==========================================START OF PAGE 1====== SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES AND EXCHANGE COMMISSION v. HEALTHCARE SERVICES GROUP, INC., DANIEL P. MCCARTNEY, THOMAS A. COOK AND MELVYN B. MASON, Civil Action No. 96cv-6464 (E.D. Pa.). Litigation Release No. 15068 / September 25, 1996. Accounting and Auditing Enforcement Release No. 823 / September 25, 1996. The U.S. Securities and Exchange Commission announced today that on September 24, 1996 it filed a lawsuit in federal district court in Philadelphia, Pennsylvania, alleging violations of the anti-fraud, reporting, internal controls and books and records provisions of the federal securities laws by Healthcare Services Group, Inc. ("HSG" or "the Company"), HSG chief executive officer and chairman of the board, Daniel P. McCartney, HSG president and former chief financial officer Thomas A. Cook, and former vice- president Melvyn B. Mason. HSG, headquartered in Huntingdon Valley, Pennsylvania, supplies housekeeping, laundry and linen services to healthcare facilities. HSG's common stock is quoted on the National Association of Securities Dealers' Automated Quotation System. In its complaint, the Commission alleged that HSG, McCartney and Cook violated the anti-fraud provisions of the federal securities laws by failing to disclose, in connection with a July 1990 $22 million public offering, that a substantial number of HSG's customers presented a material risk of cancelling their contracts with HSG. The complaint further alleges that HSG's financial statements during calendar years 1990 and 1991, as incorporated in Commission reports, were materially false and misleading. The complaint also alleges that HSG and Mason violated the anti-fraud provisions by failing to disclose that, between 1988 and 1991, HSG made over $400,000 in payments to certain third parties for no valid business purpose. Simultaneously with the filing of the complaint, the Commission filed with the Court proposed Orders, consented to by all defendants, without admitting or denying the allegations in the Commission's complaint, pursuant to which, upon entry by the Court: (i) HSG will be permanently enjoined from future violations of Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2) of the Exchange Act and Rules 10b-5, 12b- 20, 13a-1, and 13a-13 thereunder, and required to pay a civil penalty in the amount of $650,000; (ii) McCartney will be permanently enjoined from future violations of Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, 13a-13 thereunder, and required to pay a civil penalty in the amount of $100,000; (iii) Cook will be permanently enjoined from future violations of Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, 13a-13 thereunder, and required to pay a civil penalty in the amount of $50,000; and (iv) Mason will be permanently enjoined from future violations of Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5 and 13b2-1 thereunder, required to pay a civil penalty in the amount of $50,000, and prohibited, pursuant to Section 21(d)(2) of the Exchange Act, from serving as an officer or director of any public company for a period of 7 years. The Court has scheduled a hearing on the matter of this proposed settlement for October 15, 1996. HSG's Failure to Adequately Disclose Material Risks of Contract Cancellations at the Time of its July 1990 Public Offering On July 25, 1990, HSG began a $22 million public offering of its common stock, pursuant to a registration statement on Form S- 2. The initial closing occurred on August 1, 1990, with gross proceeds of $21,656,250. An over-allotment portion of the offering closed on August 17, 1990, with gross proceeds of $792,000. According to the Commission's complaint, the offering documents did not adequately disclose that there existed a material risk that a substantial number of HSG customers would cancel their HSG contracts. The complaint alleges that McCartney knew or was reckless in not knowing of the existence of this material risk, and knew or was reckless in not knowing that HSG had failed adequately to disclose this information in its July 1990 Form S-2 or otherwise. By reason of the foregoing, the complaint charges that HSG violated Section 17(a) of the Securities Act and HSG and McCartney violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The complaint alleges that, although HSG received written cancellation notices concerning 41 facilities during the initial phase of the offering and notices concerning an additional 66 facilities during the pendency of the over allotment phase of HSG's July 1990 public offering, at the closing of both the initial and over-allotment phases of the offering, the Company, in a statement signed by Cook, represented to the primary underwriter for the offering that: "There has not been any material adverse change, or any development involving a prospective material adverse change, in the condition, financial or otherwise, or in the earnings, business or operations of the Company... from that set forth in the registration statement." The complaint alleges that, in so doing, Cook violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. HSG Improperly Accounted for Cancellation Fees as Income in the Financial Statements Incorporated in Its July 1990 Form S-2, Its Form 10-Q for the Second Quarter of 1990, and Its 1990 Form 10-K In September 1988, HSG purchased American Services Company ("ASC"), a subsidiary of Southmark Corporation, in exchange for 950,000 shares of HSG common stock and $8.5 million in debentures. ASC's principal assets were service agreements with nursing and retirement facilities operated or owned by Southmark- controlled limited partnerships for the provision of housekeeping and laundry services over a term of twenty years. The service agreements provided that cancellation by the facilities without cause was subject to a substantial penalty. According to the Commission's complaint, in 1989, a change in management occurred at Southmark and new management informed HSG of its intention to terminate HSG's services to the facilities Southmark controlled. In January 1990 Southmark and HSG executed an Amended Agreement, reflecting terms agreed to in June 1989, that provided, among other things, that the HSG stock transferred to Southmark would be allocated to the various partnerships, which could then, should they decide to cancel the HSG agreements, satisfy the cancellation penalties by release of their allocation of HSG stock. The Amended Agreement closed on July 16, 1990. In the financial statements incorporated in its Form 10-Q for the second quarter of 1990, and in its consolidated statement of income for the six months ended June 30, 1990, included in its July 1990 Form S-2, the Company recognized as pre-tax income approximately $1 million in cancellation fees from the release of HSG stock pursuant to the Amended Agreement. This $1 million figure was derived primarily by multiplying the number of shares ceded to HSG with respect to cancelling facilities by the increase in market price of HSG stock between the date of the original American Services transaction and the cancellation dates. The cancellation fees increased HSG's pre-tax income for the second quarter of 1990 from $1.16 to $2.18 million. The Commission's complaint alleges that HSG was not permitted under Generally Accepted Accounting Principles ("GAAP") to recognize income from the above-described transactions in its own stock. Moreover, the $1 million in cancellation fee income was not identified as a distinct component of income, separate from service revenues, even though it represented a material amount of HSG's income for the second quarter, six month period and year, and was derived from a source outside HSG's standard business activities. See Regulation S-X,  210.5-03(b)7 ("Non- operating Income"). By reason of the foregoing, the complaint charges that HSG violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20 thereunder and that McCartney and Cook, as controlling persons of HSG for purposes of Section 20(a) of the Exchange Act at all relevant times, are liable for HSG's violations of these provisions. HSG Improperly Accounted for Cancellation Fees as ==========================================START OF PAGE 3====== Income in the Financial Statements Incorporated in Its Form 10-Q for the Third Quarter of 1990 In the financial statements included in its Form 10-Q for the third quarter of 1990, HSG reported $302,672 in income before taxes from service agreements cancelled. The inclusion of this amount increased HSG's third quarter income by 13%. In the notes to its quarterly financial statements, HSG stated that it had "deferred approximately $3,150,000 of potential pre-tax gain [from cancellation fees] and has elected to recognize it in the future on a cash recovery basis." In all instances, the facilities were deemed to have paid the cancellation fees through the release of HSG stock in connection with the unwinding of the ASC acquisition. According to the complaint, this accounting treatment was not in conformity with GAAP. HSG Improperly Recognized Gain From Appreciation in Market Value of HSG Stock in Its 1990 Form 10-K During the fourth quarter of 1990, although no cancellation fee income was recognized in the income statement, $2,577,000 in gain from the appreciation in market value of HSG stock allocated to the cancelling facilities was credited by HSG to equity to offset charges against stockholders' equity on its balance sheet, rather than recorded as expenses in the income statement for December 31, 1990. According to the complaint, this accounting treatment was not in conformity with GAAP. The charges included $1,673,000 in income taxes payable on cancellation fee income, $700,000 for a reserve against uncollectible receivables due from the cancelling facilities, and $204,000 of legal and accounting fees relating to cancellations. Further, HSG made no disclosure, in its 1990 Form 10-K, that its net income for 1990 had been materially increased by recording expenses in its stockholders' equity accounts and then offsetting those expenses with gain from the release of HSG stock. According to the Commission's complaint, the financial statements incorporated in HSG's 1990 Form 10-K were not prepared in conformity with GAAP because they reflected the accounting treatments described above with respect to HSG's quarterly financial statements for the last three quarters of 1990. As Accounting Principles Board Opinion No. 9 (Reporting the Results of Operations), 17, states, inter alia, "...net income should reflect all items of profit and loss recognized during the period;" and as 28 (Capital Transactions) states, inter alia, "the following should be excluded from determination of net income or the results of operations under all circumstances: (a) adjustments or charges or credits resulting from transactions in the company's stock..." Based on the foregoing, the complaint charges that HSG violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20 thereunder, and that McCartney and Cook, as controlling persons of HSG, are liable for HSG's ==========================================START OF PAGE 4====== violations of those provisions. HSG's Failure to Properly Accrue for Loss Contingencies From Workers' Compensation Claims The Commission's complaint alleges that, from the first quarter of 1986 through the third quarter of 1991, HSG materially overstated its net income by improperly accounting for costs related to workers' compensation, auto and general liability claims. Under its arrangement with its insurance carrier, HSG was liable for the full cost of each workers' compensation claim, and up to $250,000 for each auto and general liability claim. GAAP requires that an accrual be made for loss contingencies. See Statement of Financial Accounting Standards No. 5. The complaint alleges, however, that HSG failed to record the proper liability for estimated settlement amounts for known claims and incurred but unreported claims, but instead primarily expensed claims as they were paid. By reason of the foregoing, the complaint charges that HSG's financial statements, as incorporated in its Commission quarterly and annual reports from the first quarter of 1986 through the third quarter of 1991, were materially false and misleading, in violation of Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20, and that thereunder, and that Cook, as a controlling person of HSG, is liable for HSG's violations of those provisions. HSG's Inadequate Valuation Allowance for Accounts Receivable The total amount of HSG's accounts receivable, including notes receivable from HSG customers, increased from approximately $17 million at year-end 1989 to $28 million at year-end 1990, representing the largest asset on HSG's balance sheet. During that year, receivables over 120 days old, some of which had been sold to a financial institution with full recourse against HSG, increased from $7.5 million to $11.3 million, while HSG's allowance for bad debts increased by $300,000. With respect to approximately $27 million (of a total of approximately $28 million) in receivables as to which no probable loss was specifically identified, HSG maintained no allowance. According to the Commission's complaint, HSG's policies and procedures for determining an adequate valuation allowance for accounts receivable were materially weak. The complaint alleges that HSG did not consider the age of a receivable in evaluating its potential collectibility and did not attempt to evaluate the financial ability of individual customers to pay their obligations. The complaint further alleges that this method was ==========================================START OF PAGE 5====== inadequate to represent accurately the level of probable and estimable loss inherent in HSG's accounts receivable, as required by GAAP. As Statement of Financial Accounting Standards No. 5 (Accounting for Contingencies), 84, states: "the condition[s] for accrual [of an estimated loss]... are not intended to be so rigid that they require virtual certainty before a loss is accrued. They require only that it be probable that an asset has been impaired... and that the amount of loss be reasonably estimable." According to the Commission's complaint, as a result of its failure to provide adequate procedures to provide reasonable assurances that its valuation allowance for accounts receivable was established in accordance with GAAP, HSG, in the financial statements incorporated in its 1990 Form 10-K and its Forms 10-Q for the first three quarters of 1990, materially overstated its income for those periods, in violation of Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20 thereunder. HSG's Inadequate Disclosure and Improper Accounting for Customer Laundry Installations During the fourth quarter of 1990 and continuing through the fourth quarter of 1991, HSG provided funds to certain (primarily new) customers for the purpose, according to HSG's Commission filings, of purchasing the customers' on-site laundry installations. Such transactions that occurred in the last quarter of 1990, for example, totalled approximately $4 million, three times the amount previously carried on HSG's balance sheet. In these transactions, HSG would include a component in its price structure to those customers reflecting such provision of funds. The complaint alleges that these transactions were concessions made to customers in contract negotiations. According to the complaint, HSG did not disclose this conduct as a "material change in the mode of conducting business," as required pursuant to Regulation S-K, Item 101(a)(1), or disclose the purpose of these concessions, or record these transactions in accordance with their substance, as required under GAAP. The complaint charges that HSG thereby violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20 thereunder, and that McCartney and Cook, as controlling persons of HSG, are liable for HSG's violations of those provisions. HSG's Improper Accounting for Laundry Installation Sales During the first three quarters of 1991, HSG recorded $2.0 million in gross profits on laundry installation sales of $2.6 million. The effect of these transactions on earnings reported in the financial statements incorporated in its 1991 Forms 10-Q was to increase the first quarter by 12%, the second quarter by ==========================================START OF PAGE 6====== 67%, and the third quarter by 18%. On the largest such transaction, HSG recognized a profit of $664,638. In that instance, HSG passed to its customer legal title to equipment already in place, with a depreciated cost basis of $23,299. HSG's periodic billings to this facility were no different after the sale from what they had been before. The Commission's complaint alleges that, because HSG's laundry installation sales were intertwined with other aspects of HSG's customer relationships, HSG's recognition of revenue on these transactions did not comport with the GAAP requirement that revenue should be recognized when it is both realized or realizable and earned. See Statement of Financial Accounting Concepts No. 5, 83 (Recognition and Measurement in Financial Statements of Business Enterprises). By reason of the foregoing, the complaint charges that HSG's financial statements included in its filings on Form 10-Q for the first three quarters of 1991 were materially false and misleading in violation of Section 13(a) of the Exchange Act and Rule 13a-13 thereunder, and that McCartney and Cook, as controlling persons of HSG for purposes of Section 20(a) of the Exchange Act at all relevant times, are liable for HSG's violations of those provisions. HSG's Failure to Disclose Payments to Vendors for No Valid Business Purpose According to the Commission's complaint, between 1988 and early 1992 HSG paid approximately $400,000 in improper payments to certain vendors for the benefit of two nursing home customers, made for no valid business purpose, and the books and records of HSG did not reflect the true purpose of these payments. The complaint charges that HSG's failure to disclose the true purpose of these payments in its annual reports on Form 10-K and quarterly reports on Form 10-Q during the period from year- end 1988 to year-end 1991 violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20 thereunder. The complaint further charges that, because Mason knew or was reckless in not knowing that HSG's Commission filings were materially false and misleading, Mason and, through Mason, HSG also violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The complaint further alleges that Mason was instrumental in causing HSG to record these payments inaccurately in its books and records as legitimate business expenses. By reason of the foregoing, the complaint charges that Mason violated Section 13(b)(5) of the Exchange Act and Rule 13b2-1 thereunder. ==========================================START OF PAGE 7======