**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,DC 20549**

 

**FORM 10-K**

 

| **ANNUAL REPORT UNDER SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------------------------------------------------------------------------------------|
|                                                                                |   |   |
| **For fiscal year ended December 31, 2002**                                         |   | **Commission File Number 1-14472** |

 

**CORNELL COMPANIES, INC.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                    |   | **76-0433642**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction  of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **1700 West Loop South, Suite 1500, Houston, Texas**            |   | **77027**                             |
| (Address of Principal Executive  Offices)                       |   | (Zip Code)                            |
|                                                            |   |                                  |
| Registrant’s telephone number,  including area code:       |   | **(713) 623-0790**                    |
|                                                            |   |                                  |
| Securities registered pursuant  to Section 12(b) of the Act:    |

 

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

 

| Securities registered pursuant  to Section 12(g) of the Act: |
|--------------------------------------------------------------|
|                                                         |   |   |
| **NONE**                                                     |

 

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 Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

| Yes    ý                  | No    o |
|-------------------------------------------------------------------------------------------------------------------------------|-------------------|

 

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

 

Indicate by check mark whether the Registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2).

 

| Yes    ý                  | No    o |
|-------------------------------------------------------------------------------------------------------------------------------|-------------------|

 

 

At February 28, 2003, Registrant had outstanding 13,097,208 shares ofits common stock.  The aggregate marketvalue of the Registrant’s voting stock held by non-affiliates as of June 28,2002 was approximately $145,918,000 based on the closing price of $11.85 pershare as reported on the New York Stock Exchange.  The aggregate market value of the Registrant’s voting stock heldby non-affiliates as of February 28, 2003 was approximately $100,250,000 basedon the closing price of $7.97 per share as reported on the New York Stock Exchangeand 12,578,423 shares outstanding as of that date.  For purposes of the foregoing calculations, all directors andofficers of the Registrant have been deemed to be affiliates, but theRegistrant disclaims that any of such directors or officers is an affiliate.

 

| Documents Incorporated by Reference                                       |
|---------------------------------------------------------------------------|
|                                                                      |   |   |
| Portions of the Proxy Statement for 2003 Annual Meeting of  Stockholders. | Part III |   |

 

 

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**PARTI**

 

**BUSINESS**

 

**Company Overview**

 

Cornell Companies, Inc. (the “Company”) is a leading provider ofprivatized correctional, treatment and educational services outsourced byfederal, state and local government agencies.  As the successor to entities that began developing adult secureinstitutional facilities in 1984, pre-release correctional and treatmentfacilities in 1974 and juvenile facilities in 1973, the Company provides adiversified portfolio of services for adults and juveniles through threeoperating divisions: (1) adult secure institutional services; (2) juveniletreatment, educational and detention services and (3) pre-release correctionaland treatment services.  These servicesinclude incarceration and detention, transition from incarceration, drug andalcohol treatment programs, behavioral rehabilitation and treatment, and K-12education.  The Company provides theseessential services through its 69 facilities, in operation or underdevelopment, in 13 states and the District of Columbia.  As of December 31, 2002, the Company’sfacilities provided for a total service capacity of 15,444.  The Company’s service capacity is comprisedof the number of beds available for service upon completion of construction ofresidential facilities and the average program capacity of non-residentialcommunity-based programs.

 

Additionalinformation on the Company can be found on its website,www.cornellcompanies.com.  Here theCompany makes available free of charge its annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K and all amendmentsto those reports as soon as reasonably practical after such material iselectronically filed with or furnished to the Securities and ExchangeCommission (“SEC”).  Alternatively,reports filed with the SEC may be viewed or obtained at the SEC PublicReference Room in Washington, D.C., or at the SEC’s Internet site atwww.sec.gov.

 

**Industry Background**

 

***Privatization***

 

Correctional, detention and treatment programs are important governmentfunctions. In the United States, as the incarcerated and sentenced populationscontinue to rise, and as federal, state and local governments face continuingpressures to control costs and improve service quality, there is a growingtrend toward outsourcing of government services and functions, includingcorrectional, detention and treatment services. Outsourcing has historicallyfaced opposition in the U.S.; however, public and government acceptance hasincreased as standards of service improve and cost-savings are provided to thegovernment.

 

While juvenile and pre-release services have been outsourced fordecades, the adult private prison industry in the U.S. began in 1984 as publicauthorities began to respond to overcrowding pressures and budgetaryconstraints by exploring more efficient means of incarceration. Prisonmanagement companies offer the same range of services that governments havehistorically provided to house and care for the needs of offenders. Theseservices include facility design, construction management, health services,food services, security, transportation, education and rehabilitativeprogramming. Governments engaging private companies typically receive theseservices at a lower cost than the public authority could provide.

 

Recently, several states have identified special needs and requirementsfor private operators. For example, both federal and state governments areconsidering and recommending privatizing female prison beds. Some states, suchas Arizona, have also identified other services for private management, such asgeriatric and behavioral health incarcerated populations.

 

***Prison Population Projectionsand Over Capacity/Overcrowding***

 

Over the course of the past six months, many states that have seen areduction in excess bed space capacity. According to the United StatesDepartment of Justice, Bureau of Justice Statistics, or BJS, most states areoperating at or over capacity, and most facilities are outdated. Some states,such as Wyoming and Arizona, have proposed building new prisons. Specialhousing requirements for the rapidly increasing female 

 

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incarcerated population has also resulted in a call for new facilitiesin other states such as Tennessee, Alabama and Arizona.

 

Additionally, according to the President of the United States 2004Budget, the President has identified the private sector as a means forassisting the exploding federal government populations.  The budget states “The Bureau of Prisons isone of the fastest-growing arms of the federal government. In 1980, thebureau’s budget was $330 million, and there were 24,000 inmates in 44 prisons.In 2002, the budget was $4.6 billion, and there were 102 prisons. Eleven morefederal prisons are in various stages of construction.”

 

In fact, during 2002, according to the BJS, the federal governmentbecame the largest prison system (approximately 165,000 inmates), overtakingboth California (159,444 inmates) and Texas (162,070 inmates). During 2001,states added a net total of 3,193 prisoners, and the federal prison systemadded 11,577 prisoners.

 

The 2004 federal budget also addresses the need for private resourcesto assist the government. In fact, the budget states that “Today, 16 percent offederal inmates are housed in non-BOP prisons, approximately 13,000 are inprivately managed prisons, and another 13,000 are in state and local correctionalfacilities.  Just 1.5 percent of federalinmates were housed in non-BOP facilities 20 years ago.  Some years ago, the BOP committed tocontracting out bedspace for certain low/minimum-security inmates. Currently,the BOP has contracted bedspace for its criminal alien and juvenile inmatepopulations—as these groups fall outside the normal classification of federalinmates.  This year, BOP also developeda separate classification for female inmates. Female offenders are mostlynon-violent and generally do not require the same degree of security as maleoffenders.  Therefore, contracting outfor this population is appropriate and can save millions in constructiondollars and reduce female inmate crowding, currently estimated at 60 percentabove the number of inmates that facilities were built to house. Fundingrequested in the President’s 2003 Budget for construction of a secure femalefacility to be activated in 2005 is being proposed for rescission, so thatfunding to contract out for new female inmate bedspace is being requested in2004.”

 

Because the BJS continues to report that as of December 31, 2001, stateprisons were operating between 1% and 16% above capacity, and federal prisonswere operating at 31% above capacity, Company management believes that targetedstrategic development efforts offering solutions for financially overcrowdedprison systems will offer long-term growth opportunities for the Company.

 

**Operations**

 

Pursuant to the terms of its management contracts, the Company isresponsible for the overall operation of its facilities, including staffrecruitment, general facility administration, security and supervision of theoffenders or clients and facility maintenance. The Company also provides a variety of rehabilitative and educationalprograms at many of its facilities.

 

The Company provides this diversified portfolio of essential servicesfor adults and juveniles through three operating divisions: (1) adult secureinstitutional services; (2) juvenile treatment, educational and detentionservices and (3) pre-release correctional and treatment services.

 

***Adult SecureInstitutional Services Division***

 

The Company’s adult secure institutional division provides maximum,medium, and low-security incarceration. This division is committed to ensuring public safety through theoperation of a secure environment and offenders are provided with a variety ofprogramming and services geared toward a successful return to the community anda subsequent reduction in recidivism. At December 31, 2002, the

 

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Company operated or had under development nine facilities with a totalservice capacity of 7,351 beds that provide, or will provide, adult secureinstitutional services for incarcerated adults.

 

The adult secure institutional division provides:

 

•              low to maximum-securityincarceration services;

 

•              integrated facility developmentand operational services;

 

•              state-of-the-art correctionaltechnology including electronic controls and surveillance equipment;

 

•                                          basiceducation such as preparation and testing for the high school equivalency exam,or GED, English as a second language, or ESL, classes and Adult BasicEducation, or ABE;

 

•              health care including medical,dental, behavioral health and psychiatric services;

 

•              individual and group counseling;

 

•                                          substanceabuse treatment including detoxification, testing, counseling, 12-step programsand relapse prevention services;

 

•              life skills training includingtraining relating to proper hygiene, personal finance and parenting skills;

 

•              institutional food services; and

 

•              recreational activities such asexercise programs, hobby and craft and leisure activities.

 

According to reports issued by the BJS, the total number of prisonersunder the jurisdiction of federal or state adult correctional authorities was1,406,031 at year-end 2001. Overall, the United States incarcerated 2,100,146persons at year-end 2001, including populations held in local jails and otherfacilities. During 2001, states added a net of 3,193 prisoners, and the Federalprison system added 11,577 prisoners. The U.S. prison population grew at anoverall rate of 1.1%.

 

According to the American Correctional Association, the adult prisonmanagement industry encompassing federal, state and local jails, spent over $50billion to house its incarcerated population. As of December 31, 2001, the BJS reported that privately operatedfacilities housed 91,828 inmates (5.8% of state and 12.3% of federal inmates); localjails housed 70,681 state and federal inmates (5.0% of all prisoners). Thisrepresents an increase of approximately 3,000 inmates in 2001 from 2000.

 

Industry wide,jail expenditures are expected to increase at least 8% annually for the nextfew years, which is creating a growth opportunity for the Company in publiclyrun state facilities that can benefit from the Company’s highly efficientmanagement.

 

***Juvenile Treatment,Educational and Detention Services Division***

 

The Company’s juvenile division provides residential, community-based,behavioral health and alternative education programs to juveniles, typicallybetween the ages of ten and 17.  Inaddition to meaningful treatment options, the programs also develop continuingcare plans that help bridge the juvenile back to the community.  Under the names “Cornell Abraxas” and“Cornell Interventions,” the Company offers programs to meet the multiple needsof troubled juveniles.  At December 31,2002, the Company had 21 residential facilities, including the New MorganAcademy which was closed in the fourth quarter of 2002, and 17 non-residentialcommunity-based programs serving an aggregate capacity of approximately 4,472youths.

 

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Juvenile treatment, educational and detention services consist primarilyof programs that are designed to lead to rehabilitation while providing publicsafety and holding juveniles accountable for their decisions and behavior.  The Company operates primarily within arestorative justice model.  The basicphilosophy is that merely serving time in an institution does not relievejuvenile offenders of the obligation to repay their victims and thatincarceration alone does not compensate for the societal impact of crimes.  The use of a balanced approach gives equalemphasis to accountability, competency development and community protection.

 

The juvenile division provides:

 

•              diverse treatment settingsincluding settings that are physically-secure, staff-secure andcommunity-based;

 

•              specialized treatment for specialpopulations including females, drug sellers, sex offenders, firesetters andfamilies;

 

•              individualized treatment planningand case management;

 

•                                          counselingincluding individual, group and family therapy, cognitive behavior therapy andstress and anger management;

 

•              substance abuse treatment andrelapse prevention and education services;

 

•              life skills training such astraining relating to proper hygiene, personal finance and parenting skills;

 

•              accredited alternative and specialeducational programs;

 

•              gender-specific programs;

 

•              employment training andassistance;

 

•              medical services; and

 

•              wilderness training programs andnationally accredited ropes course challenges.

 

The juvenile corrections industry is estimated to expend $8 billion in2002 and consists of at least 108,000 secure residential beds. The juveniletreatment and educational components of the juvenile corrections industry areestimated  to be far larger. This marketsegment is fragmented, with several thousand providers across the country, mostof which are small and operate in specific geographic areas.

 

The juvenile corrections industry has expanded rapidly in recent yearsas the need for services for at-risk and adjudicated youth has risen. Accordingto the American Correctional Association’s Directory of Adult and JuvenileCorrectional Departments, Institutions, Agencies and Probation and ParoleAuthorities, spending for the provision of juvenile services has increased at acompound annual growth rate of almost 20% from 1993 to 2001.

 

The juvenileoffender population is expected to rise considerably in the years ahead,especially with the “baby boom echo” (children of baby boomers) population nowmoving into their at-risk years.

 

***Pre-ReleaseCorrectional and Treatment Services Division***

 

The Company’s pre-release division provides community-based servicesincluding job placement and treatment and education programs as an alternativeto incarceration as well as to aid in the successful 

 

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transition from a correctional facility back into society.  At December 31, 2002, the Company operatedor had contracts to provide pre-release correctional and treatment serviceswithin 16 residential facilities and six non-residential community basedprograms with an aggregate service capacity of 3,621.  The pre-release area is primarily comprised of individuals whohave been granted parole or sentenced to probation.  Probationers (individuals sentenced for an offense withoutincarceration) and parolees (individuals released prior to the completion oftheir sentence) are typically placed in pre-release settings.  These individuals typically spend three tosix months in halfway houses until they are prepared to re-enter society.

 

The pre-release division provides:

 

•                                          minimum-securityand staff-secure residential services;

 

•                                          homeconfinement and electronic monitoring;

 

•                                          employabilitytraining and assistance such as preparing for, securing and maintainingemployment;

 

•                                          basiceducation including preparation and testing for the GED, ABE, computer courses,college-level courses and extensive libraries;

 

•                                          vocationaltraining such as training in the culinary arts and construction;

 

•                                          counselingincluding individual, group and family therapy, cognitive behavior therapy andstress and anger management;

 

•                                          substance-abusetreatment including detoxification, testing, counseling, 12-step programs andrelapse prevention services; and

 

•                                          lifeskills training including training related to proper hygiene, securingappropriate housing, personal finance and parenting skills.

 

Expenditures in the pre-release correctional services industry areestimated at $4 billion in 2002 and consist of approximately 50,000 residentialbeds**.**Thismarket segment is extremely fragmented, with several thousand providers acrossthe country, most of which are small and operate in a specified geographicarea.

 

Similar to the adult secure institutional and the juvenile servicesegments, the area of pre-release correctional services has experienced substantialgrowth. According to the BJS, the number of parolees increased from 531,407 atDecember 31, 1990 to 731,147 as of December 31, 2001, a compound annual growth rate of approximately 3.0%.During the same period, the number of individuals on probation increased fromapproximately 2.7 million to 3.9 million, a compound annual growth rate ofapproximately 3.5%. The probation and parole populations representapproximately 70% of the total number of adults under correctional supervisionin the United States.

 

**Marketing andBusiness Development**

 

The Company’s principal customers are federal, state and localgovernment agencies responsible for adult and juvenile corrections, treatmentand educational services.  Thedevelopment process for obtaining facility management contracts consists ofseveral steps including issuance of a request for proposal, or RFP, by acontracting agency, submission of a response to the RFP by the Company, theaward of the contract by a government agency and the commencement of constructionor operation of the facility.  Theseagencies generally procure services from the private sector by issuing an RFPto which a number of companies may

 

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 respond.  In addition to costs, government agenciesconsider numerous other factors including bidders’ experience andqualifications when awarding contracts.

 

As part of the process of responding to RFPs, the Company’s managementmeets with appropriate personnel from the requesting agency to best determinethe agency’s distinct needs.  TheCompany may also receive inquiries from or on behalf of government agenciesconsidering privatization of certain facilities or that have already decided tocontract with private providers.  Whenthe Company receives such an inquiry, the Company determines whether there is aneed for its services and whether the legal and political climate in which thegovernment agency operates is conducive to serious consideration ofprivatization.  The Company thenconducts an initial cost analysis to further determine project feasibility.

 

If the Company believes the project is consistent with its strategicbusiness plan, the Company will submit a written response to the RFP.  When responding to RFPs, the Company incurscosts, typically ranging from $10,000 to $100,000 per proposal, to determinethe prospective client’s distinct needs and prepare a detailed response to theRFP.  In addition, the Company may incursubstantial costs to acquire options to lease or purchase land for a proposedfacility and engage outside consulting and legal expertise related to aparticular RFP.  The preparation of aresponse to an RFP typically takes from five to fifteen weeks.  The bidding and award process for an RFPtypically takes from three to nine months. Generally, if the facility for which an award has been made must beconstructed, the Company will begin operation of the newly constructed facilitybetween 12 and 24 months after the contract award.

 

When a contract requires construction of a new facility, the Company’ssuccess depends, in part, upon its ability to acquire real property ondesirable terms and at satisfactory locations. The Company anticipates that a large majority of new facilities will be constructedin rural areas.  To the extent thatthese locations are in or near populous areas, management anticipates legalaction and other forms of opposition from residents in areas surroundingcertain proposed sites.  The Company mayincur significant expenses in responding to such opposition and there can be noassurance of success.  In addition, theCompany may choose not to bid in response to an RFP or may determine towithdraw a bid if legal action or other forms of opposition are anticipated.

 

**Contracts**

 

The Company’s facility management contracts generally provide that theCompany will be compensated at an occupant per diem rate, fees for treatmentservice, guaranteed take-or-pay or cost-plus reimbursement.  Factors that the Company considers in determiningthe per diem rate to charge include (1) the programs specified by the contractand the related staffing levels, (2) wage levels customary in the respectivegeographic areas, (3) whether the proposed facility is to be leased orpurchased and (4) the anticipated average occupancy levels that the Companybelieves could reasonably be maintained. Compensation is invoiced in accordancewith the applicable contract and is typically paid to the Company on a monthlybasis.  Some of the Company’s juvenile educationcontracts provide for annual payments.

 

The Company pursues new contracts that leverage its existinginfrastructure and capabilities and meet the Company’s stringent profitabilitycriteria.  The Company has increased itsfocus on guaranteed take-or-pay contracts, which provide a fixed minimumrevenue stream regardless of occupancy and thereby add increased stability andpredictability to the Company’s revenue stream.

 

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**Quality of Operations**

 

Independent accreditation by various oversight and regulatoryorganizations is designed to show that a facility meets nationally acceptedprofessional standards for quality of operation, facility design, management,and maintenance. Accrediting entities include the American CorrectionalAssociation, or ACA, for the adult secure and pre-release sectors, and theJoint Commission on Accreditation of Healthcare Organizations, Departments ofPublic Welfare, Departments of Protective and Regulatory Services, andDepartments of Human Services and Education for the juvenile sector.  ACA standards are the national benchmark forthe effective operation of correctional systems throughout the United Statesand address services, programs, and operations essential to good correctionalmanagement including administrative and fiscal controls, staff training anddevelopment, physical plant, safety and emergency procedures, sanitation, foodservice, and rules and discipline.  ACAaccreditation is important to the courts as an indicator of improved conditionsfor adult prisons under court order.  Itis the Company’s policy that all of its facilities’ daily operations beperformed in accordance with accreditation standards.  Accreditation and the standards of service required thereby alsocontribute to the public’s increased acceptance of the Company and itsprovision of privatized corrections services.

 

Internal quality control, conducted by the Company’s senior facilitystaff and executive officers, takes the form of periodic operational,programming and fiscal audits, facility inspections, regular review of logs,reports and files and strict maintenance of personnel standards, including anactive training program.  Each of theCompany’s facilities develops its own training plan that is reviewed, evaluatedand updated annually.  All adultcorrectional officers undergo a minimum 40-hour orientation upon their hiringand receive academy-level training amounting to 120 hours and on-the-jobtraining of up to 80 hours.  Eachcorrectional officer also receives up to 40 hours of continuing training andeducation annually.  All juveniletreatment employees undergo a minimum 80-hour orientation upon their hiring andalso receive up to 40 hours of continuing training and education annually.

 

**Facilities**

 

As of December 31, 2002, the Company had 69 facilities including theMoshannon Valley Correctional Center, which is under development, and the NewMorgan Academy, which was closed in the fourth quarter of 2002.  Reference is made to “Management’s Discussionand Analysis of Financial Condition and Results of Operations - Liquidity andCapital Resources - Contractual Uncertainties Related to Certain Facilities”for a discussion of the status of the Moshannon Valley Correctional Center andthe New Morgan Academy.  In addition toproviding management services, the Company has been involved in thedevelopment, design and/or construction of many of these facilities.

 

The Company controls, either through outright ownership or long-termleases, operating facilities representing a large majority of itsrevenues.  Management believes that suchcontrol increases the likelihood of contract renewal, allows the Company toexpand existing facilities and capture higher margins, and enhances theCompany’s ability to win new contracts. In addition, long-term control of its operating facilities allows theCompany to better control operating margins and reduce cost escalationpressures.

 

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The following table summarizes certain additional information withrespect to the Company’s facilities  asof December 31, 2002.  As indicated, themajority of the facilities to which the Company provides services are eitherowned or leased by the Company. Facilities that are leased are generally under terms ranging from one to45 years.

 
|                                                                     |   | **Total   Service   Capacity(1)** |       | **Initial Contract   Date(2)** |       | **Company   Owned/   Leased or   Managed(3)** |   |
|--------------------------------------------------------------------------|--------|-----------------------------------|------------|-------------------------------------|------------|-----------------------------------------------|--------|
|                                                                     |   |                              |       |                                |
|                                                                     |   |                              |       |                                |
| **Facility Name and Location**                                           |   |                              |       |                                |
|                                                                     |   |                              | ** ** |                                | ** ** |                                          |   |
| ***Adult  Secure Institutional Correctional and Detention Facilities*:** |   |                              |       |                                |       |                                          |   |
|                                                                     |   |                              |       |                                |       |                                          |   |
| Baker Community Correctional Facility                                    |   | 262                               |       | 1987                                |       | Leased                                        |   |
| Baker, California                                                        |   |                              |       |                                |       |                                          |   |
| Big Spring Complex                                                       |   | 2,606                             |       | (4)                                 |       | Leased                                        | (5)    |
| Big Spring, Texas                                                        |   |                              |       |                                |       |                                          |   |
| D. Ray James Prison                                                      |   | 1,550                             |       | 1998                                |       | Leased                                        | (5)    |
| Charlton County, Georgia                                                 |   |                              |       |                                |       |                                          |   |
| Donald W. Wyatt Detention Facility                                       |   | 302                               |       | 1992                                |       | Managed                                       |   |
| Central Falls, Rhode Island                                              |   |                              |       |                                |       |                                          |   |
| Great Plains Correctional Facility                                       |   | 766                               |       | (6)                                 |       | Leased                                        | (5)    |
| Hinton, Oklahoma                                                         |   |                              |       |                                |       |                                          |   |
| Leo Chesney Community Correctional                                       |   |                              |       |                                |       |                                          |   |
| Facility                                                                 |   | 200                               |       | 1988                                |       | Leased                                        |   |
| Live Oak, California                                                     |   |                              |       |                                |       |                                          |   |
| Moshannon Valley Correctional Center                                     |   | 1,095                             |       | 1999                                |       | Leased                                        | (8)    |
| Philipsburg, Pennsylvania (7)                                            |   |                              |       |                                |       |                                          |   |
| Valencia County Detention Center                                         |   | 110                               |       | 2000                                |       | Managed                                       |   |
| Los Lunas, New Mexico                                                    |   |                              |       |                                |       |                                          |   |
| Westmoreland County Prison                                               |   | 460                               |       | 2001                                |       | Managed                                       |   |
| Greenburg, Pennsylvania                                                  |   |                              |       |                                |       |                                          |   |

 

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|                                                             |   | **Total   Service   Capacity(1)** |   | **Initial Contract Date(2)** |   | **Company   Owned/ Leased or   Managed(3)** |   |
|------------------------------------------------------------------|--------|-----------------------------------|--------|----------------------------------------|--------|--------------------------------------------------|--------|
|                                                             |   |                              |   |                                   |
|                                                             |   |                              |   |                                   |
| **Facility Name and Location**                                   |   |                              |   |                                   |
|                                                             |   |                              |   |                                   |   |                                             |   |
| ***Juvenile  Treatment, Educational and Detention Facilities:*** |   |                              |   |                                   |   |                                             |   |
| ***Residential  Facilities:***                                   |   |                              |   |                                   |   |                                             |   |
|                                                             |   |                              |   |                                   |   |                                             |   |
| Alexander Youth Center                                           |   | 134                               |   | 2001                                   |   | Managed                                          |   |
| Alexander, Arkansas                                              |   |                              |   |                                   |   |                                             |   |
| Contact                                                          |   | 47                                |   | (9)                                    |   | Owned                                            |   |
| Wauconda, Illinois                                               |   |                              |   |                                   |   |                                             |   |
| Cornell Abraxas I                                                |   | 248                               |   | 1973                                   |   | Leased                                           | (5)    |
| Marienville, Pennsylvania                                        |   |                              |   |                                   |   |                                             |   |
| Cornell Abraxas II                                               |   | 23                                |   | 1974                                   |   | Owned                                            |   |
| Erie, Pennsylvania                                               |   |                              |   |                                   |   |                                             |   |
| Cornell Abraxas III                                              |   | 22                                |   | 1975                                   |   | Owned                                            |   |
| Pittsburgh, Pennsylvania                                         |   |                              |   |                                   |   |                                             |   |
| Cornell Abraxas Center for Adolescent                            |   |                              |   |                                   |   |                                             |   |
| Females                                                          |   | 100                               |   | 1989                                   |   | Owned                                            |   |
| Pittsburgh, Pennsylvania                                         |   |                              |   |                                   |   |                                             |   |
| Cornell Abraxas of Ohio                                          |   | 108                               |   | 1993                                   |   | Leased                                           | (5)    |
| Shelby, Ohio                                                     |   |                              |   |                                   |   |                                             |   |
| Cornell Abraxas Youth Center                                     |   | 92                                |   | 1999                                   |   | Leased                                           |   |
| South Mountain, Pennsylvania                                     |   |                              |   |                                   |   |                                             |   |
| Danville Center for Adolescent Females                           |   | 64                                |   | 1998                                   |   | Managed                                          |   |
| Danville, Pennsylvania                                           |   |                              |   |                                   |   |                                             |   |
| DuPage Adolescent Center                                         |   | 35                                |   | (9)                                    |   | Owned                                            |   |
| Hinsdale, Illinois                                               |   |                              |   |                                   |   |                                             |   |
| Erie Residential Behavioral Health Program                       |   | 16                                |   | 1999                                   |   | Owned                                            |   |
| Erie, Pennsylvania                                               |   |                              |   |                                   |   |                                             |   |
| Griffin Juvenile Facility                                        |   | 170                               |   | 1996                                   |   | Leased                                           | (5)    |
| San Antonio, Texas                                               |   |                              |   |                                   |   |                                             |   |
| Leadership Development Program                                   |   | 120                               |   | 1994                                   |   | Leased                                           |   |
| South Mountain, Pennsylvania                                     |   |                              |   |                                   |   |                                             |   |
| New Morgan Academy (10)                                          |   | 214                               |   | 2000                                   |   | Leased                                           | (8)    |
| New Morgan, Pennsylvania                                         |   |                              |   |                                   |   |                                             |   |
| Psychosocial Rehabilitation Unit                                 |   | 13                                |   | 1994                                   |   | Owned                                            |   |
| Erie, Pennsylvania                                               |   |                              |   |                                   |   |                                             |   |
| Residential School                                               |   | 30                                |   | (9)                                    |   | Owned                                            |   |
| Matteson, Illinois                                               |   |                              |   |                                   |   |                                             |   |
| Salt Lake Valley Juvenile Detention  Facility                    |   | 160                               |   | 1996                                   |   | Managed                                          |   |
| Salt Lake City, Utah                                             |   |                              |   |                                   |   |                                             |   |
| Santa Fe County Juvenile Detention Facility                      |   | 129                               |   | 1997                                   |   | Managed                                          |   |
| Santa Fe, New Mexico                                             |   |                              |   |                                   |   |                                             |   |
| Schaffner Youth Center                                           |   | 61                                |   | 2001                                   |   | Managed                                          |   |
| Steelton, Pennsylvania                                           |   |                              |   |                                   |   |                                             |   |
| South Mountain Secure Residential                                |   |                              |   |                                   |   |                                             |   |
| Treatment Unit                                                   |   | 52                                |   | 1997                                   |   | Managed                                          |   |
| South Mountain, Pennsylvania                                     |   |                              |   |                                   |   |                                             |   |
| Woodridge                                                        |   |                              |   |                                   |   |                                             |   |
| Woodridge, Illinois                                              |   | 136                               |   | (9)                                    |   | Owned                                            |   |
|                                                             |   |                              |   |                                   |   |                                             |   |

 

10

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|                                                                  |   | **Total   Service   Capacity(1)** |   | **Initial   Contract   Date(2)** |   | **Company   Owned/ Leased or   Managed(3)** |   |
|-----------------------------------------------------------------------|--------|-----------------------------------|--------|----------------------------------|--------|--------------------------------------------------|--------|
|                                                                  |   |                              |   |                             |
|                                                                  |   |                              |   |                             |
| **Facility Name and Location**                                        |   |                              |   |                             |
|                                                                  |   |                              |   |                             |   |                                             |   |
| ***Juvenile  Non-Residential Community-Based Centers***:              |   |                              |   |                             |   |                                             |   |
|                                                                  |   |                              |   |                             |   |                                             |   |
| Adams Behavioral Health Services                                      |   | 34                                |   | 1998                             |   | Leased                                           |   |
| Oxford, Pennsylvania                                                  |   |                              |   |                             |   |                                             |   |
| Cornell Abraxas Parenting Academy                                     |   | 36                                |   | 1999                             |   | Leased                                           |   |
| Harrisburg, Pennsylvania                                              |   |                              |   |                             |   |                                             |   |
| Cornell Abraxas Student Academy                                       |   | 110                               |   | 1996                             |   | Leased                                           |   |
| Harrisburg, Pennsylvania                                              |   |                              |   |                             |   |                                             |   |
| Delaware Community Programs                                           |   | 39                                |   | 1994                             |   | Leased                                           |   |
| Milford, Delaware                                                     |   |                              |   |                             |   |                                             |   |
| Erie Behavioral Health Services                                       |   | 36                                |   | 1997                             |   | Owned                                            |   |
| Erie, Pennsylvania                                                    |   |                              |   |                             |   |                                             |   |
| Harrisburg                                                            |   | 91                                |   | 1999                             |   | Leased                                           |   |
| Harrisburg, Pennsylvania                                              |   |                              |   |                             |   |                                             |   |
| Harrisburg Day Treatment Program                                      |   | 58                                |   | 1996                             |   | Leased                                           |   |
| Harrisburg, Pennsylvania                                              |   |                              |   |                             |   |                                             |   |
| Juvenile Field Services                                               |   | 110                               |   | (9)                              |   | Managed                                          |   |
| Chicago, Illinois                                                     |   |                              |   |                             |   |                                             |   |
| Kline Plaza                                                           |   | 334                               |   | 1996                             |   | Leased                                           |   |
| Harrisburg, Pennsylvania                                              |   |                              |   |                             |   |                                             |   |
| Lehigh Valley Community Programs                                      |   | 53                                |   | 1992                             |   | Leased                                           |   |
| Lehigh Valley, Pennsylvania                                           |   |                              |   |                             |   |                                             |   |
| Lycoming/Clinton County Behavioral                                    |   |                              |   |                             |   |                                             |   |
| Health Services                                                       |   | 30                                |   | 1998                             |   | Leased                                           |   |
| Williamsport, Pennsylvania                                            |   |                              |   |                             |   |                                             |   |
| Maple Creek Home                                                      |   | 8                                 |   | (9)                              |   | Owned                                            |   |
| Matteson, Illinois                                                    |   |                              |   |                             |   |                                             |   |
| Non-Residential Care - West                                           |   | 107                               |   | 1991                             |   | Leased                                           |   |
| Pittsburgh, Pennsylvania                                              |   |                              |   |                             |   |                                             |   |
| Philadelphia Community Programs                                       |   | 222                               |   | 1992                             |   | Owned                                            |   |
| Philadelphia, Pennsylvania                                            |   |                              |   |                             |   |                                             |   |
| Washington D.C. Community Programs                                    |   | 155                               |   | 1993                             |   | Leased                                           |   |
| District of Columbia                                                  |   |                              |   |                             |   |                                             |   |
| William Penn Harrisburg Alternative School                            |   | 600                               |   | 2001                             |   | Managed                                          |   |
| Harrisburg, Pennsylvania                                              |   |                              |   |                             |   |                                             |   |
| Workbridge Allegheny                                                  |   | 475                               |   | 1994                             |   | Leased                                           |   |
| Pittsburgh, Pennsylvania                                              |   |                              |   |                             |   |                                             |   |
|                                                                  |   |                              |   |                             |   |                                             |   |
| ***Pre-Release  Residential Correctional and Treatment Facilities*:** |   |                              |   |                             |   |                                             |   |
|                                                                  |   |                              |   |                             |   |                                             |   |
| Cordova Center                                                        |   | 192                               |   | 1985                             |   | Leased                                           | (5)    |
| Anchorage, Alaska                                                     |   |                              |   |                             |   |                                             |   |
| Dallas County Judicial Center                                         |   | 300                               |   | 1991                             |   | Managed                                          |   |
| Wilmer, Texas                                                         |   |                              |   |                             |   |                                             |   |
| El Monte Center                                                       |   | 55                                |   | 1993                             |   | Leased                                           |   |
| El Monte, California                                                  |   |                              |   |                             |   |                                             |   |
| Inglewood Men’s Center                                           |   | 47                                |   | 1982                             |   | Leased                                           |   |
| Inglewood, California                                                 |   |                              |   |                             |   |                                             |   |

 

11

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** **
|                                                                              |   | **Total   Service   Capacity(1)** |   | **Initial   Contract   Date(2)** |   | **Company   Owned/   Leased or   Managed(3)** |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------------|--------|----------------------------------|--------|-----------------------------------------------|--------|
|                                                                              |   |                              |   |                             |
|                                                                              |   |                              |   |                             |
| **Facility Name and Location**                                                    |   |                              |   |                             |
|                                                                              |   |                              |   |                             |   |                                          |   |
| ***Pre-Release  Residential Correctional and Treatment Facilities (Continued)*:** |   |                              |   |                             |   |                                          |   |
|                                                                              |   |                              |   |                             |   |                                          |   |
| Leidel Community Correctional Center                                              |   | 150                               |   | 1996                             |   | Leased                                        | (5)    |
| Houston, Texas                                                                    |   |                              |   |                             |   |                                          |   |
| Marvin Gardens Center                                                             |   | 42                                |   | 1981                             |   | Leased                                        |   |
| Los Angeles, California                                                           |   |                              |   |                             |   |                                          |   |
| Midtown Center                                                                    |   | 32                                |   | 1998                             |   | Owned                                         |   |
| Anchorage, Alaska                                                                 |   |                              |   |                             |   |                                          |   |
| Northstar Center                                                                  |   | 135                               |   | 1990                             |   | Leased                                        |   |
| Fairbanks, Alaska                                                                 |   |                              |   |                             |   |                                          |   |
| Oakland Center                                                                    |   | 61                                |   | 1981                             |   | Owned                                         |   |
| Oakland, California                                                               |   |                              |   |                             |   |                                          |   |
| Parkview Center                                                                   |   | 112                               |   | 1993                             |   | Leased                                        | (5)    |
| Anchorage, Alaska                                                                 |   |                              |   |                             |   |                                          |   |
| Reid Community Correctional Center                                                |   | 350                               |   | 1996                             |   | Leased                                        | (5)    |
| Houston, Texas                                                                    |   |                              |   |                             |   |                                          |   |
| Salt Lake City Center                                                             |   | 58                                |   | 1995                             |   | Leased                                        |   |
| Salt Lake City, Utah                                                              |   |                              |   |                             |   |                                          |   |
| Santa Barbara Center (11)                                                         |   | 25                                |   | 1996                             |   | Leased                                        | (11)   |
| Santa Barbara, California                                                         |   |                              |   |                             |   |                                          |   |
| Seaside Center                                                                    |   | 40                                |   | 1999                             |   | Leased                                        |   |
| Nome, Alaska                                                                      |   |                              |   |                             |   |                                          |   |
| Taylor Street Center                                                              |   | 177                               |   | 1984                             |   | Leased                                        | (8)    |
| San Francisco, California                                                         |   |                              |   |                             |   |                                          |   |
| Tundra Center                                                                     |   | 85                                |   | 1986                             |   | Leased                                        | (5)    |
| Bethel, Alaska                                                                    |   |                              |   |                             |   |                                          |   |
|                                                                              |   |                              |   |                             |   |                                          |   |
| ***Pre-Release  Non-Residential Community-Based Treatment Centers*:**             |   |                              |   |                             |   |                                          |   |
|                                                                              |   |                              |   |                             |   |                                          |   |
| East St.   Louis                                                             |   | 80                                |   | (9)                              |   | Leased                                        |   |
| East St. Louis, Illinois                                                          |   |                              |   |                             |   |                                          |   |
| Lifeworks - Joliet                                                                |   | 156                               |   | (9)                              |   | Leased                                        |   |
| Joliet, Illinois                                                                  |   |                              |   |                             |   |                                          |   |
| Northside Clinic                                                                  |   | 252                               |   | (9)                              |   | Owned                                         |   |
| Chicago, Illinois                                                                 |   |                              |   |                             |   |                                          |   |
| Santa Fe Electronic Monitoring                                                    |   | 50                                |   | 1999                             |   | Leased                                        |   |
| Santa Fe, New Mexico                                                              |   |                              |   |                             |   |                                          |   |
| Southwestern Illinois Correctional Center  (12)                                   |   | 671                               |   | (9)                              |   | Managed                                       |   |
| East St. Louis, Illinois                                                          |   |                              |   |                             |   |                                          |   |
| Southwood                                                                         |   | 551                               |   | (9)                              |   | Owned                                         |   |
| Chicago, Illinois                                                                 |   |                              |   |                             |   |                                          |   |

 

12

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(1)                      Total service capacity iscomprised of the beds available for service upon completion of construction ofresidential facilities and the average program capacity of the non-residentialcommunity-based facilities.  In certaincases, the management contract for a facility provides for a lower number ofbeds than the facility’s service capacity.

(2)                      Date from which the Company, orits predecessor, has had a contract for services on an uninterrupted basis.

(3)                      The Company does not incur anyfacility use costs for facilities for which the Company only has a managementcontract.

(4)                      The City of Big Spring enteredinto the Intergovernmental Agreement with the BOP for an indefinite term (untilmodified or terminated) with respect to the Big Spring Complex, which beganoperations during 1989.  The Big SpringOperating Agreement, as amended, has a term through 2047 including renewaloptions at the Company’s discretion, pursuant to which the Company manages theBig Spring Complex for the City of Big Spring. 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 at theCompany’s discretion.

(5)                      Facility was sold on August 14,2001 to Municipal Corrections Finance, L.P. (“MCF”) as part of the Company’s2001 Sale and Leaseback Transaction as discussed under “Management’s Discussionand Analysis of Financial Condition and Results of Operations – Liquidity andCapital Resources”.

(6)                      The prison is operated pursuantto a one-year contract with nine one-year renewal options between the OklahomaDepartment of Corrections and the Hinton Economic Development Authority, orHEDA.  HEDA in turn has subcontractedthe operations to the Company under a 30-year operating contract with fourfive-year renewals.

(7)                      In April 1999, the Company wasawarded a contract to design, build and operate the Moshannon ValleyCorrectional Center and immediately commenced construction and activationactivities.  In June 1999, the BOPissued a Stop-Work Order pending a re-evaluation of their environmentaldocumentation supporting the decision to award the contract.  The environmental study was completed with afinding of no significant impact and the Stop-Work Order was lifted by the BOPon August 9, 2001.  In September 1999,the Company received correspondence from the Office of the Attorney General ofthe Commonwealth of Pennsylvania indicating its belief that the operation of aprivate prison in Pennsylvania is unlawful. The Company and the BOP have had discussions with the Attorney General’sstaff regarding these and related issues. As a result of these issues, the Company has not re-commenced itsconstruction efforts.  In March 2003,the Company reached an agreement with the Commonwealth of Pennsylvania thatresolved all outstanding administrative issues relative to the contract awardedto the Company by the BOP to operate the Moshannon Valley CorrectionalCenter.  If the Company is able to negotiatean amendment to the contract with the BOP, this agreement will allow theCompany to move forward with the construction and operation of the facility,subject to re-approval of the project by the lenders under the Company’samended 2000 Credit Facility.  As ofDecember 31, 2002, the Company had incurred approximately $16.1 million forconstruction and land development costs and capitalized interest for theMoshannon Valley Correctional Center. According to the BOP contract, as amended, the Company must complete theconstruction of the facility by April 15, 2003.  The Company will not be able to complete construction within thattime frame.  The Company is currentlyobtaining contract amendments monthly from the BOP. The Company anticipatesobtaining another long-term contract amendment from the BOP expending theconstruction deadline.  In the event theCompany is not able to negotiate a contract amendment with the BOP, then theBOP may have the right to assert that the Company has not completed constructionof the facility within the time frame provided in the BOP contract, asamended.  Management expects that thecontract will be amended to address cost and construction timing mattersresulting from the extended delay.  Inthe event that the BOP decides not to continue with the construction of theMoshannon Valley Correctional Center and terminates the contract, managementbelieves that the Company has the right to and will recover its investedcosts.  In the event any portion ofthese costs are determined not to be recoverable upon contract termination bythe BOP, such costs will be expensed. Management currently believes that the invested costs would be fullyrecovered in the event this contract is terminated.

(8)                      Facility was financed with theCompany’s synthetic lease financing arrangement under its amended 2000 CreditFacility.  Refer to “Management’sDiscussion and Analysis of Financial Condition and Results of Operations -Liquidity and Capital Resources”.

(9)                      The Cornell Interventionsprograms/facilities contract with numerous agencies throughout Illinois.  Initial contract dates vary by agency andrange from 1974 to 1997.

(10)                The Company closed the New MorganAcademy in the fourth quarter of 2002. The Company is currently evaluating alternative uses for the facilityfor other types of programs as well as the possibility of selling the facility.

(11)                The Company terminated the program atthe Santa Barbara Center effective February 28, 2003.

(12)                The Company manages a therapeuticcommunity drug and alcohol program within the state operated SouthwesternIllinois Correctional Center.

 

13

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**Competition**

 

The Company’s industry is currently characterized by a few largenational operators focused primarily in the adult secure institutional sectorand by a large number of smaller operators in the juvenile and pre-releasesectors.  Management believes itsprincipal competitors are Corrections Corporation of America and WackenhutCorrections Corporation.

 

**Employees**

 

At December 31, 2002, the Company had approximately 3,478 full-timeemployees and 279 part-time employees. The Company employs management, administrative and clerical, security,educational and counseling services, health services and general maintenancepersonnel.  Approximately 502 employeesat four of the Company’s facilities are represented by unions.  The Company believes its relations with itsemployees are good.

 

**Regulations**

 

The industry in which the Company operates is subject to federal, stateand local regulations administered by a variety of regulatory authorities.  Generally, prospective providers ofcorrectional, detention and pre-release services must comply with a variety ofapplicable state and local regulations, including education, healthcare andsafety regulations.  The Company’scontracts frequently include extensive reporting requirements and requiresupervision with on-site monitoring by representatives of contractinggovernmental agencies.

 

In addition to regulations requiring certain contracting governmentalagencies to enter into a competitive bidding procedure before awardingcontracts, the laws of certain jurisdictions may also require the Company toaward subcontracts on a competitive basis or to subcontract with businessesowned by women or members of minority groups.

 

**BusinessConcentration**

 

For the years ended December 31, 2002, 2001 and 2000, 20.9%, 20.2% and21.4%, respectively, of the Company’s consolidated revenues were derived frommultiple contracts with the BOP.

 

**Insurance**

 

The Company maintains a $10 million per occurrence per facility generalliability insurance policy for all its operations.  The Company also maintains insurance in amounts it deems adequateto cover property and casualty risks, workers’ compensation and directors’ andofficers’ liability.

 

The Company’s contracts and the statutes of certain states in which theCompany operates typically require the maintenance of insurance by theCompany.  The Company’s contractsprovide that, in the event the Company does not maintain such insurance, thecontracting agency may terminate its agreement with the Company.  The Company believes that it is incompliance in all material respects with these requirements.

 

14

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**ITEM2.        PROPERTIES**

 

The Company leases office space for its corporate headquarters inHouston, Texas and regional administrative offices in Ventura, California,Pittsburgh, Pennsylvania and Chicago, Illinois.  The Company also leases various facilities it is currentlyoperating or developing.  For a listingof owned and leased facilities, see “Business - Facilities.”

 

**ITEM3.        LEGAL PROCEEDINGS**

 

In March and April 2002, the Company, Steven W. Logan, and John L.Hendrix, were named as defendants in four Federal putative class actionlawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*, No. H-02-0866,in the United States District Court for the Southern District of Texas, HoustonDivision; (2) *Richard Picard, On Behalf of Himself and All Others Similarly Situatedv. Cornell Companies, Inc., et al.*, No. H-02-1075, in the UnitedStates District Court for the Southern District of Texas, Houston Division; (3)*Louis A.Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the United StatesDistrict Court for the Southern District of Texas, Houston Division, and (4) *Anthony J.Scolaro, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1567, in the United StatesDistrict Court for the Southern District of Texas, Houston Division.  The aforementioned lawsuits are putativeclass action lawsuits brought on behalf of all purchasers of the Company’scommon stock between March 6, 2001 and March 5, 2002.  The lawsuits involve disclosures made concerning two priortransactions executed by the Company: the August 2001 sale leasebacktransaction and the 2000 synthetic lease transaction.  These four lawsuits have all been consolidated into the *GraydonWilliams* action.  Recently,the Court granted Flyline Partners, LP’s motion to be appointed as leadplaintiff and Flyline Partners, LP has filed a consolidated complaint.  The consolidated complaint alleges that thedefendants violated Section 10(b) of the Securities Exchange Act of 1934 (the“Exchange Act”), Rule 10b-5 promulgated under Section 10(b) of the ExchangeAct, Section 20(a) of the Exchange Act and Section 11 of the Securities Act of1933.  The consolidated compliant seeks,among other things, restitution damages, compensatory damages, rescission or arescissory measure of damages, costs, expenses, attorneys’ fees and expertfees.  The Company believes that it hasgood defenses to each of the plaintiffs’ claims and intends to vigorouslydefend against each of the claims.

 

In March 2002, the Company, its directors, and its former independentauditor Arthur Andersen LLP, were sued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant Cornell Companies,Inc. v. Anthony R. Chase, et al.*, No. 2002-15614, in the 127th Judicial DistrictCourt of Harris County, Texas.  Thelawsuit alleges breaches of fiduciary duty by all of the individual defendantsand asserts breach of contract and professional negligence claims only againstArthur Andersen LLP.  The Companybelieves that it has good defenses to each of the plaintiff’s claims andintends to vigorously defend against each of the claims.

 

In May and June 2002, the Company and its directors were sued in threeother derivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalfof Cornell Companies, Inc. v. Steven W. Logan, et. al.,* No.H-02-1812, in the United Stated District Court for the Southern District ofTexas, Houston Division; (2) *Thomas Pagano, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.*, No. H-02-1896, in theUnited Stated District Court for the Southern District of Texas, HoustonDivision; and (3) *Jesse Menning, Derivatively on Behalf of Cornell Companies, Inc. v.Steven W. Logan, et. al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits all allege breaches of fiduciary duty and waste of corporate assets byall of the defendants.  A motion todismiss the *Guitierrez*and *Pagano*lawsuits was filed.  The court dismissedthe *Pagano*action as duplicative of the *Guitierrez* action.  The motion to dismiss the *Guitierrez*action is still pending.  The Companybelieves that it has good defenses to each of the plaintiffs’ claims and intendto vigorously defend against each of these claims.

 

15

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While the plaintiffs in these cases have not quantified their claim ofdamages and the outcome of the matters discussed above cannot be predicted withcertainty, based on information known to date, management believes that theultimate resolution of these matters will not have a material adverse effect onthe Company’s financial position, operating results or cash flow.

 

The Company currently and from time to time is subject to claims andsuits arising in the ordinary course of business, including claims for damagesfor personal injuries or for wrongful restriction of, or interference with,offender privileges and employment matters.

 

16

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**ITEM4.****                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matters were submitted to the Company’s stockholders’ during thefourth quarter of 2002.

 

**PARTII**

 

**ITEM5.****                        MARKET FORCORNELL COMPANIES, INC. COMMON STOCK AND RELATED STOCKHOLDER MATTERS**

 

The common stock of the Company is currently listed on the New YorkStock Exchange (“NYSE”) under the symbol “CRN.”  As of February 28, 2003, there were approximately 34 record holdersand approximately 1,500 beneficial holders of common stock.  The quarterly high and low closing salesprices for the common stock from January 1, 2001 through February 28, 2003 areshown below:

 
|                                      |   | **High** |        | **Low** |   |
|-------------------------------------------|--------|----------|-------------|---------|--------|
|                                      |   |     |        |    |   |
| 2001:                                     |   |     |        |    |   |
| First Quarter                             |   | $        |  8.25  |    | $      |  5.69 |   |
| Second Quarter                            |   | 15.00    |        | 7.90    |   |
| Third Quarter                             |   | 18.11    |        | 13.40   |   |
| Fourth Quarter                            |   | 17.90    |        | 14.10   |   |
| 2002:                                     |   |     |        |    |   |
| First Quarter                             |   | $        |  18.21 |    | $      |  9.96 |   |
| Second Quarter                            |   | 13.00    |        | 9.63    |   |
| Third Quarter                             |   | 12.99    |        | 7.53    |   |
| Fourth Quarter                            |   | 9.45     |        | 5.50    |   |
| 2003:                                     |   |     |        |    |   |
| First Quarter (through February 28, 2003) |   | $        |  9.46  |    | $      |  6.55 |   |

 

The Company has never declared or paid cash dividends on its capitalstock.  The Company currently intends toretain excess cash flow, if any, for use in the operation and expansion of itsbusiness and does not anticipate paying cash dividends on the common stock inthe foreseeable future.  The payment ofdividends is within the discretion of the Board of Directors and is dependentupon, among other factors, the Company’s results of operations, financialcondition, capital requirements, restrictions, if any, imposed by financingcommitments and legal requirements.  TheCompany’s Amended and Restated Credit Agreement, dated as of July 21, 2000(“2000 Credit Facility”), currently prohibits the payment of dividends.  See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations — Liquidity and CapitalResources.”

 

17

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The following table summarizes as of December 31, 2002, certaininformation regarding equity compensation to our employees, officers,directors, and other persons under the Company’s plans:

 
|                                   |   | **Number of   Securities to be   Issued upon   Exercise of  Outstanding Stock   Options and Warrants** |   | **Weighted-average    Exercise Price of   Outstanding   Stock Options   and Warrants** |   | **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                       |   | 1,106,505                                                                                              |   | $                                                                                      | 9.67   |                                                                                                                                                          | 526,175 | (1)  |
| Equity compensation plans not approved |   |                                                                                                   |   |                                                                                   |   |                                                                                                                                                          |    |
| by security holders                    |   | 375,932                                                                                                |   | $                                                                                      | 7.33   |                                                                                                                                                          | 321,552 | (2) |
| Total                                  |   | 1,482,437                                                                                              |   | $                                                                                      | 9.08   |                                                                                                                                                          | 847,727 |   |

 

----

(1)                                  Includes 107,647shares issuable pursuant to the Company’s Employee Stock Purchase Plan and59,697 shares issuable pursuant to the Company’s 2000 Director Stock Plan. Alsoincludes 358,831 shares issuable pursuant to the Company’s Amended and Restated1996 Stock Option Plan.  The totalnumber of shares issuable pursuant to the Company’s Amended and Restated 1996Stock Option Plan is equal to the greater of 1,500,000 shares or 15.0% of the numberof shares issued and outstanding immediately after the grant of any optionunder the Plan.

 

(2)                                  Includes 100,000shares issuable pursuant to the Company’s Deferred Compensation Plan and221,552 shares issuable pursuant to the Company’s 2000 Broad-Based EmployeePlan.  The number of shares issuablepursuant to the Company’s 2000 Broad-Based Plan is equal to the greater of400,000 shares or 4.0% of the shares issued and outstanding immediately afterthe grant of any option under the Plan.

 

**Equity CompensationPlans Not Approved by Security Holders**

 

*Deferred Compensation Plan*

 

The Company maintains the Cornell Companies,Inc. Deferred Compensation Plan for the purpose of providing deferredcompensation for eligible employees. The Deferred Compensation Plan is a nonqualified plan.

 

A participant in the Deferred CompensationPlan may defer into an account a percentage of compensation each year up to75.0% of the participant’s compensation received from the Company.  In addition, the Company may make contributionsto the Deferred Compensation Plan on behalf of each participant.  Compensation deferred by a participant, orcontributions made by the Company on behalf of a participant, will be investedin mutual funds and the common stock of the Company.  Participants are 100.0% vested in their accounts and may elect toreceive the amounts credited to their accounts either in a lump sum or in fiveor ten-year annual installment payments. 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*

 

In conjunction with the issuance of the Subordinated Notes in July2000, the Company issued warrants to purchase 290,370 shares of its commonstock at an exercise price of $6.70. The warrants may only be exercised by payment of the exercise price incash to the Company, by cancellation of an amount of warrants equal to the fairmarket value of the exercise price, or by the cancellation of Companyindebtedness owed to the warrant holder. During 2001, 168,292 shares of common stock were issued in conjunctionwith the exercise and cancellation of 217,778 warrants; therefore 72,592warrants remain outstanding at December 31, 2002.

 

*2000 Broad-Based Employee Plan*

 

In December 2000, the Company adopted the 2000 Broad-Based EmployeePlan (the “2000 Plan”).  Pursuant to the2000 Plan, the Company may grant non-qualified stock options to its employees,directors and eligible consultants for up to the greater of 400,000 shares or 4.0%of the aggregate number of shares of 

 

18

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common stock issued and outstanding immediately after the grant of anyoption under the 2000 Plan.  Optionsissued pursuant to the 2000 Plan vest evenly over a period of five years andexpire ten years from the grant date. The vesting schedule and term are set by the Compensation Committee ofthe Board of Directors.  The exerciseprice of options issued pursuant to the 2000 Plan can be no less than the parvalue of a share of common stock.

 

Upon notice of an Extraordinary Transaction (as defined in the 2000Plan), options granted under the 2000 Plan shall become fully vested.  Upon consummation of the ExtraordinaryTransaction, such options, to the extent not previously exercised, shallterminate.

 

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**ITEM6.        SELECTED CONSOLIDATED FINANCIALDATA**

 

The selected consolidated financial data of the Company as of December31, 2002, 2001, 2000, 1999 and 1998 and for each of the five years then endedshould be read in conjunction with the Company’s Consolidated FinancialStatements and Notes thereto and “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” included elsewhere in this report.

 

The Consolidated Financial Statements for the years ended December 31,1998 through 2001 were audited by Arthur Andersen LLP (“Andersen”) who hasceased operations.  A copy of the reportpreviously issued by Andersen on the Company’s financial statements as ofDecember 31, 2001 and 2000 and for each of the three years in the period endedDecember 31, 2001 is included elsewhere in this Form 10-K.  Such report has not been reissued byAndersen.

 
| **,**                                                                                                                      |   | **Year Ended  December 31,** |    |
|----------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                                                       |   | **2002**                     |    | **2001** |   | **2000** |   | **1999(1)** |   | **1998(2)** |   |
|                                                                                                                       |   |                         |    | **(in  thousands, except per share data)** |   |   |   |
| **Statements of Operations Data:**                                                                                         |   |                         |    |   |   |   |   |   |   |   |   |
| Revenues                                                                                                                   |   | $                            | 275,145 |   | $ | 265,250 |   | $ | 226,050 |   | $ | 176,967 |   | $ | 123,119 |   |
| Income from operations                                                                                                     |   | 31,577                       |    | 31,018 |   | 29,653 |   | 22,249 |   | 12,589 |   |
| Income before provision for income taxes,  extraordinary charge and cumulative effect of changes in accounting  principles |   | 12,279                       |    | 11,793 |   | 13,507 |   | 13,844 |   | 10,104 |   |
| Income before extraordinary charge and  cumulative effect of changes in accounting principles                              |   | 7,327                        |    | 6,835 |   | 7,969 |   | 8,306 |   | 6,062 |   |
| Extraordinary charge for early retirement  of debt, net of related income tax benefit (3)                                  |   | —                       |    | (2,946 | ) | — |   | — |   | — |   |
| Cumulative effect of changes in accounting  principles, net of related income tax provision/(benefit) (4)                  |   | (965                         | )       | 770 |   | — |   | (2,954 | ) | — |   |
| Net income                                                                                                                 |   | $                            | 6,362   |   | $ | 4,659 |   | $ | 7,969 |   | $ | 5,352 |   | $ | 6,062 |   |
| Earnings per share:                                                                                                        |   |                         |    |   |   |   |   |   |   |   |   |
| •  Basic                                                                                                              |   |                         |    |   |   |   |   |   |   |   |   |
| Income before extraordinary charge and  cumulative effect of changes in accounting principles                              |   | $                            | .57     |   | $ | .71 |   | $ | .85 |   | $ | .88 |   | $ | .64 |   |
| Extraordinary charge (3)                                                                                                   |   | $                            | —  |   | $ | (.31 | ) | $ | — |   | $ | — |   | $ | — |   |
| Cumulative effect of changes in accounting  principles (4)                                                                 |   | $                            | (.08    | ) | $ | .08 |   | $ | — |   | $ | (.31 | ) | $ | — |   |
| Net income                                                                                                                 |   | $                            | .49     |   | $ | .48 |   | $ | .85 |   | $ | .57 |   | $ | .64 |   |
| •  Diluted                                                                                                            |   |                         |    |   |   |   |   |   |   |   |   |
| Income before extraordinary charge and  cumulative effect of changes in accounting principles                              |   | $                            | .55     |   | $ | .68 |   | $ | .84 |   | $ | .86 |   | $ | .62 |   |
| Extraordinary charge (3)                                                                                                   |   | $                            | —  |   | $ | (.29 | ) | $ | — |   | $ | — |   | $ | — |   |
| Cumulative effect of changes in accounting  principles (4)                                                                 |   | $                            | (.07    | ) | $ | .07 |   | $ | — |   | $ | (.31 | ) | $ | — |   |
| Net income                                                                                                                 |   | $                            | .48     |   | $ | .46 |   | $ | .84 |   | $ | .55 |   | $ | .62 |   |
| Number of shares used to compute EPS :                                                                                     |   |                         |    |   |   |   |   |   |   |   |   |
| •  Basic                                                                                                              |   | 12,911                       |    | 9,616 |   | 9,383 |   | 9,432 |   | 9,442 |   |
| •  Diluted                                                                                                            |   | 13,232                       |    | 10,069 |   | 9,495 |   | 9,660 |   | 9,772 |   |

 

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|                                                             |   | **Year Ended  December 31,**                       |   |
|------------------------------------------------------------------|--------|----------------------------------------------------|--------|
|                                                             |   | **2002**                                           |   | **2001** |   | **2000** |   | **1999(1)** |   | **1998(2)** |   |
|                                                             |   | **(dollars  in thousands, except per share data)** |   |
| **Operating Data:**                                              |   |                                               |   |   |   |   |   |   |   |   |   |
| Total service capacity (5):                                      |   |                                               |   |   |   |   |   |   |   |   |   |
| Residential                                                      |   | 11,267                                             |   | 11,267 |   | 11,318 | (6)  | 11,796 |   | 9,135 |   |
| Non-residential community-based                                  |   | 4,177                                              |   | 4,177 |   | 3,046 |   | 3,049 |   | 1,390 |   |
| Total                                                            |   | 15,444                                             |   | 15,444 |   | 14,364 | (6)  | 14,845 |   | 10,525 |   |
| Service capacity in operation (end of  period)                   |   | 14,135                                             |   | 14,349 |   | 13,269 |   | 12,240 |   | 8,700 |   |
| Contracted beds in operation (end of  period) (7)                |   | 9,289                                              |   | 9,503 |   | 10,061 |   | 9,029 |   | 7,310 |   |
| Average occupancy based on contracted beds  in operation (7) (8) |   | 98.7                                               | %      | 95.9 | % | 94.3 | % | 95.8 | % | 93.8 | % |
| Average occupancy excluding start-up  operations (7)             |   | 98.7                                               | %      | 96.3 | % | 96.0 | % | 97.0 | % | 98.3 | % |
|                                                             |   |                                               |   |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                          |   |                                               |   |   |   |   |   |   |   |   |   |
| Working capital (deficit)                                        |   | $                                                  | 95,988 |   | $ | 97,814 |   | $ | 29,703 |   | $ | (12,636 | ) | $ | 16,828 |   |
| Total assets                                                     |   | 441,291                                            |   | 444,807 |   | 336,850 |   | 273,991 |   | 212,695 |   |
| Long-term debt, net of current portion                           |   | 232,258                                            |   | 238,768 |   | 191,722 |   | 101,500 |   | 98,407 |   |
| Stockholders’ equity                                        |   | 159,952                                            |   | 153,104 |   | 104,320 |   | 97,208 |   | 91,500 |   |
|                                                                  |        |                                                    |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Notes to SelectedConsolidated Financial Data**

 

(1)           Includes theoperations of Interventions-Illinois acquired in November 1999.

(2)                                  Includes theoperations of the Great Plains Correctional Facility acquired in January 1998and the Alaska facilities purchased from Allvest in August 1998.

(3)                                  For the year endedDecember 31, 2001, the Company recognized an extraordinary charge ofapproximately $2.9 million, net of income taxes of approximately $2.0 million,due to the write-off of unamortized deferred debt issuance costs, debt discountand assessed contractual prepayment fees related to the early retirement of theCompany’s Subordinated Notes during the fourth quarter of 2001.

(4)                                  For the year endedDecember 31, 2002, the Company recognized a cumulative effect of a change inaccounting principle charge of approximately $1.0 million, net of income taxesof approximately $0.7 million, related to the impairment of goodwill inconnection with the adoption of SFAS No. 142 in January 2002.  For the year ended December 31, 2001, theCompany recognized a cumulative effect of a change in accounting principlebenefit of approximately $770,000, net of an income tax benefit of approximately$535,000, related to a change in the Company’s method of accounting for durablesupplies.  For the year ended December31, 1999, the Company recognized a cumulative effect of a change in accountingprinciple charge of approximately $3.0 million, net of income taxes ofapproximately $2.0 million, in connection with the adoption of the AmericanInstitute of Certified Public Accountants Statement of Position 98-5 (“SOP98-5”) which required entities to expense start-up costs as incurred and toexpense previously capitalized start-up costs as cumulative effect of a changein accounting principle.

(5)                                  The Company’s servicecapacity is comprised of the number of beds available for service uponcompletion of construction of residential facilities and the average programcapacity of non-residential community-based programs.

(6)                                  The Utah Departmentof Corrections (“Utah DOC”) selected the Company’s bid in June 1999 for the 490bed Timpie Valley Correctional Facility subject to final contractnegotiations.  In 2000, the Utah DOCdeclined to pursue this project; therefore the Company’s service capacity wasreduced accordingly.

(7)                                  Occupancy percentagesare based on contracted service capacity of residential facilities inoperation.  Since certain facilities haveservice capacities that exceed contracted capacities, occupancy  percentages can exceed 100% of contractedcapacity.

(8)                                  Occupancy percentagesreflect less than normalized occupancy during the start-up phase of anyapplicable facility, resulting in a lower average occupancy in periods when theCompany has substantial start-up activities.

 

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| **ITEM 7.** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-------------|-------------------------------------------------------------------------------------------------|

 

**General**

 

The Company is a leading provider of privatized correctional, treatmentand educational services outsourced by federal, state and local governmentagencies.  The Company provides adiversified portfolio of services for adults and juveniles through its threeoperating divisions: (1) adult secure institutional services; (2) juveniletreatment, education and detention services and (3) pre-release correctionaland treatment services.  As of December31, 2002, the Company had 69 facilities with a total service capacity of 15,444,including the New Morgan Academy, which was closed in the fourth quarter of2002, and the Moshannon Valley Correctional Center, which is underdevelopment.  The Company’s facilitiesare located in 13 states and the District of Columbia.

 

The following table sets forth for the periods indicated total servicecapacity, the service capacity and contracted beds in operation at the end ofthe periods shown and average occupancy percentages.

 
|                                                            |   | **Year Ended  December 31,** |   |
|-----------------------------------------------------------------|--------|------------------------------|--------|
|                                                            |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                                            |   |                         |   |   |   |   |   |
| Total service capacity (1):                                     |   |                         |   |   |   |   |   |
| Residential                                                     |   | 11,267                       |   | 11,267 |   | 11,318 |   |
| Non-residential community-based                                 |   | 4,177                        |   | 4,177 |   | 3,046 |   |
| Total                                                           |   | 15,444                       |   | 15,444 |   | 14,364 |   |
| Service capacity in operation (end of  period)                  |   | 14,135                       |   | 14,349 |   | 13,269 |   |
| Contracted beds in operation (end of  period) (2)               |   | 9,289                        |   | 9,503 |   | 10,061 |   |
| Average occupancy based on contracted beds  in operation (2)(3) |   | 98.7                         | %      | 95.9 | % | 94.3 | % |
| Average occupancy excluding start-up  operations (2)            |   | 98.7                         | %      | 96.3 | % | 96.0 | % |

 

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(1)                                  The Company’s servicecapacity is comprised of the number of beds available for service uponcompletion of construction of residential facilities and the average programcapacity of non-residential community-based programs.

(2)                                  Occupancy percentagesare based on contracted service capacity of residential facilities inoperation.  Since certain facilitieshave service capacities that exceed contracted capacities, occupancypercentages can exceed 100% of contracted capacity.

(3)                                  Occupancy percentagesreflect less than normalized occupancy during the start-up phase of anyapplicable facility, resulting in a lower average occupancy in periods when theCompany has substantial start-up activities.

 

The Company derives substantially all its revenues from providingcorrections, treatment and educational services outsourced by federal, stateand local government agencies in the United States.  Revenues for the Company’s services are generally recognized on aper diem rate based upon the number of occupant days or hours served for theperiod, on a guaranteed take-or-pay basis or on a cost-plus reimbursementbasis.  Revenues may fluctuate from yearto year due to changes in government funding policies, the number of peoplereferred to the Company’s facilities by governmental agencies or the opening ofadditional facilities.

 

Factors that the Company considers in determining the per diem rate tocharge include (1) the programs specified by the contract and the relatedstaffing levels, (2) wage levels customary in the respective geographic areas,(3) whether the proposed facility is to be leased or purchased and (4) theanticipated average occupancy levels that the Company believes could reasonablybe maintained.

 

The Company has historically experienced higher operating margins inits adult secure institutional and pre-release divisions as compared to thejuvenile division.  Additionally, theCompany’s operating margins within a division can vary from facility tofacility based on whether a facility is owned or leased, the level ofcompetition for the contract award, the proposed length of the contract, theoccupancy levels for a facility, 

 

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the level of capital commitment required with respect to a facility,the anticipated changes in operating costs over the term of the contract, andthe Company’s ability to increase a facility's contract revenue.  A decline in occupancy of certain juveniledivision facilities may have a more significant impact on operating resultsthan the adult secure division due to higher per diem revenues of certainjuvenile facilities. The Company has experienced and expects to experienceinterim period operating margin fluctuations due to the number of calendar daysin the period, higher payroll taxes in the first half of the year, and salaryand wage increases that are incurred prior to certain contract revenueincreases.  The Company experiencedhigher employee insurance costs in the year ended December 31, 2002 as comparedto the year ended December 31, 2001 due to rising medical costs.

 

The Company is responsible for all facility operating costs, except forcertain debt service and lease payments with respect to facilities for whichthe Company has only a management contract (13 facilities in operation atDecember 31, 2002 and 2001 and nine facilities in 2000).

 

A majority of the Company’s facility operating costs consists of fixedcosts.  These fixed costs include leaseand rental expense, insurance, utilities and depreciation.  As a result, when the Company commencesoperation of new or expanded facilities, fixed operating cost increase.  The amount of the Company’s variableoperating costs, including food, medical services, supplies and clothing,depend on occupancy levels at the facilities operated by the Company.  The Company’s largest single operating cost,facility payroll expense and related employment taxes and costs, has both afixed and a variable component.  TheCompany can adjust a facility's staffing levels and the related payroll expenseto a certain extent based on occupancy at a facility, however a minimum fixednumber of employees is required to operate and maintain any facility regardlessof occupancy levels.  Personnel costsare subject to increases in tightening labor markets based on local economicand other conditions.

 

Following a contract award, the Company incurs 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 costsvary by contract.  Since pre-opening andstart-up costs are factored into the revenue per diem rate that is charged tothe contracting agency, the Company typically expects to recover these upfrontcosts over the life of the contract. Because occupancy rates during a facility’s start-up phase typicallyresult in capacity under-utilization for at least 90 to 180 days, the Companymay incur additional post-opening start-up costs.  The Company does not anticipate post-opening start-up costs atfacilities operated under any future contracts with the BOP because thesecontracts are currently and expected to continue to be take-or-pay contracts,meaning that the BOP will pay the Company at least 95.0% of the contractualmonthly revenue once the facility opens regardless of actual occupancy.

 

Newly opened facilities are staffed according to contract requirementswhen the Company begins receiving offenders or clients.  Offenders or clients are typically assignedto a newly opened facility on a phased-in basis over a one- to six-monthperiod, although certain programs require a longer time period to reachbreak-even occupancy levels.  TheCompany incurs start-up operating losses at new facilities until break-evenoccupancy levels are reached.  Althoughthe Company typically recovers these upfront costs over the life of thecontract, quarterly results can be substantially affected by the timing of thecommencement of operations as well as development and construction of newfacilities.

 

Working capital requirements generally increase immediately prior tothe Company’s commencing management of a new or expanded facility as theCompany incurs start-up costs and purchases necessary equipment and suppliesbefore facility management revenue is realized.

 

General and administrative expenses consist primarily of costs for theCompany’s corporate and administrative personnel who provide senior management,finance, accounting, human resources, payroll and 

 

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information systems, costs of business development and outsideprofessional fees.

 

**Significant 2002Events**

 

On February 6, 2002, the Company announced that a Special Committee ofthe Audit Committee of the  Board ofDirectors had been formed to review the accounting treatment for the Company’sAugust 2001 sale and leaseback transaction (the “2001 Sale and LeasebackTransaction”).  The Company entered intoa retainer agreement with an investment bank dated September 2001, which, asamended, provided that (1) the Company pay the investment bank a non-refundableretainer fee of $3.65 million to provide financial advisory services concerningseparate future financing vehicles and the strategic development of theCompany’s business and (2) the retainer would be applied on a mutually agreedupon basis toward future contingent fees associated with investment bankingservices that would be provided to the Company.  The Special Committee’s review focused on whether the retaineragreement and the payment of the related fee affected the previously reportedaccounting treatment for the 2001 Sale and Leaseback Transaction.

 

The Special Committee, which was composed solely of independentdirectors, retained independent counsel, who retained an accounting advisor, toassist the Special Committee in its review. The Special Committee was formed and conducted its review in response tocorrespondence from the Company’s independent auditors to its Audit Committeeregarding the 2001 Sale and Leaseback Transaction.  In the course of its review and pursuant to a third letter fromthe Company’s independent auditors addressed to the Company’s Chairman datedFebruary 21, 2002, the Special Committee also reviewed the accounting treatmentfor the Company’s 2000 synthetic lease transaction.  The review of the synthetic lease focused on whether a fee waspaid pursuant to an engagement letter between the Company and two financialinstitutions participating in the transaction and the impact of the fee on thepreviously reported accounting treatment.

 

At the conclusion of its review, the Special Committee recommended tothe Board of Directors, among other things, that:

 

•                                          basedon various considerations, the Company’s financial statements for 2000 and thefirst three quarters of 2001 be restated to reflect the consolidation of the2001 Sale and Leaseback Transaction and the 2000 synthetic lease transaction;and

 

•                                          actionsshould be taken to further strengthen the Company’s internal controls.

 

While the Company believes there are reasonable arguments supportingthe previously reported accounting treatment of the 2001 Sale and LeasebackTransaction and the 2000 synthetic lease transaction, pursuant to discussionswith its independent auditors and its advisors, and in view of anticipatedchanges in accounting rules and the market and regulatory environment currentlyexisting, the Company decided to consolidate both transactions for financialreporting purposes for past and future periods.  As a result, the Company restated its financial statements for2000 and the first three quarters of 2001 to reflect the consolidation of the2001 Sale and Leaseback Transaction and the 2000 synthetic lease transaction.

 

These restatements are reflected in the selected unaudited quarterlyfinancial data set forth in Note 15 to the Consolidated FinancialStatements.  The restatements of thefinancial data for the year ended December 31, 2000 are reflected in theaudited financial statements included herewith.

 

The Company recognized a pre-tax charge of approximately $1.9 millionfor legal, accounting and other professional fees for the year ended December31, 2002 as a result of the Company’s Special Committee review of certainCompany transactions, the restatement of the Company’s 2000 and 2001 financialstatements and related matters.  SeeNote 2 to the Consolidated Financial Statements.

 

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Additionally, the Company obtained certain waivers and amendments toits credit agreements in connection with the restatement of its prior year’sfinancial statements.  The Companyrecognized a pre-tax charge to interest expense of approximately $825,000 forthe year ended December 31, 2002  forlenders’ fees and related professional fees incurred to obtain these waiversand amendments.

 

On April 16, 2002, the Board of Directors amended the Company’sBylaws.  Among other things, theamendments established an Executive Chairman position, clarified specificlevels of authority for members of senior management and identified appropriatelimits on such authority.  Pursuant toboard action, Harry J. Phillips, Jr., the Company’s Chairman, was appointed theExecutive Chairman of the Company, Steven W. Logan as President, Thomas R.Jenkins as Chief Operating Officer and John L. Hendrix as Chief FinancialOfficer.

 

In September 2002, Steven W. Logan resigned his position as Presidentof the Company.  On September 18, 2002,the Board of Directors appointed Thomas R. Jenkins as President and ChiefOperating Officer.

 

The Company recognized a pre-tax charge of approximately $1.5 millionfor costs associated with the termination of the management contract withSteven W. Logan upon his resignation as President in September 2002.  This charge is reflected in general andadministrative expenses in the accompanying audited financial statements.

 

In the second quarter of 2002, the Company was informed that it had notbeen awarded the BOP Southeast contract. As a result, the Company recognized a pre-tax charge of approximately$1.0 million for the write-off of deferred project financing costs associatedwith the project.

 

On September 27, 2002, the Company announced plans to close the NewMorgan Academy.  The Company iscurrently reviewing and evaluating several options for the reutilization of thefacility as an adult and/or family detention center or as an alternativejuvenile educational facility.  Somerenovations to the facility may be required in order to operate any type ofalternative program at the facility. The Company is also considering the possibility of selling the facility.

 

In April 1999, the Company was awarded a contract to design, build andoperate a 1,095 bed prison for the BOP in Moshannon Valley, Pennsylvania (the“Moshannon Valley Correctional Center”). Construction and activation activities commenced immediately.  In June 1999, the BOP issued a Stop-WorkOrder pending a re-evaluation of their environmental documentation supportingthe decision to award the contract.  Theenvironmental study was completed with a finding of no significant impact andthe Stop-Work Order was lifted by the BOP on August 9, 2001.

 

In September 1999, the Company received correspondence from the Officeof the Attorney General of the Commonwealth of Pennsylvania indicating itsbelief that the operation of a private prison in Pennsylvania is unlawful.  The Company and the BOP have had discussionswith the Attorney General’s staff regarding these and related issues.  As a result of these issues, the Company hasnot re-commenced its construction efforts. As of December 31, 2002, the Company had incurred approximately $16.1million for construction and land development costs and capitalized interestrelated to the Moshannon Valley Correctional Center.  According to the BOP contract, as amended, the Company must completeconstruction of the facility by April 15, 2003.  The Company will not be able to complete construction within thattime frame.  The Company is currentlyobtaining contract amendments monthly from the BOP.  The Company anticipates obtaining another long-term contractamendment from the BOP 

 

25

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extending the construction deadline. In the event the Company is not able to negotiate a contract amendmentwith the BOP, then the BOP may have the right to assert that the Company hasnot completed construction of the facility within the time frame provided inthe BOP contract, as amended. Management expects that the contract will be amended to address cost andconstruction timing matters resulting from the extended delay.  In the event that the BOP decides not tocontinue with the construction of the Moshannon Valley Correctional Center andterminates the contract, management believes that the Company has the right toand will recover its invested costs.  Inthe event any portion of these costs are determined not to be recoverable uponcontract termination by the BOP, such costs will be expensed.  Management currently believes that theinvested costs would be fully recoverable in the event of this contract beingterminated.

 

At December 31, 2002, accounts receivable include costs totalingapproximately $1.4 million for direct costs incurred by the Company since theissuance of the Stop-Work Order in June 1999 for incremental payroll and otheroperating costs related to the Moshannon Valley Correctional Center.  These costs were incurred at the directionof the BOP with the understanding that such costs would be reimbursed by theBOP.  Although no formal writtenagreement exists, management believes that these costs will be reimbursed bythe BOP in the near term.  In the eventany portion of these costs is determined not to be reimbursable, such costswill be expensed.

 

**Recent Developments**

 

In January 2003, the Company executed a lease for the Bernalillo CountyJail in Albuquerque, New Mexico.  Thefacility, which will be vacated by the County in favor of a new jail, will beremodeled by the Company and used to provide adult secure confinement for awide array of government agencies that have demonstrated a need for additionalbed space.  The facility would addapproximately 1,000 beds to the Company’s current service capacity.

 

In February 2003, the Company announced plans to operate the TexasAdolescent Center in San Antonio, Texas. This 121 bed residential juvenile facility is currently scheduled toopen in the third quarter of 2003.

 

In March 2003,the Company reached an agreement with the Commonwealth of Pennsylvania thatresolved all outstanding administrative issues relative to the contract awardedto the Company by the BOP to operate the Moshannon Valley CorrectionalCenter.  If the Company is able tonegotiate an amendment to the contract with the BOP, this agreement will allowthe Company to move forward with the construction and operation of thefacility, subject to re-approval of the project by the lenders under theCompany’s amended 2000 Credit Facility.

 

 

26

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**Recently IssuedAccounting Standards**

 

In June 2001, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standard (“SFAS”) No. 143, “Accounting forAsset Retirement Obligations” (“SFAS No. 143”) which requires entities torecognize the fair value of a liability for legal obligations associated withthe retirement of tangible long-lived assets in the period incurred, if areasonable estimate of the fair value can be made. The Company adopted theprovisions related to SFAS No. 143 in January 2003.  Management believes there will be no material effect on theCompany’s financial position, results of operations or stockholders’ equity asa result of the adoption of this new pronouncement.

 

In April 2002, the FASB issued SFAS No. 145, “Rescission of SFAS Nos.4, 44, 64, Amendment of FASB Statement No. 13, and Technical Corrections”,effective for fiscal years beginning after May 15, 2002 (“SFAS No. 145”).  SFAS No. 145 rescinds SFAS Nos. 4, 44, 64and amends SFAS No. 13, “Accounting for Leases,” to eliminate an inconsistencybetween the required accounting for sale and leaseback transactions and therequired accounting for certain lease modifications that have economic effectsthat are similar to sale and leaseback transactions.  Additionally, SFAS No. 145 requires gains and losses on theextinguishment of debt to be classified as income or loss from continuingoperations rather than as extraordinary items as previously required under SFASNo. 4.  The Company adopted SFAS No. 145as required on January 1, 2003.  TheCompany recorded an extraordinary charge of approximately $0.5 million, net ofincome tax of $0.3 million, in the third quarter of 2001 for the earlyretirement of debt.  Additionally, inthe fourth quarter of 2001, the Company recognized an extraordinary charge ofapproximately $2.9 million, net of income taxes of $2.0 million, for thewrite-off of the related unamortized deferred debt issuance costs, debtdiscount and assessed contractual prepayment fees as a result of the earlyretirement of the Company’s subordinated notes.  In accordance with the provisions of SFAS No. 145, the abovecharges were reclassified to expenses from continuing operations before incometaxes in January 2003.

 

In July 2002, the FASB issued SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities” (“SFAS No. 146”), which addressesthe financial accounting and reporting associated with exit or disposalactivities initiated after December 31, 2002. Under SFAS No. 146, costs associated with an exit or disposal activityshould be recognized and measured at the fair value in the period in which theliability is incurred rather than at the date of a commitment to an exit ordisposal plan.  The Company is requiredto adopt SFAS No. 146 for all exit and disposal activities initiated afterDecember 31, 2002.  Management believesthere will be no material effect on the Company’s financial position, resultsof operations or stockholders’ equity as result of the adoption of this newpronouncement.

 

On December 31, 2002, the FASB issued SFAS No. 148, “Accounting forStock-Based Compensation — Transition and Disclosure” (“SFAS No. 148”) whichamends SFAS No. 123, “Accounting for Stock-Based Compensation.”  SFAS No. 148 provides two additionalalternative transition methods for recognizing an entity’s voluntary decisionto change its method of accounting for stock-based employee compensation to thefair-value method.  In addition, SFASNo. 148 amends the disclosure requirements of SFAS No. 123 so that entitieswill have to (1) make more-prominent disclosures regarding the pro forma effectsof using the fair-value method of accounting for stock-based compensation, (2)present those disclosures in a more accessible format in the footnotes to theannual financial statements and (3) include those disclosures in interimfinancial statements.  SFAS No. 148’stransition guidance and provisions for annual disclosures are effective forfiscal years ending after December 15, 2002 and the related disclosures arecontained in Note 10 to the Consolidated Financial Statements.  The provisions for interim perioddisclosures are effective for financial reports that contain financialstatements for interim periods beginning after December 15, 2002.  The Company adopted the annual disclosureprovisions of SFAS No. 148 in this report on Form 10-K.

 

In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”),“Guarantor’s Accounting and 

 

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Disclosure Requirements for Guarantees, Including Indirect Guaranteesof Indebtedness of Others.”  FIN 45requires a guarantor to include disclosure of certain obligations, and ifapplicable, at the inception of the guarantee, recognize a liability for thefair value of other certain obligations undertaken in issuing a guarantee.  The provisions related to the disclosurerequirements are effective for financial statement periods ending afterDecember 15, 2002.  The provisionsrelated to recognition and measurement of guarantees are effective forfinancial statement periods beginning after December 31, 2002 on a prospectivebasis.  The Company adopted thedisclosure provisions of FIN 45 in this report on Form 10-K.  The Company adopted the provisions relatedto the recognition and measurement of guarantees as of January 1, 2003.  Management believes such provisions will nothave a significant impact on the Company’s results of operations, financialposition or cash flows.  See Note 8 tothe Consolidated Financial Statements.

 

In January 2003, the FASB issued Interpretation No. 46, “Consolidationof Variable Interest Entities” (“FIN 46”), which addresses the consolidation ofvariable interest entities as defined in the Interpretation.  FIN 46 requires an assessment of equityinvestments to determine if they are variable interest entities.  FIN 46 is effective immediately for allvariable interest entities created after January 31, 2003.  For variable interest entities createdbefore February 1, 2003, the provisions of FIN 46 must be applied no later thanthe beginning of the first interim period or annual reporting period beginningafter June 15, 2003.   In addition, ifit is reasonably possible that an enterprise will consolidate or discloseinformation about a variable interest entity, the enterprise must discuss thefollowing information in all financial statements issued after January 31,2003: (1) the nature, purpose, size or activities of the variable interestentity and (2) the enterprise’s maximum exposure to loss as a result of itsinvolvement with the variable interest entity. The Company’s adoption of FIN 46 does not change the Company’saccounting for the 2000 synthetic lease transaction and the 2001 Sale andLeaseback Transaction which are consolidated for reporting purposes.  It is reasonably possible that the Company mayenter into future arrangements for the development of new facilities or tooperate facilities which may become subject to the provisions of FIN 46 and, insome cases, may be required to consolidate the related activities, facilitiesand financings.

 

**Critical AccountingPolicies and Estimates**

 

The discussion and analysis of financial condition and results ofoperations are based upon the Company’s Consolidated Financial Statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States (“GAAP”). The preparation of these financial statements requires that theCompany’s management make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses and the related disclosureof contingent assets and liabilities. The Company evaluates its estimates on an on-going basis, based onhistorical experience and on various other assumptions that management believesto be reasonable under the circumstances. Actual results may differ from these estimates under differentassumptions or conditions.

 

The Company believes the following critical accounting policies affectits more significant adjustments and estimates used in the preparation of theaccompanying Consolidated Financial Statements.

 

*Consolidation*

 

The accompanying Consolidated Financial Statements include the accountsof the Company, its wholly-owned subsidiaries, and interests in partnershipsthat are special purpose entities or may be virtual special purpose entitiespursuant for which the Company owns no partnership interest, but for financialreporting purposes only, has consolidated such special purpose entities asdiscussed below.  All significantintercompany balances and transactions have been eliminated.  Minority interest in consolidated specialpurpose entities represents equity that other investors have contributed to thespecial purpose entities.  Minorityinterest is adjusted for income and losses allocable to the owners of thespecial purpose entities.

 

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As the cumulative losses of the special purpose entity exceed theequity which is recorded as minority interest by the Company, the excess lossesare recorded in the Company’s Consolidated Statements of Operations andComprehensive Income.

 

The Company’s lease financing arrangement under its 2000 CreditFacility is a “synthetic lease”.  Asynthetic lease is a form of lease financing that qualifies for operating leaseaccounting treatment and, when all criteria pursuant to generally acceptedaccounting principles in the United States (“GAAP”) are met, are accounted for,“off-balance sheet”.  Under such astructure, the owner/lessor of the properties (“Synthetic Lease Investor”) maybe considered a virtual special purpose entity when it obtains debt and equitycapital to finance the acquisition or construction of project(s) and leases theprojects to a company.  This financialstructure was used to finance the construction of the New Morgan Academycompleted in the first quarter of 2001, the acquisition of the Taylor StreetCenter building in early 1999, and the construction-to-date costs of theMoshannon Valley Correctional Center. The synthetic lease used by the Company to finance the above projectswas executed in December 1998 and was amended in July 2000 whereby theavailable financing was increased from $40.0 million to $100.0 million and thelease term extended to July 2005.

 

Under current accounting rules, the Synthetic Lease Investor in avirtual SPE must maintain at least a 3.0% equity ownership interest in theproperty throughout the life of the lease. The Company’s synthetic lease documents, as amended in July 2000,provide for the equity investor to fund 3.5% of project costs.  There are provisions in the lease andrelated credit documents for the lenders and Synthetic Lease Investor to fundand be paid interest, yield and fees. Under current GAAP rules, the payment of any yield and fees to theinvestors is required to be treated as a return of capital rather than a returnon capital.

 

The Synthetic Lease Investor for the above mentioned projects receivedpayments to act as co-arranger in the structure of the initial $40.0 millionsynthetic lease facility in 1998 and in July 2000 when the synthetic leasefacility was increased to $100.0 million. Although the Company does not believe the lessor of the Synthetic Leaseis a special purpose entity, the lessor is considered a virtual special purposeentity under certain accounting interpretations.  Therefore, the payments discussed above could be interpreted toreduce the Synthetic Lease Investor’s equity ownership in the above leasedprojects below the required 3.0% level as of the second quarter of 2000.  Pursuant to this interpretation, theCompany’s synthetic leases no longer qualified for off-balance sheet treatmentas of the beginning of the second quarter of 2000.  Accordingly, the assets and liabilities and the related resultsof operations of the synthetic lease owned by the Synthetic Lease Investor havebeen consolidated in the Company’s financial statements as of that time.

 

As a result of consolidating the synthetic lease assets andliabilities, the Company’s accompanying Consolidated Financial Statementsreflect, among other things, the depreciation expense on the associatedproperties and interest expense related to the Synthetic Lease Investor’s debtinstead of rent expense.  For income taxpurposes, the Company recognizes rent expense pursuant to the terms of itslease with the Synthetic Lease Investor and does not consolidate the assets,liabilities or the results of operations of the Synthetic Lease Investor.

 

On August 14, 2001, the Company completed an arms’ length sale andleaseback transaction involving 11 of its real estate facilities (the “2001Sale and Leaseback Transaction”).  TheCompany sold the facilities to an unaffiliated company, Municipal CorrectionsFinance, L.P. (“MCF”), and is leasing them back for an initial period of 20years, with approximately 25 years of additional renewal period options.  The Company received $173.0 million ofproceeds from the sale of these facilities. The proceeds were used to repay $120.0 million of the Company’slong-term debt and the remainder was invested in short-term securities, $43.1million of this amount being invested in securities to be held as collateralfor the Company’s Credit Facility.  SeeNote 8 to the Consolidated Financial Statements.

 

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MCF is an unaffiliated special purpose entity (“SPE”).  Under current accounting rules, an SPE’sequity investor must maintain at least a 3.0% equity ownership interest in theproperty throughout the life of the lease. In September 2001, the Company entered into a retainer agreement with anaffiliate of the equity investor in MCF (“MCF Equity Investor”), and inNovember 2001, paid the MCF Equity Investor a retainer fee of $3.65 million forfinancial advisory services related to potential future financing projects andthe strategic development of the Company’s business.  Under certain accounting interpretations, this retainer has beendeemed to reduce the equity investment in MCF to below the required 3.0%level.  As a result, the Company hasconsolidated the assets, liabilities, and the results of operations of MCF inthe Company’s accompanying Consolidated Financial Statements as of August 14,2001.  As a result of consolidating theassets and liabilities of MCF, the Company’s Consolidated Financial Statementsreflect, among other things, the depreciation expense on the associatedproperties and interest expense on the bond debt of MCF used to finance MCF’sacquisition of the 11 facilities in the 2001 Sale and Leaseback Transaction,instead of rent expense.  For income taxpurposes, the Company recognizes rent expense pursuant to the terms of itslease with MCF and does not consolidate the assets, liabilities or the resultsof operations of MCF.

 

The cumulative losses of MCF exceeded the recorded minority interest ofMCF during the first quarter of 2002. The cumulative losses of the Synthetic Lease Investor exceeded therecorded minority interest of the Synthetic Lease Investor during the thirdquarter of 2001.  Since the cumulativelosses of MCF and the Synthetic Lease Investor exceed the equity that was recordedas minority interest by the Company, the excess losses can no longer beallocated to the minority interest in the Company’s Consolidated Statements ofOperations in 2002.  In the year endedDecember 31, 2002, the Company recorded minority interest expense ofapproximately $0.6 million as a result of a distribution made by MCF to itsequity investors.

 

*Revenue Recognition*

 

The Company recognizes revenue in accordance with SEC Staff AccountingBulletin No. 101, “Revenue Recognition in Financial Statements,” asamended.  Substantially all of theCompany’s revenues are derived from contracts with federal, state and localgovernment agencies which pay either per diem rates based upon the number ofoccupant days or hours served for the period, on a take-or-pay basis orcost-plus reimbursement.  Revenues arerecognized as services are provided under the Company’s established contractualagreements.

 

*Accounts Receivable and Related Allowance for Bad Debts*

 

The Company extends credit to the government agencies contracted withand other parties in the normal course of business.  The Company regularly reviews its outstanding receivables andhistorical collection experience, and provides for estimated losses through anallowance for doubtful accounts.  Inevaluating the adequacy of established allowances for bad debts, the Companymakes judgments regarding its customers’ ability to make required payments,economic events and other factors.  Asthe financial condition of these parties change, circumstances develop oradditional information becomes available, necessary adjustments to theallowance for doubtful accounts are made.

 

*Insurance Reserves*

 

The Company maintains insurance coverage for various aspects of itsbusiness and operations.  The Companyretains a portion of losses that occur through the use of deductibles andretention under self-insurance programs. The Company regularly reviews the estimates of reported and unreportedclaims and provides for these losses through insurance reserves.  As claims develop and additional informationbecomes available to management, adjustments are made to the related lossreserves.

 

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*Impairment or Disposal of Long-Lived Assets*

 

The Company reviews its long-lived assets for impairment annually orwhen changes in circumstances indicate that the carrying amount of the assetmay not be recoverable, in accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” SFAS No. 144 requires that long-lived assets to be held and used be reportedat the lower of their carrying amount or fair value.  Assets to be disposed of and assets not expected to provide anyfuture service potential to the Company are recorded at the lower of theircarrying amount or fair value less estimated cost to sell.

 

*Income Taxes*

 

The Company utilizes the liability method of accounting for incometaxes as required by SFAS No. 109, “Accounting for Income Taxes.”  Under this method, deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying values of existing assetsand liabilities and their respective tax bases based on enacted tax rates.  In providing for deferred taxes, managementconsiders current tax regulations, estimates of future taxable income andavailable tax planning strategies.  Iftax regulations, operating results or the ability to implement tax planningstrategies vary, adjustments to the carrying value of deferred tax assets andliabilities may be required.

 

*Accounting for Stock-Based Compensation*

 

The Company accounts for its stock-based compensation plans inaccordance with Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (“APB No. 25”). In accordance with the provisions of APB No. 25, stock-based employeecompensation cost is not reflected in net income, as all options granted underthose plans had an exercise price equal to or in excess of the market value ofthe underlying common stock on the date of grant.

 

*Goodwill*

 

The Company accounts for its Goodwill in accordance with SFAS No. 142,“Goodwill and Other Intangible Assets” which states that there will be noamortization of goodwill or intangible assets with indefinite lives.  Impairment of these assets is assessed at leastannually to determine if the estimated fair value of the reporting unit exceedsthe net carrying value of the reporting unit, including the applicablegoodwill.  The estimates of fair marketvalue are based upon management’s estimates of the present value of future cashflows.  The Company’s management makesassumptions regarding the estimated cash flows.  Management makes assumptions regarding the estimated cash flowsand if these estimates or their related assumptions change, an impairmentcharge may be incurred.

 

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**Results of Operations**

 

Material fluctuations in the Company’s results of operations areprincipally the result of the level of new contract development activityconducted by the Company, the timing and effect of facility expansions,occupancy rates at Company-operated facilities, contract terminations andfacility closures and extraordinary and non-recurring charges.

 

The following table sets forth for the periods indicated thepercentages of revenue represented by certain items in the Company’sConsolidated Statements of Operations and Comprehensive Income:

 
|                                                                                                                       |   | **Year Ended  December 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                                                       |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                                                                                                       |   |                         |   |   |   |   |   |
| Revenues                                                                                                                   |   | 100.0                        | %      | 100.0 | % | 100.0 | % |
| Operating expenses, excluding depreciation                                                                                 |   | 77.2                         |   | 77.6 |   | 77.2 |   |
| Pre-opening and start-up expenses                                                                                          |   | —                       |   | 1.4 |   | 1.0 |   |
| Depreciation and amortization                                                                                              |   | 3.6                          |   | 3.5 |   | 3.3 |   |
| General and administrative expenses                                                                                        |   | 7.8                          |   | 5.8 |   | 5.3 |   |
| Income from operations                                                                                                     |   | 11.4                         |   | 11.7 |   | 13.2 |   |
| Interest expense, net                                                                                                      |   | 6.8                          |   | 7.9 |   | 7.3 |   |
| Minority interest in consolidated special  purpose entities                                                                |   | 0.2                          |   | (0.6 | ) | (0.1 | ) |
| Income before provision for income taxes,  extraordinary charge and cumulative effect of changes in accounting  principles |   | 4.4                          |   | 4.4 |   | 6.0 |   |
| Provision for income taxes                                                                                                 |   | 1.8                          |   | 1.8 |   | 2.5 |   |
| Income before extraordinary charge and  cumulative effect of changes in accounting principles                              |   | 2.6                          | %      | 2.6 | % | 3.5 | % |

 

*Year Ended December31, 2002 Compared to Year Ended December 31, 2001*

 

*Revenues*. Revenues increased 3.7% to $275.1 million for the year ended December31, 2002 from $265.3 million for the year ended December 31, 2001.

 

Adult secure institutional division revenues decreased 0.2% to $99.5million for the year ended December 31, 2002 from $99.8 million for the year endedDecember 31, 2001.  Revenues decreasedapproximately $5.1 million as a result of the Company’s termination of theSanta Fe County Adult Detention Center contract in September 2001 due to theunder performance and operating losses experienced at the facility.  Additionally, revenues decreasedapproximately $1.3 million due to reduced occupancy at the Baker CommunityCorrectional Facility and the Leo Chesney Community Correctional Facilityduring the second and third quarters of 2002 as the Company’s contracts withthe California Department of Corrections (“CDC”) for the operation of thesefacilities were set to expire June 30, 2002 and were not expected to be renewedby the CDC due to the lack of governmental budget appropriations.  The final California state budget wasapproved in late September 2002 and included the appropriations for both ofthese facilities.  As of December 31,2002, the Company had executed contracts for both facilities and occupancy wasat contracted levels.  The decrease inrevenue due to the facilities mentioned above was offset, in part, by per diemrate increases realized in June 2001 and March 2002 at the Big Spring Complexand improved occupancy at certain other adult secure institution facilities.  There were no revenues attributable tostart-up operations for the years ended December 31, 2002 and 2001.  Average occupancy was 97.6% for the yearended December 31, 2002 compared to 97.0% for the year ended December 31, 2001.

 

Juvenile division revenues increased 7.5% to $125.0 million for theyear ended December 31, 2002 from $116.3 million for the year ended December31, 2001.  Revenues increased byapproximately $6.5 million  due to thecommencement of a management contract at the Alexander Youth Center and theopening of the 

 

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William Penn Harrisburg Alternative School in the third quarter of2001.  Additionally, revenues increasedat certain residential facilities and non-residential programs due to improvedoccupancy and increased service hours. Such facilities and programs included the Cornell Abraxas Center forAdolescent Females (“ACAF”), the Erie Residential Behavioral Health Program andthe Griffin Juvenile Facility.  Revenuesdecreased by approximately $5.1 million due to the closure of the New MorganAcademy early in the fourth quarter of 2002. On September 27, 2002, the Company announced that it would be closingthis facility.  The Company is currentlyevaluating several alternatives for the reutilization of the facility for adifferent type of program as well as the possibility of selling thefacility.  Revenues attributable to theNew Morgan Academy were approximately $13.3 million and $18.3 million for theyears ended December 31, 2002 and 2001, respectively.  There were no revenues attributable to start-up operations forthe year ended December 31, 2002. Revenues attributable to start-up operations for the year ended December31, 2001 were approximately $2.8 million and were attributable to the start-upoperations of the New Morgan Academy. This start-up revenue is included in the revenue of approximately $18.3million for the year ended December 31, 2001 as discussed above.  Average occupancy, excluding start-upoperations in 2001, was 89.8% for the year ended December 31, 2002 compared to91.2% for the year ended December 31, 2001.

 

Pre-release division revenues increased 2.9% to $50.6 million for theyear ended December 31, 2002 from $49.2 million for the year ended December 31,2001 due primarily to increased average occupancy at various facilities offset,in part, by a decrease in revenues as a result the Company’s termination of theDurham Treatment Center contract effective June 30, 2001.  Revenues for the Durham Treatment Centerwere approximately $700,000 for the year ended December 31, 2001.  There were no revenues attributable tostart-up operations for the years ended December 31, 2002 and 2001.  Average occupancy was 110.2% for the yearended December 31, 2002 compared to 98.6% for the year ended December 31,2001.  The Company experienced occupancyin excess of 100.0% due to occupancy at certain pre-release facilitiesexceeding contracted capacity.  TheCompany currently cannot predict whether this level of occupancy will continuein future periods.

 

*Operating Expenses.*  Operating expenses increased 3.2% to $212.3 million for the yearended December 31, 2002 from $205.8 million for the year ended December 31,2001.

 

Adult secure institutional division operating expenses decreased 7.0%to $69.4 million for the year ended December 31, 2002 from $74.6 million forthe year ended December 31, 2001 due primarily to the Company’s termination ofthe Santa Fe County Adult Detention Center contract effective September 30,2001.  Additionally, operating expensesdecreased at the Baker Community Correctional Facility and the Leo ChesneyCommunity Correctional Facility due to reduced occupancy during 2002 aspreviously discussed.  The decrease dueto the above facilities was offset, in part, by an increase in operating expensesat the Big Spring Complex due to a facility expansion completed in the firstquarter of 2001.  As a percentage ofrevenues, adult secure institutional division operating expenses were 69.7% forthe year ended December 31, 2002 compared to 74.8% for the year ended December31, 2001.  The 2002 operating margin wasimpacted favorably due to the termination of the lower margin Santa Fe CountyDetention Center contract, the expansion of the Big Spring Complex, per diemincreases at various facilities, unusually high utility costs during the firstquarter of 2001 as a result of increased natural gas prices and an increase ininmate medical expenses at certain facilities.

 

Juvenile division operating expenses increased 11.8% to $105.0 millionfor the year ended December 31, 2002 from $93.8 million for the year endedDecember 31, 2001 due primarily to (1) the commencement of a managementcontract at the Alexander Youth Center and the opening of the William PennHarrisburg Alternative School in the third quarter of 2001, (2) increasedoccupancy at ACAF due to a facility expansion completed early in 2001 and (3)increased average occupancy at various facilities.  Additionally, operating expenses increased at the New MorganAcademy in 2002 as a portion of 2001 operating expenses were classified aspre-opening and start-up expenses. Including 2001 pre-opening and start-up expenses, operating expenses forthe New Morgan Academy decreased in 2002 as compared to the prior year due toreduced occupancy.  As previouslydiscussed, the Company closed the New Morgan Academy early in the fourthquarter of 2002.  As a percentage ofrevenues, excluding start-up operations in 2001, juvenile division operatingexpenses were 84.0% for the year ended December 31, 2002 compared to 82.7% forthe year ended December 31, 2001.  Thedecline in the 2002 operating margin was primarily a result of the decline in 

 

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occupancy and the closing of the New Morgan Academy.  This decline was offset, in part, byimproved margins at the Alexander Youth Center in 2002 as occupancy reachedcontract capacity.

 

Pre-release division operating expenses increased 0.5% to $37.6 millionfor the year ended December 31, 2002 from $37.4 million for the year endedDecember 31, 2001 due primarily to fluctuations in average occupancy at variousfacilities offset, in part, by a decrease in operating expenses as a result ofthe termination of the Durham Treatment Center contract effective June 30,2001.  As a percentage of revenue,pre-release division operating expenses were 74.3% for the year ended December31, 2002 compared to 76.1% for the year ended December 31, 2001.  The 2002 operating margin was impactedfavorably due to the expiration of the San Diego Center contract early in 2001and the Durham Treatment Center contract in June 2001 and increased occupancyat various facilities.  The improvementin the 2002 operating margin was offset, in part, by an increase of approximately13.0% in employee insurance costs in the year ended December 31, 2002 ascompared to the prior year.

 

*Pre-Opening and Start-up Expenses.*  There were no pre-opening and start-upexpenses for the year ended December 31, 2002. Pre-opening and start-up expenses were $3.9 million for the year endedDecember 31, 2001 and were attributable to the start-up activities of the NewMorgan Academy and an expansion of ACAF.

 

*Depreciation and Amortization*.  Depreciation and amortization wasapproximately $9.8 million for the year ended December 31, 2002 compared to$9.3 million for the year ended December 31, 2001.  Amortization expense for intangibles decreased approximately$646,000 in the year ended December 31, 2002 from prior year due to theCompany’s adoption of SFAS No. 142, “Goodwill and Other Intangible Assets,”which eliminated the amortization of goodwill effective January 1, 2002.  Depreciation and amortization of propertyand equipment increased approximately $1.2 million in the year ended December 31,2002 from prior year due primarily to property and equipment purchases made in2002.

 

*General and Administrative Expenses.*  General and administrative expensesincreased 40.5% to $21.5 million for the year ended December 31, 2002 from$15.3 million for the year ended December 31, 2001.  General and administrative expenses for the year ended December31, 2002 included (1) a charge of approximately $1.9 million for legal andprofessional fees related to the Special Committee review and the subsequentrestatement of the Company’s financial statements and for defense of theCompany’s related stockholder litigation, (2) a charge of approximately $1.0million for the write-off of deferred project financing costs associated withthe BOP Southeast Project and (3) a charge of approximately $1.5 million forthe settlement of a management contract with the Company’s former president whoresigned his position in September 2002. General and administrative expenses for the year ended December 31, 2001included (1) a charge of approximately $668,000 for the write-off of deferredacquisition costs associated with the Fort Greeley, Alaska project and (2) acharge of approximately $200,000 for legal costs associated with the classaction lawsuits filed as a result of the Company’s restatement of its prioryear financial statements.  Excludingthese charges, general and administrative expenses increased 18.7% from prioryear due principally to increased personnel and compensation,  business development and certain publicaffairs costs.

 

*Interest.* Interest expense, net of interest income, decreased to $18.7 million forthe year ended December 31, 2002 from $20.9 million for the year ended December31, 2001.  The Company capitalizedinterest of approximately $823,000 for the year ended December 31, 2002 relatedto the construction of the Moshannon Valley Correctional Center.  For the year ended December 31, 2001, theCompany capitalized interest of approximately $1.3 million related primarily tothe construction of the Moshannon Valley Correctional Center.  The decrease in capitalized interest in 2002was due to decreased interest rates on the Company’s Synthetic Lease InvestorNotes discussed in more detail under “Management's Discussion and Analysis ofFinancial Condition and Results of Operations - Liquidity and Capital Resources- 2001 Sale and Leaseback Transaction”. For the year ended December 31, 2002, interest expense includesapproximately 

 

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$825,000 for lenders’ fees and related professional fees incurred toobtain certain waivers and amendments to the Company’s credit agreementobtained in conjunction with the restatement of its financial statements.  For the year ended December 31, 2001,interest expense included a charge of approximately $818,000 for the write-offof a portion of unamortized deferred debt issuance costs related to theCompany’s amended 2000 Credit Facility (defined under “Management's Discussionand Analysis of Financial Condition and Results of Operations - Liquidity andCapital Resources - Long-Term Credit Facilities”) as a result of the repaymentof all outstanding borrowings and the associated reduction in the creditcommitment.  The Company also recognizedless interest expense in the year ended December 31, 2002 due to repayment ofthe Company’s debt under its revolving line of credit and its subordinatednotes from the proceeds from a Common Stock offering in 2001 and the 2001 Saleand Leaseback Transaction. Additionally, the Company recognized less interest expense in 2002 dueto decreased interest rates on the Company’s Synthetic Lease Investor Notes.

 

*Minority Interest in Consolidated Special Purpose Entities*.  The cumulative losses of MCF exceeded therecorded minority interest of MCF during the first quarter of 2002.  The cumulative losses of the Synthetic LeaseInvestor (discussed in more detail under “Management's Discussion and Analysisof Financial Condition and Results of Operations - Liquidity and CapitalResources - Long-Term Credit Facilities”) exceeded the recorded minorityinterest of the Synthetic Lease Investor during the third quarter of 2001.  Since the cumulative losses of MCF and theSynthetic Lease Investor exceed the equity that was recorded as minorityinterest by the Company, the excess losses can no longer be allocated to theminority interest in the Company’s Consolidated Statements of Operations andComprehensive Income in 2002.  For theyear ended December 31, 2002, the Company recorded a charge of approximately$0.6 million as a result of a distribution made by MCF to its equity investors.

 

*Income Taxes.* For the year ended December 31, 2002, the Company recognized a provisionfor income taxes at an estimated effective rate of 40.3%.   For the year ended December 31, 2001, theCompany recognized a provision for income taxes at an estimated effective rateof 41.0%.  The decrease in the effectivetax rate is due primarily to a lower estimated effective state tax rate.

 

*Cumulative Effect of Changes in Accounting Principles.*  The Company recorded a cumulative effect ofa change in accounting principle charge of approximately $965,000, net of tax,for the year ended December 31, 2002 related to the impairment of goodwill inaccordance with the provisions of SFAS No. 142 related to an acquisition madein November 1999.

 

*Year Ended December31, 2001 Compared to Year Ended December 31, 2000*

 

*Revenues*. Revenues increased 17.3% to $265.3 million for the year ended December31, 2001 from $226.1 million for the year ended December 31, 2000.

 

Adult secure institutional division revenues increased 9.5% to $99.8million for the year ended December 31, 2001 from $91.2 million for the yearended December 31, 2000 due principally to (1) the final 550 bed expansion atthe D. Ray James Prison which began housing inmates late in the first quarterof 2000 and reached a full occupancy level late in the second quarter of 2000,(2) per diem rate increases realized in 2001, (3) the commencement of amanagement contract at the Valencia County Detention Center in the fourthquarter of 2000 and (4) increased occupancy at the Great Plains CorrectionalFacility as compared to the year ended December 31, 2000.  The increase in revenue was offset, in part,by a reduction in occupancy at the Santa Fe County Detention Center.  The Company’s contract to manage the SantaFe County Detention Center expired effective September 30, 2001.  Revenues for the Santa Fe County DetentionCenter were $5.1 million for the nine months ended September 30, 2001.  There were no revenues attributable tostart-up 

 

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operations for the year ended December 31, 2001.  Additionally, during the fourth quarter of2000, the Company entered into a license agreement with its constructioncontractor that conveyed certain rights to the design of an adult secureinstitution.  A non-recurring licenseagreement payment of $950,000 was recognized as revenue by the Company.  The Company has not licensed such designs inprior years and does not expect to generate significant revenues from suchactivity in future periods.  Revenuesattributable to start-up operations for the year ended December 31, 2000 were$44,000 and related to the expansion of the D. Ray James Prison.  Average occupancy, excluding start-upoperations in 2000, was 97.0% for the year ended December 31, 2001 compared to97.6% for the year ended December 31, 2000.

 

Juvenile division revenues increased 35.1% to $116.3 million for theyear ended December 31, 2001 from $86.0 million for the year ended December 31,2000 principally due to (1) the opening of the New Morgan Academy in the fourthquarter of 2000, (2) the commencement of a management contract at the AlexanderYouth Center in the third quarter of 2001, (3) the opening of the William PennHarrisburg Alternative School in the third quarter of 2001, (4) increasedoccupancy at ACAF due to a facility expansion completed early in 2001, (5)increased occupancy at various facilities including the Griffin Juvenilefacility and (6) the commencement of a management contract at the SchaffnerYouth Center.  Revenues attributable tostart-up operations were $2.8 million for the year ended December 31, 2001 andrelated to the operations of the New Morgan Academy and an expansion of ACAF.  Revenues attributable to start-up operationswere $1.2 million for the year ended December 31, 2000 and related to theoperations of the New Morgan Academy. Average occupancy, excluding start-up operations, was 91.2% for the yearended December 31, 2001 compared to 91.3% for the year ended December 31, 2000.

 

Pre-release division revenues increased to $49.2 million for the yearended December 31, 2001 from $48.9 million for the year ended December 31, 2000due to increased average occupancy at various facilities offset by a reductionin revenue due to the terminations of the San Diego Center and Durham TreatmentCenter contracts as of January 31, 2001 and June 30, 2001, respectively.  Average occupancy was 98.6% for the yearended December 31, 2001 compared to 94.2% for the year ended December 31, 2000.

 

*Operating Expenses.*  Operating expenses increased 17.9% to $205.8 million for the yearended December 31, 2001 from $174.6 million for the year ended December 31,2000.

 

Adult secure institutional division operating expenses increased 9.4%to $74.6 million for the year ended December 31, 2001 from $68.2 million forthe year ended December 31, 2000 due principally to (1) the final 550 bedexpansion of the D. Ray James Prison, which began housing inmates late in thefirst quarter of 2000 and reached a full occupancy level late in the secondquarter of 2000, (2) increased personnel costs due to contractual wage increases at the Big SpringComplex associated with receiving an increase in  per diem revenue, (3) the commencement of a management contractat the Valencia County Detention Center in the fourth quarter of 2000 and (4)increased operating expenses at the Great Plains Correctional Facility due toincreased occupancy as compared to the year ended December 31, 2000.  The increase in operating expenses wasoffset, in part, by a reduction in occupancy at the Santa Fe County DetentionCenter.  The Company’s contract tomanage the Santa Fe County Detention Center expired effective September 30,2001.  For the year ended December 31,2000, secure division operating expenses included a provision for bad debts ofapproximately $1.2 million related to the Santa Fe County DetentionCenter.  As a percentage of adult secureinstitutional division revenues, excluding start-up operations and the $950,000license agreement revenue in 2000, adult secure institutional divisionoperating expenses were 74.8% for the year ended December 31, 2001 compared to75.0% for the year ended December 31, 2000.

 

Juvenile division operating expenses increased 27.8% to $93.8 millionfor the year ended December 31, 2001 from $73.4 million for the year endedDecember 31, 2000.  The increase inoperating expenses was due to (1) the opening of the New Morgan Academy in thefourth quarter of 2000, (2) the commencement of a 

 

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management contract at the Alexander Youth Center in the third quarterof 2001, (3) the opening of the William Penn Harrisburg Alternative School inthe third quarter of 2001, (4) increased operating expenses at ACAF due to afacility expansion, (5) the commencement of a management contract at theSchaffner Youth Center and (6) increased occupancy at various facilitiesincluding the Griffin Juvenile Facility. As a percentage of juvenile division revenues, excluding start-upoperations, juvenile division operating expenses were 82.7% for the year endedDecember 31, 2001 compared to 84.4% for the year ended December 31, 2000.  The improvement in the 2001 operating marginwas due principally to the operations of the Alexander Youth Center.

 

Pre-release division operating expenses increased 4.5% to $37.4 millionfor the year ended December 31, 2001 from $35.8 million for the year endedDecember 31, 2000 due principally to increased average occupancy at variousfacilities offset, in part, by a reduction to operating expenses due to thetermination of the San Diego Center and Durham Treatment Center contracts as ofJanuary 31, 2001 and June 30, 2001, respectively.  As a percentage of pre-release division revenues pre-release divisionoperating expenses were 76.1% for the year ended December 31, 2001 compared to73.1% for the year ended December 31, 2000. The decline in the 2001 operating margin was due principally toincreased personnel and employee retention costs and utility costs due to thetermination of the San Diego Center and Durham Treatment Center contracts as ofJanuary 31, 2001 and June 30, 2001, respectively.

 

*Pre-opening and Start-up Expenses.*  Pre-opening and start-up expenses were $3.9million for the year ended December 31, 2001 and were attributable to thepre-opening and start-up activities of the New Morgan Academy, which opened inthe fourth quarter of 2000, and an expansion of ACAF.  Pre-opening and start-up expenses were $2.3 million for the yearended December 31, 2000 and were attributable to the pre-opening and start-upactivities of the New Morgan Academy, the final 550 bed expansion at the D. RayJames Prison in the first quarter of 2000 and the Moshannon Valley CorrectionalCenter.  Revenues associated withstart-up operations were $2.8 million and $1.3 million for the years endedDecember 31, 2001 and 2000, respectively.

 

*Depreciation and Amortization*.  Depreciation and amortization increased24.3% to $9.3 million for the year ended December 31, 2001 from $7.5 millionfor the year ended December 31, 2000. The increase was due to (1) depreciation related to the New MorganAcademy which began operations in the fourth quarter of 2000, (2) thecompletion of a 150 bed expansion at the Big Spring Complex in the firstquarter of 2001, (3) the purchase and renovation of a building for theexpansion of ACAF, (4) depreciation of furniture and equipment purchased forthe New Morgan Academy, (5) the write-off of leasehold improvements at theDurham Treatment Center due to its contract termination and (6) variousfacility improvements and furniture and equipment purchases.

 

*General and Administrative Expenses.*  General and administrative expensesincreased 27.2% to $15.3 million for the year ended December 31, 2001 from$12.0 million for the year ended December 31, 2000.  Included in general and administrative expenses for the yearended December 31, 2001 were non-recurring charges of $668,000 related to thewrite-off of deferred acquisition costs associated with the Fort Greeley,Alaska project and a $200,000 charge for legal costs related to the classaction lawsuits.  The remaining increasein general and administrative expenses resulted primarily from retention andincentive bonus costs, costs for additional personnel providing public affairsand business development services, certain consulting and legal costs and otheradministrative infrastructure costs. Excluding the $668,000 and $200,000 charges in the 2001 period, generaland administrative expenses were 5.4% and 5.3% of revenues for the year endedDecember 31, 2001 and 2000, respectively.

 

*Interest.* Interest expense, net of interest income, increased to $20.9 million forthe year ended December 31, 2001 from $16.4 million for the year ended December31, 2000.  In August 2001, MCF issued$197.4 

 

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million of 8.47% bonds due in August 2016 in connection with the 2001Sale and Leaseback Transaction. Proceeds from the 2001 Sale and Leaseback Transaction were used by theCompany, in part, to repay $70.0 million outstanding under the Company’srevolving line of credit and $50.0 million of outstanding 7.74% Senior SecuredNotes.  Additionally, in December 2001,the Company repaid $39.4 million of 12.875% notes under its Note and EquityPurchase Agreement (“Subordinated Notes”) with proceeds from an offering andsale of its common stock.  For the yearended December 31, 2001, interest expense increased due to (1) the increased borrowingsof MCF, (2) increased borrowings under the Company’s synthetic lease to financethe construction of the New Morgan Academy which began operations in the fourthquarter of 2000, and (3) a non-recurring charge of $818,000 to write-off aportion of unamortized deferred debt issuance costs related to the Company’s2000 Credit Facility as a result of the repayment of all outstanding borrowingsand an associated reduction in the credit commitment.  For the year ended December 31, 2001 the Company capitalizedinterest of $1.3 million related to the construction of the Moshannon ValleyCorrectional Center.  Capitalizedinterest for the year ended December 31, 2000 was $2.0 million and related tothe construction of the New Morgan Academy and the Moshannon ValleyCorrectional Center.

 

*Minority Interest in Consolidated Special Purpose Entities*.  Minority interest in consolidated specialpurpose entities represents third party equity contributed to the specialpurpose entities consolidated by the Company for financial reporting purposes.  Minority interest is adjusted for income andlosses of the special purpose entities. When the cumulative losses of MCF exceed the equity that is recorded asminority interest by the Company, the excess losses will be recorded in theCompany’s Consolidated Statement of Operations.  Notwithstanding any additional third party equity contributions,management estimates that the cumulative losses of MCF will exceed the recordedminority interest of MCF during the first quarter of 2002.  The cumulative losses of the Synthetic LeaseInvestor exceeded the recorded minority interest of the Synthetic LeaseInvestor during the third quarter of 2001.

 

*Income Taxes.* For the years ended December 31, 2001 and 2000, the Company recognized aprovision for income taxes at an estimated effective rate of 42.0% and 41.0%,respectively.  The increase in theeffective rate was due to increased taxable income in certain states havinghigher rates.

 

*Extraordinary Charge*.  For the year ended December 31, 2001, theCompany recognized an extraordinary charge of approximately $2.9 million, netof income taxes of $2.0 million, due to the write-off of unamortized deferreddebt issuance costs, debt discount and assessed contractual prepayment feesrelated to the early retirement of the Company’s subordinated notes during thefourth quarter of 2001.

 

*Changes in Accounting Principle*.  For the year ended December 31, 2001, theCompany recognized a cumulative effect of a change in accounting principlebenefit of approximately $770,000, net of an income tax benefit ofapproximately $535,000, related to a change in the Company’s method ofaccounting for durable supplies, whereby such supplies are now capitalized as aprepaid asset and amortized to expense over the estimated period of use of 18months.

 

**Liquidity and CapitalResources**

 

*General*. The Company’s primary capital requirements are for (1) construction ofnew facilities, (2) expansions of existing facilities, (3) working capital, (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 purchases. Working capital requirements generally increase immediately prior to theCompany commencing management of a new facility as the Company incurs start-upcosts and purchases necessary equipment and supplies before facility managementrevenue is realized.

 

*Cash Flows From Operations.*  Cash flows provided by operating activitieswere $35.9 million for the 

 

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year ended December 31, 2002 compared to approximately $11.5 millionfor the year ended December 31, 2001. The principal reasons for the significant increase in cash provided byoperating activities between the periods are (1) the 2001 period had a largeruse of cash of approximately $9.4 million resulting from an increase inaccounts receivable due to the ramp-up of the New Morgan Academy’s revenues andother revenue increases in 2001, and (2) the 2002 period had an increase inaccounts payable and accrued liabilities for 2002, primarily due to the timingof payments.  Payments pertaining to arestricted debt payment account for MCF’s debt service are reported as afinancing activity on the consolidated statement of cash flows.

 

*Cash Flows From Investing Activities*.  Cash used in investing activities wasapproximately $10.1 for the year ended December 31, 2002 due primarily tocapital expenditures of approximately $11.1 million related to various facilityimprovements and/or expansions, information technology and software developmentcosts.  Cash used in investingactivities was approximately $37.9 million for the year ended December 31, 2001due in part to capital expenditures of approximately $14.2 million relatedprimarily to (1) a 150 bed expansion at the Big Spring Complex, (2)construction costs for the New Morgan Academy and the Moshannon ValleyCorrectional Center, (3) the purchase and renovation of a building and relatedfurniture and equipment purchases for an expansion of ACAF, (4) purchases offurniture and equipment for the New Morgan Academy and (5) various facilityimprovements and furniture and equipment purchases.  Additionally, the Company had purchases of marketable securitiesof $23.8 million related to the initial funding of the MCF debt service reservefund in the year ended December 31, 2001.

 

*Cash Flows From Financing Activities*.  Cash used in financing activities wasapproximately $26.4 million for the year ended December 31, 2002 due primarilyto the Company’s rent payments into the MCF restricted debt service fund ofapproximately $25.1 million. Additionally, the Company repurchased approximately $2.4 million oftreasury shares and recorded an equity contribution of  $0.6 million to the equity owners of aconsolidated special purpose entity.  The Company also had cash provided from financing activities of $1.1million related to borrowings on the Synthetic Lease Investor Notes for theMoshannon Valley Correctional Center.

 

*2001 Common Stock Offering.*  On November 30, 2001 the Company completedan offering of its common stock.  Netproceeds to the Company from the sale of the 3,450,000 newly issued shares wereapproximately $43.8 million.  TheCompany used a portion of the proceeds to repay outstanding borrowings of $39.4million and retired the notes under its Note and Equity Purchase Agreement (the“Subordinated Notes”) entered into in July 2000.

 

*2001 Sale and Leaseback Transaction.*  On August 14, 2001, the Company completedthe 2001 Sale and Leaseback Transaction. The Company sold the facilities to MCF, and is leasing them back for aninitial period of 20 years, with approximately 25 years of additional renewalperiod options.

 

MCF is an unaffiliated SPE. Under applicable accounting rules, the Synthetic Lease Investor mustmaintain at least a 3.0% equity ownership interest in the property throughoutthe life of the lease.  In September2001, the Company entered into a retainer agreement with MCF Equity Investor,and in November 2001, paid a retainer fee of $3.65 million for financialadvisory services related to potential future financing projects and thestrategic development of the Company’s business.  The retainer will be applied on a mutually agreed upon basistoward future contingent fees associated with investment banking services thatare expected to be provided to the Company. Under certain accounting interpretations, this retainer has been deemedto reduce the equity investment in MCF to below the required 3.0% level.  As a result, the Company has consolidated theassets, liabilities, and results of operations of MCF in the Company’saccompanying consolidated financial statements beginning August 14, 2001.  As a result of consolidating the assets andliabilities of MCF, the Company’s consolidated financial statements reflect,among other things, the depreciation expense on the associated properties andinterest expense on the bond debt of MCF used to finance MCF’s acquisition of 

 

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the 11 facilities in the 2001 Sale and Leaseback Transaction, insteadof rent expense.  For income taxpurposes, the Company recognizes rent expense pursuant to the terms of thelease with MCF and does not consolidate the assets, liabilities or results ofoperations of MCF.

 

On August 14, 2001, MCF issued $197.4 million of 8.47% bonds due August2016.  The Company used $120.0 millionof the $173.0 million of proceeds received by the Company from MCF from thesale of the 11 facilities to repay the Company’s $120.0 million long-term seniordebt and invested the remaining proceeds of approximately $43.1 million inshort-term securities.  The Company alsorepaid the $50.0 million of outstanding 7.74% Senior Secured Notes with aportion of the proceeds from the 2001 Sale and Leaseback Transaction.

 

The Company’s accompanying Consolidated Financial Statements includethe assets and liabilities and the results of operations of MCF as of August14, 2001 and thereafter.

 

*Long-Term Credit Facilities.* The Company’samended 2000 Credit Facility provides for borrowings of up to $45.0 millionunder a revolving line of credit.  Thecommitment amount is reduced by $1.6 million quarterly beginning July 2002 andby outstanding letters of credit. Accordingly, the available commitment amount under the amended 2000Credit Facility was $36.7 million as of December 31, 2002.  The Company had outstanding letters ofcredit of approximately $5.1 million at December 31, 2002.  The amended 2000 Credit Facility matures inJuly 2005 and bears interest, at the election of the Company, at either theprime rate plus a margin of 2.0%, or a rate which is 3.0% above the applicableLIBOR rate.  The amended 2000 CreditFacility is secured by substantially all of the Company’s assets, including thestock of all of the Company’s subsidiaries; does not permit the payment of cashdividends; and requires the Company to comply with certain leverage, net worthand debt service coverage covenants. The Company has obtained a waiver from the lenders under the amended2000 Credit Facility regarding the pending contractual default for theMoshannon Valley Correctional Center’s construction delay.  The waiver is effective through October 30,2004.  Included in the Company’s cashand cash equivalents at December 31, 2002 is approximately $39.4 million thatis invested in a separate account that is available to the Company forinvestment purposes or working capital with the approval of the lenders underthe amended 2000 Credit Facility.  Thisseparate account is maintained, in part, to assure future credit availability.

 

Additionally, the amended 2000 Credit Facility provides the Companywith the ability to enter into lease financing arrangements for the acquisitionor development of operating facilities. This lease financing arrangement provides for funding to the lessorunder the leases of up to $100.0 million, of which approximately $51.0 millionhad been utilized as of December 31, 2002. The Company expects to utilize the remaining capacity under this leasefinancing arrangement to complete construction of the Moshannon ValleyCorrectional Center.  The Company payscommitment fees at a rate of 0.5% annually for the unused portion of the leasefinancing capacity.

 

The Company’s lease financing arrangement under the amended 2000 CreditFacility is a “synthetic lease”.  Asynthetic lease is a form of lease financing that qualifies for operating leaseaccounting treatment and, when all criteria pursuant to GAAP are met, isaccounted for “off-balance sheet”. Under such a structure, the Synthetic Lease Investor may be considered avirtual SPE when it obtains debt and equity capital to finance the project(s)and leases the projects to a company. This financial structure was used to finance the construction of the NewMorgan Academy completed in the first quarter of 2001, the acquisition of theTaylor Street Center building in early 1999, and the construction-to-date ofthe incomplete Moshannon Valley Correctional Center.  The synthetic lease used to finance the above projects wasoriginally entered into in December 1998 and was amended in July 2000 wherebythe available financing was increased from $40.0 million to $100.0 million andthe lease term extended to July 2005.

 

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Under current accounting rules, the Synthetic Lease Investor in avirtual SPE must maintain at least a 3.0% equity ownership interest in theproperty throughout the life of the lease. The Company’s synthetic lease documents, as amended in July 2000,provide for the equity investor to fund 3.5% of project costs.  There are provisions in the lease andrelated credit documents for the lenders and Synthetic Lease Investor to fundand be paid interest, yield and fees. Under current GAAP rules, the payment of any yield and fees to the investorsis required to be treated as a return of capital rather than a return oncapital.

 

The Synthetic Lease Investor for the above projects received paymentsto assist as co-arranger in the structure of the initial $40.0 millionsynthetic lease facility in 1998 and in July 2000 when the synthetic leasefacility was increased to $100.0 million. Although the Company does not believe the lessor is a special purposeentity, the lessor could be considered as a virtual special purpose entityunder certain accounting interpretations. Therefore, these payments could be interpreted  to reduce the Synthetic Lease Investor’s equity ownership in theleased projects below the required 3.0% level as of the second quarter of2000.  Pursuant to this interpretation,these synthetic leases no longer qualify for off-balance sheet treatmentbeginning in the second quarter of 2000. Accordingly, the assets and liabilities and results of operations of thesynthetic lease owned by the Synthetic Lease Investor are consolidated in theCompany’s financial statements beginning in the second quarter of 2000.

 

As a result of consolidating the synthetic lease assets andliabilities, the Company’s accompanying Consolidated Financial Statementsreflect the depreciation expense on the associated properties and interestexpense related to the Synthetic Lease Investor’s debt, instead of rentexpense.

 

The Company’s adoption of FIN 46 in the fourth quarter of 2002 does notchange the Company’s accounting for the 2000 synthetic lease transaction andthe 2001 Sale and Leaseback Transaction, which are consolidated for reportingpurposes.  It is reasonably possiblethat the Company may enter into future arrangements for the development of newfacilities or to operate facilities that may become subject to the provisionsof FIN 46 and, in some cases, may be required to consolidate the relatedactivities, facilities and financings.

 

The Synthetic Lease Investor’s Note A and Note B have total creditcommitments of $81.4 million and $15.1 million, respectively.  The Synthetic Lease Investor’s Notes A and Bare cross collateralized with the Company’s revolving line of credit andcontain cross default provisions.

 

*Contractual Uncertainties Related to Certain Facilities.*  The New Morgan Academy was completed andbecame operational in two phases during the fourth quarter of 2000 and thefirst quarter of 2001.  During 2002, theNew Morgan Academy experienced a reduction in occupancy as a result of budgetappropriation reductions of a significant customer.  On September 27, 2002, the Company announced plans to close theNew Morgan Academy.  The Companyconsented to relinquish its license issued by the Pennsylvania Department ofPublic Welfare in lieu of the department implementing its decision to revokethe facility’s provisional license due to operating incidents at thefacility.  The Company closed thefacility in the fourth quarter of 2002. The Company is maintaining a small staff to secure and maintain thefacility while the Company considers its options for the use or sale of thefacility.  The Company expects to incuroperating expenses of approximately $150,000 per month for payroll, propertytaxes and other operating costs from the time the facility was closed until thefacility is utilized for an alternative program or until the facility issold.  Additionally, the Company isincurring interest expense of approximately $140,000 per month related to theborrowings for the facility and depreciation expense of approximately $46,000per month for the building.

 

In April 1999, the Company was awarded a contract to design, build andoperate a 1,095 bed prison for the BOP in Moshannon Valley, Pennsylvania (the“Moshannon Valley Correctional Center”). Construction 

 

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and activation activities commenced immediately.  In June 1999, the BOP issued a Stop-WorkOrder pending a re-evaluation of their environmental documentation supportingthe decision to award the contract.  Theenvironmental study was completed with a finding of no significant impact andthe Stop-Work Order was lifted by the BOP on August 9, 2001.

 

In September 1999, the Company received correspondence from the Officeof the Attorney General of the Commonwealth of Pennsylvania indicating itsbelief that the operation of a private prison in Pennsylvania is unlawful.  The Company and the BOP have had discussionswith the Attorney General’s staff regarding these and related issues.  As a result of these issues, the Company hasnot re-commenced its construction efforts. As of December 31, 2002, the Company had incurred approximately $16.1million for construction and land development costs and capitalized interestrelated to the Moshannon Valley Correctional Center.  According to the BOP contract, as amended, the Company must havecompleted the construction of the facility by April 15, 2003.  The Company will not be able to completeconstruction within that time frame. The Company is currently obtaining contract amendments monthly from theBOP. The Company anticipates obtaining another long-term contract amendmentfrom the BOP extending the construction deadline.  In the event the Company is not able to negotiate a contractamendment with the BOP, then the BOP may have the right to assert that theCompany has not completed construction of the facility within the time frameprovided in the BOP contract, as amended. Management expects that the contract will be amended to address cost andconstruction timing matters resulting from the extended delay.  In the event that the BOP decides not tocontinue with the construction of the Moshannon Valley Correctional Center andterminates the contract, management believes that the Company has the right toand will recover its invested costs.  Inthe event any portion of these costs are determined not to be recoverable uponcontract termination by the BOP, such costs would be expensed.  Management currently believes that theinvested costs would be fully recoverable in the event this contract isterminated.

 

In March 2003,the Company reached an agreement with the Commonwealth of Pennsylvania thatresolves all outstanding administrative issues relative to the contract awardedto the Company by the BOP to operate the Moshannon Valley Correctional Center.  If the Company is able to negotiate anamendment to the contract with the BOP, this agreement will allow the Companyto move forward with the construction and operation of the facility, subject tore-approval of the project by the lender under the Company’s amended 2000 CreditFacility.

 

At December 31, 2002, accounts receivable include costs totalingapproximately $1.4 million for direct costs incurred by the Company since theissuance of the Stop-Work Order in June 1999 for payroll and other operatingcosts related to the Moshannon Valley Correctional Center.  These costs were incurred with theunderstanding that such costs would be reimbursed.  Although no formal written agreement exists, management believesthat these costs will be reimbursed by the BOP in the near term.  In the event any portion of these costs isdetermined not to be reimbursable, such costs will be expensed.

 

Development and construction costs for the New Morgan Academy and theMoshannon Valley Correctional Center have been financed with the Company’s syntheticlease financing arrangement discussed under “Long-Term Credit Facilities”.

 

*Treasury Stock/Repurchases.*  The Company repurchased in the open market277,100 shares of its common stock for approximately $2.2 million in the yearended December 31, 2002.  Additionally,in September 2002, the Company purchased at fair value 35,000 shares of itscommon stock from the Company’s former president at a cost of approximately$283,000.

 

In 2002, the board of directors authorized the repurchase of anaggregate $10.0 million of the Company’s outstanding shares.  The annual repurchase of shares is limitedto $2.5 million, and an aggregate limit of $7.5 million, under the amended 2000Credit Facility.  Under the currentaggregate limitation under the amended 2000 Credit Facility, the Company maypurchase additional shares of treasury stock valued at approximately $2.0million.

 

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*Future Liquidity.*  Management believes that the Company’s existing cash and cashequivalents and the cash flows generated from operations, together with therevolving credit available under the amended 2000 Credit Facility, and thesynthetic lease financing capacity thereunder, will provide sufficientliquidity to meet the Company’s committed capital and working capitalrequirements for currently awarded and certain potential future contracts.  To the extent the Company’s cash and currentfinancing arrangements do not provide sufficient financing to fund constructioncosts related to future adult secure institutional contract awards orsignificant facility expansions, the Company anticipates obtaining additionalsources of financing to fund such activities. However, there can be no assurance that such financing will beavailable, or will be available on terms favorable to the Company.

 

*Contractual Obligations and Commercial Commitments*.  The Company has assumed various financialobligations and commitments in the ordinary course of conducting itsbusiness.  The Company has contractualobligations requiring future cash payments under its existing contractualarrangements, such as management, consultative and non-competition agreements.

 

The Company maintains operating leases in the ordinary course of itsbusiness activities.  These leasesinclude those for operating facilities, office space and office and operatingequipment, and the terms of the agreements vary from 2003 until 2075.  As of December 31, 2002, the Company’s totalcommitment under these operating leases was approximately $31.4 million.

 

The following table details the Company’s known future cash payments(on an undiscounted basis) related to various contractual obligations as ofDecember 31, 2002 (in thousands):

 
|                                                 |   | **Payments  Due by Period** |    |
|------------------------------------------------------|--------|-----------------------------|---------|
|                                                 |   |                        |    |   |   | **2004 -** |   | **2006 -** |   |   |   |
|                                                 |   | **Total**                   |    | **2003** |   | **2005** |   | **2007** |   | **Thereafter** |   |
| Contractual Obligations:                             |   |                        |    |   |   |   |   |   |   |   |   |
| Long-term debt - Special Purpose Entities            |   | $                           | 239,851 |   | $ | 7,600 |   | $ | 8,300 |   | $ | 58,251 |   | $ | 165,700 |   |
| Capital lease obligations - Cornell  Companies, Inc. |   | 37                          |    | 37 |   | — |   | — |   | — |   |
| Operating leases                                     |   | 31,384                      |    | 7,335 |   | 4,479 |   | 1,949 |   | 17,621 |   |
| Consultative and non-competition agreements          |   | 1,530                       |    | 470 |   | 840 |   | 220 |   | — |   |
| Total contractual cash obligations                   |   | $                           | 272,802 |   | $ | 15,442 |   | $ | 13,619 |   | $ | 60,420 |   | $ | 183,321 |   |

 

The Company enters into letters of credit in the ordinary course ofoperating and financing activities.  Asof December 31, 2002, the Company had outstanding letters of credit ofapproximately $5.1 million primarily for certain workers’ compensation insuranceand other operating obligations.  Thefollowing table details the Company’s letter of credit commitments as ofDecember 31, 2002 (in thousands):
|                      |   | **Total   Amounts   Committed** |                                            |   |          |   |          |   |                     |   |   |
|---------------------------|--------|---------------------------------|-------------------------------------------------|--------|---------------|--------|---------------|--------|--------------------------|--------|--------|
|                      |   |                            | **Amount of  Commitment Expiration Per Period** |   |
|                      |   |                            | **Less than   1 Year**                          |   | **1-3 Years** |   | **4-5 Years** |   | **Over    5 Years** |   |
|                      |   |                            |                                            |   |          |   |          |   |                     |   |   |
| Commercial Commitments:   |   |                            |                                            |   |          |   |          |   |                     |   |   |
| Standby letters of credit |   | $                               | 5,108                                           |   | $             | 200    |          | $      | 4,908                    |   | $      | — |   | $ | — |   |
|                           |        |                                 |                                                 |        |               |        |               |        |                          |        |        |  |  |  |  |  |

 

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**Related PartyTransactions**

 

One of the directors of the Company is a partner in a law firm thatprovides legal services to the Company. The Company pays legal fees for such services.  Legal fees paid to this law firm were approximately $1.5 million,$2.7 million and $1.8 million for the years ended December 31, 2002, 2001 and 2000,respectively.  The services rendered tothe Company were on terms no more favorable than those with unrelated parties.

 

In July 1996, the Company entered into promissory notes with theCompany’s former president and the Company’s founder, currently a director ofthe Company.  The promissory notes bearinterest at an annual rate of 6.63%, mature in June 2004 with no interiminterest or principal payments, are full recourse and collateralized by sharesof the Company’s common stock.

 

In connection with the Company president’s resignation in September2002,  the outstanding principal andinterest balance of approximately $76,000 and $35,000, respectively, wasrepaid.  At December 31, 2002, theprincipal and related accrued interest receivable outstanding related to theCompany founder’s  note wasapproximately $270,000 and $109,000. These amounts are reflected in deferred costs and other assets in theaccompanying Consolidated Balance Sheets. The Company recognized approximately $29,000, $29,000 and $27,000 ofinterest income related to these notes for the years ended December 31, 2002,2001 and 2000.

 

Effective September 1, 1999, the Company entered into a consultingagreement with the Company’s founder, currently a director of the Company.  As compensation for consulting services, theCompany agreed to an annual payment of at least $255,000 for each of the firstfour years of the seven-year initial term of the consulting agreement with anannual salary of at least $180,000 for each of the last three years of theseven-year initial term of the consulting agreement.  The Company has an option to renew the consulting agreement foran additional three-year  term at anannual salary of at least $300,000 for each of the three years of the renewalterm.  As additional compensation, theCompany agreed to an annual bonus, subject to certain limitations, equal to$75,000 during the first four years of the seven-year initial term and anannual bonus of $60,000 during the last three years of the seven-year initialterm and during any renewal term.  TheCompany also agreed to grant options to purchase an aggregate 120,000 shares ofthe Company’s common stock in four equal annual installments beginningSeptember 1, 2000.  The options have anexercise price equal to the fair market value of the Company’s common stock onthe date of grant and vest at the time such options are granted, subject tocertain limitations on exercise.

 

As part of the consulting agreement discussed above, the Companyentered into a non-compete agreement with this director.  The non-compete agreement has a term of 10years and requires the Company to pay a monthly fee of  $10,000 for the seven-year initial term ofthe  consulting agreement.  The Company recognized amortization expenserelated to this agreement of approximately $84,000 for each of the years endedDecember 31, 2002, 2001 and 2000.

 

The Company maintains a key-man life insurance policy for this directorand made payments related to this policy of approximately $214,000, $215,000and $215,000 for the years ended December 31, 2002, 2001 and 2000,respectively.

 

The Company also compensated this director for board of director feesin amounts of $30,000, $22,000 and $24,000 for the years ended December 31,2002, 2001 and 2000, respectively.

 

Total payments made for the above consulting and non-competeagreements, board of director fees and expense reimbursements for this directorwere approximately $477,000, $428,000 and $473,000 for the years ended December31, 2002, 2001 and 2000, respectively.

 

The Company also has a non-compete agreement with a director of theCompany in connection with the acquisition of The Abraxas Group, Inc. inSeptember 1997.  Under this agreement,the Company is required to pay annual installments of $60,000 beginning January2, 1998.  These payments can and havebeen accelerated upon the mutual agreement of the director and theCompany.  The balance due on thisnon-compete agreement as of December 31, 2002 and 2001 was approximately$200,000 and $280,000, respectively. The Company made payments under this agreement of approximately $80,000and $200,000 for the years ended December 31, 2002 and 2001, respectively.  There were no payments made in the yearended December 31, 2000.

** **

**Inflation**

 

Other than personnel and offender medical costs at certain facilitiesduring 2001, management believes that inflation has not had a material effecton the Company’s results of operations during the past three years.  Most of the Company’s facility managementcontracts provide for payments to the Company of either fixed per diem fees orper diem fees that increase by only small amounts during the term of thecontracts.  Inflation couldsubstantially increase the Company’s personnel costs (the largest component ofoperating expenses) or other operating expenses at rates faster than anyincreases in contract revenues.

 

**Risk Factors andCautionary Statement for Purposes of the “Safe Harbor” Provisions of thePrivate Securities Litigation Reform Act of 1995**

 

This report contains or incorporates by reference forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995.  These statements are based oncurrent plans and expectations of management and involve risks anduncertainties that could cause actual future activities and results ofoperations to be materially different from those set forth in theforward-looking statements.  Importantfactors that could cause actual results to differ include, among others, (1) theoutcomes of pending putative class action shareholder and derivative lawsuits,and related insurance coverage (2) risks associated with acquisitions and theintegration thereof (including the ability to achieve administrative andoperating cost savings and anticipated synergies), (3) the timing and costs ofthe opening of new facilities or the expansions of existing facilities, (4)changes in governmental policy and/or funding to discontinue or not renewexisting arrangements or to eliminate or discourage the privatization ofcorrectional, detention and pre-release services in the United States, (5) theavailability of debt and equity financing on terms that are favorable to theCompany, (6) fluctuations in operating results because of occupancy,competition (including competition from two competitors that are substantiallylarger than the Company), increases in cost of operations, fluctuations ininterest rates and risks of operations, (7) significant charges to expense ofdeferred costs associated with financing and other projects in development ifmanagement determines that one or more of such projects is unlikely to besuccessfully concluded, and (8) results from alternative deployment or sale offacilities such as the New Morgan Academy.

 

Where any forward-looking statement includes a statement of theassumptions or bases underlying the forward-looking statement, the Companycautions that, while it believes these assumptions or bases to be reasonableand in good faith, assumed facts or bases almost always vary from the actualresults, and differences between assumed facts or bases and actual results canbe material, depending upon the circumstances. Where, in any forward-lookingstatement, the Company or its management express an expectation or belief as tofuture results, that expectation or belief is expressed in good faith and isbelieved to have a reasonable basis. The Company cannot assure you, however,that the statement of expectation or belief will result or be achieved oraccomplished. The words “believe,” “expect,” “estimate,” “anticipate” andsimilar expressions will generally identify forward-looking statements. All ofthe Company’s forward-looking statements, whether written or oral, areexpressly qualified by these cautionary statements and any other cautionarystatements that may accompany such forward-looking statements. In addition, theCompany disclaims any obligation to update any forward-looking statements toreflect events or circumstances after the date of this report.

 

With this in mind, you should consider the risks discussed elsewhere inthis report and other documents the Company files with the Commission from timeto time and the following important factors that could cause actual results todiffer materially from those expressed in any forward-looking statement made bythe Company or on its behalf.

 

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***Public resistance toprivatization of correctional and detention facilities could result in theCompany’s inability to obtain new contracts or the loss of existing contracts.***

 

Management of correctional and detention facilities by private entitieshas not achieved complete acceptance by either the government or the public.The movement toward privatization of correctional and detention facilities hasalso encountered resistance from certain groups, such as labor unions, localsheriff’s departments, and groups believing that correctional and detentionfacility operations should only be conducted by government agencies. Changes inthe dominant political party in any market in which correctional facilities arelocated could have an adverse impact on privatization. Further, some governmentagencies are not legally permitted to delegate their traditional managementresponsibilities for correctional and detention facilities to privatecompanies.

 

Any of these resistances may make it more difficult for the Company torenew or maintain existing contracts, to obtain new contracts or sites on whichto operate new facilities or to develop or purchase facilities and lease themto government or private entities, any or all of which could have a materialadverse effect on the Company’s business.

 

***The Company issubject to the short-term nature of government contracts.***

 

Many governmental agencies are legally limited in their ability toenter into long-term contracts that would bind elected officials responsiblefor future budgets. Therefore, many contracts with government agenciestypically either have a very short term or are subject to termination on shortnotice without cause. In addition, the Company’s contracts with governmentagencies may contain one or more renewal options that may be exercised only bythe contracting government agency. No assurance can be given that any agencywill exercise a renewal option in the future. The non-renewal or termination ofany of the Company’s significant contracts with governmental agencies couldmaterially adversely affect the Company’s financial condition, results ofoperation and liquidity, including its ability to secure new facilitymanagement contracts from others.

 

***The Company isdependent on government appropriations. If government appropriation levels arereduced, the Company’s business may be harmed.***

 

The Company’s cash flow is subject to the receipt of sufficient fundingof and timely payment by contracting governmental entities. If the appropriategovernmental agency does not receive sufficient appropriations to cover itscontractual obligations, a contract may be terminated or the amounts payable tothe Company may be deferred or reduced. Any delays in payment, or thetermination of a significant contract, could have an adverse effect on theCompany’s cash flow and financial condition. Moreover, as a result of the slowing economy and the events of September11, 2001, federal, state and local governments may encounter unusual budgetaryconstraints and there is a risk that spending on outsourced services providedby the Company may be curtailed.

 

***The Company’sability to win new contracts to develop and manage correctional, detention andtreatment facilities depends on many factors outside its control.***

 

The Company’s growth is generally dependent upon its ability to win newcontracts to develop and manage new correctional, detention and treatmentfacilities. This depends on a number of factors the Company cannot control,including crime rates and sentencing patterns in various jurisdictions.Accordingly, the demand for the Company’s facilities could be adverselyaffected by the relaxation of enforcement efforts, leniency in conviction andsentencing practices or through the legal decriminalization of certainactivities that are currently proscribed by criminal laws. For instance, anychanges with respect to drugs and controlled

 

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substances or illegal immigration could affect the number of personsarrested, convicted and sentenced, thereby potentially reducing demand forcorrectional facilities to house them. Similarly, reductions in crime ratescould lead to reductions in arrests, convictions and sentences requiringcorrectional facilities. The Bureau of Justice Statistics reports that thelevel of violent crime in the United States has declined steadily since 1994and the level of property crime is at the lowest level since 1974. However, thenumber of detained offenders has grown steadily during that period.

 

While the Company believes that governments will continue to privatizecorrectional, detention and treatment facilities, the Company believes the rateof growth experienced in the state private corrections industry during the late1980’s and early 1990’s is moderating. Certain jurisdictions recently haverequired successful bidders to make a significant capital investment inconnection with the financing of a particular project, a trend that couldrequire the Company to have sufficient capital resources to competeeffectively. The Company may not be able to obtain these capital resources whenneeded. Additionally, the Company’s success in obtaining new awards andcontracts may depend, in part, upon its ability to locate land that can beleased or acquired under favorable terms. Otherwise desirable locations may bein or near populated areas and, therefore, may generate legal action or otherforms of opposition from residents in areas surrounding a proposed site.

 

The Company iscurrently negotiating a contract amendment with the BOP related to theMoshannon Valley Correctional Center. If the Company is unable to successfully negotiate the amendment withthe BOP or if the Company is unable to obtain the re-approval of the project bythe lenders under the Company's amended 2000 Credit Facility, the Company willbe unable to move forward with the construction and operation of the facility.

 

***The Company’sprofitability may suffer if the number of offenders occupying its correctional,detention and treatment facilities decreases.***

 

The Company’s correctional, detention and treatment facilities aredependent upon government agencies supplying offenders. A substantial portionof the Company’s revenues is generated under contracts that specify a net rateper day per resident, or a per diem rate, sometimes with no minimum guaranteedoccupancy levels, even though most correctional facility cost structures arerelatively fixed.  Under such a per diemrate structure, a decrease in occupancy levels at a particular facility couldhave a material adverse effect on the financial condition and results ofoperations at such facility.

 

***A failure to complywith existing regulations could result in material penalties or non-renewal ortermination of the Company’s contracts to manage correctional, detention andtreatment facilities.***

 

The Company’s industry is subject to a variety of federal, state andlocal regulations, including education, health care and safety regulations,which are administered by various regulatory authorities. The Company may notalways successfully comply with these regulations, and failure to comply couldresult in material penalties or non-renewal or termination of facilitymanagement contracts.  The contractstypically include extensive reporting requirements and supervision and on-sitemonitoring by representatives of contracting government agencies.  Corrections officers are customarilyrequired to meet certain training standards, and in some instances facilitypersonnel are required to be licensed and subject to background investigation.Certain jurisdictions also require the subcontracts to be awarded on acompetitive basis or to subcontract with businesses owned by members ofminority groups. The Company’s facilities are also subject to operational andfinancial audits by the governmental agencies with which the Company hascontracts.  The failure to comply withany applicable laws, rules or regulations and the loss of any required licensecould adversely affect the financial condition and results of operations at theCompany’s affected facilities.

*** ***

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***Government agenciesmay investigate and audit the Company’s contracts and, if any improprieties arefound, the Company may be required to refund revenues it has received, toforego anticipated revenues and may be subject to penalties and sanctions,including prohibitions on the Company’s bidding in response to requests forproposals, or RFPs.***

 

Certain of the government agencies the Company contracts with have theauthority to audit and investigate the Company’s contracts with them.  As part of that process, the governmentagency reviews the Company’s performance on the contract, its pricingpractices, its cost structure and its compliance with applicable laws,regulations and standards.  If theagency determines that the Company has improperly allocated costs to a specificcontract, the Company may not be reimbursed for those costs and the Companycould be required to refund the amount of any such costs that have beenreimbursed.  If a government audituncovers improper or illegal activities by the Company or the Company otherwisedetermines that these activities have occurred, the Company may be subject tocivil and criminal penalties and administrative sanctions, includingtermination of contracts, forfeitures of profits, suspension of payments, finesand suspension or disqualification from doing business with the government.  Any adverse determination could adverselyimpact the Company’s ability to bid in response to RFPs in one or morejurisdictions.

 

***If the Company  fails to satisfy its contractualobligations, the Company’s ability to compete for future contracts and itsfinancial condition may be adversely affected.***

 

The Company’s failure to comply with contract requirements or to meetits client’s performance expectations when performing a contract couldmaterially and adversely affect the Company’s financial performance and itsreputation, which, in turn, would impact the Company’s ability to compete fornew contracts. The Company’s failure to meet contractual obligations could alsoresult in substantial actual and consequential damages. In addition, theCompany’s contracts often require it to indemnify clients for the Company’sfailure to meet performance standards. Some of the Company’s contracts containliquidated damages provisions and financial penalties related to performancefailures. Although the Company has liability insurance, the policy limits maynot be adequate to provide protection against all potential liabilities.

 

***New competitors inthe Company’s industry may adversely affect the profitability of the Company’sbusiness.***

 

The Company must compete on the basis of cost, quality and range ofservices offered, experience in managing facilities, reputation of personneland ability to design, finance and construct new facilities on a cost effectivecompetitive basis. While there are barriers for companies seeking to enter intothe management and operation of correctional, detention and treatmentfacilities, there can be no assurance that these barriers will be sufficient tolimit additional competition.

 

***A disturbance in oneof the Company’s facilities could result in closure of a facility or harm tothe Company’s business.***

 

An escape, riot or other disturbance at one of the Company’s facilitiescould adversely effect the financial condition, results of operations andliquidity of the Company’s operations. Among other things, the adverse publicitygenerated as a result of an event could adversely affect the Company’s abilityto retain an existing contract or obtain future ones. In addition, if such anevent were to occur, there is a possibility that the facility where the eventoccurred may be shut down by the relevant governmental agency. A closure ofcertain of the Company’s facilities could adversely affect the financialcondition, results of operations and liquidity of the Company’s operations.

 

***Terrorist attacks,such as the attacks that occurred in New York and Washington, D.C. on September11, 2001, and other acts of violence or war may affect the markets in which theCompany’s common stock trades, the markets in which the Company operates andthe Company’s profitability.***

 

Terrorist attacks may negatively affect the Company’s operations.  There can be no assurance that there willnot be further terrorist attacks against the United States or United Statesbusinesses. As a result of 

 

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terrorism, the United States may enter into a protracted armedconflict, which could have a further impact on the Company’s business. Inaddition, terrorists attacks in the United States may increase demand fortrained security personnel, which could increase the Company’s operating costs.Political and economic instability in some regions of the world may also resultand could negatively impact the Company’s business. In addition, any of theseevents may affect the markets in which the Company’s common stock trades. Theconsequences of any of these armed conflicts are unpredictable and the Companymay not be able to foresee events that could have an adverse effect on itsbusiness.

 

***Inaccurate,misleading or negative media coverage could adversely affect the Company’sreputation and its ability to bid for government contracts.***

 

The media frequently focuses its attention on private operators’contracts with government agencies. If the media coverage is negative, it couldinfluence government officials to slow the pace of outsourcing governmentservices, which could reduce the number of RFPs. The media may also focus itsattention on the activities of political consultants engaged by the Company,even when their activities are unrelated to the Company’s business, and theCompany may be tainted by adverse media coverage about their activities.Moreover, inaccurate, misleading or negative media coverage about the Companycould harm its reputation and, accordingly, its ability to bid for and wingovernment contracts.

 

***The Company mayincur significant costs before receiving related revenues, which could resultin cash shortfalls.***

 

When the Company is awarded a contract to manage a government program,it may incur significant expenses before the Company receives contract payments.These expenses include leasing office space, purchasing office equipment andhiring and training personnel. As a result, in certain large contracts wherethe government does not fund program pre-opening and start-up costs, theCompany may be required to invest significant sums of money before receivingrelated contract payments.  In addition,payments due to the Company from government agencies may be delayed due tobilling cycles or as a result of failures to approve governmental budgets andfinalize contracts in a timely manner.

 

***The Company may beunable to attract and retain sufficient qualified personnel necessary tosustain its business.***

 

The Company’s delivery of services is labor-intensive.  When the Company is awarded a governmentcontract, the Company must hire operating management, security, case managementand other personnel.  The success of theCompany’s business requires that the Company attract, develop, motivate andretain these personnel. The Company’s inability to hire sufficient personnel ona timely basis or the loss of significant numbers of personnel could adverselyaffect its business.

 

***Unsuccessfulfinancing or acquisition projects may result in charges to expense for deferredcosts.***

 

If the Company determines that one or more financing or acquisitionprojects is unlikely to be successfully concluded, the Company could incursignificant charges to expense for deferred costs associated with suchprojects.

 

***Failure to obtainadditional capital in the future could reduce the Company’s ability to grow.***

 

The Company believes that existing cash and cash equivalents and thecash flows generated from operations, together with the Company’s revolvingcredit available under the amended 2000 Credit Facility, and the lease capacitythereunder, will be adequate to fund the Company’s operating plans for theforeseeable 

 

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future.  However, the Companymay need additional debt or equity financing in order to carry out its growthstrategy.  To the extent that theCompany requires additional financing in the future and is unable to obtainsuch additional financing on satisfactory terms, if at all, it may not be ableto fully implement its growth strategy.

 

***If the Company doesnot successfully integrate the businesses that it acquires, the Company’sresults of operations could be adversely affected.***

 

The Company may be unable to manage businesses that it may acquireprofitably or integrate them successfully without incurring substantialexpenses, delays or other problems that could negatively impact the Company’sresults of operations.

 

Moreover, business combinations involve additional risks, including:

 

•              diversion of management’sattention;

•              loss of key personnel;

•              assumption of unanticipated legalor financial liabilities;

•              the Company’s becomingsignificantly leveraged as a result of the incurrence of debt to financean  acquisition;

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

•              amortization or charges ofacquired intangible assets, including goodwill; and

•              dilution to the Company’s earningsper share.

 

Also, client dissatisfaction or performance problems with an acquiredbusiness could materially and adversely affect the Company’s reputation as awhole.  Further, the acquired businessesmay not achieve the revenues and earnings the Company anticipated.

 

***Because federalenvironmental laws impose strict as well as joint and several liability forclean up costs, unforeseen environmental risks could prove to be costly.***

 

The Company’s facilities may be subject to unforeseen environmentalrisks.  The federal ComprehensiveEnvironmental Response, Compensation, and Liability Act, as amended, or CERCLA,imposes strict, as well as joint and several, liability for certainenvironmental cleanup costs on several classes of potentially responsibleparties, including current owners and operators of the property and, in somecases, lenders who did not cause or contribute to the contamination.  Furthermore, liability under CERCLA is notlimited to the original or unamortized principal balance of a loan or to thevalue of the property securing a loan. Other federal and state laws in certaincircumstances may impose liability for environmental remediation, which costsmay be substantial.  Moreover, certainfederal statutes and certain states by statute impose a lien for any cleanupcosts incurred by such state on the property that is the subject of suchcleanup costs. All subsequent liens on such property generally are subordinatedto such an environmental lien and, in some states, even prior recorded liensare subordinated to environmental liens.

 

***The Company is thesubject of class action lawsuits that, if decided against it, could have anegative effect on its financial condition, results of operations, cash flowsand future prospects.***

 

In March and April 2002, the Company, Steven W. Logan, and John L.Hendrix, have been named as defendants in four Federal putative class actionlawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*, No. H-02-0866,in the United States District Court for the Southern District of Texas, HoustonDivision; (2) *Richard Picard, On Behalf*

 

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*of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.*,No. H-02-1075, in the United States District Court for the Southern District ofTexas, 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 Southern District ofTexas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No.H-02-1567, in the United States District Court for the Southern District ofTexas, Houston Division.  Theaforementioned lawsuits are putative class action lawsuits brought on behalf ofall purchasers of the Company’s common stock between March 6, 2001 and March 5,2002.  The lawsuits involve disclosuresmade concerning two prior transactions executed by the Company: the August 2001sale leaseback transaction and the 2000 synthetic lease transaction.  These four lawsuits have all beenconsolidated into the *Graydon Williams* action.  Recently, the Court granted FlylinePartners, LP’s motion to be appointed as lead plaintiff and Flyline Partners,LP has filed a consolidated complaint. The consolidated complaint alleges that the defendants violated Section10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5promulgated under Section 10(b) of the Exchange Act, Section 20(a) of theExchange Act and Section 11 of the Securities Exchange Act of 1933.  The consolidated complaint seeks, amongother things, restitution damages, compensatory damages, rescission orrescissory measure of damages, costs, expenses, attorneys’ fees and expertfees.

 

In March 2002, the Company, its directors, and its former independentauditor Arthur Andersen LLP, were sued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant Cornell Companies,Inc. v. Anthony R. Chase, et al.*, No. 2002-15614, in the 127th Judicial DistrictCourt of Harris County, Texas.  Thelawsuit alleges breaches of fiduciary duty by all of the individual defendantsand asserts breach of contract and professional negligence claims only againstArthur Andersen LLP.

 

In May and June 2002, the Company and its directors were sued in threeother derivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalfof Cornell Companies, Inc. v. Steven W. Logan, et. al.,* No.H-02-1812, in the United Stated District Court for the Southern District ofTexas, Houston Division; (2) *Thomas Pagano, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.*, No. H-02-1896, in theUnited Stated District Court for the Southern District of Texas, HoustonDivision; and (3) *Jesse Menning, Derivatively on Behalf of Cornell Companies, Inc. v.Steven W. Logan, et. al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits all allege breaches of fiduciary duty and waste of corporate assets byall of the defendants.  A motion todismiss the *Guitierrez*and *Pagano*lawsuits was filed.  The court dismissedthe *Pagano*action as duplicative of the *Guitierrez* action.  The motion to dismiss the *Guitierrez*action is still pending.

 

While the plaintiffs in these cases have not quantified their claim ofdamages and the outcome of the matters discussed above cannot be predicted withcertainty, based on information known to date, if the plaintiffs are successfulmanagement believes that the ultimate resolution of these matters would nothave a material adverse effect on the Company’s financial position, operatingresults or cash flow.

 

Certain insurance policies held by the Company to cover potentialdirector and officer liability may limit the Company’s cash outflows in theevent of a decision adverse to the Company in the matters discussed above.  However, if an adverse decision in thesematters exceeds the insurance coverage or if the insurance coverage is deemednot to apply to these matters, an adverse decision to the Company in thesematters could have a material adverse effect on the Company, its financialcondition, its results of operations and its future prospects.

 

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**ITEM7A.**     **QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**Quantitative andQualitative Disclosures about Market Risk**

 

In the normal course of business, the Company is exposed to marketrisk, primarily from changes in interest rates.  The Company continually monitors exposure to market risk anddevelops appropriate strategies to manage this risk.  The Company is not exposed to any other significant market risks,including commodity price risk, foreign currency exchange risk or interest raterisks from the use of derivative financial instruments.  Management does not use derivative financialinstruments for trading or to speculate on changes in interest rates orcommodity prices.

 

**Interest RateExposure**

 

The Company’s exposure to changes in interest rates primarily resultsfrom its long-term debt with both fixed and floating interest rates.  The debt on the Company’s consolidatedfinancial statements with fixed interest rates consists of the 8.47% Bondsissued by MCF in August 2001 in connection with the 2001 Sale and LeasebackTransaction.  At December 31, 2002,approximately 20.5% ($49.3 million of debt outstanding to the Synthetic LeaseInvestor) of the Company’s 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 $190,000 for the yearended December 31, 2002.  At December31, 2002, the fair value of the Company’s consolidated fixed rate debtapproximated carrying value based upon discounted future cash flows usingcurrent market prices.

 

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**REPORT****OFINDEPENDENT ACCOUNTANTS**

 

To the Board of Directors and Stockholders’ ofCornell Companies, Inc.:

 

In our opinion, the accompanying consolidated balance sheet as ofDecember 31, 2002 and the related consolidated statements of operations andcomprehensive income, stockholders’ equity and cash flows present fairly, inall material respects, the financial position of Cornell Companies, Inc. andits subsidiaries (collectively the Company) at December 31, 2002, and theresults of their operations and their cash flows for the year then ended inconformity with accounting principles generally accepted in the United Statesof America.  These financial statementsare the responsibility of the Company’s management; our responsibility is toexpress an opinion on these financial statements based on our audit.  We conducted our audit of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audit provides a reasonable basis for our opinion.  The consolidated financial statements of theCompany as of December 31, 2001, and for each of the two years in the periodended December 31, 2001, prior to the revision described in Note 3 of theconsolidated financial statements, were audited by other independentaccountants who have ceased operations. Those independent accountants expressed an unqualified opinion on thosefinancial statements in their report dated April 16, 2002.

 

As discussed in Note 3 to the consolidated financial statements, theCompany changed its method of accounting for goodwill effective January 1,2002.

 

As discussed above, the consolidated financial statements of theCompany as of December 31, 2001, and for each of the two years in the periodended December 31, 2001, were audited by other independent accountants who haveceased operations.  As described in Note3, those financial statements have been revised to include the transitionaldisclosures required by Statement of Financial Accounting Standard No. 142,“Goodwill and Other Intangible Assets,” which was adopted by the Company as ofJanuary 1, 2002.  We audited thetransitional disclosures for 2001 and 2000 included in Note 3.  In our opinion, the transitional disclosuresfor 2001 and 2000 in Note 3 are appropriate. However, we were not engaged to audit, review, or apply any proceduresto the 2001 or 2000 financial statements of the Company other than with respectto such disclosures and, accordingly, we do not express an opinion or any otherform of assurance on the 2001 or 2000 financial statements taken as a whole.

 

/s/ PRICEWATERHOUSECOOPERS LLP

 

 

 

Houston, TexasFebruary 27, 2003

 

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The following report is a copy of a report previously issued by ArthurAndersen LLP (“Andersen”).  This reporthas not been reissued by Andersen and Andersen did not consent to theincorporation by reference of this report (as included in this Form 10-K) intoany of the Company’s registration statements.

 

As discussed in Note 3, the Company has revised its financialstatements for the years ended December 31, 2001 and 2000 to include thetransitional disclosures required by statement of financial accountingstandards No. 142, “Goodwill and Intangible Assets.”  The Andersen report does not extend to these changes.  The revisions to the 2001 and 2000 financialstatements related to these transitional disclosures were reported on byPricewaterhouseCoopers LLP, as stated in their report appearing herein.

 

 

**REPORTOF INDEPENDENT PUBLIC ACCOUNTANTS**

 

To the Board of Directors ofCornell Companies, Inc.:

 

We have audited the accompanying consolidated balance sheets of CornellCompanies, Inc. and subsidiaries as of December 31, 2001 and 2000*, and therelated consolidated statements of operations, stockholders’ equity and cashflows for each of the three years in the period ended December 31, 2001*.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States.  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the financial position of Cornell Companies,Inc. and subsidiaries as of December 31, 2001 and 2000*, and the results oftheir operations and their cash flows for each of the three years in the periodended December 31, 2001*, in conformity with accounting principles generallyaccepted in the United States.

 

 

/s/ ARTHUR ANDERSEN LLP

 

 

Houston, Texas

April 16, 2002

 

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*              The Company’sconsolidated balance sheet as of December 31, 2000 and the consolidatedstatements of operations and comprehensive income, shareholders’ equity andcash flows for the year ended December 31, 1999 are not included in thisForm 10-K.

 

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**ITEM8.        FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

**CORNELLCOMPANIES, INC.**

**CONSOLIDATED BALANCESHEETS**

**(inthousands, except share data)**

 
|                                                                           |   | **December  31,** |       |
|--------------------------------------------------------------------------------|--------|-------------------|------------|
|                                                                           |   | **2002**          | ** ** | **2001** | ** ** |
| ASSETS                                                                         |   |              |       |   |   |
| CURRENT ASSETS:                                                                |   |              |       |   |   |
| Cash and cash equivalents                                                      |   | $                 | 52,610     |   | $ | 53,244 |   |
| Accounts receivable (net of allowance for  doubtful accounts                   |   |              |       |   |   |
| of $2,238 and $3,068, respectively)                                            |   | 60,035            |       | 63,291 |   |
| Other restricted assets                                                        |   | 14,767            |       | 15,926 |   |
| Deferred tax assets                                                            |   | 3,300             |       | 493 |   |
| Prepaids and other                                                             |   | 5,528             |       | 5,679 |   |
| Total current assets                                                           |   | 136,240           |       | 138,633 |   |
| PROPERTY AND EQUIPMENT, net                                                    |   | 255,450           |       | 253,243 |   |
| OTHER ASSETS:                                                                  |   |              |       |   |   |
| Debt service reserve fund                                                      |   | 24,157            |       | 23,800 |   |
| Intangible assets, net                                                         |   | 13,062            |       | 15,456 |   |
| Deferred costs and other                                                       |   | 12,382            |       | 13,675 |   |
| Total assets                                                                   |   | $                 | 441,291    |   | $ | 444,807 |   |
|                                                                           |   |              |       |   |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                     |   |              |       |   |   |
|                                                                           |   |              |       |   |   |
| CURRENT LIABILITIES:                                                           |   |              |       |   |   |
| Accounts payable and accrued liabilities                                       |   | $                 | 32,622     |   | $ | 33,934 |   |
| Current portion of long-term debt                                              |   | 7,630             |       | 6,885 |   |
| Total current liabilities                                                      |   | 40,252            |       | 40,819 |   |
| LONG-TERM DEBT, net of current portion                                         |   | 232,258           |       | 238,768 |   |
| DEFERRED TAX LIABILITIES                                                       |   | 4,954             |       | 4,106 |   |
| OTHER LONG-TERM LIABILITIES                                                    |   | 3,875             |       | 7,970 |   |
| MINORITY INTEREST                                                              |   | —            |       | 40 |   |
| Total liabilities                                                              |   | 281,339           |       | 291,703 |   |
|                                                                           |   |              |       |   |   |
| COMMITMENTS  AND CONTINGENCIES                                                 |   |              |       |   |   |
|                                                                           |   |              |       |   |   |
| STOCKHOLDERS’ EQUITY:                                                     |   |              |       |   |   |
| Preferred stock, $.001 par value,  10,000,000 shares authorized,               |   |              |       |   |   |
| none issued                                                                    |   | —            |       | — |   |
| Common stock, $.001 par value, 30,000,000  shares authorized,                  |   |              |       |   |   |
| 14,201,038 and 14,005,482 shares issued and  outstanding, respectively         |   | 14                |       | 14 |   |
| Additional paid-in capital                                                     |   | 140,085           |       | 138,978 |   |
| Retained earnings                                                              |   | 30,248            |       | 23,886 |   |
| Treasury stock (1,429,586 and 1,109,816  shares of common stock, respectively, |   |              |       |   |   |
| at cost)                                                                       |   | (11,038           | )          | (8,090 | ) |
| Deferred compensation                                                          |   | (811              | )          | (1,033 | ) |
| Notes from shareholders                                                        |   | (442              | )          | (651 | ) |
| Other comprehensive income                                                     |   | 1,896             |       | — |   |
| Total stockholders’ equity                                                |   | 159,952           |       | 153,104 |   |
| Total liabilities and stockholders’ equity                                |   | $                 | 441,291    |   | $ | 444,807 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

54

----

 

**CORNELLCOMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME**

**(inthousands, except per share data)**

 
|                                                                                                                                                                   |   | **Year Ended  December 31,** |    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                                                                                                   |   | **2002**                     |    | **2001** |   | **2000** |   |
|                                                                                                                                                                   |   |                         |    |   |   |   |   |
| REVENUES                                                                                                                                                               |   | $                            | 275,145 |   | $ | 265,250 |   | $ | 226,050 |   |
| OPERATING EXPENSES, EXCLUDING DEPRECIATION                                                                                                                             |   | 212,309                      |    | 205,805 |   | 174,612 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                                                                      |   | —                       |    | 3,858 |   | 2,298 |   |
| DEPRECIATION AND AMORTIZATION                                                                                                                                          |   | 9,779                        |    | 9,278 |   | 7,463 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                                                                    |   | 21,480                       |    | 15,291 |   | 12,024 |   |
|                                                                                                                                                                   |   |                         |    |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                                                                 |   | 31,577                       |    | 31,018 |   | 29,653 |   |
| INTEREST EXPENSE                                                                                                                                                       |   | 20,698                       |    | 21,787 |   | 16,492 |   |
| INTEREST INCOME                                                                                                                                                        |   | (1,974                       | )       | (888 | ) | (100 | ) |
| MINORITY INTEREST IN CONSOLIDATED SPECIAL  PURPOSE ENTITIES                                                                                                            |   | 574                          |    | (1,674 | ) | (246 | ) |
| INCOME BEFORE PROVISION FOR INCOME TAXES,  EXTRAORDINARY CHARGE AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING  PRINCIPLES                                             |   | 12,279                       |    | 11,793 |   | 13,507 |   |
| PROVISION FOR INCOME TAXES                                                                                                                                             |   | 4,952                        |    | 4,958 |   | 5,538 |   |
| INCOME BEFORE EXTRAORDINARY CHARGE AND  CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES                                                                          |   | 7,327                        |    | 6,835 |   | 7,969 |   |
| EXTRAORDINARY CHARGE FOR EARLY RETIREMENT  OF DEBT, NET OF RELATED INCOME TAX BENEFIT OF APPROXIMATELY $2.0 MILLION IN  2001                                           |   | —                       |    | (2,946 | ) | — |   |
| CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING  PRINCIPLES, NET OF RELATED INCOME TAX PROVISION (BENEFIT) OF APPROXIMATELY  ($671) AND $535 IN 2002 AND 2001, RESPECTIVELY |   | (965                         | )       | 770 |   | — |   |
|                                                                                                                                                                   |   |                         |    |   |   |   |   |
| NET INCOME                                                                                                                                                             |   | $                            | 6,362   |   | $ | 4,659 |   | $ | 7,969 |   |
|                                                                                                                                                                   |   |                         |    |   |   |   |   |
| EARNINGS PER SHARE:                                                                                                                                                    |   |                         |    |   |   |   |   |
| BASIC                                                                                                                                                                  |   |                         |    |   |   |   |   |
| Income before extraordinary charge and  cumulative effect of changes in accounting principles                                                                          |   | $                            | .57     |   | $ | .71 |   | $ | .85 |   |
| Extraordinary charge                                                                                                                                                   |   | —                       |    | (.31 | ) | — |   |
| Cumulative effect of changes in accounting  principles                                                                                                                 |   | (.08                         | )       | .08 |   | — |   |
| Net income                                                                                                                                                             |   | $                            | .49     |   | $ | .48 |   | $ | .85 |   |
|                                                                                                                                                                   |   |                         |    |   |   |   |   |
| DILUTED                                                                                                                                                                |   |                         |    |   |   |   |   |
| Income before extraordinary charge and  cumulative effect of changes in accounting principles                                                                          |   | $                            | .55     |   | $ | .68 |   | $ | .84 |   |
| Extraordinary charge                                                                                                                                                   |   | —                       |    | (.29 | ) | — |   |
| Cumulative effect of changes in accounting  principles                                                                                                                 |   | (.07                         | )       | .07 |   | — |   |
| Net income                                                                                                                                                             |   | $                            | .48     |   | $ | .46 |   | $ | .84 |   |
|                                                                                                                                                                   |   |                         |    |   |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE  COMPUTATION:                                                                                                                       |   |                         |    |   |   |   |   |
| BASIC                                                                                                                                                                  |   | 12,911                       |    | 9,616 |   | 9,383 |   |
| DILUTED                                                                                                                                                                |   | 13,232                       |    | 10,069 |   | 9,495 |   |
|                                                                                                                                                                   |   |                         |    |   |   |   |   |
| COMPREHENSIVE INCOME:                                                                                                                                                  |   |                         |    |   |   |   |   |
| Net income                                                                                                                                                             |   | $                            | 6,362   |   | $ | 4,659 |   | $ | 7,969 |   |
| Unrealized gain on derivative instruments                                                                                                                              |   | 1,896                        |    | — |   | — |   |
| Comprehensive income                                                                                                                                                   |   | $                            | 8,258   |   | $ | 4,659 |   | $ | 7,969 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

55

----

 

**CORNELLCOMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**(inthousands, except share data)**

 
|                                                                        |   |              |       | **Additional**

**Paid-In  Capital** |       | **Retained  Earnings** |       |                       |       |         |       | **Notes  from  Shareholders** |   | **Other  Compre  hensive  Income** |   |
|-----------------------------------------------------------------------------|--------|-------------------|------------|--------------------------------------|------------|------------------------|------------|----------------------------|------------|--------------|------------|-------------------------------|--------|------------------------------------|--------|
|                                                                        |   | **Common  Stock** | ** ** |                                 |       | **Treasury  Stock**    | ** ** | **Deferred  Compensation** | ** ** | ** **   | ** ** |
|                                                                        |   | **Shares**        | ** ** | **Par  Value**                       | ** ** |                   |       | ** **                 |       | ** **   | ** ** |
|                                                                        |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| BALANCES  AT JANUARY 1, 2000                                                |   | 10,137,528        |       | $                                    | 10         |                   | $          | 90,394                     |       | $            | 11,258     |                          | $      | (3,999                             | )      | $ | –– |   | $ | (455 | ) | $ | –– |   |
|                                                                        |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| EXERCISE  OF STOCK OPTIONS                                                  |   | 10,000            |       | ––                         |       | 24                     |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| INCOME TAX BENEFITS FROM STOCK OPTIONS EXERCISED                            |   | ––      |       | ––                         |       | 15                     |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| PURCHASE OF TREASURY STOCK (258,400 SHARES AT  COST)                        |   | ––      |       | ––                         |       | ––           |       | ––               |       | (1,934       | )          | ––                  |   | ––                       |   | –– |   |
| ISSUANCE OF COMMON STOCK TO EMPLOYEE STOCK  PURCHASE PLAN                   |   | 13,585            |       | ––                         |       | 97                     |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| ISSUANCE  OF STOCK WARRANTS                                                 |   | ––      |       | ––                         |       | 1,095                  |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| ACCRUED INTEREST ON NOTES FROM SHAREHOLDERS                                 |   | ––      |       | ––                         |       | ––           |       | ––               |       | –– |       | ––                  |   | (154                               | )      | –– |   |
| NET  INCOME                                                            |   | ––      |       | ––                         |       | ––           |       | 7,969                      |       | –– |       | ––                  |   | ––                       |   | –– |   |
|                                                                        |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| BALANCES AT DECEMBER 31, 2000                                               |   | 10,161,113        |       | 10                                   |       | 91,625                 |       | 19,227                     |       | (5,933       | )          | ––                  |   | (609                               | )      | –– |   |
|                                                                        |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| EXERCISE OF STOCK OPTIONS                                                   |   | 156,923           |       | ––                         |       | 886                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| INCOME TAX BENEFITS FROM STOCK                                              |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| OPTIONS EXERCISED                                                           |   | ––      |       | ––                         |       | 619                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| DEFERRED COMPENSATION                                                       |   | ––      |       | ––                         |       | 1,088                  |       | ––               |       | –– |       | (1,088                        | )      | ––                       |   | –– |   |
| AMORTIZATION OF DEFERRED                                                    |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| COMPENSATION                                                                |   | ––      |       | ––                         |       | ––           |       | ––               |       | –– |       | 55                            |   | ––                       |   | –– |   |
| PURCHASE OF TREASURY STOCK                                                  |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| (154,316 SHARES AT COST)                                                    |   | ––      |       | ––                         |       | ––           |       | ––               |       | (2,157       | )          | ––                  |   | ––                       |   | –– |   |
| ISSUANCE OF COMMON STOCK IN PUBLIC OFFERING                                 |   | 3,450,000         |       | 4                                    |       | 43,818                 |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| ISSUANCE OF COMMON STOCK TO EMPLOYEE STOCK  PURCHASE PLAN                   |   | 46,767            |       | ––                         |       | 214                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| ISSUANCE OF COMMON STOCK UNDER 2000 DIRECTOR’S  STOCK PLAN             |   | 22,387            |       | ––                         |       | 125                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| EXERCISE OF STOCK WARRANTS                                                  |   | 168,292           |       | ––                         |       | 603                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| ACCRUED INTEREST ON NOTES FROM SHAREHOLDERS                                 |   | ––      |       | ––                         |       | ––           |       | ––               |       | –– |       | ––                  |   | (42                                | )      | –– |   |
| NET  INCOME                                                            |   | ––      |       | ––                         |       | ––           |       | 4,659                      |       | –– |       | ––                  |   | ––                       |   | –– |   |
|                                                                        |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| BALANCES AT DECEMBER 31, 2001                                               |   | 14,005,482        |       | 14                                   |       | 138,978                |       | 23,886                     |       | (8,090       | )          | (1,033                        | )      | (651                               | )      | –– |   |
|                                                                        |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| EXERCISE OF STOCK OPTIONS                                                   |   | 95,059            |       | ––                         |       | 201                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| INCOME TAX BENEFITS FROM STOCK OPTIONS EXERCISED                            |   | ––      |       | ––                         |       | 244                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| DEFERRED COMPENSATION                                                       |   | ––      |       | ––                         |       | (101                   | )          | ––               |       | –– |       | 101                           |   | ––                       |   | –– |   |
| MARK TO MARKET ADJUSTMENTS FOR DEFERRED BONUS PLAN                          |   | ––      |       | ––                         |       | (551                   | )          | ––               |       | –– |       | 551                           |   | ––                       |   | –– |   |
| OTHER COMPREHENSIVE INCOME                                                  |   | ––      |       | ––                         |       | ––           |       | ––               |       | –– |       | ––                  |   | ––                       |   | 1,896 |   |
| DEFERRED AND OTHER STOCK COMPENSATION                                       |   | ––      |       | ––                         |       | 144                    |       | ––               |       | –– |       | 89                            |   | ––                       |   | –– |   |
| PURCHASE OF TREASURY STOCK (277,100 SHARES, AT  COST)                       |   | ––      |       | ––                         |       | ––           |       | ––               |       | (2,429       | )          | ––                  |   | ––                       |   | –– |   |
| PURCHASES OF TREASURY STOCK BY DEFERRED BONUS PLAN  (39,665 SHARES AT COST) |   | ––      |       | ––                         |       | 519                    |       | ––               |       | (519         | )          | (519                          | )      | ––                       |   | –– |   |
| REPAYMENT OF SHAREHOLDERS NOTES                                             |   | ––      |       | ––                         |       | ––           |       | ––               |       | –– |       | ––                  |   | 250                                |   | –– |   |
| ISSUANCE OF COMMON STOCK TO EMPLOYEE STOCK  PURCHASE PLAN                   |   | 82,581            |       | ––                         |       | 399                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| ISSUANCE OF COMMON STOCK UNDER 2000 DIRECTOR’S STOCK  PLAN             |   | 17,916            |       | ––                         |       | 252                    |       | ––               |       | –– |       | ––                  |   | ––                       |   | –– |   |
| ACCRUED INTEREST ON NOTES FROM SHAREHOLDERS                                 |   | ––      |       | ––                         |       | ––           |       | ––               |       | –– |       | ––                  |   | (41                                | )      | –– |   |
| NET INCOME                                                                  |   | ––      |       | ––                         |       | ––           |       | 6,362                      |       | –– |       | ––                  |   | ––                       |   | –– |   |
|                                                                        |   |              |       |                                 |       |                   |       |                       |       |         |       |                          |   |                               |   |   |   |
| BALANCES AT DECEMBER 31, 2002                                               |   | 14,201,038        |       | $                                    | 14         |                   | $          | 140,085                    |       | $            | 30,248     |                          | $      | (11,038                            | )      | $ | (811 | ) | $ | (442 | ) | $ | 1,896 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

56

----

 

**CORNELLCOMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**

 
|                                                                                     |   | **Year Ended  December 31,** |       |
|------------------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                                     |   | **2002**                     | ** ** | **2001** | ** ** | **2000** | ** ** |
|                                                                                     |   |                         |       |   |   |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                    |   |                         |       |   |   |   |   |
| Net income                                                                               |   | $                            | 6,362      |   | $ | 4,659 |   | $ | 7,969 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities — |   |                         |       |   |   |   |   |
| Extraordinary charge, net of tax                                                         |   | —                       |       | 2,946 |   | — |   |
| Cumulative effect of changes in accounting  principles                                   |   | 965                          |       | (770 | ) | — |   |
| Minority interest in consolidated special  purpose entities                              |   | 574                          |       | (1,674 | ) | 615 |   |
| Depreciation                                                                             |   | 6,380                        |       | 5,535 |   | 4,366 |   |
| Amortization of intangibles and other  assets                                            |   | 3,399                        |       | 3,743 |   | 3,097 |   |
| Deferred and other stock compensation                                                    |   | 233                          |       | 55 |   | — |   |
| Amortization of deferred financing costs                                                 |   | 1,113                        |       | 2,012 |   | 1,332 |   |
| Provision for bad debts                                                                  |   | 1,246                        |       | 1,339 |   | 2,416 |   |
| Loss on sale of property and equipment                                                   |   | —                       |       | 39 |   | 13 |   |
| Deferred income taxes                                                                    |   | (1,959                       | )          | 3,637 |   | 2,125 |   |
| Change in assets and liabilities:                                                        |   |                         |       |   |   |   |   |
| Accounts receivable                                                                      |   | 2,010                        |       | (9,368 | ) | (9,740 | ) |
| Restricted assets                                                                        |   | 1,467                        |       | (3,696 | ) | 328 |   |
| Other assets                                                                             |   | 247                          |       | 4,680 |   | (5,442 | ) |
| Accounts payable and accrued liabilities                                                 |   | 16,042                       |       | 770 |   | 5,023 |   |
| Other liabilities                                                                        |   | (2,199                       | )          | (2,360 | ) | (1,561 | ) |
| Net cash provided by operating activities                                                |   | 35,880                       |       | 11,547 |   | 10,541 |   |
|                                                                                     |   |                         |       |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                    |   |                         |       |   |   |   |   |
| Capital expenditures                                                                     |   | (11,114                      | )          | (14,168 | ) | (56,792 | ) |
| Proceeds from sales of property and  equipment                                           |   | —                       |       | 98 |   | 719 |   |
| Return of restricted assets from deferred  bonus plan                                    |   | 1,000                        |       | — |   | — |   |
| Purchases of marketable securities, net                                                  |   | —                       |       | (23,800 | ) | — |   |
| Net cash used in investing activities                                                    |   | (10,114                      | )          | (37,870 | ) | (56,073 | ) |
|                                                                                     |   |                         |       |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                    |   |                         |       |   |   |   |   |
| Payments to restricted debt payment account                                              |   | (25,100                      | )          | (10,219 | ) | — |   |
| Proceeds from long-term debt and bonds                                                   |   | 1,083                        |       | 273,774 |   | 199,796 |   |
| Payments of long-term debt                                                               |   | —                       |       | (220,393 | ) | (148,500 | ) |
| Payments of capital lease obligations                                                    |   | (113                         | )          | (42 | ) | (10 | ) |
| Proceeds from issuances of common stock                                                  |   | —                       |       | 43,822 |   | 97 |   |
| Payments of debt issuance and other  financing costs                                     |   | —                       |       | (9,537 | ) | (5,084 | ) |
| Proceeds from payments on shareholder notes                                              |   | 173                          |       | (3,650 | ) | — |   |
| Proceeds from (distributions to) equity  owners of consolidated special purpose entities |   | (614                         | )          | 6,249 |   | — |   |
| Proceeds from exercise of stock options and  warrants                                    |   | 600                          |       | 1,100 |   | 24 |   |
| Purchases of treasury stock                                                              |   | (2,429                       | )          | (2,157 | ) | (1,934 | ) |
| Net cash (used in) provided by financing  activities                                     |   | (26,400                      | )          | 78,947 |   | 44,389 |   |
|                                                                                     |   |                         |       |   |   |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                    |   | (634                         | )          | 52,624 |   | (1,143 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                        |   | 53,244                       |       | 620 |   | 1,763 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                               |   | $                            | 52,610     |   | $ | 53,244 |   | $ | 620 |   |

 

57

----

 
|                                                                                                               |   |   |   |   |   |   |   |
|--------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|
| SUPPLEMENTAL CASH FLOW DISCLOSURE:                                                                                 |   |   |   |   |   |   |   |
| Interest paid, net of amounts capitalized                                                                          |   | $      | 19,544 |   | $      | 15,728 |   | $ | 16,318 |   |
| Income taxes paid                                                                                                  |   | $      | 3,369  |   | $      | 516    |   | $ | 8,619 |   |
|                                                                                                               |   |   |   |   |   |   |   |
| OTHER NON-CASH INVESTING AND FINANCING  ACTIVITIES:                                                                |   |   |   |   |   |   |   |
| Payment of principal and interest on  long-term debt of consolidated special purpose entity from restricted assets |   | $      | 22,916 |   | $      | — |   | $ | — |   |
| Other comprehensive income                                                                                         |   |   | 1,896  |   |   | — |   |   | — |   |
| Purchases of treasury stock by deferred  bonus plan                                                                |   |   | 519    |   |   | — |   |   | — |   |
| Repayment of shareholder notes                                                                                     |   |   | 77     |   |   | — |   |   | — |   |
| Debt cancelled for stock warrants exercise                                                                         |   | — |   | 603    |   | — |   |
| Common stock issued for board of director  fees                                                                    |   | 252    |   | 125    |   | — |   |
| Borrowings on capital lease                                                                                        |   | 65     |   | 50     |   | 87     |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

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**CORNELLCOMPANIES, INC.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.             DESCRIPTION OF THE BUSINESS**

 

Cornell Companies, Inc. (collectively with its subsidiaries andconsolidated special purpose entities, the “Company”), a Delaware corporation,provides to governmental agencies the integrated development, design,construction and management of facilities within three operating divisions: (1)adult secure institutional, correctional and detention services, (2) juveniletreatment, educational and detention services and (3) pre-release correctionaland treatment services.

 

**2.             SIGNIFICANT ACCOUNTING POLICIES**

 

*Consolidation*

 

The accompanying consolidated financial statements include the accountsof the Company, its wholly-owned subsidiaries, and interests in partnershipsthat are special purpose entities or may be virtual special purpose entitiesfor which the Company owns no partnership interest, but for financial reportingpurposes only, has consolidated such special purpose entities as discussed below.  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 that is recorded as minorityinterest by the Company, the excess losses are recorded in the Company’sStatements of Operations and Comprehensive Income.

 

The Company’s lease financing arrangement under its 2000 CreditFacility is a “synthetic lease”.  Asynthetic lease is a form of lease financing that qualifies for operating leaseaccounting treatment and, when all criteria pursuant to generally acceptedaccounting principles in the United States (“GAAP”) are met, are accounted for,“off-balance sheet”.  Under such astructure, the owner/lessor of the properties (“Synthetic Lease Investor”) maybe considered a virtual special purpose entity when it obtains debt and equitycapital to finance the acquisition or construction of project(s) and leases theprojects to a company.  This financialstructure was used to finance the construction of the New Morgan Academycompleted in the first quarter of 2001, the acquisition of the Taylor StreetCenter building in early 1999, and the construction-to-date costs of theMoshannon Valley Correctional Center. The synthetic lease used by the Company to finance the above projectswas executed in December 1998 and was amended in July 2000 whereby theavailable financing was increased from $40.0 million to $100.0 million and thelease term extended to July 2005.

 

Under current accounting rules, a Synthetic Lease Investor is treatedas a virtual special purpose entity as described above, must maintain at least3.0% equity ownership interest in the property throughout the life of thelease.  The Company’s synthetic leasedocuments, as amended in July 2000, provide for the equity investor to fund3.5% of project costs.  There areprovisions in the lease and related credit documents for the lenders andSynthetic Lease Investor to fund and be paid interest, yield and fees.  Under current GAAP rules, the payment of anyyield and/or fees to the investors is required to be treated as a return ofcapital rather than a return on capital.

 

The Synthetic Lease Investor for the above mentioned projects receivedpayments to act as co-arranger in the structure of the initial $40.0 millionsynthetic lease facility in 1998 and in July 2000 when the synthetic leasefacility was increased to $100.0 million. Although the Company does not believe the lessor of the Synthetic Leaseis a special purpose entity, the lessor is considered a virtual special purposeentity under certain accounting interpretations.  Therefore, the payments discussed above could be interpreted toreduce

 

 

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the Synthetic Lease Investor’s equity ownership in the above leasedprojects below the required 3.0% level as of the second quarter of 2000.  Pursuant to this interpretation, theCompany’s synthetic leases no longer qualified for off-balance sheet treatmentas of the beginning of the second quarter of 2000.  Accordingly, the assets and liabilities and the related resultsof operations of the synthetic lease owned by the Synthetic Lease Investor havebeen consolidated in the Company’s financial statements as of that time.

 

As a result of consolidating the synthetic lease assets andliabilities, the Company’s accompanying consolidated financial statementsreflect, among other things, the depreciation expense on the associatedproperties and interest expense related to the Synthetic Lease Investor’s debtinstead of rent expense.  For income taxpurposes, the Company recognizes rent expense pursuant to the terms of itslease with the Synthetic Lease Investor and does not consolidate the assets,liabilities or the results of operations of the Synthetic Lease Investor.

 

On August 14, 2001, the Company completed an arms’ length sale andleaseback transaction involving 11 of its real estate facilities (the “2001Sale and Leaseback Transaction”).  TheCompany sold the facilities to an unaffiliated company, Municipal CorrectionsFinance, L.P. (“MCF”), and is leasing them back for an initial period of 20years, with approximately 25 years of additional renewal period options.  The Company received $173.0 million ofproceeds from the sale of these facilities. The proceeds were used to repay $120.0 million of the Company’slong-term debt and the remainder was invested in short-term securities, $43.1million of this amount being invested in securities held as collateral for theCompany’s Credit Facility.  See Note 8to the Consolidated Financial Statements.

 

MCF is an unaffiliated special purpose entity (“SPE”).  Under current accounting rules, an SPE’sequity investor must maintain at least a 3.0% equity ownership interestthroughout the life of the lease.  InSeptember 2001, the Company entered into a retainer agreement with an affiliateof the equity investor in MCF (“MCF Equity Investor”), and in November 2001,paid the MCF Equity Investor a retainer fee of $3.65 million for financialadvisory services related to potential future financing projects and thestrategic development of the Company’s business.  Under certain accounting interpretations, this retainer has beendeemed to reduce the equity investment in MCF to below the required 3.0% level.  As a result, the Company has consolidatedthe assets, liabilities, and the results of operations of MCF in the Company’saccompanying consolidated financial statements as of August 14, 2001.  As a result of consolidating the assets andliabilities of MCF, the Company’s consolidated financial statements reflect,among other things, the depreciation expense on the associated properties andinterest expense on the bond debt of MCF used to finance MCF’s acquisition ofthe 11 facilities in the 2001 Sale and Leaseback Transaction, instead of rent expense.  For income tax purposes, the Companyrecognizes rent expense pursuant to the terms of its lease with MCF and doesnot consolidate the assets, liabilities or the results of operations of MCF.

 

The cumulative losses of MCF exceeded the recorded minority interest ofMCF during the first quarter of 2002. The cumulative losses of the Synthetic Lease Investor exceeded therecorded minority interest of the Synthetic Lease Investor during the thirdquarter of 2001.  Since the cumulativelosses of MCF and the Synthetic Lease Investor exceed the equity that wasrecorded as minority interest by the Company, the excess losses can no longerbe allocated to the minority interest in the Company’s Consolidated Statementsof Operations in 2002.  In the yearended December 31, 2002, the Company recorded minority interest expense ofapproximately $0.6 million as a result of a distribution made by MCF to itsequity investors.

 

 

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*Cash and Cash Equivalents*

 

The Company considers all highly liquid unrestricted investments withoriginal maturities of three months or less to be cash equivalents.  The Company invests its available cashbalances in short term money market accounts and commercial paper.

 

*Accounts Receivable*

 

The Company extends credit to the governmental agencies and otherparties contracted with in the normal course of business.  Further, management of the Company regularlyreviews outstanding receivables, and provides estimated losses through anallowance for doubtful accounts.  Inevaluating the adequacy of this allowance for doubtful accounts, managementmakes judgments regarding its customers’ ability to make required payments,economic events and other factors.  Asthe financial condition of these parties change, circumstances develop oradditional information becomes available, adjustments to the allowance fordoubtful accounts may be required.

 

At December 31, 2002, accounts receivable include costs totalingapproximately $1.4 million for direct costs incurred by the Company since theissuance of a Stop-Work Order by the Federal Bureau of Prisons (“BOP”) in June1999 for payroll and other operating costs related to the Moshannon ValleyCorrectional Center.  These costs wereincurred at the direction of the BOP with the understanding that such costswould be reimbursed.  Although no formalwritten agreement exists, management believes that these costs will bereimbursed by the BOP.  In the event anyportion of these costs are not reimbursed by the BOP, such costs will beexpensed.  See Note 12 to theConsolidated Financial Statements.

 

*Restricted Assets*

 

Included in restricted assets at December 31, 2002 and 2001 wasapproximately $12.4 million and $10.2 million, respectively, of MCF’srestricted cash accounts.  MCF’srestricted accounts are comprised principally of a debt service fund used tosegregate rental payment funds from the Company to MCF for MCF’s semi-annualdebt service.  MCF’s funds are investedin short term certificates of deposit, money market accounts and commercialpaper.

 

For certain facilities, the Company maintains bank accounts forrestricted cash belonging to offenders or residents, commissary operations andan equipment replacement fund used in state programs.  These bank accounts and commissary inventories are collectivelyreferred to as restricted assets and the corresponding obligations are includedin accrued liabilities in the accompanying financial statements.  Restricted inmate accounts were approximately$2.1 million  and $2.2 million atDecember 31, 2002 and 2001, respectively.

 

Included in restricted assets at December 31, 2002 and 2001 wasapproximately $300,000 and $3.6 million of assets held in a rabbi trust for adeferred bonus plan.  See Note 10 to theConsolidated Financial Statements.

 

 

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*Property and Equipment*

 

Property and equipment are recorded at cost.  Ordinary maintenance and repair costs are expensed, while renewaland betterment costs are capitalized. Buildings and improvements are depreciated over their estimated usefullives of 30 to 50 years using the straight-line method.  Prepaid facility use cost, which resultedfrom the July 1996 acquisition of the Big Spring Complex and the December 1999transfer of ownership of the Great Plains Correctional Facility to a leaseholdinterest, is being amortized over 50 years using the straight-line method.  Furniture and equipment are depreciated overtheir estimated useful lives of 3 to 10 years using the straight-line method.  Amortization of leasehold improvements isrecorded using the straight-line method based upon the shorter of the life ofthe asset or the term of the respective lease.

 

*Capitalized Interest*

 

The Company capitalizes interest on facilities while under developmentand construction.  Interest capitalizedfor the years ended December 31, 2002, 2001 and 2000 was approximately$823,000, $1.3 million and $2.0 million, respectively.

 

*Debt Service Reserve Fund*

 

The debt service reserve fund was established at the closing of MCF’sbond issuance and is to be used solely for MCF’s debt service to the extentthat funds in MCF’s debt services are insufficient.  The debt service reserve fund is invested in short termcommercial instruments and earns a guaranteed rate of return of 3.0%.  See Note 11 to the Consolidated FinancialStatements.

 

*Intangible Assets*

 

Reference is made to Note 3 to the Consolidated Financial Statementsfor a discussion of the Company’s policies regarding intangible assets.

 

*Deferred Costs*

 

Costs incurred related to obtaining debt financing are capitalized andamortized over the term of the related indebtedness.  At December 31, 2002 and 2001, the Company and its consolidatedspecial purpose entities had net deferred debt issuance costs of approximately$7.5 million and $9.0 million, respectively.

 

*Realization of Long-Lived Assets*

 

In October 2001, the FASB issued SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to Be Disposed Of.”  For assets held and used in operations, SFASNo. 144 follows the framework established in SFAS No. 121, which provides forthe evaluation of impairment based on management’s estimates of futureoperating results and cash flows.  TheCompany’s adoption of SFAS No. 144 on January 1, 2002 did not have a materialimpact on the Company’s financial position and results of operations.  As of December 31, 2002, management of theCompany believes that its long-lived assets are realizable and that noimpairment allowance is necessary.

 

*Revenue Recognition*

 

Substantially all revenues are derived from contracts with federal,state and local government agencies, which pay either per diem rates based uponthe number of occupant days or hours served for the period, on 

 

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a take-or-pay basis or cost-plus reimbursement.  Revenues are recognized as services areprovided under established contractual agreements.

 

Management believes its revenue recognition practices are in conformitywith the guidelines prescribed in Securities and Exchange Commission (“SEC”)Staff Accounting Bulletin No. 101, “Revenue Recognition.”

 

*Income Taxes*

 

The Company utilizes the liability method of accounting for incometaxes as required by SFAS No. 109, “Accounting for Income Taxes.”  Under this method, deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying values of existing assetsand liabilities and their respective tax bases based on enacted tax rates.  In providing for deferred taxes, managementconsiders current tax regulations, estimates of future taxable income andavailable tax planning strategies.  Iftax regulations, operating results or the ability to implement tax planningstrategies vary, adjustments to the carrying value of deferred tax assets andliabilities may be required.

 

*Use of Estimates*

 

The Company’s financial statements are prepared in accordance withaccounting principles generally accepted in the United States.  The purpose of these financial statementsrequire that management make certain estimates and judgements that affect thereported amounts of assets, liabilities, revenues and expenses and thedisclosures of contingent assets and liabilities.  Management of the Company evaluates its estimates on an on-goingbasis, based on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances.  Actual results may differ from these estimates under differentassumptions or conditions.  The assetsand liabilities and the results of operations of the synthetic lease owned bythe Synthetic Lease Investor and of MCF have been consolidated in the Company’saccompanying consolidated financial statements.  The significant estimates made by management in the accompanyingfinancial statements include the allowance for doubtful accounts, accruals forinsurance and legal costs and the realizability of long-lived assets.

 

*Business Concentration*

 

Contracts with federal, state and local governmental agencies accountfor nearly all of the Company’s revenues. The loss of, or a significant decrease in, business from one or more of thesegovernmental agencies could have a material adverse effect on the Company’sfinancial condition and results of operations. For the years ended December 31, 2002, 2001 and 2000, 20.9%, 20.2% and21.4%, respectively, of the Company’s consolidated revenues were derived fromcontracts with the BOP, the only customer constituting more than 10.0% ofrevenues during each of these periods.

 

*Insurance Coverage*

 

The Company maintains insurance coverage for various aspects of itsbusiness and operations.  The Companyretains a portion of the losses that occur through the use of deductibles andretention under the self-insurance programs. Management regularly reviews the estimates of reported and unreportedclaims and provides for losses through insurance reserves.  As claims develop and additional informationbecomes available, adjustments to loss reserves may be required.

 

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*Financial Instruments*

 

The Company considers the fair value of all its financial instrumentsnot to be materially different from their reported carrying values at the endof each year based on management’s estimate of the Company’s ability to borrowfunds under terms and conditions similar to those of the Company’s existingdebt.

 

*Accounting for Stock-Based Compensation*

 

The Company accounts for its stock-based compensation plans inaccordance with Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (“APB No. 25”). In accordance with the provisions of APB No. 25, stock-based employeecompensation cost is not reflected in net income, as all options granted underthose plans had an exercise price equal to or in excess of the market value ofthe underlying common stock on the date of grant.  The following table illustrates in accordance with SFAS No. 148the effect of net income and earnings per share as if the Company had appliedthe fair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation,” to stock-based employee compensation (in thousands,expect per share amounts):

 
|                                           |   | **Year Ended  December 31,** |   |
|------------------------------------------------|--------|------------------------------|--------|
|                                           |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                           |   |                         |   |   |   |   |   |
| Net income, as reported                        |   | $                            | 6,362  |   | $ | 4,659 |   | $ | 7,969 |   |
| Less: total stock-based employee  compensation |   |                         |   |   |   |   |   |
| expense determined under fair value based      |   |                         |   |   |   |   |   |
| method for all awards, net of related tax      |   |                         |   |   |   |   |   |
| effects (1)                                    |   | 1,925                        |   | 1,636 |   | 1,876 |   |
| Pro forma net income                           |   | $                            | 4,437  |   | $ | 3,023 |   | $ | 6,093 |   |
| Earnings per share:                            |   |                         |   |   |   |   |   |
| Basic, as reported                             |   | $                            | .49    |   | $ | .48 |   | $ | .85 |   |
| Basic, pro forma                               |   | .34                          |   | .31 |   | .65 |   |
| Diluted, as reported                           |   | .48                          |   | .46 |   | .84 |   |
| Diluted, pro forma                             |   | .34                          |   | .30 |   | .64 |   |
|                                           |   |                         |   |   |   |   |   |
| Weighted-average fair value per share          |   |                         |   |   |   |   |   |
| of options granted (1)                         |   | $                            | 6.87   |   | $ | 6.77 |   | $ | 3.03 |   |

 

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(1)           See Note 10 foradditional information regarding the computations presented above.

 

*Earnings Per Share*

 

Basic earnings per share (“EPS”) is computed by dividing net income bythe weighted average number of shares of common stock outstanding during theperiod.  Diluted EPS reflects thepotential dilution from common stock equivalents such as stock options andwarrants.  For the year ended December31, 2002,  2001 and 2000, there were363,903 shares ($16.28 average price), 249,603 shares ($27.31 averageprice)  and 593,604 shares ($12.36average price), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive.

 

*Derivative Instruments*

 

Derivative instruments are recognized in accordance with the provisionsof SFAS Nos. 133 and 138, “Accounting for Derivative Instruments and HedgingActivities,” as amended.  The Companyhas only entered into derivative contracts that are classified as hedgedderivatives.  These hedged derivativesare 

 

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recorded at their fair value with changes in fair value reported inother comprehensive income.  See Note 11to the Consolidated Financial Statements.

 

*Reclassifications*

 

Certain reclassifications have been made to the prior period financial statementscontained herein to conform to current year presentation.  The restricted cash in the rabbi trustrelated to the deferred bonus plan of approximately $3.6 million as of December31, 2001 has been reclassified from cash to restricted assets in theaccompanying Consolidated Balance Sheets and Consolidated Statements of CashFlows.  Additionally, principal andinterest payments made by MCF from the restricted debt service fund have beenreclassified  to a non-cash activity aspayments were made out of restricted assets and rent payments made by theCompany into the debt service fund have been reclassed to a financing activityin the Consolidated Statements of Cash Flows. Also, changes in minority interest in consolidated special purposeentities, other than the initial funding by the minority interest holder, havebeen reclassified from an investing activity to an operating activity in theConsolidated Statements of Cash Flows.

 

**3.             CHANGES IN ACCOUNTING PRINCIPLES**

 

*Change in Accounting Principle Effective January 1, 2002*

 

Effective January 1, 2002 the Company adopted the new requirement ofSFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and OtherIntangible Assets”.  The new rules underthese statements require that the purchase method of accounting be used for allbusiness combinations and specifies the criteria for the recognition ofintangible assets separately from goodwill. Under the new rules, goodwill is no longer amortized but is subject toan impairment test  annually.  Other intangible assets that meet the newcriteria under the new rules will continue to be amortized over their remaininguseful lives.

 

The following table reflects, on a pro forma basis, the results ofoperations as though goodwill was no longer amortized, as a result of theadoption of SFAS No. 142, as of January 1, 2000 (in thousands, except per shareamounts):

 
|                                                                                                   |   | **Year Ended  December 31,** |   |
|--------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                                   |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                                                                                   |   |                         |   |   |   |   |   |
| Reported income before extraordinary charge  and cumulative effect of changes in accounting principles |   | $                            | 7,327  |   | $ | 6,835 |   | $ | 7,969 |   |
| Goodwill amortization, net of tax                                                                      |   | —                       |   | 518 |   | 523 |   |
| Adjusted income before extraordinary charge  and cumulative effect of changes in accounting principles |   | $                            | 7,327  |   | $ | 7,353 |   | $ | 8,492 |   |
|                                                                                                   |   |                         |   |   |   |   |   |
| Reported net income                                                                                    |   | $                            | 6,362  |   | $ | 4,659 |   | $ | 7,969 |   |
| Goodwill amortization, net of tax                                                                      |   | —                       |   | 518 |   | 523 |   |
| Adjusted net income                                                                                    |   | $                            | 6,362  |   | $ | 5,177 |   | $ | 8,492 |   |
|                                                                                                   |   |                         |   |   |   |   |   |   |   |   |
| Basic earnings per share:                                                                              |   |                         |   |   |   |   |   |
| Adjusted income before extraordinary charge  and cumulative effect of changes in accounting principles |   | $                            | .57    |   | $ | .76 |   | $ | .91 |   |
| Adjusted net income                                                                                    |   | $                            | .49    |   | $ | .54 |   | $ | .91 |   |
|                                                                                                   |   |                         |   |   |   |   |   |
| Diluted earnings per share:                                                                            |   |                         |   |   |   |   |   |
| Adjusted income before extraordinary charge  and cumulative effect of changes in accounting principles |   | $                            | .55    |   | $ | .73 |   | $ | .89 |   |
| Adjusted net income                                                                                    |   | $                            | .48    |   | $ | .51 |   | $ | .89 |   |

 

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The Company determined the fair market value of the applicablereporting unit’s net assets in accordance with SFAS No. 142 and recorded acumulative effect of change in accounting principle charge of approximately$965,000, net of an income tax benefit of approximately $671,000, at January 1,2002 for the impairment of goodwill as a result of the adoption of SFAS No.142.

 

The changes in the carrying amount of goodwill for the year endedDecember 31, 2002 are as follows (in thousands):

 
|                            |   | **Adult  Secure** | ** **   |       | ** **      |       | ** ** |   |   |
|---------------------------------|--------|-------------------|--------------|------------|-----------------|------------|------------|--------|--------|
|                            |   | ** **        | **Juvenile** | ** ** | **Pre-Release** | ** ** | **Total**  |   |
|                            |   |              |         |       |            |       |       |   |   |
| Balance as of December 31, 2001 |   | $                 | 1,509        |       | $               | 1,915      |       | $      | 5,933  |   | $ | 9,357 |   |
| Impairment charge               |   | —            |         | (855       | )               | (781       | )          | (1,636 | )      |
| Balance as of December 31, 2002 |   | $                 | 1,509        |       | $               | 1,060      |       | $      | 5,152  |   | $ | 7,721 |   |

 

At December 31, 2002, management believes there is not an impairment tothe Company’s existing goodwill.

 

Other intangible assets at December 31, 2002 and 2001 consisted of thefollowing (in thousands):

 
|                        |   | **2002** |   | **2001** |   |
|-----------------------------|--------|----------|--------|----------|--------|
|                        |   |     |   |     |   |
| Non-compete agreements      |   | $        | 8,300  |     | $      | 8,180 |   |
| Accumulated amortization    |   | (2,959   | )      | (2,081   | )      |
| Non-compete agreements, net |   | $        | 5,341  |     | $      | 6,099 |   |

 

Amortization expense for the Company’s non-compete agreements wasapproximately $878,000 for each of the years ended December 31, 2002, 2001 and2000.  Amortization expense for theCompany’s non-compete agreements is expected to be approximately $878,000 foreach of the next five years.

 

*Change in Accounting Principle Effective January 1, 2001*

 

Effective January 1, 2001, the Company changed its method of accountingfor durable supplies whereby the Company capitalizes durable operating supplypurchases such as uniforms, linens and books and amortizes these costs tooperating expense over an estimated period of benefit of 18 months.  Effective January 1, 2001, the Companycapitalized a portion of previously expensed durable operating supplies and, asa result, recognized a benefit of approximately $770,000 (net of an income taxbenefit of approximately $535,000) which has been reflected as a cumulativeeffect of a change in accounting principle in the accompanying ConsolidatedStatements of Operations and Comprehensive Income.  For the year ended December 31, 2000 the pro forma impact of thischange in accounting would have been immaterial.

 

**4.             NEW ACCOUNTING PRONOUNCEMENTS**

 

In June 2001, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standard (“SFAS”) No. 143, “Accounting forAsset Retirement Obligations” (“SFAS No. 143”) which requires entities torecognize the fair value of a liability for legal obligations associated withthe retirement of tangible long-lived assets in the period incurred, if areasonable estimate of the fair value can be made. The Company adopted SFAS No.143 in January 2003.  Managementbelieves there will be no material effect on the Company’s financial position,results of operations or stockholders’ equity as a result of the adoption ofthis new pronouncement.

 

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In April 2002, the FASB issued SFAS No. 145, “Rescission of SFAS Nos.4, 44, 64, Amendment of FASB Statement No. 13, and Technical Corrections,”effective for fiscal years beginning after May 15, 2002 (“SFAS No. 145”).  SFAS No. 145 rescinds SFAS Nos. 4, 44, 64and amends SFAS No. 13, “Accounting for Leases,” to eliminate an inconsistencybetween the required accounting for sale and leaseback transactions and therequired accounting for certain lease modifications that have economic effectsthat are similar to sale and leaseback transactions.  Additionally, SFAS No. 145 requires gains and losses on the extinguishmentof debt to be classified as income or loss from continuing operations ratherthan as extraordinary items as previously required under SFAS No. 4.  The Company adopted SFAS No. 145, asrequired, on January 1, 2003.  TheCompany recorded an extraordinary charge of approximately $0.5 million, net ofincome tax of $0.3 million, in the third quarter of 2001 for the earlyretirement of debt.  Additionally, inthe fourth quarter of 2001, the Company recognized an extraordinary charge ofapproximately $2.9 million, net of income taxes of $2.0 million, for thewrite-off of the related unamortized deferred debt issuance costs, debtdiscount and assessed contractual prepayment fees as a result of the earlyretirement of the Company’s subordinated notes.  As a result of the adoption of the provisions of SFAS No. 145,for financial reporting periods subsequent to December 31, 2002, gains andlosses on the extinguishment of debt previously reflected as an extraordinarycharge will be reclassified to an expense from continuing operations beforeincome taxes.

 

In July 2002, the FASB issued SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities (“SFAS No. 146”), which addressesthe financial accounting and reporting associated with exit or disposalactivities initiated after December 31, 2002. Under SFAS No. 146, costs associated with an exit or disposal activityshould be recognized and measured at the fair value in the period in which theliability is incurred rather than at the date of a commitment to an exit ordisposal plan.  The Company is requiredto adopt SFAS No. 146 for all exit and disposal activities initiated afterDecember 31, 2002.  Management believesthere will be no material effect on the Company’s financial position, resultsof operations or stockholders’ equity as result of the adoption of this newpronouncement.

 

On December 31, 2002, the FASB issued SFAS No. 148, “Accounting forStock-Based Compensation — Transition and Disclosure” which amends SFAS No.123, “Accounting for Stock-Based Compensation.”  SFAS No. 148 provides two additional alternative transitionmethods for recognizing an entity’s voluntary decision to change its method ofaccounting for stock-based employee compensation to the fair-value method.  In addition, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 so that entities will have to (1) makemore-prominent disclosures regarding the pro forma effects of using thefair-value method of accounting for stock-based compensation, (2) present thosedisclosures in a more accessible format in the footnotes to the annualfinancial statements and (3) include those disclosures in interim financialstatements.  SFAS No. 148’s transitionguidance and provisions for annual disclosures are effective for fiscal yearsending after December 15, 2002 and the related disclosures are contained inNote 10 to these financial statements. The provisions for interim-period disclosures are effective forfinancial reports that contain financial statements for interim periodsbeginning after December 15, 2002.  TheCompany has adopted the annual disclosure provisions of SFAS No. 148 in thesefinancial statements.  See Note 2 to theConsolidated Financial Statements.

 

In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”),“Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others.”  FIN 45 requires a guarantor to include disclosure of certainobligations, and if applicable, at the inception of the guarantee, recognize aliability for the fair value of other certain obligations undertaken in issuinga guarantee.  The provisions related tothe disclosure requirements are effective for financial statement periodsending after December 15, 2002.  Theprovisions related to recognition and measurement of guarantees are effectivefor financial statement periods beginning after December 31, 2002 on aprospective basis.  The Company hasadopted the disclosure provisions of FIN 45 in these financial statements.  The Company adopted the provisions relatedto the recognition and measurement of guarantees as of January 1, 2003.  

 

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Management believes such provisions will not have a significant impacton the Company’s results of operations or financial position.  See Note 8 and 9 to the ConsolidatedFinancial Statements.

 

In January 2003, the FASB issued Interpretation No. 46, “Consolidationof Variable Interest Entities” (“FIN 46”), which addresses the consolidation ofvariable interest entities as defined in the Interpretation.  FIN 46 requires an assessment of equityinvestments to determine if they are variable interest entities.  FIN 46 is effective immediately for all variableinterest entities created after January 31, 2003.  For variable interest entities created before February 1, 2003,the provisions of FIN 46 must be applied no later than the beginning of thefirst interim period or annual reporting period beginning after June 15,2003.   In addition, if it is reasonablypossible that an enterprise will consolidate or disclose information about avariable interest entity, the enterprise must discuss the following informationin all financial statements issued after January 31, 2003: (1) the nature,purpose, size or activities of the variable interest entity and (2) theenterprise’s maximum exposure to loss as a result of its involvement with thevariable interest entity.  The Company’sadoption of FIN 46 does not change the Company’s accounting for the 2000synthetic lease transaction and the 2001 Sale and Leaseback Transaction whichare consolidated for reporting purposes. It is reasonably possible that the Company may enter into futurearrangements for the development of new facilities or to operate facilitieswhich may become subject to the provisions of FIN 46 and, in some cases, may berequired to consolidate the related activities, facilities and financings.

 

**5.             PROPERTY AND EQUIPMENT**

** **

Property and equipment were as follows (inthousands)

 
|                                      |   | **December  31,** | ** ** |
|-------------------------------------------|--------|-------------------|------------|
|                                      |   | **2002**          | ** ** | **2001** | ** ** |
|                                      |   |              |       |   |   |
| Land                                      |   | $                 | 26,354     |   | $ | 25,382 |   |
| Prepaid facility use                      |   | 71,323            |       | 71,323 |   |
| Buildings and improvements                |   | 154,910           |       | 151,354 |   |
| Furniture and equipment                   |   | 17,328            |       | 11,489 |   |
| Construction in progress                  |   | 16,364            |       | 15,681 |   |
|                                      |   | 286,279           |       | 275,229 |   |
| Accumulated depreciation and amortization |   | (30,829           | )          | (21,986 | ) |
|                                      |   | $                 | 255,450    |   | $ | 253,243 |   |

 

                Constructionin progress at December 31, 2002 and 2001 consisted primarily of constructioncosts attributable to the Moshannon Valley Correctional Center.

 

                The Companyevaluates realization of property and equipment pursuant to the provision ofSFAS No. 144.  In connection with theCompany’s evaluation, management makes judgments regarding future operatingresults and cash flows associated with individual facilities.  Additionally, should management decide tosell a facility, realization is evaluated based on the estimated salesprice.  The Company is currentlyevaluating alternatives for the New Morgan Academy and negotiating a revisedcontract with the BOP for the Moshannon Valley Correctional Center.  Realization of the Company’s investment inboth of these facilities is based on management’s judgements and expectationsrelated to legislative activities, economic events and other factors.  Management has also evaluated therealization of its other facilities and does not believe that an impairmentexists related to any of the Company’s facilities as of December 31, 2002.

 

                During thefourth quarter of 2000, the Company entered into a license agreement with aconstruction contractor that conveyed certain rights to the design of an adultsecure institution.  As a result, anon-recurring license agreement payment of $950,000 was recognized as revenueby the Company in 2000.  The 

 

68

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Company has not licensed such designs in prior years and does notexpect to generate significant revenues from such activity in future periods.

 

**6.            DETAIL OF CERTAIN BALANCE SHEETACCOUNTS**

 

***                Accounts Payable and Accrued Liabilities***

 

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

 
|                     |   | **December  31,** |   |
|--------------------------|--------|-------------------|--------|
|                     |   | **2002**          |   | **2001** |   |
|                     |   |              |   |   |   |
| Accounts payable         |   | $                 | 10,910 |   | $ | 12,317 |   |
| Accrued compensation     |   | 6,668             |   | 7,281 |   |
| Accrued interest payable |   | 6,728             |   | 6,366 |   |
| Accrued insurance        |   | 3,598             |   | 2,532 |   |
| Resident funds           |   | 2,064             |   | 2,370 |   |
| Other                    |   | 2,654             |   | 3,068 |   |
|                     |   | $                 | 32,622 |   | $ | 33,934 |   |

 

***Allowance forDoubtful Accounts***

 

The changes in the Company's allowance for doubtful accounts for theyears ended December 31, 2002, 2001 and 2000 are as follows (in thousands):

 
|                            |   | **Year Ended  December 31,** |   |
|---------------------------------|--------|------------------------------|--------|
|                            |   | **2002**                     |   | **2001** |   | **2000** |   |
| Balance at beginning of period  |   | $                            | 3,068  |   | $ | 2,578 |   | $ | 3,002 |   |
| Provision for bad debts         |   | 1,246                        |   | 1,339 |   | 2,416 |   |
| Write-offs of bad debt accounts |   | (2,076                       | )      | (849 | ) | (2,840 | ) |
| Balance at end of period        |   | $                            | 2,238  |   | $ | 3,068 |   | $ | 2,578 |   |

 

**7.             INCOME TAXES**

 

 

                The followingis an analysis of the Company’s deferred tax assets and liabilities (inthousands):

 
|                               |   | **December  31,** |   |
|------------------------------------|--------|-------------------|--------|
|                               |   | **2002**          |   | **2001** |   |
| Deferred tax assets:               |   |              |   |   |   |
| Accrued liabilities and allowances |   | $                 | 3,589  |   | $ | 2,256 |   |
| Deferred compensation              |   | 427               |   | 325 |   |
| Other                              |   | 718               |   | 552 |   |
|                               |   | 4,734             |   | 3,133 |   |
| Deferred tax liabilities:          |   |              |   |   |   |
| Depreciation and amortization      |   | 4,894             |   | 5,053 |   |
| Prepaid expenses                   |   | 716               |   | 459 |   |
| Other                              |   | 778               |   | 1,234 |   |
|                               |   | 6,388             |   | 6,746 |   |
| Net deferred tax liability         |   | $                 | (1,654 | ) | $ | (3,613 | ) |

 

                Thecomponents of the Company’s income tax provision were as follows (inthousands):

 
|                                                   |   | **Year Ended  December 31,** |   |
|--------------------------------------------------------|--------|------------------------------|--------|
|                                                   |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                                   |   |                         |   |   |   |   |   |
| Current provision (benefit)                            |   | $                            | 6,240  |   | $ | (191 | ) | $ | 3,413 |   |
| Deferred provision (benefit)                           |   | (1,959                       | )      | 3,637 |   | 2,125 |   |
|                                                   |   | $                            | 4,281  |   | $ | 3,446 |   | $ | 5,538 |   |
|                                                   |   |                         |   |   |   |   |   |
| Continuing operations                                  |   | $                            | 4,952  |   | $ | 4,958 |   | $ | 5,538 |   |
| Extraordinary charge                                   |   | —                       |   | (2,047 | ) | — |   |
| Cumulative effect of changes in accounting  principles |   | (671                         | )      | 535 |   | — |   |
|                                                   |   | $                            | 4,281  |   | $ | 3,446 |   | $ | 5,538 |   |

 

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                The followingis a reconciliation of income taxes at the statutory federal income tax rate of35% to the income tax provision recorded by the Company (in thousands):

 
|                                       |   | **Year Ended  December 31,** |   |
|--------------------------------------------|--------|------------------------------|--------|
|                                       |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                       |   |                         |   |   |   |   |   |
| Computed taxes at statutory rate           |   | $                            | 3,725  |   | $ | 2,648 |   | $ | 4,728 |   |
| Amortization of non-deductible intangibles |   | —                       |   | 119 |   | 129 |   |
| State income taxes, net of federal benefit |   | 380                          |   | 562 |   | 460 |   |
| Other                                      |   | 176                          |   | 117 |   | 221 |   |
|                                       |   | $                            | 4,281  |   | $ | 3,446 |   | $ | 5,538 |   |

** **

**8.             CREDIT FACILITIES**

 

                The Company’slong-term debt consisted of the following (in thousands):

 
|                                           |   | **December  31,** |    |
|------------------------------------------------|--------|-------------------|---------|
|                                           |   | **2002**          |    | **2001** |   |
|                                           |   |              |    |   |   |
| **Debt of Cornell Companies, Inc.:**           |   |              |    |   |   |
| Capital lease obligations                      |   | $                 | 37      |   | $ | 85 |   |
| Subtotal                                       |   | $                 | 37      |   | $ | 85 |   |
|                                           |   |              |    |   |   |
| **Debt of Special Purpose Entities:**          |   |              |    |   |   |
| Synthetic Lease Investor Note A due July  2005 |   |              |    |   |   |
| with an interest rate of LIBOR plus 3.25%      |   | $                 | 41,117  |   | $ | 40,197 |   |
| Synthetic Lease Investor Note B due July  2005 |   |              |    |   |   |
| with an interest rate of LIBOR plus 3.50%      |   | 8,134             |    | 7,971 |   |
| 8.47% Bonds due 2016                           |   | 190,600           |    | 197,400 |   |
| Subtotal                                       |   | $                 | 239,851 |   | $ | 245,568 |   |
|                                           |   |              |    |   |   |
| Consolidated total debt                        |   | $                 | 239,888 |   | $ | 245,653 |   |
|                                           |   |              |    |   |   |
| Less: current maturities                       |   | (7,630            | )       | (6,885 | ) |
|                                           |   |              |    |   |   |
| Consolidated long-term debt                    |   | $                 | 232,258 |   | $ | 238,768 |   |

 

                The Company’s2000 Credit Facility, as amended, provides for borrowings of up to $45.0million under a revolving line of credit. The commitment amount is reduced by $1.6 million quarterly beginning inJuly 2002 and by outstanding letters of credit.  Accordingly, the available commitment amount under the amended2000 Credit Facility was approximately $36.7 million at December 31, 2002.  The Company had outstanding letters ofcredit of approximately $5.1 million at December 31, 2002.  The amended 2000 Credit Facility matures inJuly 2005 and bears interest, at the election of the Company, at either theprime rate plus a margin of 2.0%, or a rate which is 3.0% above the applicableLIBOR rate.  The amended 2000 CreditFacility is collateralized by substantially all of the Company’s assets,including the stock of all of the Company’s subsidiaries; does not permit thepayment of cash dividends; and requires the Company to comply with certainleverage, net worth and debt service coverage covenants.  Additionally, the Company is limited to $2.5million annually for the repurchase of its common stock an aggregate limit of$7.5 million.  The Company has obtaineda waiver from the lenders under the amended 2000 Credit Facility regarding thepending contractual default for the Moshannon Valley Correctional Center’sconstruction delay.  This waiver iseffective through October 31, 2004.  Includedin the Company’s cash and cash equivalents at December 31, 2002 is approximately$39.4 million that is invested in a separate account that is available to theCompany for investment purposes or working capital with the approval of thelenders under the amended 2000 Credit Facility.  This separate account is maintained, in part, to assure futurecredit availability.

 

 

70

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                Additionally,the amended 2000 Credit Facility provides the Company with the ability to enterinto synthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provides for funding to the lessor under the operatingleases of up to $100.0 million, of which approximately $51.0 million had beenutilized as of December 31, 2002.  TheCompany expects to utilize the remaining capacity under this synthetic leasefinancing arrangement to complete construction of the Moshannon ValleyCorrectional Center.  The SyntheticLease Investor’s Note A and Note B have total credit commitments of $81.4million and $15.1 million, respectively. The Company pays commitment fees at a rate of 0.5% annually for theunused portion of the synthetic lease financing capacity.  The Synthetic Lease Investor’s Notes A and Bare cross-collateralized with the Company’s revolving line of credit andcontain cross-default provisions.

 

                On August 14,2001, MCF issued $197.4 million of 8.47% taxable revenue bonds due August 1,2016.  Interest on the bonds is payableby MCF semi-annually on February 1 and August 1, commencing February 1, 2002,and principal is due in escalating annual installments commencing August 1,2002.

 

                On August 14,2001, the Company repaid the $50.0 million of outstanding 7.74% Senior SecuredNotes with a portion of the proceeds from the 2001 Sale and Leaseback Transaction.

 

                On November30, 2001 the Company completed an offering of its common stock.  Net proceeds from the sale of 3,450,000 ofnewly issued shares were approximately $43.8 million.  The Company used a portion of the proceeds to repay outstandingborrowings of $39.4 million and retire the notes under the Company’s Note andEquity Purchase Agreements (the “Subordinated Notes”) entered into in July2000.

 

                As a resultof the early retirement of the Subordinated Notes during the fourth quarter of2001, the Company recognized an extraordinary charge of $2.9 million, net ofincome taxes of $2.0 million, due to the write-off of the related unamortizeddeferred debt issuance costs, debt discount and assessed contractual prepaymentfees. As a result of the adoption of the provisions of SFAS No. 145, forfinancial reporting periods subsequent to December 31, 2002, gains and losseson the extinguishment of debt previously reflected as an extraordinary chargewill be reclassified to an expense from continuing operations before incometaxes.

 

                Scheduledmaturities of long-term debt were as follows (in thousands):

 
|                             |   |                          |       | **Synthetic  Lease  Investor** |   |             |   |    |    |
|----------------------------------|--------|-------------------------------|------------|--------------------------------|--------|------------------|--------|---------|---------|
|                             |   | **Cornell  Companies,  Inc.** |       |                           |   |             |   |    |
|                             |   | ** **                    | ** ** | **MCF**                        |   | **Consolidated** |   |
|                             |   |                          |       |                           |   |             |   |    |    |
| For the year ending December 31, |   |                          |       |                           |   |             |   |    |    |
| 2003                             |   | $                             | 37         |                           | $      | —           |   | $       | 7,600   |   | $ | 7,637 |   |
| 2004                             |   | —                        |       | —                         |   | 8,300            |   | 8,300   |    |
| 2005                             |   | —                        |       | 49,251                         |   | 9,000            |   | 58,251  |    |
| 2006                             |   | —                        |       | —                         |   | 9,700            |   | 9,700   |    |
| Thereafter                       |   | —                        |       | —                         |   | 156,000          |   | 156,000 |    |
| Total                            |   | $                             | 37         |                           | $      | 49,251           |   | $       | 190,600 |   | $ | 239,888 |   |

 

The Company has certain guarantees that are required to be disclosedunder FIN 45.  The Company has arrangedfor letters of credit to be issued under the amended 2000 Credit Facilityprimarily to meet requirements for certain workers’ compensation insuranceobligations.  The Company hadoutstanding letters of credit of approximately $5.1 million at December 31,2002.  These letters of credit expireannually.

 

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**9.             COMMITMENTS AND CONTINGENCIES**

 

*Financial Guarantee*

 

During the normal course of business, the Company enters into contractsthat contain a variety of representations and warranties and provide generalindemnifications.  The Company’s maximumexposure under these arrangements is unknown as this would involve futureclaims that may be made against the Company that have not yet occurred.  However, based on experience, the Companybelieves the risk of loss to be remote.

 

*Operating Leases*

 

The Company leases office space, certain facilities and furniture andequipment under long-term operating leases. Rent expense for all operating leases for the years ended December 31,2002, 2001 and 2000, was approximately $9.0 million, $11.4 million and $9.7million, respectively.

 

Under the amended 2000 Credit Facility, the Company entered into anoperating lease agreements that are considered to be a virtual special purposeentity for the acquisition or development of operating facilities.  This synthetic lease financing arrangementprovides for funding from the virtual special purpose entity under theoperating leases of up to $100.0 million, of which approximately $51.0 millionhad been utilized as of December 31, 2002. The remaining capacity under this synthetic lease financing arrangementis expected to be utilized to complete the construction of the Moshannon ValleyCorrectional Center.  At December 31,2002, approximately $16.1 million of had been utilized under this syntheticlease financing arrangement for construction costs for the Moshannon ValleyCorrectional Center.  The leases underthis arrangement each have a term of the lesser of five years or July 2005,include purchase and renewal options, and provide for residual value guaranteesfor each lease that average 81.4% of the total cost and would be due by theCompany upon termination of the leases. Upon termination of a lease, the Company could either exercise apurchase option, or the facilities could be sold to a third party.  The Company expects the fair market value ofthe leased facilities to substantially reduce or eliminate the Company’spotential obligation under the residual value guarantee.  At December 31, 2002, there were twooperating leases under this arrangement. Lease payments under the lease financing arrangements are variable andare adjusted for changes in interest rates.

 

Because the long-term debt of the virtual special purpose entityrelated to the lease agreements described above and of MCF is consolidated inthe Company’s financial statements as described in Note 2 and 8 to theConsolidated Financial Statements, the related rental commitments under theseleases are not included in the table below.

 

In November 1999, the Company entered into an agreement for the saleand leaseback of certain of its furniture and equipment.  The Company has purchase and lease renewaloptions at projected future fair market values under this agreement.  The lease is classified as an operatingleases.  At the date of sale, furnitureand equipment with carrying values totaling approximately $11.8 million weresold and the gain realized on the sale totaling approximately $7.3 million wasdeferred and is being amortized as a credit to rent expense over the leaseterm.

 

 

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As of December 31, 2002, the Company had thefollowing rental commitments under noncancelable operating leases (inthousands):

 

| For the year ending December 31, |   |   |   |
|----------------------------------|--------|--------|--------|
| 2003                             |   | $      | 7,335  |   |
| 2004                             |   | 2,646  |   |
| 2005                             |   | 1,833  |   |
| 2006                             |   | 1,107  |   |
| 2007                             |   | 842    |   |
| Thereafter                       |   | 17,621 |   |
| Total                            |   | $      | 31,384 |   |

 

*401(k) Plan*

 

The Company has a defined contribution 401(k) plan.  The Company’s matching contributioncurrently represents 50% of a participant’s contribution, up to the first 6% ofthe participant’s salary.  For the yearsended December 31, 2002, 2001 and 2000, the Company recorded contributionexpense of approximately $1.2 million, $1.1 million and $923,000, respectively.

 

*Legal Proceedings*

 

In March and April 2002, the Company, Steven W. Logan, and John L.Hendrix, were named as defendants in four Federal putative class actionlawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*, No. H-02-0866,in the United States District Court for the Southern District of Texas, HoustonDivision; (2) *Richard Picard, On Behalf of Himself and All Others Similarly Situatedv. Cornell Companies, Inc., et al.*, No. H-02-1075, in the UnitedStates District Court for the Southern District of Texas, Houston Division; (3)*Louis A.Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the United StatesDistrict Court for the Southern District of Texas, Houston Division, and (4) *Anthony J.Scolaro, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1567, in the United StatesDistrict Court for the Southern District of Texas, Houston Division.  The aforementioned lawsuits are putativeclass action lawsuits brought on behalf of all purchasers of the Company’s commonstock between March 6, 2001 and March 5, 2002. The lawsuits involve disclosures made concerning two prior transactionsexecuted by the Company: the August 2001 sale leaseback transaction and the2000 synthetic lease transaction.  Thesefour lawsuits have all been consolidated into the *Graydon Williams*action.  Recently, the Court grantedFlyline Partners, LP’s motion to be appointed as lead plaintiff and FlylinePartners, LP has filed a consolidated complaint.  The consolidated complaint alleges that the defendants violatedSection 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule10b-5 promulgated under Section 10(b) of the Exchange Act, Section 20(a) of theExchange Act and Section 11 of the Securities Exchange Act of 1933.  The consolidated complaint seeks, amongother things, restitution damages, compensatory damages, rescission orrescissory measure of damages, costs, expenses, attorneys’ fees and expertfees.  The Company believes that it hasgood defenses to each of the plaintiffs’ claims and intends to vigorouslydefend against each of the claims.

 

In March 2002, the Company, its directors, and its former independentauditor Arthur Andersen LLP, were sued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant Cornell Companies,Inc. v. Anthony R. Chase, et al.*, No. 2002-15614, in the 127th Judicial DistrictCourt of Harris County, Texas.  Thelawsuit alleges breaches of fiduciary duty by all of the individual defendantsand asserts breach of contract and professional negligence claims only againstArthur Andersen LLP.  The Companybelieves that it has good defenses to each of the plaintiff’s claims andintends to vigorously defend against each of the claims.

 

73

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In May and June 2002, the Company and its directors were sued in threeother derivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalfof Cornell Companies, Inc. v. Steven W. Logan, et. al.,* No. H-02-1812,in the United Stated District Court for the Southern District of Texas, HoustonDivision; (2) *Thomas Pagano, Derivatively on Behalf of Cornell Companies, Inc. v.Steven W. Logan, et. al.*, No. H-02-1896, in the United StatedDistrict Court for the Southern District of Texas, Houston Division; and (3) *JesseMenning, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan,et. al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits all allege breaches of fiduciary duty and waste of corporate assets byall of the defendants.  A motion todismiss the *Guitierrez*and *Pagano*lawsuits was filed.  The court dismissedthe *Pagano*action as duplicative of the *Guitierrez* action.  The motion to dismiss the *Guitierrez*action is still pending.  The Companybelieves that it has good defenses to each of the plaintiffs’ claims and intendto vigorously defend against each of these claims.

 

While the plaintiffs in these cases have not quantified their claim ofdamages and the outcome of the matters discussed above cannot be predicted withcertainty, based on information known to date, management believes that theultimate resolution of these matters will not have a material adverse effect onthe Company’s financial position, operating results or cash flow.

 

The Company currently and from time to time is subject to claims andsuits arising in the ordinary course of business, including claims for damagesfor personal injuries or for wrongful restriction of, or interference with,offender privileges and employment matters.

 

**10.          STOCKHOLDERS’ EQUITY**

 

*Common Stock Offering*

 

On November 30, 2001, the Company completed an offering of its commonstock.  Net proceeds to the Company fromthe sale of the 3,450,000 shares of newly issued Common Stock wereapproximately $43.8 million.  Proceedsfrom the offering were used to repay indebtedness of $39.4 million with theremainder for general working capital purposes.

 

*Stockholder Rights Plan*

 

On May 1, 1998, the Company adopted a stockholder rights plan.  Under the plan, each stockholder of recordat the close of the business day on May 11, 1998, received one Preferred StockPurchase Right (“Right”) for each share of common stock held.  The Rights expire on May 1, 2008.  Each Right initially entitles thestockholder to purchase one one-thousandth of a Series A Junior ParticipatingPreferred Share for $120.00.  EachPreferred Share has terms designed to make it economically equivalent to onethousand common shares.  The Rights willbecome exercisable only in the event a person or group acquires 15% or more ofthe Company’s common stock or commences a tender or exchange offer which, ifconsummated, would result in that person or group owning 15% or more of theCompany’s common stock.  If a person orgroup acquires a 15% or more position in the Company, each Right (except thoseheld by the acquiring party) will then entitle its holder to purchase, at theexercise price, common stock of the Company having a value of twice theexercise price.  The effect will be toentitle the holder to buy the common stock at 50% of the market price.  Also, if following an acquisition of 15% ormore of the Company’s common stock, the Company is acquired by that person orgroup in a merger or other business combination transaction, each Right wouldthen entitle its holder to purchase common stock of the acquiring companyhaving a value of twice the exercise price. The effect will be to entitle the Company’s stockholders to buy stock inthe acquiring company at 50% of the market price.  The Company may redeem the Rights at $0.01 per Right at any timeprior to the acquisition of 15% or more of its common stock by a person orgroup.

 

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*Preferred Stock*

 

Preferred stock may be issued from time to time by the Board ofDirectors of the Company, which is responsible for determining the voting,dividend, redemption, conversion and liquidation features of any preferredstock.

 

*Options*

 

In December 2000, the Company adopted the 2000 Broad-Based EmployeePlan (“2000 Plan”).  Pursuant to the2000 Plan, the Company may grant non-qualified stock options for up to thegreater of 515,232 shares or 4% of the aggregate number of shares of common stockoutstanding.  The 2000 Plan options vestup to five years and expire ten years from the grant date.  In May 1996, the Company adopted the 1996Stock Option Plan and amended and restated the plan in April 1998 (“1996Plan”).  Pursuant to the 1996 Plan, theCompany may grant non-qualified and incentive stock options for up to thegreater of 1,932,119 shares or 15.0% of the aggregate number of shares ofcommon stock outstanding.  The 1996 Planoptions vest up to seven years and expire seven to ten years from the grantdate.  The Compensation Committee of theBoard of Directors, which is comprised of independent directors,  is responsible for determining the exerciseprice and vesting terms for the granted options.  The 1996 Plan and 2000 Plan option exercise prices can be no lessthan the market price of the Company’s common stock on the date of grant.

 

In conjunction with the issuance of the Subordinated Notes in July2000, the Company issued warrants to purchase 290,370 shares of the commonstock at an exercise price of $6.70. The Company recognized the fair value of these warrants of $1.1 millionas additional paid-in capital.  Thewarrants may only be exercised by payment of the exercise price in cash to theCompany, by cancellation of an amount of warrants equal to the fair marketvalue of the exercise price, or by the cancellation of Company indebtednessowed to the warrant holder.  During2001, 168,292 shares of Common Stock were issued in conjunction with theexercise and cancellation of 217,778 warrants.

 

The following is a summary of the status of the Company’s 2000 Plan,1996 Plan and other options at December 31, 2002, 2001 and 2000, and changesduring the years then ended:

 
|                                            |   | **2002**   |       | **2001**                               |       | **2000**   |       |
|-------------------------------------------------|--------|------------|------------|----------------------------------------|------------|------------|------------|
|                                            |   |       | ** ** | **Weighted  Average  Exercise  Price** | ** ** |       | ** ** | **Weighted  Average  Exercise  Price** | ** ** |   | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                            |   |       | ** ** | ** **                             |       | ** ** | ** ** |   | ** ** |   |
|                                            |   |       | ** ** | ** **                             |       | ** ** | ** ** |   | ** ** |   |
|                                            |   | **Shares** | ** ** | ** **                             | **Shares** | ** ** | ** ** | **Shares** | ** ** |   |
|                                            |   |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Outstanding at beginning of year                |   | 1,178,624  |       | $                                      | 7.98       |       | 1,294,048  |   | $ | 7.70 |   | 1,242,637 |   | $ | 11.46 |   |
| Granted                                         |   | 388,400    |       | 10.87                                  |       | 70,000     |       | 9.76 |   | 378,877 |   | 5.30 |   |
| Exercised                                       |   | (95,059    | )          | 2.11                                   |       | (156,923   | )          | 5.64 |   | (10,000 | ) | 2.50 |   |
| Forfeited or canceled                           |   | (62,120    | )          | 13.99                                  |       | (28,501    | )          | 12.26 |   | (317,466 | ) | 19.74 |   |
| Outstanding at end of year                      |   | 1,409,845  |       | 9.20                                   |       | 1,178,624  |       | 7.98 |   | 1,294,048 |   | 7.70 |   |
|                                            |   |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Exercisable at end of year                      |   | 681,787    |       | 8.65                                   |       | 602,839    |       | 7.61 |   | 619,673 |   | 6.79 |   |
|                                            |   |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Weighted average fair value of options  granted |   |       |       | $                                      | 6.87       |       |       |   | $ | 6.77 |   |   |   | $ | 3.03 |   |

 

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The following table summarizes information about the Company’soutstanding stock options at December 31, 2002:

 
|                         |   |                    |       | **Weighted  Average  Remaining  Life (Years)** |       | **Weighted  Average  Exercise  Price** |       | **Number  Exercisable** |   | **Weighted  Average  Exercise  Pr-ice** |    |
|------------------------------|--------|-------------------------|------------|------------------------------------------------|------------|----------------------------------------|------------|-------------------------|--------|-----------------------------------------|---------|
|                         |   |                    | ** ** | ** **                                     | ** ** | ** **                             | ** ** |
|                         |   | **Number  Outstanding** | ** ** | ** **                                     | ** ** | ** **                             | ** ** |
| **Range of Exercise Prices** |   |                    |       | ** **                                     |       |                                   |
|                         |   |                    |       |                                           |       |                                   |       |                    |   |                                    |    |
| $                            | 3.75   | to                      | $          | 5.64                                           |       |                                   | 492,442    |                    | 6.6    |                                    | $       | 4.68 |   | 320,247 |   | $ | 4.80 |   |
| 7.59                         | to     | 9.99                    |       |                                           | 233,000    |                                   | 8.7        |                    | 9.19   |                                    | 125,000 |   | 8.56 |   |
| 10.13                        | to     | 15.19                   |       |                                           | 530,900    |                                   | 7.2        |                    | 11.37  |                                    | 139,700 |   | 12.33 |   |
| 15.60                        | to     | 24.38                   |       |                                           | 153,503    |                                   | 7.2        |                    | 16.18  |                                    | 96,840  |   | 16.19 |   |
|                         |   | 1,409,845               |       |                                           |       |                                   |       | 681,787                 |   |                                    |    |
|                              |        |                         |            |                                                |            |                                        |            |                         |        |                                         |         |  |  |  |  |  |  |  |

 

For purposes of the pro forma disclosures in Note 2, under SFAS No.123, the fair value of each option grant was estimated on the date of grantusing the Black-Scholes option pricing model. The following weighted average assumptions were used for grants in 2002,2001 and 2000, respectively:  risk-freeinterest rates of 5.1%, 5.0% and 5.4%; dividend rates of $0, $0 and $0;expected lives of 7.0, 10.0 and 6.6 years; expected volatility of 57.58%,53.35% and 52.76%.

 

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 transferrable.  In addition, option valuation models require the input of, andare highly sensitive to, subjective assumptions including the expected stockprice volatility.  The Company’semployee stock options have characteristics significantly different from thoseof traded options, and changes in the subjective input assumptions canmaterially affect the fair value estimate.

 

*Notes from Shareholders*

 

On July 8, 1996, the Company’s former president (see below) and theCompany founder, currently a director of the Company, each exercised options topurchase an aggregate 82,750 and 137,110, respectively, of shares of Class ACommon Stock and Class B Common Stock at an aggregate price of $180,638 and$274,220, respectively.  In connectionwith each exercise, each former officer entered into a promissory note with theCompany for the respective aggregate exercise amounts.  The promissory notes bear interest at anannual rate of 6.63%, mature in June 2004 with no interim interest or principalpayments, are full recourse and collateralized by shares of the Company’scommon stock.  In September 2002, theCompany purchased at fair value 35,000 shares of its common stock from theCompany’s former president at a cost of approximately $283,000.  In connection with that stock purchase, theCompany’s former president repaid $283,000 representing the accrued interestand a portion of the outstanding related principal former loan balance.  Additionally, in December 2002, theCompany’s former president surrendered stock options with a fair value ofapproximately $77,000 which was used to repay a portion of his remainingbalance.  The fair value of these stockoptions were expensed by the Company in the year ended December 31, 2002.  At December 31, 2002, the balance due fromthe Company’s former president aggregated approximately $23,000 and the balanceof principal and interest due from the Company’s founder aggregatedapproximately $419,000.  The Companyrecognized approximately $41,000, $42,000 and $39,000 of interest incomerelated to these shareholder notes for the years ended December 31, 2002, 2001and 2000, respectively.

 

*Treasury Stock*

 

During the years ended December 31, 2002 and 2001, the Companyrepurchased in the open market 242,100 and 90,900 shares, respectively, of itscommon stock under a share repurchase program at an aggregate

 

 

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cost of $2.2 million and $1.1 million, respectively.  Additionally, in September 2002, the Companypurchased at fair value 35,000 shares of its common stock from the Company’sformer president at a cost of approximately $283,000.  In 2002, the Board of Directors authorized the repurchase of anaggregate $10.0 million of the Company’s outstanding shares.  The annual repurchase of shares is limitedto $2.5 million, and an aggregate limit of $7.5 million, under the Company’samended 2000 Credit Facility.  Under thecurrent aggregate limitation, the Company can purchase additional shares oftreasury stock valued at approximately $2.0 million.

 

*Employee Stock Purchase Plan*

 

Effective as of January 1, 2000, the Company has an employee stockpurchase plan whereby employees can make contributions to purchase theCompany’s common stock.  Purchases ofcommon stock are made annually at the lower of the beginning or end of yearmarket value, less a 15.0% discount. For the years ended December 31, 2002, 2001 and 2000, employeecontributions of approximately $399,000, $214,000 and $97,000 were used topurchase 82,581, 46,767 and 13,585 shares, respectively, of the Company’scommon stock.

 

*Deferred Bonus Plan*

 

In the fourth quarter of 2001, the Company established a deferred bonusplan for certain employees.  Pursuant tothe plan, approximately $4.7 million was deposited on behalf of individualparticipants into a rabbi trust account, which included approximately $3.6million in cash and $1.1 million in Company 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 therabbi trust represent assets of the Company and are included in theaccompanying Consolidated Balance Sheets based on the nature of the assets held.  Assets placed into the rabbi trust areirrevocable; therefore they are restricted as to the Company’s use under theterms of the trust and the deferred bonus plan.  Amounts held in the rabbi trust are generally distributable uponvesting.  At December 31, 2002,restricted assets and other current assets included approximately $300,000 and$226,000, respectively, of deposits in a rabbi trust.  For the year ended December 31, 2001, restricted assets included$3.6 million of cash in a rabbi trust. For the year ended December 31, 2002, approximately $1.3 million waspaid from plan assets as a result of the removal of the Company’s formerpresident from the plan due to his resignation as president in September2002.  Additionally, approximately $1.0million of deferred bonus plan assets were forfeited and returned to theCompany as a result of his resignation.

 

The plan generally vests 100.0% upon the achievement of an aggregateamount of monthly credits (based on a fixed monthly earnings milestone)expected to occur at the end of five years beginning October 1, 2001.  Vesting will accelerate to 60.0% at the endof three years if certain earnings targets are achieved.  Based on the expected earnings period,compensation expense and the related compensation liability for the aggregateplan value are being recognized over five years.  To the extent the vesting is extended or accelerated based on theachievement of the financial milestones, recognition of compensation expensewill be adjusted on a prospective basis. For the years ended December 31, 2002 and 2001, the Company expensedapproximately $92,000 and  $234,000,respectively, under the deferred bonus plan.

 

While periodic gains on the value of each participant’s investmentsheld in the rabbi trust are recorded currently in income, an equal amount ofcompensation expense and related compensation liability is recorded, sinceparticipants are fully vested in such gains. Periodic losses incurred by participants in their invested balances arerecorded as incurred.  Such losses inexcess of a participant’s recorded compensation expense are guaranteed by theparticipants with a full-recourse obligation to the Company.  These guarantees function to offset the losson investments to the extent the obligations are not reserved forcollectibility by the Company.

 

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Amounts held in treasury stock have been recorded at cost.  An equal amount has been established asdeferred compensation and additional paid-in capital in the accompanyingstatement of stockholders’ equity.  Thebalance in the deferred bonus plan is amortized to compensation expense overthe expected vesting period of five years.

 

**11.          DERIVATIVE FINANCIAL INSTRUMENTS ANDGUARANTEES**

 

*Debt Service Reserve Fund and Debt Service Fund*

 

In August 2001, MCF completed a bond offering to finance the 2001 Saleand Leaseback Transaction.  Inconnection with this bond offering, two reserve fund accounts were establishedby MCF pursuant to the terms of the indenture: (1) MCF’s Debt Service ReserveFund, aggregating $24.2 million at December 31, 2002, was established to makepayments on MCF’s outstanding bonds in the event the Company (as lessee) shouldfail to make the scheduled rental payments to MCF and (2) MCF’s Debt ServiceFund, aggregating $12.4 million at December 31, 2002, used to accumulate themonthly lease payments that MCF receives from the Company until such funds areused to pay MCF’s semi-annual bond interest and annual bond principal payments.  Both reserve fund accounts are subject tothe agreements with the MCF Equity Investors whereby guaranteed rates of returnof 3.0% and 5.08%, respectively, are provided for in the balance of the DebtService Reserve Fund and the Debt Service Fund.  The guaranteed rates of return are characterized as cash flowhedge derivative instruments.  Atinception, the derivatives had an aggregate fair value of $4.0 million, whichhas been recorded as a decrease to the equity investment in MCF made by the MCFEquity Investors (“MCF minority interest”) and as a deferred liability in theaccompanying Consolidated Balance Sheets. Changes in the fair value of the derivative instruments are recorded asan adjustment to deferred income and reported as other comprehensive income inthe accompanying Consolidated Statements of Operations and ComprehensiveIncome.  At December 31, 2002, the fairvalue of these derivative instruments was approximately $2.1 million.  As a result, the accompanying ConsolidatedStatements of Operations and Comprehensive Income include accumulated othercomprehensive income of approximately $1.9 million. There is no differencebetween net income and comprehensive income for 2001 and 2000.

 

In connection with MCF’s bond offering, the MCF Equity Investorprovided a guarantee of the Debt Service Reserve Fund if a bankruptcy of theCompany were to occur and a trustee for the estate of the Company were toinclude the Debt Service Reserve Fund as an asset of the Company’s estate.  This guarantee is characterized as an insurancecontract.

 

**12.          CLOSED FACILITIES AND PROJECTS UNDERDEVELOPMENT**

 

The New Morgan Academy was completed and became operational in twophases during the fourth quarter of 2000 and the first quarter of 2001.  In 2002, the New Morgan Academy  experienced a reduction in occupancy as aresult of budget appropriation reductions of a significant customer inPennsylvania.  On September 27, 2002,the Company announced plans to close the New Morgan Academy.  The Company consented to relinquish itslicense issued by the Pennsylvania Department of Public Welfare in lieu of thedepartment implementing its decision to revoke the facility’s provisionallicense due to operating incidents at the facility.  The Company closed the facility in the fourth quarter of 2002 andis currently considering several alternatives for the reutilization of thefacility for another type of program as well as possibly selling thefacility.  The Company is maintaining asmall staff to maintain the facility while the Company considers its optionsfor the use or sale of the facility.

 

The carrying value of the property and equipment at the New MorganAcademy was approximately $31.3 million at December 31, 2002.  Currently, management of the Company isexploring several potential alternative uses for the facility.  Management performed a probability-weightedrecoverability analysis and 

 

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believes that, based on its analysis, the long-lived assets at the NewMorgan Academy are recoverable from the range of alternative courses ofaction.  Accordingly, pursuant to theprovisions of SFAS No. 144, an impairment allowance is not deemed necessary asof December 31, 2002.  However,management estimates that, were the Company to sell the facility, it is reasonablypossible that the Company would not be able to fully recover the carrying valueof its long-lived assets for this facility.

 

In April 1999, the Company was awarded a contract to design, build andoperate a 1,095 bed prison for the BOP in Moshannon Valley, Pennsylvania (the“Moshannon Valley Correctional Center”). Construction and activation activities commenced immediately.  In June 1999, the BOP issued a Stop-Work Orderpending a re-evaluation of its environmental documentation supporting the decisionto award the contract. The environmental study was completed with a finding ofno significant impact and the Stop-Work Order was lifted by the BOP on August9, 2001.

 

In September 1999, the Company received correspondence from the Officeof the Attorney General of the Commonwealth of Pennsylvania indicating itsbelief that the operation of a private prison in Pennsylvania is unlawful.  The Company and the BOP have had discussionswith the Attorney General’s staff regarding these and related issues.  As a result of these issues, the Company hasnot re-commenced its construction efforts. As of December 31, 2002, the Company had incurred approximately $16.1million for construction and land development costs and capitalized interestrelated to the Moshannon Valley Correctional Center.  According to the BOP contract, as amended, the Company mustcomplete the construction of the project by April 15, 2003.  The Company will not be able to completeconstruction within that time frame. The Company is currently obtaining contract amendments monthly from theBOP. The Company anticipates obtaining another long-term contract amendmentfrom the BOP extending the construction deadline.  In the event the Company is not able to negotiate a contractamendment with the BOP, then the BOP may have the right to assert that theCompany has not completed construction of the facility within the time frameprovided in the BOP contract, as amended. Management expects that the contract will be amended to address cost andconstruction timing matters resulting from the extended delay.  In the event that the BOP decides not tocontinue with the construction of the Moshannon Valley Correctional Center andterminates the contract, management believes that the Company has the right toand will recover its invested costs.  Inthe event any portion of these costs are determined not to be recoverable uponcontract termination by the BOP, such costs would be expensed.  Management currently believes that theinvested costs would be fully recoverable in the event of this contract beingterminated.

 

At December 31, 2002, accounts receivable include costs totalingapproximately $1.4 million for direct costs incurred by the Company since theissuance of the Stop-Work Order in June 1999 for incremental payroll and otheroperating costs related to the Moshannon Valley Correctional Center.  These costs were incurred at the directionof the BOP with the understanding that such costs would be reimbursed by theBOP.  Although no formal written agreementexists, management believes that these costs will be reimbursed by the BOP inthe near term.  In the event any portionof these costs are determined not to be reimbursable, such costs will beexpensed.

 

**13.          RELATED PARTY TRANSACTIONS**

 

One of the directors of the Company is a partner in a law firm thatprovides legal services to the Company. The Company pays legal fees for such services.  Legal fees paid to this law firm were approximately $1.5 million,$2.7 million and $1.8 million for the years ended December 31, 2002, 2001 and2000, respectively.  The servicesrendered to the Company were on terms no more favorable than those with 

 

 

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unrelated parties.

 

In July 1996, the Company entered into promissory notes with theCompany’s former president and the Company’s founder, currently a director ofthe Company.  The promissory notes bearinterest at an annual rate of 6.63%, mature in June 2004 with no interim interestor principal payments, are full recourse and collateralized by shares of theCompany’s common stock.

 

In connection with the Company president’s resignation in September2002,  the outstanding principal andinterest balance of approximately $76,000 and $35,000, respectively, wasrepaid.  At December 31, 2002, theprincipal and related accrued interest receivable outstanding related to theCompany founder’s  note wasapproximately $270,000 and $109,000. These amounts are reflected in deferred costs and other assets in theaccompanying Consolidated Balance Sheets. The Company recognized approximately $29,000, $29,000 and $27,000 ofinterest income related to these notes for the years ended December 31, 2002,2001 and 2000.

 

Effective September 1, 1999, the Company entered into a consultingagreement with the Company’s founder, currently a director of the Company.  As compensation for consulting services, theCompany agreed to an annual payment of at least $255,000 for each of the firstfour years of the seven-year initial term of the consulting agreement with anannual salary of at least $180,000 for each of the last three years of theseven-year initial term of the consulting agreement.  The Company has an option to renew the consulting agreement foran additional three-year  term at anannual salary of at least $300,000 for each of the three years of the renewalterm.  As additional compensation, theCompany agreed to an annual bonus, subject to certain limitations, equal to$75,000 during the first four years of the seven-year initial term and anannual bonus of $60,000 during the last three years of the seven-year initialterm and during any renewal term.  TheCompany also agreed to grant options to purchase an aggregate 120,000 shares ofthe Company’s common stock in four equal annual installments beginningSeptember 1, 2000.  The options have anexercise price equal to the fair market value of the Company’s common stock onthe date of grant and vest at the time such options are granted, subject tocertain limitations on exercise.

 

As part of the consulting agreement discussed above, the Companyentered into a non-compete agreement with this director.  The non-compete agreement has a term of 10years and requires the Company to pay a monthly fee of  $10,000 for the seven-year initial term ofthe  consulting agreement.  The Company recognized amortization expenserelated to this agreement of approximately $84,000 for each of the years endedDecember 31, 2002, 2001 and 2000.

 

The Company maintains a key-man life insurance policy for this directorand made payments related to this policy of approximately $214,000, $215,000and $215,000 for the years ended December 31, 2002, 2001 and 2000,respectively.

 

The Company also compensated this director for board of director feesin amounts of $30,000, $22,000 and $24,000 for the years ended December 31,2002, 2001 and 2000, respectively.

 

Total payments made for the above consulting and non-competeagreements, board of director fees and expense reimbursements for this directorwere approximately $477,000, $428,000 and $473,000 for the years ended December31, 2002, 2001 and 2000, respectively.

 

The Company also has a non-compete agreement with a director of theCompany in connection with the acquisition of The Abraxas Group, Inc. inSeptember 1997.  Under this agreement,the Company is required to pay annual installments of $60,000 beginning January2, 1998.  These payments can and havebeen accelerated upon the mutual agreement of the director and the Company.  The balance due on this non-competeagreement as of December 31, 2002 and 2001 was approximately $200,000 and$280,000,

 

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respectively.  The Company madepayments under this agreement of approximately $80,000 and $200,000 for theyears ended December 31, 2002 and 2001, respectively.  There were no payments made in the year ended December 31, 2000.

 

**14.          SEGMENT DISCLOSURE**

 

The Company’s three operating divisions are its reportablesegments.  The adult secureinstitutional segment consists of the operation of secure adult incarcerationfacilities.  The juvenile segmentconsists of providing residential treatment and educational programs andnon-residential community-based programs to juveniles between the ages of tenand 17 who have either been adjudicated or suffer from behavioralproblems.  The pre-release segmentconsists of providing pre-release and halfway house programs for adultoffenders who are either on probation or serving the last three to six monthsof their sentences on parole and preparing for re-entry into society at largeas well as community-based treatment and education programs as an alternativeto incarceration.  All of the Company’scustomers and long-lived assets are located in the United States ofAmerica.  The accounting policies of theCompany’s reportable segments are the same as those described in the summary ofsignificant accounting policies in Note 2 to the Consolidated FinancialStatements.  Intangible assets are notincluded in each segment’s reportable assets, and the amortization ofintangible assets is not included in the determination of a segment’s operatingincome.  The Company evaluatesperformance based on income or loss from operations before general andadministrative expenses, incentive bonuses, amortization of intangibles,interest and income taxes.  Corporateand other assets are comprised primarily of cash, accounts receivable,deposits, property and equipment, deferred taxes, deferred costs and otherassets.

 

 

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The only significant noncash items reported in the respective segments’income from operations is depreciation and amortization (excluding intangibles)(in thousands).

 
|                                |   | **Year Ended  December 31,** |       |
|-------------------------------------|--------|------------------------------|------------|
|                                |   | **2002**                     | ** ** | **2001** |   | **2000** |   |
|                                |   |                         |       |   |   |   |   |
| Revenue:                            |   |                         |       |   |   |   |   |
| Adult secure institutional          |   | $                            | 99,549     |   | $ | 99,791 |   | $ | 91,163 |   |
| Juvenile                            |   | 124,967                      |       | 116,262 |   | 86,033 |   |
| Pre-release                         |   | 50,629                       |       | 49,197 |   | 48,854 |   |
| Total revenue                       |   | $                            | 275,145    |   | $ | 265,250 |   | $ | 226,050 |   |
|                                |   |                         |       |   |   |   |   |
| Depreciation and amortization:      |   |                         |       |   |   |   |   |
| Adult secure institutional          |   | $                            | 3,558      |   | $ | 3,222 |   | $ | 2,873 |   |
| Juvenile                            |   | 2,615                        |       | 2,149 |   | 1,285 |   |
| Pre-release                         |   | 1,391                        |       | 1,451 |   | 1,164 |   |
| Amortization of intangibles         |   | 878                          |       | 1,525 |   | 1,528 |   |
| Corporate and other                 |   | 1,337                        |       | 931 |   | 613 |   |
| Total depreciation and amortization |   | $                            | 9,779      |   | $ | 9,278 |   | $ | 7,463 |   |
|                                |   |                         |       |   |   |   |   |
| Income from operations:             |   |                         |       |   |   |   |   |
| Adult secure institutional          |   | $                            | 26,586     |   | $ | 22,347 |   | $ | 20,126 |   |
| Juvenile                            |   | 17,402                       |       | 16,857 |   | 11,371 |   |
| Pre-release                         |   | 11,609                       |       | 10,514 |   | 11,983 |   |
| Subtotal                            |   | $                            | 55,597     |   | $ | 49,718 |   | $ | 43,480 |   |
| General and administrative expenses |   | (21,480                      | )          | (15,291 | ) | (12,024 | ) |
| Incentive bonuses                   |   | —                       |       | (1,000 | ) | — |   |
| Amortization of intangibles         |   | (878                         | )          | (1,525 | ) | (1,528 | ) |
| Corporate and other                 |   | (1,662                       | )          | (884 | ) | (275 | ) |
| Total income from operations        |   | $                            | 31,577     |   | $ | 31,018 |   | $ | 29,653 |   |
|                                |   |                         |       |   |   |   |   |
| Capital expenditures:               |   |                         |       |   |   |   |   |
| Adult secure institutional          |   | $                            | 4,098      |   | $ | 4,083 |   | $ | 17,105 |   |
| Juvenile                            |   | 1,566                        |       | 7,117 |   | 33,219 |   |
| Pre-release                         |   | 2,006                        |       | 675 |   | 4,254 |   |
| Corporate and other                 |   | 3,444                        |       | 2,293 |   | 2,214 |   |
| Total capital expenditures          |   | $                            | 11,114     |   | $ | 14,168 |   | $ | 56,792 |   |
|                                |   |                         |       |   |   |   |   |
| Assets:                             |   |                         |       |   |   |   |   |
| Adult secure institutional          |   | $                            | 156,315    |   | $ | 155,085 |   | $ | 155,676 |   |
| Juvenile                            |   | 96,239                       |       | 102,766 |   | 88,801 |   |
| Pre-release                         |   | 58,071                       |       | 57,962 |   | 55,206 |   |
| Intangible assets, net              |   | 13,062                       |       | 15,456 |   | 16,861 |   |
| Corporate and other                 |   | 117,604                      |       | 113,538 |   | 20,306 |   |
| Total assets                        |   | $                            | 441,291    |   | $ | 444,807 |   | $ | 336,850 |   |

 

 

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**15.          SELECTED QUARTERLY FINANCIAL DATA(Unaudited)**

 
|                                                                                                       |   | **1st**     |   | **2nd**     |   | **3rd**     |   | **4th**     |   |     |   |
|------------------------------------------------------------------------------------------------------------|--------|-------------|--------|-------------|--------|-------------|--------|-------------|--------|----------|--------|
|                                                                                                       |   | **Quarter** |   | **Quarter** |   | **Quarter** |   | **Quarter** |   | **Year** |   |
| **2002:**                                                                                                  |   |        |   |        |   |        |   |        |   |     |   |
| Revenues                                                                                                   |   | $           | 68,475 |        | $      | 69,077      |   | $           | 69,634 |     | $      | 67,959 |   | $ | 275,145 |   |
| Income from operations                                                                                     |   | 6,375       |   | 7,888       |   | 7,992       |   | 9,322       |   | 31,577   |   |
| Income before cumulative effect of changes  in accounting principles (1)                                   |   | 635         |   | 1,974       |   | 1,793       |   | 2,925       |   | 7,327    |   |
| Net income (loss)                                                                                          |   | (330        | )      | 1,974       |   | 1,793       |   | 2,925       |   | 6,362    |   |
| Earnings per share before cumulative effect  of changes in accounting principles:                          |   |        |   |        |   |        |   |        |   |     |   |
| -  Basic                                                                                                   |   | $           | .05    |        | $      | .15         |   | $           | .14    |     | $      | .23 |   | $ | .57 |   |
| -  Diluted                                                                                                 |   | $           | .05    |        | $      | .15         |   | $           | .14    |     | $      | .21 |   | $ | .55 |   |
| Earnings per share:                                                                                        |   |        |   |        |   |        |   |        |   |     |   |
| -  Basic                                                                                                   |   | $           | (.03   | )           | $      | .15         |   | $           | .14    |     | $      | .23 |   | $ | .49 |   |
| -  Diluted                                                                                                 |   | $           | (.03   | )           | $      | .15         |   | $           | .14    |     | $      | .22 |   | $ | .48 |   |
|                                                                                                       |   |        |   |        |   |        |   |        |   |     |   |
| **2001:**                                                                                                  |   |        |   |        |   |        |   |        |   |     |   |
| Revenues                                                                                                   |   | $           | 60,628 |        | $      | 65,745      |   | $           | 68,733 |     | $      | 70,144 |   | $ | 265,250 |   |
| Income from operations                                                                                     |   | 4,570       |   | 8,121       |   | 8,493       |   | 9,834       |   | 31,018   |   |
| Income before extraordinary charge and  cumulative effect of changes in accounting principles(2)(3)        |   | 54          |   | 2,129       |   | 1,909       |   | 2,743       |   | 6,835    |   |
| Net income                                                                                                 |   | 824         |   | 2,129       |   | 1,431       |   | 275         |   | 4,659    |   |
| Earnings per share before extraordinary  charge and cumulative effect of changes in accounting principles: |   |        |   |        |   |        |   |        |   |     |   |
| - Basic                                                                                                    |   | $           | .01    |        | $      | .23         |   | $           | .21    |     | $      | .26 |   | $ | .71 |   |
| - Diluted                                                                                                  |   | $           | .01    |        | $      | .22         |   | $           | .19    |     | $      | .24 |   | $ | .68 |   |
| Earnings per share:                                                                                        |   |        |   |        |   |        |   |        |   |     |   |
| -  Basic                                                                                                   |   | $           | .09    |        | $      | .23         |   | $           | .15    |     | $      | .03 |   | $ | .48 |   |
| -  Diluted                                                                                                 |   | $           | .09    |        | $      | .22         |   | $           | .14    |     | $      | .02 |   | $ | .46 |   |
|                                                                                                       |   |        |   |        |   |        |   |        |   |     |   |
| **2002 Balance Sheet Data:**                                                                               |   |        |   |        |   |        |   |        |   |     |   |
| Working capital                                                                                            |   | $           | 99,915 |        | $      | 100,277     |   | $           | 92,749 |     | $      | 95,988 |   | $ | 95,988 |   |
| Total assets                                                                                               |   | 435,836     |   | 438,838     |   | 428,237     |   | 441,291     |   | 441,291  |   |
| Long-term debt, net of current portion                                                                     |   | 239,310     |   | 239,310     |   | 231,724     |   | 232,258     |   | 232,258  |   |
| Stockholders’ equity                                                                                  |   | 153,024     |   | 154,745     |   | 158,330     |   | 159,952     |   | 159,952  |   |
|                                                                                                       |   |        |   |        |   |        |   |        |   |     |   |
| **2001 Balance Sheet Data:**                                                                               |   |        |   |        |   |        |   |        |   |     |   |
| Working capital                                                                                            |   | $           | 35,526 |        | $      | 41,294      |   | $           | 88,584 |     | $      | 97,814 |   | $ | 97,814 |   |
| Total assets                                                                                               |   | 341,682     |   | 346,013     |   | 434,012     |   | 444,807     |   | 444,807  |   |
| Long-term debt, net of current portion                                                                     |   | 201,155     |   | 206,686     |   | 276,718     |   | 238,768     |   | 238,768  |   |
| Stockholders’ equity                                                                                  |   | 105,478     |   | 106,771     |   | 109,209     |   | 153,104     |   | 153,104  |   |

 

----

(1)          The Company adopted SFAS No. 142 in January2002 and recorded a net-of-tax charge of approximately $1.0 million as acumulative effect of a change in accounting principle. See Note 3 to theConsolidated Financial Statements.

(2)          The Company early retired $50.0 million and$39.4 million outstanding of its Senior Secured Notes and Subordinated Notes inthe third quarter and fourth quarter of 2001, respectively, and recordednet-of-tax extraordinary charges of $479,000 in the third quarter of 2001 and$2.5 million in the fourth quarter of 2001 as a result of the write-off ofunamortized deferred debt issuance costs related to these credit facilities.  See Note 8 to the Consolidated FinancialStatements.

(3)          The Company changed its method of accountingfor durable supplies effective January 1, 2001 and recorded a net-of-taxbenefit of approximately $770,000 as a cumulative effect of a change inaccounting principle.  See Note 3 to theConsolidated Financial Statements.

 

83

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**ITEM9.****                             CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

 

On May 30, 2002, upon the recommendation of the Company’s AuditCommittee, the Board of Directors approved the dismissal of Arthur Andersen LLP(“Arthur Andersen”) as the Company’s independent auditors and the appointmentof PricewaterhouseCoopers LLP (“PricewaterhouseCoopers”) to serve as the Company’sindependent auditors for the year ending December 31, 2002.  The change in auditors is effectiveimmediately.

 

Arthur Andersen’s reports on the Company’s consolidated financialstatements as of and the years ended December 31, 2001and 2000 did not containan adverse opinion or disclaimer of opinion, nor were such reports qualified ormodified as to uncertainty, audit scope or accounting principles.

 

In connection with the audits of the two fiscal years ended December31, 2001 and through May 30, 2002 there were no disagreements with ArthurAndersen on any matter of accounting principle or practice, financial statementdisclosure, or auditing scope or procedure which, if not resolved to ArthurAndersen’s satisfaction, would have caused them to make reference to thesubject matter in connection with their report on the Company’s consolidatedfinancial statements for such years; and there were no reportable events asdefined in Item 304(a)(1)(v) of Regulation S-K.

 

The Company provided Arthur Andersen with a copy of the foregoingdisclosures.  Arthur Andersen providedthe Company with a letter, dated May 31, 2002, stating its agreement with suchstatements.

 

During the two fiscal years ended December 31, 2001 and through May 30,2002 the Company did not consult PricewaterhouseCoopers with respect to theapplication of generally accepted accounting principles to a specifiedtransaction, either completed or proposed, or the type of audit opinion thatmight be rendered on the Company’s consolidated financial statements, or anyother matters or reportable events as set forth in Items 304(a)(2)(i) and (ii)of Regulation S-K.

 

 

**PARTIII**

 

Items 10, 11, 12 and 13 of Part III have been omitted from this reportbecause the Company will file with the Securities and Exchange Commission, notlater than 120 days after the close of its fiscal year, a definitive proxystatement or a Form 10-K/A.  Theinformation required by Items 10, 11, 12 and 13 of this report, which willappear in the definitive proxy statement and/or the Form 10-K/A, isincorporated by reference into Part III of this report.

 

**ITEM14.****                      DISCLOSURECONTROLS AND PROCEDURES**

 

Under the supervision and with the participation of management,including the principal executive officer and the principal financial officer,the Company has evaluated the effectiveness of the design and operation of itsdisclosure controls and procedures within 90 days of the filing date of thisannual report pursuant to Rules 13a-15 and 15d-15 under the Securities ExchangeAct of 1934 (the “Exchange Act”).  Basedon that evaluation, the principal executive officer and the principal financialofficer have concluded that these controls and procedures are effective.  There were no significant changes in theCompany’s internal controls or in other factors that could significantly affectthese controls subsequent to the date of their evaluation.

 

Disclosure controls and procedures are our controls and otherprocedures that are designed to ensure that information required to bedisclosed by the Company in the reports filed or submitted under the Exchange 

 

 

84

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Act is recorded, processed, summarized and reported, within the timeperiods specified under the Exchange Act. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed bythe Company in the reports that we filed under the Exchange Act is accumulatedand communicated to management, including the Company’s principal executiveofficer and principal financial officer, as appropriate to allow timelydecisions regarding required disclosure. As part of the Company’s preparation for compliance with theSarbanes-Oxley Act, Section 404, the Company is continuing to review itsinternal control structure and may potentially make improvements to itsinternal control structure based on this review.

 

 

85

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**PARTIV**

 

**ITEM 15.               EXHIBITS, FINANCIAL STATEMENTSCHEDULES AND REPORTS ON FORM 8-K**

 
| (a)    | **Financial  Statements, Schedules and Exhibits** |                                                                                                                                                           |   |
|--------|---------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |                                              |                                                                                                                                                           |   |
|   | 1.                                                | Financial statements and reports of  PricewaterhouseCoopers LLP and Arthur Andersen LLP                                                                        |
|   |                                              | Report of Independent Accountants                                                                                                                              |
|   |                                              | Consolidated Balance Sheets - December 31, 2002 and 2001                                                                                                       |
|   |                                              | Consolidated Statements of Operations and  Comprehensive Income for the years ended December 31, 2002, 2001 and 2000                                           |
|   |                                              | Consolidated Statements of Stockholders’  Equity for the years ended December 31, 2002, 2001 and 2000                                                     |
|   |                                              | Consolidated Statements of Cash Flows for  the years ended December 31, 2002, 2001 and 2000                                                                    |
|   |                                              | Notes to Consolidated Financial Statements                                                                                                                     |
|   | 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** |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|
| 3.1             |   | Restated Certificate of Incorporation of the Company.                                                                                                                                                                                                                          |   | 1                              |
| 3.2             |   | Amended and Restated Bylaws of the Company.                                                                                                                                                                                                                                    |   | 19                             |
| 4.1             |   | Certificate representing Common Stock.                                                                                                                                                                                                                                         |   | 2                              |
| 4.2             |   | Registration Rights Agreement dated as of March 31, 1994, as amended,  among the Company and the stockholders listed on the signature pages thereto.                                                                                                                           |   | 2                              |
| 4.3             |   | Rights Agreement dated as of May 1, 1998 between the Company and the  stockholders listed on the signature pages thereto.                                                                                                                                                      |   | 7                              |
| 9.1             |   | Stock Transfer and Voting Agreement dated November 23, 1994 between  David M. Cornell and Jane B. Cornell.                                                                                                                                                                     |   | 2                              |
| 10.1            |   | Cornell Corrections, Inc. Amended and Restated 1996 Stock Option  Plan. (a)                                                                                                                                                                                                    |   | 6                              |
| 10.2            |   | Employment Agreement dated as of September 9, 1997 between Abraxas  Group, Inc. and Arlene R. Lissner. (a)                                                                                                                                                                     |   | 3                              |
| 10.3            |   | Covenant Not to Compete Agreement dated as of September 9, 1997 by  and between the Company and Arlene R. Lissner. (a)                                                                                                                                                         |   | 3                              |
| 10.4            |   | Form of Indemnification Agreement between the Company 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 between the Company and Central  Falls Detention Facility Corporation dated July 15, 1992.                                                                                                                                                   |   | 2                              |
| 10.7            |   | Operating Agreement by and between each of MidTex Detentions, Inc.,  the City of Big Spring, Texas (“Big Spring”) and Cornell Corrections of  Texas, Inc. (“CCTI”) dated as of July 1, 1996 and related Assignment and  Assumption of Operating Agreement. |   | 2                              |
| 10.8            |   | Contract between CCCI and the CDC (No. R92.132) for the Live Oak,  California Facility dated March 1, 1993, as amended.                                                                                                                                                        |   | 2                              |

 

86

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| **Exhibit No.** |   | **Description**                                                                                                                                                                                                 |   | **Incorporated  by Reference** |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|
| 10.9            |   | Asset Purchase Agreement dated as of January 31, 1997 by and between  CCTI and Interventions Co.                                                                                                                |   | 4                              |
| 10.10           |   | Asset Purchase Agreement dated as of August 14, 1997 by and between  the Company 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 CCCI 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 among CCTI, Texas Alcoholism Foundation,  Inc. and the Texas House Foundation, Inc. dated May 14, 1996.                                                                                |   | 2                              |
| 10.14           |   | Asset Purchase Agreement among CCTI, the Company, Ed Davenport,  Johnny Rutherford and MidTex Detentions, Inc. dated May 22, 1996.                                                                              |   | 2                              |
| 10.15           |   | Lease Agreement between CCCI and Baker Housing Company dated August  1, 1987 for the Baker, California facility.                                                                                                |   | 2                              |
| 10.16           |   | Lease Agreement between Big Spring and Ed Davenport dated as of July  1, 1996 for the Interstate Unit and related Assignment and Assumption of  Leases.                                                         |   | 2                              |
| 10.17           |   | Secondary Sublease Agreement between Big Spring and Ed Davenport  dated as of July 1, 1996 for the Airpark Unit and related Assignment and  Assumption of Leases.                                               |   | 2                              |
| 10.18           |   | Secondary Sublease Agreement between Big Spring and Ed Davenport  dated as of July 1, 1996 for the Flightline Unit and related Assignment and  Assumption of Leases.                                            |   | 2                              |
| 10.19           |   | Stock Option Agreement between the Company and CEP II dated July 9,  1996.                                                                                                                                      |   | 2                              |
| 10.20           |   | Form of Option Agreement between the Company and the Optionholder  listed therein dated as of November 1, 1995.                                                                                                 |   | 10                             |
| 10.21           |   | Senior Note Agreement by and between the Company and the Note  Purchasers dated July 15, 1998.                                                                                                                  |   | 8                              |
| 10.22           |   | Asset Purchase Agreement dated as of 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 as of January 5,  1998 by and between Foresite Capital Facilities Corporation and Cornell  Corrections of Oklahoma, Inc.                                     |   | 5                              |
| 10.26           |   | Allvest Asset Purchase Agreement dated as of June 20, 1998 by and  between the Company and Allvest, Inc., St. John Investments, and William C.  Weimar.                                                         |   | 9                              |
| 10.26a          |   | Subordinated Bridge Loan Agreement by and between the Company and ING  dated October 14, 1999.                                                                                                                  |   | 11                             |
| 10.27           |   | Asset Purchase Agreement by and among the Company and Interventions  and IDDRS Foundation dated May 10, 1999.                                                                                                   |   | 11                             |
| 10.28           |   | Extension of Asset Purchase Agreement by and among the Company and  Interventions and IDDRS Foundation dated September 30, 1999.                                                                                |   | 11                             |
| 10.29           |   | Asset Purchase Agreement by and among BHS Consulting Corp., its  Shareholders and the Company dated May 10, 1999.                                                                                               |   | 11                             |

 

87

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| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                                                                                                                               |   | **Incorporated  by Reference** |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|
| 10.30           |   | Extension of Asset Purchase Agreement by and among BHS Consulting  Corp., its Shareholders and the Company dated September 30, 1999.                                                                                                                                                                                                          |   | 11                             |
| 10.31           |   | Amendment to Asset Purchase Agreement by and among BHS Consulting  Corp., its Shareholders and the Company dated November 12, 1999.                                                                                                                                                                                                           |   | 11                             |
| 10.32           |   | Participation Agreement among the Company and certain of its  subsidiaries and Heller Financial Leasing, Inc. dated November 23, 1999.                                                                                                                                                                                                        |   | 12                             |
| 10.33           |   | Lease Agreement between First Security Bank, National Association,  and the Company and certain of its subsidiaries dated November 23, 1999.                                                                                                                                                                                                  |   | 12                             |
| 10.34           |   | Lease Agreement by and among Hinton Economic Development Authority,  the Town of Hinton, Oklahoma, and Cornell Corrections of Oklahoma, Inc. dated  December 31, 1999.                                                                                                                                                                        |   | 12                             |
| 10.35           |   | Consulting Agreement between the Company and David M. Cornell dated  December 15, 1999. (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 among the Company,  certain subsidiaries of the Company, Atlantic Financial Group, Ltd., the  Lenders and ING (U.S.) Capital LLC, as Administrative Agent, dated as of July  21, 2000.                                                                                                           |   | 13                             |
| 10.38           |   | Amended and Restated Master Agreement among the Company, certain  subsidiaries of the Company, 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, dated as of July 21, 2000. |   | 13                             |
| 10.39           |   | Note and Equity Purchase Agreement among the Company, American  Capital Strategies, Ltd. and Teachers Insurance and Annuity Association of  America, dated as of July 21, 2000.                                                                                                                                                               |   | 13                             |
| 10.40           |   | Warrant issued by the Company to American Capital Strategies, Ltd.  dated as of July 21, 2000.                                                                                                                                                                                                                                                |   | 13                             |
| 10.41           |   | Warrant issued by the Company to Teachers Insurance and Annuity  Association of America, dated as of July 21, 2000.                                                                                                                                                                                                                           |   | 13                             |
| 10.42           |   | Cornell Corrections, Inc. Employee Stock Purchase Plan. (a)                                                                                                                                                                                                                                                                                   |   | 14                             |
| 10.42a          |   | Cornell Companies, Inc. Deferred Compensation Plan (a)                                                                                                                                                                                                                                                                                        |   | 14                             |
| 10.43           |   | Cornell Companies, Inc. 2000 Director Stock Plan. (a)                                                                                                                                                                                                                                                                                         |   | 15                             |
| 10.44           |   | Cornell Companies, Inc. 2000 Broad-Based Employee Plan. (a)                                                                                                                                                                                                                                                                                   |   | 16                             |
| 10.44a          |   | Cornell Companies, Inc. Deferred Bonus Plan.                                                                                                                                                                                                                                                                                                  |   | *                              |
| 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                             |
| 10.50           |   | First Amendment to Note and Equity Purchase Agreement dated August 9,  2001.                                                                                                                                                                                                                                                                  |   | 18                             |
| 11.1            |   | Computation of Per Share Earnings.                                                                                                                                                                                                                                                                                                            |   | *                              |
| 21.1            |   | Subsidiaries of the Company.                                                                                                                                                                                                                                                                                                                  |   | *                              |

 

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| **Exhibit No.** |   | **Description**                                                                                                                                         |   | **Incorporated  by Reference** |
|-----------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|
| 23.1            |   | Consent of PricewaterhouseCoopers LLP.                                                                                                                  |   | *                              |
| 23.2            |   | Information Regarding Consent of Arthur Andersen LLP.                                                                                                   |   | *                              |
| 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                             |
| 99.3            |   | Certification of Chief Executive Officer                                                                                                                |   | *                              |
| 99.4            |   | Certification of Chief Financial Officer                                                                                                                |   | *                              |

 

----

(a)           Managementcompensatory plan or contract.

(1)           Annual Report onForm 10-K of the Company for the year ended December 31, 1996.

(2)           RegistrationStatement on Form S-1 of the Company (Registration No. 333-08243).

(3)           RegistrationStatement on Form S-1 of the Company (Registration No. 333-35807).

(4)           Current Report onForm 8-K of the Company dated January 31, 1997.

(5)           Current Report onForm 8-K of the Company dated January 6, 1998.

(6)           Definitive ProxyStatement dated March 9, 1998.

(7)           RegistrationStatement on Form 8-A of the Company filed May 11, 1998.

(8)           Quarterly Report onForm 10-Q of the Company for the quarter ended June 30, 1998.

(9)           Current Report onForm 8-K of the Company dated August 13, 1998.

(10)         Annual Report on Form10-K of the Company for the year ended December 31, 1998.

(11)         Quarterly Report onForm 10-Q of the Company for the quarter ended September 30, 1999.

(12)         Annual Report on Form10-K of the Company for the year ended December 31, 1999.

(13)         Quarterly Report onForm 10-Q of the Company for the quarter ended June 30, 2000.

(14)         RegistrationStatement on Form S-8 of the Company (Registration No. 333-80187).

(15)         RegistrationStatement on Form S-8 of the Company (Registration No. 333-42444).

(16)         RegistrationStatement on Form S-8 of the Company (Registration No. 333-52236).

(17)         Current Report onForm 8-K of the Company dated August 14, 2001.

(18)         Quarterly Report onForm 10-Q of the Company for the quarter ended September 30, 2001.

(19)         Quarterly Report onForm 10-Q of the Company for the quarter ended March 31, 2001.

(20)         Annual Report on Form10-K of the Company for the year ended December 31, 2001.

*              Filed herewith

 

(b)           **Reports on Form 8-K**

 

The Company filed a Current Report on Form 8-K on December 6, 2002reporting a change to its Board of Directors and Audit Committee.

 

89

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, Registrant has duly caused this annual report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|   |           |   | CORNELL COMPANIES, INC. |
|--------|----------------|--------|-------------------------|
|   |           |   |                    |   |
| Dated: | March 31, 2003 |   | By:                     | /s/ Harry J. Phillips, Jr. |
|   |           |   |                    | Harry J. Phillips, Jr. |
|   |           |   |                    | Executive Chairman, Chairman of |
|   |           |   |                    | the Board and Director |

 
|                       |   |                                                           |   |           |
|----------------------------|--------|----------------------------------------------------------------|--------|----------------|
| **SIGNATURE**              |   | **TITLE**                                                      |   | **DATE**       |
|                       |   |                                                           |   |           |
| /s/ HARRY J. PHILLIPS, JR. |   | Executive Chairman, Chairman of the Board and Director         |   | March 31, 2003 |
| Harry J. Phillips, Jr.     |   | (Principal Executive Officer)                                  |   |           |
|                       |   |                                                           |   |           |
|                       |   |                                                           |   |           |
| /s/ JOHN L. HENDRIX        |   | Senior Vice President and                                      |   | March 31, 2003 |
| John L. Hendrix            |   | Chief Financial Officer                                        |   |           |
|                       |   | (Principal Financial Officer and Principal Accounting Officer) |   |           |
|                       |   |                                                           |   |           |
|                       |   |                                                           |   |           |
| /s/ ANTHONY R. CHASE       |   | Director                                                       |   | March 31, 2003 |
| Anthony R. Chase           |   |                                                           |   |           |
|                       |   |                                                           |   |           |
| /s/ DAVID M. CORNELL       |   | Director                                                       |   | March 31, 2003 |
| David M. Cornell           |   |                                                           |   |           |
|                       |   |                                                           |   |           |
| /s/ PETER A. LEIDEL        |   | Director                                                       |   | March 31, 2003 |
| Peter A. Leidel            |   |                                                           |   |           |
|                       |   |                                                           |   |           |
| /s/ ARLENE R. LISSNER      |   | Director                                                       |   | March 31, 2003 |
| Arlene R. Lissner          |   |                                                           |   |           |
|                       |   |                                                           |   |           |
| /s/ TUCKER TAYLOR          |   | Director                                                       |   | March 31, 2003 |
| Tucker Taylor              |   |                                                           |   |           |
|                       |   |                                                           |   |           |
| /s/ MARCUS A. WATTS        |   | Director                                                       |   | March 31, 2003 |
| Marcus A. Watts            |   |                                                           |   |           |

 

90

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Cornell Companies, Inc.

a Delaware corporation

CERTIFICATION OF PRINCIPAL CHIEF EXECUTIVEOFFICER

Section 302 Certification

 

I, Harry J. Phillips, Jr., certify that:

 

(1)                                      I have reviewedthis annual report on Form 10-K of Cornell Companies, Inc., a Delawarecorporation (the “registrant”);

 

(2)                                      Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

(3)                                      Based on myknowledge, the financial statements, and other financial information includedin this  annual report, fairly presentin all material respects the financial condition, results of operations andcash flows of the registrant as of, and for, the periods presented in thisannual report;

 

(4)                                      The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a) designed such disclosure controls and procedures to ensure thatmaterial information relating to the registrant, including its consolidatedsubsidiaries, is made known to us by others within those entities, particularlyduring the period in which this annual report is being prepared;

 

b) evaluated the effectiveness of the registrant’s disclosure controlsand procedures as of a date within 90 days prior to the filing date of thisannual report (the “Evaluation Date”); and

 

c) presented in this annual report our conclusions about theeffectiveness of the disclosure controls and procedures based on our evaluationas of the Evaluation Date;

 

(5)                                      The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a) all significant deficiencies in the design or operation of internalcontrols which could adversely affect the registrant’s ability to record,process, summarize and report financial data and have  identified for the registrant’s auditors any material weaknessesin internal controls; and

 

b) any fraud, whether or not material, that involves management orother employees who have a significant role in the registrant’s internalcontrols; and

 

91

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(6)                                      The registrant’sother certifying officers and I have indicated in this annual report whetherthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date: March 31, 2003 |   |                           |
|----------------------|--------|--------------------------------|
|                 |   |                           |
|                 |   | By: /s/ Harry J. Phillips, Jr. |   |
|                 |   | Harry J. Phillips, Jr.         |
|                 |   | Executive Chairman, Chairman   |
|                 |   | of the Board and Director      |

 

92

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Cornell Companies, Inc.

a Delaware corporation

CERTIFICATION OF PRINCIPAL CHIEF FINANCIALOFFICER

Section 302 Certification

 

I, John L. Hendrix, certify that:

 

(1)                                      I have reviewedthis annual report on Form 10-K of Cornell Companies, Inc., a Delawarecorporation (the “registrant”);

 

(2)                                      Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

(3)                                      Based on myknowledge, the financial statements, and other financial information includedin this annual report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this annual report;

 

(4)                                      The registrant’sother certifying officers and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and  have:

 

a) designed such disclosure controls and procedures to ensure thatmaterial information relating to the registrant, including its consolidatedsubsidiaries, is made known to us by others within those entities, particularlyduring the period in which this annual report is being prepared;

 

b) evaluated the effectiveness of the registrant’s disclosure controlsand procedures as of a date within 90 days prior to the filing date of thisannual report (the “Evaluation Date”); and

 

c) presented in this annual report our conclusions about theeffectiveness of the disclosure controls and procedures based on our evaluationas of the Evaluation Date;

 

(5)                                      The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a) all significant deficiencies in the design or operation of internalcontrols which could adversely affect the registrant’s ability to record,process, summarize and report financial data and have  identified for the registrant’s auditors any material weaknessesin internal controls; and

 

b) any fraud, whether or not material, that involves management orother employees who have a significant role in the registrant’s internalcontrols; and

 

93

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(6)                                      The registrant’sother certifying officers and I have indicated in this annual report whetherthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date: March 31, 2003 |   |                      |
|----------------------|--------|---------------------------|
|                 |   |                      |
|                 |   | By: /s/ John L. Hendrix   |   |
|                 |   | John L. Hendrix           |
|                 |   | Senior Vice President and |
|                 |   | Chief Financial Officer   |

 

94

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