties to obtain a transaction in the best interests of the Companyand its stockholders, restitution to the Company of any wrongful profits,benefits or other compensation obtained by the Kabota Individual Defendants,attorneys’ fees and expenses, and such other relief as the court might find justand proper.  The time for all thedefendants to answer, move or otherwise respond to the Petition has not yetrun.

 

These mattershave been settled in principle.  See *Settlement of Litigation*, below.

 

*FreeportProceedings*

 

On or aboutDecember 24, 2004, the Chairman of the board of directors received from apurported stockholder a demand letter (the “Demand Letter”) based onsubstantially the same facts as ultimately alleged in the Freeport Complaint(discussed below).  The Demand Letterrequests the board of directors to take certain action, but does not seekdamages against the Company.  The Companyhas formed a special committee of the board of directors that continues toevaluate the claims made in the Demand Letter, the Freeport Complaint and theKabota I Petition.

 

On or aboutOctober 21, 2005, a purported derivative and class action complaint (the “FreeportComplaint”) was filed by the same putative stockholder of the Company who sentthe Demand Letter in an action styled *Freeport Partners, LLC, Derivativelyon Behalf of Nominal Defendant Sourcecorp, Inc. v. Ed H. Bowman, et al.*,Civil Action No. 3:05-02085-N (the “Freeport Action”), pending in theUnited States District Court for the Northern District of Texas, DallasDivision, against certain officers and directors of the Company.  The Freeport Complaint asserts, among otherthings, claims against certain defendants, seeking forfeiture of certaincompensation, bonuses and profits pursuant to Section 304 of theSarbanes-Oxley Act and contribution to any settlement or judgment in connectionwith the Securities Litigation.  Inaddition, the Freeport Complaint alleges claims of breach of fiduciary dutiesand abuse of control against the defendants for allegedly causing or allowingthe Company purportedly to conduct its business in an imprudent or unlawfulmanner and allegedly disseminating materially false information to theinvesting public as alleged in the Securities Litigation.  Pursuant to an agreed order, datedNovember 18, 2005, all proceedings in this lawsuit were stayed pendingresolution of 

 

13

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the motions to dismiss filed inthe Securities Litigation.

 

On or aboutMarch 20, 2006, plaintiff filed a motion to lift the consensual stay sothat it may amend the Freeport Complaint. In papers filed with the motion, plaintiff stated that it wasconsidering amending the Freeport Complaint to add claims under the federalproxy laws relating, in part, to proxy materials filed in connection with themerger.  Defendants moved to opposeplaintiff’s motion to lift the consensual stay. On or about April 25, 2006, plaintiff filed a notice of voluntarilywithdrawing its motion to lift consensual stay.

 

This matterhas been settled in principle.  See *Settlement of Litigation*, below.

 

*Settlementof Litigation*

 

OnApril 28, 2006, the parties reached an agreement in principle to settlethe Davidco Action, the Kabota I Action, the Kabota II Action and the FreeportAction and on May 3, 2006 entered in to a memorandum of understanding (the“MOU”) reflecting the terms of the proposed settlement.  The proposed settlement is subject to courtapproval and certain other conditions. Under the terms of the MOU, the parties have agreed, among other things(i) to amend the Merger Agreement to reduce the termination fee payable bythe Company to Purchaser if the Merger Agreement is terminated under certaincircumstances from $15,000,000 to $12,500,000, (ii) to amend the MergerAgreement to allow the board of directors, subject to certain conditions, toprovide information to a third party, if any, who has indicated that such thirdparty will make a written proposal to acquire the Company, (iii) toinclude certain additional disclosures in the merger related proxy statement and(iv) not to object to plaintiffs’ counsel’s court application for an awardof attorney fees and expenses, provided that such application does not exceed$775,000 in fees and expenses in the aggregate. The MOU also contemplates that some discovery will be taken to confirmthe fairness of the proposed settlement. The original Merger Agreement was amended on May 3, 2006 to reducethe termination fee to $12,500,000 and to allow the board of directors, subjectto certain conditions, to provide information to a third party, if any, who hasindicated that such third party will make a written proposal to acquire theCompany.  The Company accruedapproximately $0.8 million in the first quarter of 2006 related to thesettlement.

 

*PutativeSecurities Class Action*

 

In the SecuritiesLitigation, the Company, and the Company’s Chief Executive Officer and ChiefFinancial Officer individually, have been named as defendants in severalputative securities class actions concerning the Company’s press releases datedOctober 27, 2004, in which the Company disclosed that its financialstatements for certain prior periods should no longer be relied on, and alsoprovided updated financial guidance.  Thecomplaints were filed in the United States District Court for the NorthernDistrict of Texas, Dallas Division, with the first action being filedNovember 1, 2004.  The complaintsallege violations of federal securities laws, including alleged violations ofSections 10(b) and 20(a), and Rule 10b-5 of the Exchange Act.  The four actions were transferred to a singlejudge in the Northern District of Texas, Dallas Division and consolidated intoa single action styled *In re Sourcecorp, Inc.Securities Litigation*, Case No. 3:04-CV-2351-N.  A lead plaintiff has been appointed for theconsolidated action.  In addition to theCompany and its Chief Executive Officer and Chief Financial Officer, one of itssubsidiaries and one of the former owners of that subsidiary are named asdefendants in the consolidated action. The consolidated action is purportedly on behalf of all persons whopurchased the Company’s common stock during the period between May 3,2001, and October 27, 2004, and seeks unspecified damages.  Defendants have all filed motions to dismissthe consolidated action and such motions are presently before the court.

 

*Various ROI Copy Charge Matters*

 

From time to time, various subsidiaries of the Company that performrelease of information (“ROI”) services become defendants to putative classaction lawsuits generally alleging that the charge for reproducing certainmedical records is not in conformity with such plaintiffs’ reading of theapplicable regulated charge. Such suits typically include multiple ROIcompanies and hospitals as defendants and demand reimbursement for priorcharges as well as for prospective pricing adjustments. The Company iscurrently a party to several such suits in various stages of development.

 

One such suit originally styled *McShanev. Recordex Acquisition Corp. & Sourcecorp, Incorporated*(and now styled *Liss & Marion, PCv. Recordex Acquisition Corp., & Sourcecorp, Inc.*)filed February 10, 2003, in the Court of Common Pleas Philadelphia County,Pennsylvania, alleges among other things that the Company intentionally chargedmore for providing copies of medical records than is permitted underPennsylvania law. The complaint does not specify the amount of damages sought.On June 10, 2005, the Court in this matter granted judgment in favor ofthe plaintiffs and on November 3, 2005, a separate hearing on damages washeld. Following such hearing, the Court assessed damages of approximately$0.5 million with interest, which the plaintiffs claim approximates$0.1 million. The Company is assessing its appellate options and believesit is adequately reserved for this as well as its other ROI putative copy classaction legal contingencies.

 

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*SEC Investigation*

 

OnJanuary 14, 2005, the Company received written confirmation from the SECthat the SEC had converted its informal inquiry in connection with the Company’sinternal investigation and restatement into a formal investigation. The Companyis continuing to fully cooperate with the SEC in connection with theinvestigation. The Company initially had contacted the enforcement division ofthe SEC on a voluntary basis to notify the agency of the Company’sunderstanding of the events leading to its internal investigation. The Companyis unable to predict the outcome of the investigation, the scope of mattersthat the SEC may choose to investigate in the course of this investigation orin the future, the SEC’s views of the issues being investigated, or any actionthat the SEC might take, including the imposition of fines, penalties, or otheravailable remedies.

 

**9. Internal Investigation**

 

DuringOctober 2004, the Company, with the oversight and approval of the AuditCommittee of the Board of Directors, initiated an investigation of thefinancial results of one of the Company’s operating subsidiaries in theInformation Management and Distribution reportable segment (the “OperatingSubsidiary”). The findings of the investigation concluded that the OperatingSubsidiary had incorrectly recognized revenue for certain customer arrangementsand omitted certain operating expenses from its reported financial resultswhich in turn resulted in overpayments and over accruals of contingentconsideration amounts due under the earnout provisions of the acquisitionagreement for the Operating Subsidiary. The overpayments and over accruals of contingent consideration amountswere originally recognized as additional goodwill of the acquired business.

 

Asdescribed in the Company’s critical accounting policies, revenue isrecognizable when each of the following conditions is met: persuasive evidenceof an arrangement exists, the price is fixed or determinable, delivery hasoccurred or services have been rendered and collection is reasonably assured.The investigation identified certain instances where one or more of theaforementioned revenue recognition conditions as applied to certain customercontracts were not met by the Operating Subsidiary. As a result, the revenuepreviously recognized that did not meet all the mentioned revenue recognitionconditions was reversed, resulting in a downward adjustment to certain assetaccounts or the recognition of a customer liability or deferred revenue.

 

During thefirst quarter of 2005, the Company entered into an agreement with one of itscustomers impacted by the facts relating to the subject of the internalinvestigation. As a result of the agreement, during the first quarter of 2005,the Company recognized remediation revenue of $4.1 million related torevenue reversals; however, such revenue did not contribute to the Company’soperating cash flow during 2005.

 

Additionally,during the first quarter of 2005, agreements from other customers impacted bythe facts relating to the subject of the internal investigation were receivedand the customers agreed to apply certain balances, classified as long-termcustomer liability and/or deferred revenue, against current trade accountsreceivable the Company had outstanding from such customers. The net amountapplied against trade accounts receivable during 2005 related to theseagreements was approximately $1.6 million.

 

During thesecond quarter of 2005, the Company entered into agreements with two additionalcustomers impacted by the facts relating to the subject of the internalinvestigation. As a result of the agreements, during the second quarter of2005, the Company recognized remediation revenue of $2.7 million relatedto revenue reversals; however, such revenue did not contribute to the Company’soperating cash flow during 2005.

 

During thethird quarter of 2005, the Company entered into an agreement with an additionalcustomer impacted by the facts relating to the subject of the internalinvestigation. As a result of the agreement, during the third quarter of 2005,the Company recognized remediation revenue of $1.4 million related torevenue reversals; however, such revenue did not contribute to the Company’soperating cash flow during 2005. Additionally, the customer agreed to applycertain balances, classified as deferred revenue, against current tradeaccounts receivable such customer had outstanding with the Company ofapproximately $0.1 million. At March 31, 2006, this customer has aremaining credit due from the Company of approximately $0.3 million. Theremaining credit may, at the discretion of the customer, be applied againstfuture trade accounts receivable balances and is reported in the consolidatedbalance sheets as accounts payable and accrued liabilities.

 

Noadditional agreements were entered into during the first quarter of 2006.  At March 31, 2006, approximately$1.9 million remains accrued related to other customers impacted by thefacts relating to the subject of the internal investigation. These balanceswill be recognized in accordance with the agreements negotiated and finalizedwith each applicable customer.

 

**10.Subsequent Event**

 

On May 10, 2006, the Company entered into anasset purchase agreement with Complete Claims Solutions, Inc. (“CCS”). Theasset purchase agreement contemplates a total purchase price of approximately$6.0 million, which includes potential future contingent payments described below.Approximately $3.7 million of the purchase price was paid in cash at closing. Approximately$0.5 million of the purchase price will be payable 120 days after closing,subject to offset in the event of breaches in representations or warranties ofthe asset purchase agreement. Approximately $1.8 million of contingentconsideration is potentially payable over the next three years based on theachievement of revenue targets outlined in the asset purchase agreement.

 

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**Item 2.**                   **Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

**Overview**

 

We were founded in September 1994, to create a national, singlesource provider of document and information outsourcing solutions to documentand information intensive industries, including healthcare insurance, financialservices, healthcare provider, transportation/logistics, federal and stategovernment, and legal industries. We acquired the seven founding companies (the “Founding Companies”)simultaneously with the closing of our initial public offering (the “IPO”) onJanuary 26, 1996, and effectively began operations at that time. Theconsideration for the Founding Companies consisted of a combination of cash andcommon stock of our Company.

 

Since the IPO and through March 31,2005, we have acquired 66 companies and divested 22 operating units by sales orclosures. We evaluate candidates for acquisition and periodically fordivestiture as a part of our strategic plan of providing customers a singlesolution for business process outsourcing and knowledge-based processing andconsulting services. The criteria for evaluation include geographic need,additional technology, market growth potential, industry expertise, serviceexpansion to broaden service offerings, expansion of our customer base, revenueand earnings growth potential, and expected sources and uses of capital.

 

Duringthe first quarter of 2005, we completed the sale of an asset group thatprovides computer application software and services to the public sector.  This asset group was related to ourlitigation services operations and was previously reported in our Healthcare,Regulatory and Legal Compliance segment. This asset group incurred losses, net of tax, of $0.2 million for thefull year ended December 31, 2004. See Note 4, Discontinued Operations, of Notes to Condensed ConsolidatedFinancial Statements, for a more detailed discussion.

 

Additionally, during the first quarter of2005, the Company entered into an agreement with one of its customers impactedby the facts relating to the subject of the internal investigation. As a resultof the agreement, during the first quarter of 2005, the Company recognizedremediation revenue of $4.1 million related to revenue reversals in 2004;however, such revenue did not contribute to our operating cash flow during 2005.

 

Duringthe first quarter of 2006, the Company recognized a previously anticipatedcontract termination payment/settlement of $2.6 million from a large governmentcustomer relating to a contract terminated in connection with a substantialchange in their operational plans.  As apart of such termination, we recognized revenue of approximately $1.5 million,which helped offset lower volumes from our mortgage and healthcare serviceofferings, and $1.1 million for cost recovery of actual cost incurred, whichwas recorded as an approximate $0.6 million reduction in Cost of Services, anapproximate $0.2 million reduction in Selling, General and AdministrativeExpenses and an approximate $0.3 million reduction of Other (Income) Expense inthe Condensed Consolidated Statements of Operations .  Our project oriented Class Action ClaimsAdministration service offering and Legal Consulting service offering reportedstronger revenues and margins.  Partiallyoffsetting these increases during the current quarter were incremental costsrelated to the potential Merger and higher than expected costs associated withongoing Sarbanes Oxley compliance and other expenses.

 

**Basis for Management Discussion and Analysis**

 

Thefollowing discussion and analysis focuses on the results of operations andfinancial condition from the Company’s continuing operations; as such, inaccordance with Statement of Financial Accounting Standards No. 144,references and comparisons to prior periods exclude the impact of ourdiscontinued operations.

 

Ourrevenue possesses both project and recurring characteristics.  Project revenue includes one-time projects inwhich the customer relationship is not expected to continue after projectcompletion. Project revenue margins are usually higher than our average marginsand the workload can be highly volatile. Project revenue is typically based on time and material arrangements andpredominately occurs within the Healthcare, Regulatory and Legal Compliancesegment.  Recurring revenue ischaracterized by customer relationships that are generally for one year and maycontinue for longer.  Recurring revenueis typically based on transaction volumes sent to us by our customers at anagreed upon fixed rate per unit.  Ourcustomers’ volumes are generally not contractually or otherwiseguaranteed.  Recurring revenue typicallypossesses lower margins than project revenue but is usually more predictable.

 

Costof services consists primarily of compensation and benefits to employeesproviding goods and services to our clients; occupancy costs; equipment costsand supplies. Our cost of services also includes, to a limited extent, the costof products sold for micrographics supplies and equipment; computer hardwareand software; and business imaging supplies and equipment.

 

Selling,general and administrative expenses (“SG&A”) consist primarily ofcompensation and related benefits to sales and marketing, executive management,accounting, human resources and other administrative employees; other sales andmarketing costs; communications costs; insurance costs; and legal andaccounting professional fees and expenses.

 

Inaddition, the Condensed Consolidated Financial Statements included in Item 1 “FinancialStatements”, should be read in 

 

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conjunctionwith our Consolidated Financial Statements and the related notes thereto in theAnnual Report on Form 10-K filed with the Securities and ExchangeCommission on March 31, 2006.

 

**Business Segments**

 

Weaggregate our service offerings and operations into two reportable segments:(i) Information Management and Distribution, and (ii) Healthcare,Regulatory, and Legal Compliance. Service offerings are aggregated when theyare similar in the following areas: economic characteristics, products andservices, production processes, methods for distributing or deliveringproducts, and type or class of customers. We evaluate segment performance basedon revenue and income before income taxes. All centrally incurred corporatecosts are allocated to the segments based principally on operating income ofthe reportable segments. The reporting segments follow the same accountingpolicies used for our Consolidated Financial Statements as described in thesummary of critical accounting policies.

 

Theidentified segments are as follows:

 

**Information Management and Distribution.**  Weoffer Business Process Outsourcing (“BPO”) solutions that help our customersmanage the *Document In-flow*, *Workflow Processing* and *Statement Out-flow* of their missioncritical business document processes. Our BPO solutions enable customers toautomate their complex workflow processes by digitizing extremely large volumesof documents, capturing information from the documents, hosting electronicdocuments on our Web-based repository, and preparing statements that customersmail or present electronically to their end users.  We offer our BPO solutions to businesses indocument intensive industries, such as healthcare insurance, financialservices, healthcare provider, transportation/logistics, and federal and stategovernment.  For the three months endedMarch 31, 2005 and 2006, revenue in the Information Management andDistribution segment consisted of approximately $47.9 million and $47.2 millionof recurring revenue, respectively, and $8.4 million and $5.8 million ofproject revenue, respectively.

 

**Healthcare, Regulatory and Legal Compliance.**  Weoffer specialized knowledge-based processing and consulting services thatinclude medical records release, record management services for healthcareinstitutions, temporary staffing for healthcare institutions, temporarystaffing for healthcare institutions, providing managed care payment compliancereviews, class action claims administration services, professional economicresearch and litigation services, and tax benefit services. For the threemonths ended March 31, 2005 and 2006, revenue in the Healthcare,Regulatory and Legal Compliance segment consisted of approximately $18.7million and $17.8 million of recurring revenue, respectively, and $30.9 millionand $34.5 million of project revenue, respectively.

 

**InternalInvestigation**

 

DuringOctober 2004, the Company, with the oversight and approval of the AuditCommittee of our Board of Directors, initiated an investigation of thefinancial results of one of our operating subsidiaries in the InformationManagement and Distribution reportable segment (the “Operating Subsidiary”).The findings of the investigation concluded that the Operating Subsidiary hadincorrectly recognized revenue for certain customer arrangements and omittedcertain operating expenses from its financial results which in turn resulted inoverpayments and over accruals of contingent consideration amounts due underthe earn-out provisions of the acquisition agreement for the OperatingSubsidiary.  The overpayments and overaccruals of contingent consideration amounts had been originally recognized asadditional goodwill of the acquired business.

 

As described in ourcritical accounting policies, revenue is recognizable when each of thefollowing conditions is met: persuasive evidence of an arrangement exists,the price is fixed or determinable, delivery has occurred or services have beenrendered and collection is reasonably assured. Our investigation identifiedcertain instances where one or more of the aforementioned revenue recognitionconditions as applied to certain customer contracts were not met by theOperating Subsidiary. As a result, the revenue previously recognized that didnot meet all the mentioned revenue recognition conditions was reversed,resulting in a downward adjustment to certain asset accounts or the recognitionof a customer liability or deferred revenue.

 

**THREE MONTHS ENDED MARCH 31, 2005 COMPARED TOTHREE MONTHS ENDED MARCH 31, 2006**

 
| ** **                                                 | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                              | ** ** | **2006** | ** ** |
| ** **                                                 | ** ** | **($000’s)**                     | ** ** | **% of  Revenue** | ** ** | **($000’s)** | ** ** | **% of  Revenue** | ** ** |
| **Revenue**                                                |       | $                                     | 105,932    |   | 100.0 | % | $ | 105,283 |   | 100.0 | % |
| **Gross  Profit**                                          |       | 43,974                                |       | 41.5 | % | 42,866 |   | 40.7 | % |
| **SG&A**                                               |       | 30,221                                |       | 28.5 | % | 34,309 |   | 32.6 | % |
| **Operating  income**                                      |       | 13,546                                |       | 12.8 | % | 8,351 |   | 7.9 | % |
| **Income from continuing operations before  income taxes** |       | 12,065                                |       | 11.4 | % | 7,708 |   | 7.3 | % |
| **Income  from continuing operations**                     |       | 7,355                                 |       | 6.9 | % | 4,637 |   | 4.4 | % |
|                                                            |            |                                       |            |  |  |  |  |  |  |  |  |

 

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**Revenue**

 

Ouroperations generated revenues of $105.3 million for the three months endedMarch 31, 2006, a decline of 0.6% compared to the same period in 2005. Aspreviously discussed, during the first quarter of 2005 we recognizedremediation revenue of $4.1 million related to revenue reversals in 2004;however, such revenue did not contribute to our operating cash flow during 2005.During the first quarter of 2006, we recognized revenue of approximately $1.5million related to a previously anticipated termination payment relating to acontract terminated by a customer within our Information Management andDistribution segment in connection with a substantial change in such customer’soperational plans.  After deducting thepositive revenue variances related to the remediation revenue and terminationpayment/settlement, our remaining operations achieved revenue growth of 1.9%during the first quarter of 2006 compared to the first quarter of the previousyear.  This revenue growth resultedprimarily from strong volumes in our project oriented Class Action ClaimsAdministration service offering and our Legal Consulting service offering thattogether contributed approximately $4.0 million.  This was partially offset by lower revenuesin our Information Management and Distribution segment and Medical RecordsRelease service offering of $0.7 million and $1.2 million respectively. Projectrevenue accounted for $40.3 million or 38.2% of revenue in the current yearquarter compared to $39.3 million or 37.1% of revenue in the prior yearquarter. (See “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Basis for Management Discussion and Analysis.”)

 

Revenueswithin our Information Management and Distribution segment, after adjusting forthe 2005 remediation revenue and the 2006 termination payment/settlement,revenue declined 1.5% from $52.2 million for the three months endedMarch 31, 2005, to $51.5 million for the three months ended March 31,2006.  The decline in segment revenueswere primarily the result of: (i) lower volumes from our mortgage andhealthcare vertical markets and (ii) some discontinuances in ourcommercial vertical market.  Revenues inthe Statement Processing service offering were slightly higher when compared tothe prior year quarter primarily due to higher tax season processing.

 

Revenueswithin our Healthcare, Regulatory and Legal Compliance segment increased 5.3%from $49.6 million for the three months ended March 31, 2005, to $52.3million for the three months ended March 31, 2006. Contributing to therevenue increase were higher volumes of small to medium size projects (i.e.projects with less than $500k of total revenue) in our Class Action ClaimsAdministration service offering, which increased approximately $1.7 million or16.8% and our Legal Consulting service offering that increased approximately$2.3 million due to increased billing rates and the results of additionalbillable hours from new consulting professionals, specifically in the financeservices offerings.  Partially offsettingthese increases were lower revenues of approximately $1.2 million in ourHealthSERVE service offerings principally due to lower demand for medicalrecord coding staffing services and customer attrition within our MedicalRecords Release services.

 

**Gross profit**

 

Grossprofit declined 2.5% from $44.0 million, or 41.5% of revenue, for the threemonths ended March 31, 2005, to $43.0 million, or 40.7% of revenue, forthe three months ended March 31, 2006. After adjusting for the variancesrelated to the termination payment/settlement and remediation revenuepreviously discussed, gross profit increased 2.0%.  The gross profit improvement is primarily dueto: (i) increase in volumes within our class action claims administrationoffering, which typically produces higher margins, (ii) lower productionpersonnel cost as a percentage of revenue, (iii) price increases andterminations of unprofitable contracts and (iv) cost recovery from the terminationpayment/settlement.  Gross marginimprovement resulting from personnel costs occurred in our informationmanagement service offering due to productivity and quality initiatives whichincluded:  introduction of Lean/Six Sigmaquality initiatives, implementation of high speed scanning technology toreplace labor intensive low speed scanners, implementation of pay forperformance compensation strategies, and increased utilization of offshorelabor.

 

**Selling, general and administrative expenses**

 

SG&A increased 13.5% from $30.2 million, or 28.5% of revenue, forthe three months ended March 31, 2005, to $34.3 million, or 32.6% ofrevenue, for the three months ended March 31, 2006. After adjusting forthe reduction in SG&A related to the termination payment/settlementpreviously discussed, SG&A increased to $34.5 million. The increase inSG&A expenses primarily relates to: (i) $1.4 million of incremental legalexpenses in the current year quarter related to the potential Merger, (ii) $0.5million higher than expected costs associated with ongoing Sarbanes Oxleycompliance, (iii) $0.8 million for the settlement in principle of certain legalactions and (iv) $1.1 million of additional compensation for management andsales resources within our Class Action Claims Administration and LegalConsulting service offering.

 

**Income from continuing operations before income taxes**

 

Incomefrom continuing operations before income taxes declined from $12.1 million forthe three months ended March 31, 2005 to $7.7 million for the three monthsended March 31, 2006.  Afterdeducting the variances related to the termination payment/settlement andremediation revenue previously discussed, income from continuing operationsbefore income taxes declined 

 

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$2.8million.  The decline was primarilydriven by the factors impacting SG&A discussed above offset by the gross profitincrease of 2.0%.

 

**Provision for income taxes**

 

During the first quarter of2006, our effective tax rate increased to 39.8% compared to 39.0% during thesame quarter of the previous year.  Theincrease is driven by limitations of the deductibility of individualcompensation expense in excess of $1.0 million. Without this limitation, the effective tax rate for fiscal 2006 would becomparable to that of the first quarter of 2005.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

AtMarch 31, 2006, we had $47.3 million of working capital, including $2.0million of cash.  Working capital atDecember 31, 2005 was $36.8 million, including $2.3 million of cash.  For the first three months of 2006, net cashprovided by operating activities from continuing operations was $0.5 millioncompared to cash used by operating activities from continuing operations of$4.6 million for the same period in 2005. Factors impacting the net cash provided by operating activities fromcontinuing operations consist of:  (i) increased accounts receivable balances related to slower collections ofapproximately $6.6 million, primarily within in our Information Management andDistribution reportable segment combined with higher consolidated revenues inthe current quarter, (ii) changesin compensation related accruals of approximately $6.2 million due to annualincentive compensation payments during the quarter and the timing of payrollfundings at the end of the current quarter, (iii) an approximate $4.5 millionincrease in accounts payable and accrued liabilities related to the timing ofpayments and (iv) an approximate $2.7 million increase in income taxes payableduring the current quarter.

 

Dayssales outstanding increased four business days during the quarter to 48business days at March 31, 2006, compared to 44 business days atDecember 31, 2005.  Managementexpects collections of accounts receivable balances to improve during theremainder of fiscal 2006 and as a result, expects days sales outstanding toimprove to 44 to 45 days.

 

Forthe three months ended March 31, 2006, investing activities fromcontinuing operations consisted of acquisitions of property, plant andequipment of $2.6 million and the payment of approximately $1.0 million incontingent consideration related to the 2002 acquisition of United InformationServices, Inc.  See Note 5, BusinessCombinations.

 

Netcash provided by financing activities from continuing operations was $2.6million for the three months ended March 31, 2006.  Borrowings from our line of credit of $57.8million were partially offset by payments on our line of credit of $55.7million.  We utilize our line of creditto fund general operating requirements of the Company as well as fundsignificant investments such as acquisitions or capital expenditures.

 

On September 29, 2005, the Company amended its revolving creditfacility. Under the amended and restated credit agreement (the “2005 CreditAgreement”), with Bank of America as agent and SunTrust Bank and JP MorganChase as co-agents, the Company may borrow on a revolving credit basis loans inan aggregate outstanding principal amount up to $100 million, subject tocertain customary financial covenants and ratios. Additionally, the 2005 CreditAgreement contains an accordion provision for an additional $50 million.

 

The annual interest rate applicable toborrowings under the 2005 Credit Agreement is, at the Company’s option,(i)  pricing equaling the higher of (a) the Federal Funds Rate plus 1/2 of 1% and (b) the prime rate asset by Bank of America or (ii) grid pricing ranging from 0.75% to 1.00%plus LIBOR based on the ratio of funded debt to earnings before interest,taxes, depreciation and amortization (“EBITDA”) (as defined in the creditagreement). The outstanding principal balance of revolving credit loans is dueand payable on September 29, 2008.

 

As of March 31, 2006, we have outstanding irrevocable letters ofcredit totaling approximately $13.0 million. Letters of credit in theamount of approximately $8.0 million serves as security for the Company’sself-insured workmen’s compensation program. A letter of credit in the amountof $5.0 million serves as a guarantee for performance under a contractwith New York State Workers Compensation Board.

 

As of March 31, 2006, the availability under the 2005 CreditAgreement was approximately $46.9 million and we are in compliance withall loan covenants.

 

Management believes that it has sufficient liquidityfrom its cash flow and its revolving credit facility to meet ongoing businessneeds.  Additionally, depending on themix of stock and cash used in our strategic acquisition program, if any, we mayneed to seek further financing through the public or private sale of equity ordebt securities.  However, there can beno assurance we could secure such financing if and when it is needed or withterms we deem acceptable.

 

InJanuary 2000, we registered on Form S-4 (RegistrationNo. 333-92981) 3,012,217 shares of common stock for issuance in connectionwith our acquisition program (the “Acquisition Shelf”), of which 1,359,852shares were available as of March 31, 2006; however, such registrationstatement may require amendment prior to use.

 

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**Critical Accounting Policies**

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations arebased on the related consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America. The preparation of the financial statements requiresthe use of estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses.

 

Wehave identified the following critical accounting policies that, as a result ofthe judgments, uncertainties, uniqueness and complexities of the underlyingaccounting standards and operations involved, could result in material changesto our financial condition or results of operations under different conditionsor using different assumptions. We apply a consistent methodology at the end ofeach quarter to determine our account balances that require judgmentalanalysis.

 

**Revenue Recognition.**  Revenue is recognized as it becomes realized or realizable and earnedaccording to the criteria provided by Staff Accounting Bulletin 104, *Revenue Recognition*. Revenue recognitionoccurs once persuasive evidence of an arrangement exists, delivery has occurredor services have been rendered, the sales price is fixed or otherwisedeterminable, and collection is reasonably assured. Our revenue-earningsactivities possess project and recurring customer relationships.

 

Project revenue includes one-time projects in which the customerrelationship is not expected to continue after project completion. Projectrevenue is typically based on time and material arrangements. Revenuerecognition occurs at the contractual rates as the labor hours and directexpenses are incurred.

 

Recurring revenue is characterized by customer relationships that aregenerally for one year and may continue for longer. Recurring revenue istypically based on the transaction volumes provided by our customers at anagreed upon fixed rate per unit. Our customer’s volumes are typically notcontractual or otherwise guaranteed. Revenue recognition occurs once work iscompleted and delivery has occurred or services have been rendered.

 

Revenuerecognition policies related to offerings within our Information Management andDistribution segment are based upon objective criteria that do not requiresignificant estimates or uncertainties. For example, business processoutsourcing services are recognized proportionally as services are rendered,based on specific, objective criteria under the contracts for the number ofaccounts or transactions processed. Accordingly, revenues recognized underthese methods do not require the use of significant estimates that aresusceptible to change.

 

Revenue recognition policies within our Healthcare, Regulatory, andLegal Compliance segment are based upon objective criteria that do not requiresignificant estimates or uncertainties. For example, transaction volumes and time and costs under time andmaterial and cost reimbursable arrangements are based on specific, objectivecriteria under the contracts.  Thefollowing outlines specific revenue recognition policies related to certainofferings within this segment:

 

*Medical records release services* — revenue is recognized upon completion ofthe processing of the requested medical records.  Revenue recognition for this service is basedon an agreed upon and in some cases, a regulated rate applied to the number ofrecords processed.  When a fee is paid tothe hospital, the revenue related to that fee is reported on a net basis inaccordance with Emerging Issues Task Force (“EITF”) 99-19, *Reporting Revenue Gross as a Principal versus Net asan Agent,* due to the fact that: (a) the primary obligation inthe arrangement is borne partially by both SOURCECORP and the hospital;(b) SOURCECORP has no discretion with respect to the supplier of themedical record; and (c) SOURCECORP is not involved in the determination ofproduct or service specifications.

 

*Record management services* — revenue is recognized as storage servicesare provided based linear feet of documents stored times a monthly rate forshelf storage and based on a monthly per image rate for images storedelectronically.  We recognize fees forprocessing, retrieval, delivery and return to storage as revenue uponcompletion of the service at the agreed upon rate applied to the unit count ofitems serviced.

 

*Additional healthcare and compliance services* — revenue is recognized for document and dataconversion services as the services are provided based upon an agreed upon rateper patient file applied to the number of files processed.  Storage and archiving fees are recognized asrevenue as the services are provided based upon an agreed upon monthly rate perfile stored or otherwise archived. Revenue related to coding and abstracting of medical records andstaffing services is recognized as the services are provided based on an agreedupon rate applied to the billable hours worked and eligible out-of-pocketexpenses defined by the service agreement. The out-of-pocket expense component is recognized as revenue and cost ofservices on a gross basis in accordance with EITF Issue 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket” Expenses Incurred. *Revenue related to compliance reviews is based primarily onan agreed upon percentage (or commission) of amounts identified and recoveredfrom the third party payers as a fee for services provided.  Revenue is recognized upon successfulrecovery of underpayments to our clients by their managed care and commercialpayers at the agreed upon percentage (or commission).

 

*Class action claims administration services* — revenue is recognized as these services areprovided based on the agreed upon 

 

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rateapplied to the number of hours spent providing services related toadministering the legal settlements and expenses incurred.  The out-of-pocket expense component isrecognized as revenue and cost of services on a gross basis in accordance withEITF Issue 01-14, *Income StatementCharacterization of Reimbursements Received for “Out-of-Pocket” ExpensesIncurred. *In addition,revenue related to the design and implementation of comprehensive notificationplans is based on an agreed upon percentage (i.e., commission) of the cost toplace the media communication.  Revenueis recognized at the time of public delivery of the notification through thevarious media outlets at the agreed upon percentage (or commission).

 

*Professional economic research and litigation services* — revenue is recognized as these services areprovided based on consulting hours worked at agreed upon rates at the timeservices are rendered and expenses are incurred.  The out-of-pocket expense component is recognizedas revenue and cost of services on a gross basis in accordance with EITF Issue01-14, *Income Statement Characterization ofReimbursements Received for “Out-of-Pocket” Expenses Incurred.*

 

Asa part of providing services to our customers, we incurs incidental expensescommonly referred to as “out-of-pocket” expenses. These expenses include itemssuch as airfare, hotels, mileage, etc. and are often reimbursable by ourcustomers. When reimbursable, we record both revenue and direct cost ofservices in accordance with the provisions of EITF Issue 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket’ Expenses Incurred.*

 

Unearnedincome, included in other current liabilities, represents payments from theCompany’s customers in advance of services being provided. Advanced paymentsare deferred as unearned income when received and recognized as revenue asservices are rendered.

 

**Allowance for Doubtful Accounts.**  Theallowance for doubtful accounts is established and maintained based on ourestimate of accounts receivable collectibility. Management estimatescollectibility by specifically analyzing accounts receivable aging and otherhistorical factors that affect collections. Such factors include the historicaltrends of write-offs and recovery of previously written-off accounts, thefinancial strength of the customer and projected economic and marketconditions. The evaluation of these factors involves subjective judgments andchanges in these factors may significantly impact our consolidated financialstatements.

 

**Long-Lived Asset and Other Intangible Asset Impairment.**  Asrequired by SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets,*managementcontinually evaluates whether events and circumstances indicate that thecarrying value of long-lived assets and intangible assets may not berecoverable. When events require, management performs the valuation bycomparing the estimated undiscounted future cash flows over the remaining lifeof the long-lived assets and intangible assets to the carrying amount of theasset being evaluated. An impairment loss is recognized if the carrying amountof assets being evaluated exceeds the expected future undiscounted cash flowbased on the difference between the carrying value and fair value..

 

**Goodwill Impairment.**  On January 1, 2002, weadopted SFAS No. 142, *Goodwill andOther Intangible Assets.* This statement states that goodwill andintangible assets that have indefinite useful lives will not be amortized butrather will be tested at least annually for impairment. Our annual impairmenttest is performed as of October 31st each year.  The impairment test is based on fair valuerather than undiscounted cash flows. Additionally, goodwill is tested at areporting unit level rather than the individual operating unit level. Areporting unit is either at the operating segment level or one reporting levelbelow and could consist of several service offerings aggregated into a singlereporting unit. Service offerings are aggregated when they are similar in thefollowing areas: economic characteristics, products and services, productionprocesses, methods for distributing or delivering products, and type or classof customers. Valuation methods used in determining fair value include ananalysis of the cash flows that the reporting units can be expected to generatein the future (Income Approach) and the fair value of a reporting unit ascompared to similar publicly traded companies (Market Approach). Inpreparing these valuations, management utilizes estimates to determine fairvalue of the reporting units. These estimates include future cash flows, growthrates, capital needs, and projected earning margins among other factors.Estimates utilized in future calculations could differ from estimates used inthe current period. Future years’ estimates that are unfavorable compared tocurrent estimates could cause an impairment of goodwill and other intangibleassets. Due to the fact that we are primarily a services company, our businessacquisitions typically result in significant amounts of goodwill and otherintangible assets. Therefore, an impairment charge resulting from goodwill orother intangible assets could result in a material adverse impact on ourfinancial statements during the period incurred.

 

**Self-InsuranceLiabilities and Reserves.**We are self-insured forworkmen’s compensation liabilities and a significant portion of our employeemedical costs. We account for our self-insurance programs based on actuarialestimates of the amount of loss inherent in that period’s claims, includinglosses for which claims have not been reported. These loss estimates rely onactuarial observations of ultimate loss experience for similar historicalevents. We limit our risk by carrying stop-loss policies for significant claimsincurred for both workmen’s compensation liabilities and medical costs.

 

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**Other Loss Contingencies.**  Werecord liabilities when it is probable that a liability has been incurred andthe amount of the loss is reasonably estimable in accordance with SFASNo. 5, *Accounting for Contingencies*.Disclosure is required when there is a reasonable possibility that the ultimateloss will exceed the recorded provision. Contingent liabilities are oftenresolved over long periods of time. Estimating probable losses requiresanalysis of multiple forecasts that often depend on judgments about potentialactions by third parties such as regulators. Our loss contingencies consistprimarily of estimates related to the probable outcome of current litigation.

 

***Recent Accounting Pronouncements***

 

In December 2004, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 123(R), *Share-BasedPayment*, which eliminates the alternative to account for employeestock options under APB Opinion 25 and requires the fair value of all share-basedpayments to employees, including the fair value of grants of employee stockoptions, be recognized in the income statement, generally over the vestingperiod.

 

In March 2005, the Securities and Exchange Commission issued StaffAccounting Bulletin (“SAB”) No. 107, which provides additionalimplementation guidance for SFAS 123(R). Among other things, SAB 107provides guidance on share-based payment valuations, income statementclassification and presentation, capitalization of costs and related income taxaccounting.

 

SFAS 123(R) provides for adoption usingeither the modified prospective or modified retrospective transition method.The Company adopted SFAS 123(R) on January 1, 2006 using the modifiedprospective transition method in which compensation cost is recognizedbeginning January 1, 2006 for all share-based payments granted on orafter that date and for all awards granted to employees prior toJanuary 1, 2006 that remain unvested on that date. The Company willcontinue to use the Black-Scholes option pricing model to determine thefair value of stock option awards.

 

Adoption of SFAS 123(R)’s fair valuemethod will have an effect on results of operations, although it will not havea material impact on the Company’s overall financial position. HadSFAS 123(R) been adopted in prior periods, the effect would haveapproximated the SFAS 123 pro forma net income and earnings per sharedisclosures as shown above.  See Note 3, Stockholders’Equity and Stock-Based Compensation.

 

In March 2005, the FASB issued Interpretation No. 47, *Accounting for Conditional Asset RetirementObligations*, to clarify that the term conditional asset retirementobligation as used in FASB Statement No. 143 is a legal obligation toperform an asset retirement activity in which the timing and (or) method ofsettlement are conditional on a future event that the enterprise may or may nothave control over. This Interpretation requires recognition of a liability forthe fair value of a conditional asset retirement obligation when incurred ifthe liability’s fair value can be reasonably determined. This Interpretation iseffective no later than the end of the fiscal years ending afterDecember 15, 2005. The adoption of this Interpretation did not have amaterial impact on the Company’s consolidated financial statements.

 

**RISKS ASSOCIATED WITH FORWARD-LOOKING STATEMENTS**

 

ThisReport contains certain forward-looking statements such as our intentions, hopes,beliefs, expectations, strategies, predictions or any other variation thereofor comparable phraseology of our future activities or other future events orconditions within the meaning of Section 27A of the Securities Act of1933, as amended (the “Act”), and Section 21E of the Securities ExchangeAct of 1934, as amended, which are intended to be covered by the safe harborscreated thereby. Investors are cautioned that all forward-looking statementsinvolve risks and uncertainty, including, without limitation, the actualfinal costs of our internal investigation, the Company’s ongoing SECinvestigation, the potential impairment of our ability to enter into governmentcontracts as a result of the conduct that was the subject of our investigation,remediation costs relating to our investigation, the potential customer impactof the results of the SEC investigation, the effect of our investigation andfinancial statement restatement on the trading price of our stock, the integration our operating companies, themanagement of our growth, the timing and magnitude of technological advances,the occurrences of future events that could diminish our customers’ needs forour services, a change in the degree to which companies continue to outsourcebusiness processes, the adverse outcome in any given legal proceeding or claim,the denial of insurance on a particular claim or of a party obligated toprovide indemnification being financially unable to do so, as well as suchother risks set forth under the heading Risk Factors included in our mostrecent annual report on Form 10-K.

 

Althoughwe believe that the assumptions underlying the forward-looking statementscontained herein are reasonable, any of the assumptions could be inaccurate,and, therefore, there can be no assurance that the forward-looking statementsincluded in this Report will prove to be accurate. In light of the significantuncertainties inherent in the forward-looking statements included herein, theinclusion of such information should not be regarded as a representation by usor any other person that our objectives and plans will be achieved. Further, wedisclaim any obligation to update any such forward-looking statements, exceptas required by law.

 

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**Item 3.**                **Quantitative and QualitativeDisclosures about Market Risk**

 

Weare subject to interest rate risk on our term loans and revolving creditfacility.  A 100 basis point increase inshort-term interest rates would result in approximately $0.4 million ofadditional expense in 2006 based on our expected average balance outstandingunder the credit facility during 2006. Interest rates are fixed on the capitalized lease obligations.

 

**Item 4.**           **Controls and Procedures**

 

*(a) Evaluation of disclosure controls andprocedures.*

 

The Company maintains disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in the Company’s reports under the Securities Exchange Act of 1934,as amended (the “Exchange Act”), is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms, andthat such information is accumulated and communicated to management, includingthe Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”),as appropriate, to allow timely decisions regarding required disclosure. TheCompany periodically reviews the design and effectiveness of its disclosurecontrols and internal control over financial reporting. The Company makesmodifications to improve the design and effectiveness of its disclosurecontrols and internal control over financial reporting, and may take othercorrective action, if its reviews identify a need for such modifications oractions.

 

There are inherent limitations to the effectiveness ofany system of disclosure controls and internal control over financialreporting, including the possibility of human error and the circumvention oroverriding of the controls and procedures. Accordingly, even effectivedisclosure controls and internal control over financial reporting can onlyprovide reasonable assurance of achieving their control objectives.

 

In connection with the preparation of the Company’s2005 Annual Report on Form 10-K as filed with the SEC on March 31, 2006, as ofDecember 31, 2005, an evaluation was performed under the supervision and withthe participation of the Company’s management, including the CEO and CFO, ofthe effectiveness of the design and operation of the Company’s disclosurecontrols and procedures (as defined in the Rules 13a-15(e) and 15d-15(e) underthe Exchange Act). Management concluded that control deficiencies in itsinternal control over financial reporting as of December 31, 2005 constitutedmaterial weaknesses within the meaning of the Public Company AccountingOversight Board’s Auditing Standard No. 2, “An Audit of Internal ControlOver Financial Reporting Performed in Conjunction with an Audit of FinancialStatements.” The material weaknesses identified by management were disclosed inItem 9A of the Form 10-K. Based on that evaluation, management concludedthat the Company’s system of internal control over financial reporting was noteffective as of December 31, 2005. As part of its evaluation of theeffectiveness of the design and operation of the Company’s internal controlover financial reporting as of the end of the period covered by this report,management has (i) identified no material weaknesses other than thosedescribed in the Form 10-K and (ii) evaluated whether the materialweakness described above continue to exist. Although the Company believes thatprogress has been made to address these material weakness, management hasconcluded that the material weakness disclosed in the Company’s Form 10-Kcontinues to exist as of March 31, 2006. Therefore, management has alsoconcluded that the Company’s disclosure controls and procedures were noteffective as of March 31, 2006. In light of the material weakness whichcontinues to exist as of March 31, 2006, management performed additionalanalysis and other post-closing procedures to ensure its condensed consolidatedfinancial statements are prepared in accordance with generally acceptedaccounting principles.

 

The required certifications of our principal executiveofficer and principal financial officer are included as exhibits to thisQuarterly Report on Form 10-Q. The disclosures set forth in this Item 4contain information concerning the evaluation of our disclosure controls andprocedures and changes in internal control over financial reporting referred toin those certifications. Those certifications should be read in conjunctionwith this Item 4 and Item 9A of the Company’s Form 10-K for a morecomplete understanding of the matters covered by the certifications.

 

Management,with oversight from the Audit Committee, continues to focus on timelyaddressing the material weaknesses disclosed in its Form 10-K and is committedto remediate the material weaknesses as expeditiously as possible.  Although the Company’s remediation effortsare underway, control weaknesses will not be considered remediated until newinternal controls over financial reporting: (i) are implemented andoperational for a period of time; (ii) are tested; and(iii) management concludes that these controls are operating effectively.

 

*(b) Changes in internal controls.*

 

Other than improvementsdescribed in our remediation plan described in Item 9A of the Company’s Form10-K, there have been no changes in our internal control over financialreporting during the quarter ended March 31, 2006 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting. Based on our findings that our disclosure controlsand procedures and our internal controls over financial reporting were not effective,we continue to take steps to improve our internal controls and procedures

 

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**PART II.OTHER INFORMATION**

 

**Item 1.**                     **Legal Proceedings**

 

Weare, from time to time, a party to litigation. The following is a descriptionof the most significant legal matters that we are involved in.  In the event of an adverse outcome in one ormore of our legal proceedings our business, financial condition, results ofoperations or cash flows could be materially adversely affected.

 

*DavidcoLitigation*

 

OnMarch 8, 2006, a purported class action complaint (the “Davidco Complaint”)challenging the proposed Merger with entities affiliated with Apollo was filedby a putative stockholder of the Company in an action styled *Davidco Investments, on behalf of itself and all others similarlysituated v. Ed H. Bowman, Jr., et al.*, C.A. No. 1982-N (the “DavidcoAction”), pending in the Court of the Chancery of the State of Delaware, Countyof New Castle, against the Company, certain of our officers and directors (the “DavidcoIndividual Defendants”) and Apollo.  SeeNote 7, Potential Merger.  The DavidcoComplaint alleges a claim for breach of fiduciary duties against the DavidcoIndividual Defendants, alleging, among other things, that the consideration tobe paid to the stockholders of the Company in the Merger is unfair andinadequate and was not the result of a full and fair sale process or adequatemarket check.  The Davidco Complaint alsoasserts a claim against Apollo for allegedly aiding and abetting such purportedbreaches of fiduciary duties.

 

The DavidcoComplaint seeks, among other relief, class certification, an injunctionpreventing completion of the Merger (or rescinding the Merger if it iscompleted prior to the receipt of such relief), compensatory and/or rescissorydamages to the class, attorneys’ fees and expenses, and such other relief asthe court might find just and proper. Defendants have moved to dismiss the Davidco Complaint and the motion isstill being briefed by the parties.

 

This matterhas been settled in principle.  See *Settlement of Litigation*, below.

 

*KabotaLitigation*

 

A purportedstockholder derivative action was filed on December 28, 2004, in an actionstyled *Howard Kabota, Derivatively on Behalf of Sourcecorp,Incorporated v. Thomas c. Walker, et al.*, CauseNo. 04-12854, pending in the District Court of the State of Texas, Countyof Dallas, 14th Judicial District, against certain of our currentand former officers and directors as individual defendants and the Company as anominal defendant (the “Kabota I Action”). In an amended petition (the “Kabota I Petition”), plaintiff allegesbreach of fiduciary duty, abuse of control, gross mismanagement, waste ofassets and unjust enrichment related to the allegations underlying a separatesecurities fraud action styled *In re SOURCECORP, Inc.Securities Litigation*, Case No. 3:04-CV-2351-N, pending in theUnited States District Court for the Northern District of Texas, DallasDivision (the “Securities Litigation”) (further discussed below).  All of these claims are asserted derivativelyon behalf of the Company and seek unspecified damages against thoseindividuals.

 

Upon motion bythe defendants, the court entered an order staying the case datedSeptember 27, 2005, which stays all proceedings in the action forsuccessive sixty day periods while the special committee of the board ofdirectors (discussed below) considers the allegations raised in the Kabota IPetition.  At the end of each successivesixty day period, any party may file a motion requesting that the court reviewthe continued necessity of the stay.

 

In addition,on March 8, 2006, a shareholder derivative petition for breach offiduciary duty (the “Kabota II Petition”) was filed by a putative stockholderof the Company in an action styled *Howard Kabota,Derivatively On Behalf of Sourcecorp, Incorporated v. Thomas C. Walker, et al.*,Cause No. 06-02446 (the “Kabota II Action”) pending in the District Courtof the State of Texas, County of Dallas, D-95th Judicial District,against the Company and certain of its officers and directors (the “KabotaIndividual Defendants”).  The Kabota IIPetition alleges, among other things, that the consideration contemplated underthe Merger Agreement to be paid to the Company’s stockholders is unfair andinadequate.  See Note 7, PotentialMerger.  In addition, the Kabota IIPetition alleges a claim for breach of fiduciary duties against the Kabota IndividualDefendants, asserting, among other things, that the Kabota IndividualDefendants failed to properly value the Company, ignored or did not protectagainst purported conflicts of interest of certain Kabota Individual Defendantsin connection with the Merger, and agreed to the Merger in a wrongful attemptto insulate themselves from potential personal liability alleged in the KabotaI Action (discussed above).

 

The Kabota IIPetition seeks, among other relief, an injunction preventing completion of theMerger (or rescinding the Merger if it is completed prior to the receipt ofsuch relief), a direction that the Kabota Individual Defendants exercise theirfiduciary duties to obtain a transaction in the best interests of the Companyand its stockholders, restitution to the Company of any wrongful profits,benefits or other compensation obtained by the Kabota Individual Defendants,attorneys’ fees and expenses, and such other relief as the court might findjust and proper.  The time for all thedefendants to answer, move or otherwise respond to the Petition has not yetrun.

 

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These mattershave been settled in principle.  See *Settlement of Litigation*, below.

 

*FreeportProceedings*

 

On or aboutDecember 24, 2004, the Chairman of the board of directors received from apurported stockholder a demand letter (the “Demand Letter”) based onsubstantially the same facts as ultimately alleged in the Freeport Complaint(discussed below).  The Demand Letterrequests the board of directors to take certain action, but does not seekdamages against the Company.  The Companyhas formed a special committee of the board of directors that continues toevaluate the claims made in the Demand Letter, the Freeport Complaint and theKabota I Petition.

 

On or aboutOctober 21, 2005, a purported derivative and class action complaint (the “FreeportComplaint”) was filed by the same putative stockholder of the Company who sentthe Demand Letter in an action styled *Freeport Partners, LLC,Derivatively on Behalf of Nominal Defendant Sourcecorp, Inc. v. Ed H. Bowman,et al.*, Civil Action No. 3:05-02085-N (the “Freeport Action”),pending in the United States District Court for the Northern District of Texas,Dallas Division, against certain officers and directors of the Company.  The Freeport Complaint asserts, among otherthings, claims against certain defendants, seeking forfeiture of certaincompensation, bonuses and profits pursuant to Section 304 of theSarbanes-Oxley Act and contribution to any settlement or judgment in connectionwith the Securities Litigation.  Inaddition, the Freeport Complaint alleges claims of breach of fiduciary dutiesand abuse of control against the defendants for allegedly causing or allowingthe Company purportedly to conduct its business in an imprudent or unlawfulmanner and allegedly disseminating materially false information to theinvesting public as alleged in the Securities Litigation.  Pursuant to an agreed order, datedNovember 18, 2005, all proceedings in this lawsuit were stayed pendingresolution of the motions to dismiss filed in the Securities Litigation.

 

On or aboutMarch 20, 2006, plaintiff filed a motion to lift the consensual stay sothat it may amend the Freeport Complaint. In papers filed with the motion, plaintiff stated that it wasconsidering amending the Freeport Complaint to add claims under the federalproxy laws relating, in part, to proxy materials filed in connection with themerger.  Defendants moved to opposeplaintiff’s motion to lift the consensual stay. On or about April 25, 2006, plaintiff filed a notice of voluntarilywithdrawing its motion to lift consensual stay.

 

This matterhas been settled in principle.  See *Settlement of Litigation*, below.

 

*Settlementof Litigation*

 

OnApril 28, 2006, the parties reached an agreement in principle to settlethe Davidco Action, the Kabota I Action, the Kabota II Action and the FreeportAction and on May 3, 2006 entered in to a memorandum of understanding (the“MOU”) reflecting the terms of the proposed settlement.  The proposed settlement is subject to courtapproval and certain other conditions. Under the terms of the MOU, the parties have agreed, among other things(i) to amend the Merger Agreement to reduce the termination fee payable bythe Company to Purchaser if the Merger Agreement is terminated under certaincircumstances from $15,000,000 to $12,500,000, (ii) to amend the MergerAgreement to allow the board of directors, subject to certain conditions, toprovide information to a third party, if any, who has indicated that such thirdparty will make a written proposal to acquire the Company, (iii) toinclude certain additional disclosures in the merger related proxy statementand (iv) not to object to plaintiffs’ counsel’s court application for anaward of attorney fees and expenses, provided that such application does notexceed $775,000 in fees and expenses in the aggregate.  The MOU also contemplates that some discoverywill be taken to confirm the fairness of the proposed settlement.  The original Merger Agreement was amended onMay 3, 2006 to reduce the termination fee to $12,500,000 and to allow theboard of directors, subject to certain conditions, to provide information to athird party, if any, who has indicated that such third party will make awritten proposal to acquire the Company. The Company accrued approximately $0.8 million in the first quarter of2006 related to the settlement.

 

*PutativeSecurities Class Action*

 

In theSecurities Litigation, the Company, and the Company’s Chief Executive Officerand Chief Financial Officer individually, have been named as defendants inseveral putative securities class actions concerning the Company’s pressreleases dated October 27, 2004, in which the Company disclosed that itsfinancial statements for certain prior periods should no longer be relied on,and also provided updated financial guidance. The complaints were filed in the United States District Court for theNorthern District of Texas, Dallas Division, with the first action being filedNovember 1, 2004.  The complaintsallege violations of federal securities laws, including alleged violations ofSections 10(b) and 20(a), and Rule 10b-5 of the Exchange Act.  The four actions were transferred to a singlejudge in the Northern District of Texas, Dallas Division and consolidated intoa single action styled *In re Sourcecorp, Inc.Securities Litigation*, Case No. 3:04-CV-2351-N.  A lead plaintiff has been appointed for theconsolidated action.  In addition to theCompany and its Chief Executive Officer and Chief Financial Officer, one of itssubsidiaries and one of the former owners of that subsidiary are named asdefendants in the consolidated action. The consolidated action is purportedly on behalf of all persons whopurchased the Company’s common stock during the period between May 3,2001, and October 27, 2004, and seeks unspecified damages.  Defendants have all filed motions to dismissthe consolidated action and such motions are presently before the court.

 

25

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*Various ROI Copy Charge Matters*

 

From time to time, various subsidiaries of the Company that performrelease of information (“ROI”) services become defendants to putative classaction lawsuits generally alleging that the charge for reproducing certainmedical records is not in conformity with such plaintiffs’ reading of theapplicable regulated charge. Such suits typically include multiple ROIcompanies and hospitals as defendants and demand reimbursement for priorcharges as well as for prospective pricing adjustments. The Company iscurrently a party to several such suits in various stages of development.

 

One such suit originally styled *McShanev. Recordex Acquisition Corp. & Sourcecorp, Incorporated*(and now styled *Liss & Marion, PCv. Recordex Acquisition Corp., & Sourcecorp, Inc.*)filed February 10, 2003, in the Court of Common Pleas Philadelphia County,Pennsylvania, alleges among other things that the Company intentionally chargedmore for providing copies of medical records than is permitted underPennsylvania law. The complaint does not specify the amount of damages sought.On June 10, 2005, the Court in this matter granted judgment in favor ofthe plaintiffs and on November 3, 2005, a separate hearing on damages washeld. Following such hearing, the Court assessed damages of approximately$0.5 million with interest, which the plaintiffs claim approximates$0.1 million. The Company is assessing its appellate options and believesit is adequately reserved for this as well as its other ROI putative copy classaction legal contingencies.

 

*SEC Investigation*

 

On January 14, 2005, the Company received written confirmationfrom the SEC that the SEC had converted its informal inquiry in connection withthe Company’s internal investigation and restatement into a formalinvestigation. The Company is continuing to fully cooperate with the SEC inconnection with the investigation. The Company initially had contacted theenforcement division of the SEC on a voluntary basis to notify the agency ofthe Company’s understanding of the events leading to its internal investigation.The Company is unable to predict the outcome of the investigation, the scope ofmatters that the SEC may choose to investigate in the course of thisinvestigation or in the future, the SEC’s views of the issues beinginvestigated, or any action that the SEC might take, including the impositionof fines, penalties, or other available remedies.

 

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**Item 2.****          ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

Items2(a) and (b) are inapplicable.

 

(c) STOCKREPURCHASES

 
| **Period**                      | ** ** | **(a) Total Number of  Shares Purchased** | ** ** | **(b) Average  Price Paid per  Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number of Shares (or  Approximate Dollar Value of Shares)  that May Yet Be Purchased Under  the Plans or Programs** | ** ** |
|---------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                            |       |                                           |       |                                        |       |                                                                                                   |       |                                                                                                                                        |       |
| Jan 1, 2006 – Jan 31, 2006 |       | —                                         |       | $                                           | —     |                                                                                                   | —     |                                                                                                                                        | $          | 17,415,551 |   |
| Feb 1, 2006 – Feb 28, 2006 |       | —                                         |       | $                                           | —     |                                                                                                   | —     |                                                                                                                                        | $          | 17,415,551 |   |
| Mar 1, 2006 – Mar 31, 2006 |       | —                                         |       | $                                           | —     |                                                                                                   | —     |                                                                                                                                        | $          | 17,415,551 |   |
|                                 |            |                                                |            |                                             |            |                                                                                                        |            |                                                                                                                                             |            |  |  |  |

 

**Item 6.**           **Exhibits**

 

(a) Exhibits

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 2.1                 |       | Agreement  and Plan of Merger among SOURCECORP, Incorporated, Corpsource Holdings, LLC  and Corpsource Mergersub, Inc. dated as of March 7, 2006 (Incorporated by reference  to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed March 8,  2006)                                                                                                                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 2.2                 |       | Amendment  No. 1 to Agreement and Plan of Merger (incorporated by reference to Exhibit  2.1 to the Company’s Current Report on Form 8-K filed May 4, 2006)                                                                                                                                                                                                                                                                                                                                                             |
|                |       | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 3.1                 |       | Restated Certificate of  Incorporation of *SOURCECORP*,  Incorporated (Incorporated by reference to Exhibit 99.3 to Amendment No.1 to  the Company’s Registration Statement on Form 8-A filed on February 15, 2002)                                                                                                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2                 |       | Amended and Restated  By-Laws of *SOURCECORP*,  Incorporated (Incorporated by reference to Exhibit 3.2 to the Company’s  Current Report on Form 8-K filed on June 27, 2005)                                                                                                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.1                 |       | Specimen certificate for  the Common Stock, par value $.01 per share, of the Registrant. (Incorporated  by reference to Exhibit 99.1 to Amendment No. 1 to the Company’s Registration  Statement on Form 8-A filed on February 15, 2002)                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2                 |       | Form of Rights  Agreement, dated as of June 24, 2005, between SOURCECORP, Incorporated and  American Stock Transfer & Trust Company which includes as Exhibit A the  form of Certificate of Designations of Series A Participating Preferred  Stock, as Exhibit B the form of Right Certificate and as Exhibit C the  Summary of Rights to Purchase Series A Participating Preferred Stock  (incorporated by reference to Exhibit 4.1 to the Company’s Registration  Statement on Form 8-A filed on June 27, 2005) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.3                 |       | Amendment to Rights Agreement dated as of March 7, 2006 (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed March 8, 2006)                                                                                                                                                                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1                |       | Certification Pursuant to  section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.2                |       | Certification Pursuant to  section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 32.1                |       | Certification Pursuant to  section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 32.2                |       | Certification Pursuant to  section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this Report on Form 10-Q to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                     | SOURCECORP,  INCORPORATED |
|--------------------------|---------------------------|
|                     |                      |   |
| Date:  May 10, 2006 | By:                       | /s/ ED H. BOWMAN, JR. |
|                     |                      | Ed H. Bowman, Jr. Chief Executive  Officer and President |
|                     |                      |   |
| Date:  May 10, 2006 | By:                       | /s/ BARRY L. EDWARDS |
|                     |                      | Barry L. Edwards Executive Vice  President and Chief Financial Officer  (Principal Financial and Accounting  Officer) |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 2.1                 |       | Agreement  and Plan of Merger among SOURCECORP, Incorporated, Corpsource Holdings, LLC  and Corpsource Mergersub, Inc. dated as of March 7, 2006 (Incorporated by  reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed  March 8, 2006)                                                                                                                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 2.2                 |       | Amendment  No. 1 to Agreement and Plan of Merger (incorporated by reference to Exhibit  2.1 to the Company’s Current Report on Form 8-K filed May 4, 2006)                                                                                                                                                                                                                                                                                                                                                             |
|                |       | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 3.1                 |       | Restated Certificate of  Incorporation of *SOURCECORP*,  Incorporated (Incorporated by reference to Exhibit 99.3 to Amendment No.1 to  the Company’s Registration Statement on Form 8-A filed on February 15, 2002)                                                                                                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2                 |       | Amended and Restated  By-Laws of *SOURCECORP*,  Incorporated (Incorporated by reference to Exhibit 3.2 to the Company’s  Current Report on Form 8-K filed on June 27, 2005)                                                                                                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.1                 |       | Specimen certificate for  the Common Stock, par value $.01 per share, of the Registrant. (Incorporated  by reference to Exhibit 99.1 to Amendment No. 1 to the Company’s Registration  Statement on Form 8-A filed on February 15, 2002)                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2                 |       | Form of Rights  Agreement, dated as of June 24, 2005, between SOURCECORP, Incorporated and  American Stock Transfer & Trust Company which includes as Exhibit A the  form of Certificate of Designations of Series A Participating Preferred  Stock, as Exhibit B the form of Right Certificate and as Exhibit C the  Summary of Rights to Purchase Series A Participating Preferred Stock  (incorporated by reference to Exhibit 4.1 to the Company’s Registration  Statement on Form 8-A filed on June 27, 2005) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.3                 |       | Amendment to Rights Agreement dated as of March 7, 2006 (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed March 8, 2006)                                                                                                                                                                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1                |       | Certification Pursuant to  section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.2                |       | Certification Pursuant to  section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 32.1                |       | Certification Pursuant to  section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 32.2                |       | Certification Pursuant to  section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |

 

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