UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 

FORM 10-K

 

For the fiscal year ended December 31, 2015

 

For the transition period from ______to ______

 

Commission File Number: 001-34171

 

FOUNDATION HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)

14000 N. Portland Avenue, Ste. 200

Oklahoma City, Oklahoma 73134

(Address of principal executive offices)

(405) 608-1700

(Registrant’s telephone number, including area code)

 

Securities registered under Section 12(b) of the Exchange Act

None

 

Securities registered under Section 12(g) of the Exchange Act

 

Common Stock, $0.0001 Par Value

 

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

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

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).    x  Yes    o  No

Indicate by check mark if disclosure of delinquent filers pursuant to Rule 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.    o       

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

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

As of June 30, 2015, the aggregate market value of Foundation Healthcare, Inc. common stock, par value $0.0001, held by non-affiliates (based upon the closing transaction price, or the average bid and asked price) was approximately $19,453,000.

As of March 30, 2016, 17,375,394 shares of the registrant’s common stock, $0.0001 par value, were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Definitive Proxy Statement to be filed within 120 days after December 31, 2015 of the Registrant’s Annual Shareholders’ Meeting are incorporated by reference to Part III of this Report on Form 10-K.

 

 

 

 

 

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FOUNDATION HEALTHCARE, INC.

FORM 10-K

For the Fiscal Year Ended December 31, 2015

TABLE OF CONTENTS

 

 

 

 

 

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

Certain statements under the captions “Item 1. Business,” “Item 1A. Risk Factors,” and “Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this report constitute “forward-looking statements”.  Certain, but not necessarily all, of such forward-looking statements can be identified by the use of forward-looking terminology such as “anticipates,” “believes,” “expects,” “may,” “will,” or “should” or other variations thereon, or by discussions of strategies that involve risks and uncertainties.  Our actual results or industry results may be materially different from any future results expressed or implied by such forward-looking statements.  Factors that could cause actual results to differ materially include general economic and business conditions; our ability to implement our business strategies; competition; availability of key personnel; increasing operating costs; unsuccessful promotional efforts; changes in brand awareness; acceptance of new product offerings; and changes in, or the failure to comply with government regulations.  We undertake no obligation to update or revise any forward looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable securities laws.

In this report, for example, we make forward-looking statements, including statements discussing our expectations about:  future financial performance and condition; future liquidity and capital resources; future cash flows; existing debt; our business strategy and operating philosophy; effects of competition in our markets; costs of providing care to our patients; our compliance with new and existing laws and regulations as well as costs and benefits associated with compliance; the impact of national healthcare reform; other income from electronic health records (“EHR”); the impact of accounting methodologies; industry and general economic trends; patient shifts to lower cost healthcare plans which generally provide lower reimbursement; reimbursement changes; patient volumes and related revenues; claims and legal actions relating to professional liabilities; governmental investigations and voluntary self-disclosures; and physician recruiting and retention.

Throughout this report the first personal plural pronoun in the nominative case form “we” and its objective case form “us”, its possessive and the intensive case forms “our” and “ourselves” and its reflexive form “ourselves”  refer collectively to Foundation Healthcare, Inc. and its subsidiaries.

 

 

 

 

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PART I

Company Overview

We are organized under the laws of the state of Oklahoma and we own and manage facilities which operate in the rapidly growing specialized surgical segment of the healthcare industry.  Today, our network consists of four surgical hospitals, nine ambulatory surgical centers (ASCs) and one hospital outpatient department (HOPD) in six states throughout the United States.  Our growth strategy involves increasing our footprint in our current markets by acquiring controlling interests in surgical hospitals, nearby ASCs and ancillary service facilities, including facilities where we currently own an interest.  ASCs affiliated with surgical hospitals are known as HOPDs, and both the hospitals and affiliated outpatient surgery centers benefit from regional branding, increased operating efficiencies and lower costs through economies of scale.  We believe that having the ability to perform procedures at surgical hospitals for more complex surgeries and at ASCs or HOPDs for same-day surgeries, coupled with the ability to provide other related pre and post-operative outpatient services will enable us to capture an increasing share of surgical volumes in the markets in which we serve and to generate strong patient outcomes and satisfaction.

In addition to increasing our ownership interests in our network, opportunities exist for us to grow our business strategically and profitably by:

Our facilities currently provide care for patients seeking general surgeries and specialty surgeries such as orthopedics, neurosurgery, pain management, podiatry, gynecology, optometry, gastroenterology and pediatric ENT (tubes/adenoids).  Our surgical facilities also provide wound care, sleep management, radiology, imaging and other ancillary services.  We continue to expand our service offerings at our surgical hospitals to include additional imaging, intraoperative monitoring, robotic surgery, and physical therapy services.  A key component of our success has been our strong relationships with over 300 quality physician partners.  We believe our continued emphasis on physician satisfaction and productivity will continue to position us competitively in the future.

In 2015 and 2014, our majority owned facilities performed approximately 6,357 and 6,095 outpatient surgeries, respectively, and 2,112 and 1,772 inpatient surgeries, respectively.  Our procedure rates experienced strong growth as reflected in net patient services revenues of $114.8 million in 2015, up from $91.1 million in 2014.  We anticipate demand for the types of surgeries performed at our facilities to grow in light of:

 

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Our Surgical Facilities

Today, we own at least 51% of three surgical hospitals located in San Antonio, El Paso and Houston, Texas which are reflected in our consolidated financial statements as our Consolidated Hospitals.  We maintain a noncontrolling interest in one hospital in Oklahoma and seven ASCs in five states which are referred to as Equity Owned Hospitals, Equity Owned ASCs, Equity Owned Facilities or Affiliates.  We also have an interest in one HOPD through our investment in the Edmond, Oklahoma hospital.  We have management contracts with two ASCs in Louisiana in which we have no ownership interest.  We generate revenue through our ownership interests in these surgical facilities as well as management fees for providing a variety of administrative services to substantially all of our Equity Owned Facilities.  We manage our facilities by overseeing their business office, contracting, marketing, financial reporting, accreditation, clinical, regulatory and administrative operations.  We work closely with our physician partners to increase the likelihood of successful patient and financial outcomes.

 

Our facilities are licensed at the state level, participate within the Medicare program and are accredited by the Accreditation Association for Ambulatory Healthcare (AAAHC) or the Det Norske Veritas (DNV) with the exception of our ASC in Nacogdoches, Texas.  The Nacogdoches facility meets the accreditation standards, but the governing board of the ASC has elected to not be accredited.  We recognize that accreditation is a crucial quality benchmark for payors since many managed care organizations will not contract with a facility until it is accredited.  We believe that our historical success in obtaining and retaining accreditation for our facilities reflects our commitment to providing high quality care in our facilities.

Changes in Consolidated Hospitals and Equity Owned Affiliates

On December 31, 2015, we purchased substantially all of the hospital assets and hospital operating entity of University General Health Systems, Inc., consisting primarily of a sixty-nine bed acute care hospital located in the Medical City area of Houston, Texas (“UGH”).  The purchase price of the UGH was $25.1 million, net of liabilities assumed.  The UGH hospital is now operated as Foundation Surgical Hospital of Houston.

On July 15, 2015, we sold our 10% interest in the Kirby Glen Surgery, LLC, one of our Equity Owned ASCs located in Houston, Texas. We received $0.2 million in combined proceeds for the sale of the equity interest and termination of our management agreement.

On June 12, 2015, we sold a portion of our 20% equity investment in Grayson County Physician Property, LLC (“GCPP”), our Equity Owned hospital in Sherman, Texas, through a series of transactions. In conjunction with the sale, the management agreement

 

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under which we provided certain services including billing and collections, general management services, legal support, and accounting services was terminated. Our decision to sell the assets of GCPP was part of our overall strategic plan to focus on the growth of our majority owned surgical hospital businesses and divest any minority interest holdings. We received $7.8 million in proceeds as a result of the sale and $0.5 million in additional proceeds for the termination our management agreement. We used $7.0 million of these proceeds to reduce our principal balance of the note held by our senior lender.

On March 31, 2015, Houston Orthopedic Surgical Hospital, L.L.C. (“HOSH”), our Equity Owned hospital in Houston, Texas, sold substantially all of its assets under an asset purchase agreement. Given that we do not exercise control with our 20% investment in HOSH, we account for our investment on a cost or cash basis. As a result of the HOSH sale, we received a distribution on May 12, 2015 for $1.8 million, of which $0.6 million is being held in escrow until April 2016..

On January 1, 2015, Foundation Surgery Affiliates of Northwest Oklahoma City, LLC, or FSA OKC, our Equity Owned ASC located in Oklahoma City, Oklahoma was sold to Summit Medical Center LLC, or Summit Hospital, in exchange for unit ownership in Summit Hospital which is located in Edmond, Oklahoma.  As part of the transaction, the units of Summit Hospital were distributed to the individual FSA OKC investors including us.  As a result of the transaction, we now hold an 8% ownership interest in Summit Hospital. In addition, the ASC facility in Oklahoma City is now operated as an HOPD for Summit Hospital.

Reverse Stock Split

At the Company’s annual meeting of stockholders held on May 12, 2014, the Company’s stockholders approved an amendment to its amended and restated certificate of incorporation to effect a reverse split of its common stock at a ratio between 1-for-3 to 1-for-10 shares. The Company’s stockholders further authorized the board of directors to determine the ratio at which the reverse split would be effected by filing an appropriate amendment to its amended and restated certificate of incorporation. The Company’s board of directors authorized the ratio of the reverse split and corresponding reduction in authorized shares on December 29, 2014 and effective at the close of business on January 8, 2015, the Company amended its amended and restated certificate of incorporation to effect a 1-for-10 reverse split of its common stock. The board of directors considered a ratio that would allow the Company to have a number of outstanding shares to have a sufficient trading volume while considering stock price that would be consistent with the Company’s intention to eventually uplist its common stock from the OTC Markets QB Tier to a listing on the NYSE MKT exchange, though there can be no assurance that we will ultimately pursue or be successful in seeking to uplist the Company’s common stock on such exchange. The Board of Directors determined that a ratio of 1-for-10 was the best balance of these and other factors. The effect of the reverse split reduced the Company’s outstanding common stock shares from 172,638,414 to 17,263,842 shares as of the date of the reverse split. The accompanying consolidated financial statements give effect to the reverse split as of the first date reported.

Discontinued Operations

The partial sale of GCPP in June 2015 was part of our strategic plan to focus on majority owned investments. As a result, the proceeds from the sale, the remaining equity ownership, and the results of operations and cash flows related to the equity investment in GCPP for all periods presented have been classified as discontinued operations. Therefore, we reclassified $2.2 million from equity method investments in affiliates to other assets from discontinued operations as of December 31, 2014. In addition, we reclassified $0.6 million from equity in earnings from affiliates to income from discontinued operations, net of tax, for the year ended December 31, 2014.

Company History

Our Company was originally incorporated in Oklahoma on August 18, 2003 under the name “Graymark Productions, Inc.,” and later changed its name to “Graymark Healthcare, Inc.” on December 31, 2007 and then changed its name to “Foundation Healthcare, Inc.” on December 2, 2013. Our existing focus on surgical facilities began with the Foundation Acquisition on July 22, 2013.  From January 2008 through July 2013, our primary focus had been providing sleep disorder solutions, a business we entered when our predecessor company, Graymark Productions Inc., acquired ApothecaryRx, LLC, and SDC Holdings, LLC, collectively referred to as the “Graymark Acquisition.”  For financial reporting purposes, Graymark was deemed acquired by ApothecaryRx, LLC and SDC Holdings, LLC (even though Graymark remained the legal entity of the combined organization following the Graymark Acquisition). In conjunction with the Graymark Acquisition, all former operations of Graymark Productions were discontinued.  On December 6, 2010, we completed the sale of substantially all of the assets of ApothecaryRx.

Surgical Healthcare Market and Opportunity

According to the American Hospital Association, from 1993 to 2013 outpatient surgeries increased from approximately 57% of total surgery volumes to 65%.  One of the main features of healthcare reform in the United States is that healthcare providers are being required to contain costs while generating better clinical outcomes.  We believe that such cost and performance measures have contributed to the significant shift in the delivery of surgical services away from general acute care hospitals to more cost-effective

 

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alternate sites, including ASCs, HOPDs and surgical hospitals; which reflects the benefits these facilities provide to the key participants within the healthcare system:

At traditional acute care facilities, unplanned medical emergencies can result in the postponement or delay of scheduled surgeries, disrupting both physicians’ practices and inconveniencing patients.  Due to the non-emergency nature of the procedures performed at surgical hospitals and ASCs, these facilities are able to improve the work environment, simplify scheduling and enhance physician efficiency.

New surgical techniques and technology, most notably minimally invasive surgical techniques, as well as advances in anesthesia, have significantly expanded the types of surgical procedures that are being performed in surgical hospitals and ASCs and have helped drive the growth in outpatient surgery.  Lasers, arthroscopy, enhanced endoscopic techniques and fiber optics have reduced the trauma and recovery time associated with many surgical procedures.  Improved anesthesia has shortened recovery time by minimizing post-operative side effects such as nausea and drowsiness, thereby avoiding the need for overnight hospitalization in many cases.  In addition, some states in the United States, including Oklahoma, Maryland, Ohio and Texas, permit ASCs to keep patients for up to 23 hours, allowing more complex surgeries, previously only performed in an inpatient setting, to be performed in an ASC.

Government programs, private insurance companies, managed care organizations and self-insured employers have implemented cost containment measures to limit increases in healthcare expenditures, including procedure reimbursement.  Many of these programs have shifted additional financial responsibility to patients through higher co-payments, higher deductibles and higher premium contributions.  We believe that surgery performed at a surgical hospital or an ASC is generally less expensive than hospital-based outpatient surgery because of lower facility development costs, more efficient staffing and space utilization and a specialized operating environment focused on quality of care and cost containment.

Our Competitive Strengths

While we cannot predict how changes in healthcare reimbursement trends will impact our business, we believe we are well positioned by the following competitive strengths:

Quality low cost provider.  The delivery of healthcare will continue to be directed to low cost venues.  As a result of our focus on operating efficiencies, we have been able to contain our costs in providing patient services.  We believe our comparatively low rates, coupled with our ability to provide high quality services with less overhead, will position us competitively.

Experienced management team.  Our senior management has, on average, over 21 years of experience in the healthcare industry and extensive knowledge of the growth opportunities where we operate.  These seasoned executives bring expertise in financial, operational, legal, regulatory and strategic development.  Additionally, many members of our senior management team have significant experience working for our Company.

Established systems infrastructure.  Our current sophisticated information systems and analytical tools, business office support, reporting, and purchasing power create an excellent platform for continued growth without significant additional investment.  We believe there is an opportunity for us to acquire additional facilities and to overlay our systems, thereby enabling us to add new revenue with only modest incremental increases in expenses.

Ability to identify, structure and integrate acquisitions.  Our teams of experienced operations and financial personnel conduct a review of all aspects of an acquisition target’s operations, including (1) the quality and reputation of the physicians affiliated with the facility, (2) the market position of the facility and the physicians affiliated with the facility, (3) the facility’s payor contracts and case mix, (4) competition and growth opportunities in a market, (5) the facility’s staffing and supply policies, (6) an assessment of the facility’s equipment, and (7) opportunities to improve operational efficiencies.  We also have a dedicated team experienced in negotiating deal terms and in integrating the acquired facilities.

 

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Barriers to entry.  Congress passed restrictions on the creation of new surgery hospitals that have physician ownership beginning in 2010.  We believe having physician owners in our facilities creates an enhanced level of loyalty and a general commitment to cost containment and practice growth.  Ownership also aligns our interests with those of our physician partners.  All of our managed hospitals are “grandfathered” and therefore permitted to have physician owners.  As we believe physician ownership represents a competitive advantage, our growth strategy will target surgical hospitals that we can own in partnership with physicians.

Our Growth Strategy

We have strong skills in the acquisition, development and operation of surgical facilities and ASCs.  The key components of our strategy are:

Acquire majority stakes in new surgery hospitals and ASCs.  We believe that increasingly, surgical facility owners and physicians are seeking to affiliate with experienced operators with access to capital, management expertise, payor contracting experience and other resources.  Our in-house acquisition team has identified numerous facilities that we believe could be excellent candidates for acquisition.  In addition, we seek to identify ASCs, imaging facilities and other ancillary services that can be affiliated with our surgical hospitals allowing us to leverage our regional knowledge, expand our brand, grow our revenue base, and improve overall operating efficiencies.  We seek to use our sophisticated information systems, support capacity, development capabilities, managed care expertise and analytics to become an industry consolidator.

Expand our relationships with physician partners as well as non-owner physicians to maximize the utilization of our facilities.  High-performing physicians are critical to our operating model, and we constantly strive to expand our affiliations with top-performing surgeons.  We market our facilities to physicians by emphasizing (i) the high level of patient and physician satisfaction, (ii) the high quality of our services and patient outcomes, and (iii) the numerous services we offer to make our physicians more productive while minimizing their administrative burdens.  We work with our physician partners to identify qualified non-owner physicians to use our facilities to increase our throughput and operating margins.  We believe our focus on physician satisfaction, combined with providing safe, high quality healthcare in a patient friendly and convenient environment helps us attract and retain physician partners, non-owner physicians, and referring physicians.

Provide more ancillary services.  We seek to enhance the service offering by making new pre- and post-surgery procedures and services available to our patients.  These services will expand our potential revenue, more fully satisfy patient needs and enhance the patient’s continuum of care.  Currently, many of our surgical facilities offer some of these ancillary services, and our strategy is to expand our services through direct ownership and affiliations with other service providers in order to offer a full continuum of services throughout our network.

Sources of Revenue

Our patient services revenues are derived from the fees charged for surgical and other ancillary procedures performed in our Consolidated Hospitals.  Our facility fees vary depending on the procedure, but usually include all charges for operating room usage, special equipment usage, supplies, recovery room usage, nursing staff and medications.  Facility fees do not include professional fees charged by the physician that performs the surgical procedure.  Revenue is recorded at the time services are rendered to a patient and billings for such procedures are typically done in about five to seven days.  It is our policy to collect patient co-payments and deductibles at the time the surgery and other services are performed.  Our revenues are recorded net of estimated contractual adjustments from third-party medical service payors.  Our billing and accounting systems provide us historical trends of each surgical facility’s cash collections and contractual write-offs, accounts receivable aging and established fee adjustments from third-party payors.  These estimates are recorded and monitored monthly for each of our facilities as revenue is recognized.  Our ability to accurately estimate contractual adjustments is dependent upon and supported by the fact that our facilities perform and bill for limited types of procedures.  The range of reimbursement for those procedures within each facility specialty is very narrow and payments are typically received within 15 to 45 days of billing.

Our facilities depend upon third-party reimbursement programs, including governmental and private insurance programs, to pay for substantially all of the services rendered to patients.  A modest amount of our revenue is received from payments made by patients.  Patients generally are not responsible for any difference between customary hospital charges and amounts reimbursed for the services under Medicare, Medicaid, private insurance plans, HMOs or PPOs, but patients are responsible for services not covered by these plans, exclusions, deductibles or co-payment features of their coverage.  The amount of exclusions, deductibles and co-payments has been generally increasing each year as employers have been shifting a higher percentage of healthcare costs to employees.

Our revenues from Equity Owned Facilities, also known as Affiliates, are derived from management fees for services provided under management contracts.  As compensation for our management services, the hospitals and ASCs are charged management fees which are either fixed or are based on a percentage of the Affiliate’s cash collected or the Affiliate’s net revenue.  In addition, we own equity interests in all of our surgical hospitals and ASCs except for one, and we record our pro-rata share of the earnings of the

 

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affiliates in which we exhibit significant influence.  We do not exhibit significant influence in one of our equity owned hospitals and one of our ASCs and therefore we record revenue from these facilities on a cash basis which is included in other revenue.

Our revenues by type and payor and the respective percentages of revenues and equity in earnings of affiliates during 2015 and 2014 were as follows:

 

Commercial Payors

In addition to government programs, our hospitals are reimbursed by differing types of private payors including HMOs, PPOs, other private insurance companies and employers.  Our revenues from commercial payors were approximately $92.4 million, or 72% of total revenues for the year ended December 31, 2015.  To attract additional volume, most of our hospitals offer discounts from established rates to certain large group purchasers of healthcare services.  These discount programs often limit our ability to increase rates in response to increasing costs.  Generally, patients covered by HMOs, PPOs and other private insurers will be responsible for certain co-payments and deductibles.

In some cases, our hospitals do not have written contracts prior to providing services, commonly known as “out-of-network” services.  Our out-of-network third-party payors have traditionally paid for our services at a percentage of their allowed rates.

Medicare

Our revenues from Medicare were $25.1 million, or 20% of total revenues for the year ended December 31, 2015.  Medicare provides hospital and medical insurance benefits, regardless of income, to persons age 65 and over, some disabled persons and persons with end-stage renal disease.  Our managed hospitals are currently certified as providers of Medicare services.  Amounts received under the Medicare program are often significantly less than the hospital’s customary charges for the services provided.  Since 2003, Congress and the Centers for Medicare and Medicaid Services (the “CMS”) have made several sweeping changes to the Medicare program and its reimbursement methodologies, such as the implementation of the prescription drug benefit that was created by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “MMA”) and as the provisions of the Patient Protection and Affordable Care Act (the “ACA”) continue to be implemented.

Both of our Consolidated Hospitals have been, and continue to be, licensed Medicare providers and hence eligible to receive payment through a number of Medicare systems.  Our hospitals receive reimbursement for inpatient services under Medicare’s Inpatient Prospective Payment System.  Under this system, a hospital receives a fixed amount as reimbursement for inpatient hospital services based on each patient’s final assigned Medicare severity diagnosis-related group, or MS-DRG.

Each federal fiscal year (which begins October 1), MS-DRG rates are updated and their weights are recalibrated.  The index to update the MS-DRGs known as the “market basket” gives consideration to the inflation experienced by hospitals as well as entities outside the healthcare industry in purchasing goods and services.  For the past several years, however, the percentage increases to the prospective payment rates have been generally lower than the percentage increases in the costs of goods and services for hospitals.  Further, the ACA introduced new limitations on the increase in the market basket.  Our surgical hospitals generally focus on performing outpatient procedures and perform a relatively low number of Medicare inpatient cases.

Our surgical hospitals are subject to a separate Medicare payment system for outpatient services.  Most outpatient services provided by surgical hospitals are classified into groups called Ambulatory Payment Classifications (“APCs”) that are reimbursed by

 

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Medicare under the Outpatient Prospective Payment System (“OPPS”).  A Medicare payment rate has been established for each APC.  Depending on the services provided, a hospital may be paid for more than one APC for a patient visit.  CMS establishes a payment rate for each APC by multiplying the scaled relative weight for the APC by a conversion factor.  The payment rate is further adjusted to reflect geographic wage differences.

CMS has implemented a quality data reporting program for hospital outpatient care, known as the Hospital Outpatient Quality Data Reporting Program.  CMS has adopted a similar quality data reporting program for hospital inpatient services, known as the Hospital Inpatient Quality Reporting Program.  Hospitals that fail to report inpatient or outpatient data required for the quality measures selected by CMS in the form and manner required by CMS may incur a 2% reduction in the annual payment update factor.  Therefore, if we fail to provide quality data in the manner and form required by CMS, our surgical hospitals could be subject to a reduction of the Medicare payment update by 2%.  Any reduction would apply only to the payment year involved and would not be taken into account in computing the applicable payment update factor for a subsequent payment year.

Effective October 1, 2012, Medicare began offering incentive payments to hospitals for delivering high-quality care through a value-based purchasing program.  The incentives will be funded through a 1% deduction in the base MS-DRG payments for hospitals’ discharges.  The reductions will increase over subsequent years.  Hospitals must meet or exceed a baseline score on a set of predetermined clinical and patient experience measures.

Medicaid

Our revenues under the various state Medicaid programs, including state-funded managed care programs, were $1.0 million, or 1% of total revenues for the year ended December 31, 2015.  Medicaid programs are jointly funded by federal and state governments.  As the Medicaid program is administered by the individual states under the oversight of CMS in accordance with certain regulatory and statutory guidelines, there are substantial differences in reimbursement methodologies and coverage policies from state to state.  Many states have experienced shortfalls in their Medicaid budgets and are implementing significant cuts in Medicaid reimbursement rates.  Additionally, certain states control Medicaid expenditures through restricting or eliminating coverage of certain services.

Cost Reports

Because of our participation in the Medicare and Medicaid programs, we are required to meet certain financial reporting requirements.  Federal and some state regulations require the submission by us and our surgical hospitals of annual cost reports stating the revenues, costs and expenses associated with the services provided to Medicare beneficiaries and Medicaid recipients at those hospitals.

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.  It generally takes years to settle audits of these cost reports.  These audits are used for determining if any under- or over-payments were made by payors under these programs, setting payment levels for future years and detecting fraud.  Providers are required to make certain certifications with these cost report submissions, including that they are in compliance with law.  Such certifications, if incorrect and submitted knowingly or recklessly, may result in a False Claims Act, or FCA, liability.

Patient Self-Pay

Patient self-pay revenues are derived from patients who do not have any form of healthcare coverage.  Our revenues from self-pay patients were approximately $2.7 million, or 2% of total revenues for the year ended December 31, 2015.  The revenues associated with self-pay patients are generally reported at our gross charges.  We evaluate these patients, after the patient’s medical condition is determined to be stable, for qualifications of Medicaid or other governmental assistance programs.

Provision for Doubtful Accounts

To provide for accounts receivable that could become uncollectible in the future, we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value.  The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.  Our provision for doubtful accounts had the effect of reducing total revenues by $6.4 million, or 5% of total revenues for the year ended December 31, 2015.

We have an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance.  No single statistic or measurement determines the adequacy of the allowance for doubtful accounts.  Some of the analytical tools that we utilize include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status

 

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of claims submitted to third party payors, reason codes for declined claims and an assessment of our ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan.  Accounts receivable are written off after collection efforts have been followed in accordance with our policies.

Management Fees from Affiliates

Our management fees from affiliates were $5.4 million, or 4% of total revenues for the year ended December 31, 2015.  We have entered into agreements with most of our Equity Owned Facilities to provide management services, which basically include a variety of administrative services.  In addition, we have a management agreement with an ASC in which we don’t own an equity interest.  As compensation for these services, the hospitals and ASCs are charged management fees which are either fixed or are based on a percentage of the Affiliate’s cash collected or the Affiliate’s net revenue.  The percentages range from 2.25% to 6.0%.

Equity in Earnings of Affiliates

Our equity in earnings of affiliates in which we own non-controlling interests were $1.4 million for the year ended December 31, 2015.  We account for our investments in Equity Owned Facilities over which we exhibit significant influence, but not control, in accordance with the equity method of accounting.  We do not consolidate our equity method investments, but rather we measure them at their initial costs and then subsequently adjust their carrying values through income for our respective shares of the earnings or losses during the period.

Competition for Patients and Partners

In all of our markets, our facilities compete with other providers, including major acute care hospitals, other surgical hospitals, HOPDs and ASCs. General acute care hospitals have various competitive advantages over us, including their established managed care contracts, community position, physician loyalty and geographical convenience for physicians’ inpatient and outpatient practices. However, we believe that, in comparison to acute care hospitals, our surgical hospitals, HOPDs and ASCs compete favorably on the basis of cost, quality, efficiency and responsiveness to physician needs and a more comfortable environment for the patient.

We compete with other providers in our markets for patients, physicians and for contracts with insurers or managed care payors. Competition for managed care contracts with other providers is focused on the pricing, number of facilities in the market and affiliation with key physician groups in a particular market. We believe that our relationships with our hospital partners enhance our ability to compete for managed care contracts. We also encounter competition with other companies for acquisition and development of facilities and for strategic relationships with physicians.

There are several companies, both public and private, that have been acquiring and developing freestanding multi-specialty surgical hospitals and ASCs. Some of these competitors have greater resources than we do. The principal competitive factors that affect our ability and the ability of our competitors to acquire surgical hospitals and ASCs are price, experience, reputation and access to capital. Further, many physician groups develop ASCs without a corporate partner and this presents a competitive threat to our company.

Government Regulation

The healthcare industry is subject to extensive regulation by federal, state and local governments.  Government regulation affects our business by controlling growth, requiring licensing or certification of facilities, regulating how facilities are used and controlling payment for services provided.  Our ability to conduct our business and to operate profitably will depend in part upon obtaining and maintaining all necessary licenses, certificates of need and other approvals, and complying with applicable healthcare laws and regulations.  See “Risk Factors – Risks Related To Healthcare Regulation.”

Licensure, Certificate of Need and Change of Ownership Regulations

Capital expenditures for the construction of new facilities, the addition of capacity or the acquisition, relocation, change of ownership or change of control of existing facilities may be reviewable by state regulators under certificate of need, or CON, laws.  A certificate of need is a permit issued by a state health planning authority evidencing the authority’s opinion that a proposed facility or expansion is consistent with the need for the services to be offered by the facility.  States with CON laws often place limits on the number of facilities or operating rooms in a region, or restrict providers’ ability to build, relocate, expand or change the ownership control of healthcare facilities and services.  In some states, approvals are required for capital expenditures exceeding certain specified amounts or involving certain facilities or services, including surgical hospitals and ASCs.  Currently, Maryland is the only state we operate in with CON laws that affect acute hospital beds and ASCs.

 

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Our facilities are also subject to state and local licensing requirements ranging from the quality of care to compliance with building codes and environmental protection laws.  Governmental and other authorities periodically inspect our facilities to assure continued compliance with these regulations.  Failure to comply with these regulations could result in the suspension or revocation of a facility’s license or other penalties. In addition, as of December 31, 2014, all of our managed surgical hospitals and eight of our nine ASCs were accredited by either the AAAHC or DNV, two of the major national organizations that establish standards relating to the property, administration, quality of patient care and operation of medical staffs of various types of healthcare facilities.  For more information, see “Our Business—Recent Developments—New Equity Owned Hospital.” We have one ASC whose governing board has elected to not be accredited; however, we believe that it meets the requirements for accreditation.  Many commercial payors require facilities to be accredited to be a participating provider under their health plans.

Medicare and Medicaid Programs

Medicare is a federally funded and administered health insurance program, primarily for individuals entitled to social security benefits who are age sixty-five years or older or who are disabled.  Medicare prospectively determines fixed payment amounts for procedures performed at ASCs.  Medicare reimburses hospitals based on Medicare Severity Diagnosis Related Groups or DRGs.  Hospitals treating more severely ill patients receive greater reimbursements.  These amounts are adjusted for regional wage variations.

To participate in the Medicare program and receive Medicare payments, our facilities must comply with regulations promulgated by CMS.  Among other things, these regulations, known as “conditions for coverage” for ASCs and “conditions of participation” for hospitals, set forth requirements relating to the facility’s equipment, personnel, policies, standards of medical care and compliance with state and local laws and regulations.  All of our managed surgical hospitals and ASCs are certified in the Medicare program and are subject to on-site, unannounced surveys by state survey agencies working on behalf of CMS.  The frequency of on-site hospital and ASC surveys by state survey agencies has increased in recent years.  Failure to comply with Medicare’s conditions for coverage and conditions of participation may result in loss of payment or other governmental sanctions, including termination of participation in the Medicare program.  We have established ongoing quality assurance activities to monitor our facilities’ compliance with these conditions.

Medicaid is a health insurance program jointly funded by state and federal governments that provides medical assistance to qualifying low-income persons.  State Medicaid programs cover hospital services.  Each state Medicaid program has the option to provide payment for ASC services.  All of the states in which we currently operate provide Medicaid coverage for some ASC services; however, these states may elect to discontinue covering services, and states into which we expand our operations may not cover or continue to cover surgery center services.  Medicaid programs pay us a fixed payment for our services, and the amounts paid vary state to state.

Health Reform Initiatives

There have been numerous legislative and regulatory initiatives on the federal and state levels for comprehensive reforms affecting the payment for and availability of healthcare services.  On March 23, 2010, the ACA was signed into law.  The ACA included a number of provisions specific to our facilities as described below.

The ACA represents significant change to the healthcare industry.  The ACA includes provisions designed to change how healthcare services are covered, delivered and reimbursed through, among other things, expanded coverage of uninsured individuals, reduced growth in Medicare program spending and the establishment of programs where reimbursement is tied to quality.  The ACA also reforms certain aspects of health insurance, expands existing efforts to tie Medicare and Medicaid payments to performance and quality, and contains provisions intended to strengthen fraud and abuse enforcement.  On June 28, 2012, the United States Supreme Court upheld the constitutionality of key provisions of the ACA but struck down provisions that would have allowed the U.S. Department of Health and Human Services (the “HHS”) to penalize states that do not implement the Medicaid expansion provisions of the law with the loss of existing federal Medicaid funding.  As a result, some states may choose not to implement the Medicaid expansion, and fewer individuals will be covered by a state Medicaid program than would have been covered had the Supreme Court upheld the ACA in its entirety.

The ACA includes a number of reforms that will directly affect our facilities, including without limitation the reforms summarized below.

The ACA includes a provision requiring CMS to apply a negative productivity adjustment to the indexes used to update Medicare payment rates on an annual basis.  The productivity adjustment is to equal the 10-year moving average of changes in the annual economy-wide private non-farm business multi-factor productivity measure, as reported by the Bureau of Labor Statistics and updated in the spring of each year.  Hospital and ASC services were subject to this productivity adjustment starting in calendar year 2011.  As a result, the rate of increase in reimbursement was less in calendar year 2011 than it would have been in the absence of the productivity adjustment.  For example, ASCs would have seen an increase of 1.5%, but as a result of the -1.3% productivity

 

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adjustment mandated by the ACA, the increase was only 0.2%.  Thus, the practical impact of the productivity adjustment for ASCs and hospitals is to reduce the amount of annual rate increases from Medicare, potentially to an amount below zero (that is, the index-based increase may be outweighed by the productivity adjustment and as a result reimbursement rates would decline).  For our surgical hospitals, there is an additional downward adjustment for each of the following federal fiscal years as follows: 0.1% in 2013; 0.3% in 2014; 0.2% in 2015 and 2016 and 0.75% in 2017, 2018 and 2019.

Additionally, pursuant to the ACA, HHS submitted a report to Congress in 2011 outlining HHS’s plan to implement a value-based purchasing program for ASCs.  While the report describes efforts to improve quality and payment efficiency in ASCs and examines the steps required to design and implement an ASC value-based purchasing program, Congress has not yet authorized CMS to implement such a program.

The ACA established a new Independent Payment Advisory Board or IPAB, which, if a Medicare per capita target growth rate is exceeded, will develop and submit proposals for a Medicare spending reduction to the President and Congress beginning in 2014 for implementation in 2015.  This Board would have the authority to reduce Medicare payments to certain providers, including ASCs.  In addition, the Board is precluded from submitting proposals that reduce Medicare payments prior to December 31, 2019 for providers scheduled to receive a reduction in their payment updates as a result of the Medicare productivity adjustment, which currently includes our facilities.  There is strong opposition to the IPAB, and in March 2015, the American Hospital Association urged Congress to repeal the IPAB.

Based on the Congressional Budget Office’s February 2013 projection, the ACA will expand insurance coverage to approximately 27 million individuals currently lacking health insurance by 2022.

However, on July 2, 2013, the U.S. Department of Treasury announced that it will delay for one year the mandatory employer and insurer reporting requirements under the ACA.  Firms with 100 or more full-time equivalents, or FTEs, need to insure 70% of full-time workers by 2015 and 95% by 2016.  Firms with 50 to 99 FTEs must start providing coverage in 2016.  Further, the U.S. Department of Treasury announced on that date that it will delay the implementation of “shared responsibility payments” under the ACA, which are sometimes referred to as the “play-or-pay penalties.” In addition, a number of other delays to, waivers of and exemptions from other provisions of the ACA have been granted by the current Administration.  These delays, waivers and exemptions may reduce the number of individuals to whom coverage will be expanded by 2022 to a number below the projected number; however, the Robert Wood Foundation concluded in May 2014 that there would be no significant reduction.

The extent to which this expanded coverage and associated reimbursement may or may not offset other impacts of the ACA on our results is not clear at this time.  We believe healthcare reform initiatives will continue to develop during the foreseeable future.  If adopted, some aspects of previously proposed reforms, such as further reductions in Medicare or Medicaid payments, or additional prohibitions on physicians’ financial relationships with facilities to which they refer patients, could adversely affect us in a material way.

Federal Anti-Kickback Statute

State and federal laws regulate relationships among providers of healthcare services, including employment or service contracts and investment relationships.  These restrictions include a federal criminal law, referred to as the Anti-Kickback Statute, which prohibits knowingly and willfully offering, paying, soliciting or receiving any form of remuneration in return for:

Violations of the Anti-Kickback Statute may be punished by a criminal fine of up to $25,000 for each violation or imprisonment, civil money penalties of up to $50,000 per violation and damages of up to three times the total amount of the remuneration and/or exclusion from participation in federal healthcare programs, including Medicare and Medicaid.  The ACA provides that submission of a claim for services or items generated in violation of the Anti-Kickback Statute constitutes a false or fraudulent claim and may be subject to additional penalties under the FCA.

The Anti-Kickback Statute is broad in scope and the applicability of its provisions to many business transactions in the healthcare industry has not yet been subject to judicial or regulatory interpretation.  For example, the method by which investors in our limited partnerships or limited liability companies are selected, solicited, and issuances to, and redemptions from, referring physicians and all of our other financial dealings with physicians are subject to regulation by the Anti-Kickback Statute.  Courts have found a violation of the Anti-Kickback Statute if just one purpose of the remuneration is to generate referrals, even if there are other lawful

 

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purposes.  Furthermore, the ACA provides that knowledge of the law or intent to violate the law is not required to establish a violation of the Anti-Kickback Statute.

The Federal government pays particular attention to joint ventures and other transactions among healthcare providers, particularly joint ventures involving physicians and other referral sources.  In 1989, OIG published a fraud alert that outlined questionable features of “suspect” joint ventures, and the OIG has continued to refer to those fraud alerts in later pronouncements.  The OIG has also published regulations containing numerous “safe harbors” that exempt some practices from enforcement under the Anti-Kickback Statute.  These safe harbor regulations, if fully complied with, assure participants in particular types of arrangements that the OIG will not treat their participation as a violation of the Anti-Kickback Statute.  The safe harbor regulations do not expand the scope of activities that the Anti-Kickback Statute prohibits, nor do they provide that failure to satisfy the terms of a safe harbor constitutes a violation of the Anti-Kickback Statute.  The OIG has, however, indicated that failure to satisfy the terms of a safe harbor may subject an arrangement to increased scrutiny.

On November 19, 1999, the OIG promulgated a safe harbor applicable to ASCs.  The ASC safe harbor generally protects ownership or investment interests in a center by physicians who are in a position to refer patients directly to the center and perform procedures at the center on referred patients, if certain conditions are met.  More specifically, there are four (4) ASC safe harbors which protect any payment that is a return on an ownership or investment interest to an investor if certain standards are met.  Each safe harbor has its own specific standards that an arrangement must meet in order to rely upon it.  The four (4) ASC safe harbors are: (1) physician-owned surgery centers, (2) single-specialty surgery centers, (3) multi-specialty surgery centers and (4) hospital/physician surgery centers.  Set forth below are the requirements that must be met for each safe harbor to be applicable.

For ASCs that are considered “physician-owned surgery centers” and “single-specialty surgery centers,” the following standards, among others, apply:

For ASCs that are considered “multi-specialty” surgery centers, the following standards, among others, apply:

For ASCs that are considered “hospital/physician” surgery centers, to apply the safe harbor, (1) at least one investor must be a hospital; and (2) all of the remaining investors must be physicians who meet the safe harbor requirements of either: (a) physician-owned ASCs; (b) single–specialty ASCs; or (c) multi–specialty ASCs.  Additionally, the following eight (8) standards, among others, must be met:

 

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Entities that own facilities which provide services under the Medicare and Medicaid programs, and their respective physician partners and members, are subject to the Anti-Kickback Statute.  In cases where one of our subsidiaries is an investor in the partnership or limited liability company that owns the facility, and we or our subsidiary provides management and other services to the facility, our arrangements with physician investors do not meet all of the specific terms of the ASC safe harbor or any other safe harbor.  See “Risk Factors – Risks Related to Healthcare Regulation.”

However, we believe that our operations do not violate the Anti-Kickback Statute.  Moreover, we strive to ensure that our management services and lease agreements with facilities are consistent with our standards for documented fair market value for services and space provided to or received from the facilities or the physician partners at the facilities.

Federal Physician Self-Referral Law

The Stark Law prohibits any physician from referring patients to any entity for the furnishing of certain “designated health services” otherwise payable by Medicare or Medicaid, if the physician or an immediate family member has a financial relationship with the entity, unless an exception applies.  The Stark Law also prohibits entities that provide designated health services otherwise payable by Medicare or Medicaid from billing the Medicare and Medicaid programs for any items or services that result from a prohibited referral and requires the entities to refund amounts received for items or services provided pursuant to the prohibited referral.  As defined by the Stark Law, the term “financial relationship” includes both ownership (or investment) interests and compensation arrangements. Unlike safe harbors under the Anti-Kickback Statute with which compliance is voluntary, a financial relationship must comply with every requirement of a Stark Law exception in order to not violate the Stark Law.  Persons who violate the Stark Law are subject to potential civil money penalties of up to $15,000 for each bill or claim submitted in violation of the Stark Law and up to $100,000 for each “circumvention scheme” they are found to have entered into, and potential exclusion from the Medicare and Medicaid programs.  In addition, the Stark Law requires the denial (or refund, as the case may be) of any Medicare and Medicaid payments received for designated health services that result from a prohibited referral.

CMS has promulgated regulations to implement the Stark Law.  Under these regulations, services provided by an ASC that would otherwise constitute “designated health services” are excluded from the definition of that term if the services are reimbursed by Medicare as part of the ASC’s composite payment rate.  All services provided by our ASCs that would otherwise constitute designated health services are reimbursed by Medicare as part of the composite payment rate and are thus exempted from the Stark Law, with the exception of implants.  The Stark Law provides for a special exception for implants, such as intraocular lenses and artificial joints, furnished in ASCs as long as certain regulatory requirements are met.  These requirements provide that the implant must be implanted by the referring physician or a member of his or her group practice, that the implant be implanted during a surgical procedure reimbursed as an ASC procedure by Medicare, that the arrangement for the furnishing of the implant not violate the Anti-Kickback Statute and that the billing for the implant be conducted legally.  We believe the operations of our ASCs comply with these requirements and, consequently, that the Stark Law generally does not apply to services provided by our ASCs.  See “Risk Factors – Risks Related to Healthcare Regulation.”

Four of our facilities are surgical hospitals.  The Stark Law includes an exception that permits physicians to refer Medicare and Medicaid patients to hospitals in which they have an ownership interest if certain requirements are met.  Federal legislation enacted in

 

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2010 dramatically curtailed this exception and prohibits physician ownership in hospitals that did not have a Medicare provider agreement by December 31, 2010.  This prohibition does not apply to our managed surgical hospitals, each of which had a Medicare provider agreement prior to December 31, 2010 and are therefore able to continue operating with their existing ownership structure in compliance with the applicable exception.  However, the law prohibits “grandfathered” hospitals from increasing the percentage of physician ownership, and the law limits to a certain extent their ability to grow because it prohibits such hospitals from increasing the aggregate number of inpatient beds, operating rooms and procedure rooms.  In addition, the new law required all of our surgical hospitals with physician owners to adopt certain measures addressing potential conflicts of interest, ensuring that physician investments are bona fide and relating to patient safety.  We believe our facilities are in compliance with such requirements, but even the assertion of a violation of the Stark Law could have a material adverse effect upon us.

False and Other Improper Claims

The Federal 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.  False claims filed with private insurers can also lead to criminal and civil penalties.  While the criminal statutes are generally reserved for instances of fraudulent intent, the government applies criminal, civil and administrative penalty statutes to a range of circumstances, including coding errors, billing for services not provided, submitting false cost reports and submitting claims resulting from arrangements prohibited by the Stark Law or the Anti-Kickback Statute. Over the past decade or more, the government has accused an increasing number of healthcare providers of violating the FCA, which prohibits a person from knowingly presenting, or causing to be presented, a false or fraudulent claim to the United States.  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.  Violations of the FCA can result in awards of treble damages and significant per claim penalties.

Also, under the “qui tam” provisions of the FCA, private parties (“relators” or “whistleblowers”) may bring actions against providers on behalf of the Federal government.  Such private parties are entitled to share in any amounts recovered by the government through trial or settlement.  Qui tam cases are sealed by the court at the time of filing.  The only parties privy to the information contained in the complaint are the relator, the Federal government and the presiding court.

Both direct enforcement activity by the government and whistleblower lawsuits under the FCA have increased significantly in recent years and have increased the risk of healthcare companies like us having to defend a false claims action, repay claims paid by the government, pay fines or be excluded from the Medicare and Medicaid programs.  In addition, under the ACA, if we receive an overpayment, we must report and refund the overpayments before the later of 60 days after the overpayment was identified or the date any corresponding cost report is due, if applicable.  Any overpayment that is retained after this deadline is considered an obligation subject to an action under the FCA.

Although we believe that our operations materially comply with both federal and state laws, we and our healthcare facilities are involved from time to time in lawsuits, claims, audits and investigations, including “qui tam” cases under the False Claims Act and subpoenas and investigations by the DOJ and the OIG, and there can be no assurance that our business will not be harmed as a result.  See “Risk Factors – Risks Related to Healthcare Regulation.”

State Anti-Kickback, Physician Self-Referral and False Claims Laws

Many states, including those in which we do business, have laws that prohibit payment of kickbacks or other remuneration in return for the referral of patients.  Some of these laws apply only to services reimbursable under state Medicaid programs.  In most states, these laws have not been subjected to significant judicial and regulatory interpretation.  Noncompliance with these laws could subject us to penalties and sanctions and have a material adverse effect on us.  We believe that our operations are in material compliance with the physician self-referral laws of the states in which our facilities are located.

A number of states, including some of those in which we do business, have their own laws prohibiting the submission of false claims.  These laws may be modeled on the FCA and contain qui tam provisions.  Some state false claims acts can involve broader liability in terms of the costs that losing defendants must pay or the types of claims that are subject to the act.

Healthcare Industry Investigations and Audits

Both federal and state government agencies have increased their civil and criminal enforcement efforts in the healthcare industry and the ACA includes additional federal funding of $350 million to fight healthcare fraud, waste and abuse.  Investigations by government agencies have addressed a wide variety of issues, including billing practices and financial arrangements with referral sources.  In addition, the OIG and the DOJ have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse.  We and our healthcare facilities are involved from time to time in investigations by

 

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governmental agencies such as the DOJ and the OIG, any of which could result in significant liabilities and penalties, as well as adverse publicity.

In addition, government agencies and their agents may conduct audits of the operations of our facilities.  Under the Recovery Audit Contractor (“RAC”) program, CMS contracts with RACs on a contingency basis to conduct post-payment reviews to detect and correct improper Medicare payments.  The ACA expanded the scope of the RAC program to include Medicaid claims by requiring all states to enter into contracts with RACs to audit payments to Medicaid providers.  In addition to RACs, other contractors, such as Medicare Administrative Contractors and Medicaid Integrity Contractors, perform payment audits to identify and correct improper payments.

Health Information Privacy and Security Practices

The Health Insurance Portability and Accountability Act of 1996, or HIPAA, as amended by the American Recovery and Reinvestment Act of 2009, or ARRA, and the HIPAA Omnibus Rule of 2013 (“HIPAA Omnibus”), contains provisions that require covered entities, including most healthcare providers, to employ systems and procedures designed to protect individually identifiable health information, known as “protected health information.” Pursuant to HIPAA, HHS has promulgated privacy and security regulations that extensively regulate the use and disclosure of protected health information and require covered entities to implement administrative, physical and technical safeguards to protect the security of such information.  The ARRA contains provisions that broaden the scope of the HIPAA privacy and security regulations and strengthen HIPAA’s enforcement provisions.  As covered entities under HIPAA, both we and our facilities are required to comply with rules governing the use and disclosure of protected health information and to impose those rules, by contract, on any business associate to which such information is disclosed.  In other relationships, such as when we provide management or consulting services to another covered entity, we are subject to the rules applicable under HIPAA, ARRA and HIPAA Omnibus to business associates.  Pursuant to a rule issued to implement ARRA and amended by HIPAA Omnibus, business associates and their subcontractors are subject to direct liability under the HIPAA privacy and security regulations.  In addition, a covered entity may be subject to penalties as a result of its business associate violating the HIPAA privacy and regulations if the business associate is found to be an agent of the covered entity.

As required by ARRA and HIPAA Omnibus, covered entities must report breaches of unsecured protected health information to affected individuals without unreasonable delay and in no case later than 60 days after the discovery of the breach by the covered entity or its agents.  Notification must also be made to HHS and, in certain situations involving large breaches, to the media.  HHS is required to publish on its website a list of all covered entities that report a breach involving more than 500 individuals.  Pursuant to a rule issued to implement ARRA, and amended by HIPAA Omnibus, HHS has created a presumption that all non-permitted uses or disclosures of unsecured protected health information are breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised.  Various state laws and regulations may also require us to notify affected individuals in the event of a data breach involving individually identifiable information.

Violations of the HIPAA privacy and security regulations may result in civil and criminal penalties.  ARRA and HIPAA Omnibus increased the amount of civil penalties for HIPAA violations, with penalties now ranging up to $50,000 per violation and a maximum civil penalty of $1.5 million in a calendar year for violations of the same requirement.  In addition, ARRA and HIPAA Omnibus authorizes state attorneys general to bring civil actions seeking either injunction or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.

States may impose more protective privacy and security laws, and both state and federal laws are subject to modification or enhancement of privacy and security protection at any time.  Our facilities will continue to remain subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA.  These statutes vary and could impose additional requirements on us and more severe penalties for breaches of privacy.

HIPAA Transactions and Code Sets Standards

HIPAA and its implementing regulations establish electronic data transmission standards that all healthcare providers must use for certain electronic healthcare transactions, such as submitting claims for payment for medical services.  The ACA requires the adoption of standards for additional electronic transactions and provides for the creation of operating rules to promote uniformity in the implementation of each standardized electronic transaction. Under HIPAA, HHS has also published a final rule requiring the use or updated standard code sets for certain diagnoses and procedures known as ICD-10 code sets.  Use of the ICD-10 code sets is required beginning October 1, 2015.  It is possible that our facilities could experience disruptions or delays in payment due to the implementation of new electronic data transmission standards and the transition to ICD-10 code sets.

 

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Federal Emergency Medical Treatment and Active Labor Act

The federal Emergency Medical Treatment and Active Labor Act (“EMTALA”) applies to our five surgical hospitals.  EMTALA requires hospitals participating in the Medicare program, including those without emergency rooms, to evaluate individuals who present with emergencies, provide initial stabilizing treatment and refer or transfer patients where appropriate.  Possible liability for a violation of EMTALA includes a civil action by the patient as well as civil monetary penalties and exclusion from participation in the Medicare program.

Antitrust Laws

The federal government and most states have enacted antitrust laws that prohibit certain types of conduct deemed to be anti-competitive.  These laws prohibit price fixing, concerted refusal to deal, market monopolization, price discrimination, tying arrangements, acquisitions of competitors and other practices that have, or may have, an adverse effect on competition.  Violations of federal or state antitrust laws can result in various sanctions, including criminal and civil penalties.  Antitrust enforcement in the healthcare industry is currently a priority of the Federal Trade Commission (the “FTC”).  Some of our operating activities are subject to regulation by the antitrust laws.  For example, the exchange of pricing information in connection with the creation of a joint venture or an acquisition, the formation of joint ventures with large health systems and the negotiation of our commercial payor contracts by our health system partners are all regulated by the antitrust laws.  We undertake to conduct all of our business operations in compliance with these laws.  The U.S. Department of Justice (the “DOJ”) and the FTC, the two agencies charged with enforcing the federal antitrust laws, have promulgated a series of “Statements Antitrust Enforcement Policy in Health Care.” These statements provide a series of “safety zones.” A “safety zone” describes conduct that the FTC and the DOJ will not challenge under the antitrust laws, absent extraordinary circumstances.  Our activities do not necessarily fall within any of these safety zones.  Nevertheless, we believe that our operations are in compliance with the antitrust laws, but courts or regulatory authorities may reach a contrary conclusion, and such a conclusion could adversely affect our operations.

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 admission of Medicare and Medicaid patients must be reviewed by quality improvement organizations, which review the appropriateness of Medicare and Medicaid patient admissions and discharges, the quality of care provided, the validity of diagnosis related group classifications and the appropriateness of cases of extraordinary length of stay or cost.  Quality improvement organizations may deny payment for services provided or assess fines and also have the authority to recommend to HHS that a provider which is in substantial noncompliance with the standards of the quality improvement organization be excluded from participation in the Medicare program.

Employees

As of December 31, 2015, we and our Equity Owned Facilities employed 1,232 people, 873 of whom were full-time employees and 359 of whom were part-time employees.  Of our employees, 111 are corporate employees, primarily based at our headquarters in Oklahoma City, Oklahoma.  None of these employees are represented by a union.  We believe our relationship with our employees to be good.

A detail of our employees as of December 31, 2015 follows:

 

Investor Information

Financial and other information about our company is available on our website, www.fdnh.com.  The information on our website is not incorporated by reference into this annual report on Form 10-K and should not be considered to be part of this annual report on Form 10-K.  We make available on our website, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as soon as reasonably practicable after filing such material

 

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electronically or otherwise furnishing it to the Securities and Exchange Commission (the “SEC”).  In addition, the public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549.  The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Our filings with the SEC may be accessed through the SEC's website at www.sec.gov.

Risks Related to Our Business

We will require significant amounts of additional financing to execute our business plan and fund our other liquidity needs.  If our operating results do not meet or exceed our projections, we may be unable to continue operations and could be forced to substantially curtail operations or cease operations all together.

On December 31, 2015, we completed a refinancing of substantially all of our outstanding indebtedness through the execution of a Credit Agreement, or the TCB Credit Facility, with Texas Capital Bank, National Association, or TCB.  The TCB Credit Facility provides for a term loan in the principal amount of $28.4 million, referred to as the Term Loan, and a revolving line of credit of $12.5 million, referred to as the Revolving Loan, for total principal of $40.9 million.  We believe our cash on hand, the $1.0 million available on the Revolving Loan and projected cash flow from operations will provide us enough liquidity to meet our cash requirements over the next 12 months.  However, if our cash flows from operations do not meet or exceed our projections, we may need to raise additional funds through debt or equity financings.

We have a bank credit facility of approximately $41 million and we may not maintain compliance with certain financial covenants.  These covenants and other provisions of the credit facility could also have a negative impact on our liquidity or restrict our activities.

Under the Loan Agreement covering the TCB Credit Facility we agreed to continuously maintain compliance with the following financial covenants (collectively referred to as “Debt Ratios”):

Debt to EBITDA Ratio.  As of December 31, 2015, we must maintain a Debt to EBITDA Ratio not in excess of 3.50 to 1.00.  Thereafter, we must maintain a Debt to EBITDA Ratio as of the last day of any fiscal quarter, not in excess of (a) 3.25 to 1.00 for the fiscal quarters ending December 31, 2015, March 31, 2016, June 30, 2016 and September 30, 2016; (b) 2.75 to 1.00 for the fiscal quarters ending December 31, 2016, March 31, 2017, June 30, 2017 and September 30, 2017; (c) 2.50 to 1.00 for the fiscal quarters ending December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018; and (d) 2.25 to 1.00 for the fiscal quarter ending December 31, 2018 and at the end of each fiscal quarter thereafter.

Senior Debt to EBITDA Ratio.  As of December 31, 2015, we must maintain a Senior Debt to EBITDA Ratio not in excess of 3.00 to 1.00.  Thereafter, we must maintain a Senior Debt to EBITDA Ratio as of the last day of any fiscal quarter, not in excess of (a) 3.00 to 1.00 for the fiscal quarters ending December 31, 2015, March 31, 2016, June 30, 2016 and September 30, 2016; (b) 2.50 to 1.00 for the fiscal quarters ending December 31, 2016, March 31, 2017, June 30, 2017 and September 30, 2017; (c) 2.25 to 1.00 for the fiscal quarters ending December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018; and (d) 2.00 to 1.00 for the fiscal quarter ending December 31, 2018 and at the end of each fiscal quarter thereafter.

Pre-Distribution Fixed Charge Coverage Ratio.  We must maintain as of the last day of any fiscal quarter a Pre-Distribution Fixed Charge Coverage Ratio not in excess of 1.30 to 1.00.

Post-Distribution Fixed Charge Coverage Ratio.  We must maintain as of the last day of any fiscal quarter, a Post-Distribution Fixed Charge Coverage Ratio not in excess of 1.05 to 1.00.

As of December 31, 2015, we were in compliance with the Debt Ratios.  If we are unsuccessful in complying with the Debt Ratios, there is no assurance that our Lenders will waive or delay the requirement.

 

In addition to these financial covenants, the TCB Credit Facility also contains various other provisions that limit our ability to engage in specified types of transactions.  The TCB Credit Facility has restrictive covenants that, among other things, restricts our ability to do the following without the consent of TCB:

 

 

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A breach of any of these covenants could result in a default under the TCB Credit Facility.

Moreover, in addition to the general defaults of failure to perform our obligations under the Loan Agreement, events of default also include the occurrence of a change in control, as defined, and the loss of our Medicare or Medicaid certification, collateral casualties, entry of a uninsured judgment of $500,000 or more, failure of first liens on collateral and the termination of any of our management agreements that represent more than 10% of our management fees for the preceding 18 month period.  In the event of a monetary default, all of our obligations due under the TCB Credit Facility shall become immediately due and payable.  In the event of a non-monetary default, we have 10 days, or in some cases three days, to cure before TCB has the right to declare our obligations due under the TCB Credit Facility immediately due and payable.  If TCB accelerates the payment of outstanding principal and interest, we will need to file a current report on Form 8-K with the SEC disclosing the event of default and the acceleration of payment of all principal and interest.  In addition, we do not expect to be able to pay all outstanding principal and interest if TCB accelerates the due dates for such amounts.  Since we have granted TCB a security interest in all of our assets, TCB could elect to foreclose on such assets.  If TCB declares an event of default and/or accelerate the payment of our obligations under the TCB Credit Facility, then the disclosure of such fact may cause a material decrease in the price of our stock.  The declaration of an event of default and the move to foreclose on our assets may cause a material adverse effect on our ability to operate our business in the ordinary course of business as well as a material adverse effect on our liquidity, results of operations and financial position.

Our overall leverage and the terms of the TCB Credit Facility could:

Material weaknesses in the design and operation of the internal control over financial reporting of companies that we acquire could have a material adverse effect on our financial statements.

We intend to continue to grow our business through the acquisition of existing facilities or interests in such facilities.  When we acquire such businesses or interests, our due diligence may fail to discover defects or deficiencies in the design and operations of the internal controls over financial reporting of such businesses, or defects or deficiencies in the internal controls over financial reporting may arise when we try to integrate the operations of these newly acquired businesses with our own.  We can provide no assurances that we will not experience such issues in future acquisitions, the result of which could have a material adverse effect on our financial statements.

We have experienced and may continue to see the growth of uninsured and “patient due” accounts, and deterioration in the collectability of these accounts which would adversely affect our collections of accounts receivable, revenues, results of operations and cash flows.

The primary collection risks associated with 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 doubtful accounts relates primarily to amounts due directly from patients.  This risk has increased, and will likely continue to increase, as more individuals enroll in high deductible insurance plans or those with high co-payments or who have no insurance coverage.  These trends will likely be exacerbated if general economic conditions remain challenging or if unemployment levels in the communities in which we operate rise.  As a result of such

 

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conditions, our business strategies to generate organic growth and to improve admissions and adjusted admissions at our facilities could become more difficult to accomplish.

The amount of our provision for doubtful accounts 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 comprised 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 ACA seeks to decrease, over time, the number of uninsured individuals.  Among other things, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, collectively referred to as the ACA, incentivizes states to expand their Medicaid eligibility requirements and incentivizes employers to offer, and requires individuals to carry, health insurance or be subject to penalties.  However, it is difficult to predict the full impact of the ACA due to its complexity, lack of implementing regulations and interpretive guidance, gradual and potentially delayed implementation, and possible amendment, as well as our inability to foresee how individuals, businesses and states will respond to the choices afforded them by the ACA.  In addition, even after implementation of the ACA, we may continue to experience uncollectible accounts 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.

Controls designed to reduce inpatient services may reduce our revenues.

Controls imposed by Medicare, Medicaid, 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.  Federal law contains numerous provisions designed to ensure that services rendered by healthcare facilities 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 must be reviewed by quality improvement organizations, which review the appropriateness of Medicare and Medicaid patient admissions and discharges, the quality of care provided, the validity of diagnosis related group, or MS-DRG, classifications and the appropriateness of cases of extraordinary length of stay or cost on a post-discharge basis.  Quality improvement organizations may deny payment for services or assess fines and also have the authority to recommend to the U.S. Department of Health and Human Services, or HHS, that a provider which is in substantial noncompliance with the standards of the quality improvement organization be excluded from participation in the Medicare program.  The ACA potentially expands the use of prepayment review by Medicare contractors by eliminating statutory restrictions on their use. As a result, efforts to impose more stringent cost controls are expected to continue.  Utilization review is also a requirement of most non-governmental managed care organizations and other third-party payors.  Inpatient utilization, average lengths of stay and occupancy rates continue to be negatively affected by payor-required preadmission authorization and utilization review and by third party payor pressure to maximize outpatient and alternative healthcare delivery services for less acutely ill patients.  Although we are unable to predict the effects of these controls and changes, they could have a material, adverse effect on our business, financial position and results of operations.

The healthcare industry trend towards value-based purchasing may negatively impact our revenues.

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 currently require healthcare facilities to report certain quality data to receive full reimbursement updates.  In addition, Medicare does not reimburse for care related to certain preventable adverse events.  Many large commercial payors currently require healthcare facilities to report quality data, and several commercial payors do not reimburse healthcare facilities for certain preventable adverse events.

The ACA contains a number of provisions intended to promote value-based purchasing.  Effective July 1, 2011, the ACA prohibits the use of federal funds under the Medicaid program to reimburse providers for medical assistance provided to treat hospital acquired conditions (“HAC”s).  Beginning in federal fiscal year (“FFY”) 2015, hospitals that fall into the top 25% of national risk-adjusted HAC rates for all hospitals in the previous year will receive a 1% reduction in their total Medicare payments.  Another provision reduces payments for all inpatient discharges for hospitals that experience excessive readmissions for certain conditions designated by HHS.

The ACA also requires HHS to implement a value-based purchasing program for inpatient hospital services.  The ACA requires HHS to reduce inpatient hospital payments for all discharges by a percentage beginning at 1% in FFY 2013 and increasing by 0.25% each fiscal year up to 2% in FFY 2017 and subsequent years.  HHS will pool the amount collected from these reductions to fund payments to reward hospitals that meet or exceed certain quality performance standards established by HHS.  HHS will determine the amount each hospital that meets or exceeds the quality performance standards will receive from the pool of dollars created by these payment reductions.

 

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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 negatively impact our revenues.

The lingering effects of the economic recession could materially adversely affect our financial position, results of operations or cash flows.

Certain segments and regions of the U.S. economy continue to experience the negative effects from an economic recession, and unemployment levels, in these segments and regions, remain relatively high.  While certain healthcare spending is considered non-discretionary and may not be significantly impacted by economic downturns, other types of healthcare spending may be adversely impacted by such conditions.  When patients are experiencing personal financial difficulties or have concerns about general economic conditions, they may choose:

We are unable to determine the specific impact of these economic conditions on our business at this time, but we believe that the lingering effects of the economic recession could have an adverse impact on our operations and could impact not only the healthcare decisions of our patients, but also the solvency of managed care providers and other counterparties to transactions with us.

The failure of certain employers, or the closure of certain manufacturing and other facilities in our markets, can have a disproportionate impact on our facilities.

The economies in the non-urban communities in which our facilities primarily 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 facilities for care.  The failure of one or more large employers, or the closure or substantial reduction in the number of individuals employed at manufacturing or other facilities located in or near many of the non-urban communities in which our facilities primarily 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 revenues and results of operations or impede our business strategies intended to generate organic growth and improve operating results at our facilities.

We may have difficulty acquiring healthcare facilities or interest in them on favorable terms.

One element of our business strategy is expansion through the acquisition of healthcare facilities, such as surgical hospitals or ASCs, or interests in such facilities, primarily in non-urban markets.  We face significant competition to acquire attractive facilities, and we may not find suitable acquisitions on favorable terms.  Our primary competitors for acquisitions have included for-profit and tax-exempt hospitals and hospital systems and privately capitalized start-up companies.  Buyers with a strategic desire for any particular healthcare facility, for example, a hospital located near existing hospitals or those who will realize economic synergies, have demonstrated an ability and willingness to pay premium prices for such facilities.  Strategic buyers, as a result, can present a competitive barrier to our acquisition efforts.

Given the increasingly challenging regulatory and enforcement environment, our ability to acquire healthcare facilities or interests in them could be negatively impacted if targets are found to have material unresolved compliance issues.  We may condition our purchase on the resolution of such issues.  We could experience delays in closing or fail to close transactions with targets that initially were attractive but became unattractive as a result of a poor compliance program, material non-compliance with laws or failure to timely address compliance risks.

The cost of an acquisition could have a negative effect on our results of operations, depending on various factors, including the amount paid for the acquisition, the acquired facility’s results of operations, allocation of purchase price, effects of subsequent legislation and limitations on rate increases.  In the past, we have occasionally experienced temporary delays in improving the operating margins or effectively integrating the operations of our acquired facilities.  In the future, if we are unable to improve the operating margins of acquired facilities, operate them profitably or effectively integrate their operations, we may be unable to achieve our growth strategy.

 

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Even if we are able to identify an attractive target, we may not be able to obtain financing, if necessary, for any acquisitions or joint ventures that we might undertake.  We will need capital to execute our growth strategy and may finance future acquisitions and development projects through debt or equity financings.  Disruptions to financial markets or other adverse economic conditions may adversely impact our ability to complete any such financing or the terms of any such financing.  To the extent that we undertake these financings, our stockholders may experience ownership dilution.  To the extent we incur debt, we may have significant interest expense and may be subject to covenants in the related debt agreements that affect the conduct of our business.  If we do not have sufficient capital resources, our growth could be limited and our results of operations could be adversely impacted.  Our TCB Credit Facility requires that we comply with financial covenants and may not permit additional borrowing or other sources of debt financing, especially if we are not in compliance with those covenants.  We can give you no assurances that we will be able to obtain financing necessary for our acquisition and development strategy or that, if available, the financing will be available on terms acceptable to us.  Our failure to acquire facilities or interests in them consistent with our growth plans could prevent us from increasing our revenues.

In recent years, the legislatures and attorneys general of several states have become more interested in sales of hospitals by tax-exempt entities.  This heightened scrutiny may increase the cost and difficulty, or prevent the completion, of transactions with tax-exempt organizations in the future.

We can give you no assurances that we will be successful in acquiring or developing suitable facilities, that the businesses we acquire and develop will achieve satisfactory operating results or that newly developed facilities will not incur greater than expected operating losses.

We may encounter difficulty operating, integrating and improving financial performance at acquired facilities.

We may be unable to timely and effectively integrate any facilities that we acquire with our ongoing operations.  We may experience delays in implementing operating procedures and systems in newly acquired facilities.  Integrating an acquired facility could be expensive and time consuming and could disrupt our ongoing business, negatively affect cash flow and distract management and other key personnel.  In addition, acquisition activity requires transitions from, and the integration of, operations and, usually, information systems that are used by acquired businesses.  In addition, we may not be able to achieve improved financial performance at acquired facilities within our targeted time frames, or continue to improve financial performance for sustained periods following the acquisition.

Loss of members of our senior management or failure to attract other highly qualified personnel could adversely affect the combined company’s operations.

We depend on the continued service of members of our senior management and other qualified personnel for the success of our business.  For example, we rely on our Chairman, Thomas A. Michaud, for identification, completion and integration of new acquisitions and development opportunities given his connections in the market for surgical hospitals, ASCs and ancillary service facilities.  We also rely on our Chief Executive Officer, Stanton Nelson, for his leadership of our company and its operation as a public company as well as his experience identifying and completing acquisitions and in raising both equity and debt financing.  The loss of services of any of the members of our senior management or such qualified personnel could adversely affect our business until a suitable replacement can be found.  There can be no assurance that we will be able to identify or employ such qualified personnel on acceptable terms or on a timely basis, which could cause a disruption to our business.

If we do not effectively attract, recruit and retain qualified physicians, our ability to deliver healthcare services efficiently will be adversely affected.

As a general matter, only physicians on our medical staffs may direct admissions and the services ordered once a patient is admitted to one of our facilities.  As a result, the success of our facilities depends in part on the number and quality of the physicians on the medical staffs of our facilities, the admitting practices of those physicians and maintaining good relations with those physicians.

The success of our efforts to recruit and retain quality physicians depends on several factors, including the actual and perceived quality of services provided by our facilities, our ability to meet demands for new technology and our ability to identify and communicate with physicians who want to practice in non-urban communities.  In particular, we face intense competition in the recruitment and retention of specialists because of the difficulty in convincing these individuals of the benefits of practicing or remaining in practice in non-urban communities.  If the non-urban communities in which our facilities primarily operate are not seen as attractive, then we could experience difficulty attracting and retaining physicians to practice in our communities.  In this regard, in some of the markets in which we operate, there are shortages of physicians in our targeted specialties.  In addition, in some of these markets, hospitals are recruiting physicians or groups of physicians to become employed by the hospitals, including primary care physicians and physicians in our targeted specialties, and restricting those physicians’ ability to refer patients to physicians and facilities not affiliated with the hospital.  In addition, physicians, hospitals, payors and other providers may form integrated delivery systems or utilize plan structures that restrict the physicians who may treat certain patients or the facilities at which patients may be

 

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treated.  These restrictions may impact our facilities and the medical practices of our physician partners.  We may not be able to recruit all of the physicians we target.  In addition, we may incur increased costs, expenses or other liabilities, such as those relating to malpractice if the quality of physicians we recruit does not meet our expectations.

From time to time, we have had and may have future disputes with physicians who use or own interests in our facilities.  Our revenues and profitability may be adversely affected if a key physician or group of physicians stop using or reduce their use of our facilities as a result of changes in their physician practice, changes in payment rates or systems, or a disagreement with us.  In addition, if the physicians who use our facilities do not provide quality medical care or follow required professional guidelines at our facilities or there is damage to the reputation of a physician or group of physicians who use our facilities, our business and reputation could be damaged.

Additionally, our ability to recruit physicians is closely regulated.  For example, the types, amount and duration of assistance we can provide to recruited physicians are limited by the federal physician self-referral law, referred to as the Stark law, a federal criminal law which prohibits knowingly and willfully offering, paying, soliciting or receiving any form of remuneration in return for referring patients for services or items payable under a federal healthcare program or purchasing, leasing, ordering or arranging for any good, facility, service or item for which payment may be made in whole or in part by a federal healthcare program.  The Stark law requires, among other things, that recruitment assistance can only be provided to physicians who meet certain geographic and practice requirements, that the amount of assistance cannot be changed during the term of the recruitment agreement, and that the recruitment payments cannot generally benefit physicians currently in practice in the community beyond recruitment costs actually incurred by them.  In addition to these legal requirements, there is competition from other communities and facilities for these physicians, and this competition continues after the physician is practicing in one of our communities.

The loss of certain physicians can have a disproportionate impact on certain of our facilities.

Certain physicians generate a relatively large amount of revenue at our facilities compared to other physicians.  For example, the top ten attending physicians within each of our hospitals generally represent a large share of our inpatient revenues and admissions.  The loss of any such physicians, even if temporary, could cause a material reduction in our revenues and operating profits at any of our facilities, which could take significant time to replace given the difficulty and costs associated with recruiting and retaining physicians.

Our facilities face competition for staffing, which may increase labor costs and reduce profitability.

In addition to our physicians, the operations of our facilities are dependent on the efforts, abilities and experience of our facilities management and medical support personnel, such as nurses, pharmacists and lab technicians.  We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our facilities, including nurses and other non-physician healthcare professionals.  In some markets, the scarce availability of nurses and other medical support personnel presents a significant operating issue.  This shortage may require us to enhance wages and benefits to recruit and retain nurses and other medical support personnel, recruit personnel from foreign countries, and hire more expensive temporary or contract personnel.  In addition, the states in which we operate could adopt mandatory nurse-staffing ratios or could reduce mandatory nurse staffing ratios already in place.  State-mandated nurse-staffing ratios could significantly affect labor costs and have an adverse impact on revenues if we are required to limit admissions in order to meet the required ratios.  If our labor costs increase, we may not be able to raise rates to offset these increased costs.  We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate.  Because a significant percentage of our revenue consists of fixed, prospective payments, our ability to pass along increased labor costs is constrained.  Our failure to recruit and retain qualified management, nurses and other medical support personnel or to control our labor costs could have a material adverse effect on our financial condition or results of operations.

We are subject to risks associated with outsourcing functions to third parties.

To improve operating margins, productivity and efficiency, we outsource selected nonclinical business functions to third parties.  We take steps to monitor and regulate the performance of independent third parties to whom we delegate selected functions, including revenue cycle management, patient access, billing, cash collections, payment compliance and support services, project implementation, supply chain management and payroll services.

Arrangements with third party service providers may make our operations vulnerable if vendors fail to satisfy their obligations to us as a result of their performance, changes in their own operations, financial condition, or other matters outside of our control.  The expanding role of third party providers may also require changes to our existing operations and the adoption of new procedures and processes for retaining and managing these providers, as well as redistributing responsibilities as needed, in order to realize the potential productivity and operational efficiencies.  Effective management, development and implementation of our outsourcing strategies are important to our business.  If there are delays or difficulties in enhancing business processes or our third party providers

 

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do not perform as anticipated, we may not fully realize on a timely basis the anticipated economic and other benefits of the outsourcing projects or other relationships we enter into with key vendors, which could result in substantial costs, divert management’s attention from other strategic activities, negatively affect employee morale or create other operational or financial problems for us.

Terminating or transitioning arrangements with key vendors could result in additional costs and a risk of operational delays, potential errors and possible control issues as a result of the termination or during the transition phase.

Other healthcare facilities provide services similar to those which we offer.  In addition, physicians provide services in their offices that could be provided in our facilities.  These factors increase the level of competition we face and may therefore adversely affect our revenues, profitability and market share.

Competition among healthcare service providers has intensified in recent years.  We compete with other healthcare service providers, including larger tertiary care centers located in larger metropolitan areas, and with physicians who provide services in their offices which could otherwise be provided in our facilities.  Although the healthcare service providers with which we compete may be a significant distance away from our facilities, patients in our markets may migrate on their own to, may be referred by local physicians to, or may be encouraged by their health plan to travel to these third party facilities.  Furthermore, some of the healthcare service providers with which we compete may offer more or different services than those available at our facilities, may have more advanced equipment or may have a medical staff that is thought to be better qualified.  Also, some of the healthcare service providers that compete with our facilities are owned by tax-supported governmental agencies or not-for-profit entities supported by endowments and charitable contributions.  These healthcare service providers, in many instances, are also exempt from paying sales, property and income taxes.

Quality of care and value-based purchasing have also become significant trends and competitive factors in the healthcare industry.  In 2005, the Centers for Medicare and Medicaid Services, or CMS, began making public performance data relating to ten quality measures that healthcare facilities submit in connection with their Medicare reimbursement.  Since that time, CMS has on several occasions increased the number of quality measures these facilities are required to report in order to receive the full Inpatient Prospective Payment System and Outpatient Prospective Payment System market basket updates.  In addition, the Medicare program no longer reimburses healthcare facilities for care relating to certain preventable adverse events, and many private healthcare payors have adopted similar policies.  If the public performance data become a primary factor upon which patients choose to receive care, and if competing healthcare facilities have better results than our facilities on those measures, we would expect that our patient volumes could decline.

We also face very significant and increasing competition 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).  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 will likely decrease in the future.

If we do not continually enhance our facilities with the most recent technological advances in diagnostic and surgical equipment, our ability to maintain and expand our markets may be adversely affected.

Technological advances, including with respect to computer-assisted tomography scanner (CTs), magnetic resonance imaging (MRIs) and robotic surgery devices, continue to evolve.  In addition, the manufacturers of such equipment often provide incentives to try to increase their sales, including providing favorable financing to higher credit risk organizations.  In an effort to compete, we must continually assess our equipment needs and upgrade our equipment as a result of technological improvements.  We believe that the level of patient traffic correlates directly to the quality and level of sophistication of such diagnostic and surgical equipment.  If we don’t maintain our facilities with diagnostic and surgical equipment that is in-line with current technological advances, we may lose patient traffic and our revenues may be materially reduced.

We may be subject to liabilities because of malpractice and other legal claims, which may not be covered by insurance.

We have been and may continue to be subject to medical malpractice lawsuits and other legal actions arising out of the operations of our owned and leased facilities and the activities of our employed physicians.  These actions may involve large claims and significant defense costs.  In an effort to resolve one or more of these matters, we may choose to negotiate a settlement.  Amounts we pay to settle any of these matters may be material.  Although we maintain professional and general liability insurance with unrelated commercial insurance carriers to provide for losses in excess of our deductible amount, claims could exceed the scope of the coverage in effect, or coverage of particular claims could be denied.  In this regard, as of December 31, 2015, most of our ASC’s limits on professional insurance and general insurance policies are each $2,000,000 per occurrence and $4,000,000 aggregate per year.  

 

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The rest of the ASC’s and the Hospitals each have $1,000,000 per occurrence/$3,000,000 aggregate per year.  If we are required to pay material amounts which are not covered by insurance, it could have a material adverse effect on our cash position, cash flows from operations and net income.

Our failure to successfully implement our growth plan may adversely affect our financial performance.

We intend to grow incrementally through acquisitions of healthcare facilities or interests in them.  As this growth plan is pursued, we may encounter difficulties expanding and improving our operating and financial systems to maintain pace with the increased complexity of the expanded operations and management responsibilities.

The success of our growth strategy will also depend on a number of other factors, including:

The failure of our growth strategy may have a material adverse effect on our operating results and financial condition.

If we acquire businesses with unknown or contingent liabilities, we could become liable for material obligations.

We have directly or indirectly assumed liabilities of businesses that we have acquired or obtained an interest in, and may continue to do so in the future.  There may be liabilities or risks that we fail, or are unable, to discover, or that we underestimate, in the course of performing our due diligence investigations of such businesses.  Additionally, businesses that we have acquired, invested in, or may acquire or invest in at some point in the future may have made previous acquisitions, and we will be subject to certain liabilities and risks relating to these prior acquisitions as well.  Examples of such liabilities and risks include failure to comply with healthcare laws and regulations, medical and general professional liabilities, worker’s compensation liabilities, tax liabilities and unacceptable business practices.  We cannot assure you that our rights to indemnification contained in agreements that we have entered or may enter into will be sufficient in amount, scope or duration to fully offset the possible liabilities associated with the business or property acquired.  Any such liabilities, individually or in the aggregate, could have a material adverse effect on our business, financial condition or results of operations.  As we begin to operate acquired businesses, we may learn additional information about them that adversely affects us, such as unknown or contingent liabilities, issues relating to compliance with applicable laws or issues related to ongoing operations.  Unexpected liabilities could have a material adverse impact on our business.

The goodwill and other intangible assets acquired pursuant to our acquisitions of healthcare facilities may become impaired and require write-downs and the recognition of substantial impairment expense.  Goodwill and other intangible assets related to future acquisitions may require additional write-downs and the recognition of additional substantial impairment expense.

At December 31, 2015, we had $10.4 million and $7.0 million in goodwill and other intangible assets, respectively, that were recorded in connection with the acquisitions of our facilities.  We periodically evaluate whether or not to take an impairment charge on our goodwill, as required by the applicable accounting literature.  Our evaluation is based on our (i) assessment of current and expected future economic conditions, (ii) trends, strategies and forecasted cash flows at each business unit and (iii) assumptions similar to those that market participants would make in valuing our business units.  We did not identify any impairment during our evaluation of goodwill and intangible assets completed during 2015.

In the event that this goodwill or other intangible assets are determined to be impaired for any reason, we will be required to write-down or reduce the value of the goodwill and recognize an impairment expense.  The impairment expense may be substantial in amount and adversely affect the results of our operations for the applicable period and may negatively affect the market value of our common stock.

Also, in the event that we record additional goodwill or other intangibles on future acquisitions and we subsequently determine the goodwill or other intangibles to be impaired for any reason, we will be required to write-down or reduce the value of the goodwill

 

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and recognize an impairment expense.  The impairment expense may be substantial in amount and adversely affect the results of our operations for the applicable period and may negatively affect the market value of our common stock.

We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

Our ability to make scheduled debt payments or to refinance our existing debt obligations depends on our financial condition and operating performance, both of which are subject to prevailing economic and competitive conditions and to certain financial, business, and other factors beyond our control.  We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our existing indebtedness.

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay planned investments and capital expenditures, or to sell assets, seek additional capital, or restructure or refinance our indebtedness.  Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time.  Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations.  The terms of existing or future debt instruments may restrict us from adopting some of these alternatives.  In addition, any failure to make payments of interest and principal on our outstanding indebtedness on a timely basis would likely harm our ability to incur additional indebtedness.  These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations, which could have a material adverse impact on our business.

Our business may be negatively impacted by weather and other factors beyond our control.

The financial condition and results of operations of our facilities may be adversely impacted by adverse weather conditions, including tornados or earthquakes, or other factors beyond our control that cause disruption of patient scheduling, displacement of our patients, employees and physician partners, and force certain of our facilities to close temporarily.  In certain geographic areas, we have a relatively large concentration of facilities that may be simultaneously affected by adverse weather conditions or events.  Our future financial and operating results may be adversely affected by weather and other factors that disrupt the operation of our facilities.

Failure to maintain the security and functionality of our information systems, or to defend a cyber security attack, could result in a violation of HIPAA, a breach of patient privacy and could adversely affect our business, financial position, results of operation and liquidity.

 

We are dependent on the proper function and availability of our information systems and related software programs.  Though we have taken steps to protect the safety and security of our information systems and the patient health information and other data maintained within those systems, there can be no assurance that our safety and security measures and disaster recovery plan will prevent damage, interruption or breach of our information systems and operations.  Our information systems require an ongoing commitment of significant resources to maintain, protect and enhance existing systems and develop new systems to keep pace with continuing changes in technology, evolving industry and regulatory standards, and changing customer preferences.  Because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently and may be difficult to detect for long periods of time, we may be unable to anticipate these techniques or implement adequate preventive measures.  In addition, hardware, software or applications we develop or procure from third parties may contain defects in design or manufacture or other problems that could unexpectedly compromise information security.  Unauthorized parties may also attempt to gain access to our systems or facilities, or those of third parties with whom we do business, through fraud, trickery or other forms of deceiving our employees or contractors.

 

 In addition, certain software supporting our business and information systems are licensed to us by third party software developers.  Our inability, or the inability of these developers, to continue to maintain and upgrade our information systems and software could disrupt or reduce the efficiency of our operations.  In addition, costs and potential problems and interruptions associated with the implementation of new or upgraded systems and technology or with maintenance or adequate support of existing systems also could disrupt or reduce the efficiency of our operations.

 

A cyber security attack or other incident that bypasses our information systems security could cause a security breach which may lead to a material disruption to our information systems infrastructure or business and may involve a significant loss of business or patient health information.  If a cyber security attack or other unauthorized attempt to access our systems or facilities were to be successful, it could result in the theft, destructions, loss, misappropriation or release of confidential information or intellectual property, and could cause operational or business delays that may impact materially our ability to provide various healthcare services.  Any successful cyber security attack or other unauthorized attempt to access our systems or facilities also could result in negative publicity which could damage our reputation or brand with our patients, referral sources, payors or other third parties and could subject us to substantial penalties under HIPAA and other federal and state privacy laws, in addition to private litigation with those affected.

 

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Failure to maintain the security and functionality of our information systems and related software, or to defend a cyber security attack or other attempt to gain unauthorized access to our systems, facilities or patient health information could expose us to a number of adverse consequences, the vast majority of which are not insurable, including but not limited to disruptions in our operations, regulatory and other civil and criminal penalties, fines, investigations and enforcement actions (including, but not limited to, those arising from the SEC, FTC, or state attorneys general), fines, private litigation with those affected by the data breach, loss of customers, disputes with payors and increased operating expense, which either individually or in the aggregate could have a material adverse effect on our business, financial position, results of operations and liquidity.

Risks Related to Healthcare Regulation

We cannot predict the effect that the ACA and its implementation may have on our business, financial condition or results of operations.

The ACA was signed into law, in two parts, on March 23, 2010 and March 30, 2010.  The ACA dramatically alters the U.S. healthcare system.  It will change how healthcare services are covered, delivered and reimbursed including its intended decrease of the number of uninsured Americans and reduction of the overall cost of healthcare.  The ACA 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 disproportionate share hospital (“DSH”) payments to providers, expanding the Medicare program’s use of value-based purchasing programs, tying Medicare and Medicaid reimbursement to the satisfaction of certain quality criteria, bundling payments to hospitals and other providers, and instituting certain private health insurance reforms as well as stating an intent to increase enforcement of fraud and abuse laws and increase cooperation between various federal agencies.  This increased enforcement and cooperation is intended to be achieved by establishing mechanisms for the sharing of information between federal agencies and enhancement of criminal and administrative penalties for non-compliance.  Although a majority of the measures contained in the ACA just recently became effective, 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 2010, 2011 and 2012, respectively.  Although the expansion of health insurance coverage should increase revenues from providing care to certain previously uninsured individuals, several of these provisions of the ACA have been delayed.  For example, the ACA’s employer mandate, will require certain larger employers that do not offer health insurance benefits to their employees to make “shared responsibility payments” if even a single employee obtains government-subsidized coverage through the Health Insurance Marketplace, has been delayed until January 1, 2015 for employers with 100 or more employees and January 1, 2016 for employers with 50 to 99 employees.  The impact of such expansion may be gradual and may not offset scheduled decreases in reimbursement.

On June 28, 2012, the U.S. Supreme Court upheld the constitutionality of the ACA, including the “individual mandate” provisions of the ACA that generally require all individuals to obtain healthcare insurance or pay a penalty.  However, the U.S. Supreme Court also held that the provision of the ACA that authorized the Secretary of HHS to penalize states that choose not to participate in the expansion of the Medicaid program by removing all of their existing Medicaid funding was unconstitutional.  In response to the ruling, a number of U.S. governors, including those of some states in which we operate, have stated that they oppose their state’s participation in the expanded Medicaid program, which could result in the ACA not providing coverage to some low-income persons in those states.  In addition, several bills have been and may continue to be introduced in Congress to repeal or amend all or significant provisions of the ACA.  Furthermore there is also pending litigation which has been appealed to the U.S. Supreme Court challenging the federal government granting subsidies to individuals who purchase coverage on the healthcare insurance marketplace.

Currently, it is difficult to predict or assess the full impact of the ACA on the healthcare industry.  The net effect of the ACA on our business is subject to numerous variables, including the law’s complexity, lack of complete implementing regulations and interpretive guidance, gradual and potentially delayed implementation or possible amendment, as well as the uncertainty as to the extent to which states will choose to participate in the expanded Medicaid program.  As a result, we are unable to predict the net effect on our business, financial condition or results of operations of the expected increases in insured individuals using our facilities, the reductions in government healthcare reimbursement spending, and numerous other provisions of the ACA that may affect us.  We are also unable to predict how providers, payors, employers and other market participants will respond to the various reform provisions because many provisions will not be implemented for several years under the ACA’s implementation schedule.  Further, we are unable to predict the outcome of new or remaining court challenges and the impact of continued legislative efforts to delay implementation of or amend the ACA.  As a result, one or more of these variables could have a material adverse effect on our business, financial condition, results of operation or cash flows.

 

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Our revenues will decline if federal or state programs reduce our Medicare or Medicaid payments or if managed care companies reduce reimbursement amounts.  In addition, the financial condition of payors and healthcare cost containment initiatives may limit our revenues and profitability.

In 2015, we derived 21% of our revenues from the Medicare and Medicaid programs, collectively.  The Medicare and Medicaid programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations concerning patient eligibility requirements, funding levels and the method of calculating payments or reimbursements and requirements for utilization review, among other things, and federal and state funding restrictions, which could materially increase or decrease payments from these government programs in the future, as well as affect the timing of payments to our facilities.

We are unable to predict the effect of future government healthcare funding policy changes on our operations.  If the rates paid by governmental payors are reduced, if the scope of services covered by governmental payors is limited or if we or one or more of our facilities are excluded from participation in the Medicare or Medicaid program or any other government healthcare program, there could be a material adverse effect on our business, financial condition, results of operations or cash flows.  In addition, revenues from HMOs, PPOs and other private payors are subject to contracts and other arrangements that require us to discount the amounts we customarily charge for healthcare services.

During the past several years, healthcare payors, such as federal and state governments, insurance companies and employers, have undertaken initiatives to revise payment methodologies and monitor healthcare costs.  As part of their efforts to contain healthcare costs, payors increasingly are demanding discounted fee structures or the assumption by healthcare providers of all or a portion of the financial risk related to paying for care provided, often in exchange for exclusive or preferred participation in their benefit plans.  Similarly, many individuals and employers have attempted to reduce their healthcare costs by moving to private payor plans that reimburse our facilities at significantly lower rates than other competing private payors.  We expect efforts to impose greater discounts and more stringent cost controls by government and private payors to continue, thereby reducing the payments we receive for our services.  In addition, payors have instituted policies and procedures to substantially reduce or limit the use of inpatient 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 realignments in the MS-DRG system could impact the margins we receive for certain services.  Furthermore, the ACA and taxpayer relief laws such as the American Taxpayer Relief Act, provide for material reductions in the growth of Medicare program spending, including reductions in Medicare market basket updates, and Medicare DSH funding.

In addition, the Budget Control Act of 2011 (the “BCA”) requires automatic spending reductions of $1.2 trillion for FFY 2013 through 2021, minus any deficit reductions enacted by Congress and debt service costs.  These reductions have been extended through FFY 2024.  The percentage reduction for Medicare may not be more than 2% for a FFY, with a uniform percentage reduction across all Medicare programs.  These BCA-mandated spending cuts are commonly referred to as “sequestration.” Sequestration began on March 1, 2013, and CMS imposed a 2% reduction on Medicare claims as of April 1, 2013.  We cannot predict with certainty what other deficit reduction initiatives may be proposed by Congress or whether Congress will attempt to restructure or suspend sequestration.

On November 2, 2015, the Bipartisan Budget Act (the “BBA”) was passed with limitations on the reimbursement rates for Hospital off-campus Outpatient Departments.  For off-campus outpatient surgical facilities, the BBA limits Medicare reimbursements to the ASC payment system rather than the higher outpatient prospective payment system or HOPD rates.  The BBA becomes effective on January 1, 2017, and affects any off-campus outpatient departments not in place prior to November 2, 2015.  The BBA reduces the incentive for growing the hospitals with additional surgical outpatient departments.    

Two of our hospitals are certified as providers of Medicaid services.  Medicaid programs are jointly funded by federal and state governments and are administered by states under an approved plan that provides healthcare benefits to qualifying individuals who are unable to afford care.  A number of states, however, are experiencing budget problems and have adopted or are considering legislation designed to reduce their Medicaid expenditures, including enrolling Medicaid recipients in managed care programs and imposing additional taxes on hospitals to help finance or expand such states’ Medicaid systems.  It is possible that budgetary pressures will force states to resort to some of the cost saving measures mentioned above.  These efforts could have a material adverse effect on our business, financial condition, results of operations or cash flows.

Managed care plans have increased their market share in some areas in which we operate, which has resulted in substantial competition among healthcare providers for inclusion in managed care contracting and may limit the ability of healthcare providers to negotiate favorable payment rates.  In addition, managed care payors may lower reimbursement rates in response to increased obligations on payors imposed by healthcare laws, such as the ACA, or future reductions in Medicare reimbursement rates.  Further, payors may utilize plan structures, such as narrow networks or tiered networks that limit patient provider choices or impose significantly higher cost sharing obligations when care is obtained from providers in a disfavored tier.  We can give you no assurances that future changes to reimbursement rates by government healthcare programs, cost containment measures by private third-party

 

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payors, including fixed fee schedules and capitated payment arrangements, or other factors affecting payments for healthcare services will not adversely affect our future revenues, operating margins or profitability.

We are subject to increasingly stringent governmental regulation, and may be subjected to allegations that we have failed to comply with governmental regulations which could result in sanctions and even greater scrutiny that reduce our revenues and profitability.

All participants in the healthcare industry are required to comply with many laws and regulations at the federal, state and local government levels.  These laws and regulations require that our facilities meet various requirements, including those relating to ownership and control, hospitals’ and ASCs’ relationships with physicians and other referral sources, the adequacy and quality of medical care, providing emergency care, credentialing and qualifications of medical and other ancillary support persons, inpatient admission criteria, privacy and security of health information, standards for equipment, personnel, operating policies and procedures, billing and cost reports, payment for services and supplies, handling of overpayments, maintenance of adequate records, compliance with building codes and environmental protection, relationships between referral sources and our facilities, antitrust, and various state licensing standards and requirements among other matters.  Many of the laws and regulations applicable to the healthcare industry are complex, and there are numerous enforcement authorities, including CMS, the Office of the Inspector General, or OIG, State Attorneys General, and contracted auditors, as well as whistleblowers.  Some positions taken in connection with enforcement appear to be inconsistent with historical common practices within the industry but have not previously been challenged.  Moreover, as a result of the provisions of the ACA that created potential False Claims Act, or FCA, liabilities for failing to report and repay known overpayments and return an overpayment within sixty (60) days of the identification of the overpayment or the date by which a corresponding cost report is due, whichever is later, hospitals and other healthcare providers are encouraged to disclose potential violations of law.

Hospitals continue to be one of the primary focal areas of the OIG and other governmental fraud and abuse programs.  In January 2005, the OIG issued Supplemental Compliance Program Guidance for Hospitals that focuses on hospital compliance risk areas.  Some of the risk areas highlighted by the OIG include correct outpatient procedure coding, revising admission and discharge policies to reflect current CMS rules, submitting appropriate claims for supplemental payments such as pass-through costs and outlier payments and a general discussion of the fraud and abuse risks related to financial relationships with referral sources.  Each FFY, the OIG also publishes a General Work Plan that provides a brief description of the activities that the OIG plans to initiate or continue with respect to the programs and operations of HHS and details the areas that the OIG believes are prone to fraud and abuse.

The laws and regulations with which we must comply are complex and subject to change.  In the future, different interpretations or enforcement of these laws and regulations could subject our 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.  If we fail to comply with applicable laws and regulations, we could suffer civil or criminal penalties, including the loss of our licenses to operate our facilities and our ability to participate in the Medicare, Medicaid and other federal and state healthcare programs.

We are also subject to various federal, state and local statutes and ordinances regulating the discharge of materials into the environment.  Our healthcare operations generate medical waste, such as pharmaceuticals, biological materials and disposable medical instruments that must be disposed of in compliance with federal, state and local environmental laws, rules and regulations.  Our operations are also subject to various other environmental laws, rules and regulations.  Environmental regulations also may apply when we renovate or refurbish hospitals or other facilities, particularly ones that are older.  Any of the governmental authorities that regulate us in the statues where we currently operate may consider enhancing, enforcing or establishing new requirements.  Our failure to comply with any of these requirements could have a material adverse effect on our business, financial condition, results of operation or cash flows.

As a result of increased reviews of claims to Medicare and Medicaid for our services, we may incur additional costs and may be required to repay amounts already paid to us.

We are subject to regular post-payment inquiries, investigations and audits of the claims we submit to Medicare for payment for our services.  These post-payment reviews are increasing as a result of government cost containment initiatives, including enhanced medical necessity reviews for Medicare patients admitted as inpatients to general acute care hospitals for certain procedures (e.g., cardiovascular procedures) and audits of Medicare claims under the Recovery Audit, or RAC, programs.  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, short stays, incorrect payment amounts, non-covered services and duplicate payments.  The claims review strategies used by the RACs generally include a review of high dollar claims, including inpatient hospital claims.  As a result, a large majority of the total amounts recovered by RACs has come from hospitals.  In addition, CMS has announced a pre-payment demonstration project that will allow RACs to review claims before they are paid to ensure that the provider complied with all Medicare payment rules.  Under the demonstration project, RACs conduct prepayment reviews on certain types of claims that historically result in high rates of improper payments, beginning with those involving short stay inpatient hospital services.  

 

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These reviews will focus on certain states with high populations of fraud and error-prone providers (including the state of Texas in which we operate) and other states that have high claims volumes involving short inpatient hospital stays.  The demonstration project began on August 27, 2012 and will run for a three year period.

The ACA expanded the RAC program’s scope to include managed Medicare and to include Medicaid claims, and all states are now required to establish programs to contract with RACs.  In addition, CMS employs Medicaid Integrity Contractors (“MICs”) to perform post-payment audits of Medicaid claims and identify overpayments.  The ACA increases federal funding for the MIC program for FFY 2011 and later years.  In addition to RACs and MICs, the state Medicaid agencies and other contractors have also increased their review activities.  Any such audit or investigation could have a material adverse effect on the results of our operations.

As a result of increased reviews from third party payors of claims for our services, we may incur additional costs and may be required to repay amounts already paid to us.

We are subject to regular post-payment inquiries, investigations and audits of the claims we submit to third party payors for payment for our services.  These post-payment reviews are increasing as a result of cost containment initiatives, including enhanced medical necessity reviews, managed care arrangements and audits of claims.  Third party payors have also targeted out of network providers with allegations of over billing and sought to obtain claw backs of payments made.  The claims review strategies used by the third party payors generally include a review of high dollar claims, including inpatient hospital claims, facility fees and surgical fees.  As a result, a large majority of the total amounts recovered by third party payors has come from large providers and hospitals.  Any such audit or investigation could have a material adverse effect on the results of our operations.

In this regard, two of our subsidiaries, Foundation Surgery Affiliates, LLC and Foundation Surgery Management, LLC, are currently defendants in a lawsuit in the United States District Court for the Eastern District of Pennsylvania initially filed by Aetna Life Insurance Company, or Aetna, on June 5, 2013 and amended on December 2, 2013.  Aetna sought an accounting, money damages, in amounts that would be material, and injunctive relief related to, among other things, allegedly improper referral inducements to physicians, waivers of deductibles and other payments, and non-disclosures by physician of their ownership interests in the Huntingdon Valley ASC with respect to Aetna patients such that patients would utilize out-of network providers at excessive cost to Aetna.  In a recent decision on the parties’ motions for summary judgment, the Court ruled in favor of the Foundation defendants on all but two of the nine counts.  The Court’s decision on the partial summary judgment is currently on appeal to the 3^rd Circuit.

Also in this regard, our El Paso Hospital has recently sued Aetna for improper recoupment of third party reimbursements.  The action was initially brought in the Texas District Court for El Paso County and Aetna has recently removed it to federal court.  

If federal or state laws or regulations prohibit physician ownership of our facilities, it may become necessary for us to purchase some or all of the ownership interests then owned by the physician owners.  Alternatively, we may be asked to renegotiate some of our arrangements with our physician partners and management agreements with our facilities.

In general, physicians have an ownership interest in our facilities.  For example, all of our surgical hospitals and ASCs currently have physician owners.  Due to statutory and regulatory changes or changes in the interpretation of existing laws or regulations, we may be required to purchase the ownership interests in our facilities currently held by our physician partners.  In such an event, we would have to reevaluate the relationship the facility has with such physician partners including referrals in order to ensure we are in compliance with federal and state fraud and abuse laws.  In the event we are required to purchase any of our physician partners’ equity interests, it may negatively impact our existing cash resources or have a material adverse effect on our business.  In addition, if we purchase physician partners’ equity interests in physician-owned hospitals then we may not later be able to sell that interest to another potential physician partner as a result of the ACA.

If we fail to comply with the Anti-Kickback Statute, we could be subject to criminal and civil penalties, loss of licenses and exclusion from governmental programs, which may result in a substantial loss of revenues.

The Anti-Kickback Statute prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for referring, ordering, leasing, purchasing or arranging for or recommending the ordering, purchasing or leasing of items or services payable by Medicare, Medicaid or any other federally funded healthcare program.  The Anti-Kickback Statute is broad in scope, and many of its provisions have not been uniformly or definitively interpreted by existing case law or regulations.  Courts have found a violation of the Anti-Kickback Statute if just one purpose of the remuneration is to generate referrals, even if there are other lawful purposes.  Violations of the Anti-Kickback Statute may result in substantial civil or criminal penalties, plus three times the remuneration involved or the amount claimed and exclusion from participation in the Medicare and Medicaid programs.  Our exclusion from participation in such programs would have a material adverse effect on our business, prospects, results of operations and financial condition.  In addition, many of the states in which we operate have also adopted laws, similar to the Anti-Kickback Statute, that prohibit payments to physicians in exchange for referrals, some of which apply regardless of the source of payment for care.  These statutes typically impose criminal and civil penalties, including the loss of a license to do business in the state.

 

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In July 1991, HHS issued final regulations defining various “safe harbors” under the Anti-Kickback Statute.  Two of the original safe harbors issued in 1991 apply to business arrangements similar to those used in connection with our surgical facilities.  Business arrangements that meet the requirements of the safe harbors are deemed to be in compliance with the Anti-Kickback Statute.  Business arrangements that do not meet the safe harbor requirements do not necessarily violate the Anti-Kickback Statute, but may be subject to scrutiny by the Federal government to determine compliance.

In November 1999, HHS issued final regulations creating additional safe harbor provisions, including a safe harbor that applies to physician ownership of, or investment interests in, ASCs.  However, our ASC arrangements do not comply with all of the requirements of the ASC safe harbor and, therefore, are not immune from government review or prosecution.

Although we believe that our business arrangements do not violate the Anti-Kickback Statute or similar state laws, a government agency or a private party may assert a contrary position.  Additionally, new federal or state laws may be enacted that would cause our relationships with our physician partners to become illegal or result in the imposition of penalties against us or our facilities.  If any of our business arrangements with physician partners were alleged or deemed to violate the Anti-Kickback Statute or similar laws, or if new federal or state laws were enacted rendering these arrangements illegal, it could have a material adverse effect on our business, prospects, results of operations and financial condition.

We and our healthcare facilities are involved from time to time in lawsuits, claims and investigations, and we may be subjected to actions brought by the government under anti-fraud and abuse provisions under the False Claims Act, any of which could result in substantial costs, divert management’s attention, adversely affect our business condition, or harm our reputation, regardless of their merit or outcome.

Because of the nature of our business, we and our healthcare facilities are involved from time-to-time in lawsuits, claims, audits and investigations, including “qui tam” cases under the False Claims Act and subpoenas and investigations by the DOJ and the OIG, such as those arising out of services provided, arrangements with physicians, personal injury claims, professional liability claims, billing and marketing practices, employment disputes and contractual claims.  Any of these lawsuits, claims, audits or investigations could result in substantial costs, divert management’s attention, adversely affect our business condition, or harm our reputation, regardless of their merit or outcome.

In addition, over the past several years, the federal government has accused an increasing number of healthcare providers of violating the federal False Claims Act which prohibits providers from, among other things, knowingly submitting false claims for payment to the federal 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.  The “qui tam” or “whistleblower” provisions of the False Claims Act allow private individuals to bring actions under the False Claims Act on behalf of the government.  These private parties are entitled to share in any amounts recovered by the government, and, as a result, the number of “whistleblower” lawsuits that have been filed against providers has increased significantly in recent years.  Defendants found to be liable under the federal False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties ranging between $5,500 and $11,000 for each separate false claim.  The statute of limitations for billing errors can extend to up to ten years.  Since our facilities jointly perform thousands of similar procedures, should any allegations of billing error with payment from Medicare or Medicare occur, it could have a material adverse effect on our business and result in civil or criminal penalties.  Qui tam cases are initially sealed by the court when they are filed.  The only parties that are initially aware a qui tam action has been filed are the whistleblower, the federal government and the court in which the matter was filed.  Therefore, it is possible for qui tam lawsuits to be filed against us or our facilities, and possibly without our knowledge.

There are many potential bases for liability under the False Claims Act.  The government has used the False Claims Act to prosecute Medicare and other government healthcare program fraud such as coding errors, billing for services not provided, submitting false cost reports, and providing care that is not medically necessary or that is substandard in quality.  Under the ACA, any overpayment by Medicare or Medicaid received by our facilities must be reported and repaid within sixty days of when it was identified as an overpayment.  Failure to report and submit repayment within this time period may subject the facility or facilities not in compliance to FCA action.  The ACA also provides that claims submitted in connection with patient referrals that result from violations of the Anti-kickback Statute constitute false claims for the purposes of the federal False Claims Act, and some courts have held that a violation of the Stark law can result in False Claims Act liability, as well.  In addition, a number of states have adopted their own false claims and whistleblower provisions whereby a private party may file a civil lawsuit in state court.  We are required to provide information to our employees and certain contractors about state and federal false claims laws and whistleblower provisions and protections.

In this regard, Foundation and its subsidiary, Foundation Surgery Affiliates, LLC, are defendants in a qui tam lawsuit in the United States District Court for the District of Maryland filed by Dr. Mary DuPont, as the Relator.  Dr. DuPont asserts that the Surgery Center of Chevy Chase and its management companies violated the False Claims Act and the Anti-Kickback Statute in the

 

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forced divestment of Dr. DuPont for low referrals.  The government declined to intervene and the case was unsealed in November 2014.  The Foundation defendants have denied the allegations.    

Although we intend and will endeavor to conduct our business in compliance with all applicable federal and state fraud and abuse laws, many of these laws are broadly worded and may be interpreted or applied in ways that cannot be predicted.  Therefore, we cannot assure you that our arrangements or business practices will not be subject to government scrutiny or be found to be in compliance with applicable fraud and abuse laws.  Should any of our facilities be found liable of violating the FCA, it could have a material adverse effect on our business.

If we fail to effectively and timely implement electronic health record systems, our operations could be adversely affected.

As required by The American Recovery and Reinvestment Act of 2009, as amended, or ARRA, the Secretary of HHS has developed and implemented an incentive payment program for eligible hospitals and healthcare professionals that adopt and use electronic health record (“EHR”) technology.  Currently, the ARRA incentive payment program does not apply to ASCs.  HHS uses the Provider Enrollment, Chain and Ownership System (“PECOS”) to verify Medicare enrollment prior to making EHR incentive program payments.  If our hospitals and employed professionals are unable to meet the requirements for participation in the incentive payment program, including having an enrollment record in PECOS, we will not be eligible to receive incentive payments that could offset some of the costs of implementing EHR systems.  Further, beginning in FFY 2015, eligible hospitals and professionals that fail to demonstrate meaningful use of certified EHR technology may be subject to reduced payments from Medicare.  System conversions to comply with EHR could be time consuming and disruptive for physicians and employees.  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 are in process of converting certain of our clinical and patient accounting information system applications to newer versions of existing applications or all together new applications at several of our facilities.  In connection with our implementations and conversions, we have incurred significant capitalized costs and additional training and implementation expenses.  In addition, EHR incentive payments previously recognized are subject to audit and potential recoupment if it is determined that we did not meet the applicable meaningful use standards required in connection with such incentive payments.

All healthcare providers, including our facilities, are currently required to begin using the new 10th revision of the International Statistical Classification of Diseases and Related Health Problems, a medical classification list by the World Health Organization, or ICD-10 coding system, as of October 1, 2015.  The new ICD-10 will vastly increase the number of billing codes and provide for more detailed billing codes.  The transition to ICD-10 requires the training of staff and changes to software.  The additional ICD-10 codes also may result in decreased reimbursement.  Upon the implementation of the new ICD-10, it is anticipated that there may be significant delays in payment due to technical or coding errors or other implementation issues involving either our systems or health plans and third party payors.

If we fail to comply with physician self-referral laws as they are currently interpreted or may be interpreted in the future, or if other legislative restrictions are issued, we could incur substantial monetary penalties and a significant loss of revenues.

The federal physician self-referral law, commonly referred to as the Stark Law, prohibits a physician from making a referral to an entity for the furnishing of certain “designated health services” otherwise payable under Medicare or Medicaid if the physician or a member of the physician’s immediate family has a financial relationship with the entity, such as an ownership interest or compensation arrangement, unless an exception applies.  The Stark Law also prohibits entities that provide designated health services otherwise payable by Medicare or Medicaid from billing the Medicare and Medicaid programs for any items or services that result from a prohibited referral and requires the entities to refund amounts received for items or services provided pursuant to the prohibited referral.  HHS, acting through CMS, has promulgated regulations implementing the Stark Law.  These regulations exclude health services provided by an ASC from the definition of “designated health services” if the services are included in the facility’s composite Medicare payment rate.  Therefore, the Stark Law’s self-referral prohibition generally does not apply to health services provided by an ASC.  However, if the ASC is separately billing Medicare for designated health services that are not covered under the ASC’s composite Medicare payment rate, or if either the ASC or an affiliated physician is performing (and billing Medicare) for procedures that involve designated health services that Medicare has not designated as an ASC service, the Stark Law’s self-referral prohibition would apply and such services could implicate the Stark Law.  We believe that our operations do not violate the Stark Law, as currently interpreted. All services provided by our ASCs that would otherwise constitute designated health services are reimbursed by Medicare as part of the composite payment rate and are thus subject to an exception from the Stark Law, with the exception of implants.  The Stark Law provides for a special exception for implants, such as intraocular lenses and artificial joints, furnished in ASCs as long as certain regulatory requirements are met.  These requirements provide that the implant must be implanted by the referring physician or a member of his or her group practice, that the implant be implanted during a surgical procedure reimbursed as an ASC procedure by Medicare, that the arrangement for the furnishing of the implant not violate the Anti-Kickback Statute and that the billing for the implant be conducted legally.  In addition, we believe that physician ownership of ASCs is not prohibited by similar self-referral statutes enacted at the state level.  However, the Stark Law and similar state statutes are subject to different interpretations

 

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with respect to many important provisions.  Moreover, the Stark Law applies to other of our facilities, including surgical hospitals.  Violations of these self-referral laws may result in substantial civil or criminal penalties, including large civil monetary penalties and exclusion from participation in the Medicare and Medicaid programs.  If physician self-referral laws are interpreted differently or if other legislative restrictions are issued, we could incur significant sanctions and loss of revenues, or we could have to change our arrangements and operations in a way that could have a material adverse effect on our business, prospects, results of operations and financial condition.

The federal Stark law restricts the ability of our surgical hospitals to expand surgical capacity.

The Stark Law provides an exception which permits physicians to refer Medicare and Medicaid patients to hospitals in which they have an ownership interest, if certain requirements are met.  However, the ACA vastly limited this exception by prohibiting physician ownership in hospitals which did not have a Medicare provider agreement in place as of December 31, 2010.  This prohibition does not impact our hospitals as they all had a Medicare provider agreement in place prior to December 31, 2010.  Therefore, our “grandfathered” facilities are permitted to continue to operate under the same ownership structure in place prior to the ACA.  However, the ACA prohibits our “grandfathered” hospitals from increasing their percentage of physician ownership, and prohibits “grandfathered” hospitals from increasing the number of inpatient beds, operating rooms and procedure rooms, thereby limiting the ability of the “grandfathered” hospitals to grow.

Companies within the healthcare industry continue to be the subject of federal and state audits and investigations, and we may be subject to such audits and investigations, including actions for false and other improper claims.

Federal and state government agencies, as well as commercial payors, have increased their auditing and administrative, civil and criminal enforcement efforts as part of numerous ongoing investigations of healthcare organizations.  These audits and investigations relate to a wide variety of topics, including the following: cost reporting and billing practices; quality of care; financial reporting; financial relationships with referral sources; and medical necessity of services provided.  In addition, the OIG and the U.S. Department of Justice (“DOJ”) have, from time to time, undertaken national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse.

The Federal 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.  While the criminal statutes are generally reserved for instances of fraudulent intent, the Federal government is applying its criminal, civil and administrative penalty statutes in an ever-expanding range of circumstances, including claiming payment for unnecessary services if the claimant merely should have known the services were unnecessary and claiming payment for low-quality services if the claimant should have known that the care was substandard.  In addition, a violation of the Stark Law or the Anti-Kickback Statute can result in liability under the FCA.

Over the past several years, the Federal government has accused an increasing number of healthcare providers of violating the FCA, which prohibits a person from knowingly presenting, or causing to be presented, a false or fraudulent claim to the Federal 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.  Violators of the FCA are subject to severe financial penalties, including treble damages and per claim penalties in excess of $10,000.  Because our facilities perform hundreds or thousands of similar procedures each year for which they are paid by Medicare, and since the statute of limitations for such claims extends for six years under normal circumstances (and possibly as long as ten years in the event of failure to discover material facts), a repetitive billing error or cost reporting error could result in significant, material repayments and civil or criminal penalties.

We are also subject to various state laws and regulations, as well as contractual provisions with commercial payors that prohibit us from submitting inaccurate, incorrect or misleading claims.  We believe that our facilities are in material compliance with all such laws, regulations and contractual provisions regarding the submission of claims.  We cannot be sure, however, that none of our facilities’ claims will ever be challenged.  If we were found to be in violation of a state’s laws or regulations, or of a commercial payor contract, we could be forced to discontinue the violative practice and be subject to recoupment actions, fines and criminal penalties, which could have a material adverse effect on our business, prospects, results of operations and financial condition.

Payors are increasingly conducting post-payment audits.  For example, CMS has implemented the RAC program, involving Medicare claims audits nationwide.  Under the program, CMS contracts with RACs on a contingency fee basis to conduct post-payment reviews to detect and correct improper payments in the fee-for-service Medicare program.  The ACA expanded the RAC program’s scope to include managed Medicare plans and Medicaid claims.  In addition, CMS employs Medicaid Integrity Contractors (“MICs”) to perform post-payment audits of Medicaid claims and identify overpayments.  The ACA increases federal funding for the MIC program.  In addition to RACs and MICs, the state Medicaid agencies and other contractors have increased their review activities.  We are regularly subject to these external audits and we also perform internal audits and monitoring.  Depending on the nature of the

 

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conduct found in such audits and whether the underlying conduct could be considered systemic, the resolution of these audits could have a material adverse effect on our business, prospects, results of operations and financial condition.

In order to regulate the healthcare services provided in a particular region, certain states require a Certificate of Need (CON) to be filed prior to the construction, relocation, acquisition, change of ownership, change of control or expansion of healthcare facilities.  This requirement could negatively impact our ability to increase or amend the services offered at our facilities as well as impact our ability to acquire additional facilities.

Certain states in which our facilities currently operate require that the facility apply for and receive approval for a Certificate of Need (CON) prior to the construction, expansion in the number of operating rooms or services, relocation, acquisition, change of ownership or change of control of the facility.  In states that require CON approval, authorities first assess the need for the additional or expanded services.  In response to a CON application, other similar facilities in that geographic may object and challenge the CON as it may adversely impact their business.  In addition, the CON application process can be expensive and there is no guarantee the requested change will be approved.

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. In the ordinary course of our business, we, and vendors on our behalf, collect and store sensitive data, including personal health data and other personally identifiable information of our patients.  The secure processing, maintenance and transmission of this information are critical to our operations and business strategy.  We have developed a comprehensive set of policies and procedures in our efforts to comply with the Health Insurance Portability and Accountability Act of 1996, or HIPAA, and other privacy laws.  The HHS Office for Civil Rights has imposed civil monetary penalties and corrective action plans on covered entities for violating HIPAA’s privacy rule.  If, in spite of our compliance efforts we were to experience a breach, loss, or other compromise of such personal health information, such event could disrupt our operations, 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.

HIPAA mandates the adoption of privacy, security and integrity standards related to patient information and standardizes the method for identifying providers, employers, health plans and patients.  Numerous federal regulations have been adopted under HIPAA.  We have taken actions to comply with the HIPAA privacy regulations and believe that we are in substantial compliance with those regulations.  These actions include the establishment of policies and procedures, teammate training, identifying “business associates” with whom we need to enter into HIPAA-compliant contractual arrangements and various other measures.  Ongoing implementation and oversight of these measures involves significant time, effort and expense.

Other federal regulations adopted under HIPAA require our facilities to conduct certain standardized healthcare transactions, including billing and other claim transactions.  We have undertaken significant efforts involving substantial time and expense to ensure that our facilities submit HIPAA-compliant transactions.  We anticipate that continual time and expense will be required to submit HIPAA-compliant transactions and to ensure that any newly acquired facilities can submit HIPAA-compliant transactions.

In addition, compliance with the HIPAA security regulations requires healthcare facilities and other covered entities to implement reasonable technical, physical and administrative security measures to safeguard protected healthcare information maintained, used and disclosed in electronic form.  We have taken actions in an effort to be in compliance with these regulations and believe that we are in substantial compliance with the HIPAA security regulations.  A cyber-attack that bypasses our information security systems causing an information security breach, loss of protected health information or other data subject to privacy laws or a material disruption of our operational systems could result in a material adverse impact on our business, along with fines.  Ongoing implementation and oversight of these security measures involves significant time, effort and expense.

ARRA broadened the scope of the HIPAA privacy and security regulations.  Among other things, ARRA extends the application of certain provisions of the security and privacy regulations to business associates (entities that handle identifiable health information on behalf of covered entities) and subjects business associates to civil and criminal penalties for violation of the regulations.  ARRA and its implementing regulations also require covered entities to report breaches of unsecured protected health information to affected individuals without unreasonable delay and in no case later than 60 days after the discovery of the breach by the covered entity or its agents.  Notification must also be made to HHS and, in certain situations involving large breaches, to the media.  Pursuant to a rule issued to implement ARRA, HHS has created a presumption that all non-permitted uses or disclosures of unsecured protected health information are breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised.  Violations of the HIPAA privacy and security regulations may result in civil and criminal penalties, and ARRA strengthened HIPAA’s enforcement provisions.  ARRA increased the amount of civil penalties, with penalties now ranging up to $50,000 per violation and a maximum civil penalty of $1.5 million in a calendar year for violations of the

 

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same requirement.  In addition, ARRA authorized state attorneys general to bring civil actions seeking either an injunction or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.

In addition, states may impose more protective privacy laws, and both state and federal laws are subject to modification or enhancement of privacy protection at any time.  Our facilities will continue to remain subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA.  These statutes vary and could impose additional requirements on us and more severe penalties for disclosures of confidential health information.  If we fail to comply with HIPAA or similar state laws, we could incur substantial monetary penalties.

If we fail to comply with laws and regulations related to the protection of the environment and human health and safety, we could incur substantial penalties and fines.

We are subject to various federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including those governing the management and disposal of hazardous substances and wastes, the cleanup of contaminated sites and the maintenance of a safe workplace.  Our operations include the use, generation and disposal of hazardous materials.  We also plan to acquire ownership or operational interests in new facilities and properties, some of which may have had a history of commercial or other operations.  We may, in the future, incur liability under environmental statutes and regulations with respect to contamination of sites we own or operate (including contamination caused by prior owners or operators of such sites, abutters or other persons) and the off-site disposal of hazardous substances.  Violations of these laws and regulations may result in substantial civil penalties or fines.

Healthcare is a heavily regulated industry and the laws and regulations we must comply with are constantly changing.

Healthcare is among the most heavily regulated industries on both the federal and state level, and healthcare laws and regulations are constantly changing.  Currently, we believe that our facilities, operations and agreements are in material compliance with all applicable laws and regulations.  Notwithstanding, these laws and regulations are also subject to ever-evolving interpretation, and therefore, we cannot assure you that we will be able to successfully address changes in the current regulatory environment.  As a result, the law and regulations applicable to our facilities may be interpreted or amended in a manner that could have a material adverse effect on our business.

Risks Related to Ownership of Our Common Stock

The market price of our common stock has been, and we expect it to continue to be volatile, which may adversely affect our stockholders.

The market price of our common stock has been, and we expect it to continue to be volatile.  Our common stock is also thinly traded.  There can be no assurance that the market price of our common stock will remain at its current level, and a decline could lead to significant investor losses.  The stock market has recently experienced significant price and volume fluctuations that have affected the market prices of securities, including securities of healthcare companies.  The market price of our common stock may be influenced by many factors, including:

 

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In addition, the stock market in general has experienced price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of healthcare companies.  These broad market and industry factors may materially reduce the market price of, and trading volume in, our common stock, regardless of our operating performance.  Some of these factors are beyond our control.  There is no assurance that the market price of our shares of common stock will not fall in the future.

There currently is a limited trading market for our common stock and we cannot assure investors that a robust trading market will ever develop or be sustained.

To date, there has been a limited trading market for our common stock on the OTC Markets OTCQB.  Our stock is thinly traded due to the limited number of shares available for trading on the OTCQB market thus causing large swings in price.  In this regard, the OTCQB is an inter-dealer, over-the-counter market that provides significantly less liquidity than a national securities exchange.  As such, investors and potential investors may find it difficult to obtain accurate stock price quotations, and holders of our common stock may be unable to resell their securities at or near their original offering price or at any price.  A lack of an active market may impair investors’ ability to sell their shares at the time they wish to sell them or at a price they consider reasonable.  The lack of an active trading market may also impair our ability to raise capital by selling shares of capital stock and may impair our ability to acquire other companies by using our common stock as consideration.

Even if an active market for our stock develops and continues, our stock price may nevertheless be volatile.  If our stock experiences volatility, investors may not be able to sell their common stock at or above the price they paid for such stock.  Sales of substantial amounts of our common stock, or the perception that such sales might occur, could also adversely affect prevailing market prices of our common stock and our stock price may decline substantially in a short period of time.  As a result, our stockholders could suffer losses or be unable to liquidate their holdings.

Reports published by securities or industry analysts, including projections in those reports that exceed our actual results, could adversely affect our common stock price and trading volume.

Securities research analysts establish and publish their own periodic projections for our business.  These projections may vary widely from one another and may not accurately predict the results we eventually achieve.  Our stock price may decline if our actual results do not match securities research analysts’ projections.  Similarly, if an analyst publishes a report which downgrades our stock, publishes inaccurate or unfavorable research about our business, ceases coverage of our company or fails to publish reports on us regularly, our stock price or trading volume could decline.  Any of these events could negatively impact the price and our trading volume.

Class action litigation due to stock price volatility or other factors could cause us to incur substantial costs and divert our management’s attention and resources.

It is not uncommon for securities class action litigation to be brought against a company following periods of volatility in the market price of such company’s securities.  Companies in certain industries are particularly vulnerable to this kind of litigation due to the high volatility of their stock prices.  Our common stock has experienced substantial price volatility in the past.  Accordingly, we may in the future be the target of securities litigation.  Any securities litigation could result in substantial costs and could divert the attention and resources of our management.

Our common stock has been considered to be “penny stock” under applicable SEC rules.

Our common stock has been considered to be “penny stock” under applicable SEC rules (generally defined as non-exchange traded stock with a per-share price below $5.00).  Unless we successfully list our common stock on a national securities exchange, or maintain a per-share price above $5.00, these rules impose additional sales practice requirements on broker-dealers that recommend the purchase or sale of penny stocks to persons other than those who qualify as “established customers” or “accredited investors.” For example, broker-dealers must determine the appropriateness for non-qualifying persons of investments in penny stocks.  Broker-dealers must also provide, prior to a transaction in a penny stock not otherwise exempt from the rules, a standardized risk disclosure document that provides information about penny stocks and the risks in the penny stock market.  The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, disclose the compensation of the broker-dealer and its salesperson in the transaction, furnish monthly account statements showing the market value of each penny stock held in the customer’s account, provide a special written determination that the penny stock is a suitable investment for the purchaser, and receive the purchaser’s written agreement to the transaction.

 

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Legal remedies available to an investor in “penny stocks” may include the following:

However, investors who have signed arbitration agreements may have to pursue their claims through arbitration.

These requirements may have the effect of reducing the level of trading activity, if any, in the secondary market for a security that becomes subject to the penny stock rules.  The additional burdens imposed upon broker-dealers by such requirements may discourage broker-dealers from effecting transactions in our securities, which could severely limit the market price and liquidity of our securities.  These requirements may restrict the ability of broker-dealers to sell our common stock and may affect your ability to resell our common stock.

Many brokerage firms will discourage or refrain from recommending investments in penny stocks.  Most institutional investors will not invest in penny stocks.  In addition, many individual investors will not invest in penny stocks due, among other reasons, to the increased financial risk generally associated with these investments.

For these reasons, penny stocks may have a limited market and, consequently, limited liquidity.  We can give no assurance at what time, if ever, our common stock will not be classified as a “penny stock” in the future.

Our common stock could be further diluted as the result of the issuance of additional shares of common stock, convertible securities, warrants or options.

We have in the past issued common stock and derivative securities (such as warrants) in order to raise money.  We have also issued options as compensation for services and incentive compensation for our employees and directors.  We have shares of common stock reserved for issuance upon the exercise of certain of these securities and may increase the shares reserved for these purposes in the future.  Our issuance of additional common stock, options, warrants or other derivative securities, or the issuance of shares of common stock upon the exercise or conversion of such derivative securities, could affect the rights of our stockholders, could reduce the market price of our common stock or could result in adjustments to exercise prices of outstanding warrants (resulting in these securities becoming exercisable for, as the case may be, a greater number of shares of our common stock).  There can be no assurance that we will not issue additional shares, options, warrants or other derivative securities in the future, including at a price (or exercise price) below the price at which shares of our common stock are currently traded at such time or below or above the price per share in this offering.

Shares eligible for future sale may adversely affect the market.

From time to time, certain of our stockholders may be eligible to sell all or some of their shares of common stock by means of ordinary brokerage transactions in the open market pursuant to Rule 144 promulgated under the Securities Act, subject to certain limitations.  In general, pursuant to amended Rule 144, non-affiliate stockholders may sell freely after six months subject only to the current public information requirement.  Affiliates may sell after six months subject to the Rule 144 volume, manner of sale (for equity securities), current public information, and notice requirements.  In addition, we have agreed to register the resale of additional shares of our common stock pursuant to registration obligations.  Given the limited trading of our common stock, resale of even a small number of shares of our common stock pursuant to Rule 144 or an effective registration statement may adversely affect the market price of our common stock.

Our current principal stockholders have significant influence over us and they could delay, deter or prevent a change of control or other business combination or otherwise cause us to take action with which you might not agree.

Our executive officers, directors and holders of greater than 5% of our outstanding common stock together beneficially own approximately 89% of our outstanding common stock.  As a result, these stockholders will have the ability to significantly influence all matters submitted to our stockholders for approval, including:

 

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This concentration of ownership of shares of our common stock could delay or prevent proxy contests, mergers, tender offers, open market purchase programs or other transactions that might otherwise give you the opportunity to realize a premium over the then prevailing market price of our common stock.  The interests of our executive officers, directors and holders of greater than 5% of our outstanding common stock may not always coincide with the interests of the other holders of our common stock.  This concentration of ownership may also adversely affect our stock price.

Provisions of our charter and bylaws may make an acquisition of us or a change in our management more difficult.

Certain provisions of our amended and restated certificate of incorporation and amended and restated bylaws could discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which an investor might otherwise receive a premium for their shares.  These provisions also could limit the price that investors might be willing to pay in the future for shares of our common stock or warrants, thereby depressing the market price of our common stock.  Stockholders who wish to participate in these transactions may not have the opportunity to do so.

Furthermore, these provisions could prevent or frustrate attempts by our stockholders to replace or remove our management.  These provisions:

We do not anticipate paying dividends on our common stock in the foreseeable future and, consequently, your ability to achieve a return on your investment will depend solely on appreciation in the price of our common stock.

We have not paid, and do not intend to pay dividends on our shares of common stock.  Instead, we intend to retain all future earnings to finance the continued growth and development of our business and for general corporate purposes.  In addition, we do not anticipate paying cash dividends on our common stock in the foreseeable future.  Any future payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our Board of Directors.

None

Facilities

Our corporate headquarters and offices are located in Oklahoma City, Oklahoma.  The office facilities consist of an approximately 52,000 square feet medical office building (“OKC MOB”) and are occupied under a master lease agreement, requiring monthly rental payments of $104,000, with annual rate escalations of 2% plus additional payments for our allocable share of the basic expenses.  The master lease agreement expires on September 30, 2023.  Currently, we occupy 20,800 square feet and sublease the remaining 31,200 square feet under sublease agreements that expire from October 2016 to December 2020.  We believe that suitable additional or substitute space will be available as needed on reasonable terms.

 

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As of December 31, 2015, we operated three hospitals in Texas and our Affiliates operated one hospital in Oklahoma and seven ASCs in five states.  Most of the locations are occupied under multiple-year (or long-term) lease arrangements requiring monthly rental payments.  The following table presents, as of December 31, 2015, the locations and lease expiration dates of occupancy leases, if applicable, of each facility:

 

Due to the nature of our business, we and our healthcare facilities are or may become involved in lawsuits, claims, audits and investigations, such as investigations by the DOJ or the OIG or other legal proceedings, including those arising out of services provided, arrangements with physicians, personal injury claims, professional liability claims, billing and marketing practices, employment disputes and contractual claims. See “Risk Factors.” Any of these lawsuits, claims, audits or investigations could result in substantial costs, divert management’s attention, adversely affect our business condition, or harm our reputation, regardless of their merit or outcome.

Aetna Life Insurance Company v. Huntingdon Valley Surgery Center, Foundation Surgery Affiliates, LLC and Foundation Management Affiliates, LLC, Case No. 13-3101, United States District Court for the Eastern District of Pennsylvania.  On December 2, 2013, Aetna Life Insurance Company (“Aetna”) filed a complaint against Huntingdon Valley Surgery Center (“HVSC”) and the Foundation defendants alleging that the Foundation defendants impose on the ASCs that they manage an unlawful “out of network business model” by means of which the defendants offer illegal inducements to physicians and patients to drive patient referrals to HVSC, which does not have a contract with Aetna and could therefore charge higher rates for its services.   Aetna is asserting violations of Pennsylvania’s anti-kickback statute by all defendants, conspiracy to violate Pennsylvania’s anti-kickback statute by all defendants, insurance fraud, aiding and abetting insurance fraud, tortious interference with the contracts between Aetna and its in-network physicians.  Aetna has reached a settlement with HVSC. On the Aetna claims against the Foundation defendants, the Court has granted the Foundation defendants a partial summary judgment on all such claims except tortious interference.  Aetna has appealed the decision to the Third Circuit.

United States of America ex rei. Mary Dupont, M.D., Relator, v. Metropolitan Medical Partners LLC. d/b/a Surgery Center of Chevy Chase; Surgical Synergies, Inc.; Foundation Surgery Affiliates, LLC; and Foundation Healtlzcare, Inc., Case No. No. 13-cv-03590-PJM,  U.S. District Court for the District of Maryland, Greenbelt Division.  In November, 2013, the relator, Mary Dupont, M.D. (“Dupont”), filed under seal a False Claims Act (“FCA”) or “qui tam” complaint initiating this action. On October 30, 2014, the federal government filed a Notice of Election to Decline Intervention and on November 12, 2014, the Court entered an Order unsealing the Dupont complaint.  Dupont filed her First Amended Complaint on June 19, 2015.  Dupont, a urologist and physician-investor in an ambulatory surgery center in Chevy Chase, Maryland (the "Center"), alleged that the Center, in concert with defendant Surgical Synergies, Inc. ("SSI") and the Foundation defendants, effectively shut her out of her practice at the Center by imposing a 75 procedure-per-year quota on procedures performed at the Center, and, barring her from performing an allegedly unprofitable procedure involving the surgical implantation of a mesh sling.  The First Amended Complaint alleged claims including Medicare fraud, Presentation of False Claims, and violations of the Maryland False Health Claims Act.  ln August 2015, all defendants, including the Foundation defendants, moved to dismiss the First Amended Complaint and argued that the First Amended Complaint failed to state a claim for relief as against them under Federal Rules of Civil Procedure 12(b)(6) and 9(b) because Dupont failed to plead the requisite details of any specific false claim with particularity, failed to adequately plead any conspiracy to violate the FCA, and failed to sufficiently plead any violation of the federal anti-kickback statute, which constituted the alleged substantive basis of her FCA claims. The Foundation defendants also argued that the FCA claims against them should be dismissed for lack of subject matter jurisdiction.  In September 2015, Dupont filed a Second Amended Complaint by consent, making limited factual modifications to her

 

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pleading and reasserting the claims made in the First Amended Complaint.  In October 2015, all defendants, including the Foundation defendants, filed motions to dismiss the Second Amended Complaint on essentially the same grounds as were asserted against the First Amended Complaint.  On February 3, 2016, the Court granted Defendants' motions to dismiss in part, dismissing with prejudice Dupont’s claim under the Maryland False Health Claims Act and dismissing without prejudice Dupont’s “Economic Loss” claim. The Court's February 3, 2016 Order did not reach the merits of Defendants’ motions to dismiss the remaining counts, but instead granted Dupont leave to file a Third Amended Complaint which was done in March 2016.  Defendants have until April 4, 2016 to file motions to dismiss or, in the alternative, for summary judgment. We intend to continue to defend the action vigorously.

In our management’s opinion, the ultimate resolution of any of these pending claims and legal proceedings will not have a material adverse effect on our financial position or results of operations.

 

 

Not applicable.

 

 

PART II

Market

Our common stock is traded on the OTCQB under the symbol FDNH.  The share prices have been adjusted to give effect to the Reverse Split. Such OTC market quotations reflect inter-dealer prices, without retail markup, markdown or commissions and may not necessarily represent actual transactions.  The following table sets forth, during the calendar quarters presented, the high and low sale prices of our common stock as reported by the OTCQB:

 

On March 28, 2016, the closing price of our common stock as quoted on OTCQB was $3.00.

The market price of our common stock is subject to significant fluctuations in response to, and may be adversely affected by:

Holders of Equity Securities

As of March 28, 2016, we have 174 owners of record of our common stock.

 

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Dividend Policy

Historically, we have not paid dividends on our common stock, and we do not currently intend to pay and you should not expect to receive cash dividends on our common stock.  Our dividend policy is to retain earnings to support the expansion of our operations.  If we were to change this policy, any future cash dividends will depend on factors deemed relevant by our board of directors.  These factors will generally include future earnings, capital requirements, and our financial condition contractual restrictions, such as our existing credit facilities.  Furthermore, in the event we issue shares of preferred stock, although unanticipated, no dividends may be paid on our outstanding shares of common stock until all dividends then due on our outstanding preferred stock will have been paid.  Our existing credit facility restricts our ability to pay dividends without the approval of our lenders.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – TCB Credit Facility.

Securities Authorized for Issuance under Equity Compensation Plans

The following table sets forth as of December 31, 2015, information related to each category of equity compensation plan approved or not approved by our shareholders, including individual compensation arrangements with our non-employee directors.  The equity compensation plan approved by our shareholders is our Amended & Restated 2008 Long-Term Incentive Plan (“2008 Incentive Plan”).  All stock options and rights to acquire our equity securities are exercisable for or represent the right to purchase our common stock.

 

Unregistered Sales of Equity Securities

During the three months ended December 31, 2015, we did not have any unregistered sales of our equity securities.

Repurchases of Equity Securities

During the three months ended December 31, 2015, we did not repurchase any of our equity securities. We do not have any on-going stock repurchase programs.

We are a smaller reporting company as defined in Rule 12b-2 of the Exchange Act and, accordingly, not required to provide the information required by Item 301 of Regulation S-K with respect to Selected Financial Data.

 

 

Overview

Our primary business is the ownership of surgical hospitals and ambulatory surgical centers (ASCs) in targeted regional markets in the Southeastern United States.  We currently have three majority-owned hospitals (Consolidated Hospitals) and one minority-owned hospitals (Equity Owned Hospitals) in Texas and Oklahoma.  We have seven minority-owned ASCs located in Texas, Pennsylvania, New Jersey, Maryland and Ohio.  Also, we have one hospital outpatient departments (HOPDs) through our investment in the surgery hospital in Edmond, Oklahoma.  In addition to our ownership interests, we provide management services under contract to most of our minority-owned facilities.  Finally, we have a legacy business that provides sleep testing management services.

Our strategy is to create a regional network of high-quality, yet cost effective, surgical facilities that meet the needs of patients, physicians and payors.  We believe our facilities provide a friendly and convenient environment for our patients to receive high quality care.  We operate our facilities, structure our strategic relationships and adopt staffing, scheduling and clinical systems and protocols with the goal of increasing physician productivity and satisfaction.  In light of the efficiency of our facilities, we believe we

 

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are competitively positioned among payors to generate good clinical outcomes while containing costs.  Our commitment to the needs of all relevant parties coupled with the strong growth dynamics of our markets lead us to believe that the number of procedures performed at our facilities each year will increase.

Hospital and ASC Business

At our Consolidated Hospitals, we serve as a majority owner, day-to-day manager, and we have significant influence over the operations of such facilities.  When we have control of the facility, we account for our investment in the facility as a consolidated subsidiary.  For our Equity Owned facilities, our influence does not represent control of the facility, but we do have the ability to exercise significant influence over operating and financial policies, we account for our investment in the facility under the equity method, and treat the facility as a nonconsolidated affiliate.

For our Consolidated Hospitals, our financial statements reflect 100% of the revenues and expenses for these subsidiaries, after elimination of intercompany transactions and accounts.  The net income attributable to our physician partners who have ownership in our Consolidated Hospitals is included in net income attributable to noncontrolling interests in our consolidated statements of operations.

For our Equity Owned facilities, our share of the net income of each Equity Owned facility is based on the facility’s net income and our percentage of ownership in the facility and is included in our consolidated statements as equity in earnings of affiliates.  We earn management fees from most of our Equity Owned facilities for our management of the day-to-day operations.  We also provide management services to one ASC that we don’t own any equity interest.

Changes in Consolidated Hospitals and Equity Owned Affiliates

On December 31, 2015, we purchased substantially all of the hospital assets and hospital operating entity of University General Health Systems, Inc., consisting primarily of a sixty-nine bed acute care hospital located in the Medical City area of Houston, Texas (“UGH”).  The purchase price of the UGH was $25.1 million, net of liabilities assumed.  The UGH hospital is now operated as Foundation Surgical Hospital of Houston and referred to as our “Houston Hospital.”

On July 15, 2015, we sold our 10% interest in the Kirby Glen Surgery, LLC, one of our Equity Owned ASCs located in Houston, Texas. We received $0.2 million in combined proceeds for the sale of the equity interest and termination of our management agreement.

On June 12, 2015, we sold a portion of our 20% equity investment in Grayson County Physician Property, LLC (“GCPP”), our Equity Owned hospital in Sherman, Texas, through a series of transactions. In conjunction with the sale, the management agreement under which we provided certain services including billing and collections, general management services, legal support, and accounting services was terminated. Our decision to sell the assets of GCPP was part of our overall strategic plan to focus on the growth of our majority owned surgical hospital businesses and divest any minority interest holdings. We received $7.8 million in proceeds as a result of the sale and $0.5 million in additional proceeds for the termination our management agreement. We used $7.0 million of these proceeds to reduce our principal balance of the note held by Bank SNB (our senior lender).

On March 31, 2015, Houston Orthopedic Surgical Hospital, L.L.C. (“HOSH”), our Equity Owned hospital in Houston, Texas, sold substantially all of its assets under an asset purchase agreement. Given that we do not exhibit control with our 20% investment in HOSH, we account for our investment on a cost or cash basis. As a result of the HOSH sale, we received a distribution on May 12, 2015 for $1.8 million, of which $0.6 million is being held in escrow until April 2016.

On January 1, 2015, Foundation Surgery Affiliates of Northwest Oklahoma City, LLC, or FSA OKC, our Equity Owned ASC located in Oklahoma City, Oklahoma was sold to Summit Medical Center LLC, or Summit Hospital, in exchange for unit ownership in Summit Hospital.  As part of the transaction, the units of Summit Hospital were distributed to the individual FSA OKC investors including us.  As a result of the transaction, we now hold an 8% ownership interest in Summit Hospital. In addition, the ASC facility in Oklahoma City is now operated as an HOPD for Summit Hospital.

The following summarizes certain key metrics for our surgical hospital and ASC business:

 

 

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We seek to maintain diversity of case mix at our facilities to insulate us from potential negative effects that could stem from emphasizing one particular case type.  The following is our case mix by specialty for the years ended December 31, 2015 and 2014:

 

 

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The table below provides additional operational data for our managed hospitals and ASCs as of and for the years ended December 31, 2015 and 2014:

 

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information regarding the factors driving changes in the surgical case volumes and patient revenues at our surgical hospitals. The decline in surgical volumes at our managed ASCs in 2015 compared to 2014 was primarily due to the sale of Chevy Chase in 2014.

Discontinued Operations

The partial sale of GCPP in June 2015 was part of our strategic plan to focus on majority owned investments. As a result, the proceeds from the sale, the remaining equity ownership, and the results of operations and cash flows related to the equity investment in GCPP for all periods presented have been classified as discontinued operations. Therefore, we reclassified $2.2 million from equity method investments in affiliates to other assets from discontinued operations as of December 31, 2014. In addition, we reclassified $0.6 million from equity in earnings from affiliates to income from discontinued operations, net of tax, for the year ended December 31, 2015.

Results of Operations

The following table sets forth selected results of our operations for the years ended December 31, 2015 and 2014 and was derived and taken from our audited financial statements appearing elsewhere in this report:

 

 

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Discussion of Years Ended December 31, 2015 and 2014

Patient services revenue increased $25.0 million or 26% during 2015 compared to 2014.  The increase was primarily due to:

Provision for doubtful accounts increased $1.3 million or 26% during 2015 compared with 2014.  Provision for doubtful accounts as a percent of patient services revenue was 5.2% and 5.3% for 2015 and 2014, respectively.  The increase is due to $0.3 million related to the new drug testing laboratory service and $1.0 million due to increased revenues at EEPPMC compared to 2014.  

Management fees from affiliates were $5.4 million in both 2015 and 2014.

Other revenue increased $0.5 million or 9% during 2015 compared with 2014.  The increase in other revenue during 2015 compared to 2014 includes:

The offsetting decrease in other revenue is due to:

Income from equity investments in affiliates decreased $1.0 million or 42% during 2015 compared with 2014.  Lower earnings from our ASC facilities, primarily related to lower volumes and reimbursement levels resulted in a decrease of $1.0 million.

Salaries and benefits increased $4.6 million or 16% to $33.9 million from $29.3 million during 2015 compared with 2014.  The increase in salaries and benefits was primarily due to:

Supplies expense increased $3.8 million or 16% to $27.8 million from $24.0 million during 2015 compared with 2014.  The increase in supplies expense was primarily due to an increase of $1.1 million and $2.7 million at FBH SA and EEPPMC, respectively from the overall increase in volume and complexity of procedures performed.

 

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Other operating expenses increased $11.1 million or 26% to $53.9 million from $42.8 million during 2015 compared with 2014.  The increase in other operating expenses was primarily due to:

The offsetting decrease in other operating expense is due to:

Depreciation and amortization represents the depreciation expense associated with our fixed assets and the amortization expense attributable to our intangible assets.  Depreciation and amortization increased $0.1 million in 2015 compared to 2014.  The increase was primarily due to net asset acquisitions during 2015.

Net other expense represents primarily interest expense on borrowings reduced by interest income earned on cash and cash equivalents and other transactional gains or losses.  Net other expense decreased $0.2 million in 2015 compared to 2014.  The decrease is related to a decrease of $0.2 million in interest expense related to lower interest rates on our outstanding debt which was refinanced in June 2014.

Benefit for income taxes was $1.1 million during 2015 compared to $0.9 million in 2014.  The increase is primarily related to an adjustment to the valuation allowance in 2015.

Discontinued operations represent operations related to our equity investment in Grayson County Physician Property, LLC (“GCCP”) which was discontinued in 2015 and the operations of our independent diagnostic testing facilities which were discontinued in 2013.  The results from our discontinued operations for 2015 and 2014 are summarized below:

Noncontrolling interests were allocated $6.6 million and $3.8 million of net income during 2015 and 2014, respectively.  Noncontrolling interests are the equity ownership interests in our majority owned hospital subsidiaries, EEPMC and FBH SA.  

Net income (loss) attributable to Foundation Healthcare.  Our operations resulted in net income attributable to Foundation Healthcare of $5.9 million in 2015 compared to a net loss of $1.3 million in 2014.

Liquidity and Capital Resources

Generally our liquidity and capital resource needs are funded from operations, loan proceeds and equity offerings, and more recently, lease and other real estate financing transactions.  As of December 31, 2015, our liquidity and capital resources included cash and cash equivalents of $5.1 million and working capital of $8.1 million.

Cash provided by operating activities from continuing operations was $7.3 million during 2015 compared to net cash provided of $2.9 million in 2014.  During 2015, the primary sources of cash from operating activities from continuing operations were cash generated by income from continuing operations (net income increased by non-cash items) of $17.8 million, increases in accrued liabilities and other liabilities totaling $2.0 million and decreases in receivables from affiliates, other receivables and prepaid and other current assets totaling $1.4 million.  During 2015, the primary uses of cash from continuing operations, were increases in accounts receivables, supplies inventory and other assets totaling $11.6 million and decreases in accounts payable and other current liabilities of $2.3 million.  During 2014, the primary sources of cash from operating activities from continuing operations were cash generated by income from continuing operations (net income increased by non-cash items) of $11.6 million, increases in accrued liabilities and

 

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other liabilities totaling $8.2 million.  During 2014, the primary uses of cash from continuing operations, were increases in accounts receivables, receivables from affiliates, prepaid and other current assets and other assets totaling $12.0 million and decreases in accounts payable and other current liabilities of $4.9 million.

Cash provided by discontinued operations in 2015 was $1.8 million compared to cash used of $0.5 million during 2014.

Net cash used in investing activities from continuing operations during 2015 was $25.9 million compared to $1.9 million during 2014.  Investing activities during 2015 were primarily related to the purchase of UGH for $25.1 million and property and equipment of $4.2 million which were offset by distributions received from equity investments of $1.9 million.  Investing activities during 2014 were primarily related to purchase of property and equipment of $4.9 million which were offset by distributions received from equity investments of $2.8 million and proceeds from the sale of an equity investment in affiliates of $0.2 million.

Investing activities from discontinued operations during 2015 provided $8.4 million and represented proceeds from the sale of GCCP assets attributable to discontinued operations.  We did not have any investing activities from discontinued operations during 2014.  

Net cash provided by financing activities from continuing operations during 2015 was $11.0 million compared to $2.2 million in 2014.  During 2015, we received debt proceeds of $49.0 million.  During 2015, we made debt payments of $31.3 million, made preferred noncontrolling interest payments of $1.7 million, paid $0.7 million in preferred noncontrolling interest dividends and made $4.2 million in distributions to noncontrolling interests.  During 2014, we received debt proceeds of $32.9 million and proceeds from the sale of non-controlling interests of $0.1 million.  During 2014, we made debt payments of $26.3 million, paid $0.8 million in preferred noncontrolling interest dividends and made $3.7 million in distributions to noncontrolling interests.  

There were no financing activities from discontinued operations during 2015.  Financing activities from discontinued operations during 2014 used $4.1 million and represented payments on debt attributable to discontinued operations.

We expect the total level of spending for capital expenditures to be greater in 2016 as compared to 2015 as a result of our various capital commitments in connection with the acquisition of UGH and our other Consolidated Hospitals.

Our business strategy contemplates the selective acquisition of additional hospitals, and we regularly review potential acquisitions. It could be necessary for us to seek additional financing to fund larger hospital acquisitions. We regularly evaluate opportunities to sell additional equity, obtain credit agreements from lenders or restructure our long-term debt or equity for strategic reasons or to further strengthen our financial position. The sale of additional equity could result in additional dilution to our stockholders.

We believe that cash generated from our operations and borrowings available under the TCB Credit Facility will be sufficient to meet our working capital needs and planned capital expenditures and other expected operating needs over the next twelve months and into the foreseeable future prior to the maturity dates of our outstanding debt.

TCB Credit Facility

 

Effective December 31, 2015, we entered into a Credit Agreement (the “TCB Credit Facility”) with Texas Capital Bank, National Association (“TCB”).  The TCB Credit Facility replaced substantially all of our and our subsidiaries’ debt in the principal amount of $28.4 million, which we refer to as the Term Loan, and provides for an additional revolving loan in the amount of $12.5 million, which we refer to as the Revolving Loan.  We have also entered into a number of ancillary agreements in connection with the TCB Credit Facility, including deposit account control agreements, subsidiary guarantees, security agreements and promissory notes.

 

Maturity Dates.  The Term Loan matures on December 30, 2018 and the Revolving Loan matures on December 30, 2020.

Interest Rates.  Borrowings under the TCB Credit Facility are made, at our option, as either Base Rate loans or LIBOR loans.  “Base Rate” for any day is the highest of  (i)the Prime Rate, (ii) the Federal Funds Rate plus one half of one percent (0.5%), and (iii) Adjusted LIBOR plus one percent (1.00%).  LIBOR loans are based on either the one month, two month or three month LIBOR rate at our option.  The interest rate is either a Base Rate or LIBOR plus the Applicable Margins based on our Senior Debt to EBITDA Ratio, as defined.  The Applicable Margins are as follows:

 

 

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The Applicable Margin in effect will be adjusted within 45 days following the end of each quarter based on our Senior Debt to EBITDA ratio.  The Senior Debt to EBITDA Ratio is calculated by dividing all of our senior indebtedness (excluding capital lease obligations for the Houston Hospital), that is by our EBITDA for the preceding four fiscal quarters.  EBITDA is defined in the TCB Credit Facility as our net income plus (b) the sum of the following: interest expense; income taxes; depreciation; amortization; extraordinary losses determined in accordance with GAAP; cash and noncash stock compensation expense; and other non‑recurring expenses reducing such net income which do not represent a cash item in such period or any future period, minus (c) the sum of the following: income tax credits; extraordinary gains determined in accordance with GAAP; and all non‑recurring, non‑cash items increasing net income.

 

Interest and Principal Payments.  We are required to make quarterly payments of principal and interest on the Term Loan.  The first four quarterly payments on the Term Loan will be $1,013,393, on the first day of each April, July, October, and January during the term hereof, commencing April 1, 2016.  We are required to make quarterly payments on the Revolving Loan equal to the accrued and unpaid interest.  All unpaid principal and interest on the Term Loan and Revolving Loan must be paid on the respective maturity dates of each Loan.

 

Borrowing Base.  Our ability to borrow money under the Revolving Loan is limited to our Borrowing Base.  Our Borrowing Base is equal to the sum of (i) 80% of the eligible account of our San Antonio Hospital multiplied by our ownership of the San Antonio Hospital, not to exceed the outstanding principal balance of the intercompany note payable by the San Antonio Hospital to us, (ii) 80% of the eligible account of our El Paso Hospital multiplied by our ownership of the El Paso Hospital, not to exceed the outstanding principal balance of the intercompany note payable by the El Paso Hospital to us, and (iii) 80% of the eligible account of our Houston Hospital multiplied by our ownership of the Houston Hospital, not to exceed the outstanding principal balance of the intercompany note payable by the Houston Hospital to us.

 

Increase in Revolving Loan. Provided, that we are not in default, we may request one or more increases in the maximum amount of the Revolving Loan not to exceed $10 million; provided any request for an increase must be at least $5 million.  

 

Mandatory Prepayments.  We must make mandatory prepayments of the Term Loans in the following situations, among others:

 

 

Voluntary Prepayments.  We may prepay amounts under the Term Loan or Revolving Loan at any time provided that we are required to pay a prepayment fee of 2% of the amount prepaid if payment is made prior to the first anniversary, 1.5% if the prepayment is made after the first anniversary but prior to the second anniversary and 1% if the prepayment is made after the second anniversary but prior to the third anniversary.  

 

Guaranties.  Each of our direct or indirect wholly-owned subsidiaries jointly and severally and unconditionally guaranty payment of our obligations owed to Lenders.

 

Financial Covenants:

 

Debt to EBITDA Ratio.  As of December 31, 2015, we must maintain a Debt to EBITDA Ratio, not in excess of 3.50 to 1.00.  Thereafter, we must maintain a Debt to EBITDA Ratio as of the last day of any fiscal quarter, not in excess of (a)

 

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3.25 to 1.00 for the fiscal quarters ending December 31, 2015, March 31, 2016, June 30, 2016 and September 30, 2016; (b) 2.75 to 1.00 for the fiscal quarters ending December 31, 2016, March 31, 2017, June 30, 2017 and September 30, 2017; (c) 2.50 to 1.00 for the fiscal quarters ending December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018; and (d) 2.25 to 1.00 for the fiscal quarter ending December 31, 2018 and at the end of each fiscal quarter thereafter.  As of December 31, 2015, the Company’s Debt to EBITDA Ratio was 2.66.

 

Senior Debt to EBITDA Ratio.  As of December 31, 2015, we must maintain a Senior Debt to EBITDA Ratio not in excess of 3.00 to 1.00.  Thereafter, we must maintain a Senior Debt to EBITDA Ratio as of the last day of any fiscal quarter, not in excess of (a) 3.00 to 1.00 for the fiscal quarters ending December 31, 2015, March 31, 2016, June 30, 2016 and September 30, 2016; (b) 2.50 to 1.00 for the fiscal quarters ending December 31, 2016, March 31, 2017, June 30, 2017 and September 30, 2017; (c) 2.25 to 1.00 for the fiscal quarters ending December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018; and (d) 2.00 to 1.00 for the fiscal quarter ending December 31, 2018 and at the end of each fiscal quarter thereafter.  As of December 31, 2015, the Company’s Senior Debt to EBITDA Ratio was 2.24.

 

Pre-Distribution Fixed Charge Coverage Ratio.  We must maintain as of the last day of any fiscal quarter a Pre-Distribution Fixed Charge Coverage Ratio in excess of 1.30 to 1.00.  As of December 31, 2015, the Company’s Pre-Distribution Fixed Charge Coverage Ratio was 2.45.

 

Post-Distribution Fixed Charge Coverage Ratio.  We must maintain as of the last day of any fiscal quarter, a Post-Distribution Fixed Charge Coverage Ratio in excess of 1.05 to 1.00.  As of December 31, 2015, the Company’s Post-Distribution Fixed Charge Coverage Ratio was 1.30.

 

 

Capital Expenditures.  We shall not make capital expenditures in excess of $5,000,000 during any fiscal year.

 

Collateral.  Payment and performance of our obligations under the TCB Credit Facility are secured in general by all of our and our guarantors’ assets.

 

Negative Covenants.  The TCB Credit Facility has restrictive covenants that, among other things, limits or restricts our ability to:

 

·Incur additional indebtedness;

·Create or incur additional liens on our assets;

·Engage in mergers or acquisitions;

·Pay dividends or make any other payment or distribution in respect of our equity interests;

·Make loans and investments;

·Issue equity;

·Engage in transaction with affiliates;

·Dispose of our assets;

·Engage in any sale and leaseback arrangements; and

·Prepay debt to debtors other than TCB.

 

Defaults and Remedies.  In addition to the general defaults of failure to perform our obligations under the Loan Agreement, events of default also include the occurrence of a change in control, as defined, and the loss of our Medicare or Medicaid certification, collateral casualties, entry of a uninsured judgment of $500,000 or more, failure of first liens on collateral and the termination of any of our management agreements that represent more than 10% of our management fees for the preceding 18-month period.  In the event of a monetary default, all of our obligations due under the TCB Credit Facility shall become immediately due and payable.  In the event of a non-monetary default, we have 10 days, or in some cases, three days to cure before Texas Capital Bank has the right to declare our obligations due under the TCB Credit Facility immediately due and payable.

Financial Commitments

We do not have any material capital commitments during the next 12 months; however, we have contractual commitments of $26.9 million for payments on our indebtedness, operating lease payments and preferred noncontrolling interests.  Although we have not entered into any definitive arrangements for obtaining additional capital resources, either through long-term lending arrangements or equity offering, we continue to explore various capital resource alternatives to finance our growth strategy.

 

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Our future commitments under contractual obligations by expected maturity date at December 31, 2015 are as follows:

Off-Balance Sheet Arrangements

We had no off-balance sheet arrangements (as defined in Item 303(a)(4) of Regulation S-K) as of December 31, 2015 or 2014.

CRITICAL ACCOUNTING POLICIES

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management’s prudent judgments and estimates.  Actual results may differ from these estimates.  Management believes that any reasonable deviation from those judgments and estimates would not have a material impact on our consolidated financial position or results of operations.  To the extent that the estimates used differ from actual results, however, adjustments to the statement of earnings and corresponding balance sheet accounts would be necessary.  These adjustments would be made in future statements.  Some of the more significant estimates include revenue recognition, allowance for contractual adjustments and doubtful accounts, and goodwill and intangible asset impairment.  We use the following methods to determine our estimates:

Revenue recognition and accounts receivable – We recognize revenues in the period in which services are performed and charged.  Accounts receivable primarily consist of amounts due from third-party payors and patients.  Our ability to collect outstanding receivables is critical to its results of operations and cash flows.  Amounts we receive 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 our established billing rates.  Additionally, to provide for accounts receivable that could become uncollectible in the future, we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value.  Accordingly, the revenues and accounts receivable reported in our consolidated financial statements are recorded at the net amount expected to be received.

Contractual Discounts and Cost Report Settlements – We derive a significant portion of our revenues from Medicare, Medicaid and other payors that receive discounts from its established billing rates.  We 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.  We estimate 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 our 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 our consolidated statements of operations.

Cost report settlements under reimbursement agreements with Medicare and Medicaid are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined.  There is a reasonable possibility that recorded estimates will change by a material amount in the near term.

Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation.  We believe that we are in compliance with all applicable laws and regulations and are not aware of any pending or threatened investigations involving allegations of potential wrongdoing that would have a material effect on our 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.

Provision and Allowance for Doubtful Accounts – To provide for accounts receivable that could become uncollectible in the future we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable

 

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value.  The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

We have an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance.  No single statistic or measurement determines the adequacy of the allowance for doubtful accounts.  Some of the analytical tools that we utilizes include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of our ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan.  Accounts receivable are written off after collection efforts have been followed in accordance with our policies.

Due to the nature of the healthcare industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time services are provided.  Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on our operating results and cash flows in subsequent periods.  Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for our services.  The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network.  Due to uncertainties surrounding deductible levels and the number of out-of-network patients, we are not certain of the full amount of patient responsibility at the time of service.  We estimate amounts due from patients prior to service and generally collects those amounts prior to service.  Remaining amounts due from patients are then billed following completion of service.

Long-lived assets – We evaluate our 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.  Our estimates of future cash flows are based on assumptions and projections we believe to be reasonable and supportable.  Our assumptions take into account revenue and expense growth rates, patient volumes, changes in payor mix and changes in legislation and other payor payment patterns.

Goodwill and Intangible Assets – We evaluate goodwill for impairment at least on an annual basis and more frequently if certain indicators are encountered.  Goodwill is to be tested at the reporting unit level, defined as an ASC or hospital (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill.  If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired.

Intangible assets other than goodwill which include physician membership interests, service contracts and covenants not to compete are amortized over their estimated useful lives using the straight line method.  The remaining lives range from five to seven years.  We evaluate the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Income Taxes – We recognize deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carry-forwards.  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 of deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  In the event we determine that the deferred tax assets will not be realized in the future, the valuation adjustment to the deferred tax assets is charged to earnings in the period in which we make such a determination.  We classify interest and penalties related to our tax positions as a component of income tax expense.

We use a two-step process to evaluate a tax position.  The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position.  The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements.  A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met.  Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met.  We report tax-related interest and penalties as a component of income tax expense.

 

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Recently Issued Accounting Pronouncements

Refer to Note 3 to our consolidated financial statements included elsewhere in this report for a discussion of the impact of the adoption of recently issued accounting standards and accounting standards not yet adopted.

We are a smaller reporting entity as defined in Rule 12b-2 of the Exchange Act and as such, are not required to provide the information required by Item 305 of Regulation S-K with respect to Quantitative and Qualitative Disclosures about Market Risk.

Our financial statements which are prepared in accordance with Regulation S-X are set forth in this report beginning on page F-1.

We are a smaller reporting entity as defined in Rule 12b-2 of the Exchange Act and as such, are not required to provide the information required by Item 302 of Regulation S-K with respect to Supplementary Financial Information.

 

 

During 2015 and 2014, there were no disagreements concerning matters of accounting principle or financial statement disclosure between us and our independent accountants of the type requiring disclosure hereunder.

Disclosure Controls and Procedures

Our management, with the participation of our Principal Executive Officer and Principal Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2015.  Our Principal Executive Officer and Principal Financial Officer are responsible primarily for establishing and maintaining disclosure controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the U.S. Securities and Exchange Commission.  The controls and procedures are those defined in Rules 13a-15 or 15d-15 under the Securities Exchange Act of 1934.  These controls and procedures are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.  Based on such evaluations, our Principal Executive Officer and Principal Financial Officer concluded that, as of December 31, 2015, our disclosure controls and procedures were effective.

Management’s Report on Internal Control over Financial Reporting

Furthermore, our Principal Executive Officer and Principal Financial Officer are responsible for the design and supervision of our internal control over financial reporting as defined in Rule 13a-15 of the Securities Exchange Act of 1934.  Internal control over financial reporting is then effected by and through our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  These policies and procedures

Our Principal Executive Officer and Principal Financial Officer, conducted their evaluation using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control – Integrated Framework (2013).  Based upon their evaluation of the effectiveness of our internal controls over financial reporting as of December 31, 2015, management, including our Principal Executive Officer and Principal Accounting Officer, concluded that our internal controls over financial

 

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reporting were effective as of December 31, 2015, and reported to our auditors and the audit committee of our board of directors that no changes had occurred in our internal control over financial reporting during the last fiscal quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.  In conducting their evaluation of our internal controls over financial reporting, these executive officers did not discover any fraud that involved management or other employees who have a significant role in our disclosure controls and procedures and internal controls over financial reporting.  Furthermore, there were no significant changes in our internal controls over financial reporting, or other factors that could significantly affect our internal controls over financial reporting subsequent to the date of their evaluation.

On December 31, 2015, we completed our acquisition of UGH.  As permitted by the Securities and Exchange Commission under the current year acquisition scope exception, we excluded UGH from our 2015 assessment of the effectiveness of our internal control over financial reporting.  However, we have extended our oversight and monitoring processes that support our internal control over financial reporting to include UGH operations.

Changes in Internal Control over Financial Reporting

No changes in our internal controls occurred during the fourth quarter of 2015 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting, except as described below:

As noted above, we have extended our oversight and monitoring processes that support our internal control over financial reporting to include UGH’s operations.

None.

PART III

The information required by this item is incorporated herein by reference to our Proxy Statement for our annual shareholders’ meeting (the “2016 Proxy Statement”).

The information required by this item is incorporated herein by reference to the 2016 Proxy Statement.

The information required by this item is incorporated herein by reference to the 2016 Proxy Statement.

The information required by this item is incorporated herein by reference to the 2016 Proxy Statement.

The information required by this item is incorporated herein by reference to the 2016 Proxy Statement.

 

 

PART IV

(a)  Exhibits:

 

 

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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.

 

Date: March 30, 2016

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

Each person whose signature appears below in so signing also makes, constitutes and appoints Stanton Nelson and Hubert King, and each of them, his true and lawful attorney-in-fact, with full power of substitution, for him in any and all capacities, to execute and cause to be filed with the Securities and Exchange Commission any and all amendments to this Form 10‑K, with exhibits thereto and other documents in connection therewith, and hereby ratifies and confirms all that said attorney-in-fact or his substitute or substitutes may do or cause to be done by virtue hereof.

 

 

 

 

 

56

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Exhibit Index

 

 

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FOUNDATION HEALTHCARE, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

 

 

F-1

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Audit Committee, Board of Directors,

and Shareholders of Foundation Healthcare, Inc.

We have audited the accompanying consolidated balance sheets of Foundation Healthcare, Inc. and subsidiaries (the “Company”) as of December 31, 2015 and 2014, and the related consolidated statements of operations, shareholders’ deficit and cash flows for the years then ended.  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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its 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, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Foundation Healthcare, Inc. and subsidiaries as of December 31, 2015 and 2014, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

/s/ Hein & Associates LLP

Denver, Colorado

March 30, 2016

 

 

 

 

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FOUNDATION HEALTHCARE, INC.

Consolidated Balance Sheets

December 31, 2015 and 2014

 

See Accompanying Notes to Consolidated Financial Statements

 

 

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FOUNDATION HEALTHCARE, INC.

Consolidated Statements of Operations

For the Years Ended December 31, 2015 and 2014

 

 

See Accompanying Notes to Consolidated Financial Statements

 

 

 

 

F-4

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FOUNDATION HEALTHCARE, INC.

Consolidated Statements of Shareholders’ Deficit

For the Years Ended December 31, 2015 and 2014

 

 

See Accompanying Notes to Consolidated Financial Statements

 

 

 

 

F-5

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FOUNDATION HEALTHCARE, INC.

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2015 and 2014

 

 

F-6

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FOUNDATION HEALTHCARE, INC.

Consolidated Statements of Cash Flows (continued)

For the Years Ended December 31, 2015 and 2014

 

See Accompanying Notes to Consolidated Financial Statements

 

 

 

 

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FOUNDATION HEALTHCARE, INC.

Notes to Consolidated Financial Statements

For the Years Ended December 31, 2015 and 2014

Note 1 – Nature of Business

 

Foundation Healthcare, Inc. (the “Company”) is organized under the laws of the state of Oklahoma and owns controlling and noncontrolling interests in surgical hospitals located in Oklahoma and Texas. The Company also owns noncontrolling interests in ambulatory surgery centers (“ASCs”) located in Texas, Pennsylvania, New Jersey, Ohio, and Maryland. The Company provides management services to a majority of the facilities that it has noncontrolling interests (referred to as “Affiliates”) under the terms of various management agreements.

 

Note 2 – Basis of Presentation

 

Reverse Stock Split – At the Company’s annual meeting of stockholders held on May 12, 2014, the Company’s stockholders approved an amendment to its amended and restated certificate of incorporation to effect a reverse split of its common stock at a ratio between 1-for-3 to 1-for-10 shares. The Company’s stockholders further authorized the board of directors to determine the ratio at which the reverse split would be effected by filing an appropriate amendment to its amended and restated certificate of incorporation. The Company’s board of directors authorized the ratio of the reverse split and corresponding reduction in authorized shares on December 29, 2014 and effective at the close of business on January 8, 2015, the Company amended its amended and restated certificate of incorporation to effect a 1-for-10 reverse split of its common stock. The board of directors considered a ratio that would allow the Company to have a number of outstanding shares to have a sufficient trading volume while considering stock price that would be consistent with the Company’s intention to eventually uplist its common stock from the OTC Markets QB Tier to a listing on the NYSE MKT exchange, though there can be no assurance that the Company will ultimately pursue or be successful in seeking to uplist the Company’s common stock on such exchange. The Board of Directors determined that a ratio of 1-for-10 was the best balance of these and other factors. The effect of the reverse split reduced the Company’s outstanding common stock shares from 172,638,414 to 17,263,842 shares as of the date of the reverse split. The accompanying consolidated financial statements give effect to the reverse split as of the first date reported.

 

Note 3 – Summary of Significant Accounting Policies

Consolidation – The accompanying consolidated financial statements include the accounts of Foundation Healthcare, Inc. and its wholly owned, majority owned and controlled subsidiaries.  All significant intercompany accounts and transactions have been eliminated in consolidation.

The Company accounts for its investments in Affiliates in which the Company exhibits significant influence, but not control, in accordance with the equity method of accounting.  The Company does not consolidate its equity method investments, but rather measures them at their initial costs and then subsequently adjusts their carrying values through income for their respective shares of the earnings or losses during the period.  The Company monitors its investments for other-than-temporary impairment by considering factors such as current economic and market conditions and the operating performance of the companies and records reductions in carrying values when necessary.

Use of estimates – The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company 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.

Reclassifications – Certain amounts presented in prior years have been reclassified to conform to the current year’s presentation.  Such reclassifications had no effect on net income.

Revenue recognition and accounts receivable – The Company recognizes revenues in the period in which services are performed and charged.  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.  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.  Additionally, 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.  Accordingly, the revenues and accounts receivable reported in the Company’s consolidated financial statements are recorded at the net amount expected to be received.

 

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During the years ended December 31, 2015 and 2014, the Company’s revenue payor mix was as follows:

 

 

Contractual Discounts and Cost Report Settlements – The Company derives a significant portion of its revenues from Medicare, Medicaid and other payors that receive discounts from its established billing rates.  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 accompanying consolidated statements of operations.

Cost report settlements under reimbursement agreements with Medicare and Medicaid are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined.  There is a reasonable possibility that recorded estimates will change by a material amount in the near term.  The net cost report settlements due to the Company were approximately $500,000 and $618,000 at December 31, 2015 and 2014, respectively, and are in included in prepaid and other current assets in the accompanying consolidated balance sheets.  We reduced our cost report estimate by $117,900 during 2015 based on our final filed cost report for 2014 and an estimate of the 2015 cost report. We adjusted our 2014 estimate by $382,955 for estimated cost report settlements in 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.

Provision 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.  The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

The Company has an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance.  No single statistic or measurement determines the adequacy of the allowance for doubtful accounts.  Some of the analytical tools that the Company utilizes include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of the Company’s ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan.  Accounts receivable are written off after collection efforts have been followed in accordance with the Company’s policies.

Due to the nature of the healthcare industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided.  Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on the Company’s operating results and cash flows in subsequent periods.  Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for the Company’s products and services.  The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network.  Due to uncertainties surrounding deductible levels and the number of out-of-network patients, the Company is not certain of

 

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the full amount of patient responsibility at the time of service.  The Company estimates amounts due from patients prior to service and generally collects those amounts prior to service.  Remaining amounts due from patients are then billed following completion of service.

The activity in the allowances for doubtful accounts for the years ending December 31, 2015 and 2014 follows:

 

 

Cash and cash equivalents – The Company considers all highly liquid temporary cash investments with an original maturity of three months or less to be cash equivalents.  Certificates of deposit with original maturities of more than three months are also considered cash equivalents if there are no restrictions on withdrawing funds from the account.

Restricted cash – As of December 31, 2015 and 2014, the Company had restricted cash of approximately $0.2 million and $0.7 million, respectively, included in prepaid and other current assets in the accompanying consolidated balance sheets.  The restricted cash is pledged as collateral against certain debt of the Company.

Receivables from Affiliates – Receivables from Affiliates are stated at the amount billed to the Affiliates plus any accrued and unpaid interest.

Supplies inventories – Supplies inventories are stated at the lower of cost or market and primarily include operating supplies used in the direct or indirect treatment of patients.  The Company accounts for inventories using the first in–first out method of accounting for substantially all of its inventories.

Property and equipment – Property and equipment is stated at cost and depreciated using the straight line method to depreciate the cost of various classes of assets over their estimated useful lives.  At the time assets are sold or otherwise disposed of, the cost and accumulated depreciation are eliminated from the asset and depreciation accounts; profits and losses on such dispositions are reflected in current operations.  Fully depreciated assets are written off against accumulated depreciation.  Assets under capital leases are amortized using the straight-line method over the shorter of the estimated useful life of the assets or life of the lease term, excluding any lease renewals, unless the lease renewals are reasonably assured.  Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized.  Expenditures for maintenance and repairs are charged to expense as incurred.

The estimated useful lives of the Company’s property and equipment are as follows:

 

 

Long-lived assets – 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 and changes in legislation and other payor payment patterns.

Goodwill and Intangible Assets – Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell a business.  A significant amount of judgment is involved in determining if an indicator of impairment has occurred.  Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over

 

F-10

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multiple periods, among others.  The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill.  Goodwill is allocated among and evaluated for impairment at the reporting unit level.

The Financial Accounting Standards Board (FASB) guidance on testing goodwill for impairment provides an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the estimated fair value of a reporting unit is less than its carrying amount.  If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test (described below), otherwise no further analysis is required.  An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the two-step quantitative impairment test.  The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the two-step quantitative impairment test.

The Company evaluates goodwill for impairment at least on an annual basis and more frequently if certain indicators are encountered.  Goodwill is to be tested at the reporting unit level, defined as an ASC or hospital (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill.  If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired.  The Company completed its annual impairment test as of December 31, 2015, and determined that goodwill was not impaired.

Intangible assets other than goodwill which include customer relationships, customer files, covenants not to compete, trademarks and payor contracts are amortized over their estimated useful lives using the straight line method.  The remaining lives range from two to eight years.  The Company evaluates the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Noncontrolling Interests – Noncontrolling interests in the results of operations of consolidated subsidiaries represents the noncontrolling shareholders’ share of the income or loss of the various consolidated subsidiaries.  The noncontrolling interests in the consolidated balance sheet reflect the original investment by these noncontrolling shareholders in these consolidated subsidiaries, along with their proportional share of the earnings or losses of these subsidiaries less distributions made to these noncontrolling interest holders.

Legal Issues – For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable.  Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others.  Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded.  If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded.  With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made.  Legal matters are reviewed on a continuous basis or sooner if significant changes in matters have occurred to determine if a change in the likelihood of an unfavorable outcome or the estimate of a loss is necessary.

Concentration of credit risk – The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits.  The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risk.  As of December 31, 2015 and 2014, the Company had cash deposits in excess of FDIC limits of $2.4 million and $1.9 million, respectively.

Advertising Costs – Advertising costs are expensed as incurred.  Advertising expense for 2015 and 2014, included in continuing operations, was approximately $279,000 and $312,000, respectively.

Acquisition Costs – Acquisition costs are charged directly to expense when incurred.

Income Taxes – The Company recognizes deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carry-forwards.  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 of deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  In the event the Company determines that the deferred tax assets will not be realized in the future, the valuation adjustment to the deferred tax assets is charged to earnings in the period in which the Company makes such a determination.  The Company classifies interest and penalties related to its tax positions as a component of income tax expense.

 

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The Company uses a two-step process to evaluate a tax position.  The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position.  The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements.  A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met.  Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met.  The Company reports tax-related interest and penalties as a component of income tax expense.

Based on all known facts and circumstances and current tax law, the Company believes that the total amount of unrecognized tax benefits as of December 31, 2015, is not material to its results of operations, financial condition or cash flows.  The Company also believes that the total amount of unrecognized tax benefits as of December 31, 2015, if recognized, would not have a material effect on its effective tax rate.  The Company further believes that there are no tax positions for which it is reasonably possible, based on current tax law and policy that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on the Company’s results of operations, financial condition or cash flows.

Loss per share – Basic loss per share is computed by dividing net loss by the weighted average number of common shares outstanding for the period.  Diluted loss per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period.  Dilutive securities having an anti-dilutive effect on diluted earnings (loss) per share are excluded from the calculation.

The dilutive potential common shares on options and warrants are calculated in accordance with the treasury stock method, which assumes that proceeds from the exercise of all options and warrants are used to repurchase common stock at market value.  The amount of shares remaining after the proceeds are exhausted represents the potential dilutive effect of the securities.

The following securities were not included in the computation of diluted earnings (loss) per share from continuing operations or discontinued operations as their effect would be anti-dilutive:

 

 

Stock options – The Company accounts for its stock option grants using the modified prospective method.  Under the modified prospective method, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period.

Recently Adopted and Recently Issued Accounting Guidance

Adopted Guidance

On January 1, 2015, the Company adopted changes issued by the Financial Accounting Standards Board (“FASB”) to the reporting of discontinued operations and disclosures of disposals of components of an entity. These changes require a disposal of a component to meet a higher threshold in order to be reported as a discontinued operation in an entity’s financial statements. The threshold is defined as a strategic shift that has, or will have, a major effect on an entity’s operations and financial results such as a disposal of a major geographical area or a major line of business. Additionally, the following two criteria have been removed from consideration of whether a component meets the requirements for discontinued operations presentation: (i) the operations and cash flows of a disposal component have been or will be eliminated from the ongoing operations of an entity as a result of the disposal transaction, and (ii) an entity will not have any significant continuing involvement in the operations of the disposal component after the disposal transaction. Furthermore, equity method investments now may qualify for discontinued operations presentation. These changes also require expanded disclosures for all disposals of components of an entity, whether or not the threshold for reporting as a discontinued operation is met, related to profit or loss information and/or asset and liability information of the component. The adoption of these changes had no impact on the Company’s consolidated financial statements.

In November 2015, the FASB, issued updated guidance on the presentation requirements for deferred income tax liabilities and assets to be classified as noncurrent in a classified statement of financial position. The update is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years, and early adoption is permitted for all entities as of the beginning of an interim or annual reporting period. The Company adopted these provisions during

 

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the fourth quarter of 2015 and retrospectively for all periods presented.  The adoption had no impact on the Company’s results of operations or cash flows.

Issued Guidance

In January 2015, the FASB issued changes to the presentation of extraordinary items. Such items are defined as transactions or events that are both unusual in nature and infrequent in occurrence, and, currently, are required to be presented separately in an entity’s income statement, net of income tax, after income from continuing operations. The changes eliminate the concept of an extraordinary item and, therefore, the presentation of such items will no longer be required. Notwithstanding this change, an entity will still be required to present and disclose a transaction or event that is both unusual in nature and infrequent in occurrence in the notes to the financial statements. These changes become effective for the Company on January 1, 2016. Management has determined that the adoption of these changes will not have an impact on the Company’s consolidated financial statements.

In February 2015, the FASB issued changes to the analysis that an entity must perform to determine whether it should consolidate certain types of legal entities. These changes (i) modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities or voting interest entities, (ii) eliminate the presumption that a general partner should consolidate a limited partnership, (iii) affect the consolidation analysis of reporting entities that are involved with variable interest entities, particularly those that have fee arrangements and related party relationships, and (iv) provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. These changes become effective for us on January 1, 2016. Management is currently evaluating the potential impact of these changes on the Company’s consolidated financial statements.

In April 2015, the FASB issued changes to the presentation of debt issuance costs.  Currently, such costs are required to be presented as a noncurrent asset in an entity’s balance sheet and amortized into interest expense over the term of the related debt instrument.  The changes require that debt issuance costs be presented in an entity’s balance sheet as a direct deduction from the carrying value of the related debt liability.  The amortization of debt issuance costs remains unchanged.  These changes become effective for the Company on January 1, 2016.  Management has determined that the adoption of these changes will result in a decrease of approximately $644,000 to both other assets and long-term debt, less amount due within one year of the accompanying consolidated balance sheet.

In July 2015, the FASB issued changes to the subsequent measurement of inventory. Currently, an entity is required to measure its inventory at the lower of cost or market, whereby market can be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. The changes require that inventory be measured at the lower of cost and net realizable value, thereby eliminating the use of the other two market methodologies. Net realizable value is defined as the estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal, and transportation. These changes do not apply to inventories measured using LIFO (last-in, first-out) or the retail inventory method. Currently, the Company applies the net realizable value market option to measure its inventories at the lower of cost or market. These changes become effective for the Company on January 1, 2017. Management has determined that the adoption of these changes will not have an impact on the Company’s consolidated financial statements.

In September 2015, the FASB issued changes to the accounting for business combinations simplifying the accounting for measurement period Adjustments.  The update eliminates the requirement for an acquirer to retrospectively adjust its financial statements for changes to provisional amounts that are identified during the measurement-period following the consummation of a business combination.  Instead, the update requires these types of adjustments to be made during the reporting period in which they are identified and would require additional disclosure or separate presentation of the portion of the adjustment that would have been recorded in the previously reported periods as if the adjustment to the provisional amounts had been recognized as of the acquisition date.  This change is effective prospectively for fiscal years beginning after December 15, 2015, including interim periods within those years.  The adoption of these changes is not expected to have a material impact on the Company’s results of operations.

In February 2016, the FASB issued changes to the accounting for leases, which requires an entity that leases assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. The update is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 and must be adopted using a modified retrospective approach. Management is currently evaluating the impact of this update on the consolidated financial statements.

In May 2014, the FASB issued changes to the recognition of revenue from contracts with customers.  These changes created a comprehensive framework for all entities in all industries to apply in the determination of when to recognize revenue, and, therefore, supersede virtually all existing revenue recognition requirements and guidance.  This framework is expected to result in less complex

 

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guidance in application while providing a consistent and comparable methodology for revenue recognition.  The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  To achieve this principle, an entity should apply the following steps:  (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract(s), (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract(s), and (v) recognize revenue when, or as, the entity satisfies a performance obligation.  These changes become effective for the Company on January 1, 2018 and early adoption is not permitted.  Management is currently evaluating the potential impact of these changes on the Company’s consolidated financial statements.

In August 2014, the FASB issued changes to the disclosure of uncertainties about an entity’s ability to continue as a going concern.  Under GAAP, continuation of a reporting entity as a going concern is presumed as the basis for preparing financial statements unless and until the entity’s liquidation becomes imminent.  Even if an entity’s liquidation is not imminent, there may be conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern.  Because there is no guidance in GAAP about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern or to provide related note disclosures, there is diversity in practice whether, when, and how an entity discloses the relevant conditions and events in its financial statements.  As a result, these changes require an entity’s management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that financial statements are issued.  Substantial doubt is defined as an indication that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that financial statements are issued.  If management has concluded that substantial doubt exists, then the following disclosures should be made in the financial statements: (i) principal conditions or events that raised the substantial doubt, (ii) management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations, (iii) management’s plans that alleviated the initial substantial doubt or, if substantial doubt was not alleviated, management’s plans that are intended to at least mitigate the conditions or events that raise substantial doubt, and (iv) if the latter in (iii) is disclosed, an explicit statement that there is substantial doubt about the entity’s ability to continue as a going concern.  These changes become effective for the Company for the 2016 annual period.  Management has determined that the adoption of these changes will not have an impact on the Company’s consolidated financial statements.  Subsequent to adoption, this guidance will need to be applied by management at the end of each annual period and interim period therein to determine what, if any, impact there will be on the consolidated financial statements in a given reporting period.

 

Note 4 – Acquisition

On December 31, 2015, the Company closed the acquisition comprising substantially all of the hospital assets and hospital operating entity of University General Health Systems, Inc. (“UGHS”), consisting primarily of a sixty-nine bed acute care hospital located in the Medical City area of Houston, Texas (referred to as University General Hospital, LP or “UGH” and collectively referred to as the “Acquisition”).  Subsequent to the Acquisition, UGH will be operated as Foundation Surgical Hospital of Houston.

The acquisition of UGH was based on management’s belief that UGH fits into Foundation’s acquisition and development strategy and operating model that enables the Company to grow by taking advantage of highly-fragmented markets, an increasing demand for short stay surgery and a need by physicians to forge strategic alliances to meet the needs of the evolving healthcare landscape while also shaping the clinical environments in which they practice.  The Company expects the acquisition of UGH will generate positive earnings and cash flow that will be accretive to the earnings and cash flow of the Company.  The Company expects the goodwill attributable to UGH to be tax deductible.

The Company paid $25.1 million in cash for the net assets acquired from UGHS.

 

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The fair value amounts have been initially recorded using preliminary estimates.  The Company has engaged a third-party valuation company to complete a valuation of the fair value of the assets acquired and liabilities assumed in the acquisition.  The preliminary estimates will be revised in future periods and the revisions may materially affect the presentation of the Company’s consolidated financial results.  Any changes to the initial estimates of the fair value of the assets and liabilities will be recorded as adjustments to those assets and liabilities and residual amounts will be allocated to goodwill.  The preliminary purchase allocations for the Acquisition are as follows:

 

 

During the year ended December 31, 2015, the Company incurred approximately $273,000 in expenses related to the Acquisition.  The expenses incurred related primarily to legal fees related to the purchase agreement and structure of the transaction and professional fees related to the audits of the 2015 and 2014 financial statements of UGH.

Since the Acquisition occurred on December 31, 2015, there are no acquisition revenues and earnings included in the Company’s consolidated statements of operations for the year ended December 31, 2015.  The revenue and earnings of the combined entity had the Acquisition date been January 1, 2015 are as follows:

 

 

The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

 

Note 5 – Divestitures

On July 15, 2015, The Company sold its 10% interest in the Kirby Glen Surgery, LLC, one of the Company’s Equity Owned ASCs located in Houston, Texas. The Company received $0.2 million in combined proceeds for the sale of the equity interest and termination of the Company’s management agreement.

On June 12, 2015, the Company executed an agreement pursuant to which the Company sold a portion of its 20% equity investment in Grayson County Physician Property, LLC (“GCPP”) through a series of transactions.  In conjunction with the sale, the management agreement under which the Company provided certain services including billing and collections, general management services, legal support, and accounting services was terminated.  The Company’s decision to sell the assets of GCPP was part of the Company’s strategic plan to focus on the growth of its majority owned surgical hospital businesses.  The Company received $7.8 million of proceeds as a result of the sale and $0.5 million for the termination of the management agreement.  The Company used $7.0 million of these proceeds to reduce the Company’s principal balance of the note held by Bank SNB (the Company’s senior lender).  

 

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The remainder of the proceeds will be used for working capital needs and possible future acquisitions.  See Note 6 – Discontinued Operations for additional information.

 

On March 31, 2015, Houston Orthopedic Surgical Hospital, L.L.C. (“HOSH”), the Company’s Equity Owned hospital in Houston, Texas, sold substantially all of its assets under an asset purchase agreement.  Given that the Company does not exhibit control with our 20% investment in HOSH, the Company accounts for its investment on a cost or cash basis.  As a result of the HOSH sale, the Company received a distribution on May 12, 2015 for $1.8 million, of which $0.6 million is being held in escrow until April 2016.  

 

 

Note 6 – Discontinued Operations

The partial sale of GCPP in June 2015 was part of the Company’s strategic plan to focus on majority owned investments. As a result, the proceeds from the sale, the remaining equity ownership, and the results of operations and cash flows related to the equity investment in GCPP for all periods presented have been classified as discontinued operations.  Therefore, the Company reclassified $2.2 million from equity method investments in affiliates to other assets from discontinued operations as of December 31, 2014.  In addition, the Company reclassified $0.1 million and $0.6 million from equity in earnings from affiliates to income from discontinued operations, net of tax, for the years ending December 31, 2015 and 2014, respectively.

The operating results for the Company’s discontinued operations for the year ended December 31, 2015 and 2014 are summarized below:

 

The balance sheet items for discontinued operations as of December 31, 2015 and 2014 are summarized below:

 

 

 

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Note 7 – Equity Investments in Affiliates

The Company invests in non-majority interests in its Affiliates.  The Company’s equity investments and respective ownership interest as of December 31, 2015 and 2014 are as follows:

 

 

The results of operations for the years ended and as of December 31, 2015 and 2014, of the Company’s equity investments in Affiliates are as follows:

 

The results of financial position for the years ended and as of December 31, 2015 and 2014, of the Company’s equity investments in Affiliates are as follows:

 

 

Note 8 – Property and Equipment

Following are the components of property and equipment included in the accompanying consolidated balance sheets as of December 31, 2015 and 2014:

 

 

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Depreciation expense for the years ended December 31, 2015 and 2014 was $5,697,962 and $5,550,161 respectively.

 

 

Note 9 – Goodwill and Other Intangibles

Changes in the carrying amount of goodwill during the years ended December 31, 2015 and 2014 were as follows:

 

 

Goodwill and intangible assets with indefinite lives must be tested for impairment at least once a year.  Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value.  The Company tests goodwill for impairment on an annual basis in the fourth quarter or more frequently if management believes indicators of impairment exist.  The performance of the test involves a two-step process.  The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill.  The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies.  If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the Company performs the second step of the goodwill impairment test to determine the amount of impairment loss.  The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.

Changes in the carrying amount of intangible assets during the years ended December 31, 2015 and 2014 were as follows:

 

 

Intangible assets as of December 31, 2015 and 2014 include the following:

 

 

Amortization expense for the next five years related to these intangible assets is expected to be as follows:

 

 

 

 

 

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Note 10 – Borrowings and Capital Lease Obligations

 

The Company’s short-term debt obligations as of December 31, 2015 and 2014 are as follows:

 

The Company has various insurance premium financing notes payable that bear interest rates ranging from 3.9% to 4.9%.  The insurance notes mature from January 2015 to October 2015 and the Company is required to make monthly principal and interest payments totaling $50,731.

The Company’s long-term debt as of December 31, 2015 and 2014 are as follows:

Texas Capital Bank Credit Facility

 

Effective December 31, 2015, the Company entered into a Credit Agreement (the “TCB Credit Facility”) with Texas Capital Bank, National Association (“TCB”).  The TCB Credit Facility replaced and consolidates all of the Company’s and the Company’s subsidiaries’ debt in the principal amount of $28.4 million, which is referred to as the Term Loan, and provides for an additional revolving loan in the amount of $12.5 million, which is referred to as the Revolving Loan.  The Company has also entered into a number of ancillary agreements in connection with the TCB Credit Facility, including deposit account control agreements, subsidiary guarantees, security agreements and promissory notes.

Maturity Dates.  The Term Loan matures on December 30, 2020 and the Revolving Loan matures on December 30, 2018.

Interest Rates.  Borrowings under the TCB Credit Facility are made, at the Company’s option, as either Base Rate loans or LIBOR loans.  “Base Rate” for any day is the highest of (i) the Prime Rate, (ii) the Federal Funds Rate plus one half of one percent (0.5%), and (iii) Adjusted LIBOR plus one percent (1.00%).  LIBOR loans are based on either the one month, two month or three month LIBOR rate at the Company’s option.  The interest rate is either a Base Rate or LIBOR plus the Applicable Margins based on our Senior Debt to EBITDA Ratio, as defined.

The Applicable Margins are as follows:

 

 The Applicable Margin in effect will be adjusted within 45 days following the end of each quarter based on the Company’s Senior Debt to EBITDA ratio.  The Senior Debt to EBITDA Ratio is calculated by dividing all of our senior indebtedness (excluding capital lease obligations for Foundation Surgical Hospital of Houston), that is by the Company’s EBITDA for the preceding four fiscal

 

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quarters.  EBITDA is defined in the TCB Credit Facility as the Company’s net income plus (b) the sum of the following: interest expense; income taxes; depreciation; amortization; extraordinary losses determined in accordance with GAAP; cash and noncash stock compensation expense; and other non‑recurring expenses reducing such net income which do not represent a cash item in such period or any future period, minus (c) the sum of the following: income tax credits; extraordinary gains determined in accordance with GAAP; and all non‑recurring, non‑cash items increasing net income.

 

Interest and Principal Payments.  The Company is required to make quarterly payments of principal and interest on the Term Loan.  The first four quarterly payments on the Term Loan will be $1,013,393, on the first day of each April, July, October, and January during the term hereof, commencing April 1, 2016.  The Company is required to make quarterly payments on the Revolving Loan equal to the accrued and unpaid interest.  All unpaid principal and interest on the Term Loan and Revolving Loan must be paid on the respective maturity dates of each Loan.

 

Borrowing Base.  The Company’s ability to borrow money under the Revolving Loan is limited to the Company’s Borrowing Base.  The Company’s Borrowing Base is equal to the sum of (i) 80% of the eligible account of Foundation Surgical Hospital of San Antonio, not to exceed the outstanding principal balance of the intercompany note payable by the San Antonio Hospital to the Company, (ii) 80% of the eligible account of Foundation Surgical Hospital of El Paso, not to exceed the outstanding principal balance of the intercompany note payable by the El Paso Hospital to the Company, and (iii) 80% of the eligible account of Foundation Surgical Hospital of Houston, not to exceed the outstanding principal balance of the intercompany note payable by the Houston Hospital to the Company.

 

Mandatory Prepayments.  The Company must make mandatory prepayments of the Term Loans in the following situations, among others:

 

Voluntary Prepayments.  The Company may prepay amounts under the Term Loan or Revolving Loan at any time provided that the Company is required to pay a prepayment fee of 2% of the amount prepaid if payment is made prior to the first anniversary, 1.5% if the prepayment is made after the first anniversary but prior to the second anniversary and 1% if the prepayment is made after the second anniversary but prior to the third anniversary.  

Guaranties.  Each of our direct or indirect wholly-owned subsidiaries jointly and severally and unconditionally guaranty payment of our obligations owed to Lenders.

Financial Covenants:

 

Debt to EBITDA Ratio.  As of December 31, 2015, the Company must maintain a Debt to EBITDA Ratio, not in excess of 3.50 to 1.00.  Thereafter, the Company must maintain a Debt to EBITDA Ratio as of the last day of any fiscal quarter, not in excess of (a) 3.25 to 1.00 for the fiscal quarters ending December 31, 2015, March 31, 2016, June 30, 2016 and September 30, 2016; (b) 2.75 to 1.00 for the fiscal quarters ending December 31, 2016, March 31, 2017, June 30, 2017 and September 30, 2017; (c) 2.50 to 1.00 for the fiscal quarters ending December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018; and (d) 2.25 to 1.00 for the fiscal quarter ending December 31, 2018 and at the end of each fiscal quarter thereafter.  As of December 31, 2015, the Company’s Debt to EBITDA Ratio was 2.66.

Senior Debt to EBITDA Ratio.  As of December 31, 2015, the Company must maintain a Senior Debt to EBITDA Ratio not in excess of 3.00 to 1.00.  Thereafter, the Company must maintain a Senior Debt to EBITDA Ratio as of the last day of any fiscal quarter, not in excess of (a) 3.00 to 1.00 for the fiscal quarters ending December 31, 2015, March 31, 2016, June 30, 2016 and September 30, 2016; (b) 2.50 to 1.00 for the fiscal quarters ending December 31, 2016, March 31, 2017, June 30,

 

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2017 and September 30, 2017; (c) 2.25 to 1.00 for the fiscal quarters ending December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018; and (d) 2.00 to 1.00 for the fiscal quarter ending December 31, 2018 and at the end of each fiscal quarter thereafter.  As of December 31, 2015, the Company’s Senior Debt to EBITDA Ratio was 2.24.

 

Pre-Distribution Fixed Charge Coverage Ratio.  The Company must maintain as of the last day of any fiscal quarter a Pre-Distribution Fixed Charge Coverage Ratio in excess of 1.30 to 1.00.  As of December 31, 2015, the Company’s Pre-Distribution Fixed Charge Coverage Ratio was 2.45.

 

Post-Distribution Fixed Charge Coverage Ratio.  The Company must maintain as of the last day of any fiscal quarter, a Post-Distribution Fixed Charge Coverage Ratio in excess of 1.05 to 1.00.  As of December 31, 2015, the Company’s Pre-Distribution Fixed Charge Coverage Ratio was 1.30.

 

Capital Expenditures.  The Company shall not make capital expenditures in excess of $5,000,000 during any fiscal year.

As of December 31, 2015, the Company is in compliance with all of the TCB Credit Facility financial covenants.

Collateral.  Payment and performance of the Company’s obligations under the TCB Credit Facility are secured in general by all of the Company and the Company’s guarantors’ assets.

 

Negative Covenants.  The TCB Credit Facility has restrictive covenants that, among other things, limits or restricts the Company’s ability to do the following without the consent of TCB::

Defaults and Remedies.  In addition to the general defaults of failure to perform our obligations under the Loan Agreement, events of default also include the occurrence of a change in control, as defined, and the loss of our Medicare or Medicaid certification, collateral casualties, entry of a uninsured judgment of $500,000 or more, failure of first liens on collateral and the termination of any of the Company’s management agreements that represent more than 10% of the Company’s management fees for the preceding 18 month period.  In the event of a monetary default, all of the Company’s obligations due under the TCB Credit Facility shall become immediately due and payable.  In the event of a non-monetary default, the Company has 10 days or in some cases three days to cure before Texas Capital Bank has the right to declare the Company’s obligations due under the TCB Credit Facility immediately due and payable.

At December 31, 2015, future maturities of long-term debt were as follows:

 

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The Company’s capital leases obligations as of December 31, 2015 and 2014 are as follows:

 

 

The Company has entered into a capital lease covering the FSH Houston hospital facility, see Note 4 - Acquisition.  The capital lease bears an interest at fixed rate of 7.5%.  The Company is required to make monthly principal and interest payments under the capital lease totaling $193,611.

The Company has entered into various capital leases that are collateralized by certain computer and medical equipment used by the Company.  The capital leases bear interest at fixed rates ranging from 5.5% to 10.7%.  The Company is required to monthly principal and interest payments under the capital leases totaling $131,302.

At December 31, 2015, future maturities of capital leases obligations were as follows:

 

 

 

Note 11 –Preferred Noncontrolling Interests

During 2013, the Company’s wholly-owned subsidiary, Foundation Health Enterprises, LLC (“FHE”) completed a private placement offering of $9,135,000.  The offering was comprised of 87 units (“FHE Unit” or “preferred noncontrolling interest”).  Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000, and 1,000 shares of the Company’s common stock, valued at $5,000.  The total consideration of $9,135,000 was comprised of $8,700,000 attributable to the preferred noncontrolling interest and $435,000 attributable to the 87,000 shares of the Company’s common stock.

The FHE Units provide for a cumulative preferred annual return of 9% on the amount allocated to the Class B membership interests.  The FHE Units will be redeemed by FHE in four annual installments beginning in July 2014.  The FHE Unit holders agreed to defer the first installment until March 2015.  The first and second installments were paid on April 1 and October 4, 2015.  The first three installments shall be in the amount of $10,000 per FHE Unit and the fourth installment will be in the amount of the unreturned capital contribution and any undistributed preferred distributions.  The FHE Units are convertible at the election of the holder at any time prior to the complete redemption into restricted common shares of the Company at a conversion price of $20 per share.  Since the FHE Units have a redemption feature and a conversion feature which the Company determined to be substantive, the preferred noncontrolling interests has been recorded at the mezzanine level in the accompanying consolidated balance sheets and the corresponding dividends are recorded as a reduction of accumulated deficit.

 

 

 

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Note 12 – Commitments and Contingencies

Legal Issues – The Company is exposed to asserted and unasserted legal claims encountered in the normal 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.  Management believes that the ultimate resolution of these matters will not have a material adverse effect on the operating results or the financial position of the Company.  During the years ended December 31, 2015 and 2014, the Company did not incur any settlement expenses related to its ongoing asserted and unasserted legal claims.

Operating Leases – The Company leases all of the real property used in its business for office space, surgical hospital facilities and certain medical equipment under operating lease agreements.  Rent expense for leases that contain scheduled rent increases is recognized on a straight-line basis over the lease term (“Deferred Rent”).  As of December 31, 2015 and 2014, the Company had Deferred Rent of $4,192,217 and $3,930,325, respectively, which is included in other liabilities in the accompanying consolidated balance sheets.  In addition to minimum lease payments, certain leases require reimbursement for common area maintenance and insurance, which are expensed when incurred.

The Company’s rental expense, net of sublease income, for operating leases for the years ended December 31, 2015 and 2014 were $9,462,991 and $9,933,563, respectively.

Following is a summary of the future minimum lease payments under operating leases as of December 31, 2015:

 

At December 31, 2015 and 2014, the Company had current and long-term deferred lease incentives of $7,121,172 and $9,555,581, respectively.  The lease incentives are included in current other liabilities and other liabilities the accompanying consolidated balance sheets and are amortized on a straight line basis over the life of the lease as a reduction in rent expense.

Self-insurance – Effective January 1, 2014, the Company began using a combination of insurance and self-insurance for employee-related healthcare benefits. The self-insurance liability is determined actuarially, based on the actual claims filed and an estimate of incurred but not reported claims. Self-insurance reserves as of December 31, 2015 and 2014 were $424,593 and $560,851, respectively, and are included in accrued liabilities in the accompanying consolidated balance sheets.

 

 

Note 13 – Income Taxes

The income tax provision for the years ended December 31, 2015 and 2014 consists of:

 

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Deferred income tax assets and liabilities as of December 31, 2015 and 2014 are comprised of:

 

 

The change in the Company’s valuation allowance on deferred tax assets during the years ended December 31, 2015 and 2014 follows:

 

The Company’s effective income tax rate for continuing operations differs from the U.S. Federal statutory rate as follows:

 

The amount of income taxes the Company pays is subject to ongoing examinations by federal and state tax authorities.  To date, there have been no reviews performed by federal or state tax authorities on any of the Company’s previously filed returns.  The Company’s 2009, 2011 and later tax returns are still subject to examination.

 

 

Note 14 – Capital Structure

 

At the Company’s annual meeting of stockholders held on May 12, 2014, the Company’s stockholders approved an amendment to its amended and restated certificate of incorporation to effect a reverse split of its common stock at a ratio between 1-for-3 to 1-for-

 

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10 shares. The Company’s stockholders further authorized the board of directors to determine the ratio at which the reverse split would be effected by filing an appropriate amendment to its amended and restated certificate of incorporation. The Company’s board of directors authorized the ratio of the reverse split and corresponding reduction in authorized shares on December 29, 2014 and effective at the close of business on January 8, 2015, the Company amended its amended and restated certificate of incorporation to effect a 1-for-10 reverse split of its common stock. The board of directors considered a ratio that would allow the Company to have a number of outstanding shares to have a sufficient trading volume while considering stock price that would be consistent with the Company’s intention to eventually uplist its common stock from the OTC Markets QB Tier to a listing on the NYSE MKT exchange, though there can be no assurance that we will ultimately pursue or be successful in seeking to uplist the Company’s common stock on such exchange. The Board of Directors determined that a ratio of 1-for-10 was the best balance of these and other factors. The effect of the reverse split reduced the Company’s outstanding common stock shares from 172,638,414 to 17,263,842 shares as of the date of the reverse split. The accompanying consolidated financial statements give effect to the reverse split as of the first date reported.

 

 

Note 15 – Stock Options, Grants and Warrants

The Company has adopted the Amended and Restated 2008 Long-Term Incentive Plan (the “Incentive Plan”).  The Incentive Plan consists of three separate stock incentive plans: a Non-Executive Officer Participant Plan, an Executive Officer Participant Plan and a Non-Employee Director Participant Plan.  Except for administration and the category of employees eligible to receive incentive awards, the terms of the Non-Executive Officer Participant Plan and the Executive Officer Participant Plan are identical.  The Non-Employee Director Plan has other variations in terms and only permits the grant of nonqualified stock options and restricted stock awards.  Each incentive award will be pursuant to a written award agreement.  The number of shares of common stock authorized and reserved under the Incentive Plan is 2,000,000.

The fair value of each option and warrant grant is estimated on the date of grant using the Black-Scholes option pricing model.  The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables.  These variables include the expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.  Given the Company’s limited trading history and lack of employee option exercise history, the Company has included the assumptions and variables of similar companies in the determination of the actual variables used in the option pricing model.  The Company bases the risk-free interest rate used in the option pricing model on U.S. Treasury zero-coupon issues.  The Company does not anticipate paying any cash dividends in the foreseeable future and therefore an expected dividend yield of zero is used in the option pricing model.

 

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The assumptions used to value the option and warrant grants are as follows:

 

Information with respect to stock options and warrants outstanding follows:

 

 

The options and warrants outstanding and options and warrants exercisable as of December 31, 2015 had no intrinsic value.  The intrinsic value is calculated as the difference between the market value and exercise price of the shares.

Information with respect to the Company’s restricted stock awards follows:

 

During 2015 and 2014, the Company issued 60,125 and 971,755, respectively, restricted stock grant awards to certain key employees.  The fair value of the restricted stock grant awards was approximately $256,000 and $3,518,000, respectively, and was calculated by multiplying the number of restricted shares issued times the closing share price on the date of issuance.  The value of the stock grants is recorded as compensation over the requisite service period which equals vesting period of the stock award.  During 2015 and 2014, the Company recorded compensation expense related to stock grant awards of approximately $1,637,000 and $1,337,000, respectively.  As of December 31, 2015 and 2014, the Company had unrecognized compensation expense associated with the stock grants, options and warrants of approximately $1,599,000 and $2,290,000, respectively.

 

 

 

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Note 16 – Real Estate Transaction

On March 1, 2014, the Company executed a 15 year master lease on the building occupied by the Company’s hospital subsidiary in San Antonio, Texas for an annual rent of $2.3 million with annual escalations of 3%. The current lease income on the underlying sub-lease is approximately $2.1 million per year which includes the rent paid by FBH SA. The master lease is an operating lease. In conjunction with the master lease and certain other agreements with the landlord, the Company received $4.1 million at the time of the lease. Given the disparity between the annual rent expense under the master lease and the rental income of the underlying sub-lease, the gain from cash received at the execution of the lease was deferred and is being recognized on a straight-line basis as a reduction in the rent expense under the master lease.

 

 

Note 17 – Fair Value Measurements

Fair value is the price that would be received from the sale of an asset or paid to transfer a liability (i.e., an exit price) in the principal or most advantageous market in an orderly transaction between market participants. In determining fair value, the accounting standards established a three-level hierarchy that distinguishes between (i) market data obtained or developed from independent sources (i.e., observable data inputs) and (ii) a reporting entity’s own data and assumptions that market participants would use in pricing an asset or liability (i.e., unobservable data inputs).  Financial assets and financial liabilities measured and reported at fair value are classified in one of the following categories, in order of priority of observability and objectivity of pricing inputs:

The fair value measurement level for an asset or liability is based on the lowest level of any input that is significant to the fair value measurement.  Valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs.

Recurring Fair Value Measurements:  The carrying value of the Company’s financial assets and financial liabilities is their cost, which may differ from fair value.  The carrying value of cash held as demand deposits, money market and certificates of deposit, accounts receivable, short-term borrowings, accounts payable and accrued liabilities approximated their fair value.  At December 31, 2015 and 2014, the fair value of the Company’s long-term debt approximated its fair value.  

Nonrecurring Fair Value Measurements:

Acquisition – During 2015, the Company completed the University General Hospital, LP acquisition; see Note 4 – Acquisition for additional information.  The assets acquired and liabilities assumed in the acquisition were recorded at their fair values on the date of acquisition.

For the acquisition, the nonrecurring fair value measurements were developed using significant unobservable inputs (Level 3) using discounted cash flow calculations based upon the Company’s weighted average cost of capital and third-party valuation services.      Assumptions used were similar to those that would be used by market participants performing valuations of these business units and were based on analysis of current and expected future economic conditions and the updated strategic plan for each business unit.

 

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The Company did not have assets measured at fair value on a nonrecurring basis in 2014.  The fair value measurements for the Company’s assets measured at fair value on a nonrecurring basis as of December 31, 2015 follows:

 

 

 

Note 18 – Related Party Transactions

Effective June 1, 2014, the Company’s hospital subsidiary located in El Paso, Texas entered into a sublease agreement with The New Sleep Lab International, Ltd., referred to as New Sleep. New Sleep is controlled by Dr. Robert Moreno, one of our Directors. The sublease with New Sleep calls for monthly rent payments of $8,767 and the sublease expires on November 30, 2018. The space subleased from New Sleep will be sublet to physician partners and casual uses of our hospital and is located in a building that also houses one of our imaging facilities. During the year ended December 31, 2015, the Company incurred approximately $109,142 in lease expense under the terms of the lease.

As of December 31, 2015, the Company had $0.2 million on deposit at Valliance Bank.  Valliance Bank is controlled by Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates.  Non-controlling interests in Valliance Bank are held by Mr. Stanton Nelson, the Company’s chief executive officer and Mr. Joseph Harroz, Jr., a director of the Company.  Mr. Nelson and Mr. Harroz also serve as directors of Valliance Bank.

The Company has office space subject to a lease agreement with City Place, LLC (“City Place”).   Under the lease agreement, the Company pays monthly rent of $17,970 until June 30, 2014; $0 from July 1, 2014 to January 31, 2015 and $17,970 from February 1, 2015 to May 31, 2015 plus additional payments for allocable basic expenses of City Place; the lease as terminated early effective May 31, 2015, in which the Company agreed to pay $89,850 in five equal installments of $17,970 ending October 31, 2015.  Non-controlling interests in City Place are held by Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates.  During the years ended December 31, 2015 and 2014, the Company incurred approximately $53,900 and $146,000, respectively, in lease expense under the terms of the lease.

The Company has entered into agreements with certain of its Affiliate ASCs and hospitals to provide management services.  As compensation for these services, the surgery centers and hospitals are charged management fees which are either fixed or are based on a percentage of the Affiliates cash collected or the Affiliates net revenue.  The percentages range from 2.25% to 6.0%.

 

 

Note 19 – Subsequent Events

Management evaluated all activity of the Company and concluded that no material subsequent events have occurred that would require recognition in the consolidated financial statements or disclosure in the notes to the consolidated financial statements.

 

 

 

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