Foundation Healthcare (FDNH) 10-Q 2014 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2014

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

For the transition period from                    to                    

Commission File Number: 001-34171

FOUNDATION HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)

OKLAHOMA	20-0180812
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

14000 N. Portland Avenue, Ste. 200

Oklahoma City, Oklahoma 73134

(Address of principal executive offices)

(405) 608-1700

(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.    x  Yes    ¨  No

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).    x  Yes    ¨  No

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

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨  (Do not check if a smaller reporting company)	Smaller reporting company	x

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

As of May 15, 2014, 171,247,581 shares of the registrant’s common stock, $0.0001 par value, were outstanding.

FOUNDATION HEALTHCARE, INC.

FORM 10-Q

For the Quarter Ended March 31, 2014

TABLE OF CONTENTS

Part I.	Financial Information
Item 1.	Consolidated Condensed Financial Statements (Unaudited)	1
	a) Balance Sheets	2
	b) Statements of Operations	3
	c) Statements of Cash Flows	4
	d) Notes to Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	28
Item 4.	Controls and Procedures	28
Part II.	Other Information
Item 1.	Legal Proceedings	29
Item 1A.	Risk Factors	29
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	29
Item 3.	Defaults Upon Senior Securities	30
Item 4.	Mine Safety Disclosures	30
Item 5.	Other Information	30
Item 6.	Exhibits	30
SIGNATURES		31

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

Certain statements under the captions “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Item 1A. Risk Factors,” and elsewhere in this report constitute “forward-looking statements” Certain, but not necessarily all, of such forward-looking statements can be identified by the use of forward-looking terminology such as “anticipates,” “believes,” “expects,” “may,” “will,” or “should” or other variations thereon, or by discussions of strategies that involve risks and uncertainties. Our actual results or industry results may be materially different from any future results expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially include general economic and business conditions; our ability to implement our business strategies; competition; availability of key personnel; increasing operating costs; unsuccessful promotional efforts; changes in brand awareness; acceptance of new product offerings; and adoption of, changes in, or the failure to comply with, and government regulations.

Throughout this report the first personal plural pronoun in the nominative case form “we” and its objective case form “us”, its possessive and the intensive case forms “our” and “ourselves” and its reflexive form “ourselves” refer collectively to Foundation Healthcare, Inc. and its subsidiaries including Foundation Surgery Affiliates, LLC (“FSA”) and Foundation Surgical Hospital Affiliates, LLC (“FSHA”).

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PART I. FINANCIAL INFORMATION

Item 1. Foundation Healthcare, Inc. Condensed Consolidated Financial Statements.

The condensed consolidated financial statements included in this report have been prepared by us pursuant to the rules and regulations of the Securities and Exchange Commission. The condensed consolidated balance sheets as of March 31, 2014 and December 31, 2013, the condensed consolidated statements of operations for the three months ended March 31, 2014 and 2013, and the condensed consolidated statements of cash flows for three months ended March 31, 2014 and 2013, have been prepared without audit. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed consolidated financial statements be read in conjunction with the financial statements and the related notes thereto included in our latest annual report on Form 10-K.

The consolidated statements for the unaudited interim periods presented include all adjustments, consisting of normal recurring adjustments, necessary to present a fair statement of the results for such interim periods. The results for any interim period may not be comparable to the same interim period in the previous year or necessarily indicative of earnings for the full year.

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FOUNDATION HEALTHCARE, INC.

Condensed Consolidated Balance Sheets

(Unaudited)

	March 31, 2014			December 31, 2013
ASSETS
Cash and cash equivalents	$	3,958,742		$	4,212,076
Accounts receivable, net of allowances for doubtful accounts of $2,536,980 and $4,778,915, respectively		12,655,299			12,755,642
Receivables from affiliates		854,987			848,002
Supplies inventories		1,940,870			1,931,142
Prepaid and other current assets		4,805,921			4,302,885
Current assets from discontinued operations		199,032			518,629
Total current assets		24,414,851			24,568,376
Property and equipment, net		11,479,697			12,073,986
Equity method investments in affiliates		5,600,880			5,699,093
Intangible assets, net		10,624,754			11,138,621
Goodwill		973,927			973,927
Other assets		226,784			244,598
Other assets from discontinued operations		513,379			576,228
Total assets	$	53,834,272		$	55,274,829
LIABILITIES, PREFERRED NONCONTROLLING INTEREST AND SHAREHOLDERS’ DEFICIT
Liabilities:
Accounts payable	$	10,627,288		$	11,648,987
Accrued liabilities		5,148,921			4,114,915
Preferred noncontrolling interests dividends payable		121,878			195,411
Short term debt		6,183,610			5,664,827
Current portion of long-term debt		10,592,445			7,919,179
Other current liabilities		3,031,628			4,391,587
Current liabilities from discontinued operations		5,507,982			5,620,697
Total current liabilities		41,213,752			39,555,603
Long-term debt, net of current portion		5,988,737			10,031,732
Other liabilities		15,112,635			12,255,809
Other liabilities from discontinued operations		—			9,969
Total liabilities		62,315,124			61,853,113
Preferred noncontrolling interest		8,700,000			8,700,000
Commitments and contingencies (Note 9)
Foundation Healthcare shareholders’ deficit:
Preferred stock $0.0001 par value, 10,000,000 authorized; no shares issued and outstanding		—			—
Common stock $0.0001 par value, 500,000,000 shares authorized; 171,323,381 and 163,834,886 issued and outstanding, respectively		17,132			16,383
Paid-in capital		18,759,152			18,241,756
Accumulated deficit		(37,066,821	)		(35,171,315	)
Total Foundation Healthcare shareholders’ deficit		(18,290,537	)		(16,913,176	)
Noncontrolling interests		1,109,685			1,634,892
Total deficit		(17,180,852	)		(15,278,284	)
Total liabilities, preferred noncontrolling interest and shareholders’ deficit	$	53,834,272		$	55,274,829

See Accompanying Notes to Condensed Consolidated Financial Statements

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FOUNDATION HEALTHCARE, INC.

Condensed Consolidated Statements of Operations

For the Three Months Ended March 31, 2014 and 2013

(Unaudited)

	2014			2013
Net Revenues:
Patient services	$	19,513,483		$	15,860,660
Management fees from affiliates		1,269,306			1,738,228
Equity in earnings of affiliates		527,083			1,216,715
Other revenue		1,118,326			474,889
Provision for doubtful accounts		(361,517	)		(636,851	)
Revenues		22,066,681			18,653,641
Operating Expenses:
Salaries and benefits		7,977,419			6,338,097
Supplies		4,941,370			4,500,940
Other operating expenses		9,042,701			7,756,021
Depreciation and amortization		1,466,268			1,116,687
Total operating expenses		23,427,758			19,711,745
Other Income (Expense):
Interest expense, net		(496,121	)		(466,669	)
Other income		—			93,007
Net other (expense)		(496,121	)		(373,662	)
Income (loss) from continuing operations, before taxes		(1,857,198	)		(1,431,766	)
Benefit for income taxes		852,005			—
Income (loss) from continuing operations, net of taxes		(1,005,193	)		(1,431,766	)
Loss from discontinued operations, net of tax		(312,323	)		—
Net income (loss)		(1,317,516	)		(1,431,766	)
Less: Net income attributable to noncontrolling interests		384,921			(1,092,031	)
Net income (loss) attributable to Foundation Healthcare		(1,702,437	)		(339,735	)
Preferred noncontrolling interests dividends		(193,069	)		—
Net income (loss) attributable to Foundation Healthcare common stock	$	(1,895,506	)	$	(339,735	)
Earnings per common share (basic and diluted):
Net income (loss) attributable to continuing operations attributable to Foundation Healthcare common stock	$	(0.01	)	$	(0.00	)
Loss from discontinued operations, net of tax		(0.00	)		—
Net income (loss) per share, attributable to Foundation Healthcare common stock	$	(0.01	)	$	(0.00	)
Weighted average number of common and diluted shares outstanding		167,329,517			162,523,276
Pro forma income information (Note 3):
Pro forma benefit for income taxes				$	129,099
Pro forma net loss attributable to Foundation Healthcare common stock				$	(210,636	)
Pro forma basic and diluted net income (loss) per share				$	(0.00	)

See Accompanying Notes to Condensed Consolidated Financial Statements

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FOUNDATION HEALTHCARE, INC.

Condensed Consolidated Statements of Cash Flows

For the Three Months Ended March 31, 2014 and 2013

(Unaudited)

	2014			2013
Operating activities:
Net income (loss)	$	(1,317,516	)	$	(1,431,766	)
Less: Loss from discontinued operations, net of tax		(312,323	)		—
Income (loss) from continuing operations		(1,005,193	)		(1,431,766	)
Adjustments to reconcile loss from continuing operations to net cash provided by (used in) operating activities:
Depreciation and amortization		1,466,268			1,116,687
Stock-based compensation, net of cashless vesting		518,145			—
Provision for doubtful accounts		361,517			636,851
Equity in earnings of affiliates		(527,083	)		(1,216,715	)
Changes in assets and liabilities –
Accounts receivable, net of provision for doubtful accounts		(261,174	)		(2,111,768	)
Receivables from affiliates		(6,985	)		(35,691	)
Supplies Inventories		(9,728	)		38,020
Prepaid and other current assets		(503,036	)		(246,902	)
Other assets		17,814			—
Accounts payable		(1,021,699	)		(1,437,536	)
Accrued liabilities		1,034,006			3,286,995
Other current liabilities		(1,359,959	)		30,000
Other liabilities		2,856,826			(3,905	)
Net cash provided by (used in) operating activities from continuing operations		1,559,719			(1,375,730	)
Net cash provided by operating activities from discontinued operations		76,726			—
Net cash provided by (used in) operating activities		1,636,445			(1,375,730	)
Investing activities:
Purchase of property and equipment		(358,112	)		(2,612,598	)
Distributions from affiliates		625,296			1,266,100
Net cash provided by (used in) investing activities from continuing operations		267,184			(1,346,498	)
Net cash provided by investing activities from discontinued operations		—			—
Net cash provided by (used in) investing activities		267,184			(1,346,498	)
Financing activities:
Debt proceeds	$	767,923		$	3,431,211
Debt payments		(1,618,869	)		(1,383,326	)
Preferred noncontrolling interests dividends		(266,602	)		(424,594	)
Distributions to noncontrolling interests		(910,128	)		(37,444	)
Distributions to member		—			(377,930	)
Net cash provided by (used in) financing activities from continuing operations		(2,027,676	)		1,207,917
Net cash (used in) financing activities from discontinued operations		(129,287	)		—
Net cash provided by (used in) financing activities		(2,156,963	)		1,207,917
Net change in cash and cash equivalents		(253,334	)		(1,514,311	)
Cash and cash equivalents at beginning of period		4,212,076			3,037,067
Cash and cash equivalents at end of period	$	3,958,742		$	1,522,756
Cash Paid for Interest and Income Taxes:
Interest expense	$	504,509		$	443,709
Interest expense, discontinued operations	$	62,234		$	—
Income taxes, continuing operations	$	1,950,000		$	—

See Accompanying Notes to Condensed Consolidated Financial Statements

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FOUNDATION HEALTHCARE, INC.

Notes to Condensed Consolidated Financial Statements

For the Periods Ended March 31, 2014 and 2013

(Unaudited)

Note 1 – Nature of Business

Foundation Healthcare, Inc. (the “Company”) is organized under the laws of the state of Oklahoma and owns controlling and noncontrolling interests in surgical hospitals located in Texas. The Company also owns noncontrolling interests in ambulatory surgery centers (“ASCs”) located in Texas, Oklahoma, Pennsylvania, New Jersey, Maryland and Ohio. Additionally, the Company provides sleep testing management services to various rural hospitals in Iowa, Minnesota, Missouri, Nebraska and South Dakota under management contracts with the hospitals. The Company provides management services to a majority of the facilities that it has noncontrolling interests (referred to as “Affiliates”) under the terms of various management agreements.

Note 2 – Basis of Presentation

Reverse Acquisition – On July 22, 2013, the Company acquired Foundation Surgery Affiliates, LLC (“FSA”) and FSA’s consolidated variable interest entity, Foundation Surgical Hospital Affiliates, LLC (“FSHA”) (collectively referred to as “Foundation”). For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the Company’s historical operating results included in the accompanying consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition.

Going Concern and Management’s Plan – As of March 31, 2014, the Company had an accumulated deficit of $37.1 million and a working capital deficiency of $16.8 million. During the three months ended March 31, 2014, the Company generated a net loss attributable to Foundation Healthcare of $1.7 million and generated cash flow from operating activities from continuing operations of $1.6 million. As of March 31, 2014, the Company had cash and cash equivalents of $4.0 million. Management expects to refinance, by the end of the second quarter of 2014, a significant portion of the Company’s long-term debt obligations. Management expects that the Company will be able to significantly reduce its annual debt service payments as part of the refinancing; however, there is no assurance that management will be successful in completing the debt refinancing.

If management is unable to refinance a significant portion of its existing debt as noted above, the Company may be forced to obtain extensions on existing debt obligations as they become due in 2014. Although management has historically been successful in obtaining extensions, there is no assurance that the Company’s lenders will continue to grant them in the future. In addition, management may choose to raise additional funds through the sale of equity or assets, but there is no assurance that the Company will be successful in completing such actions.

If management does not complete the debt refinancing or alternatively obtain extensions on some of its debt obligations during 2014, the Company may not have sufficient cash on hand or generate sufficient cash flow from operations to meet its cash requirements over the next 12 months. These uncertainties raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

Note 3 – Summary of Significant Accounting Policies

For a complete list of the Company’s significant accounting policies, please see the Company’s Annual Report on Form 10-K for the year ending December 31, 2013.

Interim Financial Information – The condensed consolidated financial statements included herein are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial statements and in accordance with Regulation S-X. Accordingly, they do not include all of the information and

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footnotes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2014 are not necessarily indicative of results that may be expected for the year ended December 31, 2014. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2013. The December 31, 2013 consolidated balance sheet was derived from audited financial statements.

Pro forma income information – Prior to July 22, 2013, FSA’s and FSHA’s member had elected to have FSA’s and FSHA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its tax returns and no provision for income taxes is included in the Company’s consolidated financial statements for periods prior to July 22, 2013. The pro forma income information provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 38%, which approximates the calculated statutory tax rates for the periods.

Consolidation – The accompanying consolidated financial statements include the accounts of the Company and its wholly owned, majority owned and controlled subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.

The Company accounts for its investments in Affiliates in which the Company exhibits significant influence, but not control, in accordance with the equity method of accounting. The Company does not consolidate its equity method investments, but rather measures them at their initial costs and then subsequently adjusts their carrying values through income for their respective shares of the earnings or losses during the period. The Company monitors its investments for other-than-temporary impairment by considering factors such as current economic and market conditions and the operating performance of the companies and records reductions in carrying values when necessary.

Use of estimates – The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Revenue recognition and accounts receivable – The Company recognizes revenues in the period in which services are performed. Accounts receivable primarily consist of amounts due from third-party payors and patients. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Amounts the Company receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as health maintenance organizations, preferred provider organizations and other private insurers are generally less than the Company’s established billing rates. Additionally, to provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. Accordingly, the revenues and accounts receivable reported in the Company’s consolidated financial statements are recorded at the net amount expected to be received.

Contractual Discounts and Cost Report Settlements –The Company derives a significant portion of its revenues from Medicare, Medicaid and other payors that receive discounts from its established billing rates. The Company must estimate the total amount of these discounts to prepare its consolidated financial statements. The Medicare and Medicaid regulations and various managed care contracts under which these discounts must be calculated are complex and are subject to interpretation and adjustment. The Company estimates the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. These interpretations sometimes result in payments that differ from the Company’s estimates. Additionally, updated regulations and contract renegotiations occur frequently, necessitating regular review and assessment of the estimation process by management. Changes in estimates related to the allowance for contractual discounts affect revenues reported in the Company’s accompanying consolidated statements of operations.

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Cost report settlements under reimbursement agreements with Medicare and Medicaid are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined. There is a reasonable possibility that recorded estimates will change by a material amount in the near term. There was no adjustment for estimated cost report settlements in the three month periods ended March 31, 2014 or 2013. The net cost report settlements due to the Company was approximately $235,000 and $235,000 at March 31, 2014 and December 31, 2013, respectively, and in included in prepaid and other current assets in the accompanying consolidated balance sheets. The Company’s management believes that adequate provisions have been made for adjustments that may result from final determination of amounts earned under these programs.

Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing that would have a material effect on the Company’s financial statements. Compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties and exclusion from the Medicare and Medicaid programs.

Provision and Allowance for Doubtful Accounts – To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

The Company has an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance. No single statistic or measurement determines the adequacy of the allowance for doubtful accounts. Some of the analytical tools that the Company utilizes include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of the Company’s ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan. Accounts receivable are written off after collection efforts have been followed in accordance with the Company’s policies. During the Company’s normal quarterly review process at March 31, 2014, management determined that a portion of the accounts receivable related to personal injury cases at our FSH SA location had grown to a level requiring it to be analyzed as a distinct payor category. Based on the historical cash collection experience and other analytical measures as noted above, the allowance for doubtful accounts related to the personal injury cases was lowered by $1.0 million.

Due to the nature of the healthcare industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on the Company’s operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for the Company’s products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, the Company is not certain of the full amount of patient responsibility at the time of service. The Company estimates amounts due from patients prior to service and generally collects those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.

The activity in the allowance for doubtful accounts for the three months ending March 31, 2014 follows:

	2014
Balance at beginning of period	$	4,778,915
Provisions recognized as reduction in revenues		361,517
Write-offs, net of recoveries		(2,603,452	)
Balance at end of period	$	2,536,980

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Cash and cash equivalents – The Company considers all highly liquid temporary cash investments with an original maturity of three months or less to be cash equivalents. Certificates of deposit with original maturities of more than three months are also considered cash equivalents if there are no restrictions on withdrawing funds from the account.

Goodwill and Intangible Assets – The Company evaluates goodwill for impairment at least on an annual basis and more frequently if certain indicators are encountered. Goodwill is to be tested at the reporting unit level, defined as an ASC or hospital (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired. The Company will complete its annual impairment test in December 2014.

Intangible assets other than goodwill which include physician membership interests, service contracts and covenants not to compete are amortized over their estimated useful lives using the straight line method. The remaining lives range from five to ten years. The Company evaluates the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Net income (loss) per share– Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted loss per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period. Dilutive securities having an anti-dilutive effect on diluted loss per share are excluded from the calculation.

Recently Adopted and Recently Issued Accounting Guidance

Adopted Guidance

In February 2013, the FASB issued changes to the accounting for obligations resulting from joint and several liability arrangements. These changes require an entity to measure such obligations for which the total amount of the obligation is fixed at the reporting date as the sum of (i) the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors, and (ii) any additional amount the reporting entity expects to pay on behalf of its co-obligors. An entity will also be required to disclose the nature and amount of the obligation as well as other information about those obligations. Examples of obligations subject to these requirements are debt arrangements and settled litigation and judicial rulings. These changes become effective for the Company on January 1, 2014. Management has determined that the adoption of these changes did not have an impact on the Company’s consolidated financial statements, as the Company does not currently have any such arrangements.

In July 2013, the FASB issued changes to the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. These changes require an entity to present an unrecognized tax benefit as a liability in the financial statements if (i) a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position, or (ii) the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset to settle any additional income taxes that would result from the disallowance of a tax position. Otherwise, an unrecognized tax benefit is required to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. Previously, there was diversity in practice as no explicit guidance existed. These changes become effective for the Company on January 1, 2014. Management has determined that the adoption of these changes did not have a significant impact on the Company’s consolidated financial statements.

Issued Guidance

In April 2014, the FASB issued changes to the reporting of discontinued operations and disclosures of disposals of components of an entity. The amendments change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in

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operations should be presented as discontinued operations. Additionally, the new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income and expenses of discontinued operations. The amendments are effective prospectively for all disposals (or classifications as held for sale) of components of an entity, and for all businesses that, on acquisition, are classified as held for sale that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. The Company is currently evaluating the new guidance to determine the impact it may have to its consolidated financial statements.

Note 4 – Reverse Acquisition

On July 22, 2013, the Company acquired FSA and FSA’s consolidated variable interest entity, FSHA, from Foundation Healthcare Affiliates, LLC (“FHA”) pursuant to an Amended and Restated Membership Purchase Agreement (the “Purchase Agreement”). Pursuant to the Purchase Agreement, the Company (i) issued to FHA 114,500,000 shares of its common stock, (ii) issued to FHA a demand promissory note in the principal amount of $2.0 million, and (iii) assumed certain liabilities and obligations of FHA totaling approximately $2.0 million.

For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the Company’s historical operating results included in the accompanying condensed consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition.

The acquisition of Foundation was based on management’s belief that Foundation’s acquisition and development strategy and operating model will enable the Company to grow by taking advantage of highly-fragmented markets, an increasing demand for short stay surgery and a need by physicians to forge strategic alliances to meet the needs of the evolving healthcare landscape while also shaping the clinical environments in which they practice.

Simultaneous with and subject to the reverse acquisition, the Company issued 13,333,333 shares of common stock to purchase a $6.0 million participation in the credit facility owed by the Company to Arvest Bank (see Note 5 – Discontinued Operations for more information) and 17,970,295 shares of common stock to Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates, for full satisfaction of debt owed to Mr. Oliver totaling $8,136,390. Since the completion of the reverse acquisition was subject to these transactions, they have been recorded as part of the reverse acquisition.

Since FSA is deemed to be the accounting acquirer, the reverse acquisition was recorded by allocating the purchase price of the acquisition to the assets acquired, including intangible assets and liabilities assumed, from the legacy business of Graymark Healthcare, Inc. (“Graymark”), based on their estimated fair values at the acquisition date. The excess of the cost of the acquisitions over the net amounts assigned to the estimated fair value of the assets acquired, net of liabilities assumed, was recorded as goodwill, none of which is anticipated to be tax deductible.

The fair value of the total consideration issued in the reverse acquisition amounted to $17.4 million and included $13.4 million for the issuance of the Company’s common stock to FHA, Arvest Bank and Mr. Oliver, $2.0 million for the promissory note issued to FHA and $2.0 million for the debt obligations and liabilities assumed from FHA.

The final purchase allocation for the reverse acquisition is presented in the table below:

	Graymark
Cash and cash equivalents	$	68,170
Accounts receivable		249,333
Current assets from discontinued operations		1,360,143
Other current assets		198,976
Total current assets		1,876,622

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	Graymark
Property and equipment		1,389,169
Intangible assets		2,733,000
Goodwill		21,864,781
Other assets from discontinued operations		1,224,140
Other assets		252,528
Total assets acquired		29,340,240
Liabilities assumed:
Accounts payable and accrued liabilities		2,899,823
Short term debt		2,000,000
Current portion of long-term debt		714,711
Current liabilities from discontinued operations		7,375,521
Total current liabilities		12,990,055
Long-term debt, net of current portion		742,385
Other liabilities from discontinued operations		305,969
Other liabilities		1,362,957
Total liabilities assumed		15,401,366
Net assets acquired	$	13,938,874

During the three months ended March 31, 2013, the Company incurred $93,197 in expenses related to the reverse acquisition. The expenses incurred related primarily to legal fees related to the Purchase Agreement and structure of the transaction and professional fees related to the audits of the 2012 and 2011 consolidated financial statements of FSA.

The amounts of acquisition revenues and earnings included in the Company’s consolidated statements of operations for the three months ended March 31, 2014, and the revenue and earnings of the combined entity had the reverse acquisition date for Graymark been January 1, 2013 are as follows:

			Loss from						Attributable to Foundation
	Revenue		Continuing Operations			Net Loss			Net Loss			Net Loss Per Share
Actual:
From 1/1/2014 to 3/31/2014	$	504,943	$	(1,955,672	)	$	(2,459,419	)	$	(2,459,419	)	$	(0.01	)
Supplemental Pro Forma:
Three months ending 3/31/2013	$	21,561,851	$	(4,194,248	)	$	(4,139,689	)	$	(3,000,129	)	$	(0.02	)

The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

Note 5 – Discontinued Operations

Prior to the reverse acquisition, Graymark committed to a plan to divest of or close certain sleep diagnostic and sleep therapy locations. The decision was based on a combination of the financial performance of the facilities and the shift in focus to the business model of Foundation. As a result of the pending closure or sale of these locations, the related assets, liabilities, results of operations and cash flows were classified as discontinued operations which were acquired by the Company in the reverse acquisition.

Under the plan, from July 2013 to October 2013, the Company closed or sold 24 sleep diagnostic locations including both IDTF and contracted locations in Georgia, Iowa, Kansas, Missouri, Nevada, Oklahoma and Texas and 5 sleep therapy locations in Iowa, Kansas, Nevada, Oklahoma and Texas.

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As part of the reverse acquisition, the Company acquired the special charge liability of $475,570 related to the estimated closing costs resulting from the plan to sell or close the sleep diagnostic and therapy locations. For the three month period ended March 31, 2014, the activity in the acquired accruals for restructuring charges established for lease termination costs were as follows:

	Lease Termination Costs
Balance at December 31, 2013	$	78,235
Adjustments		151,531
Cash payments		(32,121	)
Balance at March 31, 2014	$	197,645

Adjustments to the special charge liability include changes to estimated settlements or other changes to the liabilities. Additional charges or adjustments may be recorded in future periods dependent upon the Company’s ability to sub-lease or otherwise mitigate future lease costs at closed facilities.

The operating results of the discontinued sleep diagnostic and therapy locations and the Company’s other discontinued operations for the three month period ended March 31, 2014 are summarized below:

	2014
Revenues	$	123,729
Net loss before taxes	$	(503,747	)
Income tax benefit		191,424
Net loss from discontinued operations, net of tax	$	(312,323	)

The balance sheet items for discontinued operations are summarized below:

	March 31, 2014		December 31, 2013
Cash and cash equivalents	$	19,108	$	49,252
Accounts receivable, net of allowances		39,284		222,943
Inventories		—		1,893
Other current assets		140,640		244,541
Total current assets		199,032		518,629
Fixed assets, net		363,379		426,228
Other assets		150,000		150,000
Total noncurrent assets		513,379		576,228
Total assets	$	712,411	$	1,094,857
Payables and accrued liabilities	$	1,564,374	$	1,557,771
Short term debt		3,882,932		3,994,932
Current portion of long-term debt		60,676		67,994
Total current liabilities		5,507,982		5,620,697
Long-term debt		—		9,969
Total liabilities	$	5,507,982	$	5,630,666

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The Company’s borrowings and capital lease obligations included in discontinued operations are as follows:

	Rate (1)			Maturity Date		March 31, 2014			December 31, 2013
Short-term Debt:
Senior bank debt		6	%		Apr. 2014	$	3,882,932		$	3,994,932
Long-term Debt:
Sleep center notes payable		6	%		Jan. 2015	$	21,000		$	28,723
Equipment capital leases		8	%		Nov. 2014		39,676			49,389
Total							60,676			78,112
Less: Current portion of long-term debt							(60,676	)		(68,143	)
Long-term debt						$	—		$	9,969

(1) Effective rate as of March 31, 2014

At March 31, 2014, future maturities of long-term debt included in discontinued operations were as follows:

Twelve months ended March 31, 2015 $ 60,676

On July 22, 2013, the Company’s subsidiaries, SDC Holdings, LLC and ApothecaryRx, LLC (collectively the “Borrowers”), the Company and Mr. Stanton Nelson (the “Guarantor” and the Company’s chief executive officer) entered into a Second Amended and Restated Loan Agreement (the “New Loan Agreement”) and an Amended and Restated Promissory Note (the “New Note”) with Arvest Bank. The Company, Borrowers, Guarantor and other guarantors previously entered into the Amended and Restated Loan Agreement dated effective December 17, 2010, as amended by the First Amendment to Loan Agreement dated January 1, 2012, the Second Amendment to Loan Agreement dated effective June 30, 2012, and the Third Amendment to Loan Agreement dated effective October 12, 2012 (the “Prior Agreement”). Under the Prior Agreement, the Company and Borrowers were indebted to Arvest Bank under the Amended and Restated Promissory Note, in the original principal amount of $15,000,000 dated June 30, 2010 and the Second Amended and Restated Promissory Note, in the original principal amount of $30,000,000, dated June 30, 2010 (the “Prior Notes”). Arvest Bank, the Company, the Borrowers and the Guarantor have agreed to restructure the loan evidenced by the Prior Notes and the Prior Agreement. As of March 31, 2014 and December 31, 2013, the outstanding principal amount of the New Note was $9,882,932 and $9,994,932, respectively.

On July 22, 2013, in conjunction with the New Loan Agreement with Arvest Bank, the Company entered into a Participation Agreement with Arvest Bank in which we purchased a $6,000,000 participation in the New Note from Arvest Bank in exchange for 13,333,333 shares of the Company’s common stock. The Company purchased the participation in the last $6,000,000 of the principal amount due under the Arvest credit facility. The Company’s participation in the note is eliminated against the New Note in the long-term debt table shown above.

The New Loan Agreement and New Note were entered into on the same date as and in conjunction with the reverse acquisition. As such, the New Note is included in the opening balance sheet in the reverse acquisition accounting (see Note 4 – Reverse Acquisition).

The New Note is collateralized by substantially all of the assets of the Borrowers and the personal guaranty of the Guarantor which is limited to $2,919,000. The note bears interest at the greater of the prime rate or 6.0% and provided the Borrowers are not in default, the Borrowers are required to make monthly payments of interest only. The entire unpaid principal balance and all accrued and unpaid interest thereon was due and payable on April 30, 2014. Additionally, the New Note is subject to certain financial covenants including a debt service coverage ratio (“DSR”) covenant of not less than 1.25 to 1. Arvest Bank has waived the DSR and other financial covenant requirements through April 30, 2014, which was the maturity date of the New Note. The Company is in the process of extending the maturity date of the New Note and the waiver of financial covenants. Historically, management has been successful in obtaining extensions and waivers of covenant violations, however there is no assurance that Arvest Bank will continue to extend the note or waive the covenant violations. See Note 2 – Basis of Presentation for additional information on management’s plan to refinance its existing debt obligations.

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Note 6 – Goodwill and Other Intangibles

Changes in the carrying amount of goodwill are as follows:

	Gross Amount		Accumulated Impairment Losses			Net Carrying Value
December 31, 2013	$	23,019,309	$	(22,045,382	)	$	973,927
March 31, 2014	$	23,019,309	$	(22,045,382	)	$	973,927

Goodwill and intangible assets with indefinite lives must be tested for impairment at least once a year. Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value. The Company tests goodwill for impairment on an annual basis in the fourth quarter or more frequently if management believes indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the Company performs the second step of the goodwill impairment test to determine the amount of impairment loss. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.

The Company has estimated the goodwill associated with the reverse acquisition to be $21.9 million. The Company then determined the projected cash flows from the continuing operations of the legacy Graymark business were not sufficient to support the recorded goodwill. The Company evaluated the fair value of the goodwill subsequent to the reverse acquisition and determined the acquired goodwill was fully-impaired.

Changes in the carrying amount of intangible assets during the three months ended March 31, 2014 were as follows:

	Carrying Amount		Accumulated Amortization			Net
December 31, 2013	$	14,524,500	$	(3,385,879	)	$	11,138,621
Amortization		—		(513,867	)		(513,867	)
March 31, 2014	$	14,524,500	$	(3,899,746	)	$	10,624,754

Intangible assets as of March 31, 2014 and December 31, 2013 include the following:

	Useful	March 31, 2014							December 31,
	Life (Years)	Carrying Value		Accumulated Amortization			Net		2013 Net
ASC management contracts	6 – 8	$	3,498,500	$	(1,843,754	)	$	1,654,746	$	1,763,463
Covenants not to compete	5		2,027,000		(545,094	)		1,481,906		1,583,256
Physician memberships	7		6,468,000		(1,309,000	)		5,159,000		5,390,000
Trade name	5		381,000		(52,832	)		328,168		347,218
Service contracts	10		2,150,000		(149,066	)		2,000,934		2,054,684
Total		$	14,524,500	$	(3,899,746	)	$	10,624,754	$	11,138,621

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Amortization expense for the three months ended March 31, 2014 and 2013 was $513,867 and $113,242 respectively. Amortization expense for the next five years related to these intangible assets is expected to be as follows:

Twelve months ended March 31,
2015	$	2,055,474
2016		2,055,474
2017		2,055,474
2018		1,818,641
2019		1,174,757

Note 7 – Borrowings and Capital Lease Obligations

The Company’s short-term debt obligations are as follows:

	Rate (1)	March 31, 2014		December 31, 2013
Senior Lender:
Notes payable – working capital	6.5 –7.0%	$	2,803,270	$	2,814,027
Other Lenders:
Note payable – S&H Leasing	11.5%		1,865,600		1,865,600
Note payable – working capital	5.0%		800,000		800,000
Insurance premium financings	3.0 – 4.8%		652,837		101,135
Note payable – Medicare cost report	10.1%		61,903		84,065
Short-term debt		$	6,183,610	$	5,664,827

(1) Effective rate as of March 31, 2014

In April 2014, the Company extended the maturity date of two short-term working capital loans from its senior lender. The notes are collateralized by the inventory, accounts receivable, equipment and other assets of one of the Company’s hospital subsidiaries. The notes bear interest at variable rates of prime plus 1.5% and 3.75% with floors of 6.5% and 7%. The Company is required to make monthly payments totaling $15,679 with the balances due at maturity in January 2015 and February 2016. The note that matures in February 2016 is classified as short-term debt because it is due on demand.

The Company’s long-term debt and capital lease obligations are as follows:

	Rate (1)	Maturity Date	March 31, 2014			December 31, 2013
Senior Lender:
Line of credit	7.0%	Jun. 2014	$	896,000		$	896,000
Notes payable – working capital	5.5 – 7.0%	Sep. 2015 –Mar. 2016		3,322,646			3,715,088
Note payable – equity investments	6.25%	Sept. 2016		2,999,360			3,270,427
Note payable – management agreements	6.0%	Dec. 2016		591,922			640,466
Note payable – assumption	6.75%	Jan. 2015		114,270			146,857
Other Lenders:
Note payable – preferred interest redemption	10.0%	Jul. 2015		5,100,000			5,100,000
Notes payable – settlements	5.25 – 8.0%	Dec. 2014 –Jan. 2018		1,020,056			1,189,725
Note payable – THE	4.6 – 8.0%	Jan. 2015 – Feb. 2016		272,811			311,149
Notes payable – physician partners	5.25 – 6.5%	May 2014 – Dec. 2014		55,161			103,604
Notes payable – acquisition	6.0%	Dec. 2014 – Oct. 2015		79,346			99,610
Capital lease obligations	4.8 – 13.7%	Sep. 2014 – Jul. 2017		2,129,610			2,477,985
Total				16,581,182			17,950,911
Less: Current portion of long-term debt				(10,592,445	)		(7,919,179	)
Long-term debt			$	5,988,737		$	10,031,732

(1) Effective rate as of March 31, 2014

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In April 2014, the Company extended the maturity date of two working capital loans from its senior lender to March 2016. The notes bear interest at variable rates of prime plus 1.5% with floors of 6.5% and require monthly payments of principal and interest totaling $47,510. The notes are collateralized by the inventory, accounts receivable, equipment and other assets of one of the Company’s hospital subsidiaries. The total principal owed on the notes at March 31, 2014 is $1,389,582.

The Company has entered into various short-term and long-term notes payable with its senior lender, Legacy Bank (referred to as “Legacy Debt”). As of March 31, 2014 and December 31, 2013, the balance of the Legacy Debt was $10.7 million and $11.5 million, respectively. The Legacy Debt is collateralized by substantially all of the assets of the Company’s subsidiaries, FSA and FSHA, and a portion is personally guaranteed by certain officers of the Company. In conjunction with the Legacy Debt, the Company has agreed to comply with certain financial covenants (as defined and calculated at the FSA and FSHA level) including:

• Debt Service Coverage Ratio of 1.05 to 1 and increasing to 1.1 to 1 by December 31, 2013; 1.15 to 1 by March 31, 2014; and 1.2 to 1 by June 30, 2014; and

• Minimum Tangible Net Worth (as defined for FSA and FSHA) of $11.1 million increased each quarter (beginning in September 30, 2013 by 50% of FSA’s and FSHA’s net income for the quarter).

As of March 31, 2014, FSA and FSHA are not in compliance with the Legacy Debt Minimum Tangible Net Worth financial covenant. Management has requested a waiver from Legacy Bank for the covenant violation. Historically, management has been successful in obtaining waivers from the bank for any covenant non-compliance; however there is no assurance that the Company will be able to obtain waivers in the future. Management does not anticipate obtaining a waiver for a period greater than 12 months and it is unlikely that the Company will regain compliance with the Minimum Tangible Net Worth covenant within the next 12 months. As a result, the Legacy Debt has been classified as current in the accompanying consolidated balance sheets as of March 31, 2014. See Note 2 – Basis of Presentation for additional information on management’s plan to refinance its existing debt obligations.

At March 31, 2014, future maturities of long-term debt were as follows:

2015	$	10,592,445
2016		5,587,036
2017		326,688
2018		52,562
2019		22,451
Thereafter		—

Note 8 – Preferred Noncontrolling Interests

During 2013, the Company’s wholly-owned subsidiary, Foundation Health Enterprises, LLC (“FHE”) completed a private placement offering of $9,135,000. The offering was comprised of 87 units (“FHE Unit” or “preferred noncontrolling interest”). Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000, and 10,000 shares of the Company’s common stock, valued at $5,000. The total consideration of $9,135,000 was comprised of $8,700,000 attributable to the preferred noncontrolling interest and $435,000 attributable to the 870,000 shares of the Company’s common stock.

The FHE Units provide for a cumulative preferred annual return of 9% on the amount allocated to the Class B membership interests. The FHE Units will be redeemed by FHE in four annual installments beginning in July 2014. The first three installments shall be in the amount of $10,000 per FHE Unit and the fourth installment will be

15

in the amount of the unreturned capital contribution and any undistributed preferred distributions. The FHE Units are convertible at the election of the holder at any time prior to the complete redemption into restricted common shares of the Company at a conversion price of $2.00 per share. Since the FHE Units have a redemption feature and a conversion feature which the Company determined to be substantive, the preferred noncontrolling interests has been recorded at the mezzanine level in the accompanying consolidated balance sheets and the corresponding dividends are recorded as a reduction of accumulated deficit.

Note 9 – Commitments and Contingencies

Legal claims – The Company is exposed to asserted and unasserted legal claims encountered in the normal course of business, including claims for damages for personal injuries, medical malpractice, breach of contracts, wrongful restriction of or interference with physicians’ staff privileges and employment related claims. In certain of these actions, plaintiffs request payment for damages, including punitive damages that may not be covered by insurance. Management believes that the ultimate resolution of these matters will not have a material adverse effect on the operating results or the financial position of the Company. There were no settlement expenses during the three months ended March 31, 2014 and 2013 related to the Company’s ongoing unasserted legal claims.

Self-insurance – Effective January 1, 2014, the Company began using a combination of insurance and self-insurance for employee-related healthcare benefits. The self-insurance liability is determined actuarially, based on the actual claims filed and an estimate of incurred but not reported claims. Self-insurance reserves as of March 31, 2014 were $418,246 and are included in accrued liabilities in the accompanying consolidated balance sheets.

Note 10 – Fair Value Measurements

Fair value is the price that would be received from the sale of an asset or paid to transfer a liability (i.e., an exit price) in the principal or most advantageous market in an orderly transaction between market participants. In determining fair value, the accounting standards established a three-level hierarchy that distinguishes between (i) market data obtained or developed from independent sources (i.e., observable data inputs) and (ii) a reporting entity’s own data and assumptions that market participants would use in pricing an asset or liability (i.e., unobservable data inputs). Financial assets and financial liabilities measured and reported at fair value are classified in one of the following categories, in order of priority of observability and objectivity of pricing inputs:

• Level 1 – Fair value based on quoted prices in active markets for identical assets or liabilities.

• Level 2 – Fair value based on significant directly observable data (other than Level 1 quoted prices) or significant indirectly observable data through corroboration with observable market data. Inputs would normally be (i) quoted prices in active markets for similar assets or liabilities, (ii) quoted prices in inactive markets for identical or similar assets or liabilities or (iii) information derived from or corroborated by observable market data.

• Level 3 – Fair value based on prices or valuation techniques that require significant unobservable data inputs. Inputs would normally be a reporting entity’s own data and judgments about assumptions that market participants would use in pricing the asset or liability.

The fair value measurement level for an asset or liability is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs.

Recurring Fair Value Measurements:The carrying value of the Company’s financial assets and financial liabilities is their cost, which may differ from fair value. The carrying value of cash held as demand deposits, money market and certificates of deposit, accounts receivable, short-term borrowings, accounts payable and accrued liabilities approximated their fair value. At March 31, 2014, the fair value of the Company’s long-term debt, including the current portion was determined to be approximately equal to its carrying value.

Nonrecurring Fair Value Measurements:During the three months ended March 31, 2014, the Company did have any assets or liabilities recorded using nonrecurring fair value measurements.

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Note 11 – Real Estate Transaction

On March 1, 2014, the Company executed a 15 year master lease on the building occupied by the Company’s hospital subsidiary in San Antonio, Texas for an annual rent of $2.3 million with annual escalations of 3%. The current lease income on the underlying sub-lease is approximately $2.1 million per year which includes the rent paid by FBH SA. The master lease is an operating lease. In conjunction with the master lease and certain other agreements with the landlord, the Company received $4.1 million at the time of the lease. Given the disparity between the annual rent expense under the master lease and the rental income of the underlying sub-lease, the cash received at the execution of the lease was deferred and will be recorded on a straight-line basis as a reduction in the rent expense under the master lease.

Note 12 – Related Party Transactions

As of March 31, 2014, the Company had $2.3 million on deposit at Valliance Bank. Valliance Bank is controlled by Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates. In addition, the Company is obligated to Valliance Bank under certain notes payable totaling approximately $5.9 million at March 31, 2014 and December 31, 2013. The interest rates on the notes range from 5% to 10%. Non-controlling interests in Valliance Bank are held by Mr. Stanton Nelson, the Company’s chief executive officer and Mr. Joseph Harroz, Jr., a director of the Company. Mr. Nelson and Mr. Harroz also serve as directors of Valliance Bank.

In October 2013, the Company completed a private placement offering $9,135,000 (see Note 8 – Preferred Noncontrolling Interests for additional information). The offering was comprised of 87 FHE Units. Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000, and 10,000 shares of the Company’s common stock, valued at $5,000. Mr. Stanton Nelson, the Company’s chief executive officer, purchased 5 FHE units for $525,000.

The Company occupies office space subject to a lease agreement with City Place, LLC (“City Place”). Under the lease agreement, the Company pays monthly rent of $17,970 until June 30, 2014; $0.00 from July 1, 2014 to January 31, 2015 and $17,970 from February 1, 2015 to March 31, 2017 plus additional payments for allocable basic expenses of City Place; the lease expires on March 31, 2017. Non-controlling interests in City Place are held by Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates. During the three months ended March 31, 2014, the Company incurred approximately $22,000 in lease expense under the terms of the lease.

As of March 31, 2014 and December 31, 2013, the Company has obligations of $1.4 million that are owed to FHA and certain real estate subsidiaries and affiliates of FHA related to transactions that occurred prior to the Foundation acquisition in July 2013. The amounts owed to FHA and FHA affiliates are included in other liabilities on the accompanying consolidated balance sheets.

The Company has entered into agreements with certain of its Affiliate ASCs and hospitals to provide management services. As compensation for these services, the surgery centers and hospitals are charged management fees which are either fixed or are based on a percentage of the Affiliates cash collected or the Affiliates net revenue. The percentages range from 2.25% to 6.0%.

Note 13 – Subsequent Events

Management evaluated all activity of the Company and concluded that no material subsequent events have occurred, other than those disclosed in the notes to the consolidated financial statements, that would require recognition in the consolidated financial statements or disclosure in the notes to the consolidated financial statements.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Company Overview

Our primary focus is owning controlling interests in surgical hospitals. We currently have two Consolidated Hospitals and two Equity Owned Hospitals (hospitals in which we hold a non-controlling interest) in Texas. We also have ten ASCs located in Texas, Oklahoma, Pennsylvania, New Jersey, Maryland and Ohio. Additionally, we provide sleep testing management services to various rural hospitals in Iowa, Minnesota, Missouri, Nebraska and South Dakota under management contracts with the hospitals. We provide management services to a majority of our Affiliates under the terms of various management agreements.

We focus primarily on investing in and managing high quality cost effective surgical hospitals that meet the needs of patients, physicians and payors. We believe the facilities we invest in and manage provide an enhanced quality of care to our patients while providing administrative, clinical and economic benefits to physicians. Since physicians are critical to the direction of healthcare, we have developed our operating model to encourage physicians to affiliate with us and to use our facilities as an extension of their practices. We operate our facilities, structure our strategic relationships and adopt staffing, scheduling and clinical systems and protocols with the goal of increasing physician productivity. We believe that our focus on physician satisfaction, combined with providing high quality healthcare in a friendly and convenient environment for patients, will continue to increase the number of procedures performed at our facilities each year.

Foundation Transaction

On July 22, 2013, we acquired 100% of the interests in Foundation Surgery Affiliates, LLC (“FSA”) and FSA’s consolidated variable interest entity, Foundation Surgical Hospital Affiliates, LLC (“FSHA”) (collectively “Foundation”) from Foundation Healthcare Affiliates, LLC (“FHA”) in exchange for 114,500,000 shares of our common stock and a promissory note in the amount of $2,000,000 (the “Foundation Acquisition”). We also assumed certain debt and other obligations of FHA in the amount of $1,991,733. The promissory note bore interest at a fixed rate of 7% and was paid in full on October 14, 2013.

For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the historical operating results included in our consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition. Prior to July 22, 2013, FSA’s member had elected to have FSA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its respective tax returns and no provision for federal and state income taxes is included in these consolidated financial statements for periods prior to July 22, 2013. We have included pro forma income information in our consolidated statements of operations that provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 38%, which approximates the calculated statutory tax rates for the periods.

Going Concern and Management’s Plan

As of March 31, 2014, we had an accumulated deficit of $37.1 million and a working capital deficiency of $16.8 million. During the quarter ended March 31, 2014, we generated a net loss attributable to Foundation Healthcare of $1.7 million and generated cash flow from operating activities from continuing operations of $1.6 million. As of March 31, 2014, we had cash and cash equivalents of $4.0 million. We expect to refinance, by the end of the second quarter of 2014, a significant portion of our long-term debt obligations. We expect that we will be able to significantly reduce our annual debt service payments as part of the refinancing; however, there is no assurance that we will be successful in completing the debt refinancing.

If we are unable to refinance a significant portion of our existing debt as noted above, we may be forced to obtain extensions on existing debt obligations as they become due in 2014. Although we have historically been successful in obtaining extensions, there is no assurance that our banks will continue to grant them in the future. We may choose to raise additional funds through the sale of equity or assets, but we may not be able to successfully complete such actions.

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If we do not complete the debt refinancing or alternatively obtain extensions on some of its debt obligations during 2014, we may not have sufficient cash on hand or generate sufficient cash flow from operations to meet our cash requirements over the next 12 months. These uncertainties raise substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.

Hospital and ASC Business Overview

We are a nationally prominent owner and manager of surgical hospitals and ASCs with facilities located in Louisiana, Maryland, New Jersey, Ohio, Oklahoma, Pennsylvania and Texas. As of December 31, 2013, we owned interests four surgical hospitals and ten ASCs in partnership with over 400 local physicians. We own equity interests in all of our ASC and surgical hospital facilities except for one ASC that we only manage. Through our facilities, we are a major provider of surgical services; we performed approximately 72,500 outpatient and 2,200 inpatient surgical cases during 2013. We believe that our acquisition and development strategy and operating model will enable us to continue to grow by taking advantage of highly-fragmented markets, an increasing demand for short stay surgery and a need by physicians to forge strategic alliances to meet the needs of the evolving healthcare landscape while also shaping the clinical environments in which they practice.

We own over 51% in two of our larger hospitals located in San Antonio and El Paso, Texas (referred to as “Consolidated Hospitals”). Historically, our focus was to own a minority ownership in facilities and we currently have ownership, ranging from 10% to 32%, in two hospitals and ten ASCs (referred to as “Equity Owned Hospitals,” “Equity Owned ASCs,” or “Equity Owned Facilities”; also referred to as “Affiliates”). Our facilities collectively offer a “portfolio” of specialties ranging from relatively intensive specialties such as orthopedics and neurosurgery to low-surgery-intensive specialties such as pediatric ENT (tubes / adenoids), pain management and gastroenterology. Each of our facilities is located in freestanding buildings or medical office buildings. Our surgical hospitals have from 10 to 40 beds and average seven operating rooms, ranging in size from 40,000 to 126,000 square feet and are open 24 hours a day, 365 days a year. Our average ASC has approximately 16,000 square feet of space with four operating rooms, as well as ancillary areas for preparation, recovery, reception and administration. Our ASCs are normally open weekdays from 7:00 a.m. to approximately 5:00 p.m. or until the last patient is discharged.

Our facilities are licensed at the state level, participate within the Medicare program and are accredited by the Accreditation Association for Ambulatory Healthcare (AAAHC) or the Det Norske Veritas (DNV) with the exception of our ASC in Nacogdoches, Texas. The Nacogdoches facility meets the accreditation standards, but the governing board of the ASC has elected to not be accredited. We recognize that accreditation is a crucial quality benchmark for payors since many managed care organizations will not contract with a facility until it is accredited. We believe that our historical success in obtaining and retaining accreditation for our facilities reflects our commitment to providing high quality care in our facilities.

Generally, our facilities are owned and operated by limited partnerships or limited liability companies in which ownership interests are also held by local physicians who are on the medical staffs of the facilities. The facilities’ partnership and limited liability company agreements typically provide for the monthly or quarterly pro rata distribution of cash equal to net profits from operations, less amounts held in reserve for expenses and working capital. Even where we own a minority of the interests in a facility, the partnership or limited liability company agreements generally grant us representation on the facility’s governing board and ensure our participation in fundamental decisions. Our influence over the businesses of our facilities is enhanced by the management agreements which we possess with such facilities.

Our surgical hospital and ASC facilities depend upon third-party reimbursement programs, including governmental and private insurance programs, to pay for the preponderance of the services rendered to patients. Our surgical hospital and ASC facilities derive a portion of their revenues from governmental healthcare programs, primarily Medicare and managed Medicare programs, and the remainder from a wide mix of commercial payors and patient co-pays and deductibles. Private payors typically follow the method in which the government reimburses healthcare providers. Under the government’s methodology our surgical hospital and ASC facilities are reimbursed

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for the performance of services through the payment of facility fees which vary according to whether the facility is a hospital or an ASC and the type of procedure that is performed. Hospitals are reimbursed for outpatient procedures in a manner similar to ASCs except that the methodologies employed to calculate reimbursement generally result in hospitals being reimbursed in this setting at a higher rate than free-standing ASCs. ASCs are reimbursed through the payment of a composite “ASC rate” which includes payment for most of the expenses associated with the performance of a procedure such as nursing services, supplies, and staffing costs. The reimbursement rates for inpatient hospital services are determined using Medicare severity diagnosis related groups which are intended to compensate hospitals according to the estimated intensity of hospital resources necessary to furnish care for a particular diagnosed illness.

Our revenues from the ASC and surgical hospital facilities are derived from (i) the pro rata distributions we receive on our ownership in the facilities, and (ii) management fees that we receive from these facilities. Such management fees are generally calculated as a percentage of the monthly net revenues. We own equity interests in all of our ASC and surgical hospital facilities except the Lake Surgery Center in Baton Rouge, Louisiana which we manage. We possess management agreements with all of our facilities except for the Houston Orthopedic Surgical Hospital in Houston, Texas in which we own a 20% interest.

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Results of Operations

The following table sets forth selected results of our operations for the three months ended March 31, 2014 and 2013. The following information was derived and taken from our unaudited financial statements appearing elsewhere in this report.

Comparison of the Three Month Periods Ended March 31, 2014 and 2013

	For the Three Months Ended March 31,
	2014			2013
Net Revenues:
Patient services	$	19,513,483		$	15,860,660
Management fee from affiliates		1,269,306			1,738,228
Equity in earnings from affiliates		527,083			1,216,715
Other revenue		1,118,326			474,889
Provision for doubtful accounts		(361,517	)		(636,851	)
Revenue		22,066,681			18,653,641
Salaries and benefits		7,977,419			6,338,097
Supplies		4,941,370			4,500,940
Other operating expenses		9,042,701			7,756,021
Depreciation and amortization		1,466,268			1,116,687
Net other expense		496,121			373,662
Income (loss) from continuing operations, before taxes		(1,857,198	)		(1,431,766	)
Provision for income taxes		852,005			—
Income (loss) from continuing operations, net of taxes		(1,005,193	)		(1,431,766	)
Discontinued operations, net of tax		(312,323	)		—
Net income (loss)		(1,317,516	)		(1,431,766	)
Less: Noncontrolling interests		384,921			(1,092,031	)
Net income (loss) attributable to Foundation Healthcare	$	(1,702,437	)	$	(339,735	)

Discussion of Three Month Periods Ended March 31, 2014 and 2013

Overall comments – as a result of the Foundation transaction on July 22, 2013 being recorded as a reverse acquisition, the operating results of the Company’s legacy business (referred to as “legacy Graymark”) is not included in the operating results of the three months ended March 31, 2014.

Patient services revenue increased $3.6 million or 23% during the three months ended March 31, 2014 compared with the first quarter of 2013. The increase was primarily due to:

• An increase in both outpatient surgical cases and inpatient spine cases resulted in an increase in patient service revenue of $1.5 million at EEPMC and;

• An increase in surgical case volume and the average reimbursement per surgical case at Foundation Bariatric Hospital of San Antonio (“FBH SA”) which was driven by an increase in spine and orthopedic cases resulted in an increase in patient services revenue of $2.1 million.

Management fees from affiliates decreased $0.5 million or 27% during the three months ended March 31, 2014 compared with the first quarter of 2013. Our management fees at both our ASCs and surgical hospitals are based on a percentage of collections. Lower collections at our ASCs due to reduced volumes and unplanned closures due to inclement weather resulted in a decrease of $0.3 million. An agreement to lower our management fees at one of our managed hospitals resulted in a decrease of $0.2 million.

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Income from equity investments in affiliates decreased $0.7 million or 57% during the three months ended March 31, 2014 compared with the first quarter of 2013. A change in accounting method for one of our ASC’s from the equity method to the cost method resulted in the revenue from that location being booked as Other revenue in 2014 resulting in a decrease of $0.5 million. Additionally, lower volumes and average reimbursement levels at one of our ASC’s in Pennsylvania resulted in the decrease of $0.2 million.

Other revenue increased $0.7 million or 136% during the three months ended March 31, 2014 compared with the first quarter of 2013. The increase was due to $0.5 million in revenue earned during the first quarter of 2014 from the sleep center management fees earned at our legacy Graymark hospital outreach locations, there is no revenue included from the hospital outreach locations during the first quarter of 2013 as a result of the reverse acquisition recorded on July 22, 2013, and $0.5 million related to the change in accounting for one of our ASC locations from the equity method to the cost method in the first quarter of 2014 compared to the first quarter of 2013. The offsetting decrease in other revenue of $0.3 million during the first quarter of 2014 compared to the first quarter of 2013 is primarily due to a $0.3 million distribution from our minority owned hospital in Houston, Texas received in the first quarter of 2013. We did not receive a distribution from that facility in the first quarter of 2014.

Provision for doubtful accounts decreased $0.3 million or 43% during the three months ended March 31, 2014 compared with the first quarter of 2013. Provision for doubtful accounts as a percent of patient services revenue was 1.9% and 4.0% for the first quarter of 2014 and 2013, respectively. Based on our quarterly analysis of historic bad debt trends, we reduced our allowance rates in several aging categories, inline with the historical trends, at both our EPPMC and FBH SA facilities which resulted in the $0.3 million decrease compared to the first quarter of 2013.

Salaries and benefitsincreased $1.7 million or 26% to $8.0 million from $6.3 million during the three months ended March 31, 2014, compared with the first quarter of 2013. The increase in salaries and benefits was primarily due to:

• $0.8 million of stock compensation expense;

• $0.6 million of salaries and benefits at legacy Graymark; and

• $0.3 million due to increased salaries and benefits resulting from a combination of normal annual salary increases and increased personnel required to manage our expanding hospital operations.

Suppliesexpense increased $0.4 million or 10% to $4.9 million from $4.5 million during the three months ended March 31, 2014, compared with the first quarter of 2013. The increase is due to a combination of higher surgical volume at both our EEPMC and FBH SA hospital locations, including an increase in spine and orthopedic cases which have a high implant cost per case.

Other operating expensesincreased $1.2 million or 17% to $9.0 million from $7.8 million during the three months ended March 31, 2014, compared with the first quarter of 2013. The increase in other operating expenses was primarily due to:

• $0.4 million in increased professional fees related to increased audit and legal fees;

• $0.6 million of other operating expenses at legacy Graymark;

• $0.1 million increase in corporate office operating expenses related to increased corporate infrastructure;

• $0.2 million increase in operating expense at our EEPMC and FBH SA facilities related to supporting the increased volumes;

• $0.1 million decrease in out of state franchise taxes primarily related to our Maryland locations.

Depreciation and amortization represents the depreciation expense associated with our fixed assets and the amortization attributable to our intangible assets. Depreciation and amortization increased $0.3 million in the first quarter of 2014 compared to the first quarter of 2013. The increase was primarily due to $0.1 million related to additional information technology assets at our corporate offices and medical equipment assets at our EEPMC and FBH SA facilities and $0.2 million of depreciation and amortization at legacy Graymark.

Net other expenserepresents primarily interest expense on borrowings reduced by interest income earned on cash and cash equivalents and the gain or loss on the sale of equity investments in affiliates. Net other expense decreased $0.1 million in the first quarter of 2014 compared to the first quarter of 2013. The decrease is related to a $0.1 million gain on the sale of investments in affiliates in the first quarter of 2013. We did not sell any of our investments in affiliates in the first quarter of 2014.

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Provision for income taxes was a benefit $0.9 million for the first quarter of 2014. Prior to July 22, 2013, FSA’s member had elected to have FSA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its respective tax returns and no provision for federal and state income taxes is included in our consolidated financial statements for periods prior to July 22, 2013. We have included pro forma income information in our consolidated statements of operations that provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 38%, which approximates the calculated statutory tax rates for the periods.

Discontinued operations represent the net loss from the operations of our independent diagnostic testing facilities (“IDTF”) which were classified as held for sale prior the Graymark reverse acquisition. The results from our discontinued operations for the three months ended March 31, 2014 are summarized below:

Revenues	$	123,729
Net loss before taxes	$	(503,747	)
Income tax benefit		191,424
Net loss from discontinued operations, net of tax	$	(312,323	)

Noncontrolling interests were allocated $0.4 million of net income and $1.1 million of net loss during the three months ended March 31, 2014 and 2013, respectively. Noncontrolling interests are the equity ownership interests in our majority owned hospital subsidiaries, EEPMC and FBH SA.

Net income (loss) attributable to Foundation Healthcare. Our operations resulted in a net loss of $1.7 million during the first quarter of 2014, compared to net loss of $0.3 million during the first quarter of 2013.

Liquidity and Capital Resources

Generally our liquidity and capital resource needs are funded from operations, loan proceeds and equity offerings. As of March 31, 2014, our liquidity and capital resources included cash and cash equivalents of $4.0 million and a working capital deficit of $16.8 million. As of December 31, 2013, our liquidity and capital resources included cash and cash equivalents of $4.2 million and working capital deficit of $15.0 million.

Cash provided by operating activities from continuing operations was $1.6 million during the three months ended March 31, 2014 compared to the first three months of 2013 when operating activities from continuing operations used $1.4 million. During the three months ended March 31, 2014, the primary sources of cash from operating activities from continuing operations were cash generated by income from continuing operations (net loss increased by non-cash items) of $0.3 million and increases in accrued liabilities and other liabilities totaling $3.9 million. During the three months ended March 31, 2014, the primary uses of cash from continuing operations, were an increase in accounts receivables totaling $0.3 million and decreases in accounts payable and other current liabilities of $2.3 million. During the three months ended March 31, 2013, the primary uses of cash from operating activities from continuing operations were cash required to fund losses from continuing operations (net loss reduced by non-cash items) of $0.9 million and increase in accounts receivable and prepaid and other current assets totaling $2.4 million and a decrease in accounts payable of $1.4 million. The primary source of cash from operating activities from continuing operations in the first three months of 2013 was an increase in accrued liabilities of $3.3 million.

Cash used by discontinued operations for the three months ended March 31, 2014 was $0.1 million. There were no discontinued operations during the three months ended March 31, 2013.

Net cash provided by investing activities from continuing operations during the three months ended March 31, 2014 was $0.2 million compared to the first three months of 2013 when investing activities from continuing operations used $1.3 million. Investing activities during the first three months of 2014 were primarily

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related to distributions received from equity investments of $0.6 million which were offset by purchases of property and equipment of $0.4 million. Investing activities during the first three months of 2013 were primarily related to distributions received from equity investments of $1.3 million which were offset by purchases of property and equipment of $2.6 million.

Net cash used by financing activities from continuing operations during the three months ended March 31, 2014 was $2.0 million compared to the first three months of 2013 when financing activities from continuing operations provided $1.2 million. During the three months ended March 31, 2014 and 2013, we received debt proceeds of $0.8 million and $3.4 million, respectively, and we made debt payments of $1.6 million and $1.4 million, respectively. During the three months ended March 31, 2014 and 2013, we made distributions to noncontrolling interests of $0.9 million and $37 thousand, respectively. During the three months ended March 31, 2014 and 2013, we paid preferred noncontrolling dividends of $0.3 million and $0.4 million, respectively. During the three months ended March 31, 2013, we made distributions to FHA (prior to the reverse acquisition on July 22, 2013) of $0.4 million.

As of March 31, 2014, we had an accumulated deficit of $37.1 million and a working capital deficiency of $16.8 million. During the three months ended March 31, 2014, we generated a net loss attributable to Foundation Healthcare of $1.7 million and generated cash flow from operating activities from continuing operations of $1.6 million. We expect to refinance, by the end of the second quarter of 2014, a significant portion of our long-term debt obligations. We expect to significantly reduce our annual debt service payments as part of the refinancing; however, there is no assurance that we will be successful in completing the debt refinancing. We may also seek to raise additional funds through the sale of equity securities, but there is no guarantee that we will do so or that we will be successful if we seek such financing.

Legacy Bank Credit Facility

We have entered into various short-term and long-term notes payable with our senior lender, Legacy Bank (referred to as “Legacy Debt”). As of March 31, 2014, the balance of the Legacy Debt was $10.7 million. The Legacy Debt is collateralized by substantially all of the assets of our subsidiaries, FSA and FSHA, and a portion is personally guaranteed by certain of our officers. In conjunction with the Legacy Debt, we have agreed to comply with certain financial covenants (as defined and calculated at the FSA and FSHA level) including:

• Debt Service Coverage Ratio of 1.05 to 1 and increasing to 1.1 to 1 by December 31, 2013; 1.15 to 1 by March 31, 2014; and 1.2 to 1 by June 30, 2014; and

• Minimum Tangible Net Worth of $11.1 million increased each quarter (beginning in September 30, 2013 by 50% of FSA’s and FSHA’s net income for the quarter).

As of March 31, 2014, we are not in compliance with the Legacy Debt Minimum Tangible Net Worth financial covenant. We have requested a waiver from Legacy Bank for the covenant violation. Historically, we have been successful in obtaining waivers from the bank for any covenant non-compliance; however there is no assurance that we will be able to obtain waivers in the future. We do not anticipate obtaining a waiver for a period greater than 12 months and it is unlikely that we will regain compliance with the Minimum Tangible Net Worth covenant within the next 12 months. As a result, the Legacy Debt has been classified as current our consolidated balance sheets as of March 31, 2014. See Item 2. – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Going Concern and Management’s Plan for additional information on our plan to refinance our existing debt obligations.

Arvest Bank Credit Facility

On July 22, 2013, our subsidiaries, SDC Holdings, LLC and ApothecaryRx, LLC (collectively the “Borrowers”), we and Mr. Stanton Nelson (the “Guarantor” and the Company’s chief executive officer) entered into a Second Amended and Restated Loan Agreement (the “New Loan Agreement”) and an Amended and Restated Promissory Note (the “New Note”) with Arvest Bank. We, Borrowers, Guarantor and other guarantors previously entered into the Amended and Restated Loan Agreement dated effective December 17, 2010, as amended by the First Amendment to Loan Agreement dated January 1, 2012, the Second Amendment to Loan Agreement dated effective June 30, 2012, and the Third Amendment to Loan Agreement dated effective October 12, 2012 (the “Prior

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Agreement”). Under the Prior Agreement, we and Borrowers were indebted to Arvest Bank under the Amended and Restated Promissory Note, in the original principal amount of $15,000,000 dated June 30, 2010 and the Second Amended and Restated Promissory Note, in the original principal amount of $30,000,000, dated June 30, 2010 (the “Prior Notes”). We, Arvest Bank, the Borrowers and the Guarantor have agreed to restructure the loan evidenced by the Prior Notes and the Prior Agreement. As of March 31, 2014, the outstanding principal amount of the New Note was $9.9 million.

On July 22, 2013, in conjunction with the New Loan Agreement with Arvest Bank, we entered into a Participation Agreement with Arvest Bank in which we purchased a $6,000,000 participation in the New Note from Arvest Bank in exchange for 13,333,333 shares of the Company’s common stock. The Company purchased the participation in the last $6,000,000 of the principal amount due under the Arvest credit facility. The Company’s participation in the note is eliminated against the New Note. Since the operations of the Borrowers has been discontinued, the New Note, net of the participation, is included in current liabilities from discontinued operations in our consolidated balance sheet.

The New Note is collateralized by substantially all of the assets of the Borrowers and the personal guaranty of the Guarantor which is limited to $2,919,000. The note bears interest at the greater of the prime rate or 6.0% and provided the Borrowers are not in default, the Borrowers are required to make monthly payments of interest only. The entire unpaid principal balance and all accrued and unpaid interest thereon was due and payable on April 30, 2014. Additionally, the New Note is subject to certain financial covenants including a debt service coverage ratio (“DSR”) covenant of not less than 1.25 to 1. Arvest Bank has waived the DSR and other financial covenant requirements through April 30, 2014, which was the maturity date of the New Note. We are in the process of extending the maturity date of the New Note and obtaining a waiver of financial covenants. Historically, we have been successful in obtaining extensions and waivers of covenant violations, however there is no assurance that Arvest Bank will continue to extend the note or waive the covenant violations. See Item 2. – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Going Concern and Management’s Plan for additional information on our plan to refinance our existing debt obligations.

Financial Commitments

Our future commitments under contractual obligations by expected maturity date at March 31, 2014 are as follows:

	< 1 year		1-3 years		3-5 years		> 5 years		Total
Short-term debt (1)	$	6,409,647	$	—	$	—	$	—	$	6,409,647
Long-term debt (1)		11,303,859		5,972,981		78,181		—		17,355,021
Operating leases		11,967,440		24,433,748		24,361,943		92,790,617		153,553,748
Other long-term liabilities		30,000		32,500		—		—		62,500
Liabilities from discontinued operations (2)		3,983,946		—		—		—		3,983,946
Preferred noncontrolling interests (3)		1,591,074		3,017,052		6,509,914		—		11,118,040
Total	$	35,285,966	$	33,456,281	$	30,950,038	$	92,790,617	$	192,482,902

(1) Includes principal and interest obligations.

(2) Represents the debt principal and interest obligations and future minimum lease payments included in our discontinued operations.

(3) Represents the redemption obligation, including interest, of our preferred noncontrolling interests.

CRITICAL ACCOUNTING POLICIES

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management’s prudent judgments and estimates. Actual results may differ from these estimates. Management believes that any reasonable deviation from those judgments and estimates would not have a material impact on our consolidated financial position or results of operations. To the extent that the estimates used differ from actual results, however, adjustments to the statement of earnings and corresponding balance sheet accounts would be necessary. These adjustments would be made in future

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statements. For a complete discussion of all our significant accounting policies please see our 2013 annual report on Form 10-K. Some of the more significant estimates include revenue recognition, allowance for doubtful accounts, and goodwill and intangible asset impairment. We use the following methods to determine our estimates:

Revenue recognition and accounts receivable – We recognize revenues in the period in which services are performed. Accounts receivable primarily consist of amounts due from third-party payors and patients. Our ability to collect outstanding receivables is critical to its results of operations and cash flows. Amounts we receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as health maintenance organizations, preferred provider organizations and other private insurers are generally less than our established billing rates. Additionally, to provide for accounts receivable that could become uncollectible in the future, we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. Accordingly, the revenues and accounts receivable reported in our consolidated financial statements are recorded at the net amount expected to be received.

Contractual Discounts and Cost Report Settlements –We derive a significant portion of our revenues from Medicare, Medicaid and other payors that receive discounts from its established billing rates. We must estimate the total amount of these discounts to prepare its consolidated financial statements. The Medicare and Medicaid regulations and various managed care contracts under which these discounts must be calculated are complex and are subject to interpretation and adjustment. We estimate the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. These interpretations sometimes result in payments that differ from our estimates. Additionally, updated regulations and contract renegotiations occur frequently, necessitating regular review and assessment of the estimation process by management. Changes in estimates related to the allowance for contractual discounts affect revenues reported in our consolidated statements of operations.

Cost report settlements under reimbursement agreements with Medicare and Medicaid are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined. There is a reasonable possibility that recorded estimates will change by a material amount in the near term.

Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. We believe that we are in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing that would have a material effect on our financial statements. Compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties and exclusion from the Medicare and Medicaid programs.

Provision and Allowance for Doubtful Accounts – To provide for accounts receivable that could become uncollectible in the future; we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

We have an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance. No single statistic or measurement determines the adequacy of the allowance for doubtful accounts. Some of the analytical tools that we utilizes include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of our ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan. Accounts receivable are written off after collection efforts have been followed in accordance with our policies.

Due to the nature of the healthcare industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as

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additional information becomes available, which could have a material impact on our operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for our services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, we are not certain of the full amount of patient responsibility at the time of service. We estimate amounts due from patients prior to service and generally collects those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.

Goodwill and Intangible Assets – We evaluates goodwill for impairment at least on an annual basis and more frequently if certain indicators are encountered. Goodwill is to be tested at the reporting unit level, defined as an ASC or hospital (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired.

Intangible assets other than goodwill which include physician membership interests, service contracts and covenants not to compete are amortized over their estimated useful lives using the straight line method. The remaining lives range from five to seven years. We evaluate the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Adopted Guidance

In February 2013, the FASB issued changes to the accounting for obligations resulting from joint and several liability arrangements. These changes require an entity to measure such obligations for which the total amount of the obligation is fixed at the reporting date as the sum of (i) the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors, and (ii) any additional amount the reporting entity expects to pay on behalf of its co-obligors. An entity will also be required to disclose the nature and amount of the obligation as well as other information about those obligations. Examples of obligations subject to these requirements are debt arrangements and settled litigation and judicial rulings. These changes become effective for us on January 1, 2014. We have determined that the adoption of these changes did not have an impact on our consolidated financial statements, as we do not currently have any such arrangements.

In July 2013, the FASB issued changes to the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. These changes require an entity to present an unrecognized tax benefit as a liability in the financial statements if (i) a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position, or (ii) the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset to settle any additional income taxes that would result from the disallowance of a tax position. Otherwise, an unrecognized tax benefit is required to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. Previously, there was diversity in practice as no explicit guidance existed. These changes become effective us on January 1, 2014. We have determined that the adoption of these changes did not have a significant impact on our consolidated financial statements

Issued Guidance

In April 2014, the FASB issued changes to the reporting of discontinued operations and disclosures of disposals of components of an entity. The amendments change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Additionally, the new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about

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the assets, liabilities, income and expenses of discontinued operations. The amendments are effective prospectively for all disposals (or classifications as held for sale) of components of an entity, and for all businesses that, on acquisition, are classified as held for sale that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. We are currently evaluating the new guidance to determine the impact it may have to our consolidated financial statements.

Cautionary Statement Relating to Forward Looking Information

We have included some forward-looking statements in this section and other places in this report regarding our expectations. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, business plans or objectives, levels of activity, performance or achievements, or industry results, to be materially different from any future results, business plans or objectives, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Some of these forward-looking statements can be identified by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should” or “anticipates” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategies that involve risks and uncertainties. You should read statements that contain these words carefully because they

• discuss our future expectations;

• contain projections of our future operating results or of our future financial condition; or

• state other “forward-looking” information.

We believe it is important to discuss our expectations; however, it must be recognized that events may occur in the future over which we have no control and which we are not accurately able to predict. Readers are cautioned to consider the specific business risk factors described in this report and our Annual Report on Form 10-K and not to place undue reliance on the forward-looking statements contained in this report or our Annual Report, which speak only as of the date of this report or the date of our Annual Report. We undertake no obligation to publicly revise forward-looking statements to reflect events or circumstances that may arise after the date of this report.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

We are a smaller reporting entity as defined in Rule 12b-2 of the Exchange Act and as such, are not required to provide the information required by Item 305 of Regulation S-K with respect to Quantitative and Qualitative Disclosures about Market Risk.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

Our management (with the participation of our Principal Executive Officer, Principal Financial Officer and Principal Accounting Officer) evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of March 31, 2014. Disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported on a timely basis and that such information is accumulated and communicated to management, including the Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based on this evaluation, our Principal Executive Officer, Principal Financial Officer and Principal Accounting Officer concluded that these disclosure controls and procedures are effective.

On July 22, 2013, we completed our acquisition of Foundation. As permitted by the Securities and Exchange Commission under the current year acquisition scope exception, we excluded the Foundation acquisition from our 2013 assessment of the effectiveness of our internal control over financial reporting since it was not

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practicable for management to conduct an assessment of internal control over financial reporting between the acquisition date and the date of management’s assessment. However, we have extended our oversight and monitoring processes that support our internal control over financial reporting to include Foundation’s operations. During our monitoring of the internal controls over financial reporting at Foundation, we identified the material weaknesses noted below.

Description and Remediation of Material Weaknesses in Internal Controls over Financial Reporting

The internal controls at Foundation do not include sufficient independent internal review and approval of critical accounting schedules used in the preparation of financial statements. In addition, the internal controls at Foundation do not include sufficient review and approval of the accounting impact and treatment of material contracts and agreements. We have begun the remediation process for these material weaknesses by establishing review and approval procedures that extend to the operations of Foundation, but since we have not completed an assessment of the effectiveness of these and the other internal controls at Foundation. To complete the remediation process, we have developed a plan and related timeline to design a set of control procedures and the related required documentation thereof in order to address these material weakness. We have targeted to have these internal controls in place by the end of the third quarter of 2014. Specifically, we intend to engage a consultant to assist us in the identification of required key controls, the necessary steps required for procedures to ensure the appropriate independent review and approval of critical accounting schedules and the independent review and assessment of the accounting treatment of material contracts and agreements.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

In the normal course of business, we may become involved in litigation or in legal proceedings. We are not aware of any such litigation or legal proceedings that we believe will have, individually or in the aggregate, a material adverse effect on our business, financial condition and results of operations.

Item 1A. Risk Factors.

There are no material changes from the risk factors previously disclosed in our 2013 Annual Report on Form 10-K.

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

Stock Award. On February 17, 2014, the Compensation Committee of the Board of Directors granted Mr. Nelson, our Chief Executive Officer, a restricted stock award for 8,191,745 shares of common stock pursuant to our 2008 Long-Term Incentive Plan, as amended. The award is subject to vesting as follows: 20% vesting as of the date of grant and 20% vesting on each anniversary of the date.

Cashless Stock Grant Vesting. During February 2014, we acquired, by means of net share settlements, 773,250 shares of Foundation common stock, at a price of $0.35 per share, related to the vesting of an employee restricted stock award to satisfy withholding tax obligations. We do not have any on-going stock repurchase programs.

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Item 3. Defaults Upon Senior Securities.

We do not have anything to report under this Item.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

We do not have anything to report under this Item.

Item  6. Exhibits.

(a) Exhibits:

Exhibit No.	Description
10.1	Agreement in Connection with Assignment and Assumption of Membership Interest Purchase Agreement, dated February 28, 2014, by and between Foundation Surgical Hospital Affiliates, LLC and Physicians Realty L.P., is incorporated by reference to Exhibit 10.30 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2014.
10.2	Master Lease, dated March 1, 2014, by and between DOC-FSH San Antonio, LLC and Foundation Surgical Hospital Affiliates, LLC, is incorporated by reference to Exhibit 10.31 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2014.
10.3+	Change in Terms Agreement, dated March 21, 2014, by and between East El Paso Physicians’ Medical Center, LLC, Foundation Surgery Affiliates, LLC and Legacy Bank.
10.4+	Change in Terms Agreement, dated March 21, 2014, by and between East El Paso Physicians’ Medical Center, LLC, Foundation Surgery Affiliates, LLC and Legacy Bank.
10.5+	Change in Terms Agreement, dated February 28, 2014, by and between East El Paso Physicians’ Medical Center, LLC, Foundation Surgery Affiliates, LLC and Legacy Bank.
10.6+	Change in Terms Agreement, dated March 18, 2014, by and between Foundation Surgery Affiliates, LLC, East El Paso Physicians’ Medical Center, LLC and Legacy Bank.
31.1+	Certification of Stanton Nelson, Chief Executive Officer of Registrant.
31.2+	Certification of Mark R. Kidd, Chief Financial Officer of Registrant.
31.3+	Certification of Grant A. Christianson, Chief Accounting Officer of Registrant.
32.1+	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Stanton Nelson, Chief Executive Officer of Registrant.
32.2+	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Mark R. Kidd, Chief Financial Officer of Registrant.
32.3+	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Grant A. Christianson, Chief Accounting Officer of Registrant.

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101. INS	XBRL Instance Document.
101. SCH	XBRL Taxonomy Extension Schema Document.
101. CAL	XBRL Taxonomy Extension Calculation Linkbase Document.
101. DEF	XBRL Taxonomy Extension Definition Linkbase Document.
101. LAB	XBRL Taxonomy Extension Label Linkbase Document.
101. PRE	XBRL Taxonomy Extension Presentation Linkbase Document.

+ Filed herewith.

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.

	FOUNDATION HEALTHCARE, INC.
	(Registrant)
	By:	/S/ STANTON NELSON
		Stanton Nelson
		Chief Executive Officer
		(Principal Executive Officer)
Date: May 15, 2014
	By:	/S/ MARK R. KIDD
		Mark R. Kidd
		Chief Financial Officer
		(Principal Financial Officer)
Date: May 15, 2014
	By:	/S/ GRANT A. CHRISTIANSON
		Grant A. Christianson
		Chief Accounting Officer
		(Principal Accounting Officer)

Date: May 15, 2014

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