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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     We currently are one of the largest providers of long-term, subacute and related specialty healthcare services in the United States. We currently operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) pharmaceutical services.

     The following is a description of our current business segments and other operations. Financial information for the business segments is set forth in "Note 16 - Segment Information" in our consolidated financial statements.

     Inpatient Services. Our long-term and subacute care facilities provide inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. We provide 24-hour nursing care in these facilities by registered nurses, licensed practical nurses and certified nursing aides. As of March 1, 2003, we operated 233 long-term care facilities (consisting of 215 skilled nursing facilities, nine assisted living facilities and nine rehabilitation and long-term acute care hospitals) in 25 states with 26,287 licensed beds through our wholly owned subsidiary, SunBridge Healthcare Corporation and other subsidiaries (collectively, "SunBridge"). As part of our restructuring efforts, we may divest approximately 56% of our skilled nursing facilities representing approximately 16,000 licensed beds. We determined that we must cease operation of those facilities because we cannot operate them profitably under the current long-term care reimbursement and business environment. See "Overview of Current Company Financial Condition."

     Our acute rehabilitation hospitals provide a range of inpatient and outpatient services for people with traumatic brain injuries, strokes, arthritis, and other disabling conditions. Our assisted living facilities serve the elderly who do not need the level of nursing care provided by long-term or subacute care facilities, but who do need some assistance with the activities of daily living.

    During the year ended December 31, 2002, we divested 10 skilled nursing facilities. We did not receive cash consideration from these divestitures. The aggregate annual net operating losses of the divested skilled nursing facilities were approximately $4.4 million in 2002. See "Note 7 - Impairment of Long-Lived Assets and Assets Held for Sale" in our consolidated financial statements. During the period of January 1, 2003 through March 1, 2003, we divested five skilled nursing facilities and we did not receive cash for these divestitures.

     Rehabilitation Therapy Services. We provide rehabilitation therapy services primarily through SunDance Rehabilitation Corporation ("SunDance"). We provide a broad array of rehabilitation therapy services, including speech pathology, physical therapy and occupational therapy. As of March 1, 2003, SunDance provided rehabilitation therapy services to 537 facilities in 40 states, 326 of which were operated by nonaffiliated parties.

     Pharmaceutical Services. We provide pharmaceutical services primarily through SunScript PharmacyCorporation ("SunScript"). Pharmaceutical services include dispensing pharmaceuticals for such purposes as infusion therapy, oral medication, pain management, antibiotic therapy and parenteral nutrition. Additional services include providing consultant pharmacists. SunScript services are typically provided to nonaffiliated and affiliated facilities, including subacute and skilled nursing care facilities, assisted living facilities, group houses, correctional facilities, mental health facilities and home healthcare companies. As of March 1, 2003, SunScript operated 32 regional pharmacies, two hospital pharmacies, three specialty disease-state pharmacies and one Part B billing company, which together provided pharmaceutical products and services to a total of 671 long-term and subacute care facilities in 19 states, 477 of which were operated by nonaffiliated parties.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     Other Operations. We are a nationwide provider of temporary medical staffing primarily through CareerStaff Unlimited, Inc. ("CareerStaff"). CareerStaff derives approximately 50% of its revenues from schools and governmental agencies, 24% from hospitals and other providers and 26% from skilled nursing facilities. CareerStaff provides (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians and (iv) related medical personnel. As of March 1, 2003, CareerStaff had 51 division offices, which provided temporary therapy and nursing staffing services in major metropolitan areas and one division office, which specialized in the placement of temporary traveling therapists in smaller cities and rural areas.

     Through SunAlliance Healthcare Services, Inc. ("SunAlliance") and SunPlus Home Health Services, Inc. ("SunPlus"), we provide mobile radiology, medical laboratory and home healthcare services in certain locations. Through our majority-owned subsidiary, Shared Healthcare Systems, Inc., which also does business under the trade name SHS.com, we develop certain software for use in the long-term care industry.

     Prior Operations. During January 2001, we sold substantially all of the assets of our SunChoice medical supplies operations to Medline Industries, Inc. We received proceeds of $16.6 million in exchange for the SunChoice assets.

     During February 2001, we sold our operations in the United Kingdom. Those operations included 146 long-term care facilities with 8,326 licensed beds. We did not receive any material cash payments in exchange for these operations; however we were released from approximately $112.9 million of aggregate debt, capital lease obligations, notes payable and other liabilities upon consummation of the sale. Our operations in Australia were liquidated in July 2001 and we received liquidation proceeds of approximately $0.9 million. We divested our long-term care and pharmacy operations in Germany in February 2001 for approximately $3.5 million. We sold our long-term care operations in Spain in October 2000 for approximately $7.6 million. At December 31, 2001, we had no operations outside of the U.S.

     In March 2002, we divested our respiratory therapy supplies and equipment business that was operated by our wholly-owned subsidiary, SunCare Respiratory Services, Inc. We received $0.9 million in cash for these assets.

    The approximate number of facilities that we operated worldwide has decreased from approximately 600 on December 31, 1998 to 233 as of March 1, 2003. The approximate number of our full and part-time employees worldwide has decreased from approximately 80,700 on February 20, 1999 to 33,000 on March 1, 2003. We are continuing our restructuring efforts in 2003.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     Defaults under Leases and Mortgages. In our effort to reduce our costs, in January 2003, we initiated new restructuring efforts. Our ongoing efforts include an attempt to restructure the portfolio of leases under which we operate most of our long-term care facilities. We are seeking to obtain rent concessions with respect to our under-performing facilities, and if we are unable to get sufficient rent concessions on a facility lease, or if we determine that it is no longer advisable to continue operating that facility, then we will seek to transition operations of that facility to a new operator so that we will no longer be burdened by the losses generated by that facility. We are currently attempting to transition approximately 56% of our long-term care facilities to new operators. As of March 21, 2003, we had withheld payment of approximately $18.9 million in accrued rent and mortgage payments with respect to those facilities. In addition, we intend to continue withholding certain rent and mortgage payments until we complete the transition of each affected facility to new operators. Our restructuring efforts are likely to require nine to 12 months to complete and we may need to consider selling additional assets during that period in order to have sufficient liquidity to complete the restructuring. We cannot predict the extent to which landlords not receiving rent will seek to assert leasehold or other damages during the nine to 12 month restructuring period. If the landlords aggressively pursue and obtain such damages, we will likely be required to commence bankruptcy proceedings prior to the completion of our restructuring.

    2003 Restructuring. Our goal is to restructure our business so that we can fund our operations and working capital requirements while remaining a significant provider of skilled nursing and other long-term care facilities. We will also seek to reduce our overhead and other expenses significantly, commensurate with reducing the size of our long-term care facility portfolio. Although we have had encouraging discussions and are making progress with many landlords from whom we are seeking to obtain rent concessions or facility lease terminations, and have reached agreements in principle or final agreements with several of our landlords, no assurance can be given that we will be successful in our restructuring efforts. In addition, it is not certain that our available liquidity will provide us with sufficient time to allow us to reduce our overhead and other expenses as required for us to generate sustainable ongoing positive cash flow from our operations.

     Revenue Sources. We receive revenues from Medicare, Medicaid, private insurance, self-pay residents, other third party payors and long-term care facilities that utilize our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our facilities, the acuity level of patients and the rates of reimbursement among payors. Likewise, payment for ancillary medical services, including the institutional pharmacy services of SunScript and the therapy services provided by SunDance, will vary based upon payor and payment methodologies. The following table sets forth the total revenues and percentage of revenues by payor source for our U.S. operations for the years indicated (in thousands):

    Changes in the mix of patients among the Medicaid, Medicare Part A and private pay categories, and among different types of private pay sources, could significantly affect our revenues and results of operations. In addition, we cannot be certain that the facilities operated by us, or the provision of services and products by us, now or in the future, will initially meet or continue to meet the requirements for participation in the Medicare and Medicaid programs. A loss of Medicare or Medicaid certification or a change in our reimbursement under Medicare or Medicaid could reduce our revenues and adversely affect our results of operations and cash flows.

     The following table sets forth the approximate average amounts of Medicare Part A revenues per patient per day recorded by our inpatient and hospital facilities for the years indicated:

     Medicaid is a federal-state matching program, whereby the federal government, under a needs-based formula, matches funds provided by the participating states for medical assistance to "medically indigent" persons. The programs are administered by designated state agencies following federal and state rules. Although Medicaid programs vary from state to state, traditionally they have provided for the payment of certain expenses, up to established limits, at rates determined in accordance with each state's regulations. For skilled nursing facilities, most states pay prospectively determined per diem rates, and have some form of acuity adjustment. In addition to facility-based services, most states cover an array of medical ancillary services, including those services provided by institutional pharmacies. Payment methodologies for these services vary based upon state law and regulations permitted under federal rules.

      Reduced Medicare Reimbursements. Medicare reimburses our skilled nursing facilities under a prospective payment system ("PPS") for inpatient Medicare Part A covered services. PPS was adopted pursuant to the Balanced Budget Act of 1997 (the "1997 Act"). Under PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients, and such amount is determined by classifying each patient into one of 44 resource utilization groups ("RUG"). The nursing home industry came under financial pressure as a result of the implementation of PPS and other 1997 Act provisions.  As a result, Congress enacted The Balanced Budget Refinement Act of 1999 ("BBRA") and the Medicare, Medicaid and SCHIP Benefits Improvement Act of 2000 ("BIPA") to provide some relief to the industry. The BBRA and BIPA required four Medicare "add-on" payments: a 4% increase in per diem rates; a 16.7% increase in the nursing component of each RUG; a 20% increase for certain categories of high cost, medically complex patients; and a 6.7% increase for rehabilitation RUGs.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     On September 30, 2002, two of the add-on provisions of the Medicare payment regulations expired: the 4% add-on for all patient categories in the RUG system and the 16.7% add-on for nursing related costs. We currently estimate that our Medicare revenues decreased by approximately $8.6 million ($36.98 per patient day) for the period of October 1, 2002 to December 31, 2002, and we estimate, that based upon the number of facilities that we currently operate, we will experience a decrease of approximately $32.9 million for the year ended December 31, 2003 if these add-ons are not restored, although the decrease could be greater than anticipated. In addition to the elimination of the add-ons, CMS announced a 2.6% market basket increase in payments to skilled nursing facilities. For the period of October 1, 2002 to December 31, 2002, we estimate that the market basket increase resulted in approximately $2.1 million ($9.49 per patient day) in revenue, and we estimate, that based upon the number of facilities that we currently operate we will experience an increase of approximately $8.5 million in revenue to our inpatient facilities for the year ended December 31, 2003. The net result of the expiration of the add-ons and the market basket increase is an estimated Medicare revenue decrease of approximately $24.4 million ($27.49 per patient day) for the year ended December 31, 2003.

     The remaining two add-on payments, the 6.7% increase for patients requiring intense rehabilitation and a 20.0% increase for patients requiring complex medical care, are scheduled to expire on the earlier of September 30, 2003 or at such time as CMS completes the case mix refinements. The refinements are intended to ensure nursing homes are fairly and accurately reimbursed for taking care of medically complex patients. CMS has determined that the research is not sufficiently advanced at the present time to implement the refinements in the 2003 Federal fiscal year. Although the add-ons will expire when these refinements are implemented, it is expected that the add-ons will be replaced by new payment rates that are not known at this time. If the add-ons expire and are not replaced, we estimate that, based upon the number of long-term care facilities we currently operate, our per beneficiary per diems would decrease by approximately $27.00, which would account for $27.5 million annually. The loss of these add-ons would have a material adverse effect on our financial position, results of operations and cash flows.

     Medicare Part B payments are generally adjusted annually, effective upon the calendar year beginning January 1 and ending December 31. On December 31, 2002, CMS issued a final rule providing a 4.4% decrease to the payment fee, effective on March 1, 2003. However, the recently enacted federal spending bill for fiscal 2003 allowed CMS to revise the figures used in the statutory formula and increase the update from a negative 4.4% to a positive 1.6%.

     The 1997 Act also implemented a restriction applicable to Medicare Part B payments that would limit the amount of reimbursements we receive per patient per day for rehabilitation therapy. BBRA and BIPA placed a moratorium on that limitation; however, the moratorium expires on June 30, 2003.  We estimate the application of the limitation will reduce SunDance's revenue by approximately $7.2 million and our inpatient services revenue by $0.9 million for the six months ended December 31, 2003, based upon the number of long-term care facilities we currently operate.

     We also expect our annual revenue from our home health services to decrease by approximately $2.1 million due to recent legislation. Additionally, as non-affiliated healthcare providers that are serviced by our ancillary services operations, including our pharmaceutical, rehabilitative services, laboratory and radiology operations, are negatively affected by reduced reimbursements to their operations, we could experience negative trends in customer credit-worthiness, lengthened payment cycles, increased exposure to loss on accounts receivable and reductions in our ancillary services business.

     In a notice of proposed rulemaking issued on February 10, 2003, CMS proposed a significant change for the reimbursement of Medicare Part A bad debts. The proposal would subject all providers to a 30% reduction in Medicare Part A bad debt reimbursement. CMS proposes to implement the reduction incrementally over a three year period to mitigate its impact: 10% for cost reporting periods beginning October 1, 2003, 20% for cost reporting periods beginning October 1, 2004, and 30% for cost reporting years beginning October 1, 2005 and thereafter. Based upon the estimated Medicare bad debts that we will claim on our 2002 cost reports, we estimate that, based upon the number of long-term care facilities we currently operate, that our Medicare revenues would decrease by approximately $0.8 million in 2004, $1.6 million in 2005 and $2.4 million in 2006 if the proposed changes are implemented.

     To summarize, we estimate that our Medicare revenues will decrease by approximately $34.6 million during the year ended December 31, 2003 as a result of the known changes to Medicare and assuming that we continue operating all of our facilities. This decrease includes: a $32.9 million decrease to inpatient revenues as a result of the expiration of the add-ons; a $8.5 million increase to inpatient revenues as a result of the market basket increase; a $7.2 million decrease to therapy revenues and a $0.9 million decrease in inpatient services revenues as a result of the expiration of the therapy cap moratorium; and a $2.1 million decrease in home health revenues as a result of legislative changes.

     The reimbursement rates for pharmacy services under Medicaid are determined on a state-by-state basis subject to review by CMS and applicable federal law. In most states, pharmacy services are priced at the lower of "usual and customary" charges or cost (which generally is defined as a function of average wholesale price and may include a profit percentage) plus a dispensing fee. Certain states have "lowest charge legislation" or "most favored nation provisions" which require our institutional pharmacy to charge Medicaid no more than its lowest charge to other consumers in the state.

     Additionally, pharmacy coverage and cost containment are important policy debates at both the federal and state levels. Congress has considered proposals to expand Medicare coverage for outpatient pharmacy services. Enactment of such legislation could affect institutional pharmacy services. Likewise, a number of states have proposed cost containment initiatives. Specifically, California, Massachusetts and Washington have enacted pharmacy rate reductions that, based upon the number of long-term care facilities we currently operate, will reduce our revenue by approximately $2.3 million during the year ended December 31, 2003. Changes in payment formulas and delivery requirements could impact SunScript.

     Other Reimbursement Matters. Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment by payors during the settlement process. Under cost-based reimbursement plans, payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable or because additional supporting documentation is necessary. We recognize revenues from third-party payors and accrue estimated settlement amounts in the period in which the related services are provided. We estimate these settlement balances by making determinations based on our prior settlement experience and our understanding of the applicable reimbursement rules and regulations. The majority of Medicaid balances are settled two to three years following the provision of services. There can be no assurance that we will not be required to negatively adjust future earnings as a result of settlements with payors.

     Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid. This focus has not been limited to skilled nursing facilities, but include other services provided by us, such as pharmacy and therapy services. We 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 us. Efforts to impose reduced coverage, greater discounts and more stringent cost controls by government and other payors are expected to continue.

     Furthermore, government programs are subject to statutory and regulatory changes, retroactive rate adjustments, administrative rulings and government funding restrictions, all of which may materially affect the rate of payment to our facilities and our therapy and pharmaceutical services businesses. There can be no assurance that payments under governmental programs will remain at levels comparable to present levels or will be adequate to cover the costs of providing services to patients eligible for assistance under such programs. Significant decreases in utilization and changes in reimbursement could have a material adverse effect on our financial condition, results of operations, and cash flows including the possible impairment of certain assets.

     We receive approximately 28% of our revenues from private insurance, long-term care facilities that utilize our specialty medical services, self-pay facility residents, and other third party payors. These private third party payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers, increased utilization review and greater enrollment in managed care programs and preferred provider organizations. These private payors increasingly are demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

     Managed care organizations and other third party payors have continued to consolidate in order to enhance their ability to influence the delivery of healthcare services. Consequently, the healthcare needs of a large percentage of the population are increasingly served by a smaller number of managed care organizations. These organizations generally enter into service agreements with a limited number of providers for needed services. To the extent these organizations terminate us as a preferred provider and/or engage our competitors as a preferred or exclusive provider, this source of revenues would be lost. In addition, private payors, including managed care payors, increasingly are demanding discounted fee structures or the assumption by healthcare providers of all or a portion of the financial risk through prepaid capitation (i.e., a fixed amount per person) arrangements.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     For periods prior to the effective date of PPS for skilled nursing facilities and for all cost reporting providers, certain Medicare regulations applied to transactions between related parties, such as between our subsidiaries that operate skilled nursing facilities or hospitals and subsidiaries that provide ancillary services. These regulations limit the amount of reimbursement that our facilities are entitled to receive for certain goods and services provided by our ancillary subsidiaries. An exception to the related party regulations is available provided that, among other things, a substantial part of the services of the relevant subsidiary supplier be transacted with nonaffiliated entities. When that exception applies, the facility may receive reimbursement for goods and services provided by our ancillary subsidiaries at the rates applicable to goods and services provided to nonaffiliated entities. The related party regulations do not indicate a specific level of services that must be provided to nonaffiliated entities in order to satisfy the "substantial part" requirement of this exception. In instances where others have litigated this issue, no consistent standard has emerged as to the appropriate threshold necessary to satisfy the "substantial part" requirement.

     The implementation of PPS and the corresponding fee schedules have significantly reduced the Medicare impact of the related party rule, but the related party rule continues to affect certain Medicaid cost reports for our skilled nursing facilities and hospitals and will also affect Medicare cost reports for hospitals for cost reporting years ended December 31, 2001. Although we have not completed our calculations for the year ended December 31, 2002, we believe that the percentages discussed below will be approximately the same as in prior years. Our net revenues from rehabilitation therapy services, together with net revenues from temporary medical staffing services, provided to nonaffiliated facilities represented 58% and 56% of total net revenues for those two operations for the years ended December 31, 2001 and 2000, respectively. Respiratory therapy services provided to nonaffiliated facilities represented 84% and 67% of total respiratory therapy services net revenues for the years ended December 31, 2001 and 2000, respectively. Net revenues from pharmaceutical services billed to nonaffiliated facilities represented 80% and 79% of total pharmaceutical services revenues for the years ended December 31, 2001 and 2000, respectively. We use certain variables such as percent of revenue derived from nonaffiliated parties and associated service charges to determine whether we have met the requirements. Except for our software division, we met the related party exception allowing for the reimbursement of our charges to the inpatient facilities division for cost reports filed for the years ended December 31, 2000 and December 31, 2001. We adjusted the 2000 cost reports by decreasing the charges the inpatient facilities received from the software division to the cost basis of those services, and we are required to do the same for the 2001 cost reports. We have determined that the impact of these cost report adjustments in the Medicare revenues recorded for the years ended December 31, 2000 and December 31, 2001 is not significant. If we were deemed not to have satisfied these regulations, the reimbursement that we receive for goods and services provided to our own facilities could be significantly reduced, which could materially and adversely affect our financial condition, results of operations and cash flows. If, upon audit by federal or state reimbursement agencies, such agencies find that the exception has not been satisfied, and if, after appeal, their findings are sustained, we could be required to refund some or all of the difference between our cost of providing these services to any entity found to be subject to the related party regulations and the fair market value amount actually received.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     Our subsidiaries are engaged in industries that are extensively regulated. In the ordinary course of business, our operations are continuously subject to state and federal regulatory scrutiny, supervision and control. This often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which may be non-routine. In addition to being subject to the direct regulatory oversight of state and federal regulatory agencies, these industries are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is ever found by a court of competent jurisdiction to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief, and reimbursement authorities could also seek the suspension or exclusion of the provider or individuals from participation in their program. If a facility is decertified by CMS or a state as a Medicare or Medicaid provider, the facility will not thereafter be reimbursed by the federal government for caring for residents that are covered by Medicare and Medicaid, and the facility would be forced to care for such residents without being reimbursed or to transfer such residents.There can be no assurance that the outcome of any pending or future proceedings or investigations will not have a material adverse effect on our results of operations and financial condition.

     Long-term care facilities must comply with certain requirements to participate in Medicare or Medicaid. Regulations promulgated pursuant to the Omnibus Budget Reconciliation Act of 1987 obligate facilities to demonstrate compliance with requirements relating to resident rights, resident assessment, quality of care, quality of life, physician services, nursing services, infection control, physical environment and administration. Regulations governing survey, certification and enforcement procedures to be used by state and federal survey agencies to determine facilities' level of compliance with the participation requirements for Medicare and Medicaid were adopted in 1995. These regulations require that surveys focus on residents' outcomes of care and state that all deviations from participation requirements are considered deficiencies. A facility may have deficiencies and still be in substantial compliance with the regulations. The regulations identify alternative remedies for facilities and specify categories of deficiencies for which they will be applied. The alternative remedies include, but are not limited to: civil monetary penalties of up to $10,000 per day; facility closure and/or transfer of residents in emergencies; denial of payment for new or all admissions; directed plans of correction; and directed in-service training. Failure to comply with certain standards as a condition to participate in the Medicare and Medicaid programs may result in termination of the provider's Medicare and Medicaid provider agreements.

     Most states in which we operate have statutes which require that prior to the addition or construction of new nursing home beds, the addition of new services or certain capital expenditures in excess of defined levels, we first must obtain a Certificate of Need which certifies that the state has made a determination that a need exists for such new or additional beds, new services or capital expenditures. The certification process is intended to promote quality health care at the lowest possible cost and to avoid the unnecessary duplication of services, equipment and facilities.

     The Medicare and Medicaid anti-kickback statute prohibits the knowing and willful solicitation or receipt of any remuneration "in return for" referring an individual or for recommending or arranging for the purchase, lease or ordering of any item or service for which payment may be made under Medicare or a state healthcare program. In addition, the statute prohibits the offer or payment of remuneration "to induce" a person to refer an individual or to recommend or arrange for the purchase, lease or ordering of any item or service for which payment may be made under the Medicare or state healthcare programs.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     False claims are prohibited pursuant to criminal and civil statutes. Criminal provisions prohibit filing false claims or making false statements to receive payment or certification under Medicare or Medicaid or failing to refund overpayments or improper payments; violation of these provisions are felonies punishable by up to five years imprisonment and/or $25,000 fines. Civil provisions prohibit the knowing filing of a false claim or the knowing use of false statements to obtain payment; penalties for violations are fines of not less than $5,000 nor more than $10,000, plus treble damages, for each claim filed. Suits alleging false claims can be brought by individuals, including employees and competitors. Allegations have previously been made under the civil provisions of the statute in certain qui tam actions that we have filed false claims. We are not aware of any pending qui tam actions against us.

     We believe that our facilities and service providers materially comply with applicable regulatory requirements. From time to time, however, we receive notice of noncompliance with various requirements for Medicare/Medicaid participation or state licensure. We review such notices for factual correctness, and based on such reviews, either take appropriate corrective action and/or challenge the stated basis for the allegation of noncompliance. In most cases, we agree with the reviewing agency upon measures to be taken to bring the facility or service provider into compliance. Under certain circumstances, however, such as repeat violations or a high degree of perceived severity of the violations, the federal and state agencies have the authority to take adverse actions against a facility or service provider, including the imposition of monetary fines, the decertification of a facility or provider from participation in the Medicare and/or Medicaid programs or licensure revocation. Challenging and appealing notices of noncompliance can require significant legal expenses and management attention.

     We believe that enforcement activities at both the federal and state levels and qui tam actions brought by private parties have increased in recent years. In addition, during our bankruptcy proceedings, we experienced a further increase in regulatory oversight from both federal and state regulatory bodies. We may be required to expend substantial amounts to cooperate with, or to defend ourselves against, any investigations and proceedings. If we are found to have failed to comply with any of the anti-fraud provisions, including those discussed in the paragraphs above, we could be materially and adversely affected.

     If a nursing facility is decertified from the Medicare and Medicaid programs, its Medicare and Medicaid reimbursement is interrupted pending recertification, a process that can take at least several months. In the interim, the facility may continue to provide care to its residents without Medicare and Medicaid reimbursement, or the government may relocate Medicare and Medicaid residents to other facilities. Terminations, bans on admission and civil monetary penalties can cause material adverse financial and operational effects on individual facilities. The federal government has, in the past, decertified some of our facilities from the Medicare and Medicaid programs. From time to time federal and state survey agencies have also imposed bans on admissions and civil monetary penalties against our facilities on the basis of alleged regulatory deficiencies. When appropriate, we vigorously contest such sanctions and in some cases have sought and obtained federal court injunctions against proposed sanctions. Such cases require significant legal expenses and management attention. There can be no assurance that the federal government will not attempt to decertify additional facilities of ours from the Medicare and Medicaid programs in the future.

Corporate Integrity Agreement, Permanent Injunction, and Compliance Process

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     Our compliance program, referred to as the "Compliance Process," was initiated in 1996. It has evolved as the requirements of federal and private healthcare programs have changed. Significant refinements were initiated in 2001 to parallel requirements of the OIG compliance guidelines, the CIA, and the PIFJ. There are seven principle elements to the Compliance Process, which integrate the CIA and PIFJ requirements:

     Written Policies, Procedures and Standards of Conduct.  Our subsidiaries have extensive policies and procedures ("P&Ps") modeled after applicable laws, regulations, government manuals and industry practices and customs. The P&Ps govern the clinical, reimbursement, and operational aspects of each subsidiary. To emphasize adherence to our P&Ps, we publish and distribute a Code of Conduct and each subsidiary publishes and distributes an employee handbook.

     Designated Compliance Officer and Compliance Committee. In August 2000, we appointed a Corporate Compliance Officer. The responsibilities of the Corporate Compliance Officer include, among other things: (i) overseeing the Compliance Process; (ii) ensuring compliance with the CIA, PIFJ, and functioning as the liaison with the external monitors and federal government on matters related to the Compliance Process, CIA, and PIFJ; (iii) reporting to the Board of Directors and senior corporate managers on the status of the Compliance Process; and (iv) overseeing the coordination of a comprehensive education and training program which focuses on the elements of the Compliance Process.

     We also maintain a Corporate Compliance Committee, which includes the Chief Executive Officer, Chief Financial Officer, General Counsel, Senior Vice President of Human Resources, President and Executive Vice President of SunBridge, and the Corporate Compliance Officer. This Committee meets regularly to discuss compliance-related issues. Compliance matters are also reported to the Compliance Committee of the Board of Directors on a regular basis.

     Effective Training and Education. We continue to develop and implement regular training and education programs for all employees. Every employee, director and officer is trained on the Compliance Process, Code of Conduct, and CIA. All California administrators are trained on the PIFJ, as required. Training also occurs for appropriate employees in applicable provisions of the Medicare and Medicaid laws, fraud and abuse prevention, clinical standards, and practices, and claim submission and reimbursement P&Ps. These training sessions explain the consequences both to the individual and to the Company for failure to comply with any of these requirements or to report breaches of those requirements.

     Effective Lines of Communication. Employees are encouraged to report issues of concern without fear of retaliation using a Four Step Reporting Process, which includes the toll-free "Sun Quality Line." The Four Step Reporting Process encourages employees to discuss clinical, ethical, or financial concerns with supervisors and local management since these individuals will be most familiar with the laws, regulations, and policies that impact their concern. In addition, the Sun Quality Line is promoted as an always-available option that may be used for anonymous reporting if the employee so chooses. The telephone number for the Sun Quality Line is posted prominently in places that are accessible to employees in all of our facilities. Written non-retaliation and reporting policies have been developed and distributed to all employees to encourage communication and the reporting of incidents. Reports to the Sun Quality Line are internally reviewed and proper follow-up is conducted. Appropriate actions are taken during and following investigations to correct any non-compliance, including but not limited to, corrective action plans, government reports and over-payment refunds.

     Internal Monitoring and Auditing. Our Compliance Process, in accordance with the CIA, puts internal controls in place to meet the following objectives effectively:

     We have designated the subsidiary presidents and each member of the operations management team, including SunBridge facility and hospital administrators, as Compliance Liaisons. Each Compliance Liaison is responsible for making certain that all requirements of the Compliance Process and our compliance documents are completed at the operational level for which the Compliance Liaison is responsible.      

     Each business line also employs a number of licensed professionals who monitor and audit compliance with P&Ps and other standards to ensure that the objectives listed above are met.

     Enforcement of Standards. Our policies, the Code of Conduct and the employee handbook as well as all associated training materials clearly indicate that employees who violate our standards will be subjected to discipline. Sanctions range from oral warnings to suspensions, to termination of employment. Such sanctions have been applied in response to intentionally wrongful conduct as well as in instances where an employee has failed to adequately monitor the activities of others. While we have implemented such disciplinary policies, we have also adopted a pro-active approach to secure the integrity of our workforce and offset the need for punitive measures.

     First, we have implemented employee background review practices that surpass industry standards. A seven-year historical study is completed on every prospective employee and includes the OIG/GSA Sanction List Review, Criminal Record Review, Credentials Verification, and Motor Vehicle Record Review (as required).

     Second, as noted above, we devote significant resources to employee training. Our employees are required to participate in compliance training as well as other education endeavors aimed at understanding policies, procedures, standards, and laws related to job responsibilities. We believe that understanding these parameters will prevent and provide for early detection of non-compliance.

     Finally, we have adopted a performance management program intended to make certain that all employees are aware of what duties are expected of them and understand that compliance with policies, procedures, standards, and law related to job functions is required.

     Responses to Detected Offenses and Development of Corrective Actions.  Correction of detected misconduct or a violation of a Company policy is the responsibility of every manager. As appropriate, a manager is expected to develop and implement corrective action plans and monitor whether such actions are likely to keep a similar violation from occurring in the future.

     In December 2000, the federal government released the final privacy rules of the Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). The rules provide for, among other things, (i) giving consumers the right and control over the release of their medical information, (ii) the establishment of boundaries for the use of medical information, and (iii) penalties for violation of an individual's privacy rights.

     These privacy regulations apply to "protected health information," which is defined generally as individually identifiable health information transmitted or maintained in any form or medium, excluding certain education records and student medical records. The privacy regulations seek to limit the use and disclosure of most paper, oral and electronic communications regarding an individual's past, present or future physical or mental health or condition, or relating to the provision of healthcare to the individual or payment for that healthcare, if the individual can or may be identified by such information. HIPAA provides for the imposition of civil or criminal penalties if protected health information is improperly disclosed. We are required to comply with the HIPAA privacy rules beginning April 14, 2003, and we have expended substantial efforts and will require additional resources for our initial and ongoing compliance with these rules.

     HIPAA's security regulations were finalized in February 2003. The security regulations specify administrative procedures, physical safeguards and technical services and mechanisms designed to ensure the privacy of protected health information. We will be required to comply with the security regulations beginning on April 21, 2005.

     In addition, HIPAA also mandates the adoption of regulations aimed at standardizing transaction formats and billing codes for documenting medical services, dealing with claims submissions and protecting the privacy and security of individually identifiable health information. HIPAA regulations that standardize transactions and code sets became final in the fourth quarter of 2000. These regulations do not require healthcare providers to submit claims electronically, but require standard formatting for those that do. We currently submit some of our claims electronically to Medicare and Medicaid through our fiscal intermediary and will continue to do so. We will be required to comply with HIPAA transaction and code set standards on October 16, 2003. If we are not able to submit claims electronically, or the States are not able to receive claims electronically, then our receipt of our reimbursements could be disrupted.

Additional Business Risks

     Impact of 2003 Restructuring on Ancillary Operations. Approximately 61% of our rehabilitation therapy services revenue and 20% of our pharmacy services revenue is derived directly from the provision of services to our inpatient facilities.  Additionally, another 24% of our pharmacy services revenue is generated from the provision of services to patients residing in our inpatient facilities, but are billed to non-affiliated parties.  Pursuant to our 2003 restructuring, we are seeking to divest approximately 56% of our inpatient facilities.  The new operators of those facilities may determine to use alternative providers of pharmaceutical and therapy services. In the event that SunScript and SunDance no longer provide services to the divested facilities, we will be required to take appropriate steps to reduce their costs. We can provide no assurance that SunScript and SunDance will maintain the divested facilities as customers, or that they will be able to continue to achieve results of operations comparable to what they achieved in the past.

     Collection of Accounts Receivable. Our bad debt expense for the years ended December 31, 2002, 2001 and 2000 was $15.2 million, $26.0 million and $33.5 million, respectively. Our allowance for doubtful accounts was $45.9 million and $73.8 million at December 31, 2002 and 2001, respectively. Due to the expiration of certain Medicare Part A enactments on September 30, 2002 (see above), and other healthcare reforms adopted which decrease Medicare or Medicaid payments to skilled nursing facilities, our ancillary services operations may experience a significant increase in bad debt expense. In addition, as part of our 2003 restructuring, we are seeking to divest approximately 56% of our inpatient facilities, and we will retain the rights to all accounts receivable for those facilities that arose prior to the date of divestiture. Based on our prior experience, we expect that we will have an increased percentage of bad debts associated with the divested facilities. Our financial condition, results of operations, and cash flows could be materially adversely affected by the inability to collect our accounts receivable.

     Shortage of Qualified Facility Personnel and Increasing Labor Costs. We, and other providers in the long-term care industry, have had and continue to have difficulties in retaining qualified personnel to staff our long-term care facilities, particularly nurses, and in such situations we will use temporary employment agencies to provide additional personnel. The labor costs are generally higher for temporary employees than for full-time employees. In addition, many states have increased minimum staffing standards and CMS is also studying whether minimum staffing standards should be imposed on skilled nursing facilities. As minimum staffing standards are increased, we may be required to retain additional staffing. In addition, in recent years we have experienced increases in our labor costs primarily due to higher wages and greater benefits required to attract and retain qualified personnel and to increase staffing levels in our long-term and subacute care facilities.

     New Management Team. Our Chief Executive Officer, Chief Financial Officer, General Counsel, President of SunBridge Healthcare Corporation, Senior Vice President of Human Resources and our entire Board of Directors have all joined us since November 2001. As such, there has been a period of transition in which the new management team has implemented new business strategies, policies and practices. We believe that the success of the Company will depend on our ability to retain the members of our management team; however, there can be no assurance that we will be able to retain those executive officers and other key employees. The loss of the services of any of our executive officers or key employees could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     The nature of competition within our industry varies by location. Our facilities generally operate in communities that are also served by similar facilities operated by others. Some competing facilities are located in buildings that are newer than those operated by us and provide services not offered by us, and some are operated by entities having greater financial and other resources and longer operating histories than us. In addition, some facilities are operated by nonprofit organizations or government agencies supported by endowments, charitable contributions, tax revenues and other resources not available to us. Some hospitals that either currently provide long-term and subacute care services or are converting their under-utilized facilities into long-term and subacute care facilities are also a potential source of competition to us. We compete with other facilities based on key competitive factors such as our reputation for the quality and comprehensiveness of care provided; the commitment and expertise of our staff; the innovativeness of our treatment programs; local physician and hospital support; marketing programs; charges for services; and the physical appearance, location and condition of our facilities. The range of specialized services, together with the price charged for services, are also competitive factors in attracting patients from large referral sources.

     We also compete with other companies in providing rehabilitation therapy services and pharmaceutical products and services to the long-term care industry and in employing and retaining qualified therapists and other medical personnel. Many of these competing companies have greater financial and other resources than us. We may encounter increased competition in the future that would adversely affect our financial condition, results of operations and cash flows.

Employees and Labor Relations

     As of March 1, 2003, we had approximately 33,400 full-time and part-time employees. Of this total, there were 25,600 employees in our long-term and subacute care facilities, 3,000 employees in the rehabilitation therapy services operations, 1,000 employees in the pharmaceutical services operations, 1,300 employees in the temporary staffing business, 700 employees at the corporate and regional offices and 1,800 employees in other health care services. As we divest inpatient facilities pursuant to our restructuring initiative, the number of employees in our long-term and subacute care facilities will decrease accordingly and the number of employees is our ancillary businesses may also be reduced

     Certain of our employees in Alabama, California, Connecticut, Florida, Georgia, Massachusetts, New Jersey, New Mexico, Ohio, Tennessee and West Virginia are covered by collective bargaining contracts. The unions representing certain of our employees have from time to time gone on strike. Due to our financial condition, we did not raise the pay of certain workers in collective bargaining units in some of our Connecticut facilities in March 2003, as contemplated under our union contract. There can be no assurance that the unions will not go on strike in the future or that such strikes will not have a material adverse effect on our financial condition, results of operations and cash flows.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     We calculated our aggregate occupancy percentages for all of our long-term care, subacute care and assisted living facilities on a same store basis as 88.6%, 89.3% and 90.0% in the U.S. for the years ended December 31, 2002, 2001 and 2000, respectively. However, we believe that occupancy percentages, either individually or in the aggregate, should not be relied upon alone to determine the performance of a facility. Other factors include, among other things, the sources of payment, terms of reimbursement and the acuity level of the patients. We compute occupancy percentages by dividing the average daily number of beds occupied by the total number of available beds for use during the periods indicated.

     The following table sets forth certain information concerning the 233 long-term care, subacute care and assisted living facilities that we operated as of March 1, 2003, which consisted of 215 skilled nursing facilities, nine assisted living facilities and nine rehabilitation and long-term acute care hospitals. As part of our restructuring efforts, we may divest approximately 56% of the facilities in the table representing approximately 16,000 licensed beds during 2003. See Overview of Current Company Financial Condition."

     We are seeking to restructure our portfolio of leases and mortgages under which we operates 56% of our long-term care facilities. In January 2003, we began withholding rent and mortgage payments with respect to these facilities. We have negotiated and continue to negotiate with many of our landlords and mortgage holders in an effort to achieve consensual resolution of these issues. However, several landlords and mortgage holders have threatened to commence eviction or similar proceedings against us. Additional actions seeking damages or other leasehold remedies may also be commenced. See "Item 1. Business - Overview of Current Company Financial Condition."

23

     We began issuing our new common stock on February 28, 2002 as part of our Plan of Reorganization. Our new common stock began trading under the symbol "SUHG.OB" on the Over-the-Counter ("OTC") Bulletin Board on April 2, 2002. The following table shows the high and low sale prices for the common stock as reported by the OTC Bulletin Board for the periods indicated:

     Our closing stock price on March 14, 2003 was $0.30. There were approximately 670 holders of record of our common stock as of March 7, 2003. We have never paid nor declared any dividends on our common stock. Our Loan Agreements restrict our ability to pay dividends.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Overview of Current Company Financial Condition

     Current Liquidity. Our net income in 2002 was $1,047.4 million, which includes $1.498.4million extraordinary gain on extinguishment of debt and $407.8 million loss on asset impairment, and our cash flow used for operating activities for 2002 was $41.2 million. These negative results are largely due to adverse conditions in the long-term care industry, including reductions in government support for long-term care providers, such as the failure of Congress to restore Medicare funding to the levels existing prior to October 1, 2002. At March 19, 2003, we had cash and cash equivalents of $6.0 million and borrowing availability under our Loan Agreements of $28.0 million. That availability resulted, in part, from our ceasing to pay rent on certain of our facilities as described below.  In addition, the report of our independent auditors as of December 31, 2002 and for the ten month period then ended is qualified as to our ability to continue as a going concern.  See report on page F-2 and "Note 2 - Basis of Reporting and Current Operating Environment."

     Defaults under Loan Agreements. We were not in compliance with certain financial covenants in our Revolving Loan Agreement at December 31, 2002 and we continue not to be in compliance. Pursuant to certain cross-default provisions, we are also in default under our Term Loan Agreement. The lenders under the Loan Agreements have continued lending to us in spite of the defaults, although they have reserved their rights to seek to exercise their remedies contained in the Loan Agreements. We cannot assure you that the lenders under those agreements will refrain from seeking to exercise their remedies, potentially including declaring all loan amounts outstanding to be immediately due and payable, realizing upon the lenders' security interests, denying us the right to further borrowing under the Revolving Loan Agreement and other remedies. It is likely that under those circumstances we would commence bankruptcy proceedings. We have classified the Loan Agreements as current obligations at December 31, 2002 and our liquidity remains an ongoing concern for us.

     2003 Restructuring. Our goal is to restructure our business so that we can fund our operations and working capital requirements while remaining a significant provider of skilled nursing and other long-term care facilities. We will also seek to reduce our overhead and other expenses significantly, commensurate with reducing the size of our long-term care facility portfolio. Although we have had encouraging discussions and are making progress with many landlords from whom we are seeking to obtain rent concessions or facility lease terminations, and have reached agreements in principle or final agreements with several of our landlords, no assurance can be given that we will be successful in our restructuring efforts. In addition, it is not certain that our available liquidity will provide us with sufficient time to allow us to reduce our overhead and other expenses as required for us to generate sustainable ongoing positive cash flow from our operations.

     Unless we are able to generate substantial cash flow from operations and/or raise cash from asset sales or additional financing, our current available cash and borrowing capacity will be insufficient to fund our ongoing operations. Even if our restructuring allows us to create a sustainable positive cash flow from our operations, a bankruptcy filing may, nonetheless, be required to restructure outstanding obligations and claims against us. Under any circumstance, it is not certain whether we can create or sustain any value for our common stock.

Emergence from Chapter 11 Bankruptcy Proceedings

(b)  Accounts Receivable

     Estimated provisions for doubtful accounts are recorded each period as an expense to the consolidated statements of operations. In evaluating the collectibility of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection patterns, the financial condition of our customers, the composition of patient accounts by payor type, the status of ongoing disputes with third-party payors and general industry conditions. Any changes in these factors or in the actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of the change.

(c)  Insurance

     The weighted-average amortization period for favorable lease intangibles is approximately five years at December 31, 2002. Amortization expense on the favorable lease intangibles totaled $6.8 million for the ten months ended December 31, 2002.

    Our estimated aggregate annual amortization expense for those intangibles for each of the next five years is approximately $0.8 million.

Asset Impairment

Recent Accounting Pronouncements

Reimbursement Matters

     The remaining two add-on payments, the 6.7% increase for patients requiring intense rehabilitation and a 20.0% increase for patients requiring complex medical care, are scheduled to expire on the earlier of September 30, 2003 or at such time as CMS completes the case mix refinements. The refinements are intended to ensure nursing homes are fairly and accurately reimbursed for taking care of medically complex patients. CMS has determined that the research is not sufficiently advanced at the present time to implement the refinements in the 2003 Federal fiscal year. Although the add-ons will expire when these refinements are implemented, it is expected that the add-ons will be replaced by new payment rates that are not known at this time. If the add-ons expire and are not replaced, we estimate that, based upon the number of long-term care facilities we currently operate our per beneficiary per diems would decrease by approximately $27.00, which would account for $27.5 million annually. The loss of these add-ons would have a material adverse effect on our financial position, results of operations and cash flows.