** **

**UNITED STATESSECURITIES 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, 2007**                                                                                                                                                     |
|                                                                                                                                                                                                  |                                                                                                     |
| **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**

 

**CORNELLCOMPANIES, INC.**

(Exact Name of Registrant as Specified In ItsCharter)

 

| **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 pursuantto 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

 

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

Yes  o  No x

 

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

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K (§229.405) is not containedherein, and will not be contained, to the best of Registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K. o.

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See the definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.Check one.

 

| Large accelerated Filer o |   | Accelerated filer x         |
|---------------------------|--------|-----------------------------|
| Non-accelerated filer o   |   | Smaller Reporting Company 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

 

Theaggregate market value of voting stock held by non-affiliates of the registrantwas $261,953,030 on June 30, 2007. The registrant has 14,565,034 shares ofcommon stock outstanding on March 7, 2008

 

**DocumentsIncorporated by Reference**

 

The information required by Part III of this Report, to the extentnot set forth herein, is incorporated by reference from the registrant’sdefinitive proxy statement relating to its Annual Meeting of Stockholders to beheld in 2008, which definitive proxy statement will be filed with theSecurities and Exchange Commission within 120 days after the end of the fiscalyear to which this Report relates.

 

 

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**CornellCompanies, Inc.**

** **

**Tableof Contents**

 

**2007Form 10-K**

** **
| ** **        | ** **                                                                                  | **Page** |
|-------------------|---------------------------------------------------------------------------------------------|----------|
| **PART I**   | ** **                                                                                  |     |
| Item 1.           | Business                                                                                    | 4        |
| Item 1A.          | Risk Factors                                                                                | 15       |
| Item 1B.          | Unresolved Staff Comments                                                                   | 20       |
| Item 2.           | Properties                                                                                  | 20       |
| Item 3.           | Legal Proceedings                                                                           | 20       |
| Item 4.           | Submission of Matters to a Vote of Security  Holders                                        | 22       |
|              |                                                                                        |     |
| **Part II**  |                                                                                        |     |
| Item 5.           | Market for Registrant’s Common Equity and  Related Stockholder Matters                 | 22       |
| Item 6.           | Selected Financial Data                                                                     | 26       |
| Item 7.           | Management’s Discussion and Analysis of Financial Condition and  Results of Operations | 28       |
| Item 7A.          | Quantitative and Qualitative Disclosures About Market Risk                                  | 48       |
| Item 8            | Financial Statements and Supplementary Data                                                 | 48       |
| Item 9            | Changes In and Disagreements with Accountants on Accounting and  Financial Disclosure       | 89       |
| Item 9A.          | Controls and Procedures                                                                     | 89       |
| Item 9B.          | Other Information                                                                           | 89       |
|              |                                                                                        |     |
| **Part III** |                                                                                        |     |
| Item 10.          | Directors, Executive Officers of the Registrant and Corporate  Governance                   | 90       |
| Item 11.          | Executive Compensation                                                                      | 90       |
| Item 12.          | Security Ownership of Certain Beneficial Owners and Management and  Related Stockholder     | 90       |
|              | Matters                                                                                     | 90       |
| Item 13.          | Certain Relationships and Related Transactions and Director  Independence                   | 90       |
| Item 14.          | Principal Accountant Fees and Services                                                      | 90       |
|              |                                                                                        |     |
| **Part IV**  |                                                                                        |     |
| Item 15.          | Exhibits and Financial Statement Schedules                                                  | 91       |

** **

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**Forward-LookingInformation**

 

The statements included in this annual reportregarding future financial performance and results of operations and otherstatements that are not historical facts are forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. Forward-looking statements in this annual report include, but are notlimited to, statements about the following subjects:

 

·                  revenues,

·                  revenuemix,

·                  expenses,including personnel and medical costs

·                  resultsof operations,

·                  operatingmargins

·                  supplyand demand,

·                  marketoutlook in our various markets

·                  ourother expectations with regard to market outlook,

·                  utilization,

·                  parolee,detainee, inmate and youth offender trends

·                  pricingand per diem rates,

·                  contractcommencements,

·                  newcontract opportunities,

·                  operationsat and results from our Regional Correctional Center,

·                  thetiming, cost of completion and other aspects of planned expansions, includingwithout limitation the D. Ray James Prison and Great Plains CorrectionalFacility expansions,

·                  adequacyof insurance,

·                  insuranceproceeds,

·                  debtlevels,

·                  debtreduction,

·                  theeffect of FIN No. 48,

·                  oureffective tax rate,

·                  taxassessments,

·                  resultsand effects of legal proceedings and governmental audits and assessments,

·                  liquidity,

·                  cashflow from operations,

·                  adequacyof cash flow for our obligations,

·                  capitalrequirements

·                  capitalexpenditures,

·                  effectsof accounting changes and adoption of accounting policies,

·                  changesin laws and regulations,

·                  adoptionof accounting policies,

·                  benefitpayments, and

·                  changesin laws and regulations,

 

2

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Forward-lookingstatements in this annual report are identifiable by use of the following wordsand other similar expressions among others:

 

·                  “anticipates”

·                  “believes”

·                  “budgets”

·                  “could”

·                  “estimates”

·                  “expects”

·                  “forecasts”

·                  “intends”

·                  “may”

·                  “might”

·                  “plans”

·                  “predicts”

·                  “projects”

·                  “scheduled”

·                  “should”

 

Suchstatements are subject to numerous risks, uncertainties and assumptions,including, but not limited to:

 

·                        those described under “Item 1A. Risk Factors,”

·                        the adequacy of sources of liquidity,

·                        the effect and results of litigation, audits and contingencies, and

·                        other factors discussed in this annual report and in the Company’sother filings with the SEC, which are available free of charge on the SEC’swebsite at *www.sec.gov*.

 

Shouldone or more of these risks or uncertainties materialize, or should underlyingassumptions prove incorrect, actual results may vary materially from thoseindicated.

 

All subsequent written andoral forward-looking statements attributable to the Company or to persons actingon our behalf are expressly qualified in their entirety by reference to theserisks and uncertainties. You should not place undue reliance on forward-lookingstatements. Each forward-looking statement speaks only as of the date of theparticular statement, and we undertake no obligation to publicly update orrevise any forward-looking statements.

 

3

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**PART I**

 

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

####  

**Company Overview**

 

***Cornell Companies, Inc.(together with its subsidiaries and predecessors, unless the context requiresotherwise, “Cornell,” the “Company,” “we,” “us” or “our”) was incorporated inDelaware in 1996. We provide correction, detention, education, rehabilitationand treatment services for adults and juveniles. We partner with federal,state, county and local government agencies to deliver quality, cost-efficientprograms that we believe enable our customers to save taxpayers’ money. Ourcustomers include the Federal Bureau of Prisons (“BOP”), Bureau of Immigrationand Customs Enforcement (“ICE”), U.S. Marshals Service (“USMS”), various stateDepartments of Corrections, and city, county and state departments of humanservices and similar agencies.***

 

***We offer servicesin structured and secure environments throughout three operatingdivisions:  (1) Adult SecureServices (previously known as “adult secure institutions and detention centers”);(2) Abraxas Youth and Family Services (previously known as “juvenilejustice, educational and treatment programs”); and (3) Adult Community-BasedServices (previously known as “adult community-based corrections and treatmentprograms”). Cornell, through predecessor entities, began operating in juvenileoperations in 1973, adult community-based programs in 1974, and adult secureoperations in 1984. See Note 15 to the consolidated financial statements inItem 8 of this report for a discussion concerning our operating segments.***

 

As of December 31, 2007, we operated 73facilities among the three business lines, representing a total operatingservice capacity of 18,517. We also had one facility that was vacant,representing additional service capacity of 70. Service capacity is comprisedof the number of beds currently available for service in residential facilitiesand the average program capacity of non-residential community-basedprograms.  Our facilities are located in15 states and the District of Columbia.

 

Additional information about Cornell can be found onour website, *www.cornellcompanies.com*.We make available on our website, free of charge, access to ourForms 10-K, Forms 10-Q, Forms 8-K, and all amendments to thesereports as soon as reasonably practicable after such materials areelectronically filed with the Securities and Exchange Commission (SEC).Alternatively, reports filed with the SEC may be viewed or obtained at the SECPublic Reference Room in Washington, D.C., or the SEC’s website, *www.sec.gov*. Information provided on ourwebsite or on the SEC’s website is not part of this Form 10-K.

 

Each of our Board of Directors’ standing committeecharters, our corporate governance guidelines and our policy of businessconduct are available on our website or, upon request, to our General Counselat 1700 West Loop South, Suite 1500, Houston, Texas, in print, free of charge. We will post onour website all waivers to or amendments of our policy of business conduct,which are required to be disclosed by applicable law and rules of the NewYork Stock Exchange (NYSE) listing standards.

 

# **Company Operations**

 

We provide a continuum of care to adults and juvenilesin institutional, residential, and community-based settings. Regardless ofservice line, each of our facilities emphasizes the importance of engaging inthe community as a productive, responsible citizen. In many of our adult secureinstitutions, we offer vocational training curricula, as well as literacy andGeneral Equivalency Diploma (GED) programs. In our adult community-basedprograms, we offer job placement services, instruction on personal financemanagement and other skill-based training. In most of our juvenile facilities,we provide family counseling services and behavioral counseling. In facilitiesthroughout the organization, we provide drug and alcohol counseling for ourclients.

 

***We operate ourfacilities and programs under 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.

 

4

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# **Quality of Operations**

 

We operate our facilities in accordance with bothcompany and facility-specific policies and procedures. Where required bycontract or otherwise deemed appropriate for our service environments, thesepolicies and procedures are designed to meet requirements set forth byindependent industry oversight organizations, including the AmericanCorrectional Association (ACA), Joint Commission on Accreditation of HealthcareOrganizations (JCAHO), and National Commission on Correctional Health Care(NCCHC). Standards may also be implemented to meet the requirements of statedepartments of public welfare, departments of protective and regulatoryservices and departments of human services and education. We believe thataccreditation and the corresponding standards of operation enhance our abilityto provide quality programs and contribute to the public’s increased acceptanceof our services.

 

Internal quality control, conducted by seniorfacility staff and senior management, takes the form of periodic operational,programmatic and fiscal audits; facility inspections; regular review of logs,reports and files; and strict maintenance of personnel standards, including anactive training program. Each of our facilities is further subject to periodicaudits and reviews performed by our contracting agencies.

 

# **Industry and Business Segment Summary**

# ** **

***Incarceration, detention, education and treatment servicesfor adults and juveniles have historically been provided by various governmententities. In the United States, the incarcerated and sentenced populations ofadults and juveniles has continued to increase while federal, state and localgovernments face continuing pressures to control costs and improve servicequality. We believe these trends have caused growing consideration andacceptance towards outsourcing certain government services and functions.Moreover, the increasing demand facing governments (from areas such ashealthcare, maintenance/development of public infrastructure, etc.) has alsocreated competition for resources funding such services***

*** ***

Services offered among our three divisions includeincarceration and detention, transition from incarceration, drug and alcoholcounseling and treatment, behavioral rehabilitation and treatment, vocationaltraining and academic education for grades 3–12. Private-sector companies, likeus, contract with government agencies to deliver these services, at what webelieve are the same or higher quality and for a lower cost than what theagency can otherwise provide. Although outsourcing these services hashistorically faced opposition in the U.S., public and government acceptance hasincreased as standards of service improve and cost savings are documented. Asgovernment agencies face fiscal budget constraints, outsourcing to privateproviders can offer economically positive alternatives. In addition, as a costrelief measure, government agencies have sought alternatives to incarceration,including reentry, education, substance abuse and behavioral health programs –all of which are services we provide.

 

***Outsourcing has a longer history in the juvenile justice andadult community-based corrections sectors. Increasingly, states, counties andlocal governments have used both for-profit and not-for-profit organizations tomeet the needs of troubled youth and adults reintegrating into society after atime in residential treatment or prison. 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 Services***

 

Increasingly, federal and state systems arerelying upon private providers to address their incarceration needs.  We also believe that the heightened attentionthat has been placed on border patrol and immigration enforcement will continueto drive demand for services such as those offered by private providers.

 

We believe that our adult secure service line iswell positioned to respond to these marketplace conditions. We provide low- tomaximum-security incarceration and detention services. In doing so, we ensurepublic safety through the operation of a physically secure environment, whichentails, among other security and safety measures, a routine patrol of thepremises by trained correctional officers, alarmed fencing and razor wire andcentralized monitoring of activity via closed circuit camera systems. Whileincarcerated, offenders are offered a variety of educational, counseling andvocational programs aimed at providing a successful return to the community anda subsequent reduction in recidivism.

 

5

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As of December 31, 2007 we operated 10 adultsecure facilities with an aggregate service capacity of 10,558. Within thedivision, we offer the following:

 

·                  Low-to maximum-security incarceration and detention,

·                  Confinementof juveniles adjudicated as adults,

·                  Facilitydesign, construction and operation,

·                  Useof modern security technology, including electronic controls and surveillanceequipment,

·                  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,

·                  Substanceabuse counseling,

·                  Lifeskills training, including anger management, hygiene, personal finance,employment and housing issues, and parenting skills,

·                  Religiousopportunities and culturally sensitive programs,

·                  Foodand laundry service, and

·                  Recreationalactivities, including exercise programs.

 

## *Abraxas Youth and Family Services*

##  

The juvenile justice industry sector includesresidential, detention, shelter care and community-based services, along witheducational, rehabilitation and treatment programs. This sector is highlyfragmented with several thousand providers operating across the country. Mostof the private providers are small and operate in specific geographic areas.

 

Juvenile justice issues present a growing area ofconcern for many states due to the number of youth within the judicial system,as well as the related annual expenditures for placement and treatment. Beyondaddressing capacity issues within the juvenile justice system, states are alsofacing challenges posed by the unique needs of specialized juvenilepopulations, such as those with mental/behavioral health issues. Partnershipswith private providers such as Cornell can provide quality alternatives forcare.

 

We believe that our Abraxas Youth and FamilyServices division is uniquely equipped to address the issues currently facingthe juvenile justice system. While the market is fragmented with providerslocated across the country, we offer a national presence with locations in bothurban areas as well as suburban and rural settings.  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, competencydevelopment and community protection.

 

As of December 31, 2007, we operated 18residential facilities and 11 non-residential community-based programs withinour Abraxas division, representing operating service capacity of 3,633. We alsohad one vacant facility with a service capacity of 70. Within the division, weoffer 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,

·                  Substanceabuse counseling and treatment, relapse prevention and education,

·                  Lifeskills training, including hygiene, personal finance, employment and housingissues, and parenting skills,

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

·                  Recreationalactivities, including exercise programs.

 

6

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###### ***Adult Community-BasedServices***

 

Community-based corrections services involve thesupervision of adult parolees and probationers. Parolees are persons who haveserved time in a correctional facility and have been released due to eithermandatory conditional release or a parole board decision. Probationers havebeen charged with a crime but sentenced to probation in lieu of incarceration.Services provided to parolees and probationers include temporary housing,employment assistance, anger management instruction, personal financemanagement training, academic opportunities, vocational training and substanceabuse or addiction counseling.

 

Community-based treatment services include bothresidential and outpatient substance abuse programs. Services includeshort-term and long-term residential care, counseling, HIV services, DUIservices, detoxification and methadone maintenance.

 

We believe that our adult community-based programsprovide positive environments of care for both corrections and treatmentclients. The market is fragmented with providers located across the country.Whereas most providers in the industry are small and have limited geographicreach, Cornell offers a national presence with locations in large urban areas,as well as suburban and rural settings. The adult community-based programsprovide an alternative to incarceration and a focus on transitioning offendersfrom a correctional facility back into society. Through a system of education,employment training, treatment, monitoring and accountability, clients aregiven the necessary tools to make positive life choices that can reduce theincidence of recidivism.

 

As of December 31, 2007, we operated 28residential community-based facilities and six non-residential community-basedprograms with a combined total service capacity of 4,326.  Within the division, we offer the following:

 

·                  Minimum-securityand staff-secure residential services,

·                  Homeconfinement and 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,

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

·                  Lifeskills training, including hygiene, personal finance, housing issues, andparenting skills, and

·                  Municipaljail management.

 

**Facilities**

 

At December 31, 2007, we operated 73 facilitiesand had one vacant facility. In addition to providing management services, wedevelop, design and/or construct many of our facilities.

 

Either through outright ownership or long-termleases, we control operating facilities representing a large majority of ourrevenues. We believe that such control increases the likelihood of contractrenewal, allows us to expand existing facilities and thereby realize economiesof scale, and enhances our ability to win new contracts and control repaircosts. In addition, we believe that long-term control of our operatingfacilities allows us to better manage cost-escalation pressures.

 

7

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The following table summarizes certain additionalinformation with respect to our facilities as of December 31, 2007.  As indicated, the majority of the facilitiesat which we provide services are either owned or leased under long-term leases,which are generally under terms ranging from one to 45 years.

 

 
| **Facility Name and Location**                        | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed  (3)** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|---------------------------------------------------|------------|
|                                                                 |       |                                  |       |                                 |       |                                              |       |
| ***Adult Secure Services Facilities:***                              |       |                                  |       |                                 |       |                                              |       |
| ***Residential Facilities***                                         |       |                                  |       |                                 |       |                                              |       |
|                                                                 |       |                                  |       |                                 |       |                                              |       |
| Baker Community Correctional Facility                                |       |                                  |       |                                 |       |                                              |       |
| Baker,  California                                                   |       | 262                                   |       | 1987                                 |       | Owned                                             |       |
| Big Spring Correctional Center                                       |       |                                  |       |                                 |       |                                              |       |
| Big Spring, Texas                                                    |       | 3,509                                 |       | 1989                                 | (4)        | Leased                                            | (5)        |
| D. Ray James Prison                                                  |       |                                  |       |                                 |       |                                              |       |
| Folkston, Georgia                                                    |       | 1,725                                 |       | 1998                                 |       | Leased                                            | (5)        |
| Great Plains Correctional Facility                                   |       |                                  |       |                                 |       |                                              |       |
| Hinton, Oklahoma                                                     |       | 916                                   |       | 2007                                 | (6)        | Leased                                            | (5)        |
| High Plains Correctional Facility                                    |       |                                  |       |                                 |       |                                              |       |
| Brush, Colorado                                                      |       | 270                                   |       | 2007                                 |       | Owned                                             |       |
| Leo Chesney Community Correctional Facility                          |       |                                  |       |                                 |       |                                              |       |
| Live Oak, California                                                 |       | 305                                   |       | 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                                           |       |
|                                                                 |       |                                  |       |                                 |       |                                              |       |
| ***Abraxas Youth and Family Services Facilities:***                  |       |                                  |       |                                 |       |                                              |       |
| ***Residential Facilities***                                         |       |                                  |       |                                 |       |                                              |       |
|                                                                 |       |                                  |       |                                 |       |                                              |       |
| 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                                            |       |

 

*(Tablecontinued on following page)*

 

8

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| **Facility Name and Location**                                           | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|-----------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|--------------------------------------------------|------------|
|                                                                                    |       |                                  |       |                                 |       |                                             |       |
| ***Abraxas Youth and Family Services  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                                   |       | 2007                                 | (10)       | Leased                                           | (5)        |
| 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                                            |       |
| Washington Facility   Washington, D.C.                                                  |       | 70                                    |       |                                 | (11)       | Owned                                            |       |
| Woodridge   Woodridge, Illinois                                                         |       | 158                                   |       |                                 | (8)        | Owned                                            |       |
|                                                                                    |       |                                  |       |                                 |       |                                             |       |
| ***Abraxas Youth and Family Services  Facilities: Non-Residential Facilities***         |       |                                  |       |                                 |       |                                             |       |
|                                                                                    |       |                                  |       |                                 |       |                                             |       |
| Delaware Community-Based Programs   Milford, Delaware                                   |       | 66                                    |       | 1994                                 |       | Leased                                           |       |
| Harrisburg Day Treatment   Harrisburg, Pennsylvania                                     |       | 45                                    |       | 1996                                 |       | Leased                                           |       |
| Lebanon Alternative Education   Lebanon, Pennsylvania                                   |       | 225                                   |       | 2004                                 |       | Managed                                          |       |
| Lehigh Valley Community-Based Programs   Lehigh Valley, Pennsylvania                    |       | 60                                    |       | 1992                                 |       | Leased                                           |       |

 

*(Tablecontinued on following page)*

 

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| **Facility Name and Location**                                                | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|--------------------------------------------------|------------|
|                                                                                         |       |                                  |       |                                 |       |                                             |       |
| ***Abraxas Youth and Family Services  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                                           |       |
| York County Community Programs   Harrisburg, Pennsylvania                                    |       | 36                                    |       | 1999                                 |       | Leased                                           |       |
|                                                                                         |       |                                  |       |                                 |       |                                             |       |
| ***Adult Community-Based Services Facilities:  Residential Facilities***                     | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** **                                       |       |
| ** **                                                                                   | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** **                                       |       |
| Beaumont Transitional Treatment Center   Beaumont, Texas                                     |       | 180                                   |       | 2002                                 |       | Owned                                            |       |
| 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                                           |       |
| 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                                          |       |
| Los Angeles City Jails (12)   Los Angeles Metropolitan Area, California                      |       | 249                                   |       |                                 | (12)       | Managed                                          |       |
| Marvin Gardens Center   Los Angeles, California                                              |       | 52                                    |       | 1981                                 |       | Leased                                           |       |
| McCabe Center   Austin, Texas                                                                |       | 90                                    |       | 1999                                 |       | Owned                                            |       |
| Mid Valley House   Edinburg, Texas                                                           |       | 96                                    |       | 1998                                 |       | Leased                                           |       |
| Midtown Center   Anchorage, Alaska                                                           |       | 32                                    |       | 1998                                 |       | Owned                                            |       |

 

*(Tablecontinued on following page)*

 

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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 Services 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                                            |       |
| 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 Services Facilities:   Non-Residential Facilities***        | ** **   | ** **                            | ** **   | ** **                           | ** **   | ** **                                       |       |
| ** **                                                                           | ** **   | ** **                            | ** **   | ** **                           | ** **   | ** **                                       |       |
| East St. Louis   East St. Louis, Illinois                                            |         | 164                                   |         |                                 | (8)          | Leased                                           |       |
| LifeWorks   Joliet, Illinois                                                         |         | 116                                   |         |                                 | (8)          | Leased                                           |       |
| Sentencing Concepts (13)   California                                                |         | 400                                   |         |                                 | (14)         | Leased                                           |       |
| Southwood   Chicago, Illinois                                                        |         | 554                                   |         |                                 | (8)          | Owned                                            |       |

 

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| (1) |   | Residential service capacity is comprised of the number of beds currently  available for service in our residential facilities. Non-residential service  capacity is based on either contractual terms or our estimate of the number  of clients to be served. We update these estimates at least annually based on  the program’s budget and other factors.                                                                                                                                                                                                   |
|-----|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Date from which  we, or our predecessor, have had a contract for services on an uninterrupted  basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| (3) |   | We do not incur  any facility use costs, such as debt service, rent or depreciation for  facilities that we operate under a management contract only; however, we are  responsible for all other facility operating costs at these managed  facilities.                                                                                                                                                                                                                                                                                                             |
| (4) |   | The Big Spring Correctional Center was originally operated under an  Intergovernmental Agreement (“IGA”) that commenced in 1989 between the City  of Big Spring and the BOP. On April 1, 2007, the IGA was replaced by a  direct contract between the BOP and the Company. Refer to Item 7 -  “Management’s Discussion and Analysis of Financial Condition and Results of  Operations - Significant 2007 Events– Big Spring Correctional Center” for  further discussion concerning the Big Spring Correctional Center contract. |
| (5) |   | Facility was sold in August 2001 to Municipal Corrections  Finance, L.P. (“MCF”) as part of the 2001 Sale and Leaseback Transaction as  discussed in Note 13 to the consolidated financial statements in Item 8 of  this report.                                                                                                                                                                                                                                                                                                                     |

 

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| (6)  |   | This facility was formerly operated pursuant to a one-year contract  with nine one-year renewal options between the Oklahoma Department of  Corrections (“OK DOC”) and the Hinton Economic Development Authority, or  HEDA. HEDA in turn had subcontracted the operations of this facility to the  Company under a 30-year operating contract with four five-year renewal options.  In October 2006, HEDA provided the OK DOC with notice of our intent to  terminate their contract with OK DOC. In May 2007, we were  awarded a contract by the Arizona Department of Corrections for this  facility. We began receiving inmates under this contract in  September 2007. Refer to  Item 7 - “Management’s Discussion and Analysis of Financial Condition and  Results of Operations - Significant 2007 Events – Great Plains Correctional  Facility” of this report for further discussion concerning this facility and  the related operating contract.              |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (7)  |   | We leased the Regional Correctional Center in  January 2003 and renovated the facility in 2003 and 2004. The facility  commenced operations in July and December of 2004 under an IGA  between Bernalillo County and the USMS. In 2005, the IGA was replaced with a  new contract between Bernalillo County and the U.S. Department of Justice  Office of Detention Trustee, which allows for services to be provided to both  the USMS and ICE. In 2006, we added contracts with Bernalillo County and the  New Mexico Department of Corrections. In July 2007, we were notified by  ICE that they were removing all their detainees from the facility. ICE has  recently indicated that it will not resume use of the facility. Refer to Item  7 – “Management’s Discussion and Analysis of Financial Condition and Results  of Operations - Significant 2007 Events – Regional Correctional Center” of  this report for further discussion concerning this facility. |
| (8)  |   | These facilities are operated pursuant to the Cornell Interventions  programs/facilities contract with numerous agencies throughout Illinois.  Initial contract dates vary by agency and range from 1974 to 1997.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| (9)  |   | We closed the Cornell Abraxas Academy (formerly the New Morgan  Academy) in 2002. In October 2006, we reactivated the facility as  a residential treatment center. Refer to Item 7 - “Management’s Discussion  and Analysis of Financial Condition and Results of Operations – Contractual  Uncertainties Related to Certain Facilities – Cornell Abraxas Academy” of  this report for further discussion concerning the reactivation of this  facility.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| (10) |   | We closed the Hector Garza Residential  Treatment Center (formerly the Campbell Griffin Treatment Center) in the  fourth quarter of 2005. We reactivated the facility in August 2007.  Refer to Item 7 – “Management’s Discussion and Analysis of Financial  Condition and Results of Operations - Significant 2007 Events – Hector Garza  Residential Treatment Center” of this report for further discussion  concerning this facility.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| (11) |   | We closed the Washington D.C. Facility  (formerly the Jos-Arz Academy) in 2005 and are currently considering several  options for use, including the operation of a new program. Refer to Item 7 –  “Management’s Discussion and Analysis of Financial Condition and Results of  Operations - Significant 2007 Events – Washington, D.C. Facility” of this  report for further discussion concerning this facility.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| (12) |   | Los Angeles City Jails represents seven individual locations in Los  Angeles, California and the surrounding area. Initial contract dates vary by  agency and range from 1994-2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| (13) |   | Sentencing Concepts represents three  individual facilities in the following California locations: San Luis Obispo,  Santa Maria and Stockton. Initial contract dates vary by agency and range  from 1994-2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (14) |   | We gave our client, Lincoln County, notice  of termination of the management contract in February 2008. We expect  the contract to terminate in early May 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |

 

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**Marketing and Business Development**

 

Our principal customers are federal, state,and local government agencies responsible for adult and juvenile corrections,treatment and educational services. We manage our business development effortsto address opportunities available in all of our divisions and potentialmarkets. While such opportunities necessarily include forming relationshipswith new customers, we also believe that further potential lies in themanagement of our existing relationships through improved bed management(including both utilization and customer mix) and through enhancements of ourcontract terms. From time to time, we will also evaluate opportunities foraccretive acquisition.

 

In most instances, we pursue developmentopportunities through Requests for Proposal (“RFPs”) or Requests forQualifications (“RFQs”), which are submitted in response to government agencies’solicitations for bids. The decision to respond to such solicitations is basedupon several factors, including management’s assessment of customer needs, thecompany’s ability to service the needs in an operationally successful andacceptably profitable manner, and the fit of the potential program within thecompany’s existing portfolio and strategic objectives. The solicitationsgenerally require the bidder to demonstrate relevant operational experience.Furthermore, the response must also include descriptions of the services to beprovided by the bidder and the price at which the bidder is willing to providethem. Services can include not only direct care, but also the design,construction, or renovation of the related facility.

 

If we believe a project described in an RFPis consistent with our strategic business plan, we will submit a proposal tothe requesting agency. When responding to RFPs, we typically incur costsranging from $10,000 to $100,000 per proposal. In addition, we could incursubstantial costs to acquire options to lease or purchase land for a proposedfacility or to lease or purchase an existing building to house a program. Thepreparation of a response usually requires four to 12 weeks. The award processusually takes an additional three to nine months. If new construction isrequired by the contract, the selected company’s operation of the facilitygenerally begins between nine and 18 months following award announcement,although in some cases as early as four months. In instances where constructionis required, our success depends, in part, upon our ability to acquire propertythat is not only satisfactory for programmatic needs but also that lies in acommunity where social opposition does not significantly impede our ability tooperate. We may incur significant expenses in responding to such opposition,and our response may not be successful. In addition, we may choose not torespond to an RFP or may withdraw a submitted proposal if significant legalaction or other forms of opposition are anticipated or encountered.

 

In addition to responding to RFPs, we alsorely upon court-referrals, insurance- or managed care-referrals, andself-referrals for business growth, particularly in our juvenile and adultcommunity-based treatment programs. In such instances, court and communityliaisons play a significant role in developing our growing network of clients.

 

#### **Contracts**

####  

Our facility operating contracts generallyprovide that we will be compensated via an occupant per diem rate, fees fortreatment services, guaranteed take-or-pay terms, a fixed fee, or cost-plusreimbursement. Factors we consider in determining billing rates include (1) thespecified programs provided for by the contract and the related staffinglevels, (2) wage levels customary in the respective geographic area, (3) whetherthe proposed facility is to be leased or purchased, and (4) theanticipated average occupancy levels that we believe could reasonably bemaintained (and the ramp up schedule required to reach stable populations).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 contracts that leverage ourexisting infrastructure and capabilities. A significant portion 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 severaldiverse markets, we view our competition within these separate markets. Webelieve our principal non-governmental competitors in the Adult Secure marketare Corrections Corporation of America, Inc., The Geo Group, Inc.,and Management and Training Corporation. Within our two other segments —Abraxas Youth and Family Services and Adult Community-Based – we typicallyencounter a significantly more fragmented competitor base, which includes notonly for-profit operators like ourselves but also not-for-profit organizations.Within the Abraxas Youth and Family Services division, some of our primarynon-governmental competitors include ViaQuest, Youth and Family CenteredServices, Securicor New Century and Ramsay Youth Services. Our larger non-governmentalcompetitors in the adult community-based market include Dismas House, Bannum,Gateway, Salvation Army and Volunteers of America.

 

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**Employees**

 

At December 31, 2007, we had 4,037 full-timeemployees and 402 part-time employees. We employ management, administrative andclerical, security, educational and counseling services, health services andgeneral maintenance personnel. Approximately 854 employees at four of ourfacilities are represented by unions.

 

**Regulations**

 

The industry in which we operate is subject tofederal, state and local regulations administered by a variety of regulatoryauthorities. Generally, prospective providers of correctional, detention,educational, treatment and community-based services must comply with a varietyof applicable federal, state and local regulations, including correctional,education, healthcare, environmental and safety regulations. Our contractsfrequently include extensive reporting requirements, including mandatorysupervision with on-site monitoring by representatives of our contractinggovernment agencies, as well as audits by these and other governmentaldepartments.

 

In addition to regulations requiring certaincontracting government agencies to enter into a competitive bidding procedurebefore awarding contracts, the laws of certain jurisdictions may also requireus to award subcontracts on a competitive basis or to subcontract withbusinesses owned by women or members of minority groups.

 

**Business Concentration**

 

For the years ended December 31, 2007, 2006 and2005, 32.1%, 28.2% and 23.0%, respectively, of our consolidated revenues werederived from multiple contracts with the BOP.

 

**Insurance**

 

We maintain general liability insurance for all ofour operations at an amount equal to $10 million per occurrence per facilityand in the aggregate. We also maintain insurance in amounts management deemsadequate to cover property and casualty risks, workers’ compensation, anddirectors’ and officers’ liability.

 

Our contracts and the statutes of certain states inwhich we operate typically require us to maintain insurance. Our contractsprovide that, in the event we do not maintain such insurance, the contractingagency may terminate its agreement with us. We believe that we are incompliance in all material respects with these requirements.

 

**Environmental Matters**

 

We are subject to various federal, state, and local environmental lawsand regulations, and these laws can impose strict liability for the dischargeof hazardous or toxic substances. As an owner and operator of facilities, weare subject to these laws and could be responsible for the discharge ofcontaminants at our facilities. We are not currently incurring material costsassociated with environmental compliance or remediation, although in the eventwe had an environmental issue at any of our current or previously-ownedfacilities, the cost of complying with these environmental laws couldmaterially adversely affect our financial condition and results of operations.

 

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**ITEM 1A.****     RISKFACTORS**

 

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

*** ***

Management of correctional and detention facilities,particularly of adult secure facilities, by private entities has not achievedcomplete acceptance by either the government or the public. The movement towardprivatization of correctional and detention facilities has also encounteredresistance from certain groups, such as labor unions, local sheriff’sdepartments, religious organizations and groups believing that correctional anddetention facility operations should only be conducted by government agencies.Changes in the dominant political party in any market in which correctionalfacilities are located could have an adverse impact on privatization.Furthermore, some government agencies are not legally permitted to delegatetheir traditional management responsibilities for correctional and detentionfacilities to private companies.

 

In addition, as a private prison manager, we aresubject to government legislation and regulation restricting the ability ofprivate prison managers to house certain types of inmates, such as inmates fromother jurisdictions or inmates at medium or higher security levels. Legislationhas been enacted in several states, and has previously been proposed in theUnited States House of Representatives, containing such restrictions. Any suchlegislation may have a material adverse affect on us.

 

Any of these resistances may make it more difficultfor us to renew or maintain existing contracts, to obtain new contracts orsites on which to operate new facilities or to develop or purchase facilitiesand lease them to government or private entities, any or all of which couldhave a material adverse effect on our business.

 

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

 

Many governmental agencies are legally limited intheir ability to enter into long-term contracts that would bind electedofficials responsible for future budgets. Therefore, many contracts withgovernment agencies, including the BOP, typically either have a very short termor are subject to termination on short notice without cause. The majority ofour contracts have primary terms of one to three years. Our contracts withgovernmental agencies may contain one or more renewal options that may beexercised only by the contracting governmental agency. Some of these contractsmay not be renewed by the governmental agency and no assurance can be giventhat the governmental agency will exercise a renewal option in the future. Inaddition, the governmental agency may elect to solicit bids pursuant to a RFPor RFQ rather than exercise a renewal option. We may not be successful in respondingto a RFP or RFQ.

 

The non-renewal or termination of any of oursignificant contracts with governmental agencies, our inability to secure newfacility management contracts from others or our failure to successfullyrespond to a RFP or RFQ could materially adversely affect our financialcondition, results of operation and liquidity. To the extent we have madesignificant capital expenditures and have short-term contracts with ourcustomers that are not renewed or extended, we may not recover our entirecapital investment.

 

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

*** ***

Our cash flow is subject to the receipt ofsufficient funding of and timely payment by contracting governmental entities.If the appropriate governmental agency does not receive sufficientappropriations to cover its contractual obligations, a contract may beterminated or the amounts payable to us may be deferred or reduced.

 

Federal, state and local governments haveencountered, and are expected to continue to encounter, significant budgetaryconstraints that may result in a reduction of spending on the outsourcedservices that we provide. Such budgetary limitations may cause the contractualcommitments to be reduced or even eliminated, which would make it unprofitableto continue operating a certain facility and require us to find alternatecustomers or close such facility.

 

Many states are facing significant budget deficitsand are under pressure to reduce current levels of spending or controladditional spending. As a result of this increased budgetary pressure, incertain cases we have granted a few of our customers relief from formulaicincrease provisions in their agreements and some of our customers have notincluded in their appropriation legislation amounts that would increase the perdiem rates payable to us. Contractual rate increases are generally intended tooffset increases in expenses and inflation. To the extent rates are notincreased or are reduced, our profitability will be adversely affected.

 

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

 

Our growth is generally dependent upon our abilityto win new contracts to develop and manage new correctional, detention andtreatment facilities. This depends on a number of factors we cannot control,including crime rates and sentencing patterns in various jurisdictions.Accordingly, the demand for our facilities could be adversely affected by therelaxation of enforcement efforts, leniency in conviction and sentencingpractices or through the legal decriminalization of certain activitiesthat are currently proscribed by criminal laws. For instance, changes in lawsrelating to drugs and controlled substances or illegal immigration could reducethe number of persons arrested, convicted and sentenced, thereby potentiallyreducing demand for correctional facilities to house them and community-basedservices to transition offenders back into the community. Similarly, reductionsin crime rates could lead to reductions in arrests, convictions and sentencesrequiring correctional facilities.

 

When seeking bids, most governmental entitiesevaluate the financial strength of the bidders. To the extent they believe wedo not have sufficient financial resources, we will be unable to effectivelycompete for bids. Additionally, our success in obtaining new awards andcontracts may depend, in part, upon our ability to locate land that can beleased or acquired on favorable terms. Furthermore, desirable locations may bein or near populated areas and, therefore, may generate legal action or otherforms of opposition from residents in areas surrounding a proposed site.

 

***Our profitability may suffer if thenumber of offenders occupying our correctional, detention and treatmentfacilities decreases or there is a shift in occupancy among our divisions.***

 

Our correctional, detention and treatment facilitiesare dependent upon governmental agencies supplying offenders and we do notcontrol occupancy levels at our facilities. We believe the rate of growthexperienced in the adult secure sector during the late 1980s and early 1990s isstabilizing.

 

Historically, a substantial portion of our revenueshas been generated under contracts that specify a net rate per day perresident, or a per diem rate, sometimes with no minimum guaranteed occupancylevels, even though most correctional facility cost structures are relativelyfixed. Under such a per diem rate structure, a decrease in occupancy levels ata particular facility could have a material adverse effect on the financialcondition and results of operations at such facility. A decrease in theoccupancy of certain juvenile justice, education and treatment facilities wouldhave a more significant impact on our operating results than a decrease inoccupancy in the adult secure services division due to higher per diem revenueat certain juvenile facilities.

 

Certain social commentators and various political orgovernmental representatives suggest that community-based corrections of adultsmay be emphasized in the future as alternatives to traditional incarceration.We have historically experienced higher operating margins in the adult secureservices and the adult community-based services sectors than in the juvenileservices sector. A shift in occupancy among our segments of business operationscould result in a decrease in our profitability.

 

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

 

Our industry is subject to a variety of federal,state and local regulations, including education, environmental, health careand safety regulations, which are administered by various regulatoryauthorities. We may not always successfully comply with these regulations, andfailure to comply could result in material penalties or non-renewal ortermination of facility management contracts. The contracts typically includeextensive reporting requirements and supervision and on-site monitoring byrepresentatives of contracting governmental agencies. Corrections officers arecustomarily required to meet certain training standards, and in some instancesfacility personnel are required to be licensed and subject to backgroundinvestigation. Certain jurisdictions also require that subcontracts be awardedon a competitive basis or that we subcontract with businesses owned by membersof minority groups. The failure to comply with any applicable laws, rules orregulations and the loss of any required license could adversely affect thefinancial condition and results of operations at our affected facilities.

 

***Governmental agencies mayinvestigate and audit our contracts and, if any improprieties are found, we maybe required to refund revenues we have received, and/or to forego anticipatedrevenues and may be subject to penalties and sanctions, including prohibitionson our bidding in response to RFPs.***

 

Governmental agencies we contract with have theauthority to audit and investigate our contracts with them. As part of thatprocess, some governmental agencies review our performance on the contract, ourpricing practices, our cost structure and our 

 

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compliancewith applicable laws, regulations and standards. If the agency determines thatwe have improperly allocated costs to a specific contract, we may not bereimbursed for those costs and we could be required to refund the amount of anysuch costs that have been reimbursed. If a government audit uncovers improperor illegal activities by us or we otherwise determine that these activitieshave occurred, we may be subject to civil and criminal penalties andadministrative sanctions, including termination of contracts, forfeitures ofprofits, suspension of payments, fines and suspension or disqualification fromdoing business with the government. Any adverse determination could adverselyimpact our ability to bid in response to RFPs in one or more jurisdictions andsignificantly reduce the probability of our success in the bid process forfuture contracts.

 

***If we fail to satisfy ourcontractual obligations, our ability to compete for future contracts and ourfinancial condition may be adversely affected.***

 

Our failure to comply with contract requirements orto meet our client’s performance expectations when performing a contract couldmaterially and adversely affect our financial performance and our reputation,which, in turn, would impact our ability to compete for new contracts. Ourfailure to meet contractual obligations could also result in substantial actualand consequential damages. In addition, our contracts often require us toindemnify clients for our failure to meet performance standards. Some of ourcontracts contain liquidated damages provisions and financial penalties relatedto performance failures. Although we have liability insurance, the policylimits may not be adequate to provide protection against all potentialliabilities.

 

***Competitors in our industry mayadversely affect the profitability of our business.***

 

We must compete with government entities and otherprivate operators on the basis of cost, quality and range of services offered,experience in managing facilities, reputation of personnel and ability todesign, finance and construct new facilities on a cost effective competitivebasis. While there are some barriers for companies seeking to enter into themanagement and operation of correctional, detention and treatment facilities,these barriers have not been sufficient to materially limit additionalcompetition. Certain areas of our operation may not pose a significant barrierto entry into the market by private operators. For example, private operatorsmay not find it as difficult to bid for juvenile treatment, educational anddetention services and pre-release correctional and treatment services as theydo adult correctional and detention services.

 

Further, our government customers may assumethe management of a facility currently managed by us upon the termination ofthe corresponding management contract or, if such customers have capacity attheir facilities, may take inmates currently housed in our facilities andtransfer them to government run facilities. The resulting decrease in occupancylevels would reduce our revenue due to the per diem rate structure and couldresult in a significant decrease in the profitability of our business.

 

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

 

An escape, riot, disturbance or violent occurrenceat one of our facilities could adversely affect the financial condition, resultsof operations and liquidity of our operations. Among other things, the negativepublicity generated as a result of an event could adversely affect our abilityto retain an existing contract or obtain future ones. In addition, if such anevent were to occur, there is a possibility that the facility where the eventoccurred may be shut down by the relevant governmental agency. A closure ofcertain of our facilities could adversely affect the financial condition,results of operations and liquidity of our operations. Such negative events mayalso result in a significant increase in our liability insurance costs.

 

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

 

The media frequently focuses its attention onprivate operators’ contracts with governmental agencies. If the media coverageof private operators is negative, it could influence government officials toslow the pace of outsourcing government services, which could reduce the numberof RFPs. The media may also focus its attention on the activities of politicalconsultants engaged by us, even when their activities are unrelated to ourbusiness, and we may be tainted by adverse media coverage about theiractivities. Moreover, inaccurate, misleading or negative media coverage aboutus could harm our reputation and, accordingly, our ability to bid for and wingovernment contracts.

 

***We often incur significant costsbefore receiving related revenues, which could result in cash shortfalls and arisk of not recovering our investment.***

 

When we are awarded a contract to manage a newfacility, we may incur significant expenses before we receive contractpayments. These expenses include purchasing real estate, constructing newfacilities, leasing office space, purchasing office equipment and hiring andtraining personnel. As a result, when the government does not fund a facility’spre-opening and start-

 

17

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upcosts, we may be required to invest significant sums of money before receivingrelated contract payments. In addition, payments due to us from governmentalagencies may be delayed due to billing cycles or as a result of failures by ourgovernmental customers to attain necessary budget approvals and finalizecontracts in a timely manner. Several juvenile services contracts related toeducational services provide for annual collection several months after aschool year is completed. In addition, a contract may be terminated prior toits scheduled expiration and as a result we may not recover these expenses orrealize any return on our investment.

 

We may choose to undertake development projectswithout written commitments to make use of such facilities. We may not be ableto obtain contracts for these facilities in a timely fashion, if at all. To theextent we do not obtain contracts, we could be unable to recover our investmentand our financial condition and results of operations would be adversely affected.

 

***We require significant financing forcapital expenditures.***

 

Wehave several ongoing expansion projects underway and anticipate commencingother projects, and we will likely need to finance these future outlays ofcapital since our cash on hand and cash flows from operations will not besufficient to fully fund all of these potential expenditures.  To the extent our cash and current financingarrangements do not provide sufficient financing to fund these projects,financing may not be available or may only be available on terms that areunfavorable to us.

 

***We may be unable to attract andretain sufficient qualified personnel necessary to sustain our business.***

 

Our delivery of services is labor-intensive. When weare awarded a contract, we must hire operating management, security, casemanagement and other personnel. The success of our business requires that weattract, develop, motivate and retain these personnel. Our ability to recruitand retain qualified individuals varies by facility and is related to thesocio-economic factors in the particular community in which the facilityoperates. The Department of Labor wages we offer our employees are often higherthan wages they could obtain elsewhere in the community. However, if the localeconomy where a facility is located is robust and unemployment is low, we mayhave difficulty hiring and retaining qualified personnel. In addition, thereare inherent risks associated with the nature of the services we provide, whichcould cause certain qualified individuals to seek other employmentopportunities. We have experienced high turnover of personnel in our juvenileand adult secure facilities within the first year of their employment. Ourinability to hire sufficient personnel on a timely basis or the loss of significantnumbers of personnel could adversely affect our business.

 

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

 

We may be unable to manage businesses that we mayacquire profitably or integrate them successfully without incurring substantialexpenses, delays or other problems that could negatively impact our results ofoperations. Acquisitions generally require the integration of facilities, someof which may be located in states in which we do not currently have operations.

 

Moreover, business combinations involve additionalrisks, 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 possible impairment charges of acquired intangible assets, includinggoodwill; and

·   dilutionto our earnings per share.

 

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

 

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

 

Our facilities, and any facilities that we mayacquire in the future, may be subject to unforeseen environmental risks. Thefederal Comprehensive Environmental Response, Compensation, and Liability Act(CERCLA) imposes strict, as well as joint and several, liability for certainenvironmental cleanup costs on several classes of potentially responsibleparties, including current owners and operators of the property. Other federaland state laws in certain circumstances may impose liability for environmentalremediation, which costs may be substantial. Further, the operation of ourfacilities, and the development of new 

 

18

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facilities,requires that we obtain, and comply with, permits and other authorizationsunder environmental laws. Obtaining such permits and authorizations may affectour existing facilities or could delay the opening of new facilities, which couldhave a material adverse effect on our business and results of operations.

 

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

*** ***

If we close a facility, we may remain committed toperform our obligations under the applicable lease, which would include, amongother things, payment of the base rent for the balance of the lease term. Wemay also be required to incur other expenses with respect to such facilities.The potential losses associated with our inability to cancel leases may resultin our keeping open underperforming facilities. As a result, ongoing leaseoperations at closed or under-performing facilities could impair our results ofoperations.

 

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

*** ***

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

 

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

*** ***

We currently derive, and expect to continueto derive, a significant portion of our revenues from the BOP and various stateagencies. The loss of, or a significant decrease in, business from the BOP orthose state agencies could seriously harm our financial condition and resultsof operations. Our BOP contracts accounted for approximately 32.1% of our totalrevenues for the year ended December 31, 2007 ($115.8 million), 28.2 % ofour total revenues for the year ended December 31, 2006 ($101.9 million)and 23.0% of our total revenues for the year ended December 31, 2005($71.6 million). We expect to continue to depend upon the BOP and a relativelysmall group 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 fluctuate from year to year dueto changes in government funding policies, changes in the number of clientsreferred to our facilities by governmental agencies, the opening of newfacilities or the expansion of existing facilities and the termination ofcontracts for a facility or the closure of a facility. Our revenues fluctuatefrom quarter to quarter, based on the number of contracted days in eachquarter. Because our revenues can vary, we may face short-term fundingshortfalls from time to time. In addition, full-year results are not likely tobe a direct multiple of any particular quarter or combination of quarters.

 

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

*** ***

Worker’s compensation, employee health and generalliability insurance represent significant costs to us. We may continue to incurincreasing insurance costs, typically due to adverse claims experience orrising healthcare costs in general. Due to concerns over corporate governanceand recent corporate accounting scandals, liability and other types of insurancehave become more difficult and costly to obtain. In addition, stockholderlawsuits will generally serve to increase our directors and officers liabilityinsurance. Unanticipated additional insurance costs could adversely impact ourresults of operations and cash flows, and the failure to obtain or maintain anynecessary insurance coverage or the inability of an insurance carrier toperform under its obligations through issued coverage could have a materialadverse effect on us.

 

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

*** ***

Many of our facility management contracts providefor fixed management fees or fees that increase by only small amounts duringtheir term. If, due to inflation or other causes, our operating expenses, suchas wages and salaries of our employees, and insurance, medical and food costs,increase at rates faster than increases, if any, in our management fees, thenour profitability would be adversely affected.

 

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

*** ***

Our ownership of correctional and detentionfacilities subjects us to risks typically associated with investments in realestate. Moreover, correctional and detention facilities are relatively illiquidand therefore, our ability to divest ourselves of one 

 

19

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ormore of our facilities promptly in response to changed conditions is limited.Investments in correctional and detention facilities subject us to risksinvolving potential exposure to uninsured loss. Our operating costs may beaffected by the obligation to pay for the cost of complying with existing laws,ordinances and regulations, as well as the cost of complying with futurelegislation. In addition, although we maintain insurance for many types oflosses, there are certain types of losses, such as losses from earthquakes,riots and acts of terrorism, which may be either uninsurable or for which itmay not be economically feasible to obtain insurance coverage. As a result, wecould lose both our capital invested in, and anticipated profits from, one ormore of the facilities we own. Further, we could experience losses that mayexceed the limits of our insurance coverage.

 

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

 

None

 

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

 

We lease office space for our corporate headquartersin Houston, Texas and a regional administrative office in Pittsburgh,Pennsylvania. We also lease various facilities we are currently operating ordeveloping. For a listing of owned, leased and managed facilities, see “Business- Facilities” in Item 1 of this report.

 

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

 

We are party to various legal proceedings,including those noted below. While management presently believes that theultimate outcome of these proceedings will not have a material adverse effecton our financial position, overall trends in results of operations or cashflows, litigation is subject to inherent uncertainties, and unfavorable rulingscould occur. An unfavorable ruling could include monetary damages or equitablerelief, and could have a material adverse impact on the net income of theperiod in which the ruling occurs or in future periods.

 

***Valencia CountyDetention Center***

 

In April 2007, a lawsuit was filed against the Company in theFederal District court in Albuquerque, New Mexico, by Joe Torres and EufrasioArmijo, who each alleged that he was strip searched at the Valencia CountyDetention Center (“VCDC”) in New Mexico in violation of his federal rightsunder the Fourth, Fourteenth and Eighth amendments to the U.S.Constitution.  The claimants also allege violation of their rights understate law and seek to bring the case as a class action on behalf of themselvesand all detainees at VCDC during the applicable statues of limitation. The plaintiffs seek damages and declaratory and injunctive relief. Valencia County is also a named defendant in the case and operated the VCDC fora significantly greater portion of the period covered by the lawsuit.  Discovery has commenced in the case but theultimate outcome of the lawsuit cannot be determined at this time. However, weintend to vigorously defend this lawsuit.

 

***Lincoln CountyDetention Center***

 

In August 2005, a lawsuit was filed by a detainee at the LincolnCounty Detention Center (“LCDC”) in the U.S. District Court of New Mexico(Santa Fe) seeking unspecified damages. The lawsuit relates to the former LCDCpolicy that required strip and visual body cavity searches for all detaineesand inmates and alleges that such policy violates a detainee’s Fourth andFourteenth Amendment rights under the U.S. Constitution. The lawsuit was filedas a putative class action lawsuit brought on behalf of all inmates who weresearched at the LCDC from May 2002 to July 2005. In September 2006,we agreed to a proposed stipulation of settlement and the court haspreliminarily approved the settlement. The settlement amount under the terms ofthe agreement is $1.6 million, and was funded principally through our generalliability and professional liability coverage.

 

In the year ended December 31, 2005, we recorded a charge of $0.2million related to this lawsuit. In addition, we previously have providedinsurance reserves for this matter (as part of our regular review of reportedand unreported claims) totaling approximately $0.5 million. During the thirdquarter of 2006, we recorded an additional settlement charge of approximately$0.9 million and the related reimbursement from our general liability andprofessional liability insurance. The charge and reimbursement were recognizedin general and administrative expenses for the year ended December 31,2006. The reimbursement was funded by the insurance carrier in the firstquarter of 2007 into a settlement account. The court granted preliminaryapproval of the settlement in the second quarter of 2007, and the claimsadministration process is now underway. We expect the claims administrationprocess to be completed and the final court approval of the settlement in thefirst half of 2008.

 

20

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***Alexander Youth Service Center***

 

In April 2006, we were sued in an action styled as *Juana Michelle Brown, Administratrix of the Estate of LakeishaShantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV00000434, in the United States District Court for the EasternDistrict of Arkansas. The lawsuit alleges that we violated the rights ofLakeisha Shantrail Brown, the deceased daughter of Juana Michelle Brown, underthe U.S. Constitution and the laws of the State of Arkansas by denying Ms. Brownmedical treatment that caused her death and sought unspecified actual andpunitive damages. In September 2006, the plaintiff filed, and the courtgranted, an order for voluntary dismissal without prejudice. The lawsuit wasrefiled in December 2006 as *Juana Michelle Brown, Administratrixof the Estate of Lakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc.et al.,*No. 4-06 CV17808*,*in the UnitedStates District Court for the Eastern District of Arkansas. We have reached anagreement with the plaintiff to settle the matter, and the settlement must beapproved by a probate court. Our insurance coverage is sufficient to cover thesettlement subject to our normal deductible.

 

***Southern Peaks Regional Treatment Center***

 

In January 2004, we initiated legal proceedings in the lawsuitstyled *Cornell Corrections of California, Inc. v.Longboat Global Advisors, LLC, et al*., No.2004 CV79761 in theSuperior Court of Fulton County, Georgia under theories of fraud, conversion,breach of contract and other theories to determine the location of and torecover funds previously deposited by us into what we believed to be an escrowaccount in connection with the development and construction of the SouthernPeaks Regional Treatment Center. Of the funds previously deposited,approximately $5.3 million remains to be recovered at September 30, 2007.In December 2004, the jury awarded us approximately $6.5 million incompensatory damages and approximately $1.4 million in punitive damages, plusattorneys’ fees. The actual damages portion of the award under the finalJudgment and Decree (“Judgment”) entered on December 20, 2006 was adjusteddownward to the $5.4 million actually lost by us. The award for compensatorydamages accrues pre-judgment interest at a rate of 7 percent from the date ofloss through the date of judgment. Following the jury verdicts, we collectedapproximately $0.4 million in January 2005 in funds that had beenpreviously frozen under a temporary restraining order issued at the time thatwe commenced this litigation. Currently, one of the defendants has filed anappeal of the Judgment. Due to the continued uncertainty surrounding theultimate recovery of the funds previously deposited, we recorded an additionalreserve in the amount of approximately $0.3 million in the quarter ended December 31,2006. During 2007 we collected approximately $0.2 million in funds. We willcontinue to maintain our existing reserve at December 31, 2007 ofapproximately $5.1 million in an allowance for doubtful accounts against thecorresponding balance as carried in other receivables at December 31, 2007and 2006. We do not expect any additional material recovery, expense, change orresult from these proceedings.

 

***Shareholder Lawsuits***

 

OnOctober 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 complaint names asdefendants Cornell and each member of our board of directors as well as VeritasCapital Fund III, L.P. (“Veritas”). The complaint alleges, among other things,that (i) the defendants have breached fiduciary duties they assertedlyowed to our stockholders in connection with our entering into the Agreement andPlan of Merger, dated as of October 6, 2006, with Veritas, Cornell HoldingCorp., and CCI Acquisition Corp., and (ii) the merger consideration isunfair and inadequate. The plaintiffs sought, among other things, an injunctionagainst the consummation of the merger. The proposed merger was rejected at aspecial meeting of our stockholders held on January 23, 2007. We believethat the lawsuit is without merit and intend to defend ourselves vigorously.

 

We hold insurance policies to cover potential director and officerliability, some of which may limit our cash outflows in the event of a decisionadverse to us in the matters discussed above. However, if an adverse decisionin these matters exceeds the insurance coverage or if the insurance coverage isdeemed not to apply to these matters, it could have a material adverse effecton us, our financial condition, results of operations and future cash flows.

 

***Other***

 

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

 

21

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During the period from August 2000 through May 2003, ourgeneral liability and professional liability coverage was provided by SpecialtySurplus Insurance Company, a Kemper Insurance Company (“Kemper”) group member.In June 2004, the Illinois Department of Insurance gave Kemper permissionto proceed with a run-off plan it had previously submitted. The three-year planis designed to help Kemper meet its goal of resolving, to the maximum extentpossible, all valid policyholder claims. In view of the risks and uncertaintiesinvolved in implementing the plan, including the need to achieve significantpolicy buybacks, commutation of reinsurance agreements, and further agreementswith regulators, the plan may not be successfully implemented by Kemper. In theyear ended 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 released reserves of approximately $0.4 million duringthe quarter ended December 31, 2006. At December 31, 2007, 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 such matters cannot be predicated with certainty,based on the information known to date, we believe that the ultimate resolutionof these matters will not have a material adverse effect on our financialcondition, but could be material to operating results or cash flows for aparticular reporting period, operating results or cash flows.

 

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

 

None.

 

**PART II**

** **
| **ITEM 5.** | ** ** | **MARKET FOR REGISTRANT’S COMMON  EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY  SECURITIES.** |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------|

 

Our common stock is listed on the New York StockExchange (NYSE) under the symbol “CRN.” As of March 7, 2008, there were 423 record holders of our commonstock. The quarterly high and low closing sales prices for our common stockfrom January 1, 2006 through March 7, 2008 are shown below.

 
| ** **                                 | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------|------------|----------|------------|---------|------------|
|                                       |       |     |       |    |       |
| 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                              |       | $        | 21.45      |    | $          | 18.22 |   |
| Second Quarter                             |       | 25.43    |       | 20.32   |       |
| Third Quarter                              |       | 25.42    |       | 19.14   |       |
| Fourth Quarter                             |       | 27.69    |       | 21.44   |       |
| 2008:                                      |       |     |       |    |       |
| First Quarter (through March 7, 2008) |       | $        | 23.01      |    | $          | 17.42 |   |

 

We have never declared or paid cash dividends on ourcapital stock. We currently intend to retain excess cash flow, if any, for usein the operation and expansion of our business and do not anticipate payingcash dividends on our common stock in the foreseeable future. The payment ofdividends is within the discretion of the Board of Directors and is dependentupon, among other factors, our results of operations, financial condition,capital requirements, restrictions, if any, imposed by financing commitmentsand legal requirements. Our 10.75% Senior Notes, as well as our revolvingcredit facility contain certain restrictions on our ability to pay dividends.See “Management’s Discussion and Analysis of Financial Condition and Results ofOperations - Liquidity and Capital Resources – Long-Term Credit Facilities” inItem 7 of this report.

 

We did not purchase any of our common stock in thefourth quarter of 2007.

 

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The following table summarizes as of December 31,2007 certain information regarding equity compensation to our employees,officers, directors, and other persons under our plans:

 
| ** **                                                  | ** ** | **(A)  Number of  Securities to be  Issued upon  Exercise of  Outstanding Stock  Options and Warrants** | ** ** | **(B)  Weighted-average  Exercise Price of  Outstanding  Stock Options  and Warrants** | ** ** | **(C)  Number of  Securities Remaining  Available for  Future Issuance  Under Equity  Compensation  Plans (Excluding  Securities Reflected  in Column A)** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Plan  Category                                              |       |                                                                                                                                            |       |                                                                                                       |       |                                                                                                                                                                                                    |       |
|                                                        |       |                                                                                                                                            |       |                                                                                                       |       |                                                                                                                                                                                                    |       |
| Equity compensation plans approved by  security holders     |       | 394,500                                                                                                                                         |       | $                                                                                                          | 15.02      |                                                                                                                                                                                                    | 1,120,022  | (1) |
| Equity compensation plans not approved by  security holders |       | 96,342                                                                                                                                          |       | $                                                                                                          | 10.80      |                                                                                                                                                                                                    | 262,375    | (2) |
| Total                                                       |       | 490,842                                                                                                                                         |       | $                                                                                                          | 14.19      |                                                                                                                                                                                                    | 1,382,397  |   |

 

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(1)   Includes 142,433 shares issuable pursuant to our EmployeeStock Purchase Plan and 64,466 shares issuable pursuant to our 2000 DirectorsStock Plan. Also includes 87,123 shares issuable pursuant to our Amended andRestated 1996 Stock Option Plan. The total number of shares issuable pursuantto our Amended and Restated 1996 Stock Option Plan is equal to the greater of1,500,000 shares or 15.0% of the number of shares issued and outstandingimmediately after the grant of any option under the Plan.  Also includes 826,000 shares issuablepursuant to our 2006 Equity Incentive Plan.

(2)   Includes 100,000 shares issuable pursuant to our DeferredCompensation Plan and 162,375 shares issuable pursuant to our 2000 Broad-BasedEmployee Plan. The number of shares issuable pursuant to our 2000 Broad-BasedPlan (2000 Plan) is equal to the greater of 400,000 shares or 4.0% of the sharesissued and outstanding immediately after the grant of any option under thePlan.

 

**Equity Compensation Plans Not Approved by SecurityHolders**

 

***DeferredCompensation Plan***

 

We maintain a Deferred Compensation Plan for thepurpose of providing deferred compensation for eligible employees. The DeferredCompensation Plan is a nonqualified plan.

 

A participant in the Deferred Compensation Plan maydefer into an account a percentage of compensation each year up to 75.0% of theparticipant’s compensation received from Cornell. In addition, we may makecontributions to the Deferred Compensation Plan on behalf of each participant.Compensation deferred by a participant, or contributions made by us on behalfof a participant, will be invested in mutual funds or the common stock ofCornell. Participants are fully vested in their accounts and may elect toreceive the amounts credited to their accounts either in a lump sum or in fiveor ten-year annual installment payments. In the event of a change of control(as defined in the Plan), the amounts in each participant’s account will bepaid to the participant in a lump sum.

 

***Warrants***

 

In conjunction with the issuance of the SubordinatedNotes in July 2000, we issued warrants to purchase 290,370 shares of ourcommon stock at an exercise price of $6.70. The warrants may only be exercisedby payment of the exercise price in cash to us, by cancellation of an amount ofwarrants equal to the fair market value of the exercise price, or by thecancellation of indebtedness owed to the warrant holder. During 2001, 168,292shares of common stock were issued in conjunction with the exercise andcancellation of 217,778 warrants.  During2007, the remaining 72,592 shares of common stock were issues in conjunctionwith the exercise and cancellation of the remaining 72,592 warrants.

 

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***2000 Broad-BasedEmployee Plan***

 

Under our 2000 Plan, we may grant non-qualifiedstock options to our employees, directors and eligible consultants for up tothe greater of 400,000 shares or 4.0% of the aggregate number of shares ofcommon stock issued and outstanding immediately after the grant of any optionunder the 2000 Plan. The 2000 Plan options vest over a period of up to fiveyears and expire ten years from the grant date. The vesting schedule andterm are set by the Compensation Committee of the Board of Directors. Theexercise price of options issued pursuant to the 2000 Plan can be no less thanthe market price of our common stock on the date of grant.

 

Upon notice of an extraordinary transaction (asdefined in the 2000 Plan), options granted under the 2000 Plan become fullyvested. Upon consummation of the extraordinary transaction, such options, tothe extent not previously exercised, automatically terminate.

 

24

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**Performance Graph**

 

The following performance graph compares the cumulative total returnsof the Russell 2000 Stock Index and the Company’s peer group. The graph assumesthat the value of the investment in the Common Stock and each index was $100 asof December 31, 2002 and that all dividends were reinvested on a quarterlybasis.

 

**TOTAL RETURN TO STOCKHOLDERS**

**(Assumes $100 investment on 12/31/02)**

 

 
| **Company Name**      | ** ** | **Dec-02** | ** ** | **Dec-03** | ** ** | **Dec-04** | ** ** | **Dec-05** | ** ** | **Dec-06** | ** ** |
|----------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Cornell Companies Inc.** |       | 100.00     |       | 151.67     |       | 168.67     |       | 153.56     |       | 203.67     |       |
| **Peer Group (1)**         |       | 100.00     |       | 180.34     |       | 236.97     |       | 243.82     |       | 432.18     |       |
| **Russell 2000 Index**     |       | 100.00     |       | 147.27     |       | 174.40     |       | 182.46     |       | 216.08     |       |

 

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(1) Our 2007 peer group consists of the followingcompanies: Corrections Corporation of America and The Geo Group, Inc.

 

**Issuer Purchases of Equity Securities**

 
| **Period**         | ** ** | **Total Number   of Shares   Purchased (1)** | ** ** | **Average Price   Paid Per Share** | ** ** | **Total Number of   Shares Purchased as   Part of Publicly   Announced Plans or   Programs** | ** ** | **Maximum Number (or  Approximate Dollar Value) of   Shares that May Yet Be  Purchased Under the Plans or   Programs ** | ** ** |
|--------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **         | ** ** | ** **                                                            | ** ** | ** **                                             | ** ** | ** **                                                                                                                                               | ** ** | **(in millions)**                                                                                                                                                                                  | ** ** |
| October 2007  |       | 1,572                                                                 |       | $                                                      | 24.88      |                                                                                                                                                     | —     |                                                                                                                                                                                                    | —     |   |
| November 2007 |       | —                                                                |       | —                                                 |       | —                                                                                                                                                   |       | —                                                                                                                                                                                                  |       |
| December 2007 |       | —                                                                |       | —                                                 |       | —                                                                                                                                                   |       | —                                                                                                                                                                                                  |       |
| Total              |       | 1,572                                                                 |       | $                                                      | 24.88      |                                                                                                                                                     | —     |                                                                                                                                                                                                    | —     |   |

 

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(1)Totalnumber of shares purchased in the fourth quarter of 2007 includes 1,572 shareswithheld by us in satisfaction of withholding taxes due upon the vesting ofrestricted shares granted to our employees under our long-term incentive planto pay withholding taxes due upon vesting of a restricted share award.

 

25

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

 

The following data has been derived from our auditedfinancial statements, including those included in this Form 10-K for the yearended December 31, 2007 and should be read in conjunction with theconsolidated financial statements and notes thereto and Item 7 -  “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” included elsewhere in this report.

 
| ** **                                                                               | ** ** | **Year Ended December 31,**                         | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2007**                                                           | ** ** | **2006 (1)** | ** ** | **2005 (2)** | ** ** | **2004 (3)** | ** ** | **2003 (4)** | ** ** |
| ** **                                                                               | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statements of Operations Data:**                                                       |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenues                                                                                 |       | $                                                                  | 360,604    |   | $ | 360,855 |   | $ | 310,775 |   | $ | 277,190 |   | $ | 258,180 |   |
| Income from operations                                                                   |       | 45,009                                                             |       | 44,798 |   | 27,866 |   | 14,459 |   | 24,484 |   |
| Income (loss) from continuing operations   before provision (benefit) for income   Taxes |       | 20,745                                                             |       | 21,728 |   | 6,143 |   | (8,256 | ) | 6,828 |   |
| Income (loss) from continuing operations                                                 |       | 11,910                                                             |       | 12,580 |   | 3,928 |   | (5,000 | ) | 4,028 |   |
| Discontinued operations, net of tax                                                      |       | —                                                             |       | (707 | ) | (3,622 | ) | (2,433 | ) | (58 | ) |
| Net income (loss)                                                                        |       | 11,910                                                             |       | 11,873 |   | 306 |   | (7,433 | ) | 3,970 |   |
|                                                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Earnings (loss) per share:                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| · Basic                                                                             |       |                                                               |       |   |   |   |   |   |   |   |   |
|    Income (loss) from  continuing                                         |       | $                                                                  | .84        |   | $ | .90 |   | $ | .29 |   | $ | (.38 | ) | $ | .31 |   |
|    Discontinued operations,  net of tax                                   |       | —                                                             |       | (.05 | ) | (.27 | ) | (.18 | ) | — |   |
|    Net income (loss)                                                      |       | $                                                                  | .84        |   | $ | .85 |   | $ | .02 |   | $ | (.56 | ) | $ | .31 |   |
|                                                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| · Diluted                                                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
|    Income (loss) from  continuing      Operations          |       | $                                                                  | .82        |   | $ | .89 |   | $ | .29 |   | $ | (.38 | ) | $ | .30 |   |
|    Discontinued operations,  net of tax                                   |       | —                                                             |       | (.05 | ) | (.27 | ) | (.18 | ) | — |   |
|    Net income (loss)                                                      |       | $                                                                  | .82        |   | $ | .84 |   | $ | .02 |   | $ | (.56 | ) | $ | .30 |   |
|                                                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Number of shares used to compute EPS:                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                                    |       | 14,149                                                             |       | 13,918 |   | 13,580 |   | 13,203 |   | 12,941 |   |
| Diluted                                                                                  |       | 14,480                                                             |       | 14,059 |   | 13,695 |   | 13,203 |   | 13,342 |   |

 

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| ** **                                                                         | ** ** | **Year Ended December 31,**                    | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2007**                                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(in thousands, except occupancy data)** | ** ** |
| **Operating Data:**                                                                |       |                                                          |       |   |   |   |   |   |   |   |   |
|                                                                               |       |                                                          |       |   |   |   |   |   |   |   |   |
| **Residential:**                                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |
| Service capacity (5) (10)                                                     |       | 15,634                                                        |       | 14,659 |   | 14,682 |   | 13,494 |   | 12,284 |   |
| Contracted beds in operation (end of   period) (6) (10)                       |       | 14,211                                                        |       | 13,492 |   | 11,929 |   | 11,479 |   | 9,472 |   |
| Average contract occupancy on contracted  beds in operation (7) (8) (10) |       | 99.6                                                          | %          | 97.5 | % | 96.0 | % | 98.6 | % | 100.5 | % |
| Average contract occupancy excluding  start-up operations (7) (8) (10)   |       | 99.6                                                          | %          | 97.5 | % | 100.4 | % | 101.9 | % | 100.7 | % |
| **Non-Residential:**                                                               | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service capacity (9) (10)                                                     |       | 2,953                                                         |       | 3,921 |   | 4,792 |   | 3,852 |   | 3,568 |   |
|                                                                               |       |                                                          |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                                            |       |                                                          |       |   |   |   |   |   |   |   |   |
| Working capital                                                                    |       | $                                                             | 47,757     |   | $ | 75,078 |   | $ | 57,286 |   | $ | 107,597 |   | $ | 86,214 |   |
| Total assets                                                                       |       | 562,787                                                       |       | 523,533 |   | 510,628 |   | 507,631 |   | 449,103 |   |
| Long-term debt, net of current portion                                             |       | 275,298                                                       |       | 255,471 |   | 266,659 |   | 279,528 |   | 227,292 |   |
| Stockholders’ equity                                                          |       | 200,449                                                       |       | 181,564 |   | 165,461 |   | 161,312 |   | 166,235 |   |
|                                                                                    |            |                                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Notes to Selected Consolidated Financial Data**

 

(1)      Incomefrom operations for the year ended December 31, 2006 includes a charge ofapproximately $0.4 million to record impairments to the carrying value of twoof our adult community-based facilities. Refer to “Management’s 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 ended December 31,2005 includes the assets, liabilities and operations of Correction Systems, Inc.(“CSI”) acquired 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. Income (loss) from continuing operations for the year ended December 31,2004 includes a loss on extinguishment of debt of approximately $2.4 millionrelated to the early retirement of the Synthetic Lease Investor Notes A and Band the revolving line of credit under our amended 2000 Credit Facility.Discontinued operations, net of tax for the year ended December 31, 2004include charges totaling $0.8 million to record impairments to the carryingvalues of two of our juvenile facilities. Refer to “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” in Item 7 of thisreport 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 escrow deposit.Refer to “Legal Proceedings – Southern Peaks Regional Treatment Center” in Item3 of this report.

(5)      Residential service capacity is comprised ofthe number of beds currently available for service in our residentialfacilities.

(6)      At certain residential facilities, thecontracted capacity is lower than the facility’s service capacity. We couldincrease a facility’s contracted capacity by obtaining additional contracts orby renegotiating existing contracts to increase the number of beds covered. However,we may not be able to obtain contracts that provide occupancy levels at afacility’s service capacity or be able to maintain current contractedcapacities in future periods.

(7)      Occupancypercentages reflect less than normalized occupancy during the start-up phase ofany applicable facility, resulting in a lower average occupancy in periods whenwe have substantial start-up activities.

**(8)**      Average contract occupancy percentages are calculated based on actualoccupancy for the period as a percentage of the contracted capacity forresidential facilities in operation. These percentages do not reflect theoperations of non-residential community-based programs. At certain residentialfacilities, our contracted capacity is lower than the facility’s servicecapacity. Additionally, certain facilities have and are currently operatingabove the contracted capacity. As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded contractedcapacity.

**(9)**      Service capacity for non-residential programs is based on eithercontractual terms or an estimate of the number of clients to be served. Weupdate these estimates at least annually based on the program’s budget andother factors.

(10)    Datapresented excludes discontinued operating facilities.

 

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

 

**General**

 

Cornell Companies, Inc. (together with itssubsidiaries and predecessors, unless the context requires otherwise, “Cornell,”the “Company,” “we,” “us” or “our”) is a leading provider of correctional,detention, educational, rehabilitation and treatment services outsourced byfederal, state and local government agencies. We provide a diversifiedportfolio of services for adults and juveniles through our three operatingdivisions: (1) Adult Secure Services (previously known as “adult secureinstitutions and detention centers”); (2) Abraxas Youth and FamilyServices (previously known as “juvenile justice, educational and treatmentprograms”); and (3) Adult Community-Based services (previously known as “adultcommunity-based corrections and treatment programs”). At December 31,2007, we operated 73 facilities with a total service capacity of 18,517 andhad one facility with a service capacity of 70 beds that was vacant. Our facilities are located in 15 states andthe 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,** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                               | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Residential**                                                                          |       |                                       |       |   |   |   |   |
| Service capacity (1) (2)                                                            |       | 15,634                                     |       | 14,659 |   | 14,682 |   |
| Contracted beds in operation (end of  period) (1) (3)                               |       | 14,211                                     |       | 13,492 |   | 11,929 |   |
| Average contract occupancy based on  contracted beds in  operation (1) (4) (5) |       | 99.6                                       | %          | 97.5 | % | 96.0 | % |
| Average contract occupancy excluding  start-up operations (1) (4) (5)          |       | 99.6                                       | %          | 97.5 | % | 100.4 | % |
| **Non-Residential**                                                                      |       |                                       |       |   |   |   |   |
| Service capacity (1) (6)                                                            |       | 2,953                                      |       | 3,921 |   | 4,792 |   |

 

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(1)                    Data presented excludes discontinuedoperating facilities.

(2)                    Residential service capacity is comprised ofthe number of beds currently available for service in our residentialfacilities.

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

(4)      Occupancypercentages reflect less than normalized occupancy during the start-up phase ofany applicable facility, resulting in a lower average occupancy in periods whenwe have substantial start-up activities.

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

(6)      Servicecapacity for non-residential programs is based on either contractual terms oran estimate of the number of clients to be served. We update these estimates atleast annually based on the program’s budget and other factors.

 

Our operating results for 2007 weresignificantly impacted by a few major events. At our Great Plains CorrectionalFacility in Hinton, Oklahoma, we transitioned from our operating contract withthe Oklahoma Department of Corrections (“OK DOC”) to our new contract with theArizona Department of Corrections. During the marketing and transition phases,that facility was idle from April 2007 to September 2007, when thecurrent inmate ramp began. We also began expansions at several facilitiesincluding the Big Spring Correctional Facility, the D. Ray James Prison and theGreat Plains Correctional Facility. Our 2007 results of operations were alsonegatively impacted by a reduction of Immigration and Customs Enforcement (“ICE”)detainees at our Regional Correctional Center (“RCC”) and positively affectedby a $1.85 million legal settlement (against which we incurred approximately$0.4 million in expenses in 2007) we received relating to legal representationprovided to us in connection with the Southern Peaks Regional Treatment Center.See “—Significant 2007 Events.”

 

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Looking to 2008, we believe we will continueto see steady demand across our various business segments and our customer base(federal, state and local), although we are monitoring government budget plansand the effect tightened spending plans could have on our business. A key driverfor our performance in 2008 is expected to be our ability to manage our variousfacility expansions in process and bring them on stream. We also plan to remainfocused on increasing utilization and improving customer mix as we believethose initiatives are key elements of our financial performance.

 

# **ManagementOverview**

# ** **

***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 SecureServices; Abraxas Youth and Family Services; and Adult Community-BasedServices. The demand for adult and juvenile corrections and treatment serviceshas generally increased at a steady rate over the past ten years, largely as aresult of increasing sentence terms and/or mandatory sentences for criminalsand as well a greater range of criminal acts, increasing demand forincarceration of illegal aliens and a public recognition of the need to provideservices to juveniles that will improve the possibility that they will leadproductive lives. Moreover, demand for our services is also affected by theamount of available capacity in the government systems to enable governments toprovide the services themselves, as well as desire and ability of these systemsto add additional capacity. In addition, the balance between community-basedcorrections treatment of adults as an alternative to traditional incarcerationcontinues to be analyzed by many political and societal parties.  Among other things, we monitor federal, stateand industry communications and statistics relative to trends in prisonpopulations, juvenile justice statistics and initiatives, and developments inalternatives to traditional incarceration or detention of adults foropportunities to expand our scope or delivery of services.

 

Thefederal government contracts private providers for the incarceration of adults,whether they are serving prison sentences, detained as illegal aliens, detainedin anticipation of pending judicial administration or transitioning from prisonto society.  Chief among the federalagencies which use private providers are the BOP, ICE, and USMS. We provideadult secure and adult community-based services to the federal government. Mostof the federal involvement in juvenile administration in the federal system ishandled via Medicare and Medicaid assistance to state governments. Althoughthere are circumstances in which we may contract with a federal agency on asole source basis, the primary means by which we secure a contract with afederal agency is via the RFP bidding process. From time to time, we contract to provide management services to a localgovernmental unit 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 may 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 opposeprivatization of 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 adult prisons.  Many private providers are organized on anot-for-profit basis, but there are a number of for-profit providers ofjuvenile and community-based programs. We monitor opportunities in these segments via our corporate andservice-line development officials.  Manyopportunities are not published in any manner and, accordingly, we believe thattaking the initiative at the state and local levels is key in developing solesource 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, and

·                  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 increasecapacity by 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 wasbrought into service in accordance with our expectation as to time and expense;and (b) the number of projects in development or under consideration atthe relevant point in time.  In additionto the focus on new projects, capacity will reflect our success in renewing andmaintaining existing contracts and facilities. It will also reflect any closure of 

 

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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 diem reimbursementrates are the other key element of our gross revenue and operating margin sinceper diem contracts represent a majority of our revenues (74.3% for the yearended December 31, 2007).  Per diemrates are a function of negotiation between management and a governmental unitat the inception of a contract or through the bidding process.  Actual per diem rates vary dramaticallyacross our business segments, and as well as within each business segmentdepending upon the particular service or program provided. The initial per diemrates often change during the term of a contract in accordance with aschedule.  The amount of the change canbe a fixed amount set forth within the contract, an amount determined byformulas set forth within the contract or an amount determined by negotiationsbetween management and the governmental unit (often these negotiations arealong the same lines as the original per diem negotiation — a review ofexpenses and approval of an amount to recompense for expenses and assure the potentialof an operating profit).  In recentyears, as budgetary pressures on governmental units have increased, some of ourcustomers have negotiated relief from formulaic increase provisions withintheir agreements or have declined to include in their appropriation legislationamounts that would increase the per diem rates payable under the contract.  We have attempted to mitigate the impact ofthese developments by negotiating services provided, obtaining commitments forincreased volume and other measures.  Wemay also choose to consider terminating an existing relationship at a givenfacility and replacing it with a new customer (as was done with the GreatPlains Correctional Facility in 2007).

 

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, medical andprogramming costs, financing costs and administrative overhead expenses.Increases or decreases in one or more of these expenses, such as our experiencewith rising insurance costs, can have a material effect on our financialperformance.  Operating expenses are alsoimpacted by decisions to close or terminate a particular program orfacility.  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 will typically increase period costs initially (at the timeof such actions), but generally reduce post-restructuring expense levels.  We also continue to monitor the costs ofcomplying with the Sarbanes-Oxley Act of 2002, both in terms of fees paid toothers, such as independent auditors and consultants, as well as internaladministrative costs.

 

We derive substantially all of our revenuesfrom providing adult corrections and treatment and juvenile justice,educational and treatment services outsourced by federal, state and localgovernment 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, 2007, ourrevenue base consisted of 74.3% for services provided under per diem contracts,18.6% for services provided under take-or-pay and management contracts, 4.7%for services provided under cost-plus reimbursement contracts, 2.1% forservices provided under fee-for-service contracts and 0.3% from othermiscellaneous sources. Although these percentages are generally consistent withcomparable statistics for the years ended December 31, 2006 and 2005, 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 (which opened in April 2006) which is a significant take-or-paycontract.  As well, our contract with theBOP for the Big Spring Correctional Center, which began November 1, 2007,is also a significant take-or-pay contract.

 

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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 proposedfacility is to be leased or purchased; and (4) the anticipated averageoccupancy levels that could reasonably be expected to be maintained.

 

Revenuesfor our Adult Secure Services division are primarily generated from per diem,take-or-pay and management contracts. For the years ended December 31, 2007, 2006 and 2005, we realizedaverage per diem rates on our adult secure facilities of approximately $54.69,$56.12 and $48.49, respectively. The decrease in the 2007 rate is due primarilyto the increase in occupancy at the Moshannon Valley Correctional Center during2007 over the prior year.  This facility operatesunder a take-or-pay contract; as a result, the effective average per diem ratewill decrease as the population at the facility increases.  The 2006 average per diem rate also benefitedfrom the receipt of a contract-based revenue adjustment for the contract yearended March 2006 in the amount of $2.4 million at the RCC.  We periodically have experienced pressurefrom contracting governmental agencies to limit or even reduce per diemrates.  Many of these governmentalentities are under severe budget pressures and we anticipate that governmentalagencies may periodically 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 Abraxas Youth and Family Services division are primarily generated fromper diem, fee-for-service and cost-plus reimbursement contracts.  For the years ended December 31, 2007,2006 and 2005, we realized average per diem rates on our residential youth andfamily services facilities of approximately $174.93, $170.33 and $167.68,respectively.  The increase in theaverage per diem rate for 2007 reflects the continued ramp-up of the CornellAbraxas Academy (reactivated in the fourth quarter of 2006) and the reactivationof the Hector Garza Residential Treatment Center in August 2007.  For the years ended December 31, 2007,2006 and 2005, we realized average fee-for-service rates for ournon-residential community-based Abraxas Youth and Family Services facilities andprograms, including rates that are limited by Medicaid and other privateinsurance providers, of approximately $44.35, $37.59 and $34.21, respectively.The increase in the average fee-for-service rate for 2007 is due to changes inthe mix of services provided at our non-residential facilities. The majority ofour Abraxas Youth and Family Services contracts renew annually.

 

Revenuesfor our Adult Community-Based Services division are primarily generated fromper diem and fee-for-service contracts. For the years ended December 31, 2007, 2006 and 2005, we realizedaverage per diem rates on our residential adult community-based facilities ofapproximately $62.91, $61.71 and $62.02, respectively.  For the years ended December 31, 2007,2006 and 2005, we realized average fee-for-service rates on our non-residentialAdult Community-Based Services facilities and programs of approximately $13.70,$11.23 and $9.40, respectively.  Ouraverage fee-for-service rates fluctuate from year to year principally due tochanges in the mix of services provided by our various Adult Community-Based Servicesprograms and facilities.

 

Wehave historically experienced higher operating margins in our Adult SecureServices and Adult Community-Based Services divisions as compared to ourAbraxas Youth and Family Services division. Our operating margin, in a given period, will be impacted by thosefacilities which may either be dormant or have been reactivated during theperiod.  As previously discussed, we havereactivated several facilities, including the Cornell Abraxas Academy and theHector Garza Residential Treatment Center in 2006 and 2007, respectively.  Additionally, our operating margins within adivision can vary from facility to facility based on whether a facility isowned or leased, the level of competition for the contract award, the proposedlength of the contract, the mix of services provided, the occupancy levels fora facility, the level of capital commitment required with respect to afacility, the anticipated changes in operating costs over the term of thecontract and our ability to increase a facility’s contract revenue. Undertake-or-pay contracts, such as the contract at the 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 in population,operating margins will generally decline to a stabilized level. Following itsactivation in April 2006, we experienced such operating margin impactpertaining at the Moshannon Valley Correctional Center in the third and fourthquarters of 2006. A decline in occupancy at our Abraxas Youth and Family Servicesfacilities can have a more significant impact on operating margins than our AdultSecure Services division due to higher per diem rates at certain Abraxas Youthand Family Services 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 (generally in the first half of the year) andsalary and wage increases and insurance cost increases that are incurred priorto certain contract rate increases. Periodically, many of the governmental agencies with whom we contractmay experience budgetary pressures and may approach us to limit or reduce perdiem rates.  Decreases in, or the lack ofanticipated increases in, per diem rates could adversely impact our operatingmargin.  

 

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Additionally, a decrease in per diem rateswithout a corresponding decrease in operating expenses could also adversely impactour operating margin.

 

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 15 facilities under management contracts at December 31, 2007,18 facilities at December 31, 2006 and 20 facilities at December 31,2005.

 

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 markets basedon 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 secure facilitiesoperated under any future contracts with the BOP which are take-or-paycontracts, meaning that the BOP will pay at least 80.0% of the contractualmonthly revenue once the facility opens, regardless of actual occupancy.

 

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-month period.  Our start-up period for new juvenile operationsis 12 months from the date we begin recognizing revenue unless break-evenoccupancy levels are achieved before then. Our start-up period for new adult operations is nine months from thedate we begin recognizing revenue unless break-even occupancy levels areachieved before then.  Although wetypically recover these upfront costs over the life of the contract, quarterlyresults can be substantially affected by the timing of the commencement ofoperations as well as the development and construction of new facilities.

 

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, investor relations, payroll and informationsystems, costs of business development and outside professional and consultingfees.

 

#### **Significant2007 Events**

####  

***Big Spring Correctional Center***

 

During2006, the BOP solicited an RFP for services to house approximately 7,000 lowsecurity, non-United States citizen, sentenced males in an existing securecorrectional institution procured from private sources or state and localgovernments with excess capacity located in Arizona, California, Louisiana, NewMexico, Oklahoma or Texas to replace several existing intergovernmental agreements(“IGA”) for such services, including the IGA relating to our operating contractat the Big Spring Correctional Center. In January 2007, we were awarded acontract from the BOP to operate the Big Spring Correctional Center under atake-or-pay contract, which was effective April 1, 2007, provides for aninitial contract term of four years with three two-year renewal option periods.In conjunction with this contract, we undertook certain facility expansion projectsin 2007. These expansion projects, which totaled approximately $16.7 million,were completed November 1, 2007. We began operations as of this date withthe BOP under the new contract terms.

 

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***Site Acquisition in Colorado***

 

InAugust 2007, we acquired a site in Hudson, Colorado for our developmentproject for the Colorado Department of Corrections. The purchase price wasapproximately $5.1 million. As of December 31, 2007, we had invested anadditional $2.7 million on development costs. We continue to discuss the project with our client, and construction iscurrently expected to begin during the second half of 2008.

 

***Washington, D.C. Facility***

 

InSeptember 2007, we acquired a formerly leased facility in Washington, D.C.This facility, which has a service capacity of 70 beds, can provide juvenileresidential and community-based services, including educational, rehabilitationand treatment programs. The purchase price was approximately $9.6 million andwas allocated entirely to the land, building and equipment acquired. Our priorlease with the seller would have run to July 2013 and we would haveincurred approximately $0.8 million in annual rent expense.  We are currently evaluating potentialprograms for the reactivation of this facility as well as other options.

 

***High Plains Correctional Facility***

 

InMay 2007, we acquired from GRW Corporation the High Plains CorrectionalFacility in Brush, Colorado. The facility currently has the capacity to house270 medium-security female inmates and operates under an IGA with the City ofBrush and the Colorado Department of Corrections. The purchase price wasapproximately $8.9 million and was allocated entirely to the land, building andequipment acquired.

 

***Great Plains Correctional Facility***

 

InMay 2007, we were awarded a contract by the Arizona Department ofCorrections for our Great Plains Correctional Facility in Hinton, Oklahoma. Thecontract calls for a total of 2,000 medium-security inmates to be housed at thefacility. We currently house approximately 916 inmates and the remainder willbe housed through an expansion of the existing facility. We began receivinginmates in September 2007 and substantially completed the initial ramp-upin December 2007. The expansion of the facility to accommodate all 2,000 inmatescommenced in the fourth quarter of 2007 and is expected to be completed by thefourth quarter of 2008. We currently estimate that the expansion cost will beapproximately $45.0 million.  As of December 31,2007, we had incurred and capitalized costs of approximately $9.8 millionrelated to this expansion.  We believethat our existing cash and available balance under our Amended Credit Facilitywill provide adequate funding to complete this facility expansion.

 

***D. Ray James Prison***

 

Werecently completed (in the first quarter of 2008) the initial expansion of theD. Ray James Prison in Georgia to increase its service capacity by 300 beds toa total service capacity of 1,940 beds. As of December 31, 2007, we had incurred and capitalized costs ofapproximately $15.1 million related to this expansion.

 

InAugust 2007, we announced that we were initiating a second expansion ofthe D. Ray James Prison. This expansion will project increase the facility’sservice capacity by an additional 700 beds for a total service capacity of2,640. This expansion project began in the first quarter of 2008 and isexpected to be completed in the first quarter of 2009. We currently estimatethat the capital expenditures related to this expansion project will beapproximately $34.0 million. We believe that our existing cash and availablebalance under our Amended Credit Facility will provide adequate funding tocomplete this facility expansion.

 

***Regional Correctional Center***

 

InJuly 2007, we were notified by ICE that they were removing all ICEdetainees from the RCC in Albuquerque, New Mexico. The withdrawal was completedin early August 2007 and ICE has recently indicated that it will notresume use of the facility.  Also, theclient, the Office of Federal Detention Trustee (“OFDT”), recently attempted tounilaterally amend its agreement to reduce the number of minimum annualguaranteed mandays under the agreement although we do not believe OFDT has theright to make such a change.  Refer to “-Resultsof Operations – Liquidity and Capital Resources - Contractual Uncertainties Related to Certain Facilities - RegionalCorrectional Center” for more information concerning thisdevelopment.

 

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** **

***Settlement*****ofClaim**

 

In August 2007, wesettled a lawsuit we had filed in the 333rd State District Court inHouston, Texas, Cause No. 2005-55083 against Locke Liddell & SappPLLC and an individual partner of Locke Liddell & Sapp PLLC,(collectively the “Defendants”) relating to the Defendants’ representation ofthe Company in a transaction involving our Southern Peaks Regional TreatmentCenter in Canon City, Colorado. Under the terms of the settlement, we receivedapproximately $1.85 million in August 2007 which reduced general andadministrative expenses for the year ended December 31, 2007. We incurredapproximately $0.4 million in expense related to this matter in the year ended December 31,2007.

 

***WalnutGrove Youth Correctional Facility***

 

In August 2007, wewere notified by the State of Mississippi that funding had been approved for a500 bed expansion of the 914 bed Walnut Grove Youth Correctional Facility thatwe have been managing since 2004. Expansion of the facility, which is beingentirely funded by the State of Mississippi, began in the third quarter of 2007and is currently expected to be completed and operational in the fourth quarterof 2008.

 

***Amended Credit Facility***

 

In October 2007, we amended our existing Credit Facility(the “Amended Credit Facility”). The Amended Credit Facility  provides for borrowings up to $100.0 million(including letters of credit), matures in December 2011 and bearsinterest, at our election depending on our total leverage ratio, at either theprime rate plus a margin ranging from 0.00% to 0.75%, or a rate which rangesfrom 1.50% to 2.25% above the applicable LIBOR rate. Subject to certainrequirements, we have the right to increase the commitments under our AmendedCredit Facility up to $150.0 million. The Amended Credit Facility iscollateralized by substantially all of our assets, including the assets andstock of all of our subsidiaries. The Amended Credit Facility is not secured bythe assets of MCF. The Amended Credit Facility contains standard covenantsincluding compliance with laws, limitations on certain financing transactionsand mergers and compliance with financial covenants, although the covenants inthe Amended Credit Facility were amended to provide greater flexibility incertain instances, including deletion of the minimum net worth and minimumasset coverage requirements contained in the Credit Facility and more favorableleverage ratios.

 

***Other Contract Terminations***

 

We transitioned ourmanagement contract at the Donald W. Wyatt Detention Center to the facility’sowner in July 2007.  Refer to “- Results of Operations - Year Ended December 31, 2007 Compared toYear Ended December 31, 2006 - Adult Secure Services” for moreinformation concerning our termination of this contract.  In July 2007,we were notified that the funding for our Harrisburg Alternative EducationSchool Program had been eliminated for the 2007-2008 school year.  Referto “- Results of Operations - YearEnded December 31, 2007 Compared to Year Ended December 31, 2006 -Abraxas Youth and Family Services” for more information concerning thetermination of this program.

 

#### **NewAccounting Pronouncements**

####  

***Financial Accounting Standards Board Interpretation No. 48***

 

In July 2006,the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48,“Accounting for Uncertainty in Income Taxes – an Interpretation of FASBStatement No. 109” (“FIN 48”). FIN 48 established a single model to address the accounting foruncertain tax positions.  FIN 48 alsoclarified the accounting for income taxes by prescribing a minimum recognitionthreshold a tax position is required to meet before being recognized in thefinancial statements.  FIN 48 alsoprovided guidance on the measurement, recognition, classification anddisclosure of tax positions, as well as the accounting for the related interestand penalties, transition and accounting in interim periods.  FIN 48 was effective for fiscal yearsbeginning after December 15, 2006 and required that the impact of theadoption of FIN 48 be recorded as an adjustment to beginning retained earningsat January 1, 2007.  We adopted theprovisions of FIN 48 on January 1, 2007. Refer to Item 8, Footnote 9 – Income Taxes for a discussion concerningthe impact of our adoption of FIN 48.

 

***Statement of Financial Accounting Standards No. 141***

 

In December 2007,the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFASNo. 141R”).  SFAS No. 141Rsignificantly changes the accounting for business combinations.  Under SFAS No. 141R, an acquiring entitywill be required to recognize all the assets acquired and liabilities assumedin a transaction at the acquisition-date fair value with limitedexceptions.  SFAS No. 141R changesthe accounting treatment for certain specific items, including acquisition costs,

 

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noncontrolling interests,acquired contingent liabilities, in-process research and development costs,restructuring costs and changes in deferred tax asset valuation allowances andincome tax uncertainties subsequent to the acquisition date.  SFAS No. 141R applies prospectively tobusiness combinations for which the acquisition date is on or after thebeginning of the first annual reporting period beginning on or after December 15,2008.  Earlier adoption is not permitted,

 

***Statement of Financial Accounting Standards No. 157***

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”).  SFAS No. 157 establishes a framework formeasuring fair value within generally accepted accounting principles andexpands the required disclosures concerning fair value measurements. SFAS No. 157is effective for financial 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 are currentlyevaluating what effect the adoption of this new standard will have on ourfinancial position and results of operations.

 

***Statement of Financial Accounting StandardsNo. 159***

 

In February 2007,the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities – Including an amendment of FASB Statement No. 115”(“SFAS No. 159”).  SFAS No. 159 permitsentities to choose to measure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue and establishes presentation and disclosure requirements designed tofacilitate comparisons between entities that choose different measurementattributes for similar types of assets and liabilities. SFAS No. 159 iseffective as of the beginning of an entity’s first fiscal year that beginsafter 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 are currently evaluating what effect the adoption of this newstandard will have on our financial position and results of operations.

 

***Statement of Financial Accounting StandardsNo. 160***

 

In December 2007,the FASB issued SFAS No. 160, “Noncontrolling Interests in ConsolidatedFinancial Statements – An Amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 establishes new accounting andreporting standards for the noncontrolling interest in a subsidiary and for thedeconsolidation of a subsidiary.  Thisstatement requires the recognition of a noncontrolling interest (minorityinterest) as equity in the consolidated financial statements and separate fromthe parent’s equity.  The amount of netincome attributable to the noncontrolling interest will be included inconsolidated net income on the face of the income statement.  SFAS No. 160 clarifies that changes in aparent’s ownership interest in a subsidiary that do not result indeconsolidation are equity transactions if the parent retains its controllingfinancial interest.  In addition, SFASNo. 160 requires that the parent recognize a gain or loss in net income when asubsidiary is deconsolidated.  Such gainor loss will be measured using the fair value of the noncontrolling equityinvestment on the deconsolidation date.  SFASNo. 160 also includes expanded disclosure requirements regarding the interestsof the parent and it noncontrolling interest. SFAS No. 160 is effective for fiscal years, and interim periods withinthose fiscal years, beginning on or after December 15, 2008.  Earlier adoption is prohibited.

 

**Critical Accounting Policies and Estimates**

 

The preparation of our financial statements inconformity with GAAP requires management to make certain estimates andassumptions. These estimates and assumptions affect the reported amounts ofassets and liabilities, the disclosures of contingent assets and liabilities atthe balance sheet date and the amounts of revenues and expenses recognizedduring the reporting period. We analyze our estimates based on our historicalexperience and various other assumptions that we believe to be reasonable underthe circumstances. However, actual results could differ from such estimates.The following is a discussion of our critical accounting estimates. Managementconsiders an accounting estimate to be critical if:

 

·                  it requires assumptions to bemade that were uncertain at the time the estimate was 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 of our significant accountingpolicies see Note 2 to the accompanying consolidated financial statements.

 

***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, 

 

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managementfee basis, cost-plus reimbursement or fee-for-service basis.  Revenues are recognized as services areprovided under our established contractual agreements to the extent collectionis considered probable.

 

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

 

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

 

***Insurance Reserves***

 

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

 

***Impairment or Disposal of Long-Lived Assets***

 

Wereview our long-lived assets for impairment at least annually or when changesin circumstances or a triggering event indicates that the carrying amount ofthe asset may not be recoverable in accordance with the provisions of SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFASNo. 144”).  SFAS No. 144 requires that long-livedassets to be held and used recognize an impairment loss only if the carryingamount of the long-lived asset is not recoverable from its undiscounted cashflows and to measure an impairment loss as the difference between the carryingvalue and the fair value of the asset. Assets to be disposed of by sale are recorded at the lower of their carryingamount or fair value less estimated selling costs. We estimate fair value basedupon the best information available, which may include expected futurediscounted cash flows to be produced by the asset and/or available marketprices. Factors that significantly influence estimated future discounted cashflows include the periods and levels of occupancy for the facility, expectedper diem or reimbursement rates, assumptions regarding the levels of staffing,services and future operating and capital expenditures necessary to generateforecasted revenues, related costs for these activities and future rate ofincreases or decreases associated with these factors. We also consider theresults of any appraisals on the properties when assessing fair value. Theseestimates may be highly subjective, particularly in circumstances where thereis no current operating contract in place and changes in the assumptions andestimates could result in the recognition of impairment charges. The mostsubjective estimates made in this analysis for 2007 relate to the RegionalCorrectional Center and Hector Garza Residential Treatment Center.  The most subjective estimates made in thisanalysis for 2006 and 2005 relate to the Cornell Abraxas Academy and the HectorGarza Residential Treatment Center. We may be required to record an impairmentcharge in the future if we are unable to successfully negotiate a replacementcontract on any of our facilities for which we currently have an operatingcontract. Given the nature of the evaluation of future cash flows and theapplication to specific assets and specific times, it is not possible toreasonably quantify the impact of changes in these assumptions.

 

***Goodwill***

 

Weaccount for goodwill in accordance with the provisions of SFAS No. 142, “Goodwilland Other Intangible Assets,” which states that there is no amortization ofgoodwill 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.

 

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**Results of Operations**

 

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

 

The following table sets forth for the periodsindicated the percentages of revenue represented by certain items in ourConsolidated Statements of Income and Comprehensive Income (Loss).

 
| ** **                                                            | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                            | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                            | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                              |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |
|                                                                  |       |                                       |       |   |   |   |   |
| Operating expenses                                                    |       | 76.0                                       |       | 76.3 |   | 76.6 |   |
| Pre-opening and start-up expenses                                     |       | 3⁄4                                     |       | 0.7 |   | 2.9 |   |
| Impairment of long-lived assets                                       |       | 3⁄4                                     |       | 0.1 |   | 3⁄4 |   |
| Depreciation and amortization                                         |       | 4.4                                        |       | 4.5 |   | 4.9 |   |
| General and administrative expenses                                   |       | 7.1                                        |       | 6.0 |   | 6.6 |   |
| Income from operations                                                |       | 12.5                                       |       | 12.4 |   | 9.0 |   |
| Interest expense, net                                                 |       | 6.7                                        |       | 6.4 |   | 7.0 |   |
| Income from continuing operations before provision   for income taxes |       | 5.8                                        |       | 6.0 |   | 2.0 |   |
| Provision for income taxes                                            |       | 2.5                                        |       | 2.5 |   | 0.7 |   |
| Income from continuing operations                                     |       | 3.3                                        |       | 3.5 |   | 1.3 |   |
| Discontinued operations, net of taxes                                 |       | 3⁄4                                     |       | (0.2 | ) | (1.2 | ) |
| Net income                                                            |       | 3.3                                        | %          | 3.3 | % | 0.1 | % |

 

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***YearEnded December 31, 2007 Compared to Year Ended December 31, 2006***

*** ***

***Revenues*****.** Revenues decreased approximately $0.3 million, or 0.08%, to $360.6million for the year ended December 31, 2007 from $360.9 million for theyear ended December 31, 2006.

 

*Adult Secure Services.** ***Adult SecureServices revenues increased approximately $4.4 million, or 2.5%, to $183.2million for the year ended December 31, 2007 from $178.8 million for theyear ended December 31, 2006 due primarily to (1) an increase inrevenues of  $9.7 million at theMoshannon Valley Correctional Center which opened in April 2006, (2) revenuesof $2.9 million at the High Plains Correctional Facility acquired in May 2007,(3) an increase in revenues of $2.1 million at the Big Spring CorrectionalCenter due to an increase in the effective per diem rate under our newtake-or-pay contract with the BOP as well as increased occupancy as a result ofthe facility expansion completed in November 2007 and  (4) an increase in revenues ofapproximately $1.8 million at the Leo Chesney Community Correctional Facilityand $1.4 million at the D. Ray James Prison, both due primarily to per diemrate increases.  The increase in revenuesfrom the above was offset, in part, by (1) a decrease in revenues of $7.2million due to our termination of our management contract with OK DOC at theGreat Plains Correctional Facility in April 2007 (the facility beganreceiving inmates under a new operating contract with the Arizona Department ofCorrections in September 2007), (2) a decrease in revenues ofapproximately $4.9 million at the Regional Correctional Center due to thewithdrawal of inmates by ICE during the latter half of 2007 and (3) adecrease in revenues of $2.1 million at the Donald W. Wyatt Detention Centerdue to the transition of our management contract to the facility’s owner in July 2007.  The remaining net increase in revenues of approximately$0.7 million was due to various insignificant fluctuations in revenues at ourother adult secure facilities.

 

Averagecontract occupancy was 100.4% for the year ended December 31, 2007compared to 98.2% for the year ended December 31, 2006.

 

The average per diem ratewas $54.69 for the year ended December 31, 2007 compared to $56.12 for theyear ended December 31, 2006.  The2007 average per diem rate was unfavorably impacted by the increase inpopulation at the Moshannon Valley Correctional Center which opened in April 2006.  This facility is operated under a take-or-paycontract.  As a result, the average perdiem rate will decrease as population increases.  The facility was ramping up in populationsubsequent to its April 2006 opening; as a result, the higher occupancy in2007 lowered the average per diem rate for the Adult Secure Services division.  Additionally, the 2006 average per diem ratebenefited from the receipt of a contract based revenue adjustment for thecontract year ended March 2006 in the net amount of $2.4 million at the RCC.  There were no revenues attributable tostart-up operations for the years ended December 31, 2007 and 2006.

 

*Abraxas Youth and Family Services*.  Abraxas Youth and Family Services revenuesdecreased approximately $6.5 million, or 5.6%, to $109.3 million for the yearended December 31, 2007 from $115.8 million for the year ended December 31,2006 due primarily to (1) a decrease in revenues of $9.9 million due tothe termination of our management contract at the Alexander Youth ServicesCenter in January 2007, (2) a decrease in revenues of $1.9 milliondue to the termination of our management contract at the South Mountain SecureTreatment Unit (“SMSTU”) in June 2006 and (3) a decrease in revenuesof $1.2 million due to the termination of our management contract for theHarrisburg Alternative Education School Program.  In July 2007, we were notified that thefunding for this program was discontinued for the 2007-2008 school year.  The decrease in revenues due to the above wasoffset, in part, by (1) an increase in revenues of $3.5 million at theCornell Abraxas Academy which we reactivated in October 2006, (2) revenuesof approximately $0.7 million at the Hector Garza Residential Treatment Centerwhich we reactivated in August 2007 and (3) an increase in revenuesof approximately $1.6 million at the Leadership Development Program due toincreased occupancy. The remaining net increase in revenues of approximately$0.7 million was due to various insignificant fluctuations in revenues at ourother Abraxas Youth and Family Services facilities and programs.

 

Average contractoccupancy was 92.0% for the year ended December 31, 2007 compared to 93.2%for the year ended December 31, 2006.

 

The average per diem ratefor our Abraxas Youth and Family Services facilities was approximately $174.93for the year ended December 31, 2007 compared to approximately $170.33 forthe year ended December 31, 2006. The increase in the 2007 average perdiem rate was due primarily to the reactivation of the Cornell Abraxas Academyin October 2006 and the Hector Garza Residential Treatment Center in August 2007.  Additionally, we received annual rateincreases at certain of our other Abraxas Youth and Family Services residentialfacilities.  The average fee-for-servicerate for our non-residential community-based Abraxas Youth and Family Servicesfacilities and programs was approximately $44.35 for the year ended December 31,2007 compared to approximately $37.59 for the year ended December 31, 2006.  Our average fee-for-service rate canfluctuate from year to year depending on the mix of services provided at ourvarious non-residential Abraxas Youth and Family Services facilities andprograms.  There were no revenuesattributable to start-up operations for the years ended December 31, 2007and 2006.

 

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*Adult Community-Based.*****AdultCommunity-Based Services revenues increased approximately $1.8 million, or2.7%, to $68.1 million for the year ended December 31, 2007 from $66.3million for the year ended December 31, 2006 principally due to anincrease in revenues of approximately $0.8 million from the operations of twojails in California which we began managing in January 2007 and anincrease in revenues of approximately $0.5 million at the Las Vegas Center dueto increased occupancy.  Additionally, wehad a decrease in revenues of approximately $0.9 million due to the terminationof our management contract for the SWICC Turning Point Program in October 2006.  The remaining net increase in revenues of$1.4 million was due to various insignificant fluctuations in revenues at ourvarious adult community-based facilities and programs.

 

We gave notice of early termination of ourmanagement contract for the Lincoln County Detention Center in Lincoln County,New Mexico in February 2008.  Wefaced continual staffing and other issues in the rural area and decided thatcontinued operations of that facility were not in the best interest of ourshareholders.  This contract generatedrevenues of approximately $1.9 million and $1.8 million in the years ended December 31,2007 and 2006, respectively.

 

Average contractoccupancy was 101.1% for the year ended December 31, 2007 compared to97.7% for the year ended December 31, 2006.

 

The average per diem ratefor our residential Adult Community-Based Services facilities was $62.91 forthe year ended December 31, 2007 compared to $61.71 for the year ended December 31,2006. The average fee-for-service rate for our non-residential Adult Community-BasedServices facilties and programs was approximately $13.70 for the year ended December 31,2007 compared to approximately $11.23 for the year ended December 31,2006.  Our average fee-for-service ratescan fluctuate from year to year due to changes in the mix of services providedby our various non-residential Adult Community-Based Services facilities and programs.There were no revenues attributable to start-up operations for the years ended December 31,2007 and 2006.

 

***Operating Expenses.*** Operating expenses decreased approximately $0.9 million, or 0.3%, to$274.1 million for the year ended December 31, 2007 from $275.0 millionfor the year ended December 31, 2006.

 

*Adult Secure Services.*  Adult Secure Services operating expensesincreased approximately $7.2 million, or 5.8%, to $130.5 million for the yearended December 31, 2007 from $123.3million for the year ended December 31, 2006 due primarily to (1) anincrease in operating expenses of $7.9 million at the Moshannon Valley CorrectionalCenter which opened in April 2006 (approximately $2.7 million of operatingexpenses at this facility were included in pre-opening and start-up expenses in2006), (2) an increase in operating expenses of $2.6 million at the HighPlains Correctional Facility purchased in May 2007, (3) an increasein operating expenses of $0.8 million at the Big Spring Correctional Center dueto increased occupancy following completion of a facility expansion in November 2007and (4) an increase in operating expenses of $0.5 million at the LeoChesney Correctional Center due to increased occupancy.  The increase in operating expenses due to theabove was offset, in part, by (1) a decrease in operating expenses of $2.2million due to our termination of our contract at the Great Plains CorrectionalFacility with the OK DOC in April 2007 (the facility began receivinginmates under our contract with the Arizona Department of Corrections in September 2007)and (2) a decrease in operating expenses of $1.7 million due to thetransition of our management contract at the Donald W. Wyatt Detention Centerto the facility’s owner in July 2007. The remaining net decrease in operating expenses of approximately $0.7million was due to various insignificant fluctuations in operating expenses atour other adult secure facilities.

 

As a percentage ofsegment revenues, adult secure services operating expenses were 71.2% for theyear ended December 31, 2007 compared to 68.9% for the year ended December 31,2006.  The increase in the 2007percentage reflects the stabilization of the operating margin at the MoshannonValley Correctional Center (which operates under a take-or-pay contract)subsequent to its activation in April 2006.  Additionally, the 2007 operating margin wasnegatively impacted by the termination of our contract at the Great PlainsCorrectional Facility in April 2007 as we transitioned to its reactivationin September 2007 under our new contract with the Arizona Department ofCorrections.

 

*Abraxas Youth and Family Services.*  Abraxas Youth and Family Services operatingexpenses decreased approximately $6.6 million, or 6.6%, to approximately $93.5million for the year ended December 31, 2007 from $100.1 million for theyear ended December 31, 2006 due primarily to (1) a decrease inoperating expenses of $9.1 million due to the termination of our managementcontract at the Alexander Youth Services Center in January 2007, (2) adecrease in operating expenses of $1.6 million due to the termination of ourmanagement contract at the SMSTU in June 2006 and (3) a decrease inoperating expenses of $0.7 million due to the termination of our managementcontract for the Harrisburg Alternative Education School Program (in July 2007,we were notified that the funding for this program was discontinued for the2007-2008 school year).  The decrease inoperating expenses due to the above was offset, in part, by various increases(totaling approximately $4.8 million) in operating expenses at both our residentialand non-residential Abraxas Youth and Family Services facilities and programs,including an increase in operating expenses of approximately $1.7 million dueto the reactivation of the Cornell Abraxas Academy in October 

 

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2006, as well as anincrease in operating expenses of $0.6 million at our Washington DC Facility as2006 operating expenses at this facility were reflected in discontinuedoperations in the year ended December 31, 2006.

 

As a percentage of segment revenues, Abraxasoperating expenses were 85.5% for the year ended December 31, 2007compared to 86.4% for the year ended December 31, 2006.

 

*Adult Community-Based.*  Adult Community-Based Services operatingexpenses decreased approximately $1.6 million, or 3.1%, to $50.1 million forthe year ended December 31, 2007 from $51.7 million for the year ended December 31,2006 due to various fluctuations in operating expenses at our numerous adultcommunity-based facilities and programs including a decrease in operatingexpenses of approximately $0.9 million due to the termination of our managementcontract for the SWICC Turning Point Program in October 2006 and adecrease in divisional administrative costs of approximately $1.1 million.  Additionally, we had an increase in operatingexpenses of approximately $0.6 million from the two jails in California webegan operating in January 2007.

 

Asa percentage of segment revenues, the segment’s operating expenses were 73.5%for the year ended December 31, 2007 compared to 78.0% for the year ended December 31,2006.  The 2007 operating margin wasfavorably impacted by lower divisional administrative costs in year ended December 31,2007 as compared to the year ended December 31, 2006.

 

***Pre-Opening and Start-up Expenses.***** **There were no pre-opening andstart-up costs for the year ended December 31, 2007.  Pre-opening and start-up costs wereapproximately $2.7 million for the year ended December 31, 2006 and wereattributable to the Moshannon Valley Correctional Center. These expensesconsisted primarily of personnel and related expenses, professional andrecruiting expenses.

 

***Depreciation and Amortization*****.** Depreciation and amortization decreased approximately $0.3 million, or1.8%, to $16.0 million for the year ended December 31, 2007 from $16.3million for the year ended December 31, 2006.  Depreciation and amortization of propertyand equipment declined approximately $0.6 million due to a decrease indepreciation expenses related to certain fully depreciated (in 2007) furnitureand fixtures, computer and other equipment of approximately $1.1 million,offset, in part, by an increase in building depreciation expense ofapproximately $0.8 million related primarily to the Moshannon ValleyCorrectional Center which opened in April 2006, the High Plains CorrectionalFacility purchased in May 2007 and the purchase of the Washington, D.C.Facility in October 2007. Amortization of intangibles was approximately $2.4 million and $2.2million the years ended December 31, 2007 and 2006, respectively.

 

***General and Administrative Expenses.*** General and administrative expenses increased approximately $3.8million, or 17.5%, to $25.5 million for the year ended December 31, 2007from approximately $21.7 million for the year ended December 31, 2006 dueprimarily to (1) our reimbursement to Veritas of approximately $2.5million of costs related to the Merger Agreement (see Note 3 to theconsolidated financial statements concerning this Merger Agreement), (2) anincrease in legal and professional fees and development costs of approximately$1.2 million related to the Merger Agreement and (3) an increase instock-based compensation expense of approximately $0.7 million.  The increase in general and administrativeexpenses due to the above was offset, in part, by the net $1.5 million legalclaims settlement received in August 2007.

 

***Interest.***  Interestexpense, net of interest income, increased approximately $1.2 million to $24.3million for the year ended December 31, 2007 from $23.1 million for theyear ended December 31, 2006.   Forthe year ended December 31, 2007, we capitalized interest of approximately$1.2 million related to the facility expansion projects at the Big SpringCorrectional Center, the D. Ray James Prison and the Great Plains CorrectionalFacility.  For the year ended December 31,2006, we capitalized interest of approximately $1.5 million related to theMoshannon Valley Correctional Center. Furthermore, we incurred interest expense of approximately $0.4 millionrelated to our Amended Credit Facility during the year ended December 31,2007 (none incurred in 2006).  Thedecrease was also due to a reduction in interest income from approximately $3.1million in the year ended December 31, 2006 to approximately $2.0 millionin the year ended December 31, 2007 (due to lower levels of invested funds(and rates) due to the on-going 2007 expansion projects and acquisitions).  These were partially offset by reducedinterest expense of approximately $0.8 million on the MCF bonds due to a $10.5million principal payment made in July 2007.

 

***Income Taxes.***** **For the year ended December 31, 2007, we recognized a provisionfor income taxes on our income from continuing operations at an estimatedeffective rate of 42.6%.  For the yearended December 31, 2006, we recognized a provision for income taxes at anestimated effective rate of 42.1%.

 

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*** Year Ended December 31, 2006 Compared toYear Ended December 31, 2005***

*** ***

Certaincomparisons of revenue, expenses and average contract occupancy contained inthis report have been made excluding the effect of pre-opening and start-upexpenses and revenues, and related occupancy and contract capacity.  Pre-opening and start-up expenses are chargedto operations as incurred.  They includepayroll, benefits, training and other operating costs during the periods priorto opening a new or expanded facility and during the period of operation whileoccupancy is ramping up.  We believesupplemental disclosures concerning pre-opening and start-up expenses andrevenues increases the reader’s understanding 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 Services.*****Adult Secure Servicesrevenues increased approximately $50.4 million, or 39.3%, to $178.8 million forthe year ended December 31, 2006 from $128.4 million for the year ended December 31,2005 due primarily to (1) the opening of the Moshannon Valley CorrectionalCenter in April 2006 which generated revenues of approximately $26.6million in 2006, (2) revenues of approximately $7.0 million at the MesaVerde Community Correctional Facility which we began managing in January 2006,(3) an increase in revenues of approximately $10.3 million at RCC 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 millionat our two 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 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 theyear ended December 31, 2005. The average contract occupancy statisticsfor 2006 reflect the activation and ramp-up in population at both the MesaVerde Community Correctional Facility (which opened in January 2006) andthe Moshannon 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. Therewere no revenues 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 $3.3million and were attributable to the start-up operations of the RegionalCorrectional Center in New Mexico.

 

*Abraxas Youth and FamilyServices*.  AbraxasYouth and Family Services revenues decreased approximately $3.2 million, or2.7%, to $115.8 million for the year ended December 31, 2006 from $119.0million for the year ended December 31, 2005.  The decrease in revenues was due primarily to(1) a decrease in revenues of approximately $3.6 million as a result ofthe temporary closure of the Hector Garza Residential Treatment Center in October 2005,(2) a decrease in revenues of approximately $2.8 million at the DanvilleCenter for Adolescent Females (“DCAF”) due to the expiration of our managementcontract in March 2006, (3) a decrease in revenues of approximately$1.8 million due to the expiration of our management contract at the SMSTU in June 2006and (4) a decrease in revenues of approximately $0.9 million due to theexpiration of our management contract for the Washington, D.C. (“DC”)community-based programs in August 2006. The decrease in revenues due to the above factors was offset, in part,by (1) an increase in revenues of approximately $1.6 million at theSouthern Peaks Regional Treatment Center due to improved occupancy (thisfacility was ramping-up in 2005), (2) an increase in revenues ofapproximately $1.2 million at the Reading Alternative Education program webegan 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$0.9 million 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 youth and family services facilities and programs. Theconcluded/terminated contracts at DCAF, SMSTU and DC generated total revenuesfor the years ended December 31, 2006 and 2005 of approximately $3.2million and $8.6 million, respectively.

 

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 

 

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RegionalTreatment Center through the first quarter of 2005, average contract occupancywas 90.0% for the year ended December 31, 2005.

 

The average per diem ratefor our residential Abraxas Youth and Family Services facilities wasapproximately $170.33 for the year ended December 31, 2006 compared to approximately$167.68 for the year ended December 31, 2005. The average fee-for-servicerate for our non-residential community-based Abraxas Youth and Family Servicesprograms was approximately $37.59 for the year ended December 31, 2006compared to approximately $34.21 for the year ended December 31,2005.  The increase in the averagefee-for-service rate for 2006 is due to changes in the mix of services providedby our various programs, as well as the continued operations in 2006 of severalalternative education programs which we began operating mid-year 2005.

 

Therewere no revenues attributable to start-up operations for the year ended December 31,2006. Revenues attributable to start-up operations were approximately $1.5million for the year ended December 31, 2005 and were attributable to thestart-up operations of the Southern Peaks Regional Treatment Center.

 

*Adult Community-Based.** ***AdultCommunity-Based Services revenues increased approximately $3.0 million, or4.7%, to $66.3 million for the year ended December 31, 2006 from $63.3million for the year ended December 31, 2005 due primarily to an increasein revenues of approximately $3.4 million from the programs and facilitiesacquired from Correctional Systems, Inc. (“CSI”) in April 2005. Theremaining net decrease in revenues of $0.4 million was due to variousinsignificant fluctuations in revenues at our other Adult Community-Based Servicesfacilities and programs.  Averagecontract occupancy was 97.7% for the year ended December 31, 2006 comparedto 100.4% for the year ended December 31, 2005.

 

The average per diem ratefor our residential Adult Community-Based Services facilities was approximately$61.71 for the year ended December 31, 2006 compared to approximately$62.02 for the year ended December 31, 2005. The average fee-for-servicerate for our non-residential Adult Community-Based Services 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 Services programs. There were no revenuesattributable to start-up operations for the years ended December 31, 2006and 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 Services.*  Adult Secure Services operating expensesincreased approximately $34.6 million, or 39.0%, to approximately $123.3 million for the year ended December 31,2006 from approximately $88.7million for the year ended December 31, 2005 due primarily to (1) operatingexpenses of approximately $13.6 million at the Moshannon Valley CorrectionalCenter which opened in April 2006 (additional expenses of approximately$2.7 million related to this facility are included in start-up and pre-openingexpenses for the year ended December 31, 2006), (2) operatingexpenses of approximately $5.2 million at the Mesa Verde Community CorrectionalFacility which we began managing in January 2006, (3) an increase inoperating expenses of approximately $9.9 million at the Regional CorrectionalCenter due to improved occupancy as the facility was ramping up in 2005(additional expenses of approximately $6.4 million related to this facility areincluded in pre-opening and start-up expenses in the year ended December 31,2005), (4) an increase in operating expenses of approximately $1.1 millionat our two secure facilities in California due to increased occupancy and (5) anincrease in operating expenses of approximately $1.1 million at the Donald W.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 Services operating expenses were 68.9% for theyear ended December 31, 2006 compared to 69.1% for the year ended 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 SecureServices operating expenses, as a percentage of segment revenues, were 70.9%for the year ended December 31, 2005.

 

*Abraxas Youth and Family Services.*  Abraxas Youth and Family Services operatingexpenses decreased approximately $0.1 million, or 0.1%, to approximately $100.1million for the year ended December 31, 2006 from $100.2 million for theyear ended December 31, 2005 due primarily to (1) a decrease in operatingexpenses of approximately $3.1 million due to the temporary closure of theHector Garza Residential Treatment Center in October 2005, (2) adecrease in operating expenses of approximately $2.6 million at  DCAF due to the expiration of our managementcontract in March 2006, (3) a decrease in operating expenses ofapproximately $1.6 million at SMSTU due to the expiration of our managementcontract in June 2006 and (4) a decrease in operating expenses ofapproximately $0.4 million at the DC programs due to the expiration of ourmanagement contract in August 2006. The decrease in operating expenses due to the above factors was offset,in part, by (1) an increase in 

 

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operating expenses ofapproximately $3.4 million at the Southern Peaks Regional Treatment Center dueto 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) anincrease in operating expenses of approximately $1.1 million at the CornellAbraxas 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) anincrease in operating expenses of approximately $1.0 million at the AlexanderYouth Center due to increased occupancy and (5) and increase in operatingexpenses of approximately $0.6 million at the Leadership Development Programdue to increased occupancy.  Theremaining net increase in operating expenses of approximately $0.4 million isdue to various insignificant fluctuations in operating expenses at our otherAbraxas Youth and Family Services facilities and programs.

 

As a percentage of segment revenues, thesegment’s operating expenses were 86.4% for the year ended December 31,2006 compared to 84.2% for the year ended December 31, 2005.  Excluding approximately $1.5 million of revenues attributable to the start-upoperations of the Southern Peaks Regional Treatment Center in the year ended December 31,2005, Abraxas Youth and Family Services operating expenses were 85.3% for theyear ended December 31, 2005.

 

*Adult Community-Based.*Adult Community-Based Services 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 to various insignificantfluctuations at our other adult community-based facilities and programs.

 

Asa percentage of segment revenues, Adult Community-Based Services operatingexpenses were 78.0% for the year ended December 31, 2006 compared to 77.9%for the year ended December 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 ofLong-Lived Assets. ***In the year ended December 31,2006, we recorded impairment charges of approximately $0.4 million related totwo of our Adult Community-Based Services facilities in Alaska. Refer to Note 7to 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 ended December 31,2006 from $15.2 million for the year ended December 31, 2005.   Depreciation of property and equipmentincreased approximately $0.9 million primarily to depreciation expense relatedto the Moshannon Valley Correctional Center which opened in April 2006. Amortization of intangibles wasapproximately $2.2 million and $2.1 million for the years ended December 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 ended December 31,2006 from approximately $20.4 million for the year ended December 31, 2005due primarily to increased consulting and professional expenses related to ourstrategic process and the proposed Merger Agreement with Veritas (which totaledapproximately $2.1 million during 2006). In addition, there was an increase in compensation expense of approximately$1.9 million resulting from our adoption of SFAS No. 123R on January 1,2006. See Note 2 to the consolidated financial statements in Item 8 of thisreport for further discussion concerning our adoption of SFAS No. 123R. Inthe year ended December 31, 2005, general and administrative expensesincluded a $1.1 million restructuring charge for personnel costs associatedwith management’s streamlining initiatives implemented in the first and secondquarters of 2005.

 

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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 capitalizedinterest in the year ended December 31, 2006 of approximately $2.2 millionas we capitalized interest of approximately $1.5 million in the year ended December 31,2006 compared to $3.7 million in the year ended December 31, 2005 relatedto construction of the Moshannon Valley Correctional Center (which opened in April 2006)and (2) an increase in net interest expense of approximately $1.4 millionrelated to the interest rate swap.  See “-Long-TermCredit Facilities” below  for a descriptionof the interest rate swap.  In the yearended December 31, 2006, we recognized interest expense related to theinterest rate swap of approximately $0.2 million compared to interest income ofapproximately $1.1 million in the year ended December 31, 2005.

 

***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, as well as the impact from our adoption of SFAS 123R (and thenondeductible expense attributable to incentive stock option expense).

 

**Liquidity and Capital Resources**

 

***General*****.**  Ourprimary capital requirements are for (1) purchases, construction orrenovation of new facilities, (2) expansions of existing facilities, (3) workingcapital, (4) pre-opening and start-up costs related to new operatingcontracts, (5) acquisitions  ofbusinesses or facilities, (6) information systems hardware and softwareand (7) furniture, fixtures and equipment. Working capital requirements generally increase immediately prior tocommencing management of a new facility (or activation of facility expansion)as we incur start-up costs and purchase necessary equipment and supplies beforefacility management revenue is realized.

 

***Cash Flows From Operations.*** Cash provided by operating activities wasapproximately $27.2 million for the year ended December 31, 2007 comparedto approximately $29.7 million for the year ended December 31, 2006.  Thedecrease from prior year was principally due to a reduction in accounts payableand accrued liabilities due to the timing of payments during the period.

 

***Cash Flows From Investing Activities*****. **Cash used in investing activities****was approximately $64.5 million due to (1) the****purchase of the Washington, DC facilityfor $9.6 million, (2) the purchase of the High Plains CorrectionalFacility for approximately $8.9 million, (3) the Hudson, Colorado siteacquisition of approximately $5.1 million, (4) capital expenditures ofapproximately $50.9 million related primarily to construction costs associatedwith the Big Spring Correctional Center and the D. Ray James Prison expansionsand development of the Hudson, Colorado site, (5) net sales of investmentsecurities of $11.7 million and (6) net payments to the restricted debtpayment account of approximately $2.1 million. Cash used in investingactivities was approximately $17.5 million for the year ended December 31,2006 due to (1) capital expenditures of approximately $12.3 millionprimarily consisting of construction costs for the Moshannon ValleyCorrectional Center, (2) net purchases of investment securities ofapproximately $4.7 million and (3) net payments to the restricted debtpayment account of approximately $3.4 million. Additionally, we received proceeds from the sale of assets ofapproximately $2.9 million in the year ended December 31, 2006.

 

***Cash Flows From Financing Activities*****.**  Cashprovided by financing activities was approximately $21.8 million due primarilyto borrowings on our Amended Credit Facility of $30.0 million, partially offsetby a $10.5 million payment on MCF’s bonds in July 2007 and proceeds fromthe exercise of stock options and warrants of approximately $2.8 million.  Additionally, we recognized a tax benefit onstock option exercises of approximately $0.4 million and had payments ofapproximately $0.8 million for financing costs related to our Amended Credit Facility.Cash used in financing activities was approximately $7.4 million for the yearended December 31, 2006 due primarily to a $9.7 million principal paymentof MCF’s bonds in July 2006, offset by proceeds from the exercise of stockoptions of approximately $2.1 million.

 

***Long-Term Credit Facilities.***  OurCredit Facility provided for borrowings of up to $60.0 million under arevolving line of credit and was reduced by outstanding letters of credit. In October 2007, we amendedthe Credit Facility (the “Amended Credit Facility”). The Amended CreditFacility provides for borrowings up to $100.0 million (including letters ofcredit), matures in December 2011 and bears interest, at our electiondepending on our total leverage ratio, at either the prime rate plus a marginranging from 0.00% to 0.75%, or a rate which ranges from 1.50% to 2.25% abovethe applicable LIBOR rate. Theavailable commitment under our Amended Credit Facility was approximately $59.7million at December 31, 2007.  Wehad outstanding borrowings under our Amended Credit Facility of $30.0 millionand we had outstanding letters of credit of approximately $10.3 million at December 31,2007.  Subject to certain requirements,we have the right to increase the commitments under our Amended Credit Facilityup to $150.0 million.  The Amended CreditFacility iscollateralized by substantially all of our assets, 

 

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including the assets and stock of all of our subsidiaries. TheAmended Credit Facility is not secured by the assets of MCF. Our Amended CreditFacility contains standard covenants including compliance with laws,limitations on certain financing transactions and mergers and compliance withfinancial covenants, although the covenants in the Amended Credit Facility wereamended to provide greater flexibility in certain instances, including deletionof the minimum net worth and minimum asset coverage requirements contained inthe Credit Facility and more favorable leverage ratios. The most restrictivecovenant under our Amended Credit Facility is the fixed charge coverage ratio.

 

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

 

In June 2004, we issued $112.0million in principal of 10.75% Senior Notes the (“Senior Notes”) due July 1,2012.  The Senior Notes are unsecuredsenior indebtedness and are guaranteed by all of our existing and futuresubsidiaries (collectively, “the Guarantors”). The Senior Notes are not guaranteed by MCF (the “Non-Guarantor”).  Interest on the Senior Notes is payablesemi-annually on January 1 and July 1 of each year, commencing January 1,2005.  On or after July 1, 2008, wemay redeem all or a portion of the Senior Notes at the redemption prices(expressed as a percentage of the principal amount) listed below, plus accruedand unpaid interest, if any, on the Senior Notes redeemed, to the applicabledate of redemption, if redeemed during the 12-month period commencing on July 1of each of the years indicated below:

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

 

Upon the occurrence ofspecified change of control events, unless we have exercised our option toredeem all the Senior Notes as described above, each holder will have the rightto require us to repurchase all or a portion of such holder’s Senior Notes at apurchase price in cash equal to 101% of the aggregate principal amount of thenotes repurchased plus accrued and unpaid interest, if any, on the Senior Notesrepurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture which limits our ability and the ability of our Guarantors to, amongother things, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets.

 

In conjunction with theissuance of the Senior Notes, we entered into an interest rate swap transactionwith a financial institution to hedge our exposure to changes in the fair valueon $84.0 million of our Senior Notes. The purpose of this transaction was to convert future interest due on$84.0 million of the Senior Notes to a variable rate.  The terms of the interest rate swap contractand the underlying debt instrument were identical.  The swap agreement was designated as a fairvalue hedge.  The swap had a notionalamount of $84.0 million and matured in July 2012 to mirror the maturity ofthe Senior Notes.  Under the agreement,we paid, on a semi-annual basis (each January 1 and July 1), afloating 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 31,2007, we recorded interest expense related to this interest rate swap ofapproximately $0.1 million. For the year ended December 31, 2006, werecorded interest expense of approximately $0.2 million.    At December 31, 2006, the fair valueof this derivative instrument was a liability of approximately ($1.1) millionand is included in other long-term liabilities at December 31, 2006 in ourConsolidated Balance Sheets.  Thecarrying value of the Senior Notes as of this date was adjusted accordingly bythe same amount.   Because the swapagreement was an effective fair-value hedge, there was no effect on our resultsof operations from the mark-to-market adjustment while the swap was ineffect.  In October 2007, weterminated the swap agreement.  Wereceived approximately $0.2 million in conjunction with the termination, whichis being amortized over the remaining term of the Senior Notes.

 

***Contractual Uncertainties Related toCertain Facilities***

 

*Regional CorrectionalCenter.*****In July 2007, we were notified byICE that they were removing all ICE detainees from the RCC. The withdrawal ofall ICE detainees was completed in early August 2007 and ICE has recentlyindicated to us that it will not resume use of the facility. The facility isstill being utilized by the United States Marshall Service (‘USMS”) but not atits full capacity.  OFDT holds thecontract on behalf of ICE, USMS and the BOP with the Bernalillo County throughan intergovernmental services agreement, 

 

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and we have an agreementwith the County.  OFDT recently attemptedto unilaterally amend its agreement with the County to reduce the number ofminimum annual guaranteed mandays under the agreement from 182,500 to66,300.  Neither we nor the Countybelieve OFDT has the right to unilaterally amend the contract in this manner,and OFDT has been informed of our position. Either party to theintergovernmental services agreement has the right to terminate upon 180 daysnotice. Revenues for this facility were approximately $12.8 million and $17.7million for the years ended December 31, 2007 and 2006, respectively

 

Thenet carrying value of this facility was approximately $3.0 million and $4.9million at December 31, 2007 and 2006, respectively. The facility hadoperated at its service capacity during portions of the year ended December 31,2007. Our lease for this facility requires monthly rent payments ofapproximately $0.13 million for the remaining two year term of the lease. Todate we do not have an alternative customer for this facility. Our inability toobtain a new customer for this facility could have an adverse effect on our financialcondition, results of operations and liquidity. We believe that pursuant to the provisions of SFAS No. 144, noimpairment to the carrying value of this facility has occurred.

 

*Cornell Abraxas Academy.*****We closed the CornellAbraxas Academy in the fourth quarter of 2002. The facility, which wereactivated in October 2006, operates as a residential treatment facilityfor youth sex offenders. The net carrying value of the property and equipmentfor this facility was approximately $19.1 million and $19.5 million at December 31,2007 and 2006, respectively. We believe that, pursuant to the provisions ofSFAS No. 144, no impairment to the carrying value of this facility hasoccurred in 2007.

 

*Hector Garza ResidentialTreatment Center.*****In October 2005,we initiated the temporary closure of this leased facility in San Antonio,Texas. We reactivated this facility during the third quarter of 2007 for afederal customer. Our net carrying value for this facility at December 31,2007 and 2006 was approximately $4.2.  Webelieve that, pursuant to the provisions of SFAS No. 144, no impairment tothe carrying value of this facility has occurred in 2007.

 

###### ***Projects Under Development, Construction orRenovation***

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

For a discussion of ourexpansion projects at our Great Plains Correctional Facility in Hinton,Oklahoma, the D. Ray James Prison in Folkston, Georgia and the Walnut GroveYouth Correctional Facility in Walnut Grove, Mississippi, see “-Significant2007 Events.”

 

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

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

We did not purchase any of our commonstock in the years ended December 31, 2007 and 2006.

 

Underthe terms of our Senior Notes and our Amended Credit Facility, we can purchaseshares of our stock subject to certain cumulative restrictions.

 

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

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

Webelieve that the existing cash and the cash flows generated from operations,together with the credit available under our Amended Credit Facility, willprovide sufficient liquidity to meet our committed capital and working capitalrequirements for those development projects currently in process.  To the extent our cash and current financingarrangements do not provide sufficient financing to fund construction costsrelated to future adult secure institutional and other contract awards orsignificant facility expansions, we anticipate obtaining additional sources offinancing 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***

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

Wehave assumed various financial obligations and commitments in the ordinarycourse of conducting our business.  Wehave contractual obligations requiring future cash payments, such asmanagement, consulting and non-competition agreements.

 

Wemaintain 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 2008 and 2075. As of December 31, 2007, ourtotal commitment under these operating leases was approximately $23.6 million.

 

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Thefollowing table details the known future cash payments (on an undiscountedbasis) related to various contractual obligations as of December 31, 2007(in thousands):

 
| ** **                                  | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | ** **                                | ** ** | ** ** | ** ** | **2009 -** | ** ** | **2011 -** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Total**                                 | ** ** | **2008** | ** ** | **2010** | ** ** | **2012** | ** ** | **Thereafter** | ** ** |
|                                        |       |                                      |       |   |   |   |   |   |   |   |   |
| **Contractual Obligations:**                |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt – principal             |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell Companies, Inc.         |       | $                                         | 112,000    |   | $ | — |   | $ | — |   | $ | 112,000 |   | $ | — |   |
| · Special Purpose Entities             |       | 145,500                                   |       | 11,400 |   | 25,800 |   | 30,400 |   | 77,900 |   |
| Long-term debt – interest              |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell Companies, Inc.         |       | 54,180                                    |       | 12,040 |   | 24,080 |   | 18,060 |   | — |   |
| · Special Purpose Entities             |       | 68,260                                    |       | 12,324 |   | 21,666 |   | 17,110 |   | 17,160 |   |
| Revolving line of credit-principal          |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell Companies, Inc.         |       | 30,000                                    |       | — |   | — |   | 30,000 |   | — |   |
| Revolving line of credit-interest           |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell Companies, Inc.         |       | 751                                       |       | 751 |   | — |   | — |   | — |   |
| Capital lease obligations                   |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell Companies, Inc.         |       | 37                                        |       | 12 |   | 25 |   | — |   | — |   |
| Construction commitments                    |       | 70,778                                    |       | 64,778 |   | 6,000 |   | — |   | — |   |
| Operating leases                            |       | 23,550                                    |       | 6,862 |   | 8,321 |   | 1,275 |   | 7,092 |   |
| Consultative and non-competition agreements |       | 250                                       |       | 250 |   | — |   | — |   | — |   |
| Total contractual cash obligations          |       | $                                         | 505,306    |   | $ | 108,417 |   | $ | 85,892 |   | $ | 208,845 |   | $ | 102,152 |   |

 

Approximately $3.1 million of unrecognized taxbenefits have been recorded as liabilities in accordance with FIN 48 but arenot included in the contractual obligations table because we are uncertain asto if or when such amounts may be settled. Related to the unrecognized tax benefits not included in the table above,we have also recorded  a liability forpotential penalties of approximately $0.1 million and for interest ofapproximately $0.3 million.

 

We enter into letters of credit in the ordinarycourse of operating and financing activities. As of December 31, 2007, we had outstanding letters of credit ofapproximately $10.3 million primarily for certain workers’ compensationinsurance and other operating obligations. The following table details our letter of credit commitments as of December 31,2007 (in thousands):

 
| ** **                | ** ** | ** **    | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|---------------------------|------------|---------------|------------|-------------------------------------------------------------------------|------------|
| ** **                | ** ** | **Total**     | ** ** | ** **                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                | ** ** | **Amounts**   | ** ** | **Less than**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **More Than** | ** ** |
| ** **                | ** ** | **Committed** | ** ** | **1 Year**                                                         | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **5 Years** | ** ** |
| Commercial Commitments:   |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Standby letters of credit |       | $             | 10,251     |                                                                    | $          | 9,501 |   | $ | 750 |   | $ | — |   | $ | — |   |
|                           |            |               |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

47

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**ITEM 7A.****                   ****QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

In the normal course of business, we are exposed tomarket risk, primarily from changes in interest rates. We continually monitorexposure to market risk and develop appropriate strategies to manage this risk.We are not exposed to any other significant market risks, including commodityprice risk or, foreign currency exchange risk or interest rate risks from theuse of derivative financial instruments. In conjunction with the issuance ofthe Senior Notes, we had previously entered into an interest rate swap of $84.0million related to the interest obligations under the Senior Notes, in effectconverting them to a floating rate based on six-month LIBOR. As discussed in Part II,Item 8, Note 10 to the accompanying financial statements, we terminated theinterest rate swap in October 2007.

 

**Credit Risk**

 

Due to the short duration of our investments,changes in market interest rates would not have a significant impact on theirfair value.  In addition, our accountsreceivables are with federal, state, county and local government agencies.

 

**Interest Rate Exposure**

 

Our exposure to changes in interest ratesprimarily results from our Amended Credit Facility, as these borrowings havefloating interest rates.  The debt on ourconsolidated financial statements at December 31, 2007 with fixed interestrates consist of the 8.47% Bonds issued by MCF in August 2001 inconnection with the 2001 Sale and Leaseback Transaction and $112.0 million ofSenior Notes.  The detrimental effect ofa hypothetical 100 basis point increase in interest rates on our currentborrowings under our Amended Credit Facility would be to reduce income beforeprovision for income taxes by approximately $0.3 million for the year ended December 31,2007.  At December 31, 2007, thefair value of our consolidated fixed rate debt approximated carrying valuebased upon discounted future cash flows using current market prices.

 

**Inflation**

 

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

 

**ITEM 8.**                  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 
| ** ** | ** **                                                                                                                                                | **Page** |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| 1.         | Financial statements                                                                                                                                      |     |
|       | Report of Independent  Registered Public Accounting Firm                                                                                                  | 49       |
|       | Consolidated Balance  Sheets - December 31, 2007 and 2006                                                                                            | 50       |
|       | Consolidated Statements of  Operations and Comprehensive Income (Loss) for the years ended  December 31, 2007, 2006 and 2005                         | 51       |
|       | Consolidated Statements of  Stockholders’ Equity for the years ended December 31, 2007,   2006 and 2005                                         | 52       |
|       | Consolidated Statements of  Cash Flows for the years ended December 31, 2007, 2006 and 2005                                                          | 53       |
|       | Notes to consolidated  financial statements                                                                                                               | 54       |
|       | Management’s Annual Report  on Internal Control over Financial Reporting                                                                             | 89       |
| 2.         | Financial statement schedules                                                                                                                             | 91       |
|       | All schedules are omitted  because they are not applicable or because the required information is  included in the financial statements or notes thereto. |     |

 

48

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### ** **

### **Report of Independent Registered Public Accounting Firm**

### ** **

Tothe Board of Directors and Stockholders of

CornellCompanies, Inc.

 

Inour opinion, the accompanying consolidated balance sheets and the relatedconsolidated statements of income and comprehensive income, of shareholders’equity, and of cash flows present fairly, in all material respects, thefinancial position of Cornell Companies, Inc. and its subsidiaries****at December 31, 2007 and 2006, and the results oftheir operations and their****cash flows foreach of the three years in the period ended December 31, 2007 inconformity with accounting principles generally accepted in the United Statesof America.  Also in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of December 31, 2007, based on criteria establishedin *Internal Control - Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO).  The Company’s management isresponsible for these financial statements, for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting, included in the accompanying****Management’s Report on Internal Control over FinancialReporting.  Our responsibility is toexpress opinions on these financial statements and on the Company’s internalcontrol over financial reporting based on our integrated audits.  We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audits to obtain reasonable assurance about whether thefinancial statements are free of material misstatement and whether effectiveinternal control over financial reporting was maintained in all materialrespects.  Our audits of the financialstatements included examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Ouraudit of internal control over financial reporting included obtaining anunderstanding of internal control over financial reporting, assessing the riskthat a material weakness exists, and testing and evaluating the design andoperating effectiveness of internal control based on the assessed risk.  Our audits also included performing suchother procedures as we considered necessary in the circumstances. We believethat our audits provide a reasonable basis for our opinions.

 

Asdiscussed in Note 9 to the consolidated financial statements, the Company  changed the manner in which it accounts foruncertainty in income taxes effective January 1, 2007, in accordance withFinancial Accounting Standards Board Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes.”

 

Asdiscussed in Note 2 to the consolidated financial statements, the Companychanged the manner in which it accounts for stock-based compensation effective January 1,2006, in accordance with Statement of Financial Accounting Standard No. 123(R),“Share-Based Payment” using the modified prospective application method.

 

Acompany’s internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally 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.

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or 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.

 

PricewaterhouseCoopersLLP

Houston,Texas

March 14,2008

 

49

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **ASSETS**                                                                                                                                                            |       |                  |       |   |   |
| **CURRENT ASSETS:**                                                                                                                                                   |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                             |       | $                     | 3,028      |   | $ | 18,529 |   |
| Investment securities available for sale                                                                                                                              |       | 250                   |       | 11,925 |   |
| Accounts receivable - trade (net of allowance for doubtful accounts  of $4,372 and $3,644, respectively)                                                              |       | 69,787                |       | 72,723 |   |
| Other receivables (net of allowance for doubtful accounts of $5,126  and $5,297, respectively)                                                                        |       | 3,201                 |       | 3,751 |   |
| Debt service fund and other restricted assets                                                                                                                         |       | 27,523                |       | 24,611 |   |
| Deferred tax assets                                                                                                                                                   |       | 6,750                 |       | 6,672 |   |
| Prepaid expenses and other                                                                                                                                            |       | 6,131                 |       | 7,540 |   |
| **Total current assets**                                                                                                                                              |       | 116,670               |       | 145,751 |   |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                       |       | 383,952               |       | 319,064 |   |
| **OTHER ASSETS:**                                                                                                                                                     |       |                  |       |   |   |
| Debt service reserve fund                                                                                                                                             |       | 23,638                |       | 23,801 |   |
| Goodwill, net                                                                                                                                                         |       | 13,355                |       | 12,339 |   |
| Intangible assets, net                                                                                                                                                |       | 4,520                 |       | 6,926 |   |
| Deferred costs and other                                                                                                                                              |       | 20,152                |       | 15,652 |   |
| **Total assets**                                                                                                                                                      |       | $                     | 562,287    |   | $ | 523,533 |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                        |       |                  |       |   |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **CURRENT LIABILITIES:**                                                                                                                                              |       |                  |       |   |   |
| Accounts payable and accrued liabilities                                                                                                                              |       | $                     | 57,502     |   | $ | 60,163 |   |
| Current portion of long-term debt                                                                                                                                     |       | 11,411                |       | 10,510 |   |
| **Total current liabilities**                                                                                                                                         |       | 68,913                |       | 70,673 |   |
| **LONG-TERM DEBT, net of current portion**                                                                                                                            |       | 275,298               |       | 255,471 |   |
| **DEFERRED TAX LIABILITIES**                                                                                                                                          |       | 13,226                |       | 11,373 |   |
| **OTHER LONG-TERM LIABILITIES**                                                                                                                                       |       | 4,401                 |       | 4,452 |   |
| **Total liabilities**                                                                                                                                                 |       | 361,838               |       | 341,969 |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                     |       |                  |       |   |   |
|                                                                                                                                                                  |       |                  |       |   |   |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                        |       |                  |       |   |   |
| Preferred stock, $.001 par value, 10,000,000 shares authorized, none  issued                                                                                          |       | —                |       | 3⁄4 |   |
| Common stock, $.001 par value, 30,000,000 shares authorized, 16,068,677  and 15,603,917 shares issued and 14,553,631 and 14,063,523 shares  outstanding, respectively |       | 16                    |       | 16 |   |
| Additional paid-in capital                                                                                                                                            |       | 160,319               |       | 154,411 |   |
| Retained earnings                                                                                                                                                     |       | 51,127                |       | 38,964 |   |
| Treasury stock (1,515,046 and 1,540,394 shares of common stock, at  cost, respectively)                                                                               |       | (12,105               | )          | (12,308 | ) |
| Accumulated other comprehensive income                                                                                                                                |       | 1,092                 |       | 481 |   |
| **Total stockholders’ equity**                                                                                                                                   |       | 200,449               |       | 181,564 |   |
| **Total liabilities and stockholders’ equity**                                                                                                                   |       | $                     | 562,287    |   | $ | 523,533 |   |

 

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

 

50

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OFINCOME AND COMPREHENSIVE INCOME (LOSS)**

**(in thousands, except per sharedata)**

 
| ** **                                                                                                                 | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| REVENUES                                                                                                                   |       | $                                          | 360,604    |   | $ | 360,855 |   | $ | 310,775 |   |
| OPERATING EXPENSES, EXCLUDING DEPRECIATION                                                                                 |       | 274,110                                    |       | 275,040 |   | 238,305 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                          |       | —                                     |       | 2,657 |   | 9,017 |   |
| IMPAIRMENT OF LONG-LIVED ASSETS                                                                                            |       | —                                     |       | 355 |   | 3⁄4 |   |
| DEPRECIATION AND AMORTIZATION                                                                                              |       | 15,986                                     |       | 16,285 |   | 15,200 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                        |       | 25,499                                     |       | 21,720 |   | 20,387 |   |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                     |       | 45,009                                     |       | 44,798 |   | 27,866 |   |
| INTEREST EXPENSE                                                                                                           |       | 26,215                                     |       | 26,130 |   | 24,041 |   |
| INTEREST INCOME                                                                                                            |       | (1,951                                     | )          | (3,060 | ) | (2,318 | ) |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES                                                        |       | 20,745                                     |       | 21,728 |   | 6,143 |   |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| PROVISION FOR INCOME TAXES                                                                                                 |       | 8,835                                      |       | 9,148 |   | 2,215 |   |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| INCOME FROM CONTINUING OPERATIONS                                                                                          |       | 11,910                                     |       | 12,580 |   | 3,928 |   |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| DISCONTINUED OPERATIONS, NET OF TAX BENEFIT OF $381 and $1,950 in  2006 and 2005, RESPECTIVELY                             |       | —                                     |       | (707 | ) | (3,622 | ) |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| NET INCOME                                                                                                                 |       | $                                          | 11,910     |   | $ | 11,873 |   | $ | 306 |   |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| EARNINGS PER SHARE:                                                                                                        |       |                                       |       |   |   |   |   |
| BASIC:                                                                                                                     |       |                                       |       |   |   |   |   |
| Income from continuing operations                                                                                          |       | $                                          | .84        |   | $ | .90 |   | $ | .29 |   |
| Loss from discontinued operations, net of tax                                                                              |       | —                                     |       | (.05 | ) | (.27 | ) |
| Net income                                                                                                                 |       | $                                          | .84        |   | $ | .85 |   | $ | .02 |   |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| DILUTED:                                                                                                                   |       |                                       |       |   |   |   |   |
| Income from continuing operations                                                                                          |       | $                                          | .82        |   | $ | .89 |   | $ | .29 |   |
| Loss from discontinued operations, net of tax                                                                              |       | —                                     |       | (.05 | ) | (.27 | ) |
| Net income                                                                                                                 |       | $                                          | .82        |   | $ | .84 |   | $ | .02 |   |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE COMPUTATION:                                                                            |       |                                       |       |   |   |   |   |
| BASIC                                                                                                                      |       | 14,149                                     |       | 13,918 |   | 13,580 |   |
| DILUTED                                                                                                                    |       | 14,480                                     |       | 14,059 |   | 13,695 |   |
|                                                                                                                       |       |                                       |       |   |   |   |   |
| COMPREHENSIVE INCOME (LOSS):                                                                                               |       |                                       |       |   |   |   |   |
| Net income                                                                                                                 |       | $                                          | 11,910     |   | $ | 11,873 |   | $ | 306 |   |
| Unrealized gain (loss) on derivative instruments, net of tax  provision (benefit) of $425, ($75), and ($954), respectively |       | 612                                        |       | (108 | ) | (1,103 | ) |
| Comprehensive income (loss)                                                                                                |       | $                                          | 12,522     |   | $ | 11,765 |   | $ | (797 | ) |

 

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

 

51

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY**

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

 
| ** **                                                      | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** | ** **           | ** ** | ** **              | ** ** | ** **   | ** ** | **Accumulated  Other**

**Compre-** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|-------------|------------|----------------------|------------|-------------------------|------------|--------------|------------|-------------------------------------|------------|
| ** **                                                      | ** ** | ** **            | ** ** | **Par**        | ** ** | **Paid-In** | ** ** | **Retained   ** | ** ** | **Treasury Stock** | ** ** | **Deferred** | ** ** | **Hensive**                         | ** ** |
| ** **                                                      | ** ** | **Shares**            | ** ** | **Value**      | ** ** | **Capital** | ** ** | **Earnings**         | ** ** | **Shares**              | ** ** | **Cost**     | ** ** | **Compensation**                    | ** ** | **Income(Loss)** | ** ** |
| ** **                                                      | ** ** | ** **            | ** ** | ** **     | ** ** | ** **  | ** ** | ** **           | ** ** | ** **              | ** ** | ** **   | ** ** | ** **                          | ** ** | ** ** | ** ** |
| BALANCES AT  JANUARY 1, 2005                                    |       | 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       |       | —                              |       | (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 EXERCISES                 |       | 3⁄4                |       | 3⁄4         |       | 224         |       | 3⁄4               |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4                              |       | 3⁄4 |   |
| ADOPTION OF SFAS  NO. 123R                                      |       | 3⁄4                |       | 3⁄4         |       | (990        | )          | 3⁄4               |       | 3⁄4                  |       | 3⁄4       |       | 990                                 |       |   |   |
| OTHER  COMPREHENSIVE INCOME                                     |       | —                |       | 3⁄4         |       | 3⁄4      |       | 3⁄4               |       | 3⁄4                  |       | 3⁄4       |       | 3⁄4                              |       | (108 | ) |
| DEFERRED AND  OTHER STOCK COMPENSATION                          |       | 58,327                |       | —         |       | 1,622       |       | —               |       | —                  |       | —       |       | 3⁄4                              |       | — |   |
| 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                |       | 3⁄4         |       | 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 |   |
|                                                            |       |                  |       |           |       |        |       |                 |       |                    |       |         |       |                                |       |   |   |
| ADOPTION OF FIN  48                                             |       | —                |       | —         |       | —      |       | 253                  |       | —                  |       | —       |       | —                              |       | — |   |
| EXERCISE OF STOCK  OPTIONS AND WARRANTS                         |       | 234,182               |       | —         |       | 2,490       |       | —               |       | —                  |       | —       |       | 3⁄4                              |       | 3⁄4 |   |
| INCOME TAX  BENEFIT FROM STOCK OPTION EXERCISES                 |       | —                |       | —         |       | 355         |       | —               |       | —                  |       | —       |       | 3⁄4                              |       | 3⁄4 |   |
| OTHER  COMPREHENSIVE INCOME                                     |       | —                |       | —         |       | —      |       | —               |       | —                  |       | —       |       | —                              |       | 611 |   |
| DEFERRED AND  OTHER STOCK COMPENSATION                          |       | 221,428               |       | —         |       | 2,644       |       | —               |       | —                  |       | —       |       | 3⁄4                              |       | 3⁄4 |   |
| ISSUANCE OF  COMMON STOCK TO EMPLOYEE STOCK PURCHASE PLAN       |       | —                |       | —         |       | 94          |       | —               |       | (25,348                 | )          | 203          |       | 3⁄4                              |       | 3⁄4 |   |
| ISSUANCE OF  COMMON STOCK UNDER 2000 DIRECTOR’S STOCK PLAN |       | 9,150                 |       | —         |       | 325         |       | —               |       | —                  |       | —       |       | 3⁄4                              |       | 3⁄4 |   |
| NET INCOME                                                      |       | —                |       | —         |       | —      |       | 11,910               |       | —                  |       | —       |       | 3⁄4                              |       | 3⁄4 |   |
|                                                            |       |                  |       |           |       |        |       |                 |       |                    |       |         |       |                                |       |   |   |
| BALANCES AT  DECEMBER 31, 2007                             |       | 16,068,677            |       | $              | 16         |        | $          | 160,319              |       | $                       | 51,127     |         | 1,515,046  |                                | $          | (12,105 | ) | $ | — |   | $ | 1,092 |   |

 

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

 

52

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**CORNELLCOMPANIES, INC.**

#### **CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                               |       |                                       |       |   |   |   |   |
| Net income                                                                                              |       | $                                          | 11,910     |   | $ | 11,873 |   | $ | 306 |   |
| Adjustments to reconcile net income to net cash provided by  operating activities                  |       |                                       |       |   |   |   |   |
| Impairment of long-lived assets                                                                         |       | 3⁄4                                     |       | 355 |   | 3⁄4 |   |
| Depreciation                                                                                            |       | 13,580                                     |       | 14,042 |   | 13,106 |   |
| Amortization of intangibles and other assets                                                            |       | 2,406                                      |       | 2,243 |   | 2,268 |   |
| Amortization of deferred financing costs                                                                |       | 1,552                                      |       | 1,772 |   | 1,414 |   |
| Amortization of Senior Notes discount                                                                   |       | 184                                        |       | 184 |   | 184 |   |
| Stock-based compensation                                                                                |       | 2,645                                      |       | 1,970 |   | (294 | ) |
| Provision for bad debts                                                                                 |       | 2,063                                      |       | 2,702 |   | 4,745 |   |
| Gain on sale of property and equipment                                                                  |       | (190                                       | )          | (119 | ) | (50 | ) |
| Deferred income taxes                                                                                   |       | 397                                        |       | 3,216 |   | (3 | ) |
| Change in assets and liabilities, net of acquisitions:                                                  |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                                     |       | (3,757                                     | )          | (10,432 | ) | (5,586 | ) |
| Other restricted assets                                                                                 |       | (665                                       | )          | 976 |   | (62 | ) |
| Other assets                                                                                            |       | 2,060                                      |       | 44 |   | 2,881 |   |
| Accounts payable and accrued liabilities                                                                |       | (4,890                                     | )          | 780 |   | 9,513 |   |
| Other liabilities                                                                                       |       | (51                                        | )          | 58 |   | (154 | ) |
| **Net cash provided by operating activities**                                                           |       | 27,244                                     |       | 29,664 |   | 28,268 |   |
|                                                                                                    |       |                                       |       |   |   |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                               |       |                                       |       |   |   |   |   |
| Capital expenditures                                                                                    |       | (50,890                                    | )          | (12,317 | ) | (51,128 | ) |
| Acquisition of a business, net of cash acquired                                                         |       | 3⁄4                                     |       | 3⁄4 |   | (9,064 | ) |
| Purchases of investment securities                                                                      |       | (241,425                                   | )          | (427,600 | ) | (1,022,295 | ) |
| Sales of investment securities                                                                          |       | 253,100                                    |       | 422,925 |   | 1,066,785 |   |
| Facility acquisitions                                                                                   |       | (18,554                                    | )          | 3⁄4 |   | 3⁄4 |   |
| Site acquisition                                                                                        |       | (5,053                                     | )          | 3⁄4 |   | 3⁄4 |   |
| Proceeds from sale of property and equipment                                                            |       | 375                                        |       | 2,892 |   | 647 |   |
| Payments to restricted debt payment account, net                                                        |       | (2,084                                     | )          | (3,367 | ) | (2,445 | ) |
| **Net cash used in investing activities**                                                               |       | (64,531                                    | )          | (17,467 | ) | (17,500 | ) |
|                                                                                                    |       |                                       |       |   |   |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                               |       |                                       |       |   |   |   |   |
| Proceeds from line of credit                                                                            |       | 30,000                                     |       | 3⁄4 |   | 3⁄4 |   |
| Payments of MCF bonds                                                                                   |       | (10,500                                    | )          | (9,700 | ) | (9,000 | ) |
| Payments of acquired debt                                                                               |       | 3⁄4                                     |       | 3⁄4 |   | (1,905 | ) |
| Payments of capital lease obligations                                                                   |       | (10                                        | )          | (11 | ) | (176 | ) |
| Payments for debt issuance and other financing costs                                                    |       | (845                                       | )          | 3⁄4 |   | 3⁄4 |   |
| Tax benefit of stock option exercises                                                                   |       | 355                                        |       | 224 |   | 3⁄4 |   |
| Proceeds from exercise of stock options and warrants                                                    |       | 2,786                                      |       | 2,096 |   | 4,141 |   |
| **Net cash (used in) provided by financing  activities**                                                |       | 21,786                                     |       | (7,391 | ) | (6,940 | ) |
|                                                                                                    |       |                                       |       |   |   |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                    |       | (15,501                                    | )          | 4,806 |   | 3,828 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                        |       | 18,529                                     |       | 13,723 |   | 9,895 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                              |       | $                                          | 3,028      |   | $ | 18,529 |   | $ | 13,723 |   |
|                                                                                                    |       |                                       |       |   |   |   |   |
| **SUPPLEMENTAL CASH FLOW DISCLOSURE:**                                                                  |       |                                       |       |   |   |   |   |
| Interest paid, net of amounts capitalized                                                               |       | $                                          | 30,672     |   | $ | 25,317 |   | $ | 22,964 |   |
| Income taxes paid                                                                                       |       | $                                          | 7,613      |   | $ | 3,947 |   | $ | 175 |   |
|                                                                                                    |       |                                       |       |   |   |   |   |
| **OTHER NON-CASH INVESTING AND FINANCING  ACTIVITIES:**                                                 |       |                                       |       |   |   |   |   |
| Decrease in fair value of interest rate swap                                                            |       | $                                          | (1,053     | ) | $ | (908 | ) | $ | (3,353 | ) |
| Purchases and additions to property and equipment included in  accounts payable and accrued liabilities |       | 4,156                                      |       | 3⁄4 |   | 2,478 |   |
| Common stock issued for board of directors fees                                                         |       | 325                                        |       | 396 |   | 415 |   |
| Equipment additions under capital leases                                                                |       | 3⁄4                                     |       | 56 |   | 3⁄4 |   |

 

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

 

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

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

 

Cornell Companies, Inc. (collectively with itssubsidiaries and consolidated special purpose entities, unless the contextrequires otherwise, “Cornell,” the “Company,” “we,” “us” or “our”, a Delawarecorporation provides the integrated development, design, construction andmanagement of facilities to governmental agencies within three operatingsegments: (1) Adult Secure Services; (2) Abraxas Youth and FamilyServices and (3) Adult Community-Based Services.

 

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

 

***Consolidation***

 

The accompanying consolidated financial statementsinclude the accounts of the Company, our wholly-owned subsidiaries, and ouractivities relative to two financings of operating facilities. All significantintercompany balances and transactions have been eliminated. Minority interestin consolidated special purpose entities represents equity that other investorshave contributed to the special purpose entities. Minority interest is adjustedfor income and losses allocable to the owners of the special purpose entities.As the cumulative losses of the special purpose entity exceed the equity thatis recorded as minority interest, the excess losses are recorded in ourStatements of Operations and Comprehensive Income (Loss).

 

***Cash and CashEquivalents***

 

We consider all highly liquid unrestrictedinvestments with original maturities of three months or less to be cashequivalents. We invest our available cash balances in short term money marketaccounts, short term certificates of deposit and commercial paper.

 

***InvestmentSecurities***

 

Our investment securities at December 31,2007 consist of certificates of deposit. Our investment securities at December 31, 2006 consisted ofcertificates of deposit and marketable securities.

 

Our certificates of deposit, which total approximately$0.3 million and $0.8 million at December 31, 2007 and 2006, respectively,bear interest at a rate of 3.80% at December 31, 2007.  They have original maturities of one year.

 

Our marketable securities are categorized asavailable-for-sale securities. Unrealized marketable securities gains andtemporary losses are reflected as a net amount under the caption of accumulatedother comprehensive income within the statement of stockholders’ equity.Realized gains and losses are recorded within the statement of income under thecaption interest income or interest expense. For the purpose of computingrealized gains and losses, cost is identified on a specific identificationbasis.

 

At December 31, 2006, our marketablesecurities, which totaled $11.2 million, were held in auction rate municipalbonds. Our investment in these securities was recorded at cost, whichapproximated fair market value due to their variable interest rates, whichtypically reset every 7 to 35 days. As a result, we had no gross unrealizedholding gains (losses) or gross realized gains (losses) from our investmentsecurities at December 31, 2007 and 2006.

 

Contractual maturities of the underlying investmentsecurities held at December 31, 2007 mature in less than one year.

 

54

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***AccountsReceivable and Related Allowance for Doubtful Accounts***

 

We extend credit to the governmental agencies andother parties with which we contract in the normal course of business. Weregularly review our outstanding receivables and historical collectionexperience, and provide for estimated losses through an allowance for doubtfulaccounts. In evaluating the adequacy of our allowance for doubtful accounts, wemake judgments regarding our customers’ ability to make required payments,economic events and other factors. As the financial condition of these partieschange, circumstances develop or additional information becomes available,adjustments to the allowance for doubtful accounts may occur. If, afterreasonable collection efforts have been made, a receivable is determined to bepermanently uncollectible, it will be written off.

 

At December 31, 2007, other receivables includeapproximately $5.1 million related to misappropriated escrow funds for theSouthern Peaks Regional Treatment Center, which is fully reserved at December 31,2007. At December 31, 2006, other receivables includes approximately $0.9million related to the Lincoln County Detention Center lawsuit settlement thatwas ultimately reimbursed by our general liability and professional liabilitycoverage as well as the $5.3 million other receivable related to the escrowfunds as previously noted.  Refer to Note11 to the consolidated financial statements for a discussion concerning thisbalance and the related transactions.

 

Thechanges in allowance for doubtful accounts associated with trade accountsreceivable for the years ended December 31, 2007, 2006 and 2005 are asfollows (in thousands):

 
| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                 |       |                                       |       |   |   |   |   |
| Balance at beginning of period       |       | $                                          | 3,644      |   | $ | 3,278 |   | $ | 3,544 |   |
| Provision for bad debts              |       | 2,063                                      |       | 2,702 |   | 4,745 |   |
| Write-offs of uncollectible accounts |       | (1,335                                     | )          | (2,336 | ) | (5,011 | ) |
| Balance at end of period             |       | $                                          | 4,372      |   | $ | 3,644 |   | $ | 3,278 |   |

 

***Restricted Assets***

 

Restricted assets at December 31, 2007 and 2006include approximately $25.0 million and $23.0 million, respectively, ofMunicipal Correctional Finance, LP’s (“MCF”) restricted cash accounts. MCF’srestricted accounts primarily consist of a debt service fund used to segregaterental payment funds from us to MCF for MCF’s semi-annual debt service. MCF’sfunds are invested in short term certificates of deposit, money market accountsand commercial paper. They will be used to fund a portion of MCF’s debt servicedue in the coming year.

 

At certain facilities, we maintain bank accounts forrestricted cash belonging to facility residents, commissary operations andequipment replacement funds used in certain state programs. Restrictedassets at December 31, 2007 and 2006 include approximately $2.5 millionand $1.7 million, respectively, for these accounts. A corresponding liabilityfor these obligations is included in accrued liabilities in the accompanyingfinancial statements.

 

***Property andEquipment***

 

Property and equipment are recorded at cost.Ordinary maintenance and repair costs are expensed, while renewal andbetterment costs are capitalized. Buildings and improvements are depreciatedover their estimated useful lives of 30 to 50 years using the straight-linemethod. Prepaid facility use cost, which resulted from the July 1996acquisition of the Big Spring Correctional Center and the December 1999transfer of ownership of the Great Plains Correctional Facility to a leaseholdinterest, is being amortized over 50 years using the straight-line method.Furniture and equipment are depreciated over their estimated useful lives of 3to 10 years using the straight-line method. Amortization of leaseholdimprovements (including those funded by landlord incentives or allowances) isrecorded using the straight-line method based upon the shorter of the economiclife of the asset or the term of the respective lease. Landlord incentives orallowances under operating leases are recorded as deferred rent and amortizedas a reduction of rent expense over the lease term. See Note 7 to theconsolidated financial statements for further details concerning our property andequipment balances at December 31, 2007 and 2006.

 

Wereview our long-lived assets for impairment at least annually or when changesin circumstances or a triggering event indicates that the carrying amount ofthe asset may not be recoverable in accordance with the provisions of SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.”  SFAS No. 144 requires that long-livedassets to be held and used recognize an impairment loss only if the carryingamount of the long-lived asset is not recoverable from its undiscounted cashflows and to measure an impairment loss as the difference between the carryingvalue and the fair value of the asset. Assets to be disposed of by sale are recorded at the lower of theircarrying amount or fair value less estimated selling costs. We estimate fairvalue based upon the best information available, which may include expectedfuture discounted cash flows to be produced by the asset and/or availablemarket prices. Factors that significantly influence estimated future discountedcash flows include the periods and levels of occupancy for the facility,expected per diem or reimbursement rates, assumptions regarding the levels ofstaffing, services and future operating and capital expenditures necessary togenerate forecasted revenues, related costs for these activities and futurerate of increases or decreases associated with these factors. We also considerthe results of any appraisals on the properties when assessing fair value.These estimates may be highly subjective, particularly in circumstances wherethere is no current operating contract in place and changes in the assumptionsand estimates could result in the recognition of impairment charges.

 

***CapitalizedInterest***

 

We capitalize interest on facilities while underconstruction. Interest capitalized for the years ended December 31, 2007was approximately $1.2 million and related to the expansion projects at the BigSpring Correctional Center, the D. Ray James

 

55

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Prison and the Great Plains CorrectionalFacility.  Interest capitalized for theyears ended December 31, 2006 and 2005 was approximately $1.5 million and$3.7 million, respectively, and related to construction of the Moshannon ValleyCorrectional Center.

 

***Debt ServiceReserve Fund***

 

The debt service reserve fund was established at theclosing of MCF’s bond issuance and is to be used solely for MCF’s debt serviceto the extent that funds in MCF’s debt service accounts are insufficient. Thedebt service reserve fund is invested in short term commercial instruments andearns a guaranteed rate of return of 3.0%. See Note 13 to the ConsolidatedFinancial 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 impairment to the carrying value ofour existing intangibles as of December 31, 2007. See Note 5 to theconsolidated financial statements for further details concerning our intangibleassets.

 

***Deferred Costs***

 

Costs incurred related to obtaining debt financingare capitalized and amortized over the term of the related indebtedness. At December 31,2007 and 2006, we had net deferred debt issuance costs of approximately $8.6million and $9.0 million, respectively. In the year ended December 31, 2007 weincurred approximately $0.8 million in financing costs related to our AmendedCredit Facility.

 

***RevenueRecognition***

 

Substantially all of our revenues are derived fromcontracts with federal, state and local governmental agencies, which pay eitherper diem rates based upon the number of occupant days or hours served for theperiod, on a take-or-pay basis, management fee basis, cost-plus reimbursementor fee-for-service basis. Revenues are recognized as services are providedunder our established contractual agreements to the extent collection isconsidered probable.

 

***Pre-opening andStart-up Expenses***

 

Pre-opening and start-up expenses are chargedto operations as incurred. Pre-opening and start-up expenses include payroll,benefits, training and other operating costs during periods prior to opening anew or expanded facility and during the period of operation while occupancy isramping up. These costs vary by contract. Newly opened facilities are staffedaccording to applicable regulatory or contractual requirements when we beginreceiving offenders or clients. Offenders or clients are typically assigned toa newly opened facility on a phased-in basis over a one-to-six month period.Our start-up period for new juvenile operations is 12 months from the date webegin recognizing revenue unless break-even occupancy is achieved before then.Our start-up period for new adult operations is nine months from the date webegin recognizing revenue unless break-even occupancy is achieved before then.

 

***ProposalCosts***

 

We incur various expenses in conjunction withour participation in the proposal process with government agencies for theirprocurement of our services. These costs include such items as payroll andrelated employee benefits and taxes, research, consulting, legal andreproduction costs and are expensed in the periods incurred.

 

***Operatingand General and Administrative Expenses***

 

We incur various expenses within the normalcourse of our business. Included in operating expenses are direct expense itemssuch as personnel/employee benefits, resident/inmate care expenses andbuilding/utility costs pertaining to the operations of our facilities andprograms. Included in general and administrative expenses are expense itemssuch as personnel/employee benefits, professional services and building/utilitycosts pertaining to our corporate activities.

 

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***BusinessConcentration***

 

Contracts with federal, state and local governmentalagencies account for nearly all of our revenues. The loss of, or a significantdecrease in, business from one or more of these governmental agencies couldhave a material adverse effect on our financial condition and results ofoperations. For the years ended December 31, 2007, 2006 and 2005, 32.1%,28.2% and 23.0%, respectively, of our consolidated revenues were derived fromcontracts with the Federal Bureau of Prisons (“BOP”), the only customerconstituting more than 10.0% of our revenues during each of these periods.

 

***Self InsuranceReserves***

 

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.

 

***Stock-BasedCompensation***

 

Our stock incentive plans provide for the granting of stock options(both incentive stock options and nonqualified stock options), stockappreciation rights, restricted stock units and other stock-based awards toofficers, directors and employees of the Company. Grants of stock options madeto date under these plans vest over periods up to seven years after the date ofgrant and expire no more than 10 years after grant.

 

Additionally, we have an employeestock purchase plan (“ESPP”)underwhich employees can make contributions to purchase our common stock.Participation in the plan is elected annually by employees. The plan yeartypically begins each January 1st (the “Beginning Date”) and ends on December 31st(the “Ending Date”). For 2007, however, the plan year began April 1, 2007.Purchases of common stock are made at the end of the year using the lower ofthe fair market value on either the Beginning Date or Ending Date, less a 15%discount. Under SFAS No. 123Rour employee-stock purchase plan is considered to be a compensatory ESPP, andtherefore, we recognize compensation cost over the requisite service period forgrants made under the ESPP.

 

At December 31, 2006, 60,000 shares of restricted stock wereoutstanding subject to performance-based vesting criteria (30,000 of these areconsidered market-based restricted stock under SFAS No. 123R).Additionally, 137,200 stock options were outstanding subject toperformance-based vesting criteria (16,100 of these were consideredmarket-based options under SFAS No. 123R). The 30,000 shares of restrictedstock and the 16,100 stock options which were considered market-based stockawards were valued using a Monte Carlo simulation probability model to estimatefuture stock returns. The grant date fair value of these awards was $9.05 pershare for a total value of $0.5 million. We recognized $0.12 million of expenseassociated with these shares of restricted stock and options during the twelvemonths ended December 31, 2006.

 

AtDecember 31, 2007, 127,500 shares of restricted stock were outstandingsubject to performance-based vesting criteria (32,500 of these restrictedshares were considered market-based restricted stock under SFAS No. 123R).There were also 79,000 stock options outstanding subject to performance-basedvesting criteria. We recognized $0.6 million of expense associated with theseshares of restricted stock and stock options during the twelve months ended December 31,2007.

 

The amounts above relate to theimpact of recognizing compensation expense related to stock options andrestricted stock. Compensation expense related to stock options (79,000 shares)and restricted stock (95,000 shares) that vest based upon performanceconditions is not recorded for such performance-based awards until it has beendeemed probable that the related performance targets allowing the vesting ofthese options and restricted stock will be met. We are required to periodicallyre-assess the probability that these options will vest and record expense atthat point in time. During the fourth quarter of 2007 and 2006 it was deemedprobable that certain performance targets pertaining to certain restricted stockand stock options would be

 

57

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achievedby their vesting date. Accordingly, compensation expense of approximately $0.4million and $0.1 million has been recognized for the twelve months ended December 31,2007 and 2006, respectively, related to these stock-based awards.

 

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

 

*Prior Period Pro Forma Presentation*

* *

Under the modified prospective applicationmethod, results for prior periods have not been restated to reflect the effectsof implementing SFAS No. 123R. The following pro forma information, asrequired by SFAS No. 148, “Accounting for Stock-Based CompensationTransition and Disclosure, an Amendment of FASB Statement No. 123” ispresented for comparative purposes and illustrates the pro forma effect on netincome and earnings per share for the period presented as if we had applied thefair value recognition provisions of SFAS No. 123R to stock-based employeecompensation prior to January 1, 2006 (in thousands, except per-shareamounts):

 
| ** **                                                                                                                                  | ** ** | **Year Ended  December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2005**                               | ** ** |
|                                                                                                                                        |       |                                   |       |
| Net income (loss), as reported                                                                                                              |       | $                                      | 306        |   |
| Add: total stock-based compensation  recorded, net of tax                                                                                   |       | 201                                    |       |
| Less: total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (1,988                                 | )          |
| Pro forma net loss                                                                                                                          |       | $                                      | (1,481     | ) |
|                                                                                                                                        |       |                                   |       |
| Income (loss) per share:                                                                                                                    |       |                                   |       |
| Basic, as reported                                                                                                                          |       | $                                      | .02        |   |
| Basic, pro forma                                                                                                                            |       | $                                      | (.11       | ) |
| Diluted, as reported                                                                                                                        |       | $                                      | .02        |   |
| Diluted, pro forma                                                                                                                          |       | $                                      | (.11       | ) |

 

*Assumptions*

 

The fair values for the significant stock-based awards granted duringthe year ended December 31, 2007, 2006 and 2005 were estimated at the dateof grant using a Black-Scholes option pricing model with the following weighted-averageassumptions:

 
| ** **                        | ** ** | **Years Ended  December, 31** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|                              |       |                                    |       |   |   |   |   |
| Risk-free  rate of return         |       | 4.56                                    | %          | 4.31 | % | 4.28 | % |
| Expected  life of award           |       | 5.6 years                               |       | 5 years |   | 7 years |   |
| Expected  dividend yield of stock |       | 0                                       | %          | 0 | % | 0 | % |
| Expected volatility  of stock     |       | 42.19                                   | %          | 45.48 | % | 52.99 | % |
| Weighted-average  fair value      |       | $                                       |  9.86 |   | $ |  6.24 |   | $ |  8.03 |   |
|                                   |            |                                         |            |  |  |  |  |  |  |  |

 

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The expected volatility of stock assumption was derived by referring tochanges in the Company’s historical common stock prices over a timeframesimilar to that of the expected life of the award. We currently have no reasonto believe that future stock volatility will significantly differ fromhistorical stock volatility. Estimated forfeiture rates are derived fromhistorical forfeiture patterns. We believe the historical experience method isthe best estimate of forfeitures currently available.

 

In accordance with SAB 107, we generally used the “simplified” methodfor “plain vanilla” options to estimate the expected term of options grantedduring 2007 and 2006.  For those grantsduring these periods wherein we had sufficient historical or impartial data tobetter estimate the expected term, we have done so.

 

Stock-based award activity during the year ended December 31, 2007was 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, 2004                 |       | 976,947                |       | $                                      | 10.72      |                                                | 6.7        |                            | $          | 10.5 |   |
| Granted                                                |       | 350,750                |       |                                   |       |                                                |       |                            |       |
| Exercised                                              |       | (399,090               | )          |                                   |       |                                                |       |                            |       |
| Forfeited or  canceled                                 |       | (189,551               | )          |                                   |       |                                                |       |                            |       |
|                                                   |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding  at December 31, 2005                 |       | 739,056                |       | 12.25                                  |       | 5.0                                                 |       | $                               | 9.1        |   |
| Granted                                                |       | 158,000                |       |                                   |       |                                                |       |                            |       |
| Exercised                                              |       | (164,661               | )          |                                   |       |                                                |       |                            |       |
| Forfeited or  canceled                                 |       | (78,648                | )          |                                   |       |                                                |       |                            |       |
|                                                   |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding  at December 31, 2006                 |       | 653,747                |       | 12.87                                  |       | 6.1                                                 |       | $                               |  8.4  |   |
| Granted                                                |       | 72,950                 |       | 21.40                                  |       |                                                |       |                            |       |
| Exercised                                              |       | (161,590               | )          | 12.40                                  |       |                                                |       |                            |       |
| Forfeited or  canceled                                 |       | (74,265                | )          | 13.48                                  |       |                                                |       |                            |       |
|                                                   |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding  at December 31, 2007                 |       | 490,842                |       | $                                      | 14.19      |                                                | 7.3        |                            | $          | 7.0 |   |
|                                                   |       |                   |       |                                   |       |                                                |       |                            |       |
| Vested and  expected to vest at December 31, 2007 |       | 391,043                |       | $                                      | 14.15      |                                                | 7.3        |                            | $          | 5.6 |   |
|                                                   |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable  at December 31, 2007                 |       | 273,183                |       | $                                      | 13.56      |                                                | 6.8        |                            | $          | 3.7 |   |

 

The total intrinsic value of stock options exercised during the yearsended December 31, 2007, 2006 and 2005 was $1.5 million, $0.6 million and$1.9 million, respectively. Net cash proceeds from the exercise of stockoptions were approximately $2.5 million, $2.1 million and $4.1 million for theyears ended December 31, 2007, 2006 and 2005, respectively.

 

As of December 31, 2007, approximately $0.6 million of estimatedexpense with respect to nonvested stock-based awards had yet to be recognizedand will be amortized into expense over the employee’s estimated remainingweighted average service period of approximately 10.5 months.

 

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The following table summarizes information with respect to stockoptions outstanding and exercisable at December 31, 2007.

 
| **Range of Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
|                                        |       |                    |       |                                                |       |                                   |       |                    |       |                                   |       |
| $ 3.75  to  $10.00 |       | 25,510                  |       | 3.7                                                 |       | $                                      | 5.75       |                    | 24,937     |                                   | $          | 5.69 |   |
| 10.01  to  13.50        |       | 176,332                 |       | 6.6                                                 |       | 12.78                                  |       | 96,346                  |       | 12.76                                  |       |
| 13.51  to  14.50        |       | 209,800                 |       | 7.6                                                 |       | 13.96                                  |       | 111,900                 |       | 13.86                                  |       |
| 14.51  to  25.00        |       | 79,200                  |       | 9.0                                                 |       | 20.70                                  |       | 40,000                  |       | 19.53                                  |       |
|                                        |       | 490,842                 |       | 7.3                                                 |       | $                                      | 14.19      |                    | 273,183    |                                   | $          | 13.56 |   |

 

Stock-based award activity for nonvested awards during the year ended December 31,2007 was as follows:

 
| ** **                           | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2004 |       | 462,782                |       | $                                                           | 11.17      |   |
| Granted                              |       | 350,750                |       | 13.58                                                       |       |
| Vested                               |       | (318,476               | )          | 11.38                                                       |       |
| Canceled                             |       | (132,387               | )          | 11.56                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2005 |       | 362,669                |       | 13.14                                                       |       |
| Granted                              |       | 158,000                |       | 14.02                                                       |       |
| Vested                               |       | (191,919               | )          | 13.43                                                       |       |
| Canceled                             |       | (8,093                 | )          | 13.16                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2006 |       | 320,657                |       | 13.40                                                       |       |
| Granted                              |       | 72,950                 |       | 21.40                                                       |       |
| Vested                               |       | (101,683               | )          | 15.68                                                       |       |
| Canceled                             |       | (74,265                | )          | 13.48                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2007 |       | 217,659                |       | $                                                           | 14.99      |   |

 

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***Restricted Stock***

*** ***

We have previously issuedrestricted stock in connection with certain employment agreements which vestover a specific period of time, generally three to five years. During the yearended December 31, 2007, we issued restricted stock in connection withcertain employment agreements and as part of our normal equity awards, all ofwhich were issued under our 2006 Equity Incentive plan. These shares ofrestricted common stock are subject to restrictions on transfer and certainconditions to vesting.

 

Restrictedstock activity for the year ended December 31, 2007 was as follows:

 
| ** **                           | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2004 |       | 73,786                 |       | $                                                           | 17.15      |   |
| Granted                              |       | 85,000                 |       | 10.87                                                       |       |
| Vested                               |       | 3⁄4                 |       | 3⁄4                                                      |       |
| Canceled                             |       | (47,113                | )          | 17.15                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2005 |       | 111,673                |       | 12.37                                                       |       |
| Granted                              |       | 3⁄4                 |       | 3⁄4                                                      |       |
| Vested                               |       | (15,676                | )          | 17.15                                                       |       |
| Canceled                             |       | (10,997                | )          | 17.15                                                       |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2006 |       | 85,000                 |       | 10.87                                                       |       |
| Granted                              |       | 287,000                |       | 22.30                                                       |       |
| Vested                               |       | (5,000                 | )          | 21.33                                                       |       |
| Canceled                             |       | (64,000                | )          | 9.80                                                        |       |
|                                 |       |                   |       |                                                        |       |
| Nonvested at  December 31, 2007 |       | 303,000                |       | $                                                           | 21.75      |   |

 

Werecognized $0.8 million of expense associated with nonvested time-basedrestricted stock awards during the year ended December 31, 2007.  As of December 31, 2007, approximately$2.8 million of estimated expense with respect to nonvested time-basedrestricted stock awards had yet to be recognized and will be amortized over aweighted average period of 2.5 years. Approximately $2.7 millionof estimated expense with respect to nonvested performance-based restrictedstock option awards had yet to be recognized as of December 31, 2007.

 

***Income Taxes***

 

We utilize the liability method of accounting forincome taxes. Under this method, deferred tax assets and liabilities arerecognized for the future tax consequences attributable to differences betweenthe financial statement carrying values of existing assets and liabilities andtheir respective tax bases based on enacted tax rates. In providing fordeferred taxes, we consider current tax regulations, estimates of futuretaxable income and available tax planning strategies. If tax regulations,operating results or the ability to implement tax planning strategies vary,adjustments to the carrying value of tax assets and liabilities may occur. SeeNote 9 to the consolidated financial statements.

 

***Earnings PerShare***

 

Basic earnings per share (EPS) are computed bydividing net income by the weighted average number of shares of common stockoutstanding during the period. Diluted EPS reflects the potential dilution fromcommon stock equivalents such as stock options and warrants. For the year endedDecember 31, 2007, there were 19,200 shares ($24.56 average price) ofstock options that were not included in the computation of diluted EPS becauseto do so would have been anti-dilutive. For the year ended December 31,2006, there were no anti-dilutive shares. For the year ended December 31,2005 there were 113,145 shares ($15.10 average price) of stock options thatwere not included in the computation of diluted EPS because to do so would havebeen anti-dilutive.

 

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The followingtable summarizes the calculation of income (loss) and the weighted averagecommon shares and common equivalent shares outstanding for purposes of thecomputation of earnings (loss) per share (in thousands, except per share data):

 
| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income from continuing  operations                                       |       | $                                          | 11,910     |   | $ | 12,580 |   | $ | 3,928 |   |
| Loss from discontinued  operations, net of tax                           |       | 3⁄4                                     |       | (707 | ) | (3,622 | ) |
| Net income                                                               |       | $                                          | 11,910     |   | $ | 11,873 |   | $ | 306 |   |
|                                                                     |       |                                       |       |   |   |   |   |
| Weighted average common  shares outstanding                              |       | 14,149                                     |       | 13,918 |   | 13,580 |   |
| Weighted average common  share equivalents outstanding                   |       | 331                                        |       | 141 |   | 115 |   |
|                                                                     |       |                                       |       |   |   |   |   |
| Weighted average common  shares and common share equivalents outstanding |       | 14,480                                     |       | 14,059 |   | 13,695 |   |
|                                                                     |       |                                       |       |   |   |   |   |
| Basic income (loss) per  share:                                          |       |                                       |       |   |   |   |   |
| Income from continuing  operations                                       |       | $                                          | .84        |   | $ | .90 |   | $ | .29 |   |
| Loss from discontinued  operations, net of tax                           |       | 3⁄4                                     |       | (.05 | ) | (.27 | ) |
| Net income                                                               |       | $                                          | .84        |   | $ | .85 |   | $ | .02 |   |
|                                                                     |       |                                       |       |   |   |   |   |
| Diluted income (loss)  per share:                                        |       |                                       |       |   |   |   |   |
| Income from continuing  operations                                       |       | $                                          | .82        |   | $ | .89 |   | $ | .29 |   |
| Loss from discontinued  operations, net of tax                           |       | 3⁄4                                     |       | (.05 | ) | (.27 | ) |
| Net income                                                               |       | $                                          | .82        |   | $ | .84 |   | $ | .02 |   |

 

***FinancialInstruments***

 

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, 2007, the carrying amount ofconsolidated debt was $286.7 million, and the estimated fair value was $303.2million. At December 31, 2006, the carrying amount was $266.0 million, andthe estimated fair value was $296.0 million. The estimated fair value oflong-term debt is based primarily on quoted market prices or discounted cashflow analysis for the same or similar issues.

 

***DerivativeInstruments***

 

We have only entered into derivativecontracts that are classified as fair value hedges. These derivatives arerecorded at their fair value with changes in the fair value recorded asadjustments to the related liability and other comprehensive income (loss) inour Consolidated Statements of Income and Comprehensive Income (Loss). See Note13 to the consolidated financial statements.

 

***Use of Estimates***

 

Our financial statements are prepared in accordancewith accounting principles generally accepted in the United States of America,which require that we make certain estimates and judgments that affect ourreported amounts of assets, liabilities, revenues and expenses and thedisclosures of contingent assets and liabilities. We evaluate our estimates onan on-going basis, based on historical experience and on various otherassumptions that we believe to be reasonable based on the informationavailable. Actual results could differ from these estimates under differentassumptions or conditions. The significant estimates that we make in theaccompanying consolidated financial statements include the allowance fordoubtful accounts, accruals for insurance and legal claims, accruals forcompensated employee absences and the realizability of long-lived tangible andintangible assets.

 

***Reclassifications***

 

Certain reclassifications have been made to theprior period financial statements contained herein to conform to current yearpresentation. In our Consolidated Statements of Cash Flows for the years endedDecember 31, 2006 and 2005, amortization of deferred compensation has beenreclassed to stock-based compensation to conform to current year presentation.

 

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

 

On October 6, 2006, we entered into an Agreement and Plan ofMerger (the “Merger Agreement”) with The Veritas Capital Fund III, L.P., aDelaware limited partnership (“Veritas”), Cornell Holding Corp., a Delawarecorporation (“Parent”) and CCI Acquisition Corp., a Delaware corporation andwholly owned subsidiary of Parent (“Merger Sub”), pursuant to which the MergerSub would be merged with and into us (the “Merger”), with Cornell survivingafter the Merger as a wholly owned subsidiary of Parent.

 

Our Board of Directors unanimously approved the Merger Agreement. Inconnection with the Merger, the Parent and certain of our stockholders enteredinto a Voting Agreement dated on or about October 6, 2006, whereby suchstockholders agreed, among other things, to vote their respective shares of ourstock in favor of the Merger Agreement, the Merger and the transactionscontemplated thereby. At a special meeting of our stockholders held on January 23,2007, the proposed Merger Agreement was rejected.

 

Under the terms of the Merger Agreement, because the Merger wasterminated, we reimbursed $2.5 million of costs incurred by Veritas, Parent andMerger Sub in connection with the proposed merger in February 2007. Suchcosts for legal and external professional and consulting fees are reflected ingeneral and administrative expenses for the year ended December 31, 2007.

 

**4.****             ****DISCONTINUED OPERATIONS**

 

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 the year ended December 31, 2005, we classified certain componentsas discontinued operations as the result of a management decision to closecertain facilities. Notifications were made to the required contractingentities regarding the termination of the related programs. At December 31,2007 and 2006, we did not have any significant net property and equipmentbalances pertaining to these former operations. There were no revenuesgenerated by these discontinued operations in the years ended December 31,2007 and 2006.

 

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

 

Intangible assets at December 31, 2007 and 2006consisted of the following (in thousands):

 
| ** **                                              | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Non-compete agreements                                  |       | $                     | 9,040      |   | $ | 10,040 |   |
| Accumulated  amortization – non-compete agreements |       | (7,541                | )          | (7,240 | ) |
| Acquired contract value                                 |       | 6,442                 |       | 6,442 |   |
| Accumalated  amortization – contract value         |       | (3,421                | )          | (2,316 | ) |
| Identified intangibles,  net                            |       | 4,520                 |       | 6,926 |   |
| Goodwill, net                                           |       | 13,355                |       | 12,339 |   |
| Total intangibles, net                                  |       | $                     | 17,875     |   | $ | 19,265 |   |

 

Thechanges in the carrying amount of goodwill for the year ended December 31,2007 are as follows (in thousands):

 
| ** **                           | ** ** | **Adult  Secure** | ** ** | **Abraxas  Youth and  Family** | ** ** | **Adult  Community-Based** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-------------------|------------|-------------------------------------|------------|----------------------------|------------|-----------|------------|
|                                 |       |              |       |                                |       |                       |       |      |       |
| 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    |       |
| Addition to goodwill                 |       | —            |       | —                              |       | 1,016                      |       | 1,016     |       |
| Balance as of December 31, 2007 |       | $                 | 2,902      |                                | $          | 1,060                      |       | $         | 9,393      |   | $ | 13,355 |   |

 

We recorded anaddition to goodwill as a result of the final release of amounts previouslyplaced in escrow related to the acquisition of Correctional Systems, Inc.(“CSI”) in April 2005.  At December 31,2007, we believe that there is no impairment to our existing goodwill.

 

Amortizationexpense for our acquired contract value was approximately $1.1 million, $1.1million and $1.0 million for the years ended December 31, 2007, 2006 and2005, respectively. Amortization expense for our acquired contract value isexpected to be approximately $1.1 million for the next year ended December 31and approximately $0.7 million for the following year.

 

Amortization expense forour non-compete agreements was approximately $1.3 million for the year ended December 31,2007 and $1.1 million for each of the years ended December 31, 2006 and2005. Amortization expense for our non-compete agreements is expected to beapproximately $1.1 million for each of the next two years and $0.6 million forthe third year.

 

**6.****             ****ACCOUNTING PRONOUNCEMENTSNOT YET ADOPTED**

 

***Statement of Financial AccountingStandards No. 141***

 

In December 2007, the FASB issued SFAS No. 141(Revised 2007), “Business Combinations” (“SFAS No. 141R”).  SFAS No. 141R significantly changes theaccounting for business combinations.  Under SFAS No. 141R, an acquiring entitywill be required to recognize all the assets acquired and liabilities assumedin a transaction at the acquisition-date fair value with limitedexceptions.  SFAS No. 141R changesthe accounting treatment for certain specific items, including acquisitioncosts, noncontrolling interests, acquired contingent liabilities, in-processresearch and development costs, restructuring costs and changes in deferred taxasset valuation allowances and income tax uncertainties subsequent to theacquisition date.  SFAS No. 141Rapplies prospectively to business combinations for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008.  Earlieradoption is not permitted,

 

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

 

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (“SFAS No. 157”).  SFAS No. 157 establishes a framework formeasuring fair value within generally accepted accounting principles andexpands disclosures about fair value measurements. SFAS No. 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years. The provisions of SFAS No. 157should be applied prospectively as of the beginning of the fiscal year in whichSFAS No. 157 is initially applied, except in limited circumstances. We arecurrently evaluating the effect that adoption of this standard will have on ourfinancial position and results of operations.

 

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

 

In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities – Includingan amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159permits entities to choose to measure many financial instruments and certainother items at fair value that are not currently required to be measured atfair value and establishes presentation and disclosure requirements designed tofacilitate comparisons between entities that choose different measurementattributes for similar types of assets and liabilities. SFAS No. 159 iseffective as of the beginning of an entity’s first fiscal year that beginsafter 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 are currently evaluating the effect that adoption of this standardwill have on our financial position and results of operations.

 

***Statement ofFinancial Accounting Standards No. 160***

 

In December 2007, the FASB issued SFAS No. 160,“Noncontrolling Interests in Consolidated Financial Statements – An Amendmentof ARB No. 51” (“SFAS No. 160”). SFAS No. 160 establishes new accounting and reporting standards forthe noncontrolling interest in a subsidiary and for the deconsolidation of asubsidiary.  SFAS No. 160 requiresthe recognition of a noncontrolling interest (minority interest) as equity inthe consolidated financial statements and separate from the parent’sequity.  The amount of net incomeattributable to the noncontrolling interest will be included in consolidatednet income on the face of the income statement. This statement clarifies that changes in a parent’s ownership interestin a subsidiary that do not result in deconsolidation are equity transactionsif the parent retains its controlling financial interest.  In addition, this statement requires that aparent recognize a gain or loss in net income when a subsidiary isdeconsolidated.  Such gain or loss willbe measured using the fair value of the noncontrolling equity investment on thedeconsolidation date.  SFAS No. 160also includes expanded disclosure requirements regarding the interests of theparent and it noncontrolling interest.  SFASNo. 160 is effective for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2008.  Earlier adoption is prohibited.

 

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

 

Property and equipment were as follows (inthousands):

 
| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                      |       |                  |       |   |   |
| Land                                      |       | $                     | 38,763     |   | $ | 31,765 |   |
| Prepaid facility use                      |       | 71,323                |       | 71,323 |   |
| Buildings and improvements                |       | 284,041               |       | 253,218 |   |
| Furniture and equipment                   |       | 33,954                |       | 30,827 |   |
| Construction in progress                  |       | 38,261                |       | 1,031 |   |
| Sub-total                                 |       | 466,342               |       | 388,164 |   |
| Accumulated depreciation and amortization |       | (82,390               | )          | (69,100 | ) |
| Total property and equipment              |       | $                     | 383,952    |   | $ | 319,064 |   |

 

The increase in land was due primarily to theHudson, Colorado site acquisition.  Theincrease in buildings and improvements was due primarily to the purchase of theHigh Plains Correctional Facility, the Washington, DC Facility and the facilityexpansion completed at the Big Spring Correctional Center.  The increase in construction in progress wasdue primarily to development costs associated with the Hudson, Colorado siteand construction costs related to the facility expansions at the D. Ray JamesPrison and the Great Plains Correctional Facility.

 

Wereview our long-lived assets for impairment at least annually or when changesin circumstances or a triggering event indicates that the carrying amount ofthe asset may not be recoverable in accordance with the provisions of SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.”  SFAS No. 144 requires that long-livedassets to be held and used recognize an impairment loss only if the carryingamount of the long-lived asset is not recoverable from its undiscounted cashflows and to measure an impairment loss as the difference between the carryingvalue and the fair value of the asset. Assets to be disposed of by sale are recorded at the lower of theircarrying amount or fair value less estimated selling costs. We estimate fairvalue based upon the best information available, which may include expectedfuture discounted cash flows to be produced by the asset and/or availablemarket prices. Factors that significantly influence estimated future discountedcash flows include the periods and levels of occupancy for the facility,expected per diem or reimbursement rates, assumptions regarding the levels ofstaffing, services and future operating and capital expenditures necessary togenerate forecasted revenues, related costs for these activities and futurerate of increases or decreases associated 

 

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withthese factors. We also consider the results of any appraisals on the propertieswhen assessing fair value. These estimates may be highly subjective,particularly in circumstances where there is no current operating contract inplace and changes in the assumptions and estimates could result in therecognition of impairment charges. The most subjective estimates made in thisanalysis for 2007 relate to the Regional Correctional Center and the Hector Garza Residential TreatmentCenter.  The most subjective estimatesmade in this analysis for 2006 relate to the Cornell Abraxas Academy and theHector Garza Residential Treatment Center. We may be required to record animpairment charge in the future if we are unable to successfully negotiate areplacement contract on any of our facilities for which we currently have an operatingcontract. Given the nature of the evaluation of future cash flows and theapplication to specific assets and specific times, it is not possible toreasonably quantify the impact of changes in these assumptions.

 

Inconjunction with our review of our long-lived assets based on forecastedoperating and cash flow losses associated with these assets at December 31,2006, we determined that our carrying value for two of our adultcommunity-based facilities was not fully recoverable and exceeded their fairvalue and, as a result, we recorded an impairment charge of $0.4 million in theyear ended December 31, 2006. This charge was based on the best marketinformation available.

 

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**8.****             ****ACCOUNTS PAYABLE AND ACCRUEDLIABILITIES**

 

Accounts payable and accrued liabilities consistedof the following (in thousands):

 
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                           |       |                  |       |   |   |
| Accounts payable                               |       | $                     | 20,321     |   | $ | 15,286 |   |
| Accrued compensation                           |       | 9,837                 |       | 9,847 |   |
| Accrued interest payable                       |       | 5,707                 |       | 11,717 |   |
| Accrued litigation settlements                 |       | —                |       | 878 |   |
| Accrued taxes payable                          |       | 3,926                 |       | 5,519 |   |
| Accrued insurance                              |       | 7,779                 |       | 7,960 |   |
| Accrued legal                                  |       | 5,306                 |       | 4,822 |   |
| Resident funds                                 |       | 2,598                 |       | 1,659 |   |
| Other                                          |       | 2,028                 |       | 2,475 |   |
| Total accounts payable and accrued liabilities |       | $                     | 57,502     |   | $ | 60,163 |   |

 

At December 31, 2006, accounts payable andaccrued liabilities contain accrued litigation settlement charges of $0.9million pertaining to the Lincoln County Detention Center. Refer to Note 11 tothe consolidated financial statements for a discussion regarding these matters.

 

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

 

In July 2006, the Financial AccountingStandards Board (“FASB”) issued FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109”(“FIN 48”).  FIN 48 established a singlemodel to address the accounting for uncertain tax positions.  FIN 48 clarifies the accounting for incometaxes by prescribing a minimum recognition threshold a tax position is requiredto meet before being recognized in the financial statements.  FIN 48 also provides guidance on themeasurement, recognition, classification and disclosure of tax positions, aswell as the accounting for the related interest and penalties, transition andaccounting in interim periods.

 

The Company adopted the provisions of FIN 48effective January 1, 2007.  As aresult of our adoption of FIN 48, we recorded a cumulative effect adjustment ofapproximately $0.3 million which increased retained earnings at January 1,2007.  As of January 1, 2007 and December 31,2007, we had unrecognized tax benefits in the amount of $2.9 million and $3.0million, respectively, that if recognized in future periods, approximately $0.8million would reduce our income tax expense and our effective tax rate as of January 1,2007 and December 31, 2007.  Areconciliation of the beginning and ending amount of unrecognized tax benefitsis as follows (in thousands):

 
| Balance at January 1, 2007                           |   | $      | 2,948  |   |
|-----------------------------------------------------------|--------|--------|--------|--------|
| Additions based on tax positions related to  current year |   | 569    |   |
| Additions for tax positions in prior year                 |   | 4      |   |
| Reductions for tax positions in prior year                |   | — |   |
| Lapse in Statutes of Limitations                          |   | (503   | )      |
| Balance at December 31, 2007                         |   | $      | 3,018  |   |

 

Estimated interest and penalties related to theunderpayment of income taxes are classified as a component of income taxexpense in the accompanying Consolidated Statements of Income and ComprehensiveIncome and totaled approximately $0.1 million in the year ended December 31,2007.  Accrued interest and penaltieswere approximately $0.3 million and $0.2 million at December 31, 2007 and January 1,2007, respectively.

 

We are subject to income tax in the United Statesand many of the individual states we operate in.  We currently have significant operations inTexas, California and Pennsylvania. State income tax returns are generally subject to examination for aperiod of three to five years after filing. The state impact of any changes made to the federal return remainssubject to examination by various states for a period up to one year afterformal notification to the state.  We areopen to United States Federal Income Tax examinations for the tax years December 31,2004 through December 2007.

 

We do not anticipate a significant change in thebalance of our unrecognized tax benefits with the next 12 months.

 

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

 
| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Deferred tax assets:               |       |                  |       |   |   |
| Accrued liabilities and allowances |       | $                     | 8,535      |   | $ | 7,704 |   |
| State operating loss carryforwords |       | 2,088                 |       | 2,455 |   |
| Deferred compensation              |       | 1,176                 |       | 513 |   |
| Other                              |       | 1,878                 |       | 125 |   |
| Total deferred tax assets          |       | 13,677                |       | 10,797 |   |
|                               |       |                  |       |   |   |
| Deferred tax liabilities:          | ** ** | ** **            | ** ** | ** ** | ** ** |
| Property and equipment             |       | 15,531                |       | 11,688 |   |
| Prepaid expenses                   |       | 832                   |       | 1,075 |   |
| Other                              |       | 749                   |       | 280 |   |
| Total deferred tax liabilities     |       | 17,112                |       | 13,043 |   |
|                               |       |                  |       |   |   |
| Valuation allowance                |       | (2,088                | )          | (2,455 | ) |
|                               |       |                  |       |   |   |
| Net deferred tax liability         |       | $                     | 5,523      |   | $ | 4,701 |   |

 

As of December 31,2007, we have net operating losses for state income taxes of approximately $24.3million. Our tax returns are subject to periodic audit by the variousjurisdictions in which we operate. These audits, including those currentlyunderway, can result in adjustments of taxes due or adjustments of the NOLswhich are available to offset future taxable income.

 

Valuation allowances of $2.1 million have beenestablished for uncertainties in realizing the benefit of certain state incometax loss carryforwards. For the years ended December 31, 2007, 2006 and 2005,changes in our state operating loss carryforwards (decreased)/increased ourvaluation allowance by ($0.4) million, $0.3 million and $0.5 million,respectively. In assessing the realizability of carryforwards, we considerwhether it is more likely than not that some portion or all of the deferred taxassets will be realized. The valuation allowance will be adjusted in theperiods that we determine it is more likely than not that deferred tax assetswill or will not be realized.

 

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

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                       |       |                                       |       |   |   |   |   |
| Federal current provision                  |       | $                                          | 6,213      |   | $ | 4,332 |   | $ | 239 |   |
| State current provision                    |       | 1,276                                      |       | 1,617 |   | (197 | ) |
| Total current provision                    |       | 7,489                                      |       | 5,949 |   | 42 |   |
|                                       |       |                                       |       |   |   |   |   |
| Federal deferred provision                 |       | 1,034                                      |       | 3,114 |   | 2,097 |   |
| State deferred provision                   |       | 312                                        |       | 85 |   | 76 |   |
| Total deferred provision                   |       | 1,346                                      |       | 3,199 |   | 2,173 |   |
|                                       |       |                                       |       |   |   |   |   |
| Total provision from continuing operations |       | $                                          | 8,835      |   | $ | 9,148 |   | $ | 2,215 |   |

 

Our tax returns are subject to periodic audits bythe various jurisdictions in which we operate. These audits including thosecurrently underway can result in adjustments of taxes due or adjustments of theNOLs which are available to offset future taxable income.

 

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The following is a reconciliation of income taxes atthe statutory federal income tax rate of 35% to the income tax provisionrecorded by us (in thousands):

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Computed taxes at statutory rate           |       | $                                          | 7,263      |   | $ | 7,602 |   | $ | 2,138 |   |
| State income taxes, net of federal benefit |       | 1,109                                      |       | 1,042 |   | (273 | ) |
| Other                                      |       | 463                                        |       | 504 |   | 350 |   |
|                                       |       | $                                          | 8,835      |   | $ | 9,148 |   | $ | 2,215 |   |

 

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

 

Our long-term debt consisted of the following (inthousands):

 
| ** **                                                                                                                                                                  | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **Debt of Cornell Companies, Inc.:**                                                                                                                                   |       |                  |       |   |   |
| Senior Notes, unsecured, due July 2012  with an interest rate of 10.75%, net of discount                                                                               |       | $                     | 111,172    |   | $ | 110,987 |   |
| Fair-value adjustment of Senior Notes as  result of interest rate swap                                                                                                      |       | —                |       | (1,053 | ) |
| Revolving Line of Credit due  December 2011 with an interest rate of LIBOR plus 1.50% to 2.25% or  prime plus 0.00% to 0.75% (the “Amended Credit Facility”) |       | 30,000                |       | — |   |
| Capital lease obligations                                                                                                                                                   |       | 37                    |       | 47 |   |
| Subtotal                                                                                                                                                                    |       | 141,209               |       | 109,981 |   |
|                                                                                                                                                                        |       |                  |       |   |   |
| **Debt of Special Purpose Entities:**                                                                                                                                       |       |                  |       |   |   |
| 8.47% Bonds due 2016                                                                                                                                                        |       | 145,500               |       | 156,000 |   |
|                                                                                                                                                                        |       |                  |       |   |   |
| Total consolidated debt                                                                                                                                                     |       | 286,709               |       | 265,981 |   |
|                                                                                                                                                                        |       |                  |       |   |   |
| Less: current maturities                                                                                                                                                    |       | (11,411               | )          | (10,510 | ) |
|                                                                                                                                                                        |       |                  |       |   |   |
| Consolidated long-term debt                                                                                                                                                 |       | $                     | 275,298    |   | $ | 255,471 |   |

 

***Long-Term Credit Facilities.***  OurCredit Facility provided for borrowings of up to $60.0 million under arevolving line of credit and was reduced by outstanding letters of credit. In October 2007, we amendedthe Credit Facility (the “Amended Credit Facility”). The Amended CreditFacility provides for borrowings up to $100.0 million (including letters ofcredit), matures in December 2011 and bears interest, at our electiondepending on our total leverage ratio, at either the prime rate plus a marginranging from 0.00% to 0.75%, or a rate which ranges from 1.50% to 2.25% abovethe applicable LIBOR rate. Theavailable commitment under our Amended Credit Facility was approximately $59.7million at December 31, 2007.  Wehad outstanding borrowings under our Amended Credit Facility of $30.0 millionand we had outstanding letters of credit of approximately $10.3 million at December 31,2007.  Subject to certain requirements,we have the right to increase the commitments under our Amended Credit Facilityup to $150.0 million.  The Amended CreditFacility iscollateralized by substantially all of our assets, including the assets andstock of all of our subsidiaries. The Amended Credit Facility is not secured bythe assets of MCF. Our Amended Credit Facility contains standard covenantsincluding compliance with laws, limitations on certain financing transactionsand mergers and compliance with financial covenants, although the covenants inthe Amended Credit Facility were amended to provide greater flexibility incertain instances, including deletion of the minimum net worth and minimumasset coverage requirements contained in the Credit Facility and more favorableleverage ratios. The most restrictive covenant under our Amended Credit Facilityis the fixed charge coverage ratio.

 

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

 

In June 2004, we issued $112.0million in principal of 10.75% Senior Notes the (“Senior Notes”) due July 1,2012.  The Senior Notes are unsecuredsenior indebtedness and are guaranteed by all of our existing and futuresubsidiaries (collectively, “the Guarantors”). The Senior Notes are not guaranteed by MCF (the “Non-Guarantor”).  Interest on the Senior Notes is payablesemi-annually on January 1 and July 1 of each year, commencing January 1,2005.  On or after July 1, 2008, wemay redeem all or a portion of the Senior Notes at the redemption prices(expressed as a percentage of the principal amount) listed below, plus accruedand unpaid interest, if any, on the Senior Notes redeemed, to the applicabledate of redemption, if redeemed during the 12-month period commencing on July 1of each of the years indicated below:

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

 

Upon the occurrence ofspecified change of control events, unless we have exercised our option toredeem all the Senior Notes as described above, each holder will have the rightto require us to repurchase all or a portion of such holder’s Senior Notes at apurchase price in cash equal to 101% of the aggregate principal amount of thenotes repurchased plus accrued and unpaid interest, if any, on the Senior Notesrepurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture which limits our ability and the ability of our Guarantors to, amongother things, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets.

 

In conjunction with the issuance of the SeniorNotes, we entered into an interest rate swap transaction with a financialinstitution to hedge our exposure to changes in the fair value on $84.0 millionof our Senior Notes.  The purpose of thistransaction was to convert future interest due on $84.0 million of the SeniorNotes to a variable rate.  The terms ofthe interest rate swap contract and the underlying debt instrument wereidentical.  The swap agreement wasdesignated as a fair value hedge.  Theswap had a notional amount of $84.0 million and matured in July 2012 tomirror the maturity of the Senior Notes. Under the agreement, we paid, on a semi-annual basis (each January 1and July 1), a floating rate based on a six-month U.S. dollar LIBOR rate,plus a spread, and receive a fixed-rate interest of 10.75%. For the year ended December 31,2007, we recorded interest expense related to this interest rate swap ofapproximately $0.1 million. For the year ended December 31, 2006, werecorded interest expense of approximately $0.2 million.    At December 31, 2006, the fair valueof this derivative instrument was a liability of approximately ($1.1) millionand is included in other long-term liabilities at December 31, 2006 in ourConsolidated Balance Sheets.  Thecarrying value of the Senior Notes as of this date was adjusted accordingly bythe same amount.  Because the swapagreement was an effective fair-value hedge, there was no effect on our resultsof operations from the mark-to-market adjustment while the swap agreement wasin effect.  In October 2007, weterminated the swap agreement.  Wereceived approximately $0.2 million in conjunction with the termination, whichis being amortized over the remaining term of the Senior Notes.

 

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

 
| ** **                            | ** ** | **Cornell  Companies, Inc.** | ** ** | **MCF**    | ** ** | **Consolidated** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|------------|------------|------------------|------------|
| ** **                            | ** ** | ** **                        | ** ** | ** ** | ** ** | ** **       | ** ** |
| For the year ending December 31, | ** ** | ** **                        | ** ** | ** ** | ** ** | ** **       | ** ** |
| 2008                                  |       | $                                 | 12         |       | $          | 11,400           |       | $ | 11,412 |   |
| 2009                                  |       | 12                                |       | 12,400     |       | 12,412           |       |
| 2010                                  |       | 13                                |       | 13,400     |       | 13,413           |       |
| 2011                                  |       | 30,000                            |       | 14,600     |       | 44,600           |       |
| Thereafter                            |       | 112,000                           |       | 93,700     |       | 205,700          |       |
| Total                                 |       | $                                 | 142,037    |       | $          | 145,500          |       | $ | 287,537 |   |

 

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**11.  COMMITMENTSAND CONTINGENCIES**

 

***FinancialGuarantees***

 

During the normal course of business, we enter intocontracts that contain a variety of representations and warranties and providegeneral indemnifications. Our maximum exposure under these arrangements isunknown as this would involve future claims that may be made against us thathave not yet occurred. However, based on experience, we believe the risk ofloss to be remote.

 

***Operating Leases***

 

We lease office space, certain facilities andfurniture and equipment under long-term operating leases. Rent expense for alloperating leases for the years ended December 31, 2007, 2006 and 2005 wasapproximately $10.4 million, $11.5 million and $8.3 million, respectively.

 

Landlord incentives or allowances under operatingleases are recorded as deferred rent and amortized as a reduction of rentexpense over the lease term. Those operating leases with step rent provisionsor escalation clauses that are not considered contingent rent are recognized ona straight-line basis over the lease term. For those leases that include anexisting index or rate, such as the consumer price index or the prime interestrate, the related minimum lease payments are recognized on a straight-linebasis over the lease term and the amount of rent considered to be contingent isrecorded as incurred and is not included in the straight-line basis rentexpense. We do not receive significant sublease rentals under any of ourexisting operating leases.

 

Certain of our leases contain renewal options, whichrange from additional rental periods of one to five years. Escalation clausesare also included in certain of our leases. There are no significantrestrictions imposed by our lease agreements concerning such issues as dividendpayments, incurrence of additional debt or further leasing.

 

As of December 31, 2007, we had the followingrental commitments under noncancelable operating leases (in thousands):

 
| For the year ending December 31, |   |   |   |
|---------------------------------------|--------|--------|--------|
| 2008                                  |   | $      | 6,862  |   |
| 2009                                  |   | 5,303  |   |
| 2010                                  |   | 3,018  |   |
| 2011                                  |   | 648    |   |
| Thereafter                            |   | 7,719  |   |
| Total                                 |   | $      | 23,550 |   |

 

The following schedule shows the compositionof total rental expense for all operating leases (in thousands):

 
| ** **             | ** ** | **Year Ended December 31,** | ** ** |
|------------------------|------------|--------------------------------------------|------------|
| ** **             | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| Minimum rentals        |       | $                                          | 9,911      |   | $ | 11,107 |   | $ | 8,051 |   |
| Contingent rentals     |       | 458                                        |       | 426 |   | 271 |   |
| Less: sublease rentals |       | (246                                       | )          | (232 | ) | (293 | ) |
| Total                  |       | $                                          | 10,123     |   | $ | 11,301 |   | $ | 8,029 |   |

 

***401(k) Plan***

 

We have a defined contribution 401(k) plan. Ourmatching contribution currently represents 50% of a participant’s contribution,up to the first 6% of the participant’s salary. We recorded contributionexpense of approximately $1.3 million for the year ended December 31, 2007 andapproximately $1.2 million for each of the years ended December 31, 2006and 2005.

 

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***Legal Proceedings***

 

We are party to various legal proceedings,including those noted below. While management presently believes that theultimate outcome of these proceedings will not have a material adverse effecton our financial position, overall trends in results of operations or cashflows, litigation is subject to inherent uncertainties, and unfavorable rulingscould occur. An unfavorable ruling could include monetary damages or equitablerelief, and could have a material adverse impact on the net income of theperiod in which the ruling occurs or in future periods.

 

***Valencia CountyDetention Center***

 

In April 2007, a lawsuit was filed against the Company in theFederal District court in Albuquerque, New Mexico, by Joe Torres and EufrasioArmijo, who each alleged that he was strip searched at the Valencia CountyDetention Center (“VCDC”) in New Mexico in violation of his federal rightsunder the Fourth, Fourteenth and Eighth amendments to the U.S.Constitution.  The claimants also allege violation of their rights understate law and seek to bring the case as a class action on behalf of themselvesand all detainees at VCDC during the applicable statues of limitation. The plaintiffs seek damages and declaratory and injunctive relief. Valencia County is also a named defendant in the case and operated the VCDC fora significantly greater portion of the period covered by the lawsuit.  Discovery has commenced in the case but theultimate outcome of the lawsuit cannot be determined at this time. However, weintend to vigorously defend this lawsuit.

 

***Lincoln CountyDetention Center***

 

In August 2005, a lawsuit was filed by a detainee at the LincolnCounty Detention Center (“LCDC”) in the U.S. District Court of New Mexico(Santa Fe) seeking unspecified damages. The lawsuit relates to the former LCDCpolicy that required strip and visual body cavity searches for all detaineesand inmates and alleges that such policy violates a detainee’s Fourth andFourteenth Amendment rights under the U.S. Constitution. The lawsuit was filedas a putative class action lawsuit brought on behalf of all inmates who weresearched at the LCDC from May 2002 to July 2005. In September 2006,we agreed to a proposed stipulation of settlement and the court haspreliminarily approved the settlement. The settlement amount under the terms ofthe agreement is $1.6 million, and was funded principally through our generalliability and professional liability coverage.

 

In the year ended December 31, 2005, we recorded a charge of $0.2million related to this lawsuit. In addition, we previously have providedinsurance reserves for this matter (as part of our regular review of reportedand unreported claims) totaling approximately $0.5 million. During the thirdquarter of 2006, we recorded an additional settlement charge of approximately$0.9 million and the related reimbursement from our general liability andprofessional liability insurance. The charge and reimbursement were recognizedin general and administrative expenses for the year ended December 31,2006. The reimbursement was funded by the insurance carrier in the firstquarter of 2007 into a settlement account. The court granted preliminaryapproval of the settlement in the second quarter of 2007, and the claimsadministration process is now underway. We expect the claims administrationprocess to be completed and the final court approval of the settlement in thefirst half of 2008.

 

***Alexander Youth Service Center***

 

In April 2006, we were sued in an action styled as *Juana Michelle Brown, Administratrix of the Estate of LakeishaShantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV00000434, in the United States District Court for the EasternDistrict of Arkansas. The lawsuit alleges that we violated the rights ofLakeisha Shantrail Brown, the deceased daughter of Juana Michelle Brown, underthe U.S. Constitution and the laws of the State of Arkansas by denying Ms. Brownmedical treatment that caused her death and sought unspecified actual andpunitive damages. In September 2006, the plaintiff filed, and the courtgranted, an order for voluntary dismissal without prejudice. The lawsuit wasrefiled in December 2006 as *Juana Michelle Brown,Administratrix of the Estate of Lakeisha Shantrail Brown, Deceased, v. CornellInterventions, Inc. et al.,*No. 4-06 CV17808*,*in the United States District Court for the EasternDistrict of Arkansas. We have reached an agreement with the plaintiff to settlethe matter, and the settlement must be approved by a probate court. Ourinsurance coverage is sufficient to cover the settlement subject to our normaldeductible.

 

***Southern Peaks Regional Treatment Center***

 

In January 2004, we initiated legal proceedings in the lawsuitstyled *Cornell Corrections of California, Inc. v.Longboat Global Advisors, LLC, et al*., No.2004 CV79761 in theSuperior Court of Fulton County, Georgia under theories of fraud, conversion,breach of contract and other theories to determine the location of and torecover funds previously deposited by us 

 

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into what we believed to be an escrow account in connection with thedevelopment and construction of the Southern Peaks Regional Treatment Center.Of the funds previously deposited, approximately $5.1 million remains to berecovered at September 30, 2007. In December 2004, the jury awardedus approximately $6.5 million in compensatory damages and approximately $1.4million in punitive damages, plus attorneys’ fees. The actual damages portionof the award under the final Judgment and Decree (“Judgment”) entered on December 20,2006 was adjusted downward to the $5.4 million actually lost by us. The awardfor compensatory damages accrues pre-judgment interest at a rate of 7 percentfrom the date of loss through the date of judgment. Following the juryverdicts, we collected approximately $0.4 million in January 2005 in fundsthat had been previously frozen under a temporary restraining order issued atthe time that we commenced this litigation. Currently, one of the defendantshas filed an appeal of the Judgment. Due to the continued uncertaintysurrounding the ultimate recovery of the funds previously deposited, werecorded an additional reserve in the amount of approximately $0.3 million inthe quarter ended December 31, 2006. During 2007 we collectedapproximately $0.2 million in funds. We will continue to maintain our existingreserve at December 31, 2007 of approximately $5.1 million in an allowancefor doubtful accounts against the corresponding balance as carried in otherreceivables at December 31, 2007 and 2006. We do not expect any additionalmaterial recovery, expense, change or result from these proceedings.

 

***Shareholder Lawsuits***

 

OnOctober 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 complaint names asdefendants Cornell and each member of our board of directors as well as VeritasCapital Fund III, L.P. (“Veritas”). The complaint alleges, among other things,that (i) the defendants have breached fiduciary duties they assertedlyowed to our stockholders in connection with our entering into the Agreement andPlan of Merger, dated as of October 6, 2006, with Veritas, Cornell HoldingCorp., and CCI Acquisition Corp., and (ii) the merger consideration isunfair and inadequate. The plaintiffs sought, among other things, an injunctionagainst the consummation of the merger. The proposed merger was rejected at aspecial meeting of our stockholders held on January 23, 2007. We believethat the lawsuit is without merit and intend to defend ourselves vigorously.

 

We hold insurance policies to cover potential director and officerliability, some of which may limit our cash outflows in the event of a decisionadverse to us in the matters discussed above. However, if an adverse decisionin these matters exceeds the insurance coverage or if the insurance coverage isdeemed not to apply to these matters, it could have a material adverse effecton us, our financial condition, results of operations and future cash flows.

 

***Other***

 

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

 

During the period from August 2000 through May 2003, ourgeneral liability and professional liability coverage was provided by SpecialtySurplus Insurance Company, a Kemper Insurance Company (“Kemper”) group member.In June 2004, the Illinois Department of Insurance gave Kemper permissionto proceed with a run-off plan it had previously submitted. The three-year planis designed to help Kemper meet its goal of resolving, to the maximum extentpossible, all valid policyholder claims. In view of the risks and uncertaintiesinvolved in implementing the plan, including the need to achieve significantpolicy buybacks, commutation of reinsurance agreements, and further agreementswith regulators, the plan may not be successfully implemented by Kemper. In theyear ended 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 released reserves of approximately $0.4 million duringthe quarter ended December 31, 2006. At December 31, 2007, 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.

 

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

 

**12.  STOCKHOLDERS’EQUITY**

 

***StockholderRights Plan***

 

Our Board of Directors terminated Cornell’sstockholder rights plan in July 2005.

 

***Preferred Stock***

 

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

 

***Options andWarrants***

 

Under our 2000 Broad-Based Employee Plan (the “2000Plan”) we may grant non-qualified stock options to our employees, directors andeligible consultants for up to the greater of 400,000 shares or 4% of theaggregate number of shares of common stock issued and outstanding immediatelyafter grant of any option under the 2000 Plan. The 2000 Plan options vest up tofive years and expire ten years from the grant date. Under our 1996 StockOption Plan, as amended and restated in April 1998 (the “1996 Plan”) wemay grant non-qualified and incentive stock options for up to the greater of1,932,119 shares or 15.0% of the aggregate number of shares of common stockoutstanding. The 1996 Plan options vest up to seven years and expire seven toten years from the grant date. The Compensation Committee of the Board ofDirectors, which consists entirely of independent directors, is responsible fordetermining the exercise price and vesting terms for the granted options. The1996 Plan and 2000 Plan option exercise prices can be no less than the marketprice of our common stock on the date of grant.

 

In conjunction with the issuance of our SubordinatedNotes in July 2000, we issued warrants to purchase 290,370 shares of thecommon stock at an exercise price of $6.70. We recognized the fair value of thesewarrants of $1.1 million as additional paid-in capital. The warrants could onlybe exercised by payment of the exercise price in cash to us, by cancellation ofan amount of warrants equal to the fair market value of the exercise price, orby the cancellation of our indebtedness owed to the warrant holder. During2001, 168,292 shares of our common stock were issued in conjunction with theexercise and cancellation of 217,778 warrants. At December 31, 2006,72,592 warrants were outstanding.  During2007, all 72,592 warrants were exercised and canceled.

 

For a summary of the status of our variousoption plans at December 31, 2007, see Note 2 to the consolidatedfinancial statements.

 

***Treasury Stock***

 

We did not repurchase any of our common stock in theyears ended December 31, 2007 and 2006. Under the terms of our SeniorNotes and our Amended Credit Facility, we can purchase shares of our stocksubject to certain cumulative restrictions.

 

***Employee StockPurchase Plan***

 

We have an employee stock purchase plan under whichemployees can make contributions to purchase our common stock. Participation inthe plan is elected annually by employees. The plan year begins each January 1st(the “Exercise Date”) and ends on December 31st (the “EndingDate”). Purchases of common stock are made at the end of the year using thelower of the fair market value on either the Beginning Date or Ending Date,less a 15.0% discount. For the years ended December 31, 2007, 2006 and2005, employee contributions of approximately $0.2 million, $0.3 millionand  $0.4 million were used to purchase25,348, 22,593 and 30,553, respectively, of our common stock.

 

***2006Equity Incentive Plan***

 

Our stockholders approved the establishmentof the 2006 Equity Incentive Plan (the “2006 Plan”) at our June 29, 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 achievelonger-range performance goals, and (iii) enabling such individuals toparticipate in 

 

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the long-term growth andfinancial success of the Company. At the discretion of the CompensationCommittee, any employee, 

director, or consultant of theCompany or its affiliates may be granted an award under the 2006 Plan. TheCompensation Committee administers the 2006 Plan.

 

A total of 1,400,000 shares of common stockare authorized for issuance under the 2006 Plan, all of which may be issuedpursuant to incentive stock options. These shares of common stock will be in a “fungiblepool” with shares subject to restricted stock, stock compensation and otherstock-based awards counted against this limit as two (2) shares for everyone (1) share granted and any shares subject to any other type of award tobe counted against this limit as one (1) share for every one (1) sharegranted. Stock options (both non-qualified stock options and incentive stockoptions), stock appreciation rights, restricted stock, restricted stock units,performance awards, stock compensation and other stock-based awards may begranted under the 2006 Plan.

 

In the event of a Change of Control, asdefined in the 2006 Plan, any outstanding stock option, stock appreciationright, non-performance based restricted stock or restricted stock unit award,and performance based restricted stock, restricted stock units, performanceshare or performance unit award (unless otherwise provided in the performanceaward agreement) will automatically vest. Upon a Change of Control, the Boardof Directors may also take any one or more of the following actions: (i) providefor the purchase of any outstanding awards by the Company; (ii) makeadjustments to any outstanding awards; or (iii) allow for the assumptionor substitution of outstanding awards by the acquiring or survivingcorporation.  Grants of 287,000 shares ofrestricted stock were made under the 2006 Plan during the year ended December 31,2007.  No grants were made to anyindividual under the 2006 Plan during the year ended December 31, 2006.

 

***Deferred BonusPlan***

 

We have a deferred bonus plan for certain employees.Pursuant to the plan at its inception, approximately $4.7 million was depositedon behalf of individual participants into a rabbi trust account, which includedapproximately $3.6 million in cash and $1.1 million in our treasury stock. Thetreasury stock portion of the rabbi trust remained as treasury stock, while theparticipants were able to give investment directions to the trustee as to thecash portion, subject to certain limitations. The investments of the rabbitrust represented our assets and were included in our accompanying ConsolidatedBalance Sheets based on the nature of the assets held. Assets placed into therabbi trust are irrevocable; therefore, they are restricted as to our use underthe terms of the trust and the deferred bonus plan. Remaining assets held inthe rabbi trust were distributed in full upon final vesting of the trust in2006.

 

The plan generally vested 100.0% upon theachievement of an aggregate amount of monthly credits (based on a fixed monthlyearnings milestone) which occurred at the end of five years beginning October 1,2001. Based on the expected earnings period, compensation expense and therelated compensation liability for the aggregate plan value were recognizedover five years. To the extent the vesting was extended or accelerated based onthe achievement of the financial milestones, recognition of compensationexpense would be adjusted on a prospective basis. In the event of a change ofcontrol (as defined in the plan), the amounts in each participants accountwould be paid to the participant in a lump sum. For the year ended December 31,2005, we expensed approximately $0.4 million under the deferred bonusplan.  There was no expense related tothe plan for the years ended December 31, 2007 and 2006.

 

While periodic gains on the value of eachparticipant’s investments held in the rabbi trust were recorded currently inincome, an equal amount of compensation expense and related compensationliability was recorded, since participants were fully vested in such gains.Periodic losses incurred by participants in their invested balances wererecorded as incurred. Such losses in excess of a participant’s recordedcompensation expense were guaranteed by the participants with a full-recourseobligation to us. These guarantees function to offset the loss on investmentsto the extent the obligations were not reserved for collectibility by us.

 

Amounts held in treasury stock were recorded atcost. An equal amount was established as deferred compensation and additionalpaid-in capital in our Consolidated Statements of Stockholders’ Equity. Thebalance in the deferred bonus plan was amortized to compensation expense overthe expected vesting period of five years.

 

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**13.  DERIVATIVEFINANCIAL INSTRUMENTS AND GUARANTEES**

 

***Debt ServiceReserve Fund and Debt Service Fund***

 

In August 2001, MCF completed a bond offeringto finance the 2001 Sale and Leaseback Transaction (in which we sold elevenfacilities (as identified in Item 1 of this report) to MCF. In connection withthis bond offering, two reserve fund accounts were established by MCF pursuantto the terms of the indenture: (1) MCF’s Debt Service Reserve Fund,aggregating $23.6 million at December 31, 2007, was established to makepayments on MCF’s outstanding bonds in the event we (as lessee) should fail tomake the scheduled rental payments to MCF and (2) MCF’s Debt Service Fund,aggregating $25.0 million at December 31, 2007, was established toaccumulate the monthly lease payments that MCF receives from us until suchfunds are used to pay MCF’s semi-annual bond interest and annual bond principalpayments. These reserve funds are invested in short-term money markets andcommercial paper. Both reserve fund accounts are subject to the agreements withthe MCF Equity Investors whereby guaranteed rates of return of 3.0% and 5.08%,respectively, are provided for in the balance of the Debt Service Reserve Fundand the Debt Service Fund. The guaranteed rates of return are characterized ascash flow hedge derivative instruments. At inception, the derivatives had anaggregate fair value of $4.0 million, which has been recorded as a decrease tothe equity investment in MCF made by the MCF Equity Investors (MCF minorityinterest) and as a liability in our Consolidated Balance Sheets. Changes in thefair value of the derivative instruments are recorded as an adjustment to otherlong-term liabilities and reported as other comprehensive income (loss) in ourConsolidated Statements of Operations and Comprehensive Income (Loss). At December 31,2007, the fair value of these derivative instruments was approximately $2.2million. As a result, our Consolidated Statements of Operations andComprehensive Income (Loss) include accumulated other comprehensive income(loss) of approximately $0.6 million, ($0.1) million and ($1.1) million for theyears ended December 31, 2007, 2006 and 2005, respectively. The $(1.1)million net unrealized loss reported in comprehensive income (loss) for theyear ended December 31, 2005 includes an adjustment of $0.6 million forthe cumulative tax effect of changes in fair value during the years ended December 31,2002 and 2003. This adjustment decreased accumulated other comprehensive incomeand increased deferred tax liabilities in our Consolidated Balance Sheet as of December 31,2005.

 

In connection with MCF’s bond offering, the MCFEquity Investor provided a guarantee of the Debt Service Reserve Fund if abankruptcy of the Company were to occur and a trustee for the estate of theCompany were to include the Debt Service Reserve Fund as an asset of theCompany’s estate. This guarantee is characterized as an insurance contract andits fair value is being amortized to expense over the life of the debt.

 

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**14.  RELATEDPERSON TRANSACTIONS**

 

One of our former directors, Marcus Watts,  who left the board in 2005 is a partner in alaw firm that provided legal services to us. Legal fees paid to this law firm were approximately $0.1 million for theyear ended December 31, 2007 and $0.9 million for each of the years ended December 31,2006 and 2005.

 

InSeptember 1999, we entered into a consulting agreement with Cornell’sfounder, David Cornell, who was a director of Cornell through October 2003.  Services rendered under the consulting agreementincluded serving as a director of Cornell over the initial four years of theterm of the agreement and assisting in such areas as the development of newbusiness, acquisitions, financings and executive management assimilation.  As compensation for consulting services, weagreed to an annual payment of at least $255,000 for each of the first fouryears of the seven-year initial term of the consulting agreement with an annualpayment of at least $180,000 for each of the last three years of the initial term.As additional compensation, we agreed to an annual bonus, subject to certainlimitations, equal to $75,000 during the first four years of the initial termand an annual bonus of $60,000 during the last three years of the initial term.The initial term concluded in 2006 and the final bonus payment of $60,000 waspaid.  The agreement was not renewed.

 

Wealso entered into a non-compete agreement with Mr. Cornell.  The non-compete agreement has a term of 10years and required us to pay a monthly fee of $10,000 for the seven-yearinitial term of the consulting agreement. We capitalize the monthly payments and amortize the amounts over the10-year term of the non-compete agreement. We recognized amortization expense relatedto this agreement of approximately $84,000 for each of the years ended December 31,2007, 2006 and 2005.

 

Wemaintain a life insurance policy for Mr. Cornell and made payments relatedto this policy of approximately $0.2 million for each of the years ended December 31,2007, 2006 and 2005.

 

Totalpayments made for the above to Mr. Cornell were approximately $0.06million, $0.5 million and $0.9 million for the years ended December 31,2007, 2006 and 2005, respectively.

 

Weentered into a consulting agreement with a former director, Arlene Lissner,  which expires in December 2008.  Services rendered under this agreementinclude research and analysis for various topics including data collection,support and training for program development; performance-based contractualrequirements and performance-improvement processes, accreditations andregulatory requirements.  Total paymentsunder this agreement, which has a termination fee incorporated for atermination prior to maturity, totaled $0.3 million for each of the years endedDecember 31, 2007, 2006 and 2005. The termination fee at December 2007 was $0.1 million.

 

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**15.  SEGMENTDISCLOSURE**

 

Our three operating divisions are our reportablesegments. The Adult Secure Services segment (formerly known as “adult secureinstitutions and detention centers”) consists of the operations of secure adultincarceration facilities. The Abraxas Youth and Family Services segment(formerly known as “juvenile justice, educational and treatment services”)consists of providing residential treatment and educational programs andnon-residential community-based programs to juveniles between the ages of tenand 17 who have either been adjudicated or suffer from behavioral problems. TheAdult Community-Based Services segment (formerly known as “adultcommunity-based corrections and treatment services”) consists of providingpre-release and halfway house programs for adult offenders who are either onprobation or serving the last three to six-months of their sentences on paroleand preparing for re-entry into society at large as well as community-basedtreatment and education programs as an alternative to incarceration. All of ourcustomers and long-lived assets are located in the United States of America.The accounting policies of our reportable segments are the same as thosedescribed in the summary of significant accounting policies in Note 2 to theConsolidated Financial Statements. Intangible assets are not included in eachsegment’s reportable assets, and the amortization of intangible assets is notincluded in the determination of a segment’s operating income. We evaluateperformance based on income or loss from operations before general andadministrative expenses, incentive bonuses, amortization of intangibles, interestand income taxes. Corporate and other assets are comprised primarily of cash,investment securities available for sale, accounts receivable, debt servicefund, deposits, property and equipment, deferred taxes, deferred costs andother assets. Corporate and other expense from operations primarily consists ofdepreciation and amortization on the corporate office facilities and equipmentand specific general and administrative charges pertaining to corporatepersonnel (including the $1.85 million legal settlement received in the thirdquarter of 2007) and is presented separately as such charges cannot be readilyidentified for allocation to a particular segment.

 

The only significant non-cash items reportedin the respective segments’ income from operations is depreciation andamortization (excluding intangibles) and impairment of long-lived assets (inthousands).

 

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| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                               |       |                                       |       |   |   |   |   |
| Revenue:                                           |       |                                       |       |   |   |   |   |
| Adult secure services                              |       | $                                          | 183,199    |   | $ | 178,795 |   | $ | 128,440 |   |
| Abraxas youth and family services                  |       | 109,297                                    |       | 115,765 |   | 119,006 |   |
| Adult community-based services                     |       | 68,108                                     |       | 66,295 |   | 63,329 |   |
| Total revenue                                      |       | $                                          | 360,604    |   | $ | 360,855 |   | $ | 310,775 |   |
|                                               |       |                                       |       |   |   |   |   |
| Pre-opening and start-up expenses:                 |       |                                       |       |   |   |   |   |
| Adult secure services                              |       | $                                          | —     |   | $ | 2,657 |   | $ | 7,213 |   |
| Abraxas youth and family services                  |       | 3⁄4                                     |       | 3⁄4 |   | 1,804 |   |
| Adult community-based services                     |       | 3⁄4                                     |       | 3⁄4 |   | 3⁄4 |   |
| Total pre-opening and start-up expenses            |       | $                                          | —     |   | $ | 2,657 |   | $ | 9,017 |   |
|                                               |       |                                       |       |   |   |   |   |
| Impairment of long-lived assets:                   |       |                                       |       |   |   |   |   |
| Adult secure services                              |       | $                                          | —     |   | $ | — |   | $ | — |   |
| Abraxas youth and family services                  |       | 3⁄4                                     |       | 3⁄4 |   | — |   |
| Adult community-based services                     |       | 3⁄4                                     |       | 355 |   | — |   |
| Total impairment of long-lived assets              |       | $                                          | —     |   | $ | 355 |   | $ | — |   |
|                                               |       |                                       |       |   |   |   |   |
| Depreciation and amortization:                     |       |                                       |       |   |   |   |   |
| Adult secure services                              |       | $                                          | 8,570      |   | $ | 8,008 |   | $ | 6,324 |   |
| Abraxas youth and family services                  |       | 2,736                                      |       | 3,118 |   | 3,299 |   |
| Adult community-based services                     |       | 1,525                                      |       | 1,892 |   | 2,098 |   |
| Amortization of intangibles                        |       | 2,407                                      |       | 2,243 |   | 2,094 |   |
| Corporate and other                                |       | 748                                        |       | 1,024 |   | 1,385 |   |
| Total depreciation and amortization                |       | $                                          | 15,986     |   | $ | 16,825 |   | $ | 15,200 |   |
|                                               |       |                                       |       |   |   |   |   |
| Income from operations:                            |       |                                       |       |   |   |   |   |
| Adult secure services                              |       | $                                          | 44,096     |   | $ | 44,849 |   | $ | 26,186 |   |
| Abraxas youth and family services                  |       | 13,069                                     |       | 12,574 |   | 13,672 |   |
| Adult community-based services                     |       | 16,511                                     |       | 12,362 |   | 11,874 |   |
| Subtotal                                           |       | 73,676                                     |       | 69,785 |   | 51,732 |   |
| General and administrative expenses                |       | (25,499                                    | )          | (21,720 | ) | (20,387 | ) |
| Amortization of intangibles                        |       | (2,406                                     | )          | (2,243 | ) | (2,094 | ) |
| Corporate and other                                |       | (762                                       | )          | (1,024 | ) | (1,385 | ) |
| Total income from operations                       |       | $                                          | 45,009     |   | $ | 44,798 |   | $ | 27,866 |   |
|                                               |       |                                       |       |   |   |   |   |
| Loss on discontinued operations, net of tax        |       |                                       |       |   |   |   |   |
| Adult secure services                              |       | $                                          | —     |   | $ | — |   | $ | — |   |
| Abraxas youth and family services                  |       | 3⁄4                                     |       | (706 | ) | (3,560 | ) |
| Adult community-based services                     |       | 3⁄4                                     |       | (1 | ) | (62 | ) |
| Total loss on discontinued operations, net  of tax |       | $                                          | —     |   | $ | (707 | ) | $ | (3,622 | ) |
|                                               |       |                                       |       |   |   |   |   |
| Capital expenditures:                              |       |                                       |       |   |   |   |   |
| Adult secure services                              |       | $                                          | 48,538     |   | $ | 9,811 |   | $ | 48,558 |   |
| Abraxas youth and family services                  |       | 1,351                                      |       | 1,182 |   | 473 |   |
| Adult community-based services                     |       | 310                                        |       | 749 |   | 1,358 |   |
| Corporate and other                                |       | 691                                        |       | 575 |   | 739 |   |
| Total capital expenditures                         |       | $                                          | 50,890     |   | $ | 12,317 |   | $ | 51,128 |   |
|                                               |       |                                       |       |   |   |   |   |
| Assets:                                            |       |                                       |       |   |   |   |   |
| Adult secure services                              |       | $                                          | 290,930    |   | $ | 233,670 |   | $ | 213,107 |   |
| Abraxas youth and family services                  |       | 109,478                                    |       | 100,366 |   | 106,457 |   |
| Adult community-based services                     |       | 63,008                                     |       | 63,105 |   | 67,298 |   |
| Intangible assets, net                             |       | 17,875                                     |       | 19,265 |   | 21,666 |   |
| Corporate and other                                |       | 81,496                                     |       | 107,127 |   | 102,100 |   |
| Total assets                                       |       | $                                          | 562,787    |   | $ | 523,533 |   | $ | 510,628 |   |
|                                                    |            |                                            |            |  |  |  |  |  |  |  |  |

 

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**16.  GUARANTOR DISCLOSURES**

 

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 Balance Sheet as of December 31, 2007 (inthousands)**

#  

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                       |       |       |       |                        |       |                              |       |             |       |             |       |
| Current assets:                                  |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 2,565      |                        | $          | 408                               |       | $                | 55         |             | $          | — |   | $ | 3,028 |   |
| Investment securities                            |       | 250        |       | 3⁄4                      |       | 3⁄4                            |       | 3⁄4           |       | 250              |       |
| Accounts receivable                              |       | 1,814      |       | 70,495                      |       | 679                               |       | 3⁄4           |       | 72,988           |       |
| Restricted assets                                |       | 3⁄4     |       | 2,486                       |       | 25,629                            |       | (592             | )          | 27,523           |       |
| Prepaids and other                               |       | 11,362     |       | 1,519                       |       | 3⁄4                            |       | 3⁄4           |       | 12,881           |       |
| Total current assets                             |       | 15,991     |       | 74,908                      |       | 26,363                            |       | (592             | )          | 116,670          |       |
| Property and equipment,  net                     |       | 270        |       | 242,297                     |       | 146,197                           |       | (4,812           | )          | 383,952          |       |
| Other assets:                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Debt service reserve  fund                       |       | 3⁄4     |       | 3⁄4                      |       | 23,638                            |       | 3⁄4           |       | 23,638           |       |
| Deferred costs and other                         |       | 56,500     |       | 24,460                      |       | 6,035                             |       | (48,968          | )          | 38,027           |       |
| Investment in  subsidiaries                      |       | 41,445     |       | 1,856                       |       | 3⁄4                            |       | (43,301          | )          | 3⁄4           |       |
| Total assets                                     |       | $          | 114,206    |                        | $          | 343,521                           |       | $                | 202,233    |             | $          | (97,673 | ) | $ | 562,287 |   |
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| **Liabilities and Stockholders’ Equity**    |       |       |       |                        |       |                              |       |             |       |             |       |
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| Current liabilities:                             |       |       |       |                        |       |                              |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 37,751     |                        | $          | 15,463                            |       | $                | 5,186      |             | $          | (898 | ) | $ | 57,502 |   |
| Current portion of  long-term debt               |       | 3⁄4     |       | 11                          |       | 11,400                            |       | 3⁄4           |       | 11,411           |       |
| Total current  liabilities                       |       | 37,751     |       | 15,474                      |       | 16,586                            |       | (898             | )          | 68,913           |       |
| Long-term debt, net of  current portion          |       | 141,172    |       | 26                          |       | 134,100                           |       | 3⁄4           |       | 275,298          |       |
| Deferred tax  liabilities                        |       | 12,387     |       | 94                          |       | 3⁄4                            |       | 745              |       | 13,226           |       |
| Other long-term  liabilities                     |       | 6,705      |       | 162                         |       | 49,702                            |       | (52,168          | )          | 4,401            |       |
| Intercompany                                     |       | (284,258   | )          | 284,263                     |       | 3⁄4                            |       | (5               | )          | 3⁄4           |       |
| Total liabilities                                |       | (86,243    | )          | 300,019                     |       | 200,388                           |       | (52,326          | )          | 361,838          |       |
| Stockholders’ equity                        |       | 200,449    |       | 43,502                      |       | 1,845                             |       | (45,347          | )          | 200,449          |       |
| Total liabilities and  stockholders’ equity |       | $          | 114,206    |                        | $          | 343,521                           |       | $                | 202,233    |             | $          | (97,673 | ) | $ | 562,287 |   |

 

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# **Condensed Consolidating Balance Sheet as of December 31, 2006 (inthousands)**

#  

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                       |       |       |       |                        |       |                              |       |             |       |             |       |
| Current assets:                                  |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 18,083     |                        | $          | 371                               |       | $                | 75         |             | $          | — |   | $ | 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 |   |

 

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# ** **

# **CondensedConsolidating Statement of Operations for the year ended December 31, 2007**(in thousands)

#  

| ** **                                                      | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                            |       |       |       |                        |       |                              |       |             |       |             |       |
| Revenues                                                        |       | $          | 18,008     |                        | $          | 406,673                           |       | $                | 18,008     |             | $          | (82,085 | ) | $ | 360,604 |   |
| Operating expenses                                              |       | 19,843     |       | 335,879                     |       | 87                                |       | (81,699          | )          | 274,110          |       |
| Pre-opening and  start-up expenses                              |       | 3⁄4     |       | 3⁄4                      |       | 3⁄4                            |       | 3⁄4           |       | 3⁄4           |       |
| Depreciation and  amortization                                  |       | 183        |       | 12,199                      |       | 4,222                             |       | (618             | )          | 15,986           |       |
| General and  administrative expenses                            |       | 25,424     |       | 3⁄4                      |       | 75                                |       | 3⁄4           |       | 25,499           |       |
| Income (loss) from  operations                                  |       | (27,442    | )          | 58,595                      |       | 13,624                            |       | 232              |       | 45,009           |       |
| Overhead allocations                                            |       | (41,236    | )          | 41,236                      |       | 3⁄4                            |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                   |       | 6,972      |       | 5,094                       |       | 11,889                            |       | 309              |       | 24,264           |       |
| Equity earnings in  subsidiaries                                |       | 13,244     |       | 3⁄4                      |       | 3⁄4                            |       | (13,244          | )          | 3⁄4           |       |
| Income (loss) before  provision (benefit) for income taxes |       | 20,066     |       | 12,265                      |       | 1,735                             |       | (13,321          | )          | 21,745           |       |
| Provision for income  taxes                                     |       | 8,156      |       | 3⁄4                      |       | 3⁄4                            |       | 679              |       | 8,835            |       |
| Income (loss) from  continuing operations                       |       | 11,910     |       | 12,265                      |       | 1,735                             |       | (14,000          | )          | 11,910           |       |
| Discontinued operations                                         |       | 3⁄4     |       | 3⁄4                      |       | 3⁄4                            |       | 3⁄4           |       | 3⁄4           |       |
| Net income (loss)                                               |       | $          | 11,910     |                        | $          | 12,265                            |       | $                | 1,735      |             | $          | (14,000 | ) | $ | 11,910 |   |

 

82

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# ** **

# **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 |   |

 

83

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# **Condensed Consolidating Statement ofOperations 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 |   |

 

84

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** **

**Condensed Consolidating Statement of Cash Flows for the yearended December 31, 2007 (in thousands)**

 
| ** **                                                  | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|
| **Cash flows from  operating activities:**                  |       |       |       |                        |       |                            |       |             |       |
| Net cash provided by (used in)  operating activities        |       | $          | (59,489    | )                           | $          | 74,169                          |       | $                | 12,564     |   | $ | 27,244 |   |
|                                                        |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from  investing activities:**                  |       |       |       |                        |       |                            |       |             |       |
| Capital expenditures                                        |       | 3⁄4     |       | (50,890                     | )          | 3⁄4                          |       | (50,890          | )          |
| Purchase of investment  securities                          |       | (241,425   | )          | 3⁄4                      |       | 3⁄4                          |       | (241,425         | )          |
| Sales of investment securities                              |       | 253,100    |       | 3⁄4                      |       | 3⁄4                          |       | 253,100          |       |
| Facility acquisitions                                       |       | 3⁄4     |       | (18,554                     | )          | 3⁄4                          |       | (18,554          | )          |
| Site acquisition                                            |       | 3⁄4     |       | (5,053                      | )          | 3⁄4                          |       | (5,053           | )          |
| Payments to restricted debt payment account, net            |       | 3⁄4     |       | 3⁄4                      |       | (2,084                          | )          | (2,084           | )          |
| Proceeds from sale of fixed  assets                         |       | 3⁄4     |       | 375                         |       | 3⁄4                          |       | 375              |       |
| Net cash provided by (used in)  investing activities        |       | 11,675     |       | (74,122                     | )          | (2,084                          | )          | (64,531          | )          |
|                                                        |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from  financing activities:**                  |       |       |       |                        |       |                            |       |             |       |
| Proceeds from line of credit                                |       | 30,000     |       | 3⁄4                      |       | 3⁄4                          |       | 30,000           |       |
| Payments on MCF Bonds                                       |       | 3⁄4     |       | 3⁄4                      |       | (10,500                         | )          | (10,500          | )          |
| Payments for debt issuance and  other financing costs       |       | (845       | )          | 3⁄4                      |       | 3⁄4                          |       | (845             | )          |
| Payments on capital lease  obligations                      |       | 3⁄4     |       | (10                         | )          | 3⁄4                          |       | (10              | )          |
| Proceeds from exercise of stock  options and warrants       |       | 2,786      |       | 3⁄4                      |       | 3⁄4                          |       | 2,786            |       |
| Tax benefit of stock option  exercises                      |       | 355        |       | 3⁄4                      |       | 3⁄4                          |       | 355              |       |
| Net cash provided by (used in)  financing activities        |       | 32,296     |       | (10                         | )          | (10,500                         | )          | 21,786           |       |
|                                                        |       |       |       |                        |       |                            |       |             |       |
| **Net (decrease) increase in cash and cash****equivalents** |       | (15,518    | )          | 37                          |       | (20                             | )          | (15,501          | )          |
|                                                        |       |       |       |                        |       |                            |       |             |       |
| **Cash and cash  equivalents at beginning of period**       |       | 18,083     |       | 371                         |       | 75                              |       | 18,529           |       |
|                                                        |       |       |       |                        |       |                            |       |             |       |
| **Cash and cash  equivalents at end of period**             |       | $          | 2,565      |                        | $          | 408                             |       | $                | 55         |   | $ | 3,028 |   |

#  

85

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# ** **

# **Condensed Consolidating Statement of CashFlows 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 |   |

#  

86

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# ** **

# **Condensed Consolidating Statement of CashFlows 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 |   |

 

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

 
| ** **                                  | ** ** | **1stQuarter** | ** ** | **2ndQuarter** | ** ** | **3rdQuarter** | ** ** | **4thQuarter** | ** ** | **Year** | ** ** |
|---------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------|------------|
| **2007:**                                   |       |           |       |           |       |           |       |           |       |     |       |
| Revenues                                    |       | $              | 89,644     |           | $          | 91,494         |       | $              | 87,327     |     | $          | 92,139 |   | $ | 360,604 |   |
| Income from continuing operations           |       | 664            |       | 3,446          |       | 2,417          |       | 5,383          |       | 11,910   |       |
| Net income                                  |       | 664            |       | 3,446          |       | 2,417          |       | 5,383          |       | 11,910   |       |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| Earnings per share:                         |       |           |       |           |       |           |       |           |       |     |       |
| Basic -                                     |       |           |       |           |       |           |       |           |       |     |       |
| Income from continuing operations           |       | $              | 0.05       |           | $          | 0.24           |       | $              | 0.17       |     | $          | 0.38 |   | $ | 0.84 |   |
| Net income                                  |       | $              | 0.05       |           | $          | 0.24           |       | $              | 0.17       |     | $          | 0.38 |   | $ | 0.84 |   |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| Diluted -                                   |       |           |       |           |       |           |       |           |       |     |       |
| Income from continuing operations           |       | $              | 0.05       |           | $          | 0.24           |       | $              | 0.17       |     | $          | 0.37 |   | $ | 0.82 |   |
| Net income                                  |       | $              | 0.05       |           | $          | 0.24           |       | $              | 0.17       |     | $          | 0.37 |   | $ | 0.82 |   |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| **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 (loss) per share:                  |       |           |       |           |       |           |       |           |       |     |       |
| Basic -                                     |       |           |       |           |       |           |       |           |       |     |       |
| Income from continuing operations           |       | $              | 0.09       |           | $          | 0.29           |       | $              | 0.19       |     | $          | 0.33 |   | $ | 0.90 |   |
| Loss on 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 |   |
| Loss on discontinued operations, net of tax |       | $              | (0.04      | )              | $          | (0.01          | )          | $              | —     |     | $          | — |   | $ | (0.05 | ) |
| Net income                                  |       | $              | 0.05       |           | $          | 0.28           |       | $              | 0.18       |     | $          | 0.33 |   | $ | 0.84 |   |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| **2007 Balance Sheet Data:**                |       |           |       |           |       |           |       |           |       |     |       |
| Working capital                             |       | $              | 75,749     |           | $          | 59,080         |       | $              | 22,827     |     | $          | 47,757 |   | $ | 47,757 |   |
| Total assets                                |       | 516,541        |       | 535,039        |       | 537,028        |       | 562,287        |       | 562,287  |       |
| Long-term debt, net of current portion      |       | 256,085        |       | 254,463        |       | 245,083        |       | 275,298        |       | 275,298  |       |
| Stockholders’ equity                   |       | 183,913        |       | 189,122        |       | 193,792        |       | 200,449        |       | 200,449  |       |
|                                        |       |           |       |           |       |           |       |           |       |     |       |
| **2006 Balance Sheet Data:**                |       |           |       |           |       |           |       |           |       |     |       |
| Working capital                             |       | $              | 56,206     |           | $          | 63,842         |       | $              | 61,865     |     | $          | 75,078 |   | $ | 75,078 |   |
| Total assets                                |       | 498,367        |       | 514,287        |       | 509,433        |       | 523,533        |       | 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        |       | 181,564        |       | 181,564  |       |

 

----

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

 

88

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

 

None.

 

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

 

**EVALUATION OF DISCLOSURE CONTROLSAND PROCEDURES**

 

We maintaindisclosure controls and procedures designed to provide reasonable assurancethat information disclosed in our annual and periodic reports is recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms. In addition, wedesigned these disclosure controls and procedures to ensure that thisinformation is accumulated and communicated to management, including the chiefexecutive officer (CEO) and chief financial officer (CFO), to allow timelydecisions regarding required disclosures. SEC rules require that wedisclose the conclusions of our CEO and CFO about the effectiveness of ourdisclosure controls and procedures.

 

We do notexpect that our disclosure controls and procedures will prevent all errors orfraud. A control system, no matter how well conceived and operated, can provideonly reasonable, not absolute, assurance that the objectives of the controlsystem are met. In addition, the design of disclosure controls and proceduresmust reflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs. Because of the inherentlimitation in a cost-effective control system, misstatements due to error orfraud could occur and not be detected.

 

Under thesupervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, and as required byparagraph (b) of Rules 13a-15 and 15d-15 of the Exchange Act, we haveevaluated the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) ofthe Exchange Act) as of the end of the period required by this report. Based onthat evaluation, our principal executive officer and principal financialofficer have concluded that these controls and procedures are effective as ofthat date.

 

**CHANGES IN INTERNAL CONTROL OVER FINANCIALREPORTING**

 

In connectionwith the evaluation as required by paragraph (d) of Rules 13a-15 and15d-15 of the Exchange Act, we have not identified any change in internalcontrol over financial reporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that occurred during our fiscal quarterended December 31, 2007 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

The management of Cornellis responsible for establishing and maintaining adequate internal control overfinancial reporting for Cornell. 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 regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the Company’s assets that could have a material effect on the financialstatements.

 

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

 

We have assessed theeffectiveness of our internal control over financial reporting as of December 31,2007.  To make this assessment we usedthe criteria for effective internal control over financial reporting describedin *Internal Control – Integrated Framework*,issued by the Committee of Sponsoring Organizations of the TreadwayCommission.   Based on our assessment, wehave concluded that, as of December 31, 2007, the Company’s internalcontrol over financial reporting was effective.

 

Our management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2007 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,as stated in their report which appears herein.

 

**REPORT OF THE REGISTERED PUBLIC ACCOUNTING FIRM**

 

See “FinancialStatements and Supplementary Data – Report of Independent Registered PublicAccounting Firm” in Item 8 of this report.

 

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

 

None.

 

89

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**PART III**

 

Items 10, 11, 12, 13 and14 of Part III have been omitted from this report because we will filewith the Securities and Exchange Commission, not later than 120 days after theclose of our fiscal year, a definitive proxy statement or a Form 10-K/A.  The information required by Items 10, 11, 12,13 and 14 of this report, which will appear in the definitive proxy statementand/or the Form 10-K/A, is incorporated by reference into Part III ofthis report.

 

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**PART IV**

 

**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, 2007 and 2006                                                                                            |
|   |   | Consolidated Statements of  Operations and Comprehensive Income/(Loss) for the years ended  December 31, 2007, 2006 and 2005                         |
|   |   | Consolidated Statements of  Stockholders’ Equity for the years ended December 31, 2007, 2006 and  2005                                          |
|   |   | Consolidated Statements of  Cash Flows for the years ended December 31, 2007, 2006 and 2005                                                          |
|   |   | 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**                                                                                                                                                                                                                                                                                                                                                 |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Restated Certificate of Incorporation of Cornell Companies, Inc. (incorporated  by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the year  ended December 31, 1996).                                                                                                                                        |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 3.2              |       | Second Amended and Restated Bylaws of Cornell Companies, Inc. (incorporated  by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K dated December 13, 2007).                                                                                                                                                         |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 3.3              |       | Certificate of Amendment of Restated Certificate of Incorporation of  Cornell Companies, Inc. (incorporated by reference to  Exhibit 4.2 to the Company’s Registration Statement on Form S-8 (Reg. No. 333-42444)  filed on July 28, 2000.                                                                                        |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 4.1              |       | Form of Certificate representing Common Stock (incorporated  by reference to Exhibit 4.1 to the Company’s Registration Statement on Amendment 1 to  Form S-1 (Reg. No. 333-08243) filed on August 26, 1996.                                                                                                                       |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 4.6              |       | Indenture dated as of June 24, 2004 between Cornell  Companies, Inc., the guarantors named therein and JPMorgan Chase Bank,  as trustee (incorporated by reference to Exhibit 4.1 to the  Company’s Current Report on Form 8-K  dated June 25, 2004).                                                                             |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 4.7              |       | Form of 10 3/4% Senior Note due 2012 (included in  Exhibit 4.6).                                                                                                                                                                                                                                                                                      |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 4.8              |       | Registration Rights Agreement dated March 31, 1994, as amended,  among Cornell Corrections, Inc. and the stockholders listed on the  signature pages thereto (incorporated by reference to Exhibit 4.2  to the Company’s Registration Statement on Form S-1 (Reg. No. 333-  08243), filed on July 17, 1996, as amended) |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 4.9              |       | Registration Rights Agreement, dated October 14, 1999 among  Cornell Companies, Inc. and the investors party thereto (incorporated by  reference to Exhibit 4.7 to the Company’s Registration Statement on  Form S-3 (Reg. No. 333-91211) filed on November 18, 1999).                                                       |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 10.1*            |       | Cornell Corrections, Inc. Amended and Restated 1996 Stock Option  Plan (incorporated by reference to Exhibit B to the Company’s Schedule 14A dated March 9, 1998).                                                                                                                                                                          |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 10.2*            |       | Form of Indemnification Agreement between Cornell  Companies, Inc. and each of its directors and executive officers (incorporated  by reference to Exhibit 10.3 to the Company’s Registration Statement on Amendment 1 to  Form S-1 (Reg. No. 333-08243) filed on August 26, 1996.                                           |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 10.3*            |       | Cornell Corrections, Inc. Employee Stock Purchase Plan (incorporated  by reference to Exhibit 4.7 to the Company’s Registration Statement on Form S-8  (Reg. No. 333-80187) filed on June 8, 1999.                                                                                                                                |
|             |       |                                                                                                                                                                                                                                                                                                                                                            |
| 10.4*            |       | Cornell Corrections, Inc. Deferred Compensation Plan (incorporated  by reference to Exhibit 4.8 to the Company’s Registration Statement on Form S-8  (Reg. No. 333-80187) filed on June 8, 1999.                                                                                                                                  |

 

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| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5*            |       | Cornell Companies, Inc. 2000 Director Stock Plan (incorporated  by reference to Exhibit 4.9 to the Company’s Registration Statement on Form S-8  (Reg. No. 333-42444) filed on July 28, 2000.                                                                                                                                                                                                    |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.6*            |       | Cornell Companies, Inc. Deferred Bonus Plan (incorporated  by reference to Exhibit 10.44a to the Company’s Annual Report on Form 10-K for the year  ended December 31, 2002).                                                                                                                                                                                                                         |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.7             |       | Premises Transfer Agreement, dated August 14, 2001, among Cornell  Companies, 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. (incorporated  by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated August 14, 2001). |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.8             |       | Master Lease Agreement (with addenda), dated August 14, 2001,  between Municipal Corrections Finance, L.P. and Cornell Companies, Inc. (incorporated  by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K dated August 14, 2001).                                                                                                                                           |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.9             |       | Master Lease Agreement dated December 3, 1998 between Atlantic  Financial Group, Ltd. and WBP Leasing, Inc. and certain other  subsidiaries of Cornell Corrections, Inc. (incorporated by  reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the  quarter ended September 30, 2001).                                                                             |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.10            |       | Amended and Restated Credit Agreement dated October 10, 2007  among Cornell Companies, Inc., its subsidiaries, JPMorgan Chase Bank  N.A., as Administrative Agent, Bank of America, N.A., as Syndication Agent  and the Lenders party thereto (incorporated by reference to  Exhibit 10.1 to  the Company’s Current Report on Form 8-K  dated October 10, 2007).                                 |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.11*           |       | Amended and Restated Employment Agreement, dated August 2, 2007,  between Cornell Companies, Inc. and James E. Hyman (incorporated  by reference to Exhibit 10.1  to the Company’s Current Report on Form 8-K dated August 1, 2007).                                                                                                                                                             |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.12*           |       | Restricted Stock Agreement, dated March 14, 2005, between Cornell  Companies, Inc. and James E. Hyman (incorporated by reference to  Exhibit 10.2 to  the Company’s Current Report on Form 8-K  dated March 15, 2005).                                                                                                                                                                           |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.13*           |       | Employment/Separation Agreement, dated March 9, 2005, between  Cornell Companies, Inc. and John R. Nieser (incorporated by  reference to Exhibit 10.3  to the Company’s Current Report on Form 8-K dated March 15, 2005).                                                                                                                                                                        |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.14*           |       | Amendment to Employment/Separation Agreement dated March 14, 2007  by and between Cornell Companies, Inc. and John R. Nieser (incorporated  by reference to Exhibit 10.2  to the Company’s Current Report on Form 8-K dated March 8, 2007)                                                                                                                                                       |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.15*           |       | Form of Severance Agreement (incorporated by reference to  Exhibit 10.40 to the Company’s Annual Report on Form 10-K for the year ended December 31,  1999).                                                                                                                                                                                                                                          |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
|             |       | Amendment to Severance Agreement dated March 14, 2007 by and  between Cornell Companies, Inc. and Patrick N. Perrin (incorporated  by reference to Exhibit 10.4  to the Company’s Current Report on Form 8-K dated March 8, 2007)                                                                                                                                                                |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.16*†     |       | Employment Agreement, dated March 19, 2007, between Cornell  Companies, Inc. and William E. Turcotte.                                                                                                                                                                                                                                                                                                                |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.17*           |       | Cornell Companies, Inc. 2006 Equity Incentive Plan (incorporated  by reference to Appendix A to the Company’s Schedule 14A filed May 10,  2006).                                                                                                                                                                                                                                                                |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.18*           |       | Form of Cornell Companies, Inc. Restricted Stock Award — Performance  Based (incorporated by reference to Exhibit 10.1 to the Company’s Current  Report on Form 8-K dated March 6, 2008)                                                                                                                                                                                                                             |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.19*           |       | Form of Cornell Companies, Inc. Restricted Stock Award — Time Based  (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on  Form 8-K dated March 6, 2008)                                                                                                                                                                                                                                    |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 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).                                                                                                                                                                                                                                                                                                                                          |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 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. (incorporated  by reference to Exhibit 99.2 to the Company’s Annual Report on Form 10-K for the year  ended                                                                                                                                                                    |

 

92

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| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       | December 31, 2001).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 99.2             |       | Agreement, dated March 9, 2007 by and among Wynnefield Partners Small Cap  Value, L.P., Wynnefield Partners Small Cap Value Offshore Fund, Ltd.,  Wynnefield Partners Small Cap Value L.P. I, Channel Partnership II, L.P.,  Wynnefield Capital Management, LLC, Wynnefield Capital, Inc., Nelson  Obus, Joshua Landes, North Star Partners, L.P., North Star Partners II, L.P.,  NS Advisors, LLC, Andrew R. Jones and Cornell Companies, Inc.  (incorporated by reference to Exhibit 99.1 to the Company’s Current  Report on Form 8-K dated March 12, 2007). |

 

----

*      Managementcompensatory plan or contract.

†      Filed herewith

 

93

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|   |                | CORNELL COMPANIES, INC. |
|--------|---------------------|-------------------------|
|   |                |                    |   |
| Dated: | March 14, 2008 | By:                     | /s/ James E. Hyman |
|   |                |                    | James E. Hyman |
|   |                |                    | Chief Executive Officer and |
|   |                |                    | Chairman of the Board |

 

**POWEROF ATTORNEY**

 

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

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities on March 14, 2008.

 
| **SIGNATURE**                 | ** **              | **TITLE**                        |
|-------------------------------|-------------------------|----------------------------------|
|                          |                    |                             |
| /s/  James E. Hyman |                    | Chief Executive Officer and      |
| James E. Hyman                |                    | Chairman of the Board            |
|                          |                    | (Principal Executive Officer)    |
|                          |                    |                             |
| /s/  John R. Nieser |                    | Chief Financial Officer          |
| John R. Nieser                |                    | (Principal Financial Officer and |
|                          |                    | Principal Accounting Officer)    |
|                          |                    |                             |
| *                             |                    | Director                         |
| Max Batzer                    |                    |                             |
|                          |                    |                             |
| *                             |                    | Director                         |
| Anthony R. Chase              |                    |                             |
|                          |                    |                             |
| *                             |                    | Director                         |
| Richard Crane                 |                    |                             |
|                          |                    |                             |
| *                             |                    | Director                         |
| Zachary R. George             |                    |                             |
|                          |                    |                             |
| *                             |                    | Director                         |
| Todd Goodwin                  |                    |                             |
|                          |                    |                             |
| *                             |                    | Director                         |
| Andrew R. Jones               |                    |                             |
|                          |                    |                             |
| *                             |                    | Director                         |
| Alfred Jay Moran, Jr.    |                    |                             |
|                          |                    |                             |
| *                             |                    | Director                         |
| D. Stephen Slack              |                    |                             |
|                          |                    |                             |
|                          |                    |                             |
| By:                           | /s/ William E. Turcotte |                             |   |
| William E. Turcotte           |                    |                             |
| Attorney-in-Fact              |                    |                             |
|                               |                         |                                  |  |

 

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