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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

(Mark One)

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2014

or

 

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number: 333-175188

 

 

Capella Healthcare, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware		20-2767829
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
501 Corporate Centre Drive, Suite 200 Franklin, Tennessee		37067
(Address of principal executive offices)		(Zip Code)

(615) 764-3000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  x    No  ¨

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  ¨    No  x

(Note: As a voluntary filer not subject to the filing requirements of Sections 13 or 15(d) of the Exchange Act, the registrant has filed all reports pursuant to Section 13 or 15(d) of the Exchange Act during the preceding 12 months as if it were subject to such filing requirements.)

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  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

 

Large accelerated filer		¨		Accelerated filer		¨
Non-accelerated filer		x  (Do not check if a smaller reporting company)		Smaller reporting company		¨

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

None of the registrant’s common stock is held by non-affiliates.

As of March 27, 2015, the number of outstanding shares of the registrant’s common stock was 100.

 

 

 

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Table of Contents

Capella Healthcare, Inc.

TABLE OF CONTENTS

 

PART I
Item 1. Business			1
Item 1A. Risk Factors			21
Item 1B. Unresolved Staff Comments			32
Item 2. Properties			33
Item 3. Legal Proceedings			33
Item 4. Mine Safety Disclosures			34
PART II
Item  5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities			34
Item 6. Selected Financial Data			34
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations			37
Item 7A. Quantitative and Qualitative Disclosures About Market Risk			52
Item 8. Financial Statements and Supplementary Data			52
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			52
Item 9A. Controls and Procedures			52
Item 9B. Other Information			53
PART III
Item 10. Directors, Executive Officers and Corporate Governance			53
Item 11. Executive Compensation			56
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			61
Item 13. Certain Relationships and Related Transactions, and Director Independence			62
Item 14. Principal Accountant Fees and Services			64
PART IV
Item 15. Exhibits, Financial Statement Schedules			65
SIGNATURES
Exhibit Index

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PART I

 

Item 1.

Business.

Company Overview

Capella Healthcare, Inc., a Delaware corporation which was formed on April 15, 2005, is a provider of general and specialized acute care, outpatient and other medically necessary services in primarily non-urban communities. Unless otherwise noted or unless the context requires otherwise, the term “Capella” refers to Capella Healthcare, Inc. and the terms the “Company,” “we,” “us” and “our” refer to Capella and its consolidated subsidiaries. As of December 31, 2014, as part of continuing operations, we operated nine acute care hospitals (eight of which we own and one of which we lease pursuant to a long-term lease) comprised of 1,309 licensed beds in six states.

Our hospitals offer a broad range of general acute care services, including, but not limited to, internal medicine, general surgery, cardiology, oncology, orthopedics, women’s services, neurology and emergency services. In addition, our facilities also offer other specialized and ancillary services, including, for example, psychiatric, diagnostic, rehabilitation, home health and outpatient surgery.

In addition to providing capital resources, we make available a variety of management services and expertise to affiliated healthcare facilities. These services include ethics and compliance, group purchasing, accounting, financial, clinical systems, resource management, governmental reimbursement, information systems, legal, personnel management, internal audit and access to managed care networks.

We generated $658.6 million, $668.1 million and $713.4 million in revenue from continuing operations, net of the provision for bad debts, for the years ended December 31, 2012, 2013, and 2014, respectively.

Our mission is to provide high quality healthcare in the communities we serve and to provide services in an affordable and accessible manner in a patient-friendly environment. We also believe in partnering with communities to build strong local healthcare systems, especially communities that are either growing or are underserved. We invest our financial and operational resources to establish and support services that meet the needs of our communities. We seek to achieve our objectives by providing exceptional quality care to our patients, establishing strong local management teams, physician leadership groups and hospital boards, developing deep physician and employee relationships and working closely with our communities.

Availability of Information

The Company’s internet website address is www.capellahealth.com. The Company currently makes available free of charge on its website under “Investor Relations — SEC Filings” its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished as soon as reasonably practicable after the Company electronically files such materials with, or furnishes them to, the United States Securities and Exchange Commission (“SEC”).

Our Business Strategy

The key elements of our business strategy are:

Enhancing Quality of Care and Service Excellence

We place significant emphasis on consistently providing high quality patient care and service excellence. We seek to achieve this by continuously enhancing our programs and protocols through targeted investments in our employees, physicians, systems and strategic growth initiatives. We believe value-based purchasing initiatives of both governmental and private payors, such as linking payment for healthcare services to performance on objective quality measures, increasingly will become key drivers of financial performance. Examples of these initiatives include denying payment for avoidable hospital re-admissions and bundling payments for acute care services with physician or post-acute services. We believe our continued strategic investments to improve patient care excellence will prepare us to face the challenges and capitalize on the opportunities relating to the ever-changing, pay-for-performance environment. Some of our strategic initiatives in quality and service excellence include:

 

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Emergency Rooms. We embarked on a multi-year strategy to enhance quality and improve operating efficiencies in our emergency rooms. This strategy involves implementing process improvement initiatives, which are designed to improve patient experiences through more efficient utilization of resources.

 

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Local Physician Leadership Groups, or LPLGs. Our LPLGs are comprised of six to eight physician leaders and our hospital chief executive officer, or hospital CEO, in each of our hospitals. The groups (i) provide ongoing dialogue with hospital administration; (ii) help develop key clinical strategic initiatives for the hospital; and (iii) promote patient care excellence.

 

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Physician Advisory Group, or PAG. Our PAG is comprised of physician leaders across the Company. The group (i) provides clinical review and guidance related to information system design, build-out and workflow; (ii) advises us on physician communication and education; and (iii) identifies opportunities where technology can be used to improve clinical processes and outcomes.

 

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National Physician Leadership Group, or NPLG. Our NPLG is comprised of one member of each LPLG and Capella’s executive management team. The group (i) receives updates on the Company’s corporate strategy and vision; (ii) discusses quality of care issues and goals; (iii) promotes networking among Capella-affiliated physicians; (iv) offers advice on special projects where front line physician input is critical; and (v) allows members of the medical staff to have direct communication with members of Capella’s executive management team.

 

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Chief Medical Officer, or CMO. Our corporate CMO is responsible for facilitating the work of our NPLG, ensuring that physician leaders from across the Company are continuously involved in shaping our vision and future strategies. The CMO is also responsible for providing leadership for the quality and service excellence initiatives at each of our hospitals as well as for on-going communication with medical staff members.

 

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Training and Education. We provide a customized on-line learning center. We also work with an independent consulting group to provide training in the areas of improving patient care processes as well as employee, physician and patient satisfaction. We believe this is a critical element in emphasizing our philosophy that, if our employees and physicians enjoy where they work, and if they are intellectually stimulated, they will improve patient care excellence. We survey our physicians and our employees on an annual basis to identify objectives for quality and satisfaction improvement.

 

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Compensation. We base the incentive compensation for our hospital administrative teams in significant part on achieving key individual and facility quality and service metrics, such as performance on patient satisfaction surveys and other core measurements.

Investing in Technology to Improve Patient Care

We believe that investment in technology drives improvement in clinical outcomes and quality of patient care. The Health Information Technology for Economic and Clinical Health Act (the “HITECH Act”), which was enacted into law on February 17, 2009 as part of the American Recovery and Reinvestment Act of 2009 (the “ARRA”), includes provisions designed to increase the use of computerized physician order entry at hospitals and the use of electronic health records (“EHR”) by both physicians and hospitals. We believe that these systems improve quality, safety and clinical outcomes, and we intend to comply with all EHR meaningful use requirements of the HITECH Act.

Continued Physician Engagement and Alignment Initiatives

Our ability to meet the medical care needs of our communities and enhance and expand our services is highly dependent on our physician engagement strategies. We have a comprehensive recruiting program that is directed at the local level by our hospital CEOs and Boards of Trustees. We supplement our local teams with several third party recruiting firms to assist in identifying candidates that match the profile of our physician needs. We maintain a flexible approach to aligning our goals with our physician partners, including our willingness to recruit physicians through multi-year employment and/or income guarantee arrangements and to enter into other collaborative arrangements. As discussed above, our executive management team includes a CMO to assume leadership responsibility for facilitating the work of our NPLG in an effort to keep physician leaders across the Company continuously involved in shaping the Company’s vision and future strategies. In addition, we believe physicians are attracted to our hospitals because of several factors, including:

 

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our commitment to patient care excellence;

 

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our willingness to deploy strategic capital to improve the delivery of care;

 

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our focus on employing and developing high quality nursing and support staff; and

 

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our integration into, and support of, the communities we serve.

 

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Identifying and Establishing Strong Local Market Leadership

We empower our individual hospital management teams to develop comprehensive strategic plans that position their respective hospitals to meet the healthcare needs of the communities we serve. In addition to strong corporate oversight and resources, each of our local leadership teams is supported by a local Board of Trustees and a LPLG. The Board of Trustees is comprised of physicians and community leaders as well as the hospital CEO. We believe local community leaders are an important resource for our hospital CEOs to insure that we are being responsive to the needs of the communities we serve. Our LPLGs are typically comprised of local physician leaders as well as members of our hospital’s administration. These groups ensure that we are providing patient care excellence, offering the appropriate medical services, maintaining high quality employees and recruiting the best physicians to our medical staff. Our corporate office provides continuous operational, financial and human resources support to our local teams and has designed programs that allow us to share best practices across our entire portfolio of facilities.

Expanding the Services We Provide

Each year, we conduct in-depth strategic reviews at each of our facilities as well as market demand for additional services. We leverage our local market knowledge, together with input and guidance from our local physician and community leaders, to prioritize the healthcare services that our communities are seeking. We then initiate an assessment and develop an investment plan that supports the expansion of the appropriate services. Focus areas include:

 

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expanding specialty medical services, such as medical and radiation oncology, cardiovascular, orthopedic, neurology, behavioral health and women’s services;

 

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initiating and expanding outpatient services;

 

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investing in medical equipment and technology to support our service lines;

 

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improving our efficiency to deliver better quality care in our emergency rooms; and

 

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enhancing patient, physician and employee satisfaction.

We have engaged consultants and are working with our hospital CEOs to identify trends in service lines and areas for future expansion of services. We remain motivated to invest in our facilities in order to increase the quality and scope of services we provide, meet the needs of our communities and establish a strong reputation so that we may continue to recruit leading physicians, and become the healthcare provider of choice in our communities.

Pursuing Acquisitions and Strategic Relationships

We believe we will continue to have opportunities to pursue acquisitions of hospitals and other healthcare facilities both in existing and new markets. We will pursue a disciplined acquisition strategy in markets where we believe we can have the greatest impact on operational and quality performance of the acquired facility. We will continue to target acute care hospitals and ancillary facilities in attractive, primarily non-urban markets with populations generally greater than 35,000. We have focused criteria that cover multiple aspects of a new facility and include demographics, patient care results, operational improvement, financial improvement and cultural alignment. We perform a significant amount of due diligence on each facility we intend to acquire to ensure that our criteria are met.

We also anticipate we will have opportunities to pursue selective acquisitions or otherwise develop complementary ancillary businesses in the markets we currently serve. We have placed a significant emphasis on pursuing such strategic in-market transactions that support our ability to expand our community service offerings. These investments can include, but are not limited to: ambulatory surgery centers, outpatient diagnostic imaging centers, free-standing clinical laboratories, home healthcare and urgent or primary care centers. Our criteria for in-market strategic investments are similar to our criteria for external acquisitions, including focusing on outpatient ancillary centers where we can improve operations.

Delivering Strong Financial Performance

We seek to maintain disciplined financial policies aimed at growing revenue, improving margins and generating free cash flow. We continue to focus on ways in which we can increase revenue from our existing facilities, including continued investments to expand services, continued physician recruitment to meet our communities’ needs and negotiating favorable managed care contracts. We are also focused on capitalizing on several operational efficiencies to improve our margins and free cash flow, including:

 

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continued focus on revenue cycle management and collections;

 

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disciplined deployment of capital across our portfolio;

 

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encouragement and motivation of our physicians and medical staff to adhere to our established protocols related to medical supplies utilization;

 

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implementation of appropriate staffing tools and continued reduction of contract labor; and

 

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leveraged technical expertise through use of our corporate resources.

 

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Our Hospital Operations

Acute Care Services

Our hospitals typically provide the full range of services commonly available in acute care hospitals, such as internal medicine, general surgery, cardiology, oncology, neurosurgery, orthopedics, women’s services, diagnostic and emergency services, as well as select tertiary services, such as open-heart surgery. Our hospitals also generally provide outpatient and ancillary healthcare services such as outpatient surgery, laboratory, radiology, respiratory therapy and physical therapy. We also provide outpatient services at our imaging centers and ambulatory surgery centers. Certain of our hospitals have a limited number of psychiatric, skilled nursing and rehabilitation beds.

Management and Oversight

Our executive management team has extensive experience in operating multi-facility hospital networks and plays a vital role in the strategic planning for our facilities. A hospital’s local management team is generally composed of a chief executive officer, chief operating officer, chief financial officer, chief nursing officer and chief quality officer. Local management teams, in consultation with their LPLG and the hospital’s Board of Trustees and our corporate staff, develop annual operating plans setting forth growth strategies through the expansion of current services, implementation of new services and the recruitment and retention of physicians in each community, as well as plans to improve operating efficiencies and reduce costs. We believe that the ability of each local management team to identify and meet the needs of our patients, medical staffs and the community as a whole is critical to the success of our hospitals. We base the compensation for each local management team in part on its ability to achieve the goals set forth in the annual operating plan, including quality of care, patient satisfaction and financial measures.

The Board of Trustees at each hospital, consisting of local community leaders, members of the medical staff and the hospital CEO, advises the local management teams and helps develop the strategic operating plan for their hospital. In addition, it plays a key role in providing the patient care excellence that Capella demands. Members of each Board of Trustees are identified and recommended by our local management teams. The Boards of Trustees oversees policies concerning medical, professional and ethical practices, monitor these practices and ensure that they conform to our high standards. We maintain company-wide compliance and quality assurance programs and use patient care evaluations and other assessment methods to support and monitor quality of care standards and to meet accreditation and regulatory requirements.

Each hospital has a LPLG made up of key physicians and members of the hospital’s administrative team. The Chairman of each LPLG serves on Capella’s NPLG. The mission of the LPLG is to provide ongoing dialogue between hospital administration and members of the medical staff primarily in the areas of operations, quality patient care, employee satisfaction and community relations.

We also provide support to the local management teams through our corporate resources in areas such as revenue cycle, business office, legal, managed care, clinical efficiency, physician services and other administrative functions. These resources allow for sharing best practices and standardization of policies and processes among all of our hospitals.

Attracting Patients

We believe that the most important factors affecting a patient’s choice in hospitals are the reputation of the hospital, the availability and expertise of physicians and nurses and the location and convenience of the hospital. Other factors that affect utilization include local demographics and population growth, local economic conditions and the hospital’s success in contracting with a wide range of local payors.

Outpatient Services

The healthcare industry has experienced an accelerated shift during recent years from inpatient services to outpatient services as Medicare, Medicaid and managed care payors have sought to reduce costs by shifting lower-acuity cases to an outpatient setting. Advances in medical equipment technology and pharmacology also have supported the shift to outpatient utilization. However, we expect the decline in inpatient admission use rates to moderate over the long term as the baby boomer population reaches ages where inpatient admissions become more prevalent. We have responded to the shift to outpatient services through expanding service offerings and increasing the throughput and convenience of our emergency departments, outpatient surgery facilities and other ancillary units in our hospitals.

 

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Sources of Revenue

General

Revenue before the provision for bad debts at our hospitals consists mostly of fixed payments from discounted sources, including Medicare, Medicaid and managed care organizations. Reimbursement for Medicare and Medicaid services are often fixed regardless of the cost incurred or the level of services provided. Similarly, various managed care companies with which we contract reimburse providers on a fixed payment basis regardless of the costs incurred or the level of services provided. Revenue before the provision for bad debts is reported net of discounts and contractual adjustments. Contractual adjustments principally result from differences between the hospitals’ established charges and payment rates under Medicare, Medicaid and various managed care plans. Additionally, discounts and contractual adjustments result from our uninsured discount and charity care programs.

We receive payment for patient services primarily from:

 

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the federal government, primarily under the Medicare program;

 

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state Medicaid programs;

 

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managed care payors, including health maintenance organizations, preferred provider organizations, managed Medicare plans and managed Medicaid plans; and

 

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individual patients and private insurers.

The table below presents the approximate percentage of revenue before the provision for bad debts for our continuing operations that we received from the following sources for the periods indicated from:

 

		Year Ended December 31,
		2012(2)				2013				2014
Medicare(1)			38.8	%			38.0	%			39.0	%
Medicaid(1)			14.3				14.1				17.5
Managed Care and other(3)			36.9				36.8				36.0
Self-Pay			10.0				11.1				7.5
Total			100.0	%			100.0	%			100.0	%

 

(1)	Includes revenue before the provision for bad debts received under managed Medicare or managed Medicaid programs.

(2)	The increase in Medicaid revenue for 2012 is due primarily to the Oklahoma Supplemental Hospital Offset Payment Program, or SHOPP. SHOPP increased Medicaid revenue by approximately $21.5 million in fiscal 2012.

(3)	Includes the health insurance exchange beginning with the first quarter of 2014.

Medicare is a federal program that provides hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with Lou Gehrig’s Disease and end-stage renal disease. All of our hospitals are certified as providers of Medicare services. Under the Medicare program, acute care hospitals receive reimbursement under a prospective payment system that generally pays fixed rates for inpatient and outpatient hospital services. Currently, certain types of facilities are exempt or partially exempt from the prospective payment system methodology, including children’s hospitals, cancer hospitals and critical access hospitals. Hospitals and units exempt from the prospective payment system are reimbursed on a reasonable cost-based system, subject to cost limits.

Our hospitals offer discounts from established charges to managed care plans if they are large group purchasers of healthcare services. Additionally, we offer discounts to all uninsured patients receiving healthcare services who do not qualify for assistance under state Medicaid, other federal or state assistance plans or charity care. These discount programs generally limit our ability to increase revenue before the provision for bad debts in response to increasing costs. Patients generally are not responsible for any difference between established hospital charges and amounts reimbursed for such services under Medicare, Medicaid, health maintenance organizations, preferred provider organizations or private insurance plans. Patients generally are responsible for services not covered by these plans, along with exclusions, deductibles or co-insurance features of their coverage. Collecting amounts due from patients is more difficult than collecting from governmental programs, managed care plans or private insurers. Increases in the population of uninsured individuals, changes in the states’ indigent and Medicaid eligibility requirements, continued efforts by employers to pass more out-of-pocket healthcare costs to employees in the form of increased co-payments and deductibles and the effects of the recent economic environment have historically resulted in increased levels of uncompensated care. However, our hospitals have recently experienced a decline in bad debts and other uncompensated care, primarily as a result of the impact of the Affordable Care Act (as defined below).

 

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Medicare

Inpatient Services

Under the Medicare program, hospitals are reimbursed for the operating costs of acute care inpatient stays under an Inpatient Prospective Payment System (“IPPS”), pursuant to which a hospital receives a fixed payment amount per inpatient discharge based on the patient’s assigned Medicare severity-adjusted diagnosis-related groups (“MS-DRGs”), a severity-adjusted diagnosis-related group (“DRG”) system. Over a two-year transition period that began in October 2007, the Centers for Medicare & Medicaid Services (“CMS”) implemented MS-DRGs to replace the previously used Medicare diagnosis related groups in an effort to better recognize severity of illness and cost of providing care in Medicare payment rates. Each MS-DRG is assigned a payment weight that is based on the average amount of hospital resources that are needed to treat Medicare patients in that MS-DRG. MS-DRG payments are adjusted for area wage differentials. In addition, if a hospital treats a patient who is more expensive to treat than the average Medicare patient in the same MS-DRG, the hospital will receive an additional outlier payment if the hospital’s cost of treating that patient exceeds a certain threshold amount. MS-DRG classifications and weights are re-calibrated and adjusted on an annual basis to reflect the inflation experienced by hospitals (and entities outside the healthcare industry) in purchasing goods and services (the “market basket index”).

The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, the “Affordable Care Act”) were signed into law on March 23, 2010 and March 30, 2010, respectively. The Affordable Care Act contains many Medicare payment initiatives and changes. Some of the changes have not yet gone into effect, but other revisions, such as payments to accountable care organizations (“ACOs”), programs to reduce payments to hospitals for excessive readmissions, and reductions in the hospital market basket update, are effective now.

On August 22, 2014, CMS published its Medicare IPPS final rule for Federal Fiscal Year (“FFY”) 2015, which began on October 1, 2014. For FFY2013 (which began on October 1, 2012 and ended on September 30, 2013), FFY2014 (which began on October 1, 2013 and ended on September 30, 2014) and FFY 2015 (which began on October 1, 2014 and will end on September 30, 2015), the hospital market basket index increased 2.6%, 2.5%, and 2.9%, respectively. Generally, however, the percentage increase in the DRG payment rate has been lower than the projected increase in the cost of goods and services purchased by hospitals. In addition, as mandated by the Affordable Care Act, the hospital market basket increases for FFY2013, FFY2014 and FFY2015 were reduced by CMS by 0.10%, 0.30% and 0.20%, respectively. For FFY2012 and each subsequent fiscal year, as also mandated by the Affordable Care Act, the market basket increase is reduced by a productivity adjustment equal to the 10-year moving average of changes in annual economy-wide private nonfarm business multi-factor productivity. For FFY2013, FFY2014 and FFY2015, the productivity adjustment equated to a 0.7%, 0.5% and 0.5% reduction in the market basket increase, respectively. In addition, in FFY2011, FFY2012 and FFY2013, IPPS payment rates to hospitals were increased by 2.9%, decreased by 2.0% and decreased by 1.0%, respectively, for documentation and coding adjustments that were required by the Transitional Medical Assistance, Abstinence Education, and Qualifying Individuals Programs Extension Act of 2007 (the “TMA Act”), and decreased by 0.8% in FFY2014 and FFY2015 for additional documentation and coding adjustments required by the American Taxpayer Relief Act of 2012 (“ATRA”). The market basket increase for FFY2014 was also reduced by 0.2% to offset the cost of changes to the Medicare program’s admission and medical review criteria for hospital inpatient admissions services. The TMA Act also required CMS to recoup the increase in spending in FFYs 2008 and 2009 by FFY2012. In the IPPS final rule for FFY2011, CMS reduced the standardized amount by (2.9%), which represented half of the required retrospective adjustment. The remaining (2.9%) retrospective reduction was implemented in FFY2012. However, because the (2.9%) retrospective reduction that was made in FFY2011 was restored in FFY2012, the retrospective adjustment that was made in FFY2012 was essentially negated. As noted above, the (2.9%) retrospective reduction that was made in FFY2012 was restored in FFY2013. Lastly, the TMA Act also required CMS to make an additional prospective cumulative adjustment of (3.9%) to eliminate the full effect of the documentation and coding changes on future payments. The TMA Act gave CMS discretion as to the timing of the implementation of the prospective documentation and coding adjustment, and CMS did not implement any portion of the adjustment in FFY2010 and FFY2011. CMS did, however, implement a (2.0%) prospective documentation and coding adjustment in FFY2012 and completed the remaining (1.9%) prospective adjustment in FFY2013.

With respect to the Medicare program’s admission and medical review criteria for inpatient services, CMS has issued the “two midnight rule”, which modified CMS’s policy regarding how Medicare contractors will review inpatient hospital services for payment purposes, and provides that, in addition to services designated by CMS as inpatient-only services, surgical procedures, diagnostic tests, and other treatments are generally only appropriate for inpatient admission and inpatient hospital payment under Medicare Part A when the treating physician expects the beneficiary to require a stay that crosses at least two midnights and admits the beneficiary to the hospital based on that expectation. As for medical review, the two midnight rule establishes a presumption that inpatient hospital claims with lengths of stay greater than two midnights will be presumed generally appropriate for reimbursement under Medicare Part A. However, inpatient hospital claims with lengths of stay less than two midnights after the formal admission following the order will not be subject to that presumption and may be reviewed by Medicare contractors and recovery auditors for appropriateness for Medicare Part A payment. When reviewing such claims, the two midnight rule requires Medicare contractors and recovery auditors to evaluate the physician order for admission as well as certain medical documentation. CMS is prohibited from allowing recovery auditors to conduct inpatient hospital status reviews on claims with dates of admission October 1, 2013 through March 31, 2015, but, in the future, reviews could be conducted on claims with dates of admission after that time.

 

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While the two midnight rule became effective on October 1, 2013, CMS originally indicated that, for a period of 90 days after the effective date of the rule, it would not permit recovery auditors to review inpatient admissions of one midnight or less that began on or after October 1, 2013. In guidance regarding the two midnight rule issued by CMS in late 2013, CMS announced that the Medicare Administrative Contractors and recovery auditors would not conduct reviews for compliance for claims with dates of admission between October 1, 2013 and March 31, 2014. CMS subsequently extended that delay to inpatient admissions that occur on or prior to September 30, 2014. CMS did, however, instruct Medicare Administrative Contractors to review, on a pre-payment basis, a small sample (approximately 10 – 25) of inpatient hospital claims relating to admissions that occur between March 31, 2014 and September 30, 2014, and that span less than two midnights after admission in order to determine each hospital’s compliance with the new inpatient admission and medical review criteria. Hospitals can appeal the Part A inpatient denial or rebill Part B inpatient, within timely filing, for applicable charges in accordance with the rule.

On April 1, 2014, President Obama signed the Protecting Access to Medicare Act of 2014 (“PAMA”) into law. Among other things, PAMA prohibits CMS from allowing recovery auditors to conduct inpatient hospital patient status reviews on claims with dates of admission October 1, 2013 through March 31, 2015, and permits CMS to continue to allow MACs to review, on a pre-payment basis, a small sample of inpatient hospital claims relating to admissions that span less than two midnights and that occur on or after October 1, 2013 but before March 31, 2015, in order to determine hospital compliance with the new inpatient admission and medical review criteria.

On May 15, 2014, CMS solicited comments in the IPPS proposed rule for FFY 2015 regarding the development of an alternative payment methodology under the Medicare program for short inpatient hospital stays. Among other things, CMS is seeking input on how to define a short inpatient hospital stay for Medicare payment purposes and how to determine the appropriate payment amounts for short inpatient hospital stays. In the IPPS final rule for FFY 2015, CMS indicated it would consider the comments received in future rulemaking.

We cannot predict whether Congress or CMS will further delay the review of inpatient admissions of one midnight or less by recovery auditors or other Medicare review contractors or the impact that any such reviews will have on our business and results of operations when they are allowed by CMS. In addition, legislation has been introduced in Congress that, among other things, would generally prohibit Medicare review contractors from denying claims due to the length of a patient’s stay or a determination that services could have been provided in an outpatient setting and require CMS to develop a new payment methodology for services that are provided during short inpatient hospital stays. Federal lawsuits have also been filed challenging the two midnight rule primarily on the grounds that the implementation of the rule itself, and the payment reduction associated with the rule, violate the Administrative Procedure Act. We cannot predict whether the legislation that has been introduced in Congress will be adopted or, if adopted, the amount of reimbursement that would be paid under any alternative payment methodology that is developed by CMS. We also cannot predict whether the federal court challenges to the two midnight rule will be successful.

The IPPS final rule for FFY 2015 also makes changes to the Hospital Inpatient Quality Reporting (“IQR”) Program. CMS finalized 11 new measures set for the FFY 2017 payment determination and subsequent years and removed 19 measures. CMS also finalized a number of new policies related to the administration of the program including access to certain data, updates to validation and an electronic clinical quality measures validation pilot test. Beginning in FFY 2015, hospitals that do not participate in the IQR program will lose one-quarter of the percentage in their payment updates.

As authorized by the Affordable Care Act, the United States Department of Health and Human Services (“HHS”) issued its final rule on April 29, 2011 launching the Hospital Value-Based Purchasing Program (the “VBP Program”). The VBP Program, which began in October 2012, provides that hospitals will be paid for inpatient acute care services based on quality of care measures as specifically set forth by CMS. The quality measures focus on how closely hospitals follow best clinical practices and how well hospitals enhance patients’ experiences of care. The higher the quality measures, the higher the reward from CMS. In the IPPS final rule for FFY 2015, CMS adopted quality measures for the FFY 2017, FFY 2019 and FFY 2020 Hospital VBP Program years and adopted additional policies related to performance standards. The Company intends for its facilities to achieve high levels of quality under the VBP Program, however, the Company cannot guarantee that its facilities’ reimbursement will increase and will not decrease as a result of the implementation of the VBP Program.

The ATRA, which was enacted on January 1, 2013, requires CMS to recoup $11 billion from IPPS payments in FFYs 2014 through 2017 to offset an additional increase in aggregate payments to hospitals that Congress believes represent overpayments resulting from documentation and coding adjustments from the implementation of the MS-DRG system. In FFY 2014 and FFY 2015, CMS applied (0.8%) adjustments as part of the recovery process required by ATRA and indicated that it expects to make similar adjustments in FFY 2016 and FFY 2017 to recover the remaining outstanding amount.

 

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Hospitals that treat a disproportionately large number of low-income patients currently receive additional payments from Medicare in the form of disproportionate share hospital (“DSH”) payments. DSH payments are determined annually based upon certain statistical information defined by CMS and are calculated as a percentage add-on to the MS-DRG payments. This percentage varies, depending on several factors that include the percentage of low-income patients served. However, the Affordable Care Act requires Medicare DSH payments to providers to be reduced by 75% beginning in FFY 2014, subject to adjustment if the Affordable Care Act does not decrease uncompensated care to the extent anticipated. The amount that is withheld will be reduced by the percentage change in uninsured individuals under the age of 65 from 2013 to the current year (as normalized to reflect the October 1 commencement date for each FFY) minus 0.1% and minus 0.2% on FFY 2015 and then paid as additional payments to DSH hospitals based on the amount of uncompensated care provided by each hospital relative to the amount of uncompensated care provided by all hospitals receiving DSH payments during the applicable time period. The IPPS final rule for FFY 2015 established the uncompensated care amount which will be distributed to qualifying hospitals in FFY 2015 at $7.65 billion, down from $9.05 billion in FFY 2014.

On January 18, 2012, CMS published a proposed rule with a service specific definition of “uncompensated care” for purposes of DSH reductions. Under this definition, uncompensated care would include services provided to insured individuals whose insurance does not cover a particular service or who have exhausted their insurance benefits. Costs associated with bad debt, including unpaid coinsurance and deductibles and payor discounts would not be considered “uncompensated care” under the proposed rule. In the IPPS final rule for FFY 2014, CMS finalized that a hospital’s amount of uncompensated care is defined as a Medicare DSH hospital’s insured low income days, or the sum of a hospital’s Medicare Supplemental Security Income (“SSI”) days and Medicaid days, rather than by actually measuring the amount of uncompensated care that is provided by DSH hospitals. While difficult to predict, the use of Medicaid and Medicare SSI days to approximate levels of uncompensated care could have an adverse effect on DSH hospitals that are located in states that have opted to not expand their Medicaid programs.

Outpatient Payment

Under Medicare’s hospital Outpatient Prospective Payment System (“OPPS”), hospital outpatient services are classified into groups called ambulatory payment classifications (“APCs”). Services in each APC are clinically similar and are similar in terms of the resources they require. CMS establishes a payment rate for each APC, and, depending on the services provided, a hospital may be paid for more than one APC for each patient encounter. APC classifications and payment rates are reviewed and adjusted on an annual basis. Historically, the rate of increase in payments for hospital outpatient services has been higher than the rate of increase in payments for inpatient services.

On November 10, 2014, CMS issued the final OPPS rates for calendar year (“CY”) 2015. Under the final rule, the payment rates under the OPPS were increased by 2.2% for CY 2015. The increase is based on the projected hospital market basket of 2.9% minus 0.7% in statutory reduction, which includes a multifactor productivity adjustment of 0.5%, and a 0.2% percentage point adjustment required by the Affordable Care Act. CMS continues to implement the statutory 2.0% reduction in payments for hospitals failing to meet the hospital outpatient quality reporting requirements. CMS also finalized the implementation of 25 comprehensive APCs for CY 2015. The final rule also adds one claims-based quality measure for the Hospital Outpatient Quality Reporting Program. for the CY 2018 payment determination and subsequent years.

Physician Services

Physician services are reimbursed under the Medicare physician fee schedule (“PFS”) system, under which CMS has assigned a national relative value unit (“RVU”) to most medical procedures and services that reflects the various resources required by a physician to provide the services relative to all other services. Each RVU is calculated based on a combination of work required in terms of time and intensity of effort for the service, practice expense (overhead) attributable to the service and malpractice insurance expense attributable to the service. These three elements are each modified by a geographic adjustment factor to account for local practice costs, then aggregated. The aggregated amount is multiplied by a conversion factor that accounts for inflation and targeted growth in Medicare expenditures (as calculated by the sustainable growth rate (“SGR”)) to arrive at the payment amount for each service. While RVUs for various services may change in a given year, any alterations are required by statute to be virtually budget neutral, such that total payments made under the PFS may not differ by more than $20 million from what payments would have been if adjustments were not made.

The PFS rates are adjusted each year, and reductions in both current and future payments are anticipated. The SGR formula, if implemented, would result in significant reductions to payments under the PFS. Since 2003, Congress has passed fourteen legislative acts delaying application of the SGR formula to the PFS. For CY 2011, CMS issued a final rule that would have applied the SGR

 

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formula and resulted in an aggregate reduction of 24.9% to all physician payments under the PFS for FFY 2011. The Medicare and Medicaid Extenders Act of 2010 delayed application of the SGR until January 1, 2012, and the Temporary Payroll Tax Cut Continuation Act of 2011 then delayed application of the SGR for two additional months, through February 29, 2012. On February 22, 2012, the President signed into law a ten-month extension to the SGR cuts, to prevent cuts from taking effect on March 1, 2012. For CY 2014, CMS issued a final rule that would have, in the absence of Congressional action, imposed an overall reduction of 20.1% to all physician payments until the PFS for CY 2014. The Pathway for SGR Reform Act of 2013, which was enacted on December 26, 2013 (the “Pathway Act”), delayed application of the SGR and provided for a 0.5% increase in PFS payment rates through March 31, 2014. PAMA extended the 0.5% increase in PFS payment rates established by the Pathway Act through December 31, 2014, and also provided that there will be no increase to the CY 2015 PFS from January 1, 2015, through March 31, 2015. On November 13, 2014, CMS published the PFS final rule for CY 2015. In the final rule, CMS stated that application of the SGR to the PFS would result in a 21.2% reduction in payment rates for physicians’ services beginning on April 1, 2015.

On March 26, 2015, the U.S. House of Representatives passed the Medicare Access and CHIP Reauthorization Act (“MACRA”), which would permanently repeal the SGR and establish a more streamlined and improved incentive payment program that will focus on providing value and quality. We cannot predict whether the Senate will pass MACRA, whether, MACRA, if passed, will be signed by the President, or whether Congress will pass other legislation to avert the rate cut for the remainder of CY 2015 and/or otherwise adopt a permanent fix for the issues that are created by the application of the SGR. If the payment reduction to the PFS is not averted prior to March 31, 2015, the reimbursement received by our employed physicians, the physicians to whom our hospitals have provided recruitment assistance, and the physician members of our medical staffs would be adversely affected.

Budget Control Act

On August 2, 2011, the Budget Control Act of 2011 (“BCA”) was enacted. The BCA increased the nation’s debt ceiling while taking steps to reduce the federal deficit. The deficit reduction component was implemented in two phases. First, the BCA imposed caps that reduced non-entitlement spending by more than $900 billion over 10 years, beginning in FFY 2012. Second, a bipartisan Congressional Joint Select Committee on Deficit Reduction (the “Committee”) was charged with identifying at least $1.5 trillion in deficit reduction, which could include entitlement provisions like Medicare reimbursement to providers. On November 21, 2011, the Committee announced that its members were unable to agree on any measures to reduce the deficit, and as a result, $1.2 trillion in automatic, across-the-board spending reductions required by the BCA are scheduled to be imposed automatically for FFYs 2013 through 2021, split evenly between domestic and defense spending and evenly divided over the nine year period. Certain programs (including the Medicaid program) are protected from these automatic spending reductions, but the Medicare program is subject to reductions capped at 2%. The BCA’s automatic spending reductions began March 1, 2013.

On March 1, 2013, President Barack Obama signed an order implementing the automatic spending reductions required by the BCA. Payment reductions to Medicare providers became effective on April 1, 2013. However, among other things, the Pathway Act extends the automatic across-the-board spending reductions required by the BCA through FFY 2023. In addition, it extends the Medicare dependent hospital program, which provides enhanced payment support for rural hospitals that have no more than 100 beds and at least 60% of their inpatient days or discharges covered by Medicare, and the Medicare low volume hospital program, which provides additional Medicare reimbursement for general acute care hospitals that are located a certain distance from another general acute care hospital and have less than a certain number of Medicare discharges each fiscal year, through March 31, 2014.

CMS Disclosure Obligations

In addition to setting payment rates, recent CMS payment rules also imposed disclosure obligations and reporting requirements on physician-owned hospitals. Among other things, the rules require physician-owned hospitals to disclose the names of their physician owners to their patients, require physician-owners who are members of the hospital’s medical staff to disclose their ownership interests to the patients they refer to the hospital, and require the hospital to notify all patients in writing at the beginning of their inpatient hospital stay or outpatient visit if a physician is not present in the hospital 24 hours per day, 7 days per week. The notice regarding the presence of a physician must also describe how the hospital will meet the medical needs of patients who develop emergency conditions while no doctor is on the premises. We intend for our facilities to comply with these requirements.

 

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Medicaid

Medicaid programs are funded jointly by the federal government and the states and are administered by states under approved plans. Most state Medicaid program payments are made under a prospective payment system or are based on negotiated payment levels with individual hospitals. Medicaid reimbursement is less than Medicare reimbursement for the same services and is often less than a hospital’s cost of services. The federal government and many states have recently reduced or are currently considering legislation to reduce the level of Medicaid funding (including upper payment limits) or program eligibility that could adversely affect future levels of Medicaid reimbursement received by our hospitals. As permitted by law, certain states in which we operate have adopted broad-based provider taxes to fund their Medicaid programs. Since states must operate with balanced budgets and since the Medicaid program is often the state’s largest program, states may consider further reductions in their Medicaid expenditures.

Annual Cost Reports

All hospitals participating in the Medicare and Medicaid programs, whether paid on a reasonable cost basis or under a prospective payment system, must meet specific financial reporting requirements. Federal regulations require submission of annual cost reports identifying medical costs and expenses associated with the services provided by each hospital to Medicare beneficiaries and Medicaid recipients. These annual cost reports are subject to routine audits, which may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. The audit process may take several years to reach the final determination of allowable amounts under the programs. Providers also have the right of appeal, and it is common to contest issues raised in audits of prior years’ reports.

Cost reports filed by our facilities generally remain open for three years after the notice of program reimbursement date. If any of our facilities are found to have been in violation of federal or state laws relating to preparing and filing of Medicare or Medicaid cost reports, whether prior to or after our ownership of these facilities, we and our facilities could be subject to substantial monetary fines, civil and criminal penalties and exclusion from participation in the Medicare and Medicaid programs.

Recovery Audit Contractors

In 2005, CMS began using Recovery Audit Contractors (“RACs”) to detect Medicare overpayments not identified through existing claims review mechanisms. The RAC program relies on private auditing firms to examine Medicare claims filed by healthcare providers. The RAC program began as a demonstration project in a few states and was later made permanent by the Tax Relief and Health Care Act of 2006. The permanent RAC program was gradually expanded across the United States in 2008 and 2009 and is currently operating in all 50 states. The Affordable Care Act further expanded the use of RACs and required each state to establish a Medicaid RAC program in 2011.

RACs utilize a post-payment targeted review process employing data analysis techniques in order to identify those Medicare claims most likely to contain overpayments, such as incorrectly coded services, incorrect payment amounts, non-covered services and duplicate payments. CMS has given RACs the authority to look back at claims up to three years old, provided that the claim was paid on or after October 1, 2007. Claims identified as overpayments will be subject to the Medicare appeals process.

RACs are paid a contingency fee based on the overpayments they identify and collect. Therefore, we expect that the RACs will look very closely at claims submitted by our facilities in an attempt to identify possible overpayments. Although we believe our claims for reimbursement submitted to the Medicare and Medicaid programs are accurate, many of our hospitals have had claims audited by the RAC program. We cannot predict if this trend will continue or the results of any future audits. These additional post-payment reviews may require us to incur additional costs to respond to requests for records and to pursue the reversal of payment denials and ultimately may require us to refund amounts paid to us that are determined to have been overpaid.

Third-Party Payors

We also are dependent upon private third-party sources of reimbursement for services provided to patients. In addition, market and cost factors affecting the fee structure, cost containment, and utilization decisions of third-party payors and other payment factors over which we will have no control may adversely affect the amount of payment we will receive for our services. The market share growth of private third-party managed care has resulted in substantial competition among providers of services, including pain management and outpatient and inpatient surgical services, for inclusion in managed care contracting in some markets. In addition, many third-party payor contracts contain termination provisions that allow the payor to terminate the contract without cause after delivering notice of intent to terminate. Termination of a managed care contract can result in material reductions in patient volume and revenue to us. Our financial condition and results of operations may be adversely affected by fixed fee schedules, capitation payment arrangements, exclusion from participation in managed care programs, or other changes in payments for healthcare services.

 

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Self-Pay and Charity Care

Self-pay revenues are derived primarily from patients who do not have any form of healthcare coverage. We provide care without charge to certain patients that qualify under the Company’s charity/indigent care policy. At our hospitals, patients treated for non-elective care, who meet the poverty guideline requirements (generally it is uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set for by HHS), are eligible for charity care if they comply with providing supporting documentation. The federal poverty level is established by the federal government and is based on income and family size. Our hospitals provide a discount to uninsured patients who do not qualify for Medicaid or charity care. These discounts are similar to those provided to many local managed care plans. In implementing the discount policy, our first attempt is to qualify uninsured patients for Medicaid, other federal or state assistance or charity care. If an uninsured patient does not qualify for these programs, the uninsured discount is applied.

Healthcare Reform

The Affordable Care Act dramatically altered the United States healthcare system and is intended to decrease the number of uninsured Americans and reduce overall healthcare costs. The Affordable Care Act attempts to achieve these goals by, among other things, requiring most Americans to obtain health insurance, expanding Medicare and Medicaid eligibility, reducing Medicare and Medicaid payments, including DSH payments to providers, expanding the Medicare program’s use of value-based purchasing programs, tying hospital payments to the satisfaction of certain quality criteria and bundling payments to hospitals and other providers. Although some of the measures contained in the Affordable Care Act did not take effect until 2014 and others have been further delayed, certain of the reductions in Medicare spending, such as negative adjustments to the Medicare hospital inpatient and outpatient prospective payment system market basket updates and the incorporation of productivity adjustments to the Medicare program’s annual inflation updates, became effective prior to 2013.

The Affordable Care Act also contains several Medicare payment and delivery system innovations, including the establishment of a Medicare Shared Savings Program to promote accountability and coordination of care through the creation of ACOs and the establishment of a pilot program related to bundled payment for post-acute care. Under the bundled post-acute care pilot program, Medicare pays one bundled payment for acute, inpatient hospital services, physician services, outpatient hospital services, and post-acute care services for an episode of care that begins three days prior to a hospitalization and spans 30 days following discharge. The Affordable Care Act requires the Secretary of HHS to expand the pilot program if it achieves the stated goals of reducing spending while improving or not reducing quality. The five-year voluntary national bundled payment pilot program for Medicare services began in January of 2013, and may be expanded, if appropriate, by January 1, 2016.

CMS finalized the implementation of the Medicare program’s Bundled Payments for Care Improvement (“BPCI”) initiative in the IPPS final rule for FFY 2013 and announced the healthcare organizations that were selected to participate in BPCI initiative on January 31, 2013. HHS selected certain states to participate based on the potential to lower costs under the Medicaid program while improving care. State programs may target particular categories of beneficiaries, selected diagnoses or geographic regions of the state. The selected state programs will provide one payment for both hospital and physician services provided to Medicaid patients for certain episodes of inpatient care.

Under the ACO Medicare Shared Savings Program, ACOs would enter into a contract with the Secretary of the HHS in which the ACO agrees to be accountable for the overall care of its Medicare beneficiaries, to have adequate participation of primary care physicians, to define processes to promote evidence-based medicine, to report on quality and costs, and to coordinate care. ACOs that meet quality and efficiency standards would be allowed to share in the cost savings they achieve for the Medicare program. The final rule outlines certain key characteristics of an ACO, including the scope and length of an ACO’s contract with CMS, the required governance of an ACO, the assignment of Medicare beneficiaries to an ACO, the payment models under which an ACO can share in cost savings, and the quality and other reporting requirements expected of an ACO. Under the ACO rule, patient and provider participation in ACOs is voluntary. The ACO program was established January 1, 2012, and providers were able to begin enrolling on a rolling basis, with the first round of applications due in early 2012. To date, approximately 420 ACOs have been established to participate in the Medicare program, and additional ACO programs are being established by private payors.

The Affordable Care Act also contains a number of measures that are intended to reduce fraud and abuse in the Medicare and Medicaid programs, such as requiring the use of RACs in the Medicaid program, expanding the scope of the federal False Claims Act and generally prohibiting physician-owned hospitals from increasing the total percentage of physician ownership or increasing the aggregate number of operating rooms, procedure rooms, and beds for which they are licensed.

 

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As part of the effort to control or reduce healthcare spending, the Affordable Care Act places a number of significant requirements and limitations on the Whole Hospital Exception to the federal physician self-referral prohibition, commonly known as the Stark Law (the “Stark Law”), which allows physicians to have ownership interests in hospitals. Among other things, the Affordable Care Act prohibits hospitals from increasing the percentage of the total value of the ownership interest held in the hospital by physicians after March 23, 2010.

On June 28, 2012, the United States Supreme Court upheld the “individual mandate” provision of the Affordable Care Act that generally requires all individuals to obtain healthcare insurance or pay a penalty. The Supreme Court also held, however, that the provision of the Act that authorized the Secretary of HHS to penalize states that choose not to participate in the expansion of the Medicaid program by removing all existing Medicaid funding was unconstitutional. As a result, the expansion of the Medicaid program to all individuals all adults under 65 years old with incomes at or under 133% of FPL is now optional. In response to the ruling, a number of states have already indicated that they will not expand their Medicaid programs. Doing so would result in the Affordable Care Act not providing coverage to some low-income persons in those states. Additionally, several bills have been and will likely continue to be introduced in Congress to defund, delay, repeal or amend all or significant provisions of the Affordable Care Act. It is difficult to predict the full impact of the Affordable Care Act because of its complexity, lack of implementing regulations and interpretive guidance, gradual and potentially delayed implementation, potential future legal challenges, and possible defunding, repeal and/or amendment, as well as the inability to foresee how individuals and businesses will respond to the choices afforded them by the Affordable Care Act. Depending on further legislative developments and how the Affordable Care Act is ultimately interpreted and implemented, it could have an adverse effect on the business, financial condition and results of operations of the Company.

Impact of Affordable Care Act on the Company

The expansion of health insurance coverage under the Affordable Care Act may result in a material increase in the number of patients using our facilities who have either private or public program coverage. In addition, a disproportionately large percentage of the new Medicaid coverage is likely to be in states that currently have relatively low income eligibility requirements. Further, the Affordable Care Act provides for a value-based purchasing program, the establishment of ACOs and bundled payment pilot programs, which will create possible sources of additional revenue.

However, it is difficult to predict the size of the potential revenue gains to the Company as a result of these elements of the Affordable Care Act, because of uncertainty surrounding a number of material factors, including the following:

 

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how many previously uninsured individuals will obtain coverage as a result of the Affordable Care Act (the Congressional Budget Office, or CBO, originally estimated 26 million by 2022, and CMS originally estimated almost 34 million by 2019; both agencies made a number of assumptions to derive those figures, including how many individuals will ignore substantial subsidies and decide to pay the penalty rather than obtain health insurance and what percentage of people in the future will meet the new Medicaid income eligibility requirements. However, in July 2012, the CBO revised its estimate to reflect the impact of the U.S. Supreme Court’s determination that the provision of the Affordable Care Act that authorized the Secretary of HHS to penalize states that choose not to participate in the expansion of the Medicaid program was unconstitutional. The CBO now projects, as a result of the Supreme Court’s decision and other factors, that there will be six million more uninsured individuals in 2014 and four million more uninsured individuals in 2022 than originally projected);

 

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what percentage of the newly insured patients will be covered under the Medicaid program and what percentage will be covered by private health insurers;

 

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the number of states that ultimately elect to expand their Medicaid programs and when that expansion occurs;

 

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the extent to which states will enroll new Medicaid participants in managed care programs;

 

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the pace at which insurance coverage expands, including the pace of different types of coverage expansion;

 

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the change, if any, in the volume of inpatient and outpatient hospital services that are sought by and provided to previously uninsured individuals;

 

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the rate paid to hospitals by private payers for newly covered individuals, including those covered through the newly created Exchanges and those who might be covered under the Medicaid program under contracts with the state;

 

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the rate paid by state governments under the Medicaid program for newly covered individuals;

 

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how the value-based purchasing and other quality programs will be implemented;

 

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the percentage of individuals in the American Health Benefit Exchanges who select the high deductible plans, since health insurers offering those kinds of products have traditionally sought to pay lower rates to hospitals;

 

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whether the net effect of the Affordable Care Act, including the prohibition on excluding individuals based on pre-existing conditions, the requirement to keep medical costs lower than a specified percentage of premium revenue, other health insurance reforms and the annual fee applied to all health insurers, will be to put pressure on the bottom line of health insurers, which in turn might cause them to seek to reduce payments to hospitals with respect to both newly insured individuals and their existing business; and

 

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the possibility that implementation of provisions expanding health insurance coverage will be delayed, blocked, revised or eliminated as a result of court challenges and efforts to repeal or amend the new law.

On the other hand, the Affordable Care Act provides for significant reductions in the growth of Medicare spending, reductions in Medicare and Medicaid DSH payments and the establishment of programs where reimbursement is tied to quality and integration. Since 56.5% of our revenue in 2014 was from Medicare and Medicaid, collectively, reductions to these programs may significantly impact us and could offset any positive effects of the Affordable Care Act. It is difficult to predict the size of the revenue reductions to Medicare and Medicaid spending, because of uncertainty regarding a number of material factors, including the following:

 

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the amount of overall revenue we will generate from Medicare and Medicaid business when the reductions are implemented;

 

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whether reductions required by the Affordable Care Act will be changed by statute prior to becoming effective;

 

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the amount of the Medicare DSH reductions that will be made, commencing in FFY 2014;

 

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the allocation to our hospitals of the Medicaid DSH reductions, commencing in FFY 2017;

 

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what the losses in revenue will be, if any, from the Affordable Care Act’s quality initiatives;

 

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how successful ACOs, in which we participate, will be at coordinating care and reducing costs;

 

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the scope and nature of potential changes to Medicare reimbursement methods, such as an emphasis on bundling payments or coordination of care programs; and

 

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reductions to Medicare payments CMS may impose for “excessive readmissions.”

Because of the many variables involved, we are unable to predict the net effect on the Company of the expected increases in insured individuals using our facilities, the reductions in Medicare spending and reductions in Medicare and Medicaid DSH funding, and numerous other provisions in the Affordable Care Act that may affect us. Additionally, it is unclear how many states will decline to implement the Medicaid expansion in light of the U.S. Supreme Court’s ruling. Due to these factors, we are unable to predict with any reasonable certainty or otherwise quantify the likely impact of the Affordable Care Act.

Government Regulation and Other Factors

General

All participants in the healthcare industry are required to comply with extensive government regulation at the federal, state and local levels. In addition, these laws, rules and regulations are extremely complex and the healthcare industry has had the benefit of little or no regulatory or judicial interpretation of many of them. Although we believe we are in compliance in all material respects with such laws, rules and regulations, if a determination is made that we were in material violation of such laws, rules or regulations, our business, financial condition or results of operations could be materially adversely affected. If we fail to comply with applicable laws and regulations, we can be subject to criminal penalties and civil sanctions and our hospitals can lose their licenses and their ability to participate in the Medicare and Medicaid programs.

Licensing, Certification and Accreditation

Healthcare facility construction and operation is subject to complex federal, state and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, rate-setting and compliance with building codes and environmental protection laws. Our facilities also are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary for licensing and accreditation. We believe that all of our operating healthcare facilities are properly licensed under appropriate state healthcare laws.

 

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All of our hospitals are certified under the Medicare program and are accredited by The Joint Commission or the American Osteopathic Association. Some of the Company’s facilities have used Joint Commission or American Osteopathic Association accreditation in lieu of Medicare surveys to obtain Medicare certification. For those facilities, the effect of accreditation is to permit the facilities to participate in the Medicare and Medicaid programs. If any facility that obtained Medicare participation based on its accreditation loses that accreditation status, or any of our facilities otherwise lose certification under the Medicare program, then the facility will be unable to receive reimbursement from the Medicare and Medicaid programs. We intend to conduct our operations in compliance with current applicable federal, state, local and independent review body regulations and standards. The requirements for licensure, certification and accreditation are subject to change and, in order to remain qualified, we may need to make changes in our facilities, equipment, personnel and services.

Utilization Review

Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admissions of Medicare and Medicaid patients be reviewed by quality improvement organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care, validity of diagnosis-related group classifications and appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided, assess fines and recommend to the Department that a provider not in substantial compliance with the standards of the quality improvement organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review.

Medicare Participation

Our facilities have received certification under the federal Medicare program in order to qualify for reimbursement for services rendered to eligible patients under such program. The Medicare program has conditions of participation that a provider must satisfy to qualify for reimbursement including, but not limited to, compliance with state licensure requirements, governing body and management requirements, medical records requirements, credit balance refund requirements, quality assurance and utilization review requirements, surgical service standards, physical environment standards, nursing services standards, pharmaceutical standards, laboratory and radiological standards, medical staff credentialing standards, and architectural standards. We intend for all of our facilities to comply with all applicable Medicare conditions and requirements. However, the failure to obtain, or any loss or restriction of, Medicare certification may adversely affect our financial viability. In addition, any significant reduction in government payments for services provided at our facilities could have a material adverse effect on our business.

The requirements for certification and enrollment under Medicare and other government reimbursement programs such as Medicaid are subject to change and, in order to remain qualified for such programs, it may be necessary for us to make changes from time to time in its facilities, equipment, personnel or services.

Anti-Kickback Laws

The Social Security Act includes provisions addressing illegal remuneration (the “Anti-Kickback Laws”) which prohibit providers and others from, among other things, soliciting, receiving, offering or paying, directly or indirectly, any remuneration in return for either making a referral for a service or item covered by a federal healthcare program or ordering or arranging for or recommending the order of any covered service or item. Violations of the Anti-Kickback Laws are felonies that include criminal penalties or imprisonment or criminal fines up to $25,000 per violation. In addition, violations of the Anti-Kickback Laws also include civil monetary penalties of up to $50,000 per violation, damages up to three times the total amount of the improper payment made to the referral source, and exclusion from participation in Medicare, Medicaid, or other tendered healthcare programs.

In U.S. v. Greber, 760 F.2d 68 (3d Cir. 1985), the United States Court of Appeals for the Third Circuit held that the Anti-Kickback Laws are violated if one purpose (as opposed to a primary or sole purpose) of a payment to a provider is to induce referrals. Other federal circuit courts have followed the Greber case.

Under regulations issued by the Office of the Inspector General (“OIG”), certain categories of activities are deemed not to violate the Anti-Kickback Laws (the “Safe Harbors”). According to the preamble to the Safe Harbors, the failure of a particular business arrangement to comply with the regulations does not determine whether the arrangement violates the Anti-Kickback Laws. The Safe Harbors do not make conduct illegal, but instead delineate standards that, if complied with, protect conduct that might otherwise be deemed in violation of the Anti-Kickback Laws. Currently there are safe harbors for various activities, including the following: investment interests, space rental, equipment rental, practitioner recruitment, personal services and management contracts, sale of practice, referral services, warranties, discounts, employees, group purchasing organizations, waiver of beneficiary coinsurance and deductible amounts, managed care arrangements, obstetrical malpractice insurance subsidies, investments in group practices, ambulatory surgery centers and referral agreements for specialty services.

 

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The Affordable Care Act increases funding for fighting fraud and abuse, allows CMS to establish enrollment moratoria in areas identified as being at elevated risk of fraud, creates new penalties for fraud and abuse violations, increases penalties for submitting false claims, and restricts physician ownership of hospitals.

We have a variety of financial relationships with physicians who refer patients to our facilities. As of December 31, 2014, referring physicians owned interests in five of our hospitals, and four outpatient facilities in which we own a minority interest. We may sell ownership interests in certain other of our facilities to physicians and other qualified investors in the future. We also have contracts with physicians providing for a variety of financial arrangements, including employment contracts, leases and professional service agreements. We have provided financial incentives to recruit physicians to relocate to communities served by our hospitals, including income and collection guarantees and reimbursement of relocation costs, and will continue to provide recruitment packages in the future. Although we have established policies and procedures to ensure that our arrangements with physicians comply with current law and applicable regulations, we cannot assure you that regulatory authorities that enforce these laws will not determine that some of these arrangements violate the Anti-Kickback Statute or other applicable laws. An adverse determination could subject us to liabilities under the Social Security Act, including criminal penalties, civil monetary penalties and exclusion from participation in Medicare, Medicaid or other federal healthcare programs, any of which could have a material adverse effect on our business, financial condition or results of operations.

The Stark Law

Physician self-referral laws have been enacted by Congress and many states to prohibit certain self-referrals for healthcare services. The federal prohibition, commonly known as the Stark Law, prohibits physicians from referring patients for certain designated health services provided by an entity with which the physician has a financial relationship if those services are paid for, in whole or in part, by Medicare or Medicaid. The Stark Law also prohibits the entity from seeking payment from Medicare or Medicaid for services rendered pursuant to a prohibited referral. If an entity is paid for services rendered pursuant to a prohibited referral, it may incur civil penalties of up to $15,000 per prohibited claim and may be excluded from participating in Medicare and Medicaid.

Under the Stark Law, designated health services include inpatient and outpatient hospital services; radiology services, including magnetic resonance imaging, computerized axial tomography scans, and ultrasound services; physical therapy services; occupational therapy services; radiation therapy services and supplies; durable medical equipment and supplies; parenteral and enteral nutrients, equipment, and supplies; prosthetics, orthotics, and prosthetic devices and supplies; home healthcare services; and outpatient prescription drugs. Our facilities provide designated health services under the Stark Law.

As discussed below, the Affordable Care Act creates potential False Claims Act liability for failure to timely report and repay known overpayments to the federal government, including payments received for services rendered pursuant to referrals that are not Stark Law compliant. In 2010, CMS published a self-referral disclosure protocol (the “SDP”) to encourage providers to disclose and attempt to resolve potential Stark Law violations and related overpayment liabilities at levels below the maximum penalties and amounts set forth by statute. In light of these developments, we may make certain disclosures through the SDP in the future. We cannot predict how CMS will resolve any issues reported through the SDP, including whether CMS will resolve any potential Stark Law violations are related overpayments at levels below the maximum amounts set forth by law.

Laws allowing physicians to refer their patients to facilities in which they have an investment interest are presently, and are expected to continue to be, the focus of federal and state lawmakers. The Stark Law prohibits a physician from having a financial relationship in and making referrals to an entity that provides designated health services, which includes inpatient or outpatient hospital services, unless an exception applies to the financial relationship. The Stark Law provides several exceptions including exceptions for leases and personal services agreements as long as the arrangements comply with the parameters of the exceptions. In addition, there are exceptions for investments in rural areas, and there is a Whole Hospital Exception that, prior to the recent reform legislation, allowed physicians to own interests in hospitals. The Affordable Care Act also prohibits an increase in the aggregate number of beds, operating rooms, and procedure rooms in physician-owned hospitals from March 23, 2010; requires a referring physician owner or investor to disclose his or her ownership interest in a hospital (along with the ownership or investment interest of any treating physician) to patients at a time when the patient may make a meaningful decision regarding the receipt of care; requires physician-owned hospitals to submit an annual report identifying each physician owner and investor, and the nature and extent of all ownership and investment interests; requires physician-owned hospitals to disclose any physician ownership or investment interest on the hospital’s website and in any public advertisement; and ensures that ownership in hospitals by physician owners or investors is bona fide and satisfies the Whole Hospital Exception.

In addition to the physician referral requirements, the Stark Law also includes specific reporting requirements that require each entity furnishing covered items or services to provide the Secretary with certain information concerning its ownership, investment, and compensation arrangements with physicians. In a series of notices in 2007, CMS indicated its intent to require a group of 500 hospitals to submit a Disclosure of Financial Relationships Report (“DFRR”) to CMS that contains detailed information concerning each hospital’s ownership, investment, and compensation arrangements with physicians. CMS has since determined that mandating hospitals to complete the DFRR may duplicate some of the reporting obligations related to physician ownership and investment set forth in the Affordable Care Act. Therefore, CMS has decided to delay implementation of the DFRR, and instead focus on implementing relevant sections of the

 

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Affordable Care Act. CMS has indicated that it remains interested in analyzing physician compensation relationships with DHS entities, and after collecting and examining information related to ownership and investment interests pursuant to the Affordable Care Act, it will determine if it is necessary to capture information related to compensation arrangements. If CMS continues with the DFRR requirement and one of our facilities receives the DFRR request, it will have a limited amount of time to compile a significant amount of information relating to its financial relationships with physicians, including any ownership by physicians. Our facilities may be subject to substantial penalties if it is unable to assemble and report this information within the required timeframe or if CMS or any other government agency determines that its submission is inaccurate or incomplete. In addition, a facility may be the subject of investigations or enforcement actions if a government agency determines that any of the information indicates a potential violation of law. Any such investigation or enforcement action could materially adversely affect the Company’s results of operations. These activities reflect the general trend of increasing governmental scrutiny of the financial relationships between hospitals and referring physicians under the Stark Law.

Corporate Practice of Medicine and Fee Splitting

Some of the states in which we operate have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians or laws that prohibit certain direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of a physician’s license, civil and criminal penalties and rescission of business arrangements that may violate these restrictions. These statutes vary from state to state, are often vague and seldom have been interpreted by the courts or regulatory agencies. Although we exercise care to structure our arrangements with healthcare providers to comply with the relevant state law and believe these arrangements comply with applicable laws in all material respects, we cannot assure you that governmental officials responsible for enforcing these laws will not assert that we, or transactions in which we are involved, are in violation of such laws, or that such laws ultimately will be interpreted by the courts in a manner consistent with our interpretations.

HIPAA Privacy, Transaction and Security Standards

HIPAA required HHS to promulgate regulations designed to encourage electronic commerce in the healthcare industry. These regulations apply to healthcare providers that transmit information in an electronic form in connection with standard HIPAA transactions, such as electronic claims.

At this time, HHS has promulgated standards for the HIPAA transactions, standards for unique identifiers for employers and healthcare providers to be used in the HIPAA transactions, standards for the privacy of individually identifiable information, security standards for the protection of electronic health information and general administrative requirements relating to procedures for investigating violations of HIPAA, the imposition of penalties for such violations and procedures for hearings to appeal the imposition of penalties. The Company’s facilities are subject to these standards.

HIPAA security standards require our Company’s facilities to establish and maintain reasonable and appropriate administrative, technical and physical safeguards to ensure the integrity, confidentiality and the availability of electronic health and related financial information. The security standards were designed to protect electronic information against reasonably anticipated threats or hazards to the security or integrity of the information and to protect the information against unauthorized use or disclosure.

HIPAA privacy standards apply to individually identifiable health information held or disclosed by our facilities in any form, whether communicated electronically, on paper or orally. These standards impose extensive new administrative requirements on our facilities, including appointing a privacy officer, adopting privacy policies and training our facilities’ workforce on these policies. They require our facilities’ compliance with rules governing the use and disclosure of health information. They create new rights for patients in their health information, such as the right to access and amend their health information and request an accounting for certain disclosure of their health information, and they require our facilities to impose these rules, by contract, on any business associate to whom our facilities disclose such information in order to perform functions on our facilities’ behalf. In addition, our facilities will continue to remain subject to any state laws that are more restrictive than the privacy standards issued under HIPAA. In addition, the Federal Trade Commission (the “FTC”) has ruled that Section 5 of the Federal Trade Commission Act gives the FTC the authority to regulate as unfair business practices companies’ inadequate data security programs that may expose consumers to fraud, identity theft and privacy intrusions, including the security programs of entities subject to HIPAA regulation.

A violation of these regulations could result in civil money penalties of $100 per incident, up to a maximum of $25,000 per person per year per standard. HIPAA also provides for criminal penalties of up to $50,000 and one year in prison for knowingly and improperly obtaining or disclosing protected health information, up to $100,000 and five years in prison for obtaining protected health information under false pretenses, and up to $250,000 and ten (10) years in prison for obtaining or disclosing protected health information with the intent to sell, transfer or use such information for commercial advantage, personal gain or malicious harm. Since there is no significant history of enforcement efforts by the federal government at this time, it is not possible to ascertain the likelihood of enforcement efforts in connection with the HIPAA regulations or the potential for fines and penalties which may result from the violation of the regulations.

 

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On February 17, 2009, President Obama signed the ARRA into effect. The ARRA included the HITECH Act, which contains a number of provisions that significantly expand the reach of HIPAA. Among other things, the HITECH Act (i) created new security breach notification requirements for covered entities (ii) extended the HIPAA security provisions to business associates, and (iii) increased a patient’s ability to restrict access to his or her protected health information. The HITECH Act also expanded the number of enforcement mechanisms that are available to prosecute violations of HIPAA by creating a private cause-of-action for non-compliance which may be brought by state attorneys general on behalf of affected patients and increasing the civil monetary penalties that may be imposed for violations of HIPAA by establishing a tiered penalty system.

On August 24, 2009, HHS issued regulations implementing certain of the requirements of the HITECH Act, including the breach notification requirements providing obligations for compiling and reporting of certain information relating to breaches by providers and their business associates (the “Interim Final Breach Rule”), effective September 23, 2009. HHS subsequently promulgated and withdrew a final breach notification rule for review, but it intends to publish a final data breach rule in the coming months. Until such time as a new final breach rule is issued, the Interim Final Breach Rule remains in effect. In addition, our facilities remain subject to any state laws that relate to the reporting of data breaches that are more restrictive than the regulations issued under HIPAA and the requirements of the HITECH Act. Additionally, the HITECH Act requires periodic audits of covered entities and business associates conducted by governmental subcontractors to ensure their compliance with the HIPAA privacy and security regulations. In 2011, HHS initiated a pilot audit program that ran until December 2012 in the first phase of HHS implementation of this requirement. In 2014, HHS announced its plan to survey approximately 800 organizations as the first step in selecting organizations for the next round of HIPAA audits, which are expected to occur in 2015. HHS officials have indicated that these audits will consist of a combination of remote desk audits and comprehensive onsite evaluations of covered entities and business associates and will focus on compliance with the HIPAA privacy, security and breach notification rules. HHS officials have also indicated that these audits could lead to compliance reviews or enforcement actions against organizations that fail to respond appropriately to audit requests or for which an audit reveals significant compliance issues. We cannot predict whether our facilities will be selected for an audit and the results of such an audit.

On January 17, 2013, HHS issued a final rule (the “Final HIPAA Rule”) which, among other things, made final modifications to the HIPAA privacy, security, and enforcement rules mandated by the HITECH Act; adopted changes to the HIPAA enforcement rule to incorporate the increased and tiered civil money penalty structure provided by the HITECH Act; adopted a final rule on Breach Notification for Unsecured Protected Health Information, which replaces the breach notification rule’s prior “harm” threshold with a more objective standard; and modified the HIPAA privacy rule as required by the Genetic Information Nondiscrimination Act (GINA). Our facilities were required to comply with applicable requirements of the Final HIPAA Rule beginning on September 23, 2013, except that certain existing business associate agreements qualified for an extended compliance date of September 23, 2014. We cannot yet quantify the financial impact of compliance with these new regulations. We could, however, incur expenses associated with such compliance.

Violations of the HIPAA privacy and security regulations may result in civil and criminal penalties. The HITECH Act and Final HIPAA Rule significantly increased the penalties for violations by introducing a tiered penalty system reflecting increasing levels of culpability, with penalties of up to $50,000 per violation with a maximum civil penalty of $1.5 million for violations of the same requirement in a calendar year. The HITECH Act and Final HIPAA Rule also extended the application of certain provisions of the security and privacy regulations to business associates and imposes direct civil and criminal liability on business associates for violation of the HIPAA regulations. The HITECH Act also authorizes state attorneys general to bring civil actions seeking either injunction or damages up to $25,000 for violations of the same requirement in a calendar year in response to violations of HIPAA privacy and security regulations that affect their state residents. The applicable state laws regulating the privacy of patient health information could impose additional penalties. We expect increased enforcement of the requirements of HIPAA, the HITECH Act, and the Final HIPAA Rule by HHS and state attorneys general.

The Company intends to comply fully with HIPAA and the applicable portions of the HITECH Act, when required. However, the Company cannot provide any assurances that the Company’s actions will not be reviewed or challenged by the authorities having responsibility for HIPAA enforcement. The Company expects that compliance with these standards will require significant commitment and action by the Company.

In January 2009, CMS published its 10th revision of International Statistical Classification of Diseases (“ICD-10”), which establishes an updated code set to be used for classifying health care diagnoses and procedures. Entities covered under HIPAA will be required to use the ICD-10, which contains significantly more diagnostic and procedural codes than the existing ICD-9 coding system. Because of the greater number of codes, the coding for the services provided in our facilities will require much greater specificity. Implementation of ICD-10 will require a significant investment in technology and training. We may experience delays in reimbursement while our facilities and the payors from which we seek reimbursement make the transition to ICD-10. While HIPAA originally required implementation of ICD-10 to be achieved by October 1, 2013, CMS extended this deadline to October 1, 2014, and PAMA further delayed the effective date of the ICD-10 transition to October 1, 2015. If any of our facilities fail to implement the new coding system by the deadline, the affected facility will not be paid for services. We are not able to predict the timeframe or the overall financial impact of the transition to ICD-10.

 

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Federal Trade Commission “Red Flags Rule”

On November 9, 2007, the FTC issued a final rule, known as the Red Flags Rule, that requires financial institutions and other businesses which maintain accounts that are used for primarily individual purposes and that permit multiple payments, to implement written identity theft prevention programs. The FTC may seek penalties of up to $3,500 per violation for certain violations of the Red Flags Rule. In addition, states may enforce the Red Flags Rule on behalf of their citizens by either (i) seeking direct damages or (ii) penalties of up to $1,000 per independent violation, plus attorney’s fees. Finally, affected individuals may also file civil suits in which they may recover actual damages, plus attorney’s fees, for negligent violations, or actual damages of up to $1,000, plus attorney’s fees and punitive damages, for willful noncompliance.

The Red Flag Program Clarification Act of 2010, signed on December 18, 2010, appears to exclude certain healthcare providers from the Red Flags Rule, but permits the FTC or relevant agencies to designate additional creditors subject to the Red Flags Rule through future rulemaking if the agencies determine that the person in question maintains accounts subject to foreseeable risk of identity theft. The Company intends to comply with the Red Flags Rule if required. However, the Company cannot provide any assurances that its operations and identity theft prevention programs will not be reviewed or challenged by the FTC or other governmental authorities with responsibility for enforcing the Red Flags Rule, or if challenged, that its operations and programs would be found to be compliant.

False and Other Improper Claims

The U.S. government is authorized to impose criminal, civil and administrative penalties on any person or entity that files a false claim for payment from the Medicare or Medicaid programs. Claims filed with private insurers can also lead to criminal and civil penalties, including, but not limited to, penalties relating to violations of federal mail and wire fraud statutes. While the criminal statutes are generally reserved for instances of fraudulent intent, the U.S. government is applying its criminal, civil and administrative penalty statutes in an ever expanding range of circumstances. For example, the government has taken the position that a pattern of claiming reimbursement for unnecessary services violates these statutes if the claimant merely should have known the services were unnecessary, even if the government cannot demonstrate actual knowledge. The government has also taken the position that claiming payment for low quality services is a violation of these statutes if the claimant should have known that the care was substandard. In addition, some courts have held that a violation of the Stark law can result in liability under the federal False Claims Act. Additionally, under the Affordable Care Act, the False Claims Act is implicated by the knowing failure to report and return an overpayment within 60 days of identifying the overpayment or by the date a corresponding cost report is due, whichever is later, and the Affordable Care Act also specifically provides that submission of claims for services or items generated in violation of the Anti-Kickback Laws constitutes a false or fraudulent claim under the False Claims Act.

Over the past several years, the U.S. government has accused an increasing number of healthcare providers of violating the federal False Claims Act. The False Claims Act prohibits a person from knowingly presenting, or causing to be presented, a false or fraudulent claim to the U.S. government. The statute defines “knowingly” to include not only actual knowledge of a claim’s falsity, but also reckless disregard for or intentional ignorance of the truth or falsity of a claim. Because our facilities perform hundreds of similar procedures a year for which they are paid by Medicare, and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties. Under the “qui tam,” or whistleblower, provisions of the False Claims Act, private parties may bring actions on behalf of the U.S. government. These private parties, often referred to as relators, are entitled to share in any amounts recovered by the government through trial or settlement.

Both direct enforcement activity by the government and whistleblower lawsuits have increased significantly in recent years and have increased the risk that a healthcare provider, such as one of our facilities, will have to defend a false claims action, pay fines or be excluded from the Medicare and Medicaid programs as a result of an investigation resulting from a whistleblower case. Risk to our facilities is further increased by the Affordable Care Act’s elimination of the requirement that a whistleblower be an original source of information, thereby easing barriers to filing of whistleblower suits. Although it is believed that our facilities’ operations materially comply with both federal and state laws, one of our facilities or the Company itself may nevertheless be the subject of a whistleblower lawsuit, or may otherwise be challenged or scrutinized by governmental authorities. A determination that the Company or one of our facilities violated these laws could have a material adverse effect on the Company.

The Emergency Medical Treatment and Active Labor Act

The Federal Emergency Medical Treatment and Active Labor Act (“EMTALA”) was adopted by the U.S. Congress in response to reports of a widespread hospital emergency room practice of “patient dumping.” At the time of the enactment, patient dumping was considered to have occurred when a hospital capable of providing the needed care sent a patient to another facility or simply turned the patient away based on such patient’s inability to pay for his or her care. The law imposes requirements upon physicians, hospitals and other facilities that provide emergency medical services. Such requirements pertain to what care must be provided to anyone who comes to such facilities seeking care before they may be transferred to another facility or otherwise denied care. The government broadly interprets the law to cover situations in which patients do not actually present to a hospital’s emergency department, but present to a hospital-based clinic that treats emergency medical conditions on an

 

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urgent basis or are transported in a hospital-owned ambulance, subject to certain exceptions. EMTALA does not generally apply to patients admitted for inpatient services. Sanctions for violations of this statute include termination of a hospital’s Medicare provider agreement, exclusion of a physician from participation in Medicare and Medicaid programs and civil monetary penalties. In addition, the law creates private civil remedies that enable an individual who suffers personal harm as a direct result of a violation of the law, and a medical facility that suffers a financial loss as a direct result of another participating hospital’s violation of the law, to sue the offending hospital for damages and equitable relief. Although we believe that our practices are in substantial compliance with the law, we cannot assure you that governmental officials responsible for enforcing the law will not assert from time to time that our facilities are in violation of this statute.

Certificates of Need

In some states, the construction of new facilities, acquisition of existing facilities or addition of new beds or services may be subject to review by state regulatory agencies under a certificate of need program. Oklahoma, Tennessee and Washington are the only states in which we currently operate that require approval of acute care hospitals under a certificate of need program. These laws generally require appropriate state agency determination of public need and approval prior to the addition of beds or services or other capital expenditures. Failure to obtain necessary state approval can result in the inability to expand facilities, add services and complete an acquisition or change ownership. Further, violation may result in the imposition of civil sanctions or the revocation of a facility’s license.

Environmental Matters

We are subject to various federal, state and local laws and regulations relating to environmental protection. The principal environmental requirements and concerns applicable to our operations relate to:

 

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the proper handling and disposal of hazardous and low level medical radioactive waste;

 

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ownership or historical use of underground and above-ground storage tanks;

 

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management of impacts from leaks of hydraulic fluid or oil associated with elevators, chiller units or incinerators;

 

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appropriate management of asbestos-containing materials present or likely to be present at some locations; and

 

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the potential acquisition of, or maintenance of air emission permits for, boilers or other equipment.

We do not expect our compliance with environmental laws and regulations to have a material effect on us. We may also be subject to requirements related to the remediation of substances that have been released into the environment at properties owned or operated by us or at properties where substances were sent for off-site treatment or disposal. These remediation requirements may be imposed without regard to fault and whether or not we owned or operated the property at the time that the relevant releases or discharges occurred. Liability for environmental remediation can be substantial.

Competition

The hospital industry is highly competitive. We currently face competition from established not-for-profit healthcare systems, investor-owned hospital companies, large tertiary care hospitals, specialty hospitals and outpatient service providers. In the future, we expect to encounter increased competition from companies, like ours, that consolidate hospitals and healthcare companies in specific geographic markets. Continued consolidation in the healthcare industry will be a leading factor contributing to increased competition in our current markets and markets we may enter in the future. Because of the shift to outpatient care and more stringent payor-imposed pre-authorization requirements during the past few years, most hospitals have significant unused capacity resulting in increased competition for patients. Many of our competitors are larger than us and have more financial resources available than we do. Other not-for-profit competitors have endowment and charitable contribution resources available to them and can purchase equipment and other assets on a tax-free basis.

Employees and Medical Staff

As of December 31, 2014, we had approximately 5,450 employees, including approximately 1,282 part-time employees. Approximately 253 of our full-time employees at our Olympia, Washington hospital are unionized. While some of our non-unionized hospitals experience union organizing activity from time to time, currently we do not expect these efforts to affect our future operations materially. Our hospitals, like most hospitals, have experienced labor costs rising faster than the general inflation rate.

 

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While the national nursing shortage has abated somewhat as a result of the weakened U.S. economy, certain pockets of the markets we serve continue to have limited available nursing resources. Nursing shortages often result in our using more contract labor resources to meet increased demand, especially during the peak winter months. We expect our nurse leadership and recruiting initiatives to mitigate the impact of the nursing shortage. These initiatives include more involvement with nursing schools, participation in more job fairs, recruiting nurses from abroad, implementing preceptor programs, providing flexible work hours, improving performance leadership training, creating awareness of our quality of care and patient safety initiatives and providing competitive pay and benefits. We anticipate that demand for nurses will continue to exceed supply especially as the baby boomer population reaches the ages where inpatient stays become more frequent. We continue to implement best practices to reduce turnover and to stabilize our nursing workforce over time.

Annually we develop a strategic physician recruitment and retention plan for each of our hospitals. Executing these plans, we have recruited 37 physicians, 41 physicians and 54 physicians for the years ended December 31, 2012, 2013 and 2014, respectively. We have recruited specialists in areas such as general surgery, cardiology, women’s services and orthopedics, as well as primary care physicians, including hospitalists and physicians practicing in areas such as family medicine, internal medicine and pediatrics. Recruitment of family practice and internal medicine physicians as well as mid-levels is critical to building a solid foundation of referring physicians in our markets.

Our hospitals grant staff privileges to licensed physicians who may serve on the medical staffs of multiple hospitals, including hospitals not owned by us. A physician who is not an employee can terminate his or her affiliation with our hospital at any time. Although we employ a growing number of physicians, a physician does not have to be our employee to be a member of the medical staff of one of our hospitals. Any licensed physician may apply to be admitted to the medical staff of any of our hospitals, but admission to the staff must be approved by each hospital’s medical staff and Board of Trustees in accordance with established credentialing criteria. Under state laws and other licensing standards, hospital medical staffs are generally self-governing organizations subject to ultimate oversight by the hospital’s local governing board. In an effort to meet community needs in certain markets in which we operate, we have implemented a strategy of employing physicians, with an emphasis on those practicing within primary care and other certain specialties. While we believe this strategy is consistent with industry trends, we cannot be assured of the long-term success of such a strategy.

Compliance Program

We maintain a company-wide Ethics & Compliance program designed to ensure that we maintain high standards of ethical conduct in the operation of our business. We continually implement policies and procedures for all of our employees, so they can act in compliance with all applicable laws, regulations and Company policies. The organizational structure of our Ethics & Compliance program includes oversight by Capella’s Board of Directors and a high-level Corporate Ethics & Compliance Committee (“CECC”). The Board of Directors and the CECC are responsible for ensuring that the compliance program meets its stated goals and remains up-to-date to address the current regulatory environment and other issues affecting the healthcare industry. Our Chief Compliance Officer, or CCO, who is also our Executive Vice President, Chief Legal and Administrative Officer, is charged with direct responsibility for the day-to-day oversight of our compliance program. Other features of our compliance program include initial and periodic ethics and compliance training and effectiveness reviews, a toll-free hotline for employees to report, without fear of retaliation, any suspected legal or ethical violations, and monthly “coding audits” to make sure our hospitals bill the proper service codes for reimbursement from the Medicare program.

Our compliance program also oversees the implementation and monitoring of the standards set forth by HIPAA for privacy and security. Ongoing HIPAA compliance also includes self-monitoring of HIPAA policy and procedure implementation by each of our healthcare facilities and oversight by the CECC and the CCO.

Our Information Systems

We believe that our information systems must cost-effectively meet the needs of our hospital management, medical staff and nurses in a variety of areas of our business operations, such as:

 

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patient accounting, including billing and collection of revenue;

 

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accounting, financial reporting and payroll;

 

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coding and compliance;

 

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laboratory, radiology and pharmacy systems;

 

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medical records and document storage;

 

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physician access to patient data;

 

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quality indicators;

 

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materials and asset management; and

 

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negotiating, pricing and administering our managed care contracts.

 

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We believe that the importance of and reliance upon information technology (“IT”) will continue to increase in the future. Accordingly, we expect to make additional significant investments in information technology during the next several years as part of our business strategy to increase the efficiency and quality of patient care.

Although we map the financial information systems from each of our hospitals to one centralized database, we do not automatically standardize our financial information systems among all of our hospitals. We carefully review the existing systems at the hospitals we acquire. If a particular information system is unable to cost-effectively meet the operational needs of the hospital, we will convert or upgrade the information system at that hospital to a standardized information system that can cost-effectively meet these needs.

The ARRA included approximately $26.0 billion in funding for various healthcare IT initiatives, including incentives for hospitals and physicians to implement EHR-compatible systems. Implementation of these IT initiatives has been divided into three stages and we are currently on track to meet the meaningful use standards. Though additional investments in hardware and software will be required, we believe our historical capital investments in information systems, as well as quality of care programs, provide a solid platform to build upon for timely compliance with the healthcare IT requirements of the ARRA.

Professional and General Liability Insurance

As is typical in the healthcare industry, we are subject to claims and legal actions by patients and others in the ordinary course of business. For professional and general liability claims, we self-insure the first portion of each claim, and Auriga Insurance Group (“Auriga”), a wholly-owned subsidiary of Capella Holdings, Inc. (“Holdings”), insures the next portion of each claim. We maintain excess coverage from independent third-party carriers for claims exceeding the coverage provided by Auriga from Lloyds of London for the first portion of the excess policy and the Bermuda market for the remaining portion. Auriga funds its portion of claims costs from proceeds of premium payments received from us.

We believe that our current insurance program provides sufficient coverage for our facilities. We cannot, however, ensure that potential claims will not exceed those amounts. Consistent with the policy limits and indemnification agreements, our insurance coverage will cover insured professional/general liability claims made against us, during the time such insurance is in force, consistent with the policy terms and conditions; however, our insurance policy covers the members of our Board of Directors and the boards of our subsidiaries only with respect to acts performed in their capacity as board members.

Emerging Growth Company

Capella believes that it qualifies as an “emerging growth company” under the Jumpstart Our Business Startups Act, or the JOBS Act. Capella should maintain this status until the earliest of the last day of the fiscal year during which it has total annual gross revenues of more than $1 billion, the last day of the fiscal year following the fifth anniversary of the date of the first sale of common equity securities pursuant to an effective registration statement, the date on which it has issued more than $1 billion in non-convertible debt during the previous three years, or the date on which it is deemed to be a “large accelerated filer.” For as long as Capella remains an “emerging growth company” as defined in the JOBS Act, it may take advantage of certain exemptions from various reporting requirements that are applicable to “emerging growth companies” including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports.

 

Item 1A.

Risk Factors.

There are several factors, some beyond our control, that could cause results to differ significantly from our expectations. Some of these factors are described below. Other factors, such as market, operational, liquidity, interest rate and other risks, are described elsewhere in this report (see, for example, Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations). Any factor described in this report could by itself, or together with one or more factors, adversely affect our business, results of operations and/or financial condition. There may be factors not described in this report that could also cause results to differ from our expectations.

We cannot predict the effect that healthcare reform and other changes in government programs may have on our financial condition or results of operations.

The Affordable Care Act dramatically altered the United States healthcare system and is intended to decrease the number of uninsured Americans and reduce overall healthcare costs. The Affordable Care Act attempts to achieve these goals by, among other things, requiring most Americans to obtain health insurance, expanding Medicare and Medicaid eligibility, reducing Medicare and Medicaid payments, including DSH payments to providers, expanding the Medicare program’s use of value-based purchasing programs, tying hospital payments to the satisfaction of certain quality criteria, and bundling payments to hospitals and other

 

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providers. The Affordable Care Act also contains a number of measures that are intended to reduce fraud and abuse in the Medicare and Medicaid programs, such as requiring the use of RACs in the Medicaid program, expanding the scope of the federal False Claims Act and generally prohibiting physician-owned hospitals from increasing the total percentage of physician ownership or increasing the aggregate number of operating rooms, procedure rooms, and beds for which they are licensed. Because some of the measures contained in the Affordable Care Act did not take effect until 2014, it is difficult to predict the impact the Affordable Care Act will have on our facilities.

Furthermore, the U.S. Supreme Court has agreed to hear the case King v. Burwell during 2015. This case challenges the extension of premium subsidies to individuals residing in the 37 states that have federally-run health insurance exchanges. If the U.S. Supreme Court decides that the Affordable Care Act does not authorize premium subsidies to federally-run health insurance exchange participants, the decision would likely make it more difficult for uninsured individuals in those states to purchase coverage, upset the private insurance market and otherwise significantly affect implementation of the Affordable Care Act, in a manner that results in higher than projected numbers of uninsured individuals.

In addition, a number of the provisions of the Affordable Care Act that were scheduled to become effective in 2014, such as the employer mandate, the Small Business Health Option Program, and the state run exchange verification of income and Medicaid agency electronic notification of eligibility for tax credit and subsidy requirements, have been delayed until 2015 or 2016, and additional delays in the implementation of these or other provisions of the Affordable Care Act could be imposed in the future. Several bills have been and will likely continue to be introduced in Congress to defund, delay, repeal or amend all or significant provisions of the Affordable Care Act. It is difficult to predict the full impact of the Affordable Care Act because of its complexity, lack of implementing regulations and interpretive guidance, state decisions to decline Medicaid expansion, gradual and potentially delayed implementation, potential future legal challenges, and possible repeal and/or amendment, as well as our inability to foresee how individuals and businesses will respond to the choices afforded them by the Affordable Care Act.

Spending cuts resulting from the Budget Control Act of 2011 may have a material adverse effect on our financial position, results of operation or cash flow.

On August 2, 2011, the Budget Control Act of 2011, or BCA, was enacted. The BCA increased the nation’s debt ceiling while taking steps to reduce the federal deficit. First, the BCA imposed caps that reduced non-entitlement spending by more than $900 billion over 10 years, beginning in FFY 2012. Second, a bipartisan Committee was charged with identifying at least $1.5 trillion in deficit reduction, which could include entitlement provisions like Medicare reimbursement to providers. On November 21, 2011, the Committee announced that its members were unable to agree on any measures to reduce the deficit, and as a result, $1.2 trillion in automatic, across-the-board spending reductions required by the BCA are scheduled to be imposed automatically for FFYs 2013 through 2021, split evenly between domestic and defense spending. The Pathway Act extended those reductions through FFY 2023. Certain programs (including the Medicaid program) are protected from these automatic spending reductions, but the Medicare program is subject to reductions capped at 2%. On January 1, 2013, the ATRA delayed the imposition of the BCA’s automatic spending reductions from January 2, 2013 to March 1, 2013, with CMS implementing the 2% reduction in Medicare spending on April 1, 2013. The BCA’s automatic spending reductions began March 1, 2013, and are scheduled to reduce Medicare spending by $9.9 billion. The automatic spending cuts or other Congressional action on other spending reductions proposed by the Committee may reduce the revenue we receive from governmental payment programs or impose additional restrictions on those programs intended to decrease the long-term cost of such programs. Any such reductions may have a material adverse effect on our financial position, results of operation or cash flow.

Our overall business results may suffer from the lingering effects of the economic downturn.

The United States economy continues to experience the negative effects from an economic downturn and unemployment levels remain high. During economic downturns, governmental entities often experience budgetary constraints as a result of increased costs and lower than expected tax collections. These budgetary constraints may result in decreased spending for health and human service programs, including Medicare, Medicaid and similar programs, which represent significant payor sources for our hospitals. Additionally, when patients are experiencing personal financial difficulties or have concerns about general economic conditions, they may choose to defer or forego elective surgeries and other non-emergent procedures, which are generally more profitable lines of business for hospitals. Moreover, we could experience increases in the uninsured and underinsured populations and difficulties in collecting patient co-payment and deductible receivables.

 

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The growth of uninsured and “patient due” accounts and a deterioration in the collectability of these accounts could affect our results of operations adversely.

The primary collection risks of our accounts receivable relate to the uninsured patient accounts and patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding. The provision for bad debts relates primarily to amounts due directly from patients. This risk has increased, and will likely continue to increase, as more individuals enroll in insurance plans with high deductibles or with high co-payments. These trends will likely be exacerbated if general economic conditions remain challenging or if unemployment levels in the communities in which we operate rise.

The amount of our provision for bad debts is based on our assessments of historical collection trends, business and economic conditions, trends in federal and state governmental and private employer health coverage and other collection indicators. A continuation in trends that results in increasing the proportion of accounts receivable being composed of uninsured accounts and deterioration in the collectability of these accounts could adversely affect our collections of accounts receivable, results of operations and cash flows. As enacted, the Affordable Care Act seeks to decrease, over time, the number of uninsured individuals. However, it is difficult to predict the full impact of the Affordable Care Act because of its complexity, lack of implementing regulations and interpretive guidance, state decisions to decline Medicaid expansion, gradual and potentially delayed implementation, potential future legal challenges, and possible repeal and/or amendment, as well as our inability to foresee how individuals and businesses will respond to the choices afforded them by the Affordable Care Act. In addition, even after implementation of the Affordable Care Act, we may continue to experience bad debts and be required to provide uninsured discounts and charity care for undocumented aliens who are not permitted to enroll in a health insurance exchange or government healthcare programs.

Our revenue may decline if federal or state programs reduce our Medicare or Medicaid payments.

Approximately 53.1%, 52.1% and 56.5% of our revenue before the provision for bad debts for the years ended December 31, 2012, 2013, and 2014, respectively, came from the Medicare and Medicaid programs, respectively, including Medicare and Medicaid managed plans. In recent years, federal and state governments have made significant changes in the Medicare and Medicaid programs. Some of those changes adversely affect the reimbursement we receive for certain services. For example, CMS has transitioned to full implementation of the MS-DRG system, which represents a refinement to the existing diagnosis-related group system. Future alignments in the MS-DRG system could impact the margins we receive for certain services. Furthermore, the Affordable Care Act provides for material reductions in the growth of Medicare program spending, including reductions in Medicare market basket updates, and Medicare DSH funding.

Medicaid programs are funded jointly by the federal government and the states and are administered by states under approved plans. Most state Medicaid program payments are made under a prospective payment system or are based on negotiated payment levels with individual hospitals. Since most states must operate with balanced budgets and since the Medicaid program is often the state’s largest program, many states in which we operate have adopted, or are considering adopting, legislation designed to reduce coverage and program eligibility, enroll Medicaid recipients in managed care programs and/or impose additional taxes on hospitals to help finance or expand the states’ Medicaid systems. The current economic downturn has increased the budgetary pressures on most states, and these budgetary pressures have resulted and likely will continue to result in decreased spending, or decreased spending growth, for Medicaid programs in many states. Future legislation or other changes in the administration or interpretation of government health programs could have a material adverse effect on our business, financial condition and results of operations.

We are subject to regular post-payment inquiries, investigations and audits of the claims we submit to Medicare and Medicaid for payment for our services. These post-payment reviews have increased in recent years as a result of new government cost-containment initiatives, including audits of Medicare and Medicaid claims under the RAC program. RACs were first introduced only in the Medicare program; however, the Affordable Care Act expanded the RAC program’s scope to include Medicaid claims by requiring all states to establish programs to contract with RACs in 2011. In addition, CMS employs Medicaid Integrity Contractors (“MICs”) to perform post-payment audits of Medicaid claims and identify overpayments. The Affordable Care Act increased federal funding for the MIC program for FFY 2011 and beyond. In addition to RACs and MICs, state Medicaid agencies and other contractors have also increased their review activities. These additional post-payment reviews may require us to incur additional costs to respond to requests for records and to pursue the reversal of payment denials and ultimately may require us to refund amounts paid to us that are determined to have been overpaid.

Our revenue may decline if payments from our third-party payors are reduced or eliminated, or if we are unable to negotiate contracts or maintain satisfactory relationships with third-party payors.

In addition to governmental programs, we are dependent upon private third-party sources of payment for the services provided to patients at our hospitals. If these payments are reduced, our revenue will decrease. The amount of payment we receive for services provided at our hospitals may be adversely affected by market and cost factors as well as other factors over which we have no control.

 

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Controls designed to reduce inpatient services may reduce our revenue.

Controls imposed by Medicare and commercial third-party payors designed to reduce admissions and lengths of stay, commonly referred to as “utilization review,” have affected and are expected to continue to affect our facilities. Utilization review entails the review of the admission and course of treatment of a patient by managed care plans. Inpatient utilization, average lengths of stay and occupancy rates continue to be negatively affected by payor-required preadmission authorization and utilization review and by payor pressures to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. Efforts to impose more stringent cost controls are expected to continue. Fixed fee schedules, capitation payment arrangements, exclusion from participation in managed care programs or other factors affecting payments for healthcare services over which we will have no control could cause a reduction in our revenue.

There has been recent increased scrutiny of a hospital’s “Medicare Observation Rate” from outside auditors, government enforcement agencies and industry observers. The term “Medicare Observation Rate” is defined as total unique observation claims divided by the sum of total unique observation claims and total inpatient short-stay acute care hospital claims. A low rate may raise suspicions that a hospital is inappropriately admitting patients that could be cared for in an observation setting. In our hospitals, we use the independent, evidence-based clinical criteria developed by McKesson Corporation, commonly known as InterQual Criteria, to determine whether a patient qualifies for inpatient admission. The industry may anticipate increased regulatory scrutiny of inpatient admission decisions and the Medicare Observation Rate in the future.

We may experience a shortage of qualified professional and staff personnel.

Consistent with a nationwide trend in the healthcare industry, our hospitals have experienced a shortage of nurses and other qualified professional and staff personnel. The shortage of qualified professional and staff personnel may be exacerbated by the development of other healthcare facilities in the market areas of our hospitals.

As a result, our hospitals may utilize contract nurses to ensure adequate patient care, which typically are more expensive than full-time employees. In addition, our hospitals may be forced to implement more costly coverage and retention programs. There can be no assurance that our hospitals will be able to recruit or retain a sufficient number of qualified professional and staff personnel to deliver healthcare services efficiently. Accordingly, our financial condition and results of operations may be affected adversely.

Our performance depends on our ability to recruit and retain quality physicians.

Physicians generally direct the majority of hospital admissions. Thus, the success of our hospitals depends in part on the following factors:

 

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the number and quality of the physicians on the medical staffs of our hospitals;

 

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the admitting practices of those physicians; and

 

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the development and maintenance of constructive relationships with those physicians.

Most physicians at our hospitals also have admitting privileges at other hospitals. Our efforts to attract and retain physicians are affected by our efforts to promote quality, leadership, satisfaction and intellectual development, our managed care contracting relationships, national shortages in some specialties, the adequacy of our support personnel, the condition of our facilities and medical equipment, the availability of suitable medical office space, and federal and state laws and regulations prohibiting financial relationships that may have the effect of inducing patient referrals. There can be no assurance that our physician recruitment measures, including multi-year employment and/or income guarantee arrangements and other collaborative arrangements will be successful. Also, as we recruit more physicians, the costs associated with integrating and managing these new physicians could have a negative impact on our operating results and liquidity in the short term.

If facilities are not staffed with adequate support personnel or technologically advanced equipment that meets the needs of patients, physicians may be discouraged from referring patients to our facilities, which could affect our profitability adversely. Furthermore, physicians we recruit or employ may fail to maintain successful medical practices, one or more key members of a particular physician group may cease practicing with that group, or other surgeons in the community may refuse to use our hospitals. Although we have been generally successful in our physician recruiting efforts, we cannot assure you of the long-term success of this strategy. We also face continued challenges in some of our markets to recruit certain types of physician specialists who are in high demand.

 

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We are dependent on our executive management team and the loss of the services of one or more of our executive management team could have a material adverse effect on our business.

The success of our business is largely dependent upon the services and management experience of our executive management team. In addition, we depend on the ability of our executive officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. We do not maintain key man life insurance policies on any of our officers. If we were to lose any of our executive management team or members of our local management teams, or if we are unable to attract other necessary personnel in the future, it could have a material adverse effect on our business, financial condition and results of operations. If we were to lose the services of one or more members of our executive management team, we could experience a significant disruption in our operations and failure of the affected hospitals to adhere to their respective business plans.

If we fail to comply with extensive laws and government regulations, including fraud and abuse laws, we could suffer penalties or be required to make significant changes to our operations.

The healthcare industry is required to comply with many laws and regulations at the federal, state, and local government levels. These laws and regulations require that hospitals meet various requirements, including those relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes, environmental protection and privacy. These laws include the HIPAA, a section of the Social Security Act, known as the “anti-kickback” statute, and the Stark Law.

There are heightened coordinated civil and criminal enforcement efforts by both federal and state government agencies relating to the healthcare industry, including the hospital segment. The ongoing investigations of certain healthcare providers relate to various referral, inpatient status cost reporting and billing practices, laboratory and home care services, privacy and physician ownership and joint ventures involving hospitals. Moreover, the health reform laws increase funding for fraud and abuse enforcement and increase penalties under the False Claims Act. Federal regulations issued under HIPAA contain provisions that required us to implement and, in the future, may require us to implement additional costly electronic media security systems and to adopt new business procedures designed to protect the privacy and security of each of our patient’s health and related financial information. Such privacy and security regulations impose extensive administrative, physical and technical requirements on us, restrict our use and disclosure of certain patient health and financial information, provide patients with rights with respect to their health information and require us to enter into contracts extending many of the privacy and security regulation requirements to third parties that perform duties on our behalf. Additionally, on January 13, 2013, HHS issued a final rule which, among other things, made final modifications to the HIPAA Privacy, Security, and Enforcement Rules mandated by the HITECH Act; adopted changes to the HIPAA Enforcement Rule to incorporate the increased and tiered civil money penalty structure provided by the HITECH Act; adopted a final rule on Breach Notification for Unsecured Protected Health Information which replaces the breach notification rule’s prior “harm” threshold with a more objective standard; and modified the HIPAA Privacy Rule as required by GINA. We are also required to make certain expenditures to help ensure our continued compliance with such laws and regulations and, in the future, such expenses could negatively impact our results of operations. The ARRA included provisions for heightened enforcement of HIPAA and stiffer penalties for HIPAA violations.

If we fail to comply with applicable laws and regulations, including fraud and abuse laws, we could suffer civil or criminal penalties, including the loss of our licenses to operate and our ability to participate in the Medicare, Medicaid, and other federal and state healthcare programs. Our facilities also are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary for licensing and accreditation. If any facility loses its accreditation, it may be in default under its third party payor agreements, make difficult the attraction, negotiation and retention of those agreements on satisfactory terms or at all and could put its Medicare certification at risk if the facility’s Medicare certification was obtained through deemed status as a result of the facility’s accreditation. If a facility loses its certification under the Medicare program, then the facility will be unable to receive reimbursement from the Medicare and Medicaid programs. The requirements for licensure, certification and accreditation are subject to change and, in order to remain qualified, we may need to make changes in our facilities, equipment, personnel and services.

In the future, changes, different interpretations or enforcement of these laws and regulations, including any changes pursuant to the Affordable Care Act, could subject our current practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs, and operating expenses. For a more detailed discussion of these laws, rules and regulations, see “Item 1. Business — Government Regulation and Other Factors.”

 

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CMS may impose substantial fines or other penalties as a result of the matters disclosed in certain self-disclosure letters, which could have a material adverse impact on the results of operations and financial condition Cannon County Hospital, LLC, or CCH, which is a joint venture in which we own a 60.31% interest.

Laws and regulations governing the Medicare, Medicaid and other federal healthcare programs are complex and subject to interpretation. CMS and the OIG allow providers to disclose prior conduct that may have violated those laws and regulations and resolve those issues below the maximum penalties authorized by law. CMS established a Voluntary Self-Referral Disclosure Protocol under the authority provided in the Affordable Care Act, which allows providers to disclose to CMS actual or potential violations of the Stark Law and allows CMS to compromise the total amount of overpayments owed as a result of inadvertent Stark Law violations. Additionally, the OIG is responsible for imposing penalties for Stark Law violations and violations of the anti-kickback statute, which may include civil monetary penalties, imposition of a Corporate Integrity Agreement or exclusion from federal health care programs such as Medicare and Medicaid. CMS does not have the authority to compromise any of the potential penalties that may be imposed by the OIG. Based on the findings from CCH’s internal investigation, management of CCH submitted voluntary self-disclosure letters to CMS for each of DeKalb Community Hospital and Stones River Hospital on June 22, 2011 (collectively, the “Self-Disclosure Letters”). The Self-Disclosure Letters disclose certain potentially non-compliant arrangements with physicians under the Stark Law, including lack of certain written agreements with physicians and, solely with respect to Stones River Hospital, administrative failures to ensure that physicians who leased space from CCH executed compliant leases and regularly paid the rental amounts that were due. CCH’s current management is unable to predict CMS’s response to the Self-Disclosure Letters, the potential liability that may result from the Self Disclosure Letters or whether CMS may widen the scope of its investigation beyond the matters covered in the Self-Disclosure Letters or refer the matters to any other governmental agencies. If CMS imposes substantial fines as a result of the conduct described in the Self-Disclosure Letters to CMS, it would have a material adverse impact on the results of operations and financial condition of CCH, in which we own a 60.31% interest.

We are subject to competition from other hospitals or healthcare providers, including physicians, which could affect our results of operations adversely.

Our success depends on the effective and efficient operation of our hospitals, which will be affected by competition from other acute care hospitals, free-standing outpatient diagnostic and surgery centers, labs and alternative delivery systems, some of which have substantially greater resources than we do. The healthcare industry is highly competitive. Alternative forms of healthcare delivery systems, such as health maintenance organizations and preferred provider organizations, are significant factors in the delivery of healthcare services and the rates chargeable by physicians and hospitals. Typically, our hospitals’ primary competitor is a not-for-profit hospital. Further, our hospitals face competition from hospitals outside of their primary service area, including hospitals in urban areas that provide more complex services. Patients in our primary service areas may travel to these other hospitals for a variety of reasons. These reasons include physician referrals or the need for services we do not offer. Patients who seek services from these other hospitals subsequently may shift their preferences to those hospitals for the services we provide.

We also face very significant and increasing competition not only from services offered by physicians (including physicians on our medical staffs) in their offices and from other specialized care providers, including outpatient surgery, oncology, physical therapy and diagnostic centers (including many in which physicians may have an ownership interest), but also from physicians owning and operating competing hospitals. Some of our hospitals have and will seek to develop outpatient facilities where necessary to compete effectively. However, to the extent that other providers are successful in developing outpatient facilities or physicians are able to offer additional, advanced services in their offices, our market share for these services likely will decrease in the future.

Our revenue is especially concentrated in a small number of states which makes us particularly sensitive to regulatory and economic changes in those states.

Our revenue is particularly sensitive to regulatory and economic changes in states in which we generate the majority of our revenue, including Oklahoma and Arkansas. For the years ended December 31, 2012, 2013, and 2014, we generated approximately 58.6%, 59.2%, and 57.8% of our revenue before the provision for bad debts, respectively, in Oklahoma and Arkansas. This concentration makes us particularly sensitive to regulatory, economic, environmental and competitive conditions and changes in those states. Any material change in the current payment programs or regulatory, economic, environmental or competitive conditions in those states could have a disproportionate effect on our overall business results. The economies of the non-urban communities in which our hospitals operate are often dependent on a small number of large employers, especially manufacturing or other facilities. These employers often provide income and health insurance for a disproportionately large number of community residents who may depend on our hospitals for care. The failure of one or more large employers, or the closure or substantial reduction in the number of

 

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individuals employed at manufacturing or other facilities located in or near many of the non-urban communities in which our hospitals operate, could cause affected employees to move elsewhere for employment or lose insurance coverage that was otherwise available to them. The occurrence of these events may cause a material reduction in our revenue or impede our business strategies intended to generate organic growth and improve operating results at our hospitals. Any material change in the current demographic, economic, competitive or regulatory conditions in any of our markets could affect our overall business results adversely because of the significance of our operations in each of these markets to our overall operating performance. Moreover, because of the concentration of our revenue in a limited number of markets, our business is less diversified and, accordingly, is subject to greater regional risk than that of some of our larger competitors.

If our access to licensed information systems is interrupted or restricted, or if we are not able to integrate changes to our existing information systems or information systems of acquired hospitals, our operations could suffer.

Our business depends significantly on effective information systems to process clinical and financial information. Information systems require an ongoing commitment of significant resources to maintain and enhance existing systems and develop new systems in order to keep pace with continuing changes in information processing technology. We rely heavily on an affiliate of HCA Holdings, Inc. and another third-party vendor for information systems. These two parties provide us with our primary financial, clinical, revenue cycle management, patient accounting and network information services. HCA’s primary business is to own and operate hospitals, not to provide information systems. We do not control these systems, and if these systems fail or are interrupted, if our access to these systems is limited in the future or if these parties develop systems more appropriate for the urban healthcare market and not suited for our hospitals, our operations could suffer.

System conversions are costly, time consuming and disruptive for physicians and employees. Should we decide or be required to convert away from systems provided by third parties, such implementation would be very costly and could have a material adverse effect on our business, financial condition and results of operations.

In addition, as new information systems are developed in the future, we will need to integrate them into our existing systems. Evolving industry and regulatory standards, such as HIPAA and EHR regulations, may require changes to our information systems in the future. For example, the HITECH Act, contains a number of provisions that significantly expand the reach of HIPAA. Among other things, the HITECH Act (i) created new security breach notification requirements for covered entities (ii) extended the HIPAA security provisions to business associates, and (iii) increased a patient’s ability to restrict access to his or her protected health information. We may not be able to integrate new systems or changes required to our existing systems or systems of acquired hospitals in the future effectively or on a cost-efficient basis.

Additionally, as required by the ARRA, HHS is in the process of developing and implementing an incentive payment program for eligible hospitals and healthcare professionals that adopt and meaningfully use certified EHR technology. If our hospitals and employed professionals are unable to meet the requirements for participation in the incentive payment program, we will not be eligible to receive incentive payments that could offset some of the costs of implementing EHR systems. Further, beginning in 2015, eligible hospitals and professionals that fail to demonstrate meaningful use of certified EHR technology will be subject to reduced payments from Medicare. Failure to implement EHR systems effectively and in a timely manner could have a material adverse effect on our financial position and results of operations.

We may be subject to liabilities for professional liability and other claims brought against our facilities.

We may be liable for damages to persons or property arising from occurrences at our hospitals. We maintain casualty, professional and general liability insurance through Auriga, in amounts and with deductibles that we believe to be appropriate for our operations. Our reserves for professional and general liability claims and workers compensation claims are based upon independent third-party actuarial calculations, which consider historical claims data, demographic considerations, severity factors and other actuarial assumptions in determining reserve estimates. If the assumptions underlying the third-party actuarial calculations prove to be materially different from actual claims brought against us, our reserves may be insufficient. We also carry excess layers should a claim exceed Auriga’s aggregate cap. If we become subject to claims, however, our insurance coverage (i) may not cover all successful professional and general liability claims brought against us or (ii) continue to be available at a cost allowing us to maintain adequate levels of insurance. If one or more successful claims against us were not covered by or exceeded the coverage of our insurance, we could be affected adversely.

 

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We are subject to potential legal and reputational risk as a result of our access to personal information of our patients.

There are numerous federal and state laws and regulations addressing patient and consumer privacy concerns, including unauthorized access to or theft of personal information. As a provider of health care services, we process, transmit and store sensitive or confidential data, including electronic health records and other personally identifiable information of our patients. The secure processing, maintenance and transmission of this information is critical to our operations and business strategy. We have developed a comprehensive set of policies and procedures in our efforts to comply with HIPAA and other privacy and information security laws. In 2011, the HHS Office for Civil Rights imposed, for the first time, civil monetary penalties and imposed a corrective action plan on a covered entity for violating HIPAA’s privacy and information security rules. In addition, state attorneys general have brought civil actions seeking injunctions and damages in response to violations of HIPAA’s privacy and security rules. The breach, loss or other compromise of such personal health information could disrupt the operations of one or more facilities, damage our reputation, result in regulatory penalties, legal claims and liability under HIPAA and other state and federal laws, which could have a material adverse effect on our business, financial condition and results of operations.

Future capital commitments, acquisitions or joint ventures may require significant resources, may be unsuccessful or could expose us to unforeseen liabilities.

As part of our growth strategy, we may pursue acquisitions or joint ventures of hospitals or other related healthcare facilities and services. These acquisitions or joint ventures may involve significant cash expenditures, debt incurrence, additional operating losses and expenses that could have a material adverse effect on our business, financial condition and results of operations. Acquisitions or joint ventures involve numerous risks, including:

 

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difficulty and expense of integrating acquired operations into our business;

 

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diversion of management’s time from existing operations;

 

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potential loss of key employees or physicians of acquired facilities; and

 

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assumption of the liabilities and exposure to unforeseen liabilities of acquired companies, including liabilities for failure to comply with healthcare regulations.

We cannot assure you that we will succeed in obtaining financing for acquisitions or joint ventures at a reasonable cost, or that such financing will not contain restrictive covenants that limit our operating flexibility. Further, volatility and disruption of the capital and credit markets and adverse changes in the United States and global economies may further impact our ability to access both available and affordable financing. We also may be unable to operate acquired hospitals profitably or succeed in achieving improvements in their financial performance.

Additionally, many states, including some where we have hospitals and others where we may in the future attempt to acquire hospitals, have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the sale proceeds by the not-for-profit seller. These review and approval processes can add time to the consummation of an acquisition of a not-for-profit hospital, and future actions on the state level seriously could delay or even prevent future acquisitions of not-for-profit hospitals. Furthermore, as a condition to approving an acquisition, the attorney general of the state in which the hospital is located may require us to maintain specific services, such as emergency departments, or to continue to provide specific levels of charity care, which may affect our decision to acquire or the terms upon which we acquire one of these hospitals.

If we fail to enhance our hospitals with the most recent technological advances in diagnostic and surgical equipment, our ability to maintain and expand our markets may be affected adversely.

Technological advances with respect to computed axial tomography (CT), magnetic resonance imaging (MRI) and positron emission tomography (PET) equipment, as well as other equipment used in our facilities, are continually evolving. In an effort to provide high quality patient care and to compete with other healthcare providers, we must constantly evaluate our equipment needs and upgrade equipment as a result of technological improvements. Such equipment costs typically range from $1.0 million to $3.0 million, exclusive of construction or build-out costs. If we fail to remain current with the technological advancements of the medical community, our volumes and revenue may be impacted negatively.

 

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Difficulties with major expansion projects may involve significant capital expenditures that could have an adverse impact on our liquidity.

We may decide to construct major expansion projects to existing hospitals in order to achieve our growth objectives. Our ability to complete new expansion projects on budget and on schedule would depend on a number of factors, including, but not limited to:

 

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our ability to control construction costs;

 

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adverse weather conditions;

 

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shortages of labor or materials;

 

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our ability to obtain necessary licensing and other required governmental authorizations; and

 

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other unforeseen problems and delays.

As a result of these and other factors, we cannot assure you that if we decide to pursue major expansion projects we will not experience greater construction or other expansion costs than originally planned in connection with expansion projects.

State efforts to regulate the construction or expansion of healthcare facilities could impair our ability to operate and expand our operations.

Some states, including the ones in which we operate, require healthcare providers to obtain prior approval, known as a certificate of need (“CON”), for the purchase, construction or expansion of healthcare facilities, to make certain capital expenditures or to make changes in services or bed capacity. In giving approval, these states consider the need for additional or expanded healthcare facilities or services. The failure to obtain any requested CON could impair our ability to operate or expand operations. Any such failure could, in turn, adversely affect our ability to attract patients to our facilities and grow our revenue, which would have an adverse effect on our results of operations.

The industry trend toward value-based purchasing may negatively impact our revenue.

There is a trend in the healthcare industry toward value-based purchasing of healthcare services. These value-based purchasing programs include both public reporting of quality data and preventable adverse events tied to the quality and efficiency of care provided by facilities. Governmental programs, including Medicare and Medicaid, require hospitals to report certain quality data to receive full reimbursement updates. In addition Medicare does not reimburse for care related to certain preventable adverse events (also called “never events”). Many large commercial payors currently require hospitals to report quality data, and several commercial payors do not reimburse hospitals for certain preventable adverse events. Furthermore, we implemented a policy pursuant to which we do not bill patients or third-party payors for fees or expenses incurred as a result of certain preventable adverse events. We expect value-based purchasing programs, including programs that condition reimbursement on patient outcome measures, to become more common and to involve a higher percentage of reimbursement amounts. We are unable at this time to predict how this trend will affect our results of operations, but it could impact our revenue negatively.

A majority of the employees of Capital Medical Center and its related clinics are union members and subject to the terms of collective bargaining agreements.

Capital Medical Center is currently a party to collective bargaining agreements with two local unions that represent all of the employees of that hospital with the exception of professional employees, managerial employees, confidential employees, guards and supervisors (as those terms are defined in the National Labor Relations Act). The terms of the collective bargaining agreements set forth certain criteria related to the hospital’s employment practices, seniority, hours of work and overtime, holidays, use and redemption of paid time off, extended illness bank, vacation scheduling, compensation, pay practice, health and non-health benefits, leaves of absence, grievance procedures, disability accommodations and the hospital’s drug and alcohol policies. If Capital Medical Center is unable to meet any such criteria, it could result in discussions with union representatives that could be costly and time-consuming for that facility. Furthermore, the terms of the collective bargaining agreements constrain our flexibility as general partner of Capital Medical Center with respect to certain employee issues. Other facilities could experience unionizing activity, which could increase our labor costs materially.

 

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Our interest in EASTAR Health System will expire at the end of the lease term.

We currently lease or sublease EASTAR Health System and related properties pursuant to a forty-year lease with Muskogee Medical Center Authority, which expires in 2047 (the “Muskogee Lease”). Under the terms of the Muskogee Lease, EASTAR and related properties will revert automatically to the Muskogee Medical Center Authority or the City of Muskogee, as applicable, upon the expiration or termination of the Muskogee Lease. The Muskogee Lease also grants the Muskogee Medical Center Authority the option to purchase some or all of the assets owned by us and used in connection with the operation of EASTAR and related properties in the event the Lease expires or is terminated. Upon the expiration or termination of the Muskogee Lease, our interest in EASTAR and related properties will cease.

GTCR indirectly controls us and may have conflicts of interest with us or you in the future.

Capella was formed in April 2005 by four former executives of Province Healthcare with the support of a significant equity commitment by certain investment funds affiliated with GTCR Golder Rauner II L.L.C. (collectively, with GTCR Golder Rauner, LLC and certain affiliated entities, referred to as “GTCR”). GTCR benefically owns 95.1% of Holdings common stock, which in turn owns 100% of the outstanding shares of Capella’s common stock. GTCR elects a majority of the board of directors of Holdings and Capella and controls all matters affecting us, including any determination with respect to:

 

•

our direction and policies;

 

•

the acquisition and disposition of assets;

 

•

future issuances of common stock, preferred stock or other securities;

 

•

our future incurrence of debt; and

 

•

any dividends on our common stock or preferred stock.

The interests of GTCR could conflict with our interests. If we encounter financial difficulties or are unable to pay our debts as they mature, the interests of our equity holders might conflict with those of our company. In addition, GTCR may have an interest in pursuing acquisitions, divestitures, financings or other transactions, that, in its judgment, could enhance its equity investment even though such transactions might involve risks to our company. In addition, GTCR is in the business of making investments in companies and may from time to time acquire interests in businesses that directly or indirectly compete with our business.

Our hospitals are subject to potential responsibilities and costs under environmental laws that could lead to material expenditures or liability.

We are subject to various federal, state and local environmental laws and regulations, including those relating to the protection of human health and the environment. We could incur substantial costs to maintain compliance with these laws and regulations. To our knowledge, we have not been and are not currently the subject of any investigations relating to noncompliance with environmental laws and regulations. We could become the subject of future investigations, which could lead to fines or criminal penalties if we are found to be in violation of these laws and regulations. The principal environmental requirements and concerns applicable to our operations relate to proper management of hazardous materials, hazardous waste and medical waste, above-ground and underground storage tanks, operation of boilers, chillers and other equipment, and management of building conditions, such as the presence of mold, lead-based paint or asbestos. Our hospitals engage independent contractors for the transportation and disposal of hazardous waste, and we require that our hospitals be named as additional insureds on the liability insurance policies maintained by these contractors.

We also may be subject to requirements related to the remediation of substances that have been released into the environment at properties owned or operated by us or our predecessors or at properties where substances were sent for off-site treatment or disposal. These remediation requirements may be imposed without regard to fault, and liability for environmental remediation can be substantial.

 

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Our substantial indebtedness could affect our financial condition adversely.

As of December 31, 2014, our total consolidated indebtedness was approximately $613.8 million. We also have the ability to incur substantial additional indebtedness in the future. The terms of our indenture and our senior secured term loan facility consisting of a $100 million seven-year term loan (the “Term Loan Facility”) and our senior secured asset based loan (the “ABL”) do not fully prohibit us or our subsidiaries from doing so. The ABL provides commitments of up to $100.0 million (not giving effect to any outstanding letters of credit, which would reduce the amount available under our ABL), of which approximately $71.0 million would have been available for future borrowings as of December 31, 2014. In addition, we may seek to increase the borrowing availability under the ABL. All of those borrowings would be senior and secured. As of December 31, 2014, we had $5.0 million in outstanding borrowings under the ABL.

Our business and financial results depend on our ability to generate sufficient cash flow to service our debt or refinance our indebtedness on commercially reasonable terms.

Our ability to make payments on and to refinance our debt and fund planned expenditures depends on our ability to generate cash flow in the future. Our cash flow, to some extent, is subject to general economic, financial, competitive, legislative and regulatory factors and other factors that are beyond our control. We cannot guarantee that our business will generate cash flow from operations or that future borrowings will be available to us under the ABL in an amount sufficient to enable us to pay our debt or to fund our other liquidity needs. We cannot guarantee that we will be able to refinance our borrowing arrangements or any other outstanding debt on commercially reasonable terms or at all. Refinancing our borrowing arrangements could cause us to:

 

•

pay interest at a higher rate;

 

•

be subject to additional or more restrictive covenants than currently provided in our debt agreements; and

 

•

grant additional security interests in our assets.

Our inability to generate sufficient cash flow to service our debt or refinance our indebtedness on commercially reasonable terms would have a material adverse effect on our business, financial condition and results of operations.

Operating and financial restrictions in our debt agreements limit our operational and financial flexibility.

The ABL, the Term Loan Facility and our indenture contain a number of significant covenants that, among other things, restrict our ability to:

 

•

incur additional indebtedness or issue preferred stock;

 

•

pay dividends on or make other distributions or repurchase our capital stock or make other restricted payments;

 

•

make investments;

 

•

enter into certain transactions with affiliates;

 

•

issue dividends or other payments from restricted subsidiaries to Holdings or other restricted subsidiaries;

 

•

create liens;

 

•

designate our subsidiaries as unrestricted subsidiaries; and

 

•

sell certain assets or merge with or into other companies or otherwise dispose of all or substantially all of our assets.

 

 

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In addition, under the ABL and the Term Loan Facility, we are required to satisfy and maintain specified financial ratios and tests. Events beyond our control may affect our ability to comply with those provisions, and we may not be able to meet those ratios and tests. The breach of any of these covenants would result in a default under the ABL or the Term Loan Facility and the lenders could elect to declare all amounts borrowed under the ABL and the Term Loan Facility, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Because borrowings under the ABL are secured by certain of our assets and certain assets of our subsidiaries, borrowings under the ABL or the Term Loan Facility are superior in right of payment to the notes to the extent of the assets securing the ABL and the Term Loan Facility. If any of our indebtedness were to be accelerated, our assets may not be sufficient to repay in full our outstanding indebtedness.

Under the ABL, when (and for as long as) the availability under the ABL is less than a specified amount for a certain period of time, or if an event of default has occurred and is continuing, funds deposited into any of our depository accounts will be transferred on a daily basis into a blocked account with the administrative agent and applied to prepay loans under the asset-based revolving credit facility and, if an event of default has occurred and is continuing, to cash collateralize letters of credit and swingline loans issued thereunder and certain other contingent obligations arising in connection with the ABL.

Our capital expenditure and acquisition strategy requires substantial capital resources. The building of new hospitals and the operations of our existing hospitals and newly acquired hospitals require ongoing capital expenditures for construction, renovation, expansion and the addition of medical equipment and technology. More specifically, we are currently, and may in the future be, contractually obligated to make significant capital expenditures relating to the facilities we acquire. Also, construction costs to build new hospitals are substantial. Our debt agreements may restrict our ability to incur additional indebtedness to fund these expenditures.

A breach of any of the restrictions or covenants in our debt agreements could cause a cross-default under other debt agreements. A significant portion of our indebtedness then may become immediately due and payable. We are not certain whether we would have, or be able to obtain, sufficient funds to make these accelerated payments. If any senior debt is accelerated, our assets may not be sufficient to repay in full such indebtedness and our other indebtedness.

As a holding company, we rely on payments from our subsidiaries in order for us to satisfy our financial obligations.

We are a holding company with no significant operations of our own. Because our operations are conducted through our subsidiaries, we depend on dividends, loans, advances and other payments from our subsidiaries in order to allow us to satisfy our financial obligations. Our subsidiaries are separate and distinct legal entities and have no obligation to pay any amounts to us, whether by dividends, loans, advances or other payments. The ability of our subsidiaries to pay dividends and make other payments to us depends on their earnings, capital requirements and general financial conditions and is restricted by, among other things, applicable corporate and other laws and regulations as well as, in the future, agreements to which our subsidiaries may be a party.

 

Item 1B.

Unresolved Staff Comments.

None.

 

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Item 2.

Properties.

The table below presents certain information with respect to our hospitals as of December 31, 2014. For information about our discontinued operations and recent sales of assets, please refer to Note 3 of the consolidated financial statements included elsewhere in this report.

 

Hospital		Location		Acquisition/Opening/ Lease Date		Licensed Beds				Real Property Status
Capital Medical Center		Olympia, WA		December 1, 2005			110			Own(1)
DeKalb Community Hospital		Smithville, TN		July 1, 2011			71			Own(2)
Mineral Area Regional Medical Center		Farmington, MO		March 1, 2008			127			Own
EASTAR Health System (formerly Muskogee Regional Medical Center)		Muskogee, OK		April 3, 2007			320			Lease
National Park Medical Center		Hot Springs, AR		March 1, 2008			166			Own(3)
River Park Hospital		McMinnville, TN		December 1, 2005			125			Own(4)
Southwestern Medical Center		Lawton, OK		December 1, 2005			199			Own
St. Mary’s Regional Medical Center		Russellville, AR		March 1, 2008			170			Own
Stones River Hospital		Woodbury, TN		July 1, 2011			60			Own(2)
Highlands Medical Center (formerly White County Community Hospital)		Sparta, TN		March 1, 2008			60			Own(5)
Willamette Valley Medical Center		McMinnville, OR		March 1, 2008			88			Own
Total Licensed Beds							1,496

 

(1)	This hospital is owned and operated by us in a joint venture with physicians in which we own 90.25% and physicians or physician entities own the remaining 9.75%.

(2)	These two hospitals are owned and operated by us through CCH, which is a joint venture with physicians in which we own 57.85% and physicians or physician entities own 35.66%. Through a joint venture agreement, St. Thomas Health owns 6.49% of the hospitals.

(3)	This hospital is owned and operated by us in a joint venture with physicians in which we own 95.04% and physicians or physician entities own the remaining 4.96%.

(4)	This hospital is owned and operated by us in a joint venture with St. Thomas Health in which we own 93.51% and St. Thomas Health owns the remaining 6.49%.

(5)	This hospital is owned and operated by us in a joint venture with physicians in which we own 81.23% and physicians or physician entities own 12.28%. Through a joint venture agreement, St. Thomas Health owns 6.49% of the hospital.

In each of the joint ventures listed above, the managing members or general partners, as applicable, are one or more of our wholly-owned subsidiaries (each a “Capella Owner”). Each Capella Owner manages the day-to-day operation of the hospital in exchange for a management fee and reimbursement of its out-of-pocket expenses. In addition, our Capital Medical Center, Highlands Medical Center and CCH joint ventures participate in our cash management system pursuant to a Cash Management Agreement and Revolving Credit Loan (the “Cash Management Agreement”). Under the Cash Management Agreement, we may but are not obligated to, provide the applicable joint venture with working capital revolving credit loans as we deem necessary or appropriate for the conduct of the joint venture’s business.

In addition to the hospitals listed above we own, either directly or through an interest in a joint venture, certain outpatient service locations complementary to our hospitals. We also own, operate and/or lease medical office buildings in conjunction with certain of our hospitals, which are primarily occupied by physicians practicing at our hospitals.

As of December 31, 2014, we leased approximately 17,000 square feet of office space at 501 Corporate Centre Drive, Suite 200, Franklin, Tennessee, for our corporate headquarters. Our headquarters, hospitals and other facilities are suitable for their respective uses and are, in general, adequate for our present needs.

 

Item 3.

Legal Proceedings.

Hospitals are subject to the regulation and oversight of various state and federal governmental agencies. Further, under the federal False Claims Act, private parties have the right to bring qui tam, or “whistleblower,” suits against hospitals that submit false claims for payments to, or improperly retain overpayments from, governmental payors. Some states have adopted similar state whistleblower and false claims provisions. The healthcare industry has seen a number of ongoing investigations related to patient referrals, physician recruiting practices, cost reporting and billing practices, laboratory and home healthcare services, physician ownership of hospitals and other healthcare providers, and joint ventures involving hospitals and physicians. Hospitals continue to be one of the primary focal areas of the OIG and other governmental fraud and abuse programs. Certain of our individual facilities have

 

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received, and from time to time, other facilities may receive, government inquiries from federal and state agencies. Depending on whether the underlying conduct in these or future inquiries or investigations could be considered systemic, their resolution could have a material adverse effect on our financial position, results of operations and liquidity.

In addition, hospitals are, from time to time, subject to claims and suits arising in the ordinary course of business, including claims for damages for personal injuries, medical malpractice, breach of contracts, wrongful restriction of or interference with physicians’ staff privileges and employment related claims. In certain of these actions, plaintiffs request payment for damages, including punitive damages that may not be covered by insurance.

We are currently not a party to any pending or threatened proceeding which, in management’s opinion, would have a material adverse effect on our business, financial condition or results of operations.

 

Item 4.

Mine Safety Disclosures.

Not applicable.

PART II

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

We are wholly owned by Capella Holdings, Inc., or Holdings, of which GTCR beneficially owns 95.1%. There is no public trading market for our equity securities or those of Holdings. As of January 31, 2015, there were 107 holders of Holdings common stock.

 

Item 6.

Selected Financial Data.

The following table contains our selected financial data for, or as of the end of, the last five years ended December 31, 2014. The selected financial data has been derived from our audited consolidated financial statements. The timing of acquisitions and divestitures completed during the years presented below affects the comparability of the selected financial data. The selected financial data excludes the operations, as well as assets and liabilities, of our discontinued operations in our consolidated financial statements. We have also recognized certain transaction and debt costs during certain of the periods presented that affected the comparability of the selected financial data. You should read this table in conjunction with the consolidated financial statements and related notes included elsewhere in this report and in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

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		Year Ended December 31,
		2010				2011				2012				2013				2014
		(Dollars in millions)
Statement of Operations Data:
Revenue before provisions for bad debts		$	683.3			$	669.1			$	737.2			$	768.9			$	788.9
Less: Provision for bad debts			(100.7	)			(67.2	)			(78.6	)			(100.8	)			(75.5	)
Revenue			582.6				601.9				658.6				668.1				713.4
Costs and expenses:
Salaries and benefits (includes stock compensation of $0.3, $0.8, $1.0, $0.8 and $4.1, respectively)			278.1				286.9				303.1				312.7				333.4
Supplies			100.3				103.0				106.9				116.0				121.7
Other operating expenses			113.2				129.0				160.0				168.1				176.3
Other income			—				(6.5	)			(4.4	)			(10.7	)			(13.2	)
Depreciation and amortization			28.8				29.9				35.2				41.5				41.5
Interest, net			48.4				51.1				53.1				55.0				53.7
Management fee to related party			0.2				0.2				0.2				0.2				0.2
Loss on refinancing			20.8				—				—				—				—
Total costs and expenses			589.8				593.6				654.1				682.8				713.6
Income (loss) from continuing operations before income taxes			(7.2	)			8.3				4.5				(14.7	)			(0.2	)
Income taxes			3.2				1.4				3.0				4.0				4.7
Income (loss) from continuing operations			(10.4	)			6.9				1.5				(18.7	)			(4.9	)
Loss from discontinued operations, net of tax			(3.8	)			(20.2	)			(14.1	)			(11.8	)			(18.4	)
Net income (loss)		$	(14.2	)		$	(13.3	)		$	(12.6	)		$	(30.5	)		$	(23.3	)
Less: Net income attributable to non-controlling interests			1.5				1.2				1.5				1.3				1.8
Net income (loss) attributable to Capella Healthcare, Inc.		$	(15.7	)		$	(14.5	)		$	(14.1	)		$	(31.8	)		$	(25.1	)
Other Financial Data:
Adjusted EBITDA(1)		$	91.3			$	92.4			$	99.5			$	86.1			$	103.3

 

		As of December 31,
		2010				2011				2012				2013				2014
		(Dollars in millions)
Balance Sheet Data:
Cash and cash equivalents		$	48.3			$	42.4			$	33.3			$	26.4			$	28.7
Property and equipment			450.7				426.5				473.6				456.1				409.6
Total assets			767.8				787.8				844.4				830.8				869.7
Long-term debt, including current portion			494.1				495.1				551.8				557.4				613.8
Working capital(2)			119.2				109.9				88.0				82.8				77.5

 

(1)

“EBITDA,” a measure used by management to evaluate operating performance, is defined as net income plus (i) provision for income taxes, (ii) interest expense and (iii) depreciation and amortization. EBITDA is not a recognized term under GAAP and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. Additionally, EBITDA is not intended to be a measure of free cash flow available for management’s discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and other debt service requirements. Management believes EBITDA is helpful in highlighting trends because EBITDA excludes the results of decisions that are outside the control of operating management and that can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate and capital investments. Management compensates for the limitations of using non-GAAP financial measures by using them to supplement GAAP results to provide a more complete understanding of the factors and trends affecting the business than GAAP results alone. Because not all companies use identical calculations, our presentation of EBITDA may not be comparable to similarly titled measures of other companies.

“Adjusted EBITDA” is defined as EBITDA plus (i) net income attributable to non-controlling interests, (ii) loss on refinancing, (iii) loss from discontinued operations, (iv) acquisition-related expenses, (v) stock compensation expense and (vi) management fee to related party, if any, for the applicable period. We believe that the inclusion of supplementary adjustments to EBITDA applied in presenting adjusted EBITDA are appropriate to provide additional information to investors about the impact of certain noncash items, unusual items that we do not expect to continue at the same level in the future and other items.

 

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The following table presents a reconciliation to provide a more detailed analysis of these non-GAAP performance measures:

 

		Year Ended December 31,
		2010				2011				2012				2013				2014
		(Dollars in millions)
Net income (loss) attributable to Capella Healthcare, Inc.		$	(15.7	)		$	(14.5	)		$	(14.1	)		$	(31.8	)		$	(25.1	)
Plus taxes			3.2				1.4				3.0				4.0				4.7
Plus net interest expense and deferred financing cost amortization			48.4				51.1				53.1				55.0				53.7
Plus depreciation and amortization			28.8				29.9				35.2				41.5				41.5
EBITDA		$	64.7			$	67.9			$	77.2			$	68.7			$	74.8
Plus net income attributable to non-controlling interests		$	1.5			$	1.2			$	1.5			$	1.3			$	1.8
Plus loss on refinancing			20.8				—				—				—				—
Plus loss from discontinued operations			3.8				20.2				14.1				11.8				18.4
Acquisition-related expenses			—				2.1				5.5				3.3				2.2
Stock compensation			0.3				0.8				1.0				0.8				5.9
Plus management fee to related party			0.2				0.2				0.2				0.2				0.2
Adjusted EBITDA		$	91.3			$	92.4			$	99.5			$	86.1			$	103.3

 

(2)

We define working capital as current assets minus current liabilities. For 2011, 2013 and 2014, working capital excludes the impact of assets and liabilities held for sale, which is shown as a current asset and current liability on the consolidated balance sheet for those years. For 2013 and 2014, working capital also excludes restricted cash and the current portion of debt.

Selected Operating Data

The following table sets forth certain unaudited operating data for each of the periods presented.

 

		Year Ended December 31,
		2012				2013				2014
Continuing operations:(1)
Number of hospitals			9				9				9
Licensed beds(2)			1,309				1,309				1,309
Admissions(3)			39,616				38,267				37,731
Adjusted admissions(4)			82,534				81,287				82,993
Revenue per adjusted admission		$	7,980			$	8,219			$	8,596
Inpatient surgeries			9,146				9,098				8,591
Outpatient surgeries(5)			20,395				21,210				21,061
Emergency room visits(6)			194,348				194,339				202,277

 

(1)	Excludes all operations included in discontinued operations.

(2)	Licensed beds are those beds for which a facility has been granted approval to operate from the applicable state licensing agency regardless of actual use.

(3)	Represents the total number of patients admitted to our hospitals and used by management and investors as a general measure of inpatient volume.

(4)	Adjusted admissions are used as a general measure of combined inpatient and outpatient volume. We compute adjusted admissions by multiplying admissions by the outpatient factor (the sum of gross inpatient revenue and gross outpatient revenue and then dividing the result by gross inpatient revenue.

(5)	Outpatient surgeries are surgeries and invasive procedures that do not require admission to our hospitals.

(6)	Represents the total number of hospital-based emergency room visits.

 

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Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of financial condition and results of operations should be read in conjunction with our audited consolidated financial statements, the notes to our audited consolidated financial statements, and the other financial information appearing elsewhere in this report. We intend for this discussion to provide you with information that will assist you in understanding our financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes. It includes the following sections:

 

•

Forward Looking Statements;

 

•

Executive Overview;

 

•

Critical Accounting Policies;

 

•

Results of Operations Summary; and

 

•

Liquidity and Capital Resources.

FORWARD LOOKING STATEMENTS

This report and other materials the Company has filed or may file with the SEC, as well as information included in oral statements or other written statements made, or to be made, by executive management of the Company, contain, or will contain, disclosures that are “forward-looking statements,” which are intended to be covered by the safe harbors created by federal securities laws. Forward-looking statements are those statements that are based upon management’s current plans and expectations as opposed to historical and current facts and are often identified in this discussion by use of words including but not limited to “may,” “believe,” “will,” “should,” “expect,” “estimate,” “anticipate,” “intend,” and “plan.” These statements are based upon estimates and assumptions made by Capella’s management that, although believed to be reasonable, are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those projected. Except as required by law, we undertake no obligation to update publicly or to revise any forward-looking statements, whether as a result of new information, future events or otherwise.

In this report, for example, we make forward-looking statements, including statements discussing our expectations about: our business strategy and operating philosophy, including efforts to provide high quality patient care and service excellence, investments in technology, recruitment and retention of physicians and nurses, expansion of service lines, and growth strategies for existing markets and for potential acquisitions; future financial performance and condition; industry and general economic trends, including the impact of the current economic environment, changes to reimbursement, patient volumes and related revenue; our compliance with new and existing laws and regulations, such as the Affordable Care Act, as well as costs and benefits associated with compliance; effects of competition and consolidation on our hospitals’ markets; costs of providing care to our patients; the provision for bad debt and the impact of bad debt expenses, including increasing collection risks; future liquidity and capital resources; and existing and future debt.

There are several factors, some beyond our control that could cause results to differ significantly from our expectations. Some of these factors are described in “Part I, Item 1A. Risk Factors.” Other factors, such as market, operational, liquidity, interest rate and other risks, are described elsewhere in this section and “Part II, Item 7A. Quantitative and Qualitative Disclosures about Market Risk.” Any factor described in this report could by itself, or together with one or more factors, adversely affect our business, results of operations and/or financial condition. There may be factors not described in this report that could also cause results to differ from our expectations. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our business or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied by any forward-looking statements.

EXECUTIVE OVERVIEW

We are a provider of general and specialized acute care, outpatient and other medically necessary services in our primarily non-urban communities. We provide these services through a portfolio of acute care hospitals and complementary outpatient facilities and clinics. As of December 31, 2014, as part of continuing operations, we operated nine acute care hospitals (eight of which we own and one of which we lease pursuant to a long-term lease) comprised of 1,309 licensed beds in six states. We are focused on enabling our facilities to maximize their potential to deliver high quality care in a patient-friendly environment. We invest our financial and operational resources to establish and support services that meet the needs of our communities. We seek to achieve our objectives by providing exceptional quality care to our patients, establishing strong local management teams, physician leadership groups and hospital boards, developing deep physician and employee relationships and working closely with our communities.

During the year, the Company exercised its purchase option to acquire certain assets of Muskogee Community Hospital (“MCH”) that were subject to a capital lease. Additionally, the Company repaid the outstanding principal balance for the promissory note previously issued in connection with the Company’s 2012 acquisition of accounts receivable, supplies, inventory, goodwill and other intangible assets related to MCH.

 

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Trends and Developments

The following sections discuss recent trends and developments that we believe impact our current and/or future operating results and cash flows. Certain of these trends and developments apply to the entire hospital industry, while others may apply to us more specifically. These trends and developments could be short-term in nature or could require long-term attention and resources. While these trends and developments may involve certain factors that are outside of our control, the extent to which these trends and developments affect our hospitals and our ability to manage the impact of these trends and developments play vital roles in our current and future success. In many cases, we are unable to predict what impact, if any, these trends and developments will have on us.

Impact of Healthcare Reform

The Affordable Care Act dramatically altered the United States healthcare system and is intended to decrease the number of uninsured Americans and reduce the overall cost of healthcare. The Affordable Care Act attempts to achieve these goals by, among other things, requiring most Americans to obtain health insurance, expanding Medicare and Medicaid eligibility, reducing Medicare DSH and Medicaid payments to providers, expanding the Medicare program’s use of value-based purchasing programs, tying hospital payments to the satisfaction of certain quality criteria, bundling payments to hospitals and other providers, and instituting certain private health insurance reforms. Although some of the measures contained in the Affordable Care Act did not take effect until 2014, certain of the reductions in Medicare spending, such as negative adjustments to the Medicare hospital inpatient and outpatient prospective payment system market basket updates and the incorporation of productivity adjustments to the Medicare program’s annual inflation updates, became effective in prior years. A number of provisions of the Affordable Care Act that were supposed to become effective in 2014, such as the employer mandate, the Small Business Health Option Program, and the state run exchange verification of income and Medicaid agency electronic notification of eligibility for tax credit and subsidy requirements, have been delay until 2015 and additional delays could be imposed in the future. On June 28, 2012, the United States Supreme Court upheld the “individual mandate” provision of the Affordable Care Act that generally requires all individuals to obtain healthcare insurance or pay a penalty. The Supreme Court also held, however, that the provision of the Act that authorized the Secretary of HHS to penalize states that choose not to participate in the expansion of the Medicaid program by removing all existing Medicaid funding was unconstitutional. In response to the ruling, a number of states have already indicated that they will not expand their Medicaid programs. Doing so would result in the Affordable Care Act not providing coverage to some low-income persons in those states. Additionally, several bills have been and will likely continue to be introduced in Congress to repeal or amend all or significant provisions of the Affordable Care Act. It is difficult to predict the full impact of the Affordable Care Act because of its complexity, lack of implementing regulations and interpretive guidance, state decisions to decline Medicaid expansion, gradual and potentially delayed implementation, future potential legal challenges, and possible repeal and/or amendment, as well as the inability to foresee how individuals and businesses will respond to the choices afforded to them by the Affordable Care Act. As a result, it is difficult to predict the full impact that the Affordable Care Act will have on our revenue and results of operations.

Adoption of Electronic Health Records

The HITECH Act includes provisions designed to increase the use of EHR by both physicians and hospitals. We intend to comply with the EHR meaningful use requirements of the HITECH Act in time to qualify for the maximum available Medicare and Medicaid incentive payments. We will recognize income related to the Medicare or Medicaid incentive payments as we are able to satisfy all appropriate contingencies, which includes completing attestations as to our eligible hospitals adopting, implementing or demonstrating meaningful use of certified EHR technology, and additionally for Medicare incentive payments, deferring income until the related Medicare fiscal year has passed and cost report information used to determine the final amount of reimbursement is known. Our compliance has resulted in significant costs including professional services focused on successfully designing and implementing our EHR solutions along with costs associated with the hardware and software components of the project. During the years ended December 31, 2012, 2013 and 2014, we recognized $4.4 million, $10.7 million and $13.2 million, respectively, of other income related to estimated EHR incentive payments.

Medicare and Medicaid Reimbursement

Medicare payment methodologies have been, and are expected to be, significantly revised based on cost containment and policy considerations. CMS has already begun to implement some of the Medicare reimbursement reductions required by the Affordable Care Act. These revisions will likely be more frequent and significant as more of the Affordable Care Act’s changes and cost-saving measures become effective. Additionally, the Middle Class Tax Relief and Job Creation Act of 2012 and ATRA require further reductions in Medicare payments, and the BCA imposed a 2% reduction in Medicare spending effective as of April 1, 2013.

On February 2, 2015, the Office of Management and Budget released President Obama’s proposed budget for FFY 2016 (the “Proposed Budget”). Among other things, the Proposed Budget would end sequestration but would also reduce Medicare spending by approximately $400 billion over the next 10 years. The Proposed Budget would achieve these reductions by, among other things, reducing Medicare coverage of bad debt, reducing payments to hospitals for graduate medical education programs, reducing payments to critical access hospitals, reducing payments to hospitals for services that are provided at off-campus

 

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hospital outpatient departments, and increasing financial liabilities for certain Medicare beneficiaries. We cannot predict whether the Proposed Budget will be implemented in whole or in part or whether Congress will take other legislative action to reduce spending on the Medicare and Medicaid programs. Additionally, future efforts to reduce the federal deficit may result in additional revisions to and payment reductions for the amounts we receive for our services.

In addition, many states in which we operate are facing budgetary challenges and have adopted, or may be considering, legislation that is intended to control or reduce Medicaid expenditures, enroll Medicaid recipients in managed care programs, and/or impose additional taxes on hospitals to help finance or expand their Medicaid programs. Budget cuts, federal or state legislation, or other changes in the administration or interpretation of government health programs by government agencies or contracted managed care organizations could have a material adverse effect on our financial position and results of operations.

Pay for Performance Reimbursement

Many payors, including Medicare and several large managed care organizations, currently require hospital providers to report certain quality measures in order to receive the full amount of payment increases that were awarded automatically in the past. Many large managed care organizations have developed quality measurement criteria that are similar to or even more stringent than these Medicare requirements. While current Medicare guidelines and contracts with most managed care payors provide for reimbursement based upon the reporting of quality measures, we believe significant payors will utilize the quality measures to determine reimbursement rates for hospital services. We have developed key processes and infrastructure that we believe enable us to meet or exceed the current established quality guidelines. We plan to continue to invest in quality initiatives and technology in order to meet the quality demands of our payors in the future.

Value-Based Reimbursement

The trend in the healthcare industry continues towards value-based purchasing of healthcare services. These value-based purchasing programs include both public reporting and financial incentives tied to the quality and efficiency of care provided by facilities. The Affordable Care Act expands the use of value based purchasing initiatives in federal healthcare programs. We expect programs of this type to become more common in the healthcare industry.

Medicare requires providers to report certain quality measures in order to receive full reimbursement increases for inpatient and outpatient procedures that previously were awarded automatically. Historically, CMS has expanded, through a series of rulemakings, the number of patient care indicators that hospitals must report. Additionally, we anticipate that CMS will continue to expand the number of inpatient and outpatient quality measures. We have invested significant capital and resources in the implementation of our advanced clinical system that assists us in monitoring and reporting these quality measures. CMS makes the data submitted by hospitals, including our hospitals, public on its website, which began at 1.0% in FFY 2013 and increases by 0.25% for each following FFY up to 2.0% for FFY 2017 and subsequent years.

The Affordable Care Act requires HHS to implement a value-based purchasing program for inpatient hospital services. Beginning in federal fiscal year 2013, HHS reduced inpatient hospital payments for all discharges by a percentage specified by statute and pooled the total amount collected from these reductions to fund payments to reward hospitals that meet or exceed certain quality performance standards established by HHS. CMS evaluates hospitals’ performance during a performance period and hospitals receive points on each of a number of pre-determined measures based on the higher of (i) their level of achievement relative to an established standard or (ii) their improvement in performance from their performance during a prior baseline period. Each hospital’s combined scores on all the measures are translated into value-based incentive payments beginning with inpatient discharges occurring on or after October 1, 2012. HHS determines the amount each hospital that meets or exceeds the quality performance standards will receive from the pool of funds created by these payment reductions. In addition, the Affordable Care Act contains a number of other provisions that further tie reimbursement to quality and efficiency. For the FFY 2016 hospital value-based purchasing program, CMS finalized removing these measures and adding four measures. Also beginning in FFY 2013, hospitals that have “excess readmissions” for specified conditions receive reduced reimbursement. Each hospital’s performance is publicly reported, and HHS has the discretion to determine terms and conditions of the program such as what “excessive readmissions” means. Medicare also no longer pays hospitals additional amounts for the treatment of certain hospital-acquired conditions, also known as HACs, unless the conditions were present at admission. Further, beginning in FFY 2015, hospitals that rank in the worst 25% of all hospitals nationally for HACs in the previous year will receive reduced Medicare reimbursements. The FFY 2014 IPPS final rule finalized the scoring methodology and quality measures that will be used to determine the quartile for FFY 2015, as well as the processes, hospitals will use to review and correct their data. The Affordable Care Act also prohibits the use of federal funds under the Medicaid program to reimburse providers for treating certain provider-preventable conditions.

 

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Physician Alignment

Our ability to attract skilled physicians to our hospitals is critical to our success. Coordination of care and alignment of care strategies between hospitals and physicians will become more critical as reimbursement becomes more episode-based. We have physician recruitment goals with primary emphasis on recruiting physicians specializing in family practice, internal medicine, general surgery, oncology, obstetrics and gynecology, cardiology, neurology, orthopedics, urology, otolaryngology and inpatient hospital care (hospitalists). To provide our patients access to the appropriate physician resources, we actively recruit physicians to the communities served by our hospitals through employment agreements, relocation agreements or physician practice acquisitions. We invest in the infrastructure necessary to coordinate our physician alignment strategies and manage our physician operations. The costs associated with recruiting, integrating and managing a large number of new physicians will have a negative impact on our operating results and cash flows in the near term. However, we expect to realize improved clinical quality and service expansion capabilities from this initiative that will impact our operating results positively over the long term.

Physician services are reimbursed under the Medicare physician fee schedule, or PFS, system, under which CMS has assigned a national RVU to most medical procedures and services that reflects the various resources required by a physician to provide the services relative to all other services. Each RVU is calculated based on a combination of work required in terms of time and intensity of effort for the service, practice expense (overhead) attributable to the service and malpractice insurance expense attributable to the service. These three elements are each modified by a geographic adjustment factor to account for local practice costs then aggregated. The aggregated amount is multiplied by a conversion factor that accounts for inflation and targeted growth in Medicare expenditures (as calculated by the SGR) to arrive at the payment amount for each service.

The PFS rates are adjusted each year, and reductions in both current and future payments are anticipated. The SGR formula has resulted in payment decreases to physicians every year since 2002. However, all but one of those payment decreases has been averted by Congressional action. On November 13, 2014, CMS published the PFS final rule for CY 2015. In this final rule, CMS stated that application of the SGR to the PFS would result in a 21.2% reduction in payment rates for physicians’ services beginning on April 1, 2015. On March 26, 2015, the U.S. House of Representatives passed MACRA, which would permanently repeal the SGR and establish a more streamlined and improved incentive payment program that will focus on providing value and quality. We cannot predict whether the Senate will pass MACRA, whether MACRA, if passed, will be signed by the President, or whether Congress will pass other legislation to avert the rate cut for the remainder of CY 2015 and/or otherwise adopt a permanent fix for the issues that are created by the application of the SGR. If the payment reduction to the PFS is not averted prior to March 31, 2015, the reimbursement received by our employed physicians, the physicians to whom our hospitals have provided recruitment assistance, and the physician members of our medical staffs would be adversely affected.

Cost Pressures

In order to demonstrate a highly reliable environment of care, we must hire and retain nurses who share our ideals and beliefs with respect to delivering high quality patient care and who have access to the training necessary to implement our clinical quality initiatives. While the national nursing shortage has abated somewhat during the last year, the nursing workforce remains volatile. As a result, we expect continuing pressures on nursing salaries and benefits. These pressures include base wage increases, demands for flexible working hours and other increased benefits as well as higher nurse-to-patient ratios. In addition, inflationary pressures and technological advancements and increased acuity continue to drive supply costs higher. We implemented multiple supply chain initiatives, including consolidation of low-priced vendors, established value analysis teams and coordinated quality of care efforts to encourage group purchasing contract compliance.

Uncompensated Care

While the amount of uncompensated care, including discounts to the uninsured, bad debts and charity care, we deliver to the communities we serve continues to remain high in comparison to historical levels, we have experienced a decrease during the year ended December 31, 2014. During the year ended December 31, 2014, our uncompensated care as a percentage of revenue, which includes the impact of uninsured discounts and charity care, was 17.2%, compared to 24.2% in the prior year. We believe the improvement in our uncompensated care as a percentage of revenue can be attributed primarily to the impact of Medicaid expansion, as well as improvements in employment and other economic factors in our markets, which has resulted in lower self-pay volume and revenue for the year ended December 31, 2014, compared to the prior year. The improvement in our uncompensated care as a percentage of acute care revenue has been offset somewhat by the higher acuity levels at which self-pay patients are presenting for treatment through our emergency rooms.

We anticipate that uninsured volumes will continue to decline in the near future as the impact of the Affordable Care Act is fully realized. However, if we were to experience growth in uninsured volume and revenue, our uncompensated care may increase and our results of operations would be adversely affected.

 

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Similar to others in the hospital industry, we have a significant amount of self-pay receivables (including co-payments and deductibles from insured patients), and collecting these receivables may become more difficult if economic conditions worsen. The following table provides a summary of our accounts receivable payor class mix for our continuing operations as of December 31, 2013 and 2014:

 

December 31, 2013		0-90 Days				91-180 Days				Over 180 Days				Total
Medicare(1)			26.7	%			1.0	%			1.6	%			29.3	%
Medicaid(1)			6.7				0.7				0.6				8.0
Managed Care and Other			19.6				1.6				1.2				22.4
Self-Pay(2)			9.5				9.1				21.7				40.3
Total			62.5	%			12.4	%			25.1	%			100.0	%
December 31, 2014		0-90 Days				91-180 Days				Over 180 Days				Total
Medicare(1)			28.3	%			0.9	%			1.4	%			30.6	%
Medicaid(1)			7.1				0.9				1.3				9.3
Managed Care and Other			21.0				2.3				1.8				25.1
Self-Pay(2)			8.1				7.5				19.4				35.0
Total			64.5	%			11.6	%			23.9	%			100.0	%

 

(1)	Includes receivables under managed Medicare or managed Medicaid programs.

(2)	Includes both uninsured as well as estimated co-payment and deductible amounts from insured patients.

The volume of self-pay accounts receivable remains sensitive to a combination of factors, including price increases, acuity of services, higher levels of insured patient co-payments and deductibles, economic factors and the increased difficulties of uninsured patients who do not qualify for charity care programs to pay for escalating healthcare costs. We have implemented a number of practices to mitigate bad debt expense and increase collections, including our uninsured discount program, increased focus on upfront cash collections, incentive plans for our hospitals’ financial counselors and registration personnel, increased focus on payment plans with non-emergent patients, among other efforts. Despite these practices, we believe bad debts will remain a significant risk for us and the rest of the hospital industry in the near term.

Implementation of Clinical Quality Initiatives

The integral component of responding to each of the challenge areas previously discussed is quality of care. We have implemented many of our expanded clinical quality initiatives and are in the process of implementing several others. These initiatives include the following:

 

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review of the current CMS quality indicators;

 

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mock Joint Commission surveys conducted by a third-party;

 

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implementation of hourly nursing rounds;

 

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alignment of hospital management incentive compensation with quality and satisfaction indicators;

 

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feedback from our LPLGs, NPLG, and PAG;

 

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hospital board and medical staff oversight of patient safety and quality of care;

 

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patient discharge callbacks; and

 

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investment in clinical technology.

Revenue/Volume Trends

Our revenue depends upon inpatient occupancy levels, outpatient procedures, ancillary services and therapy programs as well as our ability to negotiate appropriate payment rates for services with third-party payors and our ability to achieve quality metrics to maximize payment from our payors.

The primary sources of our revenue before the provision for bad debts include various managed care payors, including managed Medicare and managed Medicaid programs, the traditional Medicare program, various state Medicaid programs, commercial health plans and patients themselves. We are typically paid less than our gross charges, regardless of the payor source, and report revenue before the provision for bad debts to reflect contractual adjustments and other allowances required by managed care providers and federal and state agencies.

 

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Revenue for the year ended December 31, 2014, increased 6.8% to $713.4 million, compared to $668.1 million in the prior year. The increase in revenues was due to an increase in revenue per adjusted admission of 4.6%. Overall, our revenues were positively impacted by the 3.2% increase in case mix as well as the favorable impact of healthcare reform. Additionally, we experienced a payor mix shift from self-pay payors to Medicaid and HMOs, PPOs and other private insurers for a portion of our patient population, which primarily was a result of healthcare reform and the expansion of Medicaid coverage in certain of the states in which we operate. At December 31, 2014, only three of the states in which we operate are currently implementing expansions to their Medicaid programs. Revenue for the year ended December 31, 2014 was also impacted negatively by the “two midnight rule” that went into effect on October 1, 2013. We estimate the negative impact at $2.4 million.

Admissions decreased 1.4% and adjusted admissions increased 2.1%, respectively, for the year ended December 31, 2014, compared to the prior year. Inpatient surgeries decreased 5.6% for the year ended December 31, 2014, compared to the prior year. Outpatient surgeries decreased 0.7% for the year ended December 31, 2014, compared to the prior year. In general, we believe our hospital volumes are still being impacted by general economic conditions where we operate along with patient decisions to defer or cancel elective procedures, general primary care and other non-emergent healthcare procedures.

We believe our volumes over the long-term will grow as a result of our business strategies, including the continued investment in our physician alignment strategy, increased efforts to promote our commitment to quality and patient satisfaction, and the general aging of the population.

The following table sets forth the percentages of revenue before the provision for bad debts by payor for the years ended December 31, 2012, 2013 and 2014:

 

		Year Ended December 31,
		2012(2)				2013				2014
Medicare(1)			38.8	%			38.0	%			39.0	%
Medicaid(1)			14.3				14.1				17.5
Managed Care and other(3)			36.9				36.8				36.0
Self-Pay			10.0				11.1				7.5
Total			100.0	%			100.0	%			100.0	%

 

(1)	Includes revenue before the provision for bad debts received under managed Medicare or managed Medicaid programs.

(2)	The increase in Medicaid revenue for fiscal 2012 is due primarily to the Oklahoma Supplemental Hospital Offset Payment Program, or SHOPP. SHOPP increased Medicaid revenue for fiscal 2012 by approximately $21.5 million.

(3)	Includes the health insurance exchanges beginning the first quarter of 2014.

Revenue per adjusted admission increased 4.6% for the year ended December 31, 2014, compared to the prior year. The increase in revenue per adjusted admission is primarily due to an increase in acuity as evidenced by a 5.3% increase in our Medicare case mix index for the year and increases in our specialty service lines. In addition, increases in our managed care pricing and the impact of healthcare reform also contributed to an increase in revenue.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts and related disclosures. We consider an accounting estimate to be critical if:

 

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it requires assumptions to be made that were uncertain at the time the estimate was made; and

 

•

changes in the estimate or different estimates that could have been made could have a material impact on our consolidated results of operations or financial condition.

Revenue and Revenue Deductions

We recognize revenue before the provision for bad debts during the period the healthcare services are provided based upon estimated amounts due from payors. We record contractual adjustments to our gross charges to reflect expected reimbursement negotiated with or prescribed by third-party payors. We estimate contractual adjustments and allowances based upon payment terms set forth in managed care health plan contracts and by federal and state regulations. For the majority of our revenue before the provision for bad debts, we apply contractual adjustments to patient accounts at the time of billing using specific payor contract terms entered into the accounts receivable systems, but in some cases we record an estimated allowance until payment is received. If our estimated contractual adjustments as a percentage of gross revenue had been 1% higher for all insured accounts, our revenue before the provision for bad debts would have been reduced by approximately $30.7 million, $30.7 million and $33.7 million for the years ended December 31, 2012, 2013 and 2014, respectively. We derive most of our revenue before the provision for bad debts from healthcare services provided to patients with Medicare (including managed Medicare plans) or managed care insurance coverage.

 

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Services provided to Medicare patients are generally reimbursed at prospectively determined rates per diagnosis, while services provided to managed care patients are generally reimbursed based upon predetermined rates per diagnosis, per diem rates or discounted fee-for-service rates. Medicaid reimbursements vary by state. Other than Medicare and Medicaid, no individual payor represents more than 10% of our revenue.

Medicare regulations and many of our managed care contracts are often complex and may include multiple reimbursement mechanisms for different types of services provided in our healthcare facilities. To obtain reimbursement for certain services under the Medicare program, we must submit annual cost reports and record estimates of amounts owed to or receivable from Medicare. These cost reports include complex calculations and estimates related to indirect medical education, disproportionate share payments, reimbursable Medicare bad debts and other items that are often subject to interpretation that could result in payments that differ from recorded estimates. We estimate amounts owed to or receivable from the Medicare program using the best information available and our interpretation of the applicable Medicare regulations. We include differences between original estimates and subsequent revisions to those estimates (including final cost report settlements) in our consolidated statements of operations in the period in which the revisions are made.

Net adjustments for the final third-party settlements increased revenue and income from continuing operations before income taxes by $0.4 million, $0.6 million and $2.0 million during the years ended December 31, 2012, 2013 and 2014, respectively. Additionally, updated regulations and contract negotiations with payors occur frequently, which necessitates continual review of revenue estimation processes by management. Management believes that future adjustments to its current third-party settlement estimates will not materially impact our results of operations, cash flows or financial position.

We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (generally it is those uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by HHS). We deduct charity care accounts from net revenue when we determine that the account meets our charity care guidelines. We also provide discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care. For the years ended December 31, 2012, 2013 and 2014, we estimate that our cost of care provided under our charity care programs was approximately $3.3 million, $2.7 million and $1.2 million, respectively.

Insurance Reserves

We are self-insured for substantially all of the medical expenses and benefits of our employees. Our reserve for employee medical benefits primarily reflects the current estimate of incurred but not reported losses, based upon an actuarial calculation.

Given the nature of our operating environment, we are subject to potential medical malpractice lawsuits and other claims as part of providing healthcare services. To mitigate a portion of this risk, we maintain insurance through Auriga in sufficient amounts for malpractice claims, subject to a self-insured retention per occurrence. Auriga has re-insurance for malpractice claims which cover additional amounts in the aggregate. Our reserves for professional and general liability claims are based upon independent actuarial calculations, which consider historical claims data, demographic considerations, severity factors and other actuarial assumptions in determining reserve estimates. Our reserve estimates are discounted to present value using a 1% discount rate.

We are also subject to potential workers’ compensation claims as part of providing healthcare services. To mitigate a portion of this risk, we maintain insurance for individual workers’ compensation claims exceeding approximately $250,000 per occurrence. Our hospital facility located in the State of Washington and our two facilities located in Oklahoma participate in state-specific programs rather than our established program. Our reserve for workers’ compensation is based upon an independent third-party actuarial calculation, which considers historical claims data, demographic considerations, development patterns, severity factors and other actuarial assumptions. Our reserve estimates are undiscounted and are revised on an annual basis. Our reserve for workers’ compensation claims reflects the current estimate of all outstanding losses, including incurred but not reported losses, based upon an actuarial calculation.

Our expense for professional and general liability claims and workers’ compensation claims each year includes: the actuarially determined estimate of losses for the current year, including claims incurred but not reported (“IBNR”); the change in the estimate of losses for prior years based upon actual claims development experience as compared to prior actuarial projections; amortization of the insurance premiums for losses in excess of our self-insured retention level; the administrative costs of the insurance program; and interest expense related to the discounted portion of the liability.

 

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The following tables summarize our claims loss and claims payment information during the years ended December 31, 2012, 2013 and 2014 and our professional and general liability reserve balances (including the current portions of such reserves, but excluding amounts recoverable from Auriga and third-party insurers) as of December 31, 2013 and 2014.

 

		Year Ended December 31,
		2012				2013				2014
		(In millions)
Accrual for general and professional liability claims at January 1		$	12.7			$	12.7			$	12.2
Expense (income) related to(1):
Current accident year			4.6				6.8				5.9
Prior accident years			(2.3	)			(4.0	)			(2.7	)
Total incurred loss and loss expense			2.3				2.8				3.2
Paid claims and expenses related to:
Current accident year			0.3				0.2				0.2
Prior accident years			2.0				3.1				2.3
Total paid claims and expense			2.3				3.3				2.5
Accrual for general and professional liability claims at December 31		$	12.7			$	12.2			$	12.9

 

(1)	Total expense, including premiums for insured coverage, was $6.3 million, $7.5 million and $6.2 million for the years ended December 31, 2012, 2013 and 2014, respectively.

Our estimate of professional and general liability and workers’ compensation IBNR utilizes statistical confidence levels that are below 75%. Using a higher statistical confidence level, while not permitted under GAAP, would increase the estimated reserve. The following table illustrates the sensitivity at reserve estimates at 75% and 90% confidence levels:

 

		Professional and General Liability				Workers’ Compensation
		(In millions)
December 31, 2013 reserve:
As reported		$	12.2			$	3.7
With 75% confidence level			14.5				4.3
With 90% confidence level			18.3				5.2
December 31, 2014 reserve:
As reported		$	12.9			$	4.0
With 75% confidence level			15.1				4.6
With 90% confidence level			18.9				5.5

If our estimate of the number of unpaid days of employee health claims expense changed by five days, our employee health IBNR estimate would change by approximately $0.5 million.

Income Taxes

We believe that our income tax provisions are accurate and supportable, but certain tax matters require interpretations of tax law that may be subject to future challenge and may not be upheld under tax audit. To reflect the possibility that all of our tax positions may not be sustained, we maintain tax reserves that are subject to adjustment as updated information becomes available or as circumstances change. We record the impact of tax reserve changes to our income tax provision in the period in which the additional information, including the progress of tax audits, is obtained.

We assess the realization of our deferred tax assets to determine whether an income tax valuation allowance is required. Based on all available evidence, both positive and negative, and the weight of that evidence to the extent such evidence can be verified objectively, we determine whether it is more likely than not that all or a portion of the deferred tax assets will be realized. The factors used in this determination include the following:

 

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cumulative losses in recent years;

 

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income/losses expected in future years;

 

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unsettled circumstances that, if favorably resolved, would adversely affect future operations;

 

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•

availability, or lack thereof, of taxable income in prior carryback periods that would limit realization of tax benefits;

 

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carryforward period associated with the deferred tax assets and liabilities; and

 

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prudent and feasible tax planning strategies.

In addition, financial forecasts used in determining the need for or amount of federal and state valuation allowances are subject to changes in underlying assumptions and fluctuations in market conditions that could significantly alter our recoverability analysis and thus have a material adverse effect on our consolidated financial condition, results of operations or cash flows. We follow the provisions of Financial Accounting Standards Board (“FASB”) authoritative guidance regarding income tax uncertainties. No tax adjustment was required upon adoption of this authoritative guidance. Under these provisions, we elected to classify interest paid on an underpayment of income taxes and related penalties as a component of income tax expense.

Long-Lived Assets and Goodwill

Long-lived assets, including property, plant and equipment and amortizable intangible assets, comprise a significant portion of our total assets. We evaluate the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist under the provisions of FASB authoritative guidance regarding the impairment or disposal of long-lived assets. When management believes impairment indicators may exist, projections of the undiscounted future cash flows associated with the use of and eventual disposition of long-lived assets held for use are prepared. If the projections indicate that the carrying values of the long-lived assets are not recoverable, we reduce the carrying values to fair value. These impairment tests are heavily influenced by assumptions and estimates that are subject to change as additional information becomes available. Given the relatively few number of hospitals we own and the significant amounts of long-lived assets attributable to those hospitals, an impairment of the long-lived assets could materially adversely impact our operating results or financial position.

Goodwill also represents a significant portion of our total assets. We review goodwill for impairment annually at October 1 or more frequently if certain impairment indicators arise under the provisions of FASB authoritative guidance regarding goodwill and other intangible assets. Our business comprises a single reporting unit for impairment of goodwill. We compare our carrying value of the consolidated net assets to the estimated fair value based primarily on net present value of our estimated discounted future cash flows. If the carrying value exceeds fair value an impairment indicator exists and an estimate of the impairment loss is calculated. The fair value calculation includes multiple assumptions and estimates, including the projected cash flows and discount rates applied. Changes in these assumptions and estimates could result in goodwill impairment that could materially adversely impact our financial position or results of operations.

We did not incur any impairment charges, other than with respect to discontinued operations, during the years ended December 31, 2012, 2013 or 2014.

Allowance for Doubtful Accounts and Provision for Bad Debts

Our ability to collect the self-pay portion of our receivables is critical to our operating performance and cash flows. Our allowance for doubtful accounts was approximately 79% and 85% of self-pay accounts receivable, net of contractual discounts, as of December 31, 2013 and December 31, 2014, respectively. Our additions to the allowance for doubtful accounts are made by means of the provision for doubtful accounts. Accounts written off as uncollectable are deducted from the allowance for doubtful accounts and subsequent recoveries are added.

As a result of an internal review in 2013, we elected to increase the uncollectible percentage for all accounts receivable greater than 360 days to a conservative 100%, thereby fully reserving for all accounts receivable regardless of payor resources. The effect of this review was to increase provision for bad debts by an additional $4.5 million as of December 31, 2013.

The Company uses a number of tests to determine the appropriate allowance for doubtful accounts. The allowance is based on the Company’s assessment of historical and expected net collections, business and economic conditions, trends in federal, state, and private employer healthcare coverage, the impact of recent acquisitions or dispositions, and other collection indicators. Accounts written off as uncollectable are deducted from the allowance for doubtful accounts and subsequent recoveries are added. The provision for doubtful accounts and the allowance for doubtful accounts relate primarily to uninsured amounts (including copayment and deductible amounts from patients) due directly from patients. We also rely on certain analytical tools, including (i) historical trended cash collections compared to net revenue less bad debt; (ii) total bad debt expense, charity care deductions and uninsured discounts as a percentage of self-pay revenue; (iii) net days in accounts receivable; and (iv) the allowance from doubtful accounts as a percentage of total self-pay accounts receivable. Adverse changes in general economic conditions, billing and collections operations, payor mix, or trends in federal or state governmental healthcare coverage could affect our collection of accounts receivable, cash flows and results of operations. If our uninsured accounts receivable as of December 31, 2014 were 1% higher, our provision for doubtful accounts would have increased by $0.8 million.

 

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RESULTS OF OPERATIONS

The following table presents summaries of results of operations for the three years ended December 31, 2012, 2013 and 2014.

 

		Year Ended December 31, 2012								Year Ended December 31, 2013								Year Ended December 31, 2014
		Amount				Percentage				Amount				Percentage				Amount				Percentage
Revenue before provision for bad debts		$	737.2				111.9	%		$	768.9				115.1	%		$	788.9				110.6	%
Provision for bad debts			(78.6	)			(11.9	)%			(100.8	)			(15.1	)%			(75.5	)			(10.6	)%
Revenue			658.6				100.0	%			668.1				100.0	%			713.4				100.0	%
Costs and expenses:
Salaries and benefits (includes stock compensation of $1.0, $0.8, and $4.1 respectively)			303.1				46.0	%			312.7				46.8	%			333.4				46.7	%
Supplies			106.9				16.2	%			116.0				17.4	%			121.7				17.1	%
Other operating expenses			160.0				24.3	%			168.1				25.2	%			176.3				24.7	%
Other income			(4.4	)			(0.7	)%			(10.7	)			(1.6	)%			(13.2	)			(1.9	)%
Depreciation and amortization			35.2				5.3	%			41.5				6.2	%			41.5				5.8	%
Interest, net			53.1				8.1	%			55.0				8.2	%			53.7				7.5	%
Management fee to related party			0.2				—				0.2				—				0.2				—
Total costs and expenses (1)			654.1				99.3	%			682.8				102.2	%			713.6				100.0	%
Income (loss) from continuing operations before income taxes			4.5				0.7	%			(14.7	)			(2.2	)%			(0.2	)			0.0	%
Income taxes			3.0				0.5	%			4.0				0.6	%			4.7				0.7	%
Income (loss) from continuing operations (1)			1.5				0.2	%			(18.7	)			(2.8	)%			(4.9	)			(0.7	)%
Loss from discontinued operations, net of tax			(14.1	)			(2.1	)%			(11.8	)			(1.8	)%			(18.4	)			(2.6	)%
Net loss (1)		$	(12.6	)			(1.9	)%		$	(30.5	)			(4.6	)%		$	(23.3	)			(3.3	)%
Less: Net income attributable to non-controlling interests			1.5				0.2	%			1.3				0.2	%			1.8				0.3	%
Net loss attributable to Capella Healthcare, Inc (1).		$	(14.1	)			(2.1	)%		$	(31.8	)			(4.8	)%		$	(25.1	)			(3.5	)%

 

(1)	The sum of the individual amounts may not total due to rounding.

Year Ended December 31, 2014 Compared to Year Ended December 31, 2013

Revenue. Revenue for the year ended December 31, 2014 was $713.4 million, an increase of $45.3 million, or 6.8%, over the year ended December 31, 2013. The increase in revenues was due to an increase in revenue per adjusted admission of 4.6%. Overall, our revenues were positively impacted by the 3.2% increase in case mix as well as the favorable impact of healthcare reform. Additionally, we experienced a payor mix shift from self-pay payors to Medicaid and HMOs, PPOs and other private insurers for a portion of our patient population, which primarily was a result of healthcare reform and the expansion of Medicaid coverage in certain of the states in which we operate. This was evidenced by our self-pay admissions as a percent of total admissions declining from 5.9% at December 31, 2013 to 3.9% as of December 31, 2014. At December 31, 2014, only three of the states in which we operate implemented expansions to their Medicaid programs. Revenue for the year ended December 31, 2014 was also impacted negatively by the “two midnight rule” that went into effect on October 1, 2013. We estimate the negative impact at $2.4 million.

Our provision for bad debts was down $25.3 million, or 25.1%, compared to the prior year period. Self-pay admissions were 3.9% of total admissions, compared to 5.9% in the prior year period. Our provision for doubtful accounts decreased as a result of lower self-pay revenues during the year ended December 31, 2014. Self-pay revenues before the provision for bad debts decreased from 11.1% for the year ended December 31, 2013 to 7.5% in the current period as a result of a shift from self-pay to Medicaid and HMOs, PPOs and other private insurers for a portion of our patient population, which primarily was a result of healthcare reform and the expansion of Medicaid coverage in certain of the states in which we operate. The provision for doubtful accounts relates principally to self-pay amounts due from patients.

 

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Salaries and benefits. Salaries and benefits for the year ended December 31, 2014 were $333.4 million, or 46.7% of revenue, compared to $312.7 million, or 46.8% of revenue, during the year ended December 31, 2013. While salaries as a percentage of revenue were consistent year over year, salaries and benefits were impacted by the reinstatement of the 401K match, higher benefit costs and increased stock based compensation expense during 2014. Non-cash stock-based compensation was $4.1 million and $0.8 million for the year ended December 31, 2014 and 2013, respectively. In connection with the increased non-cash stock-based compensation, due to the equity restructuring by the Holdings, the Company made a cash payment of $1.8 million to partially reimburse employees for tax-related liabilities associated with the award during the year ended December 31, 2014 which is also included in salaries and benefits. These increases were offset by the reduction of one time charges incurred as of December 31, 2013 of $2.9 million related to the reorganization of the corporate support center.

Supplies. Supplies expense for the year ended December 31, 2014 was $121.7 million, or 17.1% of revenue, compared to $116.0 million, or 17.4%, of revenue for the year ended December 31, 2013. The change in our supplies margin was due primarily to a decrease in supply intensive inpatient and outpatient surgical cases and increased cost savings as a result of our participation in a group purchasing organization.

Other operating expenses. Other operating expenses include, among other things, professional fees, repairs and maintenance, rents and leases, utilities, insurance, non-income taxes and physician income guarantee amortization.

Other operating expenses for the year ended December 31, 2014 were $176.3 million, or 24.7% of revenue, compared to $168.1 million, or 25.2% of revenue for the year ended December 31, 2013. The increase in other operating expenses is primarily due to an approximate $4.9 million increase in professional fees and contract services generated by new service lines at a number of our facilities and increased IT and collection fees due to inflationary increases and increases in admissions. The decrease in the operating expense margin is due to the nature of the operating expense, many of which do not increase proportionately with volume and net revenue increases.

Other income. Other income includes EHR incentive payments, which represent those incentives under the HITECH Act for which the recognition criteria have been met. For the year ended December 31, 2014, we recognized approximately $13.2 million of incentive reimbursements, compared to $10.7 million for the year ended December 31, 2013.

Income taxes. Our effective tax rate from continuing operations was approximately 2,350.0% for the year ended December 31, 2014 compared to 27.2% for the year ended December 31, 2013. The change in the effective tax rate is driven by changes in the level of pretax income combined with the Company’s net deferred tax liability position and related limitations with respect to deferred tax liabilities associated with indefinite-life intangible assets.

Year Ended December 31, 2013 Compared to Year Ended December 31, 2012

Revenue. Revenue for the year ended December 31, 2013 was $668.1 million, an increase of $9.5 million, or 1.4%, over the year ended December 31, 2012. Revenue for the year ended December 31, 2012 included approximately $13.6 million of revenue recorded related to the prior period SHOPP, approved by CMS in January 2012 (from July 1, 2011 to December 31, 2011) and rural floor settlement discussed previously. Excluding the approximately $13.6 million of revenue related to both SHOPP and the rural floor settlement described above, our revenue for the year ended December 31, 2013 increased $23.1 million, or 3.5%, compared to the prior year period. The increase in revenue was due to an increase in revenue per adjusted admission of 4.2%, offset by a decline in adjusted admissions of approximately 1.7%.

Our revenue was also impacted by an increase in our provision for bad debts, which increased $22.2 million, or 28.0% compared to the year ended December 31, 2012. The increase in bad debts was primarily due to the growth in uninsured patient volume and revenue. We continue to experience high levels of uncompensated care and high emergency room self-pay volumes. Self-pay gross revenue increased 8.1% compared to the prior year. The Company believes this trend reflects an increased collection risk from self-pay accounts, and as a result has increased the Company’s allowance for doubtful accounts. The Company uses a number of tests to determine the appropriate allowance for doubtful accounts. The allowance is based on the Company’s assessment of historical and expected net collections, business and economic conditions, trends in federal, state, and private employer healthcare coverage, the impact of recent acquisitions and disposition, and other collection indicators. Accounts written off as uncollectable are deducted from the allowance for doubtful accounts and subsequent recoveries are added. The provision for doubtful accounts and the allowance for doubtful accounts relate primarily to uninsured amounts (including copayment and deductible amounts from patients) due directly from patients. We also rely on certain analytical tools, including (i) historical trended cash collections compared to net revenue less bad debt; (ii) total bad debt expense, charity care deductions and uninsured discounts as a percentage of self-pay revenue; (iii) net days in accounts receivable; and (iv) the allowance from doubtful accounts as a percentage of total self-pay accounts receivable. Adverse changes in general economic conditions, billing and collections operations, payor mix, or trends in federal or state governmental healthcare coverage could affect our collection of accounts receivable, cash flows and results of operations. As a result of the Company’s analysis, management changed the uncollectible percentage for all accounts receivable greater than 360 days to a conservative 100%, thereby fully reserving for all accounts receivable greater than 360 days regardless of payor sources. The result of this change was to increase provision for bad debts by an additional $4.5 million.

 

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Salaries and benefits. Salaries and benefits for the year ended December 31, 2013 were $312.7 million, or 46.8% of revenue, compared to $303.1 million, or 46.0% of revenue, during the year ended December 31, 2012. Our salaries and benefits margin for the year ended December 31, 2012 was impacted by the prior period SHOPP and rural floor settlement revenue discussed previously. Excluding the revenue and expense related to the prior period SHOPP and rural floor settlement, salaries and benefits as a percentage of revenue were 47.0% for the year ended December 31, 2012. The increase in our salaries and benefits margin was due primarily to the slower revenue growth discussed previously. In November 2013, the Company began a plan of restructuring and reorganizing. This plan resulted in the elimination of certain positions within the corporate support center, which resulted in a charge of approximately $2.9 million in related payments.

Supplies. Supplies expense for the year ended December 31, 2013 was $116.0 million, or 17.4% of revenue, compared to $106.9 million, or 16.2%, of revenue for the year ended December 31, 2012. Our supplies margin for the year ended December 31, 2012 was impacted by the SHOPP program and rural floor settlement revenue discussed previously. Excluding revenue related to the prior period SHOPP program and rural floor settlement, supplies expense as a percentage of revenue was 16.6% for the year ended December 31, 2012. The change in our supplies margin was due primarily to an increase in supply intensive inpatient surgical cases and a 3.6% increase in outpatient surgeries, along with the slower revenue growth discussed previously.

Other operating expenses. Other operating expenses include, among other things, professional fees, repairs and maintenance, rents and leases, utilities, insurance, non-income taxes and physician income guarantee amortization.

Other operating expenses for the year ended December 31, 2013 were $168.1 million, or 25.2% of revenue, compared to $160.0 million, or 24.3% of revenue for the year ended December 31, 2012. The increase in other operating expenses margin is due to a primarily to an approximate $7.0 million increase in professional fees and contract services generated by hospitalist programs and new service lines at our facilities.

Other income. Other income includes EHR incentive payments, which represent those incentives under the HITECH Act for which the recognition criteria have been met. For the year ended December 31, 2013, we recognized approximately $10.7 million of incentive reimbursements, compared to $4.4 million for the year ended December 31, 2012.

Income taxes. Our effective tax rate from continuing operations was approximately 27.2% for the year ended December 31, 2013 compared to 66.7% for the year ended December 31, 2012. The change in the effective tax rate is driven by changes in the level of pretax income combined with the Company’s net deferred tax liability position and related limitations with respect to deferred tax liabilities associated with indefinite-life intangible assets.

LIQUIDITY AND CAPITAL RESOURCES

The following table shows a summary of our cash flows for the years ended December 30, 2013 and 2014.

 

		Year Ended December 31,
		2013				2014
		(In millions)
Cash provided by operating activities		$	30.8			$	44.4
Cash used in investing activities			(26.8	)			(87.9	)
Cash provided (used in) provided by financing activities			(10.9	)			45.8

Operating Activities

Cash provided by operating activities was $30.8 million for the year ended December 31, 2013, compared to $44.4 million for the year ended December 31, 2014. Our cash flows provided by continuing operations for the year ended December 31, 2014 as compared to 2013 were positively impacted by a reduction in our net loss and a decrease in our accounts receivable.

At December 31, 2014, we had working capital, excluding assets and liabilities held for sale and the current portion of long-term debt of $77.5 million, including cash and cash equivalents of $28.7 million, compared to working capital excluding assets held for sale at December 31, 2013 of $82.8 million, including cash and cash equivalents of $26.4 million.

Investing Activities

Cash used in investing activities was $26.8 million for the year ended December 31, 2013 compared to $87.9 million for the year ended December 31, 2014. During the year ended December 31, 2014, we transferred approximately $73.9 million to an escrow fund for an acquisition of a healthcare business effective January 1, 2015. In addition, we received $11.2 million in proceeds from the sale of one of our facilities. Capital expenditures for the year ended December 31, 2013 were $24.9 million compared to $24.5 million for the year ended December 31, 2014.

 

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Financing Activities

Cash flows used in financing activities was $10.9 million for the year ended December 31, 2013, compared to cash provided by financing activities of $45.8 million for the year ended December 31, 2014. During the year ended December 31, 2014, we paid approximately $49.9 million on our capital leases and other obligations and $1.8 million in distributions to non-controlling interests. Also, during the year ended December 31, 2014, we received proceeds from our term loan facility of $99.0 million.

The Refinancing

In June 2010, we completed a comprehensive refinancing plan, or the Refinancing. Under the Refinancing, we issued $500.0 million of the 9 ¹/₄% Senior Unsecured Notes due 2017 (the “9 ¹/₄ Notes”) in a private placement offering and entered into a new senior secured asset based loan, or the ABL, consisting of a $100.0 million revolving credit facility. The proceeds from the 9 ¹/₄% Notes were used to repay the outstanding principal and interest related to our previous term loan facility and to pay fees and expenses relating to the Refinancing of approximately $21.7 million.

Effective November 4, 2011, in accordance with a registration rights agreement entered into by us in connection with the private placement offering of the 9 ¹/₄% Notes, we completed the exchange of the 9 ¹/₄% Notes for $500.0 million in registered 9 ¹/₄% Notes with substantially identical terms as the 9 ¹/₄% Notes. We did not receive any proceeds from this exchange.

Interest on the 9 ¹/₄% Notes is payable semi-annually on July 1 and January 1 of each year. The 9 ¹/₄% Notes are unsecured general obligations of the Company and rank equal in right of payment to all existing and future senior unsecured indebtedness of the Company. All payments on the 9 ¹/₄% Notes are guaranteed jointly and severally on a senior unsecured basis by the Company and its subsidiaries, other than those subsidiaries that do not guarantee the obligations of the borrowers under the Company’s prior senior credit facilities.

The Company may redeem all or a part of the 9 ¹/₄% Notes at any time on or after July 1, 2013, plus accrued and unpaid interest, if any, to the date of redemption plus a redemption price equal to a percentage of the principal amount of the notes redeemed based on the following redemption schedule:

 

July 1, 2014 to June 30, 2015			104.625	%
July 1, 2015 to June 30, 2016			102.313	%
July 1, 2016 and thereafter			100.000	%

If the Company experiences a change of control under certain circumstances, the Company must offer to repurchase all of the notes at a price equal to 101.000% of their principal amount, plus accrued and unpaid interest, if any, to the repurchase date.

ABL

On December 31, 2014, the Company entered into an Amended and Restated Loan Agreement (the “ABL Agreement”), by and among the Company, the borrowing subsidiaries signatory thereto, the guarantying subsidiaries signatory thereto, the lenders party thereto, and Bank of America, N.A., as agent for the lenders (“ABL Agent”). The ABL Agreement amends, restates, and replaces in its entirety the prior agreement establishing the ABL (as previously amended, the “Prior ABL Agreement”).

The ABL Agreement amends and restates the Prior ABL Agreement to, among other things, change the maturity date of the revolving credit commitments under the ABL from December 29, 2014 to the earlier to occur of (a) June 3, 2019, (b) November 16, 2016, if, as of such date, (i) Company’s 9 ¹/₄% Notes have not been repaid in full or refinanced on terms reasonably satisfactory to ABL Agent (including a maturity date no earlier than December 3, 2019) and (ii) the Term Loan Facility has not been repaid in full or the maturity date has not been extended to a date that is no earlier than September 3, 2019, and (c) April 1, 2017 if, as of such date, the Company’s 9 ¹/₄% Notes have not been repaid in full or refinanced on terms reasonably satisfactory to ABL Agent (including a maturity date no earlier than December 3, 2019).

        Upon the occurrence of certain events, the Company may request that the commitments under the ABL be increased by an aggregate amount not to exceed $25.0 million. Availability under the ABL is subject to a borrowing base of 85% of eligible net accounts receivable. Borrowings under the ABL bear interest at a rate equal to, at the Company’s option, either (a) LIBOR plus an applicable margin or (b) Base Rate, as defined, plus an applicable margin. Subsequent to the most recent amendment and restatement of the ABL Agreement, the applicable margin in effect for borrowings under the ABL was reduced from 2.00% to 0.50% with respect to base rate borrowings and from 3.00% to 1.50% with respect to LIBOR borrowings, or reduced from a maximum of 2.50% to 1.00% with respect to base rate borrowings and reduced from a maximum of 3.50% to 2.00% for LIBOR borrowings, subject to the Company’s fixed charge coverage ratio. In addition to paying interest on outstanding principal, the Company is required to pay a commitment fee to the lenders under the ABL in respect of the unutilized commitments thereunder. Subsequent to the most recentp amendment and restatement of the ABL Agreement, based on the average facility usage for the most recently ended calendar month,

 

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the commitment fee was reduced from a range of 0.50% 0.75% to a range of 0.25% to 0.375% per annum. The Company must also pay customary letter of credit fees.

At December 31, 2014, the Company had $5.0 million outstanding balance due under the ABL. At December 31, 2014, the Company had availability under the ABL of $71.0 million, net of a $5.0 million outstanding balance due and $5.7 million outstanding letters of credit. The outstanding letters of credit are primarily used as collateral under the Company’s workers’ compensation programs

Term Loan Facility

On December 31, 2014, the Company entered into a Credit Agreement (the “Term Loan Credit Agreement”), by and among the Company, as borrower, Holdings, as a guarantor, Credit Suisse AG, Cayman Islands Branch, as administrative agent, and certain other lenders from time to time party thereto.

The Term Loan Credit Agreement establishes the Term Loan Facility, a new senior secured term loan facility consisting of a $100,000,000 seven-year term loan. The per annum interest rates applicable to borrowings under the Term Loan Facility are periodically determined at the Company’s election as either (a) the LIBO Rate (as defined in the Term Loan Credit Agreement) plus 4.25% or (b) the Base Rate (as defined in the Term Loan Credit Agreement) plus 3.25%. The interest rate as of December 31, 2014 was 5.25%.

The Term Loan Facility is to be repaid in equal quarterly principal payments of $250,000, with the balance to be paid at maturity. The maturity date applicable to borrowings under the Term Loan Facility is the earlier to occur of (a) December 31, 2021, and (b) February 16, 2017, if, as of such date, the Company’s 9 ¹/₄% Notes have not been refinanced in full with certain permitted debt. The Term Loan Facility is generally subject to mandatory prepayment in amounts equal to: (a) 100% of the net cash proceeds received from certain asset sales (including insurance recoveries and condemnation events), subject to reinvestment provisions and customary exceptions; (b) 100% of the net cash proceeds from the issuance of new debt (other than certain permitted debt); and (c) 50% of the Company’s Excess Cash Flow (as defined in the Term Loan Credit Agreement), with step-downs to (i) 25% and (ii) 0% based on the Secured Net Leverage Ratio (as defined in the Term Loan Credit Agreement).

The Company’s obligations under the Term Loan Facility are unconditionally guaranteed by all of the Company’s material domestic wholly-owned subsidiaries (other than captive insurance subsidiaries, unrestricted immaterial subsidiaries, and certain other subsidiaries identified as excluded subsidiaries in the Term Loan Credit Agreement), provided that a guarantor subsidiary may be released if certain conditions are met. The Company’s obligations under the Term Loan Facility are secured by a substantial portion of its assets as well as the assets of its subsidiaries. The Term Loan Credit Agreement contains other terms and conditions that are customary in agreements used in connection with similar transactions.

The proceeds of the Term Loan Facility primarily were used to finance the January 1, 2015 acquisition of a controlling ownership interest in Carolina Pines Regional Medical Center, a 116-bed acute care facility located in Hartsville, South Carolina through the acquisition of all of the equity interests in Hartsville Medical Group, LLC and substantially all of the equity interests in Hartsville, LLC (formerly Hartsville HMA, LLC), each a South Carolina limited liability company.

Debt Covenants

The indentures governing the 9 ¹/₄% Notes, ABL and Term Loan Facility contain a number of covenants that, among other things, restrict, subject to certain exceptions, our ability and the ability of our subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, pay dividends and distributions or repurchase our capital stock, create liens on assets, make investments, engage in mergers or consolidations, and engage in certain transactions with affiliates. At December 31, 2013 and 2014, we were in compliance with all debt covenants that were subject to testing at such dates.

Capital Resources

We expect that cash on hand, cash generated from our operations and cash expected to be available to us under the ABL Agreement will be sufficient to meet our working capital needs and planned capital expenditure programs for the next 12 months and into the foreseeable future. However, we cannot assure you that our operations will generate sufficient cash or that future borrowings under the ABL Agreement will be available to enable us to meet these requirements. Our long-term capital projects including a $26 million renovation and expansion of cardiac services to our National Park hospital and a $15 million renovation and expansion of the surgical suites at our Capital Medical Center hospital.

We had $26.4 million and $28.7 million of cash and cash equivalents as of December 31, 2013 and December 31, 2014, respectively. We rely on available cash, cash flows generated by operations and available borrowing capacity under the ABL

 

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Agreement to fund our operations and capital expenditures. The significant majority of our cash is held in accounts that are not federally-insured and could be at risk in the event of a collapse of the financial institutions at which those accounts are held.

In addition, our liquidity and ability to fund our capital requirements are dependent on our future financial performance, which is subject to general economic, financial and other factors that are beyond our control. If those factors significantly change or other unexpected factors adversely affect us, our business may not generate sufficient cash flows from operations or we may not be able to obtain future financings to meet our liquidity needs. We anticipate that, to the extent additional liquidity is necessary to fund our operations, it would be funded through borrowings under our ABL Agreement, the incurrence of other indebtedness, additional note issuances or a combination of these potential sources of liquidity. We may not be able to obtain this additional liquidity when needed on terms acceptable to us.

We will continue to pursue acquisitions or partnering arrangements, either in existing markets or new markets, which fit our growth strategies. To finance such transactions, we may draw upon cash on hand, amounts available under our revolving credit facility or seek additional funding sources. We continually assess our capital needs and may seek additional financing, including debt or equity, as considered necessary to fund potential acquisitions, fund capital projects or for other corporate purposes. We may be unable to raise additional equity proceeds from the investment funds affiliated with GTCR, which are our principal investors, or other investors should we need to obtain cash for any of these purposes. Our future operating performance, ability to service our debt and ability to draw upon other sources of capital will be subject to future economic conditions and other business factors, many of which are beyond our control.

As market conditions warrant, we and our major equity holders, including GTCR, may from time-to-time repurchase debt securities issued by us, in privately negotiated or open market transactions, by tender offer or otherwise.

Obligations and Commitments

The following table reflects a summary of obligations and commitments outstanding with payment dates as of December 31, 2014 (in millions):

 

		Payments Due by Period
		Within 1 Year				During Years 2-3				During Years 4-5				After 5 Years				Total
Contractual Cash Obligations:
Long-term debt (1)		$	52.5			$	581.7			$	12.1			$	104.9			$	751.2
Operating leases (2)			7.8				11.4				7.8				9.5				36.5
Capital lease obligations, with interest			6.1				11.9				1.3				—				19.3
Estimated self-insurance liabilities (3)			7.0				8.3				3.5				1.4				20.2
Subtotal		$	73.4			$	613.3			$	24.7			$	115.8			$	827.2
Other Commitments:
Construction and capital improvements (4)		$	17.6			$	10.5			$	—			$	—			$	28.1
Letters of credit (5)			5.7				—				—				—				5.7
Physician commitments (6)			2.6				0.1				—				—				2.7
Information technology commitments (7)			9.1				18.8				19.7				10.2				57.8
Subtotal		$	35.0			$	29.4			$	19.7			$	10.2			$	94.3
Total obligations and commitments		$	108.4			$	642.7			$	44.4			$	126.0			$	921.5

 

(1)	Includes both principal and interest portions of outstanding debt.

(2)	These obligations are not reflected in our consolidated balance sheets.

(3)	Includes the current and long-term portions of our professional and general liability, workers’ compensation and employee health reserves.

(4)	Represents our estimate of amounts we are committed to fund in future periods through executed agreements to complete projects included as construction in progress on our consolidated balance sheets. Projects consist primarily of two expansion projects expected to close in late 2015 and early 2016.

(5)	Amounts relate to instances in which we have letters of credit outstanding with the third party administrators of our self-insured workers’ compensation program.

(6)	Includes physician guarantee liabilities recognized on our consolidated balance sheets under FASB provisions regarding minimum revenue guarantees and liabilities for other fixed expenses under physician relocation agreements not yet paid.

(7)

An affiliate of HCA and another third-party vendor provide various information systems services, including but not limited to, financial, clinical, patient accounting and network information services, under contracts that expire beginning 2017. The amounts are based on estimated fees that will be charged to our hospitals with an annual fee increase to our hospitals that is capped by the consumer price index increase.

 

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Guarantees and Off-Balance Sheet Arrangements

We are a party to certain master lease agreements and other similar arrangements with non-affiliated entities.

We enter into physician income guarantees and other guarantee arrangements, including parent-subsidiary guarantees, in the ordinary course of business. We do not believe we have engaged in any transaction or arrangement with an unconsolidated entity that is reasonably likely to affect liquidity materially.

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Effects of Inflation and Changing Prices

Various federal, state and local laws have been enacted that, in certain cases, limit our ability to increase prices. Revenue for acute hospital services rendered to Medicare patients is established under the federal government’s prospective payment system. We believe that hospital industry operating margins have been, and may continue to be, under significant pressure because of changes in payor mix and growth in operating expenses in excess of the increase in prospective payments under the Medicare program. In addition, as a result of increasing regulatory and competitive pressures, our ability to maintain operating margins through price increases to non-Medicare patients is limited.

 

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk.

We are subject to market risk from exposure to changes in interest rates based on our financing, investing and cash management activities. As of December 31, 2014, our Term Loan Facility bears interest at a variable rate. However, the Term Loan Facility was entered into on December 31, 2014 and therefore the impact of a change in the LIBOR rate would not have impacted our interest expense as of December 31, 2014. Although changes in the alternate base rate or the LIBOR rate would affect the cost of funds borrowed under the 2010 Revolving Facility in the future, we believe the effect, if any, of reasonably possible near-term changes in interest rates would not be material to our results of operations or cash flows.

 

Item 8.

Financial Statements and Supplementary Data.

Information with respect to this Item is contained in our consolidated financial statements beginning on Page F-1 of this report.

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

We did not experience a change in or disagreement with our accountants during the year ended December 31, 2014.

 

Item 9A.

Controls and Procedures.

Disclosure Controls and Procedures

We carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 15d-15 of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us (including our consolidated subsidiaries) in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported on a timely basis.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting in accordance with U.S. generally accepted accounting principles. Our internal control over financial reporting includes a program of internal audits and appropriate reviews by management, written policies and guidelines, careful selection and training of qualified personnel including a dedicated compliance department and a written Code of Conduct adopted by our Board of Directors, applicable to all of our directors, officers and employees.

 

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Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets that could have a material effect on our financial statements would be prevented or detected in a timely manner. Because of its inherent limitations, including the possibility of human error and the circumvention or overriding of control procedures, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Therefore, even those internal controls determined to be effective can only provide reasonable assurance with respect to financial statement preparation and presentation.

The Company’s management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2014, based on the framework and criteria established in Internal Control — Integrated Framework (1992) (the “1992 Framework”) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on its evaluation under the 1992 Framework, the Company’s management concluded that our internal control over financial reporting was effective as of December 31, 2014.

On May 14, 2013, COSO issued an updated version of its Internal Control — Integrated Framework (the “2013 Framework”). Both the 1992 Framework and the 2013 Framework provide principles-based guidance for designing and implementing effective internal controls. As of December 31, 2014, the Company continues to utilize the 1992 Framework. The Company has started the process of implementing the 2013 Framework and plans to complete the implementation of the 2013 Framework during the fiscal year ending December 31, 2015.

This Annual Report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting in reliance on SEC rules that permit us to provide only management’s report.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the three months ended December 31, 2014 that have affected materially, or are reasonably likely to affect materially, our internal control over financial reporting.

 

Item 9B.

Other Information.

None.

PART III

 

Item 10.

Directors, Executive Officers and Corporate Governance.

The table below presents information with respect to the members of Capella’s Board of Directors and executive officers and their ages.

 

Name		Age		Position
Michael A. Wiechart		49		Director, President and Chief Executive Officer
D. Andrew Slusser		55		Executive Vice President of Acquisitions and Development
Denise W. Warren		53		Executive Vice President, Chief Financial Officer and Treasurer
Neil W. Kunkel		50		Executive Vice President, Chief Legal and Administrative Officer
Troy E. Sybert, MD, MPH		48		Executive Vice President and Chief Medical Officer
Daniel S. Slipkovich		57		Executive Chairman of the Board and Co- Founder
Joseph P. Nolan		50		Director
Robert Z. Hensley		57		Director
David A. Donnini		49		Director
Joshua M. Earl		35		Director

Michael A. Wiechart was named President and Chief Executive Officer in January 2014, and has also been a director of Capella since May 19, 2014. Mr. Wiechart served as the Senior Vice President and Chief Operating Officer of Capella from May 2009 to January 2014. From February 2004 to May 2009, Mr. Wiechart served as a Group President and Division President of LifePoint. Prior to that, Mr. Wiechart served as a Division Chief Financial Officer of the LifePoint from May 1999 until February 2004. Prior to that time, Mr. Wiechart served as vice president/operations controller of Province Healthcare and in various financial positions with HCA. Mr. Wiechart earned a Bachelor of Science degree in Accounting from the University of Kentucky. Mr. Wiechart also earned a Lean Healthcare certification from the University of Tennessee at Knoxville.

 

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D. Andrew Slusser was named Executive Vice President of Acquisitions and Development in January 2014. Mr. Slusser served as the Senior Vice President of Acquisitions and Development of Capella from the formation of Capella in April 2005 to January 2014. From August 1999 to April 2005, Mr. Slusser was the Vice President of Acquisitions and Development for Province Healthcare, responsible for all activities to develop and complete the acquisition of hospitals, including market identification, proposal presentation, negotiation of terms and conditions, pro forma financial statements and management of due diligence. Prior to that, Mr. Slusser was a founding officer and the Senior Vice President and Chief Financial Officer of Arcon Healthcare Inc., a provider of comprehensive ambulatory care services. He has also held Chief Financial Officer positions with HealthTrust and HCA, the latter including Western Group Chief Financial Officer with responsibility for 45 U.S. hospitals, five European hospitals and 125 surgical centers across the United States. Mr. Slusser is a certified public accountant (inactive). Mr. Slusser earned a Bachelor of Business Administration in Accounting from the University of Texas.

        Denise W. Warren was named Executive Vice President, Chief Financial Officer, and Treasurer in January 2014. Ms. Warren served as the Senior Vice President, Chief Financial Officer and Treasurer of Capella from October 2005 and has more than 25 years of financial experience. In 2011 and 2012, Ms. Warren was named to Becker’s Hospital Review as one of the top “Hospital and Health System CFOs To Know”. Also in 2011, Ms. Warren was named by Nashville Medical News as a “Woman to Watch.” In 2010, Ms. Warren was named as a “Woman of Influence in Tennessee” by the Nashville Business Journal. In 2009, Ms. Warren was named CFO of the Year for large private companies in Tennessee by the Nashville Business Journal. From 2001 to 2005, Ms. Warren served as a Senior Equity Analyst and former Research Director for Avondale Partners LLC (“Avondale”). Prior to her time at Avondale, from 2000 to 2001, Ms. Warren served as Senior Vice President and Chief Financial Officer for Gaylord Entertainment Company, a leading hospitality and entertainment organization (“Gaylord”). While at Gaylord, she was selected as Financial Executive of the Year by The Institute of Management Accountants. Prior to that, from 1996 to 2000, Ms. Warren worked in the New York office of Merrill Lynch & Co. as a Director and Senior Equity Analyst. Ms. Warren currently serves as a member of the Board of Governors of the Federation of American Hospitals, an investor-owned hospital industry group based in Washington, D.C. Ms. Warren earned a Bachelor of Science degree in Economics from Southern Methodist University where she graduated Phi Beta Kappa, summa cum laude. Ms. Warren also earned a Master of Business Administration from Harvard University.

Neil W. Kunkel was named Executive Vice President, Chief Legal and Administrative Officer in January 2014. Mr. Kunkel served as the Senior Vice President, General Counsel and Secretary of Capella from October 2011. Before joining Capella, he was Vice-President and Associate General Counsel for LifePoint Hospitals, which he joined in 1998 prior to its spin-off from HCA in 1999. Prior to that time, Mr. Kunkel served first as Group Operations Counsel and then as Managing Counsel for HCA. A member of the Board of Governors of the Federation of American Hospitals, Neil has served as Chair and Vice-Chair of the Legal and Operations Policy Committee. He is currently serving as Chair of the Health Facilities Interest Group of the American Bar Association’s Health Law Section. He is a member of the American Health Lawyers Association and a member of both the Tennessee and Kentucky Bar Associations. A graduate of Wake Forest University, Mr. Kunkel earned his law degree from the University of Louisville Law School, where he was a member of the Brandeis Honor Society.

Troy E. Sybert, MD, MPH became Executive Vice President and Chief Medical Officer of Capella in September 2014. From 2010 until joining Capella, Dr. Sybert served as Chief Quality and Medical Information Officer for Wellmont Health System, which owns and operates healthcare facilities located in northeast Tennessee and southwest Virginia. From 2006 to 2010, he was Chief Medical Officer for University of Texas Medical Branch in Galveston, TX. Dr. Sybert earned his medical degree from University of Texas Southwestern Medical School in 2001, completing a combined internship and residency in internal medicine and general preventive medicine. Board-certified in public health and general preventive medicine, he completed a fellowship in Hospital Medicine at Mayo Clinic. He also completed a master’s degree in public health at University of Texas Medical Branch while achieving certification in Six Sigma/Lean Thinking from the American Society for Quality.

Daniel S. Slipkovich became Executive Chairman of the Board in January 2014. Mr. Slipkovich has served as a director of Capella since May 2005 and served as the Chief Executive Officer from May 2005 to January 2014 and as President of Capella from August 2011 to January 2014. Mr. Slipkovich has managed hospitals in over 20 states through a career that has included investor relations, market strategies, physician recruitment and integration, clinical and operational management, joint venture structuring, information systems development, revenue cycle, HIPAA, ethics and compliance programs. From February 2004 until April 2005, Mr. Slipkovich served as the President and Chief Operating Officer of Province Healthcare, an operator of non-urban acute care hospitals, responsible for broad-based corporate activities as well as all hospital operations through three operating divisions with $900 million in revenue. Prior to that, Mr. Slipkovich worked for HCA and spin-off companies, HealthTrust Purchasing Group (“HealthTrust”) and LifePoint from 1983 to 2003. He previously served in hospital CFO positions and served in several Division Vice President positions and as Group Vice President for HCA in Florida responsible for hospital and ancillary operations with revenue of $5 billion. He was promoted to Senior Vice President for HCA corporate, where he was responsible for the divestiture of 24 hospitals in the spin-off of LifePoint. In addition, Mr. Slipkovich serves on the board of directors of the Federation of American Hospitals and, in 2009, was named to Modern Healthcare’s list of Top 100 Most Powerful People in Healthcare. Mr. Slipkovich is a certified public accountant. Mr. Slipkovich earned an Accounting degree from West Virginia University and attended graduate school at the University of Miami and Virginia Tech.

 

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Joseph P. Nolan has been a director of Capella since May 2005. Mr. Nolan is the founder and Managing Director of Beverly Capital, a Chicago-based investment firm. Prior to founding Beverly, Mr. Nolan enjoyed a 20-year career as a Senior Principal and Senior Advisor with GTCR, a private equity firm currently managing in excess of $7.3 billion. After joining GTCR in 1994, Mr. Nolan became a Senior Principal of the firm in 1996, a co-founder of GTCR Golder Rauner LLC in 1998, and led or co-led GTCR’s healthcare investing efforts for much of his career, before becoming a Senior Advisor to the firm in 2012. Mr. Nolan has served as an investor and director of over 20 public and private companies including HealthSpring, Province healthcare, Managed Healthcare Associates, CompBenefits, Alliant Insurance Services and Devicor Medical Products. Mr. Nolan holds a Masters of Business Administration from the University of Chicago and a Bachelors of Science in Accounting with High Honors from the University of Illinois.

Robert Z. Hensley has been a director of Capella since January 2009. From July 2002 to September 2003, Mr. Hensley was an audit partner at Ernst & Young, LLP in Nashville, Tennessee. Prior to that, he served as an audit partner at Arthur Andersen LLP in Nashville, Tennessee from 1990 to 2002, and was managing partner of the Nashville, Tennessee office of Arthur Andersen LLP from 1997 to July 2002. Mr. Hensley is the founder and an owner of two real estate and rental property development companies, each of which is located in Destin, Florida. He also serves on the board of directors of Diversicare, a publicly traded provider of long-term care services to nursing home patients and residents of assisted living facilities. He also currently serves on the board of several privately held companies. From 2011 to 2013, Mr. Hensley served on the board of directors of Greenway Medical Technologies, Inc., a publicly traded provider of software and services to ambulatory medical providers. From 2006 to 2010, Mr. Hensley also served as a director of COMSYS IT Partners, Inc., an information technology services company and Spheris, Inc., a provider of medical transcription technology and services. Since 2008, Mr. Hensley has served as a senior advisor to the healthcare and transaction advisory services groups of Alvarez and Marsal, LLC, a professional services company. Mr. Hensley holds a M.A. in Accountancy and a Bachelor of Science in Accounting from the University of Tennessee. Mr. Hensley is a certified public accountant.

David A. Donnini has been a director of Capella since March 19, 2014. Mr. Donnini joined GTCR in 1991 and is a Managing Director of GTCR. Mr. Donnini previously worked as an Associate Consultant at Bain & Company. Mr. Donnini leads GTCR’s Business Services Group and is Co-Head of the Financial Services & Technology Group. Mr. Donnini serves as a director of the following other GTCR portfolio companies: AssuredPartners, Inc., Ironshore Inc., Protection One, Inc., Sterigenics International, Inc. and Land Lease Group, LLC. Mr. Donnini is also a member of the board of directors of the Countryside School in Champaign, Illinois. Mr. Donnini earned a Masters in Business Administration from Stanford University, where he was an Arjay Miller Scholar and Robichek Finance Award winner, and a Bachelor of Arts in Economics, summa cum laude, from Yale University.

Joshua M. Earl has been a director of Capella since March 19, 2014. Mr. Earl joined GTCR in 2003 and became a Principal of GTCR in 2012. Prior to joining GTCR, he worked as an Analyst at Credit Suisse. Mr. Earl currently serves as a director of the following other GTCR portfolio companies: Correctional Healthcare Companies, Inc. and Curo Health Services. Mr. Earl holds a Bachelor of Business Administration in Finance and Business Economics and a Bachelor of Arts in Japanese, summa cum laude, from the University of Notre Dame.

Board of Directors and Board Committees

Capella’s Board of Directors consists of six members, two of whom are designated by GTCR, two of whom are designated by a majority of our investors, one of whom is Capella’s Executive Chairman of the Board, and one whom is Capella’s President and Chief Executive Officer. The Board of Directors currently has two standing committees: the Audit Committee and the Compensation Committee. Each of the directors designated by GTCR has the right to serve on all standing committees of the Board of Directors.

 

Name of Director		Audit Committee				Compensation Committee
David A. Donnini			—				X
Joshua M. Earl			X				X
Robert Z. Hensley (1) (2)			X				X
Joseph P. Nolan (2)			—				X
Daniel S. Slipkovich			—				—
Michael A. Wiechart			—				—

 

(1)	Mr. Hensley is designated as the audit committee’s financial expert.

(2)	Capella is not subject to any listing standards but the Board believes that Messrs. Hensley and Nolan would be considered “independent” based on NYSE and NASDAQ listing standards.

 

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Risk Oversight

We maintain a comprehensive, company-wide Ethics & Compliance program to address healthcare regulatory and other compliance requirements. This Ethics & Compliance program includes, among other things, initial and periodic ethics and compliance training, a toll-free reporting hotline for employees and annual coding audits. The organizational structure of our Ethics & Compliance program includes oversight by the Board of Directors and the CECC, a high-level Corporate Ethics & Compliance Committee. The Vice President of Ethics & Compliance reports jointly to the Chief Executive Officer and to the Board of Directors, serves as the Chief Compliance Officer and is charged with direct responsibility for the day-to-day oversight of our compliance program.

Code of Ethics

We have a Code of Conduct which is applicable to all of our directors, officers and employees (the “Code of Conduct”). The Code of Conduct is available on the “Ethics and Compliance Program” page of our website at www.capellahealth.com.

 

Item 11.

Executive Compensation.

EXECUTIVE COMPENSATION

Summary Compensation Table

The following table sets forth certain information concerning compensation paid or accrued by us and our subsidiaries for each of the last two years with respect to Capella’s Chief Executive Officer and two other most highly compensated executive officers. (collectively, the “Named Executive Officers” or “NEOs”):

 

Name and Principal Position		Year				Salary				Bonus (1)				Stock Awards (2)				Option Awards (2)				Non-Equity Incentive Plan Compensation (3)				All Other Compensation (4)				Total
Michael A. Wiechart (7)			2014			$	650,000			$	56,593			$	1,839,419			$	1,776,963			$	437,645			$	2,710			$	4,763,330
President and Chief Executive Officer			2013			$	450,007			$	92,020			$	—			$	—			$	—			$	277,166			$	819,193
Denise W. Warren (6)			2014			$	495,837			$	56,593			$	407,687			$	883,735			$	329,732			$	3,142			$	2,173,584
Executive Vice President, Chief Financial Officer and Treasurer			2013			$	450,007			$	91,767			$	—			$	—			$	—			$	2,710			$	544,916
Daniel S. Slipkovich (5)			2014			$	483,333			$	65,000			$	—			$	335,973			$	335,000			$	4,222			$	1,223,528
Executive Chairman of the Board			2013			$	650,000			$	112,427			$	—			$	—			$	—			$	4,222			$	766,649

 

(1)

The Compensation Committee and the Board of Directors may make discretionary bonuses outside of the non-equity incentive compensation plan. This flexibility is retained because the evaluation of the performance of an NEO may lead the Compensation Committee and the Board of Directors to determine that an NEO should receive additional compensation in a year regardless of whether the financial goal established under the non-equity incentive compensation plan is achieved. In 2013 and 2014, Ms. Warren and Messrs. Slipkovich and Wiechart each received a discretionary bonus as outlined in the table above, some of which was in conjunction with the Company’s management restructuring and reorganization plan.

(2)	Reflects the grant date fair value calculated in accordance with Accounting Standards Codification 718-10, “Compensation – Stock Compensation” (“ASC 718-10”). See additional disclosure at Note 12 to the Company Consolidated Financial Statements for more information.

(3)	Reflects cash awards earned under our non-equity incentive compensation plan. See the section below entitled “- Non-Equity Incentive Compensation Plan.”

(4)	Details of the amounts included in “All Other Compensation” for 2014 are as follows:

 

		Group term life				Long-term disability				Total
Michael A. Wiechart		$	810			$	1,900			$	2,710
Denise W. Warren			1,242				1,900				3,142
Daniel S. Slipkovich		$	2,322			$	1,900			$	4,222

 

(5)	Daniel S. Slipkovich held the position of President and Chief Executive Officer through December 31, 2013.

(6)	Denise W. Warren was named Executive Vice President, Chief Financial Officer and Treasurer effective January 1, 2014.

(7)	Michael A. Wiechart was appointed to the role of President and Chief Executive Officer effective January 1, 2014.

 

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Outstanding Equity Awards

The following table sets forth information as of December 31, 2014 with respect to outstanding equity awards granted to each of the NEO’s.

 

		Option Awards																Stock Awards
		Number of Securities Underlying Unexercised Options								Option Exercise Price				Option Expiration Date				Number of Shares or Units of Stock That Have Not Vested				Market Value of Shares or Units of Stock That Have Not Vested
Name		Exercisable				Unexercisable (1)
Michael A. Wiechart			—				31,618,555			$	0.16				4/17/2024				—				—
Denise W. Warren			—				14,924,107			$	0.16				4/17/2024				—				—
Daniel S. Slipkovich			—				5,938,338			$	0.16				4/17/2024				—				—

 

(1)	The options reflected in this column are time-vested awards that will vest and become exercisable with respect to 20% of the shares underlying the option on each of the first five anniversaries of the grant date, subject to the grantee’s compliance with the other terms of the award agreement.

Employment Agreements with the NEOs

Capella has entered into an employment agreement with each of the NEOs. Each of the employment agreements has substantially similar terms. The employment agreements establish the initial base salary of the applicable NEOs. The base salaries are reviewed and adjusted by the Compensation Committee of the Board of Directors once per year. In addition to the annual salary review, based upon the recommendations of the Chief Executive Officer, the Compensation Committee and the Board of Directors also may adjust base salaries at other times during the year in connection with promotions, increased responsibilities or to maintain competitiveness in the market. Additionally, the employment agreements establish the cash incentive bonus potential of each NEO under the non-equity compensation plan as a percentage of base salary. Each of Ms. Warren and Messrs. Slipkovich and Wiechart was eligible to earn a potential cash incentive bonus under the non-equity compensation plan of 75% of his or her base salary.

Under the terms of each employment agreement, the NEO and Capella may terminate the employment agreement at any time with or without cause. Under certain circumstances, an NEO may receive severance payments. See the section below entitled “-Potential Termination and Change-in-Control Payments.” Each NEO has agreed that during employment and for a certain period thereafter, such NEO may not directly or indirectly, anywhere in the United States, own, manage, control, participate in, consult with, render services for, or in any manner engage in any competing business with our businesses. Each of Mr. Slipkovich and Ms. Warren agreed that such restriction shall continue for a one year period after the end of his or her respective employment for any reason. Mr. Wiechart agreed that, if he voluntarily terminates his employment without good reason or is terminated for cause, he is subject to such restriction for two years following the end of his employment.

Potential Termination and Change-in-Control Payments

We believe that post-termination severance payments allow NEOs to receive value in the event of certain terminations of employment that were beyond their control. The protections afforded by post-termination severance payments allow management to focus its attention and energy on making the best objective business decisions that are in our interest without allowing personal considerations to cloud the decision-making process.

The employment agreements contain certain severance arrangements that provide for severance payments in the following circumstances:

 

•

If Mr. Wiechart is terminated without Cause or as a result of Disability or death or he resigns for Good Reason, then he is entitled to receive his annual base salary for two years.

 

•

If Ms. Warren is terminated without Cause or as a result of Disability or death or she resigns for Good Reason, then she is entitled to receive her annual base salary for one year; and

 

•

If Mr. Slipkovich is terminated without Cause or as a result of a Disability or death or he resigns for Good Reason, then he is entitled to receive his annual base salary for an 18-month period, and, upon termination for any reason other than a termination by the Company with Cause, then he is also entitled to cause Holdings to purchase of portion of his shares of Holdings common stock at fair market value as of the date such right is exercised;

 

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“Cause” is defined in each NEO’s employment agreement to mean (i) the commission of, or entry of a plea of guilty or nolo contendere, to a felony or a crime involving moral turpitude or any act or any other act or omission involving dishonesty or fraud with respect to Holdings, Capella or any of their respective subsidiaries or any of their customers or suppliers or stockholders, (ii) reporting to work repeatedly under the influence of alcohol or reporting to work under the influence of illegal drugs, the use of illegal drugs (whether or not at the workplace) or other repeated conduct causing Holdings, Capella or any of their respective subsidiaries substantial public disgrace or disrepute or substantial economic harm which, if curable, is not cured within 15 days following written notice thereof to the NEO, (iii) substantial and repeated failure to perform duties of the office held by the NEO as reasonably directed by the Board of Directors which is not cured within 15 days following written notice thereof to the NEO, (iv) a breach of the NEO’s duty of loyalty to Holdings, Capella or any of their respective subsidiaries or affiliates or any act of fraud or material dishonesty with respect to Holdings, Capella or any of their respective subsidiaries or (v) any material breach of the employment agreement or any other agreement between the NEO and Holdings, Capella or any of their respective affiliates which is not cured within 15 days after written notice thereof to the NEO.

“Disability” is defined in each NEO employment agreement to mean the disability of an NEO caused by any physical or mental injury, illness or incapacity as a result of which the NEO is unable to effectively perform the essential functions of the NEO’s duties as determined by the Board of Directors in good faith.

“Good Reason” is generally defined in each NEO’s employment agreement to mean (a) any decision by the Board of Directors which results in the primary business of Holdings being a business other than acquiring or operating acute-care hospitals, (b) substantial detrimental change in the positions or responsibilities of the NEO without the consent of the NEO, (c) where the NEO’s benefits under the employee benefit or health or welfare plan or programs of Holdings are in the aggregate materially decreased, excluding reductions because of benefit plan changes applicable to employees generally, (d) the failure by Holdings to pay the NEO’s base salary or to provide for the NEO’s annual bonus if and when due, (e) the relocation of the NEO’s primary place of employment to a location which is more than 100 miles from the city limits of Nashville, Tennessee; provided, however, that any of the foregoing (a) through (e) may be cured or remedied by Holdings within 30 days after receiving notice thereof from the NEO.

The employment agreements do not provide any of the NEOs with cash severance upon a Sale of the Company, but any unvested common stock in Holdings acquired by an NEO in accordance with his or her employment agreement may become automatically vested, unless the Sale of the Company is a result of a Public Offering. A portion of common stock purchased by Mr. Slipkovich pursuant to his employment agreements remains unvested until immediately prior to a Sale of the Company or an initial Public Offering that would result in appreciation of the value of the unvested shares.

“Public Offering” is defined in each NEO’s employment agreement to mean the sale in an underwritten public offering registered under the Securities Act of equity securities of Holdings or a corporate successor to Holdings.

“Sale of the Company” is defined in each NEO’s employment agreement to mean any transaction or series of transactions pursuant to which any person or group of related persons other than GTCR in the aggregate acquire(s) (i) equity securities of Holdings possessing the voting power (other than voting rights accruing only in the event of a default, breach or event of noncompliance) to elect a majority of the board of directors of Holdings (whether by merger, consolidation, reorganization, combination, sale or transfer of Holding’s equity, stockholder or voting agreement, proxy, power of attorney or otherwise) or (ii) all or substantially all of Holding’s assets determined on a consolidated basis; provided that a Public Offering shall not constitute a Sale of the Company.

 

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The amount of estimated compensation payable to each NEO entitled to benefits if any such event had occurred on December 31, 2014 is listed in the tables below:

Michael A. Wiechart

 

Executive Benefits and Payments upon Termination		Involuntary Termination without Cause				Resignation for Good Reason				Change in Control				Death or Disability
Cash Payments			$1,300,000				$1,300,000				—				$1,300,000
Accelerated Vesting of Unvested Stock Options			—				—				$1,776,963	(1)			—

 

(1)

Reflects the accelerated vesting of 31,618,555 options for shares of Holdings common stock that remain unvested. The amount of compensation reflected in this column is represents the grant date fair value calculated under ASC 718 of options awarded. Refer to Note 12 in the Company’s audited consolidated financial statements for a discussion of the assumptions used to determine the grant date fair value of these awards.

Denise W. Warren

 

Executive Benefits and Payments upon Termination		Involuntary Termination without Cause				Resignation for Good Reason				Change in Control				Death or Disability
Cash Payments			$500,001				—				—				$500,001
Accelerated Vesting of Unvested Stock Options			—				—				$883,735	(1)			—

 

(1)

Reflects the accelerated vesting of 14,924,107 options for shares of Holdings common stock that remain unvested. The amount of compensation reflected in this column represents the grant date fair value calculated under ASC 718 of options awarded. Refer to Note 12 in the Company’s audited consolidated financial statements for a discussion of the assumptions used to determine the grant date fair value of these awards.

Daniel S. Slipkovich

 

Executive Benefits and Payments upon Termination		Involuntary Termination without Cause				Resignation for Good Reason				Change in Control				Death or Disability
Cash Payments			$675,000				$675,000				—				$675,000
Accelerated Vesting of Unvested Restricted Stock			—				—				$163,382	(3)			—
Accelerated Vesting of Unvested Stock Options			—				—				$5,938,338	(2)			—
Put Right			$1,015,564	(1)			$1,015,564	(1)			—				—

 

(1)

Reflects the right to require Holdings to purchase 6,347,275 shares of Holdings common stock based on a per share price of $0.16 per share, which was determined to be the fair market value of Holdings common stock as of April 17, 2014 by the Board of Directors. As a fair market value of Holdings has not been determined for the Company by a third party appraiser since December 31, 2011, the current fair market value of Holdings common stock could be materially different. In May 2005, Mr. Slipkovich originally purchased the shares of common stock for fair market value.

(2)

Reflects the accelerated vesting of 5,938,338 options for shares of Holdings common stock that remain unvested. The amount of compensation reflected in this column is represents the grant date fair value calculated under ASC 718 of options awarded. Refer to Note 12 in the Company’s audited consolidated financial statements for a discussion of the assumptions used to determine the grant date fair value of these awards.

(3)

Reflects the accelerated vesting of 789,887 shares of Holdings common stock that remain unvested until certain terms are met upon a Sale of the Company or an Initial Public Offering. The amount of compensation reflected in this column is based on a per share price of $0.16, which was determined to be the fair market value of Holdings common stock as of December 31, 2014 by the Board of Directors. As the fair market value of Holdings has not been determined for the Company by a third-party appraiser since 2011, the current fair market value of Holdings common stock could be material different. Mr. Slipkovich purchased these shares for fair market value in May 2005.

 

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Non-Equity Incentive Compensation Plan

Certain of our corporate-level employees, including the NEOs, are eligible for a cash incentive bonus under our non-equity incentive compensation plan. When determining the amount of non-equity incentive compensation to be paid to each NEO, the Compensation Committee of the Board of Directors reviews and considers the following information:

 

•

evaluations of each of the NEOs, as well as any feedback from the Board of Directors, regarding each NEO’s performance;

 

•

the Chief Executive Officer’s review and evaluation of each of the other NEOs, addressing individual performance and the results of operations of the business areas and departments for which such executive had responsibility;

 

•

the financial performance of the Company, including achieving EBITDA goals established by the Chief Executive Officer and presented to and approved by the Board of Directors; and

 

•

total proposed compensation, as well as each element of proposed compensation, taking into account the recommendations of the Chief Executive Officer.

Under the non-equity incentive compensation plan, cash incentive bonuses that are earned for achievement of pre-established performance goals are generally paid in the first four months of the year following the year during which such goals were achieved; however, even if performance goals are achieved, the amount, if any, ultimately paid under the non-equity incentive compensation plan is subject to the discretion of the Board.

For 2014, the Compensation Committee of the Board of Directors, based on the recommendation of the Chief Executive Officer, determined a potential cash incentive bonus amount for each NEO based on a specific percentage of each NEO’s base salary. For 2014, each of Ms. Warren and Messrs, Slipkovich and Wiechart was eligible to earn a potential cash incentive bonus of 75% of his or her base salary (the “Maximum Cash Incentive Amount”). Each NEO can earn up to 100% of his or her Maximum Cash Incentive Amount if certain performance goals are achieved. Certain of the performance goals for 2014 were achieved and, as a result, each Mr. Weichart, Ms. Warren and Mr. Slipkovich is, subject to Board approval, eligible to receive approximately 90%, 89% and 92%, respectively, of his or her Maximum Cash Incentive Amount (the “Eligible Payment”). Amounts estimated to be received by each NEO is included in the table above.

Equity Incentive Compensation

The Board of Directors of Holdings previously adopted the Capella Holdings, Inc. 2006 Stock Option Plan (the “2006 Stock Option Plan”), which permits the Board of Directors of Holdings to issue stock options to our directors, executive officers and other key personnel, subject to the terms and conditions set forth in the 2006 Stock Option Plan and in each option award. Holdings has never issued stock options under the 2006 Stock Option Plan. In April 2014, the Board of Directors of Holdings adopted the Capella Holdings, Inc. 2014 Stock Option Plan (the “2014 Stock Option Plan”), effectively replacing the 2006 Stock Option Plan. Although equity incentive compensation awards historically have not been granted as an element of NEO compensation, in 2014, the Compensation Committee made a discretionary grant of fully vested restricted stock to the NEO’s.

 

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DIRECTOR COMPENSATION

During the year ended December 31, 2014, none of our directors received compensation for their service as a member of the Board, except for Mr. Hensley and Mr. Nolan. Mr. Hensley and Mr. Nolan are the only members of the Board that we believe would be considered “independent” based upon NYSE and NASDAQ listing standards. All of our directors are reimbursed for reasonable expenses incurred in connection with their services.

 

Name		Fees Earned or Paid in Cash				Stock Awards				All Other Compensation				Total
Joseph P. Nolan		$	35,000			$	—			$	—			$	35,000
Robert Z. Hensley			35,000				—				—				35,000

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

Messrs. Donnini, Earl, Hensley, and Nolan served as members of our Compensation Committee throughout 2014. Mr. Katz served as a member of the Compensation Committee until his resignation from the Board of Directors in March 2014. Messrs. Donnini and Earl began serving on the Compensation Committee when they joined the Board of Directors in March 2014. Although Messrs. Donnini, Earl, Hensley, and Nolan serve on the board of Holdings, none of them has at any time been an officer or employee of Capella, Holdings or any of their subsidiaries. Additionally, none of our executive officers has served as a member of another entity’s compensation committee, one of whose executive officers served on our Compensation Committee or was one of our directors. Members of our Compensation Committee have certain relationships with Capella and Holdings, as described in the section below entitled “Item 13. Certain Relationships and Related Transactions, Director Independence.”

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

All of Capella’s capital stock is owned by our parent company, Holdings. The table below presents information with respect to the beneficial ownership of Holdings common stock and Holdings preferred stock as of December 31, 2014 by (a) any person or group who beneficially owns more than five percent of Holdings common stock or Holdings preferred stock, (b) each of Capella’s directors and Named Executive Officers and (c) all directors and executive officers of Capella as a group. The percentages provided in the table are based on 767,121,857 shares of Holdings common stock outstanding as of January 31, 2015.

 

Name of Beneficial Holder(1)		Shares of Common Stock Beneficially Owned(3)				Percentage of Common Stock Beneficially Owned				Shares of Preferred Stock Beneficially Owned(3)				Percentage of Preferred Stock Beneficially Owned
GTCR(2)			729,524,235	(4)(5)			95.1	%			—				—
Daniel S. Slipkovich			11,227,796	(6)(7)			1.5				—				—
Denise W. Warren			2,278,636				0.3				—				—
Michael A. Wiechart			7,153,840				0.9				—				—
David A. Donnini			—				—				—				—
Joshua M. Earl			—				—				—				—
Robert Z. Hensley			213,963				*				—				—
Joseph P. Nolan			—				—				—				—
All directors and executive officers as a group (10 persons)			23,047,613	(8)			3.0				—				—

 

*	Less than one percent.

(1)	Each owner has agreed to vote their shares in accordance with the Stockholders Agreement. See “Certain Relationships and Related Transactions — Stockholders Agreement.”

(2)	The address of GTCR is 300 N. LaSalle Street, Suite 5600, Chicago, Illinois 60654.

(3)	Beneficial ownership includes voting or investment power with respect to securities and includes shares that an individual has a right to acquire within 60 days after January 31, 2014.

(4)	Includes 617,801,975, 108,424,810 and 3,297,450 shares owned by GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P. and GTCR Co-Invest II, L.P., respectively.

(5)	Reflects the conversion of 205,541.741 shares of Holdings preferred stock previously held by GTCR and its affiliates into 679,524,234 shares of Holdings common stock in connection with the April 2014 equity restructuring of Holdings.

(6)	Reflects the conversion of [1,173.964] shares of Holdings preferred stock previously held by Mr. Slipkovich into 6,708,366 shares of Holdings common stock in connection with the April 2014 equity restructuring of Holdings.

(7)	Includes 789,887 shares owned by Mr. Slipkovich with financial rights that do not vest until a sale of the Company or an initial public offering but for which Mr. Slipkovich currently has voting power.

(8)	Reflects the conversion of 1,185.279 shares of Holdings preferred stock previously held by all directors and executive officers as a group into 6,773,023 shares of Holdings common stock in connection with the April 2014 equity restructuring of Holdings.

 

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Holdings issues stock-based awards to the Company’s employees from time to time, including stock options and other stock-based awards in accordance with Holdings’ various board-approved compensation plans. In April 2014, Holdings adopted the 2014 Stock Option Plan, which effectively replaced the 2006 Stock Option Plan. The following table provides information as of December 31, 2014 with respect to the 2014 Stock Option Plan under which shares of the common stock of Holdings are authorized for issuance. See additional disclosure at Note 12 to the Company’s Consolidated Financial Statements for more information.

 

Plan Category		Number of securities to be issued upon exercise of outstanding options, warrants and rights				Weighted-average exercise price of outstanding options, warrants and rights				Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in second column)
Equity compensation plans approved by security holders			—				—				—
Equity compensation plans not approved by security holders (1)			89,161,241			$	0.16				1,366,361
Total			89,161,241								1,366,361

 

(1)	Represents stock options granted or issuable under the 2014 Stock Option Plan.

 

Item 13.

Certain Relationships and Related Transactions, and Director Independence.

Certain Relationships and Related Transactions

In accordance with its written charter, the Audit Committee reviews and approves all material related party transactions. Prior to its approval of any material related party transaction, the Audit Committee will discuss the proposed transaction with management and our independent auditor. In addition, our Code of Conduct requires that all of our employees, including our executive officers, remain free of conflicts of interest in the performance of their responsibilities to the Company. An executive officer who wishes to enter into a transaction in which his or her interests may conflict with ours must first receive the approval of the Audit Committee.

Stock Purchase Agreement

In accordance with a Stock Purchase Agreement, dated May 4, 2005, as amended by Supplement No. 1 to the Stock Purchase Agreement, dated April, 2007 and Amendment and Supplement No. 2 to the Stock Purchase Agreement, dated February 29, 2008 (collectively, the “Purchase Agreement”), Holdings authorized the issuance and sale to GTCR of 196,000.000 shares of Holdings Cumulative Redeemable Preferred Stock and 50,000,000 shares of Holdings common stock. At the initial closing, GTCR purchased 25,000,000 shares of Holdings common stock at a price of $0.08 per share for gross proceeds of $2,000,000. At such time, GTCR intended to provide up to $198,000,000 in equity financing to Holdings as the equity portion of the debt and equity financing necessary to fund the acquisition of acute care hospitals, in each case as approved by the board of directors of Holdings and by GTCR. Such additional equity financing would be provided through the purchase by GTCR of up to 25,000,000 shares of Holdings common stock at $0.08 per share and 196,000.000 shares of Holdings preferred stock at $1,000 per share (each such purchase, a “Subsequent Closing”). As of December 31, 2014, 50,000,000 shares of Holdings common stock and 205,541.741 shares of Holdings preferred stock have been purchased by GTCR in Subsequent Closings. This agreement called for the execution of employment agreements with executive management (see “Executive Compensation-Summary Compensation Table-Employment Agreements”), a Stockholders Agreement, a Registration Rights Agreement and a Professional Services Agreement. Pursuant to the Purchase Agreement, Holdings may not, among other things, without the prior written consent of the majority holders, pay any dividends or make distributions, make or permit any subsidiaries, including Capella, to make any loans or advances, or merge or consolidate with any person. Under the Purchase Agreement, Holdings agreed to pay certain expenses of GTCR, including fees and expenses incurred with respect to any amendments or waivers and stamp and other taxes in connection with the Purchase Agreement.

 

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Stockholders Agreement

The Stockholders Agreement, as amended by Amendment No. 1, dated February 29, 2008 and Amendment No. 2, dated April 17, 2014, includes various provisions such as restrictions with respect to the designation of the board of directors of Holdings, sale of the stock, tag-along rights and rights of first refusal. Certain of the transfer restrictions expired on May 4, 2010. The tag-along rights allow all stockholders to participate in any potential sale of Holders stock by GTCR. The right of first refusal gives Holdings a right of first refusal on the same terms as a proposed transfer until the earliest of a public offering, the time of a public sale by a stockholder, the consummation of an approved sale, or the date on which such stock has been transferred under the right of first refusal. If the board of directors of Holdings and the holders of a majority of the Holdings common stock held by GTCR and its affiliates (the “Investor Majority”) approve a sale of Holdings, each holder of shares shall vote for the sale. If the sale is a (i) merger or consolidation, each holder waives all dissenter’s rights and appraisal rights, (ii) a sale of stock, each holder of shares shall agree to sell all of his shares or rights to acquire shares on the terms and conditions approved by the Holdings Board and the Investor Majority or (iii) sale of assets, each holder of shares shall vote such holder’s shares to approve such sale.

Registration Rights Agreement

In connection with the Purchase Agreement, we entered into the Registration Rights Agreement, dated May 4, 2005. At any time, GTCR may request registration under the Securities Act of all or any portion of its registrable securities of Holdings. GTCR may request an unlimited number of both short-form and long-form registrations. Holdings must give prompt written notice of its intent to register any securities in order to allow for piggy-back registration rights of the holders of registrable securities. Whenever the holders of registrable securities have requested that any registrable securities be registered pursuant to the Registration Rights Agreement, Holdings must use its best efforts to effect the registration and the sale of such registrable securities in accordance with the intended method of disposition.

Professional Services Agreement

In connection with the Purchase Agreement, Capella and GTCR Golder Rauner II, L.L.C. entered into a Professional Services Agreement, dated May 4, 2005, as amended by that Amendment No. 1 to Professional Services Agreement, dated November 30, 2005, in order to provide financial and management consulting services to the Company. GTCR Golder Rauner II, L.L.C. agreed to consult on matters including, but not limited to, corporate strategy, budgeting of future corporate investments, acquisition and divestiture strategies and debt and equity financings in exchange for an annual fee of $100,000, which has been subsequently increased to $150,000 per the terms of the Professional Service Agreement. The Professional Services Agreement also provides that at the time of any debt financing prior to our initial public offering, Capella shall pay to GTCR Golder Rauner II, L.L.C. a placement fee in an amount mutually determined between us and GTCR Golder Rauner II, L.L.C., or its affiliate, provided that such placement fee shall not exceed one percent of the gross amount of such debt financing. The agreement will continue until GTCR and its affiliates no longer own at least 10% of the Holdings common stock and Holdings preferred stock issued under the Purchase Agreement. The Professional Services Agreement also calls for GTCR to be reimbursed by Capella for certain out of pocket expenses incurred in connection with the rendering of various services under this agreement.

Equity Restructuring of Holdings

During April 2014, Holdings completed an equity restructuring that included the conversion of $206.7 million of Holdings’ preferred stock outstanding to a net 686.3 million shares of Holdings’ common stock and the forgiveness of $140.1 million of previously accrued dividends on preferred stock accreted as of March 31, 2014. This conversion impacted GTCR, Mr. Slipkovich (the Executive Chairman of the Board) and Mr. Slusser (the Company’s Executive Vice President of Acquisitions and Development). Please refer to “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters — Security Ownership of Certain Beneficial Owners and Management” for additional information regarding the conversion and current Holdings’ ownership.

In connection with the equity restructuring, Holdings issued to the Company’s employees approximately 18,203,000 restricted shares and, under the 2014 Stock Option Plan, approximately 89,838,000 stock options. For more information about the grant of these stock and option awards to the Company’s employees, please refer to “Item 11. Executive Compensation — Summary Compensation Table” and Notes 1 and 12 to the Company Consolidated Financial Statements. Additionally, Mr. Hensley (a director of the Company) received 196,963 restricted shares and 828,955 option awards in connection with the equity restructuring.

Director Independence

Though not formally considered by the Board of Directors because our common stock is not currently listed or traded on any national securities exchange, based upon the listing standards of the New York Stock Exchange (“NYSE”) and NASDAQ, we do not believe that any of our directors other than Mr. Hensley and Mr. Nolan would be considered “independent” because of their relationships with us or GTCR, which holds significant interests in Holdings, which owns 100% of our outstanding stock. Accordingly, we do not believe that Mr. Earl a member of our Audit Committee and Compensation Committee, would meet the independence requirements of Rule 10A-1 of the Exchange Act, or the NYSE’s independence requirements. We do not have a nominating/corporate governance committee, or a committee that serves a similar purpose.

 

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Item 14.

Principal Accountant Fees and Services.

The table below provides information concerning fees for services rendered by Ernst & Young LLP during the last two fiscal years. The nature of the services provided in each such category is described following the table.

 

Description of Fees		Amount of Fees
		2013				2014
Audit Fees		$	1,216,866			$	1,129,240
Audit-Related Fees			—				132,279
Tax Fees			52,708				67,774
All Other Fees			—				—
Total		$	1,269,574			$	1,329,293

Audit Fees — These fees were primarily for professional services rendered by Ernst & Young LLP in connection with the audit of the Company’s consolidated annual financial statements, reviews of the interim condensed consolidated financial statements and its quarterly report on Form 10-Q for the first three fiscal quarters of the fiscal years ended December 31, 2013 and 2014.

Audit-Related Fees — These fees were primarily for services rendered by Ernst & Young LLP for transactional related services.

Tax Fees — These fees were for services rendered by Ernst & Young LLP for assistance with tax compliance regarding tax filings and also for other tax advice and consulting services.

All Other Fees — These fees represent fees for services provided to the Company by Ernst & Young LLP not otherwise included in the categories above.

Pre-approval of Services Performed by the Independent Registered Public Accounting Firm

The charter of the Audit Committee provides that the Audit Committee must pre-approve all services to be provided by the independent auditors prior to the commencement of work. Unless the specific service has been pre-approved with respect to that year, the Audit Committee must approve the permitted service before the independent auditors are engaged to perform it. For 2014, all services provided by Ernst & Young LLP were pre-approved by the Audit Committee.

The Audit Committee considered and determined that the provision of non-audit services by Ernst & Young LLP during 2013 and 2014 was compatible with maintaining auditor independence. None of these services is of a type that is prohibited under the independent registered public accounting firm independence standards of the SEC.

 

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PART IV

 

Item 15.

Exhibits, Financial Statement Schedules.

(a) Index to Consolidated Financial Statements, Financial Statement Schedules and Exhibits:

(1) Consolidated Financial Statements:

See Item 8 in this report.

The consolidated financial statements required to be included in Part II, Item 8, Financial Statements and Supplementary Data, begin on Page F- 1 and are submitted as a separate section of this report.

(2) Consolidated Financial Statement Schedules:

All schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes in this report.

(b) Exhibits:

 

Exhibit Number		Description
3.1		Certificate of Incorporation of Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
3.2		By-Laws of Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
4.1		Indenture, dated as of June 28, 2010, among Capella Healthcare, Inc., the Guarantors named therein and U.S. Bank National Association, as Trustee (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
4.2		Form of 9 1⁄4% Senior Notes due 2017 (included in Exhibit 4.1) (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
4.3		Form of Supplemental Indenture to add a Guaranty Subsidiary (incorporated by reference from exhibits to the Quarterly Report on Form 10-Q filed by Capella Healthcare, Inc. on November 2, 2012)
4.4		Registration Rights Agreement, dated as of June 28, 2010, among Capella Healthcare, Inc., the Guarantors party thereto, and Banc of America Securities LLC, as representatives of the initial purchasers named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.1		Stock Purchase Agreement, dated as of May 4, 2005, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.2		Supplement No. 1 to the Stock Purchase Agreement, dated as of April , 2007, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.3		Amendment and Supplement No. 2 to the Stock Purchase Agreement, dated as of February 29, 2008, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.4		Stockholders Agreement, dated as of May 4, 2005, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.5		Amendment No. 1 to the Stockholders Agreement, dated as of February 29, 2008, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

 

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Exhibit Number		Description
10.6		Amendment No. 2 to the Stockholders Agreement, dated as of April 17, 2014, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein
10.7		Registration Rights Agreement, dated as of May 4, 2005, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.8		Professional Services Agreement, dated as of May 4, 2005, between GTCR Golder Rauner II, LLC and Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.9		Amendment No. 1 to Professional Services Agreement between GTCR Golder Rauner II, LLC and Capella Healthcare, Inc., dated as of November 30, 2005 (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.10		Amended and Restated Loan Agreement, dated as of December 31, 2014, by and among Capella Healthcare, Inc. and certain borrowing subsidiaries as Borrowers, Capella Holdings, Inc. and certain guarantying subsidiaries as Guarantors, certain financial institutions as Lenders, Bank of America, N.A. as Administrative Agent and Collateral Agent, Citibank, N.A. as Syndication Agent, General Electric Capital Corporation as Documentation Agent and Merrill Lynch, Pierce, Fenner & Smith, Incorporated, Citigroup Global Markets Inc. and GE Capital Markets, Inc. as Joint Lead Arrangers and Joint Bookrunners **
10.11		Senior Management Agreement, dated as of May 4, 2005, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and Daniel S. Slipkovich (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.12		Amendment No. 1 to Senior Management Agreement, dated as of May 12, 2006, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Daniel S. Slipkovich and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.13		Amendment No. 2 to Senior Management Agreement, dated as of September 15, 2014, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Daniel S. Slipkovich and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Quarterly Report on Form 10-Q filed by Capella Healthcare, Inc. on October 31, 2014) *
10.14		Senior Management Agreement, dated May 4, 2005, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and David Andrew Slusser (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.15		Amendment No. 1 to Senior Management Agreement, dated as of May 12, 2006, by and among Capella Holdings, Inc., Capella Healthcare, Inc., David Andrew Slusser and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.16		Senior Management Agreement, dated as of October 17, 2005, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and Denise Wilder Warren (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.17		Amendment No. 1 to Senior Management Agreement, dated as of May 12, 2006, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Denise Wilder Warren and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.18		Amendment No. 2 to Senior Management Agreement, dated as of November 18, 2014, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Denise Wilder Warren and GTCR Fund VIII, L.P. *
10.19		Senior Management Agreement, dated as of May 26, 2009, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and Michael Wiechart (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.20		Form of Amendment No. 1 to Senior Management Agreement, dated as of August 24, 2011, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Michael Wiechart and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *

 

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Exhibit Number		Description
10.21		Amendment No. 2 to Senior Management Agreement, dated as of November 18, 2014, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Michael Wiechart and GTCR Fund VIII, L.P. *
10.22		Capella Holdings, Inc. Deferred Compensation Plan (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.23		Computer and Data Processing Services Agreement, effective February 21, 2011, by and among HCA-Information Technology & Services, Inc. and Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4/A filed by Capella Healthcare, Inc. on September 23, 2011, File No. 333-175188) **
10.24		Amendment No. 001 to Computer and Data Processing Services Agreement, effective May 5, 2011, by and among HCA-Information Technology & Services, Inc. and Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4/A filed by Capella Healthcare, Inc. on September 23, 2011, File No. 333-175188) **
10.25		Lease Agreement, dated April 3, 2007, by and among Muskogee Medical Center Authority, d/b/a Muskogee Regional Medical Center , Muskogee Regional Medical Center, LLC, and Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.26		Form of Redemption Agreement (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.27		Senior Management Agreement, dated September 20, 2011, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and Neil W. Kunkel (incorporated by reference from exhibits to the Quarterly Report on Form 10-Q filed by Capella Healthcare, Inc. on November 11, 2011) *
10.28		Capella Holdings, Inc. 2014 Stock Option Plan (incorporated by reference from exhibits to the Current Report on Form 8-K filed by Capella Healthcare, Inc. on April 23, 2014) *
10.29		Form of Nonqualified Stock Option Agreement under the Capella Holdings, Inc. 2014 Stock Option Plan (incorporated by reference from exhibits to the Current Report on Form 8-K filed by Capella Healthcare, Inc. on April 23, 2014) *
10.30		Credit Agreement, dated as of December 31, 2014, among Capella Healthcare, Inc., Capella Holdings, Inc., various lenders and Credit Suisse AG, Cayman Islands Branch as Administrative Agent **
21		Subsidiaries of Registrant
31.1		Certification of the Chief Executive Officer of Capella Healthcare, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of the Chief Financial Officer of Capella Healthcare, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of the Chief Executive Officer of Capella Healthcare, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of the Chief Financial Officer of Capella Healthcare, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Extension Schema Document
101.CAL		XBRL Taxonomy Calculation Linkbase Document
101.DEF		XBRL Taxonomy Definition Linkbase Document
101.LAB		XBRL Taxonomy Label Linkbase Document
101.PRE		XBRL Taxonomy Presentation Linkbase Document

 

*	Management compensatory plan or arrangement.

**	Certain information has been omitted pursuant to a confidential treatment request filed with the SEC.

 

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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

CAPELLA HEALTHCARE, INC.

 

Report of Independent Registered Public Accounting Firm			F-2
Consolidated Balance Sheets as of December 31, 2013 and 2014			F-3
Consolidated Statements of Operations for the years ended December 31, 2012, 2013 and 2014			F-4
Consolidated Statements of Stockholder’s Deficit for the years ended December 31, 2012, 2013 and 2014			F-5
Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2013 and 2014			F-6
Notes to Consolidated Financial Statements			F-7

 

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Table of Contents

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholder

Capella Healthcare, Inc.

We have audited the accompanying consolidated balance sheets of Capella Healthcare, Inc., a wholly owned subsidiary of Capella Holdings, Inc., as of December 31, 2014 and 2013, and the related consolidated statements of operations, stockholder’s deficit, and cash flows for each of the three years in the period ended December 31, 2014. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Capella Healthcare, Inc. at December 31, 2014 and 2013, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles.

/s/ Ernst & Young LLP

Nashville, Tennessee

March 27, 2015

 

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Table of Contents

Capella Healthcare, Inc.

Consolidated Balance Sheets

(In millions, except for share and per share amounts)

 

		December 31,
		2013				2014
Assets
Current assets:
Cash		$	26.4			$	28.7
Restricted cash			—				73.9
Accounts receivable, net of allowance for doubtful accounts of $105.5 and $84.4 at December 31, 2013 and 2014, respectively			126.3				120.9
Inventories			24.3				23.7
Prepaid expenses and other current assets			5.0				5.1
Other receivables			6.6				5.8
Assets held for sale			13.1				33.7
Deferred tax assets			2.5				2.4
Total current assets			204.2				294.2
Property and equipment:
Land			37.8				30.9
Buildings and improvements			389.4				366.1
Equipment			245.1				239.2
Construction in progress (estimated cost to complete at December 31, 2014 is $28.1 million)			8.0				7.9
			680.3				644.1
Accumulated depreciation			(224.2	)			(234.5	)
			456.1				409.6
Goodwill			133.6				127.9
Intangible assets, net			13.2				10.9
Other assets, net			23.7				27.1
Total assets		$	830.8			$	869.7
Liabilities and stockholder’s deficit
Current liabilities:
Accounts payable		$	28.5			$	29.8
Salaries and benefits payable			23.8				27.5
Accrued interest			23.3				23.3
Other accrued liabilities			32.7				23.5
Current portion of long-term debt			49.6				6.0
Revolving facility			—				5.0
Liabilities held for sale			1.9				3.6
Total current liabilities			159.8				118.7
Long-term debt			507.8				607.8
Deferred income taxes			17.3				18.2
Other liabilities			28.4				31.0
Redeemable non-controlling interests			21.4				11.7
Due to parent			210.9				213.7
Stockholder’s deficit:
Common stock, $0.01 par value; 1,000 shares authorized; 100 shares issued and outstanding at December 31, 2013 and 2014, respectively			—				—
Retained deficit			(114.8	)			(131.4	)
Total stockholder’s deficit			(114.8	)			(131.4	)
Total liabilities and stockholder’s deficit		$	830.8			$	869.7

See accompanying notes.

 

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Capella Healthcare, Inc.

Consolidated Statements of Operations

(In millions)

 

		Year Ended December 31,
		2012				2013				2014
Revenue before provision for bad debts		$	737.2			$	768.9			$	788.9
Provision for bad debts			(78.6	)			(100.8	)			(75.5	)
Revenue			658.6				668.1				713.4
Costs and expenses:
Salaries and benefits			303.1				312.7				333.4
Supplies			106.9				116.0				121.7
Other operating expenses			160.0				168.1				176.3
Other income			(4.4	)			(10.7	)			(13.2	)
Management fee to related party			0.2				0.2				0.2
Interest, net			53.1				55.0				53.7
Depreciation and amortization			35.2				41.5				41.5
Total costs and expenses			654.1				682.8				713.6
Income (loss) from continuing operations before income taxes			4.5				(14.7	)			(0.2	)
Income taxes			3.0				4.0				4.7
Income (loss) from continuing operations			1.5				(18.7	)			(4.9	)
Loss from discontinued operations, net of tax			(14.1	)			(11.8	)			(18.4	)
Net loss			(12.6	)			(30.5	)			(23.3	)
Less: Net income attributable to non-controlling interests			1.5				1.3				1.8
Net loss attributable to Capella Healthcare, Inc.		$	(14.1	)		$	(31.8	)		$	(25.1	)

See accompanying notes.

 

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Capella Healthcare, Inc.

Consolidated Statements of Stockholder’s Deficit

(In millions, except for share amounts)

 

		Common Stock								Retained				Total Stockholder’s
		Shares				Amount				Deficit				Deficit
Balance at December 31, 2011			100			$	—			$	(63.6	)		$	(63.6	)
Adjustment to redemption value of redeemable non-controlling interests			—				—				(0.6	)			(0.6	)
Establishment of non-controlling interests related to St. Thomas joint venture											(3.5	)			(3.5	)
Net loss			—				—				(14.1	)			(14.1	)
Balance at December 31, 2012			100				—				(81.8	)			(81.8	)
Adjustment to redemption value of redeemable non-controlling interests			—				—				(1.2	)			(1.2	)
Net loss			—				—				(31.8	)			(31.8	)
Balance at December 31, 2013			100				—				(114.8	)			(114.8	)
Adjustment to redemption value of redeemable non-controlling interests			—				—				8.5				8.5
Net loss			—				—				(25.1	)			(25.1	)
Balance at December 31, 2014			100			$	—			$	(131.4	)		$	(131.4	)

See accompanying notes.

 

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Capella Healthcare, Inc.

Consolidated Statements of Cash Flows

 

		Year Ended December 31,
		2012				2013				2014
		(In Millions)
Operating activities
Net loss		$	(12.6	)		$	(30.5	)		$	(23.3	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Loss from discontinued operations			14.1				11.8				18.4
Depreciation and amortization			35.2				41.5				41.5
Amortization of loan costs and debt discount			3.9				4.0				3.8
Provision for bad debts			78.6				100.8				75.5
Deferred income taxes			2.0				3.1				3.1
Stock-based compensation			1.0				0.8				4.1
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable, net			(91.7	)			(109.6	)			(77.3	)
Inventories			(0.8	)			(0.5	)			(1.3	)
Prepaid expenses and other current assets			0.2				0.6				.1
Accounts payable and other current liabilities			7.2				11.3				(4.2	)
Accrued salaries			1.1				0.9				5.1
Other			2.5				(2.4	)			2.2
Net cash provided by operating activities – continuing operations			40.7				31.8				47.7
Net cash provided by (used in) operating activities – discontinued operations			3.3				(1.0	)			(3.3	)
Net cash provided by operating activities			44.0				30.8				44.4
Investing activities
Purchases of property and equipment, net			(29.5	)			(24.9	)			(24.5	)
Escrow payment on acquisition of healthcare business			—				—				(73.9	)
Acquisition of healthcare businesses			(26.0	)			—				—
Proceeds from disposition of healthcare businesses			12.4				1.6				11.2
Net cash used in investing activities – continuing operations			(43.1	)			(23.3	)			(87.2	)
Net cash used in investing activities – discontinued operations			(4.3	)			(3.5	)			(0.7	)
Net cash used in investing activities			(47.4	)			(26.8	)			(87.9	)
Financing activities
Payments on capital leases and other obligations			(0.8	)			(9.8	)			(49.9	)
Borrowings on Revolving Facility			—				—				40.0
Payments on Revolving Facility			—				—				(35.0	)
Proceeds from Term Note			—				—				99.0
Advances (to) from Parent			(0.4	)			1.3				(1.2	)
Payment of debt issue costs			(0.2	)			—				(5.4	)
Distributions to non-controlling interests			(1.7	)			(1.2	)			(1.8	)
Sale (repurchase) of non-controlling interests			(1.1	)			(0.2	)			0.1
Net cash provided by (used in) financing activities – continuing operations			(4.2	)			(9.9	)			45.8
Net cash used in financing activities – discontinued operations			(1.5	)			(1.0	)			—
Net cash provided by (used in) financing activities			(5.7	)			(10.9	)			45.8
Change in cash			(9.1	)			(6.9	)			2.3
Cash at beginning of year			42.4				33.3				26.4
Cash at end of year		$	33.3			$	26.4			$	28.7
Supplemental disclosure of cash flow information
Cash paid for interest		$	47.1			$	51.2			$	49.6
Cash paid for taxes		$	0.4			$	1.6			$	1.3
Supplemental schedule of non-cash investing and financing activities:
Capital lease obligations		$	50.3			$	14.5			$	5.4

See accompanying notes.

 

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Capella Healthcare, Inc.

Notes to Consolidated Financial Statements

December 31, 2014

1. Organization and Significant Accounting Policies

Organization

Capella Healthcare, Inc., a Delaware corporation which was formed on April 15, 2005, is a wholly owned subsidiary of Capella Holdings, Inc. (the “Parent”). The Company operates hospitals and ancillary healthcare facilities in non-urban communities in the United States. Unless the context otherwise indicates, Capella Healthcare, Inc. is referred to herein as “Capella” or the “Company”.

At December 31, 2014, as part of continuing operations, the Company operated nine general acute care hospitals and ancillary healthcare facilities (eight of which the Company owns and one of which the Company leases pursuant to a long-term lease) with a total of 1,309 licensed beds. Unless noted otherwise, discussions in these notes pertain to the Company’s continuing operations, which exclude the results of those facilities that have been previously disposed or are included in assets and liabilities held for sale.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and all subsidiaries and entities controlled by the Company through the Company’s direct or indirect ownership of a majority interest and exclusive rights granted to the Company as the sole general partner of such entities. All intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of the accompanying consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Discontinued Operations

In accordance with the provisions of the Financial Accounting Standards Board (“FASB”) authoritative guidance regarding accounting for the impairment or disposal of long-lived assets, the Company has presented the operating results, financial position and cash flows of its previously disposed facilities or planned disposal of facilities classified as held for sale as discontinued operations, net of income taxes, in the accompanying consolidated financial statements.

General and Administrative Costs

The majority of the Company’s expenses are “cost of revenue” items. Costs that could be classified as “general and administrative” by the Company would include its corporate overhead costs, which were $25.5 million, $23.7 million and $28.6 million for the years ended December 31, 2012, 2013 and 2014, respectively. Business development costs and refinancing related costs also included within the aforementioned general and administrative costs, included in other operating expenses on the consolidated statement of operations, were $5.5 million, $3.3 million and $2.2 million for the years ended December 31, 2012, 2013 and 2014, respectively. Stock-based compensation costs also included within the aforementioned general and administrative costs, including in salaries and benefits on the consolidated statement of operations were $1.0 million, $0.8 million and $5.9 million for the years ended December 31, 2012, 2013 and 2014, respectively.

Fair Value of Financial Instruments

The carrying amounts reported in the consolidated balance sheets for cash, restricted cash, accounts receivable inventories, prepaid expenses and other current assets, other receivables accounts payable, salaries and benefits payable, accrued interest, and other accrued liabilities approximate fair value because of the short-term nature of these instruments. The carrying amount of the Company’s 9 ¹/4% Senior Unsecured Notes due 2017 (the “9 ¹/₄% Notes”) and the Term Loan Facility (as defined in Note 5) was $500.0 million and $99.0 million, respectively, at December 31, 2014. The estimated fair value of the 9 ¹/₄% % Notes and Term Loan Facility at December 31, 2014 was approximately $521.3 million and $99.0 million, respectively. The estimated fair value of the 9 ¹/₄% Notes was based on the average bid and ask price as quoted by the Company’s administrative agent. The estimated of fair value of the Term Loan Facility is based upon the quoted market prices or quoted market prices for similar issues of long-term debt with the same maturities. The estimated fair value of the 9 ¹/₄% Notes and Term Loan Facility are categorized as Level 2 within the fair value hierarchy in accordance with Accounting Standards Codification (“ASC”) 820-10, “Fair Value Measurements and Disclosures”.

 

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Revenue Recognition and Accounts Receivable

The Company recognizes revenue before the provision for bad debts, including revenue from in-house patients and patients which have been discharged but not yet billed, in the period in which services are performed. Accounts receivable primarily consist of amounts due from third-party payors and patients. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. The Company has entered into agreements with third-party payors, including government programs and managed care health plans, under which the Company is paid based upon established charges, the cost of providing services, predetermined rates per diagnosis, fixed per diem rates or discounts from established charges. Amounts the Company receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as health maintenance organizations, preferred provider organizations and other private insurers are generally less than the Company’s established billing rates. Accordingly, the revenues and accounts receivable reported in the Company’s consolidated financial statements are recorded at the amount expected to be received.

The year ended December 31, 2012 included an additional $7.0 million of revenue related to the State of Oklahoma’s Supplemental Hospital Offset Payment Program, or SHOPP, in which the Company’s Oklahoma hospitals participate. SHOPP allows for the establishment of a hospital provider fee assessment on all non-exempt Oklahoma hospitals. Revenue from this assessment is used to maintain hospital reimbursement from the SoonerCare Medicaid program and to secure additional matching Medicaid funds from the federal government. On January 17, 2012, the Centers for Medicare & Medicaid Services (“CMS”) approved SHOPP with an effective date of July 1, 2011. Based on the approval date of January 17, 2012, the Company recorded the $7.0 million of additional revenue related to SHOPP from the period of July 1, 2011 through December 31, 2011 during the year ended December 31, 2012.

The year ended December 31, 2012 included $6.6 million of revenue related to the industry-wide rural floor provision settlement litigation. The Balanced Budget Act of 1997, or BBA, established a rural floor provision, by which an urban hospital’s wage index within a particular state could not be lower than the statewide rural wage index. The wage index reflects the relative hospital wage level compared to the applicable average hospital wage level. The BBA also made this provision budget neutral, meaning that total wage index payments nationwide before and after the implementation of this provision must remain the same. To accomplish this, CMS was required to increase the wage index for all affected urban hospitals and to calculate a rural floor budget neutrality adjustment to reduce other wage indexes in order to maintain the same level of payments. Litigation had been pending for several years contending that CMS miscalculated the neutrality adjustment from 1999 through 2011. The litigation was settled effective April 5, 2012.

The following table sets forth the percentages of revenue before the provision for bad debts by payor for the years ended December 31, 2012, 2013 and 2014:

 

		Year Ended December 31,
		2012(2)				2013				2014
Medicare(1)			38.8	%			38.0	%			39.0	%
Medicaid(1)			14.3				14.1				17.5
Managed Care and other(3)			36.9				36.8				36.0
Self-Pay			10.0				11.1				7.5
Total			100.0	%			100.0	%			100.0	%

 

(1)	Includes revenue before the provision for bad debts received under managed Medicare or managed Medicaid programs.

(2)	Medicaid revenue includes approximately $21.5 million of SHOPP revenue.

(3)	Includes the health insurance exchanges beginning with the first quarter of 2014.

The Company derives a significant portion of its revenue before the provision for bad debts from Medicare, Medicaid and other payors that receive discounts from the Company’s standard charges. The Company must estimate the total amount of these discounts to prepare its consolidated financial statements. The Medicare and Medicaid regulations and various managed care contracts under which these discounts must be calculated are complex and are subject to interpretation and adjustment. The Company estimates the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. These interpretations sometimes result in payments that differ from the Company’s estimates. Additionally, updated regulations and contract renegotiations occur frequently, necessitating regular review and assessment of the estimation process by management. Changes in estimates related to the allowance for contractual discounts affect revenues reported in the Company’s consolidated statements of operations.

Settlements under reimbursement agreements with third-party payors are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined. Final determination of amounts earned under the Medicare and Medicaid programs often occurs subsequent to the year in which services are rendered because of audits by the programs, rights of appeal and the application of numerous technical provisions. There is at least a reasonable possibility that such estimates will change by a material amount in the near term.

 

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The net estimated third-party payor settlements payable by the Company as of December 31, 2013 totaled $5.7 million compared to a $0.1 million receivable as of December 31, 2014. The net estimated third-party payor settlements are included in other current liabilities in the accompanying consolidated balance sheets. The net adjustments to estimated cost report settlements resulted in an increase to revenue of $0.4 million for the year ended December 31, 2012, an increase of $0.6 million for the year ended December 31, 2013, and an increase of $2.0 million for the year ended December 31, 2014. The Company’s management believes that adequate provisions have been made for adjustments that may result from final determination of amounts earned under these programs.

Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing that would have a material effect on the Company’s financial statements. Compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties and exclusion from the Medicare and Medicaid programs.

Medicare Settlement of Pending Appeals

In August 2014, in response to concerns that the “two midnight rule” has caused a growth in claim appeals, CMS announced that it is now offering to settle pending appeals in exchange for timely partial payment in an amount equal to 68% of the net allowable amount of all eligible claims. CMS has encouraged hospitals with inpatient status claims currently in the appeals process (or within the timeframe to request an appeal) to make use of this administrative agreement mechanism to reduce the administrative burden of current appeals on both the hospital and Medicare systems. CMS has further advised that the agreement only applies to eligible claims from eligible providers, and specifies that “eligible claims” are those denied by a Medicare contractor on the basis that services may have been reasonable and necessary but treatment on an inpatient basis was not, that are either under appeal or within their administrative timeframe to request an appeal review, with dates of admissions prior to October 1, 2013, and where the claim was not paid under Medicare Part B. Hospitals had until October 31, 2014 to participate in the settlement, but could request an extension, if needed. CMS has advised that it will pay hospitals within 60 days of validating the eligible claims. As of December 31, 2014, the Company has elected to participate in the settlement and has recognized $1.2 million in revenues in the accompanying condensed consolidated statement of operations related to the eligible claims. For more information about the “two midnight rule” and the settlement process described above, please see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Annual Report on Form 10K.

Provision for Bad Debts and Allowance for Doubtful Accounts

To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value.

Additions to the allowance for doubtful accounts are made by means of the provision for bad debts. Accounts written off as uncollectible are deducted from the allowance for doubtful accounts and subsequent recoveries are added. The amount of the provision for bad debts is based upon management’s assessment of historical and expected net collections, business and economic conditions, trends in federal, state, and private employer healthcare coverage and other collection indicators. The provision for bad debts and the allowance for doubtful accounts relate primarily to “uninsured” amounts (including copayment and deductible amounts from patients who have healthcare coverage) due directly from patients. Accounts are written off when all reasonable internal and external collection efforts have been performed. The Company considers the return of an account from the primary external collection agency to be the culmination of its reasonable collection efforts and the timing basis for writing off the account balance. Accounts written off are based upon specific identification and the write-off process requires a write-off adjustment entry to the patient accounting system. Management relies on the results of detailed reviews of historical write-offs and recoveries (the hindsight analysis) as a primary source of information to utilize in estimating the collectability of the Company’s accounts receivable. The Company performs the hindsight analysis on a quarterly basis for all hospitals, utilizing rolling twelve-month accounts receivable collection, write-off, and recovery data. The Company supplements its hindsight analysis with other analytical tools, including, but not limited to, revenue days in accounts receivable, historical cash collections experience and revenue trends by payor classification. Adverse changes in general economic conditions, billing and collections operations, payor mix, or trends in federal or state governmental healthcare coverage could affect the Company’s collection of accounts receivable, cash flows and results of operations.

A summary of activity in the Company’s allowance for doubtful accounts is as follows (in millions):

 

		Balances at Beginning of Year				Additions Charged to provision for bad debts				Accounts Written Off, Net of Recoveries				Balances at End of Year
Year ended December 31, 2012		$	86.6			$	78.6			$	(71.6	)		$	93.6
Year ended December 31, 2013		$	93.6			$	100.8			$	(88.9	)		$	105.5
Year ended December 31, 2014		$	105.5			$	75.5			$	(96.6	)		$	84.4

 

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Charity Care

Self-pay revenue is derived primarily from patients who do not have any form of healthcare coverage. The Company provides care without charge to certain patients that qualify under the Company’s charity/indigent care policy. The Company does not report a charity/indigent care patient’s charges in revenues or in the provision for bad debts as it is the Company’s policy not to pursue collection of amounts related to these patients. At the Company’s hospitals, patients treated for non-elective care, who generally have income at or below 200% of the federal poverty level, are eligible for charity care. The federal poverty level is established by the federal government and is based on income and family size. The Company’s hospitals provide a discount to uninsured patients who do not qualify for Medicaid or charity care. These discounts are similar to those provided to many local managed care plans. In implementing the discount policy, the Company first attempts to qualify uninsured patients for Medicaid, other federal or state assistance or charity care. If an uninsured patient does not qualify for these programs, the uninsured discount is applied.

The Company estimates its cost of care provided under its charity care programs utilizing a calculated ratio of costs to gross charges multiplied by the Company’s gross charity care charges provided. For the years ended December 31, 2012, 2013 and 2014, the Company estimates that its costs of care provided under its charity care programs were approximately $3.3 million, $2.7 million and $1.2 million, respectively.

Concentration of Revenues

For the years ended December 31, 2012, 2013 and 2014, approximately 53.1%, 52.1% and 56.5%, respectively, of the Company’s revenue before the provision for bad debts related to patients participating in the Medicare and Medicaid programs. The Company’s management recognizes that revenue and receivables from government agencies are significant to the Company’s operations, but it does not believe that there are significant credit risks associated with these government agencies. The Company’s management does not believe that there are any other significant concentrations of revenue from any particular payor that would subject the Company to any significant credit risks in the collection of its accounts receivable.

Other Income

The American Recovery and Reinvestment Act of 2009 (“ARRA”) provides for incentive payments under the Medicare and Medicaid programs for certain hospitals and physician practices that demonstrate meaningful use of certified electronic health record (“EHR”) technology. These provisions of ARRA, collectively referred to as the Health Information Technology for Economic and Clinical Health Act (the “HITECH Act”), are intended to promote the adoption and meaningful use of interoperable health information technology and qualified EHR technology.

The Company accounts for EHR incentive payments in accordance with ASC 450-30, “Gain Contingencies” (“ASC 450-30”). In accordance with ASC 450-30, the Company recognizes a gain for EHR incentive payments when its eligible hospitals and physician practices have demonstrated meaningful use of certified EHR technology for the applicable period and when the cost report information for the full cost report year that determines the final calculation of the EHR incentive payment is available. The demonstration of meaningful use is based on meeting a series of objectives and varies among hospitals and physician practices, between the Medicare and Medicaid programs and within the Medicaid program from state to state. Additionally, meeting the series of objectives in order to demonstrate meaningful use becomes progressively more stringent as its implementation is phased in through stages as outlined by the CMS.

For the years ended December 31, 2012, 2013 and 2014, the Company recognized $4.4 million, $10.7 million and $13.2 million, respectively, in EHR incentive payments in accordance with the HITECH Act under the Medicaid and Medicare programs which is included in other income and discontinued operations on the accompanying consolidated statements of operations. Amounts recognized as other income that the Company anticipates collecting in future periods, but that were uncollected as of the balance sheet date are included in the accompanying consolidated balance sheet. As of December 31, 2013 and 2014, outstanding receivables from Medicaid for EHR incentive payments totaled approximately $2.0 million and $3.6 million, respectively and is included in other receivables on the accompanying consolidated balance sheets.

The Company incurs both capital expenditures and operating expenses in connection with the implementation of its various EHR initiatives. The amount and timing of these expenditures does not necessarily directly correlate with the timing of the Company’s receipt or recognition of the EHR incentive payments.

Cash

Cash consist of cash on hand. The Company places its cash in financial institutions that are federally insured in limited amounts.

 

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Restricted Cash

Restricted cash consists of cash placed in escrow for purchase of controlling ownership interest in Carolina Pines Regional Medical Center. The cash was placed in escrow on December 31, 2014 until the effective date of the transaction, which was January 1, 2015.

Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and are principally composed of medical supplies and pharmaceuticals. These inventory items are primarily operating supplies used in the direct or indirect treatment of patients.

Long-Lived Assets

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation. Routine maintenance and repairs are charged to expense as incurred. Expenditures that increase capacities or extend useful lives are capitalized. Fully depreciated assets are retained in property and equipment accounts until they are disposed.

Depreciation is computed by applying the straight-line method over the estimated useful lives of buildings and improvements and equipment. Assets under capital leases are amortized using the straight-line method over the shorter of the estimated useful life of the assets or the lease term, excluding any lease renewals, unless the lease renewals are reasonably assured. Buildings and improvements are depreciated over estimated lives ranging generally from ten to forty years. Estimated useful lives of equipment vary generally from three to ten years. Capitalized internal-use software costs are amortized over their expected useful life which is generally four years. Depreciation and amortization expense totaled approximately $35.2 million, $41.5 million and $41.5 million for the years ended December 31, 2012, 2013 and 2014, respectively. Amortization expense related to assets under the Company’s capital leases is included under depreciation and amortization expense for the years ended December 31, 2012 and 2013.

At December 31, 2013 and 2014, assets under the Company’s capital leases are as follows (in millions):

 

		2013				2014
Buildings and improvements		$	37.0			$	—
Equipment			29.8				21.8
Total			66.8				21.8
Accumulated amortization			(12.8	)			(5.4	)
Total, net		$	54.0			$	16.4

The gross carrying amount of capitalized software for internal use was approximately $30.5 million and $34.4 million at December 31, 2013 and 2014, respectively, and the net carrying amount considered accumulated amortization was approximately $9.7 million and $10.9 million at December 31, 2013 and 2014, respectively. At December 31, 2014, there was approximately $1.4 million of capitalized costs for internal-use software that is currently in the development stage and will begin amortization once the software project is complete and ready for its intended use. Amortization expense on capitalized internal-use software was $1.3 million, $7.4 million and $4.8 million at December 31, 2012, 2013 and 2014, respectively.

The Company evaluates its long-lived assets for possible impairment whenever circumstances indicate that the carrying amount of the asset, or related group of assets, may not be recoverable from estimated future cash flows. Fair value estimates are derived from established market values of comparable assets or internal calculations of estimated future net cash flows. The Company’s estimates of future cash flows are based on assumptions and projections it believes to be reasonable and supportable. The Company’s assumptions take into account revenue and expense growth rates, patient volumes, changes in payor mix, changes in legislation and other payor payment patterns.

Deferred Loan Costs

The Company records deferred loan costs for expenditures related to acquiring or issuing new debt instruments. These expenditures include bank fees and premiums, as well as attorneys’ and filing fees. During 2014, the Company recorded additional deferred loan costs of $4.6 million related to the ABL Agreement (as defined in Note 5) and the Term Loan Facility. See Note 5, Debt Obligations, for additional information. Net deferred loan costs of $0.1 million were written off to interest expense as part of the transaction costs associated with the ABL Agreement. Net deferred loan costs totaled approximately $8.3 million and $9.8 million, net of accumulated amortization of approximately $13.3 million and $12.2 million at December 31, 2013 and 2014, respectively, and are included in other assets on the accompanying consolidated balance sheets. The Company amortizes these deferred loan costs to interest expense over the life of the respective debt instrument, using the effective interest method.

 

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Goodwill and Intangible Assets

The Company accounts for its acquisitions under the provisions of FASB authoritative guidance regarding business combinations and goodwill and other intangible assets. Goodwill represents the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. Goodwill and intangible assets with indefinite lives are reviewed by the Company at least annually for impairment. The Company’s business comprises a single reporting unit for impairment test purposes. For the purposes of these analyses, the Company’s estimates of fair value are based on the income approach, which estimates the fair value of the Company based on its future discounted cash flows. In addition to the annual impairment reviews, impairment reviews are performed whenever circumstances indicate a possible impairment may exist. The Company performed its annual impairment tests as of October 1, and did not incur any impairment charges during the years ended December 31, 2012, 2013 and 2014.

The Company’s intangible assets relate to contract-based physician minimum revenue guarantees, a non-competition agreement and certificates of need. The contract-based physician revenue guarantees are amortized over the terms of the respective agreements. The certificates of need were determined to have indefinite lives and, accordingly, are not amortized.

Physician Minimum Revenue Guarantees

The Company has committed to provide certain financial assistance pursuant to recruiting agreements, or “physician minimum revenue guarantees,” with various physicians practicing in the communities it services. In consideration for a physician relocating to one of its communities and agreeing to engage in private practice for the benefit of the respective community, the Company may advance certain amounts of money to a physician, to assist in establishing his or her practice.

The Company accounts for its physician minimum revenue guarantees in accordance with the provisions of FASB authoritative guidance regarding accounting for minimum revenue guarantees. The Company records a contract-based intangible asset and related guarantee liability for new physician minimum revenue guarantees. The contract-based intangible asset is amortized to other operating expenses over the period of the respective physician contract, which is typically four years.

Income Taxes

The Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company assesses the likelihood that deferred tax assets will be recovered from future taxable income. To the extent the Company believes that recovery is more likely than not, a valuation allowance is established. To the extent the Company establishes a valuation allowance or increases this allowance, the Company must include an expense within the provision for income taxes in the consolidated statements of operations.

The Company follows the provisions of FASB authoritative guidance regarding income taxes. This guidance clarifies the accounting for uncertainties in income taxes recognized in financial statements and requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority.

 

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Other Accrued Liabilities

The Company’s other accrued liabilities, shown as a current liability in the accompanying audited consolidated balance sheet, consist of the following:

 

		Year Ended December 31,
		2013				2014
		(In millions)
Employee health IBNR reserve		$	3.4			$	3.2
Professional and general liability claims			2.5				2.6
Non-income tax accrual			2.6				3.3
Physician income guarantees liability			2.8				0.7
Workers’ compensation liability claims			1.1				1.2
Income taxes payable			0.1				0.3
Estimated amounts due to third party payors			5.7				—
Deferred revenue related to EHR			7.3				5.6
Other			7.2				6.6
Total		$	32.7			$	23.5

Professional and General Liability Claims

Given the nature of the Company’s operating environment, the Company is subject to potential medical malpractice lawsuits and other claims as part of providing healthcare services. To mitigate a portion of this risk, the Company maintains insurance through Auriga Insurance Group, a wholly owned subsidiary of the Parent (“Auriga”), for professional and general claims of $4.75 million per occurrence and $14.25 million in the aggregate per policy year, subject to a $0.25 million self-insured retention per occurrence. Auriga also maintains umbrella policies for professional and general claims which cover an additional $60 million per occurrence and in the aggregate. The Company’s reserves for professional and general liability claims are based upon independent actuarial calculations, which consider historical claims data, demographic considerations, severity factors, and other actuarial assumptions in determining reserve estimates. Reserve estimates are discounted to present value using a 1% discount rate.

Exposures at the Company’s hospitals prior to the date of their respective acquisition are indemnified by the respective prior owners. Accordingly, the Company appropriately has not estimated any exposure for claims prior to the respective acquisition dates of its facilities. The Company utilized certain information to estimate its 2013 and 2014 liability for professional and general liability claims. Using historical claim payments and developments, the Company estimated the exposure for each of its facilities and recorded a reserve of approximately $26.7 million ($12.6 million of which is due from Auriga) and $29.3 million ($14.8 million of which is due from Auriga) at December 31, 2013 and 2014, respectively. The reserves due from Auriga are included in other liabilities on the accompanying consolidated balance sheets.

The current portion of the reserves was $2.5 million and $2.6 million at December 31, 2013 and 2014, respectively, and is included in other accrued liabilities on the accompanying consolidated balance sheets. The long-term portion of the reserves for professional and general liability claims is included in other liabilities on the accompanying consolidated balance sheets.

The Company’s expense for professional and general liability claims each year includes: the actuarially determined estimate of losses for the current year, including claims incurred but not reported; the change in the estimate of losses for prior years based upon actual claims development experience as compared to prior actuarial projections; amortization of the insurance premiums for losses in excess of the Company’s self-insured retention level; the administrative costs of the insurance program; and interest expense related to the discounted portion of the liability. The total expense recorded under the Company’s professional and general liability insurance program for the years ended December 31, 2012, 2013 and 2014, was approximately $6.3 million, $7.5 million and $7.9 million, respectively.

Workers’ Compensation Reserves

Given the nature of the Company’s operating environment, it is subject to potential workers’ compensation claims as part of providing healthcare services. To mitigate a portion of this risk, the Company maintains insurance for individual workers’ compensation claims exceeding approximately $250,000 per occurrence. The Company’s facility located in the state of Washington participates in a state-specific program rather than the Company’s established program. The Company’s two facilities located in Oklahoma participate in a fully insured state-specific workers’ compensation program.

 

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The Company’s reserve for workers’ compensation is based upon an independent third-party actuarial calculation, which considers historical claims data, demographic considerations, development patterns, severity factors and other actuarial assumptions. Reserve estimates are undiscounted and are revised on an annual basis. The reserve for workers’ compensation claims at the balance sheet date reflects the current estimate of all outstanding losses, including incurred but not reported losses, based upon an actuarial calculation. The Company’s reserve for workers’ compensation claims was approximately $3.7 million and $4.0 million at December 31, 2013 and 2014, respectively. The current portion of the reserves, $1.1 million and $1.2 million at December 31, 2013 and 2014, respectively, is included in other accrued liabilities on the accompanying consolidated balance sheets. The long-term portion of the reserves for workers’ compensation claims is included in other liabilities on the accompanying consolidated balance sheets.

The Company’s expense for workers’ compensation claims each year includes: the actuarially determined estimate of losses for the current year, including claims incurred but not reported; the change in the estimate of losses for prior years based upon actual claims development experience as compared to prior actuarial projections; amortization of the insurance premiums for losses in excess of the Company’s self-insured retention level; and the administrative costs of the insurance program. The total expense recorded under the Company’s workers’ compensation insurance program for the years ended December 31, 2012, 2013 and 2014, was approximately $1.8 million, $1.9 million and $1.7 million, respectively.

Self-Insured Medical Benefits

The Company is self-insured for substantially all of the medical expenses and benefits of its employees. The reserve for medical benefits primarily reflects the current estimate of incurred but not reported losses, based upon an actuarial calculation. The undiscounted reserve for self-insured medical benefits was approximately $3.4 million and $3.2 million at December 31, 2013 and 2014, respectively, and is included in other accrued liabilities on the accompanying consolidated balance sheets. The Company purchases stop loss coverage from Auriga, in which the Company will be reimbursed for any employee’s medical claims that exceed $0.35 million per year.

Redeemable Non-controlling Interests

The Company’s accompanying consolidated financial statements include all assets, liabilities, revenue and expenses of less than 100% owned entities controlled by the Company. Accordingly, management has recorded non-controlling interests in the earnings and equity of such consolidated entities.

The Company’s non-controlling interests include redemption features, including the ability to redeem interest upon death and retirement, which cause these interests not to meet the requirements for classification as permanent equity in accordance with FASB authoritative guidance. Redemption of these non-controlling interest features would require the delivery of cash. Accordingly, these non-controlling interests are classified in the mezzanine section of the Company’s accompanying consolidated balance sheets. A rollforward of the redeemable non-controlling interests is shown in the table below:

 

		Redeemable Non-controlling interests
		(in millions)
Balance at December 31, 2012		$	21.1
Net income attributable to non-controlling interests			0.5
Distributions to non-controlling interests			(1.2	)
Repurchase of non-controlling interests			(0.2	)
Adjustment to redemption value of redeemable non-controlling interests			1.2
Balance at December 31, 2013			21.4
Net income attributable to non-controlling interests			0.5
Distributions to non-controlling interests			(1.8	)
Sale of non-controlling interests			0.1
Adjustment to redemption value of redeemable non-controlling interests			(8.5	)
Balance at December 31, 2014		$	11.7

 

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Segment Reporting

The Company owns and operates nine hospitals as part of continuing operations as of December 31, 2014. The Company manages its hospitals as one operating segment, healthcare services, for segment reporting purposes in accordance with ASC 280-10, “Segment Reporting”.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

Restructuring

During April 2014, the Parent completed an equity restructuring that included the conversion of $206.7 million preferred stock outstanding to a net 686.3 million shares of the Parent’s common stock and the forgiveness of $140.1 million of previously accrued dividends accreted as of March 31, 2014. See Note 12. Stock-Based Compensation, for additional information surrounding the issuance of stock-based awards by the Parent to the Company’s employees during the year ended December 31, 2014.

Stock-Based Compensation

The board of directors of the Parent previously adopted the Capella Holdings, Inc. 2006 Stock Option Plan (the “2006 Stock Option Plan”), which permits the board of directors of the Parent to issue stock options and other stock-based awards to certain of the Company’s employees, subject to the terms and conditions set forth in the 2006 Stock Option Plan and in each award. The Parent has never issued stock options under the 2006 Stock Option Plan. In April 2014, the board of directors of the Parent adopted the Capella Holdings, Inc. 2014 Stock Option Plan (the “2014 Stock Option Plan”) effectively replacing the 2016 Stock Option Plan. The Parent has issued to the Company’s employees 89,838,000 stock options under the 2014 Stock Option Plan. The Parent has granted restricted share awards that generally vest between a one to five year period to certain of the Company’s employees. The Company accounts for stock-based awards in accordance with the provisions of ASC 718-10 “Compensation – Stock Compensation”, (“ASC 718-10”). In accordance with ASC 718-10, the Company recognized compensation expense based on the estimated grant date fair value of each stock-based award of $1.0 million, $0.8 million, and $4.1 million for the years ended December 31, 2012, 2013, and 2014, respectively. The stock-based compensation expense is included in salaries and benefits in the accompanying consolidated statements of operations.

Recently Issued Accounting Pronouncement

Accounting Standards Update No. 2014-9

In May 2014, the FASB issued Accounting Standards Update (“ASU”) No. 2014-9, “Revenue from Contracts with Customers” (“ASU 2014-9”). ASU 2014-9 provides for a single comprehensive principles-based standard for the recognition of revenue across all industries through the application of the following five-step process:

Step 1: Identify the contract(s) with a customer.

Step 2: Identify the performance obligations in the contract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the performance obligations in the contract.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

Among other provisions and in addition to expanded disclosure about the nature, amount, timing and uncertainty of revenue, as well as certain additional quantitative and qualitative disclosures, ASU 2014-9 changes the healthcare industry specific presentation guidance under ASU 2011-7, “Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities” (“ASU 2011-7”). The provisions of ASU 2014-9 are effective for annual periods beginning after December 15, 2016, including interim periods within those years. Early adoption is not permitted. The Company is currently evaluating the impact that the adoption of ASU 2014-9 will have on its revenue recognition policies and procedures, financial position, result of operations, cash flows, financial disclosures and control framework.

 

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Accounting Standards Update No. 2014-8

In April 2014, the FASB issued ASU No. 2014-8, “Presentation of Financial Statements and Property, Plant, and Equipment – Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity” (“ASU 2014-8”). Among other provisions and in addition to expanded disclosures, ASU 2014-8 changes the definition of what components of an entity qualify for discontinued operations treatment and reporting from a reportable segment, operating segment, reporting unit, subsidiary or asset group to only those components of an entity that represent a strategic shift that has, or will have, a major effect on an entity’s operations and financial results. Additionally, ASU 2014-8 requires disclosure about a disposal of an individually significant component of an entity that does not qualify for discontinued operations presentation in the financial statements, including the pretax profit or loss, attributable to the component of an entity for the period in which it is disposed of or is classified as held for sale. The disclosure of this information is required for all of the same periods that are presented in the entity’s results of operations for the period. The provisions of ASU 2014-8 are effective prospectively for all disposals or classifications as held for sale of components of an entity that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. Early adoption is permitted. The Company adopted this ASU on January 1, 2015 and does not believe the adoption will have a material impact on its consolidated financial position, results of operations and cash flows.

2. Business Combinations

Acquisition of Muskogee RT Associates, LLC

Effective March 16, 2012, the Company acquired the assets of Muskogee RT Associates, LLC d/b/a Artesian Cancer Center at Muskogee (“MRTA”) in Muskogee, Oklahoma. The cash purchase price was $6.5 million and was funded with cash on hand. The Company finalized its application of the acquisition method of accounting based upon its estimates of fair value of assets acquired and liabilities assumed at the acquisition date, which resulted in goodwill of $6.5 million.

Lease of Muskogee Community Hospital

Effective July 1, 2012, the Company executed an asset purchase agreement in which the Company acquired from Muskogee Community Hospital (“MCH”) specific property and components of net working capital, as defined, and certain intangible assets for $21.4 million. Of the purchase price, $8.4 million was in the form of a promissory note payable (the “MCH Note”) in fifteen equal monthly installments beginning in July 2013. The MCH Note is included in current and long-term debt on the accompanying consolidated balance sheet as of December 31, 2012.

The Company also executed a master lease agreement for the real property and certain equipment used in the operation of MCH. Under the master lease agreement, the Company paid a lease payment of $565,000 per month. The Company had the option to purchase the leased real property and equipment at fair value as defined in the master lease agreement. The Company has recorded the master lease agreement as a capital lease and is included in current debt on the accompanying consolidated balance sheet as of December 31, 2013.

During July 2014, the Company exercised its purchase option under the MCH master lease agreement for approximately $39.4 million, excluding other costs and fees. Additionally, in July 2014, the Company repaid the outstanding principal balance for the MCH Note. The Company used $5.3 million in available cash and cash equivalents and $35.0 million in availability from its 2010 Revolving Facility (as defined in Note 5) to fund the purchase and repayment.

The acquisition of certain property and equipment and the net assets pursuant to the MCH asset purchase agreement was funded with cash on hand and through the execution of the MCH Note. The Company has finalized its application of the acquisition method of accounting.

 

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The fair values of assets acquired and liabilities assumed at the acquisition date are as follows (in millions):

 

Accounts receivable, net		$	2.7
Prepaids and other			0.2
Inventories			0.7
Property and equipment			3.0
Non-competition agreement			4.5
Goodwill			14.3
Total assets acquired			25.4
Accounts payable			3.3
Salaries and benefits payable			0.7
Total liabilities assumed			4.0
Net assets acquired		$	21.4

Acquisition-related expenses for MCH were $1.1 million for the year ended December 31, 2012 and are included in other operating expenses on the accompanying consolidated statements of operations.

Acquisition of Southwest Imaging Center, Inc and Raindancer LLC d/b/a Doctors MRI

Effective December 31, 2012, the Company acquired the assets of Southwest Imaging Center, Inc. and Raindancer LLC d/b/a Doctors MRI (“the Imaging Centers”) in Lawton, Oklahoma. The cash purchase price for the Imaging Centers was $6.5 million and was funded with cash on hand. The Company completed its application of the acquisition method of accounting based upon its estimates of fair value of assets acquired and liabilities assumed at the acquisition date.

The fair values of assets acquired at the acquisition date are as follows (in millions):

 

Property and equipment		$	1.3
Goodwill			5.2
Total assets acquired		$	6.5

Acquisition-related expenses for the Imaging Centers were $0.1 million for the year ended December 31, 2012 and are included in other operating expenses on the accompanying consolidated statements of operations.

3. Discontinued Operations

On March 15, 2012, the Company completed the sale of Hartselle Medical Center (“Hartselle”), a 150-bed facility located in Hartselle, Alabama for $1.6 million. The Company retained all working capital of Hartselle, with the exception of inventory. The loss on the sale of Hartselle totaled $5.3 million in 2011.

On December 31, 2012, the Company completed the sale of Jacksonville Medical Center (“Jacksonville”), an 89-bed facility located in Jacksonville, Alabama for $6.0 million plus $3.0 million for working capital. The loss recorded on the sale of Jacksonville totaled approximately $6.7 million in 2012.

On September 1, 2013, the Company completed the sale of certain home health operations at our Arkansas facilities. The combined proceeds from the sale were approximately $1.6 million. The recorded gain totaled approximately $1.2 million.

On February 28, 2014, the Company completed the sale of Grandview Medical Center (“Grandview”), a 70-bed facility located in Jasper, Tennessee. In connection with the planned divestiture, the Company recognized an estimated loss on the planned sale totaling $7.0 million during the year ended December 31, 2013. In addition, the Company recognized a $1.8 million loss on impairment for Grandview’s goodwill during the year ended December 31, 2014. The Company recognized an additional loss for the sale of Grandview of $1.6 million during the year ended December 31, 2014.

 

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At December 31, 2014, the Company committed to plans to sell certain of its other facilities in Tennessee and Missouri due to operating conditions at those facilities. In connection with these planned divestures, the Company recognized an estimated loss on the planned sale totaling $15.9 million (including $5.8 million of goodwill) during the year ended December 31, 2014. The Company has presented the operating results, financial positions and cash flows as discontinued operations in the accompanying consolidated financial statements for all periods, and the related assets and liabilities are reflected as held for sale in the accompanying consolidated balance sheet at December 31, 2014.

The Company estimated the fair value of its assets and liabilities held for sale at December 31, 2013 at approximately $13.1 million and $1.9 million, respectively. The Company estimated the fair value of its assets and liabilities held for sale at December 31, 2014 at approximately $33.7 million and $3.6 million, respectively. The estimated fair value is based on the amount outlined in the executed purchase agreement and is categorized as Level 3 within the fair value hierarchy in accordance with ASC 820-10, “Fair Value Measurements and Disclosures”.

Revenue before the provision for bad debts and the loss reported in discontinued operations are as follows (in millions):

 

		Year Ended December 31,
		2012				2013				2014
Revenue before the provision for bad debts from discontinued operations		$	131.3			$	90.7			$	63.3
Loss from discontinued operations
Loss (gain) from sale from discontinued operations, net			8.1				(1.2	)			1.6
Loss from held for sale adjustment			—				7.0				10.1
Loss from impairment of goodwill			1.0				1.8				5.8
Loss from operations			5.0				4.9				3.1
Pre-tax loss from discontinued operations			14.1				12.5				20.6
Tax benefit related to discontinued operations			—				(0.7	)			(2.2	)
Loss from discontinued operations, net of tax		$	14.1			$	11.8			$	18.4

The following table provides the components of assets and liabilities held for sale (in millions):

 

		December 31, 2013				December 31, 2014
Accounts receivable, net		$	4.3			$	6.9
Inventories			1.0				1.9
Prepaid expenses and other current assets			0.3				1.5
Property and equipment, net			7.5				23.4
Assets held for sale		$	13.1			$	33.7
Accounts payable		$	1.2			$	1.7
Salaries and benefits payable			0.7				1.4
Other current liabilities			—				0.5
Liabilities held for sale		$	1.9			$	3.6

4. Goodwill and Intangible Assets

The following table presents a roll-forward of the Company’s goodwill for the year ended December 31, 2014 (in millions):

 

		Goodwill
Balance at January 1, 2014		$	133.6
Adjustment to goodwill related to prior acquisitions			0.1
Impairment of goodwill related to the planned disposal of assets and liabilities held for sale			(5.8	)
Balance at December 31, 2014		$	127.9

 

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The following table presents the components of the Company’s intangible assets at December 31, 2013 and 2014 (in millions):

 

Class of Intangible Assets		Gross Carrying Amount				Accumulated Amortization				Net Total
Amortized intangible assets:
Contract-based physician minimum revenue guarantees:
2013		$	13.8			$	(5.3	)		$	8.5
2014		$	12.1			$	(5.4	)		$	6.7
Non-competition agreements:
2013		$	4.5			$	(0.5	)		$	4.0
2014		$	4.5			$	(0.8	)		$	3.7
Indefinite-lived intangible assets:
Certificates of need
2013		$	0.7			$	—			$	0.7
2014		$	0.5			$	—			$	0.5
Total intangible assets:
2013		$	19.0			$	(5.8	)		$	13.2
2014		$	17.1			$	(6.2	)		$	10.9

Contract-Based Physician Minimum Revenue Guarantees

As discussed in Note 1, the Company records a contract-based intangible asset and a related guarantee liability for each new physician minimum revenue guarantee contract. The contract-based intangible asset is amortized into other operating expense over the period of the physician contract, which is typically four years. The Company has committed to advance a maximum amount of approximately $2.7 million at December 31, 2014. As of December 31, 2013 and 2014, the Company’s liability balance for contract-based physician minimum revenue guarantees was approximately $2.8 million and $0.7 million, respectively, which is included in other accrued liabilities in the accompanying consolidated balance sheets.

Non-Competition Agreements

The Company has entered into non-competition agreements with certain physicians and other individuals as part of the acquisition of MCH. These non-competition agreements are amortized on a straight-line basis over the fifteen year term of the agreements.

Certificates of Need

The construction of new facilities, the acquisition or expansion of existing facilities and the addition of new services and certain equipment at the Company’s facilities may be subject to state laws that require prior approval by state regulatory agencies. These certificates of need laws generally require that a state agency determine the public need and give approval prior to the construction or acquisition of facilities of the addition of new services. The Company operates hospitals in certain states that have adopted certificate of need laws. If the Company fails to obtain necessary state approval, the Company will not be able to expand its facilities, complete acquisitions or add new services at its facilities in these states. An independent appraiser values each certificate of need when the Company acquires a hospital. In addition, these intangible assets were determined to have indefinite lives and, accordingly, are not amortized.

Amortization Expense

Total estimated amortization expense for the Company’s intangible assets during the next five years and thereafter are as follows (in millions):

 

2015		$	2.9
2016			2.1
2017			1.3
2018			0.4
2019			0.1
Thereafter			3.6
		$	10.4

 

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5. Debt Obligations

The following table presents a summary of the Company’s debt obligations at December 31, 2013 and 2014 (in millions):

 

		December 31, 2013				December 31, 2014
9 1⁄4% Notes		$	500.0			$	500.0
Unamortized discount on 9 1⁄4% Notes			(3.2	)			(2.2	)
Total 9 1⁄4% Notes		$	496.8			$	497.8
Term Loan Facility		$	—			$	100.0
Unamortized discount on Term Loan Facility			—				(1.0	)
Total Term Loan Facility		$	—			$	99.0
Capital lease obligations			55.5				17.0
MCH Note			5.1				—
Total debt obligations		$	557.4			$	613.8
Less current maturities			49.6				6.0
Total		$	507.8			$	607.8

Maturities of the Company’s long-term debt at December 31, 2014 are as follows (in millions):

 

2015		$	6.0
2016			6.2
2017			506.6
2018			2.2
2019			1.0
Thereafter			95.0
		$	617.0

9 ¹⁄₄% Senior Unsecured Notes

In June 2010, the Company completed a comprehensive refinancing plan (the “Refinancing”). Under the Refinancing, the Company issued $500 million of new 9¹/₄% Senior Unsecured Notes due 2017 (the “9¹/₄% Notes”) and entered into a new senior secured asset-based loan (“ABL”), consisting of a $100 million revolving credit facility maturing in December 2014 (the “2010 Revolving Facility”). The proceeds from the 9¹/₄% Notes were used to repay the outstanding principal and interest related to the Company’s 2008 bank credit agreement and to pay fees and expenses relating to the Refinancing of approximately $21.7 million.

Interest on the 9¹/₄% Notes is payable semi-annually on July 1 and January 1 of each year. The 9¹/₄% Notes are unsecured general obligations of the Company and rank equal in right of payment to all existing and future senior unsecured indebtedness of the Company. All payments on the 9¹/₄% Notes are guaranteed jointly and severally on a senior unsecured basis by the Company and its subsidiaries, other than those subsidiaries that do not guarantee the obligations of the borrowers under the Company’s prior senior credit facilities.

The Company may redeem up to 35% of the 9¹/₄% Notes prior to July 1, 2013, with the net cash proceeds from certain equity offerings at a price equal to 109.25% of their principal amount, plus accrued and unpaid interest. The Company may redeem all or a part of the 9¹/₄% Notes at any time on or after July 1, 2013, plus accrued and unpaid interest, if any, to the date of redemption plus a redemption price equal to a percentage of the principal amount of the notes redeemed based on the following redemption schedule:

 

July 1, 2014 to June 30, 2015			104.625	%
July 1, 2015 to June 30, 2016			102.313	%
July 1, 2016 and thereafter			100.000	%

If the Company experiences a change of control under certain circumstances, the Company must offer to repurchase all of the notes at a price equal to 101.000% of their principal amount, plus accrued and unpaid interest, if any, to the repurchase date.

The 9¹/₄% Notes contain customary affirmative and negative covenants, which among other things, limit the Company’s ability to incur additional debt, create liens, pay dividends, effect transactions with its affiliates, sell assets, pay subordinated debt, merge, consolidate, enter into acquisitions and effect sale leaseback transactions.

 

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On December 31, 2014, the Company entered into an Amended and Restated Loan Agreement (the “ABL Agreement”), by and among the Company, the borrowing subsidiaries signatory thereto, the guarantying subsidiaries signatory thereto, the lenders party thereto, and Bank of America, N.A., as agent for the lenders (“ABL Agent”). The ABL Agreement amends, restates, and replaces in its entirety the Loan and Security Agreement, dated as of June 28, 2010 (as previously amended, the “Prior ABL Agreement”), by and among the Company and certain borrowing subsidiaries as borrowers, certain guarantying subsidiaries as guarantors, certain financial institutions party thereto from time to time as lenders, and ABL Agent as agent for the lenders.

The ABL Agreement amends and restates the Prior ABL Agreement to, among other things, change the maturity date of the 2010 Revolving Facility from December 29, 2014 to the earlier to occur of (a) June 3, 2019, (b) November 16, 2016, if, as of such date, (i) Company’s 9¹/₄% Notes have not been repaid in full or refinanced on terms reasonably satisfactory to ABL Agent (including a maturity date no earlier than December 3, 2019) and (ii) the Term Loan Facility has not been repaid in full or the maturity date has not been extended to a date that is no earlier than September 3, 2019, and (c) April 1, 2017 if, as of such date, the Company’s 9¹/₄% Notes have not been repaid in full or refinanced on terms reasonably satisfactory to ABL Agent (including a maturity date no earlier than December 3, 2019).

Upon the occurrence of certain events, the Company may request the 2010 Revolving Facility to be increased by an aggregate amount not to exceed $25.0 million. Availability under the 2010 Revolving Facility is subject to a borrowing base of 85% of eligible net accounts receivable. Borrowings under the ABL bear interest at a rate equal to, at the Company’s option, either (a) LIBOR plus an applicable margin or (b) Base Rate, as defined, plus an applicable margin. Subsequent to the most recent amendment and restatement of the ABL Agreement, the applicable margin in effect for borrowings under the 2010 Revolving Facility was reduced from 2.00% to 0.50% with respect to base rate borrowings and from 3.00% to 1.50% with respect to LIBOR borrowings, or reduced from a maximum of 2.50% to 1.00% with respect to base rate borrowings and reduced from a maximum of 3.50% to 2.00% for LIBOR borrowings, subject to the Company’s fixed charge coverage ratio. In addition to paying interest on outstanding principal, the Company is required to pay a commitment fee to the lenders under the 2010 Revolving Facility in respect of the unutilized commitments thereunder. Subsequent to the most recent amendment and restatement of the ABL Agreement, based on the average facility usage for the most recently ended calendar month, the commitment fee was reduced from a range of 0.50% 0.75% to a range of 0.25% to 0.375% per annum. The Company must also pay customary letter of credit fees.

At December 31, 2014, the Company had $5.0 million outstanding balance due under the 2010 Revolving Facility. At December 31, 2014, the Company had availability under the 2010 Revolving Facility of $71.0 million, net of a $5.0 million outstanding balance due and $5.7 million outstanding letters of credit. The outstanding letters of credit are primarily used as collateral under the Company’s workers’ compensation programs

Term Loan Facility

On December 31, 2014, the Company entered into a Credit Agreement (the “Term Loan Credit Agreement”), by and among the Company, as borrower, the Parent, as a guarantor, Credit Suisse AG, Cayman Islands Branch, as administrative agent, and certain other lenders from time to time party thereto.

The Term Loan Credit Agreement establishes a new senior secured term loan facility consisting of a $100,000,000 seven-year term loan (the “Term Loan Facility”).The per annum interest rates applicable to borrowings under the Term Loan Facility are periodically determined at the Company’s election as either (a) the LIBO Rate (as defined in the Term Loan Credit Agreement) plus 4.25% or (b) the Base Rate (as defined in the Term Loan Credit Agreement) plus 3.25%. The interest rate as of December 31, 2014 was 5.25%.

The Term Loan Facility is to be repaid in equal quarterly principal payments of $250,000, with the balance to be paid at maturity. The maturity date applicable to borrowings under the Term Loan Facility is the earlier to occur of (a) December 31, 2021, and (b) February 16, 2017, if, as of such date, the 9¹/₄% Notes have not been refinanced in full with certain permitted debt. The Term Loan Facility is generally subject to mandatory prepayment in amounts equal to: (a) 100% of the net cash proceeds received from certain asset sales (including insurance recoveries and condemnation events), subject to reinvestment provisions and customary exceptions; (b) 100% of the net cash proceeds from the issuance of new debt (other than certain permitted debt); and (c) 50% of the Company’s Excess Cash Flow (as defined in the Term Loan Credit Agreement), with step-downs to (i) 25% and (ii) 0% based on the Secured Net Leverage Ratio (as defined in the Term Loan Credit Agreement).

The Company’s obligations under the Term Loan Facility are unconditionally guaranteed by all of the Company’s material domestic wholly-owned subsidiaries (other than captive insurance subsidiaries, unrestricted subsidiaries, and certain other subsidiaries identified as excluded subsidiaries in the Term Loan Credit Agreement), provided that a guarantor subsidiary may be released if certain conditions are met. The Company’s obligations under the Term Loan Facility are secured by a substantial portion of its assets as well as the assets of its subsidiaries. The Term Loan Credit Agreement contains other terms and conditions that are customary in agreements used in connection with similar transactions.

 

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The proceeds of the Term Loan Facility primarily were used to finance the January 1, 2015 acquisition of a controlling ownership interest in Carolina Pines Regional Medical Center, a 116-bed acute care facility located in Hartsville, South Carolina through the acquisition of all of the equity interests in Hartsville Medical Group, LLC and substantially all of the equity interests in Hartsville, LLC (formerly Hartsville HMA, LLC), each a South Carolina limited liability company.

Debt Covenants

The indenture governing the 9¹/₄% Notes and Term Loan Facility contains a number of covenants that among other things, restrict, subject to certain exceptions, our ability and the ability of the Company’s subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, pay dividends and distributions or repurchase our capital stock, create liens on assets, make investments, engage in mergers or consolidations, and engage in certain transactions with affiliates. At December 31, 2014, the Company was in compliance with all debt covenants for the 9¹/₄% Notes and Term Loan Facility that were subject to testing at that date.

The ABL Agreement contains a number of covenants, including the requirement that the Company’s fixed charge coverage ratio (as defined therein) cannot be less than 1.10 to 1.00 at the end of any measurement period. At December 31, 2014, the Company was in compliance with all debt covenants contained in the ABL Agreement that were subject to testing at that date.

6. Due to Parent

From time to time, the Company will receive cash advances from the Parent. The cash advances are generally for the purpose of funding business acquisitions of the Company. The amounts due to Parent are reduced by expenses paid by the Company on behalf of the Parent.

The Company also paid certain expenses incurred by the Parent in 2012, 2013 and 2014, resulting in a reduction of the amount due to Parent. The Parent does not charge interest to the Company on the amounts due to Parent.

7. Income Taxes

The provision for income taxes from continuing operations for the years ended December 31, 2011, 2012 and 2013 consists of the following (in millions):

 

		2012				2013				2014
Current:
Federal		$	—			$	—			$	—
State			1.0				0.9				1.6
Total current			1.0				0.9				1.6
Deferred:
Federal			1.8				(5.2	)			(0.5	)
State			(0.6	)			(2.0	)			(1.7	)
Total deferred			1.2				(7.2	)			(2.2	)
Increase in valuation allowance			0.8				10.3				5.3
Total		$	3.0			$	4.0			$	4.7

A reconciliation of the statutory federal income tax rate to the Company’s effective income tax rate from continuing operations for the years ended December 31, 2012, 2013 and 2014 is as follows (dollars in millions):

 

		2012								2013								2014
Federal statutory rate		$	1.5				34.0	%		$	(5.0	)			34.0	%		$	(0.1	)			34.0	%
State income taxes, net of federal income tax benefits			0.2				4.2				(0.7	)			4.4				(0.1	)			31.6
Permanent Items			0.5				7.9				0.2				(1.3	)			0.3				(121.5	)
Actualization			—				—				(0.2	)			1.2				—				—
Non-controlling interests			(0.5	)			(8.6	)			(0.2	)			1.2				(0.7	)			365.7
Valuation allowance			1.3				29.2				9.9				(66.7	)			5.3				(2768.0	)
Effective income tax rate		$	3.0				66.7	%		$	4.0				(27.2	)%		$	4.7				(2458.2	)%

 

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Deferred income taxes result from temporary differences in the recognition of assets, liabilities, revenues and expenses for financial accounting and tax purposes. Sources of these differences and the related tax effects at December 31, 2013 and 2014 are as follows (in millions):

 

		2013				2014
Deferred income tax liabilities:
Depreciation and amortization		$	33.1			$	32.0
Joint ventures			0.7				—
Other			0.3				0.1
Total deferred tax liabilities			34.1				32.1
Deferred income tax assets:
Impaired assets			2.7				3.9
Joint ventures			—				1.0
Organization costs			0.3				0.3
Professional liability claims			2.8				4.6
Accrued paid time off			2.2				2.3
Employee medical claims			0.8				0.8
Net operating losses			61.2				63.4
AMT credit			0.1				0.1
Employment credit			4.0				4.3
Accrued expenses			2.8				2.9
Charitable contributions			1.0				0.8
Provision for doubtful accounts			3.7				4.7
Other			0.3				0.2
Total deferred income tax assets			81.9				89.3
Valuation allowance			(62.7	)			(73.0	)
Net deferred income tax assets			19.2				16.3
Net deferred income tax liabilities		$	(14.9	)		$	(15.8	)

Because of uncertainties related to the realization of certain deferred tax assets, the Company recorded a valuation allowance of approximately $62.7 million as of December 31, 2013 and $73.0 million as of December 31, 2014.

The Company has federal and state net operating loss carryforwards of approximately $135 million and $251 million, respectively at December 31, 2014, which will begin to expire in 2028 and 2020. The Company also has Federal employment credits which will begin to expire in 2028. The Company is not currently under any federal or state tax examination. The Company reflected a tax benefit of $2.2 million related to discontinued operations. This tax benefit is reflected in the net loss from discontinued operations.

The Company has adopted the provisions of FASB authoritative guidance regarding income tax uncertainties. Upon adoption of these provisions, the Company did not record a liability for uncertain tax deductions. At December 31, 2014, the liability for unrecognized tax benefits remains at zero. The Company’s policy is to classify interest paid on an underpayment of income tax and related penalties as part of income tax expense.

8. Commitments and Contingencies

Employment Agreements

The Company has executed senior management agreements with six of its senior executive officers. The agreements provide for minimum salary levels, adjusted based upon individual and Company performance criteria, as well as for participation in bonus plans which are payable if specific management goals are met. The agreements also provide for severance benefits, if certain criteria are met, for a period of up to two years. The senior management agreements remain in place for each of the senior executive officers during their period of employment with the Company or any of its subsidiaries.

Legal Proceedings and General Liability Claims

The Company is, from time to time, subject to claims and suits arising in the ordinary course of business, including claims for damages for personal injuries, medical malpractice, breach of management contracts, wrongful restriction of or interference with physicians’ staff privileges and employment related claims. In certain of these actions, plaintiffs request punitive or other damages against the Company which may not be covered by insurance. The Company is currently not a party to any proceeding which, in management’s opinion, would have a material adverse effect on the Company’s business, financial condition or results of operations.

 

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9. Leases

The Company leases various buildings and equipment under operating lease agreements. The leases expire at various times and have various renewal options.

The Company has certain leases that meet the lease capitalization criteria in accordance with FASB authoritative guidance. In accordance with the FASB authoritative guidance for leases, the capital leases have been recorded as an asset and liability at the lower of the net present value of the minimum lease payments or the fair value at the inception of the lease. The interest rate used in computing the net present value of the lease payments is based on either the Company’s incremental borrowing rate at the inception of the lease or the interest rate implicit in the lease.

Operating lease rental expense relating primarily to the rental of buildings and equipment for the years ended December 31, 2012, 2013 and 2014 was approximately $12.2 million, $13.0 million and $13.6 million, respectively.

Future minimum rental commitments under non-cancelable leases with an initial term in excess of one year at December 31, 2014, consist of the following (in millions):

 

		Capital Leases				Operating Leases
2014		$	6.1			$	7.8
2015			5.9				6.1
2016			6.0				5.3
2017			1.3				4.8
2018			—				3.0
Thereafter			—				9.5
Total minimum lease payments		$	19.3			$	36.5
Less: interest portion (interest rates from 3.8% to 8.0%)			(2.3	)
Long-term obligation under capital lease		$	17.0

During the quarter ended December 31, 2012, the Company recorded an adjustment to income from continuing operations before income taxes of $2.6 million related to the correction of prior period accounting for certain internal use software costs. We have evaluated the materiality of the error from a quantitative and qualitative perspective and determined such to be immaterial to 2012 and prior periods.

10. Related-Party Transactions

On May 4, 2005, the Parent executed a Professional Services Agreement (the “PSA”) with GTCR Golder Rauner II, LLC (“GTCR”), whereby GTCR provides ongoing financial and management consulting to the Company until all investment funds managed by GTCR cease to own at least 10% of the collective Preferred Stock and Common Stock of the Parent. Under the PSA, the Company shall pay GTCR a placement fee of up to 1% of any debt financing in which GTCR is involved in raising the debt financing.

Under the PSA, the Company shall pay GTCR an annual management fee equal to $0.2 million upon the Company’s achievement of EBITDA (as defined in the PSA) of $30 million. In each of 2012, 2013 and 2014, the Company paid GTCR $0.2 million in management fees under the PSA.

11. Retirement Plan

The Company has a defined contribution plan, effective December 1, 2005, covering all employees who have completed six months of service, as defined, and are age 18 or older. Participants may contribute up to 99% of their annual compensation, as defined, up to a maximum of $17,500 for participants under the age of 50 or $22,500 for participants aged 50 years or older. The Company did not authorize an employer contribution for 2012 or 2013. For 2014, the Company authorized an employer contribution of 25% of the first 4% of employee contributions (up to 1% of the individual participant’s annual compensation, as defined. The Company has accrued for the employer contributions of $1.2 million as of December 31, 2014, which is included in other accrued liabilities on the consolidated balance sheet.

 

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12. Stock-Based Compensation

The Parent issues stock-based awards to the Company’s employees from time to time, including stock options and other stock-based awards in accordance with the Parent’s various board-approved compensation plans. In April 2014, the Parent adopted the 2014 Stock Option Plan, which effectively replaced the 2006 Stock Option Plan. The Company incurred non-cash stock-based compensation expense of $1.0 million, $0.8 million and $4.1 million during the years ended December 31, 2012, 2013 and 2014, respectively. The Company incurred additional stock-based compensation of $1.8 million which represented cash payments to partially reimburse employees for tax-related liabilities. Stock-based compensation expense is included in salaries and benefits in the accompanying consolidated statements of operations.

Restricted Shares

The Parent’s restricted share awards, granted to certain of the Company’s employees, generally vest between a one to five-year term. As of December 31, 2014, approximately 320,000 restricted share awards issued by the Parent remained unvested. As of December 31, 2014, there was approximately $0.5 million of estimated unrecognized compensation cost related to these outstanding restricted share awards. These costs are expected to be recognized by the Company over approximately 3.2 years.

During the year ended December 31, 2014, the Parent issued to the Company’s employees approximately 18,203,000 restricted shares, in connection with the Parent’s equity restructuring, as previously described in Note 1. The 18,203,000 restricted shares vested immediately and included a cash payment of $1.8 million to partially reimburse employees for tax-related liabilities associated with the award. The Company considered the cash-based incentive payment to be stock-based compensation that is included in salaries and benefits in the accompanying consolidated statements of operations.

Restricted share awards outstanding and changes during each of the years in the three-year period prior to December 31, 2014, were as follows:

 

		Shares				Weighted- Average Grant Date Fair Value
Outstanding at December 31, 2011			1,186,285			$	3.01
Granted			276,000				4.25
Forfeited			(131,350	)			3.72
Outstanding at December 31, 2012			1,330,935				3.20
Granted			20,250				3.80
Forfeited			(73,540	)			3.54
Outstanding at December 31, 2013			1,277,645				3.13
Granted			18,453,143				0.16
Forfeited			(413,658	)			0.94
Outstanding at December 31, 2014			19,317,130			$	0.38

Stock Options

The 2014 Stock Option Plan permits the Parent’s board of directors to issue approximately 90.5 million stock options to the Company’s employees. During the year ended December 31, 2014, the Parent issued to the Company’s employees 89,838,000 stock options under the 2014 Stock Option Plan. As of December 31, 2014, approximately 677,000 options have been forfeited and the Parent has the ability to issue approximately 1,366,000 additional stock based awards under the 2014 Stock Option Plan. The stock options vest over five years and have an exercise price of $0.16 per share. The Black-Sholes-Merton valuation model indicated that the fair value of options granted during the year ended December 31, 2014, at $0.06 per option. As of December 31, 2014, no options were vested, and the Company expects approximately 74.4 million options to vest over the life of the awards. As of December 31, 2014, there was approximately $3.9 million of estimated unrecognized compensation cost related to outstanding stock options. These costs are expected to be recognized over approximately 4.3 years.

 

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Options outstanding and exercisable under the 2014 Stock Option Plan as of December 31, 2014, and changes during each of the years in the three-year period prior to December 31, 2014, were as follows (in thousands, except share and per share data):

 

		Options				Option Price Per Share				Weighted- Average Exercise Price				Weighted Average Grant Date Fair Value
Outstanding at December 31, 2013			—			$	—			$	—
Granted			89,838,410				0.16				0.16			$	0.06
Exercised			—				—				—
Vested			—				—				—
Forfeited and cancelled			(677,169	)			0.16				0.16
Outstanding at December 31, 2014			89,161,241				0.16				0.16
Exercisable at December 31, 2014			—			$	—			$	—

The Company records stock-based employee compensation for options granted using a Black-Scholes-Merton model. The following table sets forth the range of assumptions the Company has utilized in the Black-Scholes-Merton model.

 

Risk-free interest rate		2.14% to 2.31%
Dividend yield		0%
Volatility (annual)		30.0% to 35.0%
Expected option life		6.5 years

For stock-based awards included in the Black-Scholes-Merton valuation model, the Company uses historical stock price information of certain peer group companies for a period of time equal to the expected award life period to determine estimated volatility. The Company determined the expected life of the stock awards by averaging the contractual life of the awards and the vesting period of the awards. The estimated fair value of awards are amortized to expense on a straight-line basis over the awards’ vesting period. Compensation cost related to stock-based awards will be adjusted for future changes in estimated forfeitures and actual results of performance measures.

13. Guarantor and Non-Guarantor Supplementary Information

The Company’s 9 ¹/₄% Notes are jointly and severally guaranteed on an unsecured senior basis by substantially all of the Company’s wholly-owned subsidiaries. The following presents the condensed consolidating financial information for the Company, as parent issuer, guarantor subsidiaries, non-guarantor subsidiaries, certain eliminations and the Company for the years ended December 31, 2012, 2013 and 2014 and as of December 31, 2013 and 2014:

 

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Capella Healthcare, Inc.

Condensed Consolidating Balance Sheets

December 31, 2013

(In Millions)

 

		Parent Issuer				Guarantors				Non- Guarantors				Eliminations				Consolidated
Assets
Current assets:
Cash and cash equivalents		$	31.9			$	(3.6	)		$	(1.9	)		$	—			$	26.4
Accounts receivable, net			—				74.9				51.4				—				126.3
Inventories			—				14.1				10.2				—				24.3
Prepaid expenses and other current assets			1.4				2.1				1.5				—				5.0
Other receivables			3.2				2.6				0.8				—				6.6
Deferred tax assets			2.5				—				—				—				2.5
Assets held for sale			—				13.1				—				—				13.1
Total current assets			39.0				103.2				62.0				—				204.2
Property and equipment, net			1.7				298.3				156.1				—				456.1
Goodwill			133.6				—				—				—				133.6
Intangible assets, net			—				10.0				3.2				—				13.2
Investments in subsidiaries			(6.1	)			—				—				6.1				—
Other assets, net			22.8				0.9				—				—				23.7
		$	191.0			$	412.4			$	221.3			$	6.1			$	830.8
Liabilities and stockholder’s deficit
Current liabilities:
Accounts payable		$	0.8			$	15.0			$	12.7			$	—			$	28.5
Salaries and benefits payable			2.9				11.4				9.5				—				23.8
Accrued interest			23.3				—				—				—				23.3
Other accrued liabilities			8.2				14.0				10.5				—				32.7
Current portion of long-term debt			—				48.2				1.4				—				49.6
Liabilities held for sale			—				1.9				—				—				1.9
Total current liabilities			35.2				90.5				34.1				—				159.8
Long-term debt			—				366.0				141.8				—				507.8
Deferred income taxes			17.3				—				—				—				17.3
Other liabilities			27.6				0.5				0.3				—				28.4
Redeemable non-controlling interests			—				—				21.4				—				21.4
Due to (from) parent			225.7				5.1				(19.9	)			—				210.9
Total stockholder’s deficit			(114.8	)			(49.7	)			43.6				6.1				(114.8	)
		$	191.0			$	412.4			$	221.3			$	6.1			$	830.8

 

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Capella Healthcare, Inc.

Condensed Consolidating Balance Sheets

December 31, 2014

(In Millions)

 

		Parent Issuer				Guarantors				Non- Guarantors				Eliminations				Consolidated
Assets
Current assets:
Cash and cash equivalents		$	36.7			$	(5.1	)		$	(2.9	)		$	—			$	28.7
Restricted Cash			73.9				—				—				—				73.9
Accounts receivable, net			—				70.4				50.5				—				120.9
Inventories			—				13.5				10.2				—				23.7
Prepaid expenses and other current assets			1.2				2.6				1.3				—				5.1
Other receivables			0.3				3.4				2.1				—				5.8
Deferred tax assets			2.4				—				—				—				2.4
Assets held for sale			—				31.6				2.1				—				33.7
Total current assets			114.5				116.4				63.3				—				294.2
Property and equipment, net			1.7				265.9				142.0				—				409.6
Goodwill			127.9				—				—				—				127.9
Intangible assets, net			—				7.5				3.4				—				10.9
Investments in subsidiaries			(6.4	)			—				—				6.4				—
Other assets, net			26.3				0.7				0.1				—				27.1
		$	264.0			$	390.5			$	208.8			$	6.4			$	869.7
Liabilities and stockholder’s deficit
Current liabilities:
Accounts payable		$	0.9			$	16.2			$	12.7			$	—			$	29.8
Salaries and benefits payable			5.0				12.8				9.7				—				27.5
Accrued interest			23.3				—				—				—				23.3
Other accrued liabilities			8.9				6.7				7.9				—				23.5
Current portion of long-term debt			1.0				3.1				1.9				—				6.0
Revolving facility			5.0				—				—				—				5.0
Liabilities held for sale			—				3.0				0.6				—				3.6
Total current liabilities			44.1				41.8				32.8				—				118.7
Long-term debt			98.0				367.4				142.4				—				607.8
Deferred income taxes			18.2				—				—				—				18.2
Other liabilities			30.3				0.4				0.3				—				31.0
Redeemable non-controlling interests			—				—				11.7				—				11.7
Due to (from) parent			204.8				33.4				(24.5	)			—				213.7
Total stockholder’s deficit			(131.4	)			(52.5	)			46.1				6.4				(131.4	)
		$	264.0			$	390.5			$	208.8			$	6.4			$	869.7

 

F-28

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Table of Contents

Capella Healthcare, Inc.

Condensed Consolidating Statements of Operations

For the Year Ended December 31, 2012

(In Millions)

 

		Parent Issuer				Guarantors				Non- Guarantors				Eliminations				Consolidated
Revenue before provision for bad debts		$	—			$	423.5			$	313.7			$	—			$	737.2
Provision for bad debts			—				(40.1	)			(38.5	)			—				(78.6	)
Revenue			—				383.4				275.2				—				658.6
Costs and expenses
Salaries and benefits			15.2				167.5				120.4				—				303.1
Supplies			—				53.4				53.5				—				106.9
Other operating expenses			10.3				88.4				61.3				—				160.0
Other income			—				(1.1	)			(3.3	)			—				(4.4	)
Equity in (earnings) losses of affiliates			0.4				—				—				(0.4	)			—
Management fees			(19.4	)			12.3				7.3				—				0.2
Interest, net			4.7				35.9				12.5				—				53.1
Depreciation and amortization			0.2				21.8				13.2				—				35.2
Total costs and expenses			11.4				378.2				264.9				(0.4	)			654.1
Income (loss) from continuing operations before income taxes			(11.4	)			5.2				10.3				0.4				4.5
Income taxes			2.7				0.1				0.2				—				3.0
Income (loss) from continuing operations			(14.1	)			5.1				10.1				0.4				1.5
Loss from discontinued operations			—				(13.5	)			(0.6	)			—				(14.1	)
Net income (loss)			(14.1	)			(8.4	)			9.5				0.4				(12.6	)
Less: Net income attributable to non-controlling interests			—				—				1.5				—				1.5
Net income (loss) attributable to Capella Healthcare, Inc.		$	(14.1	)		$	(8.4	)		$	8.0			$	0.4			$	(14.1	)

 

F-29

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Table of Contents

Capella Healthcare, Inc.

Condensed Consolidating Statements of Operations

For the Year Ended December 31, 2013

(In Millions)

 

		Parent Issuer				Guarantors				Non- Guarantors				Eliminations				Consolidated
Revenue before provision for bad debts		$	—			$	436.9			$	332.0			$	—			$	768.9
Provision for bad debts			—				(53.3	)			(47.5	)			—				(100.8	)
Revenue			—				383.6				284.5				—				668.1
Costs and expenses
Salaries and benefits			15.5				176.4				120.8				—				312.7
Supplies			—				57.5				58.5				—				116.0
Other operating expenses			8.2				93.6				66.3				—				168.1
Other income			—				(7.3	)			(3.4	)			—				(10.7	)
Equity in (earnings) losses of affiliates			18.6				—				—				(18.6	)			—
Management fees			(18.6	)			12.0				6.8				—				0.2
Interest, net			5.2				36.3				13.5				—				55.0
Depreciation and amortization			0.4				26.3				14.8				—				41.5
Total costs and expenses			29.3				394.8				277.3				(18.6	)			682.8
Income (loss) from continuing operations before income taxes			(29.3	)			(11.2	)			7.2				18.6				(14.7	)
Income taxes			3.1				0.4				0.5				—				4.0
Income (loss) from continuing operations			(32.4	)			(11.6	)			6.7				18.6				(18.7	)
Income (loss) from discontinued operations			0.6				(12.5	)			0.1				—				(11.8	)
Net income (loss)			(31.8	)			(24.1	)			6.8				18.6				(30.5	)
Less: Net income attributable to non-controlling interests			—				—				1.3				—				1.3
Net income (loss) attributable to Capella Healthcare, Inc.		$	(31.8	)		$	(24.1	)		$	5.5			$	18.6			$	(31.8	)

 

F-30

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Table of Contents

Capella Healthcare, Inc.

Condensed Consolidating Statements of Operations

For the Year Ended December 31, 2014

(In Millions)

 

		Parent Issuer				Guarantors				Non- Guarantors				Eliminations				Consolidated
Revenue before provision for bad debts		$	—			$	461.3			$	327.6			$	—			$	788.9
Provision for bad debts			—				(43.2	)			(32.3	)			—				(75.5	)
Revenue			—				418.1				295.3				—				713.4
Costs and expenses
Salaries and benefits			22.0				187.1				124.3				—				333.4
Supplies			—				63.5				58.2				—				121.7
Other operating expenses			6.6				99.7				70.0				—				176.3
Other income			—				(5.8	)			(7.4	)			—				(13.2	)
Equity in (earnings) losses of affiliates			0.3				—				—				(0.3	)			—
Management fees			(18.0	)			11.4				6.8				—				0.2
Interest, net			6.8				34.0				12.9				—				53.7
Depreciation and amortization			0.1				26.1				15.3				—				41.5
Total costs and expenses			17.8				416.0				280.1				(0.3	)			713.6
Income (loss) from continuing operations before income taxes			(17.8	)			2.1				15.2				0.3				(0.2	)
Income taxes			3.7				0.4				0.6				—				4.7
Income (loss) from continuing operations			(21.5	)			1.7				14.6				0.3				(4.9	)
Income (loss) from discontinued operations			(3.6	)			(4.5	)			(10.3	)			—				(18.4	)
Net income (loss)			(25.1	)			(2.8	)			4.3				0.3				(23.3	)
Less: Net income attributable to non-controlling interests			—				—				1.8				—				1.8
Net income (loss) attributable to Capella Healthcare, Inc.		$	(25.1	)		$	(2.8	)		$	2.5			$	0.3			$	(25.1	)

 

F-31

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Table of Contents

Capella Healthcare, Inc.

Condensed Consolidating Statements of Cash Flows

For the Year Ended December 31, 2012

(In Millions)

 

		Parent Issuer				Guarantors				Non- Guarantors				Eliminations				Consolidated
Operating activities:
Net income (loss)		$	(14.1	)		$	(8.4	)		$	9.5			$	0.4			$	(12.6	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Equity in earnings of affiliates			0.4				—				—				(0.4	)			—
Loss from discontinued operations			—				13.5				0.6				—				14.1
Depreciation and amortization			0.2				21.8				13.2				—				35.2
Amortization of loan costs and bond discount			3.0				0.5				0.4				—				3.9
Provision for bad debts			—				40.1				38.5				—				78.6
Deferred income taxes			2.0				—				—				—				2.0
Stock-based compensation			1.0				—				—				—				1.0
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable, net			—				(49.2	)			(42.5	)			—				(91.7	)
Inventories			—				(0.9	)			0.1				—				(0.8	)
Prepaid expenses and other current assets			(2.7	)			2.0				0.9				—				0.2
Accounts payable and other current liabilities			0.9				0.6				5.7				—				7.2
Accrued salaries			(0.1	)			0.9				0.3				—				1.1
Other			0.2				0.8				1.5				—				2.5
Net cash provided by (used in) operating activities – continuing operations			(9.2	)			21.7				28.2				—				40.7
Net cash used in operating activities – discontinued operations			—				2.1				1.2				—				3.3
Net cash provided by (used in) operating activities			(9.2	)			23.8				29.4				—				44.0
Investing activities:
Acquisition of healthcare businesses			(26.0	)			—				—				—				(26.0	)
Purchases of property and equipment, net			(16.0	)			(5.1	)			(8.4	)			—				(29.5	)
Proceeds from disposition of healthcare businesses			12.4				—				—				—				12.4
Net cash used in investing activities – continuing operations			(29.6	)			(5.1	)			(8.4	)			—				(43.1	)
Net cash used in investing activities – discontinued operations			—				(4.3	)			—				—				(4.3	)
Net cash used in investing activities			(29.6	)			(9.4	)			(8.4	)			—				(47.4	)
Financing activities:
Payments on capital leases and other obligations			—				(0.8	)			—				—				(0.8	)
Payment of debt issue costs			—				(0.2	)			—				—				(0.2	)
Advances to (from) Parent			29.9				(13.6	)			(16.7	)			—				(0.4	)
Repurchase of non-controlling interests			—				—				(1.1	)			—				(1.1	)
Distributions to non-controlling interests			—				—				(1.7	)			—				(1.7	)
Net cash provided by (used in) financing activities – continuing operations			29.9				(14.6	)			(19.5	)			—				(4.2	)
Net cash used in financing activities – discontinued operations			—				(1.5	)			—				—				(1.5	)
Net cash provided by (used in) financing activities			29.9				(16.1	)			(19.5	)			—				(5.7	)
Change in cash			(8.9	)			(1.7	)			1.5				—				(9.1	)
Cash at beginning of year			48.4				(2.7	)			(3.3	)			—				42.4
Cash at end of year		$	39.5			$	(4.4	)		$	(1.8	)		$	—			$	33.3

 

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Capella Healthcare, Inc.

Condensed Consolidating Statements of Cash Flows

For the Year Ended December 31, 2013

(In Millions)

 

		Parent Issuer				Guarantors				Non- Guarantors				Eliminations				Consolidated
Operating activities:
Net income (loss)		$	(31.8	)		$	(24.1	)		$	6.8			$	18.6			$	(30.5	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Equity in earnings of affiliates			18.6				—				—				(18.6	)			—
Loss (income) from discontinued operations			(0.6	)			12.5				(0.1	)			—				11.8
Depreciation and amortization			0.4				26.3				14.8				—				41.5
Amortization of loan costs			3.1				0.7				0.2				—				4.0
Provision for bad debts			—				53.3				47.5				—				100.8
Deferred income taxes			3.1				—				—				—				3.1
Stock-based compensation			0.8				—				—				—				0.8
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable, net			(0.3	)			(54.9	)			(54.4	)			—				(109.6	)
Inventories			—				(1.0	)			0.5				—				(0.5	)
Prepaid expenses and other current assets			0.3				0.9				(0.6	)			—				0.6
Accounts payable and other current liabilities			0.6				7.0				3.7				—				11.3
Accrued salaries			0.5				(0.4	)			0.8				—				0.9
Other			0.5				(2.6	)			(0.3	)			—				(2.4	)
Net cash provided by (used in) operating activities – continuing operations			(4.8	)			17.7				18.9				—				31.8
Net cash provided by (used in) operating activities – discontinued operations			—				(2.8	)			1.8				—				(1.0	)
Net cash provided by (used in) operating activities			(4.8	)			14.9				20.7				—				30.8
Investing activities:
Purchases of property and equipment, net			(0.2	)			(9.7	)			(15.0	)			—				(24.9	)
Proceeds from disposition of hospital			—				1.6				—				—				1.6
Net cash used in investing activities – continuing operations			(0.2	)			(8.1	)			(15.0	)			—				(23.3	)
Net cash used in investing activities – discontinued operations			—				(3.5	)			—				—				(3.5	)
Net cash used in investing activities			(0.2	)			(11.6	)			(15.0	)			—				(26.8	)
Financing activities:
Payments on capital leases and other obligations			—				(9.2	)			(0.6	)			—				(9.8	)
Advances to (from) Parent			(2.6	)			7.7				(3.8	)			—				1.3
Repurchase of non-controlling interests			—				—				(0.2	)			—				(0.2	)
Distributions to non-controlling interests			—				—				(1.2	)			—				(1.2	)
Net cash used in financing activities			(2.6	)			(1.5	)			(5.8	)			—				(9.9	)
Net cash used in financing activities – discontinued operations			—				(1.0	)			—				—				(1.0	)
Net cash used in financing activities			(2.6	)			(2.5	)			(5.8	)			—				(10.9	)
Change in cash			(7.6	)			0.8				(0.1	)			—				(6.9	)
Cash at beginning of year			39.5				(4.4	)			(1.8	)			—				33.3
Cash at end of year		$	31.9			$	(3.6	)		$	(1.9	)		$	—			$	26.4

 

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Capella Healthcare, Inc.

Condensed Consolidating Statements of Cash Flows

For the Year Ended December 31, 2014

(In Millions)

 

		Parent Issuer				Guarantors				Non- Guarantors				Eliminations				Consolidated
Operating activities:
Net income (loss)		$	(25.1	)		$	(2.8	)		$	4.3			$	0.3			$	(23.3	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Equity in earnings of affiliates			0.3				—				—				(0.3	)			—
Loss from discontinued operations			3.6				4.5				10.3				—				18.4
Depreciation and amortization			0.1				26.1				15.3				—				41.5
Amortization of loan costs			3.4				0.2				0.2				—				3.8
Provision for bad debts			—				43.2				32.3				—				75.5
Deferred income taxes			3.1				—				—				—				3.1
Stock-based compensation			4.1				—				—				—				4.1
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable, net			—				(45.9	)			(31.4	)			—				(77.3	)
Inventories			—				(1.3	)			—				—				(1.3	)
Prepaid expenses and other current assets			3.1				(4.0	)			1.0				—				.1
Accounts payable and other current liabilities			0.8				(3.0	)			(2.0	)			—				(4.2	)
Accrued salaries			2.1				2.8				0.2				—				5.1
Other			1.2				3.4				(2.4	)			—				2.2
Net cash provided by (used in) operating activities – continuing operations			(3.3	)			23.2				27.8				—				47.7
Net cash used in operating activities – discontinued operations			—				(2.0	)			(1.3	)			—				(3.3	)
Net cash provided by (used in) operating activities			(3.3	)			21.2				26.5				—				44.4
Investing activities:
Purchases of property and equipment, net			(0.1	)			(12.7	)			(11.7	)			—				(24.5	)
Escrow payment on acquisition of healthcare business			(73.9	)			—				—				—				(73.9	)
Proceeds from disposition of hospital			—				11.2				—				—				11.2
Net cash used in investing activities – continuing operations			(74.0	)			(1.5	)			(11.7	)			—				(87.2	)
Net cash used in investing activities – discontinued operations			—				(0.7	)			—				—				(0.7	)
Net cash used in investing activities			(74.0	)			(2.2	)			(11.7	)			—				(87.9	)
Financing activities:
Payments on capital leases and other obligations			—				(48.9	)			(1.0	)			—				(49.9	)
Borrowings on Revolving Facility			40.0				—				—				—				40.0
Payments on Revolving Facility			(35.0	)			—				—				—				(35.0	)
Proceeds from Term Note			99.0				—				—				—				99.0
Advances to (from) Parent			(16.5	)			28.4				(13.1	)			—				(1.2	)
Payment of debt issue costs			(5.4	)			—				—				—				(5.4	)
Repurchase of non-controlling interests			—				—				0.1				—				0.1
Distributions to non-controlling interests			—				—				(1.8	)			—				(1.8	)
Net cash provided by (used in) financing activities			82.1				(20.5	)			(15.8	)			—				45.8
Change in cash			4.8				(1.5	)			(1.0	)			—				2.3
Cash at beginning of year			31.9				(3.6	)			(1.9	)			—				26.4
Cash at end of year		$	36.7			$	(5.1	)		$	(2.9	)		$	—			$	28.7

 

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14. Subsequent Event

Effective January 1, 2015, the Company acquired controlling ownership interest in Carolina Pines Regional Medical Center, a 116-bed acute care facility located in Hartsville, South Carolina through the acquisition of all of the equity interests in Hartsville Medical Group, LLC and substantially all of the equity interests in Hartsville, LLC (formerly Hartsville HMA, LLC), each a South Carolina limited liability company. The cash purchase price was $67.3 million plus $6.5 million for working capital and was funded by a $100 million Term Loan Facility and resulted in goodwill of approximately $5.9 million.

The fair values of assets acquired and liabilities assumed at the acquisition date are as follows (in millions):

 

Accounts receivable, net		$	13.0
Prepaids and other			0.4
Inventories			2.3
Property and equipment			57.4
Intangibles			1.2
Goodwill			5.9
Total assets acquired			80.2
Accounts payable			1.7
Salaries and benefits payable			2.4
Accrued expenses			1.1
Non-controlling interest			1.2
Total liabilities assumed			6.4
Net assets acquired		$	73.8

The preliminary values of the consideration transferred, assets acquired and liabilities assumed, including the related tax effects, are subject to receipt of a final valuation a final working capital adjustments.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Franklin, State of Tennessee, as of the 27th day of March, 2015.

 

Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the date indicated.

 

Signature		Title		Date
/s/ Michael A. Wiechart Michael A. Wiechart		President and Chief Executive Officer (Principal Executive Officer)		March 27, 2015
/s/ Denise W. Warren Denise W. Warren		Executive Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer and Principal Accounting Officer)		March 27, 2015
/s/ David A. Donnini David A. Donnini		Director		March 27, 2015
/s/ Joshua M. Earl Joshua M. Earl		Director		March 27, 2015
/s/ Robert Z. Hensley Robert Z. Hensley		Director		March 27, 2015
/s/ Joseph P. Nolan Joseph P. Nolan		Director		March 27, 2015
/s/ Daniel S. Slipkovich Daniel S. Slipkovich		Director		March 27, 2015

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Table of Contents

Exhibit Number		Description
3.1		Certificate of Incorporation of Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
3.2		By-Laws of Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
4.1		Indenture, dated as of June 28, 2010, among Capella Healthcare, Inc., the Guarantors named therein and U.S. Bank National Association, as Trustee (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
4.2		Form of 9 1⁄4% Senior Notes due 2017 (included in Exhibit 4.1) (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
4.3		Form of Supplemental Indenture to add a Guaranty Subsidiary (incorporated by reference from exhibits to the Quarterly Report on Form 10-Q filed by Capella Healthcare, Inc. on November 2, 2012)
4.4		Registration Rights Agreement, dated as of June 28, 2010, among Capella Healthcare, Inc., the Guarantors party thereto, and Banc of America Securities LLC, as representatives of the initial purchasers named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.1		Stock Purchase Agreement, dated as of May 4, 2005, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.2		Supplement No. 1 to the Stock Purchase Agreement, dated as of April , 2007, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.3		Amendment and Supplement No. 2 to the Stock Purchase Agreement, dated as of February 29, 2008, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.4		Stockholders Agreement, dated as of May 4, 2005, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.5		Amendment No. 1 to the Stockholders Agreement, dated as of February 29, 2008, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.6		Amendment No. 2 to the Stockholders Agreement, dated as of April 17, 2014, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein
10.7		Registration Rights Agreement, dated as of May 4, 2005, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P., GTCR Co-Invest II, L.P. and the other investors named therein (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.8		Professional Services Agreement, dated as of May 4, 2005, between GTCR Golder Rauner II, LLC and Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

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Table of Contents

Exhibit Number		Description
10.9		Amendment No. 1 to Professional Services Agreement between GTCR Golder Rauner II, LLC and Capella Healthcare, Inc., dated as of November 30, 2005 (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.10		Amended and Restated Loan Agreement, dated as of December 31, 2014, by and among Capella Healthcare, Inc. and certain borrowing subsidiaries as Borrowers, Capella Holdings, Inc. and certain guarantying subsidiaries as Guarantors, certain financial institutions as Lenders, Bank of America, N.A. as Administrative Agent and Collateral Agent, Citibank, N.A. as Syndication Agent, General Electric Capital Corporation as Documentation Agent and Merrill Lynch, Pierce, Fenner & Smith, Incorporated, Citigroup Global Markets Inc. and GE Capital Markets, Inc. as Joint Lead Arrangers and Joint Bookrunners **
10.11		Senior Management Agreement, dated as of May 4, 2005, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and Daniel S. Slipkovich (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.12		Amendment No. 1 to Senior Management Agreement, dated as of May 12, 2006, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Daniel S. Slipkovich and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.13		Amendment No. 2 to Senior Management Agreement, dated as of September 15, 2014, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Daniel S. Slipkovich and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Quarterly Report on Form 10-Q filed by Capella Healthcare, Inc. on October 31, 2014) *
10.14		Senior Management Agreement, dated May 4, 2005, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and David Andrew Slusser (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.15		Amendment No. 1 to Senior Management Agreement, dated as of May 12, 2006, by and among Capella Holdings, Inc., Capella Healthcare, Inc., David Andrew Slusser and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.16		Senior Management Agreement, dated as of October 17, 2005, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and Denise Wilder Warren (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.17		Amendment No. 1 to Senior Management Agreement, dated as of May 12, 2006, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Denise Wilder Warren and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.18		Amendment No. 2 to Senior Management Agreement, dated as of November 18, 2014, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Denise Wilder Warren and GTCR Fund VIII, L.P. *
10.19		Senior Management Agreement, dated as of May 26, 2009, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and Michael Wiechart (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.20		Form of Amendment No. 1 to Senior Management Agreement, dated as of August 24, 2011, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Michael Wiechart and GTCR Fund VIII, L.P. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.21		Amendment No. 2 to Senior Management Agreement, dated as of November 18, 2014, by and among Capella Holdings, Inc., Capella Healthcare, Inc., Michael Wiechart and GTCR Fund VIII, L.P. *
10.22		Capella Holdings, Inc. Deferred Compensation Plan (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188) *
10.23		Computer and Data Processing Services Agreement, effective February 21, 2011, by and among HCA-Information Technology & Services, Inc. and Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4/A filed by Capella Healthcare, Inc. on September 23, 2011, File No. 333-175188) **

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Table of Contents

Exhibit Number		Description
10.24		Amendment No. 001 to Computer and Data Processing Services Agreement, effective May 5, 2011, by and among HCA-Information Technology & Services, Inc. and Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4/A filed by Capella Healthcare, Inc. on September 23, 2011, File No. 333-175188) **
10.25		Lease Agreement, dated April 3, 2007, by and among Muskogee Medical Center Authority, d/b/a Muskogee Regional Medical Center , Muskogee Regional Medical Center, LLC, and Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.26		Form of Redemption Agreement (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)
10.27		Senior Management Agreement, dated September 20, 2011, by and among Capella Holdings, Inc., Capella Healthcare, Inc. and Neil W. Kunkel (incorporated by reference from exhibits to the Quarterly Report on Form 10-Q filed by Capella Healthcare, Inc. on November 11, 2011) *
10.28		Capella Holdings, Inc. 2014 Stock Option Plan (incorporated by reference from exhibits to the Current Report on Form 8-K filed by Capella Healthcare, Inc. on April 23, 2014) *
10.29		Form of Nonqualified Stock Option Agreement under the Capella Holdings, Inc. 2014 Stock Option Plan (incorporated by reference from exhibits to the Current Report on Form 8-K filed by Capella Healthcare, Inc. on April 23, 2014) *
10.30		Credit Agreement, dated as of December 31, 2014, among Capella Healthcare, Inc., Capella Holdings, Inc., various lenders and Credit Suisse AG, Cayman Islands Branch as Administrative Agent **
21		Subsidiaries of Registrant
31.1		Certification of the Chief Executive Officer of Capella Healthcare, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of the Chief Financial Officer of Capella Healthcare, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of the Chief Executive Officer of Capella Healthcare, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of the Chief Financial Officer of Capella Healthcare, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Extension Schema Document
101.CAL		XBRL Taxonomy Calculation Linkbase Document
101.DEF		XBRL Taxonomy Definition Linkbase Document
101.LAB		XBRL Taxonomy Label Linkbase Document
101.PRE		XBRL Taxonomy Presentation Linkbase Document

 

*	Management compensatory plan or arrangement.

**	Certain information has been omitted pursuant to a confidential treatment request filed with the SEC.