Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended December 31, 2009

or

For the transition period from                to               

Commission file number: 1-32203

Prospect Medical Holdings, Inc.

(Exact name of registrant as specified in its charter)

(310) 943-4500

(Registrant’s telephone number, including area code)

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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes o  No x

The number of shares of the issuer’s Common Stock, par value $0.01 per share, outstanding as of February 12, 2010 was 20,792,520.

Table of Contents

PROSPECT MEDICAL HOLDINGS, INC.

Index

Table of Contents

PART I—FINANCIAL INFORMATION

Item 1.  Financial Statements.

PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

1

Table of Contents

PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

2

Table of Contents

PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(Unaudited)

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

3

Table of Contents

PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

4

Table of Contents

PROSPECT MEDICAL HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2009

(Unaudited)

1. Business

Prospect Medical Holdings, Inc. (“Prospect” or the “Company”) is a Delaware corporation. Prior to the August 8, 2007 acquisition of Alta Hospitals System, LLC (“Alta”), which was previously known as Alta Healthcare System, Inc., the Company was primarily engaged in providing management services to affiliated physician organizations that operate as independent physician associations (“Medical Groups”) or medical clinics. Following the Alta acquisition and acquisition of a majority stake in Brotman Medical Center, Inc., a California corporation (“Brotman”) on April 14, 2009 (see Note 7), as of December 31, 2009, the Company owns and operates five community-based hospitals in Southern California, and its operations are organized into three primary reportable segments: Hospital Services, Medical Group, and Corporate as discussed below.

Hospital Services Segment

Alta and Brotman (collectively, the “Hospital Services segment”) own and operate in the aggregate five hospitals in Los Angeles County, all accredited by the Joint Commission (formerly the Joint Commission on Accreditation of Healthcare Organizations), with a total of approximately 759 licensed beds served by 844 on-staff physicians at December 31, 2009. Alta owns (i) Alta Hollywood Hospitals, Inc., a California corporation dba Hollywood Community Hospital and Van Nuys Community Hospital; and (ii) Alta Los Angeles Hospitals, Inc., a California corporation dba Los Angeles Community Hospital and Norwalk Community Hospital. On April 14, 2009 (the “Acquisition Date”), the Company increased its existing approximately 33.1% ownership stake in Brotman, to approximately 71.9% via an investment of approximately $2.5 million in cash, thereby obtaining a controlling interest. Brotman owns and operates Brotman Medical Center, located in Culver City.

The three community hospitals in Hollywood, Los Angeles and Norwalk offer a comprehensive range of medical and surgical services, including general acute care hospital services, pediatrics, obstetrics and gynecology, pediatric sub-acute care, general surgery, medical-surgical services, orthopedic surgery, and diagnostic, outpatient, skilled nursing and urgent care services. The hospital in Van Nuys provides acute inpatient and outpatient psychiatric services on a voluntary basis. Brotman offers a comprehensive range of inpatient and outpatient services, including general surgery, orthopedic, spine and neurosurgery, cardiology, diagnostic outpatient, rehabilitation, psychiatric and detox services. In addition, Brotman has an active emergency room that plays an integral part in providing emergency services to the West Los Angeles area.

The table below gives a brief overview of the Company’s hospitals and the locations they serve:

5

Table of Contents

Admitting physicians are primarily practitioners in the local area. The hospitals have payment arrangements with Medicare, Medi-Cal (the California version of Medicaid) and other third-party payers, including some commercial insurance carriers, health maintenance organizations (“HMOs”) and preferred provider organizations (“PPOs”).

Medical Group Segment

The Medical Group segment is a health care management services organization that provides management services to affiliated physician organizations that operate as independent physician associations (“Medical Groups”). The affiliated physician organizations enter into agreements with health maintenance organizations (“HMOs”) to provide enrollees of the HMOs with a full range of medical services in exchange for fixed, prepaid monthly fees known as “capitation” payments. The Medical Group’s contract with physicians (primary care and specialist) and other health care providers to provide enrollees with all of their medical services. Prospect currently manages the provision of prepaid health care services for its affiliated physician organizations in Southern California. The network consists of the following physician organizations as of December 31, 2009 (each, an “Affiliate”):

Prospect Medical Group, Inc. (“PMG”)

Santa Ana-Tustin Physicians Group, Inc. (“SATPG”)

Prospect Health Source Medical Group, Inc. (“PHS”)

Prospect Professional Care Medical Group (“PPCM”)

Prospect NWOC Medical Group, Inc. (“PNW”)

Starcare Medical Group, Inc. (“PSC”)

APAC Medical Group, Inc. (“APA”) (Inactive)

Nuestra Famila Medical Group, Inc. (“Nuestra”)

AMVI/Prospect Health Network (“AMVI/Prospect”)

Genesis HealthCare of Southern California (“Genesis”)

Pomona Valley Medical Group (“PVMG”)*

Upland Medical Group (“UMG”)*

*              PVMG and UMG are collectively referred to as the “ProMed Entities.”

These Affiliates are managed by the following two medical management company subsidiaries that are wholly-owned by Prospect:

Prospect Medical Systems, Inc. (“PMS”)

ProMed Health Care Administrators, Inc. (“PHCA”)

All of the Affiliates are wholly-owned by PMG, with the exception of Nuestra, which is 55% owned by a nominee physician shareholder pursuant to an assignable option agreement described below, and AMVI/Prospect which is a 50/50 Joint Venture between AMVI and PMG. PMG is owned by the same nominee physician shareholder pursuant to a separate assignable option agreement. The results of all of these entities, with the exception of AMVI/Prospect, are consolidated in the accompanying unaudited condensed consolidated financial statements.

As of December 31, the Medical Group segment manages services to the following number of enrollees under contracts with various health plans (in thousands):

6

Table of Contents

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”) for interim consolidated financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. In accordance with the instructions and regulations of the Securities and Exchange Commission (“SEC”) for interim reports, certain information and footnote disclosures normally included in financial statements prepared in conformity with U.S. GAAP for annual reports have been omitted or condensed. All adjustments (consisting of normal recurring adjustments) and disclosures considered necessary for fair presentation have been included in the accompanying interim unaudited condensed consolidated financial statements.

The results of operations for the three months ended December 31, 2009 are not necessarily indicative of the results to be expected for the full year. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements for the year ended September 30, 2009 and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on December 21, 2009.

As discussed more fully in Note 11, the Company adopted authoritative guidance issued by the Financial Accounting Standards Board (“FASB”) that establishes accounting and reporting standards for a noncontrolling interest in a subsidiary, including the accounting treatment upon the deconsolidation of a subsidiary. As required by this guidance, the Company has adjusted the presentation of noncontrolling interests in the prior period condensed consolidated financial statements so that they are comparable to those of the fiscal 2010 period.

Principles of Consolidation

The unaudited interim condensed consolidated financial statements include the accounts of the Company and all majority owned subsidiaries and controlled entities in accordance with ASC 810-10 (previously Emerging Issues Task Force (“EITF”) No. 97-2, “Application of FASB Statement No. 94 and APB Opinion No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual Management Arrangements” and Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51). All adjustments considered necessary for a fair presentation of the results as of the date of, and for the interim periods presented, which consist solely of normal recurring adjustments, have been included. All significant inter-company balances and transactions have been eliminated in consolidation. The consolidated results of operations for the current interim period are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2010.

Use of Estimates

The preparation of financial statements in conformity with U.S. Generally Accepted Accounting Principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities at the dates, and for the periods, that the unaudited condensed consolidated financial statements are prepared. Actual results could materially differ from those estimates. Principal areas requiring the use of estimates include third-party cost report settlements, receivables for medical services, allowances for contractual discounts and uncollectible accounts, accruals for medical claims, impairment of goodwill, long-lived assets and intangible assets, valuation of interest rate swaps, share-based payments, professional and general liability claims, reserves for the outcome of litigation, and valuation allowances for deferred tax assets.

Subsequent Events

The Company’s condensed consolidated financial statements  are considered issued when filed with the SEC.  Accordingly, the Company has evaluated subsequent events up to the filing date of this Form 10-Q with the SEC (see Note 14).

7

Table of Contents

Restricted Cash

At December 31, 2009, restricted cash was established at Brotman pursuant to Brotman’s Amended Plan of Reorganization, consisting of contingency reserves, totaling $1,750,000 held in escrow for property taxes, maintenance and emergency room construction required under the JHA loan agreement (see Note 6). Additionally, $233,000 was held in a restricted account pursuant to workers compensation arrangements.

Restricted Investments

The Company is required to keep restricted deposits by certain HMOs for the payment of claims. Such restricted deposits are classified as a current asset in the accompanying unaudited condensed consolidated balance sheet, as they are restricted for payment of current liabilities.

Due to Governmental Payer and Third-Party Settlements

Following the acquisition of Brotman, effective April 14, 2009, the Company recorded a liability to the Centers for Medicare and Medicaid Services (“CMS”) arising out of outlier payments received for services provided by Brotman to Medicare eligible inpatients for the last four months of calendar 2005, all of calendar 2006, and approximately six weeks of calendar 2007 (ending February 15, 2007).

While Brotman reports financial statements on a fiscal year ending September 30, Medicare cost reports are filed on a calendar year basis. Acute care hospitals receive Medicare reimbursement payments pursuant to a prospective payment methodology based on the diagnosis of the patient, but are entitled to receive additional payments, referred to as “outliers” for patients whose treatment is unusually costly. When Brotman acquired the hospital in 2005, CMS provided a ratio of cost to charges (the “RCC”) based on the average prevailing market rate in Southern California. This RCC was an interim estimate provided by CMS, subject to final determination upon filing of the hospital’s cost reports. Upon filing cost reports, subsequent information called into question whether the interim RCC provided by CMS was supportable, giving rise to a potential claim for return of overpayments. Brotman filed its cost reports with CMS for 2005, 2006 and 2007, respectively, which have been tentatively reviewed by the fiscal intermediary exclusive of any outlier reconciliation to be conducted directly by CMS. CMS has not conducted any outlier reconciliations, has not notified the hospital of any pending reconciliation to be conducted and has not determined the amount of any liability at this point related to possible overpayments. As of December 31 and September 30, 2009, an estimated liability of $13,834,000, was included in the accompanying unaudited condensed consolidated balance sheet related to this matter. Brotman and Alta have accrued estimated settlement net receivables in the amount of $379,000 for filed cost reporting years and estimates for the three months ended December 31, 2009.  At September 30, 2009, estimated net receivables for cost reports were approximately $1,575,000.

Revenues

Revenues by reportable segment are comprised of the following amounts (in thousands):

(1)  Brotman revenues have been included in the accompanying unaudited condensed consolidated financial statements effective April 14, 2009, when the Company acquired a majority stake in Brotman.  Accordingly, the three months ended December 31, 2009 include the operations of Brotman.

8

Table of Contents

The Company presents segment information externally the same way management uses financial data internally to make operating decisions and assess performance.  The Company’s operations are organized into three reporting segments: (i) Hospital Services, (ii) Medical Group management, and (iii) Corporate (see Note 8).

Comprehensive Income (Loss)

Comprehensive income (loss) includes net income (loss), net of taxes, and changes in the fair value of interest rate swaps subject to hedge accounting that are recorded as other comprehensive income. As of April 1, 2008, the swaps ceased to be eligible for hedge accounting under ASC 815. As a result, all further changes in fair value of the swaps were recorded in the consolidated statements of operations and the effective portion of the swaps of approximately $5.4 million, after tax, that was recorded in other comprehensive income through March 31, 2008 continued to be amortized to interest expense, using the effective interest method, over the remaining life of the swaps. The remaining unamortized portion of the interest rate swaps was expensed in July 2009 in connection with the Company’s termination of such swaps.

The components of comprehensive income (loss) for the periods ended December 31, 2009 and 2008 are as follows (in thousands):

Reclassification

Certain prior period amounts have been reclassified to conform to the current period presentation with no impact on the unaudited condensed consolidated statement of operations.

3. Equity-Based Compensation Plans

On August 13, 2008, following stockholder approval, the Company adopted the 2008 Omnibus Equity Incentive Plan (“2008 Plan”) to provide flexibility in implementing equity awards, including incentive stock options (“ISO”), non-qualified stock options (“NQSO”), restricted stock grants, stock appreciation rights (“SAR”) and performance based awards to employees, directors and outside consultants, as determined by the Compensation Committee of the Board of Directors (the “Committee”). In conjunction with the adoption of the 2008 Plan, effective August 13, 2008, additional equity awards under the Company’s 1998 Stock Option Plan (“1998 Plan”) have been discontinued and new equity awards are now granted under the 2008 Plan. Remaining authorized shares under the 1998 Plan that were not subject to outstanding awards as of August 13, 2008, were canceled on August 13, 2008. The 1998 Plan will remain in effect as to outstanding equity awards granted under the 1998 Plan prior to August 13, 2008. At the inception of the 2008 Plan, 4,000,000 shares were reserved for issuance under the 2008 Plan. As of December 31, 2009, there were 795,250 shares available for future grants under the 2008 Plan.

Under the terms of the 2008 Plan, the exercise price of an ISO may not be less than 100% of the fair market value of the Company’s Common Stock on the date of grant and, if granted to a shareholder owning more than 10% of the Company’s Common Stock, then not less than 110%. Stock options granted under the 2008 Plan have a maximum term of 10 years from the grant date, and are exercisable at such time and upon such terms and conditions as determined by the Committee. Stock options granted to employees generally vest over four years, while options granted to certain executives typically vest over a shorter period, subject to continued service. In the case of an ISO, the amount of the aggregate fair market value of Common Stock (determined at the time of grant) with respect to which ISO are exercisable for the first time by an employee during any calendar year may not exceed $100,000.

9

Table of Contents

The base price, above which any appreciation of a SAR issued under the 2008 Plan is measured, will in no event be less than 100% of the fair market value of the Company’s stock on the date of grant of the SAR or, if the SAR is granted in tandem with a stock option, the exercise price under the associated option. The restrictions imposed on shares granted under a restricted stock award will lapse in accordance with the vesting requirements specified by the Committee in the award agreement. Such vesting requirements may be based on the continued service of the participant with the Company for a specified time, or on the attainment of specified performance goals established by the Committee in its discretion. If the vesting requirements of a restricted stock award are not satisfied prior to the termination of the participant’s service, the unvested portion of the award will be forfeited and the shares of Common Stock subject to the unvested portion of the award will be returned to the Company.

Stock Options Activity

The following table summarizes information about our stock options outstanding at December 31, 2009 and activity during the three-month period then ended:

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of our common stock for those awards that have an exercise price currently below the quoted value.

Stock-Based Compensation Expense

Under ASC 718, “Share-Based Payments,” compensation cost for all share-based payments in exchange for employee services (including stock options and restricted stock) is measured at fair value on the date of grant, estimated using an option pricing model.

Compensation costs for stock-based awards are measured and recognized in the financial statements, net of estimated forfeitures over the awards’ requisite service period. The Company uses the Black-Scholes option pricing model and a single option award approach to estimate the fair value of options granted. Estimated forfeitures will be revised in future periods if actual forfeitures differ from the estimates and will impact compensation cost in the period in which the change in estimate occurs. The determination of fair value using the Black-Scholes option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables, including expected stock price volatility, risk-free interest rate, expected dividends and projected employee stock option exercise behaviors. Equity-based compensation is classified within the same line items as cash compensation paid to employees. Cash retained as a result of excess tax benefits relating to share-based payments are presented in the statement of cash flows as a financing cash inflow.

The weighted average assumptions used in determining the value of options granted and a summary of the methodology applied to develop each assumption are as follows:

10

Table of Contents

Expected Term—The expected term of options granted represents the period of time that they are expected to be outstanding. The Company has adopted the “simplified method” of determining the expected term for “plain vanilla” options, as allowed under Staff Accounting Bulletin (SAB) No. 107. The “simplified method” states that the expected term is equal to the sum of the vesting term plus the contract term, divided by two. “Plain vanilla” options are defined as those granted at-the-money, having service time vesting as a condition to exercise, providing that non-vested options are forfeited upon termination and that there is a limited time to exercise the vested options after termination of service, usually 90 days, and providing the options are non-transferable and non-hedgeable. We will continue to gather additional information about the exercise behavior of participants and will adjust the expected term of our option awards to reflect the actual exercise experience when such historical experience becomes sufficient.

Expected Volatility—The Company estimates the volatility of the common stock at the date of grant based on the average of the historical volatilities of a group of peer companies. Since the Company’s shares did not become publicly traded until May 2005 and trading volume has been limited, management believes there is currently not enough historical volatility data available to predict the stock’s future volatility. The Company has identified a group of comparable companies to calculate historical volatility from publicly available data for sequential periods approximately equal to the expected terms of the option grants. In selecting comparable companies, management considered several factors including industry, stage of development, size and market capitalization.

Risk-Free Interest Rate—The Company bases the risk-free interest rate on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with equivalent remaining terms.

Dividends—The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future.

Forfeitures—Share-based compensation is recognized only for those awards that are ultimately expected to vest. Compensation expense is recorded net of estimated forfeitures. Those estimates are revised in subsequent periods if actual forfeitures differ from those estimates. The Company used historical data since May 2005 to estimate pre-vesting option forfeitures.

During the three months ended December 31, 2009, an aggregate of 420,000 options were issued under the 2008 Plan, of which 220,000 were granted to Samuel S. Lee in connection with his employment as the Chief Executive Officer of the Company and 200,000 were granted to Mike Heather in connection with his employment as Chief Financial Officer of the Company. As of December 31, 2009, two-thirds of the shares granted to the Chief Executive Officer had vested and one-third of shares granted to the Chief Financial Officer had vested.

Stock-based compensation expense for stock options recognized in the three months ended December 31, 2009 and 2008 was approximately $520,000 and $263,000, respectively. At December 31, 2009, there were 2,990,305 unvested options with related compensation expense of approximately $1,139,000 which will be recognized ratably over a weighted average remaining vesting period of 49 months.

Restricted Stock Award Activities

On August 15, 2008, the Company granted 200,000 shares of restricted stock to its Chief Financial Officer with a grant date fair value of $2.40 per share. As of December 31, 2009, all of such shares had fully vested. On December 18, 2009, the Company granted an aggregate of 210,000 shares of restricted stock to its Chief Executive Officer and Chief Financial Officer. As of December 31, 2009, two-thirds of the shares granted to the Chief Executive Officer had vested and one-third of the shares granted to the Chief Financial Officer had vested.  Compensation expense relating to restricted stock of approximately $509,000 was recorded during the three months ended December 31, 2009.

On November 12, 2009, the Company granted an aggregate of 36,000 shares of restricted stocks to the outside members of the Board of Directors. The expense relating to these shares, which vested immediately, totaling approximately $144,000, was included in general and administrative expenses in the accompanying unaudited condensed consolidated financial statements during the three months ended December 31, 2009.

4. Earnings per Share

The Company calculates basic net income (loss) per share by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding. Diluted earnings (loss) per share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding, after giving effect to potentially dilutive shares computed using the treasury stock method. Such shares are excluded if determined to be anti-dilutive.

11

Table of Contents

The calculations of basic and diluted net income (loss) per share for the three months ended December 31, 2009 and 2008 are as follows (in thousands, except share and per-share amounts):

The Company excludes equity instruments from the calculation of diluted earnings per share if the effect of including such instruments is antidilutive. Accordingly, a certain number of stock options and warrants have been excluded from the calculation of diluted earnings per share totaling 1,434,537 and 475,774 shares, respectively, during the three months ended December 31, 2009. During the three months ended December 31, 2008, the number of stock options and warrants excluded from the computation of diluted loss per share as antidilutive were 4,603,137 and 665,973, respectively.

5. Related Party Transactions

Prospect has a controlling financial interest in the affiliated physician organizations included in its unaudited interim condensed consolidated financial statements which are owned by a nominee physician shareholder designated by the Company. The control is effectuated through assignable option agreements and management services agreements, which provide the Company a unilateral right to establish or effect a change of the nominee shareholder for the affiliated physician organizations at will, and without the consent of the nominee, on an unlimited basis and at nominal cost through the term of the management agreement. Jacob Y. Terner, M.D. was, through August 8, 2008, the sole shareholder, sole director and Chief Executive Officer of Prospect Medical Group, Inc. (“PMG”) and was the Chief Executive Officer of most of PMG’s subsidiary physician organizations. Dr. Terner also served as the sole shareholder and a director and officer of Nuestra Familia Medical Group, Inc. (“Nuestra”), an affiliated physician organization. Dr. Terner is a shareholder of the Company, and formerly served as its Chairman and Chief Executive Officer through part of fiscal 2008.

The Company had an employment agreement with Dr. Terner that expired on August 1, 2008 and provided for base compensation (most recently $400,000 per year) and further provided that if the Company terminated Dr. Terner’s employment without cause, the Company would pay him $12,500 for each month of past service as the Chief Executive Officer, commencing as of July 31, 1996, up to a maximum of $1,237,500. Dr. Terner resigned as the Chief Executive Officer of the Company effective March 19, 2008 and resigned as the Chairman of the Board of Directors effective May 12, 2008. In consideration of Dr. Terner’s resignation and other promises in his resignation agreement, the Company agreed to pay to his family trust the sum of $19,361.10 each month during the twelve-month period ending on April 30, 2009 and the sum of $42,694.45 each month during the twenty-four month period ending on April 30, 2011, for the total sum of $1,257,000, which amount was recorded as a general and administrative expense in the third quarter of fiscal 2008. In September 2009, the Company ceased making payments to Dr. Terner following its determination that Dr. Terner was not entitled to receive the payments. Subsequently, Dr. Terner filed a complaint against the Company seeking restoration of the payments. The Company and Dr. Terner are currently litigating this dispute. Dr. Terner no longer serves as the nominee shareholder of the Company’s affiliated physician organizations.

Dr. Arthur Lipper currently serves as the nominee shareholder of PMG and Nuestra and as the sole director of PMG and its subsidiary physician organizations and the Chief Executive Officer, President and Treasurer of all subsidiary physician organizations, except the ProMed Entities. Dr. Lipper serves as one of two directors of Nuestra, as the sole director of the ProMed Entities, and as a Vice President of Nuestra and the ProMed Entities.

On August 1, 2005 and subsequently amended on October 25, 2007, Prospect Medical Management, Inc. (now known as Prospect Hospital Advisory Services, Inc. (“PHAS”)), an affiliate of the Company, entered into a consulting services agreement, to provide administrative, financial and management consulting services to Brotman for a monthly fee of $100,000 plus expenses. The agreement had an initial term of one year and automatically renewed for additional one-year terms unless terminated by either party with 90 days written notice. As discussed in Note 7, Brotman, which filed a voluntary petition for bankruptcy protection under Chapter 11 of the

12

Table of Contents

U. S. Bankruptcy Code on October 25, 2007, emerged from the Chapter 11 bankruptcy proceeding on April 14, 2009 (the “Effective Date”). On the Effective Date, the Company increased its approximately 33.1% ownership stake in Brotman, to approximately 71.9% via an incremental investment of approximately $2.5 million. For the three months ended December 31, 2008, total fees earned under the agreement were approximately $300,000, none of which was paid and none of which was compromised pursuant to Brotman’s Chapter 11 Plan of Reorganization. Beginning April 14, 2009, amounts earned under the agreement have been eliminated in consolidation.

Effective December 15, 2009, the Board of Directors of Brotman authorized certain designated officers to enter into an amendment to the consulting services agreement, which amendment became effective on February 1, 2010 (“Amended and Restated Consulting Services Agreement”). Pursuant to the Amended and Restated Consulting Services Agreement, the consulting fees payable by the Company to PHAS were increased to 4.5% of Brotman’s net operating revenue, retroactive to April 14, 2009.  The retroactive effectiveness of this agreement resulted in $1.2 million in additional consulting fees.  All amounts under this agreement are eliminated upon consolidation.

Effective December 15, 2009, Brotman initiated a Rights Offering (“Rights Offering”), whereby existing shareholders of Brotman could subscribe to purchase up to $5,500,000 of Brotman convertible subordinated promissory notes (the Notes).  The Notes will be due three years from the date of issuance, will bear interest at 15% per annum and will be convertible at the option of the holder into shares of Brotman, at $3.34 per share.  Prospect exercised its right to purchase its pro rata share of the Notes and, effective January 7, 2010, purchased $3,500,000 of such Notes (see Note 7).

PMG, a controlled affiliate of the Company, entered into a risk pool sharing agreement, dated May 1, 2005, with Brotman. Under the agreement, PMG and Brotman agreed to establish a Hospital Control Program (as defined) to serve HMO enrollees and would earn incentive revenue or incur penalties by sharing in the risk for hospitalization based on inpatient services utilized. Risk pools are generally settled in the following year. For the three months ended December 31, 2008, all incentive revenue earned under the agreement was compromised pursuant to Brotman’s Chapter 11 Plan of Reorganization. Beginning April 14, 2009, all amounts earned under the agreement are eliminated in consolidation.

In connection with the above-described risk-sharing agreement, Prospect Medical Systems, Inc. (“PMS”) and Brotman entered into an Administrative Services Agreement, dated October 1, 2005, as amended on October 1, 2009, that provides for the administration by PMS of the payment of claims under such risk-sharing arrangement, which are eliminated in consolidation.

On August 31, 2005, PMG, entered into a joint marketing agreement with Brotman. The agreement is for an initial term of 20 years, renewable for successive five-year terms unless terminated by either party with 180 days written notice. During the term, Brotman will contract exclusively with PMG with regard to full risk contracting with HMOs for all lines of business, including Medicare, Medicaid and commercial enrollees. Brotman will not merge into, consolidate with, or sell substantially all of its assets (unless the purchaser or surviving entity expressly assumes these managed care exclusivity arrangements), alter such agreements without the consent of PMG, and agrees to be bound by the exclusivity provision.

6. Long-Term Debt

Long-term debt consists of the following at December 31, and September 30, 2009, respectively (in thousands):

13

Table of Contents

Prospect’s Debt

Senior Secured Notes

On July 29, 2009, the Company closed the offering of $160 million in 12.75% senior secured notes due 2014 (the “Notes”) at an issue price of 92.335%. The sale was executed in accordance with Rule 144A under the Securities Act of 1933 and Regulation S under the Securities Act of 1933. Concurrent with the issuance of the Notes, the Company entered into a three-year $15 million revolving credit facility which was undrawn at the closing and is still undrawn, with any future borrowings bearing interest at London Interbank Offered Rate (“LIBOR”) plus 7.00%, with a LIBOR floor of 2.00%.

The Company used the net proceeds from the sale of the Notes to repay all remaining amounts outstanding under its former $155 million senior secured credit facility, plus a prepayment premium of approximately $2.6 million. The Company reflected the prepayment premium, together with the write-off of approximately $560,000 of deferred financing related to its former credit facilities, as interest expense in the fourth quarter of fiscal 2009. Capitalized deferred financing costs and original issue discount related to the Notes is being amortized over the term of the related debt using the effective interest method.

The terms of the Notes are governed by an indenture among the Company, certain of its subsidiaries and affiliates (as guarantors), and U.S. Bank National Association (as trustee) (the “Indenture”). Interest is payable semi-annually in arrears on January 15 and July 15, the first payment of which was made on January 15, 2010. The terms of the revolving senior secured credit facility are governed by the Credit Agreement, dated as of July 29, 2009, among the Company, Royal Bank of Canada (as administrative agent), Jefferies Finance LLC (as syndication agent) and the lenders party thereto (the “Credit Agreement”).

The Notes and the revolving senior secured credit facility are jointly and severally guaranteed on a senior secured basis by all of the Company’s restricted subsidiaries (as such term is defined in the Indenture) other than Brotman, Nuestra and certain immaterial subsidiaries. The Notes are secured pari passu with the new revolving credit facility on a first priority basis by liens on substantially all of the Company’s assets and the assets of the subsidiary guarantors (other than accounts receivable and proceeds therefrom) including all the mortgages on the Company and its subsidiary guarantors’ hospital properties (but excluding a pledge of, or mortgage on, the stock, properties or other assets of Brotman, AMVI/Prospect Health Network and certain immaterial subsidiaries). The lenders under the revolving credit facility have a first priority lien on certain of the accounts receivable of the Company and the subsidiary guarantors and proceeds therefrom while the holders of the Notes have a second priority lien on such collateral.

The Indenture requires the Company to make an offer to repurchase the Notes at 101% of their principal amount in the event of a change of control of the Company and at 100% of the principal amount thereof with certain proceeds of sales of assets. The Indenture also contains certain covenants that, among other things, limit the Company’s ability, and the ability of its restricted subsidiaries to: pay dividends or distributions on capital stock or equity interests, prepay subordinated indebtedness or make other restricted payments; incur additional debt; make investments; create liens on assets; enter into transactions with affiliates; engage in other businesses; sell or issue capital stock of restricted subsidiaries; merge or consolidate with another company; transfer and sell assets; create dividend and other payment restrictions affecting subsidiaries; and designate restricted and unrestricted subsidiaries. The Credit Agreement contains a number of customary covenants as well as covenants requiring the Company to maintain a maximum consolidated leverage ratio, minimum fixed charge coverage ratio and a maximum consolidated total leverage ratio. As of December 31, 2009, the Company was in compliance with the financial covenants.

Pursuant to its definitive Prospectus filed with the SEC on September 26, 2009, the Company commenced an offer to exchange (the “Exchange Offer”) up to $160 million of its newly registered 123/4% Senior Secured Notes, Series B, due 2014 (the “Exchange Notes” and together with the Original Notes, the “Notes”) for an equal amount of the Notes issued on July 29, 2009 (the “Original Notes”). The Exchange Notes are substantially identical to the Original Notes, except that the offer and sale of the Exchange Notes have been registered under the Securities Act of 1933, as amended, and the Exchange Notes do not bear any legend restricting their transfer. The Exchange Offer was extended on November 25, 2009 until December 3, 2009, at which time $159 million of the $160 million aggregate principal amount of private notes had been tendered and accepted for exchange. The Company filed the required Form S-4 under the Registration Rights Agreement, on September 30, 2009 and went effective on October 23, 2009.

The Notes will mature on July 15, 2014. Prior to July 15, 2012, the Company may redeem up to 35% of the original principal amount of the Notes at a redemption price equal to 112.75% of the principal amount of the Notes redeemed, plus any accrued and unpaid interest, with the proceeds of certain equity offerings. From July 15, 2012 until July 15, 2013, the Company may redeem all, or any portion, of the Notes at a redemption price equal to 106.375% of the principal amount of the Notes redeemed, plus any accrued and unpaid interest. After July 15, 2013, but before the maturity date of July 15, 2014, the Company may redeem all, or any portion, of the Notes at a redemption price equal to 100% of the principal amount of the Notes redeemed, plus any accrued and unpaid interest.

14

Table of Contents

Effective July 23, 2009, the Company terminated the former master swap agreement and the swap arrangements thereunder by payment, on July 29, 2009, of $11.7 million to the swap counterparty in final settlement of all amounts owed under the swap arrangements. All related amounts included in accumulated other comprehensive loss, including related deferred income taxes (of approximately $4.2 million) was recorded as interest expense and to the tax provision, respectively, as of the effective date of the swap terminations.

Brotman’s Debt

The Brotman entity has debt under a Senior Secured Revolving Credit Facility, Secured Term Loans and Unsecured Promissory Note entered into in conjunction with effecting the Plan of Reorganization described in Note 7. The Company has not guaranteed any portion of Brotman’s debt or other obligations. Given the Company’s majority ownership in Brotman, effective April 14, 2009, all Brotman debt is included in the Company’s consolidated financial statements. The Company has no obligation and has limited ability to fund Brotman’s operations post acquisition. Under the senior secured notes credit agreement, the Company is permitted to make additional investments in Brotman in an aggregate amount not to exceed $10,000,000, provided that such investments can exceed $10,000,000 if the amounts are funded solely with the proceeds of Equity Interests of the Company (as defined).

Senior Secured Revolving Credit Facility

On April 14, 2009, the Effective Date of the Plan of Reorganization, Brotman obtained a commitment from Gemino Healthcare Finance, LLC (“Gemino”) for a three-year, $6.0 million, senior credit facility secured by Brotman’s accounts receivable. The facility expires on the earlier of April 14, 2012 and the Los Angeles Jewish Home for Aging (“JHA”) loan (see below) maturity date and bears interest at LIBOR plus 7% per annum (11.0% at December 31, 2009), given a LIBOR floor of 4%. Interest is incurred based on the greater of $2 million or the actual outstanding principal balance. The agreement also includes an unused line fee of 0.5% per annum and a collateral line fee, based on the average outstanding principal balance, of 0.5% per annum. Loan fees associated with the Gemino loan totaling approximately $120,000, were capitalized and have been included as deferred financing costs in the accompanying unaudited condensed consolidated balance sheet as of December 31, 2009, with the amount being amortized over the term of the related debt using the effective interest method. The senior credit facility agreement contains customary covenants for facilities of this type, including restrictions on the payment of dividends, change in ownership and management, asset sales, incurrence of additional indebtedness, sale-leaseback transactions, and related party transactions. Brotman must also comply with certain financial covenants. Prior to a recent amendment discussed below, Brotman was required to comply with a fixed charge coverage ratio of not less than (i) 1.10:1.00 for the fiscal quarter ended June 30, 2009, (ii) 1.15:1.00 originally for the fiscal quarter ended September 30, 2009; and (iii) 1.20:1.00 for each fiscal quarter ending thereafter. As of September 30, 2009, Brotman was not in compliance with the required financial covenants under the Gemino credit agreement. Pursuant to an amendment entered into effective December 11, 2009, the Gemino credit agreement was amended to provide, among other things, a waiver of the specified events of default and the amendment to the definition of fixed charge coverage ratio. Under the amended credit agreement, the fixed charge coverage ratio was amended to require not less than (i) 1.00:1.00 for the fiscal quarters ending December 31, 2009 and March 31, 2010; (ii) 1.05:1.00 for the fiscal quarters ending June 30, 2010 and September 30, 2010, (iii) 1.10:1.00 for the fiscal quarters ending December 31, 2010 and March 31, 2011, and (iv) 1.20:1.00 for the fiscal quarter ending June 30, 2011 and each fiscal quarter ending thereafter. As of December 31, 2009, Brotman was in compliance with the required financial covenants under the amended credit agreement.

Secured Credit Facilities Term Loan: A and B

On April 14, 2009, the effective date of the Plan of Reorganization, Brotman consummated the transactions contemplated in the JHA financing and the JHA loan documents. Under the terms of the JHA loan agreements, JHA agreed to provide Brotman with up to $22.25 million in financing, consisting of two term loans: (i) a Term A loan of $16 million (the “Term A Loan”) with a 24-month term and (ii) a Term B loan of up to $6.25 million, with a term of 36 months (the “Term B Loan”). Subject to the notification requirements set forth in the loan agreements, the term of the Term A Loan can be extended up to 36 months. Interest on the Term A Loan is payable at 10% per annum for the first year of the loan, and 7.5% thereafter. Interest on the Term B Loan is payable at 10% per annum for the term of the loan. The Term A Loan and Term B Loan are secured by certain of Brotman’s personal property, and a mortgage on certain of Brotman’s real property. The proceeds of the JHA loans were used to repay all existing senior secured loans at Brotman as of April 14, 2009. Loan fees associated with the JHA loans totaling approximately $1,549,000, were capitalized and have been included as deferred financing costs in the accompanying unaudited condensed consolidated balance sheet as of December 31, 2009, with that amount being amortized over the term of the related debt using the effective interest method.

15

Table of Contents

With respect to the Term A Loan, JHA was granted the right (“Put Right”) to declare the unpaid loan amount, including remaining interest and any other amounts due and payable under the loan agreements, immediately due and payable at any time after April 14, 2010 and prior to the date which is twenty-four months after the Closing Date, subject to JHA providing written notification to Brotman of its exercise of the Put Right at least 180 days in advance.  Effective February 10, 2010, JHA and Brotman entered into an amendment to the Term A Loan, whereby the earliest date on which JHA could provide notice of its exercise of the Put Right was extended from April 14, 2010 to October 14, 2010.  Based on such amendment, as of December 31, 2009, the loan has been reflected as noncurrent in the accompanying unaudited condensed consolidated balance sheet.

As part of the JHA financing, Brotman has granted JHA an option to purchase certain Brotman-owned land adjacent to the hospital, where JHA plans to construct a senior living facility, for a purchase price equal to the outstanding principal balance of the Term A Loan plus any prepaid amounts. In connection with JHA’s option right, Brotman is required to deposit $130,000 monthly into a reserve account (up to a maximum of $3,120,000), with such funds specifically earmarked for the construction of a new emergency room. Additionally, Brotman is required to deposit $10,000 monthly into a reserve account for capital improvements and a Tax and Insurance Deposit Account to be funded monthly, for purposes of Brotman’s annual real estate tax assessments.

In accordance with relevant accounting pronouncements, the Term A Loan, which contains a real estate purchase option, is recorded at its present value, with any excess of the proceeds over that amount recorded as an option deposit liability account. The present value of the loan is estimated using discounted cash flow analyses based on market rates obtained from independent third parties for similar type debt. Based on an estimated market interest rate of 10.0%, the present value of the loan was estimated to be approximately $15,667,000 at inception. The difference of $345,000 between the recorded present value and the carrying value of the loan has been recorded as a discount against the loan and is being amortized to interest expense, using the effective interest rate method, over the term of the loan.

Subordinated Promissory Note

On April 14, 2009, the Effective Date of the Plan of Reorganization, Brotman executed a $4,000,000 unsecured Class 4 Note, to be held by the Creditor Trust (as defined in the Plan of Reorganization) for the benefit of holders of allowed Class 4 claims (as defined in the Plan of Reorganization) and paid pro rata to holders of allowed Class 4 claims. The Note bears interest at 7.50% per annum and is payable in sixteen equal quarterly installments of principal and accrued interest through February 15, 2013. The Note contains a covenant which, so long as amounts remain outstanding under the Note, restricts Brotman from paying Prospect Medical Holdings, Inc. in cash a consulting fee of more than $100,000 per month, as specified in the Amended and Restated Consulting Services Agreement (see Note 5).  As such, although the amount of the consulting fee was increased to 4.5% of Brotman’s net operating revenue effective April 14, 2009, the amount of such consulting fee actually paid in cash will remain at $100,000 per month until such time as permitted by applicable agreement or the Creditor Trust Note has been amended or repaid.

7. Acquisitions

Brotman Medical Center, Inc.

On August 31, 2005, the Company invested $1 million for an approximately 33.1% stake in Brotman, a 420-bed licensed and accredited acute care hospital, located in Culver City, California, with the intention of offering joint contracting to HMOs operating in Brotman’s service area. Brotman incurred significant losses before and after the Company’s initial investment and, on October 25, 2007 (the “Petition Date”), Brotman filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. Effective April 22, 2008, Samuel S. Lee (Prospect’s CEO and Chairman of the Board) was appointed as the Chairman of the Board of Directors of Brotman. On April 14, 2009 (The “Effective Date”), the U.S. Bankruptcy Court confirmed and declared effective the final Chapter 11 Plan of Reorganization (the “Plan of Reorganization”) of Brotman whereby, among other things, all of Brotman’s outstanding securities were canceled and, in exchange for their pro rata share of the New Value Contribution (as defined in the Plan of Reorganization) totaling $3,500,000, holders of Brotman’s existing securities would receive New Common Stock in Brotman in the same percentage as their pro rata share of the New Value Contribution. Pursuant to the terms of the Plan, the Company made additional cash investments in Brotman, totaling $2,519,000, thereby acquiring an additional 38.86% ownership interest, which brought its total ownership interest to 71.96%.

For financial accounting purposes, the additional investment in Brotman was referred to as the “Brotman Acquisition” and in accordance with SFAS No. 141, “Business Combinations”, the business combination, which was achieved in stages, provides for recognition of assets at current fair value with respect to the proportion of the Company’s incremental ownership interest in Brotman. Under SFAS No. 141, the aggregate cost of the acquired assets, which includes cash paid of $2.5 million and expenses incurred in connection with the acquisition totaling $37,000, were preliminarily allocated to the assets acquired and liabilities assumed. SFAS No. 141 is pre-Codification literature, the provisions of ASC 805 is not effective for the Company until October 1, 2009. The excess of the consideration over the estimated fair value of the assets and liabilities assumed has been allocated to goodwill and identifiable

16

Table of Contents

intangible asset. Due to negative net book value of assets acquired, goodwill attributable to the noncontrolling (formerly minority) interest was not recognized. As the non-controlling interest in Brotman exceeds 20%, the accounting basis in the acquired ownership in Brotman have not been pushed-down to the financial statements of Brotman and have been reflected in the Parent Company financial statements. The results of operations of Brotman have been included in consolidated financial statements since the April 14, 2009 acquisition date. Brotman’s operations for the three months ended December 31, 2009 reflected a net loss. The Company does not have the intent or ability, including under the terms of its debt agreement, to provide significant financial support to Brotman. Prior to October 1, 2009, a pro rata share of net income attributable to minority interest was not included under minority interest in the Company’s consolidated statement of operations, as the cumulative minority share of such income did not exceed their cumulative share of prior losses absorbed by the Company. Effective October 1, 2009, with the adoption date of new accounting literature (see Note 11), a pro rata share of net loss attributable to noncontrolling interest was reported as a component of equity separate from the Company’s equity in the unaudited condensed consolidated balance sheet and as net loss attributable to noncontrolling interest in the unaudited condensed consolidated statement of operations.

Effective December 15, 2009, Brotman initiated a Rights Offering (“Rights Offering”), whereby existing shareholders of Brotman could subscribe to purchase up to $5,500,000 of Brotman convertible subordinated promissory notes (the “Brotman Notes”). The Rights Offering deadline was originally December 30, 2009, but extended to January 7, 2010. The Brotman Notes will be due three years from the date of issuance, will bear interest at 15% per annum and will be convertible at the option of the holder into shares of Brotman, at $3.34 per share. PHAS planned on exercising its right to purchase its pro rata (approximately 72%) share of the Brotman Notes, as well as any Brotman Notes offered that were not purchased by other Brotman shareholders. Brotman intends to use the proceeds from the Brotman Notes to repay approximately $2 million currently due to Prospect, with the balance of the proceeds being used to retire certain other obligations of Brotman. A dispute exists between Culver Hospital Holdings, L.P. (“Culver”), Brotman’s second largest shareholder, and Prospect, PHAS, and Brotman’s directors regarding obligations allegedly owed to Culver as a minority shareholder.  In connection with this dispute, PHAS and Prospect entered into an agreement with Culver under which the parties agreed that the Rights Offering will be temporarily suspended in certain respects as it relates to Culver and PHAS and that PHAS could purchase, but not convert, $3,500,000 of the Brotman Notes.  PHAS made such purchase on January 7, 2010.

The following is an analysis of the preliminary allocation of assets acquired and liabilities assumed and the preliminary goodwill and identifiable intangible asset amount recognized in connection with the Brotman Acquisition, as of April 14, 2009 (in thousands):

The assets acquired include the relative percentage (38.83%) of the step up in basis of the assets acquired to estimated fair value amounting to $10,547,000.

Goodwill from the Brotman Acquisition is primarily related to new capacity for future growth, new geographic coverage, additional types of hospital services and in-place workforce. Through the Brotman Acquisition, the Company expanded into a new service market in the West Los Angeles, California area. As a stock purchase, the goodwill acquired in the Brotman Acquisition is not deductible for income tax purposes. Brotman recorded income related to discharge of debt upon emergence from the Chapter 11 Bankruptcy reorganization.

17

Table of Contents

The following unaudited pro forma financial information for the three month period ended December 31, 2008 gives effect to the acquisition of Brotman as if it had occurred on October 1, 2008. Such unaudited pro forma information is based on historical financial information with respect to the acquisition and does not include synergies or operational or other changes that might have been effected by the Company. Significant proforma adjustments include increased depreciation related to fixed assets acquired (in thousands).

Since emergence from bankruptcy, Brotman has continued to incur losses and experience liquidity issues. Management is currently implementing operational improvements aimed at returning Brotman to profitability and is evaluating the refinancing of this debt. Prospect has limited ability to fund Brotman’s post acquisition operations (Note 6).

Management is currently assessing the Company’s ability to utilize the state deferred tax assets, mainly comprised of California net operating loss carryforwards, acquired through the Brotman acquisition. This assessment has not yet been finalized.

8. Segment Information

ASC 815 provides disclosure guidelines for segments of a company based on a management approach to defining reporting segments.

The Company’s operations are organized into three reporting segments: (i) Hospital Services—which is comprised of Alta and Brotman reporting units, owns and operates five community-based hospitals—Los Angeles Community Hospital, Hollywood Community Hospital, Norwalk Community Hospital, Van Nuys Community Hospital and Brotman Medical Center; (ii) Medical Group—which is comprised of Prospect and ProMed reporting units, provides management services to affiliated physician organizations that operate as independent physician associations; and (iii) Corporate. Corporate represents expenses incurred in Prospect Medical Holdings, Inc. (the “Parent Entity”), which were not allocated to the other reporting segments.

The accounting policies of the reporting segments are the same as those described in the summary of significant accounting policies (see Note 2). The Company evaluates financial performance and allocates resources primarily based on earnings from continuing operations before interest expense, interest income, income taxes, depreciation and amortization, as well as income or loss from operations before income taxes, excluding infrequent or unusual items.

The reporting segments are strategic business units that offer different services within the healthcare industry. Business in each reporting segment is conducted by one or more direct or indirect wholly-owned subsidiaries of the Company and certain affiliated physician organizations controlled through assignable option agreements and management services agreements.

18

Table of Contents

The following table summarizes certain information for each of the reporting segments regularly provided to and reviewed by the chief operating decision maker (in thousands):

(1)           Prospect Medical Holdings, Inc. files consolidated tax returns and allocates costs for shared services and corporate overhead to each of the reporting segments. With the exception of Brotman Acquisition, all acquisition-related debt, including those related to the Medical Group and Hospital Services segment, is recorded at the Parent entity level. As such, the Company does not allocate interest expense, and gain or loss on interest rate swaps to each of the reporting segments.

(2)           Prospect Medical Group (which serves as a holding company for the other affiliated physician organizations) files consolidated tax returns.

(3)           Certain prior year amounts have been reclassified to conform to fiscal 2010 presentation.

(4)           Brotman amounts have been included after April 14, 2009; as such are not included for the quarter ended December 31, 2008.

9. Income Taxes

The Company recorded a tax provision (benefit) of approximately $2.5 million and $(2.4) million for the three months ended December 31, 2009 and 2008, respectively, with effective tax rates of 50.4% and 41.0%, respectively. The higher effective tax rate in the fiscal 2010 period was primarily due to not recognizing the tax benefit from Brotman’s loss for federal tax purposes.

19

Table of Contents

As part of the Brotman acquisition, management of the Company adopted ASC 740-10, accounting for uncertain tax positions, for Brotman and determined that no material unrecognized tax benefits exist as of December 31, 2009.  Since its inception in 2005, Brotman has generated, and still maintains substantial net operating loss carryfowards which are open for examination by taxing authorities.

10. Fair Value of Financial Investments

Effective April 1, 2009, the Company adopted ASC 825-10 (previously issued as FASB Staff Position FAS 107-1 and APB 28-1, “Disclosures About Fair Value of Financial Instruments”). This Statement requires that the fair value of financial instruments be disclosed in the body or notes of an entity’s financial statements in both interim and annual periods. It also requires the disclosure of methods and assumptions used to estimate fair values. It does not require comparative disclosures for periods preceding adoption. The fair values of the Company’s current assets and current liabilities approximate their reported carrying amounts. The carrying values and the fair values of non-current financial assets and liabilities, that qualify as financial instruments under ASC 825-10-50 (previously issued as FAS No. 107, “Disclosures about Fair Value of Financial Instruments,”) were as follows (in thousands).

The fair value of the notes receivable, which was received as part of the consideration for the sale of three medical clinics in April 2004, was estimated based on expected future payments discounted at risk-adjusted rates. The fair value of the Company’s long-term debt was determined based on quoted market prices with respect to Prospect’s Notes and based on expected future payments discounted at risk-adjusted rates of 10.0% with respect to Brotman’s debt.

The Company adopted ASC 820-10, (previously issued as SFAS No. 157 “Fair Value Measurements”) for financial assets and liabilities on October 1, 2008 and adopted the provisions for non-financial assets and liabilities on October 1, 2009. ASC 820-10 defines fair value, establishes guidelines for measuring fair value and expands disclosure about fair value measurements.  It does not create or modify any current GAAP requirements to apply fair value accounting.  However, it provides a single definition for fair value that is to be applied consistently for all prior accounting pronouncements.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operations.  ASC 820-10 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The three levels of the fair value hierarchy under ASC 820-10 are described below:

·      Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

·      Level 2—Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; and

·      Level 3—Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (supported by little or no market activity).

Financial Items measured at Fair Value on a Recurring Basis

The following table sets forth the Company’s financial assets and liabilities measured at fair value on a recurring basis and where they are classified within the hierarchy as of December 31, 2009 (in thousands):

The Company’s investments are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices. The investment instruments that are valued based on quoted market prices in active markets are primarily restricted certificates of deposit.

20

Table of Contents

Nonfinancial Items Measured at Fair Value on a Nonrecurring Basis

Nonfinancial assets such as goodwill and identifiable intangible assets are measured at fair value when there is an indicator of impairment and recorded at fair value only when impairment is recognized. No impairment charges of goodwill and intangible assets were recorded for the three months ended December 31, 2009. See Note 7 for additional information about goodwill and intangible assets.

11. Recent Accounting Pronouncements

In December 2007, the FASB issued guidance on ASC 810, “Noncontrolling Interests in Consolidated Financial Statements—an Amendment of ARB No. 51”, previously known as SFAS No. 160. ASC 810 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Minority interests will be re characterized as non controlling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the non controlling interest will be included in consolidated net income on the face of the income statement and upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in earnings. This standard is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. It requires retroactive adoption of the presentation and expanded disclosure requirements for existing noncontrolling interests. All other requirements of the standard shall be applied prospectively. The Company adopted this standard effective October 1, 2009. The adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In December 2007, the FASB updated guidance on ASC 805, “Business Combinations”, previously known as SFAS No. 141(R). ASC 805 retains the fundamental requirements of guidance surrounding business combinations stating that the acquisition method of accounting be used for all business combinations and for an acquirer to be identified for each business combination. ASC 805 defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as the date that the acquirer achieves control. ASC 805 requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions specified in the statement. This statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company adopted the pronouncement effective October 1, 2009. The adoption did not have a material impact on the Company’s condensed consolidated financial statements for prior periods; but the pronouncement will impact the accounting for any acquisitions subsequent to that date.

In June 2009, the FASB issued guidance on ASC 810-10, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51”, previously known as FIN No. 46, to revise the approach to determine when a variable interest entity (“VIE”) should be consolidated. The new consolidation model for VIEs considers whether the Company has the power to direct the activities that most significantly impact the VIE’s economic performance and shares in the significant risks and rewards of the entity. The guidance on VIE’s requires companies to continually reassess VIEs to determine if consolidation is appropriate and provide additional disclosures. The guidance is effective for fiscal years beginning after November 15, 2009. The Company will adopt the guidance for interim and annual reporting periods beginning in the first quarter of fiscal 2011and is currently assessing the potential impact this guidance will have on its consolidated financial statements.

In June 2008, the FASB issued guidance contained in FASB ASC 260-10, previously known FASB Staff Position No. EITF 03-6-1. Under the guidance, unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents are participating securities and, therefore, are included in computing earnings per share (“EPS”) pursuant to the two-class method. The two-class method determines earnings per share for each class of common stock and participating securities according to dividends or dividend equivalents and their respective participation rights in undistributed earnings. The Company adopted the guidance effective October 1, 2009.  The adoption of this guidance did not impact net income attributable to the Company per common share for prior periods and is not expected to have an impact on future periods until such time as the Company declares a regular quarterly dividend.

In August 2009, the FASB issued Accounting Standards Update No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820)—MeasuringLiabilities at Fair Value,” which provides guidance on how to measure liabilities at fair value in circumstance in which a quoted price in an active market for the identical liability is not available. This update is effective for the first reporting period, including interim periods, beginning after issuance. The Company has no liabilities that are governed by this update but will apply its provisions in the future as applicable.

21

Table of Contents

12. Litigation and Contingencies

Many of the Company’s payer and provider contracts are complex in nature and may be subject to differing interpretations regarding amounts due for the provision of medical services. Such differing interpretations may not come to light until a substantial period of time has passed following contract implementation. Liabilities for claims disputes are recorded when the loss is probable and can be estimated. Any adjustments to reserves are reflected in current operations.

The Company has separate commercial claims-made insurance policies for Alta and Brotman. The Alta policy covers malpractice claims in excess of $1,000,000 per claim retention, with a $10,000,000 annual aggregate. The General Liability coverage is occurrence coverage with $1,000,000 per occurrence retention.  The limit is part of the $10,000,000 annual aggregate.  Brotman has a primary limit of $1,000,000 per claim and $3,000,000 aggregate for malpractice claims in excess of a $100,000 per claim retention. The General Liability coverage is occurrence coverage with a limit of $1,000,000 per occurrence and $3,000,000 aggregate in excess of a $100,000 retention.  There is also a $9,000,000 aggregate Excess policy which is excess of the primary malpractice and general liability coverage. Total actuarial IBNR reserve balance of approximately $2,821,000 was made for estimated malpractice liability at December 31, 2009. These estimates may change in the future and such changes may be material.

The collective bargaining agreement entered into between Hollywood Community Hospital, which is one of the hospitals under the consolidated group of Alta Hospitals System, LLC, and Service Employees International Union (“SEIU”), covers a small group of Hollywood Community Hospital’s employees and will expire on May 9, 2011. The collective bargaining agreements entered into between Brotman and the California Nurses Association (“CNA”) and Brotman and the SEIU both expire on February 28, 2010. We currently do not anticipate that any changes in these agreements will have a material adverse effect on results of our Hospital Services operations in fiscal 2010.

The Company is in the process of finalizing certain post-closing matters related to the 2007 ProMed acquisition, including closing balance sheet reconciliations, escrow reconciliations and other matters. The Company has recorded estimated settlement amounts relating to such matters in the accompanying unaudited condensed consolidated financial statements.

The Company is subject to a variety of claims and suits that arise from time to time in the ordinary course of its business, acquisition, or other transactions. While management currently believes that resolving all of these matters, individually or in aggregate, will not have a material adverse impact on the Company’s financial position or its results of operations, the litigation and other claims that the Company faces are subject to inherent uncertainties and management’s view of these matters may change in the future. Should an unfavorable final outcome occur, there exists the possibility of a materially adverse impact on the Company’s financial position, results of operations and cash flows for the period in which the effect becomes probable and reasonably estimable.

22

Table of Contents

13. Condensed consolidating financial statements of Prospect Medical Holding, Inc. and subsidiaries as of December 31, 2009 and September 30, 2009 and for the three months ended December 31, 2009

On July 29, 2009, the Company closed the offering of $160 million in 12.75% senior secured notes due 2014 (the “Notes”) at an issue price of 92.335%, and entered into a three-year $15 million revolving credit facility which was undrawn at the closing. The Notes and the revolving senior credit facility are jointly and severally guaranteed on a senior secured basis by all of the Company’s restricted subsidiaries (the “Guarantors”), other than Brotman, Nuestra and certain immaterial subsidiaries. The Notes are secured pari passu with the new revolving credit facility on a first priority basis by liens on substantially all of the Company’s assets and assets of the subsidiary guarantors (other than accounts receivable and proceeds therefrom) including all mortgages on the Company and its subsidiary guarantors’ hospital properties (but excluding a pledge of, or mortgage on, the stock, properties or other assets of Brotman, AMVI/Prospect Health Network and certain immaterial subsidiaries). The lenders under the revolving credit facility have a first priority lien on certain of the accounts receivable of the Company and the subsidiary guarantors and proceeds therefrom, while the holders of the Notes have a second priority lien on such collateral (see Note 6).

The Company conducts all of its business through and derives virtually all of its income from its subsidiaries. Therefore, the Company’s ability to make required payments with respect to its indebtedness (including the Notes) and other obligations depends on the financial results and condition of its subsidiaries and its ability to receive funds from its subsidiaries.

Pursuant to Rule 3-10 of Regulation S-X, the following summarized consolidating information is provided for the Company (the “Parent”), the Guarantors, and the Company’s non-Guarantor subsidiaries with respect to the Notes as of September 30, 2009 and as of and for the three months ended December 31, 2009.  The Condensed Consolidating Statements of Operations and Cash Flows for the three months ended December 31, 2008 have not been included, as the non-guarantor subsidiaries for the comparative period were minor. This summarized financial information has been prepared from the books and records maintained by the Company, the Guarantors and the non-Guarantor subsidiaries. The summarized financial information may not necessarily be indicative of the results of operations or financial position had the Guarantors or non-Guarantor subsidiaries operated as independent entities. In addition, intercompany activities between subsidiaries and the Parent are presented within operating activities on the unaudited condensed consolidating statement of cash flows.

23

Table of Contents

Unaudited Condensed consolidating financial statements for the Company and its subsidiaries, including the Parent only, the combined Guarantor Subsidiaries and the combined Non-Guarantor Subsidiaries are as follows:

PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATING BALANCE SHEETS

As of December 31, 2009

(in thousands)

(Unaudited)