February 22, 2007
VIA FACSIMILE
United States Securities and Exchange Commission
Washington, D.C. 20549
Attn: Mr. Jim Peklenc
RE: HC INNOVATIONS, INC.
FORM 10-SB/A FILED 2/8/2007
FILE NO.: 0-52197
Dear Mr. Peklenc:
The following is in response to our recent discussion wherein you requested a
more robust discussion to clear our response to Comment 4 as filed 2/8/2007
along with a detailed analysis under EITF 97-2 that clarifies why there was a
consolidation of the entities in question for 2005 and not 2004.
OUR RESPONSE TO COMMENT 4 AS FILED 10SBG/A 2/8/2007:
Comment 4: Refer to your response to comment nine. You make the assertion in the
disclosure in the last paragraph on page 8 that you would also consolidate the
LLC entities under the provisions of EITF 97-2 which would have been applicable
for the years ended December 31, 2004 and 2003. Based on that assertion it is
still unclear to us what changed in the reporting structure between these
periods. Please clarify more specifically what is meant by the "single company
basis" used for periods 2004 and prior referred to in this disclosure in the
last paragraph of this section on page 9. Specifically list the entities
included in each of the years 2005, 2004, and 2003 so that we can see exactly
what changed between these reporting periods.
RESPONSE 4: We have revised the "Basis of Presentation" portion of Note 2 in the
Notes to Consolidated Financial Statements for December 31, 2005 to disclose
that the LLCs are not consolidated prior to 2005 and why the LLCs are not
required to be consolidated in years prior to 2005. All entities included in
each of the years 2005, 2004 and 2003 are specifically listed in the notes to
the financial statements.
FURTHER BACKGROUND
Reference is made to the following footnotes as included in the audited
financial statements of HC Innovations, Inc. as filed with Form 10 SB and which
provide detailed chronology and history of the Company and its subsidiaries.
NOTE 1 - NATURE OF OPERATIONS (FOOTNOTE TO DECEMBER 31, 2004 AUDITED FINANCIAL
STATEMENTS)
HC INNOVATIONS, INC., (THE "COMPANY") WAS INCORPORATED IN DELAWARE IN
DECEMBER 2004. IN DECEMBER 2004, THE COMPANY OBTAINED CONTROL OF ENHANCED
CARE
INITIATIVES, INC ("ECI") AND ENHANCED CARE INITIATIVES OF MAINE, INC.
THROUGH AN EXCHANGE OF SHARES WITH THE EXISTING SHAREHOLDERS OF ECI. THE
FINANCIAL STATEMENTS REFLECT THE TRANSACTION AS A REVERSE ACQUISITION AND
AS SUCH, INCLUDE THE FINANCIAL STATEMENTS FOR ECI AND ITS SUBSIDIARY AND
PREDECESSOR FOR ALL PERIODS PRESENTED. THE COMPANY'S BUSINESS IS TO PROVIDE
SPECIALTY HEALTHCARE MANAGEMENT SERVICES TO SUBGROUPS OF PEOPLE WITH HIGH
COSTS AND DISABILITY AND CREATE AND IMPLEMENT PROGRAMS AND INTERVENTIONS
THAT IMPROVE THEIR HEALTH, RESULTING IN DRAMATIC REDUCTIONS IN THE COST OF
THEIR CARE. THE COMPANY ALSO DEVELOPS AND IMPLEMENTS MEDICAL MANAGEMENT
SYSTEMS FOR THE LONG TERM CARE INDUSTRY.
1. NATURE OF OPERATIONS (FOOTNOTE TO DECEMBER 31, 2005 AUDITED FINANCIAL
STATEMENTS)
HC INNOVATIONS, INC. ("HCI") IS A HOLDING COMPANY INCORPORATED IN DELAWARE
IN DECEMBER 2004. HCI AND SUBSIDIARIES (THE "COMPANY") IS A SPECIALTY CARE
MANAGEMENT COMPANY COMPRISED OF SEPARATE DIVISIONS EACH WITH A SPECIFIC
FOCUS AND INTERVENTION. THE COMPANY'S MISSION IS TO IDENTIFY SUBGROUPS OF
PEOPLE WITH HIGH COSTS AND DISABILITY AND CREATE AND IMPLEMENT PROGRAMS AND
INTERVENTIONS THAT IMPROVE THEIR HEALTH, RESULTING IN DRAMATIC REDUCTIONS
IN THE COST OF THEIR CARE. THE COMPANY ALSO DEVELOPS AND IMPLEMENTS MEDICAL
MANAGEMENT SYSTEMS FOR THE LONG TERM CARE INDUSTRY.
ENHANCED CARE INITIATIVES, INC. ("ECI"), A WHOLLY OWNED SUBSIDIARY OF HCI
WAS FOUNDED IN 2002 AND IS THE MANAGEMENT COMPANY FOR ALL HCI ENTITIES.
ENHANCED CARE INITIATIVES OF TENNESSEE, INC. IS A WHOLLY OWNED SUBSIDIARY
OF ECI WITH OFFICES IN NASHVILLE, TN. ECI MARKETS ITS PROPRIETARY SPECIALTY
CARE MANAGEMENT PROGRAMS FOR THE MEDICALLY FRAIL AND OTHER COSTLY
SUB-POPULATIONS TO HEALTH MAINTENANCE ORGANIZATIONS ("HMOS") AND OTHER
MANAGED CARE ORGANIZATIONS ("MCOS") AS WELL AS STATE MEDICAID DEPARTMENTS.
NP CARE, LLCS ("LLCS") ARE NURSING HOME MEDICAL MANAGEMENT SYSTEMS. THE
LLCS NURSE PRACTITIONER PROGRAM PROVIDES ONSITE MEDICAL CARE BY AN ADVANCED
PRACTICE REGISTERED NURSE ("APRN") UNDER THE OVERSIGHT OF THE PATIENT'S
INDIVIDUAL PHYSICIAN TO RESIDENTS IN NURSING HOMES AND ASSISTED LIVING
FACILITIES. THE LLCS OPERATE IN THE STATES OF CONNECTICUT AND FLORIDA AND
ARE MANAGED EXCLUSIVELY BY ECI.
FACTS
On January 1, 2005 the Company, through its subsidiary Enhanced Care
Initiatives, Inc. executed a Practice Management Agreement with the NP Care,
LLC's. Prior to fiscal 2005, NP Care, LLC's had no contractual business
relationship with HC Innovations, Inc. or its subsidiaries, was under the
control of David Chess, MD and did not meet the
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criteria for consolidation under FIN 46 (R) as a "variable interest entity" and
did not meet the criteria for consolidation under EITF 97-2 in 2004.
The January 1, 2005 Practice Management Agreement between Enhanced Care
Initiatives, Inc. [ECI] (the practice management company) and NP Care, LLC's
[NP] (the entity actually engaged in the delivery of professional medical
services) does not involve the direct ownership by ECI of an equity interest in
NP. Rather, David Chess, M.D., is the sole equity owner of NP. He and ECI have
entered into a "captive interest" agreement. Under this agreement, ECI could
cause Dr. Chess to transfer his equity interest at any time to any person
specified by ECI and to vote his interest as ECI instructs. Dr. Chess has no
realistic expectation of achieving any gain (or loss) as the result of his
ownership interest in NP, because the compensation arrangements under the
Practice Management Agreement (defined below) effectively preclude the
possibility that NP will ever realize material net profits.
Under the 2005 Practice Management Agreement, ECI is paid a fee that
effectively equals all of the operating profit from NP. As the result of this
compensation provision, NP would have no reasonable prospect of earning a
profit. The Practice Management Agreement also requires ECI to provide a
substantial loan for NP's working capital requirements. This provision leaves
ECI (and not Dr. Chess) substantially at risk with respect to the performance of
NP only in 2005.
DISCUSSION
FIN 46(R)
FIN 46(R) sets forth the circumstances under which an entity is deemed
to be a "variable interest entity" and where consolidation of financial
statements is REQUIRED. We believe NP is properly deemed a variable interest
entity in 2005 only pursuant to FIN 46(R), and therefore ECI MUST consolidate
its financial statements with those of NP in 2005 only.
Paragraph 5 of FIN 46(R) (quoted in part) states that an entity shall
be subject to consolidation if:
a. The total equity investment at risk is not sufficient to
permit the entity to finance its activities without additional
subordinated financial support; or
b. As a group, the holders of the equity investment at risk
lack any one of the following three characteristics of a
controlling financial interest: (1) the direct or indirect ability
through voting rights or similar rights to make decisions about an
entity's activities that have a significant effect on the success
of the entity. (2) The obligations to absorb the expected losses
of the entity. The investor or investors do not have that
obligation if they are directly
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or indirectly protected from the expected losses or are guaranteed
a return by the entity itself or by other parties involved with
the entity. (3) The right to receive the expected residual returns
of the entity. The investors do not have that right if their
return is capped by that entity's governing documents or
arrangements with other variable interest holders or the entity.
Paragraph 5 further states that when evaluating the entity's equity
investment at risk, only interests reported as equity in the entity's financial
statements are considered. An entity's equity investment at risk does not
include equity investments that do not participate significantly in profits and
losses.
NP meets the characteristics of part a. and one or more of the
characteristics of part b. in 2005, and therefore there would seem to be little
question that NP is a variable interest entity in 2005.
A. The total equity investment at risk is not sufficient to permit the
entity to finance its activities without additional subordinated
financial support.
COMMENT:
Dr. Chess has a nominal investment in NP, and he has no obligation to
make any additional investment. Operating capital must be supplied to
NP by ECI under the Practice Management Agreement or through other
financing arrangements.
B. As a group, the holders of the equity investment at risk lack any one
of the following three characteristics of a controlling financial
interest: (1) the direct or indirect ability through voting rights or
similar rights to make decisions about an entity's activities that have
a significant effect on the success of the entity. (2) The obligations
to absorb the expected losses of the entity. The investor or investors
do not have that obligation if they are directly or indirectly
protected from the expected losses or are guaranteed a return by the
entity itself or by other parties involved with the entity. (3) The
right to receive the expected residual returns of the entity. The
investors do not have that right if their return is capped by that
entity's governing documents or arrangements with other variable
interest holders or the entity.
COMMENT:
(1) Dr. Chess is the sole equity holder of NP. Although as the sole
holder he has the right to vote and thereby indirectly make decisions
for NP, for all practical purposes decision making is vested in ECI
under the 2005 Practice Management Agreement. Moreover, the captive
interest agreement requires Dr. Chess to vote as ECI directs, and it
would permit ECI to substitute a different equity holder in place of
Dr. Chess if Dr. Chess did not vote as ECI directed. Thus, Dr. Chess
effectively lacks decision making authority.
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(2) Dr. Chess has no obligation to absorb NP's losses. Since NP is a
limited liability company, Dr. Chess cannot be held personally liable
for the debts of NP. By virtue of its obligation to provide operating
capital to NP, ECI effectively has an obligation to absorb losses.
(3) Dr. Chess has no reasonable right or expectation to receive the
residual returns of NP. The entire operating profit of NP will be paid
to ECI as compensation for ECI's services under the Practice Management
Agreement. As the result of this arrangement, NP cannot have material
profits. Dr. Chess theoretically could realize profits from NP by
voting contrary to ECI's direction, changing management and
distributing profits to himself. However, that action would violate the
Practice Management Agreement and give rise to a substantial cause of
action against Dr. Chess. Moreover, Dr. Chess is likely to be able to
take such action only once, as ECI would almost certainly immediately
remove Dr. Chess as the legal owner of the equity.
According to FIN 46(R), if an entity is a variable interest entity,
then the task is to determine the primary beneficiary of that entity because the
latter must consolidate with the variable interest entity. Paragraph 14 of FIN
46(R) requires an entity to consolidate if it "will absorb a majority of the
entity's expected losses, receive a majority of the entity's expected residual
returns, or both." Under the present circumstances, ECI fully intends to absorb
the losses and realize the returns, and ECI intends to control Dr. Chess's right
to vote as the sole member of NP. There appears to be little doubt that ECI is
the primary beneficiary of NP.
Based on the foregoing, we believe that consolidation is required under
FIN 46(R) commencing in 2005
EITF ISSUE 97-2
EITF Issue 97-2 preceded FIN46(R). It details the circumstances under
which companies engaged in the practice of medicine (i.e., NP) and those that
manage the operations of physician practices (i.e., ECI) may consolidate their
financial statements.
EITF Issue 97-2 was issued during a time when several medical practice
management companies were seeking capital from the public markets. The relevant
regulatory authorities had no particular interest in permitting or encouraging
these companies to consolidate with their managed medical practices. Had FIN
46(R) been silent with respect to this issue, the logical conclusion might be
that healthcare companies continue to be obligated to comply with EITF Issue
97-2.
However, FIN 46(R) recognizes the conflict between the two approaches
and expressly provides that the dictates of FIN 46(R) controls. According to FIN
46(R), if a "physician practice is a variable interest entity as described in
this Interpretation [46(R)], that entity is subject to the requirements of this
Interpretation [46(R)], and the consensus
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reached in [EITF] Issue 97-2 does not apply." Accordingly, we conclude that FIN
46(R) overrides EITF Issue 97-2 in 2005, and Issue 97-2 is most likely
inapplicable to this case for 2005.
Although we believe that EITF Issue 97-2 is inapplicable under these
facts in 2005, given that the U.S. Securities and Exchange Commission may find
that EITF Issue 97-2 is relevant or in fact applicable, we set forth herein how
we believe the arrangements in 2005, or lack of arrangements in 2004 between NP
Care and ECI already substantially comply with the requirements of EITF Issue
97-2 in 2005 and do not in 2004.
EITF Issue 97-2 provides that a practice management company has a
controlling financial interest over a practice, and therefore may consolidate
financial accounts with that practice, if six criteria are met. These criteria
relate to term, control and financial interest. Each criterion and its
applicability to the relationship between NP and ECI is set forth below.
TERM
1. ISSUE 97-2 REQUIREMENT: The term of the contractual arrangement must
be either (i) for a period of 10 years or more, or (ii) for the life of
NP.
2005 COMMENTARY: The term stated in Section 7.1 of the Practice
Management Agreement executed on 1/1/2005 exceeds ten years; thus this
requirement is met in 2005.
2004 COMMENTARY: there was no contractual relationship between the
Company and NP Care, LLCs in 2004, thus this requirement is not met in
2004. Since failing this very first requirement there is no need to
consider any of the other.
2. ISSUE 97-2 REQUIREMENT: The Practice Management Agreement cannot be
terminable by NP except in cases of gross negligence, fraud, or illegal
acts committed by, or the bankruptcy of, ECI.
2005 COMMENTARY: Article VII of the Practice Management Agreement
states that NP may only terminate in the above stated instances.
CONTROL
3. ISSUE 97-2 REQUIREMENT: ECI must have exclusive authority over all
decision making related to "ongoing, major and central" operations of
NP (except for the actual delivery of medical care but including
decisions about the range of medical care to be allowed by NP).
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2005 COMMENTARY: Section 1.2 of the Practice Management Agreement
grants ECI exclusive authority with respect to the medical,
professional and ethical aspects of NP's nurse practitioner business.
Among other things, ECI controls the general range or scope of medical
care that NP offers to provide as a part of its business plan and
purpose. Decisions relating to the actual treatment of specific,
individual patients remain in the realm of the treating medical
professional but fall within the realm of the general business of NP.
Thus, the only limitation to this authority is that ECI may not
undertake any actions which only a licensed medical professional may
lawfully provide.
Article II of the Practice Management Agreement further details this
exclusive authority which includes (i) the recruiting, selection,
hiring, firing and total compensation of all medical professionals and
other NP employees, (ii) authority with respect to the preparation and
recommendation of financial and managerial reports and budgets and
(iii) various other administrative and support functions.
4a. ISSUE 97-2 REQUIREMENT: ECI must have exclusive authority over all
decision making related to total compensation of all licensed medical
professionals.
2005 COMMENTARY: Sections 2.8, 2.9, 2.13 and 3.3 of the Practice
Management Agreement satisfy this requirement by granting ECI such
authority.
4b. ISSUE 97-2 REQUIREMENT: ECI must have exclusive authority over all
decision making related to the selecting, hiring and firing of licensed
medical professionals employed by NP.
2005 COMMENTARY: Section 2.3, 2.7 and 2.11 of the Practice Management
Agreement provide ECI with such authority.
FINANCIAL INTEREST
5. ISSUE 97-2 REQUIREMENT: ECI's financial interest in NP must be
unilaterally saleable or transferable by ECI.
2005 COMMENTARY: ECI's financial interest in NP is its contractual
arrangement with NP, as evidenced by both the Practice Management
Agreement and the Membership Interest Transfer Agreement. Sections 8.8
and 7 of former and latter agreements, respectively, permit ECI to
assign these agreements without the consent of NP.
6a. ISSUE 97-2 REQUIREMENT: ECI's financial interest in NP must provide ECI
with the right to receive income on an ongoing basis from the current
operations of NP.
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2005 COMMENTARY: Appendix A to the Practice Management Agreement
satisfactorily addresses this requirement. All operating profit of NP,
as stated above, is paid to ECI as a management fee.
6b. ISSUE 97-2 REQUIREMENT: ECI's financial interest in NP must provide ECI
with the right to receive income as proceeds from the sale (or
liquidation) in an amount which fluctuates based on the performance of
NP and the change in the fair market value of such interests.
2005 COMMENTARY: The economic value in this relationship is captured in
the Practice Management Agreement. To the extent that there is economic
value in NP, ECI may realize virtually all of that value by assigning
the Practice Management Agreement. Although one could conceive of a
peculiar set of circumstances under which NP could have substantial
value that somehow was independent of the arrangements with ECI, that
value could be realized by someone other than ECI only through fraud or
by actions of the captive interest holder in violation of his agreement
with ECI. We believe that likelihood of such events occurring is
sufficiently remote to conclude that ECI effectively has the right to
realize the proceeds from any sale of the economic value in NP.
Respectfully submitted,
HC Innovations, Inc,
/s/ Jeffrey L. Zwicker
Jeffrey L. Zwicker
Chief Financial Officer
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