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 September 30, 2015March 31, 2016

Commission File Number 001-31932   

_______________________

CATASYS, INC.

(Exact name of registrant as specified in its charter)

_______________________

11601 WilshireBoulevard, Suite1100, 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☑          No☐Yes ☑          No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, 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☑          No☐Yes ☑          No ☐

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

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

Yes☐            No☑Yes ☐            No ☑

As of NovemberMay 12, 2015,2016, therewere 55,007,761shares of the registrant's common stock, $0.0001 par value, per share, outstanding.

TABLE OF CONTENTS

In this report, except as otherwise stated or the context otherwise requires, the terms “we,” “us” or “our” refer to Catasys, Inc. and our wholly-owned subsidiaries. Our common stock, par value $0.0001 per share, is referred to as “common stock.”

Item 1.     Financial Statements

CATASYS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to the condensed consolidated financial statements.

CATASYS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

See accompanying notes to the condensed consolidated financial statements.

CATASYS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(unaudited)

See accompanying notes to the condensed consolidated financial statements.

Catasys, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

The expected volatility assumptions have been based on the historical and expected volatility of our stock, measured over a period generally commensurate with the expected term. The weighted average expected option term for the three and nine months ended September 30,March 31, 2016 and 2015, and 2014, reflects the application of the simplified method prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 107 (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.

As of September 30, 2015,March 31, 2016, there was $1.2 million$841,000 of total unrecognized compensation cost 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 2.011.51 years.          

Stock Options and Warrants – Non-employees

We account for the issuance of options and warrants for services from non-employees 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, the expected life of the option or warrant, and the expected volatility of our stock and the 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. For unvested shares, the change in fair value during the period is recognized in expense using the graded vesting method.

There were no options issued to non-employees for the three and nine months ended September 30,March 31, 2016 and 2015, and 2014.respectively. Share-based compensation expense relating to stock options and warrants recognized for non-employees was $0 and $3,000$2,000 for the three and nine months ended September 30,March 31, 2016 and 2015, and $2,000 and $5,000 for the three and nine months ended September 30, 2014, respectively.

Non-employeeThere was no stock option activity for the three and nine months ended September 30, 2015, are as follows:

March 31, 2016.

Common Stock

In September 2015, we entered into a Stock Purchase Agreement with Acuitas, relating to the sale and issuance of approximately 1.5 million shares of common stock for gross proceeds of $463,000 (the “September Offering”).

In May 2015, we entered into Warrant Exchange Agreements (the “Exchange Agreements”) whereby 21,277,220 warrants, at an exercise price of $0.58 per shares, issued by the Company between December 2011 and May 2014, were exchanged for 21,277,220 shares of common stock to eliminate the liability associated with these warrants.

There were 0 and 76,000 shares of common stock issued in exchange for investor relations or consulting services during the three and nine months ended September 30,March 31, 2016 and 2015, compared to 55,000 and 255,000 shares issued for the same periods in 2014, respectively. Generally, the costs associated with shares issued for services are being amortized to the related expense on a straight-line basis over the related service periods.

Income Taxes

We have recorded a full valuation allowance against our otherwise recognizable deferred tax assets as of September 30, 2015.March 31, 2016.  As such, we have not recorded a provision for income tax for the period ended September 30, 2015.March 31, 2016.  We utilize the liability method of accounting for income taxes as set forth in ASC 740, Income Taxes. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. In determining the need for valuation allowances, we consider projected future taxable income and the availability of tax planning strategies.  After evaluating all positive and negative historical and perspective evidences, management has determined it is more likely than not that our deferred tax assets will not be realized. 

We assess our income tax positions and record tax benefits for all years subject to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where there is greater than 50% likelihood that a tax benefit will be sustained, we have recorded the largest amount of tax benefit that may potentially be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where there is less than 50% likelihood that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements.  Based on management's assessment of the facts, circumstances and information available, management has determined that all of the tax benefits for the period ended September 30, 2015March 31, 2016 should be realized.   

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities recorded at fair value in the condensed consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure fair value. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level I) and the lowest priority to unobservable inputs (Level III). The three levels of the fair value hierarchy are described below:

The following table summarizes fair value measurements by level at September 30, 2015March 31, 2016 for assets and liabilities measured at fair value:

Financial instruments classified as Level III in the fair value hierarchy as of September 30, 2015,March 31, 2016, represent our liabilities measured at market value on a recurring basis which include warrant liabilities and derivative liabilities resulting from recent debt and equity financings. In accordance with current accounting rules, the warrant liabilities and derivative liabilities are being marked-to-market each quarter-end until they are completely settled. The warrants and derivative liabilities are valued using the Black-Scholes option-pricing model, using both observable and unobservable inputs and assumptions consistent with those used in our estimate of fair value of employee stock options. SeeWarrant Liabilities below.

The following table summarizes our fair value measurements using significant Level III inputs, and changes therein, for the three and nine months ended September 30, 2015:March 31, 2016:

Intangible Assets

As of September 30, 2015, there were no intangible assets subject to amortization.

During the three and nine months ended September 30, 2015, we did not acquire any new intangible assets and at September 30, 2015, we determined that the intangible assets had no value and were written off in full.

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.

Warrant Liabilities

In July 2015,March 2016, we entered into $3.55 million 12% Original Issue Discount Convertible Debenture due January 18, 2016 (the “July 2015 Convertible Debenture”)a promissory note with Acuitas, pursuant to which we received aggregate gross proceeds of $900,000 for the sale of $900,000 in principal amount (the "March 2016 Promissory Note"). The March 2016 Promissory Note is due within 30 business days of demand by Acuitas (the "Maturity Date"), and carries an interest rate on any unpaid principal amount of 8% per annum until the Maturity Date, after which the interest will increase to 12% per annum. In addition, Acuitas was granted five-year warrants to purchase 935,008an aggregate 450,000 shares of our common stock, at an exercise price of $1.90$0.47 per share, which warrants include, subject to adjustment, including for issuances of common stock and common stock equivalents below the then current conversion or exercise price, as the case may becertain exceptions, a full-ratchet anti-dilution protection (the “July 2015“March 2016 Warrants”).

The conversion price ofwarrant liability associated with the July 2015 Convertible Debenture is $1.90 per share, subject to adjustments, including for issuances of common stock and common stock equivalents below the then current conversion or exercise price, as the case may be.  The July 2015 Convertible Debentures are unsecured, bear interest at a rate of 12% per annum payable in cash or shares of common stock, subject to certain conditions, at our option, and are subject to mandatory prepayment upon the consummation of certain future financings. 

The conversion price of the July 2015 Convertible Debenture and the July 2015March 2016 Warrants were subsequently adjusted to $0.30 per sharecalculated using the Black-Scholes model based upon the September Offering.following assumptions:

In May 2015, we entered into the Exchange Agreements whereby 21,277,220 warrants, at an exercise price of $0.58 per shares, issued by the Company between December 2011 and May 2014, were exchanged for 21,277,220 shares of common stock (the “Warrant Exchange”). We recognized a $0 and $4.4 million loss related to the Warrant Exchange for the three and nine months ended September 30, 2015, respectively.

In conjunction with the Securities Purchase Agreement entered in April 2015, the Company issued five year warrants to purchase an aggregate of 530,303 shares of our common stock, at an exercise price of $2.00 per share, subject to adjustment, including for issuances of common stock and common stock equivalents below the then current conversion or exercise price, as the case may be (the “April 2015 Warrants”). The exercise price of the April 2015 Warrants was subsequently adjusted to $0.30 per share based upon the September Offering.

We have issued warrants to purchase common stock in November 2010, December 2011, February 2012, April 2015, July 2015, and July 2015.March 2016. The warrants are being accounted for as liabilities in accordance with FASB accounting rules, due to anti-dilution provisions in some warrants that protect the holders from declines in our stock price and a requirement to deliver registered shares upon exercise of the warrants, which is considered outside our control.  The warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

For the three and nine months ended September 30,March 31, 2016 and 2015, and 2014, we recognized a gainloss of $1.0 million$228,000 and $10.9 million, respectively, compared with a gain of $1.4$2.5 million, and a loss of $19.0 million for the same periods in 2014, respectively, related to the revaluation of our warrant liabilities.

Derivative LiabilitiesLiability

In July 2015, we entered into the July 2015 Convertible Debenture. The derivative liability associated with the July 2015 Convertible Debenture was calculated using the Black-Scholes model based upon the following assumptions:

The expected volatility assumption for 2015the three months ended March 31, 2016 was based on the historical volatility of our stock, measured over a period generally commensurate with the expected term. The weighted average expected lives in years for 2015 reflect the application of the simplified method set out in Security and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 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 use historical data to estimate the rate of forfeitures assumption for awards granted to employees.

For the three and nine months ended September 30,March 31, 2016 and 2015, and 2014, we recognized a loss of $5.0$1.3 million and $0 related to the revaluation of our derivative liability.liability, respectively.

Recently Issued or Newly Adopted Accounting Standards

In February 2015,April 2016, the FASB issued Accounting Standards Update (“ASU”) 2016-10,Revenue from Contracts with Customers (Topic 606), which amends certain aspects of the Board’s new revenue standard, ASU 2014-09, Revenue from Contracts with Customers. The standard should be adopted concurrently with adoption of ASU 2014-09 which is effective for annual and interim periods beginning after December 15, 2017. Early adoption is permitted. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.

In March 2016, the FASB issued ASU 2016-09, Compensation — Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which outlines new provisions intended to simplify various aspects related to accounting for share-based payments and their presentation in the financial statements. The standard is effective for the Company beginning December 15, 2016, and interim periods within those annual periods. Early adoption is permitted. The Company is evaluating the impact of the adoption of this guidance on its financial statements.

In February 2015, the FASB issued ASU 2015-02,Consolidation (Topic 810): Amendments to the Consolidation Analysis (“ASU 2015-02”). ASU 2015-02 modifies existing consolidation guidance for reporting organizations that are required to evaluate whether they should consolidate certain legal entities. ASU 2015-02 is effective for fiscal years and interim periods within those years beginning after December 15, 2015, and requires either a retrospective or a modified retrospective approach to adoptions. Early adoption is permitted. We are currently evaluating the potential impact of this standard on our consolidated financial statements, as well as the available transition methods.

In August 2014, the FASB issued FASB ASU 2014-15,Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern,(“ASU 2014-15”).ASU 2014-15 changes to the disclosure of uncertainties about an entity’s ability to continue as a going concern. Under U.S. GAAP, continuation of a reporting entity as a going concern is presumed as the basis for preparing financial statements unless and until the entity’s liquidation becomes imminent. Even if an entity’s liquidation is not imminent, there may be conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern. Because there is no guidance in U.S. GAAP about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern or to provide related note disclosures, there is diversity in practice whether, when, and how an entity discloses the relevant conditions and events in its financial statements. As a result, these changes require an entity’s management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that financial statements are issued. Substantial doubt is defined as an indication that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that financial statements are issued. If management has concluded that substantial doubt exists, then the following disclosures should be made in the financial statements: (i) principal conditions or events that raised the substantial doubt, (ii) management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations, (iii) management’s plans that alleviated the initial substantial doubt or, if substantial doubt was not alleviated, management’s plans that are intended to at least mitigate the conditions or events that raise substantial doubt, and (iv) if the latter in (iii) is disclosed, an explicit statement that there is substantial doubt about the entity’s ability to continue as a going concern. ASU 2014-15 is effective for periods beginning after December 15, 2016. The adoption of ASU 2013-15 will not have a material effect on our consolidated financial position or results of operations.

Item 2.     Management'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 includedelsewherein this report.

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 our stock 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 of 1934 and Section 27A of the Securities Act of 1933. Such forward-looking statements, including, without limitation, those relating to the future business prospects, our revenue and income, wherever they occur, are necessarily estimates reflecting the best judgment of our senior management as of 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 1A of Part I of our most recent Annual Report on Form 10-K (“Form 10-K”) for the fiscal year ended December 31, 20142015 and other reports we filed with the Securities and Exchange Commission (“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. We assume no obligation and do not intend to update these forward looking statements, except as required by law.

OVERVIEW

General

We provide data analytics based specialized healthcarebehavioral health management and treatment services to health plans and other third party payors through our OnTrak program. Our OnTrak program is designed to improve member health and at the same time lower costs to the insurer for underserved populations where behavioral health conditions are causing or exacerbating co-existing medical conditions. The program utilizes proprietary analytics, member engagement and patient centric treatment that integrates evidence-based medical and psychosocial interventions along with care coaching in a 52-week outpatient program. Our initial focus was members with substance use disorders. In the second quarter of 2015, we expanded our program into anxiety disorders, and we have plans to expand into other behavioral health conditions for depression. We currently operate our OnTrak programs in Florida, Illinois, Kansas, Kentucky, Louisiana, Massachusetts, Missouri, New Jersey, Oklahoma, Pennsylvania, Texas, West Virginia and Wisconsin.Wisconsin, and our OnTrak for anxiety program in Kansas. We provide services to commercial (employer funded), managed Medicare Advantage and managed Medicaid populations. 

Recent Developments

On October 16, 2015,In March 2016, we entered into Stock Purchase Agreements (the “Purchase Agreements”)a promissory note with each of Acuitas Group Holdings, LLC (“Acuitas”), a limited liability company 100% owned by Terren S. Peizer, Chairman andour Chief Executive Officer of the Company, Shamus, LLC (“Shamus”), a company owned by David E. Smith, a member of the Company’s board of directors, and Steve Gorlin, a member of the Company’s board of directors (the “Investors”), Chairman,pursuant to which we received aggregate gross proceeds of $2.0 million$900,000 for the sale of approximately 6.7 million$900,000 in principal amount (the "March 2016 Promissory Note"). The March 2016 Promissory Note is due within 30 business days of demand by Acuitas (the "Maturity Date"), and carries an interest rate on any unpaid principal amount of 8% per annum until the Maturity Date, after which the interest will increase to 12% per annum. In addition, Acuitas was granted five-year warrants to purchase an aggregate 450,000 shares of our common stock, at a purchasean exercise price of $0.30$0.47 per share.share which warrants include, subject to certain exceptions, a full-ratchet anti-dilution protection ( the “March 2016 Warrants”).

In addition,April 2016, we andamended the March 2016 Promissory Note with Acuitas, entered into an amendment to increase the 12% Original Issue Discount Convertible Debenture (the “Convertible Debenture”) dated July 30, 2015 which extended the maturity dateamount of the Convertible Debenture from January 18,March 2016 Promissory Note by $400,000, for a total of $1.3 million in principle amount. In connection with the amendment, Acuitas was granted five-year warrants to January 18, 2017 and extended the date bypurchase an additional 200,000 shares of our common stock, at an exercise price of $0.47 which we must consummatewarrants include, subject to certain exceptions, a qualified public offering from December 31, 2015 to June 30, 2016.full-ratchet anti-dilution protection.

Operations

In the third quarter of 2015, we operatedWe currently operate our OnTrak programs in Florida, Illinois, Kansas, Kentucky, Louisiana, Massachusetts, Missouri, New Jersey, Oklahoma, Pennsylvania, Texas, West Virginia, and Wisconsin. During the third quarter of 2015, we launched our programs in IllinoisWe provide services to commercial (employer funded), managed Medicare Advantage and Missouri and signed an agreement with one of our national health plan customers to expand our program to Pennsylvania. In addition, we received approval from one of our national health plan customers to expand our program starting in the fourth quarter of 2015 to its Medicare members in several states under our national contract, which was signed earlier this year. In the third quarter 2015 we enrolled 230% more members in our programs than in the third quarter of 2014.managed Medicaid populations. We have generated fees from our launched programs and expect to increase enrollment and fees throughout 2015.2016. However, there can be no assurance that we will generate such fees or that new programs will launch as we expect.

Discontinued Operations

We have discontinued our license and management fees segment. The operations of this segment were shut down effective April 1, 2014 and all of the assets were absorbed by the healthcare services segment.

RESULTS OF OPERATIONS

Table of Summary Consolidated Financial Information

The table below and the discussion that follows summarize our results of consolidated operations for the three and nine months ended September 30, 2015March 31, 2016 compared to the three and nine months ended September 30, 2014:March 31, 2015:

Summary of Consolidated Operating Results

Loss from continuing operations before provision for income taxes for the three and nine months ended September 30, 2015March 31, 2016 was $7.5 million and $8.3$4.3 million, compared with a net loss of $207,000 and $25.3 million$258,000 for the same periodsperiod in 2014, respectively.2015. The difference primarily relates to the increasedecrease in the change in fair value of warrant liability offset by a loss on exchange of warrants,and the decrease in the change in fair value of the derivative liability and an increase in general and administrative expenses for the three and nine months ended September 30, 2015,March 31, 2016, compared to the same periodsperiod in 2014.2015.

Revenues

During the ninethree months ended September 30, 2015,March 31, 2016, we have expanded our customer base and health plan populations covered under our programs, which has resulted in a significant increase in the number of patients enrolled in our programs compared with the same period in 2014.2015. For the ninethree months ended September 30, 2015,March 31, 2016, enrollment increased by more than 230%175% over the same period in 2014.2015. Recognized revenue increased by $168,000 and $562,000,$295,000, or 45% and 64%,68% for the three and nine months ended September 30, 2015,March 31, 2016, compared with the same periods in 2014,2015, respectively. We reserve a portion, and in some cases all, of the revenue related to these contracts as the revenue is subject to performance guarantees, or in the instance of case rates received upon enrollment and other fees in advance, recognized ratably over the period of enrollment. Deferred revenue increased by $1.2 million$593,000 since December 31, 2014, and a $701,000 increase since June 30, 2015.

Cost of Healthcare Services

Cost of healthcare services consists primarily of salaries related to our care coaches, community care coordinators, healthcare provider claimclaims payments to our network of physicians and psychologists, and fees charged by our third party administrators for processing these claims.  The increase of $374,000 and $777,000$560,000 for the three and nine months ended September 30, 2015,March 31, 2016, compared with the same periodsperiod in 2014, respectively,2015, relates primarily to the increase in the number of members being treated, and the addition of care coaches and clinical care coordinators to our staff to manage the increasing number of enrolled members, and the expansion of our program in Kansas to cover high cost members with anxiety disorders.

General and Administrative Expenses

Total general and administrative expense increaseddecreased by $372,000 and $2.5 million$547,000 for the three and nine months ended September 30, 2015,March 31, 2016, compared with the same periodsperiod in 2014, respectively.2015. The increasedecrease was due primarily due to an increasea decrease in share-based compensation expense related to stock options issued to our board of directors during the first quarter of 2015, investor relations services, and legal services.2015.

Other IncomeDepreciation and Amortization

The decrease of $1.2 million in other income relates toDepreciation and amortization was immaterial for the 2014 write off of all balances in accounts payablethree months ended March 31, 2016 and accrued liabilities related to a contract that was amended and breached in 2010 for which the statute expired in accordance with Section 337 of the California Code of Civil procedures during the second quarter of 2014.2015, respectively.

Interest Expense

Interest expense increased by $1.2 million and decreased by $455,000, respectively,$331,000 for the three and nine months ended September 30, 2015March 31, 2016 compared with the same periodsperiod in 2014, respectively.2015. The increase relatesrelated to the issuance of warrants as part of the April 2015our March 2016 financings and July 2015 financingsno such warrants were issued during the ninethree months ended September 30,March 31, 2015.

Loss on Exchange of Warrant

The loss of $4.4 million on the exchange of warrants related to the exchange of 21,277,220 warrants in for 21,277,220 shares of common stock in May 2015 for the nine months ended September 30, 2015.

Change in fair value of warrant liability

We have issued warrants to purchase common stock in November 2010, December 2011, February 2012, April 2015, July 2015, and July 2015.March 2016. The warrants are being accounted for as liabilities in accordance with Financial Accounting Standards Board (“FASB”)FASB accounting rules, due to anti-dilution provisions in some warrants that protect the holders from declines in our stock price and a requirement to deliver registered shares upon exercise of the warrants, which is considered outside our control.  The warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

The decrease in the change in fair value for the warrants was $390,000$2.7 million for the three months ended September 30, 2015 and 2014, and an increase of $29.9 million for the nine months ended September 30, 2015March 31, 2016 compared with the same period in 2014.2015.

We will continue to mark-to-market the warrants to market value each quarter-end until they are completely settled.

Change in fair value of derivativewarrant liability

The change in fair value of derivative liabilities was $5.0$2.7 million for the three and nine months ended September 30, 2015March 31, 2016 compared with the same period in 2014.2015. The derivative liability was the result of the issuance of the July 2015 Convertible Debenture.

We will continue to mark-to-market the derivative liability to market value each quarter-end until they are completely settled.

Depreciation and Amortization

Depreciation and amortization was immaterial for the three and nine months ended September 30, 2015 and 2014, respectively.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity and Going Concern

As of NovemberMay 12, 2015,2016, we had a balance of approximately $1.3 million$78,000 cash on hand. We had a working capital deficit of approximately $11.3$12.4 million at September 30, 2015.March 31, 2016. We have incurred significant operating losses and negative operating cash flows since our inception. We could continue to incur negative cash flows and operating losses for the next twelve months. Our current cash burn rate is approximately $450,000 per month, excluding non-current accrued liability payments. We expect our current cash resources to cover expenses through the first quarterend of May 2016; however delays in cash collections, revenue, or unforeseen expenditures could impact this estimate.We are in need of additional capital, however, there is no assurance that additional capital can be timely raised in an amount which is sufficient for us or on terms favorable to us and our stockholders, if at all. If we do not obtain additional capital, there is a significant doubt as to whether we can continue to operate as a going concern and we will need to curtail or cease operations or seek bankruptcy relief. If we discontinue operations, we may not have sufficient funds to pay any amounts to our stockholders.

On October 16, 2015,In April 2016, we entered intoamended the Purchase AgreementsMarch 2016 Promissory Note with eachAcuitas to increase the amount of the March 2016 Promissory Note by $400,000, for a total of $1.3 million in principle amount. In connection with the amendment, Acuitas Shamus, and Steve Gorlin, pursuantwas granted five-year warrants to which we received gross proceeds of $2.0 million for the sale of approximately 6.7 millionpurchase an additional 200,000 shares of our common stock, at a purchasean exercise price of $0.30 per share.$0.47.

In addition, we and Acuitas entered into an amendment to the Convertible Debenture which extended the maturity date of the Convertible Debenture from January 18, 2016 to January 18, 2017 and extended the date the by which we must consummate a qualified public offering from December 31, 2015 to June 30, 2016.

Our ability to fund our ongoing operations and continue as a going concern is dependent on increasing the number of members that are eligible for our programs by signing new contracts and generating fees from existing and new contracts for our Catasys managed care programs and the success of management’s plans to increase revenue and continue to control expenses. We currently operate our OnTrak programprograms in Florida, Illinois, Kansas, Kentucky, Louisiana, Massachusetts, Missouri, New Jersey, Oklahoma, Pennsylvania, Texas, West Virginia, and Wisconsin. During the third quarter of 2015, we launched our programs in IllinoisWe provide services to commercial (employer funded), managed Medicare Advantage and Missouri and signed an agreement with one of our national health plan customers to expand our program to Pennsylvania. In addition, we received approval from one of our national health plan customers to expand our program starting in the fourth quarter of 2015 to its Medicare members in several states under our national contract, which was signed earlier this year. In the third quarter of 2015 we enrolled 230% more members in our programs than in the third quarter of 2014.managed Medicaid populations. We have generated fees from our launched programs and expect to increase enrollment and fees throughout 2015.2016. However, there can be no assurance that we will generate such fees or that new programs will launch as we expect. We are in need of additional capital, however, there is no assurance that additional capital can be timely raised in an amount which is sufficient for us or on terms favorable to us and our stockholders, if at all. If we do not obtain additional capital, there is a significant doubt as to whether we can continue to operate as a going concern and we will need to curtail or cease operations or seek bankruptcy relief. If we discontinue operations, we may not have sufficient funds to pay any amounts to our stockholders.

Cash Flows

We used $3.9$1.5 million of cash for continuingfrom operating activities during the ninethree months ended September 30, 2015March 31, 2016 compared with $3.4 million$811,000 in the same period in 2014, respectively.2015. The increase in cash used in operating activities reflects the increase in the number of members being treated, the addition of care coaches and clinical care coordinators to our staff to manage the increasing number of enrolled members, and the expansion of our program in Kansas to cover high cost members with anxiety disorders. Significant non-cash adjustments to operating activities for the ninethree months ended September 30, 2015March 31, 2016 included share-based compensation expense of $1.2 million, amortization of debt discount of $2.2 million, loss on exchange of warrants of $4.4 million,a fair value adjustment on derivative liability of $5.0$1.3 million, offset by a fair value adjustment on warrant liability of $10.9 million.$228,000, and issuance costs of $216,000 related to the March 2016 Promissory Note.

Capital expenditures for the ninethree months ended September 30, 2015March 31, 2016 were not material. We anticipate that capital expenditures will increase in the future as we replace our computer systems that are reaching their useful lives, upgrade equipment to support our increased number of enrolled members, and enhance the reliability and security of our systems. These future capital expenditure requirements will depend upon many factors, including obsolescence or failure of our systems, progress with expanding the adoption of our programs, and our marketing efforts, 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.

Our net cash provided by financing activities was $3.5 million$858,000 for the ninethree months ended September 30, 2015,March 31, 2016, compared with net cash provided by financing activities of $4.1 million$195,000 for the ninethree months ended September 30, 2014, respectively.March 31, 2015. Cash provided by financing activities for the ninethree months ended September 30, 2015 primarilyMarch 31, 2016 consisted of the net proceeds from the issuanceloan provided by Acuitas in March 2016, leaving a balance of our 12% Original Issue Discount Convertible Debenture$262,000 in July 2015.cash and cash equivalents at March 31, 2016.

As discussed above, we currently expend cash at a rate of approximately $450,000 per month, excluding non-current accrued liability payments.month. We also anticipate cash inflow to increase during 20152016 as we continue to service our executed contracts and sign new contracts. We expect our current cash resources to cover our operations through the first quarterend of 2015;May 2016; however delays in cash collections, revenue, or unforeseen expenditures could impact this estimate. We are in need of additional capital, however, there is no assurance that additional capital can be timely raised in an amount which is sufficient for us or on terms favorable to us and our stockholders, if at all. If we do not obtain additional capital, there is a significant doubt as to whether we can continue to operate as a going concern and we will need to curtail or cease operations or seek bankruptcy relief. If we discontinue operations, we may not have sufficient funds to pay any amounts to our stockholders.

OFF BALANCE SHEET ARRANGEMENTS

As of September 30, 2015,March 31, 2016, we had no off-balance sheet arrangements.

CRITICAL ACCOUNTING ESTIMATES

The discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). U.S. GAAP requires management to make 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 about the carrying values of assets and liabilities that may not be readily apparent from other sources. On an on-going basis, we evaluate the appropriateness of our estimates and we maintain a thorough process to review the application of our accounting policies. Our actual results may differ from these 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 related to the fair value of warrants, the estimation of the fair value of our derivative liabilities,liability, and share-based compensation expense, and the impairment assessment for intangible assets, involve our most significant judgments and estimates that are material to our consolidated financial statements. They are discussed further below.

Warrant Liabilities

We have issued warrants to purchase common stock in November 2010, December 2011, February 2012, April 2015, July 2015, and July 2015.March 2016. The warrants are being accounted for as liabilities in accordance with FASB accounting rules, due to anti-dilution provisions in some warrants that protect the holders from declines in our stock price and a requirement to deliver registered shares upon exercise of the warrants, which is considered outside our control.  The warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

In May 2015, we entered into Warrant Exchange Agreements whereby 21,277,220 warrants, at an exercise price of $0.58 per shares, issued by the Company between December 2011 and May 2014, were exchanged for 21,277,220 shares of common stock. The principle purpose of the warrant exchange was to increase stockholders’ equity by eliminating a liability associated with these warrants. 

For the three and nine months ended September 30,March 31, 2016 and 2015, and 2014, we recognized a gainloss of $1.0 million$228,000 and $10.9 million, respectively, compared with a gain of $1.4$2.5 million, and a loss of $19.0 million for the same periods in 2014, respectively, related to the revaluation of our warrant liabilities.

We will continue to mark the warrants to market value each reporting period, using the Black-Scholes pricing model until they are completely settled or expire.

Derivative Liabilities

In July 2015, we entered into the July 2015 Convertible Debenture. The derivative liability associated with the July 2015 Convertible Debenture was calculated using the Black-Scholes model based upon the following assumptions:

The expected volatility assumption for the ninethree months ended September 30, 2015March 31, 2016 was based on the historical volatility of our stock, measured over a period generally commensurate with the expected term. The weighted average expected lives in years for 2015 reflect the application of the simplified method set out in Security and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 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 use historical data to estimate the rate of forfeitures assumption for awards granted to employees.

For the three and nine months ended September 30,March 31, 2016 and 2015, and 2014, we recognized a loss of $5.0$1.3 million and $0 related to the revaluation of our derivative liability.liability, respectively.

Share-based compensation expense

We account for the issuance of stock, stock options, and warrants for services from non-employees based on an estimate of 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 compensation 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, measured over a period generally commensurate with the expected term. If we were to use a different volatility than the actual volatility of our stock price, there may be a significant variance in the amounts of share-based compensation expense from the amounts reported. The weighted average expected option term for the ninethree months ended September 30,March 31, 2016 and 2015, and 2014, reflects the application of the simplified method set out in SEC 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.

From time to time, we retain terminated employees as part-time consultants upon their resignation from the Company. Because the employees continue to provide services to us, their options continue to vest in accordance with the original terms. Due to the change in classification of the option awards, the options are considered modified at the date of termination. The modifications are treated as exchanges of the original awards in return for the issuance of new awards. At the date of termination, the unvested options are no longer accounted for as employee awards and are accounted for as new non-employee awards. The accounting for the portion of the total grants that have already vested and have been previously expensed as equity awards is not changed. There were no employees moved to consulting status for the three and nine months ended September 30,March 31, 2016 and 2015, and 2014.

Impairment of Intangible Assets

We have capitalized significant costs for acquiring patents and other intellectual property directly related to our products and services. We review our intangible assets for impairment whenever events or circumstances indicate that the carrying amount of these assets may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and/or their eventual disposition. If the estimated undiscounted future cash flows are less 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.

During the three and nine months ended September 30, 2015, we did not acquire any new intangible assets and at September 30, 2015, we determined that the intangible assets had no value and were written off in full.respectively.

RECENT ACCOUNTING PRONOUNCEMENTS

In February 2015,April 2016, the FASB issued Accounting Standards Update (“ASU”) 2015-02,2016-10,Revenue from Contracts with Customers (Topic 606), which amends certain aspects of the Board’s new revenue standard, ASU 2014-09, Revenue from Contracts with Customers. The standard should be adopted concurrently with adoption of ASU 2014-09 which is effective for annual and interim periods beginning after December 15, 2017. Early adoption is permitted. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.

In March 2016, the FASB issued ASU 2016-09, Compensation — Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which outlines new provisions intended to simplify various aspects related to accounting for share-based payments and their presentation in the financial statements. The standard is effective for the Company beginning December 15, 2016, and interim periods within those annual periods. Early adoption is permitted. The Company is evaluating the impact of the adoption of this guidance on its financial statements.

In February 2015, the FASB issued ASU,Consolidation (Topic 810): Amendments to the Consolidation Analysis (“ASU 2015-02”). ASU 2015-02 modifies existing consolidation guidance for reporting organizations that are required to evaluate whether they should consolidate certain legal entities. ASU 2015-02 is effective for fiscal years and interim periods within those years beginning after December 15, 2015, and requires either a retrospective or a modified restrospective approach to adoptions. Early adoption is permitted. We are currently evaluating the potential impact of this standard on our consolidated financial statements, as well as the available transition methods.

In August 2014, the FASB issued FASB ASU 2014-15,Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern,(“ASU 2014-15”).ASU 2014-15 changes to the disclosure of uncertainties about an entity’s ability to continue as a going concern. Under U.S. GAAP, continuation of a reporting entity as a going concern is presumed as the basis for preparing financial statements unless and until the entity’s liquidation becomes imminent. Even if an entity’s liquidation is not imminent, there may be conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern. Because there is no guidance in U.S. GAAP about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern or to provide related note disclosures, there is diversity in practice whether, when, and how an entity discloses the relevant conditions and events in its financial statements. As a result, these changes require an entity’s management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that financial statements are issued. Substantial doubt is defined as an indication that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that financial statements are issued. If management has concluded that substantial doubt exists, then the following disclosures should be made in the financial statements: (i) principal conditions or events that raised the substantial doubt, (ii) management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations, (iii) management’s plans that alleviated the initial substantial doubt or, if substantial doubt was not alleviated, management’s plans that are intended to at least mitigate the conditions or events that raise substantial doubt, and (iv) if the latter in (iii) is disclosed, an explicit statement that there is substantial doubt about the entity’s ability to continue as a going concern. ASU 2014-15 is effective for periods beginning after December 15, 2016. The adoption of ASU 2013-15 will not have a material effect on our consolidated financial position or results of operations.

Item 3.     Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

Item 4.     Controls and Procedures

Disclosure Controls

We have evaluated, with the participation of our principal executive officer and our principal financial officer, the effectiveness of our disclosure controls and procedures (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) as of September 30, 2015.March 31, 2016. Based on this evaluation, our principal executive officer and our principal financial officer have concluded that as of September 30, 2015, March 31, 2016,our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Controlover Financial Reporting

There were no changes in our internal controls over financial reporting during the three months ended September 30, 2015,March 31, 2016, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 1.        Legal Proceedings

None.

Item 1A.     Risk Factors

There have been no material changes in our risk factors from those disclosed in our most recent Annual Report on Form 10-K.

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

None.In connection with the March 2016 Promissory Note, Acuitas was granted five-year warrants to purchase an aggregate 450,000 shares of our common stock, at an exercise price of $0.47 per share.

In connection with the amendment to the March 2016 Promissory Note with Acuitas to increase the amount of the March 2016 Promissory Note by $400,000, for a total of $1.3 million in principle amount. Acuitas was granted five-year warrants to purchase an additional 200,000 shares of our common stock, at an exercise price of $0.47.

The warrants were issued without registration pursuant to exemption afforded by Section 4(a)(2) of the Securities Act of 1933, as amended.

Item 3.        Defaults Upon Senior Securities

None.

Item 4.        Mine Safety Disclosures.

Not applicable.

Item 5.     Other Information

     None.In April 2016, we amended the March 2016 Promissory Note with Acuitas to increase the amount of the March 2016 Promissory Note by $400,000, for a total of $1.3 million in principle amount. In connection with the amendment, Acuitas was granted five-year warrants to purchase an additional 200,000 shares of our common stock, at an exercise price of $0.47 which warrants include, subject to certain exceptions, a full-ratchet anti-dilution protection.

Item 6.     Exhibits

* filed herewith.

** furnished herewith.

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.

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