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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended December 31, 2005; or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission File Number 0-23511
________________
INTEGRATED HEALTHCARE HOLDINGS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
Nevada 87-0412182
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.)
1301 North Tustin Avenue, Santa Ana, California 92705
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
Registrant's telephone number, including area code: (714) 953-3503
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.0001 par value
(TITLE OF CLASS)
________________
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes[ ] No[X]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes[ ] No[X]
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [] No [ X ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes [ ] No [X]
The aggregate market value of voting stock held by non-affiliates of the
registrant was $3,890,280 as of June 30, 2005 (computed by reference to the last
sale price of a share of the registrant's common stock on that date as reported
by the Over the Counter Bulletin Board). For purposes of this computation, it
has been assumed that the shares beneficially held by directors and officers of
registrant were "held by affiliates"; this assumption is not to be deemed to be
an admission by such persons that they are affiliates of registrant.
There were 84,351,189 shares outstanding of the registrant's common stock as of
July 18, 2006.
DOCUMENTS INCORPORATED BY REFERENCE:
No portions of other documents are incorporated by reference into this Report.
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INTEGRATED HEALTHCARE HOLDINGS, INC.
FORM 10-K
ANNUAL REPORT FOR THE YEAR ENDED DECEMBER 31, 2005
TABLE OF CONTENTS
Page
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PART I
Item 1. Business.............................................................. 1
Item 1A. Risk Factors.......................................................... 13
Item 1B. Unresolved Staff Comments............................................. 17
Item 2. Properties............................................................ 18
Item 3. Legal Proceedings..................................................... 19
Item 4. Submission of Matters to a Vote of Security Holders................... 19
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities............................. 20
Item 6. Selected Financial Data............................................... 21
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations................................................. 22
Item 7A. Quantitative and Qualitative Disclosures About Market Risk............ 30
Item 8. Financial Statements and Supplementary Data........................... 31
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.................................................. 31
Item 9A. Controls and Procedures............................................... 31
Item 9B. Other Information..................................................... 32
PART III
Item 10. Directors and Executive Officers of the Registrant.................... 33
Item 11. Executive Compensation................................................ 35
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters....................................... 37
Item 13. Certain Relationships and Related Transactions........................ 37
Item 14. Principal Accountant Fees and Services................................ 40
Item 15. Exhibits, Financial Statement Schedules............................... 40
Signatures............................................................ 43
Consolidated Financial Statements..................................... F-1
PART I
FORWARD-LOOKING INFORMATION
This Annual Report on Form 10-K contains forward-looking statements, as
that term is defined in the Private Securities Litigation Reform Act of 1995.
These statements relate to future events or our future financial performance. In
some cases, you can identify forward-looking statements by terminology such as
"may," "will," "should," "expects," "plans," "anticipates," "believes,"
"estimates," "predicts," "potential" or "continue" or the negative of these
terms or other comparable terminology. These statements are only predictions and
involve known and unknown risks, uncertainties and other factors, including the
risks discussed under the caption "Risk Factors" herein that may cause our
company's or our industry's actual results, levels of activity, performance or
achievements to be materially different from those expressed or implied by these
forward-looking statements.
Although we believe that the expectations reflected in the
forward-looking statements are reasonable, we cannot guarantee future results,
levels of activity, performance or achievements. Except as may be required by
applicable law, we do not intend to update any of the forward-looking statements
to conform these statements to actual results.
As used in this report, the terms "we," "us," "our," "the Company,"
"Integrated Healthcare Holdings" or "IHHI" mean Integrated Healthcare Holdings,
Inc., a Nevada corporation, unless otherwise indicated.
ITEM 1. BUSINESS
BACKGROUND
Integrated Healthcare Holdings, Inc. is a predominantly physician-owned
company that, on March 8, 2005, acquired and began operating the
following four hospital facilities in Orange County, California (referred to as
the "Hospitals"):
o 282-bed Western Medical Center in Santa Ana;
o 188-bed Western Medical Center in Anaheim;
o 178-bed Coastal Communities Hospital in Santa Ana; and
o 114-bed Chapman Medical Center in Orange.
Together we believe that the Hospitals represent approximately 12.1% of
all hospital beds in Orange County, California.
Prior to March 8, 2005, we were primarily a development stage company
with no material operations. On November 18, 2003, members of our current and
former executive management team purchased a controlling interest in the Company
and redirected its focus towards acquiring and operating hospitals and
healthcare facilities that are financially distressed and/or underperforming. On
September 29, 2004, the Company entered into a definitive agreement to acquire
the four Hospitals from subsidiaries of Tenet Healthcare Corporation ("Tenet"),
and the transaction closed on March 8, 2005.
The transaction included operations of 4 licensed general acute care
hospitals with 762 beds. All four hospitals are accredited by the Joint
Commission on Accreditation of Healthcare Organizations and other appropriate
accreditation agencies that accredit specific programs. All properties are in
Orange County California, and operate as described below.
WESTERN MEDICAL CENTER - SANTA ANA. Western Medical Center - Santa Ana,
located at 1001 N. Tustin Avenue, Santa Ana, CA 92705, is Orange County's first
hospital, founded over 100 years ago. The hospital is one of IHHI's two
hospitals in Santa Ana, which are the only two general acute care hospitals in
this city of 330,000 persons. The hospital has 282 beds and provides quaternary,
tertiary and secondary services. It serves the entire county as one of only
three designated trauma centers in Orange County along with other tertiary
services such as burn center, kidney transplantation, emergency and scheduled
neurosurgical care, cardiac surgical services, a paramedic base station and
receiving center. The hospital also maintains Intensive Care Units for adults
and pediatrics, and a Neonatal Intensive Care Unit. Additionally the hospital
offers telemetry, Neurosurgical definitive observation, geriatric psychiatric,
medical, surgical, pediatric and obstetric inpatient services. Supporting these
services the hospital offers operating and recovery rooms, radiology services,
respiratory therapy services, clinical laboratories, pharmacy, physical and
occupational therapy services on an inpatient and most on an outpatient basis.
The hospital has 800 active physicians and 1200 nurses and hospital staff.
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WESTERN MEDICAL CENTER - ANAHEIM. Western Medical Center - Anaheim,
located at 1025 South Anaheim Blvd., Anaheim, CA 92805, offers a full range of
acute medical and psychiatric care services serving northern Orange County and
providing tertiary services to Riverside County residents. The hospital offers
special expertise in the tertiary services of The Heart and Vascular Institute,
Behavioral Health Services. Additionally, the hospital provides the Women and
Children Health Services, and 24-hour Emergency Services. Supporting these
services the hospital offers critical care, medical, surgical and psychiatric
services supported by operating and recovery rooms, radiology services,
respiratory therapy services, clinical laboratories, pharmacy, physical and
occupational therapy services on an inpatient and most on an outpatient basis.
The hospital has 325 active physicians and 525 nurses and hospital staff.
COASTAL COMMUNITIES HOSPITAL. Coastal Communities Hospital, located in
Santa Ana at 2701 S. Bristol St., Santa Ana, CA 92704, has served the community
for more than 30 years, providing comprehensive medical and surgical services in
a caring and compassionate environment. The hospital is one of IHHI's two
hospitals in Santa Ana, which are the only two general acute care hospitals in
this city of 330,000 persons. The hospital has tailored its services to meet the
changing needs of the community. The hospital's staff reflects the cultural
diversity of the community and is particularly responsive and sensitive to
diverse health care needs. While services continue to expand, the 178-bed
facility is small enough to retain the family atmosphere associated with a
community hospital. The hospital offers critical care, medical, surgical
obstetric, psychiatric and sub acute services supported by operating and
recovery rooms, radiology services, respiratory therapy services, clinical
laboratories, pharmacy, physical and occupational therapy services on an
inpatient and most on an outpatient basis. The hospital has 300 active
physicians and 600 nurses and hospital staff.
CHAPMAN MEDICAL CENTER. Founded in 1969, Chapman Medical Center is a
114-bed acute care facility located at 2601 East Chapman Ave., Orange, CA
92869. The hospital's advanced capabilities position the facility as a leader
in specialty niche programs, including the following centers: Chapman Center for
Obesity (surgical weightloss program); Center for Heartburn and Swallowing;
Chapman Lung Center; Chapman Family Health Center; Doheny Eye Center; House Ear
Clinic; Center for Senior Mental Health; and Positive Action Center (Adult and
Adolescent Chemical Dependency Program). Supporting these services the hospital
offers critical care, medical, surgical and geriatric psychiatric services
supported by operating and recovery rooms, radiology services, respiratory
therapy services, clinical laboratories, pharmacy, physical and occupational
therapy services on an inpatient and most on an outpatient basis. The hospital
has 300 active physicians and 450 nurses and hospital staff.
On March 8, 2005, we assumed management responsibility and control over
the Hospitals. Prior to acquiring the Hospitals, our management team had been
working with the individual management staffs of the Hospitals on a transition
plan, so the transition occurred seamlessly. We believe that all primary systems
and controls have been successfully transitioned to our Company for the
effective management of the Hospitals. To date we have achieved a number of key
milestones in transitioning the Hospitals to our management, including the
following:
o We have executed long term employment agreements with all key
members of the Hospital administrative staffs;
o We have augmented our management capabilities in the areas of
legal compliance and managed care contracting;
o Employee benefits packages have been negotiated, which we believe
maintain costs at approximately 2004 levels through May 2006;
o A full portfolio of insurances is in place at costs which we
believe are a substantial discount from prior rates;
o Corporate administration and overhead has been established and
will be maintained at levels that are substantially less costly
than prior levels;
o Billing and collection activities have been centralized and are
now resident at IHHI; and
o Daily financial and accountability reporting systems have been
established which allow the Company to track financial and
operating performance in real time; and payer, vendor and
physician contracts have been reviewed and assigned and/or renewed
where appropriate.
We have transitioned to our own payroll and time and
attendance systems, which allowed us to terminate our Employee Leasing
Agreements with Tenet effective May 22, 2005.
EMPLOYEES AND MEDICAL STAFF
At December 31, 2005, we had 2,775 full time equivalent employees. Some
of our employees are represented by labor unions and covered by collective
bargaining agreements. We believe that our relations with our employees are
good.
2
Our hospitals are fully staffed by physicians and other independently
practicing medical professionals licensed by the state, who have been admitted
to the medical staff of the individual hospital. Under state laws and licensing
standards, hospitals' medical staffs are self-governing organizations subject to
ultimate oversight by the hospital's local governing board. None of these
physicians are employees of the hospitals. Physicians are not limited to medical
staff membership at our hospitals, and many are on staff at our other hospitals,
or hospitals not owned or operated by us. Physicians on our medical staffs are
free to terminate their membership on our medical staffs and admit their
patients to other hospitals, owned, or not owned by us. Non-physician staff,
including nurses, therapists, technicians, finance, registration, maintenance,
clerical, housekeeping, and administrative staff are generally employees of the
hospital, unless the service is provided by a third party contracted entity. We
are subject to federal minimum wage and hour laws and various state labor laws
and maintain an employee benefit plan.
Our hospitals' operations depend on the abilities, efforts, experience
and loyalty of our employees and physicians, most of who have no long-term
contractual relationship. Our ongoing business relies on our attraction of
skilled, quality employees, physicians and other healthcare professionals in all
disciplines.
We strive to successfully attract and retain key employees, physicians
and health care professionals. Our operations, financial position and cash flows
could be materially adversely affected by the loss of key employees or
sufficient numbers of qualified physicians and other health professionals. The
relations we have with our employees, physicians and other health care
professionals are key to our success and they are a priority in our management
philosophy.
Our nursing costs are two thirds of our labor costs. Nursing can have a
significant effect on our labor costs. The national nursing shortage continues
and is serious in California. The nursing shortage is a significant issue for
hospitals, as it is for us. The result has been an increase in the cost of
nursing personnel, thus affecting our labor expenses. Additionally, California
instituted mandatory nurse staffing ratios, thus setting a high level of nurses
to patients, but also requiring nursing staff ratios be maintained at all times
even when on breaks or lunch. These requirements in the environment of a severe
nursing shortage may cause the limiting of patient admissions with an adverse
effect on our revenues. The vast majority of hospitals in California, including
ours, are not at all times meeting the state-mandated nurse staffing ratios. Our
plan is to improve compliance and reduce the cost of contract labor needed to
achieve the nurse staffing ratios.
COMPETITION
Hospital competition is a community issue and unique to each facility.
The first factor is the services the hospital offers and the other hospitals in
the area offering the same or similar service. The hospital is dependent on the
physicians to admit the patients to the hospital. The number of physicians
around the hospital, their specialties, and the quality of medicine they
practice will have a major impact on the hospital competition. The ability of
the hospital to employ and retain qualified nurses, other healthcare
professionals and administrative staff will affect the hospitals'
competitiveness in the market place. A hospital's reputation and years of
service to the community affects its competitiveness with patients, physicians,
employees, and contracting health plans. Southern California is a highly
competitive managed health care market therefore the contracting relationships
with managed care organizations is a key factor in a hospital's competitiveness.
The hospital's location, the community immediately surrounding it and the access
to the hospital will affect the hospitals competitiveness. Other hospitals or
healthcare organizations serving the same locations determine the intensity of
the competition. The condition of the physical plant and the ability to invest
in new equipment and technology can affect the communities and physicians desire
to use the facility. The amount the hospital charges for services is also a
factor in the hospital's competitiveness. The funding sources of the competition
can also be a factor if a competitor is tax exempt, it has advantages not
available to our hospitals, such as endowments, chartable contributions,
tax-exempt financing, and exemptions from taxes. Since these factors are
individual to each hospital, each hospital must develop its own strategies, to
address the competitive factors in its local.
OUR STRATEGY
Our goal is to provide high-quality health care services in a community
setting that are responsive to the needs of the communities that we serve. To
accomplish our mission in the complex and competitive health care industry, our
operating strategies are to (1) improve the quality of care provided at our
hospitals by identifying best practices and implementing those best practices,
(2) improve operating efficiencies and reduce operating costs while maintaining
or improving the quality of care provided, (3) improve patient, physician and
employee satisfaction, and (4) improve recruitment and retention of nurses and
other employees. We intend to integrate and efficiently operate the four
Hospitals in order to achieve profitability from operations. We may also seek
additional acquisitions of hospitals or health facilities in the future when
opportunities for profitable growth arise.
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HEALTH CARE REGULATION
CERTAIN BACKGROUND INFORMATION. Health care, as one of the largest
industries in the United States, continues to attract much legislative interest
and public attention. Changes in the Medicare and Medicaid programs and other
government health care programs, hospital cost-containment initiatives by public
and private payers, proposals to limit payments and health care spending, and
industry-wide competitive factors greatly impact the health care industry. The
industry is also subject to extensive federal, state and local regulation
relating to licensure, conduct of operations, ownership of facilities, physician
relationships, addition of facilities and services, and charges and effective
reimbursement rates for services. The laws, rules and regulations governing the
health care industry are extremely complex, and the industry often has little or
no regulatory or judicial interpretation for guidance. Compliance with such
regulatory requirements, as interpreted and amended from time to time, can
increase operating costs and thereby adversely affect the financial viability of
our business. Failure to comply with current or future regulatory requirements
could also result in the imposition of various civil and criminal sanctions
including fines, restrictions on admission, denial of payment for all or new
admissions, the revocation of licensure, decertification, imposition of
temporary management or the closure of a facility.
MEDICARE
GENERALLY. Each of the Hospitals participates in the Medicare program.
Health care providers have been and will be affected significantly by changes in
the last several years in federal health care laws and regulations pertaining to
Medicare. The purpose of much of the recent statutory and regulatory activity
has been to reduce the rate of increase in Medicare payments and to make such
payments more accurately reflect patient resource use at hospitals. In addition,
important amendments to the Medicare law were made by the recent Medicare
Prescription Drug, Improvement, and Modernization Act of 2003 ("MMA"). Although
the most important provisions of MMA relate to an expansion of Medicare's
coverage for pharmaceuticals and changes intended to expand managed care under
the Medicare program, MMA also made many changes in the laws that are relevant
to how Medicare makes payments to hospitals, some of which could have an adverse
impact on the Hospitals' Medicare reimbursement.
INPATIENT OPERATING COSTS. Medicare pays acute care hospitals, such as
the Hospitals, for most services provided to inpatients under a system known as
the "Prospective Payment System" or "PPS," pursuant to which hospitals are paid
for services based on predetermined rates. Medicare payments under PPS are based
on the Diagnosis Related Group ("DRG") to which each Medicare patient is
assigned. The DRG is determined by the patient's primary diagnosis and other
factors for each particular Medicare inpatient stay. The amount to be paid for
each DRG is established prospectively by CMS. The DRG amounts are not related to
a hospital's actual costs or variations in service or length of stay. Therefore,
if a hospital incurs costs in treating Medicare inpatients that exceed the DRG
level of reimbursement plus any outlier payments, then that hospital will
experience a loss from such services, which will have to be made up from other
revenue sources. Payment limitations implemented by other third party payers may
restrict the ability of a hospital to engage in such "cost-shifting." On April
25, 2006, the Secretary of the Department of Health and Human Services proposed
sweeping changes to the Medicare program's inpatient acute care PPS that could
(1) alter the way that DRG weights are calculated, abandoning the current
charge-based weight system in favor or a cost-based weight system and (2)
dramatically expand the number of DRGs so that the severity of a given illness
is taken into account for purposes of payment. Such systemic changes are
proposed to take affect for discharges occurring on and after October 1, 2006.
The effect of such changes on an individual hospital are difficult to determine
and payments under the proposed systems could significantly decrease payments
that a hospital receives from the Medicare program as compared to the existing
system. It is not possible to determine at this time whether such systemic
changes will be adopted as proposed or if adopted, how they may affect the
Hospitals.
For certain Medicare beneficiaries who have unusually costly hospital
stays (also known as "outliers"), CMS currently provides additional payments
above those specified for the DRG. To determine whether a case qualifies for
outlier payments, hospital-specific cost-to-charge ratios are applied to the
total covered charges for the case. Operating and capital costs for the case are
calculated separately by applying separate operating and capital cost-to-charge
ratios and combining these costs to compare them with a defined fixed- loss
outlier threshold for the specific DRG. There is no assurance that outlier
payments will continue to be provided at the same level if the changes in PPS
proposed by the Secretary on April 25, 2006 are adopted.
PPS payments are adjusted annually using an inflation index, based on
the change in a "market basket" of hospital costs of providing health care
services. There can be no assurance that future updates in PPS payments will
keep pace with inflation or with the increases in the cost of providing hospital
services. It is also possible that the prospective payment for capital costs at
a Hospital will not be sufficient to cover the actual capital-related costs of
the Hospital allocable to Medicare patients' stays.
4
OUTPATIENT SERVICES. All services paid under the outpatient PPS are
classified into groups called Ambulatory Payment Classifications or "APCs."
Services in each APC are similar clinically and in terms of the resources they
require. A payment rate is established for each APC. Depending on the services
provided, hospitals may be paid for more than one APC for an encounter. CMS will
make additional payment adjustments under Outpatient PPS, including "outlier"
payments for services where the hospital's cost exceeds 2.5 times the APC rate
for that service. In addition, certain other changes have reduced coinsurance
payments below what they would have originally been under outpatient PPS.
MEDICARE BAD DEBT. Medicare beneficiaries have a coinsurance payment
and annual deductible for most inpatient and outpatient hospital services.
Hospitals must first seek payment of any such coinsurance and deductible amounts
from the Medicare beneficiary. If, after reasonable collection efforts, a
hospital is unable to collect these coinsurance and deductible amounts, Medicare
currently reimburses hospitals 70 percent of the uncollected coinsurance and
deductible amount (known as "Medicare bad debt"). The President's fiscal year
2007 proposed budget would phase out the reimbursement of most Medicare bad
debt. It is not possible to determine at this time whether such changes will be
adopted as proposed.
MEDICARE CONDITIONS OF PARTICIPATION. Hospitals must comply with
provisions called "Conditions of Participation" in order to be eligible for
Medicare reimbursement. CMS is responsible for ensuring that hospitals meet
these regulatory Conditions of Participation. Under the Medicare rules,
hospitals accredited by JCAHO are deemed to meet the Conditions of
Participation. The Hospitals are each currently accredited by JCAHO and are
therefore deemed to meet the Conditions of Participation.
MEDICARE AUDITS. Medicare participating hospitals are subject to audits
and retroactive audit adjustments with respect to reimbursement claimed under
the Medicare program. Medicare regulations also provide for withholding Medicare
payments in certain circumstances. Any such withholding with respect to the
Hospitals could have a material adverse effect on the Company. In addition,
contracts between hospitals and third-party payers often have contractual audit,
setoff and withhold language that may cause substantial, retroactive
adjustments. Medicare requires certain financial information be reported on a
periodic basis, and with respect to certain types of classifications of
information, penalties are imposed for inaccurate reports. As these requirements
are numerous, technical and complex, there can be no assurance that the Company
will avoid incurring such penalties.
MEDICARE MANAGED CARE. The Medicare program allows various managed care
plans, now known as Medicare Advantage Plans, offered by private companies to
engage in direct managed care risk contracting with the Medicare program. Under
the Medicare Advantage program, these private companies agree to accept a fixed,
per-beneficiary payment from the Medicare program to cover all care that the
beneficiary may require. Generally, in order to engage in risk contracting, a
Medicare Advantage Plan must be licensed at the state level. In recent years,
many private companies have discontinued their Medicare Advantage Plans. The
result has been that the beneficiaries who were covered by the now-discontinued
Medicare plan have been shifted back into the Medicare fee for service program
or into a Medicare cost plan. The discontinuation of Medicare Advantage Plans
has adversely affected many health care providers across the country and could
materially adversely affect the Company. Also, the decrease in the number of
Medicare beneficiaries enrolled in the Medicare Advantage program has not gone
unnoticed by the Congress and CMS. Congress has recently increased payments to
such plans and made other changes to Medicare managed care to encourage
beneficiary enrollment in managed care plans. Future legislation or regulations
may be created that attempt to increase participation in the Medicare Advantage
program. The effect of these recent changes and any future
legislation/regulation is unknown but could materially and adversely affect the
Company.
MEDI-CAL (CALIFORNIA'S MEDICAID PROGRAM)
FEE-FOR-SERVICE PROGRAM. The Medi-Cal program is a joint federal/state
program that provides health care services to certain persons who are
financially needy. Each of the Hospitals participates in the Medi-Cal program.
The Medi-Cal program includes both a fee-for-service component and a managed
care component. Inpatient hospital services under the fee-for- service component
are reimbursed primarily under the Selective Provider Contracting Program. The
Company is located in an area which is currently a "closed area" under the SPCP.
In SPCP closed areas, private hospitals must hold a contract with the Medi-Cal
program in order to be paid for their inpatient services (other than services
performed in an emergency to stabilize a patient so that they can be transferred
to a contracting hospital and additional care rendered to emergency patients who
cannot be so stabilized for transfer). Contracting hospitals are generally paid
for these services on the basis of all inclusive per diem rates they negotiate
under their SPCP contracts. Outpatient hospital services under the fee-for
service-component are paid for on the basis of a fee schedule, and it is not
necessary for hospitals to hold SPCP contracts in order to be paid for their
outpatient services. Each Hospital currently has an SPCP contract that will
remain in effect through at least November 17, 2007 and there can be no
assurance that the Hospital will maintain SPCP status thereafter or that the
current Medi-Cal payment arrangements will continue. There can be no assurance
that the SPCP contract rates paid to the Hospitals will cover each Hospital's
cost of providing care.
5
The Medi-Cal payment rates for outpatient services cover only a small
portion of a Hospital's cost of providing care.
MEDI-CAL MANAGED CARE. In addition to the fee-for-service component of
Medi-Cal, Orange County (where the Hospitals are located) participates in the
Medi-Cal managed care program. Many Medi-Cal beneficiaries in Orange County are
covered under Medi-Cal managed care, and not under fee-for-service Medi-Cal.
Medi-Cal managed care in Orange County is provided through a County Organized
Health System known as CalOptima. A hospital that wants to participate in
Medi-Cal managed care must contract with CalOptima, and is typically paid a
negotiated capitated amount each month to provide, or arrange for the provision
of, specified services to CalOptima members assigned to the hospital. Western
Medical Center-Santa Ana had a contract with CalOptima which terminated as of
June 2006. Coastal Communities Hospital has a contract with CalOptima which is
currently in effect. There can be no assurance that the capitated payments
received by Western Medical Center-Santa Ana were adequate to reimburse its
costs of providing care under its CalOptima contract, or that the capitated
payments that have been received and in the future will be received by Coastal
Communities Hospital will be adequate to cover its costs of providing care under
its capitated contract. A hospital which does not have a contract with CalOptima
may provide covered services on an emergency basis, or pursuant to arrangements
with other entities which have contracts with CalOptima. There are ongoing
disputes between CalOptima and hospitals in Orange County concerning the amount
CalOptima is obligated to pay for emergency services furnished by
non-contracting hospitals. There can be no assurance that the amount paid to any
of the Hospitals for services covered under CalOptima which are not covered
under a contract between CalOptima and the Hospital will be adequate to
reimburse a Hospital's costs of providing care.
MEDI-CAL DSH PAYMENTS. Some of the Hospitals receive substantial
additional Medi-Cal reimbursement as a disproportionate share ("DSH") hospital.
Hospitals qualify for this additional funding based on the proportion of
services they provide to Medi-Cal beneficiaries and other low-income patients.
The Medi-Cal funding for DSH hospitals, however, is dependent on state general
fund appropriations, and there can be no assurance that the state will fully
fund the Medi-Cal DSH payment programs.
WORKERS' COMPENSATION REIMBURSEMENT
FEE SCHEDULES. A portion of the Hospitals' revenues are expected to
come from Workers' Compensation program reimbursements. As part of an effort in
2003 to control costs under the Workers' Compensation program, the California
legislature enacted Labor Code Section 5307.1, which sets reimbursement for
hospital inpatient and outpatient services, including outpatient surgery
services, at a maximum of 120% of the current Medicare fee schedule for
hospitals. The Administrative Director of the Division of Workers' Compensation
is authorized to develop and, after public hearings, to adopt a fee schedule for
outpatient surgery services, but this schedule may not be more than 120% of the
current Medicare fee schedule for hospitals. This fee limitation limits the
amount that the Hospitals will be paid for their services provided to Workers'
Compensation patients.
PROVIDER NETWORKS. California Senate Bill 899 authorized employers to
establish medical provider networks for Workers' Compensation patients and to
restrict their employees' access to medical services to providers who are
participants in those networks. Employers are free to choose which providers
will and will not participate in their networks, and employers pay participating
providers on the basis of negotiated rates that may be lower than those that
would otherwise be provided for by the Workers' Compensation fee schedules.
Employers may also chose to contract with licensed HMOs and restrict access by
their employees to participating providers of these HMOs. To the extent that the
Hospitals are not selected for participation or do not participate in these
networks or the Company is required to negotiate and accept lower reimbursement
rates to gain participation in these networks, there will be an adverse
financial impact on the Company. Also, the legislation requires networks to
provide treatment in accordance with utilization controls to be established by
the Department of Workers' Compensation. If the Hospitals participate in
networks, utilization controls may limit the services for which the Hospital is
reimbursed, which would have an adverse financial impact on the Company.
FURTHER REFORM. There will likely continue to be substantial activity
in the California Workers' Compensation reform area. In the past, the
legislature has considered a number of bills, some of which would further reduce
the maximum reimbursement for medical services, including hospital services. It
is expected that any revisions to the Workers' Compensation fee schedule, when
and if implemented, will reduce the fees the Hospitals receive for Workers'
Compensation patients. The impact of such possible future fee schedule changes
cannot be estimated at this time. It is also possible that the profitability of
the Company could be impacted by other future Workers' Compensation cost control
efforts.
6
COMMERCIAL INSURANCE
Many private insurance companies contract with hospitals on a
"preferred" provider basis, and many insurers have introduced plans known as
preferred provider organizations ("PPOs"). Under preferred provider plans,
patients who use the services of contracted providers are subject to more
favorable copayments and deductibles than apply when they use non-contracted
providers. In addition, under most health maintenance organizations ("HMOs"),
private payers limit coverage to those services provided by selected hospitals.
With this contracting authority, private payers direct patients away from
nonselected hospitals by denying coverage for services provided by them. The
Hospitals currently have several managed care contracts. If the Company's
managed care contract rates are unfavorable or are reduced in the future, this
may negatively impact the Hospitals and the Company's share price.
EMTALA
In response to concerns regarding inappropriate hospital transfers of
emergency patients based on the patient's inability to pay for the services
provided, Congress enacted the Emergency Medical Treatment and Active Labor Act
("EMTALA") in 1986. This so-called "anti-dumping" law imposes certain
requirements on hospitals with Medicare provider agreements to (1) provide a
medical screening examination for any individual who comes to the hospital's
emergency department, (2) provide necessary stabilizing treatment for emergency
medical conditions and labor, and (3) not transfer a patient until the
individual is stabilized, unless the benefits of transfer outweigh the risks.
Since the Hospitals must provide emergency services without regard to a
patient's ability to pay, complying with EMTALA could have an adverse impact on
the profitability of the Hospitals, depending upon the number of patients
treated in or through the emergency room who are unable to pay. Failure to
comply with the law can result in exclusion of the physician from the Medicare
and/or Medicaid programs or termination of the hospital's Medicare provider
agreements, as well as civil penalties.
ANTI-KICKBACK, FRAUD AND SELF-REFERRAL REGULATIONS
FEDERAL ANTIKICKBACK LAW
The Social Security Act's illegal remuneration provisions (the
"Anti-kickback Statute") prohibit the offer, payment, solicitation or receipt of
remuneration (including any kickback, bribe or rebate), directly or indirectly,
overtly or covertly, in cash or in kind, for (a) the referral of patients or
arranging for the referral of patients to receive services for which payment may
be made in whole or in part under a federal health care program, which includes
Medicare, Medicaid and TRICARE (formerly CHAMPUS, which provides benefits to
dependents of members of the uniformed services) and any state health care
program, or (b) the purchase, lease, order, or arranging for the purchase, lease
or order of any good, facility, service or item for which payment may be made
under the above payment programs. The Anti-kickback Statute contains both
criminal and civil sanctions, which are enforced by the Office of Inspector
General of DHHS ("OIG") and the United States Department of Justice. The
criminal sanctions for a conviction under the Anti-kickback Statute are
imprisonment for not more than five years, a fine of not more than $50,000 for
each offense, or both, with higher penalties potentially being imposed under the
federal Sentencing Guidelines. In addition to the imposition of criminal
sanctions, the Secretary of DHHS may exclude any person or entity that commits
an act described in the Anti-kickback Statute from participation in the Medicare
program and direct states to also exclude that person from participation in
state health care programs. The Secretary of DHHS can exercise this authority
based on an administrative determination, without obtaining a criminal
conviction. The burden of proof for the exclusion would be one that is
customarily applicable to administrative proceedings, which is a lower standard
than that required for a criminal conviction. In addition, violators of the
Anti-kickback Statute may be subjected to civil money penalties of $50,000 for
each prohibited act and up to three times the total amount of remuneration
offered, paid, solicited, or received, without regard to whether a portion of
such remuneration was offered, paid, solicited, or received for a lawful
purpose.
There is ever-increasing scrutiny by federal and state law enforcement
authorities, OIG, DHHS, the courts and Congress of arrangements between health
care providers and potential referral sources to ensure that the arrangements
are not designed as a mechanism to exchange remuneration for patient care
referrals and opportunities. The law enforcement authorities, the courts and
Congress have also demonstrated a willingness to look behind the formalities of
an entity's structure to determine the underlying purpose of payments between
health care providers and potential referral sources. Enforcement actions have
been increased, and, generally, courts have broadly interpreted the scope of the
Anti-kickback Statute, and have held, for example, that the Anti-kickback
Statute may be violated if merely one purpose of a payment arrangement is to
induce referrals. In addition, the OIG has long been on record that it believes
that physician investments in health care companies can violate the
Anti-kickback Statute and the OIG has demonstrated an aggressive attitude toward
enforcement of the Anti- kickback Statute in the context of ownership
relationships.
7
The OIG has issued regulations specifying certain payment practices
that will not be treated as a criminal offense under the Anti-kickback Statute
and that will not provide a basis for exclusion from the Medicare or Medicaid
programs (the "Safe Harbor Regulations"). These regulations include, among
others, safe harbors for certain investments in both publicly traded and
non-publicly traded companies. However, investments in the Company will not be
protected by either of these safe harbor regulations. Nevertheless, the fact
that a specific transaction does not meet all of the criteria of a "safe harbor"
does not mean that such transaction constitutes a violation of the Anti-kickback
Statute, and the OIG has indicated that any arrangement that does not meet all
of the elements of a safe harbor will be evaluated on its specific facts and
circumstances to determine whether the Anti-kickback Statute has been violated
and, thus, if prosecution is warranted.
The OIG is authorized to issue advisory opinions which interpret the
Anti-kickback Statute and has issued several advisory opinions addressing
investments by physicians in health care businesses. Based upon those opinions,
it appears unlikely that the OIG would be willing to issue an advisory opinion
protecting physician investments in the Company, and no such opinion has been
requested by the Company. The Company nevertheless believes, based upon a
federal court decision involving physician investments in clinical laboratories,
that investments in it by physicians are not automatically prohibited by the
Anti-kickback Statute, depending upon the circumstances surrounding such
investment. The Company will review its physician- ownership structures in an
effort to ensure that they do not violate the Anti-kickback Statute.
The OIG also has identified many hospital-physician compensation
arrangements that are potential violations of the Anti- kickback Statute,
including: (a) payment of any incentive for the referral of patients; (b) use of
free or discounted office space or equipment; (c) provision of free or
discounted services, such as billing services; (d) free training; (e) income
guarantees; (f) loans which are not fair market value or which may be forgiven;
(g) payment for services which require few, if any substantive duties by the
physician or payment for services in excess of fair market value of the
services; and (h) purchasing goods or services from physicians at prices in
excess of fair market value. The Company will review its compensation
relationships with physicians in an effort to ensure that they do not violate
the Anti-kickback Statute.
CALIFORNIA ANTI-KICKBACK PROHIBITIONS
California law prohibits remuneration of any kind in exchange for the
referral of patients regardless of the nature of the payer of such services, and
is therefore broader in this regard than is the federal statute. Nevertheless,
this statute specifically provides that a medically necessary referral is not
illegal solely because the physician that is making the referral has an
ownership interest in the health care facility to which the referral is made if
the physician's return on investment is based upon the amount of the physician's
capital investment or proportional ownership and such ownership is not based
upon the number or value of patients referred. Further, opinions of the
California Attorney General indicate that distributions paid to physicians who
invest in entities that conduct health related businesses generally do not
violate California's anti-kickback law when the entity conducts a bona fide
business, services performed are medically needed, and profit distributions are
based upon each investor's proportional ownership interest, rather than the
relative volume of each investor's utilization of the entity's business.
California has a separate anti-kickback statute which applies only under the
Medi-Cal program and which largely parallels the prohibitions of the federal
anti-kickback statute. The Company believes that analysis under this Medi-Cal
anti-kickback statue will be the same as under the federal anti-kickback statute
discussed above.
FALSE AND OTHER IMPROPER CLAIMS
The U.S. government is authorized to impose criminal, civil and
administrative penalties on any person or entity that files a false claim for
payment from the Medicare or Medi-Cal programs. In addition to other federal
criminal and civil laws which punish health care fraud, the U.S. government,
over the past several years, has accused an increasing number of health care
providers of violating the federal Civil False Claims Act. The False Claims Act
imposes civil liability (including substantial monetary penalties and damages)
on any person or corporation which (1) knowingly presents a false or fraudulent
claim for payment to the United States government; (2) knowingly uses a false
record or statement to obtain payment; or (3) engages in a conspiracy to defraud
the federal government to obtain allowance for a false claim. False claims
allegations could arise, for example, with respect to the Hospital's billings to
the Medicare program for its services or the submission by the Hospital of
Medicare cost reports. Specific intent to defraud the federal government is not
required to act with knowledge. Instead, the False Claims Act defines
"knowingly" to include not only actual knowledge of a claim's falsity, but also
reckless disregard for or intentional ignorance of the truth or falsity of a
claim. Because the Hospitals perform hundreds of procedures a year for which
they are paid by Medicare, and there is a relatively long statute of
limitations, a billing error or cost reporting error could result in significant
civil or criminal penalties.
8
Under the qui tam, or whistleblower, provisions of the False Claims
Act, private parties may bring actions on behalf of the U.S. government. These
private parties, often referred to as relators, are entitled to share in any
amounts recovered by the government through trial or settlement. Both direct
enforcement activity by the government and whistleblower lawsuits have increased
significantly in recent years and have increased the risk that a health care
company, like us, will have to defend a false claims action, pay fines or be
excluded from the Medicare and Medicaid programs as a result of an investigation
resulting from a whistleblower case. Although the Company intends that the
operations of the Hospitals will materially comply with both federal and state
laws related to the submission of claims, there can be no assurance that a
determination that we have violated these claims-related laws will not be made,
and any such determination could have a material adverse effect on the Company.
In addition to the False Claims Act, federal civil monetary penalties
provisions authorize the imposition of substantial civil money penalties against
an entity which engages in activities including, but not limited to, (1)
knowingly presenting or causing to be presented, a claim for services not
provided as claimed or which is otherwise false or fraudulent in any way; (2)
knowingly giving or causing to be given false or misleading information
reasonably expected to influence the decision to discharge a patient; (3)
offering or giving remuneration to any beneficiary of a federal health care
program likely to influence the selection of a particular provider, practitioner
or supplier for the ordering or receipt of reimbursable items or services; (4)
arranging for reimbursable services with an entity which is excluded from
participation from a federal health care program; (5) knowingly or willfully
soliciting or receiving remuneration for a referral of a federal health care
program beneficiary; or (6) using a payment intended for a federal health care
program beneficiary for another use. The Secretary of HHS, acting through the
OIG, also has both mandatory and permissive authority to exclude individuals and
entities from participation in federal health care programs pursuant to this
statute. Also, it is a criminal federal health care fraud offense to: (1)
knowingly and willfully execute or attempt to execute any scheme to defraud any
health care benefit program, including any private or governmental program; or
(2) to obtain, by means of false or fraudulent pretenses, any property owned or
controlled by any health care benefit program. Penalties for a violation of this
federal law include fines and/or imprisonment, and a forfeiture of any property
derived from proceeds traceable to the offense. In addition, if an individual is
convicted of a criminal offense related to participation in the Medicare program
or any state health care program, or is convicted of a felony relating to health
care fraud, the Secretary of DHHS is required to bar the individual from
participation in federal health care programs and to notify the appropriate
state agencies to bar the individuals from participation in state health care
programs.
While the criminal statutes are generally reserved for instances of
fraudulent intent, the U.S. government is applying its criminal, civil and
administrative penalty statutes in an ever-expanding range of circumstances. For
example, the government has taken the position that a pattern of claiming
reimbursement for unnecessary services violates these statutes if the claimant
merely should have known the services were unnecessary, even if the government
cannot demonstrate actual knowledge. The government has also taken the position
that claiming payment for low-quality services is a violation of these statutes
if the claimant should have known that the care was substandard. In addition,
some courts have held that a violation of the Stark law or the anti-kickback
statute can result in liability under the federal False Claims Act.
Noncompliance with other regulatory requirements can also lead to
liability under the False Claims Act if it can be established that compliance
with those requirements is necessary in order for a Hospital to be paid for its
services. Claims filed with private insurers can also lead to criminal and civil
penalties under federal law, including, but not limited to, penalties relating
to violations of federal mail and wire fraud statutes and of HIPAA's provisions
which have made the defrauding of any health care insurer, whether public or
private, a crime. The Hospitals are also subject to various state insurance
statutes and regulations that prohibit the Hospitals from submitting inaccurate,
incorrect or misleading claims. The Company intends that the Hospitals will
comply with all state insurance laws and regulations regarding the submission of
claims. IHHI cannot assure, however, that each Hospital's insurance claims will
never be challenged or that the Hospitals will in all instances comply with all
laws regulating its claims. If a Hospital were found to be in violation of a
state insurance law or regulation, the Hospital could be subject to fines and
criminal penalties, which could have a material adverse effect on the Company.
9
FEDERAL PHYSICIAN SELF-REFERRAL LAW
Provisions of the Social Security Act commonly referred to as the
"Stark" law prohibit referrals by a physician of Medicare patients to providers
for a broad range of health services if the physician (or his or her immediate
family member) has an ownership or other financial arrangement with the
provider, unless an exception applies. The "designated health services" to which
the Stark law applies include all inpatient and outpatient services provided by
hospitals. Hospitals cannot bill for services they provide as a result of
referrals that are made in violation of the Stark law. In addition, a violation
of the Stark law may result in a denial of payment, require refunds to patients
and to the Medicare program, civil monetary penalties of up to $15,000 for each
violation, civil monetary penalties of up to $100,000 for certain "circumvention
schemes" and exclusion from participation in the Medicare, Medicaid and other
federal programs. Violations of the Stark law may also be actionable as
violations of the federal False Claims Act.
Notwithstanding the breadth of the Stark law's general prohibition, the
law contains an exception which protects ownership interests held by physicians
in hospitals where the referring physician is authorized to perform services at
the hospital and the physician's ownership is in the hospital itself, and not
merely in a subdivision of the hospital. The Hospitals intend to rely upon this
exception to protect the ownership interests that certain physicians, through
Orange County Physician Investment Network, LLC ("OC-PIN"), hold in them. In
addition to physician ownership, the Hospitals have arrangements by which they
compensate various physicians for services. Payments by the Company to such
physicians will constitute financial relationships for purposes of the Stark
law. Exemptions exist under the Stark law and its implementing regulations for
various types of compensation relationships. The Company will endeavor to ensure
that all of its financial relationships qualify for one or more exemptions under
the Stark law. However, there can be no assurance that the Company will be
successful in structuring all of its relationships with physicians so as to
qualify for protection under one or more of the Stark law's exceptions. The
failure to so qualify could have a material adverse effect on the Company.
SPECIALTY HOSPITALS
For an 18 month "moratorium" period beginning on December 8, 2003 and
ending on June 7, 2005, the Stark law's hospital ownership exemption was made
unavailable by the Medicare Prescription Drug, Improvement, and Modernization
Act of 2003 ("MMA") for ownership interests in "specialty" hospitals, which were
defined as hospitals that are "primarily or exclusively" engaged in providing
services to patients with cardiac conditions, patients with orthopedic
conditions or patients who undergo surgical procedures. The Medicare Payment
Advisory Commission ("MEDPAC") was required by MMA to conduct a comparative
study of specialty and general hospitals and report its findings to Congress.
MEDPAC prepared and submitted this report, which included a recommendation that
Congress extend the moratorium to January 1, 2007. MEDPAC also recommended that
adjustments be made in hospital DRGs to reduce the potential for specialty
hospitals to profit from favorable patient selection, by establishing payments
that more closely reflect the cost of providing care. CMS also studied specialty
hospital issues. While it did not recommend an extension of the moratorium, it
also recommended payment reforms for specialty hospitals and it imposed a
moratorium on the enrollment in Medicare by new specialty hospitals, whether or
not physician owned. MEDPAC's and CMS' payment reforms for specialty hospitals
also were to apply to all such hospitals, whether or not they were physician
owned. As of the date of this filing, Congress has not extended the moratorium
and therefore it is currently not in effect. However, various interest groups
continue to seek to re-institute the moratorium, make the moratorium permanent,
remove the hospital ownership exception entirely or institute payment reforms
for specialty hospitals.
Although CMS has issued extensive regulations interpreting the Stark
law and has issued a "One-Time Bulletin" addressing certain aspects of the
specialty hospital moratorium, no statute or regulation defines what it means
for a hospital to be "primarily or exclusively" providing specialty services.
Two studies by the General Accounting Office ("GAO") which were precursors of
the specialty hospital moratorium, defined specialty hospitals as hospitals
where two-thirds or more of the patient discharges fall into either cardiac or
orthopedic services, or two-thirds of the patient discharges had surgical
procedures. In conducting its mandated study, MEDPAC defined specialty hospitals
as hospitals where: (1) more than 45% of discharges are classified in the
cardiac Medical Diagnostic Classification ("MDC"); (2) more than 45% of
discharges are classified in the orthopedic MDC; (3) more than 45% of discharges
that had surgical procedures; or (4) more than 66% of discharges fall into any
two of the three prior categories. In administering its enrollment moratorium,
also CMS defined specialty hospitals as those that provided more than 45% of
their services in one of the designated specialty categories.
If the moratorium is re-instituted, or made permanent, it is unclear
what standard Congress or CMS would apply in defining a specialty hospital. The
Company has not determined whether any of its Hospitals are "specialty"
hospitals. If a Hospital is considered a "specialty" hospital, a
physician-investor who purchased his/her shares during any extended moratorium
period may not hold an ownership interest excepted from the Stark law. Further,
there can no assurance that the hospital ownership exception will not be
eliminated altogether. In addition, even if the self-referral moratorium is not
extended, it is expected that payment reforms will be implemented that will
impact all specialty hospitals, whether or not physician-owned.
10
CALIFORNIA PHYSICIAN SELF-REFERRAL LAW
Restrictions on financial relationships between physicians and
businesses to which they refer patients for specified types of services,
including some services which will be provided by the Hospitals, also exist
under California law. As is the case under federal law, the California
self-referral restrictions can be triggered by financial relationships other
than ownership. However, these laws contain a broad exemption permitting
referrals to be made to a hospital so long as the referring physician is not
compensated by the hospital for the referral and any equipment lease between the
hospital and the physician satisfies certain requirements.
An additional requirement imposed by California's self-referral laws is
that any non-emergency imaging services performed for a workers' compensation
patient with equipment that, when new, had a value of $400,000 or more must be
pre-approved by the workers' compensation insurer or self-insured employer. This
provision may require that preauthorization be obtained for MRI services ordered
by the Hospitals' physician owners and others who have financial relationships
with the Company. It is possible that insurers may refuse to provide any
required preauthorizations in connection with referrals of workers' compensation
patients made to the Hospitals by physicians who have financial relationships
with it. However, given that MRI services for Workers' Compensation patients are
not anticipated to represent a material portion of the Hospitals' services, the
Company does not believe that any such refusals to provide required
preauthorizations would have a material impact upon it.
LICENSING
Health facilities, including the Hospitals, are subject to numerous
legal, regulatory, professional and private licensing, certification and
accreditation requirements. These include requirements relating to Medicare
participation and payment, state licensing agencies, private payers and the
Joint Commission on Accreditation of Healthcare Organizations ("JCAHO"). Renewal
and continuance of certain of these licenses, certifications and accreditations
are based on inspections, surveys, audits, investigations or other reviews, some
of which may require or include affirmative action or response by the Company.
These activities generally are conducted in the normal course of business of
health facilities. Nevertheless, an adverse determination could result in a loss
or reduction in a Hospital's scope of licensure, certification or accreditation,
or could reduce the payment received or require repayment of amounts previously
remitted. Any failure to obtain, renew or continue a license, certification or
accreditation required for operation of a Hospital could result in the loss of
utilization or revenues, or the loss of the Company's ability to operate all or
a portion of a Hospital, and, consequently, could have a material and adverse
effect on the Company.
DISCLOSURE OF FINANCIAL INTERESTS
California law provides that it is unlawful for a physician to refer a
patient to an organization in which the physician or the physician's immediate
family has a significant beneficial interest unless the physician first
discloses in writing to the patient that there is such an interest and advises
the patient regarding alternative services, if such services are available. A
"significant beneficial interest" means any financial interest equal to or
greater than the lesser of five percent of the total beneficial interest or
$5,000. This disclosure requirement may be satisfied by the posting of a
conspicuous sign likely to be seen by all patients who use the facility or by
providing patients with written disclosure statements. Physicians must also make
disclosure of entities in which they hold significant financial interests to a
patient's payer upon the request of the payer (not to be made more than once a
year). A violation of this disclosure requirement constitutes "unprofessional
conduct," and is grounds for the suspension or revocation of the physician's
license. Further, it is deemed a misdemeanor punishable by imprisonment not to
exceed six months, or by a fine not to exceed $2,500.
In addition, California's general self-referral laws require that any
physician who refers a person to, or seeks consultation from, an organization in
which the physician has a financial interest must disclose the financial
interest to the patient, or the parent or legal guardian of the patient, in
writing, at the time of the referral or request for consultation. This
requirement applies regardless of whether the financial interest is otherwise
protected by one of the exemptions under the self-referral law. There is no
minimum threshold of ownership required in order for this disclosure requirement
to be triggered, and this disclosure requirement cannot be satisfied by the
posting of a sign. A violation of this disclosure requirement may be subject to
civil penalties of up to $5,000.00 for each offense. Physician investors in the
Company (through OC-PIN or otherwise) are individually responsible for complying
with these disclosure requirements with respect to their referrals to the
Hospital. The obligation of physicians to make such disclosures or the impact of
such disclosures on patients may have an effect on the Company and its business.
11
HIPAA
The Health Insurance Portability and Accountability Act of 1996 and its
implementing regulations ("HIPAA") mandates the adoption of standards for the
exchange of health information in an effort to encourage overall administrative
simplification and enhance the effectiveness and efficiency of the health care
industry. HIPAA requires that health care providers and other "covered entities"
such as health insurance companies and other third-party payers, adopt uniform
standards for the electronic transmission of, billing statements and insurance
claims forms. HIPAA also establishes new federal rules protecting the privacy
and security of personal health information. The privacy and security
regulations address the use and disclosure of individual health information and
the rights of patients to understand and control how such information is used
and disclosed. The law provides both criminal and civil fines and penalties for
covered entities that fail to comply with HIPAA. Violations of the privacy or
security standards could result in civil penalties of up to $25,000 per
violation in each calendar year and criminal penalties of up to $250,000 per
violation. In addition, the Hospitals are also subject to state privacy laws,
which in some cases are more restrictive than HIPAA and impose additional
penalties.
Compliance with the HIPAA privacy, security and electronic transmission
regulations will require significant changes in information and claims
processing practices utilized by health care providers, including the Company.
Estimates vary widely on the economic cost of implementing these provisions of
HIPAA. DHHS estimates the total nationwide cost of compliance with the privacy
rule alone at approximately five billion dollars; the Blue Cross and Blue Shield
Association estimated that the nationwide cost of compliance may exceed forty
billion dollars. As such, the future financial effect of these regulations on
the Company is uncertain at this time.
CORPORATE PRACTICE OF MEDICINE
California has laws that prohibit corporations and other entities from
employing physicians or that prohibit certain direct and indirect payments or
fee-splitting arrangements between health care providers. Although we intend to
exercise care in structuring our arrangements with health care providers to
comply with relevant California law, and we believe that such arrangements
comply with applicable laws in all material respects, we cannot give you any
assurance that governmental officials charged with responsibility for enforcing
these laws will not assert that the Company, or certain transactions that we are
involved in, are in violation of such laws, or that the courts will ultimately
interpret such laws in a manner consistent with our interpretations.
CERTAIN ANTITRUST CONSIDERATIONS
The addition of physician-investors in the Company could affect
competition in the geographic area in which its Hospitals operate in various
ways. Such effect on competition could give rise to claims that the Hospitals,
their arrangements with consumers and business entities, or with physicians
violate federal and state antitrust and unfair competition laws under a variety
of theories. Accordingly, there can be no assurance that the activities or
operations of the Hospitals will comply with federal and state antitrust or
unfair competition laws, or that the Federal Trade Commission, the Antitrust
Division of the Department of Justice, or any other party, including a physician
participating in the Company's business, or a physician denied participation in
the Company's business, will not challenge or seek to delay or enjoin the
activities of the Company on antitrust or other grounds. If such a challenge is
made, there can be no assurance that such challenge would be unsuccessful. We
have not obtained an analysis of any possible antitrust implications of the
activities of the Company or of the continuing arrangements and anticipated
operations of the Hospitals.
ENVIRONMENTAL REGULATIONS. Our health care operations generate medical
waste that must be disposed of in compliance with federal, state and local
environmental laws, rules and regulations. Our operations, as well as our
purchases and sales of facilities, also are subject to compliance with various
other environmental laws, rules and regulations.
CORPORATE HISTORY
The Company was originally incorporated under the laws of the State of
Utah on July 31, 1984 under the name "Aquachlor Marketing Inc." On December 23,
1988, the Company reincorporated in the State of Nevada. From 1989 until 2003,
the Company pursued a number of potential business opportunities but was mostly
dormant and had no material assets, revenues or business operations.
On November 18, 2003, Bruce Mogel, Larry B. Anderson, and James T.
Ligon purchased a controlling interest in the Company (then known as First
Deltavision) with the objective of transforming the Company into a leading
provider of high-quality, cost-effective healthcare through the acquisition and
management of financially distressed and/or under performing hospitals and other
healthcare facilities.
In the first quarter of 2004, the Company changed its fiscal year end
from June 30 to December 31, and changed the Company's name to "Integrated
Healthcare Holdings, Inc."
Our principal executive offices are located at 1301 North Tustin
Avenue, Santa Ana, California 92705, and our telephone number is (714) 953-3503.
12
ITEM 1A. RISK FACTORS
An investment in our common stock involves a high degree of risk. You
should consider carefully the following information about these risks, together
with the other information contained in this report, before you decide to buy
our common stock. The risks and uncertainties described below are not the only
ones we face. Additional risks and uncertainties not presently known to us or
that we currently deem immaterial may also impair our operations. If any of the
following risks actually occur, our business would likely suffer and our results
could differ materially from those expressed in any forward-looking statements
contained in this report. In such case, the trading price of our common stock
could decline, and you may lose all or part of the money you paid to buy our
common stock.
WE HAVE INCURRED A SIGNIFICANT LOSS IN OUR FIRST YEAR OF OPERATIONS. IF
OUR SUBSTANTIAL LOSSES CONTINUE, THE MARKET VALUE OF OUR COMMON STOCK WILL
LIKELY DECLINE AND WE MAY LACK THE ABILITY TO CONTINUE AS A GOING CONCERN.
As of December 31, 2005, we had an accumulated deficit of $46,656,725.
We incurred a net loss of $44,558,367 for the year ended December 31, 2005. This
included $21,064,669 in a non-cash warrant expense incurred as a result of the
Rescission, Restructuring and Assignment Agreement (see Note 7 to the
consolidated financial statements included elsewhere in this Annual Report on
Form 10-K). This loss, among other things, has had a material adverse effect on
our stockholders' equity and working capital. The acquired hospitals continued
to experience losses at levels comparable to their pre-acquisition performance.
We are attempting to improve our operating results and financial condition
through a combination of contract negotiations, expense reductions, and new
issues of equity. However, there can be no assurance that we will achieve
profitability in the future. If we are unable to achieve and maintain
profitability, the market value of our common stock will likely decline, and we
may lack the ability to continue as a going concern.
OUR INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM HAS EXPRESSED DOUBT
ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN.
Our consolidated financial statements as of December 31, 2005 have been
prepared under the assumption that we will continue as a going concern for the
year ending December 31, 2006. Our independent registered public accounting firm
has issued a report dated July 11, 2006 that included an explanatory paragraph
referring to our losses from operations and net capital deficiency and
expressing substantial doubt as to our ability to continue as a going concern
without additional capital becoming available. Our ability to continue as a
going concern in the long term is dependent upon our ability to obtain
additional equity or debt financing, attain further operating efficiencies,
reduce expenditures, and, ultimately, to generate revenues and net income. The
financial statements presented in this report do not include any adjustments
that might result from the outcome of this uncertainty.
WE MUST OBTAIN ADDITIONAL CAPITAL WHICH, IF AVAILABLE, WILL LIKELY
RESULT IN SUBSTANTIAL DILUTION TO OUR CURRENT SHAREHOLDERS.
We have incurred substantial operating losses. In addition, we have $81
million in notes payable, including a short term note for $10.7 million.
Substantially all of our assets are pledged as collateral for repayment of this
indebtedness. Of this indebtedness, $10.7 million must be refinanced by December
12, 2006 and the balance must be re-financed by March 2007. We have not yet
secured alternative sources of capital to meet these re-financing requirements
or re-negotiated these commitments with our lender. We may also need to raise
additional funds to finance our on-going operations. There can be no assurance
that we will be able raise additional funds on terms acceptable to us or at all.
We may be required to issue additional equity securities in connection with such
financings. Such additional equity, if available, is likely to substantially
dilute the interest of our current shareholders in the Company. If we are unable
to raise additional funds or re-finance our current commitments to our lender,
we may declare bankruptcy, which would likely cause our shareholders to lose all
or substantially all of their investment in our Company.
WE HAVE A HIGH DEGREE OF LEVERAGE AND SIGNIFICANT DEBT SERVICE
OBLIGATIONS.
The debt service requirements on our $81 million in debt amount to
approximately $0.9 million per month. Our relatively high level of debt and debt
service requirements have several effects on our current and future operations,
including the following: (i) we will need to devote a significant portion of our
cash flow to service debt, reducing funds available for operations and future
business opportunities and increasing our vulnerability to adverse economic and
industry conditions and competition; (ii) our leveraged position increases our
vulnerability to competitive pressures; (iii) the covenants and restrictions
contained in agreements relating to our indebtedness restrict our ability to
borrow additional funds, dispose of assets, issue additional equity or pay
dividends on or repurchase common stock; and (iv) funds available for working
capital, capital expenditures, acquisitions and general corporate purposes are
limited. Any default under the documents governing our indebtedness could have a
significant adverse effect on our business and the market value of our common
stock.
13
OUR STOCK WAS REMOVED FROM QUOTATION ON THE OTC BULLETIN BOARD, WHICH
HAS RESTRICTED THE ABILITY OF OUR SHAREHOLDERS TO SELL OUR COMMON STOCK IN THE
SECONDARY MARKET, AND COULD IMPAIR THE VALUE OF OUR COMMON STOCK. EVEN IF OUR
STOCK IS QUOTED AGAIN ON THE OTC BULLETIN BOARD, A MARKET MAY NOT DEVELOP OR
CONTINUE FOR OUR COMMON STOCK.
On or about June 6, 2006, our stock was removed from quotation on the
OTC Bulletin Board by the NASD due to our failure to timely file our Form 10-K
for the fiscal year ended December 31, 2005. We subsequently received an
additional notice from NASD indicating that we are also delinquent in filing our
Form 10-Q for the quarterly period ended March 31, 2006. We intend to take steps
to have our stock quoted again on the OTC Bulletin Board following the filing of
our delinquent reports. However, there can be no assurance that our stock will
be accepted for quotation on the OTC Bulletin Board or any other market or
exchange. If our stock is not accepted on the OTC Bulletin Board or any other
market or exchange, trading, if any, in our common stock would be conducted in
the so-called "pink sheets". Consequently, the liquidity of our securities could
be impaired, not only in the number of securities which could be bought and
sold, but also through delays in the timing of transactions, and there may be
lower prices for our securities than might otherwise be obtained.
Even if our stock is quoted on the OTC Bulletin Board, there can be no
assurance that a market will develop or continue for our common stock. Our
common stock may be thinly traded, if traded at all, and is likely to experience
significance price fluctuations. Our stock is defined as a "penny stock" under
Rule 3a51-1 adopted by the Securities and Exchange Commission under the
Securities Exchange Act of 1934, as amended. In general, a "penny stock"
includes securities of companies which are not listed on the principal stock
exchanges or the National Association of Securities Dealers Automated Quotation
System ("NASDAQ") or National Market System ("NASDAQ NMS") and have a bid price
in the market of less than $5.00. "Penny stocks" are subject to Rule 15g-9,
which imposes additional sales practice requirements on broker-dealers that sell
such securities to persons other than established customers and "accredited
investors" (generally, individuals with net worth in excess of $1,000,000 or
annual incomes exceeding $200,000, or $300,000 together with their spouses, or
individuals who are officers or directors of the issuer of the securities). For
transactions covered by Rule 15g-9, a broker-dealer must make a special
suitability determination for the purchaser and have received the purchaser's
written consent to the transaction prior to sale. Consequently, this rule may
adversely affect the ability of broker-dealers to sell our common stock, and
therefore, may adversely affect the ability of our stockholders to sell common
stock in the public market.
WE MAY FACE DIFFICULTIES INTEGRATING OUR ACQUISITION OF THE HOSPITALS.
Our acquisition of the Hospitals involves numerous potential risks,
including:
o potential loss of key employees and management of acquired
companies;
o difficulties integrating acquired personnel and distinct cultures;
o difficulties ensuring compliance with all applicable laws and
regulations;
o difficulties integrating acquired companies into our proposed
operating, financial planning and financial reporting systems;
o diversion of management attention; and
o assumption of liabilities and potentially unforeseen liabilities,
including liabilities for past failure to comply with healthcare
regulations.
If we are not able to successfully integrate the acquired hospitals,
this could have a material adverse effect on our financial position, results of
operations and cash flow.
THE SUCCESS OF THE COMPANY WILL DEPEND ON PAYMENTS FROM THIRD PARTY
PAYORS, INCLUDING GOVERNMENT HEALTH CARE PROGRAMS. IF THESE PAYMENTS ARE REDUCED
OR DELAYED, OUR REVENUE WILL DECREASE.
We are largely dependent upon private and governmental third party
sources of payment for the services provided to patients in the Hospitals. The
amount of payment a hospital receives for the various services it renders will
be affected by market and cost factors, perhaps adversely, as well as other
factors over which we have no control, including political concerns over the
cost of medical care, Medicare and Medicaid regulations and the cost containment
and utilization decisions of third party payors. Any meaningful reduction in the
amounts paid by these third party payors for services rendered at the Hospitals
will have a material adverse effect on our revenues.
14
PROVIDING QUALITY MEDICAL SERVICES FROM TALENTED PHYSICIANS IS CRITICAL TO OUR
BUSINESS.
Our business model depends, in large part, upon the efforts and success
of the physicians who will perform services at the Hospitals and the strength of
our relationships with these physicians. Any failure of these physicians to
maintain the quality of medical care provided or to otherwise adhere to
professional guidelines at the Hospitals, or any damage to the reputation of a
key physician or group of physicians, could damage the Company's and the
Hospitals' reputations in the medical marketplace and may subject us to
liability and significantly reduce our revenue and increase our costs.
IF EITHER THE COMPANY OR THE HOSPITALS FAIL TO COMPLY WITH APPLICABLE
LAWS AND REGULATIONS, WE MAY SUFFER PENALTIES OR BE REQUIRED TO MAKE SIGNIFICANT
CHANGES TO OUR OPERATIONS.
The Company and the Hospitals are subject to many laws and regulations
at the federal, state and local levels. These laws and regulations require the
Hospitals to meet various licensing, certification and other requirements,
including those relating to:
o physician ownership of the Hospitals;
o payments to specialty hospitals;
o prohibited inducements for patient referrals and restrictions
on payments for marketing;
o the adequacy of medical care, equipment, personnel, operating
policies and procedures;
o maintenance and protection of records; and
o environmental protection.
Although a moratorium that prohibited physician owners of specialty
hospitals from referring Medicare patients to the hospital they own has ended,
if the moratorium is re-instituted, or made permanent, and if the Centers for
Medicare and Medicaid Services ("CMS") determine that any Hospital is a
"specialty hospital" under applicable Medicare rules and regulations, physician
owners of the Hospitals would be prohibited from making Medicare referrals to
the facilities. Further, other efforts are likely to be made to limit or
prohibit referrals by physician owners of specialty, niche, or limited-service
hospitals, and if those efforts are successful, the ability of physician owners
to refer to the Hospitals could be adversely affected.
If the Company fails to comply with applicable laws and regulations, it
could suffer civil or criminal penalties. A number of initiatives have been
proposed during the past several years to reform various aspects of the health
care system. In the future, different interpretations or enforcement of existing
or new laws and regulations could subject the current practices to allegations
of impropriety or illegality, or could require the Company to make changes in
its facilities, equipment, personnel, services, capital expenditure programs and
operating expenses. Current or future legislative initiatives or government
regulation may have a material adverse effect on the Hospitals' operations or
reduce the demand for their services.
THE COMPANY IS IN THE PROCESS OF AUDITING ITS COMPLIANCE WITH VARIOUS LAWS
RELATED TO ITS PHYSICIAN ARRANGEMENTS.
The Company has begun auditing its compliance with the federal
anti-kickback statute, Stark law and other applicable laws as they relate to the
Company's relationships with referring physicians.
The Company's majority shareholder, Orange County Physician Investment
Network, LLC ("OC-PIN"), is owned and controlled by physicians who also refer to
and practice at the Hospitals. OC-PIN may receive dividends as a shareholder of
the Company. In addition, three of the members of OC-PIN serve as members of the
Board of Directors of the Company, which directors receive payment for their
services as directors. One physician-owner of OC-PIN, Dr. Anil Shah, is the
Chairman of the Board of Directors and an employee of the Company. In addition,
the Hospitals have various relationships with physicians who are not owners of
the Company, including medical directorships, sharing in risk pools and service
arrangements.
At this time, the Company is aware that certain of its arrangements
with physicians may not have been memorialized in a written agreement or may
have expired and not been timely renewed or may have been entered into after
services commenced, each of which may constitute a violation of the Stark law.
The Company plans to institute a compliance program that will ensure that all
physician arrangements are properly documented in the future. Additionally, the
Company is reviewing the structure of the ownership interests of
physician-investors from OC-PIN, the majority shareholder of the Company, and
certain related party transactions, such as director fees for physician
directors (see Note 10) and the related party lease with PCHI (see Note 10). If
the Company or the Hospitals are not in compliance with federal and state fraud
and abuse laws and physician self-referral laws, the Company could be subject to
fines, penalties and other sanctions which would likely have a material adverse
effect on the Company.
15
COST CONTAINMENT PROGRAMS IMPOSED BY THIRD-PARTY PAYORS, INCLUDING GOVERNMENT
HEALTH CARE PROGRAMS, MAY DECREASE THE COMPANY'S REVENUE.
The health care industry is currently undergoing significant changes
and is regularly subject to regulatory and political intervention. We expect to
derive a considerable portion of the Company's revenue through the Hospitals
from government- sponsored health care programs and third-party payors (such as
employers, private insurers, licensed health care service plans ("HMOs") or
preferred provider organizations). The health care industry is experiencing a
trend toward cost containment as government and private third-party payors seek
to impose lower payment and utilization rates and negotiate reduced payment
schedules with service providers. The Company believes that these trends will
continue to result in a reduction from historical levels in per-patient revenue
for hospitals. It is distinctly possible that Medicare reimbursement for many
procedures performed at the Hospital may be reduced in the future. Further
reductions in payments or other changes in reimbursement for health care
services could have a material adverse effect on the Company's business,
financial condition and/or results of operations. Further, rates paid by private
third-party payors are generally higher than Medicare, Medicaid and HMO payment
rates. Any decrease in the relative number of patients covered by private
insurance would have a material adverse effect on the Company's revenues and
operations.
PHYSICIAN CONTRACTING AND MEDICAL STAFF
The Company and the Hospitals have entered into a variety of
relationships with physicians. In an increasingly complex legal and regulatory
environment, these relationships may pose a variety of legal or business risks.
The primary relationship between a hospital and physicians who practice in it is
through the hospital's organized medical staff. Medical staff bylaws, rules and
policies establish the criteria and procedures at acute care hospitals, by which
a physician may have his or her privileges, participation or membership
curtailed, denied or revoked. Physicians who are denied medical staff membership
or certain clinical privileges, or who have such membership, participation or
privileges curtailed, denied or revoked often file legal actions against
hospitals. Such actions may include a wide variety of claims, some of which
could result in substantial uninsured damages to a hospital. In addition,
failure of the governing body to adequately oversee the conduct of its medical
staff may result in hospital liability to third parties.
LICENSING, SURVEYS, INVESTIGATIONS AND AUDITS
Health facilities, including the Hospitals, are subject to numerous
legal, regulatory, professional and private licensing, certification and
accreditation requirements. These include requirements relating to Medicare
participation and payment, state licensing agencies, private payors and the
Joint Commission on Accreditation of Healthcare Organizations ("JCAHO"). Renewal
and continuance of certain of these licenses, certifications and accreditations
are based on inspections, surveys, audits, investigations or other reviews, some
of which may require or include affirmative action or response by the Company.
These activities generally are conducted in the normal course of business of
health facilities. Nevertheless, an adverse determination could result in a loss
or reduction in a Hospital's scope of licensure, certification or accreditation,
or could reduce the payment received or require repayment of amounts previously
remitted. Any failure to obtain, renew or continue a license, certification or
accreditation required for operation of a Hospital could result in the loss of
utilization or revenues, or the loss of the Company's ability to operate all or
a portion of a Hospital, and, consequently, could have a material and adverse
effect on the Company.
NURSING SHORTAGE
Health care providers depend on qualified nurses to provide quality
service to patients. There is currently a nationwide shortage of qualified
nurses. This shortage and the more stressful working conditions it creates for
those remaining in the profession are increasingly viewed as a threat to patient
safety and may trigger the adoption of state and federal laws and regulations
intended to reduce that risk. For example, California has adopted legislation
and regulations mandating a series of specific minimum patient-to-nurse ratios
in all acute care hospital nursing units. Despite the fact that many hospitals
are having difficulty complying with these new ratios, particularly during break
and meal periods, a California court decision has upheld the regulations in
full. Any failure by the Hospital to comply with nurse staff ratios could result
in action by licensure authorities and may constitute evidence of negligence per
se in the event any patient is harmed as the result of inadequate nurse
staffing.
In response to the shortage of qualified nurses, health care providers
have increased and could continue to increase wages and benefits to recruit or
retain nurses and have had to hire expensive contract nurses. The shortage could
also limit the operations of healthcare providers by limiting the number of
patient beds available. The Company has increased and is likely to have to
continue to increase wages and benefits to recruit and retain nurses. The
Company may also need to engage expensive contract nurses until permanent staff
nurses can be hired to replace any departing nurses.
16
EARTHQUAKE SAFETY COMPLIANCE
The Hospitals are located in an area near active and substantial
earthquake faults and earthquake coverage with a policy limit of $50 million. A
significant earthquake could result in material damage and temporary or
permanent cessation of operations at a Hospital. In addition, the State of
California has imposed new hospital seismic safety requirements. Under these new
requirements, the Hospitals must meet stringent seismic safety criteria in the
future, and, must complete one set of seismic upgrades to the facility by
January 1, 2013. This first set of upgrades is expected to require the Company
to incur substantial seismic retrofit expenses. There are additional
requirements that must be complied with by 2030. The costs of meeting these
requirements have not yet been determined. Compliance with seismic ordinances
will be a costly venture and could have a material adverse effect on the
Company.
WE FACE INTENSE COMPETITION IN OUR BUSINESS.
The healthcare industry is highly competitive. We compete with a
variety of other organizations in providing medical services, many of which have
greater financial and other resources and may be more established in their
respective communities than we are. Competing companies may offer newer or
different centers or services than we do and may thereby attract patients or
customers who are presently patients, customers or are otherwise receiving our
services.
AN INCREASE IN INSURANCE COSTS MAY ADVERSELY AFFECT OUR OPERATING CASH
FLOW, AND WE MAY BE LIABLE FOR LOSSES NOT COVERED BY OR IN EXCESS OF
OUR INSURANCE.
An increasing trend in malpractice litigation claims, rising costs of
malpractice litigation, losses associated with these malpractice lawsuits and a
constriction of insurers have caused many insurance carriers to raise the cost
of insurance premiums or refuse to write insurance policies for hospital
facilities. Also, a tightening of the reinsurance market has affected property,
auto and excess liability insurance carriers. Accordingly, the costs of all
insurance premiums have increased.
A SIGNIFICANT PORTION OF OUR BUSINESS IS CONCENTRATED IN CERTAIN
MARKETS AND THE RESPECTIVE ECONOMIC CONDITIONS OR CHANGES IN THE LAWS
AFFECTING OUR BUSINESS IN THOSE MARKETS COULD HAVE A MATERIAL ADVERSE
EFFECT ON THE COMPANY.
We receive all of our inpatient services revenue from operations in
Orange County, California. The economic condition of this market could affect
the ability of our patients and third-party payers to reimburse us for our
services, through its effect on disposable household income and the tax base
used to generate state funding for Medicaid programs. An economic downturn, or
changes in the laws affecting our business in our market and in surrounding
markets, could have a material adverse effect on the Company.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
17
ITEM 2. PROPERTIES
In March 2005, the Company completed the acquisition of the Hospitals.
At the closing of the acquisition, the Company transferred all of the fee
interests in the real estate acquired from Tenet (the "Hospital Properties") to
Pacific Coast Holdings Investments, LLC ("PCHI"). The Company entered into a
Triple Net Lease, dated March 7, 2005 (the "Triple Net Lease"), under which it
leased back from PCHI all of the real estate that it transferred to PCHI.
Additionally, the Company leases property from other lessors. As of December 31,
2005, the Company's principal facilities are listed in the following table:
APPROXIMATE
AGGREGATE INITIAL LEASE
PROPERTY SQUARE FOOTAGE LEASE RATE EXPIRATION
- -------------------------------- -------------- ------------ -------------------
Western Medical Center-Santa Ana 360,000 See note 1. Feb. 28, 2030
1001 North Tustin Avenue
Santa Ana, CA 92705
Administrative Building 40,000 See note 1. Feb. 28, 2030
1301 N. Tustin Avenue.
Santa Ana, CA
Western Medical Center-Anaheim 132,000 See note 1. Feb. 28, 2030
1025 South Anaheim Boulevard
Anaheim, CA 92805
Coastal Communities Hospital 115,000 See note 1. Feb. 28, 2030
2701 South Bristol Street
Santa Ana, CA 92704
Doctor's Hospital Medical Office 37,000 See note 2. March 30, 2009
Building
1901/1905 N. College Avenue
Santa Ana, CA 92706
Chapman Medical Center 140,000 See note 3. December 31, 2023
2601 East Chapman Avenue
Orange, CA 92869
____________________________
1. Initial monthly lease rate for all five properties equals one-twelfth
of (a) the amount obtained by multiplying $50 million by the sum of the
average annual interest rate charged on the loan secured by the first
lien deed of trust on the Hospital Properties for the preceding month
(the "Real Estate Loan") plus the "landlord's spread" (for the first
year, the difference between 12% and the annual interest rate on the
Real Estate Loan up to 2.5%, and then 2.5% thereafter), plus (b)
beginning on the earlier of the refinancing of the Hospital Properties
or March 8, 2007, $2.5 million. Leased from PCHI.
2. Initial monthly lease rate for all of the medical office properties
equals the rent received from the tenants of these properties less the
actual monthly costs to operate the properties, including insurance and
real property taxes. Leased from PCHI.
3. Leased from an unrelated party. Monthly lease payments are
approximately $112,092.
The State of California has established standards intended to ensure
that all hospitals in the state withstand earthquakes and other seismic activity
without collapsing or posing the threat of significant loss of life. We are
required to meet these standards by December 31, 2012. In addition, over time,
hospitals must meet performance standards meant to ensure that they are capable
of providing medical services to the public after an earthquake or other
disaster. Ultimately, all general acute care hospitals in California must
conduct all necessary seismic evaluations and be retrofitted, if needed, by 2030
to be in substantial compliance with the highest seismic performance standards.
Management has not completed engineering studies nor developed compliance plans
for the acquired hospitals. At this time, all of our general acute care
hospitals in California are in compliance with all current seismic requirements.
Until completion of the engineering studies, the Company is unable to estimate
the costs of complying with future seismic regulations, which could be material.
18
ITEM 3. LEGAL PROCEEDINGS
We and our subsidiaries are involved in various legal proceedings most
of which relate to routine matters incidental to our business. We do not believe
that the outcome of these matters is likely to have a material adverse effect on
the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Our 2005 annual meeting of shareholders was held on October 25, 2005. Of
the 67,309,000 shares eligible to vote, 62,686,575 appeared by proxy and
established a quorum for the meeting. The matters listed in the table below were
approved by a majority of the shareholders appearing at the meeting.
ELECTION OF DIRECTORS VOTES FOR VOTES AGAINST VOTES WITHHELD NOT VOTED
--------------------- --------- ------------- -------------- ---------
Maurice J. DeWald 62,662,300 0 24,275 4,622,425
Bruce Mogel 62,686,575 0 0 4,622,425
James T. Ligon 62,662,300 0 24,275 4,622,425
Jaime Ludmir, M.D. 62,662,300 0 24,275 4,622,425
Syed Salman J. Naqvi, M.D. 62,662,300 0 24,275 4,622,425
J. Fernando Niebla 62,662,300 0 24,275 4,622,425
Anil V. Shah, M.D. 62,582,300 0 104,275 4,622,425
19
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
There is no organized or established trading market for our Company
Stock. The Company's common stock was, until June 6, 2006, listed for trading on
the OTC Bulletin Board under the symbol "IHCH." There currently is no public
market for the Company's common stock. Prior to the suspension of trading of our
shares on the OTC Bulletin, Board, the trading market for the Common Stock was
extremely thin. In view of the lack of an organized or established trading
market for the Common Stock and the extreme thinness of whatever trading market
may exist, the prices reflected on the chart below as reported on the OTC
Bulletin Board may not be indicative of the price at which any prior or future
transactions were or may be effected in the Common Stock. Stockholders are
cautioned against drawing any conclusions from the data contained herein, as
past results are not necessarily indicative of future stock performance.
The following table sets forth the high and low bid price for the
Company's Common Stock for each quarter for the period from January 1, 2004
through December 31, 2005, as quoted on the Over-the-Counter Bulletin Board.
Such Over-the-Counter market quotations reflect inter-dealer prices, without
retail mark-up, mark-down or commission, and may not necessarily represent
actual transactions.
YEAR PERIOD HIGH LOW
-------- -------------- ----- -----
2004 First Quarter $3.15 $0.65
Second Quarter $1.00 $0.55
Third Quarter $0.70 $0.15
Fourth Quarter $0.62 $0.25
2005 First Quarter $1.55 $0.36
Second Quarter $1.13 $0.61
Third Quarter $0.80 $0.51
Fourth Quarter $0.60 $0.35
As of the date of this report, there were approximately 232 record
holders of the Company's common stock; this number does not include an
indeterminate number of stockholders whose shares may be held by brokers in
street name. The Company has not paid and does not expect to pay any dividends
on its shares of common stock for the foreseeable future, as any earnings will
be retained for use in the business.
The Company currently has no compensation plans under which equity
securities of the Company are authorized for issuance.
20
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial information should be read
in conjunction with "Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations" and the consolidated financial statements
and footnotes included elsewhere in this Form 10-K.
AT OR FOR THE FISCAL YEARS ENDED DECEMBER 31,
- ---------------------------------------------
($ IN 000) 2005 2004 2003
------------ ------------ ------------
SELECTED BALANCE SHEET DATA:
Working Capital $ 8,679 $ (12,132) $ 149
Property and equipment 59,431 57 47
Other Assets 1,141 11,187 156
Long term Debt 70,331 -- --
Warrant Liability 21,065 -- --
Capital lease obligations 4,961 -- --
Minority interest 3,342 -- --
Stockholders' Equity (Deficiency) (30,447) (888) 353
SELECTED INCOME STATEMENT DATA:
Collectable Net Revenue $ 246,966 $ -- $ --
Salaries and Benefits (153,574) -- --
Supplies (39,250) -- --
Other Operating Expenses (58,715) (1,840) (28)
Warrant Expenses (21,065) -- --
Depreciation and Amortization (2,178) -- --
Interest Expense (9,925) -- --
Provision for Income Taxes -- -- --
Net loss before minority interest $ (46,217) $ (1,840) $ (28)
============ ============ ============
Net loss attributable to common
stock $ (44,558) $ (1,840) $ (28)
============ ============ ============
PER SHARE DATA:
Net loss:
Basic and fully diluted $ (0.49) $ (0.09) $ (0.01)
Weighted average number of common
shares outstanding: 90,330,428 19,986,750 3,470,589
On March 8, 2005 the Company completed the acquisition and commenced
operation of the Hospitals. Prior to that time the Company reported activity as
a development stage enterprise. The operating results data presented above are
not necessarily indicative of our future results of operations. Reasons for this
include, but are not limited to: changes in Medicare regulations; Medicaid
funding levels set by the State of California and the County of Orange; levels
of malpractice expense and settlement trends; availability of trained health
care personnel and changes in occupancy levels and patient volumes. Factors that
affect patient volumes and, thereby, our results of operations at our hospitals
and related health care facilities include, but are not limited to: (1)
unemployment levels; (2) the business environment of local communities; (3) the
number of uninsured and underinsured individuals in local communities treated at
our hospitals; (4) seasonal cycles of illness; (5) climate and weather
conditions; (6) physician recruitment, retention and attrition; (7) local health
care competitors; (8) managed care contract negotiations or terminations; (9)
factors relating to the timing of elective procedures.
21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and related notes included elsewhere in this Annual Report on Form
10-K. This discussion contains forward-looking statements based on current
expectations that involve risks and uncertainties. Actual results and the timing
of certain events may differ significantly from those projected in such
forward-looking statements due to a number of factors, including those discussed
in Part I "Item 1A. Risk Factors" in this Annual Report on Form 10-K.
OVERVIEW
ACQUISITION - Prior to March 8, 2005, we were primarily a development
stage company with no material operations and no revenues from operations. On
September 29, 2004, the Company entered into a definitive agreement to acquire
four hospitals from subsidiaries of Tenet Healthcare Corporation ("Tenet"), and
completed the transaction on March 8, 2005 (the "Acquisition"). Effective March
8, 2005, we acquired and began operating the following four hospital facilities
in Orange County, California (referred to in this report as our "Hospitals"):
o 282-bed Western Medical Center in Santa Ana;
o 188-bed Western Medical Center in Anaheim;
o 178-bed Coastal Communities Hospital in Santa Ana; and
o 114-bed Chapman Medical Center in Orange.
We enter into agreements with third-party payers, including government
programs and managed care health plans, under which rates are based upon
established charges, the cost of providing services, predetermined rates per
diagnosis, fixed per diem rates or discounts from established charges. During
the 24 days ended March 31, 2005, substantially all of Tenet's negotiated rate
agreements were assigned to our Hospitals. Our own Medicare provider numbers
were received in April 2005. California State Medicaid Program provider numbers
were received in June 2005.
ACQUISITION DEBT - Effective March 3, 2005, in connection with the
Acquisition, the Company and its subsidiaries collectively entered into a credit
agreement (the "Credit Agreement") with Medical Provider Financial Corporation
II ("the Lender"), whereby the Company obtained initial financing in the form of
a loan with interest at the rate of 14% per annum in the amount of $80,000,000
of which $30,000,000 is in the form of a non-revolving Line of Credit and
$50,000,000 (less $5,000,000 repayment on December 12, 2005) is in
the form of Acquisition Loan (collectively, the "Obligations"). The Company
used the proceeds from the $50 million Acquisition Loan and $3 million from the
Line of Credit to complete the Acquisition. The Acquisition Loan and Line of
Credit are secured by a lien on substantially all of the assets of the Company
and its subsidiaries, including without limitation, a pledge of the capital
stock by the Company in its wholly owned Hospitals.
LONG TERM LEASE COMMITMENT WITH VARIABLE INTEREST ENTITY - Concurrent
with the close on the Acquisition, the Company sold substantially all of the
real property acquired in the Acquisition to Pacific Coast Holdings Investment,
LLC ("PCHI"). The Company sold $5 million in limited partnership interests to
finance the Acquisition and PCHI guaranteed the Company's Acquisition Loan. PCHI
is a related party entity that is affiliated with the Company through common
ownership and control. Upon such sale, the Company entered into a 25 year lease
agreement with PCHI involving substantially all of the real property acquired in
the Acquisition. In accordance with Financial Accounting Standards Board
Interpretation Number 46R, "Consolidation of Variable Interest Entities (revised
December 2003)--an interpretation of ARB No. 51," PCHI is a variable interest
entity and has been included in the Company's consolidated financial statements
as of and for the year ended December 31, 2005.
The Company remains primarily liable under the Acquisition Loan note
notwithstanding its guarantee by PCHI, and this note is cross-collateralized by
substantially all of the Company's assets and all of the real property of the
Hospitals. All of the Company's operating activities are directly affected by
the real property that was sold to PCHI. Given these factors, the Company has
indirectly guaranteed the indebtedness of PCHI. The Company is standing ready to
perform on the Acquisition Loan should PCHI not be able to perform and has
undertaken a contingent obligation to make future payments if those triggering
events or conditions occur.
22
ACCOUNTS PURCHASE AGREEMENT - In March 2005, the Company entered into a
two year Accounts Purchase Agreement (the "APA") with Medical Provider Financial
Corporation I (the "Buyer"). The APA provides for the sale of 100% of the
Company's eligible accounts receivable, as defined, without recourse. After
accounts receivable are sold, the APA requires the Company to provide billing
and collection services, maintain the individual patient accounts, and resolve
any disputes that arise between the Company and the patient or other third party
payer. The Company accounts for its sale of accounts receivable in accordance
with SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities - A Replacement of FASB Statement 125."
On a weekly basis, the accounts receivable are sold in four purchases
representing the prior week's billings for each Hospital. The purchase price is
comprised of two components, the advance rate amount and the deferred portion
amount. The advance rate amount is based on the historical collection experience
for accounts receivable similar to those included in a respective purchase. At
the time of sale, the Buyer advances 85% of the advance rate amount (the "85%
Advance") to the Company and holds the remaining 15% as security reserve funds
on sold accounts (the "Security Reserve Funds"), which is non-interest bearing.
Except in the case of a continuing default, the Security Reserve Funds can not
exceed 25% (the "25% Cap") of the aggregate advance rate amount, as defined, of
the open purchases. The Company is charged a "purchase discount" (the
"Transaction Fee") of 1.35% per month of the advance rate amount of each
purchase until the purchase is closed, at which time the Buyer deducts the
Transaction Fee from the Security Reserve Funds. Collections are applied on a
dollar value basis, not by specific identification, to the respective Hospital's
most aged open purchase. The deferred portion amount represents amounts the
Company expects to collect, based on regulations, contracts, and historical
collection experience, in excess of the advance rate amount.
The following table reflects the components of Account Receivable and
Receivable from Buyer of Accounts as of December 31, 2005:
Accounts receivable:
Governmental $ 10,394,875
Non-governmental 9,345,678
------------
19,740,553
Less allowance for doubtful accounts (3,148,276)
------------
Net patient accounts receivable 16,592,277
------------
Security Reserve Funds 12,127,337
Deferred purchase price receivables 9,337,703
------------
Receivable from Buyer of accounts 21,465,040
------------
$ 38,057,317
============
Although 100% of the Company's accounts receivable, as defined, is
purchased by the Buyer, certain payments (generally payments that cannot be
attributed to specific patient account, such as third party settlements,
capitation payments and MediCal Disproportionate Share Hospital ("DSH")
subsidies (collectively "Other Payments")) are retained by the Company and not
applied to the purchases processed by the Buyer. In the opinion of our
management, after consultation with the Buyer, DSH payments and CalOptima
capitation premium payments of $11.0 million and $18.1 million, respectively,
for the year ended December 31, 2005, are excludable from application to the
Security Reserve Funds. However, if cash collections on purchases are not
sufficient to recover the Buyer's advance rate amount and related transaction
fees, the Buyer could be entitled to funds the Company has received in Other
Payments or require transfer of substitute accounts to cover any such shortfall.
Based on collection history under the APA to date, the Company's management
believes the likelihood of the Buyer exercising this right is remote.
Any other term of the APA notwithstanding, the parties agreed as
follows: (a) all accounts derived from any government program payer including,
without limitation, the Medicare, MediCal, or CHAMPUS programs, shall be handled
as set forth in a Deposit Account Security Agreement entered into by the
parties, which provides for the segregation and control of governmental payments
by the Company, (b) the parties agreed to take such further actions and execute
such further agreements as are reasonably necessary to effectuate the purpose of
the APA and to comply with the laws, rules, and regulations of the Medicare and
other government programs regarding the reassignment of claims and payment of
claims to parties other than the provider ("Reassignment Rules"), and (c) until
such time as accounts are delivered by the Company to the Buyer controlled
lockbox, the Company shall at all times have sole dominion and control over all
payments due from any government program payer. The Company's management (i)
believes that the foregoing method of segregating and controlling payments
received from governmental program payers complies with all applicable
Reassignment Rules, and (ii) the Company intends to request an opinion from the
Federal Center for Medicare and Medicaid Services ("CMS") that such method is
compliant with the Reassignment Rules in the view of CMS. The Company has
reported sales of $13,377,102 in governmental accounts receivable as of December
31, 2005 that are subject to the foregoing limitation.
23
The Company records estimated Transaction Fees and estimated servicing
costs related to the sold accounts receivable at the time of sale. For the year
ended December 31, 2005, the Company incurred a loss on sale of accounts
receivable of $8,470,053.
During the year ended December 31, 2005, the Company sold accounts
receivable with a net book value of $214,360,537, for which the Company received
$190,631,569, comprised of $179,744,444, representing the 85% Advance, and
$10,887,125 from the Security Reserve Funds, which exceeded the 25% Cap and was
released by the Buyer. Collections relating to the sold accounts receivable
totaled $179,788,372, resulting in a net advance rate amount to the Company of
$10,843,197 as of December 31, 2005. At December 31, 2005, the Security Reserve
Funds balance of $12,127,337 was in excess of the 25% Cap by approximately
$1,487,000, which was released to the Company subsequent to December 31, 2005.
COMMON STOCK WARRANTS - On January 27, 2005, the Company entered into a
Rescission, Restructuring and Assignment Agreement with Dr. Kali Chaudhuri and
Mr. William Thomas, both of whom have ownership interests in PCHI (the
"Restructuring Agreement"). Previously, the Company had obtained financing from
Dr. Chaudhuri and Mr. Thomas and had issued to them a $500,000 secured
convertible promissory note that was convertible into approximately 88.8% of the
Company's issued and outstanding common stock on a fully-diluted basis, a $10
million secured promissory note, and a Real Estate Purchase Option agreement
originally dated September 28, 2004 to purchase 100% of substantially all of the
real property in the Acquisition for $5 million (the "Real Estate Option"), all
of which together with related accrued interest payable pursuant to the terms of
the notes were rescinded and cancelled. Pursuant to the Restructuring Agreement,
the company released its initial deposit of $10 million plus accrued interest on
the Acquisition back to Dr. Chaudhuri and issued non-convertible secured
promissory notes totaling $1,264,014 and warrants to purchase up to 74,700,000
shares of the Company's common stock (the "Warrants") to Dr. Chaudhuri and Mr.
Thomas (not to exceed 24.9% of the Company's fully diluted capital stock at the
time of exercise). Concurrent with the close of the Acquisition, the Company
repaid the non-convertible secured promissory notes of $1,264,014 to Dr.
Chaudhuri and Mr. Thomas.
The Warrants are exercisable beginning January 27, 2007 and expire
3.5 years from the date of issuance. The exercise price for the first 43 million
shares purchased under the Warrants is $0.003125 per share, and the exercise or
purchase price for the remaining 31.7 million shares is $0.078 per share if
exercised between January 27, 2007 and July 26, 2007, $0.11 per share if
exercised between July 27, 2007 and January 26, 2008, and $0.15 per share
thereafter until expiration of the warrants.
Effective December 12, 2005, the Company entered into a credit
agreement (the "December Credit Agreement") with the Credit Parties and the
Lender. Under the December Credit Agreement, the Lender loaned $10,700,000 to
the Company as evidenced by a promissory note (the "December Note"), of which $5
million was used to pay down the Acquisition Loan. Interest is payable monthly
at the rate of 12% per annum and the December Note is due on December 12, 2006.
The December Note is secured by substantially all of the Company's
assets. In addition, the Company issued a common stock warrant (the "December
Note Warrant") to the Lender as collateral under the December Note. The December
Note Warrant is exercisable by the Lender only in the event that a default has
occurred and is continuing on the December Note. The December Note Warrant
entitles the Lender to purchase the number of shares of the Company's common
stock equal in value to the amount of the December Note not repaid at maturity,
plus accrued interest and lender fees for an aggregate exercise price of $1.00,
regardless of the number of shares acquired. The December Note Warrant is
exercisable from and after December 12, 2005 until the occurrence of either a
termination of the December Credit Agreement by the Lender or the Company's
payment in full of all obligations under the December Credit Agreement. The
Company is obligated to register the estimated number of shares of common stock
issuable upon exercise of the December Note Warrant by filing a registration
statement under the Securities Act of 1933, as amended (the "Securities Act"),
no later than ninety days prior to the maturity date of the December Note. If
the Company proposes to file a registration statement under the Securities Act
on or before the expiration date of the December Note Warrant, then the Company
must offer to the holder of the December Note Warrant the opportunity to include
the number of shares of common stock as the holder may request.
Based upon a valuation obtained by the Company from an independent
valuation firm, the Company recorded an expense of $17,604,292 related to the
issuance of the Warrants. The Company computed the expense of the Warrants based
on the fair value of the underlying shares at the date of grant and the
estimated maximum number of shares of 43,254,715 that could be issued under the
Warrants. For the period from December 12, 2005 to December 31, 2005 the Company
recognized $3,460,377 in change in fair value of derivative in the accompanying
consolidated statement of operations for the year ended December 31, 2005.
24
As a result of the Company not being able to determine the maximum
number of shares that could be required to be issued under the December Note
Warrant issued on December 12, 2005, the Company has determined that share
settlement of the Warrants issued on January 27, 2005 is no longer within its
control and reclassified the Warrants as a liability on December 12, 2005 in
accordance with EITF No. 00-19 "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock" and SFAS 133
"Accounting for Derivative Instruments and Hedging Activities." As of December
12, 2005, there was a substantial reduction in the shares outstanding to
83,932,316 shares as a result of the Company's settlement with OC-PIN. However,
the requirement to repay the December Note for $10.7 million may obligate the
Company to issue new shares of its common stock prior to the expected exercise
of the Warrants and the estimated maximum number of shares exercisable of
43,254,715 accordingly remains unchanged.
Management believes that the likelihood of the December Note Warrant
being exercised is reasonably possible and, in accordance with EITF No. 00-19
and SFAS 133, has included the December Note value of $10.7 million in warrant
liability, current, in its consolidated balance sheet as of December 31, 2005.
Under the terms of the December Credit Agreement, any proceeds from the sale of
stock received under the December Note Warrant that are in excess of the
December Note and related issuance costs are to be returned to the Company.
Accordingly, the fair value of the December Note Warrant would contractually
continue to be $10.7 million (plus any issuance and exercise costs, which are
considered immaterial).
The Company computed the fair value of the Warrants, and the fair value
of the December Note Warrant and related number of shares, based on the
Black-Scholes option pricing model. Due to the fact that the Company emerged
from the development stage during the year ended December 31, 2005, the Company
computed the volatility of its stock based on an average of public companies
that own hospitals. Although management believes this is the most reasonable and
accurate methodology to determine the Company's volatility, the circumstances
affecting volatility of the comparable companies selected may not be an accurate
predictor of the Company's volatility.
SIGNIFICANT CHALLENGES
COMPANY - Our acquisition of the Hospitals involves numerous potential
risks, including:
o potential loss of key employees and management of acquired
companies;
o difficulties integrating acquired personnel and distinct cultures;
o difficulties integrating acquired companies into our proposed
operating, financial planning and financial reporting systems;
o diversion of management attention; and
o assumption of liabilities and potentially unforeseen liabilities,
including liabilities for past failure to comply with healthcare
regulations.
Our acquisition also involved significant cash expenditures, debt
incurrence and integration expenses that could seriously strain our financial
condition. If we are required to issue equity securities to raise additional
capital, existing stockholders will likely be substantially diluted, which could
affect the market price of our stock.
INDUSTRY - Our Hospitals receive a substantial portion of their
revenues from Medicare and Medicaid. The healthcare industry is experiencing a
strong trend toward cost containment, as the government seeks to impose lower
reimbursement and resource utilization group rates, limit the scope of covered
services and negotiate reduced payment schedules with providers. These cost
containment measures generally have resulted in a reduced rate of growth in the
reimbursement for the services that we provide relative to the increase in our
cost to provide such services.
Changes to Medicare and Medicaid reimbursement programs have limited,
and are expected to continue to limit, payment increases under these programs.
Also, the timing of payments made under the Medicare and Medicaid programs is
subject to regulatory action and governmental budgetary constraints resulting in
a risk that the time period between submission of claims and payment could
increase. Further, within the statutory framework of the Medicare and Medicaid
programs, a substantial number of areas are subject to administrative rulings
and interpretations which may further affect payments.
Our business is subject to extensive federal, state and, in some cases,
local regulation with respect to, among other things, participation in the
Medicare and Medicaid programs, licensure and certification of facilities, and
reimbursement. These regulations relate, among other things, to the adequacy of
physical property and equipment, qualifications of personnel, standards of care,
government reimbursement and operational requirements. Compliance with these
regulatory requirements, as interpreted and amended from time to time, can
increase operating costs and thereby adversely affect the financial viability of
our business. Because these regulations are amended from time to time and are
subject to interpretation, we cannot predict when and to what extent liability
may arise. Failure to comply with current or future regulatory requirements
could also result in the imposition of various remedies including (with respect
to inpatient care) fines, restrictions on admission, denial of payment for all
or new admissions, the revocation of licensure, decertification, imposition of
temporary management or the closure of a facility or site of service.
25
We are subject to periodic audits by the Medicare and Medicaid
programs, which have various rights and remedies against us if they assert that
we have overcharged the programs or failed to comply with program requirements.
Rights and remedies available to these programs include repayment of any amounts
alleged to be overpayments or in violation of program requirements, or making
deductions from future amounts due to us. These programs may also impose fines,
criminal penalties or program exclusions. Other third-party payer sources also
reserve rights to conduct audits and make monetary adjustments in connection
with or exclusive of audit activities.
The healthcare industry is highly competitive. We compete with a
variety of other organizations in providing medical services, many of which have
greater financial and other resources and may be more established in their
respective communities than we are. Competing companies may offer newer or
different centers or services than we do and may thereby attract patients or
customers who are presently patients, customers or are otherwise receiving our
services.
An increasing trend in malpractice litigation claims, rising costs of
malpractice litigation, losses associated with these malpractice lawsuits and a
constriction of insurers have caused many insurance carriers to raise the cost
of insurance premiums or refuse to write insurance policies for hospital
facilities. Also, a tightening of the reinsurance market has affected property,
auto and excess liability insurance carriers. Accordingly, the costs of all
insurance premiums have increased.
We receive all of our inpatient services revenue from operations in
Orange County, California. The economic condition of this market could affect
the ability of our patients and third-party payers to reimburse us for our
services, through its effect on disposable household income and the tax base
used to generate state funding for Medicaid programs. An economic downturn, or
changes in the laws affecting our business in our market and in surrounding
markets, could have a material adverse effect on our financial position, results
of operations and cash flows.
LIQUIDITY AND CAPITAL RESOURCES
The Company's consolidated financial statements have been prepared on a
going concern basis, which contemplates the realization of assets and settlement
of obligations in the normal course of business. The Company generated losses of
$44,558,367 (inclusive of a warrant issuance and holding expenses of $21,064,669
incurred in connection with the Acquisition) during the year ended December 31,
2005 and had working capital of $8,678,836 at December 31, 2005. Current
liabilities as of December 31, 2005 excluded $70,330,734 in term loans due March
2, 2007.
On or around May 9, 2005, the Company received notice that it was in
default of its Acquisition Loan and Line of Credit. Effective December 12, 2005,
the Company entered into a one year credit agreement for $10,700,000, which
included an amendment that (i) declared cured the aforementioned default, (ii)
required the Company to pay $5,000,000 against its Acquisition Loan, (iii)
required the Company to obtain $10,700,000 in additional new capital
contributions to pay in full and retire all amounts due and owing under the one
year credit agreement and (iv) included certain indemnities and releases in
favor of the Lender. Accordingly, on December 12, 2005, the Company paid
$5,000,000 against the Acquisition Loan reducing its outstanding balance to $45
million. As of December 31, 2005, the Company had outstanding short term and
long term debt aggregating $81,030,734, of which $10,700,000 was classified as
warrant liability, current. See "Overview - Common Stock Warrants" above in this
Item 7.
Effective January 1, 2006, the Company and the Lender agreed to an
amendment to the Acquisition Loan and Line of Credit that changed the interest
rate from 14% to prime plus 5.75%. As a result, future increases in the prime
rate would increase the Company's interest expense.
Working capital as of December 31, 2005 was $8.7 million and, for the
year then ended, cash used by operations was $13.1 million. From acquisition of
the hospitals on March 8, 2005, this represents an average of $1.3 million per
month of corrective action that is required to preserve the current working
capital position. Management is working on improvements in several areas that
the Company believes will mitigate these deficits:
1. Net operating revenues: The Hospitals serve a disproportionate
number of indigent patients and receive governmental revenues and
subsidies in support of care for these patients. We have received
increases in Medicaid, Medicaid DSH, and Orange County, CA
(CalOptima) payments. Increased reimbursement and support in these
areas represent $0.7 million per month in committed improvement
and an additional $0.1 to $0.2 million per month still under
discussion. Commercial managed care rate improvements are
approximately $0.2 million per month in 2006 vs. 2005.
2. Operating expenses: Management is working aggressively to reduce
cost without reduction in service levels. These efforts have in
large part been offset by inflationary pressures. However, a net
improvement of $0.2 to $0.3 million per month is a reasonable
expectation for 2006.
26
3. Financing costs: The Company completed the Acquisition of the
Hospitals with a high level of debt financing. Additionally, the
Company entered into an Accounts Purchase Agreement (see Note 3 to
the consolidated financial statements included elsewhere in this
Annual Report on Form 10-K), and is incurring significant
discounts on the sale of accounts receivable. As described in the
notes to the consolidated financial statements, the largest
investor was unable to meet all the commitments under the stock
purchase agreement. As a result, the Company incurred additional
interest costs from default rates and higher than planned
borrowings. The Company intends to work with interested parties to
place an additional $20 million in equity, of which $10.7 million
will be applied toward the payment of the December Note and the
remainder will reduce the level required when the term notes are
refinanced. Additionally, management believes the reduction in
leverage and refinancing will yield reductions in the discount on
sales of accounts receivable. The combined impact of these changes
is expected to yield from $0.4 to $0.5 million in reduced capital
costs per month. These steps are subject to the approval of the
Company's Board of Directors which currently is comprised of three
representatives of the lead investor, two outside directors, and
one officer of the Company and, accordingly, may not be assured.
The foregoing analysis presumes that capital expenditures to replace
equipment can be kept to an immaterial amount in the short term. It is the
intent of management to fund future capital expenditures from operations.
As of December 31, 2005, the Company had $4,669,266 available under its
$30 million Line of Credit. The Line of Credit is to be used for the purpose of
providing (a) working capital financing for the Company and its subsidiaries,
(b) funds for other general corporate purposes of the Company and its
subsidiaries, and (c) other permitted purposes.
Two amendments to the APA will accelerate the Company's cash receipts
in connection with its sales of accounts receivable. Effective January 1, 2006,
the APA was amended to reflect the following changes:
Through Starting
December 31, January 1,
2005 2006
------------ ----------
Advance rate amount -
% received at time of sale 85% 95%
Advance rate amount -
% held by Buyer in Security Reserve Funds 15% 5%
Further, effective March 31, 2006, another amendment to the APA reduced
the required accumulated Security Reserve Funds amount as a percentage of the
total advance rate amount outstanding from 25% to 15%. If this amendment had
been in place as of December 31, 2005, the accumulated Security Reserve Funds
balance of $12,127,337 would have been in excess of the total advance rate
amount by approximately $5,743,000. Excess accumulated Security Reserve Funds
resulting from this amendment were released to the Company in early 2006.
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
The Company acquired the Hospitals on March 8, 2005, representing 9.8
months of operations for the 2005 fiscal year. Prior to March 8, 2005, the
Company was a development stage enterprise with no revenues and limited
expenses. Since we had no operations prior to 2005, we compare our 2005
financial performance to prior years' financial performance of the Hospitals
while they were owned by Tenet. This information was provided to us by Tenet in
conjunction with our acquisition of the Hospitals. While we believe such
information to be reliable and to have been prepared in accordance with
generally accepted accounting principles, the financial information provided to
us by Tenet relating to the Hospitals prior to March 8, 2005 was not prepared by
us or audited by our independent accounting firm.
NET OPERATING REVENUES - Net operating revenues of approximately $284
million for the period from March 8, 2005 through December 31, 2005 compare
favorably to the prorated revenues of $257 million under Tenet in the preceding
year (a 10% increase). This is the result of favorable rate negotiations with
payers following the change in ownership. Patient days were relatively flat
declining approximately 0.3%. A number of contract increases were executed
during the fourth quarter of 2005. The expected effect of these increases for
fiscal 2006 is $10 million to $11 million in additional revenues.
OPERATING EXPENSES - Operating expenses, net of noncash charges, of
approximately $297 million for the period from March 8, 2005 through December
31, 2005 increased 0.7% from the prorated operating expenses, net of noncash
charges, of $295 million under Tenet in the preceding year.
Wage increases averaged 7% in 2005 as the result of Tenet's commitment
to employees that the Company agreed to honor. These were offset by improved
efficiencies. We expect comparable wage increases in 2006 and have identified $3
million to $4 million in additional cost reductions to partially offset this.
27
OTHER EXPENSE - Other expense includes interest expense of $9.9 million
and noncash charges relating to warrant expense of $21.6 million. Warrant
expense includes a $17.6 million expense for warrants granted in connection with
a restrucurting of our agreement with our lead investor, Dr. Kali Chaudhuri, in
January 2005 and closing on the Hospital Acquisition in March 2005. This was a
one-time noncash charge. Additionally, a noncash charge of $3.5 million was
recognized for the change in carrying value on the warrants (as described more
fully in the notes to the consolidated financial statements contained in this
Annual Report on Form 10-K). Since this was characterized as a financing
activity in our amended Form 10-Q/As for the 2005 quarters, we have classified
the costs with other financing costs below the loss from operations in our
consolidated statements of operations for the year ended December 31, 2005.
CRITICAL ACCOUNTING ESTIMATES
REVENUE RECOGNITION - Net operating revenues are recognized in the
period in which services are performed and are recorded based on established
billing rates (gross charges) less estimated discounts for contractual
allowances, principally for patients covered by Medicare, Medicaid, managed care
and other health plans. Gross charges are retail charges. They are not the same
as actual pricing, and they generally do not reflect what a hospital is
ultimately paid and therefore are not displayed in the consolidated statements
of operations. Hospitals are typically paid amounts that are negotiated with
insurance companies or are set by the government. Gross charges are used to
calculate Medicare outlier payments and to determine certain elements of payment
under managed care contracts (such as stop-loss payments). Because Medicare
requires that a hospital's gross charges be the same for all patients
(regardless of payer category), gross charges are also what hospitals charge all
other patients prior to the application of discounts and allowances.
Revenues under the traditional fee-for-service Medicare and Medicaid
programs are based primarily on prospective payment systems. Discounts for
retrospectively cost-based revenues and certain other payments, which are based
on the Hospitals' cost reports, are estimated using historical trends and
current factors. Cost report settlements for retrospectively cost-based revenues
under these programs are subject to audit and administrative and judicial
review, which can take several years until final settlement of such matters are
determined and completely resolved. Since the laws, regulations, instructions
and rule interpretations governing Medicare and Medicaid reimbursement are
complex and change frequently, the estimates recorded by the Hospitals could
change by material amounts. The Company has established a settlement receivable
for the year ended December 31, 2005 of $2,273,248.
Outlier payments, which were established by Congress as part of the
diagnosis-related groups (DRG) prospective payment system, are additional
payments made to hospitals for treating Medicare patients who are costlier to
treat than the average patient in the same DRG. To qualify as a cost outlier, a
hospital's billed (or gross) charges, adjusted to cost, must exceed the payment
rate for the DRG by a fixed threshold established annually by the Centers for
Medicare and Medicaid Services of the United State Department of Health and
Human Services (CMS). Under Sections 1886(d) and 1886(g) of the Social Security
Act, CMS must project aggregate annual outlier payments to all prospective
payment system hospitals to be not less than 5% or more than 6% of total DRG
payments (Outlier Percentage). The Outlier Percentage is determined by dividing
total outlier payments by the sum of DRG and outlier payments. CMS annually
adjusts the fixed threshold to bring expected outlier payments within the
mandated limit. A change to the fixed threshold affects total outlier payments
by changing (1) the number of cases that qualify for outlier payments, and (2)
the dollar amount hospitals receive for those cases that still qualify. The most
recent change to the cost outlier threshold that became effective on October 1,
2005 was a decrease from $25,800 to $23,600, which CMS projects will result in
an Outlier Percentage of 5.1%. The Medicare fiscal intermediary calculates the
cost of a claim by multiplying the billed charges by the cost-to-charge ratio
from the hospital's most recent filed cost report.
The Hospitals received new provider numbers during the year ended
December 31, 2005 and, because there was no specific history, the Hospitals were
reimbursed for outliers based on published statewide averages. If the computed
cost exceeds the sum of the DRG payment plus the fixed threshold, the hospital
receives 80% of the difference as an outlier payment. Medicare has reserved the
option of adjusting outlier payments, through the cost report, to the hospital's
actual cost-to-charge ratio. Upon receipt of the current payment cost-to-charge
ratios from the fiscal intermediary, any variance between current payments and
the estimated final outlier settlement will be reported. The Company has
recorded reserves for excess outlier payments due to the difference between the
Hospitals' actual cost to charge rates and the statewide average in the amount
of $2,169,626. These reserves offset against the third party settlement
receivables and are included as a net receivable of $103,622 due from
governmental payers in the Company's consolidated balance sheet as of December
31, 2005.
The Hospitals receive supplemental payments from the State of
California to support indigent care (MediCal Disproportionate Share Hospital
payments or "DSH"). During the year ended December 31, 2005, the Hospitals
received $11,022,185 in payments. The Company estimates an additional $2,921,150
is receivable based on State correspondence, which is included in due from
governmental payers in the consolidated balance sheet as of December 31, 2005.
28
Revenues under managed care plans are based primarily on payment terms
involving predetermined rates per diagnosis, per-diem rates, discounted
fee-for-service rates and/or other similar contractual arrangements. These
revenues are also subject to review and possible audit by the payers. The payers
are billed for patient services on an individual patient basis. An individual
patient's bill is subject to adjustment on a patient-by-patient basis in the
ordinary course of business by the payers following their review and
adjudication of each particular bill. The Hospitals estimate the discounts for
contractual allowances utilizing billing data on an individual patient basis. At
the end of each month, the Hospitals estimate expected reimbursement for patient
of managed care plans based on the applicable contract terms. These estimates
are continuously reviewed for accuracy by taking into consideration known
contract terms as well as payment history. Although the Hospitals do not
separately accumulate and disclose the aggregate amount of adjustments to the
estimated reimbursements for every patient bill, management believes the
estimation and review process allows for timely identification of instances
where such estimates need to be revised. Management does not believe there were
any adjustments to estimates of individual patient bills that were material to
its net operating revenues.
The Company is not aware of any material claims, disputes, or unsettled
matters with any payers that would affect revenues that have not been adequately
provided for in the Company's consolidated financial statements as of and for
the year ended December 31, 2005.
The Hospitals provide charity care to patients whose income level is
below 200% of the Federal Poverty Level with only a co-payment charged to the
patient. The Hospitals' policy is to not pursue collection of amounts determined
to qualify as charity care; and accordingly, the Hospitals do not report the
amounts in net operating revenues or in the provision for doubtful accounts.
Patients whose income level is between 200% and 300% of the Federal Poverty
Level may also be considered under a catastrophic provision of the charity care
policy. Patients without insurance who do not meet the Federal Poverty Level
guidelines are offered assistance in applying for Medicaid and other programs
they may be eligible for, such as state disability, Victims of Crime, or county
indigent programs. Patient advocates from the Hospitals' Medical Eligibility
Program (MEP) screen patients in the hospital and determine potential linkage to
financial assistance programs. They also expedite the process of applying for
these government programs. Based on average revenue for comparable services from
all other payers, revenues foregone under the charity policy, including indigent
care accounts, for the year ended December 31, 2005 were approximately $3.1
million.
Receivables from patients who are potentially eligible for Medicaid are
classified as Medicaid pending under the MEP, with appropriate contractual
allowances recorded. If the patient does not quality for Medicaid, the
receivables are reclassified to charity care and written off, or they are
reclassified to self-pay and adjusted to their net realizable value through the
provision for doubtful accounts. Reclassifications of Medicaid pending accounts
to self-pay do not typically have a material impact on the results of operations
as the estimated Medicaid contractual allowances initially recorded are not
materially different than the estimated provision for doubtful accounts recorded
when the accounts are reclassified. All accounts classified as pending Medicaid
are fully reserved when they reach 180 days old.
SALE OF ACCOUNTS RECEIVABLE - During the year ended December 31, 2005,
the Company incurred $8,470,053 in loss on sale of accounts receivable. See
"Overview - Accounts Purchase Agreement" above in this Item 7.
PROVISION FOR DOUBTFUL ACCOUNTS - The Company provides for accounts
receivable that could become uncollectible by establishing an allowance to
reduce the carrying value of such receivables to their estimated net realizable
value. The Hospitals estimate this allowance based on the aging of their
accounts receivable, historical collections experience for each type of payer
and other relevant factors. There are various factors that can impact the
collection trends, such as changes in the economy, which in turn have an impact
on unemployment rates and the number of uninsured and underinsured patients,
volume of patients through the emergency department, the increased burden of
co-payments to be made by patients with insurance and business practices related
to collection efforts. These factors continuously change and can have an impact
on collection trends and the estimation process.
The Company's policy is to attempt to collect amounts due from
patients, including co-payments and deductibles due from patients with
insurance, at the time of service while complying with all federal and state
laws and regulations, including, but not limited to, the Emergency Medical
Treatment and Labor Act (EMTALA). Generally, as required by EMTALA, patients may
not be denied emergency treatment due to inability to pay. Therefore, until the
legally required medical screening examination is complete and stabilization of
the patient has begun, services are performed prior to the verification of the
patient's insurance, if any. In non-emergency circumstances or for elective
procedures and services, it is the Hospitals' policy, when appropriate, to
verify insurance prior to a patient being treated.
During the year ended December 31, 2005, the Company recorded a
provision for doubtful accounts of $37,348,984.
29
COMMON STOCK WARRANTS - During the year ended December 31, 2005, the
Company incurred $21,064,669 in warrant related expenses. See "Overview - Common
Stock Warrants" above in this Item 7.
RECENT ACCOUNTING STANDARDS
In October 2004, the FASB issued SFAS 123R, "Share-Based Payment,"
which requires all companies to measure compensation cost for all share-based
payments, including employee stock options, at fair value. The statement is
effective for the Company as of the fiscal year commencing January 1, 2006. The
statement generally requires that such transactions be accounted for using a
fair-value-based method and recognized as expenses in the consolidated
statements of operations. This standard also requires that the modified
prospective transition method be used, under which the Company will recognize
compensation cost for (1) the fair value of new awards granted, modified or
settled after the effective date of the SFAS 123(R); and (2) a portion of the
fair value of each option and stock grant made to employees or directors prior
to the implementation date that represents the unvested portion of these
share-based awards as of such date.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and
Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No.
3." SFAS 154 changes the requirements for the accounting for, and reporting of,
a change in accounting principle. Previously, most voluntary changes in
accounting principles were required to be recognized by way of a cumulative
effect adjustment within net income during the period of change. SFAS 154
generally requires retrospective application to prior periods' financial
statements of voluntary changes in accounting principles. SFAS 154 is effective
for accounting changes made in fiscal years beginning after December 15, 2005;
however, SFAS 154 does not change the transition provisions of any existing
accounting pronouncements. The Company does not believe SFAS 154 will have a
material effect on its consolidated balance sheets or statements of operations.
In December 2005, FASB issued FIN 47, "Accounting for Conditional Asset
Retirement Obligations - an Interpretation of FASB No. 143." FIN 47 clarifies
the term conditional asset retirement obligation used in SFAS No. 143
"Accounting for Asset Retirement Obligations" and is effective for fiscal years
ending after December 15, 2005. The Company does not believe FIN 47 will have a
material effect on its consolidated balance sheets or statements of operations.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140."
SFAS 155, among other things: permits the fair value re-measurement of any
hybrid financial instrument that contains an embedded derivative that otherwise
would require bifurcation and establishes a requirement to evaluate interests in
securitized financial assets to identify interests that are freestanding
derivatives or that are hybrid financial instruments that contain an embedded
derivative requiring bifurcation. SFAS 155 is effective for all financial
instruments acquired or issued in fiscal years beginning after September 15,
2006. The Company is currently evaluating the effect that adopting this
statement will have on the Company's financial position and results of
operations.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets - an amendment of FASB Statement No. 140," with respect to
the accounting for separately recognized servicing assets and servicing
liabilities. SFAS 156 permits the choice of the amortization method or the fair
value measurement method, with changes in fair value recorded in income, for the
subsequent measurement for each class of separately recognized servicing assets
and servicing liabilities. The statement is effective for years beginning after
September 15, 2006, with earlier adoption permitted. The Company is currently
evaluating the effect that adopting this statement will have on the Company's
financial position and results of operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At December 31, 2005, we did not have any investment in or outstanding
liabilities under market rate sensitive instruments. We do not enter into
hedging instrument arrangements. On December 12, 2005 we entered into a
derivative financial instrument solely for the purpose of securing a related
loan. This is discussed more fully in the Notes 5 and 7 to the consolidated
financial statements as of and for the year ended December 31, 2005. We have no
off-balance sheet arrangements.
30
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following consolidated financial statements are filed as a part of this
report beginning on page F-1:
PAGE DESCRIPTION
F-1 Report of Independent Registered Public Accounting Firm.
F-2 Report of prior Independent Registered Public Accounting Firm.
F-3 Consolidated Balance Sheets as of December 31, 2005 and 2004.
F-4 Consolidated Statements of Operations for the years ended December
31, 2005, 2004 and 2003.
F-5 Consolidated Statements of Shareholders' Deficiency as of December
31, 2005, 2004 and 2003.
F-6 Consolidated Statements of Cash Flows for the years ended December
31, 2005, 2004 and 2003.
F-7 Notes to Consolidated Financial Statements.
F-32 Schedule II - Valuation and Qualifying Accounts
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are
designed to ensure that information required to be disclosed in the Company's
periodic reports is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms, and that such information is
accumulated and communicated to the Company's management, including its Chief
Executive Officer and Chief Financial Officer, as appropriate, to allow timely
decisions regarding required disclosure based closely on the definition of
"disclosure controls and procedures" in Rule 15d-15(e). The Company's disclosure
controls and procedures are designed to provide a reasonable level of assurance
of reaching the Company's desired disclosure control objectives. In designing
and evaluating the disclosure controls and procedures, management recognized
that any controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives
and management necessarily was required to apply its judgment in evaluating the
cost-benefit relationship of possible controls and procedures.
We conducted an evaluation under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures as of December 31, 2005. During previous
quarters we conducted evaluations of the effectiveness of our disclosure
controls and procedures as of March 31, June 30 and September 30, 2005 and found
them to be effective as of such dates. However, we have subsequently conducted a
re-evaluation of the effectiveness of our disclosure controls and procedures as
of March 31, June 30 and September 30, 2005, and identified certain material
weaknesses, discussed further below.
With the participation of the Company's Chief Executive Officer and
Chief Financial Officer, management conducted an evaluation of the effectiveness
of our system of internal control over financial reporting as of December 31,
2005, based on the framework in Internal Control-Integrated Framework published
by the Committee of Sponsoring Organizations of the Treadway Commission.
Based on these evaluations and re-evaluations, management determined
that the Company's system of disclosure controls and procedures was not
effective as of March 31, June 30, September 30 and December 31, 2005, and the
Company's systems of internal control over financial reporting was not effective
as of December 31, 2005, due to the presence of certain material weaknesses.
These weaknesses contributed to the need for restatements of our financial
statements for the quarterly periods ended March 31, June 30 and September 30,
2005 as follows.
31
1. During 2005, the Company revised its calculation of Warrant
expense incurred during the three months ended March 31, 2005
after review of its accounting treatment following receipt of
comments from the Staff of the Securities and Exchange Commission.
The total adjustment required to increase the Warrant expense to
its proper balance was $780,827 pre-tax for such period. This
adjustment was necessary because the Company recognized the
Warrant expense as a nonrecurring settlement charge during the
three months ended March 31, 2005 using a probability analysis to
estimate the maximum number of warrants exercisable at the date of
issuance of 43,254,715 shares.
2. During 2005, the Company revised its provision for income taxes
due to an error in the calculation of the taxable gain on the sale
of real property to PCHI (see Note 8 to the consolidated financial
statements as of and for the year ended December 31, 2005). The
total adjustment required to reduce the provision for income taxes
was $528,000 for the three months ended March 31, 2005, $496,000
for the three months ended June 30, 2005, $799,000 for the three
months ended September 30, 2005, and $1,823,000 for the nine
months ended September 30, 2005.
3. As described in Note 3 to the consolidated financial statements,
the Company reported advances on the sale of accounts receivable
as a loan. Arguments for this treatment included limitations on
the sale of governmental accounts, as embodied in the agreement
with the purchaser, that acknowledge the legal transfer of title
is completed at the time payment is received. During the three
months ended December 31, 2005, management concluded that the
transaction meets the criteria established in SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities - A Replacement of FASB Statement
125" for recognition of the sale. The Company will also seek an
advisory opinion, explaining the distinction in its request to the
Federal Center for Medicare and Medicaid Services and the
inclusion of $13.4 million in uncollected governmental accounts
receivable under this sale agreement. The Company believes it is
compliant with the rules under which such sales may occur and can
explain its position for reporting purposes. The accrual of the
related loss on sale of accounts receivable and the associated tax
effect results in a restatement decreasing the loss from
operations by $1,232,000 and $1,361,000 for the quarters ended
June 30, 2005 and September 30, 2005, respectively. The effect has
been included in the Company's consolidated statement of
operations for the year ended December 31, 2005. See also,
Supplement Financial Information - Selected Quarterly Financial
Data elsewhere in this Annual Report on Form 10-K.
Management has identified, as a material weakness contributing to these
restatements, that the Company's research and analysis of complex accounting
issues was inadequate. Although the types of complex transactions giving rise to
the restatements are expected to occur very infrequently, management believes
that its process of analyzing and accounting for complex financial transactions
requires improvement. In addition to inadequate expertise, due to business
exigencies there was a lack of complete accounting analysis of these
transactions until after they were completed, which contributed to an incomplete
accounting analysis. Under the direction of the Audit Committee, management
intends in the future to engage experts with sufficient expertise to advise on
accounting and financial reporting of complex financial transactions, and to do
so prior to or concurrently with the Company's commitment to these transactions.
ITEM 9B. OTHER INFORMATION
None.
32
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The following table contains certain information concerning our
directors and executive officers:
NAME AGE POSITIONS WITH THE COMPANY DATE BECAME DIRECTOR
---- --- -------------------------- --------------------
Anil V. Shah, M.D. 56 Executive Chairman of the Board January 31, 2005
Maurice J. DeWald 65 Director August 1, 2005
Jaime Ludmir, M.D. 56 Director August 1, 2005
Bruce Mogel 48 Director, Chief Executive Officer November 18, 2003
Syed Salman J. Naqvi, M.D. 44 Director August 1, 2005
J. Fernando Niebla 66 Director August 1, 2005
Larry B. Anderson 57 President
Steven R. Blake 53 Chief Financial Officer
Daniel J. Brothman 51 Senior Vice President, Operations
DR. ANIL V. SHAH is Executive Chairman of the Board of Directors of the
Company. He is also the manager of Orange County Physicians Investment Network,
LLC, the Company's principal shareholder. Dr. Shah is a Board certified
cardiologist active in practice for the last 23 years. He is an interventional
and nuclear cardiologist and also performs cutting edge imaging techniques
including CT angiography of the heart. Dr. Shah was a fellow in cardiology and
subsequently a research fellow in nuclear cardiology at the VA Hospital
Wadsworth and UCLA School of Medicine. He has held several positions at
hospitals where he practices and has been an active speaker at various forums in
his field.
MAURICE J. DEWALD is a member of the Board of Directors of the Company
and sits on the Audit Committee. Mr. DeWald is Chairman and Chief Executive
Officer of Verity Financial Group, Inc., a private investment firm that he
founded in 1992. From 1962-1991, Mr. DeWald was with KPMG, LLP, one of the
world's largest international accounting and tax consulting firms, where he
served at various times as director and as the Managing Partner of the Chicago,
Orange County and Los Angeles Offices. Mr. DeWald is a director of Mizuho
Corporate Bank of California, Advanced Materials Group, Inc., and Quality
Systems, Inc., and is a former director of Tenet Healthcare Corporation. He also
sits on the Advisory Council of the University of Notre Dame Mendoza School of
Business. Mr. DeWald is a past Chairman and director of United Way of Greater
Los Angeles. Mr. DeWald received a B.B.A. from the University of Notre Dame in
1962. He is also a Certified Public Accountant.
JAIME LUDMIR, M.D. is a member of the Board of Directors of the
Company. He is a practicing physician in Orange County, California and is Board
Certified in Obstetrics and Gynecology. He was Chairman of the OB-GYN Department
at Coastal Communities Hospital until 2004, which has been owned by the Company
since March of 2005. Dr. Ludmir is a member of the Company's principal
shareholder, Orange County Physicians Investment Network, LLC.
BRUCE MOGEL, Chief Executive Officer and director of the Company, has
over 25 years of experience in operational management and has held several lead
executive roles in the healthcare field. Most recently, from 1999-2002, Mr.
Mogel served as Executive Vice President of Operations for Doctors' Community
Healthcare Corp, where he was responsible for the operations and profitability
of five acute care hospitals and one psychiatric hospital, and managed a team of
six hospital CEOs and other senior management members. Mr. Mogel earned his
Bachelor's degree from The State University of New York at Buffalo with a degree
in English.
SYED SALMAN J. NAQVI, M.D. is a member of the Board of Directors of the
Company. He is a practicing physician in Orange County, California and is Board
Certified in Pulmonary Medicine. He is an Assistant Clinical Professor of
Medicine at the University of California, Irvine. He also serves as Medical
Director of the Pulmonary Department at Kindred Hospital in Westminster,
California, and the Medical Director of the Cardio-Pulmonary Department and the
Subacute Unit at Coastal Communities Hospital in Santa Ana, California, which
has been owned by the Company since March 2005. Dr. Naqvi is the co-manager of
the Company's principal shareholder, Orange County Physician Investment Network,
LLC.
J. FERNANDO NIEBLA is a member of the Board of Directors of the Company
and sits on the Audit Committee. He has served as President of International
Technology Partners, LLC, an IT and business consulting services company based
on Orange County, California since August 1998. He is also a founder of Infotec
Development Inc. and Infotec Commercial Systems, two national information
technology firms. He currently serves on the Boards of Directors of Union Bank
of California, Pacific Life Corp. and Granite Construction Corp., the Board of
Trustees of the Orange County Health Foundation, and on the Advisory Boards to
the USC IMSC (Integrated Media Systems Center). Mr. Niebla holds a B.S. degree
in Electrical Engineering from the University of Arizona and an M.S. QBA from
the University of Southern California.
33
LARRY B. ANDERSON, President of the Company, has over 20 years of
senior level executive experience in an enterprise with over $65 billion per
year in sales. A California licensed attorney since 1975, Mr. Anderson
specializes in employment and business law matters, including collective
bargaining, arbitrations, unfair labor practices and court cases as well as
transactional work in contracts and due diligence. From 2002-2003, as the
Executive Vice President, Human Resources and General Counsel, Litigation, Mr.
Anderson managed all litigation for a seven hospital chain in Southern
California. Mr. Anderson earned his Bachelor of Arts degree in Political Science
from California State University, Long Beach, and his law degree from Loyola
University.
STEVEN R. BLAKE, who is the Chief Financial Officer of the Company, is
a California licensed Certified Public Accountant (CPA). Mr. Blake came to IHHI
with over twenty years of experience in multi-hospital financial management. He
also has extensive experience serving in financial roles with public companies.
Most recently, he served as Regional Vice President of Finance for Tenet
Healthcare Corporation, a position he held for over seventeen years. In this
position, Mr. Blake was responsible for the financial management of numerous
Tenet assets covering five western states (California, Arizona, Washington,
Nebraska and Texas). Mr. Blake's strong hospital financial background combined
with his knowledge of public company requirements made him a strong addition to
IHHI's corporate team.
DANIEL J. BROTHMAN, who is Senior Vice President, Operations, of the
Company and Chief Executive Officer of Western Medical Center Santa Ana, is an
experienced single and multi-hospital operations executive. He has spent the
last five years building the Western Medical Center in Santa Ana for Tenet
Healthcare, and improved its performance with increasing EBITDA each successive
year from 1999-2002. Mr. Brothman also ran Columbia Healthcare's Utah Division
from 1996-1998. Mr. Brothman has in excess of 30 years experience in hospital
administration. Mr. Brothman earned his Bachelor of Arts degree from Washington
University at St. Louis, and his Master's in Health Care Administration from the
University of Colorado at Denver.
Directors DeWald and Niebla constitute the Audit Committee of the Board
of Directors. The Company does not have a Nominating Committee, but the entire
Board of Directors performs the functions of this committee. Directors DeWald
and Niebla are considered "independent" under the description of independence
used for Nasdaq-listed companies. The Board of Directors has determined that
Director DeWald is an "audit committee financial expert" as defined in the SEC
rules.
CODE OF ETHICS
We have adopted a Code of Business Conduct and Ethics that applies to
our employees (including our principal executive officer, chief financial
officer and controller) and directors. Our Code of Business Conduct and Ethics
can be obtained free of charge by sending a request to our Corporate Secretary
to the following address: Integrated Healthcare Holdings, Inc., Attn: Larry
Anderson, 1301 North Tustin Avenue, Santa Ana, California 92705.
34
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires our
officers and directors, and persons who own more than 10% of a registered class
of our equity securities, to file reports of ownership and changes in ownership
with the SEC. Officers, directors and greater than 10% stockholders are required
by SEC regulation to furnish us with copies of all Section 16(a) reports they
file.
Based solely upon the copies of Section 16(a) reports which we received
from such persons or written representations from them regarding their
transactions in our common stock, we believe that, during the year ended
December 31, 2005, OC-PIN, Dr. Shah and Dr. Naqvi filed late a Form 3 and Form
4, and Dr. Ludmir and Mr. Niebla filed late a Form 3.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth summary information regarding
compensation earned by (i) our chief executive officer during fiscal year 2005;
(ii) each of our other most highly compensated executive officers employed by us
as of December 31, 2005 whose salary and bonus for the fiscal year ended
December 31, 2005 was in excess of $100,000 for their services rendered in all
capacities to us; and (iii) one additional individual for whom disclosure would
be required to be provided but for the fact that the individual was not serving
as an executive officer at December 31, 2005. The listed individuals are
referred to as the "Named Executive Officers".
SUMMARY COMPENSATION TABLE
Annual Compensation Long-Term Compensation
------------------------ -------------------------------------
Awards Payouts
-------------------------- -------
Restricted Securities
Other Annual Stock Underlying LTIP All Other
Salary Bonus Compensation Awards Option/SARs Payouts Compensation
Name and Position Year $ $ $ $ and Warrants $ $ (1)
- ----------------- ---- ------ -------- ------------ ---------- ------------ ------- ------------
Bruce Mogel 2005 360,000 0 24,871 0 0 0 0
Chief Executive 2004 250,000 50,000 33,000 0 0 0 0
Officer (1) 2003 0 0 0 0 0 0 0
Larry B. Anderson 2005 360,000 0 24,387 0 0 0 0
President (1) 2004 250,000 50,000 33,000 0 0 0 0
2003 0 0 0 0 0 0 0
Steven R. Blake 2005 216,580 0 0 0 0 0 0
Chief Financial 2004 0 0 0 0 0 0 0
Officer 2003 0 0 0 0 0 0 0
Daniel J. 2005 216,346 0 0 0 0 0 0
Brothman 2004 0 0 0 0 0 0 0
Senior Vice 2003 0 0 0 0 0 0 0
President,
Operations
Anil V. Shah, 2005 400,553 0 0 0 0 0 0
M.D. Executive 2004 0 0 0 0 0 0 0
Chairman 2003 0 0 0 0 0 0 0
James T. Ligon 2005 360,000 0 17,865 0 0 0 0
EVP Acquisitions 2004 250,000 50, 000 33, 000 0 0 0 0
(Former) (1)(2) 2003 0 0 0 0 0 0 0
(1) Messrs. Mogel, Anderson and Ligon each agreed to defer a portion
of their 2004 compensation until the Hospital Acquisition was
assured. The 2004 amounts reflected in the table above for these
individuals include $209,000, $219,000, and $209,000,
respectively, of compensation earned in 2004 and paid in 2005.
(2) Mr. Ligon resigned from all positions with the Company on or about
January 20, 2006.
35
During the periods covered by this table, none of the Company's
executive officers were granted any stock option or stock appreciation right;
accordingly, no tables relating to such items have been included within this
Item. There are no standard arrangements pursuant to which the Company's
directors are compensated for any services provided as director. No additional
amounts are payable to the Company's directors for committee participation or
special assignments.
EMPLOYMENT CONTRACTS, SEVERANCE AGREEMENTS AND CHANGE OF CONTROL ARRANGEMENTS
In February 2005, we entered into three-year employment agreements with
Messrs. Mogel, Anderson and Ligon, with each agreement on the following terms:
o Base salary of $360,000 per year;
o Bonus as determined by the Board of Directors;
o Stock options for 1,000,000 shares, vesting annually in three
equal installments; (which option have not been issued).
o Standard medical and dental insurance;
o Up to four weeks vacation annually;
o Monthly auto allowance of $1,000, and use of cellular telephone;
and
o Twelve months severance pay upon termination without cause or
resignation for cause.
In February 2005, the Company entered into a three-year employment
agreement with Daniel J. Brothman on substantially the same terms as those
described above, except with a base salary of $350,000 per year and stock
options for two million shares (which option have not been issued).
In April 2005, the Company entered into a three-year employment
agreement with Anil V. Shah as Executive Chairman on substantially the same
terms as above, except with a base salary of $500,000 per year and stock options
for one million shares (which options have not been issued).
In March 2005, the Company entered into a three-year employment
agreement with Steven R. Blake on substantially the same terms as those
described above, except with a base salary that is currently set at $275,000
(reflecting Mr. Blake's role as Chief Financial Officer of the Company beginning
in July 2005) and stock options for 150,000 shares (which options have not been
issued).
In June 2005, the Company executed a Letter Amendment to Employment
Agreements, dated June 6, 2005, with Messrs. Anderson, Mogel and Ligon, that
provides that their respective employment agreements are revised to provide
severance payments equal to each employee's compensation for a three year period
if any of them is terminated without cause or if any of them resign for good
cause (as defined in the Letter Amendment). Under the amendments, the severance
payment will be reduced by one month for each month the employee is employed
after June 1, 2005, with the minimum severance payment to be no less than
compensation for a twelve-month period.
DIRECTOR COMPENSATION
During the year ended December 31, 2005, the Board of Directors
approved a non-employee director compensation policy. The current compensation
for Directors is as follows:
(i) Cash - Each non-employee Director receives an annual retainer fee
of $30,000 and an attendance fee of $1,000 for each Board meeting
attended, and a separate fee for each committee meeting attended.
Committee Chairmen receive an additional annual retainer of
$5,000;
(ii) Stock - A director who is not an employee or an owner of the
company may receive options to purchase shares of IHHI stock at
the direction of the Board. To date, none have been granted by
the Board.
(iii) Travel Reimbursement - All travel and related expenses incurred
by Directors to attend Board meetings, committee meetings and
other IHHI activities are reimbursed by IHHI.
Employee directors receive no compensation for Board service and the
Company does not provide any retirement benefits to non-employee directors.
36
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The following table sets forth information known to us with respect to
the beneficial ownership of our common stock as of March 15, 2006, unless
otherwise noted, by:
o each shareholder known to us to own beneficially more than 5% of
our common stock;
o each of our directors and each of our executive officers at
December 31, 2005; and
o all of our current directors and executive officers as a group.
Except as otherwise noted below, the address of each person or entity
listed on the table is 1301 North Tustin Avenue, Santa Ana, California 92705.
AMOUNT AND
NATURE OF
BENEFICIAL PERCENTAGE
NAME OWNERSHIP(1) OF TOTAL
------------------------------------------------------------------------ ------------ ----------
DIRECTORS AND EXECUTIVE OFFICERS
Anil V. Shah, M.D.(1)(2)................................................ 59,098,430 67.5%
Maurice J. DeWald....................................................... 0 0
Jaime Ludmir, M.D. ..................................................... 0 0
Bruce Mogel............................................................. 5,365,500 6.13%
Syed Salman Naqvi, M.D.(1)(2)........................................... 59,098,430 67.5%
J. Fernando Niebla...................................................... 0 0
Larry B. Anderson....................................................... 5,376,000 6.41%
Steven R. Blake......................................................... 0 0
Daniel J. Brothman...................................................... 0 0
All current directors and executive officers as a group (10 persons)........... 69,893,930 79.8%
PRINCIPAL SHAREHOLDERS (OTHER THAN THOSE NAMED ABOVE)
Orange County Physicians Investment Network, LLC ("OC-PIN") (1)(2)...... 59,098,430 67.5%
Hari S. Lal............................................................. 6,500,000 7.42
%
James T. Ligon 5,376,000 6.13%
____________________________
(1) Dr. Anil Shah and Dr. Syed Salman Naqvi are co-managers
and part owners of OC-PIN. Dr. Shah, Dr. Naqvi and OC-PIN may be
deemed to be a "group" for purposes of Section 13(d)(3) of the
Securities Exchange Act of 1934. Dr. Shah and Dr. Naqvi each
disclaim beneficial ownership of all shares held by OC-PIN except
to the extent of their respective pecuniary interests therein.
(2) Includes 3,206,241 shares that remain issuable pursuant to the
Stock Purchase Agreement and subsequent amendments thereto. See
"Item 13. Certain Relationships and Related Transactions".
The Company currently has no compensation plans under which equity
securities of the Company are authorized for issuance.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The following is a summary of certain transactions occurring in the
last three years between the Company and its directors, officers and 5% or
greater shareholders (other than compensatory arrangements which are described
above):
37
In January 2004, the Company began reimbursing Mogel Management, LLC
for approximately 3,400 square feet of office space within an office building
that is leased to Mogel Management, LLC, a company owned by Bruce Mogel, Larry
B. Anderson and James T. Ligon. The Company reimbursed Mogel Management, LLC for
its use of space in the amount of $5,717 per month. This arrangement ended in
February, 2006.
On January 1, 2004, the Company acquired Mogel Management Group, Inc.,
an operating company owned by Messrs. Mogel, Anderson and Ligon, for promissory
notes with an aggregate principal amount of $60,000. The notes were forgiven
during 2004, and were reflected in the Company's consolidated statement of
operations for the year ended December 31, 2004.
On November 16, 2004, the Company entered into a Purchase Option
Agreement (the "Purchase Option Agreement") with Dr. Anil V. Shah or his
assignee, OC-PIN, granting to OC-PIN an option (the "Purchase Option") to (i)
purchase up to 50,000,000 shares of common stock of the Company for an aggregate
of $15,000,000 and (ii) invest $2,500,000 for a 49% membership interest in a new
limited liability company (the "Real Estate LLC") to be formed for the purpose
of holding real estate which the Company agreed to acquire from subsidiaries of
Tenet Healthcare Corporation. The Company also granted a stock option to Dr.
Anil V. Shah individually providing that, if the Purchase Option is exercised in
full by OC-PIN, the Company will provide Dr. Shah with an additional right to
purchase 10,000,000 shares of common stock of the Company for $0.25 per share.
On January 28, 2005, the Company entered into a Stock Purchase
Agreement (the "Stock Purchase Agreement") with OC-PIN, under which (i) the
Purchase Option Agreement was terminated, and (ii) OC-PIN agreed to invest
$30,000,000 in the Company for an aggregate of 108,000,000 shares of common
stock of the Company.
Also, on January 27, 2005, the Company entered into a Rescission,
Restructuring and Assignment Agreement (the "Restructuring Agreement") with Kali
P. Chaudhuri, M.D., William E. Thomas, and Anil V. Shah, M.D. The Restructuring
Agreement amended and canceled certain portions of an agreement under which Dr.
Chaudhui agreed to acquire stock in the Company. Also under the Restructuring
Agreement, (i) OC-PIN agreed to pay or cause to be paid to Dr. Chaudhuri his
escrow deposit of $10,000,000 plus accrued interest, and (ii) OC-PIN and Dr.
Chaudhuri agreed to form a new real estate holding company to own and operate
the Real Estate LLC, with Dr. Chaudhuri to own no more than 49% of the Real
Estate LLC.
On March 7, 2005, upon acquisition of the Hospitals, the Company
transferred its right to all of the fee interests in the Hospital Properties to
Pacific Coast Holdings Investments, LLC ("PCHI"). PCHI is 51% owned by West
Coast Holdings, LLC (owned in part by Dr. Anil Shah) and 49% by Ganesha Realty
LLC (owned in part by Dr. Kali Chaudhuri). The Company entered into a Triple Net
Lease under which it leased back from PCHI all of the Hospital Properties.
On or about June 16, 2005, the Company extended OC-PIN's additional
financing commitment under the Stock Purchase Agreement when the Company entered
into the following new agreements:
o First Amendment to the Stock Purchase Agreement, dated as of June
1, 2005 (the "First Amendment"); and
o Escrow Agreement, dated as of June 1, 2005, by and among the
Company, OC-PIN and City National Bank (the "Escrow Agreement").
The following material terms were contained in the First Amendment and
the Escrow Agreement:
o OC-PIN's total stock purchase commitment under the Stock Purchase
Agreement was reduced from $30 million to $25 million;
o A total of 57,250,000 shares of the Company's common stock
previously issued to OC-PIN were placed in an escrow account with
City National Bank in July 2005. OC-PIN had until September 1,
2005 to make monthly installments into the escrow account up to an
aggregate of approximately $15,000,000. Such portion of the
escrowed shares which were fully paid was to be returned to OC-PIN
and the balance was to be transferred back to the Company;
o OC-PIN agreed to reimburse the Company for $707,868 of its
additional debt financing costs incurred since March 8, 2005. As
of December 31, 2005, $340,000 of these costs had been recovered
by the Company;
o The Company would work to complete a new borrowing transaction;
and
o Upon receipt of at least $5,000,000 of new capital under the First
Amendment, the Company would call a shareholders meeting to
re-elect directors.
38
Under the First Amendment and the Escrow Agreement, OC-PIN deposited a
total of $12,500,000 into the escrow account.
However, following receipt of such funds, a disagreement arose between
OC-PIN and the third party which provided $11,000,000 of the $12,500,000
deposited into the escrow account. In order to resolve this matter and to avoid
potential litigation involving the Company, the Company agreed to return
$11,000,000 of these funds and provide OC-PIN with a limited opportunity to
provide alternative financing. Therefore, effective October 31, 2005, the
Company entered into a Second Amendment to the Stock Purchase Agreement (the
"Second Amendment"), pursuant to which the Company and OC-PIN issued escrow
instructions to release escrowed funds as of November 2, 2005, terminate the
Escrow Agreement and distribute the assets in the escrow account as follows:
1. $1,500,000 of the escrowed cash, plus a pro rata portion of the accrued
interest, was delivered to the Company for payment of stock.
2. $11,000,000 of the escrowed cash, plus a pro rata portion of the
accrued interest was delivered to OC-PIN.
3. 5,798,831 of the escrowed shares of the Company's common stock were
delivered to OC-PIN.
4. 40,626,684 of the escrowed shares of the Company's common stock were
delivered to the Company.
5. OC-PIN transferred $2,800,000 from another account to the Company for
which OC-PIN received 10,824,485 of the escrowed shares.
6. The Company agreed to issue to OC-PIN 5,400,000 shares of its common
stock multiplied by the percentage of OC-PIN's payment required to be
made under the Stock Purchase Agreement, as amended, which had been
made to date. As of December 31, 2005, 3,110,400 of these shares were
not issued due to a dispute with OC-PIN over the Company's recovery of
$367,868 in additional interest costs pursuant to the First Amendment.
The Company resolved this dispute with OC-PIN on July 25, 2006.
7. The Company granted OC-PIN the right to purchase up to $6,700,000 of
common stock within 30 calendar days following the cure of the
Company's default relating to the Credit Agreement at a price of
$0.2586728 per share or a maximum of 25,901,447 shares of its common
stock, plus interest on the purchase price at 14% per annum from
September 12, 2005 through the date of closing on the funds from
OC-PIN. Upon one or more closings on funds received under this section
of the Second Amendment, the Company will issue an additional portion
of the 5,400,000 shares mentioned in item (6) above.
39
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The following table sets forth the aggregate fees that we incurred for
audit and non-audit services provided by Ramirez International, which acted as
independent auditors for the year ended December 31, 2005 and performed audit
services for us during this period. The audit fees include only fees that are
customary under generally accepted auditing standards and are the aggregate fees
that we incurred for professional services rendered for the audit of our
financial statements for the years ended December 31, 2005 and 2004.
NATURE OF FEES 2005 2004
------------- ------------
Audit fees (financial) $ 1,100,000 $ 75,000
Audit related fees 274,500 23,500
Tax fees 921,000 --
------------- ------------
Total fees $ 2,295,500 $ 98,500
============= ============
The Audit Committee of the Board of Directors pre-approves all audit
and permissible non-audit services to be performed by the independent auditors.
ITEM 15. EXHIBITS; FINANCIAL STATEMENT SCHEDULES
Exhibits required to be filed are listed below and except where
incorporated by reference, immediately follow the Financial Statements. Each
management or compensation plan is marked with an asterisk (*). Each document
filed with this report is marked with two asterisks (**). References to the
"Commission" mean the U.S. Securities and Exchange Commission.
Exhibit Description
- ------- -----------
Number
- ------
2.1 Asset Sale Agreement, dated September 29, 2004, by and among the
Registrant and certain subsidiaries of Tenet Healthcare
Corporation (AHM CGH, Inc., Health Resources Corporation of
America - California, SHL/O Corp., and UWMC Hospital Corporation)
(incorporated herein by reference from Exhibit 10.2 to the
Registrant's Current Report on Form 8-K filed with the Commission
on November 22, 2004).
2.2 First Amendment to Asset Sale Agreement, dated January 28, 2005,
by and among the Registrant and certain subsidiaries of Tenet
Healthcare Corporation (incorporated herein by reference from
Exhibit 99.4 to the Registrant's Current Report on Form 8-K filed
with the Commission on February 2, 2005).
2.3 Second Amendment to Asset Sale Agreement, effective as of January
1, 2005, by and among the Registrant and certain subsidiaries of
Tenet Healthcare Corporation (incorporated herein by reference
from Exhibit 99.1 to the Registrant's Current Report on Form 8-K
filed with the Commission on March 14, 2005).
2.4 Third Amendment to Asset Sale Agreement, effective as of March
8, 2005, by and among the Registrant and certain subsidiaries of
Tenet Healthcare Corporation (incorporated herein by reference
from Exhibit 99.2 to the Registrant's Current Report on Form 8-K
filed with the Commission on March 14, 2005).
2.5 Letter Agreement, dated January 28, 2005, by and between the
Registrant and certain subsidiaries of Tenet Healthcare
Corporation (incorporated herein by reference from Exhibit 99.3
to the Registrant's Current Report on Form 8-K filed with the
Commission on February 2, 2005).
3.1 Articles of Incorporation of the Registrant (incorporated herein
by reference from Exhibits 3.3, 3.4 and 3.6 to Form 10-SB filed
by the Registrant on December 16, 1997).
3.2 Certificate of Amendment to Articles of Incorporation of the
Registrant (incorporated by reference to Appendix A to
Registrant's Definitive Information Statement on Schedule 14C
filed by the Registrant on October 20, 2004).
3.3 Amended and Restated Bylaws of the Registrant (incorporated
herein by reference from Exhibit 3.1 to the Registrant's Current
Report on Form 8-K filed with the Commission on October 26,
2005).
10.1 Employment Agreement with Bruce Mogel, dated January 1, 2004*
(incorporated herein by reference from Exhibit 10.1 to the
Registrant's Transitional Report on Form 10-K filed with the
Commission on April 15, 2004).
10.2 Employment Agreement with Larry B. Anderson, dated January 1,
2004* (incorporated herein by reference from Exhibit 10.2 to the
Registrant's Transitional Report on Form 10-K filed with the
Commission on April 15, 2004).
10.3 Employment Agreement with James T. Ligon, dated January 1, 2004*
(incorporated herein by reference from Exhibit 10.3 to the
Registrant's Transitional Report on Form 10-K filed with the
Commission on April 15, 2004).
40
10.4 Secured Convertible Note Purchase Agreement, dated as of
September 28, 2004, by and between the Registrant and Kali P.
Chaudhuri, M.D. (incorporated herein by reference from Exhibit
10.1 to the Registrant's Current Report on Form 8-K filed with
the Commission on October 5, 2004).
10.5 First Amendment to Secured Convertible Note Purchase Agreement,
dated as of November 16, 2004, by and between the Registrant and
Kali P. Chaudhuri, M.D. (incorporated herein by reference from
Exhibit 10.1 to the Registrant's Current Report on Form 8-K filed
with the Commission on November 22, 2004).
10.6 Purchase Option Agreement, dated as of November 16, 2004, by and
between the Registrant and Anil V. Shah, M.D. (incorporated
herein by reference from Exhibit 10.2 to the Registrant's Current
Report on Form 8-K filed with the Commission on November 22,
2004).
10.7 Rescission, Restructuring and Assignment Agreement, dated January
27, 2005, by and among the Registrant, Kali P. Chaudhuri, M.D.,
William E. Thomas, Anil V. Shah, M.D., and Orange County
Physicians Investment Network, LLC (incorporated herein by
reference from Exhibit 99.1 to the Registrant's Current Report on
Form 8-K filed with the Commission on February 2, 2005).
10.8 Stock Purchase Agreement, dated January 28, 2005, by and between
the Registrant and Orange County Physicians Investment Network,
LLC (incorporated herein by reference from Exhibit 99.2 to the
Registrant's Current Report on Form 8-K filed with the Commission
on February 2, 2005).
10.9 Guaranty Agreement, dated as of March 3, 2005, by Orange County
Physicians Investment Network, LLC in favor of Medical Provider
Financial Corporation II (incorporated herein by reference from
Exhibit 99.3 to the Registrant's Current Report on Form 8-K filed
with the Commission on March 14, 2005).
10.10 Guaranty Agreement, dated as of March 3, 2005, by Pacific Coast
Holdings Investments, LLC in favor of Medical Provider Financial
Corporation II (incorporated herein by reference from Exhibit
99.4 to the Registrant's Current Report on Form 8-K filed with
the Commission on March 14, 2005).
10.11 Subordination Agreement, dated as of March 3, 2005, by and among
the Registrant and its subsidiaries, Pacific Coast Holdings
Investments, LLC, and Medical Provider Financial Corporation II
(incorporated herein by reference from Exhibit 99.5 to the
Registrant's Current Report on Form 8-K filed with the Commission
on March 14, 2005).
10.12 Credit Agreement, dated as of March 3, 2005, by and among the
Registrant and its subsidiaries, Pacific Coast Holdings
Investments, LLC and its members, and Medical Provider Financial
Corporation II (incorporated herein by reference from Exhibit
99.6 to the Registrant's Current Report on Form 8-K filed with
the Commission on March 14, 2005).
10.13 Form of $50 million acquisition note by the Registrant and its
subsidiaries (incorporated herein by reference from Exhibit 99.7
to the Registrant's Current Report on Form 8-K filed with the
Commission on March 14, 2005).
10.14 Form of $30 million line of credit note by the Registrant and its
subsidiaries (incorporated herein by reference from Exhibit 99.8
to the Registrant's Current Report on Form 8-K filed with the
Commission on March 14, 2005).
10.15 Triple Net Hospital and Medical Office Building Lease dated March
7, 2005, as amended by Amendment No. 1 To Triple Net Hospital and
Medical Office Building Lease (incorporated herein by reference
from Exhibit 99.9 to the Registrant's Current Report on Form 8-K
filed with the Commission on March 14, 2005).
10.16 Employment Agreement with Bruce Mogel, dated February 25, 2005
(incorporated herein by reference from Exhibit 10.16 to the
Registrant's Annual Report on Form 10-KSB filed with the
Commission on March 31, 2005).
10.17 Employment Agreement with Larry B. Anderson, dated February 25,
2005 (incorporated herein by reference from Exhibit 10.17 to the
Registrant's Annual Report on Form 10-KSB filed with the
Commission on March 31, 2005).
10.18 Employment Agreement with James T. Ligon, dated February 25,
2005 (incorporated herein by reference from Exhibit 10.18 to the
Registrant's Annual Report on Form 10-KSB filed with the
Commission on March 31, 2005).
10.18.1 Severance Agreement with James T. Ligon, dated January 20, 2006
(incorporated herein by reference from Exhibit 99.1 to the
Registrant's Current Report on Form 8-K filed with the Commission
on January 26, 2006).
10.19 Employment Agreement with Milan Mehta, dated February 25, 2005
(incorporated herein by reference from Exhibit 10.19 to the
Registrant's Annual Report on Form 10-KSB filed with the
Commission on March 31, 2005).
10.20 Employment Agreement with Hari S. Lal, dated February 25, 2004
(incorporated herein by reference from Exhibit 10.20 to the
Registrant's Annual Report on Form 10-KSB filed with the
Commission on March 31, 2005).
10.21 Employment Agreement with Daniel J. Brothman, dated December 31,
2005 (incorporated herein by reference from Exhibit 10.21 to the
Registrant's Annual Report on Form 10-KSB filed with the
Commission on March 31, 2005).
41
10.22 Employment Agreement with Steve R. Blake, dated March 21, 2005
(incorporated herein by reference from Exhibit 10.22 to the
Registrant's Annual Report on Form 10-KSB filed with the
Commission on March 31, 2005).
10.23 Employment Agreement with Dr. Anil Shah, dated March 7, 2005.* **
21.1 The subsidiaries of the Registrant are WMC-SA, Inc., a California
corporation, WMC-A, Inc., a California corporation, Chapman
Medical Center, Inc., a California corporation, Coastal
Communities Hospital, Inc., a California corporation, and Mogel
Management, Inc., a Nevada corporation.
31.1 Certification of Chief Executive Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002 **
31.2 Certification of Chief Financial Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002 **
32.1 Certification of Chief Executive Officer Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002 **
32.2 Certification of Chief Financial Officer Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002 **
42
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
INTEGRATED HEALTHCARE HOLDINGS, INC.
Dated: July 28, 2006 By: /s/ Bruce Mogel
-------------------------------
Bruce Mogel
Chief Executive Officer
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Dated: July 18, 2006 By: /s/ Anil V. Shah, M.D.
--------------------------------------
Anil V. Shah, M.D.
Chairman of the Board of Directors
Dated: July 28, 2006 By: /s/ Bruce Mogel
--------------------------------------
Bruce Mogel
Director and Chief Executive Officer
(Principal Executive Officer)
Dated: July 18, 2006 By: /s/ Steven R. Blake
--------------------------------------
Steven R. Blake
Chief Financial Officer
(Principal Financial Officer)
Dated: July 18, 2006 By: /s/ Maurice J. DeWald
--------------------------------------
Maurice J. DeWald
Director
Dated: July 18, 2006 By: /s/ Jaime Ludmir, M.D.
--------------------------------------
Jaime Ludmir, M.D.
Director
Dated: July 18, 2006 By: /s/ Syed S. Naqvi, M.D.
--------------------------------------
Syed S. Naqvi, M.D.
Director
Dated: July 18, 2006 By: /s/ J. Fernando Niebla
--------------------------------------
J. Fernando Niebla
Director
43
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONSOLIDATED FINANCIAL STATEMENTS
TABLE OF CONTENTS
The following consolidated financial statements are filed as a part of this
Annual Report on Form 10-K:
PAGE DESCRIPTION
F-1 Report of Independent Registered Public Accounting Firm.
F-2 Report of Prior Independent Registered Public Accounting Firm.
F-3 Consolidated Balance Sheets as of December 31, 2005 and 2004.
F-4 Consolidated Statements of Operations for the years ended December
31, 2005, 2004 and 2003.
F-5 Consolidated Statements of Shareholders' Deficiency as of December
31, 2005, 2004 and 2003.
F-6 Consolidated Statements of Cash Flows for the years ended December
31, 2005, 2004 and 2003.
F-7 Notes to Consolidated Financial Statements.
F-32 Schedule II - Valuation and Qualifying Accounts
Report of Independent Registered Public Accounting Firm
The Board of Directors of
Integrated Healthcare Holdings, Inc.:
We have audited the accompanying consolidated balance sheets of Integrated
Healthcare Holdings, Inc. and subsidiaries (the "Company") as of December 31,
2005 and 2004 and the related consolidated statements of operations,
stockholders' equity (deficiency) and cash flows for each of the three years
ended December 31, 2005. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these statements based on our audits. The Company's financial
statements as of June 30, 2003 and for the period July 31, 1984 (date of
inception) through June 30, 2003 were audited by other auditors whose report,
dated September 8, 2003, expressed an unqualified opinion with an explanatory
paragraph regarding the Company's ability to continue as a going concern. The
other auditors' report has been furnished to us, and our opinion, insofar as it
relates to the amounts included for such period, is based solely on the report
of such other auditors.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, based on our audits and the reports of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the financial position of Integrated Healthcare Holdings,
Inc. and subsidiaries as of December 31, 2005 and 2004 and the results of their
operations and cash flows for each of the three years ended December 31, 2005,
in conformity with generally accepted accounting principles in the United States
of America.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As shown in the financial statements,
the Company incurred a net loss of $44,558,367 during the year ended December
31, 2005, and, as of that date, had a stockholders' deficiency of $30,446,823.
As described more fully in Note 1 to the financial statements, the company has
$81,030,734 in current and non-current notes payable which, under the terms of
the agreements, $10,700,000 is due in December 2006 and the remaining notes
payable are due in March 2007. The Company has not identified alternate sources
of capital to meet its refinancing requirements. These factors raise substantial
doubt about the Company's ability to continue as a going concern. Management's
plans in regard to these matters are described in Note 1. The financial
statements do not include any adjustments that might be necessary if the Company
is unable to continue as a going concern.
/s/ RAMIREZ INTERNATIONAL
Financial & Accounting Services, Inc.
July 11, 2006
Irvine, California
F-1
REPORT OF PRIOR INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
-------------------------------------------------------------
Board of Directors FIRST DELTAVISION, INC.
Salt Lake City, Utah
We have audited the accompanying balance sheet of First Deltavision,
Inc. (a development stage company that changed its name to Integrated Healthcare
Holdings, Inc. subsequent to the completion of our audit) at June 30, 2003, and
the related statements of operations, stockholders' equity (deficit) and cash
flows for the years ended June 30, 2003 and 2002 (not separately presented in
the Company's Form 10-K for the year ended December 31, 2005) and for the period
from inception on July 31, 1984 through June 30, 2003. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit. The financial statements of First Deltavision, Inc. for the period
from inception on July 31, 1984 to June 30, 1999 were audited by other auditors
whose report dated September 28, 1999 expressed an unqualified opinion on those
statements and included an explanatory paragraph regarding the Company's ability
to continue as a going concern. The financial statements for the period from
inception on July 31, 1984 to June 30, 1999 reflect a net loss of $129,168. Our
opinion, insofar as it relates to the amounts included for such prior periods,
is based solely on the report of such other auditors.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (Unites States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, based on our audit and the reports of other auditors,
the financial statements audited by us present fairly, in all material respects,
the financial position of First Deltavision, Inc. [a development stage company]
as of June 30, 2003 and the results of its operations and its cash flows for the
years ended June 30, 2003 and 2002 (not separately presented in the Company's
Form 10-KSB for the year ended December 31, 2004) and for the period from
inception on July 31, 1984 through June 30, 2003, in conformity with generally
accepted accounting principles in the United States of America.
The accompanying financial statements have been prepared assuming the
Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the company has incurred losses since its inception, has
significant debt, and has not yet been successful in establishing profitable
operations. These factors raise substantial doubt about its ability to continue
as a going concern. Management's plans in regards to these matters are also
described in Note 1. The financial statements do not include any adjustments
that might result from the outcome of these uncertainties.
/s/ PRITCHETT, SILER & HARDY, P.C.
September 8, 2003
Salt Lake City, Utah
F-2
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
DECEMBER 31, DECEMBER 31,
2005 2004
------------- -------------
Current assets:
Cash and cash equivalents $ 16,005,943 $ 69,454
Restricted cash 4,971,636 --
Accounts receivable, net of allowance for doubtful
accounts of $3,148,276 in 2005 16,592,277 --
Security reserve funds 12,127,337 --
Deferred purchase price receivables 9,337,703 --
Inventories of supplies, at cost 5,719,717 --
Due from governmental payers 3,024,772 --
Prepaid expenses and other current assets 6,694,045 18,519
------------- -------------
Total current assets 74,473,430 87,973
Property and equipment, net of accumulated depreciation of
$2,138,134 and $11,369, respectively 59,431,285 57,423
Investment in hospital asset purchase -- 11,142,145
Debt issuance costs, net of accumulated amortization of
$791,735 in 2005 1,141,265 --
Intangible asset, net of accumulated amortization of
$57,819 in 2004 -- 44,970
------------- -------------
Total assets $ 135,045,980 $ 11,332,511
============= =============
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
Current liabilities:
Accounts payable $ 26,835,606 $ 156,142
Accrued compensation and benefits 12,533,499 800,313
Warrant liability, current 10,700,000 --
Other current liabilities 15,725,489 --
Short term debt -- 11,264,013
------------- -------------
Total current liabilities 65,794,594 12,220,468
Long term debt 70,330,734 --
Capital lease obligations, net of current portion of $85,296 4,961,257 --
Warrant liability 21,064,669 --
Minority interest in variable interest entity 3,341,549 --
Commitments and contingencies
Stockholders' deficiency:
Common stock, $0.001 par value; 250,000,000 shares
authorized; 83,932,316 and 20,780,000 shares
issued and outstanding in 2005 and 2004,
respectively 83,932 20,780
Additional paid in capital 16,125,970 1,189,621
Accumulated deficit (46,656,725) (2,098,358)
------------- -------------
Total stockholders' deficiency (30,446,823) (887,957)
------------- -------------
Total liabilities and stockholders' deficiency $ 135,045,980 $ 11,332,511
============= =============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE
CONSOLIDATED FINANCIAL STATEMENTS
F-3
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003
2005 2004 2003
------------- ------------- -------------
Net operating revenues $ 284,314,409 $ -- $ --
------------- ------------- -------------
Operating expenses:
Salaries and benefits 153,573,944 -- --
Supplies 39,250,497 -- --
Provision for doubtful accounts 37,348,984 -- --
Other operating expenses 58,715,312 1,840,191 28,132
Loss on sale of accounts receivable 8,470,053 -- --
Depreciation and amortization 2,177,985 -- --
------------- ------------- -------------
299,536,775 1,840,191 28,132
------------- ------------- -------------
Operating loss (15,222,366) (1,840,191) (28,132)
Other expense:
Interest expense, net 9,924,983 -- --
Common stock warrant expense 17,604,292
Change in fair value of derivative 3,460,377 -- --
------------- ------------- -------------
30,989,652 -- --
------------- ------------- -------------
Loss before provision for income taxes
and minority interest (46,212,018) (1,840,191) (28,132)
Provision for income taxes 4,800 -- --
Minority interest in variable interest
entity (1,658,451) -- --
------------- ------------- -------------
Net loss $ (44,558,367) $ (1,840,191) $ (28,132)
============= ============= =============
Per Share Data:
Basic and fully diluted
Loss per common share $ (.49) $ (.09) $ (.01)
Weighted average shares outstanding 90,330,428 19,986,750 3,470,589
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE
CONSOLIDATED FINANCIAL STATEMENTS
F-4
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' DEFICIENCY
YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003
Common Stock Additional
--------------------------- Paid-in Accumulated
Shares Amount Capital Deficit Total
------------ ------------ ------------ ------------ ------------
Balance, December 31, 2002 1,342,000 $ 1,342 $ 101,269 $ (189,649) $ (87,038)
Issuance of shares for
relief of debt at $0.0062 16,128,000 16,128 83,872 -- 100,000
Issuance of common stock for
letter of indemnification
at $0.0062 per share 450,000 450 2,340 -- 2,790
Issuance of common stock for
cash at $0.25 per share 1,460,000 1,460 363,540 -- 365,000
Net loss -- -- -- (28,132) (28,132)
------------ ------------ ------------ ------------ ------------
Balance, December 31, 2003 19,380,000 $ 19,380 $ 551,021 ($ 217,781) $ 352,620
Issuance of debt for the
acquisition of MMG -- -- -- (40,386) (40,386)
Issuance of common stock for
cash at $0.25 per share 200,000 200 49,800 -- 50,000
Issuance of common stock for
cash at $0.50 per share 1,200,000 1,200 588,800 -- 590,000
Net loss -- -- -- (1,840,191) (1,840,191)
------------ ------------ ------------ ------------ ------------
Balance, December 31, 2004 20,780,000 $ 20,780 $ 1,189,621 $ (2,098,358) $ (887,957)
Issuance of common stock for
cash at $0.50 per share 1,179,000 1,179 598,322 -- 599,501
Issuance of common stock for
cash to OC-PIN 61,973,316 61,973 14,338,027 -- 14,400,000
Net loss -- -- -- (44,558,367) (44,558,367)
------------ ------------ ------------ ------------ ------------
Balance, December 31, 2005 83,932,316 $ 83,932 $ 16,125,970 $(46,656,725) $(30,446,823)
============ ============ ============ ============ ============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
F-5
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003
2005 2004 2003
------------ ------------ ------------
Cash flows from operating activities:
Net loss $(44,558,367) $ (1,840,191) $ (28,132)
Adjustments to reconcile net loss to cash
used in operating activities:
Depreciation and amortization of property and
equipment 2,133,015 62,114 7,075
Amortization of debt issuance costs and
intangible asset 836,705 -- --
Common stock warrant expense 17,604,292 -- --
Change in fair value of derivative 3,460,377
Noncash forgiveness of debt -- (60,000) --
Minority interest in net loss of variable
interest entity (1,658,451) -- --
Increase in accounts receivable, net (16,592,277) --
Increase in security reserve funds (12,127,337) -- --
Increase in deferred purchase price receivables (9,337,703) -- --
Decrease in inventories of supplies 299,278 -- --
Increase in due from governmental payers (3,024,772) (10,725) --
Increase in prepaids and other current assets (4,214,653) (10,725) --
Increase in accounts payable 26,679,464 130,415 15,727
Increase in accrued compensation and benefits 11,733,186 800,313 --
Increase in other current liabilities 15,640,193 -- 12,962
------------ ------------ ------------
Net cash (used in) provided by operating
activities (13,127,050) (918,074) 7,632
------------ ------------ ------------
Cash flows from investing activities:
Acquisition of hospital assets (63,171,676) (1,142,145) --
Deposits to restricted cash (4,971,636) -- --
Proceeds from minority investment in PCHI 5,000,000 -- --
Additions to property and equipment, net (564,037) (21,160) (47,632)
Acquisition of MMG, net of cash acquired -- 8,535 --
------------ ------------ ------------
Net cash used in investing activities (63,707,349) (1,154,770) (47,632)
------------ ------------ ------------
Cash flows from financing activities:
Proceeds from long term debt 50,000,000 1,264,013 --
Long term debt issuance costs (1,933,000) -- --
Proceeds from secured note payable 10,700,000 -- --
Drawdown on line of credit 25,330,734 -- --
Issuance of common stock 14,999,501 640,000 365,000
Repayments of debt (6,264,013) (100,000) --
Payments on capital lease obligations (62,334) -- --
Advances from (to) shareholders -- 73,285 (60,000)
------------ ------------ ------------
Net cash provided by financing activities 92,770,888 1,877,298 305,000
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents 15,936,489 (195,546) 265,000
Cash and cash equivalents, beginning of year 69,454 265,000 --
------------ ------------ ------------
Cash and cash equivalents, end of year $ 16,005,943 $ 69,454 $ 265,000
============ ============ ============
Supplemental disclosures:
Rescinded secured promissory note for the
return of initial deposit on hospital assets $ 10,000,000 $ -- $ --
Interest paid $ 9,224,444 $ -- $ --
Income taxes paid $ 1,400,000 $ -- $ --
A capital lease obligation of $5,108,887 was incurred during the year ended
December 31, 2005 when the Company entered into a lease for one of its
Hospitals.
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS
F-6
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
NOTE 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS - Integrated Healthcare Holdings, Inc., a
Nevada corporation, and subsidiaries (the "Company"), was organized under the
laws of the State of Utah on July 31, 1984 under the name of Aquachlor
Marketing. Aquachlor Marketing never engaged in business activities and was
suspended for failure to file annual reports and tax returns. In December 1988,
all required reports and tax returns were filed and Aquachlor Marketing was
reinstated by the State of Utah. In December 1988, Aquachlor Marketing merged
with Aquachlor, Inc., a Nevada corporation incorporated on December 20, 1988.
The Nevada corporation became the surviving entity and changed its name to
Deltavision, Inc. In March 1997, Deltavision, Inc. received a Certificate of
Revival from the State of Nevada using the name First Deltavision, Inc. In March
2004, First Deltavision, Inc. changed its name to Integrated Healthcare
Holdings, Inc.
On March 8, 2005, the Company completed its acquisition (the
"Acquisition") of four Orange County, California hospitals and associated real
estate, including: (i) 282-bed Western Medical Center--Santa Ana, CA; (ii)
188-bed Western Medical Center--Anaheim, CA; (iii) 178-bed Coastal Communities
Hospital in Santa Ana, CA; and (iv) 114-bed Chapman Medical Center in Orange, CA
(collectively, the "Hospitals") from Tenet Healthcare Corporation ("Tenet"). The
Hospitals were assigned to four wholly-owned subsidiaries of the Company formed
for the purpose of completing the Acquisition. The Company also acquired the
following real estate, leases and assets associated with the Hospitals: (i) a
fee interest in the Western Medical Center at 1001 North Tustin Avenue, Santa
Ana, CA, a fee interest in the administration building at 1301 North Tustin
Avenue, Santa Ana, CA, certain rights to acquire condominium suites located in
the medical office building at 999 North Tustin Avenue, Santa Ana, CA, and the
business known as the West Coast Breast Cancer Center; (ii) a fee interest in
the Western Medical Center at 1025 South Anaheim Blvd., Anaheim, CA; (iii) a fee
interest in the Coastal Communities Hospital at 2701 South Bristol Street, Santa
Ana, CA, and a fee interest in the medical office building at 1901 North College
Avenue, Santa Ana, CA; (iv) a lease for the Chapman Medical Center at 2601 East
Chapman Avenue, Orange, CA, and a fee interest in the medical office building at
2617 East Chapman Avenue, Orange, CA; and (v) equipment and contract rights
associated with the Hospitals.
The results of operations of the acquired assets from the date of
Acquisition (March 8, 2005) have been included in the Company's consolidated
statement of operations for the year ended December 31, 2005. As a result of the
Acquisition, the Company has commenced its planned principal operations and
accordingly is no longer considered a development stage enterprise.
BASIS OF PRESENTATION - The accompanying financial statements have been
prepared on a going concern basis, which contemplates the realization of assets
and settlement of obligations in the normal course of business. The Company
generated losses of $44,558,367 (inclusive of a warrant issuance and holding
expenses of $21,064,669 incurred in connection with the Acquisition) during the
year ended December 31, 2005 and has working capital of $8,678,836 at December
31, 2005.
On or around May 9, 2005, the Company received notice that it was in
default of a credit agreement comprised of a $50 million acquisition loan (the
"Acquisition Loan") and a $30 million working capital line of credit (the "Line
of Credit"). Outstanding borrowings under the line of credit were $25,330,734 as
of December 31, 2005. On December 12, 2005, the Company entered into an
additional credit agreement for $10,700,000, due December 12, 2006, which
included an amendment that (i) declared cured the aforementioned default, (ii)
required the Company to pay $5,000,000 against its Acquisition Loan, (iii)
required the Company to obtain $10,700,000 in additional new capital
contributions to pay in full and retire all amounts due and owing under the
additional credit agreement and (iv) included certain indemnities and releases
in favor of the lender.
F-7
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
For the year ended December 31, 2005, cash used in operations was
$13,127,050. From the date of the Acquisition, this represents an average use of
cash in operations of $1.3 million per month.
These factors, among others, indicate a need for the Company to take
action to resolve its financing issues and operate its business as a going
concern. Management is working on improvements in several areas that the Company
believes will mitigate this deficiency, including (i) improved contracted
reimbursements and governmental subsidies for indigent care, (ii) reduction in
operating expenses, and (iii) reduction in the costs of borrowed capital.
Changes in the level of investment are subject to the approval of the Company's
Board of Directors, which is currently comprised of three representatives of the
lead investor, two outside directors, and one officer of the Company and,
accordingly, may not be assured.
CONSOLIDATION - The consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries, the Hospitals and
Mogel Management Group, Inc. ("MMG").
As discussed further in Note 8, the Company's management has determined
that Pacific Coast Holdings Investment, LLC ("PCHI"), is a variable interest
entity as defined in Financial Accounting Standards Board ("FASB")
Interpretation Number 46R ("FIN 46R") "Consolidation of Variable Interest
Entities (revised December 2003)--an interpretation of ARB No. 51" and,
accordingly, the financial statements of PCHI are included in the consolidated
financial statements of the Company as of and for the year ended December 31,
2005.
All significant intercompany accounts and transactions have been
eliminated in consolidation.
USE OF ESTIMATES - The accounting and reporting policies of the Company
conform to accounting principles generally accepted in the United States of
America ("U.S. GAAP") and prevailing practices for investor-owned entities
within the healthcare industry. The preparation of financial statements in
conformity with U.S. GAAP requires management to make estimates and assumptions
that affect the amounts reported in the consolidated financial statements and
accompanying notes. Management regularly evaluates the accounting policies and
estimates that are used. In general, management bases the estimates on
historical experience and on assumptions that it believes to be reasonable given
the particular circumstances in which the Hospitals operate. Although management
believes that adjustments considered necessary for fair presentation have been
included, actual results may vary from those estimates.
NET OPERATING REVENUES - Net operating revenues are recognized in the
period in which services are performed and are recorded based on established
billing rates (gross charges) less estimated discounts for contractual
allowances, principally for patients covered by Medicare, Medicaid, managed care
and other health plans. Gross charges are retail charges. They are not the same
as actual pricing, and they generally do not reflect what a hospital is
ultimately paid and therefore are not displayed in the consolidated statements
of operations. Hospitals are typically paid amounts that are negotiated with
insurance companies or are set by the government. Gross charges are used to
calculate Medicare outlier payments and to determine certain elements of payment
under managed care contracts (such as stop-loss payments). Because Medicare
requires that a hospital's gross charges be the same for all patients
(regardless of payer category), gross charges are also what hospitals charge all
other patients prior to the application of discounts and allowances.
Percentages of net operating revenues, by payer type, for the Hospitals
for the year ended December 31, 2005 were Medicare - 21%, Medicaid - 17%,
managed care - 42%, and indemnity, self-pay, and other - 20%.
F-8
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
Revenues under the traditional fee-for-service Medicare and Medicaid
programs are based primarily on prospective payment systems. Discounts for
retrospectively cost-based revenues and certain other payments, which are based
on the Hospitals' cost reports, are estimated using historical trends and
current factors. Cost report settlements for retrospectively cost-based revenues
under these programs are subject to audit and administrative and judicial
review, which can take several years until final settlement of such matters are
determined and completely resolved. Since the laws, regulations, instructions
and rule interpretations governing Medicare and Medicaid reimbursement are
complex and change frequently, the estimates recorded by the Hospitals could
change by material amounts. The Company has established a settlement receivable
for the year ended December 31, 2005 of $2,273,248.
Outlier payments, which were established by Congress as part of the
diagnosis-related groups (DRG) prospective payment system, are additional
payments made to hospitals for treating Medicare patients who are costlier to
treat than the average patient in the same DRG. To qualify as a cost outlier, a
hospital's billed (or gross) charges, adjusted to cost, must exceed the payment
rate for the DRG by a fixed threshold established annually by the Centers for
Medicare and Medicaid Services of the United State Department of Health and
Human Services (CMS). Under Sections 1886(d) and 1886(g) of the Social Security
Act, CMS must project aggregate annual outlier payments to all prospective
payment system hospitals to be not less than 5% or more than 6% of total DRG
payments (Outlier Percentage). The Outlier Percentage is determined by dividing
total outlier payments by the sum of DRG and outlier payments. CMS annually
adjusts the fixed threshold to bring expected outlier payments within the
mandated limit. A change to the fixed threshold affects total outlier payments
by changing (1) the number of cases that qualify for outlier payments, and (2)
the dollar amount hospitals receive for those cases that still qualify. The most
recent change to the cost outlier threshold that became effective on October 1,
2005 was a decrease from $25,800 to $23,600, which CMS projects will result in
an Outlier Percentage of 5.1%. The Medicare fiscal intermediary calculates the
cost of a claim by multiplying the billed charges by the cost-to-charge ratio
from the hospital's most recent filed cost report.
The Hospitals received new provider numbers during the year ended
December 31, 2005 and, because there was no specific history, the Hospitals were
reimbursed for outliers based on published statewide averages. If the computed
cost exceeds the sum of the DRG payment plus the fixed threshold, the hospital
receives 80% of the difference as an outlier payment. Medicare has reserved the
option of adjusting outlier payments, through the cost report, to the hospital's
actual cost-to-charge ratio. Upon receipt of the current payment cost-to-charge
ratios from the fiscal intermediary, any variance between current payments and
the estimated final outlier settlement will be reported. The Company has
recorded reserves for excess outlier payments due to the difference between the
Hospitals actual cost to charge rates and the statewide average in the amount of
$2,169,626. These reserves offset against the third party settlement receivables
and are included as a net receivable of $103,622 in due from governmental payers
in the accompanying consolidated balance sheet as of December 31, 2005.
The Hospitals receive supplemental payments from the State of
California to support indigent care (MediCal Disproportionate Share Hospital
payments or "DSH"). During the year ended December 31, 2005, the Hospitals
received $11,022,185 in payments. The Company estimates an additional $2,921,150
is receivable based on State correspondence, which is included in due from
governmental payers in the consolidated balance sheet as of December 31, 2005.
Revenues under managed care plans are based primarily on payment terms
involving predetermined rates per diagnosis, per-diem rates, discounted
fee-for-service rates and/or other similar contractual arrangements. These
revenues are also subject to review and possible audit by the payers. The payers
are billed for patient services on an individual patient basis. An individual
patient's bill is subject to adjustment on a patient-by-patient basis in the
ordinary course of business by the payers following their review and
adjudication of each particular bill. The Hospitals estimate the discounts for
contractual allowances utilizing billing data on an individual patient basis. At
the end of each month, the Hospitals estimate expected reimbursement for patient
of managed care plans based on the applicable contract terms. These estimates
F-9
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
are continuously reviewed for accuracy by taking into consideration known
contract terms as well as payment history. Although the Hospitals do not
separately accumulate and disclose the aggregate amount of adjustments to the
estimated reimbursements for every patient bill, management believes the
estimation and review process allows for timely identification of instances
where such estimates need to be revised. Management does not believe there were
any adjustments to estimates of individual patient bills that were material to
its net operating revenues.
Management is not aware of any material claims, disputes, or unsettled
matters with any payers that would affect revenues that have not been adequately
provided for in the accompanying consolidated financial statements.
The Hospitals provide charity care to patients whose income level is
below 200% of the Federal Poverty Level with only a co-payment charged to the
patient. The Hospitals' policy is to not pursue collection of amounts determined
to qualify as charity care; and accordingly, the Hospitals do not report the
amounts in net operating revenues or in the provision for doubtful accounts.
Patients whose income level is between 200% and 300% of the Federal Poverty
Level may also be considered under a catastrophic provision of the charity care
policy. Patients without insurance who do not meet the Federal Poverty Level
guidelines are offered assistance in applying for Medicaid and other programs
they may be eligible for, such as state disability, Victims of Crime, or county
indigent programs. Patient advocates from the Hospitals' Medical Eligibility
Program (MEP) screen patients in the hospital and determine potential linkage to
financial assistance programs. They also expedite the process of applying for
these government programs. Based on average revenue for comparable services from
all other payers, revenues foregone under the charity policy, including indigent
care accounts, for the year ended December 31, 2005 were approximately $3.1
million.
Receivables from patients who are potentially eligible for Medicaid are
classified as Medicaid pending under the MEP, with appropriate contractual
allowances recorded. If the patient does not quality for Medicaid, the
receivables are reclassified to charity care and written off, or they are
reclassified to self-pay and adjusted to their net realizable value through the
provision for doubtful accounts. Reclassifications of Medicaid pending accounts
to self-pay do not typically have a material impact on the results of operations
as the estimated Medicaid contractual allowances initially recorded are not
materially different than the estimated provision for doubtful accounts recorded
when the accounts are reclassified. All accounts classified as pending Medicaid
are fully reserved when they reach 180 days old.
PROVISION FOR DOUBTFUL ACCOUNTS - During 2005, the Company sold
substantially all of its billed accounts receivable to a financing company (see
Note 3). The Company provides for accounts receivable that could become
uncollectible by establishing an allowance to reduce the carrying value of such
receivables to their estimated net realizable value. The allowance for doubtful
accounts for accounts not sold as of December 31, 2005 was $3,148,276. The
Hospitals estimate this allowance based on the aging of their accounts
receivable, historical collections experience for each type of payer and other
relevant factors. There are various factors that can impact the collection
trends, such as changes in the economy, which in turn have an impact on
unemployment rates and the number of uninsured and underinsured patients, volume
of patients through the emergency department, the increased burden of
co-payments to be made by patients with insurance and business practices related
to collection efforts. These factors continuously change and can have an impact
on collection trends and the estimation process.
The Company's policy is to attempt to collect amounts due from
patients, including co-payments and deductibles due from patients with
insurance, at the time of service while complying with all federal and state
laws and regulations, including, but not limited to, the Emergency Medical
Treatment and Labor Act (EMTALA). Generally, as required by EMTALA, patients may
not be denied emergency treatment due to inability to pay. Therefore, until the
legally required medical screening examination is complete and stabilization of
the patient has begun, services are performed prior to the verification of the
patient's insurance, if any. In non-emergency circumstances or for elective
procedures and services, it is the Hospitals' policy, when appropriate, to
verify insurance prior to a patient being treated. During the year ended
December 31, 2005, the Company recorded a provision for doubtful accounts of
$37,348,984.
F-10
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
CASH AND CASH EQUIVALENTS - The Company considers all highly liquid
debt investments purchased with a maturity of three months or less to be cash
equivalents.
RESTRICTED CASH - Restricted cash consists of amounts deposited in
short term time deposits with a commercial bank to collateralize the Company's
obligations pursuant to certain agreements. A certificate of deposit for
$4,419,636 is pledged to a commercial bank that issued a standby letter of
credit for $4,200,000 in favor of an insurance company that is the administrator
of the Company's self-insured workers compensation plan. A certificate of
deposit for $552,000 is pledged as a reserve under the Company's capitation
agreement with CalOptima.
PROPERTY AND EQUIPMENT - Property and equipment are stated at cost,
less accumulated depreciation and any impairment write-downs related to assets
held and used. Additions and improvements to property and equipment are
capitalized at cost. Expenditures for maintenance and repairs are charged to
expense as incurred. Capital leases are recorded at the beginning of the lease
term as assets and liabilities. The value recorded is the lower of either the
present value of the minimum lease payments or the fair value of the asset. Such
assets, including improvements, are amortized over the shorter of either the
lease term or their estimated useful life.
The Company uses the straight-line method of depreciation for buildings
and improvements, and equipment over their estimated useful lives of 4 to 25
years and 3 to 15 years, respectively.
The Company evaluates its long-lived assets for possible impairment
whenever circumstances indicate that the carrying amount of the asset, or
related group of assets, may not be recoverable from estimated future cash
flows. However, there is an evaluation performed at least annually. Fair value
estimates are derived from independent appraisals, established market values of
comparable assets or internal calculations of estimated future net cash flows.
The estimates of future net cash flows are based on assumptions and projections
believed by management to be reasonable and supportable. These assumptions take
into account patient volumes, changes in payer mix, revenue, and expense growth
rates and changes in legislation and other payer payment patterns. The Company
believes there has been no impairment in the carrying value of its property and
equipment at December 31, 2005.
MEDICAL CLAIMS INCURRED BUT NOT REPORTED - The Company is contracted
with CalOptima, which is a county sponsored entity that operates similarly to an
HMO, to provide health care services to indigent patients at a fixed amount per
enrolled member per month. The Company receives payments from CalOptima based on
a fixed fee and the number of enrolled members at the Hospitals. The Company
recognizes these capitation fees as revenues on a monthly basis for providing
comprehensive health care services for the period.
In certain circumstances, members will receive health care services
from hospitals not owned by the Company. In these cases, the Company records
estimates of patient member claims incurred but not reported (IBNR) for services
provided by other health care institutions. Claims incurred but not reported are
estimated using historical claims patterns, current enrollment trends, hospital
pre-authorizations, member utilization patterns, timeliness of claims
submissions, and other factors. There can be no assurance that the ultimate
liability will not exceed our estimates. Adjustments to the estimated IBNR
reserves are recorded in our results of operations in the periods when such
amounts are determined. Per guidance under Statement of Financial Accounting
Standards ("SFAS") No. 5, "Accounting for Contingencies," the Company accrues
for IBNR reserves when it is probable that expected future health care costs and
maintenance costs under an existing contract have been incurred and the amount
can be reasonably estimable. The Company records these IBNR claim reserves
against its net operating revenues. During the year ended December 31, 2005, the
Company recorded net revenues from CalOptima capitation of approximately
$3,212,000, net of IBNR reserves of approximately $4,973,000. The Company's
direct cost of providing services to patient members in its facilities is
recorded as an operating expense.
F-11
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
STOCK-BASED COMPENSATION - SFAS No. 123, "Accounting for Stock-Based
Compensation," encourages, but does not require, companies to record
compensation cost for stock-based employee compensation plans at fair value. The
Company has adopted SFAS 123. As of December 31, 2005, the Company had not
granted any stock options to employees.
FAIR VALUE OF FINANCIAL INSTRUMENTS - The Company's financial
instruments recorded in the consolidated balance sheets include cash and cash
equivalents, restricted cash, receivables, accounts payable, and other
liabilities including warrant liability and long term debt. Management believes
that the recorded value of such financial instruments is a reasonable estimate
of their fair value. To finance the Acquisition, the Company entered into
agreements that contained warrants (see Notes 5 and 7), which are required to be
accounted for as derivative liabilities in accordance with SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities."
A derivative is an instrument whose value is derived from an underlying
instrument or index such as a future, forward, swap, or option contract, or
other financial instrument with similar characteristics, including certain
derivative instruments embedded in other contracts ("embedded derivatives") and
for hedging activities. As a matter of policy, the Company does not invest in
separable financial derivatives or engage in hedging transactions. However, the
Company may engage in complex transactions in the future that also may contain
embedded derivatives. Derivatives and embedded derivatives, if applicable, are
measured at fair value and marked to market through earnings.
WARRANTS - In connection with its Acquisition of the Hospitals, the
Company entered into complex transactions that contained embedded derivatives in
the form of warrants (see Notes 5 and 7). As a result, and in accordance with
SFAS 133, as of and for the year ended December 31, 2005, the Company recorded
current and noncurrent warrant liabilities of $10,700,000 and $21,064,669,
respectively, with related expense aggregating $21,064,669.
NET LOSS PER COMMON SHARE - Net loss per share is calculated in
accordance with SFAS No. 128, "Earnings per Share." Basic net loss per share is
based upon the weighted average number of common shares outstanding. Due to the
losses from operations incurred by the Company for the years ended December 31,
2005, 2004, and 2003, the anti-dilutive effect of options and warrants has not
been considered in the calculations of loss per share.
F-12
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
GOODWILL AND INTANGIBLE ASSETS - In accordance with SFAS No. 141,
"Business Combinations," and SFAS No. 142, "Goodwill and Intangible Assets,"
acquisitions subsequent to June 30, 2001 must be accounted for using the
purchase method of accounting. The cost of intangible assets with indefinite
lives and goodwill are no longer amortized, but are subject to an annual
impairment test based upon fair value.
Goodwill and intangible assets principally result from business
acquisitions. The Company accounts for business acquisitions by assigning the
purchase price to tangible and intangible assets and liabilities. Assets
acquired and liabilities assumed are recorded at their fair values; the excess
of the purchase price over the net assets acquired is recorded as goodwill. As
of December 31, 2005 no goodwill had been recorded on acquisitions.
INCOME TAXES - The Company accounts for income taxes in accordance with
SFAS No. 109, "Accounting for Income Taxes." Under SFAS 109, deferred income tax
assets and liabilities are determined based on the differences between the book
and tax basis of assets and liabilities and are measured using the currently
enacted tax rates and laws. A valuation allowance is recorded against deferred
tax assets when it is more likely than not that such deferred tax assets will
not be realized.
ACCRUALS FOR GENERAL AND PROFESSIONAL LIABILITY RISKS - The company
accrues for estimated professional liability claims, to the extent not covered
by insurance, when they are probable and reasonably estimable. The Company has
purchased as primary coverage a claims made form insurance policy for general
and professional liability risks. The policy limits are $1,000,000 per
individual claim and $5,000,000 in the aggregate, over retentions by the Company
of $500,000 per claim up to a maximum retention of $3,000,000 for claims
reported during the policy year. The Company has also purchased all risk
umbrella liability policies with aggregate limits of $19,000,000. The umbrella
policies provide coverage in excess of the primary layer and applicable
retentions for all of its insured risks, including general and professional
liability. Estimated losses within general and professional liability retentions
from claims incurred and reported, along with incurred but not reported (IBNR)
claims, are accrued based upon actuarially determined projections and are
discounted to their net present value using a weighted average risk-free
discount rate of 5%, appropriate for our claims payout period. To the extent
that subsequent claims information varies from our estimates, the liability is
adjusted in the period such information becomes available. As of December 31,
2005, the Company had accrued approximately $2.3 million, comprised of
approximately $0.6 million in incurred and reported claims, along with
approximately $1.7 million in IBNR and an allowance for potential increases in
the costs of those claims incurred and reported.
WORKERS' COMPENSATION PROGRAM - The Company has purchased as primary
coverage an occurrence form insurance policy to help fund its obligations under
its workers' compensation program for which the Company is responsible to
reimburse the insurance carrier for losses within a deductible of $500,000 per
claim, to a maximum aggregate deductible of $9,000,000. The Company has also
purchased all risks umbrella policies with aggregate limits of $19,000,000. The
umbrella policies provide coverage in excess of the primary layer and applicable
deductibles or retentions for all of its insured risks, including the worker's
compensation program. The company accrues for estimated workers' compensation
claims, to the extent not covered by insurance, when they are probable and
reasonably estimable. The ultimate costs related to this program include
expenses for deductible amounts associated with claims incurred and reported in
addition to an accrual for the estimated expenses incurred in connection with
IBNR claims. Claims, are accrued based upon actuarially determined projections
and are discounted to their net present value using a weighted average risk-free
discount rate of 5%, appropriate for our claims payout period. To the extent
that subsequent claims information varies from our estimates, the liability is
adjusted in the period such information becomes available. As of December 31,
2005, the Company had accrued approximately $1.3 million, comprised of
approximately $0.3 million in incurred and reported claims, along with $1.0
million in IBNR.
SEGMENT REPORTING - The Company operates in one line of business, the
provision of health care services through the operation of general hospitals and
related health care facilities. Our general hospitals generated substantially
all of our net operating revenues during the year ended December 31, 2005.
F-13
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
Our four general hospitals and our related health care facilities
operate in one geographic region in Orange County, California. This region is
our operating segment, as that term is defined by SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." The regions' economic
characteristics, the nature of their operations, the regulatory environment in
which they operate, and the manner in which they are managed are all similar. In
addition, our general hospitals and related health care facilities share certain
resources and they benefit from many common clinical and management practices.
Accordingly, we aggregate the facilities into a single reportable operating
segment.
RECENTLY ENACTED ACCOUNTING STANDARDS - In October 2004, the FASB
issued SFAS No. 123R, "Share-Based Payment," which requires all companies to
measure compensation cost for all share-based payments, including employee stock
options, at fair value. The statement is effective for the Company as of the
fiscal year commencing January 1, 2006. The statement generally requires that
such transactions be accounted for using a fair-value-based method and
recognized as expenses in the consolidated statements of operations. This
standard also requires that the modified prospective transition method be used,
under which the Company will recognize compensation cost for (1) the fair value
of new awards granted, modified or settled after the effective date of the SFAS
123R; and (2) a portion of the fair value of each option and stock grant made to
employees or directors prior to the implementation date that represents the
unvested portion of these share-based awards as of such date.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and
Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No.
3." SFAS 154 changes the requirements for the accounting for, and reporting of,
a change in accounting principle. Previously, most voluntary changes in
accounting principles were required to be recognized by way of a cumulative
effect adjustment within net income during the period of change. SFAS 154
generally requires retrospective application to prior periods' financial
statements of voluntary changes in accounting principles. SFAS 154 is effective
for accounting changes made in fiscal years beginning after December 15, 2005;
however, SFAS 154 does not change the transition provisions of any existing
accounting pronouncements. The Company does not believe SFAS 154 will have a
material effect on its consolidated balance sheets or statements of operations.
In December 2005, the FASB issued FIN 47, "Accounting for Conditional
Asset Retirement Obligations - an Interpretation of FASB No. 143." FIN 47
clarifies the term conditional asset retirement obligation used in SFAS No. 143
"Accounting for Asset Retirement Obligations" and is effective for fiscal years
ending after December 15, 2005. The Company does not believe FIN 47 will have a
material effect on its consolidated balance sheets or statements of operations.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140."
SFAS 155, among other things: permits the fair value re-measurement of any
hybrid financial instrument that contains an embedded derivative that otherwise
would require bifurcation and establishes a requirement to evaluate interests in
securitized financial assets to identify interests that are freestanding
derivatives or that are hybrid financial instruments that contain an embedded
derivative requiring bifurcation. SFAS 155 is effective for all financial
instruments acquired or issued in fiscal years beginning after September 15,
2006. The Company is currently evaluating the effect that adopting this
statement will have on the Company's financial position and results of
operations.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets - an amendment of FASB Statement No. 140," with respect to
the accounting for separately recognized servicing assets and servicing
liabilities. SFAS 156 permits the choice of the amortization method or the fair
value measurement method, with changes in fair value recorded in income, for the
subsequent measurement for each class of separately recognized servicing assets
and servicing liabilities. The statement is effective for years beginning after
September 15, 2006, with earlier adoption permitted. The Company is currently
evaluating the effect that adopting this statement will have on the Company's
financial position and results of operations.
F-14
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
RECLASSIFICATIONS - Certain reclassifications have been made to the
2004 and 2003 consolidated financial statements to conform to the 2005
presentation.
NOTE 2 - ACQUISITION
The purchase price, after all purchase price adjustments, of the
Acquisition amounted to $66,246,821. The fair value of the assets acquired and
related costs consisted of the following:
Property and equipment $55,833,952
Inventories of supplies 6,018,995
Prepaid expenses and other current assets 2,460,874
-----------
64,313,821
Debt issuance costs 1,933,000
-----------
$66,246,821
===========
The Company financed the Acquisition and related financing costs (see
Note 5) by obtaining a $50 million Acquisition Loan, drawing $3 million on a
working capital line of credit, selling shares of the Company's common stock for
$10.1 Million, and receiving $5 million in proceeds from minority investments in
PCHI.
The Company recorded its initial deposit of $10 million on the
Acquisition and direct acquisition costs of $1,142,145, consisting primarily of
legal fees, as an Investment in hospital asset purchase in the accompanying
consolidated balance sheet as of December 31, 2004.
The following unaudited supplemental pro forma information represents
the Company's consolidated results of operations as if the Acquisition had
occurred on January 1, 2004 and after giving effect to certain adjustments
including interest expense, depreciation expense, and related tax effects. In
addition, the following unaudited pro forma information includes the
nonrecurring items related to the issuance of 74,700,000 common stock warrants
(Note 7), which resulted in an expense of $17,604,292 that the Company recorded
during the year ended December 31, 2005 and restructuring charges of $3,147,000
incurred by Tenet during the three months ended March 31, 2005. Such unaudited
pro forma information does not purport to be indicative of operating results
that would have been reported had the Acquisition occurred on January 1, 2004 or
future operating results.
PRO FORMA (UNAUDITED)
-----------------------------
YEAR ENDED DECEMBER 31,
-----------------------------
2005 2004
-------------- --------------
Net operating revenues $ 338,994,152 $ 314,752,741
Net loss $ (59,464,267) $ (42,747,439)
Per share data:
Basic and fully diluted:
Loss per common share $ (0.71) $ (0.52)
Weighted average number of
common shares outstanding 83,817,080 81,960,066
F-15
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
NOTE 3 - ACCOUNTS PURCHASE AGREEMENT
In March 2005, the Company entered into a two year Accounts Purchase
Agreement (the "APA") with Medical Provider Financial Corporation I, an
unrelated party (the "Buyer"). The Buyer is an affiliate of the Lender (see Note
5). The APA provides for the sale of 100% of the Company's eligible accounts
receivable, as defined, without recourse. After accounts receivable are sold,
the APA requires the Company to provide billing and collection services,
maintain the individual patient accounts, and resolve any disputes that arise
between the Company and the patient or other third party payer. The Company
accounts for its sale of accounts receivable in accordance with SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities - A Replacement of FASB Statement 125."
The accounts receivable are sold weekly based on billings for each
Hospital. The purchase price is comprised of two components, the advance rate
amount and the deferred portion amount. The advance rate amount is based on the
historical collection experience for accounts receivable similar to those
included in a respective purchase. At the time of sale, the Buyer advances 85%
of the advance rate amount (the "85% Advance") to the Company and holds the
remaining 15% as security reserve funds on sold accounts (the "Security Reserve
Funds"), which is non-interest bearing. Except in the case of a continuing
default, the Security Reserve Funds can not exceed 25% (the "25% Cap") of the
aggregate advance rate amount, as defined, of the open purchases. The Company is
charged a "purchase discount" (the "Transaction Fee") of 1.35% per month of the
advance rate amount of each purchase until closed, at which time the Buyer
deducts the Transaction Fee from the Security Reserve Funds. Collections are
applied on a dollar value basis, not by specific identification, to the
respective Hospital's most aged open purchase. The deferred portion amount
represents amounts the Company expects to collect, based on regulations,
contracts, and historical collection experience, in excess of the advance rate
amount.
The following table reconciles accounts receivable, as reported, to the
unaudited pro forma accounts receivable, as if the Company had deferred
recognition of the sales:
December 31, 2005
----------------------------
As reported Pro forma
------------ ------------
Accounts receivable: (unaudited)
Governmental $ 10,394,875 $ 23,771,977
Non-governmental 9,345,678 46,181,345
------------ ------------
19,740,553 69,953,322
Less allowance for doubtful accounts (3,148,276) (17,723,163)
------------ ------------
Net patient accounts receivable 16,592,277 52,230,159
------------ ------------
Security Reserve Funds 12,127,337 --
Deferred purchase price receivables 9,337,703 --
------------ ------------
Receivable from Buyer of accounts 21,465,040 --
------------ ------------
Advance rate amount, net -- (10,843,197)
Transaction Fees deducted from Security
Reserve Funds -- (3,329,645)
------------ ------------
$ 38,057,317 $ 38,057,317
============ ============
Although 100% of the Company's accounts receivable, as defined, is
purchased by the Buyer, certain payments (generally payments that cannot be
attributed to specific patient account, such as third party settlements,
capitation payments and MediCal Disproportionate Share Hospital ("DSH")
subsidies (collectively "Other Payments") are retained by the Company and not
applied to the purchases processed by the Buyer. In the opinion of our
management, after consultation with the Buyer, DSH payments and CalOptima
capitation premium payments of $11.0 million and $18.1 million, respectively,
for the year ended December 31, 2005, are excludable from application to the
Security Reserve Funds. However, if cash collections on purchases are not
sufficient to recover the Buyer's advance rate amount and related transaction
fees, the Buyer could be entitled to funds the Company has received in Other
Payments or require transfer of substitute accounts to cover any such shortfall.
Based on collection history under the APA to date, the Company's management
believes the likelihood of the Buyer exercising this right is remote.
F-16
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
Any other term of the APA notwithstanding, the parties agreed as
follows: (a) all accounts derived from any government program payer including,
without limitation, the Medicare, Medi-Cal, or CHAMPUS programs, shall be
handled as set forth in a Deposit Account Security Agreement entered into by the
parties, which provides for the segregation and control of governmental payments
by the Company, (b) the parties agreed to take such further actions and execute
such further agreements as are reasonably necessary to effectuate the purpose of
the APA and to comply with the laws, rules, and regulations of the Medicare and
other government programs regarding the reassignment of claims and payment of
claims to parties other than the provider ("Reassignment Rules"), and (c) until
such time as accounts are delivered by the Company to the Buyer controlled
lockbox, the Company shall at all times have sole dominion and control over all
payments due from any government program payer. The Company's management (i)
believes that the foregoing method of segregating and controlling payments
received from governmental program payers complies with all applicable
Reassignment Rules, and (ii) the Company intends to request an opinion from the
Federal Center for Medicare and Medicaid Services ("CMS") that such method is
compliant with the Reassignment Rules in the view of CMS. The Company has
reported sales of $13,377,102 in governmental accounts receivable as of December
31, 2005 that are subject to the foregoing limitation.
The Company records estimated Transaction Fees and estimated servicing
costs related to the sold accounts receivable at the time of sale. For the year
ended December 31, 2005, the Company incurred a loss on sale of accounts
receivable of $8,470,053, which is reflected in operating expenses in the
accompanying consolidated statement of operations, and is comprised of the
following:
Transaction Fees deducted from Security Reserve
Funds - closed purchases $3,329,645
Accrued Transaction Fees - open purchases 862,781
----------
Total Transaction Fees incurred 4,192,426
----------
Servicing costs for sold accounts receivable - closed
purchases 3,596,558
Accrued servicing costs for sold accounts
receivable - open purchases 681,069
----------
Total servicing costs incurred 4,277,627
----------
Loss on sale of accounts receivable for the year ended
December 31, 2005 $8,470,053
==========
During the year ended December 31, 2005, the Company sold accounts
receivable with a net book value of $214,360,537, for which the Company received
$190,631,569, comprised of $179,744,444, representing the 85% Advance, and
$10,887,125 from the Security Reserve Funds, which exceeded the 25% Cap and was
released by the Buyer. Collections relating to the sold accounts receivable
totaled $179,788,372, resulting in a net advance rate amount to the Company of
$10,843,197 as of December 31, 2005.
Effective January 1, 2006, the APA was amended to reflect the following
changes:
Through Starting
December 31, January 1,
2005 2006
---- ----
Advance rate amount -
% received at time of sale 85% 95%
Advance rate amount -
% held by Buyer in Security Reserve Funds 15% 5%
F-17
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
At December 31, 2005, the Security Reserve Funds balance of $12,127,337
was in excess of the 25% Cap by approximately $1,487,000, which was released to
the Company subsequent to December 31, 2005. Effective March 31, 2006, an
amendment to the APA reduced the required Security Reserve Funds amount as a
percentage of the total advance rate amount outstanding from 25% to 15%. If this
amendment had been in place as of December 31, 2005, the reserve balance of
$12,127,337 would have been in excess of the "15% Cap" by approximately
$5,743,000. Excess Security Reserve Funds resulting from this amendment were
released to the Company in early 2006.
NOTE 4 - PROPERTY AND EQUIPMENT
Property and equipment consists of the following as of December 31,
2005 and 2004:
2005 2004
------------ ------------
Buildings $ 33,696,897 $ --
Land and improvements 13,522,591 --
Equipment 9,241,044 68,792
Buildings under lease 5,108,887 --
------------ ------------
61,569,419 68,792
Less accumulated depreciation (2,138,134) (11,369)
------------ ------------
Property and equipment, net $ 59,431,285 $ 57,423
============ ============
The Hospitals are affected by State of California Senate Bill 1953 (SB
1953), which requires certain seismic safety building standards for acute care
hospital facilities. The Company is currently reviewing the SB 1953 compliance
requirements and developing multiple plans of action to achieve such compliance,
the estimated time frame for complying with such requirements, and the cost of
performing necessary remediation of certain of the properties. The Company
cannot currently estimate with reasonable accuracy the remediation costs that
will need to be incurred in order to make the Hospitals SB 1953-compliant, but
such remediation costs could be significant.
NOTE 5 - DEBT
The Company's debt consists of the following as of December 31, 2005
and 2004:
2005 2004
------------ ------------
Short term debt (see Note 7):
- -----------------------------
Secured note payable $ 10,700,000 $ 11,264,013
Less derivative - warrant liability, current (10,700,000) --
------------ ------------
Short term debt $ -- $ 11,264,013
============ ============
Long term debt:
- ---------------
Secured acquisition loan $ 45,000,000 $ --
Secured line of credit, outstanding borrowings 25,330,734 --
------------ ------------
Long term debt $ 70,330,734 $ --
============ ============
ACQUISITION LOAN AND LINE OF CREDIT - In connection with the
Acquisition, the Company obtained borrowings from affiliates of Medical Capital
Corporation. Effective March 3, 2005, the Company and its subsidiaries
collectively entered into a credit agreement (the "Credit Agreement") with
Medical Provider Financial Corporation II ("the Lender"), whereby the Company
obtained initial financing in the form of a loan with interest at the rate of
F-18
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
14% per annum in the amount of $80,000,000 of which $30,000,000 is in the form
of a non-revolving Line of Credit and a $50,000,000 Acquisition Loan (less
$5,000,000 repayment on December 12, 2005) in the form of a real estate loan
(collectively, the "Obligations"). The Company used the proceeds from the $50
million Acquisition Loan and $3 million from the Line of Credit to complete the
Acquisition (see Notes 1 and 2). The Line of Credit is to be used for the
purpose of providing (a) working capital financing for the Company and its
subsidiaries, (b) funds for other general corporate purposes of the Company and
its subsidiaries, and (c) other permitted purposes. Effective January 1, 2006,
the Company and the Lender agreed to an amendment to the Obligations that
changed the interest rate from 14% to prime plus 5.75%.
Interest payments are due on the Obligations on the first business day
of each calendar month while any Obligation is outstanding. The Obligations
mature at the first to occur of (i) the Commitment Termination Date for the Line
of Credit; (ii) March 2, 2007; or (iii) the occurrence or existence of a
continuing Event of Default under any of the Obligations. The Commitment
Termination Date means the earliest of (a) thirty calendar days prior to March
2, 2007; (b) the date of termination of Lender's obligations to make Advances
under the Line of Credit or permit existing Obligations to remain outstanding,
(c) the date of prepayment in full by the Company and its subsidiaries of the
Obligations and the permanent reduction of all commitments to zero dollars; or
(d) March 2, 2007. Per the Credit Agreement, all future capital contributions to
the Company by Orange County Physicians Investment Network, LLC ("OC-PIN") shall
be used by the Company as mandatory prepayments of the Line of Credit.
The Acquisition Loan and Line of Credit are secured by a lien on
substantially all of the assets of the Company and its subsidiaries, including
without limitation, a pledge of the capital stock by the Company in its wholly
owned Hospitals. In addition, (i) PCHI has agreed to guaranty the payment and
performance of the Obligations, (ii) West Coast and Ganesha (see Note 8) have
each agreed to pledge their membership interests in PCHI as security for
repayment of the Obligations, (iii) the members of West Coast have agreed to
pledge their membership interests in PCHI as security for repayment of the
Obligations, and (iv) OC-PIN (see Note 8) has agreed to guaranty the payment and
performance of all the Obligations.
CREDIT AGREEMENT FEES - Concurrently with the execution and delivery of
the Credit Agreement and as a condition to the funding of the Acquisition Loan,
the Company and its subsidiaries agreed to pay to the Lender origination fees in
amounts equal to 2% of the Credit Line, or $600,000, and 2% of the Acquisition
Loan, or $1,000,000, Such fees were required to be paid out of the Company and
its subsidiaries own funds were deemed earned in full upon receipt by the
Lender. Upon the completion of the Acquisition on March 8, 2005, the Company
paid the Lender a total of $1,600,000 in origination fees and paid the Lender's
legal fees of approximately $333,000. The Company is amortizing the debt
issuance costs of $1,933,000 over the two year term of the Obligations. During
the year ended December 31, 2005, the Company recognized approximately $792,000
of amortization expense and has unamortized debt issuance costs of approximately
$1,141,000 as of December 31, 2005.
DEFAULT NOTICE - On or about May 9, 2005, the Company received a notice
of default from the Lender in connection with the Credit Agreement. In addition,
each of OC-PIN, PCHI, Ganesha Realty, LLC, and West Coast Holdings, LLC, which
are parties to the Credit Agreement, received a notice of default.
The notice of default asserted that (i) the Company failed to provide
satisfactory evidence that the Company received capital contributions of not
less than $15,000,000, as required under the Credit Agreement, (ii) the Company
failed to prepay $5,000,000 by the Mandatory Prepay Date as required under the
Credit Agreement, and (iii) a Material Adverse Effect had occurred under the
Credit Agreement for reasons relating primarily to OC-PIN's failure to fully
fund its obligations under its Stock Purchase Agreement with the Company.
FORBEARANCE AGREEMENT - In connection with the First Amendment (see
Note 6), the Company entered into an Agreement to Forbear as of June 1, 2005 by
and among the Company, OC-PIN, West Coast Holdings, LLC and the Lender (the
"Forbearance Agreement"). Without another default, the Lender agreed for 100
days to forbear from (i) recording Notices of Default, (ii) filing a judicial
foreclosure lawsuit against the Company, OC-PIN and West Coast Holdings, LLC,
and (iii) filing lawsuits against the Company, OC-PIN and West Coast Holdings,
F-19
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
LLC. The interest rate on the notes was increased to the Default Rate of 19%,
as defined in the Credit Agreement, and all Obligations (as defined in the
Credit Agreement) were due and payable, as long as the events of default remain
uncured. The Company's Line of Credit facility was suspended to additional
advances. During the forbearance period of 100 days, OC-PIN and other investors
agreed to invest not less than $15 million in new equity capital in the Company
(see Note 6).
SECURED SHORT TERM NOTE - On December 12, 2005, the Company entered
into a credit agreement (the "December Credit Agreement"), dated as of December
12, 2005, with the Credit Parties and the Lender. Under the December Credit
Agreement, the Lender loaned $10,700,000 to the Company as evidenced by a
promissory note (the "December Note"). Interest is payable monthly at the rate
of 12% per annum and the December Note is due on December 12, 2006. The Company
may not prepay the December Note in whole or in part.
The December Note is secured by substantially all of the Company's
assets. In addition, the Company issued a common stock warrant (the "December
Note Warrant") to the Lender as collateral under the December Note. The December
Note Warrant is exercisable by the Lender only in the event that a default has
occurred and is continuing on the December Note. The December Note Warrant
entitles the Lender to purchase the number of shares of the Company's common
stock equal in value to the amount of the December Note not repaid at maturity,
plus accrued interest and lender fees for an aggregate exercise price of $1.00,
regardless of the number of shares acquired. The December Credit Agreement
provides that "upon payment in full of the obligations, surplus net proceeds, if
any, thereafter remaining shall be paid to the Borrower, subject to the rights
of any holder of a Lien on the Collateral of which the Lender or Holder has
actual notice." The December Note Warrant is exercisable from and after December
12, 2005 until the occurrence of either a termination of the December Credit
Agreement by the Lender or the Company's payment in full of all obligations
under the December Credit Agreement. The Company is obligated to register the
estimated number of shares of common stock issuable upon exercise of the
December Note Warrant by filing a registration statement under the Securities
Act of 1933, as amended (the "Securities Act"), no later than ninety days prior
to the maturity date of the December Note. If the Company proposes to file a
registration statement under the Securities Act on or before the expiration date
of the December Note Warrant, then the Company must offer to the holder of the
December Note Warrant the opportunity to include the number of shares of common
stock as the holder may request. In accordance with U.S. GAAP, the Company has
classified the December Note as current warrant liability in the accompanying
consolidated balance sheet as of December 31, 2005 (see Note 7).
CURE OF DEFAULT - On December 12, 2005, the Company entered into
Amendment No. 1 to the December Credit Agreement dated as of December 12, 2005
(the "Amendment"), that amends the Credit Agreement, with PCHI, OC-PIN, Ganesha
Realty, LLC, West Coast Holdings, LLC (the "Credit Parties") and the Lender. The
Amendment (i) declared cured those certain events of default set forth in the
notices of default received on or about May 9, 2005, from the Lender, (ii)
required the Company to pay $5,000,000 to Lender for mandatory prepayment
required under the Credit Agreement, (iii) required the Company to obtain
$10,700,000 in additional new capital contributions to pay in full and retire
all amounts due and owing under the December Note evidenced by the December
Credit Agreement and (iv) includes certain indemnities and releases in favor of
the Lender.
WAIVER OF DEFAULT - The Company is currently in default of its
obligation under its loan and security agreements to timely file financial
reports with the Securities and Exchange Commission. The Lender has been
notified of the condition of default and has conditionally waived its right to
accelerate repayment of the debt subject to filing of Form 10-K following
ratification by the Company's Board of Directors on July 18, 2006 and filing of
Form 10-Q for the quarter ended March 31, 2006 on or about August 10, 2006.
F-20
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
NOTE 6 - COMMON STOCK
STOCK PURCHASE AGREEMENT - On January 28, 2005, the Company entered
into a Stock Purchase Agreement (the "Stock Purchase Agreement") with OC-PIN, a
company founded by Dr. Anil V. Shah, the Company's chairman, and owned by a
number of physicians practicing at the acquired Hospitals, pursuant to which
OC-PIN committed to invest $30,000,000 in the Company for an aggregate of
108,000,000 shares of the Company's common stock. In addition, a prior Purchase
Option Agreement, dated November 16, 2004, between the Company and Dr. Shah, was
terminated. During the year ended December 31, 2005, the Company issued a total
of 61,973,316 shares of its common stock in consideration of $14.4 million from
OC-PIN under the Stock Purchase Agreement. The Company used the proceeds from
this stock sale as part of the consideration paid to Tenet for the Acquisition.
Under the Stock Purchase Agreement, no later than nine calendar days
before the closing of the Acquisition, OC-PIN was to deliver to the Company
additional financing totaling $20,000,000. Upon receipt of the $20,000,000, the
Company was to issue an additional 5.4 million shares of its common stock to
OC-PIN. However, OC-PIN was unable to raise the additional financing in time for
the closing of the Acquisition and OC-PIN indicated that it disagreed with the
Company's interpretation of OC-PIN's obligations under the Stock Purchase
Agreement. In order to avoid litigation, the Company agreed to extend OC-PIN's
additional $20,000,000 financing commitment, and on June 16, 2005 the Company
entered into the following new agreements with OC-PIN:
First Amendment to the Stock Purchase Agreement, dated as of June
1, 2005 (the "First Amendment"); and
Escrow Agreement, dated as of June 1, 2005, by and among the
Company, OC-PIN and City National Bank (the "Escrow
Agreement").
The following material terms were contained in the First Amendment and
the Escrow Agreement:
OC-PIN's total stock purchase commitment under the Stock Purchase
Agreement was reduced from $30 million to $25 million;
A total of 57,250,000 shares of the Company's common stock
previously issued to OC-PIN were placed in an escrow account
with City National Bank in July 2005. OC-PIN had until
September 1, 2005 to make monthly installments into the escrow
account up to an aggregate of approximately $15,000,000. Such
portion of the escrowed shares which were fully paid was to be
returned to OC-PIN and the balance was to be transferred back
to the Company;
OC-PIN agreed to reimburse the Company for $707,868 of its
additional debt financing costs incurred since March 8, 2005.
As of December 31, 2005, $340,000 of these costs had been
recovered by the Company;
The Company would work to complete a new borrowing transaction; and
Upon receipt of at least $5,000,000 of new capital under the First
Amendment, the Company would call a shareholders meeting to
re-elect directors.
Under the First Amendment and the Escrow Agreement, OC-PIN deposited a
total of $12,500,000 into the escrow account. However, following receipt of such
funds, a disagreement arose between OC-PIN and the third party which provided
$11,000,000 of the $12,500,000 deposited into the escrow account. In order to
resolve this matter and to avoid potential litigation involving the Company, the
Company agreed to return $11,000,000 of these funds and provide OC-PIN with a
F-21
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
limited opportunity to provide alternative financing. Therefore, effective
October 31, 2005, the Company entered into a Second Amendment to the Stock
Purchase Agreement (the "Second Amendment"), pursuant to which the Company and
OC-PIN issued escrow instructions to release escrowed funds as of November 2,
2005, terminate the Escrow Agreement and distribute the assets in the escrow
account as follows:
1. $1,500,000 of the escrowed cash, plus a pro rata portion of the
accrued interest, was delivered to the Company for payment of
stock.
2. $11,000,000 of the escrowed cash, plus a pro rata portion of
the accrued interest was delivered to OC-PIN.
3. $5,798,831 of the escrowed shares of the Company's common stock
were delivered to OC-PIN.
4. 40,626,684 of the escrowed shares of the Company's common stock
were delivered to the Company.
5. OC-PIN transferred $2,800,000 from another account to the
Company for which OC-PIN received 10,824,485 of the escrowed
shares.
6. The Company agreed to issue to OC-PIN 5,400,000 shares of its
common stock multiplied by the percentage of OC-PIN's payment
required to be made under the Stock Purchase Agreement, as
amended, which had been made to date. As of December 31, 2005,
3,246,201 of these shares were not issued pending the Company's
recovery of $367,868 in additional interest costs pursuant to the
First Amendment. The Company resolved this dispute with OC-PIN on
July 25, 2006.
7. The Company granted OC-PIN the right to purchase up to
$6,700,000 of common stock within 30 calendar days following the
cure of the Company's default relating to the Credit Agreement at
a price of $0.2586728 per share or a maximum of 25,901,447 shares
of its common stock, plus interest on the purchase price at 14%
per annum from September 12, 2005 through the date of closing on
the funds from OC-PIN. Upon one or more closings on funds
received under this section of the Second Amendment, the Company
will issue an additional portion of the 5,400,000 shares
mentioned in item (6) above.
NOTE 7 - COMMON STOCK WARRANTS
The Company entered into a Rescission, Restructuring and Assignment
Agreement with Dr. Kali Chaudhuri and Mr. William Thomas on January 27, 2005
(the "Restructuring Agreement"). Previously, the Company had obtained financing
from Dr. Chaudhuri and Mr. Thomas and had issued to them a $500,000 secured
convertible promissory note that was convertible into approximately 88.8% of the
Company's issued and outstanding common stock on a fully-diluted basis, a $10
million secured promissory note, and a Real Estate Purchase Option agreement
originally dated September 28, 2004 to purchase 100% of substantially all of the
real property in the Acquisition for $5 million (the "Real Estate Option"), all
of which together with related accrued interest payable pursuant to the terms of
the notes were rescinded and cancelled. Pursuant to the Restructuring Agreement,
the company released its initial deposit of $10 million plus accrued interest on
the Acquisition back to Dr. Chaudhuri and issued non-convertible secured
promissory notes totaling $1,264,014 and warrants to purchase up to 74,700,000
shares of the Company's common stock (the "Warrants") to Dr. Chaudhuri and Mr.
Thomas (not to exceed 24.9% of the Company's fully diluted capital stock at the
time of exercise). In addition, the Company amended the Real Estate Option to
provide for Dr. Chaudhuri's purchase of 49% interest in PCHI for $2,450,000.
Concurrent with the close of the Acquisition, the Company repaid the
non-convertible secured promissory notes of $1,264,014 to Dr. Chaudhuri and Mr.
Thomas.
The Warrants are exercisable beginning January 27, 2007 and expire in
3.5 years from the date of issuance. The exercise price for the first 43 million
shares purchased under the Warrants is $0.003125 per share, and the exercise or
purchase price for the remaining 31.7 million shares is $0.078 per share if
exercised between January 27, 2007 and July 26, 2007, $0.11 per share if
exercised between July 27, 2007 and January 26, 2008, and $0.15 per share
thereafter.
F-22
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
Based upon a valuation obtained by the Company from an independent valuation
firm, the Company recorded an expense of $17,604,292 related to the issuance of
the Warrants. The Company computed the expense of the Warrants based on the fair
value of the underlying shares at the date of grant and the estimated maximum
number of shares of 43,254,715 that could be issued under the Warrants. For the
period from December 12, 2005 to December 31, 2005 the Company recognized
$3,460,377 in change in fair value of derivative in the accompanying
consolidated statement of operations for the year ended December 31, 2005.
As a result of the Company not being able to determine the maximum
number of shares that could be required to be issued under the December Note
Warrant issued on December 12, 2005 (see Note 5), the Company has determined
that share settlement of the Warrants issued on January 27, 2005 is no longer
within its control and reclassified the Warrants as a liability on December 12,
2005 in accordance with EITF No. 00-19 "Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and
SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities." As
of December 12, 2005, there was a substantial reduction in the shares
outstanding to 83,932,316 shares as a result of the Company's settlement with
OC-PIN. However, the requirement to repay the December Note for $10.7 million
may obligate the Company to issue new shares of its common stock prior to the
expected exercise of the Warrants and the estimated maximum number of shares
exercisable of 43,254,715 accordingly remains unchanged.
The Company computed the fair value of the Warrants based on the
Black-Scholes option pricing model with the following assumptions:
December 12, 2005 December 31, 2005
------------------- --------------------
Risk-free interest rate 4.4% 4.4%
Expected volatility 28.6% 28.6%
Dividend yield -- --
Expected life (years) 2.62 2.57
Fair value of Warrants $0.407 $0.487
Market value per share $0.41 $0.49
Management believes that the likelihood of the December Note Warrant
being exercised is reasonably possible and, in accordance with EITF No. 00-19
and SFAS 133, has included the December Note value of $10.7 million in warrant
liability, current, in the accompanying consolidated balance sheet as of
December 31, 2005. Under the terms of the December Credit Agreement, any
proceeds from the sale of stock received under the December Note Warrant that
are in excess of the December Note and related issuance costs are to be returned
to the Company. Accordingly, the fair value of the December Note Warrant would
contractually continue to be $10.7 million (plus any issuance and exercise
costs, which are considered immaterial).
The Company computed the fair value, and related number of shares, of
the December Note Warrant based on the Black-Scholes option pricing model with
the following assumptions:
December 12, 2005 December 31, 2005
------------------- --------------------
Risk-free interest rate 4.4% 4.4%
Expected volatility 23.9% 23.9%
Dividend yield -- --
Expected life (years) 1.00 .95
Fair value of Warrants $0.410 $0.490
Number of shares 26,097,561 21,836,735
Due to the fact that the Company emerged from the development stage
during the year ended December 31, 2005, the Company computed the volatility of
its stock based on an average of the following public companies that own
hospitals:
F-23
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
Amsurg Inc (AMSG)
Community Health Systems (CYH)
HCA Healthcare Company (HCA)
Health Management Associates Inc. (HMA)
Lifepoint Hospitals Inc. (LPNT)
Tenet Healthcare Corp. (THC)
Triad Hospitals Inc. (TRI)
Universal Health Services Inc., Class B (UHS)
Although management believes this is the most reasonable and accurate
methodology to determine the Company's volatility, the circumstances affecting
volatility of the comparable companies selected may not be an accurate predictor
of the Company's volatility.
NOTE 8 - VARIABLE INTEREST ENTITY
Concurrent with the close on the Acquisition, and pursuant to an
agreement dated September 28, 2004, as amended and restated on November 16,
2004, Dr. Chaudhuri and Dr. Shah exercised their option to purchase all of the
equity interests in PCHI, which simultaneously acquired title to substantially
all of the real property acquired by the Company in the Acquisition. The Company
received $5 million and PCHI guaranteed the Company's Acquisition Loan.
The Company remains primarily liable under the Acquisition Loan note
notwithstanding its guarantee by PCHI, and this note is cross-collateralized by
substantially all of the Company's assets and all of the real property of the
Hospitals. All of the Company's operating activities are directly affected by
the real property that was sold to PCHI. Given these factors,
the Company has indirectly guaranteed the indebtedness of PCHI. The Company is
standing ready to perform on the Acquisition Loan should PCHI not be able to
perform and has undertaken a contingent obligation to make future payments if
those triggering events or conditions occur.
PCHI is a related party entity that is affiliated with the Company
through common ownership and control. It is owned 51% by West Coast Holdings,
LLC (Dr. Shah and investors) and 49% by Ganesha Realty, LLC (Dr. Chaudhuri and
Mr. Thomas). Under FIN 46R (see Note 1) a company is required to consolidate the
financial statements of any entity that cannot finance its activities without
additional subordinated financial support, and for which one company provides
the majority of that support through means other than ownership. Effective March
8, 2005, the Company determined that it provided the majority of financial
support to PCHI through various sources including lease payments, remaining
primarily liable under the Acquisition Loan, and cross-collateralization of the
Company's non-real estate assets to secure the Acquisition Loan. Accordingly,
during the year ended December 31, 2005, the Company included the net assets of
PCHI, net of consolidation adjustments, in its consolidated financial
statements. Selected information from PCHI's balance sheet as of December 31,
2005, and its results of operations for the period March 8, 2005 to December 31,
2005 are as follows:
Total assets $ 48,068,304
Total liabilities 44,726,755
Member's equity 3,341,549
Net revenues 7,276,983
Net loss 1,658,451
F-24
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
Consolidation adjustments to reflect the effects of the following
matters are included in the accompanying consolidated financial statements as of
and for the year ended December 31, 2005:
The Company's rental income and expense in the Hospitals has been
eliminated, consolidating PCHI's ownership of the land and
buildings in the accompanying financial statements. Additionally, a
gain of $4,433,374 arising from the Company's sale of the real
property of the Hospitals to PCHI has been eliminated to state the
land and buildings at the Company's cost.
PCHI's equity accounts have been classified as minority interest
variable interest entity.
The Company has a 25 year lease commitment to PCHI with rental
payments equal to the following components:
(1) Interest expense on the Acquisition Loan, or successor upon
refinancing, and
(2) Up to 2.5% spread if interest rate is below 12%, and
(3) Amortization of principal on successor loan.
Concurrent with the close of the Acquisition, the Company entered into
a sale-leaseback transaction with PCHI involving substantially all of the real
property acquired in the Acquisition, except for the fee interest in the medical
office building at 2617 East Chapman Avenue, for an initial term of 25 years and
option to renew for an additional 25 years. The rental payments are variable
based primarily on the terms of financing. Based on the existing arrangements,
aggregate payments are estimated to be approximately $226 million over the
remainder of the initial term.
Additionally, the tenant is responsible for seismic remediation (SB
1953) under the terms of the lease agreement.
Subsequent to execution of the lease, the Company was required to pay
down $5 million on the Acquisition Loan. The Company is evaluating the impact
this has, if any, on the foregoing terms.
NOTE 9 - INCOME TAXES
The Company accounts for income taxes in accordance with SFAS 109 which
requires the liability approach for the effect of income taxes. The provision
for income taxes consists of provisions for federal and state income taxes.
The preparation of consolidated financial statements in conformity
with U.S. GAAP requires us to make estimates and assumptions that affect the
reported amount of tax-related assets and liabilities and income tax provisions.
The Company assesses the recoverability of the deferred tax assets on an ongoing
basis. In making this assessment the Company is required to consider all
available positive and negative evidence to determine whether, based on such
evidence, it is more likely than not that some portion or all of our net
deferred assets will be realized in future periods. This assessment requires
significant judgment. In addition, the Company has made significant estimates
involving current and deferred income taxes, tax attributes relating to the
interpretation of various tax laws, historical bases of tax attributes
associated with certain tangible and intangible assets and limitations
surrounding the realization of our deferred tax assets. The Company does not
recognize current and future tax benefits until it is deemed probable that
certain tax positions will be sustained.
F-25
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
The provision for income taxes consisted of the following for the years
ended December 31 2005, 2004 and 2003:
2005 2004 2003
----------- ----------- ------------
Current income tax provision:
Federal $ -- $ -- $ --
State 4,800 -- --
----------- ----------- ------------
4,800 -- --
----------- ----------- ------------
Deferred income tax benefit:
Federal -- -- --
State -- -- --
----------- ----------- ------------
-- -- --
----------- ----------- ------------
Income tax provision $ 4,800 $ -- $ --
=========== =========== ============
A reconciliation between the amount of reported income tax expense and
the amount computed by multiplying loss from continuing operations before income
taxes by the statutory federal income tax rate for the years ended December 31,
2005, 2004, and 2003 follows:
2005 2004 2003
------------ ------------ ------------
U.S. federal statutory income taxes $(15,148,213) $ (625,665) $ (9,565)
State and local income taxes, net of federal benefit (2,628,661) (106,731) (1,632)
Other 3,986,796 (26,604) (2,803)
Change in valuation allowance 13,794,878 759,000 14,000
------------ ------------ ------------
Income tax provision $ 4,800 $ -- $ --
============ ============ ============
Deferred income taxes reflect the tax effects of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and the amount used for income tax purposes. The following table
discloses those significant components of our deferred tax assets and
liabilities, including the valuation allowance:
2005 2004
------------ ------------
Deferred tax assets:
Allowance for doubtful accounts $ 1,348,721 $ --
Accrued vacation 1,922,548 --
Other 861,954 --
Tax credits 6,580,090 --
Net operating losses 3,851,565 800,000
------------ ------------
14,594,878 800,000
Valuation allowance (14,594,878) (800,000)
------------ ------------
Total deferred tax assets $ -- $ --
============ ============
F-26
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
A valuation allowance of approximately $14.6 million was recorded as of
December 31, 2005 based on an assessment of the realization of our deferred tax
assets as described below. We assess the realization of our deferred tax assets
to determine whether an income tax valuation allowance is required. The Company
recorded a 100% valuation allowance on its deferred tax assets at December 31,
2005, based primarily on the following factors:
o cumulative losses in recent years;
o income/losses expected in future years;
o unsettled circumstances that, if unfavorably resolved, would
adversely affect future operations and profit levels;
o the availability, or lack thereof, of taxable income in prior
carryback periods that would limit realization of tax
benefits;
o the carryforward period associated with the deferred tax
assets and liabilities; and
o prudent and feasible tax-planning strategies.
TENET HOSPITAL ACQUISITION - The Acquisition was an asset purchase
transaction and the Company will not benefit from the net operating losses of
the acquired Hospitals prior to the date of acquistion. In connection with the
Company's completion of the Tenet Hospital Acquisition in March 2005, the
Company sold substantially all of the real estate of the acquired hospitals to
PCHI. For income tax purposes, the sale of the real estate of the acquired
hospitals could require the Company to report dividend and/or interest income.
If the Company is required to report dividend and/or interest income in
connection with this transaction, the Company would be required to withhold 28%
on any deemed dividend or interest income. The Company's sale of real estate to
PCHI on March 8, 2005 for $5 million plus the assumption of the Acquisition Loan
is a taxable event to the Company.
PCHI TAX STATUS - PCHI is a limited liability corporation. PCHI's
owners plan to make tax elections for it to be treated as a disregarded entity
for tax reporting whereby, in a manner similar to a partnership. PCHI's taxable
income or loss will flow through to its owners and be their separate
responsibility. Accordingly, the accompanying consolidated financial statements
do not include any amounts for the income tax expense or benefit, or liabilities
related to PCHI's income or loss.
NOTE 10 - RELATED PARTY TRANSACTIONS
PCHI - The Company leases substantially all of the real property of the
acquired Tenet Hospitals from PCHI. PCHI is owned by two LLC's, which are owned
and co-managed by Dr. Shah, Dr. Chaudhuri, and Mr. Thomas. Dr. Shah is the
chairman of the Company and is also the co-manager and an investor in OC-PIN,
which is the majority shareholder of the Company. Dr. Chaudhuri and Mr. Thomas
are the holders of the Warrants to purchase up to 24.9% of the Company's fully
diluted capital stock (see Note 7). The Company has consolidated the financial
statements of PCHI for the period March 8, 2005 through December 31, 2005 in
accordance with FIN 46R (see Note 8). During the year ended December 31, 2005,
the Company incurred a liability for rent expense payable to PCHI of $7,276,983,
which was eliminated upon consolidation at December 31, 2005.
MANAGEMENT AGREEMENTS - In December 2004, February 2005, and March
2005, the Company entered into seven employment agreements with its executive
officers. Among other terms, the three year employment agreements provide for
annual salaries aggregating $2,790,000, total stock option grants to purchase
7,650,000 shares of the Company's common stock at an exercise price equal to the
mean average per share for the ten days following the date of issuance with
vesting at 33% per year, and an annual bonus to be determined by the Board of
Directors. As of December 31, 2005, the Company has not issued any stock options
pursuant to the employment agreements.
F-27
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
NOTE 11 - LOSS PER SHARE
Loss per share has been calculated under SFAS No. 128, "Earnings per
Share." SFAS 128 requires companies to compute earnings (loss) per share under
two different methods, basic and diluted. Basic earnings (loss) per share is
calculated by dividing the net earnings (loss) by the weighted average shares of
common stock outstanding during the period. Diluted earnings (loss) per share is
calculated by dividing the net earnings (loss) by the weighted average shares of
common stock outstanding during the period and dilutive potential shares of
common stock. Dilutive potential shares of common stock, as determined under the
treasury stock method, consist of shares of common stock issuable upon exercise
of stock warrants or options, net of shares of common stock assumed to be
repurchased by the Company from the exercise proceeds.
Since the Company incurred losses for the year ended December 31, 2005,
antidilutive potential shares of common stock, consisting of approximately 40
million shares issuable under warrants, have been excluded from the calculation
of diluted loss per share in the following table. During the years ended
December 31, 2004 and 2003, there were no outstanding options or warrants to
purchase the Company's common stock. The following table sets forth the
computation of basic and diluted loss per share:
Years ended December 31,
--------------------------------------------
2005 2004 2003
------------ ------------ ------------
Numerator:
Net loss $(44,558,367) $ (1,840,191) $ (28,132)
Denominator:
Weighted average common shares
and denominator for basic
calculation 90,330,428 19,986,750 3,470,589
Weighted average effect of
dilutive securities -- -- --
------------ ------------ ------------
Denominator for diluted 90,330,428 19,986,750 3,470,589
calculation
Loss per share - basic $ (0.49) $ (0.09) $ (0.01)
Loss per share - diluted $ (0.49) $ (0.09) $ (0.01)
NOTE 12 - COMMITMENTS AND CONTINGENCIES
OPERATING LEASES - Concurrent with the closing of the Acquisition as of
March 8, 2005, the Company entered into a sale leaseback type agreement with a
related party entity, PCHI. The Company leases substantially all of the real
estate of the acquired Hospitals and medical office buildings from PCHI. The
term of the lease for the Hospital is approximately 25 years, commencing March
8, 2005 and terminating on February 28, 2030. The Company has the option to
extend the term of this triple net lease for an additional term of 25 years.
As noted in Note 8, PCHI is included in the Company's consolidated
financial statements. Accordingly, the Company's lease commitment with PCHI is
eliminated in consolidation.
Additionally, in connection with the Hospital Acquisition, the Company
also assumed the leases for the Chapman facility, which include buildings, land,
and other equipment with terms that were extended concurrently with the
assignment of the leases to December 31, 2023.
F-28
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
The following is a schedule of the Company's future minimum operating
lease payments, excluding the triple net lease with PCHI, that have initial or
remaining non-cancelable lease terms in excess of one year as of December 31,
2005:
Year ending December 31,
------------------------
2006 $ 2,114,106
2007 1,761,247
2008 1,233,130
2009 909,600
2010 909,600
Thereafter 16,589,772
-------------
$ 23,517,457
=============
Total rental expense was approximately $2,276,000 and $68,044 the years
ended December 31, 2005 and 2004, respectively. The Company received sublease
rental income in relation to certain leases of approximately $536,000 for the
year ended December 31, 2005.
CAPITAL LEASES - The Company has a long-term lease obligation for the
buildings at the Chapman facility. For financial reporting purposes, the lease
has been classified as a capital lease; accordingly, assets with a net book
value of $4,886,503 are included in property and equipment in the accompanying
consolidated balance sheet as of December 31, 2005. The following is a schedule
of future minimum lease payments under the capitalized building lease together
with the present value of the net minimum lease payments as of December 31,
2005:
Year ending December 31,
------------------------
2006 $ 686,292
2007 686,292
2008 686,292
2009 686,292
2010 686,292
Thereafter 8,921,796
-----------
Total minimum lease payments $12,353,256
Less amount representing interest 7,306,703
-----------
Present value of net minimum lease payments 5,046,553
Less current portion 85,296
-----------
Long-term portion $ 4,961,257
===========
AGREEMENT FOR COMPENSATION - In connection with the close of the
Acquisition, the Company entered into an Agreement for Compensation Related to
the 999 Medical Office Building (the "Compensation Agreement") with PCHI, a
related party (see Note 10). In the amended Asset Sale Agreement with Tenet,
certain medical office condominium units (the "Condo Units") were excluded from
the Company's Hospital Acquisition due to the tenants of the Condo Units having
the right of first refusal to purchase such real property. As a result, the
Company's purchase price of the Hospitals from Tenet was reduced by $5 million.
Pursuant to the amended Asset Sale Agreement, upon the expiration of the
tenants' rights of first refusal, Tenet will transfer title to the Condo Units
to the Company in exchange for consideration of $5 million, pro rated if less
than all of the Condo Units are transferred.
F-29
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
Pursuant to the Compensation Agreement, the Company shall acquire title
to the Condo Units upon expiration of the tenants' rights of first refusal and
then transfer such title to the Condo Units to PCHI. If some of the Condo Units
are acquired by the tenants, the Company shall provide compensation to PCHI and
the Company shall pay down its Acquisition Loan (see Note 5) by $5 million or
such pro rata portion. In the event of the Company's failure to obtain title to
the Condo Units, the Company shall pay to PCHI a sum to be agreed upon between
the Company, PCHI, and the owners of PCHI, but not less than the product of
$2,500,000 multiplied by a fraction, the numerator of which shall be the number
of Condo Units not acquired by the Company and transferred to PCHI, and the
denominator equal to the total Condo Units of twenty-two. The tenants are
currently in litigation with Tenet related to the purchase price of the Condo
Units offered by Tenet to the tenants.
As the financial statements of the related party entity, PCHI, a
variable interest entity (see Note 8), are included in the Company's
accompanying consolidated financial statements, management has determined that
any future payment to PCHI under the Compensation Agreement would reduce the
Company's gain on sale of assets to PCHI (see Note 8).
CLAIMS AND LAWSUITS - The Company and the Hospitals are subject to
various legal proceedings, most of which relate to routine matters incidental to
our business. The results of these claims cannot be predicted, and it is
possible that the ultimate resolution of these matters, individually or in the
aggregate, may have a material adverse effect on the Company's business (both in
the near and long term), financial position, results of operations, or cash
flows. Although the Company defends itself vigorously against claims and
lawsuits and cooperates with investigations, these matters (1) could require
payment of substantial damages or amounts in judgments or settlements, which
individually or in the aggregate could exceed amounts, if any, that may be
recovered under insurance policies where coverage applies and is available, (2)
cause substantial expenses to be incurred, (3) require significant time and
attention from the Company's management, and (4) could cause the Company to
close or sell the Hospitals or otherwise modify the way its business is
conducted. The Company accrues for claims and lawsuits when an unfavorable
outcome is probable and the amount is reasonably estimable.
NOTE 13 - UNAUDITED QUARTERLY RESULTS
The following tables contain selected unaudited consolidated statements
of operations and loss per share data for each quarter in the years ended
December 31, 2005 and 2004 (in millions, except for per share data):
Year ended December 31, 2005 - Quarters ended
---------------------------------------------------------------------------------------
December
March 31 (1) June 30 September 30 31
---------------------- ---------------------- ---------------------- ---------
Previously Previously Previously
reported Restated reported Restated reported Restated
--------- --------- --------- --------- --------- ---------
Net operating revenues $ 21,747 $ 21,747 $ 83,191 $ 83,191 $ 91,620 $ 91,620 $ 87,756
Operating loss (3) $ (18,256) $ (1,041) $ (6,288) $ (8,137) $ (3,189) $ (4,152) $ (1,892)
Net loss (2) (3) $ (19,857) $ (19,857) $ (11,428) $ (10,196) $ (7,858) $ (6,497) $ (8,008)
Loss per common share:
Basic and diluted $ (0.22) $ (0.22) $ (0.09) $ (0.08) $ (0.11) $ (0.09) $ (0.09)
Weighted average shares
outstanding:
Basic and diluted 88,494 88,494 124,539 124,539 69,853 69,853 90,330
(1) Includes the acquired Hospitals from March 8, 2005.
(2) Includes warrant expense of $17,215 in the first quarter that was
reclassified from an operating expense to other expense.
(3) The operating loss for the second and third quarters has been
restated to reflect retroactive application of SFAS 140 for the sale
of accounts receivable, and the net loss for those quarters has been
restated to reflect the related tax effect.
F-30
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
Year ended December 31, 2004 - Quarters ended
--------------------------------------------
September December
March 31 June 30 30 31
-------- -------- -------- --------
Net operating revenues $ -- $ -- $ -- $ --
Operating loss $ (492) $ (431) $ (491) $ (426)
Net loss $ (492) $ (431) $ (491) $ (426)
Loss per common share:
Basic and diluted $ (0.03) $ (0.02) $ (0.02) $ (0.02)
Weighted average shares
outstanding:
Basic and diluted 19,583 19,590 20,116 20,780
NOTE 14 - SUBSEQUENT EVENTS
On or about June 26, 2006, the Company settled a claim brought by a
former Company consultant in connection with services the consultant provided
for the Company in 2004 and 2005. The settlement calls for (1) payment of
approximately $700,000 to the consultant over sixteen (16) months, and (2) the
issuance to the consultant of an option to purchase 500,000 shares of the
Company's restricted common stock at $0.0055 per share (the "Option"). The
Option will expire on January 15, 2007, and if the Option is exercised, the
consultant must hold the shares for a minimum of twelve (12) months. The Company
has accrued $850,000 for its obligations under the settlement in the
accompanying consolidated financial statements as of and for the year ended
December 31, 2005.
On June 14, 2006, the Fourth Appellate District of California's Court
of Appeals issued a decision in the matter of Integrated Healthcare Holdings,
Inc. v. Michael Fitzgibbons. The Court found that California's Strategic
Lawsuits Against Public Participation statute applied in this matter, reversed
the Superior Court's earlier decision in favor of the Company, and remanded the
case to the Superior Court for action consistent with its Opinion.
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INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(In millions)
BALANCE
AT BALANCE AT
YEAR ENDED BEGINNING END
DECEMBER 31, DESCRIPTION OF YEAR ADDITIONS DEDUCTIONS OF YEAR
- -------------------- ------------------------------- ----------- ----------- ----------- -----------
Accounts receivable:
2005 Allowance for doubtful accounts $ -- $37,348,984 $34,200,708 $ 3,148,276
2004 Allowance for doubtful accounts $ -- $ -- $ -- $ --
2003 Allowance for doubtful accounts $ -- $ -- $ -- $ --
Deferred tax assets:
2005 Valuation allowance $ 800,000 $13,794,878 $ -- $14,594,878
2004 Valuation allowance $ 41,000 $ 759,000 $ -- $ 800,000
F-32