<PAGE>   1


                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

[X]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2001

                                       or

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

                           COMMISSION FILE NO. 1-10968

                        MARINER POST-ACUTE NETWORK, INC.
             (Exact Name of Registrant as Specified in its Charter)

                       DELAWARE                               74-2012902
            (State or Other Jurisdiction of                (I.R.S. Employer
            Incorporation or Organization)                Identification No.)

             ONE RAVINIA DRIVE, SUITE 1500                       30346
                   ATLANTA, GEORGIA                           (Zip Code)
       (Address of Principal Executive Offices)

                                 (678) 443-7000
              (Registrant's Telephone Number, Including Area Code)

     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 [ ]

     There were 73,688,379 shares of Common Stock of the registrant issued and
outstanding as of August 6, 2001.

     Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [ ] No [ ] N/A [X] (The registrant and its
subsidiaries have made filings under chapter 11 of the Bankruptcy Code and are
currently in the process of preparing a plan of reorganization. A plan of
reorganization for a subsidiary of the registrant, Mariner Health Group, Inc.
("Mariner Health"), and its direct and indirect subsidiaries (collectively, the
"Mariner Health Debtors") has been filed by the Mariner Health Debtors' senior
secured lenders. The Company has not filed any plan of reorganization for
Mariner Health and no plan of reorganization has been filed for the registrant
or any subsidiary other than the plan filed by the Mariner Health Debtors'
senior secured lenders.)


<PAGE>   2


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES

                                    FORM 10-Q

                                  JUNE 30, 2001


                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                                  PAGE
                                                                                  ----
<S>                                                                               <C>
PART I - FINANCIAL INFORMATION

   Item 1.    Condensed Consolidated Financial Statements                          1

   Item 2.    Management's Discussion and Analysis of Financial
              Condition and Results of Operations                                 23

   Item 3.    Quantitative and Qualitative Disclosure About Market Risk           41

PART II - OTHER  INFORMATION

   Item 1.    Legal Proceedings                                                   42

   Item 2.    Changes in Securities and Use of Proceeds                           43

   Item 3.    Defaults Upon Certain Securities                                    43

   Item 4.    Submission of Matters to a Vote of Security Holders                 43

   Item 5.    Other Information                                                   43

   Item 6.    Exhibits and Reports on Form 8-K                                    43

   SIGNATURE PAGE                                                                 45
</TABLE>


<PAGE>   3


PART 1     FINANCIAL INFORMATION

   ITEM 1.  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR-IN-POSSESSION AS OF JANUARY 18, 2000)
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                (dollars in thousands, except per share amounts)
                                   (unaudited)

<TABLE>
<CAPTION>
                                                              THREE MONTHS                          NINE MONTHS
                                                             ENDED JUNE 30,                        ENDED JUNE 30,
                                                     --------------------------          -------------------------------
                                                       2001               2000              2001                2000
                                                     ---------         ---------         -----------         -----------
<S>                                                  <C>               <C>               <C>                 <C>
Net revenues                                         $ 524,532         $ 532,534         $ 1,569,457         $ 1,611,254

Costs and expenses:
    Salaries, wages and benefits                       294,594           303,945             892,117             916,823
    Nursing, dietary and other supplies                 30,559            31,901              91,849              96,749
    Ancillary services                                  57,901            55,538             172,776             186,125
    General and administrative                          53,492            58,524             155,064             184,259
    Insurance                                           34,432            27,309              90,927              84,570
    Rent                                                15,245            22,837              52,706              69,112
    Depreciation and amortization                       14,045            18,638              40,033              44,275
    Provision for bad debts                              7,251            14,842              24,415              29,937
                                                     ---------         ---------         -----------         -----------
       Total costs and expenses                        507,519           533,534           1,519,887           1,611,850
                                                     ---------         ---------         -----------         -----------
Operating income (loss)                                 17,013            (1,000)             49,570                (596)

Other income (expenses):
    Interest expense (contractual interest
      for the three and nine months ended
      June 30, 2001 was $51,433 and $163,473,
      respectively and for the three and
      nine months ended June 30, 2000 was
      $62,118 and $179,202, respectively)                 (849)             (873)             (4,108)            (68,089)
    Interest and dividend income                           180             3,152               3,053              10,354
    Reorganization items                               (21,222)            8,053             (29,911)             (4,384)
    Other                                                  (41)             (729)               (437)               (952)
                                                     ---------         ---------         -----------         -----------
Net income (loss)                                    $  (4,919)        $   8,603         $    18,167         $   (63,667)
                                                     =========         =========         ===========         ===========


Net income (loss) per share - basic
  and diluted                                        $   (0.07)        $    0.12         $      0.25         $     (0.86)
                                                     =========         =========         ===========         ===========
</TABLE>


    The accompanying notes are an integral part of these financial statements


                                       1
<PAGE>   4


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR-IN-POSSESSION AS OF JANUARY 18, 2000)
                      CONDENSED CONSOLIDATED BALANCE SHEETS
                  (dollars in thousands, except share amounts)

<TABLE>
<CAPTION>
                                                                                       JUNE 30,     SEPTEMBER 30,
                                                                                         2001            2000
                                                                                    -------------   -------------
                                                                                     (unaudited)
                                       ASSETS

<S>                                                                                 <C>             <C>
Current assets:
    Cash and cash equivalents                                                       $      201,592  $      170,468
    Receivables, net of allowance for doubtful accounts of $72,572 and $68,691             306,892         282,200
    Inventories                                                                             22,139          20,670
    Prepaid and other current assets                                                        48,264          52,635
                                                                                    --------------  --------------
       Total current assets                                                                578,887         525,973

Property and equipment, net of accumulated depreciation of $377,735 and $360,055           431,578         452,413
Goodwill, net of accumulated amortization of $32,328 and $24,035                           208,094         217,381
Restricted investments                                                                      33,710          35,671
Other assets, net                                                                           33,636          19,363

                                                                                    --------------  --------------
                                                                                    $    1,285,905  $    1,250,801
                                                                                    ==============  ==============
                       LIABILITIES AND STOCKHOLDERS' DEFICIT

Current liabilities:
    Accounts payable                                                                $       60,749  $       67,810
    Accrued compensation and benefits                                                       81,109          88,340
    Accrued insurance obligations                                                           23,661          12,905
    Other current liabilities                                                               34,527          47,440

                                                                                    --------------  --------------
       Total current liabilities                                                           200,046         216,495

Liabilities subject to compromise                                                        2,368,271       2,371,213
Long-term debt, net                                                                             --              --
Long-term insurance reserves                                                               104,150          68,987
Other liabilities                                                                           34,199          34,283

                                                                                    --------------  --------------
       Total liabilities                                                                 2,706,666       2,690,978

Commitments and contingencies

Stockholders' deficit:
    Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued                   --              --
    Common stock, $.01 par value; 500,000,000 shares authorized;
        73,688,379 shares issued                                                               737             737
    Capital surplus                                                                        980,952         980,952
    Accumulated deficit                                                                 (2,402,211)     (2,420,378)
    Accumulated other comprehensive loss                                                      (239)         (1,488)

                                                                                    --------------  --------------
       Total stockholders' deficit                                                      (1,420,761)     (1,440,177)
                                                                                    --------------  --------------
                                                                                    $    1,285,905  $    1,250,801
                                                                                    ==============  ==============
</TABLE>


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


                                       2
<PAGE>   5


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR-IN-POSSESSION AS OF JANUARY 18, 2000)
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                             (dollars in thousands)
                                   (unaudited)

<TABLE>
<CAPTION>
                                                                                           NINE MONTHS ENDED
                                                                                               JUNE 30,
                                                                                    ------------------------------
                                                                                         2001            2000
                                                                                    --------------  --------------
<S>                                                                                 <C>             <C>
Cash flows from operating activities:
    Net income (loss)                                                               $       18,167  $      (63,667)
    Adjustments to reconcile net income (loss) to net cash provided by
       operating activities:
          Depreciation and amortization                                                     40,033          44,275
          Interest accretion on discounted debt                                                 --          13,178
          Equity earnings/minority interest                                                    437             952
          Reorganization items                                                              29,911           4,384
          Provision for bad debts                                                           24,415          29,937
          Gain on disposal of assets                                                            --          (1,397)
    Changes in operating assets and liabilities:
          Receivables                                                                      (53,021)        (41,007)
          Inventories                                                                       (1,968)          1,991
          Prepaid and other current assets                                                  11,800          (9,911)
          Accounts payable                                                                   4,277          12,845
          Accrued liabilities and other current liabilities                                (12,580)         98,048
    Changes in long-term insurance reserves                                                 35,163         (11,943)
    Other                                                                                     (118)         (1,430)
                                                                                    --------------  --------------
Net cash provided by operating activities before reorganization items                       96,516          76,255
    Payment of reorganization items, net                                                   (33,476)        (15,989)
                                                                                    --------------  --------------
Net cash provided by operating activities                                                   63,040          60,266

Cash flows from investing activities:
    Purchases of property and equipment                                                    (22,878)        (23,033)
    Proceeds from sale of property, equipment and other assets                               7,722           8,594
    Restricted investments                                                                   1,908          22,154
    Other                                                                                      883             421
                                                                                    --------------  --------------
Net cash (used in) provided by investing activities                                        (12,365)          8,136

Cash flows from financing activities:
    Repayment of prepetition long-term debt                                                (19,551)         (2,696)
    Other                                                                                       --            (627)
                                                                                    --------------  --------------
Net cash used in financing activities                                                      (19,551)         (3,323)

                                                                                    --------------  --------------
Increase in cash and cash equivalents                                                       31,124          65,079

Cash and cash equivalents, beginning of period                                             170,468          71,817
                                                                                    --------------  --------------
Cash and cash equivalents, end of period                                            $      201,592  $      136,896
                                                                                    ==============  ==============
</TABLE>



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


                                       3
<PAGE>   6


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


NOTE 1 - NATURE OF BUSINESS

     REPORTING ENTITY

       Mariner Post-Acute Network, Inc. through its subsidiaries (collectively,
the "Company") provides post-acute health care services, primarily through the
operation of skilled-nursing facilities. At June 30, 2001, the Company's
significant operations consisted of (i) approximately 340 nursing home and
assisted living facilities containing approximately 40,000 beds; (ii)
approximately 32 institutional pharmacies servicing more than 1,000 long-term
care centers; and (iii) 13 long-term acute care hospitals with approximately 620
licensed beds. The Company operates in 25 states with significant concentrations
of facilities and beds in five states and several metropolitan markets.

     PETITIONS FOR REORGANIZATION UNDER CHAPTER 11

       On January 18, 2000 (the "Petition Date"), the Company and substantially
all of its subsidiaries ("the Company Debtors"), including Mariner Health Group,
Inc. ("Mariner Health") and its subsidiaries (the "Mariner Health Subsidiaries"
and collectively with Mariner Health, the "Mariner Health Debtors"), filed
voluntary petitions (collectively, the "Chapter 11 Filings") in the United
States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court")
under chapter 11 title 11 of the United States Code (the "Bankruptcy Code"). The
Company is presently operating its business as a debtor-in-possession and is
subject to the jurisdiction of the Bankruptcy Court while a plan of
reorganization is formulated. Neither the Company nor Mariner Health has filed a
plan of reorganization. On June 12, 2001, the agents for the Mariner Health
Debtors' senior secured lenders under Mariner Health's prepetition senior credit
facility (the "MHG Principal Secured Lenders") filed with the Bankruptcy Court a
plan of reorganization for Mariner Health which has since been amended
(including amendments thereto, "the MHG Bank Groups' Plan") and a proposed
disclosure statement for the MHG Bank Groups' Plan; the adequacy of the
disclosure statement was subsequently approved by the Bankruptcy Court at a
hearing held on August 7, 2001, subject to various amendments in response to
objections thereto (see Note 3). The Company's need to seek relief afforded by
the Bankruptcy Code is due, in part, to the significant financial pressure
created by the implementation of the Balanced Budget Act of 1997.

NOTE 2 - BASIS OF PRESENTATION

       The accompanying unaudited condensed consolidated financial statements
have been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission. Certain information and disclosures normally included in
the financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules and
regulations. In the opinion of management, the financial information included
herein reflects all adjustments considered necessary for a fair presentation of
interim results, and, except for the costs described in Note 3, all such
adjustments are of a normal and recurring nature. Operating results for interim
periods are not necessarily indicative of the results that may be expected for
the entire year.

       The accompanying unaudited condensed consolidated financial statements
have been prepared on a going concern basis which assumes continuity of
operations and realization of assets and settlement of liabilities and
commitments in the ordinary course of business. The financial statements do not
include any adjustments reflecting the possible future effects on the
recoverability and classification of assets or the amount and classification of
liabilities that may result from the outcome of uncertainties discussed herein.
The accompanying unaudited condensed consolidated financial statements have also
been presented in conformity with the American Institute of Certified Public
Accountants Statement of Position 90-7, "Financial Reporting by Entities in
Reorganization Under the Bankruptcy Code" ("SOP 90-7"). The statement requires a
segregation of liabilities subject to compromise by the Bankruptcy Court as of
the Petition Date and identification of all transactions and events that are
directly associated with the reorganization of the Company. Pursuant to SOP
90-7, prepetition liabilities are reported on the basis of the expected amounts
of such allowed claims,


                                       4
<PAGE>   7

                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


as opposed to the amounts for which those claims may be settled. Under a
confirmed final plan of reorganization, those claims may be settled at amounts
substantially less than their allowed amounts.

       The Company's reorganization proceedings raise substantial doubt about
the Company's ability to continue as a going concern. The ability of the Company
to continue as a going concern and the appropriateness of using the going
concern basis of accounting is dependent upon, among other things, the ability
to comply with the terms of the DIP Financings (as defined herein), confirmation
of a plan of reorganization, success of future operations after such
confirmation and the ability to generate sufficient cash from operations and
financing sources to meet obligations.

       These financial statements should be read in conjunction with the audited
consolidated financial statements and notes thereto for the year ended September
30, 2000 included in the Company's Annual Report filed with the Securities and
Exchange Commission on Form 10-K.

     NET REVENUES

       Net revenues are recorded based upon estimated amounts due from patients
and third party payors for healthcare services provided, including anticipated
settlements under reimbursement agreements with Medicare, Medicaid and other
third party payors. A summary of approximate net revenues by payor type is as
follows (in thousands):

<TABLE>
<CAPTION>
                                                          THREE MONTHS ENDED               NINE MONTHS ENDED
                                                               JUNE 30,                         JUNE 30,
                                                    --------------------------------------------------------------
                                                         2001            2000            2001            2000
                                                    --------------  --------------  --------------  --------------

<S>                                                 <C>             <C>             <C>             <C>
Medicaid                                            $      248,479  $      265,694  $      763,146  $      803,062
Medicare                                                   153,957         132,958         433,166         395,899
Private and other                                          122,096         133,882         373,145         412,293

                                                    --------------  --------------  --------------  --------------
                                                    $      524,532  $      532,534  $    1,569,457  $    1,611,254
                                                    ==============  ==============  ==============  ==============
</TABLE>

     RECENT ACCOUNTING PRONOUNCEMENTS

       In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities.
It requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. Gains or losses from changes in fair value would be recognized in
earnings in the period of change unless the derivative is designated as a
hedging instrument. In June 1999, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards No. 137, which amended SFAS
133, delaying its effective date to fiscal years beginning after June 15, 2000.
The Company does not currently hold any derivative instruments nor does it
engage in hedging activities. The Company adopted this accounting standard as
required effective October 1, 2000 and it did not have a material impact on its
consolidated financial position or results of operations.

       In July 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 141, "Business Combinations" ("SFAS No.
141"), which is effective for all business combinations completed after June 30,
2001. SFAS No. 141 eliminates the pooling-of-interests method of accounting for
business combinations except for qualifying business combinations initiated
prior to July 1, 2001. In addition, SFAS No. 141 further clarifies the criteria
to recognize intangible assets separately from goodwill. The Company does not
expect there to be a material impact on its consolidated financial position,
results of operations, or cash flows as a result of adopting this accounting
standard.


                                       5
<PAGE>   8


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


       In July 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 142, "Goodwill and Other Intangible
Assets" ("SFAS No. 142"), which establishes new rules on the accounting for
goodwill and other intangible assets. Under SFAS No. 142, goodwill and
intangible assets with indefinite lives will no longer be amortized; however,
they will be subject to annual impairment tests as prescribed by the Statement.
Intangible assets with definite lives will continue to be amortized over their
estimated useful lives. The amortization provisions of SFAS No. 142 apply
immediately to goodwill and intangible assets acquired after June 30, 2001. With
respect to goodwill and intangible assets acquired prior to July 1, 2001,
companies are required to adopt SFAS No. 142 in their fiscal year beginning
after December 15, 2001. SFAS No. 142 will be effective for the Company
beginning October 1, 2002. At that time, the Company will perform the required
impairment tests on our goodwill and those intangibles deemed to have indefinite
lives. Until the Company and Mariner Health file a plan of reorganization that
is confirmed by the Bankruptcy Court, the Company cannot currently estimate the
impact these impairment tests will have on its consolidated financial position
or result of operations.

     RECLASSIFICATIONS

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

NOTE 3 - PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE

     EVENTS LEADING TO BANKRUPTCY

       During fiscal year 1999, the Company and Mariner Health experienced
significant losses, resulting in certain financial covenant violations under the
Company's various loan agreements. In addition, the Company and Mariner Health
did not make any scheduled interest and principal payments due subsequent to
September 30, 1999 which resulted in an event of default under their respective
loan agreements. The inability of the Company and Mariner Health to service or
restructure their respective debt and other obligations culminated in the
Chapter 11 Filings on January 18, 2000. Except as may be otherwise determined by
the Bankruptcy Court overseeing the Chapter 11 Filings, the automatic stay
protection afforded by the Chapter 11 Filings generally prevents any action from
being taken by creditors with regard to any defaults under the prepetition
obligations of the Company and those of its subsidiaries which are debtors in
the Chapter 11 Filings.

     REORGANIZATION

       As noted previously, on January 18, 2000, the Company, Mariner Health and
substantially all of their respective subsidiaries filed voluntary petitions for
relief under the Bankruptcy Code. The Company is presently operating its
business as a debtor-in-possession and is subject to the jurisdiction of the
Bankruptcy Court while a plan of reorganization is formulated. Neither the
Company nor Mariner Health has filed a plan of reorganization. As discussed
below, certain creditors of Mariner Health have filed a plan of reorganization
for Mariner Health. As a debtor-in-possession, the Company is authorized to
operate its business but may not engage in transactions outside its ordinary
course of business without the approval of the Bankruptcy Court (the "Chapter 11
Proceedings").

       While the Chapter 11 Filings constituted a default under the Company's,
Mariner Health's and their respective subsidiaries' various financing
arrangements, section 362 of the Bankruptcy Code imposes an automatic stay that
generally precludes any creditors and other interested parties under such
arrangements from taking any remedial action in response to any such default
outside of the Chapter 11 Proceedings without obtaining relief from the
automatic stay from the Bankruptcy Court. In addition, under the Bankruptcy Code
the Company may assume or reject executory contracts and unexpired leases.
Parties affected by these rejections may file claims with the Bankruptcy Court
in accordance with the reorganization process. The Company is actively engaged
in the process of reviewing its executory contracts and unexpired leases and,
while some contracts and leases have been assumed or rejected, final decisions
with respect to assuming or rejecting most contracts and leases, and the
approval of the Bankruptcy Court of the proposed action, are still pending.


                                       6
<PAGE>   9


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


       In connection with the Chapter 11 Filings, the Company obtained a
commitment for $100.0 million in debtor-in-possession ("DIP") financing (the
"Company DIP Financing") from a group of banks led by The Chase Manhattan Bank
("Chase"). Mariner Health also obtained a commitment for $50.0 million in DIP
financing (the "Mariner Health DIP Financing"; together with the Company DIP
Financing, the "DIP Financings") from a group of banks led by PNC Bank, National
Association ("PNC"). The commitment under the Company DIP Financing has been
reduced to $50.0 million. The commitment under the Mariner Health DIP Financing
has been reduced to $25.0 million. (See Note 5).

       On January 19, 2000, the Company received approval from the Bankruptcy
Court to pay prepetition and postpetition employee wages, salaries, benefits and
other employee obligations. The Bankruptcy Court also approved orders granting
authority, among other things, to pay prepetition claims of certain critical
vendors, utilities and patient obligations. All other prepetition liabilities at
June 30, 2001 and September 30, 2000 are classified in the condensed
consolidated balance sheets as liabilities subject to compromise. The Company
has been and intends to continue to pay bona fide postpetition claims of all
vendors and providers in the ordinary course of business.

       The Company and Mariner Health intend to develop a plan or separate plans
of reorganization through negotiations with their respective key creditor
constituencies including their respective senior bank lenders and official
unsecured creditors committees (as used herein, a plan for the Company developed
by the Company is the "Company Plan of Reorganization," a plan for Mariner
Health developed by Mariner Health is the "Mariner Plan of Reorganization," and
collectively, any such plans are the "Plans of Reorganization"). As noted
previously, on June 12, 2001, the agents for the MHG Principal Secured Lenders
filed with the Bankruptcy Court a plan of reorganization for Mariner Health. The
MHG Bank Groups' Plan provides for, among other things, (i) elimination of the
Company's equity interest in the Mariner Health Debtors whereby the Company
would receive no consideration on account of its claims against and equity
interest in the Mariner Health Debtors; (ii) termination of the Company's
management of the facilities owned by the Mariner Health Debtors, thus
eliminating a significant source of revenue for the Company; and (iii)
restructuring and/or discharging of the Mariner Health Debtors' obligation to
their creditors. A substantial portion of prepetition liabilities are subject to
settlement under the MHG Bank Groups' Plan and any plans of reorganization
submitted respectively by the Company and Mariner Health. The adequacy of the
disclosure statement filed by the MHG Principal Secured Lenders in connection
with the MHG Bank Groups' Plan was approved by the Bankruptcy Court at a hearing
held on August 7, 2001. Impaired classes of creditors and equity holders that
are entitled to vote must still approve or reject the MHG Bank Groups' Plan once
votes for the MHG Bank Groups' Plan are solicited (which solicitation will not
be made prior to August 23, 2001, and may be delayed further, at the discretion
of the MHG Principal Secured Lenders). The Company cannot predict whether the
Bankruptcy Court will confirm the MHG Bank Groups' Plan and, if such plan is
confirmed, when and whether such plan would become effective. As of August 10,
2001, neither the Company nor the Mariner Health Debtors had taken any position
as to whether to support or oppose confirmation of the MHG Bank Groups' Plan.
Any Plans of Reorganization that may be submitted must be: (i) voted upon by
impaired classes of creditors and equity holders of the Company and Mariner
Health, respectively, that are entitled to vote; and (ii) confirmed by the
Bankruptcy Court. No assurance can be given regarding the timing of such Plans
of Reorganization, the likelihood that such plans will be developed, or the
terms on which such plans may be conditioned. In addition, there can be no
assurances that the Plans of Reorganization will be approved by requisite
holders of claims and equity holders and confirmed by the Bankruptcy Court, or
that either or both Plans of Reorganization will be consummated. If the Company
Plan of Reorganization is not accepted by the required number of impaired
creditors and equity holders and the Company's exclusive right to file and
solicit acceptance of a plan of reorganization ends (see Note 5), any party in
interest may subsequently file its own plan of reorganization for the Company.
Furthermore, a different plan of reorganization with respect to Mariner Health
may be filed by another party in interest. The Bankruptcy Court may confirm a
plan of reorganization notwithstanding the non-acceptance of the plan by an
impaired class of creditors or equity holders if certain requirements of the
Bankruptcy Code are met.


                                       7
<PAGE>   10


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


     LIABILITIES SUBJECT TO COMPROMISE

       "Liabilities subject to compromise" refers to liabilities incurred prior
to the Chapter 11 Filings. These liabilities, consisting primarily of long-term
debt and certain accounts payable and accrued liabilities, represent the
Company's estimate of known or potential prepetition claims to be resolved in
connection with the Chapter 11 Filings. Such claims remain subject to future
adjustments based on negotiations, actions of the Bankruptcy Court, further
developments with respect to disputed claims, future rejection of executory
contracts or unexpired leases, determination as to the value of any collateral
securing claims, treatment under the MHG Bank Groups' Plan or the Plans of
Reorganization, and other events. Payment terms for these amounts will be
established in connection with the MHG Bank Groups' Plan or Plans of
Reorganization. A summary of the principal categories of claims classified as
liabilities subject to compromise at June 30, 2001 and September 30, 2000 are as
follows (in thousands):

<TABLE>
<CAPTION>
                                                                 JUNE 30,        SEPTEMBER 30,
                                                                   2001              2000
                                                              --------------     -------------
                                                                (unaudited)
     <S>                                                      <C>                <C>
     Long-term debt                                           $    2,128,561     $   2,149,420

     Accounts payable                                                 94,999            82,318

     Accrued interest                                                 85,076            85,564

     Other accrued liabilities                                        92,609            86,885

     Deferred loan costs                                             (32,974)          (32,974)
                                                              --------------     -------------
                                                              $    2,368,271     $   2,371,213
                                                              ==============     =============
</TABLE>


       Approximately $2.4 billion of liabilities subject to compromise would
have been classified as current liabilities at June 30, 2001 if the Chapter 11
Filings had not been filed.

       In accordance with SOP 90-7, the Company has discontinued accruing
interest relating to its debt facilities currently classified as liabilities
subject to compromise effective January 18, 2000. Contractual interest for the
three months and nine months ended June 30, 2001 was $51.4 million and $163.5
million, respectively, which is $50.6 million and $159.4 million in excess of
interest expense included in the accompanying unaudited condensed consolidated
financial statements for the three and nine months ended June 30, 2001.
Contractual interest for the three and nine months ended June 30, 2000 was $62.1
million and $179.2 million, respectively, which is $61.2 million and $111.1
million in excess of interest expense included in the accompanying unaudited
condensed consolidated financial statements for the three and nine months ended
June 30, 2000, respectively. Interest expense for the three and nine months
ended June 30, 2001 represents interest paid on certain capital leases and other
miscellaneous indebtedness.


                                       8
<PAGE>   11


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


     REORGANIZATION ITEMS

       Reorganization items consist of income, expenses and other costs directly
related to the reorganization of the Company since the Chapter 11 Filings.
Reorganization items included in the accompanying unaudited condensed
consolidated statements of operations for the three and nine months ended June
30, 2001 and 2000 consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                           THREE MONTHS ENDED              NINE MONTHS ENDED
                                                                 JUNE 30,                      JUNE 30,
                                                    -------------------------------   ----------------------------
                                                         2001            2000              2001            2000
                                                    --------------- ---------------   ------------- --------------

<S>                                                 <C>             <C>               <C>           <C>
Professional fees                                   $       13,882  $        4,223    $     30,881  $       15,517
Other reorganization costs                                   4,304             234           9,561           1,659
Gain on settlement of prepetition accounts payable              (1)           (428)            (40)           (617)
Net loss (gain) on divestitures                              4,251         (10,988)         (5,775)        (10,988)
Interest earned on accumulated cash resulting from
   Chapter 11 Filings                                       (1,214)         (1,094)         (4,716)         (1,187)

                                                    --------------  --------------  --------------  --------------
                                                    $       21,222  $       (8,053) $       29,911  $        4,384
                                                    ==============  ==============  ==============  ==============
</TABLE>

NOTE 4 - DIVESTITURES

       During the nine months ended June 30, 2001 and 2000, the Company
completed the sale of certain inpatient nursing home facilities and other assets
which resulted in a net gain on divestitures of approximately $5.8 million and
$11.0 million, respectively, which is included in the accompanying unaudited
condensed consolidated statements of operations as reorganization items. These
divested inpatient nursing home facilities reported net revenues of
approximately $44.5 million and $162.6 million for the nine months ended June
30, 2001 and 2000, respectively. The Company anticipates that in the aggregate,
these divestitures will improve operating results in future periods.

       On July 8, 2001, affiliates of the Company completed the restructuring of
their lease portfolio with Nationwide Health Properties, Inc. and its affiliates
(collectively, "NHP"). Previously, affiliates of the Company had terminated
their leases and transitioned operations of three facilities in Indiana to
designees of NHP pursuant to an agreement between the parties which was approved
by the Bankruptcy Court in June. Effective as of July 31, 2001, affiliates of
the Company conveyed their interests as tenant/sublessor in a facility located
in Gilroy, California to NHP and rejected their leases regarding eleven
facilities located in Texas, but agreed, in connection with the rejection, to
continue to operate these facilities for a limited period of time in return for
a rental abatement and the payment of a management fee to the Company to enable
operations of the facilities to be transitioned to NHP's designee in an orderly
fashion. If no such designee is able to assume operation of the Texas facilities
on a timely basis, then the Company will enter into further negotiations
regarding these facilities. Concurrently, affiliates of the Company assumed
their lease obligations and the Company reaffirmed its guaranties regarding four
facilities in California and two facilities in Illinois, and, as a part thereof,
obtained a $0.3 million rental concession with respect to one facility in
Illinois and favorable covenant amendments under the assumed leases. Damages
under the rejected leases in Texas were limited to existing security deposits
totaling approximately $0.8 million. The parties further agreed to a mutual
release of all liabilities not otherwise addressed in the relevant settlement
agreement.

       During the three months ended June 30, 2000, the Company, through its
GranCare subsidiaries leased twenty-two facilities from Senior Housing
Properties Trust ("SHPT") and its wholly-owned subsidiary SPTMNR Properties
Trust ("SPTMNR"), both of which succeeded to the interests of Health and
Retirement Properties Trust ("HRPT") to various agreements (collectively, the
"SNH Entities"). On June 30, 2000, the Company, SPTMNR and SHPT executed a
settlement agreement, which was approved by the Bankruptcy Court on May 10,
2000, whereby: (a) the Company obtained fee simple ownership of five facilities
of the SNH health care portfolio which the


                                       9
<PAGE>   12


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


Company had previously leased in the past; (b) seventeen facilities leased by
the Company and related personal property were assigned to affiliates of the SNH
Entities; (c) a cash collateral deposit of $15 million and shares of HRPT and
SPTMNR stock, with a market value of $7.2 million, were conveyed to the SNH
Entities; and (d) the Company agreed to manage the seventeen facilities
transferred to the SNH Entities during a transition period of approximately six
months. Upon termination of the management agreement, the Company has had no
further relationship with or obligations to the SNH Entities. As a result of the
settlement, the Company realized a net gain of approximately $11.1 million which
is included as part of the Company's net loss (gain) on divestitures in the
accompanying condensed consolidated statements of operations as reorganization
items.

NOTE 5 - DEBT

       Long-term debt at June 30, 2001 and September 30, 2000 is summarized in
the following table (in thousands):

<TABLE>
<CAPTION>
                                                                     JUNE 30,     SEPTEMBER 30,
                                                                       2001           2000
                                                                 --------------  ----------------
                                                                   (unaudited)
<S>                                                              <C>             <C>
Senior credit facilities:
   Senior Credit Facility                                        $      893,119  $      905,981
   Mariner Health Senior Credit Facility                                233,835         233,835
   Mariner Health Term Loan Facility                                    192,439         192,439
Subordinated debt:
   Senior Subordinated Notes                                            274,121         274,121
   Senior Subordinated Discount Notes                                   220,071         220,071
   Mariner Health Senior Subordinated Notes                             103,136         103,136
Other, including capital lease obligations                              211,840         219,837
                                                                 --------------  --------------
                                                                      2,128,561       2,149,420
Less amounts subject to compromise                                   (2,128,561)     (2,149,420)
                                                                 --------------  --------------
    Total long-term debt                                         $           --  $           --
                                                                 ==============  ==============
</TABLE>

     PREPETITION DEBT

       Due to the failure to make scheduled payments, comply with certain
financial covenants and the commencement of the Chapter 11 Proceedings, the
Company is in default on substantially all of its prepetition debt obligations.
Except as otherwise may be determined by the Bankruptcy Court, the automatic
stay protection afforded by the Chapter 11 Filings generally prevents any action
from being taken with regard to any of the defaults under the prepetition debt
obligations. These obligations are classified in the accompanying unaudited
condensed consolidated financial statements as liabilities subject to compromise
at June 30, 2001 and September 30, 2000.

       The obligations of the Company under its senior credit facility are
guaranteed by substantially all of the Company's subsidiaries other than the
Omega Debtors (as defined herein), Mariner Health, and the Mariner Health
Subsidiaries, and are secured by substantially all of the otherwise unencumbered
owned assets of the Company and such subsidiaries. Mariner Health's obligations
under its senior credit facility, which includes a revolving credit facility and
term loan facility, are guaranteed by substantially all of the Mariner Health
Subsidiaries and are secured by substantially all of the otherwise unencumbered
assets of Mariner Health and such subsidiary guarantors. Mariner Health and the
Mariner Health Subsidiaries are treated as unrestricted subsidiaries under the
Company's debt facilities. Unlike other subsidiaries of the Company (the
"Non-Mariner Health Subsidiaries"), Mariner Health and the Mariner Health
Subsidiaries neither guarantee the Company's obligations under the Company's
debt facilities nor pledge their assets to secure such obligations.
Correspondingly, the Company and the Non-Mariner Health Subsidiaries do not
guarantee or assume any obligations under the Mariner Health debt facilities.
Mariner Health and the Mariner Health Subsidiaries


                                       10
<PAGE>   13


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


are not subject to the covenants contained in the Company's debt facilities, and
the covenants contained in the Mariner Health debt facilities are not binding on
the Company and the Non-Mariner Health Subsidiaries.

       No principal payments have been made on prepetition indebtedness since
the Petition Date with the exception of repayments made against the Company's
senior credit facility, as adequate protection payments pursuant to the Final
Company DIP Order (as defined herein), primarily resulting from the application
of net cash proceeds received from the sales of certain facilities and other
assets, and notional amounts related to certain other indebtedness, including
capital equipment leases. In addition, during July 2001, Mariner Health made a
$15.0 million repayment against the Mariner Health senior credit facilities as
an adequate protection payment pursuant to the amendment to the Mariner Health
DIP Credit Agreement, which, among other things, extended the maturity date of
the Mariner Health DIP Financing to December 31, 2001 (see "Debtor in Possession
Financing for Mariner Health" below).

     DEBTOR-IN-POSSESSION FINANCING FOR THE COMPANY

       In connection with the Chapter 11 Filings, the Company entered into a
$100.0 million debtor-in-possession financing agreement (as amended from time to
time, the "Company DIP Credit Agreement") with a group of banks (the "Company
DIP Lenders") led by Chase. On March 20, 2000 the Bankruptcy Court granted final
approval (the "Final Company DIP Order,") of the Company DIP Financing.

       The Company DIP Credit Agreement initially established a $100.0 million
secured revolving credit facility to provide funds for working capital and other
lawful corporate purposes for use by the Company and the other Company Debtors.
The Company DIP Credit Agreement currently provides that amounts outstanding
under the Company DIP Financing may not at any time exceed the maximum borrowing
amounts established for the Company under the Final Company DIP Order or the
Company's borrowing base of eligible accounts receivable (the "Company Borrowing
Base"). Up to $10.0 million of the Company DIP Financing may be utilized for the
issuance of letters of credit as needed in the business of the Company Debtors.
Interest accrues on the principal amount outstanding under the Company DIP
Financing at a per annum rate of interest equal to the Alternative Base Rate
("ABR") of Chase plus three percent (3%) and is payable monthly in arrears.
During the existence and continuation of a default in the payment of any amount
due and payable by the Company Debtors under the Company DIP Credit Agreement,
interest will accrue at the default rate of ABR plus five percent (5%) per
annum.

       The terms of the Company DIP Financing require that the Company prepay
principal to the extent that the principal amount outstanding under the Company
DIP Financing at any time exceeds the Company Borrowing Base then in effect. To
the extent proceeds of loans under the Company DIP Financing are used to
complete the construction of certain healthcare facilities (which proceeds are
not permitted to exceed $8.8 million), proceeds from the sale of any such
properties must be used first to repay any portion of the loans made pursuant to
the Company DIP Financing, with 75% of any remaining net cash proceeds to be
applied as an adequate protection payment to the lenders under the Company's
prepetition senior credit facility and the remaining 25% of such excess net cash
proceeds to be retained by the Company or its applicable subsidiary as
additional working capital. Pursuant to the terms of the Final Company DIP
Order, 75% of the net cash proceeds of other asset sales approved by the
Bankruptcy Court and the requisite Company DIP Lenders are to be applied as an
adequate protection payment to the lenders under the Company's prepetition
senior credit facility. The Company has the right to make optional prepayments
in increments of $1.0 million, and to reduce the commitment under the Company
DIP Credit Agreement in increments of $5.0 million.

       The obligations of the Company under the Company DIP Credit Agreement are
jointly and severally guaranteed by each of the other Company Debtors, except
for certain Company Debtors owning or operating facilities (the "Omega
Facilities") that are mortgaged to Omega Healthcare Investors, Inc. (the "Omega
Debtors") whose guarantee is limited to the negative cash flows of the Omega
Debtors pursuant to the Company DIP Credit Agreement. Under the terms of the
Final Company DIP Order, the obligations of the Company Debtors under the
Company DIP Credit Agreement (the "Company DIP Obligations") constitute allowed
super priority administrative expense claims pursuant to section


                                       11
<PAGE>   14


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


364(c)(1) of the Bankruptcy Code (subject to a carve out for certain
professional fees and expenses incurred by the Company Debtors). The Company DIP
Obligations are secured by perfected liens on all or substantially all of the
assets of the Company Debtors (excluding bankruptcy causes of action), the
priority of which liens (relative to prepetition creditors having valid, non
avoidable, perfected liens in those assets and to any "adequate protection"
liens granted by the Bankruptcy Court) is established in the Final Company DIP
Order and the related cash collateral order entered by the Bankruptcy Court (the
"Final Company Cash Collateral Order"). The Bankruptcy Court has also granted
certain prepetition creditors of the Company Debtors replacement liens and other
rights as "adequate protection" against any diminution of the value of their
existing collateral that may result from allowing the Company Debtors to use
cash collateral in which such creditors had valid, non-avoidable and perfected
liens as of the Petition Date. The discussion contained in this paragraph is
qualified in its entirety by reference to the Final Company DIP Order, the Final
Company Cash Collateral Order, and related stipulations, and reference should be
made to such orders (which are available from the Bankruptcy Court) and
stipulations for a more complete description of such terms.

       The Company DIP Credit Agreement contains customary representations,
warranties and other affirmative and restrictive covenants of the Company
Debtors, as well as certain financial covenants relating to minimum EBITDA,
maximum capital expenditures, and minimum patient census. The breach of such
representations, warranties or covenants, to the extent not waived or cured
within any applicable grace or cure periods, could result in the Company being
unable to obtain further advances under the Company DIP Financing and possibly
the exercise of remedies by the Company DIP Lenders, either of which events
could materially impair the ability of the Company to successfully reorganize in
chapter 11 and to operate as a going concern. Such a default may also impair the
ability of the Company Debtors to use cash collateral to fund operations. At
June 30, 2001, there were no outstanding borrowings under the Company DIP Credit
Agreement. At June 30, 2001, there were letters of credit outstanding under the
Company DIP Financing of approximately $6.0 million.

       The outstanding principal of the Company DIP Financing, together with all
accrued and unpaid interest and all other obligations thereunder, was originally
due and payable one year from the Petition Date. With the approval of the
Bankruptcy Court, the Company Debtors, Chase and the requisite Company DIP
Lenders amended the Company DIP Credit Agreement as of January 11, 2001, to
(among other things) extend the maturity date of the Company DIP Financing from
January 19, 2001 to August 31, 2001 and to provide for the modification of
certain financial and other covenants (which have subsequently been modified by
an amendment dated as of June 26, 2001 that further extended the maturity date
of the Company DIP Financing to December 31, 2001). Effective as of January 19,
2001, the Company also exercised its right under the Company DIP Credit
Agreement to reduce the $100.0 million Company DIP Financing commitment to $50.0
million.

     DEBTOR-IN-POSSESSION FINANCING FOR MARINER HEALTH

       Among the orders entered by the Bankruptcy Court in the chapter 11 cases
of Mariner Health and its subsidiaries, were orders approving (a) the use of
cash collateral by the Mariner Health Debtors, and (b) the funding of up to
$50.0 million in principal amount at any time outstanding under a
debtor-in-possession financing arrangement pursuant to that certain
Debtor-in-Possession Credit Agreement dated as of January 20, 2000 (as amended
from time to time, the "Mariner Health DIP Credit Agreement") by and among
Mariner Health and each of the other Mariner Health Debtors, as co-borrowers
thereunder, the lenders signatory thereto as lenders (the "Mariner Health DIP
Lenders"), First Union National Bank, as Syndication Agent, PNC Capital Markets,
Inc. and First Union Securities, Inc., as co-arrangers, and PNC, as
Administrative Agent and Collateral Agent. After a final hearing on February 16,
2000 the Bankruptcy Court entered an order granting final approval of up to
$50.0 million of the Mariner Health DIP Financing (the "Final Mariner Health DIP
Order").

       The Mariner Health DIP Credit Agreement initially established a $50.0
million secured revolving credit facility comprised of a $40.0 million tranche A
revolving loan commitment and a $10.0 million tranche B revolving loan




                                       12
<PAGE>   15


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


commitment. Under the Mariner Health DIP Credit Agreement's current terms,
advances under the Mariner Health DIP Financing may be used by the Mariner
Health Debtors (and to a limited degree, by certain joint venture subsidiaries
of Mariner Health that are not debtors in the Mariner Health chapter 11 cases)
for working capital and other lawful corporate purposes. Amounts outstanding
under the Mariner Health DIP Financing may not at any time exceed the maximum
borrowing amounts established for the Mariner Health Debtors under the Final
Mariner Health DIP Order. Originally, up to $5.0 million of the Mariner Health
DIP Financing could be utilized for the issuance of letters of credit as needed
in the businesses of the Mariner Health Debtors; however, the letter of credit
sublimit was increased to $10.0 million pursuant to the Tenth Amendment to the
Mariner Health DIP Credit Agreement dated as of March 20, 2001 (the "Tenth
Mariner Health DIP Amendment").

       Interest accrues on the principal amount outstanding under the Mariner
Health DIP Financing at a per annum rate of interest equal to the "base rate" of
PNC (i.e., the higher of the PNC prime rate or a rate equal to the federal funds
rate plus 50 basis points) plus the applicable spread, which is 250 basis
points. Such interest is due and payable monthly in arrears. During the
existence and continuation of any event of default under the Mariner Health DIP
Credit Agreement, the interest rates normally applicable to loans under the
Mariner Health DIP Financing will be increased by another 250 basis points per
annum.

       The outstanding principal of the Mariner Health DIP Financing, together
with all accrued and unpaid interest and all other obligations thereunder, are
due and payable on the Commitment Termination Date, defined as the first to
occur of (i) January 19, 2001, unless extended (such date having since been
extended to December 31, 2001 as discussed below); (ii) the effective date of a
joint plan of reorganization for the Mariner Health Debtors; (iii) the date of
termination of the exclusivity rights of the Mariner Health Debtors to file a
plan of reorganization; (iv) the filing by the Mariner Health Debtors of any
plan of reorganization (or the modification of any such plan previously filed
with the Bankruptcy Court) not previously approved by the holders of at least
66-2/3% of the outstanding loans or commitments under the Mariner Health DIP
Financing; (v) the date of termination of the commitments under the Mariner
Health DIP Credit Agreement during the continuation of an event of default
thereunder; or (vi) the date on which all or substantially all of the assets or
stock of the Mariner Health Debtors is sold or otherwise transferred.

       Under the current terms of the Mariner Health DIP Credit Agreement, the
Mariner Health Debtors must also prepay principal to the extent that the
principal amount outstanding under the Mariner Health DIP Financing at any time
exceeds the Mariner Health borrowing base then in effect. The Mariner Health
borrowing base for any month is an amount equal to $7.5 million in excess of the
"Working Capital Facility" borrowings projected for such month in Mariner
Health's year 2000 DIP budget, plus (as a result of the Tenth Mariner Health DIP
Amendment), the undrawn availability under the $7.9 million letter of credit
issued by PNC pursuant to the Mariner Health DIP Credit Agreement to secure
Mariner Health's obligations in respect of its replacement surety program (the
"Replacement MHG Surety LOC").

       The Mariner Health DIP Credit Agreement also provides for mandatory
prepayments under the following circumstances: (a) with net cash proceeds from
asset sales, the incurrence of certain debt, the issuance of new equity, the
receipt of tax refunds exceeding $100,000 in the aggregate, and the receipt of
casualty proceeds in excess of $100,000 that are not applied within 60 days
after receipt to the repair, rebuilding, restoration or replacement of the
assets damaged or condemned (or committed within such period of time to be so
applied); and (b) on each business day, the amount of cash held by the Mariner
Health Debtors in excess of the sum of $5.0 million plus the aggregate sum of
the minimum amount required by depositary banks to be kept in deposit accounts,
concentration accounts and other accounts with such banks. Amounts prepaid
pursuant to clause (a) of the immediately preceding sentence will permanently
reduce the amount of the Mariner Health DIP Financing commitments on a dollar
for dollar basis. Amounts prepaid pursuant to clause (b) of the same sentence
will not permanently reduce such commitments. The Mariner Health Debtors have
the right to make optional prepayments in the minimum principal amount of $1.0
million, and in increments of $100,000 in excess thereof, and, on three business
days' notice, to reduce the commitments under


                                       13
<PAGE>   16


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


the Mariner Health DIP Credit Agreement in the minimum amount of $5.0 million,
or in increments of $1.0 million in excess thereof.

       As provided in the Final Mariner Health DIP Order, the obligations of the
Mariner Health Debtors under the Mariner Health DIP Credit Agreement (together
with certain potential cash management system liabilities secured on a pari
passu basis therewith, the "Mariner Health DIP Obligations") constitute allowed
super priority administrative expense claims pursuant to section 364(c)(1) of
the Bankruptcy Code (subject to a carve-out for certain professional fees and
expenses incurred by the Mariner Debtors). The Mariner Health DIP Obligations
are secured by perfected liens on all or substantially all of the assets of the
Mariner Health Debtors (excluding bankruptcy causes of action), the priority of
which liens (relative to prepetition creditors having valid, non-avoidable,
perfected liens in those assets and to any "adequate protection" liens granted
by the Bankruptcy Court) is established in the Final Mariner Health DIP Order
and the related cash collateral orders entered by the Bankruptcy Court (the
"Mariner Health Cash Collateral Orders"). The Bankruptcy Court has also granted
certain prepetition creditors of the Mariner Health Debtors replacement liens
and other rights as "adequate protection" against any diminution of the value of
their existing collateral that may result from allowing the Mariner Health
Debtors to use cash collateral in which such creditors had valid, non-avoidable
and perfected liens as of the Petition Date. The discussion contained in this
paragraph is qualified in its entirety by reference to the Final Mariner Health
DIP Order, the related Mariner Health Cash Collateral Orders, and related
stipulations, and reference should be made to such orders (which are available
from the Bankruptcy Court) and stipulations for a more complete description of
such terms.

       The Mariner Health DIP Credit Agreement contains customary
representations, warranties and other affirmative and restrictive covenants of
the Mariner Health Debtors, as well as certain financial covenants relating to
minimum profitability, minimum patient census, minimum eligible accounts
receivable, maximum variations from Mariner Health's year 2000 DIP budget and
maximum capital expenditures. The breach of such representations, warranties or
covenants, to the extent not waived or cured within any applicable grace or cure
periods, could result in the Mariner Health Debtors being unable to obtain
further advances under the Mariner Health DIP Financing and possibly the
exercise of remedies by the Mariner Health DIP Lenders, either of which events
could materially impair the ability of the Mariner Health Debtors to
successfully reorganize in chapter 11 and to operate as a going concern. The
occurrence of an event of default under the Mariner Health DIP Credit Agreement
may impair the ability of the Mariner Health Debtors to use cash collateral to
fund operations. At June 30, 2001, there were no outstanding borrowings or
letters of credit issued under the Mariner Health DIP Credit Agreement. During
July 2001, PNC issued the Replacement MHG Surety LOC in the amount of $7.9
million.

       Among its other restrictive covenants, the Mariner Health DIP Credit
Agreement limits affiliate transactions with the Company Debtors, but does
contemplate weekly overhead payments to the Company equal to 1.25% of projected
net nursing home revenues for such month, subject to a monthly "true-up," such
that the payments for such month equal 5% of actual net nursing home revenues of
the Mariner Health Debtors. Such payments may be suspended by the Mariner Health
Debtors if certain defaults specified in the Mariner Health Credit Agreement
occur and are continuing, though such fees will still accrue and will become due
and payable if and when the subject default has been cured or waived.

       By amendment dated as of January 19, 2001, and with the approval of the
Bankruptcy Court, the Mariner Health DIP Credit Agreement was amended to extend
the stated termination date for the Mariner Health DIP Credit Agreement from
January 19, 2001 to July 19, 2001, and to reduce the maximum amount of the
Mariner Health DIP Financing from $50.0 million to $25.0 million (as a result of
which the tranche B component of that credit facility was eliminated). Such
amendment also, among other things, imposed a 25 basis point utilization fee on
borrowings under the Mariner Health DIP Credit Agreement in excess of $5.0
million and amended certain reporting requirements. An amendment dated as of
March 20, 2001, among other things, increased the letter of credit sublimit and
the borrowing base to permit the issuance of the Replacement MHG Surety LOC to
facilitate implementation of a replacement surety bond program by Mariner
Health, which was issued during July 2001. Because the Replacement MHG Surety
LOC expires well after the


                                       14
<PAGE>   17


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


Commitment Termination Date for the Mariner Health DIP Facility, the
reimbursement obligations of Mariner Health in connection with the Replacement
MHG Surety LOC are secured by cash collateral equal to 105% of the stated amount
of such letter of credit, all as required by the Tenth Mariner Health DIP
Amendment.

       On or about May 14, 2001, Mariner Health and representatives of the
Mariner Health DIP Lenders and the Mariner Health Principal Secured Lenders
entered into a stipulation (the "May 14 Stipulation") (i) extending from May 21,
2001 to July 20, 2001, the Mariner Health Debtors' exclusive right to file a
plan of reorganization, and (ii) if they file a plan within that time, extending
the Mariner Health Debtor's exclusive right to solicit acceptances of such plan
to September 20, 2001; however, such exclusivity rights are modified in that
stipulation to permit the Mariner Health Principal Secured Lenders to file their
own plan or plans of reorganization for the Mariner Health Debtors and to
solicit acceptances thereto, or (at the sole option of the Mariner Health
Principal Secured Lenders) to file a joint plan of reorganization with the
Mariner Health Debtors and solicit acceptances thereto. The May 14 Stipulation
was subsequently approved by the Bankruptcy Court. The May 14 Stipulation
constituted a waiver by the Mariner Health DIP Lenders of the covenant in the
Mariner Health DIP Credit Agreement that the Mariner Health Debtors file a plan
of reorganization by a certain time and an agreement that the modification of
the Mariner Health Debtors' exclusivity rights pursuant to that stipulation
would not constitute an event of default under the Mariner Health DIP Credit
Agreement.

NOTE 6 - COMPREHENSIVE INCOME

       Comprehensive income (loss) includes net income (loss), as well as
charges and credits to stockholders' equity (deficit) not included in net income
(loss). The components of comprehensive income (loss), net of income taxes,
consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                           THREE MONTHS ENDED               NINE MONTHS ENDED
                                                                JUNE 30,                         JUNE 30,
                                                   ------------------------------- -------------------------------
                                                        2001            2000            2001             2000
                                                   --------------  --------------  ---------------  --------------
<S>                                                <C>             <C>              <C>             <C>
Net income (loss)                                  $       (4,919) $        8,603   $       18,167  $      (63,667)

Net unrealized gains on available-for-sale
   securities                                               1,036           4,688            1,249           4,508

                                                   --------------  --------------  ---------------  ---------------
Comprehensive income (loss)                        $       (3,883) $       13,291   $       19,416  $      (59,159)
                                                   ==============  ==============  ===============  ===============
</TABLE>

       Accumulated other comprehensive loss, net of income taxes, is comprised
of net unrealized losses on available-for-sale securities of $0.2 million and
$1.5 million at June 30, 2001 and September 30, 2000, respectively.


                                       15
<PAGE>   18


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


NOTE 7 - EARNINGS PER SHARE

       The following table sets forth the computation of basic and diluted
earnings per share (in thousands, except per share data) in accordance with
Financial Accounting Standards No. 128, "Earnings per Share":

<TABLE>
<CAPTION>

                                                         THREE MONTHS ENDED               NINE MONTHS ENDED
                                                              JUNE 30,                         JUNE 30,
                                                   ------------------------------- ---------------------------------
                                                        2001            2000            2001             2000
                                                   --------------- --------------- ---------------------------------
<S>                                                <C>             <C>              <C>             <C>
Numerator for basic and diluted income (loss)
  per share:
    Net income (loss)                              $       (4,919) $        8,603   $       18,167  $      (63,667)
                                                   ==============  ==============  ===============  ==============

Denominator:
    Denominator for basic income (loss) per share          73,688          73,688           73,688          73,688
    - weighted average shares


    Effect of dilutive securities - stock options              --              --               --              --

                                                   --------------   --------------  --------------- --------------
    Denominator for diluted income (loss) per
      share - adjusted weighted average shares and
       assumed conversions                                 73,688          73,688           73,688          73,688
                                                   ==============  ==============  ===============  ==============

Basic and diluted income (loss) per share:
    Net income (loss) per share                    $       (0.07)  $        0.12    $         0.25  $        (0.86)
                                                   =============   =============   ===============  ==============
</TABLE>

NOTE 8 - INCOME TAXES

       Due to the nature and composition of the Company's deferred tax assets
and the changes in the Company's valuation allowance, the Company does not
expect to incur income tax expense regarding the net profits generated during
the current fiscal year. Additionally, the Company has not reduced its deferred
asset valuation allowance any further due to the continuing uncertainty of
future profitability. Consequently, the Company maintains a valuation allowance
which completely offsets all net deferred tax assets generated from the
Company's losses.

NOTE 9 - COMMITMENTS AND CONTINGENCIES

     LITIGATION

       As is typical in the healthcare industry, the Company is and will be
subject to claims that its services have resulted in resident injury or other
adverse effects, the risks of which will be greater for higher acuity residents
receiving services from the Company than for other long-term care residents. In
addition, resident, visitor, and employee injuries will also subject the Company
to the risk of litigation. The Company has experienced an increasing trend in
the number and severity of litigation and claims asserted against the Company.
Management believes that this trend is endemic to the long-term care industry
and is a result of the increasing number of large judgments, including large
punitive damage awards, against long-term care providers in recent years
resulting in an increased awareness by plaintiff's lawyers of potentially large
recoveries. In certain states in which the Company has significant operations,
including California and Florida, insurance coverage for the risk of punitive
and certain other damages arising from general and professional liability
litigation is not available due to state law public policy prohibitions. There
can be no assurance that the Company will not be liable for punitive or other
damages awarded in litigation arising in states for which insurance coverage is
not available for such damages. The Company also believes that there has been,
and will continue to be, an


                                       16
<PAGE>   19


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


increase in governmental investigations of long-term care providers,
particularly in the area of Medicare/Medicaid false claims as well as an
increase in enforcement actions resulting from these investigations. While the
Company believes that it provides quality care to the patients in its facilities
and materially complies with all applicable regulatory requirements, given the
Company's current financial difficulties, an adverse determination in a legal
proceeding or governmental investigation, whether currently asserted or arising
in the future, could have a material adverse effect on the Company.

       From time to time, the Company and its subsidiaries have been parties to
various legal proceedings in the ordinary course of their respective businesses.
In the opinion of management, except as described below, there are currently no
proceedings which, individually, if determined adversely to the Company and
after taking into account the insurance coverage maintained by the Company,
would have a material adverse effect on the Company's financial position or
results of operations. Although the Company believes that any of the proceedings
not discussed below will not individually have a material adverse impact on the
Company if determined adversely to the Company, given the Company's current
financial condition and change in the Company's general liability and
professional liability insurance policies, settling a large number of cases
within the Company's $1 million self-insured retention limit could have a
material adverse effect on the Company.

       On August 26, 1996, a class action complaint was asserted against
GranCare, Inc. ("GranCare"), a wholly-owned subsidiary of the Company, in the
Denver, Colorado District Court, Salas, et al v. GranCare, Inc. and AMS
Properties, Inc. d/b/a Cedars Healthcare Center, Inc., case no. 96-CV-4449. On
March 15, 1998, the Court entered an Order in which it certified a class action
in the matter. On June 10, 1998, the Company filed a Motion to Dismiss all
claims and Motion for Summary Judgment Precluding Recovery of Medicaid Funds and
these motions were partially granted by the Court on October 30, 1998.
Plaintiffs' Motion for Reconsideration was denied by the Court on November 19,
1998, the Court's decision was certified as a final judgment on December 10,
1998, and plaintiffs then filed a writ with the Colorado Supreme Court, which
was denied, and an appeal with the Colorado Court of Appeal. In accordance with
the Company's voluntary filing under chapter 11 of the Bankruptcy Code and more
particularly, ss. 362 of that Code, this matter was stayed on January 18, 2000.
However, the Company did agree to limited relief from the stay in order to allow
for certain parts of the appeal to continue. The Company filed a Request for
Rehearing on February 2, 2001 and on March 22, 2001, the Court denied this
Request as well as the Request for Rehearing by Plaintiffs. On April 18, 2001
the Court of Appeals was notified of the applicability of the Bankruptcy Stay
and the Company's reservation of its rights to take a Writ to the Colorado
Supreme Court when the Stay is lifted. The Company currently believes it is
unlikely for this matter to ultimately survive as a class action and given this
and the current posture of the case, this matter is not in a position to be
evaluated in regard to a favorable outcome or in regard to the range of
potential loss. The Company will continue in its opposition to the class action
and further intends to vigorously contest all remaining allegations.

       On March 18, 1998, a complaint was filed under seal by a former employee
against the Company, certain of its predecessor entities and affiliates in the
United States District Court for the Northern District of Alabama, alleging,
inter alia, employment discrimination, wrongful discharge, negligent hiring,
violation of the Federal False Claims Act, and retaliation under the False
Claims Act. The action is titled Powell, et al. v. Paragon Health Inc., et al.,
civil action No. CV-98-0630-S. The complaint has been unsealed and the Company
has been advised that the government has declined to intervene in this matter
under the Federal False Claims Act. In accordance with the Company's voluntary
filing under chapter 11 of the Bankruptcy Code and more particularly, ss. 362 of
that Code, this matter was stayed on January 18, 2000.

       On August 25, 1998, a complaint was filed by the United States against
the Company's GranCare and International X-Ray subsidiaries and certain other
parties under the Civil False Claims Act and in common law and equity. The
lawsuit, U.S. v. Sentry X-Ray, Ltd., et al., civil action no. 98-73722, was
filed in United States District Court for the Eastern District of Michigan.
Valley X-Ray operates a mobile X-Ray company in Michigan. A Company subsidiary,
International X-Ray, owns a minority partnership interest in defendant Valley X-
Ray. The case asserts five


                                       17
<PAGE>   20


                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


claims for relief, including two claims for violation of the Civil False Claims
Act, two alternative claims of common law fraud and unjust enrichment, and one
request for application of the Federal Debt Collection Procedures Act. The two
primary allegations of the complaint are that (i) the X-Ray company received
Medicare overpayments for transportation costs in the amount of $657,767; and
(ii) the X-Ray company "upcoded" Medicare claims for EKG services in the amount
of $631,090. The United States has requested treble damages as well as civil
penalties of $5,000 to $10,000 for each of the alleged 388 submitted Medicare
claims. The total damages sought varies from $5.3 million to $7.2 million. As
the result of a motion filed by the Company on November 23, 1998, GranCare was
dismissed from the case. In accordance with the Company's voluntary filing under
chapter 11 of the Bankruptcy Code and more particularly, ss. 362 of that Code,
this matter was stayed on January 18, 2000.

       On October 1, 1998, a class action complaint was asserted against certain
of the Company's predecessor entities and affiliates and certain other parties
in the Tampa, Florida, Circuit Court, Ayres, et al v. Donald C. Beaver, et al,
case no. 98-7233. The complaint asserted three claims for relief, including
breach of fiduciary duty against one group of defendants, breach of fiduciary
duty against another group of defendants, and civil conspiracy arising out of
issues involving facilities previously operated by the Brian Center Corporation
or one of its subsidiaries, and later by a subsidiary of Living Centers of
America, Inc. ("LCA"), a wholly-owned subsidiary of the Company, as a result of
the merger with Brian Center Corporation. All defendants submitted Motions to
Dismiss which were heard by the Court on September 15, 1999. The Court granted
Defendant Donald C. Beaver's Motion to Dismiss on December 6, 1999. In
accordance with the Company's voluntary filing under chapter 11 of the
Bankruptcy Code and more particularly, ss. 362 of that Code, this matter was
stayed on January 18, 2000. On or about April 19, 2000 plaintiffs filed an
Amending Petition seeking to bring Donald C. Beaver back into the case as a
defendant. Mr. Beaver has filed a Motion to Dismiss the Amending Petition and no
date for hearing has been set. In accordance with the Company's voluntary filing
under chapter 11 of the Bankruptcy Code, and more particularly, ss. 362 of the
Bankruptcy Code, all proceedings against the Company have been stayed. Very
little discovery has been conducted and accordingly, this case is not in a
position to be evaluated in regard to the probability of a favorable outcome or
in regard to the range of potential loss. The Company intends to vigorously
contest the request for class certification, as well as all alleged claims made.

       On November 16, 1998, a complaint was filed under seal by a former
employee against the Company, certain of its predecessor entities and affiliates
in the United States District Court for the Southern District of Texas, alleging
violation of the Federal False Claims Act. The action is titled United States ex
rel. Nelius, et al., v. Mariner Health Group, Inc., et al., civil action No.
H-98-3851. To date, the Government has declined to intervene. The complaint
which was unsealed, has been amended to add additional relators and allegations
under the Federal False Claims Act. In response to the Notice of Stay submitted
under 11 U.S.C. ss. 362, the District Court, on January 26, 2000, dismissed the
plaintiffs' claims against defendants subject to reinstatement within thirty
(30) days after the stay is discontinued. The Company intends to vigorously
contest the alleged claims herein.

       On October 27, 1999, the Company was served with a Complaint in United
States ex rel. Cindy Lee Anderson Rutledge and Partnership for Fraud Analysis
and State of Florida ex rel. Cindy Lee Anderson Rutledge Group, Inc., ARA Living
Centers, Inc. and Living Centers of America, Inc., No. 97-6801, filed in the
United States District Court for the Eastern District of Pennsylvania. This
action originally was filed under seal on November 5, 1997, by relators Cindy
Lee Anderson Rutledge and the Partnership for Fraud Analysis under the Federal
False Claims Act and the Florida False Claims Act. The Complaint alleges that
the Company is liable under the Federal False Claims Act and the Florida False
Claims Act for alleged violations of regulations pertaining to the training and
certification of nurse aides at former LCA facilities. After conducting an
investigation in which the Company cooperated by producing documents responsive
to an administrative subpoena and allowing certain employee interviews, the
United States Department of Justice elected not to intervene. The district court
unsealed the Complaint on October 15, 1999. On December 14, 1999, the Company
filed a motion to dismiss the relators' complaint. In accordance with the
Company's voluntary filing under chapter 11 of the Bankruptcy Code and more
particularly, ss. 362 of that Code, this matter was stayed on January 18, 2000.
The Company intends vigorously to defend this action.


                                       18
<PAGE>   21
                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)



         On approximately January 20, 2000, the OIG issued subpoenas duces tecum
to the Company and Summit Medical Management (a subsidiary of the Company). The
subpoenas request documents relating to the purchase of Summit Medical
Management and other subsidiaries. In addition, the subpoenas request other
broad categories of documents. The Company is cooperating with the investigation
and has retained experienced counsel to assist in responding to the subpoenas
and advise the Company with respect to this investigation. This investigation is
still in its preliminary stages; therefore, the Company is unable to predict the
outcome of this matter.

         On approximately August 31, 2000, the United States Attorney for
Eastern District of Michigan issued a subpoena duces tecum to Cambridge East.
The subpoena requests medical records and other broad categories of documents.
The Company has produced a substantial amount of documents responsive to the
subpoena. The Company is cooperating with the investigation and has retained
experienced counsel to assist in responding to the subpoena and to advise the
Company with respect to this investigation. This investigation is still in its
preliminary stages; therefore, the Company is unable to predict the outcome of
this matter.

         On October 5, 2000, NovaCare Holdings, Inc. ("NCH") filed a complaint
(the "NCH Complaint") in the Chapter 11 Proceedings commencing Adversary
Proceeding No. 00-1577 (MFW), NovaCare Holdings, Inc. v. Mariner Post-Acute
Network, Inc., et al. The Company and various subsidiaries (the "defendant
subsidiaries") are named as defendants in the NCH Complaint. In the NCH
Complaint, NCH alleges that its predecessors in interest (hereinafter also
referred to as "NCH") were party to contracts with various subsidiaries of the
Company under which NCH provided services to patients at various facilities of
such subsidiaries. It further alleges that pursuant to these contracts, NCH
provided certain services for which it was paid, but with respect to which the
Health Care Financing Administration ("HCFA") (which subsequently was renamed
the Centers for Medicare and Medicaid Services, or "CMS") disallowed the
facilities' claims for reimbursement (the "NCH HCFA Disallowances"). After the
NCH HCFA Disallowances, NCH allegedly provided credits to the facilities equal
to the amount of the NCH HCFA Disallowances. Appeals of the NCH HCFA
Disallowances were filed, and NCH alleges that it holds a constructive trust or
equitable lien on any amounts which may be recovered from HCFA as a result of
such appeals. In the alternative, NCH alleges that it holds an administrative
priority claim for any such amounts that are paid by HCFA and not turned over to
NCH. The aggregate amount of the credits that are related to the NCH HCFA
Disallowances and with respect to which NCH asserts a constructive trust, an
equitable lien, and/or an administrative priority claim is $8,163,930. In
addition, NCH asserts administrative priority claims as well as claims for an
equitable lien and constructive trust for attorneys fees and expenses relating
to the appeals of other disallowance decisions by HCFA (the "Other HCFA
Disallowances"); the NCH Complaint states that NCH has incurred at least
$275,000 of such expenses. On November 9, 2000, the Company and the defendant
subsidiaries filed a motion to dismiss ("Motion to Dismiss") the NCH Complaint,
arguing that the constructive trust/equitable lien claims are barred by res
judicata based upon prior financing orders of the Bankruptcy Court, and that the
claims seeking administrative priority fail to state claims upon which such
relief may be granted. On December 12, 2000, the Bankruptcy Court heard oral
argument with respect to the Motion to Dismiss, took the matter under
submission, and requested further briefing. In early November, NCH filed a
motion ("Motion to Enjoin Settlement") which seeks to enjoin the Company and the
defendant subsidiaries from settling claims against HCFA relating to the NCH
HCFA Disallowances and to require that any funds recovered with respect to such
claims be segregated. The Company and the defendant subsidiaries have filed an
opposition. In addition the Company has filed a motion for summary judgment
(the "Motion for Summary Judgment") on those counts of the complaint which are
directed against the Company and its subsidiaries. A hearing on the Motion to
Enjoin Settlement and on the Motion for Summary Judgment has been deferred
until the Bankruptcy Court rules on the Motion to Dismiss. The parties are
currently waiting for the Bankruptcy Court to rule on the Motion to Dismiss. The
Company and the defendant subsidiaries intend to contest the case vigorously.



                                       19
<PAGE>   22
                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)




NOTE 10 - SEGMENT INFORMATION

         The following tables exhibit the segment reporting of the Company for
the three and nine months ended June 30, 2001 and 2000 (in thousands):


<TABLE>
<CAPTION>

                                              THREE MONTHS ENDED                     NINE MONTHS ENDED
                                                    JUNE 30,                               JUNE 30,
                                         -----------------------------         -------------------------------
                                            2001              2000                2001                2000
                                         ---------         -----------         -----------         -----------
<S>                                      <C>               <C>                 <C>                 <C>
Revenues from external customers:
    Nursing home services                $ 441,394         $   448,698         $ 1,325,351         $ 1,344,326
    Pharmacy services                       54,311              56,319             161,217             184,716
    Other                                   28,827              27,517              82,889              82,212
                                         ---------         -----------         -----------         -----------
                                         $ 524,532         $   532,534         $ 1,569,457         $ 1,611,254
                                         =========         ===========         ===========         ===========


Intersegment revenues:
    Pharmacy services                    $  12,964         $    13,415         $    37,890         $    39,676
    Other                                       72                  71                 214                 214
                                         ---------         -----------         -----------         -----------
                                         $  13,036         $    13,486         $    38,104         $    39,890
                                         =========         ===========         ===========         ===========


Net income (loss):
    Nursing home services                $  21,265         $    58,332         $   104,566         $   143,050
    Pharmacy services                          212                 909                (375)             (1,957)
    Other                                     (507)            (10,933)              3,261             (13,289)
                                         ---------         -----------         -----------         -----------
                                         $  20,970         $    48,308         $   107,452         $   127,804
                                         =========         ===========         ===========         ===========


<CAPTION>
                                                                                                     JUNE 30,
                                                                                                       2001
                                                                                                   ------------
Assets:
    Nursing home services                                                                          $   969,851
    Pharmacy services                                                                                   95,563
    Other                                                                                               82,103
                                                                                                   -----------
                                                                                                   $ 1,147,517
                                                                                                   ===========
</TABLE>


                                       20
<PAGE>   23
                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


       The following tables reconcile the Company's segment reporting to the
totals on the Company's unaudited condensed consolidated financial statements
for the three and nine months ended June 30, 2001 and 2000 (in thousands):

<TABLE>
<CAPTION>
                                                            THREE MONTHS ENDED                     NINE MONTHS ENDED
                                                                  JUNE 30,                             JUNE 30,
                                                         ---------------------------         -------------------------------
                                                            2001             2000               2001               2000
                                                         ---------------------------         -------------------------------
<S>                                                      <C>               <C>               <C>                 <C>
Revenues:
    External revenues for reportable segments            $ 524,532         $ 532,534         $ 1,569,457         $ 1,611,254
    Intersegment revenues for reportable segments           13,036            13,486              38,104              39,890
    Elimination of intersegment revenue                    (13,036)          (13,486)            (38,104)            (39,890)
                                                         ---------------------------         -------------------------------

Consolidated revenues                                    $ 524,532         $ 532,534         $ 1,569,457         $ 1,611,254
                                                         ===========================         ===============================

Net income (loss):
    Net income for reportable segments                   $  20,970         $  48,308         $   107,452         $   127,804
    Corporate overhead                                     (25,889)          (39,705)            (89,285)           (191,471)
                                                         ---------------------------         -------------------------------
Consolidated net income (loss)                           $  (4,919)        $   8,603         $    18,167         $   (63,667)
                                                         ===========================         ===============================

<CAPTION>
                                                                                                                   JUNE 30,
                                                                                                                     2001
                                                                                                                 -----------
<S>                                                                                                              <C>
Assets:
    Assets for reportable segments                                                                               $ 1,147,517
    Corporate overhead                                                                                             1,429,026
    Elimination of intersegment assets                                                                            (1,290,638)

                                                                                                                 -----------
                                                                                                                 $ 1,285,905
                                                                                                                 ===========

</TABLE>

NOTE 11 - SUBSEQUENT EVENTS

         At a hearing held on August 7, 2001, the Bankruptcy Court approved an
amendment, dated as of June 26, 2001, to the Company DIP Credit Agreement, which
extended the scheduled termination date of the Company DIP Credit Facility from
August 31, 2001, to December 31, 2001, and modified certain financial covenants
in the Company DIP Credit Agreement.

         By amendment to the Mariner Health DIP Credit Agreement dated as of
July 19, 2001, and approved by the Bankruptcy Court at its August 7, 2001
hearing in the Mariner Health Chapter 11 Cases, the stated termination date of
the Mariner Health DIP Credit Agreement was extended to December 31, 2001, in
exchange for, among other things, the payment of $15.0 million to the Mariner
Health Principal Secured Lenders as an adequate protection payment.

         The Company, GranCare, and the Omega Debtors entered into a Settlement
Agreement with Omega dated as of August 1, 2001 (the "Omega Settlement
Agreement"), proposing to restructure the $58.8 million prepetition mortgage
loan (the "Omega Loan") between Omega and Professional Health Care Management,
Inc., a wholly owned subsidiary of GranCare ("PHCMI"), and resolve related
disputes, by modifying the Omega Loan and entering into certain related
transactions (collectively, the "Omega Loan Modification").


                                       21
<PAGE>   24
                MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  (DEBTOR IN POSSESSION AS OF JANUARY 18, 2000)
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)


         Under the terms of the Omega Settlement Agreement, Omega has agreed
with the Company, GranCare and the Omega Debtors to modify the Omega Loan
(anticipated at closing to be in the amount of approximately $59.7 million, the
"Amended Omega Loan") by (i) extending the maturity thereof from 2007 to 2010,
with a one-time, 11-year extension option; (ii) providing for a catch-up payment
or payments of post-December 31, 2000 interest on the Omega Loan at the
compromise rate of $525,000 per month, plus an additional $300,000 (representing
interest at the rate of 11.25% per annum on the $8.0 million of principal on the
Omega Loan excluded from the parties' calculation of the $525,000 per month
compromise interest amount); (iii) providing for interest-only payments after
closing of the Omega Loan Modification at a substantially reduced interest rate
(11.57% per annum, compared to the current contractual rate of over 16%); (iv)
granting PHCMI a one-time option to prepay the Amended Omega Loan in full
between February 1, 2005 and July 31, 2005, at a prepayment price of 103% of
par, plus accrued and unpaid interest; (v) releasing the Company, GranCare and
the Omega Debtors from liability arising prior to the closing of the Omega Loan
Modification (including the GranCare "keepwell" agreement contained in the
prepetition Omega loan agreement), other than liability arising in connection
with the Omega Settlement Agreement and the loan documents evidencing,
guaranteeing and securing the Amended Omega Loan (the "Amended Omega Loan
Documents"); (vi) providing for payment to Omega of an annual amendment fee
equal to 25% of free cash flow from the Omega Facilities, and until the
occurrence of certain events, a monthly amendment fee equal to 50% of the
"return on equity" component of Medicaid reimbursement received from the State
of North Carolina with respect to the North Carolina Omega Facilities; and (vii)
providing for the management of the facilities subject to the Omega Loan by the
Company for a monthly base management fee of 5% of Omega Facility revenues, plus
an annual incentive management fee equal to 75% of free cash flow from such
facilities (reducing to 70% under certain circumstances).

       PHCMI will remain the borrower under the Amended Omega Loan, as it is
under the Omega Loan. The Amended Omega Loan will be guaranteed by PHCMI's
subsidiaries which are the licensed operators of the Omega Facilities (the
"Michigan Subsidiary Guarantors"), and also by another Company subsidiary,
Living Centers - PHCM, Inc. ("LC-PHCM", and together with the Michigan
Subsidiary Guarantors, the "Omega Guarantors"), as the owner of the Omega
Facilities located in North Carolina (such guaranties being referred to herein
as the "Amended Omega Guaranties"). The Amended Omega Loan and the Amended Omega
Guaranties will be secured by (i) amended mortgages or deeds of trust on the
Omega Facilities, (ii) amended, blanket security interests in the personal
property assets of PHCMI and the Omega Guarantors, and (iii) pledges of the
issued and outstanding capital stock of PHCMI and each of the Michigan
Subsidiary Guarantors.

       In addition, PHCMI has agreed in the Omega Settlement Agreement to assign
its residual 50% undivided interest in the $9.0 million purchase money note (the
"Ciena Note") received from the affiliate of Ciena Healthcare Management, Inc.
which acquired four former Michigan Omega Facilities from PHCMI on or about
February 1, 2001 (the "Ciena Facilities"). (The other 50% interest was
previously assigned by PHCMI to Omega at the closing of the sale of the Ciena
Facilities, in return for a $4.5 million credit against the Omega Loan
obligations.) The consideration for the assignment of PHCMI's remaining interest
in the Ciena Note would be approximately $3.5 million, plus 50% of aggregate
principal payments received under the Ciena Note in excess of $8 million and 50%
of interest payments received under the Ciena Note in excess of $960,000
annually.

       The Omega Loan Modification is subject to the approval of the Bankruptcy
Court and of the Company's DIP Lenders. A motion seeking Bankruptcy Court
approval was filed on August 2, 2001, with a hearing on the matter set for
August 22, 2001. The Company can give no assurances that the required approvals
will be obtained.

      The Company has reserved the option to cause the issued and outstanding
capital stock of LC-PHCM to be transferred, in one or more successive
transfers, to PHCMI, which would make LC-PHCM a wholly-owned subsidiary of
PHCMI, and to sell 51% of the issued and outstanding capital stock of PHCMI to
a third-party unrelated to either Omega or the Company (the "Majority PHCMI
Equity Sale"). The terms of the Majority PHCMI Equity Sale are currently being
negotiated.

                                       22
<PAGE>   25
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

     OVERVIEW

         The Company through its subsidiaries is one of the nation's largest
providers of post-acute health care services, primarily through the operation of
skilled nursing facilities. At June 30, 2001, the Company's significant
operations consisted of (i) approximately 340 inpatient and assisted living
facilities containing approximately 40,000 beds; (ii) approximately 32
institutional pharmacies servicing more than 1,000 long-term care centers; and
(iii) 13 long-term acute care hospitals with approximately 620 licensed beds.
The Company operates in 25 states with significant concentrations of facilities
and beds in five states and several metropolitan markets.

         On January 18, 2000 (the "Petition Date"), the Company and
substantially all of its subsidiaries (the "Company Debtors"), including Mariner
Health Group, Inc. ("Mariner Health") and its subsidiaries (the "Mariner Health
Subsidiaries" and collectively with Mariner Health, the "Mariner Health
Debtors"), filed voluntary petitions (collectively, the "Chapter 11 Filings") in
the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy
Court") under chapter 11 title 11 of the United States Code (the "Bankruptcy
Code"). The Company is presently operating its business as a
debtor-in-possession subject to the jurisdiction of the Bankruptcy Court while a
plan or plans of reorganization are formulated. Neither the Company nor Mariner
Health has filed a plan of reorganization. On June 12, 2001, the agents for the
Mariner Health Debtors' senior secured lenders under Mariner Health's
prepetition senior credit facility (the "MHG Principal Secured Lenders") filed
with the Bankruptcy Court a plan of reorganization for Mariner Health which has
since been amended (including amendments thereto, "the MHG Bank Groups' Plan")
and a proposed disclosure statement for the MHG Bank Groups' Plan; the adequacy
of the disclosure statement was subsequently approved by the Bankruptcy Court at
a hearing held on August 7, 2001, subject to various amendments in response to
objections thereto. The MHG Bank Groups' Plan provides for, among other things,
(i) elimination of the Company's equity interest in the Mariner Health Debtors
whereby the Company would receive no consideration on account of its claims
against and equity interest in the Mariner Health Debtors; (ii) termination of
the Company's management of the facilities owned by the Mariner Health Debtors,
thus eliminating a significant source of revenue for the Company; and (iii)
restructuring and/or discharging of the Mariner Health Debtors' obligation to
their creditors. Impaired classes of creditors and equity holders that are
entitled to vote must still approve or reject the MHG Bank Groups' Plan once
votes for the MHG Bank Groups' Plan are solicited (which solicitation will not
be made prior to August 23, 2001, and may be delayed further, at the discretion
of the MHG Principal Secured Lenders). The Company cannot predict whether the
Bankruptcy Court will confirm the MHG Bank Groups' Plan and, if such plan is
confirmed, when and whether such plan would become effective. As of August 10,
2001, neither the Company nor the Mariner Health Debtors had taken any position
as to whether to support or oppose confirmation of the MHG Bank Groups' Plan. As
a debtor-in-possession, the Company is authorized to operate its business but
may not engage in transactions outside its ordinary course of business without
the approval of the Bankruptcy Court (the "Chapter 11 Proceedings").

         The Chapter 11 Proceedings raise substantial doubt about the Company's
ability to continue as a going concern. The ability of the Company to continue
as a going concern and the appropriateness of using the going concern basis of
accounting is dependent upon, among other things, the ability of the Company to
comply with the terms of its various commitments of debtor-in-possession
financing, confirmation of a plan of reorganization, success of future
operations after such confirmation and the ability to generate sufficient cash
from operations and financing sources to meet obligations. Any plan or plans of
reorganization and other actions during the Chapter 11 Proceedings could change
materially the amounts currently recorded in the unaudited condensed
consolidated financial statements (see Note 3 of the unaudited condensed
consolidated financial statements).

     RESULTS OF OPERATIONS

         The following discussion and analysis should be read in conjunction
with the business segment data in Note 10 of the unaudited condensed
consolidated financial statements.


                                       23
<PAGE>   26

       Net revenues for inpatient nursing home services accounted for $441.4
million and $1,325.4 million of the Company's $524.5 million and $1,569.5
million total revenues for the three and nine months ended June 30, 2001,
respectively. Nursing home services revenues are derived from the provision of
routine and ancillary services and are a function of occupancy rates in the
Company's nursing facilities and payor mix.

       Weighted average occupancy, as identified in the following table,
increased by 1.5% and 1.6%, respectively, over the comparable three and nine
month periods from fiscal year 2000 to fiscal year 2001.

<TABLE>
<CAPTION>

                                               THREE MONTHS ENDED          NINE MONTHS ENDED
                                                    JUNE 30,                    JUNE 30,
                                              ---------------------     ----------------------
                                               2001         2000           2001       2000
                                              ---------------------     ----------------------
  <S>                                         <C>           <C>          <C>         <C>
  Weighted average licensed bed count          39,448       45,592        40,914      46,247
  Total average residents                      34,627       39,355        35,739      39,696
  Weighted average occupancy                     87.8%        86.3%         87.4%       85.8%
</TABLE>

         Payor mix is the source of payment for the services provided and
consists of Medicare, Medicaid and private pay. Private pay includes revenue
from individuals who pay directly for services (without government assistance
through the Medicare and Medicaid programs) and from managed care companies,
commercial insurers, health maintenance organizations, Veteran's Administration
contractual payments, and payments for services provided under contract
management programs. Managed care as a payor source to nursing home operators is
likely to increase over the next several years. However, revenue from managed
care payors does not constitute a significant portion of the Company's revenue
at this time.

         Reimbursement rates from government sponsored programs, such as
Medicare and Medicaid, are strictly regulated and subject to funding
appropriations from federal and state governments. Changes in reimbursement
rates, including the implementation of the Prospective Payment System ("PPS")
for Medicare Part A patients beginning July 1, 1998 and the fee screen schedules
and therapy caps for Medicare Part B patients beginning January 1, 1999
(although the therapy caps temporarily have been suspended), have adversely
affected the Company resulting in significantly lower Medicare revenues than the
Company would have received under the previous cost based payment methodology.
Ongoing efforts of third-party payors to contain healthcare costs by limiting
reimbursement rates, increasing case management review and negotiating reduced
contract pricing continue to affect the Company's revenues and profitability.
The federal Medicare program restricts inpatient coverage to patients who
require skilled care. State-administered Medicaid programs generally provide
more restricted coverage and lower reimbursement rates than private pay sources.

         In addition, the administrative procedures associated with the Medicare
cost reimbursement program, with respect to facilities and periods not subject
to PPS, generally preclude final determination of amounts due the Company until
annual cost reports are audited or otherwise reviewed and settled with the
applicable fiscal intermediaries and administrative agencies. Certain Medicare
fiscal intermediaries have made audit adjustments to settle cost reports for
some of the Company's facilities that reduce the amount of reimbursement that
was previously received by the facilities. The Company believes that it has
properly recorded revenue under cost reimbursement programs based on the facts
and current regulations. If the Company were to receive adverse adjustments that
it had not contemplated in recording its revenue in the past, the differences
could be significant to the Company's results of operations in the period of
final determination. See "--Liquidity and Capital Resources." Under PPS, the
Company is still required to file cost reports; however, the audit and
settlement process of Medicare cost reports is not expected to have a material
impact on total Medicare revenue. See "--Liquidity and Capital Resources." As
part of the bankruptcy process the Company, Mariner Health and their respective
subsidiaries are engaged in discussions with the Health Care Financing
Administration ("HCFA") (which subsequently was renamed the Centers for Medicare
and Medicaid Services, or "CMS") to potentially settle some or all matters
related to historical cost-based reimbursement (the "HCFA Global Settlement").
It is not possible to estimate at this time whether this process will result in
material differences of amounts previously recorded or the effects on future
cash flows.



                                       24
<PAGE>   27
         The table below presents the approximate percentage of the Company's
net patient revenues derived from the various sources of payment for the periods
indicated:

<TABLE>
<CAPTION>

                                                  THREE MONTHS ENDED         NINE MONTHS ENDED
                                                       JUNE 30,                  JUNE 30,
                                             -------------------------    ------------------------
                                                  2001         2000          2001        2000
                                             -------------------------    ------------------------
  <S>                                             <C>          <C>           <C>         <C>
  Medicaid                                         47.4%        49.9%         48.6%       49.8%
  Medicare                                         29.3%        25.0%         27.6%       24.6%
  Private and other                                23.3%        25.1%         23.8%       25.6%
</TABLE>

     THIRD QUARTER FISCAL 2001 COMPARED TO THIRD QUARTER FISCAL 2000

         Net revenues totaled $524.5 million for the three months ended June 30,
2001, a decrease of approximately $8.0 million or 1.5% from the comparable
period in fiscal year 2000. The decrease is primarily attributable to a decrease
of approximately $7.3 million or 1.6% in net revenues for inpatient nursing home
services. The impact of the divestiture of inpatient nursing home facilities
resulted in a decrease in net revenues of approximately $45.5 million for the
three months ended June 30, 2001 as compared to the three months ended June 30,
2000. The decrease in net revenues was partially offset by an increase of
approximately $38.2 million from the third quarter of fiscal year 2000 to the
third quarter of fiscal year 2001 for the current portfolio of inpatient nursing
home facilities. The increase resulted primarily from higher average per diem
rates during the three months ended June 30, 2001 as compared to the three
months ended June 30, 2000, mainly due to increases in Medicare rates (6.7%) and
Medicaid rates (7.6%) as a result of recent legislative relief to mitigate the
reduction in reimbursement under PPS (see "-Healthcare Regulatory Matters"). In
addition, although census remained relatively stable for the third quarter of
fiscal year 2001 as compared to the third quarter of fiscal year 2000, there was
a slight improvement in revenue by payor mix which also resulted in increased
revenues for the third quarter of the current fiscal year as compared to the
third quarter of the prior fiscal year.

         Costs and expenses, excluding depreciation and amortization, totaled
$493.5 million for the three months ended June 30, 2001, a decrease of $21.4
million or 4.2% from the comparable period of fiscal year 2000. These costs and
expenses primarily consist of salaries, wages, and employee benefits, which
represent approximately $294.6 million or 59.7% of the total for the three
months ended June 30, 2001 as compared to $303.9 million or $59.0% of the total
for the three months ended June 30, 2000. Various federal, state and local
regulations impose, depending on the services provided, a variety of regulatory
standards for the type, quality, and level of personnel required to provide care
or services. The regulatory requirements have an impact on staffing levels, as
well as the mix of staff, and therefore impact salaries, wages and employee
benefits. The decrease in salaries, wages and benefits of approximately $9.4
million for the three months ended June 30, 2001 as compared to the same period
in fiscal year 2000 is due to multiple factors including the impact of the
divestiture of inpatient nursing home facilities and the Company's continued
efforts to reduce overhead costs. This reduction has been partially offset by
rising labor costs in certain of its markets and the Company is expecting this
trend to continue for the foreseeable future (see "--Liquidity and Capital
Resources"). Rent decreased approximately $7.6 million or 33.2% to $15.2 million
for the three months ended June 30, 2001 as compared to the same period in
fiscal year 2000 mainly due to the impact of the divestiture of inpatient
nursing home facilities. Provision for bad debts for the three months ended June
30, 2001 was $7.3 million, a decrease of approximately $7.6 million or 51.1%
from the comparable period of the prior fiscal year. The decrease is attributed
to an additional provision for bad debts recorded by the Company during the
three months ended June 30, 2000 for receivables retained from the sale of the
Company's then remaining home health operations in fiscal year 2000. General and
administrative expenses, which include the indirect administrative costs
associated with operating the Company and its lines of business, decreased
approximately $5.0 million or 8.6% to $53.5 million for the three months ended
June 30, 2001 as compared to the same period in fiscal year 2000, mainly as a
result of the Company's continued efforts to reduce overhead costs.

         Depreciation and amortization costs were $14.1 million for the three
months ended June 30, 2001, a decrease of approximately $4.6 million or 24.6%,
which is due to the impact of the divestiture of inpatient nursing home
facilities and the result of the Company recording an impairment charge of $19.4
million in the fourth quarter of fiscal year 2000.


                                       25
<PAGE>   28

         Effective January 18, 2000, the Company discontinued accruing interest
relating to its debt facilities currently classified as liabilities subject to
compromise in accordance with the American Institute of Certified Public
Accountants Statement of Position 90-7, "Financial Reporting by Entities in
Reorganization Under the Bankruptcy Code" ("SOP 90-7"). Contractual interest for
the three months ended June 30, 2001 and 2000 was $51.4 million and $62.1
million, respectively, which is $50.6 million and $61.2 million in excess of
interest expense included in the unaudited condensed consolidated financial
statements.

         Reorganization items totaled $21.2 million for the three months ended
June 30, 2001 as compared to ($8.1) million for the three months ended June 30,
2000. The increase of approximately $29.3 million is attributable to
approximately $11.0 million of net gain on divestitures included in
reorganization items for the three months ended June 30, 2000 as compared to a
net loss on divestitures of approximately $4.3 million included in
reorganization items for the three months ended June 30, 2001. During the three
months ended June 30, 2000, the Company realized a net gain of approximately
$11.1 million due to a settlement agreement reached with Senior Housing
Properties related to certain leased facilities (see Note 4 of the unaudited
condensed consolidated financial statements). Professional fees included in
reorganization items, which primarily consist of expenses for consulting, legal
and auditing services incurred in connection with the reorganization of the
Company under Chapter 11, also increased $9.7 million from $4.2 million for the
three months ended June 30, 2000 to $13.9 million for the three months ended
June 30, 2001. Reorganization items consist of income, expenses and other costs
directly related to the reorganization of the Company incurred in connection
with the Chapter 11 Filings (see Note 3 of the unaudited condensed consolidated
financial statements).

     FISCAL 2001 YEAR TO DATE COMPARED TO FISCAL 2000 YEAR TO DATE

         Net revenues totaled $1,569.5 million for the nine months ended June
30, 2001, a decrease of approximately $41.8 million or 2.6% from the comparable
period in fiscal year 2000. The decrease is primarily attributable to a decrease
of approximately $23.5 million or 12.7% in net revenues for pharmacy services
due to a decline in the number of beds served during the nine months ended June
30, 2001 as compared to the nine months ended June 30, 2000. In addition, the
closure of five institutional pharmacies during fiscal year 2000 also
contributed to the decrease in pharmacy services revenue. Net revenues for
inpatient nursing home services decreased approximately $19.0 million or 1.4%
for the nine months ended June 30, 2001 as compared to the nine months ended
June 30, 2000. The impact of the divestiture of inpatient nursing home
facilities resulted in a decrease in net revenues of approximately $118.1
million for the nine months ended June 30, 2001 as compared to the nine months
ended June 30, 2000. This decrease in net revenues was partially offset by an
increase of approximately $99.1 million from the nine months ended June 30, 2000
to the nine months ended June 30, 2001 for the current portfolio of inpatient
nursing home facilities. The increase resulted primarily from higher average per
diem rates during the nine months ended June 30, 2001 as compared to the nine
months ended June 30, 2000 mainly due to increases in Medicaid rates (7.4%) and
Medicare rates (4.3%) as a result of recent legislative relief to mitigate the
reduction in reimbursement under PPS (see "- Healthcare Regulatory Matters"). In
addition, although census remained relatively stable for the nine months ended
June 30, 2001 as compared to comparable period of the prior year, there was a
slight improvement in revenue by payor mix which also resulted in increased
revenues for the current year as compared to the prior year.

         Costs and expenses, excluding depreciation and amortization, totaled
$1,479.9 million for the nine months ended June 30, 2001, a decrease of $87.7
million or 5.6% from the comparable period of fiscal year 2000. These costs and
expenses primarily consist of salaries, wages, and employee benefits, which
represent approximately $892.1 million or 60.3% of the total for the nine months
ended June 30, 2001 as compared to $916.8 million or 58.5% of the total for the
nine months ended June 30, 2000. Various federal, state and local regulations
impose, depending on the services provided, a variety of regulatory standards
for the type, quality, and level of personnel required to provide care or
services. The regulatory requirements have an impact on staffing levels, as well
as the mix of staff, and therefore impact salaries, wages and employee benefits.
The decrease in salaries, wages and benefits of approximately $24.7 million for
the nine months ended June 30, 2001 as compared to the same period in fiscal
year 2000 is due to multiple factors including the impact of the divestiture of
inpatient nursing home facilities and the Company's continued efforts to reduce
overhead costs. This reduction has been partially offset by rising labor costs
in certain of its markets and the Company expects this trend to continue for the
foreseeable future. See "--Liquidity and Capital Resources"). The cost of
ancillary services, which includes pharmaceuticals and therapy decreased
approximately $13.3 million or 7.2% for the nine



                                       26
<PAGE>   29

months ended June 30, 2001 as compared to the nine months ended June 30, 2000.
Costs for ancillary services are affected by the level of service provided and
patient acuity and the decrease is primarily a result of a reduction in pharmacy
services volume offset in part by an increase in per unit drug costs and a
change in pharmacy product mix. Rent decreased approximately $16.4 million or
23.7% to $52.7 million for the nine months ended June 30, 2001 as compared to
the same period in fiscal year 2000 mainly due to the impact of the divestiture
of inpatient nursing home facilities. General and administrative expenses, which
include the indirect administrative costs associated with operating the Company
and its lines of business, decreased approximately $29.2 million or 15.8% for
the nine months ended June 30, 2001 as compared to the same period in fiscal
year 2000 mainly as a result of the Company's continued efforts to reduce
overhead costs.

         Depreciation and amortization costs were $40.0 million for the nine
months ended June 30, 2001, a decrease of approximately $4.2 million or 9.6%,
which is due to the impact of the divestiture of inpatient nursing home
facilities and the result of the Company recording an impairment charge of $19.4
million in the fourth quarter of fiscal year 2000.

         Effective January 18, 2000, the Company discontinued accruing interest
relating to its debt facilities currently classified as liabilities subject to
compromise in accordance with SOP 90-7. Contractual interest for the nine months
ended June 30, 2001 and 2000 was $163.5 million and $179.2 million,
respectively, which is $159.4 million and $111.1 million in excess of interest
expense included in the unaudited condensed consolidated financial statements.

         Reorganization items totaled $29.9 million for the nine months ended
June 30, 2001 as compared to $4.4 million for the nine months ended June 30,
2001. The increase of approximately $25.5 million is attributable to an increase
of approximately $15.4 million for professional fees incurred in connection with
the reorganization of the Company under Chapter 11. In addition, net gain on
divestiture included in reorganization items decreased from $11.0 million for
the nine months ended June 30, 2000 to $5.8 million for the nine months ended
June 30, 2001. During the nine months ended June 30, 2000, the Company realized
a net gain of approximately $10.0 million due to a settlement agreement reached
with Senior Housing Properties related to certain leased facilities (see Note 4
of the unaudited condensed consolidated financial statements). Reorganization
items consist of income, expenses and other costs directly related to the
reorganization of the Company incurred in connection with the Chapter 11 Filings
(see Note 3 of the unaudited condensed consolidated financial statements).

     SEASONALITY

         The Company's revenues and operating income generally fluctuate from
quarter to quarter. This seasonality is related to a combination of factors
which include the timing of third party payment rate changes, the number of work
days in a given period and seasonal census cycles.

     LIQUIDITY AND CAPITAL RESOURCES OF THE COMPANY

         Overview. Cash and cash equivalents were $201.6 million at June 30,
2001. The Company and its subsidiaries also have available $75.0 million in DIP
financing, as described below, none of which was borrowed as of such date except
for approximately $6.0 million of letters of credit issued under the Company DIP
Financing. In addition, during July 2001 PNC issued the Replacement MHG Surety
LOC (as defined herein) under the Mariner Health DIP Financing in the amount of
$7.9 million. Subsequent to June 30, 2001, Mariner Health posted approximately
$8.3 million of cash collateral with PNC Bank to collateralize the MHG
Replacement Surety LOC, and made a $15.0 million adequate protection payment to
the Mariner Health Principal Secured Lenders in connection with the extension of
the Mariner Health DIP Credit Facility to December 31, 2001. During the nine
months ended June 30, 2001 working capital increased $69.3 million from $309.5
million at September 30, 2000 to $378.8 million at June 30, 2001.

         Cash provided by operating activities was $63.0 million for the nine
months ended June 30, 2001 as compared to $60.3 million provided by operating
activities for the nine months ended June 30, 2000. Receivables increased $53.0
million in the nine months ended June 30, 2001 principally in the Company's
nursing home segment resulting from an increase in average days outstanding due
to multiple factors including increased nursing home services revenues in the
nine month period ended June 30, 2001 as compared to the nine month period ended
September 30, 2000 and seasonal cycles, including timing of third party
payments. Long-term insurance reserves increased approximately $35.2 million


                                       27
<PAGE>   30

resulting from the provision for the current period and reduction in claims
settled due to the automatic stay protection afforded by the Chapter 11 Filings.

         Cash used in investing activities was $12.4 million for the nine months
ended June 30, 2001 as compared to $8.1 million provided by investing activities
for the nine months ended June 30, 2000. Cash used in investing activities
primarily consisted of the use of $22.9 million related to capital expenditures
for the nine months ended June 30, 2001. Cash used in investing activities also
included $7.7 million of proceeds from the sale of property, equipment and other
assets (see Note 4 of the unaudited condensed consolidated financial
statements).

         Cash used in financing activities was $19.6 million in the nine months
ended June 30, 2001 as compared to cash used in financing activities of $3.3
million for the nine months ended June 30, 2000. Cash used in financing
activities included principal repayments of prepetition long-term debt of $19.6
million for the nine months ended June 30, 2001.

         The primary sources of revenue for the Company are the federal Medicare
program and the state Medicaid programs. Although payment cycles for these
programs vary, payments generally are made within 30 to 60 days after services
are provided. For Medicare cost reporting periods beginning July 1, 1998 and
thereafter, the federal Medicare program converted to PPS for skilled nursing
facility services. Since the end of the third quarter of 1999, all of the
Company's skilled nursing facilities have been reimbursed under PPS, which
provides acuity-based rates that are established at the beginning of the
Medicare reporting year. See "--Healthcare Regulatory Matters." Payments for
nursing facility services that are provided to Medicaid recipients are paid at
rates that are set by each individual state's Medicaid program.

         For cost reporting periods that ended before the start of PPS, the
facilities were (and to the extent final cost reports for prior periods are not
settled, still are) reimbursed under Medicare on the basis of reasonable and
necessary costs as determined from annual cost reports. This retrospective
settlement system resulted in final cost report settlements that generally were
not finally settled until two years after the end of the cost reporting period
and that could be further delayed by appeals and litigation. PPS has had a
material adverse effect on the Company's financial condition and, although the
effects of PPS have been somewhat ameliorated by recent legislation, PPS is in
large part responsible for the inability of the Company to operate under its
existing capital structure. See "--Healthcare Regulatory Matters."

         The Company provides certain services and supplies between subsidiary
companies, some of which are charged at cost and others of which are charged at
market rates. Subject to certain exceptions, Medicare's "related organization
principle" generally requires that services and supplies furnished to nursing
facilities by related entities be included in the nursing facility's
reimbursable cost at the cost of the supplying entity. The Company believes that
the services and supplies furnished to nursing facilities at market rates
qualify for exception to the related organization principle. Certain of the
Company's Medicare fiscal intermediaries have taken the position that the
related party transactions do not qualify for this exception to the related
party rules and have made adjustments that reduce Medicare allowable cost to the
cost of the supplying entity. During the third quarter of fiscal 1999, the
intermediaries for the Mariner Health facilities reopened previously settled
cost reports to impose such related party adjustments for services furnished to
the facilities by Mariner Health's rehabilitation subsidiary. All related party
adjustments have been or will be appealed, if not resolved in connection with
the HCFA Global Settlement, to the Provider Reimbursement Review Board (the
"PRRB") and through the full appeal process as is warranted. The adjustments
affect only periods during which the facilities were reimbursed for Medicare on
the basis of reasonable and necessary cost; there would not be any impact for
periods that are reimbursed under PPS.

         During the third quarter of fiscal 1999, the Medicare fiscal
intermediaries for the subsidiaries operated by Mariner Health reopened
approximately fifty 1995 and 1996 cost reports and issued revised notices of
program reimbursement ("NPRs") imposing prudent buyer or related party
adjustments as well as applying an administrative resolution related to the cost
report treatment of admissions costs. The reopenings resulted in reductions in
reimbursable costs of approximately $16.9 million. The Company believes that it
has substantial arguments for both issues and has appealed the adjustments to
the PRRB. In lieu of recoupment by the fiscal intermediary, the Company reached
an agreement with HCFA and the intermediary and implemented an extended
repayment plan. The balance as of the date of the agreement was approximately
$15.9 million, which was repaid over a period of one year. The intermediary has


                                       28
<PAGE>   31

completed audit procedures but has not issued NPR's for most of the remaining
cost based Mariner Health cost reports (1997 and 1998). As part of the chapter
11 process, the Company and Mariner Health entered into stipulations with the
U.S. Department of Health and Human Services whereby, among other things, HCFA
will not recoup certain prepetition overpayments for the pendancy of the
Company's and Mariner Health's DIP Financing (as defined below) obligations.
Accordingly, repayment obligations which may arise from the issuance of NPRs may
be stayed for an interim period. Should the NPRs result in a repayment
requirement not within the purview of the stipulation, or after the pendancy of
the DIP obligations, the Company and Mariner Health would seek to enter into an
extended repayment plan with HCFA at that time. However, the Company expects
that all of the open cost-based cost reporting periods will be included in the
HCFA Global Settlement. See "--Results of Operations." However, there can be no
assurance that the HCFA Global Settlement will include all open cost-based cost
reporting periods.

         Although the Company has over the course of the last year seen a
reduction in its labor costs through the divestiture of facilities and various
business lines as well as corporate overhead reductions, this reduction has been
partially offset by wage increases for various nursing staff positions in
certain markets in which the Company plans to continue operations. While this
has not yet had a material adverse effect on the Company's operations, there can
be no assurance that an increase in nursing staff wages will not have such an
effect in the future. The Company believes that these increases are a result of
a decrease in the number of people entering the nursing profession and an
increased demand for nurses in the healthcare industry. The Company has
experienced increased staffing requirements in order to maintain compliance with
various Medicaid Programs. The Company anticipates that the nursing staff
shortage will accelerate, especially in light of a demographic review indicating
that a significant percentage of people engaged in the nursing profession are
nearing retirement age with no significant group of younger nursing staff
candidates to fill anticipated vacancies. The Company is exploring ways in which
to address this problem, including recruiting labor from overseas and providing
incentives for nurses to remain in the Company's employment.

         General liability and professional liability ("GL/PL") insurance costs
for the long-term care industry, particularly in Florida and Texas, where the
Company maintains significant operations, continue to rise at a dramatic rate.
Significant increases in the number of claims and the amount of an average claim
continue. Insurance markets have responded to this significant increase by
severely restricting the availability of long-term care GL/PL coverage. As a
result of the changes described above, fewer companies are engaged in insuring
long-term care companies; and those that do offer insurance coverage do so at a
very high cost. This is in large part a result of plaintiff lawyer activity in
certain markets in which the Company operates. The Company anticipates that this
trend will continue, and that its GL/PL costs will continue to increase. These
increases have already had an adverse effect on the Company's operations. The
Company is attempting to address this issue through supporting tort reform
initiatives in certain markets, and has had very limited success in this regard.
On May 4, 2001, the Florida legislature passed a bill, which was signed into law
and went into effect on May 15, 2001, designed to provide insurance reform for
nursing homes and increase quality of care (the "Florida Tort Reform Act"). The
Company is unable to ascertain at this time what effect, if any, the Florida
Tort Reform Act will have on its GL/PL insurance costs. No assurance can be
given that the Company's GL/PL costs will not continue to rise, that GL/PL
coverage will be available to the Company in the future, or that the tort reform
initiatives will be successful or have the desired outcome.

         As previously noted, the MHG Principal Secured Lenders filed with the
Bankruptcy Court the MHG Bank Groups' Plan and a proposed disclosure statement
with respect thereto; the adequacy of the proposed disclosure statement was
subsequently approved by the Bankruptcy Court at a hearing held on August 7,
2001. The MHG Bank Groups' Plan contemplates the termination of the existing
management arrangement pursuant to which the Company manages Mariner Health's
assets. In the event that the MHG Bank Groups' Plan is confirmed by the
Bankruptcy Court, the revenue to the Company provided by the existing
management arrangement would no longer be available and this loss of revenues
would have an adverse effect on the Company. Accordingly, if the MHG Bank
Groups' Plan is confirmed, the Company will be required to substantially reduce
its overhead costs. No assurance can be given as to whether the Company can
achieve these reductions in an expeditious fashion.

         Prepetition Debt. Due to the failure to make scheduled payments, comply
with certain financial covenants and the commencement of the Chapter 11
Proceedings, the Company is in default on all, or substantially all, of its
prepetition debt obligations. Except as otherwise may be determined by the
Bankruptcy Court, the automatic stay protection afforded by the Chapter 11
Filings prevents any action from being taken with regard to any of the defaults
under the prepetition debt obligations. These obligations are classified as
liabilities subject to compromise at June 30, 2001 and September 30, 2000.

         The obligations of the Company under its senior credit facility are
guaranteed by substantially all of the Company's subsidiaries other than the
Omega Debtors, Mariner Health and the Mariner Health Subsidiaries, and are
secured by substantially all of the otherwise unencumbered owned assets of the
Company and such subsidiaries. Mariner Health's obligations under its senior
credit facility are guaranteed by substantially all of the Mariner Health
Subsidiaries and are secured by substantially all of the otherwise unencumbered
assets of Mariner Health and such subsidiary guarantors. Unlike other
subsidiaries of the Company (the "Non-Mariner Health Subsidiaries"), Mariner
Health and the Mariner Health Subsidiaries neither guarantee the Company's
obligations under the Company's debt facilities nor pledge their assets to
secure such obligations. Correspondingly, the Company and the Non-Mariner Health
Subsidiaries do not guarantee or assume any obligations under the Mariner Health
debt facilities. Mariner Health and the Mariner


                                       29
<PAGE>   32

Health Subsidiaries are not subject to the covenants contained in the Company's
debt facilities, and the covenants contained in the Mariner Health debt
facilities are not binding on the Company and the Non-Mariner Health
Subsidiaries.

         No principal payments have been made on prepetition indebtedness since
the Petition Date with the exception of repayments made against the Company's
senior credit facility, primarily as a result of the application of certain cash
proceeds received from the sales of certain facilities and other assets,
adequate protection payments with regard to certain mortgaged facilities, and
notional amounts related to certain capital equipment leases, as adequate
protection payments, as more particularly described below (see
"--Debtor-in-Possession Financing for the Company"). In addition, during July
2001, Mariner Health made a $15.0 million repayment against the Mariner Health
senior credit facilities as an adequate protection payment pursuant to the
amendment to the Mariner Health DIP Credit Agreement, which, among other things,
extended the maturity date of the Mariner Health DIP Financing to December 31,
2001 (see "--Debtor-in-Possession Financing for Mariner Health").

         Debtor-in-Possession Financing for the Company. In connection with the
Chapter 11 Filings, the Company entered into a $100.0 million
debtor-in-possession financing agreement (as amended from time to time, the
"Company DIP Credit Agreement") with a group of banks (the "Company DIP
Lenders") led by The Chase Manhattan Bank ("Chase"). On March 20, 2000 the
Bankruptcy Court granted final approval (the "Final Company DIP Order") of the
Company DIP Financing.

         The Company DIP Credit Agreement initially established a $100.0 million
secured revolving credit facility to provide funds for working capital and other
lawful corporate purposes for use by the Company and the other Company Debtors.
At the request of the Company, the size of the Company DIP Financing was reduced
to $50.0 million on January 11, 2001. The Company DIP Credit Agreement provides
that amounts outstanding under the Company DIP Financing may not at any time
exceed the maximum borrowing amounts established for the Company under the Final
Company DIP Order or the Company's borrowing base of eligible accounts
receivable (the "Company Borrowing Base"). Up to $10.0 million of the Company
DIP Financing may be utilized for the issuance of letters of credit as needed in
the business of the Company Debtors. Interest accrues on the principal amount
outstanding under the Company DIP Financing at a per annum rate of interest
equal to the Alternative Base Rate of Chase ("ABR") plus three percent (3%) and
is payable monthly in arrears. During the existence and continuation of a
default in the payment of any amount due and payable by the Company Debtors
under the Company DIP Credit Agreement, interest will accrue at the default rate
of ABR plus five percent (5%) per annum.

         The terms of the Company DIP Financing require that the Company prepay
principal to the extent that the principal amount outstanding under the Company
DIP Financing at any time exceeds the Company Borrowing Base then in effect. To
the extent proceeds of loans under the Company DIP Financing are used to
complete the construction of certain healthcare facilities (which proceeds are
not permitted to exceed $8.8 million), proceeds from the sale of any such
properties must be used first to repay any portion of the loans made pursuant to
the Company DIP Financing, with 75% of any remaining net cash proceeds to be
applied as an adequate protection payment to the lenders under the Company's
prepetition senior credit facility, and the remaining 25% of such excess net
cash proceeds to be retained by the Company or its applicable subsidiary as
additional working capital. Pursuant to the terms of the Final Company DIP
Order, 75% of the net cash proceeds of other asset sales approved by the
Bankruptcy Court and the requisite Company DIP Lenders are to be applied as an
adequate protection payment to the lenders under the Company's prepetition
senior credit facility. The Company has the right to make optional prepayments
in increments of $1.0 million, and to reduce the commitment under the Company
DIP Credit Agreement in increments of $5.0 million.

         The obligations of the Company under the Company DIP Credit Agreement
are jointly and severally guaranteed by each of the other Company Debtors,
except for certain Company Debtors owning facilities mortgaged to Omega
Healthcare Investors, Inc. (the "Omega Debtors") whose guarantee is limited to
the negative cash flows of the Omega Debtors, pursuant to the Company DIP Credit
Agreement, the Final Company DIP Order and the Final Company Cash Collateral
Order (defined below). Under the terms of the Final Company DIP Order, the
obligations of the Company Debtors under the Company DIP Credit Agreement (the
"Company DIP Obligations") constitute allowed superiority administrative expense
claims pursuant to section 364(c)(1) of the Bankruptcy Code (subject to a carve
out for certain professional fees and expenses incurred by the Company Debtors).
The Company DIP Obligations are secured by


                                       30
<PAGE>   33

perfected liens on all or substantially all of the assets of the Company Debtors
(excluding bankruptcy causes of action), the priority of which liens (relative
to prepetition creditors having valid, non avoidable, perfected liens in those
assets and to any "adequate protection" liens granted by the Bankruptcy Court)
is established in the Final Company DIP Order and the related cash collateral
order entered by the Bankruptcy Court (the "Final Company Cash Collateral
Order"). The Bankruptcy Court has also granted certain prepetition creditors of
the Company Debtors replacement liens and other rights as "adequate protection"
against any diminution of the value of their existing collateral that may result
from allowing the Company Debtors to use cash collateral in which such creditors
had valid, non-avoidable and perfected liens as of the Petition Date. The
discussion contained in this paragraph is qualified in its entirety by reference
to the Final Company DIP Order, the Final Company Cash Collateral Order, and
related stipulations, and reference should be made to such orders (which are
available from the Bankruptcy Court) and stipulations for a more complete
description of such terms.

         The Company DIP Credit Agreement contains customary representations,
warranties and other affirmative and restrictive covenants of the Company
Debtors, as well as certain financial covenants relating to minimum EBITDA,
maximum capital expenditures, and minimum patient census. The breach of such
representations, warranties or covenants, to the extent not waived or cured
within any applicable grace or cure periods, could result in the Company being
unable to obtain further advances under the Company DIP Financing and possibly
the exercise of remedies by the Company DIP Lenders, either of which events
could materially impair the ability of the Company to successfully reorganize in
chapter 11 and to operate as a going concern. Such a default may also impair the
ability of the Company to use cash collateral to fund operations. At June 30,
2001, no revolving loans were outstanding under the Company DIP Financing and
approximately $6.0 million of letters of credit issued under the Company DIP
Credit Agreement were outstanding.

         The outstanding principal of the Company DIP Financing, together with
all accrued and unpaid interest and all other obligations thereunder, was
originally due and payable one year from the Petition Date. With the approval of
the Bankruptcy Court, the Company Debtors, Chase and the requisite Company DIP
Lenders amended the Company DIP Credit Agreement as of January 11, 2001, to
(among other things) extend the maturity date of the Company DIP Financing from
January 19, 2001 to August 31, 2001. Effective as of January 19, 2001, the
Company exercised its right under the Company DIP Credit Agreement to reduce the
$100.0 million Company DIP Financing commitment to $50.0 million. The scheduled
termination date of the Company DIP Credit Facility was subsequently extended to
December 31, 2001 by amendment to the Company DIP Credit Agreement dated as of
June 26, 2001, and approved by the Bankruptcy Court on August 7, 2001.

         Debtor-in-Possession Financing for Mariner Health. Among the orders
entered by the Bankruptcy Court on the Petition Date in the Chapter 11
Proceedings of Mariner Health and its subsidiaries were orders approving (a) the
use of cash collateral by the Mariner Health Debtors, and (b) the funding of up
to $50.0 million in principal amount at any time outstanding under a
debtor-in-possession financing arrangement (the "Mariner Health DIP Financing"
and together with the Company DIP Financing, the "DIP Financings") pursuant to
that certain Debtor-in-Possession Credit Agreement dated as of January 20, 2000
(as amended from time to time, the "Mariner Health DIP Credit Agreement") by and
among Mariner Health and each of the other Mariner Health Debtors, as
co-borrowers thereunder, the lenders signatory thereto as lenders (the "Mariner
Health DIP Lenders"), First Union National Bank, as Syndication Agent, PNC
Capital Markets, Inc. and First Union Securities, Inc., as co-arrangers, and PNC
Bank, National Association ("PNC"), as Administrative Agent and Collateral
Agent. After a final hearing on February 16, 2000, the Bankruptcy Court entered
into an order granting final approval of the Mariner Health DIP Financing (the
"Final Mariner Health DIP Order").

         The Mariner Health DIP Credit Agreement initially established a $50.0
million secured revolving credit facility comprised of a $40.0 million tranche A
revolving loan commitment and a $10.0 million tranche B revolving loan
commitment. At the request of Mariner Health, the size of the Mariner Health DIP
Financing was reduced to $25.0 million on January 19, 2001. As a result of such
reduction, the $10.0 million tranche B revolving loan commitment was eliminated.
Under the Mariner Health DIP Credit Agreement's terms, advances under the
Mariner Health DIP Financing may be used by the Mariner Health Debtors (and to a
limited degree, by certain joint venture subsidiaries of Mariner Health that are
not debtors in the Mariner Health Chapter 11 Proceedings) for working capital
and other lawful corporate purposes. Amounts outstanding under the Mariner
Health DIP Financing may not at any time exceed the


                                       31
<PAGE>   34

maximum borrowing amounts established for the Mariner Health Debtors under the
Final Mariner Health DIP Order. Originally, up to $5.0 million of the Mariner
Health DIP Financing could be utilized for the issuance of letters of credit as
needed in the businesses of the Mariner Health Debtors; however, the letter of
credit sublimit was increased to $10.0 million pursuant to the Tenth Amendment
to the Mariner Health DIP Credit Agreement dated as of March 20, 2001 (the
"Tenth Mariner Health DIP Amendment").

         Interest accrues on the principal amount outstanding under the Mariner
Health DIP Financing at a per annum rate of interest equal to the "base rate" of
PNC (i.e., the higher of the PNC prime rate or a rate equal to the federal funds
rate plus 50 basis points) plus the applicable spread, which is 250 basis
points. Such interest is due and payable monthly in arrears. During the
existence and continuation of any event of default under the Mariner Health DIP
Credit Agreement, the interest rates normally applicable to loans under the
Mariner Health DIP Financing will be increased by another 250 basis points per
annum.

         The outstanding principal of the Mariner Health DIP Financing, together
with all accrued and unpaid interest and all other obligations thereunder, are
due and payable on the Commitment Termination Date, defined as the first to
occur of (i) January 19, 2001, unless extended (see discussion below regarding
extensions to date); (ii) the effective date of a joint plan of reorganization
for the Mariner Health Debtors; (iii) the date of termination of the exclusivity
rights of the Mariner Health Debtors to file a plan of reorganization; (iv) the
filing by the Mariner Health Debtors of any plan of reorganization (or the
modification of any such plan previously filed with the Bankruptcy Court) not
previously approved by the holders of at least 66-2/3% of the outstanding loans
or commitments under the Mariner Health DIP Financing; (v) the date of
termination of the commitments under the Mariner Health DIP Credit Agreement
during the continuation of an event of default thereunder; or (vi) the date on
which all or substantially all of the assets or stock of the Mariner Health
Debtors is sold or otherwise transferred. Under the Mariner Health DIP Credit
Agreement's current terms, the Mariner Health Debtors must also prepay principal
to the extent that the principal amount outstanding under the Mariner Health DIP
Financing at any time exceeds the Mariner Health borrowing base then in effect.
The Mariner Health borrowing base for any month is an amount equal to $7.5
million in excess of the "Working Capital Facility" borrowings projected for
such month in Mariner Health's year 2000 DIP budget, plus (as a result of the
Tenth Mariner Health DIP Amendment), the undrawn availability under the $7.9
million letter of credit issued by PNC pursuant to the Mariner Health DIP
Credit Agreement to secure Mariner Health's obligations in respect of its
replacement surety program (the "Replacement MHG Surety LOC").

         The Mariner Health DIP Credit Agreement also provides for mandatory
prepayments under the following circumstances: (a) with net cash proceeds from
asset sales, the incurrence of certain debt, the issuance of new equity, the
receipt of tax refunds exceeding $100,000 in the aggregate, and the receipt of
casualty proceeds in excess of $100,000 that are not applied within 60 days
after receipt to the repair, rebuilding, restoration or replacement of the
assets damaged or condemned (or committed within such period of time to be so
applied); and (b) on each business day, the amount of cash held by the Mariner
Health Debtors in excess of the sum of $5.0 million plus the aggregate sum of
the minimum amount required by depositary banks to be kept in deposit accounts,
concentration accounts and other accounts with such banks. Amounts prepaid
pursuant to clause (a) of the immediately preceding sentence will permanently
reduce the amount of the Mariner Health DIP Financing commitments on a dollar
for dollar basis. Amounts prepaid pursuant to clause (b) of the same sentence
will not permanently reduce such commitments. The Mariner Health Debtors have
the right to make optional prepayments in the minimum principal amount of $1.0
million, and in increments of $100,000 in excess thereof, and, on three business
days' notice, to reduce the commitments under the Mariner Health DIP Credit
Agreement in the minimum amount of $5.0 million, or in increments of $1.0
million in excess thereof.

         As provided in the Final Mariner Health DIP Order, the obligations of
the Mariner Health Debtors under the Mariner Health DIP Credit Agreement
(together with certain potential cash management system liabilities secured on a
pari passu basis therewith, the "Mariner Health DIP Obligations") constitute
allowed super priority administrative expense claims pursuant to section
364(c)(1) of the Bankruptcy Code (subject to a carve-out for certain
professional fees and expenses incurred by the Mariner Debtors). The Mariner
Health DIP Obligations are secured by perfected liens on all or substantially
all of the assets of the Mariner Health Debtors (excluding bankruptcy causes of
action), the priority of which liens (relative to prepetition creditors having
valid, non-avoidable, perfected liens in those assets and to any "adequate
protection" liens granted by the Bankruptcy Court) is established in the Final
Mariner Health DIP Order and the related cash collateral orders entered by the
Bankruptcy Court (the "Mariner Health Cash Collateral Order"). The Bankruptcy
Court has also granted certain prepetition creditors of the Mariner Health
Debtors replacement liens and


                                       32
<PAGE>   35

other rights as "adequate protection" against any diminution of the value of
their existing collateral that may result from allowing the Mariner Health
Debtors to use cash collateral in which such creditors had valid, non-avoidable
and perfected liens as of the Chapter 11 Filings. The discussion contained in
this paragraph is qualified in its entirety by reference to the Final Mariner
Health DIP Order, the related Mariner Health Cash Collateral Orders, and related
stipulations, and reference should be made to such orders (which are available
from the Bankruptcy Court) and stipulations for a more complete description of
such terms.

         The Mariner Health DIP Credit Agreement contains customary
representations, warranties and other affirmative and restrictive covenants of
the Mariner Health Debtors, as well as certain financial covenants relating to
minimum EBITDAR, minimum patient census, minimum eligible accounts receivable,
maximum variations from Mariner Health's year 2000 DIP budget and maximum
capital expenditures. The breach of such representations, warranties or
covenants, to the extent not waived or cured within any applicable grace or cure
periods, could result in the Mariner Health Debtors being unable to obtain
further advances under the Mariner Health DIP Financing and possibly the
exercise of remedies by the Mariner Health DIP Lenders, either of which events
could materially impair the ability of the Mariner Health Debtors to
successfully reorganize in chapter 11 and to operate as a going concern.

         Among its other restrictive covenants, the Mariner Health DIP Credit
Agreement limits affiliate transactions with the Company Debtors, but does
contemplate weekly overhead payments to the Company equal to 1.25% of projected
net inpatient revenues for the then-current month, subject to a monthly
"true-up," such that the payments for such month equal 5% of actual net
inpatient revenues of the Mariner Health Debtors. Such payments may be suspended
by the Mariner Health Debtors if certain defaults specified in the Mariner
Health DIP Credit Agreement occur and are continuing, though such fees will
still accrue and will become due and payable if and when the subject default has
been cured or waived.

         By amendment dated as of January 19, 2001, and with the approval of the
Bankruptcy Court, the Mariner Health DIP Credit Agreement was amended to extend
the stated termination date of the Mariner Health DIP Credit Agreement from
January 19, 2001 to July 19, 2001 (which has subsequently been extended by
amendment dated as of July 19, 2001, to December 31, 2001), and to reduce the
maximum amount of the Mariner Health DIP Financing from $50.0 million to $25.0
million (as a result of which the tranche B component was eliminated). Such
amendment also, among other things, extended the deadline for filing a plan of
reorganization to February 20, 2001, imposed a 25 basis point utilization fee on
borrowings under the Mariner Health DIP Financing in excess of $5.0 million and
amended certain reporting requirements. An amendment dated as of March 20, 2001,
among other things, increased the letter of credit sublimit and the borrowing
base to permit the issuance of a $7.9 million letter of credit (the "MHG
Replacement Surety LOC") to facilitate implementation of a replacement surety
bond program by Mariner Health, which was issued in July 2001. Because the MHG
Replacement Surety LOC expires well after the Commitment Termination Date for
the Mariner Health DIP Facility, the March 20, 2001 amendment required such
letter of credit to be 105% cash collateralized.

         On or about May 14, 2001, Mariner Health and representatives of the
Mariner Health DIP Lenders and the Mariner Health prepetition senior bank group
(the "Mariner Health Principal Secured Lenders") entered into a stipulation (the
"May 14 Stipulation") (i) extending from May 21, 2000 to July 20, 2001, the
Mariner Health Debtors' exclusive right to file a plan of reorganization, and
(ii) if they file a plan within that time, extending the Mariner Health Debtor's
exclusive right to solicit acceptances of such plan to September 20, 2001;
however, such exclusivity rights are modified in that stipulation to permit the
Mariner Health Principal Secured Lenders to file their own plan or plans of
reorganization for the Mariner Health Debtors and to solicit acceptances
thereto, or (at the sole option of the Mariner Health Principal Secured Lenders)
to file a joint plan of reorganization with the Mariner Health Debtors and
solicit acceptances thereto. The May 14 Stipulation was subsequently approved by
the Bankruptcy Court. The May 14 Stipulation constituted a waiver by the Mariner
Health DIP Lenders of the covenant in the Mariner Health DIP Credit Agreement
that the Mariner Health Debtors file a plan of reorganization by a certain time
and an agreement that the modification of the Mariner Health Debtors'
exclusivity rights pursuant to that stipulation would not constitute an event of
default under the Mariner Health DIP Credit Agreement.


                                       33
<PAGE>   36
         Omega Settlement. After extensive negotiations with Omega, the Company,
GranCare and the Omega Debtors entered into a Settlement Agreement with Omega
dated as of August 1, 2001 (the "Omega Settlement Agreement"), proposing to
restructure the Company's existing $58.8 million prepetition mortgage loan (the
"Omega Loan") from Omega to Professional Health Care Management, Inc., a wholly
owned subsidiary of GranCare ("PHCMI") and resolve related disputes, by
modifying the Omega Loan and entering into certain related transactions
(collectively, the "Omega Loan Modification"). The Omega Debtors are the owners
or operators of nine skilled nursing facilities in Michigan and three skilled
nursing facilities in North Carolina (collectively, the "Omega Facilities").

         Under the terms of the Omega Settlement Agreement, Omega has agreed
with the Company, GranCare and the Omega Debtors to modify the Omega Loan
(anticipated at closing to be in the amount of approximately $59.7 million, the
"Amended Omega Loan") by (i) extending the maturity thereof from 2007 to 2010,
with a one-time, 11-year extension option; (ii) providing for a catch-up payment
or payments of post-December 31, 2000 interest on the Omega Loan at the
compromise rate of $525,000 per month, plus an additional $300,000 (representing
interest at the rate of 11.25% per annum on the $8.0 million of principal on the
Omega Loan excluded from the parties' calculation of the $525,000 per month
compromise interest amount); (iii) providing for interest-only payments after
closing of the Omega Loan Modification at a substantially reduced interest rate
(11.57% per annum, compared to the current contractual rate of over 16%); (iv)
granting PHCMI a one-time option to prepay the Amended Omega Loan in full
between February 1, 2005 and July 31, 2005, at a prepayment price of 103% of
par, plus accrued and unpaid interest; (v) releasing the Company, GranCare and
the Omega Debtors from liability arising prior to the closing of the Omega Loan
Modification (including the GranCare "keepwell" agreement contained in the
prepetition Omega loan agreement), other than liability arising in connection
with the Omega Settlement Agreement and the loan documents evidencing,
guaranteeing and securing the Amended Omega Loan (the "Amended Omega Loan
Documents"); (vi) providing for payment to Omega of an annual amendment fee
equal to 25% of free cash flow from the Omega Facilities, and until the
occurrence of certain events, a monthly amendment fee equal to 50% of the
"return on equity" component of Medicaid reimbursement received from the State
of North Carolina with respect to the North Carolina Omega Facilities; and (vii)
providing for the management of the facilities subject to the Omega Loan by the
Company for a monthly base management fee of 5% of Omega Facility revenues, plus
an annual incentive management fee equal to 75% of free cash flow from such
facilities (reducing to 70% under certain circumstances).

         PHCMI will remain the borrower under the Amended Omega Loan, as it is
under the Omega Loan. The Amended Omega Loan will be guaranteed by PHCMI's
subsidiaries which are the licensed operators of the Omega Facilities (the
"Michigan Subsidiary Guarantors"), and also by another Company subsidiary,
Living Centers - PHCM, Inc. ("LC-PHCM", and together with the Michigan
Subsidiary Guarantors, the "Omega Guarantors"), as the owner of the Omega
Facilities located in North Carolina (such guaranties being referred to herein
as the "Amended Omega Guaranties"). The Amended Omega Loan and the Amended Omega
Guaranties will be secured by (i) amended mortgages or deeds of trust on the
Omega Facilities, (ii) amended, blanket security interests in the personal
property assets of PHCMI and the Omega Guarantors, and (iii) pledges of the
issued and outstanding capital stock of PHCMI and each of the Michigan
Subsidiary Guarantors.

         In addition, PHCMI has agreed in the Omega Settlement Agreement to
assign its residual 50% undivided interest in the $9.0 million purchase money
note (the "Ciena Note") received from the affiliate of Ciena Healthcare
Management, Inc. which acquired four former Michigan Omega Facilities from PHCMI
on or about February 1, 2001 (the "Ciena Facilities"). (The other 50% interest
was previously assigned by PHCMI to Omega at the closing of the sale of the
Ciena Facilities, in return for a $4.5 million credit against the Omega Loan
obligations.) The consideration for the assignment of PHCMI's remaining interest
in the Ciena Note would be approximately $3.5 million, plus 50% of aggregate
principal payments received under the Ciena Note in excess of $8 million and 50%
of interest payments received under the Ciena Note in excess of $960,000
annually.

         The Omega Loan Modification is subject to the approval of the
Bankruptcy Court and of the Company's DIP Lenders. A motion seeking Bankruptcy
Court approval was filed on August 2, 2001, with a hearing on the matter set for
August 22, 2001. The Company can give no assurances that the required approvals
will be obtained.

                                       34
<PAGE>   37
         The Company has reserved the option to cause the issued and outstanding
capital stock of LC-PHCM to be transferred, in one or more successive transfers,
to PHCMI, which would make LC-PHCM a wholly-owned subsidiary of PHCMI, and to
sell 51% of the issued and outstanding capital stock of PHCMI to a third-party
unrelated to either Omega or the Company (the "Majority PHCMI Equity Sale"). The
terms of the Majority PHCMI Equity Sale are currently being negotiated.

         Healthcare Regulatory Matters. The Balanced Budget Act of 1997 (the
"Balanced Budget Act") contains numerous changes to the Medicare and Medicaid
programs with the intent of slowing the growth of payments under these programs
by $115.0 billion and $13.0 billion, through the end of 2001 and 2002,
respectively. Approximately 50% of the savings are to be achieved through a
reduction in the growth of payments to providers and physicians. These cuts have
had, and will continue to have, a material adverse effect on the Company.

         The Balanced Budget Act amended the Medicare program by revising the
payment system for skilled nursing services. Historically, nursing homes were
reimbursed by the Medicare program based on the actual costs of services
provided. However, the Balanced Budget Act required the establishment of PPS, a
system where Medicare payments are prospectively determined for nursing homes
for cost reporting periods beginning on or after July 1, 1998. During the first
three years of PPS, nursing homes will receive a fixed per diem rate for each of
their Medicare Part A patients, based on a blend of facility specific rates and
Federal acuity adjusted rates. Thereafter, the per diem rates will be based
solely on Federal acuity adjusted rates. Subsumed in this per diem rate are
ancillary services, such as pharmacy and rehabilitation services, which
historically have been provided to many of the Company's nursing facilities by
the Company's pharmacy and therapy subsidiaries. The inclusion of ancillary
services in the PPS per diem payments has resulted in significantly lower
margins in the Company's pharmacy operations as a result of increased pricing
competition, a change in buying patterns by customers and the decision by the
Company to exit certain businesses previously operated by the Company such as
its third party therapy, home health and hospital contract management
businesses.

         Since the passage of the Balanced Budget Act, Congress has passed
additional legislation intended to temporarily mitigate the reduction in
reimbursement for skilled nursing facilities ("SNFs") under PPS. First, in
November 1999, Congress passed the Medicare Balanced Budget Refinement Act
("BBRA"). Second, in December of 2000, Congress passed the Medicare, Medicaid
and SCHIP Benefits Improvement and Protection Act of 2000 ("BIPA"). Effective
April 1, 2000, the BBRA temporarily increased the PPS per diem rates by 20
percent for 15 patient acuity categories, including medically complex patients,
pending revisions to PPS. The increases will remain in effect until HCFA
implements a refined schedule of payment rates for the Resource Utilization
Groups ("RUG") system that better accounts for nontherapy ancillary services
medically-complex patients. The revised payment rates may be more or less than
the temporary 20 percent increase under the BBRA. The BBRA also provides for a
4% increase in the federal per diem rate for all patient acuity categories for
the government fiscal years 2001 and 2002.

         Among other things, BIPA eliminates the scheduled reduction in the SNF
market basket update in government fiscal year 2001 and is implemented in two
phases. Specifically, the update rate for the period from October 1, 2000
through June 30, 2001 is the market basket index ("MBI") increase minus one
percentage point; the update for the period from April 1, 2001 through September
30, 2001 is the MBI increase plus one percentage point. This increase will not
be included when determining PPS payment rates for subsequent periods. In the
government fiscal years 2002 and 2003, payment updates will equal the MBI
increase minus one-half of a percentage point. Temporary increases in the
federal per diem rates under the BBRA will be in addition to these payment
increases. BIPA also increases payment for the nursing component of each RUG
payment category by 16.66% for services furnished after April 1, 2001 and before
October 1, 2002.

         Moreover, BIPA further refines certain consolidated billing
requirements established by the BBA. Specifically, effective January 1, 2001,
the law limits consolidated billing requirements to items and services furnished
to SNF residents in a Medicare Part A covered stay and to therapy services
covered under Medicare Part B. For residents not covered under a Part A stay
(e.g., Part A benefits exhausted), SNFs may choose to bill for non-therapy Part
B services and supplies, or they may elect to have suppliers continue to bill
Medicare directly for these services. BIPA also modifies the treatment of the
rehabilitation patient categories to ensure that Medicare payments for skilled
nursing facility residents with "ultra high" and "high" rehabilitation therapy
needs are appropriate in relation to payments for residents needing "medium" or
"low" levels of therapy. Specifically, effective for services furnished on or
after April 1, 2001 and before implementation of a refined RUG payment system,
BIPA increases the federal per diem payments for all 14 rehabilitation
categories by 6.7%. Additionally, the 20 percent additional payment provided for
under the BBRA for three rehabilitation categories is removed to make this
provision budget neutral. BIPA also permits the Secretary of


                                       35
<PAGE>   38

Health and Human Services (the "Secretary") to establish a process for
geographic reclassification of SNFs based upon the method used for inpatient
hospitals.

         As of July 1, 1999, all of the Company's SNFs were receiving Medicare
payments under PPS. In connection with the implementation of PPS, the government
has implemented a temporary payment system to transition SNFs from the prior
cost-based payment system to a payment system based entirely on federal per diem
rates. PPS transition rates vary from facility to facility depending on each
facility's base period cost that comprises the facility specific component of
the rates and the wage adjuster that is applied to the federal component of the
PPS payment rates. For many of the Company's facilities, the facility specific
base period cost is higher than the base period cost that was used to develop
the transitional PPS payment rates. For some facilities, however, the facility
base period cost is lower than the base period cost used to develop the PPS
transitional rates. Under BBRA, SNFs are allowed to elect transition to the
permanent federal rate at the beginning of their cost reporting periods
beginning on or after January 1, 2000. SNFs may make the election up to 30 days
after the start of their cost reporting period. The Company has taken advantage
of this election where appropriate.

         The Balanced Budget Act also revised the reimbursement methodology for
therapy services under Medicare Part B. Historically, Medicare Part B therapy
services were reimbursed based on the cost of the services provided, subject to
prudent buyer and salary equivalency restrictions. In November 1998, certain fee
screen schedules were published setting forth the amounts that can be charged
for specific therapy services. Additionally, the Balanced Budget Act sets forth
maximum per beneficiary limits of $1,500 per provider for physical therapy and
speech pathology and $1,500 per provider for occupational therapy. Both the fee
screens and per beneficiary limits were effective for services rendered
following December 31, 1998. The imposition of fee screens, together with the
inclusion of ancillary services in the federal per diem rate, has had a material
adverse effect on the Company's therapy business resulting in the decision by
the Company to terminate its contract and third party therapy operations. The
BBRA temporarily mitigates the Balanced Budget Act limitations by providing that
the therapy caps will not apply in government fiscal years 2000 and 2001. The
BBRA requires the Secretary to conduct focused medical reviews of therapy
services during government fiscal years 2000 and 2001, with an emphasis on
claims for services provided to residents of SNFs. The BBRA also requires the
Secretary to study and to submit recommendations to Congress on therapy
utilization patterns in government fiscal year 2000 compared to those in the
government fiscal years 1998 and 1999. Moreover, BIPA extends the moratorium on
the therapy caps for one additional year, through 2002. It also extends the
requirement for focused reviews of therapy claims for the same period.

         The BBRA also excludes certain items and services from the formerly
all-inclusive SNF per diem rates under PPS. Specifically, the following items
and services will become separately reimbursable outside of PPS rates: (i)
ambulance services furnished to an individual in conjunction with renal dialysis
services; (ii) chemotherapy items and administration services (as identified by
certain HCFA Common Procedure Coding System ("HCPCS") codes); (iii) radioisotope
services (as identified by certain HCPCS codes); and (iv) customized prosthetic
devices (artificial limbs) and other custom prostheses if provided to a SNF
resident and intended to be used after discharge (as identified by certain HCPCS
codes and other instances chosen by HCFA). Payment for such items and services,
which are "passed-through" the per diem payment rates, will be made under Part B
of Medicare, in conformance with Part B payment rules. Although these items are
separately reimbursed from the PPS rate, the BBRA also directs HCFA to make
appropriate adjustments to the PPS payments rates to reflect the fact that
certain items and services have been excluded, in order to ensure budget
neutrality.

         In the process of finalizing certain Medicare cost reports or reopening
previously finalized cost reports filed by various of the Company's Medicare
provider facilities, certain Medicare fiscal intermediaries have issued NPRs,
which include significant audit adjustments that reduce the amount of
reimbursement that previously was received by the facilities. The adjustments
are based, for the most part, on denials of exception to the related
organization principles (described below) with regard to services and supplies
furnished to the Company's facilities by the Company's pharmacy and
rehabilitation companies. Adjustments are also based on reductions to costs
claimed for therapy services under prudent buyer principles (described below).


                                       36
<PAGE>   39

         The prudent buyer principle states, in part, "the prudent and
cost-conscious buyer not only refuses to pay more than the going price for an
item or service, he also seeks to economize by minimizing cost." Certain of the
fiscal intermediaries have alleged that the Company was not prudent in its
purchase of occupational therapy and speech pathology services prior to HCFA's
establishing salary equivalency guidelines, effective April 1998. Fiscal
intermediaries calculated facilities' costs to provide services through employed
therapists and reduced costs claimed on the cost reports for providing services
through contracts and adjusted the cost reports accordingly. Appeals were filed
with the PRRB and resulted in a favorable outcome. However, on review the Social
Security Administrator reversed the PRRB and restored the intermediaries'
adjustments. The Company received a favorable judicial decision on its initial
prudent buyer appeal and currently is negotiating a settlement with HCFA for all
if its prudent buyer appeals as part of the HCFA Global Settlement.

         The related organization principle states, in part, "a provider's
allowable cost for services, facilities, and supplies furnished by a party
related to the provider are the costs the related party incurred in furnishing
the items in question." The regulations provide for an exception to the related
organization principle if certain requirements are met and the Company believes
that it meets these requirements with respect to services its facilities
previously received from related pharmacy and rehabilitation subsidiaries. Some
fiscal intermediaries have denied the request for exception and have made
adjustments to reduce the allowable cost that is included in nursing facility
cost reports to the cost of the related organization. The Company has requested
PRRB appeals for these adjustments, but the appeals have not yet been heard.
There can be no assurance that the Company will prevail in the appeal process.

         On January 12, 2001, the Secretary issued final regulations to
implement changes to the Medicaid "upper payment limit" requirements. The
purpose of the rule is to stop states from using certain accounting techniques
to inappropriately obtain extra federal Medicaid matching funds that are not
necessarily spent on health care services for Medicaid beneficiaries. Although
the rule will be phased in over eight years to reduce the adverse impact on
certain states, the rule eventually could result in decreased federal funding to
some state Medicaid programs, which, in turn, could prompt certain states to
reduce Medicaid reimbursements to providers, including nursing facilities.

         Other federal legislation requires major changes in the transmission
and retention of health information by the Company. The Health Insurance
Portability and Accountability Act of 1996 ("HIPAA") mandates, among other
things, the adoption of standards for the exchange of electronic health
information in an effort to encourage overall administrative simplification and
enhance the effectiveness and efficiency of the healthcare industry. Among the
standards that the Department of Health and Human Services will adopt pursuant
to HIPAA are standards for the following: electronic transactions and code sets;
unique identifiers for providers, employers, health plans and individuals;
security and electronic signatures; privacy; and enforcement.

         Although HIPAA was intended ultimately to reduce administrative
expenses and burdens faced within the healthcare industry, the Company believes
that the law will result in significant and costly changes. The Department of
Health and Human Services has released two rules to date mandating the use of
new standards with respect to certain healthcare transactions and health
information. The first rule requires the use of uniform standards for common
healthcare transactions, including healthcare claims information, plan
eligibility, referral certification and authorization, claims status, plan
enrollment and disenrollment, payment and remittance advice, plan premium
payments and coordination of benefits. It also establishes standards for the use
of electronic signatures.

         The second rule released by the Department of Health and Human Services
imposes new standards relating to the privacy of individually identifiable
health information. These standards not only require the Company's compliance
with rules governing the use and disclosure of protected health information, but
they also require the Company to impose those rules, by contract, on any
business associate to whom such information is disclosed. Rules governing the
security of health information have been proposed but have not yet been issued
in final form.

         The Department of Health and Human Services finalized the new
transaction standards on August 17, 2000, and the Company will be required to
comply with them by October 16, 2002. The privacy standards were issued on
December 28, 2000, and became effective on April 14, 2001 with a compliance date
of April 14, 2003. Sanctions for failing to comply with HIPAA include criminal
penalties and civil sanctions. The Company is in the process of quantifying the
costs associated with HIPAA compliance and believes they may be material.


                                       37
<PAGE>   40

         Other Factors Affecting Liquidity and Capital Resources. In addition to
outstanding principal and accrued interest payments on its long-term
indebtedness which generally are suspended as the consequence of the Chapter 11
Filings, the Company has significant rent obligations relating to its leased
facilities. Without giving any effect to any potential restructuring of current
rent obligations, the Company's total estimated rent obligations for fiscal year
2001 are approximately $70.3 million, of which approximately $15.2 million and
$52.7 million were incurred in the three and nine months ended June 30, 2001,
respectively. In connection with its review of its portfolio of facilities, the
Company anticipates continuing to divest itself of under-performing facilities,
which will have a favorable impact on the Company's rent obligations.

         The Company's operations require capital expenditures for renovations
of existing facilities in order to continue to meet regulatory requirements, to
upgrade facilities for the treatment of subacute patients and accommodate the
addition of specialty medical services, and to improve the physical appearance
of its facilities for marketing purposes. In addition, there are capital
expenditures required for completion of certain existing facility expansions and
new construction projects in process, as well as supporting non-nursing home
operations. Capital expenditures totaled $22.9 million for the nine months ended
June 30, 2001 as compared to $23.0 million for the comparable nine months ended
June 30, 2000. Capital expenditures in the nine months ended June 30, 2001 and
2000 were financed principally through internally generated funds.

         The Company has experienced an increasing trend in the number and
severity of litigation claims asserted against the Company. Management believes
that this trend is endemic to the long-term care industry and is a result of the
increasing number of large judgments against long-term care providers in recent
years resulting in an increased awareness by plaintiff's lawyers of potentially
large recoveries. The Company also believes that there has been, and will
continue to be, an increase in governmental investigatory activity of long-term
care providers, particularly in the area of false claims. While the Company
believes that it provides quality care to the patients in its facilities and
materially complies with all applicable regulatory requirements, an adverse
determination in a legal proceeding or governmental investigation, whether
currently asserted or arising in the future, could have a material adverse
effect on the Company. See "--Legal Proceedings."

         The Company currently maintains two captive insurance subsidiaries to
provide for reinsurance obligations under workers' compensation, general and
professional liability, and automobile liability for losses that occurred prior
to April 1, 1998. These obligations are funded with long-term, fixed income
investments, which are not available to satisfy other obligations of the
Company.

         The Company currently purchases excess liability insurance only. Due to
the hardening of the liability insurance market for the long-term care industry,
the Company currently maintains an unaggregated $1 million self-insured
retention per claim. Prior to July 31, 1999, the Company's liability insurance
policies included aggregated stop loss features limiting the Company's
out-of-pocket exposure. With stop loss insurance unavailable to the Company, the
expected direct costs have continued to increase. This increased exposure will
have a delayed negative effect on operating cash flow as claims develop over the
next several years.

         The Mariner Health DIP Credit Agreement limits the ability of the
Mariner Health Debtors from engaging in affiliate transactions and making
restricted payments, specifically including payments to the Company Debtors.
However, the Mariner Health DIP Credit Agreement permits, among other things,
weekly overhead payments to the Company (see "--Mariner Health
Debtor-in-Possession Financing" above), the purchase of pharmaceutical goods and
services from certain Company Debtors, the allocation to, and payment by, the
Mariner Health Debtors of their share of certain taxes, insurance obligations
and employee benefit obligations paid for and administered on a consolidated
basis by the Company, and certain ordinary course transactions which are on
terms no less favorable to the subject Mariner Health Debtors than the terms
obtainable from a non-affiliate, and for which the approval of the requisite
Mariner Health DIP Lenders and the Bankruptcy Court have been obtained.

         At September 30, 2000, the Company, excluding Mariner Health, had, in
the aggregate, approximately $93.9 million in its corporate concentration bank
accounts that was available to be used for ongoing operations, subject to the
terms and restrictions of the Final Company Cash Collateral Orders and the Final
Company DIP Order. The aggregate amount in the Company's corporate concentration
account at July 27, 2001 was approximately $122.2


                                       38
<PAGE>   41

million. The Company expects a significant portion of this cash will be used in
the funding of any plan of reorganization. At September 30, 2000, Mariner Health
had, in the aggregate, approximately $16.2 million in its corporate
concentration bank accounts that was available to be used for ongoing
operations, subject to the terms and restrictions of the Mariner Health Cash
Collateral Orders and the Final Mariner Health DIP Order. The aggregate amount
in Mariner Health's corporate concentration account at July 27, 2001 was
approximately $12.4 million. Mariner Health expects a significant portion of
this money will be used in the funding of any plan of reorganization, including
the MHG Bank Groups' Plan if approved by the required number of impaired
creditors and equity holders.

         While management believes that the Company's cash should be sufficient
to fund the Company's working capital needs for the foreseeable future, the use
of this cash collateral is prohibited under the Bankruptcy Code absent an order
of the Bankruptcy Court permitting the use of the cash collateral. The use of
the Company's cash collateral to fund working capital is currently permitted by
the respective DIP financings.

         While management believes that the amounts available to the Company
Debtors from the Company DIP Financing and cash collateral will be sufficient to
fund the operations of the Company Debtors until such time as the Company
Debtors are able to take the steps necessary to structure a plan of
reorganization that will be acceptable to creditors and confirmed by the
Bankruptcy Court, there can be no assurances in this regard; a default under the
Company DIP Credit Agreement may impair the ability of the Company Debtors to
use cash collateral to fund operations. Finally, there can be no assurance that
any plan of reorganization confirmed in connection with the Chapter 11 Filings
of the Company Debtors will allow the Company Debtors to operate profitably
under PPS or give the Company Debtors sufficient liquidity to meet their
operational needs. The ability of the Company Debtors to fund such requirements
will depend, among other things, on future economic conditions and on financial,
business and other factors, many of which are beyond the control of the Company
Debtors.

         While management believes that the amounts available to the Mariner
Health Debtors from the Mariner Health DIP Financing and cash collateral will be
sufficient to fund the operations of the Mariner Health Debtors until such time
as the Mariner Health Debtors are able to take the steps necessary to structure
a plan of reorganization that will be acceptable to creditors and confirmed by
the Bankruptcy Court or until the MHG Bank Groups' Plan receives the required
approval from the impaired classes of creditors and is subsequently confirmed by
the Bankruptcy Court, there can be no assurances in this regard; a default under
the Mariner Health DIP Credit Agreement may impair the ability of the Mariner
Health Debtors to use cash collateral to fund operations. Finally, there can be
no assurance that any plan of reorganization confirmed in connection with the
Chapter 11 Filings of the Mariner Health Debtors will allow the Mariner Health
Debtors to operate profitably under PPS or give the Mariner Health Debtors
sufficient liquidity to meet their operational needs. The ability of the Mariner
Health Debtors to fund such requirements will depend, among other things, on
future economic conditions and on financial, business and other factors, many of
which are beyond the control of the Mariner Health Debtors.

         CAUTIONARY STATEMENTS

         Information provided herein by the Company contains, and from time to
time the Company may disseminate materials and make statements which may contain
"forward-looking" information, as that term is defined by the Private Securities
Litigation Reform Act of 1995 (the "Act"). In particular, the information
contained in "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity and Capital Resources" contains information
concerning the Company's plan to restructure its debt obligations and other
financial commitments. The aforementioned forward looking statements, as well as
other forward looking statements made herein, are qualified in their entirety by
these cautionary statements, which are being made pursuant to the provisions of
the Act and with the intention of obtaining the benefits of the "safe harbor"
provisions of the Act.

         The Company cautions investors that any forward-looking statements made
by the Company are not guarantees of future performance and that actual results
may differ materially from those in the forward-looking statements as a result
of various factors, including, but not limited to, the following:

(i)      There can be no assurance that the amounts available to the Company
         through the DIP Financings will be sufficient to fund the operations of
         the Company until such time as the Company is able to propose a Plan of


                                       39
<PAGE>   42

         Reorganization that will be acceptable to creditors and confirmed by
         the court overseeing the Company's Chapter 11 Filings.

(ii)     There can be no assurance that the Company will be able to continue to
         use cash collateral to fund its working capital needs.

(iii)    There can be no assurance that any Plan of Reorganization confirmed in
         connection with the Chapter 11 Filings will allow the Company to
         operate profitably under PPS or give the Company sufficient liquidity
         to meet its operational needs.

(iv)     There can be no assurances as to whether or not the MHG Bank Groups'
         Plan will be confirmed, and the impact confirmation of that plan may
         have on the Company, Mariner Health or their respective creditors and
         shareholders.

(v)      There can be no assurance regarding the future availability or terms of
         financing in light of the Company's Chapter 11 Filings.

(vi)     There can be no assurance regarding any adverse actions which may be
         taken by creditors or landlords of the Company which may have the
         effect of preventing or unduly delaying confirmation of a Plan of
         Reorganization in connection with the Company's Chapter 11 Filings.

(vii)    The Company may have difficulty in attracting patients or labor as a
         result of its Chapter 11 Filings.

(viii)   The Company may be subject to increased regulatory oversight as a
         result of its Chapter 11 Filings.

(ix)     In recent years, an increasing number of legislative proposals have
         been introduced or proposed by Congress and in some state legislatures
         which would effect major changes in the healthcare system. However, the
         Company cannot predict the type of healthcare reform legislation which
         may be proposed or adopted by Congress or by state legislatures.
         Accordingly, the Company is unable to assess the effect of any such
         legislation on its business. There can be no assurance that any such
         legislation will not have a material adverse impact on the future
         growth, revenues, and net income of the Company.

(x)      The Company derives substantial portions of its revenues from
         third-party payors, including government reimbursement programs such as
         Medicare and Medicaid, and some portions of its revenues from
         nongovernmental sources, such as commercial insurance companies, health
         maintenance organizations and other charge-based contracted payment
         sources. Both governmental and non-governmental payors have undertaken
         cost-containment measures designed to limit payments to healthcare
         providers. There can be no assurance that payments under governmental
         and non-governmental payor programs will be sufficient to cover the
         costs allocable to patients eligible for reimbursement. The Company
         cannot predict whether or what proposals or cost-containment measures
         will be adopted in the future or, if adopted and implemented, what
         effect, if any, such proposals might have on the operations and
         financial condition of the Company.

(xi)     The Company is subject to extensive federal, state and local
         regulations governing licensure, conduct of operations at existing
         facilities, construction of new facilities, purchase or lease of
         existing facilities, addition of new services, certain capital
         expenditures, cost-containment and reimbursement for services rendered.
         The failure to obtain or renew required regulatory approvals or
         licenses, the failure to comply with applicable regulatory
         requirements, the delicensing of facilities owned, leased or managed by
         the Company or the disqualification of the Company from participation
         in certain federal and state reimbursement programs, or the imposition
         of harsh enforcement sanctions could have a material adverse effect
         upon the operations and financial condition of the Company.

(xii)    There can be no assurance that an adverse determination in a legal
         proceeding or governmental investigation, whether currently asserted or
         arising in the future, will not have a material adverse effect on the
         Company's financial position.


                                       40
<PAGE>   43

(xiii)   There can be no assurance that the Company can continue to obtain
         insurance coverage similar to that it currently maintains or that such
         current or future coverage will be adequate to satisfy adverse
         determinations against the Company.

         In addition, the Company's Chapter 11 Filings may disrupt its
operations and may result in a number of other operational difficulties,
including the following:

(a)      The Company's ability to access capital markets will likely be limited;

(b)      The Company's senior management may be required to expend a substantial
         amount of time and effort structuring a Plan of Reorganization, which
         could have a disruptive impact on management's ability to focus on the
         operation of the Company's business;

(c)      The Company may be unable to retain top management and other key
         personnel;

(d)      The Company may experience a reduction in the census at its skilled
         nursing facilities and hospitals; and (e) Suppliers to the Company may
         stop providing supplies or services to the Company or provide such
         supplies or services only on "cash on delivery," "cash on order" or
         other terms that could have an adverse impact on the Company's cash
         flow.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

         None.


                                       41
<PAGE>   44

PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

         As is typical in the healthcare industry, the Company is and will be
subject to claims that its services have resulted in resident injury or other
adverse effects, the risks of which will be greater for higher acuity residents
receiving services from the Company than for other long-term care residents. In
addition, resident, visitor and employee injuries will also subject the Company
to the risk of litigation. The Company has experienced an increasing trend in
the number and severity of litigation and claims asserted against the Company.
Management believes that this trend is endemic to the long-term care industry
and is a result of the increasing number of large judgments, including large
punitive damage awards, against long-term care providers in recent years
resulting in an increased awareness by plaintiff's lawyers of potentially large
recoveries. In certain states in which the Company has significant operations,
including California and Florida, insurance coverage for the risk of punitive
and certain other damages arising from general and professional liability
litigation is not available due to state law public policy prohibitions. There
can be no assurance that the Company will not be liable for punitive or other
damages awarded in litigation arising in states for which insurance coverage is
not available for such damages. The Company also believes that there has been,
and will continue to be, an increase in governmental investigations of long-term
care providers, particularly in the area of Medicare/Medicaid false claims, as
well as an increase in enforcement actions resulting from these investigations.
While the Company believes that it provides quality care to the patients in its
facilities and materially complies with all applicable regulatory requirements,
given the Company's current financial difficulties and lack of liquidity, an
adverse determination in a legal proceeding or governmental investigation,
whether currently asserted or arising in the future, could have a material
adverse effect on the Company.

         From time to time, the Company and its subsidiaries have been parties
to various legal proceedings in the ordinary course of their respective
businesses. In the opinion of management, other than as set forth below, there
have been no material developments in the litigation matters set forth in the
Company's Annual Report on Form 10-K for the year ended September 30, 2000. As a
result of the Chapter 11 Filings, all matters described in the Company's Annual
Report on Form 10-K for the year ended September 30, 2000 were stayed on January
18, 2000. While the automatic stay remains in effect, the Company has agreed to
relief from the automatic stay in certain limited circumstances.

         On August 26, 1996, a class action complaint was asserted against
GranCare, Inc. ("GranCare"), a wholly-owned subsidiary of the Company, in the
Denver, Colorado District Court, Salas, et al v. GranCare, Inc. and AMS
Properties, Inc. d/b/a Cedars Healthcare Center, Inc., case no. 96-CV-4449. On
March 15, 1998, the Court entered an Order in which it certified a class action
in the matter. On June 10, 1998, the Company filed a Motion to Dismiss all
claims and Motion for Summary Judgment Precluding Recovery of Medicaid Funds and
these motions were partially granted by the Court on October 30, 1998.
Plaintiffs' Motion for Reconsideration was denied by the Court on November 19,
1998, the Court's decision was certified as a final judgment on December 10,
1998, and plaintiffs then filed a writ with the Colorado Supreme Court, which
was denied, and an appeal with the Colorado Court of Appeal. In accordance with
the Company's voluntary filing under chapter 11 of the Bankruptcy Code and more
particularly, ss. 362 of that Code, this matter was stayed on January 18, 2000.
However, the Company did agree to limited relief from the stay in order to allow
for certain parts of the appeal to continue. The Company filed a Request for
Rehearing on February 2, 2001 and on March 22, 2001, the Court denied this
Request as well as the Request for Rehearing by Plaintiffs. On April 18, 2001
the Court of Appeals was notified of the applicability of the Bankruptcy Stay
and the Company's reservation of its rights to take a Writ to the Colorado
Supreme Court when the Stay is lifted. The Company currently believes it is
unlikely for this matter to ultimately survive as a class action and given this
and the current posture of the case, this matter is not in a position to be
evaluated in regard to a favorable outcome or in regard to the range of
potential loss. The Company will continue in its opposition to the class action
and further intends to vigorously contest all remaining allegations.

         On October 5, 2000, NovaCare Holdings, Inc. ("NCH") filed a complaint
(the "NCH Complaint") in the Chapter 11 Proceedings commencing Adversary
Proceeding No. 00-1577 (MFW), NovaCare Holdings, Inc. v. Mariner Post-Acute
Network, Inc., et al. The Company and various subsidiaries (the "defendant
subsidiaries") are named as


                                       42
<PAGE>   45

defendants in the Complaint. In the NCH Complaint, NCH alleges that its
predecessors in interest (hereinafter also referred to as "NCH") were party to
contracts with various subsidiaries of the Company under which NCH provided
services to patients at various facilities of such subsidiaries. It further
alleges that pursuant to these contracts, NCH provided certain services for
which it was paid, but with respect to which HCFA disallowed the facilities'
claims for reimbursement (the "NCH HCFA Disallowances"). After the NCH HCFA
Disallowances, NCH allegedly provided credits to the facilities equal to the
amount of the NCH HCFA Disallowances. Appeals of the NCH HCFA Disallowances were
filed, and NCH alleges that it holds a constructive trust or equitable lien on
any amounts which may be recovered from HCFA as a result of such appeals. In the
alternative, NCH alleges that it holds an administrative priority claim for any
such amounts that are paid by HCFA and not turned over to NCH. The aggregate
amount of the credits that are related to the NCH HCFA Disallowances and with
respect to which NCH asserts a constructive trust, an equitable lien, and/or an
administrative priority claim is $8,163,930. In addition, NCH asserts
administrative priority claims as well as claims for an equitable lien and
constructive trust for attorneys fees and expenses relating to the appeals of
other disallowance decisions by HCFA (the "Other HCFA Disallowances"); the NCH
Complaint states that NCH has incurred at least $275,000 of such expenses. On
November 9, 2000, the Company and the defendant subsidiaries filed a motion
("Motion to Dismiss") to dismiss the NCH Complaint, arguing that the
constructive trust/equitable lien claims are barred by res judicata based upon
prior financing orders of the Bankruptcy Court, and that the claims seeking
administrative priority fail to state claims upon which such relief may be
granted. On December 12, 2000, the Bankruptcy Court heard oral argument with
respect to the motion to dismiss, took the matter under submission, and
requested further briefing. In early November, NCH filed a motion ("Motion to
Enjoin Settlement") which seeks to enjoin the Company and the defendant
subsidiaries from settling claims against HCFA relating to the NCH HCFA
Disallowances and to require that any funds recovered with respect to such
claims be segregated. The Company and the defendant subsidiaries have filed an
opposition. In addition the company has filed a motion for summary judgment
("Motion for Summary Judgment") on those counts of the complaint which are
directed against the Company and its subsidiaries. A hearing on the Motion to
Enjoin Settlement and on the Motion for Summary Judgment has been deferred
until the Bankruptcy Court rules on the Motion to Dismiss. The parties are
currently waiting for the Bankruptcy Court to rule on the Motion to Dismiss. The
Company and the defendant subsidiaries intend to contest the case vigorously.

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS

         None.

ITEM 3.  DEFAULTS UPON CERTAIN SECURITIES

         The Company made the Chapter 11 Filings on January 18, 2000. As a
result, no principal or interest payments are being made since such time on
prepetition indebtedness, with the exception of repayments made as a result of
the application of net cash proceeds received from the sales of certain
facilities and other assets and notional amounts related to certain other
indebtedness, including capital equipment leases, until a Plan of Reorganization
defining the payment terms has been approved by the Bankruptcy Court. Additional
information regarding the Chapter 11 Filings is set forth elsewhere in this Form
10-Q, including Note 3 to the unaudited condensed consolidated financial
statements and "Management's Discussion and Analysis of Financial Condition and
Results of Operations."

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

         None.

ITEM 5.  OTHER INFORMATION

         None.


                                       43
<PAGE>   46
ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(a)      Exhibits

10.1     Twelfth Amendment, dated July 19, 2001, to Debtor-in-Possession Credit
         Agreement, dated January 20, 2000 (the "Mariner Health DIP Credit
         Agreement"), by and among Mariner Health Group, Inc. ("Mariner
         Health"), the Mariner Health subsidiaries party to the Mariner Health
         DIP Credit Agreement, the lenders party to the Mariner Health DIP
         Credit Agreement, First Union National Bank as syndication agent, PNC
         Capital Markets, Inc. and First Union Securities, Inc. both as
         co-arrangers and PNC Bank, National Association as collateral and
         administrative agent and as an issuing bank for the letters of credit
         issued in connection with the Mariner Health DIP Credit Agreement.

10.2     Fourth Amendment, dated June 26, 2001, to Revolving Credit and Guaranty
         Agreement dated January 18, 2000 (the "Company DIP Credit Agreement"),
         by and among the Company, the Guarantors (as named in the Company DIP
         Credit Agreement), The Chase Manhattan Bank ("Chase"), the other
         financial institutions party thereto (together with Chase, the "Banks")
         and Chase as Agent for the Banks.

(b)      Reports on Form 8-K

         None


                                       44
<PAGE>   47

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.

                                       MARINER POST-ACUTE NETWORK, INC.
                                       (Registrant)



                                       By: /s/ William C. Straub
                                          -------------------------------------
                                          Vice President, Controller, and Chief
                                          Accounting Officer (duly authorized
                                          Officer and Chief Accounting Officer)

Date: August 14, 2001


                                       45