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

For the quarterly period ended March 31, 2005

or

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

Commission File Number: 0-49663

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

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

     As of May 2, 2005, there were 15,328,115 shares of the Registrant's $.01 par value Common Stock outstanding, inclusive of 10,182 shares of treasury stock.

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See accompanying notes.

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See accompanying notes.

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See accompanying notes.

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See accompanying notes.

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     References throughout this document to the Company include Sun Healthcare Group, Inc. and our direct and indirect consolidated subsidiaries. As of July 1, 2004, as a result of our application of the Financial Accounting Standards Board's ("FASB") Revised Interpretation No. 46 Consolidation of Variable Interest Entities ("FIN No. 46(R)"), our financial statements also include three partnerships, five limited liability companies and one sole proprietorship (collectively known as "Clipper"). We own less than eight percent of the voting interests of each of these entities. See "Note 7 - Variable Interest Entities" for additional information concerning FIN No. 46(R). In accordance with the Securities and Exchange Commission's "Plain English" guidelines, this Quarterly Report on Form 10-Q 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 consolida ted subsidiaries and not any other person.

     We are a provider of long-term, subacute and related specialty healthcare services in the United States. We operate through 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. Inpatient services represent the most significant portion of our business. As of March 31, 2005, we operated 103 long-term care facilities in 13 states.

     The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States. In our opinion, the accompanying interim consolidated financial statements present fairly our financial position at March 31, 2005 and December 31, 2004, the consolidated results of our operations and cash flows for the three-month period ended March 31, 2005 and 2004, respectively. We believe that all adjustments are of a normal and recurring nature, and are considered necessary for a fair presentation. These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations. Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2004, which are included in our Annual Report on Form 10-K for the year ended December 31, 2004. The results of operations presented in the accompanying consolidated financial statements are not necessarily representative of operations for an entire year.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of third-party payor settlements, allowances for doubtful accounts, self-insurance obligations and loss accruals. Actual results could differ from those estimates.

     Certain reclassifications of assets, liabilities, income and expense have been made to the prior period financial statements to conform to the 2005 financial statement presentation.

     For the three months ended and as of March 31, 2005, our net loss was $1.2 million and our working capital deficit was $29.4 million. As of March 31, 2005, we had cash and cash equivalents of approximately $17.2 million, $17.0 million outstanding under our Revolving Loan Agreement (defined below) and approximately $14.0 million of funds available for borrowing under our Revolving Loan Agreement, which expires March 1, 2007. We believe that our existing cash reserves, the proceeds of up to $15.0 million due to us in the third quarter of 2005 from the sale of our pharmacy operations in 2003, and availability for borrowing under our loan agreement will provide sufficient funds for our operations, capital expenditures and regularly scheduled debt service payments at least through the next twelve months.

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     For the three months ended March 31, 2005, the net cash decrease was approximately $5.4 million. The decrease was primarily due to:

     During the quarter ended March 31, 2005, we divested one facility and have identified two facilities that we would seek to transition to new operators. During the period of January 1, 2003 through March 31, 2005, we divested 134 inpatient facilities. During that restructuring of our facility portfolio, we withheld certain rent and mortgage payments from our landlords and mortgagors. As of March 31, 2005, $0.3 million of the unpaid rent and mortgages related to divested buildings remained in other accrued liabilities.

     We have a Loan and Security Agreement with CapitalSource Finance LLC, as collateral agent, and certain other lenders (the "Revolving Loan Agreement") that, as amended on March 1, 2005, expires on March 1, 2007. The Revolving Loan Agreement is a $75.0 million revolving line of credit that is secured by our accounts receivable, inventory, equipment and other assets, including the stock of our subsidiaries. Pursuant to the Revolving Loan Agreement, the interest rate for the Base Rate Loans is calculated at the greater of 4.75% or prime plus 0.5%, and the interest rate for LIBOR Loans is calculated at the greater of 4.75% or the London Interbank Offered Rate plus 3.25%. The effective interest rate as of March 31, 2005 on borrowings under the Revolving Loan Agreement was approximately 6.09%. The weighted average borrowing interest rate for the period from January 1, 2005 through March 31, 2005 was 6.27%. Our borrowing availability under the Revolving Loan Agreement is generally limited to up to eighty-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 March 31, 2005 was $40.6 million, net of specified reserves of $12.6 million. We are also prohibited under our Revolving Loan Agreement from borrowing money from third parties without the prior consent of CapitalSource Finance. As of March 31, 2005, approximately $9.6 million in letters of credit had been issued and approximately $17.0 million had been borrowed under the Revolving Loan Agreement, leaving approximately $14.0 million available to us for additional borrowing. 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. For the three months ended March 31, 2005, we amortized $0.2 million of t hese deferred financing costs.

     The availability of amounts under our Revolving Loan Agreement is subject to our compliance with certain financial covenants contained in the Revolving Loan Agreement. These covenants include a minimum fixed charge coverage calculation which requires a minimum required availability (cash on hand plus borrowing availability) that must exceed total Fixed Charges less Operating Cash Flow for a rolling twelve-month period, and a maximum of $10.0 million per any

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six-month period that may be expended on capital expenditures with respect to fixed assets. As of May 2, 2005, we were in compliance with these covenants.

(4)  Long-Term Debt

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

     The scheduled or expected maturities of long-term debt as of March 31, 2005, were as follows (in thousands):

     In accordance with the provisions of Statement of Financial Accounting Standard, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS No. 144"), the results of operations of the disposed assets and the gains (losses) related to these divestitures have been classified as discontinued operations for all periods presented in the accompanying consolidated statements of operations.

     Inpatient Services: During the three months ended March 31, 2005, we divested one skilled nursing facility in accordance with our restructuring plan.

     Rehabilitation Therapy Services: On December 31, 2004, we closed our comprehensive outpatient rehabilitation facilities ("CORF") in Colorado.

     Laboratory and Radiology Services: On November 1, 2004, BioPath Clinical Laboratories, Inc. ("BioPath"), a subsidiary of Sun, sold its clinical laboratory and radiology operations located in California. We received approximately $1.6 million in cash in connection with this sale, of which $0.9 million was received in the first quarter of 2005.

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     Other Operations: On November 7, 2003, Shared Healthcare Systems, Inc. ("SHS"), a majority owned subsidiary, sold substantially all of 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 $0.5 million paid in cash in December 2004.

     A summary of the discontinued operations for the periods presented is as follows (in thousands):

     As of March 31, 2005, assets held for sale consisted of (i) the owned assets of a skilled nursing facility with a carrying value of $0.1 million, and (ii) two undeveloped parcels of land and an office building collectively valued at $2.9 million. In the first quarter of 2005, we reclassified $0.7 million in artwork to other assets that was previously classified in assets held for sale. The skilled nursing facility reported revenues of $0.6 million and $0.5 million and net operating losses of $0.1 million and $0.1 million in discontinued operations for the three month periods ended March 31, 2005 and 2004, respectively.

     We recognized a $0.3 million charge to loss on sale of assets associated with the write-down of land and building sold in the first quarter of 2005.

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     In December 2003, the FASB issued a revision to Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN No. 46(R)"), which was originally issued in January 2003. FIN No. 46(R) provides guidance on the consolidation of certain entities when control exists through means other than ownership of voting (or similar) interests and was effective for public entities that have interests in variable interest entities commonly referred to as special purpose entities for the first reporting period that ends after March 15, 2004. FIN No. 46(R) requires consolidation by the majority holder of expected residual gains and losses of the activities of a variable interest entity ("VIE").

     We currently own less than 8% of the voting interest in three partnerships, five limited liability companies and one sole proprietorship, each of which own one facility that we operate in New Hampshire (collectively known as "Clipper"). In April 2004, we entered into an agreement with the owners of the remaining interests in those nine entities. That agreement granted us options, exercisable sequentially over a period of seven years, pursuant to which we can acquire up to 100% of the ownership of those nine entities for an aggregate amount of up to approximately $10.3 million. The agreement also provides the owners the right to require us to purchase those ownership interests at the above described option prices. These put rights can be exercised for any options that have come due but which were not exercised up to that point in time, but no later than December 31, 2010 (see "Note 15 - Subsequent Events"). Clipper's objective is to achieve rental income from the leasing of skilled nursing and assisted living facilities owned by Clipper.

     We have concluded that Clipper, as identified above, meets the definition of a VIE because we have agreements with the majority owners granting us the option to acquire, and the right of the owners to put to us, 100% ownership of Clipper. We have recognized $9.8 million of the option value in other long-term liabilities in our consolidated balance sheet. The remaining $0.5 million is recorded as current in other accrued liabilities in our consolidated balance sheet. We have not recorded any minority interest associated with the 92.5% interest in which we do not own since the partnerships' net equity was a deficit and as the primary beneficiary, we would be responsible for all of their losses. Pursuant to FIN No. 46(R), we have eliminated facility rent expense of $0.8 million and included $51.1 million of mortgage debt of Clipper in our consolidated balance sheet as of March 31, 2005, although we own less than eight percent of the voting interest in the Clipp er properties and are not directly obligated on the debt. The debt is collateralized by the fixed assets of the respective partnerships, limited liability companies and sole proprietorship that own the Clipper properties and none of our assets. Creditors do not have any general recourse against us for the mortgage debt. As the primary beneficiary of the VIE, we consolidated Clipper beginning in the third quarter of 2004. This change had no effect on previously reported net earnings.

     The following provides a summary of the balance sheet impact of Clipper upon consolidation as of March 31, 2005 (in thousands):

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     For the three months ended March 31, 2005, the consolidation of Clipper included a net loss of $0.9 million comprised of $1.1 million of interest expense, $0.3 million of depreciation expense, and a $0.4 million loss on extinguishment of debt, partially offset by a $0.9 million net credit to rent expense. The $0.9 million net credit to rent expense consisted of $1.4 million in the elimination of cash rent paid to Clipper by the New Hampshire operations offset by $0.5 million in elimination of the non-cash unfavorable lease intangible associated with the rent paid to Clipper by the New Hampshire operations.

     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 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. Provisions for estimated reserves, including incurred but not reported losses, are provided in the period of the related coverage. These provisions are based on actuarial analyses, internal evaluations of the merits of individual claims, and industry los s development factors or lag analyses. The methods of making such estimates and establishing the resulting reserves are reviewed periodically, and any resulting adjustments are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

     Prior to January 1, 2000, the maximum loss exposure with respect to the third-party insurance policies was $100,000 per claim for general and professional liability. 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, and we obtained excess insurance policies for claims above those amounts. The programs had the following self-insured retentions: (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 and 2005, $10.0 million per claim, with a single $5.0 million excess layer that attaches at $5.0 million of liability, available for claims made in 2004, 2005 and 2006. An independent actuarial analysis is prepared twice a year to determ ine the expected losses and reserves for estimated settlements for general and professional liability under the per claim retention level, including incurred but not reported losses. For the years 2000 through 2005, these reserves are provided on an undiscounted basis. We believe our range of exposure at March 31, 2005 was consistent with the actuarial estimate as of December 31, 2004. We anticipate that the range will decline over time as risks associated with facilities we no longer operate age past the applicable statute of limitations. The paid claims for the three months ended March 31, 2005 were $10.5 million, of which $5.5 million was paid for settlements and $5.0 million was paid for the release of a letter of credit. The paid claims for the three months ended March 31, 2004 were $6.0 million.

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     The majority of our workers' compensation risks are insured through insurance policies with third parties. Our reserves are estimated by independent actuaries beginning with the 2000 policy year and by company analysis using industry development factors for prior years. Effective with the policy period beginning January 1, 2002, we discount our workers' compensation reserves based on a 4% discount rate. At March 31, 2005, the discounting of these policy periods resulted in a reduction to our reserves of approximately $8.7 million. We believe our range of exposure at March 31, 2005 was consistent with the actuarial estimate as of December 31, 2004. The paid claims for each of the three months ended March 31, 2005 and 2004 were $6.5 million and $12.6 million, respectively.

     The provision for loss for insurance risks was as indicated (in thousands):

     A summary of the assets and liabilities related to insurance risks at March 31, 2005 and December 31, 2004 were as indicated (in thousands):

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(a) Common Stock

     As of March 31, 2005, the Reorganized Company had issued approximately 9,908,080 shares of common stock in connection with the extinguishment of liabilities subject to compromise. As of March 31, 2005, we expected to issue up to an additional 91,920 shares of our common stock to general unsecured creditors with claims of more than $50,000 in accordance with the provisions of the Plan of Reorganization. The fair value of the additional common stock expected to be issued is approximately $2.5 million valued at $27.00 per share by our reorganization plan and was recorded in other long-term liabilities in the March 31, 2005 consolidated balance sheet. We issued 4,425,232 shares in a private placement in February 2004 and 760,000 shares to Omega Healthcare Investors, Inc. ("Omega") upon Omega's exercise of its right to convert approximately $7.8 million of deferred base rent into our common stock in April 2004. On May 2, 2005, the closing price of our common s tock on Nasdaq was $6.04 per share.

     As of March 31, 2005, Sun had issued 150,000 shares of restricted common stock valued at $27.00 per share and 84,886 shares of restricted common stock valued at $11.25 per share to its executive officers and key employees on the date of grant. The restricted common stock vests over a four-year period. Restricted stock awards are outright stock grants. The issuance of restricted stock and other stock awards requires the recognition of compensation expense measured by the fair value of the stock on the date of grant. For the three months ended March 31, 2005 and 2004, we recognized $0.2 million in expense related to the issuance of these stock awards each period.

(b) Warrants

     In February 2004, in conjunction with our private equity offering, we issued warrants to purchase 2,017,897 shares of our common stock, of which 1,707,924 shares have a strike price of $12.65, 62,160 shares have a strike price of $12.82, and 247,813 shares have a strike price of $15.87. The warrants have an exercise period of five years.

(c) Stock Option Plan

     Our 2004 Equity Incentive Plan (the "2004 Plan") allows for the issuance of up to 2.1 million shares of our common stock. As of March 31, 2005, our employees and directors held options to purchase 975,510 shares under the 2004 plan and we had issued 234,886 shares of restricted common stock and awarded 130,500 restricted stock units.

     Our 2002 Non-employee Director Equity Incentive Plan (the "Director Plan") allows for the issuance of up to 40,000 options to purchase shares of our common stock. Upon the adoption of the 2004 Plan, the grant of further awards under the Director Plan was suspended so that no additional awards could be made under the Director Plan. As of March 31, 2005, our directors held options to purchase 40,000 shares under the Director Plan.

     As of March 31, 2005, we had outstanding options covering an aggregate of 1,015,510 shares of our common stock to our employees and directors, of which 20,000 options were granted with a strike price of $27.00 per share and expire in 2009, 425,000 options were granted with a strike price of $7.71 per share and expire in 2009, 9,910 options were granted with a strike price of $7.85 per share and expire in 2011, 365,600 options were granted with a strike price of $6.85 per share and expire in 2011, 20,000 options were granted with a strike price of $11.25 per share and expire in 2011, 25,000 options were granted with a strike price of $8.44 per share and expire in 2012, and 150,000 options were granted with a strike price of $7.41 per share and expire in 2012. The strike prices were equal to or greater than the estimated market value at date of issuance. The options vest over a two- to four-year period.

     We account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25"), and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of our stock at the date of grant over the amount an employee must pay to acquire the stock. We currently do not recognize compensation expense for most of our stock option grants, which are issued at fair market value on the date of grant and accounted for under the intrinsic value method, prescribed in APB No. 25. However, in 2004, we cancelled options with an exercise price of $27.00 per share to eliminate significantly out-of-the money options for our employees. New options totaling 262,700 with an exercise price of $6.85 were granted within six months of this cancellation. For the three months ended March 31, 2005, we

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recorded a credit of $0.1 million to compensation expense on these new options as the stock price at the end of the quarter was less than $6.85 and compensation expense previously recognized on outstanding options was reversed.

     Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure ("SFAS No. 148"), issued on December 31, 2002, provides companies alternative methods to transitioning to Statement of Financial Accounting Standards No. 123, Stock-Based Compensation ("SFAS No. 123"), fair value method of accounting for stock-based employee compensation and amends certain disclosure requirements. SFAS No. 148 does not mandate fair value accounting for stock-based employee compensation but does require all companies to meet the disclosure provisions.

     For purposes of pro forma disclosures, the estimated fair market value of the stock options is amortized to expense over their respective vesting periods. The fair market value has been estimated at the date of grant using a Black-Scholes option pricing model. The following table summarizes our pro forma basic and diluted net loss per share assuming we accounted for our stock option grants in accordance with SFAS No. 123, for the periods indicated (in thousands, except per share amounts):

     The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Since our stock options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.  The effects of applying SFAS No. 123 in this pro forma disclosure are not indicative of future amounts. Additional option grants in future years are anticipated.

     On December 16, 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment ("SFAS No. 123(R)"), which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes APB No. 25 and amends Statement of Financial Accounting Standard No. 95, Statement of Cash Flows ("SFAS No. 95.") Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.

     SFAS No. 123(R) must be adopted for fiscal years commencing no later than January 1, 2006. Early adoption will be permitted in periods in which financial statements have not yet been issued. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods:

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     We plan to adopt SFAS No. 123(R) using the modified-prospective method by January 1, 2006. Based on the estimated value of current unvested stock options, we expect wages and related expenses to increase $0.6 million for the year ended December 31, 2006, beginning January 1, 2006.

     Basic net (loss) income per share is based upon the weighted average number of common shares outstanding during the period. The weighted average number of common shares for the three months ended March 31, 2005, include the common shares issued in connection with emergence from bankruptcy, common shares to be issued once the prepetition claims are finalized, the common shares issued in connection with our private placement in February 2004, the common shares issued to Omega Healthcare Investors, Inc., in connection with restructurings of leases, and the common shares issued as common stock awards. See "Note 9 - Capital Stock."

     The diluted calculation of (loss) income per common share includes the dilutive effect of warrants, stock options and non-vested restricted stock. However, in periods of losses, diluted net loss per share is based upon the weighted average number of common shares outstanding during the period.

     The provision for income taxes is based upon our estimate of taxable income or loss for each respective accounting period. We recognized an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled. We also recognized as deferred tax assets the future tax benefits from net operating loss ("NOL"), capital loss, and tax credit carryforwards. A valuation allowance was provided for deferred tax assets as it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

     The current benefit for income taxes of $0.8 million for the three months ended March 31, 2005 consisted of $0.9 million of IRS refunds received due to NOL carrybacks offset by $0.1 million of estimated state income tax liability for the period. The current benefit for income taxes of $1.3 million for the three months ended March 31, 2004 consisted of $1.4 million of IRS refunds received due to NOL carrybacks offset by $0.1 million of estimated state income tax liability for the period. These estimated state income tax liabilities resulted from the operations of profitable subsidiaries in states that do not allow combined, consolidated or unitary tax return filings. No overall tax benefits other than for refunds received were recorded for these periods for federal income tax purposes since the realization of NOL carryforwards is uncertain.

     In connection with our emergence from bankruptcy on February 28, 2002, we realized a gain on the extinguishment of debt of approximately $1.5 billion. This gain was not taxable since the gain resulted from our reorganization under the Bankruptcy Code. However, pursuant to Section 108 of the Internal Revenue Code, we were required, as of the beginning of our 2003 taxable year to reduce certain tax attributes, including (a) NOL and capital loss carryforwards, (b) certain tax credits, and (c) tax bases in assets, in an amount equal to such gain on extinguishment.

     After considering the reduction in tax attributes discussed above, we have federal NOL carryforwards of $1.1 billion with expiration dates from 2005 through 2025. Various subsidiaries have state NOL carryforwards totaling $869.6 million with expiration dates through the year 2025. In addition, we have capital loss carryforwards of $262.9 million, of which

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$260.4 million, $2.1 million and $0.4 million will expire in 2006, 2007, and 2008, respectively. Our alternative minimum tax credit carryforward of $3.6 million has no expiration date. Our $7.2 million of other tax credit carryforwards will expire in years 2005 through 2022.

     Internal Revenue Code Section 382 imposes a limitation on the use of a company's NOL carryforwards and other losses when the company has an ownership change. In general, an ownership change occurs when shareholders owning 5% or more of a "loss corporation" (a corporation entitled to use NOL or other loss carryovers) have increased their ownership of stock in such corporation by more than 50 percentage points during any three-year testing period beginning on the first day following the change date for an earlier ownership change. The annual base Section 382 limitation is calculated by multiplying the loss corporation's value at the time of the ownership change times the greater of the long-term tax-exempt rate determined by the IRS in the month of the ownership change or the two preceding months.

     Our reorganization under the Bankruptcy Code effective February 28, 2002, constituted an ownership change under Section 382 of the Internal Revenue Code. Therefore, the use of any of our losses and tax credits generated prior to that date which remain after attribute reduction are subject to the limitations described in Section 382. Our application of the rules under Section 382 and Section 108 is subject to challenge upon IRS review. A successful challenge could significantly impact our ability to utilize deductions, losses and tax credits generated prior to 2003.

     We have had significant changes in the ownership of our stock since our emergence from bankruptcy as a result of changes in the holdings of our 5% or more stockholders and our private placement of common stock and accompanying warrants. Future acquisitions and/or capital needs may necessitate the issuance of additional shares which could trigger such a change. In addition, subsequent changes in the holdings of current or future 5% or more shareholders could result in a second ownership change. The resulting base Section 382 limitation that would be imposed on us upon a second ownership change to limit the use of our tax attributes for federal income tax purposes would depend on our value at that time as calculated under the applicable Treasury Regulations.

(a)  Litigation

     In February 2003, the Bureau of Medi-Cal Fraud and Elder Abuse (the "BMFEA"), which is a division of the Office of the Attorney General of the State of California, alleged that we violated the terms of the Permanent Injunction and Final Judgment (the "PIFJ") entered in during October 2001. Those allegations were reiterated in correspondence we received from the BMFEA in October 2004 and again in correspondence received in February 2005. 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. The BMFEA has continued to allege that our California facilities have had inadequate staffing, training and supervision. To remedy these alleged violations, the BMFEA requested that we pay their costs of the investigation, the costs of an independent audit of our operations in California, and an unspecified cash penalty. We believe tha t we are, in fact, currently in full compliance with the PIFJ; however, unless the matter is settled, it is likely that the BMFEA will initiate one or more legal proceedings against us to assert a violation. We cannot predict the remedies that a court may ultimately award against us, or the cost to us resulting from an adverse outcome in this matter. An adverse outcome in these matters could have a material adverse effect on our financial position, results of operations and cash flows. We intend to defend this matter vigorously.

     In January 2004, 12 caregivers, now former employees of SunBridge Care and Rehab for Escondido-East, were arraigned on charges brought by the California Attorney General with respect to allegations that care given to an elderly woman resident was deficient. The court dismissed all charges against the twelve defendants in June 2004. In September 2004, the California Attorney General refiled misdemeanor charges against the same defendants, certain of which charges were likewise dismissed in December 2004, but were once again refiled in December 2004. SunBridge Care and Rehab for Escondido-East is a skilled nursing facility in Escondido, California that was formerly operated by Care Enterprises West, an indirect subsidiary of Sun Healthcare Group, Inc. Care Enterprises West divested its interest in the operations of the facility to an unrelated third party at the end of October 2004. Although Care Enterprises West has paid the costs for the defense of these individuals in this matter to date, neither Sun Healthcare Group, Inc. nor Care Enterprises West has been charged with any wrongdoing.

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     On June 1, 2004, we commenced a declaratory relief action in the Orange County, California Superior Court in which Steadfast Insurance Company, American International Group ("AIG") and certain of AIG's subsidiaries are parties. The action seeks, among other things, a judicial determination that the carrier providing coverage under our excess/umbrella insurance policy for the 2000 through 2002 policy years is obligated to provide first dollar insurance coverage for those three policy years pursuant to the terms of the excess/umbrella policy. That policy provides that the excess/umbrella policy continues in force as underlying insurance upon exhaustion of the underlying primary insurance policy. If we prevail in this action, such a judicial determination would eliminate a portion of our self-insured liabilities for general and professional liability claims. We can give no assurances that we will in fact prevail and, accordingly, our financial statements refl ect no positive adjustment for the drop down of the excess/umbrella coverage asserted in this litigation.

     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. In certain states in which we have had significant operations, 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 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 continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

(b)  Reimbursement Matters

     In the ordinary course of business, fiscal intermediaries and Medicaid agencies examine cost reports filed by our skilled nursing facilities. If, as a result of any such examination, it is concluded that overpayments were made, we would be held financially responsible for such overpayments. At this time, we are unable to predict the outcome of any existing or future examinations.

     We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.

     The following summarizes the services provided by our reportable and other segments:

Inpatient Services: This segment provides, through SunBridge Healthcare Corporation and its subsidiaries (collectively "SunBridge"), 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 aids. At March 31, 2005, we operated 103 long-term care facilities (consisting of 86 skilled nursing facilities, six mental health facilities, eight assisted living facilities and three specialty acute care hospitals) with 10,599 licensed beds as compared with 108 facilities with 10,991 licensed beds at March 31, 2004. This segment also includes our Part B billing company, Americare Health Services ("Americare"), which provides Part B billing services such as enteral feeding, urological and wound care, to 91 affiliated facilities and 134 nonaffiliated facilities.

Rehabilitation Therapy Services: This segment provides, through SunDance Rehabilitation Corporation ("SunDance"), physical, occupational and speech therapy services to affiliated and nonaffiliated skilled nursing facilities. At March 31,

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2005, this segment provided services to 407 facilities, of which 317 were nonaffiliated and 90 were affiliated, as compared to 428 facilities at March 31, 2004, of which 335 were nonaffiliated and 93 were affiliated.

Medical Staffing Services: This segment provides temporary medical staffing through CareerStaff Unlimited, Inc. ("CareerStaff"). 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 31, 2005, CareerStaff had 30 division offices which provided temporary therapy and nursing staffing services in major metropolitan areas, and one division office which specialized in the placement of temporary traveling therapists and nurses in smaller cities and rural areas.

Home Health Services: This segment provides 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 two licensed pharmacies in California.

Laboratory and Radiology Services: This segment provides mobile radiology and medical laboratory services in Arizona, Colorado and Massachusetts to skilled nursing facilities, primarily through SunAlliance Healthcare Services, Inc. ("SunAlliance").

     Corporate assets primarily consist of cash and cash equivalents, receivables from subsidiary segments, notes receivable and property and equipment.

     Our reportable segments are strategic business units that provide different products and services. They are managed separately, among other reasons, because each business has different marketing strategies due to differences in types of customers, different distribution channels and different capital resource needs.

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    The following tables summarize, for the periods indicated, operating results and other financial information, by business segment:

Segment Information (in thousands):

Segment Information (in thousands):