FORM 10-K

(Mark One)

Commission file number 0-49663

SUN HEALTHCARE GROUP, INC.
(Exact name of registrant as specified in its charter)

18831 Von Karman, Suite 400
Irvine, CA 92612
(949) 255-7100
(Address and telephone number of Registrant)

Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Title of each class
Common Stock, par value $.01 per share
Warrants to purchase Common Stock, $.01 par value per share

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in the definitive proxy statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes [X]     No [ ]

   The aggregate market value of the Registrant's Common Stock held by nonaffiliates, based on the last sales price of such shares on the Over-the-Counter Bulletin Board on June 30, 2003, was approximately $12.8 million.

     Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes  [X]  No  [  ]

     On March 1, 2004, Sun Healthcare Group, Inc. had 14,559,818 outstanding shares of Common Stock.

     Documents Incorporated by Reference: None

1

SunBridge®, SunDance®, SunPlus®, CareerStaff Unlimited® and related names are registered trademarks of Sun Healthcare Group, Inc. and its subsidiaries.

___________________

     References throughout this document to the Company include Sun Healthcare Group, Inc. and its consolidated subsidiaries. In accordance with the Securities and Exchange Commission's "Plain English" guidelines, this Annual Report on Form 10-K has been written in the first person. In this document, the words "we," "our," "ours" and "us" refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

     Information provided in this Form 10-K contains "forward-looking" information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the "Act"). All statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, lease restructuring initiative, business strategy, budgets, projected costs and capital expenditures, competitive position, growth opportunities, plans and objectives of management for future operations and words such as "anticipate," "believe," "plan," "estimate," "expect," "intend," "may" and other similar expressions are forward-looking statements. The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the "safe harbor" provisions of the Act. We caution investors that any forward-looking state ments made by us are not guarantees of future performance and that actual results may differ materially from those in the forward-looking statements as a result of various factors, including, but not limited to, those set forth below and elsewhere herein. We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.

     Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements as a result of, but not limited to, the following factors:

     See "Item 1 - Business" for a discussion of various circumstances affecting us, in particular, governmental regulations and other operating factors relating to the healthcare industry and the risk factors inherent in them. The risks and uncertainties described above and under "Item 1 - Business" are not the only ones facing us. You should carefully consider the risks described herein before making any investment decisions to buy securities of Sun Healthcare Group, Inc. There may be additional risks that we do not presently know of or that we currently deem immaterial. If any of the foregoing risks or the risks described below actually occur, our business, financial position, results of operations and cash flows could be materially adversely affected. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment. Given these risks and uncertainties, we can give no assurances that these forward-looking state ments will, in fact, transpire and, therefore, caution investors not to place undue reliance on them.

     General. We are one of the largest providers of long-term, subacute and related specialty healthcare services in the United States. We currently operate through various direct and indirect subsidiaries that engage in the following five principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, (iii) medical staffing services, (iv) home health services and (v) laboratory and radiology services.  The following is a description of our current business segments and divested operations. Financial information for each of 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, 2004, we operated 108 long-term care facilities (consisting of 98 skilled nursing facilities, seven assisted living facilities and three specialty acute care hospitals) in 14 states with 11,007 licensed beds through our wholly owned subsidiary, SunBridge Healthcare Corporation and other subsidiaries (collectively, "SunBridge").

     Our specialty 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.

     In an effort to improve our financial position and address our liquidity issues, in January 2003, we initiated efforts to restructure the portfolio of leases under which we operate most of our long-term care facilities. During the period January 1, 2003 to March 1, 2004, we divested 129 of our under-performing facilities. We have reached agreement with substantially all of the landlords of the divested facilities. We cannot predict the extent to which the remaining landlords of the divested and anticipated-to-be-divested facilities with whom we have not yet reached agreement will seek to assert leasehold or other damages; however, we do not anticipate that the total of any claims that may be asserted by those landlords will have a material adverse impact on our financial position. We have substantially completed the restructuring we commenced in January 2003.

     Rehabilitation Therapy Services. We provide rehabilitation therapy services primarily through SunDance Rehabilitation Corporation ("SunDance"). SunDance provides a broad array of rehabilitation therapy services, including speech pathology, physical therapy and occupational therapy. As of March 1, 2004, SunDance provided rehabilitation therapy services to 455 facilities in 38 states, 354 of which were operated by nonaffiliated parties. SunDance also operates four outpatient rehabilitation clinics and one certified outpatient rehabilitation clinic (CORF) in Colorado. We also provide rehabilitative and special education services to pediatric clients as well as rehabilitation therapy services for adult home healthcare clients in the greater New York City metropolitan area through HTA of New York, Inc.

     Medical Staffing Services. We are a nationwide provider of temporary medical staffing primarily through CareerStaff Unlimited, Inc. ("CareerStaff"). As of March 1, 2004, CareerStaff derived approximately 12% of its revenues from schools and governmental agencies, 40% from hospitals and other providers and 48% 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, 2004, CareerStaff had 37 division offices which provided medical 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.

     Home Health. As of March 1, 2004, we provided skilled nursing care, rehabilitation therapy and home infusion services to adult and pediatric patients in California and Ohio through SunPlus Home Health Services, Inc. ("SunPlus"). SunPlus also operates three licensed infusion therapy pharmacies in California.

     Laboratory and Radiology. Through SunAlliance Healthcare Services, Inc. ("SunAlliance"), we provide mobile radiology and medical laboratory services to skilled nursing facilities in Arizona, California, Colorado and Massachusetts.

     Divested Operations. On November 7, 2003, Shared Healthcare Systems, Inc. ("SHS"), a majority- owned subsidiary, sold its software development assets to Accu-Med Services of Washington LLC, a wholly-owned subsidiary of Omnicare, Inc., for approximately $5.0 million in proceeds at closing and up to $0.5 million to be paid in cash in December 2004.

     On July 15, 2003, we sold the assets of our pharmaceutical services operations, including substantially all of the assets of SunScript Pharmacy Corporation, to Omnicare, Inc. ("Omnicare") for $90.0 million, of which $75.0 million was received in cash at closing with up to $15.0 million in additional purchase price, payable to us on or before July 15, 2005 subject to fulfillment of the conditions described below. We simultaneously entered into agreements pursuant to which Omnicare would provide pharmacy services to our inpatient facilities (the "Pharmacy Agreements"). The $15.0 million additional purchase price is subject to reduction in the event that prior to payment: (i) we reject or modify one or more Pharmacy Agreements in a bankruptcy proceeding; (ii) the new operator of any of our divested facilities does not assume the same contract with Omnicare; and/or (iii) we breach the Pharmacy Agreements.

     On October 14, 1999 (the "Filing Date"), we commenced chapter 11 bankruptcy proceedings. On February 6, 2002, the Bankruptcy Court approved our Plan of Reorganization that was filed with the Bankruptcy Court on November 7, 2001. On February 28, 2002, we emerged from proceedings under the Bankruptcy Code pursuant to the terms of our Plan of Reorganization. (See "Note 1 - Nature of Business - Reorganization" in our consolidated financial statements.)

     Under the chapter 11 proceedings commenced in 1999, certain claims against us in existence prior to the Filing Date were stayed while we continued our operations as a debtor-in-possession. These claims are reflected in the December 31, 2001 consolidated balance sheet as "liabilities subject to compromise." The payment of certain prepetition claims after the Filing Date (principally employee wages and benefits and payments to critical vendors and utilities) that were approved by the Bankruptcy Court reduced "liabilities subject to compromise." As part of our emergence from chapter 11 proceedings, all of the "liabilities subject to compromise" were discharged, reinstated or paid.

     We have determined that, generally, the fair market value of the collateral was less than the principal amount of our secured prepetition debt obligations; accordingly, we discontinued accruing interest on many of those obligations as of the Filing Date.

     For the year ended and as of December 31, 2003, our net income was $0.4 million and our working capital deficit was $57.4 million. Our working capital position was significantly improved as a result of the net proceeds of $52.3 million received from our private placement of our common stock and warrants in February 2004, even after paying off the outstanding loan balance under our revolving senior loan agreement. We anticipate that our working capital position will be further improved by, among other things, refinancing $21.2 million of mortgage debt that matures on May 1, 2004, which is classified as a current liability. We are currently in negotiation to refinance these mortgages and expect the $21.2 million to be refinanced and/or retired in part, with the remaining balance reclassified as long- term debt.

     As of March 1, 2004, we had cash and cash equivalents of approximately $40.1 million, no outstanding balance under our revolving loan agreement and approximately $31.0 million of funds available for borrowing under our revolving loan agreement. We believe that our existing cash reserves and availability for borrowing under our loan agreement will provide sufficient funds for our operations, capital expenditures and regularly scheduled debt service payments through the next twelve months.

     We have reached agreement with substantially all of our landlords regarding the disposition of past due rent on our divested or to be divested facilities. On March 1, 2004, we entered into an Amended and Restated Master Lease Agreement with Omega Healthcare Investors, Inc. and various of its affiliates ("Omega"). Prior to our portfolio restructuring, we leased 51 facilities from Omega. Pursuant to the new Master Lease, we will continue to operate 30 facilities (including 23 long-term care facilities, two rehabilitation hospitals, and five behavioral facilities). Approximately $7.8 million of accrued past due rent as of March 1, 2004 and future rent obligations that would otherwise have become due under the existing master leases will be combined into "deferred base rent". That deferred base rent will bear interest at a floating rate equal to 375 basis points over the one year LIBOR rate, subject to a floor of 6% per annum. Interest will not be pa yable until January 2008, at which time interest thereafter accruing will be payable monthly in arrears. Omega has the right to convert the deferred base rent and accrued interest into 800,000 shares of our common stock, subject to anti-dilution adjustments for sales of shares we make at less than fair market value at the time of sale. We have the right to pay cash in an amount equal to the value of the stock in lieu of issuing the stock to Omega. If the average value of the common stock issuable to Omega under the new Master Lease exceeds 140% of the deferred base rent and interest accrued thereon over a period of 30 business days, we can require Omega to convert the deferred base rent into our common stock.

     Sun Healthcare Group, Inc. was incorporated in 1993. Our principal executive offices are located at 18831 Von Karman, Suite 400, Irvine, CA 92612, and our telephone number is (949) 255-7100. We maintain a website at www.sunh.com. Through the "About Our Company," "Investor Information" and "SEC Filings" links on our website, we make available free of charge, as soon as reasonably practicable after such information has been filed or furnished to the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act.

     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. The following table sets forth the total revenues and percentage of revenues by payor source for our continuing operations, on a consolidated and on an inpatient operations only basis, for the years indicated (in thousands):

     Changes in the mix of patients among the Medicaid, Medicare 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.

      Medicare is available to nearly every United States citizen 65 years of age and older and it is a broad program of health insurance designed to help the nation's elderly meet hospital, hospice, home health and other health care costs. Health insurance coverage extends to certain persons under age 65 who qualify as disabled and those having end-stage renal disease. Medicare includes three related health insurance programs: (i) hospital insurance ("Part A"); (ii) supplementary medical insurance ("Part B"); and (iii) a managed care option for beneficiaries who are entitled to Part A and enrolled in Part B ("Medicare+Choice" or "Medicare Part C"). The Medicare program is currently administered by fiscal intermediaries (for Part A and some Part B services) and carriers (for Part B) under the direction of the Centers for Medicare and Medicaid Services ("CMS") (formerly the Health Care Finance Admini stration), a division of the Department of Health and Human Services ("HHS").

     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 ended December 31:

     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.

     On September 30, 2002, two of the add-on provisions of the Medicare payment regulations expired: the 4.0% add-on for all patient categories in the RUG system and the 16.7% add-on for nursing related costs. We estimate that our Medicare revenues decreased by approximately $23.8 million ($36.98 per patient day), for the twelve months ended December 31, 2003 as a result of the expiration of these add-ons. Approximately $9.3 million of these decreases related to the 127 inpatient facilities we divested over the same period. In addition to the elimination of the add-ons, CMS provided a 2.6% market basket increase in payments to skilled nursing facilities for the 2003 Federal fiscal year (October 1, 2002-September 30, 2003). We estimate that the market basket increase resulted in approximately $6.1 million ($9.49 per patient day) in increased revenue for the twelve months ended December 31, 2003. Approximately $2.4 million of these increases related to the 127 in patient facilities we divested over the same period. The net result of the expiration of the add-ons and the market basket increase is an estimated Medicare revenue decrease of approximately $17.7 million ($27.49 per patient day) for the twelve months ended December 31, 2003. Approximately $6.9 million of these decreases related to the 127 inpatient facilities we divested over the same period.

     On August 4, 2003 CMS published a final rule in the Federal Register to update payment rates for federal fiscal year 2004 (October 1, 2003-September 30, 2004) by providing for a 3.0% increase of the annual update to the market basket and an additional 3.3% market basket increase to correct the underestimate of the market basket forecast in prior years. We estimate our Medicare revenues increased approximately $1.9 million ($19.75 per patient day) for the three months ended December 31, 2003 as a result of the combined increases. Approximately $0.1 million of these increases related to the 13 facilities we divested over the same period.

     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, were scheduled to expire on the earlier of September 30, 2003 or at such time as CMS completes the case mix refinements. However, CMS published in the August 4, 2003 Federal Register its decision to extend the expiration date as research is not sufficiently advanced at the present time to implement refinements this year, thus leaving the current classification system in place for fiscal year 2004. The refinements are intended to ensure nursing homes are fairly and accurately reimbursed for taking care of medically complex patients. 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 by new payment rates, we estimate that our per ben eficiary per diems would decrease by approximately $24.87 per patient day. The loss of these add-ons would have a material adverse effect on our financial position, results of operations and cash flows. The actual revenue increase we experienced as a result of the two add-ons that did not expire was approximately $16.5 million for the year ended December 31, 2003.  Approximately $6.8 million was related to the 127 inpatient facilities we divested over the same period.

     Medicare Part B payments are generally adjusted annually, effective upon the calendar year beginning January 1 and ending December 31. The federal spending bill for fiscal 2003 allowed CMS to provide a 1.6% increase to the payment fee. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 authorized a 1.5% increase for fiscal year 2004. The increase would result in an estimated $0.7 million in additional revenue in 2004.

     The 1997 Act also implemented a restriction applicable to Medicare Part B payments that would limit the amount of reimbursements we receive for rehabilitation therapy, referred to as therapy caps. BBRA and BIPA placed a moratorium on the therapy caps that expired on June 30, 2003. As a result of litigation in Federal District Court, CMS agreed to delay implementation of the therapy caps until September 1, 2003. However the Medicare Prescription Drug, Improvement and Modernization Act of 2003 re-enacted the moratorium on the therapy caps effective December 8, 2003 through December 31, 2005. For the period in which the moratorium was not in place (September 1, 2003-December 7, 2003) we estimate the application of the therapy cap reduced rehabilitation therapy services' revenue by $4.7 million and our inpatient services revenue by $0.4 million.     

     For the nine months ended September 30, 2003, our home health Medicare revenues decreased approximately $1.6 million due to decreased Medicare payment rates for the 2003 Federal fiscal year (October 1, 2002-September 30, 2003). Medicare payment rates increased 3.3% for the 2004 Federal fiscal year (October 1, 2003-September 30, 2004), which we estimate increased fourth quarter 2003 Medicare revenues by $0.3 million. Other annual estimated Medicare rate decreases of $0.2 million effective beginning April 2004 are possible when 2005 Medicare rates are issued. Additionally, as nonaffiliated healthcare providers that are serviced by our ancillary services operations, including our 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 years beginning October 1, 2003, 20% for cost reporting years 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 claimed on our 2002 cost reports for the 100 skilled nursing facilities in operation as of December 31, 2003, we estimate that our Medicare revenues will decrease by approximately $0.5 million ($1.18 per patient day) in 2004, $1.0 million ($2.37 per patient day) in 2005, and $1.5 million ($3.55 per patient day) in 2006 if the proposed changes are implemented.

     Reduced Medicaid Reimbursements.    The recent economic downturn has had a detrimental affect on state revenues. Historically, these budget pressures have translated into reductions in state spending. Given that Medicaid outlays are a significant component of state budgets, we expect continuing cost containment pressures on Medicaid outlays for nursing homes in the states in which we operate. However, through the efforts of state nursing associations, previously proposed reductions in several states in which we operate (California, Massachusetts and Washington) have not been instituted. In fact, we have seen rate increases in each of these states. It is not certain whether reductions will be imposed in the future for these or any other states we operate in.

     Several states that we operate in (Georgia, New Hampshire, North Carolina and Washington) have sought to impose a provider tax against nursing homes as a method of increasing the federal matching funds paid to the State for Medicaid. The states could use the federal matching funds to increase Medicaid reimbursement rates for the nursing homes, although that is dependent upon the state's provider tax legislation. The states have submitted their provider tax applications to CMS, which is currently reviewing the applications. If CMS approves the applications, then it may result in Medicaid rate increases in those states. If CMS denies the applications then it could adversely affect our current Medicaid rates.   

     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 earning s 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 includes other services provided by us, such as 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 38.5% 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.

     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 are, and may in the future 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 the Medicare or Medicaid programs. 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.

     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. Where corrective action is required, we work with the reviewing agency to create mutually agreeable measures to be taken to bring the facility or service provider into compliance. Under certain circumstances, the federal and state agencies have the authority to take adverse actions against a facility or service provider, including the imposition of monetary fines, bans on admissions, civil monetary penalties and the decertification of a facility or provider from participation in the Medicare and/or Medicaid programs or licensure revocation. From time to time federal and state survey agencies have imposed bans on admissions and civil monetary penalties against our facilities on the basis of alleged regulatory deficiencies and can decertify a facility from the Medicare and Medicaid programs. When appropriate, we vigorously contest such sanctions and in some cases have sought and obtained federal court injunctions against proposed sanctions. Challenging and appealing notices of noncompliance can require significant legal expenses and management attention. (See "Item 3 - Legal Proceedings.")

     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. 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. There can be no assurance that the federal government will not attempt to decertify facilities of ours from the Medicare and Medicaid programs in the future.

     We entered into a Corporate Integrity Agreement (the "CIA") with the OIG in July 2001 and it became effective on February 28, 2002. We implemented further internal controls with respect to our quality of care standards and Medicare and Medicaid billing, reporting and claims submission processes and engaged an independent third party to act as Quality Monitor and Independent Review Organization under the CIA. A breach of the CIA could subject us to substantial monetary penalties and exclusion from participation in Medicare and Medicaid programs. Any such sanctions could have a material adverse effect on our financial condition, results of operations, and cash flows.

     We also entered into a Permanent Injunction and Final Judgment ("PIFJ") with the state of California on October 3, 2001. The PIFJ requires specific staff training, physical plant inspection and modification, and reporting requirements that are in addition to requirements of the CIA. The PIFJ also requires us to issue to the State reports similar to those delivered to the OIG pursuant to the CIA. If California believes that we have breached the PIFJ, then we could be subject to substantial monetary penalties. Any such sanctions could have a material adverse effect on our financial condition, results of operations, and cash flows. (See "Item 3 - Legal Proceedings.")

     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 an d 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 are completed at the operational level for which the Compliance Liaison is responsible.      

     Each business line also employs a number of 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 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 laws 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. HIPAA provides for the imposition of civil or criminal penalties for the violation of these rules. We estimate that the efforts and resources we will expend to comply with the HIPAA privacy, security and transaction code set regulations will approximate $1.8 million in total, of which $0.9 million was incurred in the year ended December 31, 2003 and approximately $0.9 million is expected to be incurred for 2004.

     These privacy regulations became effective in April 2003 and they 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 limit a provider's use and disclosure of most paper, oral and electronic communications regarding a patient's past, present or future physical or mental health or condition, or relating to the provision of healthcare to the patient or payment for that healthcare.

     HIPAA's security regulations were finalized in February 2003 and will become effective in April 2005. The security regulations specify administrative procedures, physical safeguards and technical services and mechanisms designed to ensure the privacy of protected health information. We are already complying with transaction standards where possible.

Additional Business Risks

     We rely primarily on self-funded insurance programs for general and professional liability claims against us, and as of December 31, 2003, we had reserved $121.7 million for such claims but we had only pre-funded $5.0 million for such claims. In recent years, there has been a dramatic increase in the number and size of lawsuits filed against nursing home operators alleging negligence resulting in injury or death to residents of the homes. We currently have numerous patient care lawsuits pending against us, as well as other types of lawsuits, many of which relate to facilities that we no longer operate. Since January 2000, we have relied upon self-funded insurance programs for general and professional liability claims up to a base amount per claim and an aggregate per location, which amounts we are responsible for funding, and we obtained excess insurance policies for claims above those amounts. The programs had the following coverages that we wer e responsible for self-funding: (i) for events occurring from January 1, 2000 to December 31, 2002, $1.0 million per claim, and $3.0 million aggregate per location; (ii) for claims made in 2003, $10.0 million per claim with excess coverage above this level; and (iii) for claims made in 2004, $5.0 million per claim with excess coverage of $5.0 million in the aggregate above this level. There is a risk that the amounts funded to our programs of self-insurance may not be sufficient to respond to all claims asserted under those programs. In addition, in certain states in which we operate, state law prohibits insurance coverage for punitive damages arising from general and professional liability litigation, and we could be held liable for punitive damages in those states. (See "Item 3 - Legal Proceedings" and "Note 9 - Commitments and Contingencies".)

    Our healthcare operations are extensively regulated and adverse determinations against us could result in severe penalties including loss of licensure and decertification. In the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, civil and criminal investigations, examinations, audits, site visits and surveys, some of which are, have been and/or may in the future be, non-routine. If we are found to have engaged in improper practices, we could be subject to civil, administrative or criminal fines, penalties or restitutionary relief, and reimbursement authorities could also seek our suspension or exclusion from participation in their program. The exclusion of a facility from participating in Medicare or Medicaid would have a material adverse effect on the facility's financial position, results of operations and cash flows. (See "Ite m 3 - Legal Proceedings.")

     If we are unable to collect our accounts receivable, our financial condition, results of operations, and cash flows will be adversely affected. Our total bad debt expense for our inpatient, rehabilitation services, medical staffing, home health and laboratory and radiology operations for the years ended December 31, 2003, 2002 and 2001 was $19.1 million, $15.2 million and $26.0 million, respectively, of which $6.3 million and $7.5 million related to discontinued operations at December 31, 2003 and 2002, respectively. Our total allowance for doubtful accounts was $67.1 million and $45.9 million at December 31, 2003 and 2002, respectively, of which $27.0 million and $1.6 million related to discontinued operations for the year ended December 31, 2003 and the ten months ended December 31, 2002, respectively. As part of our restructuring, we have divested many, and will divest additional, inpatient facilities and we will retain the rights to all accou nts receivable for those facilities that arose prior to the date of divestiture. Based on our prior experience, we expect that we will have a higher percentage of bad debts associated with the divested facilities than we do with operating facilities. Our financial condition, results of operations, and cash flows could be materially adversely affected by the inability to collect our accounts receivable.

     We continue to be affected by an industry-wide 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 o ur long-term and subacute care facilities.

     We are required to file, and maintain in effect, a registration statement with respect to the stock placed with investors in our February 2004 private placement and we will be subject to monetary penalties if we are unable to comply with those requirements. In connection with our private placement of our common stock and warrants to purchase common stock to investors (the "Purchasers") in February 2004 for gross proceeds of approximately $56.2 million, we entered into Registration Rights Agreements with the Purchasers. Subject to certain exceptions, we are required to file a registration statement with the Securities and Exchange Commission (the "SEC") on or before April 5, 2004 to register the shares for sale by the Purchasers of the common stock and the common stock to be issued upon the exercise of the warrants issued to the investors in the private placement, and to seek the SEC's declaration of effectiveness on or before June 1 8, 2004. Subject to certain exceptions, in the event that (i) the registration statement is not filed by April 5, 2004, (ii) the registration statement is not declared effective by May 20, 2004 (or June 19, 2004 if the registration statement is reviewed by the SEC), or (iii) it ceases to be effective for an aggregate of 30 trading days after the registration statement is declared effective, then the Registration Rights Agreement requires us to pay liquidated damages to the Purchasers in an amount per 30-day period equal to one percent of the gross proceeds from the private placement. Therefore, if we are not in compliance with the above-described provisions of the Registration Rights Agreement, we will be required to pay the Purchasers liquidated damages of approximately $562,000 for each 30-day period that we are not in compliance. There can be no assurance that we will not be required to pay liquidated damages to the Purchasers pursuant to the Registration Rights Agreement.

     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 comprehensiven ess 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, medical staffing services and home health services and in employing and retaining qualified nurses, 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.

     As of March 1, 2004, we had approximately 16,800 full-time and part-time employees. Of this total, there were 10,900 employees in our long-term and subacute care operations, 2,500 employees in the rehabilitation therapy services operations, 1,300 employees in the medical staffing business, 1,100 employees in the home health business, 300 employees at the corporate and regional offices and 700 employees in the laboratory and radiology business. As we divest inpatient facilities pursuant to our restructuring initiative, the number of employees in our long-term and subacute care operations will decrease accordingly.

     Approximately 1,031 of our employees (6.1% of our employees) who work in long-term care facilities in Alabama, California, Georgia, Massachusetts, Ohio, Tennessee and West Virginia are covered by collective bargaining contracts. Collective bargaining agreements covering 515 of these employees (3.1% of our employees) will expire in 2004 and will be subject to renegotiation with the unions. The unions representing certain of our employees have from time to time gone on strike. 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.

     Our aggregate occupancy percentages for all of our long-term care, subacute care and assisted living facilities in the United States, on a same store basis, were 90.14%, 90.65% and 90.66% for the years ended December 31, 2003, 2002 and 2001, respectively. The percentages were computed by dividing the average daily number of beds occupied by the total number of available beds for use during the periods indicated. 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.

     The following table sets forth certain information concerning the 108 long-term care, subacute care and assisted living facilities that we operated as of March 1, 2004, which consisted of 98 skilled nursing facilities, seven assisted living facilities and three specialty acute care hospitals. As part of our restructuring efforts, we expect to divest seven of the facilities in the table representing approximately 528 licensed and 498 available beds during 2004.

(1)  "Licensed Beds" refers to the number of beds for which a license has been issued, which may vary in some instances from licensed beds available for use, which is used in the computation of occupancy. Available beds for the 108 facilities were 10,621.

     Rehabilitation Services. As of March 1, 2004, we leased office space in 19 locations in 11 states to operate our rehabilitation therapy business.

     Medical Staffing Services. As of March 1, 2004, we leased office space in 26 locations in 17 states to operate our medical staffing business.

     Home Health Services. As of March 1, 2004, we leased office space in 23 locations in two states to operate our home health business.

     Corporate. We lease our executive offices in Irvine, California and we lease one and own three corporate office buildings in Albuquerque, New Mexico.

     In February 2003, the BMFEA, which is a division of the Office of the Attorney General of the State of California, alleged that we had violated the terms of the PIFJ entered into during October 2001. Pursuant to the PIFJ, we are enjoined from engaging in violations of federal or state statutes or regulations governing the operation of health care facilities in the State of California. Among other things, the BMFEA alleged that our California facilities have had inadequate staffing, training and supervision. To remedy these alleged violations, the BMFEA had requested that we pay their costs of the investigation and to audit our operations in California, and, initially, requested a significant but unspecified cash penalty. The BMFEA investigation included onsite inspections, searches, interviews and examinations of our residents and facility personnel, service of document requests and, in one instance, service of a search warrant see king documents and further information regarding the operation of certain of our California facilities.

     In January 2004, 11 current and one former employee of SunBridge Care and Rehab for Escondido-East were arraigned on charges brought by the California Department of Justice, alleging that the defendants permitted an elderly woman under their care to be placed in a situation in which her health was endangered in circumstances likely to produce great bodily harm or death. Ten of the twelve defendants were also charged with a misdemeanor count of falsifying paperwork with fraudulent intent. SunBridge Care and Rehab for Escondido-East is a skilled nursing facility in Escondido, California that is operated by Care Enterprises West, an indirect subsidiary of Sun Healthcare Group, Inc. Neither Sun Healthcare Group, Inc. nor Care Enterprises West has been charged with any wrongdoing. We have commenced an internal investigation of the California Department of Justice's allegations and continue our ongoin g efforts to work in cooperation with the California Department of Justice during the course of their investigation.

     We do not know whether the BMFEA will ultimately assert that the Company is in violation of the PIFJ and, if so, what actions the BMFEA may take. There can be no assurance that there will not be an adverse outcome in this matter, or that additional charges will not be filed against the 12 employees, other employees, Care Enterprises West or any of its affiliates, or any officers and directors. We are unable to estimate any amount that the BMFEA may ultimately seek from us, or the cost to us resulting from an adverse outcome in this matter, although an adverse outcome in this matter could have a material adverse effect on our financial position, results of operations and cash flows.

     In March and April 1999, class action lawsuits were filed against us and three individuals, who were at that time our officers, 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 we did not disclose material facts concerning the impact that changes to reimbursement for our skilled nursing facilities under Medicare's prospective payment system would have on our results of operations. The lawsuits seek compensatory damages and other relief for stockholders who purchased our common stock during the class-action period. Pursuant to an agreement among the parties, we were dismissed without prejudice in December 2000. In January 2002, the District Court dismissed the lawsuit with prejudice and entered judgment in favor of the remaining defendants. In February 2002, the plaintiffs filed a Motion to Amend the Judgment and to File an Amended Complaint. In April 2003, the plaintiffs' Motion was denied by the United States District Court for the District of New Mexico. In May 2003, the plaintiffs filed an appeal with the United States Court of Appeals for the Tenth Circuit. We intend to defend this matter vigorously.

     We are a party to various other legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our facilities, claims relating to employment and commercial matters. We have experienced an increasing trend in the number and severity of litigation claims asserted against us. We believe 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 aggressiveness, due to the heightened awareness by plaintiff's lawyers of potentially large recoveries. In certain states in which we have had significant operations, including California, insurance coverage for the risk of punitive damages arising from general and professional liability litigation may not be available due to state law public policy prohibitions. There can be no assurance that we will not be liable for punitive damages awarded in litigation arising in states for which punitive damage insurance coverage is not available.

     We operate in industries that are extensively regulated. As such, in the ordinary course of business, we 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 are or have been and/or may in the future be non-routine. In addition to being subject to 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 individual from participation in their program. We believe that there has been, and will con tinue 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 our financial position, results of operations and cash flows.

     No matters were submitted to a vote of security holders during the fourth quarter of 2003.

     We began issuing our common stock on February 28, 2002 as part of our Plan of Reorganization. Our 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 1, 2004 was $12.25. On January 20, 2004, we submitted an application to list our common stock on the Nasdaq National Market. No assurance can be given that the Sun Healthcare Group, Inc. common stock will become listed on the Nasdaq National Market.

     There were approximately 4,744 holders of record of our common stock as of March 1, 2004. We have never paid nor declared any dividends on our common stock. Our Loan Agreement and certain other agreements restrict our ability to pay dividends. We did not repurchase any shares of our common stock during the fourth quarter of 2003.

     The following selected consolidated financial data for the periods indicated have been derived from our consolidated financial statements. The financial data set forth below should be read in connection with "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations" and with our consolidated financial statements and related notes thereto (in thousands, except per share data):

      We are one of the largest providers of long-term, subacute and related speciality healthcare services in the United States. We currently operate through various direct and indirect subsidiaries that engage in the following five principal business segments: (i) inpatient services, primarily skilled nursing facilities, (ii) rehabilitation therapy services, (iii) medical staffing services, (iv) home health services and (v) laboratory and radiology services. For continuing operations, during the year ended December 31, 2003, we received approximately 25.6% of our revenues from Medicare, 35.9% from Medicaid, and 38.5% from private insurance, self-pay residents, other third party payors and long-term care facilities that utilized our specialty medical services. As with other providers in the long-term care industry, we face challenges associated with reduced levels of reimbursement from Medicare and Medicaid, increasing costs associated with litigation and insurance, compliance with federal and state regulations, and the retention of qualified personnel to staff our long-term care facilities.

     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.

26

     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 includes other services provided by us, such as 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.

     In an effort to improve our financial position and address our liquidity concerns, in January 2003, we initiated efforts to (i) reshape our portfolio of leases for our long-term care facilities to divest our under-performing facilities, decrease our exposure in any single state, exit high-cost general and professional liability states and better leverage our infrastructure; (ii) sell our pharmacy and software development operations to finance the restructuring efforts, and (iii) reduce our overhead and other expenses commensurate with the reduction in the size of our long-term care facility portfolio. Between January 1, 2003 and December 31, 2003, we divested 127 long-term care facilities, our SunScript pharmacy operations and our software development operations and reduced corporate general and administrative expenses by $32.3 million. As of March 1, 2004, we operated 108 long-term care facilities and we intend to divest seven of those facilities in 2004. With the exception of the anticipated transfer of the remaining seven facilities, we believe that the restructuring we commenced in January 2003 is substantially complete.

     In February 2004, we completed a private placement of our common stock and warrants to purchase our common stock to accredited and institutional investors for net proceeds of approximately $52.3 million. As of March 1, 2004, we had cash and cash equivalents of approximately $40.1 million and approximately $31.0 million available to us for additional borrowings under our loan agreement. We believe that our existing cash reserves and availability under our loan agreement will provide sufficient funds for our operations, capital expenditures and regularly scheduled debt service payments through the next 12 months.

     Net revenues consist of long-term and subacute care revenues, rehabilitation therapy revenues, medical staffing services revenues, home health revenues and laboratory and radiology revenues. Net revenues are recognized as services are provided. Revenues are recorded net of provisions for discount arrangements with commercial payors and contractual allowances with third-party payors, primarily Medicare and Medicaid. Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment. Estimated third-party payor settlements are recorded in the period the related services are rendered. The methods of making such estimates are reviewed periodically, and differences between the net amounts accrued and subsequent settlements or estimates of expected settlements are reflected in current results of operations, when determined.

27

(b)  Accounts Receivable and Related Allowance

     Our accounts receivable relate to services provided by our various operating divisions to a variety of payors and customers. The primary payors for services provided in long-term and subacute care facilities that we operate are the Medicare program and the various state Medicaid programs. The rehabilitation therapy service operations provide services to patients in nonaffiliated long-term, rehabilitation and acute care facilities. The billings for those services are submitted to the nonaffiliated facilities. Many of the nonaffiliated long-term care facilities receive a large majority of their revenues from the Medicare program and the state Medicaid programs.

     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.

     The allowance for uncollectible accounts related to facilities that we have divested was based on a percentage of outstanding accounts receivable at the time of divestiture and was recorded in gain or loss on disposal of discontinued operations, net. As collections are recognized, the allowance will be adjusted as appropriate. This percentage was 40% in 2002 and was adjusted to 30% in the fourth quarter of 2003. The percentages were developed from historical collection trends of our divestitures.

     The allowance for uncollectible accounts related to facilities that we currently operate is computed by applying a bad debt percentage to the individual accounts receivable aging categories based on historical collections. An adjustment is then recorded each month to adjust the allowance based on the analysis.

     We self-insure for certain insurable risks, including general and professional liability, workers' compensation liability and employee health insurance liability through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There exists a risk that any of the insurance companies we use may become insolvent and unable to fulfill their obligation to defend, pay or reimburse us when that obligation becomes due. Provisions for estimated reserves, including incurred but not reported losses, are provided in the period of the related coverage. An independent actuarial analysis is prepared twice a year to determine the expected losses and reserves for estimated settlements for general and professional liability and workers' compensation insurance under the per claims retention level, including incurred but not reported losses. The methods of mak ing such estimates and establishing the resulting reserves are reviewed periodically, and any adjustments resulting there from are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves. As of December 31, 2003, we recorded pre-funded amounts restricted for the payment of general and professional liability and workers' compensation claims in restricted cash accounts classified in current and non-current assets. Upon evaluation by our independent actuaries of claim payment trends in conjunction with the twice a year evaluation of our reserves and claims exposures, the restricted cash balances are also reviewed and reconciled.

28

(d) Impairment of Assets

Goodwill

     Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS No. 142") established new rules on the accounting for goodwill and other intangible assets. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized; however, they are subject to annual impairment tests as prescribed by the statement. Intangible assets with definite lives continue to be amortized over their estimated useful lives.

     Pursuant to SFAS No. 142, we perform our annual goodwill impairment analysis during the fourth quarter for each reporting unit that constitutes a business for which discrete financial information is produced and reviewed by operating segment management and, with the exception of the long-term care facilities, provides services that are distinct from the other components of the operating segment. We determine impairment by comparing the net assets of each reporting unit to their respective fair values. We determine the estimated fair value of each reporting unit using a discounted cash flow analysis. In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is measured by th e difference between the goodwill carrying value and the implied fair value.

Indefinite Life Intangibles

     Pursuant to SFAS No. 142, we evaluate the recoverability of the trademarks by comparing the asset's respective carrying value to estimates of fair value. We determine the estimated fair value of each trademark through a discounted cash flow analysis.

Finite Life Intangibles

     Pursuant to SFAS No. 142, we evaluate the recoverability of the favorable lease intangibles by comparing an asset's respective carrying value to estimates of undiscounted cash flows over the life of the lease. If the carrying value of the asset exceeded the undiscounted cash flows, an impairment loss was measured by comparing the estimated fair value of the asset, based on discounted cash flows, to its carrying value.

Long-Lived Assets

     The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS No. 144"), which addresses financial accounting and reporting for the impairment of long-lived assets (other than goodwill and indefinite lived intangibles) and for long-lived assets to be disposed of. SFAS No. 144 supersedes Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of ("SFAS No. 121") and Accounting Principles Board Opinion No. 30, Reporting the Results of Operations - Reporting the effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. We adopted the provisions of SFAS No. 144 as of January 1, 2002. Similar to SFAS No. 121, SFAS No. 144 requires impairment losses to be recognized for lon g-lived assets used in operations when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets' carrying amounts. The impairment loss is measured by comparing the estimated fair value of the asset, usually based on discounted cash flows, to its carrying amount. In accordance with SFAS No. 144, we assess the need for an impairment write-down when such indicators of impairment are present.

29

     We have changed the composition of our segments and therefore restated the previously reported segment information related to the Reorganized Company (see "Note 16 - Segment Information" in our consolidated financial statements.) The change since the last annual SEC filing includes new segments for Medical Staffing, Home Health, Laboratory and Radiology which previously were categorized in the Other segment and removal of the Pharmaceutical Services, International and Other segments as they have been sold. The following tables set forth the amount and percentage of certain elements of total net revenues for the following years ended December 31, (in thousands):

 30

    Inpatient services revenues for long-term care, subacute care and assisted living services include revenues billed to patients for therapy, medical staffing, and laboratory and radiology provided by our affiliated operations. The following tables set forth a summary of the intersegment revenues for the years ended December 31, (in thousands):

   The following table sets forth the amount of net segment (loss) income for the following years ended December 31, (in thousands):

Inpatient Services. The improvement in net segment income of $18.8 million in 2003 over 2002 was primarily driven by our restructuring efforts and the divestiture of 127 facilities during 2003.

Rehabilitation and Respiratory Therapy Services. The decrease in net income for this segment resulted primarily from:

• the loss of revenues from the inpatient services facilities that were divested in 2003 that used services provided by this segment;

  31

  ---

  SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

   

• the Medicare Part B therapy cap that, although now under a moratorium, that decreased revenues by $4.7 million; and
• approximately $2.0 million in bad debt collections in 2002 that was not repeated in 2003.

Medical Staffing. The year over year decrease in this segment was primarily driven by two factors:

• the economic downturn in the nursing component of this segment across the industry as more long-term facilities and hospitals utilized less contract labor in efforts to contain costs; and
• start-up costs for 12 new offices, associated with expansion of this segment, and shut-down costs for closures of 14 offices, associated with under-performing locations.

Home Health. Driven by increases in home care visits seen industry-wide in 2003, this segment performed well when compared to 2002. Two agencies were opened in 2003 also attributed to the slight increase in net income.

Laboratory and Radiology. The unfavorable comparison of 2003 to 2002 net income for this segment is attributable primarily to:

• adverse accounts receivable collection performance and increased bad debt expense, coupled with
• increased operating costs associated with wage inflation for technicians and radiologists.

Corporate. The decrease in net losses in 2003 from 2002 for this segment were primarily the result of the restructuring initiatives we undertook in 2003 with personnel reductions that resulted in lower salaries and wages and general and administrative costs.

     The following table reconciles net segment (loss) income to consolidated income (loss) before income taxes and discontinued operations:

     Corporate expenses include amounts for interest and corporate general and overhead expenses including those provided to our subsidiaries. In 2001, we allocated certain corporate expenses of $85.1 million to our other segments through overhead cost sharing arrangements and intersegment interest charges based on segment net revenues. Interest was charged based upon average net asset balances at rates determined by management. In 2002, we discontinued this process for segment reporting.

32

     In accordance with SOP 90-7, items of expense or income that are incurred or realized by us because we were in reorganization are classified as reorganization costs in our consolidated statements of operations. As a result, net segment (loss) income do not include interest earned subsequent to the Filing Date on cash accumulated because we are not paying our prepetition obligations. Interest earned prior to the Filing Date is included in net segment (loss) income.  Debt discounts and deferred issuance costs that were written-off after the Filing Date in accordance with SOP 90-7 are not included in the net segment (loss) income.  The amortization of debt discounts and deferred issuance costs prior to the Filing Date are included in net segment (loss) income. Gain on sale of assets and professional fees related to the reorganization incurred subsequent to the Filing Date are excluded from net segment income (loss) which is c onsistent with their treatment prior to the Filing Date.

     The following discussions of the "Year Ended December 31, 2003 compared to the Year Ended December 31, 2002" and the "Year Ended December 31, 2002 compared to the Year Ended December 31, 2001" are based on the financial information presented in "Note 16 - Segment Information" in our consolidated financial statements.

     Due to the number of Inpatient Services facilities divested during 2003, a "same store" basis is included for comparison purposes. A same store basis includes only facilities operated for the full period in the comparison of the operations activity, which represents 109 facilities.

     We reported a net income for the year ended December 31, 2003 of $0.4 million compared to a net income of $1,047.4 million for the prior year. The net income for the year ended December 31, 2003 included the following:

     The net income for the prior year included a gain on extinguishment of debt of $1,498.4 million related to our emergence from bankruptcy in early 2002, an asset impairment charge of $407.8 million, a $20.0 million charge for patient care liability costs related to our inpatient services operation, a favorable adjustment of $6.0 million related to workers' compensation insurance costs primarily related to our inpatient services operation, and a $8.7 million gain on sale of assets, net, primarily due to the reversal of prepetition liabilities related to disposed facilities.

     Our net revenues were $834.0 million during the year ended December 31, 2003 compared to $980.9 million for the prior year. The decrease in net revenues of approximately $146.9 million for the year ended December 31, 2003, as compared to the prior year, primarily consisted of the following:

33

     The increase in net revenues of $21.9 million from our inpatient services operations on a same store basis for the year ended December 31, 2003, as compared to the year ended December 31, 2002, was primarily due to the following:

     Operating salaries and benefits for the year ended December 31, 2003 were $528.0 million as compared to $620.0 million for the year ended December 31, 2002. The decrease of $92.0 million was primarily the result of personnel cost reductions that occurred commensurate with the inpatient facility divestitures.

     With an increase of $0.4 million for the year ended December 31, 2003 as compared to the year ended December 31, 2002, costs related to workers' compensation and general and professional liability insurance costs remained essentially flat year over year; however, the 2002 expenses were inflated with a net $14.0 million charge recorded in third quarter of 2002 for prior year policy exposures.

     We reported rent expense of $49.6 million in 2003 as compared to $68.4 million in 2002. For the year ended December 31, 2003, rent expense for our inpatient services operation was approximately $41.2 million compared to $60.0 million for the same period ended December 31, 2002 due primarily to lease terminations and divestitures of inpatient facilities during 2003. On a same store basis in the year over year comparison, rent expense decreased $2.3 million to $40.8 million compared to $43.1 million in 2002 due to the renegotiation of leases of during the restructuring of our portfolio of skilled nursing facilities in 2003.

34

     We reported other operating expenses, other corporate general and administrative expenses and provision for losses on accounts receivable of $214.4 million for the year ended December 31, 2003 compared to $256.6 million for the same period in 2002. The decrease of approximately $42.2 million consisted of the following:

     The decrease in other operating and administrative expenses and provision for losses of $38.4 million from our inpatient services operations included an increase in our same store operations of $2.0 million for the year ended December 31, 2003 as compared to the same period in 2002. The $2.0 million increase was comprised of:

     Interest expense, net, increased to $16.9 million for the year ended December 31, 2003, as compared to $15.2 million for the same period in 2002, a $1.7 million increase. $2.4 million of the increase was due primarily to the recognition of interest expense at a higher effective interest rate for our term loan offset by a $0.7 million decrease related to lower interest charges incurred due to lower carrying values on our debt instruments during 2003 as compared to 2002. While we were under bankruptcy protection through the two months ended February 28, 2002, we did not record interest on essentially all of our prepetition debt. Had we not been under bankruptcy protection, our interest expense, net, for the year ended December 31, 2002 would have been $38.9 million.

35

     Depreciation and amortization expense decreased to $7.5 million for the year ended December 31, 2003, as compared to $21.9 million for the same period in 2002. The decrease was attributable to decreases in property carrying amounts as a result of the impairment recorded in the fourth quarter of 2002.

     We recorded a provision for income taxes of approximately $1.3 million, of which $0.6 million was related to discontinued operations, for the year ended December 31, 2003, primarily related to state income taxes. We increased our valuation allowance on our deferred tax assets by $93.3 million during 2003 to $708.8 million as of December 31, 2003. This valuation allowance is required under the guidance in Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes, " due to our historical operating performance and our cumulative net losses. Our realization of the deferred tax benefits primarily associated with our net operating losses ("NOL") is dependent upon our achieving sufficient future pre-tax income. Under federal income tax law, we have up to 20 years to generate sufficient taxable income to realize the deferred benefits from NOLs. Given the size of our pre-tax loss, a valuation allowance is considered appropriate under the a ccounting standards.

     At December 31, 2003, we have Federal NOL carryforwards of $1.0 billion with expiration dates from 2004 through 2023. Various subsidiaries have state NOL carryforwards totaling $939.5 million with expiration dates through the year 2023. In addition, we have capital loss carryforwards of $272.6 million, of which $10.1 million will expire in 2004 and $260.4 million will expire in 2006 and $2.1 million will expire in 2007. Our alternative minimum tax credit carryforward of $4.3 million has no expiration date. Our $7.2 million of other tax credit carryforwards will expire in years 2004 through 2022.

     We reported a net income for the year ended December 31, 2002 of $1,047.4 million compared to a net loss of $69.4 million for the prior year. The net income for the year ended December 31, 2002 included the following:

36

     Net income for 2001 included $42.9 million for reorganization costs, net, related to our bankruptcy and restructuring activities, a loss on asset impairments of $18.8 million and a restructuring charge of $1.1 million. In 2001, we recorded our settlement with the US government, which resulted in a charge of $11.0 million. In connection with the settlement, we reversed $52.1 million of net excess reserves related to routine cost limit exception payments. The reversal of the reserves is reflected as a component of net patient revenue in the 2001 consolidated statement of operations.

     After adjusting for the impact of SFAS No. 144 for the loss from discontinued operations, our net revenues for the year ended December 31, 2002 were $980.9 million compared to $2,075.2 million for the prior year. The decrease in net revenues of approximately $1,094.3 million for the year ended December 31, 2002, as compared to the prior year, primarily consisted of the following:

   The unfavorable $34.8 million variance from inpatient services on a same store basis, reflects the impact of the aforementioned favorable adjustment of $52.1 million included in 2001 revenues. Without this adjustment in 2001, inpatient services' revenue on a same store basis increased by $17.3 million, primarily as a result of the following:

37

     Operating salaries and benefits for the year ended December 31, 2002 were $620.0 million as compared to $1,114.5 million for the year ended December 31, 2001. The decrease of $494.5 million was primarily the result of lease terminations and facility divestitures in our inpatient services operations. For the ten months ended December 31, 2002, costs associated with divested facilities have been reclassified into discontinued operations. For the year ended 2001, these costs were included in results of operations.

     We reported self-insurance costs of $38.0 million for the year ended December 31, 2002 as compared to $113.0 million for the year ended December 31, 2001. The decrease of $75.0 million is primarily related to the lease terminations and facility divestitures in our inpatient services operations and the impact of the reclassification of such costs in the ten month period ended December 31, 2002 for discontinued operations per SFAS No. 144.

     We reported rent expense of $68.4 million in 2002 as compared to $171.5 million in 2001. Excluding the impact of SFAS No. 144, on a same store basis in the year over year comparison, rent expense decreased $4.3 million to $43.1 million compared to $47.4 million in 2001 due to the renegotiation of leases and facility divestitures during the restructuring of our portfolio of skilled nursing facilities in 2002.

     We reported other operating expenses, other general and administrative expenses and provision for losses on accounts receivable of $256.6 million during the year ended December 31, 2002 compared to $627.1 million during the prior year. The decrease in expenses of $370.5 million primarily consisted of the following:

     The increase in other operating expenses for same store operations was due to the following items:

     Interest expense of $7.7 million, after the reclassification of $8.4 million to loss from discontinued operations as required by SFAS No. 144, was recorded in the year ended December 31, 2002 compared to $12.6 million in the prior year. The increase of $3.5 million in interest was due primarily to the recognition of interest for all of our debt instruments. While we were under bankruptcy protection for two months in 2002 we did not record interest expense on essentially all of our prepetition debt. Had we not been under bankruptcy protection in 2002, our interest expense, net for the year 2001 would have been $155.4 million.

     Depreciation and amortization expense was flat compared to the prior year with $32.9 million for 2002, excluding the impact of SFAS No. 144 that required the reclassification of $11.0 million to loss from discontinued operations in 2002, compared to $32.8 million for 2001.

     We recorded a provision for income taxes of approximately $0.6 million for the year ended December 31, 2002, primarily related to state income taxes. We increased our valuation allowance on our deferred tax assets by $139.4 million during 2002 to $615.5 million as of December 31, 2002. This valuation allowance is required under the guidance in Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes, " due to our historical operating performance and our cumulative net losses. Our realization of the deferred tax benefits primarily associated with our net operating losses ("NOL") is dependent upon our achieving sufficient future pre-tax income. Under federal income tax law, we have up to 20 years to generate sufficient taxable income to realize the deferred benefits from NOLs. Given the size of our pre-tax loss, a valuation allowance is considered appropriate under the accounting standards.

     For the year ended and as of December 31, 2003, our net income was $0.4 million and our working capital deficit was $57.4 million. Our working capital position was significantly improved as a result of the net proceeds of $52.3 million received from our private placement of our common stock and warrants in February 2004, even after paying off the outstanding loan balance under our revolving senior loan agreement. We anticipate that our working capital position will be further improved by, among other things, refinancing $21.2 million of mortgage debt that matures on May 1, 2004, which is classified as a current liability. We are currently in negotiation to refinance these mortgages and expect the $21.2 million to be refinanced and/or retired in part with the remaining balance reclassified as long- term debt.

     As of March 1, 2004, we had cash and cash equivalents of approximately $40.1 million, no outstanding balance under our revolving loan agreement and approximately $31.0 million of funds available for borrowing under our revolving senior loan agreement. We believe that our existing cash reserves and availability for borrowing under our loan agreement will provide sufficient funds for our operations, capital expenditures and regularly scheduled debt service payments through the next twelve months.

     We have reached agreement with substantially all of our landlords regarding the disposition of past due rent on our divested or to be divested facilities. On March 1, 2004, we entered into an Amended and Restated Master Lease Agreement with Omega Healthcare Investors, Inc. and various of its affiliates ("Omega"). Prior to our portfolio restructuring, we leased 51 facilities from Omega. Pursuant to the new Master Lease, we will continue to operate 30 facilities (including 23 long-term care facilities, two rehabilitation hospitals, and five behavioral facilities). Approximately $7.8 million of accrued past due rent as of March 1, 2004 and future rent obligations that would otherwise have become due under the existing master leases will be combined into "deferred base rent". That deferred base rent will bear interest at a floating rate equal to 375 basis points over the one year LIBOR rate, subject to a floor of 6% per annum. Interest will not be payab le until January 2008, at which time interest thereafter accruing will be payable monthly in arrears. Omega has the right to convert the deferred base rent and accrued interest into 800,000 shares of our common stock, subject to anti-dilution adjustments for sales of shares we make at less than fair market value at the time of sale. We have the right to pay cash in an amount equal to the value of the stock in lieu of issuing the stock to Omega. If the average value of the common stock issuable to Omega under the new Master Lease exceeds 140% of the deferred base rent and interest accrued thereon over a period of 30 business days, we can require Omega to convert the deferred base rent into our common stock.    

     As of September 5, 2003, we entered into a Loan and Security Agreement with CapitalSource Finance LLC, as collateral agent, and certain other lenders (the "Revolving Loan Agreement"). The Revolving Loan Agreement is a $75.0 million two-year revolving line of credit that is secured by our accounts receivable, inventory, equipment and other assets, and the stock of our subsidiaries. Pursuant to the Revolving Loan Agreement, we are paying interest (i) for Base Rate Loans at the greater of (a) prime plus 1.0% or (b) 5.25%, and (ii) for LIBOR Loans at the greater of (a) the London Interbank Offered Rate plus 3.75% or (b) 5.25%. The effective interest rate as of December 31, 2003 on borrowings under the Revolving Loan Agreement was approximately 5.25%. The weighted average borrowing interest rate for the period from September 5, 2003 through December 31, 2003 was 5.25%. Our borrowing availability under the Revolving Loan Agreement is generally limited to up to e ighty-five percent (85%) of the value of Eligible Receivables plus eighty-five percent (85%) of the value of Eligible Divested Company Receivables, but not to exceed $75.0 million. The defined borrowing base as of December 31, 2003 was $47.6 million, net of specified reserves of $15.0 million. The availability of amounts under our Revolving Loan Agreement is also subject to our compliance with certain financial ratios. As of December 31, 2003, we were in compliance with these ratios. As of December 31, 2003, we had borrowed approximately $13.1 million, which included $1.1 million of prepaid finance fees that will be amortized over the next nine months and does not count against availability, and we had issued approximately $21.7 million in letters of credit, leaving approximately $13.9 million available for additional borrowing. We have classified our Revolving Loan Agreement as a long-term liability at December 31, 2003. In connection with entering into the Revolving Loan Agreement, we incurred deferred financing costs of $2.6 million, which are amortized using the effective interest method over the life of the loan agreement.

     On February 20, 2004, we completed a private placement of our common stock and warrants to purchase common stock to investors. We received net proceeds of approximately $52.3 million in the private placement. We sold approximately 4.4 million shares of our common stock, and warrants to purchase approximately 1.8 million shares of our common stock (inclusive of warrants paid to the placement agent). The price paid by investors was $12.70 per unit, except for 155,400 units sold at $12.87 per unit. Each unit consisted of one share of common stock and a warrant to purchase 0.4 shares of common stock with a warrant exercise period of five years.

     On July 15, 2003, we sold the assets of our pharmaceutical services operations, including substantially all of the assets of SunScript Pharmacy Corporation, to Omnicare, Inc. for $90.0 million, of which $75.0 million was received in cash at closing with up to $15.0 million in additional purchase price, payable to us on or before July 15, 2005 subject to fulfillment of the conditions described below. We simultaneously entered into agreements pursuant to which Omnicare would provide pharmacy services to our inpatient facilities (the "Pharmacy Agreements"). The $15.0 million holdback portion is subject to reduction in the event that prior to payment: (i) we reject or modify one or more Pharmacy Agreements in a bankruptcy proceeding; (ii) the new operator of any of our divested facilities does not assume the same contract with Omnicare; and/or (iii) we breach the Pharmacy Agreements. On July 15, 2003, we used $39.5 million to pay off a prior term loan (including the $3.7 million discounted interest), $33.9 million to partially reduce our borrowing under our prior revolving loan agreement and $1.6 million for professional fees related to the sale.

     We have substantially completed our restructuring efforts, including the restructuring of the portfolio of leases under which we operate most of our long-term care facilities. Through December 31, 2003, we had divested 127 facilities and had identified nine facilities that we would seek to transition to new operators. During the year ended December 31, 2003 we withheld approximately $28.0 million in accrued rent payments and $0.7 million of mortgage payments on facilities that we identified for transfer to new operators. Through December 31, 2003, we were released of our obligations to pay approximately $13.5 million of the withheld rent and $20.4 million of future mortgage debt. These amounts were recorded in our net gain on disposal in discontinued operations. The gain was significantly offset by the increase of accounts receivable allowances of $24.6 million recorded in 2003 related to the divestiture of the 127 facilities and amounts recorded to reduce remaining facility assets to net realizable value, netting to a gain of $5.8 million through December 31, 2003. The remaining amounts that we withheld and that were not released are classified as current obligations at December 31, 2003.

     We incurred total capital expenditures related primarily to improvements at existing facilities, as reflected in the segment reporting, of $13.6 million, $34.7 million, $4.0 million and $30.3 million for year ended December 31, 2003, the ten months ended December 31, 2002, the two months ended February 28, 2002, and the year ended December 31, 2001, respectively. These capital expenditures include those related to discontinued operations of $3.8 million and $13.8 million, respectively, for the year ended December 31, 2003 and the ten month period ended December 31, 2002. We had construction commitments as of December 31, 2003 under various contracts of approximately $0.8 million related to improvements at facilities.     

41

     On February 28, 2002, we delivered a promissory note to the United States of America as part of our settlement agreement with the federal government and $8.0 million remains outstanding under the note. The outstanding payments coming due under the promissory note are payable as follows: $2.0 million on February 28, 2005; and $3.0 million on each of February 28, 2006 and 2007. Interest under the promissory note is based upon the weekly average one-year constant maturity treasury yield. The effective interest rate as of December 31, 2003 was approximately 2.2%.

     We continue to negotiate settlements of bankruptcy claims for periods prior to October 14, 1999 that were filed by various State Medicaid agencies. We expect to pay in excess of approximately $3.6 million to the State Medicaid agencies to resolve these claims. The payments are expected to be made partly in cash, partly with promissory notes and potentially netted against reimbursements payable to us. We currently have $4.0 million reserved against our borrowing base agreement relating to these payments.

     The following table provides information about our contractual obligations and commitments in future years as of December 31, 2003 (in thousands):

   Actual letters of credit outstanding as of December 31, 2003 were $39.4 million, however approximately $17.7 million were duplicative and required to replace existing letters of credit when our prior loan agreement was refinanced such that our total exposure for letters of credit under our credit facility was $21.7 million.

42

     Healthcare costs have been rising and are expected to continue to rise at a rate higher than that anticipated for consumer goods as a whole. Our operations could be adversely affected if we experience significant delays in receiving reimbursement rate increases from Medicaid and Medicare sources for our labor and other costs.

     We are exposed to market risk because we hold debt that is sensitive to changes in interest rates. We manage our interest rate risk exposure by maintaining a mix of fixed and variable rates for debt. The following table provides information regarding our market sensitive financial instruments and constitutes a forward-looking statement.

     Information with respect to Item 8 is contained in our consolidated financial statements and financial statement schedules and are set forth herein beginning on Page F-1.

     Not applicable.

     As of the end of the period covered by this report, our management, including our Chief Executive Officer (who also serves as Chairman of the Board) and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures. Disclosure controls and procedures are designed to ensure that information required to be disclosed in our periodic reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. No change in our internal control over financial reporting occurred during the last fiscal quarter of 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

43

     Our directors and executive officers as of March 1, 2004 were: