[ X ]     Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2002

or

[    ]     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 0-49663

Delaware                                                                85-0410612
        (State of Incorporation)                             (I.R.S. Employer Identification No.)

101 Sun Avenue, NE
Albuquerque, New Mexico 87109
(505) 821-3355
(Address and telephone number of Registrant)

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 twelve 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 ninety days.

Yes  X                              No  __

As of August 6, 2002, there were 9,226,167 shares of the Registrant's $.01 par value
Common Stock outstanding.

1

2

     Certain statements made in this Form 10-Q including, but not limited to, statements containing the words such as "anticipate," "believe," "plan," "estimate," "expect," "intend," "may" and other similar expressions, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are inherently uncertain, and stockholders must recognize that actual results may differ materially from the Company's expectations as a result of a variety of factors, including, without limitation, those discussed below. Such forward-looking statements are based on management's current expectations and include known and unknown risks, uncertainties and other factors, many of which the Company is unable to predict or control, that may cause the Company's actual results or performance to differ materially from any future results or performance expressed or implied by such forward-looking statements. Factors that may affect the plans or results of the Company include, without limitation, the factors listed below and those referred to under the caption "Certain Additional Business Risks" section of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001:

     Many of these factors are beyond the control of the Company and its management. The Company cautions investors that any forward-looking statements made by the Company are not guarantees of future performance. The Company disclaims any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments.

3

The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets.
(Continued on next page.)

4

The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets.

5

The accompanying notes to consolidated financial statement are an integral part of these statements.
(Continued on next page.)

6

The accompanying notes to consolidated financial statements are an integral part of these statements.

7

The accompanying notes to consolidated financial statements are an integral part of these statements.
(Continued on next page.)

8

The accompanying notes to consolidated financial statements are an integral part of these statements.

9

The accompanying notes to consolidated financial statements are an integral part of these statements.

10

The accompanying notes to consolidated financial statements are an integral part of these statements.
(Continued on next page.)

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(1)  Nature of Business and Basis of Presentation

Business

     Sun Healthcare Group, Inc., a Delaware corporation, through its direct and indirect subsidiaries (hereinafter referred to collectively as "Sun" or the "Company"), operates long-term, subacute and assisted living facilities and provides related specialty healthcare services, including rehabilitation therapy services and pharmaceutical services. See "Note 6 - Assets Held for Sale", which describes certain operations that the Company has sold or intends to sell.

     On February 28, 2002, the Company and its subsidiaries emerged from proceedings under Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code") pursuant to the terms of its Plan of Reorganization. On February 6, 2002, the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court") approved the Company's Plan of Reorganization that was filed with the Bankruptcy Court on November 7, 2001.

     The Company operated its businesses as a debtor-in-possession subject to the jurisdiction of the Bankruptcy Court from October 14, 1999 until February 28, 2002. Accordingly, the consolidated financial statements of the Company prior to March 1, 2002 have been prepared in accordance with the American Institute of Certified Public Accountants Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" (SOP 90-7) and generally accepted accounting principles applicable to a going concern, which assume that assets will be realized and liabilities will be discharged in the normal course of business.

     In connection with its emergence from bankruptcy, the Company reflected the terms of the Plan of Reorganization in its consolidated financial statements by adopting the fresh-start accounting provisions of SOP 90-7. Under fresh-start accounting, a new reporting entity is deemed to be created and the recorded amounts of assets and liabilities are adjusted to reflect their estimated fair values. For accounting purposes, the fresh-start adjustments have been recorded in the consolidated financial statements as of March 1, 2002. Since fresh-start accounting materially changed the amounts previously recorded in the Company's consolidated financial statements, a black line separates the post-emergence financial data from the pre-emergence data to signify the difference in the basis of preparation of the financial statements for each respective entity.

     As used in this Form 10-Q, the term "Predecessor Company" refers to the Company and its operations for periods prior to March 1, 2002, while the term "Reorganized Company" is used to describe the Company and its operations for periods beginning March 1, 2002 and thereafter.

     The adoption of fresh-start accounting as of March 1, 2002 materially changed the amounts previously recorded in the consolidated financial statements of the Predecessor Company. With respect to reported operating results, management believes that business segment operating income of the Predecessor Company is generally comparable to that of the Reorganized Company. However, capital costs (rent, interest, depreciation and amortization) of the Predecessor Company that were based on pre-petition contractual agreements and historical costs are not comparable to those of the Reorganized Company. In addition, the reported financial position and cash flows of the Predecessor Company for periods prior to March 1, 2002 generally are not comparable to those of the Reorganized Company.

     The accompanying unaudited consolidated financial statements do not include all of the disclosures normally required by accounting principles generally accepted in the United States or those normally required in annual reports on Form 10-K. Except as noted above, and in Notes 3 and 10, the Reorganized Company has adopted the accounting policies of the Predecessor Company as described in the audited consolidated financial statements of the Predecessor Company for the year ended December 31, 2001 filed with the United States Securities and Exchange Commission (the "SEC") on Form 10-K.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     The accompanying unaudited consolidated financial statements have been prepared in accordance with the Company's customary accounting practices and accounting principles generally accepted in the United States. In the opinion of the Company's management, the accompanying interim consolidated financial statements present fairly the Company's financial position at June 30, 2002 and December 31, 2001, the consolidated results of its operations and the consolidated cash flows for the four, two and six month periods ended June 30, 2002, February 28, 2002 and June 30, 2001, respectively. Management believes that except for the items described in "Note 3 - Fresh Start Accounting" and "Note 10 - Early Extinguishment of Debt", all adjustments are of a normal and recurring nature. These statements are presented in accordance with the rules and regulations of the SEC. Accordingly, they are unaudited, and certain information and footnote disclosures normally included in the Company's annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations. Readers of these statements should refer to the Company's audited consolidated financial statements and notes thereto for the year ended December 31, 2001 and the two months ended February 28, 2002, which are included in the Company's Annual Report on Form 10-K for the year ended December 31, 2001 and in the Company's Form 8-K filed on May 31, 2002. The results of operations presented in the accompanying consolidated financial statements are not necessarily representative of operations for an entire year. Certain amounts in the 2001 consolidated financial statements and notes thereto have been reclassified to conform to the 2002 presentations.

     In July 2002, the FASB issued SFAS No. 146 "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"). SFAS 146 replaces Emerging Issues Task Force Issue No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity". SFAS 146 requires the recognition of costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company has not determined the impact that the adoption of this accounting standard will have on its consolidated financial statements.

     In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS 145"). SFAS 145 rescinds SFAS No. 4 "Reporting Gains and Losses from Extinguishment of Debt" ("SFAS 4") resulting in the criteria in Accounting Principles Board Opinion No. 30 to be used to classify gains and losses from extinguishment of debt. SFAS No. 64 "Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements" amended SFAS 4; and thus, is no longer necessary. SFAS No. 44 "Accounting for Intangible Assets of Motor Carriers" was issued to establish accounting requirements for the effects of transition to the provisions of the Motor Carrier Act of 1980. Because the transition has been completed, this statement is no longer necessary. SFAS 145 amends SFAS No. 13 "Accounting for Leases" ("SFAS 13") to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. The provisions of SFAS 145 related to the rescission of SFAS 4 shall be applied in fiscal years beginning after May 15, 2002. The provisions of SFAS 145 related to SFAS 13 are effective for transactions occurring after May 15, 2002. All other provisions of SFAS 145 are effective for financial statements issued on or after May 15, 2002. The Company continues to assess but has not determined the impact that the adoption of this accounting standard will have on its consolidated financial statements.

   In October 2001 the FASB issued SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). SFAS 144 replaces SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" ("SFAS 121"). SFAS 144 requires that long-lived assets be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. Therefore, discontinued operations will no longer be measured at net realizable value or include amounts for operating losses that have not yet occurred. SFAS 144 also broadens the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. The provisions of SFAS 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001. During the two month period ended February 28, 2002, the Predecessor Company presented the operating results of all facilities identified for sale or disposition in discontinued operations on the statement of operations. From March 1, 2002, the Reorganized Company has had a limited number of facilities disposed of or transferred to assets held for sale. These facilities’ operating results are included in continuing operations and are immaterial to the consolidated financial position and results of operations.

13

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), which establishes the accounting for goodwill and other intangible assets following their recognition. SFAS 142 applies to all goodwill and other intangible assets whether acquired singly, as part of a group, or in a business combination. SFAS 142 also applies to goodwill recognized in accordance with SOP 90-7. The Reorganized Company has approximately $237.0 million of goodwill, which was primarily recorded under fresh start accounting based on an independent valuation of the fair value of the Company’s assets and liabilities as of March 1, 2002. SFAS 142 provides that goodwill should not be amortized but should be tested for impairment annually using a fair-value based approach. In addition, SFAS 142 provides that intangible assets other than goodwill should be amortized over their useful lives and reviewed for impairment in accordance with existing guidelines. With the adoption of SFAS 142 the Company did not record amortization of goodwill in 2002 compared to amortization of $2.0 million and $4.1 million for the quarter and six months ended June 30, 2001. Additionally, net losses per share would have been $0.32 and $0.55 for the basic and diluted presentations in the three month and six month periods ended June 30, 2001, respectively, if the provisions in SFAS 142 to not record amortization or goodwill had been implemented in 2001.

     On October 14, 1999, Sun and substantially all of its U.S. operating subsidiaries filed voluntary petitions for protection under Chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court for the District of Delaware ("the Bankruptcy Court"). On February 6, 2002, the Bankruptcy Court approved the Company's Plan of Reorganization and on February 28, 2002 the Company consummated the Plan of Reorganization. The principal provisions of the Plan of Reorganization are set forth below:

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     (b)  Financial Reporting Matters

     Under Chapter 11, certain claims against the Company in existence prior to the Filing Date were stayed while the Company continued its operations as a debtor-in-possession. These claims are reflected in the accompanying consolidated balance sheets as "liabilities subject to compromise." Additional Chapter 11 claims have arisen and may continue to arise resulting from the rejection of executory contracts, including leases, and from the determination by the Bankruptcy Court of allowed claims for contingencies and other disputed amounts. Claims secured by the Company's assets ("secured claims") also were stayed although the holders of such claims had the right to petition the Bankruptcy Court for relief from the automatic stay to permit such creditors to foreclose on the property securing their claim.

     The Company determined that, generally, the fair market value of the collateral was less than the principal amount of its secured prepetition debt obligations; accordingly, the Company discontinued accruing interest on substantially all of these obligations as of the Filing Date. The Company received approval from the Bankruptcy Court to pay or otherwise honor certain of its prepetition obligations, including employee wages and benefits.

     The principal categories and the balances of Chapter 11 claims reclassified in the accompanying consolidated balance sheets as of December 31, 2001 and included in "liabilities subject to compromise" are identified below.

(in thousands):

     (c)  Debtor-in-Possession Financing

     On October 14, 1999, the Company entered into a Revolving Credit Agreement with CIT/Business Credit, Inc. and Heller Healthcare Finance, Inc. (the "DIP Financing Agreement"). The DIP Financing Agreement provided for maximum borrowings by the Company of $200 million, subject to certain limitations. The Company used borrowings from new loan agreements to pay off the Company's borrowings outstanding under the DIP Financing Agreement on February 28, 2002. See "Note 4 - Loan Agreements."

     Reorganization costs under Chapter 11 are items of expense or income that were incurred or realized by the Company because it was in reorganization. These included, but were not limited to, professional fees and similar types of expenditures incurred directly relating to the Chapter 11 proceeding, loss accruals or realized gains or losses resulting from activities of the reorganization process and interest earned on cash accumulated by the Company because it was not paying its prepetition liabilities.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     The Company adopted the provisions of fresh-start accounting as of March 1, 2002. In connection with the preparation of the Predecessor Company's Disclosure Statement, an independent financial advisor determined the Company's reorganization value, or fair value, to be $360 million to $460 million, with a point estimate value of $410 million, before considering certain long-term debt or other obligations assumed in the Plan of Reorganization. The Company's Disclosure Statement was confirmed by the Bankruptcy Court. This reorganization value was based upon the Company's projected cash flows, selected comparable market multiples of publicly traded companies and other applicable ratios and valuation techniques. The estimated total equity value of the Reorganized Company aggregating $271.8 million was determined after taking into account the values of the obligations assumed in connection with the Plan of Reorganization.

     A reconciliation of fresh-start accounting recorded as of February 28, 2002 follows (in thousands):

17

     On February 28, 2002, the Company entered into (i) a Loan and Security Agreement with certain lenders, led by Heller Healthcare Finance, Inc. as collateral agent, and Citicorp USA, Inc., as administrative agent (the "Revolving Loan Agreement,") and (ii) a Term Loan and Note Purchase Agreement with certain lenders, led by U.S. Bank National Association as administrative and collateral agent (the "Term Loan Agreement," and together with the Revolving Loan Agreement, the "Loan Agreements"). The Revolving Loan Agreement is a $150 million three-year revolving line of credit that is secured by the Company's accounts receivable, inventory, equipment and other assets, a first priority pledge of the stock of the Company's subsidiaries, other than those subsidiaries providing pharmaceutical services, and a second priority pledge of the pharmaceutical services subsidiaries. The Company's borrowing availability under the Revolving Loan Agreement is limited to up to 85% of the Company's net eligible accounts receivable and up to 50% of the Company's net eligible inventory, but not to exceed $150 million. Under the Revolving Loan Agreement, provided that an event of default has not occurred, the Company will pay interest (i) for Base Rate Loans at prime (or, if higher, the federal funds rate plus 0.50%) plus 2.75% (subject to certain adjustments) and (ii) for LIBOR Loans at the London Interbank Offered Rate plus 3.75% (subject to certain adjustments).

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     The Term Loan Agreement is comprised of a three-year $20 million term loan (the "Term Loan") and a three-year $23.7 million original issue discount note (the "Discount Note"). The Term Loan Agreement is secured primarily by a first security pledge of the stock of the Company's subsidiaries that provide pharmaceutical services and a second priority security interest in substantially all of the Company's other assets. Interest rates under the Term Loan Agreement are variable based upon either the lender's base rate (as defined) or LIBOR, plus applicable margins. Under the Discount Note, the Company's borrowing availability is approximately $20.0 million. The effective interest rates as of June 30, 2002 on borrowings under the Term Loan Agreement and Discount Note was approximately 9.0%.

     The Revolving Loan Agreement provides for maximum borrowings by the Company of up to $150.0 million, but not to exceed a defined borrowing base, which was $118.0 million on June 30, 2002. As of June 30, 2002, the Company had borrowed approximately $28.2 million and had issued approximately $42.9 million in letters of credit under the Revolving Loan Agreement, leaving approximately $46.9 million available to the Company for additional borrowing. The Company's Term Loan Agreement provides for maximum borrowings of $40.0 million. As of June 30, 2002, the Company had borrowed the maximum amount available of $40.0 million and had made principal payments of $0.8 million. The effective interest rates as of June 30, 2002 on borrowings under the Revolving Loan Agreement was approximately 7.5%.

   The Loan Agreements require the Company to maintain certain financial ratios and spending limits, including fixed charge coverage ratios, minimum operating cash flows, tangible net worth and capital expenditure limits as defined in the Loan Agreements.  For the quarter ended June 30, 2002, the Company was not in compliance with its Indebtedness to EBITDA Ratio and Tangible Net Worth financial covenants contained in its Loan Agreements.  In August 2002, the lenders under the Loan Agreements entered into waivers that waived the requirement for Company compliance with those financial covenants until September 30, 2002 for the Revolving Loan Agreement and June 29, 2003 for the Term Loan Agreement. Further, under the waiver for the Term Loan Agreement, the lender has agreed not to exercise any of its rights with respect to a default until July 1, 2003.  As a result, the Term Loan has been classified on the balance sheet in accordance with its repayment terms.  The Company has classified the Revolving Loan Agreement as a current obligation.  If the Company is unable either to enter into an amendment of the financial covenants or to fulfill the existing covenants and obtain a permanent waiver of the default with respect to the Revolving Loan Agreement for the period ending June 30, 2002 prior to September 30, 2002 and June 29, 2003 with respect to the Term Loan Agreement, then the Company will be in default under the Loan Agreements.  The default interest rates under the Revolving Loan Agreement and the Term Loan Agreement are 9.5% and 11.0% as of June 30, 2002.

   Certain of the financial covenants in the Loan Agreements, including the Indebtedness to EBITDA Ratio, are based upon the Company's EBITDA as defined in the Loan Agreements.  The financial covenants relating to EBITDA were negotiated by members of the Company’s prior management team based on projected increases from the Predecessor Company's 2001 calendar year total EBITDA.  Current management believes that those financial covenants did not reflect the characterization of certain items that impacted total EBITDA for 2001.  Those one-time events and prior year adjustments were not excluded in calculating stabilized EBITDA and, since the total EBITDA rather than stabilized EBITDA forms the basis for certain of the financial covenants, the Company was unable to fulfill those financial covenants even though EBITDA has increased quarter to quarter since the quarter ended December 31, 2001.  The Company expects that the Indebtedness to EBITDA Ratio covenant, and potentially other covenants relating to EBITDA, must be revised with respect to the quarter ending September 30, 2002 and future periods for the Company to avoid future covenant defaults under the Loan Agreements. The Company has initiated negotiations with the lenders to revise the covenants to reflect more accurately the current operating position of the Company and avoid the expected covenant defaults that would otherwise be anticipated. 

   The non-compliance of the financial covenants did not affect the Company's liquidity or its ability to borrow under the Loan Agreements during the quarter ended June 30, 2002.  The Company's cash balances and available borrowing capacity totaled $47.7 million as of June 30, 2002.

   The Company can give no assurance that it will be able to amend the financial covenants.  If the Company is unable to amend the financial covenants by the dates stated above, the lenders could exercise their remedies including but not limited to declaring amounts outstanding to be immediately due and payable and denying the Company the right to further borrowing under the Revolving Loan Agreement.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     In connection with entering into the Loan Agreements, the Company incurred deferred financing costs of $3.5 million, which are amortized using the effective interest method over the lives of the Loan Agreements.

(5)  Long-Term Debt

     As a result of the Chapter 11 filings, substantially all short and long-term debt at the Filing Date were classified as "liabilities subject to compromise" in the Company's consolidated balance sheets as of December 31, 2001 in accordance with SOP 90-7. The Company did not pay any principal or accrue any interest on prepetition obligations between October 14, 1999 and February 28, 2002 except for amounts related to certain Industrial Revenue Bonds, a fully-secured mortgage, certain capital equipment leases and a nominal amount related to a promissory note. The total amount of interest that was not required to be paid is parenthetically disclosed on the consolidated statement of operations.

     Long-term debt consisted of the following as of the periods indicated (in thousands):

     Long-term debt at June 30, 2002 includes amounts owed under the Term Loan Agreement, fully secured mortgage notes payable, certain Industrial Revenue Bonds and other debt.

     Long-term debt at December 31, 2001 includes amounts owed under the DIP Financing Agreement, one fully secured mortgage note payable, certain Industrial Revenue Bonds and other debt.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     During the four months ended June 30, 2002, the Company divested four skilled nursing facilities with 427 licensed beds. The aggregate net loss on disposal for these divestitures was approximately $1.5 million recorded in (gain) loss on sale of assets, net, in the Company's consolidated statement of operations.

     During the two months ended February 28, 2002 the Company decided to divest 11 facilities due to their history of unfavorable financial results. The facilities are expected to be divested within 12 months by terminating the lease agreement and returning the facility to the landlord, transferring control of the facility to a new operator or closing the facility or returning the real property to the mortgage holder. The carrying value of these facilities was written down to estimated fair value. The Company recorded a loss of $6.1 million in the two months ended February 28, 2002 related to these facilities. These 11 facilities generated revenues of $13.5 million and operating losses of $1.6 million in the two months ended February 28, 2002.

     In 2001, the Company agreed to sell two of its headquarters buildings in Albuquerque, New Mexico. In April 2002, the Company completed the sale of the two buildings for approximately $15.3 million, which approximated their carrying value. The purchase agreement included the leaseback of one of the buildings and part of an adjacent parking structure for an initial period of ten years, with an option to extend the lease for two five-year periods. The cost of the initial lease term is approximately $7.5 million.

     As of June 30, 2002, the components of the assets held for sale included a $3.4 million carrying value for two joint ventures in the Company's pharmacy operation and $2.5 million carrying value for a building within the Company's software development operations. The Company can give no assurance that the sales will be completed.

     The following is a summary (in thousands) of the losses or gains on the sale of assets and the losses on assets held for sale for the four months ended June 30, 2002 and two months ended February 28, 2002. The gains and losses are recorded in gain and losses on sale of assets, net, and reorganization costs (gain), net, in the Company's consolidated statements of operations. See "Note 2 - Emergence from Chapter 11 Bankruptcy Proceedings" in the Company's consolidated financial statements.

21

     The Company had construction commitments of approximately $2.0 million as of June 30, 2002, under various contracts to improve existing facilities. Expenditures routinely include improvements to facility structures, equipment and fixtures.

The Company's long-term care division has a contractual agreement through January 31, 2009 with Medline Industries, Inc. ("Medline") establishing Medline as the primary medical supply vendor for all of the long-term care facilities which the Company owns, leases and/or operates. The agreement provides that the long-term care division shall purchase at least 90% of its medical supply products from Medline. Additionally, if the Company chooses to terminate the agreement without cause or if Medline chooses to terminate the agreement with cause, the Company may be required to pay Medline liquidated damages of $3,000,000 if the agreement is terminated prior to January 11, 2003, $1,500,000 if the agreement is terminated on or between January 12, 2003 and January 11, 2004 and $750,000 thereafter through January 11, 2005.

     The Company is a party to various legal actions and administrative proceedings and subject to various claims arising in the ordinary course of business. See "Note 11 - Other Events".

     (d)  Employment Agreements

     The Company has entered into employment agreements with five of its executive officers. The agreements represent an annual obligation of the Company of approximately $2.0 million and they have various renewal options and expiration terms. In addition to the base salary, the officers are entitled to annual bonuses for each fiscal year in which the Company achieves or exceeds certain financial performance targets. If the targets are achieved, depending upon the individual’s agreement and how much the targets are exceeded, the bonuses range from 33% to 100% of base salary. Pursuant to the agreements, these officers received options to purchase an aggregate of 495,000 shares of common stock at exercise prices equal to or greater than the fair market value of the common stock at the date of grant. The options vest over the four-year period ending 2006.

     Each of the employment agreements provides that in the event of termination of employment without Good Cause (as defined in the employment agreements), then the employee would be entitled to a lump sum severance amount equal to between one to three years of base salary (depending upon the terms of the applicable agreement.) Additionally, each employee would be entitled to any earned but unpaid bonus and certain of the employees would also be entitled to one or two times the amount of the bonus which would have been earned in the year of termination (depending upon the terms of the applicable agreement.)

22

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(e)  Lease Agreements   

   The Company is currently in default of two financial covenants contained in leases of 38 skilled nursing facilities. Those covenants were negotiated by the prior lessee in 1994, prior to the Company’s acquisition of the leasehold interests in the 38 facilities. The landlord has agreed to waive those defaults through all periods ending on or prior to June 30, 2002; however, the Company anticipates that, absent a modification, the financial covenants in the leases will not be fulfilled for the quarter ending September 30, 2002. The Company initiated negotiations with the landlord to modify the lease financial covenants; however, the Company can give no assurance that it will be able to amend the lease financial covenants.  If the Company is unable to amend the financial covenants it is likely that the Company will be in default of the leases and the landlord may exercise its remedies thereunder including the potential termination of the leases (resulting in the loss to the Company of the ability to operate the facilities) and assertion of leasehold damages against the Company.

(f)  Restricted Cash

   Included in Prepaid and other assets in the Company’s Balance Sheets as of June 30, 2002 and December 31, 2001, respectively, is $6.3 million and $1.0 million of restricted cash and primarily consists of amounts to pay bankruptcy fees. Other assets, net as of June 30, 2002 and December 31, 2001, respectively, includes $3.9 million and $4.1 million of restricted cash maintained to repay a mortgage.

     As of June 30, 2002, the Reorganized Company had issued approximately 9.0 million shares of its common stock in connection with the extinguishment of the Predecessor Company's liabilities subject to compromise. The Company expects to issue an additional 1.0 million shares of its common stock once certain pre-petition claims are reconciled. The fair value of the additional common stock expected to be issued is $26.1 million and is recorded in other long-term liabilities in the June 30, 2002 consolidated balance sheet.

     As of June 30, 2002, the Reorganized Company had issued 150,000 shares of restricted common stock to its Chairman and Chief Executive Officer. The restricted common stock vests as follows: 40 percent vests on the first anniversary date of the restricted stock issuance, and 20 percent vests on each of the second, third and fourth anniversaries of the restricted stock issuance.   Restricted stock awards are outright stock grants.  The issuance of restricted stock and other stock awards usually require the recognition of compensation expense measured by the fair value of the stock on the date of grant.

     In April 2002, the Reorganized Company issued warrants to purchase approximately 500,000 shares of its common stock to the holders of the Predecessor Company's senior subordinated notes. The warrants have a strike price of $76 per share and are exercisable over a three-year period. The fair value of the warrants was estimated to be $1.8 million and is recorded in additional paid in capital in the June 30, 2002 consolidated balance sheet.

     In February 2002, the Company's board of directors adopted the 2002 Management Equity Incentive Plan, which allows for the issuance of up to 900,000 options to purchase shares of the Company's common stock. In March 2002, the Company's board of directors adopted the 2002 Non-employee Director Equity Incentive Plan, which, as amended in August 2002, allows for the issuance of up to 160,000 options to purchase shares of the Company's common stock. All stock options are issued at market value under these plans.

     As of June 30, 2002, the Company has issued 700,000 options to its officers and 24,000 options to its directors to purchase an aggregate of 724,000 shares of its common stock at $27 per share, equal to or greater than the estimated market value at date of issuance. Of those options, 450,000 vest over a four-year period, with 20 percent vesting upon issuance and the remaining portion vesting ratably over the first four anniversary dates. The remaining 274,000 options vest 25 percent per year on the first four anniversary dates. All options expire in 2009.

     Basic net income (losses) per share is based upon the weighted average number of common shares outstanding during the period.  The weighted average number of common shares outstanding in the four months ended June 30, 2002 include the common shares issued in connection with the emergence and the common shares to be issued once the pre-petition claims are finalized.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     Options and warrants outstanding at June 30, 2002 were not included in the diluted earnings per share calculation because their exercise price was equal to or greater than the estimated fair value of the Company's common stock at June 30, 2002 of $16 per share.

     In connection with the restructuring of its debt in accordance with the provisions of the Plan of Reorganization, the Company realized an extraordinary gain of $1,498.4 million. This gain has been reflected in the operating results of the Predecessor Company for the two months ended February 28, 2002.

     A summary of the extraordinary gain follows (in thousands):

     In May and August 1999, former employees of two of the Company's subsidiaries, SunBridge Healthcare Corporation and SunDance Rehabilitation Corporation, filed proposed class action complaints in the Western District of Washington. The plaintiffs sought to represent certain current and former employees of SunBridge and SunDance who were allegedly not paid appropriate wages under federal and state law since May and August 1996, respectively. Plaintiffs filed claims in the chapter 11 cases in the amount of approximately $780 million in the SunDance action and $242 million in the SunBridge action. Although the Company disputed these claims, the parties executed a stipulation of settlement, which was signed by the judge presiding over the chapter 11 cases in the United States Bankruptcy Court for the District of Delaware. The settlement provides a general unsecured claim in the chapter 11 cases of up to an aggregate $3.0 million for the claimants, the payment of claimants' attorney's fees up to $300,000, and the payment of up to $500,000 to cover the cost of notice to prospective claimants in the class and claims administration. The settlement terms remain subject to court approval.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     In March and April 1999, class action lawsuits were filed against the Company and three individuals who were at that time officers of the Company in the United States District Court for the District of New Mexico. These actions have been consolidated as In re Sun Healthcare Group, Inc. Securities and Litigation Master, File No. Civ. 99-269. The lawsuits allege, among other things, that the Company did not disclose material facts concerning the impact that PPS would have on the Company's results of operations. The lawsuits seek compensatory damages and other relief for stockholders who purchased the Company's common stock during the class-action period. Pursuant to an agreement among the parties, the Company was dismissed without prejudice in December 2000. In January 2002, the District Court dismissed the lawsuit with prejudice and entered judgment in favor of the defendants. In February 2002, the plaintiffs filed a Motion to Amend the Judgment and to File an Amended Complaint. The Company has responded in opposition to the Motion and the Company intends to vigorously defend the individual defendants in this matter, who are indemnified by the Company and covered by the Company's insurance.

      The Company is a party to various other legal actions and administrative proceedings and is subject to various claims arising in the ordinary course of its business, including claims that its services have resulted in injury or death to the residents of its facilities and claims relating to employment and commercial matters. The Company has experienced an increasing trend in the number and severity of litigation claims asserted against the Company. The Company believes that this trend is endemic to the long-term care industry and is a result of the increasing number of large judgments, including large punitive damage awards, against long-term care providers in recent years resulting in an increased awareness by plaintiff's lawyers of potentially large recoveries. In certain states in which the Company has significant operations, including California, insurance coverage for the risk of punitive damages arising from general and professional liability litigation is not available due to state law public policy prohibitions. There can be no assurance that the Company will not be liable for punitive damages awarded in litigation arising in states for which punitive damage insurance coverage is not available. The Company also believes that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on the Company.

     From time to time, fiscal intermediaries and Medicaid agencies have examined and continue to examine cost reports filed by predecessor operators of the Company's skilled nursing and hospital facilities. If, as a result of any such examination, it is concluded that overpayments to a predecessor operator were made, the Company, as the current operator of such facilities, may be held financially responsible for such overpayments. The Company may also be subject to recoupment, setoff or other liability in connection with overpayments alleged to have been made to divested facilities formerly operated by the Company. At this time the Company is unable to predict the outcome of any existing or future examinations.

     The Company is subject to extensive federal, state and local government regulation relating to licensure, conduct of operations, ownership of facilities, expansion of facilities and services and reimbursement for services. As such, in the ordinary course of business, the Company's operations are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which may be non-routine. The Company believes that it is in substantial compliance with the applicable laws and regulations. However, if the Company is ever found to have engaged in improper practices, it could be subjected to civil, administrative or criminal fines, penalties or restitutionary relief, and could be excluded from participation in the Medicare and Medicaid programs, any one or more of which may have a material adverse impact on the Company's financial results and operations.

     Federal and state governments continue to focus on efforts to curb spending on health care programs such as Medicare and Medicaid. Such efforts have not been limited to skilled nursing facilities and include other services provided by the Company, such as pharmacy and therapy services. The Company cannot at this time predict the extent to which these proposals will be adopted or, if adopted and implemented, what effect, if any, such proposals will have on the Company. Efforts to impose reduced allowances, greater discounts and more stringent cost controls by government and other payors are expected to continue.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

   The Company entered into a corporate integrity agreement (the "CIA") with the United States Department of Health and Human Services Office of Inspector General in July 2001. The agreement officially took effect on February 28, 2002. Under the terms of the agreement, the Company implemented further internal controls with respect to its quality of care standards and its Medicare and Medicaid billing, reporting and claims submission processes and engaged an independent third party to act as monitor and Independent Review Organization under the CIA.

   The current provision for income taxes of $244,000 and $523,000 for the three months ended June 30, 2002 and 2001, respectively, were based on estimated state income tax liabilities for these periods. These estimated state income tax liabilities resulted from the operations of profitable subsidiaries in states that do not allow combined, consolidated or unitary tax return filings. No overall benefits were recorded for these periods since the realization of net operating loss carryforwards is uncertain.

     The Company operates predominantly in the long-term care segment of the healthcare industry. The Company is a provider of long-term, sub-acute and related ancillary care services to nursing home patients.

     The following summarizes the services provided by the Company's reportable and other segments:

Inpatient Services: This segment provides, among other services, inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. The Company provides 24-hour nursing care in these facilities by registered nurses, licensed practical nurses and certified nursing aids. At June 30, 2002, the Company operated 243 long-term care facilities (consisting of 225 skilled nursing facilities, nine rehabilitation and long-term acute care hospitals and nine assisted living facilities) with 27,571 licensed beds as compared with 275 facilities with 31,015 licensed beds at June 30, 2001. At June 30, 2002, the Company had identified 12 facilities with 1,582 licensed beds for divestiture.

Rehabilitation and Respiratory Therapy Services: This segment provides, among other services, physical, occupational, speech and respiratory therapy supplies and services to affiliated and nonaffiliated skilled nursing facilities. At June 30, 2002, this segment provided services to 540 facilities, 316 nonaffiliated and 224 affiliated, as compared to 917 facilities at June 30, 2001, of which 645 were nonaffiliated and 272 were affiliated. In March 2002, the Company sold substantially all of the assets of its respiratory therapy operations.

Pharmaceutical and Medical Supply Services: This segment provides pharmaceutical products primarily to affiliated and nonaffiliated long-term and sub-acute care facilities for such purposes as infusion therapy, pain management, antibiotic therapy and parenteral nutrition as well as providing consultant pharmacist services. This segment provided services to 665 facilities at June 30, 2002 compared with 623 facilities at June 30, 2001. Of the 665 facilities as of June 30, 2002, 452 were nonaffiliated facilities and 213 were affiliated as compared to 382 nonaffiliated facilities and 241 affiliated facilities as of June 30, 2001. On the following tables, intersegment revenues exclude Medicaid and commercial insurance revenues derived from pharmaceutical services provided to affiliated facilities since these items are not eliminated and are billed to external parties. In January 2001, the Company sold its medical supplies operations.

Corporate: This segment provides a number of shared services to the other segments, including procurement, treasury, risk management, corporate compliance, legal, information technology, facility management, reimbursement, human resources and accounting. Also included in this segment are income taxes, reorganization costs and other costs related to the Company as a whole.

Other Operations: This segment includes temporary medical staffing services, home health and hospice, software development and other ancillary services provided to affiliated and nonaffiliated facilities.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS