# UNITED STATES

# SECURITIES AND EXCHANGE COMMISSION

# Washington, D.C. 20549

# FORM 10-K

## (Mark One)

## [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

## For the fiscal year ended December 31, 2001

# OR

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

# For the transition period fromto

# Commission file number          333-64679

# Harborside Healthcare Corporation

|Delaware(State or other jurisdiction of incorporation or organization)           | 04-3307188(IRS employer identification no.)
|-------------------------------------------------------------------------------- | -------------------------------------------
|                                                                                
|One Beacon Street, Boston, Massachusetts(Address of principal executive offices) | 02108(Zip Code)                            

# (617) 646-5400

# (Registrant's telephone number, including area code)

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

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

Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x       No      Not Applicable

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 registrants
knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to this Form 10-K. [   ].   Not Applicable

At March 30, 2002, the
registrant had 7,896,499 shares of Common Stock outstanding.

## Documents incorporated by reference:



## SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this
Form 10-K, including information set forth under the caption
Managements Discussion and Analysis of Financial Condition and
Results of Operations, constitute Forward-Looking Statements
within the meaning of the Private Securities Litigation Reform Act of 1995 (the
Reform Act). The Company desires to take advantage of certain
safe harbor provisions of the Reform Act and is including this
special note to enable the Company to do so. Forward-looking statements included
in this Form 10-K, or hereafter included in other publicly available documents
filed with the Securities and Exchange Commission, reports to the Companys
stockholders and other publicly available statements issued or released by the
Company involve known and unknown risks, uncertainties, and other factors which
could cause the Companys actual results, performance (financial or
operating) or achievements to differ materially from the future results,
performance (financial or operating) or achievements expressed or implied by
such forward-looking statements. The Company believes the following important
factors could cause such a material difference to occur:

`1.   The occurrence of changes in the mix of payment sources utilized by the
     Company's patients to pay for the Company's services.

2.   The adoption of cost containment measures by private pay sources such as
     commercial insurers and managed care organizations, as well as efforts by
     governmental reimbursement sources to impose cost containment measures.

3.   Changes in the United States healthcare system, including changes in
     reimbursement levels and the method of reimbursement, under Medicaid and
     Medicare, and other changes in applicable government regulations that might
     affect the profitability of the Company.

4.   The Companys continued ability to operate in a heavily regulated
     environment and to satisfy regulatory authorities, thereby avoiding a
     number of potentially adverse consequences, such as the imposition of
     fines, temporary suspension of admission of patients, restrictions on the
     ability to acquire new facilities, suspension or decertification from
     Medicaid or Medicare programs, and in extreme cases, revocation of a
     facilitys license or the closure of a facility, including as a result
     of unauthorized activities by employees.

5.   The Companys ability to secure the capital and the related cost of
     such capital necessary to fund its future growth through acquisition and
     development, as well as internal growth.

6.   Changes in certificate of need laws that might increase competition in the
     Companys industry, including, particularly, in the states in which
     the Company currently operates or anticipates operating in the future.

7.   The Companys ability to staff its facilities appropriately with
     qualified healthcare personnel, including in times of shortages of such
     personnel and to maintain a satisfactory relationship with labor unions.

8.   The level of competition in the Companys industry, including without
     limitation, increased competition from acute care hospitals, providers of
     assisted and independent living and providers of home healthcare and
     changes in the regulatory system in the state in which the Company operates
     that facilitate such competition.

9.   The continued availability of insurance for the inherent risks of liability
     in the healthcare industry.

10.  Price increases in pharmaceuticals, durable medical equipment and other
     items.

11.  The Companys reputation for delivering high-quality care and its
     ability to attract and retain patients, including patients with relatively
     high acuity levels.

12.  Changes in general economic conditions, including changes that pressure
     governmental reimbursement sources to reduce the amount and scope of
     healthcare coverage.

  The foregoing review of significant factors should not be construed as
exhaustive or as an admission regarding the adequacy of disclosures previously
made by the Company.`

# 2

# TABLE OF CONTENTS

`PAGE
                                                                                     -----

                                     PART I

ITEM 1. BUSINESS                                                                          4

ITEM 2. PROPERTIES                                                                        14

ITEM 3. LEGAL PROCEEDINGS                                                                 15

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                               15



                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
         STOCKHOLDER MATTERS                                                              16

ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA                                17

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
         CONDITION AND RESULTS OF OPERATIONS                                              19

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES
         ABOUT MARKET RISK                                                                30

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                       31

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
         ACCOUNTING AND FINANCIAL DISCLOSURE                                              59

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                               59

ITEM 11. EXECUTIVE COMPENSATION                                                           61

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
           MANAGEMENT                                                                     64

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                   66

                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
           FORM 8-K                                                                       66

SIGNATURES                                                                                73`

# 3

PART I

ITEM 1. BUSINESS

GENERAL OVERVIEW

Harborside Healthcare Corporation, through its subsidiaries
provides high quality long-term care, subacute care and other specialty medical
services in four principal geographic regions: the Southeast (Florida), the
Midwest (Ohio and Indiana), New England (Connecticut, Massachusetts, New
Hampshire and Rhode Island), and the Mid-Atlantic (New Jersey and Maryland).
Within these regions, as of December 31, 2001, Harborside Healthcare Corporation
(on a consolidated basis, Harborside or the Company)
operated 51 licensed long-term care facilities (18 owned, 32 leased and one
managed) with a total of 6,274 licensed beds.

The Company provides traditional skilled nursing care, a wide
range of subacute care programs (such as orthopedic, CVA/stroke, cardiac,
pulmonary and wound care), as well as programs for the provision of care to
Alzheimers and hospice patients. As part of its subacute services, the
Company provides physical, occupational and speech rehabilitation therapy
services at Company-operated facilities. Through September 1999, the Company
also provided rehabilitation therapy services under contracts with
non-affiliated long-term care facilities through a wholly-owned subsidiary.
During the third quarter of 1999, the Company terminated its contracts with
non-affiliated facilities and ceased providing therapy services to
non-affiliated facilities.

Harborside was created in March 1996, in anticipation of an
initial public offering (the IPO), in order to combine under its
control the operations of various long-term care facilities and ancillary
businesses (the Predecessor Entities) which had operated since 1988.
The Company completed the IPO on June 14, 1996 and issued 3,600,000 shares of
common stock at $11.75 per share. Immediately prior to the IPO the owners of the
Predecessor Entities contributed their interests in such Predecessor Entities to
the Company and received 4,400,000 shares of the Companys common stock
(the Reorganization).

On April 15, 1998, Harborside entered into a Merger Agreement
with HH Acquisition Corp. (MergerCo), an entity organized for the
sole purpose of effecting a merger on behalf of Investcorp S.A., certain of its
affiliates and certain other international investors (the New
Investors). On August 11, 1998, MergerCo merged with and into Harborside,
with Harborside as the surviving corporation. In the merger, each share not
retained by existing shareholders was converted into $25 in cash, representing
in the aggregate, cash payments of approximately $184 million. Holders of
outstanding stock options of the Company converted the majority of their options
into cash at $25 per underlying share (less applicable exercise price and
withholding taxes) with aggregate payments of approximately $8 million. In
connection with the transaction and prior to the merger, the New Investors made
cash common equity contributions of $158.5 million, net of issuance costs, to
MergerCo, and MergerCo obtained gross proceeds of $99.5 million through the
issuance of 11% Senior Subordinated Discount Notes (Discount Notes)
due 2008 and $40 million through the issuance of 13.5% Exchangeable Preferred
Stock (Preferred Stock) mandatorily redeemable in 2010. In the third
quarter of 1998, Harborside recorded a charge to income from operations of $37
million ($29 million after taxes) for direct and other costs related to the
merger transaction. In connection with the merger and the related refinancings,
the Company exercised purchase options for seven facilities which had been
financed through synthetic leases. As a result of the transaction, and pursuant
to the Merger Agreement, the New Investors acquired approximately 91% of the
post-merger common stock of Harborside. The remaining 9% of the common stock was
retained by existing shareholders, including management. As a result of the
merger, Harborside shares were de-listed from the New York Stock Exchange.

In March 2001, the Company entered into an agreement (the
"Restructuring Agreement") with Investcorp S.A. and the holders of more than a
majority in interest of the Company's Discount Notes and Preferred Stock for
purposes of implementing a restructuring of the Discount Notes and Preferred
Stock. The Restructuring Agreement contemplated that the Company would offer to
exchange for each $1,000 amount at maturity of outstanding Discount Notes a
combination of the following: (1)0.5899118 of a new 12% Senior Subordinated
Discount Note due 2007 (the "New Notes") each having a principal amount at
maturity equal to $1,000 and an original issue price of $685.67 (assuming that
the New Notes were issued on May 4, 2001), (2) $88.2353 in cash and (3) common
stock purchase warrants for approximately 10.9 shares of its Class A Common
Stock. The Company would also offer to exchange common stock purchase warrants
for approximately 10.7 shares of its Class A Common Stock for each $1,000
liquidation preference of Preferred Stock (based on the aggregate liquidation
preference to be outstanding on May 1, 2001) plus any dividends accrued on such
Preferred Stock after May 1, 2001. In conjunction with the restructuring
proposal, the Company would solicit consents from holders of outstanding
Discount Notes and Preferred Stock to amendments to the Indenture governing the
Discount Notes and to the Certificate of Designation governing the Preferred
Stock that would eliminate or modify certain restrictive covenants and other
provisions contained in the Indenture and the Certificate of Designation and
would substantially eliminate the preferences of the Preferred Stock, including
the reduction of the liquidation preference from $1,000 to $0.01 per share and
the elimination of the right of holders to be paid dividends on shares of
Preferred Stock. Also, the Company would issue to Investcorp S.A. (or one or
more of its affiliates or designees) up to 15,000 shares of a new series of 13%
convertible exchangeable preferred stock (the "New Preferred Stock") and
1,854,422 common stock purchase warrants for a total purchase price of up to
$15,000,000.

On April 6, 2001 the Company initiated the exchange offer and
consent solicitation contemplated by the Restructuring Agreement. On May 10,
2001, the Company completed the exchange offer and consent solicitation, thereby
implementing each of the elements of the Restructuring Agreement. All of the
outstanding Discount Notes and 99.96% of the shares of Preferred Stock were
tendered and exchanged in the exchange offer. As a result of the exchange, (1)
the Company has an aggregate principal amount at maturity of $100,276,000 of New
Notes outstanding and an aggregate liquidation preference of $15,000,000 (as of
May 10, 2001) of New Preferred Stock outstanding, (2) warrants were issued to
holders of Discount Notes, to holders of Preferred Stock, and to Investcorp S.A.
representing the right to purchase an aggregate of approximately 15%, 5% and
15%, respectively, of the total number of shares of all classes of the Company's
common stock on a fully diluted basis (excluding shares issuable upon conversion

# 4

of the New Preferred Stock, each share of which will initially
be convertible into 150 shares of Class A Common Stock, and (3) the Company paid
$15,000,000 in cash as partial consideration for the tendered Discount
Notes.

The reduction in the liquidation preference of the Preferred
Stock was completed on May 10, 2001, as contemplated by the Restructuring
Agreement, the carrying amount of the Preferred Stock was reduced from
$57,595,000 to $576 and the amount of the reduction, net of unamortized deferred
financing costs related to the issuance of the Preferred Stock (approximately
$1,011,000 at May 10, 2001), was directly transferred to the Company's
Accumulated Deficit account. With the exchange of the New Notes for the Discount
Notes (the "Note Exchange"), the carrying value of the accreted principal of the
Discount Notes was reduced to $68,890,000, and the amount of the reduction, net
of the aggregate cash payment of $15,000,000, was directly transferred to the
Company's Long-term Accrued Interest account. Subsequent to their issuance, the
carrying amount of the New Notes increases as the result of accretion and
results in a corresponding decrease in the carrying amount of Long-term Accrued
Interest. Interest expense on the New Notes is recognized such that a constant
effective interest rate is applied to the aggregate carrying amount of the New
Notes and Long-term Accrued Interest for all periods between the issuance date
and the maturity date of the New Notes.

In connection with an amendment to the Company's revolving
credit facility (the "Credit Facility") and the implementation of the
Restructuring Agreement, the Company incurred a non-recurring charge of
$9,045,000. The charge resulted from the write-off of approximately $1,500,000
of unamortized deferred financing costs incurred when the Credit Facility was
obtained, the write-off of approximately $3,400,000 of unamortized deferred
financing costs related to the issuance of the Discount Notes, and the
recognition of various investment advisory, legal and other fees associated with
these events of $4,145,000.

The New Notes were issued at a discount and interest on the
New Notes accretes until August 1, 2004. Cash interest payments will be paid
semi-annually in arrears beginning on February 1, 2005 based on the fully
accreted value of the New Notes and a 12% cash interest payment rate. The New
Notes mature on August 1, 2007. The New Preferred Stock is mandatorily
redeemable on February 1, 2008. The holders of the New Preferred Stock are
entitled to dividends quarterly in arrears beginning August 1, 2001 and payable
in additional shares of New Preferred Stock. Warrants to purchase a total of
4,326,641 shares of common stock at $0.01 per share were issued on May 10,
2001.

PATIENT SERVICES

Basic Patient Services

Basic patient services are those traditionally provided to
elderly patients in long-term care facilities to assist with the activities of
daily living and to provide general medical care. The Company provides 24-hour
skilled nursing care by registered nurses, licensed practical nurses and
certified nursing aides in most of its facilities. Each facility is managed by
an on-site licensed administrator who is responsible for the overall operation
of the facility, including the quality of care provided. The medical needs of
patients at the Companys licensed skilled nursing facilities are
supervised by a medical director, who is a licensed physician. Although
treatment of patients is the responsibility of their own attending physicians,
who are not employed by the Company, the medical director monitors all aspects
of delivery of care. The Company also provides support services, including
dietary services, therapeutic recreational activities, social services,
housekeeping and laundry services, pharmaceutical and medical supplies and
routine rehabilitation therapy.

Each facility offers a number of individualized therapeutic
activities designed to enhance the quality of life of its patients. These
activities include entertainment events, musical productions, trips, arts and
crafts and volunteer and other programs that encourage community interaction.

Specialty Medical Services

Specialty medical services are those provided to patients with
medically complex needs, who generally require more extensive treatment and a
higher level of skilled nursing care. These services typically generate higher
net patient service revenues per patient day than basic patient services as a
result of increased levels of care and the provision of ancillary services.

Subacute Care. Subacute care is goal-oriented, comprehensive
care designed for an individual who has had an acute illness, injury, or
exacerbation of a disease process. Subacute care is typically rendered
immediately after, or instead of, acute hospitalization in order to treat one or
more specific, active, complex medical conditions or in order to administer one
or more technically complex treatments. The Company provides subacute care
services at substantially all of its existing facilities in such areas as
complex medical, cardiac recovery, digestive, immuno-suppressed disease,
post-surgical, wound, CVA/stroke care, hemodialysis, infusion therapy, and
diabetes and pain management.

In facilities that have shown strong demand for subacute
services, the Company has developed subacute units. Each unit contains 20 to 60
beds and is specially staffed and equipped for the delivery of subacute care.
Patients in these units typically range in age from late teens to the elderly,
and typically require high levels of nursing care and the services of
physicians, therapists, dietitians, clinical pharmacists or psycho/social
counselors. Certain patients may also require life support or monitoring
equipment. Because patient goals are generally rehabilitation-oriented, lengths
of stay in distinct subacute units are generally not expected to substantially
exceed 30 days.

Alzheimers Care. The Company has also developed units
that provide care for patients with Alzheimers disease. As of December 31,
2001, the Company operated dedicated Alzheimers units at nine facilities.

# 5

OPERATIONS

Facilities. Each of the Companys facilities is
supervised by a licensed facility administrator who is responsible for all
aspects of the facilitys operations. The facility administrator oversees
(i) a director of nursing who supervises a staff of registered nurses, licensed
practical nurses and certified nursing aides, (ii) a director of admissions who
is responsible for developing local marketing strategies and programs and (iii)
various other departmental supervisors. The Company also contracts with one or
more licensed physicians at each facility to serve as medical directors for the
purpose of supervising the medical management of patients. Facilities with
subacute or specialty medical units or programs may also contract with physician
specialists to serve as rehabilitation or specialty program medical directors in
areas such as physiatry (physical medicine), neurology or gero-psychology.
Facilities may also employ or contract for additional clinical staff such as
nurse liaisons, case managers, therapists and program directors. Department
supervisors at each of the Companys facilities oversee personnel who
provide dietary, maintenance, laundry, housekeeping, therapy and social
services. In addition, a business office staff at each facility routinely
performs administrative functions, including billing, payroll and accounts
payable processing. The Companys corporate and regional staff provide
support services such as quality assurance, management training, clinical
consultation and support, management information systems, risk management, human
resource policies and procedures, operational support, accounting and
reimbursement expertise.

Regions. The Company seeks to cluster its long-term care
facilities in selected geographic regions to establish a strong competitive
position as well as to position the Company as a healthcare provider of choice
to managed care and private payors in these markets. The Companys
facilities currently serve four principal geographic regions: the Southeast
(Florida), the Midwest (Ohio and Indiana), New England (Connecticut,
Massachusetts, New Hampshire and Rhode Island), and the Mid-Atlantic (New Jersey
and Maryland). The Company maintains regional operating offices in Palm Harbor,
Florida; Beachwood, Ohio; Indianapolis, Indiana; Topsfield, Massachusetts; West
Hartford, Connecticut; and Sharon, New Hampshire. Each region is supervised by a
regional director of operations who directs the efforts of a team of
professional support staff in the areas of clinical services, marketing,
bookkeeping, human resources and engineering. Other Company staff, who are
principally based in the regions, provide support and assistance to all of the
Companys facilities in the areas of subacute services, managed care
contracting, reimbursement services, risk management, data processing and
training. Financial control is maintained through financial and accounting
policies established at the corporate level for use at each facility. The
Company has standardized operating policies and procedures and continually
monitors operating performance to assure consistency and quality of operations.

Continuous Quality Improvement Program. The Company has
developed a continuous quality improvement program which is designed to monitor,
evaluate and improve the delivery of patient care. The program is supervised by
the Companys Senior Vice President of Clinical Services and the Vice
President of Quality Assurance and Improvement and consists of the
standardization of policies and procedures, routine site visits and assessments
and a quality control system for patient care and physical plant compliance.
Pursuant to its quality control system, the Company routinely collects
information from patients, family members, referral sources, employees and state
survey agencies which is then compiled, analyzed and distributed throughout the
Company in order to monitor the quality of care and services provided.

The Companys continuous quality improvement program is
modeled after guidelines for long-term care and subacute facilities promulgated
by the Joint Commission on Accreditation of Healthcare Organizations
(JCAHO), a nationally recognized accreditation agency for hospitals
and other healthcare organizations. The Company believes that JCAHO
accreditation is an important factor in gaining provider contracts from managed
care and commercial insurance companies. Accordingly, in late 1995 the Company
began a program to seek accreditation from JCAHO for the Companys
facilities. As of December 31, 2001, 33 of the Companys facilities had
received accreditation.

MARKETING

The Companys marketing program is designed to attract
patients who will have a favorable impact on the Companys profits and
quality mix of revenues. The Company establishes monthly occupancy and revenue
goals for each of its facilities and maintains marketing objectives to be met by
each facility. The Companys Vice President of Marketing and Managed Care
is principally responsible for the development and implementation of the
Companys marketing program. Regional marketing directors provide routine
support to the facility-based admissions directors through the development of
facility-based marketing strategies, competitive assessments and routine visits.

The Company uses a decentralized marketing approach in order
to capitalize on each facilitys strengths and reputation in the community
it serves. Admissions staff at each facility are primarily responsible for
marketing basic medical services and developing semi-annual marketing plans in
consultation with the Companys regional marketing and operations staff.
Basic medical services are marketed to area physicians, hospital discharge
planning personnel, individual patients and their families and community
referral sources. Facility personnel also market the Companys specialty
medical services to these sources. Corporate and regional personnel who
specialize in subacute care, managed care and reimbursement also assist in the
marketing of specialty medical services.

The Company believes its marketing program has demonstrated
its effectiveness. The Companys average annual occupancy rates for the
fiscal years ended December 31, 1999, 2000 and 2001 were 90.9%, 90.1% and 88.9%
respectively. In comparison, a study of approximately 17,000 nursing facilities
conducted by the U.S. Department of Health and Human Services found that in 1997
nursing facilities operated at approximately 88% of capacity.

# 6

SOURCES OF REVENUES

The Company derives its revenues primarily from private pay
sources, the Federal Medicare program for certain elderly and disabled patients
and state Medicaid programs for indigent patients. The Companys revenues
are influenced by a number of factors, including (i) the licensed bed capacity
of its facilities, (ii) the occupancy rates of its facilities, (iii) the payor
mix of its facilities and the rates of reimbursement among payor categories
(private and other, Medicare and Medicaid) and (iv) the extent to which subacute
and other specialty medical and ancillary services are utilized by the patients
and paid for by the respective payment sources. The Company employs specialists
to monitor reimbursement rules, policies and related developments in order to
comply with all reporting requirements and to assist the Company in receiving
reimbursements. Although Medicare and higher acuity patients generally produce
the highest revenue per patient day, costs associated with the higher acuity
needs of these patients also tend to be higher. The Company believes that
Medicaid patients generally produce the lowest profit margins.

`The following table identifies the Company's percentage of net revenues
attributable to each of its payor sources for the periods indicated:

                               PERCENTAGE OF TOTAL NET REVENUES BY PAYOR (1)
                                           YEAR ENDED DECEMBER 31,
                                           ----------------------

                                 1999                2000               2001
                                 ----                ----               ----

Private and other...........     28.9%              25.8%              22.6%
Medicare....................     21.8               25.0               30.7
Medicaid.....................    49.3               49.2               46.7
                              -------            -------             ------
  Total........................ 100.0%             100.0%             100.0%
                              =======            =======             ======`

(1) Total net revenues exclude net revenues of the Larkin
Chase Center which is owned by the Bowie Center Limited Partnership (Bowie
L.P.). The Company owns a 75% partnership interest in Bowie L.P. but
records its investment in Bowie L.P. using the equity method of accounting. See
Note A to the Companys consolidated financial statements included
elsewhere in this filing.

Private and Other. Private and other net revenues include
payments from individuals who pay directly for services without governmental
assistance and payments from commercial insurers, HMOs, PPOs, Blue Cross
organizations, workers compensation programs, hospice programs and other
similar payment sources. The Companys rates for private pay patients are
typically higher than rates for patients eligible for assistance under state
Medicaid programs. The Companys private pay rates vary from facility to
facility and are influenced primarily by the rates charged by other providers in
the local market and by the Companys ability to distinguish its services
from those provided by its competitors. Although private pay rates are generally
established on a facility-specific fee schedule, rates charged for individual
cases may vary widely because, in the case of managed care, they are either
negotiated on a case-by-case basis with the payor or are fixed by contract.
Rates charged to private pay patients are not subject to regulatory control in
any of the states in which the Company operates.

Medicare. Substantially all of the Companys facilities
are certified Medicare providers. Medicare is a federally funded and
administered health insurance program primarily designed for individuals who are
age 65 or over and are entitled to receive Social Security benefits. The
Medicare program consists of two parts. The first part, Part A, covers inpatient
hospital services and certain services furnished by other institutional
healthcare providers, such as skilled nursing facilities. The Medicare Part A
program provides reimbursement for skilled nursing services provided to Medicare
beneficiaries who are admitted to skilled nursing care facilities following a
minimum three-day stay in an acute care hospital. Part A covered services
include skilled nursing care, rehabilitative therapy treatment, social services,
pharmaceuticals, medical supplies in addition to other services. Part A coverage
for services delivered in a skilled nursing facility requires a three-day stay
in an acute care hospital and is limited to a specified term (generally 100 days
per spell of illness), requires beneficiaries to share some of the
cost of covered services through the payment of a deductible and a co-insurance
payment and requires beneficiaries to meet certain qualifying criteria. The
second part of the Medicare program, Part B, covers the services of doctors,
suppliers of medical items and services and various types of outpatient
services. Part B services include physical, speech and occupational therapy and
durable medical equipment and other ancillary services of the type provided by
long-term care or acute care facilities. Part B services generally require
beneficiaries to share the cost of covered services through a co-insurance
payment. Prior to December 31, 1998 there were no limits on duration of coverage
for Part B services.

Through December 31, 1998, the Medicare Part A program
reimbursed the Company for covered services under a cost-based reimbursement
system for its allowable direct and indirect costs. In August of 1997, the
Balanced Budget Act of 1997 ( the BBA) was enacted. The BBA provided
a prospective payment system (PPS) for skilled nursing facilities to
be implemented for cost reporting years beginning on or after July 1, 1998. The
Companys facilities began to be reimbursed in accordance with the BBA
beginning January 1, 1999. During the first three years of PPS, the Part A
Medicare per diem rates were based on a blend of facility-specific rates and
federal rates. Beginning on January 1, 2002, the per diem rates will be based
solely on federal rates. As a result of the implementation of PPS, the
Companys Medicare Part A per diem rate declined from $397 in 1998 to $290
in 1999. Various Federal actions during the past two years have restored some of
the funding eliminated through enactment of the BBA. However, despite these
actions, the Companys Part A Medicare per diem rate remains substantially
lower than the rate received prior to the enactment of the BBA. The
Companys Part A Medicare per diem rate increased to $322 in 2000 and $340
in 2001. See Government Regulation  and Managements
Discussion and Analysis of Financial Condition and Results of Operations.
The BBA also implemented a prospective payment system for Part B services. Prior
to January 1, 1999, the Company was reimbursed for Part B services on a cost
reimbursement basis. Beginning January 1, 1999, Medicare Part B services began
being reimbursed on a fee screen basis. These fee screens are revised by the
Centers for Medicare and Medicaid Services (CMS) on an annual basis.

# 7

The BBA also imposed an annual limitation on Part B therapy
charges of $1,500 per beneficiary.

Medicaid. Substantially all of the Companys facilities
participate in the Medicaid program of the states in which they are located.
Medicaid is a state-administered reimbursement program for indigent patients
financed by state funds (and in certain states, county funds) and matching
federal funds. Although administered under Federal regulations, states have
substantial flexibility to design programs and determine reimbursement rates,
and as a result, individuals programs and reimbursement rates vary significantly
from state to state. The Federal government retains the right to approve or
disapprove individual state plans.

Until the enactment of the BBA, a Federal Medicaid statute,
generally referred to as the Boren Amendment, required Medicaid
programs to provide reimbursement rates that were reasonable and adequate to
cover the costs that would be incurred by efficiently and economically operated
facilities while providing services in conformity with state and federal laws,
regulations and quality and safety standards. The BBA repealed the Boren
Amendment effective October 1, 1997 and allowed the states to develop their own
standards for determining Medicaid payment rates. In the past, several
states healthcare provider organizations and providers have initiated
litigation challenging the Medicaid reimbursement methodologies employed in such
states, asserting that reimbursement payments are not adequate to reimburse an
efficiently operated facility for the costs of providing Medicaid covered
services. The repeal of the Boren Amendment provides states with greater
flexibility to amend individual state programs and potentially reduce state
Medicaid payments to skilled nursing facilities. Medicaid covered services vary
by state, but generally include nursing care, room and board, and social
services. Additionally, some states provide reimbursement for pharmaceuticals,
rehabilitative therapy treatment and other services.

The Company has been in the past and could be in the future,
adversely affected by the continuing efforts of governmental third-party payors
to control health care expenditures.

MANAGEMENT INFORMATION SYSTEMS

The Companys information systems strategy is to provide
its facilities with extensive and timely information, which will allow them to
operate efficiently under prospective payment reimbursement systems. A
cornerstone of this strategy is to avoid the high costs and risks associated
with the internal development of significant transaction processing systems.
Whenever possible, the Companys buys well-tested software and avoids the
costs and risks inherent in customizing these systems. The Company also places
high importance on the interconnection of transactional and clinical data
through its extensive data warehouse capabilities.

All of the Companys facilities are supported by a
centralized, integrated financial reporting system which processes financial
transactions and which enables Company personnel to monitor and respond on a
timely basis to key operating and financial data and budget variances. Using its
data warehouse, the Company monitors its occupancy levels, payor mix and overall
staffing and temporary labor utilization on a daily basis. The Company utilizes
a payroll processing service company to process payroll transactions and
maintain human resources files for employees at all of its facilities. During
1999, the Company installed new clinical and accounts receivable systems at all
of its facilities. The Companys clinical system captures the data
necessary to obtain proper reimbursement from the Federal Part A Medicare
program as well as certain state Medicaid programs. The Companys clinical
system also provides data essential to the Companys clinical services,
continuous quality improvement program.

GOVERNMENTAL REGULATION

The Federal government and all states in which the Company
operates regulate various aspects of the Companys business. In addition to
the regulation of payment rates by governmental payor sources, the development
and operation of long-term care facilities and the provision of long-term care
services are subject to Federal, state and local licensure and certification
laws which regulate with respect to a facility, among other matters, the number
of beds, the services provided, the distribution of pharmaceuticals, equipment,
staffing requirements, patients rights, operating policies and procedures,
fire prevention measures, environmental matters and compliance with building and
safety codes. There can be no assurance that Federal, state or local
governmental regulations will not change or be subjected to new interpretations
that impose additional restrictions which might adversely affect the
Companys business.

All of the skilled nursing facilities operated by the Company
are licensed under applicable state laws and possess the required Certificates
of Need (CON) from responsible state authorities.

Substantially all of the Companys facilities are
certified or approved as providers under the Medicaid and Medicare programs.
Both the initial and continuing qualification of a long-term care facility to
participate in such programs depend upon many factors, including accommodations,
equipment, services, non-discrimination policies against indigent patients,
patient care, quality of life, patients rights, safety, personnel,
physical environment and adequacy of policies, procedures and controls.
Licensing, certification and other applicable standards vary from jurisdiction
to jurisdiction and are revised periodically. State agencies survey or inspect
all long-term care facilities on a regular basis to determine whether such
facilities are in compliance with the requirements for participation in
government-sponsored third-party payor programs. In some cases, or upon repeat
violations, the reviewing agency has the authority to take various adverse
actions against a facility, including the imposition of fines, temporary
suspension of admission of new patients to the facility, suspension or
decertification from participation in the state Medicaid program or the Medicare
program, offset of amounts due against future billings to the Medicare or
Medicaid programs, denial of payments under the state Medicaid program for new
admissions, reduction of payments, restrictions on the ability to acquire new
facilities and, in extreme circumstances, revocation of a facilitys
license or closure of a facility.

# 8

The Company believes that its facilities are in substantial
compliance with all statutes, regulations, standards and requirements applicable
to its business, including applicable Medicaid and Medicare regulatory
requirements. However, in the ordinary course of its business, the Company from
time to time receives notices of deficiencies for failure to comply with various
regulatory requirements. In most cases, the Company and the reviewing agency
will agree upon corrective measures to be taken to bring the facility into
compliance. Although the Company has been subject to some fines, statements of
deficiency and other corrective actions have not had a material adverse effect
on the Company.

The Company believes that the regulatory environment
surrounding the long-term care industry has intensified, particularly for
multi-facility for-profit operators. The Federal government has imposed
intensive enforcement policies resulting in a significant increase in the number
of inspections, citations of regulatory deficiencies, and other regulatory
sanctions including terminations from the Medicare and Medicaid programs, bars
on Medicare and Medicaid payments for new admissions and civil monetary
penalties. There can be no assurance that future agency inspections and the
actions taken by the reviewing agency based upon such inspections will not have
a material adverse effect on the Companys results of operations, cash
flows or its financial position.

Certificates of Need. All but one of the states in which the
Company operates have adopted CON or similar laws that generally require that a
state agency determine that a need exists prior to the construction of new
facilities, the addition or reduction of licensed beds or services, the
implementation of other changes, the incurrence of certain capital expenditures,
and, in certain states, the approval of certain acquisitions and changes in
ownership or the closure of a facility. Indianas CON program expired as of
June 30, 1998. State CON approval is generally issued for a specific project or
number of beds, specifies a maximum expenditure, is sometimes subject to an
inflation adjustment, and requires implementation of the proposal within a
specified period of time. Failure to obtain the necessary state approval can
result in the inability of the facility to provide the service, operate the
facility or complete the acquisition, addition or other change and can also
result in adverse reimbursement action or the imposition of sanctions or other
adverse action on the facilitys license.

Medicare. A substantial portion of the Companys revenues
are derived from the Medicare program. See Sources of Revenues. All
of the Companys skilled nursing facilities are certified Medicare
providers. Medicare is a federally funded and administered health insurance
program primarily designed for individuals who are age 65 or over and are
entitled to receive Social Security benefits. The Medicare program consists of
two parts. The first part, Part A, covers inpatient hospital services and
certain services furnished by other institutional healthcare providers, such as
skilled nursing facilities. The Medicare Part A program provides reimbursement
for skilled nursing services provided to Medicare beneficiaries who are admitted
to skilled nursing facilities following a minimum three-day stay in an acute
care hospital. Part A covered services include skilled nursing care,
rehabilitative therapy treatment, social services, pharmaceuticals, medical
supplies in addition to other services. Part A coverage for services delivered
in a skilled nursing care facility requires a three-day stay in an acute care
hospital, is limited to a specified term (generally 100 days per spell of
illness), requires beneficiaries to share some of the cost of covered
services through the payment of a deductible and a co-insurance payment and
requires beneficiaries to meet certain qualifying criteria. The second part of
the Medicare program, Part B, covers the services of doctors, suppliers of
medical items and services and various types of outpatient services. Part B
services include physical, speech and occupational therapy and durable medical
equipment and other ancillary services of the type provided by skilled nursing
or acute care facilities. Part B services generally require beneficiaries to
share the cost of covered services through a co-insurance payment. Prior to
December 31, 1998 there were no limits on duration of coverage for Part B
services.

Over the past several years, the Federal government has
enacted three significant laws that dramatically affected the payment
methodology through which skilled nursing facilities are reimbursed by the
Medicare program. The first, the BBA, was enacted in August 1997 and
significantly amended the reimbursement methodology of the Medicare program. In
addition to offering new Medicare health plan options and increasing the
penalties related to healthcare fraud and abuse, the BBA provided for a
prospective payment system for skilled nursing facilities to be implemented for
cost report periods beginning on or after July 1, 1998. Through December 31,
1998, the Medicare Part A program reimbursed the Company for covered services
under a cost-based reimbursement system for its allowable direct and indirect
costs.

Medicare PPS is being phased in over a period of four years,
beginning with skilled nursing facility cost reporting periods ending on or
after July 1, 1998. New facilities, which first received Medicare
payment on or after October 1, 1995, moved to the federal per diem rate
effective with the cost report periods beginning on or before July 1, 1998 and
do not have a transitional period. All other facilities are being
phased-in by a formula effective with the cost report period
beginning on or after July 1, 1998 and through which Medicare PPS will blend
together facility-specific rates and federal industry per diems according to the
following schedule: Year One -- 75% facility-specific, 25% federal per diem;
Year Two -- 50% each; Year Three -- 25% facility-specific, 75% federal per diem;
Year Four -- 100% federal per diem. As a result of Medicare PPS being effective
for cost reports beginning on or after July 1, 1998, Medicare PPS did not
directly impact the Companys Medicare reimbursement until the fiscal year
beginning January 1, 1999. When fully implemented, Medicare PPS will result in
each skilled nursing facility being reimbursed on a per diem rate (the
Federal per diem rate) basis with acuity-based per diem rates being
established as applicable to all Medicare Part A beneficiaries who are residents
of the skilled nursing facility. The acuity-based per diem rates are determined
by classifying each patient into one of forty-four resource utilization groups
(RUG) using the data captured by completing the minimum data
assessment (MDS) required by CMS. Each RUG classification is
assigned its own Federal per diem rate by CMS. The Federal per diem rates will
be all-inclusive rates through which the skilled nursing facility is reimbursed
for its routine, ancillary and capital costs. During the transition period, the
per diem rates for each facility consist of a blending of facility-specific
costs and Federal per diem rates. The unadjusted Federal per diem rates to be
applied to days of covered skilled nursing facility services furnished during
the first year, the case mix classification system to be applied with respect to
such services, and the factors to be applied in making area wage adjustments
with respect to such services, are included in the Medicare PPS regulations. The
Federal Medicare PPS rates were developed by CMS based on a blend of allowable
costs from hospital-based and freestanding skilled nursing facility cost reports
for reporting periods beginning in Federal Fiscal Year 1995 (i.e., October 1,
1994 -- September 30, 1995). The data used in developing the Federal rates
incorporate an estimate of the amounts payable under Part B for covered skilled
nursing facility services furnished during Federal Fiscal Year 1995 to

# 9

individuals who were residents of a facility and receiving Part
A covered services. CMS updated costs to the first year of Medicare PPS using a
skilled nursing facility market basket index standardized for facility
differences in case-mix and for geographic variations in wages. Providers that
received new provider exemptions from the routine cost limits were
excluded from the database used to compute the federal payment rates. In
addition, costs related to payments for exceptions to the routine cost limits
are excluded from the database used to compute the federal payment rates. The
facility-specific portion is based on each facilitys Medicare cost report
for cost reporting periods beginning in Federal Fiscal Year 1995, including
routine cost limit exception and exemption payments up to 150% of the routine
cost limit, the allowable costs to be updated under Medicare PPS for the skilled
nursing facility market basket minus 1% through 1999 and the full skilled
nursing facility market basket after 1999. A variety of other adjustments are
made in developing the Medicare PPS rates pursuant to the BBA and the
regulations. As noted, except in the case of new facilities, in the
first year of the transition to Medicare PPS, the per diem rates consisted of a
blend of 25% federal per diem rates and 75% facility-specific costs. Thereafter,
the facility-specific cost portion will decrease by 25% per year until in the
fourth year, beginning January 1, 2002, the rate will be 100% Federal per diem
rates. New facilities are on 100% Federal per diem rates for cost
reporting periods beginning on or after July 1, 1998.

The BBA also required skilled nursing facilities to institute
consolidated billing for a variety of services and supplies. Under
consolidated billing, the skilled nursing facility must submit all Medicare
claims for all the Part A services and supplies that its residents receive, with
the exception of certain services, including those provided by physicians.
Payments for these services and supplies billed on a consolidated basis are made
directly to the skilled nursing facility, whether or not the services were
provided directly by the skilled nursing facility or by others under a
contractual arrangement. The skilled nursing facility is responsible for paying
the provider of the services or the supplier.

The BBA also implemented a prospective payment system for Part
B services. Prior to January 1, 1999, the Company was reimbursed for Part B
services on a cost reimbursement basis. Beginning January 1, 1999, Medicare Part
B services began being reimbursed on a fee screen basis. These fee screens are
revised by the CMS on an annual basis. The BBA also imposed an annual limitation
on Part B therapy charges of $1,500 per beneficiary and imposed a future
requirement to implement consolidated billing for Part B services.

On November 29, 1999, the second major law, the Balanced
Budget Refinement Act of 1999 (the BBRA) was signed into law.
The BBRA was designed to mitigate some of the effects of the BBA. The BBRA
allowed skilled nursing facilities to elect transition to the full Federal per
diem rate at the beginning of their cost reporting periods for cost periods
beginning on or after January 1, 2000. Using the election allowed by the BBRA,
the Company chose to move fourteen facilities to the full Federal per diem rate
effective January 1, 2000. As a result, as of December 31, 2000, the Company
used the full Federal per diem rate to calculate Medicare revenue at
twenty-three of its skilled nursing facilities. Additionally, the BBRA increased
the Federal per diem rates by 20% for fifteen RUG categories (three
rehabilitative therapy RUG categories, twelve non-rehabilitative therapy RUG
categories) beginning on April 1, 2000. These increased rates were to stay in
effect until the later of (a) October 1, 2000 or (b) the date CMS implements a
revised PPS system that more accurately reimburses the costs of caring for
medically complex patients. The BBRA also provided for a four percent temporary
increase in the Federal per diem rates for all RUG categories for a two-year
period beginning October 1, 2000. The BBRA also excluded costs for certain
supplies and services that were formerly required to be reimbursed by a skilled
nursing facilitys PPS rate. The BBRA also eliminated the annual provider
limitations on Part B therapy charges per beneficiary for calendar year 2000 and
2001.

In December 2000, the third major law, the Medicare, Medicaid,
and State Child Health Insurance Program Benefits Improvement and Protection Act
of 2000 (BIPA) was enacted. BIPA temporarily increased the existing
nursing rate component of the Federal per diem rate, for each RUG category, by
16.66% from April 1, 2001 through September 30, 2002. In addition, BIPA
eliminated the 20% add-ons (provided by BBRA) for the three rehabilitative
therapy RUG categories and substituted 6.7% add-ons for all fourteen
rehabilitative therapy RUG categories. The 6.7% add-ons are scheduled to stay in
effect until CMS implements a revised PPS system as contemplated by the BBRA.
BIPA also extended the moratorium on the annual limitation on Part B therapy
charges of $1,500 per beneficiary through calendar year 2002 and repealed the
BBA requirement to implement consolidated billing for Part B services.

Certain of the increases in Medicare reimbursement for skilled
nursing facilities provided for under the BBRA and BIPA are scheduled to expire
on October 1, 2002. Unless Congress enacts new legislation, the loss of revenues
associated with this occurrence could have a material adverse effect on the
Company. If new legislation is not enacted, the Company estimates that its
revenues for the quarter ended December 31, 2002 would be reduced by
approximately $37 per Medicare Part A patient day. The Company cannot provide
assurances that Congress will act to renew the existing legislation; however,
the Company does anticipate that it would take actions to reduce costs to offset
a portion of this revenue reduction. At this time, the Company cannot predict
the course of action likely to be selected by Congress or the impact of this
issue on the Companys net income for the year ended December 31, 2002.

Medicaid. Substantially all of the Companys facilities
participate in the Medicaid program of the states in which they are located.
Medicaid is a state-administered reimbursement program for indigent patients
financed by state funds (and in certain states, county funds) and matching
federal funds. Although administered under Federal regulations, states have
substantial flexibility to design programs and determine reimbursement rates,
and as a result, individuals programs and reimbursement rates vary significantly
from state to state. The Federal government retains the right to approve or
disapprove individual state plans.

Until the enactment of the BBA, a Federal Medicaid statute,
generally referred to as the Boren Amendment, required Medicaid
programs to provide reimbursement rates that were reasonable and adequate to
cover the costs that would be incurred by efficiently and economically operated
facilities while providing services in conformity with state and federal laws,
regulations and quality and safety standards. The BBA repealed the Boren
Amendment effective October 1, 1997 and allowed the states to develop their own
standards for determining Medicaid payment rates. In the past, several
states healthcare provider organizations and providers have initiated
litigation challenging the Medicaid reimbursement methodologies employed in such
states, asserting that reimbursement payments are not adequate to reimburse an

# 10

efficiently operated facility for the costs of providing
Medicaid covered services. The repeal of the Boren Amendment provides states
with greater flexibility to amend individual state programs and potentially
reduce state Medicaid payments to skilled nursing facilities. Medicaid covered
services vary by state, but generally includes nursing care, room and board, and
social services. Additionally, some states provide reimbursement for
pharmaceuticals, rehabilitative therapy treatment and other services.

The Medicaid programs in the states in which the Company
operates pay a per diem rate for providing services to Medicaid patients based
on the facilitys reasonable allowable costs incurred in providing
services, subject to cost ceilings applicable to patient care, other operating
costs and capital costs. Some state Medicaid programs in which the Company
currently operates currently include incentive allowances for providers whose
costs are less than certain ceilings.

There are generally two types of Medicaid reimbursement rates:
retrospective and prospective, although many states have adopted plans that have
both retrospective and prospective features. A retrospective rate is determined
after completion of a cost report by the service provider and is designed to
reimburse expenses. Typically, an interim rate, based upon historical cost
factors and inflation is paid by the state during the cost reporting period and
a cost settlement is made following an audit of the filed cost report. Such
adjustments may result in additional payments being made to the Company or in
recoupments from the Company, depending on actual performance and the
limitations within an individual state plan.

The more prevalent type of Medicaid reimbursement rate is the
prospective rate. Under a prospective plan, the state sets its rate of payment
for the period before services are rendered. Actual costs incurred by operators
during a period are used by the state to establish the prospective rate for
subsequent periods. The provider must accept the prospective rate as payment in
full for all services rendered. Subsequent audits may provide a basis for the
state program to retroactively recoup monies.

To date, adjustments from Medicaid audits have not had a
material adverse effect on the Company. Although there can be no assurance that
future adjustments will not have a material adverse effect on the Company, the
Company believes that it has properly applied the various payment formulas and
that it is not likely that audit adjustments would have a material adverse
effect on the Company.

Potential Healthcare Reform. In addition to extensive existing
governmental healthcare regulation, there are numerous legislative and executive
initiatives at the federal and state levels for comprehensive reforms affecting
the payment for and availability of healthcare services. It is not clear at this
time what proposals, if any, will be adopted or, if adopted, what effect such
proposals would have on the Companys business. Aspects of certain of these
proposals, such as reductions in funding of Medicaid programs, or changes in the
administration of Medicaid at the state level, could materially adversely affect
the Company. Additionally, the BBA repealed the Boren Amendment effective
October 1, 1997 and allows the states to develop their own standards for
determining Medicaid payment rates. The BBA provides certain procedural
restrictions on the states ability to amend state Medicaid programs by
requiring that the states use a public process to establish payment
methodologies including a public comment and review process. The repeal of the
Boren Amendment provides states with greater flexibility to amend individual
state programs and potentially reduce state Medicaid payments to skilled nursing
facilities. There can be no assurance that currently proposed or future
healthcare legislation or other changes in the administration or interpretation
of governmental healthcare programs will not have an adverse effect on the
Company.

Fee Splitting and Referrals. The Company is also subject to
federal and state laws that govern financial and other arrangements between
healthcare providers. Federal laws, as well as the laws of certain states,
prohibit direct or indirect payments or fee splitting arrangements between
healthcare providers that are designed to induce or encourage the referral of
patients to, or the recommendation of, a particular provider for medical
products and services. These laws include the federal anti-kickback
law which prohibits, among other things, the offer, payment, solicitation
or receipt of any form of remuneration in return for the referral of Medicare
and Medicaid patients. A wide array of relationships and arrangements, including
ownership interests in a company by persons in a position to refer patients and
personal service agreements have, under certain circumstances, been alleged to
violate these provisions. Certain discount arrangements may also violate these
laws. Because of the broad reach of these laws, the federal government has
published certain safe harbors, which set forth the requirements
under which certain relationships will not be considered to violate such laws. A
violation of the federal anti-kickback law could result in the loss of
eligibility to participate in Medicare or Medicaid, or in criminal penalties.
Violation of state anti-kickback laws could lead to loss of licensure,
significant fines and other penalties.

Various federal and state laws regulate the relationship
between healthcare providers and physicians, including employment or service
contracts and investment relationships. These laws include the broadly worded
fraud and abuse provisions of the Medicaid and Medicare statutes, which prohibit
various transactions involving Medicaid or Medicare covered patients or
services. In particular, the Omnibus Budget Reconciliation Act of 1993
(OBRA 93) contains provisions which greatly expand the federal
prohibition on physician referrals to entities with which they have a financial
relationship. Effective January 1, 1995, OBRA 93 prohibits any physician with a
financial relationship (defined as a direct or indirect ownership or investment
interest or compensation arrangement) with an entity from making a referral for
designated health services to that entity and prohibits that entity
from billing for such services. Designated health services do not
include skilled nursing services but do include many services which long-term
care facilities provide to their patients, including physical therapy,
occupational therapy, infusion therapy and enteral and parenteral nutrition.
Various exceptions to the application of this law exist, including one which
protects the payment of fair market compensation for the provision of personal
services, so long as various requirements are met. Violations of these
provisions may result in civil or criminal penalties for individuals or entities
and/or exclusion from participation in the Medicaid and Medicare programs.
Various state laws contain analogous provisions, exceptions and penalties. The
Company believes that in the past it has been, and in the future it will be,
able to arrange its business relationships so as to comply with these
provisions.

# 11

Each of the Companys long-term care facilities has at
least one medical director that is a licensed physician. The medical directors
may from time to time refer their patients to the Companys facilities in
their independent professional judgment. The physician anti-referral
restrictions and prohibitions could, among other things, require the Company to
modify its contractual arrangements with its medical directors or prohibit its
medical directors from referring patients to the Company. From time to time, the
Company has sought guidance as to the interpretation of these laws. However,
there can be no assurance that such laws will ultimately be interpreted in a
manner consistent with the practices of the Company.

The Health Insurance Portability and Accountability Act of
1996 (HIPAA) broadened the scope of fraud and abuse laws to include
all health plans, whether or not they are reimbursed under Federal programs.
HIPAA also mandated the adoption of federal regulations designed to (a)
standardize transaction formats and billing codes for documenting health care
services, determining eligibility and processing claims for payment; and (b)
protect the privacy and security of individually identifiable health
information. Final HIPAA regulations that standardize transactions and code sets
were issued during the third quarter of 2000. The ultimate compliance date was
subsequently modified by legislation to require health care providers and health
plans to either comply with the HIPAA transaction code set standards beginning
in October of 2002 or submit a written plan to the federal government by October
of 2002 describing specific plans for compliance by October of 2003. The
regulations do not require healthcare providers to submit claims electronically,
but do require standard formatting for those that do so. The Company currently
submits most claims electronically and expects to continue to do so. The Company
is currently evaluating its plans for compliance by October of 2002 or
submitting the required plan describing its plans for compliance by October of
2003.

Final HIPAA privacy regulations were published during the
fourth quarter of 2000. However, on March 21, 2002, the U.S. Department of
Health and Human Services released a proposed rule which if finally adopted
would modify the regulations published during 2000. In general, the regulations
apply to protected health information, which is defined 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 and
oral communications, as well as those in electronic form, regarding an
individuals past, present or future physical or mental health or
condition, or relating to the provision of health care to the individual or
payment of that health care. The regulations further impose requirements on
health care providers to contractually obligate certain of their subcontractors
who may receive protected health care information during the course of rendering
services on behalf of such health care provider to abide by certain privacy
requirements as well. In addition, the current HIPAA regulations provide that
certain state privacy laws may not be preempted by HIPAA. Accordingly, the
Company, in certain instances, will remain subject to various state privacy laws
in jurisdictions in which it currently operates facilities. HIPAA provides for
the imposition of civil and criminal penalties if protected health information
is improperly disclosed. The Company must comply with the privacy regulations by
April of 2003. Given the issuance of the recent proposed rulemaking, it is
uncertain the extent to which the regulations that were published in 2000 will
change. The Company is continuing to evaluate the impact of the privacy
regulations on its operations.

HIPAAs security regulations have not been finalized. The
proposed security regulations specify administrative procedures, physical
safeguards, and technical services and mechanisms designed to ensure that
protected health information remains secure. The proposed security rules
contemplate a compliance date of 24 months after the effective date of the final
rule published in the Federal Register, although it is possible that such
compliance date will differ and could align with the compliance date for the
privacy regulations depending on when the security regulations are ultimately
finalized.

The Company is currently working in conjunction with its
software vendors to evaluate the impact of HIPAA regulations on the
Companys systems and operating procedures. The Company has not yet
completed its analysis or its estimate of the expected costs of compliance with
the HIPAA regulations. There can be no assurances that compliance with HIPAA
regulations will not have an adverse effect on the Companys results of
operations, cash flows or its financial position.

COMPETITION

The long-term care industry is highly competitive. The Company
competes with other providers of long-term care on the basis of the scope and
quality of services offered, the rate of positive medical outcomes,
cost-effectiveness and the reputation and appearance of its long-term care
facilities. The Company also competes in recruiting qualified healthcare
personnel, in acquiring and developing additional facilities and in obtaining
CONs. The Companys current and potential competitors include national,
regional and local long-term care providers, some of whom have substantially
greater financial and other resources and may be more established in their
communities than the Company. The Company also s competition from assisted
living facility operators as well as providers of home healthcare. In addition,
certain competitors are operated by not-for-profit organizations and similar
businesses which can finance capital expenditures and acquisitions on a
tax-exempt basis or receive charitable contributions unavailable to the Company.

In general, consolidation in the long-term care industry has
resulted in the Company being d with larger competitors, many of whom have
significant financial and other resources. The Company expects that this
continuing consolidation may increase the competition for the acquisition of
long-term care facilities.

The Company believes that state regulations which require a
CON before a new long-term care facility can be constructed or additional
licensed beds can be added to existing facilities reduce the possibility of
overbuilding and promote higher utilization of existing facilities. CON
legislation is currently in place in all states in which the Company operates or
expects to operate with the exception of Indiana where the CON program expired
as of June 30, 1998. Several of the states in which the Company operates have
imposed moratoriums on the issuance of CONs for new skilled nursing facility
beds. A relaxation of CON requirements could lead to an increase in competition.

# 12

In addition, as cost containment measures have reduced occupancy
rates at acute care hospitals, a number of these hospitals have converted
portions of their facilities into subacute units. In the states in which the
Company currently operates, these conversions are subject to state CON
regulations. The Company believes that the application of the new Medicare PPS
rules have made such conversions less desirable.

EMPLOYEES

As of December 31, 2001, the Company employed approximately
8,000 facility-based personnel on a full- and part-time basis. The
Companys corporate and regional staff consisted of 159 persons as of such
date. Approximately 730 employees at nine of the Companys facilities are
covered by collective bargaining agreements. Although the Company believes that
it maintains good relationships with its employees and the unions that represent
certain of its employees, it cannot predict the impact of continued or increased
union representation or organizational activities on its future operations.

The Company believes that the attraction and retention of
dedicated, skilled and experienced nursing and other professional staff has been
and will continue to be a critical factor in the successful growth of the
Company. The Company believes that its wage rates and benefit packages for
nursing and other professional staff are commensurate with market rates and
practices.

The Company competes with other healthcare providers in
attracting and retaining qualified or skilled personnel. The long-term care
industry has, at times, experienced shortages of qualified personnel. A
continued shortage of nurses or other trained personnel or general economic
inflationary pressures may require the Company to enhance its wage and benefits
package in order to compete with other employers. There can be no assurance that
the Companys labor costs will not increase or, if they do, that they can
be matched by corresponding increases in private-payor revenues or governmental
reimbursement. Failure by the Company to attract and retain qualified employees,
to control its labor costs or to match increases in its labor expenses with
corresponding increases in revenues could have a material adverse effect on the
Company.

INSURANCE

During the year ended December 31, 1998, the Company
implemented a general and professional liability insurance program that, for the
period from September 1, 1998 to August 31, 2001, limited the Companys
self-retention risk for this program to a maximum of $25,000 per year. The
long-term care industry has seen the cost of maintaining traditional
professional liability insurance increase significantly over the past two years,
especially in the State of Florida. Most insurance companies are unwilling to
underwrite new professional liability policies in the State of Florida. In May
2001, tort reform legislation was enacted in Florida. This legislation provided
caps on punitive damages, limits to add-on legal fees, stricter rules of
evidence and a shorter statute of limitations period. Given the tremendous
increase in professional liability premiums and the tort reform legislation that
was enacted in the State of Florida in May 2001, the Company concluded that it
would be more cost effective to assume a higher level of retained risk for
professional liability claims. As a result, the Company implemented a new
general and professional liability program, effective September 1, 2001, which
resulted in the Company maintaining an unaggregated self-insured retention of
$2,000,000 per occurrence for locations outside of Florida and completely
retaining risk at the Florida facilities. The Company maintains an accrual for
incurred but not reported claims. The amount of the accrual is determined
through an estimation process that uses information from both the Companys
records as well as industry data. The Company uses an independent actuary to
help estimate the required general and professional liability accrual. Factors
reviewed include the frequency of expected claims, the average cost per claim,
emerging industry trends, changes in regulatory environment (such as the
recently enacted Florida tort reform legislation) and the expected effect of
various operational and risk management initiatives. At this time, the Company
estimates that, effective September 1, 2001, its annual cost for professional
and general liability insurance for existing facilities will increase from
approximately $2,500,000 under the prior program to $6,500,000 under the new
program. The Company will continue to evaluate its insurance accrual
requirements on a quarterly basis. Required adjustments to the Companys
general and professional liability accrual will be recorded in the accounting
period in which the change in estimate occurs. There can be no assurances that
the recent Florida tort reform legislation will have a positive impact on claims
activity, that the coverage limits of the Companys insurance program will
be adequate or that insurance will continue to be available to the Company in
the future. (See Note M to the Companys consolidated financial statements
included elsewhere in this report.)

# 13

ITEM 2. PROPERTIES

The following table
summarizes certain information regarding the Companys facilities as of
December 31, 2001:

`SUMMARY OF FACILITIES

LICENSED                                           YEAR            OWNED/        LICENSED
FACILITY                       LOCATION           ACQUIRED     LEASED/MANAGED      BEDS
--------                       --------        -----------    ---------------     -----
SOUTHEAST REGION
 Florida
  Huntington Place             Rockledge           1994              Leased              100
  Sunset Point                 Clearwater          1990              Owned               120
  Orchard Ridge                New Port Richey     1990              Owned               120
  Lakeside Pavilion            Naples              1989              Leased              120
  Oakhurst                     Ocala               1990              Owned               180
  Bay Tree                     Palm Harbor         1990              Owned               120
  Pinebrook Rehabilitation     Venice              1989              Leased              120
  Springwood                   Sarasota            1990              Leased              120
  Westbay                      Oldsmar             1990              Owned               120
                                                                                      ------
                                                                                       1,120
MIDWEST REGION
 Ohio
  Defiance                     Defiance            1993              Leased              100
  Northwestern Ohio            Bryan               1993              Leased              189
  Swanton                      Swanton             1995              Leased              100
  Perrysburg                   Perrysburg          1990              Owned               100
  Troy                         Troy                1989              Leased              195
  Beachwood                    Beachwood           1996              Leased              274
  Broadview                    Broadview Heights   1996              Leased              159
  Westlake I                   Westlake            1996              Leased              153
  Westlake II                  Westlake            1996              Leased              106
  Dayton                       Dayton              1997              Owned               100
  Laurelwood                   Dayton              1997              Owned               115
  New Lebanon                  New Lebanon         1997              Owned               126
  Point Place                  Toledo              1998              Owned                98
  Sylvania                     Sylvania            1998              Owned               150
  Marietta                     Marietta            2001              Leased              150
 Indiana
  Decatur                      Indianapolis        1988              Owned                88
  Indianapolis                 Indianapolis        1988              Leased              104
  New Haven                    New Haven           1990              Leased              120
  Terre Haute                  Terre Haute         1990              Owned               120
                                                                                      ------
                                                                                       2,547
NEW ENGLAND REGION

Connecticut

 Arden House                   Hamden              1997              Leased              360
 Governor's House              Simsbury            1997              Leased               73
 Madison House                 Madison             1997              Leased               90
 The Reservoir                 West Hartford       1997              Leased               75
 Willows                       Woodbridge          1997              Leased               90
 Glen Hill                     Danbury             1998              Owned (1)           100
 Glen Crest                    Danbury             1998              Owned (1)            49

Massachusetts
  Maplewood                    Amesbury            1997              Leased              120
  Cedar Glen                   Danvers             1997              Leased              100
  Danvers-Twin Oaks            Danvers             1997              Leased              101
  North Shore                  Saugus              1997              Leased               80
  The Stone Institute          Newton Upper Falls  1997              Managed             106`

# 14

`New Hampshire
  Applewood                    Winchester          1996              Leased               70
  Crestwood                    Milford             1996              Leased               82
  Milford                      Milford             1996              Leased               52
  Northwood                    Bedford             1996              Leased              147
  Pheasant Wood                Peterborough        1996              Leased               99
  Westwood                     Keene               1996              Leased               87
Rhode Island

 Greenwood                     Warwick             1998              Owned               136
 Pawtuxet                      Warwick             1998              Owned               131
                                                                                      ------
                                                                                       2,148
MID-ATLANTIC REGION

Maryland

 Harford Gardens               Baltimore           1997              Leased              163
 Larkin Chase Center           Bowie               1994              Owned (2)           120
New Jersey

  Woods Edge                   Bridgewater         1988              Leased              176
                                                                                      ------
                                                                                         459

                                                                     Total             6,274
                                                                                       =====

(1)  Indicates an owned facility financed through a synthetic lease.

(2)  Owned by Bowie L.P. The Company's interest in Bowie L.P. is pledged to the
     facility's mortgage lender. The Company has guaranteed the indebtedness of
     Bowie L.P.`

The Company maintains its Corporate offices in Boston as well
as regional offices in Palm Harbor, Florida; Beachwood, Ohio, Indianapolis,
Indiana; Topsfield, Massachusetts; West Hartford, Connecticut; and Sharon, New
Hampshire. The Company considers its properties to be in good operating
condition and suitable for the purposes for which they are being used.

ITEM 3. LEGAL PROCEEDINGS

The Company is a party to claims and legal actions arising in
the ordinary course of business. Management does not believe that unfavorable
outcomes in any such matters, individually or in the aggregate, would have a
material adverse effect on the Companys financial condition, results of
operations or liquidity.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On November 19, 2001, by unanimous written consent in lieu of
a meeting, the stockholders of Harborside Healthcare Corporation (the
Corporation) approved the Certificate of Amendment to the
Companys Certificate of Incorporation (the Certificate of
Amendment). The Certificate of Amendment increases the total number of
shares of all classes of stock which the Corporation shall have authority to
issue to 41,200,000, of which 500,000 shares shall be preferred stock and of
which 40,700,000 shares shall be common stock and increases the total number of
shares of Class C Common Stock authorized to 2,280,000 shares.

# 15

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS' MATTERS

The Company completed its initial public offering and shares
began trading on June 14, 1996. The Companys common stock was listed on
the New York Stock Exchange under the symbol HBR.

As a result of the August 11, 1998 merger noted in the General
Overview, the Companys common stock was de-listed from the New York Stock
Exchange on August 11, 1998. There is currently no established public trading
market for the Companys common stock.

The number of stockholders of record for each class of common
stock as of March 1, 2002 is as follows:

`Class of Common Stock               Number of Holders of Record
---------------------               ---------------------------

Class A                                     47

Class B                                     15

Class C                                     40

Class D                                     11`

The Company has never declared or paid any dividends on its
common stock since its formation in 1996. The Company does not anticipate paying
cash dividends on its Common Stock for the foreseeable future and intends to
retain all of its earnings for reinvestment in the operations and activities of
the Company. Any future decision as to the payment of dividends will be at the
discretion of the Companys Board of Directors. The Companys ability
to pay dividends is also limited by the terms of current (and possibly future)
lease and financing arrangements that restrict, among other things, the ability
of the Companys subsidiaries to distribute funds to the Company.

# 16

ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA

The following table sets forth selected consolidated financial
data for the Company. The selected historical consolidated financial data for
each of the years in the five year period ended December 31, 2001 have been
derived from the Companys consolidated financial statements, which have
been audited by PricewaterhouseCoopers LLP, our independent accountants. The
financial data set forth below should be read in conjunction with the
Consolidated Financial Statements and the Notes thereto, and
Managements Discussion and Analysis of Financial Condition and
Results of Operations included elsewhere in this filing.

`SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
                                (in thousands, except share, per share and other data)

                                                               YEAR ENDED DECEMBER 31,
                                                               -----------------------

                                                          1997            1998           1999           2000           2001
                                                       ---------       ---------      ---------      ---------      ---------
Statement of operations data:
 Total net revenues ..............................      $221,777        $311,044      $ 300,615      $ 322,672      $ 346,738
                                                       ---------       ---------      ---------      ---------      ---------

Expenses:
 Facility operating ..............................       176,404         246,000        248,795        259,780        282,194
 General and administrative ......................        10,953          15,422         17,808         17,993         19,043
 Service charges paid to former affiliate ........           708           1,291          1,173          1,083            979
 Amortization of prepaid management fee ..........          --               500          1,200          1,200          1,200
 Depreciation and amortization ...................         4,074           6,350         10,249         10,210          9,355
 Facility rent ...................................        12,446          22,412         22,394         24,275         28,889
 Merger costs ....................................          --            37,172           --             --             --
 Financial restructuring costs ...................          --              --             --             --            9,045
 Facility reorganization costs ...................          --              --             --             --            1,080
 Restructuring costs .............................          --              --            5,745           --             --
 Loss on termination of capital lease ............          --              --             --            8,914           --
                                                                                                                    ---------
Total expenses ...................................       204,585         329,147        307,364        323,455        351,785
                                                      ----------       ---------      ---------      ---------      ---------

 Income (loss) from operations ...................        17,192         (18,103)        (6,749)          (783)        (5,047)

Other:
 Interest expense, net ...........................         5,853          11,271         20,895         21,675         11,945
 Other expense (income) ..........................           189            (167)           261            (74)          (315)
                                                       ---------        ---------      ---------      ---------      ---------

Income (loss) before income taxes ................        11,150         (29,207)       (27,905)       (22,384)       (16,677)
Income tax expense (benefit) .....................         4,347          (5,020)       (10,304)        14,322            225
                                                       ---------        ---------      ---------      ---------      ---------
Net income (loss) ................................         6,803         (24,187)       (17,601)       (36,706)       (16,902)
Preferred stock dividends ........................          --            (2,296)        (6,004)        (6,853)        (3,774)
                                                       ---------        ---------      ---------      ---------     ---------
Earnings (loss) applicable to common shares            $   6,803       $(26,483)      $ (23,605)      $(43,559)      $(20,676)
                                                       =========       =========      ==========      =========      =========
Earnings (loss) per common share:
    Basic ........................................     $    0.85       $   (3.42)     $   (3.25)     $   (6.00)     $   (2.82)
                                                       =========       =========      =========      =========      =========
    Diluted ......................................     $    0.84       $   (3.42)     $   (3.25)     $   (6.00)     $   (2.82)
                                                       =========       =========      =========      =========      =========

Weighted average number of common shares
  used in per share computations:
    Basic ........................................     8,037,000       7,742,000      7,261,000      7,261,000      7,335,000
    Diluted ......................................     8,139,000       7,742,000      7,261,000      7,261,000      7,335,000`

# 17

`SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued)
                                                (DOLLARS IN THOUSANDS)


                                                      YEAR ENDED DECEMBER 31,
                                                      -----------------------

                                               1997      1998       1999       2000       2001
                                               ----      ----       ----       ----       ----
Operational data (as of end of year) (1):
 Facilities                                       45         50        50         50         51
 Licensed beds                                 5,468      6,120     6,124      6,124      6,274

Average occupancy rate (2)                      92.3%      92.3%      90.9%     90.1%      88.9%

Patient days (3):
Private and other                            394,151    503,234   489,074    455,491    415,861
Medicare                                     138,023    196,222   219,924    238,574    293,257
Medicaid                                     834,637  1,169,258 1,240,228  1,246,735  1,207,004
                                           ---------  -------------------  ---------  ---------
Total                                      1,366,811  1,868,714 1,949,226  1,940,800  1,916,122
                                           =========  ========= =========  =========  =========

Sources of total net revenues:
Private and other (4)                          34.1%      30.2%     28.9%      25.8%      22.6%
Medicare                                       25.9%      27.7%     21.8%      25.0%      30.7%
Medicaid                                       40.0%      42.1%     49.3%      49.2%      46.7%

Balance sheet data:
Working capital                              $22,621   $ 36,403  $ 36,536  $  33,280  $  22,076
Total assets                                 168,562    264,536   283,233    203,097    193,369
Total debt                                    33,642    134,680   171,245    179,116    116,654
Capital lease obligation                      56,285     55,531    54,700          -          -
Stockholders' equity (deficit) (5) (6)        51,783         83   (23,522)   (67,074)   (31,167)`

(1) Includes two managed facilities with 178 licensed beds
in 1997 and one managed facility with 106 licensed beds in 1998, 1999, 2000 and 2001.

(2) Average occupancy rate is computed by
dividing the number of billed bed days by the total number of available licensed
bed days during each of the periods indicated. This calculation includes all
facilities operated by the Company excluding managed facilities.

(3) Patient Days includes billed bed days for
the facilities operated by the Company excluding billed bed days of managed
facilities and the one facility accounted for using the equity method.

(4) Consists primarily of revenues derived from private
pay individuals, managed care organizations, HMOs, hospice programs,
commercial insurers, management fees from managed facilities, and through
September 1999, rehabilitation therapy revenues from non-affiliated facilities.

(5) In accordance with Securities and Exchange Commission
requirements, the carrying amount of the Companys 13.5% Exchangeable
Preferred Stock is excluded from total stockholders equity (deficit).
As of December 31, 1998, 1999 and 2000, the carrying amount of the Companys
13.5% Exchangeable Preferred Stock was $42,293,000, $48,277,000 and $55,112,000,
respectively.

(6) In accordance with Securities and Exchange Commission
requirements, the carrying amount of the Companys 13% Convertible
Exchangeable Preferred Stock is excluded from total stockholders equity
(deficit). As of December 31, 2001, the carrying amount of the Companys
13% Convertible Exchangeable Preferred Stock was $16,286,000.

# 18

ITEM 7.

# MANAGEMENT'S DISCUSSION AND

# ANALYSIS OF FINANCIAL CONDITION AND

# RESULTS OF OPERATIONS

## OVERVIEW

Harborside Healthcare Corporation, through its
subsidiaries, is a leading provider of high-quality long-term care and specialty
medical services in the eastern United States. Harborside Healthcare Corporation
(on a consolidated basis, Harborside or the Company) has
focused on establishing strong local market positions with high-quality
facilities in four principal geographic regions: the Southeast (Florida), the
Midwest (Ohio and Indiana), New England (Connecticut, Massachusetts, New
Hampshire and Rhode Island) and the Mid-Atlantic (New Jersey and Maryland). As
of December 31, 2001, the Company operated 51 facilities (18 owned, 32 leased
and one managed) with a total of 6,274 licensed beds. As described in Note A to
the audited consolidated financial statements of the Company included elsewhere
in this filing, the Company accounts for its investment in one of its owned
facilities using the equity method of accounting. The Company provides a broad
continuum of medical services including: (i) traditional skilled nursing care
and (ii) specialty medical services, including a variety of subacute care
programs such as orthopedic rehabilitation, CVA/stroke care, cardiac recovery,
pulmonary rehabilitation and wound care, as well as distinct programs for the
provision of care to Alzheimers and hospice patients. As part of its
subacute services, the Company provides physical, occupational and speech
rehabilitation therapy services at Company-operated facilities. Through
September 1999, the Company also provided rehabilitation therapy services under
contracts with non-affiliated long-term care facilities through a wholly-owned
subsidiary. During the third quarter of 1999, the Company terminated its
contracts with non-affiliated facilities and ceased providing therapy services
to non-affiliated facilities. (See Note P to the Companys consolidated
financial statements included elsewhere in this report.)

The Company was created in March 1996, in anticipation
of an initial public offering (the IPO), in order to combine under
its control the operations of various long-term care facilities and ancillary
businesses (the Predecessor Entities) which had operated since 1988.
The Company completed the IPO on June 14, 1996 and issued 3,600,000 shares of
common stock at $11.75 per share. The owners of the Predecessor Entities
contributed their interests in such Predecessor Entities to the Company and
received 4,400,000 shares of the Companys common stock.

On April 15, 1998, Harborside entered into a Merger
Agreement with HH Acquisition Corp. (MergerCo), an entity organized
for the sole purpose of effecting a merger on behalf of Investcorp S.A., certain
of its affiliates and certain other international investors (the New
Investors). On August 11, 1998, MergerCo merged with and into Harborside,
with Harborside Healthcare Corporation as the surviving corporation. As a result
of the transaction, and pursuant to the Merger Agreement, the New Investors
acquired approximately 91% of the post-merger common stock of Harborside. The
remaining 9% of the common stock was retained by existing shareholders,
including management. As a result of the merger, Harborside shares were
de-listed from the New York Stock Exchange.

The merger was approved by a majority of the
Companys shareholders at a special meeting held on August 11, 1998. Each
share not retained by existing shareholders was converted into $25 in cash,
representing in the aggregate, cash payments of approximately $184 million.
Holders of outstanding stock options of the Company converted the majority of
their options into cash at $25 per underlying share (less applicable exercise
price and withholding taxes) with aggregate payments of approximately $8
million.

In connection with the transaction and prior to the
merger, the New Investors made cash common equity contributions of $158.5
million, net of issuance costs, to MergerCo, and MergerCo obtained gross
proceeds of $99.5 million through the issuance of 11% Senior Subordinated
Discount Notes (Discount Notes) due 2008 and $40 million through the
issuance of 13.5% Exchangeable Preferred Stock (Preferred Stock)
mandatorily redeemable in 2010. In connection with the merger, Harborside also
entered into a new $250 million collateralized credit facility. In the third
quarter of 1998, Harborside recorded a charge to income from operations of
approximately $37 million (approximately $29 million after taxes) for direct and
other costs related to the Merger transaction. In connection with the merger and
the related refinancings, the Company exercised purchase options for seven
facilities which had been financed through synthetic leases.

In March 2001, the Company entered into an agreement (the
"Restructuring Agreement") with Investcorp S.A. and the holders of more than a
majority in interest of the Company's Discount Notes and Preferred Stock for
purposes of implementing a restructuring of the Discount Notes and Preferred
Stock. The Restructuring Agreement contemplated that the Company would offer to
exchange for each $1,000 amount at maturity of outstanding Discount Notes a
combination of the following: (1)0.5899118 of a new 12% Senior Subordinated
Discount Note due 2007 (the "New Notes") each having a principal amount at
maturity equal to $1,000 and an original issue price of $685.67 (assuming that
the New Notes were issued on May 4, 2001), (2) $88.2353 in cash and (3) common
stock purchase warrants for approximately 10.9 shares of its Class A Common
Stock. The Company would also offer to exchange common stock purchase warrants
for approximately 10.7 shares of its Class A Common Stock for each $1,000
liquidation preference of Preferred Stock (based on the aggregate liquidation
preference to be outstanding on May 1, 2001) plus any dividends accrued on such
Preferred Stock after May 1, 2001. In conjunction with the restructuring
proposal, the Company would solicit consents from holders of outstanding
Discount Notes and Preferred Stock to amendments to the Indenture governing the
Discount Notes and to the Certificate of Designation governing the Preferred
Stock that would eliminate or modify certain restrictive covenants and other
provisions contained in the Indenture and the Certificate of Designation and
would substantially eliminate the preferences of the Preferred Stock, including
the reduction of the liquidation preference from $1,000 to $0.01 per share and
the elimination of the right of holders to be paid dividends on shares of
Preferred Stock. Also, the Company would issue to Investcorp S.A. (or one or

# 19

more of its affiliates or designees) up to 15,000 shares of a new series of 13%
convertible exchangeable preferred stock (the "New Preferred Stock") and
1,854,422 common stock purchase warrants for a total purchase price of up to
$15,000,000.

On April 6, 2001 the Company initiated the exchange offer and
consent solicitation contemplated by the Restructuring Agreement. On May 10,
2001, the Company completed the exchange offer and consent solicitation, thereby
implementing each of the elements of the Restructuring Agreement. All of the
outstanding Discount Notes and 99.96% of the shares of Preferred Stock were
tendered and exchanged in the exchange offer. As a result of the exchange, (1)
the Company has an aggregate principal amount at maturity of $100,276,000 of New
Notes outstanding and an aggregate liquidation preference of $15,000,000 (as of
May 10, 2001) of New Preferred Stock outstanding, (2) warrants were issued to
holders of Discount Notes, to holders of Preferred Stock, and to Investcorp S.A.
representing the right to purchase an aggregate of approximately 15%, 5% and
15%, respectively, of the total number of shares of all classes of the Company's
common stock on a fully diluted basis (excluding shares issuable upon conversion
of the New Preferred Stock, each share of which will initially be convertible
into 150 shares of Class A Common Stock, and (3) the Company paid $15,000,000 in
cash as partial consideration for the tendered Discount Notes.

The reduction in the liquidation preference of the Preferred
Stock was completed on May 10, 2001, as contemplated by the Restructuring
Agreement, the carrying amount of the Preferred Stock was reduced from
$57,595,000 to $576 and the amount of the reduction, net of unamortized deferred
financing costs related to the issuance of the Preferred Stock (approximately
$1,011,000 at May 10, 2001), was directly transferred to the Company's
Accumulated Deficit account. With the exchange of the New Notes for the Discount
Notes (the "Note Exchange"), the carrying value of the accreted principal of the
Discount Notes was reduced to $68,890,000, and the amount of the reduction, net
of the aggregate cash payment of $15,000,000, was directly transferred to the
Company's Long-term Accrued Interest account. Subsequent to their issuance, the
carrying amount of the New Notes increases as the result of accretion and
results in a corresponding decrease in the carrying amount of Long-term Accrued
Interest. Interest expense on the New Notes is recognized such that a constant
effective interest rate is applied to the aggregate carrying amount of the New
Notes and Long-term Accrued Interest for all periods between the issuance date
and the maturity date of the New Notes.

In connection with an amendment to the Company's revolving
credit facility (the "Credit Facility") and the implementation of the
Restructuring Agreement, the Company incurred a non-recurring charge of
$9,045,000. The charge resulted from the write-off of approximately $1,500,000
of unamortized deferred financing costs incurred when the Credit Facility was
obtained, the write-off of approximately $3,400,000 of unamortized deferred
financing costs related to the issuance of the Discount Notes, and the
recognition of various investment advisory, legal and other fees associated with
these events of $4,145,000.

The New Notes were issued at a discount and interest on the
New Notes accretes until August 1, 2004. Cash interest payments will be paid
semi-annually in arrears beginning on February 1, 2005 based on the fully
accreted value of the New Notes and a 12% cash interest payment rate. The New
Notes mature on August 1, 2007. The New Preferred Stock is mandatorily
redeemable on February 1, 2008. The holders of the New Preferred Stock are
entitled to dividends quarterly in arrears beginning August 1, 2001 and payable
in additional shares of New Preferred Stock. Warrants to purchase a total of
4,326,641 shares of common stock at $0.01 per share were issued on May 10,
2001.

REVENUES

The Companys total net revenues include net
patient service revenues, and beginning in 1995, rehabilitation therapy service
revenues from contracts with non-affiliated long-term care facilities until the
third quarter of 1999 when these contracts were terminated. (See Note P to the
Companys consolidated financial statements included elsewhere in this
report). The Company derives its net patient service revenues primarily from
private pay sources, the federal Medicare program for certain elderly and
disabled patients and state Medicaid programs for indigent patients. The
Companys total net revenues are influenced by a number of factors,
including: (i) the licensed bed capacity of its facilities; (ii) the occupancy
rates of its facilities; (iii) the payor mix of its facilities and the rates of
reimbursement among payor categories (private and other, Medicare and Medicaid);
and (iv) the extent to which subacute and other specialty medical and ancillary
services are utilized by the patients and paid for by the respective payment
sources. Private net patient service revenues are recorded at established per
diem billing rates. Net patient service revenues to be reimbursed under
contracts with third-party payors, primarily the Medicare and Medicaid programs,
are recorded at amounts estimated to be realized under these contractual
arrangements. The Company employs specialists to monitor reimbursement rules,
policies and related developments in order to comply with all reporting
requirements and to assist the Company in receiving reimbursements.

The table set forth below identifies the percentage of
the Companys total net revenues attributable to each of its payor sources
for each of the periods indicated. The increase in Medicare revenues as a
percentage of total revenues during fiscal 2000 and fiscal 2001 is primarily the
result of increases in the Companys average Medicare Part A per diem rate
in those years resulting from changes to the Medicare payment system. The
Federal government implemented the Medicare Prospective Payment System
(PPS) effective January 1, 1999. Implementation of PPS was effective
for all of the Companys facilities beginning January 1, 1999 and caused
the Companys average Medicare Part A per diem rate to decrease from $397
per day in 1998 to $290 per day in 1999. On November 29, 1999, the Balanced
Budget Refinement Act of 1999 (the BBRA) was enacted. The BBRA
allowed skilled nursing facilities to elect transition to the full Federal per
diem rate at the beginning of their cost reporting periods for periods beginning
on or after January 1, 2000. Using this election the Company chose to move
fourteen facilities to the full Federal per diem rate effective January 1, 2000.
Additionally, the BBRA increased the Federal per diem rates by 20% for fifteen
RUG categories (three rehabilitative therapy RUG categories, twelve
non-rehabilitative therapy RUG categories) beginning April 1, 2000. The BBRA
also provided a temporary four percent increase in the Federal per diem rates
for all RUG categories for a two-year period beginning October 1, 2000. In
December 2000, the Medicare, Medicaid, and State Child Health Insurance Program
Benefits Improvement and Protection Act of 2000 (BIPA) was enacted.
BIPA temporarily increased the existing nursing rate component of the Federal
per diem rate, for each RUG category, by 16.66% effective April 1, 2001. In

# 20

addition, BIPA eliminated the 20% add-ons (provided by the BBRA) for the three
rehabilitative therapy RUG categories and substituted 6.7% add-ons for all
fourteen rehabilitative therapy RUG categories. The 6.7% add-ons are scheduled
to stay in effect until CMS implements a revised PPS system as contemplated by
the BBRA. Primarily as the result of the effects of the BBRA, the Companys
average Medicare Part A payment rate increased from $290 per Medicare patient
day during 1999 to $322 per Medicare patient day during 2000. Primarily as the
result of the effects of BIPA, the Companys average Medicare Part A
payment rate increased from $322 per Medicare patient day during 2000 to $340
per Medicare patient day during 2001.

`TOTAL NET REVENUES (1)
                                    ----------------------

                                  1999               2000               2001
                                  ----               ----               ----

Private and other..............   28.9%              25.8%              22.6%
Medicare.......................   21.8               25.0               30.7
Medicaid.......................   49.3               49.2               46.7
                                -------            -------             ------
  Total......................... 100.0%             100.0%             100.0%
                                =======            ======              ======`

(1) Total net revenues exclude net revenues of the
Larkin Chase Center which is owned by Bowie Center Limited Partnership
(Bowie L.P.). The Company owns a 75% partnership interest in Bowie
L.P. but records its investment in Bowie L.P. using the equity method of
accounting. See Note A to the Companys consolidated financial statements
included elsewhere in this filing.

OPERATING EXPENSES

The Companys facility operating expenses consist
primarily of payroll and employee benefits related to nursing, rehabilitation
therapy services, housekeeping and dietary services provided to patients, as
well as maintenance and administration of the facilities. Other significant
facility operating expenses include the cost of medical and pharmacy supplies,
food, utilities, insurance and taxes. The Companys general and
administrative expenses include all costs associated with its regional and
corporate operations.

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of the financial condition
and results of operations of the Company are based on the Companys
consolidated financial statements, included elsewhere within this report, 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 commitments and contingencies. We rely on historical experience
and on various other assumptions that we believe to be reasonable under the
circumstances to make judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ materially from these estimates.

REVENUE RECOGNITION

Net patient service revenues to be reimbursed by
contracts with third-party payors, primarily the Medicare and Medicaid programs,
are recorded at the amount estimated to be realized under these contractual
arrangements. The Company separately estimates revenues due from each
third-party with which it has a contractual arrangement and records anticipated
settlements with these parties in the contractual period during which services
were rendered. The amounts actually reimbursable under Medicare and Medicaid are
determined by filing cost reports, which are then audited and generally
retroactively adjusted by the payor. Legislative changes to state or Federal
reimbursement systems may also retroactively affect recorded revenues. Changes
in estimated revenues due in connection with Medicare and Medicaid may be
recorded by the Company subsequent to the year of origination and prior to final
settlement based on improved estimates. Such adjustments and final settlements
with third-party payors, which could materially and adversely affect the
Company, are reflected in operations at the time of the adjustment or
settlement.

PROVISION FOR DOUBTFUL ACCOUNTS

Accounts receivable consist primarily of amounts due
from third party payors (the Medicare and Medicaid programs, other governmental
programs, managed care companies and commercial insurance companies) as well as
amounts due from private individuals. Estimated provisions for doubtful accounts
are recorded to the extent that it is probable that a portion or all of a
particular account receivable will not be collected. We estimate the provision
for doubtful accounts based on a number of factors including payor type,
historical collection patterns and the age of the receivable. Changes in
estimates for particular accounts receivable are recorded in the period in which
the change occurs.

IMPAIRMENT OF PROPERTY AND EQUIPMENT AND INTANGIBLE ASSETS

The Company reviews the carrying value of its property
and equipment and intangible assets on a quarterly basis. The Companys
review is undertaken to determine if current facts and circumstances suggest
that the assets have been impaired or that the life of the asset needs to be
changed. As part of its review, the Company considers a number of factors
including local market developments, changes in the regulatory environment,
historical financial performance, recent operating results and projected future
cash flows. Any impairment would be recognized in operating results if a
diminution in value considered to be other than temporary were to occur. The
Company recognized an adjustment to the carrying value of its goodwill during
the year ended December 31, 1999 as a result of the termination of its contract

# 21

therapy business. (See Note P to the Companys consolidated financial
statements included elsewhere in this report.) During the years ended December
31, 1999, 2000 and 2001, the Company recognized adjustments to the carrying
value of its deferred financing costs in connection with amendments to the
Companys Credit Facility and the early termination of a capital lease.
(See Notes H and I to the Companys consolidated financial statements
included elsewhere in this report.)

INSURANCE RESERVES

The Company retains a significant amount of
self-insurance risk for its employee health benefits and workers compensation
programs, and beginning on September 1, 2001, its general liability and
professional liability risks. The Company maintains stop-loss insurance such
that the Companys liability for health insurance and workers
compensation losses is limited. At the end of each accounting period, the
Company records an accrued expense for (a) estimated health benefit claims
incurred but not reported and (b) estimated workers compensation claims
incurred but not reported. The Company estimates these accruals based on a
number of factors including historical experience, industry trends, recent
claims history, programs implemented to control claims, and actuarial reports.
These accruals are by necessity based on estimates and are subject to ongoing
revision as conditions change and as new data presents itself. Adjustments to
estimated liabilities are recorded in the accounting period in which the change
in estimate occurs.

During the year ended December 31, 1998, the Company
implemented a general and professional liability insurance program which, for
the period from September 1, 1998 to August 31, 2001, limited the Companys
self-retention risk for this program to a maximum of $25,000 per year. The
long-term care industry has seen the cost of maintaining traditional
professional liability insurance increase significantly over the past two years,
especially in the State of Florida. Most insurance companies are unwilling to
underwrite new professional liability policies in the State of Florida. In May
2001, tort reform legislation was enacted in Florida. This legislation provides
caps on punitive damages, limits to add-on legal fees, stricter rules of
evidence and a shorter statute of limitations period. Given this tremendous
increase in professional liability premiums and the tort reform legislation that
was enacted in the State of Florida in May 2001, the Company concluded that it
would be more cost effective to assume a higher level of retained risk for
professional liability claims. As a result, the Company implemented a new
general and professional liability program, effective September 1, 2001, which
resulted in the Company maintaining an unaggregated self-insured retention of
$2,000,000 per occurrence for locations outside of Florida and completely
retaining risk at the Florida facilities. The Company maintains an accrual for
incurred but not reported claims. The amount of the accrual is determined
through an estimation process that uses information from both the Companys
records as well as industry data. The Company uses an independent actuary to
help estimate the required general and professional liability accrual. Factors
reviewed include the frequency of expected claims, the average cost per claim,
emerging industry trends, changes in regulatory environment (such as the
recently enacted Florida tort reform legislation) and the expected effect of
various operational and risk management initiatives. The Company will continue
to evaluate its insurance accrual requirements on a quarterly basis. Required
adjustments to the Companys general and professional liability accrual
will be recorded in the accounting period in which the change in estimate
occurs. (See Note M to the Companys consolidated financial statements
included elsewhere in this report.)

NEW ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards
(SFAS) 141, Business Combinations. SFAS 141 requires the purchase
method of accounting for business combinations initiated after June 30, 2001 and
eliminates the pooling-of-interests method. The Company does not believe that
the adoption of SFAS 141 will have a significant impact on its financial
statements.

In July 2001, the FASB issued SFAS 142, Goodwill and
Other Intangible Assets, which is effective January 1, 2002. SFAS 142 requires,
among other things, the discontinuance of goodwill amortization. In addition,
the standard includes provisions for the reclassification of certain existing
recognized intangibles as goodwill, reassessment of the useful lives of existing
recognized intangibles, reclassification of certain intangibles out of
previously reported goodwill and the identification of reporting units for
purposes of assessing potential future impairments of goodwill. SFAS 142 also
requires the Company to complete a transitional goodwill impairment test six
months from the date of adoption. As of December 31, 2001, the Companys
intangible assets included no assets that will be classified as goodwill
effective January 1, 2002.

In July 2001, the FASB issued SFAS 143, Accounting for
Asset Retirement Obligations. Companies are required to adopt SFAS 143 in their
fiscal year beginning after June 15, 2002. SFAS 143 requires that obligations
associated with the retirement of a tangible long-lived asset be recorded as a
liability when these obligations are incurred, with the amount of the liability
initially measured at fair value. Upon recognizing a liability, an entity must
capitalize the cost by recognizing an increase in the carrying amount of the
related long-lived asset, accrete the liability over time to its present value
each period, and depreciate the capitalized cost over the useful life of the
related asset. Upon settlement of the liability, the obligation is either
settled for its recorded amount or a gain or loss is recognized.

In October 2001, the FASB issued SFAS 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. Companies are required to
adopt SFAS 144 in their fiscal year beginning after December 15, 2001. SFAS 144
changes the criteria that would have to be met to classify an asset as
held-for-sale, revises the rules regarding reporting the effects of a disposal
of a segment of a business and requires expected future operating losses from
discontinued operations to be displayed in discontinued operations in the
periods in which the losses were incurred. The Company does not believe that the
adoption of SFAS 144 will have a material impact on its financial position,
results of operations, or cash flows.

# 22

# MANAGEMENT'S DISCUSSION AND

# ANALYSIS OF FINANCIAL CONDITION AND

# RESULTS OF OPERATIONS

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

Total Net Revenues. Total net revenues increased
by $24,066,000 or 7.5%, from $322,672,000 in 2000 to $346,738,000 in 2001. The
Company began operating a leased facility in Marietta, Ohio on November 1, 2001.
This facility generated approximately $1,250,000 of revenues during the year
ended December 31, 2001. Most of the remaining increase in total revenues was
the result of higher average revenues per patient day. The average occupancy
rate at all of the Companys facilities decreased from 90.1% for the year
ended December 31, 2000 to 88.9% for the year ended December 31, 2001. Average
net patient service revenues (including ancillary services) per patient day at
the Companys facilities increased from $164 for the year ended December
31, 2000 to $179 for the year ended December 31, 2001. The Companys
average Medicare Part A per diem rate increased from $322 per Medicare patient
day for the year ended December 31, 2000 to $340 per Medicare patient day for
the year ended December 31, 2001, while the Companys average per diem
Medicaid rate increased from $127 for the year ended December 31, 2000 to $134
for the year ended December 31, 2001. The Balanced Budget Refinement Act of 1999
(BBRA) temporarily increased the Federal per diem Medicare Part A
rates by 20% for fifteen RUG categories (three rehabilitative therapy RUG
categories, twelve non-rehabilitative RUG categories) beginning on April 1,
2000. These increased rates will stay in effect until the date on which the
Centers for Medicare and Medicaid Services (CMS), previously known
as the Health Care Financing Administration, implements a revised PPS system
that more accurately reimburses the costs of caring for medically complex
patients. The Company believes that it is unlikely that a new PPS system will be
implemented prior to October 1, 2002. The BBRA also provided for a four percent
temporary increase in the Federal per diem Medicare Part A rates for all RUG
categories for a two-year period beginning October 1, 2000. In December 2000,
the Medicare, Medicaid, and State Child Health Insurance Program Benefits
Improvement and Protection Act of 2000 (BIPA) was enacted. BIPA
temporarily increased the existing nursing rate component of the Federal per
diem Medicare Part A rate, for each RUG category, by 16.66% effective April 1,
2001 through September 30, 2002. In addition, BIPA eliminated the 20% add-ons
(provided by the BBRA) for the three rehabilitative therapy RUG categories and
substituted 6.7% add-ons for all fourteen rehabilitative therapy RUG categories.

Primarily as the result of the Medicare rate increases
implemented on April 1, 2000 and 2001, the Companys average Medicare Part
A payment rate increased from $322 per Medicare patient day for the year ended
December 31, 2000 to $340 per Medicare patient day for the year ended December
31, 2001. The Companys quality mix of private, Medicare and insurance
revenues was 50.8% for the year ended December 31, 2000 as compared to 53.3% for
the year ended December 31, 2001.

Facility Operating Expenses. Facility operating
expenses increased by $22,414,000, or 8.6%, from $259,780,000 in 2000 to
$282,194,000 in 2001. Approximately $1,000,000 of this expense increase resulted
from the operation of the Companys Marietta, Ohio facility commencing on
November 1, 2001. Most of the remaining increase in operating expenses in 2001
was the result of higher expenditures for employee benefit costs and temporary
nursing personnel. The increase in employee benefits costs are driven primarily
by higher costs associated with maintaining the Companys health insurance
plan. The Companys health insurance plan expense increased by $2,060,000
from 2000 to 2001. Consistent with other long-term care providers, the Company
continues to find it difficult to recruit and retain employees, most notably
nursing personnel. As a result of these difficulties, the Company has been
forced to rely more heavily on temporary nursing personnel. The expense
associated with temporary nursing personnel increased by $3,108,000, or 29.6%,
from 2000 to 2001.

General and Administrative; Service Charges Paid to
Former Affiliate. General and administrative expenses increased by
$1,050,000 or 5.8%, from $17,993,000 in 2000 to $19,043,000 in 2001. The Company
reimburses a former affiliate for data processing services provided to the
Company. During 2000, such reimbursements totaled $1,083,000 compared to
$979,000 in 2001.

Amortization of Prepaid Management Fees.Amortization of prepaid management fees was $1,200,000 in 2000 and 2001.
(See Note O to the Companys consolidated financial statements included
elsewhere in this report.)

Depreciation and Amortization. Depreciation and
amortization decreased from $10,210,000 in 2000 to $9,355,000 in 2001.
Depreciation expense decreased primarily as the result of the refinancing of the
Companys four Cleveland-area facilities. On September 27, 2000, the
Company terminated its capital leases for these properties and entered into new
operating leases for each of the Cleveland facilities. (See Note I to the
Companys consolidated financial statements included elsewhere in this
report.) As a result of this transaction, the Companys annual depreciation
and interest expense decreased by approximately $1,400,000 and $4,100,000,
respectively, while the Companys annual rent expense increased by
approximately $5,900,000. The Companys amortization expense decreased in
2001 primarily as a result of the write-off of deferred financing costs in
September 2000 and the first half of 2001. The write-off of deferred financing
costs in the first half of 2001 were made in connection with amendments to the
Companys bank credit facility and the financial restructuring completed in
the second quarter of 2001.

Facility Rent. Facility rent expense increased
by $4,614,000 from $24,275,000 in 2000 to $28,889,000 in 2001. Most of the
increase in rent expense occurred as a result of the Company terminating capital
leases for four facilities in the Cleveland area in September 2000 and entering
into four new operating leases for these facilities.

Financial Restructuring Costs.In
connection with an amendment to the Companys bank credit facility and the
financial restructuring completed during the year ended December 31, 2001, the
Company recorded non-recurring charges totaling $9,045,000. The charges resulted
from the write-off of unamortized deferred financing costs related to obtaining
the Companys bank credit facility and issuing its Discount Notes, and the

# 23

recognition of various investment advisory, legal and other fees associated with
completing the amendment to the bank credit facility and the financial
restructuring. (See Note H to the Companys consolidated financial
statements included elsewhere in this report.)

Facility Reorganization Costs. During the year
ended December 31, 2001, the Company incurred a non-recurring charge of
$1,080,000 in connection with its decision to revise the marketing approach for
facilities operated through subsidiaries in Florida. The Company determined that
a local community-based marketing approach would better serve the needs of these
facilities. The marketing approach stresses ties to the local community and
required renaming these facilities in order to emphasize this approach. In
connection with this effort, the Company also restructured certain of its
subsidiaries effective October 1, 2001. In order to implement this strategy, the
Company incurred non-recurring marketing, legal and other expenses.

Interest Expense, net. Interest expense, net,
decreased from $21,675,000 in 2000 to $11,945,000 in 2001. This decrease is the
result of the refinancing of the Cleveland-area facilities in September 2000 and
the restructuring of the Companys Discount Notes completed in May 2001.
The termination of the Cleveland-area capital leases reduced the Companys
interest expense by approximately $4,100,000 on an annual basis. The
restructuring of the Discount Notes reduced both the carrying amount of the debt
and its effective interest rate. (See Note H to the Companys consolidated
financial statements included elsewhere in this report.)

Income Tax Expense.During the year ended December 31,
2000, the Companys deferred income tax assets were eliminated (through an
adjustment to the related valuation allowance) due to uncertainty regarding
future realization of these assets, resulting in income tax expense of
$14,322,000 for that year. For the year ended December 31, 2001, income tax
expense (all related to state income taxes) was $225,000. (See Note K to the
Companys consolidated financial statements included elsewhere in this
report.)

Net Loss. The Company's net loss decreased from
$36,706,000 in 2000 to $16,902,000 in 2001.

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

Total Net Revenues. Total net revenues increased
by $22,057,000 or 7.3%, from $300,615,000 in 1999 to $322,672,000 in 2000. The
increase in total revenues from 1999 to 2000 was primarily the result of higher
average revenues per patient day. The average occupancy rate at all of the
Companys facilities decreased from 90.9% for the year ended December 31,
1999 to 90.1% for the year ended December 31, 2000. Average net patient service
revenues per patient day at the Companys facilities increased from $152
for the year ended December 31, 1999 to $164 for the year ended December 31,
2000. The Companys average Medicare Part A per diem rate increased from
$290 per Medicare patient day for the year ended December 31, 1999 to $322 per
Medicare patient day for the year ended December 31, 2000, while the
Companys average per diem Medicaid rate increased from $120 for the year
ended December 31, 1999 to $127 for the year ended December 31, 2000. In
accordance with provisions of the Balanced Budget Refinement Act of 1999, the
Company elected to have fourteen of its facilities waive their remaining
transition period available under Medicares current prospective payment
reimbursement system. Effective January 1, 2000, these fourteen facilities began
to be reimbursed at the Federal per diem payment rate for paid Medicare days.
Additionally, the Balanced Budget Refinement Act of 1999 temporarily increased
the Federal per diem rates by 20% for fifteen RUG categories beginning on April
1, 2000. These increased rates will stay in effect until the date on which the
CMS implements a revised PPS system that more accurately reimburses the costs of
caring for medically complex patients. Primarily as the result of electing to
move fourteen facilities to the Federal per diem rate and the temporary Medicare
rate increases implemented on April 1, 2000, the Companys average Medicare
Part A payment rate increased from $290 per Medicare patient day for the year
ended December 31, 1999 to $322 per Medicare patient day for the year ended
December 31, 2000. The Companys quality mix of private, Medicare and
insurance revenues was 50.7% for the year ended December 31, 1999 as compared to
50.8% for the year ended December 31, 2000.

Facility Operating Expenses. Facility operating
expenses increased by $10,985,000, or 4.4%, from $248,795,000 in 1999 to
$259,780,000 in 2000. The overall increase in operating expenses in 2000 was
primarily the result of higher expenditures for employee benefit costs and
temporary nursing personnel. The increase in employee benefits costs are driven
primarily by higher costs associated with maintaining the Companys health
insurance plan. The Companys health insurance plan expense increased by
$3,700,000 from 1999 to 2000. Consistent with other long-term care providers,
the Company continues to find it difficult to recruit and retain employees, most
notably nursing personnel. As a result of these difficulties, the Company has
been forced to rely more heavily on temporary nursing personnel. The expense
associated with temporary nursing personnel increased by $2,156,000, or 25.8%
from the year ended December 31, 1999 to the year ended December 31, 2000.

Facility operating expenses for the quarter and year
ended December 31, 2000 include a non-recurring charge in the amount of
$575,000. The charge was incurred in connection with the Companys
participation in a shared collateral arrangement designed to decrease the
Companys required letter of credit commitments for its high
deductible workers compensation insurance policy. The Company posted a letter of
credit equal to approximately 15% of the estimated workers compensation claim
requirements as collateral for a bond in favor of the insurance company that
underwrote the high deductible policy. The program to purchase the bonds as a
substitute for the letters of credit was created for a select number of
companies who agreed to jointly and severally share the potential risk of loss.
During the fourth quarter of 2000, the Company was notified that one of the
participants in the shared collateral pool caused a default under the shared
collateral agreement in connection with a bankruptcy filing. The insurance
carrier responded by drawing on all of the pledged letters of credit. The
Company has terminated its participation in the shared collateral program in
connection with its workers compensation policy, and accordingly, the Company
will incur no additional charges in connection with that program.

# 24

General and Administrative; Service Charges Paid to
Affiliate. General and administrative expenses increased by $185,000 or
1.0%, from $17,808,000 in 1999 to $17,993,000 in 2000. The Company reimburses a
former affiliate for data processing services provided to the Company. During
1999, such reimbursements totaled $1,173,000 compared to $1,083,000 in 2000.

Amortization of Prepaid Management Fees.Amortization of prepaid management fees (paid in connection with the Merger)
was $1,200,000 in 1999 and 2000. (See Note O to the Companys consolidated
financial statements included elsewhere in this report.)

Depreciation and Amortization. Depreciation and
amortization decreased slightly from $10,249,000 for the year ended December 31,
1999 to $10,210,000 for the year ended December 31, 2000. The effect of an
increase in depreciation expense was entirely offset by a decrease in
amortization expense. The increase in depreciation expense was the result of
assets placed in service during late 1999 and 2000. The decrease in amortization
expense was the result of deferred financing costs written-off in connection
with a reduction in funds committed through the Companys bank credit
facility in 2000 and goodwill written off in connection with the Companys
restructuring of its therapy services business during 1999. (See Notes H and Q
to the Companys consolidated financial statements included elsewhere in
this report.)

Facility Rent. Facility rent expense increased by
$1,881,000 from $22,394,000 in 1999 to $24,275,000 in 2000. Most of the increase
in rent expense ($1,500,000) occurred as a result of the Company terminating
capital leases for four facilities in the Cleveland area in September 2000 and
entering into four new operating leases for these facilities. (See Note I to the
Companys consolidated financial statements included elsewhere in this
report.)

Restructuring Costs. In connection with
restructuring the Companys therapy services business, the Company incurred
restructuring costs of $5,745,000 during the third quarter of 1999. (See Note P
to the Companys consolidated financial statements included elsewhere in
this report.)

Loss on the termination of capital lease.In
connection with the termination of a capital lease during the third quarter of
2000, the Company recorded a non-recurring charge of $8,900,000. The principal
components of this charge included the write-off of capital leased assets in
excess of the related capital lease obligation ($5,700,000) and the write-off of
deferred financing costs ($1,800,000) related to the Companys bank credit
facility. (See Note I to the Companys consolidated financial statements
included elsewhere in this report.)

Interest Expense, net. Interest expense, net,
increased from $20,895,000 in 1999 to $21,675,000 in 2000. This increase was the
result of higher outstanding balances in 2000 with respect to the Companys
11% Senior Subordinated Discount Notes (the Discount Notes).

Income Tax Expense (Benefit).As a result of the
loss incurred in 1999, income tax benefit of $10,304,000 was recognized in that
year. In 2000, deferred taxes were eliminated, due to uncertainty regarding
future realization of these assets, resulting in income tax expense of
$14,322,000.

Net Loss. Net loss was $17,601,000 in 1999 as
compared to a loss of $36,706,000 in 2000.

LIQUIDITY AND CAPITAL RESOURCES

The Companys primary cash needs are for
acquisitions, capital expenditures, working capital, debt service and general
corporate purposes. The Company has historically financed these requirements
primarily through a combination of internally generated cash flow, mortgage
financing and operating leases, in addition to funds borrowed under a credit
facility. The Companys existing leased facilities are leased from either
the owner of the facilities, from a real estate investment trust which has
purchased the facilities from the owner, or through synthetic lease borrowings.
The Companys existing facility leases generally require it to make monthly
lease payments and pay all property operating costs. The Company generally
negotiates leases which provide for extensions beyond the initial lease term and
an option to purchase the leased facility. In some cases, the option to purchase
the leased facility is at a price based on the fair market value of the facility
at the time the option is exercised. In other cases, the lease for the facility
sets forth a fixed purchase option price which the Company believes is equal to
the fair market value of the facility at the inception date of such lease, thus
allowing the Company to realize the value appreciation of the facility while
maintaining financial flexibility.

In connection with the leveraged recapitalization
completed on August 11, 1998, the Company obtained gross proceeds of $99.5
million through the issuance of 11% Senior Subordinated Discount Notes (the
Discount Notes) due 2008 and $40 million through the issuance of
13.5% Exchangeable Preferred Stock (the Preferred Stock) mandatorily
redeemable in 2010. Interest on the Discount Notes accreted at 11% per annum
until August 1, 2003 and then was to become payable in cash, semi-annually in
arrears, beginning on February 1, 2004. Dividends on the Preferred Stock were
payable, at the option of the Company, in additional shares of the Preferred
Stock until August 1, 2003. After that date dividends may only be paid in cash.
In August 1998, the Company also entered into a $250 million collateralized
credit facility (the Credit Facility). The terms of the Credit
Facility originally provided up to $75 million on a revolving credit basis plus
an additional $175 million initially funded on a revolving basis that would
convert to a term loan on an annual basis on each anniversary of the closing.
During the first four years of the Credit Facility, any or all of the full $250
million of availability under the Credit Facility could be used for synthetic
lease financings. Proceeds of loans under the facility may be used for
acquisitions, working capital purposes, capital expenditures and general
corporate purposes. Interest is based on either LIBOR or prime rates of interest
(plus applicable margins) at the election of the Company. The Credit Facility
contains various financial and other restrictive covenants and limits aggregate
borrowings under the Credit Facility to a predetermined multiple of earnings
before interest, taxes, depreciation and amortization (EBITDA).

# 25

During the first quarter of 1999, the Company determined
that its anticipated financial results for that quarter would cause the Company
to be out of compliance with certain financial covenants of the Credit Facility.
The Companys reduced level of EBITDA during the first quarter of 1999 was
attributable to transitional difficulties associated with the implementation of
the new Medicare prospective payment system which became effective at all of the
Companys facilities on January 1, 1999. Such transitional difficulties
resulted in lower than expected revenues, primarily due to fewer than expected
Medicare patient days, lower Medicare Part A rates, reduced revenues from
therapy services provided to non-affiliated long-term care centers and a
reduction in revenues from the provision of Medicare Part B services at the
Companys own facilities. In response, during the first quarter of 1999,
the Company initiated additional facility-based training directed towards the
documentation requirements of the revised Medicare reimbursement system. The
Company also continued to refine its admission and assessment protocols in order
to increase patient admissions and introduced a series of targeted initiatives
to lower operating expenses. Such initiatives included wage and staffing
reductions (primarily related to the delivery of rehabilitative therapy services
and indirect nursing support), renegotiation of vendor contracts and ongoing
efforts to reduce the Companys reliance on outside nurse agency personnel.
All of the staffing reductions were implemented, on or prior to, April 1, 1999.
Effective March 30, 1999, the Company obtained an amendment (the First
Amendment) to the Credit Facility which limited borrowings under the
Credit Facility to an aggregate of $58,500,000 (exclusive of undrawn letters of
credit outstanding as of March 30, 1999) and which modified certain financial
covenants. The First Amendment required minimum amounts of EBITDA, measured
quarterly, but calculated on a rolling twelve-month basis, through December 31,
2000. As long as the Company met or exceeded the required minimum cumulative
amounts of EBITDA, the Company could access the Credit Facility for general
corporate purposes, subject to the reduced amount of availability.

Until September 27, 2000, the Company, through a wholly
owned limited partnership, leased and operated four facilities in Ohio (the
Cleveland Facilities) which it acquired in 1996 through capital
leases. Each of the four leases contained an option to purchase the facility
beginning July 1, 2001 and each lease was guaranteed by the Company. The
guaranty provided that failure by the Company to have a specified minimum
consolidated net worth at the end of any two consecutive quarters would be an
event of default under the guaranty, which in turn would be an event of default
under each lease. During the third quarter of 1999, the Company recorded a $5.7
million restructuring charge to terminate its contracts to provide
rehabilitation therapy services to non-affiliated long-term care facilities.
(See Note P to the Companys condensed consolidated financial statements
included elsewhere in this report.) As a result of this restructuring charge,
the Companys consolidated net worth as of September 30, 1999 (as
calculated for purposes of this requirement) had fallen below the required
level. The Company anticipated that its net worth would continue to be below the
required level at December 31, 1999, which would have resulted in an event of
default under each of these leases with the Company potentially facing the loss
of these operations. Such default could also have triggered cross-defaults under
the Companys other lease and debt obligations. In December 1999, the
Company paid $5 million to its landlord and obtained an option (the New
Option) to acquire the Cleveland Facilities. The Company borrowed $5
million from an affiliate of Investcorp S.A. to fund this payment. The New
Option allowed the Company to exercise its right to purchase the Cleveland
Facilities beginning as of the date of the New Option, required the Company to
complete the acquisition prior to December 31, 2000 and provided a waiver of the
net worth covenant through that date. The Company exercised the New Option on
June 30, 2000 and on September 27, 2000, the Company terminated the Cleveland
Facilities capital leases and assigned its purchase rights for these facilities
to an investment entity organized by Investcorp S.A. for $5.0 million, which
acquired the Cleveland Facilities on September 27, 2000. On that date, the
Company entered into new operating leases for each of the Cleveland Facilities
with combined annual rent expense of approximately $5.9 million. The Company
also repaid the $5.0 million loan from an affiliate of Investcorp S.A. As a
result of the capital lease termination, the Company recorded a non-recurring
charge of $8.9 million. (See Note I to the Companys condensed consolidated
financial statements included elsewhere in this report.) The principal
components of this charge included the write-off of capital leased assets in
excess of the related capital lease obligation ($5.7 million) and the write-off
of deferred financing costs ($1.8 million) originally incurred in obtaining the
Companys Credit Facility. In order to complete the Cleveland Facility
leasing transaction, the Company was required to obtain the release of certain
collateral held by the bank group that provides the Credit Facility. The Company
obtained the release of the collateral as part of an amendment (the Second
Amendment) to the Credit Facility, which also resulted in a permanent
reduction of the Companys maximum borrowings under the Credit Facility
from $250 million to $150 million and an increase in the Companys
borrowing rate. As a result of the permanent reduction in funds available
through the Credit Facility, the Company was required to write off a
proportionate amount of the deferred financing costs incurred when the credit
facility was originally obtained.

On March 28, 2001, the Company obtained an additional
amendment (the Third Amendment) to the Credit Facility in order to
be able to complete the financial restructuring of the Companys Discount
Notes and Preferred Stock discussed below. The Third Amendment resulted in a
permanent reduction of the Companys maximum borrowings under the Credit
Facility from $150 million to $60 million, revised certain financial covenants,
changed the maturity date of the Credit Facility to March 31, 2004 and increased
the Companys borrowing rate. The Third Amendment also requires the Company
to repay, on an annual basis, the greater of $5.0 million or 50% of the
Companys excess cash flow (as defined). As a result of the permanent
reduction in funds available through the Credit Facility, the Company was
required to write off approximately $2.6 million of deferred financing costs
incurred when the Credit Facility was obtained. (See Note H to the
Companys consolidated financial statements included elsewhere in this
report.)

In March 2001, the Company entered into an agreement
(the Restructuring Agreement) with Investcorp S.A. and the holders
of more than a majority in interest of the Companys Discount Notes and
Preferred Stock for purposes of implementing a restructuring of the Discount
Notes and Preferred Stock. The Restructuring Agreement contemplated that the
Company would offer to exchange for each $1,000 amount at maturity of
outstanding Discount Notes a combination of the following: (1) 0.5899118 of
a new 12% Senior Subordinated Discount Note due 2007 (the New Notes)
each having a principal amount at maturity equal to $1,000 and an original issue
price of $685.67 (assuming that the New Notes were issued on May 4, 2001),
(2)  $88.2353 in cash and (3) common stock purchase warrants for
approximately 10.9 shares of its Class A Common Stock. The Company would
also offer to exchange common stock purchase warrants for approximately 10.7
shares of its Class A Common Stock for each $1,000 liquidation preference of
Preferred Stock (based on the aggregate liquidation preference to be outstanding
on May 1, 2001) plus any dividends accrued on such Preferred Stock after May 1,
2001. In conjunction with the restructuring proposal, the Company would solicit
consents from holders of outstanding Discount Notes and Preferred Stock to

# 26

amendments to the Indenture governing the Discount Notes and to the Certificate
of Designation governing the Preferred Stock that would eliminate or modify
certain restrictive covenants and other provisions contained in the Indenture
and the Certificate of Designation and would substantially eliminate the
preferences of the Preferred Stock, including the reduction of the liquidation
preference from $1,000 to $0.01 per share and the elimination of the right of
holders to be paid dividends on shares of Preferred Stock. Also, the Company
would issue to Investcorp S.A. (or one or more of its affiliates or designees)
up to 15,000 shares of a new series of 13% convertible exchangeable preferred
stock (the New Preferred Stock) and 1,854,422 common stock purchase
warrants for a total purchase price of up to $15,000,000.

On April 6, 2001 the Company initiated the exchange
offer and consent solicitation contemplated by the Restructuring Agreement. On
May 10, 2001, the Company completed the exchange offer and consent solicitation,
thereby implementing each of the elements of the Restructuring Agreement. All of
the outstanding Discount Notes and 99.96% of the shares of Preferred Stock were
tendered and exchanged in the exchange offer. As a result of the exchange, (1)
the Company has an aggregate principal amount at maturity of $100,276,000 of New
Notes outstanding and an aggregate liquidation preference of $15,000,000 (as of
May 10, 2001) of New Preferred Stock outstanding, (2) warrants were issued
to holders of Discount Notes, to holders of Preferred Stock, and to Investcorp
S.A. representing the right to purchase an aggregate of approximately 15%, 5%
and 15%, respectively, of the total number of shares of all classes of the
Companys common stock on a fully diluted basis (excluding shares issuable
upon conversion of the New Preferred Stock, each share of which will initially
be convertible into 150 shares of Class A Common Stock, and (3) the
Company paid $15,000,000 in cash as partial consideration for the tendered
Discount Notes.

The reduction in the liquidation preference of the
Preferred Stock was completed on May 10, 2001, as contemplated by the
Restructuring Agreement, the carrying amount of the Preferred Stock was reduced
from $57,595,000 to $576 and the amount of the reduction, net of unamortized
deferred financing costs related to the issuance of the Preferred Stock
(approximately $1,011,000 at May 10, 2001), was directly transferred to the
Companys Accumulated Deficit account. With the exchange of the New Notes
for the Discount Notes (the Note Exchange), the carrying value of
the accreted principal of the Discount Notes was reduced to $68,890,000, and the
amount of the reduction, net of the aggregate cash payment of $15,000,000, was
directly transferred to the Companys Long-term Accrued Interest account.
Subsequent to their issuance, the carrying amount of the New Notes increases as
the result of accretion and results in a corresponding decrease in the carrying
amount of Long-term Accrued Interest. Interest expense on the New Notes is
recognized such that a constant effective interest rate is applied to the
aggregate carrying amount of the New Notes and Long-term Accrued Interest for
all periods between the issuance date and the maturity date of the New Notes.

In connection with the Third Amendment to the Credit
Facility and the implementation of the Restructuring Agreement, the Company
incurred a non-recurring charge of $9,045,000. The charge resulted from the
write-off of approximately $1,500,000 of unamortized deferred financing costs
incurred when the Credit Facility was obtained, the write-off of approximately
$3,400,000 of unamortized deferred financing costs related to the issuance of
the Discount Notes, and the recognition of various investment advisory, legal
and other fees associated with these events of $4,145,000.

The New Notes were issued at a discount and interest on
the New Notes accretes until August 1, 2004. Cash interest payments will be paid
semi-annually in arrears beginning on February 1, 2005 based on the fully
accreted value of the New Notes and a 12% cash interest payment rate. The New
Notes mature on August 1, 2007. The New Preferred Stock is mandatorily
redeemable on February 1, 2008. The holders of the New Preferred Stock are
entitled to dividends quarterly in arrears beginning August 1, 2001 and payable
in additional shares of New Preferred Stock. Warrants to purchase a total of
4,326,641 shares of common stock at $0.01 per share were issued on May 10, 2001.

As of December 31, 2001, total obligations under the Credit
Facility were $54,930,000 and consisted of $25,250,000 of revolver loans,
$13,700,000 of synthetic lease obligations and $15,980,000 of undrawn letters of
credit. Approximately 40% of the letters of credit were issued in connection
with the Company's leasing of long-term facilities under operating leases. The
remaining letters of credit were issued to third party insurers and relate to
recorded insurance liabilities. As of December 31, 2001, the Company had
approximately $70,000 of availability under the Credit Facility (as amended by
the Third Amendment) and was not in default of the financial covenants of the
Credit Facility.

The Companys operating activities in 2000 provided
net cash of $26,366,000 as compared to providing net cash of $19,235,000 in
2001. Cash flows from operations in 2001 decreased primarily as the result of
non-recurring cash charges incurred in connection with the completion of the
Third amendment, the Financial Restructuring and the Facility Reorganization.

Net cash used by investing activities was $8,702,000
during 2000 as compared to $13,061,000 used in 2001. The primary use of cash for
investing purposes during 2000 and 2001 was to fund additions to property and
equipment associated with the maintenance of the Companys existing
facilities.

Net cash used by financing activities was $8,326,000 in
2000 as compared to $7,649,000 used in 2001. During 2001, the Company repaid
$7,500,000 on its revolving credit facility.

In addition to the Discount Notes, as of December 31,
2001, the Company had two mortgage loans outstanding totaling $17,179,000 and
$25,250,000 in revolving loans on its Credit Facility. One mortgage loan had an
outstanding principal balance of $15,676,000 of which $15,140,000 is due at
maturity in 2004. This loan bears interest at an annual rate of 10.65% plus
additional interest equal to 0.3% of the difference between the annual operating
revenues of the four mortgaged facilities and actual revenues during the
twelve-month base period. The Companys other mortgage loan, which
encumbers a single facility, had an outstanding principal balance of $1,503,000
at December 31, 2001, of which $1,338,000 is due in 2010.

# 27

The Company owns a 75% interest in a partnership that owns one
facility. The Company accounts for its investment in this partnership using the
equity method. The Company has guaranteed a loan of approximately $5,600,000
made to this partnership to refinance a loan that funded the construction of the
facility and provided working capital. The loan is also collateralized by
additional collateral pledged by the non-affiliated partner. The loan matures on
May 1, 2002 and the Company expects to refinance the loan on comparable terms
prior to the maturity date. The partnership agreement states that each partner
will contribute an amount in respect of any liability incurred by a partner in
connection with a guarantee of the partnership's debt, so that partners each
bear their proportionate share of any liability based on their percentage
ownership of the partnership.

Harborside expects that its capital expenditures for 2002,
excluding acquisitions of new long-term care facilities, will aggregate
approximately $7,000,000. Harborsides expected capital expenditures will
relate to maintenance capital expenditures, systems enhancements, special
construction projects and other capital improvements. Harborside expects that
its future facility acquisitions will be financed primarily through operating
leases or assumed debt. Harborside may be required to obtain additional equity
financing to finance any significant acquisitions in the future, to refinance
the New Notes when they mature on August 1, 2007 or to refinance the New
Preferred Stock when it becomes mandatorily redeemable on February 1, 2008.

The Company is highly leveraged, which makes it vulnerable to
changes in general economic conditions. The Company's ability to repay or
refinance its debt will depend on, among other things, financial, business,
market, competitive and other conditions, many of which are beyond the control
of the Company. The Company believes that, taken together, its current cash
balances, internally generated cash flow and availability under its credit
facilities should result in the Company having adequate cash resources to meet
its debt service and other financial obligations for at least the next twelve
months.

CONTRACTUAL OBLIGATIONS

The following table provides information about the Company's
contractual obligations as of December 31, 2001, excluding current liabilities
except for the current portion of long-term debt.

`Payments due by Years
                                          Total            2002        2003 and 2004  2005 and 2006  After 2006

Long-term debt                       $  116,654,000  $    2,776,000  $   38,213,000  $      40,000  $   75,625,000
Operating leases (1)                    214,410,000      28,311,000      56,288,000     45,538,000      84,273,000
                                     --------------  --------------  --------------  -------------  --------------
Total contractual and
cash obligations                     $  331,064,000  $   31,087,000  $   94,501,000  $  45,578,000  $  159,898,000
                 ==============  ==============  ==============  =============  ==============`

(1) The operating lease obligation amounts include the annual
  facility rent payments for two long-term care facilities whose acquisitions
  were financed by the Company through the synthetic leasing capability of its
  Credit Facility. The Company's annual rent obligations under these synthetic
  leases reflect payment of interest only on the lessor's $13,700,000 of
  underlying debt obligations. At the maturity of the leases, the Company is
  obligated to either purchase the facilities and refinance the $13,700,000 of
  underlying debt or assist the lessor in remarketing the facilities and
  reimburse the lessor if the fair market value of the facilities at that time
  is less than the amount of the underlying debt obligation.

The Company issued $15,000,000 of New Preferred Stock on May
10, 2001. As long as the Company's New Notes remain outstanding, the New
Preferred Stock is entitled to dividends at rate of 13% per annum compounded
quarterly and payable in additional shares of New Preferred Stock. The New
Preferred Stock is mandatorily redeemable on February 1, 2008.

During the year ended December 31, 1998, the Company
implemented a general and professional liability insurance program that, for the
period from September 1, 1998 to August 31, 2001, limited the Companys
self-retention risk for this program to a maximum of $25,000 per year. The
long-term care industry has seen the cost of maintaining traditional
professional liability insurance increase significantly over the past two years,
especially in the State of Florida. Most insurance companies are unwilling to
underwrite new professional liability policies in the State of Florida. In May
2001, tort reform legislation was enacted in Florida. This legislation provides
caps on punitive damages, limits to add-on legal fees, stricter rules of
evidence and a shorter statute of limitations period. Given the tremendous
increase in professional liability premiums and the tort reform legislation that
was enacted in the State of Florida in May 2001, the Company concluded that it
would be more cost effective to assume a higher level of retained risk for
professional liability claims. As a result, the Company implemented a new
general and professional liability program, effective September 1, 2001, which
resulted in the Company maintaining an unaggregated self-insured retention of
$2,000,000 per occurrence for locations outside of Florida and completely
retaining risk at the Florida facilities. As of December 31, 2001, the Company
maintains a Claims Reserve in the amount of $1,467,000 for incurred but not
reported claims. The amount of the reserve was determined through an estimation
process that used information from both the Companys records as well as
industry data. The Company uses an independent actuary to help estimate the
required general and professional liability reserve. Factors reviewed include
the frequency of expected claims, the average cost per claim, emerging industry
trends, changes in regulatory environment (such as the recently enacted Florida
tort reform legislation) and the expected effect of various operational and risk
management initiatives. At this time, the Company estimates that, effective
September 1, 2001, its annual cost for professional and general liability
insurance for existing facilities will increase from approximately $2,500,000
under the prior program to $6,500,000 under the new program. The Company will
continue to evaluate its insurance reserve requirements on a quarterly basis.
Required adjustments to the Companys general and professional liability
reserve will be recorded in the accounting period in which the change in
estimate occurs. There can be no assurances the recent Florida tort reform

# 28

legislation will have a positive impact on claims activity, that
the coverage limits of the Companys insurance program will be adequate or
that insurance will continue to be available to the Company in the future. (See
Note M to the Companys consolidated financial statements included
elsewhere in this report.)

Certain of the increases in Medicare reimbursement for skilled
nursing facilities provided for under the BBRA and BIPA are scheduled to expire
on October 1, 2002. Unless Congress enacts new legislation, the loss of revenues
associated with this occurrence could have a material adverse effect on the

Company. If new legislation is not enacted, the Company
estimates that its revenues for the quarter ended December 31, 2002 would be
reduced by approximately $37 per Medicare Part A patient day. The Company cannot
provide assurances that Congress will act to renew the existing legislation;
however, the Company does anticipate that it would take actions to reduce costs
to offset a portion of this revenue reduction. At this time, the Company cannot
predict the course of action likely to be selected by Congress or the impact of
this issue on the Company's net income for the year ended December 31,
2002.

The Health Insurance Portability and Accountability Act
of 1996 (HIPAA) broadened the scope of fraud and abuse laws to
include all health plans, whether or not they are reimbursed under Federal
programs. HIPAA also mandated the adoption of federal regulations designed to
(a) standardize transaction formats and billing codes for documenting health
care services, determining eligibility and processing claims for payment; and
(b) protect the privacy and security of individually identifiable health
information. Final HIPAA regulations that standardize transactions and code sets
were issued during the third quarter of 2000. The ultimate compliance date was
subsequently modified by legislation to require health care providers and health
plans to either comply with the HIPAA transaction code set standards beginning
in October of 2002 or submit a written plan to the federal government by October
of 2002 describing specific plans for compliance by October of 2003. The
regulations do not require healthcare providers to submit claims electronically,
but do require standard formatting for those that do so. The Company currently
submits most claims electronically and expects to continue to do so. The Company
is currently evaluating its plans for compliance by October of 2002 or
submitting the required plan describing its plans for compliance by October of
2003.

Final HIPAA privacy regulations were published during
the fourth quarter of 2000. However, on March 21, 2002, the U.S. Department of
Health and Human Services released a proposed rule which if finally adopted
would modify the regulations published during 2000. In general, the regulations
apply to protected health information, which is defined 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 and
oral communications, as well as those in electronic form, regarding an
individuals past, present or future physical or mental health or
condition, or relating to the provision of health care to the individual or
payment of that health care. The regulations further impose requirements on
health care providers to contractually obligate certain of their subcontractors
who may receive protected health care information during the course of rendering
services on behalf of such health care provider to abide by certain privacy
requirements as well. In addition, the current HIPAA regulations provide that
certain state privacy laws may not be preempted by HIPAA. Accordingly, the
Company, in certain instances, will remain subject to various state privacy laws
in jurisdictions in which it currently operates facilities. HIPAA provides for
the imposition of civil and criminal penalties if protected health information
is improperly disclosed. The Company must comply with the privacy regulations by
April of 2003. Given the issuance of the recent proposed rulemaking, it is
uncertain the extent to which the regulations that were published in 2000 will
change. The Company is continuing to evaluate the impact of the privacy
regulations on its operations.

HIPAAs security regulations have not been
finalized. The proposed security regulations specify administrative procedures,
physical safeguards, and technical services and mechanisms designed to ensure
that protected health information remains secure. The proposed security rules
contemplate a compliance date of 24 months after the effective date of the final
rule published in the Federal Register, although it is possible that such
compliance date will differ and could align with the compliance date for the
privacy regulations depending on when the security regulations are ultimately
finalized.

The Company is currently working in conjunction with its
software vendors to evaluate the impact of HIPAA regulations on the
Companys systems and operating procedures. The Company has not yet
completed its analysis or its estimate of the expected costs of compliance with
the HIPAA regulations. There can be no assurances that compliance with
HIPAA regulations will not have an adverse effect on the Companys results
of operations, cash flows or its financial position.

SEASONALITY

Harborsides earnings
generally fluctuate from quarter to quarter. This seasonality is related to a
combination of factors which include, among other things, the timing of Medicaid
and Medicare rate increases, seasonal census cycles and the number of calendar
days in a given quarter.

INFLATION

The healthcare industry is labor intensive. Wages and
other labor related costs are especially sensitive to inflation. Shortages in
the labor market or general inflationary pressure could have a significant
effect on the Company. In addition, suppliers attempt to pass along rising costs
to the Company in the form of higher prices. When d with increases in
operating costs, the Company has generally increased its charges for services.
The Companys operations could be adversely affected if it is unable to
recover future cost increases or if it experiences significant delays in
Medicare and Medicaid revenue sources increasing their rates of reimbursement.

# 29

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Most of the Companys debt obligations bear
interest at fixed rates and are not affected by changes in market interest
rates; however, borrowings under the Companys New Credit Facility are
sensitive to changes in interest rates. Under the New Credit Facility, interest
is based on either LIBOR or prime rates of interest (plus applicable margins),
at the Companys election. As the prime and LIBOR rates of interest
increase, interest expense associated with the Companys borrowings under
the New Credit Facility would also increase. An increase of 1% in the applicable
rate would have increased the Companys annual interest cost by
approximately $318,000.

The Company did not experience significant changes in
interest rates during the year ended December 31, 2001. As part of the
Companys risk management program, the Company continuously reviews its
overall exposure to interest rate risk and evaluates the benefits of interest
rate hedging through the use of derivative instruments, such as interest rate
swaps. By entering into an interest rate swap, the Company can effectively
transform variable rate debt into fixed rate debt. The Company did not have any
interest rate swap arrangements outstanding during the years ending December 31,
2000 or December 31, 2001.

# 30

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

`INDEX TO FINANCIAL STATEMENTS

HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES:
Report of Independent Accountants...........................................................32
Consolidated Balance Sheets as of December 31, 2000 and 2001................................33
Consolidated Statements of Operations for the years ended December 31,
 1999, 2000 and 2001........................................................................34
Consolidated Statements of Changes in Stockholders' Equity (Deficit) for the years ended
 December 31, 1999, 2000 and 2001...........................................................35
Consolidated Statements of Cash Flows for the years ended December 31,
1999, 2000 and 2001.........................................................................36
Notes to Consolidated Financial Statements..................................................37`

# 31

`REPORT OF INDEPENDENT ACCOUNTANTS


To the Stockholders and Board of Directors of
Harborside Healthcare Corporation

  In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, changes in stockholders equity
(deficit), and cash flows present fairly, in all material respects, the
financial position of Harborside Healthcare Corporation and its subsidiaries
(the Company) at December 31, 2001 and 2000, and the results of
their operations and their cash flows for the three years then ended in
conformity with accounting principles generally accepted in the United States of
America. 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 of these statements in
accordance with auditing standards generally accepted in the United States of
America, which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP
Boston, Massachusetts
February 19, 2002`

# 32

`HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES

                                             CONSOLIDATED BALANCE SHEETS
                              (dollars in thousands, except share and per share amounts)

                                                       AS OF DECEMBER 31,


                                                                                    2000           2001
                                                                               ---------      ---------
        ASSETS
Current assets:
  Cash and cash equivalents ..............................................     $  10,724      $   9,249
  Accounts receivable, net of allowances for doubtful
     accounts of $2,272 and $3,979 respectively ..........................        48,659         45,502
  Prepaid expenses and other .............................................        13,180         11,628
                                                                               ---------      ---------
      Total current assets ...............................................        72,563         66,379

Restricted cash (Note C) .................................................         4,805          5,898
Property and equipment, net (Note D) .....................................       105,089        108,989
Deferred financing and other non-current assets, net (Note E) ............        11,253          3,916
Other assets, net (Note O) ...............................................         1,900            700
Note receivable (Note F) .................................................         7,487          7,487
                                                                               ---------      ---------
    Total assets .........................................................     $ 203,097      $ 193,369
                                                                               =========      =========

        LIABILITIES
Current liabilities:
  Current maturities of long-term debt (Note H) ..........................     $   5,250      $   2,776
  Accounts payable .......................................................        10,883         14,711
  Employee compensation and benefits .....................................        15,865         19,270
  Other accrued liabilities ..............................................         6,301          6,878
  Accrued interest .......................................................           470            147
  Current portion of deferred income .....................................           514            521
                                                                               ---------      ---------
    Total current liabilities ............................................        39,283         44,303

Claims reserve (Note M) ..................................................          --            1,467
Long-term portion of deferred income (Note G) ............................         1,910          1,487
Long-term debt (Note H) ..................................................       173,866        113,878
Long-term accrued interest (Note H) ......................................          --           47,115
                                                                               ---------      ---------
    Total liabilities ....................................................       215,059        208,250
                                                                               ---------      ---------

Commitments and contingencies (Notes G and M)

13 1/2% Exchangeable preferred stock, redeemable, $.01 par value,
  250,000 shares authorized; 55,112 and 23 shares issued and outstanding,
  respectively (Note L) ..................................................        55,112           --

13% Convertible exchangeable preferred stock, redeemable, $.01 par value
  with a liquidation value of $1,000 per share; 100,000 shares authorized;
  0 and 16,286 shares issued and outstanding, respectively (Note L) ......          --           16,286

        STOCKHOLDERS' DEFICIT (Note L)
Common stock, $.01 par value, 19,000,000 and 40,700,000 shares
 authorized, 15,275,664 shares issued ....................................           153            153
Additional paid-in capital ...............................................       191,750        187,976
Common stock in treasury, at cost, 7,349,832 and
7,379,165 shares, respectively ...........................................      (183,746)      (183,746)
Accumulated deficit ......................................................       (75,231)       (35,550)
                                                                               ---------      ---------
    Total stockholders' deficit ..........................................       (67,074)       (31,167)
                                                                               ---------      ---------
 Total liabilities and stockholders' deficit .............................     $ 203,097      $ 193,369
                                                                               =========      =========`

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

# 33

`HARBORSIDE HEATHCARE CORPORATION AND SUBSIDIARIES

                                        CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (dollars in thousands, except per share amounts)

                                           FOR THE YEARS ENDED DECEMBER 31,


                                                               1999        2000         2001
                                                               ----        ----         ----

Total net revenues ................................     $ 300,615      $ 322,672      $ 346,738
                                                        ---------      ---------      ---------

Expenses:
  Facility operating ..............................       248,795        259,780        282,194
  General and administrative ......................        17,808         17,993         19,043
  Service charges paid to former affiliate (Note O)         1,173          1,083            979
  Amortization of prepaid management fee (Note O) .         1,200          1,200          1,200
  Depreciation and amortization ...................        10,249         10,210          9,355
  Facility rent ...................................        22,394         24,275         28,889
  Restructuring costs (Note P) ....................         5,745           --             --
  Loss on termination of capital lease (Note I) ...          --            8,914           --
  Financial restructuring cost (Note H) ...........          --             --            9,045
  Facility reorganization costs (Note Q) ..........          --             --            1,080
                                                        ---------      ---------      ---------

   Total expenses .................................       307,364        323,455        351,785
                                                        ---------      ---------      ---------

 Loss from operations .............................        (6,749)          (783)        (5,047)

Other:
Interest expense, net .............................        20,895         21,675         11,945
  Other expense (income) ..........................           261            (74)          (315)
                                                        ---------      ---------      ----------
Loss before income taxes ..........................       (27,905)       (22,384)       (16,677)

Income tax expense (benefit) (Note K) .............       (10,304)        14,322            225
                                                        ---------      ---------      ---------

Net loss ..........................................       (17,601)       (36,706)       (16,902)

Preferred stock dividends .........................        (6,004)        (6,853)        (3,774)
                                                        ---------      ---------      ---------
Loss applicable to common shares ..................     $ (23,605)     $ (43,559)     $ (20,676)
                                                        =========      =========      =========

Loss per common share (Note L):
         Basic and Diluted ........................     $   (3.25)     $   (6.00)     $  (2.82)
                                                        =========      =========      =========`

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

# 34

`HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES

                         CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)
                                                (dollars in thousands)

                                 FOR THE YEARS ENDED DECEMBER 31, 1999, 2000 and 2001


                                                              Additional
                                                   Common       Paid-in     Treasury    Accumulated
                                                    Stock       Capital       Stock       Deficit     Total
                                                    -----       -------       -----       -------     --------


Stockholders' equity, December 31, 1998                146      204,607     (183,746)     (20,924)           83

Net loss for the year ended December 31, 1999            -            -            -      (17,601)     (17,601)
Preferred stock dividends                                -       (6,004)           -            -       (6,004)
                                                ----------   ----------    ---------    ---------    ----------

Stockholders' deficit, December 31, 1999               146      198,603     (183,746)     (38,525)     (23,522)

Net loss for the year ended December 31, 2000            -            -            -      (36,706)     (36,706)

Issuance of restricted shares (664,500 shares)           7            -            -            -            7

Preferred stock dividends                                -       (6,853)           -            -       (6,853)
                                                ----------   ----------    ---------    ---------     ---------

Stockholders' deficit, December 31, 2000               153      191,750     (183,746)     (75,231)     (67,074)

Net loss for the year ended December 31, 2001            -            -            -      (16,902)     (16,902)

Reduction of liquidation preference and
       exchange of 131/2% exchangeable
       preferred stock (Note L)                          -            -            -       56,583       56,583

Preferred stock dividends                                -      (3,774)            -            -       (3,774)
                                                ----------   ---------    ----------    ----------    ---------

Stockholders' deficit, December 31, 2001        $      153    $ 187,976   $ (183,746)   $ (35,550)    $(31,167)
                                                ==========    =========   ==========    ==========    =========`

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

# 35

`HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES

                                        CONSOLIDATED STATEMENTS OF CASH FLOWS
                                                (dollars in thousands)

                                           FOR THE YEARS ENDED DECEMBER 31,

                                                            1999          2000       2001
                                                          --------      --------      -----
Operating activities:
Net loss ...........................................     $(17,601)     $(36,706)     $(16,902)
Adjustments to reconcile net loss to net
  cash provided (used) by operating activities:
Depreciation of property and equipment .............        7,173         7,776         7,682
Amortization of deferred financing and other
 non-current assets ................................        3,076         2,434         1,673
             Amortization of prepaid management fee         1,200         1,200         1,200
Amortization of deferred income ....................         (677)         (680)         (518)
Accretion of senior subordinated discount notes ....       11,771        13,095        10,400
Amortization of long-term accrued interest .........         --            --          (3,002)
Amortization of loan costs
  and fees (included in rental and interest expense)          156           143           143
Accretion of interest on capital lease obligation ..        3,443         2,753          --
Noncash restructuring charge .......................        1,852          --            --
Noncash lease termination costs ....................         --           7,542          --
Noncash issuance of restricted shares ..............         --               7          --
Noncash financial restructuring charge .............         --            --           4,896
                                                         --------       -------       -------
                                                           10,393        (2,436)        5,572
Changes in operating assets and liabilities:
 (Increase) decrease in accounts receivable ........         (222)        1,509         3,157
 (Increase) decrease in prepaid expenses and other .       (4,006)        6,343         1,552
 (Increase) decrease in deferred income taxes ......       (7,939)       14,252          --
 Increase in accounts payable ......................        1,927         1,555         3,828
 Increase in employee compensation and benefits ....          801         1,844         3,405
 Increase (decrease) in accrued interest ...........          510          (102)         (323)
 Increase (decrease) in other accrued liabilities ..       (1,977)          793           577
 Increase in income taxes payable ..................        1,265         2,608          --
 Claims reserve accrual ............................         --            --           1,467
                                                         --------       -------       -------
  Net cash provided by operating activities ........          752        26,366        19,235
                                                         --------       -------       -------

Investing activities:
 Additions to property and equipment ...............      (13,197)       (6,199)      (11,582)
 Additions to deferred financing and other
  non-current assets ...............................       (2,255)         (118)         (386)
 Transfers to restricted cash, net .................         (310)       (2,385)       (1,093)
 Payment of purchase deposit .......................       (5,000)         --            --
                                                         --------       -------       -------
Net cash used by investing activities ..............      (20,762)       (8,702)      (13,061)
                                                         --------       -------       -------

Financing activities:
 Borrowings under revolving line of credit .........       20,000          --            --
 Issuance of New Preferred Stock ...................         --            --          15,000
 Payment to holders of Discount Notes ..............         --            --         (15,000)
 Receipt of cash in connection with lease ..........         --            --             102
 Payment on revolving line of credit ...............         --            --          (7,500)
 Issuance of note payable to affiliate .............        5,000          --            --
 Payment of note payable to affiliate ..............         --          (5,000)         --
 Payment of long-term debt .........................         (206)         (224)         (245)
 Principal payments of capital lease obligation ....       (4,274)       (3,084)         --
 Dividends paid on exchangeable preferred stock ....          (20)          (18)           (6)
                                                         --------      --------      --------
   Net cash provided (used) by financing activities        20,500        (8,326)       (7,649)
                                                         --------      --------      --------

Net increase (decrease) in cash and cash equivalents          490         9,338        (1,475)
Cash and cash equivalents, beginning of year .......          896         1,386        10,724
                                                         --------      --------      --------
Cash and cash equivalents, end of year .............     $  1,386      $ 10,724      $  9,249
                                                         ========      ========      ========

Supplemental Disclosure:
  Interest paid ....................................     $  5,911      $  7,129      $  6,163
  Income taxes paid ................................     $    243      $    130      $    257
  Accretion of preferred dividends .................     $  5,984      $  6,835      $  3,768`

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

# 36

## HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES

## NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Harborside Healthcare Corporation, through its
subsidiaries (the Company or Harborside), operates
long-term care facilities and, until September 1999, provided rehabilitation
therapy services to non-affiliated long-term care facilities (See Note P). As of
December 31, 2001, the Company owned eighteen facilities, operated thirty-two
additional facilities under various leases and managed one facility. The Company
accounts for its investment in one 75% owned facility using the equity method of
accounting.

B. BASIS OF PRESENTATION

The Company was incorporated in Delaware on March 19,
1996 and was formed as a holding company in anticipation of an initial public
offering (the IPO), to combine under the control of a single
corporation the operations of various business entities which were all under the
majority control of several related stockholders.

On April 15, 1998, the Company entered into a Merger
Agreement (the Merger) with HH Acquisition Corp.
(MergerCo), an entity organized for the sole purpose of effecting a
merger on behalf of Investcorp S.A., certain of its affiliates and certain other
international investors (the New Investors). The New Investors made
common equity cash contributions totaling $165 million ($158.5 million, net of
issuance costs). On August 11, 1998, MergerCo merged with and into the Company,
with Harborside Healthcare Corporation as the surviving corporation. As a result
of the transaction, and pursuant to the Merger, the New Investors acquired
approximately 91% of the post-merger common stock of the Company. The remaining
9% of the common stock was retained by existing shareholders, including
management. As a result of the Merger, the Companys shares were de-listed
from the New York Stock Exchange.

The Merger was approved by a majority of the
Companys shareholders at a special meeting held on August 11, 1998. Each
share not retained by existing shareholders was converted into $25 in cash,
representing in the aggregate, cash payments of approximately $184 million. The
converted shares (7,349,832 shares) were recorded at cost as treasury stock and
represent a deduction from the Companys stockholders equity. Holders
of outstanding stock options of the Company converted the majority of their
options into cash at $25 per underlying share (less applicable exercise price
and withholding taxes) with aggregate payments of approximately $8 million.

In connection with the transaction and prior to the
Merger, the New Investors made cash common equity contributions of $158.5
million, net of issuance costs, to MergerCo, and MergerCo obtained gross
proceeds of $99.5 million through the issuance of 11% Senior Subordinated
Discount Notes (Discount Notes) due 2008 and $40 million through the
issuance of 13.5% Exchangeable Preferred Stock (Preferred Stock)
mandatorily redeemable in 2010. In the third quarter of 1998, Harborside
recorded a charge to income from operations of $37 million ($29 million after
taxes) for direct and other costs related to the Merger transaction. In
connection with the Merger and the related refinancings, the Company exercised
purchase options for seven facilities which had been previously financed through
synthetic leases.

C. SIGNIFICANT ACCOUNTING POLICIES

The Company uses the
following accounting policies for financial reporting purposes:

Principles of Consolidation

The consolidated financial
statements include the accounts of the Company and its subsidiaries. All
significant intercompany transactions and balances have been eliminated in
consolidation.

Total Net Revenues

Total net revenues include
net patient service revenues, management fees from managed facilities and the
facility accounted for using the equity method, and, through September 1999,
rehabilitation therapy service revenues from contracts to provide rehabilitation
therapy services to non-affiliated long-term care facilities.

Net patient service
revenues payable by patients at the Companys facilities are recorded at
established billing rates. Net patient service revenues to be reimbursed by
contracts with third-party payors, primarily the Medicare and Medicaid programs,
are recorded at the amount estimated to be realized under these contractual
arrangements. Revenues from Medicare and Medicaid are generally based on
reimbursement of the reasonable direct and indirect costs of providing services
to program participants or a prospective payment system. The Company separately
estimates revenues due from each third-party with which it has a contractual
arrangement and records anticipated settlements with these parties in the
contractual period during which services were rendered. The amounts actually
reimbursable under Medicare and Medicaid are determined by filing cost reports
which are then audited and generally retroactively adjusted by the payor.
Legislative changes to state or Federal reimbursement systems may also
retroactively affect recorded revenues. Changes in estimated revenues due in
connection with Medicare and Medicaid may be recorded by the Company subsequent
to the year of origination and prior to final settlement based on improved
estimates. Such adjustments and final settlements with third-party payors, which
could materially and adversely affect the Company, are reflected in operations
at the time of the adjustment or settlement. Accounts receivable, net, at

# 37

December 31, 2000 and 2001, include $11,451,000 and $8,467,000, respectively, of
estimated settlements due from third-party payors and $2,268,000 and $2,401,000,
respectively, of estimated settlements due to third-party payors.

Concentrations

A significant portion of
the Companys revenues are derived from the Medicare and Medicaid programs.
There have been, and the Company expects that there will continue to be, a
number of proposals to limit reimbursement allowable to long-term care
facilities under these programs. Approximately 71%, 74%, and 77% of the
Companys net revenues in the years ended December 31, 1999, 2000 and 2001,
respectively, are from the Companys participation in the Medicare and
Medicaid programs. As of December 31, 2000 and 2001, $25,601,000 and
$25,862,000, respectively, of net accounts receivable were due from the Medicare
and Medicaid programs.

Facility Operating Expenses

Facility operating expenses
include expenses associated with the normal operations of a long-term care
facility. The majority of these costs consist of payroll and employee benefits
related to nursing, rehabilitation therapy services, housekeeping and dietary
services provided to patients, as well as maintenance and administration of the
facilities. Other significant facility operating expenses include: the cost of
medical and pharmacy supplies, food and utilities. Through September 1999,
facility operating expenses included expenses associated with rehabilitation
therapy services rendered by the Company under contracts to provide
rehabilitation therapy services to non-affiliated long-term care facilities.
(See Note P to the Companys consolidated financial statements included
elsewhere in this report).

Provision for Doubtful Accounts

Provisions for
uncollectible accounts receivable of $1,655,000, $3,610,000 and $3,998,000 are
included in facility operating expenses for the years ended December 31, 1999,
2000 and 2001, respectively. Individual patient accounts deemed to be
uncollectible are written off against the allowance for doubtful accounts.

Use of Estimates

The preparation of
financial statements in conformity with generally accepted accounting principles
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements and revenues and expenses
during the period reported. Actual results could differ from those estimates.
Estimates are used when accounting for the collectibility of receivables,
depreciation and amortization, health benefit, workers compensation and
general and professional liability claims, taxes and contingencies.

Property and Equipment

Property and equipment are
stated at cost less accumulated depreciation. Expenditures that extend the lives
of affected assets are capitalized, while maintenance and repairs are charged to
expense as incurred. Upon the retirement or sale of an asset, the cost of the
asset and any related accumulated depreciation are removed from the balance
sheet, and any resulting gain or loss is included in net income (loss).

Depreciation expense is
estimated using the straight-line method. These estimates are calculated using
the following estimated useful lives:

`Buildings and improvements         31.5 to 40 years or the life of the leased facility
     Furniture and equipment            3 to 10 years
     Land improvements                  8 to 40 years`

Deferred Financing and Other Non-Current Assets

Deferred financing costs
consist of costs incurred in obtaining financing (primarily loans and facility
leases). These costs are amortized using the straight-line method (which
approximates the interest method) over the term of the related financial
obligation (See Notes E and H).

In connection with each of
its acquisitions, the Company reviewed the assets of the acquired facilities and
assessed their relative fair value in comparison to the purchase price.
Covenants not-to-compete are being amortized using the straight-line method over
the period during which competition is restricted. Goodwill resulted from the
acquisition of certain assets for which the negotiated purchase prices exceeded
the allocations of the fair market value of identifiable assets. The
Companys policy is to evaluate each acquisition separately and identify an
appropriate amortization period for goodwill based on the acquired
propertys characteristics. Through December 31, 2001, goodwill was
amortized using the straight-line method over a 15 to 40 year period (See
discussion of New Accounting Pronouncements below).

Assessment of Long-Lived Assets

The Company reviews, on a
quarterly basis, the carrying value of its long-lived assets (primarily property
and equipment and deferred financing and other non-current assets) to assess the
recoverability of these assets; any impairments would be recognized in operating
results if a diminution in value considered to be other than temporary were to
occur. As part of this assessment, the Company reviews the expected future net
operating cash flows from its facilities, as well as the values included in
appraisals of its facilities, which have periodically been obtained in

# 38

connection with various financial arrangements. (See Notes H, I and P to the
Companys consolidated financial statements included elsewhere in this
report).

Cash and Cash Equivalents

Cash and cash equivalents
consist of highly liquid investments with maturities of three months or less at
the date of their acquisition by the Company.

Restricted Cash

Restricted cash consists of
cash set aside in escrow accounts as required by several of the Companys
leases and other financing arrangements.

Income Taxes

The Company determines
deferred taxes in accordance with Statement of Financial Accounting Standards
(SFAS) 109, Accounting for Income Taxes, which requires that
deferred tax assets and liabilities be computed based on the difference between
the financial statement and income tax basis of assets and liabilities using
enacted marginal tax rates. Deferred income tax expenses or credits are based on
the changes in the assets or liabilities from period to period. A valuation
allowance reduces deferred tax assets when it is more likely than not that some
portion or all of the deferred tax assets will not be recognized (See Note K).

Reclassification of Prior Period Amounts

Certain amounts have been reclassified to conform to the 2001 presentation.

New Accounting Pronouncements

In July 2001, the Financial
Accounting Standards Board (FASB) issued SFAS 141, Business
Combinations. SFAS 141 requires the purchase method of accounting for business
combinations initiated after June 30, 2001 and eliminates the
pooling-of-interests method. The Company does not believe that the adoption of
SFAS 141 will have a significant impact on its financial statements.

In July 2001, the FASB
issued SFAS 142, Goodwill and Other Intangible Assets, which is effective
January 1, 2002. SFAS 142 requires, among other things, the discontinuance of
goodwill amortization. In addition, the standard includes provisions for the
reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential future
impairments of goodwill. SFAS 142 also requires the Company to complete a
transitional goodwill impairment test six months from the date of adoption. As
of December 31, 2001, the Companys intangible assets included no assets
that will be classified as goodwill effective January 1, 2002.

In July 2001, the FASB
issued SFAS 143, Accounting for Asset Retirement Obligations. Companies are
required to adopt SFAS 143 in their fiscal year beginning after June 15, 2002.
SFAS 143 requires that obligations associated with the retirement of a tangible
long-lived asset be recorded as a liability when these obligations are incurred,
with the amount of the liability initially measured at fair value. Upon
recognizing a liability, an entity must capitalize the cost by recognizing an
increase in the carrying amount of the related long-lived asset, accrete the
liability over time to its present value each period, and depreciate the
capitalized cost over the useful life of the related asset. Upon settlement of
the liability, the obligation is either settled for its recorded amount or a
gain or loss is recognized.

In October 2001, the FASB
issued SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Companies are required to adopt SFAS 144 in their fiscal year beginning after
December 15, 2001. SFAS 144 changes the criteria that would have to be met to
classify an asset as held-for-sale, revises the rules regarding reporting the
effects of a disposal of a segment of a business and requires expected future
operating losses from discontinued operations to be displayed in discontinued
operations in the periods in which the losses were incurred. The Company does
not believe that the adoption of SFAS 144 will have a material impact on its
financial position, results of operations, or cash flows.

# 39

D. PROPERTY AND EQUIPMENT

The Company's property and equipment are stated at cost
less accumulated depreciation and consist of the following as of December 31:

`2000                    2001
                                                ----                    ----

Land                                      $   7,238,000             $  7,238,000
Land improvements                             3,643,000                3,943,000
Buildings and improvements                   95,913,000              100,626,000
Equipment, furnishings and fixtures          28,907,000               35,364,000
                                           -----------              ------------
                                            135,701,000              147,171,000
Less accumulated depreciation                30,612,000               38,182,000
                                           ------------             ------------
                                           $105,089,000             $108,989,000
                                           ============             ============`

E. DEFERRED FINANCING AND OTHER NON-CURRENT ASSETS

Deferred financing and other non-current assets are
stated at cost less accumulated amortization and consist of the following as of
December 31:

`2000                    2001
                                                ----                    ----

Deferred financing costs                    $16,095,000              $ 7,991,000
Covenant not-to-compete                       1,200,000                1,200,000
Goodwill                                        569,000                        -
Other                                           256,000                        -
                                            -----------              -----------
                                             18,120,000                9,191,000
Less accumulated amortization                 6,867,000                5,275,000
                                            -----------              -----------
                                            $11,253,000              $ 3,916,000
                                            ===========              ===========`

F. NOTE RECEIVABLE

On December 1, 1997, the Company acquired five long-term
care facilities in Connecticut. The Company financed this acquisition through an
operating lease with the seller. In connection with this acquisition, the
Company received a note receivable from the owners in the amount of $7,487,000.
Interest is earned at the rate of 9% per annum, and payments are due monthly, in
arrears, commencing January 1, 1998 and continuing until November 30, 2010, at
which time the entire principal balance is due. The proceeds of the note were
used by the owner to repay certain indebtedness. The note is collateralized by
various mortgage interests and other collateral.

G. OPERATING LEASES

The Company leases certain long-term care facilities and
equipment under operating leases. The Companys existing leased facilities
are leased either from the owner of the facilities, from a real estate
investment trust or other real estate entity that has purchased the facilities
from the owner or through synthetic lease borrowings. The Companys
existing facility leases generally require it to make monthly lease payments and
pay all property operating costs. The Company generally negotiates leases that
provide for extensions beyond the initial lease term and an option to purchase
the leased facility. In some cases, the option to purchase the leased facility
is at a price based on the fair market value of the facility at the time the
option is to be exercised. In other cases, the lease sets forth a fixed purchase
option price. The Company leases two facilities through the synthetic leasing
capability afforded by its credit facility (See Note H). In connection with
these synthetic leases the Company has guaranteed approximately $12,000,000 of
residual property value.

Future minimum rent
commitments under the Companys non-cancelable operating leases as of
December 31, 2001 are as follows:

`Real Estate         Equipment         Total
                                                 -----------         ---------         -----

                  2002                          $ 27,978,000       $  333,000    $   28,311,000
                  2003                            28,121,000          247,000        28,368,000
                  2004                            27,907,000           13,000        27,920,000
                  2005                            27,096,000                -        27,096,000
                  2006                            18,442,000                -        18,442,000
                  Thereafter                      84,273,000                -        84,273,000
                                               ------------- ----------------     -------------
                                                $213,817,000        $ 593,000      $214,410,000
                                                ============        =========      ============`

# 40

H. LONG-TERM DEBT

The Company has a mortgage payable (the
Mortgage) in the amount of $15,676,000 at December 31, 2001. The
Mortgage is cross-collateralized by the assets of four of the Companys
facilities (the Four Facilities). The Mortgage bears interest at the
annual rate of 10.65%. Additional interest payments are also required in an
amount equal to 0.3% of the difference between the operating revenues of the
Four Facilities in each applicable year and the operating revenues of the Four
Facilities during a twelve-month base period which commenced October 1, 1995.
The Mortgage places certain restrictions on the Four Facilities; among them, the
agreement restricts their ability to incur additional debt or to make
significant dispositions of assets. The Four Facilities are also required to
maintain a debt service coverage ratio of at least 1.2 to 1.0 (as defined in the
loan agreement) and a current ratio of at least 1.0 to 1.0. The Mortgage
contains a prepayment penalty calculated in accordance with a formula.

A subsidiary of the Company assumed a first mortgage
note (the Note) with a remaining balance of $1,503,000 as part of
the acquisition of a long-term care facility in 1988. The Note requires the
annual retirement of principal in the amount of $20,000. The Company pays
interest monthly at the rate of 14% per annum on the outstanding principal
amount until maturity in October 2010, when the remaining unpaid principal
balance of $1,338,000 is due. The Note is collateralized by the property and
equipment of the facility.

On August 11, 1998, in connection with the Merger, the
Company entered into a six-year $250,000,000 collateralized credit facility (the
Credit Facility). During the first four years of the Credit
Facility, up to $250,000,000 could be used in connection with synthetic lease
financing. Proceeds of the loans could be used for working capital, capital
expenditures, acquisitions and general corporate purposes. The Credit Facility
is collateralized by substantially all of the Companys patient accounts
receivable, certain real estate and a first or second priority interest in the
capital stock of certain of the Companys subsidiaries. Interest is based
on either LIBOR or prime rates of interest (plus applicable margins), at the
election of the Company. The Credit Facility requires that the Company maintain
an interest/rent coverage ratio which varies by year, and limits aggregate
borrowings under the Credit Facility to a predetermined multiple of EBITDA. The
Credit Facility contains a number of restrictive covenants that, among other
things, restrict the Companys ability to incur additional indebtedness,
prohibit the disposition of certain assets, limit the Companys ability to
make capital expenditures in excess of pre-determined levels and limits the
ability of the Company to declare and pay certain dividends.

During the first quarter of 1999, the Company determined
that its anticipated financial results for that quarter would cause the Company
to be out of compliance with certain financial covenants of the Credit Facility.
Accordingly, the Company obtained an amendment (the First Amendment)
to the Credit Facility effective March 30, 1999 which temporarily limited
borrowings under the Credit Facility to an aggregate of $58,500,000 (exclusive
of undrawn letters of credit outstanding as of March 30, 1999) and which
modified certain financial covenants. In order to complete the Cleveland
Facility leasing transaction (See Note I), the Company was required to obtain
the release of certain collateral held by the bank group which provides the
Credit Facility. The Company obtained the release of the collateral as part of
an amendment (the Second Amendment) to the Credit Facility, which
also resulted in a permanent reduction of the Companys maximum borrowings
under the Credit Facility from $250 million to $150 million and an increase in
the Companys borrowing rate. As a result of the permanent reduction in
funds available through the Credit Facility, the Company was required to write
off a proportionate amount of the deferred financing costs incurred when the
Credit Facility was obtained.

On March 28, 2001, the Company obtained an additional
amendment (the Third Amendment) to the Credit Facility in order to
be able to implement the financial restructuring of the Companys Discount
Notes and Preferred Stock discussed below. The Third Amendment resulted in a
permanent reduction of the Companys maximum borrowings under the Credit
Facility from $150 million to $60 million, revised certain financial covenants,
changed the maturity date of the Credit Facility to March 31, 2004 and increased
the Companys borrowing rate. The Third Amendment also requires the Company
to repay, on an annual basis, the greater of $5,000,000 or 50% of the
Companys excess cash flow (as defined). As a result of the permanent
reduction in funds available through the Credit Facility, the Company was
required to write off a proportionate amount of the deferred financing costs
incurred when the Credit Facility was obtained.

As of December 31, 2001, total obligations under the
Credit Facility were $54,930,000 and consisted of $25,250,000 of revolver loans,
$13,700,000 of synthetic lease obligations and $15,980,000 of undrawn letters of
credit. As of December 31, 2001, the Company had approximately $70,000 of
remaining availability under the Credit Facility (as amended by the Third
Amendment) and was not in default of the financial covenants of the Credit
Facility. As of December 31, 2001, interest on revolver loans outstanding under
the Credit Facility ranged from 5.9% to 6.43%.

In connection with the Merger on August 11, 1998, the
Company issued $170,000,000 principal amount at maturity (approximately
$99,500,000 gross proceeds) of Discount Notes. Each Discount Note was issued
with a principal amount at maturity of $1,000 and an original issue price of
$585.25. Interest on the Discount Notes accreted in accordance with a
predetermined formula on a semi-annual basis on February 1, and August 1, of
each year. Cash interest was not to accrue on the Discount Notes until August 1,
2003. In March 2001, the Company entered into an agreement (the
Restructuring Agreement) with Investcorp S.A. and the holders of
more than a majority in interest of the Companys Discount Notes and
Preferred Stock for purposes of implementing a restructuring of the Discount
Notes and Preferred Stock. The Restructuring Agreement contemplated that the
Company would offer to exchange for each $1,000 amount at maturity of
outstanding Discount Notes a combination of the following: (1) 0.5899118 of
a new 12% Senior Subordinated Discount Note due 2007 (the New Notes)
each having a principal amount at maturity equal to $1,000 and an original issue
price of $685.67 (assuming that the New Notes were issued on May 4, 2001),
(2)  $88.2353 in cash and (3) common stock purchase warrants for
approximately 10.9 shares of its Class A Common Stock. The Company would
also offer to exchange common stock purchase warrants for approximately 10.7
shares of its Class A Common Stock for each $1,000 liquidation preference of
Preferred Stock (based on the aggregate liquidation preference to be outstanding
on May 1, 2001) plus any dividends accrued on such Preferred Stock after May 1,
2001. In conjunction with the restructuring proposal, the Company would solicit
consents from holders of outstanding Discount Notes and Preferred Stock to

# 41

amendments to the Indenture governing the Discount Notes and to the Certificate
of Designation governing the Preferred Stock that would eliminate or modify
certain restrictive covenants and other provisions contained in the Indenture
and the Certificate of Designation and would substantially eliminate the
preferences of the Preferred Stock, including the reduction of the liquidation
preference from $1,000 to $0.01 per share and the elimination of the right of
holders to be paid dividends on shares of Preferred Stock. Also, the Company
would issue to Investcorp S.A. (or one or more of its affiliates or designees)
up to 15,000 shares of a new series of 13% convertible exchangeable preferred
stock (the New Preferred Stock) and 1,854,422 common stock purchase
warrants for a total purchase price of up to $15,000,000.

On April 6, 2001, the Company initiated the exchange
offer and consent solicitation contemplated by the Restructuring Agreement. On
May 10, 2001, the Company completed the exchange offer and consent solicitation,
thereby implementing each of the elements of the Restructuring Agreement. All of
the outstanding Discount Notes and 99.96% of the Preferred Stock shares were
tendered and exchanged in the exchange offer. As a result of the exchange, (1)
the Company has an aggregate principal amount at maturity of $100,276,000 of New
Notes outstanding and an aggregate liquidation preference of $15,000,000 (as of
May 10, 2001) of New Preferred Stock outstanding, (2) warrants were issued
to holders of Discount Notes, to holders of Preferred Stock, and to Investcorp
S.A. representing the right to purchase an aggregate of approximately 15%, 5%
and 15%, respectively, of the total number of shares of all classes of the
Companys common stock on a fully diluted basis (excluding shares issuable
upon conversion of the New Preferred Stock, each share of which are initially
convertible into 150 shares of Class A Common Stock, and (3) the
Company paid $15,000,000 in cash as partial consideration for the tendered
Discount Notes.

The reduction in the liquidation preference of the
Preferred Stock was completed on May 10, 2001, as contemplated by the
Restructuring Agreement, the carrying amount of the Preferred Stock was reduced
from $57,595,000 to $576 and the amount of the reduction, net of unamortized
deferred financing costs related to the issuance of the Preferred Stock
(approximately $1,011,000 at May 10, 2001), was directly transferred to the
Companys Accumulated Deficit account. With the exchange of the New Notes
for the Discount Notes, the carrying value of the accreted principal of the
Discount Notes was reduced to $68,890,000, and the amount of the reduction, net
of the aggregate cash payment of $15,000,000, was directly transferred to the
Companys Long-term Accrued Interest account. Subsequent to their issuance,
the carrying amount of the New Notes increases as the result of accretion and
results in a corresponding decrease in the carrying amount of Long-term Accrued
Interest. Interest expense on the New Notes is recognized such that a constant
effective interest rate is applied to the aggregate carrying amount of the New
Notes and Long-term Accrued Interest for all periods between the issuance date
and the maturity date of the New Notes.

In connection with the Third Amendment to the Credit
Facility and the implementation of the Restructuring Agreement, the Company
incurred a non-recurring charge of $9,045,000. This charge resulted from the
write off of approximately $1,500,000 of unamortized deferred financing costs
incurred when the Credit Facility was obtained, the write-off of approximately
$3,400,000 of unamortized deferred financing costs related to the issuance of
the Discount Notes, and the recognition of various investment advisory, legal
and other fees associated with these events of $4,145,000.

The New Notes were issued at a discount and interest on
the New Notes accretes until August 1, 2004. Cash interest payments will be paid
semi-annually in arrears beginning on February 1, 2005 based on the fully
accreted value of the New Notes and a 12% cash interest payment rate. The New
Notes mature on August 1, 2007.

At any time on or prior to August 1, 2003, the New Notes
may be redeemed, in whole but not in part, at the option of the Company upon the
occurrence of a Change of Control (as defined) in accordance with
the prescribed procedures and the payment of any applicable premium (as
defined). Upon the occurrence of a Change in Control, unless all New Notes have
been called for redemption, each holder of the New Notes will have the right to
require, in accordance with the prescribed procedures, the Company to repurchase
all or any part of the New Notes at a price equal to 101% of the accreted value
of the New Notes. The New Notes must be redeemed in whole on August 1, 2007.

Upon the voluntary or involuntary liquidation of the
Company, holders of the New Notes will be entitled to be paid in full 100% of
principal and accrued interest out of the assets available for distribution
after holders of senior debt have been paid in full. The New Notes are
unsecured, subordinate to existing and future senior debt of the Company, but
senior in right with all existing and future subordinated debt of the Company.
Certain of the subsidiaries of the Company have jointly and severally guaranteed
the Companys payment obligations (subject to maximum amounts per
subsidiary) under the New Notes (see Note R). Each New Note guaranteed by such
subsidiary is subordinated to any senior debt of such guarantor. The Company
derives substantially all of its income from operations through its subsidiaries
and consequently, the New Notes are effectively subordinated to the potential
claims of creditors of all of the subsidiaries of the Company irrespective of
subsidiary guarantees. The New Notes also contain certain restrictive covenants
which limit the ability of the Company to incur debt, issue preferred stock,
merge or dispose of substantially all of its assets.

Interest expense charged to operations for the years
ended December 31, 1999, 2000 and 2001 was $21,678,000, $23,007,000 and
$13,270,000, respectively.

# 42

As of December 31, 2000 and 2001, the Company's
long-term debt, excluding the current portion, consisted of the following:

`2000             2001
                                                 ----             ----

12% Senior subordinated discount notes
   due 2007                                                   $  74,225,000
11% Senior subordinated discount notes
   due 2008                                  $ 128,942,000              -
Mortgages payable                               17,174,000       16,903,000
Revolving loans under Credit Facility           27,750,000       22,750,000
                                             -------------    -------------
                                             $ 173,866,000    $ 113,878,000
                                             =============    =============`

As of December 31, 2001, future long-term debt
maturities associated with the Companys debt are as follows:

`2002          $     2,776,000
           2003                5,303,000
           2004               32,910,000
           2005                   20,000
           2006                   20,000
           Thereafter         75,625,000
                          --------------
                            $116,654,000
                            ============`

Substantially all of the Companys assets are
subject to liens under long-term debt or operating lease agreements.

I.  CAPITAL LEASE OBLIGATION

Until September 27, 2000, the Company, through a wholly
owned limited partnership, leased and operated four facilities in Ohio (the
Cleveland Facilities) which it acquired in 1996 through capital
leases. Each of the four leases contained an option to purchase the facility
beginning July 1, 2001 and each lease was guaranteed by the Company. The
guaranty provided that failure by the Company to have a specified minimum
consolidated net worth at the end of any two consecutive quarters would be an
event of default under the guaranty, which in turn would be an event of default
under each lease. As a result of a restructuring charge (See Note P), the
Companys consolidated net worth as of September 30, 1999 (as calculated
for purposes of this requirement) had fallen below the required level. The
Company anticipated that its net worth would continue to be below the required
level at December 31, 1999, which would have resulted in an event of default
under each of these leases with the Company potentially facing the loss of these
operations. Such default could also have triggered cross-defaults under the
Companys other lease and debt obligations. In December 1999, the Company
paid $5 million to its landlord and obtained an option (the New
Option) to acquire the Cleveland Facilities. The Company borrowed $5
million from an affiliate of Investcorp S.A. to fund this payment. The New
Option allowed the Company to exercise its right to purchase the Cleveland
Facilities beginning as of the date of the New Option, required the Company to
complete the acquisition prior to December 31, 2000 and provided a waiver of the
net worth covenant through that date. The Company exercised the New Option on
June 30, 2000.

On September 27, 2000, the Company terminated the
Cleveland Facilities capital leases and assigned its purchase rights for these
facilities to an investment entity organized by Investcorp, for $5.0 million,
which simultaneously acquired the Cleveland Facilities. On that date, the
Company entered into new operating leases for each of the Cleveland Facilities
with combined annual rent expense of approximately $5.9 million. The Company
used the proceeds of the purchase rights assignment to repay the $5.0 million
note payable from an affiliate of Investcorp S.A. As a result of the capital
lease termination, the Company recorded a non-recurring charge of $8.9 million.
The principal components of this charge included the write-off of capital leased
assets in excess of related capital lease obligation ($5.7 million) and the
write-off of deferred financing costs ($1.8 million) related to the
Companys Credit Facility. In order to complete the Cleveland Facility
leasing transaction, the Company was required to obtain the release of certain
collateral held by the bank group which provides the Credit Facility. The
Company obtained the release of the collateral as part of an amendment to the
Companys Credit Facility, which also resulted in a permanent reduction of
the Companys maximum borrowings under the Credit Facility from $250
million to $150 million and an increase in the Companys borrowing rate. As
a result of the permanent reduction in funds available through the Credit
Facility, the Company was required to write off a proportionate amount of the
deferred financing costs incurred when the Credit Facility was originally
obtained.

On December 21, 2001, the Cleveland Facilities were sold
to an unaffiliated real estate investment trust and the Company entered into new
operating leases with that entity.

J. RETIREMENT PLANS

The Company maintains an employee 401(k) defined
contribution plan. All employees who have worked at least one thousand hours and
have completed one year (nine months effective January 1, 2002) of continuous
service are eligible to participate in the plan. The plan is subject to the
provisions of the Employee Retirement Income Security Act of 1974. Employee
contributions to this plan may be matched at the discretion of the Company. The
Company contributed $298,000 and $385,000 to the plan in 2000 and 2001. There
were no contributions made to the plan in 1999.

# 43

In September 1995, the Company established a
Supplemental Executive Retirement Plan (the SERP) to provide
benefits to key employees. Participants may defer up to 25% of their
compensation which is matched by the Company at a rate of 50% (up to 10% of base
salary). Vesting in the matching portion occurs in January of the second year
following the plan year in which contributions were made.

K. INCOME TAXES

As required by SFAS 109, the Company annually evaluates
the positive and negative evidence bearing upon the realizability of its
deferred tax assets. The Company has considered the recent and historical
results of operations and concluded; in accordance with the applicable
accounting methods that it is more likely than not that a certain portion of the
deferred tax assets will not be realizable. To the extent that an asset will not
be realizable, a valuation allowance is established. The tax effects of
temporary differences giving rise to deferred tax assets as of December 31, 2000
and 2001 are as follows:

`2000              2001
                                          ------------      ------------
Deferred tax assets:
     Reserves .......................     $    725,000      $  3,046,000
     Rental payments ................          752,000           687,000
     Interest payments ..............       12,076,000        20,466,000
     Net operating loss carryforwards       10,404,000        19,211,000
     Other ..........................          118,000           414,000
     Valuation allowance ............      (24,075,000)      (29,411,000)
                                          ------------      ------------
     Total deferred tax assets ......     $       --        $ 14,413,000
                                          ============      ============

Deferred tax liabilities:
     Depreciation & Amortization          $       --        $ 14,413,000
                                          ============      ============

  Significant components of the provision (benefit) for income taxes for the
years ended December 31, 1999, 2000 and 2001 are as follows:

                                               1999              2000             2001
                                       ------------      ------------     ------------
Current:
     Federal .....................     $ (2,784,000)
     State .......................          418,000      $     70,000     $    225,000
                                       ------------      ------------     ------------
Total current ....................       (2,366,000)           70,000          225,000
                                       ------------      ------------     ------------

Deferred:
     Federal .....................       (6,277,000)       11,596,000             --
     State .......................       (1,661,000)        2,656,000             --
                                       ------------      ------------     ------------
Total deferred ...................       (7,938,000)       14,252,000             --
                                       ------------      ------------     ------------

Total income tax expense (benefit)     $(10,304,000)     $ 14,322,000     $    225,000
                                       ============      ============     ============`

`The reconciliation of income tax computed at statutory rates to income tax
(benefit) for the years ended December 31, 1999, 2000 and 2001 are as follows:

                                                   1999                       2000                 2001
                                                   ----                       ----                 ----

Statutory rate                              $(9,767,000)  (35.0)%  $   (7,834,000) (35.0)%  $(5,837,000)  35.0%
State income tax, net of federal benefit       (808,000)   (2.9)       (1,765,000) (7.9)        146,000   (0.9)
Permanent differences                            41,000     0.2           198,000   0.9         287,000   (1.7)
Change in valuation allowance                         -      -         23,461,000 104.8       5,336,000  (32.0)
Net operating loss - rate differential          230,000     0.8            90,000   0.4         156,000   (0.9)
Other                                                 -       -           172,000   0.8         137,000   (0.8)
                                            ------------  -------  --------------  -----    -----------  -------
                                            $(10,304,000) (36.9)%  $   14,322,000  64.0%    $   225,000   (1.3)%
                                            ============  =======  ==============  =====    ===========  =======`

L.  CAPITAL STOCK

Common Stock

On August 11, 1998, as a result of the Merger, the
Company authorized the issuance of 500,000 shares of preferred stock with a par
value of $.01 per share and 19,000,000 shares (comprised of five classes) of
common stock, each with a par value of $.01 per share, consisting of Harborside
Class A Common Stock, Harborside Class B Common Stock, Harborside Class C Common
Stock, Harborside Class D Common Stock and Common Stock (collectively
Harborside Common Stock). Effective April 4, 2001, the
Companys Certificate of Incorporation was amended to (a) increase the
authorized number of shares of the Companys Class A Common Stock from
1,200,000 shares to 11,700,000 shares and (b) increase the authorized number of
shares of the Companys Common Stock from 9,500,000 shares to 20,000,000
shares. On November 19, 2001, the Companys Certificate of Incorporation
was again amended to increase the authorized number of shares of the
Companys Class C Common Stock from 1,580,000 shares to 2,280,000 shares.

# 44

The numbers of shares of Harborside Common Stock
authorized and outstanding as of December 31, 2000 and 2001 are as follows:

`2000                               2001
                                                        ----                               ----

                                            Authorized       Outstanding       Authorized       Outstanding
                                              Shares           Shares            Shares           Shares
                                              ------           ------            ------           ------
Title
-----
Harborside Class A Common Stock             1,200,000           661,332       11,700,000          661,332
Harborside Class B Common Stock             6,700,000         5,940,000        6,700,000        5,940,000
Harborside Class C Common Stock             1,580,000         1,304,500        2,280,000        1,275,167
Harborside Class D Common Stock                20,000            20,000           20,000           20,000
Common Stock                                9,500,000                 -       20,000,000                -
                                           ----------         ---------       ----------        ---------
Total                                      19,000,000         7,925,832       40,700,000        7,896,499
                                           ==========         =========       ===========       =========`

Holders of shares of Harborside Class A Common Stock and
Common Stock are entitled to one vote per share on all matters as to which
stockholders may be entitled to vote pursuant to Delaware General Corporate Law
(the DGCL). Holders of shares of Harborside Class D Common Stock are
entitled to 330 votes per share on all matters as to which stockholders may be
entitled to vote pursuant to the DGCL. This number of votes per share results in
holders of Harborside Class D Common Stock, as of December 31, 2001, being
entitled in the aggregate to a number of votes equal to the total number of
outstanding shares of Harborside Class B Common Stock, Harborside Class C Common
Stock and Harborside Class D Common Stock as of December 31, 2001. Holders of
Harborside Class B Common Stock or Harborside Class C Common Stock will not have
any voting rights, except that the holders of the Harborside Class B Common
Stock and Harborside Class C Common Stock will have the right to vote as a class
to the extent required under the laws of the State of Delaware.

Upon the occurrence of a sale of 100% of the outstanding
equity securities or substantially all of the assets of the Company, a merger as
a result of which the ownership of the Harborside Common Stock is changed to the
extent of 100%, or a public offering of any equity securities of the Company,
each share of Harborside Class A Common Stock, Harborside Class B Common Stock,
Harborside Class C Common Stock and Harborside Class D Common Stock will convert
into one share of Common Stock of the Company.

Restricted Stock

On September 29, 2000, the Company issued 664,500 shares
of restricted Class C common stock (the Restricted Shares) to
employees of the Company. As part of this restricted stock issuance, 507,705
options granted on August 11, 1998 to purchase shares of the Companys
Class C common stock at $25.00 per share were cancelled. The purpose of the
restricted stock issuance was to better enable the Company to retain and
motivate key employees. The Restricted Shares generally vest over varying
periods of time through December 31, 2003. As of December 31, 2001, 280,000
Restricted Shares were vested. Unvested shares are restricted as to disposition
and subject to forfeiture under certain circumstances. The value of the
Restricted Shares on the date of grant was approximately $7,000.

In connection with the Merger on August 11, 1998, the
Company issued 40,000 shares of Preferred Stock. The holders of the Preferred
Stock were entitled to receive quarterly dividend payments in arrears beginning
November 1, 1998. Dividends were payable in cash or in additional shares of
Preferred Stock, at the option of the Company, until August 1, 2003. After
August 1, 2003, dividends were to be paid only in cash. During the years ended
December 31, 1999, 2000 and 2001, all dividends except for fractional shares
amounting to $20,000, $18,000 and $6,000, respectively, were paid in additional
shares.

In March 2001, the Company entered into the
Restructuring Agreement with Investcorp S.A. and the holders of more than a
majority in interest of the Companys Discount Notes and Preferred Stock
for purposes of implementing a restructuring of the Discount Notes and the
Preferred Stock (See Note H). On May 10, 2001, the Company completed an exchange
offer and consent solicitation, thereby implementing each of the elements of the
Restructuring Agreement. As part of the exchange offer, 99.96% of the Preferred
Stock shares were tendered and warrants were issued to holders of the Preferred
Stock representing the right to purchase (at an exercise price of $0.01 per
share) an aggregate of approximately 5% of the total number of shares of all
classes of the Companys common stock on a fully diluted basis (excluding
shares issuable upon conversion of the New Preferred Stock, each share of which
are initially convertible into 150 shares of Class A Common Stock). As
contemplated by the Restructuring Agreement, on May 10, 2001, the liquidation
preference of the Preferred Stock was reduced from $1,000 to $0.01 per share and
the carrying amount of the Preferred Stock was reduced from $57,595,000 to $576.
The amount of this reduction, net of unamortized deferred financing costs
related to the issuance of the Preferred Stock (approximately $1,011,000 at May
10, 2001), was directly transferred to the Companys Accumulated Deficit
account.

In connection with the financial restructuring, the
Company issued 15,000 shares of New Preferred Stock for a purchase price of
$15,000,000. The New Preferred Stock had an initial liquidation preference of
$15,000,000 and is entitled to dividends at the greater of: (a) a rate of 13%
per annum compounded quarterly and payable in additional shares of New Preferred
Stock, or at any time while no New Notes are outstanding, in cash and (b) an
amount equal to the dividends payable on outstanding shares of Class A Common
Stock, payable quarterly in the same form as such dividends are payable. The New
Preferred Stock is mandatorily redeemable on February 1, 2008. Shares of the New
Preferred Stock will generally not be redeemable by the Company until August 1,
2004 and thereafter will be redeemable at a premium, which will decline ratably
to par by August 1, 2007. In the event of a Change in Control (as defined), the
Company may redeem the New Preferred Stock as a whole, but not in part, at a
price equal to 100% of the applicable liquidation preference including accrued
but unpaid dividends and a make whole premium until August 1, 2004.
If the Company does not redeem the New Preferred Stock in the event of a Change

# 45

in Control, the holders of the New Preferred Stock may require the Company to
make an offer to purchase the outstanding shares of New Preferred Stock at a
price equal to 101% of the applicable liquidation preference. Each share of the
New Preferred stock is convertible: (a) into 150 shares of the Companys
Class A Common Stock at any time at the option of the holder; (b) and subject to
compliance with certain financial covenants, will also be exchangeable into the
New Notes of the Company due 2008, at the option of the Company on any dividend
payment date, subject to certain requirements and procedures. The exchange
debentures would rank surbordinate to the New Notes.

Upon any voluntary or involuntary liquidation of the
Company, holders of the New Preferred Stock will be entitled to be paid out of
the assets available for distribution, the liquidation preference per share plus
an amount equal to all accumulated and unpaid dividends, before any distribution
is made to the holders of Harborside Common Stock. Holders of the New Preferred
Stock have no voting rights except as provided by law and in the Certificate of
Designation. In the event that dividends are not paid for any six quarterly
periods, or upon certain other events, the number of directors constituting the
Companys Board of Directors would be adjusted to permit the holders of the
majority of the then outstanding New Preferred Stock, voting separately as a
class, to elect two directors.

The Certificate of Designation also contains certain
restrictive covenants that limit the Companys restricted subsidiaries from
making certain payments or investments and which limit the Companys
ability to incur debt, issue preferred stock, merge or dispose of substantially
all of its assets.

As of December 31, 2001, preferred stock dividends
accrete based on the following schedule:

`2002      $  2,222,000
     2003         2,526,000
     2004         2,871,000
     2005         3,262,000
     2006         3,708,000
Thereafter        4,594,000
                  ---------
               $ 19,183,000
               ============`

As part of the financial restructuring (See Note H), the
Company issued Common Stock Warrants (the Warrants) to holders of
the Discount Notes, to holders of the Preferred Stock, and to Investcorp S.A.
representing the right to purchase an aggregate of approximately 15%, 5% and
15%, respectively, of the total number of shares of all classes of the
Companys common stock on a fully diluted basis (excluding shares issuable
upon conversion of the New Preferred Stock, each share of which are initially
convertible into 150 shares of Class A Common Stock). Warrants to purchase an
aggregate total of 4,326,641 shares were issued on May 10, 2001. Each warrant
entitles the holder thereof to purchase one share of Class A Common Stock at an
exercise price of $0.01 per share. The Warrants will be exercisable at the
earliest to occur of (a) a Change of Control, (b) an initial public offering of
the Companys Common Stock, (c) the full redemption of all of the New Notes
at the Companys option and (d) August 1, 2009.

Earnings (Loss) per Common Share Computation

Basic earnings (loss) per common share is computed by
dividing net earnings (loss) less preferred stock dividends by the weighted
average number of common shares outstanding. Common shares outstanding exclude
nonvested Restricted shares in the amounts of 171,000 and 578,000 for the years
ended December 31, 2000 and 2001, respectively. The computation of diluted
earnings (loss) per share is similar to that of basic earnings (loss) per share
except that the number of common shares is increased to reflect the number of
additional common shares that would have been outstanding if the dilutive
potential common shares had been issued. Dilutive potential common shares for
the Company consist of shares issuable upon exercise of the Companys stock
options.

The following table sets forth the computation of basic
and diluted earnings (loss) per common share for the years ended December 31,
1999, 2000 and 2001:

`1999              2000              2001
                                                                      -------          --------          -------
Numerator:
     Net loss ...................................................    $(17,601,000)     $(36,706,000)     $(16,902,000)
     Preferred stock dividends ..................................      (6,004,000)       (6,853,000)       (3,774,000)
                                                                     ------------      ------------      ------------
     Loss applicable to common shares ...........................    $(23,605,000)     $(43,559,000)     $(20,676,000)
                                                                     ============      ============      ============

Denominator:
Weighted average shares outstanding .............................       7,261,000         7,432,000         7,913,000

     Adjustment for nonvested Restricted Shares .................            --            (171,000)         (578,000)
                                                                     ------------      ------------      ------------

     Denominator for basic and diluted loss per common share -
     adjusted weighted - average shares and assumed conversions         7,261,000        7,261,000         7,335,000
                                                                     ============      ============      ============

     Basic and diluted loss per common share ....................    $      (3.25)     $     (6.00)      $     (2.82)
                                                                     ============      ============      ============`

# 46

For the years ended December 31, 1999, 2000 and 2001,
the weighted-average shares outstanding for the following potentially dilutive
securities were excluded from the computation of diluted loss per common share
because the effect would have been antidilutive:

`1999          2000           2001
                                                        ----          ----           ----

Options to purchase common stock                      657,610       492,512        214,131
Non-vested shares of restricted stock                       -       170,664        578,420
Conversion rights of convertible preferred stock            -             -     1,494,960
Warrants to purchase common stock                           -             -      2,797,499
                                                     --------      --------     ----------
                                                      657,610       663,176      5,085,010
                                                     ========      ========     ==========`

Stock Option Plans

During 1996, the Company established two stock
option plans, the 1996 Stock Option Plan for Non-employee Directors (the
Director Plan) and the 1996 Long-Term Stock Incentive Plan (the
Stock Plan). Directors of the Company who were not employees, or
affiliates of the Company, were eligible to participate in the Director Plan. On
the date of the IPO, each of the four non-employee directors was granted options
to acquire 15,000 shares of the Companys common stock at the IPO price. On
January 1 of each year, each non-employee director received an additional grant
for 3,500 shares at the fair market value on the date of grant. Options issued
under the Director Plan became exercisable on the first anniversary of the date
of grant and terminated upon the earlier of ten years from date of grant or one
year from date of termination as a director. Through the Directors Retainer Fee
Plan, non-employee directors of the Company could also elect to receive all or a
portion of their director fees in shares of the Companys common stock. The
Stock Plan was administered by the Stock Plan Committee of the Board of
Directors which was composed of outside directors who were not eligible to
participate in this plan. The Stock Plan authorized the issuance of
non-qualified stock options, incentive stock options, stock appreciation rights,
restricted stock and other stock-based awards. Options granted during the years
ended December 31, 1996 and 1997, were granted with exercise prices equal to or
greater than the fair market value of the stock on the date of grant. Options
granted under the stock plan during 1996 and 1997 vested over a three-year
period and had a maximum term of ten years. A maximum of 800,000 shares of
common stock were reserved for issuance in connection with these plans.

In connection with the Merger, all holders of options
issued through the Director Plan and the Stock Plan had the right to retain
their options or to have their options converted into cash at $25.00 per
underlying share less the applicable exercise price (and taxes required to be
withheld by the Company). Holders of options representing options to purchase
109,994 shares of stock retained their options while the remainder (representing
648,923 options) exercised their right to convert their options into cash.

In connection with the Merger, the Company adopted the
Harborside Healthcare Corporation Stock Incentive Plan (the Stock Option
Plan). The Stock Option Plan is administered by the Board of Directors of
the Company. The Board of Directors designates which employees of the Company
will be eligible to receive awards under the Stock Option Plan, and the amount,
timing, and other terms and conditions applicable to such awards. Options will
expire on the date determined by the Board of Directors, which will not be later
than 30 days after the seventh anniversary of the grant date. Optionees will
have certain rights to put to the Company, and the Company will have certain
rights to call from the optionee, vested stock options upon termination of the
optionees employment with the Company prior to an initial public offering.
All options granted under the Stock Option Plan during 1998 were granted with an
exercise price equal to $25.00, equal to the fair market value of the stock on
the date of grant. Options granted under the Stock Option Plan during 1998 were
to vest at the end of a seven year period or earlier if certain financial
performance criteria were met. All options granted under the Stock Option Plan
during 1998 and still outstanding as of September 29, 2000 were cancelled on
that date in connection with the issuance of the Restricted Shares. A maximum of
1,600,000 shares have been reserved for issuance in connection with the Stock
Option Plan.

On November 19, 2001, the Company granted options, with
an exercise price of $1.25 per share, to purchase 905,000 shares of the
Company's Class C common stock.

Information with respect to
options granted under the Director Plan, the Stock Plan and the Stock Option
Plan is as follows:

`Options Outstanding:              Number        Exercise Price    Weighted-Average
                                    of Shares        Per Share       Exercise Price
                                    ---------       ----------       --------------
Balance at December 31, 1999         637,226      $   8.15 - $25.00     $22.94
--------------------------------------------      -----------------     -------
Cancelled                          (527,232)      $  25.00              $25.00
Balance at December 31, 2000         109,994      $   8.15 - $21.69     $13.07
--------------------------------------------      -----------------     -------
Granted                              905,000      $   1.25              $  1.25
============================================      =================     =======
Balance at December 31, 2001       1,014,994      $   1.25 - $21.69     $  2.53
============================================      =================     =======`

As of December 31, 1999 and 2000, there were 109,994
exercisable options at a weighted-average exercise price of $13.07. As of
December 31, 2001, there were 336,244 exercisable options at a weighted-average
exercise price of $5.12.

In 1996, the Company adopted SFAS 123, Accounting
for Stock-Based Compensation. SFAS 123 requires that companies either
recognize compensation expense for grants of stock, stock options, and other
equity instruments based on fair value, or provide pro forma disclosure of net
income and earnings per share in the notes to the financial statements. The
Company has adopted the disclosure provisions of SFAS 123, and has applied
Accounting Principles Board Opinion 25 and related interpretations in accounting

# 47

for its plans. Accordingly, no compensation cost has been recognized for its
stock option plans. Had compensation cost for the Companys stock-based
compensation plans been determined based on the fair value at the grant dates as
calculated in accordance with SFAS 123, the Companys unaudited pro forma
net income and pro forma net income per share for the years ended December 31,
1999, 2000 and 2001 would have been reduced to the amounts indicated below:

`1999                                      2000                           2001
                                ----                                      ----                           ----

                              Loss          Loss              Loss             Loss             Loss            Loss
                         Applicable to      Per Common        Applicable to    Per Common       Applicable to   Per Common
                         Common Shares      Share Diluted     Common Shares    Share Diluted    Common Shares   Share Diluted
                         -------------      -------------     -------------    -------------    -------------   -------------

      As
   Reported              $(23,605,000)        $(3.25)           $(43,559,000)    $(6.00)          $(20,676,000)   $(2.82)

     Pro
   Forma                 $(24,027,000)        $(3.31)           $(43,559,000)    $(6.00)          $(20,676,000)   $(2.82)`

The weighted average fair value of options granted was
$0 in 2001. The fair value for each stock option is estimated on the date of
grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions: an expected life of five years, no dividend yield,
and a risk-free interest rate of 4.75% in 2001. Expected volatility of 0%
(except for 109,994 in options held by senior management; such options have an
assumed volatility of 40%) was assumed for the year ended December 31, 2001.

M. CONTINGENCIES

The Company is involved in legal actions and claims in
the ordinary course of its business. It is the opinion of management, based on
the advice of legal counsel, that such litigation and claims will be resolved
without material effect on the Companys consolidated financial position,
results of operations or liquidity.

The Company self-insures for health benefits provided to
a majority of its employees. The Company maintains stop-loss insurance such that
the Companys liability for losses is limited. The Company recognizes an
expense for estimated health benefit claims incurred but not reported at the end
of each year.

The Company self-insures for most workers
compensation claims. The Company maintains stop-loss insurance such that the
Companys liability for losses is limited. The Company accrues for
estimated workers compensation claims incurred but not reported at the end
of each year.

During the year ended December 31, 1998, the Company
implemented a general and professional liability insurance program which, for
the period from September 1, 1998 to August 31, 2001, limited the Companys
self-retention risk for this program to a maximum of $25,000 per year. The
Company implemented a new general and professional liability program effective,
September 1, 2001, which resulted in the Company maintaining an unaggregated
self-insured retention of $2,000,000 per occurrence for locations outside of
Florida and completely retaining risk at the Florida facilities. As of December
31, 2001, the Company maintains a Claims Reserve in the amount of $1,467,000 for
incurred but not reported claims. The liabilities for incurred but not reported
claims not covered by third-party insurance are discounted at 8% to obtain their
present value based on estimated claim payments as determined by an independent
actuary. The amount of the reserve was determined through an estimation process
that used information from both the Companys records as well as industry
data. The Company uses an independent actuary to help estimate the required
general and professional liability reserve. Factors reviewed include the
frequency of expected claims, the average cost per claim, emerging industry
trends, changes in regulatory environment and the expected effect of various
operational and risk management initiatives. The Company will continue to
evaluate its insurance reserve requirements on a quarterly basis. Required
adjustments to the Companys general and professional liability reserve
will be recorded in the accounting period in which the change in estimate
occurs.

The Company owns a 75% interest in a partnership which
owns one facility. The Company accounts for its investment in this partnership
using the equity method. The Company has guaranteed a loan of approximately
$5,600,000 made to this partnership to refinance a loan which funded the
construction of the facility and provided working capital. The loan is also
collateralized by additional collateral pledged by the non-affiliated partner.
The loan matures on May 1, 2002 and the Company expects to refinance the loan on
comparable terms prior to the maturity date. The partnership agreement states
that each partner will contribute an amount in respect of any liability incurred
by a partner in connection with a guarantee of the partnerships debt, so
that partners each bear their proportionate share of any liability based on
their percentage ownership of the partnership.

N.  DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

The methods and assumptions used to estimate the fair
value of each class of financial instruments, for those instruments for which it
is practicable to estimate that value, and the estimated fair values of the
financial instruments are as follows:

Cash and Cash Equivalents

The carrying amount approximates fair value because of
the short effective maturity of these instruments.

# 48

Note Receivable

The carrying value of the note receivable approximates
its fair value at December 31, 2000 and 2001, based on the yield of the note and
the present value of expected cash flows.

Long-term Debt

The fair value of the Companys fixed rate
long-term debt is estimated based on the quoted market prices for the same or
similar issues or on the current rates offered to the Company for debt of the
same remaining maturities. At December 31, 2001, the fair market value of the
Companys New Notes was approximately $53,146,000. The book value of the
Companys New Notes was $74,225,000. The Company estimates that the fair
value of its remaining fixed rate debt approximates its carrying amount.

O.  RELATED PARTY TRANSACTIONS

A former affiliate of the Company provides data
processing services to the Company in return for a monthly fee. Total service
charges under this arrangement were $1,173,000, $1,083,000 and $979,000, for the
years ended December 31, 1999, 2000 and 2001, respectively.

At the time of the Merger, Investcorp International Inc.
received a $6,000,000 management advisory and consulting service fee which is
being expensed on a straight-line basis over the life of the related five year
agreement. The expense recognized by the Company in connection with this
management agreement during the years ended December 31, 1999, 2000 and 2001 was
$1,200,000, $1,200,000 and $1,200,000, respectively. As of December 31, 2001,
$1,200,000 of the unamortized fee is classified in Prepaid and other
expenses while $700,000 is classified as Other assets, net.

In December 1999, an affiliate of Investcorp S.A.,
provided the Company with $5,000,000 in financing under a credit agreement. The
funds were provided for purposes of making an acquisition deposit on certain
facilities currently financed through a capital lease (See Note I). The loan was
repaid during the third quarter of 2000.

As of December 31, 2000 the net receivable due from
Bowie, L.P. was approximately $0.2 million. As of December 31, 2001 the net
payable due to Bowie, L.P. was approximately $0.4 million.

P.  RESTRUCTURING COSTS

During the third quarter of 1999, the Company terminated
its contracts to provide rehabilitation therapy services to non-affiliated
long-term care facilities. The Company, through a wholly owned subsidiary, had
provided physical, speech and occupational services to non-affiliated skilled
nursing facilities since 1995. Significant changes in the contract therapy
business, primarily related to reductions in Medicare reimbursement for therapy
services caused by the Balanced Budget Act of 1997 led to this decision. The
Company continues to provide rehabilitation therapy services to nursing
facilities which it owns.

The Companys therapy services restructuring plan
required the termination of approximately sixty rehabilitation therapy services
employees and the closure of two regional offices. During the third quarter of
1999, the Company recorded restructuring charges of approximately $5.7 million
under this plan, most of which were non-cash in nature. The restructuring charge
consisted of approximately $2.5 million of uncollectible accounts receivable,
$1.5 million of unamortized goodwill, $0.7 million of employee costs and $1.0
million due to the write-off of other assets. As of December 31, 2000, the
Companys restructuring reserve was fully utilized.

Q.  FACILITY REORGANIZATION COSTS

During the year ended December 31, 2001, the Company
recorded a non-recurring charge of $1,080,000 in connection with its decision to
revise the marketing approach for facilities operated through subsidiaries in
Florida. The Company determined that a local community-based marketing approach
would better serve the needs of these facilities. The marketing approach
stresses ties to the local community and required renaming these facilities in
order to emphasize this approach. In connection with this effort, the Company
also restructured certain of its subsidiaries effective October 1, 2001. In
order to implement this strategy, the Company recognized certain non-recurring
marketing, legal and other expenses.

# 49

R.  CONDENSED CONSOLIDATING FINANCIAL INFORMATION

Certain of the Companys subsidiaries are precluded
from guaranteeing the debt of the parent company (the
Non-Guarantors), based on current agreements in effect. The
Companys remaining subsidiaries (the Guarantors) are not
restricted from serving as guarantors of the parent company debt. The Guarantors
are comprised of Harborside Healthcare Limited Partnership, Belmont Nursing
Center Corp., Orchard Ridge Nursing Center Corp., Oakhurst Manor Nursing Center
Corp., Riverside Retirement Limited Partnership, Harborside Connecticut Limited
Partnership, Harborside of Florida Limited Partnership, Harborside of Ohio
Limited Partnership, Harborside Healthcare Baltimore Limited Partnership,
Harborside of Cleveland Limited Partnership, Harborside of Dayton Limited
Partnership, Harborside Massachusetts Limited Partnership, Harborside of Rhode
Island Limited Partnership, Harborside North Toledo Limited Partnership,
Harborside Healthcare Advisors Limited Partnership, Harborside Toledo Corp., KHI
Corporation, Harborside Danbury Limited Partnership, Harborside Acquisition
Limited Partnership V, Harborside Acquisition Limited Partnership VI, Harborside
Acquisition Limited Partnership VII, Harborside Acquisition Limited Partnership
VIII, Harborside Acquisition Limited Partnership IX, Harborside Acquisition
Limited Partnership X, Sailors, Inc., New Jersey Harborside Corp., Bridgewater
Assisted Living Limited Partnership, Maryland Harborside Corp., Harborside
Homecare Limited Partnership, Harborside Rehabilitation Limited Partnership,
Harborside Healthcare Network Limited Partnership and Harborside Health I
Corporation.

The information which follows presents the condensed
consolidating financial position as of December 31, 2000 and 2001; the condensed
consolidating results of operations for the years ended December 31, 1999, 2000
and 2001; and the condensed consolidating cash flows for the years ended
December 31, 1999, 2000 and 2001 of (a) the parent company only (the
Parent), (b) the combined Guarantors, (c) the combined Non-Guarantors, (d)
eliminating entries and (e) the Company on a consolidated basis.

# 50

`R.  CONDENSED CONSOLIDATING FINANCIAL INFORMATION (continued)

                                  HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES
                                        Condensed Consolidating Balance Sheet
                                               As of December 31, 2000
                              (dollars in thousands, except share and per share amounts)

                                                           Parent       Guarantors   Non-Guarantors Elimination  Consolidated
                                                         ---------      ---------    -------------- -----------  ------------
ASSETS
Current assets:
   Cash and cash equivalents .......................     $    --        $   9,317      $  1,407      $    --       $   10,724
   Accounts receivable, net of allowance
    for  doubtful accounts of $2,272 ...............          --           33,111        15,548           --           48,659
   Intercompany receivable .........................       146,953           --            --         (146,953)          --
   Prepaid expenses and other ......................         3,128          8,403         1,649           --           13,180
                                                         ---------      ---------      --------      ---------      ---------
Total current assets ...............................       150,081         50,831        18,604       (146,953)        72,563

Restricted cash ....................................          --            4,116           689           --            4,805
Investments in limited partnerships ................        15,584           --           4,044        (19,628)          --
Property and equipment, net ........................          --           85,719        19,370           --          105,089
Deferred financing and other
 non-current assets, net ...........................         7,109          3,001         1,143           --           11,253
Other assets, net ..................................         1,900           --            --             --            1,900
Note receivable ....................................          --            7,487          --             --            7,487
                                                         ---------      ---------      --------      ---------      ---------
Total assets .......................................     $ 174,674      $ 151,154      $ 43,850      $(166,581)     $ 203,097
                                                         =========      =========      ========      =========      =========

LIABILITIES
Current liabilities:
   Current maturities of long-term debt ............     $   5,000       $     22      $    228      $    --        $   5,250
   Accounts payable ................................          --            8,331         2,552           --           10,883
   Intercompany payable ............................          --          119,147        11,543       (130,690)          --
   Employee compensation and benefits ..............          --           12,293         3,572           --           15,865
   Other accrued liabilities .......................          --            5,364           937           --            6,301
   Accrued interest ................................           470           --            --             --              470
   Current portion of deferred income ..............          --             --            --              514            514
                                                         ---------      ---------      --------      ---------      ---------
Total current liabilities ..........................         5,470        145,157        18,832       (130,176)        39,283
Long-term portion of deferred income ...............          --              582         1,842           (514)         1,910
Long-term debt .....................................       156,692          1,498        15,676           --          173,866
                                                         ---------      ---------      --------      ---------      ---------
Total liabilities ..................................       162,162        147,237        36,350       (130,690)       215,059
                                                         --------      ---------      ---------      ---------      ---------

13 1/2% Exchangeable preferred stock, redeemable,
 $.01 par value, 250,000 shares authorized;
 55,112 shares issued and outstanding ..............        55,112           --            --             --           55,112
                                                         ---------     ---------      ---------       --------       --------

STOCKHOLDERS' EQUITY (DEFICIT)
Common stock, $.01 par value, 19,000,000
shares authorized, 15,275,664 shares issued ........           153          2,569         3,885         (6,454)           153
Additional paid-in capital .........................       191,524           --            --              226        191,750
Common stock in treasury,
at cost, 7,349,832 shares ..........................      (183,746)          --            --             --         (183,746)
Retained earnings (accumulated deficit) ............       (50,531)       (23,407)       (3,459)         2,166        (75,231)
Partners' equity ...................................          --           24,755         7,074        (31,829)          --
                                                         ---------     ----------      --------      ---------      ---------
Total stockholders' equity (deficit) ...............       (42,600)         3,917         7,500        (35,891)       (67,074)
                                                         ---------     ----------      --------      ---------      ---------
Total liabilities and stockholders'
equity (deficit) ...................................     $ 174,674      $ 151,154      $ 43,850      $(166,581)     $ 203,097
                                                         =========      =========      ========      =========      =========`

# 51

`R.  CONDENSED CONSOLIDATING FINANCIAL INFORMATION (continued)

                                  HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES
                                        Condensed Consolidating Balance Sheet
                                               As of December 31, 2001
                              (dollars in thousands except share and per share amounts)

                                                          Parent    Guarantors     Non-Guarantors      Elimination  Consolidated
                                                        ---------   ---------      ---------------     -----------  ------------
ASSETS
Current assets:
   Cash and cash equivalents .......................    $     --     $      7,886     $   1,363      $    --       $    9,249
   Accounts receivable, net of allowance
   for doubtfull accounts of $3,979                           --           32,531        12,971           --           45,502
   Intercompany receivable .........................       141,929           --            --         (141,929)          --
   Prepaid expenses and other ......................         1,400          9,308           920           --           11,628
                                                         ---------      ---------      --------      ---------     ----------
Total current assets ...............................       143,329         49,725        15,254       (141,929)        66,379

Restricted cash ....................................          --            5,130           768           --            5,898
Investments in limited partnerships ................        15,584           --           4,044        (19,628)          --
Property and equipment, net ........................          --           87,815        21,174           --          108,989
Deferred financing and other
 non-current assets, net ...........................           677          2,330           909           --            3,916
Other assets, net ..................................           700           --            --             --              700
Note receivable ....................................          --            7,487          --             --            7,487
                                                         ---------   ------------      --------      ---------      ---------
Total assets .......................................     $ 160,290   $    152,487      $ 42,149      $(161,557)     $ 193,369
                                                         =========   ============      ========      =========      =========

LIABILITIES
Current liabilities:
   Current maturities of long-term debt ............     $  2,500    $         22      $    254      $    --        $   2,776
   Accounts payable ................................          --           12,514         2,197           --           14,711
   Intercompany payable ............................          --          112,416        13,567       (125,983)          --
   Employee compensation and benefits ..............          --           16,153         3,117           --           19,270
   Other accrued liabilities .......................          --            5,800         1,078           --            6,878
   Accrued interest ................................           147           --            --             --              147
   Current portion of deferred income ..............          --             --            --              521            521
                                                         ---------    -----------      --------      ---------      ---------
Total current liabilities ..........................         2,647        146,905        20,213       (125,462)        44,303
Claims reserve .....................................          --            1,467          --             --            1,467
Long-term portion of deferred income ...............          --              534         1,474           (521)         1,487
Long-term debt .....................................        96,975          1,481        15,422           --          113,878
Long-term accrued interest .........................        47,115           --            --             --           47,115
                                                          --------    -----------      --------      ---------      ---------
Total liabilities ..................................       146,737        150,387        37,109       (125,983)       208,250
                                                          --------    -----------      --------      ---------      ---------

13% Convertible exchangeable preferred stock,
 redeemable,  $.01 par value with a liquidation
 value of  $1,000 per share; 100,000 shares
 authorized; 16,286 shares issued and outstanding ..        16,286           --            --             --           16,286
                                                                                                                                                       ------

STOCKHOLDERS' EQUITY (DEFICIT)
Common stock, $.01 par value, 40,700,000
shares authorized, 15,275,664 shares issued ........           153          2,569         3,885         (6,454)           153
Additional paid-in capital .........................       187,748           --            --              228        187,976
Common stock in treasury,
at cost, 7,379,165 shares ..........................      (183,746)          --            --             --         (183,746)
Retained earnings (accumulated deficit) ............        (6,888)       (25,224)       (5,919)         2,481        (35,550)
Partners' equity ...................................          --           24,755         7,074        (31,829)          --
                                                         ---------      ---------      --------      ---------      ---------
Total stockholders' equity (deficit) ...............        (2,733)         2,100         5,040        (35,574)       (31,167)
                                                         ---------      ---------      ---------     ---------      ---------
Total liabilities and stockholders'
equity (deficit) ...................................     $ 160,290      $ 152,487      $ 42,149      $(161,557)     $ 193,369
                                                         =========      =========      ========      =========      =========`

# 52

`R.  CONDENSED CONSOLIDATING FINANCIAL INFORMATION (continued)

                                  HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES
                                   Condensed Consolidating Statement of Operations
                                         For the year ended December 31, 1999
                                                (dollars in thousands)

                                                         Parent      Guarantors  Non-Guarantors  Elimination   Consolidated
                                                         -------      ---------      --------      --------      ---------

Total net revenues .................................     $    24      $ 217,818      $ 96,498      $(13,725)     $ 300,615
                                                         -------      ---------      --------      --------      ---------

Expenses:
   Facility operating ..............................        --          181,995        80,525       (13,725)       248,795
   General and administrative ......................          65         17,743          --            --           17,808
   Service charges paid to former affiliate ........        --            1,173          --            --            1,173
   Amortization of prepaid management fee ..........       1,200           --            --            --            1,200
   Depreciation and amortization ...................       1,718          6,720         1,811          --           10,249
   Facility rent ...................................        --           13,890         8,504          --           22,394
   Restructuring costs .............................        --            5,745          --            --            5,745
Management fees paid to affiliates .................        --           (5,757)        5,757          --             --
                                                                      ---------      --------      --------      ---------
Total expenses .....................................       2,983        221,509        96,597       (13,725)       307,364
                                                         -------      ---------      --------      --------      ---------


Loss from operations ...............................      (2,959)        (3,691)          (99)         --           (6,749)

Other:
   Interest expense, net ...........................       2,945         16,241         1,709          --           20,895
   Other expense ...................................        --             --            --             261            261
                                                         -------      ---------      --------      ---------     ---------

Loss before income taxes ...........................      (5,904)       (19,932)       (1,808)         (261)       (27,905)
Income tax benefit .................................      (2,303)        (7,195)         (704)         (102)       (10,304)
                                                         -------      ----------     --------      ---------     ---------

Net loss ...........................................     $(3,601)     $ (12,737)     $ (1,104)     $   (159)     $ (17,601)
                                                         =======      =========      ========      ========      =========`

`HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES
                                   Condensed Consolidating Statement of Operations
                                         For the year ended December 31, 2000
                                                (dollars in thousands)

                                                         Parent       Guarantors   Non-Guarantors Elimination  Consolidated
                                                         --------      ---------      ---------      -------      ---------

Total net revenues .................................     $   --        $ 222,479      $ 102,217      $(2,024)     $ 322,672
                                                         --------      ---------      ---------      -------      ---------

Expenses:
   Facility operating ..............................         --          177,732         84,072       (2,024)       259,780
   General and administrative ......................         --           17,993           --           --           17,993
   Service charges paid to former affiliate ........         --            1,083           --           --            1,083
   Amortization of prepaid management fee ..........        1,200           --             --           --            1,200
   Depreciation and amortization ...................        1,808          6,469          1,933         --           10,210
   Facility rent ...................................         --           15,629          8,646         --           24,275
   Loss on termination of capital lease ............         --            8,914           --           --            8,914
   Management fees paid to affiliates ..............         --           (6,045)         6,045         --             --
                                                         --------      ---------      ---------      -------      ---------
Total expenses .....................................        3,008        221,775        100,696       (2,024)       323,455
                                                         --------      ---------      ---------      -------      ---------

Income (loss) from operations ......................       (3,008)           704          1,521         --             (783)

Other:
   Interest expense, net ...........................        4,028         15,941          1,706         --           21,675
Other income .......................................         --             --             --            (74)           (74)
                                                         --------      ---------      ---------      -------      ---------

Income (loss) before income taxes ..................       (7,036)       (15,237)          (185)          74        (22,384)
Income tax expense .................................       14,322           --             --           --           14,322
                                                         --------      ---------      ---------      -------      ---------

Net income (loss) ..................................     $(21,358)     $ (15,237)     $    (185)     $    74      $ (36,706)
                                                         ========      =========      =========      =======      =========`

# 53

`R.  CONDENSED CONSOLIDATING FINANCIAL INFORMATION (continued)

                                  HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES
                                   Condensed Consolidating Statement of Operations
                                         For the year ended December 31, 2001
                                                (dollars in thousands)



                                                          Parent      Guarantors  Non-Guarantors Elimination  Consolidated
                                                         --------      ---------      ---------      -------      ---------

Total net revenues .................................     $   --        $ 250,547      $ 102,686      $(6,495)     $ 346,738
                                                         --------      ---------      ---------      -------      ---------

Expenses:
   Facility operating ..............................         --          202,412         86,277       (6,495)       282,194
   General and administrative ......................           67         18,976           --           --           19,043
   Service charges paid to former affiliate ........         --              979           --           --              979
   Amortization of prepaid management fee ..........        1,200           --             --           --            1,200
   Depreciation and amortization ...................          525          6,717          2,113         --            9,355
   Facility rent ...................................         --           20,476          8,413         --           28,889
   Financial restructuring costs ...................        8,645            400           --           --            9,045
   Facility reorganization costs ...................         --            1,080           --           --            1,080
   Management fees paid to affiliates ..............         --           (6,489)         6,489         --             --
                                                         --------      ---------      ---------      -------      ---------
Total expenses .....................................       10,437        244,551        103,292       (6,495)       351,785

Income (loss) from operations ......................      (10,437)         5,996           (606)        --           (5,047)

Other:
   Interest expense, net ...........................        2,278          7,813          1,854         --           11,945
Other income .......................................         --             --             --           (315)          (315)
                                                         --------      ---------      ---------      -------      ---------

Income (loss) before income taxes ..................      (12,715)        (1,817)        (2,460)         315        (16,677)
Income tax expense .................................          225           --             --           --              225
                                                         --------      ---------      ---------      -------      ---------

Net income (loss) ..................................     $(12,940)     $  (1,817)     $  (2,460)     $   315      $ (16,902)
                                                         ========      =========      =========      =======      =========`

# 54

`R.  CONDENSED CONSOLIDATING FINANCIAL INFORMATION (continued)

                                  HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES
                                   Condensed Consolidating Statement of Cash Flows
                                         For the year ended December 31, 1999
                                                (dollars in thousands)

                                                             Parent      Guarantors Non-Guarantors  Elimination   Consolidated
                                                            --------      --------   -------------  -----------   ------------
Operating activities:
Net cash provided (used) by operating activities ......     $  (23,096)   $ 19,958      $ 2,892      $    998      $    752
                                                            --------      --------   -------------  -----------    ---------

Investing activities:
     Additions to property and equipment ..............         --         (10,435)       (2,288)        (474)      (13,197)
     Additions to deferred financing and
      other non-current assets ........................       (1,935)         (308)          (12)        --          (2,255)
     Transfers to (from) restricted cash, net .........         --             336          (122)        (524)         (310)
     Payment of purchase deposit ......................         --          (5,000)         --           --          (5,000)
                                                             --------      --------   ----------     --------       --------

     Net cash used by investing activities ............       (1,935)      (15,407)       (2,422)        (998)      (20,762)
                                                             --------      --------   ----------     --------       --------

Financing activities:
     Borrowings under the revolving line of
      credit ..........................................       20,000          --            --           --          20,000
     Issuance of note payable to affiliate ............        5,000          --            --           --           5,000
     Payment of long-term debt ........................         --             (21)         (185)        --            (206)
     Principal payments of capital lease obligation ...         --          (4,274)         --           --          (4,274)
     Dividends paid on exchangeable preferred stock ...          (20)         --            --           --             (20)
                                                             --------      -------      --------      -------       -------
Net cash provided (used) by financing activities ......       24,980        (4,295)         (185)        --          20,500
                                                             --------      --------     --------      -------       -------

Net increase (decrease) in cash and cash equivalents ..          (51)          256           285         --             490
Cash and cash equivalents, beginning of year ..........           51            99           746         --             896
                                                             --------     --------      --------      -------       -------
Cash and cash equivalents, end of year ................      $   --       $    355      $  1,031      $   --        $ 1,386
                                                             ========     ========      ========      ========      =======

Supplemental Disclosure:
    Interest paid .....................................     $    834      $  4,594      $    483      $   --        $ 5,911
    Income taxes paid .................................     $    243      $    --       $   --        $   --        $   243
    Accretion of preferred dividends ..................     $  5,984      $    --       $   --        $   --        $ 5,984`

# 55

`R.  CONDENSED CONSOLIDATING FINANCIAL INFORMATION (continued)

                                  HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES
                                   Condensed Consolidating Statement of Cash Flows
                                         For the year ended December 31, 2000
                                                (dollars in thousands)

                                                           Parent     Guarantors  Non-Guarantors  Elimination   Consolidated
                                                          --------   ------------ --------------  -----------   ------------
Operating activities:
Net cash provided by operating activities .............    $  5,029      $19,097       $   2,240     $   --        $ 26,366
                                                           --------      -------       ---------     --------      --------

Investing activities:
     Additions to property and equipment ..............        --          (4,467)       (1,732)         --          (6,199)
     Additions to deferred financing and
      other non-current assets ........................         (11)         (275)          168          --            (118)
     Transfers to restricted cash, net ................        --          (2,290)          (95)         --          (2,385)
                                                           --------      --------      --------     --------       --------
Net cash used by investing activities .................         (11)       (7,032)       (1,659)         --          (8,702)
                                                           --------      --------      --------     --------       --------

Financing activities:
         Payment of note payable to affiliate .........      (5,000)         --            --            --          (5,000)
     Payment of long-term debt ........................        --             (19)         (205)         --            (224)
     Principal payments of capital lease obligation ...        --          (3,084)         --            --          (3,084)
     Dividends paid on exchangeable preferred stock ...         (18)         --            --            --             (18)
                                                           --------      --------      --------     --------       --------
Net cash used by financing activities .................      (5,018)       (3,103)         (205)         --          (8,326)
                                                           --------      --------      --------     --------       --------

Net increase in cash and cash equivalents .............        --           8,962           376          --           9,338
Cash and cash equivalents, beginning of year ..........        --             355         1,031          --           1,386
                                                           --------      --------      --------     --------       --------
Cash and cash equivalents, end of year ................    $   --        $  9,317      $  1,407     $    --        $ 10,724
                                                           ========      ========      ========     ========       ========

Supplemental Disclosure:
    Interest paid .....................................    $ 1,325       $  5,243      $    561     $    --        $  7,129
    Income taxes paid .................................    $   130       $   --        $    --      $    --        $    130
    Accretion of preferred dividends ..................    $ 6,835       $   --        $    --      $    --        $  6,835`

# 56

`R.  CONDENSED CONSOLIDATING FINANCIAL INFORMATION (continued)

                                  HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES
                                   Condensed Consolidating Statement of Cash Flows
                                         For the year ended December 31, 2001
                                                (dollars in thousands)

                                                            Parent   Guarantors   Non-Guarantors  Elimination   Consolidated
                                                           --------  -----------  --------------  -----------   ------------
Operating activities:
Net cash provided by operating activities .............    $  7,404    $    7,959  $     3,872     $   --        $ 19,235
                                                           --------    ----------  -----------     --------      --------

Investing activities:
     Additions to property and equipment ..............         --         (7,973)      (3,609)        --         (11,582)
     Additions to deferred financing and
      other non-current assets ........................         --           (386)        --           --            (386)
     Transfers to restricted cash, net ................         --         (1,014)         (79)        --          (1,093)
                                                           --------    ----------  -----------     --------      --------
Net cash used by investing activities .................         --         (9,373)      (3,688)        --         (13,061)
                                                           --------    ----------  -----------     --------      --------

Financing activities:
         Issuance of New Preferred Stock ..............       15,000         --           --           --          15,000
         Payment to holders of Discount Notes .........      (15,000)        --           --           --         (15,000)
     Receipt in connection with lease .................          102         --           --           --             102
     Payment on revolving line of credit ..............       (7,500)        --           --           --          (7,500)
     Payment of long-term debt ........................         --            (17)        (228)        --            (245)
     Dividends paid on preferred stock ................           (6)        --           --           --              (6)
                                                            --------      -------      -------      --------      --------
Net cash used by financing activities .................       (7,404)         (17)        (228)        --          (7,649)
                                                            --------      -------      -------      --------      --------

Net decrease in cash and cash equivalents .............         --         (1,431)         (44)        --          (1,475)
Cash and cash equivalents, beginning of year ..........         --          9,317        1,407         --          10,724
                                                            --------      -------      -------      --------      --------
Cash and cash equivalents, end of year ................     $   --        $ 7,886      $ 1,363      $  --         $  9,249
                                                            ========      =======      =======      ========      ========

Supplemental Disclosure:
    Interest paid .....................................     $  1,175      $ 4,030      $   958      $   --        $  6,163
    Income taxes paid .................................     $    257      $   --       $   --       $   --        $    257
    Accretion of preferred dividends ..................     $  3,768      $   --       $   --       $   --        $  3,768`

# 57

`S.  SUMMARY QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

  The Company's unaudited quarterly financial information follows:


                                             Year Ended December 31, 1999
                                             ----------------------------

                                     First              Second              Third            Fourth
                                    Quarter             Quarter            Quarter          Quarter         Total
                                    -------             -------            -------          -------         -----

Total net revenues                $71,704,000        $75,016,000         $77,590,000      $76,305,000    $300,615,000
Income (loss) from operations      (4,541,000)           347,000         (3,972,000)        1,417,000     (6,749,000)

Loss before
 income taxes                      (9,404,000)       (4,976,000)         (9,241,000)      (4,284,000)    (27,905,000)
Income tax (benefit)               (3,668,000)       (1,940,000)         (3,604,000)      (1,092,000)    (10,304,000)
                                   -----------       -----------         -----------      -----------    ------------
Net loss                           (5,736,000)       (3,036,000)         (5,637,000)      (3,192,000)    (17,601,000)
Preferred stock dividends          (1,427,000)       (1,475,000)         (1,525,000)      (1,577,000)     (6,004,000)
                                   -----------       -----------         -----------      -----------   -------------
Loss applicable to
common shares                      (7,163,000)       (4,511,000)         (7,162,000)      (4,769,000)    (23,605,000)
                                   ===========       ===========         ===========      ===========    ============

Loss per
 common share:
   Basic and Diluted              $     (0.99)       $    (0.62)         $    (0.99)      $    (0.58)    $     (3.25)
                                  ===========        ==========          ===========      ==========     ============

                                             Year Ended December 31, 2000
                                             ----------------------------

                                     First              Second              Third            Fourth
                                    Quarter             Quarter            Quarter          Quarter         Total
                                    -------             -------            -------          -------         -----

Total net revenues                $78,976,000        $79,414,000        $ 80,927,000     $ 83,355,000    $322,672,000
Income (loss) from operations      2,075,000           2,379,000         (6,219,000)          982,000       (783,000)

Loss before
 income taxes                      (3,949,000)       (3,325,000)        (11,944,000)      (3,166,000)    (22,384,000)
Income tax (benefit) expense       (1,540,000)       (1,297,000)         (4,658,000)       21,817,000      14,322,000
                                   -----------       -----------         -----------       ----------      ----------
Net loss                           (2,409,000)       (2,028,000)         (7,286,000)     (24,983,000)    (36,706,000)
Preferred stock dividends          (1,630,000)       (1,685,000)         (1,741,000)      (1,797,000)     (6,853,000)
                                   -----------       -----------         -----------      -----------     -----------
Loss applicable to
common shares                      (4,039,000)       (3,713,000)         (9,027,000)     (26,780,000)    (43,559,000)
                                   ===========       ===========         ===========     ============    ============

Loss per
 common share:
   Basic and Diluted              $     (0.56)       $    (0.51)         $    (1.24)     $     (3.69)    $     (6.00)
                                  ============       ===========         ===========     ============    ============

                                             Year Ended December 31, 2001
                                             ----------------------------

                                     First              Second              Third            Fourth
                                    Quarter             Quarter            Quarter          Quarter         Total
                                    -------             -------            -------          -------         -----

Total net revenues                $82,086,000       $ 86,127,000         $88,210,000     $90,315,000   $ 346,738,000
Income (loss) from operations      (1,767,000)       (4,815,000)           1,593,000         (58,000)     (5,047,000)

Loss before
 income taxes                      (6,436,000)       (7,734,000)           (455,000)      (2,052,000)    (16,677,000)
Income tax expense                         -                   -                   -         225,000         225,000
                                   ----------       ------------         -----------      -----------   ------------
Net loss                           (6,436,000)       (7,734,000)           (455,000)      (2,277,000)    (16,902,000)
Preferred stock dividends          (1,860,000)         (905,000)           (497,000)        (512,000)     (3,774,000)
                                   -----------      ------------         -----------      -----------   ------------
Loss applicable to
common shares                      (8,296,000)       (8,639,000)           (952,000)      (2,789,000)    (20,676,000)
                                   ==========        ==========          ===========      ===========   =============

Loss per
 common share:
   Basic and Diluted               $    (1.13)       $    (1.18)         $    (0.13)     $    (0.38)    $      (2.82)
                                   ===========       ===========         ===========     ===========    =============`

# 58

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

# PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

DIRECTORS

The Company pays no remuneration to its employees or to
executives of Investcorp for serving as directors.

The following table sets forth certain information
  regarding the current directors and executive officers of the Company:

`Name and Principal Offices with the Company

 NAME                               AGE         POSITION
 ----                               ---         --------
Stephen L. Guillard                 52    Chief Executive Officer and Director
Damian N. Dell'Anno                 42    President, Chief Operating Officer and Director
William H. Stephan                  45    Senior Vice President, Chief Financial Officer and
Director
Christopher J. O'Brien              43    Director
Lars  C. Haegg                      36    Director
James O. Egan                       53    Director
William C. McCollum                 30    Director`

Stephen L. Guillard has served as Chief Executive
Officer of the Company since March 21, 1996 (and President from March 21, 1996
through August 30, 2001) and of the predecessors of the Company since May 1988
and as a Director and Chairman of the Board of the Company since its
incorporation. Mr. Guillard previously served as Chairman, President and Chief
Executive Officer of Diversified Health Services (DHS), a long-term
care company which Mr. Guillard co-founded in 1982. DHS operated approximately
7,500 long-term care and assisted living beds in five states. Mr. Guillard has a
total of 28 years of experience in the long-term care industry and is a licensed
Nursing Home Administrator.

Damian N. DellAnno has served as President of the
Company since August 30, 2001. Mr. DellAnno previously had served as
Executive Vice President of Operations of the Company since March 21, 1996 and
its predecessors since 1994. From 1993 to 1994, he served as the head of the
specialty services group for the predecessors of the Company and was
instrumental in developing the Companys rehabilitation therapy business.
From 1989 to 1993, Mr. DellAnno was Vice President of Reimbursement for
the predecessors of the Company. From 1988 to 1989, Mr. DellAnno served as
Director of Budget, Reimbursement and Cash Management for The Mediplex Group,
Inc. (Mediplex), a long-term care company. Mr. DellAnno has a
total of 18 years of experience in the long-term care industry.

William H. Stephan has served as Senior Vice President
and Chief Financial Officer since March 21, 1996 and its predecessors since
joining the Company in 1994. From 1986 to 1994, Mr. Stephan was a Manager in the
health care practice of Coopers & Lybrand LLP. His clients there included
long-term care facilities, continuing care retirement centers, physician
practices and acute care hospitals. Mr. Stephan is a Certified Public Accountant
and a member of the Healthcare Financial Management Association.

Christopher J. O'Brien has been an executive of
Investcorp S.A. since December 1993. Prior to joining Investcorp S.A., he was a
Managing Director of Mancuso & Company, a private New York-based merchant bank.
He is a director of IWO Holdings, Inc. (Independent Wireless One Corporation),
SIND Holdings, Inc. (SI Corporation), Stratus Computer Systems International
S.A. and H.S. TelePacific Holdings Corp.

Lars C. Haegg has been an executive of Investcorp S.A. since
1998. Prior to joining Investcorp S.A., Mr. Haegg worked with McKinsey &
Company where he was responsible for leading consulting teams for media, retail
and electronics clients. Mr. Haegg previously worked with Strategic Planning
Associates (now Mercer Management Consulting) in the telecommunications and
consumer goods sectors. He is a director of Stratus Computer Systems
International S.A. and H.S. TelePacific Holdings Corp.

James O. Egan has been an executive of Investcorp S.A.
since January 1999. Prior to joining Investcorp S.A., he was employed by KPMG,
an accounting firm, as a Partner; Riverwood International, a paperboard,
packaging and machinery company, as Senior Vice President and Chief Financial
Officer; and Coopers & Lybrand LLP, an accounting firm, as a Partner. He is a
director of CSK Auto Corporation, Werner Holding Co. (DE), Inc., IWO Holdings,
Inc. (Independent Wireless One Corporation) and Jostens Inc.

William C. McCollum has been an executive of Investcorp
S.A. since May 1996. Prior to joining Investcorp S.A., Mr. McCollum was a
financial Analyst with Chase Securities Inc. He is a director of the Neptune
Technology Group Holdings Inc.

# 59

EXECUTIVE OFFICERS

The following table sets forth certain information with
respect to the executive officers of the Company:

`NAME                               AGE                           POSITION
----                               ---                           --------

Stephen L. Guillard                   52    Chief Executive Officer and Director
Damian N. Dell'Anno                   42    President, Chief Operating Officer and Director
William H. Stephan                    45    Senior Vice President, Chief Financial Officer and
Director
Bruce J. Beardsley                    38    Senior Vice President of Acquisitions
Steven Raso                           37    Senior Vice President of Operations

  Information on Mr. Guillard, Mr. Dell'Anno and Mr. Stephan appears above.`

Bruce J. Beardsley has served as Senior Vice President
of Acquisitions since March 21, 1996 and its predecessors since 1994. From 1992
to 1994, he was Vice President of Planning and Development of the Company with
responsibility for the development of specialized services, planning and
engineering. From 1990 to 1992, he was an Assistant Vice President of the
Company responsible for risk management and administrative services. From 1988
to 1990, Mr. Beardsley served as Special Projects Manager of the Company. Prior
to joining the Company in 1988, Mr. Beardsley was a commercial and residential
real estate appraiser.

Steven V. Raso has served as Senior Vice President of
Operations since 1998. From 1994 to 1998, he served as Vice President of
Reimbursement for the Company and he served as Director of Reimbursement and
Budgets from 1989 to 1994. In these capacities, Mr. Raso has been responsible
for various aspects of Company Operations, including the Medicare and Medicaid
reimbursement cost reporting functions, including audits, appeals, licensing and
rate determinations. Mr. Raso also oversees the budgeting, accounts receivable
and compliance departments within the Company.

# 60

ITEM 11. EXECUTIVE COMPENSATION

# SUMMARY COMPENSATION TABLE

The following table sets forth the cash and non-cash
compensation for 2001, 2000 and 1999 awarded to or earned by the Chief Executive
Officer and the four other most highly compensated executive officers of the
Company (collectively, the Named Executive Officers).

`Annual Compensation                     Long Term Compensation
                                    -------------------                     ----------------------
                                                                              Awards            Payouts

                                                      Other                      Securities
                                                      Annual      Restricted     Underlying All Other
Name and                            Salary   Bonus    Compen-     Stock          Options/   Compen-
Principal Position         Year        ($)  ($)(1)    sation ($)  Award(s)($)(2) SARs #     sation($)(3)
------------------         ----     ------  --------- ----------  -------------- ------     -----------

Stephen L. Guillard        2001    423,094    95,000           0        0       320,000       34,794
Chief Executive            2000    397,523    86,250           0    1,550             0       28,280
Officer                    1999    345,000         0           0        0             0       14,440

Damian N. Dell'Anno        2001    300,780    70,000           0        0       150,000       17,768
President and Chief        2000    281,259    45,000           0    1,010             0       13,750
Operating Officer          1999    225,000         0           0        0             0        9,000

William H. Stephan         2001    253,842    55,000           0        0       105,000       13,349
Senior Vice                2000    227,692    38,000           0      700             0       11,295
President and              1999    190,000         0           0        0             0        9,500
Chief Financial
Officer

Bruce J. Beardsley         2001    238,078    50,000           0        0       105,000       14,415
Senior Vice                2000    226,249    40,000           0      700             0       11,000
President of               1999    200,000         0           0        0             0       10,000
Acquisitions

Steven V. Raso             2001    181,538    35,000           0        0        67,500       11,515
Senior Vice                2000    177,499    28,000           0      490             0        8,750
President of               1999    140,000         0           0        0             0        7,000
Operations`

(1) On May 23, 2001, in recognition of the successful
     completion of the Companys financial restructuring plan, the
     Companys Board of Directors awarded bonus payments in the amounts of
     $95,000, $70,000, $55,000, $50,000 and $35,000 to Messrs. Guillard,
     DellAnno, Stephan, Beardsley and Raso, respectively.

(2) On September 29, 2000, the Company granted 155,000,
     101,000, 70,000, 70,000 and 49,000 shares of restricted stock to Messrs.
     Guillard, DellAnno, Stephan, Beardsley and Raso, respectively. As
     part of this stock issuance, options granted on August 11, 1998 to purchase
     shares of the Companys Class C common stock at $25.00 per share in
     the amounts of 160,904, 104,666, 72,641, 72,641, and 50,771 shares for
     Messrs. Guillard, DellAnno, Stephan, Beardsley and Raso,
     respectively, were cancelled. One-third of the shares of restricted stock
     vest annually beginning on December 31, 2001. As of December 31, 2001, the
     aggregate restricted stock holdings for each of the Named Executive
     Officers consisted of the following: Mr. Guillard, 155,000 shares with
     a value of $1,510; Mr. DellAnno, 101,000 shares with a value of
     $1,010; Mr. Stephan, 70,000 shares with a value of $700;
     Mr. Beardsley, 70,000 shares with a value of $700; and Mr. Raso,
     49,000 shares with a value of $490.

(3) Includes matching contributions made by the Company
     under its Supplemental Executive Retirement Plan and 401(k)
     Plan.

# 61

# OPTION/SAR GRANTS IN LAST FISCAL YEAR

`INDIVIDUAL GRANTS

                         NUMBER OF       PERCENT OF TOTAL                                          GRANT
                        SECURITIES         OPTIONS/SARS                                            DATE
                        UNDERLYING          GRANTED TO            EXERCISE OR                     PRESENT
                       OPTIONS/SARS        EMPLOYEES IN           BASE PRICE     EXPIRATION        VALUE
       NAME             GRANTED (#)         FISCAL YEAR             ($/SH)          DATE          ($)(2)
       ----             -----------         -----------             ------          ----          ------


Stephen L. Guillard   (1)    320,000          35.4%                  1.25     November 19, 2008        -

Damian N. Dell'Anno   (1)    150,000          16.6%                  1.25     November 19, 2008        -

William H. Stephan    (1)    105,000          11.6%                  1.25     November 19, 2008        -

Bruce J. Beardsley    (1)    105,000          11.6%                  1.25     November 19, 2008        -

Steven V. Raso        (1)     67,500           7.5%                  1.25     November 19, 2008        -`

(1) Messrs. Guillard, DellAnno, Stephan, Beardsley
     and Raso received options to purchase shares of Harborside Class C Common
     Stock on November 19, 2001. These options become exercisable to the extent
     of one-fourth of the number of option shares on December 31, 2001,
     one-fourth of the number of option shares on December 31, 2002, one-fourth
     of the number of option shares on December 31, 2003 and one-fourth of the
     number of option shares on December 31, 2004. In certain circumstances,
     vesting of these options is accelerated. These options terminate (with
     certain exceptions) thirty days after the seventh anniversary of their date
     of grant.

(2) Underlying shares are not publicly traded and are
     subject to repurchase by the Company under certain circumstances at the
     employees cost or at the then current value of the underlying share,
     as determined by the Companys Board of Directors upon the termination
     of the employees employment with the Company. None of these options
     are classified as in-the-money for purposes of this table.

# AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR

# AND FISCAL YEAR END OPTION/SAR VALUES

The following table sets forth information concerning
the aggregate number of exercisable and unexercisable stock options and stock
appreciation rights held as of the end of 2001. No stock options were exercised
by the Named Executive Officers during 2001.

`NUMBER OF
                               SECURITIES                 VALUE OF
                               UNDERLYING                 UNEXERCISED
                               UNEXERCISED                IN-THE MONEY
                               OPTIONS/SARS AT            OPTIONS/SARS AT
                               FISCAL YEAR END            FISCAL YEAR END ($)


                               EXERCISABLE/                EXERCISABLE/
         NAME                  UNEXERCISABLE            UNEXERCISABLE (1)
         ----                  -------------            -----------------

       Stephen L. Guillard        80,000/240,000                      0
       Damian N. Dell'Anno        48,060/112,500                      0
       William H. Stephan          64,582/78,750                      0
       Bruce J. Beardsley          65,412/78,750                      0
       Steven V. Raso              38,815/50,625                      0`

(1) Underlying shares are
not publicly traded and are subject to repurchase by the Company under certain
circumstances at the employees cost or at the then current value of the
underlying share, as determined by the Companys Board of Directors upon
the termination of the employees employment with the Company. None of
these options are classified as in-the-money for purposes of this table. The
Company has not established any recent valuations for such shares.

# 62

EMPLOYMENT AGREEMENTS

The Company has entered into employment agreements with
Messrs. Guillard, DellAnno, Stephan, Beardsley and Raso (collectively, the
Employment Agreements). Under the terms of the Employment
Agreements, Mr. Guillard serves as Chief Executive Officer of the Company, Mr.
DellAnno serves as President and Chief Operating Officer of the Company,
Mr. Stephan serves as Senior Vice President and Chief Financial Officer of the
Company, Mr. Beardsley serves as Senior Vice President of Acquisitions of the
Company and Mr. Raso serves as Senior Vice President of Operations of the
Company. Through March 31, 1999, Messrs. Guillard, DellAnno, Stephan,
Beardsley and Raso received minimum annual base salaries of $345,000, $225,000,
$190,000, $200,000 and $140,000, respectively. The salaries of Messrs. Guillard,
DellAnno, Stephan, Beardsley and Raso were to be increased to $375,000,
$240,000, $200,000, $215,000 and $150,000, respectively, effective April 1,
1999. Through December 31, 1999, Messrs. Guillard, DellAnno, Stephan,
Beardsley and Raso elected to forgo the scheduled compensation adjustments. In
January 2000, the amounts of compensation due to these individuals as a result
of these elective deferrals were paid by the Company, and as of January 1, 2000,
the salaries of Messrs. Guillard, DellAnno, Stephan, Beardsley, and Raso
were increased to $375,000, $270,000, $200,000, $215,000 and $170,000,
respectively. On March 1, 2000, Mr. Stephans salary was increased to
$225,000. On August 11, 2001, the salaries of Messrs. Guillard, DellAnno,
Stephan, Beardsley and Raso were increased to $500,000, $350,000, $300,000,
$275,000 and $200,000, respectively. Under the terms of these Employment
Agreements, the salaries of each officer will be subject to further adjustment
at the discretion of the Compensation Committee of the Board of Directors of the
Company.

The Employment Agreements also provide (i) for an annual
bonus to be paid to Messrs. Guillard, DellAnno, Stephan, Beardsley and
Raso, part of which will be based upon achievement of specific performance
targets and part of which will be discretionary, in maximum amounts of 120% of
base salary in the case of Mr. Guillard, 96% of base salary in the case of Mr.
DellAnno and 78% of base salary in the cases of Messrs. Stephan, Beardsley
and Raso, and (ii) that upon termination of employment prior to an initial
public offering, the Company will have certain rights to call from such officers
shares of Harborside Common Stock owned by such officers (including shares
underlying then-exercisable stock options), and such officers will have certain
rights to put such shares to an affiliate of Investcorp (subject to a right of
first refusal in favor of the Company).

Each officer has the right to terminate his Employment
Agreement on 30 days notice. The Company has the right to terminate an
Employment Agreement without obligation for severance only for Good Cause (as
defined in the Employment Agreements). The Employment Agreements provide for
severance benefits to be paid in the event an officers employment is
terminated if such termination is, in the case of termination by the Company,
without Good Cause, or, in the case of termination by an officer, for Good
Reason (as defined in the Employment Agreements). If the Company terminates the
employment of an officer without Good Cause or the officer terminates his
employment for Good Reason, the officer will be entitled to receive severance
benefits which will include (i) the vesting of the pro rata portion of stock
options subject to vesting in the then current year attributable to the part of
the year that the officer was employed, (ii) the ability to exercise vested
stock options for the period ending on the earlier of the date that is 180 days
from the date his employment is terminated or the specific expiration date
stated in the options, and (iii) in the case of Mr. Guillard, for the period
ending 30 months after termination, in the case of Mr. DellAnno, for the
period ending 24 months after termination, and in the cases of Messrs. Stephan,
Beardsley and Raso, for the period ending 18 months after termination, payment
of the officers compensation at the rate most recently in effect; subject
to such officers compliance with noncompetition and nonsolicitation
covenants for such 18, 24 or 30 month period, as applicable.

SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

Effective September 15, 1995, Harborside established a
Supplemental Executive Retirement Plan (SERP) to provide benefits
for key employees of Harborside. Participants may defer up to 25% of their
salary and bonus compensation by making contributions to the SERP. Amounts
deferred by the participant are credited to his or her account and are always
fully vested. Harborside matches 50% of amounts contributed until 10% of base
salary has been contributed. Matching contributions made by Harborside become
vested as of January 1 of the second year following the end of the plan year for
which contributions were credited, provided the employee is still employed with
Harborside on that date. In addition, participants will be fully vested in such
matching contribution amounts in the case of death or permanent disability or at
the discretion of Harborside. Participants are eligible to receive benefits
distributions upon retirement or in certain pre-designated years. Participants
may not receive distributions prior to a pre-designated year, except in the case
of termination, death or disability or demonstrated financial hardship. Only
amounts contributed by the employee may be distributed because of financial
hardship. Although amounts deferred and Company matching contributions are
deposited in a rabbi trust, they are subject to risk of loss. If
Harborside becomes insolvent, the rights of participants in the SERP would be
those of an unsecured general creditor of Harborside.

STOCK INCENTIVE PLAN

Immediately following the Merger, the Company adopted
the Harborside Healthcare Corporation Stock Incentive Plan (the Stock
Option Plan). Initially, 806,815 shares were made available to be awarded
under the Stock Option Plan, representing approximately 10% of the shares of
common stock of Harborside outstanding immediately after the Effective Time,
determined after giving effect to the exercise of the options issued or issuable
under the Stock Option Plan. Options to purchase approximately 7.7% of such
shares (determined on such basis) were granted to members of the Companys
management upon consummation of the Merger. Options for the remaining
approximately 2.3% of the shares of capital stock of the Company (determined on
such basis) were reserved for grant to current or future officers and employees
of the Company.

The Stock Option Plan is administered by the
Companys Board of Directors. The Board designates which employees of the
Company are eligible to receive awards under the Stock Option Plan, and the
amount, timing and other terms and conditions applicable to such awards. Future
options will be exercisable in accordance with the terms established by the
Board and will expire on the date determined by the Board, which will not be

# 63

later than 30 days after the seventh anniversary of the grant date. An optionee
will have certain rights to put to the Company, and the Company will have
certain rights to call from the optionee, vested stock options issued to the
optionee under the Stock Option Plan upon termination of the optionees
employment with the Company prior to an initial public offering.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

PRINCIPAL SHAREHOLDERS

The Company is authorized to issue shares of five
classes of common stock, each with a par value of $0.01, consisting of Class A
Common Stock (Harborside Class A Common Stock), Class B Common Stock
(Harborside Class B Common Stock), Class C Common Stock
(Harborside Class C Common Stock), Class D Common Stock
(Harborside Class D Common Stock) and Common Stock (Common
Stock) (collectively Harborside Common Stock). Harborside
Class A Common Stock, Harborside Class D Common Stock and Common Stock are the
only classes of the Companys common stock that have the power to vote.
Holders of Harborside Class B Common Stock and Harborside Class C Common Stock
do not have any voting rights, except that the holders of Harborside Class B
Common Stock and Harborside Class C Common Stock have the right to vote as a
class to the extent required under the laws of the State of Delaware.

As of March 1, 2002, there were 661,332 shares of
Harborside Class A Common Stock, 20,000 shares of Harborside Class D Common
Stock and no shares of Common Stock outstanding. Holders of shares of Harborside
Class A Common Stock and Common Stock of the Company are entitled to one vote
per share on all matters as to which stockholders may be entitled to vote
pursuant to the DGCL. Holders of Harborside Class D Common Stock are entitled to
330 votes per share on all matters as to which stockholders may be entitled to
vote pursuant to the DGCL.

As a result of the consummation of the Merger, the New
Investors beneficially own all of the outstanding Harborside Class D Common
Stock, constituting approximately 91% of the outstanding voting power of the
Company, and pre-Merger stockholders, including certain members of management,
beneficially own all of the outstanding Harborside Class A Common Stock,
constituting approximately 9% of the outstanding voting power of the Company. In
addition, the New Investors own 5,940,000 shares of Harborside Class B Common
Stock and 640,000 shares of Harborside Class C Common Stock.

The following table sets forth certain information
regarding the beneficial ownership of the voting stock of the Company as of
March 1, 2002. The table sets forth, as of that date, (i) each person known by
the Company to be the beneficial owner of more than 5% of any class of voting
stock of the Company, (ii) each person who was a director of the Company or a
Named Executive Officer of the Company and (iii) all directors of the Company
and executive officers of the Company as a group. None of the Companys
directors or officers own shares of Harborside Class D Common Stock. Unless
otherwise indicated, each of the stockholders shown in the table below has sole
voting and investment power with respect to the shares beneficially owned.

`HARBORSIDE CLASS A COMMON STOCK
                                          (9% Of Voting Power)

Name and address of               Number of   Number of               Percent of
Beneficial Owner (1)             Shares (2) Options (3)        Total   Class (4)
--------------------             ---------- ------------       -----   ---------

George Krupp (5)                   196,079        --          196,079       29.6
Douglas Krupp (5)                  196,079        --          196,079       29.6
Stephen L. Guillard                177,688        --          177,688       26.9
Damian N. Dell'Anno                 47,563    10,560           58,123        8.7
Bruce J. Beardsley                      --    39,162           39,162        5.6
William H. Stephan                     400    38,332           38,732        5.5
Steven V. Raso                          --    21,940           21,940        3.2
Christopher J. O'Brien                  --        --               --         --
Lars C. Haegg                           --        --               --         --
James O. Egan                           --        --               --         --
William C. McCollum                     --        --               --         --
All directors and executive officers as
a group (9 persons)                225,651   109,994          335,645       43.5`

# 64

`HARBORSIDE CLASS D COMMON STOCK
                                          (91% Of Voting Power)

                                                    Number of         Percent of
Name and address of Beneficial Owner                Shares (2)         Class
------------------------------------                ----------         -----

INVESTCORP S.A. (6)(7).........................       20,000            100.0
SIPCO Limited (8)..............................       20,000            100.0
CIP Limited (9)(10)............................       18,400             92.0
Ballet Limited (9)(10).........................        1,840              9.2
Denary Limited (9)(10).........................        1,840              9.2
Gleam Limited (9)(10)..........................        1,840              9.2
Highlands Limited (9)(10)......................        1,840              9.2
Nobel Limited (9)(10)..........................        1,840              9.2
Outrigger Limited (9)(10)......................        1,840              9.2
Quill Limited (9)(10)..........................        1,840              9.2
Radial Limited (9)(10).........................        1,840              9.2
Shoreline Limited (9)(10)......................        1,840              9.2
Zinnia Limited (9)(10).........................        1,840              9.2
INVESTCORP Investment Equity Limited (7).......        1,600              8.0`

(1) The address of each person listed in the table as a
     holder of Harborside Class A Common Stock is c/o Harborside Healthcare
     Corporation, One Beacon Street, Boston, Massachusetts 02108.

(2) As used in the table above, a beneficial owner of a
     security includes any person who, directly or indirectly, through contract,
     arrangement, understanding, relationship, or otherwise has or shares (i)
     the power to vote, or direct the voting of, such security or (ii)
     investment power which includes the power to dispose, or to direct the
     disposition of, such security.

(3) Includes shares of stock that are subject to options
     exercisable within 60 days of March 1, 2002.

(4) Reflects the percentage such shares and options
     represent of the number of outstanding shares of such class of the
     Companys common stock after giving effect to the exercise of options
     owned by such person or persons.

(5) The shares beneficially owned by George Krupp are
     owned of record by The George Krupp 1994 Family Trust (GKFT).
     The shares beneficially owned by Douglas Krupp are owned of record by The
     Douglas Krupp 1994 Family Trust (DKFT). The trustees of both
     GKFT and DKFT are Lawrence I. Silverstein, Paul Krupp and M. Gordon Ehrlich
     (the Trustees). The Trustees share control over the power to
     dispose of the assets of GKFT and DKFT and thus each may be deemed to
     beneficially own the shares held by GKFT and DKFT; however, each of the
     Trustees disclaims beneficial ownership of all of such shares.

(6) Investcorp S.A. does not directly own any stock in the
     Company. The number of shares shown as owned by Investcorp S.A. includes
     all of the shares owned by INVESTCORP Investment Equity Limited (See note
     (7) below). Investcorp S.A. owns no stock in Ballet Limited, Denary
     Limited, Gleam Limited, Highlands Limited, Noble Limited, Outrigger
     Limited, Quill Limited, Radial Limited, Shoreline Limited, Zinnia Limited,
     or in the beneficial owners of these entities (See note (10) below).
     Investcorp S.A. may be deemed to share beneficial ownership of the shares
     of voting stock of the Company held by these entities because the entities
     have entered into revocable management services or similar agreements with
     an affiliate of Investcorp S.A., pursuant to which each such entities has
     granted such affiliate the authority to direct the voting and disposition
     of the Company voting stock owned by such entity for so long as such
     agreement is in effect. Investcorp S.A. is a Luxembourg corporation with
     its address at 37 rue Notre-Dame, Luxembourg.

(7) INVESTCORP Investment Equity Limited is a Cayman
     Islands corporation, and a wholly owned subsidiary of Investcorp S.A., with
     its address at P.O. Box 1111, West Wind Building, George Town, Grand
     Cayman, Cayman Islands.

(8) SIPCO Limited may be deemed to control Investcorp S.A.
     through its ownership of a majority of a company's stock that indirectly
     owns a majority of Investcorp's shares. SIPCO Limited's address is P.O. Box
     1111, West Wind Building, George Town, Grand Cayman, Cayman
     Islands.

(9) CIP Limited (CIP) owns no stock in the
     Company. CIP indirectly owns less than 0.1% of the stock in each of Ballet
     Limited, Denary Limited, Gleam Limited, Highlands Limited, Noble Limited,
     Outrigger Limited, Quill Limited, Radial Limited, Shoreline Limited and
     Zinnia Limited (See note (10) below). CIP may be deemed to share beneficial
     ownership of the shares of voting stock of the Company held by such
     entities because CIP acts as a director of such entities and the ultimate
     beneficial stockholders of each of those entities have granted to CIP
     revocable proxies in companies that own those entities stock. None of
     the ultimate beneficial owners of such entities beneficially owns
     individually more than 5% of the Companys voting stock.

(10) Each of CIP Limited, Ballet Limited, Denary Limited,
     Gleam Limited, Highlands Limited, Noble Limited, Outrigger Limited, Quill
     Limited, Radial Limited, Shoreline Limited and Zinnia Limited is a Cayman
     Islands corporation with its address at P.O. Box 2197, West Wind Building,
     GeorgeTown, Grand Cayman, Cayman Islands.

# 65

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

In December of 1999, the Company borrowed $5 million
from an affiliate of Investcorp S.A. to fund a payment of $5 million to the
landlord of four facilities in Ohio. In return for the payment, the Company
received an option to acquire the four facilities. Interest on this loan was
payable quarterly in arrears and was based on a ninety-day LIBOR rate plus 275
basis points. The Company exercised its option to acquire the four facilities on
June 30, 2000. On September 27, 2000, the Company assigned its purchase rights
for the four facilities to an investment entity organized by Investcorp, for
$5.0 million, which simultaneously acquired the four facilities. Also on that
date, the Company entered into new operating leases for each of the four
facilities with combined annual rent of approximately $5.9 million. The Company
used the proceeds of the purchase rights assignment to repay the $5.0 million
note payable from an affiliate of Investcorp S.A. On December 21, 2001, the four
facilities were sold to an unaffiliated real estate investment trust and the
Company entered into new operating leases with that entity.

# PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

`(a)


         1.       Financial Statements:

                  See Index to Consolidated Financial Statements in Item 8
                  of this annual report.

         2.       Financial Statement Schedules:


                  None.


         3.       Exhibits


  The exhibits listed in the accompanying index to exhibits are incorporated by
reference herein or are filed as part of this annual report.`

`Exhibit

        Number           Description of Exhibit


      2.1**              Agreement and Plan of Merger dated as of April 15, 1998


      3.1(a)****#        Amended and Restated Certificate of Incorporation of the Registrant


      3.1(b)****         Certificate of Designation of the Registrant with respect to the Exchangeable
                         Preferred Stock


      3.1(c)**           Amended and Restated By-laws of the Registrant


      3.1(d)****         Form of Certificate of Incorporation of certain registrants, as amended


      3.2(a)****         Certificate of Incorporation of Sailors, Inc.


      3.1(e)***          Amended Certificate of Designation of the Registrant for the Redeemable Preferred
                         Stock (formerly known as131/2% Exchangeable Preferred Stock)


      3.1(f)***          Certificate of Designation of the Registrant for the 13% Convertible Exchangeable
                         Preferred Stock


      3.2(b)****         Form A of Articles of Organization, Articles of Amendment and Articles of Merger of
                         certain registrants


      3.2(c)****         Form B of Articles of Organization of certain registrants


      3.2(d)****         Form of First Amendment to and Restatement of Agreement of Limited Partnership of
                         certain registrants


      3.2(e)****         Form of Agreement of Limited Partnership of certain registrants


     3.2(f)****          Amended and Restated Agreement of Limited Partnership of Harborside Healthcare
                         Limited Partnership, dated as of May 12, 1987, as amended and restated as of
                         July 1, 1995`

# 66

`3.2(g)****         Agreement of Limited Partnership of KHC Partners, Limited Partners, dated as of May
                         28, 1987, as amended


      3.2(h)****         Form A of Certificate of Limited Partnership of certain registrants


      3.2(i)****         Form B of Certificate of Limited Partnership of certain registrants


      3.2(j)****         Certificate of Limited Partnership of Bridgewater Assisted Living Limited Partnership


      3.2(k)****         First Amendment to and Restatement of Certificate of Limited Partnership of KHC
                         Partners Limited Partnership (now known as Harborside Healthcare Advisors Limited
                         Partnership)


      3.2(l)****         First Amendment to and Restatement of Certificate of Limited Partnership of Harborside
                         Acquisition Limited Partnership IV (now known as Harborside Danbury Limited
                         Partnership)


      3.2(m)****         Certificate of Formation and Agreement of Limited Partnership of Riverside Retirement
                         Limited Partnership, as amended


      3.2(n)****         Certificate of Limited Partnership of Harborside Healthcare Limited Partnership


      3.2(o)****         Form A of By-laws of certain registrants


      3.2(p)****         Form B of By-laws of certain registrants


      4.1****            Indenture between MergerCo and the Trustee, dated as of July 31, 1998, with respect to
                         the Notes


      4.2****            Supplemental Indenture between the Registrant, the Guarantors and the Trustee, dated
                         as of August 11, 1998


      4.3****#           Form of New Note


      4.4****            Registration Rights Agreement, dated July 31, 1998, between the Registrant (as
                         successor to MergerCo) and the Placement Agents, relating to the Old Notes


      4.5****            Certificate of Designation of the Registrant with respect to the Exchangeable
                         Preferred Stock (filed as Exhibit 3.1.(b))


      4.6****            Form of Stock Certificate representing New Preferred Stock


      4.7****            Registration Rights Agreement, dated July 31, 1998, between the Registrant
                         (as successor to MergerCo) and the Placement Agents, relating to the Old
                         Preferred Stock (filed as Exhibit 1.3)

      4.8****            Form of Letter of Transmittal (filed as Exhibit 1.4)


      4.9***             Second Supplemental Indenture, dated as of May 10, 2001, between the Registrant,
                         the Guarantors as defined therein and United States Trust Company of New York,
                         as trustee, relating to the 11% Senior Subordinated Discount Notes due 2008

      4.10***            Indenture, dated as of May 10, 2001, among the Registrant, the Guarantors as defined
                         therein and United States Trust Company of New York, as trustee, relating to the 12%
                         Senior Subordinated Discount Notes due 2007

     10.1(a)*            Facility Lease Agreement, dated as of December 31, 1995, between Meditrust Tri-States,
                         Inc. and HHCI Limited Partnership (New Haven Facility)


     10.1(b)*            Facility Lease Agreement, dated as of December 31, 1995, between Meditrust Tri-States,
                         Inc. and HHCI Limited Partnership (Indianapolis Facility)


     10.1(c)*            Facility Lease Agreement, dated as of December 31, 1995, between Meditrust of Ohio,
                         Inc. and HHCI Limited Partnership (Troy Facility)


     10.1(d)*            Facility Lease Agreement, dated as of December 31, 1995, between Meditrust of Florida,
                         Inc. and HHCI Limited Partnership (Sarasota Facility)


     10.1(e)*            Facility Lease Agreement, dated as of December 31, 1995, between Meditrust of Florida,
                         Inc. and HHCI Limited Partnership (Pinebrook Facility)`

# 67

`10.1(f)*            Facility Lease Agreement, dated as of December 31, 1995, between Meditrust of Florida,
                         Inc. and HHCI Limited Partnership (Naples Facility)


     10.1(g)*            Facility Lease Agreement, dated as of December 31, 1995, between Meditrust of New
                         Jersey, Inc. and HHCI Limited Partnership (Woods Edge Facility)


     10.1(h)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust Tri-States, Inc. and HHCI Limited Partnership (New Haven Facility)


     10.1(i)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust Tri-States, Inc. and HHCI Limited Partnership (Indianapolis Facility)


     10.1(j)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of Ohio, Inc. and HHCI Limited Partnership (Troy Facility)


     10.1(k)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of Florida, Inc. and HHCI Limited Partnership (Sarasota Facility)


     10.1(l)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of Florida, Inc. and HHCI Limited Partnership (Pinebrook Facility)


     10.1(m)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of Florida, Inc. and HHCI Limited Partnership (Naples Facility)


     10.1(n)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of New Jersey, Inc. and HHCI Limited Partnership (Woods Edge Facility)


     10.2(a)*            Loan Agreement, dated October 13, 1994, among Meditrust Mortgage Investments, Inc.
                         and Bay Tree Nursing Center Corporation, Belmont Nursing Center Corporation,
                         Countryside Care Center Corporation, Oakhurst Manor Nursing Center Corporation,
                         Orchard Ridge Nursing Center Corporation, Sunset Point Nursing Center Corporation,
                         West Bay Nursing Center Corporation and Harborside Healthcare Limited Partnership.

     10.2(b)*            Guaranty, dated October 14, 1994, to Meditrust Mortgage Investments, Inc. from
                         Harborside Healthcare Limited Partnership


     10.2(c)*            Environmental Indemnity Agreement, dated October 13, 1994, by and among Bay Tree
                         Nursing Center Corporation, Belmont Nursing Center Corporation, Countryside Care
                         Center Corporation, Oakhurst Manor Nursing Center Corporation, Orchard Ridge Nursing
                         Center Corporation, Sunset Point Nursing Center Corporation, West Bay Nursing
                         Center Corporation and Harborside Healthcare Limited Partnership and Meditrust
                         Mortgage Investments, Inc.

     10.2(d)*            Consolidated and Renewed Promissory Note, dated October 13, 1994, from Bay Tree
                         Nursing Center Corporation, Belmont Nursing Center Corporation, Countryside Care
                         Center Corporation, Oakhurst Manor Nursing Center Corporation, Orchard Ridge Nursing
                         Center Corporation, Sunset Point Nursing Center Corporation, West Bay Nursing
                         Center Corporation and Harborside Healthcare Limited Partnership and Meditrust
                         Mortgage Investments, Inc.

     10.2(e)*            Negative Pledge Agreement, dated October 13, 1994, by and among Douglas Krupp,
                         George Krupp, Bay Tree Nursing Center Corporation, Belmont Nursing Center Corporation,
                         Countryside Care Center Corporation, Oakhurst Manor Nursing Center Corporation,
                         Orchard Ridge Nursing Center Corporation, Sunset Point Nursing Center Corporation,
                         West Bay Nursing Center Corporation and Harborside Healthcare Limited Partnership
                         and Meditrust Mortgage Investments, Inc.

     10.2(f)*            Affiliated Party Subordination Agreement, dated October 13, 1994, by and among\
                         Bay Tree Nursing Center Corporation, Belmont Nursing Center Corporation, Countryside
                         Care Center Corporation, Oakhurst Manor Nursing Center Corporation, Orchard Ridge
                         Nursing Center Corporation, Sunset Point Nursing Center Corporation, West Bay Nursing
                         Center Corporation and Harborside Healthcare Limited Partnership and Meditrust
                         Mortgage Investments, Inc.

     10.2(g)*            First Amendment to Loan Agreement, dated May 17, 1996, by and among Meditrust
                         Mortgage Investments, Inc. and Bay Tree Nursing Center Corporation, Belmont Nursing
                         Center Corporation, Countryside Care Center Corporation, Oakhurst Manor Nursing
                         Center Corporation, Orchard Ridge Nursing Center Corporation, Sunset Point Nursing
                         Center Corporation, West Bay Nursing Center Corporation and Harborside
                         Healthcare Limited Partnership

     10.3(a)*            Facility Lease Agreement, dated as of January 1, 1996, between Meditrust of New
                         Hampshire Inc. and Harborside New Hampshire Limited Partnership (Westwood Facility)`

# 68

`10.3(b)*            Facility Lease Agreement, dated as of January 1, 1996, between Meditrust of New
                         Hampshire Inc. and Harborside New Hampshire Limited Partnership (Pheasant Wood
                         Facility)


     10.3(c)*            Facility Lease Agreement, dated as of January 1, 1996, between Meditrust of New
                         Hampshire Inc. and Harborside New Hampshire Limited Partnership (Crestwood Facility)


     10.3(d)*            Facility Lease Agreement, dated as of January 1, 1996, between Meditrust of New
                         Hampshire Inc. and Harborside New Hampshire Limited Partnership (Milford Facility)


     10.3(e)*            Facility Lease Agreement, dated as of January 1, 1996, between Meditrust of New
                         Hampshire Inc. and Harborside New Hampshire Limited Partnership (Applewood Facility)


     10.3(f)*            Facility Lease Agreement, dated as of December 31, 1996, between Meditrust of New
                         Hampshire Inc. and Harborside New Hampshire Limited Partnership (Northwood Facility)


     10.3(g)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of New Hampshire, Inc. and Harborside New Hampshire Limited Partnership
                         (Westwood Facility)


     10.3(h)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of New Hampshire, Inc. and Harborside New Hampshire Limited Partnership
                         (Pheasant Wood Facility)


     10.3(i)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of New Hampshire, Inc. and Harborside New Hampshire Limited Partnership
                         (Crestwood Facility)


     10.3(j)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of New Hampshire, Inc. and Harborside New Hampshire Limited Partnership
                         (Milford Facility)


     10.3(k)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of New Hampshire, Inc. and Harborside New Hampshire Limited Partnership
                         (Applewood Facility)


     10.3(l)*            First Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of New Hampshire, Inc. and Harborside New Hampshire Limited Partnership
                         (Northwood Facility)


     10.4(a)*            Facility Lease Agreement, dated as of March 31, 1995, between Meditrust of Ohio, Inc.
                         and Harborside of Toledo Limited Partnership (Swanton Facility)


     10.4(b)*            First Amendment to Facility Lease Agreement, dated as of December 31, 1995, by and
                         between Harborside Toledo Limited Partnership and Meditrust of Ohio, Inc. (Swanton
                         Facility)


     10.4(c)*            Second Amendment to Facility Lease Agreement, dated as of May 17, 1996, by and between
                         Meditrust of Ohio, Inc. and Harborside Toledo Limited Partnership (Swanton Facility)


     10.5*               Amended and Restated Agreement of Limited Partnership of Bowie Center Limited
                         Partnership, dated April 7, 1993


     10.6*               Agreement of Lease, dated March 16, 1993, between Bryan Nursing Home, Inc. and
                         Harborside of Ohio Limited Partnership (Defiance and Northwestern Ohio Facilities)


     10.7*               First Amendment to Agreement of Lease, dated June 1, 1993, by and between Bryan
                         Nursing Home, Inc. and Harborside Ohio Limited Partnership


     10.8*               Option to Purchase Agreement, dated March 16, 1993, by and between Bryan Nursing Home,
                         Inc. and Harborside Ohio Limited Partnership


     10.9(a)*            Lease, dated September 30, 1994, between Rockledge T. Limited Partnership and
                         Harborside of Florida Limited Partnership (Brevard Facility)


     10.9(b)*            Lease Guaranty, dated September 30, 1994, to Rockledge T. Limited Partnership from
                         Harborside Healthcare Limited Partnership


     10.9(c)*            Indemnity Agreement, dated September 30, 1994, between Rockledge T. Limited
                         Partnership, Harborside of Florida Limited Partnership, Harborside Healthcare Limited
                         Partnership and Southtrust Bank of Alabama


     10.9(d)*            Assignment and Security Agreement, dated September 30, 1994, to Rockledge T. Limited
                         Partnership, Harborside of Florida Limited Partnership and Southtrust Bank of Alabama`

# 69

`10.9(e)*            Subordination Agreement (Lease), dated September 30, 1994, between Rockledge T.
                         Limited Partnership, Harborside of Florida Limited Partnership and Southtrust Bank of
                         Alabama


     10.9(f)*            Subordination Agreement (Management), dated September 30, 1994, by and among Rockledge
                         T. Limited Partnership, Harborside of Florida Limited Partnership, Harborside
                         Healthcare Limited Partnership and Southtrust Bank of Alabama


     10.10(a)****+       Employment Agreement, dated as of August 11, 1998, between the Registrant and Stephen
                         L. Guillard


     10.10(b)****+       Employment Agreement, dated as of August 11, 1998, between the Registrant and Damian
                         Dell'Anno


     10.10(c)****+       Employment Agreement, dated as of August 11, 1998, between the Registrant and Bruce
                         Beardsley


     10.10(d)****+       Employment Agreement, dated as of August 11, 1998, between the Registrant and William
                         Stephan


     10.10(e)****+       Employment Agreement, dated as of August 11, 1998, between the Registrant and Steven
                         Raso


     10.11(a)****+       Management Stock Incentive Plan, established by the Registrant as of August 11, 1998


     10.11(b)****+       Form of Stock Option Agreement pursuant to Management Stock Incentive Plan


     10.11(c)+           Form of Restricted Stock Agreement pursuant to Management Stock Incentive Plan


     10.12(a)*+          1996 Long-Term Stock Incentive Plan


     10.12(b)*+          Form of Nonqualified Stock Option Agreement pursuant to the 1996 Long-Term Stock
                         Incentive Plan


     10.13****+          Form of Put/Call Agreement, dated August 11, 1998, between the Registrant and each of
                         Messrs. Guillard, Dell'Anno, Beardsley, Stephan and Raso


     10.14*+             Supplemental Executive Retirement Plan of the Registrant


     10.15*              Administrative Services Agreement, dated April 15, 1988, between the Registrant and
                         The Berkshire Companies Limited Partnership ("BCLP")


     10.16*              Agreement to Lease, dated as of May 3, 1996, among Westbay Manor Company,
                         Westbay Manor II Development Company, Royal View Manor Development Company,
                         Beachwood Care Center Limited Partnership, Royalview Manor Company, Harborside
                          Health I Corporation and Harborside Healthcare Limited Partnership

     10.17*              Guaranty by Harborside in favor of Westbay Manor Company, Westbay Manor II Development
                         Company, Royalview Manor Development Company and Beachwood Care Center Limited
                         Partnership


     10.18****           Master Rights Agreement, dated as of August 11, 1998, by and among the Registrant,
                         BCLP, certain affiliates of BCLP and the New Investors


     10.19 (a)****       Credit Agreement, dated as of August 11, 1998, among the Registrant, Chase Securities,
                         Inc., as Arranger, Morgan Stanley Senior Funding, Inc. and BT Alex. Brown
                         Incorporated, as Co-Arrangers, Bankers Trust Company, as Documentation Agent, Morgan
                         Stanley Senior Funding, Inc., as Syndication Agent, The Chase Manhattan Bank, as
                         Administrative Agent, and the lenders party thereto (the "Lenders")


     10.19 (b)           First Amendment to Credit Agreement, dated as of March 30, 1999, among the Registrant,
                         Morgan Stanley Senior Funding, Inc. and BT Alex. Brown Incorporated, as Co-Arrangers,
                         Bankers Trust Company, as Documentation Agent, Morgan Stanley Senior Funding Inc., as
                         Syndication Agent, The Chase Manhattan Bank, as Administrative Agent, and the Lenders


     10.19 (c)           SECOND AMENDMENT, dated as of September 25, 2000 to the       Credit Agreement, dated
                         as of August 11, 1998 among HARBORSIDE HEALTHCARE CORPORATION, a Delaware corporation,
                         the other entities listed on the signature pages thereof, as joint and several
                         borrowers thereunder, the banks and other financial institutions or entities parties
                         thereto, CHASE SECURITIES INC., as arranger, MORGAN STANLEY SENIOR FUNDING, INC. and
                         BT ALEX. BROWN INCORPORATED, as co-arrangers, MORGAN STANLEY SENIOR FUNDING, INC., as
                         syndication agent, BANKERS TRUST COMPANY, as documentation agent, and THE CHASE
                         MANHATTAN BANK, as administrative agent for the Lenders.


     10.19 (d)           THIRD AMENDMENT, dated as of March 28, 2001, to the Credit Agreement, dated as of
                         August 11, 1998 (as amended, supplemented or otherwise modified from time to time, the`

# 70

`"Credit Agreement"), among HARBORSIDE HEALTHCARE CORPORATION, a Delaware corporation
                         (the "Company"), the other entities listed on the signature pages thereof, as joint
                         and several borrowers thereunder (the Company and such other entities being,
                         collectively, the "Borrowers"), the banks and other financial institutions or entities
                         parties thereto (the "Lenders"), CHASE SECURITIES INC., as arranger, MORGAN STANLEY
                         SENIOR FUNDING, INC. and BT ALEX. BROWN INCORPORATED, as co-arrangers, MORGAN STANLEY
                         SENIOR FUNDING, INC., as syndication agent, BANKERS TRUST COMPANY, as documentation
                         agent, and THE CHASE MANHATTAN BANK, as administrative agent for the Lenders (in such
                         capacity, the "Administrative Agent")


     10.21****           HHC 1998-1 Trust Credit Agreement, $238,125,000 Credit Facility, dated as of August
                         11, 1998, among the Registrant, Chase Securities Inc., as Arranger, Morgan Stanley
                         Senior Funding, Inc. and BT Alex. Brown Incorporated, as Co-Arrangers, Bankers Trust
                         Company, as Documentation Agent, Morgan Stanley Senior Funding, Inc., as Syndication
                         Agent, The Chase Manhattan Bank, as Administrative Agent, and the lenders party thereto


     10.22****           Participation Agreement, dated as of August 11, 1998, among Harborside of Dayton
                         Limited Partnership, as Lessee, HHC 1998-1 Trust, as Lessor, Wilmington Trust Company,
                         BTD Harborside Inc., Morgan Stanley Senior Funding, Inc. and CSL Leasing, Inc., as
                         Investors, The Chase Manhattan Bank, as Agent, and the lenders party thereto


     10.23****           Lease, dated August 11, 1998, between HHC 1998-1 Trust, as Lessor, and Harborside of
                         Dayton Limited Partnership, as Lessee


     10.24****           Accounts Receivable Intercreditor Agreement (Leased Facilities), dated as of August
                         11, 1998, among (i) The Chase Manhattan Bank, as administrative agent, (ii) HHC 1998-1
                         Trust, (iii) CSL Leasing, Inc., BTD Harborside, Inc. and Morgan Stanley Senior
                         Funding, Inc. and (iv) Meditrust Company LLC


     10.25****           Accounts Receivable Intercreditor Agreement (Mortgaged Facilities), dated as of August
                         11, 1998, among (i) The Chase Manhattan Bank, as administrative agent, (ii) HHC 1998-1
                         Trust, (iii) CSL Leasing, Inc., BTD Harborside, Inc. and Morgan Stanley Senior
                         Funding, Inc. and (iv) Meditrust Mortgage Investments, Inc.


     10.27****           Agreement for Management Advisory, Strategic Planning and Consulting Services, dated
                         August 11, 1998, between the Registrant (as successor to MergerCo) and III


     10.28****           Second Amendment to Loan Agreement, Consent to Merger and Confirmation of Guaranties,
                         dated as of July 31, 1998, by and among Bay Tree Nursing Center Corp., Countryside
                         Cave Center Corp., Sunset Point Nursing Center Corp., West Bay Nursing Center Corp.,
                         Harborside Healthcare Limited Partnership, Harborside Healthcare Corporation and
                         Meditrust Mortgage Investments, Inc.


     10.29****           Omnibus Amendment to Facility Lease Agreements, Consent to Merger and Confirmation
                         of Guaranties, dated as of July 31, 1998, by and among Harborside New Hampshire
                         Limited Partnership, Harborside Toledo Limited Partnership, HHCI Limited Partnership,
                         Harborside Healthcare Limited Partnership, Harborside Healthcare Corporation and
                         Meditrust Company LLC

     10.30***            LEASE dated September 26, 2000, by and between, HHC BEACHWOOD, INC. as LANDLORD AND
                         HARBORSIDE OF CLEVELAND LIMITED PARTNERSHIP as TENANT

     10.31***            LEASE dated September 26, 2000, by and between, HHC BROADVIEW, INC. as LANDLORD AND
                         HARBORSIDE OF CLEVELAND LIMITED PARTNERSHIP as TENANT


     10.32***            LEASE dated September 26, 2000, by and between, HHC WESTBAY, INC. as LANDLORD AND
                         HARBORSIDE CLEVELAND LIMITED PARTNERSHIP as TENANT


     10.33*****          Series A Warrant Agreement, dated as of May 10, 2001, between the Registrant and
                         United States Trust Company of New York, as warrant agent

     10.34*****          Series B Warrant Agreement, dated as of May 10, 2001, between the Registrant and
                         United States Trust Company of New York, as warrant agent

     10.35*****          Warrant Registration Rights Agreement, dated as of May 10, 2001, by the Registrant
                         for the benefit of holders of Series A Warrants and Series B Warrants

     10.36*****          Preferred Stock Registration Rights Agreement, dated as of May 10, 2001, between the
                         Registrant and the investors listed on the signature pages thereto


     21.1                Subsidiaries of the Registrant`

# 71

`*                  Incorporated by reference to the Registrant's Registration Statement on Form S-1
                         (Registration No. 333-3096)


     **                  Incorporated by reference to the Registrant's Registration Statement on Form S-4
                         (Registration No. 333-51633)


     ***                 Incorporated by reference to the Registrants Quarterly Report on Form 10-Q
                         for the quarter ended September 30, 2000 (Registration No. 333-64679)

     ****                Incorporated by reference to the Registrant's Registration Statement on Form S-4
                         (Registration No. 333-64679)

     *****               Incorporated by reference to the Registrants Quarterly Report on Form 10-Q
                         for the quarter ended June 30, 2001 (Registration No. 333-64679)

      #                  Replaces previously filed exhibit


      +                  Management contract or compensation plan or arrangement required to be filed as an
                         exhibit.


    (b)                  Reports on Form 8-K:


                         None`

# 72

`SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on the 30th day of
March 2002.


                         HARBORSIDE HEALTHCARE
                         CORPORATION

                         By   /s/ Stephen L. Guillard
                              -----------------------
                              Chief Executive Officer and Director

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


/s/ Stephen L. Guillard        Chief Executive Officer and Director
-----------------------
                               (Principal Executive Officer)

/s/ Damian N. Dell'Anno        President and Director
-----------------------

/s/ William H. Stephan         Senior Vice President, Chief Financial Officer and Director
----------------------
                               (Principal Financial and Accounting Officer)

/s/ Christopher J. O'Brien     Director
--------------------------

/s/ Lars C. Haegg              Director
-----------------

/s/ James O. Egan              Director
-----------------

/s/ William C. McCollum        Director
-----------------------`

# 73

`Harborside Healthcare Corporation
                                                  One Beacon Street
                                                   Boston, MA 02210


March 30, 2002



Securities and Exchange Commission
450 Fifth Avenue, N.W.
Washington, D.C.  20549



Ladies and Gentlemen:

In accordance with Item
601(b)(4)(iii) of Regulation S-K, Harborside Healthcare Corporation (the
Company) has not filed herewith any instrument with respect to long
term debt not being registered where the total number of securities authorized
thereunder does not exceed ten percent (10%) of the total assets of the Company
and its subsidiaries on a consolidated basis. The Company hereby agrees to
furnish a copy of any such agreement to the Securities and Exchange Commission
upon request.

                                           Very truly yours,

                                           HARBORSIDE HEALTHCARE CORPORATION

                                           By: /s/ William H.Stephan
                                               ----------------------
                                               Chief Financial Officer`

# 74

`Exhibit 21.1

Subsidiaries of Harborside Healthcare Corporation as of December 31, 2001:

                                                 Jurisdiction of
                                                 Incorporation or
        Name                                     Organization              Doing Business As
        -----                                    ------------              -----------------


1.    Bay Tree Nursing Center Corp.              Massachusetts

2.    Belmont Nursing Center Corp.               Massachusetts             Harborside Healthcare - Perrysburg

3.    Bowie Center Limited Partnership           Maryland                  Larkin Chase Nursing and Restorative Center

4.    Countryside Care Center Corp.              Massachusetts             Harborside Healthcare -Terre Haute

5.    Harborside of Cleveland
       Limited Partnership                       Massachusetts             Harborside Healthcare - Beachwood
                                                                           Rehabilitation and Nursing Center
                                                                           Harborside Healthcare - Broadview Heights
                                                                           Rehabilitation and Nursing
                                                                           Center
                                                                           Harborside Healthcare - Westlake I
                                                                           Rehabilitation and Nursing Center
                                                                           Harborside Healthcare - Westlake II
                                                                           Rehabilitation and Nursing Center

6.   Huntington Place Limited Partnership        Florida                   Huntington Place Rehabilitation and
     (f/k/a Harborside Florida Limited                                     Nursing Center
     Partnership)

7.    Harborside of Ohio Limited Partnership     Massachusetts             Harborside Healthcare - Northwest Ohio
                                                                           Harborside Healthcare - Defiance

8.    Harborside Funding Limited Partnership     Massachusetts

9.    Harborside Health I Corporation            Delaware                  Harborside Nursing Homes, Inc.

10.  Harborside Healthcare Advisors              Massachusetts
       Limited Partnership

11.  Harborside Healthcare Limited               Massachusetts             Allicor
       Partnership                                                         Harborside Healthcare Management
                                                                           Limited Partnership
12.  Harborside Healthcare Network               Florida
       Limited Partnership

13.  Harborside Homecare Limited                 Massachusetts             Behavioral Health Care
       Partnership`

# 75

`14.  Harborside New Hampshire                    Massachusetts             Harborside Nursing Facilities Limited
       Limited Partnership                                                 Partnership
                                                                           Harborside Healthcare - Applewood
                                                                           Rehabilitation and Nursing Center
                                                                           Harborside Healthcare - Crestwood
                                                                           Rehabilitation and Nursing Center
                                                                           Harborside Healthcare - Milford
                                                                           Rehabilitation and Nursing Center
                                                                           Harborside Healthcare - Northwood
                                                                           Rehabilitation and Nursing Center
                                                                           Harborside Healthcare - Pheasantwood
                                                                           Rehabilitation and Nursing Center
                                                                           Harborside Healthcare - Westwood
                                                                           Rehabilitation and Nursing Center

15.  Harborside Rehabilitation Limited           Massachusetts             Theracor Rehabilitation Services
       Partnership                                                         Ready Nurse

16.  Harborside Toledo Corporation               Massachusetts

17.  Harborside Toledo Limited Partnership       Massachusetts             Harborside Healthcare - Swanton

18.  HHCI Limited Partnership                    Massachusetts             Harborside Healthcare - New Haven
                                                                           Harborside Healthcare - Woods Edge
                                                                           Harborside Healthcare - Indianapolis
                                                                           Harborside Healthcare - Troy

19.  KHI Corporation                             Delaware

20.  Maryland Harborside Corp.                   Massachusetts

21.  Oakhurst Manor Nursing Center               Massachusetts
       Corp.

22.  Orchard Ridge Nursing Center                Massachusetts
       Corp.

23.  Riverside Retirement Limited Partnership    Massachusetts             Harborside Healthcare - Decatur

24.  Sunset Point Nursing Center Corp.           Massachusetts

25.  West Bay Nursing Center Corp.               Massachusetts

26.  Harborside Healthcare Baltimore Limited
       Partnership                               Massachusetts             Harborside Healthcare - Harford Gardens

27.  Harborside Massachusetts
       Limited Partnership                       Massachusetts             Harborside Healthcare - North Shore
                                                                           Harborside Healthcare - Maplewood
                                                                           Harborside Healthcare - Cedar Glen
                                                                           Harborside Healthcare - Danvers
28.  Harborside of Dayton
       Limited Partnership                       Massachusetts             Harborside Healthcare - Laurelwood
                                                                           Harborside Healthcare - New Lebanon
                                                                           Harborside Healthcare - Dayton`

# 76

`29.  Harborside Connecticut
       Limited Partnership                       Massachusetts             Harborside Healthcare - Arden House
                                                                           Harborside Healthcare - Governor's House
                                                                           Harborside Healthcare - Willows
                                                                           Harborside Healthcare - Madison House
                                                                           Harborside Healthcare - Reservoir

30.  Harborside Rhode Island
     Limited Partnership                         Massachusetts             Harborside Healthcare - Greenwood
                                                                           Harborside Healthcare - Pawtuxet Village

31.  Harborside North Toledo
     Limited Partnership                         Massachusetts             Harborside Healthcare - Sylvania
                                                                           Harborside Healthcare - Point Place

32.  Harborside Danbury
     Limited Partnership                         Massachusetts             Harborside Healthcare - Glen Hill
                                                                           Harborside - Glen Crest

33.  Harborside Acquisition
     Limited Partnership V                       Massachusetts

34.  Harborside Acquisition
     Limited Partnership VI                      Massachusetts

35.  Harborside Acquisition
     Limited Partnership VII                     Massachusetts

36.  Harborside Acquisition
     Limited Partnership VIII                    Massachusetts

37.  Harborside Acquisition
     Limited Partnership IX                      Massachusetts

38.  Harborside Acquisition
     Limited Partnership X                       Massachusetts

39.  Sailors, Inc.                               Delaware

40.  New Jersey Harborside Corp.                 Massachusetts

41.  Bridgewater Assisted Living                 New Jersey

42.  Harborside Healthcare Management, LLC       Delaware


43.  Harborside Administrative Services, LLC     Delaware                  Harborside Healthcare

44.  Florida Administrative Services, LLC        Delaware                  Compass Healthcare Services

45.  Florida Holdings I, LLC                     Delaware

46.  Florida Holdings II, LLC                    Delaware

47.  Florida Holdings III, LLC                   Delaware

48.  1775 Huntington Lane, LLC                   Delaware`

# 77

`49.  2600 Highlands Boulevard North, LLC         Delaware                  Bay Tree Rehabilitation and Nursing Center


50.  2900 Twelfth Street North, LLC              Delaware                  Lakeside Pavilion Rehabilitation and
                                                                           Nursing Center

51.  1501 SE 24th Road, LLC                      Delaware                  Oakhurst Rehabilitation and
                                                                           Nursing Center

52.  4927 Voorhees Road, LLC                     Delaware                  Orchard Ridge Rehabilitation and
                                                                           Nursing Center

53.  1240 Pinebrook Road, LLC                    Delaware                  Pinebrook Rehabilitation and
                                                                           Nursing Center


54.  4602 Northgate Court, LLC                   Delaware                  Springwood Rehabilitation and
                                                                           Nursing Center

55.  1980 Sunset Point Road, LLC                 Delaware                  Sunset Point Rehabilitation and
                                                                           Nursing Center


56.  3865 Tampa Road North, LLC                  Delaware                  West Bay Rehabilitation and Nursing Center


57.  Massachusetts Holdings I, LLC               Delaware

58.  Ohio Holdings I, LLC                        Delaware

59.  Marietta Healthcare, LLC                    Delaware                  Marietta Nursing and Rehabilitation Center

60.  Mashpee Healthcare, LLC                     Delaware                  Harborside Healthcare - Mashpee

61.  Wakefield Healthcare, LLC                   Delaware                  Harborside Healthcare - Wakefield

62.  Falmouth Healthcare, LLC                    Delaware                  Harborside Healthcare - Falmouth

63.  Westfield Healthcare, LLC                   Delaware                  Harborside Healthcare - Westfield`

# 78