---

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)

[X]    Annual
    Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934For the fiscal year ended
    December 31, 2001OR[  ]    Transition
    Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
    For the transition period from 
    to


Commission file number 1-12040

SUN HEALTHCARE GROUP, INC.(Exact name of registrant as specified in its charter)

Delaware
    (State of Incorporation)
    85-0410612
    (I.R.S. Employer Identification No.)


101 Sun Avenue NE
Albuquerque, New Mexico 87109
(505) 821-3355
(Address and telephone number of Registrant)

Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act: Title of each classCommon Stock, par value $.01 per share

Indicate by check mark whether the
registrant (1) has filed all reports required by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes
[X]     No [  ]

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and
will not be contained, to the best of the registrant's knowledge, in the definitive proxy
statement incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.     [X]

On March 18, 2002, Sun Healthcare
Group, Inc. had 8,949,977 outstanding shares of Common Stock. Of those, 6,769,976
shares of Common Stock were held by nonaffiliates. As of March 28, 2002, there was no
established trading market for the Common Stock.

Indicate by check mark whether the
registrant has filed all documents and reports required to be filed by Section 12, 13
or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of
securities under a plan confirmed by a court.
Yes  [X]  No  [  ]

Documents Incorporated by Reference: None
1

---

SUN HEALTHCARE GROUP, INC.
(Debtor-in-Possession)FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001



PagePART IItem 1.
    Business
    3Item 2.
    Properties
    22Item 3.
    Legal Proceedings
    24Item 4.
    Submission of Matters to a Vote of
    Security Holders
    25PART IIItem 5.
    Market for Registrant's Common Equity and Related Stockholder Matters
    25Item 6.
    Selected Financial Data
    26Item 7.
    Management's Discussion and
    Analysis of Financial Condition and Results of Operations
    29Item 7A.
    Quantitative and Qualitative
    Disclosures About Market Risk
    52Item 8.
    Financial Statements and
    Supplementary Data
    53Item 9.
    Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosures
    53PART IIIItem 10.
    Directors and Executive Officers of the Registrant
    54Item 11.
    Executive Compensation
    58Item 12.
    Security Ownership of Certain
    Beneficial Owners and Management
    61Item 13.
    Certain Relationships and Related
    Transactions
    63PART IVItem 14.
    Exhibits, Financial Statement Schedules and Reports on Form 8-K
    65Signatures
    
    68


SunBridge

___________________

2

---

PART I

Item 1. Business

General

Sun Healthcare Group, Inc. through
its direct and indirect subsidiaries (collectively referred to herein as "Sun"
or the "Company"), is one of the largest providers of long-term, subacute and
related specialty healthcare services in the United States. The Company currently operates
through three principal business segments: (i) inpatient services,
(ii) rehabilitation therapy services, and (iii) pharmaceutical services. The
following is a description of the Company's current business segments and other
operations. Financial information for the business segments is set forth in "Note 21
- Segment Information" in the Company's consolidated financial statements.

Inpatient Services. As of March 1,
2002, Sun operated 247 long-term, subacute care and assisted living facilities (consisting
of 229 skilled nursing facilities, nine assisted living facilities and nine acute
rehabilitation hospitals) in 25 states with 27,954 licensed beds in the United States
through its wholly owned subsidiary, SunBridge Healthcare Corporation and other direct and
indirect subsidiaries (collectively, "SunBridge"). The Company intends to divest
13 skilled nursing facilities with 1,764 licensed beds during 2002. The Company's
long-term and subacute care facilities provide inpatient skilled nursing and custodial
services as well as rehabilitative, restorative and transitional medical services. The
Company provides 24-hour nursing care in these facilities by registered nurses, licensed
practical nurses and certified nursing aides.

The long-term care industry encompasses a
broad range of related specialty healthcare services provided to the elderly and to other
patients with medically complex needs who can be cared for outside of the acute care
hospital environment but who generally cannot be efficiently and effectively cared for at
home. Long-term and subacute care facilities offer skilled nursing care, routine
rehabilitation therapy and other support services, primarily to elderly patients.
Long-term and subacute care facilities may also provide a broad range of specialized
healthcare services such as care for patients with Alzheimer's disease and subacute needs.
Subacute care includes those services provided to patients with medically complex
conditions who require ongoing medical and nursing supervision and access to specialized
equipment and services, but do not require many of the other services provided by an acute
care hospital. Services in this category include ventilator and oxygen care, HIV care,
intravenous therapy, complex wound care, traumatic brain injury care, post-stroke care and
hospice care. The facilities also provide a broad range of support services including
rehabilitation therapy, dietary services, therapeutic recreational activities, social
services, housekeeping and laundry services and pharmaceutical and medical supplies.

The Company's acute rehabilitation
hospitals provide a range of inpatient and outpatient services for people with traumatic
brain injuries, strokes, arthritis, and other disabling conditions. The Company's assisted
living facilities serve the elderly who do not need the level of nursing care provided by
long-term or subacute care facilities, but who do need some assistance with the activities
of daily living.

Rehabilitation Therapy Services. Sun
provides rehabilitation therapy services primarily through its wholly-owned subsidiary,
SunDance Rehabilitation Corporation ("SunDance"). As of March 1, 2002, SunDance
provided rehabilitation therapy services to 553 facilities in 40 states, 335 of which
were operated by nonaffiliated parties. The Company provides a broad array of
rehabilitation therapy services, including speech pathology, physical therapy and
occupational therapy. These services are provided by

3

---

approximately 3,000 licensed rehabilitation therapists and assistants
employed or contracted by SunDance.

Pharmaceutical Services. The Company
provides pharmaceutical services primarily through its wholly-owned subsidiary, SunScript
Pharmacy Corporation ("SunScript"). Pharmaceutical services include dispensing
pharmaceuticals for such purposes as infusion therapy, oral medication, pain management,
antibiotic therapy and parenteral nutrition. Additional services include providing
consultant pharmacists. SunScript services are typically provided to nonaffiliated and
affiliated facilities, including subacute and skilled nursing care facilities, assisted
living facilities, group houses, correctional facilities, mental health facilities and
home healthcare companies. As of March 1, 2002, SunScript operated 32 regional pharmacies,
11 in-house long-term care pharmacies and one pharmaceutical billing and consulting
center, which together provided pharmaceutical products and services to a total of 651
long-term and subacute care facilities in 21 states, 436 of which were operated by
nonaffiliated parties.

Other Operations. The Company is a
nationwide provider of temporary medical staffing primarily through its wholly-owned
subsidiary, CareerStaff Unlimited, Inc. ("CareerStaff"). CareerStaff
derives approximately 46% of its revenues from schools and governmental agencies, 43% from
hospitals and other providers and 11% from skilled nursing facilities. CareerStaff
provides (i) licensed therapists skilled in the areas of physical, occupational and speech
therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging
technicians and (iv) related medical personnel. As of March 1, 2002, CareerStaff had 25
division offices which provided temporary therapy and nursing staffing services in major
metropolitan areas and one division office which specialized in the placement of temporary
traveling therapists in smaller cities and rural areas.

Through the Company's wholly-owned
subsidiaries, SunAlliance Healthcare Services, Inc. ("SunAlliance") and SunPlus
Home Health Services, Inc. ("SunPlus"), the Company provides mobile radiology,
medical laboratory and home healthcare services in certain locations. Through its
majority-owned subsidiary, Shared Healthcare Systems, Inc., which also does business under
the trade name SHS.com, the Company develops certain software for use in the long-term
care industry.

General Information. Sun
Healthcare Group, Inc. was incorporated in 1993. The Company's principal executive offices
are located at 101 Sun Avenue, NE, Albuquerque, NM 87109, and its telephone number is
(505) 821-3355. The Company maintains a web site at www.sunh.com.

Reorganization

Emergence from Chapter 11 Bankruptcy
Proceedings.On October 14, 1999, Sun and substantially all of its U.S.
operating subsidiaries filed voluntary petitions for protection under chapter 11 of the
U.S. Bankruptcy Code with the U.S. Bankruptcy Court for the District of Delaware (the
"Bankruptcy Court"), (case nos. 99-3657 through 99-3841, inclusive). On February
3, 2000, HoMed Convalescent Equipment, Inc. ("HoMed"), an indirect subsidiary of
Sun, commenced its chapter 11 case in the Bankruptcy Court (case no. 00-00841). On
February 6, 2002, the Bankruptcy Court approved the Company's joint plan of reorganization
(the "Plan") and on February 28, 2002 the Company consummated the Plan. The
principal provisions of the Plan are set forth below:

4

---

Type
    of
    Claim/Security
    
    Treatment
    under
    Plan1.
    General unsecured creditors with claims less than $50,000
    
    To be issued cash payments at the rate of 7% of their claims2.
    General unsecured creditors with claims of $50,000 or more
    
    To be issued an aggregate of approximately 900,000 shares (9%) of new common stock3.
    Senior bank lenders
    
    Issued approximately 8.9 million shares of new common stock (89%) and received a cash
    payment of approximately $6.6 million4.
    Senior subordinated note holders
    
    To be issued an aggregate of 200,000 shares (2%) of new common stock and warrants to
    purchase an additional 500,000 shares (5%)5.
    Common stock, options, warrants, convertible debt, and convertible trust issued preferred
    securities
    
    Canceled with no recovery to holders


See "Note 2 - Emergence from Chapter 11 Bankruptcy
Proceedings" and "Note 23 -Subsequent Events" in the Company's consolidated
financial statements.

New Management Team. In November
2001, Richard K. Matros was appointed as Chief Executive Officer. Also, in November 2001,
the then remaining members of the Board of Directors of the Company resigned and Mr.
Matros, Gregory S. Anderson, Bruce C. Vladeck, Steven L. Volla and Milton J. Walters were
appointed to the Board. In February 2002, John W. Adams, Charles W. McQueary, John F.
Nickoll and Sanjay H. Patel were added to the Board. Kevin W. Pendergest was appointed as
the Company's Chief Financial Officer and William A. Mathies was appointed as the
President of SunBridge in March 2002 and Heidi J. Fisher was appointed Senior Vice
President of Human Resources in February 2002. See "Item 10 - Directors and Executive
Officers of the Registrant."

New Loan Agreements. On February 28,
2002, the Company entered into (i) a Loan and Security Agreement with certain lenders, led
by Heller Healthcare Finance, Inc. as collateral agent, and Citicorp USA, Inc., as
administrative agent (the "Revolving Loan Agreement") and (ii) a Term Loan and
Note Purchase Agreement with certain lenders, led by U.S. Bank National Association as
administrative and collateral agent (the "Term Loan Agreement," and together
with the Revolving Loan Agreement, the "Loan Agreements"). The Revolving Loan
Agreement is a $150.0 million three-year revolving line of credit that is secured by the
Company's accounts receivable, inventory, equipment and other assets, a first priority
pledge of the stock of the Company's subsidiaries, other than those subsidiaries providing
pharmaceutical services, and a second priority pledge of the pharmaceutical services
subsidiaries. The Company's borrowing availability under the Revolving Loan Agreement is
limited to up to 85% of the Company's net eligible accounts receivable and up to 50% of
the Company's net eligible inventory, but not to exceed $150.0 million. As of March 1,
2002, there was $39.9 million available to the Company for

5

---

additional borrowing
under the Loan Agreements. See "Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital Resources."

The Term Loan Agreement is comprised of a
three-year $20 million term loan (the "Term Loan") and a three-year $23.7
million original issue discount note (the "Discount Note" and together with the
Term Loan, the "Term Debt"). The Term Debt is secured primarily by a first
priority pledge of the stock of the Company's subsidiaries that provide pharmaceutical
services and a second priority security interest in substantially all of the Company's
other assets. Under the Discount Note, the Company's borrowing availability is
approximately $20.0 million. Provided that an event of default has not occurred, interest
accrues on the Term Loan at the greater of (i) prime (or, if higher, the federal funds
rate plus 0.50%) plus 4.00% or (ii) 9.00%. The Company will pay interest on the Discount
Note for base rate borrowings a rate of interest equal to the greater of (i) prime (or, if
higher, the federal funds rate plus 0.50%) or (ii) 2.65% and for Eurodollar borrowings a
rate of interest equal to the Adjusted Eurodollar Rate (as defined in the Term Loan
Agreement) plus 0.50%.

Divestitures. During the years
ended December 31, 2001 and 2000, Sun divested 43 and 49 skilled nursing facilities in the
United States, respectively. In addition, Sun divested 20 assisted living facilities
during 2000. The Company did not receive cash consideration from the skilled nursing
facility divestitures during 2001 or 2000. The Company received cash consideration of
approximately $1.2 million in 2000 for the 20 divested assisted living facilities. The
aggregate net operating losses of the skilled nursing facilities and the assisted living
facilities were approximately $7.5 million in 2001 and $5.7 million and $3.2 million in
2000, respectively. See "Note 7 - Impairment of Long-Lived Assets and Assets Held for
Sale" in the Company's consolidated financial statements. During the period of
January 1, 2002 through March 1, 2002, no skilled nursing facilities were divested.

During January 2001, the Company sold
substantially all of the assets of its SunChoice medical supplies operations to Medline
Industries, Inc. The Company received proceeds of $16.6 million in exchange for the
SunChoice assets.

During February 2001, the Company sold
its operations in the United Kingdom. Those operations included 146 long-term care
facilities with 8,326 licensed beds. The Company did not receive any material cash
payments in exchange for these operations, however the Company was released from
approximately $112.9 million of aggregate debt, capital lease obligations, notes payable
and other liabilities upon consummation of the sale. The Company's operations in Australia
were liquidated in July 2001 and the Company received liquidation proceeds of
approximately $0.9 million. The Company divested its long-term care and pharmacy
operations in Germany in February 2001 for approximately $3.5 million. The Company sold
its long-term care operations in Spain in October 2000 for approximately $7.6 million. At
December 31, 2001, the Company had no operations outside of the U.S.

In March 2002, the Company divested its
respiratory therapy supplies and equipment business that was operated by its wholly-owned
subsidiary, SunCare Respiratory Services, Inc. The Company received $0.9 million in cash
for these assets.

Restructuring. The Company's
restructuring began in 1998. The approximate number of full and part-time employees of the
Company worldwide has decreased from approximately 80,700 on February 20, 1999 to 57,100
on March 31, 2000, to 42,000 on February 28, 2001 and to 36,000 on March 1, 2002. The
decrease in 1999 was primarily attributable to the elimination of rehabilitation therapy
employees through attrition, layoffs and the disposition of a number of inpatient
facilities. The Company restructured its domestic operations to more closely align the
inpatient, rehabilitation and pharmaceutical services divisions. The Company also
decreased the number of layers in its management structure. The

6

---

decreases in 2000 and early 2001 primarily resulted from
the disposition of the Company's international operations, medical supplies operations and
inpatient facilities. The Company intends to continue its restructuring efforts in 2002 in
its efforts to reduce overhead costs.

Reimbursement from Medicare and Medicaid

Revenue Sources.The Company
receives revenues from Medicare, Medicaid, private insurance, self-pay residents, other
third party payors and long term care facilities which utilize the Company's specialty
medical services. The healthcare industry is experiencing the effects of the trend toward
cost containment as federal and state governments and other third party payors seek to
impose lower reimbursement and negotiate reduced payment schedules with providers. These
cost containment measures, combined with the increasing influence of managed care payors
and competition for patients, generally have resulted in reduced rates of reimbursement
for services provided by the Company.

The sources and amounts of the Company's
inpatient services revenues are determined by a number of factors, including the number of
licensed beds and occupancy rates of the Company's facilities, the acuity level of
patients and the rates of reimbursement among payors. Likewise, payment for ancillary
medical services, including the institutional pharmacy services of SunScript and the
therapy services provided by SunDance, will vary based upon payor and payment
methodologies. Changes in the case mix of the patients, as well as payor mix among private
pay, Medicare, and Medicaid will significantly affect the Company's profitability.

The following table sets forth the total
revenues and percentage of revenues by payor source for the Company's U.S. operations only
for the years indicated (in thousands):

Years
    Ended December 31,Sources of Revenues
    2001
    2000
    1999Medicaid
    $940,110
    45.8%
    $1,025,600
    46.8%
    $1,041,662
    46.7%Medicare
    536,113
    26.1%
    515,492
    23.5%
    446,820
    20.0%Private pay and other (1)
    575,124
    28.1%
    652,334
    29.7%
    743,651
    33.3%


(1)
    Includes revenues from the
    provision of ancillary services, which includes payments for rehabilitation and
    respiratory therapy, temporary medical staffing services and pharmaceutical services
    provided to nonaffiliated long-term and subacute facilities and not directly charged to
    Medicaid or Medicare. Nonaffiliated sources may themselves derive all or a portion of
    their revenues from Medicaid and/or Medicare.


Medicare and Medicaid. The Health
Insurance for Aged and Disabled Act, known as "Medicare," has made available to
nearly every United States citizen 65 years of age and older a broad program of health
insurance designed to help the nation's elderly meet hospital, hospice, home health and
other health care costs. Health insurance coverage has been extended to certain persons
under age 65 qualifying as disabled and those having end-stage renal disease. Medicare
includes three related health insurance programs: (i) hospital insurance ("Part
A"); (ii) supplementary medical insurance ("Part B"); and (iii) a managed
care option for beneficiaries who are entitled to Part A and enrolled in Part B
("Medicare+Choice" or "Medicare Part C"). The Medicare program is
currently administered by fiscal intermediaries (for Part A and some Part B services) and
carriers (for Part B) under the direction of the Centers for Medicare and Medicaid
Services ("CMS") (formerly the Health Care Finance Administration), a division
of the Department of Health and Human Services ("HHS").

7

---

The following table sets forth the
approximate average amounts of Medicare Part A revenues per patient per day recorded by
the Company's long-term care facilities for the years indicated ended December 31:

Fiscal Year
    Average Medicare Part ARevenue Per Patient, Per Day (2)2001
    $376.78   (3) (4)2000
    343.041999
    322.52   (1)1998
    448.80   (1)1997
    472.90   (1)


(1)  Includes estimated adjustments for routine cost limit ("RCL")
exception revenue.
(2)  The year-to-year comparisons are not on a same-store basis due to
acquisitions and divestitures.
(3)  Includes a significant rate increase during 2001 of approximately 10.0%.
(4)  Excludes approximately $52.1 million of excess reserves reversed into net
patient revenues
      due to the Settlement Agreement.  See "Item
3 - Legal Proceedings" for a description
      of the Settlement Agreement.

Medicaid is a federal-state matching
program, whereby the federal government, under a needs based formula, matches funds
provided by the participating states for medical assistance to "medically
indigent" persons. The programs are administered by designated state agencies under
federal rules. Although Medicaid programs vary from state to state, traditionally they
have provided for the payment of certain expenses, up to established limits, at rates
determined in accordance with each state's regulations. For skilled nursing facilities,
most states pay prospectively determined rates, and have some form of acuity adjustment.
In addition to facility-based services, most states cover an array of medical ancillary
services, including those services provided by institutional pharmacies. Payment
methodologies for these services vary based upon state law and regulations permitted under
federal rules.

The Company is subject to periodic audits
by the Medicare and Medicaid programs, which have various rights and remedies against the
Company if they assert that the Company has overcharged the programs or failed to comply
with program requirements. These rights and remedies may include requiring the repayment
of any amounts alleged to be overpayments or in violation of program requirements, or
making deductions from future amounts due to the Company. Such programs may also impose
fines, criminal penalties or program exclusions. Other third party payor sources also
reserve rights to conduct audits and make monetary adjustments.

Congress has enacted three major laws
since 1997 that have significantly altered payment for nursing home and medical ancillary
services. The Balanced Budget Act of 1997 (the "1997 Act"), signed into law on
August 5, 1997, reduced federal spending on the Medicare and Medicaid programs. The
Medicare Balanced Budget Refinement Act ("BBRA"), enacted in November 1999
addressed a number of the funding difficulties caused by the 1997 Act. The Benefits
Improvement and Protection Act of 2000 ("BIPA"), was enacted on December 15,
2000, further modifying the law and restoring additional funding. The following provides a
brief summary of these laws and an overview of the impact of these enactments on the
Company's services.

Under the 1997 Act, participating skilled
nursing facilities are reimbursed under a prospective payment system ("PPS") for
inpatient Medicare Part A covered services. The PPS system commenced with a facility's
first cost reporting period beginning on or after July 1, 1998. Under PPS, nursing

8

---

facilities are paid a predetermined amount per patient, per day
("per diem") based on the anticipated costs of treating patients. The per diem
rate is determined by classifying each patient into one of forty-four resource utilization
groups ("RUG") using the information gathered during a minimum data set
assessment. There is a separate per diem rate for each of the RUG classifications. The per
diem rate also covers rehabilitation and non-rehabilitation ancillary services. The law
phased in PPS over a three-year period, during which the rate was based on a blend of the
facility's adjusted historical 1995 costs and the federally established per diem rate. As
of January 1, 2002, all of the Company's facilities are subject to 100% of the federal
rate.

In November 1999, the BBRA was passed in
Congress. This enactment provided relief for certain reductions in Medicare reimbursement
caused by the 1997 Act. For covered skilled nursing facility services furnished on or
after April 1, 2000, the federal per diem rate was increased by 20.0% for 15 RUG payment
categories. While this provision was initially expected to adjust payment rates for only
six months, CMS withdrew proposed RUG refinement rules. These payment add-ons will
continue until CMS completes certain mandated recalculations of current RUG weightings.
For fiscal years 2001 and 2002, the BBRA mandated federal per diem rates for all RUG
categories be increased by an additional 4% over the required market basket adjustment.
The law provided that certain specific services (such as prostheses and chemotherapy
drugs) would be reimbursed separately from, and in addition to, the federal per diem rate.
A provision was included that provided for cost report years beginning on or after January
1, 2000, skilled nursing facilities could waive the PPS transition period and elect to
receive 100% of the federal per diem rate. The enactment also lifted for two years a
$1,500 cap on rehabilitation therapy services provided under Medicare Part B.

On December 15, 2000, Congress passed
BIPA, which increased the nursing component of Federal PPS rates by approximately 16.7%
for the period from April 1, 2001 through September 30, 2002. The legislation also changed
the 20.0% add-on to three of the 14 rehabilitation RUG categories to a 6.7% add-on to all
14 rehabilitation RUG categories beginning April 1, 2001. The Part B consolidated billing
provision of BBRA was repealed except for Medicare Part B therapy services and the
moratorium on the $1,500 therapy caps was extended through calendar year 2002. These
changes have had a positive impact on operating results.



9

---

funding provisions on September 30, 2002 or the
implementation of the changes sought in the 2003 budget proposal would likely cause the
Company to fail to meet financial covenants contained in its Loan Agreements if the
Company's overall payor mix, case mix, and customer base are not sufficiently able to
offset this impact.

The 1997 Act contains provisions that
have affected amounts paid to the Company's ancillary medical operations services.
Reimbursement for certain products covered under Medicare Part B is limited to 95% of the
"average wholesale price." The move to PPS under the 1997 Act has made pricing a
more mportant consideration in the selection of pharmacy providers. Also, Congress
included provisions in the 1997 Act that would require nursing facilities to submit all
claims for Medicare-covered services that their residents receive, both Medicare Part A
and Part B, even if such services are provided by outside suppliers, including but not
limited to pharmacy and rehabilitation therapy providers, except for certain excluded
services. The BIPA, enacted in December 2000, repealed this provision, except for therapy
services.

The 1997 Act included several provisions
affecting Medicaid. The 1997 Act repealed the Boren Amendment federal payment standard for
Medicaid payments to nursing facilities effective October 1, 1997. The Boren Amendment
required that Medicaid payments to certain healthcare providers be reasonable and adequate
in order to cover the costs of efficiently and economically operated healthcare
facilities. Under the 1997 Act, states must now use a public notice and comment period in
order to determine rates and provide interested parties a reasonable opportunity to
comment on proposed rates and the justification for and the methodology used in
calculating such rates. With the repeal of the federal payment standards, there can be no
assurances that budget constraints or other factors will not cause states to reduce
Medicaid reimbursement to nursing facilities and pharmacies or that payments to nursing
facilities and pharmacies will be made on a timely basis. The 1997 Act also grants greater
flexibility to states to establish Medicaid managed care projects without the need to
obtain a federal waiver. Although these projects generally exempt institutional care,
including nursing facilities and institutional pharmacy services, no assurances can be
given that these projects ultimately will not change the reimbursement methodology for
nursing facility services or institutional pharmacy services from fee-for-service to
managed care negotiated or capitated rates. The Company anticipates that federal and state
governments will continue to review and assess alternative health care delivery systems
and payment methodologies.

The BIPA enactment mandates a phase out
of intergovernmental transfer transactions by states. In states which have artificially
inflated payments to certain public facilities to increase federal matching funds, this
action may reduce federal support for a number of state Medicaid plans. The reduced
federal payments may impact aggregate available funds requiring states to further limit
payments to providers such as the Company.

Recent data compiled by the National
Conference of State Legislatures indicate that the recent economic downturn has had a
detrimental affect on state revenues. Historically these budget pressures have translated
into reductions in state spending. Given that Medicaid outlays are a significant component
of state budgets, the Company expects continuing cost containment pressures on Medicaid
outlays for nursing homes and pharmacy services in the states in which the Company
operates. The reimbursement rates for pharmacy services under Medicaid are determined on a
state-by-state basis subject to review by CMS and applicable federal law. In most states,
pharmacy services are priced at the lower of "usual and customary" charges or
cost (which generally is defined as a function of average wholesale price and may include
a profit percentage) plus a dispensing fee. Certain states have "lowest charge
legislation" or "most favored nation provisions" which require the
Company's institutional pharmacy to charge Medicaid no more than its lowest charge to
other consumers in the state.

10

---

Pharmacy coverage and cost containment
are important policy debates at both the federal and state levels. Congress has considered
proposals to expand Medicare coverage for outpatient pharmacy services. Enactment of such
legislation could affect institutional pharmacy services. Likewise, a number of states
have proposed cost containment initiatives pending. Changes in payment formulas and
delivery requirements could impact SunScript. See "Certain Additional Business
Risks."

Federal and state governments continue to
focus on efforts to curb spending on health care programs such as Medicare and Medicaid.
Such efforts have not been limited to skilled nursing facilities, but include other
services provided by the Company, such as pharmacy and therapy services. The Company
cannot at this time predict the extent to which these proposals will be adopted or, if
adopted and implemented, what effect, if any, such proposals will have on the Company.
Efforts to impose reduced allowances, greater discounts and more stringent cost controls
by government and other payors are expected to continue.

Various cost containment measures adopted
by governmental and private pay sources restrict the scope and amount of reimbursable
healthcare expenses and limit increases in reimbursement rates for medical services. Any
reductions in reimbursement levels under Medicaid, Medicare or private payor programs and
any changes in applicable government regulations or interpretations of existing
regulations could significantly and adversely affect the Company's profitability.
Furthermore, government programs are subject to statutory and regulatory changes,
retroactive rate adjustments, administrative rulings and government funding restrictions,
all of which may materially affect the rate of payment to the Company's facilities and its
therapy and pharmaceutical services businesses. There can be no assurance that payments
under governmental or private payor programs will remain at levels comparable to present
levels or will be adequate to cover the costs of providing services to patients eligible
for assistance under such programs. Significant decreases in utilization and changes in
reimbursement could have a material adverse effect on the Company's financial condition
and results of operations, including the possible impairment of certain assets.

Related Party Rule.  For
periods prior to the effective date of PPS, certain Medicare regulations applied to
transactions between related parties, such as between the Company's subsidiaries that
operate skilled nursing facilities and subsidiaries that provide ancillary services. These
regulations are relevant to the amount of reimbursement that the Company's skilled nursing
facilities are entitled to receive for certain goods and services provided by the
Company's ancillary subsidiaries. An exception to the related party regulations is
available provided that, among other things, a substantial part of the services of the
relevant subsidiary supplier be transacted with nonaffiliated entities. When that
exception applies, the skilled nursing facility may receive reimbursement for goods and
services provided by the Company's ancillary subsidiaries at the rates applicable to goods
and services provided to nonaffiliated entities. The related party regulations do not
indicate a specific level of services that must be provided to nonaffiliated entities in
order to satisfy the "substantial part" requirement of this exception. In
instances where this issue has been litigated by others, no consistent standard has
emerged as to the appropriate threshold necessary to satisfy the "substantial
part" requirement.

The implementation of PPS and the
corresponding fee schedules have significantly reduced the Medicare impact of the related
party rule, but the related party rule continues to affect certain Medicaid cost reports
for the Company's skilled nursing facilities and hospitals and will also affect Medicare
cost reports for hospitals for cost reporting years ended December 31, 2001. The Company's
net revenues from rehabilitation therapy services, including net revenues from temporary
medical staffing services, provided to nonaffiliated facilities represented 58%, 56% and
56% of total rehabilitation services net revenues for the years ended December 31,
2001, 2000 and 1999, respectively. Respiratory therapy

11

---

services provided to nonaffiliated facilities
represented 84%, 67% and 55% of total respiratory therapy services net revenues for the
years ended December 31, 2001, 2000 and 1999, respectively. Net revenues from
pharmaceutical services billed to nonaffiliated facilities represented 80%, 79% and 76% of
total pharmaceutical services revenues for the years ended December 31, 2001, 2000
and 1999, respectively. The Company uses certain variables such as percent of revenue
derived from nonaffiliated parties and associated service charges to determine whether it
has met the requirements. For cost reports filed for the year ended December 31, 1999, the
Company met the appropriate thresholds to satisfy the "substantial part"
requirement of the related party exception. Except for the Company's software division,
the Company met the related party exception allowing for the reimbursement of their
charges to the inpatient facilities division for cost reports filed for the years ended
December 31, 2000 and December 31, 2001. The Company adjusted the 2000 cost reports by
decreasing the charges the inpatient facilities received from the software division to the
cost basis of those services, and is required to do the same for the 2001 cost reports.
The Company has determined that the impact of these cost report adjustments in the
Medicare revenues recorded for the years ended December 31, 2000 and December 31, 2001 is
not significant. If the Company was deemed not to have satisfied these regulations, the
reimbursement that the Company receives for goods and services provided to its own
facilities could be significantly reduced, which could materially and adversely affect the
Company's financial condition and results of operations. If, upon audit by federal or
state reimbursement agencies, such agencies find that the exception has not been
satisfied, and if, after appeal, such findings are sustained, the Company could be
required to refund some or all of the difference between its cost of providing these
services to any entity found to be subject to the related party regulations and the fair
market value amount actually received.

Government Regulation

Regulatory Requirements.The
Company's subsidiaries that provide long-term care, rehabilitation therapy and
pharmaceutical services are engaged in industries that are extensively regulated. As such,
in the ordinary course of business, the operations of these subsidiaries are continuously
subject to state and federal regulatory scrutiny, supervision and control. Such regulatory
scrutiny often includes inquiries, investigations, examinations, audits, site visits and
surveys, some of which may be non-routine. In addition to being subject to the direct
regulatory oversight of state and federal regulatory agencies, these industries are
frequently subject to the regulatory supervision of fiscal intermediaries. If a provider
is ever found by a court of competent jurisdiction to have engaged in improper practices,
it could be subject to civil, administrative or criminal fines, penalties or
restitutionary relief, and reimbursement authorities could also seek the suspension or
exclusion of the provider or individuals from participation in their program. If a
facility is decertified by CMS or a state as a Medicare or Medicaid provider, the facility
will not thereafter be reimbursed by the federal government for caring for residents that
are covered by Medicare and Medicaid, and the facility would be forced to care for such
residents without being reimbursed or to transfer such residents.

Long-term care facilities must comply
with certain requirements to participate in Medicare or Medicaid. Regulations promulgated
pursuant to the Omnibus Budget Reconciliation Act of 1987 obligate facilities to
demonstrate compliance with requirements relating to resident rights, resident assessment,
quality of care, quality of life, physician services, nursing services, infection control,
physical environment and administration. Regulations governing survey, certification and
enforcement procedures to be used by state and federal survey agencies to determine
facilities' level of compliance with the participation requirements for Medicare and
Medicaid were adopted in 1995. These regulations require that surveys focus on residents'
outcomes of care and state that all deviations from participation requirements will be
considered deficiencies. A facility may have deficiencies and still be in substantial
compliance with the regulations. The regulations identify alternative remedies against
facilities and

12

---

specify the categories of deficiencies for which they will be applied.
The alternative remedies include, but are not limited to: civil monetary penalties of up
to $10,000 per day; facility closure and/or transfer of residents in emergencies; denial
of payment for new or all admissions; directed plans of correction; and directed
in-service training. Failure to comply with certain standards as a condition to
participate in the Medicare and Medicaid programs may result in termination of the
provider's Medicare and Medicaid provider agreements.

Most states in which the Company operates
have statutes which require that prior to the addition or construction of new nursing home
beds, the addition of new services or certain capital expenditures in excess of defined
levels, the Company first must obtain a Certificate of Need which certifies that the state
has made a determination that a need exists for such new or additional beds, new services
or capital expenditures. The certification process is intended to promote quality health
care at the lowest possible cost and to avoid the unnecessary duplication of services,
equipment and facilities.

The Medicare and Medicaid anti-kickback
statute prohibits the knowing and willful solicitation or receipt of any remuneration
"in return for" referring an individual or for recommending or arranging for the
purchase, lease or ordering of any item or service for which payment may be made under
Medicare or a state healthcare program. In addition, the statute prohibits the offer or
payment of remuneration "to induce" a person to refer an individual or to
recommend or arrange for the purchase, lease or ordering of any item or service for which
payment may be made under the Medicare or state healthcare programs.

False claims are prohibited pursuant to
criminal and civil statutes. Criminal provisions prohibit filing false claims or making
false statements to receive payment or certification under Medicare or Medicaid or failing
to refund overpayments or improper payments; violation of these provisions are felonies
punishable by up to five years imprisonment and/or $25,000 fines. Civil provisions
prohibit the knowing filing of a false claim or the knowing use of false statements to
obtain payment; penalties for violations are fines of not less than $5,000 nor more than
$10,000, plus treble damages, for each claim filed. Suits alleging false claims can be
brought by individuals, including employees and competitors. Allegations have previously
been made under the civil provisions of the statute in certain qui tam actions that
the Company has filed false claims. The Company is not aware of any pending *qui tam*
actions against the Company. See "Note 18 - Other Events" in the Company's
consolidated financial statements.

HIPAA. In December 2000, the
federal government released the final privacy rules of the Health Insurance Portability
and Accountability Act of 1996 ("HIPAA"). The rules provide for, among other
things, (i) giving consumers the right and control over the release of their medical
information, (ii) the establishment of boundaries for the use of medical information, and
(iii) penalties for violation of an individual's privacy rights.

These privacy regulations apply to
"protected health information," which is defined generally as individually
identifiable health information transmitted or maintained in any form or medium, excluding
certain education records and student medical records. The privacy regulations seek to
limit the use and disclosure of most paper, oral and electronic communications regarding
an individual's past, present or future physical or mental health or condition, or
relating to the provision of healthcare to the individual or payment for that healthcare,
if the individual can or may be identified by such information. HIPAA provides for the
imposition of civil or criminal penalties if protected health information is improperly
disclosed. The Company is not required to comply with the HIPAA privacy rules until April
2003, but the Company will require substantial efforts and resources to prepare for
meeting the compliance deadline and for continued compliance thereafter. No assurance can
be given that the Company will meet the April 2003 deadline. See "Certain Additional
Business Risks."

13

---

HIPAA's security regulations have not yet
been finalized. The proposed security regulations specify administrative procedures,
physical safeguards and technical services and mechanisms designed to ensure the privacy
of protected health information. The Company will be required to comply with the security
regulations 26 months after the regulations become final.

In addition, HIPAA also mandates the
adoption of regulations aimed at standardizing transaction formats and billing codes for
documenting medical services, dealing with claims submissions and protecting the privacy
and security of individually indentifiable health information. HIPAA regulations that
standardize transactions and code sets became final in the fourth quarter of 2000. These
regulations do not require healthcare providers to submit claims electronically, but
require standard formatting for those that do. The Company currently submits some of its
claims electronically to Medicare and Medicaid through its fiscal intermediary and will
continue to do so. The Company will be required to comply with HIPAA transaction and code
set standards by October 2003.

Survey, Certification and Enforcement
Activities Against the Company. The Company believes that its facilities and service
providers materially comply with applicable regulatory requirements. From time to time,
however, the Company receives notice of noncompliance with various requirements for
Medicare/Medicaid participation or state licensure. The Company reviews such notices for
factual correctness, and based on such reviews, either takes appropriate corrective action
and/or challenges the stated basis for the allegation of noncompliance. In most cases, the
Company and the reviewing agency will agree upon any measures to be taken to bring the
facility or service provider into compliance. Under certain circumstances, however, such
as repeat violations or the perceived severity of the violations, the federal and state
agencies have the authority to take adverse actions against a facility or service
provider, including the imposition of monetary fines, the decertification of a facility or
provider from participation in the Medicare and/or Medicaid programs or licensure
revocation. Challenging and appealing notices of noncompliance can require significant
legal expenses and management attention.

The Company believes that enforcement
activities at both the federal and state levels and qui tam actions brought by
private parties have increased since 1997. In addition, during the Company's bankruptcy
proceedings, the Company experienced a further increase in regulatory oversight from both
federal and state regulatory bodies. The Company may be required to expend substantial
amounts to cooperate with any investigations and proceedings or to defend allegations
arising therefrom. If it were found that any of the Company's practices failed to comply
with any of the anti-fraud provisions, including those discussed in the paragraphs above,
the Company could be materially and adversely affected.

If a nursing facility is decertified from
the Medicare and Medicaid programs, its Medicare and Medicaid reimbursement is interrupted
pending recertification, a process that can take at least several months. In the interim,
the facility may continue to provide care to its residents without Medicare and Medicaid
reimbursement, or the government may relocate Medicare and Medicaid residents to other
facilities. Terminations, bans on admission and civil monetary penalties can cause
material adverse financial and operational effects on individual facilities.

14

---

additional facilities of the Company from the Medicare and Medicaid
programs, or that the Company will contest and be successful in contesting such
decertifications.

Corporate Compliance Process

The Company entered into a Corporate
Integrity Agreement ("CIA") with the Office of the Inspector General
("OIG") of the Department of Health and Human Services ("HHS")
effective February 28, 2002 to promote the Company's compliance with the requirements of
Medicare, Medicaid, and all other federal healthcare programs. The CIA is patterned after
OIG compliance guidance but sets specific requirements intended to demonstrate adherence
to the compliance program elements. Under the CIA, the Company is implementing
comprehensive internal quality improvement programs and a system of internal financial
controls in the Company's nursing homes, hospitals, and ancillary entities. Furthermore,
it requires external oversight and reporting requirements to validate compliance.

The Company's compliance program,
referred to as the "Compliance Process," was initiated in 1996. It has evolved
as the requirements of federal and private healthcare programs have changed. Significant
refinements were initiated in 2001 to parallel requirements of the OIG compliance
guidelines and the CIA. There are seven principle elements to the Compliance Process.

*Written Policies, Procedures and Standards of Conduct*

The Company's subsidiaries that provide
patient care and products have extensive policies and procedures ("P&Ps")
which are modeled after applicable laws, regulations, government manuals and industry
practices and customs. The P&Ps govern the clinical and operational aspects of each
regulated subsidiary. For instance, the Company's P&Ps require that a reasonable and
prudent background investigation be completed on every new employee. To emphasize
adherence to its P&Ps, the Company publishes and distributes a Code of Conduct and
each subsidiary publishes and distributes an employee handbook.

*Designated Compliance Officer and Compliance Committee*

In August 2000, the Company appointed a
Corporate Compliance Officer. The responsibilities of the Corporate Compliance Officer
include, among other things: (i) overseeing the Compliance Process; (ii) ensuring
compliance with the CIA and functioning as the liaison with the external monitors and
federal government on matters related to the Compliance Process and CIA; (iii) reporting
to the Board of Directors and senior corporate managers on the status of the Compliance
Process; and (iv) overseeing the coordination of a comprehensive education and training
program which focuses on the elements of the Compliance Process.

The Company also maintains a Corporate
Compliance Committee which includes the Chief Executive Officer, Chief Financial Officer,
General Counsel, the Senior Vice President of Ancillary Services, Senior Vice President of
Human Resources, President of SunBridge and the Corporate Compliance Officer. This
Committee meets regularly to discuss compliance-related issues. Compliance matters are
also reported to the Compliance Committee of the Board of Directors on a quarterly basis.

*Effective Training and Education*

The Company continues to develop and
implement regular training and education programs for all employees. Training programs
include the Compliance Process, the CIA, Code of Conduct, applicable provisions of the
Medicare and Medicaid laws, including fraud and abuse laws and reimbursement P&Ps

15

---

that reflect current legal and program standards.

*Effective Lines of Communication*

During employee training, employees are
encouraged to report issues of concern without fear of retaliation using a Four Step
Reporting Process, which includes the toll-free "Sun Quality Line." The Four
Step Reporting Process encourages employees to discuss clinical, ethical, or financial
concerns with supervisors and local management since these individuals will be most
familiar with the laws, regulations, and policies that impact their concern. The telephone
number for the Sun Quality Line is posted prominently in places that are accessible to
employees in all of the Company's facilities. Internal independent reviews of the Sun
Quality Line ensure that proper follow-up is conducted.

*Internal Monitoring and Auditing*

The Company employs a number of licensed
professionals who monitor compliance with P&Ps, including registered nurses,
dietitians and program analysts for the skilled nursing facility operations. For the
Company's hospitals, each hospital employs a Quality Improvement Nurse who is responsible
for monitoring the Company's clinical standards. The Company's rehabilitation therapy
operations employ Compliance Directors, each of whom is a licensed therapist. Vice
Presidents of Compliance are responsible for all compliance activity within the Company's
pharmacy operations and home health, home pharmacy, and laboratory and radiology services
operations.

*Enforcement of Standards Through Well-Publicized Disciplinary
Guidelines*

The Company's P&Ps, the Code of
Conduct and the Employee Handbook as well as all associated training materials clearly
indicate that violators of the Company's policies and procedures will be subjected to
discipline. Sanctions include oral warnings, to suspensions, and termination of
employment.

*Responses to Detected Offenses and Development of Corrective
Actions*

Correction of detected misconduct or a
violation of a Company policy is the responsibility of every manager. As appropriate, a
manager is expected to develop and implement corrective action plans and monitor whether
such actions are likely to keep a similar violation from occurring in the future.

Competition

The long-term care industry is highly
competitive. The nature of competition varies by location. The Company's facilities
generally operate in communities that are also served by similar facilities operated by
others. Some competing facilities are located in buildings that are newer than those
operated by the Company and provide services not offered by the Company, and some are
operated by entities having greater financial and other resources and longer operating
histories than the Company. In addition, some facilities are operated by nonprofit
organizations or government agencies supported by endowments, charitable contributions,
tax revenues and other resources not available to the Company. Some hospitals that either
currently provide long-term and subacute care services or are converting their
under-utilized facilities into long-term and subacute care facilities are also a potential
source of competition to the Company. The Company competes with other facilities based on
key competitive factors such as its reputation for the quality and comprehensiveness of
care provided; the commitment and expertise of its staff; the innovativeness of its
treatment programs; local physician and hospital support; marketing programs; charges for
services; and the physical appearance, location and condition of its facilities. The range
of specialized services, together with the price charged for services, are also
competitive factors in

16

---

attracting patients from large referral sources.

The Company also competes with other
companies in providing rehabilitation therapy services and pharmaceutical products and
services to the long-term care industry and in employing and retaining qualified
therapists and other medical personnel. Many of these competing companies have greater
financial and other resources than the Company. There can be no assurance that Sun will
not encounter increased competition in the future that would adversely affect its
financial condition and results of operations.

Employees

As of March 1, 2002, the Company had
approximately 36,000 full-time and part-time employees. Of this total, there were
approximately 28,000 employees in the Company's long-term and subacute care facilities,
3,000 employees in the rehabilitation therapy services, 1,000 employees in the
pharmaceutical services operations, 1,000 employees in the temporary staffing business,
150 employees in the respiratory therapy business, 850 employees at the corporate and
regional offices and 2,000 employees in other health care services.

Certain of the Company's employees in
Alabama, California, Connecticut, Georgia, Massachusetts, New Mexico, Ohio, Tennessee,
Washington and West Virginia are covered by collective bargaining contracts. The unions
representing certain of the Company's employees have from time to time gone on strike.
There can be no assurance that the unions will not go on strike in the future or that such
strikes will not have a material adverse effect on the Company's results of operations or
financial condition.

Certain Additional Business Risks

Information provided in this Form 10-K by
the Company contains "forward-looking" information as that term is defined by
the Private Securities Litigation Reform Act of 1995 (the "Act"). All statements
regarding the Company's expected future financial position, results of operations, cash
flows, liquidity, financing plans, business strategy, budgets, projected costs and capital
expenditures, competitive position, growth opportunities, plans and objectives of
management for future operations and words such as "anticipate,"
"believe," "plan," "estimate," "expect,"
"intend," "may" and other similar expressions are forward-looking
statements. The forward-looking statements are qualified in their entirety by these
cautionary statements, which are being made pursuant to the provisions of the Act and with
the intention of obtaining the benefits of the "safe harbor" provisions of the
Act. The Company cautions investors that any forward-looking statements made by the
Company are not guarantees of future performance and that actual results may differ
materially from those in the forward-looking statements as a result of various factors,
including, but not limited to, those set forth below and elsewhere herein:

The Company's borrowing capacity under
its Loan Agreements may be insufficient to fund the Company's operations until it achieves
positive cash flows or obtains additional financing.The Company's Revolving
Loan Agreement provides for maximum borrowings by the Company of up to $150.0 million, but
not to exceed a defined borrowing base, which was $111.0 million on March 1, 2002. The
Company's Term Loan Agreement provides for maximum borrowings of $40.0 million. As of
March 1, 2002, the Company had borrowed approximately $66.8 million and had issued
approximately $44.3 million in letters of credit under the Loan Agreements, leaving
approximately $39.9 million available to the Company for additional borrowing. The Company
had cash flows provided by (used for) operating activities of $24.4 million, $(1.7)
million and $7.3 million for the years ended December 31, 2001, 2000 and 1999,
respectively. Until the Company is able to consistently generate substantial positive cash
flow

17

---

from operations or obtain additional financing, the Company will be
required to rely on its available borrowing capacity to fund its ongoing operations. There
can be no assurance that the amount available to the Company under the Loan Agreements
will be sufficient for these purposes. See "Item 7 - Management's Discussion and
Analysis of Financial Condition and Results of Operations - Liquidity and Capital
Resources."

The financial covenants in the Loan
Agreements will be difficult to achieve and if not achieved could result in a lack of
funding. The Company must achieve significant improvements in its results of
operations in order to comply with the financial covenants contained in the Loan
Agreements. If the Company's results of operations do not significantly improve, the
Company would likely be in default under the Loan Agreements. If the Company fails to
comply with the covenants in its Loan Agreements and is unable to obtain a waiver of any
such covenant violation, then the Company would lose its ability to borrow under the Loan
Agreements for its working capital needs and could lose access to a substantial portion of
its operating cash until such time as the outstanding debt under the Loan Agreements is
repaid. In such event, the Company would be unable to fund its ongoing operations without
obtaining additional financing. Furthermore, upon a payment default of the Revolving Loan
Agreement, the Term Loan Agreement lenders have the right to purchase the portion of the
Revolving Loan Agreement debt relating to the Company's pharmacy operations and then sell
these operations in a foreclosure sale. There can be no assurance that the Company will
meet required financial and operating covenants under the Loan Agreements. See "Item
7 - Management's Discussion and Analysis of Financial Condition and Results of Operations
- Liquidity and Capital Resources."

The Company's Medicare reimbursements may
materially and adversely decline after September 30, 2002. A number of provisions of
the BBRA and BIPA enactments providing additional funding for Medicare participating
skilled nursing facilities expire on September 30, 2002. Expiring provisions are estimated
to, on average, reduce the Company's per beneficiary per diems by approximately $36.00 (as
compared to $376.78 in 2001), although the reduction could be greater than anticipated.
Moreover, the Centers for Medicare and Medicaid Services ("CMS") has indicated
its desire to complete refinements to the case mix classification system as part of the
Fiscal 2003 rule-making. Under the law, when these refinements are implemented, the
add-on's authorized by the BBRA and BIPA will expire. As a result of the combination of
these factors, the Medicare skilled nursing facility sector is faced with an estimated
10.4% reduction in the average median per diems. A 10.4% decline in the Company's current
average Medicare rate per patient day would result in an estimated annual reduction in
Medicare revenues of approximately $35.0 million, which would have a material adverse
effect on the Company's financial position, results of operations and cash flows. In
addition, President Bush's fiscal year 2003 budget proposal assumes that CMS will refine
the per diem system by October 2002 in order to reduce Medicare payments to skilled
nursing facilities by $5.6 billion over the next five years. Taken together with the
expiration of the additional funding provisions on September 30, 2002, the Company
estimates that its average Medicare payments would decrease approximately $63.00 per
patient per day, although the reduction could be greater than anticipated. If the
refinements sought by President Bush are implemented, the loss of an estimated $60.4
million in revenues would have a material adverse effect on the Company's financial
position, results of operations and cash flows. The expiration of additional funding
provisions on September 30, 2002 or the implementation of the changes sought in the 2003
budget proposal would likely cause the Company to fail to meet financial covenants
contained in its Loan Agreements if the Company's overall payor mix, case mix, and
customer base are not sufficiently able to offset this impact.

The Company is continuously subject to
federal and state regulatory scrutiny.The Company's subsidiaries are engaged in
healthcare industries which are extensively regulated. As such, in the ordinary course of
business, the operations of these subsidiaries are continuously subject to state and

18

---

federal regulatory scrutiny, including inquiries, investigations,
examinations, audits, site visits and surveys.If any of the Company's subsidiaries
are ever found to have engaged in improper practices, it could be subjected to civil,
administrative or criminal fines, penalties or restitutionary relief, and reimbursement
authorities could also seek the suspension or exclusion of the subsidiary or individuals
from participation in their program. The Department of Health and Human Services - Office
of Inspector General and the Department of Justice periodically investigate matters that
have come to their attention concerning the Company. The existence of regulatory
investigations has previously hindered or prevented the Company from pursuing certain
business opportunities. There can be no assurance that the outcome of any pending or
future proceedings or investigations will not have a material adverse effect on the
results of operations and financial condition of the Company. See "Note 18 - Other
Events" in the Company's consolidated financial statements.

The Company is subject to numerous
lawsuits. In recent years, there has been a dramatic increase in the number and size
of lawsuits filed against nursing home operators alleging negligence resulting in injury
or death to residents of the homes. The Company currently has numerous patient care
lawsuits pending against it, as well as other types of lawsuits. As a result, general and
professional liability costs have increased and are expected to continue to increase.
There can be no assurance that the outcome of any patient care lawsuits individually or in
the aggregate will not have a material adverse effect on the Company's results of
operations or financial condition.

The Company's general and professional
liability risk is generally self-funded. The Company's insurance carriers declined to
renew the Company's general and professional liability insurance policies that expired on
December 31, 1999. Several major insurance companies no longer provide this type of
coverage to long-term care providers. Beginning in January 2000, the Company established a
self-funded insurance program for general and professional liability claims up to a base
amount of $1.0 million per claim, and $3.0 million aggregate per location, and obtained
excess insurance for coverage above these levels. If the Company's self-funded insurance
reserves are insufficient to fund any future judgments or settlements resulting from
litigation against the Company, such deficiency could have a material adverse impact on
the Company's financial condition and results of operations. In addition, in certain
states in which the Company has significant operations, including California, insurance
coverage for the risk of punitive damages arising from general and professional liability
litigation is prohibited by state law. There can be no assurance that the Company will not
be liable for punitive damages awarded in litigation arising in states for which punitive
damage insurance coverage is prohibited by law. See "Note 10 - Commitments and
Contingencies" in the Company's consolidated financial statements.

The Company could be required to
return inpatient facility revenues as a result of retroactive adjustments. The Company
derives a substantial percentage of its total revenues from Medicare, Medicaid and private
insurance. Net revenues realizable under third-party payor agreements are subject to
change due to examination and retroactive adjustment by payors during the settlement
process. Under cost-based reimbursement plans, payors may disallow, in whole or in part,
requests for reimbursement based on determinations that certain costs are not reimbursable
or reasonable or because additional supporting documentation is necessary. The Company
recognizes revenues from third-party payors and accrues estimated settlement amounts in
the period in which the related services are provided. The Company estimates these
settlement balances by making determinations based on its prior settlement experience and
its understanding of the applicable reimbursement rules and regulations. The majority of
Medicaid balances are settled two to three years following the provision of services
although the Company has from time to time experienced delays in receiving final
settlement and reimbursement. There can be no assurance that the Company will not be
required to negatively adjust prior earnings as a result of future settlements with
payors.

19

---

The inability to collect accounts
receivable has in the past, and may in the future, have a material adverse effect on the
Company. The Company's bad debt expense for the years ended December 31, 2001, 2000
and 1999 was $26.0 million, $33.5 million and $123.2 million, respectively. The Company's
allowance for doubtful accounts at December 31, 2001 was $73.8 million. The Company
believes that the implementation of PPS for certain customers of the Company's ancillary
services operations negatively affected their cash flows and in many instances caused them
to file for bankruptcy. If certain Medicare Part A enactments expire on September 30, 2002
(see above), or other healthcare reform proposals are adopted which decrease Medicare or
Medicaid payments to skilled nursing facilities, then the Company's ancillary services
operations would experience a significant increase in bad debts. The Company's financial
condition and results of operation could be materially adversely affected by the inability
to collect its accounts receivable.

The Company may not be in compliance
with the HIPAA privacy rules by April 2003. The HIPAA privacy regulations seek to
limit the use and disclosure of most paper, oral and electronic communications regarding
an individual's past, present or future physical or mental health or condition, if the
individual can be identified by such information. HIPAA provides for the imposition of
civil or criminal penalties if protected health information is improperly disclosed. There
can be no assurance that the Company's business will not be materially adversely affected
if it is unable to meet the compliance deadline of April 2003. See "Government
Regulation."

The Company has limited operational
flexibility because it leases substantially all of its inpatient facilities. The
Company leases 235 of the 247 inpatient facilities that it operates. These leases
generally limit or restrict the Company's ability to assign the lease to another party.
The Company's failure to comply with the terms of the leases could result in an event of
default and subject the Company to material damages. Given these restrictions, the Company
may be forced to continue operating non-profitable facilities to avoid defaults under the
leases.

If the Company fails to comply with its
Corporate Integrity Agreement, it could be subject to severe sanctions. Under the
Corporate Integrity Agreement, the Company must have a comprehensive internal quality
improvement program and a system of internal financial controls in its nursing facilities,
hospitals and regional and corporate offices. A breach of the Corporate Integrity
Agreement could subject the Company to substantial monetary penalties and exclusion from
participation in Medicare and Medicaid programs. Any such sanctions could have a material
adverse effect on the Company's financial condition and results of operations. See
"Business - Corporate Compliance Process."

Changes in pharmacy legislation and
payment formulas could adversely impact the Company's pharmacy operations. Most states
reimburse pharmacies for drug prescriptions using an average wholesale price
("AWP") less a percentage discount. The OIG has estimated that the pharmacies'
actual acquisition costs for generic drugs averaged 65.9% below AWP. The OIG and CMS are
working to develop a prescription drug reimbursement method that they believe is more
accurate than using AWPs. Likewise, a number of states have either implemented or proposed
cost containment initiatives. Changes in payment formulas and delivery requirements could
materially adversely impact the SunScript pharmacy operations.

Efforts of third party payors to control
cost may adversely affect the Company's revenues and operating margins. The Company
receives approximately 28% of its revenues from private insurance, long-term care
facilities which utilize the Company's specialty medical services, self-pay facility
residents, and other third party payors. These private third party payors are continuing
their efforts to control healthcare costs through direct contracts with healthcare
providers, increased utilization review and greater enrollment in managed care programs
and preferred provider organizations. These private

20

---

payors increasingly
are demanding discounted fee structures and the assumption by healthcare providers of all
or a portion of the financial risk.

Further consolidation of managed care
organizations and other third party payors may adversely affect the Company's operating
results. Managed care organizations and other third party payors have continued to
consolidate in order to enhance their ability to influence the delivery of healthcare
services. Consequently, the healthcare needs of a large percentage of the United States
population is increasingly served by a smaller number of managed care organizations. These
organizations generally enter into service agreements with a limited number of providers
for needed services. To the extent such organizations terminate the Company as a preferred
provider and/or engage its competitors as a preferred or exclusive provider, this source
of revenues would be lost. In addition, private payors, including managed care payors,
increasingly are demanding discounted fee structures or the assumption by healthcare
providers of all or a portion of the financial risk through prepaid capitation
arrangements.

Future healthcare reform could
adversely affect the Company's business. In recent years, a number of legislative
proposals have been introduced or proposed in Congress and in some state legislatures that
would effect major changes in the healthcare system, either nationally or at the state
level. Among the proposals that have been introduced are further changes in reimbursement
by federal and state payors such as Medicare and Medicaid and health insurance reforms. It
is not clear at this time when or whether any new proposals will be adopted, or if
adopted, what effect, if any, such proposals would have on Sun's business.

Changes in revenue sources could
adversely affect the Company's business. Changes in the mix of patients among the
Medicaid, Medicare Part A and private pay categories, and among different types of private
pay sources, could significantly affect the revenues and results of operations. The
Company's current payor or revenue mix could change. The Company's percentage of revenues
attributable to private pay residents has decreased from 33.3% in 1999 to 28.1% in 2001.
In addition, the Company cannot be certain that the facilities operated by Sun, or the
provision of services and products by Sun, now or in the future, will initially meet or
continue to meet the requirements for participation in the Medicare and Medicaid programs.
A loss of Medicare or Medicaid certification or a change in Sun's reimbursement under
Medicare or Medicaid could reduce the Company's revenues and adversely affect its results
of operations.

The Company expects that it will
continue to experience a shortage of qualified personnel to staff its facilities and
increasing labor costs.The Company and other providers in the long-term care industry
have had and continue to have difficulties in retaining qualified personnel to staff its
long-term care facilities, particularly nurses, and as a result the Company often uses
temporary employment agencies to provide additional personnel. The labor costs are higher
for temporary employees than for full-time employees. In addition, many states have
increased minimum staffing standards and CMS is also studying whether minimum staffing
standards should be imposed on skilled nursing facilities. As minimum staffing standards
are increased, the Company may be required to retain additional staffing. In addition, in
recent years Sun has experienced increases in its labor costs primarily due to higher
wages and greater benefits required to attract and retain qualified personnel and to
increase staffing levels in its long-term and subacute care facilities. Sun may not be
able to continue to hire and retain a sufficient number of qualified personnel to operate
its inpatient facilities.

The Company's success is substantially
dependent on the leadership and performance of its new management team. The Company's
Chief Executive Officer, Chief Financial Officer, President of SunBridge Healthcare
Corporation, Senior Vice President of Human Resources and its entire Board of

21

---

Directors have all joined the Company since November 2001. As such,
there will be a period of transition in which the new management team implements new
business strategies, policies and practices.

In addition, there can be no assurance that the Company will be able to
retain its executive officers and key employees. The loss of the services of any of the
Company's executive officers or key employees could have a material adverse effect on the
Company's business, financial condition and results of operations. See "Item 10 -
Directors and Executive Officers of the Registrant."



Inpatient Facilities. The Company
operated an aggregate of 247 long-term care, subacute care and assisted living facilities
in the U.S. as of March 1, 2002, 235 of which were subject to long-term operating leases
or subleases and 12 of which were owned. The Company considers its properties to be in
good operating condition and suitable for the purposes for which they are being used. The
Company's facilities that are leased are subject to long-term operating leases or
subleases which require the Company, among other things, to fund all applicable capital
expenditures, taxes, insurance and maintenance costs. The annual rent payable under most
of the leases generally increases based on a fixed percentage or increases in the U.S.
Consumer Price Index. Many of the leases contain renewal options to extend the term.
Substantially all of the Company's leasehold interests serve as collateral for its
obligations under its Credit Agreements.

The Company calculated its aggregate
occupancy percentages for all of its long-term care, subacute care and assisted living
facilities on a same store basis as 89%, 90% and 91% in the U.S. for the years ended
December 31, 2001, 2000 and 1999, respectively. However, the Company believes that
occupancy percentages, either individually or in the aggregate, should not be relied upon
alone to determine the performance of a facility. Other factors include, among other
things, the sources of payment, terms of reimbursement and the acuity level for each of
the patients in such facilities. The Company computes occupancy percentages by dividing
the average daily number of beds occupied by the total number of available beds for use
during the periods indicated.

The following table sets forth certain
information concerning the long-term care, subacute care and assisted living facilities
leased or owned by the Company in the United States as of March 1, 2002. Included in
the table are 247 facilities (229 skilled nursing facilities, nine assisted living
facilities and nine hospitals) that are included in the inpatient services segment. Also,
included in the table are 13 facilities with 1,764 licensed beds that the Company intends
to divest during 2002.

22

---



State
    Number of Licensed Beds (1)
    Number of
    Facilities
         Leased         Owned     TotalCalifornia
    7,518
    75
    2
    77Massachusetts
    4,255
    30
    2
    32Georgia
    1,764
    13
    3
    16Connecticut
    1,530
    9
    1
    10Tennessee
    1,359
    11
    1
    12Washington
    1,320
    14
    -
    14Texas
    1,126
    8
    -
    8North Carolina
    1,031
    8
    -
    8New Hampshire
    1,010
    9
    -
    9Arizona
    1,006
    6
    -
    6Alabama
    783
    7
    -
    7West Virginia
    739
    7
    -
    7Idaho
    706
    6
    1
    7Florida
    590
    5
    -
    5New Jersey
    580
    4
    -
    4Ohio
    575
    4
    1
    5Illinois
    470
    4
    -
    4Maryland
    343
    2
    -
    2Colorado
    341
    2
    1
    3New Mexico
    286
    4
    -
    4Kentucky
    137
    2
    -
    2Oklahoma
    135
    2
    -
    2Louisiana
    131
    1
    -
    1Virginia
    120
    1
    -
    1Indiana
    99
    1
    -
    1Total
    27,954
    235
    12
    247=============
    =========
    =========
    ========


(1)  "Licensed Beds" refers to the number of beds
for which a license has been issued, which may vary in some instances from licensed beds
available for use.

Rehabilitation Services. As of March
1, 2002, the Company leased office space in 22 locations in 16 states to operate its
rehabilitation therapy business.

Pharmaceutical Services. As of March
1, 2002, the Company operated 32 regional pharmacies, 11 in-house long-term care
pharmacies and one pharmaceutical billing and consulting center, which together provided
pharmaceutical products and services in 21 states. All of these locations were leased.

23

---

Other Operations. As of March 1,
2002, the Company leased approximately 64 locations in 22 states to operate its other
businesses, including temporary medical staffing (CareerStaff), home health care (SunPlus)
and mobile radiology and medical laboratory (SunAlliance). The Company owns its corporate
headquarters buildings in Albuquerque, New Mexico. In January 2002, the Company entered
into an agreement to sell two of its headquarters buildings.  The sale is expected to
be completed in April 2002, although no assurance can be given that the sale will be
completed.

Item 3. Legal Proceedings

In May and August 1999, former employees
of two of the Company's subsidiaries, SunBridge Healthcare Corporation and SunDance
Rehabilitation Corporation, filed proposed class action complaints in the Western District
of Washington. The plaintiffs sought to represent certain current and former employees of
SunBridge and SunDance who were allegedly not paid appropriate wages under federal and
state law since May and August 1996, respectively. Plaintiffs filed claims in the chapter
11 cases in the amount of approximately $780.0 million in the SunDance action and $242.0
million in the SunBridge action. Although the Company disputed these claims, the parties
executed a stipulation of settlement which was signed by the judge presiding over the
chapter 11 cases in the United States Bankruptcy Court for the District of Delaware. The
settlement provides a general unsecured claim in the chapter 11 cases of up to an
aggregate $3.0 million for the claimants, the payment of claimants' attorney's fees up to
$300,000, and the payment of up to $500,000 to cover the cost of notice to prospective
claimants in the class and claims administration. The settlement terms remain subject to
court approval.

In March and April 1999, class action
lawsuits were filed against the Company and three individuals who were at that time
officers of the Company in the United States District Court for the District of New
Mexico. These actions have been consolidated as In re Sun Healthcare Group, Inc.
Securities and Litigation Master, File No. Civ. 99-269. The lawsuits allege, among other
things, that the Company did not disclose material facts concerning the impact that PPS
would have on the Company's results of operations. The lawsuits seek compensatory damages
and other relief for stockholders who purchased the Company's common stock during the
class-action period. Pursuant to an agreement among the parties, the Company was dismissed
without prejudice in December 2000. On January 31, 2002, the District Court dismissed the
lawsuit with prejudice and entered judgment in favor of the defendants. On February 14,
2002, the plaintiffs filed a Motion to Amend the Judgment and to File an Amended
Complaint. The Company intends to vigorously defend the individual defendants in this
matter, who are indemnified by the Company and covered by the Company's insurance.

The United States Department of
Health & Human Services ("HHS") and the United States Department of Justice
("DOJ") periodically investigate matters that come to their attention concerning
the Company, including cost reporting matters. Several years ago, to expedite resolution
of any outstanding investigations, the Company requested that HHS and DOJ inform it of any
such investigations or outstanding concerns. In response, DOJ informed the Company of the
existence of a number of outstanding inquiries, several of which were prompted by the
filing of eleven qui tamlawsuits by private individuals ("Relators")
pursuant to the False Claims Act. HHS had also asserted claims against the Company
for overpayments in connection with Medicare reimbursement for services performed prior to
the implementation of the Medicare prospective payment system, and HHS and DOJ also
asserted claims for violations of the False Claims Act. The Company denied any violations
and asserted claims against HHS for underpayments in connection with services performed
for Medicare beneficiaries for the same periods which HHS disputes.

24

---

In February 2002, the Company, HHS, CMS,
DOJ, the Tricare Management Activity Support Office ("TMA"), and the Relators in
eight of the qui tam cases signed a comprehensive settlement agreement which
resolved all the claims of the parties. The Bankruptcy Court has approved the settlement.
The settlement agreement provided for, among other things, a release of pre-petition
claims of HHS, DOJ, TMA and the Relators against the Company. The settlement agreement
also provided for a release of substantially all the claims of the Company against HHS for
the same period; the Company previously reserved all such claims due to the uncertainty of
the Company recovering such amounts. The settlement agreement required the Company to pay
$1,000,000 in cash and deliver a promissory note for $10,000,000. The Relators in the
remaining three qui tamcases previously separately entered into settlement
agreements with the Company resolving all of their claims against the Company.

In contemplation of a settlement with
HHS, the Company entered into a corporate integrity agreement with the HHS' Office of
Inspector General in July 2001. The agreement officially took effect upon the Company's
emergence from bankruptcy. Under the terms of this agreement, the Company implemented
further internal controls with respect to its quality of care standards and its Medicare
and Medicaid billing, reporting and claims submission processes.

The Company is a party to various other
legal actions and administrative proceedings and is subject to various claims arising in
the ordinary course of its business, including claims that its services have resulted in
injury or death to the residents of its facilities. The Company has experienced an
increasing trend in the number and severity of litigation claims asserted against the
Company. The Company believes that this trend is endemic to the long-term care industry
and is a result of the increasing number of large judgments, including large punitive
damage awards, against long-term care providers in recent years resulting in an increased
awareness by plaintiff's lawyers of potentially large recoveries. In certain states in
which the Company has significant operations, including California, insurance coverage for
the risk of punitive damages arising from general and professional liability litigation is
not available due to state law public policy prohibitions. There can be no assurance that
the Company will not be liable for punitive damages awarded in litigation arising in
states for which punitive damage insurance coverage is not available. The Company also
believes that there has been, and will continue to be, an increase in governmental
investigations of long-term care providers, particularly in the area of Medicare/Medicaid
false claims, as well as an increase in enforcement actions resulting from these
investigations. Adverse determinations in legal proceedings or governmental
investigations, whether currently asserted or arising in the future, could have a material
adverse effect on the Company.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of
security holders during the fourth quarter of 2001.

PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters

The Company began issuing new common
stock on February 28, 2002 as part of its Plan of Reorganization. The new common stock has
CUSIP number 866933 40 1. The Company's old common stock which was issued and outstanding
as of February 28, 2002 was cancelled as part of the Plan of Reorganization. The old
common stock had CUSIP number 866933 10 4. See "Item 1. - Business -
Reorganization."

25

---

The Company's new common stock has been
given the symbol "SUHGV.OB" on the Over-the-Counter ("OTC") Bulletin
Board.  However, as of March 28, 2002, there was no established trading market for
the Company's common stock.

There were approximately 50 holders of
record of the Company's common stock as of March 18, 2002. The number of record holders
and the number of shares outstanding will increase as the Company continues issuing its
new common stock pursuant to the Plan of Reorganization. The Company has never paid nor
declared any dividends on its common stock. The Company's Credit Agreements restrict the
Company's ability to pay dividends.

Item 6. Selected Financial Data

The following selected consolidated
financial data for the years indicated have been derived from the Company's consolidated
financial statements. The financial data set forth below should be read in connection with
"Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations" and with the Company's consolidated financial statements and related
notes thereto (in thousands, except per share data):

26

---

Years
    Ended December
    31,2001(1)
    
    2000(2)
    
    1999(3)
    
    1998(4)
    
    1997(5)Total net
    revenues
    $2,075,234
    
    $2,458,928
    
    $2,529,039
    
    $3,088,460
    
    $2,010,820(Losses)
    income before income taxes,
      extraordinary loss and cumulative effect
      of change in accounting principle
    (69,116
    )
    (545,455
    )
    (1,076,481
    )
    (689,842
    )
    95,882(Losses)
    income before extraordinary loss
      and cumulative effect of change in
      accounting principle
    (69,437
    )
    (545,711
    )
    (1,076,642
    )
    (743,419
    )
    54,729Extraordinary
    loss
    -
    
    -
    
    -
    
    (10,274
    )
    (19,928
    )Cumulative
    effect of change in accounting
      principle
    -
    
    -
    
    (12,816
    )
    -
    
    -Net
    (losses) income
    $              (69,437
    )
    $             (545,711
    )
    $        (1,089,458
    )
    $             (753,693
    )
    $                 34,801========
    
    ========
    
    ========
    
    ========
    
    ========Net
    (losses) income per common and
      common equivalent share:Net
    (losses) income before
      Extraordinary loss and cumulative effect
      of change in accounting principle:Basic
    $                  (1.14
    )
    $                   (9.04
    )
    $                (18.40
    )
    $                  (14.29
    )
    $                     1.18========
    
    ========
    
    =========
    
    ========
    
    ========Diluted
    $                  (1.14
    )
    $                   (9.04
    )
    $                (18.40
    )
    $                  (14.29
    )
    $                     1.06========
    
    ========
    
    =========
    
    ========
    
    ========Net
    (losses) income:Basic
    $                  (1.14
    )
    $                   (9.04
    )
    $                (18.62
    )
    $                  (14.49
    )
    $                     0.75========
    
    ========
    
    =========
    
    ========
    
    ========Diluted
    $                  (1.14
    )
    $                   (9.04
    )
    $                (18.62
    )
    $                  (14.49
    )
    $                     0.67========
    
    ========
    
    =========
    
    ========
    
    ========Weighted
    Average number of common and
        common equivalent shares:Basic
    61,096
    
    60,347
    
    58,504
    
    52,008
    
    46,329========
    
    ========
    
    =========
    
    ========
    
    ========Diluted
    61,096
    
    60,347
    
    58,504
    
    52,008
    
    51,851========
    
    ========
    
    =========
    
    ========
    
    ========Working
    Capital (Deficit)
    $              (13,259
    )
    $             (138,901
    )
    $              (17,282
    )
    $              (539,636
    )
    $               307,025========
    
    ========
    
    =========
    
    ========
    
    ========Total
    Assets
    $              649,804
    
    $               849,988
    
    $          1,438,488
    
    $            2,468,038
    
    $            2,579,236========
    
    ========
    
    =========
    
    ========
    
    ========Liabilities
    subject to compromise
    $           1,549,139
    
    $            1,529,928
    
    $          1,558,518
    
    $                           -
    
    $                           -========
    
    ========
    
    =========
    
    ========
    
    ========Long-term
    debt
    $                97,184
    
    $              157,227
    
    $             145,541
    
    $            1,518,274
    
    $            1,545,678========
    
    ========
    
    =========
    
    ========
    
    ========Stockholders'
    (deficit) equity
    $         (1,602,290
    )
    $          (1,545,338
    )
    $         (1,023,000
    )
    $                 33,759
    
    $               617,053========
    
    ========
    
    =========
    
    ========
    
    ========


(1)
    Results for the year ended December 31, 2001exclude
    approximately $52.1 million of excess reserves reversed into net patient revenues due to
    the Settlement Agreement andinclude
    a non-cash charge of $18.8 million representing a reduction in the Company's estimate of
    goodwill and other long-lived assets impairment (see "Note 7-Impairment of
    Long-Lived Assets and Assets Held for Sale" in the Company's consolidated financial
    statements), a net non-cash gain on sale of assets of $0.8 million due to the prepetition
    termination of certain facility lease agreements, the sale of
    27
    certain other facilities, and reduction of the carrying amount of
    certain assets that the Company had determined are not integral to its core business
    operations (see "Note 7 - Impairment of Long-Lived Assets and Assets Held for
    Sale" in the Company's consolidated financial statements) and a $42.9 million charge
    for reorganization items due to the Company's chapter 11 filings (see "Note 2 -
    Emergence from Chapter 11 Bankruptcy Proceedings" in the Company's consolidated
    financial statements).(2)
    Results for the year ended December 31, 2000 include a non-cash charge of $191.3
    million representing a reduction in the Company's estimate of goodwill and other
    long-lived assets impairment (see "Note 7-Impairment of Long-Lived Assets
    and Assets Held for Sale" in the Company's consolidated financial statements), a net
    non-cash gain on sale of assets of $21.4 million due to the prepetition termination of
    certain facility lease agreements, the sale of certain other facilities, and reduction of
    the carrying amount of certain assets that the Company had determined are not integral to
    its core business operations (see "Note 7 - Impairment of Long-Lived Assets and
    Assets Held for Sale" in the Company's consolidated financial statements), a $1.1
    million non-cash recovery of previously recorded cost for corporate and financial
    restructuring (see "Note 4 - Restructuring Costs" in the Company's consolidated
    financial statements), a $2.5 million charge for legal and regulatory charges due to the
    Company's chapter 11 filings (see "Note 2 - Emergence from Chapter 11 Bankruptcy
    Proceedings" in the Company's consolidated financial statements) and a $335.9 million
    charge for reorganization items due to the Company's chapter 11 filings (see "Note 2
    - Emergence from Chapter 11 Bankruptcy Proceedings" in the Company's consolidated
    financial statements).(3)
    Results for the year ended December 31, 1999 include a non-cash charge of
    $457.4 million representing a reduction in the Company's estimate of goodwill and other
    long-lived asset impairment (see "Note 7-Impairment of Long-Lived Assets and
    Assets Held for Sale" in the Company's consolidated financial statements), a net
    non-cash charge of $78.7 million due to the prepetition termination of certain facility
    lease agreements, the sale of certain other facilities and to reduce the carrying amount
    of certain assets that the Company had determined are not integral to its core business
    operations (see "Note 7 - Impairment of Long-Lived Assets and Assets Held for
    Sale" in the Company's consolidated financial statements), a $27.4 million charge for
    corporate and financial restructuring (see "Note 4 - Restructuring Costs" in the
    Company's consolidated financial statements), a $2.5 million loss on the termination of
    the interest rate swaps (see "Note 9 - Long-Term Debt" in the Company's
    consolidated financial statements) and a $48.1 million charge for reorganization items due
    to the Company's chapter 11 filings (see "Note 2 - Emergence from Chapter 11
    Bankruptcy Proceedings" in the Company's consolidated financial statements).(4)
    Results for the year ended December 31, 1998 include a non-cash charge of
    $397.5 million representing a reduction in the Company's estimate of goodwill and other
    asset impairment (see "Note 7 - Impairment of Long-Lived Assets and Assets Held for
    Sale" in the Company's consolidated financial statements), a non-cash charge of
    $206.2 million due to the termination of certain facility lease agreements, the sale
    of certain other facilities and to reduce the carrying amount of certain assets that the
    Company had determined are not integral to its core business operations (see "Note 7
    - Impairment of Long-Lived Assets and Assets Held for Sale" in the Company's
    consolidated financial statements), a $22.5 million charge for legal and regulatory
    matters, a $4.6 million charge for restructuring costs in order to more closely align the
    Company's inpatient, rehabilitation and respiratory therapy, and pharmaceutical and
    medical supplies segments (see "Note 4 - Restructuring Costs" in the Company's
    consolidated financial statements), and an extraordinary loss of $10.3 million, net of
    income tax benefit of $3.7 million, to permanently pay-down $300 million of the term loan
    portion of the Company's senior credit facility in addition to the $3.7 million
    28
    to retire $5.0
    million of the Contour Medical, Inc. convertible debentures purchased by the Company.(5)
    Results for the year
    ended December 31, 1997 include a charge of $7.0 million recognized by the Company in
    order to reduce the carrying value of its Canadian operations to fair value based on
    revised estimates of selling value and of costs to sell. In addition, in 1997, the Company
    recorded an extraordinary charge of $19.9 million, net of the related tax benefit, in
    connection with the Company's purchase of Regency's 12.25% Junior Subordinated Notes due
    2003 and of Regency Health Services, Inc.'s 9.875% Senior Subordinated Notes due 2002 and
    an extraordinary charge of $2.1 million, net of the related tax benefit, related to the
    refinancing of the Company's senior credit facility.


Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations

Overview

The Company is one of the largest
providers of long-term, subacute and related specialty healthcare services in the United
States. The Company operates through three principal business segments: inpatient
services, rehabilitation therapy services and pharmaceutical services.

Inpatient Services: This segment
provides, among other services, inpatient skilled nursing and custodial services as well
as rehabilitative, restorative and transitional medical services. The Company provides
24-hour nursing care in these facilities by registered nurses, licensed practical nurses
and certified nursing assistants. As of December 31, 2001, the Company operated 247
inpatient facilities with 27,954 licensed beds compared to 303 facilities with 33,363
licensed beds as of December 31, 2000. Included in the December 31, 2001 amounts are seven
skilled nursing facilities with 1,021 licensed beds that the Company intends to divest
through foreclosure sales, lease terminations through mutual agreements with the lessors
or by transferring operations to successor operators. As of March 1, 2002, the Company has
identified a total of 13 skilled nursing facilities with 1,764 licensed beds for disposal.
See "Note 7 - Impairment of Long-Lived Assets and Assets Held for Sale" in the
accompanying consolidated financial statements.

Rehabilitation Therapy Services:
This segment provides, among other things, physical, occupational and speech therapy
services to affiliated and nonaffiliated skilled nursing facilities. As of December 31,
2001, the Company's rehabilitation therapy services segment provided services to 859
facilities in 42 states, of which 622 were operated by nonaffiliated parties compared to
942 facilities in 41 states as of December 31, 2000, of which 652 were operated by
nonaffiliated parties.

Pharmaceutical Services: This
segment provides pharmaceutical products primarily to long-term and subacute care
facilities for such purposes as infusion therapy, pain management, antibiotic therapy and
parenteral nutrition. Additional services include providing consultant pharmacists and
assistance in preparation of billing documentation. The pharmaceutical subsidiary provided
pharmaceutical products and services to 654 long-term and subacute care facilities,
including 439 nonaffiliated facilities, as of December 31, 2001. As of December 31, 2000,
pharmaceutical products and services were provided to approximately 1,506 facilities,
including 1,217 nonaffiliated facilities.

Other Operations: From 1999 through
2001, the Company's other operations included temporary medical staffing services, home
health, software development and other ancillary services.

29

---

Divested Operations: The Company
divested its respiratory therapy operations in March 2002. These operations were
previously included with the rehabilitation therapy services segment.

The Company divested its medical supplies
operations in January 2001. These operations were previously included within the
pharmaceutical services segment.

In February 2001, the Company sold its
operations in the United Kingdom. In April 2001, the Company sold its operations in
Germany. In July 2001, the Company's Australian operations were sold. Prior to the
divestitures of its international operations, the Company reported them as a fourth
business segment. See "Item 1 - Business - Reorganization" and "Note 7 -
Impairment of Long-lived Assets and Assets Held for Sale" in the Company's
consolidated financial statements.

The Company divested its hospice
operations in the fourth quarter of 1999 and most of its assisted living operations in the
fourth quarter of 1999 and the first half of 2000. These operations were previously
reported under "Other Operations."

Emergence from Chapter 11 Bankruptcy Proceedings

On October 14, 1999 (the "Filing
Date"), Sun Healthcare Group, Inc. and substantially all of its U.S. operating
subsidiaries filed voluntary petitions for reorganization under chapter 11 of the U.S.
Bankruptcy Code ("chapter 11"). On February 6, 2002, the Bankruptcy Court
approved the Company's joint plan of reorganization (the "Plan") and on February
28, 2002 the Company consummated the Plan. See "Item 1 - Business -
Reorganization."

Factors That Will Affect the Company's Future Financial Condition and Results of
Operations

The Company's future financial condition
and operating results will be affected by a number of factors, including but not limited
to the following, each of which is more fully described under "Item 1 - Business -
Certain Additional Business Risks:"

|- |  | the Company's ability to continue borrowing under the Company's Loan
    Agreements,                                                           
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------
|- |  | exposure to liabilities in excess of the Company's self-funded liability
    risk and insured risk,                                            
|- |  | the Company's ability to retain a sufficient level of staff for the
    Company's inpatient facilities,                                        
|- |  | the Company's ability to comply with government regulations and the costs
    of such compliance, including the costs to comply with HIPAA, and
|- |  | the Company's ability to generate positive cash flow from operations.                                                                          

Critical Accounting Policies

The Company's discussion and analysis of
the financial condition and results of operations are based upon the consolidated
financial statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these financial statements
requires the use of estimates and judgments that affect the reported amounts and related
disclosures of assets and liabilities, the disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results may differ materially from these estimates.
The Company believes the following critical accounting policies, among others,

30

---

affect the more
significant judgments and estimates used in the preparation of the consolidated financial
statements.

The consolidated financial statements of
the Company have been presented in accordance with the American Institute of Certified
Public Accountants Statement of Position 90-7: "Financial Reporting by Entities in
Reorganization under the Bankruptcy Code" ("SOP 90-7") and have been
prepared in accordance with the Company's accounting principles generally accepted in the
United States applicable to a going concern, which principles, except as otherwise
disclosed, assume that the Company's assets will be realized and the Company's liabilities
will be discharged in the normal course of business.

Under chapter 11, certain claims against
the Company in existence prior to the Filing Date were stayed while the Company continued
its operations as a debtor-in-possession. These claims are reflected in the December 31,
2001 and 2000 balance sheets as "liabilities subject to compromise." Since
October 14, 1999, the payment of certain prepetition claims (principally employee wages
and benefits and payments to critical vendors and utilities) that were approved by the
Bankruptcy Court have reduced "liabilities subject to compromise." As part of
the Company's emergence from chapter 11 proceedings, all of the "liabilities subject
to compromise" have been discharged, reinstated or repaid.

The Company has determined that,
generally, the fair market value of the collateral was less than the principal amount of
its secured prepetition debt obligations; accordingly, the Company discontinued accruing
interest on many of these obligations as of the Filing Date.

(a)  Net Revenues

Net revenues consist of long-term and
subacute care revenues, temporary medical staffing services revenues, pharmaceutical
services revenues and other ancillary services revenues. Net revenues are recognized as
services are provided. Revenues are recorded net of provisions for discount arrangements
with commercial payors and contractual allowances with third-party payors, primarily
Medicare and Medicaid. Net revenues realizable under third-party payor agreements are
subject to change due to examination and retroactive adjustment. Estimated third-party
payor settlements are recorded in the period the related services are rendered. The
methods of making such estimates are reviewed periodically, and differences between the
net amounts accrued and subsequent settlements or estimates of expected settlements are
reflected in current results of operations.

In February 2002, the Company, HHS, CMS,
DOJ, the Tricare Management Activity Support Office ("TMA"), and the Relators in
eight qui tam cases, entered into a comprehensive settlement agreement (the
"Settlement Agreement"). Under the Settlement Agreement, the Company and the
above mentioned parties agreed to mutually release each other from substantially all
prepetition claims. The Settlement Agreement requires the Company to pay $1.0 million in
cash and deliver a promissory note for $10.0 million, plus interest to CMS over the next
five years.

Since 1999, the Company recorded various
reserves due to the uncertainty of the reimbursement adjustments that might have been
required to settle the matters raised by the parties of the Settlement Agreement,
including a reserve of approximately $31.0 million recorded in 1999 for routine cost limit
exception payments previously paid to the Company. Such amounts totaled a net reserve of
$52.1 million. As a result of the Settlement Agreement, the Company reversed the $52.1
million of net excess reserved exposures and reflected it as a component of net patient
revenue in the 2001 consolidated statement of operations.

31

---

(b)  Accounts Receivable

The Company's accounts receivable relate
to services provided by its various operating divisions to a variety of payors and
customers. The primary payors for services provided in long-term and subacute care
facilities that the Company operates in the United States are the Medicare program and the
various state Medicaid programs. The rehabilitation and respiratory therapy service
operations in the United States provide services to patients in unaffiliated long-term,
rehabilitation and acute care facilities. The billings for those services are submitted to
the unaffiliated facilities. Many of the unaffiliated long-term care facilities receive a
large majority of their revenues from the Medicare program and the state Medicaid
programs.

Estimated provisions for doubtful
accounts are recorded each period as an expense to the income statement. In evaluating the
collectibility of accounts receivable, the Company considers a number of factors,
including the age of the accounts, changes in collection patterns, the financial condition
of the Company's customers, the composition of patient accounts by payor type, the status
of ongoing disputes with third-party payors and general industry conditions. Any changes
in these factors or in the actual collections of accounts receivable in subsequent periods
may require changes in the estimated provision for loss. Changes in these estimates are
charged or credited to the results of operations in the period of the change.

(c)  Impairment of Long-Lived Assets

The Company evaluates the carrying value
of long-lived assets, including goodwill, in relation to the future projected undiscounted
cash flows of the underlying businesses to assess recoverability in accordance with
Statement of Financial Accounting Standards No. 121 "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of"
("SFAS 121"). Those projected future undiscounted cash flows require
significant assumptions about future operations, such as reimbursement rates for Medicaid
and Medicare patients, occupancy rates, wage rates, workers compensation costs and
professional liability costs. Under SFAS 121, an impairment loss is recognized if the
sum of the future net expected cash flows is less than the carrying amount of the
long-lived assets being evaluated. The difference between the carrying amount of the
long-lived assets being evaluated and the estimated fair market value of the assets
represents the impairment loss. The Company determines estimated fair value for the
long-lived assets that it intends to retain based on anticipated future cash flows
discounted at rates commensurate with the risks involved.

(d)  Accrued Self-Insurance Obligations

It is the Company' s policy to
self-insure for certain insurable risks, including general and professional liability and
workers' compensation liability through the use of self-insurance or retrospective and
high deductible insurance policies and other hybrid policies, which vary among the states
in which the Company operates. Provisions for estimated settlements, including incurred
but not reported losses, are provided in the period of the related coverage. These
provisions are based on internal evaluations of the merits of individual claims and the
reserves assigned by the Company's independent insurance carriers. The methods of making
such estimates and establishing the resulting accrued liabilities are reviewed
periodically, and any adjustments resulting therefrom are reflected in current earnings.
Claims are paid over varying periods, which generally range from one to five years. Future
payments may be different than the estimated expense. Accrued liabilities for future
claims are not discounted.

32

---

Recent Accounting Pronouncements

In October 2001 the FASB issued SFAS No.
144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS
144"). SFAS 144 replaces SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lives Assets to be Disposed of." SFAS 144 requires
that long-lived assets be measured at the lower of carrying amount or fair value less cost
to sell, whether reported in continuing operations or in discontinued operations.
Therefore, discontinued operations will no longer be measured at net realizable value or
include amounts for operating losses that have not yet occurred. SFAS 144 also broadens
the reporting of discontinued operations to include all components of an entity with
operations that can be distinguished from the rest of the entity and that will be
eliminated from the ongoing operations of the entity in a disposal transaction. The
provisions of SFAS 144 are effective for financial statements issued for fiscal years
beginning after December 15, 2001. This new pronouncement will become effective January 1,
2002. The Company has not determined the impact that the adoption of this accounting
standard will have on its consolidated financial statements.

In June 2001 the FASB issued SFAS No.
141, "Business Combinations" ("SFAS 141") which provides that all
business combinations should be accounted for using the purchase method of accounting and
establishes criteria for the initial recognition and measurement of goodwill and other
intangible assets recorded in connection with a business combination. The provisions of
SFAS 141 apply to all business combinations initiated after June 30, 2001 and to all
business combinations accounted for by the purchase method that are completed after June
30, 2001.

In addition, in June 2001 the FASB issued
SFAS No. 142, "Goodwill and Other Intangible Assets," ("SFAS 142")
which establishes the accounting for goodwill and other intangible assets following their
recognition. SFAS 142 applies to all goodwill and other intangible assets whether acquired
singly, as part of a group, or in a business combination. SFAS 142 also applies to
goodwill recognized in accordance with SOP 90-7. The new pronouncement provides that
goodwill should not be amortized but should be tested for impairment annually using a
fair-value based approach. In addition, SFAS 142 provides that intangible assets other
than goodwill should be amortized over their useful lives and reviewed for impairment in
accordance with existing guidelines. SFAS 142 will become effective for the Company
beginning on January 1, 2002. The Company's application of fresh-start accounting, in
connection with the Company's emergence from bankruptcy is expected to result in goodwill,
however, the amount of goodwill has not currently been determined. See "Note 23 -
Subsequent Events" in the accompanying consolidated financial statements. The Company
has not determined the impact that the adoption of this accounting standard will have on
its consolidated financial statements.

In 1998, the American Institute of
Certified Public Accountants issued Statement of Position 98-5 "Reporting on the
Costs of Start-up Activities" ("SOP 98-5"). This statement requires costs
of start-up activities and organization costs to be expensed as incurred. The statement
was effective for financial statements for fiscal years beginning after December 15,
1998. During the first quarter of 1999, the Company adopted the provisions of SOP 98-5,
which resulted in a cumulative effect of a change in accounting principle charge of
approximately $12.8 million.

In June 1998, the FASB issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities"
("SFAS 133"). Under SFAS 133, all derivatives are required to be recognized
in the balance sheet at fair value. Gains or losses from changes in fair value would be
recognized in earnings in the period of change unless the derivative is designated as a
hedging instrument. In June 1999, the FASB issued SFAS No. 137, which amended SFAS 133,
delaying its effective date to fiscal years beginning after June 15, 2000. The Company
does not currently hold any derivative instruments nor does it engage in hedging
activities.

33

---

Results of Operations

The following tables set forth the amount
and percentage of certain elements of total net revenues for the years ended December 31
(in thousands):

2001
    2000
    1999Inpatient
    Services
    $    1,609,388
    
    77.6
    %
    $    1,718,178
    
    69.9
    %
    $    1,704,436
    
    67.4
    %Rehabilitation
    and Respiratory Therapy Services
    175,159
    
    8.4
    %
    204,367
    
    8.3
    %
    234,054
    
    9.3
    %Pharmaceutical
    and Medical Supply Services
    257,579
    
    12.4
    %
    311,276
    
    12.6
    %
    316,880
    
    12.5
    %International
    Operations
    23,887
    
    1.1
    %
    265,501
    
    10.8
    %
    296,906
    
    11.7
    %Other
    Operations
    178,065
    
    8.6
    %
    171,430
    
    7.0
    %
    196,760
    
    7.8
    %Corporate
    1,393
    
    0.1
    %
    1,381
    
    0.1
    %
    2,574
    
    0.1
    %Intersegment
    eliminations
    (170,237
    )
    (8.2
    )%
    (213,205
    )
    (8.7
    )%
    (222,571
    )
    (8.8
    )%Total Net
    Revenues
    $    2,075,234
    
    100.0
    %
    $  2,458,928
    
    100.0
    %
    $  2,529,039
    
    100.0
    %======
    
    ===
    
    ======
    
    ===
    
    ======
    
    ===




Same
    Store (1)
    2001
    2000
    1999Inpatient
    Services
    $    1,528,988
    
    73.6
    %
    $    1,407,024
    
    57.2
    %
    $    1,254,326
    
    49.6
    %Rehabilitation
    and Respiratory Therapy Services
    167,659
    
    8.1
    %
    97,834
    
    4.0
    %
    111,378
    
    4.4
    %Pharmaceutical
    and Medical Supply Services
    246,517
    
    11.9
    %
    235,802
    
    9.6
    %
    232,907
    
    9.2
    %Other
    Operations
    169,442
    
    8.2
    %
    150,266
    
    6.1
    %
    136,357
    
    5.4
    %Corporate
    1,393
    
    0.1
    %
    1,381
    
    0.1
    %
    2,574
    
    0.1
    %Intersegment
    eliminations
    (170,237
    )
    (8.2
    )%
    (213,205
    )
    (8.7
    )%
    (222,571
    )
    (8.8
    )%Discontinued
    Operations
    131,472
    
    6.3
    %
    779,826
    
    31.7
    %
    1,014,068
    
    40.1
    %Total Net
    Revenues
    $    2,075,234
    
    100.0
    %
    $  2,458,928
    
    100.0
    %
    $  2,529,039
    
    100.0
    %======
    
    ===
    
    ======
    
    ===
    
    ======
    
    ===


(1)
    A same store basis includes only facilities operated for the full 12 months of each year
    in the comparison of the operations activity. The table above shows the results of each
    segment for 2001, 2000 and 1999 for facilities that existed as of January 1, 1999 and were
    operated continuously through December 31, 2001.


Inpatient facilities revenues for
long-term care, subacute care and assisted living services include revenues billed to
patients for therapy and pharmaceutical services and medical supplies provided by the
Company's affiliated operations. Revenues for rehabilitation and respiratory therapy
services provided to domestic affiliated facilities were approximately $99.5 million,
$113.3 million and $126.9 million for the years ended December 31, 2001, 2000 and 1999,
respectively. Revenues for pharmaceutical and medical supply services provided to domestic
affiliated facilities were approximately $62.2 million, $88.3 million and $80.9 million
for the years ended December 31, 2001, 2000 and 1999, respectively. Revenues for services
provided by other non-reportable segments to affiliated facilities were approximately $9.0
million, $10.7 million and $10.0 million for the years ended December 31, 2001, 2000 and
1999, respectively.

The following tables set forth the amount
of net segment income/(loss) for the years ended December 31 (in thousands):

34

---



2001
    
    2000
    
    1999Inpatient
    Services
    $         (20,006
    )
    $       (29,339
    )
    $      (240,201
    )Rehabilitation
    and Respiratory Therapy Services
    12,691
    
    16,391
    
    (44,125
    )Pharmaceutical
    and Medical Supply Services
    4,235
    
    (4,789
    )
    (30,310
    )International
    Operations
    (249
    )
    (21,521
    )
    (41,878
    )Other
    Operations
    (9,469
    )
    (15,341
    )
    (53,301
    )Net segment
    loss before Corporate
    (12,798
    )
    (54,599
    )
    (409,815
    )Corporate
    16,663
    
    16,325
    
    (52,533
    )Net segment
    income/(loss)
    $            3,865
    
    $      (38,274)
    
    $      (462,348
    )========
    
    ========
    
    ========




Same
    Store (1)
    2001
    
    2000
    
    1999Inpatient
    Services
    $            1,884
    
    $          3,637
    
    $      (169,366
    )Rehabilitation
    and Respiratory Therapy Services
    20,953
    
    (10,621
    )
    (68,961
    )Pharmaceutical
    and Medical Supply Services
    18,300
    
    11,151
    
    (3,016
    )Other
    Operations
    (3,617
    )
    (10,334
    )
    (28,409
    )Net segment
    (loss) income before Corporate and
      Discontinued Operations
    37,520
    
    (6,167
    )
    (269,752
    )Corporate
    16,663
    
    16,213
    
    (49,882
    )Discontinued
    Operations
    (50,318
    )
    (48,320
    )
    (142,714
    )Net segment
    income/(loss)
    $            3,865
    
    $      (38,274)
    
    $      (462,348
    )========
    
    =======
    
    ========


(1)
    A same store basis includes only facilities operated for the full 12 months of each year
    in the comparison of the operations activity. The table above shows the results of each
    segment for 2001, 2000 and 1999 for facilities that existed as of January 1, 1999 and were
    operated continuously through December 31, 2001.


The net segment income/(loss) amounts
detailed above do not include the following items: legal and regulatory matters, net; gain
(loss) on sale of assets, net; loss on termination of interest rate swaps; impairment
loss; restructuring costs; reorganization costs, net; income taxes; and cumulative effect
of a change in accounting principle.

The Company's subsidiaries which operate
inpatient facilities have historically used and continue to use pharmaceutical and
rehabilitation services that are provided by separate subsidiaries of the Company,
SunScript and SunDance, respectively. Effective on January 1, 2002, the rates charged by
SunScript and SunDance to the Company's inpatient facilities were adjusted to more
accurately reflect competitive, national market rates. While the change in these rates
will not impact the Company's consolidated results, the Company expects that on a segment
basis the pharmaceutical services and rehabilitation therapy services segments' net income
in 2002 will decrease by approximately $7.6 million and $3.5 million, respectively, and
the inpatient ancillary services expenses to decrease by approximately $11.1 million in
2002.

35

---

In accordance with SOP 90-7, items of
expense or income that are incurred or realized by the Company because it was in
reorganization are classified as reorganization costs in the Company's consolidated
statements of losses. As a result, net segment income/(losses) do not include interest
earned subsequent to the Filing Date on cash accumulated because the Company is not paying
its prepetition obligations. Interest earned prior to the Filing Date is included in net
segment income/(losses).  Debt discounts and deferred issuance costs that were
written-off after the Filing Date in accordance with SOP 90-7 are not included in the net
segment income/(losses).  The amortization of debt discounts and deferred issuance
costs prior to the Filing Date are included in net segment income/(losses). Losses on
sales of assets and professional fees related to the reorganization incurred subsequent to
the Filing Date are excluded from net segment income/(losses) which is consistent with
their treatment prior to the Filing Date.

Corporate expenses include amounts for
interest and corporate general and overhead expenses including those related to managing
the Company's subsidiaries. The Company allocates these to its segments through management
fees and intersegment interest charges. Management fees are assessed based on segment net
revenues. Interest is charged based upon average net asset balances at rates determined by
management.

The following discussions of the
"Year Ended December 31, 2001 compared to the Year Ended December 31, 2000" and
the "Year Ended December 31, 2000 compared to the Year Ended December 31, 1999"
are based on the financial information presented in "Note 21 - Segment
Information" in the Company's consolidated financial statements.

Year Ended December 31, 2001 Compared to Year Ended December 31, 2000

Inpatient Services

Due to the number of Inpatient Service
facilities being divested during the time periods being compared, a "same store"
basis is also included for comparison purposes.

Net revenues, which includes revenues
from therapy and pharmaceutical services provided at the Inpatient Services facilities,
decreased approximately $108.8 million from $1,718.2 million for the year ended December
31, 2000 to $1,609.4 million for the year ended December 31, 2001. On a same store basis,
net revenues increased approximately $122.0 million from $1,407.0 million for the year
ended December 31, 2000 to $1,529.0 million for the year ended December 31, 2001, an 8.7%
increase. This increase was primarily the result of increased Medicaid and Medicare
reimbursement rates during 2001.

Operating expenses, which include rent
expense of approximately $181.0 million and $149.3 million for the years ended December
31, 2000 and December 31, 2001, respectively, decreased $83.0 million, or 5.2%, from
$1,594.8 million for the year ended December 31, 2000 to $1,511.8 million for the year
ended December 31, 2001. The decrease resulted primarily from the divestiture of
facilities during 2001. On a same store basis, operating expenses, which include rent
expense of $142.4 million and $143.4 million for the years ended December 31, 2000 and
2001, respectively, increased 11.1% from $1,276.6 million for the year ended December 31,
2000 to $1,418.2 million for the year ended December 31, 2001. On a same store basis,
operating expenses as a percentage of net revenues increased from 90.7% for the year ended
December 31, 2000 to 92.8% for the year ended December 31, 2001. The increase in operating
expenses as a percentage of revenue was primarily due to increased labor costs as a result
of the competition for staff and contract personnel within the industry and the subsequent
pressure on labor rates. Various federal, state and local regulations impose, depending
upon the services provided, a variety

36

---

of regulatory standards for the quality and level of personnel required
to provide care or services. These requirements have an impact on staffing level and mix
which therefore impact costs and expenses.

Corporate general and administrative
expenses, which include regional costs related to the supervision of operations, were
$39.8 million and $34.2 million for the years ended December 31, 2000 and December 31,
2001, respectively. The decrease was primarily due to head count reduction following
divestitures of inpatient facilities during 2001. On a same store basis, as a percentage
of net revenues, corporate general and administrative expenses were 2.8% and 2.2% for the
years ended December 31, 2000 and December 31, 2001, respectively.

Depreciation and amortization decreased
approximately $7.6 million from $20.2 million for the year ended December 31, 2000 to
$12.6 million for the year ended December 31, 2001. On a same store basis, depreciation
and amortization decreased 30.3% from $17.8 million for the year ended December 31, 2000
to $12.4 million for the year ended December 31, 2001. On a same store basis, as a
percentage of net revenues, depreciation and amortization expense decreased from 1.3% for
the year ended December 31, 2000 to 0.8% for the year ended December 31, 2001. The
decreases are primarily the result of the determination that certain of the Company's
long-lived assets were impaired, which resulted in write-downs during 2000 of certain
long-lived assets pursuant to the Statement of Financial Accounting Standards No. 121
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be
Disposed Of" (SFAS 121). These write-downs reduced the depreciable basis of the
long-lived assets which caused depreciation and amortization expenses to be reduced in
2001.

The provision for losses on accounts
receivable increased 1.9% from approximately $15.4 million for the year ended December 31,
2000 to approximately $15.7 million for the year ended December 31, 2001. On a same store
basis, provision for losses on accounts receivable increased 34.3% from $10.8 million for
the year ended December 31, 2000 to $14.5 million for the year ended December 31, 2001. On
a same store basis, as a percentage of net revenues, provision for losses on accounts
receivable increased from 0.8% for the year ended December 31, 2000 to 0.9% for the year
ended December 31, 2001. The increases were primarily due to the aging of receivables
which require a higher level of reserves against them.

Net interest expense decreased
approximately $7.8 million from $10.6 million for the year ended December 31, 2000 to $2.8
million for the year ended December 31, 2001. On a same store basis, net interest expense
decreased 68.2% from $8.8 million for the year ended December 31, 2000 to $2.8 million for
the year ended December 31, 2001. The decreases were primarily due to the determination in
2001 that certain debt obligations which existed prior to the Company's bankruptcy filing
were subject to compromise; as a result, the Company stopped recording interest expense in
2001.

Rehabilitation and Respiratory Therapy Services

Net revenues from rehabilitation and
respiratory therapy services decreased $29.2 million, or 14.3%, from $204.4 million for
the year ended December 31, 2000 to $175.2 million for the year ended December 31, 2001.
Revenues from services provided to affiliated facilities decreased $13.8 million, or
12.2%, from $113.3 million for the year ended December 31, 2000 to $99.5 million for the
year ended December 31, 2001. Revenues from services provided to nonaffiliated facilities
decreased approximately $15.5 million, or 17.0%, from $91.1 million for the year ended
December 31, 2000 to $75.6 million for the year ended December 31, 2001. These decreases
were primarily the result of the Company's termination of certain nonaffiliated contracts
based on issues related to customers' credit-worthiness and contract profitability. In
addition, certain nonaffiliated contracts were terminated in the ordinary course

37

---

of business. The Company's divestitures of inpatient facilities in 2000
and 2001 also contributed to the decrease in affiliated revenues.

In March 2002, the Company sold its
respiratory therapy operations. The net revenues and the segment loss for these operations
for the year ended December 31, 2001 were $14.8 million and $2.3 million, respectively.

Operating expenses decreased $15.3
million, or 9.6%, from $159.8 million for the year ended December 31, 2000 to $144.5
million for the year ended December 31, 2001. The decrease resulted primarily from the
decline in the demand for the Company's therapy services resulting in a reduction in the
number of therapists employed by the Company's therapy services subsidiary. Operating
expenses as a percentage of net revenues increased from 78.2% for the year ended December
31, 2000 to 82.5% for the year ended December 31, 2001. This increase was attributable to
the decline in average revenue per therapy service while salaries and wage costs per
service decreased by a smaller percentage.

Depreciation and amortization decreased
40.0% from $3.0 million for the year ended December 31, 2000, to $1.8 million for the year
ended December 31, 2001. As a percentage of net revenues, depreciation and amortization
expense decreased from 1.5% for the year ended December 31, 2000 to 1.0% for the year
ended December 31, 2001, respectively. The decrease was a result of the Company's
classification of its respiratory therapy business as an asset held for sale in 2000. As
an asset held for sale, the respiratory therapy supplies business no longer recorded
depreciation or amortization.

Provision for losses on accounts
receivable decreased $5.3 million, or 79.1%, from $6.7 million for the year ended December
31, 2000 to $1.4 million for the year ended December 31, 2001. As a percentage of net
revenues, provision for losses on accounts receivable decreased from 3.3% for the year
ended December 31, 2000 to 0.8% for the year ended December 31, 2001. The decrease was
primarily due to a change in estimate for the allowance for doubtful accounts related to
the rehabilitation therapy business. Through improved management of customer accounts
during 2001, the business was able to reduce reserve allowances required.  The
decrease was partially offset by the reduction in revenues for the segment as discussed
previously.

Pharmaceutical and Medical Supply Operations

Net revenues from pharmaceutical and
medical supply services decreased $53.7 million, or 17.3%, from $311.3 million for the
year ended December 31, 2000 to $257.6 million for the year ended December 31, 2001.
Pharmaceutical services' net revenues from nonaffiliated parties increased approximately
$1.2 million, or 0.6%, while net revenues from affiliated parties increased approximately
$5.7 million, or 10.4%. The increase in pharmaceutical services' affiliated revenues was
primarily due to emphasis within the business to market its services to the Company's
inpatient services business. Medical supply services' net revenues decreased approximately
$60.6 million, or 85.1%. The decrease was primarily due to the discontinuation of revenue
from the Company's medical supply service business, which was sold in January 2001.

Operating expenses decreased $53.6
million, or 19.1%, from $279.9 million for the year ended December 31, 2000 to $226.3
million for the year ended December 31, 2001. As a percentage of net revenues, operating
expenses decreased from 89.9% for the year ended December 31, 2000 to 87.8% for the year
ended December 31, 2001. Pharmaceutical services' operating expenses increased
approximately $5.6 million, or 2.6%. The increase in the pharmaceutical services'
operating expenses was primarily attributed to increases in labor, benefit and insurance
costs along with an increase in cost of goods sold based on an increase in sales. Medical
supply services' operating expenses decreased 89.2% from $66.4

38

---

million for the year ended December 31, 2000 to $7.2 million for the
year ended December 31, 2001. The decrease in medical supply services' cost of goods sold
was a result of the decrease in sales.

Corporate general and administrative
expenses, which include regional costs related to the supervision of operations, decreased
25.0% from $5.2 million for the year ended December 31, 2000 to $3.9 million for the year
ended December 31, 2001. The decrease was primarily a result of the sale in January 2001
of the Company's medical supplies services business. As a percentage of net revenues,
corporate general and administrative expenses decreased from 1.7% for the year ended
December 31, 2000 to 1.5% for the year ended December 31, 2001.

Depreciation and amortization decreased
37.7% from $6.9 million for the year ended December 31, 2000 to $4.3 million for the year
ended December 31, 2001. As a percentage of net revenues, depreciation and amortization
expense was approximately 2.2% and 1.7% for the years ended December 31, 2000 and 2001,
respectively. The decrease was primarily a result of the sale in January 2001 of the
medical supplies services business for which depreciation ceased.

Provision for losses on accounts
receivable decreased 39.3% from $6.1 million for the year ended December 31, 2000 to $3.7
million for the year ended December 31, 2001. As a percentage of net revenues, the
provision for losses on accounts receivable decreased from 2.0% for the year ended
December 31, 2000 to 1.4% for the year ended December 31, 2001. The decrease was primarily
a result of the improved collection trend within the pharmaceutical services business
which allows for a decrease in the reserve. Additionally, the Company's medical supplies
service business was sold in January 2001 and the provision for that business ceased.

International Operations

Revenues from international operations
decreased $241.6 million from $265.5 million for the year ended December 31, 2000 to $23.9
million for the year ended December 31, 2001. The decrease was due to the sale of the
United Kingdom operations in January 2001 and the divestitures of its operations in
Germany in April 2001 and in Australia in July 2001.

Operating expenses which include rent
expense of $40.5 million and $4.6 million for the years ended December 31, 2000 and
December 31, 2001, respectively, decreased approximately 91.5% from $248.8 million for the
year ended December 31, 2000 to $21.2 million for the year ended December 31, 2001. This
decrease was a result of the same factors which led to a decrease in revenue as discussed
above. As a percentage of revenues, operating expenses decreased from 93.7% for the year
ended December 31, 2000 to 88.7% for the year ended December 31, 2001.

Corporate general and administrative
expenses were $13.0 million and $1.7 million for the years ended December 31, 2000 and
December 31, 2001, respectively. The decrease was a result of the same factors which led
to a decrease in revenue as discussed above.

Depreciation and amortization for
international operations was $2.5 million for the year ended December 31, 2000.
International operations were classified as an asset held for sale in the first quarter of
2000 which requires that depreciation and amortization cease on the operations.

Net interest expenses were $13.0 million
and $1.2 million for the years ended December 31, 2000 and December 31, 2001,
respectively. The decrease in expense was a result of the same factors which led to a
decrease in revenue as discussed above.

39

---

The Company sold its remaining
international operations in Germany in April 2001 and in Australia in July 2001. The
Company recorded a charge of approximately $141.1 million in the first quarter of 2000 to
reduce the carrying value of its international operations to its estimate of selling value
less costs to sell. The charge was recorded in reorganization costs in the Company's
consolidated statements of losses. At December 31, 2001, the Company had no operations
outside of the United States. See "Note 7 - Impairment of Long-Lived Assets and
Assets Held for Sale" in the Company's consolidated financial statements.

Other NonReportable Segments and Corporate General and Administrative Departments

Nonreportable segments include temporary
therapy and nursing staffing, home health, assisted living, software development and other
ancillary services. Revenues from other nonreportable segments increased 3.9% from $172.8
million for the year ended December 31, 2000 to $179.5 million for the year ended December
31, 2001. The Company's temporary therapy staffing business' revenue increased $10.9
million from $62.5 million for the year ended December 31, 2000 to $73.4 million for the
year ended December 31, 2001. The increase was primarily due to continuing growth in
demand for labor across the industry. The Company's laboratory business' revenue increased
$5.3 million from $28.3 million for the year ended December 31, 2000 to $33.6 million for
the year ended December 31, 2001. The increase was primarily due to an additional revenue
stream for mobile radiology developed within the business coupled with efforts by new
management personnel within the organization to realize opportunities for growth. The
assisted living revenue for the year ended December 31, 2000 was $7.2 million. During
2000, the Company divested 20 assisted living facilities. The Company transferred its two
remaining assisted living facilities from its other operations segment to its Inpatient
Services segment during 2000. Total revenues and operating expenses for nonreportable
segments represents less than 10% of the consolidated Company's results.

The Company's temporary therapy staffing
business' operating expense increased $10.3 million from $53.6 million for the year ended
December 31, 2000 to $63.9 million for the year ended December 31, 2001. The increase
was primarily due to the increase in revenue which resulted in an increase in labor and
other staffing costs to support the business. The Company's laboratory business' operating
expenses increased $4.3 million from $24.0 million for the year ended December 31, 2000 to
$28.3 million for the year ended December 31, 2001. The increase was primarily due to
the increase in revenue which was supported partially with an increase in labor and
associated costs.

The Company's assisted living operating
expenses decreased $6.5 million from $6.6 million for the year ended December 31, 2000 to
$0.1 million for the year ended December 31, 2001. The decrease in expense is a result of
the same factors which led to a decrease in revenue as discussed above. The Company's
software development business' operating expenses decreased $4.9 million from $16.6
million for the year ended December 31, 2000 to $11.7 million for the year ended December
31, 2001. The decrease is primarily due to restructuring efforts during 2001 which reduced
operating structures and staff within the business. Operating expenses for the Company's
corporate segment decreased $4.7 million from $0.7 million for the year ended December 31,
2000 to $(4.0) million for the year ended December 31, 2001. The decrease was primarily
due to infrastructure reorganization charges made while under bankruptcy protection that
streamlined overhead.

Corporate general and administrative
costs not directly attributed to segments decreased 34.0% from $90.9 million for the year
ended December 31, 2000 to $60.0 million at December 31, 2001. As a percentage of
consolidated net revenues of $2,458.9 million and $2,075.2 million for the years ended
December 31, 2000 and 2001, respectively, corporate general and administrative expenses
not directly attributed to segments decreased from 3.7% to 2.9%, respectively. The
decrease was primarily the result of

40

---

the reorganization changes made within the corporate division to
streamline overhead and contain costs.  This effort reduced the number of employees
in the division which correlated to a reduction in administrative and salary and benefit
costs.

Depreciation and amortization expense not
directly attributed to segments increased 5.2% or $0.7 million from $13.4 million for the
year ended December 31, 2000 to $14.1 million for the year ended December 31, 2001. The
increase was primarily due to an increase in property and equipment within the temporary
therapy staffing business to which depreciation was charged.

Net interest expense not directly
attributed to segments decreased 17.1% or $1.8 million from $10.5 million for the year
ended December 31, 2000 to $8.7 million for the year ended December 31, 2001. As a
percentage of consolidated net revenues, interest expense was 0.4% for the year ended
December 31, 2000 and 2001. The decrease was primarily due to the determination in 2001
that certain debt obligations which existed prior to the Company's bankruptcy filing were
subject to compromise; as a result, the Company stopped recording interest expense in
2001. For the year ended December 31, 2001, the Company did not pay or accrue
approximately $142.8 million of interest expense in accordance with SOP 90-7.

The corporate segment management fee
increased 40.0% or $24.3 million from $60.8 million for the year ended December 31, 2000
to $85.1 million for the year ended December 31, 2001. The increase was primarily
attributable to the assessment of additional management fees as specified in the
settlement provision of the management agreement between the corporate division and the
operating divisions.

Dividends on Convertible Preferred Stock

In May 1998, a statutory business trust,
all of whose common securities are owned by the Company, issued $345.0 million of 7.0%
CTIPS with a liquidation amount of $25.00 per CTIP. Each CTIP is convertible into 1.2419
shares of the Company's common stock (equivalent to a conversion price of $20.13 per
share). CTIPS holders were entitled to receive cumulative cash distributions at an annual
rate of 7.0%, payable quarterly. Payment of the cash distributions and principal are
irrevocably guaranteed by the Company. The Company may defer cash distribution for up to
20 consecutive quarters. Beginning with the interest payment due on May 1, 1999, the
Company exercised its right to defer cash distributions. As cash distributions are
deferred, dividends on the CTIPS continue to accrue.

During 2000, approximately $26.9 million
of CTIPS were converted into approximately 1.3 million shares of common stock. During
1999, $22.0 million of CTIPS were converted into approximately 1.1 million shares of
common stock. See "Note 14 - Convertible Trust Issued Preferred Securities" in
the Company's consolidated financial statements.

Other Special and Non-Recurring Charges

Restructuring Cost

During 2001, the Company recorded
restructuring costs of $1.1 million in its software development division. The
restructuring plan included reductions of staff and other overhead expenses and a
streamlining of the management structure.

Impairment of Goodwill and Other Long-Lived Assets

41

---

The Company periodically evaluates the
carrying value of goodwill and any other related long-lived assets in relation to the
future projected cash flows of the underlying business segments. The assets are considered
to be impaired when the expected future cash flows of the inpatient facilities or other
business segment divisions do not exceed the carrying balances of the goodwill or other
long-lived assets.

During 2001, the Company recorded a
non-cash impairment charge of approximately $18.8 million. The impairment was primarily
due to the decrease of revenues as compared with profitability projections for each
facility. This charge included approximately $14.5 million to its inpatient facilities
segment and $4.3 million related to the Company's software development business.

Other Long-Lived Assets

During 2000, a net non-cash charge of
approximately $310.1 million was recorded to reduce the carrying amount of the medical
supply operations and certain domestic inpatient facilities which were classified as
assets held for sale in the Company's consolidated 2000 balance sheet. Additionally, a
charge of $26.6 million was recorded to reduce the carrying amount of the corporate
headquarters building. The building was classified as an asset held for sale at December
31, 2000 and 2001. The charges are recorded in reorganization costs, net, in the Company's
consolidated statements of losses. See "Note 7 - Impairment of Long-Lived Assets and
Assets Held for Sale" in the Company's consolidated financial statements.

*Gain on Sale of Assets*

During the year ended December 31, 2001,
the Company recorded a net gain on the sale of assets of approximately $0.8 million due
primarily to decisions of the Company during 2001 to keep inpatient facilities previously
classified as assets held for sale.

During the year ended December 31, 2000,
the Company recorded gains on the sale of assets of approximately $25.1 million.
Approximately $21.4 million and $3.7 million was recorded in gain on sale of assets and
reorganization costs, net, respectively in the Company's consolidated statements of
losses. See "Note 2 - Emergence from Chapter 11 Bankruptcy Proceedings" and
"Note 7 - Impairment of Long-Lived Assets and Assets Held for Sale" in the
Company's consolidated financial statements.

Legal and Regulatory

In August 2000, the Bankruptcy Court
approved an agreement entered into between the Company and the U.S. Departments of Justice
and Health and Human Services pursuant to which the Company paid the U.S. government
approximately $1.2 million. The payment was in consideration of the government's agreement
to allow the Company to transfer certain of its facilities to new operators without
pursuing the new operators for alleged claims against the Company's facilities for
pre-transfer overpayment liabilities, and for the release and waiver of certain
pre-transfer claims against the Company related to the facilities to be transferred to new
operators. The Company recorded approximately $2.5 million in expenses during 2000 related
to the transfer of certain of its facilities to new operators, which includes the $1.2
million payment described above.

42

---

Reorganization Costs

The Company recorded net reorganization
costs of $335.9 million and $42.9 million for the years ended December 31, 2000 and 2001,
respectively. See "Note 2 - Emergence from Chapter 11 Bankruptcy Proceedings" in
the Company's consolidated financial statements.

Consolidated Results of Operations

The net loss for the year ended December
31, 2000 was $545.7 million compared to a net loss of $69.4 million for the year ended
December 31, 2001. The loss before considering impairment loss, legal and regulatory
matters, net, restructuring costs, gain (loss) on sale of assets, net, reorganization
costs, net, and income taxes was $38.3 million for the year ended December 31, 2000
compared to earnings of $3.9 million for the year ended December 31, 2001. The net loss
during the year ended December 31, 2000 is primarily due to the implementation of PPS and
the continuing adverse impact on the demand for the Company's ancillary services. The net
earnings for the year ended December 31, 2001 were primarily due to the Company's efforts
while under bankruptcy protection to divest under-performing facilities, mainly in the
inpatient services business, and to manage the business to maximize revenue opportunities
while controlling costs and expenses.

In accordance with SOP 90-7, no interest
was paid or accrued on prepetition debt, classified as liabilities subject to compromise
in the Company's consolidated balance sheets, and on the CTIPS since the Filing Date.
These claims were discharged as part of the Company's emergence from bankruptcy in
February 2002. Contractual interest expense not paid or accrued was $146.4 million and
$142.8 million for the years ended December 31, 2000 and December 31, 2001, respectively.

Income tax expense was $0.3 million for
each of the years ended December 31, 2000 and 2001. For the year ended December 31, 2000,
the Company increased its valuation allowance for the deferred tax assets resulting from
its net operating losses which may not be realizable depending upon whether the Company
generates future taxable income.

Year Ended December 31, 2000 Compared to Year Ended December 31, 1999

Inpatient Services

Due to the number of Inpatient Service
facilities being divested during the time periods being compared, a "same store"
basis is also included for comparison purposes.

Net revenues, which include revenues
generated from therapy and pharmaceutical services provided at the Inpatient Services
facilities, increased approximately $13.8 million from $1,704.4 million for the year ended
December 31, 1999, to $1,718.2 million for the year ended December 31, 2000, a 0.8%
increase. On a same store basis, net revenues increased approximately $152.7 million from
$1,254.3 million for the year ended December 31, 1999 to $1,407.0 million for the year
ended December 31, 2000, a 12.2% increase. Net revenues for 1999 include negative revenue
adjustments of approximately $105.0 million related to reserves established for cost
reports which, after audit, may require adjustments to revenues. Excluding the negative
revenue adjustments for 1999, on a same store basis, net revenues increased $47.7 million
or 3.5% for the year ended December 31, 2000. This increase was primarily the result of
improved Medicaid rates during 2000.

43

---

On a same store basis, operating
expenses, which include rent expense of $146.1 million and $142.4 million for the years
ended December 31, 1999 and 2000, respectively, increased 1.8% from $1,254.0 million for
the year ended December 31, 1999 to $1,276.6 million for the year ended December 31, 2000.
Operating expenses as a percentage of net revenues, excluding the negative revenue
adjustments for 1999, decreased from 92.3% for the year ended December 31, 1999 to 90.7%
for the year ended December 31, 2000. The decrease in operating expenses as a percentage
of revenue was primarily due to an increase in revenues combined with decreases in
administrative costs associated with the divestitures of skilled nursing facilities during
2000.

On a same store basis, corporate general
and administrative expenses, which include regional costs for the supervision of
operations, increased 38.7% from $28.7 million for the year ended December 31, 1999, to
$39.8 million for the year ended December 31, 2000. Excluding the effect of the negative
revenue adjustments, corporate general and administrative expenses were 2.1% and 2.8% of
the net revenues for the years ended December 31, 1999 and 2000, respectively. The change
was primarily due to an increase in the corporate overhead allocation partially offset by
a reduction in regional overhead to skilled nursing facility divestitures.

On a same store basis, depreciation and
amortization decreased 19.5% from $22.1 million for the year ended December 31, 1999 to
$17.8 million for the year ended December 31, 2000. Excluding the effect of the negative
revenue adjustments for 1999, as a percentage of net revenues, depreciation and
amortization expense decreased from 1.6% for the year ended December 31, 1999 to 1.3% for
the year ended December 31, 2000. The decreases were primarily the result of the
determination that certain of the Company's long-lived assets were impaired, which
resulted in write-downs of certain long-lived assets pursuant to the Statement of
Financial Accounting Standards No. 121 "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of ("SFAS 121").

On a same store basis, provision for
losses on accounts receivable decreased 71.2% from $37.5 million for the year ended
December 31, 1999, to $10.8 million for the year ended December 31, 2000. Excluding the
effect of the negative revenue adjustments for 1999 as a percentage of net revenues,
provision for losses on accounts receivable decreased from 2.8% for the year ended
December 31, 1999, to 0.8% for the year ended December 31, 2000. During 1999 the Company
increased its provision for losses on accounts receivable in response to deterioration in
the aging of the accounts receivable. An equivalent increase was not necessary in 2000.

On a same store basis, net interest
increased 33.3% from $6.6 million for the year ended December 31, 1999 to $8.8 million for
the year ended December 31, 2000. The increase was primarily due to interest charges
incurred related to the late filing of certain Medicare cost reports.

Rehabilitation and Respiratory Therapy Services

The Company's rehabilitation therapy
services division experienced a high level of management turnover in late 2000.
Historically, the disruption of management can negatively affect the stability of
maintaining existing contracts as well as obtaining additional contracts. In November 2000
a new management team was put in place within the rehabilitation therapy services division
and the structure and management of the sales team were overhauled. New models for
facility revenue proformas, pricing strategies and floor pricing were established.

Net revenues from rehabilitation and
respiratory therapy services decreased 12.7% from $234.1 million for the year ended
December 31, 1999 to $204.4 million for the year ended December 31, 2000. Revenues from
services provided to affiliated facilities decreased from $126.9 million for the year
ended December 31, 1999 to $113.3 million for the year ended

44

---

December 31, 2000, a decrease of 10.7%. Revenues from
services provided to nonaffiliated facilities decreased approximately $16.1 million, or
15.0%, from $107.2 million for the year ended December 31, 1999 to $91.1 million for the
year ended December 31, 2000. These decreases are a result of the industry's transition to
PPS. PPS resulted in a reduction of therapy provided (volume) and downward pressure on
market rates as contract therapy companies lowered prices in an effort to remain
competitive with other methods of therapy provision. Specifically, many facilities moved
away from the use of contract therapy companies in favor of "in-house"
rehabilitation and respiratory models in an effort to better control costs under a fixed
reimbursement system. This was especially existent within respiratory therapy as this
service was not covered under the ancillary component of the new PPS rate structure. The
decline in net revenues has continued, with a significant reduction in contracts from 1999
to 2000. Specifically, there were 1,153 affiliated and nonaffiliated contracts as of
December 31, 1999 compared to 942 affiliated and nonaffiliated contracts as of December
31, 2000. During 2000, the Company terminated certain nonaffiliated contracts based on
issues related to customers' credit worthiness and contract profitability. In addition,
certain nonaffiliated contracts were terminated in the ordinary course of business. The
Company's divestitures of inpatient facilities in 1999 and 2000 also contributed to the
decrease in affiliated revenues.

Operating expenses decreased $54.3
million, or 25.4%, from $214.1 million for the year ended December 31, 1999 to $159.8
million for the year ended December 31, 2000. The decrease resulted primarily from the
decline in the demand for the Company's therapy services resulting in a reduction in the
number of therapists employed by the Company's therapy services subsidiary. Operating
expenses as a percentage of net revenues decreased from 91.5% for the year ended December
31, 1999 to 78.2% for the year ended December 31, 2000. This decrease was attributable to
reductions in cost structure. The Company's rehabilitation subsidiary went through a
significant restructuring in the first quarter of 1999 which continued to dramatically
reduce its cost structure during 2000 by reducing overhead costs through the reduction of
regional offices. In addition, new operating models were put in place to improve the
productivity of the therapists. Equipment rental costs decreased approximately $11.4
million from 1999 to 2000 primarily due to the Company shutting down its therapy equipment
manufacturing operations.

Corporate general and administrative
expenses, which include regional costs related to the supervision of operations, were
approximately $4.3 million for the year ended December 31, 2000. Corporate general and
administrative expenses as a percentage of net revenues were 2.1% for the year ended
December 31, 2000. The Company did not allocate corporate general and administrative
expenses to the Rehabilitation and Respiratory Therapy Services segment during the year
ended December 31, 1999. The Company began allocating costs directly attributable to the
segment in January 2000.

Depreciation and amortization decreased
58.3% from $7.2 million for the year ended December 31, 1999, to $3.0 million for the year
ended December 31, 2000. As a percentage of net revenues, depreciation and amortization
expense decreased from 3.1% for the year ended December 31, 1999 to 1.5% for the year
ended December 31, 2000, respectively. The decrease was primarily a result of the
write-downs during 1999 of goodwill and certain other long-lived assets pursuant to SFAS
121.

Provision for losses on accounts
receivable decreased $27.4 million, or 80.4%, from $34.1 million for the year ended
December 31, 1999 to $6.7 million for the year ended December 31, 2000. As a percentage of
net revenues, provision for losses on accounts receivable decreased from 14.6% for the
year ended December 31, 1999 to 3.3% for the year ended December 31, 2000. During the
fourth quarter of 1999, the Company increased its reserves due to the impact of PPS, which
for certain nonaffiliated customers had negatively affected cash flows adversely affecting
the collectibility of amounts due the Company. An equivalent increase in reserves for year
ended December 31, 2000 was not necessary.

45

---

Pharmaceutical and Medical Supply Operations

Net revenues from pharmaceutical and medical
supply services decreased $5.6 million, or 1.8%, from $316.9 million for the year ended
December 31, 1999 to $311.3 million for the year ended December 31, 2000. Pharmaceutical
services' net revenues decreased approximately $0.1 million from $240.2 million for the
year ended December 31, 1999 to $240.1 million for the year ended December 31, 2000.
Medical supply services' net revenues from nonaffiliated parties decreased approximately
$14.4 million, or 27.5%, while net revenues from affiliated parties increased
approximately $8.9 million, or 36.5%. The Company experienced a loss in nonaffiliated
contracts when sales personnel left the Company and certain of their customers ceased
doing business with the Company. The increase in affiliated revenues was a result of an
increase in sales to the Company's Inpatient Services segment.

Operating expenses
decreased $4.1 million, or 1.4%, from $284.0 million for the year ended December 31, 1999
to $279.9 million for the year ended December 31, 2000. As a percentage of net revenues,
operating expenses increased from 89.6% for the year ended December 31, 1999 to 89.9% for
the year ended December 31, 2000. Pharmaceutical services' operating expenses increased
approximately $1.2 million, or 0.6%. The increase in the pharmaceutical services'
operating expenses was primarily attributed to increases in labor, benefit and insurance
costs along with an increase in cost of goods sold based on an increase in sales. Medical
supply services' operating expenses decreased 7.4% from $71.7 million for the year ended
December 31, 1999 to $66.4 million for the year ended December 31, 2000. The decrease in
medical supply services' cost of goods sold was a result of the decrease in sales.

Corporate general and administrative
expenses, which include regional costs related to the supervision of operations, were
approximately $5.2 million for the year ended December 31, 2000. Corporate general and
administrative expenses as a percentage of net revenues were 1.7% for the year ended
December 31, 2000. The Company did not allocate corporate general and administrative
expenses to the Pharmaceutical and Medical Supply Services segment during the year ended
December 31, 1999. The Company began allocating costs directly attributable to the segment
in January 2000.

Depreciation and amortization decreased
16.9% from $8.3 million for the year ended December 31, 1999 to $6.9 million for the year
ended December 31, 2000. As a percentage of net revenues, depreciation and amortization
expense was approximately 2.6% and 2.2% for the years ended December 31, 1999 and 2000,
respectively. The decrease was primarily a result of the write-downs of certain long-lived
assets during 1999 in accordance with SFAS 121.

Provision for losses on accounts
receivable decreased 78.6% from $28.5 million for the year ended December 31, 1999 to $6.1
million for the year ended December 31, 2000. As a percentage of net revenues, the
provision for losses on accounts receivable decreased from 9.0% for the year ended
December 31, 1999 to 2.0% for the year ended December 31, 2000. During 1999, the Company
increased its reserves due to a deterioration in the aging of certain accounts receivable.
An equivalent increase was not necessary in 2000.

International Operations

Revenues from international operations
decreased $31.4 million from $296.9 million for the year ended December 31, 1999 to $265.5
million for the year ended December 31, 2000. The decrease was primarily due to the fact
that the Australian subsidiaries were placed in receivorship during the third quarter of
2000 and no revenue was recorded subsequently. Additionally, 18 pharmacies operating in
the

46

---

United Kingdom were divested in June 2000 and the operating division in
Spain was sold in October 2000.

Operating expenses which include rent
expense of $41.1 million and $40.5 million for the years ended December 31, 1999 and
December 31, 2000, respectively, decreased approximately 9.8% from $275.9 million for the
year ended December 31, 1999 to $248.8 million for the year ended December 31, 2000. This
decrease was a result of the same factors which led to a decrease in revenue as discussed
above. As a percentage of revenues, operating expenses increased from 92.9% for the year
ended December 31, 1999 to 93.7% for the year ended December 31, 2000.

Corporate general and administrative
expenses were $14.4 million and $13.0 million for the years ended December 31, 1999 and
December 31, 2000, respectively. As a percentage of revenues, corporate, general and
administrative expenses were 4.9% for the years ended December 31, 1999 and 2000.

Depreciation and amortization for
international operations was $12.8 million and $2.5 million for the year ended December
31, 1999 and 2000, respectively. In accordance with SFAS 121, depreciation and
amortization were no longer recognized after operations were placed for sale. Therefore,
depreciation and amortization was significantly reduced in 2000.

Net interest expense was $13.2 million
for the year ended December 31, 1999 and $13.0 million for the year ended December 31,
2000. Net interest expense as a percentage of revenues increased from 4.4% for the year
ended December 31, 1999 to 4.9% for the year ended December 31, 2000.

Other Non-reportable Segments and Corporate General Administrative Departments

Non-reportable segments include temporary
therapy and nursing staffing, home health, assisted living, software development and other
ancillary services. Revenues from other non-reportable segments decreased 13.3% from
$199.3 million for the year ended December 31, 1999, to $172.8 million for the year ended
December 31, 2000. Operating expenses decreased 23.2% from $208.9 million for the year
ended December 31, 1999, to $160.4 million for the year ended December 31, 2000. Operating
expenses as a percentage of revenues were 104.8% and 92.8% for the years ended December
31, 1999 and 2000, respectively. Total revenues and operating expenses for non-reportable
segments represent less than 10% of the consolidated Company's results. The decrease in
revenues and operating expenses was primarily a result of the sale of 20 assisted living
facilities during 2000. Additionally, the hospice operations were divested during the
fourth quarter of 1999. Operating results were also negatively impacted by expenses
related to software development costs incurred by the Company's majority owned subsidiary,
Shared Healthcare Systems, Inc. These costs were being expensed in accordance with
Statement of Financial Accounting Standards No. 86: Accounting for Costs of Computer
Software to be Sold, Leased or Otherwise Marketed. Development of the Company's software
products were not expected to reach the stage under which capitalization is permitted
until sometime in 2002.

Corporate general and administrative
costs not directly attributed to segments decreased 22.0% from $116.5 million for the year
ended December 31, 1999, to $90.9 million for the year ended December 31, 2000. As a
percentage of consolidated net revenues of $2,529.0 million and $2,458.9 million for the
years ended December 31, 1999 and 2000, respectively, corporate general and administrative
expenses not directly attributed to segments decreased from 4.6% in 1999 to 3.7% in 2000.

Net interest expense not directly
attributed to segments decreased 90.0% from $105.5 million for the year ended December 31,
1999 to $10.5 million for the year ended December 31, 2000. As a percentage of
consolidated net revenues, interest expense decreased from 4.2% for the year ended
December 31,

47

---

1999 to 0.4% for the year ended December 31, 2000. Sun
discontinued charging Mediplex for interest during 2000 due to the Company's chapter 11
filing.

Dividends on Convertible Preferred Stock

In May 1998, a statutory business trust,
all of whose common securities are owned by the Company, issued $345.0 million of 7.0%
CTIPS with a liquidation amount of $25.00 per CTIP. Each CTIP is convertible into 1.2419
shares of the Company's common stock (equivalent to a conversion price of $20.13 per
share). CTIPS holders were entitled to receive cumulative cash distributions at an annual
rate of 7.0%, payable quarterly. During 2000, approximately $26.9 million of CTIPS were
converted into approximately 1.3 million shares of common stock. During 1999, $22.0
million of CTIPS were converted into approximately 1.1 million shares of common stock. See
"Note 14 - Convertible Trust Issued Preferred Securities" in the Company's
consolidated financial statements.

Other Special and Non-Recurring Charges

Financial Restructuring

During 1999, the Company recorded
financial restructuring costs of $16.0 million, primarily professional fees, related to
the Company's activities in preparation for its filing for protection under chapter 11 of
the U. S. Bankruptcy Code. During 2000, the Company reversed a non-cash reserve of $1.1
million previously recorded in restructuring costs during 1999.

Impairment of Goodwill and Other Long-Lived Assets

The Company periodically evaluates the
carrying value of goodwill and any other related long-lived assets in relation to the
future projected cash flows of the underlying business segments. The assets are considered
to be impaired when the expected future cash flows of the inpatient facilities or other
business segment divisions do not exceed the carrying balances of the goodwill or other
long-lived assets.

During 2000, the Company recorded a
non-cash impairment charge of approximately $191.3 million related to the Company's
estimate of goodwill and other long-lived assets. This charge included approximately
$189.3 million related to 141 of its inpatient facilities segment and $2.0 million to its
pharmaceutical and other operations segments.

During 2001, the Company recorded a
non-cash impairment charge of approximately $18.8 million related to the Company's
estimate of goodwill and other long-lived assets.  This charge included approximately
$14.5 million to its inpatient facilities segment and $4.3 million related to the
Company's software development business.

Other Long-Lived Assets

Gain on Sale of Assets

During the year ended December 31, 2000,
the Company recorded gains on the sale of assets of approximately $25.1 million.
Approximately $21.4 million and $3.7 million is recorded in gain on sale of assets and
reorganization costs, net, respectively in the Company's consolidated statements of
losses. See "Note 2 - Emergence from Chapter 11 Bankruptcy Proceedings" and
"Note 7 - Impairment of Long-Lived Assets and Assets Held for Sale" in the
Company's consolidated financial statements.

Loss on Sale of Assets

During 1999, the Company recorded a net
non-cash charge of approximately $85.7 million due to the anticipated and/or completed
termination of certain facility lease agreements and to further reduce the carrying amount
of certain assets that the Company determined were not integral to its core business

48

---

operations. See "Note 7 - Impairment of Long-Lived Assets and
Assets Held for Sale" in the Company's consolidated financial statements.

During 2000, a net non-cash charge of
approximately $310.1 million was recorded to reduce the carrying amount of the medical
supply operations and certain domestic inpatient facilities which are classified as assets
held for sale in the Company's consolidated balance sheets. Additionally, a charge of
$26.6 million was recorded to reduce the carrying amount of the corporate headquarters
building. The building is classified as an asset held for sale at December 31, 2001. The
charges were recorded in reorganization costs, net, in the Company's consolidated
statements of losses. See "Note 7 - Impairment of Long-Lived Assets and Assets Held
for Sale".

Legal and Regulatory



Reorganization Costs

The Company recorded net reorganization
costs of $48.1 million and $335.9 million for the years ended December 31, 1999 and 2000,
respectively. See "Note 2 - Emergence from Chapter 11 Bankruptcy Proceedings" in
the Company's consolidated financial statements.

Consolidated Results of Operations

The net loss for the year ended December
31, 1999 was $1,089.5 million compared to a net loss of $545.7 million for the year ended
December 31, 2000. The loss before considering impairment loss, gain or loss on sale of
assets, net, reorganization costs, net, restructuring costs, loss on termination of
interest rate swaps, cumulative effect of change in accounting principle and income taxes
was $462.4 million for the year ended December 31, 1999 compared to a loss of $40.8
million for the year ended December 31, 2000. The net loss during the years ended December
31, 1999 and 2000 was primarily due to the implementation of PPS and the continuing
adverse impact on the demand for the Company's ancillary services.

In accordance with SOP 90-7, no interest
was paid or accrued on prepetition debt, classified as liabilities subject to compromise
in the Company's consolidated balance sheets and the CTIPS since the Filing Date.
Contractual interest expense not paid or accrued was $30.5 million and $146.4 million for
the years ended December 31, 1999 and December 31, 2000, respectively.

Income tax expense for the year ended
December 31, 1999 and for the year ended December 31, 2000 was $0.2 million and $0.3
million, respectively. For the year ended December 31, 1999, the Company increased its
valuation allowance for the deferred tax assets resulting from its net operating losses
which may not be realizable, depending upon whether the Company generates future taxable
income.

49

---

Liquidity and Capital Resources

New Loan Agreements. On February 28,
2002, the Company entered into (i) a Loan and Security Agreement with certain lenders, led
by Heller Healthcare Finance, Inc. as collateral agent, and Citicorp USA, Inc., as
administrative agent (the "Revolving Loan Agreement") and (ii) a Term Loan and
Note Purchase Agreement with certain lenders, led by U.S. Bank National Association as
administrative and collateral agent (the "Term Loan Agreement"), and together
with the Revolving Loan Agreement, (the "Loan Agreements"). The Revolving Loan
Agreement is a $150.0 million three-year revolving line of credit that is secured by the
Company's accounts receivable, inventory, equipment and other assets, a first priority
pledge of the stock of the Company's subsidiaries other than those subsidiaries providing
pharmaceutical services, and a second priority pledge of the stock of the Company's
pharmaceutical services subsidiaries. The Company's borrowing availability under the
Revolving Loan Agreement is limited to up to 85% of the Company's net eligible accounts
receivable and up to 50% of the Company's net eligible inventory, but not to exceed $150.0
million. Under the Revolving Loan Agreement, dependingupon the type of loan made and
provided that an event of default has not occurred, the Company will pay interest at
either (i) prime (or, if higher, the  federal funds rate plus 0.50%) plus 2.75%
(subject to certain adjustments) or (ii) the London Interbank Offered Rate plus 3.75%
(subject to certain adjustments).

The Term Loan Agreement is comprised of a
three-year $20.0 million term loan (the "Term Loan") and a three-year $23.7
million original issue discount note (the "Discount Note" and together with the
Term Loan, the "Term Debt"). The Term Debt is secured primarily by a first
priority pledge of the stock of the Company's subsidiaries that provide pharmaceutical
services and a second priority security interest in substantially all of the Company's
other assets. Under the Discount Note, the Company's borrowing availability is
approximately $20.0 million. Provided that an event of Default has not occurred, interest
accrues on the Term Loan at the greater of (i) prime (or, if higher, the federal funds
rate plus 0.50%) plus 4.00% and (ii) 9.00%. The Company will pay interest on the Discount
Note for base rate borrowings at a rate of interest equal to the greater of (i) prime (or,
if higher, the federal funds rate plus 0.50%) and (ii) 2.65% and for Eurodollar borrowings
a rate of interest equal to the Adjusted Eurodollar Rate (as defined in the Term Loan
Agreement) plus 0.50%.

As of March 1, 2002, the Company's gross
borrowing availability under the Loan Agreements was approximately $111.0 million. As of
March 1, 2002, the Company had borrowed approximately $66.8 million and had issued
approximately $44.3 million in letters of credit under the Loan Agreements, leaving a net
amount of approximately $39.9 million for additional borrowing. In addition to the
available funds under the Loan Agreements, the Company had cash and cash equivalents book
balances at March 1, 2002 of approximately $73.6 million. The combination of the Company's
cash balances and available borrowing capacity was $113.5 million and $54.6 million as of
March 1, 2002 and December 31, 2001, respectively.

In February 2002, the Company developed a
restructuring plan to reduce overhead expenses across all businesses during 2002. The
Company estimates annual savings of approximately $25.0 million as a result of the
restructuring primarily related to salaries and benefits, although the savings could be
less than anticipated. The Company recorded approximately $5.1 million as a restructuring
reserve primarily for severance benefits under a severance program that the Company has
implemented in conjunction with the plan. This is a "forward looking statement"
within the meaning of the Private Securities Litigation Reform Act of 1995 and is subject
to a number of factors, including but not limited to the Company's ability to operate its
business consistent with the plan and other factors set forth in "Item 1 - Business -
Certain Additional Business Risks."

50

---

The Company's revenues will be adversely
affected if enactments providing for additional funding expire as currently scheduled. A
number of provisions of the BBRA and BIPA enactments providing additional funding for
Medicare participating skilled nursing facilities expire on September 30, 2002. In
addition, President Bush's fiscal year 2003 budget proposal assumes that CMS will refine
the per diem system by October 2002 in order to reduce Medicare payments to skilled
nursing facilities. For a discussion regarding the effects of the expiration of the
enactment and the proposed 2003 budget, see "Item 1 - Business - Certain Additional
Business Risks - The Company's Medicare reimbursements may materially and adversely
decline after September 30, 2002."

The Company believes that it will have
sufficient liquidity to meet its operational needs for the next 12 months assuming that
(i) the Company maintains its ability to borrow under its Loan Agreements, (ii) the
Company achieves its 2002 budgeted results of operations, (iii) the Company does not
experience any material and adverse decrease in its results of operations and (iv)
Medicare and Medicaid reimbursement rates do not decrease. This is a "forward-looking
statement" within the meaning of the Private Securities Litigation Reform Act of 1995
and is subject to a number of factors, including, but not limited to, the Company's
ability to divest unprofitable facilities, operate its business consistent with plan,
comply with the covenants of the Credit Agreement, and other risks described elsewhere.
See "Item 1 - Business - Certain Additional Business Risks".

For the year ended December 31, 2001, net
cash provided by operating activities was approximately $24.4 million compared to net cash
used for operating activities for the year ended December 31, 2000 of approximately $1.7
million. The increase in net cash provided by operating activities for the year ended
December 31, 2001 was primarily from the improved collection of accounts receivable.

The Company incurred approximately $30.3
million, $55.4 million and $102.5 million in capital expenditures during the years ended
December 31, 2001, 2000 and 1999, respectively The significant decreases were primarily
due to divestitures during 1999 and 2000. In 2001, expenditures related primarily to
improvements at existing facilities and routine capital expenditures. The Company had
construction commitments of approximately $0.7 million as of December 31, 2001 under
various contracts to improve existing facilities. The decrease from 2000 to 2001 was
primarily related to the Company reaching a stage of construction completion for the
corporate headquarters.

The Company recorded net reorganization
costs of $42.9 million for the year ended December 31, 2001. Included in these charges at
December 31, 2001 are approximately $15.3 million for loss on sale of assets related to
the divestiture of under-performing assets and approximately $25.8 million for
professional fees relating to the legal consideration of the bankruptcy filing. See
"Note 2 - Emergence from Chapter 11 Bankruptcy Proceedings" in the Company's
consolidated financial statements.

In January 2000, the Company established
a self-funded insurance program for general and professional liability claims up to a base
amount of $1.0 million per claim, and $3.0 million aggregate per location, and obtained
excess insurance coverage for exposure above these levels. The Company's insurance
carriers declined to renew the Company's general and professional liability insurance
policies that expired on December 31, 1999. Several major insurance companies no longer
provide this type of coverage to long-term care providers due to general underwriting
issues with the long-term care industry. Prior to January 2000, the Company's insurance
companies paid substantially more to third parties under its policies than the Company
paid in insurance premiums and deductibles. There can be no assurance that this
self-funded insurance program and any excess insurance coverage will be sufficient to fund
any future judgements or settlement resulting from litigation against the Company.  
The provision recorded in the Company's statements of losses for the years ended December
31, 2001, 2000 and 1999 were approximately $58.1 million, $35.3 million and $23.9 million,
respectively. During 2000, the Company

51

---

pre-funded $22.2 million for general and professional liability claims
into a cash collateral trust account held by the Company's insurance carrier.  The
Company funded an additional $5.0 million into the trust account in 2001.  The
combined pre-funding will be used to pay claims for policy years 2000 through 2002. 
Claims paid from the trust account were immaterial in 2000 and were $5.8 million for the
year ended December 31, 2001.

For the year ended December 31, 1999, the
workers' compensation insurance was a guaranteed cost program, and thus, after payment of
the premium, risk was fully transferred to the third party insurance carrier. Subsequent
to December 31, 1999, the Company purchased workers' compensation insurance for all
states, except Washington, Ohio, and West Virginia where the Company is required to
subscribe to those state and/or self-insured programs. The 2001 and 2000 policies provide
coverage above $250,000 per claim. An acturial analysis prepared in the current year
determined the undiscounted expected losses and costs under this retention level to be
approximately $35.5 million as of December 31, 2001 and $36.0 million as of December 31,
2000. The Company has pre-funded cash collateral trust accounts with its insurance carrier
in the amount of $26.8 million and $32.4 million as of December 31, 2001 for the 2001 and
2000 policy years, respectively. Claims paid from the 2001 policy year trust account were
$4.7 million, and claims paid from the 2000 policy year trust account were $12.5 million
and $5.7 million as of December 31, 2001 and 2000, respectively. The accounts were
established to fund the Company's ultimate estimated exposure and will be adjusted
retrospectively based on revisions to the estimates. For years prior to 1998 in which the
Company carried various forms of workers' compensation insurance, aggregate losses are
provided on a fully developed basis, including any incurred but not reported claims. The
reserve for such workers' compensation risks was approximately $29.5 million and $14.2
million as of December 31, 2001 and 2000, respectively. Provisions for such risks totaled
approximately $54.9 million, $27.4 million and $30.9 million for the years ended December
31, 2001, 2000 and 1999, respectively, and were included in operating expenses and
corporate general and administrative expenses.

On June 30, 1998, a wholly owned
subsidiary of the Company merged with Retirement Care Associates, Inc. ("RCA"),
an operator of skilled nursing and assisted living facilities in eight states principally
in the southeastern United States (the "RCA Merger"). In connection with the RCA
Merger, the Company recorded purchase liabilities including $24.7 million for severance
and related costs and $1.4 million for costs associated with the shutdown of certain
administrative facilities. As of December 31, 2001 and December 31, 2000, the Company's
purchase liabilities reserve balance was approximately $7.0 million and $12.0 million,
respectively.

Effects of Inflation

Healthcare costs have been rising and are
expected to continue to rise at a rate higher than that anticipated for consumer goods as
a whole. The Company's operations could be adversely affected if it experiences
significant delays in receiving reimbursement rate increases from Medicaid and Medicare
sources for its labor and other costs.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

The Company's long-term debt that was
outstanding as of December 31, 2001 was generally either canceled as part of its Plan of
Reorganization or paid off on February 28, 2002. The Company's Revolving Loan Agreement
and Term Loan Agreement entered into on February 28, 2002, are sensitive to changes in
interest rates.

The Revolving Loan Agreement is a $150.0
million three-year revolving line of credit. The Company's borrowing availability under
the Revolving Loan Agreement is limited to up to 85% of the

52

---

Company's net eligible accounts receivable and up to 50% of the
Company's net eligible inventory, but not to exceed $150 million. Under the Revolving Loan
Agreement, depending upon the type of loan made and provided that an event of default has
not occurred, the Company will pay interest at either (i) prime (or, if higher, the
federal funds rate plus 0.50%) plus 2.75% (subject to certain adjustments) or (ii) the
London Interbank Offered Rate plus 3.75% (subject to certain adjustments). For each
additional percentage point increase in the LIBOR, assuming an outstanding balance of
$100.0 million, the Company will incur additional interest expense of approximately $1.0
million annually.

The Term Loan Agreement is comprised of a
three-year $20.0 million term loan (the "Term Loan") and a three-year $23.7
million original issue discount note (the "Discount Note") and together with the
Term Loan, the "Term Debt"). Under the Discount Note, the Company's borrowing
availability is approximately $20.0 million.

Item 8. Financial Statements and Supplementary Data

Information with respect to Item 8 is
contained in the Company's consolidated financial statements and financial statement
schedules and are set forth herein beginning on Page F-1.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure

None.

53

---

PART III

Item 10. Directors and Executive Officers of the Registrant

The directors and executive officers of Sun as of March 1, 2002 were:



|Name                   | Position with Sun                                       
|---------------------- | --------------------------------------------------------
|                       |                                                         
|Richard K. Matros      | Chairman of the Board and
    Chief Executive Officer   
|Kevin W. Pendergest    | Executive Vice President
    and Chief Financial Officer
|Wallace E. Boston, Jr. | Principal Financial Officer                             
|William A. Mathies     | President of SunBridge
    Healthcare Corporation       
|Warren C. Schelling    | Senior Vice President of
    Ancillary Services         
|Heidi J. Fisher        | Senior Vice President of
    Human Resources            
|Robert F. Murphy       | General Counsel and
    Secretary                       
|Chauncey J. Hunker     | Corporate Compliance
    Officer                        
|Robert K. Schneider    | Vice President and
    Treasurer                        
|Jennifer L. Botter     | Vice President and
    Corporate Controller             
|John W. Adams          | Director                                                
|Gregory S. Anderson    | Director                                                
|Charles W. McQueary    | Director                                                
|John F. Nickoll        | Director                                                
|Sanjay H. Patel        | Director                                                
|Bruce C. Vladeck       | Director                                                
|Steven L. Volla        | Director                                                
|Milton J. Walters      | Director                                                

Richard K. Matros, age 48, has been the
Chairman of the Board and Chief Executive Officer of the Company since November 2001. Mr.
Matros served as Chief Executive Officer and President of Bright Now! Dental from 1998 to
2000. He served Regency Health Services, Inc., a publicly held long-term care operator, as
Chief Executive Officer from 1995 to 1997, as President and a director from 1994 to 1997,
and as Chief Operating Officer from 1994 to 1995. He served Care Enterprises, Inc. as
Chief Executive Officer during 1994, as President, Chief Operating Officer and a director
from 1991 to 1994, and as Executive Vice President - Operations from 1988 to 1991. Mr.
Matros currently serves on the board of directors of Bright Now! Dental, Care Meridian
LLC, Geriatrix and Protocare, Inc.

Kevin W. Pendergest, age 48, has been an
Executive Vice President and the Chief Financial Officer of the Company since March 1,
2002. Mr. Pendergest was the President and owner of Strategic Alliance Network, a
healthcare services advisory firm, from 1995 to February 2002. From 1990 to 1995 he was
Executive Vice President and Chief Financial Officer of GranCare, Inc., a publicly held
long-term care company. From 1981 to 1989, Mr. Pendergest held various positions with
Deloitte Haskins & Sells, most recently as Partner in Charge of Healthcare Consulting
for the Western Region of the United States.

Wallace E. Boston, Jr., age 47, has been
the Principal Financial Officer of the Company since March 1, 2002. Mr. Boston was
the Chief Financial Officer of the Company from August 2001 until March 2002. Mr. Boston
served Neighborcare Pharmacies, an institutional pharmacy company, as President and Chief
Executive Officer from 1999 to 2001 and as Executive Vice President and Chief Operating
Officer from 1998 to 1999. He served Manor Care Health Services, Inc., a long-term care
company, as Senior Vice President-Acquisitions & Development from 1996 to 1998 and as
Vice

54

---

President-Finance from 1993 to 1996. Mr. Boston previously served as
Vice President and Chief Financial Officer of Meridian Healthcare, Inc. from 1985 to 1992,
as Senior Vice President and Chief Financial Officer of National Realty Services from 1983
to 1985, and with Price Waterhouse Management Advisory Services from 1978 to 1983, most
recently as Manager.

William A. Mathies, age 42, has been
President of SunBridge Healthcare Corporation, an inpatient services subsidiary of the
Company, since March 1, 2002. From 1995 to March 2002, Mr. Mathies served as Executive
Vice President of Beverly Enterprises, Inc., a long-term care company. Most recently, he
was the Executive Vice President of Innovation/Services for Beverly. He previously served
Beverly as President of Beverly's Health and Rehabilitation Services, (the LTC subsidiary
of Beverly) from 1995 to 2000, Vice President of Operations for California from 1988 to
1995, as a Regional Manager from 1986 to 1988 and as a facility administrator from 1981 to
1986.

Warren C. Schelling, age 48, has been
Senior Vice President of Ancillary Services of the Company since 2000. Mr. Schelling
previously served the Company as President and Chief Operating Officer of its
international operations from 1999 to 2001, as Senior Vice President for its
pharmaceuticals division from 1996 to 1999, on the Board of Directors from 1996 to 1998
and as President of SunScript Pharmacy Corporation from 1994 to 1996. Mr. Schelling was
the President and Chief Operating Officer of HPI Health Care Services, Inc., which
provided pharmacy management services, from 1993 to 1994. During 1994, Mr. Schelling also
served as the Executive Vice President/Pharmacy Services Officer at Diagnostek, Inc. From
1985 to 1993, Mr. Schelling was a manager at HPI Health Care Services, Inc. Mr. Schelling
was an executive officer of the Company when it commenced its chapter 11 bankruptcy
proceeding in October 1999.

Heidi J. Fisher, age 45, has been Senior
Vice President of Human Resources of the Company since February 2002. From 1998 to 2002,
Ms. Fisher was Vice President Human Resources of Bright Now! Dental, a dental practice
management company. From 1997 to 1998, she was Corporate director of Human Resources at
Covenant Care, Inc., a long-term care company. From 1994 to 1997, Ms. Fisher was with
Regency Health Services, Inc., a long-term care company, most recently with the title
Senior Director of Human Resources. From 1987 to 1994, Ms. Fisher was Senior Manager of
Human Resources with Volt Delta Resources, Inc.

Robert F. Murphy, age 48, has been
General Counsel of the Company since 1995 and Secretary of the Company since 1996. From
1986 to 1995 Mr. Murphy served in several capacities as an officer and legal counsel
to FHP International Corporation, including most recently as Vice President and Associate
General Counsel. Prior to 1986, Mr. Murphy was in private practice. Mr. Murphy was an
executive officer of the Company when it commenced its chapter 11 bankruptcy proceeding in
October 1999.

Chauncey J. Hunker, Ph.D., age 51, has
been Corporate Compliance Officer of the Company since 2000. From 1996 to 2000, Dr. Hunker
served as Vice President of Continuous Quality Improvement of SunDance Rehabilitation
Corporation, the Company's rehabilitation therapy subsidiary ("SunDance"). From
1995 to 1996, he was a Clinical Director of SunDance, and from 1992 to 1995 he was
Regional Vice President of Learning Services - Midwestern Regional Facility in Madison,
Wisconsin. Dr. Hunker has also served as Adjunct Assistant Professor, Department of
Neurology, at the University of Wisconsin Medical School since 1989.

Robert K. Schneider, age 54, has been a
Vice President and the Treasurer of the Company since July 2001. Mr. Schneider provided
investment banking consulting services from 1996 to 2001. He was Treasurer of the
Hillhaven Corporation and Vencor, Inc. (after Vencor's acquisition of Hillhaven) from

55

---

1990 to 1996. Mr. Schneider was a Vice President and Manager of Seattle
First National Bank from 1974 to 1990.

Jennifer L. Botter, age 39, has been Vice
President and Corporate Controller of the Company since 2000. From 1998 to 1999, Ms.
Botter held various positions within the Company. From 1996 to 1998, she was Director of
Finance for Fulcrum Direct, Inc., a manufacturer and cataloguer of children's apparel.
From 1984 to 1996 she held financial consulting and accounting positions in the high
technology and manufacturing industries.

John W. Adams, age 58, has served as a
Director of the Company since February 28, 2002. Mr. Adams has served as President of
Smith Management, LLC, a private investment firm, since 1984. From 1972 to 1983 he was a
partner at the law firm of Dillon, Bitar & Luther. Mr. Adams currently serves as
Chairman of the Board of Hawaiian Airlines, a publicly held airline.

Gregory S. Anderson, age 45, has served
as a Director of the Company since November 2001. Mr. Anderson has served as the President
and Chief Executive Officer of Quality Care Solutions, Inc. ("QCSI"), a publicly
held provider of software and services for the healthcare industry, since 1998. Prior to
1998 Mr. Anderson was in the venture capital business. From 1993 to 1998 he was President
of Anderson & Wells Co., the venture capital manager of Sundance Venture Partners and
El Dorado Investment Co. Mr. Anderson currently serves on the board of directors of QCSI,
American OBGYN, Inc., Glendora Hospital and Valley Commerce Bank.

Charles W. McQueary, age 49, has served
as a Director of the Company since February 28, 2002. Mr. McQueary served ProMedCo, Inc.,
a national medical practice management company, as Chief Executive Officer from February
2001 to December 2001 and as Senior Vice President - Operations from May 1997 to February
2001. Mr. McQueary previously served as Regional Vice President of Med Partners, Inc. from
1995 to 1997 and as Chief Operating Officer and Chief Financial Officer of Asthma &
Allergy CareAmerica, Inc. from 1993 to 1995. Prior to that, he held offices with other
health care companies and various positions with independent accounting firms.

John F. Nickoll, age 67, has served as a
Director of the Company since February 28, 2002. Mr. Nickoll has served as President,
Chairman and Chief Executive Officer of the Foothill Group, Inc., a subsidiary of Wells
Fargo, since 1970. Mr. Nickoll is also Managing General Partner of Foothill Partners,
L.P., Foothill Partners II, L.P., Foothill Partners III, L.P. and Foothill Income Trust
II, L.P., each of which invest in senior bank debt and other types of debt issues. Mr.
Nickoll currently serves as a director of the Foothill Group, Inc. and CIM High Yield
Securities, a closed end high yield bond fund.

Sanjay H. Patel, age 41, has served as a
Director of the Company since February 28, 2002. Mr. Patel has served as Co-President of
GSC Partners, a private equity firm, since 1998. Mr. Patel served Goldman, Sachs & Co.
as Managing Director in the Principal Investment Area from 1992 to 1998, in the Leveraged
Buyout Department from 1987 to 1992 and in the Mergers and Acquisitions Department from
1983 to 1985. Mr. Patel currently serves on the Board of Directors of Project Time &
Cost, Inc., ETEC Ventures, Ltd. (Mauritus), ForcesGroup, Ltd., Waddington North America,
Inc., Tracmail (Bermuda) Ltd., Atlantic Express Transportation Group and GSCP Recovery,
Inc.

Bruce C. Vladeck, Ph.D., age 52, has
served as a Director of the Company since November 2001. Dr. Vladeck has served as Senior
Vice President for Policy for Mount Sinai NYU Health, Director of the Institute for
Medicare Practice and Professor of Health Policy and Geriatrics at the Mount Sinai School
of Medicine since 1998. From 1993 to 1997 Dr. Vladeck was Administrator of the Health Care
Financing

56

---

Administration (HCFA)
of the U.S. Department of Health and Human Services. From 1983 to 1993, Dr. Vladeck served
as President of United Hospital Fund of New York. Dr. Vladeck currently serves on the
board of directors of Senior Health Partners, a managed long-term care program, and as a
Trustee of Ascension Health, the March of Dimes Birth Defects Foundation and the Medicare
Rights Center.

Steven L. Volla, age 55, has been a
director of the Company since November 2001. Mr. Volla has served as President of Health
Equities Management, Inc., an investor in and advisor to healthcare companies, since 1994.
He served as Chairman of Primary Health Systems, Inc., an acute care hospital management
company, from 1994 to 2001. He served as President, Chief Executive Officer and Chairman
of the Board of American Healthcare Management, Inc., a publicly held hospital management
company, from 1989 to 1994. He has also served Universal Health Services, Inc. as Senior
Vice President - Operations and UHS Hospital Company as President. Mr. Volla currently
serves on the board of directors of Pathmark Stores, Inc., a publicly held operator of
supermarkets; Brown Schools, Inc., a privately held education company; and Specialty
Hospital of America, a privately held long-term acute care hospital management company.

Milton J. Walters, age 59, has been a
director of the Company since November 2001. Mr. Walters has served with investment
banking companies for over 30 years, including: Tri-River Capital since 1999 and from 1988
to 1997, as President; Prudential Securities from 1997 to 1999, most recently as Managing
Director; Smith Barney from 1984 to 1988, most recently as Senior Vice President and
Managing Director; Warburg Paribas Becker from 1965 to 1984, most recently as Managing
Director. He currently serves on the Board of Directors of Quest Products Corporation, a
publicly held marketing company, and as Chairman of MDHIO, Inc. Marketing, a privately
held marketer of golf contests.

Pursuant to the Company's Joint Plan of
Reorganization, the Company's Board of Directors consists of nine members. The holders of
the senior lender claims selected eight of the members: Messrs. Adams, Anderson, McQueary,
Nickoll, Patel, Vladeck, Volla and Walters to serve on the Board for a one-year term. The
Plan provides that the ninth member is the Company's Chief Executive Officer, Mr. Matros.
After the initial year, the holders of Sun's common stock will elect new members to the
Board.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Exchange Act
and the rules promulgated thereunder require the Company's directors and executive
officers and persons who own more than ten percent of the Company's Common Stock to report
their ownership and changes in their ownership of Common Stock to the Securities and
Exchange Commission (the "Commission"). Copies of the reports must also be
furnished to the Company. Specific due dates for the reports have been established by the
Commission and the Company is required to report any failure of its directors, executive
officers and more than ten percent stockholders to file by these dates.

Based solely on a review of the copies of
such forms received by it, or written representations from certain reporting persons, the
Company believes that during 2001 all Section 16(a) filing requirements applicable to
its directors, executive officers and greater than ten percent beneficial owners were met.

57

---

Item 11. Executive Compensation

Summary Compensation Table

The following table provides information
concerning employment compensation for services to the Company and its subsidiaries for
the fiscal years shown for those persons (the "Named Executive Officers") who
were, during the year ended December 31, 2001, (i) the individuals who served as
chief executive officer, (ii) the other four most highly compensated executive
officers of the Company and (iii) a former officer who would have been one of the most
highly compensated officers but who was not with the Company on December 31, 2001.

Name andPrincipal Position
    Year
    Annual
    Compensation             
             Salary                      Bonus
    Long-Term
    CompensationAwardsSecurities
    UnderlyingOptions (#)
    All OtherCompensationRichard K. Matros (1)
      Chairman of the Board
      and Chief Executive
      Officer
    2001
    2000
    1999
    $       85,000
    -
    -
    $                  -
    -
    -
    -     
      
    -        
    -
    $                -
    -
    -Warren C. Schelling  Senior Vice  President Ancillary  Services
    2001
    2000
    1999
    340,808
    320,008
    320,008
    200,000
    150,000
    -
    -   
        
    -        
    13,600   (2)
    1,082
    780
    1,587
    (3)Robert F.
    Murphy  General Counsel andSecretary
    2001
    2000
    1999
    313,905
    285,012
    285,012
    113,359
    -
    -
    -
           
    -        
    11,200   (2)
    1,187
    1,097
    2,458
    (4)Chauncey J. Hunker
      Corporate Compliance
      Officer
    2001
    2000
    1999
    234,790
    182,288133,500
    29,700
    28,100
    9,938
    -
           
    -        
    3,160   (2)
    1,774
    1,5321,390
    (5)Mark G. Wimer (6)FormerChief
      Executive Officer and  President
    2001
    2000
    1999
    691,875
    596,255
    450,008
    389,424
    -
    -
    -       
    -       
    16,960  (2)
    899,007
    2,092
    3,313
    (7)Robert D. Woltil (8)  Former Chief
      Financial Officer
    2001
    2000
    1999
    291,963
    425,022
    425,022
    169,038
    -
    -
    -
           
    -        
    14,000   (2)
    456,426
    1,797
    1,810
    (9)Jack Tindal
      Chief Administrative
      Officer
    2001
    2000
    1999
    183,343
    206,373154,508
    78,179
    -
    -
    -
           
    -        
    2,960   (2)
    1,9231,7451,550
    (10)


______________________

(1)
    Mr. Matros was appointed Chief Executive Officer of the Company on
    November 7, 2001.(2)
    Represents options issued by the Company in exchange for the
    cancellation of previously granted stock options in May 1999. The new options were later
    cancelled upon the Company's emergence from
    chapter 11 bankruptcy proceedings on February 28, 2002.(3)
    Consists
    of the value of life insurance premiums paid on his behalf by the Company.58(4)
    Consists of $744 of matching contributions under the Company's 401(k) Plan
    and the value of $443 of life insurance premiums paid on his behalf by the Company.(5)
    Consists of $1,275 of matching contributions under the Company's 401(k) Plan and the value
    of $499 of life insurance premiums paid on his behalf by the Company.(6)
    Mr. Wimer resigned from the Company on November 6, 2001.(7)
    Consists of $892,882 paid to Mr. Wimer in severance payments, $1,000 of matching
    contributions under the Company's 401(k) Plan and the value $5,125 of life insurance
    premiums paid on his behalf by the Company.(8)
    Mr. Woltil's services to the Company terminated in July 2001.(9)
    Consists of $454,750 paid to Mr. Woltil in severance payments, $1,275 of matching
    contributions under the Company's 401(k) Plan and the value $401 of life insurance
    premiums paid on his behalf by the Company.(10)
    Consists of $1,275 of matching contributions under the Company's 401(k) Plan and the value
    of $648 of life insurance premiums paid on his behalf by the Company.


Fiscal Year-End Option Values

Set forth in the table below is
information concerning the value of stock options held as of December 31, 2001 by
each of the Named Executive Officers. None of the Named Executive Officers exercised any
stock options during the year ended December 31, 2001.

Number of
    Securities
    Underlying UnexercisedOptions-at-Year-End
    (#)
    Value of
    Unexercised
    In-the-Money OptionsAt-Year-End
    ($)(1)Name
    Exercisable
    Unexercisable
    Exercisable
    UnexercisableRichard K. Matros
    -
    -
    $                   -
    $                      -Warren C. Schelling
    9,067
    4,533
    -
    -Robert F. Murphy
    7,467
    3,733
    -
    -Chauncey J. Hunker
    2,107
    1,053
    -
    -Mark G. Wimer
    -
    -
    -
    -Robert D. Woltil
    -
    -
    -
    -Jack Tindal
    1,974
    986
    -
    -


__________________

(1)  The
last reported sales price of the Common Stock, as reported on the Over-The-Counter
Bulletin
       Board at December 31, 2001 was less than the
exercise price of all stock options.

Compensation of Directors

59

---

Non-employee directors of
the Company, other than the Chairman of the Board, are entitled to receive: (i) an annual
fee of $24,000, which is payable in four equal quarterly installments, (ii) $1,750 for
each Board of Directors meeting attended in person, (iii) an additional $500 for each
subsequent meeting attended that same day, and (iv) $500 for any meetings attended by
telephone. In addition, each Chairperson of a committee of the Board of Directors is
entitled to receive an additional annual fee of $4,000, payable in four equal quarterly
installments. Each of the non-employee directors is reimbursed for out-of-pocket expenses
for attendance at Board and committee meetings.

Employment Agreement

The Company entered into an Employment
Agreement with Richard K. Matros on February 28, 2002. The agreement terminates on
November 6, 2005, although the term is automatically extended for an additional year on
November 6, 2004, and on each anniversary thereafter, unless the Company or Mr. Matros
provides notice of non-extension. Pursuant to the agreement, Mr. Matros will receive an
annual base salary of $650,000 that is subject to annual merit increases as determined by
the Board of Directors. In addition to the base salary, Mr. Matros is entitled to an
annual bonus for each fiscal year in which the Company achieves or exceeds certain
financial performance targets. If the targets are achieved, the bonus could be 50%, 75% or
100% of base salary, depending upon how much the targets are exceeded. Mr. Matros was also
awarded 150,000 shares of restricted common stock and an option to purchase 150,000 shares
of common stock on February 28, 2002. The restricted stock will vest as to 60,000 shares
on February 28, 2003 and 30,000 shares on each of February 28, 2004, 2005 and 2006.

Mr. Matros' Employment Agreement provides
that in the event of his termination of employment by the Company without Good Cause, by
Mr. Matros for Good Reason (each as defined in the Employment Agreement), or upon the
expiration of the term of the agreement following the Company's notice of non-extension,
then Mr. Matros would be entitled to a lump sum severance payment in the amount equal to
the greater of: (i) the unpaid and unearned portion of his base salary for the remainder
of the term of the agreement, or (ii) two year's base salary or, in the event such
termination occurs on or within two years following the date of a change of control (as
defined in the Employment Agreement), then three year's base salary.

The Company is currently in the
process of documenting employment agreements with Kevin W. Pendergest, William A. Mathies
and Heidi J. Fisher.

Severance Agreements

The Company has entered into Severance
Agreements with Mr. Schelling and Mr. Murphy pursuant to which they would receive
severance payments in the event of their Involuntary Termination of employment (as defined
in the Agreements). The severance payments would be equal to 24 months of their
then-current salary. In addition to the severance payments, they would have the right to
participate for a defined period of time in the medical, dental, health, life and other
fringe benefit plans and arrangements applicable to them immediately prior to termination.
Severance payments would be made in a lump sum or over a period of time at the discretion
of the Company. If so elected, the Company could make the severance payments over time,
which would release the executive from existing non-compete restrictions. Under this
option, if the executive finds employment during the severance period, his severance
payment will be reduced by the amount of the salary earned by him, up to a maximum of 50%
of the aggregate severance payments. Otherwise, the payments could be made in a lump sum
and the executive would remain subject to certain competitive prohibitions.

60

---



Item 12. Security Ownership of Certain Beneficial Owners and Management

The following table and footnotes set
forth certain information regarding the beneficial ownership of Common Stock as of March
18, 2002 by (i) each director, (ii) the Named Executive Officers (as defined
above) and (iii) all directors and executive officers of the Company as a group.

Name of Beneficial
    Owner
    SharesBeneficially Owned(1)
    Percent ofClass(1)John W. Adams
    -
    
    -Gregory S. Anderson
    -
    
    -Chauncey J. Hunker
    -
    
    -Richard K. Matros
    180,000
    (2)
    2.0%
    (3)Charles W. McQueary
    -
    
    -Robert F. Murphy
    -
    
    -John F. Nickoll
    873,239
    (4)
    9.8%
    (3)Sanjay H. Patel
    1,156,762
    (5)
    12.9%
    (3)Warren C. Schelling
    -
    
    -Jack Tindal
    -
    
    -Bruce C. Vladeck
    -
    
    -Steven L. Volla
    -
    
    -Milton J. Walters
    -
    
    -Mark G. Wimer
    -
    
    -Robert D. Woltil
    -
    
    -All directors and executive officers
    as a group (18 persons, including
    those named above)
    2,250,001
    (4)(5)(6)
    24.9%
    (3)


_____________________

*        Less
  than 1.0%

|(1) | Beneficial ownership is determined in accordance with the rules of
    the Commission and generally includes voting or investment power with respect to
    securities. Options exercisable within 60 days of March 18, 2002 are deemed to be
    currently exercisable. Except as indicated in the footnotes to this table and pursuant to
    applicable community property laws, the persons named in the table have sole voting and
    investment power with respect to all shares of Common Stock beneficially owned.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|(2) | Includes (i) 150,000 restricted shares awarded under the Company's 2002
    Management Equity Incentive Plan which may be subject to a substantial risk of forfeiture
    and (ii) 30,000 shares which could be purchased pursuant to stock options.                                                                                                                                                                                                                                                                       
|    | 61                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|(3) | As of March 18, 2002, only 8,949,977 shares of common stock had been
    issued under the Company's Plan of Reorganization, which provides for the issuance of
    approximately 10,150,000 shares in total. Upon issuance of the remaining shares, the
    beneficial ownership percentages would be as follows: Mr. Matros, 1.8%; Mr. Nickoll, 8.6%;
    Mr. Patel, 11.4%; and all directors and officers, 22.0%.                                                                                                        
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|(4) | Consists of shares held by The Foothill Group, Inc. and its affiliates, of
    which Mr. Nickoll is an executive officer. The shares are subject to shared voting and
    investment power. See table below.                                                                                                                                                                                                                                                                                                               
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|(5) | Consists of shares held by GSC Partners, and its affiliates. The shares may be subject to
    shared voting and dispositive power. Mr. Patel disclaims beneficial ownership of these
    securities. See table below.                                                                                                                                                                                                                                                                                                      
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|(6) | Includes (i) 150,000 restricted shares awarded under the Company's 2002
    Management Equity Incentive Plan and (ii) 70,000 shares which could be purchased pursuant
    to stock options.                                                                                                                                                                                                                                                                                                                                

The following table and footnotes set
forth certain information regarding the beneficial ownership of Common Stock as of March
18, 2002 by each person believed by the Company to be the beneficial owner of more than
five percent of Common stock of the Company.

|Name and Address of Beneficial Owner                                                                 | SharesBeneficially Owned(1) | Percent of Class(1)
|---------------------------------------------------------------------------------------------------- | --------------------------- | -------------------
|The Foothill Group, Inc.
       2450 Colorado Avenue
       Suite 3000
       Santa Monica, CA 90404 | 873,239   (2)               | 9.8%  (3)          
|Goldman Sachs & Co.
       85 Broad Street
       6th Floor
       New York, NY 10004                | 805,614   (4)               | 9.0%  (3)          
|GSC Partners
       500 Campus Drive
       Suite 220
       Florham Park, NJ 07932                  | 1,156,762  (5)              | 12.9%  (3)         
|JP Morgan Chase Bank
       1 Chase Manhattan Plaza
       8th Floor
       New York, NY 10081       | 702,602  (6)                | 7.8%  (3)          

|(1) | Beneficial ownership is determined in accordance with the rules of
    the Commission and generally includes voting or investment power with respect to
    securities. Except as indicated in the footnotes to this table and pursuant to applicable
    community property laws, the persons named in the table have shared voting and investment
    power with respect to all shares of Common Stock beneficially owned.
    62
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | Based on information
    included in Schedule 13G filed with the Commission on March 12, 2002. Consists of shares
    beneficially held by The Foothill Group, Inc., Foothills Partners III, L.P., Stearns
    Family Trust 2001, Dennis R. Ascher, Jeffrey T. Nikora Family Trust, John F. Nickoll
    Living Trust, Foothill Income Trust, L.P., FIT GP, LLC, Foothill Partners IV, L.P., and FP
    IV GP, LLC.                 
|(3) | As of March 18, 2002, only
    8,949,977 shares of common stock have been issued pursuant to the Company's Plan of
    Reorganization, which provides for the issuance of approximately 10,150,000 shares in
    total. Upon issuance of the remaining shares, the beneficial ownership percentages would
    be as follows: Foothill Partners, 8.6%; Goldman Sachs, 7.9%; GSCP Recovery, 11.4%; and JP
    Morgan, 6.9%.          
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                    
|(4) | Based on information provided to the Company by a representative of Goldman Sachs &
    Co. on March 26, 2002.                                                                                                                                                                                                                                                                                                                     
|(5) | Based on information included in Schedule 13D filed with the Commission on March 13, 2002.
    Consists of shares beneficially held by Greenwich Street Capital Partners II, L.P., GSCP
    (NJ), L.P., GSCP (NJ), Inc., Greenwich Street Investments II, L.L.C., GSC Recovery II,
    L.P., GSC Recovery II GP, L.P., GSC Recovery, Inc., GSC Recovery IIA, L.P. and GSC
    Recovery IIA GP, L.P.                                
|(6) | Based on the number of shares issued to J.P. Morgan Chase Bank on February 28, 2002.                                                                                                                                                                                                                                                                                                                                               

Item 13. Certain Relationships and Related Transactions

As of December 31, 2001, SunBridge
was a lessee or assignee of five facilities from partnerships in which Mr. John
Bingaman, a former director of the Company, has an equity interest of greater than ten
percent. The aggregate lease payments, including base rents, contingent rents and other
miscellaneous payments in connection with these leases, totaled approximately $2.0 million
in 2001.

Prior to Mr. Pendergest joining the
Company as Executive Vice President and Chief Financial Officer in March 2002, he served
as a court appointed examiner of the Company during its chapter 11 bankruptcy proceedings.
Mr. Pendergest provided these services as an independent contractor of Crossroads, LLC, of
which he had no ownership interest. All of the payments made to Mr. Pendergest in his
capacity as the examiner were approved by the bankruptcy court. The Company paid
Crossroads a total of approximately $1,509,000 for services rendered, plus expenses, and
Crossroads paid Mr. Pendergest a total of approximately $215,000 for his services, plus
expenses. In addition to Mr. Pendergest, Crossroads provided other professionals and
consultants to assist with the Company.

Prior to Mr. Schneider joining the
Company as Vice President and Treasurer in July 2001, he provided certain consulting
services to the Company during its chapter 11 bankruptcy proceedings related to the
renegotiation of various facility leases. During the year ended December 31, 2001, the
Company paid Mr. Schneider an aggregate of approximately $142,000 for his consulting
services, plus expenses. All of the payments to Mr. Schneider were approved by the
bankruptcy court. Mr. Schneider did not provide any consulting services to the Company
after he became Vice President and Treasurer.



63

---

common stock. See "Item 10 - Directors and Executive Officers of the
Registrant" and "Item 12 - Security Ownership of Certain Beneficial Owners and
Management." An affiliate of GSC Partners, GSC Partners CDO Fund III, is a party to
the Company's Term Loan Agreement and as of March 28, 2002 the Company was indebted to GSC
Partners CDO Fund III under that agreement for approximately $11.0 million.

John F. Nickoll is a member of the Company's Board of
Directors and the President, Chairman and Chief Executive Officer of The Foothill Group,
Inc. and the Managing Member of FIT GP, LLC, the General Partner of Foothill Income Trust,
L.P. Through its affiliates, The Foothill Group, Inc. beneficially holds more than 5% of
the Company's common stock. See "Item 10 - Directors and Executive Officers of the
Registrant" and "Item 12 - Security Ownership of Certain Beneficial Owners and
Management." Foothill Income Trust L.P. is a party to the Company's Revolving Loan
Agreement and Term Loan Agreement and as of March 28, 2002 the Company was indebted to
Foothill Income Trust L.P. under those agreements for approximately $7.9 million.

64

---

PART IV

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K

(a)  Financial Statements and Financial Statement Schedules

(i)  Financial Statements:

Report of Independent Public Accountants

Consolidated Balance Sheets for the years ended December 31, 2001 and 2000

Consolidated Statements of Losses for the years ended December 31, 2001, 2000 and
  1999

Consolidated Statements of
Stockholders' Deficit for the years ended December 31
                2001,
2000 and 1999

Consolidated
Statements of Cash Flows for the years ended December 31, 2001, 2000 and
                1999

Notes to Consolidated
Financial Statements

(ii)   Financial Statement Schedules:

Report of
Independent Public Accountants

Schedule II
Valuation and Qualifying Accounts for the years ended December 31,
                2001,
2000 and 1999

(All other financial statement schedules required by Rule 5-04 of
Regulation S-X are not applicable or not required).

(b)  Reports on Form 8-K

Form 8-K dated November 7, 2001 reporting the
filing of the Company's Joint Plan of
      Reorganization in the U.S. Bankruptcy Court for the
District of Delaware.
(c)  Exhibits

65

---

|ExhibitNumber | Description of Exhibits                                                                                                                                                                                                                                                                        
|------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|              |                                                                                                                                                                                                                                                                                                
|3.1(1)        | Amended and Restated
    Certificate of Incorporation of the Company                                                                                                                                                                                                                           
|              |                                                                                                                                                                                                                                                                                                
|3.2(1)        | Amended and Restated Bylaws
    of the Company                                                                                                                                                                                                                                                 
|              |                                                                                                                                                                                                                                                                                                
|4.1*          | Form of Registration Rights
    Agreement among the Company and the parties named therein dated as of February 28, 2002                                                                                                                                                                        
|              |                                                                                                                                                                                                                                                                                                
|4.2(1)        | Warrant Agreement dated
    February 28, 2002 between the Company and American Stock Transfer & Trust Company                                                                                                                                                                                  
|              |                                                                                                                                                                                                                                                                                                
|4.3(1)        | Sample Common Stock
    Certificate of Sun Healthcare Group, Inc.                                                                                                                                                                                                                              
|              |                                                                                                                                                                                                                                                                                                
|10.1*         | Loan and Security Agreement
    dated February 28, 2002 among the Company and certain of its subsidiaries as Borrowers,
    Heller Healthcare Finance, Inc., as Collateral Agent and Lender, Citicorp, USA, Inc., as
    Administrative Agent and Lender and certain other lending institutions
|              |                                                                                                                                                                                                                                                                                                
|10.2*         | Term Loan and Note Purchase
    Agreement dated February 28, 2002 among the Company and certain of its subsidiaries as
    Borrowers, U.S. Bank as Administrative Agent and certain other lending institutions                                                                                 
|              |                                                                                                                                                                                                                                                                                                
|10.3*         | The Company's 2002
    Management Equity Incentive Plan                                                                                                                                                                                                                                        
|              |                                                                                                                                                                                                                                                                                                
|10.4*         | Form of Expense
    Indemnification Agreement between the Company and certain former and current directors and
    officers                                                                                                                                                                    
|              |                                                                                                                                                                                                                                                                                                
|10.5*         | Form of Severance
    Agreements entered into between the Company and Robert F. Murphy and Warren C. Schelling                                                                                                                                                                                 
|              |                                                                                                                                                                                                                                                                                                
|10.6*         | Form of Severance Agreement
    entered into between the Company and Chauncey J. Hunker                                                                                                                                                                                                        
|              |                                                                                                                                                                                                                                                                                                
|10.7(2)       | Joint Plan of
    Reorganization dated December 18, 2001                                                                                                                                                                                                                                       
|              |                                                                                                                                                                                                                                                                                                
|10.7.1(2)     | Amendments to Joint Plan of
    Reorganization                                                                                                                                                                                                                                                 
|              |                                                                                                                                                                                                                                                                                                
|10.8(2)       | Disclosure Statement dated
    December 18, 2001                                                                                                                                                                                                                                               
|              |                                                                                                                                                                                                                                                                                                
|10.9*         | Employment Agreement dated
    February 28, 2002 between the Company and Richard K. Matros                                                                                                                                                                                                     
|              |                                                                                                                                                                                                                                                                                                
|10.10*        | Corporate Integrity
    Agreement between the Office of Inspector General of the Department of Health and Human
    Services and the Company dated July 12, 2001                                                                                                                               
|              |                                                                                                                                                                                                                                                                                                
|21*           | Subsidiaries of the
    Registrant                                                                                                                                                                                                                                                             
|              |                                                                                                                                                                                                                                                                                                
|99.1*         | Confirmation of Receipt of Assurances from
    Arthur Andersen LLP                                                                                                                                                                                                                             
|              |                                                                                                                                                                                                                                                                                                

66

---

_______________

*       Filed herewith.

(1)  Incorporated by reference from exhibits to the Company's
Form 8-A filed on March 6, 2002.

(2)  Incorporated by reference from exhibits to the Company's
Form 8-K dated February 28, 2002, as amended on Form 8-K/A.

67

---

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.

SUN HEALTHCARE GROUP, INC.By:  /s/
    Richard K.
    MatrosRichard
    K. MatrosChairman
    of the Board and ChiefExecutive
    Officer


March 29, 2002



68

---

POWER OF ATTORNEY

Each person whose signature appears below
hereby appoints each of Richard K. Matros and Robert F. Murphy as his attorney-in-fact, to
sign this Report on his or her behalf, individually and in the capacity stated below, and
to file all supplements and amendments to this Report and any and all instruments or
documents filed as a part of or in connection with this Report or any amendment or
supplement thereto, and any such attorney-in-fact may make such changes and additions to
this Report as such attorney-in-fact may deem necessary or appropriate.

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 on March 29, 2002 in the capacities indicated.

Signatures
    Title/s/ Richard K.
    Matros   Richard K. Matros
    Chairman of the Board, Chief Executive Officer
    (Principle Executive Officer)/s/ Wallace E. Boston, Jr.
       Wallace E. Boston, Jr.
    Principal Financial Officer (Principal
    Financial Officer)/s/ Jennifer L.
    Botter   Jennifer L. Botter
    Vice President and Corporate Controller
    (Principal Accounting Officer)/s/ John W.
    Adams
      John W. Adams
    Director/s/ Gregory S. Anderson  Gregory S. Anderson
    Director/s/ Charles W. McQueary  Charles W. McQueary
    Director/s/ John F.
    Nickoll  John F. Nickoll
    Director/s/ Sanjay H.
    Patel  Sanjay H. Patel
    Director/s/ Bruce C. Vladek   Bruce C. Vladek
    Director69/s/ Steven L.
    Volla   Steven L. Volla
    Director/s/ Milton J. Walters   Milton J. Walters
    Director


70

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
Index to Consolidated Financial Statements

December 31, 2001



PageReport of
    Independent Public Accountants
    F-2Consolidated
    Balance Sheets as of December 31, 2001 and 2000
    F-3Consolidated
    Statements of Losses for the years ended December 31, 2001, 2000
       and 1999
    F-5Consolidated
    Statements of Stockholders' Deficit for the years endedDecember 31, 2001, 2000 and 1999
    F-6Consolidated
    Statements of Cash Flows for the years ended December 31, 2001,
       2000 and 1999
    F-7Notes to
    Consolidated Financial Statements
    F-8


F-1

---

REPORT OF
INDEPENDENT PUBLIC ACCOUNTANTS

To the Stockholders and Board of Directors of Sun Healthcare Group,
Inc.:

We have audited the accompanying consolidated balance sheets of Sun
Healthcare Group, Inc. (Debtor-in-Possession) (a Delaware corporation) and subsidiaries as
of December 31, 2001 and 2000, and the related consolidated statements of losses,
stockholders' deficit and cash flows for each of the three years in the period ended
December 31, 2001. 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 auditing standards generally
accepted in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Sun Healthcare Group,
Inc. (Debtor-in-Possession) and subsidiaries as of December 31, 2001 and 2000, and the
results of their operations and their cash flows for each of the three years in the period
ended December 31, 2001, in conformity with accounting principles generally accepted in
the United States.



/s/ Arthur Andersen
LLP

ARTHUR ANDERSEN LLP

Albuquerque, New Mexico
March 18, 2002

F-2

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
CONSOLIDATED BALANCE SHEETS

As of December 31, 2001 and 2000
(in thousands)

2001
    
    2000ASSETSCurrent
    assets:Cash
    and cash equivalents
    $         50,649
    
    $          37,589Accounts
    receivable, net of allowance for doubtful accounts of $73,819 and $128,106
        at December 31, 2001 and 2000, respectively
    204,733
    
    195,362Inventory,
    net
    20,415
    
    22,676Other
    receivables, net of allowance of $2,566 and $1,351 at December 31, 2001 and
        2000, respectively
    9,556
    
    6,896Prepaids
    and other assets
    5,653
    
    4,693Total
    current assets
    291,006
    
    267,216Property
    and equipment, net
    133,216
    
    180,285Assets held
    for sale
    18,158
    
    156,342Notes
    receivable, net of allowance of $3,650 and $628 at December 31, 2001 and 2000,
      respectively
    4,895
    
    14,554Goodwill,
    net
    177,202
    
    188,005Other
    assets, net
    25,327
    
    43,586Total
    assets
    $       649,804
    
    $        849,988========
    
    ========




The accompanying notes to consolidated financial statements are an
integral part of these consolidated balance sheets.

F-3

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
CONSOLIDATED BALANCE SHEETS (Continued)

As of December 31, 2001 and 2000
(in thousands except share data)



|                                                                                                                                                                                                 | 2001                |   | 2000              |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------- | - | ----------------- | -
|Current
    liabilities:                                                                                                                                                                         |                     |   |                   |  
|Current
    portion of long-term debt                                                                                                                                                            | $            54,975 |   | $          86,039 |  
|Accounts
    payable                                                                                                                                                                             | 30,335              |   | 37,526            |  
|Accrued
    compensation and benefits                                                                                                                                                            | 79,328              |   | 101,977           |  
|Accrued
    self-insurance obligations                                                                                                                                                           | 47,097              |   | 28,018            |  
|Income
    taxes payable                                                                                                                                                                         | 12,430              |   | 13,328            |  
|Other
    accrued liabilities                                                                                                                                                                    | 80,100              |   | 139,229           |  
|Total
    current liabilities                                                                                                                                                                    | 304,265             |   | 406,117           |  
|Liabilities
    subject to compromise (see Note 2)                                                                                                                                               | 1,549,139           |   | 1,529,928         |  
|Accrued
    self-insurance obligations, net of current portion                                                                                                                                   | 51,380              |   | 22,719            |  
|Long-term
    debt, net of current portion                                                                                                                                                       | 23,260              |   | 54,211            |  
|Obligations
    under capital leases, net of current portion                                                                                                                                     | -                   |   | 53,553            |  
|Other
    long-term liabilities                                                                                                                                                                  | 22,544              |   | 26,737            |  
|Total
    liabilities                                                                                                                                                                            | 1,950,588           |   | 2,093,265         |  
|Commitments
    and contingencies (see Note 10)                                                                                                                                                  |                     |   |                   |  
|Minority
    interest                                                                                                                                                                            | 5,405               |   | 5,960             |  
|Company-obligated
    mandatorily redeemable convertible preferred securities of a 
      subsidiary trust holding solely 7% convertible junior subordinated debentures
    of the
      Company | 296,101             |   | 296,101           |  
|Stockholders'
    deficit:                                                                                                                                                                       |                     |   |                   |  
|Common
    stock of $.01 par value, authorized 155,000,000 shares, 65,209,188 and
        65,230,853 shares issued and outstanding as of December 31,
    2001 and 2000,
        respectively    | 652                 |   | 652               |  
|Additional
    paid-in capital                                                                                                                                                                   | 825,099             |   | 825,147           |  
|Accumulated
    deficit                                                                                                                                                                          | (2,400,655          | ) | (2,331,218        | )
|Accumulated
    other comprehensive loss                                                                                                                                                         | -                   |   | (12,483           | )
|                                                                                                                                                                                                 | (1,574,904          | ) | (1,517,902        | )
|Less:                                                                                                                                                                                            |                     |   |                   |  
|Common
    stock held in treasury, at cost, 2,213,537 shares as of December 31, 2001
          and 2000                                                                                          | (27,376             | ) | (27,376           | )
|Grantor
    stock trust, at market, 1,915,935 shares as of December 31, 2001 and 2000                                                                                                            | (10                 | ) | (60               | )
|Total
    stockholders' deficit                                                                                                                                                                  | (1,602,290          | ) | (1,545,338        | )
|Total
    liabilities and stockholders' deficit                                                                                                                                                  | $          649,804  |   | $        849,988  |  
|                                                                                                                                                                                                 | =========           |   | ========          |  

The accompanying notes to consolidated financial statements are an
integral part of these consolidated balance sheets.

F-4

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
CONSOLIDATED STATEMENTS OF LOSSES

For the Years Ended December 31, 2001, 2000 and 1999
(in thousands except per share data)

2001
    
    2000
    
    1999Total net
    revenues
    $2,075,234
    
    $2,458,928
    
    $2,529,039Costs and
    expenses:Operating
    costs
    1,895,662
    
    2,230,423
    
    2,477,713Corporate
    general and administrative
    104,315
    
    153,133
    
    159,671Depreciation
    and amortization
    32,785
    
    45,881
    
    81,325Provision
    for losses on accounts receivable
    25,972
    
    33,496
    
    123,217Loss
    on impairment
    18,825
    
    191,316
    
    457,449Interest,
    net (contractual interest expense of $142,800, $146,406 and
        $30,546 for 2001, 2000 and 1999, respectively)
    12,635
    
    34,269
    
    129,054Legal
    and regulatory matters, net
    11,000
    
    2,480
    
    38Restructuring
    costs
    1,064
    
    (1,090
    )
    27,353(Gain)
    loss on sale of assets, net
    (825
    )
    (21,400
    )
    78,673Loss
    on termination of interest rate swaps
    -
    
    -
    
    2,488Total
    costs and expenses before reorganization items
    2,101,433
    
    2,668,508
    
    3,536,981Dividends
    on convertible preferred securities of subsidiary
    -
    
    -
    
    20,407Losses
    before reorganization costs, income taxes and cumulative effect
      of change in accounting principle
    (26,199
    )
    (209,580
    )
    (1,028,349
    )Reorganization
    costs, net
    42,917
    
    335,875
    
    48,132Losses
    before income taxes and cumulative effect of change in accounting
      principle
    (69,116
    )
    (545,455
    )
    (1,076,481
    )Income tax
    provision
    321
    
    256
    
    161Losses
    before cumulative effect of change in accounting principle
    (69,437
    )
    (545,711
    )
    (1,076,642
    )Cumulative
    effect of change in accounting principle
    -
    
    -
    
    (12,816
    )Net losses
    $          (69,437
    )
    $         (545,711
    )
    $      (1,089,458
    )=======
    
    ========
    
    =======Net losses
    per common and common equivalent share:Losses
    before cumulative effect of change in accounting principleBasic
    and diluted
    $               (1.14
    )
    $               (9.04
    )
    $             (18.40
    )=======
    
    ========
    
    =======Net losses:Basic
    and diluted
    $               (1.14
    )
    $               (9.04
    )
    $          (18.62
    )=======
    
    ========
    
    =======Weighted
    average number of common and common equivalent shares
      outstanding:Basic
    and diluted
    61,096
    
    60,347
    
    58,504=======
    
    ========
    
    =======


The accompanying notes to consolidated financial statements are an
integral part of these statements.

F-5

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
For the Years Ended December 31, 2001, 2000 and 1999
(in thousands)

|                                                                                     | 2001   |   | 2000               |   | 1999   |  
|------------------------------------------------------------------------------------ | ------ | - | ------------------ | - | ------ | -
|                                                                                     | Shares |   | Amount             |   | Shares |  
|Common
    Stock                                                                     |        |   |                    |   |        |  
|Issued and
    outstanding at beginning of year                                      | 65,231 |   | $              652 |   | 63,937 |  
|Conversion
    of 6-1/2% Convertible Subordinated Debentures due 2003                | -      |   | -                  |   | -      |  
|Conversion
    of 7% Convertible Trust Issued Preferred Securities                   | -      |   | -                  |   | 1,335  |  
|Cancellation
    of Restricted Stock Awards                                          | (22    | ) | -                  |   | (41    | )
|Employee
    Stock Purchase and other                                                | -      |   | -                  |   | -      |  
|Common
    Stock Issued and outstanding at
      end of year                         | 65,209 |   | 652                |   | 65,231 |  
|                                                                                     | =====  |   |                    |   | ====   |  
|Additional
    Paid-in Capital                                                       |        |   |                    |   |        |  
|Balance at
    beginning of year                                                     |        |   | 825,147            |   |        |  
|Conversion
    of 6-1/2% Convertible Subordinated
      Debentures due 2003          |        |   | -                  |   |        |  
|Conversion
    of 7% Convertible Trust Issued
      Preferred Securities             |        |   | -                  |   |        |  
|Adjustment
    to market value of common stock
      held by the Grantor Stock Trust |        |   | (50                | ) |        |  
|Conversion
    of Mediplex convertible debt                                          |        |   | -                  |   |        |  
|Cancellation
    of Restricted Stock Awards                                          |        |   | 2                  |   |        |  
|Additional
    paid-in capital at end of year                                        |        |   | 825,099            |   |        |  
|                                                                                     |        |   |                    |   |        |  
|Retained
    Deficit                                                                 |        |   |                    |   |        |  
|Balance at
    beginning of year                                                     |        |   | (2,331,218         | ) |        |  
|Net losses                                                                           |        |   | (69,437            | ) |        |  
|Retained
    deficit at end of year                                                  |        |   | (2,400,655         | ) |        |  
|                                                                                     |        |   |                    |   |        |  
|Accumulated
    Other Comprehensive Income                                           |        |   |                    |   |        |  
|Balance at
    beginning of year                                                     |        |   | (12,483            | ) |        |  
|Foreign
    currency translation adjustment, net of
      tax                        |        |   | 12,483             |   |        |  
|Accumulated
    other comprehensive income
      (loss) at end of year               |        |   | -                  |   |        |  
|Total                                                                                |        |   | (1,574,904         | ) |        |  
|                                                                                     |        |   |                    |   |        |  
|Unearned
    Compensation                                                            |        |   |                    |   |        |  
|Balance at
    beginning of year                                                     |        |   | -                  |   |        |  
|Cancellation
    of Restricted Stock Awards                                          |        |   | -                  |   |        |  
|Amortization
    of stock issued under restricted stock option plan                  |        |   | -                  |   |        |  
|Unearned
    compensation at end of year                                             |        |   | -                  |   |        |  
|                                                                                     |        |   |                    |   |        |  
|Common
    Stock in Treasury                                                         |        |   |                    |   |        |  
|Balance at
    beginning of year                                                     | 2,213  |   | (27,376            | ) | 2,213  |  
|Acquired at
    cost                                                                 | -      |   | -                  |   | -      |  
|Common
    stock in treasury at end of year                                          | 2,213  |   | (27,376            | ) | 2,213  |  
|                                                                                     | =====  |   |                    |   | ====   |  
|Grantor
    Stock Trust                                                              |        |   |                    |   |        |  
|Balance at
    beginning of year                                                     | 1,916  |   | (60                | ) | 1,916  |  
|Issuance of
    common stock from the Grantor Stock Trust                            | -      |   | -                  |   | -      |  
|Adjustment
    to market value of common stock
      held by the Grantor Stock Trust | -      |   | 50                 |   | -      |  
|Grantor
    stock trust at end of year                                               | 1,916  |   | (10                | ) | 1,916  |  
|                                                                                     | =====  |   |                    |   | ====   |  
|Total
    stockholders' deficit                                                      |        |   | $   (1,602,290     | ) |        |  
|                                                                                     |        |   | =======            |   |        |  

The accompanying notes to consolidated
financial statements are an integral part of these statements.

F-6

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2001, 2000 and 1999
(in thousands)

2001
    
    2000
    
    1999Cash
    flows from operating activities:Net
    losses
    $(69,437
    )
    $(545,711
    )
    $(1,089,458
    )Adjustments
    to reconcile net losses to net cash provided by (used for)
       operating activities:(Gain)
    loss on sale of assets, net
    (825
    )
    (21,400
    )
    78,673Loss
    on impairment
    18,825
    
    191,316
    
    457,449Cumulative
    effect of change in accounting principle
    -
    
    -
    
    12,816Reorganization
    costs, net
    42,917
    
    335,875
    
    48,132Depreciation
    and amortization
    32,785
    
    45,881
    
    81,325Provision
    for losses on accounts receivable
    25,972
    
    33,496
    
    123,217Legal
    and regulatory costs
    11,000
    
    1,245
    
    -Other,
    net
    9,596
    
    (20,186
    )
    18,055Changes in
    operating assets and liabilities:Accounts
    receivable
    (36,914
    )
    (18,720
    )
    160,864Other
    current assets
    945
    
    11,029
    
    8,412Other
    current liabilities
    8,021
    
    859
    
    72,607Income
    taxes payable
    1,067
    
    2,115
    
    35,430Net
    cash provided by operating activities before reorganization costs
    43,952
    
    15,799
    
    7,522Net
    cash paid for reorganization costs
    (19,583
    )
    (17,520
    )
    (269
    )Net
    cash provided by (used for) provided by operating activities
    24,369
    
    (1,721
    )
    7,253Cash
    flows from investing activities:Capital
    expenditures
    (30,330
    )
    (55,366
    )
    (102,453
    )Acquisitions,
    net of cash acquired
    -
    
    (974
    )
    (5,731
    )Proceeds
    from sale of assets
    18,164
    
    24,980
    
    8,735Proceeds
    from redemption of strategic investment
    10,115
    
    -
    
    -Repayment
    (issuance) of long-term notes receivable
    885
    
    (6,088
    )
    15,857Decrease
    in other assets
    2,626
    
    5,536
    
    45,179Proceeds
    from sale and leaseback of property and equipment
    -
    
    -
    
    38,600Net
    cash provided by (used for) investing activities
    1,460
    
    (31,912
    )
    187Cash
    flows from financing activities:(Payments)
    borrowings under Revolving Credit Agreement
         (postpetition), net
    (12,441
    )
    54,901
    
    12,125Long-term
    debt borrowings
    3,842
    
    9,667
    
    126,062Long-term
    debt repayments (prepetition)
    (82
    )
    (14,663
    )
    (92,502
    )Principal
    payments on prepetition debt authorized by Bankruptcy
         Court
    (3,017
    )
    (3,406
    )
    (36,118
    )Conversion
    of Mediplex 6.5% Convertible Subordinated Debentures due
         2003
    -
    
    -
    
    (6,649
    )Net
    proceeds from issuance of common stock
    -
    
    -
    
    1,784Purchases
    of treasury stock
    -
    
    -
    
    (409
    )Other
    financing activities
    (1
    )
    (4
    )
    (14,480
    )Net
    cash (used for) provided by financing activities
    (11,699
    )
    46,495
    
    (10,187
    )Effect of
    exchange rate on cash and cash equivalents
    (1,070
    )
    (320
    )
    290Net
    increase (decrease) in cash and cash equivalents
    13,060
    
    12,542
    
    (2,457
    )Cash and
    cash equivalents at beginning of year
    37,589
    
    25,047
    
    27,504Cash and
    cash equivalents at end of year
    $                   50,649
    
    $               37,589
    
    $             25,047=========
    
    =======
    
    =======


The accompanying notes to consolidated financial statements are an
integral part of these statements.

F-7

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2001

(1)  Nature of Business

Sun Healthcare Group, Inc., a
Delaware corporation, through its direct and indirect subsidiaries (hereinafter
collectively referred to as "Sun" or the "Company"), is a provider of
long-term, subacute and related specialty healthcare services, including rehabilitation
therapy services and pharmaceutical services. Long-term and subacute care, outpatient
therapy and pharmaceutical services are provided through Company-operated facilities.
Rehabilitative therapy services are provided both in Company-operated and other
nonaffiliated facilities located in the United States.

(2)  Emergence from Chapter 11 Bankruptcy Proceedings

On October 14, 1999 (the "Filing
Date"), Sun Healthcare Group, Inc. and substantially all of its U.S. operating
subsidiaries filed voluntary petitions for reorganization under chapter 11 of the U.S.
Bankruptcy Code ("chapter 11"). On February 6, 2002, the U.S. Bankruptcy Court
for the District of Delaware (the "Bankruptcy Court") confirmed the Company's
joint plan of reorganization ("Plan of Reorganization") and on February 28, 2002
the Company consummated the Plan. See "Note 23 - Subsequent Events." The
consolidated financial statements of the Company have been presented in accordance with
the American Institute of Certified Public Accountants Statement of Position 90-7,
"Financial Reporting by Entities in Reorganization under the Bankruptcy Code"
("SOP 90-7") and have been prepared in accordance with accounting principles
generally accepted in the United States applicable to a going concern, which principles,
except as otherwise disclosed, assume that assets will be realized and liabilities will be
discharged in the normal course of business.

Under chapter 11, certain claims against
the Company in existence prior to the Filing Date were stayed while the Company continued
its operations as a debtor-in-possession. These claims are reflected in the December 31,
2001 and 2000 balance sheets as "liabilities subject to compromise." Since
October 14, 1999, the payment of certain prepetition claims (principally employee wages
and benefits and payments to critical vendors and utilities) that were approved by the
Bankruptcy Court have reduced "liabilities subject to compromise." As part of
the Company's emergence from chapter 11 proceedings, all of the "liabilities subject
to compromise" have been discharged, reinstated or repaid.

The Company determined that, generally,
the fair market value of the collateral was less than the principal amount of its secured
prepetition debt obligations; accordingly, the Company discontinued accruing interest on
substantially all of these obligations as of the Filing Date. The Company received
approval from the Bankruptcy Court to pay or otherwise honor certain of its prepetition
obligations, including employee wages and benefits.

The principal categories and the balances
of chapter 11 claims reclassified in the accompanying consolidated balance sheets and
included in "liabilities subject to compromise" are identified below. These
amounts may be subject to future adjustments depending upon Bankruptcy Court actions,
further developments with respect to disputed claims, whether or not such claims are
secured, and the value of any security interests securing such claims or other events.

F-8

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

Liabilities Subject to Compromise

|                                                         | December 31, 2001  |  | December 31, 2000 
|-------------------------------------------------------- | ------------------ |  | ------------------
|                                                         | (in
    thousands) |  | (in
    thousands)
|                                                         |                    |  |                   
|Revolving Credit Facility                                | $     437,066      |  | $    433,319      
|Credit Facility Term Loans                               | 358,981            |  | 358,981           
|Senior Subordinated Notes due 2007                       | 250,000            |  | 250,000           
|Senior Subordinated Notes due 2008                       | 150,000            |  | 150,000           
|Interest payable                                         | 101,856            |  | 102,094           
|Convertible Subordinated Debentures due 2004             | 83,300             |  | 83,300            
|Prepetition trade and other miscellaneous claims         | 88,171             |  | 65,834            
|Mortgage notes payable due at various dates through 2005 | 46,023             |  | 46,214            
|Other long-term debt                                     | 14,377             |  | 15,984            
|Industrial Revenue Bonds                                 | 8,365              |  | 8,620             
|Senior Subordinated Notes due 2002                       | 6,161              |  | 6,161             
|Capital Leases                                           | 3,457              |  | 8,039             
|Convertible Subordinated Debentures due 2003             | 1,382              |  | 1,382             
|Total liabilities subject to compromise                  | $  1,549,139       |  | $ 1,529,928       
|                                                         | =======            |  | =======           

During 2001 the Company identified
approximately $16.5 million of additional self-insurance obligations which is included in
the prepetition trade and other miscellaneous claims as of December 31,
2001.

Since October 14, 1999, the payment of
certain prepetition claims (principally employee wages and benefits and payments to
critical vendors and utilities) that were approved by the Bankruptcy Court have reduced
"liabilities subject to compromise."

Under the Bankruptcy Code, the Company
could elect to assume or reject real estate leases, employment contracts, personal
property leases, service contracts and other unexpired executory prepetition contracts,
subject to Bankruptcy Court approval. The Bankruptcy Code generally accords priority to
claims and expenses in the following order. First, distributions are made to secured
creditors to the extent of their interest in collateral. Unencumbered assets, or the value
thereof, are distributed in the following order: to holders of super-priority claims, such
as the lenders under the debtor-in-possession financing (the "DIP Financing
Agreement"), holders of administrative expense claims, holders of claims for wages
and salaries, holders of claims with respect to contributions to employee benefit plans,
holders of certain tax claims, holders of unsecured claims and holders of equity
interests. See "Note 8 - Debtor-in-Possession Financing" and "Note 23 -
Subsequent Events."

At December 31, 2001, the Company was in
default with respect to substantially all of its prepetition borrowings. The Company's
prepetition bank debt was collateralized by (i) a pledge of stock in the Company's U.S.
subsidiaries, (ii) a pledge of approximately 66 percent of the stock in certain of the
Company's direct foreign subsidiaries, (iii) a security interest in intersegment debt owed
by subsidiaries to the Company and (iv) a pledge of certain notes held by the Company.

F-9

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

Reorganization Costs

Reorganization costs under chapter 11 are
items of expense or income that are incurred or realized by the Company because it is in
reorganization. These include, but are not limited to, professional fees and similar types
of expenditures incurred directly relating to the chapter 11 proceeding, loss accruals or
realized gains or losses resulting from activities of the reorganization process and
interest earned on cash accumulated by the Company because it is not paying its
prepetition liabilities.

For the period from the Filing Date
through December 31, 2001, reorganization costs, net, were a total of $426.9 million.

|                                                                   | 2001       |   | 2000       |   | 1999       |  
|------------------------------------------------------------------ | ---------- | - | ---------- | - | ---------- | -
|                                                                   |            |   |            |   |            |  
|Professional fees                                                  | $   25,779 |   | $   27,756 |   | $    4,115 |  
|Loss on sale of assets                                             | 15,267     |   | 313,781    |   | 7,085      |  
|Other                                                              | 3,795      |   | 866        |   | -          |  
|Write-off
    of debt discounts and deferred
       issuance costs | -          |   | -          |   | 37,614     |  
|Less interest earned on accumulated cash                           | (1,924     | ) | (2,807     | ) | (682       | )
|Gain on sale of assets                                             | -          |   | (3,721     | ) | -          |  
|Total                                                              | $   42,917 |   | $  335,875 |   | $  48,132  |  
|                                                                   | ======     |   | =======    |   | ======     |  

(3)  Summary of Significant Accounting and Financial Reporting Policies

(a)  Principles of Consolidation

The consolidated financial statements
include the accounts of the Company and its greater than 50% owned subsidiaries.
Investments in affiliates in which the Company owns 20% to 50% are carried on the equity
method. Investments in companies owned less than 20% are carried at cost. All significant
intersegment accounts and transactions have been eliminated in consolidation. As a
consequence of the bankruptcy filings in 1999, the non-filing subsidiaries of the Company
fully reserved for their intersegment receivables from the filing subsidiaries. These
amounts were not material.

(b)  Cash and Cash Equivalents

The Company considers all highly liquid,
unrestricted investments with original maturities of three months or less to be cash
equivalents. Cash equivalents are stated at cost, which approximates fair value.

(c)  Net Revenues

Net revenues consist of long-term and subacute
care revenues, temporary medical staffing services revenues, pharmaceutical services
revenues and other ancillary services revenues. Net revenues are

F-10

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

recognized as services are provided. Revenues are recorded net of
provisions for discount arrangements with commercial payors and contractual allowances
with third-party payors, primarily Medicare and Medicaid. Net revenues realizable under
third-party payor agreements are subject to change due to examination and retroactive
adjustment. Estimated third-party payor settlements are recorded in the period the related
services are rendered. The methods of making such estimates are reviewed periodically, and
differences between the net amounts accrued and subsequent settlements or estimates of
expected settlements are reflected in current results of operations.

In February 2002, the Company, the United
States Department of Health and Human Services ("HHS"), the United States
Department of Justice (" DOJ"), the Center for Medicare and Medicaid Services
("CMS"), the Tricare Management Activity Support Office ("TMA"), and
the Relators in eight qui tam cases, entered into a comprehensive settlement
agreement (the "Settlement Agreement"). Under the Settlement Agreement, the
Company and the above mentioned parties agreed to mutually release each other from
substantially all prepetition claims. The Settlement Agreement requires the Company to pay
$1.0 million in cash and deliver a promissory note for $10.0 million, plus interest to CMS
over the next five years.

Since 1999, the Company recorded various
reserves due to the uncertainty of the reimbursement adjustments that might have been
required to settle the matters raised by the parties of the Settlement Agreement,
including a reserve of approximately $31.0 million recorded in 1999 for routine cost limit
exception payments previously paid to the Company. Such amounts totaled a net reserve of
$52.1 million. As a result of the Settlement Agreement, the Company reversed the $52.1
million of net excess reserved exposures and reflected it as a component of net patient
revenue in the 2001 consolidated statement of operations.

(d)  Accounts Receivable

The Company's accounts receivable relate
to services provided by its various operating divisions to a variety of payors and
customers. The primary payors for services provided in long-term and subacute care
facilities that the Company operates are the Medicare program and the various state
Medicaid programs. The rehabilitation and respiratory therapy service operations provide
services to patients in Company-operated and unaffiliated long-term, rehabilitation and
acute care facilities. The billings for services to unaffiliated facilities are submitted
to those facilities. Many of the unaffiliated long-term care facilities receive a large
majority of their revenues from the Medicare program and the state Medicaid programs.

(e)  Inventories



Property and equipment is stated at cost.
Property and equipment held under capital lease is stated at

F-11

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

the net present value of future minimum lease payments.
Major renewals or improvements are capitalized whereas ordinary maintenance and repairs
are expensed as incurred. Depreciation and amortization is computed using the
straight-line method over the estimated useful lives of the assets as follows: buildings
and improvements - 5 to 40 years; leasehold improvements-the shorter of the
estimated useful lives of the assets or the life of the lease including renewal options;
and equipment - 3 to 20 years. The Company capitalizes interest directly related
to the development and construction of new facilities as a cost of the related asset.

(g)  Goodwill

The excess of the purchase price over the
fair value of the net assets of the businesses acquired by the Company, to the extent not
subsequently impaired, is amortized using the straight-line method over periods ranging
from 20 to 40 years. Accumulated amortization of such costs was approximately $101.1
million and $242.7 million as of December 31, 2001 and 2000, respectively.

(h)  Impairment of Long-Lived Assets

The Company periodically evaluates the
carrying value of goodwill along with other related long-lived assets in relation to the
future undiscounted cash flows of the underlying businesses to assess recoverability in
accordance with Statement of Financial Accounting Standards No. 121 "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of"
("SFAS 121"). Under SFAS 121, an impairment loss is recognized if the
sum of the expected cash flows is less than the carrying amount of the goodwill and other
long-lived assets being evaluated. The difference between the carrying amount of the
goodwill and other long-lived assets being evaluated and the estimated fair market value
of the assets represents the impairment loss. The Company determines estimated fair value
for the long-lived assets based on anticipated future cash flows discounted at rates
commensurate with the risks involved.

(i)  Accrued Self-Insurance Obligations

It is the Company' s policy to
self-insure for certain insurable risks, including general and professional liability and
workers' compensation liability through the use of self-insurance or retrospective and
high deductible insurance policies and other hybrid policies, which vary by the states in
which the Company operates. Provisions for estimated settlements, including incurred but
not reported losses, are provided in the period of the related coverage. These provisions
are based on internal evaluations of the merits of individual claims and the reserves
assigned by the Company's independent insurance carriers. The methods of making such
estimates and establishing the resulting accrued liabilities are reviewed periodically,
and any adjustments resulting therefrom are reflected in current earnings. Claims are paid
over varying periods, which generally range from one to five years. Future payments may be
different than the estimated expense. Accrued liabilities for future claims are not
discounted.

(j)Software Development Costs

The Company, through an indirect,
majority owned subsidiary, is internally developing software that it plans to use in its
operations and to market to unaffiliated long-term care providers. All costs incurred

F-12

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

related to the development of the software have been
expensed. Once the Company concludes that technological feasibility is established, all
subsequent development costs will be capitalized and reported at the lower of unamortized
cost or net realizable value. Software development costs are included in operating
expenses in the accompanying consolidated statements of losses.

(k)  Income Taxes

Income tax expense is based on reported
earnings before income taxes. Deferred income taxes reflect the impact of temporary
differences between the amount of assets and liabilities recognized for financial
reporting purposes and such amounts recognized for tax purposes. A valuation allowance is
recognized if it is anticipated that some or all of a deferred tax asset may not be
realized.

(l)  Foreign Currency Translation Adjustment

The financial position and results of
operations of the Company's foreign subsidiaries were measured using local currency as the
functional currency. Assets and liabilities of these subsidiaries were translated at the
exchange rate in effect at each year end. Statements of losses accounts were translated at
the average rate of exchange prevailing during the year. Translation adjustments arising
from differences in exchange rates from period to period are included in accumulated other
comprehensive income in the consolidated statements of stockholders' deficit. All foreign
operations were divested as of December 31, 2001.

(m)  Stock-Based Compensation

The Company accounts for stock-based
compensation using the intrinsic value method prescribed in Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. Accordingly, compensation cost for stock options is measured as the
excess, if any, of the quoted market price of the Company's stock at the date of the grant
over the amount an employee must pay to acquire the stock. Statement of Financial
Accounting Standards No. 123 "Accounting for Stock-Based Compensation"
("SFAS 123") was issued in 1995, and the Company has adopted the disclosure
requirements of SFAS 123 (see "Note 15 - Capital Stock").

(n)  Net Losses Per Share

Diluted net losses per share is based
upon the weighted average number of common shares outstanding during the period. The
Company's convertible securities are described in "Note 14 - Convertible Trust
Issued Preferred Securities". These securities were not dilutive for the years ended
December 31, 2001, 2000 and 1999. See "Note 16 - Earnings Per Share"
for calculation of losses per share data for the years ended December 31, 2001, 2000
and 1999.

(o)  Adoption of New Accounting Pronouncements

In October 2001 the FASB issued SFAS No.
144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS
144"). SFAS 144 replaces SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lives Assets to be Disposed of." SFAS 144 requires
that

F-13

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001



long-lived assets be measured at the lower of carrying amount or fair
value less cost to sell, whether reported in continuing operations or in discontinued
operations. Therefore, discontinued operations will no longer be measured at net
realizable value or include amounts for operating losses that have not yet occurred. SFAS
144 also broadens the reporting of discontinued operations to include all components of an
entity with operations that can be distinguished from the rest of the entity and that will
be eliminated from the ongoing operations of the entity in a disposal transaction. The
provisions of SFAS 144 are effective for financial statements issued for fiscal years
beginning after December 15, 2001. This new pronouncement will become effective January 1,
2002. The Company has not determined the impact that the adoption of this accounting
standard will have on its consolidated financial statements.

In June 2001 the FASB issued SFAS No.
141, "Business Combinations" ("SFAS 141") which provides that all
business combinations should be accounted for using the purchase method of accounting and
establishes criteria for the initial recognition and measurement of goodwill and other
intangible assets recorded in connection with a business combination. The provisions of
SFAS 141 apply to all business combinations initiated after June 30, 2001 and to all
business combinations accounted for by the purchase method that are completed after June
30, 2001.

In addition, in June 2001 the FASB issued
SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"),
which establishes the accounting for goodwill and other intangible assets following their
recognition. SFAS 142 applies to all goodwill and other intangible assets whether acquired
singly, as part of a group, or in a business combination. SFAS 142 also applies to
goodwill recognized in accordance with SOP 90-7. The new pronouncement provides that
goodwill should not be amortized but should be tested for impairment annually using a
fair-value based approach. In addition, SFAS 142 provides that intangible assets other
than goodwill should be amortized over their useful lives and reviewed for impairment in
accordance with existing guidelines. SFAS 142 will become effective for the Company
beginning on January 1, 2002. The Company's application of fresh-start accounting, in
connection with the Company's emergence from bankruptcy is expected to result in goodwill,
however, the amount of goodwill has not currently been determined. See "Note 23 -
Subsequent Events" in the accompanying consolidated financial statements. The Company
has not determined the impact that the adoption of this accounting standard will have on
its consolidated financial statements.

In 1998, the American Institute of
Certified Public Accountants issued Statement of Position 98-5 "Reporting on the
Costs of Start-up Activities" ("SOP 98-5"). This statement requires costs
of start-up activities and organization costs to be expensed as incurred. The statement
was effective for financial statements for fiscal years beginning after December 15,
1998. During the first quarter of 1999, the Company adopted the provisions of SOP 98-5,
which resulted in a cumulative effect of a change in accounting principle charge of
approximately $12.8 million.

In June 1998, the FASB issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities"
("SFAS 133"). Under SFAS 133, all derivatives are required to be recognized
in the balance sheet at fair value. Gains or losses from changes in fair value would be
recognized in earnings in the period of change unless the derivative is designated as a
hedging instrument. In June 1999, the FASB issued SFAS No. 137, which amended SFAS 133,
delaying its effective date to fiscal years beginning after June 15, 2000. The Company
does not currently hold any derivative instruments nor does it engage in hedging
activities.

F-14

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

(p)Financial Statement Preparation and
Presentation

The preparation of financial statements
in conformity with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amounts of assets
and liabilities, the disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the
reporting period. Significant estimates include determination of third-party payor
settlements, allowances for doubtful accounts, self-insurance obligations and loss
accruals. Actual results could differ from those estimates. Certain amounts in the 2000
and 1999 consolidated financial statements and notes thereto have been reclassified to
conform to the 2001 presentation, however, there was no impact to the previous reported
net loss or stockholders' deficit amounts.

(4)  Restructuring Costs

During 2001, the Company recorded
restructuring costs of $1.1 million in its software development division. The
restructuring plan included reductions of staff and other overhead expenses and a
streamlining of the management structure.

In the first quarter of 1999, the Company
initiated a corporate restructuring plan focused on reducing the operating expenses of its
United States operations. The restructuring plan included the termination of approximately
3,000 employees, primarily in its rehabilitation and respiratory therapy services
operations, and the closure of approximately 23 divisional and regional offices.
Relocation of the management of the Company's medical supply subsidiary and temporary
medical staffing services subsidiary to the Company's corporate headquarters in
Albuquerque, New Mexico was also included. The restructuring charge consisted of
approximately $9.1 million related to employee terminations, approximately $1.4 million
related to lease termination costs and $0.9 million related to asset disposals or
write-offs. As of December 31, 1999, the restructuring plan was complete. During 2000, the
Company reversed approximately $1.1 million of reserves related to the restructuring plan
because the reserves were considered no longer necessary.

During 1999, the Company recorded
financial restructuring costs of approximately $16.0 million, primarily professional fees,
related to the Company's activities in response to the defaults under the Senior Credit
Facility, the 9-3/8% Subordinated Notes and the 9-1/2% Subordinated Notes and in
preparation for its filing for protection under chapter 11 of the U.S. Bankruptcy Code.

(5)  Acquisitions

The effects of the Company's acquisitions
during 2001, 2000 and 1999, individually and in the aggregate, are immaterial to the
operating results of the Company, and therefore, pro forma information is not provided.

F-15

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

**(6)  Property and
Equipment**
     The Company recorded an impairment of property and equipment
of approximately $11.0 million during the fourth quarter of 2001 and a write-down of
approximately $26.6 million during 2001 of the two buildings on the corporate campus which
are now held for sale.  The change in the net value of the property and equipment is
represented by the table below.

Property and
equipment at December 31 consisted of the following (in thousands):

2001
    
    2000Land
    $                       16,153
    
    $                      17,841Buildings
    and improvements
    21,433
    
    56,046Equipment
    94,904
    
    113,050Leasehold
    improvements
    22,496
    
    33,233Construction
    in progress
    6,329
    
    19,341Total
    161,315
    
    239,511Less
    accumulated depreciation
    (28,099
    )
    (59,226
    )Property
    and equipment, net
    $                     133,216
    
    $                    180,285============
    
    ============


(7)  Impairment of Long-Lived Assets and Assets Held for Sale

(a)  Impairment of Long-Lived Assets

The Balanced Budget Act of 1997
established, among other things, a new Medicare PPS for skilled nursing facilities. PPS
became effective for approximately 25% of the Company's facilities on July 1, 1998,
and for the Company's remaining facilities on January 1, 1999. The Company's revenues
from its Inpatient Services Division, Rehabilitation and Respiratory Therapy Services
Division and Pharmaceutical and Medical Supply Services Division were significantly and
adversely impacted by the reduction of the federally established reimbursement rates. In
the first quarter of 1999, the Company became aware that these reductions were expected to
have a material adverse impact on net revenues in 1999 and the decline was other than
temporary. This analysis served as an indication to the Company that the carrying values
of the long-lived assets of its Inpatient Services Division, Rehabilitation and
Respiratory Therapy Services Division and its Pharmaceutical and Medical Supply Services
Division were impaired.

During the second quarter of 1999, the
Company revised its projections of future cash flows for its various business units due to
the fact that actual operating results were below expectations. The significant write-down
of goodwill and other long-lived assets is the result of lower cash flows experienced by
the Company due to the continued adverse impact of PPS on the level of Medicare
reimbursement and occupancy and the demand for the Company's rehabilitation and
respiratory therapy and pharmaceutical and medical supply services. Additionally, certain
of the United Kingdom facilities had not achieved profitability targets established upon
their acquisition.

F-16



---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

As events warrant, the Company evaluates its
facilities for impairment through the review of historical results, creation of future
projected cash flows and awareness of the future reimbursement and regulatory environment
in which the Company operates. During the fourth quarter of 2000, the Company identified
several factors that adversely impacted the future projections of net operating income
(loss) and net cash flows for certain facilities, primarily in the Inpatient Services
division of the Company. These factors were: (i) the continuation of the tight labor
market that increased the Company's use of contract and temporary staffing, (ii)
additional regulatory pressures within the healthcare industry, as a whole, including new
laws in California that specify the labor dollars spent on patient care and increased the
operating costs at a significant number of the Company's facilities, and (iii) additional
staffing and other overhead within the Company's long-term care division to respond to
survey results. During 2000, the Inpatient Services Division, which operates long-term
care facilities, recognized an impairment of $189.3 million related to 141 of the 303
facilities it operated in the United States. The impairment was primarily due to the
decrease of revenues as compared with profitability projections for each facility.

During the fourth quarter of 2001, the
Company reviewed its projections for the future earnings of its businesses as actual
results were below initial forecasts. In connection with the review, the Company recorded
an impairment charge of approximately $18.8 million to reduce to estimated fair value its
investment in goodwill and certain other long-lived assets within the inpatient services
and software development divisions. The write-down of $14.5 to the inpatient services
business was primarily the result of decreased future projections of net operating income
(loss) and net cash flows due to lower revenue projections. The write down of $4.3 million
to the software development division relates to the business' longer than expected
time-to-market of certain of its products which adversely impacted the division's cash
flow projections.

F-17

---



December 31, 2001

The following is a summary of the
impairment loss by segment for the years ended December 31 (in thousands):

Goodwill
    
    Property and
      Equipment
    
    OtherAssets
    
    Total2001:Inpatient
    Services
    $          7,797
    
    $            6,685
    
    $                   -
    
    $         14,482Other
    Operations
    -
    
    4,343
    
    -
    
    4,343Total
    $          7,797
    
    $          11,028
    
    $                   -
    
    $         18,825======
    
    =======
    
    =======
    
    =======Goodwill
    
    Property and
      Equipment
    
    OtherAssets
    
    Total2000:Inpatient
    Services
    $      130,148
    
    $          58,712
    
    $               448
    
    $       189,308Pharmaceuticals
    and Medical Supply Services
    -
    
    42
    
    -
    
    42Other
    Operations
    1,000
    
    953
    
    13
    
    1,966Total
    $      131,148
    
    $          59,707
    
    $               461
    
    $       191,316======
    
    =======
    
    =======
    
    =======Goodwill
    
    Property and
      Equipment
    
    OtherAssets
    
    Total1999:Inpatient
    Services
    $      192,459
    
    $          88,852
    
    $         13,701
    
    $       295,012Rehabilitation
    and Respiratory Therapy
    49,529
    
    11,005
    
    11
    
    60,545Pharmaceuticals
    and Medical Supply Services
    29,133
    
    2,417
    
    -
    
    31,550International
    Operations
    29,322
    
    31,959
    
    -
    
    61,281Other
    Operations
    5,327
    
    1,794
    
    1,940
    
    9,061Total
    $      305,770
    
    $        136,027
    
    $         15,652
    
    $       457,449=======
    
    =======
    
    =======
    
    =======


(b)Assets Held for Sale

SFAS 121 requires that long-lived
assets held for disposal be carried at the lower of carrying value or fair value less
costs of disposal, once management has committed to a plan of disposal.

Inpatient Facilities

During the year ended December 31, 2001,
the Company divested 43 skilled nursing facilities. The net revenues and net operating
losses for the year ended December 31, 2001 for these 43 facilities were approximately
$85.3 million and $7.5 million, respectively. The aggregate net loss on disposal during
the year ended December 31, 2001 for these divestitures was approximately $1.4 million
recorded in (gain) loss on sale of assets, net, and $23.6 million which was included in
reorganization costs, net, in the Company's 2001 consolidated statements of losses.

As of December 31, 2001, the Company had
identified seven skilled nursing facilities with 1,021 licensed beds for disposal. The
Company had previously recorded losses of $7.5 million on certain of these assets. The net
revenues and aggregate net operating losses for the year ended December 31, 2001 for the

F-18

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

seven skilled nursing facilities were $38.7 million and $1.0 million,
respectively.   As of March 1, 2002, the Company has identified a total of 13 skilled
nursing facilities with 1,764 licensed beds for disposal.

During the year ended December 31, 2000,
the Company divested 49 skilled nursing facilities and 20 assisted living facilities. The
net revenues and net operating losses for the year ended December 31, 2000 for these
69 facilities were approximately $132.3 million and $9.0 million, respectively. The
aggregate net loss on disposal during the year ended December 31, 2000 for these
divestitures was approximately $1.7 million recorded in (gain) loss on sale of assets,
net, and $21.1 million which was included in reorganization costs, net, in the Company's
2000 consolidated statement of losses. In 2000, the Company decided not to divest 23
skilled nursing facilities and six outpatient rehabilitation facilities. A reversal of
approximately $34.8 million was recorded in reorganization costs, net, in the Company's
2000 consolidated statement of losses.

Of the 20 assisted living facilities
identified above, the Company sold 16 assisted living facilities for a total consideration
of $67.3 million in 2000. The cash consideration received was approximately $1.2 million,
and the Company received a note receivable of approximately $0.5 million. In addition, the
aggregate debt, capital leases and other liabilities assumed by the purchaser totaled
approximately $65.6 million. The Company previously recorded the anticipated loss on the
sale of approximately $71.4 million in 1999. During 2000, the Company reversed
approximately $1.5 million of the loss recorded in 1999. The reversal of the loss is
recorded in (gain) loss on sale of assets, net, in the Company's 2000 consolidated
statement of losses. During 2000, the Company divested four assisted living facilities. No
material cash consideration was received for these facilities, but the Company was
released from approximately $6.9 million of aggregate debt. The Company recorded a gain of
$4.9 million, net, in (gain) loss on sale of assets, net, in the Company's 2000
consolidated statement of losses. In addition, the Company transferred its two remaining
assisted living facilities from its Other Operations segment to its Inpatient Services
segment. In December 2000, the Company sold a parcel of land for cash consideration of
approximately $1.4 million. The land was received in the sale of the assisted living
facilities.

In December 1999, the Company divested
eight assisted living facilities in which it had held a ten-percent equity interest. The
Company managed these eight facilities until divesting them in December 1999. The cash
consideration received from this transaction was approximately $3.7 million. In addition,
the Company received parcels of land valued at approximately $9.2 million in this
transaction. The aggregate net loss on this transaction was approximately $31.2 million of
which approximately $15.8 million was recorded in (gain) loss on sale of assets, net, in
1999.

During 1999, the Company sold three
skilled nursing facilities. The Company did not receive any cash consideration from these
sales. The purchasers assumed secured debt of $10.7 million related to these sales. The
aggregate net revenues and aggregate net operating losses before management charges in
1999 for these facilities were approximately $9.5 million and approximately $2.6 million,
respectively. The Company recorded an aggregate net gain of approximately $6.5 million on
these sales in 1999.

During 1999, 11 skilled nursing facility
leases expired and were not renewed. The aggregate net revenues and aggregate net
operating losses before management charges in 1999 for these facilities were approximately
$13.4 million and approximately $0.1 million, respectively. The Company recorded an

F-19

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

aggregate net loss of approximately $3.8 million in 1999 primarily
related to the write-off of the carrying amount of the related building and leasehold
improvements, equipment and goodwill.

During 1999, through mutual agreements
with the lessors, the Company terminated 35 skilled nursing facility leases. The Company
recorded an aggregate net loss of approximately $5.8 million, primarily related to the
write-off of the carrying amount of building and leasehold improvements, equipment and
goodwill. The aggregate net revenues and aggregate net operating losses before management
charges in 1999 for these facilities were approximately $71.6 million and approximately
$12.2 million, respectively.

In addition during December 1999, the
Company sold a majority interest in four assisted living facilities housed on three
campuses, one of which included a skilled nursing facility. The Company managed these
facilities on behalf of the purchaser during the first quarter of 2000. The cash
consideration received from this transaction was approximately $0.4 million. The Company
also obtained a note receivable of approximately $1.0 million from the purchaser. The
aggregate debt, capital leases, notes payable and other liabilities assumed by the
purchaser totaled approximately $21.0 million. The aggregate net loss on this transaction
was approximately $37.2 millionof which approximately $9.1 million was recorded in
(gain) loss on sale of  assets, net, in 1999.

International Operations

During the first quarter of 2000, the
Company began soliciting offers to purchase its international operations. The Company
recorded a loss of approximately $168.6 million in 2000 to reduce the carrying value of
its international operations to the Company's estimate of selling value less selling
costs. The charge was recorded in reorganization costs, net, in the Company's 2000
consolidated statement of losses.

The Company's long-term care operations
in Spain were sold for approximately $7.6 million in October 2000. The Company also sold
18 pharmacies in the United Kingdom for approximately $14.4 million in the first and
second quarters of 2000.

The Company sold its remaining operations
in the United Kingdom, consisting of 146 inpatient facilities with 8,326 licensed beds, in
February 2001. No material cash consideration was received for these operations, but the
Company was released from approximately $112.9 million of aggregate debt, capital lease
obligations, notes payable and other liabilities upon the sale. The Company's operations
in Australia were liquidated in July 2001 and the Company received liquidation proceeds of
approximately $0.9 million. The Company sold its long-term care and pharmacy operations in
Germany in April 2001 and received proceeds of approximately $3.5 million.

Ancillary Service Operations

In 2000, the Company began pursuing the
disposition of its respiratory therapy business. The Company recorded losses of
approximately $6.3 million and $0.4 million in 2000 and 2001, respectively, to reduce the
carrying value of its respiratory therapy business to the Company's estimate of selling
value less selling costs. The charges were recorded in reorganization costs, net, in the
Company's consolidated statements of losses. SunCare's net revenues and net operating loss
before management charges for the year ended

F-20



---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001



December 31, 2001 were $14.8 million and $1.4 million, respectively. In
March 2002, the Company sold certain assets used in its respiratory therapy business for
an aggregate of $0.9 million cash.

During 2000, the Company decided to sell
its SunChoice medical supplies operations. The Company recorded losses of approximately
$59.4 million and $2.2 million in 2000 and 2001, respectively, to reduce the carrying
value of its medical supplies operations to the Company's estimate of the selling value
less selling costs. The charges were recorded in reorganization costs, net, in the
Company's consolidated statement of losses. SunChoice's net revenues and net operating
loss before management charges for the year ended December 31, 2000 were $61.0 million and
$3.2 million, respectively. In January 2001, the Company sold the assets of SunChoice to
Medline Industries, Inc. The Company received proceeds of $16.6 million in exchange for
the SunChoice assets.

During the fourth quarter of 1999, the
Company divested its hospice operations in the United States. The Company received cash
consideration of approximately $0.2 million from this transaction. The aggregate net
revenues and the aggregate net losses before management charges in 1999 for the hospice
operations were approximately $7.5 million and approximately $1.8 million, respectively.
The loss on this transaction was approximately $7.2 million, which was recorded in 1999.

Other Operations
     In 2001, the Company concluded that it would sell two of its
headquarters buildings in Albuquerque, New Mexico and recorded a loss on assets held for
sale of $26.6 million in reorganization costs, net, in the Company's consolidated
statement of losses. In January 2002, the Company entered into an agreement to sell the
two buildings for approximately $15.3 million. The sale is expected to be completed in
April 2002, although no assurance can be given that the sale will be completed.

During December 1999, the Company also
sold a parcel of land. The cash consideration received from this transaction was
approximately $4.6 million. This transaction resulted in a gain of approximately $0.7
million.

Summary

The following is a summary of the
carrying amounts of assets held for sale at December 31, 2001 and 2000 and the loss on
sales of assets and assets held for sale, net, for each of the years ended December 31,
2001, 2000 and 1999. The loss on sales of assets recorded subsequent to the Company's
chapter 11 filings in the years ended December 31, 2001, 2000 and 1999 included
approximately $15.3 million, $310.1 million and $7.1 million, respectively, recorded as a
reorganization cost in the Company's consolidated statements of losses.

F-21

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

|                              | Carrying
    Amounts 
|----------------------------- | ---------------------
|                              | 2001                 
|                              |                      
|International
    operations  | $                   -
|Other
    non-core businesses | 18,158               
|Total                         | $         18,158     
|                              | =======              



Loss
    Amount2001
    
    2000
    
    1999Assisted
    living facilities
    $               5
    
    $      76,055
    
    $     41,667Rehabilitation
    hospitals and other inpatient facilities
    13,367
    
    35,431
    
    15,132International
    operations
    (47
    )
    110,154
    
    -Other
    non-core businesses
    1,117
    
    67,020
    
    28,959Total
    $      14,442
    
    $    288,660
    
    $     85,758======
    
    ======
    
    ======


(8)  Debtor-in-Possession Financing

On October 14, 1999, the Company entered
into a Revolving Credit Agreement with CIT/Business Credit, Inc. and Heller Healthcare
Finance, Inc. (the "DIP Financing Agreement"). The DIP Financing Agreement
provided for maximum borrowings by the Company of $200 million, subject to certain
limitations. On February 28, 2002 the Company's DIP Financing Agreement was repaid in
full. The Company entered into new loan agreements to replace the DIP Financing Agreement.
See "Note 23 - Subsequent Events."

Interest accrued on the principal amount
outstanding under the DIP Financing Agreement at a per annum rate of interest equal to the
Alternate Base Rate ("ABR") (Chase Manhattan) plus 0.25% or the London Interbank
Borrowing Offer Rate ("LIBOR") plus 2.75% and was payable in arrears on each
Interest Payment Date. The one-month LIBOR was approximately 1.9% at December 31, 2001 and
6.6% at December 31, 2000. In the event of an Event of Default, interest accrued on the
principal amount of the loans outstanding at a rate per annum equal to the ABR plus 2.0%
and was payable daily. The ABR was approximately 4.8% and 9.4% at December 31, 2001 and
2000, respectively.

At December 31, 2001, approximately $96.9
million was available under the DIP Financing Agreements of which the Company had borrowed
approximately $54.5 million and had issued letters of credit outstanding of approximately
$38.4 million. Peak borrowings under the agreement during 2001 and 2000 were $88.8 and
$86.1 million, respectively, with an effective interest rate during 2001 and 2000 of
approximately 7.7% and 9.4%, respectively.

F-22

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

(9)  Long-Term Debt

As a result of the chapter 11 filing,
substantially all short and long-term debt at the Filing Date were classified as
"liabilities subject to compromise" in the Company's consolidated balance sheets
in accordance with SOP 90-7. Through December 31, 2001, no principal had been paid or
interest accrued on prepetition obligations since the Filing Date, except for amounts
related to certain Industrial Revenue Bonds, a fully-secured mortgage, certain capital
equipment leases and a nominal amount related to a promissory note.

Long-term debt at December 31 consisted
of the following (in thousands):

2001
    
    2000Senior Credit Facility:Revolving Credit Facility
    (see below)
    $           437,066
    (1)
    $        433,319
    (1)Credit Facility Term Loans
    (see below)
    358,981
    (1)
    358,981
    (1)9-1/2% Senior Subordinated Notes due 2007
    250,000
    (1)
    250,000
    (1)9-3/8% Senior Subordinated Notes due 2008
    150,000
    (1)
    150,000
    (1)Convertible Subordinated Debentures due 2004,
    interest at 6.0% per annum
    83,300
    (1)
    83,300
    (1)DIP Financing Agreement
    54,586
    
    67,027Mortgage notes payable due at various dates
    through 2014, interest at rates
       from 8.0% to 11.4%, collateralized by various facilities
    53,102
    (2)
    53,517
    (2)Mortgage notes payable in pound sterling due
    at various dates in 2015 and
       2016, interest at 9.5% per annum, collateralized by various facilities
    in the
       United Kingdom
    -
    (5)
    31,354
    (5)Mortgage notes payable in Australian dollars
    due at various dates through
       2001, interest from 7.6 % to 8.04% collateralized by various facilities
    in
       Australia
    -
    (5)
    12,980
    (5)Industrial Revenue Bonds
    8,365
    (3)
    8,785
    (3)Mortgage notes payable in German marks due at
    various dates through 2003,
       interest at rates from 6.3% to 6.8%, collateralized by various
    facilities in
       Germany
    -
    (5)
    7,978
    (5)Senior Subordinated Notes due 2002, interest
    at 11-3/4% per annum
    6,161
    (1)
    6,161
    (1)Convertible Subordinated Debentures due 2003,
    interest at 6-1/2% per annum
    1,382
    (1)
    1,382
    (1)Other long-term debt
    30,947
    (4)
    29,427
    (4)Total long-term debt
    1,433,890
    
    1,494,211Less long-term debt subject to compromise
    (1,355,655
    )
    (1,353,961
    )Less amounts due within one year
    (54,975
    )
    (86,039
    )Long-term debt, net of current portion
    $             23,260
    
    $          54,211=========
    
    ========


Long-term debt at December 31, 2001
includes amounts owed under the DIP Financing Agreement, one fully secured mortgage note
payable, certain Industrial Revenue Bonds and other debt.

Long-term debt at December 31, 2000
includes amounts owed under the DIP Financing Agreement, one fully secured mortgage note
payable, certain Industrial Revenue Bonds and other debt, of which approximately $85.4
million was assumed by the purchaser in a Bankruptcy Court approved sales transaction
subsequent to December 31, 2000 and the Company's foreign debt obligations.

F-23

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

|(1) | Classified as "liabilities subject to compromise" in the
    Company's consolidated balance sheets as of December 31, 2001 and December 31, 2000.                                                            
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                              
|(2) | Approximately
    $46,023 and $46,214 are classified as "liabilities subject to compromise" in the
    Company's consolidated balance sheets as of December 31, 2001 and December 31, 2000,
    respectively.

|(3) | Approximately
    $8,365 and $8,620 are classified as "liabilities subject to compromise" in the
    Company's consolidated balance sheets as of December 31, 2001 and December 31, 2000,
    respectively.  
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                              
|(4) | Approximately $14,377 and
    $15,984 are classified as "liabilities subject to compromise" in the
    Company's consolidated balance sheets as of December 31, 2001 and December 31, 2000,
    respectively.
|    |                                                                                                                                                                                                              
|(5) | International operations related to these mortgages were sold during 2001.                                                                                                                                   

The scheduled maturities of long-term debt as of December 31 (not
including that which is subject to compromise) is as follows (in thousands):

2002
    $                  54,9752003
    1,4642004
    1,5062005
    7,2002006
    3,516Thereafter
    9,574$                  78,235============


(10)  Commitments and Contingencies

(a)  Lease Commitments

The Company leases real estate and
equipment under cancelable and noncancelable agreements. Under the Bankruptcy Code, the
Company could generally elect to assume or reject executory contracts, including lease
agreements, prior to confirmation of the Company's Plan of Reorganization. Future minimum
lease payments under real estate leases and equipment assumed by the Company are as
follows for the years ended December 31(in thousands):

F-24

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CapitalLeases
    
    OperatingLeases2002
    $             1,335
    
    $         136,4682003
    784
    
    132,7782004
    597
    
    129,6862005
    235
    
    117,1522006
    248
    
    90,733Thereafter
    1,440
    
    287,380Total
    minimum lease payments
    4,639
    
    $         894,197Less
    amount representing interest
    (1,194
    )
    =========Present
    value of net minimum lease payments under capital leases
    $             3,445=========


Rent expense under operating leases
totaled approximately $166.1 million, $237.6 million and $267.5 million for the years
ended December 31, 2001, 2000 and 1999, respectively, and are included in operating costs.
In 2002, the
Company entered into a purchase agreement for the sale of two of the buildings on its
corporate campus.  The sale, expected to be completed in April 2002, is for
approximately $15.3 million.  The purchase agreement includes the leaseback of one of
the buildings and part of an adjacent parking structure for an initial period of ten
years, with an option to extend the lease for two five-year periods.  The cost of the
initial ten-year term is approximately $7.5 million.  There is no assurance that the
sale of the buildings will be completed.

(b)  Insurance

In the past, the Company has insured
certain risks, including general and professional liability and workers' compensation
liability, through the use of self-funded retrospectively rated premium, self-funded and
other hybrid policies which varied by the states in which the Company operated.

In January 2000, the Company established
a self-funded insurance program for general and professional liability claims up to a base
amount of $1.0 million per claim and $3.0 million aggregate per location and obtained
excess insurance for coverage above these levels. Prior to January 1, 2000, the maximum
loss exposure with respect to the third-party insurance policies was $100,000 per claim
for general and professional liability. The aggregate annual loss exposure with respect to
the general and professional liability policies was unlimited in 1999 and $8.0 million in
1998. In 2001 and for 2000, there was an unlimited aggregate loss exposure under the per
claim retention on these types of claims. An actuarial analysis prepared in the current
year determined the expected losses under this retention level to be approximately $39.0
million and $44.2 million in 2001 and 2000, respectively. Annual

F-25

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

reviews of the
actuarial determinations are performed to determine variations from this expected loss
amount, and any adjustments are made to the reserve at that time. Reserves for estimated
settlements for general and professional liability under the per claim retention level,
including incurred but not reported losses, are provided on an undiscounted basis in the
period that the event occurred. The reserve for such risks is approximately $81.6 million,
of which $21.1 million is subject to compromise and $32.9 million, of which $4.6 million
is subject to compromise as of December 31, 2001 and 2000, respectively. Provisions for
such risks were approximately $58.1 million, $35.3 million and $23.9 million for the years
ended December 31, 2001, 2000 and 1999, respectively, and are included in operating
expenses and corporate general and administrative expenses. During 2000, the Company
pre-funded $22.2 million for general and professional liability claims into a cash
collateral trust account held by the Company's insurance carrier. The Company funded an
additional $5.0 million into the trust account in 2001. The combined pre-funding will be
used to pay claims for policy years 2000 through 2002.  Claims paid from the trust
account were immaterial in 2000 and were $5.8 million for the year ended December 31,
2001.

For the year ended December 31, 1999, the
workers' compensation insurance was a guaranteed cost program, and thus, after payment of
the premium, risk was fully transferred to the third party insurance carrier. Subsequent
to December 31, 1999, the Company purchased workers' compensation insurance for all
states, except Washington, Ohio, and West Virginia where the Company is required to
subscribe to those state and/or self-insured programs. The 2001 and 2000 policies provide
coverage above $250,000 per claim. An analysis prepared in the current year determined the
undiscounted expected losses and costs under this retention level to be approximately
$35.5 million as of December 31, 2001 and $36.0 million as of December 31, 2000. The
Company has pre-funded cash collateral trust accounts with its insurance carrier in the
amount of $26.8 million and $32.4 million as of December 31, 2001 for the 2001 and 2000
policy years, respectively. Claims paid from the 2001 policy year trust account were $4.7
million, and claims paid from the 2000 policy year trust account were $12.5 million and
$5.7 million as of December 31, 2001 and 2000, respectively. The accounts were established
to fund the Company's ultimate estimated exposure and will be adjusted retrospectively
based on revisions to the estimates. For years prior to 1998 in which the Company carried
various forms of workers' compensation insurance, aggregate losses are provided on a fully
developed basis, including any incurred but not reported claims. The reserve for such
workers' compensation risks is approximately $29.5 million and $14.2 million as of
December 31, 2001 and 2000, respectively. Provisions for such risks totaled approximately
$54.9 million, $27.4 million and $30.9 million for the years ended December 31, 2001, 2000
and 1999, respectively, and are included in operating expenses and corporate general and
administrative expenses.

As of December 31, 2001, the Company had
construction commitments under various contracts of approximately $0.7 million. These
items consisted primarily of contractual commitments to improve existing facilities.
(d)  Litigation

The Company is a party to various legal actions and
administrative proceedings and subject to various claims arising in the ordinary course of
business. See "Note 18 - Other Events (a)."

(e)  Employment Agreement

F-26

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

The Company entered into an Employment
Agreement with Richard K. Matros on February 28, 2002. The agreement terminates on
November 6, 2005, although the term is automatically extended for an additional year on
November 6, 2004, and on each anniversary thereafter, unless the Company or Mr. Matros
provides notice of non-extension. Pursuant to the agreement, Mr. Matros will receive an
annual base salary of $650,000 that is subject to annual merit increases as determined by
the Board of Directors. In addition to the base salary, Mr. Matros is entitled to an
annual bonus for each fiscal year in which the Company achieves or exceeds certain
financial performance targets. If the targets are achieved, the bonus could be 50%, 75% or
100% of base salary, depending upon how much the targets are exceeded. Mr. Matros was also
awarded 150,000 shares of restricted common stock and an option to purchase 150,000 shares
of common stock on February 28, 2002. The restricted stock will vest as to 60,000 shares
on February 28, 2003 and 30,000 shares on each of February 28, 2004, 2005 and 2006.

Mr. Matros' Employment Agreement provides
that in the event of his termination of employment by the Company without Good Cause, by
Mr. Matros for Good Reason (each as defined in the Employment Agreement), or upon the
expiration of the term of the agreement following the Company's notice of non-extension,
then Mr. Matros would be entitled to a lump sum severance payment in the amount equal to
the greater of: (i) the unpaid and unearned portion of his base salary for the remainder
of the term of the agreement, or (ii) two year's base salary or, in the event such
termination occurs on or within two years following the date of a change of control (as
defined in the Employment Agreement), then three year's base salary.

The Company is currently in the
process of documenting employment agreements with Kevin W. Pendergest, William A. Mathies
and Heidi J. Fisher.

(f)  Severance Agreements

The Company has entered into Severance
Agreements with Mr. Schelling and Mr. Murphy pursuant to which they would receive
severance payments in the event of their Involuntary Termination of employment (as defined
in the Agreements). The severance payments would be equal to 24 months of their
then-current salary. In addition to the severance payments, they would have the right to
participate for a defined period of time in the medical, dental, health, life and other
fringe benefit plans and arrangements applicable to them immediately prior to termination.
Severance payments would be made in a lump sum or over a period of time at the discretion
of the Company. If so elected, the Company could make the severance payments over time,
which would release the executive from existing non-compete restrictions. Under this
option, if the executive finds employment during the severance period, his severance
payment will be reduced by the amount of the salary earned by him, up to a maximum of 50%
of the aggregate severance payments. Otherwise, the payments could be made in a lump sum
and the executive would remain subject to certain competitive prohibitions.



F-27

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

participate for a defined period of time in the medical, dental,
health, life and other fringe benefit plans and arrangements applicable to him immediately
prior to termination. His severance payment would be made in a lump sum.

(11)  Income Taxes

Income tax expense (benefit) on losses
before extraordinary loss consists of the following for the years ended December 31
(in thousands):

2001
    
    2000
    
    1999Current:Federal
    $                       -
    
    $                       -
    
    $             (4,913
    )State
    321
    
    256
    
    120Foreign
    -
    
    -
    
    41321
    
    256
    
    (4,752
    )Deferred:Federal
    -
    
    -
    
    4,076State
    -
    
    -
    
    837-
    
    -
    
    4,913Total
    $                  321
    
    $                  256
    
    $                  161==========
    
    ==========
    
    ==========


Actual tax expense differs from the expected tax expense on losses
before extraordinary loss which is computed by applying the U.S. Federal corporate income
tax rate of 35% to losses before income taxes of the Company as follows for the years
ended December 31 (in thousands):

2001
    
    2000
    
    1999Computed expected tax
    benefit
    $          (24,191
    )
    $     (190,909
    )
    $     (381,254
    )Adjustments in income taxes
    resulting from:Amortization of
    goodwill
    3,016
    
    2,067
    
    5,036Impairment loss
    3,785
    
    31,641
    
    94,978Increase in
    valuation allowance
    99,508
    
    88,889
    
    311,708Legal and
    regulatory matters
    8,105
    
    3,261
    
    -(Loss reversal)
    loss on planned asset dispositions
    (93,360
    )
    81,257
    
    (21,236
    )State income tax expense
    (benefit), net of Federal
        income tax benefit
    (1,716
    )
    (18,795
    )
    (12,863
    )Other
    5,174
    
    2,845
    
    3,792$                 321
    
    $             256
    
    $             161=========
    
    ========
    
    ========


F-28

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

Deferred tax assets (liabilities) at
December 31 consisted of the following (in thousands):

2001
    
    2000Deferred
    tax assets:Accounts
    and notes receivable
    $          28,586
    
    $            72,679Accrued
    liabilities
    77,910
    
    56,655Property
    and equipment
    49,021
    
    71,232Intangible
    assets
    76,499
    
    69,120Carryforward
    of deductions limited by Internal Revenue Code
          Section 382
    6,250
    
    6,250Write-down
    of assets held for sale
    41,473
    
    69,967Deferred
    income
    -
    
    1,374Partnership
    investments
    2,655
    
    4,229Alternative
    minimum tax credit
    5,753
    
    7,873Jobs
    and other credit carryforwards
    6,146
    
    6,517Capital
    loss carryforwards
    116,315
    
    19,272State
    net operating loss carryforwards
    42,181
    
    44,570Federal
    net operating loss carryforwards
    222,129
    
    162,061United
    Kingdom trading loss carryforwards
    -
    
    14,846United
    Kingdom capital loss carryforwards
    -
    
    1,142Property
    and equipment attributable to United Kingdom operations
    -
    
    3,851Other
    1,992
    
    4,323676,910
    
    615,961Less
    valuation allowance:Federal
    (561,352
    )
    (492,472
    )State
    (114,070
    )
    (99,914
    )United
    Kingdom
    -
    
    (21,854
    )(675,422
    )
    (614,240
    )Total
    deferred tax assets
    1,488
    
    1,721Deferred
    tax liabilities:Changes
    in certain subsidiaries' methods of accounting for income taxes
    (1,488
    )
    (1,721
    )(1,488
    )
    (1,721
    )Deferred
    taxes, net
    $                    -
    
    $                      -=========
    
    ==========


The Company has Federal net operating
loss ("NOL") carryforwards of $634.7 million with expiration dates from 2004
through 2021. Various subsidiaries have state NOL carryforwards totaling $926.3 million
with expiration dates through the year 2021. In addition, the Company has capital loss
carryforwards of $332.3 million, of which $50.6 million will expire in 2004 and $281.7
million will expire in 2006. The alternative minimum tax credit carryforward of $5.8
million has no expiration date. The $6.1 million of other tax credit carryforwards will
expire in years 2005 through 2019. The compromise of debt resulting from the Company's
approved plan of reorganization will result in a significant reduction in these tax loss
and tax credit carryforwards. In addition, the change in ownership in the approved plan of
reorganization will materially impact the Company's ability to utilize any remaining tax
loss and tax credit carryforwards. The actual amount of reduction in tax loss and tax
credit carryforwards, and the limitation on any remaining carryforwards, has not been
determined.

F-29

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

In 2001 and 2000, the Company increased
the valuation allowance by $83.0 million and $88.9 million, respectively, to fully reserve
for deferred tax assets which may not be realized. The deferred tax assets and the
valuation allowance related to the United Kingdom operations were written off in 2001 in
connection with the Company's sale of these operations.

(12)  Supplementary Information Relating to Statements of Cash Flows

Supplementary information for the
consolidated statements of cash flows is set forth below for the years ended
December 31 (in thousands):

2001
    
    2000
    
    1999Cash paid
    during the year ended December 31 for:Interest,
    net of $69, $82 and $1,124 capitalized during
       2001, 2000 and 1999, respectively
    $          17,589
    
    $         29,826
    
    $        49,710Income
    taxes refunded
    (931
    )
    (3,022
    )
    (47,974
    )


The Company's acquisitions during 2001,
2000 and 1999 consisted of the following for the years ended December 31 (in
thousands):

2001
    
    2000
    
    1999Fair value
    of assets acquired
    $                    -
    
    $         29,475
    
    $            6,781Liabilities
    assumed
    -
    
    (28,501
    )
    (1,050
    )Cash
    payments made, net of cash received from others
    $                    -
    
    $              974
    
    $            5,731==========
    
    =========
    
    ==========


(13)  Fair Value of Financial Instruments

The estimated fair values of the
Company's financial instruments as of December 31 are as follows (in thousands):

2001
    2000CarryingAmount
    Fair Value
    Carrying
        Amount
    Fair ValueCash and
    cash equivalents
    $      50,649
    $      50,649
    $       37,589
    $    37,589Long-term
    debt including current portion and amounts
       subject to compromise:Practicable
    to estimate fair value
    1,433,890
    371,155
    1,494,211
    550,161Convertible
    Trust Issued Preferred Securities
       (CTIPS)
    296,101
    -
    296,101
    -


F-30

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

The cash and cash equivalents carrying
amount approximates fair value because of the short maturity of these instruments. The
fair value of the Company's long-term debt, including current maturities and amounts
subject to compromise, and the CTIPS was estimated based on quoted market prices and
information received from an international investment banking firm that is experienced
with such securities.

(14)  Convertible Trust Issued Preferred Securities

In May 1998, a statutory business trust,
all of whose common securities are owned by the Company, issued $345.0 million of 7.0%
Convertible Trust Issued Preferred Securities ("CTIPS") with a liquidation
amount of $25.00 per CTIP. Each CTIP was convertible into 1.2419 shares of the Company's
common stock (equivalent to a conversion price of $20.13 per share). The CTIPS holders
were entitled to receive cumulative cash distributions at an annual rate of 7.0%, payable
quarterly. During 2000, approximately $26.9 million of CTIPS were converted into
approximately 1.3 million shares of common stock. During 1999, $22.0 million of CTIPS were
converted into approximately 1.1 million shares of common stock. The Company's 2001 and
2000 statements of losses excluded the dividends as the fair value of the dividends was
immaterial. As a result of the consummation of the Company's Joint Plan of Reorganization
on February 28, 2002, all of the CTIPS were cancelled without any recovery to the CTIP
holders.

(15)  Capital Stock

(a)  Stock Option Plans

The Company previously had stock option
plans for certain employees, officers, consultants and non-employee directors of the
Company. Awards made under the plan could be in the form of stock options, stock
appreciation rights, stock awards, performance share awards or other stock-based awards.
The stock option plans were terminated upon the consummation of the Company's Joint Plan
of Reorganization on February 28, 2002 and the outstanding stock options under these plans
were cancelled. The old stock option plans have been terminated and the Company adopted a
new 2002 Management Equity Incentive Plan on February 28, 2002.

As of December 31, 2001, stock options
for 533,592 shares were outstanding and 10,786,803 shares were available for future grant
under the stock option plans. No options were exercised during the year ended December 31,
2001. Exercise prices of the Company's outstanding stock options ranged from $1.06 to
$24.00. No restricted stock awards were made in 2001 or 2000. During January 2000, all
unvested restricted shares held by employees were cancelled and rescinded.

F-31

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

The following is a summary of the status
of the Company's old Stock Option Plans as of December 31 and changes during the
years ended (shares in thousands):

2001
    
    2000
    
    1999Shares
    
    Weighted
    AverageExercise Price
    
    Shares
    
    Weighted
    AverageExercise Price
    
    Shares
    
    Weighted
    AverageExercise PriceOutstanding
    at beginning of year
    856
    
    $                    8.25
    
    1,368
    
    $                  9.00
    
    4,748
    
    $                16.75Granted:Price
    equals fair value
    -
    
    -
    
    -
    
    -
    
    910
    
    1.91Cancelled
    (322
    )
    7.40
    
    (512
    )
    10.14
    
    (4,290
    )
    15.92Outstanding
    at year-end
    534
    
    8.81
    
    856
    
    8.25
    
    1,368
    
    9.00=====
    
    
    
    ======
    
    
    
    =====Options
    exercisable at year-end
    451
    
    10.22
    
    544
    
    11.43
    
    591
    
    15.01=====
    
    
    
    ======
    
    
    
    =====Options
    available for future grant
    10,787
    
    
    
    10,905
    
    
    
    10,393=====
    
    
    
    ======
    
    
    
    =====Weighted
    average fair value of
      options granted during the year
    N/A
    
    
    
    N/A
    
    
    
    $       1.00=====
    
    
    
    ======
    
    
    
    =====


No options were granted in 2001 and 2000.
The fair value of each option granted in 1999 is estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted-average assumptions:

1999Expected
    Life (in years)
    4Risk-free
    Interest Rate
    5.4
    %Expected
    Volatility
    76.0
    %Dividend
    Yield
    -


F-32

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

Had compensation cost for the Company's
2001, 2000 and 1999 option grants been determined consistent with SFAS 123 (see
"Note 3 - Summary of Significant Accounting and Financial Reporting
Policies", which describes that SFAS 123 establishes fair value as the measurement
basis for stock-based awards) the Company's net losses and net losses per share for the
years ended December 31 would approximate the pro forma amounts below (in thousands,
except per share data):

|                          | 2001            | 2000 | 1999         
|------------------------- | --------------- | ---- | -------------
|                          | As Reported     |      | Pro forma    
|                          |                 |      |              
|Net losses                | $     (69,437   | )    | $   (70,648  
|                          | =======         |      | ======       
|Net losses
    per share: |                 |      |              
|Basic                     | $         (1.14 | )    | $       (1.16
|Diluted                   | (1.14           | )    | (1.16        

The effects of applying SFAS 123 in
this pro forma disclosure are not indicative of future amounts. SFAS 123 does not
apply to options granted prior to 1995, and additional option grants in future years are
anticipated although not under the existing plans. The following table summarizes
information about stock options outstanding as of December 31, 2001 (shares in
thousands):

Options
    Outstanding
    
    Options
    ExercisableRange of Exercise Price
    NumberOutstanding
    
    Weighted Average
    RemainingContractual Life
    
    Weighted
    AverageExercise Price
    
    NumberOutstanding
    
    Weighted
    AverageExercise Price$  1.06
    -
    $  9.50
    298
    
    7.06
    
    $           
          2.08
    
    215
    
    $                 2.4811.00
    -
    15.84
    67
    
    2.54
    
    12.50
    
    67
    
    12.5016.44
    -
    19.44
    112
    
    4.90
    
    17.63
    
    112
    
    17.6420.13
    -
    24.00
    57
    
    4.28
    
    22.18
    
    57
    
    22.18534
    
    
    
    
    
    451========
    
    
    
    
    
    ========


(b)  Grantor Stock Trust

In the first quarter of 1996, the Company
sold 3,050,000 newly issued shares of the Company's common stock to a newly established
Grantor Stock Trust ("Trust") in exchange for a promissory note of approximately
$37.7 million. The Trust was created to fund future obligations under certain of the
Company's benefit plans, including, but not limited to, stock option plans, a stock
purchase plan, and employee compensation. The sale of the shares to the Trust was recorded
as an increase in stockholders' equity with a corresponding reduction for the value of the
shares held by the Trust. As stock was released from the Trust to satisfy certain employee
compensation and benefit plans, the number and the related fair value of shares held by
the Trust was reduced and stockholders' equity increased correspondingly. The Trust held
1,915,935 shares of the Company's common stock as of December 31, 2001 and 2000.

The Trust delivered to the Company a promissory
note for approximately $37.7 million. The cash portion of the purchase price of
approximately $31,000 represented the par value of the shares of the

F-33

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

Company's common stock sold to the Trust. The consummation of the
Company's Plan of Reorganization on February 28, 2002 cancelled the Company's existing
common stock, including the shares held by the Trust. As a result, the Trust has been
terminated and the debt it owed to the Company has been forgiven.

(16)  Earnings per Share

Diluted net earnings per share is based
upon the weighted average number of common shares outstanding during the period plus the
number of incremental shares of common stock contingently issuable upon exercise of stock
options and if dilutive, include the assumption that the Company's convertible securities
were converted as of the beginning of the period. Net earnings are adjusted for the
interest on the convertible securities, net of interest related to additional assumed
borrowings to fund the cash consideration on conversion of certain convertible securities
and the related income tax benefits. In periods of losses, diluted net losses per share is
based upon the weighted average number of common shares outstanding during the period. As
the Company had a net loss for the years ended December 31, 2001, 2000 and 1999, the
Company's stock options and convertible debentures were anti-dilutive.

Losses per share for the years ended December 31 is calculated as
follows (in thousands, except per share data):

2001
    
    2000
    
    1999Basic:Losses
    before cumulative effect of change in accounting principle
    $           (69,437
    )
    $         (545,711
    )
    $     (1,076,642
    )Cumulative
    effect of change in accounting principle
    -
    
    -
    
    (12,816
    )Net losses
    $           (69,437
    )
    $         (545,711
    )
    $     (1,089,458
    )=========
    
    =========
    
    =========Weighted
    average shares outstanding
    61,096
    
    60,347
    
    58,504=========
    
    =========
    
    =========Losses per
    share:Net
    losses before cumulative effect of change in accounting 
         principle
    $               (1.14
    )
    $               (9.04
    )
    $            (18.40
    )Cumulative
    effect of change in accounting principle
    -
    
    -
    
    (0.22
    )Net
    losses
    $               (1.14
    )
    $               (9.04
    )
    $           (18.62
    )=========
    
    =========
    
    =========Diluted:Losses
    before cumulative effect of change in accounting
       principle used in basic calculation
    $           (69,437
    )
    $         (545,711
    )
    $     (1,076,642
    )Cumulative
    effect of change in accounting principle
    -
    
    -
    
    (12,816
    )Net losses
    $           (69,437
    )
    $         (545,711
    )
    $     (1,089,458
    )=========
    
    =========
    
    =========Losses
    per share:Losses
    before cumulative effect of change in accounting principle
    $               (1.14
    )
    $               (9.04
    )
    $            (18.40
    )Cumulative
    effect of change in accounting principle
    -
    
    -
    
    (0.22
    )Net
    losses
    $               (1.14
    )
    $               (9.04
    )
    $            (18.62
    )=========
    
    =========
    
    =========Weighted average shares used in basic and dilutive calculations
    61,096
    
    60,347
    
    58,504=========
    
    =========
    
    =========


F-34

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

(17)  Preferred
Stock Purchase Rights

On June 2, 1995, the Board of
Directors declared a dividend of one preferred stock purchase right ("Right")
for each outstanding share of the old common stock of the Company for stockholders of
record on June 15, 1995 and for all future issuances of the old common stock. The
consummation of the Company's Plan of Reorganization on February 28, 2002 cancelled the
Company's old common stock, and the Rights were thereby also cancelled.

(18)  Other Events

(a)  Litigation

In May and August 1999, former employees
of two of the Company's subsidiaries, SunBridge Healthcare Corporation and SunDance
Rehabilitation Corporation, filed proposed class action complaints in the Western District
of Washington. The plaintiffs sought to represent certain current and former employees of
SunBridge and SunDance who were allegedly not paid appropriate wages under federal and
state law since May and August 1996, respectively. Plaintiffs filed claims in the chapter
11 cases in the amount of approximately $780 million in the SunDance action and $242
million in the SunBridge action. Although the Company disputed these claims, the parties
executed a stipulation of settlement which was signed by the judge presiding over the
chapter 11 cases in the United States Bankruptcy Court for the District of Delaware. The
settlement provides a general unsecured claim in the chapter 11 cases of up to an
aggregate $3.0 million for the claimants, the payment of claimants' attorney's fees up to
$300,000, and the payment of up to $500,000 to cover the cost of notice to prospective
claimants in the class and claims administration. The settlement terms remain subject to
court approval.

In March and April 1999, class action
lawsuits were filed against the Company and three individuals who were at that time
officers of the Company in the United States District Court for the District of New
Mexico. These actions have been consolidated as In re Sun Healthcare Group, Inc.
Securities and Litigation Master, File No. Civ. 99-269. The lawsuits allege, among other
things, that the Company did not disclose material facts concerning the impact that PPS
would have on the Company's results of operations. The lawsuits seek compensatory damages
and other relief for stockholders who purchased the Company's common stock during the
class-action period. Pursuant to an agreement among the parties, the Company was dismissed
without prejudice in December 2000. On January 31, 2002, the District Court dismissed the
lawsuit with prejudice and entered judgment in favor of the defendants. On February 14,
2002, the plaintiffs filed a Motion to Amend the Judgment and to File an Amended
Complaint. The Company intends to vigorously defend the individual defendants in this
matter, who are indemnified by the Company and covered by the Company's insurance.
      The United States Department of Health & Human
Services ("HHS") and the United States Department of Justice ("DOJ")
periodically investigate matters that come to their attention concerning the Company,
including cost reporting matters. Several years ago, to expedite resolution of any
outstanding investigations, the Company requested that HHS and DOJ inform it of any such
investigations or outstanding concerns. In response, DOJ informed the Company of the
existence of a number of outstanding inquiries, several of which were prompted by the
filing of eleven qui tamlawsuits

F-35

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

by private individuals ("Relators") pursuant to the False
Claims Act. HHS had also asserted claims against the Company for overpayments in
connection with Medicare reimbursement for services performed prior to the implementation
of the Medicare prospective payment system, and HHS and DOJ also asserted claims for
violations of the False Claims Act. The Company denied any violations and asserted claims
against HHS for underpayments in connection with services performed for Medicare
beneficiaries for the same periods which HHS disputes.

In February 2002, the Company, HHS, CMS,
DOJ, the Tricare Management Activity Support Office ("TMA"), and the Relators in
eight of the qui tam cases signed a comprehensive settlement agreement which
resolved all the claims of the parties. The Bankruptcy Court has approved the settlement.
The settlement agreement provided for, among other things, a release of pre-petition
claims of HHS, CMS, DOJ, TMA and the Relators against the Company. The settlement
agreement also provided for a release of substantially all the claims of the Company
against HHS for the same period; the Company previously reserved all such claims due to
the uncertainty of the Company recovering such amounts. The settlement agreement required
the Company to pay $1,000,000 in cash and deliver a promissory note for $10,000,000. The
Relators in the remaining three qui tamcases previously separately entered into
settlement agreements with the Company resolving all of their claims against the Company.

In contemplation of a settlement with
HHS, the Company entered into a corporate integrity agreement with the HHS' Office of
Inspector General in July 2001. The agreement officially took effect upon the Company's
emergence from bankruptcy. Under the terms of this agreement, the Company implemented
further internal controls with respect to its quality of care standards and its Medicare
and Medicaid billing, reporting and claims submission processes.

The Company is a party to various other
legal actions and administrative proceedings and is subject to various claims arising in
the ordinary course of its business, including claims that its services have resulted in
injury or death to the residents of its facilities. The Company has experienced an
increasing trend in the number and severity of litigation claims asserted against the
Company. The Company believes that this trend is endemic to the long-term care industry
and is a result of the increasing number of large judgments, including large punitive
damage awards, against long-term care providers in recent years resulting in an increased
awareness by plaintiff's lawyers of potentially large recoveries. In certain states in
which the Company has significant operations, including California, insurance coverage for
the risk of punitive damages arising from general and professional liability litigation is
not available due to state law public policy prohibitions. There can be no assurance that
the Company will not be liable for punitive damages awarded in litigation arising in
states for which punitive damage insurance coverage is not available. The Company also
believes that there has been, and will continue to be, an increase in governmental
investigations of long-term care providers, particularly in the area of Medicare/Medicaid
false claims, as well as an increase in enforcement actions resulting from these
investigations. Adverse determinations in legal proceedings or governmental
investigations, whether currently asserted or arising in the future, could have a material
adverse effect on the Company.

(b)  Other Inquiries

F-36

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001



From time to time, fiscal intermediaries
and Medicaid agencies examine cost reports filed by predecessor operators of the Company's
skilled nursing facilities. If, as a result of any such examination, it is concluded that
overpayments to a predecessor operator were made, the Company, as the current operator of
such facilities, may be held financially responsible for such overpayments. At this time
the Company is unable to predict the outcome of any existing or future examinations.

(c)  Legislation, Regulations and Market Conditions

The Company is subject to extensive
federal, state and local government regulation relating to licensure, conduct of
operations, ownership of facilities, expansion of facilities and services and
reimbursement for services. As such, in the ordinary course of business, the Company's
operations are continuously subject to state and federal regulatory scrutiny, supervision
and control. Such regulatory scrutiny often includes inquiries, investigations,
examinations, audits, site visits and surveys, some of which may be non-routine. The
Company believes that it is in substantial compliance with the applicable laws and
regulations. However, if the Company is ever found to have engaged in improper practices,
it could be subjected to civil, administrative or criminal fines, penalties or
restitutionary relief which may have a material adverse impact on the Company's financial
results and operations. 
     In December 2000, the federal government released the final
privacy rules of the Health Insurance Portability and Accountability Act of 1996
("HIPPA").  The rules provide for, among other things, (i) giving consumers
the right and control over the release of their medical records, (ii) the establishment of
boundaries for the use of medical information, and (iii) penalties for violation of an
individual's privacy rights.

These privacy regulations apply to
"protected health information," which is defined generally as individually
identifiable health information transmitted or maintained in any form or medium, excluding
certain education records and student medical records. The privacy regulations seek to
limit the use and disclosure of most paper, oral and electronic communications regarding
an individual's past, present or future physical or mental health or condition, or
relating to the provision of healthcare to the individual or payment for that healthcare,
if the individual can or may be identified by such information. HIPAA provides for the
imposition of civil or criminal penalties if protected health information is improperly
disclosed. The Company is not required to comply with the HIPAA privacy rules until April
2003, but the Company will require substantial efforts and resources to prepare for
meeting the compliance deadline and for continued compliance thereafter. No assurance can
be given that the Company will meet the April 2003 deadline. See "Item 1 - Business -
Certain Additional Business Risks."

HIPAA's security regulations have not yet
been finalized. The proposed security regulations specify administrative procedures,
physical safeguards and technical services and mechanisms designed to ensure the privacy
of protected health information. The Company will be required to comply with the security
regulations 26 months after the regulations become final.

In addition, HIPAA also mandates the
adoption of regulations aimed at standardizing transaction formats and billing codes for
documenting medical services, dealing with claims submissions and protecting the privacy
and security of individually indentifiable health information. HIPAA regulations that
standardize transactions and code sets became final in the fourth quarter of 2000. These
regulations

F-37

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

do not require healthcare providers to submit claims
electronically, but require standard formatting for those that do. The Company currently
submits some of its claims electronically and will continue to do so. The Company will be
required to comply with HIPAA transaction and code set standards by October 2003.

(19)  Summarized Financial Information

The Company acquired Mediplex on
June 23, 1994, and became a co-obligor with Mediplex with respect to the 6-1/2%
Debentures and the 11-3/4% Debentures subsequent to the acquisition. Summarized financial
information of Mediplex is provided below (in thousands):

|                           | As of December
    31
|-------------------------- | ---------------------
|                           | 2001                 
|                           |                      
|Current
    assets         | $           64,803   
|Noncurrent
    assets      | 69,576               
|Current
    liabilities    | 22,411               
|Noncurrent
    liabilities | 50,294               
|Due to
    parent          | 262,082              



Year
    Ended  December
    312001
    
    2000
    
    1999Net
    revenues
    $       449,754
    
    $        441,929
    
    $     442,914Costs and
    expenses
    (490,462
    )
    (438,707
    )
    (426,418
    )Loss on
    impairment
    (8,647
    )
    -
    
    (46,779
    )Loss on
    sale of assets, net
    -
    
    -
    
    (41,019
    )Cumulative
    effect of change in accounting principle
    -
    
    -
    
    (2,520
    )(Losses)
    income before intersegment charges and income
       taxes
    (49,355
    )
    3,222
    
    (73,822
    )Intersegment
    charges (1)
    (9,940
    )
    (15,939
    )
    (94,759
    )Losses
    before income taxes
    (59,295
    )
    (12,717
    )
    (168,581
    )Income tax
    expense
    -
    
    -
    
    (32)Net losses
    $        (59,295
    )
    $(12,717
    )
    $    (168,613
    )========
    
    ========
    
    =======


(1)
    Through various intersegment agreements entered into by the
    Company and Mediplex, the Company provides management services, licenses the use of its
    trademarks and acts on behalf of Mediplex to make financing available for its operations.
    The Company charged Mediplex for management services totaling approximately $14.4 million,
    $13.4 million and $14.9 million for the years ended December 31, 2001, 2000
    and 1999, respectively. Royalty fees charged to Mediplex for the year ended
    December 31, 1999 for the use of the Company's trademarks were approximately
    $7.0 million. The Company discontinued charging Mediplex for royalty fees as of
    December 31, 1999. Intersegment interest charged to Mediplex for the years ended
    December 31, 2000 and 1999, for


F-38

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

| | advances from the Company was approximately
    $2.6 million and $72.9 million. Sun discontinued charging Mediplex for interest
    during 2000 due to the chapter 11 filing.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

(20) Quarterly Financial Data (Unaudited)



Year
    Ended December 31,
    2001FirstQuarter
    
    SecondQuarter
    
    ThirdQuarter
    
    FourthQuarterTotal net
    revenues
    $           529,834
    
    $           507,160
    
    $         494,939
    
    $        543,301=======
    
    =======
    
    ======
    
    ======Losses
    before income taxes
    $            (15,944
    )
    $            (21,328
    )
    $          (10,438
    )
    $        (21,406
    )=======
    
    =======
    
    ======
    
    ======Net losses
    $            (15,967
    )
    $            (21,851
    )
    $          (10,552
    )
    $        (21,067
    )=======
    
    =======
    
    ======
    
    ======Net losses per common and common equivalent share:Net losses
    (1):Basic
    and diluted
    $                (0.26
    )
    $                (0.36
    )
    $              (0.17
    )
    $            (0.34
    )=======
    
    =======
    
    ======
    
    ======


(1)    Earnings
per share are computed independently for each of the quarters presented and
               
therefore, may not sum to the totals for the year (see "Note 16 - Earnings Per
Share").

Year
    Ended December 31,
    2000FirstQuarter
    
    SecondQuarter
    
    ThirdQuarter
    
    FourthQuarterTotal net
    revenues
    $           637,992
    
    $           620,954
    
    $         607,722
    
    $        592,260=======
    
    =======
    
    =======
    
    ======Losses
    before income taxes
    $          (165,607
    )
    $            (31,387
    )
    $       (132,250
    )
    $      (216,211
    )=======
    
    =======
    
    =======
    
    ======Net losses
    $          (165,661
    )
    $            (31,445
    )
    $       (132,360
    )
    $      (216,245
    )=======
    
    =======
    
    =======
    
    ======Net losses per common and common equivalent share:Net losses
    (1):Basic
    and diluted
    $                (2.78
    )
    $                (0.54
    )
    $              (2.18
    )
    $            (3.56
    )=======
    
    =======
    
    =======
    
    ======




F-39

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

(21)  Segment Information

The Company operates predominantly in the
long-term care segment of the healthcare industry. The Company is a provider of long-term,
sub-acute and related ancillary care services to nursing home patients. In addition to
services provided in the United States, the Company previously provided services in the
United Kingdom, Spain, Germany and Australia.

The following summarizes the services
provided by the Company's reportable and other segments:

Inpatient Services: This segment provides, among other services,
inpatient skilled nursing and custodial services as well as rehabilitative, restorative
and transitional medical services. The Company provides 24-hour nursing care in these
facilities by registered nurses, licensed practical nurses and certified nursing aids. At
December 31, 2001, the Company operated 247 long-term care facilities with 27,954 licensed
beds as compared with 303 facilities with 33,363 licensed beds at December 31, 2000. At
December 31, 2001, the Company had identified seven facilities with 1,021 licensed beds
for divestiture in 2002.

Rehabilitation and Respiratory Therapy Services: This segment
provides, among other services, physical, occupational, speech and respiratory therapy
supplies and services to affiliated and nonaffiliated skilled nursing facilities. At
December 31, 2001, this segment provided services to 859 facilities, 622 nonaffiliated and
237 affiliated, as compared to 942 facilities at December 31, 2000, of which 652 were
nonaffiliated and 290 were affiliated. In March 2002, the Company sold substantially all
of the assets of its respiratory therapy operation.

Pharmaceutical and Medical Supply Services: This segment provides
pharmaceutical products primarily to affiliated and nonaffiliated long-term and sub-acute
care facilities for such purposes as infusion therapy, pain management, antibiotic therapy
and parenteral nutrition as well as providing consultant pharmacist services. This segment
provided services to 654 facilities at December 31, 2001 compared with 1,506 facilities at
December 31, 2000. Of the 654 facilities in 2001, 439 were nonaffiliated facilities and
215 were affiliated as compared to 1,217 nonaffiliated facilities and 289 affiliated
facilities in 2000.

The Company previously provided medical
supplies to nonaffiliated and affiliated parties through SunChoice Medical Supply, Inc.
("SunChoice"). In January 2001, the Company sold substantially all of the
operating assets of SunChoice.

International Operations: The Company sold its operations in the
United Kingdom, Germany and Australia during 2001 in February, April and July,
respectively. During 2000, the Company sold 18 pharmacies in the United Kingdom and its
operations in Spain. The Company did not have any international operations at December 31,
2001.

Other Operations: This segment includes temporary medical staffing
services, assisted living services, home health and hospice, software development and
other ancillary services provided to affiliated and nonaffiliated facilities.

F-40

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

The accounting policies of the segments
are the same as those described in the Note 3 - "Summary of Significant Accounting
and Financial Reporting Policies". The Company primarily evaluates segment
performance based on profit or loss from operations after allocated expenses and before
reorganization items, income taxes, extraordinary items and the cumulative effect of
change in accounting principle. Gains or losses on sales of assets and certain items
including impairment of assets recorded in connection with SFAS 121, legal and
regulatory matters and restructuring costs are not considered in the evaluation of segment
performance. Allocated expenses include intersegment charges assessed to segments for
management services and asset use based on segment operating results and average asset
balances, respectively. The Company accounts for intersegment sales and provision of
services at estimated market prices.

Corporate assets primarily consist of
cash and cash equivalents, receivables from subsidiary segments, notes receivable,
property, plant and equipment, unallocated intangible assets and goodwill. Although
corporate assets include unallocated intangible assets and goodwill, the amortization of
these items is reflected in the results of operations of the associated segment.

The Company's reportable segments are
strategic business units that provide different products and services. They are managed
separately because each business has different marketing strategies due to differences in
types of customers, different distribution channels and different capital resource needs.

F-41

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

The following tables summarize, for the years indicated, operating
results and other financial information, by business segment (in thousands):

|                                                                                                                                           | InpatientServices   |   | Rehabilitation and
    RespiratoryTherapy Services |   | Pharmaceutical
    and MedicalSupply Services |   | InternationalOperations   |   | OtherOperations    |   | Corporate              |   | IntersegmentEliminations  |   | Consolidated                |  
|------------------------------------------------------------------------------------------------------------------------------------------ | ------------------- | - | -------------------------------------------------- | - | --------------------------------------------- | - | ------------------------- | - | ------------------ | - | ---------------------- | - | ------------------------- | - | --------------------------- | -
|For the Year Ended
    December 31, 2001                                                                                                   |                     |   |                                                    |   |                                               |   |                           |   |                    |   |                        |   |                           |  
|Total Net Revenues                                                                                                                         | $     1,609,388     |   | $                175,159                           |   | $                   257,579                   |   | $             23,887      |   | $        178,065   |   | $            1,393     |   | $          (170,237       | ) | $           2,075,234       |  
|Operating expenses,
      corporate general and
      administrative expense
      and provision for losses on
      accounts receivable   | 1,561,766           |   | 150,340                                            |   | 233,944                                       |   | 22,953                    |   | 176,468            |   | 50,715                 |   | (170,237                  | ) | 2,025,949                   |  
|Depreciation and
      amortization                                                                                                        | 12,576              |   | 1,752                                              |   | 4,311                                         |   | -                         |   | 3,193              |   | 10,953                 |   | -                         |   | 32,785                      |  
|Interest, net                                                                                                                              | 2,758               |   | 32                                                 |   | 4                                             |   | 1,183                     |   | 513                |   | 8,145                  |   | -                         |   | 12,635                      |  
|Income (losses) before
      corporate allocations                                                                                         | 32,288              |   | 23,035                                             |   | 19,320                                        |   | (249                      | ) | (2,109             | ) | (68,420                | ) | -                         |   | 3,865                       |  
|Corporate management fees                                                                                                                  | 52,294              |   | 10,344                                             |   | 15,085                                        |   | -                         |   | 7,360              |   | (85,083                | ) | -                         |   | -                           |  
|Net segment income/(losses)                                                                                                                | $         (20,006   | ) | $                  12,691                          |   | $                       4,235                 |   | $                 (249    | ) | $           (9,469 | ) | $          16,663      |   | $                       - |   | $                  3,865    |  
|                                                                                                                                           | ======              |   | ========                                           |   | =========                                     |   | =======                   |   | ======             |   | =======                |   | =======                   |   | ========                    |  
|Intersegment revenues                                                                                                                      | $              (526 | ) | $                  99,549                          |   | $                     62,209                  |   | $                       - |   | $            9,005 |   | $                    - |   | $          (170,237       | ) | $                         - |  
|Identifiable segment assets                                                                                                                | $        382,581    |   | $                  30,515                          |   | $                     74,815                  |   | $                       - |   | $          59,796  |   | $        519,711       |   | $          (417,614       | ) | $              649,804      |  
|Segment capital expenditures                                                                                                               | $          17,595   |   | $                       472                        |   | $                          937                |   | $                  537    |   | $            1,865 |   | $            8,924     |   | $                       - |   | $                30,330     |  
|                                                                                                                                           |                     |   |                                                    |   |                                               |   |                           |   |                    |   |                        |   |                           |  
|For the Year Ended
    December 31, 2000                                                                                                   |                     |   |                                                    |   |                                               |   |                           |   |                    |   |                        |   |                           |  
|Total Net Revenues                                                                                                                         | $     1,718,178     |   | $                204,367                           |   | $                   311,276                   |   | $           265,501       |   | $        171,430   |   | $            1,381     |   | $          (213,205       | ) | $           2,458,928       |  
|Operating expenses,
      corporate general and
      administrative expenses,
      and provision for losses on
      accounts receivable | 1,649,920           |   | 170,722                                            |   | 291,140                                       |   | 261,814                   |   | 172,359            |   | 84,171                 |   | (213,074                  | ) | 2,417,052                   |  
|Depreciation and
      amortization                                                                                                        | 20,192              |   | 3,023                                              |   | 6,856                                         |   | 2,502                     |   | 3,084              |   | 10,355                 |   | (131                      | ) | 45,881                      |  
|Interest, net                                                                                                                              | 10,567              |   | 188                                                |   | 58                                            |   | 12,989                    |   | 1,416              |   | 9,051                  |   | -                         |   | 34,269                      |  
|Income (losses) before
      corporate allocations                                                                                         | 37,499              |   | 30,434                                             |   | 13,222                                        |   | (11,804                   | ) | (5,429             | ) | (102,196               | ) | -                         |   | (38,274                     | )
|Corporate interest
      allocation                                                                                                        | 24,444              |   | 8,946                                              |   | 10,577                                        |   | 7,902                     |   | 5,823              |   | (57,692                | ) | -                         |   | -                           |  
|Corporate management fees                                                                                                                  | 42,394              |   | 5,097                                              |   | 7,434                                         |   | 1,815                     |   | 4,089              |   | (60,829                | ) | -                         |   | -                           |  
|Net segment income (losses)                                                                                                                | $         (29,339   | ) | $                  16,391                          |   | $                      (4,789                 | ) | $            (21,521      | ) | $         (15,341  | ) | $          16,325      |   | $                       - |   | $              (38,274      | )
|                                                                                                                                           | ======              |   | ========                                           |   | =========                                     |   | =======                   |   | ======             |   | =======                |   | =======                   |   | ========                    |  
|Intersegment revenues                                                                                                                      | $               601 |   | $                113,265                           |   | $                     88,295                  |   | $                       - |   | $          10,716  |   | $               328    |   | $          (213,205       | ) | $                         - |  
|Identifiable segment assets                                                                                                                | $        234,735    |   | $                  48,018                          |   | $                     52,022                  |   | $             83,826      |   | $          68,974  |   | $     1,011,775        |   | $          (649,362       | ) | $              849,988      |  
|Segment capital
      expenditures                                                                                                         | $          24,781   |   | $                       289                        |   | $                          994                |   | $               4,590     |   | $            3,172 |   | $          21,540      |   | $                       - |   | $                55,366     |  
|                                                                                                                                           |                     |   |                                                    |   |                                               |   |                           |   |                    |   |                        |   |                           |  
|For the Year Ended
    December 31, 1999                                                                                                   |                     |   |                                                    |   |                                               |   |                           |   |                    |   |                        |   |                           |  
|Total Net Revenues                                                                                                                         | $     1,704,436     |   | $                234,054                           |   | $                   316,880                   |   | $           296,906       |   | $        196,760   |   | $            2,574     |   | $          (222,571       | ) | $           2,529,039       |  
|Operating expenses,
      corporate general and
      administrative expenses,
      and provision for losses on
      accounts receivable | 1,790,865           |   | 248,269                                            |   | 312,500                                       |   | 290,272                   |   | 217,670            |   | 120,730                |   | (219,705                  | ) | 2,760,601                   |  
|Depreciation and
      amortization                                                                                                        | 29,195              |   | 7,173                                              |   | 8,287                                         |   | 12,805                    |   | 11,285             |   | 12,796                 |   | (216                      | ) | 81,325                      |  
|Interest, net                                                                                                                              | 9,944               |   | 305                                                |   | 86                                            |   | 13,191                    |   | 6,721              |   | 98,807                 |   | -                         |   | 129,054                     |  
|Dividends on Preferred
      Securities                                                                                                    | -                   |   | -                                                  |   | -                                             |   | -                         |   | -                  |   | 20,407                 |   | -                         |   | 20,407                      |  
|Losses before corporate
      allocations                                                                                                  | (125,568            | ) | (21,693                                            | ) | (3,993                                        | ) | (19,362                   | ) | (38,916            | ) | (250,166               | ) | (2,650                    | ) | (462,348                    | )
|Corporate interest
      allocation                                                                                                        | 42,945              |   | 12,977                                             |   | 13,863                                        |   | 19,550                    |   | 8,392              |   | (97,727                | ) | -                         |   | -                           |  
|Corporate management fees                                                                                                                  | 71,688              |   | 9,455                                              |   | 12,454                                        |   | 2,966                     |   | 5,993              |   | (99,906                | ) | (2,650                    | ) | -                           |  
|Net segment income (losses)                                                                                                                | $       (240,201    | ) | $                (44,125                           | ) | $                    (30,310                  | ) | $            (41,878      | ) | $         (53,301  | ) | $         (52,533      | ) | $                       - |   | $            (462,348       | )
|                                                                                                                                           | ======              |   | ========                                           |   | =========                                     |   | =======                   |   | ======             |   | =======                |   | =======                   |   | ========                    |  
|Intersegment revenues                                                                                                                      | $               598 |   | $                126,880                           |   | $                     80,944                  |   | $                       - |   | $            9,981 |   | $            4,168     |   | $          (222,571       | ) | $                         - |  
|Identifiable segment assets                                                                                                                | $        350,038    |   | $                  74,466                          |   | $                   121,260                   |   | $           267,604       |   | $        143,317   |   | $     1,143,134        |   | $          (661,331       | ) | $           1,438,488       |  
|Segment capital
      expenditures                                                                                                         | $          23,114   |   | $                    6,696                         |   | $                       3,184                 |   | $             25,632      |   | $          11,616  |   | $          32,211      |   | $                       - |   | $              102,453      |  

F-42

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

The following tables reconcile net segment income (losses) to
consolidated losses before income taxes and cumulative effect of change in accounting
principle:

For the Year EndedDecember 31, 2001
    
    For the Year EndedDecember 31, 2000
    
    For the Year EndedDecember 31, 1999Net segment
    income (losses)
    $                              3,865
    
    $                       (38,274
    )
    $                      (462,348
    )Loss on
    impairment
    18,825
    
    191,316
    
    457,449Legal and
    regulatory matters, net
    11,000
    
    2,480
    
    38Restructuring
    costs
    1,064
    
    (1,090
    )
    27,353(Gain) loss
    on sale of assets, net
    (825
    )
    (21,400
    )
    78,673Loss on
    termination of interest rate swaps
    -
    
    -
    
    2,488Reorganization
    costs, net
    42,917
    
    335,875
    
    48,132Losses
    before income taxes and cumulative effect of
       change in accounting principle
    $                          (69,116
    )
    $                     (545,455
    )
    $                   (1,076,481
    )===========
    
    ==========
    
    ==========




F-43

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CONSOLIDATING BALANCE SHEET

As of December 31, 2001
(in thousands)

(22)  Filer/Non-Filer Financial Statements

In accordance with SOP 90-7, the debtor entities are
required to present condensed consolidated financial statements for the years ended after
the Filing Date:

ASSETSFilers
    
    Non-filers
    
    Elimination
    
    ConsolidatedCurrent
    assets:Cash
    and cash equivalents
    $             49,917
    
    $                732
    
    $                       -
    
    $               50,649Accounts receivable, net
    200,445
    
    4,515
    
    (227
    )
    204,733Inventory,
    net
    19,492
    
    923
    
    -
    
    20,415Other
    receivables, net
    9,556
    
    -
    
    -
    
    9,556Prepaids
    and other assets
    5,610
    
    43
    
    -
    
    5,653Total
    current assets
    285,020
    
    6,213
    
    (227
    )
    291,006Property
    and equipment, net
    124,832
    
    8,384
    
    -
    
    133,216Assets held
    for sale
    15,803
    
    2,355
    
    -
    
    18,158Notes
    receivable, net
    4,895
    
    -
    
    -
    
    4,895Goodwill,
    net
    177,027
    
    175
    
    -
    
    177,202Other
    assets, net
    20,788
    
    4,539
    
    -
    
    25,327Investment
    in subsidiaries
    (280,290
    )
    -
    
    280,290
    
    -Total
    assets
    $           348,075
    
    $           21,666
    
    $           280,063
    
    $             649,804=======
    
    ======
    
    =======
    
    ========


F-44

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CONSOLIDATING BALANCE SHEET

As of December 31, 2001
(in thousands except share data)

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)Filers
    
    Non-filers
    
    Elimination
    
    ConsolidatedCurrent
    liabilities:Current
    portion of long-term debt
    $           54,892
    
    $                     83
    
    $                     -
    
    $              54,975Accounts
    payable
    29,055
    
    1,507
    
    (227
    )
    30,335Accrued
    compensation and benefits
    78,716
    
    612
    
    -
    
    79,328Accrued
    self-insurance obligations
    45,878
    
    1,219
    
    -
    
    47,097Income
    taxes payable
    12,430
    
    -
    
    -
    
    12,430Other
    accrued liabilities
    79,708
    
    392
    
    -
    
    80,100Total
    current liabilities
    300,679
    
    3,813
    
    (227
    )
    304,265Liabilities
    subject to compromise (see Note 2)
    1,549,139
    
    -
    
    -
    
    1,549,139Accrued
    self-insurance obligations, net of current portion
    51,380
    
    -
    
    -
    
    51,380Long-term
    debt, net of current portion
    17,813
    
    5,447
    
    -
    
    23,260Other
    long-term liabilities
    22,136
    
    408
    
    -
    
    22,544Total
    liabilities
    1,941,147
    
    9,668
    
    (227
    )
    1,950,588Commitments
    and contingencies (see Note 10)Minority
    interest
    3,177
    
    2,228
    
    -
    
    5,405Company-obligated
    mandatorily redeemable convertible
       preferred securities of a subsidiary trust holding solely 7%
       convertible junior subordinated debentures of the
       Company
    296,101
    
    -
    
    -
    
    296,101Intersegment
    (290,060
    )
    290,060
    
    -
    
    -Stockholders'
    deficit:Common
    stock of $.01 par value, authorized
         155,000,000 shares, 65,209,188 shares issued and
         outstanding as of December 31, 2001
    652
    
    262
    
    (262
    )
    652Additional
    paid-in capital
    825,099
    
    49,805
    
    (49,805
    )
    825,099Accumulated
    deficit
    (2,400,655
    )
    (330,357
    )
    330,357
    
    (2,400,655
    )Less:Common
    stock held in treasury, at cost, 2,213,537
             shares as of December 31, 2001
    (27,376
    )
    -
    
    -
    
    (27,376
    )Grantor
    stock trust, at market, 1,915,935 shares as of
             December 31, 2001
    (10
    )
    -
    
    -
    
    (10
    )Total
    stockholders' deficit
    (1,602,290
    )
    (280,290
    )
    280,290
    
    (1,602,290
    )Total
    liabilities and stockholders' deficit
    $        348,075
    
    $             21,666
    
    $         280,063
    
    $            649,804======
    
    =======
    
    ======
    
    =======


F-45

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CONSOLIDATING BALANCE SHEET

As of December 31, 2000
(in thousands)

ASSETSFilers
    
    Non-filers
    
    Elimination
    
    ConsolidatedCurrent
    assets:Cash
    and cash equivalents
    $           32,600
    
    $            4,989
    
    $                    -
    
    $             37,589Accounts receivable, net
    188,366
    
    7,415
    
    (419
    )
    195,362Inventory,
    net
    21,726
    
    950
    
    -
    
    22,676Other
    receivables, net
    104,808
    
    (97,912
    )
    -
    
    6,896Prepaids
    and other assets
    4,653
    
    40
    
    -
    
    4,693Total
    current assets
    352,153
    
    (84,518
    )
    (419
    )
    267,216Property
    and equipment, net
    164,433
    
    15,852
    
    -
    
    180,285Assets held
    for sale
    17,567
    
    138,775
    
    -
    
    156,342Notes
    receivable, net
    14,554
    
    -
    
    -
    
    14,554Goodwill,
    net
    187,781
    
    224
    
    -
    
    188,005Other
    assets, net
    38,385
    
    5,201
    
    -
    
    43,586Investment
    in subsidiaries
    (57,143
    )
    -
    
    57,143
    
    -Total
    assets
    $         717,730
    
    $          75,534
    
    $          56,724
    
    $           849,988======
    
    ======
    
    ======
    
    =======




F-46

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CONSOLIDATING BALANCE SHEET

As of December 31, 2000
(in thousands except share data)

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)Filers
    
    Non-filers
    
    Elimination
    
    ConsolidatedCurrent
    liabilities:Current
    portion of long-term debt
    $           67,208
    
    $             18,831
    
    $                     -
    
    $             86,039Accounts
    payable
    26,736
    
    11,209
    
    (419
    )
    37,526Accrued
    compensation and benefits
    86,259
    
    15,718
    
    -
    
    101,977Accrued
    self-insurance obligations
    27,406
    
    612
    
    -
    
    28,018Income
    taxes payable
    13,328
    
    -
    
    -
    
    13,328Other
    accrued liabilities
    126,291
    
    12,938
    
    -
    
    139,229Total
    current liabilities
    347,228
    
    59,308
    
    (419
    )
    406,117Liabilities
    subject to compromise (see Note 2)
    1,529,928
    
    -
    
    -
    
    1,529,928Accured
    self-insurance obligations, net of current portion
    22,719
    
    -
    
    -
    
    22,719Long-term
    debt, net of current portion
    6,797
    
    47,414
    
    -
    
    54,211Obligations
    under capital leases, net of current portion
    -
    
    53,553
    
    -
    
    53,553Other
    long-term liabilities
    25,953
    
    784
    
    -
    
    26,737Total
    liabilities
    1,932,625
    
    161,059
    
    (419
    )
    2,093,265Commitments
    and contingencies (see Note 10)Minority
    interest
    3,178
    
    2,782
    
    -
    
    5,960Company-obligated
    mandatorily redeemable convertible
       preferred securities of a subsidiary trust holding solely 7%
       convertible junior subordinated debentures of the
       Company
    296,101
    
    -
    
    -
    
    296,101Intersegment
    31,164
    
    (31,195
    )
    31
    
    -Stockholders'
    deficit:Common
    stock of $.01 par value, authorized
          155,000,000 shares, 65,230,853 shares issued and
          outstanding as of  December 31, 2000
    652
    
    2,568
    
    (2,568
    )
    652Additional
    paid-in capital
    825,147
    
    273,696
    
    (273,696
    )
    825,147Accumulated
    deficit
    (2,331,218
    )
    (320,893
    )
    320,893
    
    (2,331,218
    )Accumulated
    other comprehensive loss
    (12,483
    )
    (12,483
    )
    12,483
    
    (12,483
    )Less:Common
    stock held in treasury, at cost, 2,213,537
             shares as of December 31, 2000
    (27,376
    )
    -
    
    -
    
    (27,376
    )Grantor
    stock trust, at market, 1,915,935 shares as of
             December 31, 2000
    (60
    )
    -
    
    -
    
    (60
    )Total
    stockholders' deficit
    (1,545,338
    )
    (57,112
    )
    57,112
    
    (1,545,338
    )Total
    liabilities and stockholders' deficit
    $        717,730
    
    $             75,534
    
    $           56,724
    
    $            849,988======
    
    =======
    
    ======
    
    =======




F-47

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CONSOLIDATING STATEMENT OF LOSSES

For the Year Ended December 31, 2001
(in thousands)

Filers
    
    Non-filers
    
    Elimination
    
    ConsolidatedTotal net
    revenues
    $ 2,008,534
    
    $ 71,668
    
    $ (4,968
    )
    $ 2,075,234Costs and
    expenses:Operating
    costs
    1,832,761
    
    67,869
    
    (4,968
    )
    1,895,662Corporate
    general and administrative
    102,599
    
    1,716
    
    -
    
    104,315Depreciation
    and amortization
    31,371
    
    1,414
    
    -
    
    32,785Provision
    for losses on accounts receivable
    25,162
    
    810
    
    -
    
    25,972Loss
    on impairment
    14,482
    
    4,343
    
    -
    
    18,825Interest,
    net (contractual interest expense $142,800)
    10,960
    
    1,675
    
    -
    
    12,635Legal
    and regulatory matters, net
    11,000
    
    -
    
    -
    
    11,000Restructuring
    costs
    -
    
    1,064
    
    -
    
    1,064Gain
    on sale of assets, net
    (782
    )
    (43
    )
    -
    
    (825
    )Equity
    interest in losses of subsidiaries
    9,463
    
    -
    
    (9,463
    )
    -Total costs
    and expenses
    2,037,016
    
    78,848
    
    (14,431
    )
    2,101,433Management
    fee (income) expense before reorganization
       items
    (2,810
    )
    2,810
    
    -
    
    -Losses
    before reorganization costs, net, and income taxes
    (25,672
    )
    (9,990
    )
    9,463
    
    (26,199
    )Reorganization
    costs, net
    43,473
    
    (556
    )
    -
    
    42,917Income
    taxes
    291
    
    30
    
    -
    
    321Net
    losses
    $         (69,436
    )
    $            (9,464
    )
    $              9,463
    
    $             (69,437
    )======
    
    ======
    
    ======
    
    =======


F-48

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CONSOLIDATING STATEMENT OF LOSSES

For the Year Ended December 31, 2000
(in thousands)



Filers
    
    Non-filers
    
    Elimination
    
    ConsolidatedTotal net
    revenues
    $ 2,145,659
    
    $ 318,485
    
    $ (5,216
    )
    $ 2,458,928Costs and
    expenses:Operating
    costs
    1,931,901
    
    303,738
    
    (5,216
    )
    2,230,423Corporate
    general and administrative
    140,117
    
    13,016
    
    -
    
    153,133Depreciation
    and amortization
    43,000
    
    2,881
    
    -
    
    45,881Provision
    for losses on accounts receivable
    32,973
    
    523
    
    -
    
    33,496Loss
    on impairment
    191,199
    
    117
    
    -
    
    191,316Interest,
    net (contractual interest expense $146,406)
    20,260
    
    14,009
    
    -
    
    34,269Legal
    and regulatory matters, net
    2,480
    
    -
    
    -
    
    2,480Restructuring
    costs
    (1,090
    )
    -
    
    -
    
    (1,090
    )(Gain) loss on sale of assets, net
    (21,405
    )
    5
    
    -
    
    (21,400
    )Equity
    interest in losses of subsidiaries
    129,311
    
    -
    
    (129,311
    )
    -Intersegment
    interest expense (income)
    (2,198
    )
    2,198
    
    -
    
    -Total costs
    and expenses
    2,466,548
    
    336,487
    
    (134,527
    )
    2,668,508Management
    fee (income) expense before reorganization
       items
    (828
    )
    828
    
    -
    
    -Losses
    before reorganization costs, net, and income taxes
    (320,061
    )
    (18,830
    )
    129,311
    
    (209,580
    )Reorganization
    costs, net
    225,423
    
    110,452
    
    -
    
    335,875Income
    taxes
    227
    
    29
    
    -
    
    256Net
    losses
    $       (545,711
    )
    $       (129,311
    )
    $         129,311
    
    $           (545,711
    )======
    
    ======
    
    ======
    
    =======


F-49

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CONSOLIDATING STATEMENT OF CASH FLOWS

For the Year Ended December 31, 2001
(in thousands)



|                                                                                                        | Filers                         |   | Non-filers              |   | Elimination              |   | Consolidated         |  
|------------------------------------------------------------------------------------------------------- | ------------------------------ | - | ----------------------- | - | ------------------------ | - | -------------------- | -
|Cash
    flows from operating activities:                                                               |                                |   |                         |   |                          |   |                      |  
|Net
    losses                                                                                          | $ (69,437                      | ) | $ (9,464                | ) | $ 9,464                  |   | $ (69,437            | )
|Adjustments
    to reconcile net losses to net cash
       provided by (used for) operating activities: |                                |   |                         |   |                          |   |                      |  
|Equity
    interest in losses of subsidiaries                                                           | 9,464                          |   | -                       |   | (9,464                   | ) | -                    |  
|Loss
    on impairment                                                                                  | 14,482                         |   | 4,343                   |   | -                        |   | 18,825               |  
|Depreciation
    and amortization                                                                       | 31,371                         |   | 1,414                   |   | -                        |   | 32,785               |  
|Provision
    for losses on accounts receivable                                                         | 25,162                         |   | 810                     |   | -                        |   | 25,972               |  
|Legal
    and regulatory costs                                                                          | 11,000                         |   | -                       |   | -                        |   | 11,000               |  
|(Gain) loss on sale of assets, net                                                                      | (782                           | ) | (43                     | ) | -                        |   | (825                 | )
|Reorganization
    costs, net                                                                           | 43,473                         |   | (556                    | ) | -                        |   | 42,917               |  
|Other,
    net                                                                                          | 9,844                          |   | (248                    | ) | -                        |   | 9,596                |  
|Changes in
    operating assets and liabilities:                                                        |                                |   |                         |   |                          |   |                      |  
|Accounts
    receivable                                                                                 | (39,226                        | ) | 2,312                   |   | -                        |   | (36,914              | )
|Other
    current assets                                                                                | (2,749                         | ) | 3,694                   |   | -                        |   | 945                  |  
|Other
    current liabilities                                                                           | 16,072                         |   | (8,051                  | ) | -                        |   | 8,021                |  
|Income
    taxes payable                                                                                | 3,810                          |   | (2,743                  | ) | -                        |   | 1,067                |  
|Net
    cash provided by (used for) operating
          activities before reorganization costs          | 52,484                         |   | (8,532                  | ) | -                        |   | 43,952               |  
|Net
    cash paid for reorganization costs                                                              | (19,583                        | ) | -                       |   | -                        |   | (19,583              | )
|Net
    cash (used for) provided by operating
          activities                                      | 32,901                         |   | (8,532                  | ) | -                        |   | 24,369               |  
|Cash
    flows from investing activities:                                                               |                                |   |                         |   |                          |   |                      |  
|Capital
    expenditures, net                                                                           | (29,793                        | ) | (537                    | ) | -                        |   | (30,330              | )
|Acquisitions,
    net of cash acquired                                                                  | -                              |   | -                       |   | -                        |   | -                    |  
|Proceeds
    from sale of assets                                                                        | 14,676                         |   | 3,488                   |   | -                        |   | 18,164               |  
|Proceeds
    from redemption of strategic
           investment                                         | 10,115                         |   | -                       |   | -                        |   | 10,115               |  
|(Increase) decrease in long-term notes
           receivable                                            | 885                            |   | -                       |   | -                        |   | 885                  |  
|Decrease
    in other assets                                                                            | 6,568                          |   | (3,942                  | ) | -                        |   | 2,626                |  
|Net
    cash (used for) provided by investing
           activities                                     | 2,451                          |   | (991                    | ) | -                        |   | 1,460                |  
|Cash
    flows from financing activities:                                                               |                                |   |                         |   |                          |   |                      |  
|Net
    (repayments) borrowings under Revolving
          Credit Agreement (postpetition)               | (12,441                        | ) | -                       |   | -                        |   | (12,441              | )
|Long-term
    debt borrowings                                                                           | 3,748                          |   | 94                      |   | -                        |   | 3,842                |  
|Long-term
    debt repayments (prepetition)                                                             | -                              |   | (82                     | ) | -                        |   | (82                  | )
|Principal
    payments on prepetition debt
          authorized by Bankruptcy Court                     | (3,017                         | ) | -                       |   | -                        |   | (3,017               | )
|Other
    financing activities                                                                          | 2                              |   | (3                      | ) | -                        |   | (1                   | )
|Intersegment
    advances                                                                               | (5,257                         | ) | 5,257                   |   | -                        |   | -                    |  
|Net
    cash provided by (used for) financing
             activities                                   | (16,965                        | ) | 5,266                   |   | -                        |   | (11,699              | )
|Effect of
    exchange rate on cash and cash
       equivalents                                         | (1,070                         | ) | -                       |   | -                        |   | (1,070               | )
|Net
    increase (decrease) in cash and cash
       equivalents                                         | 17,317                         |   | (4,257                  | ) | -                        |   | 13,060               |  
|Cash and
    cash equivalents at beginning of year                                                      | 32,600                         |   | 4,989                   |   | -                        |   | 37,589               |  
|Cash and
    cash equivalents at end of year                                                            | $                       49,917 |   | $                   732 |   | $                      - |   | $             50,649 |  
|                                                                                                        | ==========                     |   | =======                 |   | =======                  |   | =======              |  



F-50

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

CONSOLIDATING STATEMENT OF CASH FLOWS

For the Year Ended December 31, 2000
(in thousands)

|                                                                                                        | Filers                       |   | Non-filers             |   | Elimination              |   | Consolidated          |  
|------------------------------------------------------------------------------------------------------- | ---------------------------- | - | ---------------------- | - | ------------------------ | - | --------------------- | -
|Cash
    flows from operating activities:                                                               |                              |   |                        |   |                          |   |                       |  
|Net
    losses                                                                                          | $ (545,711                   | ) | $ (129,311             | ) | $ 129,311                |   | $ (545,711            | )
|Adjustments
    to reconcile net losses to net cash
       provided by (used for) operating activities: |                              |   |                        |   |                          |   |                       |  
|Equity
    interest in losses of subsidiaries                                                           | 129,311                      |   | -                      |   | (129,311                 | ) | -                     |  
|Loss
    on impairment                                                                                  | 191,199                      |   | 117                    |   | -                        |   | 191,316               |  
|Depreciation
    and amortization                                                                       | 43,000                       |   | 2,881                  |   | -                        |   | 45,881                |  
|Provision
    for losses on accounts receivable                                                         | 32,973                       |   | 523                    |   | -                        |   | 33,496                |  
|Legal
    and regulatory costs                                                                          | 1,245                        |   | -                      |   | -                        |   | 1,245                 |  
|(Gain) loss on sale of assets, net                                                                      | (21,405                      | ) | 5                      |   | -                        |   | (21,400               | )
|Reorganization
    costs, net                                                                           | 225,423                      |   | 110,452                |   | -                        |   | 335,875               |  
|Other,
    net                                                                                          | (18,388                      | ) | (1,798                 | ) | -                        |   | (20,186               | )
|Changes in
    operating assets and liabilities:                                                        |                              |   |                        |   |                          |   |                       |  
|Accounts
    receivable                                                                                 | (19,886                      | ) | 1,166                  |   | -                        |   | (18,720               | )
|Other
    current assets                                                                                | (6,737                       | ) | 17,766                 |   | -                        |   | 11,029                |  
|Other
    current liabilities                                                                           | 1,582                        |   | (723                   | ) | -                        |   | 859                   |  
|Income
    taxes payable                                                                                | 4,827                        |   | (2,712                 | ) |                          |   | 2,115                 |  
|Net
    cash provided by (used for) operating
          activities before reorganization costs          | 17,433                       |   | (1,634                 | ) | -                        |   | 15,799                |  
|Net
    cash paid for reorganization costs                                                              | (17,520                      | ) | -                      |   |                          |   | (17,520               | )
|Net
    cash (used for) provided by operating
          activities                                      | (87                          | ) | (1,634                 | ) |                          |   | (1,721                | )
|Cash
    flows from investing activities:                                                               |                              |   |                        |   |                          |   |                       |  
|Capital
    expenditures, net                                                                           | (48,236                      | ) | (7,130                 | ) | -                        |   | (55,366               | )
|Acquisitions,
    net of cash acquired                                                                  | (974                         | ) | -                      |   | -                        |   | (974                  | )
|Proceeds
    from sale of assets held for sale                                                          | 2,987                        |   | 21,993                 |   | -                        |   | 24,980                |  
|(Increase) decrease in long-term notes receivable                                                       | (8,024                       | ) | 1,936                  |   | -                        |   | (6,088                | )
|Decrease
    in other assets                                                                            | 5,536                        |   | -                      |   |                          |   | 5,536                 |  
|Net
    cash (used for) provided by investing
          activities                                      | (48,711                      | ) | 16,799                 |   |                          |   | (31,912               | )
|Cash
    flows from financing activities:                                                               |                              |   |                        |   |                          |   |                       |  
|Net
    borrowings under Revolving Credit
           Agreement (postpetition)                           | 54,901                       |   | -                      |   | -                        |   | 54,901                |  
|Long-term
    debt borrowings                                                                           | 6,108                        |   | 3,559                  |   | -                        |   | 9,667                 |  
|Long-term
    debt repayments (prepetition)                                                             | -                            |   | (14,663                | ) | -                        |   | (14,663               | )
|Principal
    payments on prepetition debt
          authorized by Bankruptcy Court                     | (3,358                       | ) | (48                    | ) | -                        |   | (3,406                | )
|Other
    financing activities                                                                          | 28                           |   | (32                    | ) | -                        |   | (4                    | )
|Intersegment
    advances                                                                               | 5,187                        |   | (5,187                 | ) |                          |   | -                     |  
|Net
    cash provided by (used for) financing
              activities                                  | 62,866                       |   | (16,371                | ) |                          |   | 46,495                |  
|Effect of
    exchange rate on cash and cash
       equivalents                                         | -                            |   | (320                   | ) |                          |   | (320                  | )
|Net
    increase (decrease) in cash and cash equivalents                                                | 14,068                       |   | (1,526                 | ) | -                        |   | 12,542                |  
|Cash and
    cash equivalents at beginning of year                                                      | 18,532                       |   | 6,515                  |   | -                        |   | 25,047                |  
|Cash and
    cash equivalents at end of year                                                            | $                     32,600 |   | $                4,989 |   | $                      - |   | $              37,589 |  
|                                                                                                        | =========                    |   | ========               |   | =======                  |   | =======               |  

F-51

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

(23)  Subsequent Events



On October 14, 1999, Sun and
substantially all of its U.S. operating subsidiaries filed voluntary petitions for
protection under chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court for
the District of Delaware ("the Bankruptcy Court"), (case nos. 99-3657 through
99-3841, inclusive). On February 3, 2000, HoMed Convalescent Equipment, Inc.
("HoMed"), an indirect subsidiary of Sun, commenced its chapter 11 case in the
Bankruptcy Court (case no. 00-00841). On February 6, 2002, the Bankruptcy Court approved
the Company's joint plan of reorganization (the "Plan") and on February 28, 2002
the Company consummated the Plan. The principal provisions of the Plan are set forth
below:

Type
    of
    Claim/Security
    
    Treatment
    under
    Plan1.
    General unsecured creditors with claims less than $50,000
    
    To be issued cash payments at the rate of 7% of their claims2.
    General unsecured creditors with claims of $50,000 or more
    
    To be issued an aggregate of approximately 900,000 shares (9%) of new common stock3.
    Senior bank lenders
    
    Issued approximately 8.9 million shares of new common stock (89%) and received a cash
    payment of approximately $6.6 million4.
    Senior subordinated note holders
    
    To be issued an aggregate of 200,000 shares (2%) of new common stock and warrants to
    purchase an additional 500,000 shares (5%)5.
    Common stock, options, warrants, convertible debt, and convertible trust issued preferred
    securities
    
    Canceled with no recovery to holders


(b)  *New Loan Agreements*

On February 28, 2002, the Company entered
into (i) a Loan and Security Agreement with certain lenders, led by Heller Healthcare
Finance, Inc. as collateral agent, and Citicorp USA, Inc., as administrative agent (the
"Revolving Loan Agreement,") and (ii) a Term Loan and Note Purchase Agreement
with certain lenders, led by U.S. Bank National Association as administrative and
collateral agent (the "Term Loan Agreement," and together with the Revolving
Loan Agreement, the "Loan Agreements"). The Revolving Loan Agreement is a $150
million three-year revolving line of credit that is secured by the Company's accounts
receivable, inventory, equipment and other assets, a first priority

F-52

---

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

December 31, 2001

pledge of the stock
of the Company's subsidiaries, other than those subsidiaries providing pharmaceutical
services, and a second priority pledge of the pharmaceutical services subsidiaries. The
Company's borrowing availability under the Revolving Loan Agreement is limited to up to
85% of the Company's net eligible accounts receivable and up to 50% of the Company's net
eligible inventory, but not to exceed $150 million. Under the Revolving Loan Agreement,
depending upon the type of loan made and provided that an event of default has not
occurred, the Company will pay interest at either (i) prime (or, if higher, the federal
funds rate plus 0.50%) plus 2.75% (subject to certain adjustments) or (ii) the London
Interbank Offered Rate plus 3.75% (subject to certain adjustments).

The Term Loan Agreement is comprised of a
three-year $20 million term loan (the "Term Loan") and a three-year $23.7
million original issue discount note (the "Discount Note" and together with the
Term Loan, the "Term Debt"). The Term Debt is secured primarily by a first
security pledge of the stock of the Company's subsidiaries that provide pharmaceutical
services and a second priority security interest in substantially all of the Company's
other assets. Under the Discount Note, the Company's borrowing availability is
approximately $20.0 million. Provided that an event of Default has not occurred, interest
accrues on the Term Loan at the greater of (i) prime (or, if higher, the federal funds
rate plus 0.50%) plus 4.00% and (ii) 9.00%. The Company will pay interest on the Discount
Note for base rate borrowings a rate of interest equal to the greater of (i) prime (or, if
higher, the federal funds rate plus 0.50%) and (ii) 2.65% and for Eurodollar borrowings a
rate of interest equal to the Adjusted Eurodollar Rate (as defined in the Term Loan
Agreement) plus 0.50%.

The Company used borrowings from the Loan
Agreements to pay off the Company's debtor-in-possession credit facility on February 28,
2002.

(c)  *Divestitures subsequent to December 31, 2001*

During the first quarter of 2002, the
Company identified 13 skilled nursing facilities with 1,764 licensed beds for divestiture.
The aggregate net revenues and net losses were $92.0 million and $7.7 million,
respectively, for the year ended December 31, 2001.
     In March 2002, the Company sold substantially all of the
assets of its SunCare respiratory therapy operations.  The aggregate sales proceeds
to the Company were $0.9 million in cash.

(d)  *Fresh-start accounting*

The Company's emergence from chapter 11
bankruptcy and subsequent application of fresh-start acounting will include the following:
  allowed claims that are discharged will be removed from the financial statements;
long-lived assets will be recorded at fair market value; and equity will be reset with no
retained earnings (deficit) as of February 28, 2002. The Company expects to record
goodwill in the emerged Company's consolidated financial statements. The goodwill amount
has not currently been determined.
     The Company is in the process of determining the fair value
of the long-lived assets; this information is expected to be available in April 2002.
  The Company's first quarter 2002 consolidated financial statements will include a
summary of the fresh start accounting.

F-53

---



REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To the Board of Directors and Stockholders of
Sun Healthcare Group, Inc.:

We have audited in accordance with
auditing standards generally accepted in the United States, the consolidated financial
statements of Sun Healthcare Group, Inc. (Debtor-in-Possession) and subsidiaries in
this Form 10-K and have issued our report thereon dated March 18, 2002. Our audit was
made for the purpose of forming an opinion on the basic consolidated financial statements
taken as a whole. The schedule identified as SCHEDULE II is the responsibility of the
Company's management and is presented for purposes of complying with the Securities and
Exchange Commission's rules and is not part of the basic consolidated financial
statements. This schedule has been subjected to the auditing procedures applied in our
audit of the basic consolidated financial statements and, in our opinion, fairly states in
all material respects the financial data required to be set forth therein in relation to
the basic consolidated financial statements taken as a whole.

/s/  Arthur Andersen LLP

Albuquerque, New Mexico
March 18, 2002

1

---

SCHEDULE II

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
(Debtor-in-Possession)

VALUATION AND QUALIFYING ACCOUNTS
(in thousands)

Column A
    
    Column B
    
    Column C
    
    Column D
    
    Column EDescription
    Balance at
    Beginningof Period
    
    Charged to
    Costs andExpenses
    
    Additions
    Charged toOther Accounts
    
    DeductionsOther
    
    Balance at
    End ofPeriodYear ended December 31, 2001:Allowance for doubtful
         accounts
    $              128,106
    
    $             22,435
    (1)
    $                            -
    
    $        (76,722
    )
    $                   73,819========
    
    =======
    
    =========
    
    ======
    
    =========Notes receivable reserve
    $                  1,979
    
    $               3,537
    (1)
    $                       700
    
    $                   -
    
    $                     6,216
    (2)========
    
    =======
    
    =========
    
    ======
    
    =========Reserve for assets held for
    sale
    $              233,746
    
    $             14,442
    
    $                            -
    
    $      (235,284
    )
    $                   12,904========
    
    =======
    
    =========
    
    ======
    
    =========Corporate restructure
    reserve
    $                     729
    
    $               1,064
    
    $                            -
    
    $             (888
    )
    $                        905========
    
    =======
    
    =========
    
    ======
    
    =========Year ended December 31, 2000:Allowance for doubtful
          accounts
    $              151,841
    
    $             33,496
    (1)
    $                            -
    
    $        (57,231
    )
    $                 128,106========
    
    =======
    
    =========
    
    ======
    
    =========Notes receivable reserve
    $                  6,556
    
    $                       -
    
    $                            -
    
    $          (4,577
    )
    $                     1,979
    (2)========
    
    =======
    
    =========
    
    ======
    
    =========Reserve for assets held for
    sale
    $                84,522
    
    $           288,660
    
    $                            -
    
    $      (139,436
    )
    $                 233,746========
    
    =======
    
    =========
    
    ======
    
    =========Corporate restructure
    reserve
    $                  1,964
    
    $              (1,090
    )
    $                            -
    
    $             (145
    )
    $                        729========
    
    =======
    
    =========
    
    ======
    
    =========Year ended December 31, 1999:Allowance for doubtful
          accounts
    $                79,015
    
    $           118,373
    (1)
    $                            -
    
    $        (45,547
    )
    $                 151,841========
    
    =======
    
    =========
    
    ======
    
    =========Exit costs for acquired
          businesses
    $                  4,240
    
    $                       -
    
    $                            -
    
    $          (4,240
    )
    $                             -========
    
    =======
    
    =========
    
    ======
    
    =========Notes receivable reserve
    $                  1,712
    
    $               4,844
    (1)
    $                            -
    
    $                    -
    
    $                     6,556========
    
    =======
    
    =========
    
    ======
    
    =========Reserve for assets held for
    sale
    $              159,828
    
    $             85,758
    
    $                            -
    
    $      (161,064
    )
    $                   84,522========
    
    =======
    
    =========
    
    ======
    
    =========Corporate restructure
          reserve
    $                  3,138
    
    $              27,353
    
    $                            -
    
    $         (28,527
    )
    $                     1,964========
    
    =======
    
    =========
    
    ======
    
    =========




(2)     Included in the note receivable reserve are the
  following:
              $2,566 and $1,351
  recorded as allowance for other receivable, net, current as of
              December 31, 2001 and
  2000, respectively; and $3,650 and $628 recorded as
              allowance for note
  receivable, long-term as of December 31, 2001 and 2000,
              respectively.

2