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 March 31, 2010; or





[_]      Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934





Commission File Number 0-23511


INTEGRATED HEALTHCARE HOLDINGS, INC.


(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)





Nevada
87-0573331(STATE OF INCORPORATION)
(I.R.S. EMPLOYER IDENTIFICATION NO.)





1301 North Tustin Avenue, Santa Ana, California
92705(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(ZIP CODE)





Registrant's telephone number, including area code: (714) 953-3503





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





Securities registered pursuant to Section 12(g) of the Act:





Common Stock, $.001 par value


(TITLE OF CLASS)





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





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





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 [_]





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [_] No [_]





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





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





Large accelerated filer [_]
Accelerated filer [_]
Non-accelerated filer [_]
Smaller reporting company [X]





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





The aggregate market value of voting stock held by non-affiliates of the registrant was $1,386,810 as of September 30, 2009 (computed by reference to the last sale price of a share of the registrant's common stock on that date as reported by the Over the Counter Bulletin Board). For purposes of this computation, it has been assumed that the shares beneficially held by directors and officers of registrant were "held by affiliates"; this assumption is not to be deemed to be an admission by such persons that they are affiliates of registrant.





There were 255,307,262 shares outstanding of the registrant's common stock as of June 15, 2010.





DOCUMENTS INCORPORATED BY REFERENCE:





No portions of other documents are incorporated by reference into this Annual Report.








INTEGRATED HEALTHCARE HOLDINGS, INC.





FORM 10-K





ANNUAL REPORT FOR THE YEAR ENDED MARCH 31, 2010





TABLE OF CONTENTS





PART I
3ITEM 1. BUSINESS
3ITEM 1A. RISK FACTORS
17ITEM 2. PROPERTIES
22ITEM 3. LEGAL PROCEEDINGS
23ITEM 4. REMOVED AND RESERVED
26PART II
27ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
27ITEM 6. SELECTED FINANCIAL DATA
28ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
28ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
39ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
40ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
40ITEM 9A(T). CONTROLS AND PROCEDURES
40ITEM 9B. OTHER INFORMATION
41PART III
42ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
42ITEM 11. EXECUTIVE COMPENSATION
46ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
49ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
51ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
54ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
55SIGNATURES
57








2








PART I





FORWARD-LOOKING INFORMATION





This Annual Report on Form 10-K contains forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks discussed under the caption "Risk Factors" herein that may cause our Company's or our industry's actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by these forward-looking statements.




Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Except as may be required by applicable law, we do not intend to update any of the forward-looking statements to conform these statements to actual results.




As used in this report, the terms "we," "us," "our," "the Company," "Integrated Healthcare Holdings" or "IHHI" mean Integrated Healthcare Holdings, Inc., a Nevada corporation, unless otherwise indicated.





ITEM 1. BUSINESS





BACKGROUND





Integrated Healthcare Holdings, Inc. is a predominantly physician owned company that, on March 8, 2005, acquired and began operating the following four hospital facilities in Orange County, California (referred to as the "Hospitals"):





·
282-bed Western Medical Center in Santa Ana


·
188-bed Western Medical Center in Anaheim


·
178-bed Coastal Communities Hospital in Santa Ana


·
114-bed Chapman Medical Center in Orange





Together we believe that the Hospitals currently represent approximately 12.1% of all hospital available beds in Orange County, California (based on the most recent data on the Office of Statewide Health Planning and Development for California website as of September 22, 2009).




Prior to March 8, 2005, we were primarily a development stage company with no material operations. On November 18, 2003, members of our former executive management purchased a controlling interest in the Company and redirected its focus towards acquiring and operating hospitals and healthcare facilities that are financially distressed and/or underperforming. On September 29, 2004, the Company entered into a definitive agreement to acquire the four Hospitals from subsidiaries of Tenet Healthcare Corporation ("Tenet"), and the transaction closed on March 8, 2005.




The transaction included operations of four licensed general acute care hospitals with a total of 762 beds. All four hospitals are accredited by the Joint Commission on Accreditation of Healthcare Organizations and other appropriate accreditation agencies that accredit specific programs. All properties are in Orange County California, and operate as described below.




WESTERN MEDICAL CENTER - SANTA ANA. Western Medical Center - Santa Ana, located at 1001 North Tustin Avenue, Santa Ana, CA 92705, is Orange County's first hospital, founded over 100 years ago. The hospital is one of IHHI's two hospitals in Santa Ana, which are the only two general acute care hospitals in this city of 350,000 people. The hospital has 282 beds and provides quaternary, tertiary and secondary services. It serves the entire county as one of only three designated trauma centers in Orange County along with other tertiary services such as burn center, kidney transplantation, emergency and scheduled neurosurgical care, cardiac surgical services, a paramedic base station and receiving center. The hospital also maintains Intensive Care Units for adults and pediatrics, and a Neonatal Intensive Care Unit. Additionally the hospital offers telemetry, neurosurgical definitive observation, geriatric, medical, surgical, pediatric and obstetric inpatient services. Supporting these services the hospital offers operating and recovery rooms, radiology services, respiratory therapy services, clinical laboratories, pharmacy, physical and occupational therapy services on an inpatient and most on an outpatient basis. The hospital has approximately 140 active physicians and 465 employee nurses, and hospital staff.




3




WESTERN MEDICAL CENTER - ANAHEIM. Western Medical Center - Anaheim, located at 1025 South Anaheim Boulevard, Anaheim, CA 92805, offers a full range of acute medical and psychiatric care services serving northern Orange County and providing tertiary services to Riverside County residents. The hospital offers special expertise in the tertiary services of The Heart and Vascular Institute, and Behavioral Health Services. Additionally, the hospital provides the Women and Children Health Services, and 24-hour Emergency Services. Supporting these services the hospital offers critical care, medical, surgical and psychiatric services supported by operating and recovery rooms, radiology services, respiratory therapy services, clinical laboratories, pharmacy, physical and occupational therapy services on an inpatient and most on an outpatient basis. The hospital has approximately 75 active physicians and 255 employee nurses, and hospital staff.




COASTAL COMMUNITIES HOSPITAL - SANTA ANA. Coastal Communities Hospital, located in Santa Ana at 2701 South Bristol Street, Santa Ana, CA 92704, has served the community for more than 30 years, providing comprehensive medical and surgical services in a caring and compassionate environment. The hospital is one of IHHI's two hospitals in Santa Ana, which are the only two general acute care hospitals in this city of 350,000 people. The hospital has tailored its services to meet the changing needs of the community. The hospital's staff reflects the cultural diversity of the community and is particularly responsive and sensitive to diverse healthcare needs. While services continue to expand, the 178-bed facility is small enough to retain the family atmosphere associated with a community hospital. The hospital offers critical care, medical, surgical obstetric, psychiatric and sub acute services supported by operating and recovery rooms, radiology services, respiratory therapy services, clinical laboratories, pharmacy, physical and occupational therapy services on an inpatient and most on an outpatient basis. The hospital has approximately 55 active physicians and 215 employee nurses, and hospital staff.




CHAPMAN MEDICAL CENTER - ORANGE. Founded in 1969, Chapman Medical Center is a 114-bed acute care facility located at 2601 East Chapman Avenue, Orange, CA 92869. The hospital's advanced capabilities position the facility as a leader in specialty niche programs, including the following centers: Chapman Center for Obesity (surgical weight loss program); Center for Heartburn and Swallowing; Chapman Lung Center; Chapman Family Health Center; Doheny Eye Center; House Ear Clinic; Center for Senior Mental Health; and Positive Action Center (Adult and Adolescent Chemical Dependency Program). Supporting these services the hospital offers critical care, medical, surgical and geriatric psychiatric services supported by operating and recovery rooms, radiology services, respiratory therapy services, clinical laboratories, pharmacy, physical and occupational therapy services on an inpatient and most on an outpatient basis. The hospital has approximately 35 active physicians and 120 employee nurses, and hospital staff.




On March 8, 2005, the Company assumed management responsibility and control over the Hospitals. All primary systems and controls have been successfully transitioned to our Company for the effective management of the Hospitals.




EMPLOYEES AND MEDICAL STAFF





At March 31, 2010, the Company had approximately 3,255 employees. Of these employees, approximately 1,180 are represented by two labor unions, the California Nurses Association ("CNA") and Service Employee International Union -United Healthcare Workers ("SEIU"), who are covered by collective bargaining agreements. We believe that our relations with our employees are good. The Company also had approximately 100 individuals from contracting agencies at March 31, 2010, consisting primarily of nursing staff.




Our hospitals are fully staffed by physicians and other independently practicing medical professionals licensed by the state, who have been admitted to the medical staff of the individual hospital. Under state laws and licensing standards, hospitals' medical staffs are self-governing organizations subject to ultimate oversight by the hospital's local governing board. None of these physicians are employees of the hospitals. Physicians are not limited to medical staff membership at our hospitals, and many are on staff at our other hospitals, or hospitals not owned or operated by us. Physicians on our medical staffs are free to terminate their membership on our medical staffs and admit their patients to other hospitals, owned, or not owned by us. Non-physician staff, including nurses, therapists, technicians, finance, registration, maintenance, clerical, housekeeping, and administrative staff are generally employees of the hospital, unless the service is provided by a third party contracted entity. We are subject to federal minimum wage and hour laws and various state labor laws and maintain an employee benefit plan.




Our hospitals' operations depend on the abilities, efforts, experience and loyalty of our employees and physicians, most of who have no long-term contractual relationship. Our ongoing business relies on our attraction of skilled, quality employees, physicians and other healthcare professionals in all disciplines.




We strive to successfully attract and retain key employees, physicians and healthcare professionals. Our operations, financial position and cash flows could be materially adversely affected by the loss of key employees or sufficient numbers of qualified physicians and other healthcare professionals. The relations we have with our employees, physicians, and other healthcare professionals are key to our success and they are a priority in our management philosophy.




Nursing can have a significant effect on our labor costs. The national nursing shortage continues and is serious in California. The result has been an increase in the cost of nursing personnel, thus affecting our labor expenses. Recently, there has been some lessening in the need for contract agency nurses following the recession as nurses return to the work force. There is still no basis to predict the longevity of this effect. Additionally, California instituted mandatory nurse staffing ratios, thus setting a high level of nurses to patients, but also requiring nursing staff ratios be maintained at all times even when on breaks or lunch. These requirements in the environment of a severe nursing shortage may cause the limiting of patient admissions with an adverse effect on our revenues. The vast majority of hospitals in California, including ours, are not at all times meeting the state mandated nurse staffing ratios. Our plan is to improve compliance and reduce the cost of contract labor needed to achieve the nurse staffing ratios.






4




COMPETITION





Hospital competition is a community issue and unique to each facility. The first factor is the services the hospital offers and the other hospitals in the area offering the same or similar service. The hospital is dependent on the physicians to admit the patients to the hospital. The number of physicians around the hospital, their specialties, and the quality of medicine they practice will have a major impact on the hospital competition. The ability of the hospital to employ and retain qualified nurses, other healthcare professionals, and administrative staff will affect the hospitals' competitiveness in the market place. A hospital's reputation and years of service to the community affects its competitiveness with patients, physicians, employees, and contracting health plans. Southern California is a highly competitive managed healthcare market therefore the contracting relationships with managed care organizations is a key factor in a hospital's competitiveness. The hospital's location, the community immediately surrounding it and the access to the hospital will affect the hospital's competitiveness. Other hospitals or healthcare organizations serving the same locations determine the intensity of the competition. The condition of the physical plant and the ability to invest in new equipment and technology can affect the communities and physicians desire to use the facility. The amount the hospital charges for services is also a factor in the hospital's competitiveness. The funding sources of the competition can also be a factor if a competitor is tax exempt; it has advantages not available to our Hospitals, such as endowments, charitable contributions, tax-exempt financing, and exemptions from taxes.




Finally, laws and regulations governing antitrust, anti-kickback, physician referrals and other applicable regulations, such as requirements imposed on physician-owned hospitals, impact a hospital's ability to compete. Since these factors are individual to each hospital, and are subject to change, each hospital must develop its own strategies, to address the competitive factors in its local.





OUR STRATEGY




Our goal is to provide high quality healthcare services in a community setting that are responsive to the needs of the communities that we serve. To accomplish our mission in the complex and competitive healthcare industry, our operating strategies are to (1) improve the quality of care provided at our hospitals by identifying best practices and implementing those best practices, (2) improve operating efficiencies and reduce operating costs while maintaining or improving the quality of care provided, (3) improve patient, physician and employee satisfaction, and (4) improve recruitment and retention of nurses and other employees. We continue to integrate and efficiently operate the four Hospitals in order to achieve profitability from operations. We may also seek additional acquisitions of hospitals or health facilities in the future when opportunities for profitable growth arise.





HEALTHCARE REGULATION





CERTAIN BACKGROUND INFORMATION. Health care, as one of the largest industries in the United States, continues to attract much legislative interest and public attention. Changes in the Medicare and Medicaid programs and other government healthcare programs, hospital cost containment initiatives by public and private payers, proposals to limit payments and healthcare spending, and industry wide competitive factors greatly impact the healthcare industry. The industry is also subject to extensive federal, state and local regulation relating to licensure, conduct of operations, ownership of facilities, physician relationships, addition of facilities and services, and charges and effective reimbursement rates for services. The laws, rules and regulations governing the healthcare industry are extremely complex, and the industry often has little or no regulatory or judicial interpretation for guidance. Compliance with such regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of our business. Failure to comply with current or future regulatory requirements could also result in the imposition of various civil and criminal sanctions including fines, restrictions on admission, denial of payment for all or new admissions, the revocation of licensure, decertification, imposition of temporary management or the closure of a facility.
 
 In March 2010, the U.S. Congress adopted and President Obama signed into law comprehensive health care reform legislation through the passage of the Patient Protection and Affordable Care Act (H.R. 3590) and the Health Care and Education Reconciliation Act (H.R. 4872) (collectively, the “PPACA”), which became effective on March 23, 2010. We are analyzing the PPACA and will continue to do so to assess the effects of the legislation on current and projected operations, financial performance and financial condition.  However, we cannot predict with certainty or reliability any interim or ultimate effects of the new legislation.
 
 Some of the specific provisions of the PPACA that may affect our hospitals’ operations, financial performance or financial condition are described below.  This listing is not, nor intended to be, comprehensive.
 
 ·
With varying effective dates, the annual Medicare market basket updates for many providers, including hospitals, will be reduced, and adjustments to payment for expected productivity gains will be implemented.


5




·
Commencing in federal fiscal year 2014, Medicare disproportionate share hospital (“DSH”) payments will be reduced initially by 75% and increased thereafter to account for the national rate of consumers who do not have healthcare insurance and are provided uncompensated care.  Commencing in 2014, a state’s Medicaid DSH allotment from federal funds will also be reduced.
  ·
Expansion of Medicaid programs to a broader population with incomes up to 133% of federal poverty levels.
  ·
Commencing in federal fiscal year 2012, Medicare payments that would otherwise be made to hospitals will be reduced by specified percentages to account for excess and “preventable” hospital readmissions.
  ·
Commencing in federal fiscal year 2015, Medicare payments to certain hospitals for hospital-acquired conditions will be reduced by 1%.  Commencing in federal fiscal year 2011, federal payments to states for Medicaid services related to hospital-acquired conditions will be prohibited.
  ·
Effective in 2012, a value-based purchasing program will be established under the Medicare program designed to pay hospitals based on performance on quality measures.
  ·
With varying effective dates, a mandated reduction of waste, fraud, and abuse in public programs by allowing provider enrollment screening, enhanced oversight periods for new providers and suppliers, and enrollment moratoria in areas identified as being at elevated risk of fraud in all public programs, and by requiring Medicare and Medicaid program providers and suppliers to establish compliance programs.  The PPACA requires the development of a database to capture and share healthcare provider data across federal healthcare programs and provides for increased penalties for fraud and abuse violations, and increased funding for anti-fraud activities.
  ·
The establishment of an Independent Payment Advisory Board to develop legislative proposals to improve the quality of care and limit cost increases.  Starting in 2014, these proposals will be automatically implemented if Congress does not act to invalidate them and substitute its own recommendation.
  The PPACA also provides for the implementation of various demonstration programs and pilot projects to test, evaluate, encourage and expand new payment structures and methodologies to reduce health care expenditures while maintaining or improving quality of care, including bundled payments under Medicare and Medicaid, and comparative effectiveness research programs that compare the clinical effectiveness of medical treatments and develop recommendations concerning practice guidelines and coverage determinations.  Other provisions encourage the creation of new health care delivery programs, such as accountable care organizations, or combinations of provider organizations, that voluntarily meet quality thresholds to share in the cost savings they achieve for the Medicare program.  The outcomes of these projects and programs, including their effect on payments to providers and financial performance, cannot be predicted.
  As a result of PPACA’s passage, the health care industry will be subjected to significant new statutory and regulatory requirements and consequently to structural and operation changes and challenges for a substantial period of time.  We will continue to assess the effect of the PPACA and additional legislation on current and projected operations, financial performance and financial condition.
  It is also reasonable to predict that all payers will continue to seek sizable reductions from hospitals and other providers. Through this time of flux, our Hospitals will continue to be largely dependent upon private and governmental third party sources of payment for the services provided to patients in the Hospitals. The amount of payment a hospital receives for the various services it renders will be affected by market and cost factors, as well as other factors over which we have no control, including the significant political concerns described above. Although we anticipate ongoing pressure to accept reduced payment amounts, and any meaningful reduction in the amounts paid by these third party payers for services rendered at the Hospitals will have a material adverse effect on our revenues.




MEDICARE
 
 GENERALLY. Each of the Hospitals participates in the Medicare program. Health care providers continue to be affected significantly by changes occurring in laws and regulations pertaining to Medicare. These changes are designed to reduce the rate of increase in Medicare payments and to make such payments more accurately reflect patient resource use at hospitals. In addition, important amendments to the Medicare law were made by the Deficit Reduction Act of 2005 (“DRA”) and the PPACA.





6




INPATIENT OPERATING COSTS. Medicare pays the Hospitals, for most services to inpatients under a system known as the Prospective Payment System ("PPS") where hospitals are paid for services based on predetermined rates. Medicare payments under PPS are based on the Diagnosis Related Group ("DRG") to which each Medicare patient is assigned. The DRG is determined by the patient's primary diagnosis and other factors for each particular Medicare inpatient stay. The amount to be paid for each DRG is established prospectively by the Centers for Medicare and Medicaid Services ("CMS"). The DRG amounts are not related to a hospital's actual costs or variations in service or length of stay. Therefore, if a hospital incurs costs in treating Medicare inpatients that exceed the DRG level of reimbursement plus any outlier payments, then that hospital will experience a loss from such services, which will have to be made up from other revenue sources. Payment limitations implemented by other third party payers may restrict the ability of a hospital to engage in such "cost-shifting." In 2008, CMS replaced the existing 538 DRGs with 745 new severity-adjusted diagnosis related groups (“Medicare Severity DRGs” or “MS-DRGs”). The new MS-DRGs are intended to more accurately reflect the cost of providing inpatient services and eliminate any incentives that hospitals may have to only treat the healthiest and most profitable patients. CMS anticipates that the conversion to MS-DRGs will result in an increase in payments to hospitals that serve more severely ill patients and a decrease to hospitals that serve patients who are less severely ill.





For certain Medicare beneficiaries who have unusually costly hospital stays (“outliers”), CMS will provide additional payments above those specified for the DRG. Outlier payments cease to be available upon the exhaustion of such patient’s Medicare benefits or a determination that acute care is no longer necessary, whichever occurs first. There is no assurance that any of these payments will cover the actual costs incurred by a hospital. In addition, recent revisions to the outlier regulations, implemented in order to curb outlier payment abuse, may adversely affect hospitals’ ability to receive such subsidies. In addition to outlier payments, DRG payments are adjusted for area wage differentials. These change on a yearly basis.





The DRG rates are adjusted by an update factor on October 1 of each year. The index used to adjust the DRG rates, known as the “market basket index,” takes into consideration the inflation experienced by hospitals in purchasing goods and services. DRG payment rates were increased by the full market basket index, for fiscal years 2007, 2008, 2009 and 2010 or 3.4%, 3.3%, 3.6% and 2.1%, respectively. Generally, however, the percentage increases in the DRG payments have been lower than the projected increase in the cost of goods and services purchased by hospitals. There is no assurance that in the future the Hospitals will be paid amounts that will reflect adequately changes in the cost of providing health care or in the cost of health care technology being made available to patients.




The DRA imposes a two percentage point reduction to the market basket index beginning October 1, 2007, and each year thereafter, if patient quality data is not submitted. CMS added new quality measures that hospitals must report during calendar year 2010 in order to qualify for the full market basket update in federal fiscal year 2011. The Hospitals are complying with the quality data submission requirements. PPACA establishes a value based purchasing program (“VBP”) for hospitals under the Medicare Inpatient Prospective Payment System (“IPPS”) to be effective in 2013. Under the VBP, a percentage of the payments to hospitals will be tied to a hospital’s performance on a number of quality measures selected by CMS, relating to at least the following conditions or procedures for 2013: acute myocardial infection, heart failure, pneumonia, surgeries, and healthcare associated infections. Where a hospital meets or exceeds the performance standard for the performance period, the base operating DRG payment amount is increased by a percentage for the fiscal year subsequent to the performance period. Where a hospital falls below the performance standard for the performance period, the base operating DRG payment amounts is decreased by a percentage for the fiscal year subsequent to the performance period. The amount of the payment increase percentage is to be determined by the total amount of payment decreases for all hospitals as the law requires the cost of paying for the increase in payment for those hospitals that exceed the performance standard to be offset by the reduction in payment for those that fall below the performance standard in a cost-neutral manner. The applicable payment decrease percentage is set forth in the law as 1% beginning in 2013, increasing 0.24% each year through 2017, to a maximum of 2%.





PPACA will reduce the annual Medicare market basket updates through September 30, 2019. Beginning on October 1, 2011, PPACA also provides that annual Medicare market basket updates will be subject to productivity adjustments. The reductions in market basket updates and the productivity adjustments will have a disproportionately negative effect upon those providers that are relatively more dependent upon Medicare than other providers. Additionally, the reductions in market basket updates will be effective prior to the periods during which insurance coverage and the insured consumer base will expand, which may have an interim negative effect on revenues. The combination of reductions to the market basket updates and the imposition of the productivity adjustments may, in some cases and in some years, result in reductions in Medicare payment per discharge on a year-to-year basis.





CMS has also implemented a documentation and coding adjustment to account for changes in payments under the new Medicare Severity Diagnosis Related Group, or MS-DRG, system that are not related to changes in case mix. The documentation and coding adjustments for federal fiscal years 2008 and 2009 were reductions to the base payment rate of 0.6% and 0.9% respectively. CMS was given the authority to retrospectively determine if the documentation and coding adjustments for these years were adequate to account for changes in payments not related to changes in case mix.




7





OUTPATIENT SERVICES. Hospital outpatient services, including hospital operating and capital costs, are reimbursed on a PPS basis. Several Medicare Part B services are specifically excluded from this rule, including certain physician and non-physician practitioner services, ambulance, clinical diagnostic laboratory services and non-implantable orthotics and prosthetics, physical and occupational therapy, and speech language pathology services. All services paid under the outpatient PPS are classified into groups called Ambulatory Payment Classifications or "APCs." Services in each APC are similar clinically and in terms of the resources they require. Using hospital outpatient claims data from the most recent available hospital cost reports, CMS determines the median costs for the services and procedures in each APC group, and a payment rate is established for each APC. Depending on the services provided, hospitals may be paid for more than one APC for an encounter. CMS will make additional payment adjustments under Outpatient PPS (“OPPS”), including "outlier" payments for services where the hospital's cost exceeds 2.5 times the APC rate for that service. In addition, certain other changes have reduced coinsurance payments below what they would have originally been under outpatient PPS.




OPPS rates are adjusted annually based on the hospital inpatient market basket percentage increase. CMS has authorized a 2.1% increase for calendar year 2010 as the APC market basket adjustment. There can be no assurance that the hospital OPPS rate, which bases payment on APC groups rather than on individual services, will be sufficient to cover the actual costs of the Hospitals allocable to Medicare patient care. Hospitals that fail to report data related to seven required quality measures will have their market basket percentage increase reduced by two percentage points. In addition to the APC rate, there is a predetermined beneficiary coinsurance amount for each APC group. There can be no assurance that the beneficiary will pay this amount.





MEDICARE BAD DEBT. Medicare beneficiaries have a coinsurance payment and annual deductible for most inpatient and outpatient hospital services. Hospitals must first seek payment of any such coinsurance and deductible amounts from the Medicare beneficiary. If, after reasonable collection efforts, a hospital is unable to collect these coinsurance and deductible amounts, Medicare currently reimburses hospitals 70 percent of the uncollected coinsurance and deductible amount (known as "Medicare bad debt"). The amounts uncollectible from specific beneficiaries are to be charged off as bad debts in the accounting period in which the accounts are deemed to be worthless. Amounts incurred by a hospital as reimbursement for bad debts are subject to audit and recoupment by the fiscal intermediary. Bad debt reimbursement has been a focus of audit/recoupment efforts in the past.




MEDICARE CONDITIONS OF PARTICIPATION. Hospitals must comply with provisions called "Conditions of Participation" in order to be eligible for Medicare reimbursement. CMS is responsible for ensuring that hospitals meet these regulatory Conditions of Participation. Under the Medicare rules, hospitals accredited by the Joint Commission on Accreditation of Healthcare Organizations ("JCAHO") are deemed to meet the Conditions of Participation. The Hospitals are each currently accredited by JCAHO and are therefore deemed to meet the Conditions of Participation.




MEDICARE AUDITS. Medicare participating hospitals are subject to audits and retroactive audit adjustments with respect to reimbursement claimed under the Medicare program. Medicare regulations also provide for withholding Medicare payments in certain circumstances. Any such withholding with respect to the Hospitals could have a material adverse effect on the Company. In addition, contracts between hospitals and third party payers often have contractual audit, setoff and withhold language that may cause substantial, retroactive adjustments. Medicare requires certain financial information be reported on a periodic basis, and with respect to certain types of classifications of information, penalties are imposed for inaccurate reports. In addition, the Medicare Modernization Act of 2003 (“MMA”) established the Recovery Audit Contractor ("RAC") program to intensify its audit efforts. The RAC audits have already subjected those hospitals who have been audited to significant repayments. As the requirements governing audits, including the RAC audits, are numerous, technical and complex, there can be no assurance that the Company will avoid incurring such penalties. Such penalties could materially and adversely affect the Company.




MEDICARE MANAGED CARE. The Medicare program allows various managed care plans, now known as Medicare Advantage Plans, offered by private companies to engage in direct managed care risk contracting with the Medicare program. Under the Medicare Advantage program, these private companies agree to accept a fixed, per beneficiary payment from the Medicare program to cover all care that the beneficiary may require. Health care providers such as the Corporation must contract with Medicare Advantage plans to treat Medicare Advantage enrollees at agreed upon rates. Covered inpatient and emergency services rendered to a Medicare Advantage beneficiary by a hospital that is an out-of-plan provider (i.e., that has not entered into a contract with a Medicare Advantage plan) will be paid at Medicare fee-for-service payment rates as payment in full.





The MMA made several substantive changes to Medicare Advantage in addition to renaming the program. These changes are designed to improve Medicare Advantage by providing increased payments to providers and by offering more health plan choices, including expanded rural coverage through the inclusion of regional plans. There can be no assurance, however, that rates negotiated for the treatment of Medicare Advantage enrollees will be sufficient to cover the cost of providing services to such patients of the Corporation.




The PPACA provides that from October 1, 2010 through September 30, 2019, payments under the Medicare Advantage programs will be reduced, which may result in increased premiums or out-of-pocket costs to Medicare beneficiaries enrolled in Medicare Advantage plans. These beneficiaries may terminate their participation in such Medicare Advantage plans and opt for the traditional Medicare fee-for-service program. The reduction in payments to Medicare Advantage plans may also lead to decreased payments to providers by managed care companies operating Medicare Advantage plans. All or any of these outcomes will have a disproportionately negative effect upon those providers with relatively high dependence upon Medicare managed care revenues.




8





MEDI-CAL (CALIFORNIA'S MEDICAID PROGRAM)




FEE-FOR-SERVICE PROGRAM. The Medi-Cal program is a joint federal/state program that provides healthcare services to certain persons who are financially needy. Each of the Hospitals participates in the Medi-Cal program. The Medi-Cal program includes both a fee-for-service component and a managed care component. Inpatient hospital services under the fee-for-service component are reimbursed primarily under the Selective Provider Contracting Program ("SPCP"), which are negotiated by the California Medical Assistance Commission ("CMAC"). The SPCP and CMAC system for payments to hospitals are designed to pay hospitals below their costs of services to Medi-Cal beneficiaries. The Company is located in an area which is currently a "closed area" under the SPCP. In SPCP closed areas, private hospitals must hold a contract with the Medi-Cal program in order to be paid for their inpatient services (other than services performed in an emergency to stabilize a patient so that they can be transferred to a contracting hospital and additional care rendered to emergency patients who cannot be so stabilized for transfer or where no contracting hospital accepts the patient). Contracting hospitals are generally paid for these services on the basis of all inclusive per diem rates they negotiate under their SPCP/CMAC contracts. Outpatient hospital services under the fee-for service-component are paid for on the basis of a fee schedule, and it is not necessary for hospitals to hold SPCP/CMAC contracts in order to be paid for their outpatient services. Each Hospital currently has an SPCP/CMAC contract in which it is contractually bound to continue until April 30, 2011, and there can be no assurance that the Hospital will maintain SPCP status thereafter or that the current Medi-Cal payment arrangements will continue. There can be no assurance that the SPCP/CMAC contract rates paid to the Hospitals will cover each Hospital's cost of providing care. The Medi-Cal payment rates for outpatient services cover only a small portion of a Hospital's cost of providing care. In addition, pursuant to the DRA, CMS has developed a Medicaid Integrity Plan ("MIP") that requires increased auditing of State Medicaid programs, and intensified efforts by State Medicaid programs to investigate fraud and overpayments. If the Hospitals become the subject to any of such audits and are required to refund any payments, those refunds could financially affect the Company.




MEDI-CAL MANAGED CARE. In addition to the fee-for-service component of Medi-Cal, Orange County, California (where the Hospitals are located) participates in the Medi-Cal managed care program. Many Medi-Cal beneficiaries in Orange County are covered under Medi-Cal managed care, and not under fee-for-service Medi-Cal. Medi-Cal managed care in Orange County is provided through a County Organized Health System known as CalOptima. An Orange County hospital that wants to participate in Medi-Cal managed care on a capitated basis must contract with CalOptima, and is typically paid a capitated amount each month to provide, or arrange for the provision of, specified services to CalOptima members assigned to the hospital. The capitated hospital is financially responsible for a predetermined list of services, whether those services are provided at the capitated hospital or another service provider, provided during the term of the contract, including allowable claims received after contract termination. Western Medical Center - Santa Ana had a capitated contract with CalOptima which terminated as of June 2006. Coastal Communities Hospital had a capitated contract with CalOptima which terminated in April 2007. Mid-year 2006, CalOptima focused on entering into contracts with hospitals on a fee-for-services basis for managed care Medi-Cal enrollees managed directly by CalOptima and CalOptima's capitated hospitals. The rates in these contracts are based on the greater of a county wide rate established by CalOptima based on past average SPCP/CMAC rates or the individual hospital's SPCP/CMAC rate. Chapman Medical Center, Coastal Communities Hospital, Western Medical Center - Anaheim and Western Medical Center - Santa Ana entered into these CalOptima fee for service contracts effective June 2006. A hospital which does not have a contract with CalOptima may provide covered services. An amendment to the federal Medicaid Act which became effective January 1, 2007, appears to set reimbursement from Medi-Cal managed care plans, like CalOptima, to hospital providers of emergency services that do not have contracts with those plans at an average SPCP/CMAC contracted rate for general acute care hospitals or the average contract rate for tertiary hospitals. The State of California has established a non-contracted tertiary hospitals definition, which Western Medical Center - Santa Ana qualifies and the other three Hospitals qualify as general acute care hospitals. Additionally, the State of California adopted a mechanism to determine the rates that will be paid to non-contract hospitals for emergency services and post emergency care. CalOptima has adjusted the rates paid to contracted tertiary hospitals to equate to the non-contracted tertiary hospital rates. CalOptima general acute care hospital rates are similar to the State established non-contract rate, therefore CalOptima made no adjustment to general acute care hospital rates. All four Hospitals maintained their Medi-Cal managed care contract at the end of the fourth quarter. There can be no assurance that the amount paid to any of the Hospitals for services covered under CalOptima which are covered or not covered under a contract between CalOptima and each Hospital will be adequate to reimburse a Hospital's costs of providing care.




MEDI-CAL DSH PAYMENTS. Some of the Hospitals receive substantial additional Medi-Cal reimbursement as a disproportionate share (“DSH”) hospital from the DSH Replacement Fund and the Private Hospital Supplemental Fund. Hospitals qualify for additional funding based on the proportion of services they provide to Medi-Cal beneficiaries and other low-income patients. Payments to a hospital are determined on a formula basis set forth in California law and the Medi-Cal State Plan. Hospitals receive funds from the Private Hospital Supplemental Fund pursuant to amendments to their SPCP contracts negotiated with the California Medical Assistance Commission. The Medi-Cal funding for DSH hospitals, however, is dependent on state general funding appropriations, and there can be no assurance that the state will fully fund the Medi-Cal DSH payment programs. There also can be no assurance that the Hospitals which quality as DSH will be able to negotiate SPCP contract amendments for Private Hospital Supplemental Fund Payments, although state law currently provides that a qualifying hospital may not receive less from the Private Hospital Supplemental Fund that it received from predecessor funds in the State’s 2002-2003 fiscal year. The total DSH payments within a state have long been capped according to state-specific “allotments.” The American Recovery and Reinvestment Act of 2009 (“ARRA”) provides for a $460 million temporary increase in payments by increasing all state Medicaid payment program allotments by 2.5% in 2009 and an additional 2.5% (above the new 2009 allotments) in 2010. After 2010, states’ annual allotments will return to 100% of the annual allotments as determined under current law. Under PPACA, however, beginning on October 1, 2013 in fiscal years 2014 through 2020, a state’s Medicaid DSH allotment from federal funds will be substantially reduced pursuant to a methodology, determined by the Secretary of HHS, that makes the greatest cuts in states that direct the lowest amount of DSH allotments and the lowest percentage of uninsured.





9




WORKERS' COMPENSATION REIMBURSEMENT





FEE SCHEDULES. A portion of the Hospitals' revenues are expected to come from Workers' Compensation program reimbursements. As part of an effort in 2003 to control costs under the Workers' Compensation program, the California legislature enacted Labor Code Section 5307.1, which sets reimbursement for hospital inpatient and outpatient services, including outpatient surgery services, at a maximum of 120% of the current Medicare fee schedule for hospitals. The Administrative Director of the Division of Workers' Compensation is authorized to develop and, after public hearings, to adopt a fee schedule for outpatient surgery services, but this schedule may not be more than 120% of the current Medicare fee schedule for hospitals. This fee limitation limits the amount that the Hospitals will be paid for their services provided to Workers' Compensation patients. We can provide no assurance that the amount of revenues attributable to these payments may not be reduced in the future, which reductions may have an adverse financial impact on the Company.




PROVIDER NETWORKS. Under California law, employers may establish medical provider networks for Workers' Compensation patients and may restrict their employees' access to medical services to providers that are participants in those networks. Employers are free to choose which providers will and will not participate in their networks, and employers pay participating providers on the basis of negotiated rates that may be lower than those that would otherwise be provided for by the Workers' Compensation fee schedules. Employers may also choose to contract with licensed Health Maintenance Organizations ("HMO") and restrict access by their employees to participating providers of these HMOs. The Hospitals are participating providers in several Workers' Compensation networks, and to the extent that the Hospitals are required to negotiate and accept lower reimbursement rates to participate in these networks, there may be an adverse financial impact on the Company. Also, network providers are required to provide treatment in accordance with utilization controls to be established by the Department of Workers' Compensation. Therefore, as network participants, such utilization controls may limit the services for which the Hospital is reimbursed, which would have an adverse financial impact on the Company.




FURTHER REFORM. There will likely continue to be substantial activity in the California Workers' Compensation reform area. In the past, the legislature has considered a number of bills, some of which would further reduce the maximum reimbursement for medical services, including hospital services. It is expected that any revisions to the Workers' Compensation fee schedule, when and if implemented, will reduce the fees the Hospitals receive for Workers' Compensation patients. The impact of such possible future fee schedule changes cannot be estimated at this time. It is also possible that the profitability of the Company could be impacted by other future Workers' Compensation cost control efforts.





COMMERCIAL INSURANCE





Many private insurance companies contract with hospitals on a "preferred" provider basis, and many insurers have introduced plans known as preferred provider organizations ("PPO"). Under preferred provider plans, patients who use the services of contracted providers are subject to more favorable copayments and deductibles than apply when they use non-contracted providers. In addition, under most HMOs, private payers limit coverage to those services provided by selected hospitals. With this contracting authority, private payers direct patients away from nonselected hospitals by denying coverage for services provided by them. The Hospitals currently have several managed care contracts. If the Company's managed care contract rates are unfavorable or are reduced in the future, this may negatively impact the Company's profitability.





ELECTRONIC HEALTH RECORDS





The 2009 ARRA provides stimulus monies for hospitals and physicians that are meaningful electronic health records ("EHR") users beginning in 2011, and imposes penalties on providers who are not meaningful users by the end of 2015. The intent is to promote the use of electronic technology to improve health outcomes and reduce health care costs. To become a meaningful EHR user, a provider must adopt a "certified EHR system" according to Department of Health & Human Services ("DHHS") standards, to be issued, that include e-prescribing. Also, the user must demonstrate that it engages in the exchange of health information to promote quality of care and coordination, and reports on clinical quality efforts. DHHS intends to issue proposed meaningful EHR user regulations in the near future. The Hospitals will endeavor to qualify for available stimulus monies and avoid penalties, and to generally maximize the use of EHR. However, the purchase and implementation of EHR systems can be expensive. Further, as the health information becomes more pervasive, we anticipate additional regulations and costs related to the exchange of health information on a regional and national basis.





EMTALA





In response to concerns regarding inappropriate hospital transfers of emergency patients based on the patient's inability to pay for the services provided, Congress enacted the Emergency Medical Treatment and Labor Act ("EMTALA") in 1986. This so-called "anti-dumping" law imposes certain requirements on hospitals with Medicare provider agreements to (1) provide a medical screening examination for any individual who comes to the hospital's emergency department, (2) provide necessary stabilizing treatment for emergency medical conditions and labor, and (3) not transfer a patient until the individual is stabilized, unless the benefits of transfer outweigh the risks or the patient gives informed consent to the transfer. Since the Hospitals must provide emergency services without regard to a patient's ability to pay, complying with EMTALA could have an adverse impact on the profitability of the Hospitals, depending upon the number of patients treated in or through the emergency room who are unable to pay. Failure to comply with the law can result in exclusion of the physician from the Medicare and/or Medicaid programs or termination of the hospital's Medicare provider agreements, as well as civil penalties.




10





ANTI-KICKBACK, FRAUD AND SELF-REFERRAL REGULATIONS





FEDERAL ANTI-KICKBACK LAW. The Social Security Act's illegal remuneration provisions (the "Anti-kickback Statute") prohibit the offer, payment, solicitation or receipt of remuneration (including any kickback, bribe or rebate), directly or indirectly, overtly or covertly, in cash or in kind, for (a) the referral of patients or arranging for the referral of patients to receive services for which payment may be made in whole or in part under a federal healthcare program, which includes Medicare, Medicaid and TRICARE (formerly CHAMPUS, which provides benefits to dependents of members of the uniformed services) and any state healthcare program, or (b) the purchase, lease, order, or arranging for the purchase, lease or order of any good, facility, service or item for which payment may be made under the above payment programs. The Anti-kickback Statute contains both criminal and civil sanctions, which are enforced by the Office of Inspector General ("OIG") of DHHS and the United States Department of Justice. The criminal sanctions for a conviction under the Anti-kickback Statute are imprisonment for not more than five years, a fine of not more than $50,000 for each offense, or both, with higher penalties potentially being imposed under the federal Sentencing Guidelines. In addition to the imposition of criminal sanctions, the Secretary of DHHS may exclude any person or entity that commits an act described in the Anti-kickback Statute from participation in the Medicare program and direct states to also exclude that person from participation in state healthcare programs. The Secretary of DHHS can exercise this authority based on an administrative determination, without obtaining a criminal conviction. The burden of proof for the exclusion would be one that is customarily applicable to administrative proceedings, which is a lower standard than that required for a criminal conviction. In addition, violators of the Anti-kickback Statute may be subjected to civil money penalties of $50,000 for each prohibited act and up to three times the total amount of remuneration offered, paid, solicited, or received, without regard to whether a portion of such remuneration was offered, paid, solicited, or received for a lawful purpose.




There is ever-increasing scrutiny by federal and state law enforcement authorities, OIG, DHHS, the courts, and Congress of arrangements between healthcare providers and potential referral sources to ensure that the arrangements are not designed as a mechanism to exchange remuneration for patient care referrals and opportunities. The law enforcement authorities, the courts, and Congress have also demonstrated a willingness to look behind the formalities of an entity's structure to determine the underlying purpose of payments between healthcare providers and potential referral sources. Enforcement actions have been increased and, generally, the courts have broadly interpreted the scope of the Anti-kickback Statute and have held, for example, that the Anti-kickback Statute may be violated if merely one purpose of a payment arrangement is to induce referrals. In addition, the OIG has long been on record that it believes that physician investments in healthcare companies can violate the Anti-kickback Statute and the OIG has demonstrated an aggressive attitude toward enforcement of the Anti-kickback Statute in the context of ownership relationships.




The OIG has issued regulations specifying certain payment practices that will not be treated as a criminal offense under the Anti-kickback Statute and that will not provide a basis for exclusion from the Medicare or Medicaid programs (the "Safe Harbor Regulations"). These regulations include, among others, safe harbors for certain investments in both publicly traded and non-publicly traded companies. However, investments in the Company will not be protected by either of these safe harbor regulations. Nevertheless, the fact that a specific transaction does not meet all of the criteria of a "safe harbor" does not mean that such transaction constitutes a violation of the Anti-kickback Statute, and the OIG has indicated that any arrangement that does not meet all of the elements of a safe harbor will be evaluated on its specific facts and circumstances to determine whether the Anti-kickback Statute has been violated and, thus, if prosecution is warranted.




The OIG is authorized to issue advisory opinions which interpret the Anti- kickback Statute and has issued several advisory opinions addressing investments by physicians in healthcare businesses. Based upon those opinions, it appears unlikely that the OIG would be willing to issue an advisory opinion protecting physician investments in the Company, and no such opinion has been requested by the Company. The Company nevertheless believes, based upon a federal court decision involving physician investments in clinical laboratories, that investments in it by physicians are not automatically prohibited by the Anti- kickback Statute, depending upon the circumstances surrounding such investment. The Company has reviewed the terms of the purchase of ownership interests in the Company by Orange County Physician Investment Network, LLC ("OC-PIN") (which is owned by physicians that refer patients to the Hospitals) and has determined that the purchase should not violate the Anti-kickback Statute.




The OIG also has identified many hospital-physician compensation arrangements that are potential violations of the Anti-kickback Statute, including: (a) payment of any incentive for the referral of patients; (b) use of free or discounted office space or equipment; (c) provision of free or discounted services, such as billing services; (d) free training; (e) income guarantees; (f) loans which are not fair market value or which may be forgiven; (g) payment for services which require few, if any substantive duties by the physician or payment for services in excess of fair market value of the services; and (h) purchasing goods or services from physicians at prices in excess of fair market value. The Company has reviewed many of its compensation relationships with physicians, and on-going reviews are occurring, in an effort to ensure that such relationships do not violate the Anti-kickback Statute.





11




CALIFORNIA ANTI-KICKBACK PROHIBITIONS. California law prohibits remuneration of any kind in exchange for the referral of patients regardless of the nature of the payer of such services, and is therefore broader in this regard than is the federal statute. Nevertheless, this statute specifically provides that a medically necessary referral is not illegal solely because the physician that is making the referral has an ownership interest in the healthcare facility to which the referral is made if the physician's return on investment is based upon the amount of the physician's capital investment or proportional ownership and such ownership is not based upon the number or value of patients referred. Further, opinions of the California Attorney General indicate that distributions paid to physicians who invest in entities that conduct health related businesses generally do not violate California's anti-kickback law when the entity conducts a bona fide business, services performed are medically needed, and profit distributions are based upon each investor's proportional ownership interest, rather than the relative volume of each investor's utilization of the entity's business. California has a separate anti-kickback statute which applies only under the Medi-Cal program and which largely parallels the prohibitions of the federal Anti-kickback Statute. The Company believes that analysis under this Medi-Cal anti-kickback statue will be the same as under the federal Anti-kickback Statute discussed above.




FALSE AND OTHER IMPROPER CLAIMS. The federal government is authorized to impose criminal, civil, and administrative penalties on any person or entity that files a false claim for payment from the Medicare or Medi-Cal programs. In addition to other federal criminal and civil laws which punish healthcare fraud, the federal government, over the past several years, has accused an increasing number of healthcare providers of violating the federal Civil False Claims Act. The False Claims Act imposes civil liability (including substantial monetary penalties and damages) on any person or corporation which (1) knowingly presents a false or fraudulent claim for payment to the federal government; (2) knowingly uses a false record or statement to obtain payment; or (3) engages in a conspiracy to defraud the federal government to obtain allowance for a false claim. Recently, provisions of the False Claims Act were clarified under the Fraud Enforcement and Recovery Act of 2009 to eliminate the requirement that a false claim be presented to a federal official, or that it directly involves federal funds (i.e., indirect payments to a subcontractor are covered). False claims allegations could arise, for example, with respect to the Hospital's billings to the Medicare program for its services or the submission by the Hospital of Medicare cost reports. Specific intent to defraud the federal government is not required to act with knowledge. Instead, the False Claims Act defines "knowingly" to include not only actual knowledge of a claim's falsity, but also reckless disregard for or intentional ignorance of the truth or falsity of a claim. Because the Hospitals perform hundreds of procedures a year for which they are paid by Medicare, and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties.




Under the qui tam, or whistleblower, provisions of the False Claims Act, private parties may bring actions on behalf of the federal government. These private parties, often referred to as relators, are entitled to share in any amounts recovered by the government through trial or settlement. Both direct enforcement activity by the government and whistleblower lawsuits have increased significantly in recent years and have increased the risk that a healthcare company, like us, will have to defend a false claims action, pay fines or be excluded from the Medicare and Medicaid programs as a result of an investigation resulting from a whistleblower case. Although the Company intends that the operations of the Hospitals will materially comply with both federal and state laws related to the submission of claims, there can be no assurance that a determination that we have violated these claims-related laws will not be made, and any such determination would have a material adverse effect on the Company.




In addition to the False Claims Act, federal civil monetary penalties provisions authorize the imposition of substantial civil money penalties against an entity which engages in activities including, but not limited to, (1) knowingly presenting or causing to be presented, a claim for services not provided as claimed or which is otherwise false or fraudulent in any way; (2) knowingly giving or causing to be given false or misleading information reasonably expected to influence the decision to discharge a patient; (3) offering or giving remuneration to any beneficiary of a federal healthcare program likely to influence the selection of a particular provider, practitioner or supplier for the ordering or receipt of reimbursable items or services; (4) arranging for reimbursable services with an entity which is excluded from participation from a federal healthcare program; (5) knowingly or willfully soliciting or receiving remuneration for a referral of a federal healthcare program beneficiary; or (6) using a payment intended for a federal healthcare program beneficiary for another use.




The Secretary of DHHS, acting through the OIG, also has both mandatory and permissive authority to exclude individuals and entities from participation in federal healthcare programs pursuant to this statute. Also, it is a criminal federal healthcare fraud offense to: (1) knowingly and willfully execute or attempt to execute any scheme to defraud any healthcare benefit program, including any private or governmental program; or (2) to obtain, by means of false or fraudulent pretenses, any property owned or controlled by any healthcare benefit program. Penalties for a violation of this federal law include fines and/or imprisonment, and a forfeiture of any property derived from proceeds traceable to the offense. In addition, if an individual is convicted of a criminal offense related to participation in the Medicare program or any state healthcare program, or is convicted of a felony relating to healthcare fraud, the Secretary of DHHS is required to bar the individual from participation in federal healthcare programs and to notify the appropriate state agencies to bar the individuals from participation in state healthcare programs.




12




While the criminal statutes are generally reserved for instances of fraudulent intent, the federal government is applying its criminal, civil, and administrative penalty statutes in an ever-expanding range of circumstances. For example, the government has taken the position that a pattern of claiming reimbursement for unnecessary services violates these statutes if the claimant merely should have known the services were unnecessary, even if the government cannot demonstrate actual knowledge. The government has also taken the position that claiming payment for low-quality services is a violation of these statutes if the claimant should have known that the care was substandard. In addition, some courts have held that a violation of the Stark Law or the Anti-kickback Statute can result in liability under the federal False Claims Act. Noncompliance with other regulatory requirements can also lead to liability under the False Claims Act if it can be established that compliance with those requirements are necessary in order for a hospital to be paid for its services.




Claims filed with private insurers can also lead to criminal and civil penalties under federal law, including, but not limited to, penalties relating to violations of federal mail and wire fraud statutes and of the Health Insurance Portability and Accountability Act of 1996 and its implementing regulations ("HIPAA") provisions which have made the defrauding of any healthcare insurer, whether public or private, a crime. The Hospitals are also subject to various state insurance statutes and regulations that prohibit the Hospitals from submitting inaccurate, incorrect or misleading claims. The Company intends that the Hospitals will comply with all state insurance laws and regulations regarding the submission of claims. IHHI cannot assure, however, that each Hospital's insurance claims will never be challenged or that the Hospitals will in all instances comply with all laws regulating its claims. If a Hospital were found to be in violation of a state insurance law or regulation, the Hospital could be subject to fines and criminal penalties, which would have an adverse effect on IHHI's business and operating results.




FEDERAL PHYSICIAN SELF-REFERRAL LAW. Provisions of the Social Security Act commonly referred to as the Stark Law prohibit referrals by a physician of Medicare patients to providers for a broad range of health services if the physician (or his or her immediate family member) has an ownership or other financial arrangement with the provider, unless an exception applies. The "designated health services" to which the Stark Law applies include all inpatient and outpatient services provided by hospitals. Hospitals cannot bill for services they provide as a result of referrals that are made in violation of the Stark Law. In addition, a violation of the Stark Law may result in a denial of payment, require refunds to patients and to the Medicare program, civil monetary penalties of up to $15,000 for each violation, civil monetary penalties of up to $100,000 for certain "circumvention schemes" and exclusion from participation in Medicare, Medicaid, and other federal programs. Violations of the Stark Law may also be actionable as violations of the federal False Claims Act.




Notwithstanding the breadth of the Stark Law's general prohibition, the law contains an exception which protects ownership interests held by physicians in hospitals where the referring physician is authorized to perform services at the hospital and the physician's ownership is in the hospital itself, and not merely in a subdivision of the hospital. The Hospitals intend to rely upon this exception to protect the ownership interests that physicians hold in them. Although the Company does not believe that any of its Hospitals will be considered to be "specialty hospitals", changes in this area of the law that would affect the classification of the Hospitals as "specialty hospitals" may affect the Company's operations. CMS continues to review and evaluate the rules related to ownership interests held in hospitals by physicians. The proposed fiscal year 2010 Inpatient Prospective Payment Rule, published May 22, 2009, does not contain any significant updates to the current regulations. Additionally, similar disclosure requirements are imposed by California law (see "DISCLOSURE OF FINANCIAL INTERESTS" section below). It is unlikely that implementation of new CMS or California requirements would have a material effect on the Company's operations.




In addition to physician ownership, the Hospitals have arrangements by which they compensate various physicians for services. Payments by the Company to such physicians will constitute financial relationships for purposes of the Stark Law. Exemptions exist under the Stark Law and its implementing regulations for various types of compensation relationships. Effective October, 2009, certain exceptions for services obtained "under arrangement" from physicians will end, and the Company will have to review and, if necessary, revise any arrangements in this category. The Company will endeavor to ensure that all of its financial relationships qualify for one or more exemptions under the Stark Law. However, there can be no assurance that the Company will be successful in structuring all of its relationships with physicians so as to qualify for protection under one or more of the Stark Law's exceptions.




CALIFORNIA PHYSICIAN SELF-REFERRAL LAW RESTRICTIONS. Restrictions on financial relationships between physicians and businesses to which they refer patients for specified types of services, including some services which will be provided by the Hospitals, also exist under California law. As is the case under federal law, the California self-referral restrictions can be triggered by financial relationships other than ownership. However, these laws contain a broad exemption permitting referrals to be made to a hospital so long as the referring physician is not compensated by the hospital for the referral and any equipment lease between the hospital and the physician satisfies certain requirements.




An additional requirement imposed by California's self-referral laws is that any non-emergency imaging services performed for a Workers' Compensation patient with equipment that, when new, had a value of $400,000 or more must be pre-approved by the Workers' Compensation insurer or self-insured employer. This provision may require that preauthorization be obtained for MRI services ordered by the Hospitals' physician owners and others who have financial relationships with the Company. It is possible that insurers may refuse to provide any required preauthorizations in connection with referrals of Workers' Compensation patients made to the Hospitals by physicians who have financial relationships with it. However, given that MRI services for Workers' Compensation patients are not anticipated to represent a material portion of the Hospitals' services, the Company does not believe that any such refusals to provide required preauthorizations would have a material impact upon it.





13




LICENSING





Health facilities, including the Hospitals, are subject to numerous legal, regulatory, professional, and private licensing, certification, and accreditation requirements. These include requirements relating to Medicare participation and payment, state licensing agencies, private payers and the Joint Commission on Accreditation of Healthcare Organizations ("Joint Commission"). Renewal and continuance of certain of these licenses, certifications and accreditations are based on inspections, surveys, audits, investigations or other reviews, some of which may require or include affirmative action or response by the Company. These activities generally are conducted in the normal course of business of health facilities. Nevertheless, an adverse determination could result in a loss or reduction in a Hospital's scope of licensure, certification or accreditation, or could reduce the payment received or require repayment of amounts previously remitted. Any failure to obtain, renew or continue a license, certification or accreditation required for operation of a Hospital could result in the loss of utilization or revenues, or the loss of the Company's ability to operate all or a portion of a Hospital, and, consequently, could have a material and adverse effect on the Company.





DISCLOSURE OF FINANCIAL INTERESTS





California law provides that it is unlawful for a physician to refer a patient to an organization in which the physician or the physician's immediate family has a significant beneficial interest unless the physician first discloses in writing to the patient that there is such an interest and advises the patient regarding alternative services, if such services are available. A "significant beneficial interest" means any financial interest equal to or greater than the lesser of five percent of the total beneficial interest or $5,000. This disclosure requirement may be satisfied by the posting of a conspicuous sign likely to be seen by all patients who use the facility or by providing patients with written disclosure statements. Physicians must also make disclosure of entities in which they hold significant financial interests to a patient's payer upon the request of the payer (not to be made more than once a year). A violation of this disclosure requirement constitutes "unprofessional conduct," and is grounds for the suspension or revocation of the physician's license. Further, it is deemed a misdemeanor punishable by imprisonment not to exceed six months, or by a fine not to exceed $2,500.




In addition, California's general self-referral laws require that any physician who refers a person to, or seeks consultation from an organization in which the physician has a financial interest, must disclose the financial interest to the patient, or the parent or legal guardian of the patient, in writing, at the time of the referral or request for consultation. This requirement applies regardless of whether the financial interest is otherwise protected by one of the exemptions under the self-referral law. There is no minimum threshold of ownership required in order for this disclosure requirement to be triggered, and this disclosure requirement cannot be satisfied by the posting of a sign. A violation of this disclosure requirement may be subject to civil penalties of up to $5,000 for each offense. Physician investors in the Company will be individually responsible for complying with these disclosure requirements with respect to their referrals to the Hospital. The obligation of physicians with financial interests in the Company to make such disclosures or the effect of such disclosures on patients may have an adverse impact on the Company.





HIPAA





HIPAA mandated the adoption of standards for the exchange of health information in an effort to encourage overall administrative simplification and enhance the effectiveness and efficiency of the healthcare industry. Under HIPAA, healthcare providers and other "covered entities" such as health insurance companies and other third-party payers, must adopt uniform standards for the electronic transmission of billing statements and insurance claims forms. These standards require the use of standard data formats and code sets when electronically transmitting information in connection with health claims and equivalent encounter information, healthcare payment and remittance advice and health claim status.




On January 23, 2004, DHHS published a final rule that adopted the National Provider Identifier ("NPI") as the standard unique health identifier for healthcare providers. The NPI is a 10-digit all numeric number that is assigned to eligible healthcare providers, including our hospitals, by the National Provider System ("NPS"), an independent government contractor. Our hospitals have obtained and are using NPIs in connection with the standard electronic transactions. The NPI rule was implemented in 2008, requiring that our Hospitals use only the NPI to identify themselves in connection with electronic transactions. Legacy numbers, such as Medicaid numbers, CHAMPUS numbers and Blue Cross-Blue Shield numbers, are not permitted. Healthcare providers no longer have to keep track of multiple numbers to identify themselves in the standard electronic transactions with one or more health plans.




14




DHHS also has promulgated HIPAA security standards and privacy standards which are aimed, in part, at protecting the confidentiality, availability and integrity of health information by "covered entities," including health plans, healthcare clearinghouses and healthcare providers that receive, store, maintain or transmit health and related financial information in electronic form, regardless of format. Recently, the 2009 ARRA amended HIPAA to include "business associates," i.e., those entities that perform business functions for health plans, clearinghouses and providers, as covered entities effective February 17, 2010 or a date set by DHHS. The privacy standards require compliance with rules governing the use and disclosure of patient health and billing information. They create rights for patients in their health information, such as the right to amend their health information, and they require us to impose these rules, by contract, on any business associate to which we disclose such information to perform functions on our behalf. These provisions required us to implement expensive computer systems, employee training programs and business procedures to protect the privacy and security of each patient health information and enable electronic billing and claims submissions consistent with HIPAA.




The security standards require us to maintain reasonable and appropriate administrative, technical, and physical safeguards to ensure the integrity, confidentiality and the availability of electronic health and related financial information. The security standards were designed to protect electronic information against reasonably anticipated threats or hazards to the security or integrity of the information and to protect the information against unauthorized use or disclosure. Under the 2009 ARRA, covered entities, including the Hospitals, must notify patients of most security breaches pursuant to DHHS regulations and on the effective date established by DHHS.




HIPAA provides both criminal and civil fines and penalties for covered entities that fail to comply. These fines and penalties were strengthened under the 2009 ARRA to provide for a penalty in the amount of $1,000 per violation due to "reasonable cause and not to willful neglect" (with a maximum penalty of $100,000); up to $10,000 for each violation due to willful neglect that is corrected (subject to a $250,000 maximum); and up to $50,000 for each willful violation that is not corrected properly (subject to a maximum penalty of $1.5 million dollars during a calendar year). Hospitals are also subject to state privacy laws, which depending on the circumstances may be more restrictive than HIPAA and impose additional penalties.





CORPORATE PRACTICE OF MEDICINE





California has laws that prohibit non-professional corporations and other entities from employing or otherwise controlling physicians or that prohibits certain direct and indirect payment arrangements between healthcare providers. Although we intend to exercise care in structuring our arrangements with healthcare providers to comply with relevant California law, and we believe that such arrangements will comply with applicable laws in all material respects, we cannot provide any assurance that governmental officials charged with responsibility for enforcing these laws will not assert that the Company, or certain transactions that we are involved in, are in violation of such laws, or that the courts will ultimately interpret such laws in a manner consistent with our interpretations.





CERTAIN ANTITRUST CONSIDERATIONS




The addition of physician-investors in the Company could affect competition in the geographic area in which its Hospitals operate in various ways. Such effects on competition could give rise to claims that the Hospitals, their arrangements with consumers and business entities or with physicians violate federal and state antitrust and unfair competition laws under a variety of theories. Accordingly, there can be no assurance that the activities or operations of the Hospitals will comply with federal and state antitrust or unfair competition laws, or that the Federal Trade Commission, the Antitrust Division of the Department of Justice, or any other party, including a physician participating in the Company's business, or a physician denied participation in the Company's business, will not challenge or seek to delay or enjoin the activities of the Company on antitrust or other grounds. If such a challenge is made, there can be no assurance that such challenge would be unsuccessful. We have not obtained an analysis of any possible antitrust implications of the activities of the Company or of the continuing arrangements and anticipated operations of the Hospitals.


LICENSING, SURVEYS, INVESTIGATIONS AND AUDITS
 
 Health facilities, including the Hospitals, are subject to numerous legal, regulatory, professional and private licensing, certification and accreditation requirements. The hospital industry has seen a number of ongoing investigations related to referrals, physician recruiting practices, cost reporting and billing practices, laboratory and home healthcare services and physician ownership and joint ventures involving hospitals. Federal and state government agencies have announced heightened and coordinated civil and criminal enforcement efforts. These include requirements relating to Medicare and Medi-Cal participation and payment, state licensing agencies, private payers and the Joint Commission. Renewal and continuance of certain of these licenses, certifications and accreditations are based on inspections, surveys, audits, investigations or other reviews, some of which may require or include affirmative action or response by the Company. Some investigations by licensing bodies can result in financial penalties to the Hospitals. These activities generally are conducted in the normal course of business of health facilities. Nevertheless, an adverse determination could result in a loss or reduction in a Hospital's scope of licensure, certification or accreditation, or could reduce the payment received or require repayment of amounts previously remitted. Any failure to obtain, renew or continue a license, certification or accreditation required for operation of a Hospital could result in the loss of utilization or revenues, or the loss of the Company's ability to operate all or a portion of a Hospital, and, consequently, could have a material and adverse effect on the Company.
  15
  The laws and regulations with which we must comply are complex and subject to change. In the future, different interpretations or enforcement of these laws and regulations could subject our practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs and operating expenses. If we fail to comply with applicable laws and regulations, we could suffer civil or criminal penalties, including the loss of our licenses to operate our hospitals and our ability to participate in the Medicare, Medicaid and other federal and state healthcare programs.
  Finally, we are subject to various federal, state and local statutes and ordinances regulating the discharge of materials into the environment. Our healthcare operations generate medical waste, such as pharmaceuticals, biological materials and disposable medical instruments that must be disposed of in compliance with federal, state and local environmental laws, rules and regulations. Our operations are also subject to various other environmental laws, rules and regulations. Environmental regulations also may apply when we renovate or refurbish hospitals, particularly older facilities
 
 EARTHQUAKE SAFETY COMPLIANCE
 
 The Hospitals are located in an area near active and substantial earthquake faults. The Hospitals carry earthquake insurance with a policy limit of $50.0 million. A significant earthquake could result in material damage and temporary or permanent cessation of operations at one or more of the Hospitals.
  In addition, the State of California has imposed new hospital seismic safety requirements. Under these new requirements, the Hospitals must meet stringent seismic safety criteria in the future. In addition, there could be other remediation costs pursuant to this seismic retrofit.  However, subsequent new review methodologies have caused an inability to fully determine the estimate of these costs at March 31, 2010.
  The State of California has introduced a new seismic review methodology known as HAZUS. The HAZUS methodology may preclude the need for some structural modifications. All four Hospitals requested HAZUS review and received a favorable notice pertaining to structural reclassification.  All hospital buildings, with the exception of one (an administrative building), have been deemed compliant until January 1, 2030 for both structural and nonstructural retrofit.
  There are additional requirements that must be complied with by 2030. The costs of meeting these requirements have not yet been determined. Compliance with seismic ordinances will be a costly venture and could have a material adverse effect on the Company's cash flow.  In addition, remediation could possibly result in certain environmental liabilities, such as asbestos abatement.


ENVIRONMENTAL REGULATIONS





Our healthcare operations generate medical waste that must be disposed of in compliance with federal, state, and local environmental laws, rules, and regulations. Our operations, as well as our purchases and sales of facilities, also are subject to compliance with various other environmental laws, rules, and regulations. Remediation costs relating to toxic substances, if encountered during construction, could be material to the Company.





CORPORATE HISTORY





The Company was originally incorporated under the laws of the State of Utah on July 31, 1984 under the name "Aquachlor Marketing Inc." On December 23, 1988, the Company reincorporated in the State of Nevada. From 1989 until 2003, the Company was a development stage company with no material assets, revenues or business operations. On November 18, 2003, a group of investors purchased a controlling interest in the Company (then known as First Deltavision) with the objective of transforming the Company into a leading provider of high quality, cost-effective health care through the acquisition and management of financially distressed and/or underperforming hospitals and other healthcare facilities. On September 29, 2004, the Company entered into a definitive agreement to acquire the four Hospitals from Tenet and the transaction closed on March 8, 2005.




In the first quarter of 2004, the Company changed its fiscal year end from June 30 to December 31, and changed the Company's name to "Integrated Healthcare Holdings, Inc." On December 21, 2006, the Company changed its fiscal year end from December 31 to March 31. Our principal executive offices are located at 1301 North Tustin Avenue, Santa Ana, California 92705, and our telephone number is (714) 953-3503.




16





ITEM 1A. RISK FACTORS





An investment in our common stock involves a high degree of risk. You should consider carefully the following information about these risks, together with the other information contained in this report. Our business is subject to a number of risks and uncertainties - many of which are beyond our control - that may cause our actual operating results or financial performance to be materially different from our expectations. You should consider carefully the following information about these risks, together with the other information contained in this report, before you decide to buy our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also harm our operations. If any of the following risks actually occur, our business would likely suffer and our results could differ materially from those expressed in any forward-looking statements contained in this Annual Report on Form 10-K including our consolidated financial statements and related notes. In such case, the trading price of our common stock could decline, and shareholders could lose all or part of their investment.





WE MAY HAVE INSUFFICIENT CREDIT FACILITIES
 
 Due to the failure of the Company’s former principal lender, Medical Capital Corporation and its affiliates, at March 31, 2010 the Company relied solely on its cash receipts from payers to fund its operations. Therefore, any significant disruption in such receipts could have a material adverse effect on our ability to continue as a going concern. Subsequent to March 31, 2010, the Company entered into an agreement with a new lender whereby $10.0 million in revolving funds will be available to the Company for working capital and general corporate purposes. However, a $10.0 million revolving line of credit may be insufficient to meet the Company’s cash needs. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.




These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern and indicate a need for it to take action to continue to operate its business as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.




For a further discussion of this uncertainty see “Management's Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources”.





WE MUST OBTAIN ADDITIONAL CAPITAL WHICH, IF AVAILABLE, WILL LIKELY RESULT IN SUBSTANTIAL DILUTION TO OUR CURRENT SHAREHOLDERS




We will require additional capital to fund our business. If we raise additional funds through the issuance of common or preferred equity, warrants or convertible debt securities, these securities will likely substantially dilute the equity interests and voting power of our current shareholders, and may have rights, preferences or privileges senior to those of the rights of our current shareholders. We cannot predict whether additional financing will be available to us on favorable terms or at all.





WE ARE CURRENTLY INVOLVED IN LITIGATION WITH VARIOUS CURRENT AND FORMER MEMBERS OF OUR BOARD OF DIRECTORS AND A SIGNIFICANT SHAREHOLDER





On May 10, 2007, the Company filed suit in Orange County Superior Court against three of the six members of its Board of Directors (as then constituted) and also against the Company's then largest shareholder, Orange County Physicians Investment Network, LLC (“OC-PIN”). The suit sought damages, injunctive relief and the appointment of a provisional director. A discussion of this litigation and a summary of the status of the litigation to date is set forth below under "Item 3. Legal Proceedings - Orange County Physicians Investment Network, LLC". Such litigation, was mostly resolved under a global settlement agreement dated April 2, 2009. However, certain elements of the settlement are the subject of ongoing litigation among the parties, and the Company has become a party to new litigation among several members of OC-PIN. Therefore, these matters may continue to require a substantial commitment of financial resources and management's attention, and may have a material effect on our business and results of operation.





WE HAVE EXPERIENCED SIGNIFICANT DIFFICULTIES WITH OUR LIQUIDITY AND THE CONSOLIDATED FINANCIAL STATEMENTS HAVE BEEN PREPARED ON A GOING CONCERN BASIS





The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. As of March 31, 2010, the Company has a working capital deficit of $4.5 million and accumulated stockholders' deficiency of $36.8 million.




These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern and indicate a need for the Company to take action to continue to operate its business as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.




17





WE HAVE INCURRED SIGNIFICANT LOSSES IN OPERATIONS TO DATE. IF OUR SUBSTANTIAL LOSSES CONTINUE, THE MARKET VALUE OF OUR COMMON STOCK WILL LIKELY DECLINE FURTHER. WE HAVE A HIGH DEGREE OF LEVERAGE AND SIGNIFICANT DEBT SERVICE OBLIGATIONS.





As of March 31, 2010, we had an accumulated deficit of $36.8 million. We are attempting to improve our operating results and financial condition through a combination of contract negotiations, expense reductions, lowering the costs of borrowings through refinancing our debt, and new issues of equity. However, new issues of equity are encumbered by warrant anti-dilution provisions and there can be no assurance that we will achieve profitability in the future. If we are unable to achieve and maintain profitability, the market value of our common stock will likely decline further, and we will lack the ability to continue as a going concern.




As of March 31, 2010, the debt service requirements on our $81.0 million debt approximate $0.7 million per month. Our relatively high level of debt and debt service requirements have several effects on our current and future operations, including the following: (i) we will need to devote a significant portion of our cash flow to service debt, reducing funds available for operations and future business opportunities and increasing our vulnerability to adverse economic and industry conditions and competition; (ii) our leveraged position increases our vulnerability to competitive pressures; (iii) the covenants and restrictions contained in agreements relating to our indebtedness restrict our ability to borrow additional funds, dispose of assets, issue additional equity or pay dividends on or repurchase common stock; and (iv) funds available for working capital, capital expenditures, acquisitions and general corporate purposes are limited. Any default under the documents governing our indebtedness could have a significant adverse effect on our business and the market value of our common stock.




As of March 31, 2010, the Company had no ability to borrow under its $50.0 million Revolving Credit Agreement due to the failure of the Company’s principal lender. Subsequent to March 31, 2010, the Company entered into an agreement with a new lender and secured a replacement line of credit whereby $10.0 million in revolving funds will be available to the Company for working capital and general corporate purposes. However, the Company is still actively seeking alternate lending sources with sufficient liquidity to service its financing arrangement. There can be no assurance that the Company will be successful in securing replacement financing.





THE IMPACT OF THE RECENTLY ENACTED FEDERAL HEALTHCARE REFORM LEGISLATION ON OUR BUSINESS IS UNCERTAIN.




In March 2010, the U.S. Congress adopted and President Obama signed into law comprehensive health care reform legislation through the passage of the Patient Protection and Affordable Care Act (H.R. 3590) and the Health Care and Education Reconciliation Act (H.R. 4872).  Many of the details of the new law will be included in new and revised regulations, which have not yet been promulgated, and require additional guidance and specificity to be provided by the Department of Health and Human Services, Department of Labor and Department of the Treasury.  Accordingly, while it is too early to understand and predict the ultimate impact of the new legislation on our business, the legislation could have a material adverse effect on our business, cash flows, financial condition and results of operations.  For a further discussion of the new law, see “Business – Healthcare Regulation”.




IF WE ARE UNABLE TO ENTER INTO MANAGED CARE PROVIDER ARRANGEMENTS ON ACCEPTABLE TERMS, OR IF WE HAVE DIFFICULTY COLLECTING FROM MANAGED CARE PAYERS, OUR RESULTS OF OPERATIONS COULD BE ADVERSELY AFFECTED





It would harm our business if we were unable to enter into managed care provider arrangements on acceptable terms. Any material reductions in the payments that we receive for our services, coupled with any difficulties in collecting receivables from managed care payers, could have a material adverse effect on our financial condition, results of operations or cash flows.





CHANGES IN THE MEDICARE AND MEDICAID PROGRAMS OR OTHER GOVERNMENT HEALTH CARE PROGRAMS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS





The Medicare and Medicaid programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations concerning patient eligibility requirements, funding levels and the method of calculating payments or reimbursements, among other things; requirements for utilization review; and federal and state funding restrictions, all of which could materially increase or decrease payments from these government programs in the future, as well as affect the cost of providing services to our patients and the timing of payments to our facilities. We are unable to predict the effect of future government health care funding policy changes on our operations. The State of California's continuing fiscal crisis will likely result in a reduction in the State's Medi-Cal payments to our hospitals, offset only in part by federal healthcare reforms. The Governor’s revisions to the fiscal year 2010-2011 budget include a number of reductions within the Medi-Cal program, including increased cost sharing for emergency room visits and hospital stays,  and freeze inpatient hospital rates at the Jan. 1, 2010 level.




If the rates paid by governmental payers are reduced, if the scope of services covered by governmental payers is limited or if we, or one or more of our subsidiaries' hospitals, are excluded from participation in the Medicare or Medicaid program or any other government health care program, there could be a material adverse effect on our business, financial condition, results of operations or cash flows.




18




OUR BUSINESS CONTINUES TO BE ADVERSELY AFFECTED BY A HIGH VOLUME OF UNINSURED AND UNDERINSURED PATIENTS





The primary collection risks associated with our accounts receivable relate to the uninsured patient accounts and patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding. The provision for doubtful accounts relates primarily to amounts due directly from patients. This risk has increased, and will likely continue to increase, as more individuals enroll in high deductible insurance plans or those with high co-payments or who have no insurance coverage. These trends will likely be exacerbated if general economic conditions remain challenging or if unemployment levels in the communities in which we operate rise. As unemployment rates increase, our business strategies to generate organic growth and to improve admissions and adjusted admissions at our hospitals could become more difficult to accomplish.




The amount of our provision for doubtful accounts is based on our assessments of historical collection trends, business and economic conditions, trends in federal and state governmental and private employer health coverage and other collection indicators. A continuation in trends that results in increasing the proportion of accounts receivable being comprised of uninsured accounts and deterioration in the collectability of these accounts could adversely affect our collections of accounts receivable, results of operations and cash flows.





COST CONTAINMENT, PAY FOR PERFORMANCE, AND OTHER PROGRAMS IMPOSED BY THIRD-PARTY PAYERS, INCLUDING GOVERNMENT HEALTH CARE PROGRAMS, MAY DECREASE THE COMPANY'S REVENUE





The health care industry is currently undergoing significant changes and is regularly subject to regulatory and political intervention. We expect to derive a considerable portion of the Company's revenue through the Hospitals from government-sponsored health care programs and third-party payers (such as employers, private insurers, HMOs or preferred provider organizations). The trend towards  comprehensive reform epitomized by PPACA will likely continue to result in a reduction from historical levels in per-patient revenue for hospitals. It is possible that reimbursement from government and private third-party payers for many procedures performed at the Hospital may be reduced in the future. Further reductions in payments or other changes in reimbursement for health care services could have a material adverse effect on the Company's business, financial condition and/or results of operations. Further, rates paid by private third-party payers are generally higher than Medicare, Medicaid and HMO payment rates. Any decrease in the relative number of patients covered by private insurance would have a material adverse effect on the Company's revenues and operations.


CONTINUING TO PROVIDE QUALITY MEDICAL SERVICES FROM TALENTED PHYSICIANS IS CRITICAL TO OUR BUSINESS
  Our business depends, in large part, upon the efforts and success of the physicians who will perform services at the Hospitals and the strength of our relationships with these physicians. Any failure of these physicians to maintain the quality of medical care provided or to otherwise adhere to professional guidelines at the Hospitals, or any damage to the reputation of a key physician or group of physicians, could damage the Company's and the Hospitals' reputations in the medical marketplace and may subject us to liability and significantly reduce our revenue and increase our costs.




Like many hospitals, we face a growing shortage of primary care and specialty physicians. Should this shortage continue or worsen, the utilization of our hospitals may be adversely impacted. This could have a negative impact on our revenues and profitability.





WE MAY BE INVOLVED IN LITIGATION WITH OUR MEDICAL STAFF





The primary relationship between a hospital and physicians who practice in it is through the hospital's organized medical staff. Medical staff bylaws, rules and policies establish the criteria and procedures at acute care hospitals, by which a physician may have his or her privileges, participation or membership curtailed, denied or revoked. Physicians who are denied medical staff membership or certain clinical privileges, or who have such membership, participation or privileges curtailed, denied or revoked often file legal actions against hospitals. Such actions may include a wide variety of claims, some of which could result in substantial uninsured damages to a hospital. In addition, failure of the governing body to adequately oversee the conduct of its medical staff may result in hospital liability to third parties.





THE ONGOING NURSING SHORTAGE MAY HARM OUR BUSINESS





Health care providers depend on qualified nurses to provide quality service to patients. There is currently a nationwide shortage of qualified nurses. This shortage and the more stressful working conditions it creates for those remaining in the profession are increasingly viewed as a threat to patient safety and may trigger the adoption of state and federal laws and regulations intended to reduce that risk. For example, California has adopted legislation and regulations mandating a series of specific minimum patient-to-nurse ratios in all acute care hospital nursing units. Any failure by the Hospital to comply with nurse staff ratios could result in action by licensure authorities and may constitute evidence of negligence per se in the event any patient is harmed as the result of inadequate nurse staffing. The vast majority of hospitals in California, including ours, are not at all times meeting the state mandated nurse staffing ratios.




In response to the shortage of qualified nurses, health care providers have increased-and could continue to increase-wages and benefits to recruit or retain nurses; many providers have had to hire expensive contract nurses. The shortage could also limit the operations of healthcare providers by limiting the number of patient beds available. The Company has likewise increased and is likely to have to continue to increase-wages and benefits to recruit and retain nurses. The Company may also need to engage expensive contract nurses until permanent staff nurses can be hired to replace any departing nurses. Recently, there has been some lessening in the need for contract agency nurses following the recession as nurses return to the work force. There is still no basis to predict the longevity of this effect.




19


UNION CONTRACTS HAVE BEEN RENEWED BUT THERE CAN BE NO ASSURANCE THAT THE CONTRACTS WILL BE RENEWED IN THE FUTURE





Approximately 36% of the Company's employees are represented by labor unions as of March 31, 2010. The current SEIU Agreement expires on August 31, 2011, and the Agreement with the CNA expires on February 28, 2011. Both Agreements have "no strike" provisions and compensation caps which provide the Company with long term compensation and workforce stability.




For both unions, all prior grievances regarding retiree medical benefits, the administration of pay adjustments and pay practices, changes in medical benefits and several wrongful terminations have been resolved in the form of settlement agreements.




IF EITHER THE COMPANY OR THE HOSPITALS FAIL TO COMPLY WITH APPLICABLE LAWS AND REGULATIONS, WE MAY SUFFER PENALTIES OR BE REQUIRED TO MAKE SIGNIFICANT CHANGES TO OUR OPERATIONS





The Company and the Hospitals are subject to many laws and regulations at the federal, state and local levels. These laws and regulations require the Hospitals to meet various licensing, certification and other Requirements, including those relating to:




·
physician ownership of the Hospital;


·
payments to specialty hospitals, should any of the Hospitals be determined to be a specialty hospital;


·
prohibited inducements for patient referrals and restrictions on payments for marketing;


·
the adequacy of medical care, equipment, personnel, operating policies and procedures;


·
maintenance and protection of records;


·
reimbursement audits; and environmental protection.





If the Company fails to comply with applicable laws and regulations, it could suffer civil or criminal penalties. States are increasingly regulating the delivery of health care services. The hospital industry is subject to extensive state and local regulation with respect to reimbursement, licensure, certification and health planning. This regulation relates, among other things, to the adequacy of physical plant and equipment, qualifications of personnel, standards of medical care and operational requirements. Compliance with such regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of the company. In the future, different interpretations or enforcement of existing or new laws and regulations could subject the current practices to allegations of impropriety or illegality, or could require the Company to make changes in its facilities, equipment, personnel, services, capital expenditure programs and operating expenses. Current or future legislative initiatives or government regulation may have a material adverse effect on the Hospitals' operations or reduce the demand for their services.




THE COMPANY CONDUCTS ON-GOING REVIEWS OF ITS COMPLIANCE WITH VARIOUS LAWS RELATED TO PHYSICIAN ARRANGEMENTS, WHICH MAY REVEAL VIOLATIONS THAT COULD SUBJECT THE COMPANY TO FINES OR PENALTIES





The Company and the Hospitals have entered into a variety of relationships with physicians. In an increasingly complex legal and regulatory environment, these relationships may pose a variety of legal or business risks. The Company conducts reviews of its compliance with the federal Anti-kickback Statute, Stark law and other applicable laws as they relate to the Company's relationships with referring physicians.




One of the Company's largest shareholder, OC-PIN, is owned and controlled by physicians who also refer to and practice at the Hospitals. OC-PIN may receive dividends as a shareholder. In addition, one of the members of OC-PIN served as Chairman of the Board of Directors of the Company. As a director, he received payment from the Company for his service as Chairman. In addition, the Hospitals have various relationships with physicians who are not owners of the Company, as well as with OC-PIN physicians, including medical directorships, sharing in risk pools and service arrangements.




The Company entered into a sale leaseback transaction for substantially all of the real estate with Pacific Coast Holdings Investment, LLC ("PCHI") whereby the Company leases substantially all of the real property of the acquired Hospitals from PCHI. PCHI is owned by Ganesha Realty, LLC, which is managed by Dr. Kali P. Chaudhuri, and various physician investors.




The Company has undertaken a review of its agreements with physicians and has a review process in place to ensure that such agreements are in writing and comply with applicable laws. Although there may have been arrangements in the past with physicians that may not have been memorialized in a written agreement or may have expired and not been timely renewed or may have been entered into after services commenced, each of which may have lead to violations of the Stark law, the Company's current review process should prevent such occurrences. Additionally, the Company has reviewed the terms of the purchase of ownership interests in the Company by OC-PIN (which is owned by physicians that refer patients to the Hospitals) and has determined that the purchase should be determined to be permissible under applicable law. The Company has also reviewed certain related party transactions, such as director fees for physician directors and payment of the employment severance package to Dr. Anil Shah, an OC-PIN member. If the Company or the Hospitals are not in compliance with federal and state fraud and abuse laws and physician self-referral laws, the Company could be subject to repayment obligations, fines, penalties, exclusive from participation in federal health care programs, and other sanctions which would have a material adverse effect on the Company's profitability.




20


WE FACE INTENSE COMPETITION IN OUR BUSINESS.





The healthcare industry is highly competitive. We compete with a variety of other organizations in providing medical services, many of which have greater financial and other resources and may be more established in their respective communities than we are. Competing companies may offer newer or different centers or services than we do and may thereby attract patients or customers who are presently patients, customers or are otherwise receiving our services.




Some of the hospitals that compete with our hospitals are owned by government agencies or not-for-profit organizations. Tax-exempt competitors may have certain financial advantages not available to our facilities, such as endowments, charitable contributions, tax-exempt financing, and exemptions from sales, property and income taxes. In certain states, including California, some not-for-profit hospitals are permitted by law to directly employ physicians while for-profit hospitals are prohibited from doing so. We also face increasing competition from physician-owned specialty hospitals and freestanding surgery, diagnostic and imaging centers for market share in high margin services and for quality physicians and personnel. If competing health care providers are better able to attract more patients, recruit and retain physicians, expand services or obtain favorable managed care contracts at their facilities, we may continue to experience a decline in patient volume levels.





A SIGNIFICANT PORTION OF OUR BUSINESS IS CONCENTRATED IN CERTAIN MARKETS AND THE RESPECTIVE ECONOMIC CONDITIONS OR CHANGES IN THE LAWS AFFECTING OUR BUSINESS IN THOSE MARKETS COULD HAVE A MATERIAL ADVERSE EFFECT ON THE COMPANY





We receive all of our inpatient services revenue from operations in Orange County, California. The economic condition of this market could affect the ability of our patients and third-party payers to reimburse us for our services, through its effect on disposable household income and the tax base used to generate state funding for Medicaid programs. An economic downturn, or changes in the laws affecting our business in our market and in surrounding markets, could have a material adverse effect on the Company.





WE MAY BE LIABLE FOR LOSSES NOT COVERED BY OR IN EXCESS OF OUR INSURANCE





An increasing trend in malpractice litigation claims, rising costs of malpractice litigation, losses associated with these malpractice lawsuits and a constriction of insurers have caused many insurance carriers to raise the cost of insurance premiums or refuse to write insurance policies for hospital facilities. Accordingly, we have increased on retention limits and our estimated reserves may not be adequate.





21




ITEM 2. PROPERTIES





In March 2005, the Company completed the acquisition of the Hospitals and their associated real estate from Tenet. At the closing of the acquisition, the Company transferred all of the fee interests in the acquired real estate to PCHI, a company owned indirectly by two of the Company's largest shareholders. The Company entered into a Triple Net Lease dated March 7, 2005 (amended and restated as of April 13, 2010) under which it leased back from PCHI all of the real estate that it transferred to PCHI. Additionally, the Company leases property from other lessors. As of March 31, 2010, the Company's principal facilities are listed in the following table:





PROPERTY

APPROXIMATE

AGGREGATE

SQUARE

FOOTAGE

LEASE

RATE

INITIAL LEASE

EXPIRATIONWestern Medical Center-Santa Ana

360,000

See note 1.

February 28, 20301001 North Tustin AvenueSanta Ana, CA 92705Administrative Building

40,000

See note 1.

February 28, 20301301 N. Tustin AvenueSanta Ana, CAWestern Medical Center-Anaheim

132,000

See note 1.

February 28, 20301025 South Anaheim BoulevardAnaheim, CA 92805Coastal Communities Hospital

115,000

See note 1.

February 28, 20302701 South Bristol StreetSanta Ana, CA 92704Chapman Medical Center

140,000

See note 2.

December 31, 20232601 East Chapman AvenueOrange, CA 92869





1.
Effective April 13, 2010, the Company entered into an amended and restated lease with PCHI. The amended lease terminates on the 25-year anniversary of the original lease (March 8, 2005), grants the Company the right to renew for one additional 25-year period, and requires annual base rental payments of $8.3 million. However, until PCHI refinances the related real estate loan, the annual base rental payments are reduced to $7.3 million (increased from $7.1 million, which was the effective annual base rent as of March 31, 2010). In addition, the Company may offset against its rental payments owed to PCHI interest payments that it makes on the related real estate loan. Lease payments to PCHI are eliminated in consolidation.





2.
Leased from an unrelated party. Monthly lease payments are $133,860. On March 11, 2009 Tenet filed an action against the Company seeking indemnification and reimbursement for rental payments paid by Tenet pursuant to a guarantee agreement contained in the original Asset Purchase Agreement between the Company and Tenet. On or about October 20, 2009, the Company and Tenet entered into a settlement agreement under which the Company will pay to Tenet $742,548 plus interest representing reimbursement for $669,300 expended in rental payments for the Chapman Medical Center lease, plus attorneys' fees and related costs. As of March 31, 2010, the Company had made payments under the settlement agreement totaling $245,000. The balance due under the settlement agreement of approximately $530,000 has been accrued in the Company's consolidated financial statements as of and for the year ended March 31, 2010.





22


The State of California has imposed new hospital seismic safety requirements. Under these new requirements, the Hospitals must meet stringent seismic safety criteria in the future. In addition, there could be other remediation costs pursuant to this seismic retrofit.  However, subsequent new review methodologies have caused an inability to fully determine the estimate of these costs at March 31, 2010.





The State of California has introduced a new seismic review methodology known as HAZUS. The HAZUS methodology may preclude the need for some structural modifications. All four Hospitals requested HAZUS review and received a favorable notice pertaining to structural reclassification.  All hospital buildings, with the exception of one (an administrative building), have been deemed compliant until January 1, 2030 for both structural and nonstructural retrofit.




There are additional requirements that must be complied with by 2030. The costs of meeting these requirements have not yet been determined. Compliance with seismic ordinances will be a costly venture and could have a material adverse effect on the Company's cash flow.




The Company believes that its current leased space is adequate for its current purposes and for the next fiscal year.





ITEM 3. LEGAL PROCEEDINGS





LABOR AND EMPLOYMENT





From time to time, health care facilities receive requests for information in the form of a subpoena from licensing entities, such as the Medical Board of California, regarding members of their medical staffs. Also, California state law mandates that each medical staff is required to perform peer review of its members. As a result of the performance of such peer reviews, action is sometimes taken to limit or revoke an individual's medical staff membership and privileges in order to assure patient safety.




Approximately 36% of the Company's employees are represented by labor unions as of March 31, 2010. The current SEIU Agreement expires on August 31, 2011, and the Agreement with the CNA expires on February 28, 2011. Both Agreements have "no strike" provisions and compensation caps which provide the Company with long term compensation and workforce stability.




For both unions, all prior grievances regarding retiree medical benefits, the administration of pay adjustments and pay practices, changes in medical benefits and several wrongful terminations have been resolved in the form of settlement agreements.




On June 5, 2009, a potential class action lawsuit was filed against the Company by Alexandra Avery.  Ms. Avery purports to represent all 12-hourly employees and the complaint alleges causes of action for restitution of unpaid wages as a result of unfair business practices, injunctive relief for unfair business practices, failure to pay overtime wages, and penalties associated therewith. On December 23, 2009, the Company filed an answer to the complaint, generally denying all of the plaintiff’s allegations.  The parties are currently exchanging initial discovery in the action, and a status conference has been scheduled by the Court for July 14, 2010.  At this early stage, the Company is unable to determine the cost of defending this lawsuit or the impact, if any, this action may have on its results of operations.




On January 25, 2010, a potential class action lawsuit was filed against the Company by Julie Ross.  Ms. Ross purports to represent all similarly-situated employees and the complaint alleges causes of action for violation of the California Labor Code and unfair competition law.  The parties are currently exchanging initial discovery in the action.  At this early stage in the proceedings, the Company is unable to determine the cost of defending this lawsuit or the impact, if any, this action may have on its results of operations.




On December 31, 2007, the Company entered into a severance agreement with its then-President, Larry Anderson ("Anderson") (the "Severance Agreement"). On or about September 5, 2008, based upon information and belief that Anderson breached the Severance Agreement, the Company ceased making the monthly severance payments. On September 3, 2008, Anderson filed a claim with the California Department of Labor seeking payment of $243,000. A hearing date has not yet been set.




On or about February 11, 2009, Anderson filed a petition for arbitration before JAMS alleging the same wage claim as he previously alleged in his claim with the California Department of Labor described above. Anderson's petition also claims that the Company failed to pay him a commission of $300,000 for his efforts toward securing financing from the Company's lender to purchase an additional hospital. On May 20, 2009, Anderson filed an amended petition with JAMS, incorporating allegations (1) that the Company filed an incorrect IRS Form 1099 with respect to a Company vehicle and (2) that Anderson was constructively discharged as a result of reporting various alleged violations of State and Federal law. On August 4, 2009, the Company filed a cross-complaint against Anderson alleging, inter alia, Anderson breached paragraphs 4, 5 and 6 of the Severance Agreement, and similar clauses in his December 31, 2007 Consulting Agreement, by providing confidential and proprietary information to individuals outside of the Company’s management and voluntarily providing information to individuals who intended to use the information to sue the Company.  The Company also alleges Anderson concealed material information from the Company in breach of his overlapping fiduciary duties to the Company as an officer, Chief Compliance Officer and its attorney. Arbitration of this matter began on June 7, 2010. While the Company is optimistic regarding the outcome of these various related Anderson matters, at this early stage, the Company is unable to determine the cost of defending and prosecuting this lawsuit or the impact, if any, that these actions may have on its results of operations.







23




ORANGE COUNTY PHYSICIANS INVESTMENT NETWORK, LLC
 
 On May 10, 2007, the Company filed suit in Orange County Superior Court against three of the six members of its Board of Directors (as then constituted) and also against the Company's then largest shareholder, OC-PIN. The suit sought damages, injunctive relief and the appointment of a provisional director. Among other things, the Company alleged that the defendants breached their fiduciary duties owed to the Company by putting their own economic interests above those of the Company, its other shareholders, creditors, employees and the public-at-large. The suit further alleged the defendants' attempts to change the composition of the Company's management and Board (as then constituted) threatened to trigger multiple "Events of Default" under the express terms of the Company's existing credit agreements.





On May 17, 2007, OC-PIN filed a separate suit against the Company in Orange County Superior Court. OC-PIN's suit sought injunctive relief and damages. OC-PIN alleged the management issue referred to above, together with issues related to monies claimed by OC-PIN, needed to be resolved before completion of the Company's then pending refinancing of its secured debt. OC-PIN further alleged that the Company's President failed to call a special shareholders' meeting, thus denying OC-PIN the opportunity to elect a new member to the Company's Board of Directors.




Both actions were consolidated before one judge. On July 11, 2007, the Company's motion seeking the appointment of an independent provisional director to fill a vacant seventh Board seat was granted. On the same date, OC-PIN's motion for a mandatory injunction forcing the Company's President to notice a special shareholders meeting was denied. All parties to the litigation thereafter consented to the Court's appointment of the Hon. Robert C. Jameson, retired, as a member of the Company's Board.




In December 2007, the Company entered into a mutual dismissal and tolling agreement with OC-PIN. On April 16, 2008, the Company filed an amended complaint, alleging that the defendant directors' failure to timely approve a refinancing package offered by the Company's largest lender caused the Company to default on its then-existing loans. Also on April 16, 2008, these directors filed cross-complaints against the Company for alleged failures to honor its indemnity obligations to them in this litigation. On July 31, 2008, the Company entered into a settlement agreement with two of the three defendants, which agreement became effective on December 1, 2008, upon the trial court's grant of the parties motion for determination of a good faith settlement. On January 16, 2009, the Company dismissed its claims against these defendants.




On April 3, 2008, the Company received correspondence from OC-PIN demanding that the Company's Board of Directors investigate and terminate the employment agreement of the Company's Chief Executive Officer, Bruce Mogel. Without waiting for the Company to complete its investigations of the allegations in OC-PIN's letter, on July 15, 2008, OC-PIN filed a derivative lawsuit naming Mr. Mogel and the Company as defendants. All allegations contained in this suit, with the exception of OC-PIN's claims against Mr. Mogel as it pertains to the Company's refinancing efforts, were stayed by the Court pending the resolution of the May 10, 2007 suit brought by the Company.




On May 2, 2008, the Company received correspondence from OC-PIN demanding an inspection of various broad categories of Company documents. In turn, the Company filed a complaint for declaratory relief in the Orange County Superior Court seeking instructions as to how and/or whether the Company should comply with the inspection demand. In response, OC-PIN filed a petition for writ of mandate seeking to compel its inspection demand. On October 6, 2008, the Court stayed this action pending the resolution of the lawsuit filed by the Company on May 10, 2007. OC-PIN filed a petition for writ of mandate with the Court of Appeals seeking to overturn this stay order, which was summarily denied on November 18, 2008.




On June 19, 2008, the Company received correspondence from OC-PIN demanding that the Company notice a special shareholders' meeting no later than June 26, 2008, to occur during the week of July 21 - 25, 2008. The stated purpose of the meeting was to (1) repeal a bylaws provision setting forth a procedure for nomination of director candidates by shareholders, (2) remove the Company's entire Board of Directors, and (3) elect a new Board of Directors. The Company denied this request based on, among other reasons, failure to comply with the appropriate bylaws and SEC procedures and failure to comply with certain requirements under the Company's credit agreements with its primary lender. OC-PIN repeated its request on July 29, 2008, and on July 30, 2008, filed a petition for writ of mandate in the Orange County Superior Court seeking a court order to compel the Company to hold a special shareholders' meeting. On August 18, 2008, the Court denied OC-PIN's petition.




On September 17, 2008, OC-PIN filed another petition for writ of mandate seeking virtually identical relief as the petition filed on July 30, 2008. This petition was stayed by the Court on October 6, 2008 pending the resolution of May 10, 2007 suit brought by the Company. OC-PIN subsequently filed a petition for writ of mandate with the Court of Appeals, which was summarily denied on November 18, 2008. OC-PIN then filed a petition for review before the California Supreme Court, which was denied on January 14, 2009.




On July 8, 2008, in a separate action, OC-PIN filed a complaint against the Company in Orange County Superior Court alleging causes of action for breach of contract, specific performance, reformation, fraud, negligent misrepresentation and declaratory relief. The complaint alleges that the Stock Purchase Agreement that the Company executed with OC-PIN on January 28, 2005 "inadvertently omitted" an anti-dilution provision (the "Allegedly Omitted Provision") which would have allowed OC-PIN a right of first refusal to purchase common stock of the Company on the same terms as any other investor in order to maintain OC-PIN's holding at no less than 62.4% of the common stock on a fully diluted basis. The complaint further alleged that the Company issued stock options under a Stock Incentive Plan and warrants to its lender in violation of the Allegedly Omitted Provision. The complaint further alleged that the issuance of warrants to purchase the Company's stock to Dr. Chaudhuri and Mr. Thomas, and their exercise of a portion of those warrants, were improper under the Allegedly Omitted Provision. On October 6, 2008, the Court placed a stay on this lawsuit pending the resolution of the action filed by the Company on May 10, 2007. On October 22, 2008, OC-PIN filed an amended complaint naming every shareholder of the Company as a defendant, in response to a ruling by the Court that each shareholder was a "necessary party" to the action. OC-PIN filed a petition for writ of mandate with the Court of Appeals which sought to overturn the stay imposed by the trial court. This appeal was summarily denied on November 18, 2008.




24




On April 2, 2009, the Company, OC-PIN, Anil V. Shah, M.D. (“Shah”), Bruce Mogel, Pacific Coast Holdings Investment, LLC (“PCHI”), West Coast Holdings, LLC (“WCH”), Kali P. Chaudhuri, M.D., Ganesha Realty, LLC (“Ganesha”), William E. Thomas and Medical Capital Corporation and related entities (“Medical Capital”) (together, the “Global Settlement Parties”) entered into a global settlement agreement and mutual release (the “Global Settlement Agreement”).  Key elements of the Global Settlement Agreement included: (1) a full release of claims by and between the Global Settlement Parties, (2) two payments of $750,000 each (the second of which may be applied toward the purchase of stock by OC-PIN and Shah) by the Company payable to a Callahan & Blaine trust account in conjunction with payments and a guarantee by other Global Settlement Parties, (3) a loan interest and rent reduction provision resulting in a 3.75% interest rate reduction on the $45 million real estate term note, (4) the Company’s agreement to bring the PCHI and Chapman leases current and pay all arrearages due, (5) the Board of Directors’ approval of bylaw amendments fixing the number of Director seats to seven and, effective after the 2009 Annual Meeting of Shareholders, allowing a 15% or more shareholder to call one special shareholders’ meeting per year, (6) the right of OC-PIN to appoint one director candidate to serve on the Company’s Board of Directors to fill the seat of Kenneth K. Westbrook until the 2009 Annual Meeting of Shareholders, and (7) the covenant of Shah to not accept any nomination, appointment, or service in any capacity as a director, officer or employee of the Company for a two (2) year period so long as the Company keeps the PCHI and Chapman leases current.  Two stock purchase agreements (the “Stock Purchase Agreements”) were also executed in conjunction with the Global Settlement Agreement, whereby (1) OC-PIN and Shah each agreed to purchase 14,700,000 shares of Common Stock at $0.03 per share, and (2) Kali P. Chaudhuri agreed to purchase 30,600,000 shares of Common Stock at $0.03 per share.




Purportedly pursuant to the Global Settlement Agreement, OC-PIN and/or Shah placed a demand on the Company to seat Shah’s personal litigation attorney, Daniel Callahan (“Callahan”), on the Board of Directors.  The Company declined this request based on several identified conflicts of interest, as well as a violation of the covenant of good faith and fair dealing.  OC-PIN and/or Shah then filed a motion to enforce the Global Settlement Agreement under California Code of Civil Procedure Section 664.6 and force the Company to appoint Callahan to the Board of Directors.  The Company opposed this motion, in conjunction with an opposition by several members of OC-PIN, contesting Callahan as the duly authorized representative of OC-PIN.  On April 27, 2009, the Court denied Shah/OC-PIN’s motion, finding several conflicts of interest preventing Callahan from serving on the Company’s Board of Directors.  On May 5, 2009, Shah/OC-PIN filed a petition for writ of mandate with the Court of Appeals seeking to reverse the Court’s ruling and force Callahan’s appointment as a director, which was summarily denied on May 7, 2009.




On August 20, 2009, Judge Lewis ordered all parties to the Global Settlement Agreement to meet and confer with Hon. Gary Taylor regarding the issue of entering the Global Settlement Agreement as final judgment. On or about November 1, 2009, Judge Taylor issued a written recommendation to the court acknowledging several complications with entering the Global Settlement Agreement as judgment, largely based upon the pending litigation among the members of OC-PIN.  On December 7, 2009, Judge Lewis concurred with Judge Taylor’s recommendation to postpone entering judgment on the Global Settlement Agreement pending a resolution of the action among the members of OC-PIN.  The court has scheduled a status conference on April 5, 2010 for further consideration of this issue.  On April 5, 2010, Judge Lewis maintained the current stay order and scheduled an additional status conference for May 17, 2010.  At the May 17, 2010 status conference, the competing OC-PIN factions (referred to below) indicated they would attempt to agree to a plan for the stock issuances described in the Global Settlement Agreement.  The Court set a further status conference for July 12, 2010.




On April 24, 2009, a conglomeration of several OC-PIN members led by Ajay G. Meka, M.D. filed a lawsuit against Dr. Shah, other OC-PIN members, and various attorneys, alleging breach of fiduciary duty and seeking damages as well as declaratory and injunctive relief (the "First Meka Complaint"). While the Company is named as a defendant in the action, plaintiffs are only seeking declaratory and injunctive relief with respect to various provisions of the Global Settlement Agreement and a prior stock issuance to OC-PIN’s former attorney, Hari Lal. Due to the competing demands related to the Stock Purchase Agreements placed upon the Company from factions within OC-PIN, on May 13, 2009, the Company filed a Motion for Judicial Instructions regarding enforcement of the Global Settlement Agreement. On May 14, 2009, the Company, Dr. Shah, as well as both "factions" of OC-PIN entered into a "stand still" agreement regarding both the nomination of an OC-PIN Board representative as well as the allocation of shares under the Stock Purchase Agreements. Subsequently, on June 22, 2009, the Court granted a stay of the Company's obligations under the Global Settlement Agreement to issue stock to OC-PIN or appoint an OC-PIN representative on the Company’s Board of Directors until the resolution of the Amended Meka Complaint and related actions.




On June 1, 2009, a First Amended Complaint was filed to replace the First Meka Complaint (the "Amended Meka Complaint"). On October 9, 2009, the newly-assigned judge, Hon. Nancy Wieben-Stock, sustained a demurrer to the Amended Meka Complaint.  On or about March 19, 2010, Dr. Meka et al. filed a Third Amended Complaint (the “Third Amended Meka Complaint”).  It appears that the relief sought against the Company in the Third Amended Meka Complaint does not materially alter from the declaratory and injunctive relief sought in the First Meka Complaint. The Company filed its answer to the Third Amended Meka Complaint on April 9, 2009.  Numerous motions were filed by other parties challenging the Third Amended Meka Complaint.  The Court held an omnibus hearing on these motions on May 7, 2010, partly sustaining and partly overruling these several demurrers, without leave to further amend.  The Company believes it is a neutral stakeholder in the action, and that the results of the action will not have a material adverse impact on the Company's results of operations.




On June 17, 2009, Dr. Shah demanded that both the Company and PCHI indemnify him for his defense of the Amended Meka Complaint.  In response, both the Company and PCHI filed motions to enforce the releases contained in the Global Settlement Agreement, which the Company and PCHI believe waive Dr. Shah’s claim for indemnification in the Meka v. Shah lawsuit.  The court did not rule on PCHI’s or the Company’s motions, but left intact a prior injunction essentially staying the arbitration of Dr. Shah’s indemnity claim.




On January 25, 2010, the Company received correspondence purportedly on behalf of OC-PIN challenging the MOU with KPC Resolution Company.  The letter demanded that the Company take certain action in response to the MOU.  The Company issued a response to the letter on February 9, 2010 contesting several factual and legal conclusions therein and is currently awaiting confirmation from the court as to who properly represents OC-PIN.




25





OTHER LEGAL PROCEEDINGS




On June 16, 2008, Michael Fitzgibbons, M.D., filed a complaint against the Company alleging malicious prosecution, intentional interference with prospective economic advantage, defamation, and intentional infliction of emotional distress.  Most of the causes of action in the June 16, 2008 complaint derive from events precipitating a lawsuit filed by the Company against Dr. Fitzgibbons in 2005.  On September 9, 2008, the Company filed a “SLAPP Back” motion seeking to remove the malicious prosecution cause of action from Dr. Fitzgibbons’ complaint, as well as an Anti-SLAPP motion directed to the remaining causes of action.  The Court denied both motions on October 20, 2008.  The Company appealed the denial of the Anti-SLAPP motion, which was denied by the Court of Appeal on October 27, 2009.  The remittitur, releasing jurisdiction back to the trial court, was issued on December 31, 2009.  Discovery is currently ongoing.  At this early stage in the litigation, the Company is unable to determine the cost of defending this lawsuit or the impact, if any, this action may have on its results of operations.




On or about August 1, 1996, Southern California Specialty Care, Inc. ("SCSC") entered into a property lease agreement with PCHI whereby SCSC agreed to pay 10 percent of its net income to PCHI each quarter (the “Percentage Rent”).  In April 2008, PCHI brought a complaint in arbitration against SCSC alleging SCSC’s failure to pay the Percentage Rent since 2005.  In November 2009, PCHI and SCSC reached a settlement pursuant to which PCHI received $1.9 million for unpaid Percentage Rent through December 31, 2008, including late fees and litigation expenses, and $407,000 for Percentage Rent for the first three calendar quarters of 2009.




We and our subsidiaries are involved in various other legal proceedings most of which relate to routine matters incidental to our business. We do not believe that the outcome of these matters, individually or collectively, is likely to have a material adverse effect on the Company.





ITEM 4. REMOVED AND RESERVED




26




PART II





ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES





The Company's common stock is listed for trading on the OTC Bulletin Board under the symbol "IHCH.OB." The trading market for the Company's common stock has been extremely thin. In view of the extreme thinness of the trading market, the prices reflected on the chart below as reported on the OTC Bulletin Board may not be indicative of the price at which any prior or future transactions were or may be effected in the Company's common stock. Stockholders are cautioned against drawing any conclusions from the data contained herein, as past results are not necessarily indicative of future stock performance.




The following table sets forth the quarterly high and low bid price for the Company's common stock for each quarter for the period from April 1, 2008 through March 31, 2010, as quoted on the Over-the-Counter Bulletin Board. Such Over-the-Counter market quotations reflect inter dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.





PERIOD

HIGH

LOWApr 2008 - Jun 2008

$0.12

$0.07Jul 2008 - Sep 2008

$0.14

$0.01Oct 2008 - Dec 2008

$0.06

$0.01Jan 2009 - Mar 2009

$0.05

$0.01Apr 2009 - Jun 2009

$0.03

$0.01Jul 2009 - Sep 2009

$0.15

$0.01Oct 2009 - Dec 2009

$0.12

$0.05Jan 2010 - Mar 2010

$0.10

$0.04





As of the date of this report, there were approximately 171 record holders of the Company's common stock; this number does not include an indeterminate number of stockholders whose shares may be held by brokers in street name. The Company has not paid and does not expect to pay any dividends on its shares of common stock for the foreseeable future, as any earnings will be retained for use in the business.




The following table provides summary information concerning the Company's equity compensation plan as of March 31, 2010.





Equity Compensation Plan Information





Plan Category
Number of Securities to

be issued upon exercise

of outstanding options,

warrants and rights
Weighted-average

exercise price of

outstanding options,

warrants and rights
Number of securities

remaining available for

future issuance under

equity compensation

plans (excluding

securities reflected in

column (a))(a)
(b)
(c)Equity compensation plans approved by security holders
8,645,000
$  0.19
9,774,343Equity compensation plans not approved by security holders
-
-
-Total
8,645,000
$  0.19
9,774,343







27





ITEM 6. SELECTED FINANCIAL DATA





Not applicable.




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





FORWARD-LOOKING INFORMATION





This Annual Report on Form 10-K contains forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks discussed under the caption "Risk Factors" herein that may cause our Company's or our industry's actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by these forward-looking statements.




Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Except as may be required by applicable law, we do not intend to update any of the forward-looking statements to conform these statements to actual results.




As used in this report, the terms "we," "us," "our," "the Company," "Integrated Healthcare Holdings" or "IHHI" mean Integrated Healthcare Holdings, Inc., a Nevada corporation, unless otherwise indicated.




Unless otherwise indicated, all amounts included in this Item 7 are expressed in thousands (except percentages and per share amounts).





OVERVIEW





On March 8, 2005, the Company completed its acquisition (the "Acquisition") of four Orange County, California hospitals and associated real estate, including: (i) 282-bed Western Medical Center - Santa Ana, CA; (ii) 188-bed Western Medical Center - Anaheim, CA; (iii) 178-bed Coastal Communities Hospital in Santa Ana, CA; and (iv) 114-bed Chapman Medical Center in Orange, CA (collectively, the "Hospitals") from Tenet Healthcare Corporation ("Tenet"). The Hospitals were assigned to four wholly owned subsidiaries of the Company formed for the purpose of completing the Acquisition. The Company also acquired the following real estate, leases and assets associated with the Hospitals: (i) a fee interest in the Western Medical Center at 1001 North Tustin Avenue, Santa Ana, CA, a fee interest in the administration building at 1301 North Tustin Avenue, Santa Ana, CA, certain rights to acquire condominium suites located in the medical office building at 999 North Tustin Avenue, Santa Ana, CA, and the business known as the West Coast Breast Cancer Center; (ii) a fee interest in the Western Medical Center at 1025 South Anaheim Blvd., Anaheim, CA; (iii) a fee interest in the Coastal Communities Hospital at 2701 South Bristol Street, Santa Ana, CA, and a fee interest in the medical office building at 1901 North College Avenue, Santa Ana, CA; (iv) a lease for the Chapman Medical Center at 2601 East Chapman Avenue, Orange, CA, (v) a fee interest in the medical office building at 2617 East Chapman Avenue, Orange, CA; and (vi) equipment and contract rights. At the closing of the Acquisition, the Company transferred all of the fee interests in the acquired real estate, except for item (v) above, to Pacific Coast Holdings Investment, LLC ("PCHI"), a company owned indirectly by two of the Company's largest shareholders.





SIGNIFICANT CHALLENGES





COMPANY - Our Acquisition involved significant cash expenditures, debt incurrence and integration expenses that has seriously strained our consolidated financial condition. If we are required to issue equity securities to raise additional capital or for any other reasons, existing stockholders will likely be substantially diluted, which could affect the market price of our stock.




INDUSTRY - Our Hospitals receive a substantial portion of their revenues from Medicare and Medicaid. The healthcare industry is experiencing a strong trend toward cost containment, as the government seeks to impose lower reimbursement rates, limit the scope of covered services and negotiate reduced payment schedules with providers. These cost containment measures generally have resulted in a reduced rate of growth in the reimbursement for the services that we provide relative to the increase in our cost to provide such services.




28




Changes to Medicare and Medicaid reimbursement programs have limited, and are expected to continue to limit, payment increases under these programs. Also, the timing of payments made under the Medicare and Medicaid programs is subject to regulatory action and governmental budgetary constraints resulting in a risk that the time period between submission of claims and payment could increase. Further, within the statutory framework of the Medicare and Medicaid programs, a substantial number of areas are subject to administrative rulings and interpretations which may further affect payments.




Our business is subject to extensive federal, state and, in some cases, local regulation with respect to, among other things, participation in the Medicare and Medicaid programs, licensure and certification of facilities, and reimbursement. These regulations relate, among other things, to the adequacy of physical property and equipment, qualifications of personnel, standards of care, government reimbursement and operational requirements. Compliance with these regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of our business. Because these regulations are amended from time to time and are subject to interpretation, we cannot predict when and to what extent liability may arise. Failure to comply with current or future regulatory requirements could also result in the imposition of various remedies including (with respect to inpatient care) fines, restrictions on admission, denial of payment for all or new admissions, the revocation of licensure, decertification, imposition of temporary management or the closure of a facility or site of service.




We are subject to periodic audits by the Medicare and Medicaid programs, which have various rights and remedies against us if they assert that we have overcharged the programs or failed to comply with program requirements. Rights and remedies available to these programs include repayment of any amounts alleged to be overpayments or in violation of program requirements, or making deductions from future amounts due to us. These programs may also impose fines, criminal penalties or program exclusions. Other third-party payer sources also reserve rights to conduct audits and make monetary adjustments in connection with or exclusive of audit activities.




The healthcare industry is highly competitive. We compete with a variety of other organizations in providing medical services, many of which have greater financial and other resources and may be more established in their respective communities than we are. Competing companies may offer newer or different centers or services than we do and may thereby attract patients or customers who are presently our patients or customers or are otherwise receiving our services.




An increasing trend in malpractice litigation claims, rising costs of malpractice litigation, losses associated with these malpractice lawsuits and a constriction of insurers have caused many insurance carriers to raise the cost of insurance premiums or refuse to write insurance policies for hospital facilities. Also, a tightening of the reinsurance market has affected property, vehicle, and excess liability insurance carriers.




We receive all of our inpatient services revenue from operations in Orange County, California. The economic condition of this market could affect the ability of our patients and third-party payers to reimburse us for our services, through its effect on disposable household income and the tax base used to generate state funding for Medicaid programs. An economic downturn, or changes in the laws affecting our business in our market and in surrounding markets, could have a material adverse effect on our financial position, results of operations, and cash flows. The Company's liquidity is highly dependent upon the continued availability under its existing credit facilities.




LIQUIDITY AND CAPITAL RESOURCES





The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. The Company had a stockholders’ deficiency of $36.8 million and a working capital deficit of $4.5 million at March 31, 2010.




LENDER RECEIVERSHIP AND DEFAULT – On January 28, 2009, the Company’s “Lender” (consisting of Medical Capital Corporation and its affiliates, Medical Provider Financial Corporation I, Medical Provider Financial Corporation II, and Medical Provider Financial Corporation III) began to collect and retain amounts in excess of the amounts due to it (“Excess Amounts”) under the $50.0 million Revolving Credit Agreement. From January 28, 2009 to on or about May 18, 2009, the Lender had swept an aggregate of $14.3 million in Excess Amounts.  The Lender continued to release Excess Amounts to defray the Company’s monthly interest obligations under all other loan agreements between it and the Company through June 30, 2009, resulting in a balance in Excess Amounts of $11.3 million.




On April 14, 2009, the Company issued a letter (the “Demand Letter”) notifying the Lender that it was in default on the $50.0 million Revolving Credit Agreement, to make demand for return of all Excess Amounts, and to reserve the rights of the borrowers and credit parties with respect to other actions and remedies available to them. The Company considered the Lender’s failure to return the Excess Amounts as an improper conversion of assets and a breach of the Lender’s fiduciary and custodial obligations. On April 17, 2009, following receipt of a copy of the Demand Letter, the bank that maintained the lock boxes pursuant to a restricted account and securities account control agreement (the “Lockbox Agreement”) notified the Company and the Lender that it would terminate the Lockbox Agreement within 30 days. On May 18, 2009, the Lockbox Agreement was terminated and the Company's bank accounts were frozen. On May 19, 2009, the Lender relinquished any and all control over the bank accounts pursuant to the Lockbox Agreement. The Lender’s relinquishment provided the Company with full access to its bank accounts and the accounts were no longer accessible by the Lender.




29




On July 16, 2009, the SEC filed a fraud complaint with the United States District Court against the parent company and affiliates of the Lender for violations of federal securities laws and barred it from entering into material transactions pending presentation of the government’s case. On August 3, 2009, Mr. Thomas A. Seaman was appointed receiver ("Lender's Receiver") by the United States District Court in this securities fraud enforcement action.




Hereafter, unless otherwise indicated, the term "Lender" will be used in all references to the Lender and the Lender's Receiver included in this Item 7.




Due to the uncertainty created under receivership, as of September 30, 2009, the Company applied ASC 450, “Contingencies,” in assessing the need for a valuation reserve and concluded that the loss was both probable and estimable. As a result, during the three months ended September 30, 2009, the Company fully reserved the balance of $11.3 million in Excess Amounts.




Subsequent to March 31, 2010, pursuant to the Release (See “MEMORANDUM OF UNDERSTANDING” and “OMNIBUS AMENDMENT”) the Lender released $6.4 million in Excess Amounts to apply against interest expense the Company had accrued under its term loans. As a result, as of March 31, 2010, the Lender retained a net amount of $4.9 million in Excess Amounts under the $50.0 million Revolving Credit Agreement. Under the terms of the MOU and Omnibus Amendment, an additional $1.0 million was recovered by the Company as a reduction in principal of the Company’s outstanding debt, resulting in a gross recovery of $7.4 million. As an offsetting cost of the recovery and pursuant to the aforementioned MOU, the Company issued a warrant to purchase up to 170.0 million shares of the Company’s common stock at $0.07 per share to Dr. Kali P. Chaudhuri, the Company’s majority shareholder, who facilitated the Release that provided for the $6.4 million release by the Lender of Excess Amounts and the $1.0 million reduction in principal noted above, among other benefits, to the Company (See “MEMORANDUM OF UNDERSTANDING” and “OMNIBUS AMENDMENT”). The fair value of the warrant is estimated at $2.1 million using the Black-Scholes valuation model. Accordingly, as of March 31, 2010, the Company revised its estimate of the valuation reserve based on the more recent and certain outcome using the guidance of ASC 450, resulting in a net expense amount of $6.0 million for the year ended March 31, 2010.




The Company currently relies solely on its cash receipts from payers to fund its operations, and any significant disruption in such receipts could have a material adverse effect on its ability to continue as a going concern. Subsequent to March 31, 2010, the Company entered into an agreement with a new lender whereby $10.0 million in revolving funds will be available to the Company for working capital and general corporate purposes (See “OMNIBUS AMENDMENT”). However, a $10.0 million revolving line of credit may be insufficient to meet the Company’s cash needs. The consolidated financial statements do not include any adjustments that might result from the outcome this uncertainty.




These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern and indicate a need for it to take action to continue to operate its business as a going concern. There is no assurance that we will be successful in improving reimbursements, reducing operating expenses, or obtaining sufficient working capital financing. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. (See “MEMORANDUM OF UNDERSTANDING” and “OMNIBUS AMENDMENT”.)




Key items for the year ended March 31, 2010 included:





1.
During the year ended March 31, 2010, the Company received a lump sum amendment to the CMAC agreement for $3.0 million and $2.3 million received by PCHI in a settlement with a third party for additional back rent. During the year ended March 31, 2009, the Company received a lump sum amendment to the CMAC agreement for $3.7 million. Adjusting for these lump-sum payments, net collectible revenues (net operating revenues less provision for doubtful accounts) for the year ended March 31, 2010 and 2009 were $346.3 million and $347.1 million, respectively, representing a decrease of 0.23%. The Hospitals serve a disproportionate number of indigent patients and receive governmental revenues and subsidies in support of care for these patients. Governmental revenues include payments from Medicaid, Medicaid DSH, and Orange County, CA (CalOptima). Governmental revenues increased $10.3 million for the year ended March 31, 2010 compared to the year ended March 31, 2009.





Inpatient admissions decreased by 4.5% to 25.6 for the year ended March 31, 2010 compared to 26.8 for the year ended March 31, 2009. The decline in admissions is the combined result of lower obstetrical deliveries, psychiatric admissions, and managed care contracts that reached term pending renegotiation.





Uninsured patients, as a percentage of gross charges, decreased to 5.2% from 6.0% for the year ended March 31, 2010 compared to the year ended March 31, 2009.





2.
Operating expenses: Management is working aggressively to reduce costs without reduction in service levels. Operating expenses before interest for the year ended March 31, 2010 were $363.6 million, or 4.4%, lower than in fiscal year 2009. The most significant factors of this decrease were the $10.5 million decrease in the provision for doubtful accounts due to improvements in collection efforts, $2.8 million decrease in salaries and benefits, $11.4 million decrease in other operating expenses, which were partially offset by the $6.0 million loss related to Excess Amounts noted above.





30




As of March 31, 2010, the Company’s debt consisted of the following (see “OMNIBUS AMENDMENT”):





·
A $45.0 million Term Note issued under the $80.0 million credit agreement, being a fixed interest rate of 10.25% per year.





·
A $35.0 million Non-Revolving Line of Credit Note issued under the $80.0 million credit agreement, bearing a fixed interest rate of 9.25% per year and an unused commitment fee of 0.50% per year.





·
A $10.7 million credit agreement, under which we issued a $10.7 million Convertible Term Note bearing a fixed interest rate of 9.25% per year. The $10.7 million Convertible Term Note is convertible into common stock of the Company at $0.21 per share during the term of the note, subject to certain dilution adjustments.





·
A $50.0 million Revolving Credit Agreement, under which we issued a $50.0 million Revolving Line of Credit Note bearing a fixed interest rate of 24% per year and an unused commitment fee of 0.50% per year. As noted above, the Lender is in default under this agreement.





SECURITIES PURCHASE AGREEMENT - On July 18, 2008, the Company entered into a Securities Purchase Agreement (the "Purchase Agreement") with Dr. Chaudhuri and Mr. Thomas. Pursuant to the Purchase Agreement, Dr. Chaudhuri had a right to purchase ("Purchase Right") from the Company 63.3 million shares of its common stock for consideration of $0.11 per share, aggregating $7.0 million.




Concurrent with the execution of the Purchase Agreement, Dr. Chaudhuri exercised in full outstanding, previously issued, warrants to purchase 24.9 million shares of common stock at an exercise price of $0.15 per share, for a total purchase price of $3.7 million. The Company used the $3.7 million in proceeds from the warrant exercise described above to pay down the $10.7 million Convertible Term Note. The Purchase Right expired on January 10, 2009.




On January 30, 2009, the Company entered into an amendment of the Purchase Agreement ("Amended Purchase Agreement"). Under the Amended Purchase Agreement, Dr. Chaudhuri agreed to purchase immediately from the Company 33.3 million shares of Company common stock (the "Additional Shares") at a purchase price of $0.03 per share, or an aggregate purchase price of $1.0 million. In consideration for Dr. Chaudhuri's entry into the Amended Purchase Agreement and payment to the Company of $30, under the Amended Purchase Agreement the Company granted to Dr. Chaudhuri the right, in Dr. Chaudhuri's sole discretion (subject to the Company having sufficient authorized capital), to invest at any time and from time to time through January 30, 2010 up to $6.0 million through the purchase of shares of the Company's common stock at a purchase price of $0.11 per share. The Amended Purchase Agreement expired on January 30, 2010.




Since the shares purchased under the Amended Purchase Agreement resulted in a change in control, the Company is subject to limitations on the use of its net operating loss carryforwards.




GLOBAL SETTLEMENT AGREEMENT - Effective April 2, 2009, the Company, Dr. Shah, OC-PIN, Mr. Mogel, PCHI, West Coast, Dr. Chaudhuri, Ganesha, Mr. Thomas, and the Lender entered into a Settlement Agreement, General Release and Covenant Not to Sue ("Global Settlement Agreement") in connection with the settlement of pending and threatened litigation, arbitration, appellate, and other legal proceedings (the "Actions") among the various parties. Pursuant to the Global Settlement Agreement, the Company agreed to pay to OC-PIN and Dr. Shah a total sum of $2.4 million in two installments consisting of $1.6 million at closing and $750, together with interest thereon at 8%, payable on September 25, 2009 (the "Second Payment $750"). The Company also agreed to pay the sum of $15 as satisfaction of Dr. Shah's individual claims. Additionally, the Company and Mr. Mogel agreed to stipulate to the release and return of a $50 bond which was posted in connection with a shareholder derivative suit filed by OC-PIN against both Mr. Mogel and the Company. The completion of this transaction is still pending (see "MEKA COMPLAINT"). The balance due of $750 is accrued at March 31, 2010.





In addition, Dr. Shah covenanted and agreed, that for a period of 2 years after the Closing, he will not accept any nomination, appointment or will not serve in the capacity as a director, officer, or employee of the Company, so long as the Company keeps the PCHI and Chapman Medical Center leases current by making payments within 45 days of when payments are due.




Pursuant to the Global Settlement Agreement, the Company agreed to amend its Bylaws to provide (i) that the number of members of the Company's Board of Directors shall be fixed at 7 and (ii) that a shareholder who owns 15% or more of the voting stock of the Company is entitled to call one special shareholders meeting per year. As of March 31, 2010, OC-PIN's representative has not been duly appointed by OC-PIN (see "MEKA COMPLAINT").




Also pursuant to the Global Settlement Agreement, the Company entered into Stock Purchase Agreements (the "2009 Stock Purchase Agreements") with Dr. Chaudhuri, Dr. Shah, and OC-PIN. Pursuant to these 2009 Stock Purchase Agreements, Dr. Shah and OC-PIN will receive an aggregate of 14.7 million shares of the Company's common stock each and Dr. Chaudhuri will receive an aggregate of 30.6 million shares of the Company's common stock, for a price of $0.03 per share (the "2009 Stock Purchase Shares"). As of March 31, 2010, the 2009 Stock Purchase Shares have been issued but full payment has not been received by the Company. The completion of this transaction is still pending (see "MEKA COMPLAINT").




31




In conjunction with the Global Settlement Agreement, on April 2, 2009, the Company and the Lender entered into the Amendment No. 1 to Credit Agreement. The Lender agreed to reduce the interest rate on the $45.0 million Term Note from 14.0% to 10.25% and to maintain such interest rate up to and including the maturity date of the Term Note, or any extension thereof, as defined in the $80 million credit agreement, under which the $45.0 million Term Note was issued.  The reduction of the interest rate was deemed not to meet the criteria for a troubled debt restructuring.




MEKA COMPLAINT - On April 24, 2009, a conglomeration of several OC-PIN members led by Ajay G. Meka, M.D. filed a lawsuit against Dr.Shah, other OC-PIN members, and various attorneys, alleging breach of fiduciary duty and seeking damages as well as declaratory and injunctive relief (the "First Meka Complaint"). While the Company is named as a defendant in the action, plaintiffs are only seeking declaratory and injunctive relief with respect to various provisions of the Global Settlement Agreement. Due to the competing demands related to the Stock Purchase Agreements placed upon the Company from factions within OC-PIN, on May 13, 2009, the Company filed a Motion for Judicial Instructions regarding enforcement of the Global Settlement Agreement. On May 14, 2009, the Company, Dr. Shah, as well as both "factions" of OC-PIN entered into a "stand still" agreement regarding both the nomination of an OC-PIN Board representative as well as the allocation of shares under the Stock Purchase Agreements.




On June 1, 2009, a First Amended Complaint was filed to replace the First Meka Complaint (the "Amended Meka Complaint"). It appears that the relief sought against the Company in the Amended Meka Complaint does not materially alter from the declaratory and injunctive relief sought in the First Meka Complaint. The Company believes it is a neutral stakeholder in the action, and that the results of the action will not have a material adverse impact on the Company's results of operations. On June 22, 2009, the Court granted a stay of the Company's remaining obligations under the Global Settlement Agreement until the resolution of the Amended Meka Complaint and related actions.




MEMORANDUM OF UNDERSTANDING - On January 13, 2010, the Company entered into an Amended and Restated Memorandum of Understanding (the “MOU”) with Dr. Chaudhuri and KPC Resolution Company, LLC (“KPC”), an affiliate of Dr. Chaudhuri. The MOU amended and restated the original Memorandum of Understanding entered into by the Company and Dr. Chaudhuri on or about August 12, 2009.  Concurrently with entering into the MOU, KPC entered into a Loan Purchase and Sale Agreement (the “Sale Agreement”) with the court-appointed receiver for the Lender to purchase all of the Company’s credit facilities with the Lender and the related warrants to purchase common stock of the Company that were issued to the Lender. Included as an exhibit to the Sale Agreement was a release between the Company and the Receiver. Under the terms of the “Release,” among other things, the Receiver would release Excess Amounts representing interest on the Company’s term loans for the period from July 1, 2009 though the date of sale of all of the Company’s notes with the Lenders. The Release would be effective only if KPC, or its designee, would be the purchaser of the notes from the Receiver. On March 22, 2010, the Release was signed by the Company and hand delivered to the Receiver’s legal counsel. At that point, the Release was acceptable to both the Receiver and the Company and was being held by the Receiver’s legal counsel until KPC, or its designee, would purchase the Company’s notes from the Receiver.
 
 In consideration of obtaining the Release and other benefits for the Company, the Company agreed to issue a warrant to purchase up to 170.0 million shares of the Company’s common stock at $0.07 per share to Dr. Chaudhuri.  The MOU was terminated on April 13, 2010, upon execution of the Omnibus Amendment. Some of the terms in the MOU survived and are included in the Omnibus Amendment (see “OMNIBUS AMENDMENT”).
  OMNIBUS AMENDMENT - On April 13, 2010, the Company entered into an Omnibus Credit Agreement Amendment (the “Omnibus Amendment”) with SPCP Group IV, LLC and SPCP Group, LLC (together, “Silver Point”), Silver Point Finance, LLC, as the Lender Agent, PCHI, Ganesha, Dr. Chaudhuri, and KPC. KPC and Ganesha are companies owned and controlled by Dr. Chaudhuri, who is the majority shareholder of the Company. Ganesha is a member of PCHI with a 49% membership interest.





The Omnibus Amendment amends the $80.0 million credit facility dated as of October 9, 2007, as amended (the “$80.0 million credit agreement”), the $50.0 million revolving credit facility) dated as of October 9, 2007, as amended (the “$50.0 million revolving credit agreement”), and the $10.7 million credit facility dated as of October 9, 2007, as amended (the “$10.7 million credit agreement” and together with the $80.0 million credit agreement and the $50.0 million revolving credit agreement, the “Credit Agreements”), by and among the Company and certain affiliates of the Lender.




The Company entered into the Omnibus Amendment in connection with the Loan Purchase and Sale Agreement, dated as of January 13, 2010, as amended, by and between KPC and the Lender’s Receiver. Under the Loan Purchase Agreement, KPC agreed to purchase all of the Credit Agreements from the Lender’s Receiver for $70.0 million. Concurrent with the closing of the Loan Purchase Agreement, KPC sold its interest in acquiring the Credit Agreements to Silver Point, and KPC purchased from Silver Point a participation interest in the Credit Agreements. On April 13, 2010, concurrent with the effectiveness of the Omnibus Amendment and the closing of the Loan Purchase Agreement, Silver Point acquired all of the Credit Agreements, including the security agreements and other ancillary documents executed by the Company in connection with the Credit Agreements, and became the “New Lender” under the Credit Agreements.




32




The following are material terms of the Omnibus Amendment:




·
The stated maturity date under each Credit Agreement was changed to April 13, 2013.  The Credit Agreements were otherwise due to mature on October 8, 2010.


·
Affirming release of prior claims between the Company and the Lender’s Receiver, Silver Point agreed to waive any events of default that had occurred under the Credit Agreements and waived claims to accrued and unpaid interest and fees under the Credit Agreements as of April 13, 2010.


·
The $80.0 million credit agreement was amended so that the $45.0 million Term Note (the “$45.0 million loan”) and $35.0 million Non-Revolving Line of Credit Note (the “$35.0 million loan”) will each bear a fixed interest rate of 14.5% per year.  These loans previously bore interest rates of 10.25% and 9.25%, respectively.  In addition, the Company agreed to make certain mandatory prepayments of the $35.0 million loan if it receives proceeds from certain new financing of its accounts receivable or provider fee funds from Medi-Cal under California AB 1383.


·
The $50.0 million Revolving Credit Agreement was amended so that Silver Point will, subject to the terms and conditions contained therein, make up to $10.0 million in new revolving funds available to the Company for working capital and general corporate purposes.  Each advance under the $50.0 million revolving credit agreement will bear interest at an annual rate of Adjusted LIBOR (calculated as LIBOR subject to certain adjustments, with a floor of 2% and a cap of 5%) plus 12.5%, compared to an interest rate of 24.0% that was previously in effect under the $50.0 million revolving credit agreement.  In addition, the Company agreed to make mandatory prepayments of the $50.0 million revolving credit agreement under the conditions described above with respect to the $80.0 million credit agreement.  The financial covenants under the $50.0 million revolving credit agreement were also amended to increase the required levels of minimum EBITDA (as defined in the Omnibus Amendment) from the levels previously in effect under the $50.0 million Revolving Credit Agreement.


·
The $10.7 million credit agreement was amended so that the $10.7 million Convertible Term Note will bear a fixed interest rate of 14.5% per year, compared to the interest rate of 9.25% previously in effect and to eliminate the conversion feature of the loan.  In addition, the Company agreed to make mandatory prepayments of the $10.7 million credit agreement under the conditions described above with respect to the $80.0 million credit agreement.





·
In connection with the sale of the Credit Agreements, all warrants and stock conversion rights previously issued to the Lender were cancelled.  In connection with the Omnibus Amendment, the Company issued new warrants (the “Omnibus Warrants”) to purchase its common stock for a period of three years at an exercise price of $0.07 per share in the following denominations: 139.0 million shares to KPC or its designees and 96.0 million shares to Silver Point or its designees.  The Omnibus Warrants also provide the holders with certain pre-emptive, information and registration rights.





In addition, on April 13, 2010, the Company issued a three-year warrant to acquire up to 170.0 million shares of common stock at $0.07 per share to Dr. Chaudhuri who facilitated the Release and a $1.0 million reduction in principal of the Company’s outstanding debt which were existing obligations under the MOU, among other benefits to the Company.  The MOU was terminated upon effectiveness of the Omnibus Amendment (see “MEMORANDUM OF UNDERSTANDING”).




On April 13, 2010, in connection with the sale of the Credit Agreements by the Receiver, the Company and the Receiver entered into a release (the “Release”) under which the Company agreed to provide a general release to the Receiver from any claims arising under the Credit Agreements.  The Company received a limited release from the Receiver for claims arising under the Credit Agreements and the sale of the Credit Agreements by the Receiver.




LONG TERM LEASE COMMITMENT WITH VARIABLE INTEREST ENTITY – Concurrent with the closing of the Acquisition as of March 8, 2005, the Company entered into a sale leaseback type agreement with a related party entity, PCHI. The Company leases substantially all of the real estate of the acquired Hospitals and medical office buildings from PCHI. In October 2007, the Company entered into an Amended Lease with PCHI. The Amended Lease terminates on the 25-year anniversary of the original lease (March 8, 2005), grants the Company the right to renew for one additional 25-year period, and requires annual base rental payments of $8.3 million. However, until certain refinancing takes place, the annual base rental payments were reduced to $7.1 million. In addition, the Company may offset against its rental payments owed to PCHI interest payments that it makes to the Lender under certain of its indebtedness discussed above.




Pursuant to the Global Settlement Agreement, the Company and PCHI entered into the Amendment to Amended and Restated Triple Net Hospital Building Lease (the "2009 Lease Amendment"), whereby PCHI agreed to reduce the rent paid by the Company under the Amended Lease by an amount equal to the debt service reduction (i.e., the difference between 14.0% and 10.25%) during the debt service reduction period, as defined, reducing the annual base rent from $7.1 million to $5.4 million.




33




On April 13, 2010, the Company and PCHI entered into a Second Amendment to Amended and Restated Triple Net Hospital Building Lease (the “2010 Lease Amendment”). Under the 2010 Lease Amendment, the annual base rent to be paid by the Company to PCHI was increased from $5.4 million to $7.3 million, but if PCHI refinances the $45.0 million loan, the annual base rent will increase to $8.3 million. In addition, since the Company has not paid rent due under the lease for the period from November 1, 2008 through April 30, 2010, the Company agreed that upon receipt of provider fee funds from Medi-Cal under California AB 1383 (subject to its obligation to prepay certain of the Credit Agreements from such funds under the Omnibus Amendment), the Company will pay all unpaid rent due to PCHI, but in any event not later than December 1, 2010. This lease commitment with PCHI is eliminated in consolidation (see "GLOBAL SETTLEMENT AGREEMENT" and "OMNIBUS AMENDMENT").




The Company remains primarily liable under the $45.0 million loan notwithstanding its guarantee by PCHI, and this note is cross collateralized by substantially all of the Company's assets and all of the real property of the Hospitals. All of the Company's operating activities are directly affected by the real property that was sold to PCHI. Given these factors, the Company has indirectly guaranteed the indebtedness of PCHI. The Company is standing ready to perform on the $45.0 million loan should PCHI not be able to perform and has undertaken a contingent obligation to make future payments if those triggering events or conditions occur.




COMMITMENTS AND CONTINGENCIES - The State of California has imposed new hospital seismic safety requirements. Under these new requirements, the Hospitals must meet stringent seismic safety criteria in the future. In addition, there could be other remediation costs pursuant to this seismic retrofit. However, subsequent new review methodologies have caused an inability to fully determine the estimate of these costs at March 31, 2010.




The State of California has introduced a new seismic review methodology known as HAZUS. The HAZUS methodology may preclude the need for some structural modifications. All four Hospitals requested HAZUS review and received a favorable notice pertaining to structural reclassification. All hospital buildings, with the exception of one (an administrative building), have been deemed compliant until January 1, 2030 for both structural and nonstructural retrofit.




There are additional requirements that must be complied with by 2030. The costs of meeting these requirements have not yet been determined. Compliance with seismic ordinances will be a costly venture and could have a material adverse effect on the Company's cash flow.




CASH FLOW - Net cash provided by operating activities for the years ended March 31, 2010 and 2009 was $18.4 million and $20.1 million, respectively. Net income, adjusted for depreciation and other non-cash items, excluding the provision for doubtful accounts and net income from noncontrolling interests, totaled $11.0 million and $3.3 million for the years ended March 31, 2010 and 2009, respectively. The Company used $1.4 million and produced $16.8 million in working capital for the year ended March 31, 2010 and 2009, respectively. Net cash produced by growth in (used by decrease in) accounts payable, accrued compensation and benefits and other current liabilities was $(3.4) million and $14.1 million for year ended March 31, 2010 and 2009, respectively. Cash provided by accounts receivable, net of provision for doubtful accounts, was $2.7 million and $1.6 million for the years ended March 31, 2010 and 2009, respectively.




Net cash used in investing activities during the years ended March 31, 2010 and 2009 was $2.9 million and $0.8 million, respectively. In the year ended March 31, 2010 and 2009, the Company invested $2.9 million and $0.8 million in cash, respectively, in new equipment.




Net cash used in financing activities for the year ended March 31, 2010 and 2009 was $8.8 million and $18.9 million, respectively. The decrease in net cash used in financing activities for the year ended March 31, 2010 was primarily due to $5.7 million in amounts collected and retained by the Lender in excess of the amounts due to the Lender under the $50.0 million Revolving Credit Agreement.




34





RESULTS OF OPERATIONS AND FINANCIAL CONDITION





The following table sets forth, for the years ended March 31, 2010 and 2009, our consolidated statements of operations expressed as a percentage of net operating revenues.




Year ended March 31,2010


2009Net operating revenues


100.0%



100.0%Operating expenses:Salaries and benefits


54.8%



54.1%Supplies


13.8%



13.1%Provision for doubtful accounts


8.3%



10.7%Other operating expenses


15.3%



17.9%Depreciation and amortization


1.0%



0.9%Loss - due from Lender


1.6%



0.0%94.8%



96.7%Operating income


5.2%



3.3%Other expense:Interest expense, net


(2.4%
)


(3.2%
)Warrant expense


0.0%



(0.0%
)(2.4%
)


(3.2%
)Income before provision for income taxes


2.8%



0.1%Income tax provision (benefit)


(0.0%
)


0.1%Net income (loss)


2.8%



(0.0%
)Net income attributable tononcontrolling interests


(1.0%
)


(0.3%
)Net income (loss) attributable toIntegrated Healthcare Holdings, Inc.


1.8%



(0.3%
)





FISCAL YEAR ENDED MARCH 31, 2010 COMPARED TO FISCAL YEAR ENDED MARCH 31, 2009





NET OPERATING REVENUES - Net operating revenues for the year ended March 31, 2010 decreased 2.4% compared to fiscal year 2009, from $393.0 million to $383.4 million. Net operating revenues for the year ended March 31, 2010 included a lump sum amendment to the CMAC agreement for $3.0 million and $2.3 million received by PCHI in a settlement with a third party for additional back rent. Net operating revenues for the year ended March 31, 2009 included a lump sum amendment to the CMAC agreement for $3.7 million.  Admissions for the year ended March 31, 2010 decreased 4.3% compared to fiscal year 2009. The decline in admissions is the combined result of lower obstetrical deliveries, psychiatric admissions, and managed care contracts that have reached term and are pending renegotiation. Net operating revenues per admission improved by 1.9% during the year ended March 31, 2010 as a result of negotiated managed care and governmental payment rate increases. Based on average revenue for comparable services from all other payers, revenues foregone under the charity policy, including indigent care accounts, for the years ended March 31, 2010 and 2009 were $8.3 million and $8.2 million, respectively.




Essentially all net operating revenues come from external customers. The largest payers are the Medicare and Medicaid programs accounting for 59.1% and 55.0% of the net operating revenues for the years ended March 31, 2010 and 2009, respectively.




Uninsured patients, as a percentage of gross charges, decreased to 5.2% from 6.0% for the year ended March 31, 2010 compared to the year ended March 31, 2009.




35




Although not a GAAP measure, the Company defines "Net Collectible Revenues" as net operating revenues less provision for doubtful accounts. This eliminates the distortion caused by the changes in patient account classification. Excluding the $5.3 million and $3.7 million lump sum payments referred to above during the years ended March 31, 2010 and 2009, respectively, Net Collectible Revenues were $346.3 million (net revenues of $378.1 million less $31.8 million in provision for doubtful accounts) and $347.1 million (net revenues of $389.3 million less $42.2 million in provision for doubtful accounts) for the years ended March 31, 2010 and 2009, respectively, representing an decrease of $0.8 million. There was an increase in Net Collectible Revenues per admission of 4.2% for the year ended March 31, 2010 compared to the year ended March 31, 2009.




OPERATING EXPENSES - Operating expenses for the year ended March 31, 2010 decreased to $363.6 million from $380.5 million, a decrease of $16.9 million, or 4.4%, compared to fiscal year 2009. Operating expenses expressed as a percentage of net operating revenues for the years ended March 31, 2010 and 2009 were 94.8% and 96.8%, respectively. On a per admission basis, operating expenses decreased 0.2%.




Salaries and benefits decreased $2.8 million (1.3%) for the year ended March 31, 2010 compared to fiscal year 2009. Contract labor decreased $6.2 million as nurses returned to the workforce in response to the current economic downturn.




Other operating expenses during the year ended March 31, 2010 decreased to $59.1 million from $70.5 million, a decrease of $11.4 million, or 16.2%, compared to fiscal 2009, primarily due to the decline in admissions and decreases in professional fees ($7.8 million decrease) and purchased services ($2.2 million decrease).  Also, during the year ended March 31, 2009, the Company recorded $2.4 million in other operating expenses relating to the Settlement Agreement effective April 2, 2009 (see "GLOBAL SETTLEMENT AGREEMENT").




The provision for doubtful accounts for year ended March 31, 2010 decreased to $31.8 million from $42.2 million, or 24.8%, compared to the same period in fiscal year 2009. The decrease in the provision for doubtful accounts for the year ended March 31, 2010 is primarily due to improvement in collections, which were 2.2% higher during the year ended March 31, 2010 compared to the year ended March 31, 2009 and increase in government payments as a percentage of total revenues.  Other factors contributing to the decrease include improved recovery from a non-contracted managed care payer and decrease in self-pay.




OPERATING INCOME - The operating income for the year ended March 31, 2010 and 2009 was $19.8 million and $12.5 million, respectively.




OTHER EXPENSE - Interest expense for the year ended March 31, 2010 was $9.3 million compared to $12.4 million for the same period in fiscal year 2010. The decrease primarily related to the reduction in the outstanding balance of the Company’s $50 million Revolving Line of Credit.




NET INCOME (LOSS) - Net income for the year ended March 31, 2010 was $7.1 million compared to a net loss of $1.5 million for fiscal year 2009.





CRITICAL ACCOUNTING POLICIES AND ESTIMATES





REVENUE RECOGNITION - Net operating revenues are recognized in the period in which services are performed and are recorded based on established billing rates (gross charges) less estimated discounts for contractual allowances, principally for patients covered by Medicare, Medicaid, managed care, and other health plans. Gross charges are retail charges. They are not the same as actual pricing, and they generally do not reflect what a hospital is ultimately paid and therefore are not displayed in the consolidated statements of operations. Hospitals are typically paid amounts that are negotiated with insurance companies or are set by the government. Gross charges are used to calculate Medicare outlier payments and to determine certain elements of payment under managed care contracts (such as stop-loss payments). Because Medicare requires that a hospital's gross charges be the same for all patients (regardless of payer category), gross charges are also what the Hospitals charge all other patients prior to the application of discounts and allowances.




Revenues under the traditional fee-for-service Medicare and Medicaid programs are based primarily on prospective payment systems. Discounts for retrospectively cost based revenues and certain other payments, which are based on the Hospitals' cost reports, are estimated using historical trends and current factors. Cost report settlements for retrospectively cost-based revenues under these programs are subject to audit and administrative and judicial review, which can take several years until final settlement of such matters are determined and completely resolved. Estimates of settlement receivables or payables related to a specific year are updated periodically and at year end and at the time the cost report is filed with the fiscal intermediary. Typically no further updates are made to the estimates until the final Notice of Program Reimbursement is received, at which time the cost report for that year has been audited by the fiscal intermediary. There could be several years time lag between the submission of a cost report and receipt of the Final Notice of Program Reimbursement. Since the laws, regulations, instructions and rule interpretations governing Medicare and Medicaid reimbursement are complex and change frequently, the estimates recorded by the Hospitals could change by material amounts. The Company has established settlement receivables of $220 thousand and $1.6 million as of March 31, 2010 and 2009, respectively.




36




Outlier payments, which were established by Congress as part of the diagnosis-related groups ("DRG") prospective payment system, are additional payments made to Hospitals for treating Medicare patients who are costlier to treat than the average patient in the same DRG. To qualify as a cost outlier, a hospital's billed (or gross) charges, adjusted to cost, must exceed the payment rate for the DRG by a fixed threshold established annually by the Centers for Medicare and Medicaid Services of the United States Department of Health and Human Services ("CMS"). Under Sections 1886(d) and 1886(g) of the Social Security Act, CMS must project aggregate annual outlier payments to all prospective payment system Hospitals to be not less than 5% or more than 6% of total DRG payments ("Outlier Percentage"). The Outlier Percentage is determined by dividing total outlier payments by the sum of DRG and outlier payments. CMS annually adjusts the fixed threshold to bring expected outlier payments within the mandated limit. A change to the fixed threshold affects total outlier payments by changing (1) the number of cases that qualify for outlier payments, and (2) the dollar amount Hospitals receive for those cases that still qualify. The most recent change to the cost outlier threshold that became effective on October 1, 2009 was an increase from $20.045 to $23.140. CMS projects this will result in an Outlier Percentage that is approximately 5.1% of total payments. The Medicare fiscal intermediary calculates the cost of a claim by multiplying the billed charges by the cost-to-charge ratio from the hospital's most recent filed cost report.




The Hospitals received new provider numbers following the Acquisition and, because there was no specific history, the Hospitals were reimbursed for outliers based on published statewide averages. If the computed cost exceeds the sum of the DRG payment plus the fixed threshold, a hospital receives 80% of the difference as an outlier payment. Medicare has reserved the option of adjusting outlier payments, through the cost report, to a hospital's actual cost-to-charge ratio. Upon receipt of the current cost-to-charge ratios from the fiscal intermediary, any variance between current payments and the estimated final outlier settlement are examined by the Medicare fiscal intermediary. During the year ended March 31, 2010, the Company recorded $172.9 in Final Notice of Program Reimbursement settlements.   During the year ended March 31, 2009, the Company reversed $1.7 million in reserves related to excess outlier payments based on the receipt of the Final Notice of Program Reimbursement for 2006. As of March 31, 2009, the Company had reversed all reserves for excess outlier payments.




The Hospitals receive supplemental payments from the State of California to support indigent care (Medi-Cal Disproportionate Share Hospital payments or "DSH") and from the California Medical Assistance Commission ("CMAC") under the SB 1100 and SB 1255 programs. The Hospitals received supplemental payments of $18.9 million and $21.9 million during the years ended March 31, 2010 and 2009, respectively. The related revenue recorded for the years ended March 31, 2010 and 2009 was $21.0 million and $19.7 million, respectively. As of March 31, 2010 and 2009, estimated DSH receivables were $4.8 million and $2.7 million, respectively.




Revenues under managed care plans are based primarily on payment terms involving predetermined rates per diagnosis, per-diem rates, discounted fee-for-service rates and/or other similar contractual arrangements. These revenues are also subject to review and possible audit by the payers. The payers are billed for patient services on an individual patient basis. An individual patient's bill is subject to adjustment on a patient-by-patient basis in the ordinary course of business by the payers following their review and adjudication of each particular bill. The Hospitals estimate the discounts for contractual allowances utilizing billing data on an individual patient basis. At the end of each month, the Hospitals estimate expected reimbursement for patients of managed care plans based on the applicable contract terms. These estimates are continuously reviewed for accuracy by taking into consideration known contract terms as well as payment history. Although the Hospitals do not separately accumulate and disclose the aggregate amount of adjustments to the estimated reimbursements for every patient bill, management believes the estimation and review process allows for timely identification of instances where such estimates need to be revised. The Company does not believe there were any adjustments to estimates of individual patient bills that were material to its net operating revenues.




The Hospitals provide charity care to patients whose income level is below 300% of the Federal Poverty Level. Patients with income levels between 300% and 350% of the Federal Poverty Level qualify to pay a discounted rate under AB774 based on various government program reimbursement levels. Patients without insurance are offered assistance in applying for Medicaid and other programs they may be eligible for, such as state disability, Victims of Crime, or county indigent programs. Patient advocates from the Hospitals' Medical Eligibility Program ("MEP") screen patients in the hospital and determine potential linkage to financial assistance programs. They also expedite the process of applying for these government programs. Based on average revenue for comparable services from all other payers, revenues foregone under the charity policy, including indigent care accounts, were $8.3 million and $8.2 million for the years ended March 31, 2010 and 2009, respectively.




Receivables from patients who are potentially eligible for Medicaid are classified as Medicaid pending under the MEP, with appropriate contractual allowances recorded. If the patient does not qualify for Medicaid, the receivables are reclassified to charity care and written off, or they are reclassified to self-pay and adjusted to their net realizable value through the provision for doubtful accounts. Reclassifications of Medicaid pending accounts to self-pay do not typically have a material impact on the results of operations as the estimated Medicaid contractual allowances initially recorded are not materially different than the estimated provision for doubtful accounts recorded when the accounts are reclassified. All accounts classified as pending Medicaid, as well as certain other governmental receivables, over the age of 90 days were reserved in contractual allowances as of March 31, 2010 and 2009 based on historical collections experience.




37




Beginning in fiscal year 2008, the Company received payments for indigent care under California section 1011. As of March 31, 2010 and 2009, the Company established a receivable in the amount of $1.7 million and $1.4 million, respectively, related to discharges deemed eligible to meet program criteria.




The Company is not aware of any material claims, disputes, or unsettled matters with any payers that would affect revenues that have not been adequately provided for in the accompanying consolidated financial statements.




PROVISION FOR DOUBTFUL ACCOUNTS - The Company provides for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. The Hospitals estimate this allowance based on the aging of their accounts receivable, historical collections experience for each type of payer and other relevant factors. There are various factors that can impact the collection trends, such as changes in the economy, which in turn have an impact on unemployment rates and the number of uninsured and underinsured patients, volume of patients through the emergency department, the increased burden of copayments to be made by patients with insurance and business practices related to collection efforts. These factors continuously change and can have an impact on collection trends and the estimation process.




The Company's policy is to attempt to collect amounts due from patients, including copayments and deductibles due from patients with insurance, at the time of service while complying with all federal and state laws and regulations, including, but not limited to, the Emergency Medical Treatment and Labor Act ("EMTALA"). Generally, as required by EMTALA, patients may not be denied emergency treatment due to inability to pay. Therefore, until the legally required medical screening examination is complete and stabilization of the patient has begun, services are performed prior to the verification of the patient's insurance, if any. In nonemergency circumstances or for elective procedures and services, it is the Hospitals' policy, when appropriate, to verify insurance prior to a patient being treated.




INCOME TAXES - GAAP requires the liability approach for the effect of income taxes. In accordance with GAAP, deferred income tax assets and liabilities are determined based on the differences between the book and tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws. The Company assesses the realization of deferred tax assets to determine whether an income tax valuation allowance is required. The Company has recorded a 100% valuation allowance on its deferred tax assets.




Effective April 1, 2007, the Company implemented a standard issued by the FASB which clarifies the accounting and disclosure for uncertain tax positions. The standard prescribes a recognition threshold and measurement attribute for recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.




INSURANCE - The Company accrues for estimated general and professional liability claims, to the extent not covered by insurance, when they are probable and reasonably estimable. The Company has purchased as primary coverage a claims-made form insurance policy for general and professional liability risks. Estimated losses within general and professional liability retentions from claims incurred and reported, along with IBNR claims, are accrued based upon projections and are discounted to their net present value using a weighted average risk-free discount rate of 5%. To the extent that subsequent claims information varies from estimates, the liability is adjusted in the period such information becomes available. As of March 31, 2010 and 2009, the Company had accrued $10.5 million and $8.7 million, respectively, which is comprised of $4.1 million and $4.1 million, respectively, in incurred and reported claims, along with $6.4 million and $4.6 million, respectively, in estimated IBNR.




The Company has also purchased occurrence coverage insurance to fund its obligations under its workers' compensation program. The Company has a "guaranteed cost" policy, under which the carrier pays all workers' compensation claims, with no deductible or reimbursement required of the Company. The Company accrues for estimated workers' compensation claims, to the extent not covered by insurance, when they are probable and reasonably estimable. The ultimate costs related to this program include expenses for deductible amounts associated with claims incurred and reported in addition to an accrual for the estimated expenses incurred in connection with IBNR claims. Claims are accrued based upon projections and are discounted to their net present value using a weighted average risk-free discount rate of 5%. To the extent that subsequent claims information varies from estimates, the liability is adjusted in the period such information becomes available. As of March 31, 2010 and 2009, the Company had accrued $717 and $711, respectively, comprised of $239 and $202, respectively, in incurred and reported claims, along with $478 and $509, respectively, in estimated IBNR.




Effective May 1, 2007, the Company initiated a self-insured health benefits plan for its employees. As a result, the Company has established and maintains an accrual for IBNR claims arising from self-insured health benefits provided to employees. The Company's IBNR accruals at December 31 and March 31, 2009 were based upon projections. The Company determines the adequacy of this accrual by evaluating its limited historical experience and trends related to both health insurance claims and payments, information provided by its insurance broker and third party administrator and industry experience and trends. The accrual is an estimate and is subject to change. Such change could be material to the Company's consolidated financial statements. As of March 31, 2010 and 2009, the Company had accrued $1.7 million and $1.8 million, respectively, in estimated IBNR. The Company believes this is the best estimate of the amount of IBNR relating to self insured health benefit claims at March 31, 2010 and 2009.




The Company has also purchased umbrella liability policies with aggregate limits of $25 million. The umbrella policies provide coverage in excess of the primary layer and applicable retentions for insured liability risks such as general and professional liability, auto liability, and workers compensation (employers liability).




38





NEW ACCOUNTING STANDARDS





In June 2009, the FASB issued a new standard that eliminates the previously allowed exceptions of consolidating qualifying special purpose entities, contains new criteria for determining the primary beneficiary and increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a variable interest entity. The adoption of this standard, which is effective for fiscal years beginning after November 15, 2009, is not expected to have a material effect on the Company’s consolidated financial statements.




In May 2009, the FASB issued a new standard that establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. Because the Company’s accompanying consolidated financial statements are considered issued when filed with the SEC, it has evaluated subsequent events to the filing date of this Form 10-K with the SEC.




In June 2008, the FASB issued a new standard that addresses the determination of whether an instrument (or an embedded feature) is indexed to an entity’s own stock. If an instrument (or an embedded feature) that has the characteristics of a derivative instrument under this standard is indexed to an entity’s own stock, it is still necessary to evaluate whether it is classified in stockholders’ equity (or would be classified in stockholders’ equity if it were a freestanding instrument). Effective April 1, 2009, the Company adopted this standard, which had no material impact on the Company's consolidated financial statements.




In May 2008, the FASB issued a new standard that clarifies that convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement). Additionally, the statement specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. Effective April 1, 2009, the Company adopted this standard, which had no material impact on the Company's consolidated financial statements.




In March 2008, the FASB issued a new standard that requires enhanced disclosures about an entity’s derivative and hedging activities. The Company does not currently have derivatives or enter into hedging activities; therefore, the adoption of this standard as of April 1, 2009 did not have an effect on the Company’s consolidated financial statements.




In December 2007, the FASB issued a new standard that requires the noncontrolling interest in a subsidiary be reported as a separate component of stockholders’ equity in the consolidated financial statements. The standard also requires net income attributable to the noncontrolling interest in a subsidiary be reported separately on the face of the consolidated statements of earnings. Changes in ownership interest are to be accounted for as equity transactions and, when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary is to be measured at fair value with any gain or loss recognized in earnings. The adoption of this standard as of April 1, 2009 did not have a material effect on the Company’s consolidated financial statements. In connection with the adoption of this new standard, the prior year financial statements have been adjusted to conform to the new required presentation.




In December 2007, the FASB issued a new standard that changes the accounting treatment for business combinations on a prospective basis. It requires that all assets, liabilities, contingent considerations and contingencies of an acquired business be recorded at fair value at the acquisition date. The standard also requires that acquisition costs be expensed as incurred and restructuring costs be expensed in periods after the acquisition date. The Company had no business combinations during the current reporting periods; therefore, the adoption of this standard as of April 1, 2009 did not have an effect on the Company’s consolidated financial statements. The effect of the adoption of this standard will depend upon the nature and terms of any future business combinations the Company undertakes.





OFF BALANCE SHEET ARRANGEMENTS





As of March 31, 2010 the Company had no off-balance sheet arrangements.





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





Not applicable.







39


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





The following consolidated financial statements are filed as a part of this report beginning on page F-1:





PAGE

DESCRIPTIONF-1

Report of Independent Registered Public Accounting FirmF-2

Consolidated Balance Sheets as of March 31, 2010 and 2009 (adjusted)F-3

Consolidated Statements of Operations for the years ended March 31, 2010 and 2009 (adjusted)F-4

Consolidated Statements of Stockholders' Deficiency for the years ended March 31, 2010 and 2009 (adjusted)F-5

Consolidated Statements of Cash Flows for the years ended March 31, 2010 and 2009 (adjusted)F-6

Notes to Consolidated Financial StatementsF-40

Schedule II - Valuation and Qualifying Accounts for the years ended March 31, 2010 and 2009








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





None





ITEM 9A(T). CONTROLS AND PROCEDURES





MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING





Management of Integrated Healthcare Holdings, Inc. is responsible for the preparation, integrity and fair presentation of its published consolidated financial statements. The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles and, as such, include amounts based on judgments and estimates made by management. The Company also prepared the other information included in the annual report and is responsible for its accuracy and consistency with the consolidated financial statements.




Management is also responsible for establishing and maintaining effective internal control over financial reporting. The Company's internal control over financial reporting includes those policies and procedures that pertain to the Company's ability to record, process, summarize and report reliable financial data. The Company maintains a system of internal control over financial reporting, which is designed to provide reasonable assurance to the Company's management and board of directors regarding the preparation of reliable published consolidated financial statements and safeguarding of the Company's assets. The system includes a documented organizational structure and division of responsibility, established policies and procedures, including a code of conduct to foster a strong ethical climate, which are communicated throughout the Company, and the careful selection, training and development of our people.




The Board of Directors, acting through its Audit Committee, is responsible for the oversight of the Company's accounting policies, financial reporting, and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent registered public accounting firm. It meets periodically with management, the independent registered public accounting firm, and the internal auditors to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the Company in addition to reviewing the Company's financial reports. Internal auditors monitor the operation of the internal control system and report findings and recommendations to management and the Audit Committee. Corrective actions are taken to address control deficiencies and other opportunities for improving the internal control system as they are identified. The independent registered public accounting firm and the internal auditors have full and unlimited access to the Audit Committee, with or without management, to discuss the adequacy of internal control over financial reporting, and any other matters which they believe should be brought to the attention of the Audit Committee.




Management recognizes that there are inherent limitations in the effectiveness of any system of internal control over financial reporting, including the possibility of human error and the circumvention or overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation and may not prevent or detect misstatements. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time.




The Company assessed its internal control system as of March 31, 2010 in relation to criteria for effective internal control over financial reporting described in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on its assessment, the Company has determined that, as of March 31, 2010, its system of internal control over financial reporting was effective.




This annual report does not include an attestation report of the Company's registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's report in this annual report.




40


CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
 
 During the fiscal quarter ended March 31, 2010, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
 DISCLOSURE CONTROLS AND PROCEDURES
 
 We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company's reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Our disclosure controls and procedures are designed to provide a reasonable level of assurance of reaching the Company's desired disclosure control objectives. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.
 
 We conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2010. This evaluation was based on the framework in Internal Control Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission. The evaluation by management as of March 31, 2010 concluded that the Company's disclosure controls and procedures are effective as of such date to ensure that the information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
 
 ITEM 9B. OTHER INFORMATION
 
 None.




41


PART III





ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE





The following table contains certain information concerning our directors and executive officers as of March 31, 2010:





NAME
AGE
POSITION WITH COMPANY
DATE BECAME DIRECTORMaurice J. DeWald
70
Chairman of the Board
August 1, 2005Hon. C. Robert Jameson
70
Director
July 11, 2007Ajay G. Meka, M.D.
59
Director
September 28, 2006Michael Metzler
63
Director
September 5, 2007J. Fernando Niebla
70
Director
August 1, 2005William E. Thomas
61
Director
September 5, 2007Kenneth K. Westbrook
59
Director, Chief Executive Officer & President
December 2, 2008Steven R. Blake
57
Chief Financial Officer & Executive Vice President, FinanceDaniel J. Brothman
55
Chief Operating Officer & Executive Vice President, Operations





MAURICE J. DEWALD has served as a member of the Board of Directors of the Company since August 1, 2005 and has served as Chairman of the Board of Directors since October 7, 2008. Mr. DeWald sits on the Audit Committee, Compensation Committee, Finance Committee and Special Committee. As a senior finance executive, Mr. DeWald brings to our Board extensive qualifications and experience in management, finance, and public accounting, as well as his experience in the healthcare industry.  Mr. DeWald is Chairman and Chief Executive Officer of Verity Financial Group, Inc., a private investment firm that he founded in 1992. From 1962-1991, Mr. DeWald was with KPMG LLP, one of the world's largest international accounting and tax consulting firms, where he served at various times as director and as the Managing Partner of the Chicago, Orange County and Los Angeles Offices. Mr. DeWald is a director of Mizuho Corporate Bank of California, Healthcare Trust of America, Inc., and is a former director of Tenet Healthcare Corporation ("Tenet") and Quality Systems, Inc. He also sits on the Advisory Council of the University of Notre Dame Mendoza School of Business. Mr. DeWald is a past Chairman and director of United Way of Greater Los Angeles. Mr. DeWald received a B.B.A. from the University of Notre Dame in 1962. He is also a Certified Public Accountant (inactive) and a member of the American Institute of CPAs and California Society of CPAs.
 
 HON. C. ROBERT JAMESON has been a director of the Company since July 11, 2007. Judge Jameson is a retired Orange County Superior judge.  Judge Jameson brings to our Board extensive experience in the legal profession and negotiating skills.  He is now affiliated with Judicate West, a provider of alternative dispute resolution, handling complex alternative dispute resolution matters. Before leaving the bench, he was Presiding Judge of the Orange County Superior Court Appellate Division. Judge Jameson obtained his B.A. degree in Political Science from the University of California, Davis in 1963 and his Juris Doctor degree at the University of California, Hastings College of the Law in 1966. He served as a judge from 1984-2005 and also was President of the Banyard Inn of Court and an Adjunct Professor of Law at Whittier Law School during his tenure. Judge Jameson was awarded "Judge of the Year" nine times over the course of his career by organizations such as: the Orange County Bar Association Business Litigation section, Orange County Trial Lawyers, the American Board of Trial Advocates and the Consumer Attorneys of California.
 
 AJAY G. MEKA, M.D has served as a member of the Board of Directors of the Company since September 28, 2006. Dr. Meka brings to our Board extensive experience in the healthcare industry.  Dr. Meka has been a licensed physician in California for the past 26 years. He is a board certified physician practicing in Orange County, California. Dr. Meka received his medical degree from Guntur Medical College in Gunter, India. He performed his postgraduate training at Brooklyn Jewish Hospital and Coney Island Hospital, both in Brooklyn, New York.
 
 MICHAEL METZLER has been a member of the Board of Directors of the Company since September 5, 2007 and sits on the Audit Committee and is Chairman of the Governance Committee.  Mr. Metzler brings to our Board extensive leadership, organizational, and management skills.  He is CEO of Metzler and Associates, a consulting firm specializing in organization development. He served as President and Chief Executive Officer of the Greater Santa Ana Business Alliance, formerly known as the Santa Ana Chamber of Commerce, for 27 years from 1983 to 2010. Mr. Metzler has served on numerous community boards, city commissions, and county, regional, state and national committees and task forces. He was a founder of the Santa Ana Business Bank and sits on its board of directors. Mr. Metzler received a Ford Foundation Fellowship in Regionalism and Sustainable Development in 2008. He is a graduate of California State University, Fullerton, and attended Loyola University School of Law and the Peter F. Drucker Graduate School of Management at Claremont University.
 
 J. FERNANDO NIEBLA has served as a member of the Board of Directors of the Company since August 1, 2005 and sits on the Audit Committee, Compensation Committee, Finance Committee and Special Committee. Mr. Niebla brings to our Board extensive experience in executive leadership and board membership experience with large publicly traded companies.  He has served as President of International Technology Partners, LLC, an information technology and business consulting services company based on Orange County, California since August 1998. He is also a founder of Infotec Development Inc. and Infotec Commercial Systems, two national information technology firms. He currently serves on the Boards of Directors of Union Bank of California, Pacific Life Corp., Life Modeler, Inc., and Granite Construction Corp., the Board of Trustees of the Orange County Health Foundation, and is the Chairman of the California Advisory Committee to Nacional Financiera, a Mexican Government agency similar to the U.S. Government Small Business Administration office. Mr. Niebla holds a B.S. degree in Electrical Engineering from the University of Arizona and an M.S. QBA from the University of Southern California.


42




WILLIAM E. THOMAS brings to our Board extensive experience in the legal profession and healthcare industry.  Mr. Thomas is the Executive Vice President and General Counsel of Strategic Global Management, Inc., a healthcare ventures firm in Riverside, California. He has served in such capacity since October of 1998. Prior to that Mr. Thomas was a founding and managing partner of a law firm in Riverside, California specializing in business, real estate, and other transactional matters.  He is a member of the board of directors of Provident Financial Holdings, Inc. Mr. Thomas graduated from the University of California at Santa Barbara with a Bachelor of Arts degree in History and Political Science. He holds a Juris Doctor degree from the University of California, Hastings College of the Law, and a Master of Laws degree from New York University. He is a member of the California Bar Association.
 
 KENNETH K. WESTBROOK has served as President and Chief Executive Officer of the Company since December 2, 2008. Mr. Westbrook brings to our Board extensive experience as a healthcare executive with unique operational and management skills. Mr. Westbrook was Senior Vice President for Operations for OrNda HealthCorp (1996) and Senior Vice President of Operations for Tenet (1997 through 2004). Mr. Westbrook sold the four hospitals that created the Company as he left Tenet. During the years at OrNda and Tenet, Mr. Westbrook also had the experience of acting as each of the four hospitals' interim CEO when vacancies occurred. Prior to OrNda, Mr. Westbrook was the Chief Operating Officer for Hospital Corporation of America's Pacific Division and was previously a hospital CEO at several Southern California hospitals. Mr. Westbrook served as a director for Aperture Health, Inc. from August 2006 until December 2008. He has graduate and undergraduate degrees in business from the University of Redlands and is currently a member of several healthcare professional associations.
 
 STEVEN R. BLAKE has served as Chief Financial Officer of the Company since July 1, 2005 and Executive Vice President, Finance since March 21, 2008. He is a California licensed Certified Public Accountant (inactive). Mr. Blake came to the Company with over 20 years of experience in multi-hospital financial management. He also has extensive experience serving in financial roles with public companies. Most recently, he served as Regional Vice President of Finance for Tenet, a position he held for over 17 years. In this position, Mr. Blake was responsible for the financial management of numerous Tenet assets covering five western states (California, Arizona, Washington, Nebraska and Texas). Mr. Blake's strong hospital financial background combined with his knowledge of public company requirements made him a strong addition to the Company's corporate team.
 
 DANIEL J. BROTHMAN has served as Chief Operating Officer & Executive Vice President, Operations since May 6, 2008 and as Chief Executive Officer of Western Medical Center - Santa Ana since March 8, 2005. Mr. Brothman also served as Senior Vice President, Operations of the Company from March 8, 2005 to May 6, 2008. Mr. Brothman is an experienced single and multi-hospital operations executive. Since 1999, prior to the acquisition of the Hospitals by the Company he helped build the Western Medical Center in Santa Ana for Tenet. Mr. Brothman also ran Columbia Healthcare's Utah Division from 1996 to 1998. Mr. Brothman has in excess of 30 years experience in hospital administration. Mr. Brothman earned his Bachelor of Arts degree from Washington University at St. Louis and his Master's in Health Care Administration from the University of Colorado at Denver.
 
 CORPORATE GOVERNANCE
 
 Director Independence and Executive Sessions
 
 The Board of Directors has determined that Directors DeWald, Meka, Metzler, Niebla and Jameson each satisfy the definition of "independent director" as established in the NASDAQ listing standards.  The independent directors regularly meet in executive sessions without the CEO or other members of management present to review the performance of management and other relevant matters.
 
 Board’s Leadership Structure
 
 The Board’s current leadership structure is characterized by an active and independent Chairman (who is not the same person as our CEO), robust Committee structure with oversight of various types of risks and an engaged and majority-independent Board.  The Board believes that its current leadership structure provides strong and independent board leadership while deriving the benefit of having our CEO serve as a member of our Board.
 
 Risk Oversight
 
 Our Board oversees an enterprise-wide approach to risk management, designed to support the achievement of our strategic and organizational objectives, to improve long-term organizational performance and enhance shareholder value. A fundamental part of risk oversight is to understand the risks our Company faces, the steps management is taking to manage those risks and to assess management’s appetite for risk. It is management’s responsibility to manage risk and bring to the Board’s attention material risks facing our Company. Our Board receives regular reports from management on matters relating to strategic and operational initiatives, financial performance and legal developments which are each integrated with enterprise-risk exposures. The Compensation Committee of our Board also approves our CEO’s performance goals for each year. In doing so, the Committee has an opportunity to ensure that the CEO’s goals include responsibility for broad risk management. The involvement of the full Board in setting our strategic plan is a key part of its assessment of the risks inherent in our corporate strategy.
  43
 
 While the Board has the ultimate responsibility for overall risk oversight, each Committee of the Board also has responsibility for particular areas of risk oversight. For example, the Audit Committee focuses on financial risk and internal controls, and receives an annual risk assessment report from our internal auditors. In addition, the Compensation Committee evaluates and sets compensation programs that encourage decision making predicated upon a level of risk consistent with our business strategy. The Compensation Committee also reviews compensation and benefit plans affecting employees in addition to those applicable to executive officers.
 
 Attendance at Meetings
 
 Directors are elected at our annual meeting and each director serves until the following annual meeting and until his successor is elected and qualified.
 
 Although we do not have a formal policy regarding attendance by Board members at our annual meeting of stockholders, directors are encouraged to attend our annual meetings. All of our current directors attended our 2008 Annual Meeting of Stockholders.
 
 Our Board of Directors held 25 meetings during fiscal 2010. Each director attended or participated in 75% or more of the aggregate number of meetings of the Board and of meetings of the committees of the Board on which such director served.


SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE





Section 16(a) of the Securities Exchange Act of 1934 requires our officers and directors, and persons who own more than 10% of a registered class of our equity securities, to file reports of ownership and changes in ownership with the SEC. Officers, directors and greater than 10% stockholders are required by SEC regulation to furnish us with copies of all Section 16(a) reports they file.




Based solely upon the copies of Section 16(a) reports which we received from such persons or written representations from them regarding their transactions in our common stock, we believe that, during the year ended March 31, 2010, all such forms were filed in a timely fashion.





CODE OF ETHICS





We have adopted Standards of Conduct and Ethics that apply to our employees (including our principal executive officer, principal financial officer, principal accounting officer, and controller) and our directors. Our Standards of Conduct and Ethics can be accessed on our website at http://www.ihhioc.com under the Investor Relations section.
 STOCKHOLDER RECOMMENDATION OF NOMINEES





While there are no formal procedures for stockholders to recommend nominations, the Board of Directors will consider stockholder recommendations. Such recommendations should be addressed to the Corporate Secretary at the address listed above.





44




STOCKHOLDER COMMUNICATIONS





In order to facilitate communications with the Board of Directors, or any individual members or any committees of the Board of Directors, stockholders should direct all communication in writing to our General Counsel at Integrated Healthcare Holdings, Inc., 1301 North Tustin Avenue, Santa Ana, California 92705, who will forward all such correspondence to the Board of Directors, individual members of the Board of Directors or applicable chairpersons of any committee of the Board of Directors, as appropriate and as directed in the communication.




BOARD COMMITTEES
 
 Our board of directors has established an Audit Committee and Compensation Committee.  The Company does not have a Nominating Committee, as the entire Board of Directors performs the functions of this committee and this process has been adequate to handle the Board nomination process to date.
 
 Audit Committee


The Audit Committee of the Board of Directors was formed in August 2005 and consists of three of our independent directors, Maurice DeWald and J. Fernando Niebla, who joined the Board of Directors in August 2005, and Michael Metzler, who joined the Board of Directors in September 2007. The Board of Directors has determined that Maurice DeWald is an "audit committee financial expert" as defined in the rules and regulations of the SEC. The Audit Committee of the Board of Directors preapproves all audit and permissible non-audit services to be performed by the independent registered public accounting firm. The Audit Committee will also advise management on the engagement of experts with sufficient expertise to advise on accounting and financial reporting of complex financial transactions. Of the six audit committee meetings held during the year ended March 31, 2010, Messrs DeWald, Niebla, and Metzler attended all meetings. The Board of Directors has adopted and approved an Audit Committee Charter for the Audit Committee.  A current copy of this charter is posted on our website at http://www.ihhioc.com under the Investor Relations section.
  Management is responsible for the Company's internal controls and financial reporting process. The independent registered public accounting firm is responsible for performing an independent audit of the Company's consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States) and to issue a report on the consolidated financial statements. The Audit Committee's responsibility is to oversee these activities.




In this context, the Audit Committee has met and held discussions with management and the independent registered public accounting firm. Management represented to the Audit Committee that the Company's consolidated financial statements were prepared in accordance with accounting principals generally accepted in the United States and the Audit Committee has reviewed and discussed the consolidated financial statements with management and the independent registered public accounting firm. The Audit Committee also discussed with the independent registered public accounting firm matters required to be discussed by Statement on Auditing Standards No. 114, "Communication with Audit Committees," as modified or supplemented, including the auditor's judgment about the quality, as well as the acceptability, of our accounting principles as applied in the financial reporting.




Our independent registered public accounting firm also provided to the Audit Committee the written disclosures required by Rule 3520 of the Public Company Accounting Oversight Board (Independence Discussions with Audit Committees), and the Audit Committee discussed with the independent registered public accounting firm that firm's independence as well as internal quality control procedures.




Based on the Audit Committee's discussions with management and the independent registered public accounting firm and the Audit Committee's review of the representations of management and the report of the independent registered public accounting firm to the Audit Committee, the Audit Committee recommended to the Board of Directors, and the Board has approved, that the audited consolidated financial statements be included in the Company's Annual Report on Form 10-K for the year ended March 31, 2010 for filing with the SEC. This report was submitted by Mr. DeWald, Chair, and Messrs. Metzler and Niebla.





45




Compensation Committee
 
 The Compensation Committee of the Board of Directors was formed in October 2005 and consists of three directors, Mr. Maurice DeWald, Mr. J. Fernando Niebla, chair, and Mr. William E. Thomas. In our fiscal year ended March 31, 2010, the Compensation Committee held five meetings. The Compensation Committee is responsible for overseeing the administration of the Company's executive compensation programs, establishing and interpreting the Company's compensation policies and approving all compensation paid to executive officers, including the named executive officers listed in the Summary Compensation Table. The Board of Directors has adopted and approved a Compensation Committee Charter for the Compensation Committee.  A current copy of this charter is posted on our web site at http://www.ihhioc.com under the Investor Relations section.
 
 ITEM 11. EXECUTIVE COMPENSATION
 
 The following table sets forth summary information regarding compensation to (i) our Chief Executive Officer; and (ii) our two other most highly compensated executive officers employed by us as of March 31, 2010 whose salary and bonus for the fiscal year ended March 31, 2010 was in excess of $100,000 for their services rendered in all capacities to us. The listed individuals are referred to as the "Named Executive Officers."


SUMMARY COMPENSATION TABLE




Name and

Principal Position

Year

Salary

($)


Bonus

($)


Option

awards

($)(4)


All other

compensation

($)


Total

($)Kenneth K. Westbrook

2010


500,001



137,500



-



28,101



665,602Principal Executive Officer (1)

2009


144,231



11,936



6,839



6,000



169,006Steven R. Blake

2010


423,108



105,500



-



12,000



540,608Principal Financial Officer &

Executive Vice President, Finance (2)

2009


422,000



30,222



-



15,476



467,698Daniel J. Brothman

2010


422,000



105,500



-



18,750



546,250Chief Operating Officer (3)

2009


422,000



26,375



-



18,750



467,125




(1)
All other compensation for 2010 includes auto allowance of $18,000 and the balance is Company contribution to the 401(k) plan. Salary for 2009  commenced on December 1, 2008.  All other compensation for 2009 consists of an auto allowance of $6,000.


(2)
All other compensation for 2010 consists of an auto allowance of $12,000.   All other compensation for 2009 includes auto allowance of $12,000 and the balance is Company contribution to the 401(k) plan.


(3)
All other compensation for 2010 includes auto allowance of $12,000 and the balance is Company contribution to the 401(k) plan. All other compensation for 2009 includes auto allowance of $12,000 and the balance is Company contribution to the 401(k) plan.





(4)
Values in this column represent the fair value of options on the date of grant. These amounts do not represent the intrinsic or market value of the awards on the date of grant, at year end or at present. For grant date values of all outstanding options at March 31, 2010, please see table entitled "Outstanding Equity Awards at Fiscal Year-End."







46


The following table sets forth summary information regarding stock options the Company has granted to the Named Executive Officers as of March 31, 2010 under the Company's 2006 Stock Incentive Plan.




OUTSTANDING STOCK OPTIONS AWARDS AT FISCAL YEAR-END


Name
Grant

date
Number of

securities

underlying

unexercised

options

exercisable
Number of

securities

underlying

unexercised

options

unexercisable
Equity

incentive

plan awards:

Number of

securities

underlying

unexercised

unearned

options
Option

exercise

price

($)
Option

expiration

date
Grant date

fair value

per share

($)Kenneth K. Westbrook (1)
December 2, 2008
1,500,000
500,000
500,000
0.01
December 2, 2015
0.00Steven R. Blake (2)
August 6, 2007
275,000
25,000
25,000
0.26
August 6, 2014
0.03Daniel J. Brothman (3)
August 6, 2007
1,000,000
-
-
0.26
August 6, 2014
0.02





(1)
1/3 of the shares vested on the grant date, and an additional 1/12 of the shares vest on each subsequent fiscal quarter-end of the Company beginning on March 31, 2009.(2)
1/3 of the shares vested on the twelve month anniversary of the grant date, and an additional 1/12 of the shares vest on each subsequent fiscal quarter-end of the Company following such twelve month anniversary.(3)
Vesting retroactively commenced on March 8, 2005, all options were fully vested as of March 31, 2008.





EMPLOYMENT CONTRACTS, SEVERANCE AGREEMENTS AND CHANGE OF CONTROL ARRANGEMENTS





On March 29, 2010, the Company entered into amended and restated employment agreements (the "Amended Employment Agreements") with each of Kenneth K. Westbrook, its President and CEO, Daniel J. Brothman, its COO, and Steven R. Blake, its CFO & EVP, Finance (each, an "Named Executive Officer" and collectively, the "Named Executive Officers"). The Amended Employment Agreements provide for the following material terms, effective April 1, 2010, and the following material amendments to each individual's original employment agreement:





·
Each individual's employment was changed from an "at will" arrangement to a fixed term of employment of three years, commencing April 1, 2010, with automatic renewals for successive one year periods. The Company or the Named Executive may only terminate the employment relationship during the final 120 days of the initial three-year period or one-year renewal periods, except for a termination by either party "for cause" (as defined in the Amended Employment Agreements). In addition, the events allowing each Named Executive to resign "for cause" have been expanded to include a permanent relocation of his employment outside of Orange County, California.





·
The base salary of Mr. Westbrook was increased from $500,000 to $550,000 per annum, effective February 1, 2010.  The base salaries of each of Messrs. Blake and Brothman remained constant at $422,000 per annum.





·
The Amended Employment Agreements provide for the establishment of annual performance targets for each individual by the Compensation Committee and the Executive within 60 days after the end of each fiscal year. Each Executive's annual bonus will be determined based on his achievement in reaching his individual performance targets.





·
The original employment agreements provided for payment of a severance package to each Executive upon a termination by the Executive "for cause" or termination by the Company "without cause." The severance period has been increased from 12 months to 24 months (36 months during the first year of effectiveness of the Amended Employment Agreements). The Amended Employment Agreements also provide for payment of severance in the event of (i) a termination of employment following a change of control of the Company or (ii) a non-renewal of the Executive's employment by the Company at the end of the fixed 3-year or 1-year employment term. In the case of Messrs. Westbrook and Brothman, the right to receive severance terminates if the individual accepts employment with a competing hospital in a specified geographic area during the severance period.







47




Pension benefits and Nonqualified Deferred Compensation tables are not included as there are no items to report.





POTENTIAL PAYMENTS UPON TERMINATION





Each of the Company's Named Executive Officers have employment agreements which provide, generally, for payments in the event of resignation for cause. Cause includes, among other items, changes in job duties, reporting relationships, bankruptcy of the Company or change in shareholders of over 50% of the stock. Unless otherwise note, each Named Executive Officer would be entitled to up to 36 months salary, benefits and health insurance, but not any additional accruals of paid time off, vacation or sick pay.




The following table provides information concerning the estimated payments and benefits that would be provided in the circumstances described above for each of the Named Executive Officers. Payments and benefits are estimated assuming that the triggering event took place on April 1, 2010, the effective date of the new employment agreements. There can be no assurance that a triggering event would produce the same or similar results as those estimated below if such event occurs on any other date or if any other assumption used to estimate potential payments and benefits is not correct. The amounts which would be due the Named Executive Officers as of April 1, 2010, if they resigned for cause is as follows.





PAYMENTS DUE UPON TERMINATION





Name and

principal

position

Salary


Employee

health

insurance


Car

allowance


Other

benefits


TotalKenneth K. Westbrook

$
1,650,000


$
10,230


$
54,000



-


$
1,714,230Chief Executive Officer (1)Steven R. Blake

$
1,266,000


$
22,377


$
36,000



-


$
1,324,377Chief Financial Officer &Executive Vice President,Finance (1)Daniel J. Brothman

$
1,266,000


$
13,095


$
36,000



-


$
1,315,095Senior Vice President,Operations (1)





(1) Represents payments for 36 months per employment agreement.








48


COMPENSATION OF DIRECTORS





The following table provides information concerning the compensation of our non-management directors during the fiscal year ended March 31, 2010.





DIRECTOR COMPENSATION




Fees earned

Stockor paid in cash

options

TotalName


($)

($)

($)Maurice J. DeWald

10,000

-

10,000Hon. C. Robert Jameson

10,000

-

10,000Ajay G. Meka, M.D.

10,000

-

10,000Michael Metzler

10,000

-

10,000J. Fernando Niebla

10,000

-

10,000William E. Thomas

10,000

-

10,000




Our current compensation and reimbursement policy for Directors is as follows:





i.
Cash - Each non-employee Director earns an annual fee of $30,000 and an attendance fee of $1,500 for each Board meeting attended, and a separate $1,000 fee for each committee meeting attended. Committee Chairmen earn an additional annual retainer of $5,000. The above fees were received in cash by the named Directors during the year ended March 31, 2010.


ii.
Stock - No options were granted to the Directors during the year ended March 31, 2010.


iii.
Travel Reimbursement - All travel and related expenses incurred by Directors to attend Board meetings, committee meetings and other Company activities are reimbursed by the Company.





Employee directors receive no compensation for Board service and the Company does not provide any retirement benefits to non-employee directors. Director Westbrook is not included above as all compensation paid to him is included in the Summary Compensation Table.




ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS





For a discussion of securities authorized for issuance under equity compensation plans, please refer to Item 5 above.





SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT





The following table sets forth information known to us with respect to the beneficial ownership of our Common Stock as of June 15, 2010 by:


·
each stockholder known to us to own beneficially more than 5% of our Common Stock;
 ·
each of our directors and executive officers; and
 ·
all of our current directors and executive officers as a group.


49





Except as otherwise noted below, the address of each person or entity listed on the table is 1301 North Tustin Avenue, Santa Ana, California 92705.  The address of Dr. Kali P. Chaudhuri, KPC Resolution Company, LLC, and William E. Thomas is 6800 Indiana Avenue, Suite 130, Riverside, CA 92506.  The address of Silver Point Capital, L.P. is Two Greenwich Plaza, 1st Floor, Greenwich, CT 06830.  The address of Orange County Physicians Investment Network, LLC and Dr. Anil V. Shah is 2621 S. Bristol Street, Santa Ana, CA 92704.




NAME

BENEFICIAL OWNERSHIP (1)

PERCENTAGE OF TOTAL (2)DIRECTORS AND EXECUTIVE OFFICERSMaurice J. DeWald (3)

350,000


*Hon. C. Robert Jameson (3)

183,333


*Ajay G. Meka, M.D. (3)(4)

300,000


*Michael Metzler (3)

183,333


*J. Fernando Niebla (3)

350,000


*William E. Thomas (5)

9,931,831


3.89%Kenneth K. Westbrook (3)

1,666,667


*Steven R. Blake (3)

300,000


*Daniel J. Brothman (3)

1,000,000


*All current directors and executive officers as a group (9 persons)

14,073,497


5.51%PRINCIPAL STOCKHOLDERSKali P. Chaudhuri, M.D. (6)

437,601,334


77.55%KPC Resolution Company, LLC (7)

139,000,000


35.25%Silver Point Capital, L.P. (8)

96,000,000


27.33%Orange County Physicians Investment Network, LLC (9)

73,798,430


28.91%Anil V. Shah, M.D. (10)

19,812,000


7.76%* Less than 1%


(1)
Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and generally includes voting or investment power with respect to securities.  Shares of Common Stock subject to options, warrants and convertible instruments that are exercisable or convertible within 60 days of June 15, 2010 are deemed outstanding for computing the percentage of the person holding such option, warrant or convertible instrument, but are not deemed outstanding for computing the percentage of any other person.  In addition, the information in this table assumes that all shares subject to options, warrants and convertible instruments may be issued by the Company notwithstanding that the total number of shares subject to options, warrants and convertible instruments may exceed the 500,000,000 authorized shares of Common Stock under the Company’s Articles of Incorporation as of June 15, 2010, since the Company has received approval to increase its authorized shares to 800,000,000 as discussed elsewhere in this Information Statement.  Except as reflected in the footnotes or pursuant to applicable community property laws, the persons named in this table have sole voting and investment power with respect to all shares of Common Stock beneficially owned.
  (2)
Percentages are based on 255,307,262 shares of Common Stock outstanding as of June 15, 2010, which does not include up to 17,819,343 shares of Common Stock which may be issued under the Company’s 2006 Stock Incentive Plan, and are otherwise calculated in accordance with Rule 13d-3 under the Exchange Act.
  (3)
Consists of a portion of a stock option award approved by the Board of Directors which is exercisable within 60 days of June 15, 2010 pursuant to the Company’s 2006 Stock Incentive Plan.
  (4)
Dr. Meka is a member of Orange County Physicians Investment Network, LLC (“OC-PIN”) and disclaims beneficial ownership of shares held by OC-PIN except to the extent of his pecuniary interest therein.
  (5)
Consists of 9,748,498 issued and outstanding shares and a portion of a stock option award approved by the Board of Directors which is exercisable within 60 days of June 15, 2010 pursuant to the Company’s 2006 Stock Incentive Plan.
  (6)
Consists of 128,601,334 issued and outstanding shares (including 30,600,000 shares for which stock certificates have been issued but not delivered pending payment of the purchase price), 170,000,000 shares which may be acquired by Kali P. Chaudhuri, M.D. pursuant to a three-year warrant issued to him on April 13, 2010, and 139,000,000 shares which may be acquired by KPC Resolution Company, LLC (“KPC Resolution”) pursuant to a three-year warrant issued to it on April 13, 2010.  Dr. Chaudhuri is the manager of KPC Resolution and, as a result, he may be deemed to be the beneficial owner of the securities held by KPC Resolution.  Dr. Chaudhuri disclaims beneficial ownership of the reported securities held by KPC Resolution except to the extent of his pecuniary interest therein.
   50
  (7)
Consists of 139,000,000 shares which may be acquired by KPC Resolution pursuant to a three-year warrant issued to it on April 13, 2010.
  (8)
Consists of 79,182,635 shares and 16,817,365 shares which may be acquired by SPCP Group, LLC and SPCP Group IV, LLC (the “Funds”), respectively, pursuant to three-year warrants issued to the Funds on April 13, 2010.  Silver Point Capital, L.P. (“Silver Point”) is the investment manager of the Funds and, by reason of such status, may be deemed to be the beneficial owner of all of the reported securities held by the Funds. Silver Point Capital Management, LLC (“Management”) is the general partner of Silver Point and, as a result, may be deemed to be the beneficial owner of the securities held by the Funds.  Messrs. Edward A. Mule and Robert J. O’Shea are each members of Management and, as a result, may be deemed to be the beneficial owner of all of the securities held by the Funds.  Silver Point, Management and Messrs. Mule and O’Shea disclaim beneficial ownership of the reported securities held by the Funds except to the extent of their respective pecuniary interests therein.
  (9)
Includes 14,700,000 shares for which stock certificates have been issued but not delivered pending payment of the purchase price.
  (10)
Includes 14,700,000 shares for which stock certificates have been issued but not delivered pending payment of the purchase price, and does not include any shares held of record by OC-PIN.  Dr. Shah is a member of OC-PIN. The inclusion of 5,112,000 shares in Dr. Shah's holdings is based on information filed by Dr. Shah in a Schedule 13D/A filed on April 9, 2009.  The Company has no independent information verifying the acquisition of such shares by Dr. Shah.


ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE





TRANSACTIONS WITH RELATED PARTIES




OC-PIN





Effective April 2, 2009, the Company, Dr. Shah, OC-PIN, Mr. Mogel, PCHI, West Coast, Dr. Chaudhuri, Ganesha, Mr. Thomas, and the Lender entered into a Settlement Agreement, General Release and Covenant Not to Sue ("Global Settlement Agreement") in connection with the settlement of pending and threatened litigation, arbitration, appellate, and other legal proceedings (the "Actions") among the various parties. Pursuant to the Global Settlement Agreement, the Company agreed to pay to OC-PIN and Dr. Shah a total sum of $2.4 million in two installments consisting of $1.6 million at closing and $750, together with interest thereon at 8%, payable on September 25, 2009 (the "Second Payment $750"). The Company also agreed to pay the sum of $15 as satisfaction of Dr. Shah's individual claims. Additionally, the Company and Mr. Mogel agreed to stipulate to the release and return of a $50 bond which was posted in connection with a shareholder derivative suit filed by OC-PIN against both Mr. Mogel and the Company.




In addition, Dr. Shah covenanted and agreed, that for a period of 2 years after the Closing, he will not accept any nomination, appointment or will not serve in the capacity as a director, officer, or employee of the Company, so long as the Company keeps the PCHI and Chapman Medical Center leases current by making payments within 45 days of when payments are due.




Pursuant to the Global Settlement Agreement, the Company agreed to amend its Bylaws to provide (i) that the number of members of the Company's Board of Directors shall be fixed at 7 and (ii) that a shareholder who owns 15% or more of the voting stock of the Company is entitled to call one special shareholders meeting per year. As of March 31, 2010, OC-PIN's representative has not been duly appointed by OC-PIN (see "MEKA COMPLAINT").




Also pursuant to the Global Settlement Agreement, the Company entered into Stock Purchase Agreements (the "2009 Stock Purchase Agreements") with Dr. Shah, Dr. Chaudhuri and OC-PIN respectively. Pursuant to these 2009 Stock Purchase Agreements, Dr. Shah and OC-PIN will receive an aggregate of 14.7 million shares of the Company's common stock each and Dr. Chaudhuri will receive an aggregate of 30.6 million shares of the Company's common stock, for a price of $0.03 per share (the "2009 Stock Purchase Shares"). As of March 31, 2010, the 2009 Stock Purchase Shares have been issued but payment has not been received by the Company. The completion of this transaction is still pending.




51




In conjunction with the Global Settlement Agreement, on April 2, 2009, the Company and the Lender entered into the Amendment No. 1 to Credit Agreement ("Credit Amendment"). The Lender agreed to reduce the interest rate on the $45.0 million Term Note to simple interest of 10.25% (the "Debt Service Reduction") and to maintain such interest rate up to and including the maturity date of the Term Note, or any extension thereof, as defined in the $80 million credit agreement, under which the $45.0 million Term Note was issued (the "Debt Service Reduction Period").  The reduction of the interest rate was deemed not to meet the criteria for a troubled debt restructuring.




On April 24, 2009, a conglomeration of several OC-PIN members led by Ajay G. Meka, M.D. filed a lawsuit against Dr.Shah, other OC-PIN members, and various attorneys, alleging breach of fiduciary duty and seeking damages as well as declaratory and injunctive relief (the "First Meka Complaint"). While the Company is named as a defendant in the action, plaintiffs are only seeking declaratory and injunctive relief with respect to various provisions of the Global Settlement Agreement. Due to the competing demands related to the Stock Purchase Agreements placed upon the Company from factions within OC-PIN, on May 13, 2009, the Company filed a Motion for Judicial Instructions regarding enforcement of the Global Settlement Agreement. On May 14, 2009, the Company, Dr. Shah, as well as both "factions" of OC-PIN entered into a "stand still" agreement regarding both the nomination of an OC-PIN Board representative as well as the allocation of shares under the Stock Purchase Agreements. Subsequently, on June 22, 2009, the Court granted a stay of the Company's remaining obligations under the Global Settlement Agreement until the resolution of the Amended Meka Complaint and related actions.




On June 1, 2009, a First Amended Complaint was filed to replace the First Meka Complaint (the "Amended Meka Complaint"). It appears that the relief sought against the Company in the Amended Meka Complaint does not materially alter from the declaratory and injunctive relief sought in the First Meka Complaint. The Company believes it is a neutral stakeholder in the action, and that the results of the action will not have a material adverse impact on the Company's results of operations.




Credit Agreements




On January 28, 2009, the Company’s “Lender” (consisting of Medical Capital Corporation and its affiliates, Medical Provider Financial Corporation I, Medical Provider Financial Corporation II, and Medical Provider Financial Corporation III) began to collect and retain amounts in excess of the amounts due to it (“Excess Amounts”) under the $50.0 million Revolving Credit Agreement. From January 28, 2009 to on or about May 18, 2009, the Lender had swept an aggregate of $14.3 million in Excess Amounts.   The Lender continued to release Excess Amounts to defray the Company’s monthly interest obligations under all other loan agreements between it and the Company through June 30, 2009, resulting in a balance in Excess Amounts of $11.3 million.




On April 14, 2009, the Company issued a letter (the “Demand Letter”) notifying the Lender that it was in default on the $50.0 million Revolving Credit Agreement, to make demand for return of all Excess Amounts, and to reserve the rights of the borrowers and credit parties with respect to other actions and remedies available to them. The Company considered the Lender’s failure to return the Excess Amounts as an improper conversion of assets and a breach of the Lender’s fiduciary and custodial obligations.  On April 17, 2009, following receipt of a copy of the Demand Letter, the bank that maintained the lock boxes pursuant to a restricted account and securities account control agreement (the “Lockbox Agreement”) notified the Company and the Lender that it would terminate the Lockbox Agreement within 30 days. On May 18, 2009, the Lockbox Agreement was terminated and the Company's bank accounts were frozen.  On May 19, 2009, the Lender relinquished any and all control over the bank accounts pursuant to the Lockbox Agreement. The Lender’s relinquishment provided the Company with full access to its bank accounts and the accounts were no longer accessible by the Lender.




On July 16, 2009, the SEC filed a fraud complaint with the United States District Court against the parent company and affiliates of the Lender for violations of federal securities laws and barred it from entering into material transactions pending presentation of the government’s case.  On August 3, 2009, Mr. Thomas A. Seaman was appointed receiver ("Lender's Receiver") by the United States District Court in this securities fraud enforcement action.




Hereafter, unless otherwise indicated, the term "Lender" will be used in all references to the Lender and the Lender's Receiver included in this Item 13.




Due to the uncertainty created under receivership, as of September 30, 2009, the Company applied ASC 450, “Contingencies,” in assessing the need for a valuation reserve and concluded that the loss was both probable and estimable.  As a result, during the three months ended September 30, 2009, the Company fully reserved the balance of $11.3 million in Excess Amounts.




On January 13, 2010, the Company entered into an Amended and Restated Memorandum of Understanding (the “MOU”) with Dr. Chaudhuri, the majority shareholder of the Company, and KPC Resolution Company, LLC (“KPC”), an affiliate of Dr. Chaudhuri.  The MOU amended and restated the original Memorandum of Understanding entered into by the Company and Dr. Chaudhuri on or about August 12, 2009.




Concurrently with entering into the MOU, KPC entered into a Loan Purchase and Sale Agreement (the “Sale Agreement”) with the Receiver to purchase all of the Company’s credit facilities with the Lender and the related warrants to purchase common stock of the Company that were issued to the Lender.  Included as an exhibit to the Sale Agreement was a release between the Company and the Receiver. Under the terms of the “Release,” among other things, the Receiver would release Excess Amounts representing interest on the Company’s term loans for the period from July 1, 2009 though the date of sale of all of the Company’s notes with the Lenders.  The Release would be effective only if KPC, or its designee, would be the purchaser of the notes from the Receiver. On March 22, 2010, the Release was signed by the Company and hand delivered to the Receiver’s legal counsel.  At that point, the Release was acceptable to both the Receiver and the Company and was being held by the Receiver’s legal counsel until KPC, or its designee, would purchase the Company’s notes from the Receiver.
 
 In consideration of obtaining the Release, a $1.0 million reduction in principal of the Company’s outstanding debt and other benefits for the Company,, the Company agreed to issue a warrant to purchase up to 170.0 million shares of the Company’s common stock at $0.07 per share to Dr. Chaudhuri.


52




The MOU was terminated on April 13, 2010, upon execution of the Omnibus Amendment.  Some of the terms in the MOU survived and are included in the Omnibus Amendment (Note 12).




Subsequent to March 31, 2010, pursuant to the Release between the Company and the Lender, the Lender released $6.4 million in Excess Amounts to apply against interest expense the Company had accrued under its term loans. As a result, as of March 31, 2010, the Lender retained a net amount of $4.9 million in Excess Amounts under the $50.0 million Revolving Credit Agreement. As noted above, an additional $1.0 million was recovered by the Company as a reduction in principal of the Company’s outstanding debt, resulting in a gross recovery of $7.4 million.  As an offsetting cost of the recovery, the fair value of the aforementioned warrant is estimated at $2.1 million using the Black-Scholes valuation model.  Accordingly, as of March 31, 2010, the Company revised its estimate of the valuation reserve based on the more recent and certain outcome using the guidance of ASC 450, resulting in a net expense amount of $6.0 million for the year ended March 31, 2010.




On April 13, 2010, the Company entered into an Omnibus Credit Agreement Amendment (the “Omnibus Amendment”) with SPCP Group IV, LLC and SPCP Group, LLC (together, “Silver Point”), Silver Point Finance, LLC, as the Lender Agent, PCHI, Ganesha, Dr. Chaudhuri and KPC Resolution Company, LLC (“KPC”).  KPC and Ganesha are companies owned and controlled by Dr. Chaudhuri, who is the majority shareholder of IHHI.  Ganesha is a member of PCHI with a 49% membership interest.




The Omnibus Amendment amends the Credit Agreement ($80.0 million facility) dated as of October 9, 2007, as amended (the “$80.0 million credit agreement”), the Revolving Credit Agreement ($50.0 million facility) dated as of October 9, 2007, as amended  (the “$50.0 million Revolving Credit Agreement”), and the Credit Agreement ($10.7 million facility) dated as of October 9, 2007, as amended (the “$10.7 million credit agreement” and together with the $80.0 million credit agreement and the $50.0 million credit agreement, the “Credit Agreements”), by and among the Company and certain affiliates of Medical Capital Corporation.




The Company entered into the Omnibus Amendment in connection with the Loan Purchase and Sale Agreement, dated as of January 13, 2010, as amended, by and between KPC and the Receiver.  Under the Loan Purchase Agreement, KPC agreed to purchase all of the Credit Agreements from the Receiver for $70.0 million.  Concurrent with the closing of the Loan Purchase Agreement, KPC sold its interest in the Credit Agreements to Silver Point, and KPC purchased from Silver Point a participation interest in the Credit Agreements.  On April 13, 2010, concurrent with the effectiveness of the Omnibus Amendment and the closing of the Loan Purchase Agreement, Silver Point acquired all of the Credit Agreements, including the security agreements and other ancillary documents executed by the Company in connection with the Credit Agreements, and became the “New Lender” under the Credit Agreements.




The following are material terms of the Omnibus Amendment:




·
The stated maturity date under each Credit Agreement was changed to April 13, 2013.  The Credit Agreements were otherwise due to mature on October 8, 2010.


·
Affirming release of prior claims between the Company and the Lender’s Receiver, Silver Point agreed to waive any events of default that had occurred under the Credit Agreements and waived claims to accrued and unpaid interest and fees under the Credit Agreements as of April 13, 2010.


·
The $80.0 million credit agreement was amended so that the $45.0 million Term Note (the “$45.0 million loan”) and $35.0 million Non-Revolving Line of Credit Note (the “$35.0 million loan”) will each bear a fixed interest rate of 14.5% per year.  These loans previously bore interest rates of 10.25% and 9.25%, respectively.  In addition, the Company agreed to make certain mandatory prepayments of the $35.0 million loan if it receives proceeds from certain new financing of its accounts receivable or provider fee funds from Medi-Cal under California AB 1383.





·
The $50.0 million Revolving Credit Agreement was amended so that Silver Point will, subject to the terms and conditions contained therein, make up to $10.0 million in new revolving funds available to the Company for working capital and general corporate purposes.  Each advance under the $50.0 million revolving credit agreement will bear interest at an annual rate of Adjusted LIBOR (calculated as LIBOR subject to certain adjustments, with a floor of 2% and a cap of 5%) plus 12.5%, compared to an interest rate of 24.0% that was previously in effect under the $50.0 million revolving credit agreement.  In addition, the Company agreed to make mandatory prepayments of the $50.0 million revolving credit agreement under the conditions described above with respect to the $80.0 million credit agreement.  The financial covenants under the $50.0 million revolving credit agreement were also amended to increase the required levels of minimum EBITDA (as defined in the Omnibus Amendment) from the levels previously in effect under the $50.0 million Revolving Credit Agreement.





·
The $10.7 million credit agreement was amended so that the $10.7 million Convertible Term Note will bear a fixed interest rate of 14.5% per year, compared to the interest rate of 9.25% previously in effect and to eliminate the conversion feature of the loan.  In addition, the Company agreed to make mandatory prepayments of the $10.7 million credit agreement under the conditions described above with respect to the $80.0 million credit agreement.





·
In connection with the sale of the Credit Agreements, all warrants and stock conversion rights previously issued to the Lender were cancelled.  In connection with the Omnibus Amendment, the Company issued new warrants (the “Omnibus Warrants”) to purchase its common stock for a period of three years at an exercise price of $0.07 per share in the following denominations: 139.0 million shares to KPC or its designees and 96.0 million shares to Silver Point or its designees.  The Omnibus Warrants also provide the holders with certain pre-emptive, information and registration rights.







53


In addition, as noted above, on April 13, 2010, the Company issued a three-year warrant to acquire up to 170.0 million shares of common stock at $0.07 per share to Dr. Chaudhuri pursuant to the MOU.


REVIEW, APPROVAL OR RATIFICATION OF TRANSACTIONS WITH RELATED PARTIES





The Company's human resources written policies and procedures provide guidance for conflicts of interest and their relation to the standards of ethical behavior expected of employees. The policies specifically require immediate written disclosure of any business, financial, or other relationship that either creates, or is perceived to create a conflict of interest. The Corporate Compliance Officer is responsible for monitoring compliance with this policy.




As part of the quarterly disclosure control procedures, the Chief Financial Officer and Chief Executive Officer for each hospital disclose or certify that employees or officers have not acted in a manner inconsistent with the Company policy related to Conflict of Interest. The CFO and Director of Internal Audit monitor certifications for potential disclosure events.




Company policy requires the General Counsel to review and approve all contracts involving related parties, including contracts with related parties who are considered potential referral sources. The Audit Committee has requested that the General Counsel provide periodic updates of such transactions to the Committee.




During the initial acquisition of the Hospitals, the Company entered into agreements with the Medical Executive committee ("MEC") at the largest hospital, Western Medical Center - Santa Ana ("WMC-SA") requiring MEC's advance consent for all agreements involving hospital operations with related parties, excluding the lease arrangements between the Company and PCHI. The Company applies the disclosure provisions applicable to WMC-SA to all of its facilities.





ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES





The following table sets forth the aggregate fees that we incurred for audit and non-audit services provided by BDO Seidman, LLP, which acted as our independent registered public accounting firm for the year ended March 31, 2010 and 2009, and performed audit services for us during those periods. The audit fees include only fees that are customary under generally accepted auditing standards and are the aggregate fees that we incurred for professional services rendered for the years ended March 31, 2010 and 2009.





For the year ended March 31,2010


2009Audit fees (financial)

$
900,000


$
1,100,000Audit related fees


15,000



16,000Tax fees


67,000



50,000All other


-



-Total fees

$
982,000


$
1,166,000





The Audit Committee of the Board of Directors pre-approves all audit and permissible non-audit services to be performed by the independent auditors. The Board of Directors of the Company considered that the provision of the services and the payment of the fees described above are compatible with maintaining the auditors' independence.




54




ITEM 15. EXHIBITS; FINANCIAL STATEMENT SCHEDULES





Exhibits required to be filed are listed below and except where incorporated by reference, immediately follow the Financial Statements. Each document filed with this report is marked with an asterisk (*). References to the “Commission” mean the U.S. Securities and Exchange Commission.





Exhibit Number
Description3.1
Amended and Restated Articles of Incorporation (incorporated by reference to Appendix A to the Registrant’s Information Statement on Schedule 14C filed on March 17, 2009).3.2
Amended and Restated Bylaws (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K filed with the Commission on April 7, 2009).4.1
Warrant to purchase 170,000,000 shares of common stock, dated April 13, 2010, issued to Kali P. Chaudhuri, M.D. (incorporated by reference to Exhibit 99.2 to the Registrant’s Report on Form 8-K filed on April 19, 2010).4.2
Warrant to purchase 139,000,000 shares of common stock, dated April 13, 2010, issued to KPC Resolution Company, LLC (incorporated by reference to Exhibit 99.3 to the Registrant’s Report on Form 8-K filed on April 19, 2010).4.3
Warrant to purchase 79,182,635 shares of common stock, dated April 13, 2010, issued to SPCP Group, LLC (incorporated by reference to Exhibit 99.4 to the Registrant’s Report on Form 8-K filed on April 19, 2010).4.4
Warrant to purchase 16,817,365 shares of common stock, dated April 13, 2010, issued to SPCP Group IV, LLC (incorporated by reference to Exhibit 99.5 to the Registrant’s Report on Form 8-K filed on April 19, 2010).10.1
2006 Stock Incentive Plan (incorporated by reference to Appendix B to the Registrant’s Definitive Proxy Statement on Schedule 14A filed by the Registrant on November 14, 2006).10.2
Form of Notice of Stock Option Award and Stock Option Agreement under 2006 Stock Incentive Plan (incorporated herein by reference from Exhibit 4.5 to the Registrant’s Registration Statement under the Securities and Exchange Act of 1933 on Form S-8 filed with the Commission on February 2, 2007).10.3
Legal representation agreement between the Registrant and William E. Thomas, Inc., a Professional Law Corporation (incorporated by reference to Exhibit 99.1 to the Registrant’s Report on Form 8-K filed on September 26, 2008).10.4
Amended and Restated Triple Net Hospital Building Lease, dated as of October 1, 2007, between Pacific Coast Holdings Investment, LLC and the Registrant (incorporated by reference to Exhibit 99.10 to the Registrant’s Report on Form 8-K filed on October 15, 2007).10.4.1
Amendment to Amended and Restated Triple Net Hospital Building Lease, dated as of March 27, 2009, between Pacific Coast Holdings Investment, LLC and the Registrant (incorporated by reference to Exhibit 10.8 to the Registrant’s Report on Form 8-K filed on April 7, 2009).10.4.2
Second Amendment to Amended and Restated Triple Net Hospital Building Lease, dated as of April 13, 2010, between Pacific Coast Holdings Investment, LLC and the Registrant (incorporated by reference to Exhibit 99.6 to the Registrant’s Report on Form 8-K filed on April 19, 2010).10.5
$80,000,000 Credit Agreement, dated October 9, 2007 (incorporated by reference to Exhibit 99.1 to the Registrant’s Report on Form 8-K filed on October 15, 2007).10.5.1
$45,000,000 Term Note, dated October 9, 2007 (incorporated by reference to Exhibit 99.2 to the Registrant’s Report on Form 8-K filed on October 15, 2007).10.5.2
$35,000,000 Non-Revolving Line of Credit Note, dated October 9, 2007 (incorporated by reference to Exhibit 99.3 to the Registrant’s Report on Form 8-K filed on October 15, 2007).10.5.3
Amendment No. 1 to $80,000,000 Credit Agreement, dated as of April 2, 2009, by and among the Registrant, WMC-SA, Inc., WMC-A, Inc., Chapman Medical Center, Inc., Coastal Communities Hospital, Inc., Pacific Coast Holdings Investment, LLC, Orange County Physicians Investment Network, LLC, Ganesha Realty, LLC, West Coast Holdings, LLC, and Medical Provider Financial Corporation II (incorporated by reference to Exhibit 10.6 to the Registrant’s Report on Form 8-K filed on April 7, 2009).10.6
$50,000,000 Revolving Credit Agreement, dated October 9, 2007 (incorporated by reference to Exhibit 99.4 to the Registrant’s Report on Form 8-K filed on October 15, 2007).10.6.1
$50,000,000 Revolving Line of Credit Note, dated October 9, 2007 (incorporated by reference to Exhibit 99.5 to the Registrant’s Report on Form 8-K filed on October 15, 2007).10.6.2
Amendment No. 1 to $50,000,000 Revolving Credit Agreement, dated June 10, 2008 (incorporated by reference to Exhibit 10.11.1 to the Registrant’s Annual Report on Form 10-K filed on July 14, 2008).10.6.3
Amendment No. 2 to $50,000,000 Revolving Credit Agreement, dated June 20, 2008 (incorporated by reference to Exhibit 10.11.2 to the Registrant’s Annual Report on Form 10-K filed on July 14, 2008).10.6.4
Amendment No. 1 to $50,000,000 Revolving Credit Agreement, dated as of April 2, 2009, by and among the Registrant, WMC-SA, Inc., WMC-A, Inc., Chapman Medical Center, Inc., Coastal Communities Hospital, Inc., Pacific Coast Holdings Investment, LLC, Orange County Physicians Investment Network, LLC, Ganesha Realty, LLC, West Coast Holdings, LLC, and Medical Provider Financial Corporation I (incorporated by reference to Exhibit 10.5 to the Registrant’s Report on Form 8-K filed on April 7, 2009).   55
  10.7
$10,700,000 Credit Agreement, dated October 9, 2007 (incorporated by reference to Exhibit 99.6 to the Registrant’s Report on Form 8-K filed on October 15, 2007).10.7.1
$10,700,000 Convertible Term Note, dated October 9, 2007 (incorporated by reference to Exhibit 99.7 to the Registrant’s Report on Form 8-K filed on October 15, 2007).10.8
Early Loan Payoff Agreement, dated effective as of July 18, 2008, among the Registrant, WMC-SA, Inc., WMC-A, Chapman Medical Center, Inc., Coastal Communities Hospital, Inc., Medical Provider Financial Corporation I, Medical Provider Financial Corporation II, Medical Provider Financial Corporation III, and Healthcare Financial Management & Acquisitions, Inc. (incorporated by reference to Exhibit 10.2 to the Registrant’s Report on Form 8-K filed on July 21, 2008).10.8.1
Amendment No. 1 to Early Loan Payoff Agreement, dated as of January 30, 2009, among the Registrant; WMC-SA, Inc., WMC-A, Chapman Medical Center, Inc., Coastal Communities Hospital, Inc., Medical Provider Financial Corporation I, Medical Provider Financial Corporation II, Medical Provider Financial Corporation III, and Healthcare Financial Management & Acquisitions, Inc. (incorporated by reference to Exhibit 10.2 to the Registrant’s Report on Form 8-K filed on February 2, 2009).10.9
Full and Final Settlement and Mutual Release Agreement, effective as of December 1, 2008, by and between the Registrant and Ajay Meka, M.D. and Salman Naqvi, M.D. (incorporated by reference to Exhibit 99.1 to the Registrant’s Report on Form 8-K filed on December 4, 2008).10.10
Securities Purchase Agreement, dated effective as of July 18, 2008, among the Registrant, Kali P. Chaudhuri, M.D., and William E. Thomas (incorporated by reference to Exhibit 10.1 to the Registrant’s Report on Form 8-K filed on July 21, 2008).10.10.1
Amendment No. 1 to Securities Purchase Agreement, dated as of January 30, 2009, among the Registrant, Kali P. Chaudhuri, M.D., and William E. Thomas (incorporated by reference to Exhibit 10.1 to the Registrant’s Report on Form 8-K filed on February 2, 2009).10.10.2
Amendment No. 2 to Securities Purchase Agreement, dated as of March 6, 2009, among the Registrant, Kali P. Chaudhuri, M.D., and William E. Thomas (incorporated by reference to Exhibit 10.1 to the Registrant’s Report on Form 8-K filed on March 10, 2009).10.11
Settlement Agreement, General Release and Covenant Not to Sue, dated March 25, 2009, by and among the Registrant, Anil V. Shah, M.D., Orange County Physicians Investment Network, LLC, Bruce Mogel, Pacific Coast Holdings Investment, LLC, West Coast Holdings, LLC, Dr. Kali P. Chaudhuri, Ganesha Realty, LLC, William E. Thomas, Medical Capital Corporation, Medical Provider Financial Corporation I, Medical Provider Financial Corporation II and Medical Provider Financial Corporation III (incorporated by reference to Exhibit 10.1 to the Registrant’s Report on Form 8-K filed on April 7, 2009).10.12
Stock Purchase Agreement, dated as of April 2, 2009, by and between the Registrant and Dr. Kali P. Chaudhuri (incorporated by reference to Exhibit 10.2 to the Registrant’s Report on Form 8-K filed on April 7, 2009).10.13
Stock Purchase Agreement, dated as of April 2, 2009, by and between the Registrant and Dr. Anil V. Shah (incorporated by reference to Exhibit 10.3 to the Registrant’s Report on Form 8-K filed on April 7, 2009).10.14
Stock Purchase Agreement, dated as of April 2, 2009, by and between the Registrant and Orange County Physicians Investment Network, LLC (incorporated by reference to Exhibit 10.4 to the Registrant’s Report on Form 8-K filed on April 7, 2009).10.15
Acknowledgement, Waiver and Consent and Amendment to Credit Agreements, dated as  of April 2, 2009, by and among the Registrant, Anil V. Shah, M.D., Orange County Physicians Investment Network, LLC, Bruce Mogel, Pacific Coast Holdings Investment, LLC, West Coast Holdings, LLC, Dr. Kali P. Chaudhuri, Ganesha Realty, LLC, William E. Thomas, Medical Capital Corporation, Medical Provider Financial Corporation I, Medical Provider Financial Corporation II and Medical Provider Financial Corporation III (incorporated by reference to Exhibit 10.7 to the Registrant’s Report on Form 8-K filed on April 7, 2009).10.16
Amended and Restated Memorandum of Understanding, dated as of January 13, 2010, by and among the Registrant, WMC-A, Inc., WMC-SA, Inc., Coastal Communities Hospital, Inc., Chapman Medical Center, Inc., Dr. Kali P. Chaudhuri and KPC Resolution Company, LLC. (incorporated by reference to Exhibit 99.1 to the Registrant’s Report on Form 8-K filed on January 20, 2010).10.17
Amended and Restated Employment Agreement, executed as of March 29, 2010, by and between the Registrant and Kenneth K. Westbrook.*10.18
Amended and Restated Employment Agreement, executed as of March 29, 2010, by and between the Registrant and Steven R. Blake.*10.19
Amended and Restated Employment Agreement, executed as of March 29, 2010, by and between the Registrant and Daniel J. Brothman.*10.20
Omnibus Credit Agreement Amendment, dated as of April 13, 2010, among the Registrant, WMC-SA, Inc., WMC-A, Inc., Chapman Medical Center, Inc., Coastal Communities Hospital, Inc., Pacific Coast Holdings Investment, LLC, Ganesha Realty, LLC, SPCP Group IV, LLC, SPCP Group, LLC, and Silver Point Finance, LLC, as the Lender Agent (incorporated by reference to Exhibit 99.1 to the Registrant’s Report on Form 8-K filed on April 19, 2010).10.21
Release, dated April 13, 2010, by and between the Registrant and Thomas A. Seaman, Receiver (incorporated by reference to Exhibit 99.7 to the Registrant’s Report on Form 8-K filed on April 19, 2010).21.1
The subsidiaries of the Registrant are WMC-SA, Inc., a California corporation, WMC-A, Inc., a California corporation, Chapman Medical Center, Inc., a California corporation, Coastal Communities Hospital, Inc., a California corporation, and Mogel Management, Inc., a Nevada corporation.23.1
Consent of BDO Seidman, LLP.*31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*32.1
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*32.2
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*











56


SIGNATURES





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




INTEGRATED HEALTHCARE HOLDINGS, INC.Dated: June 29, 2010
By:
/s/ Kenneth K. WestbrookKenneth K. WestbrookChief Executive Officer & President(Principal Executive Officer)




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






Dated: June 29, 2010
/s/ Kenneth K. WestbrookKenneth K. WestbrookChief Executive Officer, President & Director(Principal Executive Officer)Dated: June 29, 2010
/s/ Steven R. BlakeSteven R. BlakeChief Financial Officer(Principal Financial Officer)Dated: June 29, 2010
/s/ Jeremiah R. KanalyJeremiah R. KanalyChief Accounting Officer and Treasurer(Principal Accounting Officer)Dated: June 29, 2010
/s/ Maurice J. DeWaldMaurice J. DeWaldChairman of the Board of DirectorsDated: June 29, 2010
/s/ Hon. C. Robert JamesonHon. C. Robert JamesonDirectorDated: June 29, 2010
/s/ Ajay Meka, M.D.Ajay Meka, M.DDirectorDated: June 29, 2010
/s/ Michael MetzlerMichael MetzlerDirectorDated: June 29, 2010
/s/ J. Fernando NieblaJ. Fernando NieblaDirectorDated: June 29, 2010
/s/ William E. ThomasWilliam E. ThomasDirector




57




Report of Independent Registered Public Accounting Firm









Board of Directors and Stockholders


Integrated Healthcare Holdings, Inc.


Santa Ana, California




We have audited the accompanying consolidated balance sheets of Integrated Healthcare Holdings, Inc. as of March 31, 2010 and 2009 and the related consolidated statements of operations, stockholders’ deficiencies, and cash flows for each of the two years in the period ended March 31, 2010.  In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule listed as Schedule II.  These consolidated financial statements and schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.




We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.




In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Integrated Healthcare Holdings, Inc. at March 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the two years in the period ended March 31, 2010, in conformity with accounting principles generally accepted in the United States of America.




Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.




As discussed in Note 1 to the consolidated financial statements, effective April 1, 2009 the Company adopted the provisions of Accounting Standards Codification 810-10-45 which addresses the presentation of noncontrolling interests.




The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has a working capital deficit and a net stockholders’ deficiency at March 31, 2010. These factors raise substantial doubt about its ability to continue as a going concern.  The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.







/s/ BDO Seidman, LLP
 Costa Mesa, California
 June 29, 2010


F-1





INTEGRATED HEALTHCARE HOLDINGS, INC. CONSOLIDATED BALANCE SHEETS (amounts in 000's, except par value)




March 31,

2010


March 31,

2009(adjusted)ASSETSCurrent assets:Cash and cash equivalents

$
10,159


$
3,514Restricted cash


27



18Accounts receivable, net of allowance for doubtful accounts of $15,258 and $17,377, respectively


53,144



55,876Inventories of supplies


5,818



5,742Due from governmental payers


4,979



4,297Due from lender, net


5,234



5,576Prepaid insurance


400



339Other prepaid expenses and current assets


5,915



5,097Total current assets


85,676



80,459Property and equipment, net


54,506



55,414Debt issuance costs, net


-



123Total assets

$
140,182


$
135,996LIABILITIES AND STOCKHOLDERS' DEFICIENCYCurrent liabilities:Debt

$
-


$
80,968Accounts payable


45,468



59,265Accrued compensation and benefits


20,420



16,809Accrued insurance retentions


12,983



11,212Other current liabilities


11,264



6,265Total current liabilities


90,135



174,519Debt, noncurrent


80,968



-Capital lease obligations, net of current portion of $838 and $835, respectively


5,864



6,703Total liabilities


176,967



181,222Commitments, contingencies, and subsequent eventsStockholders' deficiency:Integrated Healthcare Holdings, Inc. stockholders' deficiency:Common stock, $0.001 par value; 500,000 shares authorized; 255,307 and 195,307 shares issued and outstanding, respectively


255



195Additional paid in capital


62,871



61,080Receivable from stockholders


(1,800
)


-Accumulated deficit


(99,445
)


(106,501
)Total Integrated Healthcare Holdings, Inc. stockholders' deficiency


(38,119
)


(45,226
)Noncontrolling interests


1,334



-Total stockholders' deficiency


(36,785
)


(45,226
)Total liabilities and stockholders' deficiency

$
140,182


$
135,996
 The accompanying notes are an integral part of these consolidated financial statements.
   F-2





INTEGRATED HEALTHCARE HOLDINGS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (amounts in 000's, except per share amounts)


For the year ended March 31,2010


2009(adjusted)Net operating revenues

$
383,372


$
393,015Operating expenses:Salaries and benefits


209,995



212,764Supplies


52,822



51,431Provision for doubtful accounts


31,777



42,241Other operating expenses


59,125



70,495Depreciation and amortization


3,823



3,593Loss - due from Lender (Notes 1 and 3)


6,019



-363,561



380,524Operating income


19,811



12,491Other expense:Interest expense, net


(9,310
)


(12,437
)Warrant expense


-



(22
)(9,310
)


(12,459
)Income before income tax provision (benefit)


10,501



32Income tax provision (benefit)


(180
)


290Net income (loss)


10,681



(258
)Net income attributable to noncontrolling interests (Note 9)


(3,625
)


(1,250
)Net income (loss) attributable to Integrated Healthcare Holdings, Inc.

$
7,056


$
(1,508
)Per Share Data:Earnings (loss) per common share attributable toIntegrated Healthcare Holdings, Inc. stockholdersBasic

$
0.03


$
(0.01
)Diluted

$
0.03


$
(0.01
)Weighted average shares outstandingBasic


248,568



160,183Diluted


278,622



160,183
 The accompanying notes are an integral part of these consolidated financial statements.
   F-3




INTEGRATED HEALTHCARE HOLDINGS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIENCY (amounts in 000's)


Integrated Healthcare Holdings, Inc. StockholdersAdditional


ReceivableCommon Stock


Paid-in


from


Accumulated


NoncontrollingShares


Amount


Capital


Stockholders


Deficit


Interests


TotalBalance, March 31, 2008, adjusted


137,096


$
137


$
56,148


$
-


$
(104,993
)

$
1,150


$
(47,558
)Exercise of warrants


58,211



58



4,674



-



-



-



4,732Issuance of right to purchase stock


-



-



80



-



-



-



80Issuance of warrants


-



-



22



-



-



-



22Share-based compensation


-



-



156



-



-



-



156Net income (loss)


-



-



-



-



(1,508
)


1,250



(258
)Noncontrolling interests distributions


-



-



-



-



-



(2,400
)


(2,400
)Balance, March 31, 2009, adjusted


195,307



195



61,080



-



(106,501
)


-



(45,226
)Issuance of common stock (Note 11)


60,000



60



1,740



(1,800
)


-



-



-Share-based compensation


-



-



51



-



-



-



51Net income


-



-



-



-



7,056



3,625



10,681Noncontrolling interests distributions


-



-



-



-



-



(2,291
)


(2,291
)Balance, March 31, 2010


255,307


$
255


$
62,871


$
(1,800
)

$
(99,445
)

$
1,334


$
(36,785
)


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






F-4




INTEGRATED HEALTHCARE HOLDINGS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (amounts in 000's)


For the year ended March 31,2010


2009(adjusted)Cash flows from operating activities:Net income (loss)

$
10,681


$
(258
)Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:Depreciation and amortization of property and equipment


3,823



3,593Provision for doubtful accounts


31,777



42,241Amortization of debt issuance costs


248



879Loss - due from Lender


6,019



-Common stock warrant expense


-



22Noncash share-based compensation expense


51



156(Recovery) loss on disposition of property and equipment


(195
)


195Changes in operating assets and liabilities:Accounts receivable


(29,045
)


(40,635
)Inventories of supplies


(76
)


111Due from governmental payers


(682
)


580Prepaid insurance, other prepaid expenses and current assets, and other assets


(808
)


853Accounts payable


(13,797
)


12,584Accrued compensation and benefits


3,611



2,108Due to governmental payers


-



(1,690
)Accrued insurance retentions and other current liabilities


6,769



(636
)Net cash provided by operating activities


18,376



20,103Cash flows from investing activities:Decrease in restricted cash


(9
)


2Additions to property and equipment


(2,915
)


(842
)Net cash used in investing activities


(2,924
)


(840
)Cash flows from financing activities:Drawdown on revolving line of credit, net


-



(9,879
)Paydown on convertible note


-



(4,732
)Excess funds withheld by lender


(5,677
)


(5,576
)Issuance of common stock


-



4,732Issuance of purchase right


-



80Noncontrolling interests distributions


(2,291
)


(2,400
)Payments on capital lease obligations


(839
)


(1,115
)Net cash used in financing activities


(8,807
)


(18,890
)Net increase in cash and cash equivalents


6,645



373Cash and cash equivalents, beginning of period


3,514



3,141Cash and cash equivalents, end of period

$
10,159


$
3,514





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








F-5





INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010








NOTE 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





BASIS OF PRESENTATION - The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business.




The Company has also determined that Pacific Coast Holdings Investment, LLC ("PCHI") (Note 9), is a variable interest entity as defined by GAAP and, accordingly, the financial statements of PCHI are included in the accompanying consolidated financial statements.




All significant intercompany accounts and transactions have been eliminated in consolidation. Unless otherwise indicated, all amounts included in these notes to the consolidated financial statements are expressed in thousands (except per share amounts, percentages and stock option prices and values).




In June 2009, the FASB issued a new standard that changes the referencing and organization of accounting guidance and establishes the Financial Accounting Standards Board’s ("FASB") Accounting Standards Codification (“ASC”) as the single source of authoritative nongovernmental GAAP. Rules and interpretive releases of the SEC under the authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. In connection with the adoption of this standard the Company’s financial statements will only cite certain specific GAAP references.




Effective April 1, 2009, the Company adopted a new standard that requires the noncontrolling interest in a subsidiary or variable interest entity be reported as a separate component of stockholder’s equity in the consolidated financial statements. The standard also requires net income attributable to noncontrolling interest be reported as a separate component of the consolidated statements of earnings.  In connection with the adoption of this new standard, the prior year financial statements have been adjusted to conform to the new required presentation.





LIQUIDITY AND MANAGEMENT'S PLANS - As of March 31, 2010, the Company has a working capital deficit of $4.5 million and accumulated total deficiency of $36.8 million.




On January 28, 2009, the Company’s “Lender” (consisting of Medical Capital Corporation and its affiliates, Medical Provider Financial Corporation I, Medical Provider Financial Corporation II, and Medical Provider Financial Corporation III) began to collect and retain amounts in excess of the amounts due to it (“Excess Amounts”) under the $50.0 million Revolving Credit Agreement (Note 3). From January 28, 2009 to on or about May 18, 2009, the Lender had swept an aggregate of $14.3 million in Excess Amounts.   The Lender continued to release Excess Amounts to defray the Company’s monthly interest obligations under all other loan agreements between it and the Company through June 30, 2009, resulting in a balance in Excess Amounts of $11.3 million.




On April 14, 2009, the Company issued a letter (the “Demand Letter”) notifying the Lender that it was in default on the $50.0 million Revolving Credit Agreement, to make demand for return of all Excess Amounts, and to reserve the rights of the borrowers and credit parties with respect to other actions and remedies available to them. The Company considered the Lender’s failure to return the Excess Amounts as an improper conversion of assets and a breach of the Lender’s fiduciary and custodial obligations.  On April 17, 2009, following receipt of a copy of the Demand Letter, the bank that maintained the lock boxes pursuant to a restricted account and securities account control agreement (the “Lockbox Agreement”) notified the Company and the Lender that it would terminate the Lockbox Agreement within 30 days. On May 18, 2009, the Lockbox Agreement was terminated and the Company's bank accounts were frozen.  On May 19, 2009, the Lender relinquished any and all control over the bank accounts pursuant to the Lockbox Agreement. The Lender’s relinquishment provided the Company with full access to its bank accounts and the accounts were no longer accessible by the Lender.




On July 16, 2009, the SEC filed a fraud complaint with the United States District Court against the parent company and affiliates of the Lender for violations of federal securities laws and barred it from entering into material transactions pending presentation of the government’s case.  On August 3, 2009, Mr. Thomas A. Seaman was appointed receiver ("Receiver") by the United States District Court in this securities fraud enforcement action.




Hereafter, unless otherwise indicated, the term "Lender" will be used in all references to the Lender and the Receiver included in these notes to consolidated financial statements.




Due to the uncertainty created under receivership, as of September 30, 2009, the Company applied ASC 450, “Contingencies,” in assessing the need for a valuation reserve and concluded that the loss was both probable and estimable.  As a result, during the three months ended September 30, 2009, the Company fully reserved the balance of $11.3 million in Excess Amounts.




On January 13, 2010, the Company entered into an Amended and Restated Memorandum of Understanding (the “MOU”) with Dr. Chaudhuri, the majority shareholder of the Company, and KPC Resolution Company, LLC (“KPC”), an affiliate of Dr. Chaudhuri.  The MOU amended and restated the original Memorandum of Understanding entered into by the Company and Dr. Chaudhuri on or about August 12, 2009. Specifically, under the MOU, it was agreed that the Company would furnish to the Lender a release of the Lender and the Receiver from all claims (including claims for the Excess Amounts). In return, KPC agreed to pay to the Company an amount equal to the value that such claims would have had as an unsecured claim in the receivership estate of the Lender. Therefore, the MOU provided provisions for the Company to recoup and reduce some of the losses incurred stemming from the Excess Amounts retained by the Lender.




F-6


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010








Concurrently with entering into the MOU, KPC entered into a  Loan Purchase and Sale Agreement (the “Sale Agreement”) with the Receiver to purchase all of the Company’s credit facilities with the Lender and the related warrants to purchase common stock of the Company that were issued to the Lender.  Included as an exhibit to the Sale Agreement was a release between the Company and the Receiver. Under the terms of the “Release,” among other things, the Receiver would release Excess Amounts representing interest on the Company’s term loans for the period from July 1, 2009 though the date of sale of all of the Company’s notes with the Lenders.  The Release would be effective only if KPC, or its designee, would be the purchaser of the notes from the Receiver. On March 22, 2010, the Release was signed by the Company and hand delivered to the Receiver’s legal counsel.  At that point, the Release was acceptable to both the Receiver and the Company and was being held by the Receiver’s legal counsel until KPC, or its designee, would purchase the Company’s notes from the Receiver.
 
 In consideration of obtaining the Release, a $1.0 million reduction in principal of the Company’s outstanding debt and other benefits for the Company, the Company agreed to issue a warrant to purchase up to 170.0 million shares of the Company’s common stock at $0.07 per share to Dr. Chaudhuri.
 
 The MOU was terminated on April 13, 2010, upon execution of the Omnibus Amendment.  Some of the terms in the MOU survived and are included in the Omnibus Amendment (Note 12).
 
 Subsequent to March 31, 2010, pursuant to the Release the Lender released $6.4 million in Excess Amounts to apply against interest expense the Company had accrued under its term loans. As a result, as of March 31, 2010, the Lender retained a net amount of $4.9 million in Excess Amounts under the $50.0 million Revolving Credit Agreement. As noted above, an additional $1.0 million was recovered by the Company as a reduction in principal of the Company’s outstanding debt, resulting in a gross recovery of $7.4 million.  As an offsetting cost of the recovery, the fair value of the aforementioned warrant is estimated at $2.1 million using the Black-Scholes valuation model.  The Loan Purchase agreement (entered into in January 2010) between KPC and the Receiver incorporated the Release as an integral component of the Sale Agreement and the Release was fully negotiated, signed, and held by the Receiver prior to March 31, 2010. Therefore, although the form of the arrangements were not formalized until subsequent to year-end, the transaction substance was deemed to have been substantially completed and acknowledged by all parties (including the Receiver) prior to year-end.  The overbidding process and approval by the Court was a requirement of receivership, and from the Court approval on April 2, 2010 through April 13, 2010, nothing substantive occurred to change the overall understanding of the arrangement specifically related to the MOU and the Release. Accordingly, as of March 31, 2010, the Company revised its estimate of the valuation reserve based on the more recent and certain outcome using the guidance of ASC 450, resulting in a net expense amount of $6.0 million for the year ended March 31, 2010.
 
 The Company currently relies solely on its cash receipts from payers to fund its operations, and any significant disruption in such receipts could have a material adverse effect on its ability to continue as a going concern. Subsequent to March 31, 2010, the Company entered into an agreement with a new lender (Note 12) whereby $10.0 million in revolving funds will be available to the Company for working capital and general corporate purposes. However, a $10.0 million revolving line of credit may be insufficient to meet the Company’s cash needs.  The consolidated financial statements do not include any adjustments that might result from the outcome this uncertainty.
  These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern and indicate a need for it to take action to continue to operate its business as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.




DESCRIPTION OF BUSINESS - Effective March 8, 2005, the Company acquired four hospitals (the "Hospitals") from subsidiaries of Tenet Healthcare Corporation (the "Acquisition"). The Company owns and operates the four community-based hospitals located in southern California, which are:




·
282-bed Western Medical Center in Santa Ana, California;


·
188-bed Western Medical Center in Anaheim, California;


·
178-bed Coastal Communities Hospital in Santa Ana, California; and


·
114-bed Chapman Medical Center in Orange, California.





RECLASSIFICATION FOR PRESENTATION - Certain immaterial amounts previously reported have been reclassified to conform to the current period's presentation with no impact on the reported net income (loss) of the Company.




F-7


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010








CONCENTRATION OF CREDIT RISK - The Company has secured its working capital and its long term debt from the same lender and, thus, is subject to significant credit risk as a result of the Lender’s inability to perform (Notes 3 and 12).




The Hospitals are subject to licensure by the State of California and accreditation by the Joint Commission on Accreditation of Healthcare Organizations. Loss of either licensure or accreditation would impact the ability to participate in various governmental and managed care programs, which provide the majority of the Company's revenues.




Essentially all net operating revenues come from external customers. The largest payers are the Medicare and Medicaid, which combined accounted for 59% and 55% of the net operating revenues for the years ended March 31, 2010 and 2009, respectively. No other payers represent a significant concentration of the Company's net operating revenues.




We receive all of our inpatient services revenue from operations in Orange County, California. The economic condition of this market could affect the ability of our patients and third-party payers to reimburse us for our services, through its effect on disposable household income and the tax base used to generate state funding for Medicaid programs.




USE OF ESTIMATES - The accompanying consolidated financial statements have been prepared in accordance with GAAP and prevailing practices for investor owned entities within the healthcare industry. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Principal areas requiring the use of estimates include third-party cost report settlements, income taxes, accrued insurance retentions and self-insurance reserves, and net patient receivables. Management regularly evaluates the accounting policies and estimates that are used. In general, management bases the estimates on historical experience and on assumptions that it believes to be reasonable given the particular circumstances in which its Hospitals operate. Although management believes that all adjustments considered necessary for fair presentation have been included, actual results may materially vary from those estimates.




REVENUE RECOGNITION - Net operating revenues are recognized in the period in which services are performed and are recorded based on established billing rates (gross charges) less estimated discounts for contractual allowances, principally for patients covered by Medicare, Medicaid, managed care, and other health plans. Gross charges are retail charges. They are not the same as actual pricing, and they generally do not reflect what a hospital is ultimately paid and therefore are not displayed in the consolidated statements of operations. Hospitals are typically paid amounts that are negotiated with insurance companies or are set by the government. Gross charges are used to calculate Medicare outlier payments and to determine certain elements of payment under managed care contracts (such as stop-loss payments). Because Medicare requires that a hospital's gross charges be the same for all patients (regardless of payer category), gross charges are also what the Hospitals charge all other patients prior to the application of discounts and allowances.




Revenues under the traditional fee-for-service Medicare and Medicaid programs are based primarily on prospective payment systems. Discounts for retrospectively cost based revenues and certain other payments, which are based on the Hospitals' cost reports, are estimated using historical trends and current factors. Cost report settlements for retrospectively cost-based revenues under these programs are subject to audit and administrative and judicial review, which can take several years until final settlement of such matters are determined and completely resolved. Estimates of settlement receivables or payables related to a specific year are updated periodically and at year end and at the time the cost report is filed with the fiscal intermediary. Typically no further updates are made to the estimates until the final Notice of Program Reimbursement is received, at which time the cost report for that year has been audited by the fiscal intermediary. There could be several years time lag between the submission of a cost report and receipt of the Final Notice of Program Reimbursement. Since the laws, regulations, instructions and rule interpretations governing Medicare and Medicaid reimbursement are complex and change frequently, the estimates recorded by the Hospitals could change by material amounts. The Company has established settlement receivables of $220 and $1.6 million as of March 31, 2010 and 2009, respectively, which are included as due from government payers in the accompanying consolidated balance sheets.




Outlier payments, which were established by Congress as part of the diagnosis-related groups ("DRG") prospective payment system, are additional payments made to Hospitals for treating Medicare patients who are costlier to treat than the average patient in the same DRG. To qualify as a cost outlier, a hospital's billed (or gross) charges, adjusted to cost, must exceed the payment rate for the DRG by a fixed threshold established annually by the Centers for Medicare and Medicaid Services of the United States Department of Health and Human Services ("CMS"). Under Sections 1886(d) and 1886(g) of the Social Security Act, CMS must project aggregate annual outlier payments to all prospective payment system Hospitals to be not less than 5% or more than 6% of total DRG payments ("Outlier Percentage"). The Outlier Percentage is determined by dividing total outlier payments by the sum of DRG and outlier payments. CMS annually adjusts the fixed threshold to bring expected outlier payments within the mandated limit. A change to the fixed threshold affects total outlier payments by changing (1) the number of cases that qualify for outlier payments, and (2) the dollar amount Hospitals receive for those cases that still qualify. The most recent change to the cost outlier threshold that became effective on October 1, 2009 was an increase from $20.045 to $23.140. CMS projects this will result in an Outlier Percentage that is approximately 5.1% of total payments. The Medicare fiscal intermediary calculates the cost of a claim by multiplying the billed charges by the cost-to-charge ratio from the hospital's most recent filed cost report.




F-8


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010








The Hospitals received new provider numbers following the Acquisition and, because there was no specific history, the Hospitals were reimbursed for outliers based on published statewide averages. If the computed cost exceeds the sum of the DRG payment plus the fixed threshold, a hospital receives 80% of the difference as an outlier payment. Medicare has reserved the option of adjusting outlier payments, through the cost report, to a hospital's actual cost-to-charge ratio. Upon receipt of the current cost-to-charge ratios from the fiscal intermediary, any variance between current payments and the estimated final outlier settlement are examined by the Medicare fiscal intermediary. During the year ended March 31, 2010, the Company recorded $172.9 in Final Notice of Program Reimbursement settlements.   During the year ended March 31, 2009, the Company reversed $1.7 million in reserves related to excess outlier payments based on the receipt of the Final Notice of Program Reimbursement for 2006. As of March 31, 2009, the Company had reversed all reserves for excess outlier payments.




The Hospitals receive supplemental payments from the State of California to support indigent care (Medi-Cal Disproportionate Share Hospital payments or "DSH") and from the California Medical Assistance Commission ("CMAC") under the SB 1100 and SB 1255 programs. The Hospitals received supplemental payments of $18.9 million and $21.9 million during the years ended March 31, 2010 and 2009, respectively. The related revenue recorded for the years ended March 31, 2010 and 2009 was $21.0 million and $19.7 million, respectively. As of March 31, 2010 and 2009, estimated DSH receivables were $4.8 million and $2.7 million, respectively, which are included as due from government payers in the accompanying consolidated balance sheets.




The following is a summary of due from governmental payers as of March 31:





March 31,


March 31,2010


2009Due from government payersMedicare

$
220


$
1,618Medicaid


4,759



2,679$
4,979


$
4,297





Revenues under managed care plans are based primarily on payment terms involving predetermined rates per diagnosis, per-diem rates, discounted fee-for-service rates and/or other similar contractual arrangements. These revenues are also subject to review and possible audit by the payers. The payers are billed for patient services on an individual patient basis. An individual patient's bill is subject to adjustment on a patient-by-patient basis in the ordinary course of business by the payers following their review and adjudication of each particular bill. The Hospitals estimate the discounts for contractual allowances utilizing billing data on an individual patient basis. At the end of each month, the Hospitals estimate expected reimbursement for patients of managed care plans based on the applicable contract terms. These estimates are continuously reviewed for accuracy by taking into consideration known contract terms as well as payment history. Although the Hospitals do not separately accumulate and disclose the aggregate amount of adjustments to the estimated reimbursements for every patient bill, management believes the estimation and review process allows for timely identification of instances where such estimates need to be revised. The Company does not believe there were any adjustments to estimates of individual patient bills that were material to its net operating revenues.




The Hospitals provide charity care to patients whose income level is below 300% of the Federal Poverty Level. Patients with income levels between 300% and 350% of the Federal Poverty Level qualify to pay a discounted rate under AB774 based on various government program reimbursement levels. Patients without insurance are offered assistance in applying for Medicaid and other programs they may be eligible for, such as state disability, Victims of Crime, or county indigent programs. Patient advocates from the Hospitals' Medical Eligibility Program ("MEP") screen patients in the hospital and determine potential linkage to financial assistance programs. They also expedite the process of applying for these government programs. Based on average revenue for comparable services from all other payers, revenues foregone under the charity policy, including indigent care accounts, were $8.3 million and $8.2 million for the years ended March 31, 2010 and 2009, respectively.




Receivables from patients who are potentially eligible for Medicaid are classified as Medicaid pending under the MEP, with appropriate contractual allowances recorded. If the patient does not qualify for Medicaid, the receivables are reclassified to charity care and written off, or they are reclassified to self-pay and adjusted to their net realizable value through the provision for doubtful accounts. Reclassifications of Medicaid pending accounts to self-pay do not typically have a material impact on the results of operations as the estimated Medicaid contractual allowances initially recorded are not materially different than the estimated provision for doubtful accounts recorded when the accounts are reclassified. All accounts classified as pending Medicaid, as well as certain other governmental receivables, over the age of 90 days were reserved in contractual allowances as of March 31, 2010 and 2009 based on historical collections experience.




Beginning in fiscal year 2008, the Company received payments for indigent care under California section 1011. As of March 31, 2010 and 2009, the Company established a receivable in the amount of $1.7 million and $1.4 million, respectively, related to discharges deemed eligible to meet program criteria.




F-9


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


The Company is not aware of any material claims, disputes, or unsettled matters with any payers that would affect revenues that have not been adequately provided for in the accompanying consolidated financial statements.




PROVISION FOR DOUBTFUL ACCOUNTS - The Company provides for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. The Hospitals estimate this allowance based on the aging of their accounts receivable, historical collections experience for each type of payer and other relevant factors. There are various factors that can impact the collection trends, such as changes in the economy, which in turn have an impact on unemployment rates and the number of uninsured and underinsured patients, volume of patients through the emergency department, the increased burden of copayments to be made by patients with insurance and business practices related to collection efforts. These factors continuously change and can have an impact on collection trends and the estimation process.




The Company's policy is to attempt to collect amounts due from patients, including copayments and deductibles due from patients with insurance, at the time of service while complying with all federal and state laws and regulations, including, but not limited to, the Emergency Medical Treatment and Labor Act ("EMTALA"). Generally, as required by EMTALA, patients may not be denied emergency treatment due to inability to pay. Therefore, until the legally required medical screening examination is complete and stabilization of the patient has begun, services are performed prior to the verification of the patient's insurance, if any. In nonemergency circumstances or for elective procedures and services, it is the Hospitals' policy, when appropriate, to verify insurance prior to a patient being treated.




CASH AND CASH EQUIVALENTS - The Company considers all highly liquid debt investments purchased with a maturity of three months or less to be cash equivalents. Cash balances held at limited financial institutions at times are in excess of federal depository insurance limits. The Company has not experienced any losses on cash and cash equivalents.




As of March 31, 2010 and 2009, cash and cash equivalents includes approximately $0 and $3.5 million, respectively, deposited in lock box accounts that were swept daily by the Lender under various credit agreements (Note 3).




LETTERS OF CREDIT - At March 31, 2010 and 2009, the Company had outstanding standby letters of credit totaling $1.5 million. These letters of credit were issued by the Company's Lender and correspondingly reduce the Company's borrowing availability under its credit agreements with the Lender.  However, due to the Lender’s receivership and default (Notes 1 and 3), it is uncertain if the Lender would be able to honor the outstanding standby letters of credit, if presented for payment.




INVENTORIES OF SUPPLIES - Inventories of supplies are valued at the lower of weighted average cost or market.




PROPERTY AND EQUIPMENT - Property and equipment are stated at cost, less accumulated depreciation and any impairment write-downs related to assets held and used. Additions and improvements to property and equipment are capitalized at cost. Expenditures for maintenance and repairs are charged to expense as incurred. Capital leases are recorded at the beginning of the lease term as property and equipment and a corresponding lease liability is recognized. The value of the property and equipment under capital lease is recorded at the lower of either the present value of the minimum lease payments or the fair value of the asset. Such assets, including improvements, are amortized over the shorter of either the lease term or their estimated useful life, where applicable.




The Company uses the straight-line method of depreciation for buildings and improvements, and equipment over their estimated useful lives of 25 years and 3 to 15 years, respectively.




LONG-LIVED ASSETS - The Company evaluates its long-lived assets for possible impairment whenever circumstances indicate that the carrying amount of the asset, or related group of assets, may not be recoverable from estimated future cash flows. However, there is an evaluation performed at least annually. Fair value estimates are derived from established market values of comparable assets or internal calculations of estimated future net cash flows. The estimates of future net cash flows are based on assumptions and projections believed by the Company to be reasonable and supportable. These assumptions take into account patient volumes, changes in payer mix, revenue, and expense growth rates and changes in legislation and other payer payment patterns. During the year ended March 31, 2009, the Company recorded an impairment of $195 in the carrying value of the Company's property and equipment relating to PCHI. The full amount was recovered through insurance reimbursement during the year ended March 31, 2010.




F-10


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


DEBT ISSUANCE COSTS - Deferred charges consisted of a $750.0 origination fee for the Company's $50.0 million Revolving Line of Credit (new debt) and $742.6 in legal and other expenses paid to third parties in connection with the Company's debt (Note 3). These amounts are amortized over the financing agreements' three year lives using the straight-line method, which approximates the effective interest method. Other credit agreements (Note 3) entered into on the October 9, 2007 effective date of the $50.0 million Revolving Line of Credit were accounted for as extinguishment of existing debt in accordance with GAAP. Accordingly, debt issuance costs consisting of loan origination fees of $1.4 million paid to the Lender associated with those credit agreements were expensed as an interest charge at the time of refinancing. Debt issuance costs of $247.5 and $878.8 were amortized during the year ended March 31, 2010 and 2009, respectively.  At March 31, 2010 and 2009, prepaid expenses and other current assets in the accompanying consolidated balance sheets included $130.0 and $254.9, respectively, as debt issuance costs. Subsequent to March 31, 2010 when new financing was obtained by the Company, the balance was written off (Note 12).




FAIR VALUE MEASUREMENTS - The Company's financial assets and liabilities recorded in the consolidated balance sheets include cash and cash equivalents, restricted cash, receivables, accounts payable, and other liabilities, all of which are recorded at book value which approximates fair value. The Company's debt is also considered a financial liability for which the Company is unable to reasonably determine the fair value.




GAAP has established a hierarchy for ranking the quality and reliability of the information used to determine fair values and requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:





Level 1:
Unadjusted quoted market prices in active markets for identical assets or liabilities.Level 2:
Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.Level 3:
Unobservable inputs for the asset or liability.





The Company will endeavor to utilize the best available information in measuring fair value.  Assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. The Company currently has no financial or nonfinancial assets or liabilities subject to fair value measurement on a recurring basis.




In April 2009, the FASB issued a standard which provides additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased. The standard re-emphasizes that regardless of market conditions the fair value measurement is an exit price concept.  The standard clarifies and includes additional factors to consider in determining whether there has been a significant decrease in market activity for an asset or liability and provides additional clarification on estimating fair value when the market activity for an asset or liability has declined significantly. The scope of the standard does not include assets and liabilities measured under level 1 inputs. The standard is applied prospectively to all fair value measurements where appropriate and is effective for interim and annual periods ending after June 15, 2009. The Company adopted the standards’ provisions effective April 1, 2009, without a material impact to its consolidated financial statements.




WARRANTS - The Company has entered into complex transactions that contain warrants (Notes 3 and 4).




INCOME (LOSS) PER COMMON SHARE - Income (loss) per share is calculated in accordance with GAAP. Basic income (loss) per share is based upon the weighted average number of common shares outstanding (Note 8). Due to a net loss incurred by the Company for the year ended March 31, 2009, the anti-dilutive effects of warrants and stock options have been excluded in the calculations of diluted loss per share in the accompanying consolidated statements of operations for the year ended March 31, 2009.




SUPPLEMENTAL CASH FLOW INFORMATION - Interest paid during the year ended March 31, 2010 and 2009 was $0.6 million and $11.4 million, respectively. Interest paid during the year ended March 31, 2010 does not include Excess Amounts retained by the Lender.




The Company made cash payments for taxes of $1.5 million during the year ended March 31, 2010 and $37 during the year ended March 31, 2009.




The Company entered into new capital lease obligations of $0 and $1.5 million during the year ended March 31, 2010 and 2009, respectively.




F-11


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


INCOME TAXES - GAAP requires the liability approach for the effect of income taxes. In accordance with GAAP, deferred income tax assets and liabilities are determined based on the differences between the book and tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws. The Company assesses the realization of deferred tax assets to determine whether an income tax valuation allowance is required. The Company has recorded a 100% valuation allowance on its deferred tax assets.




Effective April 1, 2007, the Company implemented a standard issued by the FASB which clarifies the accounting and disclosure for uncertain tax positions. The standard prescribes a recognition threshold and measurement attribute for recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.




The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and California. Certain tax attributes carried over from prior years continue to be subject to adjustment by taxing authorities. Penalties or interest, if any, arising from federal or state taxes are recorded as a component of the income tax provision.




SEGMENT REPORTING - The Company operates in one line of business, the provision of healthcare services through the operation of general hospitals and related healthcare facilities. The Company's Hospitals generate substantially all of its net operating revenues.




The Company's four general Hospitals and related healthcare facilities operate in one geographic region in Orange County, California. The region's economic characteristics, the nature of the Hospitals' operations, the regulatory environment in which they operate, and the manner in which they are managed are all similar. This region is an operating segment, as defined by GAAP. In addition, the Company's general Hospitals and related healthcare facilities share certain resources and benefit from many common clinical and management practices. Accordingly, the Company aggregates the facilities into a single reportable operating segment.




NEW ACCOUNTING STANDARDS - In June 2009, the FASB issued a new standard that eliminates the previously allowed exceptions of consolidating qualifying special purpose entities, contains new criteria for determining the primary beneficiary and increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a variable interest entity. The adoption of this standard, which is effective for fiscal years beginning after November 15, 2009, is not expected to have a material effect on the Company’s consolidated financial statements.




In May 2009, the FASB issued a new standard that establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. Because the Company’s accompanying consolidated financial statements are considered issued when filed with the SEC, it has evaluated subsequent events to the filing date of this Form 10-K with the SEC.




In June 2008, the FASB issued a new standard that addresses the determination of whether an instrument (or an embedded feature) is indexed to an entity’s own stock. If an instrument (or an embedded feature) that has the characteristics of a derivative instrument under this standard is indexed to an entity’s own stock, it is still necessary to evaluate whether it is classified in stockholders’ equity (or would be classified in stockholders’ equity if it were a freestanding instrument). Effective April 1, 2009, the Company adopted this standard, which had no material impact on the Company's consolidated financial statements.




In May 2008, the FASB issued a new standard that clarifies that convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement). Additionally, the statement specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. Effective April 1, 2009, the Company adopted this standard, which had no material impact on the Company's consolidated financial statements.




In March 2008, the FASB issued a new standard that requires enhanced disclosures about an entity’s derivative and hedging activities. The Company does not currently have derivatives or enter into hedging activities; therefore, the adoption of this standard as of April 1, 2009 did not have an effect on the Company’s consolidated financial statements.





In December 2007, the FASB issued a new standard that requires the noncontrolling interest in a subsidiary be reported as a separate component of stockholders’ equity in the consolidated financial statements. The standard also requires net income attributable to the noncontrolling interest in a subsidiary be reported separately on the face of the consolidated statements of earnings. Changes in ownership interest are to be accounted for as equity transactions and, when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary is to be measured at fair value with any gain or loss recognized in earnings. The adoption of this standard as of April 1, 2009 did not have a material effect on the Company’s consolidated financial statements. In connection with the adoption of this new standard, the prior year financial statements have been adjusted to conform to the new required presentation.






F-12


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010







In December 2007, the FASB issued a new standard that changes the accounting treatment for business combinations on a prospective basis. It requires that all assets, liabilities, contingent considerations and contingencies of an acquired business be recorded at fair value at the acquisition date. The standard also requires that acquisition costs be expensed as incurred and restructuring costs be expensed in periods after the acquisition date. The Company had no business combinations during the current reporting periods; therefore, the adoption of this standard as of April 1, 2009 did not have an effect on the Company’sconsolidated financial statements.The effect of the adoption of this standard will depend upon the nature and terms of any future business combinations the Company undertakes.





NOTE 2 - PROPERTY AND EQUIPMENT





Property and equipment consists of the following:




March 31,


March 31,2010


2009Buildings


$
33,842


$
33,606Land and improvements


13,523



13,523Equipment



12,766



11,223Construction in progress


617



-Assets under capital leases


9,371



8,99170,119



67,343Less accumulated depreciation


(15,613
)


(11,929
)Property and equipment, net

$
54,506


$
55,414





Accumulated depreciation on assets under capital leases as of March 31, 2010 and 2009 was $2.7 million and $1.8 million, respectively.




The Hospitals are located in an area near active and substantial earthquake faults. The Hospitals carry earthquake insurance with a policy limit of $50.0 million. A significant earthquake could result in material damage and temporary or permanent cessation of operations at one or more of the Hospitals.




In addition, the State of California has imposed new hospital seismic safety requirements. Under these new requirements, the Hospitals must meet stringent seismic safety criteria in the future. In addition, there could be other remediation costs pursuant to this seismic retrofit.  However, subsequent new review methodologies have caused an inability to fully determine the estimate of these costs at March 31, 2010.




The State of California has introduced a new seismic review methodology known as HAZUS. The HAZUS methodology may preclude the need for some structural modifications. All four Hospitals requested HAZUS review and received a favorable notice pertaining to structural reclassification.  All hospital buildings, with the exception of one (an administrative building), have been deemed compliant until January 1, 2030 for both structural and nonstructural retrofit.




There are additional requirements that must be complied with by 2030. The costs of meeting these requirements have not yet been determined. Compliance with seismic ordinances will be costly and could have a material adverse effect on the Company's cash flow.  In addition, remediation could possibly result in certain environmental liabilities, such as asbestos abatement.





NOTE 3 – DEBT





LENDER RECEIVERSHIP AND DEFAULT – As described in Note 1, on January 28, 2009, the Lender began to collect and retain Excess Amounts. From January 28, 2009 to on or about May 18, 2009, the Lender had swept an aggregate of $14.3 million in Excess Amounts.   The Lender continued to release Excess Amounts to defray the Company’s monthly interest obligations under all other loan agreements between it and the Company through June 30, 2009, resulting in a balance in Excess Amounts of $11.3 million.




F-13


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


On April 14, 2009, the Company issued a Demand Letter notifying the Lender that it was in default on the $50.0 million Revolving Credit Agreement, to make demand for return of all Excess Amounts, and to reserve the rights of the borrowers and credit parties with respect to other actions and remedies available to them. The Company considered the Lender’s failure to return the Excess Amounts as an improper conversion of assets and a breach of the Lender’s fiduciary and custodial obligations.  On April 17, 2009, following receipt of a copy of the Demand Letter, the bank that maintained the lock boxes pursuant to a Lockbox Agreement notified the Company and the Lender that it would terminate the Lockbox Agreement within 30 days. On May 18, 2009, the Lockbox Agreement was terminated and the Company's bank accounts were frozen.  On May 19, 2009, the Lender relinquished any and all control over the bank accounts pursuant to the Lockbox Agreement. The Lender’s relinquishment provided the Company with full access to its bank accounts and the accounts were no longer accessible by the Lender.




On July 16, 2009, the SEC filed a fraud complaint with the United States District Court against the parent company and affiliates of the Lender for violations of federal securities laws and barred it from entering into material transactions pending presentation of the government’s case.  On August 3, 2009, Mr. Thomas A. Seaman was appointed receiver by the United States District Court in this securities fraud enforcement action.




Due to the uncertainty created under receivership, as of September 30, 2009, the Company applied ASC 450, “Contingencies,” in assessing the need for a valuation reserve and concluded that the loss was both probable and estimable.  As a result, during the three months ended September 30, 2009, the Company fully reserved the balance of $11.3 million in Excess Amounts.




Subsequent to March 31, 2010, pursuant to the Release (Notes 11 and 12) the Lender released $6.4 million in Excess Amounts to apply against interest expense the Company had accrued under its term loans. As a result, as of March 31, 2010, the Lender retained a net amount of $4.9 million in Excess Amounts under the $50.0 million Revolving Credit Agreement. Under the terms of the MOU and Omnibus Amendment (Notes 11 and 12), an additional $1.0 million was recovered by the Company as a reduction in principal of the Company’s outstanding debt, resulting in a gross recovery of $7.4 million.  As an offsetting cost of the recovery and pursuant to the aforementioned MOU, the Company issued a warrant to purchase up to 170.0 million shares of the Company’s common stock at $0.07 per share to Dr. Chaudhuri, who facilitated the Release that provided for the $6.4 million release by the Lender of Excess Amounts and the $1.0 million reduction in principal noted above, among other benefits, to the Company (Notes 11 and 12).  The fair value of the warrant is estimated at $2.1 million using the Black-Scholes valuation model.  Accordingly, as of March 31, 2010, the Company revised its estimate of the valuation reserve based on the more recent and certain outcome using the guidance of ASC 450, resulting in a net expense amount of $6.0 million for the year ended March 31, 2010.




The Company's debt payable to the Lender consists of the following as of March 31:




March 31,


March 31,2010


2009Current:Revolving line of credit, outstanding borrowings

$
-


$
-Convertible note


-



5,968Secured term note


-



45,000Secured line of credit, outstanding borrowings


-



30,000$
-


$
80,968Noncurrent:Revolving line of credit, outstanding borrowings

$
-


$
-Convertible note


5,968



-Secured term note


45,000



-Secured line of credit, outstanding borrowings


30,000



-$
80,968


$
-
 
  F-14
 INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010
 As of March 31, 2010, the Company’s debt consisted of the following (see Note 12):





·
A $45.0 million Term Note issued under the $80.0 million credit agreement, bearing a fixed interest rate of 10.25% per year.





·
A $35.0 million Non-Revolving Line of Credit Note issued under the $80.0 million credit agreement, bearing a fixed interest rate of 9.25% per year and an unused commitment fee of 0.50% per year.





·
A $10.7 million credit agreement, under which we issued a $10.7 million Convertible Term Note bearing a fixed interest rate of 9.25% per year. The $10.7 million Convertible Term Note is convertible into common stock of the Company at $0.21 per share during the term of the note, subject to certain dilution adjustments.





·
A $50.0 million Revolving Credit Agreement, under which we issued a $50.0 million Revolving Line of Credit Note bearing a fixed interest rate of 24% per year and an unused commitment fee of 0.50% per year. As noted above, the Lender is in default under this agreement.





Each of the above credit agreements and notes were scheduled to mature in October 2010 and are collateralized by all of the assets of the Company.  On April 13, 2010, the Company executed the Omnibus Credit Agreement Amendment (Note 12) which affected the terms of the credit facilities, including extending the maturity dates to April 2013.  As such, the outstanding balances have been reflected as noncurrent as of March 31, 2010.





NOTE 4 - COMMON STOCK WARRANTS





In October 2007, the Company issued to an affiliate of the Lender a five-year warrant to purchase the greater of approximately 16.9 million shares of the Company's common stock or up to 4.95% of the Company's common stock equivalents, as defined, at $0.21 per share (the "4.95% Warrant"). In addition, the Company and the Lender entered into Amendment No. 2 to Common Stock Warrant, originally dated December 12, 2005, which entitles an affiliate of the Lender to purchase the greater of 26.1 million shares of the Company's common stock or up to 31.09% of the Company's common stock equivalents, as defined, at $0.21 per share (the "31.09% Warrant"). Amendment No. 2 to the 31.09% Warrant extended the expiration date of the Warrant to October 9, 2017, removed the condition that it only be exercised if the Company is in default on its previous credit agreements, and increased the exercise price to $0.21 per share unless the Company's stock ceases to be registered under the Securities Exchange Act of 1934, as amended, at which time the exercise price would be an aggregate of one dollar. The 4.95% Warrant and the 31.09% Warrant are collectively referred to herein as the "New Warrants."




The New Warrants were exercisable as of October 9, 2007, the effective date of the credit facilities (the "Effective Date"). As of the Effective Date, the Company recorded warrant expense, and a related warrant liability, of $10.2 million relating to the New Warrants.  The New Warrants were cancelled pursuant to the Omnibus Amendment (Note 12).




SECURITIES PURCHASE AGREEMENT - On July 18, 2008, the Company entered into a Securities Purchase Agreement (the "Purchase Agreement") with Dr. Chaudhuri and Mr. Thomas. Pursuant to the Purchase Agreement, Dr. Chaudhuri had a right to purchase ("Purchase Right") from the Company 63.3 million shares of its common stock for consideration of $0.11 per share, aggregating $7.0 million.




Concurrent with the execution of the Purchase Agreement, Dr. Chaudhuri exercised in full outstanding, previously issued, warrants to purchase 24.9 million shares of common stock at an exercise price of $0.15 per share, for a total purchase price of $3.7 million. The Company used the $3.7 million in proceeds from the warrant exercise described above to pay down the $10.7 million Convertible Term Note. The Purchase Right expired on January 10, 2009.




On January 30, 2009, the Company entered into an amendment of the Purchase Agreement ("Amended Purchase Agreement"). Under the Amended Purchase Agreement, Dr. Chaudhuri agreed to purchase immediately from the Company 33.3 million shares of Company common stock (the "Additional Shares") at a purchase price of $0.03 per share, or an aggregate purchase price of $1.0 million. In consideration for Dr. Chaudhuri's entry into the Amended Purchase Agreement and payment to the Company of $30, under the Amended Purchase Agreement the Company granted to Dr. Chaudhuri the right, in Dr. Chaudhuri's sole discretion (subject to the Company having sufficient authorized capital), to invest at any time and from time to time through January 30, 2010 up to $6.0 million through the purchase of shares of the Company's common stock at a purchase price of $0.11 per share. The Amended Purchase Agreement expired on January 30, 2010.




Since the Amended Purchase Agreement resulted in a change in control as defined by the Internal Revenue Code (“IRC”) Section 382, the Company is subject to limitations on the use of its net operating loss (“NOL”) carryforwards (Note 5).




Also see Note 12 regarding issuance of warrants pursuant to the Omnibus Amendment.





F-15


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010








NOTE 5 - INCOME TAXES





The preparation of consolidated financial statements in conformity with U.S. GAAP requires the Company to make estimates and assumptions that affect the reported amount of tax-related assets and liabilities and income tax provisions. The Company assesses the recoverability of the deferred tax assets on an ongoing basis. In making this assessment the Company is required to consider all available positive and negative evidence to determine whether, based on such evidence, it is more likely than not that some portion or all of the net deferred assets will be realized in future periods. This assessment requires significant judgment. In addition, the Company has made significant estimates involving current and deferred income taxes, tax attributes relating to the interpretation of various tax laws, historical bases of tax attributes associated with certain tangible and intangible assets and limitations surrounding the realization of the deferred tax assets. The Company does not recognize current and future tax benefits until it is deemed more likely than not that certain tax positions will be sustained.




The provision (benefit) for income taxes, all current, consisted of the following:





For the year endedMarch 31, 2010


March 31, 2009Current income tax provision (benefit)Federal

$
(34
)

$
130State


(146
)


160Income tax provision (benefit)

$
(180
)

$
290





A reconciliation between the amount of reported income tax expense and the amount computed by multiplying loss from continuing operations before income taxes by the statutory federal income tax rate is as follows:





For the year endedMarch 31, 2010


March 31, 2009U.S. federal statutory income taxes

$
4,290


$
(513
)State and local income taxes, net of federal benefits


656



(87
)Change in valuation allowance


(3,742
)


766Enterprise zone credits


-



41Variable interest entity


(1,233
)


425Deferred tax adjustments


(179
)


(356
)Other


28



14Income tax provision (benefit)

$
(180
)

$
290





Changes in the valuation allowance relates to the reversal of timing differences, primarily associated with a change in a tax method of accounting.





F-16


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


Deferred income taxes reflect the tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amount used for income tax purposes. The following table discloses those significant components of deferred tax assets and liabilities, including the valuation allowance at March 31:





2010


2009Deferred tax assets:Allowance for doubtful accounts

$
486


$
7,501Accrued vacation


2,328



2,262Tax credits


18,896



18,896Net operating losses


15,847



12,032State taxes


(7,487
)


(7,821
)Accrued insurance


4,637



3,827Other


(1,835
)


(26
)32,872



36,671Valuation allowance


(32,872
)


(36,671
)Total deferred tax assets

$
-


$
-





The valuation allowances above were recorded based on an assessment of the realization of deferred tax assets as described below. The Company assesses the realization of deferred tax assets to determine whether an income tax valuation allowance is required. The Company recorded a 100% valuation allowance on its deferred tax based primarily on the following factors:





·
cumulative losses in recent years;


·
income/losses expected in future years;


·
unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels;


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


·
the carryforward period associated with the deferred tax assets and liabilities.





PCHI TAX STATUS - PCHI is a limited liability corporation. PCHI's owners plan to make tax elections for it to be treated as a disregarded entity for tax reporting whereby, in a manner similar to a partnership. PCHI's taxable income or loss will flow through to its owners and be their separate responsibility. Accordingly, the accompanying consolidated financial statements do not include any amounts for the income tax expense or benefit, or liabilities related to PCHI's income or loss.




The Company has net operating loss carryfowards which expire as follows:





Tax year ending

March 31,

Federal

amount expiring


State

amount expiring2013

$
-


$
22014

$
-


$
1,5522015

$
-


$
222016

$
-


$
3,4682018

$
-


$
2142020

$
-


$
3,0742021

$
-


$
7,9312023

$
-


$
3572025

$
10,054


$
5,3202026

$
20,899


$
-2027

$
1,396


$
-2029

$
8,555


$
-






F-17


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


The utilization of NOL and credit carryforwards are limited under the provisions of the IRC Section 382 and similar state provisions. Section 382 of the IRC of 1986 generally imposes an annual limitation on the amount of NOL carryforwards that may be used to offset taxable income where a corporation has undergone significant changes in stock ownership. In fiscal year 2009, the Company entered into the Amended Purchase Agreement (Note 4) which resulted in a change in control. The Company conducted an analysis and determined that it is subject to significant IRC Section 382 limitations. For both Federal and state tax purposes, the Company's utilization of NOL and credit carryforwards is subject to significant IRC Section 382 limitations, and these limitations have been incorporated into the tax provision calculation.




The Company has two Hospitals located in the State of California Enterprise Zone which has provided significant state tax credits ($18.9 million as of March 31, 2010) which are allowable to reduce California income tax on a dollar-for-dollar basis. The credits, which are not subject to expiration, are granted by a State agency whose issuance can be reviewed by the California Franchise Tax Board.




The California Franchise Tax Board has been conducting an ongoing examination of Enterprise Zone hiring tax credits claimed on the Company’s California income tax returns filed for the open tax years.  However, management of the Company does not anticipate that the examination will result in any material impact to the amount of credits claimed and the Company’s consolidated financial statements.





NOTE 6 - STOCK INCENTIVE PLAN





The Company's 2006 Stock Incentive Plan (the "Plan"), which is shareholder-approved, permits the grant of share options to its employees and board members for up to a maximum aggregate of 12.0 million shares of common stock. In addition, as of the first business day of each calendar year in the period 2007 through 2015, the maximum aggregate number of shares shall be increased by a number equal to one percent of the number of shares of common stock of the Company outstanding on December 31 of the immediately preceding calendar year. Accordingly, as of March 31, 2010, the maximum aggregate number of shares under the Plan was 18.4 million. The Company believes that such awards better align the interests of its employees with those of its shareholders. In accordance with the Plan, incentive stock options, nonqualified stock options, and performance based compensation awards may not be granted at less than 100 percent of the estimated fair market value of the common stock on the date of grant. Incentive stock options granted to a person owning more than 10 percent of the voting power of all classes of stock of the Company may not be issued at less than 110 percent of the fair market value of the stock on the date of grant. Option awards generally vest based on 3 years of continuous service (1/3 of the shares vest on the twelve month anniversary of the grant date, and an additional 1/12 of the shares vest on each subsequent fiscal quarter-end of the Company following such twelve month anniversary). Certain option awards provide for accelerated vesting if there is a change of control, as defined. The option awards have 7-year contractual terms.




On December 2, 2008, the Board of Directors approved the granting of options with the right to purchase 2.0 million shares of the Company's common stock to the CEO pursuant to the Plan. The grant price approved on that day was $0.01 per share. One-third of the options vested on the grant date and the remaining options vest in eight equal quarterly installments on each fiscal quarter-end of the Company beginning with the quarter ended March 31, 2009. The aggregate fair value of these options were estimated at approximately $7 using the Black-Scholes valuation model.




When the measurement date is certain, the fair value of each option grant is estimated on the date of grant using the Black-Scholes valuation model. Since there is limited historical data with respect to both pre-vesting forfeiture and post-vesting termination, the expected life of the options was determined utilizing the simplified method described in the SEC's Staff Accounting Bulletin 107, "Share-Based Payment"("SAB 107"). SAB 107 provides guidance whereby the expected term is calculated by taking the sum of the vesting term plus the original contractual term and dividing that quantity by two. The expected volatility is based on an analysis of the Company's stock and the stock of  the following publicly traded companies that own hospitals.





Amsurg Inc. (AMSG)


Community Health Systems (CYH)


Health Management Associates Inc. (HMA)


Lifepoint Hospitals Inc. (LPNT)


Medcath Corp. (MDTH)


Tenet Healthcare Corp. (THC)


Universal Health Services Inc. Class B (USH)


F-18


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


The risk-free interest rate is based on the average yield on U.S. Treasury zero-coupon issues with remaining terms equal to the expected terms of the options. The dividend yield reflects that the Company has not paid any cash dividends since inception and does not anticipate paying cash dividends in the foreseeable future.





Expected dividend yield
0.0%Risk-free interest rate
1.4%Expected volatility
42.4%Expected term (in years)
3.9





The Company recorded $51.2 and $156.0 of compensation expense relative to stock options during the year ended March 31, 2010 and 2009, respectively. No options were exercised during the year ended March 31, 2010 and 2009. A summary of stock option activity for the two years ended March 31, 2010 is presented as follows.




Weighted-averageWeighted-


Weighted-

remainingaverage


average

contractual



Aggregateexercise


grant date

term



intrinsicShares


price


fair value

(years)



valueOutstanding, March 31, 2008


7,445


$
0.24Granted


2,600


$
0.03


$
0.01Exercised


-


$
-Forfeited or expired


(1,210
)

$
0.18Outstanding, March 31, 2009


8,835


$
0.19Granted


-


$
-


$
-Exercised


-


$
-Forfeited or expired


(190
)

$
0.26Outstanding, March 31, 2010


8,645


$
0.19





4.8


$
-Exercisable at March 31, 2010


7,732


$
0.20





4.5


$
-
 
 A summary of the Company's nonvested options as of March 31, 2010, and changes during the two years ended March 31, 2010 is presented as follows.
  Weighted-averagegrant dateShares


fair valueNonvested at March 31, 2008


2,982


$
0.03Granted


2,600


$
0.01Vested


(2,406
)

$
0.03Forfeited


(926
)

$
0.04Nonvested at March 31, 2009


2,250


$
0.03Granted


-


$
-Vested


(1,285
)

$
0.03Forfeited


(52
)

$
0.07Nonvested at March 31, 2010


913


$
0.03
  As of March 31, 2010, there was $40.7 of total unrecognized compensation expense related to nonvested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 1.2 years.




F-19


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010





NOTE 7 - RETIREMENT PLAN





The Company has a 401(k) plan for its employees. All employees with 90 days of service are eligible to participate, unless they are covered by a collective bargaining agreement which precludes coverage. The Company matches employee contributions up to 3% of the employee's compensation, subject to IRS limits. During the year ended March 31, 2010 and 2009, the Company incurred expenses of $3.1 million and $3.0 million, respectively, which are included in salaries and benefits in the accompanying consolidated statements of operations.





NOTE 8 - INCOME (LOSS) PER SHARE





Income (loss) per share is calculated under two different methods, basic and diluted. Basic income (loss) per share is calculated by dividing the net income (loss) by the weighted average shares of common stock outstanding during the period. Diluted income (loss) per share is calculated by dividing the net income (loss) by the weighted average shares of common stock outstanding during the period and dilutive potential shares of common stock. Dilutive potential shares of common stock, as determined under the treasury stock method, consist of shares of common stock issuable upon exercise of stock warrants or options, net of shares of common stock assumed to be repurchased by the Company from the exercise proceeds.




Since the Company incurred losses for the year ended March 31, 2009, the potential shares of common stock, consisting of approximately 332 million shares issuable under warrants and stock options, have been excluded from the calculations of diluted loss per share for that year.




Income per share for the year ended March 31, 2010 was computed as shown below. Stock options and warrants aggregating approximately 294 million shares were not included in the diluted calculation since they were not in-the-money during the year ended March 31, 2010.




Numerator:Net income attributable toIntegrated Healthcare Holdings, Inc.

$
7,056Interest on $10.7 million Convertible Term Note


560Adjusted net income attributable toIntegrated Healthcare Holdings, Inc.

$
7,616Denominator:Weighted average common shares


248,568Shares - $10.7 million Convertible Term Note


28,419Options in the money, net


1,635Denominator for diluted calculation


278,622Income per share - basic

$
0.03Income per share - diluted

$
0.03






F-20


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


NOTE 9 - VARIABLE INTEREST ENTITY





Concurrent with the close of the Acquisition, and pursuant to an agreement dated September 28, 2004, as amended and restated on November 16, 2004, Dr. Chaudhuri and Dr. Shah exercised their options to purchase all of the equity interests in PCHI, which simultaneously acquired title to substantially all of the real property acquired by the Company in the Acquisition. The Company received $5.0 million and PCHI guaranteed the Company's Acquisition Loan (the Acquisition Loan was refinanced on October 9, 2007 with a $45.0 million Term Note (Note 3)). The Company remains primarily liable as the borrower under the $45.0 million Term Note notwithstanding its guarantee by PCHI, and this note is cross-collateralized by substantially all of the Company's assets and all of the real property of the Hospitals. All of the Company's operating activities are directly affected by the real property that was sold to PCHI. PCHI is a related party entity that is affiliated with the Company through common ownership and control. As of March 31, 2010, it was owned 51% by West Coast Holdings, LLC (Dr. Shah and investors) and 49% by Ganesha Realty, LLC (Dr. Chaudhuri and Mr. Thomas). In accordance with GAAP, a company is required to consolidate the financial statements of any entity that cannot finance its activities without additional subordinated financial support, and for which one company provides the majority of that support through means other than ownership. Effective March 8, 2005, the Company determined that it provided the majority of financial support to PCHI through various sources including lease payments, remaining primarily liable under the $45.0 million Term Note, and cross-collateralization of the Company's non-real estate assets to secure the $45.0 million Term Note. Accordingly, the financial statements of PCHI are included in the accompanying consolidated financial statements.




PCHI's assets, liabilities, and accumulated deficit at March 31 are set forth below.


March 31,


March 31,2010


2009Cash

$
943


$
27Property, net


43,388



43,688Other


324



133Total assets

$
44,655


$
43,848Debt

$
45,000


$
45,000Other


3,649



534Total liabilities


48,649



45,534Accumulated deficit


(3,994
)


(1,686
)Total liabilities and accumulated deficit

$
44,655


$
43,848





As noted above, the Company is a guarantor on the $45.0 million Term Note should PCHI not be able to perform. PCHI's total liabilities represent the Company's maximum exposure to loss.




PCHI rental income and the Company’s related rental expense of $5.4 million and $7.1 million were eliminated upon consolidation for the years ended March 31, 2010 and 2009, respectively.




The Company has a lease commitment to PCHI (Note 11). Additionally, the Company is responsible for seismic remediation under the terms of the lease agreement (Note 2).





NOTE 10 - RELATED PARTY TRANSACTIONS





PCHI - The Company leases substantially all of the real property of the acquired Hospitals from PCHI. PCHI is owned by Ganesha Realty, LLC, which is managed by Dr. Kali P. Chaudhuri, and various physician investors. Dr. Chaudhuri and Mr. Thomas are the beneficial holders of 138.3 million and 107.7 million shares of the outstanding stock of the Company as of March 31, 2010 and 2009, respectively. As described in Note 9, PCHI is a variable interest entity and, accordingly, the Company has consolidated the financial statements of PCHI in the accompanying consolidated financial statements.





F-21


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010





NOTE 11 - COMMITMENTS AND CONTINGENCIES





GLOBAL SETTLEMENT AGREEMENT - Effective April 2, 2009, the Company, Dr. Shah, OC-PIN, Mr. Mogel, PCHI, West Coast, Dr. Chaudhuri, Ganesha, Mr. Thomas, and the Lender entered into a Settlement Agreement, General Release and Covenant Not to Sue ("Global Settlement Agreement") in connection with the settlement of pending and threatened litigation, arbitration, appellate, and other legal proceedings (the "Actions") among the various parties. Pursuant to the Global Settlement Agreement, the Company agreed to pay to OC-PIN and Dr. Shah a total sum of $2.4 million in two installments consisting of $1.6 million at closing and $750, together with interest thereon at 8%, payable on September 25, 2009 (the "Second Payment $750"). The Company also agreed to pay the sum of $15 as satisfaction of Dr. Shah's individual claims. Additionally, the Company and Mr. Mogel agreed to stipulate to the release and return of a $50 bond which was posted in connection with a shareholder derivative suit filed by OC-PIN against both Mr. Mogel and the Company. The completion of this transaction is still pending (see “CLAIMS AND LAWSUITS”) The balance due of $750 is accrued at March 31, 2010.




In addition, Dr. Shah covenanted and agreed, that for a period of 2 years after the Closing, he will not accept any nomination, appointment or will not serve in the capacity as a director, officer, or employee of the Company, so long as the Company keeps the PCHI and Chapman Medical Center leases current by making payments within 45 days of when payments are due.




Pursuant to the Global Settlement Agreement, the Company agreed to amend its Bylaws to provide (i) that the number of members of the Company's Board of Directors shall be fixed at 7 and (ii) that a shareholder who owns 15% or more of the voting stock of the Company is entitled to call one special shareholders meeting per year. As of March 31, 2010, OC-PIN's representative has not been duly appointed by OC-PIN (see “CLAIMS AND LAWSUITS”).




Also pursuant to the Global Settlement Agreement, the Company entered into Stock Purchase Agreements (the "2009 Stock Purchase Agreements") with Dr. Chaudhuri, Dr. Shah, and OC-PIN. Pursuant to these 2009 Stock Purchase Agreements, Dr. Shah and OC-PIN will receive an aggregate of 14.7 million shares of the Company's common stock each and Dr. Chaudhuri will receive an aggregate of 30.6 million shares of the Company's common stock, for a price of $0.03 per share (the "2009 Stock Purchase Shares"). As of March 31, 2010, the 2009 Stock Purchase Shares have been issued but full payment has not been received by the Company.  As a result, the accompanying consolidated statement of stockholders’ deficiency reflects a receivable from shareholders for $1.8 million. The completion of this transaction is still pending (see "CLAIMS AND LAWSUITS").




In conjunction with the Global Settlement Agreement, on April 2, 2009, the Company and the Lender entered into the Amendment No. 1 to Credit Agreement. The Lender agreed to reduce the interest rate on the $45.0 million Term Note from 14.0% to 10.25% and to maintain such interest rate up to and including the maturity date of the Term Note, or any extension thereof, as defined in the $80 million credit agreement, under which the $45.0 million Term Note was issued.  The reduction of the interest rate was deemed not to meet the criteria for a troubled debt restructuring.




OPERATING LEASES - Concurrent with the closing of the Acquisition as of March 8, 2005, the Company entered into a sale leaseback type agreement with a related party entity, PCHI. The Company leases substantially all of the real estate of the acquired Hospitals and medical office buildings from PCHI. In October 2007, the Company entered into an Amended Lease with PCHI. The Amended Lease terminates on the 25-year anniversary of the original lease (March 8, 2005), grants the Company the right to renew for one additional 25-year period, and requires annual base rental payments of $8.3 million. However, until certain refinancing takes place, the annual base rental payments were reduced to $7.1 million. In addition, the Company may offset against its rental payments owed to PCHI interest payments that it makes to the Lender under certain of its indebtedness discussed above.




Pursuant to the Global Settlement Agreement, the Company and PCHI entered into the Amendment to Amended and Restated Triple Net Hospital Building Lease (the "2009 Lease Amendment"), whereby PCHI agreed to reduce the rent paid by the Company under the Amended Lease by an amount equal to the debt service reduction (i.e., the difference between 14.0% and 10.25%) during the debt service reduction period, as defined, reducing the annual base rent from $7.1 million to $5.4 million.




On April 13, 2010, the Company and PCHI entered into a Second Amendment to Amended and Restated Triple Net Hospital Building Lease (the “2010 Lease Amendment”) (Note 12).  Under the 2010 Lease Amendment, the annual base rent to be paid by the Company to PCHI was increased from $5.4 million to $7.3 million, but if PCHI refinances the $45.0 million loan, the annual base rent will increase to $8.3 million.  In addition, since the Company has not paid rent due under the lease for the period from November 1, 2008 through April 30, 2010, the Company agreed that upon receipt of provider fee funds from Medi-Cal under California AB 1383 (subject to its obligation to prepay certain of the Credit Agreements from such funds under the Omnibus Amendment), the Company will pay all unpaid rent due to PCHI, but in any event not later than December 1, 2010.




F-22


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


Following is a schedule of the Company's future minimum operating lease payments, excluding the triple net lease with PCHI, that have initial or remaining non-cancelable lease terms in excess of one year as of March 31, 2010:





Year ended March 31,2011

$
1,6342012


1,5612013


1,5642014


1,3992015


1,189Thereafter


14,878Total

$
22,225





Total rental expense for the years ended March 31, 2010 and 2009 was $4.3 million and $4.5 million, respectively. The Company received sublease rental income in relation to certain leases of approximately $616 and $647 for the years ended March 31, 2010 and 2009, respectively.




This lease commitment with PCHI is eliminated in consolidation.




CAPITAL LEASES - In connection with the Hospital Acquisition, the Company also assumed the leases for the Chapman facility, which include buildings and land with terms that were extended concurrently with the assignment of the leases to December 31, 2023. The Company leases equipment under capital leases expiring at various dates through January 2013. Assets under capital leases with a net book value of $6.3 million and $7.1 million are included in the accompanying consolidated balance sheets as of March 31, 2010 and 2009, respectively. Interest rates used in computing the net present value of the lease payments are based on the interest rates implicit in the leases.




The following is a schedule of future minimum lease payments under the capitalized leases with the present value of the minimum lease payments as of March 31, 2010:





Year ended March 31,2011

$
1,6172012


1,4922013


1,1172014


7442015


744Thereafter


6,511Total minimum lease payments


12,225Less amount representing interest (weighted average interest rate of 9.8%)


(5,523
)Net present value of net minimum lease payments


6,702Less current portion


(838
)Noncurrent portion

$
5,864





INSURANCE - The Company accrues for estimated general and professional liability claims, to the extent not covered by insurance, when they are probable and reasonably estimable. The Company has purchased as primary coverage a claims-made form insurance policy for general and professional liability risks. Estimated losses within general and professional liability retentions from claims incurred and reported, along with IBNR claims, are accrued based upon projections and are discounted to their net present value using a weighted average risk-free discount rate of 5%. To the extent that subsequent claims information varies from estimates, the liability is adjusted in the period such information becomes available. As of March 31, 2010 and 2009, the Company had accrued $10.5 million and $8.7 million, respectively, which is comprised of $4.1 million and $4.1 million, respectively, in incurred and reported claims, along with $6.4 million and $4.6 million, respectively, in estimated IBNR.




F-23


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


The Company has also purchased occurrence coverage insurance to fund its obligations under its workers' compensation program. The Company has a "guaranteed cost" policy, under which the carrier pays all workers' compensation claims, with no deductible or reimbursement required of the Company. The Company accrues for estimated workers' compensation claims, to the extent not covered by insurance, when they are probable and reasonably estimable. The ultimate costs related to this program include expenses for deductible amounts associated with claims incurred and reported in addition to an accrual for the estimated expenses incurred in connection with IBNR claims. Claims are accrued based upon projections and are discounted to their net present value using a weighted average risk-free discount rate of 5%. To the extent that subsequent claims information varies from estimates, the liability is adjusted in the period such information becomes available. As of March 31, 2010 and 2009, the Company had accrued $717 and $711, respectively, comprised of $239 and $202, respectively, in incurred and reported claims, along with $478 and $509, respectively, in estimated IBNR.




Effective May 1, 2007, the Company initiated a self-insured health benefits plan for its employees. As a result, the Company has established and maintains an accrual for IBNR claims arising from self-insured health benefits provided to employees. The Company's IBNR accruals at December 31 and March 31, 2009 were based upon projections. The Company determines the adequacy of this accrual by evaluating its limited historical experience and trends related to both health insurance claims and payments, information provided by its insurance broker and third party administrator and industry experience and trends. The accrual is an estimate and is subject to change. Such change could be material to the Company's consolidated financial statements. As of March 31, 2010 and 2009, the Company had accrued $1.7 million and $1.8 million, respectively, in estimated IBNR. The Company believes this is the best estimate of the amount of IBNR relating to self insured health benefit claims at March 31, 2010 and 2009.




The Company has also purchased umbrella liability policies with aggregate limits of $25 million. The umbrella policies provide coverage in excess of the primary layer and applicable retentions for insured liability risks such as general and professional liability, auto liability, and workers compensation (employers liability).




The Company finances various insurance policies at interest rates ranging from 3.88% to 4.80% per annum. The Company incurred finance charges relating to such policies of $89.5 and $64.8 during the years ended March 31, 2010 and 2009, respectively. As of March 31, the accompanying consolidated balance sheets include the following balances relating to the financed insurance policies.





March 31, 2010


March 31, 2009Prepaid insurance

$
400


$
339Accrued insurance premiums

$
-


$
19(Included in other current liabilities)





PURCHASE COMMITMENTS - The Company has commitments with two unrelated party service provider vendors extending over one year. Commitments total $3.7 million, $3.7 million, $0, $0, and $0 for the years ending March 31, 2011, 2012, 2013, 2014, and 2015, respectively.




EMPLOYMENT AGREEMENTS - On March 29, 2010, the Company entered into amended and restated employment agreements (the "Amended Employment Agreements") with each its President and Chief Executive Officer, its Executive Vice President and Chief Operating Officer, its Executive Vice President, Finance & Chief Financial Officer, its Executive Vice President & General Counsel, and its Treasurer & Chief Accounting Officer. The Amended Employment Agreements, effective April 1, 2010, are included as exhibits to this Form 10-K.




BONUSES - During the years ended March 31, 2010 and 2009, the Company implemented discretionary bonus plans, under which eligible employees could receive bonuses based on the Company's performance and individual performances. For the years ended March 31, 2010 and 2009, the Company awarded eligible employees an aggregate of $1.3 million and $300, respectively. The total of the 2010 and 2009 discretionary bonuses were included in accrued compensation and benefits in the accompanying consolidated balance sheet as of March 31, 2010. The 2010 bonuses were approved by the Company's Board of Directors and were paid in June 2010. The 2009 bonuses were approved by the Company's Board of Directors and were paid in May 2010.




UNION CONTRACTS - Approximately 36% of the Company's employees are represented by labor unions as of March 31, 2010. The current SEIU Agreement expires on August 31, 2011, and the Agreement with the CNA expires on February 28, 2011. Both Agreements have "no strike" provisions and compensation caps which provide the Company with long term compensation and workforce stability.




For both unions, all prior grievances regarding retiree medical benefits, the administration of pay adjustments and pay practices, changes in medical benefits and several wrongful terminations have been resolved in the form of settlement agreements.




F-24


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


CLAIMS AND LAWSUITS – The Company and the Hospitals are subject to various legal proceedings, most of which relate to routine matters incidental to operations. The results of these claims cannot be predicted, and it is possible that the ultimate resolution of these matters, individually or in the aggregate, may have a material adverse effect on the Company's business (both in the near and long term), financial position, results of operations, or cash flows. Although the Company defends itself vigorously against claims and lawsuits and cooperates with investigations, these matters (1) could require payment of substantial damages or amounts in judgments or settlements, which individually or in the aggregate could exceed amounts, if any, that may be recovered under insurance policies where coverage applies and is available, (2) cause substantial expenses to be incurred, (3) require significant time and attention from the Company's management, and (4) could cause the Company to close or sell the Hospitals or otherwise modify the way its business is conducted. The Company accrues for claims and lawsuits when an unfavorable outcome is probable and the amount is reasonably estimable.




On May 10, 2007, the Company filed suit in Orange County Superior Court against three of the six members of its Board of Directors (as then constituted) and also against the Company's then largest shareholder, OC-PIN. The suit sought damages, injunctive relief and the appointment of a provisional director. Among other things, the Company alleged that the defendants breached their fiduciary duties owed to the Company by putting their own economic interests above those of the Company, its other shareholders, creditors, employees and the public-at-large. The suit further alleged the defendants' attempts to change the composition of the Company's management and Board (as then constituted) threatened to trigger multiple "Events of Default" under the express terms of the Company's existing credit agreements.




On May 17, 2007, OC-PIN filed a separate suit against the Company in Orange County Superior Court. OC-PIN's suit sought injunctive relief and damages. OC-PIN alleged the management issue referred to above, together with issues related to monies claimed by OC-PIN, needed to be resolved before completion of the Company's then pending refinancing of its secured debt. OC-PIN further alleged that the Company's President failed to call a special shareholders' meeting, thus denying OC-PIN the opportunity to elect a new member to the Company's Board of Directors.




Both actions were consolidated before one judge. On July 11, 2007, the Company's motion seeking the appointment of an independent provisional director to fill a vacant seventh Board seat was granted. On the same date, OC-PIN's motion for a mandatory injunction forcing the Company's President to notice a special shareholders meeting was denied. All parties to the litigation thereafter consented to the Court's appointment of the Hon. Robert C. Jameson, retired, as a member of the Company's Board.




In December 2007, the Company entered into a mutual dismissal and tolling agreement with OC-PIN. On April 16, 2008, the Company filed an amended complaint, alleging that the defendant directors' failure to timely approve a refinancing package offered by the Company's largest lender caused the Company to default on its then-existing loans. Also on April 16, 2008, these directors filed cross-complaints against the Company for alleged failures to honor its indemnity obligations to them in this litigation. On July 31, 2008, the Company entered into a settlement agreement with two of the three defendants, which agreement became effective on December 1, 2008, upon the trial court's grant of the parties motion for determination of a good faith settlement. On January 16, 2009, the Company dismissed its claims against these defendants.




On April 3, 2008, the Company received correspondence from OC-PIN demanding that the Company's Board of Directors investigate and terminate the employment agreement of the Company's Chief Executive Officer, Bruce Mogel. Without waiting for the Company to complete its investigations of the allegations in OC-PIN's letter, on July 15, 2008, OC-PIN filed a derivative lawsuit naming Mr. Mogel and the Company as defendants. All allegations contained in this suit, with the exception of OC-PIN's claims against Mr. Mogel as it pertains to the Company's refinancing efforts, were stayed by the Court pending the resolution of the May 10, 2007 suit brought by the Company.




On May 2, 2008, the Company received correspondence from OC-PIN demanding an inspection of various broad categories of Company documents. In turn, the Company filed a complaint for declaratory relief in the Orange County Superior Court seeking instructions as to how and/or whether the Company should comply with the inspection demand. In response, OC-PIN filed a petition for writ of mandate seeking to compel its inspection demand. On October 6, 2008, the Court stayed this action pending the resolution of the lawsuit filed by the Company on May 10, 2007. OC-PIN filed a petition for writ of mandate with the Court of Appeals seeking to overturn this stay order, which was summarily denied on November 18, 2008.




On June 19, 2008, the Company received correspondence from OC-PIN demanding that the Company notice a special shareholders' meeting no later than June 26, 2008, to occur during the week of July 21 - 25, 2008. The stated purpose of the meeting was to (1) repeal a bylaws provision setting forth a procedure for nomination of director candidates by shareholders, (2) remove the Company's entire Board of Directors, and (3) elect a new Board of Directors. The Company denied this request based on, among other reasons, failure to comply with the appropriate bylaws and SEC procedures and failure to comply with certain requirements under the Company's credit agreements with its primary lender. OC-PIN repeated its request on July 29, 2008, and on July 30, 2008, filed a petition for writ of mandate in the Orange County Superior Court seeking a court order to compel the Company to hold a special shareholders' meeting. On August 18, 2008, the Court denied OC-PIN's petition.




F-25


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010





On September 17, 2008, OC-PIN filed another petition for writ of mandate seeking virtually identical relief as the petition filed on July 30, 2008. This petition was stayed by the Court on October 6, 2008 pending the resolution of May 10, 2007 suit brought by the Company. OC-PIN subsequently filed a petition for writ of mandate with the Court of Appeals, which was summarily denied on November 18, 2008. OC-PIN then filed a petition for review before the California Supreme Court, which was denied on January 14, 2009.




On July 8, 2008, in a separate action, OC-PIN filed a complaint against the Company in Orange County Superior Court alleging causes of action for breach of contract, specific performance, reformation, fraud, negligent misrepresentation and declaratory relief. The complaint alleges that the Stock Purchase Agreement that the Company executed with OC-PIN on January 28, 2005 "inadvertently omitted" an anti-dilution provision (the "Allegedly Omitted Provision") which would have allowed OC-PIN a right of first refusal to purchase common stock of the Company on the same terms as any other investor in order to maintain OC-PIN's holding at no less than 62.4% of the common stock on a fully diluted basis. The complaint further alleged that the Company issued stock options under a Stock Incentive Plan and warrants to its lender in violation of the Allegedly Omitted Provision. The complaint further alleged that the issuance of warrants to purchase the Company's stock to Dr. Chaudhuri and Mr. Thomas, and their exercise of a portion of those warrants, were improper under the Allegedly Omitted Provision. On October 6, 2008, the Court placed a stay on this lawsuit pending the resolution of the action filed by the Company on May 10, 2007. On October 22, 2008, OC-PIN filed an amended complaint naming every shareholder of the Company as a defendant, in response to a ruling by the Court that each shareholder was a "necessary party" to the action. OC-PIN filed a petition for writ of mandate with the Court of Appeals which sought to overturn the stay imposed by the trial court. This appeal was summarily denied on November 18, 2008.




On April 2, 2009, the Company, OC-PIN, Anil V. Shah, M.D. (“Shah”), Bruce Mogel, Pacific Coast Holdings Investment, LLC (“PCHI”), West Coast Holdings, LLC (“WCH”), Kali P. Chaudhuri, M.D., Ganesha Realty, LLC (“Ganesha”), William E. Thomas and Medical Capital Corporation and related entities (“Medical Capital”) (together, the “Global Settlement Parties”) entered into a global settlement agreement and mutual release (the “Global Settlement Agreement”).  Key elements of the Global Settlement Agreement included: (1) a full release of claims by and between the Global Settlement Parties, (2) two payments of $750 each (the second of which may be applied toward the purchase of stock by OC-PIN and Shah) by the Company payable to a Callahan & Blaine trust account in conjunction with payments and a guarantee by other Global Settlement Parties, (3) a loan interest and rent reduction provision resulting in a 3.75% interest rate reduction on the $45 million real estate term note, (4) the Company’s agreement to bring the PCHI and Chapman leases current and pay all arrearages due, (5) the Board of Directors’ approval of bylaw amendments fixing the number of Director seats to seven and, effective after the 2009 Annual Meeting of Shareholders, allowing a 15% or more shareholder to call one special shareholders’ meeting per year, (6) the right of OC-PIN to appoint one director candidate to serve on the Company’s Board of Directors to fill the seat of Kenneth K. Westbrook until the 2009 Annual Meeting of Shareholders, and (7) the covenant of Shah to not accept any nomination, appointment, or service in any capacity as a director, officer or employee of the Company for a two (2) year period so long as the Company keeps the PCHI and Chapman leases current.  Two stock purchase agreements (the “Stock Purchase Agreements”) were also executed in conjunction with the Global Settlement Agreement, whereby (1) OC-PIN and Shah each purchased 14,700 shares of Common Stock, and (2) Kali P. Chaudhuri purchased 30,600 shares Stock.




Purportedly pursuant to the Global Settlement Agreement, OC-PIN and/or Shah placed a demand on the Company to seat Shah’s personal litigation attorney, Daniel Callahan (“Callahan”), on the Board of Directors.  The Company declined this request based on several identified conflicts of interest, as well as a violation of the covenant of good faith and fair dealing.  OC-PIN and/or Shah then filed a motion to enforce the Global Settlement Agreement under California Code of Civil Procedure Section 664.6 and force the Company to appoint Callahan to the Board of Directors.  The Company opposed this motion, in conjunction with an opposition by several members of OC-PIN, contesting Callahan as the duly authorized representative of OC-PIN.  On April 27, 2009, the Court denied Shah/OC-PIN’s motion, finding several conflicts of interest preventing Callahan from serving on the Company’s Board of Directors.  On May 5, 2009, Shah/OC-PIN filed a petition for writ of mandate with the Court of Appeals seeking to reverse the Court’s ruling and force Callahan’s appointment as a director, which was summarily denied on May 7, 2009.




On August 20, 2009, Judge Lewis ordered all parties to the Global Settlement Agreement to meet and confer with Hon. Gary Taylor regarding the issue of entering the Global Settlement Agreement as final judgment. On or about November 1, 2009, Judge Taylor issued a written recommendation to the court acknowledging several complications with entering the Global Settlement Agreement as judgment, largely based upon the pending litigation among the members of OC-PIN.  On December 7, 2009, Judge Lewis concurred with Judge Taylor’s recommendation to postpone entering judgment on the Global Settlement Agreement pending a resolution of the action among the members of OC-PIN.  The court has scheduled a status conference on April 5, 2010 for further consideration of this issue.  On April 5, 2010, Judge Lewis maintained the current stay order and scheduled an additional status conference for May 17, 2010.  At the May 17, 2010 status conference, the competing OC-PIN factions (referred to below) indicated they would attempt to agree to a plan for the stock issuances described in the Global Settlement Agreement.  The Court set a further status conference for July 12, 2010.




F-26


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


On April 24, 2009, a conglomeration of several OC-PIN members led by Ajay G. Meka, M.D. filed a lawsuit against Dr. Shah, other OC-PIN members, and various attorneys, alleging breach of fiduciary duty and seeking damages as well as declaratory and injunctive relief (the "First Meka Complaint"). While the Company is named as a defendant in the action, plaintiffs are only seeking declaratory and injunctive relief with respect to various provisions of the Global Settlement Agreement and a prior stock issuance to OC-PIN’s former attorney, Hari Lal. Due to the competing demands related to the Stock Purchase Agreements placed upon the Company from factions within OC-PIN, on May 13, 2009, the Company filed a Motion for Judicial Instructions regarding enforcement of the Global Settlement Agreement. On May 14, 2009, the Company, Dr. Shah, as well as both "factions" of OC-PIN entered into a "stand still" agreement regarding both the nomination of an OC-PIN Board representative as well as the allocation of shares under the Stock Purchase Agreements. Subsequently, on June 22, 2009, the Court granted a stay of the Company's obligations under the Global Settlement Agreement to issue stock to OC-PIN or appoint an OC-PIN representative on the Company’s Board of Directors until the resolution of the Amended Meka Complaint and related actions.




On June 1, 2009, a First Amended Complaint was filed to replace the First Meka Complaint (the "Amended Meka Complaint"). On October 9, 2009, the newly-assigned judge, Hon. Nancy Wieben-Stock, sustained a demurrer to the Amended Meka Complaint.  On or about March 19, 2010, Dr. Meka et al. filed a Third Amended Complaint (the “Third Amended Meka Complaint”).  It appears that the relief sought against the Company in the Third Amended Meka Complaint does not materially alter from the declaratory and injunctive relief sought in the First Meka Complaint. The Company filed its answer to the Third Amended Meka Complaint on April 9, 2009.  Numerous motions were filed by other parties challenging the Third Amended Meka Complaint.  The Court held an omnibus hearing on these motions on May 7, 2010, partly sustaining and partly overruling these several demurrers, without leave to further amend.  The Company believes it is a neutral stakeholder in the action, and that the results of the action will not have a material adverse impact on the Company's results of operations.




On June 17, 2009, Dr. Shah demanded that both the Company and PCHI indemnify him for his defense of the Amended Meka Complaint.  In response, both the Company and PCHI filed motions to enforce the releases contained in the Global Settlement Agreement, which the Company and PCHI believe waive Dr. Shah’s claim for indemnification in the Meka v. Shah lawsuit.  The court did not rule on PCHI’s or the Company’s motions, but left intact a prior injunction essentially staying the arbitration of Dr. Shah’s indemnity claim.




On December 31, 2007, the Company entered into a severance agreement with its then-President, Larry Anderson ("Anderson") (the "Severance Agreement"). On or about September 5, 2008, based upon information and belief that Anderson breached the Severance Agreement, the Company ceased making the monthly severance payments. On September 3, 2008, Anderson filed a claim with the California Department of Labor seeking payment of $243. A hearing date has not yet been set.




On or about February 11, 2009, Anderson filed a petition for arbitration before JAMS alleging the same wage claim as he previously alleged in his claim with the California Department of Labor described above. Anderson's petition also claims that the Company failed to pay him a commission of $300 for his efforts toward securing financing from the Company's lender to purchase an additional hospital. On May 20, 2009, Anderson filed an amended petition with JAMS, incorporating allegations (1) that the Company filed an incorrect IRS Form 1099 with respect to a Company vehicle and (2) that Anderson was constructively discharged as a result of reporting various alleged violations of State and Federal law. On August 4, 2009, the Company filed a cross-complaint against Anderson alleging, inter alia, Anderson breached paragraphs 4, 5 and 6 of the Severance Agreement, and similar clauses in his December 31, 2007 Consulting Agreement, by providing confidential and proprietary information to individuals outside of the Company’s management and voluntarily providing information to individuals who intended to use the information to sue the Company.  The Company also alleges Anderson concealed material information from the Company in breach of his overlapping fiduciary duties to the Company as an officer, Chief Compliance Officer and its attorney. Arbitration of this matter began on June 7, 2010. While the Company is optimistic regarding the outcome of these various related Anderson matters, at this early stage, the Company is unable to determine the cost of defending and prosecuting this lawsuit or the impact, if any, that these actions may have on its results of operations.




On June 5, 2009, a potential class action lawsuit was filed against the Company by Alexandra Avery.  Ms. Avery purports to represent all 12-hourly employees and the complaint alleges causes of action for restitution of unpaid wages as a result of unfair business practices, injunctive relief for unfair business practices, failure to pay overtime wages, and penalties associated therewith. On December 23, 2009, the Company filed an answer to the complaint, generally denying all of the plaintiff’s allegations.  The parties are currently exchanging initial discovery in the action, and a status conference has been scheduled by the Court for July 14, 2010.  At this early stage, the Company is unable to determine the cost of defending this lawsuit or the impact, if any, this action may have on its results of operations.




On January 25, 2010, a potential class action lawsuit was filed against the company by Julie Ross.  Ms. Ross purports to represent all similarly-situated employees and the complaint alleges causes of action for violation of the California Labor Code and unfair competition law.  The parties are currently exchanging initial discovery in the action. At this early stage in the proceedings, the Company is unable to determine the cost of defending this lawsuit or the impact, if any, this action may have on its results of operations.




F-27


INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010


On June 16, 2008, Michael Fitzgibbons, M.D., filed a complaint against the Company alleging malicious prosecution, intentional interference with prospective economic advantage, defamation, and intentional infliction of emotional distress.  Most of the causes of action in the June 16, 2008 complaint derive from events precipitating a lawsuit filed by the Company against Dr. Fitzgibbons in 2005.  On September 9, 2008, the Company filed a “SLAPP Back” motion seeking to remove the malicious prosecution cause of action from Dr. Fitzgibbons’ complaint, as well as an Anti-SLAPP motion directed to the remaining causes of action.  The Court denied both motions on October 20, 2008.  The Company appealed the denial of the Anti-SLAPP motion, which was denied by the Court of Appeal on October 27, 2009.  The remittitur, releasing jurisdiction back to the trial court, was issued on December 31, 2009.  Discovery is currently ongoing.  At this early stage in the litigation, the Company is unable to determine the cost of defending this lawsuit or the impact, if any, this action may have on its results of operations.




On January 25, 2010, the Company received correspondence purportedly on behalf of OC-PIN challenging the MOU with KPC Resolution Company (Note 12).  The letter demanded that the Company take certain action in response to the MOU.  The Company issued a response to the letter on February 9, 2010 contesting several factual and legal conclusions therein and is currently awaiting confirmation from the court as to who properly represents OC-PIN.




On or about August 1, 1996, Southern California Specialty Care, Inc. ("SCSC") entered into a property lease agreement with PCHI whereby SCSC agreed to pay 10 percent of its net income to PCHI each quarter (the “Percentage Rent”).  In April 2008, PCHI brought a complaint in arbitration against SCSC alleging SCSC’s failure to pay the Percentage Rent since 2005.  In November 2009, PCHI and SCSC reached a settlement pursuant to which PCHI received $1.9 million for unpaid Percentage Rent through December 31, 2008, including late fees and litigation expenses, and $407 for Percentage Rent for the first three calendar quarters of 2009. Such amounts were recorded in net operating revenues during the three months ended December 31, 2009.





NOTE 12 – SUBSEQUENT EVENTS (unaudited)





On April 13, 2010, the Company entered into an Omnibus Credit Agreement Amendment (the “Omnibus Amendment”) with SPCP Group IV, LLC and SPCP Group, LLC (together, “Silver Point”), Silver Point Finance, LLC, as the Lender Agent, PCHI, Ganesha, Dr. Chaudhuri and KPC.  KPC and Ganesha are companies owned and controlled by Dr. Chaudhuri, who is the majority shareholder of IHHI.  Ganesha is a member of PCHI with a 49% membership interest in PCHI.




The Omnibus Amendment amends the Credit Agreement ($80.0 million facility) dated as of October 9, 2007, as amended (the “$80.0 million credit agreement”), the Revolving Credit Agreement ($50.0 million facility) dated as of October 9, 2007, as amended  (the “$50.0 million Revolving Credit Agreement”), and the Credit Agreement ($10.7 million facility) dated as of October 9, 2007, as amended (the “$10.7 million credit agreement” and together with the $80.0 million credit agreement and the $50.0 million credit agreement, the “Credit Agreements”), by and among the Company and certain affiliates of Medical Capital Corporation.




The Company entered into the Omnibus Amendment in connection with the Loan Purchase and Sale Agreement, dated as of January 13, 2010, as amended, by and between KPC and the Receiver.  Under the Loan Purchase Agreement and as approved by the Court on April 2, 2010, KPC agreed to purchase all of the Credit Agreements from the Receiver for $70.0 million.  Concurrent with the closing of the Loan Purchase Agreement, KPC sold its interest in the Credit Agreements to Silver Point, and KPC purchased from Silver Point a 15% participation interest in the Credit Agreements.  On April 13, 2010, concurrent with the effectiveness of the Omnibus Amendment and the closing of the Loan Purchase Agreement, Silver Point acquired all of the Credit Agreements, including the security agreements and other ancillary documents executed by the Company in connection with the Credit Agreements, and became the “New Lender” under the Credit Agreements.




The following are material terms of the Omnibus Amendment:




·
The stated maturity date under each Credit Agreement was changed to April 13, 2013.  The Credit Agreements were otherwise due to mature on October 8, 2010.


·
Affirming release of prior claims between the Company and the Lender’s Receiver, Silver Point agreed to waive any events of default that had occurred under the Credit Agreements and waived claims to accrued and unpaid interest and fees under the Credit Agreements as of April 13, 2010.


·
The $80.0 million credit agreement was amended so that the $45.0 million Term Note (the “$45.0 million loan”) and $35.0 million Non-Revolving Line of Credit Note (the “$35.0 million loan”) will each bear a fixed interest rate of 14.5% per year.  These loans previously bore interest rates of 10.25% and 9.25%, respectively.  In addition, the Company agreed to make certain mandatory prepayments of the $35.0 million loan if it receives proceeds from certain new financing of its accounts receivable or provider fee funds from Medi-Cal under California AB 1383.


F-28
 INTEGRATED HEALTHCARE HOLDINGS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010
 ·
The $50.0 million Revolving Credit Agreement was amended so that Silver Point will, subject to the terms and conditions contained therein, make up to $10.0 million in new revolving funds available to the Company for working capital and general corporate purposes.  Each advance under the $50.0 million revolving credit agreement will bear interest at an annual rate of Adjusted LIBOR (calculated as LIBOR subject to certain adjustments, with a floor of 2% and a cap of 5%) plus 12.5%, compared to an interest rate of 24.0% that was previously in effect under the $50.0 million revolving credit agreement.  In addition, the Company agreed to make mandatory prepayments of the $50.0 million revolving credit agreement under the conditions described above with respect to the $80.0 million credit agreement.  The financial covenants under the $50.0 million revolving credit agreement were also amended to increase the required levels of minimum EBITDA (as defined in the Omnibus Amendment) from the levels previously in effect under the $50.0 million Revolving Credit Agreement.





·
The $10.7 million credit agreement was amended so that the $10.7 million Convertible Term Note will bear a fixed interest rate of 14.5% per year, compared to the interest rate of 9.25% previously in effect and to eliminate the conversion feature of the loan.  In addition, the Company agreed to make mandatory prepayments of the $10.7 million credit agreement under the conditions described above with respect to the $80.0 million credit agreement.





·
In connection with the sale of the Credit Agreements, all warrants and stock conversion rights previously issued to the Lender were cancelled.  In connection with the Omnibus Amendment, the Company issued new warrants (the “Omnibus Warrants”) to purchase its common stock for a period of three years at an exercise price of $0.07 per share in the following denominations: 139.0 million shares to KPC or its designees and 96.0 million shares to Silver Point or its designees.  The Omnibus Warrants also provide the holders with certain pre-emptive, information and registration rights. The estimated value of these warrants total $2.9 million.


In addition, on April 13, 2010, the Company issued a three-year warrant to acquire up to 170.0 million shares of common stock at $0.07 per share to Dr. Chaudhuri who facilitated the Release and a $1.0 million reduction in principal of the Company’s outstanding debt, among other benefits to the Company.  The estimated value of these warrants total $2.1 million.  The MOU was terminated upon effectiveness of the Omnibus Amendment (Note 1).
 
 On April 13, 2010, the Company and PCHI entered into a Second Amendment to Amended and Restated Triple Net Hospital Building Lease (the “Amendment to Lease”), which amended the Amended And Restated Triple Net Hospital Building between the parties.  Under the Amendment to Lease, the annual base rent to be paid by the Company to PCHI was increased from approximately $5.4 million to approximately $7.3 million, but if PCHI refinances the $45.0 million Loan, the annual base rent will increase to $8.3 million.  In addition, since the Company has not paid rent due under the lease since October 1, 2008, the Company agreed that upon receipt of provider fee funds from Medi-Cal under California AB 1383 (subject to its obligation to prepay certain of the Credit Agreements from such funds under the Omnibus Amendment), the Company will pay all unpaid rent due to PCHI for the period from November 1, 2008 through April 30, 2010, but in any event not later than December 1, 2010.




On April 30, 2010, the Company received the written consent, in lieu of a meeting of stockholders, from the holders of a majority of the Company's outstanding shares of common stock approving an amendment of the Company's Articles of Incorporation to increase the number of authorized shares of common stock from 500 million to 800 million shares. Stockholders holding a total of 138.3 million shares of common stock voted to approve the amendment out of a total of 255.3 million shares issued and outstanding.




F-29




The following financial statement schedule is the only schedule required to be filed under the applicable accounting regulations of the Securities and Exchange Commission.





INTEGRATED HEALTHCARE HOLDINGS, INC.


SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS


[amounts in 000's]







PERIOD

DESCRIPTION

BALANCE AT BEGINNING OF PERIOD


ADDITIONS


DEDUCTIONS


BALANCE AT END OF PERIODAccounts Receivable:Year ended March 31, 2010

Allowance for doubtful accounts

$
17,377


$
37,533


$
39,652


$
15,258Year ended March 31, 2009

Allowance for doubtful accounts

$
14,383


$
49,269


$
46,275


$
17,377Deferred tax assets:Year ended March 31, 2010

Valuation allowance

$
36,671


$
4,709


$
8,671


$
32,709Year ended March 31, 2009

Valuation allowance

$
35,905


$
766


$
-


$
36,671