** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**FORM10-K**

 

**(Mark One)**

**ý****          ****ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For fiscal year ended December 31, 2005**

 

**OR**

 

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

 

**For the transition period from              to              **

 

**Commission File Number 1-14472**

** **

**CORNELL COMPANIES, INC.**

(Exact Name of Registrant as Specified In Its Charter)

 

| **Delaware**                                         | ** ** | **76-0433642**      |
|------------------------------------------------------|------------|---------------------|
| (State or Other Jurisdiction                         |       | (I.R.S. Employer    |
| of Incorporation or Organization)                    |       | Identification No.) |
|                                                 |       |                |
| **1700 West Loop South, Suite 1500, Houston, Texas** | ** ** | **77027**           |
| (Address of Principal Executive Offices)             |       | (Zip Code)          |

 

Registrant’s telephone number, including areacode:    **(713) 623-0790**

 

Securities registered pursuant toSection 12(b) of the Act:

 
| **Title of Each Class**                     | ** ** | **Name of Each Exchange on Which Registered** |
|---------------------------------------------|------------|-----------------------------------------------|
| **Common Stock, $.001 par value per share** | ** ** | **New York Stock Exchange**                   |
| **Preferred Stock Purchase Rights**         | ** ** | **New York Stock Exchange**                   |

 

Securities registered pursuant toSection 12(g) of the Act:  **None**

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act.

Yes o  No ý

Indicate by check mark if the registrant isnot required to file reports pursuant to Section 13 or Section 15(d) of theAct.

Yes  o  No ý

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

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K (229.405 of this Chapter) is not contained herein, and will notbe contained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o.

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. Checkone.

Large accelerated Filer o                                   Acceleratedfiler ý                              Non-acceleratedfiler o

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

Yes  o     No  ý

Theaggregate market value of voting stock held by non-affiliates of the registrantwas $153,636,963 on June 30, 2005. The registrant has 13,944,972 shares ofcommon stock outstanding on March 10, 2006

 

**Documents Incorporated by Reference**

The information required by Part III of this Report, to the extent notset forth herein, is incorporated by reference from the registrant’s definitiveproxy relating to its Annual Meeting of Stockholders to be held in 2006, whichdefinitive proxy statement will be filed with the Securities and ExchangeCommission within 120 days after the end of the fiscal year to which thisReport relates.

 

** **

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** **

**Cornell Companies, Inc.**

** **

**Table of Contents**

 

**2005 Form 10-K**

** **

** **
| ** **   | ** ** |                                                                                                               | **Page**   |
|--------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|
| **PART I**   | ** ** | ** **                                                                                                         | ** ** |
| Item 1.      |       | Business                                                                                                           | 3          |
| Item 1A.     |       | Risk Factors                                                                                                       | 14         |
| Item  1B.    |       | Unresolved Staff Comments                                                                                          | 20         |
| Item 2.      |       | Properties                                                                                                         | 20         |
| Item 3.      |       | Legal  Proceedings                                                                                                 | 20         |
| Item  4.     |       | Submission of Matters to a Vote of Security Holders                                                                | 22         |
|         |       |                                                                                                               |       |
| **Part II**  | ** ** | ** **                                                                                                         | ** ** |
| Item 5.      |       | Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities | 23         |
| Item 6.      |       | Selected  Consolidated Financial Data                                                                              | 26         |
| Item 7.      |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                        | 29         |
| Item 7A.     |       | Quantitative  and Qualitative Disclosures About Market Risk                                                        | 51         |
| Item 8       |       | Financial  Statements and Supplemental Data                                                                        | 52         |
| Item 9       |       | Changes In  and Disagreements with Accountants on Accounting and Financial Disclosure                              | 93         |
| Item 9A.     |       | Controls and  Procedures                                                                                           | 93         |
| Item 9B.     |       | Other Information                                                                                                  | 93         |
|         |       |                                                                                                               |       |
| **Part III** | ** ** | ** **                                                                                                         | ** ** |
| Item 10.     |       | Directors  and Executive Officers of the Registrant                                                                | 94         |
| Item 11.     |       | Executive  Compensation                                                                                            | 100        |
| Item 12.     |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                   | 102        |
| Item 13.     |       | Certain  Relationships and Related Transactions                                                                    | 104        |
| Item 14.     |       | Principal  Accountant Fees and Services                                                                            | 105        |
|         |       |                                                                                                               |       |
| **Part IV**  | ** ** | ** **                                                                                                         | ** ** |
| Item 15.     |       | Exhibits and  Financial Statement Schedules                                                                        | 107        |

** **

2

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**PART I**

 

#### **ITEM 1.**  BUSINESS

 

**Company Overview**

 

***Cornell Companies, Inc. was incorporatedin Delaware in 1996. We provide correction, detention, education,rehabilitation and treatment services for adults and juveniles. We partner withfederal, state, county and local government agencies to deliver quality,cost-efficient programs that we believe enable our customers to save taxpayers’money. Our customers include the Federal Bureau of Prisons (BOP), Bureau ofImmigration and Customs Enforcement (ICE), U.S. Marshals Service (USMS),various state Departments of Corrections, and city, county and stateDepartments of Human Services.***

 

***Cornell offers services in structured andsecure environments throughout three operating divisions:  (1) adult secure institutions and detentioncenters; (2) juvenile justice, educational and treatment programs; and (3)adult community-based corrections and treatment programs. Cornell, throughpredecessor entities, began operating in juvenile operations in 1973, adultcommunity-based programs in 1974, and adult secure operations in 1984. See Note16 to the Consolidated Financial Statements for a discussion concerning ouroperating segments.***

 

Asof December 31, 2005, we operated 79 facilities among the three business lines,representing a total operating service capacity of 17,473 in 18 states and theDistrict of Columbia. We also had two facilities under development orconstruction and three facilities that were substantially vacant. Collectively,these five facilities represent additional service capacity of 2,066. Servicecapacity is comprised of the number of beds currently available for service oravailable upon completion of construction of residential facilities and theaverage program capacity of non-residential community-based programs.

 

Additionalinformation about Cornell can be found on our website, *www.cornellcompanies.com*. We make availableon our website, free of charge, access to our Form 10-K, Form 10-Q,Form 8-K, and all amendments to these reports as soon as reasonablypracticable after such materials are electronically filed with the Securitiesand Exchange Commission (SEC). Alternatively, reports filed with the SEC may beviewed or obtained at the SEC Public Reference Room in Washington, D.C., or theSEC’s website, *www.sec.gov*. Informationprovided on our website or on the SEC’s website is not part of thisForm 10-K.

 

Each of our Board ofDirectors’ standing committee charters, our corporate governance guidelines andour policy of business conduct are available on our website or, upon request,in print, free of charge. We will post on our website all waivers to oramendments of our policy of business conduct, which are required to bedisclosed by applicable law and rules of the New York Stock Exchange (NYSE)listing standards.

 

# **Company Operations**

# ** **

We provide a continuum ofcare to adults and juveniles in institutional, residential, and community-basedsettings. Regardless of service line, each of our facilities emphasizes theimportance of engaging in the community as a productive, responsible citizen. Inmany of our adult secure institutions, we offer vocational training curricula, aswell as literacy and General Equivalency Diploma (GED) programs. In our adultcommunity-based programs, we offer job placement services, instruction onpersonal finance management, and other skill-based training. In most of ourjuvenile facilities, we provide family counseling services and behavioralcounseling. In facilities throughout the organization, we provide drug andalcohol counseling for our clients.

 

***We operate our facilities and programsunder the framework of our Seven Key Principles of Care***â. Theseprinciples state that our operations must maintain the safety and security ofour clients, our employees, and the local community. In addition, theprinciples require that we hold the individuals in our care accountable fortheir actions and expect them to assume responsibility. Furthermore, we expectour employees to act as role models, to communicate effectively andprofessionally, and to treat our clients with dignity and respect. Finally, ourprinciples call for us to manage physically clean and appropriately maintainedfacilities that are safe and conducive to an environment of care.

*** ***

# **Quality ofOperations**

# ** **

Weoperate our facilities in accordance with both company and facility-specificpolicies and procedures. Where required by contract or otherwise deemedappropriate for our service environments, these policies and procedures aredesigned to meet requirements set forth by independent industry oversightorganizations, including the American Correctional Association (ACA), JointCommission on Accreditation of Healthcare Organizations (JCAHO), and NationalCommission on Correctional 

 

3

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HealthCare (NCCHC). Standards may also be implemented to meet the requirements ofstate Departments of Public Welfare, Departments of Protective and RegulatoryServices, and Departments of Human Services and Education. We believe thataccreditation and the corresponding standards of operation enhance our abilityto provide quality programs and contribute to the public’s increased acceptanceof our services.

 

Internal quality control,conducted by senior facility staff and executive officers, takes the form ofperiodic operational, programmatic and fiscal audits; facility inspections;regular review of logs, reports and files; and strict maintenance of personnelstandards, including an active training program. Each of our facilitiesdevelops its own training plan in connection with customer requirements and isresponsible for performing annual updates to the plan.

 

# **Industry andBusiness Line Summary**

# ** **

***Incarceration,detention, education and treatment service for adults and juveniles havehistorically been provided by various government entities. In the UnitedStates, the incarcerated and sentenced populations of adults and juveniles hascontinued to increase while federal, state and local governments facecontinuing pressures to control costs and improve service quality. These trendshave caused growing consideration and acceptance towards outsourcing essentialgovernment services and functions.***

*** ***

Services offered amongCornell’s three divisions include incarceration and detention, transition fromincarceration, drug and alcohol counseling and treatment, behavioralrehabilitation and treatment, vocational training and academic education forgrades3 – 12. Private-sector companies, like Cornell, contract with governmentagencies to deliver these services, often at the same or higher quality and fora lower cost than what the agency can otherwise provide. Although outsourcingsuch essential services has historically faced opposition in the U.S., publicand government acceptance has increased as standards of service improve andcost savings are documented. As government agencies face fiscal budgetconstraints, outsourcing to private providers can offer economically positivealternatives. Recent publications have documented savings from privatizedincarceration in the States of Texas, Mississippi, and California – all statesin which Cornell operates. In addition, as a cost relief measure, governmentagencies have sought alternatives to incarceration, including reentry,education, substance abuse and behavioral health programs – all of which areservices Cornell provides.

 

***Outsourcing hasa longer history in the juvenile justice and adult community-based correctionssectors of the industry. Increasing steadily over the past 50 years, states,counties and local governments have used both for-profit and not-for-profitorganizations to meet the needs of troubled youth and adults reintegrating intosociety after a time in residential treatment or prison. Recently, governmentshave sought alternatives to the rising costs of incarceration for offenders whoare non-violent and need treatment, education and rehabilitation. Adultcommunity-based reentry programs as well as education, substance abuse andbehavioral health programs that can successfully divert an offender from prisonaddress this need.***

*** ***

###### ***Adult SecureInstitutional Services***

###### *** ***

The Bureau of JusticeStatistics reports that, in 2004, while the nation’s prison population grewonly 1.9 percent overall, the number of inmates in private facilities increased3.3 percent. Private facilities held 5.6 percent of all state prisoners and13.7 percent of federal prisoners in 2004. Increasingly, federal and statesystems are relying upon private providers to address continuously overcrowdedprisons. As of December 31, 2004, the federal prison system was operating at 40percent above capacity, sustaining the conditions reported for 2003.

 

Meanwhile,heightened attention has been placed on border patrol and immigrationenforcement. The President’s Budget for Fiscal Year 2007 provides $2.1 billionto support detention and removal efforts – an increase of 42 percent overFiscal Year 2006. Included in this initiative are plans for 6,700 new detentionbeds.

 

We believe that our adultsecure service line is well positioned to respond to these marketplaceconditions. We provide low- to maximum-security incarceration and detentionservices. In doing so, we ensure public safety through the operation of aphysically secure environment, which entails, among other security and safetymeasures, a routine patrol of the premises by trained correctional officers,alarmed fencing and razor wire, and centralized monitoring of activity viaclosed circuit camera systems. While incarcerated, offenders are offered avariety of educational, counseling and vocational programs aimed at providing asuccessful return to the community and a subsequent reduction in recidivism.

 

4

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As of December 31, 2005, weoperated 16 adult secure facilities with an aggregate service capacity of 8,181.We also had two adult secure facilities under development or construction withan aggregate service capacity of 1,660. Within the division, we offer thefollowing:

 

•      Low- to maximum-security incarceration anddetention

•      Confinement of juveniles adjudicated asadults

•      Facility design, construction and operation

•      Use of modern security technology, includingelectronic controls and surveillance equipment

•      Education courses, including preparation andtesting for the GED, English as a Second Language classes, and Adult BasicEducation (ABE)

•      Holistic healthcare services, includingmedical, dental, vision, psychiatric, and individual and group counselingservices

•      Substance abuse counseling

•      Life skills training, including angermanagement, hygiene, personal finance, employment and housing issues, andparenting skills

•      Religious opportunities and culturallysensitive programs

•      Food and laundry service

•      Recreational activities, including exerciseprograms

 

## ***Juvenile Justice, Educational and Treatment Services***

## ** **

Thejuvenile justice industry sector includes residential, detention, shelter care,and community-based services, along with educational, rehabilitation andtreatment programs. This sector is highly fragmented with several thousandproviders operating across the country. Most of the private providers are smalland operate in specific geographic areas.

 

Accordingto the Office of Juvenile Justice and Delinquency Prevention, approximately 2.2million juveniles (persons under the age of 18) were arrested in 2003. A recentstudy out of Columbia University suggests that annual spending on the juvenilejustice system is at least $14 billion. Juvenile justice issues present agrowing area of concern for many states due to the number of youth within thejudicial system and the related annual expenditures for placement and treatment.As a result, partnerships with private providers such as Cornell can providequality alternatives for care. In 2003, of the nearly 97,000 juveniles assignedto residential facilities in the U.S., over 30 percent were placed with privateproviders.

 

Beyondaddressing capacity issues within the juvenile justice system, states are alsofacing challenges posed by the unique needs of specialized juvenilepopulations, such as those with mental health issues. In a 2004 study, theNational Mental Health Association reported that the prevalence of youth in thejuvenile justice system with mental disorders was as high as 60 percent, ascompared to 22 percent in the general population. The study also noted that,for those youth who received treatment, the recidivism rate was as much as 25percent lower than untreated children and teens in study control groups.

 

Webelieve that our juvenile services division is uniquely equipped to address theissues currently facing the juvenile justice system. We provide a broad arrayof services to youth, typically between the ages of 10 and 17, in residentialand community-based settings. The programs and services provided at ourfacilities are designed to rehabilitate juveniles, hold them accountable fortheir actions and behaviors, and help them successfully reintegrate back intothe community. An underlying principle of our juvenile programming is theBalanced and Restorative Justice (BARJ) model, which provides a restorativecomponent to the victim, be it an individual, family, or community. The use ofthe BARJ model, in connection with our Seven Key Principles of Careâ, emphasizes accountability, competencydevelopment and community protection.

 

Asof December 31, 2005, we operated 19 residential facilities and 14non-residential community-based programs within our juvenile services division,representing operating service capacity of 4,165. We also had three facilitiesthat were substantially vacant with a service capacity of 406. Within thedivision, we offer the following:

 

•      Diverse treatment settings, includingphysically-secure, staff-secure, and community-based

•      Specialized treatment for unique populations,including females, drug addicts, sex offenders, fire starters, and families

•      Accredited alternative and special educationservices

•      Wilderness training programs and nationallyaccredited ropes course challenges

•      Individualized treatment planning and casemanagement

•      Individual, group and family counseling andtherapy, cognitive behavior therapy and stress and anger management instruction

•      Substance abuse counseling and treatment,relapse prevention and education

•      Life skills training, including hygiene,personal finance, employment and housing issues, and parenting skills

•      Holistic healthcare services includingmedical, dental, behavioral health and psychiatric services

•      Recreational activities, including exerciseprograms

 

5

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###### ***AdultCommunity-Based Corrections and Treatment Services***

###### *** ***

Community-basedcorrections services involve the supervision of adult parolees and probationers.Parolees are persons who have served time in a correctional facility and havebeen released due to either mandatory conditional release or a parole boarddecision. Probationers have been charged with a crime but sentenced toprobation in lieu of incarceration. Services provided to parolees andprobationers include temporary housing, employment assistance, anger managementinstruction, personal finance management training, academic opportunities,vocational training and substance abuse or addiction counseling. The highestpopulations of community corrections are located in Texas and California, whocollectively supervise 21 percent of all parolees and probationers in the U.S.,and where some of Cornell’s largest facilities in the division are located.

 

Asof year-end 2004, the Bureau of Justice Statistics reports that over 4.9million adults were supervised on probation or parole, up slightly from theprior year. Of this population, 41 percent of probationers were convicted of drugor alcohol-related violations and 38 percent of parolees were convicted fordrug offenses. This population requires substance abuse counseling andtreatment to help them successfully re-enter their communities and remain outof the criminal justice system.

 

Community-basedtreatment services include both residential and outpatient substance abuseprograms. Services include short-term and long-term residential care,counseling, HIV services, DUI services, detoxification and methadonemaintenance. According to the 2004 National Survey of Substance Abuse TreatmentServices, for-profit substance abuse treatment facilities treated 28 percent ofall clients and comprised 26 percent of all facilities. Clients in theseprograms can be self-admitted or referred by a local or state agency.

 

Webelieve that our adult community-based programs provide positive environmentsof care for both corrections and treatment clients. The market is fragmentedwith providers located across the country. Whereas most providers in theindustry are small and have limited geographic reach, Cornell offers a nationalpresence with locations in large urban areas, as well as suburban and ruralsettings. The adult community-based programs provide an alternative toincarceration and a focus on transitioning offenders from a correctionalfacility back into society. Through a system of education, employment training,treatment, monitoring and accountability, clients are given the necessary toolsto make positive life choices that can reduce the incidence of recidivism.

 

Asof December 31, 2005, we operated 20 residential community-based facilities and10 non-residential community-based programs with a combined total servicecapacity of 5,127. Within the division, we offer the following:

 

•      Minimum-security and staff-secure residentialservices

•      Home confinement and electronic monitoring

•      Substance-abuse counseling and treatment,including detoxification, testing, 12-step programs and relapse preventionservices

•      Employment training and assistance

•      Education, including preparation and testingfor the GED, ABE, computer courses, college-level courses and access tolibraries

•      Vocational training

•      Individual, group and family counseling andtherapy, cognitive behavior therapy and stress and anger management instruction

•      Life skills training, including hygiene,personal finance, housing issues, and parenting skills

 

**Facilities**

 

Asof December 31, 2005, we operated 79 facilities and had two facilities underdevelopment or construction. We also had three facilities that weresubstantially vacant. In addition to providing management services, we develop,design and/or construct many of our facilities.

 

Eitherthrough outright ownership or long-term leases, we control operating facilitiesrepresenting a large majority of our revenues. We believe that such controlincreases the likelihood of contract renewal, allows us to expand existingfacilities and thereby realize economies of scale, and enhances our ability towin new contracts and control repair costs. In addition, we believe thatlong-term control of our operating facilities allows us to better manage costescalation pressures.

 

6

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Thefollowing table summarizes certain additional information with respect to ourfacilities as of December 31, 2005. As indicated, the majority of thefacilities to which we provide services are either owned or leased underlong-term leases, which are generally under terms ranging from one to 45 years.

 
| **Facility Name and Location**                                                             | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|
|                                                                                       |       |                             |       |                            |       |                                        |       |
| ***Adult Secure Institutional Facilities:***                                               |       |                             |       |                            |       |                                        |       |
|                                                                                       |       |                             |       |                            |       |                                        |       |
| Baker Community Correctional Facility  Baker, California                                   |       | 262                              |       | 1987                            |       | Owned                                       |       |
| Big Spring Correctional Center  Big Spring, Texas                                          |       | 2,646                            |       |                            | (4)        | Leased                                      | (5)        |
| D. Ray James Prison  Folkston, Georgia                                                     |       | 1,640                            |       | 1998                            |       | Leased                                      | (5)        |
| Donald W. Wyatt Detention Center  Central Falls, Rhode Island                              |       | 357                              |       | 1992                            |       | Managed                                     |       |
| Great Plains Correctional Facility  Hinton, Oklahoma                                       |       | 766                              |       |                            | (6)        | Leased                                      | (5)        |
| Leo Chesney Community Correctional Facility  Live Oak, California                          |       | 200                              |       | 1988                            |       | Leased                                      |       |
| Lincoln County Detention Center  Carrizozo, New Mexico                                     |       | 144                              |       | 2001                            |       | Managed                                     | (7)        |
| Los Angeles City Jails (8)  Los Angeles Metropolitan Area, California                      |       | 255                              |       |                            | (8)        | Managed                                     | (7)        |
| Regional Correctional Center  Albuquerque, New Mexico                                      |       | 970                              |       | 2004                            | (9)        | Leased                                      |       |
| Walnut Grove Youth Correctional Facility  Walnut Grove, Mississippi                        |       | 941                              |       | 2004                            |       | Managed                                     |       |
|                                                                                       |       |                             |       |                            |       |                                        |       |
| ***Juvenile Justice, Educational and  Treatment******Facilities: Residential Facilities*** |       |                             |       |                            |       |                                        |       |
|                                                                                       |       |                             |       |                            |       |                                        |       |
| Alexander Youth Services Center  Alexander, Arkansas                                       |       | 143                              |       | 2001                            |       | Managed                                     |       |
| Campbell Griffin Treatment Center  San Antonio, Texas                                      |       | 122                              |       |                            | (10)       | Leased                                      | (5)        |
| Contact  Wauconda, Illinois                                                                |       | 51                               |       |                            | (11)       | Owned                                       |       |
| Cornell Abraxas I  Marienville, Pennsylvania                                               |       | 274                              |       | 1973                            |       | Leased                                      | (5)        |
| Cornell Abraxas II  Erie, Pennsylvania                                                     |       | 23                               |       | 1974                            |       | Owned                                       |       |
| Cornell Abraxas III  Pittsburgh, Pennsylvania                                              |       | 24                               |       | 1975                            |       | Owned                                       |       |
| Cornell Abraxas Center for Adolescent  Females  Pittsburgh, Pennsylvania                   |       | 108                              |       | 1989                            |       | Owned                                       |       |
| Cornell Abraxas of Ohio  Shelby, Ohio                                                      |       | 108                              |       | 1993                            |       | Leased                                      | (5)        |
| Cornell Abraxas Youth Center  South Mountain, Pennsylvania                                 |       | 72                               |       | 1999                            |       | Leased                                      |       |

 

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| **Facility Name and Location**                                                                     | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                         | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** **                                  | ** ** |
| ***Juvenile Justice, Educational and Treatment  Facilities:  Residential Facilities (Continued)*** |       |                             |       |                            |       |                                        |       |
|                                                                                               |       |                             |       |                            |       |                                        |       |
| Danville Center for Adolescent Females  Danville, Pennsylvania                                     |       | 64                               |       | 1998                            |       | Managed                                     |       |
| DuPage Adolescent Center  Hinsdale, Illinois                                                       |       | 38                               |       |                            | (11)       | Owned                                       |       |
| Erie Residential Behavioral Health Program  Erie, Pennsylvania                                     |       | 17                               |       | 1999                            |       | Owned                                       |       |
| Jos-Arz Academy  Washington, D.C.                                                                  |       | 70                               |       |                            | (12)       | Leased                                      |       |
| Leadership Development Program  South Mountain, Pennsylvania                                       |       | 120                              |       | 1994                            |       | Leased                                      |       |
| New Morgan Academy  New Morgan, Pennsylvania                                                       |       | 214                              |       |                            | (13)       | Owned                                       |       |
| Psychosocial Rehabilitation Unit  Erie, Pennsylvania                                               |       | 13                               |       | 1994                            |       | Owned                                       |       |
| Salt Lake Valley Detention Center  Salt Lake City, Utah                                            |       | 160                              |       | 1996                            |       | Managed                                     |       |
| Schaffner Youth Center  Steelton, Pennsylvania                                                     |       | 63                               |       | 2001                            |       | Managed                                     |       |
| South Mountain Secure Treatment Unit  South Mountain, Pennsylvania                                 |       | 56                               |       | 1997                            |       | Managed                                     |       |
| Southern Peaks Regional Treatment Center  Canon City, Colorado                                     |       | 160                              |       | 2004                            |       | Owned                                       |       |
| Texas Adolescent Treatment Center  San Antonio, Texas                                              |       | 124                              |       | 2003                            |       | Leased                                      |       |
| Woodridge  Woodridge, Illinois                                                                     |       | 163                              |       |                            | (11)       | Owned                                       |       |
|                                                                                               |       |                             |       |                            |       |                                        |       |
| ***Juvenile Justice, Educational and Treatment  Facilities:  Non-Residential Facilities***         |       |                             |       |                            |       |                                        |       |
|                                                                                               |       |                             |       |                            |       |                                        |       |
| Cornell Abraxas Parenting Academy  Harrisburg, Pennsylvania                                        |       | 36                               |       | 1999                            |       | Leased                                      |       |
| Delaware Community-Based Programs  Milford, Delaware                                               |       | 66                               |       | 1994                            |       | Leased                                      |       |
| Harrisburg Day Treatment  Harrisburg, Pennsylvania                                                 |       | 45                               |       | 1996                            |       | Leased                                      |       |
| Leadership Academy/ACTS Program  Harrisburg, Pennsylvania                                          |       | 400                              |       | 2001                            |       | Managed                                     |       |
| Lebanon Alternative Education  Lebanon, Pennsylvania                                               |       | 225                              |       | 2004                            |       | Managed                                     |       |
| Lehigh Valley Community-Based Programs  Lehigh Valley, Pennsylvania                                |       | 60                               |       | 1992                            |       | Leased                                      |       |

 

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| **Facility Name and Location**                                                                         | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                             | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** **                                  | ** ** |
| ***Juvenile Justice, Educational and Treatment  Facilities:  Non-Residential Facilities (Continued)*** |       |                             |       |                            |       |                                        |       |
|                                                                                                   |       |                             |       |                            |       |                                        |       |
| Non-Residential Detention/Non-Residential  Treatment  Harrisburg, Pennsylvania                         |       | 91                               |       | 1999                            |       | Leased                                      |       |
| Philadelphia Alternative Education  Philadelphia, Pennsylvania                                         |       | 165                              |       | 2004                            |       | Managed                                     |       |
| Philadelphia Community-Based Programs  Philadelphia, Pennsylvania                                      |       | 71                               |       | 1992                            |       | Owned                                       |       |
| Reading Alternative Education  Reading, Pennsylvania                                                   |       | 200                              |       | 2005                            |       | Managed                                     |       |
| State Reintegration Program  Harrisburg, Pennsylvania                                                  |       | 225                              |       | 1991                            |       | Managed                                     |       |
| Sankofa House  Laurel, Maryland                                                                        |       | 40                               |       | 2005                            |       | Managed                                     |       |
| Washington D.C. Community-Based Programs  District of Columbia                                         |       | 160                              |       | 1993                            |       | Leased                                      |       |
| WorkBridge  Pittsburgh, Pennsylvania                                                                   |       | 600                              |       | 1994                            |       | Leased                                      |       |
|                                                                                                   |       |                             |       |                            |       |                                        |       |
| ***Adult Community-Based Corrections and  Treatment Facilities:  Residential Facilities***             | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** **                                  | ** ** |
| ** **                                                                                             | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** **                                  | ** ** |
| Beaumont Transitional Treatment Center  Beaumont, Texas                                                |       | 180                              |       | 2002                            |       | Owned                                       | (7)        |
| Cordova Center  Anchorage, Alaska                                                                      |       | 192                              |       | 1985                            |       | Leased                                      | (5)        |
| Dallas County Judicial Treatment Center  Wilmer, Texas                                                 |       | 300                              |       | 1991                            |       | Managed                                     |       |
| El Monte Center  El Monte, California                                                                  |       | 55                               |       | 1993                            |       | Leased                                      |       |
| Grossman Center  Leavenworth, Kansas                                                                   |       | 150                              |       | 2002                            |       | Leased                                      | (7)        |
| Las Vegas Community Correctional Center  Las Vegas, Nevada                                             |       | 100                              |       | 2004                            |       | Leased                                      |       |
| Leidel Comprehensive Sanction Center  Houston, Texas                                                   |       | 150                              |       | 1996                            |       | Leased                                      | (5)        |
| Marvin Gardens Center  Los Angeles, California                                                         |       | 52                               |       | 1981                            |       | Leased                                      |       |
| McCabe Center  Austin, Texas                                                                           |       | 90                               |       | 1999                            |       | Owned                                       | (7)        |
| Mid Valley House  Edinburg, Texas                                                                      |       | 96                               |       | 1998                            |       | Leased                                      | (7)        |
| Midtown Center  Anchorage, Alaska                                                                      |       | 32                               |       | 1998                            |       | Owned                                       |       |

 

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| **Facility Name and Location**                                                                         | ** **   | **Total  Service  Capacity (1)** | ** **   | **Initial  Contract  Date (2)** | ** **   | **Company  Owned/  Leased or  Managed (3)** | ** **   |
|--------------------------------------------------------------------------------------------------------|--------------|----------------------------------|--------------|---------------------------------|--------------|---------------------------------------------|--------------|
|                                                                                                   |         |                             |         |                            |         |                                        |         |
| ***Adult Community-Based Corrections and  Treatment Facilities:  Residential Facilities (Continued)*** | ** **   | ** **                       | ** **   | ** **                      | ** **   | ** **                                  | ** **   |
| ** **                                                                                             | ** **   | ** **                       | ** **   | ** **                      | ** **   | ** **                                  | ** **   |
| Northstar Center  Fairbanks, Alaska                                                                    |         | 135                              |         | 1990                            |         | Leased                                      |         |
| Oakland Center  Oakland, California                                                                    |         | 61                               |         | 1981                            |         | Owned                                       |         |
| Parkview Center  Anchorage, Alaska                                                                     |         | 112                              |         | 1993                            |         | Leased                                      | (5)          |
| Reality House  Brownsville, Texas                                                                      |         | 66                               |         | 1998                            |         | Owned                                       | (7)          |
| Reid Community Residential Facility  Houston, Texas                                                    |         | 500                              |         | 1996                            |         | Leased                                      | (5)          |
| Salt Lake City Center  Salt Lake City, Utah                                                            |         | 78                               |         | 1995                            |         | Leased                                      |         |
| Seaside Center  Nome, Alaska                                                                           |         | 48                               |         | 1999                            |         | Leased                                      |         |
| Taylor Street Center  San Francisco, California                                                        |         | 177                              |         | 1984                            |         | Owned                                       | (14)         |
| Tundra Center  Bethel, Alaska                                                                          |         | 85                               |         | 1986                            |         | Leased                                      | (5)          |
| *** ***                                                                                           | *** *** | *** ***                     | *** *** | *** ***                    | *** *** | *** ***                                | *** *** |
| ***Adult Community-Based Corrections and  Treatment Facilities:  Non-Residential Facilities***         | ** **   | ** **                       | ** **   | ** **                      | ** **   | ** **                                  | ** **   |
| ** **                                                                                             | ** **   | ** **                       | ** **   | ** **                      | ** **   | ** **                                  | ** **   |
| Dixon Correctional Center (15)  Dixon, Illinois                                                        |         | 68                               |         | 2003                            |         | Managed                                     |         |
| East St. Louis  East St. Louis, Illinois                                                               |         | 164                              |         |                            | (11)         | Leased                                      |         |
| LifeWorks  Joliet, Illinois                                                                            |         | 116                              |         |                            | (11)         | Leased                                      |         |
| Sentencing Concepts (16)  California                                                                   |         | 900                              |         |                            | (16)         | Leased                                      | (7)          |
| Southwestern Illinois Correctional Center  (17)  East St. Louis, Illinois                              |         | 671                              |         |                            | (11)         | Managed                                     |         |
| Southwood  Chicago, Illinois                                                                           |         | 549                              |         |                            | (11)         | Owned                                       |         |
|                                                                                                   |         |                             |         |                            |         |                                        |         |
| ***Facilities Under Development or  Construction:***                                                   | *** *** | *** ***                     | *** *** | *** ***                    | *** *** | *** ***                                | *** *** |
| *** ***                                                                                           | *** *** | *** ***                     | *** *** | *** ***                    | *** *** | *** ***                                | *** *** |
| Mesa Verde Community Correctional Facility  Bakersfield, California                                    |         | 360                              |         | 2006                            | (18)         | Leased                                      |         |
| Moshannon Valley Correctional Center (19)  Philipsburg, Pennsylvania                                   |         | 1,300                            |         | 2006                            |         | Owned                                       |         |

 

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(1)       Residential service capacity is comprised ofthe number of beds currently available for service or available upon thecompletion of construction or renovation of residential facilities.Non-residential service capacity for programs is based on either contractualterms or our estimate of the number of clients to be served. These estimatesare updated by us at least annually based on the program’s budget and otherfactors.

(2)       Date fromwhich we, or our predecessor, have had a contract for services on anuninterrupted basis.

(3)      We do not incurany facility use costs, such as debt service, rent or depreciation, forfacilities that we operate under a management contract only; however, we areresponsible for all other facility operating costs at these facilities.

(4)      The City of Big Spring entered into anIntergovernmental Agreement (IGA) with the BOP for an indefinite term (untilmodified or terminated) with respect to the Big Spring Correctional Center,which began operations in 1989. The Big Spring Operating Agreement, as amended,has a term through 2047 including renewal options at our discretion, pursuantto which we manage the Big Spring Correctional Center for the City of BigSpring. The portion of the Big Spring Operating Agreement relating to the CedarHill Unit has a term of 30 years with four five-year renewal options, exercisableat our discretion.

(5)      Facility was sold in August 2001 toMunicipal Corrections Finance, L.P. (MCF) as part of a 2001 sale and leasebacktransaction as discussed in Item 8. “Financial Statements and SupplementaryData – Note 13.”

(6)      The prison is operated pursuant to a one-yearcontract with nine one-year renewal options between the Oklahoma Department ofCorrections and the Hinton Economic Development Authority, or HEDA. HEDA inturn has subcontracted the operations to us under a 30-year operating contractwith four five-year renewals.

(7)      Facility/programwas acquired in April 2005 in connection with the Company’s purchase ofCorrectional Systems, Inc. (CSI) Refer to Item 7. “Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Significant 2005Events” for a discussion of the acquisition.

(8)      Los Angeles City Jails represents sevenindividual locations in Los Angeles, California and the surrounding area.Initial contract dates vary by agency and range from 1994-2000.

(9)      We leased the Regional CorrectionalCenter in January 2003 and have since renovated the facility. The facilitycommenced operation in 2004 under an IGA between Bernalillo County and theUSMS. In 2005, the IGA was replaced with a new contract between BernalilloCounty and the U.S. Department of Justice Office of Detention Trustee, whichallows for services to be provided to both the USMS and ICE. Refer to Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Liquidity and Capital Resources – Contractual Uncertainties Related to CertainFacilities – Regional Correctional Center” for further discussion concerningthis facility.

(10)    Weclosed the Campbell Griffin Treatment Center in the fourth quarter of 2005 andare currently considering several options for use, including operation of a newprogram. Refer to Item 7. “Management’s Discussion and Analysis of FinancialCondition and Results of Operations – Liquidity and Capital Resources –Contractual Uncertainties Related to Certain Facilities – Campbell GriffinTreatment Center” for further discussion concerning this facility.

(11)    The Cornell Interventions programs/facilitiescontract with numerous agencies throughout Illinois. Initial contract datesvary by agency and range from 1974 to 1997.

(12)    Weclosed the Jos-Arz Academy in 2005 and are currently considering severaloptions for use, ranging from the subletting or possible sale of the facilityto the utilization of the facility for another type of program.

(13)    We closed the New Morgan Academy in 2002 andcurrently intend to reopen as a residential treatment facility for youth sexoffenders by the fourth quarter of 2006. Refer to Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Liquidity and Capital Resources – Contractual Uncertainties Related to CertainFacilities – New Morgan Academy” for further discussion concerning thisfacility.

(14)    Facility was initially financed with oursynthetic lease financing arrangement under our amended 2000 Credit Facility.The amended 2000 Credit Facility was refinanced in 2004 through our issuance ofthe Senior Notes. Refer to Item 7. “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations - Liquidity and Capital Resources– Long-Term Credit Facilities.”

(15)    We manage a 68 bed dual diagnosis programlocated within the Special Treatment Center of the state-operated DixonCorrectional Center.

(16)    SentencingConcepts represents five individual facilities in the following Californialocations: Anaheim, Lake Forest, San Luis Obispo, Santa Maria and Stockton.Initial contract dates vary by agency and range from 1994-2002.

(17)    We manage a therapeutic community drug andalcohol program within the state-operated Southwestern Illinois CorrectionalCenter.

(18)    TheMesa Verde Community Correctional Facility commenced operations in the firstquarter of 2006.

(19)    Asof December 31, 2005, construction on the Moshannon Valley Correctional Centerwas in process. The facility is scheduled to open during 2006 under anoperating agreement with the BOP. Refer to Item 7. “Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Recent Developments– Moshannon Valley Correctional Center” for further discussion concerning thisfacility.

 

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**Marketing and Business Development**

 

Our principal customers are federal, state, and local governmentagencies responsible for adult and juvenile corrections, treatment andeducational services. We manage our business development efforts to addressopportunities available in all of our divisions and potential markets. Whilesuch opportunities necessarily include forming relationships with newcustomers, we also believe that further potential lies in the management of ourexisting relationships through improved bed management and through enhancementsof our contract terms. From time to time, we will also evaluate opportunitiesfor accretive acquisition.

 

In most instances, we pursue development opportunities through Requestsfor Proposal (RFPs) or Requests for Qualifications (RFQs), which are submittedin response to government agencies’ solicitations for bids. The decision torespond to such solicitations is based upon several factors, includingmanagement’s assessment of customer needs, the company’s ability to service theneeds in an operationally successful and acceptably profitable manner, and thefit of the potential program within the company’s existing portfolio andstrategic objectives. The solicitations generally require the bidder todemonstrate relevant operational experience. Furthermore, the response mustalso include descriptions of the services to be provided by the bidder and theprice at which the bidder is willing to provide them. Services can include notonly direct care, but also the design, construction, or renovation of therelated facility.

 

If we believe a project described in an RFP is consistent with ourstrategic business plan, we will submit a proposal to the requesting agency. Whenresponding to RFPs, we typically incur costs ranging from $10,000 to $100,000per proposal. In addition, we could incur substantial costs to acquire optionsto lease or purchase land for a proposed facility or to lease or purchase anexisting building to house a program. The preparation of a response usuallyrequires four to 12 weeks. The award process usually takes an additional threeto nine months. If new construction is required by the contract, the selectedcompany’s operation of the facility generally begins between 18 and 36 monthsfollowing award announcement, although in some cases as early as four months. Ininstances where construction is required, our success depends, in part, uponour ability to acquire property that is not only satisfactory for programmaticneeds but also that lies in a community where social opposition does notsignificantly impede our ability to operate. We may incur significant expensesin responding to such opposition, and there can be no assurance of success. Inaddition, we may choose not to respond to an RFP or may withdraw a submittedproposal if significant legal action or other forms of opposition areanticipated or encountered.

 

In addition to responding to RFPs, we also rely upon court-referrals,insurance- or managed care-referrals, and self-referrals for business growth,particularly in our juvenile and adult community-based treatment programs. Insuch instances, court and community liaisons play a significant role in developingthe company’s growing network of clients.

 

#### **Contracts**

#### ** **

Our facility operating contracts generally provide that we will becompensated via an occupant per diem rate, fees for treatment services,guaranteed take-or-pay terms, a fixed fee, or cost-plus reimbursement. Factorswe consider in determining billing rates include (1) the specified programsprovided for by the contract and the related staffing levels, (2) wage levelscustomary in the respective geographic area, (3) whether the proposed facilityis to be leased or purchased, and (4) the anticipated average occupancy levelsthat we believe could reasonably be maintained. Compensation is invoiced inaccordance with the applicable contract and is typically paid on a monthlybasis. Some of our juvenile education contracts provide for annual payments.

 

We pursue new contracts that leverage our existing infrastructure andcapabilities. The majority of our opportunities are other than take-or-paycontracts, which provide a fixed minimum revenue stream regardless of occupancy.All of the other types of contracts produce revenue that varies with the numberof individuals housed or served, the types of services provided and/or thefrequency of the service.

 

**Competition**

 

Because our services encompass several diverse markets, we view ourcompetition within market segments. We believe our principal non-governmentalcompetitors in the adult secure market are Corrections Corporation of America,Inc., The Geo Group, Inc., and Management and Training Corporation. Within ourtwo other segments – juvenile justice, education and treatment and adultcommunity-based corrections and treatment – we typically encounter asignificantly more fragmented competitor base, which includes not onlyfor-profit operators like ourselves but also not-for-profit organizations. Withinthe juvenile justice, education and treatment segment, some of our primarynon-governmental competitors include ViaQuest, Youth and Family CenteredServices, Securicor New Century, and Ramsay Youth Services. Our largernon-governmental competitors in the adult community-based corrections andtreatment market include Dismas House, Bannum, Gateway, Salvation Army, and

 

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Volunteers of America.

** **

**Employees**

 

AtDecember 31, 2005, we had 3,911 full-time employees and 602 part-timeemployees. We employ management, administrative and clerical, security,educational and counseling services, health services and general maintenancepersonnel. Approximately 718 employees at six of our facilities are representedby unions.

 

**Regulations**

 

Theindustry in which we operate is subject to federal, state and local regulationsadministered by a variety of regulatory authorities. Generally, prospectiveproviders of correctional, detention, educational, treatment andcommunity-based services must comply with a variety of applicable federal,state and local regulations, including education, healthcare and safetyregulations. Our contracts frequently include extensive reporting requirements,including mandatory supervision with on-site monitoring by representatives ofour contracting government agencies.

 

Inaddition to regulations requiring certain contracting government agencies toenter into a competitive bidding procedure before awarding contracts, the lawsof certain jurisdictions may also require us to award subcontracts on acompetitive basis or to subcontract with businesses owned by women or membersof minority groups.

 

**Business Concentration**

 

Forthe years ended December 31, 2005, 2004 and 2003, 23.0%, 22.3% and 21.7%,respectively, of our consolidated revenues were derived from multiple contractswith the BOP. The increase in the percentage for 2005 as compared to the priortwo years is due to additional BOP revenue in 2005 resulting from theacquisition of Correctional Systems, Inc. (CSI) in April 2005.

 

Our contract to manage the Big Spring Correctional Center accounts formore than ten percent of our consolidated revenues. The loss of this contractwould have a material effect on our financial condition, results of operationsand cash flows.

 

**Insurance**

 

Wemaintain general liability insurance for all of our operations at an amountequal to $10 million per occurrence per facility and in the aggregate. We alsomaintain insurance in amounts management deems adequate to cover property andcasualty risks, workers’ compensation, and directors’ and officers’ liability.

 

Ourcontracts and the statutes of certain states in which we operate typicallyrequire us to maintain insurance. Our contracts provide that, in the event wedo not maintain such insurance, the contracting agency may terminate itsagreement with us. We believe that we are in compliance in all materialrespects with these requirements.

 

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**ITEM 1A.****      ****RISK FACTORS**

 

**Risk Factors and Cautionary Statement for Purposes of the “SafeHarbor” Provisions of the Private Securities Litigation Reform Act of 1995**

 

Thisreport contains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. These statements are based on current plans and actual futureactivities and results of operations may be materially different from those setforth in the forward-looking statements. Where any forward-looking statement includes a statement of theassumptions or bases underlying the forward-looking statement, we caution that,while we believe these assumptions or bases to be reasonable and in good faith,assumed facts or bases almost always vary from the actual results, anddifferences between assumed facts or bases and actual results can be material,depending upon the circumstances. Where, in any forward-looking statement, weexpress an expectation or belief as to future results, that expectation orbelief is expressed in good faith and is believed to have a reasonable basis.We cannot assure you, however, that the statement of expectation or belief willresult or be achieved or accomplished. The words “believe,” “could,” “expect,” “estimate,”“anticipate,” “may” and similar expressions will generally identifyforward-looking statements. All of our forward-looking statements, whetherwritten or oral, are expressly qualified by these cautionary statements and anyother cautionary statements that may accompany such forward-looking statements.In addition, we disclaim any obligation to update any forward-lookingstatements to reflect events or circumstances after the date of this report.

 

Withthis in mind, you should consider the risks discussed below and elsewhere inthis report and other documents we file with the Commission from time to timeand the following important factors that could cause actual results to differmaterially from those expressed in any forward-looking statement made by us oron our behalf.

 

***Resistance to privatizationof correctional and detention facilities could result in our inability toobtain new contracts or the loss of existing contracts.***

*** ***

Managementof correctional and detention facilities, particularly of adult securefacilities, by private entities has not achieved complete acceptance by eitherthe government or the public. The movement toward privatization of correctionaland detention facilities has also encountered resistance from certain groups,such as labor unions, local sheriff’s departments, religious organizations andgroups believing that correctional and detention facility operations shouldonly be conducted by government agencies. Changes in the dominant politicalparty in any market in which correctional facilities are located could have anadverse impact on privatization. Furthermore, some government agencies are notlegally permitted to delegate their traditional management responsibilities forcorrectional and detention facilities to private companies.

 

Inaddition, as a private prison manager, we are subject to government legislationand regulation restricting the ability of private prison managers to housecertain types of inmates, such as inmates from other jurisdictions or inmatesat medium or higher security levels. Legislation has been enacted in severalstates, and has previously been proposed in the United States House ofRepresentatives, containing such restrictions. Any such legislation may have amaterial adverse affect on us.

 

Anyof these resistances may make it more difficult for us to renew or maintainexisting contracts, to obtain new contracts or sites on which to operate newfacilities or to develop or purchase facilities and lease them to government orprivate entities, any or all of which could have a material adverse effect onour business.

 

***We are subject to the short-term nature ofgovernment contracts.***

 

Manygovernmental agencies are legally limited in their ability to enter intolong-term contracts that would bind elected officials responsible for futurebudgets. Therefore, many contracts with government agencies, including the BOP,typically either have a very short term or are subject to termination on shortnotice without cause. The majority of our contracts have primary terms of oneto three years. Our contracts with governmental agencies may contain one ormore renewal options that may be exercised only by the contracting governmentagency. Some of these contracts may not be renewed by the governmental agencyand no assurance can be given that the governmental agency will exercise arenewal option in the future. In addition, the governmental agency may elect tosolicit bids pursuant to an RFP or RFQ rather than exercise a renewal option.No assurance of success can be given for any RFP or RFQ.

 

Thenon-renewal or termination of any of our significant contracts withgovernmental agencies or our failure to successfully respond to a RFP or RFQ couldmaterially adversely affect our financial condition, results of operation andliquidity, including our ability to secure new facility management contractsfrom others. To the extent we have made significant capital expenditures andhave short-term contracts with our customers that are not renewed or extended,we may not recover our entire capital investment.

 

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***Budgetary pressure onfederal, state and local governments may result in contract cancellation or areduction in per diem rates, which would reduce our profitability.***

*** ***

Ourcash flow is subject to the receipt of sufficient funding of and timely paymentby contracting governmental entities. If the appropriate government agency doesnot receive sufficient appropriations to cover its contractual obligations, acontract may be terminated or the amounts payable to us may be deferred orreduced.

 

Federal,state and local governments have encountered, and are expected to continue toencounter, significant budgetary constraints that may result in a reduction ofspending on the outsourced services that we provide. Such budgetary limitationsmay cause the contractual commitments to be reduced or even eliminated, whichwould make it unprofitable to continue operating a certain facility and requireus to find alternate customers or close such facility.

 

Manystates are facing significant budget deficits and are under pressure to reducecurrent levels of spending or control additional spending. As a result of thisincreased budgetary pressure, we have granted a few of our customers relieffrom formulaic increase provisions in their agreements and some of ourcustomers have not included in their appropriation legislation amounts thatwould increase the per diem rates payable to us. Contractual rate increases aregenerally intended to offset increases in expenses and inflation. To the extentrates are not increased or are reduced, our profitability will be adverselyaffected.

 

***Our ability to win new contracts to developand manage correctional, detention and treatment facilities depends on manyfactors outside our control.***

 

Ourgrowth is generally dependent upon our ability to win new contracts to developand manage new correctional, detention and treatment facilities. This dependson a number of factors we cannot control, including crime rates and sentencingpatterns in various jurisdictions. Accordingly, the demand for our facilitiescould be adversely affected by the relaxation of enforcement efforts, leniencyin conviction and sentencing practices or through the legaldecriminalization of certain activities that are currently proscribed bycriminal laws. For instance, changes in laws relating to drugs and controlledsubstances or illegal immigration could reduce the number of persons arrested,convicted and sentenced, thereby potentially reducing demand for correctionalfacilities to house them and community-based services to transition offendersback into the community. Similarly, reductions in crime rates could lead toreductions in arrests, convictions and sentences requiring correctionalfacilities.

 

When seeking bids, most governmental entities evaluate the financialstrength of the bidders. To the extent they believe we do not have sufficientfinancial resources, we will be unable to effectively compete for bids. Additionally,our success in obtaining new awards and contracts may depend, in part, upon ourability to locate land that can be leased or acquired on favorable terms.Furthermore, desirable locations may be in or near populated areas and,therefore, may generate legal action or other forms of opposition from residentsin areas surrounding a proposed site.

 

***Our profitability may suffer if the numberof offenders occupying our correctional, detention and treatment facilitiesdecreases or there is a shift in occupancy among our divisions.***

 

Ourcorrectional, detention and treatment facilities are dependent upongovernmental agencies supplying offenders and we do not control occupancylevels at our facilities. We believe the rate of growth experienced in theadult secure sector during the late 1980s and early 1990s is stabilizing.

 

Historically,a substantial portion of our revenues has been generated under contracts thatspecify a net rate per day per resident, or a per diem rate, sometimes with nominimum guaranteed occupancy levels, even though most correctional facilitycost structures are relatively fixed. Under such a per diem rate structure, adecrease in occupancy levels at a particular facility could have a materialadverse effect on the financial condition and results of operations at suchfacility. A decrease in the occupancy of certain juvenile justice, educationand treatment facilities would have a more significant impact on our operatingresults than a decrease in occupancy in the adult secure institutional servicesdivision due to higher per diem revenue at certain juvenile facilities.

 

Socialcommentators and various political or governmental representatives suggest thatcommunity-based corrections of adults may be emphasized in the future asalternatives to traditional incarceration. We have historically experiencedhigher operating margins in the adult secure institutional services and theadult community-based corrections and treatment services sectors than in thejuvenile services sector. A shift in occupancy among our segments of businessoperations could result in a decrease in our profitability.

 

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***A failure to comply with existingregulations could result in material penalties or non-renewal or termination ofour contracts.***

 

Ourindustry is subject to a variety of federal, state and local regulations,including education, environmental, health care and safety regulations, whichare administered by various regulatory authorities. We may not alwayssuccessfully comply with these regulations, and failure to comply could resultin material penalties or non-renewal or termination of facility managementcontracts. The contracts typically include extensive reporting requirements andsupervision and on-site monitoring by representatives of contracting governmentalagencies. Corrections officers are customarily required to meet certaintraining standards, and in some instances facility personnel are required to belicensed and subject to background investigation. Certain jurisdictions alsorequire that subcontracts be awarded on a competitive basis or that wesubcontract with businesses owned by members of minority groups. The failure tocomply with any applicable laws, rules or regulations and the loss of anyrequired license could adversely affect the financial condition and results ofoperations at our affected facilities.

 

***Governmental agencies may investigate andaudit our contracts and, if any improprieties are found, we may be required torefund revenues we have received, and/or to forego anticipated revenues and maybe subject to penalties and sanctions, including prohibitions on our bidding inresponse to RFPs.***

 

Governmentalagencies we contract with have the authority to audit and investigate ourcontracts with them. As part of that process, some governmental agencies reviewour performance on the contract, our pricing practices, our cost structure andour compliance with applicable laws, regulations and standards. If the agencydetermines that we have improperly allocated costs to a specific contract, wemay not be reimbursed for those costs and we could be required to refund theamount of any such costs that have been reimbursed. If a government audituncovers improper or illegal activities by us or we otherwise determine thatthese activities have occurred, we may be subject to civil and criminalpenalties and administrative sanctions, including termination of contracts,forfeitures of profits, suspension of payments, fines and suspension ordisqualification from doing business with the government. Any adversedetermination could adversely impact our ability to bid in response to RFPs inone or more jurisdictions and significantly reduce the probability of oursuccess in the bid process for future contracts.

 

***If we fail to satisfy our contractualobligations, our ability to compete for future contracts and our financialcondition may be adversely affected.***

 

Ourfailure to comply with contract requirements or to meet our client’sperformance expectations when performing a contract could materially and adverselyaffect our financial performance and our reputation, which, in turn, wouldimpact our ability to compete for new contracts. Our failure to meetcontractual obligations could also result in substantial actual andconsequential damages. In addition, our contracts often require us to indemnifyclients for our failure to meet performance standards. Some of our contractscontain liquidated damages provisions and financial penalties related toperformance failures. Although we have liability insurance, the policy limitsmay not be adequate to provide protection against all potential liabilities.

 

***Competitors in our industry may adverselyaffect the profitability of our business.***

 

Wemust compete with government entities and other private operators on the basisof cost, quality and range of services offered, experience in managingfacilities, reputation of personnel and ability to design, finance andconstruct new facilities on a cost effective competitive basis. While there arebarriers for companies seeking to enter into the management and operation ofcorrectional, detention and treatment facilities, there can be no assurancethat these barriers will be sufficient to limit additional competition. Certainareas of our operation may not pose a significant barrier to entry into themarket by private operators. For example, private operators may not find it asdifficult to bid for juvenile treatment, educational and detention services andpre-release correctional and treatment services as they do adult secure institutional,correctional and detention services.

 

Further, our government customers may assume the management of afacility currently managed by us upon the termination of the correspondingmanagement contract or, if such customers have capacity at their facilities,may take inmates currently housed in our facilities and transfer them togovernment run facilities. The resulting decrease in occupancy levels wouldreduce our revenue due to the per diem rate structure and could result in asignificant decrease in the profitability of our business.

 

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***A disturbance or violent occurrence in oneof our facilities could result in closure of a facility or harm to ourbusiness.***

 

Anescape, riot, disturbance or violent occurrence at one of our facilities couldadversely affect the financial condition, results of operations and liquidityof our operations. Among other things, the negative publicity generated as aresult of an event could adversely affect our ability to retain an existingcontract or obtain future ones. In addition, if such an event were to occur,there is a possibility that the facility where the event occurred may be shutdown by the relevant governmental agency. A closure of certain of ourfacilities could adversely affect the financial condition, results ofoperations and liquidity of our operations. Such negative events may alsoresult in a significant increase in our liability insurance costs.

 

***Negative media coverage, includinginaccurate or misleading information, could adversely affect our reputation andour ability to bid for government contracts.***

 

Themedia frequently focuses its attention on private operators’ contracts withgovernmental agencies. If the media coverage of private operators is negative,it could influence government officials to slow the pace of outsourcinggovernment services, which could reduce the number of RFPs. The media may alsofocus its attention on the activities of political consultants engaged by us,even when their activities are unrelated to our business, and we may be taintedby adverse media coverage about their activities. Moreover, inaccurate,misleading or negative media coverage about us could harm our reputation and,accordingly, our ability to bid for and win government contracts.

 

***We often incur significant costs beforereceiving related revenues, which could result in cash shortfalls and a risk ofnot recovering our investment.***

 

Whenwe are awarded a contract to manage a new facility, we may incur significant expensesbefore we receive contract payments. These expenses include purchasing realestate, constructing new facilities, leasing office space, purchasing officeequipment and hiring and training personnel. As a result, when the governmentdoes not fund a facility’s pre-opening and start-up costs, we may be requiredto invest significant sums of money before receiving related contract payments.In addition, payments due to us from governmental agencies may be delayed dueto billing cycles or as a result of failures by our governmental customers toattain necessary budget approvals and finalize contracts in a timely manner. Severaljuvenile services contracts related to educational services provide for annualcollection several months after a school year is completed. In addition, acontract may be terminated prior to its scheduled expiration and as a result wemay not recover these expenses or realize any return on our investment.

 

Wemay choose to undertake development projects without written commitments to makeuse of such facilities. We may not be able to obtain contracts for thesefacilities in a timely fashion, if at all. To the extent we do not obtaincontracts, we could be unable to recover our investment and our financialcondition and results of operations would be adversely affected.

 

***We may be unable to attract and retainsufficient qualified personnel necessary to sustain our business.***

 

Ourdelivery of services is labor-intensive. When we are awarded a contract, wemust hire operating management, security, case management and other personnel. Thesuccess of our business requires that we attract, develop, motivate and retainthese personnel. Our ability to recruit and retain qualified individuals variesby facility and is related to the socio-economic factors in the particularcommunity in which the facility operates. The Department of Labor wages weoffer our employees are often higher than wages they could obtain elsewhere inthe community. However, if the local economy where a facility is located is robustand unemployment is low, we may have difficulty hiring and retaining qualifiedpersonnel. In addition, there are inherent risks associated with the nature ofthe services we provide and this could cause certain qualified individuals toseek other employment opportunities. We have experienced high turnover ofpersonnel in our juvenile facilities within the first year of their employment.Our inability to hire sufficient personnel on a timely basis or the loss ofsignificant numbers of personnel could adversely affect our business.

 

***If we do not successfully integrate thebusinesses that we acquire, our results of operations could be adverselyaffected.***

 

Wemay be unable to manage businesses that we may acquire profitably or integratethem successfully without incurring substantial expenses, delays or otherproblems that could negatively impact our results of operations. Acquisitionsgenerally require the integration of facilities, some of which may be locatedin states in which we do not currently have operations.

 

17

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Moreover,business combinations involve additional risks, including:

 

•      diversion of management’s attention;

•      loss of key personnel;

•      assumption of unanticipated legal orfinancial liabilities;

•      our becoming significantly leveraged as aresult of the incurrence of debt to finance an acquisition;

•      unanticipated operating, accounting ormanagement difficulties in connection with the acquired entities;

•      amortization or charges of acquired intangibleassets, including goodwill; and

•      dilution to our earnings per share.

 

Also,client dissatisfaction or performance problems with an acquired business couldmaterially and adversely affect our reputation as a whole. Further, theacquired businesses may not achieve the revenues and earnings we anticipated.

 

***Because environmental laws impose strict aswell as joint and several liability for clean up costs, unforeseenenvironmental risks could prove to be costly.***

 

Ourfacilities, and any facilities that we may acquire in the future, may besubject to unforeseen environmental risks. The federal ComprehensiveEnvironmental Response, Compensation, and Liability Act, (CERCLA), imposesstrict, as well as joint and several, liability for certain environmentalcleanup costs on several classes of potentially responsible parties, includingcurrent owners and operators of the property. Other federal and state laws incertain circumstances may impose liability for environmental remediation, whichcosts may be substantial. Further, the operation of our facilities, and thedevelopment of new facilities, requires that we obtain, and comply with,permits and other authorizations under environmental laws. Obtaining suchpermits and authorizations can prove to be difficult and time consuming.

 

***We have in the pastincurred, and may continue to incur, significant expenses for facilities thatwe no longer operate.***

*** ***

Ifwe close a facility, we may remain committed to perform our obligations underthe applicable lease, which would include, among other things, payment of thebase rent for the balance of the lease term. We may also be required to incurother expenses with respect to such facilities. The potential losses associatedwith our inability to cancel leases may result in our keeping openunderperforming facilities. As a result, ongoing lease operations at closed orunder performing facilities could impair our results of operations.

 

***We may continue to operateunder unprofitable contracts at facilities that we own to offset expensesassociated with ownership of the facility.***

*** ***

If we close a facility that we own, we will remain obligated forexpenses associated with the facility. If our operations are unprofitable at aleased facility or if the leased facility is performing significantly belowtargeted levels, we would typically terminate the contract and the lease.However, we may continue to operate our contract at an owned facility to offsetthe expenses associated with ownership. Continued performance of such acontract could have a material adverse effect on our business and results ofoperations.

 

***We depend on a limitednumber of governmental customers for significant portion of our revenues.***

*** ***

We currently derive, and expect to continue to derive, a significantportion of our revenues from the BOP and various state agencies. The loss of,or a significant decrease in, business from the BOP or those state agenciescould seriously harm our financial condition and results of operations. The BOPaccounted for approximately 23.0% of our total revenues for the fiscal yearended December 31, 2005 ($71.6 million), 22.3% for the fiscal year endedDecember 31, 2004 ($61.9 million) and 21.7% for the fiscal year endedDecember 31, 2003 ($56.1 million). Our contract to manage the Big SpringCorrectional Center accounts for a significant amount of our total revenuesattributable to the BOP. We expect to continue to depend upon the BOP and arelatively small group of other governmental customers for a significantpercentage of our revenues.

 

***Because our revenues canfluctuate from period to period, we may face short-term funding shortfalls fromtime to time.***

*** ***

Revenues can fluctuate from year to year due to changes in governmentfunding policies, changes in the number of clients referred to our facilitiesby governmental agencies, the opening of new facilities or the expansion ofexisting facilities and the termination of contracts for a facility or theclosure of a facility. Our revenues fluctuate from quarter to quarter, based onthe 

 

18

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number of contracted days in each quarter. Because our revenues canvary, we may face short-term funding shortfalls from time to time. In addition,full-year results are not likely to be a direct multiple of any particularquarter or combination of quarters.

 

***We are subject tosignificant insurance costs.***

*** ***

Worker’scompensation, employee health and general liability insurance representsignificant costs to us. We continue to incur increasing insurance costs due toadverse claims experience and rising healthcare costs in general. Due toconcerns over corporate governance and recent corporate accounting scandals,liability and other types of insurance have become more difficult and costly toobtain. In addition, as a result of the stockholder lawsuits brought within thelast few years, our directors and officers liability insurance has increased. Unanticipatedadditional insurance costs could adversely impact our results of operations andcash flows, and the failure to obtain or maintain any necessary insurancecoverage or the inability of an insurance carrier to perform under itsobligations through issued coverage could have a material adverse effect on us.

 

***We may be adversely affectedby inflation.***

*** ***

Manyof our facility management contracts provide for fixed management fees or feesthat increase by only small amounts during their term. If, due to inflation orother causes, our operating expenses, such as wages and salaries of ouremployees, and insurance, medical and food costs, increase at rates faster thanincreases, if any, in our management fees, then our profitability would beadversely affected.

 

***We are subject to risksassociated with ownership of real estate.***

*** ***

Ourownership of correctional and detention facilities subjects us to riskstypically associated with investments in real estate, and in particular,correctional and detention facilities, are relatively illiquid and, therefore,our ability to divest ourselves of one or more of our facilities promptly inresponse to changed conditions is limited. Investments in correctional anddetention facilities subject us to risks involving potential exposure touninsured loss. Our operating costs may be affected by the obligation to payfor the cost of complying with existing laws, ordinances and regulations, aswell as, the cost of complying with future legislation. In addition, althoughwe maintain insurance for many types of losses, there are certain types oflosses, such as losses from earthquakes, riots and acts of terrorism, which maybe either uninsurable or for which it may not be economically feasible toobtain insurance coverage. As a result, we could lose both our capital investedin, and anticipated profits from, one or more of the facilities we own. Further,it is possible to experience losses that may exceed the limits of insurancecoverage.

 

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**ITEM 1B.****      ****UNRESOLVED STAFF COMMENTS**

 

None

 

**ITEM 2.****         ****PROPERTIES**

 

Welease office space for our corporate headquarters in Houston, Texas andregional administrative offices in Ventura, California, Pittsburgh,Pennsylvania and Chicago, Illinois. We also lease various facilities we arecurrently operating or developing. For a listing of owned and leasedfacilities, see “Business - Facilities.”

 

**ITEM 3.****         ****LEGAL PROCEEDINGS**

 

Cornell is a party to various legal proceedings, including those notedbelow. While management presently believes that the ultimate outcome of theseproceedings will not have a material adverse effect on our financial position,overall trends in results of operations or cash flows, litigation is subject toinherent uncertainties, and unfavorable rulings could occur. An unfavorableruling could include monetary damages or equitable relief. Were an unfavorable tooccur, there exists the possibility of a material adverse impact on the netincome of the periods in which the ruling occurs or future periods.

 

##### **LincolnCounty Detention Center**

 

In August 2005, a lawsuit was filed by a detainee atthe Lincoln County Detention Center (LCDC) in the U.S. District Court of NewMexico (Santa Fe). The lawsuit relates to the former LCDC policy that requiredstrip and visual body cavity searches for all detainees and inmates and allegesthat such policy violates a detainee’s Fourth and Fourteenth Amendment right. Thelawsuit was filed as a putative class action lawsuit brought on behalf of allinmates who were searched at the LCDC from May 2002 to July 2005. This lawsuit is in its early stages and nomaterial discovery has been conducted. At December 31, 2005, we recorded acharge of $0.2 million and have estimated our range of additional exposure tobe $0.3 million. We have adequate insurance coverage in the event our actualexposure exceeds our estimated exposure. In addition, in connection with ouracquisition of the LCDC facility, certain amounts were placed in escrow tooffset any undisclosed liability relating to such acquisition. We have givennotice to the prior owner of LCDC that we will seek to recover from the escrowany losses we may incur as a result of this litigation. The ultimate outcome ofthe lawsuit cannot be determined at this time and we intend to aggressivelydefend this lawsuit.

 

##### **SouthernPeaks Regional Treatment Center**

##### ** **

In January 2004, we initiated legal proceedingsin the lawsuit styled *Cornell Corrections ofCalifornia, Inc. v. Longboat Global Advisors, LLC, et al*.,No.2004 CV79761 in the Superior Court of Fulton County, Georgia under theoriesof fraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development andconstruction of the Southern Peaks Regional Treatment Center. Of the fundspreviously deposited, approximately $5.3 million remains to be recovered atDecember 31, 2005. In December 2004, the case was tried before ajury and the jury verdict awarded approximately $6.5 million in compensatorydamages and approximately $1.4 million in punitive damages, plus attorneys’fees. We expect that the actual damages awarded under the verdict will beadjusted downward to the $5.4 million actually lost by us and that the punitivedamages award may be adjusted downward because of a Georgia statute regardingcaps on punitive damages awards. No judgment has yet been entered on thisverdict. The award for compensatory damages accrues pre-judgment interest at arate of 7 percent from the date of loss through the date of judgment. Following the jury verdicts, we collected approximately$0.4 million in January 2005 in funds which had been previously frozenunder a temporary restraining order issued at the time that we commenced thislitigation. Currently, certain of the defendants have filed motions to move fora new trial. No judgment will be entered on the verdict until after thesemotions for a new trial have been heard and ruled on by the court. Due to thecontinued uncertainty surrounding the ultimate recovery of the funds previouslydeposited, we will continue to maintain our existing reserve of approximately$5.0 million in an allowance for doubtful accounts.

 

###### ***Shareholder Lawsuits***

###### *** ***

In March and April 2002, Cornell, Steven W. Logan (our formerPresident and Chief Executive Officer), and John L. Hendrix (our former Chief FinancialOfficer), were named as defendants in four federal putative class actionlawsuits styled as follows: (1) *GraydonWilliams, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc, et al.*, No. H-02-0866, in the United StatesDistrict Court for the Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*,No. H-02-1075, in the United States District

 

20

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Court for the Southern District of Texas, Houston Division; (3) *Louis A. Daly, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.,*No. H-02-1522, in the United States District Court for the SouthernDistrict of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and All Others SimilarlySituated v. Cornell Companies, Inc., et al.,*No. H-02-1567, in the United States District Court for the SouthernDistrict of Texas, Houston Division. The aforementioned lawsuits were putativeclass action lawsuits brought on behalf of all purchasers of our common stockbetween March 6, 2001 and March 5, 2002 and relate to our restatementin 2002 of certain financial statements. The lawsuits involved disclosures madeconcerning two prior transactions executed by us: the August 2001 saleleaseback transaction and the 2000 synthetic lease transaction. These fourlawsuits were consolidated into the *GraydonWilliams* action and Flyline Partners, LP was appointed leadplaintiff. As a result, a consolidated complaint was filed by Flyline Partners,LP. Richard Picard and Anthony Scolaro were also named as plaintiffs. Sincethen, the court allowed plaintiffs to file an amended consolidated complaint. Theamended consolidated complaint alleges that the defendants violatedSection 10(b) of the Securities Exchange Act of 1934 (the “ExchangeAct”), Rule 10b-5 promulgated under Section 10(b) of theExchange Act, Section 20(a) of the Exchange Act, Section 11 ofthe Securities Act of 1933 (the “Securities Act”) and/or Section 15 of theSecurities Act. The amended consolidated complaint seeks, among other things,restitution damages, compensatory damages, rescission or a rescissory measureof damages, costs, expenses, attorneys’ fees and expert fees. In February 2006,the court approved the settlement of this matter. Under the settlementagreement, Cornell has not admitted any wrongdoing. Settlement in the amount of$7.0 million has been funded through our directors’ and officers’ liabilityinsurance. During the fourth quarter of 2005, we recorded the settlement chargeof $7.0 million and the related reimbursement of $7.0 million from ourdirector’s and officer’s liability insurance. The charge and reimbursement havebeen recognized in general and administrative expenses in our ConsolidatedStatements of Operations and Comprehensive Income (Loss) for the year endedDecember 31, 2005. The liability is carried in accounts payable and accruedliabilities and the reimbursement is included in other receivables at December31, 2005. The reimbursement was funded by the insurance carrier in 2005 into atrust account and funds were disbursed from the trust account to plaintiffs’counsel’s escrow account upon court approval of the settlement in February2006.

 

In March 2002, Cornell, its directors, and its former independentauditor Arthur Andersen LLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of HarrisCounty, Texas. The lawsuit related to our restatement in 2002 of certainfinancial statements. The lawsuit alleged breaches of fiduciary duty by all ofthe individual defendants and asserted breach of contract and professionalnegligence claims only against Arthur Andersen LLP. This lawsuit has beendismissed without prejudice by agreement. In January 2004, we received aletter from William Williams, the plaintiff in the *William Williams* action discussed above, demanding that wepursue breach of fiduciary duty claims against various officers and directorsbased on the August 2001 sale leaseback transaction and the subsequentrestatement. We have issued a preliminary response to the letter indicatingthat the Board will consider the request and inform Mr. Williams of itsdecision. In May and September 2002, the Company and our thendirectors were sued in three other derivative lawsuits styled as follows:(1) *Juan Guitierrez, Derivatively onBehalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,* No. 2002-28924,in the 164th Judicial District Court of Harris County, Texas. Theselawsuits relate to our restatement in 2002 of certain financial statements.These lawsuits all allege breaches of fiduciary duty and waste of corporateassets by all of the defendants. A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano* action as duplicative of the *Guitierrez* action. The court granted themotion to dismiss the *Guitierrez*action and the plaintiffs have appealed that ruling. The *Menning* action has been dismissed, butwith an agreement that the plaintiff’s claims as to Cornell are tolled until 30days following the final resolution of the *Guitierrez*case, including any appeals. The plaintiffs in these cases have not quantified theirclaim of damages and the outcome of the matters discussed above cannot bepredicted with certainty. However, our management believes that we have gooddefenses and intends to vigorously defend against the claims asserted in theseactions. We have not recorded any loss accruals related to these claims.

 

Certain insurance policies held by us tocover potential director and officer liability may limit our cash outflows inthe event of a decision adverse to us in the matters discussed above. However,if an adverse decision in these matters exceeds the insurance coverage or ifthe insurance coverage is deemed not to apply to these matters, an adversedecision to us in these matters could have a material adverse effect on us, ourfinancial condition, results of operations and future cash flows.

 

**Other**

 

Additionally, we currently and from time to time are subject to claimsand suits arising in the ordinary course of business, including claims fordamages for personal injuries or for wrongful restriction of or interferencewith offender privileges and employment matters. If an adverse decision inthese matters exceeds our insurance coverage, or if our coverage is deemed notto

 

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apply to these matters, or if the underlying insurance carrier wasunable to fulfill its obligation under the insurance coverage provided, itcould have a material adverse effect on our financial condition, results ofoperations or cash flows.

 

During the period of August 2000 through May 2003, ourgeneral liability and professional liability coverage was provided by SpecialtySurplus Insurance Company, a Kemper Insurance Company (Kemper) group member. InJune 2004, the Illinois Department of Insurance gave Kemper permission toproceed with a run-off plan it had previously submitted. The three-year plan isdesigned to help Kemper meet its goal of resolving, to the maximum extentpossible, all valid policyholder claims. In view of the risks and uncertaintiesinvolved in implementing the plan, including the need to achieve significantpolicy buybacks, commutation of reinsurance agreements, and further agreementswith regulators, no assurance can be given that the plan will be successfullyimplemented by Kemper. In the year ended December 31, 2004, we accrued aprovision of $0.6 million, and estimated our range of additional exposure to beapproximately $0.5 million with respect to outstanding claims incurred duringthis policy period with Kemper which would become our obligation to resolve ifnot settled through Kemper.

 

During the year ended December 31, 2005, Kemper continued toimplement its run-off plan. As a result, several of our significant claims weresettled by Kemper during 2005. In conjunction with these settlements, werecorded a charge against our existing accrual in the amount of $0.3 million.We believe that the uncertainty surrounding the ability of Kemper to settle ourremaining outstanding claims still exists. Based on our analysis of the claimsactivity during 2005, we felt it necessary to accrue an additional provision inthe amount of approximately $0.2 million during the third quarter of 2005. AtDecember 31, 2005, we believe our estimated range of exposure, above ourexisting $0.5 million accrual, to be approximately $0.1 million related to theoutstanding claims which could become our obligation to resolve if not settledthrough Kemper.

 

While the outcome of such matters cannot be predicated with certainty,based on the information known to date, we believe that the ultimate resolutionof these matters will not have a material adverse effect on our financialcondition, operating results or cash flows.

 

***ITEM 4.***          SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS

*** ***

Nomatters were submitted to our stockholders during the fourth quarter of 2005.

 

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**PART II**

** **

**ITEM 5.****       ****MARKET FOR REGISTRANT’SCOMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITYSECURITIES**

 

Ourcommon stock is listed on the New York Stock Exchange (NYSE) under the symbol “CRN.”  As of March 10, 2006, there were 448 recordholders of our common stock. The quarterly high and low closing sales pricesfor our common stock from January 1, 2004 through March 10, 2006 areshown below.

 
| ** **                                  | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------|------------|----------|------------|---------|------------|
|                                        |       |     |       |    |       |
| 2004:                                       |       |     |       |    |       |
| First Quarter                               |       | $        | 13.75      |    | $          | 11.36 |   |
| Second Quarter                              |       | 14.05    |       | 11.20   |       |
| Third Quarter                               |       | 14.62    |       | 11.75   |       |
| Fourth Quarter                              |       | 15.33    |       | 12.21   |       |
| 2005:                                       |       |     |       |    |       |
| First Quarter                               |       | $        | 15.64      |    | $          | 12.42 |   |
| Second Quarter                              |       | 13.60    |       | 11.60   |       |
| Third Quarter                               |       | 14.71    |       | 12.96   |       |
| Fourth Quarter                              |       | 14.78    |       | 13.58   |       |
| 2006:                                       |       |     |       |    |       |
| First Quarter (through March 10, 2006) |       | $        | 14.06      |    | $          | 13.26 |   |

 

Wehave never declared or paid cash dividends on our capital stock. We currentlyintend to retain excess cash flow, if any, for use in the operation andexpansion of our business and do not anticipate paying cash dividends on ourcommon stock in the foreseeable future. The payment of dividends is within thediscretion of the Board of Directors and is dependent upon, among otherfactors, our results of operations, financial condition, capital requirements,restrictions, if any, imposed by financing commitments and legal requirements.Our 10.75% Senior Notes, as well as our revolving credit facility containcertain restrictions on our ability to pay dividends. See Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations -Liquidity and Capital Resources – Long-Term Credit Facilities.”

 

Wedid not purchase any of our common stock in the fourth quarter of 2005.

 

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Thefollowing table summarizes as of December 31, 2005 certain informationregarding equity compensation to our employees, officers, directors, and otherpersons under our plans:

 
| ** **                                                  | ** ** | **(A)  Number of  Securities to be  Issued upon  Exercise of  Outstanding Stock  Options and Warrants** | ** ** | **(B)  Weighted-average  Exercise Price of  Outstanding  Stock Options  and Warrants** | ** ** | **(C)  Number of  Securities Remaining  Available for  Future Issuance  Under Equity  Compensation  Plans (Excluding  Securities Reflected  in Column A)** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Plan Category                                               |       |                                                                                                    |       |                                                                                   |       |                                                                                                                                                       |       |
|                                                        |       |                                                                                                    |       |                                                                                   |       |                                                                                                                                                       |       |
| Equity  compensation plans approved by security holders     |       | 504,700                                                                                                 |       | $                                                                                      | 12.89      |                                                                                                                                                       | 530,684    | (1) |
| Equity  compensation plans not approved by security holders |       | 265,598                                                                                                 |       | $                                                                                      | 9.42       |                                                                                                                                                       | 230,112    | (2) |
| Total                                                       |       | 770,298                                                                                                 |       | $                                                                                      | 11.69      |                                                                                                                                                       | 760,796    |   |

 

----

 

(1)   Includes 190,395 shares issuable pursuantto our Employee Stock Purchase Plan and 101,516 shares issuable pursuant to our2000 Director Stock Plan. Also includes 238,773 shares issuable pursuant to ourAmended and Restated 1996 Stock Option Plan. The total number of sharesissuable pursuant to our Amended and Restated 1996 Stock Option Plan is equalto the greater of 1,500,000 shares or 15.0% of the number of shares issued andoutstanding immediately after the grant of any option under the Plan.

(2)   Includes 100,000 shares issuable pursuantto our Deferred Compensation Plan and 130,112 shares issuable pursuant to our2000 Broad-Based Employee Plan. The number of shares issuable pursuant to our2000 Broad-Based Plan (2000 Plan) is equal to the greater of 400,000 shares or4.0% of the shares issued and outstanding immediately after the grant of anyoption under the Plan.

 

**Equity Compensation Plans Not Approved by Security Holders**

 

***Deferred Compensation Plan***

 

Wemaintain a Deferred Compensation Plan for the purpose of providing deferredcompensation for eligible employees. The Deferred Compensation Plan is anonqualified plan.

 

Aparticipant in the Deferred Compensation Plan may defer into an account apercentage of compensation each year up to 75.0% of the participant’s compensationreceived from Cornell. In addition, we may make contributions to the DeferredCompensation Plan on behalf of each participant. Compensation deferred by aparticipant, or contributions made by us on behalf of a participant, will beinvested in mutual funds or the common stock of Cornell. Participants are fullyvested in their accounts and may elect to receive the amounts credited to theiraccounts either in a lump sum or in five or ten-year annual installmentpayments. In the event of a change of control (as defined in the Plan), theamounts in each participant’s account will be paid to the participant in a lumpsum.

 

***Warrants***

 

Inconjunction with the issuance of the Subordinated Notes in July 2000, weissued warrants to purchase 290,370 shares of our common stock at an exerciseprice of $6.70. The warrants may only be exercised by payment of the exerciseprice in cash to us, by cancellation of an amount of warrants equal to the fairmarket value of the exercise price, or by the cancellation of indebtedness owedto the warrant holder. During 2001, 168,292 shares of common stock were issuedin conjunction with the exercise and cancellation of 217,778 warrants;therefore, 72,592 warrants remain outstanding at December 31, 2005.

 

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***2000 Broad-Based Employee Plan***

 

Underour 2000 Plan, we may grant non-qualified stock options to our employees,directors and eligible consultants for up to the greater of 400,000 shares or4.0% of the aggregate number of shares of common stock issued and outstandingimmediately after the grant of any option under the 2000 Plan. The 2000 Planoptions vest over a period of up to five years and expire ten years from thegrant date. The vesting schedule and term are set by the CompensationCommittee of the Board of Directors. The exercise price of options issuedpursuant to the 2000 Plan can be no less than the market price of our commonstock on the date of grant.

 

Uponnotice of an extraordinary transaction (as defined in the 2000 Plan), optionsgranted under the 2000 Plan become fully vested. Upon consummation of theextraordinary transaction, such options, to the extent not previouslyexercised, automatically terminate.

 

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**ITEM 6.****         ****SELECTED CONSOLIDATEDFINANCIAL DATA**

 

Thefollowing data has been derived from our audited financial statements,including those included in this Form 10-K for the year ended December 31,2005 and should be read in conjunction with the consolidated financial statementsand notes thereto and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included elsewhere in this report.

 

Theconsolidated financial statements for the year ended December 31, 2001were audited by Arthur Andersen LLP who has ceased operations.

 
| ** **                                                                                                                                       | ** ** | **Year Ended December 31,**          | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                       | ** ** | **2005 (1)**                              | ** ** | **2004 (2)** | ** ** | **2003 (3)** | ** ** | **2002** | ** ** | **2001 (4)** | ** ** |
| ** **                                                                                                                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statements  of Operations Data:**                                                                                                              |       |                                      |       |   |   |   |   |   |   |   |   |
| Revenues                                                                                                                                         |       | $                                         | 310,775    |   | $ | 277,190 |   | $ | 258,180 |   | $ | 263,023 |   | $ | 254,820 |   |
| Income from operations                                                                                                                           |       | 27,866                                    |       | 14,459 |   | 24,484 |   | 30,150 |   | 29,407 |   |
| Income (loss) from continuing operations  before provision (benefit) for income taxes and cumulative effect of changes  in accounting principles |       | 6,143                                     |       | (8,256 | ) | 6,828 |   | 10,852 |   | 5,236 |   |
| Income (loss) from continuing operations  before cumulative effect of changes in accounting principles                                           |       | 3,928                                     |       | (5,000 | ) | 4,028 |   | 6,475 |   | 2,939 |   |
| Discontinued operations, net of tax                                                                                                              |       | (3,622                                    | )          | (2,433 | ) | (58 | ) | 852 |   | 950 |   |
| Cumulative effect of changes in accounting  principles, net of tax (5)                                                                           |       | 3⁄4                                    |       | — |   | — |   | (965 | ) | 770 |   |
| Net income (loss)                                                                                                                                |       | $                                         | 306        |   | $ | (7,433 | ) | $ | 3,970 |   | $ | 6,362 |   | $ | 4,659 |   |
|                                                                                                                                             |       |                                      |       |   |   |   |   |   |   |   |   |
| Earnings  (loss) per share:                                                                                                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| •  Basic                                                                                                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations  before cumulative effect of changes in accounting principles                                           |       | $                                         | .29        |   | $ | (.38 | ) | $ | .31 |   | $ | .50 |   | $ | .30 |   |
| Discontinued operations, net of tax                                                                                                              |       | $                                         | (.27       | ) | $ | (.18 | ) | $ | — |   | $ | .07 |   | $ | .10 |   |
| Cumulative effect of changes in  accounting principles, net of tax (5)                                                                      |       | $                                         | —     |   | $ | — |   | $ | — |   | $ | (.08 | ) | $ | .08 |   |
| Net income (loss)                                                                                                                                |       | $                                         | .02        |   | $ | (.56 | ) | $ | .31 |   | $ | .49 |   | $ | .48 |   |
|                                                                                                                                             |       |                                      |       |   |   |   |   |   |   |   |   |
| •  Diluted                                                                                                                             |       |                                      |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations  before cumulative effect of changes in accounting principles                                           |       | $                                         | .29        |   | $ | (.38 | ) | $ | .30 |   | $ | .49 |   | $ | .30 |   |
| Discontinued operations, net of tax                                                                                                              |       | $                                         | (.27       | ) | $ | (.18 | ) | $ | — |   | $ | .06 |   | $ | .09 |   |
| Cumulative effect of changes in  accounting principles, net of tax (5)                                                                      |       | $                                         | —     |   | $ | — |   | $ | — |   | $ | (.07 | ) | $ | .07 |   |
| Net income (loss)                                                                                                                                |       | $                                         | .02        |   | $ | (.56 | ) | $ | .30 |   | $ | .48 |   | $ | .46 |   |
|                                                                                                                                             |       |                                      |       |   |   |   |   |   |   |   |   |
| Number of  shares used to compute EPS:                                                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic                                                                                                                                            |       | 13,580                                    |       | 13,203 |   | 12,941 |   | 12,911 |   | 9,616 |   |
| Diluted                                                                                                                                          |       | 13,695                                    |       | 13,203 |   | 13,342 |   | 13,129 |   | 10,069 |   |
|                                                                                                                                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                                                               | ** ** | **Year Ended December 31,**           | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                               | ** ** | **(in thousands, except occupancy data )** | ** ** |
| **Operating  Data:**                                                     |       |                                       |       |   |   |   |   |   |   |   |   |
|                                                                     |       |                                       |       |   |   |   |   |   |   |   |   |
| **Residential:**                                                         |       |                                       |       |   |   |   |   |   |   |   |   |
| Service capacity (6) (7)                                                 |       | 14,682                                     |       | 13,494 |   | 12,284 |   | 11,237 |   | 11,237 |   |
| Contracted beds in operation (end of  period) (6) (8)                    |       | 11,764                                     |       | 11,479 |   | 9,472 |   | 9,259 |   | 9.473 |   |
| Average contract occupancy on contracted  beds in operation (6) (9) (10) |       | 97.3                                       | %          | 98.6 | % | 100.5 | % | 98.5 | % | 95.8 | % |
| Average contract occupancy excluding  start-up operations (6) (9) (10)   |       | 101.8                                      | %          | 101.9 | % | 100.7 | % | 98.5 | % | 96.2 | % |
| **Non-Residential:**                                                     | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service capacity (6) (11)                                                |       | 4,787                                      |       | 3,852 |   | 3,568 |   | 3,601 |   | 3,601 |   |
|                                                                     |       |                                       |       |   |   |   |   |   |   |   |   |
| **Balance  Sheet Data:**                                                 |       |                                       |       |   |   |   |   |   |   |   |   |
| Working capital                                                          |       | $                                          | 57,286     |   | $ | 107,597 |   | $ | 86,214 |   | $ | 95,988 |   | $ | 97,814 |   |
| Total assets                                                             |       | 510,628                                    |       | 507,631 |   | 449,103 |   | 441,291 |   | 444,807 |   |
| Long-term debt, net of current portion                                   |       | 266,659                                    |       | 279,528 |   | 227,292 |   | 232,258 |   | 238,768 |   |
| Stockholders’ equity                                                |       | 165,461                                    |       | 161,312 |   | 166,235 |   | 159,952 |   | 153,104 |   |
|                                                                          |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Notes to Selected Consolidated Financial Data**

 

(1)      Thestatement of operations and balance sheet data presented for the year endedDecember 31, 2005 includes the assets, liabilities and operations of CSIacquired in April 2005.

(2)      Incomefrom operations for the year ended December 31, 2004 includes a charge of$9.3 million to record an impairment to the carrying value of the New MorganAcademy. Income (loss) from continuing operations before provision (benefit)for income taxes and cumulative effect of changes in accounting principles forthe year ended December 31, 2004 includes a loss on extinguishment of debtof approximately $2.4 million related to the early retirement of the SyntheticLease Investor Notes A and B and the revolving line of credit under our amended2000 Credit Facility. Discontinued operations, net of tax for the year endedDecember 31, 2004 include charges totaling $0.8 million to record an impairmentto the carrying values of two of our juvenile facilities. Refer to Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” fora detailed discussion concerning these charges.

(3)      Incomefrom operations for the year ended December 31, 2003 includes a charge ofapproximately $5.4 million to provide an allowance for an unrecovered escrowdeposit. Refer to Item 3. “Legal Proceedings – Southern Peaks RegionalTreatment Center.”

(4)      We adopted the provisions of Statementof Financial Accounting Standard (SFAS) No. 145 on January 1, 2003. Priorto the adoption of the provisions of SFAS No. 145, we recorded an extraordinarycharge of approximately $2.9 million, net of an income tax of approximately$2.0 million, in 2001 for the early retirement of debt. As a result of the adoptionof the provisions of SFAS No. 145, we reclassified costs of approximately $4.9million to loss on extinguishment of debt and the related income tax benefit ofapproximately $2.0 million to provision for income taxes. This reclassificationis reflected in the 2001 amounts presented in this table.

(5)      For the year ended December 31, 2002, werecognized a cumulative effect of changes in accounting principles charge ofapproximately $1.0 million, net of an income tax benefit of approximately $0.7million, related to the impairment of goodwill in connection with the adoptionof SFAS No. 142 in January 2002. For the year ended December 31,2001, we recognized a cumulative effect of changes in accounting principlesbenefit of approximately $0.8 million, net of an income tax provision ofapproximately $0.5 million, related to a change in our method of accounting fordurable supplies.

(6)      Datapresented excludes discontinued operating facilities.

(7)      Residential service capacity is comprised ofthe number of beds currently available for service or available upon thecompletion of construction of residential facilities.

(8)      At certain residential facilities, thecontracted capacity is lower than the facility’s service capacity. We couldincrease a facility’s contracted capacity by obtaining additional contracts orby renegotiating existing contracts to increase the number of beds covered.However, there is no guarantee that we will be able to obtain contracts thatprovide occupancy levels at a facility’s service capacity or that currentcontracted capacities can be maintained in future periods.

 

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(9)      Average contract occupancy percentagesreflect less than normalized occupancy during the start-up phase of any applicablefacility, resulting in a lower average contract occupancy in periods when wehave substantial start-up activities.

**(10)**    Average contract occupancypercentages are calculated based on actual occupancy for the period as apercentage of the contracted capacity for residential facilities in operation.These percentages do not reflect the operations of non-residentialcommunity-based programs. At certain residential facilities, our contractedcapacity is lower than the facility’s service capacity. Additionally, certainfacilities have and are currently operating above the contracted capacities. Asa result, average contract occupancy percentages can exceed 100% if the averageactual occupancy exceeded contracted capacity.

**(11)**    Non-residential service capacityis based on either contractual terms or an estimate of the number of clients tobe served. We update these estimates at least annually based on the program’sbudget and other factors.

** **

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**ITEM 7.****          MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

**General**

 

Weare a leading provider of correctional, detention, educational, rehabilitationand treatment services outsourced by federal, state and local governmentagencies. We provide a diversified portfolio of services for adults andjuveniles through our three operating divisions: (1) adult secure institutionand detention services; (2) juvenile justice, educational and treatmentservices and (3) adult community-based corrections and treatment services. AtDecember 31, 2005, we operated 79 facilities with a total service capacityof 17,473 and had two facilities under development or construction withan aggregate service capacity of 1,660 upon completion. Additionally, we hadthree facilities with an aggregate service capacity of 406 beds that weresubstantially vacant. Ourfacilities are located in 18 states and the District of Columbia.

 

Thefollowing table (which excludes data related to discontinued operatingfacilities) sets forth for the periods indicated total residential servicecapacity and contracted beds in operation at the end of the periods shown,average contract occupancy percentages and total non-residential servicecapacity.

 

 
| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Residential**                                                                    |       |                             |       |   |   |   |   |
| Service capacity (1) (2)                                                           |       | 14,682                           |       | 13,494 |   | 12,284 |   |
| Contracted beds in operation (end of  period) (1) (3)                              |       | 11,764                           |       | 11,479 |   | 9,472 |   |
| Average contract occupancy based on  contracted beds in operation (1) (4) (5) |       | 97.3                             | %          | 98.6 | % | 100.5 | % |
| Average contract occupancy excluding  start-up operations (1) (4) (5)              |       | 101.8                            | %          | 101.9 | % | 100.7 | % |
| **Non-Residential**                                                                |       |                             |       |   |   |   |   |
| Service capacity (1) (6)                                                           |       | 4,787                            |       | 3,852 |   | 3,568 |   |

 

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(1)       Data presented excludes discontinuedoperating facilities.

(2)       Residential service capacity is comprised ofthe number of beds currently available for service or available upon thecompletion of construction or renovation of residential facilities.

(3)      At certain residential facilities, thecontracted capacity is lower than the facility’s service capacity. We couldincrease a facility’s contracted capacity by obtaining additional contracts orby renegotiating existing contracts to increase the number of beds covered. However,there is no guarantee that we will be able to obtain contracts that provideoccupancy levels at a facility’s service capacity or that current contractedcapacities can be maintained in future periods.

(4)      Average contract occupancy percentagesreflect less than normalized occupancy during the start-up phase of anyapplicable facility, resulting in a lower average occupancy in periods when wehave substantial start-up activities.

(5)      Average contract occupancy percentages arecalculated based on actual occupancy for the period as a percentage of thecontracted capacity for residential facilities in operation. These percentagesdo not reflect the operations of non-residential community-based programs. Atcertain residential facilities, our contracted capacity is lower than thefacility’s service capacity. Additionally, certain facilities have and arecurrently operating above the contracted capacities. As a result, averagecontract occupancy percentages can exceed 100% if the average actual occupancyexceeded contracted capacity.

(6)      Non-residential service capacity is based oneither contractual terms or an estimate of the number of clients to be served.We update these estimates at least annually based on the program’s budget andother factors.

 

We derive substantially all of our revenues from providing adultcorrections and treatment and juvenile justice, educational and treatmentservices outsourced by federal, state and local government agencies in theUnited States. Revenues for our services are generally recognized on a per diemrate based upon the number of occupant days or hours served for the period, ona guaranteed take-or-pay basis or on a cost-plus reimbursement basis. For theyear ended December 31, 2005, our revenue base consisted of 76.3% forservices provided under per diem contracts, 10.1% for services provided undertake-or-pay and management contracts, 9.4% for services provided undercost-plus reimbursement contracts, 2.9% for services provided underfee-for-service contracts and 1.3% from other miscellaneous sources. Whilethese percentages are generally consistent with comparable statistics for theyears ended December 31, 2004 and 2003, there has been an increase in thepercentage of revenues for services provided under per diem contracts and adecrease in the percentage of revenues provided under fee-for-service contractsbetween the comparable periods for 2005 and 2004. The increase in thepercentage of revenues for services provided under per diem contracts isprincipally due to the acquisition of Correctional Systems Inc. (CSI) in April2005, as well as the increased operations of Regional Correctional Center in2005. Revenues can fluctuate from year to year due to changes in

 

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government funding policies,changes in the number or types of clients referred to our facilities bygovernmental agencies, the opening of new facilities or the expansion ofexisting facilities and the termination of contracts for a facility or theclosure of a facility.

 

Revenues for our adult secure institutionalservices division are primarily generated from per diem, take-or-pay andmanagement contracts.  For the yearsended December 31, 2005, 2004 and 2003, we realized average per diem rateson our adult secure institutional facilities of approximately $49.08, $48.45and $47.79, respectively. The increase in the average per diem rate for 2005 isdue to the opening of the two-unit Regional Correctional Center inJuly and December 2004, the acquisition of the Walnut Grove YouthCorrectional Facility management contract in June 2004 and the acquisitionof CSI in April 2005. We continue to experience increasing pressure fromcontracting governmental agencies to limit or even reduce per diem rates.  Many of these governmental entities are undersevere budget pressures and we anticipate that more governmental agencies mayapproach us about per diem rate concessions. Decreases, or the lack of anticipated increases, in per diem rates couldadversely impact our operating margin.

 

Factors considered in determining billingrates to charge include: (1) the programs specified by the contract and therelated staffing levels; (2) wage levels customary in the respective geographicareas; (3) whether the proposed facility is to be leased or purchased and (4)the anticipated average occupancy levels that could reasonably be expected tobe maintained.

 

Revenues for our juvenile justice,educational and treatment services division are primarily generated from perdiem, fee-for-service and cost-plus reimbursement contracts.  For the years ended December 31, 2005,2004 and 2003, we realized average per diem rates on our residential juvenilejustice, educational and treatment facilities of approximately $167.68, $164.54and $162.88, respectively.  The increasein the average per diem rate for 2005 is due to the opening of the SouthernPeaks Regional Treatment Center in August 2004.  For the years ended December 31, 2005,2004 and 2003, we realized average fee-for-service rates for ournon-residential community-based juvenile facilities and programs, includingrates that are limited by Medicaid and other private insurance providers, ofapproximately $34.21, $27.53 and $26.40, respectively. The increase in theaverage fee-for-service rate for 2005 is due to changes in the mix of the servicesprovided by our various juvenile justice, educational and treatment programsand facilities, as well as the addition of several new alternative educationprograms in 2005.  The majority of ourjuvenile services contracts renew annually.

 

Revenues for our adult community-basedcorrections and treatment services division are primarily generated from perdiem contracts and fee-for-service contracts. For the years ended December 31, 2005, 2004 and 2003, we realizedaverage per diem rates on our residential adult corrections and treatmentfacilities of approximately $60.77, $62.10 and $58.69, respectively.  For the years ended December 31, 2005,2004 and 2003, we realized average fee-for-service rates on our non-residentialadult community-based corrections and treatment facilities and programs ofapproximately $9.40, $8.23 and $9.05, respectively.  Our average fee-for-service rates fluctuatefrom year to year principally due to changes in the mix of services provided byour various adult community-based programs and facilities.

 

We have historically experienced higheroperating margins in our adult secure institutional services and adultcommunity-based corrections and treatment services as compared to the juvenilejustice, educational and treatment services division.  Additionally, our operating margins within adivision can vary from facility to facility based on whether a facility isowned or leased, the level of competition for the contract award, the proposedlength of the contract, the mix of services provided, the occupancy levels fora facility, the level of capital commitment required with respect to afacility, the anticipated changes in operating costs over the term of thecontract, and our ability to increase a facility’s contract revenue.  A decline in occupancy of certain juvenilejustice, educational and treatment facilities can have a more significantimpact on operating results than the adult secure institutional servicesdivision due to higher per diem rates at certain juvenile facilities.  We have experienced and expect to continue toexperience interim period operating margin fluctuations due to factors such asthe number of calendar days in the period, higher payroll taxes in the firsthalf of the year and salary and wage increases and insurance cost increasesthat are incurred prior to certain contract rate increases.  Moreover, many of the governmental agencieswith whom we contract are experiencing budgetary pressures and may approach usto limit or reduce per diem rates. Decreases in, or the lack of anticipated increases in, per diem ratescould adversely impact our operating margin. Additionally, a decrease in per diem rates without a correspondingdecrease in operating expenses could also adversely affect our operatingmargin.

 

We are responsible for all facilityoperating costs, except for certain debt service and interest or lease paymentsfor facilities where we have a management contract only.  At these facilities, the facility owner isresponsible for all debt service and interest or lease payments related to thefacility.  We are responsible for allother operating expenses at these facilities. We operated 20 facilities undermanagement contracts at December 31, 2005, 12 facilities at December 31,2004 and 10 facilities at December 31, 2003.  The increase in facilities operated undermanagement contracts in 2005 was principally due to those contracts obtained asa result of the acquisition of CSI in April 2005.

 

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A majority of our facility operatingcosts consists of fixed costs.  Thesefixed costs include lease and rental expense, insurance, utilities anddepreciation.  As a result, when wecommence operation of new or expanded facilities, fixed operating costs mayincrease.  The amount of our variableoperating costs, including food, medical services, supplies and clothing,depend on occupancy levels at the facilities we operate.  Our largest single operating cost, facilitypayroll expense and related employment taxes and expenses, has both a fixed anda variable component.  We can adjust afacility’s staffing levels and the related payroll expense to a certain extentbased on occupancy at a facility, however a minimum fixed number of employeesis required to operate and maintain any facility regardless of occupancylevels.  Personnel costs are subject toincreases in tightening labor markets based on local economic environments andother conditions.

 

We incur pre-opening and start-upexpenses including payroll, benefits, training and other operating costs priorto opening a new or expanded facility and during the period of operation whileoccupancy is ramping up. These costs vary by contract.  Since pre-opening and start-up costs aregenerally factored into the revenue per diem rate that is charged to thecontracting agency, we typically expect to recover these upfront costs over thelife of the contract.  Because occupancyrates during a facility’s start-up phase typically result in capacity under-utilizationfor at least 90 to 180 days, we may incur additional post-opening start-upcosts.  We do not anticipate post-openingstart-up costs at any adult secure facilities operated under any futurecontracts with the BOP which are take-or-pay contracts, meaning that the BOPwill pay at least 80.0% of the contractual monthly revenue once the facilityopens, regardless of actual occupancy.

 

Newly opened facilities are staffedaccording to applicable regulatory or contractual requirements when we beginreceiving offenders or clients.  Offendersor clients are typically assigned to a newly opened facility on a phased-inbasis over a one- to six-month period. Our start-up period for new juvenile operations is 12 months from thedate we begin recognizing revenue unless break-even occupancy levels areachieved before then.  Our start-upperiod for new adult operations is nine months from the date we beginrecognizing revenue unless break-even occupancy levels are achieved beforethen.  Although we typically recoverthese upfront costs over the life of the contract, quarterly results can besubstantially affected by the timing of the commencement of operations as wellas the development and construction of new facilities.

 

Working capital requirements generallyincrease immediately prior to commencing management of a new or expandedfacility as we incur start-up costs and purchase necessary equipment andsupplies before facility management revenue is realized.

 

General and administrative expensesconsist primarily of costs for corporate and administrative personnel whoprovide senior management, legal, finance, accounting, human resources, payrolland information systems, costs of business development and outside professionaland consulting fees.

 

# **Management Overview**

# ** **

***Demand*****.** Our business is driven generally by demand for incarceration ortreatment services, and specifically by demand for private incarceration ortreatment services, within our three primary business segments: adult secureinstitutional services; juvenile justice, educational and treatment services;and adult community-based corrections and treatment services.  The demand for adult and juvenile correctionsand treatment services has generally increased at a steady rate over the pastten years, largely as a result of increasing sentence terms and/or mandatorysentences for criminals and as well a greater range of criminal acts,increasing demand for incarceration of illegal aliens and a public recognitionof the need to provide services to juveniles that will improve the possibilitythat they will lead productive lives. Recent suggestions by social commentators and various political orgovernmental representatives suggest that community-based corrections of adultsshould be emphasized in the future as alternatives to traditional incarceration.  Among other things, we monitor federal, stateand industry communications and statistics relative to trends in prisonpopulations, juvenile justice statistics and initiatives, and developments inalternatives to traditional incarceration or detention of adults foropportunities to expand our scope or delivery of services.

 

The federal government increasingly isturning to private providers for the incarceration of adults whether they areserving prison sentences, detained as illegal aliens, detained in anticipationof pending judicial administration or transitioning from prison tosociety.  Chief among the federalagencies which use private providers are the BOP, ICE, and USMS. We provideadult secure and adult community-based services to the federal government.  Most of the federal involvement in juvenileadministration in the federal system is handled via Medicare and Medicaidassistance to state governments. Although there are circumstances in which wemay contract with a federal agency on a sole source basis, the primary means bywhich we secure a contract with a federal agency is via the RFP biddingprocess.  From time to time, we contractto provide management services to a local governmental unit who then bids on afederal contract.

 

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States and smaller governmental unitsremain divided on the issue of private prisons and private provision ofjuvenile and community-based programs, although a majority of states permitprivate provision for our services.  Weanticipate that increasing budget pressure on states and smaller governmentalunits will cause more states and smaller governmental units to considerutilizing private providers such as us to provide these services on a moreeconomical basis.  Although it variesfrom governmental unit to governmental unit, the primary political forces whotypically oppose privatization of prisons are organized labor and religiousgroups.

 

Private juvenile and community-basedprograms are much more widely accepted and utilized by states and localgovernmental units than private adult prisons. Many private providers are organized on a not-for-profit basis, butthere are a number of large, for-profit providers of juvenile and community-basedprograms.  We monitor opportunities inthese segments via our corporate and regional development officials.  Many opportunities are not published in anymanner and, accordingly, we believe that taking the initiative at the state andlocal levels is key in developing sole source opportunities.

 

***Performance*****.** We track a number of factors as we monitor financial performance.  Chief among them are:

 

•      capacity (thenumber of beds within each business segment’s facilities)

•      occupancy(utilization)

•      perdiem reimbursement rates

•      operatingexpenses

 

Capacity, commonly expressed in terms ofa number of beds, is primarily impacted by the number and size of thefacilities we own or lease and the facilities which are not owned or leased butwhich are operated by us on behalf of a third party owner or lessee.  We view capacity as a measure of ourdevelopment efforts, through which we may increase capacity by adding newprojects or by expanding existing projects. As part of measuring our development efforts, we will assess (a) whethera given development project was brought into service in accordance with ourexpectation as to time and expense; and (b) the number of projects indevelopment or under consideration at the relevant point in time.  In addition to the focus on new projects,capacity will reflect our success in renewing and maintaining existingcontracts and facilities.  It will alsoreflect any closure of programs or facilities due to underutilization orfailure to earn an adequate risk-adjusted rate of return.  We must also be cognizant of the possibilitythat state or local budgetary limitations may cause the contractual commitmentto a given facility to be reduced or even eliminated, which would cause us tosecure an alternate customer or close the operation.

 

Occupancy is typically expressed in termsof percentage of contract capacity utilized. We look at occupancy to assess the efficacy of both our efforts tomarket our facilities and our efforts to retain existing customers orcontracts.  Because revenue variesdirectly with occupancy, occupancy is a driver of our revenues. Some of ourcontracts are “take-or-pay,” meaning that the agency making use of the facilityis obligated to pay for beds even though they are not used.  Historically, occupancy percentages in manyof our facilities have been high and we are mindful of the need to maintainhigh occupancy levels.  As newdevelopment projects are brought into service, occupancy percentages maydecline until the projects reach full utilization.  Where we have commitments for utilizationbefore the commencement of operations, occupancy percentages reflects the speedat which a facility achieves full service/implementation. However, we maydecide to undertake development projects without written commitments to makefull use of a facility. In these instances, we have performed our ownassessment, based on discussions with local government or other potentialcustomer representatives and analysis of other factors, of the demand forservices at the facility.  There is noassurance that we will recover our initial investment in these projects.  We will monitor occupancy as a measure of theaccuracy of our estimation of the demand for the services of a developmentfacility, and will incorporate this information in future assessments of potentialprojects.

 

Per diem reimbursementrates are the other key element of our gross revenue and operating margin sinceper diem contracts represent a majority of our revenues (76.3% for the yearended December 31, 2005).  Per diemrates are a function of negotiation between management and a governmental unitat the inception of a contract or through the RFP process.  Actual per diem rates vary dramaticallyacross our business segments, and as well within each business segmentdepending upon the particular service or program provided. The initial per diemrates often change during the term of a contract in accordance with aschedule.  The amount of the change canbe a fixed amount set forth within the contract, an amount determined byformulas set forth within the contract or an amount determined by negotiationsbetween management and the governmental unit (often these negotiations arealong the same lines as the original per diem negotiation — a review ofexpenses and approval of an amount to recompense for expenses and assure thepotential of an operating profit).  Inrecent years, as budgetary pressures on governmental units have increased, someof our governmental customers have negotiated relief from formulaic increaseprovisions within their agreements or have declined to include in theirappropriation legislation amounts that would increase the per diem ratespayable under the contract (needed in some cases to offset operating expenseincreases).  Although we have 

 

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mitigated a portion ofthe impact of these developments by negotiating services provided or obtainingcommitments for increased volume, we have taken steps primarily in the area oflegislative and governmental monitoring and lobbying to avoid these sorts ofadverse developments in the future.  Wewill continue to monitor per diem rates as a measure of negotiation skill,customer service, management and maintenance, political and businessastuteness.

 

We track severaldifferent areas of our operating expenses. Foremost among these expenses are employee compensation and benefits andexpenses, risk related areas such as general liability, medical and worker’scompensation, client/inmate costs such as food, clothing and programming costs,financing costs and administrative overhead expenses. Increases or decreases inone or more of these items, such as our experience with rising insurance costs,can have a material effect on our financial performance.  Operating expenses are also impacted bydecisions to close or terminate a particular program or facility, as occurredduring 2005.  Such decisions are based onour assessments of operating results, operating efficiency and risk-adjustedreturns and are an ongoing part of our portfolio management.  In addition, decisions to restructureemployee positions (as occurred in 2005) will typically increase period costsinitially (at the time of such actions), but generally reducepost-restructuring expense levels.  Weare particularly monitoring the continued costs of complying with theSarbanes-Oxley Act of 2002, both in terms of fees paid to others, such asindependent auditors and consultants, as well as internal administrative costs.

 

Werecognize that our operating margins are subject to pressure from a variety offactors, but most notably rising costs and governmental and agency budgetaryconstraints.  We also believe thatsuccessful development of higher margin and low capital projects is key tomitigating such pressure.  We haveseveral development projects committed and in various stages of execution.Until those projects are completed and brought into full service, we willcontinue to monitor operations and existing customer relationships in anattempt to minimize the duration of start-up periods and the related pressureon operating margins.

 

#### **Significant 2005 Events**

 

***Acquisition of CorrectionalSystems, Inc.***

 

InApril 2005, we completed our acquisition of CorrectionalSystems, Inc. (CSI), a San Diego-based provider of privatized jail,community corrections and alternative sentencing services.  The transaction was consummated in cash ofapproximately $9.1 million, net of cash acquired, all of which was paid inApril 2005.  The acquisition included theoperations of eight jails, six adult community-based correction facilities andfive alternative sentencing programs located in California, New Mexico, Texasand Kansas.  The acquisition addedapproximately 986 corrections beds, as well as alternatives to incarcerationservices.  The results of operations forCSI subsequent to the date of acquisition (April 1, 2005) are included in ourconsolidated financial statements.

 

Weacquired substantially all of CSI’s assets and assumed all of theirliabilities.  The excess of the purchaseprice over the fair value of the assets acquired and liabilities assumed wasallocated to goodwill.  The initialpurchase price allocations can and have been adjusted within the shorter of adefined allocation period or one year of the purchase date for changes in theestimates of the fair values of assets acquired and liabilities assumed.   The following table summarizes the estimatedfair values of the assets acquired and liabilities assumed at the date ofacquisition (in thousands).

 
| ** **                                | ** ** | **April 1, 2005** | ** ** |
|-------------------------------------------|------------|-------------------|------------|
|                                      |       |              |       |
| Receivables                               |       | $                 | 1,769      |   |
| Prepaids and other  assets                |       | 305               |       |
| Property and equipment                    |       | 2,097             |       |
| Contract value                            |       | 4,121             |       |
| Other assets                              |       | 1,351             |       |
| Goodwill                                  |       | 4,586             |       |
| Assets acquired                           |       | 14,229            |       |
|                                      |       |              |       |
| Accounts payable and  accrued liabilities |       | 1,076             |       |
| Long-term debt                            |       | 2,239             |       |
| Deferred tax liabilities                  |       | 1,720             |       |
| Other long-term  liabilities              |       | 130               |       |
| Liabilities assumed                       |       | 5,165             |       |
| Net assets acquired                       |       | $                 | 9,064      |   |

 

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We believe that the CSI acquisition resulted in the recognitionof goodwill because of its industry position, operational strength andpotential to provide additional growth opportunities for us.  During the nine months ended December 31,2005, we adjusted goodwill by approximately $0.3 million due to adjustments tothe cost basis of the property acquired based on final property appraisals andfor certain post-closing acquisition costs.

 

Our amortization period for acquired contracts is the greater ofthe acquired contract life or seven years.

 

On an unaudited basis, the effects of the CSI acquisition werenot material to our results of operations had they been included in priorperiods.

 

InAugust 2005, a lawsuit was filed by a detainee at one of the facilitiesacquired from CSI. See Item 3. “Legal Proceedings — Lincoln County DetentionCenter” for further discussion regarding this matter.

 

**Recent Developments**

 

***New Morgan Academy***

 

Weclosed the New Morgan Academy in the fourth quarter of 2002 and haveconsidered several options ranging from the utilization of the facility foranother type of program or the sale or lease of the facility. As ofDecember 31, 2005, we are focusing our efforts on the reopening of thefacility by the fourth quarter of 2006. Once opened, the facility will operate as a residential treatmentfacility for youth sex offenders.  We arecurrently maintaining a smallstaff to secure and maintain the facility during the finalization of thereactivation plans.  We have recognizedpre-tax costs of $3.6 million and $13.5 million (including an impairment chargeof $9.3 million as discussed below) in our Consolidated Statements ofOperations and Comprehensive Income (Loss) for the years endedDecember 31, 2005 and 2004, respectively, for related holding costs(depreciation, interest, property, taxes and other maintenance costs).

 

AtDecember 31, 2004, as a result of our analysis pursuant to therequirements of SFAS No. 144, we determined that the carrying amount of the NewMorgan Academy was not fully recoverable and exceeded its fair value (as basedon current estimates of future cash flows). The developing inability during late 2004 of various governmentalagencies with whom we had been in negotiations to obtain the level of fundingto contract with us for the use of the New Morgan Academy indicated anexpectation of continuing losses associated with this facility.  As a result, we recorded an impairment chargeof $9.3 million, pursuant to the provisions of SFAS No. 144, in ourConsolidated Statements of Operations and Comprehensive Income (Loss) for theyear ended December 31, 2004.  As ofDecember 31, 2005, we believe that, pursuant to the provisions of SFAS No. 144,no additional impairment allowance is necessary.  The carrying value of the property andequipment for the New Morgan Academy, after the impairment charge, was approximately$19.9 million and $20.4 million at December 31, 2005 and 2004,respectively.

 

***Central California Treatment Center***

 

In January 2004, wepurchased a building in Los Angeles, California for which our carrying valuewas approximately $2.7 million at December 31, 2005.   In 2005, we received notice from a localgovernmental agency indicating a desire to acquire the facility.  In early 2006, the governmental agencyinitiated condemnation proceedings relating to the facility and depositedapproximately $2.9 million of condemnation proceeds with the court.  We have petitioned the court to release thedeposit and commenced litigation contesting the valuation of the facilitysubmitted by the governmental agency.

 

***Campbell Griffin Treatment Center***

 

In October 2005, weinitiated the temporary closure of this leased facility in San Antonio, Texas,and transferred the residents to our Texas Adolescent Treatment Center (alsolocated in San Antonio). It is our intent to reactivate this facility during2006. Accordingly, it has not been included in discontinued operations.

 

***Moshannon Valley Correctional Center***

 

In March 2003, wereached an agreement with the Commonwealth of Pennsylvania that resolved alloutstanding administrative issues relative to the contract awarded by theBureau of Prisons (BOP) to operate the Moshannon Valley Correctional Center. InOctober 2004, we received the signed Finding of No Significant Impact forthe facility.  We have a three-yearcontract with the BOP to operate the facility and the BOP has the option togrant seven one-year extensions.  Thefacility, which can house 1,300 male federal inmates, is scheduled to beginoperations in early 2006.

 

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InSeptember 2004, we resolved our claim with the BOP for the reimbursementof a portion of the expenses we incurred in connection with the issuance of theStop-Work Order and the delay of the project (included among these expenses wasapproximately $1.4 million in accounts receivable for expenses incurred by usafter the September 1999 issuance of the Stop-Work Order).  We settled the claim, as well as the claimfor the reimbursement of costs related to the original construction effortsincurred beginning in 1999, with the BOP and were reimbursed approximately $7.0million in September 2004.  Theexcess reimbursement of approximately $5.6 million over the $1.4 million inaccounts receivable was credited against the carrying cost of the facility.

 

As of December 31,2005, we had incurred (net of the BOP reimbursement) approximately $63.8 million for the design,construction and development costs and capitalized interest related to theMoshannon Valley Correctional Center facility. We believe that our existingcash and credit facility will provide adequate funding to complete theconstruction of the facility.

 

***Mesa Verde Community Correctional Facility***

 

In December 2005, weentered into a five year agreement with the California Department ofCorrections to operate the Mesa Verde Community Correctional Facility, which isleased.  The facility commencedoperations in early 2006 and can house up to 360 male California inmates.

 

#### **New AccountingPronouncements**

 

***Statement of Financial Accounting Standards No. 123R***

#### ** **

InDecember 2004, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standard (SFAS) No. 123R, “Share BasedPayment,” which requires companies to expense the value of employee stockoptions and other types of equity-based compensation based on the fair value ofthe options at the award’s grant date based on the estimated number of awardsthat are expected to vest. Compensation cost for awards that vest would not bereversed if the awards expire without being exercised. When measuring fairvalue, companies can choose an option-pricing model (e.g., Black-Scholes orbinominal models) that approximately reflects their specific circumstances andthe economics of their transactions. Companies will recognizecompensation cost for share based payment awards as they vest, including therelated tax effects.  The effective dateof SFAS No. 123R, as amended, applies to annual periods beginning afterJune 15, 2005, and applies to all outstanding and unvested share basedpayment awards at the company’s adoption date. In April 2005, the Securities and Exchange Commission adopted arule that amends the adoption date of SFAS No. 123R toJanuary 1, 2006.

 

We adopted SFAS No. 123Ron January 1, 2006 using the modified prospective method in which compensationcost is recognized beginning with the January 1, 2006 adoption date (a) basedon the requirements of SFAS No 123R for all share-based payments granted afterJanuary 1, 2006 and (b) based on the requirements of SFAS No. 123 for allawards granted to employees prior to January 1, 2006 that remain unvested onthe adoption date.  We also plan to valueoptions using the Black-Scholes option pricing model.

 

As permitted by SFAS No.123, until December 31, 2005 we accounted for share-based payments to employeesusing APB No. 25’s intrinsic value method and, as such, generally recognized nocompensation cost on grants of employee stock options. Accordingly, theadoption of SFAS No. 123R may have a significant impact on our results ofoperations, although it will have no impact on our overall financialposition.  The impact of adoption of SFASNo. 123R cannot be predicted at this time because it will depend on the futurelevels of share-based grants.  However,had we adopted SFAS No. 123R in prior periods, the impact of that standardwould have approximated the impact of SFAS No. 123 as described in thedisclosure of pro forma net income (loss) per share in Note 2 to ourconsolidated financial statements.  SFASNo. 123R also requires the benefits of tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature.

 

Under SFAS No. 123R,compensatory employee stock purchase plans (ESPP) are required to recognizecompensation cost over the requisite service period for grants made under theESPP.  The criteria that an ESPP mustmeet to be considered non-compensatory are more restrictive under SFASNo. 123R than they are under APB No. 25.  We are evaluating the impact on our ESPP bySFAS No. 123R, and currently believe our ESPP may be deemed a compensatoryplan as defined by SFAS No. 123R.  We donot expect this to have a material effect on our financial condition, resultsof operations or cash flows.

 

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***Statement of Financial Accounting Standards No. 154***

 

TheFASB issued SFAS No. 154, “Accounting Changes and Error Corrections — areplacement of APB Opinion No. 20 and FASB Statement No. 3.”  SFAS No. 154 is effective, and will beadopted, for accounting changes made in fiscal years beginning afterDecember 15, 2005 and is to be applied retrospectively.  SFAS No. 154 requires that retroactiveapplication of a change in accounting principle be limited to the directeffects of the change.  Our adoption ofSFAS No. 154 is not expected to have a material effect on our financialcondition, results of operations or cash flows.

 

**CriticalAccounting Policies and Estimates**

 

Ourdiscussion and analysis of financial condition and results of operations arebased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States(GAAP).  The preparation of thesefinancial statements requires that we make estimates and judgments that affectour reported amounts of assets, liabilities, revenues and expenses and therelated disclosure of contingent assets and liabilities.  We evaluate our estimates on an on-goingbasis, based on historical experience and on various other assumptionsthat we believe to be reasonable under the circumstances.  Actual results may differ from theseestimates under different assumptions or conditions.

 

Webelieve the following critical accounting policies affect our more significantaccounting policies and estimates used in the preparation of the accompanyingconsolidated financial statements.

 

***Consolidation***

 

Theaccompanying consolidated financial statements include the accounts of CornellCompanies, Inc., our wholly-owned subsidiaries, and activities relative to twofinancings of operating facilities. All significant intercompany balances andtransactions have been eliminated. Minority interest in consolidated special purpose entities representsequity that other investors have contributed to the special purposeentities.  Minority interest is adjustedfor income and losses allocable to the owners of the special purposeentities.  As the cumulative losses ofthe special purpose entity exceed the equity which is recorded as minorityinterest by the Company, the excess losses are recorded in our ConsolidatedStatements of Operations and Comprehensive Income (Loss).

 

***Revenue Recognition***

 

Werecognize revenue in accordance with SEC Staff Accounting Bulletin No. 104,“Revenue Recognition in Financial Statements,” as amended.  Substantially all of our revenues are derivedfrom contracts with federal, state and local governmental agencies which payeither per diem rates based upon the number of occupant days or hours servedfor the period, on a take-or-pay basis, management fee basis, cost-plusreimbursement or fee-for-service basis. Revenues are recognized as services are provided under our establishedcontractual agreements to the extent collection is considered probable.

 

***Accounts Receivable and RelatedAllowance for Doubtful Accounts***

 

Weextend credit to the governmental agencies contracted with and other parties inthe normal course of business.  Weregularly review our outstanding receivables and historical collectionexperience, and provide for estimated losses through an allowance for doubtfulaccounts.  In evaluating the adequacy ofour allowances for doubtful accounts, we make judgments regarding ourcustomers’ ability to make required payments, economic events and other factors.  As the financial condition of these partieschange, circumstances develop or additional information becomes available,adjustments to the allowance for doubtful accounts may occur.  If, after reasonable collection efforts havebeen made, a receivable is determined to be permanently uncollectible, it willbe written off.

 

***Insurance Reserves***

 

Wemaintain insurance coverage for various aspects of our business andoperations.  We retain a portion oflosses that occur through the use of deductibles and retention underself-insurance programs.  We regularlyreview our estimates of reported and unreported claims and provide for theselosses through insurance reserves. These reserves are influenced by risingcosts of health care and other costs, increases in claims, time lags in claimsinformation and levels of insurance coverage carried. As claims develop andadditional information becomes available to us, adjustments to the related lossreserves may occur.  Our reserves formedical and worker’s compensation claims are subject to change based on ourestimate of the number and the magnitude of claims to be incurred.

 

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***Impairment or Disposal of Long-LivedAssets***

 

Wereview our long-lived assets for impairment at least annually or when changesin circumstances or a triggering event indicate that the carrying amount of theasset may not be recoverable in accordance with SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets.”  SFAS No. 144 requires that long-lived assetsto be held and used be reported at the lower of their carrying amount or fairvalue.  Assets to be disposed of by saleare recorded at the lower of their carrying amount or fair value less estimatedcost to sell. We estimate fair value based upon the best information available,which may include discounted expected future cash flows to be produced by theassets and/or available market prices. Factors that significantly influenceestimated future cash flows include the periods and levels of occupancy for thefacility, expected per diem or reimbursement rates, assumptions regarding thelevels of staffing, services and future operating and capital expendituresnecessary to generate forecasted revenues, related costs for these activitiesand future rate of increases or decreases associated with these factors. Wealso consider the results of any appraisals on the properties when assessingfair value. These estimates are highly subjective, particularly incircumstances where there is no current operating contract in place and changesin the assumptions and estimates could result in the recognition of impairmentcharges. The most subjective estimates made in this analysis for 2005 relate tothe New Morgan Academy and the Campbell Griffin Treatment Center, for 2004relate to the New Morgan Academy, the Residential School and the Maple CreekHome and for 2003 relate to the New Morgan Academy and the Moshannon ValleyCorrectional Center. We may be required to record an impairment charge in thefuture should we not be able to successfully negotiate a contract on any of ourfacilities for which we do currently have an operating contract.

 

***Goodwill***

 

Weaccount for our goodwill in accordance with SFAS No. 142, “Goodwill and OtherIntangible Assets,” which states that there will be no amortization of goodwillor intangible assets with indefinite lives. Impairment of these assets is assessed annually to determine if theestimated fair value of the reporting unit exceeds the net carrying value of thereporting unit, including the applicable goodwill.  The estimates of fair market value are basedupon our estimates of the present value of future cash flows.  We make assumptions regarding the estimatedcash flows and if these estimates or their related assumptions change, animpairment charge may be incurred.

 

**Results ofOperations**

 

Material fluctuations inour results of operations are principally the result of the level of newcontract development activity, the timing and effect of facility expansions,occupancy or contract rates, contract renewals or terminations and facilityclosures and non-recurring charges.

 

Thefollowing table sets forth for the periods indicated the percentages of revenuerepresented by certain items in our Consolidated Statements of Operations andComprehensive Income (Loss).

 
| ** **                                                                            | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                              |       | 100.0                            | %          | 100.0 | % | 100.0 | % |
|                                                                                  |       |                             |       |   |   |   |   |
| Operating expenses                                                                    |       | 76.6                             |       | 76.1 |   | 76.9 |   |
| Pre-opening and start-up expenses                                                     |       | 2.9                              |       | 3.2 |   | 0.4 |   |
| Impairment of long-lived assets                                                       |       | 3⁄4                           |       | 3.4 |   | 3⁄4 |   |
| Depreciation and amortization                                                         |       | 4.9                              |       | 4.8 |   | 4.1 |   |
| General and administrative expenses                                                   |       | 6.6                              |       | 7.3 |   | 9.1 |   |
| Income from operations                                                                |       | 9.0                              |       | 5.2 |   | 9.5 |   |
| Interest expense, net                                                                 |       | 7.0                              |       | 7.3 |   | 6.8 |   |
| Loss on extinguishment of debt                                                        |       | 3⁄4                           |       | 0.9 |   | 3⁄4 |   |
| Income (loss) from continuing operations  before provision (benefit) for income taxes |       | 2.0                              |       | (3.0 | ) | 2.7 |   |
| Provision (benefit) for income taxes                                                  |       | 0.7                              |       | (1.2 | ) | 1.1 |   |
| Income (loss) from continuing operations                                              |       | 1.3                              |       | (1.8 | ) | 1.6 |   |
| Discontinued operations, net of taxes                                                 |       | (1.2                             | )          | (0.9 | ) | (0.1 | ) |
| Net income (loss)                                                                     |       | 0.1                              | %          | (2.7 | )% | 1.5 | % |

 

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***Year Ended December 31,2005 Compared to Year Ended December 31, 2004***

*** ***

Certaincomparisons of revenue, expenses and average contract capacity contained hereinhave been made excluding the effect of pre-opening and start-up expenses andrelated revenues.  Disclosures excludingthe effect of pre-opening and start-up expenses and revenues represent measurescalculated in a manner that is not consistent with GAAP.  We believe exclusion of the non-recurringeffect of pre-opening and start-up expenses and revenues increases the reader’sunderstanding of our operating trends.

*** ***

***Revenues*****.** Revenues increased approximately $33.6 million, or 12.1%, to $310.8million for the year ended December 31, 2004 from $277.2 million for theyear ended December 31, 2004.

 

***Adult Secure Institutional.***Adult secure institutional division revenuesincreased approximately $16.9 million, or 14.7%, to $131.7 million for the yearended December 31, 2005 from $114.8 million for the year endedDecember 31, 2004 due primarily to (1) the opening of the two-unitRegional Correctional Center in July and December 2004 whichincreased 2005 revenues by approximately $5.5 million, (2) revenues ofapproximately $3.2 million generated by the eight adult secure facilitiesacquired from CSI in April 2005, (3) the acquisition of the Walnut Grove YouthCorrectional Facility management contract in June 2004 which increased 2005revenues by approximately $6.3 million, (4) an increase in revenues ofapproximately $2.5 million at the Big Spring Correctional Center due toimproved occupancy and (5) an increase in revenues of approximately $1.4million at the D. Ray James Prison due to a per diem rate increase received inthe latter half of 2004.  The increase inrevenues due to the above was offset, in part, by a decrease in revenues ofapproximately $3.3 million due to the non-renewal of the Valencia County DetentionCenter contract as of December 31, 2004. The remaining net increase in revenueof approximately $1.3 million was due to various insignificant revenuefluctuations at our other adult secure institutional facilities.

 

Averagecontract occupancy was 96.0% for the year ended December 31, 2005 comparedto 98.8% for the year ended December 31, 2004.  The decline in the average contract occupancypercentage in 2005 is due to the Regional Correctional Center which did notoperate at full capacity.  Excluding theactual occupancy and contract capacity for the start-up operations of theRegional Correctional Center in 2005 (through August 2005) and 2004, averagecontract occupancy was 102.6% and 102.4%, respectively.

 

Theaverage per diem rate was $49.08 for the year ended December 31, 2005compared to $48.45 for the year ended December 31, 2004.  The increase in the average per diem rate for2005 is due to the opening of the Regional Correctional Center in July andDecember 2004, the acquisition of the Walnut Grove Youth Correctional Facilitymanagement contract in June 2004 and the acquisition of CSI in April 2005.  We continue to experience increasing pressurefrom contracting governmental agencies to limit or even reduce per diem rates.  Many of these governmental entities are undersevere budget pressures and we anticipate that more governmental agencies mayapproach us about per diem rate concessions. Decreases, or the lack of anticipated increases, in per diem rates couldadversely impact our operating margin.

 

Weanticipate an increase in revenues for this division in 2006 due to theactivation of the Mesa Verde Correctional Facility and the Moshannon ValleyCorrectional Facility.

 

Revenuesattributable to start-up operations were approximately $3.3 million and $1.9million for the year ended December 31, 2005 and 2004, respectively, and wereattributable to the start-up operations of the Regional Correctional Center.

 

***Juvenile***.  Juvenile justice, educational and treatmentservices division revenues increased approximately $5.2 million, or 4.6%, to$119.0 million for the year ended December 31, 2005 from $113.8 millionfor the year ended December 31, 2004. The increase in revenues was due primarily to (1) the opening of theSouthern Peaks Regional Treatment Center in August 2004 which increased2005 revenues by approximately $6.0 million, (2) the commencement of ourmanagement contract for the Philadelphia Alternative Education program inAugust 2004 which increased revenues by approximately $1.2 million, (3)the commencement of our management contract for the Lebanon AlternativeEducation program in September 2004 which increased revenues byapproximately $1.0 million and (4) the commencement of our management contractfor the Reading Alternative Education program in July 2005 which contributedrevenues of approximately $1.2 million. The increase in revenues due to the above was offset, in part, by adecrease in revenues of approximately $1.4 million at the Abraxas Center forAdolescent Females (ACAF) and approximately $2.6 million at the Campbell GriffinTreatment Center due to reduced occupancy. The Campbell Griffin TreatmentCenter was temporarily closed in the fourth quarter of 2005.  We currently expect to reactivate thefacility in 2006.

 

Average contractoccupancy was 89.2% for the year ended December 31, 2005 compared to 92.7%for the year ended December 31, 2004. Excluding the actual occupancy and the contract capacity for thestart-up activities of the Southern Peaks

 

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Regional Treatment Center(through the first quarter) in 2005 and 2004 and for the start-up activities ofthe Plankinton Regional Detention Center in 2004, average contract occupancywas 90.0% for the year ended December 31, 2005 compared to 96.4% for theyear ended December 31, 2004.

 

The average per diem ratefor our residential juvenile facilities was approximately $167.68 for the yearended December 31, 2005 compared to approximately $164.54 for the yearended December 31, 2004. The increase in the average per diem rate in 2005is due to the opening of the Southern Peaks Regional Treatment Center in August2004. The average fee-for-service rate for our non-residential community-basedjuvenile programs was approximately $34.21 for the year ended December 31,2005 compared to approximately $27.53 for the year ended December 31,2004.  The increase in the averagefee-for-service rate for 2005 is due to changes in the mix of services providedby our various juvenile justice, educational and treatment services, as well asthe addition of several new alternative education programs in 2005.

 

Revenues attributable tostart-up operations were approximately $1.5 million for the year endedDecember 31, 2005 and were attributable to the start-up operations of theSouthern Peaks Regional Treatment Center. Revenues attributable to start-up operations were approximately $1.2million for the year ended December 31, 2004 and were attributable to theSouthern Peaks Regional Treatment Center and the Plankinton Regional DetentionCenter.

 

***Adult Community-Based.***Adultcommunity-based corrections and treatment services division revenues increasedapproximately $11.5 million, or 23.7%, to $60.1 million for the year endedDecember 31, 2005 from $48.6 million for the year ended December 31,2004 due primarily to (1) revenues of approximately $7.9 million from theeleven adult community-based programs and facilities acquired from CSI in April2005, (2) the opening of the Las Vegas Center in December 2004 whichcontributed revenues of approximately $1.4 million, (3) an increase in revenuesof approximately $0.7 million at the Dallas County Judicial Treatment Centerdue to improved occupancy and (4) and increase in revenues of approximately$0.6 million at the Taylor Street Center due to improved occupancy.  The remaining net increase in revenues ofapproximately $0.9 million was due to various insignificant fluctuations inrevenues at our other adult community-based facilities and programs.

 

Average contractoccupancy was 108.0% for the year ended December 31, 2005 compared to103.1% for the year ended December 31, 2004.  We experienced average contract occupancypercentages in excess of 100.0% due to the actual occupancy at certainresidential facilities exceeding its contracted capacity.  We currently cannot predict whether thislevel of occupancy will continue in future periods.

 

The average per diem ratefor our residential adult community-based facilities was approximately $60.77for the year ended December 31, 2005 compared to approximately $62.10 forthe year ended December 31, 2004. The average fee-for-service rate for ournon-residential adult community-based programs was approximately $9.40 for theyear ended December 31, 2005 compared to approximately $8.23 for the yearended December 31, 2004.  Ouraverage fee-for-service rates can fluctuate from year to year due to changes inthe mix of services provided by our various non-residential adultcommunity-based programs. There were no revenues attributable to start-upoperations for the years end December 31, 2005 and 2004.

 

***Operating Expenses.*** Operating expenses increased approximately $27.1 million, or 12.8%, to$238.3 million for the year ended December 31, 2005 from approximately$211.2 million for the year ended December 31, 2004.

 

***Adult Secure Institutional.***  Adult secure institutional division operatingexpenses increased approximately $11.5 million, or 14.4%, to approximately $91.5 million for theyear ended December 31, 2005 fromapproximately $80.0 million for the year ended December 31, 2004 dueprimarily to (1) the acquisition of the Walnut Grove Youth Correctional Facilitymanagement contract in June 2004 which increased operating expenses byapproximately $4.3 million, (2) an increase in operating expenses ofapproximately $3.3 million at the Big Spring Correctional Center due toincreased occupancy, (3) an increase in operating expenses of approximately$3.8 million at the two-unit Regional Correctional Center that began operatingin July and December 2004 and (4) operating expenses of approximately $2.6million from the eight adult secure facilities purchased from CSI inApril 2005.  The increase inoperating expenses due to the above was offset, in part, by a decrease inoperating expenses of approximately $2.7 million due to the non-renewal of theValencia County Detention Center management contract as of December 31,2004.

 

As a percentage ofsegment revenues, adult secure institutional services operating expenses were69.5% for the year ended December 31, 2005 compared to 69.6% for the yearended December 31, 2004.  Excludingapproximately $3.3 million and $1.9 million of revenues attributable to thestart-up operations of the Regional Correctional Center in 2005 and 2004,respectively, adult secure institutional services division operating expenseswere 71.2% and 70.8%, respectively.

 

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***Juvenile.***  Juvenile justice, educational and treatmentservices division operating expenses increased approximately $6.6 million, or7.1%, to approximately $100.2 million for the year ended December 31, 2005from $93.6 million for the year ended December 31, 2004 due primarily to(1) the opening of the Southern PeaksRegional Treatment Center in August 2004 which increased operatingexpenses by approximately $5.3 million, (2) the commencement of ourmanagement contract for the Philadelphia Alternative Education Program inAugust 2004 which increased operating expenses by approximately $1.1million and (3) the commencement of our management contract for the LebanonAlternative Education Program in September 2004 which increased operatingexpenses by approximately $0.9 million. Additionally, in the year endedDecember 31, 2005, we recorded a restructuring charge of approximately $1.0million for personnel costs associated with management streamlining initiativesimplemented in the first quarter of 2005. The increase in operating expenses due to the above was offset, in part,by a decrease in operating expenses of approximately $0.6 million due to thetermination of the Santa Fe County Youth Development Program inJanuary 2004.  The remaining netdecrease in operating expenses of approximately $1.1 million was due to variousinsignificant fluctuations in operating expenses at our other juvenilefacilities and programs.

 

As a percentage of segment revenues, juvenileservices division operating expenses were 84.2% for the year ended December 31,2005 compared to 82.2% for the year ended December 31, 2004.  Excluding approximately $1.5 million of revenues attributable to thestart-up operations of the Southern Peaks Regional Treatment Center in the yearended December 31, 2005 and approximately $1.2 million of revenuesattributable to the start-up operations of the Southern Peaks RegionalTreatment Center and the Plankinton Regional Detention Center in the year endedDecember 31, 2004, juvenile services division operating expenses were 85.3% and83.1%, respectively.  The increase in thepercentage for 2005 is largely due to the $1.0 million charge discussed above.

 

***AdultCommunity-Based.*** Adult community-based corrections and treatment services divisionoperating expenses increased approximately $9.1 million, or 24.3%, to $46.6million for the year ended December 31, 2005 from $37.5 million for theyear ended December 31, 2004 due to (1) operating expenses ofapproximately $6.5 million attributable to the eleven adult community-basedprograms and facilities acquired from CSI in April 2005, (2) theopening of the Las Vegas Center in December 2004 which increased operatingexpenses by approximately $1.0 million and (3) a charge of approximately$0.3 million for terminated facility lease option costs.  The remaining net increase in operatingexpenses of approximately $1.3 million was due to various insignificantfluctuations in operating expenses at our other adult community-based programsand facilities.

 

Asa percentage of segment revenues, adult community-based corrections andtreatment services division operating expenses were 77.5% for the year endedDecember 31, 2005 compared to 77.3% for the year ended December 31,2004.

 

***Pre-Opening and Start-up Expenses.***** **Pre-opening and start-up expenses were approximately $9.0 million forthe year ended December 31, 2005 and were attributable to the pre-openingand start-up activities of the Regional Correctional Center, theSouthern Peaks Regional Treatment Center, the Mesa Verde Community CorrectionalFacility and the Moshannon Valley Correctional Center.  Pre-opening and start-up expenses for theyear ended December 31, 2004 were approximately $8.8 million and wereattributable to the pre-opening and start-up activities of the Southern PeaksRegional Treatment Center, the Regional Correctional Center, the Las VegasCenter, the Moshannon Valley Correctional Center and the Plankinton RegionalDetention Center.  These expensesconsisted primarily of personnel and related expenses, building rent,professional and recruiting expenses.

 

***Depreciation and Amortization*****.** Depreciation and amortization increased approximately $2.0 million, or15.2%, to $15.2 million for the year ended December 31, 2005 from $13.2million for the year ended December 31, 2004.  Depreciation and amortization of propertyand equipment increased approximately $1.2 million due primarily todepreciation related to the Southern Peaks Regional Treatment Center thatbecame operational in August 2004 and the Regional Correctional Centerbuildings and building improvements that became operational in July andDecember 2004.  Amortization ofintangibles was approximately $2.1 million and $1.4 million for the years endedDecember 31, 2005 and 2004, respectively. The increase in amortization of intangibles in 2005 was due toamortization of the June 2004 purchased contract value for the WalnutGrove Youth Correctional Facility management contract and the April 2005purchased contract value for the facilities and programs acquired from CSI.

 

***General and Administrative Expenses.*** General and administrative expenses increased approximately $0.1million, or 0.5%, to approximately $20.4 million for the year endedDecember 31, 2005 from approximately $20.3 million for the year endedDecember 31, 2004.    General andadministrative expenses for the year ended December 31, 2005 include a $1.1million restructuring charge for personnel costs associated with management’sstreamlining initiatives implemented in the first and second quarter of2005.  This was offset, in part, by adecrease of approximately $1.3 million in professional fees, principally

 

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associated with certain accountingservices (including Sarbanes-Oxley compliance), executive recruitment services,and business development expenses.

 

***Interest.***  Interestexpense, net of interest income, increased approximately $1.3 million to $21.7million for the year ended December 31, 2005 from $20.4 million for theyear ended December 31, 2004. Interest expense increased approximately$1.7 million due to interest on the Senior Notes of approximately $10.9 million(net of swap interest income of $1.1 million) in the year endedDecember 31, 2005 compared to interest of $5.1 million (net of swapinterest income of $1.2 million) in the year ended December 31, 2004.  This increase in interest expense was offset,in part, by a decrease in interest expense of approximately $1.8 million (netof amortization of deferred financing costs) due to the repayment of theoutstanding balances on both our amended 2000 Credit Facility and the SyntheticLease Investor Notes A and B in June 2004. Capitalized interest for the yearended December 31, 2005 was approximately $3.7 million and related todevelopment and construction costs for the Moshannon Valley Correctional Center.  Capitalized interest for the year endedDecember 31, 2004 was approximately $1.8 million and related todevelopment and construction costs for the Moshannon Valley CorrectionalCenter, the Southern Peaks Regional Treatment Center, the Regional CorrectionalCenter and the Las Vegas Center. Additionally, interest income increased approximately $0.4 million forthe year ended December 31, 2005 as compared to 2004 due to higher fundbalances and higher interest rates in the 2005 period.

 

***Income Taxes.***** **For the year ended December 31, 2005, we recognized a provisionfor income taxes on our income from continuing operations at an estimatedeffective rate of 36.1%.  For the yearended December 31, 2004, we recognized a benefit for income taxes at anestimated effective rate of 39.4%.   Thereduction in the estimated income tax rate in 2005 is related to a reduction inour estimated state tax liability, as partially offset by the impact of certainnon-deductible expenses such as lobbying.

 

***Discontinued Operations, net of tax.***  Thenet loss from discontinued operations increased approximately $1.2 million to$3.6 million for the year ended December 31, 2005 from $2.4 million for theyear ended December 31, 2004.  The lossfrom discontinued operations for the years ended December 31, 2005 and 2004includes the operating results for the Residential School, Maple Creek Home,our mental health programs in Pennsylvania, the Northside Clinic and theJos-Arz Academy.  The increase in lossfrom discontinued operations, net of tax, in 2005 was due to decliningperformance prior to closing the facilities (which occurred in 2005) as well asrelated closure costs. Subsequent to the closure of these programs, we havedisposed (during 2005) of those discontinued facilities which we owned.

 

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***Year Ended December 31,2004 Compared to Year Ended December 31, 2003***

*** ***

Certaincomparisons of revenue, expenses and average contract capacity contained hereinhave been made excluding the effect of pre-opening and start-up expenses andrelated revenues.  Disclosures excludingthe effect of pre-opening and start-up expenses and revenues represent non-GAAPmeasures calculated in a manner that is not consistent with GAAP.  We believe exclusion of the non-recurringeffect of pre-opening and start-up expenses and revenues increases the reader’sunderstanding of our operating trends.

*** ***

***Revenues*****.** Revenues increased approximately $19.0 million, or 7.4%, to $277.2million for the year ended December 31, 2004 from $258.2 million for theyear ended December 31, 2003.

 

***Adult Secure Institutional.  ***Adult secure institutional division revenues increased approximately$12.7 million, or 12.4%, to $114.8 million for the year ended December 31,2004 from $102.1 million for the year ended December 31, 2003 dueprimarily to (1) per diem rate increases at the Big Spring Correctional Centerin September 2003 and March 2004 which increased 2004 revenues byapproximately $5.1 million, (2) the acquisition of the Walnut Grove YouthCorrectional Facility management contract in June 2004 which contributedrevenues of approximately $4.8 million, (3) the opening of the two-unitRegional Correctional Center in July and December 2004 whichcontributed revenues of approximately $1.9 million and (4) increased occupancyat the Donald D. Wyatt Detention Center which increased 2004 revenues byapproximately $1.2 million.  We openedthe 528 bed South Tower of the Regional Correctional Center in July 2004and the 442 bed North Tower in December 2004.  Revenues attributable to start-up operationswere approximately $1.9 million for the year ended December 31, 2004 andwere attributable to the Regional Correctional Center.  There were no revenues attributable tostart-up operations for the year ended December 31, 2003.

 

Our adult secureinstitutional services division revenues are generated primarily from contractswith federal and state agencies.  AtDecember 31, 2004, we operated nine adult secure facilities with anaggregate service capacity of 7,940 and a contracted capacity of 7,679.

 

Averagecontract occupancy was 98.8% for the year ended December 31, 2004 comparedto 99.3% for the year ended December 31, 2003.  The decline in the average contract occupancypercentage in 2004 is due to the opening of the Regional Correctional Center inJuly and December and did not operate at full capacity in 2004.  Excluding the actual occupancy and contractcapacity for the start-up activities of the Regional Correctional Center in2004, average contract occupancy was 102.4%. The average per diem rate was $48.45 for the year ended December 31,2004 compared to $47.79 for the year ended December 31, 2003.  The increase in the average per diem rate for2004 as compared to 2003 is due to the opening of the two-unit RegionalCorrectional Center in July and December 2004 and the acquisition ofthe Walnut Grove Youth Correctional Facility management contract inJune 2004.  Additionally, wereceived per diem rate increases at our Big Spring Correctional Center inSeptember 2003 and March 2004. We continue to experience increasing pressure from contractinggovernmental agencies to limit or even reduce per diem rates.  Many of these governmental entities are undersevere budget pressures and we anticipate that more governmental agencies mayapproach us about per diem rate concessions.

 

***Juvenile***.  Juvenile justice, education and treatmentservices division revenues increased approximately $7.3 million, or 6.9%, to$113.8 million for the year ended December 31, 2004 from $106.5 millionfor the year ended December 31, 2003. The increase in revenues was due primarily to (1) the opening of theTexas Adolescent Treatment Center in October 2003 which increased 2004revenues by approximately $5.5 million, (2) increased occupancy at the CornellAbraxas 1 (A-1) facility which increased 2004 revenues by approximately $1.7million, (3) the opening of the Southern Peaks Regional Treatment Center inAugust 2004 which contributed revenues of approximately $1.2 million, (4)the commencement of our management contract for the Philadelphia AlternativeEducation program in August 2004 which contributed revenues ofapproximately $1.0 million and (5) the commencement of our management contractfor the Lebanon Alternative Education program in September 2004 whichcontributed revenues of approximately $0.5 million.  The increase in revenues due to the above wasoffset, in part, by a decrease in 2004 revenues of approximately $3.8 milliondue to our termination of the Santa Fe County Youth Development Program inJanuary 2004.  The remaining netincrease in revenues of $1.2 million was due to various insignificantfluctuations at our other juvenile facilities and programs.

 

At December 31,2004, excluding those facilities subsequently classified as discontinuedoperations in 2005, we operated 20 residential juvenile facilities with a totalservice capacity of 1,765 and 12 non-residential juvenile community-basedprograms with a total program capacity of 2,482.  The contracts for our juvenile facilities andprograms are generally with state and local government agencies and generallyrenew annually.

 

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Average contractoccupancy was 92.7% for the year ended December 31, 2004 compared to 92.6%for the year ended December 31, 2003. Excluding the actual occupancy and the contracted capacity of theSouthern Peaks Regional Treatment Center and the Plankinton Regional DetentionCenter for the year ended December 31, 2004 and the actual occupancy andthe contracted capacity of the Texas Adolescent Treatment Center for the yearended December 31, 2003, average contract occupancy was 96.4% for the yearended December 31, 2004 compared to 93.2% for the year endedDecember 31, 2003.

 

The average per diem ratefor our residential juvenile facilities was approximately $164.54 for the yearended December 31, 2004 compared to approximately $162.88 for the yearended December 31, 2003.  Theincrease in the average per diem rate for 2004 as compared to 2003 is due tothe opening of the Southern Peaks Regional Treatment Center in August 2004and annual rate increases for our Pennsylvania programs received inJuly 2004.  The averagefee-for-service rate for our non-residential community-based juvenile programswas approximately $27.53 for the year ended December 31, 2004 compared toapproximately $26.40 for the year ended December 31, 2003.

 

Revenues attributable tostart-up operations were approximately $1.2 million for the year endedDecember 31, 2004 and were attributable to the start-up operations of theSouthern Peaks Regional Treatment Center and the Plankinton Regional DetentionCenter.  Revenues attributable tostart-up operations were approximately $0.3 million for the year endedDecember 31, 2003 and were attributable to the Texas Adolescent TreatmentCenter.

 

***Adult Community-Based. ***Adult community-based corrections and treatmentservices division revenues decreased approximately $0.9 million, or 1.8%, to$48.6 million for the year ended December 31, 2004 from $49.5 million forthe year ended December 31, 2003 due primarily to (1) reduced occupancy atthe Dallas County Judicial Treatment Center which reduced 2004 revenues byapproximately $0.9 million (2) our termination of the Inglewood Men’s Centercontract in September 2003 which reduced 2004 revenues by approximately$0.3 million and (3) our termination of the Santa Fe County ElectronicMonitoring Program in January 2004 which reduced 2004 revenues byapproximately $0.5 million.  The decreasein revenues due to the above was offset by a net increase in revenues ofapproximately $0.8 million at our various other adult community-basedfacilities and programs.

 

At December 31,2004, excluding those facilities subsequently classified as discontinuedoperations in 2005, we operated 15 residential adult community-basedcorrections and treatment facilities with a total service capacity of 2,261 andfive non-residential community-based corrections and treatment programs with atotal service capacity of 1,384.  Ourcontracts for these services are primarily with federal, state and localgovernmental agencies.

 

Average contractoccupancy was 103.1% for the year ended December 31, 2004 compared to110.7% for the year ended December 31, 2003.  The decline in occupancy was primarily due toreduced occupancy at the Dallas County Judicial Treatment Center.  We experienced average contract occupancypercentages in excess of 100.0% due to the actual occupancy at certainresidential facilities exceeding its contracted capacity.  We currently cannot predict whether thislevel of occupancy will continue in future periods.

 

The average per diem ratefor our residential adult community-based facilities was approximately $62.10for the year ended December 31, 2004 compared to approximately $58.69 forthe year ended December 31, 2003. The increase in the average per diemrate for 2004 as compared to 2003 is due to mid-year rate increases at ourAlaskan facilities and per diem rate increases at certain other of ourresidential adult community-based facilities due to contract renewals and othercontractual rate increases.  The averagefee-for-service rate for our non-residential adult community-based programs wasapproximately $8.23 for the year ended December 31, 2004 compared toapproximately $9.05 for the year ended December 31, 2003.  Our average fee-for-service rates fluctuatefrom year to year due to changes in the mix of services provided by our variousnon-residential adult community-based programs.

 

***Operating Expenses.*** Operating expenses increased approximately $12.7 million, or 6.4%, to$211.2 million for the year ended December 31, 2004 from approximately$198.5 million for the year ended December 31, 2003.

 

***Adult Secure Institutional.***  Adult secure institutional division operatingexpenses increased approximately $7.7 million, or 10.7%, to approximately $80.0 million for theyear ended December 31, 2004 fromapproximately $72.3 million for the year ended December 31, 2003due primarily to (1) the acquisition of the Walnut Grove Youth CorrectionalFacility management contract in June 2004 which incurred operating expensesof approximately $3.5 million and (2) an increase in operating expenses ofapproximately $4.2 million resulting from the increased occupancy at the BigSpring Correctional Center and the Donald D. Wyatt Detention Center.

 

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As a percentage ofsegment revenues, adult secure institutional services operating expenses were69.6% for the year ended December 31, 2004 compared to 70.8% for the yearended December 31, 2003.  Excluding$1.9 million of revenue attributable to the start-up operations of the RegionalCorrectional Center in 2004, adult secure institutional services operatingexpenses, as a percent of segment revenues, were 70.8% for the year endedDecember 31, 2004.  The 2004operating margin was favorably impacted by the September 2003 purchase offurniture and equipment that was formerly leased under a sale and leasebacktransaction in 1999.  In addition, inApril 2004 we purchased the Baker Community Correctional Center buildingwhich was formerly leased.  As a result,rent expense decreased, favorably impacting the 2004 operating margin.  Furthermore, the acquisition of the WalnutGrove Youth Correctional Facility management contract in June 2004favorably impacted the operating margin due to its lower operating capitalrequirements.

 

***Juvenile.***  Juvenile justice, educational and treatmentservices division operating expenses increased approximately $4.7 million, or5.3%, to $93.6 million for the year ended December 31, 2004 from $88.9million for the year ended December 31, 2003 due primarily to (1) theopening of the Texas Adolescent Treatment Center in October 2003 whichincreased 2004 operating expenses by approximately $3.9 million, (2) anincrease in operating expenses of approximately $1.1 million at the A-1facility due to increased occupancy, (3) an increase in the provision for baddebts of approximately $0.5 million for certain facilities and programs and (4)increase of approximately $1.0 million in employee insurance costs.  The increase in operating expenses due to theabove was offset, in part, by a decrease in operating expenses of approximately$3.1 million due to our termination of the Santa Fe County Youth DevelopmentProgram in January 2004.  Theremaining increase of $1.3 million in operating expenses was due to variousinsignificant fluctuations at our other juvenile programs.

 

Asa percentage of segment revenues, juvenile division operating expenses were82.2% for the year ended December 31, 2004 compared to 83.4% for the yearended December 31, 2003.  Excluding $1.2million of revenue attributable to the Southern Peaks Regional Treatment Centerand the Plankinton Regional Detention Center for the year endedDecember 31, 2004 and $0.3 million of revenue attributable to the start-upoperations of the Texas Adolescent Treatment Center for the year endedDecember 31, 2003, juvenile services division operating expenses, as apercentage of segment revenues, were 83.1% and 83.7% for the years endedDecember 31, 2004 and 2003, respectively.

 

***AdultCommunity-Based.*** Adult community-based corrections and treatment services divisionoperating expenses increased approximately $0.1 million, or 0.3%, to $37.5million for the year ended December 31, 2004 from $37.4 million for theyear ended December 31, 2003 due to (1) a decrease in operating expensesof approximately $0.7 million as a result of reduced occupancy at the DallasCounty Judicial Treatment Center, (2) our termination of the Inglewood Men’sCenter contract in September 2003 which reduced 2004 operating expenses byapproximately $0.4 million and (3) our termination of the Santa Fe CountyElectronic Monitoring Program in January 2004 which reduced 2004 operatingexpenses by approximately $0.4 million. The decrease in 2004 operating expenses due to the above was offset, inpart, by net increases in operating expenses of approximately $1.6 million atour various other adult community-based facilities and programs.

 

Asa percentage of segment revenues, adult community-based corrections and treatmentservices division operating expenses were 77.3% for the year endedDecember 31, 2004 compared to 75.5% for the year ended December 31,2003.  The 2004 operating margin wasunfavorably impacted by employee severance and other related costs as a result ofcentralizing the operations of our mid-west administrative office into ourcorporate operations.  Additionally, weexperienced increases in certain insurance costs in 2004.  The 2004 operating margin was favorablyimpacted by a reduction in rent expense due to the September 2003 purchaseof furniture and equipment that was formerly leased under a sale and leasebacktransaction in 1999.

 

***Pre-Opening and Start-up Expenses.***** **  Pre-opening and start-upexpenses were approximately $8.8 million for the year ended December 31,2004 and were attributable to the pre-opening and start-up activities of the RegionalCorrectional Center, the Southern Peaks Regional Treatment Center, thePlankinton Regional Detention Center, the Moshannon Valley Correctional Centerand the Las Vegas Center.  Pre-openingand start-up expenses for the year ended December 31, 2003 wereapproximately $1.2 million and were attributable to the pre-opening andstart-up activities of the Southern Peaks Regional Treatment Center, theRegional Correctional Center and the Texas Adolescent Treatment Center.  These expenses consisted primarily ofpersonnel and related expenses, building rent, professional and recruitingexpenses.

 

***Impairment of Long-Lived Assets***.  An impairment charge of $0.8 million wasrecorded as of December 31, 2004 pertaining to the Residential Schoolbuilding and Maple Creek Home facility carrying costs as a result of ouranalysis pursuant to the requirements of SFAS No. 144.   Based on recent and projected operations ofthese facilities, we determined that our carrying value was not fullyrecoverable and exceeded its fair value based on current estimates of futurecash flows.   These facilities and therelated impairment charges are included in discontinued operations in the juvenilesegment.  Additionally, we recorded animpairment charge of $9.3 million as of December 31, 2004 pertaining tothe New Morgan Academy building carrying cost. Based on the current and forecasted operating and cash flow lossesassociated with this facility, we determined

 

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that our carrying valuefor the facility was not fully recoverable and exceeded its fair value.  The New Morgan Academy is a part of ourjuvenile segment and the impairment charge recorded in 2004 is included inincome (loss) from operations from the juvenile segment.

 

***Depreciation and Amortization*****.** Depreciation and amortization increased approximately $2.6 million, or24.5%, to $13.2 million for the year ended December 31, 2004 from $10.6million for the year ended December 31, 2003.  Depreciation and amortization of fixedassets increased approximately $2.1 million, or 21.9%, to approximately $11.8million for the year ended December 31, 2004 from $9.7 million for theyear ended December 31, 2003 due primarily to depreciation expenseresulting from the September 2003 purchase of furniture and equipment thatwas formerly leased under a sale and leaseback transaction in 1999 anddepreciation expense on property and equipment purchased in 2004 and the latterhalf of 2003.

 

Amortization ofintangibles and other assets increased approximately $0.5 million, or 55.6%, toapproximately $1.4 million for the year ended December 31, 2004 comparedto $0.9 million for the year ended December 31, 2003. The increase is dueto amortization expense related to the Walnut Grove Youth Correctional FacilityManagement contract that was acquired in June 2004 and for the non-competeagreements entered into in connection with the acquisition of this contract.

 

***General and Administrative Expenses.*** General and administrative expenses decreased approximately $3.1million, or 13.2%, to $20.3 million for the year ended December 31, 2004from $23.4 million for the year ended December 31, 2003.  General and administrative expensesfor the year ended December 31, 2003 include a charge of approximately$5.4 million to provide an allowance on the unrecovered escrow deposit relatedto the Southern Peaks Regional Treatment Center and costs of approximately $0.6million for site acquisition costs and related legal expenses resulting fromour increased development activity, expenses related to various financingefforts and other compensation costs. The increase in 2004 general and administrative expenses is primarilydue to increased professional and consulting expenses related to, among otherthings, Sarbanes-Oxley compliance and expenses related to the Southern PeaksRegional Treatment Center litigation. Additionally, we experienced increases in certain insurance costs in theyear ended December 31, 2004.

 

***Interest.***  Interestexpense, net of interest income, increased approximately $2.7 million to $20.4million for the year ended December 31, 2004 from $17.7 million for theyear ended December 31, 2003.  Theincrease was primarily due to net interest expense of approximately $5.1million associated with the Senior Notes issued in June 2004 (net ofinterest rate swap income of $1.2 million) offset, in part, by a decrease ininterest expense of approximately $1.2 million due to the repayment of theSynthetic Lease Investor Notes A and B in June 2004 and an increase ofapproximately $1.0 million in capitalized interest in the year endedDecember 31, 2004.  Capitalizedinterest for the year ended December 31, 2004 was approximately $1.8million and related to the Moshannon Valley Correctional Center, the RegionalCorrectional Center, the Las Vegas Center and the Southern Peaks RegionalTreatment Center.  Capitalized interestfor the year ended December 31, 2003 was approximately $0.8 million andrelated solely to the development and construction of the Moshannon ValleyCorrectional Center.

 

***Loss on Extinguishment of Debt*.**  For the year ended December 31, 2004, werecognized a loss on the extinguishment of debt of approximately $2.4 millionrelated to the write-off of unamortized financing costs and other chargesrelated to the early retirement of our obligations of the Synthetic LeaseInvestor Notes A and B and our amended 2000 Credit Facility in June 2004.

 

***Income Taxes.***** **For the year ended December 31, 2004, we recognized an income taxbenefit at an estimated effective rate of 39.5%.  For the year ended December 31, 2003, werecognized a provision for income taxes at an estimated effective rate of41.0%.  The change in our estimatedeffective tax rate in 2004 is related to a reduction in operating income acrossour business segments and the impact of certain non-deductible expenses such aslobbying.

 

***Discontinued Operations, net of tax.***  Thenet loss from discontinued operations increased approximately $2.3 million to$2.4 million for the year ended December 31, 2004 from $0.1 million for theyear ended December 31, 2003.  The lossfrom discontinued operations for both periods included results of operationspertaining to the Residential School, the Maple Creek Home, our mental healthprograms in Pennsylvania, the Northside Clinic and the Jos-Arz Academy.  The increased operating loss in 2004 was oneof the factors that led to the shut down of these programs as noted in 2005.

 

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**Liquidity and Capital Resources**

 

***General*****.**  Ourprimary capital requirements are for (1) purchases, construction or renovationof new facilities, (2) expansions of existing facilities, (3) workingcapital, (4) pre-opening and start-up costs related to new operating contracts,(5) acquisitions, (6) information systems hardware and software and(7) furniture, fixtures and equipment. Working capital requirements generally increase immediately prior tocommencing management of a new facility as we incur start-up costs and purchasenecessary equipment and supplies before facility management revenue isrealized.

 

***Cash Flows From Operations.*** Cash provided by operating activities wasapproximately $28.3 million for the year ended December 31, 2005 comparedto approximately $12.1 million for the year ended December 31, 2004.  The increasewas principally due to greater collections of accounts receivable whichresulted from increased revenues in 2005 over 2004.  The increase in cash flows was also due togrowth in accounts payable and accrued liabilities associated with increased operationsfrom developing facilities (including Mesa Verde Community CorrectionalFacility and Moshannon Valley Correctional Center).

 

***Cash Flows From Investing Activities*****. **Cash used in investing activities was approximately $17.5 million forthe year ended December 31, 2005 due primarily to capital expenditures of $51.2million, which included $46.2 million for the construction of the MoshannonValley Correctional Center and the $9.1 million Correctional Systems, Inc.acquisition in April 2005, offset by net investment securities sales ofapproximately $44.5 million. Additionally, we had proceeds from the sale of fixed assets ofapproximately $0.6 million and $2.4 million of net payments to the restricteddebt payment account.** **Cash used in investingactivities was approximately $85.7 million for the year ended December 31,2004 primarily due to the net purchase of $51.7 million of investmentsecurities, and capital expenditures of $40.2 million for the purchase anddevelopment of the Southern Peaks Regional Treatment Center, the Las VegasCenter, the Central California Treatment Center and the Baker CommunityCorrectional Center buildings, renovation of the Regional Correctional Center,the Plankinton Regional Detention Center, capitalized interest on the MoshannonValley Correctional Center, the Regional Correctional Center, the Las VegasCenter and the Southern Peaks Regional Treatment Center and various otherfacility improvements and/or expansions and information technology and softwaredevelopment costs.  Additionally, wepurchased the Walnut Grove Youth Correctional Facility management contract andcertain related assets in June 2004 for $3.0 million.  We received approximately $5.6 million fromthe BOP for reimbursement of costs incurred subsequent to the Stop-Work Orderrelated to the construction of the Moshannon Valley Correctional Center.  We also received $5.0 million from ourrestricted escrow arrangement related to the Southern Peaks Regional TreatmentCenter.

 

***Cash Flows From Financing Activities*****.**  Cashused in financing activities was approximately $6.9 million for the year endedDecember 31, 2005 due primarily to a $9.0 million principal payment on MCF’sbonds in July 2005 and repayment of approximately $1.9 million debt acquired inthe Correctional Systems, Inc. acquisition in April 2005, partially offset byproceeds from the exercise of stock options of approximately $4.1 million.  Cash provided by financing activitieswas approximately $43.4 million for the year ended December 31, 2004 dueprimarily to cash proceeds of $110.5 million from the issuance of the SeniorNotes in June 2004 offset by net repayments on our revolving line ofcredit under our amended 2000 Credit Facility of $2.0 million and the repaymentof the Synthetic Lease Investor Notes A and B of $50.6 million.  Additionally, we made cash payments ofapproximately $1.9 million related to the early retirement of the Synthetic LeaseInvestor Notes A and B, $8.3 million related to the MCF bonds and approximately$6.1 million related to the issuance of the Senior Notes and our 2004 CreditFacility.  Additionally, we had proceedsfrom the exercise of stock options of approximately $1.9 million.

 

***Long-Term Credit Facilities.***  The2004 Credit Facility provides for borrowings of up to $60.0 million under arevolving line of credit and is reduced by outstanding letters of credit.  The available commitment under the 2004Credit Facility was approximately $50.6 million at December 31, 2005.  We had no outstanding borrowings on the 2004Credit Facility at December 31, 2005, but we had outstanding letters of creditof approximately $9.4 million.  Subject tocertain requirements, we have the right to increase the aggregate commitmentsunder the 2004 Credit Facility up to an aggregate amount of $100.0million.  The 2004 Credit Facilitymatures in June 2008 and bears interest, at our election, depending on ourtotal leverage ratio, at either the prime rate plus a margin ranging from 0.75%to 2.00%, or a rate which ranges from 2.25% to 3.50% above the applicable LIBORrate. The 2004 Credit Facility is collateralized by substantially allof our assets, including the assets and stock of all of our subsidiaries.  The 2004 Credit Facility is not secured bythe assets of MCF.  The 2004 CreditFacility contains standard covenants including compliance with laws,limitations on capital expenditures, restrictions on dividend payments,limitations on mergers and compliance with financial covenants.

 

MCF is obligated for the outstandingbalance of its 8.47% Taxable Revenue Bonds, Series 2001.  The bonds bear interest at a rate of 8.47%per annum and are payable in semi-annual installments of interest and annualinstallments of principal.  All unpaid principaland accrued interest on the bonds is due on the earlier of August 1, 2016(maturity) or as noted under the bond documents.  The bonds are limited, nonrecourseobligations of MCF and secured by the property and equipment, bond reserves,assignment of subleases and substantially all assets related to the facilitiesincluded in the 2001 Sale and Leaseback Transaction.  The bonds are not guaranteed by the Company.

 

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In June 2004, we issued $112.0 millionin principal of 10.75% Senior Notes (Senior Notes) due July 1, 2012.  The Senior Notes are unsecured seniorindebtedness and are guaranteed by all of our existing and future subsidiaries(collectively, the Guarantors).  TheSenior Notes are not guaranteed by MCF (Non-Guarantor).  Interest on the Senior Notes is payablesemi-annually on January 1 and July 1 of each year, commencingJanuary 1, 2005.  On or afterJuly 1, 2008, we may redeem all or a portion of the Senior Notes at theredemption prices (expressed as a percentage of the principal amount) listedbelow, plus accrued and unpaid interest, if any, on the Senior Notes redeemed,to the applicable date of redemption, if redeemed during the 12-month periodcommencing on July 1 of the years indicated below:

 
| **Year**            | ** ** | **Percentages** | ** ** |
|---------------------|------------|-----------------|------------|
|                |       |            |       |
| 2008                |       | 105.375         | %          |
| 2009                |       | 102.688         | %          |
| 2010 and thereafter |       | 100.000         | %          |

 

Any time prior toJuly 1, 2007, we may redeem up to 35% of the original aggregate principalamount of the Senior Notes at a redemption price of 110.75% of the principalamount thereof with the net cash of public offerings of equity, provided thatat least 65% of the original aggregate principal amount of the Senior Notesremains outstanding after the redemption and other conditions are met.  Upon the occurrence of specified change ofcontrol events, unless we have exercised our option to redeem all the SeniorNotes as described above, each holder will have the right to require us torepurchase all or a portion of such holder’s Senior Notes at a purchase pricein cash equal to 101% of the aggregate principal amount of the notesrepurchased plus accrued and unpaid interest, if any, on the Senior Notesrepurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture which limits our ability and the ability of our Guarantors to, amongother things, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets.

 

In conjunction with theissuance of the Senior Notes, we entered into an interest rate swap transactionwith a financial institution to hedge our exposure to changes in the fair valueon $84.0 million of our Senior Notes. The purpose of this transaction was to convert future interest due on$84.0 million of the Senior Notes to a variable rate.  The terms of the interest rate swap contractand the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1)a floating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceive a fixed-rate interest of 10.75%. For years ended December 31, 2005 and 2004, we recorded interest savingsrelated to this interest rate swap of approximately $1.1 million and $1.2million, respectively, which is reflected as a reduction to interest expense inour accompanying financial statements. The swap agreements are marked to market each quarter with acorresponding mark-to-market adjustment reflected as either a discount orpremium on the Senior Notes.  At December31, 2005 and 2004, the fair value of this derivative instrument was approximately($0.1) million and $3.2 million, respectively, and is included in otherlong-term liabilities (at December 31, 2005) and other assets (at December 31,2004) in our Consolidated Balance Sheets. The carrying value of the Senior Notes as of these dates was adjustedaccordingly by the same amount. Because the swap agreement is considered aneffective fair-value hedge, there will be no effect on our results ofoperations from the mark-to-market adjustment as long as the swap is in effect.

 

***Contractual Uncertainties Related toCertain Facilities***

 

***Regional Correctional Center. ***In January 2003, we executed a five-yearlease for the Regional Correctional Center in Albuquerque, New Mexico. This 970bed facility consists of two units, the 528 South Tower and the 442 bed NorthTower. We renovated the South Tower and opened the unit in July 2004. Werenovated the North Tower and opened the unit in December 2004.  As of December 31, 2005, we had investedapproximately $9.8 million on renovations and furniture and equipment for bothtowers. For the year ended December 31, 2005, we incurred pre-opening andstart-up expenses of approximately $6.4 million and recognized revenue ofapproximately $7.4 million related to this facility. We currently anticipatethat there will be periods that the facility will reach substantial capacityduring 2006.  However, there can be noassurance that we will develop (maintain) enough volume at the facility toassure its profitability.  The lease forthe facility requires monthly rental payments of approximately $113,000 for thefirst two years and $130,000 for the last three years of the lease.

 

***New Morgan Academy.***  Weclosed the New Morgan Academy in the fourth quarter of 2002 and have consideredseveral options ranging from the utilization of the facility for another typeof program or the sale or lease of the facility. As of December 31, 2005, weare focusing our efforts on the reopening of the facility by the fourth quarterof 2006.  Once opened, the facility willoperate as a residential treatment facility for youth sex offenders.  We are maintaining a small staff to secureand maintain 

 

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thefacility during the finalization of the reactivation plans.  We recognized pre-tax costs of $3.6 millionin our Consolidated Statements of Operations and Comprehensive Income (Loss)for the year ended December 31, 2005 and pre-tax costs of $13.5 millionincluding an impairment charge of $9.3 million (as discussed below) for theyear ended December 31, 2004, respectively, for related holding costs(depreciation, interest, property, taxes and other maintenance costs).

 

Thedeveloping inability during late 2004 of various governmental agencies withwhom we had been in negotiations to obtain the level of funding to contractwith us for the use of the New Morgan Academy indicated an expectation ofcontinuing losses associated with this facility.  As a result, we recorded an impairment chargeof $9.3 million, pursuant to the requirements of SFAS No. 144, atDecember 31, 2004.  As of December31, 2005, we believe that, pursuant to the provisions of SFAS No. 144, noadditional impairment allowance is necessary. The carrying value of the property and equipment for the New MorganAcademy, after the impairment charge, was approximately $19.9 million and $20.4million at December 31, 2005 and 2004, respectively.

 

***Central California Treatment Center***.  InJanuary 2004, we purchased a building in Los Angeles, California for whichour carrying value was approximately $2.7 million at December 31, 2005.  In 2005, we received notice from a localgovernmental agency indicating a desire to acquire the facility.  In early 2006, the governmental agencyinitiated condemnation proceedings relating to the facility and depositedapproximately $2.9 million of condemnation proceeds with the court.  We have petitioned the court to release thedeposit and we have commenced litigation contesting the valuation of thefacility submitted by the governmental agency.

 

***Campbell Griffin Treatment Center.***  In October 2005, we initiated the temporaryclosure of this leased facility in San Antonio, Texas, and transferred theresidents to our Texas Adolescent Treatment Center (also located in SanAntonio).  It is our intent to reactivatethis facility during 2006. Accordingly, it has not been included indiscontinued operations.

 

***Treasury Stock Repurchases***

 

We did not purchase any of our commonstock in the year ended December 31, 2005. We repurchased inthe open market 10,000 shares of our common stock for approximately $0.1 millionin the year ended December 31, 2004.

 

Underthe terms of our Senior Notes and 2004 Credit Facility, we can purchase sharesof our stock subject to certain cumulative restrictions.

 

***Future Liquidity***

 

Webelieve that the existing cash and the cash flows generated from operations,together with the credit available under our 2004 Credit Facility, will providesufficient liquidity to meet our committed capital and working capitalrequirements for currently awarded and certain potential future development contracts,including the construction of the Moshannon Valley Correctional Center.  To the extent our cash and current financingarrangements do not provide sufficient financing to fund construction costsrelated to future adult secure institutional contract awards or significantfacility expansions, we anticipate obtaining additional sources of financing tofund such activities.  However, there canbe no assurance that such financing will be available or will be available onterms favorable to us.

 

***Contractual Obligations and Commercial Commitments***

 

Wehave assumed various financial obligations and commitments in the ordinarycourse of conducting our business.  Wehave contractual obligations requiring future cash payments under our existingcontractual arrangements, such as management, consulting and non-competitionagreements.

 

Wemaintain operating leases in the ordinary course of our businessactivities.  These leases include thosefor operating facilities, office space and office and operating equipment, andthe terms of the agreements vary from 2006 until 2075.  As of December 31, 2005, our totalcommitment under these operating leases was approximately $36.5 million.

 

48

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Thefollowing table details the known future cash payments (on an undiscountedbasis) related to various contractual obligations as of December 31, 2005(in thousands):

 
| ** **                                  | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|
| ** **                                  | ** ** | **Total**                  | ** ** | **2006** | ** ** | **2007-  2008** | ** ** | **2009-  2010** | ** ** | **Thereafter** | ** ** |
|                                        |       |                       |       |   |   |   |   |   |   |   |   |
| Contractual Obligations:                    |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term debt - principal                  |       |                       |       |   |   |   |   |   |   |   |   |
| •  Cornell Companies, Inc.        |       | $                          | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| •  Special Purpose Entities            |       | 165,700                    |       | 9,700 |   | 21,900 |   | 25,800 |   | 108,300 |   |
| Long-term debt - interest                   |       |                       |       |   |   |   |   |   |   |   |   |
| •  Cornell Companies, Inc.        |       | 76,458                     |       | 11,761 |   | 23,546 |   | 23,522 |   | 17,629 |   |
| •  Special Purpose Entities            |       | 96,508                     |       | 14,035 |   | 25,537 |   | 22,666 |   | 34,270 |   |
| Construction commitments                    |       | 5,949                      |       | 5,949 |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| Capital lease obligations                   |       |                       |       |   |   |   |   |   |   |   |   |
| •  Cornell Companies, Inc.        |       | 2                          |       | 1 |   | 1 |   | 3⁄4 |   | 3⁄4 |   |
| Operating leases                            |       | 36,477                     |       | 6,407 |   | 11,050 |   | 8,540 |   | 10,480 |   |
| Consultative and non-competition agreements |       | 2,145                      |       | 1,585 |   | 560 |   | — |   | — |   |
| Total contractual cash obligations          |       | $                          | 495,239    |   | $ | 49,438 |   | $ | 82,594 |   | $ | 80,528 |   | $ | 282,699 |   |
|                                             |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Wehave an interest rate swap agreement under which we receive a fixed interestrate and pay a floating interest rate. The future cash payments on the CornellCompanies, Inc. long-term debt assume an effective rate of 10.275% on therelated interest rate swap contract.

 

Weenter into letters of credit in the ordinary course of operating and financingactivities.  As of December 31,2005, we had outstanding letters of credit of approximately $9.4 millionprimarily for certain workers’ compensation insurance and other operatingobligations.  The following table detailsour letter of credit commitments as of December 31, 2005 (in thousands):

 
| ** **                | ** ** | **Total**              | **Amount of Commitment Expiration Per Period** | ** **            |
|---------------------------|------------|------------------------|------------------------------------------------|-----------------------|
| ** **                | ** ** | **Amounts  Committed** | ** **                                     | **Less than  1 Year** | ** ** | **Over  1-3 Years** | ** ** | **4-5 Years** | ** ** | **5 Years** | ** ** |
| Commercial Commitments:   |       |                   |                                           |                  |   |   |   |   |   |   |   |
| Standby letters of credit |       | $                      | 9,378                                          |                  | $ | 8,628 |   | $ | — |   | $ | 750 |   | $ | — |   |
|                           |            |                        |                                                |                       |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Related Party Transactions***

 

Oneof our former directors is a partner in a law firm that provides legal servicesto us.  Legal fees paid to this law firmwere approximately $0.9 million for the year ended December 31, 2005.

 

InSeptember 1999, we entered into a consulting agreement with Cornell’sfounder, who was a director of Cornell through October 2003.  Services rendered under the consultingagreement included serving as a director of Cornell over the initial four yearsof the term of the agreement, and assisting in such areas as the development ofnew business, acquisitions, financings and executive management assimilation.  As compensation for consulting services, weagreed to an annual payment of at least $255,000 for each of the first fouryears of the seven-year initial term of the consulting agreement with an annualpayment of at least $180,000 for each of the last three years of the seven-yearinitial term of the consulting agreement. We have an option to renew the consulting agreement for an additionalthree-year term at an annual salary of at least $300,000 for each of the threeyears of the renewal term.  As additionalcompensation, we agreed to an annual bonus, subject to certain limitations,equal to $75,000 during the first four years of the seven-year initial term andan annual bonus of $60,000 during the last three years of the seven-yearinitial term and during any renewal term.

 

Wealso entered into a non-compete agreement with Cornell’s founder.  The non-compete agreement has a term of 10years and requires us to pay a monthly fee of $10,000 for the seven-yearinitial term of the consulting agreement. We capitalize the monthly payments and amortize the amounts over the10-year term of the consulting agreement. We recognized amortization expenserelated to this agreement of approximately $84,000 for the year endedDecember 31, 2005.

 

Wemaintain a life insurance policy for Cornell’s founder and made paymentsrelated to this policy of approximately $0.2 million for the year endedDecember 31, 2005.

 

49

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Totalpayments made for the above consulting and non-compete agreements, andinsurance premiums for Cornell’s founder were approximately $0.9 million forthe year ended December 31, 2005.

 

Weentered into a consulting agreement with a former director for a term whichexpires in December 2008.  Servicesrendered under this agreement include research and analysis for various topicsincluding data collection, support and training for program development;performance-based contractual requirements and performance-improvementprocesses, accreditations and regulatory requirements.  Total payments under this agreement, whichhas a termination fee incorporated for a termination prior to maturity, totaled$0.3 million for the year ended December 31, 2005.  The termination fee at December 2005 was $0.3million.

 

**Inflation**

 

Otherthan personnel, offender medical costs at certain facilities, and employeemedical and worker’s compensation insurance costs, we believe that inflationhas not had a material effect on our results of operations during the pastthree years.  Most of our facility managementcontracts provide for payments of either fixed per diem fees or per diem feesthat increase by only small amounts during the term of the contracts. Inflationcould substantially increase our personnel costs (the largest component of ouroperating expenses), medical and insurance costs or other operating expenses atrates faster than any increases in contract revenues.

 

50

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**ITEM 7A.       QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**Quantitative and Qualitative Disclosures about Market Risk**

 

Inthe normal course of business, we are exposed to market risk, primarily fromchanges in interest rates.  Wecontinually monitor exposure to market risk and develop appropriate strategiesto manage this risk.  We are not exposedto any other significant market risks, including commodity price risk, foreigncurrency exchange risk or interest rate risks from the use of derivativefinancial instruments.  In conjunctionwith the issuance of our Senior Notes, we entered into an interest rate swap of$84.0 million related to the interest obligations under the Senior Notes ineffect converting them to a floating rate based on six-month LIBOR.

 

**Interest Rate Exposure**

 

Our exposure to changes in interest ratesprimarily results from our long-term debt with both fixed and floating interestrates.  The debt on our consolidatedfinancial statements with fixed interest rates consist of the 8.47% Bondsissued by MCF in August 2001 in connection with the 2001 Sale and LeasebackTransaction and approximately $28.0 million of Senior Notes not hedged by anyinterest rate swap.  At December 31,2005, 30.4% ($84.0 million of debt outstanding on our Senior Notes issued inJune 2004) of our consolidated long-term debt was subject to variableinterest rates.  The detrimental effectof a hypothetical 100 basis point increase in interest rates would be to reduceincome before provision for income taxes by approximately $0.8 million for the yearended December 31, 2005.  At December 31,2005, the fair value of our consolidated fixed rate debt approximated carryingvalue based upon discounted future cash flows using current market prices.

 

51

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**ITEM 8.                   FINANCIALSTATEMENTS AND SUPPLEMENTAL DATA**

 
|   |                                                                                                                                                      |   |   |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| 1.     | Financial  statements                                                                                                                                     |   |   |   |
|   | Management’s Report on Internal Control over Financial Reporting                                                                                     |   | 53     |   |
|   | Report of Independent Registered Public Accounting Firm                                                                                                   |   | 54     |   |
|   | Consolidated Balance Sheets - December 31, 2005 and 2004                                                                                             |   | 55     |   |
|   | Consolidated Statements of Operations and Comprehensive Income (Loss)  for the years ended December 31, 2005, 2004 and 2003                          |   | 56     |   |
|   | Consolidated Statements of Stockholders’ Equity for the years ended  December 31, 2005, 2004 and 2003                                           |   | 57     |   |
|   | Consolidated Statements of Cash Flows for the years ended  December 31, 2005, 2004 and 2003                                                          |   | 58     |   |
|   | Notes to consolidated financial statements                                                                                                                |   | 59     |   |
| 2.     | Financial  statement schedules                                                                                                                            |   |   |   |
|   | All schedules are omitted because they are  not applicable or because the required information is included in the  financial statements or notes thereto. |   |   |   |
|        |                                                                                                                                                           |        |        |  |  |

 

52

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**Management’s Report on Internal Control over Financial Reporting**

 

The management of Cornellis responsible for establishing and maintaining adequate internal control overfinancial reporting.  Cornell’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.  Cornell’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the Company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the Company are being made only in accordance withauthorizations of management and directors of the Company; and, (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the Company’s assets that could have amaterial effect on the financial statements.

 

Due to its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

 

We have assessed theeffectiveness of our internal control over financial reporting as ofDecember 31, 2005.  To make thisassessment we used the criteria for effective internal control over financialreporting described in Internal Control — Integrated Framework, issued by theCommittee of Sponsoring Organizations of the Treadway Commission.   Based on our assessment, we have concludedthat, as of December 31, 2005, the Company’s internal control overfinancial reporting was effective.

 

Our management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2005 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,as stated in their report which appears herein.

 

53

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**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

To the Board of Directorsand Stockholders of

Cornell Companies, Inc.

 

We have completedintegrated audits of Cornell Companies, Inc.’s 2005 and 2004 consolidatedfinancial statements and of its internal control over financial reporting as ofDecember 31*,*2005 and an audit of its 2003consolidated financial statements in accordance with the standards of thePublic Company Accounting Oversight Board (United States).  Ouropinions, based on our audits, are presented below.

 

Consolidated financial statements and financial statementschedules

 

In our opinion, the consolidated financial statements listed inthe accompanying index presentfairly, in all material respects, the financial position of Cornell Companies,Inc. and its subsidiaries at December 31, 2005 and 2004 and the results oftheir operations and their cash flows for each of the three years in the periodended December 31, 2005****in conformitywith accounting principles generally accepted in the United States of America.In addition, in our opinion, the financial statement schedules listed inaccompanying index present fairly, in all material respects, the informationset forth therein when read in conjunction with the related consolidatedfinancial statements. These financial statements and financial statementschedules are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements and financial statement schedules****based on our audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit of financial statements includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

Internal control overfinancial reporting

 

Also, in our opinion,management’s assessment, included in the accompanying Management’s Report onInternal Control over Financial Reporting, appearing under Item 8 that theCompany maintained effective internal control over financial reporting as ofDecember 31, 2005 based on criteria established in *InternalControl-Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of December 31, 2005 based on criteria establishedin *Internal Control-Integrated Framework*issued by the COSO.  The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting.  Ourresponsibility is to express opinions on management’s assessment and onthe effectiveness of the Company’s internal control over financial reportingbased on our audit. We conducted our audit of internal control over financialreporting in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects.  Anaudit of internal control over financial reporting includes obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.  Acompany’s internal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

 

PricewaterhouseCoopersLLP

Houston, Texas

March 16, 2006

 

54

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(in thousands, except share data)**

 
| ** **                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                            |       |                  |       |   |   |
| **CURRENT ASSETS:**                                                                                                                                                   |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                             |       | $                     | 13,723     |   | $ | 9,895 |   |
| Investment securities available for sale                                                                                                                              |       | 7,250                 |       | 51,740 |   |
| Accounts receivable - trade (net of  allowance for doubtful accounts of $3,278 and $3,544, respectively)                                                              |       | 58,701                |       | 60,174 |   |
| Other receivables (net of allowance for  doubtful accounts of $5,040)                                                                                                 |       | 9,726                 |       | 4,691 |   |
| Debt service fund and other restricted  assets                                                                                                                        |       | 22,219                |       | 19,713 |   |
| Deferred tax assets                                                                                                                                                   |       | 5,089                 |       | 8,520 |   |
| Prepaid expenses and other                                                                                                                                            |       | 9,076                 |       | 9,106 |   |
| **Total current assets**                                                                                                                                              |       | 125,784               |       | 163,839 |   |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                       |       | 323,861               |       | 282,255 |   |
| **OTHER ASSETS:**                                                                                                                                                     |       |                  |       |   |   |
| Debt service reserve fund                                                                                                                                             |       | 23,802                |       | 23,801 |   |
| Goodwill, net                                                                                                                                                         |       | 12,577                |       | 7,721 |   |
| Intangible assets, net                                                                                                                                                |       | 9,089                 |       | 7,026 |   |
| Deferred costs and other                                                                                                                                              |       | 15,515                |       | 22,989 |   |
| **Total assets**                                                                                                                                                      |       | $                     | 510,628    |   | $ | 507,631 |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                        |       |                  |       |   |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **CURRENT LIABILITIES:**                                                                                                                                              |       |                  |       |   |   |
| Accounts payable and accrued liabilities                                                                                                                              |       | $                     | 58,797     |   | $ | 47,237 |   |
| Current portion of long-term debt                                                                                                                                     |       | 9,701                 |       | 9,005 |   |
| **Total current liabilities**                                                                                                                                         |       | 68,498                |       | 56,242 |   |
| **LONG-TERM DEBT, net of current portion**                                                                                                                            |       | 266,659               |       | 279,528 |   |
| **DEFERRED TAX LIABILITIES**                                                                                                                                          |       | 6,708                 |       | 8,088 |   |
| **OTHER LONG-TERM LIABILITIES**                                                                                                                                       |       | 3,302                 |       | 2,461 |   |
| **Total liabilities**                                                                                                                                                 |       | 345,167               |       | 346,319 |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                     |       |                  |       |   |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                        |       |                  |       |   |   |
| Preferred stock, $.001 par value,  10,000,000 shares authorized, none issued                                                                                          |       | 3⁄4                |       | —— |   |
| Common stock, $.001 par value, 30,000,000  shares authorized, 15,352,159 and 14,845,107 shares issued and 13,789,172 and  13,297,524 shares outstanding, respectively |       | 15                    |       | 15 |   |
| Additional paid-in capital                                                                                                                                            |       | 151,329               |       | 145,825 |   |
| Retained earnings                                                                                                                                                     |       | 27,091                |       | 26,785 |   |
| Treasury stock (1,562,987 and 1,547,583  shares of common stock, at cost, respectively)                                                                               |       | (12,573               | )          | (12,573 | ) |
| Deferred compensation                                                                                                                                                 |       | (990                  | )          | (432 | ) |
| Accumulated other comprehensive income                                                                                                                                |       | 589                   |       | 1,692 |   |
| **Total stockholders’ equity**                                                                                                                                   |       | 165,461               |       | 161,312 |   |
| **Total liabilities and stockholders’ equity**                                                                                                                   |       | $                     | 510,628    |   | $ | 507,631 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS ANDCOMPREHENSIVE INCOME (LOSS)**

**(in thousands, except per share data)**

 
| ** **                                                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                         | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                               |       |                             |       |   |   |   |   |
| REVENUES                                                                                                           |       | $                                | 310,775    |   | $ | 277,190 |   | $ | 258,180 |   |
| OPERATING EXPENSES                                                                                                 |       | 238,305                          |       | 211,157 |   | 198,531 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                  |       | 9,017                            |       | 8,803 |   | 1,155 |   |
| IMPAIRMENT OF LONG-LIVED ASSETS                                                                                    |       | 3⁄4                           |       | 9,300 |   | 3⁄4 |   |
| DEPRECIATION AND AMORTIZATION                                                                                      |       | 15,200                           |       | 13,187 |   | 10,595 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                |       | 20,387                           |       | 20,284 |   | 23,415 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                             |       | 27,866                           |       | 14,459 |   | 24,484 |   |
| INTEREST EXPENSE                                                                                                   |       | 24,041                           |       | 22,298 |   | 19,280 |   |
| INTEREST INCOME                                                                                                    |       | (2,318                           | )          | (1,944 | ) | (1,624 | ) |
| LOSS ON EXTINGUISHMENT OF DEBT                                                                                     |       | 3⁄4                           |       | 2,361 |   | 3⁄4 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| INCOME (LOSS) FROM CONTINUING OPERATIONS  BEFORE PROVISION (BENEFIT) FOR INCOME TAXES                              |       | 6,143                            |       | (8,256 | ) | 6,828 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| PROVISION (BENEFIT) FOR INCOME TAXES                                                                               |       | 2,215                            |       | (3,256 | ) | 2,800 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| INCOME (LOSS) FROM CONTINUING OPERATIONS                                                                           |       | 3,928                            |       | (5,000 | ) | 4,028 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| DISCONTINUED OPERATIONS, NET OF TAX BENEFIT  OF $1,950, $1,589 AND $40, RESPECTIVELY                               |       | (3,622                           | )          | (2,433 | ) | (58 | ) |
|                                                                                                               |       |                             |       |   |   |   |   |
| NET INCOME (LOSS)                                                                                                  |       | $                                | 306        |   | $ | (7,433 | ) | $ | 3,970 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| EARNINGS (LOSS) PER SHARE:                                                                                         |       |                             |       |   |   |   |   |
| BASIC:                                                                                                             |       |                             |       |   |   |   |   |
| Income (loss) from continuing operations                                                                           |       | $                                | .29        |   | $ | (.38 | ) | $ | .31 |   |
| Loss from discontinued operations, net of  tax                                                                     |       | (.27                             | )          | (.18 | ) | — |   |
| Net income (loss)                                                                                                  |       | $                                | .02        |   | $ | (.56 | ) | $ | .31 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| DILUTED:                                                                                                           |       |                             |       |   |   |   |   |
| Income (loss) from continuing operations                                                                           |       | $                                | .29        |   | $ | (.38 | ) | $ | .30 |   |
| Loss from discontinued operations, net of  tax                                                                     |       | (.27                             | )          | (.18 | ) | — |   |
| Net income (loss)                                                                                                  |       | $                                | .02        |   | $ | (.56 | ) | $ | .30 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE  COMPUTATION:                                                                   |       |                             |       |   |   |   |   |
| BASIC                                                                                                              |       | 13,580                           |       | 13,203 |   | 12,941 |   |
| DILUTED                                                                                                            |       | 13,695                           |       | 13,203 |   | 13,342 |   |
|                                                                                                               |       |                             |       |   |   |   |   |
| COMPREHENSIVE INCOME (LOSS):                                                                                       |       |                             |       |   |   |   |   |
| Net income (loss)                                                                                                  |       | $                                | 306        |   | $ | (7,433 | ) | $ | 3,970 |   |
| Unrealized gain (loss) on derivative  instruments, net of tax provision (benefit) of ($954) and $123, respectively |       | (1,103                           | )          | 164 |   | (368 | ) |
| Comprehensive income (loss)                                                                                        |       | $                                | (797       | ) | $ | (7,269 | ) | $ | 3,602 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

**(in thousands, except share data)**

 
| ** **

** **                                                     | ** ** | ** **            | ** ** | ** **      | ** ** | ** **  | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | ** **       | ** ** | ** **  | ** ** | **Accumulated ** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|-----------------|------------|-------------|------------|--------------|------------|-------------------------|------------|--------------|------------|------------------|------------|-------------|------------|-----------------------|------------|
| ** **                                                                 | ** ** | ** **            | ** ** | ** **      | ** ** | ** **  | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | ** **       | ** ** | **Notes**   | ** ** | **Other**             | ** ** |
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Additional**  | ** ** | ** **  | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | **from**         | ** ** | **Compre-** | ** ** |
| ** **                                                                 | ** ** | ** **            | ** ** | **Par**         | ** ** | **Paid-In** | ** ** | **Retained** | ** ** | **Treasury Stock** | ** ** | **Deferred** | ** ** | **Share-**       | ** ** | **hensive** | ** ** |
| ** **                                                                 | ** ** | **Shares**            | ** ** | ** Value** | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Shares**              | ** ** | **Cost**     | ** ** | **Compensation** | ** ** | **holders** | ** ** | **Income/(Loss)**     | ** ** |
| ** **                                                                 | ** ** | ** **            | ** ** | ** **      | ** ** | ** **  | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | ** **       | ** ** | ** **  | ** ** | ** **            | ** ** |
| BALANCES AT  JANUARY 1, 2003                                               |       | 14,201,038            |       | $               | 14         |        | $          | 140,085      |       | $                       | 30,248     |         | 1,444,990  |             | $          | (11,038     | )          | $                     | (811       | ) | $ | (442 | ) | $ | 1,896 |   |
|                                                                       |       |                  |       |            |       |        |       |         |       |                    |       |         |       |             |       |        |       |                  |       |
| EXERCISE OF STOCK  OPTIONS                                                 |       | 315,853               |       | 1               |       | 2,069       |       | —       |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
| INCOME TAX  BENEFITS FROM STOCK OPTIONS EXERCISED                          |       | —                |       | —          |       | 575         |       | —       |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
| MARK TO MARKET  ADJUSTMENTS FOR DEFERRED BONUS PLAN                        |       | —                |       | —          |       | 315         |       | —       |       | —                  |       | —       |       | (315             | )          | —      |       | —                |       |
| OTHER  COMPREHENSIVE INCOME (LOSS)                                         |       | —                |       | —          |       | —      |       | —       |       | —                  |       | —       |       | —           |       | —      |       | (368                  | )          |
| DEFERRED AND  OTHER STOCK COMPENSATION                                     |       | —                |       | —          |       | —      |       | —       |       | —                  |       | —       |       | 513              |       | —      |       | —                |       |
| PURCHASE OF  TREASURY STOCK (106,500 SHARES, AT COST)                      |       | —                |       | —          |       | —      |       | —       |       | 106,500                 |       | (1,230       | )          | —           |       | —      |       | —                |       |
| PURCHASES OF  TREASURY STOCK BY DEFERRED BONUS PLAN (1,497 SHARES AT COST) |       | —                |       | —          |       | 190         |       | —       |       | 1,497                   |       | (190         | )          | (190             | )          | —      |       | —                |       |
| REPAYMENT OF  SHAREHOLDER NOTES                                            |       | —                |       | —          |       | —      |       | —       |       | —                  |       | —       |       | —           |       | 464         |       | —                |       |
| ISSUANCE OF  COMMON STOCK TO EMPLOYEE STOCK PURCHASE PLAN                  |       | 46,486                |       | —          |       | 356         |       | —       |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
| ISSUANCE OF  COMMON STOCK UNDER 2000 DIRECTOR’S STOCK PLAN            |       | 15,128                |       | —          |       | 145         |       | —       |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
| ACCRUED INTEREST  ON NOTES FROM SHAREHOLDERS                               |       | —                |       | —          |       | —      |       | —       |       | —                  |       | —       |       | —           |       | (22         | )          | —                |       |
| NET INCOME                                                                 |       | —                |       | —          |       | —      |       | 3,970        |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
|                                                                       |       |                  |       |            |       |        |       |         |       |                    |       |         |       |             |       |        |       |                  |       |
| BALANCES AT DECEMBER 31,  2003                                        |       | 14,578,505            |       | 15              |       | 143,735     |       | 34,218       |       | 1,552,987               |       | (12,458      | )          | (803             | )          | 3⁄4      |       | 1,528                 |       |
|                                                                       |       |                  |       |            |       |        |       |         |       |                    |       |         |       |             |       |        |       |                  |       |
| EXERCISE OF STOCK  OPTIONS                                                 |       | 213,694               |       | 3⁄4          |       | 1,521       |       | —       |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
| INCOME TAX  BENEFITS FROM STOCK OPTIONS EXERCISED                          |       | —                |       | —          |       | 312         |       | —       |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
| MARK TO MARKET  ADJUSTMENTS FOR DEFERRED BONUS PLAN                        |       | —                |       | —          |       | (306        | )          | —       |       | —                  |       | —       |       | 306              |       | —      |       | —                |       |
| OTHER  COMPREHENSIVE INCOME                                                |       | —                |       | —          |       | —      |       | —       |       | —                  |       | —       |       | —           |       | —      |       | 164                   |       |
| DEFERRED AND  OTHER STOCK COMPENSATION                                     |       | —                |       | —          |       | —      |       | —       |       | —                  |       | —       |       | 65               |       | —      |       | —                |       |
| PURCHASE OF  TREASURY STOCK (10,000 SHARES, AT COST)                       |       | —                |       | —          |       | —      |       | —       |       | 10,000                  |       | (115         | )          | —           |       | —      |       | —                |       |
| ISSUANCE OF  COMMON STOCK TO EMPLOYEE STOCK PURCHASE PLAN                  |       | 40,213                |       | —          |       | 323         |       | —       |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
| ISSUANCE OF  COMMON STOCK UNDER 2000 DIRECTOR’S STOCK PLAN            |       | 12,695                |       | —          |       | 240         |       | —       |       | —                  |       | —       |       | —           |       | —      |       | —                |       |
| NET LOSS                                                                   |       | —                |       | —          |       | —      |       | (7,433       | )          | —                  |       | —       |       | —           |       | —      |       | —                |       |
|                                                                       |       |                  |       |            |       |        |       |         |       |                    |       |         |       |             |       |        |       |                  |       |
| BALANCES AT  DECEMBER 31, 2004                                        |       | 14,845,107            |       | 15              |       | 145,825     |       | 26,785       |       | 1,562,987               |       | (12,573      | )          | (432             | )          | —      |       | 1,692                 |       |
|                                                                       |       |                  |       |            |       |        |       |         |       |                    |       |         |       | 3⁄4           |       | 3⁄4      |       |                  |       |
| EXERCISE OF STOCK  OPTIONS                                                 |       | 446,141               |       | 3⁄4          |       | 3,783       |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4      |       | 3⁄4                |       |
| INCOME TAX  BENEFITS FROM STOCK OPTIONS EXERCISED                          |       | 3⁄4                |       | 3⁄4          |       | 724         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4      |       | 3⁄4                |       |
| MARK TO MARKET  ADJUSTMENTS FOR DEFERRED BONUS PLAN                        |       | 3⁄4                |       | 3⁄4          |       | (156        | )          | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 156              |       | 3⁄4      |       | 3⁄4                |       |
| OTHER  COMPREHENSIVE INCOME                                                |       | 3⁄4                |       | 3⁄4          |       | 3⁄4      |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | —      |       | (1,103                | )          |
| DEFERRED AND  OTHER STOCK COMPENSATION                                     |       | 3⁄4                |       | 3⁄4          |       | 381         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | (714             | )          | 3⁄4      |       | 3⁄4                |       |
| ISSUANCE OF  COMMON STOCK TO EMPLOYEE STOCK PURCHASE PLAN                  |       | 30,553                |       | 3⁄4          |       | 357         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4      |       | 3⁄4                |       |
| ISSUANCE OF  COMMON STOCK UNDER 2000 DIRECTOR’S STOCK PLAN            |       | 30,358                |       | 3⁄4          |       | 415         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4      |       | 3⁄4                |       |
| NET INCOME                                                                 |       | 3⁄4                |       | 3⁄4          |       | 3⁄4      |       | 306          |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4      |       | 3⁄4                |       |
|                                                                       |       |                  |       |            |       |        |       |         |       |                    |       |         |       |             |       |        |       |                  |       |
| BALANCES AT  DECEMBER 31, 2005                                        |       | 15,352,159            |       | $               | 15         |        | $          | 151,329      |       | $                       | 27,091     |         | 1,562,987  |             | $          | (12,573     | )          | $                     | (990       | ) | $ | — |   | $ | 589 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

57

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**CORNELL COMPANIES, INC.**

#### **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                               |       |                             |       |   |   |   |   |
| Net income (loss)                                                                                       |       | $                                | 306        |   | $ | (7,433 | ) | $ | 3,970 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities           |       |                             |       |   |   |   |   |
| Impairment of long-lived assets                                                                         |       | 3⁄4                           |       | 10,100 |   | 3⁄4 |   |
| Loss on extinguishment of debt                                                                          |       | 3⁄4                           |       | 2,361 |   | 3⁄4 |   |
| Depreciation                                                                                            |       | 13,106                           |       | 12,183 |   | 9,804 |   |
| Amortization of intangibles and other  assets                                                           |       | 2,268                            |       | 1,364 |   | 895 |   |
| Amortization of deferred compensation                                                                   |       | (294                             | )          | 65 |   | 502 |   |
| Amortization of deferred financing costs                                                                |       | 1,414                            |       | 1,437 |   | 1,157 |   |
| Amortization of Senior Notes discount                                                                   |       | 184                              |       | 92 |   | 3⁄4 |   |
| Provision for bad debts                                                                                 |       | 4,745                            |       | 2,371 |   | 7,550 |   |
| (Gain) loss on sale of property and  equipment                                                          |       | (50                              | )          | (397 | ) | 50 |   |
| Deferred income taxes                                                                                   |       | (3                               | )          | (4,154 | ) | 1,941 |   |
| Change in assets and liabilities:                                                                       |       |                             |       |   |   |   |   |
| Accounts receivable                                                                                     |       | (5,586                           | )          | (12,206 | ) | (583 | ) |
| Other restricted assets                                                                                 |       | (62                              | )          | (66 | ) | 24 |   |
| Other assets                                                                                            |       | 2,881                            |       | (260 | ) | (2,283 | ) |
| Accounts payable and accrued liabilities                                                                |       | 9,513                            |       | 6,625 |   | 4,675 |   |
| Deferred revenues and other liabilities                                                                 |       | (154                             | )          | 11 |   | (1,491 | ) |
| **Net cash provided by operating activities**                                                           |       | 28,268                           |       | 12,093 |   | 26,211 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                               |       |                             |       |   |   |   |   |
| Capital expenditures                                                                                    |       | (51,128                          | )          | (40,243 | ) | (22,304 | ) |
| Acquisition of a business, net of cash  acquired                                                        |       | (9,064                           | )          | 3⁄4 |   | 3⁄4 |   |
| Payments to restricted escrow arrangement,  net                                                         |       | 3⁄4                           |       | — |   | (10,385 | ) |
| Purchases of investment securities                                                                      |       | (1,022,295                       | )          | (471,410 | ) | 3⁄4 |   |
| Sales of investment securities                                                                          |       | 1,066,785                        |       | 419,670 |   | 3⁄4 |   |
| Receipt from restricted escrow arrangement                                                              |       | 3⁄4                           |       | 5,000 |   | —— |   |
| BOP claim reimbursement                                                                                 |       | 3⁄4                           |       | 5,566 |   | —— |   |
| Purchase of facility management contract                                                                |       | 3⁄4                           |       | (3,000 | ) | —— |   |
| Proceeds from sale of property and  equipment                                                           |       | 647                              |       | 1,137 |   | 3⁄4 |   |
| Payments of non-compete agreements                                                                      |       | 3⁄4                           |       | — |   | (1,000 | ) |
| Payments to restricted debt payment  account, net                                                       |       | (2,445                           | )          | (2,463 | ) | (2,275 | ) |
| **Net cash used in investing activities**                                                               |       | (17,500                          | )          | (85,743 | ) | (35,964 | ) |
|                                                                                                    |       |                             |       |   |   |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                               |       |                             |       |   |   |   |   |
| Proceeds from long-term debt and line of  credit                                                        |       | 3⁄4                           |       | 69,000 |   | 24,339 |   |
| Payments on line of credit                                                                              |       | 3⁄4                           |       | (71,000 | ) | (21,000 | ) |
| Payments of MCF bonds                                                                                   |       | (9,000                           | )          | (8,300 | ) | (7,600 | ) |
| Payments of synthetic lease                                                                             |       | 3⁄4                           |       | (52,499 | ) | 3⁄4 |   |
| Payments of acquired debt                                                                               |       | (1,905                           | )          | 3⁄4 |   | 3⁄4 |   |
| Payments of capital lease obligations                                                                   |       | (176                             | )          | (7 | ) | (31 | ) |
| Proceeds from Senior Notes, net of discount                                                             |       | 3⁄4                           |       | 110,527 |   | 3⁄4 |   |
| Payments for debt issuance and other  financing costs                                                   |       | 3⁄4                           |       | (6,076 | ) | (31 | ) |
| Collections of payments of shareholder  notes                                                           |       | 3⁄4                           |       | — |   | 440 |   |
| Proceeds from exercise of stock options and  warrants                                                   |       | 4,141                            |       | 1,844 |   | 2,427 |   |
| Purchases of treasury stock                                                                             |       | 3⁄4                           |       | (115 | ) | (1,230 | ) |
| **Net cash (used in) provided by financing  activities**                                                |       | (6,940                           | )          | 43,374 |   | (2,686 | ) |
|                                                                                                    |       |                             |       |   |   |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                                   |       | 3,828                            |       | (30,276 | ) | (12,439 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                                       |       | 9,895                            |       | 40,171 |   | 52,610 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                              |       | $                                | 13,723     |   | $ | 9,895 |   | $ | 40,171 |   |
| ** **                                                                                              |       |                             |       |   |   |   |   |
| **SUPPLEMENTAL CASH FLOW DISCLOSURE:**                                                                  |       |                             |       |   |   |   |   |
| Interest paid, net of amounts capitalized                                                               |       | $                                | 22,964     |   | $ | 16,054 |   | $ | 18,690 |   |
| Income taxes paid                                                                                       |       | $                                | 175        |   | $ | 400 |   | $ | 3,387 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| **OTHER NON-CASH INVESTING AND FINANCING  ACTIVITIES:**                                                 |       |                             |       |   |   |   |   |
| Increase (decrease) in fair value of  interest rate swap                                                |       | $                                | (3,353     | ) | $ | 3,208 |   | $ | — |   |
| Purchases of treasury stock by deferred  bonus plan                                                     |       | 3⁄4                           |       | — |   | 190 |   |
| Purchases and additions to property and  equipment included in accounts payable and accrued liabilities |       | 2,478                            |       | 2,904 |   | — |   |
| Common stock issued for board of directors  fees                                                        |       | 415                              |       | 240 |   | 145 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

58

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****    ****DESCRIPTION OF THE BUSINESS**

 

CornellCompanies, Inc. (collectively with its subsidiaries and consolidated specialpurpose entities, the “Company”), a Delaware corporation, provides theintegrated development, design, construction and management of facilities togovernmental agencies within three operating segments: (1) adult secureinstitutional services; (2) juvenile justice, educational and treatmentservices and (3) adult community-based corrections and treatment services.

 

**2.****    ****SIGNIFICANT ACCOUNTINGPOLICIES**

 

***Consolidation***

 

Theaccompanying consolidated financial statements include the accounts of theCompany, our wholly-owned subsidiaries, and our activities relative to twofinancings of operating facilities. All significant intercompany balances andtransactions have been eliminated. Minority interest in consolidated specialpurpose entities represents equity that other investors have contributed to thespecial purpose entities. Minority interest is adjusted for income and lossesallocable to the owners of the special purpose entities. As the cumulativelosses of the special purpose entity exceed the equity that is recorded asminority interest, the excess losses are recorded in our Statements ofOperations and Comprehensive Income (Loss).

 

***Cash and Cash Equivalents***

 

Weconsider all highly liquid unrestricted investments with original maturities ofthree months or less to be cash equivalents. We invest our available cashbalances in short term money market accounts, short term certificates ofdeposit and commercial paper.

 

***Investment Securities***

 

Our investment securities at December 31, 2005 consist of certificatesof deposit and certain marketable securities.

 

Our certificates of deposit, which total $0.8 million at December 31, 2005,bear interest at a rate of 3.25%. They have original maturities of one year andare pledged as collateral under certain outstanding letters of credit.

 

Our marketable securities are categorized as available-for-salesecurities, as defined by the Statement of Financial Accounting Standards(SFAS) No. 115, “Accounting for Certain Investments in Debt and EquitySecurities.” Unrealized marketable securities gains and temporary losses arereflected as a net amount under the caption of accumulated other comprehensiveincome within the statement of stockholders’ equity. Realized gains and lossesare recorded within the statement of income under the caption interest incomeor interest expense. For the purpose of computing realized gains and losses,cost is identified on a specific identification basis.

 

AtDecember 31, 2005 and 2004, our marketable securities, which total $6.5million and $51.7 million, respectively, were held in auction rate municipalbonds. Our investment in these securities is recorded at cost, whichapproximates fair market value due to their variable interest rates, whichtypically reset every 7 to 35 days, and, despite the long-term nature of theirstated contractual maturities, we have the ability to quickly liquidate thesesecurities. As a result, we had no gross unrealized holding gains (losses) orgross realized gains (losses) from our investment securities at December 31,2005 and 2004.

 

Contractualmaturities of the underlying investment securities held at December 31, 2005are as follows (in thousands):

 

| Due within 1 year                   |   | $      | 750    |   |
|-------------------------------------|--------|--------|--------|--------|
| Due after 1 year  through 5 years   |   | 3⁄4 |   |
| Due after 5 years  through 10 years |   | 3⁄4 |   |
| Due after 10 years                  |   | 6,500  |   |
| Total investment  securities        |   | $      | 7,250  |   |

 

59

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***Accounts Receivable and RelatedAllowance for Doubtful Accounts***

 

Weextend credit to the governmental agencies and other parties with which wecontract in the normal course of business. We regularly review our outstandingreceivables and historical collection experience, and provide for estimatedlosses through an allowance for doubtful accounts. In evaluating the adequacyof our allowance for doubtful accounts, we make judgments regarding ourcustomers’ ability to make required payments, economic events and otherfactors. As the financial condition of these parties change, circumstancesdevelop or additional information becomes available, adjustments to theallowance for doubtful accounts may occur. If, after reasonable collectionefforts have been made, a receivable is determined to be permanentlyuncollectible, it will be written off.

 

AtDecember 31, 2005, other receivables includes approximately $7.0 millionrelated to the shareholder lawsuit settlement that will be reimbursed by ourdirectors’ and officers’ liability insurance carrier and approximately $5.3million related to misappropriated escrow funds for the Southern Peaks RegionalTreatment Center. We have provided an allowance for doubtful accounts ofapproximately $5.0 million on the balance related to the misappropriated escrowfunds due to the uncertainty surrounding its recovery. Refer to Note 11 to theconsolidated financial statements for a discussion concerning these balancesand the related transactions.

 

Thechanges in allowance for doubtful accounts associated with trade accountsreceivable for the years ended December 31, 2005, 2004 and 2003 are asfollows (in thousands):

 

| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                 |       |                             |       |   |   |   |   |
| Balance at beginning of period       |       | $                                | 3,544      |   | $ | 1,929 |   | $ | 2,238 |   |
| Provision for bad debts              |       | 4,745                            |       | 2,717 |   | 2,165 |   |
| Write-offs of uncollectible accounts |       | (5,011                           | )          | (1,102 | ) | (2,474 | ) |
| Balance at end of period             |       | $                                | 3,278      |   | $ | 3,544 |   | $ | 1,929 |   |

 

InSeptember 2004, we resolved our claim with the Bureau of Prisons (BOP) forthe reimbursement of a portion of the expenses incurred in connection with theissuance of the Stop-Work Order and the delay of the Moshannon ValleyCorrectional Center project (included among these expenses was approximately$1.4 million in accounts receivable for expenses incurred by us after theSeptember 1999 issuance of the Stop–Work Order). We settled the claim, aswell as the claim for the reimbursement of costs related to the originalconstruction efforts incurred beginning in 1999 with the BOP, and werereimbursed approximately $7.0 million in September 2004. The excessreimbursement of approximately $5.6 million over the $1.4 million in accountsreceivable was credited against the carrying cost of the facility.

 

***Restricted Assets***

 

Restrictedassets at December 31, 2005 and 2004 include approximately $19.6 millionand $17.1 million, respectively, of Municipal Correctional Finance, LP’s (MCF)restricted cash accounts. MCF’s restricted accounts are comprised primarily ofa debt service fund used to segregate rental payment funds from us to MCF forMCF’s semi-annual debt service. MCF’s funds are invested in short termcertificates of deposit, money market accounts and commercial paper. Thebalances are current as the debt service in the coming year is greater than thebalance in these funds.

 

Atcertain facilities, we maintain bank accounts for restricted cash belonging tofacility residents, commissary operations and equipment replacement funds usedin certain state programs. Restricted assets at December 31, 2005and 2004 include approximately $2.6 million and $2.5 million, respectively, forthese accounts. A corresponding liability for these obligations is included inaccrued liabilities in the accompanying financial statements.

 

Restrictedassets at December 31, 2004 include approximately $0.1 million of assetsheld in a rabbi trust for a deferred bonus plan. The assets held in this rabbitrust were minimal at December 31, 2005. See Note 12 to the ConsolidatedFinancial Statements.

 

***Property and Equipment***

 

Propertyand equipment are recorded at cost. Ordinary maintenance and repair costs areexpensed, while renewal and betterment costs are capitalized. Buildings andimprovements are depreciated over their estimated useful lives of 30 to 50years using the straight-line method. Prepaid facility use cost, which resultedfrom the July 1996 acquisition of the Big Spring

 

60

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CorrectionalCenter and the December 1999 transfer of ownership of the Great PlainsCorrectional Facility to a leasehold interest, is being amortized over 50 yearsusing the straight-line method. Furniture and equipment are depreciated overtheir estimated useful lives of 3 to 10 years using the straight-linemethod. Amortization of leasehold improvements (including those funded bylandlord incentives or allowances) is recorded using the straight-line methodbased upon the shorter of the economic life of the asset or the term of therespective lease. Landlord incentives or allowances under operating leases arerecorded as deferred rent and amortized as a reduction of rent expense over thelease term. See Note 7 to the Consolidated Financial Statements for furtherdetails concerning our property and equipment balances at December 31,2005 and 2004.

 

***Capitalized Interest***

 

Wecapitalize interest on facilities while under construction. Interestcapitalized for the year ended December 31, 2005 was approximately $3.7 millionand related to the construction of the Moshannon Valley Correctional Center. Interestcapitalized for the year ended December 31, 2004 was approximately $1.8million and related to the Moshannon Valley Correctional Center, the RegionalCorrectional Center, the Las Vegas Center and the Southern Peaks RegionalTreatment Center. Interest capitalized for the year endedDecember 31, 2003 was approximately $0.8 million and related primarily tothe design and development of the Moshannon Valley Correctional Center.

 

***Debt Service Reserve Fund***

 

Thedebt service reserve fund was established at the closing of MCF’s bond issuanceand is to be used solely for MCF’s debt service to the extent that funds inMCF’s debt service accounts are insufficient. The debt service reserve fund isinvested in short term commercial instruments and earns a guaranteed rate ofreturn of 3.0%. See Note 13 to the Consolidated Financial Statements.

 

***Intangible Assets***

 

Weaccount for our intangible assets in accordance with the provisions ofStatement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and OtherIntangible Assets.”  In accordance withthis statement, we evaluate the carrying value of our existing intangibles(which are the result of prior acquisitions – both business facilities andoperating contracts) for impairment annually. We have evaluated the carryingvalue of our existing intangibles according to the provisions of SFAS No. 142and we believe there has not been an impairment to the carrying value of ourexisting intangibles as of December 31, 2005. See Note 5 to theConsolidated Financial Statements for further details concerning our intangibleassets.

 

***Deferred Costs***

 

Costsincurred related to obtaining debt financing are capitalized and amortized overthe term of the related indebtedness. At December 31, 2005 and 2004, wehad net deferred debt issuance costs of approximately $9.6 million and $11.0million, respectively.

 

***Realization of Long-Lived Assets***

 

Weassess the realization of our long-lived assets pursuant to SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.”  For assets held and used in operations,realization is assessed based on our estimate of future operating results andcash flows. We assess the realization of our long-lived assets annually or whena triggering event has occurred. As of December 31, 2005, we haveevaluated our long-lived assets and believe that these assets are realizableand that no impairments to the carrying value of these assets exist at December31, 2005. See Note 7 to the Consolidated Financial Statements for a discussionconcerning impairment charges recognized in the year ended December 31, 2004.

 

***Revenue Recognition***

 

Werecognize revenue in accordance with SEC Staff Accounting Bulletin No. 104,“Revenue Recognition in Financial Statements, as amended.”  Substantially all of our revenues are derivedfrom contracts with federal, state and local governmental agencies, which payeither per diem rates based upon the number of occupant days or hours servedfor the period, on a take-or-pay basis, management fee basis, cost-plus reimbursementor fee-for-service basis. Revenues are recognized as services are providedunder our established contractual agreements to the extent collection isconsidered probable.

 

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*** ***

***Pre-opening and Start-up Expenses***

 

Pre-opening and start-up expenses are charged to operations asincurred. Pre-opening and start-up expenses include payroll, benefits, trainingand other operating costs during periods prior to opening a new or expandedfacility and during the period of operation while occupancy is ramping up.These costs vary by contract. Newly opened facilities are staffed according toapplicable regulatory or contractual requirements when we begin receivingoffenders or clients. Offenders or clients are typically assigned to a newlyopened facility on a phased-in basis over a one-to-six month period. Ourstart-up period for new juvenile operations is 12 months from the date we beginrecognizing revenue unless break-even occupancy is achieved before then. Ourstart-up period for new adult operations is nine months from the date we beginrecognizing revenue unless break-even occupancy is achieved before then.

 

***Proposal Costs***

 

We incur various expenses in conjunction with our participation in theproposal process with government agencies for their procurement of ourservices. These costs include such items as payroll/employee benefits,research, consulting, legal and reproduction costs and are expensed in theperiods incurred.

 

***Operating andGeneral and Administrative Expenses***

 

We incur various expenses within the normal course of our business.Included in operating expenses are direct expense items such aspersonnel/employee benefits, resident/inmate care expenses and building/utilitycosts pertaining to the operations of our facilities and programs. Included ingeneral and administrative expenses are expense items such aspersonnel/employee benefits, professional services and building/utility costspertaining to our corporate activities.

 

***Business Concentration***

 

Contractswith federal, state and local governmental agencies account for nearly all ofour revenues. The loss of, or a significant decrease in, business from one ormore of these governmental agencies could have a material adverse effect on ourfinancial condition and results of operations. For the years endedDecember 31, 2005, 2004 and 2003, 23.0%, 22.3% and 21.7%, respectively, ofour consolidated revenues were derived from contracts with the Federal Bureauof Prisons (BOP), the only customer constituting more than 10.0% of ourrevenues during each of these periods. The increase in the percentage for 2005as compared to the prior two years is due to additional BOP revenue in 2005resulting from the acquisition of Correctional Systems, Inc. (CSI) in April2005.

 

***Self Insurance Reserves***

 

Wemaintain insurance coverage for various aspects of our business and operations.We retain a portion of losses that occur through the use of deductibles andretention under self-insurance programs. These programs include workers compensationand employer’s liability, general liability and professional liability,directors and officers’ liability and medical and dental insurance. We maintaindeductibles under these programs in amounts ranging from $0.5 million to $1.0million. We maintain excess loss insurance for amounts exceeding ourdeductibles.

 

Weregularly review our estimates of reported and unreported claims and providefor these losses through insurance reserves. These reserves are influenced byrising costs of health care and other costs, increases in claims, time lags inclaim information and levels of insurance coverage carried. As claims developand additional information becomes available to us, adjustments to the relatedloss reserves may occur. Our estimated reserves for workers compensation claimsincorporate the use of a 5% discount factor. Our reserves for medical andworker’s compensation claims are subject to change based on our estimate of thenumber and magnitude of claims to be incurred.

 

***Accounting for Stock-BasedCompensation***

 

In accordance with the provisions ofStatement of Financial Accounting Standard (SFAS) No. 123, “Accounting forStock-Based Compensation,” we have elected to account for our stock-basedcompensation plans under the intrinsic value method established by AccountingPrinciples Board Opinion (APB) No. 25, “Accounting for Stock Issued toEmployees.”  In accordance with theprovisions of APB No. 25, the fair value of fixed stock options granted toemployees is not reflected in net income, as all options granted under thoseplans had an exercise price equal to or in excess of the market value of theunderlying common stock on the date of grant. The following table illustrates,in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation— Transition and Disclosure, an Amendment of SFAS No. 123,” the effect onour net income (loss) per

 

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share as if we had applied the fair valuerecognition provisions of SFAS No. 123 to stock-based employeecompensation (in thousands, except per share amounts):

 

| ** **                                                                                                                                           | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                           | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss), as reported                                                                                                                       |       | $                                | 306        |   | $ | (7,433 | ) | $ | 3,970 |   |
| Add: total stock-based compensation  recorded, net of tax                                                                                            |       | 201                              |       | 146 |   | 94 |   |
| Less: total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects (1) |       | 1,908                            |       | 1,022 |   | 1,383 |   |
| Pro forma net income (loss)                                                                                                                          |       | $                                | (1,401     | ) | $ | (8,309 | ) | $ | 2,681 |   |
| Earnings (loss) per share:                                                                                                                           |       |                             |       |   |   |   |   |
| Basic, as reported                                                                                                                                   |       | $                                | .02        |   | $ | (.56 | ) | $ | .31 |   |
| Basic, pro forma                                                                                                                                     |       | (.10                             | )          | (.63 | ) | .21 |   |
| Diluted, as reported                                                                                                                                 |       | .02                              |       | (.56 | ) | .30 |   |
| Diluted, pro forma                                                                                                                                   |       | (.10                             | )          | (.64 | ) | .20 |   |
|                                                                                                                                                 |       |                             |       |   |   |   |   |
| Weighted-average fair value per share of  options granted (1)                                                                                        |       | $                                | 8.03       |   | $ | 7.94 |   | $ | 6.02 |   |

 

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(1)   See Note12 to the Consolidated Financial Statements for additional informationregarding the computations presented above.

 

***Income Taxes***

 

Weutilize the liability method of accounting for income taxes as required by SFASNo. 109, “Accounting for Income Taxes.” Under this method, deferred tax assets and liabilities are recognizedfor the future tax consequences attributable to differences between thefinancial statement carrying values of existing assets and liabilities andtheir respective tax bases based on enacted tax rates. In providing fordeferred taxes, we consider current tax regulations, estimates of futuretaxable income and available tax planning strategies. If tax regulations,operating results or the ability to implement tax planning strategies vary,adjustments to the carrying value of tax assets and liabilities may occur. SeeNote 9 to the Consolidated Financial Statements.

 

***Earnings Per Share***

 

Basicearnings per share (EPS) is computed by dividing net income by the weightedaverage number of shares of common stock outstanding during the period. DilutedEPS reflects the potential dilution from common stock equivalents such as stockoptions and warrants. For the years ended December 31, 2005, 2004 and2003, there were 113,145 shares ($15.10 average price), 437,078 shares ($13.01average price) and 371,145 shares ($12.86 average price), respectively, ofstock options that were not included in the computation of diluted EPS becauseto do so would have been anti-dilutive.

 

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The following table summarizes thecalculation of income (loss) and the weighted average common shares and commonequivalent shares outstanding for purposes of the computation of earnings(loss) per share (in thousands, except per share data):

 
| ** **                                                               | ** ** | **Year Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                               | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income (loss) from  continuing operations                                |       | $                            | 3,928      |   | $ | (5,000 | ) | $ | 4,028 |   |
| Loss from discontinued  operations, net of tax                           |       | (3,622                       | )          | (2,433 | ) | (58 | ) |
| Net income (loss)                                                        |       | $                            | 306        |   | $ | (7,433 | ) | $ | 3,970 |   |
|                                                                     |       |                         |       |   |   |   |   |
| Weighted average common  shares outstanding                              |       | 13,580                       |       | 13,203 |   | 12,941 |   |
| Weighted average common  share equivalents outstanding                   |       | 115                          |       | 3⁄4 |   | 401 |   |
|                                                                     |       |                         |       |   |   |   |   |
| Weighted average common shares and common share  equivalents outstanding |       | 13,695                       |       | 13,203 |   | 13,342 |   |
|                                                                     |       |                         |       |   |   |   |   |
| Basic income (loss) per  share:                                          |       |                         |       |   |   |   |   |
| Income (loss) from  continuing operations                                |       | $                            | .29        |   | $ | (.38 | ) | $ | .31 |   |
| Loss from discontinued  operations, net of tax                           |       | (.27                         | )          | (.18 | ) | 3⁄4 |   |
| Net income (loss)                                                        |       | $                            | .02        |   | $ | (.56 | ) | $ | .31 |   |
|                                                                     |       |                         |       |   |   |   |   |
| Diluted income (loss)  per share:                                        |       |                         |       |   |   |   |   |
| Income (loss) from  continuing operations                                |       | $                            | .29        |   | $ | (.38 | ) | $ | .30 |   |
| Loss from discontinued  operations, net of tax                           |       | (.27                         | )          | (.18 | ) | 3⁄4 |   |
| Net income (loss)                                                        |       | $                            | .02        |   | $ | (.56 | ) | $ | .30 |   |

 

***Financial Instruments***

 

Thecarrying amounts of our financial instruments, including cash and cashequivalents, investment securities, accounts receivable and accounts payableand accrued expenses, approximate fair value due to the short maturities ofthese financial instruments. At December 31, 2005, the carrying amount oflong-term debt was $276.4 million, and the estimated fair value was $301.0million. At December 31, 2004, the carrying amount was $288.5 million, andthe estimated fair value was $305.5 million. The estimated fair value oflong-term debt is based primarily on quoted market prices for the same orsimilar issues.

 

***Derivative Instruments***

 

Derivativeinstruments are recognized in accordance with the provisions of SFAS No. 149,“Amendment of Statement No. 133 on Derivative Instruments and HedgingActivities.”  We have only entered into derivativecontracts that are classified as hedges. These hedges are recorded at theirfair value with changes in the fair value recorded as adjustments to the relatedliability and other comprehensive income (loss) in our Consolidated Statementsof Operations and Comprehensive Income (Loss). See Note 13 to the ConsolidatedFinancial Statements.

 

***Use of Estimates***

 

Ourfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the United States of America, which require that we makecertain estimates and judgments that affect our reported amounts of assets,liabilities, revenues and expenses and the disclosures of contingent assets andliabilities. We evaluate our estimates on an on-going basis, based onhistorical experience and on various other assumptions that we believe to bereasonable based on the information available. Actual results could differ fromthese estimates under different assumptions or conditions. The significantestimates made by us in the accompanying consolidated financial statementsinclude the allowance for doubtful accounts, accruals for insurance and legalclaims, accruals for compensated employee absences and the realizability oflong-lived tangible and intangible assets.

 

***Reclassifications***

 

Certainreclassifications have been made to the prior period financial statementscontained herein to conform to current year presentation.

 

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**3.****    ****DISCONTINUED OPERATIONS ANDMANAGEMENT RESTRUCTURING**

 

Weclassify as discontinued operations those components of our business that wehold for sale or that have been disposed and have cash flows that are clearlydistinguishable operationally and for financial reporting purposes from therest of our operations. For those components, we have no significant continuinginvolvement after completion of disposal and their operations are eliminatedfrom our ongoing operations. During the year ended December 31, 2005, weclassified certain components as discontinued operations. This was the resultof a management decision to close certain facilities in the first and secondquarter of 2005. These facilities and programs include the Residential School,the Maple Creek Home and our mental health wrap programs in Pennsylvania in thefirst quarter of 2005 and the Northside Clinic and the Jos-Arz Academy in thesecond quarter of 2005. Notifications were made to the required contractingentities regarding the termination of the related programs. AtDecember 31, 2005, we did not have any significant net property andequipment balances pertaining to these operations. These discontinuedoperations generated revenues of approximately $2.6 million, $13.8 million and$13.5 million in the years ended December 31, 2005, 2004 and 2003,respectively.

 

Duringthe first quarter of 2005, a review was performed of our management structureand, as a result, approximately 14 positions were eliminated. In conjunctionwith this action, a charge of approximately $2.1 million was recorded in thefirst quarter of 2005 for employee termination costs. Approximately $1.0million of this charge was reflected in operating expenses and $1.1 million ingeneral and administrative expenses. The accrued liability pertaining to thischarge was approximately $0.7 million at December 31, 2005. There are nosignificant additional costs expected to be incurred in conjunction with thisactivity in future periods.

 

**4.****    ****ACQUISITION OF CORRECTIONALSYSTEMS, INC.**

 

In April 2005, wecompleted our acquisition of Correctional Systems, Inc. (CSI), a SanDiego-based provider of privatized jail, community corrections and alternativesentencing services. The transaction was consummated in cash of approximately$9.1 million, net of cash acquired, all of which was paid in April 2005.The acquisition included the operations of eight jails, six adultcommunity-based correction facilities and five alternative sentencing programslocated in California, New Mexico, Texas and Kansas. The acquisition addedapproximately 986 corrections beds, as well as alternatives to incarcerationservices. The results of operations for CSI subsequent to the date ofacquisition (April 1, 2005) are included in our consolidated financialstatements.

 

We acquired substantiallyall of CSI’s assets and assumed all of their liabilities. The excess of thepurchase price over the fair value of the assets acquired and liabilitiesassumed was allocated to goodwill. The initial purchase price allocations can beadjusted within the shorter of a defined allocation period or one year of thepurchase date for changes in the estimates of the fair values of assetsacquired and liabilities assumed. The following table summarizes the estimatedfair values of the assets acquired and liabilities assumed at the date ofacquisition (in thousands).

 

| ** **                                | ** ** | **April 1, 2005** | ** ** |
|-------------------------------------------|------------|-------------------|------------|
|                                      |       |              |       |
| Receivables                               |       | $                 | 1,769      |   |
| Prepaids and other  assets                |       | 305               |       |
| Property and equipment                    |       | 2,097             |       |
| Contract value                            |       | 4,121             |       |
| Other assets                              |       | 1,351             |       |
| Goodwill                                  |       | 4,586             |       |
| Assets acquired                           |       | 14,229            |       |
|                                      |       |              |       |
| Accounts payable and  accrued liabilities |       | 1,076             |       |
| Long-term debt                            |       | 2,239             |       |
| Deferred tax  liabilities                 |       | 1,720             |       |
| Other long-term  liabilities              |       | 130               |       |
| Liabilities assumed                       |       | 5,165             |       |
| Net assets acquired                       |       | $                 | 9,064      |   |

 

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Webelieve that the CSI acquisition resulted in the recognition of goodwillbecause of its industry position, operational strength and potential to provideadditional growth opportunities for us. During the nine months ended December31, 2005, we adjusted goodwill by approximately $0.3 million due to adjustmentsto the cost basis of the property acquired based on final property appraisalsand for certain post-closing acquisition costs.

 

Our amortizationperiod for acquired contracts is the greater of the acquired contract life orseven years.

 

On an unaudited basis, the effectsof the CSI acquisition were not significant to our results of operations hadthey been included in prior periods.

 

In August 2005, a lawsuitwas filed by a detainee at one of the facilities acquired from CSI. See Note 11to the Consolidated Financial Statements for further discussion concerning thismatter.

 

**5.****    ****INTANGIBLE ASSETS**

 

Intangibleassets at December 31, 2005 and 2004 consisted of the following (inthousands):

 

| ** **                   | ** ** | **December 31,** | ** ** |
|------------------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Non-compete agreements       |       | $                     | 9,960      |   | $ | 9,840 |   |
| Acquired contract value      |       | 6,442                 |       | 2,405 |   |
| Accumulated  amortization    |       | (7,313                | )          | (5,219 | ) |
| Identified intangibles,  net |       | 9,089                 |       | 7,026 |   |
| Goodwill, net                |       | 12,577                |       | 7,721 |   |
| Total intangibles, net       |       | $                     | 21,666     |   | $ | 14,747 |   |

 

The changes in thecarrying amount of goodwill for the year ended December 31, 2005 are as follows(in thousands):

 

| ** **                      | ** ** | **Adult Secure** | ** ** | **Juvenile** | ** ** | **Pre-Release** | ** ** | **Total** | ** ** |
|---------------------------------|------------|------------------|------------|--------------|------------|-----------------|------------|-----------|------------|
|                            |       |             |       |         |       |            |       |      |       |
| Balance as of December 31, 2004 |       | $                | 1,509      |         | $          | 1,060           |       | $         | 5,152      |   | $ | 7,721 |   |
| Addition to goodwill            |       | 1,393            |       | —       |       | 3,463           |       | 4,856     |       |
| Balance as of December 31, 2005 |       | $                | 2,902      |         | $          | 1,060           |       | $         | 8,615      |   | $ | 12,577 |   |

 

At December 31, 2005, we believe there isno impairment to our existing goodwill.

 

Amortization expense for our acquiredcontract value was approximately $1.0 million and $0.3 million for the yearsended December 31, 2005 and 2004, respectively. Amortization expense for ouracquired contract value is expected to be approximately $1.1 million for eachof the next four years ended December 31 and approximately $0.6 millionfor the fifth year.

 

Amortizationexpense for our non-compete agreements was approximately $1.1 million, $1.1million and $0.9 million for the years ended December 31, 2005, 2004 and2003. Amortization expense for our non-compete agreements is expected to beapproximately $1.1millionfor each of the next four years and $0.7 million for the fifth year.

 

**6.****    ****NEW ACCOUNTING PRONOUNCEMENTS**

 

***Statement ofFinancial Accounting Standards No. 123R***

 

In December 2004, the FinancialAccounting Standards Board (FASB) issued SFAS No. 123R, “Share BasedPayment,” which requires companies to expense the value of employee stockoptions and other types of equity-based compensation based on the fair value ofthe options at the award’s grant date based on the estimated number of awardsthat are expected to vest. Compensation cost for awards that vest would not bereversed if the awards expired without being exercised. When measuring fairvalue, companies can choose an option-pricing model (e.g., Black Scholes orbinominal models) that approximately reflects their specific circumstances andthe economics of their transactions. Companies will recognize compensation costfor share-based payment awards as they vest, including the related tax effects.The effective date of SFAS No. 123R, as amended, applies

 

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to annual periods beginningafter June 15, 2005, and applies to all outstanding and unvested sharebased payment awards at the company’s adoption date.

 

We adopted SFAS No. 123R on January 1, 2006 using the modifiedprospective method in which compensation cost is recognized beginning with theJanuary 1, 2006 adoption date (a) based on the requirements of SFAS No 123R forall share-based payments granted after January 1, 2006 and (b) based on therequirements of SFAS No. 123 for all awards granted to employees prior toJanuary 1, 2006 that remain unvested on the adoption date. We also plan tovalue options using the Black Scholes option pricing model.

 

As permitted by SFAS No. 123, until December 31, 2005 we accounted forshare-based payments to employees using APB No. 25’s intrinsic value methodand, as such, generally recognized no compensation cost on grants of employeestock options. Accordingly, the adoption of SFAS No. 123R may have asignificant impact on our results of operations, although it will have noimpact on our overall financial position. The impact of adoption of SFAS No.123R cannot be predicted at this time because it will depend on the futurelevels of share-based grants. However, had we adopted SFAS No. 123R in priorperiods, the impact of that standard would have approximated the impact of SFASNo. 123 as described in the disclosure of pro forma net income (loss) per sharein Note 1 to our consolidated financial statements. SFAS No. 123R also requiresthe benefits of tax deductions in excess of recognized compensation cost to bereported as a financing cash flow, rather than as an operating cash flow asrequired under current literature.

 

Under SFAS No. 123R, compensatory employee stock purchase plans(ESPP) are required to recognize compensation cost over the requisite serviceperiod for grants made under the ESPP. The criteria that an ESPP must meet tobe considered non-compensatory are more restrictive under SFAS No. 123Rthan they were under APB No. 25. We are currently evaluating the impact onour ESPP by SFAS No. 123R, and currently believe our ESPP may be deemed acompensatory plan as defined by SFAS No. 123R. We do not expect this to have amaterial effect on our financial position, results of operations or cash flows.

 

***Statement ofFinancial Accounting Standards No. 154***

 

The FASB issued SFAS No. 154,“Accounting Changes and Error Corrections — a replacement of APB OpinionNo. 20 and FASB Statement No. 3.” SFAS No. 154 is effective, and will be adopted, for accountingchanges made in fiscal years beginning after December 15, 2005 and is tobe applied retroactively. SFAS No. 154 requires that retroactive application ofa change in accounting principle be limited to the direct effects of thechange. Our adoption of SFAS No. 154 is not expected to have a materialeffect on our financial position, results of operations or cash flows.

 

**7.****    ****PROPERTY AND EQUIPMENT**

 

Propertyand equipment were as follows (in thousands):

 

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
|                                      |       |                  |       |   |   |
| Land                                      |       | $                     | 31,765     |   | $ | 31,448 |   |
| Prepaid facility use                      |       | 71,323                |       | 71,323 |   |
| Buildings and improvements                |       | 179,533               |       | 174,702 |   |
| Furniture and equipment                   |       | 29,889                |       | 30,942 |   |
| Construction in progress                  |       | 69,729                |       | 22,444 |   |
| Sub-total                                 |       | 382,239               |       | 330,859 |   |
| Accumulated depreciation and amortization |       | (58,378               | )          | (48,604 | ) |
| Total property and equipment              |       | $                     | 323,861    |   | $ | 282,255 |   |

 

The increase in construction in progress in the year ended December 31,2005 is primarily due to construction costs of approximately $46.0 millionrelated to the Moshannon Valley Correctional Center. The increase in buildingsand improvements in 2005 is due to the CSI acquisition in April 2005.

 

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Significant purchases/additions to property and equipment made in theyear ended December 31, 2004 included (1) the construction of the SouthernPeaks Regional Treatment Center for approximately $14.2 million,  (2) renovations to the Regional CorrectionalCenter of approximately $7.8 million, (3) construction costs and capitalizedinterest related to the Moshannon Valley Correctional Center for approximately$6.2 million, (4) the purchase and partial renovation of the Central CaliforniaTreatment Center for approximately $2.7 million,  (5) the purchase and renovation of the LasVegas Center for approximately $2.6 million and (6) the purchase of the Baker CommunityCorrectional Center building for approximately $2.0 million. We previouslyleased the Baker Community Correctional Center.

 

Constructionin progress at December 31, 2005 consisted primarily of construction costs forthe Moshannon Valley Correctional Center. Construction in progress atDecember 31, 2004 consisted primarily of construction and renovation costsfor the Moshannon Valley Correctional Center, the Regional Correctional Centerand the Central California Treatment Center.

 

Weevaluate the realization of our long-lived assets according to the provisionsof SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets,” at least annually or when changes in circumstances or a specifictriggering event indicates that the carrying value of the asset may not berecoverable. As a part of our evaluation, we make judgments regarding thepotential future operating results and cash flows associated with individualfacilities. Additionally, should we decide to sell a facility, realization isevaluated based on the estimated sales price based on the best marketinformation available.

 

Weclosed the New Morgan Academy in 2002 and have considered alternative uses forthis facility. We are focusing our efforts on the reopening of the facility bythe fourth quarter of 2006. Once opened, the facility will operate as aresidential treatment facility for youth sex offenders. During 2004, based onforecasted operating and cash flow losses associated with this facility, and inaccordance with the provisions of SFAS No. 144, we determined that our carryingvalue of the facility was not fully recoverable and exceeded its fair valueand, as a result, we recorded an impairment charge of $9.3 million in the yearended December 31, 2004. This charge was determined based on the resultsof our probability-weighted cash flow analysis.

 

Inaddition, as a result of our review of our other long-lived assets based onforecasted operating and cash flow losses associated with these assets, wedetermined that our carrying values for two of our juvenile residentialfacilities was not fully recoverable and exceeded their fair value and, as aresult, we recorded an impairment charge of $0.8 million in the year endedDecember 31, 2004. This charge was estimated based on the best marketinformation available. This charge is included in discontinued operations inthe accompanying consolidated financial statements for the year ended December31, 2004.

 

Wehave evaluated the realization of our facilities and do not believe that animpairment exists related to any of our facilities as of December 31, 2005.

 

**8.****    ****ACCOUNTS PAYABLE AND ACCRUED LIABILITIES**

 

Accountspayable and accrued liabilities consisted of the following (in thousands):

 

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
|                                            |       |                  |       |   |   |
| Accounts payable                                |       | $                     | 14,690     |   | $ | 11,057 |   |
| Accrued compensation                            |       | 7,463                 |       | 6,426 |   |
| Accrued interest payable                        |       | 11,870                |       | 12,565 |   |
| Accrued litigation settlements                  |       | 7,200                 |       | 3⁄4 |   |
| Accrued taxes payable                           |       | 3,876                 |       | 3,615 |   |
| Accrued insurance                               |       | 6,840                 |       | 6,116 |   |
| Accrued legal                                   |       | 2,563                 |       | 3,334 |   |
| Resident funds                                  |       | 2,634                 |       | 2,451 |   |
| Other                                           |       | 1,661                 |       | 1,673 |   |
| Total accounts payable and accrued  liabilities |       | $                     | 58,797     |   | $ | 47,237 |   |

 

AtDecember 31, 2005, accounts payable and accrued liabilities contains accruedlitigation settlement charges of $7.0 million relating to the shareholderlawsuits and $0.2 million pertaining to Lincoln County Detention Center. Referto Note 11 to the consolidated financial statements for a discussion regardingthose matters.

 

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**9.****    ****INCOME TAXES**

 

Thefollowing is an analysis of our deferred tax assets and liabilities (inthousands):

 

| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred tax assets:                 |       |                  |       |   |   |
| Accrued liabilities and allowances   |       | $                     | 5,846      |   | $ | 4,856 |   |
| Federal operating loss carryforwords |       | 1,381                 |       | 3⁄4 |   |
| State operating loss carryforwords   |       | 2,129                 |       | 1,625 |   |
| Deferred compensation                |       | —                |       | 25 |   |
| Other                                |       | 341                   |       | 49 |   |
| Total deferred tax assets            |       | 9,697                 |       | 6,555 |   |
|                                 |       |                  |       |   |   |
| Deferred tax liabilities:            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Property and equipment               |       | 8,035                 |       | 3,165 |   |
| Prepaid expenses                     |       | 776                   |       | 845 |   |
| Other                                |       | 376                   |       | 488 |   |
| Total deferred tax liabilities       |       | 9,187                 |       | 4,498 |   |
|                                 |       |                  |       |   |   |
| Valuation allowance                  |       | (2,129                | )          | (1,625 | ) |
|                                 |       |                  |       |   |   |
| Net deferred tax asset (liability)   |       | $                     | (1,619     | ) | $ | 432 |   |

 

As of December 31,2005, we have net operating losses for state income taxes of approximately$27.7 million. Our tax returns are subject to periodic audit by the variousjurisdictions in which we operate. These audits, including those currentlyunderway, can result in adjustments of taxes due or adjustments of the NOLswhich are available to offset future taxable income.

 

Valuationallowances of $2.1 million have been established for uncertainties in realizingthe benefit of certain state income tax loss carryforwards. In assessing therealizability of carryforwards, we consider whether it is more likely than notthat some portion or all of the deferred tax assets will be realized. Thevaluation allowance will be adjusted in the periods that we determine it ismore likely than not that deferred tax assets will or will not be realized.

 

The components of our income tax provision (benefit) were as follows(in thousands):

 
| ** **                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                  |       |                             |       |   |   |   |   |
| Federal current provision                             |       | $                                | 239        |   | $ | (453 | ) | $ | 517 |   |
| State current provision                               |       | (197                             | )          | (238 | ) | 342 |   |
| Total current provision (benefit)                     |       | 42                               |       | (691 | ) | 859 |   |
|                                                  |       |                             |       |   |   |   |   |
| Federal deferred provision                            |       | 2,097                            |       | (2,894 | ) | 1,604 |   |
| State deferred provision                              |       | 76                               |       | 329 |   | 337 |   |
| Total deferred provision (benefit)                    |       | 2,173                            |       | (2,565 | ) | 1,941 |   |
|                                                  |       |                             |       |   |   |   |   |
| Total provision (benefit) from continuing  operations |       | $                                | 2,215      |   | $ | (3,256 | ) | $ | 2,800 |   |

 

Ourtax returns are subject to periodic audits by the various jurisdictions inwhich we operate. These audits including those currently underway, can resultin adjustments of taxes due or adjustments of the NOLs which are available tooffset future taxable income.

 

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Thefollowing is a reconciliation of income taxes at the statutory federal incometax rate of 35% to the income tax provision (benefit) recorded by us (inthousands):

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| ** **                                 | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Computed taxes at statutory rate           |       | $                                | 2,138      |   | $ | (2,708 | ) | $ | 2,396 |   |
| State income taxes, net of federal benefit |       | (273                             | )          | (617 | ) | 281 |   |
| Other                                      |       | 350                              |       | 69 |   | 123 |   |
|                                       |       | $                                | 2,215      |   | $ | (3,256 | ) | $ | 2,800 |   |

 

**10.**** ****CREDIT FACILITIES**

 

Ourlong-term debt consisted of the following (in thousands):

 
| ** **                                                                                                                                          | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                          | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Debt of Cornell Companies, Inc.:**                                                                                                                |       |                  |       |   |   |
| Senior Notes, unsecured, due July 2012  with an interest rate of 10.75%, net of discount                                                       |       | $                     | 110,803    |   | $ | 110,619 |   |
| Fair-value adjustment of Senior Notes as  result of interest rate swap                                                                              |       | (145                  | )          | 3,208 |   |
| Revolving Line of Credit (2004 Credit  Facility) due June 2008 with an interest rate of LIBOR plus 2.25% to  3.5% or prime plus 0.75% to 2.00% |       | 3⁄4                |       | — |   |
| Revolving Line of Credit due July 2005  with an interest rate of prime plus 2.0% or LIBOR plus 3.0%, repaid in  June 2004                 |       | 3⁄4                |       | — |   |
| Capital lease obligations                                                                                                                           |       | 2                     |       | 6 |   |
| Subtotal                                                                                                                                            |       | 110,660               |       | 113,833 |   |
|                                                                                                                                                |       |                  |       |   |   |
| **Debt of Special Purpose Entities:**                                                                                                               |       |                  |       |   |   |
| 8.47% Bonds due 2016                                                                                                                                |       | 165,700               |       | 174,700 |   |
|                                                                                                                                                |       |                  |       |   |   |
| Total consolidated debt                                                                                                                             |       | 276,360               |       | 288,533 |   |
|                                                                                                                                                |       |                  |       |   |   |
| Less: current maturities                                                                                                                            |       | (9,701                | )          | (9,005 | ) |
|                                                                                                                                                |       |                  |       |   |   |
| Consolidated long-term debt                                                                                                                         |       | $                     | 266,659    |   | $ | 279,528 |   |

 

***Long-Term Credit Facilities.***The 2004 Credit Facility provides forborrowings of up to $60.0 million under a revolving line of credit and isreduced by outstanding letters of credit. The available commitment under the2004 Credit Facility was approximately $50.6 million at December 31, 2005.We had no outstanding borrowings on the 2004 Credit Facility atDecember 31, 2005, but we had outstanding letters of credit ofapproximately $9.4 million. Subject to certain requirements, we have the rightto increase the aggregate commitments under the 2004 Credit Facility up to anaggregate amount of $100.0 million. The 2004 Credit Facility matures inJune 2008 and bears interest, at our election, depending on our totalleverage ratio, at either the prime rate plus a margin ranging from 0.75% to2.00%, or a rate which ranges from 2.25% to 3.50% above the applicable LIBORrate. The 2004 Credit Facility is collateralized by substantially allof our assets, including the assets and stock of all of our subsidiaries. The2004 Credit Facility is not secured by the assets of Municipal CorrectionsFinance, LP (MCF). The 2004 Credit Facility contains standard covenantsincluding compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

 

MCF is obligated for the outstandingbalance of its 8.47% Taxable Revenue Bonds, Series 2001. The bonds bearinterest at a rate of 8.47% per annum and are payable in semi-annual installmentsof interest and annual installments of principal. All unpaid principal andaccrued interest on the bonds is due on the earlier of August 1, 2016(maturity) or as noted under the bond documents. The bonds are limited,nonrecourse obligations of MCF and secured by the property and equipment, bondreserves, assignment of subleases and substantially all assets related to thefacilities included in the 2001 Sale and Leaseback Transaction. The bonds arenot guaranteed by the Company.

 

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In June 2004, we issued $112.0million in principal of 10.75% Senior Notes (Senior Notes) due July 1,2012. The Senior Notes are unsecured senior indebtedness and are guaranteed byall of our existing and future subsidiaries (collectively, the Guarantors). TheSenior Notes are not guaranteed by MCF (Non-Guarantor). Interest on the SeniorNotes is payable semi-annually on January 1 and July 1 of each year,commencing January 1, 2005. On or after July 1, 2008, we may redeem allor a portion of the Senior Notes at the redemption prices (expressed as apercentage of the principal amount) listed below, plus accrued and unpaidinterest, if any, on the Senior Notes redeemed, to the applicable date ofredemption, if redeemed during the 12-month period commencing on July 1 ofthe years indicated below:

 

| **Year**            | ** ** | **Percentages** | ** ** |
|---------------------|------------|-----------------|------------|
|                |       |            |       |
| 2008                |       | 105.375         | %          |
| 2009                |       | 102.688         | %          |
| 2010 and thereafter |       | 100.000         | %          |

 

Any time prior to July 1, 2007, we may redeem up to 35% of theoriginal aggregate principal amount of the Senior Notes at a redemption priceof 110.75% of the principal amount thereof with the net cash of publicofferings of equity, provided that at least 65% of the original aggregateprincipal amount of the Senior Notes remains outstanding after the redemptionand other conditions are met. Upon the occurrence of specified change ofcontrol events, unless we have exercised our option to redeem all the SeniorNotes as described above, each holder will have the right to require us torepurchase all or a portion of such holder’s Senior Notes at a purchase pricein cash equal to 101% of the aggregate principal amount of the notesrepurchased plus accrued and unpaid interest, if any, on the Senior Notesrepurchased, to the applicable date of purchase. The Senior Notes were issuedunder an indenture (the “Indenture”) which limits our ability and the abilityof our Guarantors to, among other things, incur additional indebtedness, paydividends or make other distributions, make other restricted payments andinvestments, create liens, incur restrictions on the ability of the Guarantorsto pay dividends or other payments to us, enter into transactions withaffiliates, and engage in mergers, consolidations and certain sales of assets.

 

In conjunction with the issuance of the Senior Notes, we entered intoan interest rate swap transaction with a financial institution to hedge ourexposure to changes in the fair value on $84.0 million of our Senior Notes. Thepurpose of this transaction was to convert future interest due on $84.0 millionof the Senior Notes to a variable rate. The terms of the interest rate swapcontract and the underlying debt instrument are identical. We have designatedthe swap agreement as a fair value hedge. The swap has a notional amount of$84.0 million and matures in July 2012 to mirror the maturity of theSenior Notes. Under the agreement, we pay on a semi-annual basis (eachJanuary 1 and July 1) a floating rate based on a six-month U.S.dollar LIBOR rate, plus a spread, and receive a fixed-rate interest of 10.75%. Forthe years ended December 31, 2005 and 2004, we recorded interest savingsrelated to this interest rate swap of approximately $1.1 million and $1.2million, respectively, which is reflected as a reduction to interest expense inour accompanying financial statements. The swap agreements are marked to marketeach quarter with a corresponding mark-to-market adjustment reflected as eithera discount or premium on the Senior Notes. At December 31, 2005 and 2004,the fair value of this derivative instrument was approximately ($0.1) millionand $3.2 million, respectively, and is included in other long-term liabilities(at December 31, 2005) and other assets (at December 31, 2004) in ourConsolidated Balance Sheets. The carrying value of the Senior Notes as of thesedates was adjusted accordingly by the same amount. Because the swap agreementis considered an effective fair-value hedge, there will be no effect on ourresults of operations from the mark-to-market adjustment as long as the swap isin effect.

 

Scheduled maturities of our consolidated long-term debt were as follows(in thousands):

 
| ** **                            | ** ** | **Cornell  Companies, Inc.** | ** ** | **MCF**    | ** ** | **Consolidated** | ** ** |
|---------------------------------------|------------|------------------------------|------------|------------|------------|------------------|------------|
| ** **                            | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **       | ** ** |
| For the year ending December 31, | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **       | ** ** |
| 2006                                  |       | $                            | 1          |       | $          | 9,700            |       | $ | 9,701 |   |
| 2007                                  |       | 1                            |       | 10,500     |       | 10,501           |       |
| 2008                                  |       | —                       |       | 11,400     |       | 11,400           |       |
| 2009                                  |       | —                       |       | 12,400     |       | 12,400           |       |
| 2010                                  |       | —                       |       | 13,400     |       | 13,400           |       |
| Thereafter                            |       | 112,000                      |       | 108,300    |       | 220,300          |       |
| Total                                 |       | $                            | 112,002    |       | $          | 165,700          |       | $ | 277,702 |   |

 

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**11.  COMMITMENTS ANDCONTINGENCIES**

 

***Financial Guarantees***

 

Duringthe normal course of business, we enter into contracts that contain a varietyof representations and warranties and provide general indemnifications. Ourmaximum exposure under these arrangements is unknown as this would involvefuture claims that may be made against us that have not yet occurred. However,based on experience, we believe the risk of loss to be remote.

 

***Operating Leases***

 

Welease office space, certain facilities and furniture and equipment underlong-term operating leases. Rent expense for all operating leases for the yearsended December 31, 2005, 2004 and 2003, was approximately $8.3 million,$7.4 million and $9.9 million, respectively.

 

Landlordincentives or allowances under operating leases are recorded as deferred rentand amortized as a reduction of rent expense over the lease term. Thoseoperating leases with step rent provisions or escalation clauses that are notconsidered contingent rent are recognized on a straight-lined basis over thelease term. For those leases that include an existing index or rate, such asthe consumer price index or the prime interest rate, the related minimum leasepayments are recognized on a straight-line basis over the lease term and theamount of rent considered to be contingent is recorded as incurred and is notincluded in the straight-line basis rent expense. We do not receive significantsublease rentals under any of our existing operating leases.

 

Certainof our leases contain renewal options, which range from additional rentalperiods of one to five years. Escalation clauses are also included in certainof our leases. There are no significant restrictions imposed by our leaseagreements concerning such issues as dividend payments, incurrence of additionaldebt or further leasing.

 

Asof December 31, 2005, we had the following rental commitments undernoncancelable operating leases (in thousands):

 
| For the year ending December 31, |   |   |   |
|---------------------------------------|--------|--------|--------|
| 2006                                  |   | $      | 6,407  |   |
| 2007                                  |   | 5,959  |   |
| 2008                                  |   | 5,091  |   |
| 2009                                  |   | 4,561  |   |
| 2010                                  |   | 3,979  |   |
| Thereafter                            |   | 10,480 |   |
| Total                                 |   | $      | 36,477 |   |

 

The following schedule shows the composition of total rental expensefor all operating leases (in thousands):

 
| ** **             | ** ** | **Year Ended  December 31,** | ** ** |
|------------------------|------------|------------------------------|------------|
| ** **             | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Minimum rentals        |       | $                            | 8,051      |   | $ | 7,208 |   | $ | 9,738 |   |
| Contingent rentals     |       | 271                          |       | 201 |   | 179 |   |
| Less: sublease rentals |       | (293                         | )          | (330 | ) | (406 | ) |
| Total                  |       | $                            | 8,029      |   | $ | 7,079 |   | $ | 9,511 |   |

 

***401(k) Plan***

 

Wehave a defined contribution 401(k) plan. Our matching contribution currentlyrepresents 50% of a participant’s contribution, up to the first 6% of theparticipant’s salary. We recorded contribution expense of approximately $1.1million for the year ended December 31, 2005 and $1.2 million for each of theyears ended December 31, 2004 and 2003.

 

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***Legal Proceedings***

 

##### ***Lincoln County Detention Center***

##### ** **

In August 2005, a lawsuit was filed by a detainee atthe Lincoln County Detention Center (LCDC) in the U.S. District Court of NewMexico (Santa Fe). The lawsuit relates to the former LCDC policy that requiredstrip and visual body cavity searches for all detainees and inmates and allegesthat such policy violates a detainee’s Fourth and Fourteenth Amendment right. Thelawsuit was filed as a putative class action lawsuit brought on behalf of allinmates who were searched at the LCDC from May 2002 to July 2005. This lawsuit is in its early stages and nomaterial discovery has been conducted. At December 31, 2005, we recorded acharge of $0.2 million and have estimated our range of additional exposure tobe $0.3 million. We have adequate insurance coverage in the event our actualexposure exceeds our estimated exposure. In addition, in connection with ouracquisition of the LCDC facility, certain amounts were placed in escrow tooffset any undisclosed liability relating to such acquisition. We have givennotice to the prior owner of LCDC that we will seek to recover from the escrowany losses we may incur as a result of this litigation. The ultimate outcome ofthe lawsuit cannot be determined at this time and we intend to aggressivelydefend this lawsuit.

 

##### ***Southern Peaks Regional TreatmentCenter***

##### ** **

In January 2004, we initiated legal proceedingsin the lawsuit styled *Cornell Corrections ofCalifornia, Inc. v. Longboat Global Advisors, LLC, et al*.,No.2004 CV79761 in the Superior Court of Fulton County, Georgia under theoriesof fraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development andconstruction of the Southern Peaks Regional Treatment Center. Of the fundspreviously deposited, approximately $5.3 million remains to be recovered atDecember 31, 2005. In December 2004, the case was tried before ajury and the jury verdict awarded approximately $6.5 million in compensatorydamages and approximately $1.4 million in punitive damages, plus attorneys’fees. We expect that the actual damages awarded under the verdict will beadjusted downward to the $5.4 million actually lost by us and that the punitivedamages award may be adjusted downward because of a Georgia statute regardingcaps on punitive damages awards. No judgment has yet been entered on thisverdict. The award for compensatory damages accrues pre-judgment interest at arate of 7 percent from the date of loss through the date of judgment. Following the jury verdicts, we collectedapproximately $0.4 million in January 2005 in funds that had beenpreviously frozen under a temporary restraining order issued at the time thatwe commenced this litigation. Currently, certain of the defendants have filedmotions for a new trial. No judgment will be entered on the verdict until afterthese motions for a new trial have been heard and ruled on by the court. Due tothe continued uncertainty surrounding the ultimate recovery of the fundspreviously deposited, we will continue to maintain our existing reserve ofapproximately $5.0 million in an allowance for doubtful accounts.

 

###### ***Shareholder Lawsuits***

###### *** ***

In March and April 2002, Cornell, Steven W. Logan (our formerPresident and Chief Executive Officer), and John L. Hendrix (our former ChiefFinancial Officer), were named as defendants in four federal putative classaction lawsuits styled as follows: (1) *GraydonWilliams, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc, et al.*, No. H-02-0866, in the United StatesDistrict Court for the Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*,No. H-02-1075, in the United States District Court for the SouthernDistrict of Texas, Houston Division; (3) *LouisA. Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the UnitedStates District Court for the Southern District of Texas, Houston Division, and(4) *Anthony J. Scolaro, On Behalf ofHimself and All Others Similarly Situated v. Cornell Companies, Inc., etal.,* No. H-02-1567, in the United States District Court for theSouthern District of Texas, Houston Division. The aforementioned lawsuits wereputative class action lawsuits brought on behalf of all purchasers of ourcommon stock between March 6, 2001 and March 5, 2002 and relate toour restatement in 2002 of certain financial statements. The lawsuits involveddisclosures made concerning two prior transactions executed by us: theAugust 2001 sale leaseback transaction and the 2000 synthetic leasetransaction. These four lawsuits were consolidated into the *Graydon Williams* action and FlylinePartners, LP was appointed lead plaintiff. As a result, a consolidatedcomplaint was filed by Flyline Partners, LP. Richard Picard and Anthony Scolarowere also named as plaintiffs. Since then, the court allowed plaintiffs to filean amended consolidated complaint. The amended consolidated complaint allegesthat the defendants violated Section 10(b) of the Securities ExchangeAct of 1934 (the “Exchange Act”), Rule 10b-5 promulgated underSection 10(b) of the Exchange Act, Section 20(a) of theExchange Act, Section 11 of the Securities Act of 1933 (the “SecuritiesAct”) and/or Section 15 of the Securities Act. The amended consolidatedcomplaint seeks, among other things, restitution damages, compensatory damages,rescission or a rescissory measure of damages, costs, expenses, attorneys’ feesand expert fees. In February 2006, the court approved the settlement of thismatter. Under the settlement agreement, Cornell has not admitted any wrongdoing.Settlement in the amount

 

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of $7.0 million has been funded through our directors’ and officers’liability insurance. During the fourth quarter of 2005, we recorded thesettlement charge of $7.0 million and the related reimbursement of $7.0 millionfrom our director’s and officer’s liability insurance. The charge andreimbursement have been recognized in general and administrative expenses inour Consolidated Statements of Operations and Comprehensive Income (Loss) forthe year ended December 31, 2005. The liability is carried in accounts payableand accrued liabilities and the reimbursement is included in other receivablesat December 31, 2005. The reimbursement was funded by the insurance carrier in2005 into a trust account and funds were disbursed from the trust account toplaintiffs’ counsel’s escrow account upon court approval of the settlement inFebruary 2006.

 

In March 2002, Cornell, its directors, and its former independentauditor Arthur Andersen LLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of HarrisCounty, Texas. The lawsuit related to our restatement in 2002 of certainfinancial statements. The lawsuit alleged breaches of fiduciary duty by all ofthe individual defendants and asserted breach of contract and professionalnegligence claims only against Arthur Andersen LLP. This lawsuit has beendismissed without prejudice by agreement. In January 2004, we received aletter from William Williams, the plaintiff in the *William Williams* action discussed above, demanding that wepursue breach of fiduciary duty claims against various officers and directorsbased on the August 2001 sale leaseback transaction and the subsequentrestatement. We have issued a preliminary response to the letter indicatingthat the Board will consider the request and inform Mr. Williams of itsdecision. In May and September 2002, the Company and our thendirectors were sued in three other derivative lawsuits styled as follows:(1) *Juan Guitierrez, Derivatively onBehalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,*No. 2002-28924, in the 164th Judicial District Court of HarrisCounty, Texas. These lawsuits relate to our restatement in 2002 of certainfinancial statements. These lawsuits all allege breaches of fiduciary duty andwaste of corporate assets by all of the defendants. A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano* action as duplicative of the *Guitierrez* action. The court granted themotion to dismiss the *Guitierrez*action and the plaintiffs have appealed that ruling. The *Menning* action has been dismissed, butwith an agreement that the plaintiff’s claims as to Cornell are tolled until 30days following the final resolution of the *Guitierrez*case, including any appeals. The plaintiffs in these cases have not quantifiedtheir claim of damages and the outcome of the matters discussed above cannot bepredicted with certainty. However, our management believes that we have gooddefenses and intends to vigorously defend against the claims asserted in theseactions. We have not recorded any loss accruals related to these claims.

 

Certain insurance policies held by us tocover potential director and officer liability may limit our cash outflows inthe event of a decision adverse to us in the matters discussed above. However,if an adverse decision in these matters exceeds the insurance coverage or ifthe insurance coverage is deemed not to apply to these matters, an adversedecision to us in these matters could have a material adverse effect on us, ourfinancial condition, results of operations and cash flows.

 

***Other***

 

Additionally, we currently and from time to time are subject to claimsand suits arising in the ordinary course of business, including claims fordamages for personal injuries or for wrongful restriction of or interferencewith offender privileges and employment matters. If an adverse decision inthese matters exceeds our insurance coverage, or if our coverage is deemed notto apply to these matters, or if the underlying insurance carrier was unable tofulfill its obligation under the insurance coverage provided, it could have amaterial adverse effect on our financial condition, results of operations orcash flows.

 

During the period of August 2000 through May 2003, ourgeneral liability and professional liability coverage was provided by SpecialtySurplus Insurance Company, a Kemper Insurance Company (“Kemper”) group member. InJune 2004, the Illinois Department of Insurance gave Kemper permission toproceed with a run-off plan it had previously submitted. The three-year plan isdesigned to help Kemper meet its goal of resolving, to the maximum extentpossible, all valid policyholder claims. In view of the risks and uncertaintiesinvolved in implementing the plan, including the need to achieve significantpolicy buybacks, commutation of reinsurance agreements, and further agreementswith regulators, no assurance can be given that the plan will be successfullyimplemented by Kemper. In the year ended December 31, 2004, we accrued aprovision of $0.6 million, and estimated our range of additional exposure to beapproximately $0.5 million with respect to outstanding claims incurred duringthis policy period with Kemper which would become our obligation to resolve ifnot settled through Kemper.

 

During the year ended December 31, 2005, Kemper continued to implementits run-off plan. As a result, several of our significant claims were settledby Kemper in the second quarter of 2005. In conjunction with these settlements,we recorded a charge against our existing accrual in the amount of $0.3 million.We believe that the uncertainty surrounding the ability of

 

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Kemper to settle our remaining outstanding claims still exists. Basedon our analysis of the claims activity during the third quarter of 2005, wefelt it necessary to accrue an additional provision in the amount of approximately$0.2 million during the third quarter of 2005. At December 31, 2005, we believeour estimated range of exposure, above our existing $0.5 million accrual, to beapproximately $0.1 million related to the outstanding claims which could becomeour obligation to resolve if not settled through Kemper.

 

While the outcome of such matters cannot be predicated with certainty,based on the information known to date, we believe that the ultimate resolutionof these matters will not have a material adverse effect on our financialcondition, operating results or cash flows.

 

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** **

**12.  STOCKHOLDERS’EQUITY**

 

***Stockholder Rights Plan***

 

Our Board of Directors terminated Cornell’s stockholder rights plan inJuly 2005.

 

***Preferred Stock***

 

Preferredstock may be issued from time to time by our Board of Directors, which isresponsible for determining the voting, dividend, redemption, conversion andliquidation features of any preferred stock.

 

***Options***

 

Underour 2000 Broad-Based Employee Plan (2000 Plan) we may grant non-qualified stockoptions to our employees, directors and eligible consultants for up to thegreater of 400,000 shares or 4% of the aggregate number of shares of commonstock issued and outstanding immediately after grant of any option under the2000 Plan. The 2000 Plan options vest up to five years and expire ten yearsfrom the grant date. Under our 1996 Stock Option Plan, as amended and restatedin April 1998 (1996 Plan) we may grant non-qualified and incentive stockoptions for up to the greater of 1,932,119 shares or 15.0% of the aggregatenumber of shares of common stock outstanding. The 1996 Plan options vest up toseven years and expire seven to ten years from the grant date. The CompensationCommittee of the Board of Directors, which is comprised of independentdirectors, is responsible for determining the exercise price and vesting termsfor the granted options. The 1996 Plan and 2000 Plan option exercise prices canbe no less than the market price of our common stock on the date of grant.

 

Inconjunction with the issuance of our Subordinated Notes in July 2000, weissued warrants to purchase 290,370 shares of the common stock at an exerciseprice of $6.70. We recognized the fair value of these warrants of $1.1 millionas additional paid-in capital. The warrants may only be exercised by payment ofthe exercise price in cash to us, by cancellation of an amount of warrantsequal to the fair market value of the exercise price, or by the cancellation ofour indebtedness owed to the warrant holder. During 2001, 168,292 shares of ourcommon stock were issued in conjunction with the exercise and cancellation of217,778 warrants. At December 31, 2005 and 2004, 72,592 warrants remainedoutstanding.

 

Thefollowing is a summary of the status of our 2000 Plan, 1996 Plan and otheroptions at December 31, 2005, 2004 and 2003, and changes during the yearsthen ended:

 
| ** **                                      | ** ** | **2005**   | ** ** | **2004**                               | ** ** | **2003**   | ** ** |
|-------------------------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| ** **                                      | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                            |       |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Outstanding at beginning of year                |       | 976,947    |       | $                                      | 10.72      |       | 1,131,964  |   | $ | 9.55 |   | 1,409,845 |   | $ | 9.20 |   |
| Granted                                         |       | 311,550    |       | 13.67                                  |       | 167,150    |       | 13.46 |   | 215,475 |   | 10.02 |   |
| Exercised                                       |       | (399,090   | )          | 9.50                                   |       | (196,852   | )          | 7.16 |   | (327,695 | ) | 6.50 |   |
| Forfeited or canceled                           |       | (191,701   | )          | 12.62                                  |       | (125,315   | )          | 10.12 |   | (165,661 | ) | 12.63 |   |
| Outstanding at end of year                      |       | 697,706    |       | 12.21                                  |       | 976,947    |       | 10.72 |   | 1,131,964 |   | 9.55 |   |
|                                            |       |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Exercisable at end of year                      |       | 354,397    |       | 11.26                                  |       | 514,165    |       | 10.31 |   | 615,701 |   | 9.55 |   |
|                                            |       |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Weighted average fair value of options  granted |       |       |       | $                                      | 8.03       |       |       |   | $ | 7.94 |   |   |   | $ | 6.02 |   |

 

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Thefollowing table summarizes information about our outstanding stock options atDecember 31, 2005:

 
| **Range of Exercise Prices**                    | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|------------------------------------------------|------------|----------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
|                                            |       |                    |       |                                           |       |                                   |       |                    |       |                                   |       |
| $3.75  to  $6.50            |       | 36,360                  |       | 4.9                                            |       | $                                      | 4.08       |                    | 36,360     |                                   | $          | 4.08 |   |
|   6.51  to  10.00 |       | 60,946                  |       | 6.3                                            |       | 8.55                                   |       | 54,277                  |       | 8.56                                   |       |
| 10.01  to  13.50            |       | 321,300                 |       | 7.1                                            |       | 11.98                                  |       | 144,410                 |       | 11.06                                  |       |
| 13.51  to  16.00            |       | 279,100                 |       | 7.9                                            |       | 14.34                                  |       | 119,350                 |       | 14.92                                  |       |
|                                            |       | 697,706                 |       | 7.2                                            |       | 12.21                                  |       | 354,397                 |       | 11.26                                  |       |
|                                                 |            |                         |            |                                                |            |                                        |            |                         |            |                                        |            |  |  |

 

Forpurposes of the pro forma disclosures in Note 2, under SFAS No. 123, the fairvalue of each option grant was estimated on the date of grant using theBlack-Scholes option pricing model. The following weighted average assumptionswere used for grants in 2005, 2004 and 2003, respectively:  risk-free interest rates of 4.28%, 4.33% and3.60%; dividend rates of $0, $0 and $0; expected lives of 7.0, 7.0 and 7.0years; expected volatility of 52.99%, 52.89% and 56.43%.

 

The Black-Scholes option pricing model and other existing models weredeveloped for use in estimating the fair value of traded options that have novesting restrictions and are fully transferable. In addition, option valuationmodels require the input of, and are highly sensitive to, subjective assumptionsincluding the expected stock price volatility. Our employee stock options havecharacteristics significantly different from those of traded options, andchanges in the subjective input assumptions can materially affect the fairvalue estimate.

 

***Treasury Stock***

 

Wedid not repurchase any of our common stock in the year ended December 31, 2005.During the year ended December 31, 2004, we repurchased in the open market10,000 shares of our common stock under a share repurchase program at anaggregate cost of $0.1 million. Under the terms of our Senior Notes and 2004Credit Facility, we can purchase shares of our stock subject to certaincumulative restrictions.

 

***Employee Stock Purchase Plan***

 

Wehave an employee stock purchase plan under which employees can makecontributions to purchase our common stock. Participation in the plan iselected annually by employees. The plan year begins each January 1st(the “Grant Date”) and ends on December 31st (the “Exercise Date”). Purchasesof common stock are made at the end of the year using the lower of the fairmarket value on either the Grant Date or Exercise Date, less a 15.0% discount. Forthe years ended December 31, 2005, 2004 and 2003, employee contributionsof approximately $0.4 million, $0.3 million and $0.4 million were used topurchase 30,553, 40,213 and 46,486 shares, respectively, of our common stock.

 

***Deferred Bonus Plan***

 

Wehave a deferred bonus plan for certain employees. Pursuant to the plan,approximately $4.7 million was deposited on behalf of individual participantsinto a rabbi trust account, which included approximately $3.6 million in cashand $1.1 million in our treasury stock. The treasury stock portion of the rabbitrust is to remain as treasury stock, while the participants may give investmentdirections to the trustee as to the cash portion, subject to certainlimitations. The investments of the rabbi trust represent our assets and areincluded in our accompanying Consolidated Balance Sheets based on the nature ofthe assets held. Assets placed into the rabbi trust are irrevocable; therefore,they are restricted as to our use under the terms of the trust and the deferredbonus plan. Amounts held in the rabbi trust are generally distributable uponvesting. At December 31, 2004, restricted assets and other current assetsincluded approximately $0.1 million of deposits in a rabbi trust. The assetsheld in this rabbi trust were minimal at December 31, 2005.

 

Theplan generally vests 100.0% upon the achievement of an aggregate amount ofmonthly credits (based on a fixed monthly earnings milestone) expected to occurat the end of five years beginning October 1, 2001. Vesting willaccelerate to 60.0% at the end of three years if certain earnings targets areachieved. Based on the expected earnings period, compensation expense and therelated compensation liability for the aggregate plan value are beingrecognized over five years. To the extent the vesting is extended oraccelerated based on the achievement of the financial milestones, recognitionof compensation expense will be adjusted on a prospective basis. In the eventof a change of control (as defined in the plan), the amounts in each

 

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participantsaccount will be paid to the participant in a lump sum. For the years endedDecember 31, 2005, 2004 and 2003, we expensed approximately $0.4 million,$0.07 million and $0.05 million, respectively, under the deferred bonus plan.

 

Whileperiodic gains on the value of each participant’s investments held in the rabbitrust are recorded currently in income, an equal amount of compensation expenseand related compensation liability is recorded, since participants are fullyvested in such gains. Periodic losses incurred by participants in theirinvested balances are recorded as incurred. Such losses in excess of aparticipant’s recorded compensation expense are guaranteed by the participantswith a full-recourse obligation to us. These guarantees function to offset theloss on investments to the extent the obligations are not reserved forcollectibility by us.

 

Amountsheld in treasury stock have been recorded at cost. An equal amount has beenestablished as deferred compensation and additional paid-in capital in ourConsolidated Statements of Stockholders’ Equity. The balance in the deferredbonus plan is amortized to compensation expense over the expected vestingperiod of five years.

 

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** **

**13.  DERIVATIVEFINANCIAL INSTRUMENTS AND GUARANTEES**

 

***Debt Service Reserve Fund and DebtService Fund***

 

InAugust 2001, MCF completed a bond offering to finance the 2001 Sale andLeaseback Transaction. In connection with this bond offering, two reserve fundaccounts were established by MCF pursuant to the terms of the indenture: (1)MCF’s Debt Service Reserve Fund, aggregating $23.8 million at December 31,2005, was established to make payments on MCF’s outstanding bonds in the eventwe (as lessee) should fail to make the scheduled rental payments to MCF and (2)MCF’s Debt Service Fund, aggregating $19.6 million at December 31, 2005,used to accumulate the monthly lease payments that MCF receives from us untilsuch funds are used to pay MCF’s semi-annual bond interest and annual bondprincipal payments. Both reserve fund accounts are subject to the agreementswith the MCF Equity Investors whereby guaranteed rates of return of 3.0% and5.08%, respectively, are provided for in the balance of the Debt ServiceReserve Fund and the Debt Service Fund. The guaranteed rates of return are characterizedas cash flow hedge derivative instruments. At inception, the derivatives had anaggregate fair value of $4.0 million, which has been recorded as a decrease tothe equity investment in MCF made by the MCF Equity Investors (MCF minorityinterest) and as a liability in our Consolidated Balance Sheets. Changes in thefair value of the derivative instruments are recorded as an adjustment to otherlong-term liabilities and reported as other comprehensive income (loss) in ourConsolidated Statements of Operations and Comprehensive Income (Loss). AtDecember 31, 2005, the fair value of these derivative instruments wasapproximately $3.0 million. As a result, our Consolidated Statements ofOperations and Comprehensive Income (Loss) include accumulated othercomprehensive income (loss) of approximately $(1.1) million, $0.2 million and($0.4) million for the years ended December 31, 2005, 2004 and 2003,respectively. The $(1.1) million net unrealized loss reported in comprehensiveincome (loss) for the year ended December 31, 2005 includes an adjustment of$0.6 million for the cumulative tax effect of changes in fair value during theyears ended December 31, 2002 and 2003. This adjustment decreased accumulatedother comprehensive income and increased deferred tax liabilities in ourConsolidated Balance Sheet as of December 31, 2005.

 

Inconnection with MCF’s bond offering, the MCF Equity Investor provided aguarantee of the Debt Service Reserve Fund if a bankruptcy of the Company wereto occur and a trustee for the estate of the Company were to include the DebtService Reserve Fund as an asset of the Company’s estate. This guarantee ischaracterized as an insurance contract and its fair value is being amortized toexpense over the life of the debt.

 

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**14.  PROJECTS UNDERDEVELOPMENT, CONSTRUCTION OR RENOVATION**

 

Weclosed the New Morgan Academy in 2002 and have considered severaloptions ranging from the utilization of the facility for another type ofprogram or the sale or lease of the facility. As of December 31, 2005, weare focusing our efforts on the reopening of the facility by the fourth quarterof 2006. Once opened, the facility will operate as a residential treatmentfacility for youth sex offenders. We are currently maintaining a small staff to secure andmaintain the facility during the finalization of the reactivation plans. Wehave recognized pre-tax costs of $3.6 million and $13.5 million (including animpairment charge of $9.3 million discussed below) in our ConsolidatedStatements of Operations and Comprehensive Income (Loss) for the years endedDecember 31, 2005 and 2004, respectively, for related holding costs(depreciation, interest, property, taxes and other maintenance costs).

 

AtDecember 31, 2004, as a result of our analysis pursuant to the provisionsof SFAS No. 144, we determined that the carrying amount of the New MorganAcademy was not fully recoverable and exceeded its fair value (as based oncurrent estimates of future cash flows). The developing inability during late2004 of various governmental agencies with whom we had been in negotiations toobtain the level of funding to contract with us for the use of the New MorganAcademy indicated an expectation of continuing losses associated with thisfacility. As a result, we recorded an impairment charge of $9.3 million,pursuant to the provisions of SFAS No. 144, in our Consolidated Statements ofOperations and Comprehensive Income (Loss) for the year ended December 31,2004. As of December 31, 2005, we believe that, pursuant to the provisions ofSFAS No. 144, no additional impairment allowance is necessary. The carryingvalue of the property and equipment for the New Morgan Academy, after theimpairment charge, was approximately $19.9 million and $20.4 million atDecember 31, 2005 and 2004, respectively.

 

In March 2003, we reached an agreementwith the Commonwealth of Pennsylvania that resolved all outstandingadministrative issues relative to the contract awarded to us by the BOP tooperate the Moshannon Valley Correctional Center. In October 2004, wereceived the signed Finding of No Significant Impact for the facility. We havea three-year contract with the BOP to operate the facility and the BOP has theoption to grant seven one-year extensions. The facility, which can house 1,300male federal inmates, is scheduled to begin operations in early 2006.

 

InSeptember 2004, we resolved our claim with the BOP for the reimbursementof a portion of the expenses we incurred in connection with the issuance of theStop-Work Order and the delay of the project (included among these expenses wasapproximately $1.4 million in accounts receivable for expenses incurred by usafter the September 1999 issuance of the Stop–Work Order). We settled theclaim, as well as the claim for the reimbursement of costs related to theoriginal construction efforts incurred beginning in 1999, with the BOP and werereimbursed approximately $7.0 million in September 2004. The excessreimbursement of approximately $5.6 million over the $1.4 million in accountsreceivable was credited against the carrying cost of the facility.

 

As of December 31, 2005, we had incurred (net of the BOPreimbursement) approximately $63.8 million for the design, construction anddevelopment costs and capitalized interest related to the Moshannon ValleyCorrectional Center facility. We estimate an additional capital investment(excluding furniture and equipment) of approximately $5.9 million is requiredto complete construction of the facility. We believe that our existing cash andcredit facilities will provide adequate funding to complete the construction ofthe facility.

 

In December 2005, we entered into a five year agreement with theCalifornia Department of Corrections to operate the Mesa Verde CorrectionalFacility, which is leased. The facility commenced operations in early 2006 andcan house up to 360 male California inmates.

 

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**15.  RELATED PARTYTRANSACTIONS**

 

Oneof our former directors is a partner in a law firm that provides legal servicesto us. Legal fees paid to this law firm were approximately $0.9 million for theyear ended December 31, 2005.

 

InSeptember 1999, we entered into a consulting agreement with the Company’sfounder, who was a director of the Company through October 2003. Servicesrendered under the consulting agreement included serving as a director of theCompany over the initial four years of the term of the agreement, and assistingin such areas as the development of new business, acquisitions, financings andexecutive management assimilation. As compensation for consulting services, weagreed to an annual payment of at least $255,000 for each of the first fouryears of the seven-year initial term of the consulting agreement with an annualsalary of at least $180,000 for each of the last three years of the seven-yearinitial term of the consulting agreement. We have an option to renew theconsulting agreement for an additional three-year term at an annual salary ofat least $300,000 for each of the three years of the renewal term. Asadditional compensation, we agreed to an annual bonus, subject to certainlimitations, equal to $75,000 during the first four years of the seven-yearinitial term and an annual bonus of $60,000 during the last three years of theseven-year initial term and during any renewal term.

 

Wealso entered into a non-compete agreement with the Company’s founder. Thenon-compete agreement has a term of 10 years and requires us to pay a monthlyfee of $10,000 for the seven-year initial term of the consulting agreement. Wecapitalize the monthly payments and amortize the amounts over the 10-year termof the consulting agreement. We recognized amortization expense related to thisagreement of approximately $84,000 for the year ended December 31, 2005.

 

Wemaintain a life insurance policy for the Company’s founder and made paymentsrelated to this policy of approximately $0.2 million for the year endedDecember 31, 2005.

 

Totalpayments made for the above consulting and non-compete agreements, board ofdirector fees and expense reimbursements for the Company’s founder wereapproximately $0.9 million for the year ended December 31, 2005.

 

Weentered into a consulting agreement with a former director for a term whichexpires in December 2008. Services rendered under this agreement includeresearch and analysis for various topics including data collection, support andtraining for program development; performance-based contractual requirementsand performance-improvement processes, accreditations and regulatoryrequirements. Total payments under this agreement, which has a termination feeincorporated for a termination prior to maturity, totaled $0.3 million in 2005.The termination fee at December 2005 was $0.3 million.

 

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**16.  SEGMENT DISCLOSURE**

 

Ourthree operating divisions are our reportable segments. The adult secureinstitutional services segment consists of the operations of secure adultincarceration facilities. The juvenile segment consists of providingresidential treatment and educational programs and non-residentialcommunity-based programs to juveniles between the ages of ten and 17 who haveeither been adjudicated or suffer from behavioral problems. The adult community-basedcorrections and treatment services segment consists of providing pre-releaseand halfway house programs for adult offenders who are either on probation orserving the last three to six-months of their sentences on parole and preparingfor re-entry into society at large as well as community-based treatment andeducation programs as an alternative to incarceration. All of our customers andlong-lived assets are located in the United States of America. The accountingpolicies of our reportable segments are the same as those described in thesummary of significant accounting policies in Note 2 to the ConsolidatedFinancial Statements. Intangible assets are not included in each segment’sreportable assets, and the amortization of intangible assets is not included inthe determination of a segment’s operating income. We evaluate performancebased on income or loss from operations before general and administrativeexpenses, incentive bonuses, amortization of intangibles, interest and incometaxes. Corporate and other assets are comprised primarily of cash, investmentsecurities available for sale, accounts receivable, debt service fund,deposits, property and equipment, deferred taxes, deferred costs and otherassets. Corporate and other expense from operations primarily consists ofdepreciation and amortization on the corporate office facilities and equipment,and is presented separately as such charges cannot be readily identified forallocation to a particular segment.

 

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The only significant non-cash items reported in the respective segments’income from operations is depreciation and amortization (excluding intangibles)and impairment of long-lived assets (in thousands).

 
| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                         | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                               |       |                             |       |   |   |   |   |
| Revenue:                                           |       |                             |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | 131,684    |   | $ | 114,819 |   | $ | 102,120 |   |
| Juvenile                                           |       | 119,006                          |       | 113,821 |   | 106,541 |   |
| Adult community-based                              |       | 60,085                           |       | 48,550 |   | 49,519 |   |
| Total revenue                                      |       | $                                | 310,775    |   | $ | 277,190 |   | $ | 258,180 |   |
|                                               |       |                             |       |   |   |   |   |
| Pre-opening and start-up expenses:                 |       |                             |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | 7,213      |   | $ | 4,971 |   | $ | 321 |   |
| Juvenile                                           |       | 1,804                            |       | 3,790 |   | 834 |   |
| Adult community-based                              |       | 3⁄4                           |       | 42 |   | — |   |
| Total pre-opening and start-up expenses            |       | $                                | 9,017      |   | $ | 8,803 |   | $ | 1,155 |   |
|                                               |       |                             |       |   |   |   |   |
| Impairment of long-lived assets:                   |       |                             |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | —     |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | —                           |       | 9,300 |   | — |   |
| Adult community-based                              |       | —                           |       | — |   | — |   |
| Total impairment of long-lived assets              |       | $                                | —     |   | $ | 9,300 |   | $ | — |   |
|                                               |       |                             |       |   |   |   |   |
| Depreciation and amortization:                     |       |                             |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | 6,327      |   | $ | 4,967 |   | $ | 3,868 |   |
| Juvenile                                           |       | 3,299                            |       | 3,276 |   | 2,620 |   |
| Adult community-based                              |       | 2,095                            |       | 1,788 |   | 1,512 |   |
| Amortization of intangibles                        |       | 2,094                            |       | 1,365 |   | 895 |   |
| Corporate and other                                |       | 1,385                            |       | 1,791 |   | 1,700 |   |
| Total depreciation and amortization                |       | $                                | 15,200     |   | $ | 13,187 |   | $ | 10,595 |   |
|                                               |       |                             |       |   |   |   |   |
| Income from operations:                            |       |                             |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | 26,645     |   | $ | 24,911 |   | $ | 25,647 |   |
| Juvenile                                           |       | 13,672                           |       | 3,811 |   | 14,221 |   |
| Adult community-based                              |       | 11,415                           |       | 9,177 |   | 10,626 |   |
| Subtotal                                           |       | 51,732                           |       | 37,899 |   | 50,494 |   |
| General and administrative expenses                |       | (20,387                          | )          | (20,284 | ) | (23,415 | ) |
| Amortization of intangibles                        |       | (2,094                           | )          | (1,364 | ) | (895 | ) |
| Corporate and other                                |       | (1,385                           | )          | (1,792 | ) | (1,700 | ) |
| Total income from operations                       |       | $                                | 27,866     |   | $ | 14,459 |   | $ | 24,484 |   |
|                                               |       |                             |       |   |   |   |   |
| Loss on discontinued operations, net of tax        |       |                             |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | —     |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | (3,560                           | )          | (2,856 | ) | (225 | ) |
| Adult community-based                              |       | (62                              | )          | 423 |   | 167 |   |
| Total loss on discontinued operations, net  of tax |       | $                                | (3,622     | ) | $ | (2,433 | ) | $ | (58 | ) |
|                                               |       |                             |       |   |   |   |   |
| Capital expenditures:                              |       |                             |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | 48,558     |   | $ | 17,456 |   | $ | 5,742 |   |
| Juvenile                                           |       | 473                              |       | 14,790 |   | 11,176 |   |
| Adult community-based                              |       | 1,358                            |       | 6,703 |   | 2,173 |   |
| Corporate and other                                |       | 739                              |       | 1,294 |   | 3,213 |   |
| Total assets                                       |       | $                                | 51,128     |   | $ | 40,243 |   | $ | 22,304 |   |
|                                               |       |                             |       |   |   |   |   |
| Assets:                                            |       |                             |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | 213,107    |   | $ | 172,793 |   | $ | 152,229 |   |
| Juvenile                                           |       | 106,457                          |       | 123,890 |   | 110,748 |   |
| Adult community-based                              |       | 67,298                           |       | 62,984 |   | 57,787 |   |
| Intangible assets, net                             |       | 21,666                           |       | 14,747 |   | 13,287 |   |
| Corporate and other                                |       | 102,100                          |       | 133,217 |   | 115,052 |   |
| Total assets                                       |       | $                                | 510,628    |   | $ | 507,631 |   | $ | 449,103 |   |

 

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**17.  GUARANTOR DISCLOSURES**

 

We completed an offering of $112.0million of Senior Notes in June 2004. The Senior Notes are guaranteed byeach of our subsidiaries (Guarantor Subsidiaries). MCF does not guarantee theSenior Notes (Non-Guarantor Subsidiary). These guarantees are joint and severalobligations of the Guarantor Subsidiaries. The following condensedconsolidating financial information presents the financial condition, resultsof operations and cash flows for the parent company, the Guarantor Subsidiariesand the Non-Guarantor Subsidiary, together with the consolidating adjustmentsnecessary to present our results on a consolidated basis.

 

# **Condensed Consolidating Balance Sheet as of December 31, 2005 (inthousands)**

# ** **

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                       |       |       |       |                        |       |                            |       |             |       |             |       |
| Current assets:                                  |       |       |       |                        |       |                            |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 12,579     |                        | $          | 1,114                           |       | $                | 30         |             | $          | — |   | $ | 13,723 |   |
| Investment securities                            |       | 7,250      |       | 3⁄4                      |       | 3⁄4                          |       | 3⁄4           |       | 7,250            |       |
| Accounts receivable                              |       | 7,718      |       | 60,337                      |       | 372                             |       | 3⁄4           |       | 68,427           |       |
| Restricted assets                                |       | 3⁄4     |       | 2,633                       |       | 19,586                          |       | 3⁄4           |       | 22,219           |       |
| Prepaids and other                               |       | 11,828     |       | 2,337                       |       | 3⁄4                          |       | 3⁄4           |       | 14,165           |       |
| Total current assets                             |       | 39,375     |       | 66,421                      |       | 19,988                          |       | 3⁄4           |       | 125,784          |       |
| Property and equipment,  net                     |       | 148        |       | 174,886                     |       | 154,641                         |       | (5,814           | )          | 323,861          |       |
| Other assets:                                    |       |       |       |                        |       |                            |       |             |       |             |       |
| Debt service reserve  fund                       |       | 3⁄4     |       | 3⁄4                      |       | 23,802                          |       | 3⁄4           |       | 23,802           |       |
| Deferred costs and  other                        |       | 41,926     |       | 23,861                      |       | 8,772                           |       | (37,378          | )          | 37,181           |       |
| Investment in  subsidiaries                      |       | 14,602     |       | 3,806                       |       | 3⁄4                          |       | (18,408          | )          | 3⁄4           |       |
| Total assets                                     |       | $          | 96,051     |                        | $          | 268,974                         |       | $                | 207,203    |             | $          | (61,600 | ) | $ | 510,628 |   |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| **Liabilities and Stockholders’ Equity**    |       |       |       |                        |       |                            |       |             |       |             |       |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| Current liabilities:                             |       |       |       |                        |       |                            |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 43,561     |                        | $          | 11,920                          |       | $                | 5,879      |             | $          | (2,563 | ) | $ | 58,797 |   |
| Current portion of  long-term debt               |       | 3⁄4     |       | 1                           |       | 9,700                           |       | 3⁄4           |       | 9,701            |       |
| Total current  liabilities                       |       | 43,561     |       | 11,921                      |       | 15,579                          |       | (2,563           | )          | 68,498           |       |
| Long-term debt, net of  current portion          |       | 110,659    |       | 3⁄4                      |       | 156,000                         |       | 3⁄4           |       | 266,659          |       |
| Deferred tax  liabilities                        |       | 8,076      |       | (1,763                      | )          | 3⁄4                          |       | 395              |       | 6,708            |       |
| Other long-term  liabilities                     |       | 5,490      |       | 108                         |       | 35,640                          |       | (37,936          | )          | 3,302            |       |
| Intercompany                                     |       | (237,196   | )          | 237,196                     |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Total liabilities                                |       | (69,410    | )          | 247,462                     |       | 207,219                         |       | (40,104          | )          | 345,167          |       |
| Stockholders’ equity                        |       | 165,461    |       | 21,512                      |       | (16                             | )          | (21,496          | )          | 165,461          |       |
| Total liabilities and  stockholders’ equity |       | $          | 96,051     |                        | $          | 268,974                         |       | $                | 207,203    |             | $          | (61,600 | ) | $ | 510,628 |   |

 

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# **Condensed Consolidating Balance Sheet as of December 31, 2004 (in thousands)**

# ** **

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                       |       |       |       |                        |       |                            |       |             |       |             |       |
| Current assets:                                  |       |       |       |                        |       |                            |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 9,559      |                        | $          | 296                             |       | $                | 40         |             | $          | — |   | $ | 9,895 |   |
| Investment securities                            |       | 51,740     |       | —                      |       | —                          |       | —           |       | 51,740           |       |
| Accounts receivable                              |       | 3,298      |       | 61,189                      |       | 378                             |       | 3⁄4           |       | 64,865           |       |
| Restricted assets                                |       | 121        |       | 2,451                       |       | 17,141                          |       | 3⁄4           |       | 19,713           |       |
| Prepaids and other                               |       | 15,664     |       | 1,962                       |       | 3⁄4                          |       | 3⁄4           |       | 17,626           |       |
| Total current assets                             |       | 80,382     |       | 65,898                      |       | 17,559                          |       | 3⁄4           |       | 163,839          |       |
| Property and equipment,  net                     |       | 672        |       | 128,965                     |       | 158,863                         |       | (6,245           | )          | 282,255          |       |
| Other assets                                     |       |       |       |                        |       |                            |       |             |       |             |       |
| Debt service reserve  fund                       |       | 3⁄4     |       | 3⁄4                      |       | 23,801                          |       | 3⁄4           |       | 23,801           |       |
| Deferred costs and  other                        |       | 39,392     |       | 19,225                      |       | 9,362                           |       | (30,243          | )          | 37,736           |       |
| Investment in subsidiaries                       |       | 20,613     |       | 1,856                       |       | 3⁄4                          |       | (22,469          | )          | 3⁄4           |       |
| Total assets                                     |       | $          | 141,059    |                        | $          | 215,944                         |       | $                | 209,585    |             | $          | (58,957 | ) | $ | 507,631 |   |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| **Liabilities and Stockholders’ Equity**    |       |       |       |                        |       |                            |       |             |       |             |       |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| Current liabilities:                             |       |       |       |                        |       |                            |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 36,191     |                        | $          | 7,369                           |       | $                | 6,197      |             | $          | (2,520 | ) | $ | 47,237 |   |
| Current portion of  long-term debt               |       | 3⁄4     |       | 5                           |       | 9,000                           |       | 3⁄4           |       | 9,005            |       |
| Total current  liabilities                       |       | 36,191     |       | 7,374                       |       | 15,197                          |       | (2,520           | )          | 56,242           |       |
| Long-term debt, net of  current portion          |       | 113,827    |       | 1                           |       | 165,700                         |       | 3⁄4           |       | 279,528          |       |
| Deferred tax  liabilities                        |       | 7,966      |       | 3⁄4                      |       | 3⁄4                          |       | 122              |       | 8,088            |       |
| Other long-term  liabilities                     |       | 5,846      |       | 80                          |       | 28,546                          |       | (32,011          | )          | 2,461            |       |
| Intercompany                                     |       | (184,083   | )          | 184,083                     |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Total liabilities                                |       | (20,253    | )          | 191,538                     |       | 209,443                         |       | (34,409          | )          | 346,319          |       |
| Stockholders’ equity                        |       | 161,312    |       | 24,406                      |       | 142                             |       | (24,548          | )          | 161,312          |       |
| Total liabilities and  stockholders’ equity |       | $          | 141,059    |                        | $          | 215,944                         |       | $                | 209,585    |             | $          | (58,957 | ) | $ | 507,631 |   |

 

85

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# **Condensed Consolidating Statement of Operations for the year endedDecember 31, 2005 (in thousands)**

# ** **

| ** **                                                    | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                          |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                      |       | $          | 18,014     |                        | $          | 349,497                         |       | $                | 18,008     |             | $          | (74,744 | ) | $ | 310,775 |   |
| Operating expenses                                            |       | 16,794     |       | 295,860                     |       | 56                              |       | (74,405          | )          | 238,305          |       |
| Pre-opening and  start-up expenses                            |       | 3⁄4     |       | 9,017                       |       | 3⁄4                          |       | 3⁄4           |       | 9,017            |       |
| Depreciation and  amortization                                |       | 3⁄4     |       | 11,409                      |       | 4,222                           |       | (431             | )          | 15,200           |       |
| General and  administrative expenses                          |       | 20,312     |       | 3⁄4                      |       | 75                              |       | 3⁄4           |       | 20,387           |       |
| Income (loss) from  operations                                |       | (19,092    | )          | 33,211                      |       | 13,655                          |       | 92               |       | 27,866           |       |
| Overhead allocations                                          |       | (27,920    | )          | 27,920                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                 |       | 2,771      |       | 5,089                       |       | 13,814                          |       | 49               |       | 21,723           |       |
| Equity earnings in  subsidiaries                              |       | (3,491     | )          | 3⁄4                      |       | 3⁄4                          |       | 3,491            |       | 3⁄4           |       |
| Income (loss) before  provision for income taxes              |       | 2,566      |       | 202                         |       | (159                            | )          | 3,534            |       | 6,143            |       |
| Provision for income  taxes                                   |       | 2,260      |       | 3⁄4                      |       | 3⁄4                          |       | (45              | )          | 2,215            |       |
| Income (loss) from  continuing operations                     |       | 306        |       | 202                         |       | (159                            | )          | 3,579            |       | 3,928            |       |
| Discontinued  operations, net of income tax benefit of $1,950 |       | 3⁄4     |       | (3,622                      | )          | 3⁄4                          |       | 3⁄4           |       | (3,622           | )          |
| Net income (loss)                                             |       | $          | 306        |                        | $          | (3,420                          | )          | $                | (159       | )                | $          | 3,579 |   | $ | 306 |   |

 

86

----

# ** **

# **Condensed Consolidating Statement of Operations for the year endedDecember 31, 2004**(in thousands)

# ** **

| ** **                                                    | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                          |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                      |       | $          | 18,272     |                        | $          | 312,924                         |       | $                | 18,008     |             | $          | (72,014 | ) | $ | 277,190 |   |
| Operating expenses                                            |       | 24,480     |       | 257,774                     |       | 52                              |       | (71,149          | )          | 211,157          |       |
| Pre-opening and  start-up expenses                            |       | 3⁄4     |       | 8,803                       |       | 3⁄4                          |       | 3⁄4           |       | 8,803            |       |
| Impairment of  long-lived assets                              |       | 3⁄4     |       | 9,300                       |       | 3⁄4                          |       | 3⁄4           |       | 9,300            |       |
| Depreciation and  amortization                                |       | 84         |       | 9,189                       |       | 4,222                           |       | (308             | )          | 13,187           |       |
| General and  administrative expenses                          |       | 20,209     |       | 3⁄4                      |       | 75                              |       | 3⁄4           |       | 20,284           |       |
| Income (loss) from  operations                                |       | (26,501    | )          | 27,858                      |       | 13,659                          |       | (557             | )          | 14,459           |       |
| Overhead allocations                                          |       | (33,851    | )          | 33,851                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                 |       | (304       | )          | 5,974                       |       | 14,641                          |       | 43               |       | 20,354           |       |
| Loss on extinguishment  of debt                               |       | 3⁄4     |       | 2,361                       |       | 3⁄4                          |       | 3⁄4           |       | 2,361            |       |
| Equity earnings in  subsidiaries                              |       | (18,328    | )          | 3⁄4                      |       | 3⁄4                          |       | 18,328           |       | 3⁄4           |       |
| Loss before provision  (benefit) for income taxes        |       | (10,675    | )          | (14,328                     | )          | (982                            | )          | 17,728           |       | (8,256           | )          |
| Provision (benefit) for  income taxes                         |       | (3,241     | )          | 423                         |       | 3⁄4                          |       | (438             | )          | (3,256           | )          |
| Loss from continuing  operations                              |       | (7,433     | )          | (14,751                     | )          | (982                            | )          | 18,166           |       | (5,000           | )          |
| Discontinued  operations, net of income tax benefit of $1,589 |       | 3⁄4     |       | (2,433                      | )          | 3⁄4                          |       | 3⁄4           |       | (2,433           | )          |
| Net loss                                                      |       | $          | (7,433     | )                           | $          | (17,184                         | )          | $                | (982       | )                | $          | 18,166 |   | $ | (7,433 | ) |

 

87

----

# ** **

# **Condensed Consolidating Statement of Operations for the year endedDecember 31, 2003 (in thousands)**

# ** **

| ** **                                                                            | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                  |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                                              |       | $          | 18,124     |                        | $          | 291,360                         |       | $                | 18,001     |             | $          | (69,305 | ) | $ | 258,180 |   |
| Operating expenses                                                                    |       | 21,222     |       | 246,252                     |       | 32                              |       | (68,975          | )          | 198,531          |       |
| Pre-opening and  start-up expenses                                                    |       | 3⁄4     |       | 1,155                       |       | 3⁄4                          |       | 3⁄4           |       | 1,155            |       |
| Depreciation and  amortization                                                        |       | 84         |       | 6,459                       |       | 4,222                           |       | (170             | )          | 10,595           |       |
| General and  administrative expenses                                                  |       | 23,289     |       | 3⁄4                      |       | 126                             |       | 3⁄4           |       | 23,415           |       |
| Income (loss) from  operations                                                        |       | (26,471    | )          | 37,494                      |       | 13,621                          |       | (160             | )          | 24,484           |       |
| Overhead allocations                                                                  |       | (25,270    | )          | 25,270                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                                         |       | (4,672     | )          | 6,914                       |       | 15,371                          |       | 43               |       | 17,656           |       |
| Equity earnings in  subsidiaries                                                      |       | 4,416      |       | 3⁄4                      |       | 3⁄4                          |       | (4,416           | )          | 3⁄4           |       |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | 7,887      |       | 5,310                       |       | (1,750                          | )          | (4,619           | )          | 6,828            |       |
| Provision (benefit) for  income taxes                                                 |       | 3,917      |       | (317                        | )          | 3⁄4                          |       | (800             | )          | 2,800            |       |
| Income from operations                                                                |       | 3,970      |       | 5,627                       |       | (1,750                          | )          | (3,819           | )          | 4,028            |       |
| Discontinued  operations, net of tax benefit of $40                                   |       | 3⁄4     |       | (58                         | )          | 3⁄4                          |       | 3⁄4           |       | (58              | )          |
| Net income (loss)                                                                     |       | $          | 3,970      |                        | $          | 5,569                           |       | $                | (1,750     | )                | $          | (3,819 | ) | $ | 3,970 |   |

 

88

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# **Condensed Consolidating Statement of Cash Flows for the year endedDecember 31, 2005 (in thousands)**

 
| ** **                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|
| **Cash  flows from operating activities:**                |       |       |       |                        |       |                          |       |             |       |
| Net cash (used in)  provided by operating activities      |       | $          | (34,642    | )                           | $          | 51,475                        |       | $                | 11,435     |   | $ | 28,268 |   |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash  flows from investing activities:**                |       |       |       |                        |       |                          |       |             |       |
| Capital expenditures                                      |       | 3⁄4     |       | (51,128                     | )          | 3⁄4                        |       | (51,128          | )          |
| Acquisition of a  business                                |       | (9,064     | )          | 3⁄4                      |       | 3⁄4                        |       | (9,064           | )          |
| Purchases of investment  securities                       |       | (1,022,295 | )          | 3⁄4                      |       | 3⁄4                        |       | (1,022,295       | )          |
| Sales of investment  securities                           |       | 1,066,785  |       | 3⁄4                      |       | 3⁄4                        |       | 1,066,785        |       |
| Payments to restricted  debt payment account, net         |       | 3⁄4     |       | 3⁄4                      |       | (2,445                        | )          | (2,445           | )          |
| Proceeds from sale of  fixed assets                       |       | 3⁄4     |       | 647                         |       | 3⁄4                        |       | 647              |       |
| Net cash provided by  (used in) investing activities      |       | 35,426     |       | (50,481                     | )          | (2,445                        | )          | (17,506          | )          |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash  flows from financing activities:**                |       |       |       |                        |       |                          |       |             |       |
| Payments of MCF bonds                                     |       | 3⁄4     |       | 3⁄4                      |       | (9,000                        | )          | (9,000           | )          |
| Payments of acquired  debt                                |       | (1,905     | )          | 3⁄4                      |       | 3⁄4                        |       | (1,905           | )          |
| Payments on capital  lease obligations                    |       | 3⁄4     |       | (176                        | )          | 3⁄4                        |       | (176             | )          |
| Proceeds from exercise  of stock options and warrants     |       | 4,141      |       | 3⁄4                      |       | 3⁄4                        |       | 4,141            |       |
| Net cash (used in)  provided by financing activities      |       | 2,236      |       | (176                        | )          | (9,000                        | )          | (6,940           | )          |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Net  increase (decrease) in cash and cash equivalents** |       | 3,020      |       | 818                         |       | (10                           | )          | 3,828            |       |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash and cash equivalents at beginning of****period**   |       | 9,559      |       | 296                         |       | 40                            |       | 9,895            |       |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash  and cash equivalents at end of period**           |       | $          | 12,579     |                        | $          | 1,114                         |       | $                | 30         |   | $ | 13,723 |   |

 

89

----

 

**Condensed Consolidating Statement of CashFlows for the year ended December 31, 2004 (in thousands)**

 
| ** **                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|
| **Cash flows from operating activities:**                    |       |       |       |                        |       |                          |       |             |       |
| Net cash provided by  (used in) operating activities         |       | $          | (87,701    | )                           | $          | 89,046                        |       | $                | 10,748     |   | $ | 12,093 |   |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Cash flows from investing activities:**                    |       |       |       |                        |       |                          |       |             |       |
| Capital expenditures                                         |       | —     |       | (40,243                     | )          | —                        |       | (40,243          | )          |
| Purchase of investment  securities                           |       | (471,410   | )          | —                      |       | —                        |       | (471,410         | )          |
| Sales of investment  securities                              |       | 419,670    |       | —                      |       | —                        |       | 419,670          |       |
| Purchase of facility  management contract                    |       | —     |       | (3,000                      | )          | —                        |       | (3,000           | )          |
| Refund from restricted  escrow arrangement                   |       | 5,000      |       | —                      |       | —                        |       | 5,000            |       |
| BOP claim reimbursement                                      |       | —     |       | 5,566                       |       | —                        |       | 5,566            |       |
| Payments to restricted debt payment  account, net            |       | —     |       | —                      |       | (2,463                        | )          | (2,463           | )          |
| Proceeds from sale of  fixed assets                          |       | —     |       | 1,137                       |       | —                        |       | 1,137            |       |
| Net cash used in investing activities                        |       | (46,740    | )          | (36,540                     | )          | (2,463                        | )          | (85,743          | )          |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Cash flows from financing activities:**                    |       |       |       |                        |       |                          |       |             |       |
| Proceeds from long-term  debt and line of credit             |       | 69,000     |       | —                      |       | —                        |       | 69,000           |       |
| Payments on line of  credit                                  |       | (71,000    | )          | —                      |       | —                        |       | (71,000          | )          |
| Payments on synthetic  lease                                 |       | —     |       | (52,499                     | )          | —                        |       | (52,499          | )          |
| Proceeds from Senior  Notes, net of discount                 |       | 110,527    |       | —                      |       | —                        |       | 110,527          |       |
| Payments on MCF Bonds                                        |       | —     |       | —                      |       | (8,300                        | )          | (8,300           | )          |
| Payment for debt  issuance and other financing costs         |       | (6,076     | )          | —                      |       | —                        |       | (6,076           | )          |
| Payments on capital  lease obligations                       |       | (7         | )          | —                      |       | —                        |       | (7               | )          |
| Proceeds from exercise  of stock options                     |       | 1,844      |       | —                      |       | —                        |       | 1,844            |       |
| Purchases of treasury  stock                                 |       | (115       | )          | —                      |       | —                        |       | (115             | )          |
| Net cash provided by (used in) financing  activities         |       | 104,173    |       | (52,499                     | )          | (8,300                        | )          | 43,374           |       |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Net  (decrease) increase in cash and cash****equivalents** |       | (30,268    | )          | 7                           |       | (15                           | )          | (30,276          | )          |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Cash and cash equivalents at beginning of  period**        |       | 39,827     |       | 289                         |       | 55                            |       | 40,171           |       |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Cash and cash equivalents at end of period**               |       | $          | 9,559      |                        | $          | 296                           |       | $                | 40         |   | $ | 9,895 |   |

 

90

----

 

**CondensedConsolidating Statement of Cash Flows for the year ended December 31, 2003(in thousands)**

 
| ** **                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|
| **Cash  flows from operating activities:**                |       |       |       |                        |       |                          |       |             |       |
| Net cash (used in)  provided by operating activities      |       | $          | (4,633     | )                           | $          | 20,960                        |       | $                | 9,884      |   | $ | 26,211 |   |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash  flows from investing activities:**                |       |       |       |                        |       |                          |       |             |       |
| Capital expenditures                                      |       | (1,137     | )          | (21,167                     | )          | 3⁄4                        |       | (22,304          | )          |
| Payments to restricted  escrow arrangement, net           |       | (10,385    | )          | 3⁄4                      |       | 3⁄4                        |       | (10,385          | )          |
| Payments of non-compete agreements                        |       | 3⁄4     |       | (1,000                      | )          | 3⁄4                        |       | (1,000           | )          |
| Payments to restricted debt payment  account, net         |       | 3⁄4     |       | 3⁄4                      |       | (2,275                        | )          | (2,275           | )          |
| Net cash used in  investing activities                    |       | (11,522    | )          | (22,167                     | )          | (2,275                        | )          | (35,964          | )          |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash  flows from financing activities:**                |       |       |       |                        |       |                          |       |             |       |
| Proceeds from long-term  debt and line of credit          |       | 23,000     |       | 1,339                       |       | 3⁄4                        |       | 24,339           |       |
| Payments on line of  credit                               |       | (21,000    | )          | 3⁄4                      |       | 3⁄4                        |       | (21,000          | )          |
| Payments on capital  lease obligations                    |       | (31        | )          | 3⁄4                      |       | 3⁄4                        |       | (31              | )          |
| Payments of debt  issuance and other financing costs      |       | (31        | )          | 3⁄4                      |       | 3⁄4                        |       | (31              | )          |
| Collections of payments  of shareholder notes             |       | 440        |       | 3⁄4                      |       | 3⁄4                        |       | 440              |       |
| Payments on MCF Bonds                                     |       | 3⁄4     |       | 3⁄4                      |       | (7,600                        | )          | (7,600           | )          |
| Proceeds from exercise  of stock options and warrants     |       | 2,427      |       | 3⁄4                      |       | 3⁄4                        |       | 2,427            |       |
| Purchases of treasury  stock                              |       | (1,230     | )          | 3⁄4                      |       | 3⁄4                        |       | (1,230           | )          |
| Net cash provided by  (used in) financing activities      |       | 3,575      |       | 1,339                       |       | (7,600                        | )          | (2,686           | )          |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Net  (decrease) increase in cash and cash equivalents** |       | (12,580    | )          | 132                         |       | 9                             |       | (12,439          | )          |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash and cash equivalents at beginning of****period**   |       | 52,407     |       | 157                         |       | 46                            |       | 52,610           |       |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash  and cash equivalents at end of period**           |       | $          | 39,827     |                        | $          | 289                           |       | $                | 55         |   | $ | 40,171 |   |

 

91

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| **18****.** | **SELECTED QUARTERLY FINANCIAL DATA (Unaudited)** |
|-------------|---------------------------------------------------|
|        | **(in thousands, except per share data)**         |

 
| ** **                                  | ** ** | **1stQuarter** | ** ** | **2ndQuarter** | ** ** | **3rdQuarter** | ** ** | **4thQuarter** | ** ** | **Year** | ** ** |
|---------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------|------------|
| **2005:**                                   |       |           |       |           |       |           |       |           |       |     |       |
| Revenues                                    |       | $              | 73,640     |           | $          | 78,502         |       | $              | 79,198     |     | $          | 79,435 |   | $ | 310,775 |   |
| Income (loss) from continuing operations    |       | (840           | )          | 1,371          |       | 1,556          |       | 1,841          |       | 3,928    |       |
| Discontinued operations, net of tax         |       | (1,433         | )          | (1,682         | )          | (279           | )          | (228           | )          | (3,622   | )          |
| Net income (loss)                           |       | (2,273         | )          | (311           | )          | 1,277          |       | 1,613          |       | 306      |       |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| Earnings (loss) per share:                  |       |           |       |           |       |           |       |           |       |     |       |
| Basic -                                     |       |           |       |           |       |           |       |           |       |     |       |
| Income (loss) from continuing operations    |       | $              | (0.05      | )              | $          | 0.10           |       | $              | 0.11       |     | $          | 0.13 |   | $ | 0.29 |   |
| Loss on discontinued operations, net of tax |       | $              | (0.11      | )              | $          | (0.12          | )          | $              | (0.02      | )        | $          | (0.01 | ) | $ | (0.27 | ) |
| Net income (loss)                           |       | $              | (0.16      | )              | $          | (0.02          | )          | $              | 0.09       |     | $          | 0.12 |   | $ | 0.02 |   |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| Diluted -                                   |       |           |       |           |       |           |       |           |       |     |       |
| Income (loss) from continuing operations    |       | $              | (0.05      | )              | $          | 0.10           |       | $              | 0.11       |     | $          | 0.13 |   | $ | 0.29 |   |
| Loss on discontinued operations, net of tax |       | $              | (0.11      | )              | $          | (0.12          | )          | $              | (0.02      | )        | $          | (0.01 | ) | $ | (0.27 | ) |
| Net income (loss)                           |       | $              | (0.16      | )              | $          | (0.02          | )          | $              | 0.09       |     | $          | 0.12 |   | $ | 0.02 |   |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| **2004:**                                   |       |           |       |           |       |           |       |           |       |     |       |
| Revenues                                    |       | $              | 65,574     |           | $          | 66,377         |       | $              | 71,336     |     | $          | 73,903 |   | $ | 277,190 |   |
| Income (loss) from continuing operations    |       | 4,545          |       | (687           | )          | 91             |       | (8,949         | )          | (5,000   | )          |
| Discontinued operations, net of tax         |       | (321           | )          | (412           | )          | (988           | )          | (712           | )          | (2,433   | )          |
| Net income (loss)                           |       | 708            |       | (1,099         | )(1)       | (897           | )          | (6,145         | )(2)       | (7,433   | )          |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| Earnings (loss) per share:                  |       |           |       |           |       |           |       |           |       |     |       |
| Basic -                                     |       |           |       |           |       |           |       |           |       |     |       |
| Income (loss) from continuing operations    |       | $              | 0.04       |           | $          | (0.05          | )          | $              | 0.01       |     | $          | (0.38 | ) | $ | (0.38 | ) |
| Discontinued operations, net of tax         |       | $              | 0.01       |           | $          | (0.03          | )          | $              | (0.08      | )        | $          | (0.08 | ) | $ | (0.18 | ) |
| Net income (loss)                           |       | $              | 0.05       |           | $          | (0.08          | )          | $              | (0.07      | )        | $          | (0.46 | ) | $ | (0.56 | ) |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| Diluted -                                   |       |           |       |           |       |           |       |           |       |     |       |
| Income (loss) from continuing operations    |       | $              | 0.04       |           | $          | (0.05          | )          | $              | 0.01       |     | $          | (0.38 | ) | $ | (0.38 | ) |
| Discontinued operations, net of tax         |       | $              | 0.01       |           | $          | (0.03          | )          | $              | (0.08      | )        | $          | (0.08 | ) | $ | (0.18 | ) |
| Net income (loss)                           |       | $              | 0.05       |           | $          | (0.08          | )          | $              | (0.07      | )        | $          | (0.46 | ) | $ | (0.56 | ) |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| **2005 Balance Sheet Data:**                |       |           |       |           |       |           |       |           |       |     |       |
| Working capital                             |       | $              | 103,643    |           | $          | 89,550         |       | $              | 63,603     |     | $          | 57,286 |   | $ | 57,286 |   |
| Total assets                                |       | 501,026        |       | 511,247        |       | 496,406        |       | 510,628        |       | 510,628  |       |
| Long-term debt, net of current portion      |       | 276,893        |       | 279,752        |       | 267,416        |       | 266,659        |       | 266,659  |       |
| Stockholders’ equity                   |       | 159,088        |       | 159,622        |       | 163,243        |       | 165,461        |       | 165,461  |       |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| **2004 Balance Sheet Data:**                |       |           |       |           |       |           |       |           |       |     |       |
| Working capital                             |       | $              | 93,434     |           | $          | 118,933        |       | $              | 105,674    |     | $          | 107,597 |   | $ | 107,597 |   |
| Total assets                                |       | 453,630        |       | 503,060        |       | 500,243        |       | 507,631        |       | 507,631  |       |
| Long-term debt, net of current portion      |       | 239,292        |       | 284,852        |       | 279,373        |       | 279,528        |       | 279,528  |       |
| Stockholders’ equity                   |       | 168,139        |       | 166,354        |       | 166,586        |       | 161,312        |       | 161,312  |       |

 

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(1)   Includes aloss on the extinguishment of debt of approximately $2.4 million for the earlyretirement of the Synthetic Lease Notes A and B and the revolving line ofcredit under our amended 2000 Credit Facility in June 2004.

(2)   Includesan impairment charge on our long-lived assets for the New Morgan Academy of$9.3 million.

 

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**ITEM 9.****         ****CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A.****      ****CONTROLS AND PROCEDURES**

#### ** **

We maintain disclosure controls andprocedures designed to ensure that information disclosed in our annual andperiodic reports is recorded, processed, summarized and reported, within thetime periods specified in the Securities and Exchange Commission’s rules andforms. In addition, we designed these disclosure controls and procedures toensure that this information is accumulated and communicated to management,including the chief executive officer (CEO) and chief financial officer (CFO),to allow timely decisions regarding required disclosures. SEC rules requirethat we disclose the conclusions of our CEO and CFO about the effectiveness ofour disclosure controls and procedures.

 

We do not expect that our disclosure controlsand procedures will prevent all errors or fraud. A control system, no matterhow well conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. In addition, thedesign of disclosure controls and procedures must reflect the fact that thereare resource constraints, and the benefits of controls must be consideredrelative to their costs. Because of the inherent limitation in a cost-effectivecontrol system, misstatements due to error or fraud could occur and not bedetected.

 

Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, and as required by paragraph (b) of Rules 13a-15and 15d-15 of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) we have evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)of the Exchange Act) as of the end of the period required by this report. Basedon that evaluation, our principal executive officer and principal financialofficer have concluded that these controls and procedures are effective as ofthat date.

 

In connection with the evaluation as requiredby paragraph (d) of Rules 13a-15 and 15d-15 of the Exchange Act, we have notidentified any change in internal control over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) thatoccurred during our fiscal quarter ended December 31, 2005 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**ITEM 9B.****      ****OTHER INFORMATION**

 

None.

 

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**PART III**

 

**ITEM 10.****      ****DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

The following table sets forth the name, ageand principal position of the Company’s directors as of March 10, 2006.  There are no family relationships between anyof the Company’s officers or directors.

 
| **Name**               | ** ** | **Age** | ** ** | **Position**                       |
|------------------------|------------|---------|------------|------------------------------------|
| Anthony  R. Chase      |       | 51      |       | Director                           |
| Leon  Clements         |       | 64      |       | Director                           |
| Richard Crane          |       | 59      |       | Director                           |
| Zachary  R. George     |       | 28      |       | Director                           |
| Todd  Goodwin          |       | 74      |       | Director                           |
| Thomas  R. Hudson, Jr. |       | 40      |       | Lead Director                      |
| James  E. Hyman        |       | 46      |       | Chairman, Chief Executive  Officer |
| Alfred  Jay Moran, Jr. |       | 62      |       | Director                           |
| D.  Stephen Slack      |       | 56      |       | Director                           |
| Sally  L. Walker       |       | 57      |       | Director                           |

 

**Anthony R.Chase** has been a director of the Company since October1999.  Mr. Chase has served as Chairman and Chief Executive Officer ofChaseCom Limited Partnership since December 1998 and as President and ChiefExecutive Officer of Faith Broadcasting, L.P. since November 1993.  Mr.Chase is also Chairman of the Board of the Telecom Opportunity Institute, anon-profit organization to increase career, education and job trainingopportunities in technological fields for poor and** **historically underservedcommunities.  Mr. Chase serves on the Board of Trustees for FiskUniversity.  Mr. Chase** **is Vice Chairman of the FederalReserve Bank of Dallas and** **isa Professor of Law at the University of Houston Law Center.  Mr. Chase received his JD from Harvard LawSchool, his MBA from Harvard Business School and his AB from Harvard College.

 

**Leon Clements**has been a director of the Company since June 2005.  Mr. Clements has been the President and ChiefExecutive Officer of League Medical Concepts, a provider of health careservices for the corrections sector, since December 2004. From 1994 to2004, Mr. Clements served as the Associate Vice President of Managed Careand Chief Administrative Officer at the University of Texas Medical Branch, aprovider of health care for the prison system in Texas. Mr. Clementspreviously served as the Chief Administrative Officer of the University ofCalifornia at Los Angeles Medical Group and the Cleveland Clinic in Florida.Mr. Clements also served as a director of Maxicare Health Plans, Inc.Mr. Clements has completed executive programs at both Harvard BusinessSchool and the Wharton School of Finance and received his MBA from theUniversity of Southwestern Louisiana.

 

**Richard Crane**has been a director of the Company since June 2005.  An attorney at law, Mr. Crane has been a solepractitioner since 1988. Mr. Crane represents individual, corporate, andgovernment clients in corrections and sentencing matters. Mr. Crane hasalso been a consultant in more than 30 corrections privatization projects andserves on the Practitioners’ Advisory Group to the United States SentencingCommission.  From 1984 through 1987,Mr. Crane served as General Counsel for Corrections Corporation ofAmerica. Mr. Crane also previously served as Chief Legal Counsel for theLouisiana Department of Corrections and as Director of the AmericanCorrectional Association’s Legal Issues Project. Mr. Crane received his JDfrom Louisiana State University.  Mr.Crane has authored numerous articles on prison and privatization issues,including *Monitoring Correctional Services Provided byPrivate Firms.*

 

**Zachary R.George** has been a director of the Company since June2005.  Mr. George has been a SeniorInvestment Analyst of Pirate Capital LLC, performing extensive financialmodeling and analysis of private corrections and other industries sinceMarch 2004. Through his work with Pirate Capital LLC, Mr. George hasdeveloped relationships with management teams, institutional investors,financiers, consultants and other parties with an interest in the privatecorrections sector. Additionally, Mr. George has assisted in thedevelopment of an investment team which manages a $1.5 billion portfolio ofdomestic securities. From 2002 to 2004, Mr. George worked at MizuhoCorporate Bank LTD where he served as an officer in Portfolio Management,assisting in the management of a $50 billion domestic loan portfolio andoriginating credit default swap and bank debt trade recommendations.Mr. George received his JD from Brooklyn Law School.

 

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**xxxToddGoodwin** has been a director of the Company since June2005.  Mr. Goodwin retired in 2002 as aPartner of Gibbons, Goodwin, van Amerongen (“GGvA”), having spent 18 yearswith the investment banking firm.  DuringMr. Goodwin’s tenure, GGvA organized management buyouts and purchasedbusinesses with a total value of approximately $7 billion. Mr. Goodwinpreviously served as a Managing Director of Merrill Lynch.  Mr. Goodwin has served as a director on theboards of several companies, including Southwest Forest Industries, RT FrenchCompany, Rival Company, Schult Homes, Specialty Equipment, Horace MannEducation Corporation, Robert Half International, Riverwood International,Johns Manville Corporation, Ladish Company, EKCO Housewares, Merrill LynchInstitutional Fund, Southampton Hospital and the Peconic Health Corporation.Mr. Goodwin is currently a Trustee of the Madison Square Boys &Girls Club.  Mr. Goodwin received his ABfrom Harvard College.

 

**Thomas R.Hudson, Jr.**has been the lead director of the Company since June 2005.  Mr. Hudson has been the ManagingMember of Pirate Capital LLC and Portfolio Manager of the Jolly Roger Fund LPand Jolly Roger Offshore Fund LTD since July, 2002. From 1999 to 2001,Mr. Hudson served as a Managing Director of Amroc Investments LLC, aprivate investment firm, where he managed distressed trading and investmentanalysis. Mr. Hudson previously served as a Vice President at Goldman,Sachs & Co., where he was a Senior Distressed Trader and PortfolioManager responsible for a $500 million portfolio of domestic andinternational distressed private assets. Mr. Hudson is a former Chairmanof the Loan Syndication and Trading Association’s Distressed Committee, and iscurrently a Director of the Centurion Foundation, which supports the New YorkPolice Department and other law enforcement agencies. Mr. Hudson receivedhis MBA from the Tuck School of Business at Dartmouth.

 

**James E. Hyman** has been the Chief Executive Officersince January 2005 and was named Chairman of the Board inFebruary 2005. Mr. Hyman was a Senior Managing Director at FTIPalladium Partners from October 2004 to January 2005. From 2003 to2004, Mr. Hyman was a Partner with Sandhurst Capital.  From 1999 to 2002, Mr. Hyman was withStarwood Hotels and Resorts Worldwide, where he served as Executive VicePresident.  From 1996 to 1999,Mr. Hyman was with GE Capital, where he served as President of a Europeansubsidiary.  Mr. Hyman received an MBA,with distinction, from the Harvard Business School and an AB, with honors, fromthe University of Chicago.

 

**Alfred JayMoran, Jr.** hasbeen a director of the Company since June 2005. Mr. Moran is Chairman and Chief Executive Officer of the MoranGroup, LLC, a turnaround, value creation consulting firm that he founded in2003. During 2004, he served as Chief Strategy and Restructuring Officer ofCooperheat MQS, Inc. Throughout his career, Mr. Moran has beenresponsible for the turnaround or value enhancement of over 50 companies inmany industries. Prior to 2003, he was Senior Managing Director of the ValueCreation Practice, as well as Principal and Member of the Executive Committeeof Kibel, Green, Inc. Mr. Moran received his MBA from HarvardBusiness School.

 

**D. StephenSlack** has been a director of the Company since March 2003.Mr. Slack has been President and Chief Executive Officer of South BayResources, LLC, an energy exploration company since March 2003.Mr. Slack was Chief Financial Officer and Principal of Andex Resources,LLC, an energy exploration and production company, from June 2000 toJanuary 2003. From 1995 to 2000, Mr. Slack was Chief FinancialOfficer of Inventory Management and Distribution Company, an independentmanager of natural gas storage and transportation assets. Mr. Slackpreviously served as Chief Financial Officer of Pogo Producing Company.  Mr. Slack received his BS from the Universityof Southern California and his MBA from Columbia University.

 

**Sally L.Walker** has been a director of the Company since June2005.  Ms. Walker has been the Presidentof Encourage Youth Corporation, a consulting firm specializing in programmingfor high risk youths and juvenile offenders since 1996. From 1997 to 2004,Ms. Walker pioneered an effective and cost-efficient secure custody andaftercare program for high risk young offenders. Beyond her government andprivate corrections experience, Ms. Walker also previously served as theExecutive Director of Finance and Administration for a large central servicesdepartment for the Province of Manitoba. Ms. Walker received her Master ofCorrectional Administration from the University of Ottawa.

 

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** **

**DIRECTOR COMPENSATION**

 

*2005 Compensation*

 

During 2005, our directors received thefollowing compensation, in addition to the expense reimbursements discussedbelow.

 
| ** **             | ** ** | **Annual Retainer** | ** ** | **Meeting  Attendance  Fees** | ** ** | **Shares  Issued (4)** | ** ** |
|------------------------|------------|---------------------|------------|-------------------------------|------------|------------------------|------------|
|                   |       |                |       |                          |       |                   |       |
| Anthony R.  Chase      |       | $                   | 47,000     | (1)                           | $          | 76,000                 |       | 1,603 |   |
| Leon M.  Clements      |       | $                   | 27,750     | (2)(3)                        | $          | 32,000                 |       | 1,603 |   |
| Richard  Crane         |       | $                   | 26,000     | (2)(3)                        | $          | 28,000                 |       | 1,603 |   |
| Zachary R.  George     |       | $                   | 22,500     | (2)(3)                        | $          | 24,000                 |       | 3,315 |   |
| Todd Goodwin           |       | $                   | 24,250     | (2)(3)                        | $          | 28,000                 |       | 3,727 |   |
| Thomas R.  Hudson, Jr. |       | $                   | 26,000     | (2)(3)                        | $          | 26,000                 |       | 3,703 |   |
| James E.  Hyman        |       | $                   | —     | (5)                           | $          | —                 |       | — |   |
| Alfred J.  Moran, Jr.  |       | $                   | 28,000     | (2)(3)                        | $          | 26,000                 |       | 1,603 |   |
| D. Stephen  Slack      |       | $                   | 49,000     | (2)                           | $          | 87,000                 |       | 10,063 |   |
| Sally L.  Walker       |       | $                   | 19,250     | (3)                           | $          | 28,000                 |       | — |   |

 

----

(1)   Upon election of the new board members in June 2005, Mr. Chase electedto receive his annual retainer fee in the form of Common Stock.  Prior to that time, such fees were paid toMr. Chase in cash.

(2)   Each of these non-employee directors elected to receive annual retainerfees in the form of common stock under the terms of the Company’s 2000Directors Stock Plan (“2000 Directors Plan”).

(3)   Each of these non-employee directors joined the Board of Directors June2005.  As a result, each earned apro-rata portion of their annual retainer fee. See further discussion of annual fees below.

(4)   Former director, Marcus A. Watts, not listed here, received 3,627shares of Common Stock of the Company at this election under the terms of the2000 Directors Plan.

(5)   As an employee of the Company, Mr. Hyman does not receive compensationfor serving as Chairman of the Board.

 

*Fees*

 

We pay non-employee directors $35,000 (cashelection) or $45,000 (stock election) per year plus reimbursement of expensesfor all services as a director, including committee participation or specialassignments.  The Chairman of theNominating/Corporate Governance Committee and Compensation Committee receive anadditional $3,500 annual retainer fee. The Chairman of the Audit Committee receives an additional $7,500 annualretainer fee.  All committee membersreceive an additional annual retainer fee of $3,500.  At the election of each director, fees may bepaid in cash or common stock of the Company under the 2000 Directors Plan.

 

In addition to the annual retainers,non-employee directors receive the following fees for attendance at meetings:

 

•      for each Board meeting, including committee meetings held inconjunction with such meetings, all non-employee directors in attendancereceive a fee of $3,000, and

•      for committee meetings (not held in conjunction with regular Boardmeeting), committee members in attendance receive $2,000.

 

*Stock Options*

 

In connection with their election to theBoard in June 2005, each non-employee director was granted stock options topurchase 15,000 shares of Common Stock under the Company’s Amended and Restated1996 Stock Option Plan (“1996 Plan”). These options vested 25% on the date ofgrant, with the remainder vesting ratably over the subsequent three years.These options have a term of ten years and have a per share exercise priceequal to the market value of a share of Common Stock on the date of grant.

 

96

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In connection with his employment agreement,in March 2005, Mr. Hyman was granted stock options to purchase 50,000shares of Common Stock under the 1996 Plan. These options vest 33% onJanuary 24, 2006, 2007 and 2008, respectively, if Mr. Hyman remainscontinuously employed by the Company. These options have a term of ten yearsand have a per share exercise price equal to the market value of a share ofCommon Stock on the date of grant. Mr. Hyman was also granted 85,000restricted shares of Common Stock which vest based on the following criteria:

 

**•**      25,000 shares vest on January 24, 2008 if Mr. Hyman remainscontinuously employed by the Company;

•      30,000 shares vest upon the Company achieving a certain stock pricewithin a certain time period, as established by the Compensation Committee; and

•      30,000 shares will vest upon the Company achieving a certain earningsper share within a certain time period, as established by the CompensationCommittee.

 

**EXECUTIVE OFFICERS AND OTHER KEYEMPLOYEES**

 

The following table sets forth the names,ages and positions of the persons who are executive officers and other keyemployees of the Company as of****March 10,2006:

 
| **Name**               | ** ** | **Age** | ** ** | **Position**                                            |
|------------------------|------------|---------|------------|---------------------------------------------------------|
|                   |       |    |       |                                                    |
| James  E. Hyman        |       | 46      |       | Chief Executive Officer                                 |
| John  R. Nieser        |       | 47      |       | Chief Financial Officer  and Treasurer                  |
| Mark  S. Croft         |       | 44      |       | General Counsel and  Corporate Secretary                |
| Patrick  N. Perrin     |       | 45      |       | Senior Vice President and  Chief Administrative Officer |
| Benjamin  E. Erwin     |       | 28      |       | Vice President, Corporate  Development                  |
| Michael  L. Caltabiano |       | 48      |       | Vice President, Adult  Secure Division                  |
| Jonathan  P. Swatsburg |       | 35      |       | Vice President, Youth  Services Division                |
| Laura  H. Hall         |       | 37      |       | Vice President, Adult  Community-Based Division         |

 

**James E.Hyman** has been the Chief Executive Officer sinceJanuary 2005 and was named Chairman of the Board of Directors of theCompany in February 2005. Mr. Hyman was a Senior Managing Director atFTI Palladium Partners from October 2004 to January 2005. From 2003to 2004, Mr. Hyman was a Partner with Sandhurst Capital.  From 1999 to 2002, Mr. Hyman was withStarwood Hotels and Resorts Worldwide where he served as Executive VicePresident.  From 1996 to 1999,Mr. Hyman was with GE Capital where he served as President of a Europeansubsidiary.

 

**John R.Nieser** was named Chief Financial Officer in February2005.  Mr. Nieser has served as Treasurersince April 2004 and Acting Chief Financial Officer since August 2004.  Prior to joining Cornell in April 2004, heserved as Controller from December 2000 to June 2003 for a number oforganizations, including GE Aero Energy Products. He also served GuardianSavings and Loan Association in various capacities, including senior vicepresident, chief financial officer and treasurer from September 1988 to March2000.

 

**Mark S.Croft** was named General Counsel and CorporateSecretary in November 2005.  Prior tojoining Cornell, Mr. Croft was Co-Founder and Managing Partner of ENVCAInvestments, L.P., a private equity firm, from August 2003 to October 2005.  Mr. Croft was also served as Senior Counsel toReliant Resources, Inc. from November 2002 to August 2003.  Mr. Croft was a corporate and securitiesattorney with the international law firm Akin, Gump, Strauss, Hauer & Feld,LLP from May 1997 to November 2002.

 

**Patrick N.Perrin** has served as Senior Vice President since June2003, Vice President from June 2001 to June 2003 and Chief AdministrativeOfficer since November 1998. Prior to November 1998, Mr. Perrin served asCorporate Director of Risk Management, Employee Benefits and Retirement Plansfor Tracor, Inc. from November 1991 to October 1998.

 

**BenjaminE. Erwin** was named Vice President, CorporateDevelopment in January 2005 after serving as Director, Strategic Analysis fromJanuary 2002 to January 2005.  Prior tojoining Cornell in January 2002, Mr. Erwin served as Business Analyst, EmergingBusinesses for Enron Corporation from February 2001 to December 2001, and fromJune 1999 to February 2001 as Manager, Business Development for TrilogySoftware.

 

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** **

**Michael L.Caltabiano** was named Vice President, Adult SecureDivision in August 2005, having served as Director of Marketing, Adult Securefrom April 2004 to August 2005.  Prior tojoining Cornell in April 2004, Mr. Caltabiano served as Director, DetentionManagement Division for the Department of Homeland Security, Immigration andCustoms Enforcement from January 2001 to March 2004 and in various capacitieswith the Department of Justice, Federal Bureau of Prisons from 1979 to 2001.

 

**JonathanP. Swatsburg** was named Vice President, Youth ServicesDivision in May 2005.  Prior to May 2005,Mr. Swatsburg served Cornell in various capacities, including Regional Directorfrom February 2004 to May 2005 and as Program Director for various youthservice programs from January 2000 to February 2004.

 

**Laura H.Hall** was named Vice President, Adult Community-BasedDivision in February 2006.  Ms. Hallpreviously served as Director of Development from July 2005 to January 2006 andas Division Director, Western Region from January 1999 to July 2005.

 

**AUDITCOMMITTEE MATTERS**

 

The Company’s Audit Committee has beenestablished in accordance with section 3(a)(58)(A) of the Exchange Act. TheAudit Committee was composed of Anthony R. Chase, D. Stephen Slack and TuckerTaylor until July 2005. The Audit Committee is currently composed of Alfred J.Moran, Jr., Anthony R. Chase, Leon M. Clements and D. Stephen Slack.  Under the rules of the New York StockExchange, all of the members of the Audit Committee are independent.

 

The Audit Committee plays an important rolein promoting effective corporate governance, and it is imperative that membersof the Audit Committee have requisite financial literacy and expertise. Allmembers of the Company’s Audit Committee meet the financial literacy standardrequired by the NYSE rules, and at least one member qualifies as havingaccounting or related financial management expertise under the NYSE rules.  In addition, as required by theSarbanes-Oxley Act of 2002, the SEC adopted rules requiring that publiccompanies disclose whether or not its audit committee has an “audit committeefinancial expert” as a member. An “audit committee financial expert” is definedas a person who, based on his or her experience, satisfies all of the followingattributes:

 
| • | An understanding of  generally-accepted accounting principles and financial statements.                                                                                                                                                                                                                                                                                                                      |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| • | An ability to assess the  general application of such principles in connection with the accounting for  estimates, accruals, and reserves.                                                                                                                                                                                                                                                                   |
| • | Experience preparing,  auditing, analyzing or evaluating financial statements that present a breadth  and level of complexity of accounting issues that are generally comparable to  the breadth and level of complexity of issues that can reasonably be expected  to be raised by Company’s financial statements, or experience actively  supervising one or more persons engaged in such activities. |
| • | An understanding of  internal controls and procedures for financial reporting.                                                                                                                                                                                                                                                                                                                               |
| • | An understanding of audit  committee functions.                                                                                                                                                                                                                                                                                                                                                              |

 

The Board of Directors has affirmativelydetermined that Mr. Alfred J.Moran, Jr.****satisfies the definition of “auditcommittee financial expert,” and has designated him as an “audit committeefinancial expert.”   Mr. Moran is an independent director, asthat term is used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act.

 

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**SECTION 16(A) BENEFICIALOWNERSHIP REPORTING COMPLIANCE**

 

Section 16(a) of the Exchange Act requiresthe Company’s directors and executive officers to file with the SEC and theNYSE initial reports of ownership and reports of changes in ownership of CommonStock. Based solely on a review of the copies of such reports furnished to theCompany and written representations that no other reports were required, theCompany believes that all its directors and executive officers during 2005complied on a timely basis with all applicable filing requirements underSection 16(a) of the Exchange Act, except (i) Marcus A. Watts, a formerdirector, failed to file timely a Form 4 to report one transaction relating tothe acquisition of 2,575 shares, (ii) D. Stephen Slack, a director, failed tofile timely a Form 4 to report one transaction relating to the acquisition of3,961 shares and (iii) James E. Hyman, Chief Executive Office and Chairman ofthe Board, failed to file timely a Form 4 to report one transaction relating tothe acquisition of 1,043 shares.

 

**CERTIFICATIONS**

 

The Company submitted our Annual Section303A.12(a) Chief Executive Officer Certification with the New York StockExchange. The certification was not qualified in any respect. The Company also filedwith the Securities and Exchange Commission, as exhibits to our Form 10-K forthe year ended December 31, 2005, the Chief Executive Officer and ChiefFinancial Officer Certifications required under Section 302 of theSarbanes-Oxley Act of 2002.

 

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** **

**ITEM11.****      ****EXECUTIVE COMPENSATION**

 

The following table sets forth informationwith respect to our Chief Executive Officer, our four most highly compensatedexecutive officers of the Company whose total annual salary and bonus exceeded$100,000 for the fiscal year ended December 31, 2005 and up to two additional formerexecutive officers who would have been among the four most highly compensatedexecutive officers but for the fact the individual was no longer serving as anexecutive officer for the fiscal year ended December 31, 2005 (the “NamedExecutive Officers”).

 

**SUMMARYCOMPENSATION TABLE**

 
| ** **                                     | ** ** | ** ** | ** ** | ** **              | ** ** | ** **            | ** ** | **Long-Term Compensation** | ** ** | ** **     | ** ** |
|------------------------------------------------|------------|------------|------------|-------------------------|------------|-----------------------|------------|----------------------------|------------|----------------|------------|
| ** **                                     | ** ** | **Fiscal** | ** ** | **Annual Compensation** | ** ** | **Restricted  Stock** | ** ** | **Securities  Underlying** | ** ** | **All  Other** | ** ** |
| **Name and Principal Position** | ** ** | **Year**   | ** ** | **Salary**              | ** ** | **Bonus**             | ** ** | **Award(s)**               | ** ** | **Options**    | ** ** | **Compensation** | ** ** |
|                                           |       |       |       | **($)**                 | ** ** | **($)**               | ** ** | **($)**                    | ** ** | **(#)**        | ** ** | **($)** |   |
|                                           |       |       |       |                    |       |                  |       |                       |       |           |       |   |   |
| James E.  Hyman (1)                            |       | 2005       |       | 438,462                 |       | 635,907               |       | 1,133,900                  | (7)        | 50,000         |       | 7,001 |   |
| Chairman of  the Board and                     |       | 2004       |       | —                  |       | —                |       | —                     |       | —         |       | — |   |
| Chief  Executive Officer                       |       | 2003       |       | —                  |       | —                |       | —                     |       | —         |       | — |   |
|                                           |       |       |       |                    |       |                  |       |                       |       |           |       |   |   |
| Harry J.  Phillips, Jr. (2)                    |       | 2005       |       | 97,692                  |       | —                |       | —                     |       | —         |       | 3,172 |   |
| Former Chief  Executive Officer                |       | 2004       |       | 430,002                 |       | —                |       | —                     |       | 20,000         |       | 6,908 |   |
|                                           |       | 2003       |       | 394,500                 |       | —                |       | —                     |       | —         |       | 6,937 |   |
|                                           |       |       |       |                    |       |                  |       |                       |       |           |       |   |   |
| John R.  Nieser (3)                            |       | 2005       |       | 194,923                 |       | 30,000                |       | —                     |       | 46,000         |       | 6,694 |   |
| Chief  Financial Officer                       |       | 2004       |       | 102,230                 |       | —                |       | —                     |       | 20,000         |       | 3,324 |   |
| and  Treasurer                                 |       | 2003       |       | —                  |       | —-               |       | —                     |       | —         |       | — |   |
|                                           |       |       |       |                    |       |                  |       |                       |       |           |       |   |   |
| Patrick N.  Perrin (4)                         |       | 2005       |       | 177,723                 |       | 13,650                |       | —                     |       | —         |       | 19,982 |   |
| Senior Vice  President and                     |       | 2004       |       | 168,108                 |       | —                |       | —                     |       | 10,000         |       | 5,131 |   |
| Chief  Administrative Officer                  |       | 2003       |       | 164,000                 |       | —                |       | —                     |       | 3,730          |       | 5,056 |   |
|                                           |       |       |       |                    |       |                  |       |                       |       |           |       |   |   |
| Thomas R.  Jenkins (5)                         |       | 2005       |       | 150,181                 |       | —                |       | —                     |       | —         |       | 576,065 |   |
| Former Chief  Operating                        |       | 2004       |       | 307,543                 |       | —                |       | —                     |       | 15,000         |       | 8,027 |   |
| Officer                                        |       | 2003       |       | 280,812                 |       | —                |       | —                     |       | 12,330         |       | 7,263 |   |
|                                           |       |       |       |                    |       |                  |       |                       |       |           |       |   |   |
| John C.  Godlesky (6)                          |       | 2005       |       | 91,378                  |       | —                |       | —                     |       | —         |       | 183,461 |   |
| Former  Senior Vice President,                 |       | 2004       |       | 150,388                 |       | —                |       | —                     |       | 5,000          |       | 4,320 |   |
| Eastern  Region                                |       | 2003       |       | 143,365                 |       | —                |       | —                     |       | 2,460          |       | 4,067 |   |

 

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(1)   Amounts in All Other Compensation for Mr. Hyman include the Company’s401(k) matching contributions of $6,300 and group term life insurance premiumsof $701.

(2)   Mr. Phillips served his last day as Chief Executive Officer on January24, 2005.  Amounts in All OtherCompensation include the Company’s 401(k) matching contributions of $2,931 andgroup term life insurance premiums of $241.

(3)   Amounts in All Other Compensation for Mr. Nieser include the Company’s401(k) matching contributions of $5,848, group term life insurance premiums of$246 and a cell phone allowance of $600.

(4)   Amounts in All Other Compensation for Mr. Perrin include the Company’s401(k) matching contributions of $5,752, group term life insurance premiums of$230, and payment for certain vested vacation plan benefits in the amount of$14,000.

(5)   Mr. Jenkins served his last day as Chief Operating Officer on March 10,2005.  Amounts in All Other Compensationinclude the Company’s 401(k) matching contributions of $2,401, group term lifeinsurance premiums of $427, relocation and outplacement fees of $25,000 andseverance in the amount of $548,237.

(6)   Mr. Godlesky served his last day as Senior Vice President, EasternRegion on June 30, 2005.  Amounts in AllOther Compensation include the Company’s 401(k) matching contributions of$2,249, group term life insurance premiums of $301 and severance in the amountof $180,911.

(7)   The value of Mr. Hyman’s shares as of December 31, 2005 based on ashare price of $13.82 was $1,174,700. 25,000 shares vest on January 24, 2008 if Mr. Hyman remainscontinuously employed by the Company; 30,000shares vest upon the Company achieving a certain stock price within a certaintime period, as established by the Compensation Committee; and 30,000 sharesvest upon the Company achieving a certain earnings per share within a certaintime period, as established by the Compensation Committee.

 

100

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The following table presents informationregarding options granted to each of the Named Executive Officers in 2005.

 

**OPTIONGRANTS IN 2005**

 
| ** **            | ** ** | **Number of  Securities  Underlying  Options** | ** ** | **Percentage  of Total  Options  Granted to  Employees** | ** ** | **Exercise  Price** | ** ** | **Expiration** | ** ** | **Potential Realizable  Value at Assumed  Rates of Stock Price  Appreciation  for Option Term (1)** | ** ** |
|-----------------------|------------|------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| **Name**              | ** ** | **Granted**                                    | ** ** | **in 2005**                                              | ** ** | **Per Share**       | ** ** | **Date**       | ** ** | **5%**                                                                                              | ** ** | **10%** | ** ** |
| ** **            | ** ** | ** **                                     | ** ** | ** **                                               | ** ** | ** **          | ** ** | ** **     |       |                                                                                                |       |   |   |
| James E. Hyman        |       | 50,000                                         |       | 14.26                                                    | %          | $                   | 13.34      |           | 3/14/2015  |                                                                                                | $          | 419,473 |   | $ | 1,063,026 |   |
| Harry J. Phillips, Jr |       | —                                         |       | —                                                   |       | —              |       | —         |       | —                                                                                              |       | — |   |
| John R. Nieser        |       | 46,000                                         |       | 13.11                                                    | %          | $                   | 12.60      |           | 3/31/2015  |                                                                                                | $          | 364,507 |   | $ | 923,733 |   |
| Patrick N. Perrin     |       | —                                         |       | —                                                   |       | —              |       | —         |       | —                                                                                              |       | — |   |
| Thomas R. Jenkins     |       | —                                         |       | —                                                   |       | —              |       | —         |       | —                                                                                              |       | — |   |
| John C. Godlesky      |       | —                                         |       | —                                                   |       | —              |       | —         |       | —                                                                                              |       | — |   |

 

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(1)   The values shown are based on the indicated assumed annual rates ofappreciation compounded annually. Actual gains realized, if any, on stockoption exercises and Common Stock holdings are dependent on the futureperformance of the Common Stock and overall stock market conditions. There canbe no assurance that the values shown in this table will be achieved.

 

The followingtable presents information regarding options exercised in 2005 and the value ofoptions outstanding at December 31, 2005 for each of the Named ExecutiveOfficers.

 

**AGGREGATEDOPTION EXERCISES IN LAST FISCAL YEAR AND**

**FISCALYEAR-END OPTION VALUES**

 
| ** **             | ** ** | **Number of  Shares Acquired** | ** ** | **Value**    | ** ** | **Number of Securities  Underlying Unexercised  Options at Fiscal Year End** | ** ** | **Value of Unexercised  In-the-Money Options  at Fiscal Year End (1)** | ** ** |
|------------------------|------------|--------------------------------|------------|--------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| **Name**               | ** ** | **on Exercise**                | ** ** | **Realized** | ** ** | **Exercisable**                                                              | ** ** | **Unexercisable**                                                      | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
| ** **             | ** ** | ** **                     | ** ** | ** **   | ** ** | ** **                                                                   | ** ** | **(2)**                                                                | ** ** | ** ** | ** ** | **(2)** | ** ** |
| James E. Hyman         |       | —                         |       | —       |       | 16,667                                                                       |       | 33,333                                                                 |       | $ | 8,000 |   | $ | 16,000 |   |
| Harry J. Phillips, Jr. |       | 119,000                        |       | $            | 1,135,620  |                                                                         | —     |                                                                   | —     |   | — |   | — |   |
| John R. Nieser         |       | —                         |       | —       |       | 4,000                                                                        |       | 62,000                                                                 |       | $ | 3,580 |   | $ | 70,440 |   |
| Patrick N. Perrin      |       | —                         |       | —       |       | 33,111                                                                       |       | 13,119                                                                 |       | $ | 94,202 |   | $ | 11,265 |   |
| Thomas R. Jenkins      |       | 43,964                         |       | $            | 279,965    |                                                                         | —     |                                                                   | —     |   | — |   | — |   |
| John C. Godlesky       |       | 13,560                         |       | $            | 76,944     |                                                                         | —     |                                                                   | —     |   | — |   | — |   |
|                        |            |                                |            |              |            |                                                                              |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)   Equal to the excess, if any, of the market value of Common Stock atDecember 31, 2005 ($13.82) over the option exerciseprice(s).

(2)   All of these options become immediatelyexercisable upon a change in control of the Company.

 

**COMPENSATIONCOMMITTEE INTERLOCKS AND INSIDER PARTICIPATION**

 

The members of the Compensation Committee are ThomasR. Hudson, Jr., Richard Crane and Sally L. Walker. None of these directors hasat any time been an officer or employee of the Company, and none of thesedirectors serve as a member of the board of directors or compensation committeeof any entity that has one or more executive officers serving as a member ofthe Company’s Board or Compensation Committee.

 

101

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** **

**ITEM 12.****      ****SECURITIES OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ANDRELATED STOCKHOLDER MATTERS**

 

The following table sets forth informationwith respect to the shares of common stock of the Company (the only outstandingclass of voting securities of the Company) owned of record and beneficially asof March 10, 2006, unless otherwise specified, by (i) all persons known topossess voting or dispositive power over more than 5% of the common stock ofthe Company, (ii) each director and named executive officer, and (iii) alldirectors and executive officers of the Company as a group:

 
| ** **                                           | ** ** | **Amount and Nature of  Beneficial Ownership (1)** | ** ** | **Percentage** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|----------------|------------|
| Pirate  Capital LLC (2)(10)                          |       | 2,321,100                                          |       | 16.64          | %          |
| 200 Connecticut Avenue, 4th  Floor                   |       |                                               |       |           |       |
| Norwalk, CT 06854                                    |       |                                               |       |           |       |
| Merrill  Lynch & Co. (on behalf of Merrill Lynch |       |                                               |       |           |       |
| Investment Managers (“MILM”)) (3)          |       | 1,390,600                                          |       | 9.97           | %          |
| World Financial Center, North Tower                  |       |                                               |       |           |       |
| 250 Vesey Street                                     |       |                                               |       |           |       |
| New York, NY 10381                                   |       |                                               |       |           |       |
| Dimensional  Fund Advisors, Inc. (4)                 |       | 1,225,800                                          |       | 8.79           | %          |
| 1299 Ocean Avenue, 11th Floor                        |       |                                               |       |           |       |
| Santa Monica, CA 90401                               |       |                                               |       |           |       |
| Albert Fried  & Company, LLC (5)                 |       | 1,219,564                                          |       | 8.75           | %          |
| 60 Broad Street, 39th Floor                          |       |                                               |       |           |       |
| New York, NY 10004                                   |       |                                               |       |           |       |
| Wynnefield  Capital Management, LLC (6)              |       | 1,070,800                                          |       | 7.68           | %          |
| 450 Seventh Avenue, Suite 509                        |       |                                               |       |           |       |
| New York, NY 10123                                   |       |                                               |       |           |       |
| Bank of  America Corporation (7)                     |       | 916,232                                            |       | 6.57           | %          |
| 100 North Tyron Street, Floor 25                     |       |                                               |       |           |       |
| Bank of America Corporate Center                     |       |                                               |       |           |       |
| Charlotte, NC 28255                                  |       |                                               |       |           |       |
| North Star  Partners, L.P. (8)                       |       | 838,683                                            |       | 6.01           | %          |
| 274 Riverside Avenue                                 |       |                                               |       |           |       |
| Westport, CT 06880                                   |       |                                               |       |           |       |
| JPMorgan Chase  & Co. (9)                        |       | 802,670                                            |       | 5.76           | %          |
| 270 Park Avenue                                      |       |                                               |       |           |       |
| New York, NY 10017                                   |       |                                               |       |           |       |

 

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| Anthony R. Chase                                              |   | 53,189    |   | *     |   |
|---------------------------------------------------------------|--------|-----------|--------|-------|--------|
| Leon Clements                                                 |   | 10,353    |   | *     |   |
| Richard Crane                                                 |   | 10,453    |   | *     |   |
| Zachary R. George                                             |   | 12,065    |   | *     |   |
| John C. Godlesky                                              |   | —    |   | *     |   |
| Todd Goodwin                                                  |   | 19,477    |   | *     |   |
| Thomas R. Hudson, Jr. (10)                                    |   | 2,333,553 |   | 16.73 | %      |
| James E. Hyman                                                |   | 114,167   |   | *     |   |
| Thomas R. Jenkins                                             |   | —    |   | *     |   |
| Alfred J. Moran, Jr.                                          |   | 10,353    |   | *     |   |
| John R. Nieser                                                |   | 4,000     |   | *     |   |
| Patrick N. Perrin                                             |   | 86,214    |   | *     |   |
| Harry J. Phillips, Jr.                                        |   | —    |   | *     |   |
| D. Stephen Slack                                              |   | 65,063    |   | *     |   |
| Sally L. Walker                                               |   | 8,750     |   | *     |   |
| All directors and executive officers as a  group (20 persons) |   | 2,739,997 |   | 19.36 | %      |

 

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*          Less than 1.0%.

 

(1)   Shares of Common Stock listed include sharessubject to stock options exercisable within 60 days (44,600 for Mr. Chase,8,750 for Mr. Clements, 8,750 for Mr. Crane, 8,750 for Mr. George, 8,750 forMr. Goodwin, 8,750 for Mr. Hudson, 16,667 for Mr. Hyman, 8,750 for Mr. Moran,4,000 for Mr. Nieser, 35,484 for Mr. Perrin, 35,000 for Mr. Slack, 8,750 forMs. Walker, and 197,001 for all the above as a group).

(2)   Based on a filing made with the SECreflecting ownership of Common Stock as of December 31, 2005 as filed by PirateCapital LLC.  The filing indicates solevoting power and shared dispositive power with respect to the referenced sharesof Common Stock.

(3)   Based on a filing made with the SECreflecting ownership of Common Stock as of December 31, 2005. The filingindicates shared voting power and shared dispositive power for the referencedshares of Common Stock. Merrill Lynch & Co., Inc. is a parent holdingcompany. Merrill Lynch Investment Managers is an operating division of MerrillLynch & Co., Inc. consisting of Merrill Lynch & Co., Inc.’s indirectly-ownedasset management subsidiaries including Fund Asset Management LP and MerrillLynch Investment Managers LP.

(4)   Based on a filing made with the SECreflecting ownership of Common Stock as of December 31, 2005 as filed byDimensional Fund Advisors, Inc. The filing indicates sole voting power and soledispositive power with respect to the referenced shares of Common Stock.

(5)   Based on a filing made with the SECreflecting ownership of Common Stock as of December 31, 2005 as filed by AlbertFried, Jr. and Albert Fried & Company, LLC. The filing indicates solevoting power and sole dispositive power with respect to the referenced sharesof Common Stock.

(6)   Based on a filing made with the SEC reflecting ownership of CommonStock as of December 31, 2005 as filed by Wynnefield Capital Management,LLC.  The filing indicates sole voting powerand sole dispositive power with respect to the referenced shares of CommonStock.

(7)   Based on a filing made with the SECreflecting ownership of Common Stock as of December 31, 2005 as filed by Bankof America Corporation. The filing indicates shared voting power for 762,068shares of Common Stock and shared dispositive power for 916,232 shares ofCommon Stock with NB Holdings Corporation, Bank of America, NA, ColumbiaManagement Group, LLC and Columbia Management Advisors, LLC.

(8)   Based on a filing made with the SECreflecting ownership of Common Stock as of December 29, 2005 as filed by NorthStar Partners, L.P., North Star Partners II, L.P., Circle T Master Limited, NSAdvisors, LLC and Andrew R. Jones. The filing indicates sole voting power andsole dispositive power with respect to the referenced shares of Common Stock.

(9)   Based on a filing made with the SECreflecting ownership of Common Stock as of December 30, 2005 as filed byJPMorgan Chase & Co. The filing indicates sole voting power for 741,270shares of Common Stock and sole dispositive power for 802,670 shares of CommonStock.

(10)Based on the Statement of BeneficialOwnership on Form 4 filed with the SEC, indicating sole voting power and soledispositive power with respect to the referenced shares of Common Stock.  As the managing member of Pirate Capital LLC,Thomas R. Hudson, Jr. (i) may be deemed to be the beneficial owner of allshares of Common Stock owned by Pirate Capital LLC and (ii) is deemed to havesole voting power and sole dispositive power with respect to all shares ofCommon Stock as to which Pirate Capital LLC has a voting or dispositive power.

 

103

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**ITEM 13.****      ****CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

**JamesE. Hyman**

 

In March 2005, the Company entered into an employment agreement withJames E. Hyman, pursuant to which Mr. Hyman serves as the Company’s ChiefExecutive Officer and Chairman of the Board.

 

The agreement has a rolling two-year term (the “Employment Period”). Under the agreement, Mr. Hyman’s annual base salary is $475,000, and he iseligible to receive a bonus upon the achievement of certain performanceobjectives equal to $25,000 plus up to 112% of Mr. Hyman’s annual basesalary.  Mr. Hyman also received a $165,000 signing bonus.  Mr. Hymanis required to return all of the signing bonus if his employment is terminatedby the Company for cause (as defined in the agreement) or if he voluntarilyterminates his employment without good reason (as defined in the agreement)before January 24, 2006, and is required to return 50% if, after January 24,2006 but before January 24, 2007, he voluntarily terminates his employmentwithout good reason (as defined in the agreement).

 

Pursuant to the agreement, Mr. Hyman was granted options to purchase50,000 shares of Common Stock pursuant to the 1996 Plan, with an exercise priceequal to the closing price of the Common Stock of the Company on the New YorkStock Exchange on the Effective Date (the “Hyman Stock Options”). One third ofthe Hyman Stock Options become exercisable on January 24, 2006, 2007, and 2008,respectively, provided that Mr. Hyman has remained continuously employed by theCompany.

 

Mr. Hyman was also granted 85,000 restricted shares of Common Stock(the “Restricted Stock”) under the agreement.  The shares of RestrictedStock vest as follows: 25,000 shares of Restricted Stock vest on January 24,2008; 30,000 shares of Restricted Stock shall vest upon the Company achieving acertain stock price within a certain time period as established by theCompensation Committee; and 30,000 shares of Restricted Stock vest upon theCompany achieving a certain earnings per share within a certain time period asestablished by the Compensation Committee, subject, in each case to Mr. Hyman’scontinued employment with the Company through each such date.

 

Pursuant to the agreement, if Mr. Hyman’s employment is terminated bythe Company for cause, Mr. Hyman is entitled to receive his base salary accruedthrough the termination date and reimbursement of all reasonable expensesincurred by Mr. Hyman.  If Mr. Hyman’s employment is terminated due to hisdeath or disability (as defined in the agreement), Mr. Hyman or his estate willreceive (i) his base salary accrued through the date of death or disability,(ii) a prorated bonus for the year in which the death or disability occurs,(iii) reimbursement of all reasonable expenses incurred by Mr. Hyman and (iv) extendedhealth care benefits (COBRA) at the Company’s expense for six months.  Ifthe Company terminates the employment of Mr. Hyman without cause or hevoluntarily terminates his employment with good reason, then, he is entitled toreceive the following: (i) base salary accrued through the termination date,(ii) a prorated bonus for the year in which the termination occurs, (iii) anamount equal to Mr. Hyman’s base salary plus his target bonus for the remainderof the Employment Period, (iv) reimbursement of all reasonable expensesincurred by Mr. Hyman, (v) extended health care benefits (COBRA) at the Company’sexpense for eighteen months following his termination, and (vi) all shares ofRestricted Stock immediately vest.  All cash payments due from the Companyupon termination are due to Mr. Hyman or his estate within one month of thedate of termination.

 

In the event that Mr. Hyman voluntarily terminates his employment withgood reason within 180 days following a change in control, then, suchtermination will be considered to be with good reason, and Mr. Hyman shall beentitled to receive the same benefits as above, except that no vesting of Mr.Hyman’s Restricted Stock will occur.  Mr. Hyman will also receivereimbursement for relocation expenses if his employment is terminated withoutcause or for good reason within 180 days following a change in control.

 

104

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** **

**John R. Nieser**

 

In March 2005, the Company and Mr. Nieser, the Company’s ChiefFinancial Officer, entered into an employment/separation agreement.  Theagreement begins with a rolling two-year term until March 14, 2007 and thenbeginning March 15, 2007 has a rolling one-year term.  Mr. Nieser’sannual base salary is not less than $200,000 per year, and he is eligible for acash bonus at a targeted amount of 40% of his base salary.  If Mr. Nieser’semployment is terminated due to death or disability (as defined in theagreement), Mr. Nieser or his estate is entitled to his base salary and bonusearned through the date of termination (as defined in the agreement).  IfMr. Nieser’s employment is terminated for cause (as defined in the agreement)or due to voluntary resignation, Mr. Nieser is entitled to his base salarythrough the date of termination.  If Mr. Nieser is terminated withoutcause or due to a change in control (as defined in the agreement), he isentitled to his base salary and bonus through the date of termination and (i)two times his base salary if the termination occurs prior to March 9, 2007or (ii) one time his base salary if termination occurs between March 9,2007 and March 8, 2008.

 

**Mark S. Croft**

 

In November 2005, the Company and Mr. Croft entered into anemployment/severance arrangement. Mr. Croft’s annual base salary is $190,000per year, and he is eligible for a discretionary cash bonus at a targetedamount of 30% of his annual base salary. Under the terms of the severance agreement, if, within one year after achange in control (as defined in the agreement), Mr. Croft’s employment isterminated for any reason, with or without cause, he will receive a lump sumcash payment, concurrent with the date of his termination, equal to the sum of(i) Mr. Croft’s highest annual base salary as of the date of termination or thedate the change in control occurs, plus (ii) the average of the annual bonuspaid or payable to Mr. Croft in respect of the two most recent full fiscalyears ending on or prior to the date of his termination (or if Mr. Croft hasnot been employed for two full fiscal years, then the annual bonus in respectof the most recent full fiscal year). In addition, all stock options,restricted stock awards and similar awards granted to Mr. Croft prior to thedate of termination will immediately vest on the date of termination.

 

**PatrickN. Perrin**

 

In December 1999, the Company entered into an employment/severanceagreement with Patrick N. Perrin.  IfMr. Perrin’s employment is terminated for any reason within a year after achange in control (as defined in the severance agreement), all stock options,restricted stock awards and similar awards granted to Mr. Perrin prior to thetermination date will vest immediately on the date of termination.

 

In addition, pursuant to the agreement, the Company will remit to Mr.Perrin, as severance, a payment equal to the sum of (a) his highest annual basesalary as of the termination date and the change in control date, and(b) the average bonus paid to him for the two most recent full fiscalyears ending on or prior to the termination date.  The Company has agreed to pay the severanceamounts in a lump sum in cash (i) on the termination date if the Companyterminates Mr. Perrin, or (ii) within thirty days after the termination date ifMr. Perrin’s employment is terminated by him or upon his

deathor retirement.

 

**ITEM 14.****      ****PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 

**Informationon Independent Registered Public Accounting Firm**

 

The Audit Committee of the Board of Directors has considered thequalifications of PricewaterhouseCoopers LLP and will recommend that the Boardof Directors appoint them as our independent registered public accounting firmfor the fiscal year ending December 31, 2006.

 

PricewaterhouseCoopers LLP served as our independent registered publicaccounting firm in 2005 and 2004. Representatives from PricewaterhouseCoopers LLP are expected to bepresent at the annual meeting of shareholders and will have an opportunity tomake a statement, if they so desire, as well as to respond to appropriatequestions that may be asked by shareholders.

 

105

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** **

**PrincipalAccountant Fees and Services**

 

The following table sets forth the aggregate fees billed or estimatedto be billed to the Company by PricewaterhouseCoopers LLP for the years endedDecember 31, 2005 and 2004:

 

| ** **         | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------|------------|----------|------------|----------|------------|
| Audit fees         |       | $        | 1,113,800  |     | $          | 1,474,106 |   |
| Audit related fees |       | 54,500   |       | 53,825   |       |
| Tax fees           |       | 10,000   |       | —   |       |
| All other fees     |       | —   |       | —   |       |
|               |       | $        | 1,178,300  |     | $          | 1,527,931 |   |
|                    |            |          |            |          |            |  |  |  |  |

 

**AuditFees**

 

Audit fees represent the aggregate fees billed or estimated to bebilled to the Company for professional services rendered for the audit of ourannual financial statements, review of financial statements included in Form10-Q’s and services normally provided by our accountants in connection withstatutory and regulatory filings or engagements.

 

**AuditRelated Fees**

 

Audit related fees represent the aggregate fees billed to the Companyor estimated to be billed to the Company for assurance and related servicesthat were reasonably related to the performance of the audit or review of ourfinancial statements and are not reported under “Audit Fees” above, includingthe implementation and readiness assistance with the requirements of theSarbanes-Oxley Act of 2002, assistance with registration statements, comfortletters and consents.

 

**TaxFees**

 

Tax fees represent the aggregate fees billed to the Company orestimated to be billed to the Company for professional services rendered fortax compliance, tax advice and tax planning. The nature of the services comprising these fees were to supportcompliance with federal and state tax reporting and payment requirements,including tax return review and review of tax laws, regulations or cases.

 

**AllOther Fees**

 

All other fees represent the aggregate fees billed to the Company orestimated to be billed to the Company for products or services provided to theCompany by PricewaterhouseCoopers LLP, other than the services reported in theabove categories.  For 2005 and 2004,there were no fees billed related to other services.

 

The Audit Committee has considered whether the provision of non-auditservices by PricewaterhouseCoopers LLP is compatible with maintaining auditorindependence and has determined that auditor independence has not beencompromised.

 

**Pre-approvalPolicies and Procedures**

 

The Audit Committee Charter, as amended in October 2004, is availablethrough the Corporate Governance link on the Company’s website atwww.cornellcompanies.com and to any stockholder upon request, provides that theAudit Committee is responsible for pre-approving all audit services andpermitted non-audit services to be performed for the Company by the independentregistered public accounting firm. All of the fees paid to the independentregistered public accounting firm in 2005 were pre-approved by the AuditCommittee.

 

106

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** **

**PART IV**

 

**ITEM 15.****      ****EXHIBITS, FINANCIALSTATEMENTS AND FINANCIAL STATEMENT SCHEDULES**

 

(a)           **Financial Statements,Schedules and Exhibits**

 
| 1.     | Financial  statements          |                                                                                                                                                      |   |
|--------|--------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |                           | Report of  Independent Registered Public Accounting Firm                                                                                                  |   | 54 |
|   |                           | Consolidated Balance  Sheets - December 31, 2005 and 2004                                                                                            |   | 55 |
|   |                           | Consolidated  Statements of Operations and Comprehensive Income/(Loss) for the years ended  December 31, 2005, 2004 and 2003                         |   | 56 |
|   |                           | Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2005, 2004 and 2003                                          |   | 57 |
|   |                           | Consolidated  Statements of Cash Flows for the years ended December 31, 2005, 2004 and  2003                                                         |   | 58 |
|   |                           | Notes to  consolidated financial statements                                                                                                               |   | 59 |
| 2.     | Financial  statement schedules |                                                                                                                                                      |   |
|   |                           | All schedules are omitted because they are not  applicable or because the required information is included in the financial  statements or notes thereto. |   |   |
|   |                           |                                                                                                                                                      |   |   |
| 3.     | Exhibits                       |                                                                                                                                                      |   |

 
| **Exhibit  No.** | ** ** | **Description** | ** **                                                                                                                                                                                                                          | **Incorporated by Reference** |
|------------------|------------|-----------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------|
| 2.1              |       |            | Agreement and Plan of Merger, dated January 24, 2005, among Cornell  Companies, Inc., Correctional Systems, Inc., Cornell Acquisition Corp. and  Infrastructure and Environmental Private Equity Fund III, L.P.                     |                                    | 22 |
| 2.2              |       |            | Amendment  to Agreement and Plan of Merger, dated March 16, 2005, among Cornell  Companies, Inc., Correctional Systems, Inc. Cornell Acquisition Corp. and  Infrastructure and Environmental Private Equity Fund III, L.P.          |                                    | 25 |
| 3.1              |       |            | Restated  Certificate of Incorporation of Cornell Companies, Inc.                                                                                                                                                                   |                                    | 1 |
| 3.2              |       |            | Amended  and Restated Bylaws of Cornell Companies, Inc.                                                                                                                                                                             |                                    | 19 |
| 4.1              |       |            | Certificate  representing Common Stock.                                                                                                                                                                                             |                                    | 2 |
| 4.2              |       |            | Registration  Rights Agreement, dated March 31, 1994, as amended, among Cornell  Corrections, Inc. and the stockholders listed on the signature pages thereto.                                                                 |                                    | 2 |
| 4.3              |       |            | Rights  Agreement, dated May 1, 1998, between Cornell Corrections, Inc. and the  stockholders listed on the signature pages thereto.                                                                                                |                                    | 7 |
| 4.4              |       |            | Amendment  No. 1 to the Rights Agreement, dated May 1, 1998, between Cornell  Corrections, Inc. and the stockholders listed in the signature pages thereto.                                                                         |                                    | 24 |
| 4.5              |       |            | Certificate  Eliminating Series A Participating Preferred Stock.                                                                                                                                                                    |                                    | 24 |
| 9.1              |       |            | Stock  Transfer and Voting Agreement, dated November 23, 1994, between David  M. Cornell and Jane B. Cornell.                                                                                                             |                                    | 2 |
| 10.1             | a          |            | Cornell  Corrections, Inc. Amended and Restated 1996 Stock Option Plan.                                                                                                                                                             |                                    | 6 |
| 10.2             | a          |            | Employment  Agreement, dated as of September 9, 1997, between Abraxas Group, Inc.  and Arlene R. Lissner.                                                                                                                      |                                    | 3 |
| 10.3             | (a)        |            | Covenant  Not to Compete Agreement, dated September 9, 1997, by and between  Cornell Corrections, Inc. and Arlene R. Lissner.                                                                                                  |                                    | 3 |
| 10.4             |       |            | Form  of Indemnification Agreement between Cornell Companies, Inc. and each of its  directors and executive officers.                                                                                                               |                                    | 2 |
| 10.5             |       |            | Stockholders  Agreement among certain stockholders named therein dated September 15,  1997.                                                                                                                                    |                                    | 3 |
| 10.6             |       |            | Professional  Management Agreement, dated July 15, 1992, between Cornell Corrections, Inc.  and Central Falls Detention Facility Corporation.                                                                                       |                                    | 2 |
| 10.7             |       |            | Operating  Agreement by and between each of MidTex Detentions, Inc., the City of Big  Spring, Texas and Cornell Corrections of Texas, Inc., dated July 1,  1996, and related Assignment and Assumption of Operating Agreement. |                                    | 2 |

 

107

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| **Exhibit  No.** | ** ** | **Description** | ** **                                                                                                                                                                                                                      | **Incorporated by Reference** |
|------------------|------------|-----------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------|
| 10.8             |       |            | Contract  between Cornell Corrections of California, Inc. and the California Department  of Corrections (No. R92.132) for the Live Oak, California Facility, dated  March 1, 1993, as amended.                             |                                    | 2 |
| 10.9             |       |            | Asset  Purchase Agreement, dated January 31, 1997, by and between Cornell  Corrections of Texas, Inc. and Interventions Co.                                                                                                |                                    | 4 |
| 10.10            |       |            | Asset  Purchase Agreement, dated August 14, 1997, by and between Cornell  Corrections, Inc. and Abraxas Group, Inc., Foundation for Abraxas, Inc.,  Abraxas Foundation, Inc., Abraxas Foundation of Ohio and Abraxas, Inc. |                                    | 3 |
| 10.11            |       |            | Contract  between Texas Alcoholism Foundation, Inc. and the Texas Department of  Criminal Justice, Parole Division for the Reid Facility, dated  January 31, 1996, as amended.                                             |                                    | 2 |
| 10.12            |       |            | Form  of Contract between Cornell Corrections of California and the Utah State  Department of Human Services, Division of Youth Corrections for the Salt Lake  City, Utah Juvenile Facility.                                    |                                    | 2 |
| 10.13            |       |            | Asset  Purchase Agreement, dated May 14, 1996, among Cornell Corrections of Texas,  Inc., Texas Alcoholism Foundation, Inc. and the Texas House Foundation, Inc.                                                                |                                    | 2 |
| 10.14            |       |            | Asset  Purchase Agreement, dated May 22, 1996, among Cornell Corrections of Texas  Inc., the Company, Ed Davenport, Johnny Rutherford and MidTex Detentions,  Inc.                                                              |                                    | 2 |
| 10.15            |       |            | Lease  Agreement, dated August 1, 1987, between Cornell Corrections of California  Inc. and Baker Housing Company for the Baker, California facility.                                                                           |                                    | 2 |
| 10.16            |       |            | Lease  Agreement between City of Big Spring, Texas and Ed Davenport, dated  July 1, 1996, for the Interstate Unit and related Assignment and  Assumption of Leases.                                                        |                                    | 2 |
| 10.17            |       |            | Secondary  Sublease Agreement between City of Big Spring and Ed Davenport, dated  July 1, 1996, for the Airpark Unit and related Assignment and Assumption  of Leases.                                                     |                                    | 2 |
| 10.18            |       |            | Secondary  Sublease Agreement between City of Big Spring and Ed Davenport, dated  July 1, 1996, for the Flightline Unit and related Assignment and  Assumption of Leases.                                                  |                                    | 2 |
| 10.19            |       |            | Stock  Option Agreement between Cornell Corrections, Inc. and CEP II dated  July 9, 1996.                                                                                                                                  |                                    | 2 |
| 10.20            |       |            | Form  of Option Agreement between Cornell Corrections, Inc. and the optionholder  listed therein dated as of November 1, 1995.                                                                                             |                                    | 10 |
| 10.21            |       |            | Senior  Note Agreement by and between Cornell Corrections, Inc. and the note  purchasers dated July 15, 1998.                                                                                                              |                                    | 8 |
| 10.22            |       |            | Asset  Purchase Agreement, dated November 17, 1997, by and between Foresite  Capital Facilities Corporation and the Hinton Economic Development Authority.                                                                 |                                    | 5 |
| 10.23            |       |            | Amendment,  dated December 10, 1997, to Asset Purchase Agreement dated as of  November 17, 1997.                                                                                                                      |                                    | 5 |
| 10.24            |       |            | Amendment  No. 2, dated January 6, 1998, to Asset Purchase Agreement dated as of  November 17, 1997.                                                                                                                  |                                    | 5 |
| 10.25            |       |            | Assignment  of Agreement of Purchase and Sale, dated January 5, 1998, by and between  Foresite Capital Facilities Corporation and Cornell Corrections of Oklahoma,  Inc.                                                   |                                    | 5 |
| 10.26            |       |            | Allvest  Asset Purchase Agreement, dated June 20, 1998, by and between Cornell  Corrections, Inc. and Allvest, Inc., St. John Investments, and William C.  Weimar.                                                         |                                    | 9 |
| 10.26            | (a)        |            | Subordinated  Bridge Loan Agreement by and between Cornell Corrections, Inc. and ING dated  October 14, 1999.                                                                                                              |                                    | 11 |
| 10.27            |       |            | Asset  Purchase Agreement, dated May 10, 1999, by and among Cornell Corrections,  Inc. and Interventions and IDDRS Foundation.                                                                                                  |                                    | 11 |
| 10.28            |       |            | Extension  of Asset Purchase Agreement, dated September 30, 1999, by and among  Cornell Corrections, Inc. and Interventions and IDDRS Foundation.                                                                          |                                    | 11 |

 

108

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| **Exhibit  No.** | ** ** | **Description** | ** **                                                                                                                                                                                                                                                                                                                                                        | **Incorporated by Reference** |
|------------------|------------|-----------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------|
| 10.29            |       |            | Asset  Purchase Agreement, dated May 10, 1999, by and among BHS Consulting Corp.,  its shareholders and Cornell Corrections, Inc.                                                                                                                                                                                                                                 |                                    | 11 |
| 10.30            |       |            | Extension  of Asset Purchase Agreement, dated September 30, 1999, by and among BHS  Consulting Corp., its shareholders and Cornell Corrections, Inc.                                                                                                                                                                                                              |                                    | 11 |
| 10.31            |       |            | Amendment  to Asset Purchase Agreement, dated November 12, 1999, by and among BHS  Consulting Corp., its shareholders and Cornell Corrections, Inc.                                                                                                                                                                                                               |                                    | 11 |
| 10.32            |       |            | Participation  Agreement, dated November 23, 1999, among Cornell Corrections, Inc. and  certain of its subsidiaries and Heller Financial Leasing, Inc.                                                                                                                                                                                                            |                                    | 12 |
| 10.33            |       |            | Lease  Agreement, dated November 23, 1999, between First Security Bank, National  Association, and Cornell Corrections, Inc. and certain of its subsidiaries.                                                                                                                                                                                                     |                                    | 12 |
| 10.34            |       |            | Lease  Agreement, dated December 31, 1999, by and among Hinton Economic Development  Authority, the Town of Hinton, Oklahoma, and Cornell Corrections of Oklahoma,  Inc.                                                                                                                                                                                          |                                    | 12 |
| 10.35            |       |            | Consulting  Agreement, dated December 15, 1999, between Cornell Corrections, Inc. and  David M. Cornell. (a)                                                                                                                                                                                                                                                      |                                    | 12 |
| 10.36            |       |            | Form  of Severance Agreement executed by John Hendrix, Arlene Lissner, Thomas  Jenkins, Thomas Rathjen, Patrick Perrin and Steven Logan. (a)                                                                                                                                                                                                                      |                                    | 12 |
| 10.37            |       |            | Fourth  Amended and Restated Credit Agreement, dated July 21, 2000, among Cornell  Companies, Inc., certain subsidiaries of Cornell Companies, Inc., Atlantic  Financial Group, Ltd., the Lenders and ING (U.S.) Capital LLC, as  Administrative Agent.                                                                                                           |                                    | 13 |
| 10.38            |       |            | Amended  and Restated Master Agreement, dated July 21, 2000, among Cornell Companies,  Inc., certain subsidiaries of Cornell Companies, Inc., Atlantic Financial  Group, Ltd., the Lenders, ING (U.S.) Capital LLC, as Administrative Agent,  Bank of America N.A., as Syndication Agent, and Suntrust Equitable Securities  Corporation, as Documentation Agent. |                                    | 13 |
| 10.39            |       |            | Note  and Equity Purchase Agreement, dated July 21, 2000, among Cornell Companies,  Inc., American Capital Strategies, Ltd. and Teachers Insurance and Annuity  Association of America.                                                                                                                                                                           |                                    | 13 |
| 10.40            |       |            | Warrant  issued by Cornell Companies, Inc. to American Capital Strategies, Ltd. dated  July 21, 2000.                                                                                                                                                                                                                                                        |                                    | 13 |
| 10.41            |       |            | Warrant  issued by Cornell Companies, Inc. to Teachers Insurance and Annuity  Association of America, dated July 21, 2000.                                                                                                                                                                                                                                   |                                    | 13 |
| 10.42            |       |            | Cornell  Corrections, Inc. Employee Stock Purchase Plan.                                                                                                                                                                                                                                                                                                          |                                    | 14 |
| 10.42            | (a)        |            | Cornell  Companies, Inc. Deferred Compensation Plan.                                                                                                                                                                                                                                                                                                              |                                    | 14 |
| 10.43            |       |            | Cornell  Companies, Inc. 2000 Director Stock Plan.                                                                                                                                                                                                                                                                                                                |                                    | 15 |
| 10.44            |       |            | Cornell  Companies, Inc. 2000 Broad-Based Employee Plan.                                                                                                                                                                                                                                                                                                          |                                    | 16 |
| 10.44            | (a)        |            | Cornell  Companies, Inc. Deferred Bonus Plan.                                                                                                                                                                                                                                                                                                                     |                                    | 21 |
| 10.45            |       |            | Premises  Transfer Agreement, dated August 14, 2001, among Cornell Company, Inc.,  Cornell Corrections of Georgia, L.P., Cornell Corrections of Oklahoma, Inc.,  Cornell Corrections of Texas, Inc., WBP Leasing, Inc., and Municipal  Corrections Finance, L.P.                                                                                             |                                    | 17 |
| 10.46            |       |            | Master  Lease Agreement (with addenda), dated August 14, 2001, between Municipal  Corrections Finance, L.P. and Cornell Companies, Inc.                                                                                                                                                                                                                      |                                    | 17 |
| 10.47            |       |            | Master  Lease Agreement dated December 3, 1998 between Atlantic Financial Group  and WBP Leasing, Inc. and certain other subsidiaries of Cornell Corrections,  Inc.                                                                                                                                                                                          |                                    | 18 |
| 10.48            |       |            | Amendment  No. 1 to Credit Agreement dated January 31, 2001.                                                                                                                                                                                                                                                                                                 |                                    | 18 |
| 10.49            |       |            | Amendment  No. 2 to Credit Agreement and Amendment No. 1 to Master Agreement dated  August 9, 2001.                                                                                                                                                                                                                                                          |                                    | 18 |

 

109

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| **Exhibit  No.** | ** ** | **Description** | ** **                                                                                                                                                                                                                       | **Incorporated by Reference** |
|------------------|------------|-----------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------|
| 10.50            |       |            | First  Amendment to Note and Equity Purchase Agreement dated August 9, 2001.                                                                                                                                                |                                    | 18, 23 |
| 10.51            |       |            | Credit  Agreement, dated June 24, 2004, among Cornell Companies, Inc., as Borrower,  such subsidiaries of the Borrower as named therein, JPMorgan Chase Bank, as  Administrative Agent, and such other lenders as named therein. |                                    |   |
| 10.52            | (a)        |            | Employment  Agreement, dated March 14, 2005, between Cornell Companies, Inc. and James E.  Hyman.                                                                                                                                |                                    | 26 |
| 10.53            | (a)        |            | Restricted  Stock Agreement, dated March 14, 2005, between Cornell Companies, Inc. and  James E. Hyman.                                                                                                                          |                                    | 26 |
| 10.54            | (a)        |            | Employment/Separation  Agreement, dated March 9, 2005, between Cornell Companies, Inc. and John R.  Nieser.                                                                                                                      |                                    | 26 |
| 10.5             | (a)        |            | Summary  description of oral agreement, dated March 9, 2005, between Cornell  Companies, Inc. and Harry J. Phillips, Jr.                                                                                                         |                                    | 26 |
| 10.56            | (a)        |            | Release  of Claims, Covenant Not to Sue, and Older Workers Act Waiver,  dated March 21, 2005, between Cornell  Companies, Inc. and Thomas R.  Jenkins.                                                                 |                                    | 27 |
| 10.57            | (a)        |            | Release  of Claims, Covenant Not to Sue, and Older Workers Act Waiver,  dated March 21, 2005, between Cornell  Companies, Inc. and Paul B.  Doucette.                                                                  |                                    | 27 |
| 10.58            | (a)        |            | Release  of Claims, Covenant Not to Sue, dated April 12, 2005, between Cornell  Companies, Inc. and Luis A. Collazo.                                                                                                             |                                    | 28 |
| 10.59            | (a)        |            | Independent  Contractor Agreement, effective June 6, 2005, between Cornell Companies, Inc.  and Luis A. Collazo.                                                                                                                 |                                    | 28 |
| 10.60            | (a)        |            | Release  of Claims, Covenant Not to Sue, and Older Workers Act Waiver,  dated April 25, 2005, between Cornell  Companies, Inc. and John C.  Godlesky.                                                                  |                                    | 29 |
| 10.61            | (a)        |            | Independent  Contractor Agreement effective, July 1, 2005, between Cornell Companies, Inc.  and John C. Godlesky.                                                                                                                |                                    | 29 |
| 10.62            |       |            | Letter  Agreement, dated May 17, 2005 (but effective as of May 18, 2005), between  Cornell Companies, Inc. and Pirate Capital LLC.                                                                                               |                                    | 30 |
| 10.63            | (a)        |            | Summary  description of employment agreement, dated November 28, 2005, between Cornell  Companies, Inc. and Mark S. Croft.                                                                                                       |                                    | 31 |
| 10.64            | (a)        |            | Severance  Agreement, dated November 28, 2005, between Cornell Companies, Inc. and Mark  S. Croft.                                                                                                                               |                                    | * |
| 21.1             |       |            | List  of Subsidiaries.                                                                                                                                                                                                           |                                    | * |
| 23.1             |       |            | Consent  of PricewaterhouseCoopers LLP.                                                                                                                                                                                          |                                    | * |
| 23.2             |       |            | Information  Regarding Consent of Arthur Andersen LLP.                                                                                                                                                                           |                                    | 21 |
| 24.1             |       |            | Power  of Attorney (see signature page of this Annual Report on Form 10-K).                                                                                                                                                      |                                    | * |
| 31.1             |       |            | Section 302  Certification of Chief Executive Officer.                                                                                                                                                                      |                                    | * |
| 31.2             |       |            | Section 302  Certification of Chief Financial Officer.                                                                                                                                                                      |                                    | * |
| 32.1             |       |            | Section 906  Certification of Chief Executive Officer.                                                                                                                                                                      |                                    | * |
| 32.2             |       |            | Section 906  Certification of Chief Financial Officer.                                                                                                                                                                      |                                    | * |
| 99.1             |       |            | Letter  from Cornell Companies, Inc. to the Securities and Exchange Commission, dated  April 15, 2002, regarding representation from Arthur Andersen LLP.                                                                   |                                    | 20 |
| 99.2             |       |            | Letter  Agreement, dated September 5, 2001, as amended, between Cornell  Companies, Inc. and Lehman Brothers, Inc.                                                                                                          |                                    | 20 |

 

----

  (a)  Management compensatory plan or contract.

  (1)  AnnualReport on Form 10-K for the year ended December 31, 1996.

  (2) Registration Statement on Form S-1 (Registration No. 333-08243).

  (3) Registration Statement on Form S-1 (Registration No. 333-35807).

  (4) Current Report on Form 8-K dated January 31, 1997.

 

110

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  (5) Current Report on Form 8-K dated January 6, 1998.

  (6) Definitive Proxy Statement dated March 9, 1998.

  (7) Registration Statement on Form 8-A filed May 11, 1998.

  (8) Quarterly Report on Form 10-Q for the quarter ended June 30, 1998.

  (9) Current Report on Form 8-K dated August 13, 1998.

(10)  Annual Report on Form 10-K for the year endedDecember 31, 1998.

(11)  Quarterly Report on Form 10-Q for the quarterended September 30, 1999.

(12)  Annual Report on Form 10-K for the year endedDecember 31, 1999.

(13)  Quarterly Report on Form 10-Q for the quarterended June 30, 2000.

(14)  Registration Statement on Form S-8(Registration No. 333-80187).

(15)  Registration Statement on Form S-8(Registration No. 333-42444).

(16)  Registration Statement on Form S-8(Registration No. 333-52236).

(17)  Current Report on Form 8-K datedAugust 14, 2001.

(18)  Quarterly Report on Form 10-Q for the quarterended September 30, 2001.

(19)  Quarterly Report on Form 10-Q for the quarterended March 31, 2001.

(20)  Annual Report on Form 10-K for the year endedDecember 31, 2001.

(21)  Annual Report on Form 10-K for the year endedDecember 31, 2002.

(22)  Current Report on Form 8-K dated January 24,2005.

(23)  Current Report on Form 8-K dated June 25,2004.

(24)  Current Report on Form 8-Kdated July 6, 2005.

(25)  Current Report on Form 8-Kdated April 5, 2005.

(26)  Current Report on Form 8-Kdated March 15, 2005.

(27)  Current Report on Form 8-Kdated March 24, 2005.

(28)  Current Report on Form 8-Kdated April 18, 2005.

(29)  Current Report on Form 8-Kdated April 29, 2005.

(30)  Current Report on Form 8-Kdated May 19, 2005.

(31)  Current Report on Form 8-Kdated November 28, 2005.

  *    Filed herewith

 

111

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**SIGNATURES**

 

**Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.**

 
|   |                 | CORNELL  COMPANIES, INC. |
|--------|----------------------|--------------------------|
|   |                 |                     |   |
| Dated: | March 16,  2006 | By:                      | /s/  James E. Hyman |
|   |                 |                     | James  E. Hyman |
|   |                 |                     | Chief  Executive Officer and |
|   |                 |                     | Chairman  of the Board |

 

**POWER OF ATTORNEY**

 

KNOW ALL MEN BY THESE PRESENTS, that eachperson whose signature appears below constitutes and appoints James E. Hyman,John R. Nieser and Mark S. Croft, and each of them, his true and lawfulattorneys-in-fact, each with full power of substitution, for him or her in anyand all capacities, to sign any amendments to this report on Form 10-K and tofile the same, with exhibits thereto and other documents in connectiontherewith, with the Securities and Exchange Commission, hereby ratifying andconfirming all that each of said attorneys-in-fact or their substitute orsubstitutes may do or cause to be done by virtue hereof.

 

**Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.**

 
| **SIGNATURE**              | ** ** | **TITLE**                         | ** ** | **DATE**             |
|----------------------------|------------|-----------------------------------|------------|----------------------|
|                       |       |                              |       |                 |
| /s/  James E. Hyman        |       | Chief  Executive Officer and      |       | March 16,  2006 |
| James  E. Hyman            |       | Chairman  of the Board            |       |                 |
|                       |       | (Principal  Executive Officer)    |       |                 |
|                       |       |                              |       |                 |
| /s/  John R. Nieser        |       | Chief  Financial Officer          |       | March 16,  2006 |
| John  R. Nieser            |       | (Principal  Financial Officer and |       |                 |
|                       |       | Principal  Accounting Officer)    |       |                 |
|                       |       |                              |       |                 |
| /s/  ANTHONY R. CHASE      |       | Director                          |       | March 16,  2006 |
| Anthony  R. Chase          |       |                              |       |                 |
|                       |       |                              |       |                 |
| /s/  THOMAS R. HUDSON, JR. |       | Director                          |       | March 16,  2006 |
| Thomas  R. Hudson, Jr.     |       |                              |       |                 |
|                       |       |                              |       |                 |
| /s/  D. STEPHEN SLACK      |       | Director                          |       | March 16,  2006 |
| D.  Stephen Slack          |       |                              |       |                 |
|                       |       |                              |       |                 |
| /s/  ALFRED JAY MORAN, JR. |       | Director                          |       | March 16,  2006 |
| Alfred  Jay Moran, Jr.     |       |                              |       |                 |
|                       |       |                              |       |                 |
| /s/  TODD GOODWIN          |       | Director                          |       | March 16,  2006 |
| Todd  Goodwin              |       |                              |       |                 |
|                       |       |                              |       |                 |
| /s/  SALLY L. WALKER       |       | Director                          |       | March 16,  2006 |
| Sally  l. Walker           |       |                              |       |                 |
|                       |       |                              |       |                 |
| /s/  RICHARD CRANE         |       | Director                          |       | March 16,  2006 |
| Richard  Crane             |       |                              |       |                 |
|                       |       |                              |       |                 |
| /s/  LEON M. CLEMENTS      |       | Director                          |       | March 16,  2006 |
| Leon  M. Clements          |       |                              |       |                 |
|                       |       |                              |       |                 |
| /s/  ZACHARY R. GEORGE     |       | Director                          |       | March 16,  2006 |
| Zachary  R. George         |       |                              |       |                 |

 

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