UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________

FORM 10-Q


QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008March 31, 2009


Commission File Number 001-31932
_______________________

HYTHIAM, INC.
(Exact name of registrant as specified in its charter)
_______________________

Delaware88-0464853
(State or other jurisdiction of incorporation or organization)(I.R.S. Employer Identification No.)

11150 Santa Monica Boulevard, Suite 1500, Los Angeles, California 90025
(Address of principal executive offices, including zip code)

(310) 444-4300
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ          No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    

Yes þ          No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.filer or a smaller reporting company. See definitiondefinitions of “accelerated‘‘accelerated filer,” “large accelerated filer,’’ and large accelerated filer”“smaller reporting company” in Rule 12b-2 of the Exchange ActAct. (Check one):


Large accelerated filer  o      Accelerated filer  þ      Non-accelerated filer  o      Smaller reporting company  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o            No þ

As of August 6, 2008,May 8, 2009, there were 54,536,33955, 154, 688 shares of registrant's common stock, $0.0001 par value, outstanding.

 
 
 

TABLE OF CONTENTS


PART I - FINANCIAL INFORMATION
3
    
 
ITEM 1.
Financial Statements
3
    
  
Condensed Consolidated Balance Sheets as of June 30, 2008 March 31, 2009
and December 31, 20072008
3
    
  
Condensed Consolidated Statements of Operations for the Three and Six Months
 
  
Three Months Ended June 30,March 31, 2009 and 2008 and 2007
4
    
  
Condensed Consolidated Statements of Cash Flows for the Six Months
 
  
Three Months Ended June 30,March 31, 2009 and 2008 and 2007
5
    
  
Notes to Condensed Consolidated Financial Statements
67
    
 
ITEM 2.
Management's Discussion and Analysis of Financial Condition and
 
  
Condition and Results of Operations
21
    
 
ITEM 3.
Quantitative and Qualitative Disclosures About Market Risk
4035
    
 
ITEM 4.
Controls and Procedures
4136
    
PART II – OTHER INFORMATION
II-1
    
 
ITEM 1A.
Risk Factors6.  Exhibits
II-1
    
ITEM 2.
Unregistered Sales of Equity Securities and Use of Proceeds
II-1
ITEM 4.
Submission of Matters to a Vote of Security Holders
II-1
ITEM 5.
Other InformationSIGNATURES
II-2
    
ITEM 6.
Exhibits
II-3
SIGNATURES
II-4
EXHIBIT 31.1 
EXHIBIT 31.2 
EXHIBIT 32.1 
EXHIBIT 32.2 





2


PART I - FINANCIAL INFORMATION

Item 1.                 Consolidated Financial Statements

HYTHIAM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)

(In thousands, except share data) June 30,  December 31, 
(In thousands) March 31,  December 31, 
 2008  2007  2009  2008 
ASSETS            
Current assets            
Cash and cash equivalents $6,413  $11,149  $5,884  $9,756 
Marketable securities, at fair value  20,201   35,840   139   146 
Restricted cash  87   39   31   24 
Receivables, net  3,168   1,787   543   654 
Notes receivable  64   133 
Prepaids and other current assets  859   1,394   179   357 
Current assets of discontinued operations  -   3,053 
Total current assets  30,792   50,342   6,776   13,990 
Long-term assets                
Property and equipment, net of accumulated depreciation        Property and equipment, net of accumulated depreciation     
of $5,988 and $5,630, respectively  3,806   4,291 
Goodwill  10,445   10,557 
of $5,118,000 and $5,035,000 respectively  1,541   2,625 
Intangible assets, less accumulated amortization of        Intangible assets, less accumulated amortization of     
$2,150 and $1,609, respectively  4,426   4,836 
$1,317,000 and $1,250,000, respectively  2,839   3,257 
Marketable securities, at fair value  10,365   10,072 
Deposits and other assets  736   620   222   318 
Non-current assets of discontinued operations  -   1,604 
Total Assets $50,205  $70,646  $21,743  $31,866 
                
LIABILITIES AND STOCKHOLDERS' EQUITY                
Current liabilities                
Accounts payable $5,337  $4,038  $2,464  $3,396 
Accrued compensation and benefits  1,878   2,860   795   1,476 
Accrued liabilities  2,674   2,030 
Accrued claims payable  6,733   5,464 
Other accrued liabilities  1,669   2,082 
Short-term debt  4,962   4,742   10,455   9,835 
Income taxes payable  100   94 
Current liabilities from discontinued operations  -   8,675 
Total current liabilities  21,684   19,228   15,383   25,464 
Long-term liabilities                
Long-term debt  2,099   2,057 
Accrued reinsurance claims payable  2,526   2,526 
Warrant liability  1,842   2,798 
Long-term Liabilities  234   - 
Deferred rent and other long-term liabilities  266   127 
Warrant liabilities  87   156 
Capital lease obligations  232   331   71   81 
Deferred rent and other long-term liabilities  279   442 
Non-current liabilities from discontinued operations  -   4,930 
Total liabilities  28,662   27,382   16,041   30,758 
                
Commitments and contingencies (See Note 6)
        
Commitments and contingencies        
                
Stockholders' equity                
Preferred stock, $.0001 par value; 50,000,000 shares authorized;        Preferred stock, $.0001 par value; 50,000,000 shares authorized;     
no shares issued and outstanding  -   -   -   - 
Common stock, $.0001 par value; 200,000,000 shares authorized;        Common stock, $.0001 par value; 200,000,000 shares authorized;     
54,536,000 and 54,335,000 shares issued and outstanding        
at June 30, 2008 and December 31, 2007, respectively  5   5 
55,075,000 and 54,965,000 shares issued and outstanding55,075,000 and 54,965,000 shares issued and outstanding     
at March 31, 2009 and December 31, 2008, respectively  6   6 
Additional paid-in-capital  170,321   166,460   175,837   174,721 
Accumulated other comprehensive loss  (776)  - 
Accumulated other comprehensive income  425   - 
Accumulated deficit  (148,007)  (123,201)  (170,566)  (173,619)
Total Stockholders' Equity  21,543   43,264   5,702   1,108 
Total Liabilities and Stockholders' Equity $50,205  $70,646  $21,743  $31,866 

See accompanying notes to the financial statements.

3



HYHYTTHIAM,HIAM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTSSTATEMENT OF OPERATIONS
(unaudited)


  Three Months Ended  Six Months Ended 
(In thousands, except per share amounts) June 30,  June 30, 
  2008  2007  2008  2007 
Revenues            
Behavioral health managed care services $9,582  $9,159  $18,915  $16,765 
Healthcare services  2,031   2,181   4,037   3,432 
Total revenues  11,613   11,340   22,952   20,197 
                 
Operating expenses                
Behavioral health managed care expenses  11,707   9,348   21,446   16,501 
Cost of healthcare services  524   423   1,005   759 
General and administrative expenses  10,438   12,250   22,570   22,832 
Research and development  915   729   2,273   1,740 
Depreciation and amortization  688   610   1,391   1,157 
Total operating expenses  24,272   23,360   48,685   42,989 
                 
Loss from operations  (12,659)  (12,020)  (25,733)  (22,792)
                 
Interest income  203   396   644   908 
Interest expense  (315)  (641)  (647)  (1,114)
Change in fair value of warrant liability  (1,312)  -   955   - 
Other non-operating income, net  -   29   -   29 
Loss before provision for income taxes  (14,083)  (12,236)  (24,781)  (22,969)
Provision for income taxes  10   16   23   26 
Net loss $(14,093) $(12,252) $(24,804) $(22,995)
                 
Net loss per share - basic and diluted $(0.26) $(0.28) $(0.46) $(0.52)
                 
Weighted average number of shares outstanding - basic and diluted  54,440   44,126   54,403   43,984 
  Three Months Ended 
(In thousands, except per share amounts) March 31, 
  2009  2008 
Revenues      
Healthcare services revenues $707  $2,006 
         
Operating expenses        
         
Cost of healthcare services $273  $481 
General and administrative  5,603   11,154 
Research and development  -   1,358 
Impairment losses  1,113   - 
Depreciation and amortization  404   463 
Total operating expenses $7,393  $13,456 
         
Loss from operations $(6,686) $(11,450)
         
Interest and other income  46   429 
Interest expense  (408)  (265)
Loss on extinguishment of debt  (276)  - 
Other than temporary impairment of marketable securities  (132)  - 
Change in fair value of warrant liability  69   2,267 
Loss from continuing operations before provision for income taxes $(7,387) $(9,019)
Provision for income taxes  8   10 
Loss from continuing operations $(7,395) $(9,029)
         
Discontinued Operations:        
Results of discontinued operations, net of tax (Note 5) $10,449  $(1,682)
         
Net income (loss) $3,054  $(10,711)
         
Basic and diluted net income (loss) per share:        
Continuing operations $(0.13) $(0.17)
Discontinued operations  0.19   (0.03)
Net income (loss) per share $0.06  $(0.20)
         
Weighted number of shares outstanding  55,075   54,366 

See accompanying notes to the financial statements.
 

4


HYTHIAM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTSSTATEMENT OF CASH FLOWS
(unaudited)

  Three Months Ended 
(In thousands) March 31, 
  2009  2008 
Operating activities:      
Net income (loss) $3,054  $(10,711)
Adjustments to reconcile net income (loss) to net cash used in operating activities: 
(Income) Loss from Discontinued Operations   (10,449)    1,682 
Depreciation and amortization  404   462 
Amortization of debt discount and isuance costs included in interest expense  524   129 
Other than temporary impairment on marketable securities  132   - 
Provision for doubtful accounts  281   136 
Deferred rent  (20)  (140)
Share-based compensation expense  1,208   2,276 
Loss on debt extinguishment  276   - 
Fair value adjustment on warrant liability  (69)  (2,267)
Impairment losses  1,113   49 
Changes in current assets and liabilities:        
Receivables  (78)  47 
CompCare receivable  -   (47)
Prepaids and other current assets  120   486 
Accounts payable and other accrued liabilities  (1,872)  (685)
Long term accrued liabilities  234   - 
Net cash used in operating activities of continuing operations  (5,142)  (8,583)
Net cash used in operating activities of discontinued operations  (1,103)  (2,404)
Net cash used in operating activities $(6,245) $(10,987)
         
Investing activities:        
Purchases of marketable securities $-  $(12,112)
Proceeds from sales and maturities of marketable securities  -   23,683 
Proceeds from sales of property and equipment  2   - 
Proceeds from disposition of CompCare  1,500   - 
Restricted cash  -   (41)
Purchases of property and equipment  (9)  (529)
Deposits and other assets  (289)  105 
Cost of intangibles  (3)  (61)
Net cash from investing activities of continuing operations  1,201   11,045 
Net cash from (used in) investing activities of discontinued operations  39   (17)
Net cash from investing activities $1,240  $11,028 
         
Financing activities:        
Cost related to issuance of debt and warrants $-  $(20)
Proceeds from drawdown on UBS line of credit  1,542   - 
Paydown on senior secured note  (1,446)  - 
Capital lease obligations  (27)  (21)
Net cash from (used in) financing activities of continuing operations  69   (41)
Net cash from (used in) financing activities of discontinued operations  (73)  18 
Net cash used in financing activities $(4) $(23)
Net increase (decrease) in cash and cash equivalents $(5,009) $18 
Cash and cash equivalents at beginning of period  10,893   11,149 
Cash and cash equivalents at end of period $5,884  $11,167 
Less cash and cash equivalents of discontinued operations $-  $3,909 
Cash and cash equivalents of continuing operations at end of period $5,884  $7,258 

  Six Months Ended 
(In thousands) June 30, 
  2008  2007 
Operating activities      
Net loss $(24,804) $(22,995)
         
Adjustments to reconcile net loss to net cash used in operating activities:        
Depreciation and amortization  1,391   1,156 
Amortization of debt discount and issuance cost included in interest expense  303   517 
Provision for doubtful accounts  248   68 
Deferred rent  (175)  63 
Share-based compensation expense  4,245   1,405 
Fair value adjustment on warrant liability  (955)  - 
Loss on disposition of fixed assets  358   - 
Changes in current assets and liabilities, net of business acquired:        
Receivables  (1,629)  (350)
Prepaids and other current assets  526   26 
Accrued claims payable  1,275   2,584 
Accounts payable and accrued liabilities  483   (2,211)
Net cash used in operating activities  (18,734)  (19,737)
         
Investing activities        
Purchases of marketable securities  (46,520)  (35,797)
Proceeds from sales and maturities of marketable securities  61,384   60,603 
Proceeds from sales of property and equipment  16   - 
Cash paid related to acquisition of a business, net of cash acquired  -   (4,760)
Restricted cash  (47)  (39)
Purchases of property and equipment  (732)  (477)
Deposits and other assets  136   129 
Cost of intangibles  (132)  (93)
Net cash provided by investing activities  14,105   19,566 
         
Financing activities        
Cost related to issuance of common stock  -   (230)
Cost related to issuance of debt and warrants  (41)  (302)
Proceeds from issuance of debt and warrants  -   10,000 
Capital lease obligations  (98)  (79)
Exercise of stock options and warrants  32   1,208 
Net cash (used in) provided by financing activities  (107)  10,597 
         
Net increase (decrease) in cash and cash equivalents  (4,736)  10,426 
Cash and cash equivalents at beginning of period  11,149   5,701 
Cash and cash equivalents at end of period $6,413  $16,127 
         
Supplemental disclosure of cash paid        
Interest $292  $376 
Income taxes  16   32 
         
Supplemental disclosure of non-cash activity        
Common stock, options and warrants issued for outside services $471  $111 
Common stock issued for acquisition of a business  -   2,084 
Property and equipment aquired through capital leases and other financing  6   192 
(continued on next page)
 
See accompanying notes to the financial statements.

5
HYTHIAM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)

(continued)

  Three Months Ended 
(In thousands) March 31, 
  2009  2008 
Supplemental disclosure of cash paid      
Interest $92  $157 
Income taxes $30  $3 
Supplemental disclosure of non-cash activity     
Common stock, options and warrants issued for outside services $126  $139 
See accompanying notes to the financial statements.

6

Hythiam, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 1.  Basis of Consolidation, Presentation and PresentationGoing Concern

The accompanying unaudited interim condensed consolidated financial statements for Hythiam, Inc. (referred to herein as the Company, Hythiam, we, us or our) and our subsidiaries have been prepared in accordance with the Securities and Exchange Commission (SEC) rules for interim financial information and do not include all information and notes required for complete financial statements. In our opinion, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included.  Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto in our most recent Annual Report on Form 10-K,10-K/A, from which the December 31, 20072008 balance sheet has been derived.

Our consolidated financial statements includehave been prepared on the basis that we will continue as a going concern. We have incurred significant operating losses and negative cash flows from operations since our accountsinception. As of March 31, 2009, these conditions raised substantial doubt as to our ability to continue as a going concern. At March 31, 2009, cash, cash equivalents and current marketable securities amounted to $6.0 million and we had a working capital deficit of approximately $8.6 million.  Our working capital deficit is impacted by $7.2 million of outstanding borrowings under the UBS line of credit that is payable on demand and classified in current liabilities, but are secured by $10.4 million of auction-rate securities (ARS) that are classified in long-term assets. During the three months ended March 31, 2009, our cash and cash equivalents used in operating activities amounted to $6.2 million.
Our ability to fund our ongoing operations and continue as a going concern is dependent on raising additional capital, signing and generating revenue from new contracts for our Catasys managed care programs and the accountssuccess of management’s plans to increase revenue and continue to decrease expenses.   In the fourth quarter of 2008, management took actions that we expect will result in reducing annual operating expenses by $10.2 million compared to the third quarter of 2008.  In addition, management currently has plans for additional cost reductions from the elimination of certain positions in our licensee and PROMETA Center operations and related corporate staff and a reduction in certain support and occupancy costs, consulting and other outside services if required. Also, we have renegotiated certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms. We have also negotiated and plan to negotiate more favorable payment terms with vendors, which include negotiating settlements for outstanding liabilities. We may exit certain additional markets in our licensee and PROMETA Center operations that management has determined will not provide short term profitability.  We are currently evaluating the cost impact of such actions, but we do not expect the impact to be material.  Additionally, we are pursuing new Catasys contracts, additional capital and will consider liquidating our ARS, if necessary. As of April 30, 2009, we had net cash on hand of approximately $4.7 million. Excluding short-term debt and non-current accrued liability payments, our current plans call for expending cash at a rate of approximately $1 million per month. At presently anticipated rates, which do not include management’s plans for additional cost reductions, we will need to obtain additional funds within the next two to three months to avoid drastically curtailing or ceasing our operations.  In March 2009, we began discussions with third parties regarding financing that management anticipates would, if concluded, meet our capital needs until we are able to generate positive cash flows.  The financing is contingent upon signing a new Catasys contract.  There can be no assurance that we will be successful in our efforts to generate, increase, or maintain revenue; or raise necessary funds on acceptable terms or at all, and we may not be able to offset this by sufficient reductions in expenses and increases in revenue.  If this occurs, we may be unable to meet our cash obligations as they become due and we may be required to further delay or reduce operating expenses and curtail our operations, which would have a material adverse effect on us, or we may be unable to continue as a going concern. This has raised substantial doubts from our auditors as to our ability to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability of the carrying amount of the recorded assets or the amount of liabilities that might result from the outcome of this uncertainty.

Pursuant to a Stock Purchase Agreement between WoodCliff (our wholly-owned subsidiary) and Core Corporate Consulting Group, Inc., dated January 14, 2009, and effective as of January 20, 2009, we have disposed of our wholly-owned subsidiaries,entire interest in our controlled subsidiary, Comprehensive Care Corporation (CompCare), and our company-managed professional medical corporations.

On January 12, 2007, we acquired allconsisting of the outstanding membership interest14,400 shares of Woodcliff Healthcare Investment Partners, LLC (Woodcliff), which ownsClass A Series Preferred Stock, and 1,739,130 shares of common stock and 14,400 shares of Series A Convertible Preferred StockCompCare held by Woodcliff, for aggregate gross proceeds of CompCare. The conversion$1.5 million. We did not present CompCare as “held for sale” at

7

December 31, 2008 since all of the preferred stock would result in us owning approximately 49.53%criteria specified by SFAS 144, Accounting for the impairment or Disposal of Long-Lived Assets (SFAS 144), had not been met as of that date. The financial statements and footnotes present the outstanding sharesoperations, assets, liabilities and cash flows of CompCare based on shares outstanding as of June 30, 2008. The preferred stock has voting rights and, combined with the common shares held by us, gives us voting control over CompCare. We have anti-dilution protection and the right to designate a majority of the board of directors of CompCare. In addition, CompCare is required to obtain our consentdiscontinued operations. See Note 5, Discontinued Operations, for a sale or merger involving a material portion of CompCare's assets or business, and prior to entering into any single or series of related transactions exceeding $500,000 or incurring any debt in excess of $200,000. We began consolidating CompCare’s accounts on January 13, 2007.further discussion.

Based on the provisions of management services agreements between us and our managed professional medical corporations, we have determined that they constitute variable interest entities, and that we are the primary beneficiary as defined in Financial Accounting Standards Board (FASB) Interpretation No. 46R,Consolidation of Variable Interest Entities,an Interpretation of Accounting Research Bulletin No. 51  (FIN 46R). Accordingly, we are required to consolidate the revenue and expenses of our managed professional medical corporations. See Note 2 under the header Management Service Agreements for more discussion.

All intercompany transactions and balances have been eliminated in consolidation. Certain amounts in the consolidated financial statements for the three and six months ended June 30, 2007March 31, 2008 have been reclassified to conform to the presentation for the three and six months ended June 30, 2008.March 31, 2009.

Note 2.   Summary of Significant Accounting Policies

Revenue Recognition

Managed care activities are performedOur healthcare services revenues to date have been primarily derived from licensing our PROMETA Treatment Program and providing administrative services to hospitals, treatment facilities and other healthcare providers, and from revenues generated by CompCareour managed treatment centers.  We record revenues earned based on the terms of our licensing and management contracts, which requires the use of judgment, including the assessment of the collectability of receivables. Licensing agreements typically provide for a fixed fee on a per-patient basis, payable to us following the providers’ commencement of the use of our program to treat patients.  For revenue recognition purposes, we treat the program licensing and related administrative services as one unit of accounting.  We record the fees owed to us under the terms of the agreements with health maintenance organizations (HMOs), preferredat the time we have performed substantially all required services for each use of our program, which for the significant majority of our license agreements to date is in the period in which the provider organizations,begins using the program for medically directed and supervised treatment of a patient and, in other health plans or payerscases, is at the time that medical treatment has been completed. 

The revenues of our managed treatment centers, which we include in our consolidated financial statements, are derived from charging fees directly to provide contracted behavioral healthcare services to subscribing participants. Revenue under a substantial portion of these agreements is earned monthlypatients for medical treatments, including the PROMETA Treatment Program.  Revenues from patients treated at the managed treatment centers are recorded based on the number of qualified participants regardlessdays of services actually provided (generally referred totreatment completed during the period as capitation arrangements).  The information regarding qualified participants is supplied by CompCare’s clients and CompCare reviews membership eligibility records and other reported information to verify its accuracy in determininga percentage of the amount of revenue to be recognized. Capitation agreements accounted for 97% of CompCare’s revenue, or $9.3 million and $18.3 million, respectively,total number treatment days for the threePROMETA Treatment Program.  Revenues relating to the continuing care portion of the PROMETA Treatment Program are deferred and six months ended June 30, 2008, compared to $8.8 millionrecorded over the period during which the continuing care services are provided.

Cost of Healthcare Services

Cost of healthcare services represent direct costs that are incurred in connection with licensing our treatment programs and $16.2 million, respectivelyproviding administrative services in accordance with the various technology license and services agreements, and are associated directly with the revenue that we recognize. Consistent with our revenue recognition policy, the costs associated with providing these services are recognized, for a significant majority of our agreements, in the period in which patient treatment commences, and in other cases, at the time treatment has been completed. Such costs include royalties paid for the three months ended June 30, 2007use of the PROMETA Treatment Program for patients treated by all licensees, and direct labor costs, continuing care expense, medical supplies and program medications for patients treated at the period January 13 through June 30, 2007. The remaining CompCare revenue is earned on a fee-for-service basis and is recognized as services are rendered.managed treatment centers.


68
Under CompCare’s major Indiana contract, approximately $200,000 of monthly revenue is dependent on CompCare’s satisfaction of various monthly performance criteria and is recognized only after verification that the specified performance targets have been achieved.

Managed Care Expense Recognition

Managed care operating expense is recognized in the period in which an eligible member actually receives services and includes an estimate of the cost of behavioral health services that have been incurred but not yet reported (IBNR).  See “Accrued Claims Payable” for a discussion of IBNR. CompCare contracts with various healthcare providers including hospitals, physician groups and other managed care organizations either on a discounted fee-for-service or a per-case basis.  CompCare determines that a member has received services when CompCare receives a claim within the contracted timeframe with all required billing elements correctly completed by the service provider.  CompCare then determines whether the member is eligible to receive such services, the service provided is medically necessary and is covered by the benefit plan’s certificate of coverage and, in most cases, whether the service is authorized by one of the plan's employees.  If the applicable requirements are met, the claim is entered into CompCare’s claims system for payment.
Accrued Claims Payable

The accrued claims payable liability represents the estimated ultimate net amounts owed by CompCare for all behavioral health managed care services provided through the respective balance sheet dates, including estimated amounts for IBNR claims to CompCare.  The accrued claims payable liability is estimated using an actuarial paid completion factor methodology and other statistical analyses and is continually reviewed and adjusted, if necessary, to reflect any change in the estimated liability. These estimates are subject to the effects of trends in utilization and other factors.  However, actual claims incurred could differ from the estimated claims payable amount reported. Although considerable variability is inherent in such estimates, CompCare management believes, based on an internal review, that the unpaid claims liability of $6.7 million as of June 30, 2008 is adequate.

Premium Deficiencies

Losses are accrued under capitated managed care contracts when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. The loss accrual analysis is performed internally on a specific contract basis taking into consideration such factors as future contractual revenue, projected future healthcare and maintenance costs, and each contract's specific terms related to future revenue increases as compared to expected increases in healthcare costs. The projected future healthcare and maintenance costs are estimated based on historical trends and estimates of future cost increases.

At any time prior to the end of a contract or contract renewal, if a capitated contract is not meeting its financial goals, CompCare generally has the ability to cancel the contract with 60 to 90 days written notice.  Prior to cancellation, CompCare will submit a request for a rate increase accompanied by supporting utilization data. Although historically CompCare’s clients have been generally receptive to such requests, no assurance can be given that such requests will be fulfilled in the future.  If a rate increase is not granted, CompCare generally has the ability to terminate the contract as described above, limiting its risk to a short-term period.

On a quarterly basis, CompCare performs a review of the portfolio of its contracts for the purpose of identifying loss contracts (as defined in the American Institute of Certified Public Accountants Audit and Accounting Guide – Health Care Organizations) and developing a contract loss reserve, if applicable, for succeeding periods. As of June 30, 2008, CompCare’s review identified the large Indiana HMO contract as a contract for which it is probable that a loss will be incurred during the remaining contract term of July 2008 through December 2008.  Based on available information, CompCare has estimated the loss at $300,000, which has been recognized in the consolidated balance sheet at June 30, 2008 and the statement of operations for the three and six months ended   June 30, 2008.


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Comprehensive Income (Loss)

Our comprehensive lossincome (loss) is as follows:

  Three Months Ended  Six Months Ended 
(In thousands) June 30,  June 30, 
  2008  2007  2008  2007 
Net loss $(14,093) $(12,252) $(24,804) $(22,995)
Other comprehensive loss:                
Net unrealized loss on marketable securities available for sale  (210)  -   (776)  - 
Comprehensive loss $(14,303) $(12,252) $(25,580) $(22,995)
  Three Months Ended 
(In thousands) March 31, 
  2009  2008 
Net income (loss) $3,054  $(10,711)
Other comprehensive gain:        
Net unrealized gain (loss) on marketable securities available for sale  425   (566)
Comprehensive income (loss) $3,479  $(11,277)

Basic and Diluted Loss per Share

 
In accordance with Statement of Financial Accounting Standards (SFAS) 128,Computation of Earnings Per Share, basic loss per share is computed by dividing the net loss to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted loss per share is computed by dividing the net loss for the period by the weighted average number of common and dilutive common equivalent shares outstanding during the period.

Common equivalent shares, consisting of 13,393,00014,123,000 and 7,452,00011,536,000 of incremental common shares as of June 30,March 31, 2009 and 2008, and 2007, respectively, issuable upon the exercise of stock options and warrants have been excluded from the diluted earnings per share calculation because their effect is anti-dilutive.

Share-Based Compensation

The Hythiam, Inc. 2003 Stock Incentive Plan and 20072008 Stock Incentive Plan (the Plans), both as amended, provide for the issuance of up to 15 million shares of our common stock. Incentive stock options (ISOs) under Section 422A of the Internal Revenue Code and non-qualified options (NSOs) are authorized under the Plans. We have granted stock options to executive officers, employees, members of our board of directors, and certain outside consultants. The terms and conditions upon which options become exercisable vary among grants, but option rights expire no later than ten years from the date of grant and employee and board of director awards generally vest over three to five years. At June 30, 2008,March 31, 2009, we had 9,830,0009,904,000 vested and unvested shares outstanding and 4,322,0004,257,000 shares available for future awards.

Total share-basedShare-based compensation expense attributable to continuing operations amounted to $1.9$1.2 million and $4.2 million, respectively, for the three and six months ended June 30, 2008, compared to $914,000 and $1.4 million, respectively, for the three months ended June 30, 2007 andMarch 31, 2009, compared to $2.3 million for the period January 13 through June 30 2007.three months ended March 31, 2008.

Stock Options – Employees and Directors

We account for all share-based payment awards made to employees and directors in accordance with SFAS No. 123 (Revised 2004), “Share-Based Payment”Share-Based Payment (SFAS 123R), which requires the measurement and recognition of compensation expense based on estimated fair values. SFAS 123R requires companies to estimate the fair value of share-based payment awards to employees and directors on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations. Prior to the adoption of SFAS 123R on January 1, 2006, we accounted for share-based awards to employees and directors using the intrinsic value method, in accordance with Accounting Principles Board Opinion No. 25, “AccountingAccounting for Stock Issued to Employees”Employees as allowed under SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). Under the intrinsic value method, no share-based compensation expense had been recognized in our consolidated statements of operations for awards to employees and directors because the exercise price of our stock options equaled the fair market value of the underlying stock at the date of grant.


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We adopted SFAS 123R using the modified prospective method. Share-based compensation expense attributable to continuing operations recognized under SFAS 123R for employees and directors for the three and six months ended June 30, 2008March 31, 2009 amounted to $1.2 million and $3.3$1.05 million, compared to $576,000 and $1.1$2.08 million respectively, for the three and six months ended June 30, 2007.March 31, 2008.

Share-based compensation expense recognized in our consolidated statements of operations for the sixthree months ended June 30,March 31, 2009 and 2008 and 2007 includes compensation expense for share-based payment awards granted prior to, but not yet vested, as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS 123, and for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. For share-based awards issued to employees and directors, share-based compensation is attributed to expense using the straight-line single option method. Share-based compensation expense recognized in our consolidated statements of operations for the three and six months ended June 30,March 31, 2009 and 2008 and 2007 is based on awards ultimately expected to vest, reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

During the three and six months ended June 30,March 31, 2009 and 2008, and 2007, we granted options to employees for 2,125,000, 4,152,000, 42,000,271,700 and 374,0002 million shares, respectively, at the weighted average per share exercise price of $2.62, $2.64, $7.34,$0.31 and $8.18,$2.65, respectively, the fair market value of our common stock at the dates of grants. Approximately 1,023,000271,700 of the options granted in 20082009 vested immediately on the date of grant and approximately 3,129,000 options vest monthly on a pro-rata basis, over three years.grant. Employee and director stock option activity for the three and six months ended June 30, 2008March 31, 2009 was as follows:

    Weighted Avg.     Weighted Avg. 
 Shares  Exercise Price  Shares  Exercise Price 
Balance December 31, 2007  5,152,000  $4.61 
Balance, December 31, 2008  8,260,000  $3.07 
                
2009        
Granted  2,027,000  $2.65   272,000   0.31 
Transfer *  (100,000) $5.78 
Exercised  -  $-   -   - 
Cancelled  (326,000) $6.65   (487,000)  2.27 
        
Balance March 31, 2008  6,753,000  $3.91 
        
Granted  2,125,000  $2.62 
Transfer *  (60,000) $2.50 
Exercised  -  $- 
Cancelled  (314,000) $5.51 
        
Balance June 30, 2008  8,504,000  $3.54 
Balance, March 31, 2009  8,045,000  $3.03 
 
*  Option transfer due to status change from employee to non-employee

The estimated fair value of options granted to employees during the three and six months ended June 30,March 31, 2009 and 2008 was $54,000 and 2007 was $3.4 million, $6.5 million, $200,000 and $2.0$3.1 million, respectively, calculated using the Black-Scholes pricing model with the following assumptions:

  Three Months Ended  Six Months Ended 
  June 30,  June 30, 
  2008  2007  2008  2007 
Expected volatility  64%   66%   64%   66% 
Risk-free interest rate  3.68%   4.57%   3.30%   4.57% 
Weighted average expected lives in years  6.0   6.5   5.8   6.5 
Expected dividend  0%   0%   0%   0% 

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Table of Contents
 Three Months Ended
 March 31,
 2009 2008
Expected volatility72% 64%
Risk-free interest rate2.16% 2.88%
Weighted average expected lives in years6.0 5.4
Expected dividend0% 0%

The expected volatility assumptions have been based on the historical and expected volatility of our stock, and the stock of other public healthcare companies, measured over a period generally commensurate with the expected term. The weighted average expected option term for the three and six months ended June 30, 2008March 31, 2009 reflects the application of the simplified method prescribed in SEC Staff Accounting Bulletin (SAB) No. 107 (and as amended by SAB 110), which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

We have elected to adopt the detailed method provided in SFAS 123R for calculating the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee share-based compensation awards that are outstanding upon adoption of SFAS 123R.

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As of June 30, 2008,March 31, 2009, there was $12.6 million$6,186,000 of total unrecognized compensation costs related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of approximately 1.71.2 years.

Stock Options and Warrants – Non-employees

We account for the issuance of options and warrants for services from non-employees in accordance with SFAS 123 by estimating the fair value of warrants issued using the Black-Scholes pricing model. This model’s calculations include the option or warrant exercise price, the market price of shares on grant date, the weighted average risk-free interest rate, expected life of the option or warrant, expected volatility of our stock and expected dividends.

For options and warrants issued as compensation to non-employees for services that are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received as provided by FASB Emerging Issues Task Force (EITF) No. 96-18, “AccountingAccounting For Equity Instruments That Are Issued To Other Than Employees For Acquiring Or In Conjunction With Selling Goods Or Services.”Services. For unvested shares, the change in fair value during the period is recognized in expense using the graded vesting method.

There were no options and warrants granted for the three months ended March 31, 2009. During  the  three and six months ended  June 30,March 31, 2008, and 2007, we granted  options and warrants for 46,000,  85,000, 25,000, and 40,00039,000 shares respectively,  to non-employees at a weighted average pricesprice of  $2.63, $2.64 $7.32 and $7.58, respectively.$2.65. For the three and six months ended June 30,March 31, 2009 and 2008, and 2007, share-based expense attributable to continuing operations relating to stock options and warrants granted to non-employees was $67,000, $52,000, $282,000$ 12,000 and $134,000,$15,000, respectively.


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Non-employee stock option and warrant activity for the three and six months ended June 30, 2008March 31, 2009 was as follows:

     Weighted Avg. 
  Shares  Exercise Price 
Balance December 31, 2007 *
  1,362,000   5.02 
         
Granted  39,000   2.65 
Transfer **
  100,000   5.78 
Exercised  -   0.00 
Cancelled  (50,000)  7.32 
         
Balance March 31, 2008  1,451,000   4.93 
         
Granted  46,000   2.63 
Transfer **
  60,000   5.78 
Exercised  -   0.00 
Cancelled        
         
Balance June 30, 2008  1,557,000   4.90 
         
* Certain reclassifications have been made to the beginning balance to conform to the current year's presentation.
 
** Option transfer due to status change from employee to non-employee consultant. 
     Weighted Avg. 
  Shares  Exercise Price 
Balance, December 31, 2008  2,095,000  $3.91 
         
2009        
Granted  -   - 
Exercised  -   - 
Cancelled  (195,000)  6.92 
Balance, March 31, 2009  1,900,000  $3.61 
 
Common Stock

During the three and six months ended June 30,March 31, 2009 and 2008, respectively, we issued 140,000110,156 and 193,00052,500 shares of common stock, respectively valued at $56,000 and $ 139,000 respectively, in exchange for consulting services valued at $332,000 and  $471,000, respectively.  During the six months ended June 30, 2007, we issued 14,000 shares of common stock for consulting services valued at $111,000. There were no shares issued for such services during the three months ended June 30, 2007.services.   These costs are being amortized to share-based expense on a straight-line basis over the related sixnine month to one year service periods. For the three months ended March 31, 2009 and six month periods ended June 30, 2008, and 2007, share-based expense relating to all common stock issued for consulting services was $583,000, $794,000, $43,000$149,000 and $95,000,$212,000, respectively.

Employee Stock Purchase Plan

We have a qualified employee stock purchase plan (ESPP), approved by our stockholders, which allows qualified employees to participate in the purchase of designated shares of our common stock at a price equal to 85% (ESPP discounted price) of the lower of the closing price at the beginning or end of each specified stock purchase period. As of June 30, 2008,During the three months ended March 31, 2009, there were 36,000no shares of our common stock issued pursuant to the ESPP.ESPP and , thus, no expense incurred for this period. Share-based expense relating to the ESPP discount price was $1,000, $2,000, $4,000 and $8,000, respectively,$3,000 for the three and six month periodsmonths ended June 30, 2008 and 2007.March 31, 2008.

Stock Options – CompCare Employees, Directors and Consultants

CompCare’s 1995 Incentive Plan and 2002 Incentive Plan (the CompCare Plans) provide for the issuance of up to 1 million shares of CompCare common stock for each plan. ISOs, NSOs, stock appreciation rights, limited stock appreciation rights, and restricted stock grants to eligible employees and consultants are authorized under the CompCare Plans. CompCare issues stock options to its employees and non-employee directors allowing them to purchase common stock pursuant to the CompCare Plans.  Options for ISOs may be granted for terms of up to ten years and are generally exercisable in cumulative increments of 50% each six months.  The exercise price for ISOs must equal or exceed the fair market value of the shares on the date of grant. The Plans also provide for the full vesting of all outstanding options under certain change of control events.  As of June 30, 2008, under the 2002 Incentive Plan, there were 374,000 options available for grant and there were 586,000 options outstanding, of which

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282,000 are exercisable.  Additionally, as of June 30, 2008, under the 1995 Incentive Plan, there were 259,000 options outstanding and exercisable. The 1995 Incentive Plan was terminated effective August 31, 2005 such that there are no further options available for grant under this plan.

CompCare also has a non-qualified stock option plan for its outside directors (the CompCare Directors’ Plan). Each non-qualified stock option is exercisable at a price equal to the average of the closing bid and asked prices of the common stock in the over-the-counter market for the last preceding day in which there was a sale of the stock prior to the grant date. Grants of options vest in accordance with vesting schedules established by CompCare’s Compensation and Stock Option Committee.  Upon joining the CompCare Board, directors receive an initial grant of 25,000 options.  Annually, directors are granted 15,000 options on the date of CompCare’s annual meeting.  As of June 30, 2008, under the CompCare Directors’ Plan, there were 777,000 shares available for option grants and there were 125,000 options outstanding, of which 63,000 shares were exercisable.

CompCare has adopted SFAS 123R, using the modified prospective method and used a Black-Scholes valuation model to determine the fair value of options on the grant date. Share-based compensation expense recognized for employees and directors for the three and six months ended June 30, 2008 was $47,000 and $82,000, respectively and for the three months ended June 30, 2007 and the period January 13, 2007 through June 30, 2007, share-based compensation expense was $9,000 and $29,000, respectively.

CompCare stock option activity for the three and six month periods ended June 30, 2008 was as follows:

     Weighted Avg. 
  Shares  Exercise Price 
Balance December 31, 2007  1,070,000  $1.27 
         
Granted  185,000  $0.60 
Exercised  (125,000) $0.26 
Cancelled  (245,000) $1.38 
         
Balance March 31, 2008  885,000  $1.24 
         
Granted  110,000  $0.43 
Exercised  -  $- 
Cancelled  (25,000) $1.76 
         
Balance June 30, 2008  970,000  $1.13 

Stock options totaling 110,000 and 295,000 shares were granted to CompCare board of director members and employees during the three and six month periods ended June 30, 2008, at weighted average exercise prices of $0.43 and $0.54, respectively.  No stock options were granted to CompCare board of director members or employees during the period January 13 through June 30, 2007.

No stock options were exercised during three months ended June 30, 2008 and 2007. During the six months ended June 30, 2008 and 2007, respectively, 125,000 and 38,000 stock options were exercised, which had total intrinsic values of $50,000 and $13,000, respectively. During the three and six months ended June 30, 2008, stock options expired or cancelled totaled 25,000 and 270,000 shares, respectively. During the three months ended June 30, 2007 and the period January 13 through June 30, 2007, respectively, 40,000 and 120,000 shares expired or were cancelled. Expiration or cancelled shares were generally due to the recipients’ resignation from CompCare or its board of directors.

The following table lists the assumptions utilized in applying the Black-Scholes valuation model.  CompCare uses historical data to estimate the expected term of the option.  Expected volatility is based on the historical volatility of the CompCare’s traded stock.  CompCare did not declare dividends in the past nor does it expect to do

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so in the near future, and as such it assumes no expected dividend.  The risk-free rate is based on the U.S. Treasury yield curve with the same expected term as that of the option at the time of grant. As mentioned above, no stock options were granted during the period January 13 through June 30, 2007.

  Three Months Ended  Six Months Ended 
  June 30,  June 30, 
  2008  2007  2008  2007 
Expected volatility  130%   -   125-130%   - 
Risk-free interest rate  2.98%   -   2.98-3.24%   - 
Weighted average expected lives in years  5.0   -   5.0-6.0   - 
Expected dividend  0%   -   0%   - 
Income Taxes

We account for income taxes using the liability method in accordance with SFAS No. 109, Accounting for Income TaxesTaxes.. To date, no current income tax liability has been recorded due to our accumulated net losses. Deferred tax assets and liabilities are recognized for temporary differences between the financial statement carrying amount of assets and liabilities and the amounts that are reported in the tax return. Deferred tax assets and liabilities are recorded on a net basis; however, our net deferred tax assets have been fully reserved by a valuation allowance due to the uncertainty of our ability to realize future taxable income and to recover our net deferred tax assets.

In June 2006, theWe account for uncertain tax positions in accordance with FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes (FIN 48), which clarifies the accounting for uncertainty in income taxes. FIN 48 requires that companies recognize in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 on January 1, 2007, with no impact to our consolidated financial statements.To date, we have not recorded any uncertain tax positions.

Costs associated with streamlining our operations

In January 2008, we streamlined our operations to increase our focus on managed care opportunities, significantly reducing our field and regional sales personnel and related corporate support personnel, the number of outside consultants utilized, closing our PROMETA Center in San Francisco and lowering overall corporate overhead costs. These initiatives are expected to result in an overall reduction of 25% to 30% of cash operating expenses for the fiscal year ending December 31, 2008. In April 2008, the fourth quarter of 2008, and in the first quarter of 2009, we took further actionactions to streamline our operations by reducing totaland increase the focus on managed care opportunities. The actions we took in the first quarter of 2009 also included renegotiation of certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms with vendors, which included negotiating settlements for outstanding liabilities, and has resulted in delays and reductions in operating costs by an additional 20% to 25%.expenses.

During the firstthree months ended March 31, 2009 and second quarters of 2008, we recorded $1.1 million$212,000 and $1.2 million, respectively, in costs associated with actions taken to streamline our operations in both January 2008 and April 2008 to increase our focus on managed care opportunities. Such one-timeoperations.  These costs primarily represent severance and related benefits andbenefits. The costs incurred in 2008 also include costs incurred to close the San Francisco PROMETA Center. We have accounted for these costs in accordance with SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146). SFAS 146 states that a liability for a cost associated with an exit or disposal activity shall be recognized and measured initially at its fair value in the period when the liability is incurred.

Marketable Securities

Investments include auction rate securities (ARS),ARS, U.S. Treasury bills, commercial paper and certificates of deposit with maturity dates greater than three months when purchased, which are classified as available-for-sale investments and reflected in current or long-term assets as marketable securities at fair market value in accordance with SFAS No. 115,Accounting for Certain Investments in Debt and Equity Securities (SFAS 115). Unrealized gains and losses are reported in our consolidated balance sheet within the caption entitled “Accumulated other comprehensive loss”income (loss)” and within comprehensive lossincome (loss) under the caption “other comprehensive loss.income (loss).” Realized gains and losses and declines in value judged to be other-than-temporary are recognized as an impairment charge in the statement of operations on the specific identification method in the period in which they occur.

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ThroughMarch 31, 2009, our total investment in ARS was $11.5 million. Since February 13, 2008, all of our ARS held at December 31, 2007 had completed at least one auction successfully through the normal auction process, and we had reduced our total investments in ARS to $11.5 million. However, since February 14, auctions for these securities have failed,failed; meaning the parties desiring to sell securities could not be matched with an adequate number of buyers, resulting in our having to continue to hold these securities. Although the securities are Aaa/AAA rated and collateralized by portfolios of student loans guaranteed by the U.S. government, based on current market conditions it is likely that auctions will continue to be unsuccessful in the short-term, limiting the liquidity of these investments until the auction succeeds, the issuer calls the securities, or they mature. The remaining maturity periods range from nineteen to thirty-eight years. As a result, our ability to liquidate our investment and fully recover the carrying value of our investment in the near term may be limited or not exist.  Accordingly,In December 2008, we recognized a temporary$1.4 million other-than-temporary decline in value related to our investment in ARS. For the fairthree months ended March 31, 2009, we recognized an additional $132,000 other-than-temporary decline in value related to our investment in certain ARS, and an increase in value of approximately $425,000 related to our ARS investments of approximately $776,000investment in other ARS. In accordance with SFAS 115, other-than-temporary declines in value are reflected as of June 30, 2008, based on estimates of the fair value using valuation models and methodologies that utilize an income-based approach to estimate the price that would be received to sell our securities in an orderly transaction between market participants.a non-operating

If the issuers

expense in our Consolidated Statement of Operations, whereas subsequent increases in value are unable to successfully close future auctions or their credit ratings deteriorate, we mayreflected in the future record an impairment chargeStockholders’ Equity on these investments. In addition, these types of developments could cause us to reclassify our investments in ARS from a current asset to a long-term asset.  We believe that the higher reset interest rates on failed auctions for our investments provide sufficient incentive for the security issuers to address this lack of liquidity. While these failures in the auction process have affected our ability to access these funds in the short-term, we do not believe that the underlying securities or collateral have been materially affected.  At this time, we have not obtained sufficient evidence to conclude that these investments are impaired or that they will not be settled within the next twelve months, although the market for these investments is uncertain. We believe that we will not require access to these funds within the next twelve months or prior to restoration of liquidity in this market. It is our intention to hold our ARS until they can be liquidated in a market that facilitates orderly transactions and we believe that we have the ability to maintain our investment over that time frame. In May 2008, we obtained a demand margin loan facility from our investment portfolio manager, allowing us to borrow up to $5.4 million to provide additional cash liquidity if so needed, collateralized by the ARS. As of June 30, 2008, we have not drawn any funds against the facility. Any draw-downs would be subject to a rate of interest equal to the prevailing 30-day LIBOR rate plus 100 basis points. Consolidated Balance sheet.

These securities will continue to be analyzed each reporting period for other-than-temporary impairment factors. We may be required to adjust the carrying value of these investments through an impairment charge if any loss is considered to be other than temporary. If our efforts to raise additional capital discussed in Note 1 are successful, we believe that we will not require access to the underlying ARS prior to June 2010. Due to the current uncertainty in the credit markets and the terms of the Rights offering with UBS (discussed in our 2008 Form 10-K), we have classified the fair value of our ARS as long-term assets as of March 31, 2009.

Fair Value Measurements

Effective January 1, 2008, we adopted SFAS No. 157,Fair Value Measurements, (SFAS 157). SFAS 157 does not require any new fair value measurements; rather, it defines fair value, establishes a framework for measuring fair value in accordance with existing generally accepted accounting principles and expands disclosures about fair value measurements. In February 2008, FASB Staff Position (FSP) FAS 157-2,Effective Date of FASB Statement No. 157, was issued, which delaysdelayed the effective date of SFAS 157 to fiscal years and interim periods within those fiscal years beginning after November 15, 2008 for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We elected to defer the adoption of the standard for these non-financial assets and liabilities, and are currently evaluating the impact, if any, thatadopted the deferred provisions of the standard will have on our consolidatedeffective January 1, 2009, with no significant effect. In October 2008, FSP FAS 157-3, Fair Value Measurements (FSP FAS 157-3), was issued, which clarifies the application of SFAS 157 in an inactive market and provides an example to demonstrate how the fair value of a financial statements.asset is determined when the market for that financial asset is inactive. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. The adoption of SFAS 157 for our financial assets and liabilities and FSP FAS 157-3 did not have an impact on our financial position or operating results. Beginning January 1, 2008, assets and liabilities recorded at fair value in the consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Level inputs, as defined by SFAS 157, are as follows:

Level Input: Input Definition:
Level I Inputs are unadjusted, quoted prices for identical assets or liabilities in active markets at the measurement date.
Level II Inputs, other than quoted prices included in Level I, that are observable for the asset or liability through corroboration with market data at the measurement date.
Level III Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date.


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The following table summarizes fair value measurements by level at June 30, 2008March 31, 2009 for assets and liabilities measured at fair value on a recurring basis:

(In thousands) Level I  Level II  Level III  Total 
Cash and cash equivalents $6,413  $-  $-  $6,413 
Marketable securities:                
 Variable auction rate securities  -   -   10,724   10,724 
 Commercial paper  9,144   -   -   9,144 
 Certificates of deposit  333   -   -   333 
Total assets $15,890  $-  $10,724  $26,614 
                 
Warrant liability $-  $1,842  $-  $1,842 
Total liabilities $-  $1,842  $-  $1,842 
(Dollars in thousands) Level I  Level II  Level III  Total 
Marketable securities $139  $-  $-  $139 
Variable auction rate securities  -   -   10,365   10,365 
Certificates of deposit *  133   -   -   133 
 Total assets $272  $-  $10,365  $10,637 
                 
Warrant liabilities $-  $87  $-  $87 
 Total liabilities $-  $87  $-  $87 

* included in "deposits and other assets" on our Consolidated Balance Sheets


Liabilities measured at market value on a recurring basis include the warrant liabilityliabilities resulting from the registered direct stock placement completed on November 7, 2007.recent debt and equity financing. In accordance with EITF 00-19,Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock (EITF 00-19), the warrant liability isliabilities are being marked to market each quarter-end until they are completely settled. The warrants wereare valued using the Black-Scholes method, using assumptions consistent with our application of SFAS 123R. See Warrant Liabilities below.

All of our assets measured at fair value on a recurring basis using significant Level III inputs as of June 30, 2008March 31, 2009 were ARS. See discussion above in “Marketable Securities”Securities for additional information on our ARS, including a description of the securities, and underlying collateral, a discussion of the uncertainties relating to their liquidity and our accounting treatment under SFAS 115. The following table summarizes our fair value measurements using significant Level III inputs, and changes therein, for the three-month periodsthree months ended March 31and June 30, 2008:31, 2009:

(In thousands) Level III 
Balance as of December 31, 2007 $19,000 
 Purchases and sales, net  (7,500)
 Net unrealized losses  (566)
 Net realized gains (losses)  - 
 Transfers in/out of Level III  - 
Balance as of March 31, 2008  10,934 
     
 Purchases and sales, net  - 
 Net unrealized losses  (210)
 Net realized gains (losses)  - 
 Transfers in/out of Level III  - 
Balance as of June 30, 2008 $10,724 
(Dollars in thousands) Level III 
Balance as of December 31, 2008 $10,072 
 Transfers in/out of Level III  - 
 Purchases and sales, net  - 
 Net unrealized gains (losses)  425 
 Net realized gains (losses)*  (132)
Balance as of March 31, 2009 $10,365 
     

* Reflects other-than-temporary loss on auction-rate securities.

As discussed above, there have been continued auction failures with our ARS portfolio. As a result, quoted prices for our ARS did not exist as of June 30, 2008March 31, 2009 and, accordingly, we concluded that Level 1 inputs were not available and unobservable inputs were used. We determined that use of a valuation model was the best available technique for measuring the fair value of our ARS portfolio and we based our estimates of the fair value using valuation models and methodologies that utilize an income-based approach to estimate the price that would be received to sell our securities in an orderly transaction between market participants. The estimated price was derived as the present value of expected cash flows over an estimated period of illiquidity, using a risk adjusted discount rate that was based on the credit risk and liquidity risk of the securities.  Based on the valuation models and methodologies, and consideration of other factors, we havewrote-down certain of our ARS to their estimated fair value as of March 31, 2009 and considered the $132,000 reduction in value as “other-than-temporary”. Additionally, we recorded a temporary declineincrease in the fair value of ourcertain other ARS investments of approximately $776,000$425,000 as of June 30, 2008.March 31, 2009. While our valuation model was based on both Level II (credit quality and interest rates) and Level III inputs, we determined that the Level III inputs were the most significant to the overall fair value measurement, particularly the estimates of risk adjusted discount rates and estimated periods of illiquidity. The valuation model also reflected our intention to hold our ARS until they can be liquidated in a market that facilitates

15

orderly transactions, which we believe will occur within the next twelve months, and our belief that we have the ability to maintain our investment over that time frame.

Goodwill and Other Intangible Assets

In accordance with SFAS No. 141, Business Combinations (SFAS 141), the purchase price for the CompCare acquisition was allocated to the fair values of the assets acquired, including identifiable intangible assets, in accordance with our proportionate share of ownership interest, and the excess amount of purchase price over the fair values of net assets acquired resulted in goodwill that will not be deductible for tax purposes. We believe our association with CompCare creates synergies to facilitate the use of PROMETA treatment programs by managed care treatment providers and to provide access to an infrastructure for our planned disease management product offerings. Accordingly, the resulting goodwill has been assigned to our healthcare services reporting unit. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), goodwill is not amortized, but instead is subject to impairment tests. Goodwill was tested for impairment with no exceptions as of December 31, 2007.

The change in the carrying amount of goodwill by reporting unit is as follows:

     Behavioral    
(In thousands) Healthcare  Health Managed    
  Services  Care  Total 
Balance as of December 31, 2007 $10,064  $493  $10,557 
Additional equity issued to minority            
 shareholders  (112)  -   (112)
Balance as of June 30, 2008 $9,952  $493  $10,445 

Identified intangible assets acquired as part of the CompCare acquisition include the value of managed care contracts and marketing-related assets associated with its managed care business, including the value of the healthcare provider network and the professional designation from the National Council on Quality Association (NCQA). Such assets are being amortized on a straight-line basis over their estimated remaining lives, which approximate the rate at which we believe the economic benefits of these assets will be realized.

As of June 30, 2008,March 31, 2009, the gross and net carrying amounts of intangible assets that are subject to amortization are as follows:

  Gross        Amortization 
(In thousands) Carrying  Accumulated  Net  Period 
  Amount  Amortization  Balance  (in years) 
Intellectual property $4,440  $(971) $3,469   12-18 
Managed care contracts  831   (404)  427   3-4 
Provider networks, NCQA  1,305   (775)  530   1-3 
Balance as of June 30, 2008 $6,576  $(2,150) $4,426     
  Gross        Amortization 
(In thousands) Carrying  Accumulated  Net  Period 
  Amount  Amortization  Balance  (in years) 
Intellectual property $4,156  $(1,317) $2,839   12-18 

During the three months ended March 31, 2009 we did not acquire any new intangible assets and at March 31, 2009, all of our intangible assets consisted of intellectual property, which is not subject to renewal or extension. In accordance with SFAS 144,Accounting for the impairment or Disposal of Long-Lived Assets(SFAS 144), we performed impairment tests on intellectual property as of March 31, 2009 and otherafter considering numerous factors, including a valuation of the intellectual property by an independent third party, we determined that the carrying value of certain intangible assets was not recoverable and exceeded the fair value and we recorded an impairment charge totaling $355,000 for these assets as of DecemberMarch 31, 20072009.  These charges included $122,000 for intangible assets related to our managed treatment center in Dallas and also re-evaluated$233,000 related to intellectual property for additional indications for the useful livesuse of such intangible assets.the PROMETA Treatment Program that is currently non-revenue generating.  In its


valuation, the independent third-party valuation firm relied on the “relief from royalty” method, as this method was deemed to be most relevant to the intellectual property assets of the Company.  We determined that the estimated useful lives of the remaining intellectual property and other intangible assets properly reflected the current remaining economic useful lives of thesethe assets.


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Estimated remaining amortization expense for intangible assets for the current year and each of the next five years ending December 31 is as follows:

(In thousands)    
2008 $  465
Year Amount 
2009 $  901 $186 
2010 $  310 $238 
2011 $  286 $238 
2012 $  286 $238 
2013 $238 
Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to seven years for furniture and equipment. Leasehold improvements are amortized over the lesser of the estimated useful lives of the assets or the related lease term, which is typically five to seven years.

During the three months ended March 31, 2009, we performed an impairment test on all property and equipment, including capitalized software related to our Catasys segment. As a result of this testing, we determined that the carrying value of this asset was not recoverable and exceeded its fair value and we wrote off the $758,000 net book value of this software as of March 31, 2009. This impairment charge was recognized in operating expenses in our consolidated statements of operations in accordance with SFAS 144.

Variable Interest Entities

Generally, an entity is subject to FIN 46R and is called a Variable Interest Entity (VIE) if it has (a) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (b) equity investors that cannot make significant decisions about the entity’s operations, or that do not absorb the expected losses or receive the expected returns of the entity. When determining whether an entity that is a business qualifies as a VIE, we also consider whether (i) we participated significantly in the design of the entity, (ii) we provided more than half of the total financial support to the entity, and (iii) substantially all of the activities of the VIE either involve us or are conducted on our behalf. A VIE is consolidated by its primary beneficiary, which is the party that absorbs or receives a majority of the entity’s expected losses or expected residual returns.

As discussed under the heading Management Services Agreements below, we have management services agreements with managed medical corporations. Under these management services agreements, the equity owner of the affiliated medical group has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of these management services agreements. We also agree to provide working capital loans to allow for the medical group to pay for its obligations. Substantially all of the activities of these managed medical corporations either involve us or are conducted for our benefit, as evidenced by the facts that (i) the operations of the managed medical corporations are conducted primarily using our licensed protocols and (ii) under the management services agreements, we agree to provide and perform all non-medical management and administrative services for the respective medical group. Payment of our management fee is subordinate to payments of the obligations of the medical group, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated medical group or other third party. Creditors of the managed medical corporations do not have recourse to our general credit.


CompCare had negative cash flow
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Based on the six months ended June 30, 2008design and had aprovisions of these management services agreements and the working capital deficit of $6.0 million and a stockholders’ deficit of $9.2 million at June 30, 2008. CompCare’s continuation as a going concern depends upon its ability to generate sufficient cash flow to conduct its operations and its ability to obtain additional sources of capital and financing. CompCare’s management has taken action to reduce operating expenses, has requested rate increases from several of its existing clients and is exploring its options to raise additional equity capital, sell all or a portion of its assets, or seek additional debt and financing. We evaluated the carrying values of intangible assets and goodwill relatedloans provided to the CompCare acquisition ($957,000 and $493,000, respectively, as of June 30, 2008) for possible impairment as of June 30, 2008 andmedical groups, we believe there is no impairment. However, we will continue to review these assets for potential impairment each reporting period. An impairment loss would be recognized if and when we concludehave determined that the carrying amountsmanaged medical corporations are VIEs, and that we are the primary beneficiary as defined in FIN 46R. Accordingly, we are required to consolidate the revenues and expenses of such assets exceed the related undiscounted cash flows for the intangible assets and the implied fair value for the CompCare goodwill.managed medical corporations.

Minority InterestManagement Services Agreements

Minority interest representsWe have executed management services agreements (MSAs) with medical professional corporations and related treatment centers, with terms generally ranging from five to ten years and provisions to continue on a month-to-month basis following the minority stockholders’ proportionate shareinitial term, unless terminated for cause.

Under each of these MSAs, we generally license to the equitymedical group or treatment center the right to use our proprietary treatment programs and related trademarks and provide all required day-to-day business management services, including, but not limited to:

●  general administrative support services;
●  
information systems;
●  
recordkeeping;
●  
scheduling;
●  
billing and collection;
●  
marketing and local business development; and
●  
obtaining and maintaining all federal, state and local licenses, certifications and regulatory permits

The medical group or treatment facility retains the sole right and obligation to provide medical services to its patients and to make other medically related decisions, such as the choice of CompCare. As discussed above, we acquired a controlling interest in CompCare as partmedical professionals to hire or medical equipment to acquire and the ordering of our Woodcliff acquisition, and we have the ability to control 49.53% of CompCare’s common stock as of June 30, 2008 from our ownership of 1,739,130 shares of common stock and 14,400 shares of CompCare’s Series A Convertible Preferred Stock (assuming conversion). drugs.

In addition, we have the abilityprovide medical office space to appointeach medical group on a majority of board members through our preferred stock investment. Our ownership percentage as of June 30, 2008 has decreased from 50.25% as of the date of our acquisition duenon-exclusive basis, and we are responsible for all costs associated with rent and utilities. The medical group pays us a monthly fee equal to additional common stock issued by CompCare during the period. Our controlling interest requires that CompCare’s operations be included in our consolidated financial statements, with the remaining 50.47% being attributed to minority stockholder interest. Due to CompCare’s accumulated deficit on the date of our acquisition, a deficit minority stockholders’ balance in the amount of $544,000 existed at the time of the acquisition which was valued at zero, resulting in an increase in the amount of goodwill recognized in the acquisition. The minority stockholders’ interest in any further net losses will not be recorded due to the accumulated deficit. The cumulative unrecorded minority stockholders’ interest in net loss amounted to $4.2 million as of June 30, 2008. The minority stockholders’ interest in any future net income will first be credited to goodwill to the extent of the original deficit interest, and will not be recognized in the financial statements until the aggregate amount of (a) our costs of providing management services (including reasonable overhead allocable to the delivery of our services and including start-up costs such profits equalsas pre-operating salaries, rent, equipment, and tenant improvements incurred for the aggregatebenefit of the medical group, provided that any capitalized costs will be amortized over a five year period), (b) 10%-15% of the foregoing costs, and (c) any performance bonus amount, as determined by the medical group at its sole discretion. The medical group’s payment of unrecognized losses.our fee is subordinate to payment of the medical group's obligations, including physician fees and medical group employee compensation.

We have also agreed to provide a credit facility to each medical practice to be available as a working capital loan, with interest at the Prime Rate plus 2%.  Funds are advanced pursuant to the terms of the MSAs described above.  The notes are due on demand, or upon termination of the respective management services agreement. At March 31, 2009, there were three outstanding credit facilities under which $10.0 million was outstanding.

Generally, an entity is subject to FIN 46R and is called a Variable Interest Entity (VIE) if it has (a) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (b) equity investors that cannot make significant decisions about the entity’s operations, or that do not absorb the expected losses or receive the expected returns of the entity. When determining whether an entity that is a business qualifies as a VIE, we also consider whether (i) we participated significantly in the design of the entity, (ii) we provided more than half of the total financial support to the entity, and (iii) substantially all of the activities of the VIE either involve us or are conducted on our behalf. A VIE is consolidated by its primary beneficiary, which is the party that absorbs or receives a majority of the entity’s expected losses or expected residual returns.

Under the MSAs, the equity owner of the affiliated medical group has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of the MSAs. We also agree to provide working capital loans to allow for the medical group to pay for its obligations. Substantially all of the activities of these managed medical corporations either involve us or are conducted for our benefit, as evidenced by the facts that (i) the operations of the managed medical corporations are conducted primarily using our licensed protocols and (ii) under the MSAs, we agree to provide and perform all non-medical management and administrative services for the respective medical group. Payment of our

16

management fee is subordinate to payments of the obligations of the medical group, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated medical group or other third party. Creditors of the managed medical corporations do not have recourse to our general credit. Based on these facts, we have determined that the managed medical corporations are VIEs and that we are the primary beneficiary as defined in FIN 46R.  Accordingly, we are required to consolidate the assets, liabilities, revenues and expenses of the managed treatment centers.

The amounts and classification of assets and liabilities of the VIEs included in our Consolidated Balance Sheets at March 31, 2009 and 2008 are as follows:

  March 31,  December 31, 
(Dollars in thousands) 2009  2008 
Cash and cash equivalents $354  $274 
Receivables, net  157   281 
Prepaids and other current assets  3   3 
Total assets $514  $558 
         
Accounts payable  26  $30 
Intercompany loans  9,968   9,238 
Accrued compensation and benefits  37   54 
Accrued liabilities  14   13 
Total liabilities $10,045  $9,335 
Warrant Liabilities

We have issued warrants in connection with the registered direct placement of our common stock in November 2007 and the amended and restated Highbridge senior secured note in July 2008. The warrants include provisions that require us to record them at fair value as a liability in accordance with EITF 00-19, with subsequent changes in fair value recorded as a non-operating gain or loss in our statement of operations. The fair value of the warrants is determined using a Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility, interest rates and expected term.

For the three months ended March 31, 2009 and 2008, we recognized non-operating gains of $69,000 and $2.3 million, respectively, related to the revaluation of our warrant liabilities. We will continue to re-measure the warrant liabilities at fair value each quarter-end until they are completely settled or expire.

Recent Accounting Pronouncements

Recently Adopted

In September 2006,December 2008, the FASB issued SFAS 157, which defines fair value, establishes a frameworkFSP FAS 140-4 and FASB Interpretation No. (FIN) 46R-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities . This FSP amends FASB Statement No. 140 Accounting for measuring fair value in generally accepted accounting principles,Transfers and expandsServicing of Financial Assets and Extinguishments of Liabilities to require public entities to provide additional disclosures about fair value measurements. The statement istransfers of financial assets. It also amends FIN 46, Consolidation of Variable Interest Entities as revised to require public enterprises to provide additional disclosures about their involvement with VIEs. FSP FAS 140-4 and FIN 46(R)-8 are effective for financial statements issued forthe Company's fiscal years beginning after November 15, 2007,year ending December 31, 2008.  We are required to consolidate the revenues and interim periods within those fiscal years. In February 2008, FSP FAS 157-2 was issued, which delays the effective date of SFAS 157 to fiscal years and interim periods within those fiscal years beginning after November 15, 2008 for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We elected to defer the adoptionexpenses of the standard for these non-financial assets and liabilities, andmanaged medical corporations.  The financial results of managed treatment centers are currently evaluating the impact, if any, that the deferred provisions of the standard will have onincluded in our consolidated financial statements. The adoption of SFAS 157 forstatements under accounting standards applicable to VIEs, and the required disclosures regarding our financial assets and liabilities did not have an impact on our financial position or operating results.

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In February 2007,involvement with VIEs are included above under the FASB issued SFAS No. 159,heading The Fair Value Option for Financial Assets and Financial LiabilitiesVariable Interest Entities (SFAS 159). SFAS 159 allows companies to measure many financial assets and liabilities at fair value. It also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years.

The adoption of SFAS No. 159 did not have a material impact on our financial position, results of operations or cash flows.

Recently Issued

In December 2007, the FASB issued SFAS No. 141(R),Business Combinations (SFAS 141(R)). SFAS 141(R) replaces SFAS No. 141,Business Combinations (SFAS 141), which retains the requirement that the purchase method of accounting for acquisitions be used for all business combinations. SFAS 141(R) expands on the disclosures previously required by SFAS 141, better defines the acquirer and the acquisition date in a business combination, and establishes principles for recognizing and measuring the assets acquired (including goodwill), the


liabilities assumed and any non-controlling interests in the acquired business. SFAS 141(R) also requires an acquirer to record an adjustment to income tax expense for changes in valuation allowances or uncertain tax positions related to acquired businesses. SFAS 141(R) is effective for all business combinations with an acquisition date in the first annual period following December 15, 2008; early adoption is not permitted. We will adoptadopted this statement as of January 1, 2009. The2009, and it did not have a material impact that the adoption of SFAS 141(R) will have on our consolidated financial statements.

In April 2008, the FASB issued FSP FAS 142-3, Determination of the Useful Life of Intangible Assets.  FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets . This change is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141R and other GAAP. FSP 142-3 is effective for financial statements will depend on the nature, termsissued for fiscal years beginning after December 15, 2008, and size of our business combinations that occurinterim periods within those fiscal years. The requirement for determining useful lives must be applied prospectively to intangible assets acquired after the effective date and the disclosure requirements must be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. The adoption of this statement did not have a material impact on our consolidated results of operations, financial position or cash flows, and the required disclosures regarding our intangible assets are included above under the heading Intangible Assets.

In December 2007, the FASB issued SFAS No. 160, "NoncontrollingNoncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51"51 (SFAS 160). SFAS 160 requires that non-controlling (or minority) interests in subsidiaries be reported in the equity section of the company's balance sheet, rather than in a mezzanine section of the balance sheet between liabilities and equity. SFAS 160 also changes the manner in which the net income of the subsidiary is reported and disclosed in the controlling company's income statement. SFAS 160 also establishes guidelines for accounting for changes in ownership percentages and for deconsolidation. SFAS 160 is effective for financial statements for fiscal years beginning on or after December 1, 2008 and interim periods within those years. The adoption ofWe adopted SFAS 160 isfor the fiscal year begun January 1, 2009, and it did not expected to have a material impact on our financial position, results of operations or cash flows.

In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of SFAS 133.   SFAS 161 requires enhanced disclosures about an entity’s derivative and hedging activities, including how an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133,  Accounting for Derivative Instruments and Hedging Activities , and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The provisions of SFAS 161 were effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The adoption of SFAS 161 had no impact on our consolidated financial statements as we do not have derivative instruments.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS 162).  SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States (the GAAP hierarchy).  SFAS 162 became effective November 15, 2008. We adopted SFAS 162 for the fiscal year begun January 1, 2009, and it did not have a material impact on our financial position, results of operations or cash flows.

In June 2008, the FASB ratified EITF Issue 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” (EITF 07-5). Paragraph 11(a) of Statement of Financial Accounting Standard No 133 “Accounting for Derivatives and Hedging Activities” (“SFAS 133”) specifies that a contract that would otherwise meet the definition of a derivative but is both (a) indexed to the Company’s own stock and (b) classified in stockholders’ equity in the statement of financial position would not be considered a derivative financial instrument. EITF 07-5 provides a new two-step model to be applied in determining whether a financial instrument or an embedded feature is indexed to an issuer’s own stock and thus able to qualify for the SFAS 133 paragraph 11(a) scope exception. EITF 07-5 was effective for the first annual reporting period beginning after December 15, 2008, and early adoption was prohibited. EITF 07-5 did not have any impact on our financial position, results of operations or cash flows.



Recently Issued

In April 2009, the FASB issued the following three FSPs intended to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities:

●  
FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments;
●  
FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments; and
●  
FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly

These FSPs will be effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We have not elected to early adopt these FSPs and are currently evaluating the impact the FSPs will have on our financial position and financial statement disclosures.

Note 3.   Segment Information

We manage and report our operations through two business segments: healthcare servicesBehavioral Health and Healthcare Services. During the three months ended March 31, 2009, we revised our segments to reflect the disposal of CompCare (see Note 5, Discontinued Operations), and to properly reflect how our segments are currently managed. Our behavioral health managed care services.services segment, which had been comprised entirely of the operations of CompCare, is now presented in discontinued operations and is not a reportable segment. The Healthcare Services segment has been segregated into Behavioral Health and Healthcare Services. Prior years have been restated to reflect this revised presentation.

Behavioral Health

Catasys’s integrated substance dependence solution combines innovative medical and psychosocial treatments with elements of traditional disease management and ongoing member support to help organizations treat and manage substance dependent populations to impact both the medical and behavioral health costs associated with substance dependence and the related co-morbidities.

We are currently marketing our Catasys integrated substance dependence solutions to managed care health plans for reimbursement on a case rate or monthly fee, which involves educating third party payors on the disproportionately high cost of their substance dependent population and demonstrating the potential for improved clinical outcomes and reduced cost associated with using our Catasys programs. In addition, we are launching other specialty behavioral health products and programs, including Autism and Attention Deficit Hyperactivity Disorder (ADHD), that can leverage our existing infrastructure and sales force.

Healthcare Services

Our healthcare servicesHealthcare Services segment is focused on delivering solutions for those suffering from alcohol, cocaine, methamphetamine and other substance dependencies by researching, developing, licensing and commercializing innovative physiological, nutritional, and behavioral treatment programs. Treatment with our PROMETA Treatment Programs, which integrate behavioral, nutritional, and medical components, are available through physicians and other licensed treatment providers who have entered into licensing agreements with us for the use of our treatment programs. Also included in this segment are licensed and managed treatment centers, which offer a range of addiction treatment services, including the PROMETA Treatment Programs for dependencies on alcohol, cocaine and methamphetamines.

Our healthcare services segment also comprises international and government sector operations; however, these operating segments are not separately reported as they do not meet any of the quantitative thresholds under SFAS No. 131,Disclosures about Segments of an Enterprise and Related Information.

The behavioral health managed care services segment is focused on providing managed care services in the behavioral health and psychiatric fields, and principally includes the operations of our controlled subsidiary, CompCare, which was acquired on January 12, 2007. CompCare manages the delivery of a continuum of psychiatric and substance abuse services to commercial, Medicare and Medicaid members on behalf of employers, health plans, government organizations, third-party claims administrators, and commercial and other group purchasers of

18

behavioral healthcare services.  The customer base for CompCare’s services includes both private and governmental entities. We also plan to offer disease management programs for substance dependence built around our proprietary PROMETA Treatment Program for alcoholism and dependence to stimulants as part of our behavioral health managed care services operations. 

We evaluate segment performance based on total assets, revenue and net income or loss before provision for income taxes. Our assets are included within each discrete reporting segment. In the event that any services are provided to one reporting segment by the other, the transaction istransactions are valued at the market price. No such services were provided during the six


three months ended June 30, 2008March 31, 2009 and 2007.

2008. Summary financial information for our two reportable segments is as follows:

  Three Months Ended  Six Months Ended 
(In thousands) June 30,  June 30, 
  2008  2007  2008  2007 
Behavioral health managed care services (1)
            
Revenues $9,582  $9,159  $18,915  $16,765 
Loss before provision for income taxes  (3,905)  (1,335)  (5,584)  (1,901)
Assets *  5,337   10,385   5,337   10,385 
                 
Healthcare services                
Revenues $2,031  $2,181  $4,037  $3,432 
Loss before provision for income taxes  (10,178)  (10,901)  (19,197)  (21,068)
Assets *  44,868   42,740   44,868   42,740 
                 
Consolidated operations                
Revenues $11,613  $11,340  $22,952  $20,197 
Loss before provision for income taxes  (14,083)  (12,236)  (24,781)  (22,969)
Assets *  50,205   53,125   50,205   53,125 
*Assets are reported as of June 30.
(1)Results for the six months ended June 30, 2007 in this segment represent the period January 13 through June 30, 2007.
  Three Months Ended 
(in thousands) March 31, 
  2009  2008 
       
Healthcare services      
Revenues $707  $2,006 
Loss before provision for income taxes  (5,693)  (7,747)
Assets * $21,743   51,739 
         
Behavioral health        
Revenues $-  $- 
Loss before provision for income taxes  (1,694)  (1,212)
Assets *  -   729 
         
Consolidated continuing operations        
Revenues $707  $2,006 
Loss before provision for income taxes  (7,387)  (9,019)
Assets *  21,743   52,468 
         
* Assets are reported as of March 31.        

Note 4.   Major Customers/ContractsDebt Outstanding

CompCare’s contracts with its customers are typically for initial termsDuring the three months ended March 31, 2009, we drew down an additional $1.5 million under the UBS line of one year with automatic annual extensions, unless either party terminates by giving the requisite notice.  Such contracts generally provide for cancellation by either party with 60 to 90 days written notice prior to the expirationcredit facility, and used $1.4 million of the then current terms.proceeds to pay down the principal balance on our senior secured note with Highbridge International LLC.  We recognized a $276,000 loss on extinguishment of debt resulting from the pay down, which is included in our loss from continuing operations for the three months ended March 31, 2009.

ForThe following table shows the six months ended June 30, 2008, 89%,total principal amount, related interest rates and maturities of revenuedebt outstanding, as of March 31, 2009 and December 31, 2008:

  March 31,  December 31, 
(dollars in thousands, except where otherwise noted) 2009  2008 
Short-term Debt      
Senior secured note due January, 2010; callable by the holder on July 18, 2009;      
interest payable quarterly at prime plus 2.5% (5.75% and 7.0% at March 31,      
2009 and December 31, 2008, respectively), $3.7 million principal net of $375      
unamortized discount at March 31, 2009 and $5 million principal net of $899    
unamortized discount at December 31, 2008 $3,275  $4,101 
         
UBS line of credit, payable on demand, interest payable monthly at 91-day        
T-bill rate plus 120 basis points (1.41% at March 31, 2009 and 1.675%        
at December 31, 2008)  7,180   5,734 
         
Total Short-term Debt $10,455  $9,835 
Note 5.   Discontinued Operations

On January 20, 2009, we sold our interest in CompCare, in which we had acquired a controlling interest in January 2007 for $1.5 million cash. The CompCare operations are now presented as discontinued operations in accordance with SFAS 144. Prior to this sale, the assets and results of operations related to CompCare had constituted our behavioral health managed care services segment (or 73%segment. See note 3, Segment Information, for an updated discussion of consolidated revenue forour business segments after the same period) was concentrated in CompCare’s contracts with four health plans to provide behavioral healthcare services under commercial, Medicare, Medicaid, and children’s health insurance plans (CHIP). This includes the new Indiana HMO contract discussed below. For the period January 13 through June 30, 2007, 87%sale of revenue (or 72% of consolidated revenue for the six months ended June 30, 2007) was concentrated in six health plans providing such services.CompCare.

CompCare has contracts to provide behavioral health services to approximately 50,000 members of a Medicare Advantage HMO in the states of Maryland and Pennsylvania. Revenue under the contracts accounted for $4.5 million, or 24%, and $1.6 million, or 10%, of our behavioral health managed care services segment for the six months ended June 30, 2008 and the period January 13 through June 30, 2007, respectively. This revenue amounted to 20% and 8% of consolidated revenue for the same periods. The contracts are for an initial one-year term with automatic annual renewals unless either party provides notice of cancellation at least 90 days prior to the expiration of the then current terms. In January 2008, this client issued a request for proposal for management of behavioral healthcare services for its Pennsylvania, Maryland, and Texas regions. CompCare submitted a bid to retain the

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current business with this client as well as contract for the Texas membership. In March 2008, the client sent CompCare a termination notice, effective July 31, 2008, relating to the Pennsylvania region. Revenue under this contract accounted for $3.6 million, or 19%, and $1.0 million, or 6%, for the six months ended June 30, 2008 and the period January 13 through June 30, 2007, respectively. In August 2008, the client notified CompCare that the contract for the Maryland membership would not be renewed and would terminate December 31, 2008.  The loss of this client, unless replaced by new business, may require CompCare to delay or reduce operating expenses and curtail its operations.

In January 2007, CompCare began providing behavioral health services to approximately 250,000 Indiana Medicaid recipients pursuant to a contract with an Indiana HMO. The contract accounted for approximately $8.8 million, or 46% of behavioral health managed care services revenue for the six months ended June 30, 2008 and approximately $7.1 million, or 43% of such revenue for the period January 13 through June 30, 2007. Such revenue amounted to 38% and 35% of consolidated revenue for the same periods.  The contract is for an initial term of two years (set to expire on December 31, 2008) with subsequent extensions by mutual written agreement. Early termination of the contract by either party may only be effected by reason of a failure to perform that has not been corrected within the agreed upon time limits.

Note 5.                      Related Party Transactions

Andrea Grubb Barthwell, M.D., a director, is the founder and chief executive officer of a healthcare and policy consulting firm providing consulting services to us. For the six months ended June 30, 2007, we paid or accrued $75,000 for such consulting services. No amounts were paid or accrued during the six months ended June 30, 2008.

In February 2006, we entered into an agreement with CompCare whereby CompCare would have the exclusive right to market our substance abuse disease management program to its current and certain mutually agreed upon prospective clients.  The program is an integrated disease management approach designed to offer less restrictive levels of care in order to minimize repeat detoxifications.  Under the agreement, CompCare pays us license and service fees for each enrollee who is treated.  As of June 30, 2008, there have been no material transactions resulting from this agreement.  

Note 6.                      Commitments and Contingencies

Relating to CompCare’s major Indiana contract, the client and the state of Indiana are requiring CompCare to reconsider payment of claims billing codes that they previously instructed CompCare to deny.  To reevaluate these claims, CompCare formulated “reconsideration criteria,” which were approved by the client and the state of Indiana.  Based on application of the criteria, CompCare has estimated that it will be responsible for the payment of approximately $200,000 of additional amounts relating to certain of these claims for the period January 1, 2007 to June 30, 2008. CompCare has included this estimate in its accrued claims payable included in the consolidated balance sheet at June 30, 2008.

Also in relation to the behavioral managed care contract with an Indiana HMO, CompCare maintains a performance bond in the amount of $1.0 million.

Related to CompCare’s discontinued hospital operations, which were discontinued in 1999, Medicare guidelines allow the Medicare fiscal intermediary to re-open previously filed cost reports. The cost report for the fiscal 1999 year, the final year that CompCare was required to file a cost report, is being reviewed and the intermediary may determine that additional amounts are due to or from Medicare.  CompCare’s management believes that cost reports for fiscal years prior to fiscal 1999 are closed and considered final.

Note 7.                      Subsequent Event

On July 31, 2008, we amended our senior secured note (the “Note”) with Highbridge International LLC (“Highbridge”) to extend from July 18, 2008 to July 18, 2009 the optional redemption date exercisable by Highbridge for the $5 million remaining under the Note, and remove certain restrictions on our ability to obtain a margin loan on our auction-rate securities.  In connection with this extension, we granted Highbridge additional

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redemption rights in the event of certain strategic transactions or other events generating additional liquidity for us, including without limitation the conversion of some or all of our auction-rate securities into cash.  We also granted Highbridge a right of first refusal relating to the disposition of our auction-rate securities, and amended the existing warrant held by Highbridge for 285,185 shares of our common stock at $10.52 per share.  The amended warrant expires five years from the amendment date and is exercisable for 1,300,000 shares of our common stock at a price per share of $2.15, priced off of the $2.14 closing price of our common stock on July 22, 2008.

We recognized a gain of approximately $11.2 million from this sale, which is included in income from discontinued operations in our Consolidated Statement of Operations for the three month period ended March 31, 2009. The revenues and expenses of discontinued operations for the period January 1 through January 20, 2009 and the three months ended March 31, 2008 are currently assessing the accounting impact that the amendment will have on our consolidated financial statements.as follows:

     Three Months 
  Period Ended  Ended 
  January 20,  March 31, 
(in thousands) 2009  2008 
Revenues:      
Behavioral managed health care revenues $710  $9,333 
         
Expenses:        
Behavioral managed health care operating expenses $703  $9,739 
General and administrative expenses  711   978 
Other  50   295 
Loss from discontinued operations before provision for income tax $(754) $(1,679)
         
Provision for income taxes $1  $3 
Loss from discontinued operations, net of tax $(755) $(1,682)
         
Gain on sale $11,204  $- 
Results from discontinued operations, net of tax $10,449  $(1,682)
The carrying amount of the assets and liabilities of discontinued operations at December 31, 2008 and on the date of the sale were as follows:

  January 20,  December 31, 
(in thousands) 2009  2008 
Cash and cash equivalents $523  $1,138 
Receivables, net  -   1,580 
Notes receivable  -   17 
Prepaids and other current assets  940   318 
Property and equipment, net  230   235 
Goodwill, net  403   493 
Intangible assets, net  608   642 
Deposits and other assets  230   234 
Total Assets $2,934  $4,657 
         
Accounts payable and accrued liabilities $2,065  $1,884 
Accrued claims payable  5,637   6,791 
Long-term debt  2,346   2,341 
Accrued reinsurance claims payable  2,527   2,526 
Capital lease obligations, net of current portion  63   63 
Total Liabilities $12,638  $13,605 
         
Net assets (liabilities) of discontinued operations $(9,704) $(8,948)
ItemItem 2.                 Management'sManagement's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements including the related notes, and the other financial information included in this report. For ease of reference, “we,” “us” or “our” refer to Hythiam, Inc., our wholly-owned subsidiaries Comprehensive Care Corporation (CompCare), and The PROMETA Center, Inc. unless otherwise stated.



Forward-Looking Statements

The forward-looking comments contained in this report involve risks and uncertainties. Our actual results may differ materially from those discussed here due to factors such as, among others, limited operating history, difficulty in developing, exploiting and protecting proprietary technologies, intense competition and substantial regulation in the healthcare industry. Additional factors that could cause or contribute to such differences can be found in the following discussion, as well as in the “Risks Factors” set forth in Item 1A of Part I of our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 17, 2008.31, 2009.

OVERVIEW

General

We are a healthcare services management company, providing through our CatasysTM offeringCatasys™ subsidiary behavioral health management services for substance abuse to health plans, employers and unions through a network of licensed and company managed healthcare providers.plans.  Catasys offersis focused on offering integrated substance dependence solutions, built aroundincluding our patented PROMETA® Treatment Program, for alcoholism and stimulant dependence. The PROMETA Treatment Program, which integrates behavioral, nutritional, and medical components, is also available on a private-pay basis through licensed treatment providers and company managed treatment centers.centers that offer the PROMETA Treatment Program, as well as other treatments for substance dependencies. We also research, develop, license and commercialize innovative and proprietary physiological, nutritional, and behavioral treatment programs. We manage behavioral health disorders through our controlled subsidiary, Comprehensive Care Corporation (CompCare).  We also license or manage treatment centers that offer the PROMETA Treatment Programs, as well as other treatments for substance dependencies.

CompCare Acquisition

Effective January 12, 2007, we acquired a 50.25% controlling interest in Comprehensive Care Corporation (CompCare) through the acquisition of Woodcliff Healthcare Investment Partners, LLP (Woodcliff), which is now at 49.53% as of June 30, 2008. As part of the acquisition, we have obtained anti-dilution protection and the right to designate a majority of the board of directors of CompCare, giving us voting control. Our consolidated financial statements include the business and operations of CompCare subsequent to this date.

CompCare provides managed care services in the behavioral health and psychiatric fields.  CompCare manages the delivery of a continuum of psychiatric and substance abuse services to commercial, Medicare and Medicaid members on behalf of employers, health plans, government organizations, third-party claims administrators, and commercial and other group purchasers of behavioral healthcare services.  The customer base for CompCare’s services includes both private and governmental entities.


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Segment Reporting

We currently operate within two reportable segments: healthcareHealthcare services and behavioral health managed care services.Behavioral Health. Our healthcare services segment focuses on providing licensing, administrative and management services to licensees that administer PROMETA and other treatment programs, including managed treatment centers that are licensed and/or managed by us. Our Behavioral Health segment, through our Catasys™ subsidiary, combines innovative medical and psychosocial treatments with elements of traditional disease management and ongoing member support to help organizations treat and manage substance dependent populations, and is designed to lower both the medical and behavioral health managed care services segment focuses on providing managed care services incosts associated with substance dependence and the behavioral health, psychiatric and substance abuse fields, and principally includes the operationsrelated co-morbidities. Over 80% of our controlled subsidiary, CompCare. Over 95%revenue from continuing operations and substantially all of our consolidated revenue and assets are earned or located within the United States.

Discontinued Operations

On January 20, 2009 we sold our entire interest in our controlled subsidiary CompCare for aggregate gross proceeds of $1.5 million. We recognized a gain of approximately $11.2 million from the sale of our CompCare interest, which is included in our Consolidated Statement of Operations for the three months ended March 31, 2009. Additionally, we entered into an administrative services only (ASO) agreement with CompCare to provide certain administrative services under CompCare’s National Committee for Quality Assurance (NCQA) accreditation, including but not limited to case management and authorization services, in support of our newly launched specialty products and programs for autism and ADHD.

Prior to the sale, we reported the operations of CompCare in our behavioral health managed care segment. For detailed information regarding the impact of the sale of our interest in CompCare, see our consolidated balance sheets, statements of operations, statements of cash flows and Note 5, Discontinued Operations, included with this report.

Operations

Healthcare Services

Licensing Operations

Under our licensing agreements, we provide physicians and other licensed treatment providers with access to our PROMETA treatment programs,Treatment Program, education and training in the implementation and use of the licensed technology and marketing support.technology. The patient’s physician determines the appropriateness of the use of the PROMETA Treatment Program. We receive


a fee for the licensed technology and related services generally on a per patient basis. As of June 30, 2008,March 31, 2009, we had 97 licensed commercialactive licensing agreements with physicians, hospitals and treatment providers for 40 sites throughout the United States, anwith 18 sites contributing to revenue in 2009. We will continue to enter into agreements on a selective basis with additional healthcare providers to increase the availability of 15% overthe PROMETA Treatment Program, but only in markets we are presently operating or where such sites will provide support for our Catasys products.  As such revenues are generally related to the number of licensed sites at June 30, 2007. Duringpatients treated, key indicators of our financial performance for the threePROMETA Treatment Program will be the number of facilities and six months ended June 30, 2008, 31healthcare providers that license our technology, and 45the number of these sites, respectively, hadpatients that are treated patients, comparedby those providers using our PROMETA Treatment Program. As discussed below in Recent Developments, we are currently evaluating and considering additional actions to 42 and 47 sites duringstreamline our operations that may impact the same respective periods in 2007.licensing operations.

Managed Medical Practices and Treatment Centers

In December 2005,We currently manage two treatment centers under our licensing agreements, located in Santa Monica, California (dba The PROMETA Center, Inc., a medical professional corporation (now owned by Lawrence Weinstein, M.D., our senior vice president of medical affairs), opened a state-of-the-art outpatient facility in Santa Monica, California, which we built out under a lease agreement. Under the terms of a full business service management agreement, we manage the business components of the medical practice) and license the PROMETA Treatment Programs and the use of our trademarks in exchange for management and licensing fees. The practice offers treatment with the PROMETA Treatment Programs for dependencies on alcohol, cocaine and methamphetamines, as well as medical interventions for other substance dependencies.Dallas, Texas (Murray Hill Recovery, LLC). In January 2007, a second PROMETA Center was opened in San Francisco, which was subsequently closed in January 2008. In 2007, we also entered into additional management services agreements with other medical corporations andWe manage the business components of the treatment centers under similar terms and conditions, includinglicense the Murray Hill Recovery Center located in Dallas, Texas. The financial resultsPROMETA Treatment Program and use of the managedname in exchange for management and licensing fees under the terms of full business service management agreements. These centers offer treatment with the PROMETA Treatment Program for dependencies on alcohol, cocaine and methamphetamines and also offer medical practicesinterventions for other substance dependencies. The revenues and treatmentexpenses of these centers are included in our consolidated financial statements under accounting standards applicable to variable interest entities. RevenueRevenues from licensed and managed treatment centers, including the PROMETA Centers, accounted for approximately 21% and 27%, respectively,55% of our healthcare services revenue inrevenues for the three and six months ended June 30, 2008, comparedMarch 31, 2009. As discussed below in Recent Developments, we are currently evaluating and considering additional actions to 26% and 31%, respectively, duringstreamline our operations that may impact the same periods in 2007.managed treatment centers.

Research and DevelopmentBehavioral Health

To date,In 2007 and 2008, we have spent approximately $11.5 million related to research and development, including $915,000, $2.3 million, $1.0 million and $2.0 million, respectively, indeveloped our Catasys integrated substance dependence solutions for third-party payors. We believe that our Catasys offerings will address a large part of the three and six months ended June 30, 2008 and 2007, in fundingsegment of the healthcare market for commercial pilots and unrestricted grants for a number of clinical research studies by researchers in the field of substance dependence, and leading research institutionswe are currently marketing our Catasys integrated substance dependence solutions to evaluatemanaged care health plans for reimbursement on a case rate or monthly fee, which involves educating third party payors on the efficacydisproportionately high cost of their substance dependent population and demonstrating the PROMETA Treatment Program in treating alcoholpotential for improved clinical outcomes and stimulant dependence. For the remainder of 2008,reduced cost associated with using our Catasys programs. In addition, we planmay be launching other specialty behavioral health products and programs, including Autism and ADHD, that can leverage our existing infrastructure and sales force, but this effort is largely on hold due to spend an additional $1.5 million for unrestricted research grants and commercial pilots.budget constraints.

International

We have expanded our operations into Europe, with our Swiss foreign subsidiary signing PROMETA license and services agreements with sites in Switzerland in 2006 to serve the international market.  These sites commenced operations in the first quarter of 2007.  Our European operations were also expanded in 2007 to include the treatment of other dependencies.   Our international operations have accounted for revenue of $433,000, $908,000, $241,000 and $352,000, respectively, for the three and six months ended June 30, 2008 and 2007.

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Recent Developments

In Januarythe first quarter of 2009, we completed actions that we began in the fourth quarter of 2008 we streamlinedto reduce our operations to increase our focus on managed care opportunities, which we expect to result in an overall reduction of 25% to 30% of cash operating expenses forby an additional $10.2 million from the fiscal year ending December 31,third quarter 2008 compared to 2007 levels.expenditure level. The actions we took included significant reductions in field and regional sales personnel and related corporate support personnel, closing the PROMETA Center in San Francisco,curtailment of our international operations, a reduction in outside consultant expense and overall reductions in overhead costs. One-time costs associated with these actions were approximately $1.1 million and have been recognized as a charge to operating expenses in the statement of operations for the six months ended June 30, 2008. Such costs primarily represent severance and related benefits and costs incurred to close the San Francisco PROMETA Center.

In April 2008Additionally, we took further actionactions in the first quarter of 2009 to streamline our operations by reducing total operating costs an additional 20%and increase the focus on managed care opportunities and to 25%. Additional one-time costs associatedrenegotiate certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms with these actions were approximately $1.2 millionvendors, which included negotiating settlements for outstanding liabilities. These efforts have resulted in delays and have been recognized as a charge toreductions in operating expenses, resulting in the statementtotal budgeted operating expenses of operationsapproximately $10 million for the three and six months ended June 30, 2008.remainder of 2009.

In May 2008, we entered into an agreement with a CIGNA HealthCare affiliate to be reimbursed for providing our PROMETA based substance dependence treatment program in Texas. The program became effective July 1 and is initially being offered through our managed treatment center in Dallas, and will not require any significant infrastructure investment by us to support the agreement. Medical and psychosocial treatment is being provided by our licensed providers to CIGNA HealthCare members, and although we anticipate expansion throughout Texas, the clinical and financial impact of the program will be evaluated with the objective of continued expansion beyond Texas.

In July 2008, we announced that a double-blind, placebo-controlled alcohol study of our PROMETA Treatment Program demonstrated statistically significant improvement in patients with symptoms of alcohol withdrawal. The initial results of the study were presented at the Research Society on Alcoholism (RSA) conference in Washington, DC, by leading alcoholism expert and RSA President, Raymond Anton, M.D., of Medical University of South Carolina. At the time of the RSA presentation, the data presented covered the initial 6-week active treatment phase of the 14-week study. The study was designed to evaluate the impact of PROMETA on percent days abstinent, other use measures and cravings. Additional data reviews of the full 14-week study, including the results of functional MRI and acoustic startle (sound-based reflex test) are ongoing, and Dr. Anton plans to release these specifics in a peer-reviewed publication.

Behavioral Health Managed Care Services

Our consolidated subsidiary, CompCare, typically enters into contracts on an annual basis to provide managed behavioral healthcare and substance abuse treatment to clients’ members. Arrangements with clients fall into two broad categories: capitation arrangements, where clients pay CompCare a fixed fee per member per month, and fee-for-service and administrative service arrangements where CompCare may manage behavioral healthcare programs or perform various managed care services.  Approximately $9.3 million and $18.3 million, or 97% and 97% respectively, of CompCare’s revenue for the three and six months ended June 30, 2008 were derived from capitation arrangements, compared to $8.8 million and $16.2 million, or 97% and 97% respectively, for the three months ended June 30, 2007 and the period January 13 through June 30, 2007. Under capitation arrangements, CompCare receives premiums from clients based on the number of covered members as reported by the clients. The amount of premiums received for each member is fixed at the beginning of the contract term. These premiums may be subsequently adjusted, up or down, generally at the commencement of each renewal period.

Effective January 1, 2007, CompCare commenced a contract with a health plan to provide behavioral healthcare services to approximately 250,000 Medicaid recipients in Indiana. This contract amounted to $4.4 million and $8.8 million, respectively, in revenue for the three and six months ended June 30, 2008, compared to $3.9 million and $7.1 million, respectively, in revenue for the three months ended June 30, 2007 and the period January 13 through June 30, 2007. This contract is anticipated to generate approximately $17 million to $18 million, or approximately 50%, of CompCare’s anticipated annual revenue in 2008.


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Seasonality of Business

Historically, CompCare has experienced increased member utilization during the months of March, April and May, and consistently low utilization by members during the months of June, July, and August.  Such variations in member utilization impact CompCare’s costs of care during these months, generally having a positive impact on CompCare’s gross margins and operating profits during the June through August period and a negative impact on CompCare’s gross margins and operating profits during the months of March through May.

Concentration of Risk

For the six months ended June 30, 2008, 89%, of revenue in our behavioral health managed care services segment (or 73% of consolidated revenue for the same period) was concentrated in CompCare’s contracts with four health plans to provide behavioral healthcare services under commercial, Medicare, Medicaid, and children’s health insurance plans. For the period January 13 through June 30, 2007, 87% of revenue (or 72% of consolidated revenue for the six months ended June 30, 2007) was concentrated in six health plans providing such services. This includes the Indiana Medicaid HMO contract, which represented approximately 46% and 42% of behavioral health managed care services revenue for the six months ended June 30, 2008 and for the period January 13 through June 30, 2007, respectively (or 38% and 35% of our consolidated revenue for the six months ended June 30, 2008 and 2007, respectively).  The term of each contract is generally for one year and is automatically renewable for additional one-year periods unless terminated by either party by giving the requisite written notice.  The loss of any one of these clients, unless replaced by new business, may require CompCare to delay or reduce operating expenses and curtail its operations.

Recent Developments

On June 19, 2008 the court awarded $325,000 in fees and expenses to attorneys for plaintiffs that had filed two class action lawsuits against CompCare in January 2007 seeking to prevent Hythiam from acquiring outstanding common shares it did not own pursuant to a plan of merger between CompCare and Hythiam.  The merger was terminated in May 2007 rendering the lawsuits moot, but plaintiffs’ attorneys’ claims for fees and expenses remained, resulting in the judgment against CompCare for $325,000.  CompCare’s claim for coverage of the judgment by CompCare’s directors’ and officers’ insurance policy has been initially denied.  Accordingly, CompCare has recognized a $325,000 charge in general and administrative expenses.  However, CompCare will be aggressively appealing the initial determination of the insurance carrier to assert its belief that the judgment is covered by our directors’ and officers’ insurance policy. 
In March 2008, CompCare signed an amendment to its major HMO contract in Indiana, which accounted for approximately 46% of its total revenue for the six months ended June 30, 2008. Effective January 1, 2008, CompCare was eligible to receive a 15.9% rate increase, or approximately $200,000 per month, subject to meeting monthly performance measures. CompCare met or exceeded all performance measures for the six months ended June 30, 2008 and, consequently, has received funds representing the rate increase retroactive to January 1, 2008.

In January 2008, CompCare’s Pennsylvania and Maryland Medicare Advantage health plan client, representing $4.5 million, or approximately 24%, of CompCare’s total revenue during the six months ended June 30, 2008, issued a request for proposal for management of behavioral healthcare services for its Pennsylvania, Maryland, and Texas regions. CompCare submitted a bid to retain its current business from this client as well as contract for the Texas membership. In March 2008, the client sent CompCare a termination notice relating to the Pennsylvania region. Revenue under this contract accounted for $3.6 million, or approximately 19%, of behavioral health managed care services revenue for the six months ending June 30, 2008.  In August 2008, the client informed CompCare that the contract for the Maryland membership would not be renewed and would terminate December 31, 2008. The loss of this client, unless replaced by new business, may require CompCare to delay or reduce operating expenses and curtail its operations.
How We Measure Our Results

Our healthcare services revenue arerevenues to date have been primarily generated from fees that we charge to hospitals, healthcare facilities and other healthcare providers that license our PROMETA Treatment Programs,Program, and from patient service revenuerevenues related to our licensing and management services agreements with managed treatment centers. Our technology

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license and management services agreements provide for an initial fee for training and other start-up related costs, plus a combined fee for the licensed technology and other related services, generally set on a per-treatment basis, and thus a substantial portion of our revenue arerevenues is closely related to the number of patients treated.


Patients treated by managed treatment centers generate higher average revenuerevenues per PROMETA patient than our other licensed sites due to consolidation of their gross patient revenuerevenues in our financial statements.  We believe that keyKey indicators of our financial performance arewill be the number of health plans and other organizations that contract with us for our Catasys products, the number of managed care lives covered by such plans, and the number of facilities and healthcare providers that contract with us to license our technology and the number of patients that are treated by those providers using the PROMETA Treatment Programs.Program. Additionally, our financial results will depend on our ability to expand the adoption of Catasys and the PROMETA among third party payer groups,Treatment Program, and our ability to effectively price these products, and manage general, administrative and other operating costs.

For behavioral health managed care services, the largest expense is CompCare’s cost of behavioral health managed care services that it provides, which is based primarily on its arrangements with healthcare providers. Since CompCare’s costs are subject to increases in healthcare operating expenses based on an increase in the number and frequency of the members seeking behavioral health care services, CompCare’s profitability depends on its ability to predict and effectively manage healthcare operating expenses in relation to the fixed premiums it receives under capitation arrangements.  Providing services on a capitation basis exposes CompCare to the risk that its contracts may ultimately be unprofitable if CompCare is unable to anticipate or control healthcare costs.   Estimation of healthcare operating expense is one of our most significant critical accounting estimates. See “Critical Accounting Estimates.”

CompCare currently depends upon a relatively small number of customers for a significant percentage of behavioral health managed care operating revenue. A significant reduction in sales to any of CompCare’s large customers or a customer exerting significant pricing and margin pressures on CompCare would have a material adverse effect on our consolidated results of operations and financial condition. In the past, some of CompCare’s customers have terminated their arrangements or have significantly reduced the amount of services requested. There can be no assurance that present or future customers will not terminate their arrangements or significantly reduce the amount of services requested. Any such termination of a relationship or reduction in use of our services would have a material adverse effect on our consolidated results of operations or financial condition (see Note 4 — “Major Customers/Contracts”).


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RESULTS OF OPERATIONS

Table of Summary Consolidated Financial Information
 
We acquired a controlling interest in CompCare, resulting from our acquisition of Woodcliff on January 12, 2007, and began including its results in our consolidated financial statements subsequent to that date. These results are reported in our behavioral health managed care services segment. The table below and the discussion that follows summarize our results of consolidated continuing operations and certain selected operating statistics for the three and six months ended June 30, 2008March 31, 2009 and 2007:2008:

  Three Months Ended 
(In thousands, except per share amounts) March 31, 
  2009  2008 
Revenues      
Healthcare services revenues $707  $2,006 
         
Operating expenses        
         
Cost of healthcare services $273  $481 
General and administrative  5,603   11,154 
Research and development  -   1,358 
Impairment losses  1,113   - 
Depreciation and amortization  404   463 
Total operating expenses $7,393  $13,456 
         
Loss from operations $(6,686) $(11,450)
         
Interest and other income  46   429 
Interest expense  (408)  (265)
Loss on extinguishment of debt  (276)  - 
Other than temporary impairment of marketable securities  (132)  - 
Change in fair value of warrant liability  69   2,267 
Loss from continuing operations before provision for income taxes $(7,387) $(9,019)
  Three Months Ended  Six Months Ended 
(In thousands) June 30,  June 30, 
  2008  2007  2008  2007 
Revenues            
Behavioral health managed care services $9,582  $9,159  $18,915  $16,765 
Healthcare services  2,031   2,181   4,037   3,432 
Total revenues  11,613   11,340   22,952   20,197 
                 
Operating expenses                
Behavioral health managed care expenses  11,707   9,348   21,446   16,501 
Cost of healthcare services  524   423   1,005   759 
General and administrative expenses  10,438   12,250   22,570   22,832 
Research and development  915   729   2,273   1,740 
Depreciation and amortization  688   610   1,391   1,157 
Total operating expenses  24,272   23,360   48,685   42,989 
                 
Loss from operations  (12,659)  (12,020)  (25,733)  (22,792)
                 
Interest income  203   396   644   908 
Interest expense  (315)  (641)  (647)  (1,114)
Change in fair value of warrant liability  (1,312)  -   955   - 
Other non-operating income, net  -   29   -   29 
Loss before provision for income taxes $(14,083) $(12,236) $(24,781) $(22,969)

Summary of Consolidated Operating Results

The net loss from continuing operations before provision for income taxes increased to $14.1 million from $12.2decreased by $1.6 million during the three months ended June 30, 2008 whenMarch 31, 2009 compared to the same period in 2007,2008, primarily due to the decrease in operating expenses, resulting mainly duefrom actions to streamline our Healthcare Services operations, partially offset by a $2.2 million decrease in the change in fair value of the warrant liability, higher share-based compensation expense, an increasea $1.3 million decrease in healthcare services revenue and impairment losses totaling $1.1 million. Additionally, operating expenses in the net loss from behavioral health managed care services and one-time2008 period included $1.2 million in costs incurred from additionalassociated with actions taken in April 2008 to streamline our healthcare services operations, partially offset by lower general and administrativecompared to $212,000 of such expense in healthcare services. The increase in loss before provision2008.  See the discussion of operating results under the headings Healthcare Services and Behavioral Health below for income taxes in the six months ended June 30, 2008 to $24.8 million from $23.0 million for the same period in 2007 was mainly due to an increase in the net loss from behavioral health managed care services and one-time costs incurred from actions taken in both January 2008 and April 2008 to streamline our healthcare services operations, partially offset by a gain from the change in the fair valuedetailed discussion of our warrant liability. Approximately $3.9 million and $5.6 million, respectively, of the loss before provision for income taxes for the three and six months ended June 30, 2008 is attributable to CompCare’s operations and purchase accounting adjustments, compared to $1.3 million and $1.9 million for the same periods in 2007.these changes.

Our healthcare services revenueRevenue decreased by $150,000 (or 7%)$1.3 million for the three months ended June 30, 2008March 31, 2009 compared to the same period in 2007,2008, due mainly to a decreasesdecline in licensed sites contributing to revenue and in the number of patients treated at our U.S licensed sites and the managed treatment centers, the decision to shut down sites in our international operations and a decrease in administrative fees earned from new U.S. licensees and a decrease in patients treated at managed treatment centers, partially offset by an increase in revenue in our international operations. Healthcare services revenue increased by $605,000 (or 18%) for the six months ended June 30, 2008 compared to the same period in 2007, due mainly to an increase in the number of patients treated atlicensees.


U.S. licensed sites and our international operations, partially offset by a decrease in administrative fees earned from new licensees and a decrease in the number of patients treated at managed treatment centers. CompCare’s behavioral health managed care revenue increased primarily due to an increase in the overall average revenue per-member, per-month rate and the additional twelve days included in our consolidated financial statements for the 2008 period relative to 2007.

Excluding the impact of CompCare, total operating
General and administrative expenses for our healthcare services business for the three months ended June 30, 2008 decreased by approximately $2.0 million when compared to the same period in 2007. This decrease was due mainly to the overall reduction in operating expenses resulting from the streamlining of operations that was initiated in January and April 2008 to increase our focus on managed care opportunities, partially offset by an increase in share-based compensation expense andalso include $1.2 million in one-time costs associated with streamlining our operations.  Suchnon-cash expenses remained flat for the six months ended June 30, 2008, whenshare-based compensation, compared to the same period$2.3 million of such expense in 2007, due2008.  The impairment losses included $758,000 for capitalized software in our Behavioral Health segment and $355,000 related to the overall reduction in operating expenses resulting from the streamlining of operations, partially offset by an increase in share-based expense and $2.4 million in one-time costs associated with the streamlining of operations. Total share-based compensation expense, excluding CompCare but including one-time costs associated with streamlining our operations, amounted to $1.9 million and $4.2 million, respectively, for the three and six months ended June 30, 2008, compared to $905,000 and $1.4 million, respectively, for the three and six months ended June 30, 2007. The increase in share-based compensation expense was primarily attributable to the 2 million options granted to Hythiam employees during the three months ended March 31, 2008, of which approximately 47% were immediately vested and expensed in the period.

The proceeds attributable to warrants issued in connection with the registered direct stock placement completed in November  2007 are being accounted for as a liability in accordance with the Financial Accounting Standards Board (FASB) Emerging Issues Task Force (EITF) Issue No. 00-19 (EITF 00-19), based on their fair value. The warrant liability was revalued at $1.8 million at June 30, 2008, compared to $2.8 million at December 31, 2007, resulting in a $1.0 million non-operating gain in the statement of operations for the six months ended June 30, 2008.intangible assets.

Reconciliation of Segment Results

The following table summarizes and reconciles the loss from operationsbefore provision for income taxes of our reportable segments in continuing operations to the loss for continuing operations before provision for income taxes from our consolidated statements of operations for the three and six months ended June 30, 2008March 31, 2009 and 2007:2008:

 Three Months Ended  Six Months Ended  Three Months Ended 
(In thousands) June 30,  June 30,  March 31, 
 2008  2007  2008  2007  2009  2008 
Healthcare services $(10,178) $(10,901) $(19,197) $(21,068) $(5,693) $(7,767)
Behavioral health managed care services  (3,905)  (1,335)  (5,584)  (1,901)
Loss before provision for income taxes $(14,083) $(12,236) $(24,781) $(22,969)
Behavioral health  (1,694)  (1,272)
Loss from continuing operations before provision for income taxes $(7,387) $(9,019)



Healthcare Services

The following table summarizes the operating results for healthcare services for the three and six months ended June 30, 2008March 31, 2009 and 2007:2008:

  Three Months Ended 
(In thousands, except patient treatment data) March 31, 
  2009  2008 
Revenues      
U.S. licensees $184  $823 
Managed treatment centers (a)  389   664 
Other revenues  134   519 
Total healthcare services revenues $707  $2,006 
         
Operating expenses        
Cost of healthcare services $273  $481 
General and administrative expenses        
Salaries and benefits  2,774   6,267 
Other expenses  1,976   3,615 
Research and development  -   1,358 
Impairment losses  355   - 
Depreciation and amortization  321   463 
Total operating expenses $5,699  $12,184 
         
Loss from operations $(4,992) $(10,178)
         
Interest and other income  46   429 
Interest expense  (408)  (265)
Loss on extinguishment of debt  (276)  - 
Other than temporary impairment on marketable securities  (132)  - 
Change in fair value of warrant liability  69   2,267 
Loss before provision for income taxes $(5,693) $(7,747)
         
PROMETA patients treated        
U.S. licensees  42   144 
Managed treatment centers (a)  37   57 
Other  11   29 
   90   230 
         
Average revenue per patient treated (b)
        
U.S. licensees $5,524  $5,678 
Managed treatment centers (a) $9,145  $9,028 
Other $9,959  $8,397 
Overall average $6,327  $6,851 
  Three Months Ended  Six Months Ended 
(In thousands, except patient treatment data) June 30,  June 30, 
  2008  2007  2008  2007 
Revenues            
U.S. licensees $1,164  $1,364  $1,987  $2,006 
Managed treatment centers (a)  424   518   1,088   998 
Other revenues  443   299   962   428 
Total revenues  2,031   2,181   4,037   3,432 
                 
Operating expenses                
Cost of healthcare services  524   422   1,005   759 
General and administrative expenses                
Salaries and benefits  4,536   5,557   11,367   11,057 
Other expenses  4,425   5,766   8,748   10,080 
Research and development  915   729   2,273   1,740 
Depreciation and amortization  447   383   910   716 
Total operating expenses  10,847   12,857   24,303   24,352 
                 
Loss from operations  (8,816)  (10,676)  (20,266)  (20,920)
                 
Interest income  196   348   625   840 
Interest expense  (247)  (573)  (512)  (988)
Change in fair value of warrant liability  (1,311)  -   956   - 
Loss before provision for income taxes $(10,178) $(10,901) $(19,197) $(21,068)
                 
PROMETA patients treated                
U.S. licensees  198   165   342   264 
Managed treatment centers (a)  31   51   84   100 
Other  17   33   52   40 
   246   249   478   404 
                 
Average revenues per patient treated (b)
                
U.S. licensees $5,753  $5,984  $5,722  $5,948 
Managed treatment centers (a)  9,978   9,239   9,823   9,432 
Other  11,390   3,955   8,407   3,758 
Overall average  6,675   6,382   6,734   6,593 

(a)Includes managed and/or licensed PROMETA Centers.
(b)The average revenue per patient treated excludes administrative fees and other non-PROMETA patient revenues.

Revenue

RevenueRevenues for the three months ended June 30, 2008March 31, 2009 decreased $150,000, or 7%,$1.3 million compared to the three months ended June 30, 2007.March 31, 2008. The decrease was primarily attributable to a decline in licensed sites contributing to revenues and in the number of patients treated at our U.S licensed sites and the managed treatment centers, the decision to shut down sites in our international operations and a decrease in administrative fees earned from new licensees totaling approximately $305,000 and a decreaselicensees. The number of patients treated decreased by 61% in revenue at managed treatment centers amountingthe three months ended March 31, 2009 compared to $94,000, partially offset by a $144,000 increasethe same period in other revenue and a $105,000 increase in license fee revenue from U.S.


licensees, excluding administrative fees. The increase in other revenue was due to a $192,000 increase in revenue from our international operations, offset by a $48,000 decrease in revenue from state and local criminal justice systems.2008. The number of licensed sites that contributed to revenue alsorevenues decreased to 3118 in the three months ending June 30, 2008ended March 31, 2009 from 4240 in the same period in 2007.three months ended March 31, 2008. The average revenue per patient treated at U.S. licensed sites also decreased inand at the PROMETA Centers did not materially change during the three months ended June 30, 2008March 31, 2009 compared to the same period in 2007 due to higher average discounts granted by and to our licensees. The higher average discounts originated principally from our patient financial assistance program which we implemented with our licensees in the second half of 2007, and from our increased business development initiatives in 2008. The number of patients treated at managed treatment centers decreased by 39% in the three months ended June 30, 2008 compared to the same period in 2007, due in part to the closing of our PROMETA Center in San Francisco in the first quarter of 2008, while the average revenue per patient at managed treatment centers increased by 8%. The average revenue for patients treated at the managed treatment centers is higher than our other licensed sites due to the consolidation of their gross patient revenue in our financial statements. Other revenues consist of revenue from our international operations and third-party payers. 
For the six months ended June 30, 2008, revenue increased by $605,000 or 18%, from $3.4 million in the same period last year, mainly due to an increase in the license fee revenue earned from U.S. licensed sites (excluding $340,000 in administrative fees earned from new licensees), an increase in revenue from our international operations, which amounted $555,000 and a $90,000 increase in revenue at managed treatment centers, partially offset by a $360,000 decrease in administrative fees earned from new licensees. The increase in revenue at managed treatment centers was driven mainly by revenue from the new center in Dallas, Texas, which commenced operations in August 2008. During the six months ended June 30, 2008, the number of patients treated at U.S. licensed sites increased by 30%, but decreased by 16% at managed treatment centers. The number of licensed sites contributing to revenue amounted to 45 in the six months ended June 30, 2008 compared to 47 sites in the same period last year.  Our revenue may be impacted for each of the remianing quarters of fiscal year 2008 by market conditions due to the uncertain economy, and also as we maintain our commitment to reduce cash expenditures in components of healthcare services that are revenue generating, but providing negative cash flow.  Although a reallocation of these expenses may reduce revenues in the near-term, we anticipate that over subsequent quarters, our enhanced ability will provide significant benefit as we invest in various marketing initiatives, on which we anticipate a positive cash flow and significant return on investment.

Operating Expenses

Our total operating expenses decreased by $2.0 million in the three months ended June 30, 2008 compared to the same period in 2007, primarily due to a $4.6 million decrease in general and administrative expenses, partially offset by a $982,000 increase in share-based expense, $1.2 millionCost of severance and other one-time costs associated with additional actions taken in April 2008 to streamline our operations and an increase of $186,000 in funding for clinical research studies. For the six months ended June 30, 2008, our total operating expenses remained relatively unchanged when compared to the same period in 2007, as the $6.2 million decrease in general and administrative expenses was offset by a $2.8 million increase in share-based expense, $2.4 million incurred for severance and other one-time costs associated with streamlining our operations in 2008 to increase our focus on managed care opportunities and a $533,000 increase in research and development costs. The actions we took to streamline operations included significant reductions in field and regional sales personnel and related corporate support personnel, closing the PROMETA Center in San Francisco, and reducing overall overhead costs and the number of outside consultants, all of which is expected to result in an overall reduction of 25% to 30% of cash operating expenses for the fiscal year ending December 31, 2008. In April 2008, we took further action to streamline our operations by reducing total operating costs an additional 20% to 25%.Healthcare Services

Cost of healthcare services consists of royalties we pay for the use of the PROMETA Treatment Program, and thecosts incurred by our consolidated managed treatment centers’centers (including PROMETA Centers) for direct labor costs for physicianphysicians and nursing staff, continuing care expense, medical supplies and treatment program medicine costs. The decrease in these costs for patients treated atprimarily reflects the decrease in revenues from these treatment centers.

General and administrative expenses consist primarily of salaries and benefits expense and other operating expense, including legal, accounting and audit professional services, support and occupancy costs, other outside services and marketing and advertising. Such expenses for the three and six month periods ended June 30, 2008 included approximately $1.9 million and $4.2 million, respectively, in share-based expense.  General and administrative expenses for the three and six month periods ended June 30, 2008 included $1.2 million and $2.4 million (including $54,000 and $542,000 in share based expense), respectively, in one-timeAdministrative Expenses

Excluding costs associated with actions taken to streamlinestreamlining our operations totaling $212,000 in both January2009 and $1.2 million in 2008, total general and April 2008 to increase our focus on managed care opportunities. Such one-time costs primarily represent severance and related benefits and costs incurred to close the San Francisco PROMETA Center. Excluding these one-time costs and share-based expense,total general and administrative expenses decreased by approximately $4.6$5.1 million and $6.2 million, respectively, duringin the three and six month periodsmonths ended June 30, 2008March 31, 2009 compared to the same periodsperiod in 2007,2008. This decrease is attributable to decreases of $3.5 million in salaries and benefits and $1.6 million in other general and administrative expenses as a result of the streamlining of our operations.  General and administrative expenses include $1.2 million in non-cash expense for share-based compensation, compared to $2.3 million of such expense in 2008.

Research and Development

Our total research and development expenses decreased by $1.4 million in the three months ended March 31, 2009 compared to the same period in 2008. This decrease is attributable to clinical studies undertaken in 2008 and prior years that were substantially completed in 2008 and for which no expense was recognized during the three months ended March 31, 2009.

Impairment Losses

Impairment charges included $122,000 for intangible assets related to our managed treatment center in Dallas and $233,000 related to intellectual property for additional indications for the use of the PROMETA Treatment Program that are currently non-revenue-generating, both of which resulted from impairment testing at March 31, 2009.

Interest and Other Income

Interest income for the three months ended March 31, 2009 decreased by $383,000 compared to the same period in 2008 due mainly to a decrease in salaries, benefitsthe invested balance of marketable securities and related travel expensesa decrease in interest rates.

Interest Expense

Interest expense for the three months ended March 31, 2009 increased by $143,000 compared to the same period in 2008 due to higher debt balances from the UBS line of credit during the three months ended March 31, 2009, partially offset by the effect of lower interest rates during this same period.

Loss from Extinguishment of Debt

We recognized a $276,000 loss on extinguishment of debt resulting from the impact$1.4 million pay down on the Highbridge senior secured note, primarily representing unamortized discount.

Other than Temporary Impairment on Marketable Securities

An impairment charge of reducing$132,000 related to certain of our auction rate securities (ARS) was recognized for the salesthree months ended March 31, 2009. The charge was based on an updated valuation of the securities performed by management as of March 31, 2009 and corporate support personnel and outside services for marketing and consultants.deemed necessary after an analysis of other-than-temporary impairment factors, most notably, our inability to hold the ARS until they are expected to recover in value.


The total number of U.S. personnel has been reduced from approximately 140 employees at June 30, 2007 to 90 employees at June 30, 2008.

Research and development expense increased by $186,000 and $533,000, respectively, for the three and six months ended June 30, 2008 compared to the same periods in 2007 due to increases in funding for unrestricted grants for research studies to evaluate the clinical effectiveness of our PROMETA Treatment Programs.  We plan to spend approximately $1.5 million for the remainder of 2008 for such studies.

Interest Income

Interest income for the three and six month periods ending June 30, 2008 decreased compared to the same periods in 2007 due to decreases in the invested balance of marketable securities and in average investment yields.

Interest Expense

Interest expense primarily relates to the senior secured note issued on January 17, 2007 to finance the CompCare acquisition, with a current principal balance of $5 million at June 30, 2008, accrued at a rate equal to prime plus 2.5%. The decrease in interest expense for the three and six months ended June 30, 2008 compared to the same periods in 2007 resulted from the $5 million redemption on November 7, 2007, that was completed in conjunction with the registered direct placement that closed on that date. Additionally, interest rates have declined between the 2008 and 2007 periods. For the three and six months ended June 30, 2008 and 2007, interest expense includes $132,000, $262,000, $293,000 and $481,000, respectively, in amortization of the $1.4 million discount resulting from the value allocated to the warrants issued with the debt and related borrowing costs.

Change in fair value of warrant liability

WeWarrants issued 5-year warrants to purchase an aggregate of approximately 2.4 million additional shares of our common stock at an exercise price of $5.75 per share in connection with a registered direct stock placement completed on November 7, 2007. The proceeds attributable2007 and warrants issued in connection with the Highbridge note issued on January 18, 2007 and amended on July 31, 2008, are being accounted for as liabilities in accordance with EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, the warrants,and Potentially Settled in, a Company’s Own Stock  (EITF 00-19), based on an analysis of the terms and conditions of the warrant agreement.

Both warrants are re-valued at each reporting period using the Black-Scholes pricing model to determine the fair market value per share.  The change in fair value of the warrants atissued in connection with the date of issue,November 7, 2007 registered direct stock placement amounted to approximately $6.3 million and were accounted for as a liability in accordance with EITF 00-19. The warrant liability was revalued at $2.8 million at December 31, 2007 and $1.8 million at June 30, 2008, resulting in a $1.0 million$26,000 non-operating gain toin the statementConsolidated Statement of operationsOperations for the sixthree months ended June 30, 2008.March 31, 2009.  The change in fair value for the warrants issued in connection with the Highbridge note amounted to a $43,000 non-operating gain in the Consolidated Statement of Operations for the three months ended March 31, 2009. We will continue to mark the warrants to market value each quarter-end until they are completely settled.



Behavioral Health Managed Care Services

The following table summarizes the operating results for behavioral health managed care services for the six months ended June 30, 2008 and the period January 13 through June 30, 2007, which consisted entirely of the operations of CompCare subsequent to our acquisition of a controlling interest in CompCare on January 12, 2007 and related purchase accounting adjustments.

           For the period 
        Six Months  Jan 13 
  Three Months Ended  Ended  through 
(Dollar amounts in thousands) June 30,  June 30,  June 30, 
  2008  2007  2008  2007 
Revenues            
Capitated contracts $9,258  $8,848  $18,345  $16,245 
Non-capitated contracts  324   311   570   520 
Total revenues  9,582   9,159   18,915   16,765 
                 
Operating expenses                
Claims expense  9,750   7,550   17,900   13,541 
Other behavioral health managed care services expenses  1,957   1,798   3,546   2,959 
Total healthcare operating expense  11,707   9,348   21,446   16,500 
General and administrative expenses  1,477   928   2,455   1,697 
Depreciation and amortization  242   227   482   441 
Total operating expenses  13,426   10,503   24,383   18,638 
                 
Loss from operations  (3,844)  (1,344)  (5,468)  (1,873)
                 
Interest income  7   48   19   68 
Interest expense  (68)  (68)  (135)  (125)
Other non-operating income, net  -   29   -   29 
Loss before provision for income taxes $(3,905) $(1,335) $(5,584) $(1,901)
                 
Total membership  1,014,000   1,143,000   1,014,000   1,143,000 
Medical Loss Ratio (1)  105.3%  85.3%  97.6%  83.4%

(1)  Medical loss ratio reflects claims expenses as a percentage of revenues of capitated contracts.

Revenue

Operating revenue from capitated contracts increased by approximately $410,000 to $9.3 millionBehavioral Health for the three months ended June 30, 2008 compared to $8.8 million for the same periodMarch 31, 2009 and 2008:

  Three Months Ended 
(in thousands) March 31, 
  2009  2008 
       
Revenues $-  $- 
         
Operating Expenses        
General and administrative expenses        
Salaries and benefits $656  $564 
Other expenses  197   708 
Impairment charges  758   - 
Depreciation and amortization  83   - 
Total operating expenses $1,694  $1,272 
         
Loss before provision for income taxes $1,694  $1,272 
General and Administrative Expenses

Total general and administrative expenses decreased by $419,000 in 2007. The increase is attributable to $2.0 million of additional business, primarily from two existing customers in Pennsylvania and Indiana, offset by the loss of three clients in Indiana and Texas accounting for approximately $1.6 million of revenue. Non-capitated revenue increased slightly to $324,000 from $311,000 for the three months ended June 30, 2008March 31, 2009 compared to the same period in 2007.2008. This decrease is attributable primarily to a reduction of $511,000 in other expenses, which was a result of the streamlining of our operations, partially offsetting a $92,000 increase in salaries and benefits.

Impairment Losses

For
An impairment charge of $758,000 was recognized during the sixthree months ended June 30, 2008, operating revenue from capitated contracts increased by approximately $2.1 million when comparedMarch 31, 2009 related to capitalized software for our Behavioral Health segment. We performed an impairment analysis in accordance with SFAS 144 and determined that the carrying value was not recoverable and was fully impaired.

Depreciation and Amortization

Depreciation and amortization for the three months ended March 31, 2009 consisted of depreciation of the capitalized software prior to the period January 13 through June 30, 2007 due to $5.1 million of additional business fromimpairment discussed above. There was no depreciation during the three existing customersmonths ended March 31, 2008 as the asset had not yet been placed in Pennsylvania, Maryland, Michigan and Indiana and the additional twelve days included in our consolidated financial statements for the 2008 period relative to 2007, partially offset by the loss of three clients in Indiana and Texas accounting for approximately $2.7 million in revenue. The additional Indiana revenue reflects the impact of a 15.9% increase in the per-member, per-month rate paid to CompCare by its large HMO client for calendar year 2008, which amounts to approximately $2 million perservice.



year. Non-capitated revenue increased approximately $50,000, to $570,000 for the six months ended June 30, 2008, compared to $520,000 for the period January 13 through June 30, 2007.

Operating Expenses

Claims expense on capitated contracts increased approximately $2.2 million or 29% for the three months ended June 30, 2008 when compared to the same period in 2007, due to higher capitated revenue and medical loss ratios related to clients in Indiana, Pennsylvania, and Maryland. Accordingly, claims expense as a percentage of capitated revenue increased from 85.3% for the three months ended June 30, 2007 to 105.3% for the three months ended June 30, 2008. For the six months ended June 30, 2008, claims expense on capitated contracts increased by approximately $4.4 million when compared to the period January 13 through June 30, 2007 due to higher capitated revenue and higher medical loss ratios related to clients in Indiana, Pennsylvania, and Maryland, and the additional twelve days included in our consolidated financial statements for the 2008 period relative to 2007.

Other healthcare operating expenses, attributable to servicing both capitated contracts and non-capitated contracts, increased by $159,000, or approximately 9%, for the three months ended June 30, 2008 when compared to the same period in 2007, due primarily to a $300,000 provision for loss on capitated contracts related to the large Indiana HMO contract, since it is probable that a loss will be incurred during the remaining contract term of July 2008 through December 2008, partially offset by reduced usage of external medical review services in the current quarter. Such expenses increased by approximately $587,000 for the six months ended June 30, 2008 when compared to the period January 13 through June 30, 2007, due primarily to the $300,000 provision for loss on capitated contracts, the net effect of upgrades to our healthcare management information system, the cost of a provider contracting consultant and the additional twelve days included in our consolidated financial statements for the 2008 period relative to 2007.

General and administrative expenses increased by approximately $549,000, or 59.2%, for the three months ended June 30, 2008 when compared to same period in 2007, primarily due to a $325,000 charge for a legal judgment to pay plaintiff’s attorney fees and expenses for the dismissed class action lawsuit related to the terminated merger between Hythiam and CompCare, increased consulting fees of $175,000 for Medicare compliance work, a HIPAA compliance review, and external information systems department management. The increase is also attributed to higher compensation expense from stock options of $47,000 due to stock option grants to CompCare directors in July 2007 and to CompCare’s new Chief Executive Officer and other employees during the first and second quarters of 2008. For the six months ended June 30, 2008, general and administrative expenses increased by approximately $758,000, or 44.7%, when compared to the period January 13 through June 30, 2007, primarily due to an accrual of $325,000 for a legal judgment , increased consulting fees of $241,000 for Medicare compliance and information system management services, an increase in sales and marketing expenses in the amount of $141,000, $45,000 in additional compensation expense from stock options due to option grants subsequent to June 30, 2007 and the additional number of days included in our consolidated financial statements in the 2008 period.  These increases were partially offset by expense reductions of $137,000 in directors’ fees, $73,000 in audit fees and $58,000 in legal fees.

Depreciation and amortization for the three and six months ended June 30, 2008, the three months ended June 30, 2007 and the period January 13 through June 30, 2007 includes $201,000, $402,000, $189,000 and $371,000, respectively, of amortization related to purchase accounting adjustments for the fair value attributed to managed care contracts and other identifiable intangible assets acquired as part of the CompCare acquisition.

Interest Income

Interest income for the three and six month periods ending June 30, 2008 decreased compared to the same periods in 2007 due to decreases in the invested balance of marketable securities and in average investment yields.

Interest Expense

Interest expense relates to the $2.0 million in 7.5% convertible subordinated debentures at CompCare and includes approximately $21,000, $42,000, $19,000 and $36,000, respectively, of amortization related to the purchase price allocation adjustment resulting from the CompCare acquisition for the three and six months ended June 30, 2008, the three months ended June 30, 2007 and the period January 13 through June 30, 2007.


LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations, since inception, primarily through the sale of shares of our common stock in publicLiquidity and private placement stock offerings.  The following table sets forth a summary of our equity offering proceeds, net of expenses, since our inception (in millions):

DateTransaction TypeAmount
September 2003 Private placement $       21.3
December 2004 Private placement          21.3
November 2005 Public offering          40.2
December 2006 Private placement          24.4
November 2007 Registered direct placement          42.8
 $     150.0
Going Concern

As of June 30, 2008,March 31, 2009, we had a balance of approximately $26.6$6.0 million in cash, cash equivalents and current marketable securities, of whichsecurities. In addition, we had approximately $1.3$10.4 million is held by CompCare. As of June 30, 2008, approximately $10.7 million (net of $776,000 unrealized loss discussed below) of our marketable securities consisted of auction rate securities (ARS), which is classified in long-term assets as of March 31, 2009.

ARS are variable-rate instruments with longer stated maturities whose interest rates are reset at predetermined short-term intervals through a Dutch auction system. However, commencing in February 2008, auctions for these securities have failed, meaning the parties desiring to sell securities could not be matched with an adequate number of buyers, resulting in our having to continue to hold these securities. AlthoughWe believe that we ultimately should be able to liquidate all of our ARS investments without significant loss because the securities are Aaa/AAA rated and collateralized by portfolios of student loans guaranteed by the U.S. government, based ongovernment.  However, current conditions in the ARS market conditionsmake it is likely that auctions will continue to be unsuccessful in the short-term, limiting the liquidity of these investments until the auction succeeds, the issuer calls or refinances the securities, or they mature. The maturity dates range from nineteen to thirty-eight years. As a result of the current turmoil in the credit markets, our ability to liquidate our investment and fully recover the carrying value of our investment in the near term may be limited or not exist. Based on the foregoing, management believes at the current time that its ARS investments most likely cannot be sold at par within the next 12 months.  Therefore, we have classified the ARS investments in long-term assets at March 31, 2009.

In October 2008, UBS made a rights offering to its clients, pursuant to which we are entitled to sell to UBS all auction-rate securities held by us in our UBS account. The rights offering permits us to require UBS to purchase our ARS for a price equal to original par value plus any accrued but unpaid interest beginning on June 30, 2010 and ending on July 2, 2012 if the securities are not earlier redeemed or sold.  As part of the rights offering, UBS provided to us a line of credit equal to 75% of the market value of the ARS until they are purchased by UBS.  However, as discussed below, we granted Highbridge additional redemption rights in connection with the amendment of the senior secured note that would require us to use any margin loan proceeds in excess of $5.8 million to pay down the principal amount of the senior secured note.  The line of credit has certain restrictions described in the prospectus.  We accepted this offer in November 2008.

Due to our current financial condition, we are no longer able to conclude that we have the ability to hold the ARS until we are able to recover full value for them. Accordingly, for the three months ended March 31, 2009, we recognized $132,000 in other-than-temporary decline in value related to our investment in certain ARS.  We also recognized a temporary declineincrease in the fair value of approximately $425,000 related to our investment in certain other ARS investments of approximately $776,000 as of June 30, 2008,March 31, 2009 based on estimates of the fair value using valuation models and methodologies that utilize an income-based approach to estimate the price that would be received to sell our securities in an orderly transaction between market participants. We may record additional temporary or permanent impairment charges on these investments in the future if there are any further declines in estimated fair value as determined by management. If current market conditions deteriorate further, the credit rating of the ARS issuers deteriorates, or whenthe anticipated recovery in the market values does not occur, we may be required to make further adjustments to the carrying value of the ARS through impairment charges in the Consolidated Statement of Operations, and any such impairment adjustments may be material. In accordance with SFAS 115, other-than-temporary declines in value are consideredreflected as a non-operating expense in our Consolidated Statements of Operations, whereas subsequent temporary increases in value are reflected in Stockholders’ Equity on our Consolidated Balance Sheets.

The actions we took to be other than temporary. In addition,streamline operations and related cost reductions implemented in 2008, and the additional actions we took in the first quarter of 2009, are expected to reduce our operating expenditures significantly for 2009 compared to 2008. As discussed in Recent Developments above, these typesefforts have resulted in delays and reductions in operating expenses, resulting in total budgeted operating expenses of developments could cause us to reclassify our investments in ARS from a current asset to a long-term asset.  We believe that the higher average reset interest rates on failed auctions provide sufficient incentiveapproximately $10 million for the security issuersremainder of 2009.

As of March 31, 2009, we had a working capital deficit of approximately $8.6 million.  Our working capital deficit is impacted by $7.2 million of outstanding borrowings under the UBS line of credit that is payable on demand and classified in current liabilities, but are secured by $10.4 million of ARS investments that are classified in long-term assets as discussed above.  We have incurred significant net losses and negative operating cash flows since our inception. We expect to address this lackcontinue to incur negative cash flows and net losses for at least the next twelve months. As of liquidity. WhileMarch 31, 2009, these failures in the auction process have affectedconditions raised substantial doubt from our auditors as to our ability to accesscontinue as a going concern. Our ability to fund our ongoing operations and continue as a going concern is


dependent on raising additional capital, signing and generating revenue from new contracts for our Catasys managed care programs and the success of management’s plans to increase revenue and continue to decrease expenses. In the fourth quarter of 2008, management took actions that resulted in reducing annual operating expenses by $10.2 million compared to the third quarter of 2008.  In addition, management currently has plans for additional cost reductions from the elimination of certain positions in our licensee and PROMETA Center operations and related corporate staff and a reduction in certain support and occupancy costs, consulting and other outside services if required. Certain of these fundsreductions have already been implemented as of the reporting date, resulting in the nearestimated annual reductions in operating expenses totaling $3.7 million. Also, we have renegotiated certain leasing and vendor agreements to restructure payment terms. We have also negotiated and plan to negotiate more favorable payment terms with vendors, which include negotiating settlements for outstanding liabilities. We may exit additional markets in our licensee and PROMETA Center operations to reduce costs or if management determines that those markets will not provide short term profitability. Additionally, we are pursuing new Catasys contracts, additional capital and will consider liquidating our ARS, if necessary. As of April 30, 2009, we had net cash on hand of approximately $4.7 million. Excluding short-term debt and non-current accrued liability payments, our current plans call for expending cash at a rate of approximately $1 million per month. At presently anticipated rates, which do not believe that the underlying securities or collateral have been affected. At this time,include management’s plans for additional cost reductions, we have not obtained sufficient evidencewill need to conclude that these investments are impaired or that they will not be settledobtain additional funds within the next twelvetwo to three months althoughto avoid drastically curtailing or ceasing our operations.  In March 2009, we began discussions with third parties regarding financing that management anticipates would, if concluded, meet our capital needs until we are able to generate positive cash flows.  The financing is contingent upon the market for these investments is uncertain. We believesigning of a new Catasys contract.  There can be no assurance that we will be successful in our efforts to generate, increase, or maintain revenue; or raise necessary funds on acceptable terms or at all, and we may not require accessbe able to these ARS withinoffset this by sufficient reductions in expenses and increases in revenue.  If this occurs, we may be unable to meet our cash obligations as they become due and we may be required to further delay or reduce operating expenses and curtail our operations, which would have a material adverse effect on us, or we may be unable to continue as a going concern.

Cash Flows

We used $5.1 million of cash for continuing operating activities during the next twelvethree months byended March 31, 2009. Use of funds in operating activities include general and administrative expense (excluding share-based expense), the cost of healthcare services revenue and research and development costs, which timetotaled approximately $4.9 million for the three months ended March 31, 2009, compared to $10.7 million for the same period in 2008. This decrease in net cash used reflects the decline in such expenses, resulting mainly from our efforts to streamline operations, as described below.

In the first quarter of 2009, we expect liquidity to be restoredcompleted actions that we began in the credit markets.  In Mayfourth quarter of 2008 we obtained a demand margin loan facility fromto reduce our investment portfolio manager, allowing us to borrow up to $5.4 million to provide additional cash liquidity if so needed, collateralized by the ARS. As of June 30, 2008, we have not drawn any funds against the facility. Any draw-downs would be subject to a rate of interest equal to the prevailing 30-day LIBOR rate plus 100 basis points.

In January 2008, we streamlined our operations to increase our focus on managed care opportunities, which is expected to result in an overall reduction of 25% to 30% of cash operating expenses forby an additional $10.2 million from the fiscal year ending December 31,third quarter 2008 compared to fiscal 2007.expenditure level. The actions we took included significant reductions in field and regional sales personnel and related corporate support personnel, closingcurtailment of our international operations, a reduction in outside consultant expense and overall reductions in overhead costs. Additionally, we took further actions in the PROMETA Center in San Francisco and reducing overall overhead costs and the numberfirst quarter of outside consultants. In April 2008 we continued2009 to streamline our operations by reducing future monthly costs an additional 20%and increase the focus on managed care opportunities and to 25% comparedrenegotiate certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms with vendors, which included negotiating settlements for outstanding liabilities. These efforts have resulted in delays and reductions in operating expenses, resulting in total budgeted operating expenses of approximately $10 million for the remainder of 2009.

Capital expenditures for the three months ended March 31, 2008. We recorded approximately $1.1 million and $1.2 million2009 were $9,000 compared to $529,000 for the same period in one-time costs associated with these actions during the three months ended March 31, 2008 and June 30, 2008, respectively. Such costs primarily represent severance and related benefits and costs incurred to close the San Francisco PROMETA Center. All such costs are included in general and administrative expenses in the statement of operations.


The significant cost reductions already implemented are expected to reduce our cash expenditures significantly for 2008 compared to 2007. Following the streamlining actions taken in January 2008 and April 2008, our cash expenditures were $7.7 million in three months ended June 30, 2008, compared to an average of $11.5 million per quarter in 2007, including research and development costs, but excluding costs incurred by our consolidated subsidiary, CompCare; and we plan to further reduce our cash expenditures in the third and fourth quarters in fiscal year 2008.  We define cash expenditures as the net change in our cash, cash equivalents and marketable securities, plus revenues for the period (excluding equity or financing transactions).

CompCare had negative cash flow of $5.0 million during the six months ended June 30, 2008, mainly attributable to payment of claims on its Indiana, Pennsylvania, and Maryland contracts which have experienced high utilization of services by members.  Approximately $1.5 million of the total cash usage was due to a timing difference in the monthly capitation remittance from the large Indiana HMO client, which was received July 1, 2008. In addition, approximately $700,000 in cash was used to pay accrued claims payable relating to three contracts that terminated during the quarter ended December 31, 2007 and a contractually required severance payment of $410,000 was made to CompCare’s former chief executive officer. CompCare had a working capital deficit of $6.0 million and a stockholders’ deficit of $9.2 million at June 30, 2008. During June and July of 2008, CompCare reduced its usage of consultants and temporary employees as well as eliminated certain permanent staffing positions.  In addition CompCare implemented a 10% salary reduction for employees at the vice president level and above and has reduced outside directors fees by 10%. CompCare has also requested rate increases from several of its existing clients. A significant portion of the reduction in CompCare’s cash position is attributable to the large Indiana contract, which accounted for 46% of behavioral health managed care services revenue for the six months ended June 30, 2008. CompCare is seeking to improve its overall liquidity by obtaining a rate increase from this client and by reducing related claims expenses.
In the six months ended June 30, 2008, we expended approximately $732,000 in capital expenditures for the development of our information systems and other equipment needs. Wedo not expect our capital expenditures to be approximately $200,000material for the remainder of 2008, primarily for the development of computer software related to our planned disease management products. Capital spending by CompCare in 2008 is not expected to be material.2009. Our future capital requirements will depend upon many factors, including progress with our marketing efforts, the time and costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other proprietary rights, the necessity of, and time and costs involved in obtaining, regulatory approvals, competing


technological and market developments, and our ability to establish collaborative arrangements, effective commercialization, marketing activities and other arrangements.
We expect to continue to incur negative cash flows and net losses for at least the next twelve months. Based upon our current projections, including anticipated revenue, we believe that our existing cash, cash equivalents and marketable securities will be sufficient to fund our operating expenses and capital requirements for at least the next 18 months or, if sooner, until we generate positive cash flows. Our ability to meet our obligations as they become due and payable will depend on our ability to maintain or further reduce operating expenses, increase revenue, sell securities, borrow funds or some combination thereof. We may also seek to raise additional capital through public or private financing in order to increase the amount of our cash reserves on hand. We may not be successful in raising necessary funds on acceptable terms, or at all.  If this occurs, and we do not or are unable to borrow funds or sell additional securities, we may be unable to meet our cash obligations as they become due and we may be required to delay or further reduce operating expenses and curtail our operations, which would have a material adverse effect on us.
CompCare Acquisition and Financing

In January 2007,Debt

During the three months ended March 31, 2009, we acquired alldrew down an additional $1.5 million under the UBS demand margin loan facility, and used $1.4 million of the outstanding membership interests of Woodcliff for $9 million in cash and 215,053 shares of our common stock. Woodcliff owns 1,739,130 shares of common stock and 14,400 shares of Series A Convertible Preferred Stock of CompCare,proceeds to pay down the conversion of which would result in us owning over 50% the outstanding shares of common stock of CompCare. The preferred stock has voting rights and, combined with the common shares held by us, gives us voting control over CompCare. The preferred stock gives us certain rights, including:

●the right to designate the majority of CompCare’s board of directors
●dividend and liquidation preferences, and
●anti-dilution protection.

In addition, without our consent, CompCare is prevented from engaging in any of the following transactions:

●any sale or merger involving a material portion of assets or business
●any single or series of related transactions in excess of $500,000, and
●incurring any debt in excess of $200,000.

In January 2007, to finance the Woodcliff acquisition, we entered into a Securities Purchase Agreement pursuant to which we sold to Highbridge International LLC (Highbridge) (a) $10 million original principal amount of senior secured notes and (b) warrants to purchase up to 249,750 shares of our common stock (adjusted to 285,000 shares as of December 31, 2007). The note bears interest at a rate of prime plus 2.5%, with interest payable quarterly commencing on April 15, 2007, and matures on January 15, 2010, with an option for Highbridge to demand redemption of the Notes beginning on July 18, 2008.

In connection with the debt financing, we entered into a security agreement granting Highbridge a first-priority perfected security interest in all of our assets now owned or thereafter acquired. We also entered into a pledge agreement with Highbridge, as collateral agent, pursuant to which we delivered equity interests evidencing 65% of our ownership of our foreign subsidiaries. In the event of a default, the collateral agent is given broad powers to sell or otherwise dispose of the pledged collateral.

We redeemed $5 million in principal related to the senior secured note on November 7, 2007 in conjunction with the registered direct placement. As of June 30, 2008 the remaining principal balance on this debt is $5.0 million. On July 31, 2008, we amended our senior secured note with Highbridge to extend from July 18, 2008 to July 18, 2009 the optional redemption date exercisable by Highbridge for the $5 million remaining under the senior secured note, and remove certain restrictions on our ability to obtain a margin loan on our auction-rate securities.  In connection with this extension, we granted Highbridge additional redemption rights in the event of certain strategic transactions or other events generating additional liquidity for us, including without limitation the conversion of some or all of our auction-rate securities into cash.  We also granted Highbridge a right of first refusal relating to the disposition of our auction-rate securities, and amended the existing warrant held by Highbridge for 285,185 shares of our common stock at $10.52 per share.  The amended warrant expires five years from the amendment date and is exercisable for 1,300,000 shares of our common stock at a price per share of $2.15, priced off of the $2.14 closing price of our common stock on July 22, 2008. We are currently assessing the accounting impact that the amendment will have on our consolidated financial statements.International LLC.

The acquisition of Woodcliff and a controlling interest in CompCare is not expected to require any material amount of additional cash investment or expenditures by us in 2008, other than expenditures expected to be made by CompCare from its existing cash reserves and cash flow from its operations.

The unpaid claims liability for managed care services is estimated using an industry-accepted actuarial paid completion factor methodology and other statistical analyses.  These estimates are subject to the effects of trends in utilization and other factors.  Any significant increase in member utilization that falls outside of our estimations would increase healthcare operating expenses and may impact the ability for these plans to achieve and sustain profitability and positive cash flow. Although considerable variability is inherent in such estimates, we believe that the unpaid claims liability is adequate. However, actual results could differ from the $6.7 million claims payable amount reported as of June 30, 2008.

CompCare as a Going Concern
As of July 31, 2008, CompCare had net cash on hand of approximately $1.3 million.  Excluding non-current accrued liability payments, CompCare’s current plans call for expending cash at a rate of approximately $500,000 to $700,000 per month, which raises substantial doubt about CompCare's ability to continue as a going concern.  At presently anticipated rates, CompCare will need to obtain additional funds within the next two to three months to avoid ceasing or drastically curtailing its operations.  If CompCare is not able to obtain a rate increase or significant additional payments from their major Indiana client within that time frame, it is likely CompCare will need to raise additional equity capital, sell all or a portion of their assets, or seek additional debt financing to fund their operations during the fourth quarter of 2008.  There can be no assurance that CompCare will be successful in its efforts to obtain a rate increase from its major Indiana client; generate, increase, or maintain revenue; or raise additional capital on terms acceptable to it, or at all, or that CompCare will be able to continue as a going concern.  We are under no obligation to provide CompCare with any form of financing, and we do not currently anticipate making an additional cash investment in CompCare. CompCare’s board of directors’ special committee, currently comprised solely of independent directors, together with professional advisors, has been evaluating and pursuing available strategic alternatives for enhancing stockholder value, including a possible sale of CompCare. 


LEGAL PROCEEDINGS

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business.   As of the date of this report, we are not currently involved in any legal proceeding that we believe would have a material adverse effect on our business, financial condition or operating results.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

The following table sets forth a summary of our material contractual obligations and commercial commitments as of June 30, 2008March 31, 2009 (in thousands):

     Less than       
Contractual Obligations Total  1 year  1-3 years  3-5 years 
Debt obligations, including interest $7,677  $5,264  $2,413  $- 
Claims payable (1)
  6,733   6,733   -   - 
Reinsurance claims payable (2)
  2,526   -   2,526   - 
Capital lease obligations  458   221   221   16 
Operating lease obligations (3)
  3,788   1,539   2,128   121 
Contractual commitments for clinical studies  2,983   2,983   -   - 
  $24,165  $16,740  $7,288  $137 
     Less than  1 - 3  3 - 5  More than 
Contractual Commitments Total  1 year  years  years  5 years 
Outstanding Debt Obligations $10,951  $10,951            
Capital Lease  Obligations  176   101   75   -   - 
Operating Lease Obligations  2,565   1,228   1,337   -   - 
Clinical Studies  1,801   1,333   468   -   - 
Total $15,493  $13,613  $1,880  $-  $- 

(1)  These claim liabilities represent the best estimate of benefits to be paid under capitated contracts and consist of reserves for claims and claims incurred but not yet reported (IBNR). Because of the nature of such contracts, there is typically no minimum contractual commitment associated with covered claims. Both the amounts and timing of such payments are estimates, and the actual claims paid could differ from the estimated amounts presented.

(2)  This item represents a potential liability to providers relating to denied claims for a terminated reinsurance contract. Any adjustment to the reinsurance claims liability would be accounted for in our statement of operations in the period in which the adjustment is determined.

(3)  Operating lease commitments for our and CompCare’s corporate office facilities and two managed treatment centers, including deferred rent liability.

OFF BALANCE SHEET ARRANGEMENTS

As of June 30, 2008,March 31, 2009, we had no off-balance sheet arrangements.

CRITICAL ACCOUNTING ESTIMATES

OurCritical Accounting Estimates

The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires usStates. GAAP require management to make significant estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. We base our estimates on experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments to developabout the amounts reflectedcarrying values of assets and disclosed in the consolidated financial statements, most notably the estimate for IBNR.liabilities that may not be readily apparent from other sources. On an ongoingon-going basis, we evaluate the appropriateness of our estimates and we maintain a thorough process to review the application of our accounting policies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances.  ActualOur actual results may differ from these estimates under different assumptions or conditions.estimates.

We consider our critical accounting estimates to be those that (1) involve significant judgments and uncertainties, (2) require estimates that are more difficult for management to determine, and (3) may produce materially different results when using different assumptions. We have discussed these critical accounting estimates, the basis for their underlying assumptions and estimates and the nature of our related disclosures herein with the audit committee of our Board of Directors. We believe our accounting policies specific to behavioral health managed care services revenue recognition, accrued claims payable and claimsshare-based compensation expense, for managed care services, managed care services premium deficiencies,


the impairment assessments for goodwill and other intangible assets and share-based compensation expensevaluation of marketable securities involve our most significant judgments and estimates that are material to our consolidated financial statements (see Note 2 – “Summary of Significant Accounting Policies” to the unaudited, consolidated financial statements).statements. They are discussed further below:

Managed Care Services Revenue Recognition

We provide managed behavioral healthcare and substance abuse services to recipients, primarily through subcontracts with HMOs.  Revenue under the vast majority of these agreements is earned and recognized monthly based on the number of covered members as reported to us by our clients regardless of whether services actually provided are lesser or greater than anticipated when we entered into such contracts (generally referred to as capitation arrangements). The information regarding qualified participants is supplied by CompCare’s clients and CompCare reviews membership eligibility records and other reported information to verify its accuracy in determining the amount of revenue to be recognized. Consequently, the vast majority of CompCare’s revenue is determined by the monthly receipt of covered member information and the associated payment from the client, thereby removing uncertainty and precluding us from needing to make assumptions to estimate monthly revenue amounts.

Under CompCare’s major Indiana contract, approximately $200,000 of monthly revenue is dependent on CompCare’s satisfaction of various monthly performance criteria and is recognized only after verification that the specified performance targets have been achieved.

CompCare may experience adjustments to its revenue to reflect changes in the number and eligibility status of members subsequent to when revenue is recognized.  To date, subsequent adjustments to CompCare’s revenue have not been material.

Premium Deficiencies

CompCare accrues losses under capitated contracts when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. CompCare performs this loss accrual analysis on a specific contract basis taking into consideration such factors as future contractual revenue, projected future healthcare and maintenance costs, and each contract's specific terms related to future revenue increases as compared to expected increases in healthcare costs. The projected future healthcare and maintenance costs are estimated based on historical trends and estimates of future cost increases.

At any time prior to the end of a contract or contract renewal, if a capitated contract is not meeting its financial goals, CompCare generally has the ability to cancel the contract with 60 to 90 days written notice.  Prior to cancellation, CompCare will submit a request for a rate increase accompanied by supporting utilization data.  Although historically, CompCare’s clients have been generally receptive to such requests, no assurance can be given that such requests will be fulfilled in the future.  If a rate increase is not granted, CompCare generally has the ability to terminate the contract and limit its risk to a short-term period.

On a quarterly basis, CompCare performs a review of its portfolio of contracts for the purpose of identifying loss contracts (as defined in the American Institute of Certified Public Accountants Audit and Accounting Guide – Health Care Organizations) and developing a contract loss reserve, if applicable, for succeeding periods. During the six months ended June 30, 2008, CompCare’s review identified the large Indiana HMO contract as a contract for which it is probable that a loss will be incurred during the remaining contract term of July 2008 through December 2008.  Based on available information, CompCare has estimated the loss at $300,000, which has been recognized in the consolidated balance sheet at June 30, 2008 and the statement of operations for the three and six months ended June 30, 2008.

Accrued Claims Payable and Claims Expense

Managed care operating expenses are comprised of claims expense, other healthcare expenses and reserve for loss contracts.  Claims expense includes amounts paid to hospitals, physician groups and other managed care organizations under capitated contracts. Other healthcare expenses include items such as information systems, provider contracting, case management and quality assurance, attributable to both capitated and non-capitated


contracts. Reserves for loss contracts is the present value of future benefits payments and healthcare operating expenses less the present value of expected future premiums (see Premium Deficiencies above).

The cost of behavioral health services is recognized in the period in which an eligible member actually receives services and includes an estimate of IBNR. CompCare contracts with various healthcare providers including hospitals, physician groups and other managed care organizations on either a discounted fee-for-service or a per-case basis.  CompCare determines that a member has received services when it receives a claim within the contracted timeframe with all required billing elements correctly completed by the service provider.  CompCare then determines whether (1) the member is eligible to receive such services, (2) the service provided is medically necessary and is covered by the benefit plan’s certificate of coverage, and (3) the service has been authorized by one of CompCare’s employees, if authorization is required.  If the applicable requirements are met, the claim is entered into CompCare’s claims system for payment and the associated cost of behavioral health services is recognized.

Accrued claims payable consists primarily of CompCare’s reserves established for reported claims and IBNR, which are unpaid through the respective balance sheet dates. CompCare’s policy is to record management’s best estimate of IBNR. The IBNR liability is estimated monthly using an industry-accepted actuarial paid completion factor methodology and is continually reviewed and adjusted, if necessary, to reflect any change in the estimated liability as more information becomes available. In deriving an initial range of estimates, CompCare’s management uses an industry accepted actuarial model that incorporates past claims payment experience, enrollment data and key assumptions such as trends in healthcare costs and seasonality. Authorization data, utilization statistics, calculated completion percentages and qualitative factors are then combined with the initial range to form the basis of management’s best estimate of the accrued claims payable balance.

At June 30, 2008, CompCare’s management determined its best estimate of the accrued claims liability to be $6.7 million. Approximately $3.6 million of the accrued claims payable balance at June 30, 2008 is attributable to the major HMO contract in Indiana that started January 1, 2007.  As of June 30, 2008, CompCare has accrued as claims expense approximately 106% of the revenue from this contract.

Accrued claims payable at June 30, 2008 comprises approximately $1.0 million liability for submitted and approved claims, which had not yet been paid, and a $5.7 million accrued liability for IBNR claims.

Many aspects of the managed care business are not predictable with consistency. Therefore, estimating IBNR claims involves a significant amount of judgment by management.  Actual claims incurred could differ from the estimated claims payable amount presented.  The following are factors that would have an impact on CompCare’s future operations and financial condition:

●Changes in utilization patterns
●Changes in healthcare costs
●Changes in claims submission timeframes by providers
●Success in renegotiating contracts with healthcare providers
●Adverse selection
●Changes in benefit plan design
●The impact of present or future state and federal regulations

A 5% increase or decrease in assumed healthcare cost trends from those used in the calculations of IBNR at June 30, 2008 could increase or decrease CompCare’s claims expense by approximately $153,000.

Share-based expense

Commencing January 1, 2006, we implemented the accounting provisions of FASB Statement of Financial Accounting Standards (SFAS) No. 123RShare Based Payment (SFAS 123(R), on a modified-prospective basis to recognize share-based compensation for employee stock option awards in our statements of operations for future periods. Prior to adoption of SFAS 123 (R), weWe accounted for the issuance of stock, stock options and warrants for services from non-employees in accordance with SFAS No. 123,Accounting for Stock-Based Compensation and EITFFASB Emerging Issues Task Force Issue No. 96-18, “AccountingAccounting For Equity Instruments That Are Issued To Other Than Employees For Acquiring Or In


Conjunction With Selling Goods Or Services.”Services .. We estimate the fair value of options and warrants issued using the Black-Scholes pricing model. This model’s calculations include the exercise price, the market price of shares on grant date, weighted average assumptions for risk-free interest rates, expected life of the option or warrant, expected volatility of our stock and expected dividend yield.

The amounts recorded in the financial statements for share-based expense could vary significantly if we were to use different assumptions. For example, the assumptions we have made for the expected volatility of our stock price have been based on the historical volatility of our stock and the stock of other public healthcare companies, measured over a period generally commensurate with the expected term, since we have a limited history as a public company and complete reliance on our actual stock price volatility would not be meaningful. If we were to use the actual volatility of our stock price, there may be a significant variance in the amounts of share-based expense from the amounts reported. Based on the 2008 assumptions used for the Black-Scholes pricing model, a 50% increase in stock price volatility would have increased the fair values of options by approximately 25%. The weighted average expected option term for 2008, 2007 and 2006 reflects the application of the simplified method set out in the Securities and Exchange CommissionSEC Staff Accounting Bulletin No. 107, which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

Goodwill

The excess amount of purchase price overFrom time to time, we have retained terminated employees as part-time consultants upon their resignation from the fair values of net assets acquiredcompany. Because the employees continued to provide services to us, their options continued to vest in accordance with the CompCare acquisition resulted in goodwill. We evaluate goodwill for impairment annually based on the estimated fair value of our healthcare services reportable segment. We test for impairment on a more frequent basis in cases where events and changes in circumstances would indicate that we might not recover the carrying value of goodwill. In estimating the fair value, management considers both the income and market approaches to fair value determination. The income approach is based on a discounted cash flow methodology, in which management makes its best assumptions regarding future cash flows and a discount rate to be appliedoriginal terms. Due to the cash flows to yield a present, fair valuechange in classification of the reporting unit.option awards, the options were considered modified at the date of termination in accordance with SFAS 123R. The market approach is based primarily on reference to transactions involving the company’s common stock and the quoted market pricesmodifications were treated as exchanges of the company’s common stock. As a resultoriginal awards in return for the issuance of such tests at    December 31, 2007,new awards. At the date of termination, the unvested options were no loss from impairmentlonger accounted for as employee awards under SFAS 123R and were accounted for as new non-employee awards under EITF 96-18. The accounting for the portion of goodwill appeared to exist atthe total grants that time. have already vested and have been previously expensed as equity awards is not changed.

Impairment of intangible assetsIntangible Assets

We have capitalized significant costs, and plan to capitalize additional costs for acquiring patents and other intellectual property directly related to our products and services. Identified intangible assets acquired as partIn accordance with SFAS 144, Accounting for the Impairment or Disposal of the CompCare acquisition include the value of managed care contracts and marketing-related assets associated with its managed care business, including the value of the healthcare provider network and the professional designation from the National Council on Quality Association (NCQA). We will continue to evaluateLong-Lived Assets , we review our intangible assets for impairment on an ongoing basis by assessingwhenever events or circumstances indicate that the future recoverabilitycarrying amount of these assets may not be recoverable. In reviewing for impairment, we compare the carrying value of such capitalized costs based on estimatesassets to the estimated undiscounted future cash flows expected from the use of ourthe assets and/or their eventual disposition. If the estimated undiscounted future revenuecash flows are less estimated costs.than their carrying amount, we record an impairment loss to recognize a loss for the difference between the assets’ fair value and their carrying value. Since we have not recognized significant revenue to date, our estimates of future revenue may not be realized and the net realizable value of our capitalized costs of intellectual property or other intangible assets may become impaired.

CompCare had negative cash flow of $5.0 million during the six months ended June 30, 2008 and had a working capital deficit of $6.0 million and a stockholders’ deficit of $9.2 million at June 30, 2008. CompCare’s continuation as a going concern depends upon its ability to generate sufficient cash flow to conduct its operations and its ability to obtain additional sources of capital and financing. CompCare’s management has taken action to reduce operating expenses, has requested rate increases from several of its existing clients and is exploring its options to raise additional equity capital, sell all or a portion of its assets, or seek additional debt and financing. We have evaluated the carrying valuesvalue of intangible assets and goodwill related to the CompCare acquisition ($957,000 and $493,000, respectively, as of June 30, 2008) for possible impairment at March 31, 2009 and, after considering numerous factors, including a valuation of the intellectual property by an independent third party, we determined that the carrying value of certain intangible assets was not recoverable and exceeded the fair value as of June 30, 2008that date.  We recorded impairment charges totaling $355,000, including $122,000 for intangible assets related to our managed treatment center in Dallas and we believe there$233,000 related to intellectual property for additional indications for the use of the PROMETA Treatment program that is no impairment. However, wecurrently non-revenue-generating.  In its valuation, the independent third-party valuation firm relied on the “relief from royalty” method as this method was deemed to be most relevant to the intellectual property assets of the Company.  We determined that the estimated useful lives of the intellectual property properly reflected the current remaining economic useful lives of the assets. We will continue to review these assets for potential impairment each reporting period. An impairment loss would be recognized if and when we are able to conclude that the carrying amounts of such assets exceed the related undiscounted cash flows for intangible assets and the implied fair value for the CompCare goodwill.




Valuation of Marketable Securities

Investments include ARS, U.S. Treasury bills, commercial paper and certificates of deposit with maturity dates greater than three months when purchased, which are classified as available-for-sale investments and reflected in current or long-term assets, as appropriate, as marketable securities at fair market value in accordance with SFAS 115, Accounting for Certain Investments in Debt and Equity Securities.  Unrealized gains and losses are reported in our Consolidated Balance Sheet within accumulated other comprehensive loss and within other comprehensive loss. Realized gains and losses and declines in value judged to be “other-than-temporary” are recognized as a non-reversible impairment charge in the Statement of Operations on the specific identification method in the period in which they occur.

Since there have been continued auction failures with our ARS portfolio, quoted prices for our ARS did not exist as of March 31, 2009 and un-observable inputs were used. We determined that use of a valuation model was the best available technique for measuring the fair value of our ARS portfolio and we based our estimates of the fair value using valuation models and methodologies that utilize an income-based approach to estimate the price that would be received if we sold our securities in an orderly transaction between market participants. The estimated price was derived as the present value of expected cash flows over an estimated period of illiquidity, using a risk adjusted discount rate that was based on the credit risk and liquidity risk of the securities. Based on the valuation models and methodologies, and consideration of other factors, for the three months ended March 31, 2009, we recognized an additional $132,000 other-than-temporary decline in value related to our investment in certain ARS, and a temporary increase in value of approximately $425,000 related to our investment in other certain ARS. In accordance with SFAS 115, other-than-temporary declines in value are reflected as a non-operating expense in our Consolidated Statements of Operations, whereas subsequent increases in value are reflected in Stockholders’ Equity on our Consolidated Balance Sheets. While our valuation model includes inputs based on observable measures (credit quality and interest rates) and un-observable inputs, we determined that the un-observable inputs were the most significant to the overall fair value measurement, particularly the estimates of risk adjusted discount rates and estimated periods of illiquidity.

We regularly review the fair value of our investments. If the fair value of any of our investments falls below our cost basis in the investment, we analyze the decrease to determine whether it represents an other-than-temporary decline in value. In making our determination for each investment, we consider the following factors:

●  How long and by how much the fair value of the investments have been below cost
●  
The financial condition of the issuers
●  
Any downgrades of the investment by rating agencies
●  
Default on interest or other terms
●  
Our intent and ability to hold the investments long enough for them to recover their value

RECENT ACCOUNTING PRONOUNCEMENTS

Recent Accounting Pronouncements

Recently Adopted

In September 2006,December 2008, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.  In February 2008, FSP FAS 157-2, “Effective Date140-4 and FASB Interpretation No. (FIN) 46R-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities . This FSP amends FASB Statement No. 157” was issued, which delays140 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities to require public entities to provide additional disclosures about transfers of financial assets. It also amends FIN 46, Consolidation of Variable Interest Entities as revised to require public enterprises to provide additional disclosures about their involvement with VIEs. FSP FAS 140-4 and FIN 46(R)-8 are effective for the effective date of SFAS 157Company's fiscal year ending December 31, 2008.  We are required to fiscal yearsconsolidate the revenues and interim periods within those fiscal years beginning after November 15, 2008 for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We elected to defer the adoptionexpenses of the standard for these non-financial assets and liabilities, andmanaged medical corporations.  The financial results of managed treatment centers are currently evaluating the impact, if any, that the deferred provisions of the standard will have onincluded in our consolidated financial statements. The adoption of SFAS 157 did not have a material impact onstatements under accounting standards applicable to VIEs, and the required disclosures regarding our financial position, results of operations or cash flows.involvement with VIEs are included above under the heading Variable Interest Entities.

In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" (SFAS 159). SFAS 159 allows companies to measure many financial assets and liabilities at fair value. It also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types

Recently Issued

In December 2007, the FASB issued SFAS No. 141(R), "Business Combinations" Business Combinations (SFAS 141(R)). SFAS 141(R) replaces SFAS No. 141, "Business Combinations" Business Combinations (SFAS 141), which retains the requirement that the purchase method of accounting for acquisitions be used for all business combinations. SFAS 141(R) expands on the disclosures previously required by SFAS 141, better defines the acquirer and the acquisition date in a business combination, and establishes principles for recognizing and measuring the assets acquired (including goodwill), the liabilities assumed and any non-controlling interests in the acquired business. SFAS 141(R) also requires an acquirer to record an adjustment to income tax expense for changes in valuation allowances or uncertain tax positions related to acquired businesses. SFAS 141(R) is effective for all business combinations with an acquisition date in the first annual period following December 15, 2008; early adoption is not permitted. We will adoptadopted this statement as of January 1, 2009. We are currently evaluating the2009, and it did not have a material impact SFAS 141(R) will have on our consolidated financial statements.

In April 2008, the FASB issued FSP FAS 142-3, Determination of the Useful Life of Intangible Assets.  FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets . This change is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141R and other GAAP. FSP 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The requirement for determining useful lives must be applied prospectively to intangible assets acquired after the effective date and the disclosure requirements must be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. The adoption of this statement did not have a material impact on our consolidated results of operations, financial position or cash flows, and the required disclosures regarding our intangible assets are included above under the heading Intangible Assets.

In December 2007, the FASB issued SFAS No. 160, "NoncontrollingNoncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51"51 (SFAS 160). SFAS 160 requires that non-controlling (or minority) interests in subsidiaries be reported in the equity section of the company's balance sheet, rather than in a mezzanine section of the balance sheet between liabilities and equity. SFAS 160 also changes the manner in which the net income of the subsidiary is reported and disclosed in the controlling company's income statement. SFAS 160 also establishes guidelines for accounting for changes in ownership percentages and for deconsolidation. SFAS 160 is effective for financial statements for fiscal years beginning on or after December 1, 2008 and interim periods within those years. The adoption ofWe adopted SFAS 160 isfor the fiscal year begun January 1, 2009, and it did not expected to have a material impact on our financial position, results of operations or cash flows.

ItemIn March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of SFAS 133.   SFAS 161 requires enhanced disclosures about an entity’s derivative and hedging activities, including how an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133,  Accounting for Derivative Instruments and Hedging Activities , and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The provisions of SFAS 161 were effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The adoption of SFAS 161 had no impact on our consolidated financial statements as we do not have derivative instruments.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS 162).  SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States (the GAAP hierarchy).  SFAS 162 became effective November 15, 2008. We adopted SFAS 162 for the fiscal year begun January 1, 2009, and it did not have a material impact on our financial position, results of operations or cash flows.

In June 2008, the FASB ratified EITF Issue 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” (EITF 07-5). Paragraph 11(a) of Statement of Financial Accounting Standard No 133 “Accounting for Derivatives and Hedging Activities” (“SFAS 133”) specifies that a contract that would otherwise meet the definition of a derivative but is both (a) indexed to the Company’s own stock and (b) classified in stockholders’ equity in the statement of financial position would not be considered a derivative financial instrument. EITF 07-5 provides a new two-step model to be applied in determining whether a financial instrument or an embedded feature is indexed to an issuer’s own stock and thus able to qualify for the SFAS 133 paragraph 11(a)


scope exception. EITF 07-5 was effective for the first annual reporting period beginning after December 15, 2008, and early adoption was prohibited. EITF 07-5 did not have any impact on our financial position, results of operations or cash flows as we do not have any contracts that would otherwise meet the definition of a derivative but are both indexed to the Company’s own stock and classified in stockholders’ equity in the statement of financial position.

Recently Issued

In April 2009, the FASB issued the following three FSPs intended to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities:

●  
FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments;
●  
FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments; and
●  
FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly

These FSPs will be effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We have not elected to early adopt these FSPs and are currently evaluating the impact the FSPs will have on our financial position and financial statement disclosures.

Item 3.                 QuantitativeQuantitative and Qualitative Disclosures About Market Risk

We invest our cash in short term high grade commercial paper, certificates of deposit, money market accounts and marketable securities. We consider any liquid investment with an original maturity of three months or less when purchased to be cash equivalents. We classify investments with maturity dates greater than three months when purchased as marketable securities, which have readily determined fair values at the time of purchase and are classified as available-for-sale securities. Our investment policy requires that all investments be investment grade quality and no more than ten percent of our portfolio may be invested in any one security or with one institution.


As of June 30, 2008, approximatelyMarch 31, 2009 our total investment in ARS was $11.5 million of our marketable securities consisted of auction rate securities (ARS), which are variable-rate instruments with longer stated maturities whose interest rates are reset at predetermined short-term intervals through a Dutch auction system.million. Since February 14,13, 2008, auctions for these securities have failed, meaning the parties desiring to sell securities could not be matched with an adequate number of buyers, resulting in our having to continue to hold these securities. Although the securities are Aaa/AAA rated and collateralized by portfolios of student loans guaranteed by the U.S. government, based on current market conditions it is likely that auctions will continue to be unsuccessful in the short-term, limiting the liquidity of these investments until the auction succeeds, the issuer calls the securities, or they mature. The remaining maturity periods range from nineteen to thirty-eight years. As a result, our ability to liquidate our investment and fully recover the carrying value of our investment in the near term may be limited or not exist. Accordingly,

In making our determination whether losses are considered to be “other-than-temporary” declines in value, we consider the following factors at each quarter-end reporting period:

●  
How long and by how much the fair value of the ARS securities have been below cost,
●  
The financial condition of the issuers,
●  
Any downgrades of the securities by rating agencies,
●  
Default on interest or other terms, and
●  
Our intent & ability to hold the ARS long enough for them to recover their value.

For the three months ended March 31, 2009, we recognized $132,000 in other-than-temporary decline in value related to our investment in certain ARS. We also recognized a temporary declineincrease in value of approximately $425,000 related to our investment in certain other ARS as of March 31, 2009 based on the estimated fair value of our ARS investments of approximately $776,000 as of June 30, 2008, based on estimates of the fair value using valuation models and methodologies that utilize an income-based approach to estimate the price that would be received to sell our securities in an orderly transaction between market participants.

If the issuers are unable to successfully close future auctions or their credit ratings deteriorate, we may in the future record an impairment charge on these investments. In addition, these types of developments could cause us to reclassify our investments in ARS from a current asset to a long-term asset.  We believe that the higher average reset interest rates on failed auctions provide sufficient incentive for the security issuers to address this lack of liquidity. While these failures in the auction process have affected our ability to access these funds in the near term, we do not believe that the underlying securities or collateral have been affected.  At this time, we have not obtained sufficient evidence to conclude that these investments are impaired or that they will not be settled within the next twelve months, although the market for these investments is uncertain. We believe that we will not require access to these funds within the next twelve months or prior to restoration of liquidity in this market. It is our intention to hold our ARS until they can be liquidated in a market that facilitates orderly transactions and we believe we have the ability to maintain our investment over that timeframe. In May 2008, we obtained a demand margin loan facility from our investment portfolio manager, allowing us to borrow up to $5.4 million to provide additional cash liquidity if so needed, collateralizeddetermined by the ARS. As of June 30, 2008, we have not drawn any funds against the facility. Any draw-downs would be subject to a rate of interest equal to the prevailing 30-day LIBOR rate plus 100 basis points.
management. These securities will be analyzed each reporting period for additional other-than-temporary impairment factors.  We may be requiredDue to adjust the carryingcurrent uncertainty in the credit markets and the terms of the Rights offering with UBS, we have classified the fair value of these investments through an impairment charge, if any loss is considered to be other than temporary.our ARS as long-term assets as of March 31, 2009.


In May 2008, our investment portfolio manager, UBS AG (UBS), provided us with a demand margin loan facility, allowing us to borrow up to 50% of the market value of the ARS, as determined by UBS. The margin loan facility is collateralized by the ARS.  In October 2008, UBS made a “Rights” offering to its clients, pursuant to which we are entitled to sell to UBS all auction-rate securities held by us in our UBS account. The Rights permit us to require UBS to purchase our ARS for a price equal to original par value plus any accrued but unpaid interest beginning on June 30, 2010 and ending on July 2, 2012 if the securities are not earlier redeemed or sold. As part of the offering, UBS would provide us a line of credit equal to 75% of the market value of the ARS until they are purchased by UBS. The line of credit has certain restrictions described in the prospectus.  We accepted this offer on November 6, 2008.

The weighted average interest rate of marketable securities held at March 31, 2009 was 1.30%. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk arising from changes in the level or volatility of interest rates; however interest rate movements do not materially affect the market value of our ARS because of the frequency of the interest rate resets and the short-term nature of these investments. A reduction in the overall level of interest rates may produce less interest income from our investment portfolio. If overall interest rates had declined by an average of 100 basis points during the three months ended March 31, 2009, the amount of interest income earned from our investment portfolio during that period would have decreased by an estimated amount of $31,000. The market risk associated with our investments in debt securities other than the ARS, as discussed above, is substantially mitigated by the frequent turnover of our portfolio.

ItemItem 4.                 ControlsControls and Procedures

We have evaluated, with the participation of our chief executive officer and our chief financial officer, the effectiveness of our system of disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation our chief executive officer and our chief financial officer have determined that they are effective in connection with the preparation of this report.   There were no changes in the internal controls over financial reporting that occurred during the quarter ended June 30, 2008March 31, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 



PART II – OTHER INFORMATION

Item 1A.                       Risk Factors

  Our results of operations and financial condition are subject to numerous risks and uncertainties described in our Annual Report on Form 10-K for 2007, filed on March 17, 2008, and incorporated herein by reference. You should carefully consider these risk factors in conjunction with the other information contained in this report. Should any of these risks materialize, our business, financial condition and future prospects could be negatively impacted. As of June 30, 2008, there have been no material changes to the disclosures made on the above-referenced Form 10-K.

Item 2.                  Unregistered Sales of Equity Securities and Use of Proceeds

In February 2008, we issued 52,500 shares of common stock to a consultant providing investor relations services valued at approximately $139,000. These securities were issued without registration pursuant to the exemption afforded by Section 4(2) of the Securities Act of 1933, as a transaction by us not involving any public offering.

Item 4.                  Submission of Matters to a Vote of Security Holders

Our annual meeting of stockholders was held on June 20, 2008. There were 45,731,192 shares present in person or by proxy. Our stockholders elected all of the board’s nominees for director and approved various amendments to the 2007 Stock Incentive Plan. The stockholders voted at the meeting as follows:

Proposal One : Election of Directors
Seven nominees of the Board of Directors were elected for one-year terms expiring on the date of the annual meeting in 2009.

 For Withheld
   Terren S. Peizer 39,744,320   5,998,687 
   Richard A. Anderson 39,748,547   5,982,645 
   Andrea Grubb Barthwell., M.D. 39,716,987   6,014,205 
   Marc G. Cummins 43,297,811   2,433,381 
   Christopher S. Hassan 39,748,699   5,982,493 
   Steven A. Kreigsman 43,938,133   1,793,059 
   Jay A. Wolf 43,935,115   1,796,077 

Proposal Two : Increasing Shares Under 2007 Stock Incentive Plan

   For17,439,469
   Against10,824,181
   Abstain16,964
   Non votes17,450,578

Proposal Three : Increasing Shares Available For Incentive Stock Options Under 2007 Stock Incentive Plan

   For17,451,931
   Against10,811,649
   Abstain17,034
   Non votes17,450,578




Proposal Four : Increasing Shares Available For Awards In Any Calendar Year Under 2007 Stock Incentive Plan

   For17,448,858
   Against10,813,46281
   Abstain18,294
   Non votes17,450,578

Proposal Five : Increasing Shares Available For Awards To Any Participant In Any Fiscal Year Under 2007 Stock Incentive Plan

   For17,456,341
   Against10,810,409
   Abstain13,964
   Non votes17,450,578
Item 5.                  Other Information
    Our chief financial officer, Chuck Timpe, intends to retire after the end of the third quarter, and will remain available to work with the company as needed to ensure an orderly and smooth transition.
CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING INFORMATION

This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, business strategies, operating efficiencies or synergies, competitive positions, growth opportunities for existing products, plans and objectives of management, markets for stock of Hythiam and other matters. Statements in this report that are not historical facts are hereby identified as “forward-looking statements” for the purpose of the safe harbor provided by Section 21E of the Exchange Act and Section 27A of the Securities Act. Such forward-looking statements, including, without limitation, those relating to the future business prospects, revenue and income of Hythiam, wherever they occur, are necessarily estimates reflecting the best judgment of the senior management of Hythiam on the date on which they were made, or if no date is stated, as of the date of this report. These forward-looking statements are subject to risks, uncertainties and assumptions, including those described in the “Risk Factors” in Item 1 of Part I of our most recent Annual Report on Form 10-K, filed with the SEC, that may affect the operations, performance, development and results of our business. Because the factors discussed in this report could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any such forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

You should understand that the following important factors, in addition to those discussed above and in the “Risk Factors” could affect our future results and could cause those results to differ materially from those expressed in such forward-looking statements:

●
the anticipated results of clinical studies on our treatment programs, and the publication of those results in medical journals
●
plans to have our treatment programs approved for reimbursement by third-party payers
●
plans to license our treatment programs to more healthcare providers
●
marketing plans to raise awareness of our PROMETA treatment programs
●
anticipated trends and conditions in the industry in which we operate, including
●our future operating results, capital needs, and ability to obtain financing
●
CompCare’s ability to estimate claims, predict utilization and manage its contracts
 
We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or any other reason. All subsequent forward-looking statements attributable to the Company or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to herein. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report may not occur.

Item 6.                 Exhibits

Exhibit 4.1Form of Indenture, incorporated by reference to Exhibit 4.2 to Hythiam, Inc.'s Registration Statement on Form S-3 filed on April 3, 2009
Exhibit 31.1Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


Item 6.                 Exhibits

Exhibit 31.1  Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2  Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1  Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2  Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002




SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
HYTHIAM, INC.
 
 
Date:   AugustMay 11, 20082009 By:  /s/ TERREN S. PEIZER  
  Terren S. Peizer 
  
Chief Executive Officer
(Principal Executive Officer) 
  
Date:   AugustMay 11, 20082009 By:  /s/ CHUCK TIMPEMAURICE HEBERT  
  Chuck Timpe Maurice Hebert
  
Chief Financial Officer
(Principal Financial Officer) 
Date:   August 11 2008 By:  /s/ MAURICE HEBERT  
Maurice Hebert 
Corporate Controller
(Principaland Accounting Officer) 


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