**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

**FORM 10-K**
| **(Mark One)**                                                                                                                                                                                         |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                                  | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                             | ** ** |
| **For  fiscal year ended December 31, 2006**                                                                                                                                                      |
| ** **                                                                                                                                                                                             |
| **OR**                                                                                                                                                                                                 |
| ** **                                                                                                                                                                                             |
| **o**                                                                                                                                                                                                  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                             | ** ** |
| **For the  transition period from                 to              ** |

 

**Commission File Number 1-14472**

**CORNELL COMPANIES, INC.**

(Exact Name of Registrant asSpecified In Its Charter)

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

 

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

Securitiesregistered pursuant to Section 12(b) of the Act:
| **Title of Each Class**                      | ** ** | **Name of  Each Exchange on Which Registered** |
|----------------------------------------------|------------|------------------------------------------------|
| **Common  Stock, $.001 par value per share** | ** ** | **New  York Stock Exchange**                   |
| **Preferred  Stock Purchase Rights**         | ** ** | **New  York Stock Exchange**                   |

 

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

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  o   No x

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act.Yes  o  No x

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405of this Chapter) is not contained herein, and will not be contained, to thebest of Registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. o.

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. Check one.
| Large accelerated Filer o |   | Accelerated filer x |   | Non-accelerated filer o |
|---------------------------|--------|---------------------|--------|-------------------------|

 

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

The aggregate market value of voting stock held bynon-affiliates of the registrant was $177,696,845 on June 30, 2006. Theregistrant has 14,064,108 shares of common stock outstanding on March 9, 2007.

**DocumentsIncorporated by Reference**

The information required byPart III of this Report, to the extent not set forth herein, is incorporated byreference from the registrant’s definitive proxy relating to its Annual Meetingof Stockholders to be held in 2007, which definitive proxy statement will befiled with the Securities and Exchange Commission within 120 days after the endof the fiscal year to which this Report relates.

 

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**Cornell Companies, Inc.**

**Table of Contents**

**2006 Form 10-K**
| **PART  I**  | ** ** | ** **                                                                                      | ** ** | ** ** |
|--------------|------------|-------------------------------------------------------------------------------------------------|------------|------------|
| Item 1.      |       | Business                                                                                        |       |       |
| Item 1A.     |       | Risk Factors                                                                                    |       |       |
| Item 1B.     |       | Unresolved Staff Comments                                                                       |       |       |
| Item 2.      |       | Properties                                                                                      |       |       |
| Item  3.     |       | Legal  Proceedings                                                                              |       |       |
| Item 4.      |       | Submission of Matters to a Vote of Security Holders                                             |       |       |
|         |       |                                                                                            |       |       |
| **Part II**  | ** ** | ** **                                                                                      | ** ** | ** ** |
| Item 5.      |       | Market for Registrant’s Common Equity and Related  Stockholder Matters                     |       |       |
| Item 6.      |       | Selected Financial Data                                                                         |       |       |
| Item 7.      |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations     |       |       |
| Item 7A.     |       | Quantitative and Qualitative Disclosures About Market  Risk                                     |       |       |
| Item 8       |       | Financial Statements and Supplementary Data                                                     |       |       |
| Item 9       |       | Changes In and Disagreements with Accountants on  Accounting and Financial Disclosure           |       |       |
| Item 9A.     |       | Controls and Procedures                                                                         |       |       |
| Item  9B.    |       | Other  Information                                                                              |       |       |
|         |       |                                                                                            |       |       |
| **Part III** | ** ** | ** **                                                                                      | ** ** | ** ** |
| Item 10.     |       | Directors, Executive Officers of the Registrant and  Corporate Governance                       |       |       |
| Item 11.     |       | Executive Compensation                                                                          |       |       |
| Item 12.     |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters |       |       |
| Item 13.     |       | Certain Relationships and Related Transactions and  Director Independence                       |       |       |
| Item 14.     |       | Principal Accountant Fees and Services                                                          |       |       |
|         |       |                                                                                            |       |       |
| **Part IV**  | ** ** | ** **                                                                                      | ** ** | ** ** |
| Item 15.     |       | Exhibits and Financial Statement Schedules                                                      |       |       |

 

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**PART I**

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

**Company Overview**

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

***Cornell offers services in structured andsecure environments throughout three operating divisions:  (1) adult secure institutions and detentioncenters; (2) juvenile justice, educational and treatment programs; and (3)adult community-based corrections and treatment programs. Cornell, throughpredecessor entities, began operating in juvenile operations in 1973, adultcommunity-based programs in 1974, and adult secure operations in 1984. See Note16 to the Consolidated Financial Statements in Item 8 of this report for adiscussion concerning our operating segments.***

As of December 31, 2006,we operated 76 facilities among the three business lines, representing a totaloperating service capacity of 18,356. We also had three facilities that werevacant, representing additional service capacity of 224. Service capacity iscomprised of the number of beds currently available for service or availableupon completion of construction or renovation of residential facilities and theaverage program capacity of non-residential community-based programs.  Our facilities are located in 17 states andthe District of Columbia.

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

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

# **Company Operations**

We provide a continuum ofcare to adults and juveniles in institutional, residential, and community-basedsettings. Regardless of service line, each of our facilities emphasizes theimportance of engaging in the community as a productive, responsible citizen.In many of our adult secure institutions, we offer vocational trainingcurricula, as well as literacy and General Equivalency Diploma (GED) programs.In our adult community-based programs, we offer job placement services,instruction on personal finance management, and other skill-based training. Inmost of our juvenile facilities, we provide family counseling services andbehavioral counseling. In facilities throughout the organization, we providedrug and alcohol counseling for our clients.

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

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# **Quality of Operations**

We operate our facilitiesin accordance with both company and facility-specific policies and procedures.Where required by contract or otherwise deemed appropriate for our serviceenvironments, these policies and procedures are designed to meet requirementsset forth by independent industry oversight organizations, including theAmerican Correctional Association (ACA), Joint Commission on Accreditation ofHealthcare Organizations (JCAHO), and National Commission on CorrectionalHealth Care (NCCHC). Standards may also be implemented to meet the requirementsof state Departments of Public Welfare, Departments of Protective andRegulatory Services, and Departments of Human Services and Education. Webelieve that accreditation and the corresponding standards of operation enhanceour ability to provide quality programs and contribute to the public’sincreased acceptance of our services.

Internal quality control,conducted by senior facility staff and executive officers, takes the form ofperiodic operational, programmatic and fiscal audits; facility inspections;regular review of logs, reports and files; and strict maintenance of personnelstandards, including an active training program. Each of our facilities isfurther subject to periodic audits and reviews performed by our contractingagencies.

# **Industry and Business Line Summary**

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

Services offered amongour three divisions include incarceration and detention, transition fromincarceration, drug and alcohol counseling and treatment, behavioralrehabilitation and treatment, vocational training and academic education forgrades 3 – 12. Private-sector companies, like us, contract with governmentagencies to deliver these services, often at the same or higher quality and fora lower cost than what the agency can otherwise provide. Although outsourcingsuch essential services has historically faced opposition in the U.S., publicand government acceptance has increased as standards of service improve andcost savings are documented. As government agencies face fiscal budgetconstraints, outsourcing to private providers can offer economically positive alternatives.Publications have documented savings from privatized incarceration in theStates of Texas, Mississippi, and California – all states in which we operate.In addition, as a cost relief measure, government agencies have soughtalternatives to incarceration, including reentry, education, substance abuseand behavioral health programs – all of which are services we provide.

***Outsourcing hasa longer history in the juvenile justice and adult community-based correctionssectors of the industry. Increasingly, states, counties and local governmentshave used both for-profit and not-for-profit organizations to meet the needs oftroubled youth and adults reintegrating into society after a time inresidential treatment or prison. Recently, governments have sought alternativesto the rising costs of incarceration for offenders who are non-violent and needtreatment, education and rehabilitation. Adult community-based reentry programsas well as education, substance abuse and behavioral health programs that cansuccessfully divert an offender from prison address this need.***

###### ***Adult Secure Institutional Services***

The Bureau of JusticeStatistics reports that, in 2005, while the nation’s prison population grewonly two percent overall, the number of inmates in private facilities increasedalmost nine percent. Private facilities held six percent of all state prisonersand over 14 percent of federal prisoners in 2005. Increasingly, federal andstate systems are relying upon private providers to address continuously overcrowdedprisons. As of December 31, 2005, the federal prison system was operating at 34percent above capacity.

Meanwhile, heightenedattention has been placed on border patrol and immigration enforcement. ThePresident’s Budget for Fiscal Year 2008 provides $2.2 billion to supportdetention and removal efforts – sustaining last year’s 42 percent increase overFiscal Year 2006. Included in this initiative are plans for 950 new detentionbeds, in addition to the 6,700 new beds contemplated in the Fiscal Year 2007budget.  Also included in the Fiscal Year2008 budget is an allocation of $3.5 billion for the Border Patrol (an increaseof 27 percent overt the Fiscal Year 2007 budget), including funding for 3,000new agents.

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

As of December 31, 2006,we operated 10 adult secure facilities with an aggregate service capacity of9,442. Within the division, we offer the following:

·                  Low- tomaximum-security incarceration and detention

·                  Confinement ofjuveniles adjudicated as adults

·                  Facility design,construction and operation

·                  Use of modernsecurity technology, including electronic controls and surveillance equipment

·                  Educationcourses, including preparation and testing for the GED, English as a SecondLanguage classes, and Adult Basic Education (ABE)

·                  Holistichealthcare services, including medical, dental, vision, psychiatric, andindividual and group counseling services

·                  Substance abusecounseling

·                  Life skillstraining, including anger management, hygiene, personal finance, employment andhousing issues, and parenting skills

·                  Religiousopportunities and culturally sensitive programs

·                  Food and laundryservice

·                  Recreationalactivities, including exercise programs

## ***Juvenile Justice, Educationaland Treatment Services***

The juvenile justiceindustry sector includes residential, detention, shelter care, andcommunity-based services, along with educational, rehabilitation and treatmentprograms. This sector is highly fragmented with several thousand providersoperating across the country. Most of the private providers are small andoperate in specific geographic areas.

According to the Officeof Juvenile Justice and Delinquency Prevention, approximately 2.2 millionjuveniles were arrested in 2003 (the most recent year for which data isavailable). Within the juvenile justice system, as of 2002, 16% of publicly-managed youth facilities operated at capacity, and another 15% operated abovecapacity. Juvenile justice issues present a growing area of concern for manystates due to the number of youth within the judicial system, as well as therelated annual expenditures for placement and treatment. A Columbia Universitystudy suggests that annual spending on the juvenile justice system is at least$14 billion. Partnerships with private providers such as Cornell can providequality alternatives for care. In 2003, of the nearly 97,000 juveniles assignedto residential facilities in the U.S., over 30 percent were placed with privateproviders. In fact, from 1997 to 2003, while the overall residential populationof juvenile offenders decreased 8 percent, the number housed in private facilitiesincreased by 3 percent.

Beyond addressingcapacity issues within the juvenile justice system, states are also facingchallenges posed by the unique needs of specialized juvenile populations, suchas those with mental health issues. In a 2004 study, the National Mental HealthAssociation reported that the prevalence of youth in the juvenile justicesystem with mental disorders was as high as 60 percent, as compared to 22percent in the general population. The study also noted that, for those youth whoreceived treatment, the recidivism rate was as much as 25 percent lower thanuntreated children and teens in study control groups.

We believe that ourjuvenile services division is uniquely equipped to address the issues currentlyfacing the juvenile justice system. We provide a broad array of services toyouth, typically between the ages of 10 and 17, in residential andcommunity-based settings. The programs and services provided at our facilitiesare designed to rehabilitate juveniles, hold them accountable for their actionsand behaviors, and help them successfully reintegrate back into the community.An underlying principle of our juvenile programming is the Balanced andRestorative Justice (“BARJ”) model, which provides a restorative component tothe victim, be it an individual, family, or community. The use of the BARJmodel, in connection with our Seven Key Principles of Careâ,emphasizes accountability, competency development and community protection.

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As of December 31, 2006,we operated 18 residential facilities and 12 non-residential community-basedprograms within our juvenile services division, representing operating servicecapacity of 4,059. We also had two vacant facilities with a service capacity of192. Within the division, we offer the following:

·                  Diversetreatment settings, including physically-secure, staff-secure, andcommunity-based

·                  Specializedtreatment for unique populations, including females, drug addicts, sexoffenders, fire starters, and families

·                  Accreditedalternative and special education services

·                  Wildernesstraining programs and nationally accredited ropes course challenges

·                  Individualizedtreatment planning and case management

·                  Individual,group and family counseling and therapy, cognitive behavior therapy and stressand anger management instruction

·                  Substance abusecounseling and treatment, relapse prevention and education

·                  Life skillstraining, including hygiene, personal finance, employment and housing issues,and parenting skills

·                  Holistichealthcare services including medical, dental, behavioral health andpsychiatric services

·                  Recreationalactivities, including exercise programs

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

Community-basedcorrections services involve the supervision of adult parolees andprobationers. Parolees are persons who have served time in a correctionalfacility and have been released due to either mandatory conditional release ora parole board decision. Probationers have been charged with a crime butsentenced to probation in lieu of incarceration. Services provided to paroleesand probationers include temporary housing, employment assistance, angermanagement instruction, personal finance management training, academicopportunities, vocational training and substance abuse or addiction counseling.The highest populations of community corrections are located in Texas andCalifornia, who collectively supervise 21 percent of all parolees andprobationers in the U.S., and where some of Cornell’s largest facilities in thedivision are located.

As of year-end 2005, theBureau of Justice Statistics reports that over 4.9 million adults weresupervised on probation or parole, up slightly from the prior year. Of thispopulation, 43 percent of probationers were convicted of drug or alcohol-relatedviolations, and 37 percent of parolees were convicted for drug offenses. Thispopulation requires substance abuse counseling and treatment to help themsuccessfully re-enter their communities and remain out of the criminal justicesystem.

Community-based treatmentservices include both residential and outpatient substance abuse programs.Services include short-term and long-term residential care, counseling, HIVservices, DUI services, detoxification and methadone maintenance. According tothe 2005 National Survey of Substance Abuse Treatment Services, for-profitsubstance abuse treatment facilities treated 28 percent of all clients andcomprised 27 percent of all facilities. Clients in these programs can beself-admitted or referred by a local or state agency.

We believe that our adultcommunity-based programs provide positive environments of care for bothcorrections and treatment clients. The market is fragmented with providerslocated across the country. Whereas most providers in the industry are smalland have limited geographic reach, Cornell offers a national presence withlocations in large urban areas, as well as suburban and rural settings. Theadult community-based programs provide an alternative to incarceration and afocus on transitioning offenders from a correctional facility back intosociety. Through a system of education, employment training, treatment,monitoring and accountability, clients are given the necessary tools to makepositive life choices that can reduce the incidence of recidivism.

As of December 31, 2006,we operated 27 residential community-based facilities and 9 non-residentialcommunity-based programs with a combined total service capacity of 4,855. Wealso had one vacant facility with a service capacity of 32. Within thedivision, we offer the following:

·                  Minimum-securityand staff-secure residential services

·                  Home confinementand electronic monitoring

·                  Substance-abusecounseling and treatment, including detoxification, testing, 12-step programsand relapse prevention services

·                  Employmenttraining and assistance

·                  Education,including preparation and testing for the GED, ABE, computer courses,college-level courses and access to libraries

·                  Vocationaltraining

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·                  Individual,group and family counseling and therapy, cognitive behavior therapy and stressand anger management instruction

·                  Life skillstraining, including hygiene, personal finance, housing issues, and parentingskills

·                  Municipal jail management

**Facilities**

At December 31, 2006, weoperated 76 facilities. Additionally, we had three vacant facilities. Inaddition to providing management services, we develop, design and/or constructmany of our facilities.

Either through outrightownership or long-term leases, we control operating facilities representing a largemajority of our revenues. We believe that such control increases the likelihoodof contract renewal, allows us to expand existing facilities and therebyrealize economies of scale, and enhances our ability to win new contracts andcontrol repair costs. In addition, we believe that long-term control of ouroperating facilities allows us to better manage cost-escalation pressures.

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Thefollowing table summarizes certain additional information with respect to ourfacilities as of December 31, 2006.  Asindicated, the majority of the facilities to which we provide services areeither owned or leased under long-term leases, which are generally under termsranging from one to 45 years.
| **Facility Name and Location**                                          | ** **   | **Total  Service  Capacity (1)** | ** **   | **Initial  Contract  Date (2)** | ** **   | **Company  Owned/  Leased or  Managed (3)** | ** **   |
|----------------------------------------------------------------------------------------|--------------|---------------------------------------|--------------|--------------------------------------|--------------|-------------------------------------------------------|--------------|
|                                                                                   |         |                                  |         |                                 |         |                                                  |         |
| ***Adult  Secure Institutional Facilities:***                                          | *** *** | *** ***                          | *** *** | *** ***                         | *** *** | *** ***                                          | *** *** |
|                                                                                   |         |                                  |         |                                 |         |                                                  |         |
| Baker Community Correctional  Facility  Baker, California                              |         | 262                                   |         | 1987                                 |         | Owned                                                 |         |
| Big Spring Correctional  Center  Big Spring, Texas                                     |         | 2,646                                 |         |                                 | (4)          | Leased                                                | (5)          |
| D. Ray James Prison  Folkston, Georgia                                                 |         | 1,640                                 |         | 1998                                 |         | Leased                                                | (5)          |
| Donald W. Wyatt  Detention Center  Central Falls, Rhode Island                         |         | 357                                   |         | 1992                                 |         | Managed                                               |         |
| Great Plains  Correctional Facility  Hinton, Oklahoma                                  |         | 766                                   |         |                                 | (6)          | Leased                                                | (5)          |
| Leo Chesney Community  Correctional Facility  Live Oak, California                     |         | 200                                   |         | 1988                                 |         | Leased                                                |         |
| Mesa Verde Community  Correctional Facility  Bakersfield, California                   |         | 360                                   |         | 2006                                 |         | Leased                                                |         |
| Moshannon Valley  Correctional Center  Philipsburg, Pennsylvania                       |         | 1,300                                 |         | 2006                                 |         | Owned                                                 |         |
| Regional Correctional  Center  Albuquerque, New Mexico                                 |         | 970                                   |         | 2004                                 | (7)          | Leased                                                |         |
| Walnut Grove Youth  Correctional Facility  Walnut Grove, Mississippi                   |         | 941                                   |         | 2004                                 |         | Managed                                               |         |
|                                                                                   |         |                                  |         |                                 |         |                                                  |         |
| ***Juvenile  Justice, Educational and Treatment Facilities:  Residential Facilities*** | * *     | * *                              | * *     | * *                             | * *     | * *                                              | * *     |
|                                                                                   |         |                                  |         |                                 |         |                                                  |         |
| Alexander Youth  Services Center  Alexander, Arkansas                                  |         | 143                                   |         | 2001                                 |         | Managed                                               |         |
| Contact  Wauconda, Illinois                                                            |         | 51                                    |         |                                 | (8)          | Owned                                                 |         |
| Cornell Abraxas Academy  New Morgan, Pennsylvania                                      |         | 214                                   |         |                                 | (9)          | Owned                                                 |         |
| Cornell Abraxas I  Marienville, Pennsylvania                                           |         | 274                                   |         | 1973                                 |         | Leased                                                | (5)          |
| Cornell Abraxas II  Erie, Pennsylvania                                                 |         | 23                                    |         | 1974                                 |         | Owned                                                 |         |
| Cornell Abraxas III  Pittsburgh, Pennsylvania                                          |         | 24                                    |         | 1975                                 |         | Owned                                                 |         |
| Cornell Abraxas Center  for Adolescent Females  Pittsburgh, Pennsylvania               |         | 108                                   |         | 1989                                 |         | Owned                                                 |         |
| Cornell Abraxas of Ohio  Shelby, Ohio                                                  |         | 108                                   |         | 1993                                 |         | Leased                                                | (5)          |
| Cornell Abraxas Youth Center  South Mountain, Pennsylvania                             |         | 72                                    |         | 1999                                 |         | Leased                                                |         |

 

* *

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| **Facility Name and Location**                                                      | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                         | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** **                                            | ** ** |
| ***Juvenile  Justice, Educational and Treatment Facilities:  Residential Facilities (Continued)*** | * *   | * *                              | * *   | * *                             | * *   | * *                                              | * *   |
|                                                                                               |       |                                  |       |                                 |       |                                                  |       |
| DuPage  Adolescent Center  Hinsdale, Illinois                                                      |       | 38                                    |       |                                 | (8)        | Owned                                                 |       |
| Erie Residential  Behavioral Health Program  Erie, Pennsylvania                                    |       | 17                                    |       | 1999                                 |       | Owned                                                 |       |
| Hector Garza  Residential Treatment Center  San Antonio, Texas                                     |       | 122                                   |       |                                 | (10)       | Leased                                                | (5)        |
| Jos-Arz Academy  Washington, D.C.                                                                  |       | 70                                    |       |                                 | (11)       | Leased                                                |       |
| Leadership  Development Program  South Mountain, Pennsylvania                                      |       | 120                                   |       | 1994                                 |       | Leased                                                |       |
| Psychosocial  Rehabilitation Unit  Erie, Pennsylvania                                              |       | 13                                    |       | 1994                                 |       | Owned                                                 |       |
| Salt Lake Valley  Detention Center  Salt Lake City, Utah                                           |       | 160                                   |       | 1996                                 |       | Managed                                               |       |
| Schaffner Youth  Center  Steelton, Pennsylvania                                                    |       | 63                                    |       | 2001                                 |       | Managed                                               |       |
| Southern Peaks  Regional Treatment Center  Canon City, Colorado                                    |       | 160                                   |       | 2004                                 |       | Owned                                                 |       |
| Texas Adolescent  Treatment Center  San Antonio, Texas                                             |       | 124                                   |       | 2003                                 |       | Owned                                                 |       |
| Woodridge  Woodridge, Illinois                                                                     |       | 163                                   |       |                                 | (8)        | Owned                                                 |       |
|                                                                                               |       |                                  |       |                                 |       |                                                  |       |
| ***Juvenile  Justice, Educational and Treatment Facilities:  Non-Residential Facilities***         | * *   | * *                              | * *   | * *                             | * *   | * *                                              | * *   |
|                                                                                               |       |                                  |       |                                 |       |                                                  |       |
| Cornell Abraxas  Parenting Academy  Harrisburg, Pennsylvania                                       |       | 36                                    |       | 1999                                 |       | Leased                                                |       |
| Delaware  Community-Based Programs  Milford, Delaware                                              |       | 66                                    |       | 1994                                 |       | Leased                                                |       |
| Harrisburg Day  Treatment  Harrisburg, Pennsylvania                                                |       | 45                                    |       | 1996                                 |       | Leased                                                |       |
| Leadership  Academy/ACTS Program  Harrisburg, Pennsylvania                                         |       | 400                                   |       | 2001                                 |       | Managed                                               |       |
| Lebanon  Alternative Education  Lebanon, Pennsylvania                                              |       | 225                                   |       | 2004                                 |       | Managed                                               |       |
| Lehigh Valley  Community-Based Programs  Lehigh Valley, Pennsylvania                               |       | 60                                    |       | 1992                                 |       | Leased                                                |       |

 

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| **Facility Name and Location**                                                          | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** **                                            | ** ** |
| ***Juvenile  Justice, Educational and Treatment Facilities:  Non-Residential Facilities (Continued)*** | * *   | * *                              | * *   | * *                             | * *   | * *                                              | * *   |
|                                                                                                   |       |                                  |       |                                 |       |                                                  |       |
| Non-Residential  Detention/Non-Residential Treatment  Harrisburg, Pennsylvania                         |       | 91                                    |       | 1999                                 |       | Leased                                                |       |
| Philadelphia  Alternative Education  Philadelphia, Pennsylvania                                        |       | 165                                   |       | 2004                                 |       | Managed                                               |       |
| Philadelphia  Community-Based Programs  Philadelphia, Pennsylvania                                     |       | 71                                    |       | 1992                                 |       | Owned                                                 |       |
| Reading  Alternative Education  Reading, Pennsylvania                                                  |       | 200                                   |       | 2005                                 |       | Leased                                                |       |
| State  Reintegration Program  Harrisburg, Pennsylvania                                                 |       | 225                                   |       | 1991                                 |       | Managed                                               |       |
| WorkBridge  Pittsburgh, Pennsylvania                                                                   |       | 600                                   |       | 1994                                 |       | Leased                                                |       |
|                                                                                                   |       |                                  |       |                                 |       |                                                  |       |
| ***Adult  Community-Based Corrections and Treatment Facilities:  Residential Facilities***             | * *   | * *                              | * *   | * *                             | * *   | * *                                              | * *   |
| ** **                                                                                             | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** **                                            | ** ** |
| Beaumont  Transitional Treatment Center  Beaumont, Texas                                               |       | 180                                   |       | 2002                                 |       | Owned                                                 | (12)       |
| Cordova Center  Anchorage, Alaska                                                                      |       | 192                                   |       | 1985                                 |       | Leased                                                | (5)        |
| Dallas County  Judicial Treatment Center  Wilmer, Texas                                                |       | 300                                   |       | 1991                                 |       | Managed                                               |       |
| El Monte Center  El Monte, California                                                                  |       | 55                                    |       | 1993                                 |       | Leased                                                |       |
| Grossman Center  Leavenworth, Kansas                                                                   |       | 150                                   |       | 2002                                 |       | Leased                                                | (12)       |
| Las Vegas  Community Correctional Center  Las Vegas, Nevada                                            |       | 100                                   |       | 2004                                 |       | Owned                                                 |       |
| Leidel  Comprehensive Sanction Center  Houston, Texas                                                  |       | 190                                   |       | 1996                                 |       | Leased                                                | (5)        |
| Lincoln County  Detention Center  Carrizozo, New Mexico                                                |       | 144                                   |       | 2001                                 |       | Managed                                               | (12)       |
| Los Angeles City  Jails (13)  Los Angeles Metropolitan Area, California                                |       | 247                                   |       |                                 | (13)       | Managed                                               | (12)       |
| Marvin Gardens  Center  Los Angeles, California                                                        |       | 52                                    |       | 1981                                 |       | Leased                                                |       |
| McCabe Center  Austin,  Texas                                                                          |       | 90                                    |       | 1999                                 |       | Owned                                                 | (12)       |
| Mid Valley House  Edinburg, Texas                                                                      |       | 96                                    |       | 1998                                 |       | Leased                                                | (12)       |
| Midtown Center  Anchorage, Alaska                                                                      |       | 32                                    |       | 1998                                 |       | Owned                                                 |       |

 

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| **Facility Name and Location**                                                          | ** **   | **Total  Service  Capacity (1)** | ** **   | **Initial  Contract  Date (2)** | ** **   | **Company  Owned/  Leased or  Managed (3)** | ** **   |
|--------------------------------------------------------------------------------------------------------|--------------|---------------------------------------|--------------|--------------------------------------|--------------|-------------------------------------------------------|--------------|
|                                                                                                   |         |                                  |         |                                 |         |                                                  |         |
| ***Adult  Community-Based Corrections and Treatment Facilities:  Residential Facilities (Continued)*** | * *     | * *                              | * *     | * *                             | * *     | * *                                              | * *     |
| ** **                                                                                             | ** **   | ** **                            | ** **   | ** **                           | ** **   | ** **                                            | ** **   |
| Northstar Center  Fairbanks, Alaska                                                                    |         | 135                                   |         | 1990                                 |         | Leased                                                |         |
| Oakland Center  Oakland, California                                                                    |         | 61                                    |         | 1981                                 |         | Owned                                                 |         |
| Parkview Center  Anchorage, Alaska                                                                     |         | 112                                   |         | 1993                                 |         | Leased                                                | (5)          |
| Reality House  Brownsville, Texas                                                                      |         | 66                                    |         | 1998                                 |         | Owned                                                 | (12)         |
| Reid Community  Residential Facility  Houston, Texas                                                   |         | 500                                   |         | 1996                                 |         | Leased                                                | (5)          |
| Salt Lake City  Center  Salt Lake City, Utah                                                           |         | 78                                    |         | 1995                                 |         | Leased                                                |         |
| Seaside Center  Nome, Alaska                                                                           |         | 48                                    |         | 1999                                 |         | Leased                                                |         |
| Taylor Street  Center  San Francisco, California                                                       |         | 177                                   |         | 1984                                 |         | Owned                                                 |         |
| Tundra Center  Bethel, Alaska                                                                          |         | 85                                    |         | 1986                                 |         | Leased                                                | (5)          |
| *** ***                                                                                           | *** *** | *** ***                          | *** *** | *** ***                         | *** *** | *** ***                                          | *** *** |
| ***Adult  Community-Based Corrections and Treatment Facilities:  Non-Residential Facilities***         | * *     | * *                              | * *     | * *                             | * *     | * *                                              | * *     |
| ** **                                                                                             | ** **   | ** **                            | ** **   | ** **                           | ** **   | ** **                                            | ** **   |
| Dixon  Correctional Center (14)  Dixon, Illinois                                                       |         | 68                                    |         | 2003                                 |         | Managed                                               |         |
| East St. Louis  East St. Louis, Illinois                                                               |         | 164                                   |         |                                 | (8)          | Leased                                                |         |
| LifeWorks  Joliet, Illinois                                                                            |         | 116                                   |         |                                 | (8)          | Leased                                                |         |
| Sentencing  Concepts (15)  California                                                                  |         | 900                                   |         |                                 | (15)         | Leased                                                | (12)         |
| Southwood  Chicago, Illinois                                                                           |         | 549                                   |         |                                 | (8)          | Owned                                                 |         |

 

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(1)                    Residentialservice capacity is comprised of the number of beds currently available forservice or available upon the completion of construction or renovation ofresidential facilities. Non-residential service capacity is based on eithercontractual terms or our estimate of the number of clients to be served. Weupdate these estimates at least annually based on the program’s budget andother factors.

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

(3)                   Wedo not incur any facility use costs, such as debt service, rent or depreciationfor facilities that we operate under a management contract only; however, weare responsible for all other facility operating costs at these managedfacilities.

(4)                   The Big Spring Correctional Center wasoriginally operated under an Intergovernmental Agreement (“IGA”) that commencedin 1989 between the City of Big Spring and the BOP. On April 1, 2007, the IGAwill be replaced by a direct contract between the BOP and the company. Refer toItem 7 - “Recent Developments – Big Spring Correctional Center” for furtherdiscussion concerning the Big Spring Correctional Center contract.

(5)                   Facility wassold in August 2001 to Municipal Corrections Finance, L.P. (“MCF”) as partof the 2001 sale and leaseback transaction as discussed in Note 14 to theconsolidated financial statements in Item 8 of this report.

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(6)                   This facilityhas been operated pursuant to a one-year contract with nine one-year renewaloptions between the Oklahoma Department of Corrections (“OK DOC”) and theHinton Economic Development Authority, or HEDA. HEDA in turn had subcontractedthe operations of this facility to the company under a 30-year operatingcontract with four five-year renewal options. In October 2006, HEDA providedthe OK DOC with notice of intent to terminate their contract with OK DOC. Referto Item 7 - “Significant 2006 Events – Great Plains Correctional Facility” of thisreport for further discussion concerning this facility and related operatingcontract.

(7)                   We leased theRegional Correctional Center in January 2003 and renovated the facility in2003 and 2004. The facility commenced operations in July and December of 2004under an IGA between Bernalillo County and the USMS. In 2005, the IGA wasreplaced with a new contract between Bernalillo County and the U.S. Departmentof Justice Office of Detention Trustee, which allows for services to beprovided to both the USMS and ICE. In 2006, we added contracts with BernalilloCounty and the New Mexico Department of Corrections.

(8)                   The CornellInterventions programs/facilities contract with numerous agencies throughoutIllinois. Initial contract dates vary by agency and range from 1974 to 1997.

(9)                   We closed theCornell Abraxas Academy (formerly the New Morgan Academy) in 2002. In October2006, we reactivated the facility as a residential treatment center for youthsex offenders.  Refer to Item 7 - “Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Contractual Uncertainties Related to Certain Facilities – Cornell AbraxasAcademy” of this report for further discussion concerning this the reactivationof this facility and the related operating contract.

(10)             We closed the HectorGarza Residential Treatment Center (formerly the Campbell Griffin TreatmentCenter) in the fourth quarter of 2005 and intend to reactivate this program in2007. Refer to “Management’s Discussion and Analysis of Financial Condition andResults of Operations – Contractual Uncertainties Related to Certain Facilities– Hector Garza Residential Treatment Center” in Item 7 of this report forfurther discussion concerning this facility.

(11)             We closed the Jos-ArzAcademy in 2005 and are currently considering several options for use,including the operation of a new program.

(12)             Facility/program wasacquired in April 2005 in connection with the Company’s purchase ofCorrectional Systems, Inc. (CSI).

(13)             Los Angeles City Jails represents sevenindividual locations in Los Angeles, California and the surrounding area.Initial contract dates vary by agency and range from 1994-2006.

(14)             Wemanage a 68 bed dual diagnosis program located within the Special TreatmentCenter of the state-operated Dixon Correctional Center.

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

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**Marketing and Business Development**

Our principal customersare federal, state, and local government agencies responsible for adult andjuvenile corrections, treatment and educational services. We manage ourbusiness development efforts to address opportunities available in all of ourdivisions and potential markets. While such opportunities necessarily includeforming relationships with new customers, we also believe that furtherpotential lies in the management of our existing relationships through improvedbed management and through enhancements of our contract terms. From time totime, we will also evaluate opportunities for accretive acquisition.

In most instances, wepursue development opportunities through Requests for Proposal (RFPs) orRequests for Qualifications (RFQs), which are submitted in response togovernment agencies’ solicitations for bids. The decision to respond to suchsolicitations is based upon several factors, including management’s assessmentof customer needs, the company’s ability to service the needs in anoperationally successful and acceptably profitable manner, and the fit of thepotential program within the company’s existing portfolio and strategicobjectives. The solicitations generally require the bidder to demonstraterelevant operational experience. Furthermore, the response must also includedescriptions of the services to be provided by the bidder and the price atwhich the bidder is willing to provide them. Services can include not onlydirect care, but also the design, construction, or renovation of the relatedfacility.

If we believe a projectdescribed in an RFP is consistent with our strategic business plan, we willsubmit a proposal to the requesting agency. When responding to RFPs, wetypically incur costs ranging from $10,000 to $100,000 per proposal. Inaddition, we could incur substantial costs to acquire options to lease orpurchase land for a proposed facility or to lease or purchase an existingbuilding to house a program. The preparation of a response usually requiresfour to 12 weeks. The award process usually takes an additional three to ninemonths. If new construction is required by the contract, the selected company’soperation of the facility generally begins between 9 and 18 months followingaward announcement, although in some cases as early as four months. Ininstances where construction is required, our success depends, in part, uponour ability to acquire property that is not only satisfactory for programmaticneeds but also that lies in a community where social opposition does notsignificantly impede our ability to operate. We may incur significant expensesin responding to such opposition, and our response may not be successful. Inaddition, we may choose not to respond to an RFP or may withdraw a submittedproposal if significant legal action or other forms of opposition areanticipated or encountered.

In addition to respondingto RFPs, we also rely upon court-referrals, insurance- or managedcare-referrals, and self-referrals for business growth, particularly in ourjuvenile and adult community-based treatment programs. In such instances, courtand community liaisons play a significant role in developing our growingnetwork of clients.

#### **Contracts**

Our facility operatingcontracts generally provide that we will be compensated via an occupant perdiem rate, fees for treatment services, guaranteed take-or-pay terms, a fixedfee, or cost-plus reimbursement. Factors we consider in determining billingrates include (1) the specified programs provided for by the contract and therelated staffing levels, (2) wage levels customary in the respective geographicarea, (3) whether the proposed facility is to be leased or purchased, and (4)the anticipated average occupancy levels that we believe could reasonably be maintained.Compensation is invoiced in accordance with the applicable contract and istypically paid on a monthly basis. Some of our juvenile education contractsprovide for annual payments.

We pursue new contractsthat leverage our existing infrastructure and capabilities. The majority of ouropportunities are other than take-or-pay contracts, which provide a fixedminimum revenue stream regardless of occupancy. All of the other types ofcontracts produce revenue that varies with the number of individuals housed orserved, the types of services provided and/or the frequency of the service.

**Competition**

Because our services encompass several diversemarkets, we view our competition within market segments. We believe ourprincipal non-governmental competitors in the adult secure market areCorrections Corporation of America, Inc., The Geo Group, Inc., and Managementand Training Corporation. Within our two other segments – juvenile justice,education and treatment and adult community-based corrections and treatment –we typically encounter a significantly more fragmented competitor base, whichincludes not only for-profit operators like ourselves but also not-for-profitorganizations. Within the juvenile justice, education and treatment segment,some of our primary non-governmental competitors include ViaQuest, Youth andFamily Centered Services, Securicor New Century, and Ramsay Youth Services. Ourlarger non-governmental competitors in the adult community-based correctionsand treatment market include Dismas House, Bannum, Gateway, Salvation Army, andVolunteers of America.

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**Employees**

AtDecember 31, 2006, we had 4,186 full-time employees and 467 part-timeemployees. We employ management, administrative and clerical, security,educational and counseling services, health services and general maintenancepersonnel. Approximately 745 employees at 5 of our facilities are representedby unions.

**Regulations**

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

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

**BusinessConcentration**

Forthe years ended December 31, 2006, 2005 and 2004, 28.2%, 23.0% and 22.3%,respectively, of our consolidated revenues were derived from multiple contractswith the BOP. The increase in the percentage for 2006 as compared to the priortwo years is due to additional BOP revenue in 2006 resulting from theactivation of our Moshannon Valley Correctional Facility in April 2006.

**Insurance**

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

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

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

**RiskFactors and Cautionary Statement for Purposes of the “Safe Harbor” Provisionsof the Private Securities Litigation Reform Act of 1995**

Thisreport contains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. These statements are based oncurrent plans and actual future activities and results of operations may bematerially different from those set forth in the forward-looking statements. Where any forward-looking statement includesa statement of the assumptions or bases underlying the forward-lookingstatement, we caution that, while we believe these assumptions or bases to bereasonable and in good faith, assumed facts or bases almost always vary fromthe actual results, and differences between assumed facts or bases and actualresults can be material, depending upon the circumstances. Where, in anyforward-looking statement, we express an expectation or belief as to futureresults, that expectation or belief is expressed in good faith and is believedto have a reasonable basis. We cannot assure you, however, that the statementof expectation or belief will result or be achieved or accomplished. The words “believe,”“could,” “expect,” “estimate,” “anticipate,” “may” and similar expressions willgenerally identify forward-looking statements. All of our forward-lookingstatements, whether written or oral, are expressly qualified by thesecautionary statements and any other cautionary statements that may accompanysuch forward-looking statements. In addition, we disclaim any obligation toupdate any forward-looking statements to reflect events or circumstances afterthe date of this report.

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

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

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

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

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

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

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

Thenon-renewal or termination of any of our significant contracts withgovernmental agencies, our inability to secure new facility managementcontracts from others or our failure to successfully respond to a RFP or RFQcould materially adversely affect our financial condition, results of operationand liquidity. To the extent we have made significant capital expenditures andhave short-term contracts with our customers that are not renewed or extended,we may not recover our entire capital investment.

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

Ourcash flow is subject to the receipt of sufficient funding of and timely paymentby contracting governmental entities. If the appropriate governmental agencydoes not receive sufficient appropriations to cover its contractualobligations, a contract may be terminated or the amounts payable to us may bedeferred or reduced.

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

Manystates are facing significant budget deficits and are under pressure to reducecurrent levels of spending or control additional spending. As a result of thisincreased budgetary pressure, in certain cases we have granted a few of ourcustomers relief from formulaic increase provisions in their agreements andsome of our customers have not included in their appropriation legislationamounts that would increase the per diem rates payable to us. Contractual rateincreases are generally intended to offset increases in expenses and inflation.To the extent rates are not increased or are reduced, our profitability will beadversely affected.

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

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

When seeking bids, mostgovernmental entities evaluate the financial strength of the bidders. To theextent they believe we do not have sufficient financial resources, we will beunable to effectively compete for bids. Additionally, our success in obtainingnew awards and contracts may depend, in part, upon our ability to locate landthat can be leased or acquired on favorable terms. Furthermore, desirablelocations may be in or near populated areas and, therefore, may generate legalaction or other forms of opposition from residents in areas surrounding aproposed site.

***Our profitability may suffer if the number of offenders occupying ourcorrectional, detention and treatment facilities decreases or there is a shiftin occupancy among our divisions.***

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

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

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

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***A failure to comply with existing regulations could result in materialpenalties or non-renewal or termination of our contracts.***

Ourindustry is subject to a variety of federal, state and local regulations,including education, environmental, health care and safety regulations, whichare administered by various regulatory authorities. We may not alwayssuccessfully comply with these regulations, and failure to comply could resultin material penalties or non-renewal or termination of facility managementcontracts. The contracts typically include extensive reporting requirements andsupervision and on-site monitoring by representatives of contractinggovernmental agencies. Corrections officers are customarily required to meetcertain training standards, and in some instances facility personnel arerequired to be licensed and subject to background investigation. Certainjurisdictions also require that subcontracts be awarded on a competitive basisor that we subcontract with businesses owned by members of minority groups. Thefailure to comply with any applicable laws, rules or regulations and the lossof any required license could adversely affect the financial condition andresults of operations at our affected facilities.

***Governmental agencies may investigate and audit our contracts and, ifany improprieties are found, we may be required to refund revenues we havereceived, and/or to forego anticipated revenues and may be subject to penaltiesand sanctions, including prohibitions on our bidding in response to RFPs.***

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

***If we fail to satisfy our contractual obligations, our ability tocompete for future contracts and our financial condition may be adverselyaffected.***

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

***Competitors in our industry may adversely affect the profitability ofour business.***

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

Further, our governmentcustomers may assume the management of a facility currently managed by us uponthe termination of the corresponding management contract or, if such customershave capacity at their facilities, may take inmates currently housed in ourfacilities and transfer them to government run facilities. The resultingdecrease in occupancy levels would reduce our revenue due to the per diem ratestructure and could result in a significant decrease in the profitability ofour business.

***A disturbance or violent occurrence in one of our facilities couldresult in closure of a facility or harm to our business.***

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

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of certain of our facilitiescould adversely affect the financial condition, results of operations andliquidity of our operations. Such negative events may also result in asignificant increase in our liability insurance costs.

***Negative media coverage, including inaccurate or misleadinginformation, could adversely affect our reputation and our ability to bid forgovernment contracts.***

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

***We often incur significant costs before receiving related revenues, whichcould result in cash shortfalls and a risk of not recovering our investment.***

Whenwe are awarded a contract to manage a new facility, we may incur significantexpenses before we receive contract payments. These expenses include purchasingreal estate, constructing new facilities, leasing office space, purchasingoffice equipment and hiring and training personnel. As a result, when thegovernment does not fund a facility’s pre-opening and start-up costs, we may berequired to invest significant sums of money before receiving related contractpayments. In addition, payments due to us from governmental agencies may bedelayed due to billing cycles or as a result of failures by our governmentalcustomers to attain necessary budget approvals and finalize contracts in atimely manner. Several juvenile services contracts related to educationalservices provide for annual collection several months after a school year iscompleted. In addition, a contract may be terminated prior to its scheduledexpiration and as a result we may not recover these expenses or realize anyreturn on our investment.

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

***We may be unable to attract and retain sufficient qualified personnelnecessary to sustain our business.***

Ourdelivery of services is labor-intensive. When we are awarded a contract, wemust hire operating management, security, case management and other personnel.The success of our business requires that we attract, develop, motivate andretain these personnel. Our ability to recruit and retain qualified individualsvaries by facility and is related to the socio-economic factors in theparticular community in which the facility operates. The Department of Labor wageswe offer our employees are often higher than wages they could obtain elsewherein the community. However, if the local economy where a facility is located isrobust and unemployment is low, we may have difficulty hiring and retainingqualified personnel. In addition, there are inherent risks associated with thenature of the services we provide, which could cause certain qualifiedindividuals to seek other employment opportunities. We have experienced highturnover of personnel in our juvenile and adult secure facilities within thefirst year of their employment. Our inability to hire sufficient personnel on atimely basis or the loss of significant numbers of personnel could adverselyaffect our business.

***If we do not successfully integrate the businesses that we acquire, ourresults of operations could be adversely affected.***

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

Moreover,business combinations involve additional risks, including:

·      diversionof management’s attention;

·      lossof key personnel;

·      assumptionof unanticipated legal or financial liabilities;

·      ourbecoming significantly leveraged as a result of the incurrence of debt tofinance an acquisition;

·      unanticipatedoperating, accounting or management difficulties in connection with theacquired entities;

·      amortizationor charges of acquired intangible assets, including goodwill; and

·      dilutionto our earnings per share.

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Also, client dissatisfaction or performanceproblems with an acquired business could materially and adversely affect ourreputation as a whole. Further, the acquired businesses may not achieve therevenues and earnings we anticipated.

***Because environmental laws impose strict as well as joint and severalliability for clean up costs, unforeseen environmental risks could prove to becostly.***

Ourfacilities, and any facilities that we may acquire in the future, may besubject to unforeseen environmental risks. The federal ComprehensiveEnvironmental Response, Compensation, and Liability Act (CERCLA) imposesstrict, as well as joint and several, liability for certain environmentalcleanup costs on several classes of potentially responsible parties, includingcurrent owners and operators of the property. Other federal and state laws incertain circumstances may impose liability for environmental remediation, whichcosts may be substantial. Further, the operation of our facilities, and thedevelopment of new facilities, requires that we obtain, and comply with, permitsand other authorizations under environmental laws. Obtaining such permits andauthorizations may affect our existing facilities or could delay the opening ofnew facilities, which could have a material adverse effect on our business andresults of operations.

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

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

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

If we close a facilitythat we own, we will remain obligated for expenses associated with thefacility. If our operations are unprofitable at a leased facility or if theleased facility is performing significantly below targeted levels, we wouldtypically terminate the contract and the lease. However, we may continue tooperate our contract at an owned facility to offset the expenses associatedwith ownership. Continued performance of such a contract could have a materialadverse effect on our business and results of operations.

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

We currently derive, andexpect to continue to derive, a significant portion of our revenues from theBOP and various state agencies. The loss of, or a significant decrease in,business from the BOP or those state agencies could seriously harm ourfinancial condition and results of operations. Our BOP contracts accounted forapproximately 28.2 % of our total revenues for the year ended December 31, 2006($101.9 million), 23.0% of our total revenues for the year ended December 31,2005 ($71.6 million) and 22.3% for the year ended December 31, 2004 ($61.9million). We expect to continue to depend upon the BOP and a relatively smallgroup of other governmental customers for a significant percentage of ourrevenues.

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

Revenues can fluctuatefrom year to year due to changes in government funding policies, changes in thenumber of clients referred to our facilities by governmental agencies, theopening of new facilities or the expansion of existing facilities and thetermination of contracts for a facility or the closure of a facility. Ourrevenues fluctuate from quarter to quarter, based on the number of contracteddays in each quarter. Because our revenues can vary, we may face short-termfunding shortfalls from time to time. In addition, full-year results are notlikely to be a direct multiple of any particular quarter or combination ofquarters.

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

Worker’s compensation, employee health and generalliability insurance represent significant costs to us. We continue to incurincreasing insurance costs due to adverse claims experience and risinghealthcare costs in general. Due to concerns over corporate governance andrecent corporate accounting scandals, liability and other types of insurancehave become more difficult and costly to obtain. In addition, as a result ofthe stockholder lawsuits brought within the last few years, our directors andofficers liability insurance has increased. Unanticipated additional insurancecosts could adversely impact our results of operations and cash flows, and thefailure to obtain or maintain any necessary insurance coverage or the inabilityof an insurance carrier to perform under its obligations through issuedcoverage could have a material adverse effect on us.

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

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

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

Ourownership of correctional and detention facilities subjects us to riskstypically associated with investments in real estate. Moreover, correctionaland detention facilities are relatively illiquid and therefore, our ability todivest ourselves of one or more of our facilities promptly in response tochanged conditions is limited. Investments in correctional and detentionfacilities subject us to risks involving potential exposure to uninsured loss.Our operating costs may be affected by the obligation to pay for the cost ofcomplying with existing laws, ordinances and regulations, as well as the costof complying with future legislation. In addition, although we maintaininsurance for many types of losses, there are certain types of losses, such aslosses from earthquakes, riots and acts of terrorism, which may be eitheruninsurable or for which it may not be economically feasible to obtaininsurance coverage. As a result, we could lose both our capital invested in,and anticipated profits from, one or more of the facilities we own. Further, wecould experience losses that may exceed the limits of our insurance coverage.

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

None

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

Welease office space for our corporate headquarters in Houston, Texas and have aregional administrative office in Pittsburgh, Pennsylvania. We also leasevarious facilities we are currently operating or developing. For a listing ofowned, leased and managed facilities, see “Business - Facilities” in Item 1 ofthis report.

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

Cornell is a party tovarious legal proceedings, including those noted below. While managementpresently believes that the ultimate outcome of these proceedings will not havea material adverse effect on our financial position, overall trends in resultsof operations or cash flows, litigation is subject to inherent uncertainties,and unfavorable rulings could occur. An unfavorable ruling could includemonetary damages or equitable relief, and could have a material adverse impacton the net income of the period in which the ruling occurs or in futureperiods.

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

In August 2005, a lawsuitwas filed by a detainee at the Lincoln County Detention Center (LCDC) in theU.S. District Court of New Mexico (Santa Fe) seeking unspecified damages. Thelawsuit related to the former LCDC policy that required strip and visual bodycavity searches for all detainees and inmates and alleged that such policyviolates a detainee’s Fourth and Fourteenth Amendment rights under the U.S. Constitution.The lawsuit was filed as a putative class action lawsuit brought on behalf ofall inmates who were searched at the LCDC from May 2002 to July 2005.  In September 2006, we agreed to a proposedstipulation of settlement which, subject to the approval of the court, willresolve this action.  The settlementamount under the terms of the agreement is $1.6 million, and will be fundedprincipally through our general liability and professional liability coverage.

In the year endedDecember 31, 2005, we recorded a charge of $0.2 million related to thislawsuit. In addition, we previously have provided insurance reserves for thismatter (as part of our regular review of reported and unreported claims)totaling approximately $0.5 million. During the third quarter of 2006, werecorded an additional settlement charge of approximately $0.9 million and therelated reimbursement of $0.9 million from our general liability andprofessional liability insurance. The charge and reimbursement was recognizedin general and administrative expenses in our Consolidated Statements ofOperations and Comprehensive Income (loss) for the year ended December 31,2006. The liability is carried in accounts payable and accrued liabilities andthe reimbursement is included in other receivables at December 31, 2006. Thefunding of the settlement amount will occur upon the entry by the court of theorder granting preliminary approval of the stipulation of settlement, which iscurrently anticipated to occur during the first quarter of 2007.

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In addition, inconnection with our acquisition of the LCDC facility, certain amounts wereplaced in escrow to offset any undisclosed liability relating to suchacquisition. We have given notice to the prior owner of LCDC that we will seekto recover from the escrow any losses we may incur as a result of thislitigation.

##### ***Alexander Youth Service Center***

In April 2006, we weresued in an action styled as *Juana MichelleBrown, Administratrix of the Estate of Lakeisha Shantrail Brown, Deceased, v.Cornell Interventions, Inc. et al.,* No. 4-06 CV00000434, in theUnited States District Court for the Eastern District of Arkansas.  The lawsuit alleged that we violated therights of Lakeisha Shantrail Brown, the deceased daughter of Juana Michelle Brown,under the U.S. Constitution and the laws of the State of Arkansas by denyingMs. Brown medical treatment that caused her death and sought unspecified actualand punitive damages.  In September 2006,the plaintiff filed, and the court granted, an order for voluntary dismissalwithout prejudice.  The lawsuit wasrefiled in December 2006 as *Juana MichelleBrown, Administratrix of the Estate of Lakeisha Shantrail Brown, Deceasedv.Cornell Interventions, Inc. et al.,* No. 4-06 CV1708, in the UnitedStates District Court for the Eastern District of Arkansas.  We are unable to estimate our financialexposure relating to this lawsuit. We believe our insurance coverage isadequate to cover any potential damages relating to this action. We intend tovigorously defend this matter; however, the ultimate outcome of such a lawsuitcannot be determined at this time.

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

In January 2004, weinitiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v. Longboat GlobalAdvisors, LLC, et al*., No. 2004 CV79761 in the Superior Court ofFulton County, Georgia under theories of fraud, conversion, breach of contractand other theories to determine the location of and to recover funds that wepreviously deposited into what we believed to be an escrow account inconnection with the development and construction of the Southern Peaks RegionalTreatment Center. Of the funds previously deposited, approximately $5.3 millionremains to be recovered at December 31, 2006. In December 2004, the juryawarded us approximately $6.5 million in compensatory damages and approximately$1.4 million in punitive damages, plus attorneys’ fees. The actual damagesportion of the award under the final Judgment and Decree (“Judgment”) enteredon December 20, 2006 was adjusted downward to the $5.4 million actually lost byus. The award for compensatory damages accrues pre-judgment interest at a rateof 7 percent from the date of loss through the date of judgment. Following thejury verdicts, we collected approximately $0.4 million in January 2005 infunds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation. Currently, one of thedefendants has filed an appeal of the Judgment. Due to the continueduncertainty surrounding the ultimate recovery of the funds previouslydeposited, we recorded an additional reserve in the amount of approximately$0.3 million during the quarter ended December 31, 2006. We will continue tomaintain our existing reserve of approximately $5.3 million in an allowance fordoubtful accounts against the corresponding balance as carried in otherreceivables at December 31, 2006.

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

In March andApril 2002, Cornell, Steven W. Logan (our former President and ChiefExecutive Officer), and John L. Hendrix (our former Chief Financial Officer),were named as defendants in four federal putative class action lawsuits styledas follows: (1) *Graydon Williams, OnBehalf of Himself and All Others Similarly Situated v. Cornell Companies, Inc,et al.*, No. H-02-0866, in the United States District Court forthe Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*,No. H-02-1075, in the United States District Court for the SouthernDistrict of Texas, Houston Division; (3) *LouisA. Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the UnitedStates District Court for the Southern District of Texas, Houston Division, and(4) *Anthony J. Scolaro, On Behalf ofHimself and All Others Similarly Situated v. Cornell Companies, Inc., etal.,* No. H-02-1567, in the United States District Court for theSouthern District of Texas, Houston Division. The aforementioned lawsuits wereputative class action lawsuits brought on behalf of all purchasers of ourcommon stock between March 6, 2001 and March 5, 2002 and relate toour restatement in 2002 of certain financial statements. The lawsuits involveddisclosures made concerning two prior transactions executed by us: theAugust 2001 sale leaseback transaction and the 2000 synthetic leasetransaction. These four lawsuits were consolidated into the *Graydon Williams* action and FlylinePartners, LP was appointed lead plaintiff. As a result, a consolidatedcomplaint was filed by Flyline Partners, LP. Richard Picard and Anthony Scolarowere also named as plaintiffs. Since then, the court allowed plaintiffs to filean amended consolidated complaint. The amended consolidated complaint allegesthat the defendants violated Section 10(b) of the Securities ExchangeAct of 1934 (the “Exchange Act”), Rule 10b-5 promulgated underSection 10(b) of the Exchange Act, Section 20(a) of theExchange Act, Section 11 of the Securities Act of 1933 (the “SecuritiesAct”) and/or Section 15 of the Securities Act. The amended consolidatedcomplaint seeks, among other things, restitution damages, compensatory damages,rescission or a rescissory measure of damages, costs, expenses, attorneys’ feesand expert fees. In February 2006, the court approved the 

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settlement of this matter. Under the settlementagreement, Cornell has not admitted any wrongdoing. Settlement in the amount of$7.0 million was funded through our directors’ and officers’ liabilityinsurance. During the fourth quarter of 2005, we recorded the settlement chargeof $7.0 million and the related reimbursement of $7.0 million from our director’sand officer’s liability insurance. The charge and reimbursement were recognizedin general and administrative expenses in our Consolidated Statements ofOperations and Comprehensive Income (Loss) for the year ended December 31,2005. The liability was carried in accounts payable and accrued liabilities andthe reimbursement was included in other receivables at December 31, 2005. Thereimbursement was funded by the insurance carrier in 2005 into a trust accountand funds were disbursed from the trust account to plaintiffs’ counsel’s escrowaccount upon court approval of the settlement in February 2006.

In March 2002,Cornell, its directors, and its former independent auditor 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 District Court of Harris County,Texas. The lawsuit related to our restatement in 2002 of certain financialstatements. The lawsuit alleged breaches of fiduciary duty by all of theindividual defendants and asserted breach of contract and professionalnegligence claims only against Arthur Andersen LLP. This lawsuit has beendismissed without prejudice by agreement. In January 2004, we received aletter from William Williams, the plaintiff in the *William Williams* action discussed above, demanding that wepursue breach of fiduciary duty claims against various officers and directorsbased on the August 2001 sale leaseback transaction and the subsequentrestatement. We have issued a preliminary response to the letter indicatingthat the Board will consider the request and inform Mr. Williams of itsdecision. In May and September 2002, the Company and our thendirectors were sued in three other derivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,* No. 2002-28924,in the 164th Judicial District Court of Harris County,Texas. These lawsuits relate to our restatement in 2002 of certain financialstatements. These lawsuits all allege breaches of fiduciary duty and waste ofcorporate assets by all of the defendants. A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano* action as duplicative of the *Guitierrez* action. The court granted themotion to dismiss the *Guitierrez*action and the plaintiffs have appealed that ruling. The *Menning* action has been dismissed, butwith an agreement that the plaintiff’s claims as to Cornell are tolled until 30days following the final resolution of the *Guitierrez*case, including any appeals. The plaintiffs in these cases have not quantifiedtheir claim of damages. In December 2006, we agreed to a proposed stipulationof settlement which, subject to the approval of the court, will resolve thisaction.  The settlement terms includedreimbursement of up to $0.15 million of plaintiff’s legal expenses (to befunded through our director’s and officer’s liability insurance) as well as theimplementation of certain corporate governance enhancements (which we hadimplemented prior to the agreement). The settlement was approved by the courtin February 2007.  We have not recordedany loss accruals related to these claims.

On October 19, 2006, a purported class action complaint was filed in theDistrict Court of Harris County, Texas, 269th Judicial District (No.2006-67413) by Ted Kinbergy, an alleged stockholder of Cornell. The complaintnames as defendants Cornell and each member of our board of directors as wellas Veritas Capital Fund III, L.P. (“Veritas”). The complaint is a purportedclass action that alleges, among other things, that (i) the defendants havebreached fiduciary duties they assertedly owed to our stockholders inconnection with our entering into the Agreement and Plan of Merger, dated as ofOctober 6, 2006, with Veritas, Cornell Holding Corp., and CCI AcquisitionCorp., and (ii) the merger consideration is unfair and inadequate. Theplaintiffs sought, among other things, an injunction against the consummationof the merger. The proposed merger was rejected at a special meeting of ourstockholders held on January 23, 2007. We believe that the lawsuit is withoutmerit and intend to defend ourselves vigorously.

We hold insurance policies to cover potential directorand officer liability, some of which may limit our cash outflows in the eventof a decision adverse to us in the matters discussed above. However, if anadverse decision in these matters exceeds the insurance coverage or if theinsurance coverage is deemed not to apply to these matters, it could have amaterial adverse effect on us, our financial condition, results of operationsand future cash flows.

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**Other**

Additionally, wecurrently and from time to time are subject to claims and suits arising in theordinary course of business, including claims for damages for personal injuriesor for wrongful restriction of or interference with offender privileges andemployment matters. If an adverse decision in these matters exceeds ourinsurance coverage, or if our coverage is deemed not to apply to these matters,or if the underlying insurance carrier was unable to fulfill its obligationunder the insurance coverage provided, it could have a material adverse effecton our financial condition, results of operations or cash flows.

From August 2000through May 2003, our general liability and professional liabilitycoverage was provided by Specialty Surplus Insurance Company, a KemperInsurance Company (Kemper) group member. In June 2004, the IllinoisDepartment of Insurance gave Kemper permission to proceed with a run-off planit had previously submitted. The three-year plan is designed to help Kempermeet its goal of resolving, to the maximum extent possible, all validpolicyholder claims. In view of the risks and uncertainties involved inimplementing the plan, including the need to achieve significant policybuybacks, commutation of reinsurance agreements, and further agreements withregulators, the plan may not be successfully implemented by Kemper. In the yearended December 31, 2004, we accrued a provision of $0.6 million, andestimated our range of additional exposure to be approximately $0.5 millionwith respect to outstanding claims incurred during this policy period withKemper which would become our obligation to resolve if not settled throughKemper. During the year ended December 31, 2005, Kemper continued toimplement its run-off plan. As a result, several of our significant claims weresettled by Kemper during 2005. In conjunction with these settlements, werecorded a charge against our existing accrual in the amount of $0.3 million.Based on our analysis of the claims activity during the third quarter of 2005,we felt it necessary to accrue an additional provision in the amount ofapproximately $0.2 million during the third quarter of 2005. Additionalsignificant claims continued to be settled by Kemper during the second half of2006. As a result, we have released reserves of approximately $0.4 millionduring the quarter ended December 31, 2006. At December 31, 2006, we do notbelieve there is significant exposure above our existing $0.1 million accrualfor those outstanding claims which could become our obligation to resolve ifnot settled through Kemper.

While the outcome of suchmatters cannot be predicated with certainty, based on the information known todate, we believe that the ultimate resolution of these matters will not have amaterial adverse effect on our financial condition, operating results or cashflows.

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***ITEM 4.***                             SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

***On January 23, 2007, the Companyheld a Special Meeting of Stockholders to vote upon (1) a proposal to approveand adopt the Agreement and Plan of Merger, dated October 6, 2006, among TheVeritas Capital Fund III, L.P., Cornell Holding Corp., CCI Acquisition Corp.and Cornell Companies, Inc., as amended November 9, 2006 (the “Merger Agreement”)and (2) a proposal to adjourn the special meeting.***

***The Stockholders voted not toadopt the Merger Agreement, with 4,735,753 shares voted for, 8,420,729 sharesvoted against, 2,782 shares abstaining and 5,913 shares not voted.***

***The Stockholders voted against theproposal to adjourn the special meeting with 3,402,034 shares voted for,9,159,466 shares voted against and 603,667 shares abstaining.***

**PART II**

**ITEM 5.****                            ****MARKET FOR REGISTRANT’SCOMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

Ourcommon stock is listed on the New York Stock Exchange (NYSE) under the symbol “CRN.”  As of March 9, 2007, there were 440 recordholders of our common stock. The quarterly high and low closing sales pricesfor our common stock from January 1, 2005 through March 9, 2007 areshown below.
|                                             | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------|------------|----------|------------|---------|------------|
|                                        |       |     |       |    |       |
| 2005:                                       |       |     |       |    |       |
| First Quarter                               |       | $        | 15.64      |    | $          | 12.42 |   |
| Second Quarter                              |       | 13.60    |       | 11.60   |       |
| Third Quarter                               |       | 14.71    |       | 12.96   |       |
| Fourth Quarter                              |       | 14.78    |       | 13.58   |       |
| 2006:                                       |       |     |       |    |       |
| First Quarter                               |       | $        | 14.71      |    | $          | 13.26 |   |
| Second Quarter                              |       | 17.88    |       | 13.45   |       |
| Third Quarter                               |       | 18.40    |       | 15.12   |       |
| Fourth Quarter                              |       | 18.68    |       | 17.24   |       |
| 2007:                                       |       |     |       |    |       |
| First Quarter  (through March 9, 2007) |       | $        | 21.45      |    | $          | 18.22 |   |

 

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

Wedid not purchase any of our common stock in the fourth quarter of 2006.

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**ITEM 6.****         ****SELECTED FINANCIAL DATA**

Thefollowing data has been derived from our audited financial statements,including those included in this Form 10-K for the year ended December 31,2006 and should be read in conjunction with the consolidated financialstatements and notes thereto and Item 7 - “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations” included elsewhere in this report.
| ** **                                                                                                                                       | ** ** | **Year Ended December 31,**                         | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                                                       | ** ** | **2006 (1)**                                                  | ** ** | **2005 (2)** | ** ** | **2004 (3)** | ** ** | **2003 (4)** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statements of Operations Data:**                                                                                                               | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                                                                                         |       | $                                                                  | 360,855    |   | $ | 310,775 |   | $ | 277,190 |   | $ | 258,180 |   | $ | 263,023 |   |
| Income from  operations                                                                                                                          |       | 44,798                                                             |       | 27,866 |   | 14,459 |   | 24,484 |   | 30,150 |   |
| Income (loss)  from continuing operations before provision (benefit) for income taxes and  cumulative effect of changes in accounting principles |       | 21,728                                                             |       | 6,143 |   | (8,256 | ) | 6,828 |   | 10,852 |   |
| Income (loss)  from continuing operations before cumulative effect of changes in accounting  principles                                          |       | 12,580                                                             |       | 3,928 |   | (5,000 | ) | 4,028 |   | 6,475 |   |
| Discontinued  operations, net of tax                                                                                                             |       | (707                                                               | )          | (3,622 | ) | (2,433 | ) | (58 | ) | 852 |   |
| Cumulative  effect of changes in accounting principles, net of tax (5)                                                                           |       | 3⁄4                                                             |       | 3⁄4 |   | — |   | — |   | (965 | ) |
| Net income  (loss)                                                                                                                               |       | $                                                                  | 11,873     |   | $ | 306 |   | $ | (7,433 | ) | $ | 3,970 |   | $ | 6,362 |   |
|                                                                                                                                             |       |                                                               |       |   |   |   |   |   |   |   |   |
| Earnings (loss)  per share:                                                                                                                      |       |                                                               |       |   |   |   |   |   |   |   |   |
| ·        Basic                                                                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income (loss)  from continuing operations before cumulative effect of changes in accounting  principles                                          |       | $                                                                  | .90        |   | $ | .29 |   | $ | (.38 | ) | $ | .31 |   | $ | .50 |   |
| Discontinued  operations, net of tax                                                                                                             |       | $                                                                  | (.05       | ) | $ | (.27 | ) | $ | (.18 | ) | $ | — |   | $ | .07 |   |
| Cumulative  effect of changes in accounting principles, net of tax (5)                                                                      |       | $                                                                  | 3⁄4     |   | $ | 3⁄4 |   | $ | — |   | $ | — |   | $ | (.08 | ) |
| Net income  (loss)                                                                                                                               |       | $                                                                  | .85        |   | $ | .02 |   | $ | (.56 | ) | $ | .31 |   | $ | .49 |   |
|                                                                                                                                             |       |                                                               |       |   |   |   |   |   |   |   |   |
| ·        Diluted                                                                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income (loss)  from continuing operations before cumulative effect of changes in accounting  principles                                          |       | $                                                                  | .89        |   | $ | .29 |   | $ | (.38 | ) | $ | .30 |   | $ | .49 |   |
| Discontinued  operations, net of tax                                                                                                             |       | $                                                                  | (.05       | ) | $ | (.27 | ) | $ | (.18 | ) | $ | — |   | $ | .06 |   |
| Cumulative  effect of changes in accounting principles, net of tax (5)                                                                      |       | $                                                                  | 3⁄4     |   | $ | 3⁄4 |   | $ | — |   | $ | — |   | $ | (.07 | ) |
| Net income  (loss)                                                                                                                               |       | $                                                                  | .84        |   | $ | .02 |   | $ | (.56 | ) | $ | .30 |   | $ | .48 |   |
|                                                                                                                                             |       |                                                               |       |   |   |   |   |   |   |   |   |
| Number of shares  used to compute EPS:                                                                                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                                                                                            |       | 13,918                                                             |       | 13,580 |   | 13,203 |   | 12,941 |   | 12,911 |   |
| Diluted                                                                                                                                          |       | 14,059                                                             |       | 13,695 |   | 13,203 |   | 13,342 |   | 13,129 |   |

 

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| ** **                                                               | ** ** | **Year Ended December 31,**                    | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                               | ** ** | **(in thousands, except occupancy data)** | ** ** |
| **Operating Data:**                                                      | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                     |       |                                                          |       |   |   |   |   |   |   |   |   |
| **Residential:**                                                         | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service capacity  (6) (11)                                               |       | 14,659                                                        |       | 14,682 |   | 13,494 |   | 12,284 |   | 11,237 |   |
| Contracted beds  in operation (end of period) (7) (11)         |       | 13,492                                                        |       | 11,929 |   | 11,479 |   | 9,472 |   | 9,259 |   |
| Average contract  occupancy on contracted beds in operation (8) (9) (11) |       | 97.5                                                          | %          | 96.0 | % | 98.6 | % | 100.5 | % | 98.5 | % |
| Average contract  occupancy excluding start-up operations (8) (9) (11)   |       | 97.5                                                          | %          | 100.4 | % | 101.9 | % | 100.7 | % | 98.5 | % |
| **Non-Residential:**                                                     | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service capacity  (10) (11)                                              |       | 3,921                                                         |       | 4,792 |   | 3,852 |   | 3,568 |   | 3,601 |   |
|                                                                     |       |                                                          |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                                  | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Working capital                                                          |       | $                                                             | 75,078     |   | $ | 57,286 |   | $ | 107,597 |   | $ | 86,214 |   | $ | 95,988 |   |
| Total assets                                                             |       | 523,533                                                       |       | 510,628 |   | 507,631 |   | 449,103 |   | 441,291 |   |
| Long-term debt,  net of current portion                                  |       | 255,471                                                       |       | 266,659 |   | 279,528 |   | 227,292 |   | 232,258 |   |
| Stockholders’ equity                                                |       | 181,564                                                       |       | 165,461 |   | 161,312 |   | 166,235 |   | 159,952 |   |
|                                                                          |            |                                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Notes to Selected ConsolidatedFinancial Data**

(1)                   Incomefrom operations for the year ended December 31, 2006 includes a change ofapproximately $0.4 million to record impairments to the carrying value of twoof our adult community-based facilities. Refer to “Management Discussion andAnalysis of Financial Condition and Results of Operations” in Item 7 of thisreport.

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

(3)                   Incomefrom operations for the year ended December 31, 2004 includes a charge of$9.3 million to record an impairment to the carrying value of the CornellAbraxas Academy (formerly the New Morgan Academy). Income (loss) fromcontinuing operations before provision (benefit) for income taxes andcumulative effect of changes in accounting principles for the year endedDecember 31, 2004 includes a loss on extinguishment of debt ofapproximately $2.4 million related to the early retirement of the SyntheticLease Investor Notes A and B and the revolving line of credit under our amended2000 Credit Facility. Discontinued operations, net of tax for the year endedDecember 31, 2004 include charges totaling $0.8 million to record impairmentsto the carrying values of two of our juvenile facilities. Refer to “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” inItem 7 of this report for a detailed discussion concerning these charges.

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

(5)                   Forthe year ended December 31, 2002, we recognized a cumulative effect ofchanges in accounting principles charge of approximately $1.0 million, net ofan income tax benefit of approximately $0.7 million, related to the impairmentof goodwill in connection with the adoption of SFAS No. 142 inJanuary 2002.

(6)                   Residentialservice capacity is comprised of the number of beds currently available forservice or available upon the completion of construction or renovation ofresidential facilities.

(7)                   Atcertain residential facilities, the contracted capacity is lower than thefacility’s service capacity. We could increase a facility’s contracted capacityby obtaining additional contracts or by renegotiating existing contracts toincrease the number of beds covered. However, we may not be able to obtaincontracts that provide occupancy levels at a facility’s service capacity or beable to maintain current contracted capacities in future periods.

(8)                   Occupancy percentages reflect less thannormalized occupancy during the start-up phase of any applicable facility,resulting in a lower average occupancy in periods when we have substantialstart-up activities.

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

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(10)             Service capacity for non-residential programsis based on either contractual terms or an estimate of the number of clients tobe served. We update these estimates at least annually based on the program’sbudget and other factors.

(11)             Data presentedexcludes discontinued operating facilities.

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**ITEM 7.****          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**General**

Weare a leading provider of correctional, detention, educational, rehabilitationand treatment services outsourced by federal, state and local governmentagencies. We provide a diversified portfolio of services for adults andjuveniles through our three operating divisions: (1) adult secure institutionand detention services; (2) juvenile justice, educational and treatmentservices and (3) adult community-based corrections and treatment services. AtDecember 31, 2006, we operated 76 facilities with a total service capacityof 18,356 and had three facilities with an aggregate service capacity of224 beds that were vacant. Ourfacilities are located in 17 states and the District of Columbia.

Thefollowing table (which excludes data related to discontinued operatingfacilities) sets forth for the periods indicated total residential servicecapacity and contracted beds in operation at the end of the periods shown,average contract occupancy percentages and total non-residential servicecapacity.
| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Residential**                                                                    | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service capacity  (1) (2)                                                          |       | 14,659                                     |       | 14,682 |   | 13,494 |   |
| Contracted beds  in operation (end of period) (1) (3)                              |       | 13,492                                     |       | 11,929 |   | 11,479 |   |
| Average contract  occupancy based on contracted beds in operation (1) (4) (5) |       | 97.5                                       | %          | 96.0 | % | 98.6 | % |
| Average contract  occupancy excluding start-up operations (1) (4) (5)              |       | 97.5                                       | %          | 100.4 | % | 101.9 | % |
| **Non-Residential**                                                                | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service capacity (1)  (6)                                                          |       | 3,921                                      |       | 4,792 |   | 3,852 |   |

 

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(1)                    Data presented excludes discontinuedoperating facilities.

(2)                    Residentialservice capacity is comprised of the number of beds currently available forservice or available upon the completion of construction or renovation ofresidential facilities.

(3)                   Atcertain residential facilities, the contracted capacity is lower than thefacility’s service capacity. We could increase a facility’s contracted capacityby obtaining additional contracts or by renegotiating existing contracts toincrease the number of beds covered. However, there is no guarantee that wewill be able to obtain contracts that provide occupancy levels at a facility’sservice capacity or that current contracted capacities can be maintained infuture periods.

(4)                   Occupancy percentages reflect less thannormalized occupancy during the start-up phase of any applicable facility,resulting in a lower average occupancy in periods when we have substantialstart-up activities.

(5)                   Averagecontract occupancy percentages are calculated based on actual occupancy for theperiod as a percentage of the contracted capacity for residential facilities inoperation. These percentages do not reflect the operations of non-residentialcommunity-based programs. At certain residential facilities, our contractedcapacity is lower than the facility’s service capacity. Additionally, certainfacilities have and are currently operating above the contracted capacity. As aresult, average contract occupancy percentages can exceed 100% if the averageactual occupancy exceeded contracted capacity.

(6)                   Service capacity for non-residentialprograms is based on either contractual terms or an estimate of the number ofclients to be served. We update these estimates at least annually based on theprogram’s budget and other factors.

We derive substantiallyall of our revenues from providing adult corrections and treatment and juvenilejustice, educational and treatment services outsourced by federal, state andlocal government agencies in the United States. Revenues for our services aregenerally recognized on a per diem rate based upon the number of occupant daysor hours served for the period, on a guaranteed take-or-pay basis or on acost-plus reimbursement basis. For the year ended December 31, 2006, ourrevenue base consisted of 73.0% for services provided under per diem contracts,16.1% for services provided under take-or-pay and management contracts, 7.2%for services provided under cost-plus reimbursement contracts, 2.4% forservices provided under fee-for-service contracts and 1.3% from othermiscellaneous sources. Although these percentages are generally consistent withcomparable statistics for the years ended December 31, 2005 and 2004, thepercentage of revenues for services provided under per diem contracts hasdecreased and the percentage of revenues provided under take-or-pay andmanagement contracts has increased between the comparable periods for 2006 and2005 due primarily to the operations at the Moshannon Valley CorrectionalCenter opened in April 2006 which is a significant take-or-pay contract..  Additionally, the decrease in the percentageof revenues from per diem contracts between the comparable periods for 2006 and2005 was partially offset by the increased operations of the Regional CorrectionalCenter in 2006.

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Revenues can fluctuate fromyear to year due to changes in government funding policies, changes in thenumber or types of clients referred to our facilities by governmental agencies,the opening of new facilities or the expansion of existing facilities and thetermination of contracts for a facility or the closure of a facility.

Factorsconsidered in determining billing rates to charge include: (1) the programsspecified by the contract and the related staffing levels; (2) wage levelscustomary in the respective geographic areas; (3) whether the proposed facilityis to be leased or purchased and (4) the anticipated average occupancy levelsthat could reasonably be expected to be maintained

Revenuesfor our adult secure institutional services division are primarily generatedfrom per diem, take-or-pay and management contracts.  For the years ended December 31, 2006,2005 and 2004, we realized average per diem rates on our adult secureinstitutional facilities of approximately $56.12, $48.49 and $48.45,respectively. The increase in the average per diem rate in 2006 is dueprimarily to the opening of the Moshannon Valley Correctional Center in April2006. We periodically have experienced pressure from contracting governmentalagencies to limit or even reduce per diem rates.  Many of these governmental entities are undersevere budget pressures and we anticipate that governmental agencies mayperiodically approach us about per diem rate concessions.  Decreases in, or the lack of anticipatedincreases, in per diem rates could adversely impact our operating margin.

Revenuesfor our juvenile justice, educational and treatment services division areprimarily generated from per diem, fee-for-service and cost-plus reimbursementcontracts.  For the years endedDecember 31, 2006, 2005 and 2004, we realized average per diem rates onour residential juvenile justice, educational and treatment facilities ofapproximately $170.33, $167.68 and $164.54, respectively. The increase in theaverage per diem rate for 2006 is due to several factors including increasedoccupancy at the Southern Peaks Regional Treatment Center and the reactivationof the Cornell Abraxas Academy (formerly the New Morgan Academy) in the fourthquarter of 2006.  For the years endedDecember 31, 2006, 2005 and 2004, we realized average fee-for-servicerates for our non-residential community-based juvenile facilities and programs,including rates that are limited by Medicaid and other private insuranceproviders, of approximately $37.59, $34.21 and $27.53, respectively. Theincrease in the average fee-for-service rates for 2006 is due to changes in themix of services at our non-residential juvenile facilities, as well as theaddition of several new alternative education programs in 2005. The majority ofour juvenile services contracts renew annually.

Revenuesfor our adult community-based corrections and treatment services division areprimarily generated from per diem and fee-for-service contracts.  For the years ended December 31, 2006,2005 and 2004, we realized average per diem rates on our residential adultcorrections and treatment facilities of approximately $61.71, $62.02 and$62.10, respectively.  For the yearsended December 31, 2006, 2005 and 2004, we realized average fee-for-servicerates on our non-residential adult community-based corrections and treatmentfacilities and programs of approximately $11.23, $9.40 and $8.23,respectively.  Our averagefee-for-service rates fluctuate from year to year principally due to changes inthe mix of services provided by our various adult community-based programs andfacilities.

Wehave historically experienced higher operating margins in our adult secureinstitutional services and adult community-based corrections and treatmentservices as compared to the juvenile justice, educational and treatmentservices division.  Additionally, ouroperating margins within a division can vary from facility to facility based onwhether a facility is owned or leased, the level of competition for the contractaward, the proposed length of the contract, the mix of services provided, theoccupancy levels for a facility, the level of capital commitment required withrespect to a facility, the anticipated changes in operating costs over the termof the contract, and our ability to increase a facility’s contract revenue.Under take-or-pay contracts, such as the contract relating to Moshannon ValleyCorrectional Center, operating margins are typically higher during the earlystages of the contract as the facility’s population ramps up (as revenues arereceived at contract percentages regardless of actual occupancy).  As the variable costs (primarilyresident-related and certain facility costs) increase with the growth inpopulation, operating margins will generally decline to a stabilized level.Following its activation in April 2006, we experienced such margin impactpertaining to our Moshannon Valley Correctional Center in the third and fourthquarters of 2006. A decline in occupancy of certain juvenile justice,educational and treatment facilities can have a more significant impact onoperating results than the adult secure institutional services division due tohigher per diem rates at certain juvenile facilities.

Wehave experienced and expect to continue to experience interim period operatingmargin fluctuations due to factors such as the number of calendar days in theperiod, higher payroll taxes in the first half of the year and salary and wageincreases and insurance cost increases that are incurred prior to certaincontract rate increases.  Periodically,many of the governmental agencies with whom we contract may experiencebudgetary pressures and may approach us to limit or reduce per diem rates.  Decreases in, or the lack of anticipatedincreases in, per diem rates could adversely impact our operating margin.  Additionally, a decrease in per diem rateswithout a corresponding decrease in operating expenses could also adverselyaffect our operating margin.

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Weare responsible for all facility operating costs, except for certain debtservice and interest or lease payments for facilities where we have amanagement contract only.  At thesefacilities, the facility owner is responsible for all debt service and interestor lease payments related to the facility. We are responsible for all other operating expenses at these facilities.We operated 18 facilities under management contracts at December 31, 2006,20 facilities at December 31, 2005 and 12 facilities at December 31,2004.

Amajority of our facility operating costs consists of fixed costs.  These fixed costs include lease and rentalexpense, insurance, utilities and depreciation. As a result, when we commence operation of new or expanded facilities,fixed operating costs may increase.  Theamount of our variable operating costs, including food, medical services,supplies and clothing, depend on occupancy levels at the facilities weoperate.  Our largest single operatingcost, facility payroll expense and related employment taxes and expenses, hasboth a fixed and a variable component. We can adjust a facility’s staffing levels and the related payrollexpense to a certain extent based on occupancy at a facility, however a minimumfixed number of employees is required to operate and maintain any facilityregardless of occupancy levels. Personnel costs are subject to increases in tightening labor marketsbased on local economic environments and other conditions.

Weincur pre-opening and start-up expenses including payroll, benefits, trainingand other operating costs prior to opening a new or expanded facility andduring the period of operation while occupancy is ramping up. These costs varyby contract.  Since pre-opening andstart-up costs are generally factored into the revenue per diem rate that ischarged to the contracting agency, we typically expect 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, we may incuradditional post-opening start-up costs. We do not anticipate post-opening start-up costs at any adult securefacilities operated under any future contracts with the BOP which aretake-or-pay contracts, meaning that the BOP will pay at least 80.0% of thecontractual monthly revenue once the facility opens, regardless of actualoccupancy.

Newlyopened facilities are staffed according to applicable regulatory or contractualrequirements when we begin 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.  Our start-up period for newjuvenile operations is 12 months from the date we begin recognizing revenueunless break-even occupancy levels are achieved before then.  Our start-up period for new adult operationsis nine months from the date we begin recognizing revenue unless break-evenoccupancy levels are achieved before then. Although we typically recover these upfront costs over the life of thecontract, quarterly results can be substantially affected by the timing of thecommencement of operations as well as the development and construction of newfacilities.

Workingcapital requirements generally increase immediately prior to commencingmanagement of a new or expanded facility as we incur start-up costs andpurchase necessary equipment and supplies before facility management revenue isrealized.

Generaland administrative expenses consist primarily of costs for corporate andadministrative personnel who provide senior management, legal, finance,accounting, human resources, payroll and information systems, costs of businessdevelopment and outside professional and consulting fees. We incurredadditional legal and outside professional and consulting fees related to theMerger Agreement with Veritas, discussed in “Significant 2006 Events” below,during both 2006 and the first quarter of 2007.

# **Management Overview**

***Demand*****.** Our business is driven generally by demand for incarceration ortreatment services, and specifically by demand for private incarceration ortreatment services, within our three primary business segments: adult secureinstitutional services; juvenile justice, educational and treatment services;and adult community-based corrections and treatment services.  The demand for adult and juvenile correctionsand treatment services has generally increased at a steady rate over the pastten years, largely as a result of increasing sentence terms and/or mandatorysentences for criminals and as well a greater range of criminal acts, increasingdemand for incarceration of illegal aliens and a public recognition of the needto provide services to juveniles that will improve the possibility that theywill lead productive lives. Moreover, demand for our services is also affectedby the amount of available capacity in the government systems to enablegovernments to provide the services themselves, as well as  desire and ability of these systems to addadditional capacity. Recent recommendations by social commentators and variouspolitical or governmental representatives suggest that community-basedcorrections of adults should be emphasized in the future as alternatives totraditional incarceration.  Among otherthings, we monitor federal, state and industry communications and statisticsrelative to trends in prison populations, juvenile justice statistics andinitiatives, and developments in alternatives to traditional incarceration ordetention of adults for opportunities to expand our scope or delivery ofservices.

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Thefederal government increasingly is turning to private providers for theincarceration of adults whether they are serving prison sentences, detained asillegal aliens, detained in anticipation of pending judicial administration ortransitioning from prison to society. Chief among the federal agencies which use private providers are theBOP, ICE, and USMS. We provide adult secure and adult community-based servicesto the federal government.  Most of thefederal involvement in juvenile administration in the federal system is handledvia Medicare and Medicaid assistance to state governments. Although there arecircumstances in which we may contract with a federal agency on a sole sourcebasis, the primary means by which we secure a contract with a federal agency isvia the RFP bidding process.  From timeto time, we contract to provide management services to a local governmentalunit who then bids on a federal contract.

Statesand smaller governmental units remain divided on the issue of private prisonsand private provision of juvenile and community-based programs, although amajority of states permit private provision for our services.  We anticipate that increasing budget pressureon states and smaller governmental units will cause more states and smallergovernmental units to consider utilizing private providers such as us toprovide these services on a more economical basis.  Although it varies from governmental unit togovernmental unit, the primary political forces who typically oppose privatizationof prisons are organized labor and religious groups.

Privatejuvenile and community-based programs are much more widely accepted andutilized by states and local governmental units than private adultprisons.  Many private providers areorganized on a not-for-profit basis, but there are a number of large,for-profit providers of juvenile and community-based programs.  We monitor opportunities in these segmentsvia our corporate and service-line development officials.  Many opportunities are not published in anymanner and, accordingly, we believe that taking the initiative at the state andlocal levels is key in developing sole source opportunities.

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

·                  capacity (the number of beds withineach business segment’s facilities)

·                  occupancy(utilization)

·                  perdiem reimbursement rates

·                  operatingexpenses

Capacity,commonly expressed in terms of a number of beds, is primarily impacted by thenumber and size of the facilities we own or lease and the facilities which arenot owned or leased but which are operated by us on behalf of a third partyowner or lessee.  We view capacity as oneof the measures of our development efforts, through which we may increase capacityby adding new projects or by expanding existing projects.  As part of the evaluation of our developmentefforts, we will assess (a) whether a given development project was broughtinto service in accordance with our expectation as to time and expense; and (b)the number of projects in development or under consideration at the relevantpoint in time.  In addition to the focuson new projects, capacity will reflect our success in renewing and maintainingexisting contracts and facilities.  Itwill also reflect any closure of programs or facilities due to underutilizationor failure to earn an adequate risk-adjusted rate of return.  We must also be cognizant of the possibilitythat state or local budgetary limitations may cause the contractual commitmentto a given facility to be reduced or even eliminated, which would require us toeither secure an alternate customer or close the operation.

Occupancyis typically expressed in terms of percentage of contract capacityutilized.  We look at occupancy to assessthe efficacy of both our efforts to market our facilities and our efforts toretain existing customers or contracts. Because revenue varies directly with occupancy, occupancy is a driver ofour revenues. Some of our contracts are “take-or-pay,” meaning that the agencymaking use of the facility is obligated to pay for beds even though they arenot used.  Historically, occupancypercentages in many of our facilities have been high and we are mindful of theneed to maintain high occupancy levels. As new development projects are brought into service, occupancypercentages may decline until the projects reach full utilization.  Where we have commitments for utilizationbefore the commencement of operations, occupancy percentages reflect the speedat which a facility achieves full service/implementation. However, we maydecide to undertake development projects without written commitments to makefull use of a facility. In these instances, we have performed our ownassessment, based on discussions with local government or other potentialcustomer representatives and analysis of other factors, of the demand forservices at the facility.  There is noassurance that we will recover our initial investment in these projects.  We will monitor occupancy as a measure of theaccuracy of our estimation of the demand for the services of a developmentfacility, and will incorporate this information in future assessments ofpotential projects.

Per diemreimbursement rates are the other key element of our gross revenue andoperating margin since per diem contracts represent a majority of our revenues(73.0% for the year ended December 31, 2006).  Per diem rates are a function of negotiationbetween management and a governmental unit at the inception of a contract orthrough the RFP process.  Actual per diemrates vary dramatically across our business segments, and as well within eachbusiness segment depending upon the particular service or program provided. Theinitial per diem rates often change during the term of a contract in accordancewith a schedule.  The

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amount of thechange can be a fixed amount set forth within the contract, an amountdetermined by formulas set forth within the contract or an amount determined bynegotiations between management and the governmental unit (often thesenegotiations are along the same lines as the original per diem negotiation — areview of expenses and approval of an amount to recompense for expenses andassure the potential of an operating profit). In recent years, as budgetary pressures on governmental units haveincreased, some of our governmental customers have negotiated relief fromformulaic increase provisions within their agreements or have declined toinclude in their appropriation legislation amounts that would increase the perdiem rates payable under the contract (needed in some cases to offset operatingexpense increases).  Although we havemitigated a portion of the impact of these developments by negotiating servicesprovided or obtaining commitments for increased volume, we may also take stepsprimarily in the area of legislative and governmental monitoring and lobbyingto try to reduce or avoid these sorts of adverse developments in thefuture.  We will continue to monitor perdiem rates as a measure of negotiation skill, customer service, management andmaintenance, political and business astuteness.

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

We recognize that our operating margins are subject to pressure from avariety of factors, but most notably rising costs and governmental and agencybudgetary constraints.  We also believethat successful development of higher margin and low capital projects is key tomitigating such pressure.  For anydevelopment projects committed or facility reactivations in progress, untilthose projects are completed and brought into full service, we will continue tomonitor operations and existing customer relationships in an attempt tominimize the duration of start-up periods and the related pressure on operatingmargins.

#### **Significant2006 Events**

***Merger Agreement***

On October 6, 2006, we entered into an Agreement and Plan of Merger(the “Merger Agreement”) with The Veritas Capital Fund III, L.P., a Delawarelimited partnership (“Veritas”), Cornell Holding Corp., a Delaware corporation(“Parent”) and CCI Acquisition Corp., a Delaware corporation and wholly ownedsubsidiary of Parent (“Merger Sub”), pursuant to which the Merger Sub would bemerged with and into us (the “Merger”), with Cornell surviving after the Mergeras a wholly owned subsidiary of Parent.

Our Board of Directors unanimously approved the MergerAgreement. In connection with the Merger, the Parent and certain of ourstockholders entered into a Voting Agreement dated on or about October 6, 2006,whereby such stockholders agreed, among other things, to vote their respectiveshares of our stock in favor of the Merger Agreement, the Merger and thetransactions contemplated thereby.  At aspecial meeting of our stockholders held on January 23, 2007, the proposedMerger Agreement was rejected.

Under the terms of theMerger Agreement, because the Merger was terminated, we reimbursed $2.5 millionof these costs incurred by Veritas, Parent and Merger Sub in connection withthe proposed merger in February 2007. Such costs will be reported in generaland administrative expenses in the first quarter of 2007.

***Great Plains Correctional Facility***

We believe thatour existing contract with the Oklahoma Department of Corrections (“OK DOC”)with respect to our Great Plains Correctional Facility expired in July 2006.Despite negotiations with the OK DOC beginning early in 2006, we have beenunable to agree on terms for a new contract. As a result, to preserve our rights relative to other businessopportunities, in October 2006 HEDA notified OK DOC of our intent to terminatethe contract.  With our Great PlainsCorrectional Facility, as with all our facilities, we seek to maximize theoperating potential based on an assessment of which potential customer(s) wouldenable us to realize the highest economic value. To date we do not have analternate customer for this facility, which generated revenues of approximately$12.5 million, $12.8 million and $12.5 million in the years ended December 31,2006, 2005 and 2004, respectively. Our inability to obtain a new customer forthis facility could have an adverse effect on our financial condition, resultsof operations and liquidity.

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***Cornell Abraxas Academy (formerly the New Morgan Academy)***

We closed the CornellAbraxas Academy (formerly the New Morgan Academy) in the fourth quarter of 2002and considered several options ranging from the utilization of the facility foranother type of program or the sale or lease of the facility. In 2005 we beganfocusing our efforts on reactivating the facility under a new program.  We reactivated this facility  in October 2006 as a residential treatmentcenter for youth sex offenders. We recognized pre-tax costs of $4.8 million,$3.6 million and $13.5 million (including an impairment charge of $9.3 millionin 2004 as discussed below) in our Consolidated Statements of Operations andComprehensive Income (Loss) for the years ended December 31, 2006, 2005 and 2004,respectively, for related holding costs (depreciation, interest, property,taxes and other maintenance costs). The expenses for the 2006 period increasedin conjunction with the reactivation of the facility in October 2006.

In December 2004, we recorded an impairment charge ofapproximately $9.3 million related to this facility as it was determined,pursuant to the requirements of SFAS No. 144, that the carrying amount of thefacility was not fully recoverable and exceeded its fair value (as based on themost current estimates of cash flows). As of December 31, 2006, we believethat, pursuant to the provisions of SFAS No. 144, no additional impairmentallowance is necessary. The carrying value of the property and equipment forthe Cornell Abraxas Academy, after the impairment charge in 2004, wasapproximately $19.5 million and $19.9 million at December 31, 2006 and2005, respectively.

***Central California Treatment Center***

InJanuary 2004, we purchased a building in Los Angeles, California for whichour carrying value was approximately $2.7 million at December 31, 2005.   In 2005, we received notice from a localgovernmental agency indicating a desire to acquire the facility.  In early 2006, the governmental agencyinitiated condemnation proceedings relating to the facility and depositedapproximately $2.9 million of condemnation proceeds with the court which wereceived in July 2006.  We subsequentlycommenced litigation contesting the valuation of the facility submitted by thegovernmental agency.

***Hector Garza Residential Treatment Center (formerly theCampbell Griffin Treatment Center)***

In October 2005,we initiated the temporary closure of this leased facility in San Antonio,Texas. It is our intent to reactivate this facility during 2007 and therefore,it has not been included in discontinued operations in the years ended December31, 2006 and 2005. Our net book carrying value for this facility  was approximately $4.2 million at December31, 2006.

***Alexander Youth Services Center***

In November 2006, the Arkansas Department of Healthand Human Services (“DHHS”) notified us of its intent to terminate ourmanagement contract relating to the Alexander Youth Services Center. Thetransition of this contract to the new operator occurred in January 2007 (at nosignificant cost to us). This contract generated revenues of approximately$10.8 million, $9.9 million and $9.3 million in the years ended December 31,2006, 2005 and 2004, respectively. We did not maintain any significant netproperty and equipment pertaining to this contract at December 31, 2006.

***Moshannon Valley Correctional Center***

We began operatingthe 1,300 bed Moshannon Valley Correctional Center in April 2006 under athree-year take-or-pay contract with the BOP (the BOP has the option to grantseven one-year extensions).  Our net bookcarrying value of this facility at December 31, 2006 was approximately $70.5million. We recognized pre-opening and start-up expenses of approximately $2.7million, $0.6 million and $0.06 million in the years ended December 31, 2006,2005 and 2004, respectively.

***Mesa Verde Community Correctional Facility***

In December 2005,we entered into a five-year agreement with the California Department ofCorrections to operate the Mesa Verde Community Correctional Facility which welease.  The facility commenced operationsin January 2006 and houses up to 360 male California inmates.

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#### **RecentDevelopments**

***Big Spring Correctional Center***

During 2006, the BOP solicited a RFP for services tohouse approximately 7,000 low security non-United States citizen sentencedmales in an existing secure correctional institution procured from private sourcesor state and local governments, with excess capacity, located in Arizona,California, Louisiana, New Mexico, Oklahoma or Texas to replace severalexisting intergovernmental agreements (“IGA”) for such services, including theIGA relating to our Big Spring Correctional Center.  In January 2007, we were awarded a contractfrom the BOP to operate the Big Spring Correctional Center. The take-or-paycontract, which is effective April 1, 2007, provides for an initial contractterm of four years with three two-year renewal option periods.

#### **NewAccounting Pronouncements**

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

On January 1, 2006, we adopted theprovisions of the Financial Accounting Standards Board (“FASB”), Statement ofFinancial Accounting Standards (“SFAS”) No. 123R, “Share Based Payment” andelected to use the modified prospective transition method.  The modified prospective transition methodrequires that compensation cost be recognized in the financial statements forall awards granted after the date of adoption as well as for existing awardsfor which the requisite service has not been rendered as of the date ofadoption and requires that prior periods be restated.  Our stock incentive plans provide for thegranting of incentive options and nonqualified options to our officers,directors and key employees. Outstanding options vest over periods up to sevenyears after the date of grant and expire no more than 10 years after the dateof grant. Prior to the adoption of SFAS No. 123R, we used the intrinsic-valuebased method to account for stock options and recorded no charges againstearnings with respect to options granted. We have elected to use the “short-cutmethod” to calculate the historical pool of windfall tax benefits upon adoptionof SFAS 123R. The election to use the “short-cut method” had no effect on ourconsolidated financial statements for the year ended December 31, 2006.

The adoption of SFAS No. 123Rreduced income from continuing operations before income taxes for the yearended December 31, 2006 by approximately $1.9 million and reduced net incomefor the year ended December 31, 2006 by approximately $1.1 million ($0.08 perbasic and diluted share). The adoption of SFAS No. 123R had an immaterialeffect on our Consolidated Statement of Cash Flows for the year ended December31, 2006. Refer to Note 1 to the consolidated financial statements in Item 8 ofthis report for further information concerning our adoption of SFASNo. 123R.

***Financial AccountingStandards Board Interpretation No. 48***

In June 2006, the FASB issued Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes” (“FIN 48”), to clarify the accounting foruncertainty in income taxes recognized in an entity’s financial statements inaccordance with SFAS No. 109, “Accounting for Income Taxes.”  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  Thecumulative effect of applying the provisions of FIN 48 will be reported in ourfirst quarter of 2007 financial statements as an adjustment to the openingbalance of retained earnings for 2007. We estimate that the cumulative effect adjustment will increase retainedearnings by up to $0.6 million which is subject to revision when managementcompletes an analysis of the impact of FIN 48.

***Statement of Financial AccountingStandards No. 157***

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements.” This statement establishes a framework for measuring fairvalue within generally accepted accounting principles and expands the requireddisclosures concerning fair value measurements. SFAS No. 157 is effective forfinancial statements issued for fiscal years beginning after November 15, 2007,and interim periods within those fiscal years. The provisions of SFAS No. 157must be applied prospectively as of the beginning of the fiscal year in whichSFAS No. 157 is adopted, except in limited circumstances. We plan to adopt theprovisions of SFAS No. 157 January 1, 2008. We are currently evaluating theimpact that the adoption of this standard may have on our consolidatedfinancial statements.

***Statement ofFinancial Accounting Standards No. 159***

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities – Including anamendment of FASB Statement No. 115.” This statement permits entities to chooseto measure many financial instruments and certain other items at fair valuethat are not currently required to be measured at fair value and establishespresentation and disclosure requirements designed to facilitate comparisonsbetween entities that choose different measurement attributes for similar typesof assets and liabilities. SFAS No. 159 is effective as of the beginning of anentity’s first fiscal year 

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thatbegins after November 15, 2007. Early adoption is permitted as of the beginningof a fiscal year that begins on or before November 15, 2007, provided theentity also elects to apply the provisions of SFAS No. 157, “Fair ValueMeasurements.” We plan to adopt the provisions of SFAS No. 159 January 1, 2008.We are currently evaluating the impact of the adoption of this standard mayhave on our consolidated financial statements.

**CriticalAccounting Policies and Estimates**

The preparation of ourfinancial statements in conformity with GAAP requires management to makecertain estimates and assumptions. These estimates and assumptions affect thereported amounts of assets and liabilities, the disclosures of contingentassets and liabilities at the balance sheet date and the amounts of revenuesand expenses recognized during the reporting period. We analyze our estimatesbased on our historical experience and various other assumptions that we believeto be reasonable under the circumstances. However, actual results could differfrom such estimates. The following is a discussion of our critical accountingestimates. Management considers an accounting estimate to be critical if:

·                  itrequires assumptions to be made that were uncertain at the time the estimatewas made; and

·                  changes in the estimate or different estimatesthat could have been selected could have a material impact on our consolidatedfinancial position or results of operations.

For a summary of all ofour significant accounting policies see Note 2 to the accompanying consolidatedfinancial statements.

***Revenue Recognition***

Substantially all of our revenues are derived from contracts withfederal, state and local governmental agencies which pay either per diem ratesbased upon the number of occupant days or hours served for the period, on atake-or-pay basis, management fee basis, cost-plus reimbursement orfee-for-service basis.  We recognize revenuewhen we determine that the following criteria are met: (i) persuasive evidenceof an arrangement exists; (ii) delivery has occured or services have been rendered;(iii) the fee is fixed or determinable; and (iv) collectibility is reasonablyassured.

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

We extend credit to the governmental agencies contracted with and otherparties in the normal course of business. We regularly review our outstanding receivables and historicalcollection experience and provide for estimated losses through an allowance fordoubtful accounts.  In evaluating theadequacy of our allowance for doubtful accounts, we make judgments regardingour customers’ ability to make required payments, economic events and otherfactors.  As the financial condition ofthese parties change, circumstances develop or additional information becomesavailable, adjustments to the allowance for doubtful accounts may occur.  If, after reasonable collection efforts havebeen made, a receivable is determined to be permanently uncollectible, it iswritten off.

***Insurance Reserves***

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

Based on the risks discussed above, it is necessary for us to estimatethe level of our liability related to insurance and record reserves for theseamounts in our consolidated financial statements.  Reserves related to self-insurance are basedon the facts and circumstances specific to the claims and our past experiencewith similar claims.  The actual outcomeof self-insured claims could differ significantly from estimated amounts.  Our reserves are based on certain assumptionsdeveloped utilizing historical data to project future losses.  Loss estimates in the calculation of theseaccruals are adjusted based upon actual claim settlements and reportedclaims.  These loss estimates andaccruals recorded in our financial statements for claims have historically beenreasonable in light of the actual amount of claims paid.

As the determination of our liability for self-insured claims issubject to significant management judgment and in certain instances is based onactuarially estimated and calculated amounts, and such liabilities could bematerial in nature, management believes that accounting estimates related toself-insurance reserves are critical.

For the years ended December 31, 2006, 2005 and 2004, nosignificant changes have been made to the methodology utilized to estimateinsurance reserves.  For purposes of earningssensitivity analysis, if the December 31, 2006 reserves for insurance wereadjusted (increased or decreased) by 10%, operating expenses would have changedby approximately $1.1 million, or 0.4%.

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

We review our long-lived assets for impairment at least annually orwhen changes in circumstances or a triggering event indicates that the carryingamount of the asset may not be recoverable in accordance with the provisions ofSFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  SFAS No. 144 requires that long-lived assetsto be held and used be reported at the lower of their carrying amount or fairvalue.  Assets to be disposed of by saleare recorded at the lower of their carrying amount or fair value less estimatedselling costs. We estimate fair value based upon the best informationavailable, which may include expected future discounted cash flows to beproduced by the asset and/or available market prices. Factors that significantlyinfluence estimated future discounted cash flows include the periods and levelsof occupancy for the facility, expected per diem or reimbursement rates,assumptions regarding the levels of staffing, services and future operating 

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and capital expenditures necessary to generate forecasted revenues,related costs for these activities and future rate of increases or decreasesassociated with these factors. We also consider the results of any appraisalson the properties when assessing fair value. These estimates are highlysubjective, particularly in circumstances where there is no current operatingcontract in place and changes in the assumptions and estimates could result inthe recognition of impairment charges. The most subjective estimates made inthis analysis for 2006 and 2005 relate to the Cornell Abraxas Academy and theHector Garza Residential Treatment Center and for 2004 relate to the CornellAbraxas Academy, the Residential School and the Maple Creek Home. We may berequired to record an impairment charge in the future if we are unable tosuccessfully negotiate a replacement contract on any of our facilities forwhich we currently have an operating contract. Given the nature of theevaluation of future cash flows and the application to specific assets andspecific times, it is not possible to reasonably quantify the impact of changesin these assumptions.

***Share-Based Compensation***

We have typicallycompensated our officers, directors and key employees through the awarding of stock-basedawards.  Based on the requirements ofSFAS 123R, which we adopted on January 1, 2006, we account for stock-basedawards in 2006 using a fair-value based method, resulting in compensationexpense for stock option awards being recorded in our consolidated statementsof operations.  Additionally, under theprovisions of SFAS No. 148, “Accounting for Stock-Based Compensation - anAmendment to FAS 123,” we are currently required to disclose the effect on ournet income (loss) and earnings (loss) per share as if we had applied the fairvalue recognition provisions of SFAS 123 to the periods presented in ourconsolidated statements of operations; or the years ended December 31,2005 and 2004.  This tabular disclosureis included in Note 1 to our accompanying consolidated financial statements.  Determining the fair value of stock-basedawards at the grant date requires judgment, including estimating the expectedterm of stock options, the expected volatility of our stock and any expecteddividends.  In addition, judgment is alsorequired in estimating the amount of stock-based awards that are expected to beforfeited.  As the determination of thesevarious assumptions is subject to significant management judgment and differentassumptions could result in material differences in amounts recorded in ourconsolidated financial statements beginning in the first quarter of 2006 and inour disclosure presented in the footnotes to our accompanying consolidatedfinancial statements for the years ended December 31, 2006, 2005, and2004, management believes that accounting estimates related to the valuation ofstock options are critical.

The assumptionsused to estimate the fair market value of our stock options are based onhistorical and expected performance of our common shares in the open market,expectations with regard to the pattern with which our employees will exercisetheir options and the likelihood that dividends, if any, will be paid toholders of our common shares.  For theyears ended December 31, 2006, 2005, and 2004, no significant changes havebeen made to the methodology utilized to determine the assumptions used inthese calculations.

***Goodwill***

We account for goodwill in accordance with the provisions of SFAS No.142, “Goodwill and Other Intangible Assets,” which states that there is noamortization of goodwill or intangible assets with indefinite lives.  Impairment of these assets is assessedannually 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 valueare based upon our estimates of the present value of future cash flows.  We make assumptions regarding the estimatedcash flows and if these estimates or their related assumptions change, animpairment charge may be incurred.  Giventhe nature of the evaluation of future cash flows and the application tospecific assets and specific times, it is not possible to reasonably quantifythe impact of changes in these assumptions.

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**Results ofOperations**

Materialfluctuations in our results of operations are principally the result of thelevel of new contract development activity, the timing and effect of facilityexpansions, occupancy or contract rates, contract renewals or terminations andfacility closures and non-recurring charges.

The following table setsforth for the periods indicated the percentages of revenue represented bycertain items in our Consolidated Statements of Operations and ComprehensiveIncome (Loss).
|                                                                                       | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                            | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                              |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |
|                                                                                  |       |                                       |       |   |   |   |   |
| Operating  expenses                                                                   |       | 76.1                                       |       | 76.6 |   | 76.1 |   |
| Pre-opening and  start-up expenses                                                    |       | 0.7                                        |       | 2.9 |   | 3.2 |   |
| Impairment of  long-lived assets                                                      |       | 0.1                                        |       | 3⁄4 |   | 3.4 |   |
| Depreciation and  amortization                                                        |       | 4.5                                        |       | 4.9 |   | 4.8 |   |
| General and  administrative expenses                                                  |       | 6.0                                        |       | 6.6 |   | 7.3 |   |
| Income from  operations                                                               |       | 12.4                                       |       | 9.0 |   | 5.2 |   |
| Interest  expense, net                                                                |       | 6.4                                        |       | 7.0 |   | 7.3 |   |
| Loss on  extinguishment of debt                                                       |       | 3⁄4                                     |       | 3⁄4 |   | 0.9 |   |
| Income (loss)  from continuing operations before provision (benefit) for income taxes |       | 6.0                                        |       | 2.0 |   | (3.0 | ) |
| Provision  (benefit) for income taxes                                                 |       | 2.5                                        |       | 0.7 |   | (1.2 | ) |
| Income (loss)  from continuing operations                                             |       | 3.5                                        |       | 1.3 |   | (1.8 | ) |
| Discontinued  operations, net of taxes                                                |       | (0.2                                       | )          | (1.2 | ) | (0.9 | ) |
| Net income (loss)                                                                     |       | 3.3                                        | %          | 0.1 | % | (2.7 | )% |

 

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***YearEnded December 31, 2006 Compared to Year Ended December 31, 2005***

Certain comparisons of revenue, expenses and average contract occupancycontained in this report have been made excluding the effect of pre-opening andstart-up expenses and revenues, and related occupancy and contractcapacity.  Disclosures excluding theeffect of pre-opening and start-up expenses and revenues represent measurescalculated in a manner that is not consistent with GAAP.  We believe the exclusion of the non-recurringeffect of pre-opening and start-up expenses and revenues increases the reader’sunderstanding of our operating trends.

***Revenues*****.** Revenues increased approximately $50.1 million, or 16.1%, to $360.9million for the year ended December 31, 2006 from $310.8 million for theyear ended December 31, 2005.

***Adult Secure Institutional.***Adultsecure institutional division revenues increased approximately $50.4 million,or 39.3%, to $178.8 million for the year ended December 31, 2006 from $128.4million for the year ended December 31, 2005 due primarily to (1) theopening of the Moshannon Valley Correctional Center in April 2006 whichgenerated revenues of approximately $26.6 million in 2006, (2) revenues ofapproximately $7.0 million at the Mesa Verde Community Correctional Facilitywhich we began managing in January 2006, (3) an increase in revenues ofapproximately $10.3 million at the Regional Correctional Center due toincreased occupancy in 2006 (including a contract-based revenue adjustment forthe contract year ended March 2006 in the amount of $2.4 million), (4) anincrease in revenues of approximately $3.1 million at the D. Ray James Prisondue to increased occupancy coupled with a per diem rate increase receivedmid-year 2005, (5) an increase in revenues of approximately $1.3 million at ourtwo secure facilities in California due to increased occupancy and (6) anincrease in revenues of approximately $1.1 million at the Donald W. WyattDetention Center due to improved occupancy. The remaining net increase inrevenues of approximately $1.0 million was due to various insignificant revenuefluctuations at our other adult secure institutional facilities.

Averagecontract occupancy was 98.2% for the year ended December 31, 2006 comparedto 96.1% for the year ended December 31, 2005.  Excluding the actual occupancy and contractcapacity for the start-up operations of the Regional Correctional Center in2005 (through August 2005), average contract occupancy was 102.9% for the yearended December 31, 2005. The average contract occupancy statistics for 2006reflect the activation and ramp-up in population at both the Mesa VerdeCommunity Correctional Facility (which opened in January 2006) and theMoshannon Valley Correctional Center (which opened in April 2006).

Theaverage per diem rate was $56.12 for the year ended December 31, 2006compared to $48.49 for the year ended December 31, 2005.  The increase in the average per diem rate for2006 is primarily due to the opening of the Moshannon Valley CorrectionalCenter in April 2006 which is a significant take-or-pay contract. There were norevenues attributable to start-up operations in the year ended December 31,2006.  Revenues attributable to start-upoperations for the year ended December 31, 2005 were approximately $3.3 millionand were attributable to the start-up operations of the Regional CorrectionalCenter in New Mexico.

***Juvenile***.  Juvenile justice, educational and treatmentservices division revenues decreased approximately $3.2 million, or 2.7%, to$115.8 million for the year ended December 31, 2006 from $119.0 millionfor the year ended December 31, 2005. The decrease in revenues was due primarily to (1) a decrease in revenuesof approximately $3.6 million as a result of the temporary closure of theHector Garza Residential Treatment Center (formerly the Campbell GriffinTreatment Center) in October 2005, (2) a decrease in revenues of approximately$2.8 million at the Danville Center for Adolescent Females (“DCAF”) due to theexpiration of our management contract in March 2006, (3) a decrease in revenuesof approximately $1.8 million due to the expiration of our management contractat the South Mountain Secure Treatment Unit (“SMSTU”) in June 2006 and (4) adecrease in revenues of approximately $0.9 million due to the expiration of ourmanagement contract for the Washington, DC (“DC”) community-based programs inAugust 2006.  The decrease in revenuesdue to the above factors was offset, in part, by (1) an increase in revenues ofapproximately $1.6 million at the Southern Peaks Regional Treatment Center dueto improved occupancy (this facility was ramping-up in 2005), (2) an increasein revenues of approximately $1.2 million at the Reading Alternative Educationprogram we began managing in July 2005, (3) an increase in revenues ofapproximately $0.9 million at the Leadership Development Program (due toprogram occupancy/mix) and (4) an increase in revenues of approximately $0.9million at the Alexander Youth Center due to increased occupancy.  The remaining net increase in revenues ofapproximately $1.3 million was due to various insignificant fluctuations inrevenues at our other juvenile facilities and programs. Theconcluded/terminated contracts at DCAF, SMSTU and DC generated total revenues forthe years ended December 31, 2006 and 2005 of approximately $3.2 million and$8.6 million, respectively.

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Averagecontract occupancy was 93.2% for the year ended December 31, 2006 comparedto 89.2% for the year ended December 31, 2005.  Excluding the actual occupancy and thecontract capacity for the start-up operations of the Southern Peaks RegionalTreatment Center through the first quarter of 2005, average contract occupancywas 90.0% for the year ended December 31, 2005.

The average perdiem rate for our residential juvenile facilities was approximately $170.33 forthe year ended December 31, 2006 compared to approximately $167.68 for theyear ended December 31, 2005. The average fee-for-service rate for ournon-residential community-based juvenile programs was approximately $37.59 forthe year ended December 31, 2006 compared to approximately $34.21 for theyear ended December 31, 2005.  Theincrease in the average fee-for-service rate for 2006 is due to changes in themix of services provided by our various programs, as well as the continuedoperations in 2006 of several alternative education programs which we beganoperating mid-year 2005.

Therewere no revenues attributable to start-up operations for the year endedDecember 31, 2006. Revenues attributable to start-up operations wereapproximately $1.5 million for the year ended December 31, 2005 and wereattributable to the start-up operations of the Southern Peaks RegionalTreatment Center.

***Adult Community-Based. ***Adult community-based corrections and treatmentservices division revenues increased approximately $3.0 million, or 4.7%, to$66.3 million for the year ended December 31, 2006 from $63.3 million forthe year ended December 31, 2005 due primarily to an increase in revenuesof approximately $3.4 million from the programs and facilities acquired fromCorrectional Systems, Inc. (“CSI”) in April 2005. The remaining net decrease inrevenues of $0.4 million was due to various insignificant fluctuations inrevenues at our other adult community-based facilities and programs.  Average contract occupancy was 97.7% for theyear ended December 31, 2006 compared to 100.4% for the year endedDecember 31, 2005.

The average perdiem rate for our residential adult community-based facilities wasapproximately $61.71 for the year ended December 31, 2006 compared toapproximately $62.02 for the year ended December 31, 2005. The averagefee-for-service rate for our non-residential adult community-based programs wasapproximately $11.23 for the year ended December 31, 2006 compared toapproximately $9.40 for the year ended December 31, 2005.  Our average fee-for-service rates fluctuatefrom year to year due to changes in the mix of services provided by our variousnon-residential adult community-based programs. There were no revenuesattributable to start-up operations for the years ended  December 31, 2006 and 2005.

***Operating Expenses.*** Operating expenses increased approximately $36.7 million, or 15.4%, to$275.0 million for the year ended December 31, 2006 from approximately$238.3 million for the year ended December 31, 2005.

***Adult Secure Institutional.***  Adult secure institutional division operatingexpenses increased approximately $34.6 million, or 39.0%, to approximately $123.3 million for theyear ended December 31, 2006 fromapproximately $88.7 million for the year ended December 31, 2005due primarily to (1) operating expenses of approximately $13.6 million at theMoshannon Valley Correctional Center which opened in April 2006 (additionalexpenses of approximately $2.7 million related to this facility are included instart-up and pre-opening expenses for the year ended December 31, 2006), (2)operating expenses of approximately $5.2 million at the Mesa Verde CommunityCorrectional Facility which we began managing in January 2006, (3) an increasein operating expenses of approximately $9.9 million at the RegionalCorrectional Center due to improved occupancy as the facility was ramping up in2005 (additional expenses of approximately $6.4 million related to this facilityare included in pre-opening and start-up expenses in the year ended December31, 2005), (4) an increase in operating expenses of approximately $1.1 millionat our two secure facilities in California due to increased occupancy and (5)an increase in operating expenses of approximately $1.1 million at the DonaldW. Wyatt Detention Center due to improved occupancy.  The remaining net increase in operatingexpenses of approximately $3.7 million was due to various fluctuations inoperating expenses at our other adult secure facilities as well as an increasein operating expenses at the divisional level.

As a percentage ofsegment revenues, adult secure institutional division operating expenses were68.9% for the year ended December 31, 2006 compared to 69.1% for the yearended December 31, 2005.  Excludingapproximately $3.3 million of revenues attributable to the start-up operationsof the Regional Correctional Center in 2005 (through August 2005), adult secureinstitutional division operating expenses, as a percentage of segment revenues,were 70.9% for the year ended December 31, 2005.

***Juvenile.***  Juvenile justice, educational and treatmentservices division operating expenses decreased approximately $0.1 million, or0.1%, to approximately $100.1 million for the year ended December 31, 2006from $100.2 million for the year ended December 31, 2005 due primarily to(1) a decrease in operating expenses of approximately $3.1 million due to thetemporary closure of the Hector Garza Residential Treatment Center (formerlythe Campbell Griffin Treatment Center) in October 2005, 

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(2) a decrease inoperating expenses of approximately $2.6 million at  DCAF due to the expiration of our managementcontract in March 2006, (3) a decrease in operating expenses of approximately$1.6 million at SMSTU due to the expiration of our management contract in June2006 and (4) a decrease in operating expenses of approximately $0.4 million atthe DC programs due to the expiration of our management contract in August2006.  The decrease in operating expensesdue to the above factors was offset, in part, by (1) an increase in operatingexpenses of approximately $3.4 million at the Southern Peaks Regional TreatmentCenter due to increased occupancy as the facility was ramping up in 2005 (additionalexpenses of approximately $1.8 million were included in pre-opening andstart-up expenses for the year ended December 31, 2005), (2) an increase inoperating expenses of approximately $1.1 million at the Cornell Abraxas Academy(formerly the New Morgan Academy) which began operating in October 2006, (3) anincrease in operating expenses of approximately $1.2 million for the ReadingAlternative Education program we began operating in July 2005, (4) an increasein operating expenses of approximately $1.0 million at the Alexander YouthCenter due to increased occupancy and (5) and increase in operating expenses ofapproximately $0.6 million at the Leadership Development Program due toincreased occupancy.  The remaining netincrease in operating expenses of approximately $0.3 million is due to variousinsignificant fluctuations in operating expenses at our other juvenilefacilities and programs.

As a percentage of segmentrevenues, juvenile services division operating expenses were 86.4% for the yearended December 31, 2006 compared to 84.2% for the year ended December 31,2005.  Excluding approximately $1.5 million ofrevenues attributable to the start-up operations of the Southern Peaks RegionalTreatment Center in the year ended December 31, 2005, juvenile servicesdivision operating expenses were 85.3% for the year ended December 31, 2005.

***AdultCommunity-Based.*** Adult community-based corrections andtreatment services division operating expenses increased approximately $2.3million, or 4.7%, to $51.7 million for the year ended December 31, 2006from $49.4 million for the year ended December 31, 2005 due primarily toan increase in operating expenses of approximately $3.3 million attributable tothe facilities and programs acquired from CSI in April 2005.  The remaining net decrease in operatingexpenses of approximately $1.0 million was due various insignificantfluctuations at our other adult community-based facilities and programs.

As a percentage of segment revenues, adult community-based correctionsand treatment services division operating expenses were 78.0% for the yearended December 31, 2006 compared to 77.9% for the year endedDecember 31, 2005.

***Pre-Opening and Start-up Expenses.***** **Pre-opening and start-up expenses were approximately $2.7 million forthe year ended December 31, 2006 and were attributable to the MoshannonValley Correctional Center.  Pre-openingand start-up expenses for the year ended December 31, 2005 wereapproximately $9.0 million and were attributable to the pre-opening andstart-up activities of the Regional Correctional Center, the Southern PeaksRegional Treatment Center, Mesa Verde Community Correctional Facility and theMoshannon Valley Correctional Center. These expenses consisted primarily ofpersonnel and related expenses, building rent, professional and recruitingexpenses.

***Impairment of Long-Lived Assets. ***In the year endedDecember 31, 2006, we recorded impairment charges of approximately $0.4 millionrelated to two of our adult community-based facilities in Alaska. Refer to Note7 to the consolidated financial statements in Item 8 of this report for furtherdiscussion concerning these impairment charges.

***Depreciation and Amortization*.**  Depreciation and amortization increasedapproximately $1.1 million, or 7.2%, to $16.3 million for the year endedDecember 31, 2006 from $15.2 million for the year ended December 31,2005.   Depreciation of property andequipment increased approximately $0.9 million primarily to depreciationexpense related to the Moshannon Valley Correctional Center which opened inApril 2006. Amortization ofintangibles was approximately $2.2 million and $2.1 million for the years endedDecember 31, 2006 and 2005, respectively.

***General and Administrative Expenses.*** General and administrative expenses increased approximately $1.3million, or 6.4%, to approximately $21.7 million for the year endedDecember 31, 2006 from approximately $20.4 million for the year endedDecember 31, 2005 due primarily to increased consulting and professionalexpenses related to our strategic process and the proposed Merger Agreementwith Veritas (which totaled approximately $2.1 million during 2006).  In addition, there was an increase incompensation expense of approximately $1.9 million resulting from our adoptionof SFAS No. 123R on January 1, 2006. See Note 1 to the consolidated financialstatements in Item 8 of this report for further discussion concerning ouradoption of SFAS No. 123R. In the year ended December 31, 2005, general andadministrative expenses included a $1.1 million restructuring charge forpersonnel costs associated with management’s streamlining initiativesimplemented in the first and second quarters of 2005.  In the first quarter of 2007, we willrecognize $2.5 million of general and administrative expenses related to thetermination of the merger agreement with Veritas.

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***Interest.***  Interestexpense, net of interest income, increased approximately $1.4 million, or 6.5%,to $23.1 million for the year ended December 31, 2006 from $21.7 millionfor the year ended December 31, 2005. Interest expense increased due to (1) a decrease in capitalized interestin the year ended December 31, 2006 of approximately $2.2 million as wecapitalized interest of approximately $1.5 million in the year ended December31, 2006 compared to $3.7 million in the year ended December 31, 2005 relatedto construction of the Moshannon Valley Correctional Center (which opened inApril 2006) and (2) an increase in net interest expense of approximately $1.4million related to the interest rate swap. In the year ended December 31, 2006, we recognized interest expenserelated to the interest rate swap of approximately $0.2 million compared tointerest income of approximately $1.1 million in the year ended December 31,2005.  This was partially offset by adecrease of net interest expense in the year ended December 31, 2006 pertainingto Municipal Corrections Finance, LP of approximately $2.5 million (principallydue to increased interest income earned during 2006).

***Income Taxes.***** **For the year ended December 31, 2006, we recognized a provisionfor income taxes on our income from continuing operations at an estimatedeffective rate of 42.1%. For the year ended December 31, 2005, werecognized a provision for income taxes at an estimated effective rate of36.1%. The increase in the estimated income tax rate in 2006 is related to anincrease in operating income across certain of our business segments relativeto prior periods, apportionment of income to higher tax rate jurisdictions, aswell as the impact from our adoption of SFAS 123R (and the nondeductibleexpense attributable to incentive stock option expense) .

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

Certain comparisons of revenue, expenses and average contract capacitycontained herein have been made excluding the effect of pre-opening andstart-up expenses and revenues. Disclosures excluding the effect of pre-opening and start-up expensesand revenues represent measures calculated in a manner that is not consistentwith GAAP.  We believe exclusion of thenon-recurring effect of pre-opening and start-up expenses and revenuesincreases the reader’s understanding of our operating trends.

***Revenues*****.** Revenues increased approximately $33.6 million, or 12.1%, to $310.8million for the year ended December 31, 2005 from $277.2 million for theyear ended December 31, 2004.

***Adult Secure Institutional.***Adult secure institutional division revenuesincreased approximately $13.6 million, or 11.8%, to $128.4 million for the yearended December 31, 2005 from $114.8 million for the year endedDecember 31, 2004 due primarily to (1) the opening of the two-unitRegional Correctional Center in July and December 2004 whichincreased 2005 revenues by approximately $5.5 million, (2) the acquisition ofthe Walnut Grove Youth Correctional Facility management contract in June 2004which increased 2005 revenues by approximately $6.3 million, (3) an increase inrevenues of approximately $2.5 million at the Big Spring Correctional Centerdue to improved occupancy and (4) an increase in revenues of approximately $1.4million at the D. Ray James Prison due to a per diem rate increase received inthe latter half of 2004.  The increase inrevenues due to the above was offset, in part, by a decrease in revenues ofapproximately $3.3 million due to the non-renewal of the Valencia CountyDetention Center contract as of December 31, 2004. The remaining net increasein revenue of approximately $1.2 million was due to various insignificantrevenue fluctuations at our other adult secure institutional facilities.

Average contract occupancy was 96.1% for the year endedDecember 31, 2005 compared to 98.8% for the year ended December 31,2004.  The decline in the averagecontract occupancy percentage in 2005 is due to the Regional CorrectionalCenter which did not operate at full capacity. Excluding the actual occupancy and contract capacity for the start-upoperations of the Regional Correctional Center in 2005 (through August 2005) and2004, average contract occupancy was 102.9% and 102.4%, respectively.

The average per diem rate was $48.49 for the year endedDecember 31, 2005 compared to $48.45 for the year ended December 31,2004.  The increase in the average perdiem rate for 2005 was due to the opening of the Regional Correctional Centerin July and December 2004 and the acquisition of the Walnut Grove YouthCorrectional Facility management contract in June 2004.  We continue to experience increasing pressurefrom contracting governmental agencies to limit or even reduce per diemrates.  Many of these governmentalentities are under severe budget pressures and we anticipate that moregovernmental agencies may approach us about per diem rate concessions.  Decreases or the lack of anticipatedincreases, in per diem rates could adversely impact our operating margin.

Revenues attributable to start-up operations were approximately $3.3million and $1.9 million for the year ended December 31, 2005 and 2004,respectively, and were attributable to the start-up operations of the RegionalCorrectional Center.

***Juvenile***.  Juvenile justice, educational and treatmentservices division revenues increased approximately $5.2 million, or 4.6%, to$119.0 million for the year ended December 31, 2005 from $113.8 millionfor the year ended December 31, 2004. The increase in revenues was due primarily to (1) the opening of theSouthern Peaks Regional Treatment Center in August 2004 which increased2005 revenues by approximately $6.0 million, (2) the commencement of ourmanagement contract for the Philadelphia Alternative Education program inAugust 2004 which increased revenues by approximately $1.2 million, (3)the commencement of our management contract for the Lebanon AlternativeEducation program in September 2004 which increased revenues byapproximately $1.0 million and (4) the commencement of our management contractfor the Reading Alternative Education program in July 2005 which contributedrevenues of approximately $1.2 million. The increase in revenues due to the above factors was offset, in part,by a decrease in revenues of approximately $1.4 million at the Abraxas Centerfor Adolescent Females (ACAF) and approximately $2.6 million at the CampbellGriffin Treatment Center due to reduced occupancy. The Campbell GriffinTreatment Center was temporarily closed in the fourth quarter of 2005.  The remaining net decrease in revenues of$0.2 million was due to various insignificant fluctuations in revenues atour other juvenile facilities and programs.

Average contractoccupancy was 89.2% for the year ended December 31, 2005 compared to 92.7%for the year ended December 31, 2004. Excluding the actual occupancy and the contract capacity for thestart-up activities of the Southern Peaks Regional Treatment Center in 2005(through the first quarter) and 2004 and for the start-up activities of thePlankinton Regional Detention Center in 2004, average contract occupancy was90.0% for the year ended December 31, 2005 compared to 96.4% for the yearended December 31, 2004.

The average perdiem rate for our residential juvenile facilities was approximately $167.68 forthe year ended December 31, 2005 compared to approximately $164.54 for theyear ended December 31, 2004. The increase in the average per diem rate in

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2005 was due tothe opening of the Southern Peaks Regional Treatment Center in August 2004. Theaverage fee-for-service rate for our non-residential community-based juvenileprograms was approximately $34.21 for the year ended December 31, 2005compared to approximately $27.53 for the year ended December 31,2004.  The increase in the averagefee-for-service rate for 2005 is due to changes in the mix of services providedby our various juvenile justice, educational and treatment services, as well asthe addition of several new alternative education programs in 2005.

Revenuesattributable to start-up operations were approximately $1.5 million for theyear ended December 31, 2005 and were attributable to the start-upoperations of the Southern Peaks Regional Treatment Center.  Revenues attributable to start-up operationswere approximately $1.2 million for the year ended December 31, 2004 andwere attributable to the Southern Peaks Regional Treatment Center and thePlankinton Regional Detention Center.

***Adult Community-Based.***Adultcommunity-based corrections and treatment services division revenues increasedapproximately $14.7 million, or 30.2%, to $63.3 million for the year endedDecember 31, 2005 from $48.6 million for the year ended December 31,2004 due primarily to (1) revenues of approximately $11.2 million from thefacilities and programs acquired from CSI in April 2005, (2) the opening of theLas Vegas Center in December 2004 which contributed revenues of approximately$1.4 million, (3) an increase in revenues of approximately $0.7 million at theDallas County Judicial Treatment Center due to improved occupancy and (4) andincrease in revenues of approximately $0.6 million at the Taylor Street Centerdue to improved occupancy.  The remainingnet increase in revenues of approximately $0.8 million was due to variousinsignificant fluctuations in revenues at our other adult community-basedfacilities and programs.

Average contractoccupancy was 100.4% for the year ended December 31, 2005 compared to103.1% for the year ended December 31, 2004.  We experienced average contract occupancypercentages in excess of 100.0% due to the actual occupancy at certainresidential facilities exceeding its contracted capacity.  We currently cannot predict whether this levelof occupancy will continue in future periods.

The average perdiem rate for our residential adult community-based facilities wasapproximately $62.02 for the year ended December 31, 2005 compared toapproximately $62.10 for the year ended December 31, 2004. The averagefee-for-service rate for our non-residential adult community-based programs wasapproximately $9.40 for the year ended December 31, 2005 compared toapproximately $8.23 for the year ended December 31, 2004.  Our average fee-for-service rates canfluctuate from year to year due to changes in the mix of services provided byour various non-residential adult community-based programs. There were norevenues attributable to start-up operations for the years end December 31,2005 and 2004.

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

***Adult Secure Institutional.***  Adult secure institutional division operatingexpenses increased approximately $8.7 million, or 10.9%, to approximately $88.7 million for theyear ended December 31, 2005 fromapproximately $80.0 million for the year ended December 31, 2004due primarily to (1) the acquisition of the Walnut Grove Youth Correctional Facilitymanagement contract in June 2004 which increased operating expenses byapproximately $4.3 million, (2) an increase in operating expenses ofapproximately $3.3 million at the Big Spring Correctional Center due toincreased occupancy and (3) an increase in operating expenses of approximately$3.8 million at the two-unit Regional Correctional Center that began operatingin July and December 2004. The increase in operating expenses due to the abovewas offset, in part, by a decrease in operating expenses of approximately $2.7million due to the non-renewal of the Valencia County Detention Centermanagement contract as of December 31, 2004.

As a percentage ofsegment revenues, adult secure institutional services operating expenses were69.1% for the year ended December 31, 2005 compared to 69.6% for the yearended December 31, 2004.  Excludingapproximately $3.3 million and $1.9 million of revenues attributable to thestart-up operations of the Regional Correctional Center in 2005 (through August2005) and 2004, respectively, adult secure institutional services divisionoperating expenses were 70.9% and 70.8%, respectively.

***Juvenile.***  Juvenile justice, educational and treatmentservices division operating expenses increased approximately $6.6 million, or7.1%, to approximately $100.2 million for the year ended December 31, 2005from $93.6 million for the year ended December 31, 2004 due primarily to(1) the opening of the Southern PeaksRegional Treatment Center in August 2004 which increased operatingexpenses by approximately $5.3 million, (2) the commencement of ourmanagement contract for the Philadelphia Alternative Education Program inAugust 2004 which increased operating expenses by approximately $1.1million and (3) the commencement of our management contract for theLebanon Alternative Education Program in September 2004 which increasedoperating expenses by approximately $0.9 million. Additionally, in the yearended December 31, 2005, we recorded a restructuring charge of approximately$1.0 million for personnel costs associated with management streamlining

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initiatives implemented in the first quarter of 2005.  The increase in operating expenses due to theabove was offset, in part, by a decrease in operating expenses of approximately$0.6 million due to the termination of the Santa Fe County Youth DevelopmentProgram in January 2004.  Theremaining net decrease in operating expenses of approximately $1.1 million wasdue to various insignificant fluctuations in operating expenses at our otherjuvenile facilities and programs.

As a percentage of segmentrevenues, juvenile services division operating expenses were 84.2% for the yearended December 31, 2005 compared to 82.2% for the year ended December 31,2004.  Excluding approximately $1.5 million ofrevenues attributable to the start-up operations of the Southern Peaks RegionalTreatment Center in the year ended December 31, 2005 and approximately$1.2 million of revenues attributable to the start-up operations of theSouthern Peaks Regional Treatment Center and the Plankinton Regional DetentionCenter in the year ended December 31, 2004, juvenile services divisionoperating expenses were 85.3% and 83.1%, respectively.  The increase in the percentage for 2005 islargely due to the $1.0 million charge discussed above.

***AdultCommunity-Based.*** Adult community-based corrections and treatment services divisionoperating expenses increased approximately $11.9 million, or 31.7%, to $49.4million for the year ended December 31, 2005 from $37.5 million for theyear ended December 31, 2004 due to (1) operating expenses ofapproximately $9.0 million attributable to the facilities and programs andfacilities acquired from CSI in April 2005, (2) the opening of theLas Vegas Center in December 2004 which increased operating expenses byapproximately $1.0 million and (3) a charge of approximately $0.3 millionfor terminated facility lease option costs. The remaining net increase in operating expenses of approximately $1.6million was due to various insignificant fluctuations in operating expenses atour other adult community-based programs and facilities.

As a percentage of segment revenues, adult community-based correctionsand treatment services division operating expenses were 77.9% for the yearended December 31, 2005 compared to 77.3% for the year endedDecember 31, 2004.

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

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

***General and Administrative Expenses.*** General and administrative expenses increased approximately $0.1million, or 0.5%, to approximately $20.4 million for the year endedDecember 31, 2005 from approximately $20.3 million for the year endedDecember 31, 2004.    General andadministrative expenses for the year ended December 31, 2005 include a $1.1 millionrestructuring charge for personnel costs associated with management’sstreamlining initiatives implemented in the first and second quarter of2005.  This was offset, in part, by adecrease of approximately $1.3 million in professional fees, principallyassociated with certain accounting services (including Sarbanes-Oxleycompliance), executive recruitment services, and business development expenses.

***Interest.***  Interestexpense, net of interest income, increased approximately $1.3 million to $21.7million for the year ended December 31, 2005 from $20.4 million for theyear ended December 31, 2004. Interest expense increased approximately$1.7 million due to interest on the Senior Notes of approximately $10.9 million(net of swap interest income of $1.1 million) in the year endedDecember 31, 2005 compared to interest of $5.1 million (net of swapinterest income of $1.2 million) in the year ended December 31, 2004.  This increase in interest expense was offset,in part, by a decrease in interest expense of approximately $1.8 million (netof amortization of deferred financing costs) due to the repayment of theoutstanding balances on both our amended 2000 Credit Facility and the SyntheticLease Investor Notes A and B in June 2004. Capitalized interest for the

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year ended December 31, 2005was approximately $3.7 million and related to development and constructioncosts for the Moshannon Valley Correctional Center.  Capitalized interest for the year endedDecember 31, 2004 was approximately $1.8 million and related todevelopment and construction costs for the Moshannon Valley CorrectionalCenter, the Southern Peaks Regional Treatment Center, the Regional CorrectionalCenter and the Las Vegas Center. Additionally, interest income increased approximately $0.4 million forthe year ended December 31, 2005 as compared to 2004 due to higher fundbalances and higher interest rates in the 2005 period.

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

***Discontinued Operations, net of tax.***  Thenet loss from discontinued operations increased approximately $1.2 million to $3.6million for the year ended December 31, 2005 from $2.4 million for the yearended December 31, 2004.  The loss fromdiscontinued operations for the years ended December 31, 2005 and 2004 includesthe operating results for the Residential School, Maple Creek Home, our mentalhealth programs in Pennsylvania, the Northside Clinic and the Jos-ArzAcademy.  The increase in loss fromdiscontinued operations, net of tax, in 2005 was due to declining performanceprior to closing the facilities  in 2005as well as related closure costs. Subsequent to the closure of these programs,in 2005 we disposed of those discontinued facilities which we owned.

** Liquidity andCapital Resources**

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

***Cash Flows From Operations.*** Cash provided by operating activities wasapproximately $29.7 million for the year ended December 31, 2006 comparedto approximately $28.3 million for the year ended December 31, 2005.  Theincrease was principally due to increased operations from new facilitiesincluding the Mesa Verde Community Correctional Facility and theMoshannon Valley Correctional Center.  The increasein certain working capital accounts, mainly accounts receivable was associatedwith these new operations.

***Cash Flows From Investing Activities*****. **Cash used in investing activities was approximately $17.5 million forthe year ended December 31, 2006 due to (1) capital expenditures ofapproximately $12.3 million primarily consisting of construction costs for theMoshannon Valley Correctional Center, (2) net purchases of investmentsecurities of approximately $4.7 million and (3) net payments to the restricted debt payment account of approximately$3.4 million.  Additionally, we receivedproceeds from the sale of assets of approximately $2.9 million.****Cash used in investing activities wasapproximately $17.5 million for the year ended December 31, 2005 due primarilyto capital expenditures of $51.1 million, which included $46.2 million for theconstruction of the Moshannon Valley Correctional Center and the $9.1 millionCSI acquisition in April 2005, offset by net investment securities sales ofapproximately $44.5 million. Additionally, we had proceeds from the sale of fixed assets of approximately$0.6 million and $2.4 million of net payments to the restricted debt paymentaccount during the year ended December 31, 2005.

***Cash Flows From Financing Activities*****.**  Cashused in financing activities was approximately $7.4 million for the year endedDecember 31, 2006 due primarily to a $9.7 million principal payment of MCF’sbonds in July 2006, offset by proceeds from the exercise of stock options ofapproximately $2.1 million. Cash used in financing activities was approximately$6.9 million for the year ended December 31, 2005 due primarily to a $9.0million principal payment on MCF’s bonds in July 2005 and repayment ofapproximately $1.9 million debt acquired in the CSI acquisition in April 2005,partially offset by proceeds from the exercise of stock options ofapproximately $4.1 million.

***Long-Term Credit Facilities.***  OurCredit Facility provides for borrowings of up to $60.0 million under arevolving line of credit and is reduced by outstanding letters of credit. Theavailable commitment under our Credit Facility was approximately $50.4 millionat December 31, 2006.  We had nooutstanding borrowings under our Credit Facility at December 31, 2006, but wehad outstanding letters of credit of approximately $9.6 million.  Subject to certain requirements, we have theright to increase the aggregate commitments under our Credit Facility up to anaggregate amount of $100.0 million.  TheCredit Facility matures in June 2008 and bears interest, at our election,depending on our total leverage ratio, at either the prime rate plus a margin 

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ranging from 0.75% to 2.00%, or a rate which ranges from 2.25% to 3.50%above the applicable LIBOR rate. Our Credit Facility is collateralizedby substantially all of our assets, including the assets and stock of all ofour subsidiaries.  Our Credit Facility isnot secured by the assets of Municipal Corrections Finance, LP (“MCF”).  The Credit Facility contains standardcovenants including compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

MCF is obligated for theoutstanding balance of its 8.47% Taxable Revenue Bonds, Series 2001.  The bonds bear interest at a rate of 8.47%per annum and are payable in semi-annual installments of interest and annualinstallments of principal.  All unpaidprincipal and accrued interest on the bonds is due on the earlier ofAugust 1, 2016 (maturity) or as noted under the bond documents.  The bonds are limited, nonrecourseobligations of MCF and secured by the property and equipment, bond reserves,assignment of subleases and substantially all assets related to the facilitiesincluded in the 2001 Sale and Leaseback Transaction (in which we sold elevenfacilities (as identified in Item 1 of this report) to MCF).  The bonds are not guaranteed by us.

In June 2004, we issued$112.0 million in principal of 10.75% Senior Notes the (“Senior Notes”) dueJuly 1, 2012.  The Senior Notes areunsecured senior indebtedness and are guaranteed by all of our existing andfuture subsidiaries (collectively, “the Guarantors”).  The Senior Notes are not guaranteed by MCF(the “Non-Guarantor”).  Interest on theSenior Notes is payable semi-annually on January 1 and July 1 of eachyear, commencing January 1, 2005. On or after July 1, 2008, we may redeem all or a portion of theSenior Notes at the redemption prices (expressed as a percentage of theprincipal amount) listed below, plus accrued and unpaid interest, if any, onthe Senior Notes redeemed, to the applicable date of redemption, if redeemed duringthe 12-month period commencing on July 1 of each of the years indicatedbelow:

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

 

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

In conjunctionwith the issuance of the Senior Notes, we entered into an interest rate swaptransaction with a financial institution to hedge our exposure to changes inthe fair value on $84.0 million of our Senior Notes.  The purpose of this transaction was toconvert future interest due on $84.0 million of the Senior Notes to a variablerate.  The terms of the interest rateswap contract and the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1)a floating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceive a fixed-rate interest of 10.75%. For the year ended December 31, 2006, we recorded interest expenserelated to this interest rate swap of approximately $0.2 million.  For year ended December 31, 2005, we recordedinterest income related to this interest rate swap of approximately $1.1million, which is reflected as a reduction to 2005 interest expense in ouraccompanying financial statements.  Theswap agreements are marked to market each quarter with a correspondingmark-to-market adjustment reflected as either a discount or premium on theSenior Notes.  At December 31, 2006 and2005, the fair value of this derivative instrument was a liability ofapproximately ($1.1) million and ($0.1) million, respectively, and is includedin other long-term liabilities at December 31, 2006 and 2005 in ourConsolidated Balance Sheets.  Thecarrying value of the Senior Notes as of these dates was adjusted accordinglyby the same amount. Because the swap agreement is considered an effectivefair-value hedge, there will be no effect on our results of operations from themark-to-market adjustment as long as the swap is in effect.

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***Contractual Uncertainties Related toCertain Facilities***

***Cornell Abraxas Academy (formerly the New Morgan Academy).***  We closed the Cornell Abraxas Academy(formerly the New Morgan Academy) in the fourth quarter of 2002 and consideredseveral options ranging from the utilization of the facility for another typeof program or the sale or lease of the facility. In 2005 we began focusing ourefforts on the reopening of the facility. The facility, which reopened inOctober 2006, operates as a residential treatment facility for youth sexoffenders. We recognized pre-tax costs of $4.8 million and $3.6 million in ourConsolidated Statements of Operations and Comprehensive Income (Loss) for theyears ended December 31, 2006 and 2005, respectively, for related holding costs(depreciation, interest, property, taxes and other maintenance costs).  The expenses for the 2006 period increased inconjunction with the reactivation of the facility.

In December 2004, we recorded an impairment charge ofapproximately $9.3 million related to this facility as it was determined,pursuant to the requirements of SFAS No. 144, that the carrying amount of thefacility not fully recoverable and exceeded its fair value (as based on themost current estimates of cash flows). As of December 31, 2006, we believe that, pursuant to the provisions ofSFAS No. 144, no additional impairment allowance is necessary.  The carrying value of the property andequipment for the Cornell Abraxas Academy, after the impairment charge in 2004,was approximately $19.5 million and $19.9 million at December 31, 2006 and2005, respectively.

***Great Plains Correctional Facility.*** We believe that our existing contract with theOklahoma Department of Corrections (“OK DOC”) with respect to our Great PlainsCorrectional Facility expired in July 2006. Despite negotiations with the OKDOC since early 2006, we have been unable to agree on terms for a newcontract.  As a result, to preserve ourrights relative to other business opportunities, in October 2006 HEDA notifiedOK DOC of our intent to terminate the contract. With our Great Plains Correctional Facility, as with all our facilities,we seek to maximize the operating potential based on an assessment of whichpotential customer(s) would enable us to realize the highest economic value. Todate, we do not have an alternate customer for this facility, which generatedrevenues of approximately $12.5 million, $12.8 million and $12.5 million in theyears ended December 31, 2006, 2005 and 2004, respectively. Our inability toobtain a new customer for this facility could have an adverse effect on ourfinancial condition, results of operations and liquidity.

***Hector Garza Residential Treatment Center (formerly theCampbell Griffin Treatment Center).***  In October 2005, we initiated the temporaryclosure of this leased facility in San Antonio, Texas.  It is our intent to reactivate this facilityduring 2007. Accordingly, it has not been included in discontinued operationsfor the years ended December 31, 2006 and 2005. Our net carrying value for this facility at December 31, 2006 wasapproximately $4.2 million.

###### ***Treasury Stock Repurchases***

We did not purchase any of ourcommon stock in the years ended December 31, 2006 and 2005.

Under the terms of our Senior Notes and Credit Facility, we canpurchase shares of our stock subject to certain cumulative restrictions.

***Projects UnderDevelopment, Construction or Renovation***

During 2006, the FederalBureau of Prisons (“BOP”) solicited a Request for Proposals (“RFP”) forservices to house approximately 7,000 low security non-United States citizenssentenced males in an existing secure correctional institution procured from privatesources or state and local governments, with excess capacity, located inArizona, California, Louisiana, New Mexico, Oklahoma or Texas to replaceseveral existing intergovernmental agreements (“IGA”) for such services,including the IGA relating to our Big Spring Correctional Center. In January2007 the Company was awarded a contract from the BOP for our Big SpringCorrectional Center. In conjunction with this contract we will undertakecertain facility expansion construction in 2007. We had not incurred anysignificant costs for this expansion at December 31, 2006. We believe that ourexisting cash and credit facility will provide adequate funding to complete theconstruction.

It is also our intent toexpand our D. Ray James Prison facility during 2007 to increase capacity byapproximately 300. We had not incurred any significant costs for this expansionat December 31, 2006, and we believe that our existing cash and credit facilitywill provide adequate funding to complete this expansion.

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###### ***Future Liquidity***

We believe that the existing cash and the cash flows generated fromoperations, together with the credit available under our Credit Facility, willprovide sufficient liquidity to meet our committed capital and working capitalrequirements for currently awarded and certain potential future developmentcontracts.  To the extent our cash andcurrent financing arrangements do not provide sufficient financing to fundconstruction costs related to future adult secure institutional contract awardsor significant facility expansions, we anticipate obtaining additional sourcesof financing to fund such activities. However, there can be no assurance that such financing will be availableor will be available on terms favorable to us.

###### ***Contractual Obligations and CommercialCommitments***

We have assumed various financial obligations and commitments in theordinary course of conducting our business. We have contractual obligations requiring future cash payments under ourexisting contractual arrangements, such as management, consulting andnon-competition agreements.

We maintain operating leases in the ordinary course of our businessactivities.  These leases include thosefor operating facilities, office space and office and operating equipment, andthe agreements expire between 2007 and 2075. As of December 31, 2006, ourtotal commitment under these operating leases was approximately $23.5 million.

The following table details the known future cash payments (on anundiscounted basis) related to various contractual obligations as ofDecember 31, 2006 (in thousands):
| ** **                                   | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | ** **                                | ** ** | ** ** | ** ** | **2008 -** | ** ** | **2010 -** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Total**                                 | ** ** | **2007** | ** ** | **2009** | ** ** | **2011** | ** ** | **Thereafter** | ** ** |
|                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Contractual  Obligations:                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt -  principal                  |       |                                      |       |   |   |   |   |   |   |   |   |
| ·  Cornell Companies, Inc.    |       | $                                         | 112,000    |   | $ | 3⁄4 |   | $ | 3⁄4 |   | $ | 3⁄4 |   | $ | 112,000 |   |
| ·  Special Purpose Entities        |       | 156,000                                   |       | 10,500 |   | 23,800 |   | 28,000 |   | 93,700 |   |
| Long-term debt -  interest                   |       |                                      |       |   |   |   |   |   |   |   |   |
| ·  Cornell Companies, Inc.    |       |                                      |       |   |   |   |   |   |   |   |   |
| ·  Special Purpose Entities        |       | 67,836                                    |       | 12,331 |   | 24,689 |   | 24,663 |   | 6,153 |   |
| Construction  commitments                    |       | 29,258                                    |       | 29,258 |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| Capital lease  obligations:                  |       |                                      |       |   |   |   |   |   |   |   |   |
| ·  Cornell Companies, Inc.    |       | 47                                        |       | 10 |   | 23 |   | 14 |   | 3⁄4 |   |
| Operating leases                             |       | 23,493                                    |       | 4,513 |   | 6,199 |   | 3,733 |   | 9,048 |   |
| Consultative and  non-competition agreements |       | 778                                       |       | 528 |   | 250 |   | 3⁄4 |   | 3⁄4 |   |
| Total contractual cash obligations           |       | $                                         | 389,412    |   | $ | 57,140 |   | $ | 54,961 |   | $ | 56,410 |   | $ | 220,901 |   |

 

We have an interest rateswap agreement under which we receive a fixed interest rate and pay a floatinginterest rate. The future cash payments on the Cornell Companies, Inc.long-term debt assume an effective rate of 10.945% on the related interest rateswap contract.

We enter into letters ofcredit in the ordinary course of operating and financing activities.  As of December 31, 2006, we hadoutstanding letters of credit of approximately $9.6 million primarily forcertain workers’ compensation insurance and other operating obligations.  The following table details our letter ofcredit commitments as of December 31, 2006 (in thousands):
| ** **                 | ** ** | ** **    | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|----------------------------|------------|---------------|------------|-------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **Total**     | ** ** | ** **                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Amounts**   | ** ** | **Less than**                                                      | ** ** | **Over** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Committed** | ** ** | **1 Year**                                                         | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **5 Years** | ** ** |
| Commercial  Commitments:   |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Standby letters  of credit |       | $             | 9,620      |                                                                    | $          | 8,870 |   | $ | — |   | $ | 750 |   | $ | — |   |
|                            |            |               |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

*** ***

48

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***Related Person Transactions***

One of our former directorsis a partner in a law firm that provided legal services to us.  Legal fees paid to this law firm wereapproximately $0.09 million, $0.9 million and $2.0 million for the years endedDecember 31, 2006, 2005 and 2004, respectively.

In September 1999, we entered into a consulting agreement withCornell’s founder, who was a director of Cornell throughOctober 2003.  Services renderedunder the consulting agreement included serving as a director of Cornell overthe initial four years of the term of the agreement and assisting in such areasas the development of new business, acquisitions, financings and executivemanagement assimilation.  As compensationfor consulting services, we agreed to an annual payment of at least $255,000 foreach of the first four years of the seven-year initial term of the consultingagreement with an annual payment of at least $180,000 for each of the lastthree years of the initial term. As additional compensation, we agreed to anannual bonus, subject to certain limitations, equal to $75,000 during the firstfour years of the initial term and an annual bonus of $60,000 during the lastthree years of the initial term. The initial term concluded in 2006 and thefinal bonus payment of $60,000 was paid. The agreement was not renewed.

We also entered into a non-compete agreement with Cornell’sfounder.  The non-compete agreement has aterm of 10 years and required us to pay a monthly fee of $10,000 for theseven-year initial term of the consulting agreement.  We capitalize the monthly payments andamortize the amounts over the 10-year term of the non-compete agreement. Werecognized amortization expense related to this agreement of approximately$84,000 for each of the years ended December 31, 2006, 2005 and 2004.

We maintain a life insurance policy for Cornell’s founder and madepayments related to this policy of approximately $0.2 million for each of theyears ended December 31, 2006, 2005 and 2004.

Total payments made for the above to Cornell’s founder wereapproximately $0.5 million, $0.9 million and $0.7 million for the years endedDecember 31, 2006, 2005 and 2004, respectively.

We entered into a consulting agreement with a former director whichexpires in December 2008.  Servicesrendered under this agreement include research and analysis for various topicsincluding data collection, support and training for program development;performance-based contractual requirements and performance-improvementprocesses, accreditations and regulatory requirements.  Total payments under this agreement, whichhas a termination fee incorporated for a termination prior to maturity, totaled$0.3 million for each of the years ended December 31, 2006 and 2005.  The termination fee at December 2006 was $0.2million.

**Inflation**

Other than personnel, offender medical costs at certain facilities, andemployee medical and worker’s compensation insurance costs, we believe thatinflation has not had a material effect on our results of operations during thepast three years.  Most of our facilitymanagement contracts provide for payments of either fixed per diem fees or perdiem fees that increase by only small amounts during the term of the contracts.Inflation could substantially increase our personnel costs (the largestcomponent of our operating expenses), medical and insurance costs or otheroperating expenses at rates faster than any increases in contract revenues.

49

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**ITEM 7A.****                   ****QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

**Quantitative and Qualitative Disclosures about MarketRisk**

In the normal course of business, we are exposed to market risk,primarily from changes in interest rates. We continually monitor exposure to market risk and develop appropriatestrategies to manage this risk.  We arenot exposed to any other significant market risks, including commodity pricerisk, foreign currency exchange risk or interest rate risks from the use ofderivative financial instruments.  Inconjunction with the issuance of our Senior Notes, we entered into an interestrate swap of $84.0 million related to the interest obligations under the SeniorNotes in effect converting them to a floating rate based on six-month LIBOR.

**Interest Rate Exposure**

Our exposure to changes ininterest rates primarily results from our long-term debt with both fixed andfloating interest rates.  The debt on ourconsolidated financial statements with fixed interest rates consist of the8.47% Bonds issued by MCF in August 2001 in connection with the 2001 Saleand Leaseback Transaction and approximately $28.0 million of Senior Notes nothedged by any interest rate swap.  AtDecember 31, 2006, 31.6% ($84.0 million of debt outstanding on our SeniorNotes issued in June 2004) of our consolidated long-term debt was subjectto variable interest rates.  Thedetrimental effect of a hypothetical 100 basis point increase in interest rateswould be to reduce income before provision for income taxes by approximately $0.8million for the year ended December 31, 2006.  At December 31, 2006, the fair value of ourconsolidated fixed rate debt approximated carrying value based upon discountedfuture cash flows using current market prices.

50

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**ITEM 8.                  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**
|        | 1.     | Financial statements                                                                                                                                      |   |   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|   |   | Management’s Report on  Internal Control over Financial Reporting                                                                                    |   |   |
|   |   | Report of Independent  Registered Public Accounting Firm                                                                                                  |   |   |
|   |   | Consolidated Balance  Sheets - December 31, 2006 and 2005                                                                                            |   |   |
|   |   | Consolidated Statements of Operations and  Comprehensive Income (Loss) for the years ended December 31, 2006, 2005  and 2004                         |   |   |
|   |   | Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2006, 2005 and 2004                                           |   |   |
|   |   | Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                                                          |   |   |
|   |   | 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. |   |   |

 

51

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**Management’s Report on Internal Control overFinancial Reporting**

The management ofCornell is responsible for establishing and maintaining adequate internalcontrol over financial reporting. Cornell’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles.  Cornell’s internal control over financialreporting includes those policies and procedures that (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the Company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the Company arebeing made only in accordance with authorizations of management and directorsof the Company; and, (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of theCompany’s assets that could have a material effect on the financial statements.

Due to itsinherent limitations, internal control over financial reporting may not preventor detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

We have assessedthe effectiveness of our internal control over financial reporting as ofDecember 31, 2006.  To make thisassessment we used the criteria for effective internal control over financialreporting described in Internal Control — Integrated Framework, issued by theCommittee of Sponsoring Organizations of the Treadway Commission.   Based on our assessment, we have concludedthat, as of December 31, 2006, the Company’s internal control overfinancial reporting was effective.

Our management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2006 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,as stated in their report which appears herein.

52

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors and Stockholders of

Cornell Companies,Inc.

We have completedintegrated audits of Cornell Companies, Inc.’s consolidated financialstatements and of its internal control over financial reporting as ofDecember 31*,*2006, in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statementschedules

In our opinion, the consolidated financial statements listed inthe accompanying index present fairly,in all material respects, the financial position of Cornell Companies, Inc. andits subsidiaries at December 31, 2006 and 2005 and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2006****in conformitywith accounting principles generally accepted in the United States of America. Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.  We conducted our audits of these statementsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit of financial statements includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

As discussed inNote 2 to the consolidated financial statements, effective January 1, 2006, theCompany adopted the provisions of Statement of Financial Accounting StandardsNo. 123(R), “Share-Based Payment,” using the modified prospective applicationmethod.

Internal controlover financial reporting

Also, in ouropinion, management’s assessment, included in the accompanying Management’sReport on Internal Control over Financial Reporting, appearing under Item 8,that the Company maintained effective internal control over financial reportingas of December 31, 2006 based on criteria established in *Internal Control-Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), isfairly stated, in all material respects, based on those criteria. Furthermore,in our opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2006 based oncriteria established in *InternalControl-Integrated Framework* issued by the COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is to expressopinions on management’s assessment and on the effectiveness of theCompany’s internal control over financial reporting based on our audit. Weconducted our audit of internal control over financial reporting in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  An audit of internalcontrol over financial reporting includes obtaining an understanding ofinternal control over financial reporting, evaluating management’s assessment,testing and evaluating the design and operating effectiveness of internalcontrol, and performing such other procedures as we consider necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinions.

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

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

PricewaterhouseCoopers LLP

Houston, Texas

March 16,2007

53

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(in thousands, except share data)**
| ** **                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                            | ** ** | ** **            | ** ** | ** ** | ** ** |
| **CURRENT ASSETS:**                                                                                                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                            |       | $                     | 18,529     |   | $ | 13,723 |   |
| Investment  securities available for sale                                                                                                                             |       | 11,925                |       | 7,250 |   |
| Accounts  receivable - trade (net of allowance for doubtful accounts of $3,644 and  $3,278, respectively)                                                             |       | 72,723                |       | 58,701 |   |
| Other  receivables (net of allowance for doubtful accounts of $5,297 and $5,040,  respectively)                                                                       |       | 3,751                 |       | 9,726 |   |
| Debt service  fund and other restricted assets                                                                                                                        |       | 24,611                |       | 22,219 |   |
| Deferred tax  assets                                                                                                                                                  |       | 6,672                 |       | 5,089 |   |
| Prepaid expenses  and other                                                                                                                                           |       | 7,540                 |       | 9,076 |   |
| **Total  current assets**                                                                                                                                             |       | 145,751               |       | 125,784 |   |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                       |       | 319,064               |       | 323,861 |   |
| **OTHER ASSETS:**                                                                                                                                                     | ** ** | ** **            | ** ** | ** ** | ** ** |
| Debt service  reserve fund                                                                                                                                            |       | 23,801                |       | 23,802 |   |
| Goodwill, net                                                                                                                                                         |       | 12,339                |       | 12,577 |   |
| Intangible  assets, net                                                                                                                                               |       | 6,926                 |       | 9,089 |   |
| Deferred costs  and other                                                                                                                                             |       | 15,652                |       | 15,515 |   |
| **Total  assets**                                                                                                                                                     |       | $                     | 523,533    |   | $ | 510,628 |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                        | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                                                                                                                                                  |       |                  |       |   |   |
| **CURRENT LIABILITIES:**                                                                                                                                              | ** ** | ** **            | ** ** | ** ** | ** ** |
| Accounts payable  and accrued liabilities                                                                                                                             |       | $                     | 60,163     |   | $ | 58,797 |   |
| Current portion  of long-term debt                                                                                                                                    |       | 10,510                |       | 9,701 |   |
| **Total  current liabilities**                                                                                                                                        |       | 70,673                |       | 68,498 |   |
| **LONG-TERM DEBT, net of current  portion**                                                                                                                           |       | 255,471               |       | 266,659 |   |
| **DEFERRED TAX LIABILITIES**                                                                                                                                          |       | 11,373                |       | 6,708 |   |
| **OTHER LONG-TERM LIABILITIES**                                                                                                                                       |       | 4,452                 |       | 3,302 |   |
| **Total  liabilities**                                                                                                                                                |       | 341,969               |       | 345,167 |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                     | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                                                                                                                                                  |       |                  |       |   |   |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                        | ** ** | ** **            | ** ** | ** ** | ** ** |
| Preferred stock,  $.001 par value, 10,000,000 shares authorized, none issued                                                                                          |       | 3⁄4                |       | 3⁄4 |   |
| Common stock,  $.001 par value, 30,000,000 shares authorized, 15,603,917 and 15,352,159  shares issued and 14,063,523 and 13,789,172 shares outstanding, respectively |       | 16                    |       | 15 |   |
| Additional  paid-in capital                                                                                                                                           |       | 154,411               |       | 151,329 |   |
| Retained  earnings                                                                                                                                                    |       | 38,964                |       | 27,091 |   |
| Treasury stock  (1,540,394 and 1,562,987 shares of common stock, at cost, respectively)                                                                               |       | (12,308               | )          | (12,573 | ) |
| Deferred  compensation                                                                                                                                                |       | —                |       | (990 | ) |
| Accumulated  other comprehensive income                                                                                                                               |       | 481                   |       | 589 |   |
| **Total  stockholders’ equity**                                                                                                                                  |       | 181,564               |       | 165,461 |   |
| **Total liabilities and stockholders’  equity**                                                                                                                  |       | $                     | 523,533    |   | $ | 510,628 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

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**CORNELL COMPANIES, INC.**

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

**(in thousands, except per share data)**
| ** **                                                                                                                | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| REVENUES                                                                                                                  |       | $                                          | 360,855    |   | $ | 310,775 |   | $ | 277,190 |   |
| OPERATING  EXPENSES                                                                                                       |       | 275,040                                    |       | 238,305 |   | 211,157 |   |
| PRE-OPENING AND  START-UP EXPENSES                                                                                        |       | 2,657                                      |       | 9,017 |   | 8,803 |   |
| IMPAIRMENT OF  LONG-LIVED ASSETS                                                                                          |       | 355                                        |       | 3⁄4 |   | 9,300 |   |
| DEPRECIATION AND  AMORTIZATION                                                                                            |       | 16,285                                     |       | 15,200 |   | 13,187 |   |
| GENERAL AND  ADMINISTRATIVE EXPENSES                                                                                      |       | 21,720                                     |       | 20,387 |   | 20,284 |   |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                    |       | 44,798                                     |       | 27,866 |   | 14,459 |   |
| INTEREST EXPENSE                                                                                                          |       | 26,130                                     |       | 24,041 |   | 22,298 |   |
| INTEREST INCOME                                                                                                           |       | (3,060                                     | )          | (2,318 | ) | (1,944 | ) |
| LOSS ON  EXTINGUISHMENT OF DEBT                                                                                           |       | 3⁄4                                     |       | 3⁄4 |   | 2,361 |   |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE  PROVISION (BENEFIT) FOR INCOME TAXES                                     |       | 21,728                                     |       | 6,143 |   | (8,256 | ) |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| PROVISION  (BENEFIT) FOR INCOME TAXES                                                                                     |       | 9,148                                      |       | 2,215 |   | (3,256 | ) |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| INCOME (LOSS) FROM CONTINUING OPERATIONS                                                                                  |       | 12,580                                     |       | 3,928 |   | (5,000 | ) |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| DISCONTINUED  OPERATIONS, NET OF TAX BENEFIT OF $381, $1,950 and $1,589, RESPECTIVELY                                     |       | (707                                       | )          | (3,622 | ) | (2,433 | ) |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| NET INCOME (LOSS)                                                                                                         |       | $                                          | 11,873     |   | $ | 306 |   | $ | (7,433 | ) |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| EARNINGS (LOSS)  PER SHARE:                                                                                               |       |                                       |       |   |   |   |   |
| BASIC:                                                                                                                    |       |                                       |       |   |   |   |   |
| Income (loss) from continuing operations                                                                                  |       | $                                          | .90        |   | $ | .29 |   | $ | (.38 | ) |
| Loss from discontinued operations, net of tax                                                                             |       | (.05                                       | )          | (.27 | ) | (.18 | ) |
| Net income (loss)                                                                                                         |       | $                                          | .85        |   | $ | .02 |   | $ | (.56 | ) |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| DILUTED:                                                                                                                  |       |                                       |       |   |   |   |   |
| Income (loss) from continuing operations                                                                                  |       | $                                          | .89        |   | $ | .29 |   | $ | (.38 | ) |
| Loss from discontinued operations, net of tax                                                                             |       | (.05                                       | )          | (.27 | ) | (.18 | ) |
| Net income (loss)                                                                                                         |       | $                                          | .84        |   | $ | .02 |   | $ | (.56 | ) |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| NUMBER OF SHARES  USED IN PER SHARE COMPUTATION:                                                                          |       |                                       |       |   |   |   |   |
| BASIC                                                                                                                     |       | 13,918                                     |       | 13,580 |   | 13,203 |   |
| DILUTED                                                                                                                   |       | 14,059                                     |       | 13,695 |   | 13,203 |   |
|                                                                                                                      |       |                                       |       |   |   |   |   |
| COMPREHENSIVE  INCOME (LOSS):                                                                                             |       |                                       |       |   |   |   |   |
| Net income (loss)                                                                                                         |       | $                                          | 11,873     |   | $ | 306 |   | $ | (7,433 | ) |
| Unrealized gain (loss) on derivative instruments,  net of tax provision (benefit) of ($75), ($954) and $123, respectively |       | (108                                       | )          | (1,103 | ) | 164 |   |
| Comprehensive  income (loss)                                                                                              |       | $                                          | 11,765     |   | $ | (797 | ) | $ | (7,269 | ) |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

55

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

**(in thousands, except share data)**
| ** **                                                      | ** ** | ** **            | ** ** | ** **     | ** ** | ** **  | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | ** **       | ** ** | **Accumulated**  | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|-------------|------------|--------------|------------|-------------------------|------------|--------------|------------|------------------|------------|------------------|------------|
| ** **                                                      | ** ** | ** **            | ** ** | ** **     | ** ** | ** **  | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | ** **       | ** ** | **Other**        | ** ** |
| ** **                                                      | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | **Compre-**      | ** ** |
| ** **                                                      | ** ** | ** **            | ** ** | **Par**        | ** ** | **Paid-In** | ** ** | **Retained** | ** ** | **Treasury Stock** | ** ** | **Deferred** | ** ** | **hensive**      | ** ** |
| ** **                                                      | ** ** | **Shares**            | ** ** | **Value**      | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Shares**              | ** ** | **Cost**     | ** ** | **Compensation** | ** ** | **Income(Loss)** | ** ** |
| ** **                                                      | ** ** | ** **            | ** ** | ** **     | ** ** | ** **  | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | ** **       | ** ** | ** **       | ** ** |
| BALANCES AT  JANUARY 1, 2004                                    |       | 14,578,505            |       | $              | 15         |        | $          | 143,735      |       | $                       | 34,218     |         | 1,552,987  |             | $          | (12,458          | )          | $ | (803 | ) | $ | 1,528 |   |
|                                                            |       |                  |       |           |       |        |       |         |       |                    |       |         |       |             |       |             |       |
| EXERCISE OF STOCK  OPTIONS                                      |       | 213,694               |       | 3⁄4         |       | 1,521       |       | —       |       | —                  |       | —       |       | 3⁄4           |       | —           |       |
| INCOME TAX  BENEFIT FROM STOCK OPTION EXERCISES                 |       | —                |       | —         |       | 312         |       | —       |       | —                  |       | —       |       | 3⁄4           |       | —           |       |
| MARK TO MARKET  ADJUSTMENTS FOR DEFERRED BONUS PLAN             |       | —                |       | —         |       | (306        | )          | —       |       | —                  |       | —       |       | 306              |       | —           |       |
| OTHER  COMPREHENSIVE INCOME                                     |       | —                |       | —         |       | —      |       | —       |       | —                  |       | —       |       | 3⁄4           |       | 164              |       |
| DEFERRED AND  OTHER STOCK COMPENSATION                          |       | —                |       | —         |       | —      |       | —       |       | —                  |       | —       |       | 65               |       | —           |       |
| PURCHASE OF  TREASURY STOCK (10,000 SHARES, AT COST)            |       | —                |       | —         |       | —      |       | —       |       | 10,000                  |       | (115         | )          | 3⁄4           |       | —           |       |
| ISSUANCE OF  COMMON STOCK TO EMPLOYEE STOCK PURCHASE PLAN       |       | 40,213                |       | —         |       | 323         |       | —       |       | —                  |       | —       |       | 3⁄4           |       | —           |       |
| ISSUANCE OF  COMMON STOCK UNDER 2000 DIRECTOR’S STOCK PLAN |       | 12,695                |       | —         |       | 240         |       | —       |       | —                  |       | —       |       | 3⁄4           |       | —           |       |
| NET LOSS                                                        |       | —                |       | —         |       | —      |       | (7,433       | )          | —                  |       | —       |       | 3⁄4           |       | —           |       |
|                                                            |       |                  |       |           |       |        |       |         |       |                    |       |         |       |             |       |             |       |
| BALANCES AT  DECEMBER 31, 2004                             |       | 14,845,107            |       | 15             |       | 145,825     |       | 26,785       |       | 1,562,987               |       | (12,573      | )          | (432             | )          | 1,692            |       |
|                                                            |       |                  |       |           |       |        |       |         |       |                    |       |         |       |             |       |             |       |
| EXERCISE OF STOCK  OPTIONS                                      |       | 446,141               |       | 3⁄4         |       | 3,783       |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
| INCOME TAX  BENEFIT FROM STOCK OPTION EXERCISES                 |       | 3⁄4                |       | 3⁄4         |       | 724         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
| MARK TO MARKET  ADJUSTMENTS FOR DEFERRED BONUS PLAN             |       | —                |       | —         |       | (156        | )          | —       |       | —                  |       | —       |       | 156              |       | —           |       |
| OTHER  COMPREHENSIVE INCOME                                     |       | 3⁄4                |       | 3⁄4         |       | 3⁄4      |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       |             |       | (1,103           | )          |
| DEFERRED AND  OTHER STOCK COMPENSATION                          |       | 3⁄4                |       | 3⁄4         |       | 381         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | (714             | )          | 3⁄4           |       |
| ISSUANCE OF  COMMON STOCK TO EMPLOYEE STOCK PURCHASE PLAN       |       | 30,553                |       | 3⁄4         |       | 357         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
| ISSUANCE OF  COMMON STOCK UNDER 2000 DIRECTOR’S STOCK PLAN |       | 30,358                |       | 3⁄4         |       | 415         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
| NET INCOME                                                      |       | 3⁄4                |       | 3⁄4         |       | 3⁄4      |       | 306          |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
|                                                            |       |                  |       |           |       |        |       |         |       |                    |       |         |       |             |       |             |       |
| BALANCES AT  DECEMBER 31, 2005                             |       | 15,352,159            |       | 15             |       | 151,329     |       | 27,091       |       | 1,562,987               |       | (12,573      | )          | (990             | )          | 589              |       |
|                                                            |       |                  |       |           |       |        |       |         |       |                    |       |         |       |             |       |             |       |
| EXERCISE OF STOCK  OPTIONS                                      |       | 165,531               |       | 1              |       | 1,830       |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
| INCOME TAX  BENEFIT FROM STOCK OPTION EXERCISED                 |       | 3⁄4                |       | 3⁄4         |       | 224         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
| OTHER  COMPREHENSIVE INCOME                                     |       | 3⁄4                |       | 3⁄4         |       | 3⁄4      |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       |             |       | (108             | )          |
| DEFERRED AND  OTHER STOCK COMPENSATION                          |       | 58,327                |       | 3⁄4         |       | 1,622       |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
| ADOPTION OF SFAS  123(R)                                        |       | —                |       | —         |       | (990        | )          | —       |       | —                  |       | —       |       | 990              |       | —           |       |
| ISSUANCE OF  COMMON STOCK TO EMPLOYEE STOCK PURCHASE PLAN       |       | 3⁄4                |       | 3⁄4         |       | 3⁄4      |       | 3⁄4       |       | (22,593                 | )          | 265          |       | 3⁄4           |       | 3⁄4           |       |
| ISSUANCE OF  COMMON STOCK UNDER 2000 DIRECTOR’S STOCK PLAN |       | 27,900                |       | —         |       | 396         |       | 3⁄4       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
| NET INCOME                                                      |       | 3⁄4                |       | 3⁄4         |       | 3⁄4      |       | 11,873       |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4           |       | 3⁄4           |       |
|                                                            |       |                  |       |           |       |        |       |         |       |                    |       |         |       |             |       |             |       |
| BALANCES AT  DECEMBER 31, 2006                             |       | 15,603,917            |       | $              | 16         |        | $          | 154,411      |       | $                       | 38,964     |         | 1,540,394  |             | $          | (12,308          | )          | $ | 3⁄4 |   | $ | 481 |   |
|                                                                 |            |                       |            |                |            |             |            |              |            |                         |            |              |            |                  |            |                  |            |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

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**CORNELLCOMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**
| ** **                                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                              | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                       |       | $                                          | 11,873     |   | $ | 306 |   | $ | (7,433 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities           |       |                                       |       |   |   |   |   |
| Impairment of long-lived assets                                                                         |       | 355                                        |       | 3⁄4 |   | 10,100 |   |
| Loss on extinguishment of debt                                                                          |       | 3⁄4                                     |       | 3⁄4 |   | 2,361 |   |
| Depreciation                                                                                            |       | 14,042                                     |       | 13,106 |   | 12,183 |   |
| Amortization of intangibles and other assets                                                            |       | 2,243                                      |       | 2,268 |   | 1,364 |   |
| Amortization of deferred compensation                                                                   |       | 77                                         |       | (294 | ) | 65 |   |
| Amortization of deferred financing costs                                                                |       | 965                                        |       | 1,414 |   | 1,437 |   |
| Amortization of Senior Notes discount                                                                   |       | 184                                        |       | 184 |   | 92 |   |
| Stock-based compensation                                                                                |       | 1,893                                      |       | 3⁄4 |   | 3⁄4 |   |
| Provision for bad debts                                                                                 |       | 2,967                                      |       | 4,745 |   | 2,371 |   |
| Gain on sale of property and equipment                                                                  |       | (119                                       | )          | (50 | ) | (397 | ) |
| Deferred income taxes                                                                                   |       | 3,216                                      |       | (3 | ) | (4,154 | ) |
| Change in assets and liabilities, net of  acquisitions:                                                 |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                                     |       | (10,696                                    | )          | (5,586 | ) | (12,206 | ) |
| Other restricted assets                                                                                 |       | 976                                        |       | (62 | ) | (66 | ) |
| Other assets                                                                                            |       | 850                                        |       | 2,881 |   | (260 | ) |
| Accounts payable and accrued liabilities                                                                |       | 780                                        |       | 9,513 |   | 6,625 |   |
| Other liabilities                                                                                       |       | 58                                         |       | (154 | ) | 11 |   |
| **Net cash provided by operating activities**                                                           |       | 29,664                                     |       | 28,268 |   | 12,093 |   |
|                                                                                                    |       |                                       |       |   |   |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                              | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capital expenditures                                                                                    |       | (12,317                                    | )          | (51,128 | ) | (40,243 | ) |
| Acquisition of a business, net of cash acquired                                                         |       | 3⁄4                                     |       | (9,064 | ) | 3⁄4 |   |
| Purchases of investment securities                                                                      |       | (427,600                                   | )          | (1,022,295 | ) | (471,410 | ) |
| Sales of investment securities                                                                          |       | 422,925                                    |       | 1,066,785 |   | 419,670 |   |
| Receipt from restricted escrow arrangement                                                              |       | 3⁄4                                     |       | 3⁄4 |   | 5,000 |   |
| BOP claim reimbursement                                                                                 |       | 3⁄4                                     |       | 3⁄4 |   | 5,566 |   |
| Purchase of facility management contract                                                                |       | 3⁄4                                     |       | 3⁄4 |   | (3,000 | ) |
| Proceeds from sale of property and equipment                                                            |       | 2,892                                      |       | 647 |   | 1,137 |   |
| Payments to restricted debt payment account, net                                                        |       | (3,367                                     | )          | (2,445 | ) | (2,463 | ) |
| **Net cash used in investing activities**                                                               |       | (17,467                                    | )          | (17,500 | ) | (85,743 | ) |
|                                                                                                    |       |                                       |       |   |   |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                              | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from long-term debt and line of credit                                                         |       | 3⁄4                                     |       | 3⁄4 |   | 69,000 |   |
| Payments on line of credit                                                                              |       | 3⁄4                                     |       | 3⁄4 |   | (71,000 | ) |
| Payments of MCF bonds                                                                                   |       | (9,700                                     | )          | (9,000 | ) | (8,300 | ) |
| Payments of synthetic lease                                                                             |       | 3⁄4                                     |       | 3⁄4 |   | (52,499 | ) |
| Payments of acquired debt                                                                               |       | 3⁄4                                     |       | (1,905 | ) | 3⁄4 |   |
| Payments of capital lease obligations                                                                   |       | (11                                        | )          | (176 | ) | (7 | ) |
| Proceeds from Senior Notes, net of discount                                                             |       | 3⁄4                                     |       | 3⁄4 |   | 110,527 |   |
| Payments for debt issuance and other financing costs                                                    |       | 3⁄4                                     |       | 3⁄4 |   | (6,076 | ) |
| Tax benefit of stock option exercises                                                                   |       | 224                                        |       | 3⁄4 |   | — |   |
| Proceeds from exercise of stock options                                                                 |       | 2,096                                      |       | 4,141 |   | 1,844 |   |
| Purchases of treasury stock                                                                             |       | 3⁄4                                     |       | 3⁄4 |   | (115 | ) |
| **Net cash (used in) provided by financing  activities**                                                |       | (7,391                                     | )          | (6,940 | ) | 43,374 |   |
|                                                                                                    |       |                                       |       |   |   |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                                   |       | 4,806                                      |       | 3,828 |   | (30,276 | ) |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF PERIOD                                                       |       | 13,723                                     |       | 9,895 |   | 40,171 |   |
| CASH AND CASH  EQUIVALENTS AT END OF PERIOD                                                             |       | $                                          | 18,529     |   | $ | 13,723 |   | $ | 9,895 |   |
| ** **                                                                                              | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| **SUPPLEMENTAL  CASH FLOW DISCLOSURE:**                                                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest paid, net of amounts capitalized                                                               |       | $                                          | 25,317     |   | $ | 22,964 |   | $ | 16,054 |   |
| Income taxes paid                                                                                       |       | $                                          | 3,947      |   | $ | 175 |   | $ | 400 |   |
|                                                                                                    |       |                                       |       |   |   |   |   |
| **OTHER  NON-CASH INVESTING AND FINANCING ACTIVITIES:**                                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Increase (decrease) in fair value of interest rate  swap                                                |       | $                                          | (908       | ) | $ | (3,353 | ) | $ | 3,208 |   |
| Purchases and additions to property and equipment  included in accounts payable and accrued liabilities |       | 3⁄4                                     |       | 2,478 |   | 2,904 |   |
| Common stock issued for board of directors fees                                                         |       | 396                                        |       | 415 |   | 240 |   |
| Equipment  additions under capital leases                                                               |       | 56                                         |       | 3⁄4 |   | 3⁄4 |   |

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

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

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

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

**2.****    ****SIGNIFICANT ACCOUNTING POLICIES**

***Consolidation***

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

***Cash and Cash Equivalents***

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

***Investment Securities***

Our investment securitiesat December 31, 2006 consist of certificates of deposit and certain marketablesecurities.

Our certificates ofdeposit, which total $0.8 million at December 31, 2006 and 2005, bear interestat a rate of 3.93%. They have original maturities of one year and are pledgedas collateral under certain outstanding letters of credit.

Our marketable securitiesare categorized as available-for-sale securities. Unrealized marketablesecurities gains and temporary losses are reflected as a net amount under thecaption of accumulated other comprehensive income within the statement ofstockholders’ equity. Realized gains and losses are recorded within thestatement of income under the caption interest income or interest expense. Forthe purpose of computing realized gains and losses, cost is identified on aspecific identification basis.

AtDecember 31, 2006 and 2005, our marketable securities, which total $11.2million and $6.5 million, respectively, were held in auction rate municipalbonds. Our investment in these securities is recorded at cost, whichapproximates fair market value due to their variable interest rates, whichtypically reset every 7 to 35 days, and, despite the long-term nature of theirstated contractual maturities, we have the ability to quickly liquidate thesesecurities. As a result, we had no gross unrealized holding gains (losses) orgross realized gains (losses) from our investment securities at December 31,2006 and 2005.

Contractualmaturities of the underlying investment securities held at December 31, 2006are as follows (in thousands):
| Due within 1 year                  |   | $      | 750    |   |
|------------------------------------|--------|--------|--------|--------|
| Due after 1 year through 5 years   |   | 3⁄4 |   |
| Due after 5 years through 10 years |   | 3⁄4 |   |
| Due after 10 years                 |   | 11,175 |   |
| Total investment securities        |   | $      | 11,925 |   |

 

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***Accounts Receivable and Related Allowancefor Doubtful Accounts***

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

AtDecember 31, 2006, other receivables include approximately $0.9 millionrelated to the Lincoln County Detention Center lawsuit settlement that isexpected to be reimbursed by our general liability and professional liabilitycoverage and approximately $5.3 million related to misappropriated escrow fundsfor the Southern Peaks Regional Treatment Center, which is fully reserved atDecember 31, 2006. At December 31, 2005, other receivables includesapproximately $7.0 million related to the shareholder lawsuit settlement thatwas ultimately reimbursed by our directors’ and officers’ liability insurancecarrier as well as the $5.3 million other receivable related to the escrowfunds as previously noted.  Refer to Note12 to the consolidated financial statements for a discussion concerning this balanceand the related transactions.

Thechanges in allowance for doubtful accounts associated with trade accountsreceivable for the years ended December 31, 2006, 2005 and 2004 are asfollows (in thousands):
|                                       | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                  |       |                                       |       |   |   |   |   |
| Balance at  beginning of period       |       | $                                          | 3,278      |   | $ | 3,544 |   | $ | 1,929 |   |
| Provision for  bad debts              |       | 2,702                                      |       | 4,745 |   | 2,717 |   |
| Write-offs of  uncollectible accounts |       | (2,336                                     | )          | (5,011 | ) | (1,102 | ) |
| Balance at end of  period             |       | $                                          | 3,644      |   | $ | 3,278 |   | $ | 3,544 |   |

 

***Restricted Assets***

Restrictedassets at December 31, 2006 and 2005 include approximately $23.0 millionand $19.6 million, respectively, of Municipal Correctional Finance, LP’s (MCF)restricted cash accounts. MCF’s restricted accounts primarily consist of a debtservice fund used to segregate rental payment funds from us to MCF for MCF’ssemi-annual debt service. MCF’s funds are invested in short term certificatesof deposit, money market accounts and commercial paper. They will be used tofund a portion of MCF’s debt service due in the coming year.

Atcertain facilities, we maintain bank accounts for restricted cash belonging tofacility residents, commissary operations and equipment replacement funds usedin certain state programs. Restricted assets at December 31, 2006and 2005 include approximately $1.7 million and $2.6 million, respectively, forthese accounts. A corresponding liability for these obligations is included inaccrued liabilities in the accompanying financial statements.

***Property and Equipment***

Propertyand equipment are recorded at cost. Ordinary maintenance and repair costs areexpensed, while renewal and betterment costs are capitalized. Buildings andimprovements are depreciated over their estimated useful lives of 30 to 50years using the straight-line method. Prepaid facility use cost, which resultedfrom the July 1996 acquisition of the Big Spring Correctional Center andthe December 1999 transfer of ownership of the Great Plains CorrectionalFacility to a leasehold interest, is being amortized over 50 years using thestraight-line method. Furniture and equipment are depreciated over theirestimated useful lives of 3 to 10 years using the straight-line method.Amortization of leasehold improvements (including those funded by landlordincentives or allowances) is recorded using the straight-line method based uponthe shorter of the economic life of the asset or the term of the respectivelease. Landlord incentives or allowances under operating leases are recorded asdeferred rent and amortized as a reduction of rent expense over the lease term.See Note 8 to the consolidated financial statements for further detailsconcerning our property and equipment balances at December 31, 2006 and2005.

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***Capitalized Interest***

Wecapitalize interest on facilities while under construction. Interestcapitalized for the years ended December 31, 2006 and 2005 was approximately$1.5 million and $3.7 million, respectively, and related to the construction ofthe Moshannon Valley Correctional Center. Interest capitalized for the yearended December 31, 2004 was approximately $1.8 million and related to theMoshannon Valley Correctional Center, the Regional Correctional Center, the LasVegas Center and the Southern Peaks Regional Treatment Center.

***Debt Service Reserve Fund***

Thedebt service reserve fund was established at the closing of MCF’s bond issuanceand is to be used solely for MCF’s debt service to the extent that funds in MCF’sdebt service accounts are insufficient. The debt service reserve fund isinvested in short term commercial instruments and earns a guaranteed rate ofreturn of 3.0%. See Note 14 to the consolidated financial statements.

***Intangible Assets***

Weevaluate the carrying value of our existing intangibles (which are the resultof prior acquisitions – both business facilities and operating contracts) forimpairment annually. We have evaluated the carrying value of our existingintangibles and believe there has not been an impairment to the carrying valueof our existing intangibles as of December 31, 2006. See Note 6 to theconsolidated financial statements for further details concerning our intangibleassets.

***Deferred Costs***

Costsincurred related to obtaining debt financing are capitalized and amortized overthe term of the related indebtedness. At December 31, 2006 and 2005, wehad net deferred debt issuance costs of approximately $9.0 million and $9.6million, respectively.

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

Wereview our assets for impairment annually and when events or changes incircumstances indicate that the net book value of such assets may not berecovered over its remaining service life. For assets held and used inoperations, realization is assessed based on our estimate of future operatingresults and undiscounted cash flows. As of December 31, 2006, we haveevaluated our long-lived assets and believe that these assets, other than thetwo facilities for which we recognized impairment charges of approximately $0.4million during 2006, are realizable and that no additional impairments to thecarrying value of these assets exists. See Note 8 to the consolidated financialstatements for further discussion concerning impairment charges recognized inthe years ended December 31, 2006 and 2004.

***Revenue Recognition***

Substantiallyall of our revenues are derived from contracts with federal, state and localgovernmental 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,management fee basis, cost-plus reimbursement or fee-for-service basis. Werecognize revenue when we determine that the following criteria are met: (i)persuasive evidence of an arrangement exists; (ii) delivery has occured orservices have been rendered; (iii) the fee is fixed or determinable; and (iv)collectibility is reasonable assured.

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

Pre-opening and start-upexpenses are charged to operations as incurred. Pre-opening and start-upexpenses include payroll, benefits, training and other operating costs duringperiods prior to opening a new or expanded facility and during the period ofoperation while occupancy is ramping up. These costs vary by contract. Newlyopened facilities are staffed according to applicable regulatory or contractualrequirements when we begin receiving offenders or clients. Offenders or clientsare typically assigned to a newly opened facility on a phased-in basis over aone-to-six month period. Our start-up period for new juvenile operations is 12months from the date we begin recognizing revenue unless break-even occupancyis achieved before then. Our start-up period for new adult operations is ninemonths from the date we begin recognizing revenue unless break-even occupancyis achieved before then.

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***Proposal Costs***

We incur various expensesin conjunction with our participation in the proposal process with governmentagencies for their procurement of our services. These costs include such itemsas payroll and related employee benefits and taxes, research, consulting, legaland reproduction costs and are expensed in the periods incurred.

***Operating and General and Administrative Expenses***

We incur various expenseswithin the normal course of our business. Included in operating expenses aredirect expense items such as personnel/employee benefits, resident/inmate careexpenses and building/utility costs pertaining to the operations of ourfacilities and programs. Included in general and administrative expenses areexpense items such as personnel/employee benefits, professional services andbuilding/utility costs pertaining to our corporate activities.

***Business Concentration***

Contractswith federal, state and local governmental agencies account for nearly all ofour revenues. The loss of, or a significant decrease in, business from one ormore of these governmental agencies could have a material adverse effect on ourfinancial condition and results of operations. For the years endedDecember 31, 2006, 2005 and 2004, 28.2%, 23.0% and 22.3%, respectively, ofour consolidated revenues were derived from contracts with the Federal Bureauof Prisons (BOP), the only customer constituting more than 10.0% of ourrevenues during each of these periods. The increase in the percentage for 2006as compared to the prior two years is due to additional BOP revenue in 2006resulting from the Moshannon Valley Correctional Center which opened in April2006 and the acquisition of Correctional Systems, Inc. (“CSI”) in April 2005.

***Self Insurance Reserves***

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

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

***Accounting for Stock-Based Compensation***

Our stock incentive plans provide forthe granting of incentive options and nonqualified options to officers,directors and key employees of the Company. Grants under these plans vest overperiods up to seven years after the date of grant and expire no later than thetenth anniversary of the date of grant.

Prior to January 1, 2006, we accountedfor our stock option and stock-based compensation plans using theintrinsic-value method outlined by Accounting Principles Board (“APB”) OpinionNo. 25. Accordingly, we computed compensation cost for each employee stockoption granted as the amount by which the quoted market price of our shares onthe date of grant exceeded the amount the employee must pay to acquire theshares. The amount of compensation cost, if any, would be charged to incomeover the vesting period. No compensation cost had been recognized for theoptions granted, as the exercise price was equal to the market price on themeasurement date.

Effective January 1, 2006, weadopted the provisions of the Financial Accounting Standards Board (“FASB”)Statement of Financial Accounting Standard (“SFAS”) No. 123R, “Share BasedPayment” and elected to use the modified prospective transition method. Underthis method, compensation cost recognized for the year ended December 31, 2006,includes the applicable amounts of: (a) compensation cost of all stock-basedawards granted prior to, but not yet vested, as of January 1, 2006 (based onthe grant-date fair value estimated in accordance with the original provisionsof SFAS No. 123 and previously presented in pro forma footnote disclosures),and (b) compensation cost for all stock-based awards granted subsequent toJanuary 1, 2006 (based on the grant-date fair value estimated in accordancewith the provisions of SFAS No. 123R). Results for prior periods have not beenrestated.

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Additionally,we have an employee stock purchase plan (“ESPP”) underwhich employees can make contributions to purchase our common stock.Participation in the plan is elected annually by employees. The plan yearbegins each January 1st (the “Grant Date”) and ends on December 31st (the “ExerciseDate”). Purchases of common stock are made at the end of the year using thelower of the fair market value on either the Grant Date or Exercise Date, lessa 15% discount. Prior to January 1, 2006, we were not required torecognize any compensation cost related to our ESPP. Under SFAS No. 123R ouremployee-stock purchase plan is considered to be a compensatory ESPP and;therefore, we are required to recognize compensation cost over the requisiteservice period for grants made under the ESPP.

SFAS No.123R amends SFAS No. 95, “Statement of Cash Flows,” to require reporting ofcertain tax benefits as a financing cash flow, rather than as a reduction oftaxes paid. These tax benefits result from tax deductions in excess of the  compensation expense recognized for optionsexercised. Prior to the adoption of SFAS No. 123R, we presented all taxbenefits resulting from the exercise of stock options as operating cash flowsin our consolidated statement of cash flows.

On March29, 2005, the SEC issued Staff Accounting Bulletin (“SAB”) 107 to addresscertain issues related to SFAS No. 123R. SAB 107 provides guidance ontransition methods, valuation methods, income tax effects and other share-basedpayment topics, and we had also applied this guidance in our adoption of SFASNo. 123R.

On November 10, 2005, the FASB issued FASB Staff Position (“FSP”)No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects ofShare-Based Payment Awards” (“FSP 123R-3”). FSP 123R-3 provides for analternative transition method for establishing the beginning balance of theadditional paid-in capital pool (“APIC pool”) related to the tax effects ofemployee share-based compensation, which is available to absorb taxdeficiencies recognized subsequent to the adoption of SFAS No. 123R. We adoptedthis alternative transition method, otherwise known as the “simplified method,”in establishing our beginning APIC pool at January 1, 2006.

***Effect ofAdopting SFAS No. 123R***

The following table indicates theeffect of adopting**SFAS No. 123R as of January 1,2006 (in thousands, except per share amounts):
|                                                           | ** ** | **Year Ended  December 31,  2006** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------------|------------|
|                                                      |       |                                         |       |
| Stock-based  compensation expense – stock options    |       | $                                            | 1,493      |   |
| Stock-based  compensation expense – restricted stock |       | 309                                          |       |
| Employee-stock  purchase plan                             |       | 91                                           |       |
| Related deferred  income tax benefit                      |       | (776                                         | )          |
| Net loss                                                  |       | $                                            | 1,117      |   |
|                                                      |       |                                         |       |
| Decrease in basic earnings per share                      |       | $                                            | 0.08       |   |
|                                                      |       |                                         |       |
| Decrease in  diluted earnings per share                   |       | $                                            | 0.08       |   |

 

At December 31, 2006, 60,000 restrictedshares of our common stock were outstanding subject to performance-basedvesting criteria (30,000 of which are considered market-based restricted stockunder SFAS No. 123R. Additionally, 137,200 stock options were outstandingsubject to performance-based vesting criteria (16,100 of which are consideredmarket-based options under SFAS No. 123R).

The 30,000 shares of restricted stockand the 16,100 stock options which are considered market-based restricted stockwere valued using a Monte Carlo simulation probability model to estimate futurestock returns. The grant date fair value of these shares was $9.05 per sharefor a total value of $0.4 million. We recognized approximately $0.12 million ofexpense associated with these shares of restricted stock and options during theyear ended December 31, 2006.

The amountsabove relate to the impact of recognizing compensation expense related to stockoptions, restricted stock and our employee-stock purchase plan. Compensationexpense related to stock options (121,100 shares) and restricted stock grants(30,000 shares) that vest based upon performance conditions is not recorded forsuch performance-based awards until it has been

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deemed probable that the relatedperformance targets allowing the vesting of the options and restricted stockwill be met. We are required to periodically re-assess the probability andrecord expense at the point in time, if ever, it becomes probable these sharesof restricted stock and stock options will vest.

Based onour financial performance in 2006, a portion of the 2006 performance-basedawards met their related performance targets. Accordingly, 21,000 stock optionswere vested and compensation expense was recognized of $0.13 million. Inaddition, it was also deemed probable that the related performance targetspertaining to certain restricted stock and stock options will also be achievedby their vesting date. Accordingly, compensation expense of approximately $0.1million has been recognized for the year ended December 31, 2006.

We recognize expense for ourstock-based compensation over the vesting period, which represents the periodin which an employee is required to provide service in exchange for the award.We recognize compensation expense for stock-based awards immediately if theaward has immediate vesting.

***Prior Period ProForma Presentation***

Under the modified prospectiveapplication method, results for prior periods have not been restated to reflectthe effects of implementing SFAS No. 123R. The following pro forma information,as required by SFAS No. 148, “Accounting for Stock-Based CompensationTransition and Disclosure, an Amendment of FASB Statement No. 123” is presentedfor comparative purposes and illustrates the pro forma effect on net income andearnings per share for the period presented as if we had applied the fair valuerecognition provisions of SFAS No. 123 to stock-based employee compensationprior to January 1, 2006 (in thousands, except per-share amounts):
|                                                                                                                                             | ** ** | **Year Ended  December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2005**                               | ** ** | **2004** | ** ** |
|                                                                                                                                        |       |                                   |       |   |   |
| Net income  (loss), as reported                                                                                                             |       | $                                      | 306        |   | $ | (7,433 | ) |
| Add: total  stock-based compensation recorded, net of tax                                                                                   |       | 201                                    |       | 146 |   |
| Less: total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (1,988                                 | )          | (1,022 | ) |
| Pro forma net  loss                                                                                                                         |       | $                                      | (1,481     | ) | $ | (8,309 | ) |
|                                                                                                                                        |       |                                   |       |   |   |
| Income (loss)  per share:                                                                                                                   |       |                                   |       |   |   |
| Basic, as reported                                                                                                                          |       | $                                      | .02        |   | $ | (.56 | ) |
| Basic, pro forma                                                                                                                            |       | $                                      | (.11       | ) | $ | (.63 | ) |
| Diluted, as reported                                                                                                                        |       | $                                      | .02        |   | $ | (.56 | ) |
| Diluted, pro  forma                                                                                                                         |       | $                                      | (.11       | ) | $ | (.63 | ) |

 

*Assumptions*

The fair values for the significant stock-based awardsgranted during the year ended December 31, 2006, 2005 and 2004 were estimatedat the date of grant using a Black-Scholes option pricing model with thefollowing weighted-average assumptions:
|                                   | ** ** | **Years Ended  December, 31** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|                              |       |                                    |       |   |   |   |   |
| Risk-free rate  of return         |       | 4.31                                    | %          | 4.28 | % | 4.33 | % |
| Expected life of  award           |       | 5 years                                 |       | 7 years |   | 7 years |   |
| Expected  dividend yield of stock |       | 0                                       | %          | 0 | % | 0 | % |
| Expected  volatility of stock     |       | 45.48                                   | %          | 52.99 | % | 52.89 | % |
| Weighted-average fair  value      |       | $                                       | 6.24       |   | $ | 8.03 |   | $ | 7.94 |   |
|                                   |            |                                         |            |  |  |  |  |  |  |  |

 

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The expected volatility of stock assumption wasderived by referring to changes in the Company’s historical common stock pricesover a timeframe similar to that of the expected life of the award. While wehave no reason to believe that future stock volatility will significantlydiffer from historical stock volatility, we would modify our appliedassumptions in the future if factors warranted. Estimated forfeiture rates arederived from historical forfeiture patterns. We believe the historicalexperience method is the best estimate of forfeitures currently available.

In accordance with SAB 107, we used the “simplified”method for “plain vanilla” options to estimate the expected term of optionsgranted during 2006.

Stock-based award activity during the year endedDecember 31, 2006 was as follows (aggregate intrinsic value in millions):
|                                                   | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  December 31, 2003            |       | 1,131,964              |       | $                                      | 9.55       |                                                | 7.2        |                            | $          | 10.8 |   |
| Granted                                           |       | 167,150                |       |                                   |       |                                                |       |                            |       |
| Exercised                                         |       | (196,852               | )          |                                   |       |                                                |       |                            |       |
| Forfeited or  canceled                            |       | (125,315               | )          |                                   |       |                                                |       |                            |       |
|                                              |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  December 31, 2004            |       | 976,947                |       | 10.72                                  |       | 6.7                                                 |       | $                               | 10.5       |   |
| Granted                                           |       | 311,550                |       |                                   |       |                                                |       |                            |       |
| Exercised                                         |       | (399,090               | )          |                                   |       |                                                |       |                            |       |
| Forfeited or  canceled                            |       | (191,701               | )          |                                   |       |                                                |       |                            |       |
|                                              |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  December 31, 2005                 |       | 697,706                |       | $                                      | 12.21      |                                                | 7.2        |                            | $          | 8.5 |   |
| Granted                                           |       | 45,000                 |       | 13.71                                  |       |                                                |       |                            |       |
| Exercised                                         |       | (164,661               | )          | 11.07                                  |       |                                                |       |                            |       |
| Forfeited or  canceled                            |       | (62,135                | )          | 12.96                                  |       |                                                |       |                            |       |
|                                              |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  December 31, 2006                 |       | 515,910                |       | $                                      | 12.62      |                                                | 7.2        |                            | $          | 6.5 |   |
|                                              |       |                   |       |                                   |       |                                                |       |                            |       |
| Vested and  expected to vest at December 31, 2006 |       | 485,027                |       | $                                      | 12.58      |                                                | 7.1        |                            | $          | 6.1 |   |
|                                              |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable at December  31, 2006                 |       | 310,026                |       | $                                      | 12.22      |                                                | 6.6        |                            | $          | 3.8 |   |

 

The total intrinsic value of stock options exercisedduring the years ended December 31, 2006 and 2005 was $0.6 million and $1.9million, respectively. Net cash proceeds from the exercise of stock optionswere approximately $2.1 million and $4.1 million for the years ended December31, 2006 and 2005, respectively.

As of December 31, 2006, approximately $1.0 million ofestimated expense with respect to nonvested stock-based awards had yet to berecognized and will be amortized into expense over the employee’s estimatedremaining weighted average service period of approximately 3.0 years.

The following table summarizes information withrespect to stock options outstanding and exercisable at December 31, 2006.
| Range of Exercise Prices         | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
|                                            |       |                    |       |                                                |       |                                   |       |                    |       |                                   |       |
| $3.75  to  $6.50            |       | 23,140                  |       | 3.9                                                 |       | $                                      | 4.12       |                    | 23,140     |                                   | $          | 4.12 |   |
|   6.51  to  10.00 |       | 35,445                  |       | 6.0                                                 |       | 8.40                                   |       | 33,659                  |       | 8.40                                   |       |
| 10.01  to  13.50            |       | 211,125                 |       | 7.2                                                 |       | 12.56                                  |       | 94,327                  |       | 12.25                                  |       |
| 13.51  to  16.00            |       | 246,200                 |       | 7.7                                                 |       | 14.07                                  |       | 158,900                 |       | 14.19                                  |       |
|                                            |       | 515,910                 |       | 7.2                                                 |       | $                                      | 12.62      |                    | 310,026    |                                   | $          | 12.22 |   |

 

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Stock-based awardactivity for nonvested awards during the year ended December 31, 2006 was asfollows:
|                                      | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at December 31,  2003 |       | 516,463                |       | $                                                           | 9.72       |   |
| Granted                              |       | 167,150                |       | 13.46                                                       |       |
| Vested                               |       | (127,126               | )          | 10.31                                                       |       |
| Canceled                             |       | (93,705                | )          | 9.23                                                        |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2004 |       | 462,782                |       | 11.17                                                       |       |
| Granted                              |       | 311,550                |       | 13.67                                                       |       |
| Vested                               |       | (318,476               | )          | 11.38                                                       |       |
| Forfeited or  canceled               |       | (132,387               | )          | 11.56                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2005      |       | 323,469                |       | 13.17                                                       |       |
| Granted                              |       | 45,000                 |       | 13.71                                                       |       |
| Vested                               |       | (156,005               | )          | 13.26                                                       |       |
| Canceled                             |       | (6,580                 | )          | 13.24                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at December  31, 2006      |       | 205,884                |       | $                                                           | 13.22      |   |

 

***Restricted Stock***

We have issued restrictedstock under certain employment agreements and a deferred bonus plan which vestsover a specific period of time, generally three to five years.  These shares of restricted common stock aresubject to restrictions on transfer and certain conditions to vesting.

Restricted stock activityfor the year ended December 31, 2006 was as follows:
|                                      | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at  December 31, 2003 |       | 107,583                |       | $                                                           | 17.15      |   |
| Granted                              |       | —                 |       |                                                        |       |
| Vested                               |       | —                 |       |                                                        |       |
| Canceled                             |       | (33,797                | )          | 17.15                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2004 |       | 73,786                 |       | 17.15                                                       |       |
| Granted                              |       | 25,000                 |       | 15.24                                                       |       |
| Vested                               |       | —                 |       |                                                        |       |
| Canceled                             |       | (47,113                | )          | 17.15                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2005      |       | 51,673                 |       | 16.23                                                       |       |
| Granted                              |       | —                 |       |                                                        |       |
| Vested                               |       | (15,676                | )          | 17.15                                                       |       |
| Canceled                             |       | (10,997                | )          | 17.15                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at December  31, 2006      |       | 25,000                 |       | $                                                           | 15.24      |   |

                                                                                                                                                                                                                                                

As of December 31, 2006,approximately $0.14 million of estimated expense with respect to nonvestedrestricted stock awards had yet to be recognized and will be amortized over aweighted average period of 1.1 years.

***Income Taxes***

Weutilize the liability method of accounting for income taxes. Under this method,deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying values of existing assets and liabilities and their respective taxbases based on enacted tax rates. In providing for deferred taxes, we considercurrent tax regulations, estimates of future taxable income and available taxplanning strategies. If tax regulations, operating results or the ability toimplement tax planning strategies vary, adjustments to the carrying value oftax assets and liabilities may occur. See Note 10 to the Consolidated FinancialStatements.

***Earnings Per Share***

Basicearnings per share (EPS) is computed by dividing net income by the weightedaverage number of shares of common stock outstanding during the period. DilutedEPS reflects the potential dilution from common stock equivalents such as stockoptions and warrants. For the year ended December 31, 2006, there were noanti-dilutive shares. For the years ended December 31, 2005 and 2004, therewere 113,145 shares ($15.10 average price) and 437,078 shares ($13.01 averageprice), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive.

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The following table summarizes thecalculation of income (loss) and the weighted average common shares and commonequivalent shares outstanding for purposes of the computation of earnings(loss) per share (in thousands, except per share data):
| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income (loss) from continuing operations                                 |       | $                                          | 12,580     |   | $ | 3,928 |   | $ | (5,000 | ) |
| Loss from discontinued operations, net of tax                            |       | (707                                       | )          | (3,622 | ) | (2,433 | ) |
| Net income (loss)                                                        |       | $                                          | 11,873     |   | $ | 306 |   | $ | (7,433 | ) |
|                                                                     |       |                                       |       |   |   |   |   |
| Weighted average common shares outstanding                               |       | 13,918                                     |       | 13,580 |   | 13,203 |   |
| Weighted average common share equivalents outstanding                    |       | 141                                        |       | 115 |   | 3⁄4 |   |
|                                                                     |       |                                       |       |   |   |   |   |
| Weighted average common shares and common share equivalents  outstanding |       | 14,059                                     |       | 13,695 |   | 13,203 |   |
|                                                                     |       |                                       |       |   |   |   |   |
| Basic income (loss) per share:                                           |       |                                       |       |   |   |   |   |
| Income (loss)  from continuing operations                                |       | $                                          | .90        |   | $ | .29 |   | $ | (.38 | ) |
| Loss from  discontinued operations, net of tax                           |       | (.05                                       | )          | (.27 | ) | (.18 | ) |
| Net income  (loss)                                                       |       | $                                          | .85        |   | $ | .02 |   | $ | (.56 | ) |
|                                                                     |       |                                       |       |   |   |   |   |
| Diluted income (loss) per share:                                         |       |                                       |       |   |   |   |   |
| Income (loss)  from continuing operations                                |       | $                                          | .89        |   | $ | .29 |   | $ | (.38 | ) |
| Loss from  discontinued operations, net of tax                           |       | (.05                                       | )          | (.27 | ) | (.18 | ) |
| Net income (loss)                                                        |       | $                                          | .84        |   | $ | .02 |   | $ | (.56 | ) |

 

***Financial Instruments***

Thecarrying amounts of our financial instruments, including cash and cashequivalents, investment securities, accounts receivable and accounts payableand accrued expenses, approximate fair value due to the short maturities ofthese financial instruments. At December 31, 2006, the carrying amount of ourlong-term debt was approximately $266.0 million, and the estimated fair valuewas $296.0 million. At December 31, 2005, the carrying amount was $276.4million, and the estimated fair value was $301.0 million. The estimated fairvalue of long-term debt is based primarily on quoted market prices for the sameor similar issues.

***Derivative Instruments***

Wehave only entered into derivative contracts that are classified as fairvalue hedges. These derivatives are recorded at their fair value with changesin the fair value recorded as adjustments to the related liability and othercomprehensive income (loss) in our Consolidated Statements of Operations andComprehensive Income (Loss). See Note 14 to the consolidated financial statements.

***Use of Estimates***

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

***Reclassifications***

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

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**3.****             ****MERGER AGREEMENT**

On October 6, 2006, we entered into an Agreement and Plan of Merger(the “Merger Agreement”) with The Veritas Capital Fund III, L.P., a Delawarelimited partnership (“Veritas”), Cornell Holding Corp., a Delaware corporation(“Parent”) and CCI Acquisition Corp., a Delaware corporation and wholly ownedsubsidiary of Parent (“Merger Sub”), pursuant to which the Merger Sub would bemerged with and into us (the “Merger”), with Cornell surviving after the Mergeras a wholly owned subsidiary of Parent.

Our Board of Directors unanimously approved the MergerAgreement. In connection with the Merger, the Parent and certain of ourstockholders entered into a Voting Agreement dated on or about October 6, 2006,whereby such stockholders agreed, among other things, to vote their respectiveshares of our stock in favor of the Merger Agreement, the Merger and thetransactions contemplated thereby.  At aspecial meeting of our stockholders held on January 23, 2007, the proposedMerger Agreement was rejected.

Under the terms of theMerger Agreement, because the Merger was terminated, we reimbursed $2.5 millionof these costs incurred by Veritas, Parent and Merger Sub in connection withthe proposed merger in February 2007. Such costs will be reported in generaland administrative expenses in the first quarter of 2007.

**4.****             ****DISCONTINUED OPERATIONS ANDMANAGEMENT RESTRUCTURING**

We classify as discontinued operations thosecomponents of our business that we hold for sale or that have been disposed andhave cash flows that are clearly distinguishable operationally and forfinancial reporting purposes from the rest of our operations. For thosecomponents, we have no significant continuing involvement after completion ofdisposal and their operations are eliminated from our ongoing operations.During 2005, management closed certain facilities that qualified fordiscontinued operations and notifications were made to the required contractingentities regarding the termination of the related programs. Such facilities areclassified as discontinued operations for the years ended December 31, 2006 and2005. At December 31, 2006 and 2005, we did not have any significant netproperty and equipment balances pertaining to these operations. Thesediscontinued operations did not generate any revenues in the year endedDecember 31, 2006. These discontinued operations generated revenues ofapproximately $2.6 million and $13.8 million in the years endedDecember 31, 2005 and 2004, respectively.

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**5.****    ****ACQUISITION OF CORRECTIONAL SYSTEMS, INC.**

In April 2005, we completed our acquisition of CorrectionalSystems, Inc. (CSI), a San Diego-based provider of privatized jail,community corrections and alternative sentencing services. The transaction wasconsummated in cash of approximately $9.1 million, net of cash acquired,all of which was paid in April 2005. The acquisition included the operations ofeight jails, six adult community-based correction facilities and fivealternative sentencing programs located in California, New Mexico, Texas andKansas. The acquisition added approximately 986 corrections beds, as well asalternatives to incarceration services. The results of operations for CSIsubsequent to the date of acquisition (April 1, 2005) are included in ourconsolidated financial statements.

We acquired substantially all of CSI’s assets and assumed all of theirliabilities.  The excess of the purchaseprice over the fair value of the assets acquired and liabilities assumed wasallocated to goodwill.  The initialpurchase price allocations can and have been adjusted within the shorter of adefined allocation period or one year of the purchase date for changes in theestimates of the fair values of assets acquired and liabilities assumed. Thefollowing table summarizes the estimated fair values of the assets acquired andliabilities assumed at the date of acquisition (in thousands).
|                                          | ** ** | **April 1, 2005** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|
|                                     |       |                        |       |
| Receivables                              |       | $                           | 1,769      |   |
| Prepaid expenses and other assets        |       | 305                         |       |
| Property and equipment                   |       | 2,097                       |       |
| Contract value                           |       | 4,121                       |       |
| Other assets                             |       | 1,351                       |       |
| Goodwill                                 |       | 4,586                       |       |
| Assets acquired                          |       | 14,229                      |       |
|                                     |       |                        |       |
| Accounts payable and accrued liabilities |       | 1,076                       |       |
| Long-term debt                           |       | 2,239                       |       |
| Deferred tax liabilities                 |       | 1,720                       |       |
| Other long-term liabilities              |       | 130                         |       |
| Liabilities assumed                      |       | 5,165                       |       |
| Net assets acquired                      |       | $                           | 9,064      |   |

 

The CSIacquisition resulted in the recognition of goodwill because of its industryposition, operational strength and potential to provide additional growthopportunities for us. During the years ended December 31, 2006 and 2005, weadjusted goodwill by approximately ($0.2) million and $0.3 million,respectively, due to adjustments to the cost basis of the property acquiredbased on final property appraisals and for certain post-closing acquisitioncosts.

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

On an unauditedpro forma basis, the effects of the CSI acquisition were not significant to ourresults of operations for 2004 and 2005.

In August 2005, a lawsuit was filed by a detainee at one of thefacilities acquired from CSI. See Note 11 to the consolidated financial statementsfor further discussion of this proceeding.

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**6.****             ****INTANGIBLE ASSETS**

Intangible assets at December 31, 2006 and 2005 consisted of thefollowing (in thousands):
|                             | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Non-compete agreements      |       | $                     | 10,040     |   | $ | 9,960 |   |
| Acquired contract value     |       | 6,442                 |       | 6,442 |   |
| Accumulated amortization    |       | (9,556                | )          | (7,313 | ) |
| Identified intangibles, net |       | 6,926                 |       | 9,089 |   |
| Goodwill, net               |       | 12,339                |       | 12,577 |   |
| Total intangibles, net      |       | $                     | 19,265     |   | $ | 21,666 |   |

 

The changes in the carrying amount of goodwill for the year endedDecember 31, 2006 are as follows (in thousands):
|                                  | ** ** | **Adult  Secure** | ** ** | **Juvenile** | ** ** | **Pre-  Release** | ** ** | **Total** | ** ** |
|----------------------------------|------------|-------------------|------------|--------------|------------|-------------------|------------|-----------|------------|
|                             |       |              |       |         |       |              |       |      |       |
| Balance as of December  31, 2004 |       | $                 | 1,509      |         | $          | 1,060             |       | $         | 5,152      |   | $ | 7,721 |   |
| Addition to goodwill             |       | 1,393             |       | —       |       | 3,463             |       | 4,856     |       |
| Balance as of December  31, 2005 |       | 2,902             |       | 1,060        |       | 8,615             |       | 12,577    |       |
| Reduction to goodwill            |       | —            |       | —       |       | (238              | )          | (238      | )          |
| Balance as of December 31, 2006  |       | $                 | 2,902      |         | $          | 1,060             |       | $         | 8,377      |   | $ | 12,339 |   |

 

At December 31, 2006, there is noimpairment to our existing goodwill.

Amortization expense for our acquiredcontract value was approximately $1.1 million, $1.0 million and $0.3 millionfor the years ended December 31, 2006, 2005 and 2004, respectively.Amortization expense for our acquired contract value is expected to beapproximately $1.1 million for each of the next four years ended December 31and approximately $0.6 million for the fifth year.

Amortizationexpense for our non-compete agreements was approximately $1.1 million for theyears ended December 31, 2006, 2005 and 2004. Amortization expense for ournon-compete agreements is expected to be approximately $1.1million for each of the next four years and$0.7 million for the fifth year.

**7.****             ****NEW ACCOUNTINGPRONOUNCEMENTS**

***Financial AccountingStandards Board Interpretation No. 48***

In June 2006, the FASB issued Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes” (“FIN 48”), to clarify the accounting foruncertainty in income taxes recognized in an entity’s financial statements inaccordance with SFAS No. 109, “Accounting for Income Taxes.”  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  Thecumulative effect of applying the provisions of FIN 48 will be reported in ourfirst quarter of 2007 financial statements as an adjustment to the openingbalance of retained earnings for 2007. We estimate that the cumulative effect adjustment will increase retainedearnings by up to $0.6 million which is subject to revision whenmanagement completes an analysis of the impact of FIN 48.

***Statement of Financial AccountingStandards No. 157***

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements.” This statement establishes a framework for measuring fairvalue within generally accepted accounting principles and expands disclosuresabout fair value measurements. SFAS No. 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007, andinterim periods within those fiscal years. The provisions of SFAS No. 157 shouldbe applied prospectively as of the beginning of the fiscal year in which SFASNo. 157 is initially applied, except in limited circumstances. We expect toadopt SFAS No. 157 beginning January 1, 2008. We are currently evaluating theimpact that the adoption of this interpretation may have on our consolidatedfinancial statements.

***Statement ofFinancial Accounting Standards No. 159***

In February 2007, the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities – Including anamendment of FASB Statement No. 115.” This statement permits entities to chooseto measure many financial

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instrumentsand certain other items at fair value that are not currently required to bemeasured at fair value and establishes presentation and disclosure requirementsdesigned to facilitate comparisons between entities that choose differentmeasurement attributes for similar types of assets and liabilities. SFAS No.159 is effective as of the beginning of an entity’s first fiscal year that beginsafter November 15, 2007. Early adoption is permitted as of the beginning of afiscal year that begins on or before November 15, 2007, provided the entityalso elects to apply the provisions of SFAS No. 157. We expect to adopt SFASNo. 159 beginning January 1, 2008. We are currently evaluating the impact that theadoption of this interpretation may have on our consolidated financialstatements.

**8.****             ****PROPERTY AND EQUIPMENT**

Property and equipment were as follows (inthousands):
|                                            | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                                       |       |                  |       |   |   |
| Land                                       |       | $                     | 31,765     |   | $ | 31,765 |   |
| Prepaid facility use                       |       | 71,323                |       | 71,323 |   |
| Buildings and  improvements                |       | 253,218               |       | 179,533 |   |
| Furniture and equipment                    |       | 30,827                |       | 29,889 |   |
| Construction in  progress                  |       | 1,031                 |       | 69,729 |   |
| Sub-total                                  |       | 388,164               |       | 382,239 |   |
| Accumulated  depreciation and amortization |       | (69,100               | )          | (58,378 | ) |
| Total property and  equipment              |       | $                     | 319,064    |   | $ | 323,861 |   |

 

The decrease inconstruction in progress and the increase in building and improvements in theyear ended December 31, 2006 is primarily due to the completion of theMoshannon Valley Correctional Center which opened in April 2006.

Weevaluate the realization of our long-lived assets at least annually or whenchanges in circumstances or a specific triggering event indicates that thecarrying value of the asset may not be recoverable. As a part of ourevaluation, we make judgments regarding the potential future operating resultsand undiscounted cash flows associated with individual facilities.Additionally, should we decide to sell a facility, realization is evaluatedbased on the estimated sales price based on the best market informationavailable.

Inconjunction with our review of our long-lived assets based on forecastedoperating and cash flow losses associated with these assets, we determined thatour carrying value for two of our adult community-based facilities was notfully recoverable and exceeded their fair value and, as a result, we recordedan impairment charge of $0.4 million in the year ended December 31, 2006. Thischarge was based on the best market information available.

Weclosed the Cornell Abraxas Academy (formerly the New Morgan Academy) in 2002and reactivated the facility in October 2006 as a residential treatmentfacility for youth sex offenders. During 2004, based on forecasted operatingand cash flow losses associated with this facility we determined that ourcarrying value of the facility was not fully recoverable and exceeded its fairvalue and, as a result, we recorded an impairment charge of $9.3 million in theyear ended December 31, 2004. This charge was determined based on theresults of our probability-weighted cash flow analysis.

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

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**9.****             ****ACCOUNTS PAYABLE AND ACCRUEDLIABILITIES**

Accountspayable and accrued liabilities consisted of the following (in thousands):
|                                                 | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                                            |       |                  |       |   |   |
| Accounts payable                                |       | $                     | 15,286     |   | $ | 14,690 |   |
| Accrued compensation                            |       | 9,847                 |       | 7,463 |   |
| Accrued interest  payable                       |       | 11,717                |       | 11,870 |   |
| Accrued litigation  settlements                 |       | 878                   |       | 7,200 |   |
| Accrued taxes payable                           |       | 5,519                 |       | 3,876 |   |
| Accrued insurance                               |       | 7,960                 |       | 6,840 |   |
| Accrued legal                                   |       | 4,822                 |       | 2,563 |   |
| Resident funds                                  |       | 1,659                 |       | 2,634 |   |
| Other                                           |       | 2,475                 |       | 1,661 |   |
| Total accounts payable  and accrued liabilities |       | $                     | 60,163     |   | $ | 58,797 |   |

 

At December 31, 2006, accounts payable and accrued liabilities containaccrued litigation settlement charges of $0.9 million pertaining to the LincolnCounty Detention Center. At December 31, 2005, accounts payable and accruedliabilities contained accrued litigation settlement charges of $7.0 millionrelating to the shareholder lawsuits and $0.2 million pertaining to LincolnCounty Detention Center.  Refer to Note12 to the consolidated financial statements for a discussion regarding thesematters.

**10.****      ****INCOME TAXES**

Thefollowing is an analysis of our deferred tax assets and liabilities (inthousands):
|                                       | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax assets:                  |       |                  |       |   |   |
| Accrued  liabilities and allowances   |       | $                     | 7,704      |   | $ | 5,846 |   |
| Federal  operating loss carryforwords |       | —                |       | 1,381 |   |
| State operating  loss carryforwords   |       | 2,455                 |       | 2,129 |   |
| Deferred  compensation                |       | 513                   |       | — |   |
| Other                                 |       | 125                   |       | 341 |   |
| Total deferred  tax assets            |       | 10,797                |       | 9,697 |   |
|                                  |       |                  |       |   |   |
| Deferred tax  liabilities:            |       |                  |       |   |   |
| Property and  equipment               |       | 11,688                |       | 8,035 |   |
| Prepaid expenses                      |       | 1,075                 |       | 776 |   |
| Other                                 |       | 280                   |       | 376 |   |
| Total deferred  tax liabilities       |       | 13,043                |       | 9,187 |   |
|                                  |       |                  |       |   |   |
| Valuation  allowance                  |       | (2,455                | )          | (2,129 | ) |
|                                  |       |                  |       |   |   |
| Net deferred tax  liability           |       | $                     | 4,701      |   | $ | 1,619 |   |

 

As of December 31,2006, we have net operating losses for state income taxes of approximately $29.7million. Approximately $1.4 million of net operating losses for stateincome taxes will expire if unutilized in 2007. Our tax returns are subject toperiodic audit by the various jurisdictions in which we operate. These audits,including those currently underway, can result in adjustments of taxes due oradjustments of the NOLs which are available to offset future taxable income.

Valuation allowances of$2.5 million have been established for uncertainties in realizing the benefitof certain state income tax loss carryforwards. In assessing the realizabilityof carryforwards, we consider whether it is more likely than not that some portionor all of the deferred tax assets will be realized. The valuation allowancewill be adjusted in the periods that we determine it is more likely than notthat deferred tax assets will or will not be realized.

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The components of ourincome tax provision (benefit) were as follows (in thousands):
|                                                       | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                  |       |                                       |       |   |   |   |   |
| Federal current  provision                            |       | $                                          | 4,332      |   | $ | 239 |   | $ | (453 | ) |
| State current  provision                              |       | 1,617                                      |       | (197 | ) | (238 | ) |
| Total current provision (benefit)                     |       | 5,949                                      |       | 42 |   | (691 | ) |
|                                                  |       |                                       |       |   |   |   |   |
| Federal deferred  provision                           |       | 3,114                                      |       | 2,097 |   | (2,894 | ) |
| State deferred  provision                             |       | 85                                         |       | 76 |   | 329 |   |
| Total deferred provision (benefit)                    |       | 3,199                                      |       | 2,173 |   | (2,565 | ) |
|                                                  |       |                                       |       |   |   |   |   |
| Total provision  (benefit) from continuing operations |       | $                                          | 9,148      |   | $ | 2,215 |   | $ | (3,256 | ) |

 

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

The following is areconciliation of income taxes at the statutory federal income tax rate of 35%to the income tax provision (benefit) recorded by us (in thousands):
|                                             | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Computed taxes at  statutory rate           |       | $                                          | 7,602      |   | $ | 2,138 |   | $ | (2,708 | ) |
| State income taxes, net  of federal benefit |       | 1,042                                      |       | (273 | ) | (617 | ) |
| Other                                       |       | 504                                        |       | 350 |   | 69 |   |
|                                        |       | $                                          | 9,148      |   | $ | 2,215 |   | $ | (3,256 | ) |

 

**11.****      ****CREDIT FACILITIES**

Ourlong-term debt consisted of the following (in thousands):
|                                                                                                                                                                | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Debt of  Cornell Companies, Inc.:**                                                                                                                          | ** ** | ** **            | ** ** | ** ** | ** ** |
| Senior Notes, unsecured, due July 2012 with an  interest rate of 10.75%, net of discount                                                                  |       | $                     | 110,987    |   | $ | 110,803 |   |
| Fair-value adjustment of Senior Notes as result of  interest rate swap                                                                                         |       | (1,053                | )          | (145 | ) |
| Revolving Line of Credit due June 2008 with an  interest rate of LIBOR plus 2.25% to 3.5% or prime plus 0.75% to 2.00% (the  “Credit Facility”) |       | —                |       | 3⁄4 |   |
| Capital lease obligations                                                                                                                                      |       | 47                    |       | 2 |   |
| Subtotal                                                                                                                                                       |       | 109,981               |       | 110,660 |   |
|                                                                                                                                                           |       |                  |       |   |   |
| **Debt of  Special Purpose Entities:**                                                                                                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| 8.47% Bonds due 2016                                                                                                                                           |       | 156,000               |       | 165,700 |   |
|                                                                                                                                                           |       |                  |       |   |   |
| Total  consolidated debt                                                                                                                                       |       | 265,981               |       | 276,360 |   |
|                                                                                                                                                           |       |                  |       |   |   |
| Less: current  maturities                                                                                                                                      |       | (10,510               | )          | (9,701 | ) |
|                                                                                                                                                           |       |                  |       |   |   |
| Consolidated long-term  debt                                                                                                                                   |       | $                     | 255,471    |   | $ | 266,659 |   |

 

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***Long-Term Credit Facilities. ***Our Credit Facility provides for borrowings of up to $60.0 millionunder a revolving line of credit and is reduced by outstanding letters ofcredit. The available commitment under our Credit Facility was approximately$50.4 million at December 31, 2006. We had no outstanding borrowings onour Credit Facility at December 31, 2006, but we had outstanding lettersof credit of approximately $9.6 million. Subject to certain requirements, we havethe right to increase the aggregate commitments under our Credit Facility up toan aggregate amount of $100.0 million. Our Credit Facility matures inJune 2008 and bears interest, at our election, depending on our totalleverage ratio, at either the prime rate plus a margin ranging from 0.75% to2.00%, or a rate which ranges from 2.25% to 3.50% above the applicable LIBORrate. Our Credit Facility is collateralized by substantially all of ourassets, including the assets and stock of all of our subsidiaries. Our CreditFacility is not secured by the assets of Municipal Corrections Finance, LP (“MCF”).Our Credit Facility contains standard covenants including compliance with laws,limitations on capital expenditures, restrictions on dividend payments,limitations on mergers and compliance with financial covenants.

MCF is obligated for the outstandingbalance of its 8.47% Taxable Revenue Bonds, Series 2001. The bonds bearinterest at a rate of 8.47% per annum and are payable in semi-annualinstallments of interest and annual installments of principal. All unpaidprincipal and accrued interest on the bonds is due on the earlier ofAugust 1, 2016 (maturity) or as noted under the bond documents. The bondsare limited, nonrecourse obligations of MCF and secured by the property andequipment, bond reserves, assignment of subleases and substantially all assetsrelated to the facilities included in the 2001 Sale and Leaseback Transaction.The bonds are not guaranteed by the Company.

In June 2004, we issued $112.0million in principal of 10.75% Senior Notes (the “Senior Notes”) dueJuly 1, 2012. The Senior Notes are unsecured senior indebtedness and areguaranteed by all of our existing and future subsidiaries (collectively, theGuarantors). The Senior Notes are not guaranteed by MCF (the “Non-Guarantor”).Interest on the Senior Notes is payable semi-annually on January 1 andJuly 1 of each year, commencing January 1, 2005. On or afterJuly 1, 2008, we may redeem all or a portion of the Senior Notes at theredemption prices (expressed as a percentage of the principal amount) listedbelow, plus accrued and unpaid interest, if any, on the Senior Notes redeemed,to the applicable date of redemption, if redeemed during the 12-month periodcommencing on July 1 of the years indicated below:
| Year                | ** ** | **Percentages** | ** ** |
|---------------------|------------|-----------------|------------|
|                |       |            |       |
| 2008                |       | 105.375         | %          |
| 2009                |       | 102.688         | %          |
| 2010 and thereafter |       | 100.000         | %          |

 

Any time prior toJuly 1, 2007, we may redeem up to 35% of the original aggregate principalamount of the Senior Notes at a redemption price of 110.75% of the principalamount thereof with the net cash of public offerings of equity, provided thatat least 65% of the original aggregate principal amount of the Senior Notesremains outstanding after the redemption and other conditions are met. Upon theoccurrence of specified change of control events, unless we have exercised ouroption to redeem all the Senior Notes as described above, each holder will havethe right to require us to repurchase all or a portion of such holder’s SeniorNotes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase. The SeniorNotes were issued under an indenture (the “Indenture”) which limits our abilityand the ability of our Guarantors to, among other things, incur additionalindebtedness, pay dividends or make other distributions, make other restrictedpayments and investments, create liens, incur restrictions on the ability ofthe Guarantors to pay dividends or other payments to us, enter intotransactions with affiliates, and engage in mergers, consolidations and certainsales of assets.

In conjunction with theissuance of the Senior Notes, we entered into an interest rate swap transactionwith a financial institution to hedge our exposure to changes in the fair valueon $84.0 million of our Senior Notes. The purpose of this transaction was toconvert future interest due on $84.0 million of the Senior Notes to a variablerate. The terms of the interest rate swap contract and the underlying debtinstrument are identical. We have designated the swap agreement as a fair valuehedge. The swap has a notional amount of $84.0 million and matures inJuly 2012 to mirror the maturity of the Senior Notes. Under the agreement,we pay on a semi-annual basis (each January 1 and July 1) a floatingrate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive afixed-rate interest of 10.75%. For the year ended December 31, 2006, werecorded interest expense related to this interest rate swap of approximately$0.3 million. For the years ended December 31, 2005 and 2004, we recordedinterest savings related to this interest rate swap of approximately $1.1 millionand $1.2 million, respectively, which is reflected as a reduction to interestexpense in our accompanying financial statements. The swap agreements aremarked to market each quarter with a corresponding mark-to-market adjustmentreflected as either a discount or premium on the Senior Notes. AtDecember 31, 2006 and 2005, the fair value of this derivative instrumentwas a liability of approximately ($1.1) and ($0.1) million, respectively, andis included in other long-term liabilities at December 31, 2006 and 2005 in ourConsolidated

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Balance Sheets. The carrying value of the Senior Notesas of these dates was adjusted accordingly by the same amount. Because the swapagreement is considered an effective fair-value hedge, there will be no effecton our results of operations from the mark-to-market adjustment as long as theswap is in effect.

Scheduled maturities ofour consolidated long-term debt were as follows (in thousands):
|                                        | ** ** | **Cornell  Companies,  Inc.** | ** ** | **MCF**    | ** ** | **Consolidated** | ** ** |
|----------------------------------------|------------|-------------------------------|------------|------------|------------|------------------|------------|
| ** **                             | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **       | ** ** |
| For the year ending  December 31, |       |                          |       |       |       |             |       |
| 2007                                   |       | $                             | 10         |       | $          | 10,500           |       | $ | 10,510 |   |
| 2008                                   |       | 11                            |       | 11,400     |       | 11,411           |       |
| 2009                                   |       | 12                            |       | 12,400     |       | 12,412           |       |
| 2010                                   |       | 13                            |       | 13,400     |       | 13,413           |       |
| Thereafter                             |       | 112,001                       |       | 108,300    |       | 220,301          |       |
| Total                                  |       | $                             | 112,047    |       | $          | 156,000          |       | $ | 268,047 |   |

 

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**12.  COMMITMENTS AND CONTINGENCIES**

***Financial Guarantees***

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

***Operating Leases***

Welease office space, certain facilities and furniture and equipment underlong-term operating leases. Rent expense for all operating leases for the yearsended December 31, 2006, 2005 and 2004 was approximately $11.5 million,$8.3 million and $7.4 million, respectively.

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

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

Asof December 31, 2006, we had the following rental commitments undernoncancelable operating leases (in thousands):
| For the year ending December 31, | ** ** | ** ** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|
| 2007                                                      |       | $          | 6,221      |   |
| 2008                                                      |       | 5,017      |       |
| 2009                                                      |       | 4,598      |       |
| 2010                                                      |       | 3,305      |       |
| Thereafter                                                |       | 10,535     |       |
| Total                                                     |       | $          | 29,676     |   |

 

The following scheduleshows the composition of total rental expense for all operating leases (inthousands):
|                        | ** ** | **Year Ended December 31,** | ** ** |
|------------------------|------------|--------------------------------------------|------------|
| ** **             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Minimum rentals        |       | $                                          | 11,107     |   | $ | 8,051 |   | $ | 7,208 |   |
| Contingent rentals     |       | 426                                        |       | 271 |   | 201 |   |
| Less: sublease rentals |       | (232                                       | )          | (293 | ) | (330 | ) |
| Total                  |       | $                                          | 11,301     |   | $ | 8,029 |   | $ | 7,079 |   |

 

***401(k) Plan***

Wehave a defined contribution 401(k) plan. Our matching contribution currentlyrepresents 50% of a participant’s contribution, up to the first 6% of theparticipant’s salary. We recorded contribution expense of approximately $1.2million for each of the years ended December 31, 2006, 2005 and 2004.

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***Legal Proceedings***

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

In August 2005, a lawsuitwas filed by a detainee at the Lincoln County Detention Center (LCDC) in theU.S. District Court of New Mexico (Santa Fe) seeking unspecified damages. Thelawsuit related to the former LCDC policy that required strip and visual bodycavity searches for all detainees and inmates and alleged that such policyviolates a detainee’s Fourth and Fourteenth Amendment rights under the U.S.Constitution. The lawsuit was filed as a putative class action lawsuit broughton behalf of all inmates who were searched at the LCDC from May 2002 to July2005.  In September 2006, we agreed to aproposed stipulation of settlement which, subject to the approval of the court,will resolve this action.  The settlementamount under the terms of the agreement is $1.6 million, and will be fundedprincipally through our general liability and professional liability coverage.

In the year endedDecember 31, 2005, we recorded a charge of $0.2 million related to thislawsuit. In addition, we previously have provided insurance reserves for thismatter (as part of our regular review of reported and unreported claims)totaling approximately $0.5 million. During the third quarter of 2006, werecorded an additional settlement charge of approximately $0.9 million and therelated reimbursement of $0.9 million from our general liability andprofessional liability insurance. The charge and reimbursement was recognizedin general and administrative expenses in our Consolidated Statements ofOperations and Comprehensive Income (loss) for the year ended December 31,2006. The liability is carried in accounts payable and accrued liabilities andthe reimbursement is included in other receivables at December 31, 2006. Thefunding of the settlement amount will occur upon the entry by the court of theorder granting preliminary approval of the stipulation of settlement, which iscurrently anticipated to occur during the first quarter of 2007.

In addition, inconnection with our acquisition of the LCDC facility, certain amounts wereplaced in escrow to offset any undisclosed liability relating to suchacquisition. We have given notice to the prior owner of LCDC that we will seekto recover from the escrow any losses we may incur as a result of thislitigation.

##### ***Alexander Youth Service Cente****r*

In April 2006, we weresued in an action styled as *Juana MichelleBrown, Administratrix of the Estate of Lakeisha Shantrail Brown, Deceased, v.Cornell Interventions, Inc. et al.,* No. 4-06 CV00000434, in theUnited States District Court for the Eastern District of Arkansas.  The lawsuit alleged that we violated therights of Lakeisha Shantrail Brown, the deceased daughter of Juana MichelleBrown, under the U.S. Constitution and the laws of the State of Arkansas bydenying Ms. Brown medical treatment that caused her death and soughtunspecified actual and punitive damages. In September 2006, the plaintiff filed, and the court granted, an orderfor voluntary dismissal without prejudice. The lawsuit was refiled in December 2006 as *Juana Michelle Brown, Administratrix of the Estate of LakeishaShantrail Brown, Deceased v.Cornell Interventions, Inc. et al.,* No.4-06 CV1708, in the United States District Court for the Eastern District ofArkansas.  We are unable to estimate ourfinancial exposure relating to this lawsuit. We believe our insurance coverageis adequate to cover any potential damages relating to this action. We intendto vigorously defend this matter; however, the ultimate outcome of such alawsuit cannot be determined at this time.

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

In January 2004, weinitiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v. Longboat GlobalAdvisors, LLC, et al*., No. 2004 CV79761 in the Superior Court ofFulton County, Georgia under theories of fraud, conversion, breach of contractand other theories to determine the location of and to recover funds that wepreviously deposited into what we believed to be an escrow account inconnection with the development and construction of the Southern Peaks RegionalTreatment Center. Of the funds previously deposited, approximately $5.3 millionremains to be recovered at December 31, 2006. In December 2004, the juryawarded us approximately $6.5 million in compensatory damages and approximately$1.4 million in punitive damages, plus attorneys’ fees. The actual damagesportion of the award under the final Judgment and Decree (“Judgment”) enteredon December 20, 2006 was adjusted downward to the $5.4 million actually lost byus. The award for compensatory damages accrues pre-judgment interest at a rateof 7 percent from the date of loss through the date of judgment. Following thejury verdicts, we collected approximately $0.4 million in January 2005 infunds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation. Currently, one of thedefendants has filed an appeal of the Judgment. Due to the continueduncertainty surrounding the ultimate recovery of the funds previouslydeposited, we recorded an additional reserve in the amount of approximately$0.3 million during the quarter ended December 31, 2006. We will continue tomaintain our existing reserve of approximately $5.3 million in an allowance fordoubtful accounts against the corresponding balance as carried in otherreceivables at December 31, 2006.

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

In March andApril 2002, Cornell, Steven W. Logan (our former President and ChiefExecutive Officer), and John L. Hendrix (our former Chief Financial Officer),were named as defendants in four federal putative class action lawsuits styledas follows: (1) *Graydon Williams, OnBehalf of Himself and All Others Similarly Situated v. Cornell Companies, Inc,et al.*, No. H-02-0866, in the United States District Court forthe Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*,No. H-02-1075, in the United States District Court for the SouthernDistrict of Texas, Houston Division; (3) *LouisA. Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the UnitedStates District Court for the Southern District of Texas, Houston Division, and(4) *Anthony J. Scolaro, On Behalf ofHimself and All Others Similarly Situated v. Cornell Companies, Inc., etal.,* No. H-02-1567, in the United States District Court for theSouthern District of Texas, Houston Division. The aforementioned lawsuits wereputative class action lawsuits brought on behalf of all purchasers of ourcommon stock between March 6, 2001 and March 5, 2002 and relate toour restatement in 2002 of certain financial statements. The lawsuits involveddisclosures made concerning two prior transactions executed by us: theAugust 2001 sale leaseback transaction and the 2000 synthetic lease transaction.These four lawsuits were consolidated into the *GraydonWilliams* action and Flyline Partners, LP was appointed leadplaintiff. As a result, a consolidated complaint was filed by Flyline Partners,LP. Richard Picard and Anthony Scolaro were also named as plaintiffs. Sincethen, the court allowed plaintiffs to file an amended consolidated complaint.The amended consolidated complaint alleges that the defendants violatedSection 10(b) of the Securities Exchange Act of 1934 (the “ExchangeAct”), Rule 10b-5 promulgated under Section 10(b) of theExchange Act, Section 20(a) of the Exchange Act, Section 11 ofthe Securities Act of 1933 (the “Securities Act”) and/or Section 15 of theSecurities Act. The amended consolidated complaint seeks, among other things,restitution damages, compensatory damages, rescission or a rescissory measureof damages, costs, expenses, attorneys’ fees and expert fees. In February 2006,the court approved the settlement of this matter. Under the settlementagreement, Cornell has not admitted any wrongdoing. Settlement in the amount of$7.0 million was funded through our directors’ and officers’ liabilityinsurance. During the fourth quarter of 2005, we recorded the settlement chargeof $7.0 million and the related reimbursement of $7.0 million from our director’sand officer’s liability insurance. The charge and reimbursement were recognizedin general and administrative expenses in our Consolidated Statements ofOperations and Comprehensive Income (Loss) for the year ended December 31,2005. The liability was carried in accounts payable and accrued liabilities andthe reimbursement was included in other receivables at December 31, 2005. Thereimbursement was funded by the insurance carrier in 2005 into a trust accountand funds were disbursed from the trust account to plaintiffs’ counsel’s escrowaccount upon court approval of the settlement in February 2006.

In March 2002,Cornell, its directors, and its former independent auditor Arthur Andersen LLP,were sued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant CornellCompanies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of Harris County,Texas. The lawsuit related to our restatement in 2002 of certain financialstatements. The lawsuit alleged breaches of fiduciary duty by all of theindividual defendants and asserted breach of contract and professionalnegligence claims only against Arthur Andersen LLP. This lawsuit has beendismissed without prejudice by agreement. In January 2004, we received aletter from William Williams, the plaintiff in the *William Williams* action discussed above, demanding that wepursue breach of fiduciary duty claims against various officers and directorsbased on the August 2001 sale leaseback transaction and the subsequentrestatement. We have issued a preliminary response to the letter indicatingthat the Board will consider the request and inform Mr. Williams of itsdecision. In May and September 2002, the Company and our thendirectors were sued in three other derivative lawsuits styled as follows:(1) *Juan Guitierrez, Derivatively onBehalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,*No. 2002-28924, in the 164th Judicial District Court of Harris County,Texas. These lawsuits relate to our restatement in 2002 of certain financialstatements. These lawsuits all allege breaches of fiduciary duty and waste ofcorporate assets by all of the defendants. A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano* action as duplicative of the *Guitierrez* action. The court granted themotion to dismiss the *Guitierrez*action and the plaintiffs have appealed that ruling. The *Menning* action has been dismissed, butwith an agreement that the plaintiff’s claims as to Cornell are tolled until 30days following the final resolution of the *Guitierrez*case, including any appeals. The plaintiffs in these cases have not quantifiedtheir claim of damages. In December 2006, we agreed to a proposed stipulationof settlement which, subject to the approval of the court, will resolve this action.  The settlement terms included reimbursementof up to $0.15 million of plaintiff’s legal expenses (to be funded through ourdirector’s and officer’s liability insurance) as well as the implementation ofcertain corporate governance enhancements (which the Company had implementedprior to the agreement). The settlement was approved by the court in February2007.  We have not recorded any lossaccruals related to these claims.

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On October 19, 2006, a purported class action complaint was filed in theDistrict Court of Harris County, Texas, 269th Judicial District (No.2006-67413) by Ted Kinbergy, an alleged stockholder of Cornell. The complaintnames as defendants Cornell and each member of our board of directors as wellas Veritas Capital Fund III, L.P. (“Veritas”). The complaint is a purportedclass action that alleges, among other things, that (i) the defendants havebreached fiduciary duties they assertedly owed to our stockholders inconnection with our entering into the Agreement and Plan of Merger, dated as ofOctober 6, 2006, with Veritas, Cornell Holding Corp., and CCI AcquisitionCorp., and (ii) the merger consideration is unfair and inadequate. Theplaintiffs sought, among other things, an injunction against the consummationof the merger. The proposed merger was rejected at a special meeting of ourstockholders held on January 23, 2007. We believe that the lawsuit is withoutmerit and intend to defend ourselves vigorously.

We hold insurance policies to cover potential directorand officer liability, some of which may limit our cash outflows in the eventof a decision adverse to us in the matters discussed above. However, if anadverse decision in these matters exceeds the insurance coverage or if theinsurance coverage is deemed not to apply to these matters, it could have amaterial adverse effect on us, our financial condition, results of operationsand future cash flows.

**Other**

Additionally, wecurrently and from time to time are subject to claims and suits arising in theordinary course of business, including claims for damages for personal injuriesor for wrongful restriction of or interference with offender privileges andemployment matters. If an adverse decision in these matters exceeds ourinsurance coverage, or if our coverage is deemed not to apply to these matters,or if the underlying insurance carrier was unable to fulfill its obligationunder the insurance coverage provided, it could have a material adverse effecton our financial condition, results of operations or cash flows.

During the period fromAugust 2000 through May 2003, our general liability and professionalliability coverage was provided by Specialty Surplus Insurance Company, aKemper Insurance Company (Kemper) group member. In June 2004, the IllinoisDepartment of Insurance gave Kemper permission to proceed with a run-off planit had previously submitted. The three-year plan is designed to help Kempermeet its goal of resolving, to the maximum extent possible, all validpolicyholder claims. In view of the risks and uncertainties involved inimplementing the plan, including the need to achieve significant policybuybacks, commutation of reinsurance agreements, and further agreements withregulators, the plan may not be successfully implemented by Kemper. In the yearended December 31, 2004, we accrued a provision of $0.6 million, andestimated our range of additional exposure to be approximately $0.5 millionwith respect to outstanding claims incurred during this policy period withKemper which would become our obligation to resolve if not settled throughKemper. During the year ended December 31, 2005, Kemper continued toimplement its run-off plan. As a result, several of our significant claims weresettled by Kemper during 2005. In conjunction with these settlements, we recordeda charge against our existing accrual in the amount of $0.3 million. Based onour analysis of the claims activity during the third quarter of 2005, we feltit necessary to accrue an additional provision in the amount of approximately$0.2 million during the third quarter of 2005. Additional significant claimscontinued to be settled by Kemper during the second half of 2006. As a result,we have released reserves of approximately $0.4 million during the quarterended December 31, 2006. At December 31, 2006, we do not believe there issignificant exposure above our existing $0.1 million accrual for thoseoutstanding claims which could become our obligation to resolve if not settledthrough Kemper.

While the outcome of suchmatters cannot be predicated with certainty, based on the information known todate, we believe that the ultimate resolution of these matters will not have amaterial adverse effect on our financial condition, operating results or cashflows.

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**13.  STOCKHOLDERS’ EQUITY**

***Stockholder Rights Plan***

Our Board of Directorsterminated Cornell’s stockholder rights plan in July 2005.

***Preferred Stock***

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

***Options and Warrants***

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

Inconjunction with the issuance of our Subordinated Notes in July 2000, weissued warrants to purchase 290,370 shares of the common stock at an exerciseprice of $6.70. We recognized the fair value of these warrants of $1.1 millionas additional paid-in capital. The warrants may only be exercised by payment ofthe exercise price in cash to us, by cancellation of an amount of warrantsequal to the fair market value of the exercise price, or by the cancellation ofour indebtedness owed to the warrant holder. During 2001, 168,292 shares of ourcommon stock were issued in conjunction with the exercise and cancellation of217,778 warrants. At December 31, 2006 and 2005, 72,592 warrants remainedoutstanding.

For a summary of thestatus of our various option plans at December 31, 2006, see Note 2 to theconsolidated financial statements.

***Treasury Stock***

Wedid not repurchase any of our common stock in the year ended December 31, 2006and 2005. During the year ended December 31, 2004, we repurchased in theopen market 10,000 shares of our common stock under a share repurchase programat an aggregate cost of $0.1 million. Under the terms of our Senior Notes andour Credit Facility, we can purchase shares of our stock subject to certaincumulative restrictions.

***Employee Stock Purchase Plan***

Wehave an employee stock purchase plan under which employees can makecontributions to purchase our common stock. Participation in the plan iselected annually by employees. The plan year begins each January 1st (the “Grant Date”) and ends onDecember 31st (the “ExerciseDate”). Purchases of common stock are made at the end of the year using thelower of the fair market value on either the Grant Date or Exercise Date, lessa 15.0% discount. For the years ended December 31, 2006, 2005 and 2004,employee contributions of approximately $0.3 million, $0.4 million and $0.3million were used to purchase 22,593, 30,553 and 40,213 shares, respectively,of our common stock.

***2006 Equity Incentive Plan***

Our stockholders approvedthe establishment of the 2006 Equity Incentive Plan (2006 Plan) at our 2006annual meeting. The purpose of the 2006 Plan is to promote the interests of theCompany and its stockholders by (i) attracting and retaining employees,directors, and consultants of the Company and its affiliates, (ii) motivatingsuch individuals by means of performance-related incentives to achieve longer-rangeperformance goals, and (iii) enabling such individuals to participate in thelong-term growth and financial success of the Company. At the discretion of theCompensation Committee, any employee, director, or consultant of the Company orits affiliates may be granted an award under the 2006 Plan. The CompensationCommittee administers the 2006 Plan.

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A total of 1,400,000shares of common stock are authorized for issuance under the 2006 Plan, all ofwhich may be issued pursuant to incentive stock options. These shares of commonstock will be in a “fungible pool” with shares subject to restricted stock,stock compensation and other stock-based awards counted against this limit astwo (2) shares for every one (1) share granted and any shares subject to anyother type of award to be counted against this limit as one (1) share for everyone (1) share granted. Stock options (both non-qualified stock options andincentive stock options), stock appreciation rights, restricted stock,restricted stock units, performance awards, stock compensation and otherstock-based awards may be granted under the 2006 Plan.

In the event of a Changeof Control, as defined in the 2006 Plan, any outstanding stock option, stockappreciation right, non-performance based restricted stock or restricted stockunit award, and performance based restricted stock, restricted stock units,performance share or performance unit award (unless otherwise provided in theperformance award agreement) will automatically vest. Upon a Change of Control,the Board of Directors may also take any one or more of the following actions:(i) provide for the purchase of any outstanding awards by the Company; (ii)make adjustments to any outstanding awards; or (iii) allow for the assumptionor substitution of outstanding awards by the acquiring or survivingcorporation. No awards have been made to any individual under the 2006 Plan asof December 31, 2006.

***Deferred Bonus Plan***

Wehave a deferred bonus plan for certain employees. Pursuant to the plan at its inception,approximately $4.7 million was deposited on behalf of individual participantsinto a rabbi trust account, which included approximately $3.6 million in cashand $1.1 million in our treasury stock. The treasury stock portion of the rabbitrust remained as treasury stock, while the participants were able to giveinvestment directions to the trustee as to the cash portion, subject to certainlimitations. The investments of the rabbi trust represented our assets and wereincluded in our accompanying Consolidated Balance Sheets based on the nature ofthe assets held. Assets placed into the rabbi trust are irrevocable; therefore,they are restricted as to our use under the terms of the trust and the deferredbonus plan. Remaining assets held in the rabbi trust were distributed in fullupon final vesting of the trust in 2006.

Theplan generally vested 100.0% upon the achievement of an aggregate amount ofmonthly credits (based on a fixed monthly earnings milestone) which occurred atthe end of five years beginning October 1, 2001. Based on the expectedearnings period, compensation expense and the related compensation liabilityfor the aggregate plan value were recognized over five years. To the extent thevesting was extended or accelerated based on the achievement of the financialmilestones, recognition of compensation expense would be adjusted on aprospective basis. In the event of a change of control (as defined in theplan), the amounts in each participants account would be paid to theparticipant in a lump sum. For the years ended December 31, 2005 and 2004,we expensed approximately $0.4 million and $0.07 million, respectively, underthe deferred bonus plan. There was no expense related to the plan in the yearended December 31, 2006.

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

Amountsheld in treasury stock were recorded at cost. An equal amount was establishedas deferred compensation and additional paid-in capital in our ConsolidatedStatements of Stockholders’ Equity. The balance in the deferred bonus plan wasamortized to compensation expense over the expected vesting period of fiveyears.

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**14.  DERIVATIVE FINANCIAL INSTRUMENTS AND GUARANTEES**

***Debt Service Reserve Fund and Debt ServiceFund***

InAugust 2001, MCF completed a bond offering to finance the 2001 Sale andLeaseback Transaction (in which we sold eleven facilities (as identified inItem 1 of this report) to MCF). In connection with this bond offering, tworeserve fund accounts were established by MCF pursuant to the terms of theindenture: (1) MCF’s Debt Service Reserve Fund, aggregating $23.8 million atDecember 31, 2006, was established to make payments on MCF’s outstandingbonds in the event we (as lessee) should fail to make the scheduled rentalpayments to MCF and (2) MCF’s Debt Service Fund, aggregating $23.0 million atDecember 31, 2006, was established to accumulate the monthly leasepayments that MCF receives from us until such funds are used to pay MCF’ssemi-annual bond interest and annual bond principal payments. Both reserve fundaccounts are subject to the agreements with the MCF Equity Investors wherebyguaranteed rates of return of 3.0% and 5.08%, respectively, are provided for inthe balance of the Debt Service Reserve Fund and the Debt Service Fund. Theguaranteed rates of return are characterized as cash flow hedge derivativeinstruments. At inception, the derivatives had an aggregate fair value of $4.0million, which has been recorded as a decrease to the equity investment in MCFmade by the MCF Equity Investors (MCF minority interest) and as a liability inour Consolidated Balance Sheets. Changes in the fair value of the derivativeinstruments are recorded as an adjustment to other long-term liabilities andreported as other comprehensive income (loss) in our Consolidated Statements ofOperations and Comprehensive Income (Loss). At December 31, 2006, the fairvalue of these derivative instruments was approximately $3.2 million. As aresult, our Consolidated Statements of Operations and Comprehensive Income(Loss) include accumulated other comprehensive income (loss) of approximately($0.1), ($1.1) million and $0.2 million for the years ended December 31,2006, 2005 and 2004, respectively. The ($1.1) million net unrealized lossreported in comprehensive income (loss) for the year ended December 31, 2005includes an adjustment of $0.6 million for the cumulative tax effect of changesin fair value during the years ended December 31, 2002 and 2003. Thisadjustment decreased accumulated other comprehensive income and increaseddeferred tax liabilities in our Consolidated Balance Sheet as of December 31,2005.

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

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**15.  RELATED PERSON TRANSACTIONS**

One of our former directorsis a partner in a law firm that provides legal services to us.  Legal fees paid to this law firm wereapproximately $0.1 million, $0.9 million and $2.0 million for the years endedDecember 31, 2006, 2005 and 2004, respectively.

In September 1999, we entered into a consulting agreement withCornell’s founder, who was a director of Cornell throughOctober 2003.  Services renderedunder the consulting agreement included serving as a director of Cornell overthe initial four years of the term of the agreement, and assisting in suchareas as the development of new business, acquisitions, financings andexecutive management assimilation.  Ascompensation for consulting services, we agreed to an annual payment of atleast $255,000 for each of the first four years of the seven-year initial termof the consulting agreement with an annual payment of at least $180,000 foreach of the last three years of the initial term. As additional compensation,we agreed to an annual bonus, subject to certain limitations, equal to $75,000during the first four years of the initial term and an annual bonus of $60,000during the last three years of the initial term. The initial term concluded in2006 and the final bonus payment of $60,000 was paid.  The agreement was not renewed.

We also entered into a non-compete agreement with Cornell’sfounder.  The non-compete agreement has aterm of 10 years and required us to pay a monthly fee of $10,000 for theseven-year initial term of the consulting agreement.  We capitalize the monthly payments andamortize the amounts over the 10-year term of the non-compete agreement. Werecognized amortization expense related to this agreement of approximately$84,000 for each of the years ended December 31, 2006, 2005 and 2004.

We maintain a life insurance policy for Cornell’s founder and madepayments related to this policy of approximately $0.2 million for each of theyears ended December 31, 2006, 2005 and 2004.

Total payments made for the consulting and insurance premiums, asdescribed above, for Cornell’s founder were approximately $0.5 million, $0.9million and $0.7 million for the years ended December 31, 2006, 2005 and2004, respectively.

We entered into a consulting agreement with a former director whichexpires in December 2008.  Servicesrendered under this agreement include research and analysis for various topicsincluding data collection, support and training for program development;performance-based contractual requirements and performance-improvementprocesses, accreditations and regulatory requirements.  Total payments under this agreement, whichhas a termination fee incorporated for a termination prior to maturity, totaled$0.3 million for each of the years ended December 31, 2006 and 2005.  The termination fee at December 2006 was $0.2million.

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**16.  SEGMENT DISCLOSURE**

Ourthree operating divisions are our reportable segments. The adult secureinstitutional services segment consists of the operations of secure adultincarceration facilities. The juvenile segment consists of providingresidential treatment and educational programs and non-residentialcommunity-based programs to juveniles between the ages of ten and 17 who haveeither been adjudicated or suffer from behavioral problems. The adultcommunity-based corrections and treatment services segment consists ofproviding pre-release and halfway house programs for adult offenders who areeither on probation or serving the last three to six-months of their sentenceson parole and preparing for re-entry into society at large as well ascommunity-based treatment and education programs as an alternative toincarceration. All of our customers and long-lived assets are located in theUnited States of America. The accounting policies of our reportable segmentsare the same as those described in the summary of significant accountingpolicies in Note 2 to the Consolidated Financial Statements. Intangible assetsare not included in each segment’s reportable assets, and the amortization ofintangible assets is not included in the determination of a segment’s operatingincome. We evaluate performance based on income or loss from operations beforegeneral and administrative expenses, incentive bonuses, amortization ofintangibles, interest and income taxes. Corporate and other assets arecomprised primarily of cash, investment securities available for sale, accountsreceivable, debt service fund, deposits, property and equipment, deferredtaxes, deferred costs and other assets. Corporate and other expense fromoperations primarily consists of depreciation and amortization on the corporateoffice facilities and equipment, and is presented separately as such chargescannot be readily identified for allocation to a particular segment.

The only significantnon-cash items reported in the respective segments’ income from operations isdepreciation and amortization (excluding intangibles) and impairment oflong-lived assets (in thousands).

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| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                               |       |                                       |       |   |   |   |   |
| Revenue:                                           |       |                                       |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                          | 178,795    |   | $ | 128,440 |   | $ | 114,819 |   |
| Juvenile                                           |       | 115,765                                    |       | 119,006 |   | 113,821 |   |
| Adult  community-based                             |       | 66,295                                     |       | 63,329 |   | 48,550 |   |
| Total revenue                                      |       | $                                          | 360,855    |   | $ | 310,775 |   | $ | 277,190 |   |
|                                               |       |                                       |       |   |   |   |   |
| Pre-opening and  start-up expenses:                |       |                                       |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                          | 2,657      |   | $ | 7,213 |   | $ | 4,971 |   |
| Juvenile                                           |       | 3⁄4                                     |       | 1,804 |   | 3,790 |   |
| Adult  community-based                             |       | 3⁄4                                     |       | 3⁄4 |   | 42 |   |
| Total pre-opening and  start-up expenses           |       | $                                          | 2,657      |   | $ | 9,017 |   | $ | 8,803 |   |
|                                               |       |                                       |       |   |   |   |   |
| Impairment of  long-lived assets:                  |       |                                       |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                          | 3⁄4     |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | 3⁄4                                     |       | — |   | 9,300 |   |
| Adult  community-based                             |       | 355                                        |       | — |   | — |   |
| Total impairment of  long-lived assets             |       | $                                          | 355        |   | $ | — |   | $ | 9,300 |   |
|                                               |       |                                       |       |   |   |   |   |
| Depreciation and  amortization:                    |       |                                       |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                          | 8,008      |   | $ | 6,324 |   | $ | 4,967 |   |
| Juvenile                                           |       | 3,118                                      |       | 3,299 |   | 3,276 |   |
| Adult  community-based                             |       | 1,892                                      |       | 2,098 |   | 1,788 |   |
| Amortization of  intangibles                       |       | 2,243                                      |       | 2,094 |   | 1,365 |   |
| Corporate and  other                               |       | 1,024                                      |       | 1,385 |   | 1,791 |   |
| Total depreciation and  amortization               |       | $                                          | 16,285     |   | $ | 15,200 |   | $ | 13,187 |   |
|                                               |       |                                       |       |   |   |   |   |
| Income from operations:                            |       |                                       |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                          | 44,849     |   | $ | 26,186 |   | $ | 24,911 |   |
| Juvenile                                           |       | 12,574                                     |       | 13,672 |   | 3,811 |   |
| Adult  community-based                             |       | 12,362                                     |       | 11,874 |   | 9,177 |   |
| Subtotal                                           |       | 69,785                                     |       | 51,732 |   | 37,899 |   |
| General and  administrative expenses               |       | (21,720                                    | )          | (20,387 | ) | (20,284 | ) |
| Amortization of  intangibles                       |       | (2,243                                     | )          | (2,094 | ) | (1,364 | ) |
| Corporate and  other                               |       | (1,024                                     | )          | (1,385 | ) | (1,792 | ) |
| Total income from  operations                      |       | $                                          | 44,798     |   | $ | 27,866 |   | $ | 14,459 |   |
|                                               |       |                                       |       |   |   |   |   |
| Loss on discontinued  operations, net of tax       |       |                                       |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                          | 3⁄4     |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | (706                                       | )          | (3,560 | ) | (2,856 | ) |
| Adult  community-based                             |       | (1                                         | )          | (62 | ) | 423 |   |
| Total loss on  discontinued operations, net of tax |       | $                                          | (707       | ) | $ | (3,622 | ) | $ | (2,433 | ) |
|                                               |       |                                       |       |   |   |   |   |
| Capital expenditures:                              |       |                                       |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                          | 9,811      |   | $ | 48,558 |   | $ | 17,456 |   |
| Juvenile                                           |       | 1,182                                      |       | 473 |   | 14,790 |   |
| Adult community-based                              |       | 749                                        |       | 1,358 |   | 6,703 |   |
| Corporate and  other                               |       | 575                                        |       | 739 |   | 1,294 |   |
| Total assets                                       |       | $                                          | 12,317     |   | $ | 51,128 |   | $ | 40,243 |   |
|                                               |       |                                       |       |   |   |   |   |
| Assets:                                            |       |                                       |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                          | 233,670    |   | $ | 213,107 |   | $ | 172,793 |   |
| Juvenile                                           |       | 100,366                                    |       | 106,457 |   | 123,890 |   |
| Adult community-based                              |       | 63,105                                     |       | 67,298 |   | 62,984 |   |
| Intangible  assets, net                            |       | 19,265                                     |       | 21,666 |   | 14,747 |   |
| Corporate and  other                               |       | 107,127                                    |       | 102,100 |   | 133,217 |   |
| Total assets                                       |       | $                                          | 523,533    |   | $ | 510,628 |   | $ | 507,631 |   |

 

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**17.  GUARANTORDISCLOSURES**

Wecompleted an offering of $112.0 million of Senior Notes in June 2004. TheSenior Notes are guaranteed by each of our subsidiaries (GuarantorSubsidiaries). MCF does not guarantee the Senior Notes (Non-GuarantorSubsidiary). These guarantees are joint and several obligations of theGuarantor Subsidiaries. The following condensed consolidating financialinformation presents the financial condition, results of operations and cashflows for the parent company, the Guarantor Subsidiaries and the Non-GuarantorSubsidiary, together with the consolidating adjustments necessary to presentour results on a consolidated basis.

# **Condensed Consolidating BalanceSheet as of December 31, 2006 (in thousands)**

| ** **                                      | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                      | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                 |       |       |       |                        |       |                            |       |             |       |             |       |
| Cash and cash  equivalents                      |       | $          | 18,083     |                        | $          | 371                             |       | $                | 75         |             | $          | 3⁄4 |   | $ | 18,529 |   |
| Investment  securities                          |       | 11,925     |       | 3⁄4                      |       | 3⁄4                          |       | 3⁄4           |       | 11,925           |       |
| Accounts  receivable                            |       | 2,661      |       | 73,448                      |       | 365                             |       | 3⁄4           |       | 76,474           |       |
| Restricted  assets                              |       | 3⁄4     |       | 1,658                       |       | 22,953                          |       | 3⁄4           |       | 24,611           |       |
| Prepaids and  other                             |       | 11,909     |       | 2,303                       |       | 3⁄4                          |       | 3⁄4           |       | 14,212           |       |
| Total current  assets                           |       | 44,578     |       | 77,780                      |       | 23,393                          |       | 3⁄4           |       | 145,751          |       |
| Property and equipment, net                     |       | 108        |       | 173,916                     |       | 150,419                         |       | (5,379           | )          | 319,064          |       |
| Other assets:                                   |       |       |       |                        |       |                            |       |             |       |             |       |
| Debt service  reserve fund                      |       | 3⁄4     |       | 3⁄4                      |       | 23,801                          |       | 3⁄4           |       | 23,801           |       |
| Deferred costs  and other                       |       | 48,448     |       | 21,943                      |       | 6,754                           |       | (42,228          | )          | 34,917           |       |
| Investment in  subsidiaries                     |       | 27,427     |       | 2,237                       |       | 3⁄4                          |       | (29,664          | )          | 3⁄4           |       |
| Total assets                                    |       | $          | 120,561    |                        | 275,876    |                            | $          | 204,367          |       | (77,271          | )          | $ | 523,533 |   |
|                                            |       |       |       |                        |       |                            |       |             |       |             |       |
| **Liabilities and  Stockholders’ Equity**  | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Current liabilities:                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Accounts  payable and accrued liabilities       |       | $          | 46,791     |                        | $          | 9,371                           |       | $                | 5,577      |             | $          | (1,576 | ) | $ | 60,163 |   |
| Current portion  of long-term debt              |       | 3⁄4     |       | 10                          |       | 10,500                          |       | 3⁄4           |       | 10,510           |       |
| Total current  liabilities                      |       | 46,791     |       | 9,381                       |       | 16,077                          |       | (1,576           | )          | 70,673           |       |
| Long-term debt, net of current portion          |       | 109,934    |       | 37                          |       | 145,500                         |       | 3⁄4           |       | 255,471          |       |
| Deferred tax liabilities                        |       | 10,959     |       | 94                          |       | 3⁄4                          |       | 320              |       | 11,373           |       |
| Other long-term liabilities                     |       | 6,011      |       | 211                         |       | 42,680                          |       | (44,450          | )          | 4,452            |       |
| Intercompany                                    |       | (234,698   | )          | 234,698                     |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Total  liabilities                              |       | (61,003    | )          | 244,421                     |       | 204,257                         |       | (45,706          | )          | 341,969          |       |
| Stockholders’ equity                       |       | 181,564    |       | 31,455                      |       | 110                             |       | (31,565          | )          | 181,564          |       |
| Total liabilities and stockholders’ equity |       | $          | 120,561    |                        | $          | 275,876                         |       | $                | 204,367    |             | $          | (77,271 | ) | $ | 523,533 |   |

 

85

----

# **Condensed Consolidating BalanceSheet as of December 31, 2005 (in thousands)**

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

 

86

----

# **CondensedConsolidating Statement of Operations for the year ended December 31, 2006(in thousands)**

| ** **                                                 | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                       |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                   |       | $          | 18,008     |                        | $          | 408,832                         |       | $                | 18,008     |             | $          | (83,993 | ) | $ | 360,855 |   |
| Operating expenses                                         |       | 23,498     |       | 335,160                     |       | 33                              |       | (83,651          | )          | 275,040          |       |
| Pre-opening and start-up expenses                          |       | 3⁄4     |       | 2,657                       |       | 3⁄4                          |       | 3⁄4           |       | 2,657            |       |
| Impairment of long-lived assets                            |       | 3⁄4     |       | 355                         |       | 3⁄4                          |       | 3⁄4           |       | 355              |       |
| Depreciation and amortization                              |       | 3⁄4     |       | 12,499                      |       | 4,222                           |       | (436             | )          | 16,285           |       |
| General and administrative expenses                        |       | 21,617     |       | 3⁄4                      |       | 103                             |       | 3⁄4           |       | 21,720           |       |
| Income (loss) from operations                              |       | (27,107    | )          | 58,161                      |       | 13,650                          |       | 94               |       | 44,798           |       |
| Overhead allocations                                       |       | (40,432    | )          | 40,432                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                              |       | 6,653      |       | 5,085                       |       | 13,522                          |       | (2,190           | )          | 23,070           |       |
| Equity earnings in subsidiaries                            |       | 13,360     |       | 3⁄4                      |       | 3⁄4                          |       | (13,360          | )          | 3⁄4           |       |
| Income before provision for income taxes                   |       | 20,032     |       | 12,644                      |       | 128                             |       | (11,076          | )          | 21,728           |       |
| Provision for income taxes                                 |       | 8,159      |       | 3⁄4                      |       | 3⁄4                          |       | 989              |       | 9,148            |       |
| Income from continuing operations                          |       | 11,873     |       | 12,644                      |       | 128                             |       | (12,065          | )          | 12,580           |       |
| Discontinued operations, net of income tax benefit of $381 |       | 3⁄4     |       | (707                        | )          | 3⁄4                          |       | 3⁄4           |       | (707             | )          |
| Net income                                                 |       | $          | 11,873     |                        | $          | 11,937                          |       | $                | 128        |             | $          | (12,065 | ) | $ | 11,873 |   |

 

87

----

**CondensedConsolidating Statement of Operations for the year ended December 31, 2005(in thousands)**
| ** **                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                         |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                     |       | $          | 18,014     |                        | $          | 349,497                         |       | $                | 18,008     |             | $          | (74,744 | ) | $ | 310,775 |   |
| Operating expenses                                           |       | 16,794     |       | 295,860                     |       | 56                              |       | (74,405          | )          | 238,305          |       |
| Pre-opening and start-up expenses                            |       | 3⁄4     |       | 9,017                       |       | 3⁄4                          |       | 3⁄4           |       | 9,017            |       |
| Depreciation and amortization                                |       | 3⁄4     |       | 11,409                      |       | 4,222                           |       | (431             | )          | 15,200           |       |
| General and administrative expenses                          |       | 20,312     |       | 3⁄4                      |       | 75                              |       | 3⁄4           |       | 20,387           |       |
| Income (loss) from operations                                |       | (19,092    | )          | 33,211                      |       | 13,655                          |       | 92               |       | 27,866           |       |
| Overhead allocations                                         |       | (27,920    | )          | 27,920                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                |       | 2,771      |       | 5,089                       |       | 13,814                          |       | 49               |       | 21,723           |       |
| Equity earnings in subsidiaries                              |       | (3,491     | )          | 3⁄4                      |       | 3⁄4                          |       | 3,491            |       | 3⁄4           |       |
| Income (loss) before provision for income taxes              |       | 2,566      |       | 202                         |       | (159                            | )          | 3,534            |       | 6,143            |       |
| Provision for income taxes                                   |       | 2,260      |       | 3⁄4                      |       | 3⁄4                          |       | (45              | )          | 2,215            |       |
| Income (loss) from continuing operations                     |       | 306        |       | 202                         |       | (159                            | )          | 3,579            |       | 3,928            |       |
| Discontinued operations, net of income tax benefit of $1,950 |       | 3⁄4     |       | (3,622                      | )          | 3⁄4                          |       | 3⁄4           |       | (3,622           | )          |
| Net income (loss)                                            |       | $          | 306        |                        | $          | (3,420                          | )          | $                | (159       | )                | $          | 3,579 |   | $ | 306 |   |

 

88

----

# **CondensedConsolidating Statement of Operations for the year ended December 31, 2004****(inthousands)**

| ** **                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                         |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                     |       | $          | 18,272     |                        | $          | 312,924                         |       | $                | 18,008     |             | $          | (72,014 | ) | $ | 277,190 |   |
| Operating expenses                                           |       | 24,480     |       | 257,774                     |       | 52                              |       | (71,149          | )          | 211,157          |       |
| Pre-opening and start-up expenses                            |       | 3⁄4     |       | 8,803                       |       | 3⁄4                          |       | 3⁄4           |       | 8,803            |       |
| Impairment of long-lived assets                              |       | 3⁄4     |       | 9,300                       |       | 3⁄4                          |       | 3⁄4           |       | 9,300            |       |
| Depreciation and amortization                                |       | 84         |       | 9,189                       |       | 4,222                           |       | (308             | )          | 13,187           |       |
| General and administrative expenses                          |       | 20,209     |       | 3⁄4                      |       | 75                              |       | 3⁄4           |       | 20,284           |       |
| Income (loss) from operations                                |       | (26,501    | )          | 27,858                      |       | 13,659                          |       | (557             | )          | 14,459           |       |
| Overhead allocations                                         |       | (33,851    | )          | 33,851                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                |       | (304       | )          | 5,974                       |       | 14,641                          |       | 43               |       | 20,354           |       |
| Loss on extinguishment of debt                               |       | 3⁄4     |       | 2,361                       |       | 3⁄4                          |       | 3⁄4           |       | 2,361            |       |
| Equity earnings in subsidiaries                              |       | (18,328    | )          | 3⁄4                      |       | 3⁄4                          |       | 18,328           |       | 3⁄4           |       |
| Loss before provision (benefit) for income taxes        |       | (10,674    | )          | (14,328                     | )          | (982                            | )          | 17,728           |       | (8,256           | )          |
| Provision (benefit) for income taxes                         |       | (3,241     | )          | 423                         |       | 3⁄4                          |       | (438             | )          | (3,256           | )          |
| Loss from continuing operations                              |       | (7,433     | )          | (14,751                     | )          | (982                            | )          | 18,166           |       | (5,000           | )          |
| Discontinued operations, net of income tax benefit of $1,589 |       | 3⁄4     |       | (2,433                      | )          | 3⁄4                          |       | 3⁄4           |       | (2,433           | )          |
| Net loss                                                     |       | $          | (7,433     | )                           | $          | (17,184                         | )          | $                | (982       | )                | $          | 18,166 |   | $ | (7,433 | ) |

89

----

**CondensedConsolidating Statement of Cash Flows for the year ended December 31, 2006(in thousands)**
| ** **                                               | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|
| ** **                                               | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| **Cash flows from operating activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Net cash provided by operating activities                |       | $          | 7,859      |                        | $          | 8,693                           |       | $                | 13,112     |   | $ | 29,664 |   |
|                                                     |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from investing activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Capital expenditures                                     |       | 3⁄4     |       | (12,317                     | )          | 3⁄4                          |       | (12,317          | )          |
| Purchases of investment securities                       |       | (427,600   | )          | 3⁄4                      |       | 3⁄4                          |       | (427,600         | )          |
| Sales of investment securities                           |       | 422,925    |       | 3⁄4                      |       | 3⁄4                          |       | 422,925          |       |
| Payments to restricted debt payment account, net         |       | 3⁄4     |       | 3⁄4                      |       | (3,367                          | )          | (3,367           | )          |
| Proceeds from sale of fixed assets                       |       | 3⁄4     |       | 2,892                       |       | 3⁄4                          |       | 2,892            |       |
| Net cash used in investing activities                    |       | (4,675     | )          | (9,425                      | )          | (3,367                          | )          | (17,467          | )          |
|                                                     |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from financing activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Payments of MCF bonds                                    |       | 3⁄4     |       | 3⁄4                      |       | (9,700                          | )          | (9,700           | )          |
| Tax benefit of stock option exercises                    |       | 224        |       | 3⁄4                      |       | 3⁄4                          |       | 224              |       |
| Payments on capital lease obligations                    |       | 3⁄4     |       | (11                         | )          | 3⁄4                          |       | (11              | )          |
| Proceeds from exercise of stock options                  |       | 2,096      |       | 3⁄4                      |       | 3⁄4                          |       | 2,096            |       |
| Net cash (used in) provided by financing activities      |       | 2,320      |       | (11                         | )          | (9,700                          | )          | (7,391           | )          |
|                                                     |       |       |       |                        |       |                            |       |             |       |
| **Net increase (decrease) in cash and cash equivalents** |       | 5,504      |       | (743                        | )          | 45                              |       | 4,806            |       |
|                                                     |       |       |       |                        |       |                            |       |             |       |
| **Cash and cash equivalents at  beginning of****period** |       | 12,579     |       | 1,114                       |       | 30                              |       | 13,723           |       |
|                                                     |       |       |       |                        |       |                            |       |             |       |
| **Cash and cash  equivalents at end of period**          |       | $          | 18,083     |                        | $          | 371                             |       | $                | 75         |   | $ | 18,529 |   |

 

90

----

**CondensedConsolidating Statement of Cash Flows for the year ended December 31, 2005(in thousands)**
| ** **                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|
| **Cash flows from operating activities:**                 | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Net cash (used  in) provided by operating activities      |       | $          | (34,642    | )                           | $          | 51,475                          |       | $                | 11,435     |   | $ | 28,268 |   |
|                                                      |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from investing activities:**                 | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Capital  expenditures                                     |       | 3⁄4     |       | (51,128                     | )          | 3⁄4                          |       | (51,128          | )          |
| Acquisition of  a business                                |       | (9,064     | )          | 3⁄4                      |       | 3⁄4                          |       | (9,064           | )          |
| Purchases of  investment securities                       |       | (1,022,295 | )          | 3⁄4                      |       | 3⁄4                          |       | (1,022,295       | )          |
| Sales of  investment securities                           |       | 1,066,785  |       | 3⁄4                      |       | 3⁄4                          |       | 1,066,785        |       |
| Payments to  restricted debt payment account, net         |       | 3⁄4     |       | 3⁄4                      |       | (2,445                          | )          | (2,445           | )          |
| Proceeds from  sale of fixed assets                       |       | 3⁄4     |       | 647                         |       | 3⁄4                          |       | 647              |       |
| Net cash provided by (used in) investing activities       |       | 35,426     |       | (50,481                     | )          | (2,445                          | )          | (17,500          | )          |
|                                                      |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from financing activities:**                 | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Payments of MCF  bonds                                    |       | 3⁄4     |       | 3⁄4                      |       | (9,000                          | )          | (9,000           | )          |
| Payments of  acquired debt                                |       | (1,905     | )          | 3⁄4                      |       | 3⁄4                          |       | (1,905           | )          |
| Payments on  capital lease obligations                    |       | 3⁄4     |       | (176                        | )          | 3⁄4                          |       | (176             | )          |
| Proceeds from  exercise of stock options and warrants     |       | 4,141      |       | 3⁄4                      |       | 3⁄4                          |       | 4,141            |       |
| Net cash (used in) provided by financing activities       |       | 2,236      |       | (176                        | )          | (9,000                          | )          | (6,940           | )          |
|                                                      |       |       |       |                        |       |                            |       |             |       |
| **Net increase (decrease) in cash and cash  equivalents** |       | 3,020      |       | 818                         |       | (10                             | )          | 3,828            |       |
|                                                      |       |       |       |                        |       |                            |       |             |       |
| **Cash  and cash equivalents at beginning of****period**  |       | 9,559      |       | 296                         |       | 40                              |       | 9,895            |       |
|                                                      |       |       |       |                        |       |                            |       |             |       |
| **Cash and cash equivalents at end of period**            |       | $          | 12,579     |                        | $          | 1,114                           |       | $                | 30         |   | $ | 13,723 |   |

 

91

----

**Condensed Consolidating Statement of Cash Flows for the yearended December 31, 2004 (in thousands)**
| ** **                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|
| **Cash flows from operating activities:**                    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Net cash  provided by (used in) operating activities         |       | $          | (87,701    | )                           | $          | 89,046                          |       | $                | 10,748     |   | $ | 12,093 |   |
|                                                         |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from investing activities:**                    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Capital  expenditures                                        |       | —     |       | (40,243                     | )          | —                          |       | (40,243          | )          |
| Purchase of  investment securities                           |       | (471,410   | )          | —                      |       | —                          |       | (471,410         | )          |
| Sales of  investment securities                              |       | 419,670    |       | —                      |       | —                          |       | 419,670          |       |
| Purchase of  facility management contract                    |       | —     |       | (3,000                      | )          | —                          |       | (3,000           | )          |
| Refund from  restricted escrow arrangement                   |       | 5,000      |       | —                      |       | —                          |       | 5,000            |       |
| BOP claim  reimbursement                                     |       | —     |       | 5,566                       |       | —                          |       | 5,566            |       |
| Payments to restricted debt payment account, net             |       | —     |       | —                      |       | (2,463                          | )          | (2,463           | )          |
| Proceeds from  sale of fixed assets                          |       | —     |       | 1,137                       |       | —                          |       | 1,137            |       |
| Net cash used in investing activities                        |       | (46,740    | )          | (36,540                     | )          | (2,463                          | )          | (85,743          | )          |
|                                                         |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from financing activities:**                    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Proceeds from  long-term debt and line of credit             |       | 69,000     |       | —                      |       | —                          |       | 69,000           |       |
| Payments on  line of credit                                  |       | (71,000    | )          | —                      |       | —                          |       | (71,000          | )          |
| Payments on  synthetic lease                                 |       | —     |       | (52,499                     | )          | —                          |       | (52,499          | )          |
| Proceeds from  Senior Notes, net of discount                 |       | 110,527    |       | —                      |       | —                          |       | 110,527          |       |
| Payments on MCF  Bonds                                       |       | —     |       | —                      |       | (8,300                          | )          | (8,300           | )          |
| Payment for  debt issuance and other financing costs         |       | (6,076     | )          | —                      |       | —                          |       | (6,076           | )          |
| Payments on  capital lease obligations                       |       | (7         | )          | —                      |       | —                          |       | (7               | )          |
| Proceeds from  exercise of stock options                     |       | 1,844      |       | —                      |       | —                          |       | 1,844            |       |
| Purchases of  treasury stock                                 |       | (115       | )          | —                      |       | —                          |       | (115             | )          |
| Net cash provided by (used in) financing activities          |       | 104,173    |       | (52,499                     | )          | (8,300                          | )          | 43,374           |       |
|                                                         |       |       |       |                        |       |                            |       |             |       |
| **Net  (decrease) increase in cash and cash****equivalents** |       | (30,268    | )          | 7                           |       | (15                             | )          | (30,276          | )          |
|                                                         |       |       |       |                        |       |                            |       |             |       |
| **Cash and cash equivalents at beginning of  period**        |       | 39,827     |       | 289                         |       | 55                              |       | 40,171           |       |
|                                                         |       |       |       |                        |       |                            |       |             |       |
| **Cash and cash equivalents at end of period**               |       | $          | 9,559      |                        | $          | 296                             |       | $                | 40         |   | $ | 9,895 |   |

 

92

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| **17****.** | **SELECTED QUARTERLY FINANCIAL DATA (Unaudited)** |
|-------------|---------------------------------------------------|
|        | **(in thousands, except per share data)**         |

 
| ** **                                  | ** ** | **1**stQuarter | ** ** | **2**ndQuarter | ** ** | **3**rdQuarter | ** ** | **4**thQuarter | ** ** | **Year**   | ** ** |
|---------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|------------|------------|
| **2006:**                                   | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** ** |
| Revenues                                    |       | $              | 83,847     |           | $          | 90,497         |       | $              | 92,383     |       | $          | 94,128 |   | $ | 360,855 |   |
| Income from continuing operations           |       | 1,210          |       | 4,063          |       | 2,584          |       | 4,723          |       | 12,580     |       |
| Discontinued operations, net of tax         |       | (526           | )          | (182           | )          | —         |       | —         |       | (707       | )          |
| Net income                                  |       | 684            |       | 3,881          |       | 2,584          |       | 4,723          | (1)        | 11,873     |       |
|                                        |       |           |       |           |       |           |       |           |       |       |       |
| Earnings per share:                         |       |           |       |           |       |           |       |           |       |       |       |
| Basic -                                     |       |           |       |           |       |           |       |           |       |       |       |
| Income from continuing operations           |       | $              | 0.09       |           | $          | 0.29           |       | $              | 0.19       |       | $          | 0.33 |   | $ | 0.90 |   |
| Discontinued operations, net of tax         |       | $              | (0.04      | )              | $          | (0.01          | )          | $              | —     |       | $          | — |   | $ | (0.05 | ) |
| Net income                                  |       | $              | 0.05       |           | $          | 0.28           |       | $              | 0.19       |       | $          | 0.33 |   | $ | 0.85 |   |
|                                        |       |           |       |           |       |           |       |           |       |       |       |
| Diluted -                                   |       |           |       |           |       |           |       |           |       |       |       |
| Income from continuing operations           |       | $              | 0.09       |           | $          | 0.29           |       | $              | 0.18       |       | $          | 0.33 |   | $ | 0.89 |   |
| Discontinued operations, net of tax         |       | $              | (0.04      | )              | $          | (0.01          | )          | $              | —     |       | $          | — |   | $ | (0.05 | ) |
| Net income                                  |       | $              | 0.05       |           | $          | 0.28           |       | $              | 0.18       |       | $          | 0.33 |   | $ | 0.84 |   |
| ** **                                  | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** ** |
| **2005:**                                   |       |           |       |           |       |           |       |           |       |       |       |
| Revenues                                    |       | $              | 73,640     |           | $          | 78,502         |       | $              | 79,198     |       | $          | 79,435 |   | $ | 310,775 |   |
| Income (loss) from continuing operations    |       | (840           | )          | 1,371          |       | 1,556          |       | 1,841          |       | 3,928      |       |
| Discontinued operations, net of tax         |       | (1,433         | )          | (1,682         | )          | (279           | )          | (228           | )          | (3,622     | )          |
| Net income (loss)                           |       | (2,273         | )          | (311           | )          | 1,277          |       | 1,613          |       | 306        |       |
|                                        |       |           |       |           |       |           |       |           |       |       |       |
| Earnings (loss) per share:                  |       |           |       |           |       |           |       |           |       |       |       |
| Basic -                                     |       |           |       |           |       |           |       |           |       |       |       |
| Income (loss) from continuing operations    |       | $              | (0.05      | )              | $          | 0.10           |       | $              | 0.11       |       | $          | 0.13 |   | $ | 0.29 |   |
| Loss on discontinued operations, net of tax |       | $              | (0.11      | )              | $          | (0.12          | )          | $              | (0.02      | )          | $          | (0.01 | ) | $ | (0.27 | ) |
| Net income (loss)                           |       | $              | (0.16      | )              | $          | (0.02          | )          | $              | 0.09       |       | $          | 0.12 |   | $ | 0.02 |   |
|                                        |       |           |       |           |       |           |       |           |       |       |       |
| Diluted -                                   |       |           |       |           |       |           |       |           |       |       |       |
| Income (loss) from continuing operations    |       | $              | (0.05      | )              | $          | 0.10           |       | $              | 0.11       |       | $          | 0.13 |   | $ | 0.29 |   |
| Loss on discontinued operations, net of tax |       | $              | (0.11      | )              | $          | (0.12          | )          | $              | (0.02      | )          | $          | (0.01 | ) | $ | (0.27 | ) |
| Net income (loss)                           |       | $              | (0.16      | )              | $          | (0.02          | )          | $              | 0.09       |       | $          | 0.12 |   | $ | 0.02 |   |
|                                        |       |           |       |           |       |           |       |           |       |       |       |
| **2006  Balance Sheet Data:**               | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** ** |
| Working capital                             |       | $              | 56,206     |           | $          | 63,842         |       | $              | 61,865     |       | $          | 75,257 |   | $ | 75,078 |   |
| Total assets                                |       | 498,367        |       | 514,287        |       | 509,433        |       | 522,561        |       | 523,533    |       |
| Long-term debt, net of current portion      |       | 264,948        |       | 263,852        |       | 255,472        |       | 255,471        |       | 255,471    |       |
| Stockholders’ equity                   |       | 167,624        |       | 172,411        |       | 176,618        |       | 180,596        |       | 181,564    |       |
|                                        |       |           |       |           |       |           |       |           |       |       |       |
| **2005  Balance Sheet Data:**               | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** ** |
| Working capital                             |       | $              | 103,643    |           | $          | 89,550         |       | $              | 63,603     |       | $          | 57,286 |   | $ | 57,286 |   |
| Total assets                                |       | 501,026        |       | 511,247        |       | 496,406        |       | 510,628        |       | 510,628    |       |
| Long-term debt, net of current portion      |       | 276,893        |       | 279,752        |       | 267,416        |       | 266,659        |       | 266,659    |       |
| Stockholders’  equity                  |       | 159,088        |       | 159,622        |       | 163,243        |       | 165,461        |       | 165,461    |       |

 

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(1)          Includesimpairment charges of $0.4 million on long-lived assets for two of our adultcommunity-based facilities.

93

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| **ITEM 9.** | ** ** | **CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|------------|-------------------------------------------------------------------------------------------|

 

None.
| **ITEM 9A.** | ** ** | **CONTROLS AND PROCEDURES** |
|--------------|------------|-----------------------------|

 

**Evaluationof Disclosure Controls and Procedures**

We maintain disclosure controls andprocedures designed to provide reasonable assurance that information disclosedin our annual and periodic reports is recorded, processed, summarized andreported, within the time periods specified in the Securities and Exchange Commission’srules and forms. In addition, we designed these disclosure controls andprocedures to ensure that this information is accumulated and communicated tomanagement, including the chief executive officer (CEO) and chief financialofficer (CFO), to allow timely decisions regarding required disclosures. SECrules require that we disclose the conclusions of our CEO and CFO about theeffectiveness of our disclosure controls and procedures.

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

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

**Changes inInternal Control over Financial Reporting**

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

**Management’sReport on Internal Control Over Financial Reporting**

See “Financial Statements and SupplementaryData—Management’s Report on Internal Control over Financial Reporting” in Item8 of this report.

**Report ofthe Registered Public Accounting Firm**

See “Financial Statements and SupplementaryData—Report of Independent Registered Public Accounting Firm” in Item 8 of thisreport.
| **ITEM 9B.** | ** ** | **OTHER INFORMATION** |
|--------------|------------|-----------------------|

 

None.

94

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**PARTIII**

Items 10, 11, 12, 13 and 14 of Part III have beenomitted from this report because we will file with the Securities and ExchangeCommission, not later than 120 days after the close of our fiscal year, adefinitive proxy statement or a Form 10-K/A. The information required by Items10, 11, 12, 13 and 14 of this report, which will appear in the definitive proxystatement and /or the Form 10-K/A, is incorporated by reference into Part IIIof this report.

95

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**PARTIV**

**ITEM 15.****                     ****EXHIBITS AND FINANCIALSTATEMENT SCHEDULES**
| (a)    | **Financial  Statements, Schedules and Exhibits** |                          |
|--------|---------------------------------------------------|-------------------------------|
|   |                                              |                          |   |
|        | 1.                                                | Financial statements          |   |
|   |                                              |                          | Report of Independent Registered Public Accounting  Firm |   |
|   |                                              |                          | Consolidated Balance Sheets - December 31, 2006  and 2005 |   |
|   |                                              |                          | Consolidated  Statements of Operations and Comprehensive Income/(Loss) for the years ended  December 31, 2006, 2005 and 2004 |   |
|   |                                              |                          | Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2006, 2005 and 2004 |   |
|   |                                              |                          | Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004 |   |
|   |                                              |                          | 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 Cornell  Companies, Inc.                                                                                                                                                                   |       | 1                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 3.2          |       | Amended and Restated Bylaws of Cornell Companies,  Inc.                                                                                                                                                                             |       | 18                                  |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 3.3          |       | Certificate of Amendment of Restated Certificate of  Incorporation of Cornell Companies, Inc.                                                                                                                                       |       | 14                                  |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 4.1          |       | Certificate representing Common Stock.                                                                                                                                                                                              |       | 2                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 4.2          |       | Registration Rights Agreement, dated March 31,  1994, as amended, among Cornell Corrections, Inc. and the stockholders listed  on the signature pages thereto.                                                                 |       | 2                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 4.6          |       | Indenture dated as of June 24, 2004 between Cornell  Companies, Inc., the guarantors named therein and JPMorgan Chase Bank, as  trustee.                                                                                            |       | 21                                  |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 4.7          |       | Form of 10 3/4% Senior Note due 2012 (included in  Exhibit 4.6).                                                                                                                                                                    |       | 21                                  |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 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.                                                                                                                                                             |       | 6                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 10.2*        |       | Employment Agreement, dated as of September 9,  1997, between Abraxas Group, Inc. and Arlene R. Lissner.                                                                                                                       |       | 3                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 10.3*        |       | Covenant Not to Compete Agreement, dated  September 9, 1997, by and between Cornell Corrections, Inc. and Arlene  R. Lissner.                                                                                                  |       | 3                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 10.4         |       | Form of Indemnification Agreement between Cornell  Companies, Inc. and each of its directors and executive officers.                                                                                                                |       | 2                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 10.5         |       | Stockholders Agreement among certain stockholders  named therein dated September 15, 1997.                                                                                                                                     |       | 3                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 10.6         |       | Professional Management Agreement, dated July 15,  1992, between Cornell Corrections, Inc. and Central Falls Detention Facility  Corporation.                                                                                       |       | 2                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 10.7         |       | Operating Agreement by and between each of MidTex  Detentions, Inc., the City of Big Spring, Texas and Cornell Corrections of  Texas, Inc., dated July 1, 1996, and related Assignment and Assumption  of Operating Agreement. |       | 2                                   |
|         |       |                                                                                                                                                                                                                                |       |                                |
| 10.8         |       | Contract between Cornell Corrections of California,  Inc. and the California Department of Corrections (No. R92.132) for the Live  Oak, California Facility, dated March 1, 1993, as                                           |       | 2                                   |

 

96

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| Exhibit  No. | ** ** | **Description**                                                                                                                                                                                                                 | ** ** | **Incorporated by  Reference** |
|--------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|
|         |       | amended.                                                                                                                                                                                                                        |       |                                |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.9         |       | Asset Purchase Agreement, dated January 31,  1997, by and between Cornell Corrections of Texas, Inc. and Interventions Co.                                                                                                 |       | 4                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.10        |       | Asset Purchase Agreement, dated August 14,  1997, by and between Cornell Corrections, Inc. and Abraxas Group, Inc.,  Foundation for Abraxas, Inc., Abraxas Foundation, Inc., Abraxas Foundation of  Ohio and Abraxas, Inc. |       | 3                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.11        |       | Contract between Texas Alcoholism Foundation, Inc.  and the Texas Department of Criminal Justice, Parole Division for the Reid  Facility, dated January 31, 1996, as amended.                                              |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.12        |       | Form of Contract between Cornell Corrections of  California and the Utah State Department of Human Services, Division of Youth  Corrections for the Salt Lake City, Utah Juvenile Facility.                                     |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.13        |       | Asset Purchase Agreement, dated May 14, 1996, among  Cornell Corrections of Texas, Inc., Texas Alcoholism Foundation, Inc. and the  Texas House Foundation, Inc.                                                                |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.14        |       | Asset Purchase Agreement, dated May 22, 1996, among  Cornell Corrections of Texas Inc., the Company, Ed Davenport, Johnny  Rutherford and MidTex Detentions, Inc.                                                               |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.15        |       | Lease Agreement, dated August 1, 1987, between  Cornell Corrections of California Inc. and Baker Housing Company for the  Baker, California facility.                                                                           |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.16        |       | Lease Agreement between City of Big Spring, Texas  and Ed Davenport, dated July 1, 1996, for the Interstate Unit and  related Assignment and Assumption of Leases.                                                         |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.17        |       | Secondary Sublease Agreement between City of Big  Spring and Ed Davenport, dated July 1, 1996, for the Airpark Unit and  related Assignment and Assumption of Leases.                                                      |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.18        |       | Secondary Sublease Agreement between City of Big  Spring and Ed Davenport, dated July 1, 1996, for the Flightline Unit and  related Assignment and Assumption of Leases.                                                   |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.19        |       | Stock Option Agreement between Cornell Corrections,  Inc. and CEP II dated July 9, 1996.                                                                                                                                   |       | 2                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.20        |       | Form of Option Agreement between Cornell  Corrections, Inc. and the optionholder listed therein dated as of  November 1, 1995.                                                                                             |       | 9                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.21        |       | Senior Note Agreement by and between Cornell  Corrections, Inc. and the note purchasers dated July 15, 1998.                                                                                                               |       | 7                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.22        |       | Asset Purchase Agreement, dated November 17,  1997, by and between Foresite Capital Facilities Corporation and the Hinton  Economic Development Authority.                                                                 |       | 5                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.23        |       | Amendment, dated December 10, 1997, to Asset  Purchase Agreement dated as of November 17, 1997.                                                                                                                       |       | 5                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.24        |       | Amendment No. 2, dated January 6, 1998, to  Asset Purchase Agreement dated as of November 17, 1997.                                                                                                                   |       | 5                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.25        |       | Assignment of Agreement of Purchase and Sale, dated  January 5, 1998, by and between Foresite Capital Facilities Corporation  and Cornell Corrections of Oklahoma, Inc.                                                    |       | 5                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.26        |       | Allvest Asset Purchase Agreement, dated  June 20, 1998, by and between Cornell Corrections, Inc. and Allvest,  Inc., St. John Investments, and William C. Weimar.                                                          |       | 8                                   |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.27*       |       | Subordinated Bridge Loan Agreement by and between  Cornell Corrections, Inc. and ING dated October 14, 1999.                                                                                                               |       | 10                                  |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.28        |       | Asset Purchase Agreement, dated May 10, 1999, by and  among Cornell Corrections, Inc. and Interventions and IDDRS Foundation.                                                                                                   |       | 10                                  |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.29        |       | Extension of Asset Purchase Agreement, dated  September 30, 1999, by and among Cornell Corrections, Inc. and  Interventions and IDDRS Foundation.                                                                          |       | 10                                  |
|         |       |                                                                                                                                                                                                                            |       |                                |
| 10.30        |       | Asset Purchase Agreement, dated May 10, 1999, by and  among BHS Consulting Corp., its                                                                                                                                           |       | 10                                  |

 

97

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| Exhibit  No. | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                  | ** ** | **Incorporated by  Reference** |
|--------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|
|         |       | shareholders and Cornell Corrections, Inc.                                                                                                                                                                                                                                                                                                                       |       |                                |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.31        |       | Extension of Asset Purchase Agreement, dated  September 30, 1999, by and among BHS Consulting Corp., its shareholders and  Cornell Corrections, Inc.                                                                                                                                                                                                             |       | 10                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.32        |       | Amendment to Asset Purchase Agreement, dated  November 12, 1999, by and among BHS Consulting Corp., its shareholders and  Cornell Corrections, Inc.                                                                                                                                                                                                              |       | 10                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.33        |       | Participation Agreement, dated November 23, 1999, among  Cornell Corrections, Inc. and certain of its subsidiaries and Heller  Financial Leasing, Inc.                                                                                                                                                                                                           |       | 11                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.34        |       | Lease Agreement, dated November 23, 1999, between  First Security Bank, National Association, and Cornell Corrections, Inc. and  certain of its subsidiaries.                                                                                                                                                                                                    |       | 11                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.35        |       | Lease Agreement, dated December 31, 1999, by and  among Hinton Economic Development Authority, the Town of Hinton, Oklahoma,  and Cornell Corrections of Oklahoma, Inc.                                                                                                                                                                                          |       | 11                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.36*       |       | Consulting Agreement, dated December 15, 1999,  between Cornell Corrections, Inc. and David M. Cornell.                                                                                                                                                                                                                                                          |       | 11                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.37*       |       | Form of Severance Agreement executed by John  Hendrix, Arlene Lissner, Thomas Jenkins, Thomas Rathjen, Patrick Perrin and  Steven Logan.                                                                                                                                                                                                                         |       | 11                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.38        |       | Fourth Amended and Restated Credit Agreement, dated  July 21, 2000, among Cornell Companies, Inc., certain subsidiaries of Cornell  Companies, Inc., Atlantic Financial Group, Ltd., the Lenders and ING (U.S.)  Capital LLC, as Administrative Agent.                                                                                                           |       | 12                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.39        |       | Amended and Restated Master Agreement, dated July  21, 2000, among Cornell Companies, Inc., certain subsidiaries of Cornell  Companies, Inc., Atlantic Financial Group, Ltd., the Lenders, ING (U.S.)  Capital LLC, as Administrative Agent, Bank of America N.A., as Syndication  Agent, and Suntrust Equitable Securities Corporation, as Documentation Agent. |       | 12                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.40        |       | Note and Equity Purchase Agreement, dated July 21,  2000, among Cornell Companies, Inc., American Capital Strategies, Ltd. and  Teachers Insurance and Annuity Association of America.                                                                                                                                                                           |       | 12                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.41        |       | Warrant issued by Cornell Companies, Inc. to  American Capital Strategies, Ltd. dated July 21, 2000.                                                                                                                                                                                                                                                        |       | 12                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.42        |       | Warrant issued by Cornell Companies, Inc. to  Teachers Insurance and Annuity Association of America, dated July 21,  2000.                                                                                                                                                                                                                                  |       | 12                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.43        |       | Cornell Corrections, Inc. Employee Stock Purchase  Plan.                                                                                                                                                                                                                                                                                                         |       | 13                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.44*       |       | Cornell Companies, Inc. Deferred Compensation Plan.                                                                                                                                                                                                                                                                                                              |       | 13                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.45        |       | Cornell Companies, Inc. 2000 Director Stock Plan.                                                                                                                                                                                                                                                                                                                |       | 14                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.46        |       | Cornell Companies, Inc. 2000 Broad-Based Employee  Plan.                                                                                                                                                                                                                                                                                                         |       | 15                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.47*       |       | Cornell Companies, Inc. Deferred Bonus Plan.                                                                                                                                                                                                                                                                                                                     |       | 20                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.48        |       | 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.                                                                                             |       | 16                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.49        |       | Master Lease Agreement (with addenda), dated  August 14, 2001, between Municipal Corrections Finance, L.P. and Cornell  Companies, Inc.                                                                                                                                                                                                                     |       | 16                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.50        |       | Master Lease Agreement dated December 3, 1998  between Atlantic Financial Group and WBP Leasing, Inc. and certain other  subsidiaries of Cornell Corrections, Inc.                                                                                                                                                                                          |       | 17                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.51        |       | Amendment No. 1 to Credit Agreement dated  January 31, 2001.                                                                                                                                                                                                                                                                                                |       | 17                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                             |       |                                |
| 10.52        |       | Amendment No. 2 to Credit Agreement and Amendment  No. 1 to Master Agreement dated August 9, 2001.                                                                                                                                                                                                                                                          |       | 17                                  |

 

98

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| Exhibit  No. | ** ** | **Description**                                                                                                                                                                                                                                    | ** ** | **Incorporated by  Reference** |
|--------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|
| 10.53        |       | First Amendment to Note and Equity Purchase  Agreement dated August 9, 2001.                                                                                                                                                                  |       | 17                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.54        |       | Registration Rights Agreement dated as of June 24,  2004 between Cornell Companies, Inc, the guarantors named therein and the  Initial Purchasers                                                                                                  |       | 21                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.54        |       | Credit Agreement, dated June 24, 2004, among Cornell  Companies, Inc., as Borrower, such subsidiaries of the Borrower as named  therein, JPMorgan Chase Bank, as Administrative Agent, and such other lenders  as named therein.                   |       | 21                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.55        |       | Negative Pledge Agreement dated as of June 24, 2004  among Cornell Companies, Inc., as Borrower, such subsidiaries of the Borrower  as named therein, as Pledgor(s), and JPMorgan Chase Bank, as Administrative  Agent for a syndicate of lenders. |       | 21                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.56        |       | Guarantee dated as of June 24, 2004 by such  subsidiaries of Cornell Companies, Inc. named therein and accepted and agreed  by JPMorgan Chase Bank, as Administrative Agent for a syndicate of lenders.                                            |       | 21                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.57*       |       | Employment Agreement, dated March 14, 2005, between  Cornell Companies, Inc. and James E. Hyman.                                                                                                                                                   |       | 22                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.58*       |       | Restricted Stock Agreement, dated March 14, 2005,  between Cornell Companies, Inc. and James E. Hyman.                                                                                                                                             |       | 22                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.59*       |       | Employment/Separation Agreement, dated March 9,  2005, between Cornell Companies, Inc. and John R. Nieser.                                                                                                                                         |       | 22                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.60*       |       | Summary description of oral agreement, dated March  9, 2005, between Cornell Companies, Inc. and Harry J. Phillips, Jr.                                                                                                                            |       | 22                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.61*       |       | Release of Claims, Covenant Not to Sue, and Older  Workers Act Waiver, dated March 21, 2005, between Cornell Companies, Inc. and  Thomas R. Jenkins.                                                                                               |       | 23                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.62*       |       | Release of Claims, Covenant Not to Sue, and Older  Workers Act Waiver, dated March 21, 2005, between Cornell Companies, Inc. and  Paul B. Doucette.                                                                                                |       | 23                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.63*       |       | Release of Claims, Covenant Not to Sue, dated April  12, 2005, between Cornell Companies, Inc. and Luis A. Collazo.                                                                                                                                |       | 24                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.64*       |       | Independent Contractor Agreement, effective June 6,  2005, between Cornell Companies, Inc. and Luis A. Collazo.                                                                                                                                    |       | 24                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.65*       |       | Release of Claims, Covenant Not to Sue, and Older  Workers Act Waiver, dated April 25, 2005, between Cornell Companies, Inc. and  John C. Godlesky.                                                                                                |       | 25                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.66*       |       | Independent Contractor Agreement effective, July 1,  2005, between Cornell Companies, Inc. and John C. Godlesky.                                                                                                                                   |       | 25                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.67        |       | Letter Agreement, dated May 17, 2005 (but effective  as of May 18, 2005), between Cornell Companies, Inc. and Pirate Capital LLC.                                                                                                                  |       | 26                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.68*       |       | Summary description of employment agreement, dated  November 28, 2005, between Cornell Companies, Inc. and Mark S. Croft.                                                                                                                          |       | 27                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.69*       |       | Severance Agreement, dated November 28, 2005,  between Cornell Companies, Inc. and Mark S. Croft.                                                                                                                                                  |       | 28                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.70        |       | Amendment to Severance Agreement, dated August 9,  2006, between Cornell Companies, Inc. and Mark S. Croft.                                                                                                                                        |       | 29                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 10.71        |       | Cornell Companies, Inc. 2006 Equity Incentive Plan                                                                                                                                                                                                 |       | 30                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 21.1         |       | List of Subsidiaries.                                                                                                                                                                                                                              |       | **                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 23.1         |       | Consent of PricewaterhouseCoopers LLP.                                                                                                                                                                                                             |       | **                                  |
|         |       |                                                                                                                                                                                                                                               |       |                                |
| 24.1         |       | Power of Attorney (see signature page of this Annual  Report on Form 10-K).                                                                                                                                                                        |       | **                                  |

 

99

----

 
| Exhibit  No. | ** ** | **Description**                                                                                                        | ** ** | **Incorporated by  Reference** |
|--------------|------------|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|
| 31.1         |       | Section 302 Certification of Chief Executive  Officer.                                                            |       | **                                  |
|         |       |                                                                                                                   |       |                                |
| 31.2         |       | Section 302 Certification of Chief Financial  Officer.                                                            |       | **                                  |
|         |       |                                                                                                                   |       |                                |
| 32.1         |       | Section 906 Certification of Chief Executive  Officer.                                                            |       | **                                  |
|         |       |                                                                                                                   |       |                                |
| 32.2         |       | Section 906 Certification of Chief Financial  Officer.                                                            |       | **                                  |
|         |       |                                                                                                                   |       |                                |
| 99.1         |       | Letter Agreement, dated September 5, 2001, as  amended, between Cornell Companies, Inc. and Lehman Brothers, Inc. |       | 19                                  |

 

----

  (1)  Annual Report on Form 10-K for the year endedDecember 31, 1996.

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

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

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

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

  (6)  Definitive Proxy Statement datedMarch 9, 1998.

  (7)  Quarterly Report on Form 10-Q for the quarterended June 30, 1998.

  (8)  Current Report on Form 8-K datedAugust 13, 1998.

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

(10)  QuarterlyReport on Form 10-Q for the quarter ended September 30, 1999.

(11)  AnnualReport on Form 10-K for the year ended December 31, 1999.

(12)  QuarterlyReport on Form 10-Q for the quarter ended June 30, 2000.

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

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

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

(16)  CurrentReport on Form 8-K dated August 14, 2001.

(17)  QuarterlyReport on Form 10-Q for the quarter ended September 30, 2001.

(18)  QuarterlyReport on Form 10-Q for the quarter ended March 31, 2001.

(19)  AnnualReport on Form 10-K for the year ended December 31, 2001.

(20)  AnnualReport on Form 10-K for the year ended December 31, 2002.

(21)  CurrentReport on Form 8-K dated June 25, 2004.

(22)  Current Report on Form 8-K dated March 15,2005.

(23)  Current Report on Form 8-K dated March 24,2005.

(24)  Current Report on Form 8-K dated April 18,2005.

(25)  Current Report on Form 8-K dated April 29,2005.

(26)  Current Report on Form 8-K dated May 19,2005.

(27)  Current Report on Form 8-K dated November 28,2005.

(28)  Annual Report on Form 10-K for the year endedDecember 31, 2005.

(29)  Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.

(30)  Schedule 14A filed May 10, 2006.

*       Management compensatory plan or contract.

**     Filed herewith

100

----

**SIGNATURES**

**Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.**
|                                                                      |   |   |   | CORNELL COMPANIES, INC. |
|----------------------------------------------------------------------|--------|--------|--------|-------------------------|
|                                                                 |   |   |   |                    |
| Dated:       March 16,  2007 |   |   |   | By:                     | /s/ James E. Hyman |
|                                                                 |   |   |   |                    | James E. Hyman |
|                                                                 |   |   |   |                    | Chief Executive Officer and |
|                                                                 |   |   |   |                    | Chairman of the Board |

 

**POWER OF ATTORNEY**

KNOW ALL MEN BY THESEPRESENTS, that each person whose signature appears below constitutes andappoints James E. Hyman, John R. Nieser and Patrick N. Perrin, and each ofthem, his true and lawful attorneys-in-fact, each with full power ofsubstitution, for him or her in any and all capacities, to sign any amendmentsto this report on Form 10-K and to file the same, with exhibits thereto andother documents in connection therewith, with the Securities and ExchangeCommission, hereby ratifying and confirming all that each of saidattorneys-in-fact or their substitute or substitutes may do or cause to be doneby virtue hereof.

**Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.**
| SIGNATURE                  | ** ** | **TITLE**                                                                                          | ** ** | **DATE**            |
|----------------------------|------------|----------------------------------------------------------------------------------------------------|------------|---------------------|
|                       |       |                                                                                               |       |                |
| /s/ James E.  Hyman        |       | Chief Executive Officer and                                                                        |       | March 16, 2007 |
| James E. Hyman             |       | Chairman of the Board                                                                              |       |                |
|                       |       | (Principal Executive Officer)                                                                      |       |                |
|                       |       |                                                                                               |       |                |
| /s/ John R.  Nieser        |       | Chief Financial Officer                                                                            |       | March 16, 2007 |
| John R. Nieser             |       | (Principal Financial Officer and                                                                   |       |                |
|                       |       | Principal Accounting Officer)                                                                      |       |                |
|                       |       |                                                                                               |       |                |
|                       |       |                                                                                               |       |                |
| /s/ ANTHONY R.  CHASE      |       |                Director |       | March 16, 2007 |
| Anthony R. Chase           |       |                                                                                               |       |                |
|                       |       |                                                                                               |       |                |
| /s/ D. STEPHEN  SLACK      |       |                Director |       | March 16, 2007 |
| D. Stephen Slack           |       |                                                                                               |       |                |
|                       |       |                                                                                               |       |                |
| /s/ ALFRED JAY  MORAN, JR. |       |                Director |       | March 16, 2007 |
| Alfred Jay  Moran, Jr.     |       |                                                                                               |       |                |
|                       |       |                                                                                               |       |                |
| /s/ TODD GOODWIN           |       |                Director |       | March 16, 2007 |
| Todd Goodwin               |       |                                                                                               |       |                |
|                       |       |                                                                                               |       |                |
| /s/ SALLY L.  WALKER       |       |                Director |       | March 16, 2007 |
| Sally l. Walker            |       |                                                                                               |       |                |
|                       |       |                                                                                               |       |                |
| /s/ RICHARD  CRANE         |       |                Director |       | March 16, 2007 |
| Richard Crane              |       |                                                                                               |       |                |
|                       |       |                                                                                               |       |                |
| /s/ ANDREW R. JONES        |       |                Director |       | March 16, 2007 |
| Andrew R. Jones            |       |                                                                                               |       |                |
|                       |       |                                                                                               |       |                |
| /s/ ZACHARY R.  GEORGE     |       |                Director |       | March 16, 2007 |
| Zachary R.  George         |       |                                                                                               |       |                |

 

101

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