Ontrak, Inc. - FORM 10-Q - August 16, 2010

Attached files

file	filename
EX-31.2 - Ontrak, Inc.	exhibit_31-2.htm
EX-32.3 - Ontrak, Inc.	exhibit_32-3.htm
EX-32.2 - Ontrak, Inc.	exhibit_32-2.htm
EX-31.1 - Ontrak, Inc.	exhibit_31-1.htm
EX-31.3 - Ontrak, Inc.	exhibit_31-3.htm
EX-32.1 - Ontrak, Inc.	exhibit_32-1.htm
EX-10.32 - Ontrak, Inc.	exhibit_10-32.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

____________________________

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

Commission File Number 001-31932

___________________________

HYTHIAM, INC.

(Exact name of registrant as specified in its charter)

____________________________

Delaware		88-0464853
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

11150 Santa Monica Boulevard, Suite 1500, Los Angeles, California 90025

(Address of principal executive offices, including zip code)

(310) 444-4300

(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 þ 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes þ No o

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

Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

As of July 31, 2010, there were 81,423,631 shares of registrant's common stock, $0.0001 par value, outstanding.

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PART I - FINANCIAL INFORMATION			3

	ITEM 1. Consolidated Financial Statements		3

		Condensed Consolidated Balance Sheets as of June 30, 2010
		and December 31, 2009	3

		Condensed Consolidated Statements of Operations for the
		Three and Six Months Ended June 30, 2010 and 2009	4

		Condensed Consolidated Statements of Cash Flows for the
		Six Months Ended June 30, 2010 and 2009	5

		Notes to Condensed Consolidated Financial Statements	7

	ITEM 2. Management's Discussion and Analysis of Financial
		Condition and Results of Operations	24

	ITEM 3. Quantitative and Qualitative Disclosures About Market Risk		34

	ITEM 4. Controls and Procedures		34

PART II – OTHER INFORMATION			II-1

	ITEM 1. Legal Proceedings		II-1

	ITEM 1A. Risk Factors		II-1

	ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds		II-13

	ITEM 3. Defaults Upon Senior Securities		II-13

	ITEM 4. Other Information		II-13

	ITEM 5. Exhibits		II-13

SIGNATURES			II-14

EXHIBIT 10.32
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 31.3
EXHIBIT 32.1
EXHIBIT 32.2
EXHIBIT 32.3

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PART I - FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

	(unaudited)			(audited)
(In thousands,except for number of shares)	June 30,			December 31,
	2010			2009
ASSETS
Current assets
Cash and cash equivalents	$	1,783		$	4,595
Marketable securities, at fair value		-			9,468
Receivables from sale of marketable securities		2,225			-
Receivables, net		134			308
Prepaids and other current assets		152			989
Total current assets		4,294			15,360
Long-term assets
Property and equipment, net of accumulated depreciation
of $6,952 and $6,697 respectively		455			877
Intangible assets, net of accumulated amortization of					-
$1,820 and $1,702 respectively		2,540			2,658
Deposits and other assets		197			210
Total Assets	$	7,486		$	19,105

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable	$	1,885		$	2,266
Accrued compensation and benefits		839			941
Other accrued liabilities		1,748			2,431
Short-term debt		3,311			9,643
Total current liabilities		7,783			15,281
Long-term liabilities
Long-term Liabilities
Deferred rent and other long-term liabilities		73			46
Warrant liabilities		195			1,089
Capital lease obligations		23			48
Total liabilities		8,074			16,464

Stockholders' equity
Preferred stock, $.0001 par value; 50,000,000 shares authorized;
no shares issued and outstanding		-			-
Common stock, $.0001 par value; 200,000,000 shares authorized;
71,424,000 and 65,283,000 shares issued and outstanding
at June 30, 2010 and December 31, 2009, respectively		7			7
Additional paid-in-capital		187,808			184,715
Accumulated other comprehensive income		-			696
Accumulated deficit		(188,403	)		(182,777	)
Total Stockholders' Equity		(588	)		2,641
Total Liabilities and Stockholders' Equity	$	7,486		$	19,105

See accompanying notes to the financial statements.

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HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

	Three Months Ended						Six Months Ended
(In thousands, except per share amounts)	June 30,						June 30,
	2010			2009			2010			2009
Revenues
Total revenues	$	111		$	371		$	234		$	1,078

Operating expenses
Cost of healthcare services		51			161			75			434
General and administrative		3,141			4,526			6,673			10,129
Impairment losses		-			-			38			1,113
Depreciation and amortization		246			302			501			706
Total operating expenses		3,438			4,989			7,287			12,382

Loss from operations		(3,327	)		(4,618	)		(7,053	)		(11,304	)

Interest and other income		85			77			128			123
Interest expense		(134	)		(370	)		(271	)		(778	)
Loss on extinguishment of debt		-			-			-			(276	)
Gain on the sale of marketable securities		664			-			696			-
Other than temporary impairment of marketable
securities		-			(28	)		-			(160	)
Change in fair value of warrant liability		237			15			894			84
Loss from continuing operations before provision
for income taxes		(2,475	)		(4,924	)		(5,606	)		(12,311	)
Provision for income taxes		2			2			20			10
Loss from continuing operations	$	(2,477	)	$	(4,926	)	$	(5,626	)	$	(12,321	)

Discontinued Operations:
Results of discontinued operations, net of tax		-			-			-			10,449

Net income (loss)	$	(2,477	)	$	(4,926	)	$	(5,626	)	$	(1,872	)

Basic and diluted net income (loss) per share:
Continuing operations	$	(0.03	)	$	(0.09	)	$	(0.08	)	$	(0.22	)
Discontinued operations		-			-			-			0.19
Net income (loss) per share	$	(0.03	)	$	(0.09	)	$	(0.08	)	$	(0.03	)

Weighted number of shares outstanding		70,918			55,155			68,388			55,115

See accompanying notes to the financial statements.

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HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	Six Months Ended
(In thousands)	June 30,
	2010			2009
Operating activities
Net loss	$	(5,626	)	$	(1,872	)
Adjustments to reconcile net loss to net cash used in operating activities:
(Income) from Discontinued Operations	$	-			(10,449	)
Depreciation and amortization		501			706
Amortization of debt discount and issuance costs included in
interest expense		126			805
Other than temporary impairment on marketable securities		-			160
Gain on sale of marketable securities		(696	)		-
Provision for doubful accounts		19			491
Deferred rent		(61	)		26
Share-based compensation expense		2,175			2,459
Loss on debt extinguishment		-			276
Fair value adjustment on warrant liabilitiy		(894	)		(84	)
Impairment losses		38			1,113
Changes in current assets and liabilities:
Receivables		155			(66	)
Prepaids and other current assets		(26	)		66
Accounts payable		10			(1,970	)
Long term accrued liabilities		-			51
Net cash used in operating activities of continuing operations		(4,279	)		(8,288	)
Net cash used in operating activities of discontinued operations		-			(1,103	)
Net cash used in operating activities		(4,279	)		(9,391	)
Investing activities
Proceeds from sales and maturities of marketable securities	$	8,000		$	-
Proceeds from sales of property and equipment		1			2
Proceeds from disposition of CompCare		-			1,500
Purchases of property and equipment		-			(17	)
Deposits and other assets		-			(281	)
Net cash from investing activities by continuing operations		8,001			1,204
Net cash from investing activities by discontinued operations		-			39
Net cash provided by investing activities		8,001			1,243

(continued on next page)

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HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(continued from previous page)

	Six Months Ended
(In thousands)	June 30,
	2010	2009

Financing activities
Costs related to registered direct offering	$	(51	)	$	-
Proceeds from line of credit		450			1,663
Paydown on line of credit		(6,908	)		(79	)
Paydown on senior secured note		-			(1,350	)
Capital lease obligations		(25	)		(47	)
Net cash provided by (used in) financing activities by
continuing operations		(6,534	)		187
Net cash from (used in) financing activities by discontinued
operations		-			(73	)
Net cash from (used in) financing activities		(6,534	)		114

Net decrease in cash and cash equivalents for continuing operations		(2,812	)		(6,897	)
Net decrease in cash and cash equivalents for discontinued operations		-			(1,137	)
Net decrease in cash and cash equivalents		(2,812	)		(8,034	)
Cash and cash equivalents at beginning of period		4,595			10,893
Cash and cash equivalents at end of period	$	1,783		$	2,859

Supplemental disclosure of cash paid
Interest	$	98		$	144
Income taxes	$	34		$	30
Supplemental disclosure of non-cash activity
Common stock issued for outside services	$	271		$	189
Common stock issued for debt settlement	$	1,235		$	-

See accompanying notes to the financial statements.

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Hythiam, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 1. Basis of Consolidation, Presentation and Going Concern

The accompanying unaudited interim condensed consolidated financial statements as of June 30, 2010 and for the three and six months ended June 30, 2010 and 2009, for Hythiam, Inc. (referred to herein as the Company, Hythiam, we, us or our) and our subsidiaries have been prepared in accordance with the Securities and Exchange Commission (SEC) rules for interim financial information and do not include all information and notes required for complete financial statements. In our opinion, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the financial position of the Company as of June 30, 2010, results of operations for the three and six months ended June 30, 2010 and 2009, and cash flows for the six months ended June 30, 2010 and 2009 have been included. Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto in our most recent Annual Report on Form 10-K for the year ended December 31, 2009. Amounts as of December 31, 2009 are derived from those audited consolidated financial statements.

Our financial statements have been prepared on the basis that we will continue as a going concern. At June 30, 2010, cash, cash equivalents and settlement receivable related to the sale of our auction rate securities (ARS) amounted to $4.1 million, and our short-term debt with maturity in July 2010 amounted to $3.3 million. As of June 30, we had a working capital deficit of approximately $3.5 million. During the second quarter we sold all of our remaining ARS at par for $10.2 million and $6.9 million of the proceeds were used to pay down the related line of credit (see Marketable Securities heading under Note 2 Summary of Significant Accounting Policies).

In July 2010 we closed on $2 million of a registered direct financing with certain institutional investors which represented $1.7 million in net proceeds to the Company. In addition we received payment on our settlement account receivable in the amount of $2.2 million in July 2010. We paid off our senior secured note payable in the amount of $3.3 million at maturity on July 15, 2010 and as a result the Company no longer has any short or long-term debt outstanding (see Note 7 Subsequent Events). We have incurred significant operating losses and negative cash flows from operations since our inception. During the six months ended June 30, 2010, our cash used in operating activities amounted $4.3 million. We expect to continue to incur negative cash flows and net losses for the next twelve months. As of June 30, 2010, these conditions raised substantial doubt as to our ability to continue as a going concern.

Our ability to fund our ongoing operations and continue as a going concern is dependent on raising additional capital, signing and generating revenue from new Catasys contracts and the success of management’s plans to increase revenue and continue to decrease expenses. Beginning in the fourth quarter of 2008, and continuing in each of the quarters during 2010, management took actions that have resulted in reducing annual operating expenses. We have, and continue to, renegotiated certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms with vendors (see Note 6 Commitments and Contingencies). In August 2010 we amended the lease for our managed treatment center to extend the lease by six months. The lease was set to expire in August 2010. Under the terms of the amendment we reduced the square footage leased and decreased the monthly cost to approximately $7,100 per month which represented a 78% reduction in the monthly cost versus the first six months of 2010. This extension allowed us to reduce existing costs while avoiding additional costs that would have been associated with moving to a new facility and avoid the potential disruption to revenues. During the six months ended June 30, 2010, we settled approximately $1.2 million in payables through the issuance of common stock. In previous quarters, we have exited markets in our licensee operations that we have determined will not provide short-term profitability. We may exit additional markets in our licensee operations and further curtail or restructure our managed treatment center to reduce costs if management determines that those markets will not provide short-term profitability and/or positive cash flow. We do not expect any direct costs associated with streamlining our organization further to have a material impact on our cash position or our ability to continue as a going concern.

As of July 31, 2010, we had cash on hand of approximately $1.6 million. We are pursuing additional Catasys contracts and capital and are seeking to increase revenue from both our Catasys and private pay businesses. We are currently implementing the recently signed contract in Nevada, which is expected to become operational in the fourth quarter of 2010. We are currently evaluating other measures available to us as we address

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our liquidity situation. At presently anticipated rates of spending, which do not include any plans for additional cost reductions, we will need to obtain additional funds prior to the end of September 2010 to avoid drastically curtailing or even ceasing our operations. There can be no assurance that we will be successful in our efforts to generate, increase, or maintain revenue; or raise necessary funds on acceptable terms or at all, and we will not be able to offset this by sufficient reductions in expenses. If this occurs, we may be unable to meet our cash obligations as they become due, we may default on our financial commitments and we may be required to further delay or reduce operating expenses and even curtail our operations, which would have a material adverse effect on us, or we may be unable to continue as a going concern. This has raised substantial doubt from our auditors as to our ability to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability of the carrying amount of the recorded assets or the amount of liabilities that might result from the outcome of this uncertainty.

Pursuant to a Stock Purchase Agreement between WoodCliff (our wholly-owned subsidiary) and Core Corporate Consulting Group, Inc., dated January 14, 2009, and effective as of January 20, 2009, we have disposed of our entire interest in our controlled subsidiary, Comprehensive Care Corporation (CompCare), consisting of 14,400 shares of Class A Series Preferred Stock, and 1,739,130 shares of common stock of CompCare held by Woodcliff, for aggregate gross proceeds of $1.5 million. We did not present CompCare as “held for sale” at December 31, 2008 since all of the criteria specified by SFAS 144, Accounting for the impairment or Disposal of Long-Lived Assets (SFAS 144), had not been met as of that date. The financial statements and footnotes present the operations, assets, liabilities and cash flows of CompCare as a discontinued operation. See Note 5 Discontinued Operations for further discussion.

Based on the provisions of the management services agreement (MSA) between us and our managed professional medical corporation, we have determined that it constitutes a variable interest entity, and that we are the primary beneficiary as defined in Financial Accounting Standards Board (FASB) Interpretation No. 46R, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (FIN 46R). Accordingly, we are required to consolidate the revenue and expenses of our managed professional medical corporation. See Management Service Agreements heading under Note 2 Summary of Significant Accounting Policies for more discussion.

All intercompany transactions and balances have been eliminated in consolidation.

Note 2. Summary of Significant Accounting Policies

Revenue Recognition

Healthcare Services

Our healthcare services revenues to date have been primarily derived from licensing our PROMETA Treatment Program and providing administrative services to hospitals, treatment facilities and other healthcare providers, and from revenues generated by our managed treatment centers. We record revenues earned based on the terms of our licensing and management contracts, which requires the use of judgment, including the assessment of the collectability of receivables. Licensing agreements typically provide for a fixed fee on a per-patient basis, payable to us following the providers’ commencement of the use of our program to treat patients. For revenue recognition purposes, we treat the program licensing and related administrative services as one unit of accounting. We record the fees owed to us under the terms of the agreements at the time we have performed substantially all required services for each use of our program, which for the significant majority of our license agreements to date is in the period in which the provider begins using the program for medically directed and supervised treatment of a patient and, in other cases, is at the time that medical treatment has been completed.

The revenues of our managed treatment center, which we include in our consolidated financial statements, are derived from charging fees directly to patients for medical treatments, including the PROMETA Treatment Program. Revenues from patients treated at the managed treatment center are recorded based on the number of days of treatment completed during the period as a percentage of the total number treatment days for the PROMETA Treatment Program. Revenues relating to the continuing care portion of the PROMETA Treatment Program are deferred and recorded over the period during which the continuing care services are provided.

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Behavioral Health

Our Catasys contracts are generally designed to provide revenues in the form of member fees and service revenues on a monthly basis. Some of our contracts include performance guarantees and we will defer revenues until the performance measurement period is completed and we have met all the conditions necessary to record revenues.

Cost of Healthcare Services

Healthcare Services

Cost of healthcare services represent direct costs that are incurred in connection with licensing our treatment programs and providing administrative services in accordance with the various technology license and services agreements, and are associated directly with the revenue that we recognize. Consistent with our revenue recognition policy, the costs associated with providing these services are recognized, for a significant majority of our agreements, in the period in which patient treatment commences, and in other cases, at the time treatment has been completed. Such costs include royalties paid for the use of the PROMETA Treatment Program for patients treated by all licensees, and direct labor costs, continuing care expense, medical supplies and program medications for patients treated at the managed treatment center.

Behavioral Health

Behavioral health cost of services is recognized in the period in which an eligible member actually receives services. Our Catasys subsidiary contracts with various healthcare providers, including licensed behavioral healthcare professionals, on a contracted basis. We determine that a member has received services when we receive a claim within the contracted timeframe with all required billing elements correctly completed by the service provider.

Comprehensive Income (Loss)

Our comprehensive loss is as follows:

	Three Months Ended						Six Months Ended
(In thousands)	June 30,						June 30,
	2010			2009			2010			2009
Net income (loss)	$	(2,477	)	$	(4,926	)	$	(5,626	)	$	(1,872	)
Other comprehensive gain:
Net unrealized gain (loss) on marketable securities available for sale		-			27		$	(17	)	$	453
Net realized gain on marketable securities included in loss from continuing operations		(666	)				$	(679	)	$	-
Comprehensive income (loss)	$	(3,143	)	$	(4,899	)	$	(6,322	)	$	(1,419	)

Basic Income (Loss) per Share

Basic income (loss) per share is computed by dividing the net income (loss) to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted income per share is computed by dividing the net income for the period by the weighted average number of common and dilutive common equivalent shares outstanding during the period.

Common equivalent shares, consisting of 18,636,000 and 14,242,000 of incremental common shares as of June 30, 2010 and 2009, respectively, issuable upon the exercise of stock options and warrants have been excluded from the diluted earnings per share calculation because their effect is anti-dilutive.

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Share-Based Compensation

The Hythiam, Inc. 2003 Stock Incentive Plan and 2008 Stock Incentive Plan (the Plans), both as amended, provide for the issuance of up to 15 million shares of our common stock. Incentive stock options (ISOs) under Section 422A of the Internal Revenue Code and non-qualified options (NSOs) are authorized under the Plans. We have granted stock options to executive officers, employees, members of our board of directors, and certain outside consultants. The terms and conditions upon which options become exercisable vary among grants, but option rights expire no later than ten years from the date of grant and employee and board of director awards generally vest over three to five years. At June 30, 2010, we had 11,242,000 vested and unvested shares outstanding and 2,898,000 shares available for future awards.

Share-based compensation expense attributable to continuing operations amounted to $1.1 and $2.2 million respectively for the three and six months ended June 30, 2010, compared to $1.3 and $2.5 million respectively for the three and six months ended June 30, 2009. This includes share-based compensation expense attributable to continuing operations recognized for employees and directors discussed below.

Stock Options – Employees and Directors

We measure and recognize compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the date of grant. We estimate the fair value of share-based payment awards using the Black Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations subsequent to January 1, 2006. We accounted for share-based awards to employees and directors using the intrinsic value method under previous FASB rules, allowable prior to January 1, 2006. Under the intrinsic value method, no share-based compensation expense had been recognized in our consolidated statements of operations for awards to employees and directors because the exercise price of our stock options equaled the fair market value of the underlying stock at the date of grant.

Share-based compensation expense attributable to continuing operations recognized for employees and directors for the three and six months ended June 30, 2010 and 2009 amounted to $1.0 million and $1.8 million compared to $1.2 million and $2.3 million, respectively.

Share-based compensation expense recognized in our consolidated statements of operations for the three and six months ended June 30, 2010 and 2009 includes compensation expense for share-based payment awards granted prior to, but not yet vested, as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS 123, and for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. For share-based awards issued to employees and directors, share-based compensation is attributed to expense using the straight-line single option method. Share-based compensation expense recognized in our consolidated statements of operations for the three months ended June 30, 2010 and 2009 is based on awards ultimately expected to vest, reduced for estimated forfeitures. Accounting rules for stock options require forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

During the three and six months ended June 30, 2009, we granted options to employees for 225,000 and 497,000 shares, respectively, at the weighted average per share exercise price of $0.28 and $0.30, respectively, the fair market value of our common stock at the dates of grants. Approximately 271,700 of the options granted in 2009 vested immediately on the date of grant. There were no stock option grants to employees nor were there any

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exercises by directors and employees during the three and six months ended June 30, 2010. Employee and director stock option activity for the three months ended June 30, 2010, included cancellations only and was as follows:

				Weighted Avg.
	Shares			Exercise Price
Balance December 31, 2009		10,913,000		$	2.16
Cancelled		(365,000	)		0.93

Balance March 31, 2010		10,548,000		$	2.20
Cancelled		(886,000	)		2.70

Balance June 30, 2010		9,662,000		$	2.15

The estimated fair value of options granted to employees during the three and six months ended June 30, 2009 was $40,000 and $94,000 respectively, calculated using the Black-Scholes pricing model with the following assumptions:

	Three Months Ended		Six Months Ended
	June 30,		June 30,
	2010	2009	2010	2009
Expected volatility	NA	72%	NA	72%
Risk-free interest rate	NA	2.28%-2.36%	NA	2.16%-2.36%
Weighted average expected lives in years	NA	5.0-6.0	NA	5.0-6.0
Expected dividend	NA	0%	NA	0%

The expected volatility assumptions have been based on the historical and expected volatility of our stock, measured over a period generally commensurate with the expected term. The weighted average expected option term for the three months ended June 30, 2010 reflects the application of the simplified method prescribed in SEC Staff Accounting Bulletin (SAB) No. 107 (and as amended by SAB 110), which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

As of June 30, 2010, there was $3,724,000 of total unrecognized compensation costs related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of approximately 3.5 years

Stock Options and Warrants – Non-employees

We account for the issuance of options and warrants for services from non-employees by estimating the fair value of warrants issued using the Black-Scholes pricing model. This model’s calculations include the option or warrant exercise price, the market price of shares on grant date, the weighted average risk-free interest rate, expected life of the option or warrant, expected volatility of our stock and expected dividends.

For options and warrants issued as compensation to non-employees for services that are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received. For unvested shares, the change in fair value during the period is recognized in expense using the graded vesting method.

There were no options granted and no share-based expense attributable to continuing operations relating to stock options and warrants granted to non-employees during the three and six months ended June 30, 2010. For the same periods in 2009 we granted options for 60,000 shares at the weighted average per share exercise price of $0.52, the fair market value of our common stock at the dates of grants. For the three and six months ended June 30, 2009, share-based expense attributable to continuing operations relating to stock options and warrants granted to non-employees was $38,000 and $199,000, respectively.

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Non-employee stock option and warrant activity for the three and six months ended June 30, 2010 was as follows:

				Weighted Avg.
	Shares			Exercise Price
Balance December 31, 2009		1,690,000		$	3.57
Cancelled		-			-
Balance March 31, 2010		1,690,000		$	3.57

Cancelled		(105,000	)		2.60

Balance June 30, 2010		1,585,000		$	3.63

Common Stock

During the three and six months ended June 30, 2010 and 2009, we issued 5 million and 6.1 million shares of common stock, respectively, in exchange for various services and in settlement of claims. The costs associated with shares issued for services are being amortized to share-based expense on a straight-line basis over the related nine month to one year service periods. For the three and six months ended June 30, 2010 and 2009, share-based expense relating to all common stock issued for consulting services was $211,000 and $377,000 compared to $27,000 and $175,000, respectively. The cost of the shares issued in settlement of claims in the amount of $1.2 million, due for services provided to us which had not been paid were recognized in prior periods. The court approved the settlements of complaints against us in California state court in exchange for issuing 445,000 shares of common stock in January 2010 and 5,000,000 shares of our common stock in April 2010 pursuant to Section 3(a)(10) of the Securities Act of 1933 as amended. The April settlement is subject to adjustment 180 days subsequent to the issuance of the shares and the owner of the claim will not sell more than the greater of 49,000 shares or 10% of the daily trading volume per the terms of the settlement. (See Note 7 Subsequent Events.)

Employee Stock Purchase Plan

We have a qualified employee stock purchase plan (ESPP), approved by our stockholders, which allows qualified employees to participate in the purchase of designated shares of our common stock at a price equal to 85% of the lower of the closing price at the beginning or end of each specified stock purchase period. There were no shares of our common stock issued pursuant to the ESPP and, thus, no expense incurred during the six months ended June 30, 2010. For the same period in 2009, we issued 8,803 shares of common stock and incurred a $1,000 expense related to the ESPP discount price.

Income Taxes

We account for income taxes using the liability method in accordance with current FASB income tax accounting rules. To date, no current income tax liability has been recorded due to our accumulated net losses. Deferred tax assets and liabilities are recognized for temporary differences between the financial statement carrying amount of assets and liabilities and the amounts that are reported in the tax return. Deferred tax assets and liabilities are recorded on a net basis; however, our net deferred tax assets have been fully reserved by a valuation allowance due to the uncertainty of our ability to realize future taxable income and to recover our net deferred tax assets.

We recognize the impact of tax positions in the consolidated financial statements if that position is more likely than not of being sustained on audit, based on the technical merits of the position. To date, we have not identified any uncertain tax positions.

Costs associated with streamlining our operations

During the three and six months ended June 30, 2010 and 2009, we continued to streamline our operations to increase our focus on managed care opportunities and reposition ourselves to be more competitive in the marketplace. We recorded ($64,000) and ($43,000) compared to $222,000 and $360,000 of such costs in the three

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and six months ended June 30, 2010 and 2009, respectively. These recoveries and expenses consisted primarily of rent, severance and related benefits. In addition, we renegotiated certain leasing and vendor agreements to restructure payment terms, reduce operating expenses and manage short term cash requirements.

Marketable Securities

At June 30, 2010, investments include certificates of deposit with maturity dates greater than three months when purchased compared to ARS and certificates of deposit at December 31, 2009. These investments are classified as available-for-sale investments, are reflected in current assets as marketable securities and are stated at fair market value in accordance with FASB accounting rules related to investment in debt securities. Unrealized gains and losses are reported in our Consolidated Balance Sheet within the caption entitled “Accumulated other comprehensive income (loss)” and within Comprehensive Income (Loss) under the caption “other comprehensive income (loss).” Realized gains and losses and declines in value judged to be other-than-temporary are recognized as an impairment charge in the statement of operations on the specific identification method in the period in which they occur.

In making our determination whether losses are considered to be other-than-temporary declines in value, we consider the following factors at each quarter-end reporting period:

●	How long and by how much the fair value of the ARS securities have been below cost;

●	The financial condition of the issuers;

●	Any downgrades of the securities by rating agencies;

●	Default on interest or other terms; and

●	Whether it is more likely than not that we will be required to sell the ARS before they recover in value.

In accordance with current accounting rules for investments in debt securities and additional application guidance issued by the FASB in April 2009, other-than-temporary declines in value are reflected as a non-operating expense in our consolidated statement of operations if it is more likely than not that we will be required to sell the ARS before they recover in value, whereas subsequent increases in value are reflected as unrealized gains in accumulated other comprehensive income in stockholders’ equity in our consolidated balance sheet.

Our marketable securities consisted of investments with the following maturities as of June 30, 2010 and December 31, 2009:

(in thousands)	Fair Market		Less than		More than
	Value		1 Year		10 Years
Balance at December 31, 2009
Certificates of deposit	$	133	$	133	$	-
Auction-rate securities		9,468		9,468		-

Balance at June 30, 2010
Certificates of deposit	$	133	$	133	$	-
Auction-rate securities		-		-		-

The carrying value of all securities presented above approximated fair market value at June 30, 2010 and December 31, 2009.

Auction-Rate Securities

Since February 2008, auctions for these securities have failed; meaning the parties desiring to sell securities could not be matched with an adequate number of buyers, resulting in our having to continue to hold these securities. Although the securities are Aaa/AAA rated and collateralized by portfolios of student loans guaranteed by the U.S. government, based on current market conditions it is likely that auctions will continue to be unsuccessful in the short-term, limiting the liquidity of these investments until the issuer calls the securities. The maturity dates of the underlying securities of our ARS investments ranged from 18 to 37 years. In October 2008, our portfolio manager, UBS AG (UBS) made a rights offering to its clients, pursuant to which we are entitled to sell to UBS all ARS held by us in our UBS account. We subscribed to the rights offering in November 2008, which permits us to require UBS to purchase our ARS for a price equal to original par value plus any accrued but unpaid interest

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beginning on June 30, 2010 and ending on July 2, 2012, if the securities were not earlier redeemed or sold. During the six months ended June 30, 2010, $10.2 million (par value) of ARS were redeemed at par by the issuer with $8 million settling prior to the end of the quarter and the balance of the portfolio settling on July 2, 2010.

Because of our ability to sell the ARS under the UBS rights offering beginning on June 30, 2010, the ARS investments were classified in current assets as of December 31, 2009.

The rights offering referred to above was effectively a put option agreement. Consequently, we recognized the put option agreement as a separate asset in the amount of approximately $758,000 in accordance with FASB accounting rules and it is included at fair market value in other current assets in our consolidated balance sheet at December 31, 2009. As the ARS were redeemed at par value we determined that the fair market value of the ARS at June 30, 2010 was the redemption amount, and as a result have written down the value of the put option to zero at June 30, 2010. The related $758,000 reduction in the value of the put option is reflected as a charge to gain on sale of marketable securities in our consolidated income statement for the three and six months ended June 30, 2010.

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities recorded at fair value in the consolidated balance sheets are categorized based upon the level of judgment associated with the inputs use to measure fair value. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources observable inputs and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable outputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:

Level Input:		Input Definition:
Level I		Inputs are unadjusted, quoted prices for identical assets or liabilities in active markets at the measurement date.
Level II		Inputs, other than quoted prices included in Level I, that are observable for the asset or liability through corroboration with market data at the measurement date.
Level III		Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date.

The following table summarizes fair value measurements by level at June 30, 2010 for assets and liabilities measured at fair value on a recurring basis:

(Dollars in thousands)		Level I	Level II	Level III	Total
Intangible assets		-	-	2,540	2,540
Certificates of deposit (1)		133	-	-	133
	Total assets	133	-	2,540	2,673

Warrant liabilities		-	-	195	195
	Total liabilities	-	-	195	195

(1) included in deposits and other assets on our consolidated balance sheets

Financial instruments classified as Level I in the fair value hierarchy as of June 30, 2010 represent our certificates of deposit. Financial instruments classified as Level III in the fair value hierarchy reflected in the table below as of December 31, 2009 represent our investment in ARS and the associated put option.. As discussed above, the market for ARS effectively ceased when the vast majority of auctions began to fail in February 2008. As a result, reliable quoted prices for ARS did not exist at December 31, 2009 and, accordingly, we concluded that Level I inputs were not available and unobservable inputs were used. We determined that use of a valuation model was the best available technique for measuring fair value of our ARS portfolio and we based our estimates of the fair value using valuation models and methodologies that utilize an income-based approach to estimate the price that

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would be received to sell our securities in an orderly transaction between market participants. The estimated price was derived as the present value of expected cash flows over an estimated period of illiquidity, using a risk adjusted discount rate that was based on the credit risk and liquidity risk of the securities. While our valuation model was based on both Level II (credit quality and interest rates) and Level III inputs, we determined that the Level III inputs were the most significant to the overall fair value measurement, particularly the estimates of risk adjusted discount rates and estimated periods of illiquidity.

Liabilities measured at market value on a recurring basis at June 30, 2010 and December 31, 2009 include warrant liabilities resulting from debt and equity financing. They do not include the 7.5 million warrants issued along with 10 million in shares for our $2 million dollar funding in July 2010. In accordance with current accounting rules, the warrant liabilities are being marked to market each quarter-end until they are completely settled. The warrants are valued using the Black-Scholes method, using both observable and unobservable inputs and assumptions consistent with those used in our estimate of fair value of employee stock options. See Warrant Liabilities below.

The following table summarizes our fair value measurements by level at December 31, 2009, and changes therein, for the three months ended March 31, 2010 and the six months ended June 30, 2010:

	Level III			Level III
	ARS			Warrant
(Dollars in thousands)	& Put			Liabilities
Balance as of December 31, 2009	$	10,225		$	1,089
Transfers in/(out) of Level III		-			-
Change in Fair Value		-			(657	)
Net purchases (sales)		(250	)		-
Net unrealized gains (losses)		(30	)		-
Net realized gains (losses)		30			-
Balance as of March 31, 2010	$	9,975		$	432


Transfers in/(out) of Level III		(2,225	)		-
Change in Fair Value		-			(237	)
Net purchases (sales)		(7,750	)		-
Net unrealized gains (losses)		(693	)		-
Net realized gains (losses)		693			-
Balance as of June 30, 2010	$	-		$	195

As discussed above, there have been continued auction failures with our ARS portfolio and as a result, active markets for our ARS did not exist and we relied primarily on Level III inputs, for fair valuation measures as of December 31, 2009. As of June 30, 2010, we relied upon the sale price of the marketable securities to measure fair value.

Intangible Assets

As of June 30, 2010, the gross and net carrying amounts of intangible assets that are subject to amortization are as follows:

	Gross			Amortization
(In thousands)	Carrying	Accumulated	Net	Period
	Amount	Amortization	Balance	(in years)
Intellectual property	$ 4,360	$ (1,820)	$ 2,540	11-16

During the six months ended June 30, 2010, we did not acquire any new intangible assets and at June 30, 2010, all of our intangible assets consisted of intellectual property, which is not subject to renewal or extension. We performed impairment tests on intellectual property as of June 30, 2010 and after considering numerous factors, we determined that the carrying value of certain intangible assets was recoverable as of June 30, 2010. During the six

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months ended June 30, 2010 we did not record impairment charges associated with our intellectual property. At December 31, 2009, we had an independent third-party perform a valuation of our intellectual property. They relied on the “relief from royalty” method, as this method was deemed to be most relevant to the intellectual property assets of the Company. We determined that the estimated useful lives of the remaining intellectual property properly reflected the current remaining economic useful lives of the assets.

Estimated remaining amortization expense for intangible assets for the current year and each of the next five years ending December 31 is as follows:

(In thousands)
Year		Amount
2010		$ 120
2011		$ 241
2012		$ 241
2013		$ 241
2014		$ 241

Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to seven years for furniture and equipment. Leasehold improvements are amortized over the lesser of the estimated useful lives of the assets or the related lease term, which is typically five to seven years.

Variable Interest Entities

Generally, an entity is defined as a Variable Interest Entity (VIE) if it has (a) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (b) equity investors that cannot make significant decisions about the entity’s operations, or that do not absorb the expected losses or receive the expected returns of the entity. When determining whether an entity that is a business qualifies as a VIE, we also consider whether (i) we participated significantly in the design of the entity, (ii) we provided more than half of the total financial support to the entity, and (iii) substantially all of the activities of the VIE either involve us or are conducted on our behalf. A VIE is consolidated by its primary beneficiary, which is the party that absorbs or receives a majority of the entity’s expected losses or expected residual returns.

As discussed under the heading Management Services Agreements below, we have a MSA with a managed medical corporation. Under this MSA, the equity owner of the affiliated medical group has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of this MSA. We also agree to provide working capital loans to allow for the medical group to pay for its obligations. Substantially all of the activities of this managed medical corporation either involve us or are conducted for our benefit, as evidenced by the facts that (i) the operations of the managed medical corporations are conducted primarily using our licensed protocols and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the respective medical group. Payment of our management fee is subordinate to payments of the obligations of the medical group, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated medical group or other third party. Creditors of the managed medical corporations do not have recourse to our general credit.

Based on the design and provisions of this MSA and the working capital loans provided to the medical group, we have determined that the managed medical corporation is a VIE, and that we are the primary beneficiary as defined in the current accounting rules. Accordingly, we are required to consolidate the revenues and expenses of the managed medical corporation.

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Management Services Agreements

We have executed MSAs with medical professional corporations and related treatment centers, with terms generally ranging from five to ten years and provisions to continue on a month-to-month basis following the initial term, unless terminated for cause. In May 2009, we terminated the MSAs with a medical professional corporation and a managed treatment center located in Dallas, Texas “for cause” and because the Company had fully met its funding requirements with respect to the MSAs. As a result, we no longer consolidate these entities as VIEs.

Under the remaining MSA, we license to the treatment center the right to use our proprietary treatment programs and related trademarks and provide all required day-to-day business management services, including, but not limited to:

●	general administrative support services;

●	information systems;

●	recordkeeping;

●	scheduling;

●	billing and collection;

●	marketing and local business development; and

●	obtaining and maintaining all federal, state and local licenses, certifications and regulatory permits.

The treatment center retains the sole right and obligation to provide medical services to its patients and to make other medically related decisions, such as the choice of medical professionals to hire or medical equipment to acquire and the ordering of drugs.

In addition, we provide medical office space to the treatment center on a non-exclusive basis, and we are responsible for all costs associated with rent and utilities. The treatment center pays us a monthly fee equal to the aggregate amount of (a) our costs of providing management services (including reasonable overhead allocable to the delivery of our services and including start-up costs such as pre-operating salaries, rent, equipment, and tenant improvements incurred for the benefit of the medical group, provided that any capitalized costs will be amortized over a five year period), (b) 10%-15% of the foregoing costs, and (c) any performance bonus amount, as determined by the treatment center at its sole discretion. The treatment center’s payment of our fee is subordinate to payment of the treatment center's obligations, including physician fees and medical group employee compensation.

We have also agreed to provide a credit facility to treatment center to be available as a working capital loan, with interest at the Prime Rate plus 2%. Funds are advanced pursuant to the terms of the MSAs described above. The notes are due on demand or upon termination of the respective MSA. At June 30, 2010, there was one outstanding credit facility under which $9.9 million was outstanding. Our maximum exposure to loss could exceed this amount, and cannot be quantified as it is contingent upon the amount of losses incurred by the respective treatment center that we are required to fund under the credit facility.

Under the MSA, the equity owner of the affiliated treatment center has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of the MSA. We also agree to provide working capital loans to allow for the treatment center to pay for its obligations. Substantially all of the activities of these managed medical corporations either involve us or are conducted for our benefit, as evidenced by the facts that (i) the operations of the managed medical corporations are conducted primarily using our licensed protocols and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the respective treatment center. Payment of our management fee is subordinate to payments of the obligations of the treatment center, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated treatment center or other third party. Creditors of the managed medical corporations do not have recourse to our general credit. Based on these facts, we have determined that the managed medical corporations are VIEs and that we are the primary beneficiary as defined in current accounting rules. Accordingly, we are required to consolidate the assets, liabilities, revenues and expenses of the managed treatment centers.

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The amounts and classification of assets and liabilities of the VIEs included in our Consolidated Balance Sheets at June 30, 2010 and December 31, 2009 are as follows:

	June 30,		December 31,
(in thousands)	2010		2009
Cash and cash equivalents	$	69		23
Receivables, net		7		-
Total assets	$	76		23

Accounts payable		32		14
Note payable		9,877		9,214
Accrued liabilities		19		6
Total liabilities	$	9,928		9,234

Warrant Liabilities

Prior to the end of the second quarter 2010 we had issued warrants in connection with the registered direct placement of our common stock in November 2007, September 2009 and the amended and restated Highbridge senior secured note in July 2008. The warrants include provisions that require us to record them at fair value as a liability in accordance with EITF 00-19, with subsequent changes in fair value recorded as a non-operating gain or loss in our statement of operations. The fair value of the warrants is determined using a Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility, interest rates and expected term.

For the three and six months ended June 30, 2010 and 2009, we recognized non-operating gains/(losses) of $237,000 and $894,000 compared to $15,000 and $84,000, respectively, related to the revaluation of our warrant liabilities. We will continue to re-measure the warrant liabilities at fair value each quarter-end until they are completely settled or expire. (See Note 7 Subsequent Events.)

Recent Accounting Pronouncements

Recently Adopted

In February 2010, the FASB issued ASU 2010-09, “Subsequent Events, Amendments to Certain Recognition and Disclosure Requirements” which made a number of changes to the existing requirements to the FASB Accounting Standards Codification 855 Subsequent Events. The amended guidance was effective upon issuance and as a result of the amendments, SEC filers that file financial statements after February 24, 2010 are not required to disclose the date through which subsequent events have been evaluated. This ASU was adopted as of June 30, 2010 and did not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures: Improving Disclosures about Fair Value Measurements” which is intended to enhance the usefulness of fair value measurements by requiring both the disaggregation of the information in certain existing disclosures, as well as the inclusion of more robust disclosures about valuation techniques and inputs to recurring and non-recurring fair value measurements. The amended guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disaggregation requirement for the reconciliation disclosure of Level 3 measurements, which is effective for fiscal years beginning after December 31, 2010 and for interim periods within those years. This ASU was adopted as of June 30, 2010 and did not have a material impact on our consolidated financial statements.

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increased disclosures about deconsolidation of a subsidiary. It requires retrospective application and is effective for the first interim or annual periods ending on or after December 15, 2009. Adoption of this ASU will not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2020-01 “Accounting for Distributions to Shareholders with Components of Stock and Cash” which is intended to clarify the accounting treatment for a stock portion of a shareholder distribution that (1) contains both cash and stock components, (2) allows shareholders to select their preferred form of distribution, and (3) limits the total amount of cash to be distributed. It defines a stock dividend as a dividend that takes nothing from the property of an entity and adds nothing to the interests of an entity’s shareholders because the proportional interest of each shareholder remains the same. The stock portion of the distribution must be treated as a stock issuance and be reflected in the EPS calculation prospectively. It requires retrospective application and is effective for annual periods ending on or after December 15, 2009. Adoption of this ASU will not have a material impact on our consolidated financial statements.

In August 2009, the FASB issued ASU 2009-15, which changes the fair value accounting for liabilities. These changes clarify existing guidance that in circumstances in which a quoted price in an active market for the identical liability is not available, an entity is required to measure fair value using either a valuation technique that uses a quoted price of either a similar liability or a quoted price of an identical or similar liability when traded as an asset, or another valuation technique that is consistent with the principles of fair value measurements, such as an income approach (e.g., present value technique). This guidance also states that both a quoted price in an active market for the identical liability and a quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. This ASU was adopted effective on January 1, 2010 and did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued ASU 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities,” the FASB issued changes to the accounting for variable interest entities. These changes require an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity; to require ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity; to eliminate the quantitative approach previously required for determining the primary beneficiary of a variable interest entity; to add an additional reconsideration event for determining whether an entity is a variable interest entity when any changes in facts and circumstances occur such that holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance; and to require enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a variable interest entity. These changes became effective for us beginning on January 1, 2010. The adoption of this change did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued ASU 2009-16, “Accounting for Transfers of Financial Assets,” which changes the accounting for transfers of financial assets. These changes remove the concept of a qualifying special-purpose entity and remove the exception from the application of variable interest accounting to variable interest entities that are qualifying special-purpose entities; limits the circumstances in which a transferor derecognizes a portion or component of a financial asset; defines a participating interest; requires a transferor to recognize and initially measure at fair value all assets obtained and liabilities incurred as a result of a transfer accounted for as a sale; and requires enhanced disclosure; among others. These changes became effective January 1, 2010 and did not have a material impact on our financial statements.

Recently Issued

The following Accounting Standards Updates were issued between December 2009 and June 30, 2010 and contain amendments and technical corrections to certain SEC references in FASB's codification:

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for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The Company expects to adopt the amended guidance on January 1, 2011. The Company does not believe that the adoption of the amended guidance will have a significant effect on its consolidated financial statements.

In April 2010, the FASB issued ASU 2010-17, “Milestone Method of Revenue Recognition” guidance to address accounting for research or development arrangements in which a vendor satisfies its performance obligations over time, with all or a portion of the consideration contingent on future events, referred to as milestones. The new guidance allows a vendor to adopt an accounting policy to recognize all of the arrangement consideration that is contingent on the achievement of a milestone in the period the milestone is achieved, if the milestone meets the criteria to be considered a substantive milestone. The milestone method described in the new guidance is not the only acceptable revenue attribution model for milestone consideration. However, other methods that result in the recognition of all of the milestone consideration in the period the milestone is achieved are precluded. A vendor is not precluded from electing to apply a policy that results in the deferral of some portion of the milestone consideration. The new guidance is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those fiscal years, beginning on or after June 15, 2010, with early adoption permitted. If an entity early adopts in a period that is not the beginning of its fiscal year, it must apply the guidance retrospectively from the beginning of the year of adoption. A vendor may elect to adopt the new guidance retrospectively for all prior periods, but is not required to do so. The Company is still evaluating the effect, if any, the amended guidance may have on its consolidated financial statements.

Note 3. Segment Information

We manage and report our operations through two business segments: Behavioral Health and Healthcare Services. During the three months ended March 31, 2009, we revised our segments to reflect the disposal of CompCare (see Note 5 Discontinued Operations), and to properly reflect how our segments are currently managed. Our behavioral health managed care services segment, which had been comprised entirely of the operations of CompCare, is now presented in discontinued operations and is not a reportable segment. The Healthcare Services segment has been segregated into Behavioral Health and Healthcare Services.

We evaluate segment performance based on total assets, revenue and income or loss before provision for income taxes. Our assets are included within each discrete reporting segment. In the event that any services are provided to one reporting segment by the other, the transactions are valued at the market price. No such services were provided during the three and six months ended June 30, 2010 and 2009. Summary financial information for our two reportable segments is as follows:

	Three Months Ended						Six Months Ended
(in thousands)	June 30,						June 30,
	2010			2009			2010			2009
Healthcare services
Revenues	$	104		$	371		$	224		$	1,078
Loss before provision for income taxes		(1,964	)		(4,290	)		(4,431	)		(9,985	)
Assets *		7,486			18,229			-			18,229

Behavioral health
Revenues	$	7		$	-		$	10		$	-
Loss before provision for income taxes		(511	)		(634	)		(1,175	)		(2,326	)
Assets *		-			-			-			-

Consolidated continuing operations
Revenues	$	111		$	371		$	234		$	1,078
Loss before provision for income taxes		(2,475	)		(4,924	)		(5,606	)		(12,311	)
Assets *		7,486			18,229			-			18,229

* Assets are reported as of June 30.

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Behavioral Health

Catasys’s integrated substance dependence solution combines innovative medical and psychosocial treatments with elements of traditional disease management and ongoing member support to help organizations treat and manage substance dependent populations to impact both the medical and behavioral health costs associated with substance dependence and the related co-morbidities.

We are currently marketing our Catasys integrated substance dependence solutions to managed care health plans for reimbursement on a case rate or monthly fee, which involves educating third party payors on the disproportionately high cost of their substance dependent population and demonstrating the potential for improved clinical outcomes and reduced cost associated with using our Catasys programs.

The following table summarizes the operating results for Behavioral Health for the three and six months ended June 30, 2010 and 2009:

	Three Months Ended						Six Months Ended
(in thousands)	June 30,						June 30,
	2010			2009			2010			2009
Revenues	$	7		$	-		$	10		$	-

Operating Expenses
General and administrative expenses
Salaries and benefits	$	502		$	556		$	1,121		$	1,210
Other expenses		16			78			64			275
Impairment charges		-			-			-			758
Depreciation and amortization		-			-			-			83
Total operating expenses	$	518		$	634		$	1,185		$	2,326

Loss before provision for income taxes	$	(511	)	$	(634	)	$	(1,175	)	$	(2,326	)

Healthcare Services

Our Healthcare Services segment is focused on delivering solutions for those suffering from alcohol, cocaine, methamphetamine and other substance dependencies by researching, developing, licensing and commercializing innovative physiological, nutritional, and behavioral treatment programs. Treatment with our PROMETA Treatment Programs, which integrate behavioral, nutritional, and medical components, are available through physicians and other licensed treatment providers who have entered into licensing agreements with us for the use of our treatment programs. Also included in this segment are licensed and managed treatment centers, which offer a range of addiction treatment and mental health services, including the PROMETA Treatment Programs for dependencies on alcohol, cocaine and methamphetamines.

Our healthcare services segment also comprises international operations; however, these operating segments are not separately reported as they do not meet any of the quantitative thresholds under SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information.

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The following table summarizes the operating results for Healthcare Services for the three and six months ended June, 2010 and 2009:

(In thousands, except patient treatment data)		Three months ended						Six months ended
		June 30,						June 30,
		2010			2009			2010			2009
Revenues
	U.S. licensees	$	30		$	152		$	75		$	336
	Managed treatment centers		74			219			149			608
	Other revenues		-			-			-			134
	Total healthcare services revenues	$	104		$	371		$	224		$	1,078

Operating expenses
	Cost of healthcare services	$	51		$	161		$	75		$	434
	General and administrative expenses
	Salaries and benefits		856			1,608			1,853			4,384
	Other expenses		1,767			2,284			3,635			4,260
	Research and development		-			-			-			-
	Impairment losses		-			-			38			355
	Depreciation and amortization		246			302			501			623
	Total operating expenses	$	2,920		$	4,355		$	6,102		$	10,056

Loss from operations		$	(2,816	)	$	(3,984	)	$	(5,878	)	$	(8,978	)
	Interest and other income		(673	)		77			(630	)		123
	Interest expense		(134	)		(370	)		(271	)		(778	)
	Loss on extinguishment of debt		-			-			-			(276	)
	Gain on the sale of marketable securities		1,422			-			1,454			-
	Other than temporary impairment on											-
	marketable securities		-			(28	)		-			(160	)
	Change in fair value of warrant liabilities		237			15			894			84
Loss before provision for income taxes		$	(1,964	)	$	(4,290	)	$	(4,431	)	$	(9,985	)

PROMETA patients treated
	U.S. licensees		7			30			18			72
	Managed treatment centers		5			19			14			56
	Other		-			-			-			11
			12			49			32			139

Average revenue per patient treated (a)
	U.S. licensees	$	4,371		$	5,067		$	4,192		$	4,528
	Managed treatment centers		9,100			7,211			7,008			6,661
	Other		-			-			-			12,182
	Overall average		6,342			5,898			4,873			5,993

(a)	The average revenue per patient treated excludes administrative fees and other non-PROMETA patient revenues.

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Note 4. Debt Outstanding

The following table shows the total principal amount, related interest rates and maturities of debt outstanding, as of June 30, 2010 and December 31, 2009:

	June 30		December 31,
(dollars in thousands, except where otherwise noted)	2010		2009
Short-term debt
Senior secured note due July 15, 2010; interest payable quarterly at prime
plus 2.5% (5.75% at June 30, 2010 and December 31, 2009, respectively)
$3,332,000 principal net of $21,000 unamortized discount at June 30, 2010
and $3,332,000 principal net of $147,000 unamortized discount
at December 31, 2009	$	3,311	$	3,185

UBS line of credit, payable on demand, interest payable monthly at 90-day
T-bill rate plus 120 basis points (1.301% at June 30, 2010 and
1.237% at December 31, 2009)		-		6,458

Total Short-term debt	$	3,311	$	9,643

During the second quarter we sold $10.2 million of par value ARS and settled $8 million with the balance of $2.2 million settling on July 2, 2010. We drew down $450,000 on the UBS line of credit and paid our debt of $6.9 million in full according to the terms and conditions of our line of credit. On July 15, 2010, our senior secured note in the amount of $3.3 million matured and we paid from available funds.

Note 5. Discontinued Operations

On January 20, 2009, we sold our interest in CompCare, in which we had acquired a controlling interest in January 2007 for $1.5 million in cash. The CompCare operations are now presented as discontinued operations in accordance with accounting rules related to the disposal of long-lived assets. Prior to the sale, the assets, and results of operations related to CompCare had constituted our behavioral health managed care services segment. See Note 3 Segment Information for an updated discussion of our business segments after the sale of CompCare.

We recognized a gain of approximately $11.2 million from this sale, which is included in income from discontinued operations in our Consolidated Statement of Operations for the three months ended March 31, 2009. The revenues and expenses of discontinued operations for the period January 1 through January 20, 2009 are as follows:

	Period from
	January 1 to
	January 20,
(in thousands)	2009
Revenues:
Behavioral managed health care revenues	$	710

Expenses:
Behavioral managed health care operating expenses	$	703
General and administrative expenses		711
Other		50
Income (loss) from discontinued operations before
provision for income tax	$	(754	)

Provision for income taxes	$	1
Income (loss) from discontinued operations, net of tax	$	(755	)

Gain on sale	$	11,204
Results from discontinued operations, net of tax	$	10,449

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Note 6. Commitments and Contingencies

			Less than		1 - 3		3 - 5		More than
Contractual Commitments	Total		1 year		years		years		5 years
Outstanding Debt Obligations	$	3,379	$	3,379
Capital Lease Obligations		89		65		24		-		-
Operating Lease Obligations		792		766		26		-		-
Clinical Studies		356		356		-		-		-
Total	$	4,616	$	4,566	$	50	$	-	$	-

In May 2010, we entered into an amendment to one of our operating leases which resulted in the deferral of rents of approximately $124,000 into the third quarter of 2010.

In August 2006, the Company entered into a 5 year lease agreement for approximately 4,000 square feet of medical space for a company managed treatment center in San Francisco, CA. The Company ceased operations at the center in January 2008. In the first quarter of 2009, the Company ceased making rent payments under the lease. In November of 2009, the landlord filed a lawsuit against the Company seeking damages of at least $350,000, plus attorney fees and costs. On March 23, 2010 the Company settled this lawsuit for $200,000 to be paid in monthly installments from March 23, 2010 to February 2011.

Note 7. Subsequent Events

On July 2, 2010, upon trade settlement, we collected the $2.2 million receivable related to the sale of the remainder of our ARS portfolio. On July 15, 2010, our senior secured note in the amount of $3.3 million was paid off at maturity. On June 30, 2010 we entered into definitive agreements for $3.5 million registered direct financing with certain institutional investors. On July 6, 2010, the Company closed on $2 million of gross proceeds, prior to fees and expenses, of that financing. The remaining investor did not meet closing conditions prior to the expiration of the offering, and on August 15, 2010 the offering expired without additional closings. In conjunction with the financing the Company issued 10 million shares and 7.5 million warrants exercisable at $.20 per share.

The warrants issued will be accounted for as liabilities in accordance with current accounting rules, due to a requirement to deliver registered shares upon exercise of the warrants, which is considered outside the control of the Company. The warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

On August 11, 2010 we extended our lease for the company managed treatment facility, which was set to expire on August 14, for six months for a reduced amount of square footage at a monthly cost of $7,100 per month.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements including the related notes, and the other financial information included in this report. For ease of reference, “we,” “us” or “our” refer to Hythiam, Inc., our wholly-owned subsidiaries and The PROMETA Center, Inc. unless otherwise stated.

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING INFORMATION

In addition to historical information this report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, business strategies, operating efficiencies or synergies, competitive positions, market and industry segment growth opportunities for existing products, plans and objectives of management, markets for stock of Hythiam and other matters. Statements in this report that are not historical facts are hereby identified as “forward-looking statements” for the purpose of the safe harbor provided by Section 21E of the Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Such forward-looking statements, including, without limitation, those relating to the future business prospects, revenue and income of Hythiam, wherever they occur, are necessarily estimates reflecting the

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best judgment of the senior management of Hythiam on the date on which they were made, or if no date is stated, as of the date of this report. These forward-looking statements are subject to risks, uncertainties and assumptions, including those described in the “Risk Factors” in Item 1A of Part I of our most recent Annual Report on Form 10-K, filed with the SEC, that may affect the operations, performance, development and results of our business. Because the factors discussed in this report could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any such forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. The Company assumes no obligation and does not intend to update these forward-looking statements, except as required by law.

OVERVIEW

General

We are a healthcare services management company, providing through our Catasys® subsidiary behavioral health management services for substance abuse to health plans. Catasys is focused on offering integrated substance dependence solutions, including our patented PROMETA® Treatment Program, for alcoholism and stimulant dependence. The PROMETA Treatment Program, which integrates behavioral, nutritional, and medical components, is also available on a private-pay basis through licensed treatment providers and a company managed treatment center that offers the PROMETA Treatment Program, as well as other substance dependence and mental health services. We also research, develop, license and commercialize innovative and proprietary physiological, nutritional, and behavioral treatment programs.

Discontinued Operations

On January 20, 2009 we sold our entire interest in our controlled subsidiary CompCare for aggregate gross proceeds of $1.5 million. We recognized a gain of approximately $11.2 million from the sale of our CompCare interest, which is included in Results of Discontinued Operations in our Consolidated Statement of Operations for the three months ended March 31, 2009.

Prior to the sale, we reported the operations of CompCare in our behavioral health managed care segment. For detailed information regarding the impact of the sale of our interest in CompCare, see our consolidated financial statements and Note 5 Discontinued Operations included with this report.

Operations

Under our licensing agreements, we provide physicians and other licensed treatment providers access to our PROMETA Treatment Program, education and training in the implementation and use of the licensed technology. The patient’s physician determines the appropriateness of the use of the PROMETA Treatment Program. We receive a fee for the licensed technology and related services generally on a per patient basis. While we continue to maintain licensing agreements with physicians, hospitals and treatment providers for 50 sites throughout the United States, the number of active sites has decreased as a result of our streamline operations, removing field support personnel and significant reductions or eliminations of advertising related to the private pay business. Eleven sites contributed to revenue in the first six months of 2010. We will continue to enter into agreements on a selective basis with additional healthcare providers to increase the availability of the PROMETA Treatment Program, but generally only in markets we are presently operating or where such sites will provide support for our Catasys products. As such revenues are generally related to the number of patients treated, key indicators of our financial performance for the PROMETA Treatment Program will be the number of facilities and healthcare providers that license our technology, and the number of patients that are treated by those providers using our PROMETA Treatment Program. As discussed below in Recent Developments, we are currently evaluating and considering additional actions to streamline our operations that may impact the licensing operations.

We currently manage, under a licensing agreement, one treatment center located in Santa Monica, California (dba The Center to Overcome Addiction). We manage the business components of the treatment center and license the PROMETA Treatment Program and use of the name in exchange for management and licensing fees under the

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terms of full business service management agreements. The center offers treatment with the PROMETA Treatment Program for dependencies on alcohol, cocaine and methamphetamines and also offers medical and psychosocial interventions for other substance dependencies and mental health disorders. The revenues and expenses of these centers are included in our consolidated financial statements under accounting standards applicable to variable interest entities. As discussed below in Recent Developments, we are currently evaluating and considering additional actions to streamline our operations that may impact the managed treatment center.

Beginning in 2007, we developed our Catasys integrated substance dependence solutions for third-party payors. We believe that our Catasys offerings will address a high cost segment of the healthcare market for substance dependence, and we are currently marketing our Catasys integrated substance dependence solutions to managed care health plans on a case rate or monthly fee, which involves educating third party payors on the disproportionately high cost of their substance dependent population and demonstrating the potential for improved clinical outcomes and reduced cost associated with using our Catasys programs.

RESULTS OF OPERATIONS

Table of Summary Consolidated Financial Information

The table below and the discussion that follows summarize our results of consolidated continuing operations for the three and six months ended June 30, 2010 and 2009:

	Three Months Ended						Six Months Ended
(In thousands, except per share amounts)	June 30,						June 30,
	2010			2009			2010			2009
Revenues
Total revenues	$	111		$	371		$	234		$	1,078

Operating expenses
Cost of healthcare services		51			161			75			434
General and administrative		3,141			4,526			6,673			10,129
Impairment losses		-			-			38			1,113
Depreciation and amortization		246			302			501			706
Total operating expenses		3,438			4,989			7,287			12,382

Loss from operations		(3,327	)		(4,618	)		(7,053	)		(11,304	)

Interest and other income		85			77			128			123
Interest expense		(134	)		(370	)		(271	)		(778	)
Loss on extinguishment of debt		-			-			-			(276	)
Gain on the sale of marketable securities		664			-			696			-
Other than temporary impairment of marketable
securities		-			(28	)		-			(160	)
Change in fair value of warrant liability		237			15			894			84
Loss from continuing operations before provision
for income taxes		(2,475	)		(4,924	)		(5,606	)		(12,311	)

Summary of Consolidated Operating Results

The net loss from continuing operations before provision for income taxes decreased by $2.4 million and $6.7 million during the three and six months ended June 30, 2010 respectively, compared to the same periods in 2009, primarily due to the impact of actions to streamline our Healthcare Services operations, partially offset by an increase in the change in fair value of warrant liability of $222,000 and $810,000, a decrease in the cost of health care services revenue of $110,000 and $359,000 and decreases in impairment losses totaling $38,000 and $1.1 million, respectively.

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Revenues

Revenue decreased by $260,000 and $844,000 for the three and six months ended June 30, 2010 compared to the same periods in 2009, due mainly to a decline in licensed sites contributing to revenue and in the number of patients treated at our U.S licensed sites and the managed treatment centers, and a decrease in administrative fees earned from licensees. The number of patients treated decreased by 76% and 77% in the three and six months ended June 30, 2010 compared to the same period in 2009. The average revenue per patient treated at U.S. licensed sites and at Company managed centers increased by approximately $400 and decreased by approximately $1,100 during the three and six months ended June 30, 2010 compared to the same periods in 2009.

Cost of Healthcare Services

Cost of healthcare services consists of royalties we pay for the use of the PROMETA Treatment Program, and costs incurred by our consolidated managed treatment center (The Center to Overcome Addiction) for direct labor costs for physicians and nursing staff, continuing care expense, medical supplies and treatment program medicine costs. The decrease in these costs reflects a decrease in revenues from the reduction of treatment centers; management services agreements, licensed sites and corresponding patient volume in the first six months of 2010.

General and Administrative Expenses

Total general and administrative expenses decreased by $1.4 million, and $3.4 million in the three and six months ended June 30, 2010 compared to the same period in 2009. This decrease is attributable to decreases of $1.0 million and $1.9 million in salaries and benefits for the three and six months ended June 30, 2010 compared to the same periods in 2009. General and administrative expenses for the first six months of 2010 include $1.1 million in non-cash expense for share-based compensation, compared to $1.2 million of such expense in 2009.

Depreciation and amortization decreased by $56,000 and $205,000 during the three and six months ended June 30, 2010 compared to the same period in 2009.

Impairment Losses

There was an impairment loss related to property plant and equipment of $0 and $38,000 for the three and six months ended June 30, 2010, compared to $0 and $1.1 million for the three and six months ended June 30, 2009. During the three and six month period ended June 30, 2009, impairment charges included $122,000 for intangible assets related to our managed treatment center in Dallas and $233,000 related to intellectual property for additional indications for the use of the PROMETA Treatment Program that are currently non-revenue-generating. There was no impairment charge related to intellectual property in the three and six months ended June 30, 2010.

Interest and other income

During the three and six months ended June 30, 2010, we recorded losses of $84,000 and $128,000 in interest and other income or loss compared to $77,000 and $123,000, respectively in the three and six months ended June 30, 2009.

Interest Expense

Interest expense declined by $236,000 and $507,000 from the three and six months ended June 30, 2010 compared to 2009, primarily due to a reduction of $7.6 million in interest bearing liabilities.

Loss from Extinguishment of Debt

There was no charge for loss from extinguishment of debt during the three and six months ending June 30, 2010. In the first quarter of 2009 we recognized a $276,000 loss on extinguishment of debt resulting from the $1.4 million pay down on the Highbridge senior secured note, primarily representing unamortized discount.

Gain on Sale of Marketable Securities

As a result of the sale of approximately $10.2 million in ARS, we recorded $664,000 and $696,000 of gain on sale of marketable securities for the three and six months ended June 20, 2010, respectively.

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Other than Temporary Impairment on Marketable Securities

There was no impairment charge related to certain ARS during the three and six months ended June 30, 2010 compared to $28,000 and $160,000 impairment charges related to certain of our ARS during the three and six months ended June 30, 2009. The charge was based on an updated valuation of the securities performed by management as of March 31, 2009 and deemed necessary after an analysis of other-than-temporary impairment factors, most notably, our inability to hold the ARS until they might recover in value.

Change in fair value of warrant liability

We issued warrants in connection with our registered direct stock placements completed in November 2007 and September 2009, and the amended and restated Highbridge senior secured note in July 2008. The warrants are being accounted for as liabilities in accordance with FASB accounting rules, due to provisions in some warrants that protect the holders from declines in the Company’s stock price and a requirement to deliver registered shares upon exercise of the warrants, which is considered outside the control of the Company. The warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

The change in fair value of the warrants for the three and six months ended June 30, 2010 was $237,000 and $894,000, respectively. We will continue to mark the warrants to market value each quarter-end until they are completely settled.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity and Going Concern

As of July 31, 2010, we had cash on hand of approximately $1.6 million. We are seeking to increase revenue and pursuing additional Catasys contracts and raising additional capital. At presently anticipated rates of spending, which do not include any plans for additional cost reductions, we will need to obtain additional funds prior to the end of September 2010 to avoid drastically curtailing or even ceasing our operations. We are currently in discussions with third parties regarding additional financing and are evaluating other measures available to us as we address our liquidity situation. There can be no assurance that we will be successful in our efforts to generate, increase, or maintain revenue; or raise necessary capital on acceptable terms or at all, and we will not be able to offset this by sufficient reductions in expenses and increases in revenue. If this occurs, we may be unable to meet our cash obligations as they become due, we may default on our financial commitments and we may be required to further delay or reduce operating expenses and even curtail our operations, which would have a material adverse effect on us, or we may be unable to continue as a going concern. This has raised substantial doubt as to our ability to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability of the carrying amount of the recorded assets or the amount of liabilities that might result from the outcome of this uncertainty.

As of June 30, 2010, we had a balance of approximately $4.0 million in cash, cash equivalents and settlement receivables compared to $14.1 million in cash, cash equivalents and current marketable securities at December 31, 2009. We had short term debt of approximately $3.3 million and $9.6 million at June 30, 2010 and December 31, 2009, respectively. At December 31, 2009 we had approximately $9.5 million (fair market value) of ARS classified in current assets. During the six months ended June 30, 2010 approximately $10.2 million of ARS at par value were redeemed by the issuers and $6.6 million of the proceeds were used to pay down the line of credit with UBS that was secured by these ARS securities. Approximately $2.2 million of the ARS were redeemed on June 30, 2010 but did not settle until July 2010, and this amount is reflected as a receivable in current assets at June 30, 2010. We had a working capital deficit of approximately $3.5 million at June 30, 2010 compared to a surplus of approximately $100,000 as of December 31, 2009. We have incurred significant net losses and negative operating cash flows since our inception. We expect to continue to incur negative cash flows and net losses for at least the next twelve months. These conditions raised substantial doubt from our auditors as to our ability to continue as a going concern.

We are currently in the process of implementing our recent Catasys contract in Nevada and we expect that contract to become operational in the fourth quarter of 2010. In July 2010 we closed on $2 million of a registered

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direct financing with certain institutional investors which represented $1.7 million in net proceeds to the Company. The balance of $1.5 million which was committed was not consummated due to a failure by the investor to meet the closing conditions (see Note 7 Subsequent Events). In addition, in July 2010 we received payment on our settlement account receivable in the amount of $2.2 million. We paid off our senior, secured note payable in the amount of $3.3 million at maturity on July 15, 2010, and as a result the Company no longer has any short or long-term debt outstanding.

Our ability to fund our ongoing operations and continue as a going concern is dependent on raising additional capital, signing and generating revenue from new contracts for our Catasys managed care programs and the success of management’s plans to increase revenue and continue to decrease expenses. Beginning in the fourth quarter of 2008, and continuing in each of the quarters during 2010, management took actions that have resulted in reducing annual operating expenses. We have renegotiated certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms with vendors, and have paid some expenses through the issuance of common stock. We amended the lease on premises which resulted in deferring payments and agreed to settle a lawsuit filed by a landlord in March 2010 related to a facility that is no longer in use. This amendment and the legal settlement require payments aggregating $234,000 between July 1, 2010 and February 2011. To date we have made all payments under this arrangement as they have come due. In addition, during the six months ended June 30, 2010, we settled, through the issuance of common stock, approximately $1.2 million of liabilities. In previous periods, we have exited markets for our licensee operations that we have determined would not provide short-term profitability. We may exit additional markets for our licensee operations and further curtail or restructure our managed treatment center to reduce costs if management determines that those markets are not expected to provide short-term profitability and/or positive cash flow. We do not expect any direct costs associated with streamlining our organization to have a material positive impact on our cash position or our ability to continue as a going concern.

Cash Flows

We used $4.3 million of cash for continuing operating activities during the six months ended June 30, 2010 compared to $8.0 million of cash for continuing operating activities during the same period last year. Use of funds in operating activities include general and administrative expense (excluding share-based expense), the cost of healthcare services revenue and research and development costs, which totaled approximately $4.4 million for the six months ended June 30, 2010, compared to $7.3 million for the same period in 2009. This decrease in net cash used reflects the decline in such expenses from our efforts to streamline operations.

Capital expenditures for the six months ended June 30, 2010 and 2009 were not material. Our future capital expenditure requirements will depend upon many factors, including progress with our marketing efforts, the time and costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other proprietary rights, the necessity of, and time and costs involved in obtaining, regulatory approvals, competing technological and market developments, and our ability to establish collaborative arrangements, effective commercialization, marketing activities and other arrangements.

Highbridge Senior Secured Note

On August 11, 2009, we amended our amended and restated senior secured note with Highbridge International LLC (Highbridge), to extend the maturity date from January 15, 2010 to July 15, 2010, and Highbridge agreed to give up its optional redemption rights. We also committed to exercising our right to sell our ARS in accordance with the terms of the rights offering by UBS, who sold them to us, and use the proceeds from the sale to redeem the note. If we borrow or raise capital, we will use all or a portion of the funds raised to redeem the note at 110%. We also amended all 1.8 million warrants that had been previously issued to Highbridge to purchase shares of our common stock (including 1.3 million issued in conjunction with the amended and restated note in 2008 and 540,000 issued in conjunction with the November 2007 registered direct financing), to change the exercise price to $0.28 per share, and extend the expiration date to five years from the amendment date. During the three months ended March 31, 2009, we drew down an additional $1.5 million under the UBS demand margin loan facility, and used $1.4 million of the proceeds to pay down the principal balance on our senior secured note with Highbridge International LLC. During April 2010, we issued common stock which triggered an anti-dilution adjustment to the 1.3 million warrants associated with the 2008 amended and restated senior and secured note held by Highbridge LLC. The adjustment resulted in an increase to the number of warrants outstanding in the amount of 26,204 and a decrease in

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the exercise price from $0.28 to $0.27 per share. On July 15, 2010, we paid this note in full upon maturity (see Note 7 Subsequent Events).

UBS Line of Credit

In May 2008, our investment portfolio manager, UBS, provided us with a demand margin loan facility collateralized by our ARS, which allowed us to borrow up to 50% of the UBS-determined market value of our ARS.

In October 2008, UBS made a “Rights” offering to its clients pursuant to which we were entitled to sell to UBS all ARS held in our UBS account. As part of the offering, UBS provided us a line of credit (replacing the demand margin loan), subject to certain restrictions as described in the prospectus, equal to 75% of the market value of the ARS, until they are purchased by UBS. We accepted the UBS offer on November 6, 2008.

During the first six months of 2010, approximately $10.2 million of our ARS was redeemed at par. We drew down $450,000 on this line of credit during the second quarter 2010 and paid off the line of credit in full as of June 30, 2010. The loan was subject to a rate of interest based upon the current 90-day U.S. Treasury bill rate plus 120 basis points, payable monthly, and was carried in short-term liabilities on our Condensed Consolidated Balance Sheet at December 31, 2009.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

The following table sets forth a summary of our material contractual obligations and commercial commitments as of June 30, 2010 (in thousands):

			Less than		1 - 3		3 - 5		More than
Contractual Commitments	Total		1 year		years		years		5 years
Outstanding Debt Obligations	$	3,379	$	3,379
Capital Lease Obligations		89		65		24		-		-
Operating Lease Obligations		792		766		26		-		-
Clinical Studies		356		356		-		-		-
Total	$	4,616	$	4,566	$	50	$	-	$	-

OFF BALANCE SHEET ARRANGEMENTS

As of June 30, 2010 we had no off-balance sheet arrangements.

CRITICAL ACCOUNTING ESTIMATES

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. We base our estimates on experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that may not be readily apparent from other sources. On an on-going basis, we evaluate the appropriateness of our estimates and we maintain a thorough process to review the application of our accounting policies. Our actual results may differ from these estimates.

We consider our critical accounting estimates to be those that (1) involve significant judgments and uncertainties, (2) require estimates that are more difficult for management to determine, and (3) may produce materially different results when using different assumptions. We have discussed these critical accounting estimates, the basis for their underlying assumptions and estimates and the nature of our related disclosures herein with the audit committee of our Board of Directors. We believe our accounting policies specific to share-based compensation expense; the impairment assessments for intangible assets, valuation of derivative liabilities, and valuation of

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marketable securities involve our most significant judgments and estimates that are material to our consolidated financial statements. They are discussed further below.

Warrant Liabilities

We have issued warrants in connection with the registered direct placements of our common stock in November 2007, September 2009 and the amended and restated Highbridge senior secured note in July 2008. The warrant agreements include provisions that require us to record them as a liability, at fair value, pursuant to FASB accounting rules, including provisions in some warrants that protect the holders from declines in the Company’s stock price and a requirement to deliver registered shares upon exercise, which is considered outside the control of the Company. The warrant liabilities are marked-to-market each reporting period and changes in fair value are recorded as a non-operating gain or loss in our statement of operations, until they are completely settled or expire. The fair value of the warrants is determined each reporting period using the Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility, interest rates and expected term.

The change in fair value of the warrant liabilities amounted to net gains of $237,000 and $894,000 for the three and six months ended June 30, 2010, compared to net gains of $15,000 and $84,000 for the same period in 2009. The gains resulted mainly from a decline in the Company’s stock price. We will continue to re-measure the warrant liabilities at fair value each quarter-end until they are completely settled or expire.

Share-based expense

Commencing January 1, 2006, we implemented the accounting provisions of Statement of Financial Accounting Standards (SFAS) 123R on a modified-prospective basis to recognize share-based compensation for employee stock option awards in our statements of operations for future periods. We accounted for the issuance of stock, stock options and warrants for services from non-employees in accordance with SFAS 123, Accounting for Stock-Based Compensation and FASB Emerging Issues Task Force Issue No. 96-18, Accounting For Equity Instruments That Are Issued To Other Than Employees For Acquiring Or In Conjunction With Selling Goods Or Services . We estimate the fair value of options and warrants issued using the Black-Scholes pricing model. This model’s calculations include the exercise price, the market price of shares on grant date, weighted average assumptions for risk-free interest rates, expected life of the option or warrant, expected volatility of our stock and expected dividend yield.

The amounts recorded in the financial statements for share-based expense could vary significantly if we were to use different assumptions. For example, the assumptions we have made for the expected volatility of our stock price have been based on the historical volatility of our stock measured over a period generally commensurate with the expected term, since we have a limited history as a public company and complete reliance on our actual stock price volatility would not be meaningful. If we were to use the actual volatility of our stock price, there may be a significant variance in the amounts of share-based expense from the amounts reported. Based on the 2008 assumptions used for the Black-Scholes pricing model, a 50% increase in stock price volatility would have increased the fair values of options by approximately 25%. The weighted average expected option term for 2008, 2007 and 2006 reflects the application of the simplified method set out in SEC Staff Accounting Bulletin No. 107, which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

From time to time, we have retained terminated employees as part-time consultants upon their resignation from the company. Because the employees continued to provide services to us, their options continued to vest in accordance with the original terms. Due to the change in classification of the option awards, the options were considered modified at the date of termination in accordance with SFAS 123R. The modifications were treated as exchanges of the original awards in return for the issuance of new awards. At the date of termination, the unvested options were no longer accounted for as employee awards under SFAS 123R and were accounted for as new non-employee awards under EITF 96-18. The accounting for the portion of the total grants that have already vested and have been previously expensed as equity awards is not changed.

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Impairment of Intangible Assets

We have capitalized significant costs for acquiring patents and other intellectual property directly related to our products and services. We review our intangible assets for impairment whenever events or circumstances indicate that the carrying amount of these assets may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and/or their eventual disposition. If the estimated undiscounted future cash flows are less than their carrying amount, we record an impairment loss to recognize a loss for the difference between the assets’ fair value and their carrying value. Since we have not recognized significant revenue to date, our estimates of future revenue may not be realized and the net realizable value of our capitalized costs of intellectual property or other intangible assets may become impaired.

During the six months ended June 30, 2010 we did not acquire any new intangible assets and at June 30, 2009, all of our intangible assets consisted of intellectual property, which is not subject to renewal or extension. We performed impairment tests on intellectual property as of June 30, 2010 and after considering numerous factors, we determined that the carrying value of certain intangible assets was recoverable as of June 30, 2010. During the six months ended June 30, 2010 we did not record impairment charges associated with our intellectual property. At March 31, 2010, we had an independent third-party perform a valuation of our intellectual property. They relied on the “relief from royalty” method, as this method was deemed to be most relevant to the intellectual property assets of the Company. We determined that the estimated useful lives of the remaining intellectual property properly reflected the current remaining economic useful lives of the assets.

Valuation of Marketable Securities

Investments include ARS and certificates of deposit with maturity dates greater than three months when purchased, which are classified as available-for-sale investments and reflected in current or long-term assets, as appropriate, as marketable securities at fair market value. Unrealized gains and losses are reported in our Condensed Consolidated Balance Sheet within accumulated other comprehensive loss and within other comprehensive loss. Realized gains and losses and declines in value judged to be “other-than-temporary” are recognized as a non-reversible impairment charge in the Statement of Operations on the specific identification method in the period in which they occur.

We regularly review the fair value of our investments. If the fair value of any of our investments falls below our cost basis in the investment, we analyze the decrease to determine whether it represents an other-than-temporary decline in value. In making our determination for each investment, we consider the following factors:

●	How long and by how much the fair value of the investments have been below cost;

●	The financial condition of the issuers;

●	Any downgrades of the investment by rating agencies;

●	Default on interest or other terms; and

●	Our intent and ability to hold the investments long enough for them to recover their value.

RECENT ACCOUNTING PRONOUNCEMENTS

Recently Adopted

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measurements. The amended guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disaggregation requirement for the reconciliation disclosure of Level 3 measurements, which is effective for fiscal years beginning after December 31, 2010 and for interim periods within those years. This ASU was adopted as of June 30, 2010 and did not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-02, “Accounting and Reporting for Decreases in Ownership of a Subsidiary – Scope Clarification” which is intended to clarify which transactions require a decrease in ownership provisions particularly for non-controlling interests in consolidated financial statements. In addition, it requires increased disclosures about deconsolidation of a subsidiary. It requires retrospective application and is effective for the first interim or annual periods ending on or after December 15, 2009. Adoption of this ASU will not have a material impact on our consolidated financial statements.

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Recently Issued

The following Accounting Standards Updates were issued between December 2009 and June 30, 2010 and contain amendments and technical corrections to certain SEC references in FASB’s codification:

In April 2010, the FASB issued ASU 2010-13, “Share-based payment awards denominated in certain currencies” provides clarification on an employee share-based payment award that has an exercise price denominated in the currency of the market in which a substantial portion of the entity’s equity shares trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity should not classify such an award as a liability if it otherwise qualifies as equity. The amended guidance is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The Company expects to adopt the amended guidance on January 1, 2011. The Company does not believe that the adoption of the amended guidance will have a significant effect on its consolidated financial statements.

In April 2010, the FASB issued ASU 2010-17, “Milestone Method of Revenue Recognition” guidance to address accounting for research or development arrangements in which a vendor satisfies its performance obligations over time, with all or a portion of the consideration contingent on future events, referred to as milestones. The new guidance allows a vendor to adopt an accounting policy to recognize all of the arrangement consideration that is contingent on the achievement of a milestone in the period the milestone is achieved, if the milestone meets the criteria to be considered a substantive milestone. The milestone method described in the new guidance is not the only acceptable revenue attribution model for milestone consideration. However, other methods that result in the recognition of all of the milestone consideration in the period the milestone is achieved are precluded. A vendor is not precluded from electing to apply a policy that results in the deferral of some portion of the milestone consideration. The new guidance is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those fiscal years, beginning on or after June 15, 2010, with early adoption permitted. If an entity early adopts in a period that is not the beginning of its fiscal year, it must apply the guidance retrospectively from the beginning of the year of adoption. A vendor may elect to adopt the new guidance retrospectively for all prior periods, but is not required to do so. The Company is still evaluating the effect, if any, and the impact the amended guidance may have on its consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

Item 4. Controls and Procedures

We have evaluated, with the participation of our chief executive officer and our chief financial officer, the effectiveness of our system of disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation our chief executive officer and our chief financial officer have determined that they are effective in connection with the preparation of this report. There were no changes in the internal controls over financial reporting that occurred during the quarter ended June 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business. As of the date of this report, we are not currently involved in any legal proceeding that we believe would have a material adverse effect on our business, financial condition or operating results.

Item 1A. Risk Factors

Risks and uncertainties in addition to those we describe below, that may not be presently known to us, or that we currently believe are immaterial, may also harm our business and operations. If any of these risks occur, our business, results of operations and financial condition could be harmed, the price of our common stock could decline, and future events and circumstances could differ significantly from those anticipated in the forward-looking statements contained in this report.

Risks related to our business

We have a limited operating history, expect to continue to incur substantial operating losses and may be unable to obtain additional financing, causing our independent auditors to express substantial doubt about our ability to continue as a going concern

We have been unprofitable since our inception in 2003 and expect to continue to incur substantial additional operating losses and negative cash flow from operations for at least the next twelve months. As of December 31, 2009, these conditions raised substantial doubt as to our ability to continue as a going concern. At July 31, 2010, cash and cash equivalents amounted to $1.6 million. Between January and July 2010, we settled claims for current liabilities in the amount of approximately $1.2 million through the issuance of stock. During the year ended December 31, 2009 and the six months ended June 30, 2010, our cash and cash equivalents used in operating activities amounted to $14.5 million and $4.3 million, respectively. Although we have recently taken actions to decrease expenses, increase revenues and obtain additional financing, there can be no assurance that we will be successful in our efforts. We may not be successful in raising necessary funds on acceptable terms or at all, and we may not be able to offset this by sufficient reductions in expenses and increases in revenue. If this occurs, we may be unable to meet our cash obligations as they become due and we may be required to further delay or reduce operating expenses and curtail our operations, which would have a material adverse effect on us.

We may fail to successfully manage and grow our business, which could adversely affect our results of operations, financial condition and business

Continued expansion could put significant strain on our management, operational and financial resources. The need to comply with the rules and regulations of the SEC will continue to place significant demands on our financial and accounting staff, financial, accounting and information systems, and our internal controls and procedures, any of which may not be adequate to support our anticipated growth. We may not be able to effectively hire, train, retain, motivate and manage required personnel. Our failure to manage growth effectively could limit our ability to satisfy our reporting obligations, or achieve our marketing, commercialization and financial goals. Recent actions to reduce costs and streamline our operations, as well as planned future cost reductions, could place further demands on our personnel, which could hinder our ability to effectively execute on our business strategies.

We will need additional funding, and we cannot guarantee that we will find adequate sources of capital in the future

We have incurred negative cash flows from operations since inception and have expended, and expect to continue to expend, substantial funds to grow our business. We currently estimate that our existing cash, cash equivalents and marketable securities will not be sufficient to fund our operating expenses and capital requirements through November 2010. We will require additional funds before we achieve positive cash flows and we may never become cash flow positive.

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If we raise additional funds by issuing equity securities, such financing will result in further dilution to our stockholders. Any equity securities issued also may provide for rights, preferences or privileges senior to those of holders of our common stock. If we raise additional funds by issuing additional debt securities, these debt securities would have rights, preferences and privileges senior to those of holders of our common stock, and the terms of the debt securities issued could impose significant restrictions on our operations. If we raise additional funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our technology or products, or to grant licenses on terms that are not favorable to us.

We do not know whether additional financing will be available on commercially acceptable terms, or at all. If adequate funds are not available or are not available on commercially acceptable terms, we may need to continue to downsize, curtail program development efforts or halt our operations altogether.

Our treatment programs may not be as effective as we believe them to be, which could limit our revenue growth

Our belief in the efficacy of our Catasys solution and PROMETA Treatment Program is based on a limited number of studies and commercial pilots that have been conducted to date and our initial experience with a relatively small number of patients. Such results may not be statistically significant, have not been subjected to close scientific scrutiny, and may not be indicative of the long-term future performance and safety of treatment with our programs. Controlled scientific studies, including those in process, may yield results that are unfavorable or demonstrate that treatment with our programs is not clinically effective or safe. If the initially indicated results cannot be successfully replicated or maintained over time, utilization of our programs could decline substantially. Our success is dependent on our ability to enroll third-party payor members in our Catasys programs. Large scale outreach and enrollment efforts have not been conducted and we may not be able to achieve the anticipated enrollment rates.

Our Catasys Program or PROMETA Treatment Program may not become widely accepted, which could limit our growth

Further marketplace acceptance of our treatment programs may largely depend upon healthcare providers’ and third-party payors’ interpretation of our limited data, the results of studies, pilots and programs, including financial and clinical outcome data from our Catasys Programs, or upon reviews and reports that may be given by independent researchers or other clinicians. In the event such research does not establish our treatment programs to be safe and effective, it is unlikely we will be able to achieve widespread market acceptance.

In addition, our ability to achieve further marketplace acceptance for our Catasys Program may be dependent on our ability to contract with a sufficient number of third party payors to and demonstrate financial and clinical outcomes from those agreements. If we are unable to secure sufficient contracts to achieve recognition of acceptance of our Catasys program or if our program does not demonstrate the expected level of clinical improvement and cost savings it is unlikely we will be able to achieve widespread market acceptance.

Disappointing results for our PROMETA Treatment Program or Catasys Program, or failure to attain our publicly disclosed milestones, could adversely affect market acceptance and have a material adverse effect on our stock price

There are several studies, evaluations and pilot programs that have been completed, or are currently in progress, that are evaluating our PROMETA Treatment Program and the Catasys Program. Some results have been published and we expect results to become available and/or published over time. Disappointing results, later-than-expected press release announcements or termination of evaluations, pilot programs or commercial programs could have a material adverse effect on the commercial acceptance of the PROMETA Treatment Program, our stock price and on our results of operations. In addition, announcements regarding results, or anticipation of results, may increase volatility in our stock price. In addition to numerous upcoming milestones, from time to time we provide financial guidance and other forecasts to the market. While we believe that the assumptions underlying projections and forecasts we make publicly available are reasonable, projections and forecasts are inherently subject to numerous risks and uncertainties. Any failure to achieve milestones, or to do so in a timely manner, or to achieve publicly announced guidance and forecasts, could have a material adverse effect on our results of operations and the price of our common stock.

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Our industry is highly competitive, and we may not be able to compete successfully

The healthcare business, in general, and the substance dependence treatment business in particular, are highly competitive. We compete with many types of substance dependence treatment methods, treatment facilities and other service providers, many of whom are more established and better funded than we are. Many of these other treatment methods and facilities are well established in the same markets we target, have substantial sales volume, and are provided and marketed by companies with much greater financial resources, facilities, organization, reputation and experience than we have. The historical focus on the use of psychological or behavioral therapies, as opposed to medical or physiological treatments for substance dependence, may create further resistance to penetrating the substance dependence treatment market.

There are a number of companies developing or marketing medications for reducing craving in the treatment of alcoholism, including:

●

the addiction medication naltrexone, an opiate receptor antagonist, is marketed by a number of generic pharmaceutical companies as well as under the trade names ReVia® and Depade®, for treatment of alcohol dependence;

●

VIVITROL®, an extended release formulation of naltrexone manufactured by Alkermes, administered via monthly injections for the treatment of alcohol dependence in patients who are able to abstain from drinking in an outpatient setting, and are not actively drinking prior to treatment initiation. Alkermes reported that in clinical trials, when used in combination with psychosocial support, VIVITROL was shown to reduce the number of drinking days and heavy drinking days and to prolong abstinence in patients who abstained from alcohol the week prior to starting treatment;

●

Campral® Delayed-Release Tablets (acamprosate calcium), an NMDA receptor antagonist taken two to three times per day on a chronic or long-term basis and marketed by Forest Laboratories. Clinical studies supported the effectiveness in the maintenance of abstinence for alcohol-dependent patients who had undergone inpatient detoxification and were already abstinent from alcohol; and

●

Tropiramate (Topamax®), a drug manufactured by Ortho-McNeill Jannssen, which is approved for the treatment of seizures. A multi-site clinical trial reported in October 2007 found that tropiramate significantly reduced heavy drinking days in alcohol-dependent individuals.

Our competitors may develop and introduce new processes and products that are equal or superior to our programs in treating alcohol and substance dependencies. Accordingly, we may be adversely affected by any new processes and technology developed by our competitors.

There are approximately 13,500 facilities reporting to the Substance Abuse and Mental Health Services Administration that provide substance abuse treatment on an inpatient or outpatient basis. Well known examples of residential treatment programs include the Betty Ford Center®, Caron Foundation®, Hazelden® and Sierra Tucson®. In addition, individual physicians may provide substance dependence treatment in the course of their practices. While we believe our products and services are unique, we operate in highly competitive markets. We compete with other healthcare management service organizations and disease management companies, including MBHOs, HMOs, PPOs, third-party administrators and other specialty healthcare and managed care companies. Most of our competitors are significantly larger and have greater financial, marketing and other resources than us. We believe that our ability to offer customers a comprehensive and integrated substance dependence solution, including the utilization of innovative medical and psychosocial treatments, and our unique technology platform will enable us to compete effectively. However, there can be no assurance that we will not encounter more effective competition in the future, which would limit our ability to maintain or increase our business.

We depend on key personnel, the loss of which could impact the ability to manage our business

Our future success depends on the performance of our senior management, in particular our chairman and chief executive officer, Terren S. Peizer, president and chief operating officer, Richard A. Anderson, senior vice president and global head scientific affairs, Gary Ingenito, M.D., PhD., and senior vice president of sales and marketing, Greg McLane.

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The loss of the services of any key member of management could have a material adverse effect on our ability to manage our business.

We may be subject to future litigation, which could result in substantial liabilities that may exceed our insurance coverage

All significant medical treatments and procedures, including treatment utilizing our programs, involve the risk of serious injury or death. Even under proper medical supervision, withdrawal from alcohol may cause severe physical reactions. While we have not been the subject of any such claims, our business entails an inherent risk of claims for personal injuries and substantial damage awards. We cannot control whether individual physicians will apply the appropriate standard of care, or conform to our treatment programs in determining how to treat their patients. While our agreements typically require physicians to indemnify us for their negligence, there can be no assurance they will be willing and financially able to do so if claims are made. In addition, our license agreements require us to indemnify physicians, hospitals or their affiliates for losses resulting from our negligence.

We currently have insurance coverage for up to $5 million per year, in the aggregate, for personal injury claims. We maintain directors’ and officers’ liability insurance coverage, subject to a self insured retention of $0 to $250,000 per claim, and errors and omissions insurance. We may not be able to maintain adequate liability insurance at acceptable costs or on favorable terms. We expect that liability insurance will be more difficult to obtain and that premiums will increase over time and as the volume of patients treated with our programs increases. In the event of litigation, we may sustain significant damages or settlement expense (regardless of a claim's merit), litigation expense and significant harm to our reputation.

If third-party payors fail to provide coverage and adequate payment rates for our programs, our revenue and prospects for profitability will be harmed

Our future revenue growth will depend in part upon our ability to contract with third-party payors, such as self-insured employers, insurance plans and unions for our Catasys program. To date, we have received an insignificant amount of revenue from our Catasys substance dependence programs from managed care organizations and other third-party payors, and acceptance of our Catasys substance dependence programs is critical to the future prospects of our business. In addition, third-party payors are increasingly attempting to contain healthcare costs, and may not cover or provide adequate payment for treatment using our programs. Adequate third-party reimbursement might not be available to enable us to realize an appropriate return on investment in research and product development, and the lack of such reimbursement could have a material adverse effect on our operations and could adversely affect our revenues and earnings.

We may not be able to achieve promised savings for our Catasys contracts, which could result in pricing levels insufficient to cover our costs or ensure profitability

We anticipate that many or all of our Catasys contracts will be based upon anticipated or guaranteed levels of savings for our customers and achieving other operational metrics resulting in incentive fees based on savings. If we are unable to meet or exceed promised savings or achieve agreed upon operational metrics, or favorably resolve contract billing and interpretation issues with our customers, we may be required to refund from the amount of fees paid to us any difference between savings that were guaranteed and the savings, if any, which were actually achieved; or we may fail to earn incentive fees based on savings. Accordingly, during or at the end of the contract terms, we may be required to refund some or all of the fees paid for our services. This exposes us to significant risk that contracts negotiated and entered into may ultimately be unprofitable. In addition, managed care operations are at risk for costs incurred to provide agreed upon services under our program. Therefore, failure to anticipate or control costs could have materially adverse effects on our business.

Our prior international operations may be subject to foreign regulation

The criteria of foreign laws, regulations and requirements are often vague and subject to change and interpretation. Our prior international operations may become the subject of foreign regulatory, civil, criminal or other investigations or proceedings, and our interpretations of applicable laws and regulations may be challenged. The defense of any such challenge could result in substantial cost and a diversion of management’s time and attention, regardless of whether it ultimately is successful. If we fail to comply with any applicable international

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laws, or a determination is made that we have failed to comply with these laws, our financial condition and results of operations could be adversely affected.

Our ability to utilize net operating loss carryforwards may be limited

As of December 31, 2009, we had net operating loss carryforwards (NOLs) of approximately $140.7 million for federal income tax purposes that will begin to expire in 2023. These NOLs may be used to offset future taxable income, to the extent we generate any taxable income, and thereby reduce or eliminate our future federal income taxes otherwise payable. Section 382 of the Internal Revenue Code imposes limitations on a corporation's ability to utilize NOLs if it experiences an ownership change as defined in Section 382. In general terms, an ownership change may result from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percent over a three-year period. In the event that an ownership change has occurred, or were to occur, utilization of our NOLs would be subject to an annual limitation under Section 382 determined by multiplying the value of our stock at the time of the ownership change by the applicable long-term tax-exempt rate as defined in the Internal Revenue Code. Any unused annual limitation may be carried over to later years. We may be found to have experienced an ownership change under Section 382 as a result of events in the past or the issuance of shares of common stock upon a conversion of notes, or a combination thereof. If so, the use of our NOLs, or a portion thereof, against our future taxable income may be subject to an annual limitation under Section 382, which may result in expiration of a portion of our NOLs before utilization.

Risks related to our intellectual property

We may not be able to adequately protect the proprietary PROMETA Treatment Program which is important to our business

We consider the protection of our proprietary PROMETA Treatment Program to be critical to our business prospects. We obtained the rights to some of our most significant PROMETA technologies through an agreement that is subject to a number of conditions and restrictions, and a breach or termination of that agreement or the bankruptcy of any party to that agreement could significantly impact our ability to use and develop our technologies. While we have two issued U.S. patents, one relating to the treatment of cocaine dependency with our PROMETA Treatment Program and one relating to our PROMETA Treatment Program for the treatment of certain symptoms associated with alcohol dependency, we currently have no issued U.S. patents covering our PROMETA Treatment Program for the treatment of methamphetamine dependency. The patent applications we have licensed or filed may not issue as patents, and any issued patents may be too narrow in scope to provide us with a competitive advantage. Our patent position is uncertain and includes complex factual and legal issues, including the existence of prior art that may preclude or limit the scope of patent protection. Issued patents will generally expire twenty years after their priority date. Our two issued U.S. patents will expire in 2021. Further, our patents and pending applications for patents and other intellectual property have been pledged as collateral to secure our obligations to pay certain debts, and our default with respect to those obligations could result in the transfer of our patents to our creditor. In the event of such a transfer, we may be unable to continue to operate our business.

Patent examiners may reject our patent applications and thereby prevent us from receiving more patents. Competitors, licensees and others may challenge our patents and, if successful, our patents may be denied, subjected to reexamination, rendered unenforceable, or invalidated. We may not be able to adequately protect the aspects of our treatment programs that are not patented or have only limited patent protection. Furthermore, competitors and others may independently develop similar or more advanced treatment programs and technologies, may design around aspects of our technology, or may discover or duplicate our trade secrets and proprietary methods. The cost of litigation to uphold the validity of patents, and to protect and prevent infringement can be substantial.

To the extent we utilize processes and technology that constitute trade secrets under applicable laws, we must implement appropriate levels of security to ensure protection of such laws, which we may not do effectively. Policing compliance with our confidentiality agreements and unauthorized use of our technology is difficult. In addition, the laws of many foreign countries do not protect proprietary rights as fully as the laws of the United States. The loss of any of our trade secrets or proprietary rights which may be protected under the foregoing intellectual property safeguards may result in the loss of our competitive advantage over present and potential

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competitors. Our intellectual property may not prove to be an effective barrier to competition, in which case our business could be materially adversely affected.

Our pending patent applications disclose and claim various approaches to the use of the PROMETA Treatment Program. There is no assurance that we will receive one or more patents from these pending applications, or that, even if we receive one or more patents, the patent claims will be sufficiently broad to create patent infringement liability for competitors using treatment programs similar to the PROMETA Treatment Program.

Confidentiality agreements with employees, licensees and others may not adequately prevent disclosure of trade secrets and other proprietary information

In order to protect our proprietary technology and processes, we rely in part on confidentiality provisions in our agreements with employees, licensees, treating physicians and others. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover trade secrets and proprietary information. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position. We have had several instances in which it was necessary to send a formal demand to cease and desist using our programs to treat patients due to breach of confidentiality provisions in our agreements, and in one instance have had to file suit to enforce these provisions.

We may be subject to claims that we infringe the intellectual property rights of others, and unfavorable outcomes could harm our business

Our future operations may be subject to claims, and potential litigation, arising from our alleged infringement of patents, trade secrets or copyrights owned by other third parties. Within the healthcare, drug and bio-technology industry, many companies actively pursue infringement claims and litigation, which makes the entry of competitive products more difficult. We may experience claims or litigation initiated by existing, better-funded competitors and by other third parties. Court-ordered injunctions may prevent us from continuing to market existing products or from bringing new products to market and the outcome of litigation and any resulting loss of revenues and expenses of litigation may substantially affect our ability to meet our expenses and continue operations.

Risks related to our industry

The recently enacted healthcare reforms pose risks and uncertainties that may have a material adverse affect on our business.

There may be risks and uncertainties arising from the recently enacted healthcare reform and the implementing regulations that will be issued in the future. If we fail to comply with these laws or are unable to deal with these risks and uncertainties in an effective manner, our financial condition and results of operations could be adversely affected.

Our policies and procedures may not fully comply with complex and increasing regulation by state and federal authorities, which could negatively impact our business operations

Our PROMETA Treatment Program has not been approved by the Food and Drug Administration (FDA), and while the drugs incorporated in the PROMETA Treatment Program have been approved for other indications, they are not FDA approved for the treatment of alcohol or substance dependency. We have not sought, and do not currently intend to seek, FDA approval for the PROMETA Treatment Program. It is possible that in the future the FDA could require us to seek FDA approval for the PROMETA Treatment Program.

The healthcare industry is highly regulated and continues to undergo significant changes as third-party payors, such as Medicare and Medicaid, traditional indemnity insurers, managed care organizations and other private payors increase efforts to control cost, utilization and delivery of healthcare services. Healthcare companies are subject to extensive and complex federal, state and local laws, regulations and judicial decisions. The U.S. Congress and state legislatures are considering legislation that could limit funding to our licensees. In addition, the FDA regulates development, testing, labeling, manufacturing, marketing, promotion, distribution, record-keeping and reporting

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requirements for prescription drugs, medical devices and biologics. Other regulatory requirements apply to dietary supplements, including vitamins. Compliance with laws and regulations enforced by regulatory agencies that have broad discretion in applying them may be required for our programs or other medical programs or services developed or used by us. Many healthcare laws and regulations applicable to our business are complex, applied broadly and subject to interpretation by courts and government agencies. Regulatory, political and legal action and pricing pressures could prevent us from marketing some or all of our products and services for a period of time or permanently. Our failure, or the failure of our licensees, to comply with applicable regulations may result in the imposition of civil or criminal sanctions that we cannot afford, or require redesign or withdrawal of our programs from the market.

We may be subject to regulatory, enforcement and investigative proceedings, which could adversely affect our financial condition or operations

We could become the subject of regulatory, enforcement, or other investigations or proceedings, and our relationships, business structure, and interpretations of applicable laws and regulations may be challenged. The defense of any such challenge could result in substantial cost and a diversion of management’s time and attention. In addition, any such challenges could require significant changes to how we conduct our business. Any such challenge could have a material adverse effect on our business, regardless of whether it ultimately is successful. If determination is made that we have failed to comply with any applicable laws, our business, financial condition and results of operations could be adversely affected.

The promotion of our treatment programs may be found to violate federal law concerning off-label uses of prescription drugs, which could prevent us from marketing our programs

Generally, the Food, Drug, and Cosmetic (FDC) Act, requires that a prescription drug be approved by the FDA for a specific indication before the product can be distributed in interstate commerce. Although the FDC Act does not prohibit a doctor’s use of a drug for another indication (this is referred to as off-label use), it does prohibit the promotion of a drug product for an unapproved use. The FDA also permits the non-promotional discussion of information related to off-label use in the context of scientific or medical communications. Our treatment programs include the use of prescription drugs that have been approved by the FDA, but not for the treatment of chemical dependence and drug addiction, which is how the drugs are used in our programs. Although we carefully structure our communications in a way that is intended to comply with the FDC Act and FDA regulations, it is possible that our actions could be found to violate the prohibition on off-label promotion of drugs. In addition, the FDC Act imposes limits on the types of claims that may be made for a dietary supplement, and the promotion of a dietary supplement beyond such claims may also be seen as the unlawful promotion of a drug product for an unapproved use. Because our treatment programs also include the use of nutritional supplements, it is possible that claims made for those products could also put us at risk of FDA enforcement for making unlawful claims.

Violations of the FDC Act or FDA regulations can result in a range of sanctions, including administrative actions by the FDA (such as issuance of a Warning Letter), seizure of product, issuance of an injunction prohibiting future violations, and imposition of criminal or civil penalties. A successful enforcement action could prevent promotion of our treatment programs and we may be unable to continue operating under our current business model. Even if we defeat an enforcement action, the expenses associated with doing so, as well as the negative publicity concerning the “off-label” use of drugs in our treatment programs, could adversely affect our business and results of operation.

The FDA has recently increased enforcement efforts in the area of promotion of “off-label” use of drugs, and we cannot assure you that our business practices or third party clinical trials will not come under scrutiny.

Treatment using our programs may be found to require FDA or other review or approval, which could delay or prevent the study or use of our treatment programs

Under authority of the FDC Act, the FDA extensively regulates entities and individuals engaged in the conduct of clinical trials, which broadly includes experiments in which a drug is administered to humans. FDA regulations require, among other things, submission of a clinical trial treatment program for FDA review, obtaining from the agency an investigational new drug (IND) exemption before initiating a clinical trial, obtaining appropriate informed consent from study subjects, having the study approved and subject to continuing review by an Institutional Review

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Board (IRB), and reporting to FDA safety information regarding the conduct of the trial. Certain third parties have engaged or are engaging in the use of our treatment program and the collection of outcomes data in ways that may be considered to constitute a clinical trial, and that may be subject to FDA regulations and require IRB approval and oversight. In addition, it is possible that use of our treatment program by individual physicians in treating their patients may be found to constitute a clinical trial or investigation that requires IRB review or submission of an IND or is otherwise subject to regulation by FDA. The FDA has authority to inspect clinical investigation sites and IRBs, and to take action with regard to any violations. Violations of FDA regulations regarding clinical trials can result in a range of actions, including suspension of the trial, prohibiting the clinical investigator from ever participating in clinical trials, and criminal prosecution. Individual hospitals and physicians may also submit their use of our treatment programs to their IRBs, which may prohibit or place restrictions on it. FDA enforcement actions or IRB restrictions could adversely affect our business and the ability of our customers to use our treatment programs.

The FDA has recently increased enforcement efforts regarding clinical trials, and we cannot assure you that the activities of our customers or others using our treatment programs will not come under scrutiny.

Failure to comply with FTC or similar state laws could result in sanctions or limit the claims we can make

Our promotional activities and materials, including advertising to consumers and professionals, and materials provided to licensees for their use in promoting our treatment programs, are regulated by the Federal Trade Commission (FTC) under the FTC Act, which prohibits unfair and deceptive acts and practices, including claims which are false, misleading or inadequately substantiated. The FTC typically requires competent and reliable scientific tests or studies to substantiate express or implied claims that a product or service is safe or effective. If the FTC were to interpret our promotional materials as making express or implied claims that our treatment programs are safe or effective for the treatment of alcohol, cocaine or methamphetamine addiction, or any other claims, it may find that we do not have adequate substantiation for such claims. Allegations of a failure to comply with the FTC Act or similar laws enforced by state attorneys general and other state and local officials could result in administrative or judicial orders limiting or eliminating the claims we can make about our treatment programs, and other sanctions including substantial financial penalties.

Our business practices may be found to constitute illegal fee-splitting or corporate practice of medicine, which may lead to penalties and adversely affect our business

Many states, including California in which our principal executive offices and our managed treatment center is located, have laws that prohibit business corporations, such as us, from practicing medicine, exercising control over medical judgments or decisions of physicians, or engaging in arrangements with physicians such as employment, payment for referrals or fee-splitting. Courts, regulatory authorities or other parties, including physicians, may assert that we are engaged in the unlawful corporate practice of medicine by providing administrative and other services in connection with our treatment programs or by consolidating the revenues of the physician practices we manage, or that licensing our technology for a license fee that could be characterized as a portion of the patient fees, or subleasing space and providing turn-key business management to affiliated medical groups in exchange for management and licensing fees, constitute improper fee-splitting or payment for referrals, in which case we could be subject to civil and criminal penalties, our contracts could be found invalid and unenforceable, in whole or in part, or we could be required to restructure our contractual arrangements. If so, we may be unable to restructure our contractual arrangements on favorable terms, which would adversely affect our business and operations.

Our business practices may be found to violate anti-kickback, physician self-referral or false claims laws, which may lead to penalties and adversely affect our business

The healthcare industry is subject to extensive federal and state regulation with respect to financial relationships and kickbacks involving healthcare providers, physician self-referral arrangements, filing of false claims and other fraud and abuse issues. Federal anti-kickback laws and regulations prohibit offers, payments, solicitations, or receipts of remuneration in return for (i) referring patients for items or services covered by Medicare, Medicaid or other federal healthcare programs, or (ii) purchasing, leasing, ordering or arranging for or recommending any service, good, item or facility for which payment may be made by a federal health care program. In addition, subject to numerous exceptions, federal physician self-referral legislation, commonly known as the Stark law, generally prohibits a physician from referring patients for certain designated health services reimbursable by Medicare or Medicaid from any entity with which the physician has a financial relationship, and many states have analogous

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laws. Other federal and state laws govern the submission of claims for reimbursement, or false claims laws. One of the most prominent of these laws is the federal Civil False Claims Act, and violations of other laws, such as the federal anti-kickback law or the FDA prohibitions against promotion of off-label uses of drugs, may also be prosecuted as violations of the Civil False Claims Act. Federal or state authorities may claim that our fee arrangements, agreements and relationships with contractors, hospitals and physicians violate these laws and regulations. Violations of these laws may be punishable by monetary fines, civil and criminal penalties, exclusion from participation in government-sponsored healthcare programs and forfeiture of amounts collected in violation of such laws. If our business practices are found to violate any of these provisions, we may be unable to continue with our relationships or implement our business plans, which would have an adverse effect on our business and results of operations.

We may be subject to healthcare anti-fraud initiatives, which may lead to penalties and adversely affect our business

State and federal governments are devoting increased attention and resources to anti-fraud initiatives against healthcare providers, and may take an expansive definition of fraud that includes receiving fees in connection with a healthcare business that is found to violate any of the complex regulations described above. While to our knowledge we have not been the subject of any anti-fraud investigations, if such a claim were made defending our business practices could be time consuming and expensive, and an adverse finding could result in substantial penalties or require us to restructure our operations, which we may not be able to do successfully.

Our use and disclosure of patient information is subject to privacy and security regulations, which may result in increased costs

In conducting research or providing administrative services to healthcare providers in connection with the use of our treatment programs, we may collect, use, disclose, maintain and transmit patient information in ways that will be subject to many of the numerous state, federal and international laws and regulations governing the collection, use, disclosure, storage, transmission and/or confidentiality of patient-identifiable health information, including the administrative simplification requirements of the Health Insurance Portability and Accountability Act of 1996 and its implementing regulations (HIPAA) and the Health Information Technology for Economic and Clinical Health Act of 2009 (HITECH). The HIPAA Privacy Rule restricts the use and disclosure of patient information, and requires safeguarding that information. The HIPAA Security Rule and HITECH establish elaborate requirements for safeguarding patient information transmitted or stored electronically. HIPAA applies to covered entities, which may include healthcare facilities and does include health plans that will contract for the use of our programs and our services. The HIPAA and HITECH rules require covered entities to bind contractors like us to compliance with certain burdensome HIPAA rule requirements known as business associate requirements and data security provision and reporting requirements. If we are providing management services that include electronic billing on behalf of a physician practice or facility that is a covered entity, we may be required to conduct those electronic transactions in accordance with the HIPAA and HITECH regulations governing the form and format of those transactions. Services provided under our Catasys program also require us to comply with HIPAA, HITECH, Title 42 of the Code of Federal Regulations, which governs the confidentiality of certain patient identified drug and alcohol information, and other privacy and security regulations. Other federal and state laws restricting the use and protecting the privacy and security of patient information also apply to our licensees directly and in some cases to us, either directly or indirectly. We may be required to make costly system purchases and modifications to comply with the HIPAA and HITECH rule requirements that are imposed on us and our failure to comply may result in liability and adversely affect our business. Our failure to comply with the applicable regulations may result in imposition of civil or criminal sanctions that we cannot afford, or require redesign or withdrawal of our programs from the market.

Federal and state consumer protection laws are being applied increasingly by the FTC and state attorneys general to regulate the collection, use, storage, and disclosure of personal or patient information, through web sites or otherwise, and to regulate the presentation of web site content. Courts may also adopt the standards for fair information practices promulgated by the FTC, which concern consumer notice, choice, security and access. Numerous other federal and state laws protect the confidentiality and security of personal and patient information. Other countries also have, or are developing laws governing the collection, use, disclosure and transmission of personal or patient information and these laws could create liability for us or increase our cost of doing business.

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Our business arrangements with health care providers may be deemed to be franchises, which could negatively impact our business operations

Franchise arrangements in the United States are subject to rules and regulations of the FTC and various state laws relating to the offer and sale of franchises. A number of the states in which we operate regulate the sale of franchises and require registration of the franchise offering circular with state authorities and the delivery of a franchise offering circular to prospective franchisees. State franchise laws often limit, among other things, the duration and scope of non-competitive provisions, the ability of a franchisor to terminate or refuse to renew a franchise and the ability of a franchisor to designate sources of supply. Franchise laws and regulations are complex, apply broadly and are subject to interpretation by courts and government agencies. Federal or state authorities or healthcare providers with whom we contract may claim that the agreements under which we license rights to our technology and trademarks and provide services violate these laws and regulations. Violations of these laws are punishable by monetary fines, civil and criminal penalties, and forfeiture of amounts collected in violation of such laws. If our business practices are found to constitute franchises, we could be subject to civil and criminal penalties, our contracts could be found invalid and unenforceable, in whole or in part, or we could be required to restructure our contractual arrangements. We may be unable to continue with our relationships or restructure them on favorable terms, which would have an adverse effect on our business and results of operations. We may also be required to furnish prospective franchisees with a franchise offering circular containing prescribed information, and restrict how we market to or deal with healthcare providers, potentially limiting and substantially increasing our cost of doing business.

Certain of our professional healthcare employees, such as nurses, must comply with individual licensing requirements

All of our healthcare professionals who are subject to licensing requirements, such as our care coaches, are licensed in the state in which they are physically present. Multiple state licensing requirements for healthcare professionals who provide services telephonically over state lines may require us to license some of our healthcare professionals in more than one state. New and evolving agency interpretations, federal or state legislation or regulations, or judicial decisions could increase the requirement for multi-state licensing of all call center health professionals, which would increase our costs of services.

Risks related to our common stock

Delisting from The NASDAQ Stock Market has negatively affected the liquidity of our stock, subjected us to the “penny stock” rules making our stock more difficult to sell, and it may become increasingly more difficult to obtain accurate quotations of our common stock and it may become increasingly more difficult to find buyers to purchase our shares or market makers to support the stock price. The stock price immediately declined in value upon the open of business on Friday, February 26, 2010, when quoted on the Over The Counter (OTC) Bulletin Board for the first time and the stock price may decline further if these difficulties are realized.

As previously reported in Current Reports on Form 8-K filed on May 19, 2009, August 28, 2009, September 21, 2009 and December 1, 2009, we failed to comply with various listing requirements of The NASDAQ Stock Market. We disclosed we had received a letter from NASDAQ granting our request to remain listed on NASDAQ subject to the condition that, on or before February 24, 2010, we evidence stockholders’ equity of at least $10 million or achieve a market value of its listed securities of at least $50 million. On February 23, 2010, we notified NASDAQ of our inability to comply with the conditions set forth in the letter referenced above. On February 24, 2010, we received a letter from The NASDAQ Stock Market notifying us that we failed to meet its minimum stockholders’ equity of $2.5 million. The letter indicated that our stock will be suspended from trading on NASDAQ effective at the open of business on Friday, February 26, 2010. We did not and do not intend to appeal NASDAQ’s decision. We received notification from FINRA that our common stock will be quoted on the OTC Bulletin Board beginning Friday, February 26, 2010. We intend to continue filing periodic reports with the Securities Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended.

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Failure to maintain effective internal controls could adversely affect our operating results and the market for our common stock

Section 404 of the Sarbanes-Oxley Act of 2002 requires that we maintain internal control over financial reporting that meets applicable standards. We recently concluded that certain of our internal controls and procedures were inadequate. While we believe we have remediated this issue, as with many smaller companies with small staff, other material weaknesses in our financial controls and procedures may be discovered. If we are unable, or are perceived as unable, to produce reliable financial reports due to internal control deficiencies, investors could lose confidence in our reported financial information and operating results, which could result in a negative market reaction and adversely affect our ability to raise capital.

Approximately 19.2% of our stock is controlled by our chairman and chief executive officer, who has the ability to substantially influence the election of directors and other matters submitted to stockholders

Reserva Capital, LLC and Bonmore, LLC, whose sole managing member is our chairman and chief executive officer, beneficially own 13,600,000 shares of our common stock, which represent 16.7% of our 81,423,631 shares outstanding as of July 31, 2010. As a result, he has and is expected to continue to have the ability to significantly influence the election of our Board of Directors and the outcome of all other issues submitted to our stockholders. The interests of these principal stockholders may not always coincide with our interests or the interests of other stockholders, and they may act in a manner that advances his best interests and not necessarily those of other stockholders. One consequence to this substantial influence or control is that it may be difficult for investors to remove management of the company. It could also deter unsolicited takeovers, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices.

Our stock price may be subject to substantial volatility, and the value of your investment may decline

Effective at the open of business on Friday, February 26, 2010, our securities were delisted from The NASDAQ Stock Market and trading in our shares was suspended The market price of our common stock has experienced downward price pressure as a result, and substantial volatility. As a result, the current price for our common stock as quoted on the OTC Bulletin Board is a less reliable indicator of our fair market value. The price at which our common stock will trade may fluctuate as a result of a number of factors, including the number of shares available for sale in the market, quarterly variations in our operating results and actual or anticipated announcements of pilots and scientific studies of the effectiveness of our PROMETA Treatment Program, our Catasys Program, announcements regarding new or discontinued Catasys Program contracts, new products or services by us or competitors, regulatory investigations or determinations, acquisitions or strategic alliances by us or our competitors, recruitment or departures of key personnel, the gain or loss of significant customers, changes in the estimates of our operating performance, actual or threatened litigation, market conditions in our industry and the economy as a whole.

Volatility in the price of our common stock on the OTC Bulletin Board may depress the trading price of our common stock. The risk of volatility and depressed prices of our common stock also applies to warrant holders who receive shares of common stock upon conversion.

Numerous factors, including many over which we have no control, may have a significant impact on the market price of our common stock, including:

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announcements of new products or services by us or our competitors; current events affecting the political, economic and social situation in the United States and other countries where we operate;

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trends in our industry and the markets in which we operate;

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changes in financial estimates and recommendations by securities analysts;

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acquisitions and financings by us or our competitors;

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the gain or loss of a significant customer;

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quarterly variations in operating results;

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volatility in rates of exchanges between the US dollar and the currencies of the foreign countries in which we operate;

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the operating and stock price performance of other companies that investors may consider to be comparable;

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purchases or sales of blocks of our securities; and

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issuances of stock.

Furthermore, stockholders may initiate securities class action lawsuits if the market price of our stock drops significantly, which may cause us to incur substantial costs and could divert the time and attention of our management.

Future sales of common stock by existing stockholders, or the perception that such sales may occur, could depress our stock price

The market price of our common stock could decline as a result of sales by, or the perceived possibility of sales by, our existing stockholders. We have completed a number of private placements of our common stock and other securities over the last several years, and we have effective resale registration statements pursuant to which the purchasers can freely resell their shares into the market. In addition, most of our outstanding shares are eligible for public resale pursuant to Rule 144 under the Securities Act of 1933, as amended. Approximately 15 million shares of our common stock are currently held by our affiliates and may be sold pursuant to an effective registration statement or in accordance with the volume and other limitations of Rule 144 or pursuant to other exempt transactions. Future sales of common stock by significant stockholders, including those who acquired their shares in private placements or who are affiliates, or the perception that such sales may occur, could depress the price of our common stock.

Future issuances of common stock and hedging activities may depress the trading price of our common stock

Any future issuance of equity securities, including the issuance of shares upon direct registration, upon satisfaction of our obligations, compensation of vendors, exercise of outstanding warrants, could dilute the interests of our existing stockholders, and could substantially decrease the trading price of our common stock. We currently have outstanding approximately 11.2 million options and 14.9 million warrants to acquire our common stock at prices between $0.20 and $8.00 per share. We may issue equity securities in the future for a number of reasons, including to finance our operations and business strategy, in connection with acquisitions, to adjust our ratio of debt to equity, to satisfy our obligations upon the exercise of outstanding warrants or options or for other reasons.

Provisions in our certificate of incorporation, bylaws, charter documents and Delaware law could discourage a change in control, or an acquisition of us by a third party, even if the acquisition would be favorable to you, thereby and adversely affect existing stockholders

Our certificate of incorporation and the Delaware General Corporation Law contain provisions that may have the effect of making more difficult or delaying attempts by others to obtain control of our company, even when these attempts may be in the best interests of stockholders. For example, our certificate of incorporation also authorizes our Board of Directors, without stockholder approval, to issue one or more series of preferred stock, which could have voting and conversion rights that adversely affect or dilute the voting power of the holders of common stock. Delaware law also imposes conditions on certain business combination transactions with “interested stockholders.”

These provisions and others that could be adopted in the future could deter unsolicited takeovers or delay or prevent changes in our control or management, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices. These provisions may also limit the ability of stockholders to approve transactions that they may deem to be in their best interests.

We do not expect to pay dividends in the foreseeable future, and accordingly you must rely on stock appreciation for any return on your investment

We have paid no cash dividends on our common stock to date, and we currently intend to retain our future earnings, if any, to fund the continued development and growth of our business. As a result, we do not expect to pay any cash dividends in the foreseeable future. Further, any payment of cash dividends will also depend on our financial condition, results of operations, capital requirements and other factors, including contractual restrictions to which we may be subject, and will be at the discretion of our Board of Directors.

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You should understand that the following important factors, in addition to those referred to above could affect our future results and could cause those results to differ materially from those expressed in such forward-looking statements:

●	the anticipated results of clinical studies on our treatment programs, and the publication of those results in medical journals;

●	plans to have our treatment programs approved for reimbursement by third-party payers;

●	plans to license our treatment programs to more healthcare providers;

●	marketing plans to raise awareness of our PROMETA Treatment Program and Catasys treatment programs; and

●	anticipated trends and conditions in the industry in which we operate, including our future operating results, capital needs, and ability to obtain financing.

We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or any other reason. All subsequent forward-looking statements attributable to the Company or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to herein. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report may not occur.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The information set forth in Item 5. “Recent Sales of Unregistered Securities” in our Annual Report on form 10-K for the year ended December 31, 2009 is incorporated by reference.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Other Information

None.

Item 5. Exhibits

Exhibit 10.32		Lease Amendment No. 3 between Lincoln Holdings, LLC and Hythiam, Inc. dated July 27, 2010

Exhibit 31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.3		Certification of Chief Operating Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.3		Certification of Chief Operating Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURES

Pursuant to the requirements 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.

	HYTHIAM, INC.
Date: August 16, 2010	By:	/s/ TERREN S. PEIZER
		Terren S. Peizer
		Chief Executive Officer (Principal Executive Officer)


Date: August 16, 2010	By:	/s/ JOHN V. RIGALI
		John V. Rigali
		Chief Financial Officer (Principal Financial and Accounting Officer)


Date: August 16, 2010	By:	/s/ RICHARD A. ANDERSON
		Richard A. Anderson
		Chief Operating Officer

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Ontrak, Inc. Reports

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