Back to GetFilings.com
1
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES Exchange Act of 1934 for the
fiscal year ended December 31, 1998 or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES Exchange Act of 1934 for the
transition period from ________ to ________
Commission file number 0-22019
SPECIALTY CARE NETWORK, INC.
(Exact name of registrant as specified in its charter)
Delaware
(State or other jurisdiction of 62-1623449
incorporation or organization) (I.R.S. Employer Identification No.)
44 Union Boulevard, Suite 600
Lakewood, Colorado 80228
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (303) 716-0041
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Title of each class Name of each exchange on which registered
None None
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Common Stock, par value $.001 per share
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No __
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in the definitive proxy statement incorporated
by reference in Part III of this annual report on Form 10-K or any amendment to
this annual report on Form 10-K. __
As of March 26, 1999, the aggregate market value of the Common Stock held by
non-affiliates of the registrant
1
2
was $11,815,026. Such aggregate market value was computed by reference to the
closing sale price of the Common Stock as reported on the Nasdaq National Market
on such date. For purposes of making this calculation only, the registrant has
defined "affiliates" as including all directors and beneficial owners of more
than five percent of the Common Stock of the Company.
As of March 26, 1999 there were 16,381,229 shares of the registrant's Common
Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement for the Registrant's 1999 Annual
Meeting of Stockholders to be filed within 120 days after the end of the fiscal
year covered by this Annual Report on Form 10-K -- Part III.
2
3
TABLE OF CONTENTS
PART I
Item 1. Business............................................................................................... 4
Item 2. Properties.............................................................................................28
Item 3. Legal Proceedings......................................................................................28
Item 4. Submission of Matters to a Vote of Security Holders....................................................32
PART II
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters.................................................................................34
Item 6. Selected Financial Data................................................................................35
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations...........................................................................36
Item 7A Quantitative and Qualitative Disclosures About Market Risk.............................................43
Item 8. Financial Statements and Supplementary Data............................................................43
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................................................................43
PART III
Item 10. Directors and Executive Officers of the Registrant.....................................................44
Item 11. Executive Compensation.................................................................................44
Item 12. Security Ownership of Certain Beneficial Owners and Management.........................................44
Item 13. Certain Relationships and Related Transactions.........................................................44
PART IV
Item 14. Exhibits, Financial Statement Schedules,
and Reports on Form 8-K.............................................................................44
This Report contains forward-looking statements that address, among other
things, the proposed restructuring transaction, the anticipated agreement with
Provider Partnerships, Inc. ("PPI") and its stockholders, the Company's ability
to reduce the amount outstanding under its Credit Facility, liquidity, possible
third-party payor arrangements, possible effects of changes in government
regulation and availability of insurance. These statements may be found under
"Item 1- Business," "Item 1-Risk Factors," and "Item 7-Management's Discussion
and Analysis of Financial Condition and Results of Operations" as well as in the
Report generally. Actual events or results may differ materially from those
discussed in forward-looking statements as a result of various factors,
including the failure of the stockholders to approve the proposed restructuring
transaction, the failure of the bank syndicate to consent to the restructuring,
the failure of the Company to reach an agreement with the former stockholders of
PPI, insufficient capital resources, competition, changes in the regulatory
environment and other factors discussed below, including without limitation
those discussed in "Item 1-Risk Factors" and matters set forth in the Report
generally.
Unless the context indicates otherwise, the terms "Specialty Care Network,"
"SCN" and "Company" refer to Specialty Care Network, Inc. References to
practices affiliated with the Company include predecessors of those practices.
3
4
PART I
Item 1. Business.
GENERAL
We are a health care management services company that provides practice
management services to physicians. We also provide a health care rating internet
site, HealthCareReportCards.com, that rates the quality of outcomes at various
hospitals for several medical procedures. In addition, through our subsidiary,
Ambulatory Services, Inc., ("ASI") we are establishing a business engaged in the
development and management of freestanding and in-office ambulatory surgery
centers. We also have a subsidiary, Provider Partnerships, Inc., ("PPI") that
provides hospital consulting services. However, we expect to return the assets
of PPI to its former stockholders in connection with the resolution of certain
issues relating to our acquisition of PPI.
PRACTICE MANAGEMENT SERVICES
Our practice management services focus on musculoskeletal care. Musculoskeletal
care, or orthopaedics, is the treatment of conditions relating to bones, joints,
muscles and related connective tissues. We have contracted to provide services
to 23 orthopaedic practice groups. We have contracted to provide comprehensive
management services to 17 of the groups under exclusive, long-term service
agreements. We refer to these groups as our "affiliated practices." We have
contracted to provide more limited services to six of the groups. We are
involved in litigation with three of our affiliated practices, and the
description below of services provided does not currently apply to these
practices. In addition, we manage outpatient surgery centers, physical therapy
centers and an occupational medicine center which allow our affiliated
practices to provide ancillary services, such as magnetic resonance imaging,
orthotics and radiology.
We recently entered into restructure agreements with ten of our practices to
restructure our relationship with them. We initially affiliated with these
practices by acquiring substantially all of the assets and certain liabilities
of these practices, and entered into long-term service agreements with them.
Under the proposed restructuring transaction, we will sell to the practices
assets relating to the practices, including many of the assets we acquired from
the practices at the time of our original affiliation with them, and enter into
new management services arrangements relating to the practices. Our services
under the new arrangements will be limited to only certain practice needs, and
we will lower the amount of our service fees. All but one of the management
service agreements with the practices will have terms expiring between November,
2001 and March, 2003.
Approval of the restructuring transaction is subject to several conditions,
including approval of our stockholders and consent of our bank syndicate. We can
give no assurance that these conditions will be met.
We were incorporated in December 1995 and began our management services in
November 1996.
Our Practice Management Services to Affiliated Practices
Our Management Services. We assist in strategic planning, preparation of
operating budgets and capital project analysis. We coordinate group purchasing
of medical supplies, and medical malpractice insurance for our affiliated
practices as a group. We develop strategies for contracting with managed care
plans and help to establish relationships with managed care plans. We assist in
physician recruitment by introducing physician candidates to our affiliated
practices. In addition, we advise in structuring employment arrangements. We
also provide or arrange for a variety of additional services relating to the
day-to-day non-medical operations of our affiliated practices. These services
include management and monitoring of:
o billing levels, invoicing procedures and accounts receivable
collection;
4
5
o accounting, payroll and legal services and records; and
o cash management and centralized disbursements.
By providing these management services, we reduce the administrative
responsibilities of our affiliated physicians. This is designed to enable the
physicians to dedicate more time toward the delivery of health care services.
We have also assisted our affiliated practices in developing ancillary
services, such as:
o outpatient surgery;
o bone densitometry;
o outpatient imaging;
o pain management;
o rehabilitation therapy; and
o orthotics.
We believe that our administrative support facilitates more effective billing
and collections and has provided economies of scale in effecting certain
purchases.
Our Practice Services. We employ most of our affiliated practices' non-physician
personnel. These non-physician personnel, along with additional personnel at our
headquarters, provide the infrastructure that enables us to manage the
day-to-day non-medical operations of each of our affiliated practices. We
provide secretarial, bookkeeping, scheduling and other routine administrative
support services. Under our service agreements, we must provide practice
facilities and equipment to our affiliated practices. To satisfy these
obligations, we lease the facilities utilized by our affiliated practices. In
many cases, these facilities are owned by our affiliated physicians. We also
purchase the equipment utilized by each of our affiliated practices.
Our Management Information Systems. Our corporate accounting systems include
interfaces between payroll, banking, accounts payable and accounts receivable
applications. These interfaces enable us to capture, analyze and report
centrally financial data from most of our affiliated practice locations and
provide analyses of financial data on a fully integrated basis. In addition, our
internally developed purchase order system, which is installed at every
affiliated practice location, monitors daily practice inventory purchases from
order to receipt. This allows us to centrally control the disbursement of funds
and to identify economies in purchasing.
We believe that an important factor in the successful management of
musculoskeletal disease is the creation of a database that tracks the results of
specific methods of treatment. This information can be used to establish
treatment protocols. With the input of our affiliated physicians who specialize
in specific orthopaedic subspecialties, we are gathering information from some
of our affiliated practices in a standardized fashion. In addition to treatment
information, we collect financial information such as:
o personal patient data;
o physician and procedure identifier codes;
o payor class; and
o amounts charged and reimbursed.
Information is gathered in areas such as:
5
6
o incidence rates (the number of specified procedural, diagnostic and
medical events during a defined period with respect to a particular
patient population);
o utilization (frequency of patient care and activity relating to the
patient); and
o Payor mix information
We intend to use this information to assist our affiliated physicians in
developing:
o clinical protocols;
o ensuring that standards of quality are met; and
o determining the most cost-effective course for treating patients.
Our Contracting. We negotiate both fee-for-service and capitated contracts on
behalf of our affiliated practices. Capitated contracts involve various forms
of risk-sharing. There are two traditional categories of risk sharing. In the
first instance, the health care provider accepts risk only with respect to the
costs of physician services required by a patient (i.e., professional fee
capitation). In the second scenario, the health care provider accepts risk for
all of the medical costs required by a patient, including professional,
institutional and ancillary services (i.e., global capitation). Managed care
companies have refined traditional models by segmenting fees into episode of
care and per member per month capitation. Under episode of care capitation,
health care providers deliver care for covered enrollees with a specified
medical condition, or enrollees who require a particular treatment, for a fixed
fee on a per episode basis. Under per member per month capitation, the health
care providers receive fixed monthly fees per covered enrollee and assume the
financial responsibility for the treatment of medical conditions requiring
procedures specified in the contract. We have negotiated "episode of care" or
package pricing arrangements with several major health maintenance
organizations and workers compensation carriers covering several surgical
procedures.
Practice Governance and Quality Assurance
Each affiliated practice has a Joint Policy Board. The membership of the Joint
Policy Board includes an equal number of representatives of our company and the
affiliated practice. The Joint Policy Boards have responsibilities that include:
o developing long-term strategic objectives;
o developing practice expansion and payor contracting guidelines;
o promoting practice efficiencies;
o identifying and recommending significant capital expenditures; and
o facilitating communication and information exchanges.
Our Contractual Agreements with Our Affiliated Practices
6
7
We have entered into long-term service agreements with each of our affiliated
practices to provide management and administrative services. We have included
below a general summary of our service agreements. The actual terms of the
individual service agreements vary in certain respects from the description
below. These variances are a result of negotiations with the individual
practices and the requirements of state and local laws and regulations.
Beginning April 1, 1999, our obligations with respect to the practices that
have entered into restructure agreements with us will be limited to providing
furniture, fixtures and equipment necessary for the practices to operate their
offices and, in some instances, the billing and collection service personnel.
Our fees will also be reduced. This interim arrangement will continue until
closing under the restructure agreements or June 15, 1999, whichever occurs
first. If closing occurs, the practices will be subject to management services
agreements having terms described below under "Our Practice Management Service
to Other Practices - Our Contractual Agreements with the Other Practices."
Our Responsibilities. We, among other things:
o act as the exclusive manager and administrator of non-physician
services relating to the operation of our affiliated practices (with
the exception of certain matters for which our affiliated practices
maintain responsibility or which are referred to the Joint Policy
Boards of our affiliated practices);
o bill patients, insurance companies and other third-party payors and
collect the fees for professional medical and other services
rendered, including goods and supplies sold;
o provide or arrange for, as necessary, clerical, accounting,
purchasing, payroll, legal, bookkeeping and computer services and
personnel, information management, preparation of certain tax
returns, printing, postage and duplication services and medical
transcribing services;
o supervise and maintain custody of substantially all files and records
(medical records of our affiliated practices remain the property of
our affiliated practices);
o provide facilities and equipment for our affiliated practices;
o prepare, in consultation with the Joint Policy Boards and our
affiliated practices, all annual and capital operating budgets for
our affiliated practices;
o order and purchase inventory and supplies as reasonably requested by
our affiliated practices;
o implement, in consultation with the Joint Policy Boards and our
affiliated practices, local public relations or advertising programs;
and
o provide financial and business assistance in the negotiation,
establishment, supervision and maintenance of contracts and
relationships with managed care plans and other similar providers and
payors.
Most employees providing such services were employed by our affiliated
practices prior to the practice's affiliation with us.
The Responsibilities of Our Affiliated Practices. Our affiliated practices
retain the responsibility for:
o hiring and compensating physician employees and other medical
professionals;
o ensuring that physicians have the required licenses, credentials,
approvals and other certifications needed to perform their duties;
and
o complying with certain federal and state laws and regulations
applicable to the practice of medicine.
7
8
In addition, our affiliated practices maintain exclusive control of all
aspects of the practice of medicine and the delivery of medical services.
Our Service Fees. We collect fees from our affiliated practices on a monthly
basis generally equal to the following:
o the greater of a guaranteed base service fee or a percentage (the
"service fee percentage"), ranging from 20%-50% of the adjusted
pre-tax income of our affiliated practices, which is defined
generally as revenue of our affiliated practices related to
professional services less amounts equal to certain clinic expenses
of our affiliated practices, not including physician owner
compensation or most benefits to physician owners; and
o amounts equal to the clinic expenses of our affiliated practices, not
including physician owner compensation or most benefits to physician
owners.
o Generally, for the first three years following a practice's
affiliation, the service fee is subject to a fixed dollar minimum. The
fixed dollar minimum generally was determined by multiplying the
affiliated practice's adjusted pre-tax income for the 12 months prior
to its affiliation by the service fee percentage. In addition, with
respect to our management (and, in certain instances, ownership) of
certain facilities and ancillary services associated with certain of
our affiliated practices, we are paid additional fees based on a
percentage of net revenue or pre-tax income related to such facilities
and services.
Our Accounts Receivable. Each month, most of our affiliated practices sell all
of their monthly accounts receivable to us. The purchase price generally equals
the gross amounts of the accounts receivable recorded each month, subject to
adjustment for certain potentially uncollectible amounts. We are making periodic
adjustments so that amounts paid for the accounts receivable of certain
affiliated practices are adjusted upwards or downwards based on our actual
collection experience.
The Term of Our Service Agreements. Our service agreements with affiliated
practices have initial terms of 40 years. They are automatically extended
(unless specified notice is given) for additional five-year terms.
Other Provisions. The service agreement contains additional provisions,
including:
o certain non-competition provisions;
o cross-indemnification provisions;
o required insurance coverage to be obtained by us and our affiliated
practices; and
o provisions requiring replacement of physicians retiring within the
first five years of the agreement and limiting the number of
physicians who may retire within any one-year period thereafter.
Third Party Reimbursement Policies
8
9
A significant amount of the revenues of the practices we serve are derived from
government and private third party payors. The health care industry is
experiencing a trend toward cost containment. In addition, the federal
government has implemented a resource-based relative value scale payment
methodology under Medicare for physician services.
The resource-based relative value scale is a fee schedule that, except for
certain geographical and other adjustments, pays similarly situated physicians
the same amount for the same services. The fee schedule is adjusted each year.
It is subject to increases or decreases at the discretion of Congress. To date,
the implementation of the resource-based relative value scale method of payment
has reduced payment rates for certain of the procedures historically provided
by the practices that contract with us. Further changes in the Medicare fee
schedule payment methodology could adversely affect our business.
Physician reimbursement rates paid by private third-party payors are, in large
part, still based on established charges. However, resource-based relative value
scale types of payment systems are being adopted by private third-party payors.
Increased implementation of such payment systems may result in reduced payments
from private third-party payors and thereby reduce our revenue. Although private
third party payors are adopting resource-based relative value scale-type
reimbursement or other managed care-type restrictions on reimbursement, such
rates still are generally higher than Medicare payment rates. Further reductions
in reimbursement levels or other changes in reimbursement for health care
services could be detrimental to the practices with which we have contracted or
our business. Additionally, the treatment methods for orthopaedic conditions may
shift from surgical treatments to non-surgical treatments. In addition to the
above concerns, any payment reductions or change in the patient mix of any of
the practices that contract with us that results in a decrease in patients
covered by private third-party payors could be detrimental to us.
AMBULATORY SURGICAL SERVICES
Ambulatory Services, Inc. is a subsidiary of ours formed to engage in
development and management services for ambulatory surgery centers. ASI is
seeking to enter into arrangements with physicians, physician groups and
hospitals, to plan, construct, and operate and, in some instances, own a
portion of ambulatory surgery centers. We anticipate that our development of
ASI's operations will require substantial capital commitments that we are not
currently able to make. We are exploring alternatives to obtain financing,
including the possibility of selling an equity interest in ASI.
Currently, through an agreement with Greater Chesapeake Associates, LLC, ASI is
providing management services with regard to a surgery center affiliated with
that practice. We have an approximately 33% ownership interest in this surgery
center. We hope to expand ASI's services to include comprehensive consultation
and project planning in connection with the construction of surgery centers. In
addition, our development services would involve assisting medical providers
in:
o obtaining necessary certificates of need and fulfilling other legal
requirements;
o assisting in planning for construction, including site selection and
interior design; and
o developing a project schedule and project budget coordination of
construction activities.
Management services offered by ASI include the following:
o accounting/financial services - including annual budget preparation,
preparation of financial statements and tax reports and, at the
option of the provider, billing and collection functions;
o vendor contracting - acquisition of supplies and pharmaceuticals;
o payor contracting;
9
10
o marketing - design and implementation of a marketing plan for the
surgery center;
o management information system support;
o payroll services; and
o regulatory compliance support services.
ASI has hired a Vice President, Operations and has also retained several
consultants to assist in the development of its business. ASI is actively
marketing its services at the present time. While we are hopeful that our
efforts will result in a profitable business, we cannot assure that ASI will be
successful.
HEALTHCAREREPORTCARDS.COM INTERNET SITE
We currently operate HealthCareReportCards.com. This is an internet site
that applies a proprietary risk adjustment formula to data acquired from the
Health Care Financing Administration of the U.S. Department of Health and
Human Services to rate the quality of outcomes at U.S. hospitals with respect
to several medical specialties, including the following:
o cardiology
o orthopaedics
o neuroscience
o pulmonary/respiratory
o vascular surgery
HealthCareReportCards.com purchased its initial dataset, known as the MEDPAR
(Medicare Provider Analysis and Review) file, from the Health Care Financing
Administration. Working with Susan Des Harnis, Ph.D., Chairman of the
Department of Health Administration and Policy at the Medical University of
South Carolina, HealthCareReportCards.com developed a risk-adjustment model to
take into account variations in the risk of illness of patients cared for by
different hospitals. Utilizing the risk adjusted data,
HealthCareReportCards.com rates hospitals with a five-star rating system. To
receive a five-star rating, a hospital must have a score in the top ten percent
of all hospitals performing a rated procedure or caring for patients with the
appropriate diagnosis and the difference between actual and predicted
performance must be statistically significant.
Access to the HealthCareReportCards.com site is free. HealthCareReportCards.com
seeks to fund its operations through the sale to four and five-star rated
hospital of banners, hyperlinks and similar types of advertising on its web
site.
GOVERNMENT REGULATION AND SUPERVISION
The delivery of health care services has become one of the most highly
regulated of professional and business endeavors in the United States. Both the
federal government and the individual state governments are responsible for
overseeing the activities of individuals and businesses engaged in the delivery
of health care services. Federal law and regulations are based primarily upon
the Medicare and Medicaid programs. Each of these programs is financed, at
least in part, with federal funds. State jurisdiction is based upon the state's
interest in regulating the quality of health care in the state, regardless of
the source of payment.
10
11
We believe our physician practice management operations materially comply with
applicable laws. However, we have not received or applied for a legal opinion
from counsel or from any federal or state judicial or regulatory authority with
respect to our practice management operations. Additionally, many aspects of
our business have not been the subject of state or federal regulatory
interpretation. The laws applicable to us and the practices that contract with
us are subject to evolving interpretations. If we, or these practices, are
reviewed by a government authority, we may receive a determination that could
be adverse to us or the practices. Furthermore, the laws applicable to either
us or the practices may be amended in a manner that could adversely affect us.
The federal health care laws apply to us when we submit a claim on behalf of a
practice that contracts with us to Medicare, Medicaid or any other
federally-funded health care program. The principal federal laws that we must
abide by in these situations include:
o those that prohibit the filing of false or improper claims for
federal payment;
o those that prohibit unlawful inducements for the referral of business
reimbursable under federally-funded health care programs; and
o those that prohibit the billing to Medicare or Medicaid for
provision of certain services by a provider to a patient if the
patient was referred by a physician and the referring physician or a
member of his immediate family has certain types of financial
relationships with the provider.
False and Other Improper Claims. The federal government may impose criminal,
civil and administrative penalties on anyone that files a false claim for
reimbursement from Medicare, Medicaid or other federally-funded programs.
Criminal penalties apply in the case of claims filed with private insurers.
While the criminal statutes are generally reserved for instances involving
fraudulent intent, the civil and administrative penalty statutes are applied by
the government in an increasingly broad range of circumstances. For example,
the government has taken the position that a pattern of claiming payment for
unnecessary services or services that are substandard may violate these
statutes if the practice (or the party submitting the claim on behalf of the
practice) should have known the services were unnecessary or substandard.
Additionally, the amount of documentation that must be compiled to support a
claim has increased the possibility that a submitted claim may be improper. In
1997, the Department of Health and Human Services issued new documentation
guidelines applicable to Medicare claims involving the musculoskeletal system,
which are substantially more burdensome than the previous requirements.
In late 1998, the Inspector General of the Department of Health and Human
Services issued compliance guidance for third-party medical billing companies.
This guidance contains specific elements that companies which bill for provider
clients should include in their compliance program and identifies specific risk
areas for billing companies. The guidelines encourage billing companies to
facilitate the restitution of overpayments, coordinate compliance matters with
providers, refrain from submitting false or inappropriate claims, and terminate
contracts with providers and/or report providers who engage in continued
misconduct or fraudulent or abusive conduct.
We believe that our billing activities on behalf of our affiliated practices
comply with applicable law and we are working to insure that they comply with
the third-party billing guidelines. Governmental authorities may challenge or
scrutinize our activities. A determination that we or our practices that have
contracts with us have violated applicable laws could have an adverse impact on
us.
Federal Anti-kickback Law. A federal law commonly known as the "Anti-kickback
Law" prohibits the knowing or willful, solicitation, receipt, offer or payment
of any remuneration which is made in return for:
o the referral of patients covered under Medicare, Medicaid and most
other federally-funded health care programs; or
11
12
o the purchasing, leasing, ordering, or arranging for any good,
facility, items or service reimbursable under those programs.
The law also prohibits remuneration that is made for the recommendation of, or
the arranging for, the purchasing, leasing, or ordering of any good, facility,
item or service, reimbursable under those programs. The law has been broadly
interpreted by a number of courts to prohibit remuneration that is solicited,
received, offered or paid for otherwise legitimate purposes if one purpose of
the arrangement is to induce referrals or the other prescribed activities. Even
bona fide investment interests in a health care provider may be questioned under
the Anti-kickback Law. The penalties for violations of this law include:
o civil monetary penalties;
o criminal sanctions;
o exclusion from further participation in federally-funded health care
programs (mandatory exclusion in certain cases);
o the ability of the Secretary of Health and Human Services to refuse
to enter into or terminate a provider agreement; and
o debarment from participation in other federal programs.
In 1991, the federal government published regulations that provide exceptions
or "safe harbors," to the Anti-kickback Law. Among the safe harbors included in
the regulations were:
o provisions relating to the sale of physician practices;
o management and personal services agreements;
o office and equipment rental agreements; and
o employee relationships.
Subsequently, in 1993 proposed regulations were published offering safe harbor
protection to additional activities, including referrals within group practices
consisting of active investors. Proposed amendments clarifying the existing
safe harbor regulations were published in 1994. The failure of an activity to
qualify under a safe harbor provision, while potentially leading to greater
regulatory scrutiny, does not render the activity illegal.
There are several aspects of our relationships with our affiliated physicians
to which the Anti-kickback Law may be relevant. In some instances, for example,
the government may construe some of our marketing and managed care contracting
activities as recommending patients to our affiliated physicians who pay us a
management fee, in part, for such activities.
On April 15, 1998, the Inspector General of the Department of Health and Human
Services issued Advisory Opinion No. 98-4, which was a response to a request by
a physician for an advisory opinion as to whether a proposed management
services contract between a medical practice management company and a physician
practice would constitute illegal remuneration as defined in the Anti-kickback
Law. Under the facts as presented in the advisory opinion request, a physician
practice management company proposed to enter into a management agreement with
a physician medical practice, under which the management company would provide
the clinic facilities, clinic personnel other than the physicians, and the
operating services for the medical practice including accounting, billing and
purchasing services. Additionally, the management company contracted to provide
the medical practice "with management and marketing services for the clinic,
including the negotiation and oversight of healthcare contacts with various
payors, including indemnity plans, managed care plans, and federal healthcare
programs." Also, the management company's activities on behalf of the medical
practice included the establishment of provider networks, The management fee to
be paid by the medical practice to the management
12
13
company was, in part, based on a percentage of the medical practice's monthly
net revenues. In the advisory opinion, the Inspector General determined that
the proposed management services arrangement did not satisfy a safe harbor
under the Anti-kickback Law. However, the fact that the proposed management
services arrangement did not fit within a safe harbor did not mean that the
proposed arrangement was necessarily unlawful. Rather, the Inspector General
stated that it would be necessary to analyze the proposed arrangement on a
case-by-case basis. In analyzing the proposed arrangement, the Inspector
General determined that it had insufficient information to ascertain the level
of risk of fraud or abuse presented by the proposed arrangement, because the
proposed arrangement may include financial incentives to increase patient
referrals through the marketing and managed care contracting services provided
by the management company. Additionally, the Inspector General stated in the
advisory opinion that the proposed arrangement could present a problem because
the proposed arrangement contained no safeguards against over-utilization and
may include financial incentives that increase the risk of abusive billing
practices. Accordingly, the advisory opinion, while not concluding that the
proposed management services arrangement was a violation of the Anti-kickback
Law, did not conclude definitively that such arrangement would not result in a
violation of the Anti-kickback Law.
In addition, we own an interest in a joint venture (and may, in the future, own
an additional interest in entities) which owns and operates an outpatient
surgery center. Some of our affiliated physicians also own an interest in the
joint venture (and others may, in the future own an interest in an entity that
owns and operates an outpatient surgery center) and may refer their patients to
the surgery center for treatment. The Inspector General has stated that a joint
venture arrangement where Physicians are both investors in the joint venture and
in a position to refer patients to the joint venture may violate the
Anti-kickback Law where remuneration paid to the physicians in exchange for
referrals is disguised as profit distribution. Also, we provide management
services to outpatient surgery centers. The Inspector General has stated that
the provisions of certain marketing services under a management agreement may
implicate the Anti-kickback Law, as discussed above.
Although general marketing and managed care contracting activities and the
ownership of interests in an outpatient surgery center by both us and our
affiliated physicians do not qualify for protection under the safe harbor
regulations, we believe that our activities and joint venture ownership
arrangements are not the type of activities and arrangements the Anti-kickback
Law prohibits. We are not aware of any legal challenge or proceeding pending
against similar physician practice management activities or joint venture
arrangements under the Anti-kickback Law. A determination that we violated the
Anti-kickback Law would be detrimental to us.
The Stark Self-Referral Law. The Stark Self-Referral Law prohibits a physician
from referring a patient to an entity that provides "designated health
services" reimbursable by Medicare or Medicaid if the physician or an immediate
family member has a financial relationship with the entity. "Designated health
services" include physical therapy services, diagnostic imaging services, and
orthotics and prosthetics devices and services some or all of which are
furnished by our affiliated practices. In addition to the conduct directly
prohibited by the law, the statute also prohibits schemes that are designed to
obtain referrals indirectly that cannot be made directly. The penalties for
violating the law include:
o a refund of any Medicare or Medicaid payments for services that
resulted from an unlawful referral;
o civil fines; and
o exclusion from the Medicare and Medicaid programs.
On January 9, 1998, the Health Care Financing Administration issued proposed
rules regarding the Stark Self-Referral Law as it relates to the designated
health services listed above. The proposed rules state that the entity that
provides the designated health services may be a physician's practice or any
other entity that actually owns the operations of the designated health
services. An entity that merely owns certain components of a health services
operation, such as the building that houses the operations or the medical
equipment used in the operations will not be considered as owning the
operations of the health services. It is not clear whether and to what extent
our provision of management services to our affiliated practices (including our
provision of medical equipment, personnel and management services with respect
to designated health services provided by our affiliated practices) and our
receipt of a service fee based on net patient revenues would cause us to be
deemed to own the designated health services operation. It is also not clear
whether our provision of more limited services to the other practices that
contract with us would raise this issue. In addition, the proposed regulations
would apply to an entity that does not bill under its own Medicare number but
receives payment for the services from the billing entity as part of a
so-called "under arrangements" agreement (a term of art under the regulations
relating to certain hospital
13
14
arrangements) or similar agreements. It is not clear whether the term "similar
agreements" would apply to our arrangements with practices that have contracted
with us. If we are deemed to "own the operation" of designated health services
or to be engaged in an arrangement similar to an "under arrangements" agreement,
with respect to designated health services which are billed by our affiliated
practices, we would be deemed a provider of designated health services addressed
by the proposed rules.
We believe that we will not be deemed to be a provider of designated health
services. However, if we are deemed a provider of designated health services for
purposes of the Stark Self-Referral Law, and accordingly, the recipient of
referrals from physicians affiliated with practices that have contracted with
us, such referrals will be permissible only if:
o the financial arrangements under the service agreements with the
practices meet certain exceptions in the Stark Self-Referral Law;
o the ownership of our stock by the referring physicians meets certain
investment exceptions under the Stark Self-Referral Law; and
o we have no other financial arrangements with a referring physician
which are not covered by an exception under the Stark Self-Referral
Law.
We believe that the financial arrangements under our management agreements with
the practices qualify for applicable exceptions under the Stark Self-Referral
Law. However, the issuance of the final rules, a review by courts or a review
by regulatory authorities may result in a contrary determination. The ownership
of our stock by the referring physicians will not meet the Stark Self-Referral
Law exception related to investment interests. The proposed rules provide that
in order to meet the investment interest exception the investment has to be in
securities which, at the time they were obtained, could be purchased on the
open market. This proposed rule would prohibit referral relationships between
a physician and an entity in which such physician (or a family member) owns
stock or options if such stock or options were acquired prior to the time that
the entity was publicly held. Some of the physicians in our affiliated
practices acquired our stock prior to our initial public offering. Other
physicians in our affiliated practices acquired our stock after our initial
public offering. However, the Stark Self-Referral Law requires that to satisfy
the investment interest exception, our stockholder equity would have to exceed
$75 million.
Accordingly, none of the physicians who are in our affiliated practices and who
own stock in our company would be covered by the investment interest exception
and therefore could not refer patients for any designated health services which
we are deemed to provide.
With respect to our ambulatory surgery center operations, where we may either
provide management services to an ambulatory surgery center owned by physicians
or a physician practice, own an interest in an ambulatory surgery center jointly
with physicians or a physician practice, or both, the proposed rules provide
that services furnished in an ambulatory surgery center will not be deemed
"designated health services" if payment for those services is included within
the ambulatory surgery center's payment rate. Since we intend to operate the
ambulatory surgery centers which we manage or own an interest in a manner
that is intended to comply with this exception, we do not believe that the Stark
Self-Referral Law will apply to our ambulatory surgery center operations.
A determination that we have violated the Stark Self-Referral Law would have a
material adverse effect on us.
State Anti-Kickback Laws. Many states have laws that prohibit payment of
kickbacks in return for the referral of patients. Some of these laws apply only
to services reimbursable under state Medicaid programs. A number of these laws
apply to all health care services in the state, regardless of the source of
payment for the service. Based on court and administrative interpretation of
federal anti-kickback laws, we believe that most of these laws prohibit
payments to referral sources where a purpose for the payment is the referral.
Most state anti-kickback laws have received only limited judicial and
regulatory interpretation. Therefore, it is possible that our activities may be
found not to comply with these laws. Noncompliance with such laws could subject
us and the physicians in our affiliated practices to penalties and sanctions.
State Self-Referral Laws. A number of states have laws that are similar in
purpose to the Stark Self-Referral Law but which impose different restrictions.
Some states only prohibit referrals when the physician's financial relationship
with a health care provider is based upon an investment interest. Other state
laws apply only to a limited number of health services. Some states do not
prohibit referrals, but require that a patient be informed of the financial
relationship before the referral is made. We believe that our operations comply
with the self-referral laws of the states in which the practices that contract
with us are located.
14
15
Fee-Splitting Laws. Most states prohibit a physician from splitting fees with a
referral source. Some states have a broader prohibition against any splitting of
a physician's fees, regardless of whether the other party is a referral source.
In most states, we believe that a management fee payment made by a physician to
a management company would not be considered fee-splitting if the payment
constitutes reasonable payment for services rendered to the physician or
physician's medical practice.
We are paid by physicians (and their medical practices) for whom we provide
management services. Our service agreements and management service agreements
have been designed to comply with applicable state laws relating to
fee-splitting. However, a state authority may nevertheless determine that we and
the practices that contract with us are violating the state's fee-splitting
laws. Such a determination could render any of our service agreements in such
state unenforceable or subject to modification in a manner that is adverse to
us.
In November 1997, pursuant to the request by Magan L Bakarania, M.D. the Florida
Board of Medicine issued a declaratory statement that payments of a percentage
of a physician group's net income to a practice management company in return for
services constituted fee-splitting and therefore that could subject Dr.
Bakarania to disciplinary action. The specific services to be provided by the
management company, which the Florida Board of Medicine stated would, in their
opinion, result in a prohibited fee-splitting arrangement were services intended
to increase the physician group's revenue by:
o increasing patient referrals through the creation of preferred
provider networks;
o establishing managed care networks; and
o negotiation of managed care contracts
The declaratory statement only applies to the physician that requested the
declaratory statement (and certain other physicians who formally joined in the
Florida Board of Medicine proceedings). The Florida Board of Medicine agreed to
stay final issuance of the declaratory statement pending appeal of the decision
by the physician practice management company to a Florida court.
On October 2, 1998, TOC Specialists, P.L., an affiliated practice located in
Tallahassee, Florida, filed a petition for declaratory statement with the
Florida Board of Medicine requesting advice as to whether TOC Specialists, P.L.
and its physician owners would be subject to discipline under the statutory
prohibitions against fee-splitting, based upon the services agreement between us
and TOC Specialists, P.L. Because of the pending appeal of the declaratory
statement issued with respect to Dr. Bakarania, the Florida Board of Medicine
has agreed not to consider TOC Specialists, P.L.'s petition until the pending
appeal has been concluded. Although the issuance of a declaratory statement by
the Florida Board of Medicine with respect to TOC Specialists, P.L. stating that
the management services arrangement between us and TOC Specialists, P.L.
violates the Florida fee-splitting statute would not directly affect us or our
agreement with TOC Specialists, P.L. because we are not a party to the petition
filed by TOC Specialists, P.L., such an adverse decision would be detrimental to
us since it could serve as the basis for an assertion by TOC Specialists, P.L.
that the services agreement between us and the practice results in a violation
of Florida law and subjects the TOC Specialists, P.L. physicians to disciplinary
action unless the services agreement is either terminated or modified in a
manner that may be detrimental to us.
Corporate Practice of Medicine. Most states prohibit corporations from engaging
in the practice of medicine. Many of these state doctrines prohibit a business
corporation from employing a physician. Some states allow a licensed physician
to affiliate with corporate entities for the delivery of medical services. On
the other hand, some states interpret the "practice of medicine" broadly to
include activities such as ours. This is true even if the corporation's
activities only have an indirect impact on the practice of medicine, the
physician rendering the medical services is not an employee of the corporation,
and the corporation exercises no discretion with respect to the diagnosis or
treatment of a particular patient.
15
16
We structure our service and management service agreements so that we do not
exercise any responsibility on behalf of physicians that should be construed as
affecting the practice of medicine. Accordingly, we believe that our operations
do not violate state laws relating to the corporate practice of medicine. Such
laws and legal doctrines have been subjected to only limited judicial and
regulatory interpretation with respect to physician practice management
companies. If challenged, we may not be considered to be in compliance with all
such laws and doctrines. A determination in any state that we are engaged in the
corporate practice of medicine could render our agreements with practices
located in such state unenforceable or subject to modification in a manner
adverse to us.
Health Care Reform. In recent years, a variety of legislative proposals designed
to change access to and payment for health care services in the United States
have been introduced. Although no health reform proposals have been passed by
Congress to date, other proposed health care reform legislation, including the
regulation of patient referral practices, reimbursement of health care
providers, formation and operation of physician joint ventures and tort reform,
has been and may be considered by Congress and the legislatures of many of the
states in which we operate. No predictions can be made as to whether health care
reform legislation or similar legislation will be enacted or, if enacted, its
effect on us. Any federal or state legislation prohibiting, among other things,
the referral to or treatment of patients at surgery centers by health care
providers with an investment interest in the surgery centers may have a material
adverse effect on our surgery center joint venture. In the event that federal or
state regulations prohibit the ownership of surgery centers by physicians, we
would seek to purchase the interests held by the physicians. We believe that we
would be able to purchase the interest of the physician members of our joint
ventures, if required.
Ambulatory Surgery Center Regulatory Environment. Our surgery center and the
physicians utilizing our centers are subject to numerous regulatory,
accreditation and certification requirements, including requirements related to
licensure, certificate of need, reimbursement from insurance companies and other
private third-party payors, Medicare and Medicaid participation and
reimbursement, and utilization and quality review organizations. The grant and
renewal of these licenses, certifications and accreditations are based upon
governmental and private regulatory agency inspections, surveys, audits,
investigations or other reviews, including self-reporting requirements. An
adverse review or determination by any regulatory authority could result in
denial of a center's plan of development or proposed expansion of facilities or
services, the loss or restriction of licensure by a center or one of its
practitioners, or loss of center certification or accreditation. A regulatory
authority could also reduce, delay or terminate reimbursement to a center or
require repayment of reimbursement received. The loss, denial or restriction of
any such licensure, accreditation, certification (including certificates of need
or exemption therefrom) or reimbursement through changes in the regulatory
requirements, an enforcement action, or otherwise, could have a material adverse
effect on us.
AMA Restrictions. In June 1994, the American Medical Association severely
restricted the ability of physicians to refer to entities in which such
physicians have an ownership interest, except when the physician directly
provides care or services at a facility that is an extension of the physician's
practice and in very limited circumstances such as in rural areas where there is
lack of available capital from non-physician sources. If the American Medical
Association changes its ethical requirements to preclude all referrals by
physicians, physician referrals to our ambulatory surgery centers could be
adversely affected. It is possible that a prohibition on physician ownership
could adversely affect our future operations, although we believe that the
majority of physicians would continue to perform surgery at the surgery centers
even if they were no longer limited partners.
Infectious Waste. As generators of infectious waste, the Company's surgery
centers are required to satisfy all federal, state and local waste disposal
requirements. If any regulatory agency finds a center to be in violation of
waste laws, penalties and fines may be imposed for each day of violation, and
the affected center could be forced to cease operations. The Company believes
its surgery centers dispose of such waste properly.
Antitrust Laws. The federal antitrust laws (principally the Sherman Act, the
Clayton Act and the Federal Trade Commission Act) are designed to maintain
market competition. They address both structural issues (market share through
merger, acquisition or otherwise) and conduct issues (contracts or combinations
in restraints of trade). The Federal Trade Commission and the Department of
Justice addressed competitive issues, both structural and conduct, in the
health care industry in their 1996 Statements of Enforcement Policy in Health
Care. The statements could apply to various aspects of our business. While we
believe that we are in compliance with these laws, there is no assurance that
our operations will not become the focus of inquiry and potential challenge.
Responding to such challenges could result in substantial costs.
Insurance Licensure Laws. All states have licensure requirements to regulate
the business of insurance and the operation of HMOs. Some states also have
separate licensure requirements for provider-sponsored managed care networks
(also known as "provider-sponsored organizations," or "PSOs") and for other
managed care entities such as third-party administrators. A person who fails to
obtain the appropriate insurance license may be subject to civil and criminal
penalties in certain states. These licensure requirements for insurers, HMOs
and PSOs would not generally apply to companies that provide only management
services to physician providers. However, there is little uniformity in how the
states interpret the scope of their respective laws and regulations.
We believe that our operations do not violate insurance licensure laws for
insurers, HMOs and PSOs in the states where we currently do business. Yet,
there is a risk that state regulatory authorities may apply these laws to
require us to be licensed as an insurer, an HMO, or a PSO. Compliance with such
laws could result in substantial costs. In addition, practices that contract
with us may require licensure as PSOs under separate statutory requirements for
PSOs or, if such practices enter into capitated or other risk-assumption
arrangements, under requirements relating to HMOs or insurers.
See "Provider Risk Assumption," below.
Finally, we may need to obtain separate licensure as a third-party
administrator, as a utilization review agent, or as an HMO or insurance
marketing agent if our services for physicians are deemed by a state authority
to involve "administration," "utilization review" or "marketing functions." If
we are deemed to be in noncompliance with insurance licensure laws, our
business would be adversely affected.
In Florida, entities performing "fiduciary or fiscal intermediary services" on
behalf of health care professionals who contract with HMOs must register with
the Florida Department of Insurance under a "Fiscal Intermediary Services" law.
This statue defines "fiduciary or fiscal intermediary services" to include (i)
receipt or collection of reimbursements for services rendered on behalf of
health care professionals; (ii) patient and provider accounting; (iii) financial
reporting and auditing; (iv) receipts and collections management; (iv)
compensation and reimbursement disbursement services; and (v) other related
fiduciary services rendered pursuant to contracts between health care
professionals and health maintenance organizations. A party otherwise qualifying
as a fiscal intermediary services organization and which is operated for the
purpose of acquiring and administering provider contracts with managed care
plans for professional health care services must secure and maintain in force a
fidelity bond in the minimum amount of $10 million. The fidelity bond must (i)
be posted with the state; (ii) be on an approved form; (iii) insure against
misappropriation of funds by the registrant; and (iv) run to the benefit of the
interested managed care plans, subscribers and health care providers.
We are reviewing the management services we provide to Florida practices and
investigating the possible application of this law to our Florida operations. If
we conclude the law applies to those operations, we will take appropriate
steps to register or otherwise comply with its requirements.
16
17
Provider Risk Assumption. When health care providers or provider networks agree
to provide services on a capitated basis, they assume "insurance risk" and may
be regarded by the regulatory authorities as conducting an "insurance business"
for which licensure is required. Whether licensure as an insurer, health
maintenance organization or other equivalent will be required depends on the
relationship between the provider or network and the individuals who receive
the services.
If the relationship is "direct" such that the provider network has directly
contracted with the "insured" (whether and individual or group policyholder) to
provide services in return for a fixed payment, all jurisdictions would likely
find the provider or provider network to be engaged in the "doing of an
insurance business" requiring licensure and full regulation equivalent to that
which applies to commercial health insurers and health maintenance
organizations.
If, however, the provider or network has contracted with a licensed insurer or
health maintenance organization to provide services to that entity's policy
holders or members, licensure is not required in most states, even if the
provider or network agreed to do so on a capitated basis and thereby assumed
insurance risk. These latter arrangements, where a licensed insurer or health
maintenance organization is interposed between the insured and the capitated
provider or network, are referred to as "downstream" risk-sharing arrangements.
Most states that have considered the questions have determined on policy
grounds not to regulate or require licensing of a capitated provider or
provider network so long as it is "downstream" from a licensed insurer or
health maintenance organization. However, a few other states will require
licensing of "downstream" capitation arrangements of those arrangements involve
"global" or "episode of care" capitation allowances.
On behalf of certain of the practices, we regularly negotiate "downstream"
capitated service arrangements, including global and episode of care capitation
allowances. It would not be practical to have the practices licensed as either
an insurer of health maintenance organization if this were required as a result
of those capitation arrangements. The inability to enter into such capitation
arrangements would adversely affect us.
Managed Care Contracting Laws. An increasing volume of state regulation
addresses the terms of contracts between managed care payors and managed care
providers. Some of these laws and regulations can affect the composition of a
managed care network. Other laws and regulations are aimed at protecting health
care consumers. A determination that we or our affiliated practices do not
comply with such laws could be detrimental to us.
Physician Incentive Plan Rule. A regulation of the Health Care Financing
Administration, United States Department of Health and Human Services, imposes
limitations with respect to, and prescribes the terms and conditions under
which, health maintenance organizations operating "physician incentive plans"
may offer incentives to physicians that could tend to reduce or limit medically
necessary services to an enrollee. This regulation applies to physician
incentive plans which base compensation, in whole or in part, on the use or cost
of services furnished to Medicare beneficiaries or Medicaid recipients. Among
other things, this regulation requires the organization to provide adequate
stop-loss protection for physicians if the organization's system for
compensating physicians does not provide mandated limits on the amount of
physician compensation that is put at risk by the incentive plan. This
regulation may adversely affect our operations and the operations of our
affiliated practices.
Employee Leasing Services. Several states have legislation prohibiting the
provision of "employee leasing services" without a license. We
17
18
continue to evaluate the application of such laws to our service agreements. We
will seek licensure where we believe it to be appropriate. Failure to obtain a
license may result in civil or criminal penalties.
OUR COMPETITION
Physician Practice Management Services
We compete with numerous entities. Physician practice management companies and
some hospitals, clinics and HMOs also engage in activities similar to ours.
Several of our competitors have established operating histories and greater
resources than ours. We may not be able to compete effectively with such
competitors.
The practices that contract with us compete with local musculoskeletal care
service providers as well as some managed care organizations. We believe that
changes in governmental and private reimbursement policies have increased
competition among musculoskeletal care providers. We believe that cost,
accessibility and quality of services provided are the principal factors that
affect competition. If affiliated practices are not able to compete effectively
in the markets that they serve, we would be adversely affected.
The practices that contract with us also compete with other providers for
managed musculoskeletal care contracts. We believe that trends toward managed
care increased competition for such contracts. Other practices and management
service organizations may have more experience than in obtaining such contracts
than us or the practices that contract with us. We may not be able to
successfully acquire sufficient managed care contracts to compete effectively.
Ambulatory Surgery Center Services
The Company competes principally with hospitals and other operators of
freestanding surgery centers to attract physicians and patients to its
ambulatory surgery centers and for inclusion in managed care programs. In
developing new surgery centers and acquiring existing surgery centers the
Company will compete with other surgery center companies and local hospitals. In
competing for physicians and patients, important competitive factors are
convenience, cost, quality of service, physician loyalty and reputation.
Hospitals may have competitive advantages in attracting physicians and patients,
including established standing in the community, historical physician loyalty
and convenience for physicians making rounds or performing inpatient surgery in
the hospital. However, the Company believes that many physicians may prefer to
utilize and affiliate with freestanding ambulatory surgery centers due to
greater scheduling flexibility, more consistent nurse staffing and faster
turnaround time between cases, thereby allowing a physician to perform more
surgeries in a defined period of time.
Health Care Rating Web Site
Several companies have instituted health care rating services on the internet.
In addition, because barriers to entry are low, we anticipate that other
companies may seek to begin health care rating services on the internet. As a
18
19
result, competition to obtain advertising from hospitals and other health care
providers is expected to intensify in the future.
We attempt to compete by emphasizing the objective nature of our data, the
source of our data and the sophistication of the methodology used to provide our
data. We think that these factors should make HealthCareReportCards.com an
attractive site for advertising by those hospitals that have received a four or
five-star rating.
OUR EMPLOYEES
As of January 1, 1999, we had 885 employees, of whom 59 were located at our
headquarters and 826 were located at our affiliated practices. As a result of
the proposed restructuring transaction and interim arrangements with certain
participating practices, we anticipate that we will no longer employ a
substantial majority of these persons.
OUR CORPORATE LIABILITY AND INSURANCE
Professional malpractice claims and similar claims are risks in connection with
the provision of medical services. Under our agreements with practices we serve,
we do not influence or control the practice of medicine by physicians. We do not
have responsibility for compliance with regulatory requirements directly
applicable to physicians and physician groups. Nevertheless, as a result of our
relationship with medical practices, we could be subject to medical malpractice
actions. Our medical professional liability insurance provides coverage of up to
$5 million per incident, with maximum aggregate coverage of $5 million per year.
Our general liability insurance provides coverage of up to $5 million per
incident, with maximum aggregate coverage of $5 million per year. We believe our
insurance will extend to professional liability claims asserted against our
employees that work at our affiliated practices. The practices that have
contracted with us also maintain comprehensive professional liability insurance.
The cost of insurance and expenses resulting from claims against us that exceed
our policy limits could adversely affect us.
RISK FACTORS
If we consummate a proposed restructuring transaction that substantially
restructures our arrangements with ten practices, we will confront substantial
challenges. Under the proposed restructuring transaction, we will sell to the
practices non-medical assets relating to the practices. As part of the
transaction, we will also enter into new management service arrangements with
the practices that will reduce the term of the management agreements from 40
years to terms generally expiring between November 2001 and March 2003. We will
limit our services only to specific practice needs. Fees payable under the
management service agreements will be substantially reduced. In return, we will
receive approximately $17.0 million in cash and 3,786,957 shares of our common
stock. In addition, approximately $.6 million related to a convertible debenture
by us to physicians in one of our affiliated practices will be canceled. The
amount of cash we receive in the restructuring transaction is subject to
adjustment based on the value, at the closing of the restructuring transaction,
of most of the assets that we are selling to the practices and liabilities being
assumed by the practices. If the restructuring transaction is completed, we will
confront the following risks:
19
20
o Our revenues will decrease substantially - Although our obligations
to the participating practices under the new management services
agreements will also be reduced substantially, we will have to
institute additional cost saving measures in order to avoid losses.
o We may not receive revenues from service agreements with the
participating practices after the term of the new management services
agreements - This means that between November 2001 and March 2003, we
will no longer receive revenues from some of the participating
practices unless they agree to an extension of the management services
agreement. Presently, we do not anticipate that such an extension will
occur. Some of the practices have agreed to pay a lump sum fee at
closing, and will provide no further payments under the agreements. As
a result, we increasingly must rely on our other businesses, including
our health care rating internet site and ambulatory surgery center
businesses.
o The other businesses on which we rely may not be successful - While
we believe that the health care rating internet site and ambulatory
surgery center businesses that we will focus on present more
promising opportunities for growth than our physician practice
management business, these businesses have only recently been formed
and may not be successful.
o We will continue to have substantial bank indebtedness - Although we
intend to use all of the cash proceeds of the restructuring
transaction to pay down our bank indebtedness, we anticipate that we
will continue to have approximately $25.6 million of indebtedness
under our bank credit facility. Our obligations under the credit
facility will divert resources that otherwise would be useful for our
non-physician practice management businesses. Moreover, we will
continue to be in default under our credit facility. While we have
been engaged in discussions with our banks to restructure our credit
arrangement, we cannot assure that we will be successful in
restructuring this arrangement. If the banks were to accelerate our
obligations under the credit facility, our viability as a going
concern would be severely impaired.
Our Long-term Viability Will Be at Risk If the Restructuring Transaction Is Not
Consummated. While we will confront significant risks if the restructuring
transaction is consummated, we believe we will confront even more substantial
risks if the restructuring transaction is not consummated. Among the risks we
will confront if the restructuring transaction is not consummated are the
following:
o We may confront additional disputes with our affiliated practices -
Currently, we are in litigation with three of our affiliated
practices. Two of the other affiliated practices that are not
participating in the restructuring transaction are seeking to
terminate their service agreements based on allegations (which we
dispute) that we are in default of our obligations under their
agreements. If the restructuring transaction is not approved, we may
well confront additional disputes with the practices that would
otherwise participate in the restructuring transaction. Several of
these practices have, in the past claimed that we are in default under
the terms of the service agreement (we do not agree), and some have
even threatened litigation. The diversion of management resources and
financial costs in connection with these disputes would materially
adversely affect us.
o We would continue to be in default under our credit facility - We are
not currently in compliance with certain financial covenants under our
credit facility. If the restructuring transaction is not completed we
believe it is unlikely that we will be able to comply with those
covenants. Based on our current operating structure, if our lenders
determine to take action to enforce their rights under the credit
facility, our long term viability as a going concern would be severely
impaired.
o Our operating performance has declined - Due to the proposed
restructuring transaction and transactions in 1998 that led to new
management service arrangements with four practices, we have written
down our long-term service agreements by $94.6 million. Largely as a
result, we recorded a net loss for 1998 of $61.8 million, as compared
to a net income of $5.9 million for 1997. Our operating results would
have declined even if we had not taken the write-off. In light of the
transitional nature of our operations, we may not be able to once
again become profitable.
Our Web Site Business Could Be Adversely Affected If We Are Not Able to Resolve
Issues With the Former PPI Stockholders
o We are engaged in negotiations to resolve certain issues raised by the
former stockholders of PPI. We currently contemplate that an
arrangement will be reached with the PPI stockholders that will
involve, among other things, the following:
20
21
o The formation of a new company that will own the
HealthCareReportCards.com web site and one or more additional health
care rating web sites. The new company will be a majority-owned
subsidiary of the Company, and the former PPI shareholders will have a
minority shareholder interest in the new company;
o The former PPI shareholders will return the 420,000 shares of Company
common stock that they received in connection with the Company's
acquisition of PPI;
o The Company will return most of the assets of PPI to the former PPI
shareholders; and
o The PPI shareholders will become majority shareholders of the new
company if Specialty Care Network does not obtain $4 million in
financing for the new company by December 31, 1999.
In addition, it is anticipated that the agreement will address corporate
governance issues relating to the new company, allocation of expenses and other
matters. While we are optimistic that an agreement will be reached, we cannot
assure that an agreement will be signed or that the terms of the agreement would
not differ from those described above. We will be materially adversely affected
if we are not able to resolve the issues raised by the PPI stockholders.
21
22
We Will Need Additional Financing - The contraction of our physician practice
management business, and our efforts to establish our other businesses will
cause us to seek additional capital. In the future we may seek additional funds
through debt financing or the issuance of equity or debt securities. We may not
be able to secure sufficient funds on terms acceptable to us, if at all. If
equity securities are issued, either to raise funds or in connection with future
affiliations, our stockholders' equity may be diluted. If additional funds are
raised through debt, we may be subject to significant restrictions. As noted
above, we are currently in default under our bank credit facility due to our
failure to comply with certain financial covenants. Our ability to effect
additional financings will likely continue to be impaired unless we can
successfully restructure our indebtedness. We cannot assure that we will be able
to obtain a restructured loan arrangement.
We anticipate that, in order to raise required capital, we will have to sell a
portion of the equity of our subsidiaries that operate our health care rating
web site and ambulatory surgery center businesses. Such sales will decrease our
share of revenues and profits, if any, of these entities.
Our Stock Price Has Declined Markedly. While we cannot identify with certainty
the cause for the decline, we believe the following factors, among others have,
and some may continue to have an adverse effect on our stock price:
o conditions in the physician practice management industry;
o changes in earnings estimates by securities analysts;
o announcements regarding non-compliance with bank covenants;
o litigation;
o change in accounting rules regarding amortization period for
intangible assets; and
o operating and financial results.
Variations in our operating and financial results have been caused by the
timing of the actions by affiliated practices that we believe are related to
the decline in our stock price, such as diverting accounts receivables
receipts, non-payment of service fees and engaging litigation against us.
We Depend on Our Affiliated Practices and Physicians. If the practices that
contract with us are not successful, we will be materially adversely affected.
Moreover, certain of our affiliated practices have claimed, for various reasons,
that their service agreement is no longer in effect. Others have attempted to
invoke termination provisions based on a contention that we have defaulted in
carrying out our obligations under the service agreements. We believe that these
claims are invalid. Nevertheless, if the practices are able to terminate any of
our service agreements, we could be materially adversely affected. Some of the
practices that contract with us derive a significant portion of their revenue
from a limited number of physicians. A practice's loss of one or more key
members could reduce our revenue.
There is a Risk of Change in Payment for Medical Services. We may not be able to
offset successfully any or all payment reductions that may be imposed by
government and private third party payors. The health care industry is
experiencing a trend toward cost containment. Government and private third-party
payors are imposing lower reimbursement and utilization rates and negotiating
reduced payment schedules with service providers. Reductions in payments to
health care providers or other changes in reimbursement for health care services
may have a negative effect on us. See "Business - Third Party Reimbursement."
Our Business is Extensively Regulated by the Government. The delivery of health
care is subject to extensive federal and state regulation. Much of this
regulation is complex and open to different interpretations. We believe our
operations materially comply with applicable laws. Nevertheless, a review of
our operations by federal or state
22
23
judicial or regulatory authorities could result in a determination that we
violated one or more provisions of federal or state law.
The federal and state laws to which we are subject cover a broad range of
activities. Among other things, these laws:
o prohibit the filing of false or other improper medical claims;
o prohibit "kickback" and similar activities intended to induce patient
referrals or the ordering of reimbursable items or services;
o prohibit physicians from making referrals to entities providing
"designated health services" with which the physicians have a
financial relationship;
o prohibit fee-splitting under certain circumstances; and
o prohibit corporations from engaging in the practice of medicine.
In addition, a variety of laws of general applicability many have a restrictive
effect on our operations and activities. These laws include:
o antitrust;
o insurance;
o environmental;
o occupational safety;
o employment;
o medical leave; and
o civil rights laws.
Violations of these laws could result in:
o severe civil or criminal penalties;
o exclusion from participation in Medicare and Medicaid programs or
other federally funded health care programs; and
o censure or delicensing of physician-violators.
See "Government Regulation and Supervision."
There have been numerous recent federal and state initiatives for comprehensive
or incremental reforms affecting the payment for and availability of health
care services. Many of the proposals under consideration could adversely affect
us if they are enacted.
Several states have legislation prohibiting the provision of "employee leasing
services" without a license. We are evaluating the application of such laws to
our provision of non-physician personnel to physician practices. We will seek
licensure where it is appropriate. We may not receive the license for which we
apply. Our failure to obtain a license where required may result in civil or
criminal penalties. Additionally, lack of licensure may affect our ability to
provide personnel in accordance with the terms of our service agreements.
23
24
We Depend on Our Information Systems. Our information systems are needed to:
o helping our affiliated practices realize operating efficiencies; and
o negotiating, pricing and managing capitated managed care contracts.
24
25
We must continue to invest in, and administer, management information systems to
support these activities. There may be unanticipated delays, complications and
expenses in implementing, integrating and operating these systems. We will have
to modify, improve or replace these systems if new technologies become
available. Modifications, improvements or replacements could be expensive and
interrupt our operations. We may not be able to implement successfully and
maintain adequate practice management, financial and clinical information
systems.
We May be Affected by the Year 2000 Issue. The Year 2000 issue is the result of
computer programs being written using two digits rather than four to define the
applicable year. In other words, date-sensitive software may recognize a date
using the "00" as the year 1900 rather than the year 2000. This could result in
system failures or miscalculations causing disruptions of operations,
including, among others, a temporary inability to process transactions, send
invoices, or engage in similar normal business activities.
Because we were formed in 1996, most of our corporate computer hardware is
relatively new. In addition, most of the software applications are "off the
shelf." All vendors of these "off the shelf" products have been contacted and
remediation activities are underway with respect to those applications that are
not currently Year 2000 compliant. Internal applications are currently being
reviewed and updated. However, if we fail to attain compliance by Year 2000, we
could be materially adversely affected.
We are seeking to coordinate our efforts to address the Year 2000 issue with
our affiliated practices, payors and vendors. However, the systems of other
companies on which we rely may not be timely converted. A failure to convert by
another company, or a conversion that is incompatible with our systems, could
have a material adverse effect on us.
There Are Risks Associated with Our Managed Care Contracts. Our success in our
physician practice management operations will depend in part upon our and our
affiliated practices' abilities to negotiate contracts with HMOs, employer
groups and other private third-party payors. We may not be able to enter into
satisfactory arrangements with such payors for reasons beyond our control.
We have negotiated contracts providing a fixed global fee for each episode of
care covering certain musculoskeletal procedures. Certain affiliated practices
also have other capitated fee arrangements that existed prior to their
affiliation with us. We anticipate that our affiliated practices may enter into
additional contracts based on capitated and global fee arrangements. To the
extent that patients or enrollees covered by such arrangements require more
frequent or more extensive care than anticipated, our affiliated practices
would bear the cost. In the worst case, revenue negotiated under these
contracts would be insufficient to cover the costs of the care provided. See
"Business - Payor Contracting."
Several states have regulations prohibiting physicians from entering into
capitated payment or other risk sharing contracts except through HMOs or
insurance companies. In addition, some states subject physicians and physician
networks to insurance laws and regulations which provide for minimum capital
requirements. We would be adversely affected if practices that contract with us
are unable to enter into capitated fee arrangements. Moreover, the costs of
compliance with insurance laws may be significant. See "Government Regulation
and Supervision - Insurance Laws."
We may not establish or maintain satisfactory relationships with managed care
and other third-party payors. In addition, we may lose significant revenue as a
result of the termination of third-party payor contracts or otherwise.
We Face Intense Competition. Several companies with established operating
histories and greater resources than ours are pursuing management contracts with
musculoskeletal practices or development and management services arrangements
for ambulatory surgery centers. Because of the depressed level of our stock
price and our limited financial resources, we do not believe that we can
complete any additional affiliations with musculoskeletal medical
25
26
practices on terms beneficial to us. Moreover, unless we can obtain financing
for our ambulatory surgery center business, we will not be able to compete
effectively. In addition, practices that have contracted with us may not be
able to compete effectively in the markets they serve.
We Depend Upon Our Key Personnel. We are dependent upon the ability and
experience of our executive officers, as well as on our other key personnel. If
we are unable to retain these persons, or if we are unable to find additional
management and other key personnel as required, we could be adversely affected.
We have employment contracts with all but one of our executive officers.
Our Insurance May Be Inadequate to Protect us From the Costs of Potential
Liability and Legal Proceedings. The provision of medical services by
physicians entails an inherent risk of exposure to professional malpractice
claims and other similar claims. While the practices that contract with us
generally maintain malpractice insurance, any claim asserted against any of
those practices may not be covered by, or may exceed the coverage limits of,
applicable insurance.
We do not engage in the practice of medicine. Nevertheless, we could be
implicated in professional malpractice and similar claims. Although we maintain
insurance, claims asserted against us for professional or other liability may
not be covered by, or may exceed the coverage limits of, our insurance.
The availability and cost of professional liability insurance is beyond our
control. We may not be able to maintain insurance in the future at a cost that
is acceptable. See "Corporate Liability and Insurance."
There are Risks Related to Our Purchase of Our Affiliated Practices'
Receivables. We purchase each of our affiliated practices accounts receivable
each month. The purchase price for such accounts receivable generally equals the
gross amounts of the accounts receivable recorded each month, less:
o adjustments for contractual allowances;
o allowances for doubtful accounts; and
o other potentially uncollectible amounts based on the practice's
historical collection rate, as determined by us.
Actual collections may be less than the amounts we paid for the receivables, or
payment of receivables may not be made on a timely basis.
The Market for Internet Advertising is Uncertain. We expect that
HealthCareReportCards.com will seek to derive a substantial amount of its
revenues from advertising for the foreseeable future, and demand and market
acceptance for internet advertising is uncertain.
There are currently no standards for the measurement of the effectiveness of
internet advertising, and the industry may need to develop standard
measurements to support and promote internet advertising as a significant
advertising medium. If such standards do not develop, existing advertisers may
not continue their levels of internet advertising. Furthermore, advertisers
that have traditionally relied upon other advertising media may be reluctant to
advertise on the internet. Our web site business would be adversely affected if
the market for internet advertising fails to develop or develops more slowly
than expected.
Software programs that limit or prevent advertising from being delivered to an
internet user's computer are available. Widespread adoption of this software
could adversely affect the commercial viability of internet advertising.
26
27
We May Be Sued For Information Retrieved from the Web. We may be subjected to
claims for defamation, negligence, copyright or trademark infringement,
personal injury or other legal theories relating to the information we publish
on the HealthCareReportCards.com web site. These types of claims have been
brought, sometimes successfully, against online services as well as other print
publications in the past. We could also be subjected to claims based upon the
content that is accessible from our Web sites through links to other Web site.
There is Intense Competition for Internet-based Business. The number of web
sites competing for the attention of health care related advertisers has
increased and we expect it to continue to increase. Because
HealthCareReportCards.com is a relatively new business, it must compete with
more established and better financed entities. Moreover, since barriers to entry
are not great, increased competition is likely. This could result in price
reductions and reduced margins, which could adversely affect our web site
business.
The Receipt of Advertising Revenues by Our Web Site is Uncertain. The time
between the date of initial contact with a potential advertiser for the
HealthCareReportCards.com web site and the execution of a contract with the
advertiser is not predictable, and is subject to delays over which we have
little or no control, including:
o customers' budgetary constraints;
o customers' internal acceptance reviews;
o the success and continued internal support of advertisers' own
development efforts; and
o the possibility of cancellation or delay of projects by advertisers.
We may expend substantial funds and management resources and yet not obtain
advertising revenues. Accordingly, our results of operations may be adversely
affected if sales to advertisers are delayed or do not otherwise occur.
We are Dependent on Continued Growth in Use of the Internet. Our web site
business would be adversely affected if internet usage does not continue to
grow. A number of factors may inhibit internet usage, including:
o inadequate network infrastructure;
o inconsistent quality of service; and
o lack of availability of cost-effective, high-speed service.
If internet usage grows, the internet infrastructure may not be able to support
the demands placed on it by this growth and its performance and reliability may
decline. In addition, Web sites have experienced interruptions in their service
as a result of outages and other delays occurring throughout the internet
network infrastructure. If these outages or delays frequently occur in the
future, internet usage, as well as the usage of our Web sites, could grow more
slowly or decline.
We May be Unable to Respond to Rapid Technological Change. The internet is
characterized by rapidly changing technologies, frequent new product and
service introductions and evolving industry standards. If
HealthCareReportCards.com is to be successful, we need to effectively integrate
the various software programs and tools required to enhance and improve our web
site. Our future success will depend on our ability to adapt to rapidly
changing technologies by continually improving the performance features and
reliability of our web site. We may experience difficulties that could delay or
prevent the successful development, introduction or marketing of new services.
We could also incur substantial costs if we need to modify our service or
infrastructures to adapt to these changes.
27
28
Governmental Regulation and Legal Uncertainties Could Add Additional Costs to
Doing Business on the Internet. There are currently few laws or regulations
that specifically regulate communications or commerce on the internet. However,
laws and regulations may be adopted in the future that address issues such as
user privacy, pricing, and the characteristics and quality of products and
services. Several telecommunications companies have petitioned the Federal
Communications Commission to regulate internet service providers and online
service providers in a manner similar to long distance telephone carriers and
to impose access fees on those companies. This could increase the cost of
transmitting data over the internet. Moreover, it may take years to determine
the extent to which existing laws relating to issues such as property
ownership, libel and personal privacy are applicable to the internet. Any new
laws or regulations relating to the internet could adversely affect our
business.
Our Systems May Fail or Experience a Slowdown and Our Users Depend on Others for
Access to Our Web Sites - Substantially all of our communications hardware and
some of our other computer hardware operations are located at KDM Consulting
Service's facilities in Aurora, Colorado. Fire, floods, earthquakes, power loss,
telecommunications failures, break-ins and similar events could damage these
systems. Computer viruses, electronic break-ins or other similar disruptive
problems could also adversely affect our web site. Our business could be
adversely affected if our systems were affected by any of these occurrences. Our
insurance policies may not adequately compensate us for any losses that may
occur due to any failures or interruptions in our systems. We do not presently
have any secondary "off-site" systems or a formal disaster recovery plan.
In addition, our users depend on internet service providers, online service
providers and other web site operators for access to our web site. Many of them
have experienced significant outages in the past, and could experience outages,
delays and other difficulties due to system failures unrelated to our systems.
We May Not be Able to Deliver Various Services if Third Parties Fail to Provide
Reliable Software, Systems and Related Services to Us - We are dependent on
various third parties for software, systems and related services. Several of the
third parties that provide software and services to us have a limited operating
history, have relatively immature technology and are themselves dependent on
reliable delivery of services from others. As a result, our ability to deliver
various services to our users may be adversely affected by the failure of these
third parties to provide reliable software, systems and related services to us.
Item 2. Properties
We have a five-year lease for our approximately 12,000 sq. foot headquarters
facility in Lakewood, Colorado, which expires on March 15, 2001. We have
entered into leases for the facilities utilized by our affiliated practices for
annual lease payments of approximately $4.1 million. Several of the leases
involve properties owned by physician owners of our affiliated practices. If we
complete the restructuring transaction, we expect our annual lease payments for
such facilities to decrease to $2.5 million.
Item 3. Legal Proceedings
28
29
The Specialists Litigation
There are two actions currently pending between us and the Specialists
Orthopedic Medical Corporation, one of our affiliated practices, and the
Specialists Surgery Center, a partnership that operates a surgery center
(collectively "the Specialists"), one in Solano County Superior Court, which was
recently stayed by that court ("the state action"), and one in the United States
District Court for the Eastern District of California, which is currently being
litigated (the "federal action").
The state action was filed on November 13, 1998 in the Solano County Superior
Court by the Specialists and four physicians who practice at, and own an
interest in, one or both of the plaintiff entities (the "Specialists Doctors"),
against the Specialists' former administrator; legal, accounting and consulting
advisors to the plaintiffs in connection with the affiliation transactions
(collectively with the administrator, the "Advisors"); entities affiliated with
certain of the Advisors; us; an employee of the Company, and 25 unnamed
defendants.
The complaint contains numerous allegations against one or more of the Advisors,
including among others, fraud, misrepresentation, conversion, breach of
fiduciary duty, negligence, professional negligence and legal malpractice. With
respect to us, and our employee, the complaint alleges, among other things, that
we and our employee conspired with the Advisors to induce the Specialists
Doctors to enter into the transactions by which we acquired the practice assets
and entered into the service agreements with Specialists; that we and our
employee misrepresented the terms of the transaction to the Specialists Doctors;
that, in connection with the issuance of our common stock to the Doctors, we and
the other defendants violated California securities law by making material
misstatements or omitting material facts; that the service agreements are void;
that the required service fees are unconscionable; and that the service
agreements do not represent the true intention of the parties with regard to the
service fees to be charged.
The Specialists Doctors seek a judicial declaration that the service fees are
unenforceable, a reformation of the service agreements to reflect service fees
within the alleged intent of the parties, an accounting of the cash proceeds
from the acquisition transactions, special damages of $2.48 million (including
$300,000 paid to us), compensatory, consequential and punitive damages, damages
for emotional distress, attorney fees and costs.
In addition, co-defendant Ronald Fike, the Specialists' former administrator,
filed a cross-complaint on December 18, 1998, naming as cross-defendants all
co-defendants (including us and our employee), all plaintiffs and seven new
parties. The cross-complaint alleges causes of action for breach of contract,
slander, negligent infliction of emotional distress, deceit and conspiracy, and
indemnity. We and our employee are named as defendants to the last three causes
of action only.
We believe the allegations, as they pertain to us and an employee of the
Company, are without merit and have vigorously contested the action and
cross-complaint. As an initial response, we have filed a Motion to Stay or
Dismiss both the action and the cross-complaint, based upon a forum selection
clause contained in the original acquisition agreement, requiring the
Specialists and Mr. Fike to file any and all actions in Jefferson County,
Colorado. The court granted our Motion on March 12, 1999, and stayed the action
in its entirety, as to all named parties.
In the federal action, filed by us on January 12, 1999 in the United States
District Court for the Eastern District of California against the Specialists
and the Doctors, we are seeking relief for various breaches of contract,
conversion of our assets, and tortious interference with contractual relations.
Additionally, our complaint seeks to recover damages for the Specialists'
wrongful possession and detention of our personal property, and the wrongful
ejectment of us from our leasehold interest in various real properties we have
leased.
29
30
Defendants have filed a Motion to Stay or Dismiss the action.
In addition, we recently filed an Application for a Right to Attach Order and
Writ of Attachment. We seek to attach any and all of the assets of the
Specialists and the Doctors, in order to secure the claims in our federal
complaint. This matter is set for hearing on April 26, 1999.
TOC Litigation
There are two actions pending between us and TOC Specialists, P.L. ("TOC") and
its physician owners (collectively, the "TOC Doctors"), one in the Circuit Court
of the Second Judicial Circuit in and for Leon County, Florida, which was
recently stayed by that court (the "state action"), and one in the United States
District Court for the Northern District of Florida, Tallahassee Division, which
is currently being litigated (the "federal action").
On November 16, 1998, we filed a complaint in the Circuit Court of the Second
Judicial Circuit in and for Leon County, Florida against TOC, the 15 TOC
doctors, and the State of Florida, Department of Health, Board of Medicine. The
complaint alleges that, in violation of their service agreement with us, TOC and
the TOC Doctors diverted our accounts receivable receipts into an account
controlled by TOC and the TOC Doctors, that TOC and the TOC Doctors failed to
pay our service fees, and that TOC and the TOC Doctors failed to provide the
necessary records to us for us to effectively perform our management functions.
Additionally, the complaint alleges that TOC and the TOC Doctors improperly
attempted to terminate the service agreement, attempted to interfere with our
contractual relations with other affiliated practices, and violated the
confidentiality, noncompetition and restrictive covenant provisions of the
service agreement.
TOC and the TOC Doctors answered that complaint on December 7, 1998, and filed a
counterclaim against us alleging breach of service agreement, fraud in the
inducement, fraud, negligent misrepresentation, conspiracy to commit fraud,
breach of fiduciary duties, and violations of Florida securities law. The
counterclaim also named Kerry Hicks, our President and Chief Executive Officer
and Patrick Jaeckle, our Executive Vice President - Corporate Development, as
defendants. The state court action was stayed on January 13, 1999.
On December 1, 1998, while the state court litigation was ongoing, TOC and 10 of
the TOC doctors filed a complaint against us in the United States District Court
for the Northern District of Florida, Tallahassee Division. That complaint also
named Kerry Hicks and Patrick Jaeckle as defendants. The complaint alleges
violations of the Securities Exchange Act, breach of contract, fraud, negligent
misrepresentation, and breach of fiduciary duty. These, absent the federal
securities claim, were essentially the same causes of action asserted as a
counterclaim against us by the defendants in the earlier state court litigation.
On January 11, 1999, we filed our answer and counterclaim to the federal court
action. We also named four other TOC doctors as defendants in our counterclaim.
In our answer and counterclaim we denied all wrongdoing, and asserted claims
against TOC and the TOC Doctors for merger agreement indemnification, breach of
contract, breach of good faith and fair dealing, tortious interference with
contractual relations, conversion, and civil theft.
We have, in addition to monetary damages, claimed a right to injunctive relief
to prohibit dissemination of financial information and to further limit tortious
interference with contractual relations, and sought an injunction to enforce the
TOC restrictive covenants. The federal court litigation is ongoing, and is
presently in the discovery phase.
30
31
We believe that we have strong legal and factual defenses to these
claims of TOC and the TOC doctors, and intend to vigorously defend the
allegations against us while aggressively pursuing our counterclaims.
3B Litigation
On January 22, 1999, 3B Orthopaedics, P.C. ("3B"), one of our
affiliated practices, Robert E. Booth, Jr., M.D., Arthur Bartolozzi, M.D., and
Richard A. Balderston, M.D., (collectively, the "Plaintiffs") filed a complaint
against us in the United States District Court for the Eastern District of
Pennsylvania.
The complaint asserts causes of action under Pennsylvania law for
breach of contract and seeks unspecified compensatory damages and a declaratory
judgment terminating any and all applicable agreements between the parties. In
essence, the plaintiffs claim that we breached our obligations to them under an
unexecuted service agreement, and any other agreement, by failing to provide the
promised management services and that the plaintiffs were damaged when they had
to provide such services themselves. The plaintiffs seek to invalidate
restrictive covenants entered into in favor of us through the lawsuit.
We filed our answer on March 24, 1999, denying all of the material
allegations of the plaintiffs' complaint and asserting affirmative defenses and
various counterclaims. We have asserted counterclaims against all plaintiffs for
breach of contract, unjust enrichment, conversion, and breach of the implied
duty of good faith and fair dealing. We have also asserted a counterclaim solely
against Dr. Booth for breach of fiduciary duty based upon his conduct as a
member of our board of directors from approximately November 1996 through
October 1998. We dispute the plaintiffs' claim that we failed to provide the
promised management services. Among other remedies, we seek to enforce
restrictive covenants entered into by the physician plaintiffs and to recover,
among other things, damages equal to 300% of the physician plaintiffs'
professional services' revenue. We also seek the return of all cash and all of
our common stock, or the proceeds from the sale of the our stock, given to the
physician plaintiffs pursuant to the November 12, 1996, merger between the
plaintiffs' former practice, Reconstructive Orthopaedic Associates, P.C. and us.
Prior to the formation of 3B, the defendant physicians practiced with
Reconstructive Orthopaedic Associates, P.C.
We believe that we have strong legal and factual defenses to
plaintiffs' claims. We intend to vigorously defend against the lawsuit and
aggressively pursue our counterclaims.
31
32
Mid-Atlantic Orthopaedic Specialists, P.C. Default Notice
On January 4, 1999, Mid-Atlantic Orthopaedic Specialists, P.C., one of
our affiliated practices, gave us notice that they intended to terminate the
service agreement between us and the practice based on our material default in
the performance of our duties and obligations imposed upon us by the service
agreement. Under the terms of the service agreement, in the event that an
affiliated practice asserts a material default under the service agreement, we
have sixty days in which to cure any such default. In our response letter to
the practice, we informed the practice that we did not believe that we were in
material default under the service agreement and that in any event the practice
had failed to give us adequate notice of a material default in order to give us
a reasonable opportunity to cure any specific default within the sixty-day
period provided for in the service agreement. After reviewing this matter in
detail, we continue to believe that we are not in material default under the
terms of our service agreement with Mid-Atlantic Orthopaedic Specialists, P.C.
In the event that Mid-Atlantic Orthopaedic Specialists, P.C. attempts to
terminate the service agreement with us, we have informed the practice that we
will pursue any and all legal remedies available to us including aggressive
litigation in federal and state courts.
Associated Orthopaedics & Sports Medicine, P.A. Default Notice
On March 18, 1999, Associated Orthopaedics & Sports Medicine, P.A., one
of our affiliated practices, gave us notice of default under the terms of the
service agreement between us and the medical practice. Under the terms of the
service agreement between us and Associated Orthopaedics & Sports Medicine,
P.A., we have thirty days to cure any material default under the service
agreement. After reviewing the letter dated March 18, 1999 and the items of
default specified therein, and our operations with respect to this practice, we
do not believe that we are in material default under the terms of the service
agreement. We have notified the practice that we do not believe that we are in
material default under the terms of the service agreement, that with respect to
the matters set forth in their letter of March 18, 1999, we will continue to
work with the practice to resolve any outstanding issues, and that in any event
should the practice terminate the service agreement we will pursue any and all
legal remedies available to us, including aggressive litigation in federal and
state courts.
Vanderbilt University Default Notice
On March 19, 1999, we received a default notice from Vanderbilt
University, with respect to a management services agreement we entered into
with Vanderbilt University to provide certain limited management services to
their orthopaedics department. Under the terms of the management services
agreement, we have sixty days to cure any material default. We have reviewed
the provisions of the default notice, and are undertaking steps to determine if
any such defaults have in fact occurred, whether they are material, and what
steps, if any, we need to take in order to cure any material defaults. In
addition, on March 19, 1999, we received notice from Vanderbilt University that
they would not renew the management services agreement upon its stated
termination date of June 30, 1999.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
32
33
Executive Officers of the Registrant
The following table sets forth certain information concerning the executive
officers of the Company:
NAME AGE POSITION
Kerry R. Hicks............ 39 President, Chief Executive Officer
Patrick M. Jaeckle........ 40 Executive Vice President - Corporate Development,
Secretary and Director
Kevin J. Hicks............ 39 Executive Vice President - Provider Businesses
D. Paul Davis............. 41 Senior Vice President - Finance
David G. Hicks............ 40 Vice President - Management Information Systems
Timothy D. O'Hare......... 46 Vice President - Payor Operations
KERRY R. HICKS, a founder of the Company, has served as President and Chief
Executive Officer and as a director of the Company since its inception in
December 1995. From 1985 to March 1996, Mr. Hicks served as Senior Vice
President of LBA Health Care Management ("LBA"), a developer of health care and
management information services. LBA provided management consulting services
(including orthopaedic projects) to medical centers to support the purchasing,
planning, marketing and delivery of health care. Mr. Hicks was principally
responsible for developing LBA's orthopaedic product line and its information
systems. LBA's orthopaedic product line established quality and cost benchmarks
and developed clinical protocols and patient care algorithms intended to
enhance both the quality and effectiveness of the delivery of orthopaedic care.
PATRICK M. JAECKLE, a founder of the Company, has served as Executive Vice
President - Corporate Development since July 1998 and Executive Vice President -
Finance/Development from December 1995 to July 1998, and as a director of the
Company since its inception in December 1995. From February 1994 to March 1996,
Dr. Jaeckle served as director of health care corporate finance at Morgan Keegan
& Company, Inc., a regional investment banking firm. Prior to February 1994, Dr.
Jaeckle was a member of the health care investment banking groups at both Credit
Suisse First Boston Corporation (from June 1992 to February 1994) and Smith
Barney, Inc. (from May 1991 to June 1992). Dr. Jaeckle holds an M.B.A. degree
from Columbia Business School, a D.D.S. degree from Baylor College of Dentistry
and a B.A. degree from The University of Texas at Austin.
KEVIN J. HICKS is Executive Vice President - Provider Businesses. Mr. Hicks
oversees ongoing consulting projects and manages HealthCareReportCards.com's
client relationships. Mr. Hicks was Chief Operating Officer of LBA Healthcare
Management form 1985 through 1995. He then served as Senior Vice President of
LBA when LBA was sold to Healthvision Inc. and then subsequently sold to HCIA
Inc. Mr. Hicks joined the Company in 1998. Mr. Hicks has provided consulting
assistance to numerous client hospitals, physician practices and integrated
networks. Mr. Hicks received a BS in Finance and an MBA from the University of
Colorado at Boulder.
D. PAUL DAVIS has served as Chief Financial Officer since August 1998, Senior
Vice President - Finance since June 1997 and he served as Vice President of
Finance from March 1996 until June 1997. He also served as the Company's
controller from March 1996 until September 1997. From January 1993 to March
1996, Mr. Davis served as Vice President of Finance for Surgical Partners of
America, Inc. From April 1987 to January 1993, he served as Chief Financial
Officer for Anesthesia Service Medical Group, Inc. Mr. Davis received a B.S.
degree in Accounting from the University of Utah. He is a certified public
accountant and a certified management accountant.
DAVID G. HICKS has served as Vice President - Management Information Systems of
the Company since March 1996. From November 1994 to March 1996, Mr. Hicks
worked as Manager of Information Technology for the Association of Operating
Room Nurses, responsible for information technology maintenance and
development. From February 1993 to November 1994, he served as Manager of
Information Systems Administration for Coors Brewing Company, and from January
1982 to February 1993, Mr. Hicks served as Manager of Internal Systems for
Martin Marietta Data Systems. Mr. Hicks received a B.S. degree in Management
Information Systems from Colorado State University.
TIMOTHY D. O'HARE has been Vice President - Payor Operations since August 1996.
From May 1994 to July 1996, Mr. O'Hare served as Executive Director of Kaiser
Foundation HealthPlan of North Carolina, where his responsibilities included
the negotiation of capitated and incentive contracts with hospitals, physician
hospital organizations and physician group practices. From April 1987 to May
1994, Mr. O'Hare served as Vice President/Executive Director of CIGNA Health
Care of North Carolina. From March 1986 to April 1987, Mr. O'Hare served as
Vice President of Operations for Preferred Health Network. Mr. O'Hare received
a B.S. degree from Virginia Polytechnic Institute and State University and a
M.H.A. degree from Virginia Commonwealth University.
Kerry R. Hicks, Kevin J. Hicks and David G. Hicks are all brothers.
33
34
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Since February 7, 1997, our Common Stock has been quoted on the Nasdaq Stock
Market under the symbol "SCNI." The following table sets forth the high and low
sales prices for the Common Stock for the quarters indicated as reported on the
Nasdaq Stock Market.
High Low
---- ---
Year Ended December 31, 1998
First Quarter........................... $13 3/8 $11 1/8
Second Quarter.......................... 12 1/2 5 3/4
Third Quarter........................... 6 5/8 1 1/32
Fourth Quarter.......................... 2 7/32 3/4
Year Ended December 31, 1997
First Quarter (1)....................... $10 5/8 $ 8
Second Quarter.......................... 12 1/2 7 5/8
Third Quarter........................... 13 3/4 10 7/8
Fourth Quarter.......................... 14 10 3/4
(1) Represents trading of the Common Stock from February 7, 1997 through
March 31, 1997.
The Company has never paid or declared any cash dividends and does not
anticipate paying any cash dividends in the foreseeable future. The Company
currently intends to retain any future earnings for use in its business.
The Company's credit facility with a bank syndicate prohibits the payment
of any dividends without written approval from the bank syndicate.
34
35
Item 6. Selected Financial Data
Statement of Operations Data
Year Ended Year Ended Year Ended
December 31, 1998 December 31, 1997 December 31,1996
----------------- ----------------- ----------------
Revenue:
Service fees $ 76,649,778 $ 45,966,531 $ 4,392,050
Other 2,531,524 3,689,390 --
------------- ------------ -----------
79,181,302 49,655,921 4,392,050
------------- ------------ -----------
Costs and expenses:
Clinic expenses 55,188,411 31,644,618 2,820,743
General and administrative 14,468,537 7,861,015 3,770,263
Impairment loss on service agreements 94,582,227 -- --
Litigation and other costs 3,564,392 -- --
Impairment loss on intangible assets and
other long-lived assets 3,316,651 -- --
------------- ------------ -----------
Total costs and expenses 171,120,218 39,505,633 6,591,006
------------- ------------ -----------
(Loss) income from operations (91,938,916) 10,150,288 (2,198,956)
Other:
Gain on sale of equity investment 1,240,078 -- --
Interest income 187,450 536,180 11,870
Interest expense (3,741,089) (942,144) (90,368)
------------- ------------ -----------
(Loss) income before income taxes (94,252,477) 9,744,324 (2,277,454)
Income tax benefit (expense) 32,466,391 (3,873,926) 506,071
------------- ------------ -----------
Net (loss) income $ (61,786,086) $ 5,870,398 $(1,771,383)
============= ============ ===========
Net (loss) income per common share (basic)(1) $ (3.39) $ 0.38 $ (0.16)
============= ============ ===========
Weighted average number of common shares
used in computation (basic)(1) 18,237,827 15,559,368 11,422,387
============= ============ ===========
Net (loss) income per common share (diluted)(1) $ (3.39) $ 0.37 $ (0.14)
============= ============ ===========
Weighted average number of common
shares and common share equivalents
used in computation (diluted) 18,237,827 16,071,153 12,454,477
============= ============ ===========
Balance Sheet Data
December 31, 1998 December 31, 1997 December 31, 1996
----------------- ----------------- -----------------
Working capital (deficit) $(21,457,105) $ 21,924,386 $ 7,637,724
Total assets 70,179,278 140,301,650 16,013,125
Total long-term debt 680,152 33,885,141 5,142,450
(1) The 1996 net income (loss) per share and weighted average share
amounts have been restated to comply with Statement of Financial
Accounting Standards No. 128, Earnings Per Share.
35
36
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
Specialty Care Network, Inc ("the Company") is a health care management services
company that provides practice management services to physicians. The Company
also provides a health care rating internet site, HealthCareReportCards.com,
that rates the quality of outcomes at various hospitals for several medical
procedures. In addition, through its subsidiary, Ambulatory Services, Inc., the
Company is establishing a business engaged in the development and management of
freestanding and in-office ambulatory surgery centers.
The Company has entered into long-term service agreements (the "Service
Agreements") with practices affiliated with the Company (the "Affiliated
Practices"), pursuant to which the Company, among other things, provides
facilities and management, administrative and development services, and employs
most non-physician personnel, in return for specified service fees. The
operating expenses incurred by the Company include the salaries, wages and
benefits of personnel (other than physician owners and certain technical medical
personnel), supplies, expenses involved in administering the clinical practices
of the Affiliated Practices and depreciation and amortization of assets. The
Company seeks to reduce certain operating expenses, as a percentage of net
revenue, of the Affiliates Practices. The negotiated amounts of the Company's
service fee also affects the Company's operating expenses, measured as a
percentage of net revenue. In addition to the operating expenses discussed
above, the Company incurs personnel and administrative expenses in connection
with its corporate offices, which provide management, administrative and
development services to the Affiliated Practices.
RESTRUCTURING TRANSACTION
In March 1999, the Company entered into restructuring agreements with ten of its
affiliated practices. The agreements:
o Provide for the repurchase by affiliated physicians or affiliated
practices of practice assets and for new management service
arrangements in exchange for cash and/or common stock;
o Limit management services provided to the affiliated practices by the
Company under its service agreements;
o Reduce the term of the Company's service agreements with the affiliated
practices; and
o Lower service fees paid to the Company by the affiliated practices.
36
37
The purchase price paid to the Company will consist of payments for the book
value of the assets to be purchased by the practices, less the practice
liabilities as of the closing date of the transaction and payments for the
execution of a new management services agreement to replace the existing service
agreement. If the restructuring transaction is approved by the Company's
stockholders and bank syndicate, the Company expects to reacquire 3,786,957
shares of its common stock and have the ability to reduce its indebtedness by
approximately $17.6 million including $0.6 million through cancellation of an
outstanding convertible debenture. (See Note 11, to the Consolidated Financial
Statements, for further discussion of the new management service agreements).
MODIFICATION OF ARRANGEMENTS WITH FOUR PRACTICES
Near the end of 1998, the Company entered into transactions with four of its
affiliated practices. In these transactions, the Company sold to each of the
practices accounts receivable, fixed assets and certain other assets relating to
the respective practices and replaced the original management service
arrangements with new arrangements. Under the management services agreements,
which terminate at certain dates between November 2001 and March 2003, the
Company provides substantially reduced services to the practices, and the
practices pay significantly reduced service fees. These transactions were closed
effective December 31, 1998. As a result of the completion of these four
transactions, the Company reacquired 2,124,959 shares of its common stock and
reduced its outstanding indebtedness at December 31, 1998 by approximately $5.5
million through the cancellation of a convertible note with one of the
affiliated practices. Additionally, in 1999, the Company used the proceeds from
the completion of these four transactions to reduce the amount outstanding under
its Credit Facility by approximately $8.5 million.
ACCOUNTING TREATMENT
Commencing January 1, 1999, costs of obtaining long-term service agreements are
amortized using the straight-line method over estimated lives of 3 - 5 years
(see Note 3 to the Consolidated Financial Statements for discussion regarding
the amortization period for the Company's long-term service agreements and
changes in accounting estimates). Under the service agreements between the
Company and each of the affiliated practices, the Company has the exclusive
right to provide management, administrative and development services during the
term of the agreement.
37
38
In light of the pending restructuring transaction, as well as numerous other
factors in the physician practice management industry in general, during the
fourth quarter of 1998, management of the Company undertook an evaluation of the
carrying amount of its service agreements pursuant to the provisions of
Statement of Financial Accounting Standards No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of. As
a result of this evaluation, the Company recorded an impairment loss on its
service agreements of approximately $94.6 million in December 1998. (See Note 2
to the Consolidated Financial Statements for further discussion of this
impairment charge.)
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998
Revenue
The Company's service fees revenue, including reimbursement of clinic expenses,
increased by $30.6 million to $76.6 million for the twelve months ended December
31, 1998 compared to $46.0 million for the same period in 1997. These increases
primarily reflect affiliation transactions that occurred during the latter part
of 1997 and in the first quarter in 1998. Other revenue for the twelve months
ended December 31, 1998 was $2.5 million compared to $3.7 million for the same
period in 1997. The decrease in other revenue was primarily due to a decrease in
business consulting fees earned and bad debt recovery in 1998 compared to the
same period of 1997. As a result of the transactions with the four practices in
December 1998, the Company expects service fee revenue to decline in 1999. If
the restructuring transaction is completed, service fees revenue will decrease
materially.
Clinic expenses and general and administrative expenses
For the twelve months ended December 31, 1998, total clinic expenses were $55.1
million compared to $31.6 million for the same period of 1997. Clinic expenses
are costs incurred by the Company, in accordance with the Service Agreements, on
behalf of the affiliated practices for which they are obligated to reimburse the
Company. Reimbursement of clinic expenses is a component of the service fee
revenue recorded by the Company. Principally, as a result of the transactions
with the four practices in December 1998, the Company expects clinic expenses to
decline in 1999. If the restructuring transaction is completed, clinic expenses
will decrease more substantially.
For the twelve months ended December 31, 1998, general and administrative
expenses were $14.5 million compared to $7.9 million for the same period of
1997. This increase was primarily due to increased amortization expense related
to the Company entering into additional long-term service agreements with
affiliated practices in the latter part of 1997 and first quarter 1998. In
addition, the Company shortened the lives over which the service agreements are
amortized over effective June 1998 (see Note 3 to the Consolidated Financial
Statements).
38
39
Impairment losses, litigation and other costs
In light of the pending restructuring transaction, as well as numerous other
factors in the physician practice management industry in general, during the
fourth quarter of 1998, management of the Company undertook an evaluation of the
carrying amount of its management service agreements pursuant to the provisions
of Statement of Financial Accounting Standards No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of. As
a result of this evaluation, the Company recorded an impairment loss on its
management service agreements of approximately $94.6 million in December 1998.
(See Note 2 to the Consolidated Financial Statements for further discussion of
this impairment charge.)
The Company is currently involved in disputes with TOC Specialists, P.L., The
Specialists Orthopaedic Medical Corporation and 3B Orthopaedics, P.C., which are
affiliated practices of the Company. (See Note 13 to the Consolidated Financial
Statements, for further discussion related to these legal proceedings). As a
result of these disputes, the Company has recorded a charge of approximately
$2.7 million to reserve for service fees recorded for these practices, which to
date have not been paid. In addition, as of December 31, 1998, the Company had
incurred approximately $.2 million in legal fees directly related to these
disputes. In connection with the proposed restructuring transaction described
above, the Company has also incurred expenses of approximately $.7 million for
financial advisors and legal consultation.
The Company is engaged in negotiations to resolve certain issues raised be the
former stockholders of Provider Partnerships, Inc. ("PPI"), a corporation
acquired by the Company in August 1998. PPI is a company engaged in providing
consulting services to hospitals, and it also provided certain assets that were
developed by the Company into its HealthCareReportCards.com web site. It is
currently contemplated by the Company that an arrangement will be reached with
the PPI stockholders that will involve, among other things, the following:
o The formation of a new company that will own the
HealthCareReportCards.com web site and one or more additional health
care rating web sites. The new company will be a majority-owned
subsidiary of the Company, and the former PPI shareholders will have
a minority shareholder interest in the company;
o The former PPI shareholders will return the 420,000 shares of Company
common stock that they received in connection with the Company's
acquisition of PPI;
o The Company will return most of the assets of PPI to the former PPI
shareholders; and
o The PPI shareholders will become majority shareholders of the new
company if SCN does not obtain $4 million in financing for the new
company by December 31, 1999.
While the Company is optimistic that an agreement will be reached, it cannot
assure that an agreement will be signed or that the terms of the agreement will
not differ from those above.
Because of the dispute with the former PPI stockholders, the Company recorded an
impairment loss in December 1998 of approximately $1.2 million on the intangible
asset created with the acquisition of PPI. In addition, as a result of the
proposed restructuring transaction, management of the Company performed a review
of the carrying amount of its other long-lived assets, which resulted in an
impairment loss of approximately $2.1 million during the fourth quarter of 1998.
Gain on sale of equity investment. In March 1998, the Company sold its entire
interest in West Central Ohio Group, Ltd., an Ohio limited liability company,
for a pre-tax gain of approximately $1.2 million.
Interest expense. During the twelve months ended December 31, 1998, the Company
incurred interest expense of $3.7 million compared to $.9 million for the same
period of 1997. This increase was primarily the result of additional borrowings
under the Company's bank credit facility (the "Credit Facility"), which were
made to fund the Company's affiliation transactions and to fund the Company's
purchase of ancillary equipment for installation at affiliated practices.
YEAR ENDED DECEMBER 31, 1997
During 1996, the Company was in its start-up phase and, consequently, the 1996
results are not comparable with the 1997 results.
For 1997, the Company had service fees revenues of approximately $46.0 million,
including reimbursement of
39
40
clinic expenses. Of this amount, approximately $17.6 million in service fees
were derived from practices that affiliated with the Company during 1997. The
Company also generated other revenues totaling approximately $3.7 million,
which consist mainly of business consulting fees, medical director fees and
miscellaneous revenue, of which approximately $.5 million is derived from
ongoing operations and may be deemed recurring.
During 1997, the Company incurred costs and expenses totaling approximately
$39.5 million, of which approximately $7.9 million are general and
administrative expenses, principally comprised of personnel and administrative
expenses relating to the provision of services to the Affiliated Practices. In
addition, approximately $1.2 million of such expenses constitutes amortization
expense relating to the costs and expenses incurred in the Service Agreement
intangible asset.
In 1997, the Company incurred approximately $942,000 of interest expense on
weighted average outstanding debt of approximately $14.7 million. At the end of
1997, outstanding indebtedness on the Company's bank line of credit was
approximately $33 million.
YEAR ENDED DECEMBER 31, 1996
Prior to November 12, 1996, the Company had not entered into any service
agreements and, consequently, generated no revenue. For the period from January
1, 1996 through October 31, 1996, the Company incurred a pre-tax loss of
approximately $2.9 million, reflecting management salaries, business start-up
expenses and travel, legal and accounting costs associated with its initial five
affiliation transactions. For the period from November 1, 1996 through December
31, 1996, the Company generated net revenue, including reimbursement of clinic
expenses, of approximately $4.4 million and pre-tax income of approximately
$611,000. The income tax benefit reflected in the Company's statement of
operations differs from amounts currently payable because certain revenue and
expenses are reported differently in the statement of operations than they are
for tax filing purposes. For the year ended December 31, 1996, the Company's
effective tax rate was (22.2%). See "Liquidity and Capital Resources" below for
additional information.
The following table presents certain statement of operations data for the year
ended December 31, 1996, for the ten months ended October 31, 1996, during
which the Company did not conduct any significant operations and devoted most
of its efforts toward completing the Initial Affiliation Transactions, and for
the two months ended December 31, 1996, which includes operations following the
affiliation with the Initial Affiliated Practices on November 12, 1996.
Ten Months Two Months Twelve Months
Ended Ended Ended
October 31, 1996 December 31, 1996 December 31, 1996
---------------- ----------------- -----------------
Revenue:
Service fees $ -- $ 4,392,050 $ 4,392,050
Other -- -- --
----------- ----------- -----------
-- 4,392,050 4,392,050
Costs and expenses:
Clinic expenses -- 2,820,743 2,820,743
General and administrative expenses 2,845,973 924,290 3,770,263
----------- ----------- -----------
2,845,973 3,745,033 6,591,006
Income (loss) from operations (2,845,973) 647,017 (2,198,956)
Other:
Interest income 6,070 5,800 11,870
Interest expense (48,760) (41,608) (90,368)
----------- ----------- -----------
Income (loss) before income taxes ($2,888,663) $ 611,209 $(2,277,454)
=========== =========== ===========
40
41
LIQUIDITY AND CAPITAL RESOURCES
For the year ended December 31, 1998, the Company incurred a loss from
operations of approximately $91.9 million due primarily to an impairment charge
related to its management service agreements, as more fully described above.
Additionally, as of December 31, 1998, the Company had a working capital deficit
of approximately $21.5 million and was not in compliance with certain of the
financial ratio covenants required by the Company's Credit Facility. As a result
of the non-compliance with certain financial ratio covenants, the Company is in
default under the terms of the Credit Facility. In the event of default, the
terms of the Credit Facility provide that the bank syndicate can immediately
terminate its obligation to make further advances under the respective
commitments and/or declare the Company's outstanding debt under the Credit
Facility to be immediately due and payable. Accordingly, the total amount
outstanding under the Credit Facility of approximately $52.9 million has been
included in the Company's Consolidated Balance Sheet as a current liability at
December 31, 1998. The bank syndicate notified the Company in December 1998 that
it was suspending any further advances under the Credit Facility. The Company is
currently negotiating with the bank syndicate to obtain a waiver of
non-compliance with the financial ratio covenants and to revise the financial
ratio covenants to bring the Company into compliance for the remaining term of
the Credit Facility.
The issues described above raise substantial doubt about the Company's ability
to continue as a going concern. Management of the Company intends to address
these issues through a restructuring transaction involving ten of its affiliated
practices, which is intended to substantially reduce the Company's outstanding
debt and allow management to pursue the development of a health care rating
internet site and of its ambulatory surgery center business. The proposed
restructuring transaction, which is subject to approval by the Company's
stockholders as well as the bank syndicate, is more fully described above, under
"Restructuring." Additionally, management believes that the cash flow from
operations will be sufficient to the fund the Company's operations at its
current level for the next twelve months. However, the Company is incurring
significant legal fees and other costs related to pending litigation with three
of its affiliated practices. In addition, the Company is incurring significant
legal fees and other costs related to the proposed restructuring. The Company
anticipates that it will require additional funds to finance capital
expenditures relating to expansion of its business. The Company expects that
capital expenditures during 1999 will relate primarily to (i) the development of
its surgery center business, (ii) expansion and replacement of medical and
office equipment for the affiliated practices not restructuring, and (iii) the
purchase of equipment to expand the Company's computer capabilities. The
availability and terms of any financing will depend on market and other
conditions. The Company cannot assure that sufficient funds will be available on
terms acceptable to the Company, if at all.
During 1998, the Company's expenditures for property, plant and equipment were
$9.1 million. These expenditures primarily related to purchase of magnetic
resonance imaging units and other ancillary equipment items at the affiliated
practices. The Company borrowed $20.3 million under the Credit Facility in 1998,
primarily to fund the cash requirements of its practice affiliations ($12.4
million) and costs associated with the acquisition of PPI ($0.2 million), to
finance ancillary equipment purchases ($5.3 million), and to fund cash shortages
due to two affiliated practices diverting accounts receivable cash receipts
inappropriately during the fourth quarter of 1998 ($2.4 million), the Company is
currently in litigation with those practices.
Pursuant to the Service Agreements with the Affiliated Practices, the Company
purchases, subject to adjustment, the accounts receivable of the Affiliated
Practices monthly.
41
42
The purchase price for such accounts receivable generally equals the gross
amounts of the accounts receivable recorded each month, less adjustments for
contractual allowances, allowances for doubtful accounts and other potentially
uncollectible amounts based on the practice's historical collection experience,
as determined by the Company. However, the Company and certain Affiliated
Practices are currently making periodic adjustments so that amounts paid by the
Company for the accounts receivable are adjusted upwards or downwards based on
the Company's actual collection experience. The Company expects to use working
capital to fund its obligation to purchase, subject to adjustment, the accounts
receivable on an ongoing basis. No adjustments are made to reflect financing
costs related to the carrying of such receivables by the Company.
YEAR 2000
The Year 2000 (Y2K) issue is a result of a global programming standard that
records dates as six digits (i.e. MM/DD/YY), using only the last two digits for
the year. Any software application or hardware product that uses two-digit
fields could interpret the year 2000 as the year 1900. Systems that do not
properly recognize the correct year could generate erroneous data or cause a
system to fail, resulting in business interruption. This situation is not
limited to computers; it has the potential to affect many systems, components,
and devices, which have embedded computer chips that may be date sensitive.
We are coordinating our efforts to address the Y2K issue with our affiliated
practices, third-party payors, and vendors. We cannot assure that the systems of
other companies on which our systems rely will be timely converted. A failure to
convert by another company or a conversion that is incompatible with our systems
could have a material adverse effect on us.
In 1997, we established a Y2K Coordinator to oversee all corporate-wide Y2K
initiatives. These initiatives encompass all of our computer software and
embedded systems. Teams of internal and external specialists were established to
inventory and test critical computer programs and automated operational systems.
Additionally, a detailed project plan has been created that outlines all
activities related to the Y2K issue. Generally speaking, the project involves
three areas: Corporate Headquarters, Affiliated Practices and Third-party
Payors.
Corporate Headquarters: Because we began operations in 1996, most of our
corporate computer hardware is relatively new. Additionally, most of the
software applications are "off the shelf", resulting in few internal software
modifications. In the prior six-month period, all significant internal
applications have been reviewed and updated. We currently anticipate that all
remaining internal applications will be Y2K compliant by the end of the second
quarter of 1999. Total costs incurred by us to modify the software used at the
corporate office were not material.
Affiliated Practices: We have assessed the status of the computer systems at our
affiliated practices. Based on the results of this assessment, we have
determined that the majority of our affiliated practices' systems are Y2K
compliant. The remaining practices are currently upgrading their systems or are
in the testing phase. Based upon our review, and discussion with our affiliated
practices, we expect all remaining affiliated practices to be compliant by the
end of the second quarter of 1999. All costs to modify systems to become Y2K
compliant have been and will be borne by the affiliated practices.
Third-Party Payors: Although our affiliated practices' internal systems are
expected to be compliant by the end of the second quarter of 1999, our
affiliated practices also have important relationships with third party payors
and managed care organizations. We have been reviewing with these major payors
and managed care organizations the status of their Y2K readiness. Most of our
major payors are large insurance carriers and government agencies. Based on
discussions with some of our affiliated practices, many of the major third-party
payors are either compliant or are in the testing phase at this time. However,
we also understand there are some government payors, such as Medicare, that are
not yet Y2K compliant. Any failure by one of our significant third-party payors
to fully address all Y2K issues could have a material adverse effect on us.
Although we believe we are addressing all significant Y2K issues which could
affect us, we have few alternatives available, other than reversion to manual
methods, in order to avoid the effects of not establishing Y2K readiness. As a
result, if any significant issues arise with our corporate headquarters, our
practices or third-party payors, we could incur significant additional costs to
correct the problem. There can be no assurance that any remediation plan will
address all the problems that may arise. For the Y2K non-compliance issues
identified to date, the cost to upgrade or prepare for Y2K is not expected to
have a material impact on our operating results.
42
43
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Because we are in default under our Credit Facility, amounts outstanding under
the Credit Facility bear interest at the prime lending rate plus 0.5%. As a
result, this debt is subject to fluctuations in the market which affect the
prime rate.
Item 8. Financial Statements and Supplementary Data
See pages F-1 through F-48 and page S-1 of this document.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Not applicable.
43
44
PART III
Item 10. Directors and Executive Officers of the Registrant
This information (other than the information relating to executive officers
included in Part I) will be included in the Company's Proxy Statement relating
to its Annual Meeting of Stockholders, or in a amendment to this Form 10-K,
which will be filed within 120 days after the close of the Company's fiscal
year covered by this report, and is hereby incorporated by reference to such
Proxy Statement or amendment.
Item 11. Executive Compensation
This information will be included in the Company's Proxy Statement relating to
its Annual Meeting of Stockholders, or an amendment to this Form 10-K, which
will be filed within 120 days after the close of the Company's fiscal year
covered by this report, and is hereby incorporated by reference to such Proxy
Statement or amendment.
Item 12. Security Ownership of Certain Beneficial Owners and Management
This information will be included in the Company's Proxy Statement relating to
its Annual Meeting of Stockholders, or in a amendment to this Form 10-K, which
will be filed within 120 days after the close of the Company's fiscal year
covered by this report, and is hereby incorporated by reference to such Proxy
Statement or amendment.
Item 13. Certain Relationships and Related Transactions
This information will be included in the Company's Proxy Statement relating to
its Annual Meeting of Stockholders, or in a amendment to this Form 10-K, which
will be filed within 120 days after the close of the Company's fiscal year
covered by this report, and is hereby incorporated by reference to such Proxy
Statement or amendment.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) 1. Financial Statements.
The financial statements listed in the accompanying Index to Financial
Statements and Financial Statement Schedule at page S-1 are filed as
part of this Form 10-K.
2. Financial Statement Schedules.
The following financial statement schedule is filed as part of this Form 10-K:
Schedule II - Valuation and Qualifying Accounts.
All other schedules have been omitted because they are not applicable, or not
required, or the information is shown in the Financial Statements or notes
thereto.
3. Exhibits.
The following is a list of exhibits filed as part of this annual report on Form
10-K. Where so indicated by footnote, exhibits which were previously filed are
incorporated by reference.
44
45
Exhibit
Number Description
- ------ -----------
2.1 Restructure Agreement by and Among Specialty Care Network, Inc.,
Medical Rehabilitation Specialists II, P.A. and Kirk J. Mauro, M.D.
dated as of December 31, 1998.
2.11 Management Services Agreement by and Among Specialty Care Network,
Inc., Medical Rehabilitation Specialists II, P.A., and Kirk J. Mauro,
M.D. dated as of January 1, 1999.
2.2 Restructure Agreement by and Among Specialty Care Network, Inc.,
Greater Chesapeake Orthopaedic Associates, L.L.C., Paul L. Asdourian,
M.D., Frank R. Ebert, M.D., Leslie S. Matthews, M.D., Stewart D.
Miller, M.D., Mark S. Meyerson, M.D., John B. O'Donnell, M.D. and Lew
C. Schon, M.D., dated as of December 31, 1998.
2.21 Management Services Agreement by and Among Specialty Care Network,
Inc., Greater Chesapeake Orthopaedic Associates, L.L.C., Paul L.
Asdourian, M.D., Frank R. Ebert, M.D., Leslie S. Matthews, M.D.,
Stewart D. Miller, M.D., Mark S. Meyerson, M.D., John B. O'Donnell,
M.D. and Lew C. Schon, M.D., dated as of January 1, 1999.
2.3 Restructure Agreement by and Among Specialty Care Network, Inc., Vero
Orthopaedics II, P.A., James L. Cain, M.D., David W. Griffin, M.D.,
George K. Nichols, M.D. and Peter G. Wernicki, M.D. dated as of
December 31, 1998.
2.31 Management Services Agreement by and Among Specialty Care Network,
Inc., Vero Orthopaedics II, P.A., James L. Cain, M.D., David W.
Griffin, M.D., George K. Nichols, M.D. and Peter G. Wernicki, M.D.
dated as of January 1, 1999.
2.4 Restructure Agreement by and Among Specialty Care Network, Inc.,
Orlin & Cohen Orthopedic Associates, LLP, Harvey Orlin, M.D., Isaac
Cohen, M.D., John M. Feder, M.D., Gregory Lieberman, M.D., Sebastian
Lattuga, M.D., Harvey Orlin, M.D., P.C. and Rockville Centre
Arthroscopic Associates, P.C. dated as of December 31, 1998.
2.41 Management Services Agreement by and Among Specialty Care Network,
Inc., Orlin & Cohen Orthopedic Associates, LLP, Harvey Orlin, M.D.,
Isaac Cohen, M.D., John M. Feder, M.D., Gregory Lieberman, M.D.,
Sebastian Lattuga, M.D., Harvey Orlin, M.D., P.C. and Rockville
Centre Arthroscopic Associates, P.C. dated as of January 1, 1999.
3.1 Amended and Restated Certificate of Incorporation (incorporated by
reference to Exhibit 3.1 to the Company's Registration Statement on
Form S-1 (File No. 333-17627))
3.2 Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2
to the Company's Registration Statement on Form S-1 (File No.
333-17627))
10.1+ 1996 Equity Compensation Plan, as amended (incorporated by reference
to Exhibit 10 to the Company's June 30, 1998 Quarterly Report on
Form 10-Q for the quarter ended June 30, 1998.)
45
46
10.2 Second Amended and Restated Revolving Loan and Security Agreement
dated as of November 21, 1997 among Specialty Care Network, Inc., SCN
of Princeton, Inc., NationsBank of Tennessee N.A., AmSouth Bank,
Banque Paribas, Key Corporate Capital Inc. and NationsBank of
Tennessee, N.A., as Agent (incorporated by reference to Exhibit 10.2
to the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 1997)
10.3+ Employment Agreement dated as of April 1, 1996 by and between
Specialty Care Network, Inc. and Kerry R. Hicks (incorporated by
reference to Exhibit 10.3 to the Company's Registration Statement on
Form S-1 (File No. 333-17627))
10.4+ Employment Agreement dated as of April 1, 1996 by and between
Specialty Care Network, Inc. and Patrick M. Jaeckle (incorporated by
reference to Exhibit 10.4 to the Company's Registration Statement on
Form S-1 (File No. 333-17627))
10.6+ Employment Agreement dated as of February 22, 1996 by and between
Specialty Care Network, Inc. and Paul Davis (incorporated by
reference to Exhibit 10.6 to the Company's Registration Statement on
Form S-1 (File No. 333-17627)).
10.6.1+ Amendment to Employment Agreement between Specialty Care Network,
Inc. and D. Paul Davis dated December 5, 1997. (incorporated by
reference to Exhibit 10.6.1 to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1997)
10.7+ Employment Agreement dated as of March 1, 1996 by and between
Specialty Care Network, Inc. and David Hicks (incorporated by
reference to Exhibit 10.8 of the Company's Registration Statement on
Form S-1 (File No. 333-17627))
10.7.1+ Amendment to Employment Agreement between Specialty Care Network,
Inc. and David Hicks, dated December 2, 1997. (incorporated by
reference to Exhibit 10.8.1 to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1997)
46
47
21 Subsidiaries of the registrant.
23 Consent of Ernst & Young LLP.
27.1 Financial Data Schedule for the year ended December 31, 1998.
+ Constitutes management contract or compensatory plan or arrangement required
to be filed as an exhibit to this form.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the last quarter of the period covered
by this report.
47
48
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
SPECIALTY CARE NETWORK, INC.
Date: April 6, 1999 By /s/ Kerry R. Hicks
-------------------------------------
Kerry R. Hicks
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Name Title Date
---- ----- ----
/s/ Kerry R. Hicks President and Chief Executive Officer April 6, 1999
- ----------------------------------------- (Principal Executive Officer)
Kerry R. Hicks
/s/ Patrick M. Jaeckle Executive Vice President - Development April 6, 1999
- -----------------------------------------
Patrick M. Jaeckle
/s/ D. Paul Davis Senior Vice President - Finance April 6, 1999
- ----------------------------------------- (Chief Financial Officer)
D. Paul Davis
/s/ Peter H. Cheesbrough Director April 6, 1999
- -----------------------------------------
Peter H. Cheesbrough
/s/ Richard E. Fleming, Jr. Director April 6, 1999
- -----------------------------------------
Richard E. Fleming, Jr., M.D.
/s/ Leslie S. Matthews Director April 6, 1999
- -----------------------------------------
Leslie S. Matthews, M.D.
/s/ Mats Wahlstrom Director April 6, 1999
- -----------------------------------------
Mats Wahlstrom
48
49
INDEX TO FINANCIAL STATEMENTS
SPECIALTY CARE NETWORK, INC. AND SUBSIDIARIES:
Report of Independent Auditors .............................................F-1
Consolidated Balance Sheets ................................................F-3
Consolidated Statements of Operations.......................................F-5
Consolidated Statements of Stockholders' Equity ............................F-6
Consolidated Statements of Cash Flows ......................................F-7
Notes to Consolidated Financial Statements .................................F-9
50
Report of Independent Auditors
Board of Directors and Stockholders
Specialty Care Network, Inc.
We have audited the accompanying consolidated balance sheets of Specialty Care
Network, Inc. and subsidiaries (collectively the "Company") as of December 31,
1998 and 1997, and the related consolidated statements of operations,
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 1998. Our audits also included the financial statement
schedule listed in the Index at Item 14(a). These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Specialty Care
Network, Inc. and subsidiaries at December 31, 1998 and 1997, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As more fully described in
Note 2, the Company has incurred a significant operating loss related to the
restructuring and impairment of its affiliated physician practice arrangements,
has a working capital deficit and is in technical violation of certain financial
covenants in its bank credit facility. These conditions raise substantial doubt
about the Company's ability to continue as a going concern. Management's plans
F-1
51
in regard to these matters are also described in Note 2. The consolidated
financial statements do not include any adjustments to reflect the possible
future effects on the recoverability and classification of assets or the amounts
and classification of liabilities that may result from the outcome of these
uncertainties.
/s/ ERNST & YOUNG LLP
---------------------
Ernst & Young LLP
Denver, Colorado
March 26, 1999
F-2
52
Specialty Care Network, Inc. and Subsidiaries
Consolidated Balance Sheets
DECEMBER 31
1998 1997
------------ ------------
ASSETS
Cash and cash equivalents $ 1,418,201 $ 3,444,517
Accounts receivable, net 22,281,471 25,957,367
Due from affiliated practices in litigation, net 4,747,940 --
Receivables from sales of affiliated practices assets
and execution of new service agreements 7,953,068 --
Loans to physician stockholders 521,355 914,737
Prepaid expenses, inventories and other 1,500,382 796,903
Prepaid and recoverable income taxes 4,258,102 --
------------ ------------
Total current assets 42,680,519 31,113,524
Property and equipment, net 11,050,365 5,276,219
Intangible assets, net of accumulated amortization of
$64,241 and $189,485 in 1998 and 1997,
respectively 134,319 1,137,808
Management service agreements, net of accumulated
amortization of $4,350,647 and $1,210,391 in
1998 and 1997, respectively
13,153,048 100,732,431
Advances to affiliates and other 944,520 922,022
Other assets 2,216,507 1,119,646
------------ ------------
Total assets $ 70,179,278 $140,301,650
============ ============
F-3
53
DECEMBER 31
1998 1997
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current portion of capital lease obligations $ 244,446 $ 263,007
Accounts payable 785,649 701,087
Accrued payroll, incentive compensation and related
expenses 2,453,653 2,014,573
Accrued expenses 2,730,069 1,507,382
Line-of-credit 52,925,000 --
Income taxes payable -- 944,632
Due to affiliated practices 3,326,014 2,885,602
Deferred income taxes 1,083,178 872,855
Convertible debentures 589,615 --
------------ ------------
Total current liabilities 64,137,624 9,189,138
Line-of-credit -- 33,000,000
Capital lease obligations, less current portion 680,152 885,141
Deferred income taxes -- 32,115,476
------------ ------------
Total liabilities 64,817,776 75,189,755
Commitments and contingencies
Stockholders' equity:
Preferred stock, $0.001 par value, 2,000,000
shares authorized, no shares issued or outstanding -- --
Common stock, $0.001 par value, 50,000,000
shares authorized, and 18,618,873 and
17,703,293 shares issued and outstanding in 1998
and 1997, respectively 18,619 17,703
Additional paid-in capital 66,993,627 60,995,177
(Accumulated deficit) retained earnings (57,687,071) 4,099,015
Treasury stock (3,963,673) --
------------ ------------
Total stockholders' equity 5,361,502 65,111,895
============ ============
Total liabilities and stockholders' equity $ 70,179,278 $140,301,650
============ ============
See accompanying notes to consolidated financial statements.
F-4
54
Specialty Care Network, Inc. and Subsidiaries
Consolidated Statements of Operations
Years ended December 31, 1998, 1997 and 1996
1998 1997 1996
------------- ------------- -------------
Revenue:
Service fees $ 76,649,778 $ 45,966,531 $ 4,392,050
Other 2,531,524 3,689,390 --
------------- ------------- -------------
79,181,302 49,655,921 4,392,050
------------- ------------- -------------
Costs and expenses:
Clinic expenses 55,188,411 31,644,618 2,820,743
General and administrative 14,468,537 7,861,015 3,770,263
Impairment loss on service
agreements 94,582,227 -- --
Litigation and other costs 3,564,392 -- --
Impairment loss on intangible assets
and other long-lived assets 3,316,651 -- --
------------- ------------- -------------
171,120,218 39,505,633 6,591,006
------------- ------------- -------------
(Loss) income from operations (91,938,916) 10,150,288 (2,198,956)
Other:
Gain on sale of equity investment 1,240,078 -- --
Interest income 187,450 536,180 11,870
Interest expense (3,741,089) (942,144) (90,368)
------------- ------------- -------------
(Loss) income before income taxes (94,252,477) 9,744,324 (2,277,454)
Income tax benefit (expense) 32,466,391 (3,873,926) 506,071
============= ============= =============
Net (loss) income $ (61,786,086) $ 5,870,398 $ (1,771,383)
============= ============= =============
Net (loss) income per common share
(basic) $ (3.39) $ 0.38 $ (0.16)
============= ============= =============
Weighted average number of common
shares used in computation (basic) 18,237,827 15,559,368 11,422,387
============= ============= =============
Net (loss) income per common
share (diluted) $ (3.39) $ 0.37 $ (0.14)
============= ============= =============
Weighted average number of common
shares and common share equivalents
used in computation (diluted) 18,237,827 16,071,153 12,454,477
============= ============= =============
See accompanying notes to consolidated financial statements.
F-5
55
Specialty Care Network, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
Years ended December 31, 1998, 1997 and 1996
COMMON STOCK (ACCUMULATED
$0.001 PAR VALUE ADDITIONAL DEFICIT)
---------------------------- PAID-IN RETAINED TREASURY
SHARES AMOUNT CAPITAL EARNINGS STOCK TOTAL
------------ ------------ ------------ ------------ ------------ ------------
Balances at January 1, 1996 1,690,000 $ 1,690 $ -- $ -- $ -- $ 1,690
Purchase and retirement of
common stock in connection
with a severance agreement (425,000) (425) -- -- -- (425)
Shares issued to one of the
affiliated practices 100,000 100 299,900 -- -- 300,000
Convertible debt and accrued
interest thereon converted to
common shares 2,020,900 2,021 2,220,018 -- -- 2,222,039
Shares issued in connection
with the acquisitions of
net assets of affiliated
practices 7,659,115 7,659 5,483,159 -- -- 5,490,818
Dividends paid to physician
owners as promoters -- -- (1,537,872) -- -- (1,537,872)
Net loss -- -- -- (1,771,383) -- (1,771,383)
------------ ------------ ------------ ------------ ------------ ------------
Balances at December 31, 1996 11,045,015 11,045 6,465,205 (1,771,383) -- 4,704,867
Shares issued in connection with
an initial public offering of
common stock, including the
underwriters' overallotment 3,208,338 3,208 22,188,283 -- -- 22,191,491
Shares and other equity
instruments issued in
connection with the
acquisitions of net assets of
affiliated practices 3,222,891 3,223 31,147,368 -- -- 31,150,591
Exercise of employee stock options 227,049 227 265,160 -- -- 265,387
Tax benefit related to employee
stock options -- -- 717,140 -- -- 717,140
Non-cash compensation expense
related to employee stock
options -- -- 212,021 -- -- 212,021
Net income -- -- -- 5,870,398 -- 5,870,398
------------ ------------ ------------ ------------ ------------ ------------
Balances at December 31, 1997 17,703,293 17,703 60,995,177 4,099,015 -- 65,111,895
Shares and other equity
instruments issued in
connection with the
acquisitions of net assets of
affiliated practices and
Provider Partnerships, Inc. 879,480 880 5,561,101 -- -- 5,561,981
Exercise of employee stock options 36,100 36 231,314 -- -- 231,350
2,237,644 shares acquired as
treasury stock -- -- -- -- (3,963,673) (3,963,673)
Tax benefit related to employee
stock options -- -- 86,863 -- -- 86,863
Non-cash compensation expense
related to employee stock -- -- 119,172 -- -- 119,172
options
Net loss -- -- -- (61,786,086) -- (61,786,086)
------------ ------------ ------------ ------------ ------------ ------------
Balances at December 31, 1998 18,618,873 $ 18,619 $ 66,993,627 $(57,687,071) $ (3,963,673) $ 5,361,502
============ ============ ============ ============ ============ ============
See accompanying notes to consolidated financial statements.
F-6
56
Specialty Care Network, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Years ended December 31, 1998, 1997 and 1996
1998 1997 1996
------------ ------------ ------------
OPERATING ACTIVITIES
Net (loss) income $(61,786,086) $ 5,870,398 $ (1,771,383)
Adjustments to reconcile net (loss) income to net
cash provided by (used in) operating activities:
Non-cash compensation expense related to
employee stock options 119,172 212,021 --
Depreciation expense 2,227,101 965,492 136,216
Amortization expense 4,374,607 1,377,746 22,130
Gain on sale of equity investment (1,240,078) -- --
Impairment loss on service agreements, non-cash 94,582,227 -- --
Impairment loss on intangible assets and
other long-lived assets, non-cash 3,316,651 -- --
Litigation and other costs, non-cash 3,431,734 -- --
Interest on convertible debentures -- -- 52,039
Deferred income tax benefit (31,520,026) (1,279,497) (1,735,346)
Changes in operating assets and liabilities, net
of the effects of the non-cash acquisitions of
net assets of affiliated physician practices and
Provider Partnerships, Inc., and sale of assets
and execution of new service agreements:
Accounts receivable, net (9,092,730) (9,313,152) (2,066,190)
Prepaid expenses and other assets (1,265,926) (1,572,849) (204,911)
Prepaid and recoverable income taxes (4,170,177) -- --
Accounts payable 223,450 (88,566) 49,764
Accrued payroll, incentive compensation
and related expenses 735,390 876,369 982,982
Accrued expenses 1,196,577 (1,083,330) 850,035
Income taxes payable (944,632) 432,497 1,229,275
Due to affiliated physician practices, net 734,676 1,798,545 1,087,057
------------ ------------ ------------
Net cash provided by (used in) operating activities 921,930 (1,804,326) (1,368,332)
INVESTING ACTIVITIES
Purchases of property and equipment (9,141,785) (1,568,795) (354,595)
Proceeds from the sale of equity investment 1,075,000 -- --
Repayments of advances to affiliates and
notes receivable 1,022,621 -- --
Increases in intangible assets (116,048) (1,111,257) (186,452)
Equity investment and related advances (1,753,742) (922,022) --
Acquisitions of physician practices and Provider
Partnerships, Inc., net of cash acquired (12,636,948) (44,452,105) --
------------ ------------ ------------
Net cash used in investing activities (21,550,902) (48,054,179) (541,047)
F-7
57
Specialty Care Network, Inc. and Subsidiaries
Consolidated Statement of Cash Flows (continued)
1998 1997 1996
------------- ------------- -------------
FINANCING ACTIVITIES
Proceeds from initial public offering, net of
period offering costs $ -- $ 22,939,338 $ --
Proceeds from line-of-credit agreement 20,325,000 35,500,000 4,177,681
Proceeds from convertible debentures -- -- 2,170,000
Principal repayments on line-of-credit agreement (400,000) (6,677,681) --
Principal repayments on capital lease obligations (221,757) (229,711) (33,422)
Retirement of common stock -- -- (425)
Purchases of treasury stock (921,491) -- --
Capital contribution from one physician practice -- -- 300,000
Prepaid offering costs -- -- (747,847)
Dividends paid to promoters -- -- (1,537,872)
Exercise of employee stock options 231,350 265,387 --
Advances from officers and stockholders -- -- (9,410)
Principal payments from loans to physician
stockholders 78,427 1,026,419 --
Loans to physician stockholders (488,873) (964,737) (976,419)
------------- ------------- -------------
Net cash provided by financing activities 18,602,656 51,859,015 3,342,286
------------- ------------- -------------
Net (decrease) increase in cash and
cash equivalents (2,026,316) 2,000,510 1,432,907
Cash and cash equivalents at beginning of period 3,444,517 1,444,007 11,100
============= ============= =============
Cash and cash equivalents at end of period $ 1,418,201 $ 3,444,517 $ 1,444,007
============= ============= =============
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid $ 3,509,592 $ 910,000 $ 38,329
============= ============= =============
Income taxes paid $ 4,169,506 $ 4,720,926 $ --
============= ============= =============
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING
AND FINANCING ACTIVITIES
Effects of the acquisitions of net assets of
affiliated physician practices:
Assets acquired $ 23,196,873 $ 110,952,707 $ 10,761,466
Liabilities assumed (294,042) (2,429,726) (2,187,759)
Income tax liabilities assumed -- (32,920,285) (3,082,889)
Convertible note payable issued (6,044,054) -- --
Less: Cash paid for acquisitions (12,400,360) (44,452,105) --
------------- ------------- -------------
$ 4,458,417 $ 31,150,591 $ 5,490,818
============= ============= =============
Realized loss on four affiliated practice
restructurings in 1998:
Assets disposed of $ 29,909,279 $ -- $ --
Liabilities transferred (1,361,040) -- --
Convertible debentures payable forgiven (5,454,439) -- --
Treasury stock acquired (2,656,199) -- --
Less: Receivable from affiliated practices (7,953,068) -- --
------------- ------------- -------------
Pretax impairment loss on four restructurings closed in 1998 $ 12,484,533 $ -- $ --
============= ============= =============
Conversion of convertible debentures and accrued
interest thereon into common stock $ -- $ -- $ 2,222,039
============= ============= =============
See accompanying notes to consolidated financial statements.
F-8
58
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 1998
1. DESCRIPTION OF BUSINESS
Specialty Care Network, Inc. and subsidiaries (collectively the "Company") is a
health care management services company that provides practice management
services to physicians. Commencing on November 12, 1996, the Company began
providing comprehensive management services under long-term management service
agreements with five physician practices in various states.
The Company provides practice management services to physicians in practices
that focus on musculoskeletal care. Healthcare Report Cards, Inc., ("HRCI") was
formed in September 1998 as a wholly-owned subsidiary of the Company. In
November 1998, HRCI launched an Internet web site,
HealthcareReportCards.com((TM)), that rates the quality of outcomes at various
hospitals for several medical procedures. In addition, in December 1998,
Ambulatory Services, Inc., ("ASI") was formed as a wholly-owned subsidiary of
the Company. ASI was formed to engage in the development and management of
freestanding and in-office ambulatory surgery centers.
The Company's wholly-owned subsidiary, Provider Partnerships, Inc. ("PPI"),
provides consulting services to hospitals to increase their operating
performance, with a specific focus on the cardiac area. However, the Company is
currently involved in a dispute with the principals of PPI. Management of the
Company is exploring alternatives to terminate its relationship with PPI. (See
Note 12 for further discussion regarding the Company's acquisition of PPI and
Note 2 for discussion of the dispute with the principals of PPI.)
2. BASIS OF PRESENTATION AND RESTRUCTURING
For the year ended December 31, 1998, the Company incurred a loss from
operations of approximately $91.9 million due primarily to an impairment charge
related to its management service agreements, as more fully described below.
Additionally, as of December 31, 1998, the Company had a working capital deficit
of approximately $21.5 million and was not in compliance with certain of the
financial ratio covenants required by the Company's Credit Facility. As a result
of the non-compliance with certain financial ratio covenants, the Company is in
default under the terms of the Credit Facility. In the event of default, the
terms of the Credit Facility provide that the bank syndicate can immediately
terminate its obligation to make further advances under the respective
commitments and/or declare the Company's outstanding debt under the Credit
Facility to be immediately due and payable. Accordingly, the total amount
outstanding under the Credit Facility of approximately $52.9 million has been
included in the Company's Consolidated Balance Sheet as a current liability at
December 31, 1998. The bank
F-9
59
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. BASIS OF PRESENTATION AND RESTRUCTURING (CONTINUED)
syndicate notified the Company in December 1998 that it was suspending any
further advances under the Credit Facility. The Company is currently negotiating
with the bank syndicate to revise the financial ratio covenants to bring the
Company into compliance for the remaining term of the Credit Facility. (See Note
6 for further discussion of the Company's Credit Facility).
The issues described above raise substantial doubt about the Company's ability
to continue as a going concern. Management of the Company intends to address
these issues through a restructuring transaction involving ten of its affiliated
practices, which is intended to substantially reduce the Company's outstanding
debt and allow management to pursue the development of HRCI's health care rating
internet site and pursue the development of ambulatory surgery centers through
the Company's wholly-owned subsidiary, ASI. The proposed restructuring
transaction, which is subject to approval by the Company's stockholders as well
as the bank syndicate, is more fully described below. The accompanying
consolidated financial statements do not include any adjustments to reflect the
possible future effects on the recoverability and classification of assets or
the amounts and classification of liabilities that might result from the outcome
of these uncertainties.
RESTRUCTURING
In March 1999, the Company entered into restructuring agreements with ten of its
affiliated practices. The agreements:
o Provide for the repurchase by affiliated physicians or affiliated
practices of practice assets and for new management service
arrangements in exchange for cash and/or common stock;
o Limit management services provided to the affiliated practices by the
Company under its management services arrangements;
o Reduce the term of the Company's service agreements with the affiliated
practices; and
o Lower service fees paid to the Company by the affiliated practices.
F-10
60
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. BASIS OF PRESENTATION AND RESTRUCTURING (CONTINUED)
The purchase price paid to the Company will consist of payments for the book
value of the assets to be purchased by the practices, less the practice
liabilities as of the closing date of the transaction and payments for the
execution of a new management services agreement to replace the existing service
agreement. If the restructuring transaction is consummated, the Company expects
to reacquire 3,786,957 shares of its common stock and have the ability to reduce
its outstanding indebtedness by approximately $17.6 million including $0.6
million through cancellation of an outstanding convertible debenture. (See Note
11, Physician Practice Net Asset Acquisitions and Service Agreements, New
Management Service Agreement Discussion, for further discussion of the new
management service agreements).
Modification of Arrangements With Four Practices
Near the end of 1998, the Company entered into transactions with four of its
affiliated practices. In these transactions, the Company sold to each of the
practices accounts receivable, fixed assets and certain other assets relating to
the respective practices and replaced the original service agreements with new
agreements. Under the new agreements, which terminate at certain dates between
November 2001 and March 2003, the Company provides substantially reduced
services to the practices, and the practices pay significantly reduced service
fees. These transactions were closed effective December 31, 1998. As a result of
the completion of these four transactions, the Company reacquired 2,124,959
shares of its common stock and reduced its outstanding indebtedness at December
31, 1998 by approximately $5.5 million through the cancellation of a convertible
note with one of the affiliated practices. Additionally, in 1999, the Company
used additional proceeds from these four transactions to reduce the amount
outstanding under its Credit Facility by approximately $8.5 million.
IMPAIRMENT LOSSES, LITIGATION AND OTHER COSTS
Impairment Loss on Management Service Agreements
In light of the pending restructuring transaction, as well as numerous other
factors in the physician practice management industry in general, during the
fourth quarter of 1998, management of the Company undertook an evaluation of the
carrying amount of its management service agreements pursuant to the provisions
of Statement of Financial
F-11
61
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. BASIS OF PRESENTATION AND RESTRUCTURING (CONTINUED)
Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed of. As a result of this evaluation, the
Company recorded an impairment loss on its management service agreements of
approximately $94.6 million in December 1998. This impairment loss consisted of
approximately $12.5 million related to the management service agreements on the
four transactions which closed effective December 31, 1998, approximately $53.6
million related to the management service agreements for practices which have
entered into restructuring agreements pending stockholder and bank syndicate
approval, approximately $9.0 million related to the management service
agreements for practices which are currently involved in litigation with the
Company and approximately $19.5 million related to the management service
agreements for practices which are maintaining their long-term agreements with
the Company. (See Note 13 for further discussion of legal proceedings involving
the Company's Affiliated Practices).
Litigation And Other Costs
The Company is currently involved in disputes with TOC Specialists, P.L., The
Specialists Orthopaedic Medical Corporation and 3B Orthopaedics, P.C., which are
affiliated practices of the Company. (See Note 13 for further discussion related
to these legal proceedings). As a result of these disputes, the Company has
recorded a charge of approximately $2.7 million to reserve for service fees
recorded for these practices, which to date have not been paid. In addition, as
of December 31, 1998, the Company had incurred approximately $0.2 million in
legal fees directly related to these disputes.
In connection with the proposed restructuring transaction described above, the
Company has also incurred expenses of approximately $0.7 million for financial
advisors and legal consultation.
Impairment loss on Intangible Assets And Other Long-Lived Assets
The Company is engaged in negotiations to resolve certain issues raised by the
former stockholders of Provider Partnerships, Inc. ("PPI"), a corporation
acquired by the Company in August 1998. PPI is a company engaged in providing
consulting services to hospitals, and it also provided certain assets that were
developed by the Company into its HealthCareReportCards.com web site.
F-12
62
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. BASIS OF PRESENTATION AND RESTRUCTURING (CONTINUED)
It is currently contemplated by the Company that an arrangement will be reached
with the PPI stockholders that will involve, among other things, the following:
o The formation of a new company that will own the
HealthCareReportCards.com web site and one or more additional health
care rating web sites. The new company will be a majority owned
subsidiary of the Company, and the former PPI shareholders will have a
minority shareholder interest in the company;
o The former PPI stockholders will return the 420,000 shares of Company
common stock that they received in connection with the Company's
acquisition of PPI;
o The Company will return most of the assets of PPI to the former PPI
stockholders; and
o The PPI stockholders will become majority shareholders of the new
company if the Company does not obtain $4 million in financing for the
new company by December 31, 1999.
Because of this dispute, the Company recorded an impairment loss in December
1998 of approximately $1.2 million on the intangible asset created with the
acquisition of PPI.
Additionally, as a result of the proposed restructuring transaction, management
of the Company performed a review of the carrying amount of its other long-lived
assets, which resulted in an impairment loss of approximately $2.1 million
during the fourth quarter of 1998.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include Specialty Care Network, Inc. and
its wholly-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation. The Company uses the equity
method of accounting to account for investments in entities in which it exhibits
significant influence, but not control, and does not have an ownership interest
in excess of 50%.
F-13
63
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
PRINCIPLES OF ACQUISITION ACCOUNTING AND CHANGE IN ACCOUNTING ESTIMATE
The accompanying financial statements give effect to the acquisitions of
substantially all of the assets of five physician practices on November 12,
1996, through an asset purchases, a share exchange and mergers, at their
historical cost basis in accordance with the accounting treatment prescribed by
Securities and Exchange Commission Staff Accounting Bulletin No. 48, Transfers
of Nonmonetary Assets by Promoters or Shareholders. In connection with all
subsequent affiliations with physician practices, a substantial portion of the
consideration paid to the physician owners of the practice is restricted
securities and cash, and is allocated to the management service agreement (the
"Service Agreements"). Hereinafter, all physician practices that have affiliated
with the Company, including the initial five physician practices, are referred
to collectively as the "Affiliated Practices." The Company also recognizes the
income tax effects of temporary differences related to all identifiable
acquisition intangible assets, including the Service Agreements.
Beginning June 1, 1998, the Company reduced the amortizable lives of its
long-term management service agreements to a range of 5 to 30 years by assigning
specific lives to each management service agreement based on factors such as
practice market share, length of operating history and other factors.
Previously, the Company amortized such service agreements over the term of the
underlying agreements, which is generally forty years. This action was taken in
response to viewpoints expressed by the Securities and Exchange Commission
regarding the amortization periods used by the physician practice management
industry. The change in accounting estimate resulted in additional amortization
expense of approximately $870,000 for the period June 1, 1998 through December
31, 1998, or $0.03 per common share for the year ended December 31, 1998 after
consideration of the related income tax effect.
In addition, as a result of the Company's evaluation of the carrying amount of
its management service agreements (as more fully described in Note 2),
effective January 1, 1999, the Company reduced the estimated useful lives of
its management service agreements to lives ranging from 3 to 5 years.
F-14
64
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and footnotes. Although
these estimates are based on management's knowledge of current events and
actions they may undertake in the future, actual results could differ from those
estimates.
REVENUE RECOGNITION AND ACCOUNTS RECEIVABLE
Service fee revenue is recognized based upon the contractual arrangements of the
underlying long-term Service Agreements between the Company and the Affiliated
Practices. The five largest Affiliated Practices represent 48%, 39%, and 100%,
of total management service fee revenue for the years ended December 31, 1998,
1997 and 1996, respectively. See Note 11 for further discussion of such
contractual arrangements, including certain guaranteed minimum management fees.
Other revenue consists primarily of business evaluation fees, recoveries of bad
debts and other miscellaneous income. Accounts receivable represents amounts due
from patients and other independent third parties for medical services provided
by the Affiliated Practices and management fee revenue earned by the Company.
Under the Service Agreements, each Affiliated Practice agrees to sell and assign
to the Company, and the Company agrees to buy, all of the Affiliated Practices'
accounts receivable each month during the existence of the Service Agreement.
The purchase price for such accounts receivable generally equals the gross
amounts of the accounts receivable each month less adjustments for contractual
allowances, allowances for doubtful accounts and other potentially uncollectible
amounts based on the Affiliated Practice's historical collection rate, as
determined by the Company. However, the Company and certain of the Affiliated
Practices are currently making periodic adjustments so that amounts paid by the
Company for the accounts receivable are adjusted upwards or downwards based on
the Company's actual collection experience. The Company generally bears the
collection risk with respect to accounts receivable acquired in connection with
an affiliation transaction.
EARNINGS PER SHARE
In 1997, Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"),
Earnings Per Share, was issued. SFAS No. 128 replaced the calculation of primary
and
F-15
65
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to fully diluted earnings per share under the
previous method of reporting earnings per share. All earnings per share amounts
for all periods have been presented in conformity with SFAS No. 128
requirements.
FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments as reported in the accompanying
balance sheets approximate their fair value primarily due to the short-term
and/or variable-rate nature of such financial instruments.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, including assets acquired from the
Affiliated Practices. Equipment held under capital leases is stated at the
present value of minimum lease payments at inception of the related lease. Costs
of repairs and maintenance are expensed as incurred. Depreciation is computed
using the straight-line method over the estimated useful lives of the underlying
assets. Amortization of capital lease assets and leasehold improvements are
computed using the straight-line method over the shorter of the lease term or
the estimated useful lives of the underlying assets. The estimated useful lives
used are as follows:
Computer equipment and software 3-5 years
Furniture and fixtures 5-7 years
Leasehold improvements 5 years
INTANGIBLE ASSETS
Intangible assets, which are stated at cost, primarily consist of deferred debt
issuance costs of $1,297,709 at December 31, 1997, that were being amortized on
a straight-line basis over a three-year period. In connection with the
circumstances described in Note 6, the Company recognized an impairment loss
related to its debt issuance costs in the fourth quarter of 1998 for the
unamortized balance remaining at December 31, 1998.
Pursuant to the provisions of Statement of Financial Accounting Standards No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of, the carrying value of long-lived assets, including
management service
F-16
66
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
agreements and goodwill, is reviewed quarterly to determine if any impairment
indicators are present. If it is determined that such indicators are present and
the review indicates that the assets will not be recoverable, based on
undiscounted estimated cash flows over the remaining amortization and
depreciation period, the carrying value of such assets are reduced to estimated
fair market value. Impairment indicators include, among other conditions, cash
flow deficits; an historic or anticipated decline in revenue or operating
profit; adverse legal, regulatory or reimbursement developments; accumulation of
costs significantly in excess of amounts originally expected to acquire the
asset; or a material decrease in the fair market value of some or all of the
assets.
The Company reviews its long-lived assets separately for each physician practice
because the cash flows and operations of each individual physician practice are
largely independent of each other and of other aspects of the Company's
business. Intangible and other long-lived assets are allocated to each physician
practice based on the specific identification methodology. During the years
ended December 31, 1997 and 1996, no impairment charges were recognized by the
Company. However, during the fourth quarter of 1998, based on the circumstances
described in Note 2, the Company recorded impairment losses of approximately
$94.6 million on its service agreements, $1.2 million on the intangible asset
created with the acquisition of PPI and $2.1 million on its other long-lived
assets, including deferred debt issuance costs.
The evaluation of the recoverability of long-lived assets, including management
service agreements and goodwill, is significantly affected by estimates of
future cash flows from each of the Company's market areas and individual
physician practices. If future estimates of cash flows from operations decrease,
the Company may be required to further write down its long-lived assets. Any
such write-down could have a material adverse effect on the Company's financial
position and results of operations.
STOCK-BASED COMPENSATION
The Company accounts for its stock-based compensation arrangements under the
provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees ("APB No. 25"). In 1995, Financial Accounting Standards
Board Statement No. 123, Accounting for Stock-Based Compensation ("SFAS No.
123"), was issued, whereby companies may elect to account for stock-based
compensation using a fair value based method or continue measuring compensation
expense using the intrinsic value method prescribed in APB No. 25. SFAS No. 123
requires that companies electing to continue to use the intrinsic value method
make pro forma disclosure of net income
F-17
67
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
and net income per share as if the fair value based method of accounting had
been applied.
ESTIMATED MALPRACTICE PROFESSIONAL LIABILITY CLAIMS
The Company and its affiliated physician practices are insured with respect to
medical malpractice risks on either an occurrence-rate or a claims-made basis.
Management is not aware of any claims against it or its affiliated physician
practices which might have a material impact on the Company's financial position
or results of operations.
REPORTING COMPREHENSIVE INCOME
Statement of Financial Accounting Standards No. 130 ("SFAS No. 130"), Reporting
Comprehensive Income, was issued in June 1997. SFAS No. 130 establishes
standards for reporting and display of comprehensive income and its components
(e.g., revenue, expenses, gains, losses, etc.) in a full set of general purpose
financial statements. This new accounting pronouncement requires that all items
that are required to be recognized under accounting standards as components of
comprehensive income be reported in a financial statement that is displayed with
the same prominence as other financial statements and display the accumulated
balance of other comprehensive income separately from retained earnings and
additional paid-in capital in the equity section of the balance sheet. SFAS No.
130 was effective for the Company's year ended December 31, 1998; however, as
the Company currently has no comprehensive income items, there was no impact on
the Company's financial statement presentation. If the Company has items of
comprehensive income in future periods, these items will be reported and
displayed in accordance with SFAS No. 130.
OPERATING SEGMENTS
During 1998, the Company adopted Statement of Financial Accounting Standard No.
131, Disclosures About Segments of an Enterprise and Related Information, ("SFAS
No. 131") which requires reporting of summarized financial results for operating
segments and establishes standards for related disclosures about products and
services, geographic areas and major customers. The Company evaluates
performance based on three different operating segments: physician practice
management, internet services, and the development and management of ambulatory
service centers. For 1998, 1997 and 1996, physician practice management was the
only significant operating segment.
F-18
68
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FUTURE ACCOUNTING PRONOUNCEMENTS
Accounting For Derivative Instruments And Hedging Activities
In June 1998, Statement of Financial Accounting Standard No. 133, Accounting for
Derivative Instruments and Hedging Activities ("SFAS No. 133") was issued. SFAS
No. 133 requires the recording all derivative instruments as assets or
liabilities, measured at fair value. SFAS No. 133 is effective for fiscal years
beginning after June 15, 1999 and, therefore, the Company will adopt the new
requirement effective January 1, 2000. Management has not completed its review
of SFAS No. 133 and has not yet determined the impact on its financial position
or results of operations.
Reporting the Costs of Start-up Activities
In April 1998, the AICPA issued SOP 98-5, Reporting the Costs of Start-up
Activities. The SOP is effective beginning on January 1, 1999, and requires that
start-up costs capitalized prior to January 1, 1999 be written-off and any
future start-up costs be expensed as incurred. The Company estimates the impact
of adopting this SOP will not result in a material reduction of 1999 earnings as
there were no start-up costs capitalized as of December 31, 1998.
RECLASSIFICATIONS
Certain reclassifications have been made to the 1997 financial statements to
conform with the 1998 presentation.
F-19
69
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
4. ACCOUNTS RECEIVABLE AND MANAGEMENT FEE REVENUE
Accounts receivable consisted of the following:
DECEMBER 31
1998 1997
----------- -----------
Gross patient accounts receivable purchased
from the affiliated physician practices $41,779,935 $48,922,686
Less allowance for contractual adjustments
and doubtful accounts 22,161,082 26,225,860
----------- -----------
19,618,853 22,696,826
Management fees, including reimbursement of
clinic expenses 2,501,628 3,260,541
Other receivables 160,990 --
----------- -----------
$22,281,471 $25,957,367
=========== ===========
Management fee revenue, exclusive of reimbursed clinic expenses, was
approximately $21.5 million, $14.3 million and $1.6 million for the years ended
December 31, 1998, 1997 and 1996, respectively. One of the Affiliated Practices
exceeded 20% of the 1997 and 1996 totals.
An integral component of the computation of management fees earned by the
Company is net patient revenue of the Affiliated Practices. The Affiliated
Practices recognize net patient revenue for medical services at established
rates reduced by allowances for contractual adjustments and doubtful accounts.
Contractual adjustments arise due to the terms of certain reimbursement and
managed care contracts. Such adjustments represent the difference between
charges at established rates and estimated recoverable amounts and are
recognized by the Affiliated Practices in the period the services are rendered.
Any differences between estimated contractual adjustments and actual final
settlements under reimbursement and managed care contracts are reported as
contractual adjustments in the year the final settlements are made. Net patient
revenue is not recognized as revenue in the accompanying financial statements.
The Company's Affiliated Practices derived approximately 19.4%, 21.9% and 22.6%
of their net revenue from services provided under the Medicare program for the
years ended December 31, 1998, 1997 and 1996, respectively. Laws and regulations
governing the Medicare program are complex and subject to interpretation. The
Company believes that the Affiliated Practices are in compliance, in all
material respects,
F-20
70
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
4. ACCOUNTS RECEIVABLE AND MANAGEMENT FEE REVENUE (CONTINUED)
with all applicable laws and regulations and is not aware of any pending or
threatened investigations involving allegations of potential wrongdoing. Such
laws and regulations can be subject to future government review and
interpretation. Violation of such laws could result in significant regulatory
action including fines, penalties and exclusion from the Medicare program. Other
than the Medicare program, no single payor provided more than 10% of aggregate
net clinic revenue or 5% of accounts receivable as of and for the years ended
December 31, 1998, 1997 and 1996. Accordingly, concentration of credit risk
related to patient accounts receivable is limited by the diversity and number of
providers, patients and payors.
Receivables from Affiliated Practices in litigation represent amounts due from
three Affiliated Practices with which the Company is currently involved in
disputes. See Note 13 for further discussion of legal proceedings involving the
Company's Affiliated Practices. At December 31, 1998, gross accounts receivable
for these practices were $12,145,102, net of an allowance for contractual
adjustments and doubtful accounts of $7,397,144. Gross accounts receivable
include patient accounts receivable purchased from the related Affiliated
Practice, management fees and reimbursement of clinic expenses.
5. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
DECEMBER 31
1998 1997
----------- ----------
Furniture and fixtures $10,455,889 $5,386,107
Computer equipment and software 2,851,399 1,983,477
Leasehold improvements and other 770,717 1,227,720
Construction in progress 1,749,731 -
----------- ----------
15,827,736 8,597,304
Accumulated depreciation and amortization 4,777,371 3,321,085
=========== ==========
Net property and equipment $11,050,365 $5,276,219
=========== ==========
Construction in progress relates primarily to magnetic resource imaging ("MRI")
equipment installations at two of the Company's Affiliated Practices and
construction of an ambulatory surgery center.
F-21
71
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. PROPERTY AND EQUIPMENT (CONTINUED)
Included in the above are assets recorded under capital leases which consist of
the following:
DECEMBER 31
1998 1997
------------ ------------
Furniture and fixtures $ 1,234,383 $ 1,536,411
Computer equipment 178,693 178,693
------------ ------------
1,413,076 1,715,104
Accumulated amortization 917,336 983,603
============ ============
Net assets under capital leases $ 495,740 $ 731,501
============ ============
6. DEBT
Convertible Debentures Issued in 1996
In connection with private placements in 1996, the Company raised $2.17 million
of short-term unsecured convertible debt. The proceeds thereof were utilized to
fund the Company's start-up and its organizational phase until certain net
assets of the original five Affiliated Practices were acquired on November 12,
1996.
F-22
72
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
6. DEBT (CONTINUED)
Contemporaneous with the acquisitions of these physician practices, the holders
of the debentures converted the unpaid principal amounts plus any accrued
interest thereon (calculated at 5.0%), into the Company's common stock at the
conversion ratio of $1.00 ($1,920,332) and $3.00 ($301,707) of debenture
principal and accrued interest for one share of common stock. The following
table summarizes the conversions:
ACCRUED
PRINCIPAL INTEREST TOTAL
---------- -------- ----------
Stockholders of the Company $ 640,000 $18,153 $ 658,153
Physician practices and
related stockholders 1,530,000 33,886 1,563,886
---------- ------- ----------
$2,170,000 $52,039 $2,222,039
========== ======= ==========
Convertible Debentures Issued in 1998
In connection with an acquisition of an Affiliated Practice on March 31, 1998,
the Company issued $5,454,439 of convertible debentures; however, such
convertible debentures and the related accrued interest totaling $205,479 were
subsequently canceled contemporaneous with a restructuring of the related
Affiliated Practice's management service agreement on December 31, 1998. See
Note 11 for further details.
In connection with an affiliation on October 1, 1998 of certain assets of two
physicians who were made party to one of the Company's service agreements with
an Affiliated Practice, the Company issued $589,615 of convertible debentures.
The 2% convertible debentures are convertible into Company common stock at a
conversion price of $10 per share. No debt was converted in 1998. The debentures
are due September 30, 1999. Management expects these debentures to be canceled
in connection with the restructuring transactions described in Note 2.
Line-of-Credit
On November 1, 1996, the Company entered into a $30 million Revolving Loan and
Security Agreement (the "Credit Facility") with a bank, which provided certain
amounts necessary to effectuate acquisitions of Affiliated Practices. Through
October 31, 1997, the Credit Facility interest rates ranged from 7.2% to 7.4%,
primarily based on a LIBOR rate plus an applicable margin.
F-23
73
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
6. DEBT (CONTINUED)
In November 1997, the Credit Facility was restated to permit maximum borrowings
of $75 million, subject to certain limitations. Prior to the loan covenant
violations described below, the Credit Facility could be used (i) to fund the
cash portion of affiliation transactions, and (ii) for the development of
musculoskeletal focused surgery centers. The Company could elect to borrow on
the Credit Facility at a floating rate based on the prime rate plus an
adjustable applicable margin of 0% to 0.75% or at a rate based on LIBOR plus an
adjustable applicable margin of 1.0% to 2.25%. Currently, the Company's interest
rate is determined based on the prime rate plus 0.5%.
At December 31, 1998, the Company had approximately $52.9 million outstanding
under the Credit Facility at an effective rate of interest of approximately 8.5%
per annum. The Credit Facility is secured by substantially all of the assets of
the Company and contains several affirmative and negative covenants, including
covenants limiting the Company's ability to incur additional indebtedness,
limiting the Company's ability to and restricting the terms upon which the
Company can affiliate with physician practices in the future, prohibiting the
payment of cash dividends on, and the redemption or repurchase of, the Company's
common stock and requiring the maintenance of certain financial ratios and
stockholders' equity.
As of December 31, 1998, the Company was not in compliance with certain of the
financial ratio covenants required by the Company's Credit Facility. As a result
of the non-compliance, the Company is in default under the terms of the Credit
Facility. In the event of default, the terms of the Credit Facility provide that
the bank syndicate can immediately terminate its obligation to make further
advances under the respective commitments and/or declare the Company's
outstanding debt under the Credit Facility to be immediately due and payable.
Accordingly, the total amount outstanding under the Credit Facility of
approximately $52.9 million has been included in the Company's Consolidated
Balance Sheet as a current liability at December 31, 1998. The bank syndicate
notified the Company in December 1998 that it was suspending further advances
under the Credit Facility; however, as of March 26, 1999, the bank syndicate has
not demanded repayment of any amounts outstanding under the Credit Facility. The
Company is currently negotiating with the bank syndicate to revise the financial
ratio covenants to bring the Company into compliance for the remaining term of
the Credit Facility. However, there can be no assurances that a mutually
satisfactory arrangement can be reached and, accordingly, unsuccessful
negotiation efforts could have a materially adverse impact on the Company's
ability to continue as a going concern.
F-24
74
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
6. DEBT (CONTINUED)
Prior to the Credit Facility covenant violation, the commitment fee on the
unused portion of the Credit Facility was 0.25% per annum, subject to reduction
to a minimum of 0.20% per annum if the Company's leverage coverage (a ratio of
funded debt to consolidated cash flow) was less than 1.00.
7. COMMON STOCK
At December 31, 1996, 1,180,000 and 85,000 shares of certain outstanding
nontransferable common stock were held by current employees and former
employees, respectively. Pursuant to the common stock subscription agreements
and a related Stockholders Agreement, executed by the Company and its employees,
all unvested shares became vested as a result of the initial public offering of
the Company's common stock.
During the year ended December 31, 1996, the Company issued an additional
100,000 shares of common stock to one of its Affiliated Practices at $3.00 per
share.
On February 6, 1997, the Company's initial public offering of its common stock
became effective. In connection therewith, 3,208,338 shares of common stock were
issued at $8.00 per share, including 208,338 common shares issued upon exercise
of the underwriters' overallotment option.
In connection with the acquisition, through merger, of substantially all of the
assets and certain liabilities of Orthopaedic Surgery, Ltd. ("OSL"), on July 1,
1997, the Company granted one physician associated with OSL the option to
require the Company to purchase 74,844 shares of common stock issued to such
physician as consideration for the OSL merger at a purchase price equal to
approximately $11.21 per share. In addition, in connection with the acquisition,
by asset purchase, of substantially all of the assets and certain liabilities of
Steven P. Surgnier, M.D., P.A., the Company granted Dr. Surgnier the option to
require the Company to purchase 37,841 shares of common stock at a purchase
price equal to approximately $12.38 per share. During the year ended December
31, 1998, the above mentioned options were exercised. The Company paid $921,491
and canceled a loan to a physician stockholder in the amount of $385,983 as
consideration for the repurchase of shares and has included this amount as
treasury stock in its consolidated balance sheet at December 31, 1998.
The Company records treasury stock at cost with regard to monetary transactions
(e.g., settlement of put options). With regard to non-monetary transactions,
F-25
75
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
7. COMMON STOCK (CONTINUED)
including the Affiliated Practice restructurings effective December 31, 1998,
the common stock transferred to the Company is record at estimated fair value.
As of December 31, 1998, the Company had the following common shares reserved
for future issuance:
Awards under the 1996 Equity Compensation Plan 5,261,165
Awards under the 1996 Incentive and Non-Qualified Stock Option Plan 3,500
Warrants in connection with one of the Affiliated Practice
acquisitions (Note 11)
544,681
Convertible debentures 58,961
Shares which may be released as additional consideration for one of
the Affiliated Practice acquisitions (Note 11) 113,393
============
Total shares reserved for future issuance 5,981,700
============
8. STOCK OPTION PLANS
On March 22, 1996, the Company adopted the 1996 Incentive and Non-Qualified
Stock Option Plan (the "Plan") pursuant to which nontransferable options to
purchase up to 5,000,000 shares of common stock of the Company were available
for award to eligible directors, officers, advisors, consultants and key
employees. On January 10, 1997, the Board of Directors voted to terminate the
Plan. The exercise price for incentive stock options awarded during the year
ended December 31, 1996 was not less than the fair market value of each share at
the date of the grant and the options granted thereunder were for a period of
ten years. Options, which are generally contingent on continued employment with
the Company, may be exercised only in accordance with a vesting schedule
established by the Company's Board of Directors. Of the 553,500 shares
underlying the option grants approved during the year ended December 31, 1996 at
an exercise price of $1.00 per share, 3,500 shares underlying the options remain
outstanding and exercisable at December 31, 1998. The other 550,000 grant
options were forfeited or exercised during 1997.
On October 15, 1996, the Company's Board of Directors approved the 1996 Equity
Compensation Plan (the "Equity Plan"), which provides for the granting of
options to purchase up to 2,000,000 shares of the Company's common stock. The
total number of shares authorized by the Equity Plan increased to 6,000,000 in
1998
F-26
76
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
8. STOCK OPTION PLANS (CONTINUED)
Both incentive stock options and non-qualified stock options may be issued under
the provisions of the Equity Plan. Employees of the Company and any future
subsidiaries, members of the Board of Directors and certain advisors are
eligible to participate in this plan, which will terminate no later than October
14, 2006. The granting and vesting of options under the Equity Plan are provided
by the Company's Board of Directors or a committee of the Board of Directors.
Pro forma information regarding net income and earnings per share is required by
SFAS No. 123 and has been determined as if the Company had accounted for its
employee stock options under the fair value method of that accounting
pronouncement. The fair value for options awarded during the years ended
December 31, 1998, 1997 and 1996 were estimated at the date of grant using an
option pricing model with the following weighted-average assumptions: risk-free
interest rate over the life of the option of 6.0%; no dividend yield; and
expected two to eight year lives of the options. The estimated fair value for
these options was calculated using the minimum value method in 1996 and may not
be indicative of the future impact since this model does not take into
consideration volatility and the commencement of public trading in the Company's
common stock on February 7, 1997. The Black-Scholes model was utilized to
calculate the value of the options issued during 1998 and 1997. The volatility
factors utilized in 1998 and 1997 were 0.36 and 0.47, respectively.
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. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
For purposes of pro forma disclosure, the estimated fair value of the options is
amortized to expense over the options' vesting period. Because compensation
expense associated with an award is recognized over the vesting period, the
impact on pro forma net (loss) income as disclosed below may not be
representative of compensation expense in future years.
F-27
77
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
8. STOCK OPTION PLANS (CONTINUED)
The Company's pro forma information for the years ended December 31 is as
follows:
1998 1997 1996
-------------- -------------- --------------
Pro forma net (loss) income $ (64,073,357) $ 5,354,571 $ (1,815,272)
Pro forma net (loss) income per common
share (basic) (3.51) 0.34 (0.16)
Pro forma net (loss) income per common
share (diluted) (3.51) 0.33 (0.15)
A summary of the Company's stock option activity and related information for the
years ended December 31 is as follows:
1998 1997 1996
---------------------------- ---------------------------- ---------------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Options Price Options Price Options Price
------------ ------------ ------------ ------------ ------------ ------------
Outstanding at Beginning of Year 2,365,007 $ 9.57 1,758,748 $ 5.25 -- $ --
Granted
Exercise price equal to
fair value of common stock 3,625,572 7.89 1,073,751 12.07 603,500 1.41
Exercise price greater than
fair value of common stock -- -- 160,000 10.00 726,658 8.00
Exercise price less than
fair value of common stock -- -- -- -- 428,590 6.00
Exercised (36,100) 6.41 (227,049) 1.17 -- --
Forfeited (689,814) 9.82 (400,443) 2.26 -- --
------------ ------------ ------------ ------------ ------------ ------------
Outstanding at end of year 5,264,665 8.40 2,365,007 $ 9.57 1,758,748 $ 5.25
============ ============ ============ ============ ============
Exercisable at end of year 644,341 9.75 231,537 $ 7.38 3,500 $ 1.00
============ ============ ============ ============ ============
F-28
78
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
8. STOCK OPTION PLANS (CONTINUED)
1998 1997 1996
--------- --------- ---------
Weighted-Average Fair Value of Options:
Exercise price equal to fair value of
common stock $ 2.56 $ 4.62 $ 0.19
Exercise price greater than fair value
of common stock -- 4.35 0.99
Exercise price less than fair value of
common stock -- -- 2.75
Exercise prices for options outstanding and the weighted-average remaining
contractual lives of those options at December 31, 1998 are as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------------- ------------------------------
Weighted-
Average Weighted- Weighted-
Remaining Average Average
Range of Number Contractual Exercise Number Exercise
Exercise Prices Outstanding Life Price Exercisable Price
- ---------------------------------------------------------------------- ------------------------------
$ 1.00 3,500 7.20 $ 1.00 3,500 $ 1.00
3.00 760,000 9.59 3.00 - 3.00
6.00 - 6.99 1,462,394 9.00 6.53 55,973 6.00
8.00 584,666 8.06 8.00 282,001 8.00
9.00 - 9.99 1,001,020 9.33 9.86 25,867 9.65
10.00 - 12.99 1,086,078 9.12 11.97 149,551 11.70
13.25 - 13.25 367,007 9.11 13.25 127,449 13.25
------------ ------------
1.00 - 13.25 5,264,665 9.07 8.40 644,341 9.75
============ ============
F-29
79
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
9. LEASES
The Company is obligated under operating and capital lease agreements for
offices and certain equipment. In some circumstances, these lease arrangements
are with entities owned or controlled by physician stockholders who are also
equity holders of the Company's Affiliated Practices. Certain leases are subject
to standard escalation clauses and include renewal options. Future minimum
payments under noncancelable capital and operating leases with lease terms in
excess of one year are summarized as follows for the years ending December 31:
CAPITAL OPERATING
LEASES LEASES
----------- -----------
1999 $ 321,742 $ 4,137,748
2000 306,917 4,155,303
2001 227,464 3,969,095
2002 235,064 3,234,134
2003 -- 1,830,231
Thereafter -- 6,904,599
----------- -----------
Total minimum lease payments 1,091,187 $24,231,110
===========
Less amount representing interest (166,589)
-----------
Present value of net minimum lease payments 924,598
Less current portion 244,446
-----------
Long-term portion $ 680,152
===========
Rent expense for the years ended December 31, 1998, 1997 and 1996 under all
operating leases was approximately $7,800,000, $4,800,000 and $400,000,
respectively. Approximately $7,600,000, $4,600,000 and $355,000, respectively,
of such amounts were charged directly to the Affiliated Practices as clinic
expenses. Excluded from total minimum operating lease payments are approximately
$13.3 million in total future payments related to Affiliated Practices currently
in litigation with the Company. These Affiliated Practices are currently paying
these leases directly. Additionally, one of the Company's Affiliated Practices
which entered into restructuring agreements with the Company has assumed
responsibility for its payables effective January 1, 1999. The total future
lease payments for this Affiliated Practice of approximately $11.5 million has
been excluded from the Company's future operating lease commitments in the table
above.
F-30
80
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
10. INCOME TAXES
The Company is a corporation subject to federal and certain state and local
income taxes. The provision for income taxes is made pursuant to the liability
method as prescribed in Statement of Financial Accounting Standards No. 109,
Accounting for Income Taxes. The liability method requires recognition of
deferred income taxes based on temporary differences between the financial
reporting and income tax bases of assets and liabilities, using currently
enacted income tax rates and regulations.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities at December 31, 1998 and 1997
are as follows:
1998 1997
------------ ------------
Deferred tax assets:
Management service agreements $ 4,510,554 $ --
Deferred start-up expenditures 678,515 718,491
Property and equipment, net 421,654 209,244
Accrued liabilities 307,603 345,030
Allowance for doubtful accounts 389,062 41,000
Financing fees 293,697 --
Stock option compensation -- 85,698
------------ ------------
6,601,085 1,399,463
Valuation allowance for deferred
tax assets (5,498,609) --
------------ ------------
Net deferred tax asset 1,102,476 1,399,463
------------ ------------
Deferred tax liabilities:
Management service agreements -- 31,125,220
Net cash basis assets assumed
in physician practice affiliations 1,483,279 3,079,428
Prepaid expenses 483,399 183,146
Deferred gain on installment sale 218,976 --
------------ ------------
2,185,654 34,387,794
------------ ------------
Net deferred tax liability $ 1,083,178 $ 32,988,331
============ ============
The Company has established a $5,498,609 valuation allowance as of December 31,
1998. The valuation allowance results from uncertainty regarding the Company's
ability
F-31
81
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
10. INCOME TAXES (CONTINUED)
to produce sufficient taxable income in future periods necessary to realize the
benefits of the related deferred tax assets.
The income tax expense (benefit) for the years ended December 31, 1998, 1997 and
1996 is summarized as follows:
1998 1997 1996
------------ ------------ ------------
Current:
Federal $ (1,071,968) $ 4,074,033 $ 971,192
State 125,603 1,079,390 258,083
------------ ------------ ------------
(946,365) 5,153,423 1,229,275
------------ ------------ ------------
Deferred:
Federal (24,424,176) (991,430) (1,362,954)
State (7,095,850) (288,067) (372,392)
------------ ------------ ------------
(31,520,026) (1,279,497) (1,735,346)
------------ ------------ ------------
Total $(32,466,391) $ 3,873,926 $ (506,071)
============ ============ ============
The income tax expense (benefit) differs from amounts currently payable because
certain revenue and expenses are reported in the statement of operations in
periods that differ from those in which they are subject to taxation. The
principal differences relate to asset impairment charges that are not deductible
for income tax purposes, business acquisition and start-up expenditures that are
capitalized for income tax purposes and expensed for financial statement
purposes, and the amortization of certain cash basis net assets included in
taxable income in periods subsequent to the date of affiliation with physician
practices.
F-32
82
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
10. INCOME TAXES (CONTINUED)
A reconciliation between the statutory federal income tax rate of 34% and the
Company's (34.4%), 39.8% and (22.2%) effective tax rates for the years ended
December 31, 1998, 1997 and 1996, respectively, is as follows:
1998 1997 1996
------------ ------------ ------------
Federal statutory income tax rate (34.0%) 34.0% (34.0%)
State income taxes, net of federal benefit (5.8) 5.1 (2.8)
Nondeductible business acquisition and
other costs -- 0.7 11.5
Miscellaneous (0.4) -- 3.1
Deferred tax asset valuation allowance 5.8 -- --
------------ ------------ ------------
Effective income tax rates (34.4%) 39.8% (22.2%)
============ ============ ============
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS
1996 ACTIVITY
Effective November 12, 1996, the Company acquired substantially all of the
assets, including accounts receivable and fixed assets, and certain liabilities,
including current trade payables, accrued expenses and certain capital lease
obligations, of five physician practices. The physician owners, functioning as
promoters, effectively contributed these assets and liabilities in exchange for
an aggregate of 7,659,115 shares of common stock of the Company and $1,537,872
in cash. Upon closing, the Company, under signed agreements, assumed all risks
of ownership related to these net assets.
F-33
83
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS
The following table summarizes certain financial information related to this
transaction for the five original Affiliated Practices:
COMMON STOCK CASH
CONSIDERATION CONSIDERATION
PAID BY THE PAID BY THE
COMPANY COMPANY
-------------- --------------
(Shares)
Reconstructive Orthopaedic Associates, Inc.(1) 3,169,379 $ 1,537,872
Princeton Orthopaedic Associates, P.A 1,196,793 --
Tallahassee Orthopedic Clinic, P.A 1,072,414 --
Greater Chesapeake Orthopaedic Associates, LLC 1,568,922 --
Vero Orthopaedics, P.A 651,607(2) --
(1) Pursuant to a Separation Agreement dated June 9, 1997, between the
stockholders of Reconstructive Orthopaedic Associates, II, P.C. ("ROA")
(successor to Reconstructive Orthopaedic Associates, Inc.), and Drs. Booth,
Bartolozzi and Balderston (collectively 3B Orthopaedics), 3B Orthopaedics
formed a new Pennsylvania corporation in order to practice medicine.
Currently, the Company is involved in a dispute with 3B Orthopaedics, (See
Note 13 for further discussion).
(2) Excludes non-qualified stock options to purchase an additional 50,000 shares
of the Company's common stock at $6.00 per share, which became fully vested
November 12, 1998.
F-34
84
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS (CONTINUED)
1997 ACTIVITY
During 1997, the Company acquired substantially all of the assets and certain
liabilities of additional physician practices through a combination of asset
purchases and mergers as detailed in the table below:
-------------------- -------------------------------- -------------- ------------------------
AFFILIATION AFFILIATED ACQUISITION HEADQUARTERS
DATE PRACTICE(1) TYPE LOCATION
-------------------- -------------------------------- -------------- ------------------------
March 1997 Medical Rehabilitation Merger Tallahassee, Florida
Specialists II, P.A., Riyaz H. Baltimore, Maryland
Jinnah, M.D., II, P.A., Floyd Thomasville, Georgia
R. Jaggears, Jr., M.D., P.C.,
II
April 4, 1997 The Orthopaedic and Sports Merger Annapolis, Maryland
Medicine Center, II, P.A.
July 1, 1997 Southeastern Neurology Group Asset Portsmouth, Virginia
II, P.C. Purchase/
Merger
July 1, 1997 Orthopaedic Surgery Centers, Merger Portsmouth, Virginia
P.C. II
July 3, 1997 Associated Orthopaedics & Merger Plano, Texas
Sports Medicine, P.A.
July 3, 1997 Associated Arthroscopy Asset Plano, Texas
Institute, Inc. Purchase
July 3, 1997 Access Medical Supply, Inc. Asset Plano, Texas
d/b/a Associated Physical Purchase
Therapy
July 3, 1997 Allied Health Services, P.A. Asset Plano, Texas
d/b/a Associated Occupational Purchase
Rehabilitation
July 7, 1997 Ortho-Associates P.A. d/b/a Asset Plantation, Florida
Park Place Therapeutic Center Purchase
July 16, 1997 Mid-Atlantic Orthopaedic Asset Hagerstown, Maryland
Specialists\Drs. Cirincione, Purchase
Milford, Stowell, and
Amalfitano, P.C.
August 29, 1997 Northeast Florida Merger Orange Park, Florida
Orthopaedics, Sports Medicine
and Rehabilitation II, P.A.
F-35
85
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS (CONTINUED)
----------------------- ------------------------------- -------------- -----------------------------
AFFILIATION AFFILIATED ACQUISITION HEADQUARTERS
DATE PRACTICE(1) TYPE LOCATION
----------------------- ------------------------------- -------------- -----------------------------
August 29, 1997 Steven P. Surgnier, M.D., Asset Mariana, Florida
P.A., II Purchase
September 1, 1997 Orthopaedic Associates of Merger Clearwater, Florida
West Florida, P.A.
September 10, 1997 Orthopedic Institute of Ohio, Merger Lima, Ohio
Inc.
November 14, 1997 The Specialists Orthopaedic Merger/ Fairfield, California
Medical Corporation Asset
Purchase
November 14, 1997 The Specialists Surgery Center Asset Fairfield, California
Purchase
(1) Some of the Affiliated Practices listed are successors to entities
acquired by the Company.
Total consideration for the 1997 merger and asset acquisitions was 3,222,891
shares of the Company's common stock and $44,452,105 in cash. As part of the
consideration in three of the mergers, the Company issued an aggregate 13,322
shares of common stock and paid an aggregate $189,000 in cash to Michael E.
West, who served as a consultant to three of the predecessors to the Affiliated
Practices. Mr. West subsequently became Senior Vice President of Operations of
the Company in August 1997 and terminated his employment with the Company in
March 1999. Furthermore, the Company granted one physician associated with
Orthopaedic Surgery Centers, P.C. II the right, until June 30, 1998, to require
the Company to re-purchase 74,844 shares of common stock issued to such
physician in the merger at a purchase price equal to $11.21 per share and, in
connection therewith, such shares were put to the Company in 1998 (see Note 7).
Additionally, in connection with the asset purchase of Ortho-Associates P.A.
d/b/a Park Place Therapeutic Center, the Company issued to the physician owners
warrants to purchase, in the aggregate, 544,681 shares of common stock at an
exercise price of $14.69 per share. The Company also has an escrowed deposit of
approximately $900,000 in cash and 113,393 shares which may be released as
additional consideration for one of the Company's physician practice
acquisitions.
F-36
86
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS (CONTINUED)
Effective September 10, 1997, the Company acquired, by purchase from the
physician owners of Orthopedic Institute of Ohio, Inc., one-half of the
outstanding membership interests of West Central Ohio Group, Ltd., an Ohio
limited liability company ("WCOG"). WCOG constructed an orthopaedic institute in
Lima, Ohio (the "Institute"), which commenced operations in February 1998. In
connection with the acquisition, the Company paid $400,000 in cash for its
investment in WCOG, which consisted of a $180,000 equity investment and $220,000
of goodwill. Included in advances to affiliates and other in the accompanying
financial statements at December 31, 1997 is the $400,000 investment in WCOG and
$522,022 in advances to WCOG. Additionally, the Company agreed to pay an amount
equal to 25% of WCOG's first $6,000,000 of net income as contingent
consideration.
1998 ACTIVITY
In March 1998, the Company sold its entire interest in WCOG to the physician
owners of Orthopedic Institute of Ohio, Inc. and a company (the "Acquiring
Company") for total consideration of approximately $1,950,000. In addition, the
Company was relieved of its obligation to pay an amount equal to 25% of WCOG's
first $6,000,000 of net income as contingent consideration. The sale resulted in
a pre-tax gain of $1,240,078 which has been included in the accompanying
consolidated financial statements for the year ended December 31, 1998. At
December 31, 1998, the Company maintains non-interest bearing long-term advances
receivable from WCOG in the aggregate amount of $944,520. An officer and 50%
stockholder of the Acquiring Company is the brother of the President and Chief
Executive Officer of the Company (see also Note 12).
Effective March 31, 1998, in connection with the acquisition, by asset purchase,
of substantially all of the assets and certain liabilities of Orlin & Cohen
Associates LLP ("OCOA"), the Company issued to OCOA 459,562 shares of common
stock and a promissory note (convertible debenture) in the principal amount of
$5,454,539 and paid cash in the amount of $11,375,000. In addition, the Company
paid a finder's fee of $114,000 in connection with the acquisition. The
promissory note (convertible debenture) was canceled pursuant to one of the
transactions described in Note 2.
F-37
87
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS (CONTINUED)
MANAGEMENT SERVICE AGREEMENT DISCUSSION
Concurrent with its acquisitions, the Company simultaneously entered into
long-term service agreements with the Affiliated Practices. Pursuant to the
terms of the Service Agreements, the Company, among other things, provides
facilities and management, administrative and development services, including
assistance in the negotiations of contracts signed between the affiliate
practice and third party payors, in return for service fees. Such fees are
payable monthly and consist of the following: (i) service fees based on a
percentage ranging from 20%-50% of the adjusted pre-tax income of the Affiliated
Practices (generally defined as revenue of the Affiliated Practices related to
professional services less amounts equal to certain clinic expenses but not
including physician owner compensation or most benefits to physician owners)
plus (ii) reimbursement of certain clinic expenses.
Typically, for the first three years following affiliation, however, the portion
of the service fees described under clause (i) is specified to be the greater of
the amount payable as described under clause (i) above or a fixed dollar amount
(the "Base Service Fee"), which was generally calculated by applying the
respective service fee percentage of adjusted pre-tax income of the predecessors
to the Affiliated Practices for the twelve months prior to affiliation. In
addition, with respect to its management of certain facilities and ancillary
services associated with certain of the Affiliated Practices, the Company
receives fees ranging from 2%-8% of net revenue.
The Service Agreements have terms of forty years, with automatic extensions
(unless specified notice is given) of additional five-year terms. A Service
Agreement may be terminated by either party if the other party (i) files a
petition in bankruptcy or other similar events occur or (ii) defaults on the
performance of a material duty or obligation, which default continues for a
specified term after notice. In addition, the Company may terminate the
agreement if the Affiliated Practice's Medicare or Medicaid number is terminated
or suspended as a result of some act or omission of the Affiliated Practice or
the physicians, and the Affiliated Practice may terminate the agreement if the
Company misapplies funds or assets or violates certain laws.
F-38
88
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS (CONTINUED)
Upon termination of a Service Agreement by the Company for one of the reasons
set forth above, the Company generally has the option to require the Affiliated
Practice to purchase and assume the assets and liabilities related to the
Affiliated Practice at the fair market value thereof. In addition, upon
termination of a Service Agreement by the Company during the first five years of
the term, the physician owners of the Affiliated Practice are required to pay
the Company or return to the Company an amount of cash or stock of the Company
equal to one-third of the total consideration received by such physicians in
connection with the Company's affiliation with the practice.
Under the Service Agreements, each physician owner must give the Company twelve
months notice of an intent to retire from the Affiliated Practice. If a
physician gives such notice during the first five years of the agreement, the
physician must also locate a replacement physician or physicians acceptable to a
Joint Policy Board and pay the Company an amount based on a formula relating to
any loss of service fee for the first five years of the term. Furthermore, the
physician must pay the Company an amount of cash or stock of the Company equal
to one-third of the total consideration received by such physician in connection
with the Company's affiliation with the practice. The agreement also provides
that after the fifth year no more than 20% of the physician owners at an
Affiliated Practice may retire within a one-year period.
NEW MANAGEMENT SERVICE AGREEMENT DISCUSSION
As discussed in Note 2, the Board of Directors of the Company has approved
restructuring agreements with ten of the Company's Affiliated Practices. The
purchase price paid to the Company will consist of payment for the book value of
the assets to be purchased by the practices, less the practice liabilities as of
the closing date of the transaction and payment for the execution of a new
management services agreement to replace the existing service agreement.
F-39
89
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS (CONTINUED)
The ten Affiliated Practices and the proposed consideration are as follows:
COMMON
AFFILIATED PRACTICE CASH PAYMENT STOCK
- ------------------------------------------------------ --------------------------------------
Floyd R. Jaggears, Jr., M.D., P.C., II $ 264,000 --
Riyaz H. Jinnah, M.D., II, P.A. 170,476 73,000
The Orthopaedic and Sports Medicine
Center, II, P.A. 3,389,298 440,079
Orthopaedic Associates of West Florida,
P.A. 2,458,585 332,983
Orthopedic Institute of Ohio, Inc. 2,307,161 505,040
Orthopaedic Surgery Centers, P.C. II 1,644,899 266,615
Princeton Orthopaedic Associates, II, P.A. 2,219,000 897,595
Reconstructive Orthopaedic Associates, II,
P.C. 2,944,841 1,224,626
Southeastern Neurology Group II, P.C. 1,416,720 35,866
Steven P. Surgnier, M.D., P.A., II 227,269 11,153
----------- ---------
Totals $17,042,249 3,786,957
=========== =========
In addition to the cash and common stock consideration, convertible debentures
outstanding to one of the affiliated practices of approximately $0.6 million
will be cancelled.
Under the new management service agreements, the Company will reduce the level
of services currently provided to the practices participating in the
restructuring. The following services will be offered to each practice:
o Assessing the financial performance, organizational structure, wages and
strategic plan of the practice;
o Advising with respect to current and future marketing and contracting plans
with third party payors and managed care plans;
o Negotiating malpractice insurance coverage;
o Providing access to patient information databases;
o Analyzing annual performance on a comparative basis with other practices that
have contracted with the Company; and
o Analyzing billing practices.
F-40
90
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. PHYSICIAN PRACTICE NET ASSET ACQUISITIONS AND SERVICE AGREEMENTS (CONTINUED)
The Company will not provide any equipment, facilities, supplies or employee
staffing at practice sites under the new management service agreements. In
addition, the management services provided to the practices will be reduced. The
following management services are those that were performed under the prior
arrangement but will not be provided under the new management service
agreements:
o Personnel evaluations;
o Billing and collection services;
o Computer hardware/software support;
o Payroll services;
o Accounts payable processing/managing services;
o On-site procurement; and
o Any other type of day-to-day practice management services.
As a result of the reduced services offered, the service fees under the new
management service agreements will be substantially reduced; however, such new
service fees will generally be paid for a period ending five years from the
initial practice affiliation date. The Company has also agreed that beginning
April 1, 1999 and ending on the earlier of the date of closing of the
restructuring transaction or June 15, 1999, the service fees under the current
service agreements will be reduced from the current fees and the Company will
also provide a limited level of services during such period. Upon the closing of
the restructuring transaction, the new management service agreement will control
the relationship.
12. ACQUISITION OF PROVIDER PARTNERSHIPS, INC. ("PPI")
During the third quarter of 1998, the Company acquired PPI in exchange for
420,000 shares of its common stock. PPI is a recently formed company that
provides consulting services to hospitals to increase their operating
performance, with a specific focus on the cardiac areas.
One of the principals of PPI, who has been elected to serve as Executive Vice
President-Provider Businesses of the Company, is the brother of the President
and Chief Executive Officer of the Company.
See Note 2, Impairment of Intangible Assets and Other Long-Lived Assets, for the
status of an ongoing dispute between the Company and the former principals of
PPI.
F-41
91
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
13. LEGAL PROCEEDINGS
The Specialists Litigation
There are two actions currently pending between the Company and the Specialists
Orthopaedic Medical Corporation, one of the Company's affiliated practices, and
the Specialists Surgery Center, a partnership that operates a surgery center
(collectively the "Specialists"), one in Solano County Superior Court, which was
recently stayed by that court ("the state action"), and one in the United States
District Court for the Eastern District of California, which is currently being
litigated (the "federal action").
The state action was filed on November 13, 1998 in the Solano County Superior
Court by the Specialists and four physicians who practice at, and own an
interest in, one or both of the plaintiff entities (the "Specialists Doctors"),
against the Specialists' former administrator; legal, accounting and consulting
advisors to the plaintiffs in connection with the affiliation transactions
(collectively with the administrator, the "Advisors"); entities affiliated with
certain of the Advisors; us; an employee of the Company, and 25 unnamed
defendants.
The complaint contains numerous allegations against one or more of the Advisors,
including among others, fraud, misrepresentation, conversion, breach of
fiduciary duty, negligence, professional negligence and legal malpractice. With
respect to the Company, and its employee, the complaint alleges, among other
things, that the Company and its employee conspired with the Advisors to induce
the Specialists Doctors to enter into the transactions by which the Company
acquired the practice assets and entered into the service agreements with the
Specialists; that the Company and its employee misrepresented the terms of the
transaction to the Specialists Doctors; that, in connection with the issuance of
the Company's common stock to the Doctors, the Company and the other defendants
violated California securities law by making material misstatements or omitting
material facts; that the service agreements are void; that the required service
fees are unconscionable; and that the service agreements do not represent the
true intention of the parties with regard to the service fees to be charged.
The Specialists Doctors seek a judicial declaration that the service fees are
unenforceable, a reformation of the service agreements to reflect service fees
within the alleged intent of the parties, an accounting of the cash proceeds
from the acquisition transactions, special damages of $2.48 million (including
$300,000 paid to us), compensatory, consequential and punitive damages, damages
for emotional distress, attorney fees and costs.
In addition, co-defendant Ronald Fike, the Specialists' former administrator,
filed a cross-complaint on December 18, 1998, naming as cross-defendants all
co-defendants (including us and our employee), all plaintiffs and seven new
parties. The cross-complaint alleges causes of action for breach of contract,
slander, negligent infliction of emotional distress, deceit and conspiracy, and
indemnity. The Company and its employee are named as defendants to the last
three causes of action only.
Management believes the allegations, as they pertain to the Company and an
employee of the Company, are without merit and have vigorously contested the
action and cross-complaint. As an initial response, the Company has filed a
Motion to Stay or Dismiss both the action and the cross-complaint, based upon a
forum selection clause contained in the original acquisition agreement,
requiring the Specialists and Mr. Fike to file any and all actions in Jefferson
County, Colorado. The court granted the Company's Motion on March 12, 1999, and
stayed the action in its entirety, as to all named parties.
In the federal action, filed by the Company on January 12, 1999 in the United
States District Court for the Eastern District of California against the
Specialists and the Specialists Doctors, the Company is seeking relief for
various breaches of contract, conversion of its assets, and tortious
interference with contractual relations. Additionally, the Company's complaint
seeks to recover damages for the Specialists' wrongful possession and detention
of its personal property, and the wrongful ejectment of the Company from
leasehold interests in various real properties it has leased.
F-42
92
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
13. LEGAL PROCEEDINGS (CONTINUED)
Defendants have filed a Motion to Stay or Dismiss the action.
In addition, the Company has recently filed an Application for a Right to Attach
Order and Writ of Attachment. The Company seeks to attach any and all of the
assets of the Specialists and the Specialists Doctors, in order to secure the
claims in our federal complaint. This matter is set for hearing on April 26,
1999.
TOC Litigation
There are two actions pending between the Company and TOC Specialists, P.L.
("TOC") and its physician owners (collectively, the "TOC Doctors"), one in the
Circuit Court of the Second Judicial Circuit in and for Leon County, Florida,
which was recently stayed by that court (the "TOC state action"), and one in the
United States District Court for the Northern District of Florida, Tallahassee
Division, which is currently being litigated (the "TOC federal action").
On November 16, 1998, the Company filed a complaint in the Circuit Court of the
Second Judicial Circuit in and for Leon County, Florida against TOC, the 15 TOC
doctors, and the State of Florida, Department of Health, Board of Medicine. The
complaint alleges that, in violation of their service agreement with the
Company, TOC and the TOC Doctors diverted the Company's accounts receivable
receipts into an account controlled by TOC and the TOC Doctors, that TOC and the
TOC Doctors failed to pay the Company's service fees, and that TOC and the TOC
Doctors failed to provide the necessary records to the Company for the Company
to effectively perform its management functions. Additionally, the complaint
alleges that TOC and the TOC Doctors improperly attempted to terminate the
service agreement, attempted to interfere with the Company's contractual
relations with other affiliated practices, and violated the confidentiality,
noncompetition and restrictive covenant provisions of the service agreement.
TOC and the TOC Doctors answered that complaint on December 7, 1998, and filed a
counterclaim against us alleging breach of service agreement, fraud in the
inducement, fraud, negligent misrepresentation, conspiracy to commit fraud,
breach of fiduciary duties, and violations of Florida securities law. The
counterclaim also named Kerry Hicks, the Company's President and Chief Executive
Officer and Patrick Jaeckle, the Company's Executive Vice President -
Development, as defendants. The state court action was stayed on January 13,
1999.
On December 1, 1998, while the state court litigation was ongoing, TOC and 10 of
the TOC doctors filed a complaint against the Company in the United States
District Court for the Northern District of Florida, Tallahassee Division. That
complaint also named Kerry Hicks and Patrick Jaeckle as defendants. The
complaint alleges violations of the Securities Exchange Act, breach of contract,
fraud, negligent misrepresentation, and breach of fiduciary duty. These, absent
the federal securities claim, were essentially the same causes of action
asserted as a counterclaim against us by the defendants in the earlier state
court litigation.
On January 11, 1999, we filed the Company's answer and counterclaim to the
federal court action. The Company also named four other TOC doctors as
defendants in its counterclaim. In the Company's answer and counterclaim the
Company denied all wrongdoing, and asserted claims against TOC and the TOC
Doctors for merger agreement indemnification, breach of contract, breach of good
faith and fair dealing, tortious interference with contractual relations,
conversion, and civil theft.
The Company has, in addition to monetary damages, claimed a right to injunctive
relief to prohibit dissemination of financial information and to further limit
tortious interference with contractual relations, and sought an injunction to
enforce the TOC restrictive covenants. The federal court litigation is ongoing,
and is presently in the discovery phase.
F-43
93
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
The Company believes that it has strong legal and factual defenses to these
claims of TOC and the TOC Doctors, and intend to vigorously defend the
allegations against the Company while aggressively pursuing its counterclaims.
3B Litigation
On January 22, 1999, 3B Orthopaedics, P.C. ("3B"), one of the Company's
affiliated practices, Robert E. Booth, Jr., M.D., Arthur Bartolozzi, M.D., and
Richard A. Balderston, M.D., (collectively, the "Plaintiffs") filed a complaint
against the Company in the United States District Court for the Eastern District
of Pennsylvania.
The complaint asserts causes of action under Pennsylvania law for breach of
contract and seeks unspecified compensatory damages and a declaratory judgment
terminating any and all applicable agreements between the parties. In essence,
the Plaintiffs claim that the Company breached its obligations to them under an
unexecuted service agreement, and any other agreement, by failing to provide the
promised management services and that the Plaintiffs were damaged when they had
to provide such services themselves. The Plaintiffs seek to invalidate
restrictive covenants entered into in favor of the Company through the lawsuit.
The Company filed its answer on March 24, 1999, denying all of the material
allegations of the Plaintiffs' complaint and asserting affirmative defenses and
various counterclaims. The Company has asserted counterclaims against all
Plaintiffs for breach of contract, unjust enrichment, conversion, and breach of
the implied duty of good faith and fair dealing. The Company has also asserted a
counterclaim solely against Dr. Booth for breach of fiduciary duty based upon
his conduct as a member of the Company's board of directors from approximately
November 1996 through October 1998. The Company disputes the Plaintiffs' claim
that the Company failed to provide the promised management services. Among other
remedies, the Company seeks to enforce restrictive covenants entered into by the
physician plaintiffs and to recover, among other things, damages equal to 300%
of the physician Plaintiffs' professional services' revenue. The Company also
seeks the return of all cash and all of its common stock, or the proceeds from
the sale of the stock, given to the physician Plaintiffs pursuant to the
November 12, 1996, merger between the Plaintiffs' former practice,
Reconstructive Orthopaedic Associates, P.C. and the Company. Prior to the
formation of 3B, the defendant physicians practiced with Reconstructive
Orthopaedic Associates, P.C.
The Company believes that it has strong legal and factual defenses to
plaintiffs' claims. We intend to vigorously defend against the lawsuit and
aggressively pursue the counterclaims.
OTHER
Subsequent to December 31, 1998, the Company received notices of default under
the terms of the service agreements between the Company and two of its
affiliated practices. Additionally, the Company received notice of default with
respect to a management services agreement entered into with a medical group to
provide certain limited management services. Management of the Company is
undertaking steps to determine if any defaults have, in fact occurred, whether
they are material, and what steps, if any, are necessary in order to cure any
material defaults.
14. COMMITMENTS AND CONTINGENCIES
The Company has entered into employment agreements that provide key executives
and employees with minimum base pay, annual incentive awards and other fringe
benefits. The Company expenses all costs related to the agreements in the period
that the services are rendered by the employee. In the event of death,
disability, termination with or without cause, voluntary employee termination,
change in ownership of the Company, etc., the Company may be partially or wholly
relieved of its financial obligations to such individuals. However, under
certain circumstances, a change in control of the Company may provide
significant and immediate enhanced compensation to the employees possessing
employment contracts. At December 31, 1998, the Company was contractually
obligated for the following base pay compensation amounts (summarized by years
ending December 31):
1999 $1,053,000
2000 1,053,000
2001 477,167
-----------
$2,583,167
===========
The Company may become subject to certain pending claims as the result of
successor liability in connection with the assumption of certain liabilities of
the Affiliated Practices; nevertheless, the Company believes it is unlikely that
the ultimate resolution of such claims will have material adverse effect on the
Company.
The Company and Reconstructive Orthopaedic Associates II, P.C. (the successor to
Reconstructive Orthopaedic Associates, Inc.) have been advised that the
Department of Health and Human Services is conducting an inquiry regarding
Reconstructive Orthopaedic Associates, Inc. and physicians formerly associated
with that practice, including two of the Company's former directors. The inquiry
appears to be concerned with the submission of claims for Medicare reimbursement
by the practice. The Company has not been contacted by the Department of Health
and Human Services in connection with the inquiry.
F-44
94
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
15. RELATED PARTY TRANSACTIONS
Advances to Affiliated Practices aggregating $521,355 and $914,737 at December
31, 1998 and 1997, respectively, bear interest at various rates and are
collateralized by 16,807 shares of the Company's common stock owned by the
individual physicians. Interest income related to advances was $25,438, $102,508
and $7,231 for the years ended December 31, 1998, 1997 and 1996, respectively.
F-45
95
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
16. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per
share for the years ended December 31, 1998, 1997 and 1996.
1998 1997 1996
------------ ------------ ------------
Numerator for both basic and diluted earnings
per share:
Net (loss) income $(61,786,086) $ 5,870,398 $ (1,771,383)
============ ============ ============
Denominator:
Weighted average shares outstanding 18,237,827 15,559,368 1,450,138
Cheap stock shares:
Conversion of convertible debentures
and interest thereon -- -- 2,020,900
Dividends paid to promoters -- -- 192,234
November 12, 1996 affiliation transactions
assumed to be outstanding since
January 1, 1996 -- -- 7,659,115
Employee stock options -- 118,761 --
Shares issued to one of the Affiliated
Practices -- -- 100,000
------------ ------------ ------------
18,237,827 15,678,129 11,422,387
Denominator for basic net (loss) income per
common share--weighted average shares
Effect of dilutive securities:
Employee stock options -- 393,024 1,032,090
------------ ------------ ------------
Denominator for diluted net (loss) income per
common share--adjusted weighted average
shares and assumed conversion 18,237,827 16,071,153 12,454,477
============ ============ ============
Net (loss) income per common share (basic) $ (3.39) $ 0.38 $ (0.16)
============ ============ ============
Net (loss) income per common share (diluted) $ (3.39) $ 0.37 $ (0.14)
============ ============ ============
F-46
96
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
16. EARNINGS PER SHARE (CONTINUED)
For additional disclosures regarding employee stock options, puts and warrants,
see Notes 7, 8 and 11.
Outstanding warrants and options were not included in the computation of diluted
earnings per share for the year ended December 31, 1998 because their effect
would be antidilutive.
Options to purchase 419,887 shares of common stock at $13.25 were outstanding
during 1997 but were not included in the computation of diluted earnings per
common share for 1997 because the options' exercise price was greater than the
average market price of the common shares and, therefore, the effect would be
antidilutive. Options to purchase 44,936 shares of common stock at $11.25 were
outstanding during 1997 but were not included in the computation of diluted
earnings per share because the warrants' exercise price was greater than the
average market price of the common shares and, therefore, the effect would be
antidilutive.
Warrants to purchase 544,681 shares of common stock at $14.69 were outstanding
during 1997 but were not included in the computation of diluted earnings per
share because the warrants' exercise price was greater than the average market
price of the common shares and, therefore, the effect would be antidilutive.
See Note 11 for discussion of the contingent shares issuable as additional
consideration for one of the Company's practice acquisitions. These shares were
not included in the computation of diluted earnings per share because the
necessary conditions for issuance had not been satisfied.
Pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 83
("SAB No. 83") and staff policy, common and common share equivalents issued
prior to the Company's initial public offering for nominal consideration are
presumed to have been issued in contemplation of the public offering, even if
antidilutive, and have been included in the calculations of net income (loss)
per common share as if these common and common equivalent shares were
outstanding for the period immediately preceding the Company's initial public
offering of common stock. Pursuant to Securities and Exchange Commission Staff
Accounting Bulletin No. 98, which modifies certain of the provisions of SAB No.
83, the treasury stock method for measuring the dilutive effect related to
nominal issuances of stock options and warrants is no longer permitted.
Accordingly, the above calculations assume that common shares are outstanding
from the
F-47
97
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
16. EARNINGS PER SHARE (CONTINUED)
date of the stock option grant to the date of the Company's initial public
offering, if the corresponding option strike price is deemed to be nominal
consideration.
The Company used a portion of the proceeds from the initial public offering of
its common stock to repay borrowings under the Company's Credit Facility
Agreement. If shares issued to repay amounts outstanding under the Company's
Credit Facility Agreement were outstanding for the years ended December 31, 1997
and 1996, the net income (loss) per common share would not have changed from the
amount reported.
17. EMPLOYEE BENEFIT PLAN
Effective May 1, 1997, the Company adopted a defined contribution employee
benefit plan covering substantially all employees of the Company, most
affiliated physicians and other employees of the affiliated practices.
Participants must have attained age 21 and completed one year of service with
either the Company or one of the Affiliated Practices in order to participate in
the plan. The plan is designed to qualify under Section 401(k) of the Internal
Revenue Code of 1986, as amended. The plan includes a matching contribution
equal to up to 4% of eligible employee salaries and a discretionary defined
contribution (5.5% in 1998 and 1997). The 1998 contribution percentage remains
subject to final approval of the Company's Board of Directors. Expense under
this plan, including the discretionary defined contributions, aggregated
approximately $1,611,000 and $711,000 for 1998 and 1997, respectively, of which
approximately $1,445,000 and $654,000 was charged directly to the Affiliated
Practices as clinic expenses.
18. SUBSEQUENT EVENT
On March 26, 1999, the Company entered into an agreement with an Affiliated
Practice to sell 67% of its interest in SCN of Maryland, LLC, a limited
liability corporation established in 1998 to develop and operate an ambulatory
surgery center in Baltimore, Maryland, for consideration of $360,505.
F-48
98
Specialty Care Network, Inc. and Subsidiaries
Schedule II -- Valuation and Qualifying Accounts
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END OF
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS PERIOD
- -------------------------------------- ----------------- ---------------- ----------------- ------------------ ---------------
Year ended December 31, 1998
Reserves and allowances deducted
from asset accounts:
Allowance for contractual
adjustments and doubtful
accounts on patient
accounts receivable $26,225,860 $ 1,210,126 (8) 125,086,140(1) (12,454,506) (6) $22,161,082
(592,659)(4) 6,816,751(2) (119,406,005) (3)
Allowance for contractual (4,724,624) (7)
adjustments and doubtful
accounts on receivables
due from affiliated
physician practices
in litigation $ -- $ 2,672,520(5) $ 4,724,624(7) $ -- $ 7,397,144
Year ended December 31, 1997
Reserves and allowances deducted
from asset accounts:
Allowance for contractual
adjustments and doubtful
accounts on patient
accounts receivable $15,719,542 $ 100,380 $87,199,182(1) $(84,589,217) (3) $26,225,860
(1,542,354)(4) 9,338,327(2)
Year ended December 31, 1996
Reserves and allowances deducted
from asset accounts:
Allowance for contractual
adjustments and doubtful
accounts on patient
accounts receivable $ -- $ -- $11,264,784(1) $(11,085,869) (3) $15,719,452
15,540,627(2)
(1) Contractual adjustments recognized in the purchase of monthly net
accounts receivable balances for the periods presented.
(2) Acquired in conjunction with acquisition of affiliated practices.
(3) Represents actual amounts charged against the allowance for the periods
presented.
(4) Recoveries of amounts previously reserved, included in other revenue in
the consolidated financial statements.
(5) Charged to litigation and other costs in the consolidated statements of
operations.
(6) Sold in conjunction with disposition of restructured affiliated
practices.
(7) Transferred from allowance for contractual adjustments and doubtful
accounts for patient accounts receivable to allowance for contractual
adjustments and doubtful accounts due from affiliated practices in
litigation.
(8) Charged to impairment loss on service agreements in the consolidated
statements of operations.
S-1
99
EXHIBIT INDEX
Exhibit
Number Description
- ------ -----------
2.1 Restructure Agreement by and Among Specialty Care Network, Inc.,
Medical Rehabilitation Specialists II, P.A. and Kirk J. Mauro, M.D.
dated as of December 31, 1998.
2.11 Management Services Agreement by and Among Specialty Care Network,
Inc., Medical Rehabilitation Specialists II, P.A., and Kirk J. Mauro,
M.D. dated as of January 1, 1999.
2.2 Restructure Agreement by and Among Specialty Care Network, Inc.,
Greater Chesapeake Orthopaedic Associates, L.L.C., Paul L. Asdourian,
M.D., Frank R. Ebert, M.D., Leslie S. Matthews, M.D., Stewart D.
Miller, M.D., Mark S. Meyerson, M.D., John B. O'Donnell, M.D. and Lew
C. Schon, M.D., dated as of December 31, 1998.
2.21 Management Services Agreement by and Among Specialty Care Network,
Inc., Greater Chesapeake Orthopaedic Associates, L.L.C., Paul L.
Asdourian, M.D., Frank R. Ebert, M.D., Leslie S. Matthews, M.D.,
Stewart D. Miller, M.D., Mark S. Meyerson, M.D., John B. O'Donnell,
M.D. and Lew C. Schon, M.D., dated as of January 1, 1999.
2.3 Restructure Agreement by and Among Specialty Care Network, Inc., Vero
Orthopaedics II, P.A., James L. Cain, M.D., David W. Griffin, M.D.,
George K. Nichols, M.D. and Peter G. Wernicki, M.D. dated as of
December 31, 1998.
2.31 Management Services Agreement by and Among Specialty Care Network,
Inc., Vero Orthopaedics II, P.A., James L. Cain, M.D., David W.
Griffin, M.D., George K. Nichols, M.D. and Peter G. Wernicki, M.D.
dated as of January 1, 1999.
2.4 Restructure Agreement by and Among Specialty Care Network, Inc.,
Orlin & Cohen Orthopedic Associates, LLP, Harvey Orlin, M.D., Isaac
Cohen, M.D., John M. Feder, M.D., Gregory Lieberman, M.D., Sebastian
Lattuga, M.D., Harvey Orlin, M.D., P.C. and Rockville Centre
Arthroscopic Associates, P.C. dated as of December 31, 1998.
2.41 Management Services Agreement by and Among Specialty Care Network,
Inc., Orlin & Cohen Orthopedic Associates, LLP, Harvey Orlin, M.D.,
Isaac Cohen, M.D., John M. Feder, M.D., Gregory Lieberman, M.D.,
Sebastian Lattuga, M.D., Harvey Orlin, M.D., P.C. and Rockville
Centre Arthroscopic Associates, P.C. dated as of January 1, 1999.
3.1 Amended and Restated Certificate of Incorporation (incorporated by
reference to Exhibit 3.1 to the Company's Registration Statement on
Form S-1 (File No. 333-17627))
3.2 Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2
to the Company's Registration Statement on Form S-1 (File No.
333-17627))
10.1+ 1996 Equity Compensation Plan, as amended (incorporated by reference
to Exhibit 10 to the Company's June 30, 1998 Quarterly Report on
Form 10-Q for the quarter ended June 30, 1998.)
100
10.2 Second Amended and Restated Revolving Loan and Security Agreement
dated as of November 21, 1997 among Specialty Care Network, Inc., SCN
of Princeton, Inc., NationsBank of Tennessee N.A., AmSouth Bank,
Banque Paribas, Key Corporate Capital Inc. and NationsBank of
Tennessee, N.A., as Agent (incorporated by reference to Exhibit 10.2
to the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 1997)
10.3+ Employment Agreement dated as of April 1, 1996 by and between
Specialty Care Network, Inc. and Kerry R. Hicks (incorporated by
reference to Exhibit 10.3 to the Company's Registration Statement on
Form S-1 (File No. 333-17627))
10.4+ Employment Agreement dated as of April 1, 1996 by and between
Specialty Care Network, Inc. and Patrick M. Jaeckle (incorporated by
reference to Exhibit 10.4 to the Company's Registration Statement on
Form S-1 (File No. 333-17627))
10.6+ Employment Agreement dated as of February 22, 1996 by and between
Specialty Care Network, Inc. and Paul Davis (incorporated by
reference to Exhibit 10.6 to the Company's Registration Statement on
Form S-1 (File No. 333-17627)).
10.6.1+ Amendment to Employment Agreement between Specialty Care Network,
Inc. and D. Paul Davis dated December 5, 1997. (incorporated by
reference to Exhibit 10.6.1 to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1997)
10.7+ Employment Agreement dated as of March 1, 1996 by and between
Specialty Care Network, Inc. and David Hicks (incorporated by
reference to Exhibit 10.8 of the Company's Registration Statement on
Form S-1 (File No. 333-17627))
10.7.1+ Amendment to Employment Agreement between Specialty Care Network,
Inc. and David Hicks, dated December 2, 1997. (incorporated by
reference to Exhibit 10.8.1 to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1997)
101
21 Subsidiaries of the registrant.
23 Consent of Ernst & Young LLP.
27.1 Financial Data Schedule for the year ended December 31, 1998.
+ Constitutes management contract or compensatory plan or arrangement required
to be filed as an exhibit to this form.