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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2001
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 001-14057
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KINDRED HEALTHCARE, INC.
(Exact name of registrant as specified in its charter)
Delaware 61-1323993
(State or other (I.R.S.
jurisdiction Employer Identification
of incorporation or Number)
organization)
680 South Fourth Street
Louisville, Kentucky 40202-2412
(Address of principal (Zip Code)
executive offices)
(502) 596-7300
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange on
Title of Each Class which Registered
------------------- -----------------------
None None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.25 per share
Series A Warrants to Purchase Common Stock
Series B Warrants to Purchase Common Stock
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K ((S)229.405 of this chapter) is not contained herein, and
will not be contained, to the best of Registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment of this Form 10-K. [_]
As of January 31, 2002, there were 17,682,917 shares of the Registrant's
common stock, $0.25 par value, outstanding. The aggregate market value of the
shares of the Registrant held by non-affiliates of the Registrant, based on the
closing price of such stock on the NASDAQ on January 31, 2002, was
approximately $467,996,000. For purposes of the foregoing calculation only, all
directors and executive officers of the Registrant have been deemed affiliates.
Indicate by check mark whether the Registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No [_]
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement for the Annual Meeting of
Shareholders to be held on April 16, 2002 are incorporated by reference into
Part III of this Form 10-K.
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TABLE OF CONTENTS
Page
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PART I
Item 1. Business............................................................................. 3
Item 2. Properties........................................................................... 37
Item 3. Legal Proceedings.................................................................... 38
Item 4. Submission of Matters to a Vote of Security Holders.................................. 40
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................ 43
Item 6. Selected Financial Data.............................................................. 44
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 45
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........................... 66
Item 8. Financial Statements and Supplementary Data.......................................... 66
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. 67
PART III
Item 10. Directors and Executive Officers of the Registrant................................... 67
Item 11. Executive Compensation............................................................... 67
Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 67
Item 13. Certain Relationships and Related Transactions....................................... 67
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K..................... 68
2
PART I
Item 1. Business
GENERAL
Kindred Healthcare, Inc. provides long-term healthcare services primarily
through the operation of nursing centers and hospitals. At December 31, 2001,
our health services division operated 305 nursing centers (39,293 licensed
beds) in 32 states and a rehabilitation therapy business. Our hospital division
operated 57 hospitals (4,961 licensed beds) in 23 states and an institutional
pharmacy business. All references in this Annual Report on Form 10-K to
"Kindred," "our company," "we," "us," or "our" mean Kindred Healthcare, Inc.
and, unless the context otherwise requires, its consolidated subsidiaries.
On April 20, 2001 (the "Effective Date"), we and our subsidiaries emerged
from proceedings under Chapter 11 of Title 11 of the United States Code (the
"Bankruptcy Code") pursuant to the terms of our Fourth Amended Joint Plan of
Reorganization (the "Plan of Reorganization"). On March 1, 2001, the United
States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court")
approved our Plan of Reorganization. In connection with our emergence, we
changed our name to Kindred Healthcare, Inc.
Since filing for protection under the Bankruptcy Code on September 13, 1999,
we operated our businesses as a debtor-in-possession subject to the
jurisdiction of the Bankruptcy Court. Accordingly, our consolidated financial
statements have been prepared in accordance with the American Institute of
Certified Public Accountants Statement of Position ("SOP") 90-7, "Financial
Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7")
and generally accepted accounting principles applicable to a going concern,
which assume that assets will be realized and liabilities will be discharged in
the normal course of business.
In connection with our emergence from bankruptcy, we reflected the terms of
the Plan of Reorganization in our consolidated financial statements by adopting
the fresh-start accounting provisions of SOP 90-7. Under fresh-start
accounting, a new reporting entity is deemed to be created and the recorded
amounts of assets and liabilities are adjusted to reflect their estimated fair
values. For accounting purposes, the fresh-start adjustments have been recorded
in the consolidated financial statements as of April 1, 2001. Since fresh-start
accounting materially changed the amounts previously recorded in our
consolidated financial statements, a black line separates the post-emergence
financial data from the pre-emergence data to signify the difference in the
basis of preparation of the financial statements for each respective entity.
As used in this Form 10-K, the term "Predecessor Company" refers to us and
our operations for periods prior to April 1, 2001, while the term "Reorganized
Company" is used to describe us and our operations for periods thereafter.
On May 1, 1998, Ventas, Inc. ("Ventas") (formerly known as Vencor, Inc.)
completed the spin-off of its healthcare operations to its stockholders through
the distribution of our former common stock (the "Spin-off"). Ventas retained
ownership of substantially all of its real property and leases such real
property to us. In anticipation of the Spin-off, we were incorporated on March
27, 1998 as a Delaware corporation. For accounting purposes, the consolidated
historical financial statements of Ventas became our historical financial
statements following the Spin-off. Any discussion concerning events prior to
May 1, 1998 refers to our businesses as they were conducted by Ventas prior to
the Spin-off.
On September 28, 1995, The Hillhaven Corporation ("Hillhaven") merged into
us. On March 21, 1997, we acquired TheraTx, Incorporated ("TheraTx"), a
provider of rehabilitation and respiratory therapy program management services
to nursing centers and an operator of 26 nursing centers. On June 24, 1997, we
acquired a controlling interest in Transitional Hospitals Corporation
("Transitional"), an operator of 19 long-term acute care hospitals located in
13 states. We completed the merger of our wholly owned subsidiary into
Transitional on August 26, 1997.
3
This Annual Report on Form 10-K includes forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. See
"-Cautionary Statements."
HEALTHCARE OPERATIONS
We are organized into two operating divisions: the health services division,
which provides long-term care services by operating nursing centers and a
rehabilitation therapy business and the hospital division, which provides
long-term acute care services to medically complex patients by operating
hospitals and an institutional pharmacy business. We believe that the
independent focus of each division on the unique aspects and quality concerns
of its business enhances its ability to attract patients, improve operations
and achieve cost containment objectives.
HEALTH SERVICES DIVISION
Our health services division provides quality, cost-effective long-term care
through the operation of a national network of 305 nursing centers (39,293
licensed beds) located in 32 states and a rehabilitation therapy business as of
December 31, 2001. Through our nursing centers, we provide residents with
long-term care services, a full range of pharmacy, medical and clinical
services and routine services, including daily dietary, social and recreational
services. We also provide rehabilitation services, including physical,
occupational and speech therapies to our residents as well as to residents in
nursing facilities operated by other parties.
In addition, at more than 80 of our nursing centers, we offer specialized
programs for patients suffering from Alzheimer's disease. Within these nursing
centers, we provide quality care to these patients by dedicating to them
separate units run by teams of professionals that specialize in the unique
problems experienced by Alzheimer's patients. We believe that we are a leading
provider of nursing care to patients with Alzheimer's disease, based on the
specialization and size of our program for caring for these patients.
We monitor and enhance the quality of care at our nursing centers through
the use of quality assurance and performance improvement committees as well as
family satisfaction surveys. Our quality assurance and performance improvement
committees oversee patient healthcare needs and patient and staff safety.
Physicians serve on these committees as medical directors and advise on
healthcare policies and practices. We conduct surveys of patients' families
periodically and these surveys are reviewed by our performance improvement
committees at each facility to promote quality patient care. Substantially all
of our nursing centers are certified to provide services under Medicare and
Medicaid programs. Our nursing centers have been certified because the quality
of our accommodations, equipment, services, safety, personnel, physical
environment and policies and procedures meet or exceed the standards of
certification set by those programs.
Health Services Division Strategy
Our goal is to become the provider of choice in the markets our health
services division serves, which we believe will allow us to increase our
patient census and enhance our payor mix. In addition, we have implemented
several initiatives to improve our profitability. To supplement these
internally-focused initiatives, we intend to expand selectively our operations
through development and acquisition activities. The principal elements of our
health services division strategy are:
Providing Quality, Clinical-Based Services. The health services division is
focused on qualitative and quantitative clinical performance indicators with
the goal of providing quality care under the cost containment objectives
imposed by government and private payors. In an effort to improve the quality
of the services we deliver, we intend to pursue an aggressive plan to:
. hire and retain quality healthcare personnel by becoming the employer of
choice in the industry,
. establish improved processes to monitor and promote our patient care
objectives,
4
. integrate clinical advice of our chief medical officer and other
physicians into our operational procedures, and
. develop and enhance our internal training programs.
Enhancing Sales and Marketing Programs. We conduct our nursing center
marketing efforts, which focus on the quality of care provided at our
facilities, at the local market level through our nursing center administrators
and admissions coordinators. The marketing efforts of our nursing center
personnel are supplemented by strategies provided by our regional marketing
staffs. In order to increase awareness of our services and the provision of
quality care, we intend to:
. direct a targeted marketing effort at the elderly population, which we
believe is the fastest growing segment in the United States and which
will, therefore, be the driving force behind the growth in our industry
in the coming years, and
. improve our relationships with local referral sources.
Increasing Operating Efficiency. The health services division continually
seeks to improve operating efficiency with a view to maintaining high-quality
care in an environment that demands an increasingly greater control of costs.
We believe that operating efficiency is critical in maintaining our position as
a leading provider of nursing center services in the United States. In our
effort to improve operating efficiency we have:
. centralized administrative functions such as accounting, payroll, legal,
reimbursement, compliance and human resources,
. developed an industry-leading management information system to aid in
financial reporting as well as billing and collecting, and
. focused our efforts to hire and retain quality personnel.
Managing Efficient Delivery of Ancillary Services. We are dedicated to
providing quality nursing services to the patients in our facilities while at
the same time optimizing our operating efficiency. We realigned and refocused
our ancillary services business in response to the decline in the demand for
ancillary services that followed the implementation of the prospective payment
system in 1998. Today, our nursing centers generally provide ancillary services
to their patients through the use of internal staff. We are continuing to
refine the delivery of ancillary services to external customers to maintain
profitability under the cost constraints of the prospective payment system.
Accordingly, over the past two years, the health services division has
terminated many unprofitable external ancillary services contracts and does not
intend to emphasize the marketing of ancillary services contracts to third
parties.
Expanding Selectively Through Acquisitions and Development Activities. We
believe that we are well positioned strategically and financially to pursue
opportunities to expand our business through acquisitions and development
activities on a selective basis. We will evaluate development opportunities to
expand our operations, either through acquiring or leasing individual or small
portfolios of nursing facilities in selected markets or by managing the
operations of third parties. We also will evaluate opportunities to acquire
companies with operations in attractive markets.
5
Selected Health Services Division Operating Data
The following table sets forth certain operating data for the health
services division after reflecting the realignment of the former ancillary
services business for all periods presented (dollars in thousands, except
statistics):
Reorganized |
Company | Predecessor Company
------------| ------------------------------------
Nine months | Three months
ended | ended Year ended December 31,
December 31,| March 31, -----------------------
2001 | 2001 2000 1999
------------| ------------ ----------- -----------
Nursing centers: |
Revenues.......................... $1,348,236 | $ 429,523 $ 1,675,627 $ 1,594,244
Operating income.................. $ 234,500 | $ 70,543 $ 278,738 $ 169,128
Facilities in operation at end of |
period: |
Owned or leased............... 282 | 278 278 282
Managed....................... 23 | 35 34 13
Licensed beds at end of period: |
Owned or leased............... 36,926 | 36,469 36,466 36,912
Managed....................... 2,367 | 3,861 3,723 1,661
Patient days (a).................. 8,583,270 | 2,804,982 11,580,295 11,656,439
Revenues per patient day (a)...... $ 157 | $ 153 $ 145 $ 137
Average daily census (a).......... 31,212 | 31,166 31,640 31,935
Occupancy % (a)................... 84.9 | 85.2 86.1 86.8
Rehabilitation services: |
Revenues.......................... $ 27,451 | $ 10,695 $ 135,036 $ 195,731
Operating income.................. $ 8,112 | $ 690 $ 8,047 $ 2,891
Other ancillary services: |
Revenues.......................... $ - | $ - $ - $ 43,527
Operating income.................. $ 508 | $ 250 $ 4,737 $ 4,166
- --------
(a) Excludes managed facilities.
The term "operating income" is defined as earnings before interest, income
taxes, depreciation, amortization, rent, corporate overhead, unusual
transactions and reorganization items. The term "licensed beds" refers to the
maximum number of beds permitted in the facility under its license regardless
of whether the beds are actually available for patient care. "Patient days"
refers to the total number of days of patient care provided for the periods
indicated. "Average daily census" is computed by dividing each facility's
patient days by the number of calendar days the respective facility is in
operation. "Occupancy %" is computed by dividing average daily census by the
number of licensed beds, adjusted for the length of time each facility was in
operation during each respective period.
Total assets of the health services division were $393 million and $495
million at the end of 2001 and 2000, respectively.
Sources of Nursing Center Revenues
Nursing center revenues are derived principally from Medicare and Medicaid
programs and from private payment patients. Consistent with the nursing center
industry, changes in the mix of the health services division's patient
population among these three categories significantly affect the profitability
of its operations. Although Medicare and higher acuity patients generally
produce the most revenue per patient day, profitability with respect to higher
acuity patients is reduced by the costs associated with the higher level of
nursing care and other services generally required by such patients. We believe
that private payment patients generally constitute the most profitable category
and Medicaid patients generally constitute the least profitable category.
6
The following table sets forth the approximate percentages of nursing center
patient days and revenues derived from the payor sources indicated:
Medicare Medicaid Private and Other
--------------- --------------- ----------------
Patient Patient Patient
Period Days Revenues Days Revenues Days Revenues
- ------ ------- -------- ------- -------- ------- --------
Nine months ended December 31, 2001 14% 32% 67% 47% 19% 21%
Three months ended March 31, 2001.. 15 31 66 47 19 22
Year ended December 31,
2000............................ 13 28 67 49 20 23
1999............................ 12 26 66 49 22 25
For the nine months ended December 31, 2001 and the three months ended March
31, 2001, revenues of the health services division totaled approximately $1.4
billion or 58% and $440 million or 57%, respectively, of our total revenues
(before eliminations).
Both governmental and private third-party payors employ cost containment
measures designed to limit payments made to healthcare providers. Those
measures include the adoption of initial and continuing recipient eligibility
criteria which may limit payment for services, the adoption of coverage
criteria which limit the services that will be reimbursed and the establishment
of payment ceilings which set the maximum reimbursement that a provider may
receive for services. Furthermore, government reimbursement programs are
subject to statutory and regulatory changes, retroactive rate adjustments,
administrative rulings and government funding restrictions, all of which may
materially increase or decrease the rate of program payments to the health
services division for its services.
Medicare. The Medicare Part A program provides reimbursement for extended
care services furnished to Medicare beneficiaries who are admitted to nursing
centers after at least a three-day stay in an acute care hospital. Covered
services include supervised nursing care, room and board, social services,
physical and occupational therapies, pharmaceuticals, supplies and other
necessary services provided by nursing centers.
The Balanced Budget Act of 1997 (the "Balanced Budget Act") established a
prospective payment system ("PPS") for nursing centers for cost reporting
periods beginning on or after July 1, 1998. Prior to the implementation of PPS,
nursing centers were reimbursed by Medicare based on the facility-specific,
reasonable direct and indirect costs of services provided to their patients.
All of our nursing centers adopted PPS on July 1, 1998. The payments received
under PPS cover all services for Medicare patients including all ancillary
services, such as respiratory therapy, physical therapy, occupational therapy,
speech therapy and certain covered pharmaceuticals.
Medicaid. Medicaid is a state-administered program financed by state funds
and matching federal funds. The program provides for medical assistance to the
indigent and certain other eligible persons. Although administered under broad
federal regulations, states are given flexibility to construct programs and
payment methods consistent with their individual goals. Accordingly, these
programs differ in many respects from state to state.
The health services division provides to eligible individuals
Medicaid-covered services consisting of nursing care, room and board and social
services. In addition, states may at their option cover other services such as
physical, occupational and speech therapies and pharmaceuticals. Prior to the
Balanced Budget Act, federal law, generally referred to as the "Boren
Amendment," required Medicaid programs to pay rates that were reasonable and
adequate to meet the costs incurred by an efficiently and economically operated
nursing center providing quality care and services in conformity with all
applicable laws and regulations. Despite the federal requirements,
disagreements frequently arose between nursing centers and states regarding the
adequacy of Medicaid rates. By repealing the Boren Amendment, the Balanced
Budget Act eased the restrictions on the states' ability to reduce their
Medicaid reimbursement levels for such services. In addition, Medicaid programs
are subject to statutory
7
and regulatory changes, administrative rulings, interpretations of policy by
the state agencies and certain government funding limitations, all of which may
materially increase or decrease the level of program payments to nursing
centers operated by the health services division. We believe that the payments
under many of these programs may not be sufficient on an overall basis to cover
the costs of serving certain patients participating in these programs.
Furthermore, the Omnibus Budget Reconciliation Act of 1987, as amended,
mandates an increased emphasis on ensuring quality patient care, which has
resulted in additional expenditures by nursing centers.
Private Payment. The health services division seeks to maximize the number
of private payment patients admitted to its nursing centers, including those
covered under private insurance and managed care health plans. Private payment
patients typically have financial resources (including insurance coverage) to
pay for their monthly services and do not rely on government programs for
support.
We cannot assure you that payments under governmental and private
third-party payor programs will remain at levels comparable to present levels
or will be sufficient to cover the costs allocable to patients eligible for
reimbursement pursuant to such programs. In addition, we cannot assure you that
facilities operated by the health services division, or the provision of
services and supplies by the health services division, will meet the
requirements for participation in such programs. We could be adversely affected
by the continuing efforts of governmental and private third-party payors to
contain the cost of healthcare services. See "-Cautionary Statements."
8
Nursing Center Facilities
The following table lists by state the number of nursing centers and related
licensed beds owned by us or leased from Ventas and other third parties as of
December 31, 2001:
Number of Facilities
------------------------------------------------
Licensed Owned by Leased from Leased from
State Beds Us Ventas (2) Other Parties Managed Total
----- -------- -------- ----------- ------------- ------- -----
Alabama (1)....... 777 - 3 1 2 6
Arizona........... 1,393 - 6 - 6 12
California........ 2,262 4 11 3 1 19
Colorado.......... 695 - 4 1 - 5
Connecticut (1)... 983 - 8 - - 8
Florida (1)....... 2,473 2 15 1 - 18
Georgia (1)....... 1,211 1 5 3 - 9
Idaho............. 880 1 8 - - 9
Indiana........... 4,947 - 14 14 6 34
Kentucky (1)...... 2,076 1 12 4 - 17
Louisiana (1)..... 305 - - 1 1 2
Maine (1)......... 775 - 10 - - 10
Massachusetts (1). 4,181 - 31 3 3 37
Mississippi (1)... 125 - - 1 - 1
Missouri (1)...... 400 - - 3 - 3
Montana (1)....... 446 - 2 1 - 3
Nebraska (1)...... 163 - 1 - - 1
Nevada (1)........ 180 - 2 - - 2
New Hampshire (1). 622 - 3 - 1 4
North Carolina (1) 2,764 - 19 4 - 23
Ohio (1).......... 2,005 - 11 4 - 15
Oregon (1)........ 254 - 2 - - 2
Pennsylvania...... 200 - 1 1 - 2
Rhode Island (1).. 201 - 2 - - 2
Tennessee (1)..... 2,669 - 4 12 - 16
Texas............. 737 - 1 2 1 4
Utah.............. 848 - 5 1 1 7
Vermont (1)....... 310 - 1 - 1 2
Virginia (1)...... 629 - 4 - - 4
Washington (1).... 1,012 1 9 - - 10
Wisconsin (1)..... 2,319 - 12 2 - 14
Wyoming........... 451 - 4 - - 4
------ -- --- -- -- ---
Totals......... 39,293 10 210 62 23 305
====== == === == == ===
- --------
(1) These states have Certificate of Need regulations. See "-Governmental
Regulation-Federal, State and Local Regulation."
(2) See "-Master Lease Agreements."
Health Services Division Management and Operations
Each of our nursing centers is managed by a state-licensed administrator who
is supported by other professional personnel, including a director of nursing,
staff development professional (responsible for employee training), activities
director, social services director, business office manager and, in general,
physical, occupational and speech therapists. The directors of nursing are
state-licensed nurses who supervise our nursing staffs that include registered
nurses, licensed practical nurses and nursing assistants. Staff size and
composition
9
vary depending on the size and occupancy of each nursing center and on the type
of care provided by the nursing center. The nursing centers contract with
physicians who provide medical director services and serve on quality assurance
committees. We provide our facilities with centralized information systems,
human resources management, state and federal reimbursement assistance, state
licensing and certification maintenance, legal, finance and accounting support
and purchasing and facilities management. The centralization of these services
improves efficiency and permits facility staff to focus on the delivery of high
quality nursing services.
Our health services division is managed by a divisional president and a
chief financial officer. Our nursing center operations are divided into four
geographic regions, each of which is headed by an operational vice president.
These four operational vice presidents report to the divisional president. The
clinical issues and quality concerns of the health services division are
managed by the division's chief medical officer and vice president of clinical
operations. District and/or regional staff in the areas of nursing, dietary and
rehabilitation services, state and federal reimbursement, human resources
management, maintenance, sales and financial services supports the health
services division. Regional and district nursing professionals visit each
nursing center periodically to review practices and, where necessary, recommend
improvements in the level of care provided.
Quality Assessment and Improvement
Quality of care is monitored and enhanced by quality assurance or
performance improvement committees and family satisfaction surveys. These
committees oversee patient healthcare needs and patient and staff safety.
Additionally, physicians serve on these committees as medical directors and
advise on healthcare policies and practices. Regional and district nursing
professionals visit each nursing center periodically to review practices and
recommend improvements where necessary in the level of care provided and to
assure compliance with requirements under applicable Medicare and Medicaid
regulations. Surveys of patients' families are conducted from time to time in
which the families are asked to rate various aspects of service and the
physical condition of the nursing centers. These surveys are reviewed by
performance improvement committees at each facility to promote quality patient
care.
The health services division provides training programs for nursing center
administrators, managers, nurses and nursing assistants. These programs are
designed to maintain high levels of quality patient care.
Substantially all of the nursing centers currently are certified to provide
services under Medicare and Medicaid programs. A nursing center's qualification
to participate in such programs depends upon many factors, such as
accommodations, equipment, services, safety, personnel, physical environment
and adequate policies and procedures.
Health Services Division Competition
Our nursing centers compete with other nursing centers and similar long-term
care facilities primarily on the basis of quality of care, reputation, their
location and physical appearance and, in the case of private patients, the
charges for our services. Some competitors are located in buildings that are
newer than those operated by us and may provide services that we do not offer.
Our nursing centers compete on a local and regional basis with other nursing
centers as well as with facilities providing similar services, including
hospitals, extended care centers, assisted living facilities, home health
agencies and similar institutions. The industry includes government-owned,
religious organization-owned, secular not-for-profit and for-profit
institutions. Many of these competitors have greater financial and other
resources than we do. Although there is limited, if any, price competition with
respect to Medicare and Medicaid patients (since revenues received for services
provided to such patients are based generally on fixed rates), there is
significant competition for private payment patients.
In addition, our health services division competes in the fragmented and
highly competitive ancillary services markets. Many nursing centers are
developing internal staff to provide these services, particularly in response
to the implementation of PPS. The primary competitive factors for the ancillary
services markets are quality of services, charges for services and
responsiveness to the needs of patients and families, and the facilities in
which the services are provided.
10
HOSPITAL DIVISION
Our hospital division primarily provides long-term acute care services to
medically complex patients through the operation of a national network of 57
hospitals (which includes four hospitals certified as general acute care
hospitals) with 4,961 licensed beds located in 23 states as of December 31,
2001. We opened our first long-term acute care hospital in 1985 and today
operate the largest network of long-term acute care hospitals in the United
States based on revenues. As a result of our commitment to the long-term acute
care business, we have developed a comprehensive program of care for medically
complex patients which allows us to deliver quality care in a cost-effective
manner. In addition, the hospital division operates an institutional pharmacy
business, which focuses on providing a full array of institutional pharmacy
services to nursing centers and specialized care centers, including the nursing
centers we operate.
In addition to our long-term acute care hospitals, the hospital division
operates four hospitals licensed as general acute care hospitals. A number of
the hospital division's long-term acute care hospitals also provide outpatient
services. General acute care and outpatient services may include inpatient
services, diagnostic services, CT scanning, one-day surgery, laboratory, X-ray,
respiratory therapy, cardiology and physical therapy.
In our hospitals, we treat medically complex patients who suffer from
multiple systemic failures or conditions such as neurological disorders, head
injuries, brain stem and spinal cord trauma, cerebral vascular accidents,
chemical brain injuries, central nervous system disorders, developmental
anomalies and cardiopulmonary disorders. In particular, we have a core
competency in treating patients with pulmonary disorders. Medically complex
patients often are dependent on technology, such as mechanical ventilators,
total parental nutrition, respiratory or cardiac monitors and dialysis
machines, for continued life support. Approximately 50% of our medically
complex patients are ventilator-dependent for some period of time during their
hospitalization. During 2001, the average length of stay for patients in our
long-term acute care hospitals was approximately 37 days. Although the hospital
division's patients range in age from pediatric to geriatric, approximately 70%
of these patients are over 65 years of age.
Our hospital division patients have conditions which require a high level of
monitoring and specialized care, yet may not need the services of a traditional
intensive care unit. Due to their severe medical conditions, these patients
generally are not clinically appropriate for admission to a nursing center and
their medical conditions are periodically or chronically unstable. By combining
selected general acute care services with the ability to care for medically
complex patients, we believe that our long-term acute care hospitals provide
their patients with high quality, cost-effective care.
Our long-term acute care hospitals employ a comprehensive program of care
for their medically complex patients which draws upon the talents of
interdisciplinary teams, including physician specialists. The teams evaluate
medically complex patients upon admission to determine treatment programs. Our
hospital division has developed specialized treatment programs focused on the
needs of medically complex patients. Where appropriate, the treatment programs
may involve the services of several disciplines, such as pulmonary medicine,
infectious disease and physical medicine. In our treatment programs, we
emphasize individual attention to patients.
Hospital Division Strategy
Our goal is to remain a leading operator of long-term acute care hospitals
in terms of both quality of care and operating efficiency. Our strategies for
achieving this goal include:
Maintaining High Quality of Care. The hospital division differentiates its
hospitals through its ability to care for medically complex patients in a
high-quality, cost-effective setting. We are committed to maintaining and
improving the quality of our patient care by dedicating appropriate resources
to each facility and refining our clinical initiatives. In this regard, we have
taken the following measures to improve and maintain the quality of care at our
hospitals:
. Established an integrated quality assessment and improvement program,
administered by a quality review manager, which encompasses utilization
review, quality improvement, infection control and risk management.
11
. Developed and implemented a patient classification system called
CustomCare that is designed to ensure that patients receive the
necessary level of care. This model allows the hospital division to
monitor employee skill mix and manage labor costs.
. Maintained a strategic outcomes program, which includes a concurrent
review of all of our patient population against utilization and quality
screenings, as well as quality of life outcomes data collection and
patient and family satisfaction surveys.
. Implemented a program whereby our hospitals are reviewed by internal
quality auditors for compliance with standards of the Joint Commission
on Accreditation of Health Care Organizations.
. Committed to attracting the highest quality of professional staff within
each market. The hospital division believes that its future success will
depend in part upon its continued ability to hire and retain qualified
healthcare personnel.
. Incorporated the clinical advice of our chief clinical officer, medical
advisory board and other physicians into our operational procedures.
Improving Operating Efficiency. The hospital division is continually
focused on improving operating efficiency and controlling costs while
maintaining quality patient care. Our hospital division seeks to improve
operating efficiencies and control costs by standardizing operations and
optimizing the skill mix of its staff based on the hospital's occupancy and the
clinical needs of its patients. The initiatives we have undertaken to control
our costs and improve efficiency include:
. managing pharmacy costs through adherence to formularies and utilization
management and leveraging drug costs through participation in a group
purchasing organization,
. managing labor costs by adjusting staffing to patient acuity and
fluctuations in census,
. centralizing administrative functions such as accounting, payroll,
legal, reimbursement, compliance and human resources, and
. utilizing industry-leading management information technology to aid in
financial reporting as well as billing and collecting.
Growing Through Business Development and Acquisitions. Our growth strategy
is focused on the development and expansion of our services:
. Hospital-in-Hospital. We look to partner with non-Kindred hospitals in
order to operate 30 to 40 long-term acute care hospital beds within the
partner hospital. Under such arrangements, we would lease space and
purchase ancillary services from our partners and provide them with the
option to discharge their clinically appropriate patients into our care.
. Pulmonary Units. We seek to operate 20 to 30 bed specialty pulmonary
care units within non-Kindred hospitals in attractive markets. Under
such arrangements we would lease space and purchase ancillary services
from our partners. We believe that such arrangements will serve as
bridges to broader hospital-in-hospital opportunities and relationships
within these markets. Since our reorganization, we have opened two new
pulmonary units covering a total of 46 beds.
. Free-standing Hospitals. We seek to add free-standing hospitals in
certain strategic markets. We opened a new free-standing hospital in Las
Vegas, Nevada which contains approximately 90 beds, in December 2001.
. Growing Through Acquisitions. We seek growth opportunities through
strategic acquisitions in selected target markets.
12
Expanding Breadth of Industry Leadership. We are the leading provider of
long-term acute care to patients with pulmonary dysfunction. In addition, we
deliver other services in areas such as wound care, surgery, acute
rehabilitation and pain management. We intend to broaden our expertise beyond
pulmonary services and to leverage our leadership position in pulmonary care to
expand our market strength to other clinical services.
Increasing Higher Margin Commercial Volume. We typically receive higher
reimbursement rates from commercial insurers than we do from the Medicare and
Medicaid programs. As a result, we work to expand relationships with insurers
to increase commercial patient volume. Each of our hospitals employs case
managers who focus on the patient intake and referral process.
Improving Relationships with Referring Providers. Substantially all of the
acute and medically complex patients admitted to our hospitals are transferred
to us by other healthcare providers such as general acute care hospitals,
intensive care units, managed care programs, physicians, nursing centers and
home care settings. Accordingly, we are focused on maintaining strong
relationships with these providers. In order to maintain these relationships,
we employ case managers who are responsible for coordinating admissions and
assessing the nature of services necessary for the proper care of the patient.
Case managers also are responsible for educating healthcare professionals from
referral sources as to the unique nature of the services provided by our
long-term acute care hospitals. Specifically, case managers train and educate
the staffs of referring institutions about long-term acute care hospital
services and the types of patients who could benefit from such services.
Selected Hospital Division Operating Data
The following table sets forth certain operating data for the hospital
division after reflecting the realignment of the former ancillary services
business for all periods presented (dollars in thousands, except statistics):
Reorganized |
Company | Predecessor Company
------------ | ------------------------------------
Nine months | Three months
ended | ended Year ended December 31,
December 31, | March 31, -----------------------
2001 | 2001 2000 1999
------------ | ------------ ---------- --------
Hospitals: |
Revenues................................. $822,935 | $271,984 $1,007,947 $850,548
Operating income......................... $157,613 | $ 54,778 $ 205,858 $132,050
Facilities in operation at end of period. 57 | 56 56 56
Licensed beds at end of period........... 4,961 | 4,867 4,886 4,931
Patient days............................. 802,425 | 273,029 1,044,663 982,301
Revenues per patient day................. $ 1,026 | $ 996 $ 965 $ 866
Average daily census..................... 2,918 | 3,034 2,854 2,691
Occupancy %.............................. 62.6 | 65.3 60.8 56.9
Pharmacy: |
Revenues................................. $176,105 | $ 54,880 $ 204,252 $171,493
Operating income......................... $ 20,831 | $ 6,176 $ 7,421 $ 342
Total assets of the hospital division were $497 million and $354 million at
the end of 2001 and 2000, respectively.
Sources of Hospital Revenues
The hospital division receives payment for its hospital services from
third-party payors, including government reimbursement programs such as
Medicare and Medicaid and non-government sources such as commercial insurance
companies, health maintenance organizations, preferred provider organizations
and contracted providers. Patients covered by non-government payors generally
will be more profitable to the
13
hospital division than those covered by the Medicare and Medicaid programs. The
following table sets forth the approximate percentages of the hospital patient
days and revenues derived from the payor sources indicated:
Medicare Medicaid Private and Other
--------------- --------------- ----------------
Patient Patient Patient
Period Days Revenues Days Revenues Days Revenues
- ------ ------- -------- ------- -------- ------- --------
Nine months ended December 31, 2001 67% 57% 13% 9% 20% 34%
Three months ended March 31, 2001.. 68 56 13 11 19 33
Year ended December 31,
2000............................ 67 55 13 10 20 35
1999............................ 68 58 12 11 20 31
For the nine months ended December 31, 2001 and the three months ended March
31, 2001, revenues of the hospital division totaled approximately $1 billion or
42% and $327 million or 43%, respectively, of our total revenues (before
eliminations). Changes caused by the Balanced Budget Act have reduced Medicare
payments made to the hospital division related to incentive payments under the
Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), allowable costs for
capital expenditures and bad debts, and payments for services to patients
transferred from a general acute care hospital. See "-Governmental
Regulation-Regulatory Changes" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
Hospital Facilities
The following table lists by state the number of hospitals and related
licensed beds owned by us or leased from Ventas and other third parties as of
December 31, 2001:
Number of Facilities
----------------------------------------
Licensed Owned by Leased from Leased from
State Beds Us Ventas (2) Other Parties Total
----- -------- -------- ----------- ------------- -----
Arizona........... 109 - 2 - 2
California........ 543 2 6 - 8
Colorado.......... 68 - 1 - 1
Florida (1)....... 536 - 6 1 7
Georgia (1)....... 72 - - 1 1
Illinois (1)...... 545 - 4 1 5
Indiana........... 167 - 2 1 3
Kentucky (1)...... 374 - 1 - 1
Louisiana......... 168 - 1 - 1
Massachusetts (1). 86 - 2 - 2
Michigan (1)...... 400 - 2 - 2
Minnesota......... 92 - 1 - 1
Missouri (1)...... 227 - 2 - 2
Nevada (1)........ 144 1 1 - 2
New Mexico........ 61 - 1 - 1
North Carolina (1) 124 - 1 - 1
Oklahoma.......... 59 - 1 - 1
Pennsylvania...... 115 - 2 - 2
Tennessee (1)..... 49 - 1 - 1
Texas............. 716 2 6 2 10
Virginia (1)...... 164 - 1 - 1
Washington (1).... 80 1 - - 1
Wisconsin......... 62 1 - - 1
----- - -- - --
Totals......... 4,961 7 44 6 57
===== = == = ==
- --------
(1) These states have Certificate of Need regulations. See "-Governmental
Regulation-Federal, State and Local Regulation."
(2) See "-Master Lease Agreements."
14
Quality Assessment and Improvement
The hospital division maintains a strategic outcome program which includes a
centralized pre-admission evaluation program and concurrent review of all of
its patient population against utilization and quality screenings, as well as
clinical outcomes data collection and patient and family satisfaction surveys.
In addition, each hospital has an integrated quality assessment and improvement
program administered by a quality review manager which encompasses utilization
review, quality improvement, infection control and risk management. The
objective of these programs is to ensure that patients are admitted
appropriately to our hospitals and that quality healthcare is provided in a
cost-effective manner.
The hospital division has implemented a program whereby its hospitals are
reviewed by internal quality auditors for compliance with standards of the
Joint Commission on Accreditation of Health Care Organizations. The purposes of
this internal review process are to (a) ensure ongoing compliance with industry
recognized standards for hospitals, (b) assist management in analyzing each
hospital's operations and (c) provide consulting and educational programs for
each hospital to identify opportunities to improve patient care.
Hospital Division Management and Operations
Each of our hospitals has a fully credentialed, multi-specialty medical
staff to meet the needs of the medically complex, long-term acute patient. Each
of our hospitals offers a broad range of physician services including,
pulmonology, internal medicine, infectious diseases, neurology, nephrology,
cardiology, radiology and pathology. In addition, each of our hospitals is
staffed with a multi-disciplinary team of healthcare professionals including: a
professional nursing staff trained to care for long-term acute patients,
respiratory, physical, occupational and speech therapists; pharmacists;
registered dietitians; and social workers.
Substantially all of the acute and medically complex patients admitted to
our hospitals are transferred from other healthcare providers. Patients are
referred from general acute care hospitals, nursing centers and home care
settings. Referral sources include physicians, discharge planners, case
managers of managed care plans, social workers, third-party administrators,
health maintenance organizations and insurance companies. The hospital division
employs case managers who are primarily responsible for coordinating admissions
and assessing the nature of services necessary for the proper care of the
patient. Case managers also are responsible for educating healthcare
professionals from referral sources as to the unique nature of the services
provided by our long-term acute care hospitals. Specifically, case managers
train and educate the staffs of referring institutions about long-term acute
care hospital services and the types of patients who could benefit from such
services.
Each hospital maintains a pre-admission assessment system to evaluate
clinical needs and other information in determining the appropriateness of each
patient referral. Upon admission, each patient's case is reviewed by the
hospital's interdisciplinary team to determine treatment programs. Where
appropriate, the treatment programs may involve the services of several
disciplines, such as pulmonary medicine, infectious disease and physical
medicine.
A hospital chief executive officer supervises and is responsible for the
day-to-day operations at each of our hospitals. Each hospital also employs a
chief financial officer who monitors the financial matters of each hospital,
including the measurement of actual operating results compared to budgets. In
addition, each hospital employs a chief operating officer to oversee the
clinical operations of the hospital and a quality assurance manager to direct
an integrated quality assurance program. We provide centralized services in the
areas of information systems design and development, training, human resources
management, reimbursement expertise, legal advice, technical accounting support
and purchasing and facilities management to each of our hospitals. We believe
that this centralization improves efficiency and allows hospital staff to spend
more time on patient care.
A divisional president and a chief financial officer manage the hospital
division. The operations of the hospitals are divided into three geographic
regions with each region headed by an operational vice president,
15
each of whom reports to the divisional president. Institutional pharmacy
operations also are managed by a vice president who reports to the divisional
president. The clinical issues and quality concerns of the hospital division
are managed by the division's chief clinical officer. Our corporate
headquarters also provides services in the areas of information systems design
and development, training, human resources management, reimbursement expertise,
legal advice, technical accounting support, purchasing and facilities
management.
Hospital Division Competition
As of December 31, 2001, the hospitals operated by the hospital division
were located in 42 geographic markets in 23 states. In each geographic market,
there are general acute care hospitals which provide services comparable to
those offered by our hospitals. In addition, the hospital division believes
that as of December 31, 2001 there were approximately 300 hospitals in the
United States certified by Medicare as general long-term hospitals, some of
which provide similar services to those provided by the hospital division.
Certain competing hospitals are operated by not-for-profit, nontaxpaying or
governmental agencies, which can finance capital expenditures on a tax-exempt
basis, and which receive funds and charitable contributions unavailable to the
hospital division.
Competition for patients covered by non-government reimbursement sources is
intense. The primary competitive factors in the long-term acute care business
include quality of services, charges for services and responsiveness to the
needs of patients, families, payors and physicians. Other companies have
entered the long-term acute care market with licensed hospitals that compete
with our hospitals. The competitive position of any hospital also is affected
by the ability of its management to negotiate contracts with purchasers of
group healthcare services, including private employers, managed care companies,
preferred provider organizations and health maintenance organizations. Such
organizations attempt to obtain discounts from established hospital charges.
The importance of obtaining contracts with preferred provider organizations,
health maintenance organizations and other organizations which finance
healthcare, and its effect on a hospital's competitive position, vary from
market to market, depending on the number and market strength of such
organizations.
OUR REORGANIZATION
As a result of decreased Medicare and Medicaid reimbursement rates
introduced by the Balanced Budget Act and other issues associated with our
company, we were unable to meet our then existing financial obligations,
including rent payable to Ventas and debt service obligations under our then
existing indebtedness. Accordingly, on September 13, 1999, we filed voluntary
petitions for protection under Chapter 11 of the Bankruptcy Code. From the date
of our bankruptcy filing until we emerged from bankruptcy on April 20, 2001, we
operated our businesses as a "debtor-in-possession" subject to the jurisdiction
of the Bankruptcy Court. On March 1, 2001, the Bankruptcy Court approved our
Plan of Reorganization. See note 2 of the notes to consolidated financial
statements.
Pursuant to our Plan of Reorganization, on the Effective Date of the Plan of
Reorganization:
. we issued to certain claimholders, including senior creditors and Ventas,
in exchange for their claims:
. an aggregate of $300 million of senior secured notes, bearing
interest at the London Interbank Offered Rate (as defined in the
agreement) plus 4 1/2%, which began accruing interest approximately
two quarters after the Effective Date,
. an aggregate of 15,000,000 shares of our common stock,
. an aggregate of 2,000,000 Series A warrants, and
. an aggregate of 5,000,000 Series B warrants,
. we entered into a new $120 million revolving credit facility to
provide us with working capital and to be used for other general
corporate purposes,
16
. we entered into amended and restated Master Lease Agreements (as
defined below) with Ventas covering 210 of the nursing centers and 44
of the hospitals that we operate,
. we entered into a registration rights agreement with Ventas and each
holder of 10% or more of our common stock following the exchange
described above, providing such holders with certain shelf, demand
and "piggy-back" registration rights, and
. our then existing senior indebtedness and debt and equity securities
were canceled.
As a result of the exchange described above, the holders of certain claims
acquired control of our company and the holders of our pre-reorganization
common stock relinquished control.
In addition, in connection with our emergence from bankruptcy:
. we changed our name to Kindred Healthcare, Inc.,
. a new board of directors, including representatives of the principal
security holders following the exchange, was appointed, and
. effective April 1, 2001, we adopted fresh-start accounting in
accordance with SOP 90-7. This has resulted in the creation of a new
reporting entity for financial accounting reporting purposes and a
revaluation of our assets and liabilities to reflect their estimated
fair values. Because of the adoption of fresh-start accounting,
amounts previously recorded in our historical financial statements
have changed materially. As a result, our financial statements for
periods after our emergence from bankruptcy are not comparable in all
respects to our financial statements for periods prior to the
reorganization.
MASTER LEASE AGREEMENTS
Under our Plan of Reorganization, we assumed our original master lease
agreements with Ventas and its affiliates and simultaneously amended and
restated the agreements into four new master leases, which we refer to as the
"Master Lease Agreements." The following summary description of the Master
Lease Agreements is qualified in its entirety by reference to the Master Lease
Agreements, as filed with the Securities and Exchange Commission.
Term and Renewals
Each Master Lease Agreement includes land, buildings, structures and other
improvements on the land, easements and similar appurtenances to the land and
improvements, and permanently affixed equipment, machinery and other fixtures
relating to the operation of the leased properties. There are several bundles
of leased properties under each Master Lease Agreement, with each bundle
containing approximately 7 to 12 leased properties. Each bundle contains both
nursing centers and hospitals. All leased properties within a bundle have base
terms ranging from 10 to 15 years beginning from May 1, 1998, subject to
certain exceptions.
At our option, all, but not less than all, of the leased properties in a
bundle may be extended for one five-year renewal term beyond the base term at
the then existing rental rate plus the then existing escalation amount per
annum. We may further extend for two additional five-year renewal terms beyond
the first renewal term at the greater of the then existing rental rate plus the
then existing escalation amount per annum or the then fair market value rental
rate. The rental rate during the first renewal term and any additional renewal
term in which rent due is based on the then existing rental rate will escalate
each year during such term(s) at the applicable escalation rate.
We may not extend the Master Lease Agreements beyond the base term or any
previously exercised renewal term if, at the time we seek such extension and at
the time such extension takes effect, (1) an event of default has
17
occurred and is continuing or (2) a Medicare/Medicaid event of default (as
described below) and/or a licensed bed event of default (as described below)
has occurred and is continuing with respect to three or more leased properties
subject to a particular Master Lease Agreement. The base term and renewal term
of each Master Lease Agreement are subject to termination upon default by us
(subject to certain exceptions) and certain other conditions described in the
Master Lease Agreements.
Rental Amounts and Escalators
Each Master Lease Agreement is commonly known as a triple-net lease or an
absolute-net lease. Accordingly, in addition to rent, we are required to pay
the following: (1) all insurance required in connection with the leased
properties and the business conducted on the leased properties, (2) all taxes
levied on or with respect to the leased properties (other than taxes on the net
income of Ventas) and (3) all utilities and other services necessary or
appropriate for the leased properties and the business conducted on the leased
properties.
Under each Master Lease Agreement, the aggregate annual rent is referred to
as base rent. Base rent equals the sum of current rent and accrued rent. We are
obligated to pay the portion of base rent that is current rent, and unpaid
accrued rent will be paid as set forth below.
From the effective date of the Master Lease Agreements through April 30,
2004, base rent will equal the current rent. Under the Master Lease Agreements,
the annual aggregate base rent owed by us currently is $180.7 million. For the
period from May 1, 2001 through April 30, 2004, annual aggregate base rent
payable in cash will escalate at an annual rate of 3 1/2% over the prior period
base rent if certain revenue parameters are obtained. The Company paid rents to
Ventas approximating $135.6 million for the nine months ended December 31,
2001, $45.4 million for the three months ended March 31, 2001, $181.6 million
for 2000 and $191.2 million for 1999.
Each Master Lease Agreement also provides that beginning May 1, 2004, the
annual aggregate base rent payable in cash will escalate at an annual rate of
2% (plus, upon the occurrence of certain events, an additional annual accrued
escalator amount of 1 1/2% of the prior period base rent) which will accrete
from year to year including an interest accrual at the London Interbank Offered
Rate plus 4 1/2% to be added to the annual accreted amount. This interest will
not be added to the aggregate base rent in subsequent years.
The unpaid accrued rent will become payable upon the refinancing of our
existing credit agreements or the termination or expiration of the applicable
Master Lease Agreement.
Reset Rights
During the one-year period commencing in July 2006, Ventas will have a
one-time option to reset the base rent, current rent and accrued rent under
each Master Lease Agreement to the then fair market rental of the leased
properties. Upon exercising this reset right, Ventas will pay us a fee equal to
a prorated portion of $5 million based upon the proportion of base rent payable
under the Master Lease Agreement(s) with respect to which rent is reset to the
total base rent payable under all of the Master Lease Agreements. The
determination of the fair market rental will be effectuated through the
appraisal procedures in the Master Lease Agreements.
Use of the Leased Property
The Master Lease Agreements require that we utilize the leased properties
solely for the provision of healthcare services and related uses and as Ventas
may otherwise consent. We are responsible for maintaining or causing to be
maintained all licenses, certificates and permits necessary for the leased
properties to comply with various healthcare regulations. We also are obligated
to operate continuously each leased property as a provider of healthcare
services.
18
Events of Default
Under each Master Lease Agreement, an "Event of Default" will be deemed to
occur if, among other things:
. we fail to pay rent or other amounts within five days after notice,
. we fail to comply with covenants, which failure continues for 30 days
or, so long as diligent efforts to cure such failure are being made,
such longer period (not over 180 days) as is necessary to cure such
failure,
. certain bankruptcy or insolvency events occur, including filing a
petition of bankruptcy or a petition for reorganization under the
Bankruptcy Code,
. an event of default arising from our failure to pay principal or
interest on our senior secured notes or any other indebtedness exceeding
$50 million,
. the maturity of the senior secured notes or any other indebtedness
exceeding $50 million is accelerated,
. we cease to operate any leased property as a provider of healthcare
services for a period of 30 days,
. a default occurs under any guaranty of any lease or the indemnity
agreements with Ventas,
. we or our subtenant lose any required healthcare license, permit or
approval or fail to comply with any legal requirements as determined by
a final unappealable determination,
. we fail to maintain insurance,
. we create or allow to remain certain liens,
. we breach any material representation or warranty,
. a reduction occurs in the number of licensed beds in a facility,
generally in excess of 10% (or less than 10% if we have voluntarily
"banked" licensed beds) of the number of licensed beds in the applicable
facility on the commencement date (a "licensed bed event of default"),
. Medicare or Medicaid certification with respect to a participating
facility is revoked and re-certification does not occur for 120 days
(plus an additional 60 days in certain circumstances) (a
"Medicare/Medicaid event of default"),
. we become subject to regulatory sanctions as determined by a final
unappealable determination and fail to cure such regulatory sanctions
within its specified cure period for any facility, we fail to cure a
breach of any permitted encumbrance within the applicable cure period
and, as a result, a real property interest or other beneficial property
right of Ventas is at material risk of being terminated, or
. we fail to cure the breach of any of the obligations of Ventas as lessee
under any existing ground lease within the applicable cure period and,
if such breach is a non-monetary, non-material breach, such existing
ground lease is at material risk of being terminated.
Remedies for an Event of Default
Except as noted below, upon an Event of Default under one of the Master
Lease Agreements, Ventas may, at its option, exercise the following remedies:
(1) after not less than ten days' notice to us, terminate the Master Lease
Agreement to which such Event of Default relates, repossess any leased
property, relet any leased property to a third party and require that we pay to
Ventas, as liquidated damages, the net present value of the rent for the
balance of the term, discounted at the prime rate,
(2) without terminating the Master Lease Agreement to which such Event of
Default relates, repossess the leased property and relet the leased property
with us remaining liable under such Master Lease Agreement for all
19
obligations to be performed by us thereunder, including the difference, if any,
between the rent under such Master Lease Agreement and the rent payable as a
result of the reletting of the leased property, and
(3) seek any and all other rights and remedies available under law or in
equity.
In addition to the remedies noted above, under the Master Lease Agreements,
in the case of a facility-specific event of default Ventas may terminate a
Master Lease Agreement as to the leased property to which the Event of Default
relates, and may, but need not, terminate the entire Master Lease Agreement.
Each of the Master Lease Agreements includes special rules relative to
Medicare/Medicaid events of default and licensed bed events of default. In the
event a Medicare/Medicaid event of default and/or a licensed bed event of
default occurs and is continuing (a) with respect to not more than two
properties at the same time under a Master Lease Agreement that covers 41 or
more properties and (b) with respect to not more than one property at the same
time under a Master Lease Agreement that covers 21 to and including 40
properties, Ventas may not exercise termination or dispossession remedies
against any property other than the property or properties to which the event
of default relates. Thus, in the event Medicare/Medicaid events of default and
licensed bed events of default would occur and be continuing (a) with respect
to one property under a Master Lease Agreement that covers less than 20
properties, (b) with respect to two or more properties at the same time under a
Master Lease Agreement that covers 21 to and including 40 properties, or (c)
with respect to three or more properties at the same time under a Master Lease
Agreement that covers 41 or more properties, then Ventas would be entitled to
exercise all rights and remedies available to it under the Master Lease
Agreements.
Assignment and Subletting
Except as noted below, the Master Lease Agreements provide that we may not
assign, sublease or otherwise transfer any leased property or any portion of a
leased property as a whole (or in substantial part), including by virtue of a
change of control, without the consent of Ventas, which may not be unreasonably
withheld if the proposed assignee (1) is a creditworthy entity with sufficient
financial stability to satisfy its obligations under the related Master Lease
Agreement, (2) has not less than four years experience in operating healthcare
facilities, (3) has a favorable business and operational reputation and
character and (4) has all licenses, permits, approvals and authorizations to
operate the facility and agrees to comply with the use restrictions in the
related Master Lease Agreement. The obligation of Ventas to consent to a
subletting or assignment is subject to the reasonable approval rights of any
mortgagee and/or the lenders under its credit agreement. We may sublease up to
20% of each leased property for restaurants, gift shops and other stores or
services customarily found in hospitals or nursing centers without the consent
of Ventas, subject, however, to there being no material alteration in the
character of the leased property or in the nature of the business conducted on
such leased property.
In addition, each Master Lease Agreement allows us to assign or sublease (a)
without the consent of Ventas, 10% of the nursing center facilities in each
Master Lease Agreement and (b) with Ventas' consent (which consent will not be
unreasonably withheld, delayed or conditioned), two hospitals in each Master
Lease Agreement, if either (i) the applicable regulatory authorities have
threatened to revoke an authorization necessary to operate such leased property
or (ii) we cannot profitably operate such leased property. Any such proposed
assignee/sublessee must satisfy the requirements listed above and it must have
all licenses, permits, approvals and other authorizations required to operate
the leased properties in accordance with the applicable permitted use. With
respect to any assignment or sublease made under this provision, Ventas agrees
to execute a nondisturbance and attornment agreement with such proposed
assignee or subtenant. Upon any assignment or subletting, we will not be
released from our obligations under the applicable Master Lease Agreement.
Subject to certain exclusions, we must pay to Ventas 80% of any
consideration received by us on account of an assignment and 80% (50% in the
case of existing subleases) of sublease rent payments (roughly equal to revenue
net of specified allowed expenses attributable to a sublease, and specifically
defined in the Master Lease Agreements), provided that Ventas' right to such
payments will be subordinate to that of our lenders.
20
Ventas will have the right to approve the purchaser at a foreclosure of one
or more of our leasehold mortgages by our lenders. Such approval will not be
unreasonably withheld so long as such purchaser is creditworthy, reputable and
has four years experience in operating healthcare facilities. Any dispute
regarding whether Ventas has unreasonably withheld its consent to such
purchaser will be subject to expedited arbitration.
Under the Master Lease Agreements, Ventas has a right to sever properties
from the existing leases in order to create additional leases, a device adopted
to facilitate its financing flexibility. In such circumstances, our aggregate
lease obligations remain unchanged. Ventas exercised this severance right with
respect to Master Lease Agreement No. 1 to create a new lease of 40 nursing
centers (the "CMBS Lease") and mortgaged these properties in connection with a
securitized mortgage financing. The CMBS Lease is in substantially the same
form as the other Master Lease Agreements with certain modifications requested
by Ventas' lender and required to be made by us pursuant to the Master Lease
Agreements. The transaction closed on December 12, 2001.
GOVERNMENTAL REGULATION
Medicare and Medicaid
Medicare is a federal program that provides certain hospital and medical
insurance benefits to persons age 65 and over and certain disabled persons.
Medicaid is a medical assistance program administered by each state pursuant to
which healthcare benefits are available to certain indigent patients. Within
the Medicare and Medicaid statutory framework, there are substantial areas
subject to administrative rulings, interpretations and discretion that may
affect payments made under Medicare and Medicaid. A substantial portion of our
revenues are derived from patients covered by the Medicare and Medicaid
programs. See "-Health Services Division-Sources of Nursing Center Revenues"
and "-Hospital Division-Sources of Hospital Revenues."
Federal, State and Local Regulation
In the ordinary course of our business, we are subject regularly to
inquiries, investigations and audits by federal and state agencies that oversee
applicable healthcare regulations.
The extensive federal, state and local regulations affecting the healthcare
industry include, but are not limited to, regulations relating to licensure,
conduct of operations, ownership of facilities, addition of facilities,
allowable costs, services and prices for services. In addition, various laws
including antikickback, antifraud and abuse amendments codified under the
Social Security Act prohibit certain business practices and relationships that
might affect the provision and cost of healthcare services reimbursable under
Medicare and Medicaid, including the payment or receipt of remuneration for the
referral of patients whose care will be paid by Medicare or other governmental
programs. Sanctions for violating these antikickback amendments include
criminal penalties and civil sanctions, including fines and possible exclusion
from government programs such as the Medicare and Medicaid programs. The U.S.
Department of Health and Human Services has issued regulations that describe
some of the conduct and business relationships permissible under the
antikickback amendments. The fact that a given business arrangement does not
fall within one of these safe harbors does not render the arrangement per se
illegal. Business arrangements of healthcare service providers that fail to
satisfy the applicable criteria, however, risk increased scrutiny and possible
sanctions by enforcement authorities.
In addition, Section 1877 of the Social Security Act, which restricts
referrals by physicians of Medicare and other government-program patients to
providers of a broad range of designated health services with which they have
ownership or certain other financial arrangements, was amended effective
January 1, 1995, to broaden significantly the scope of prohibited physician
referrals under the Medicare and Medicaid programs. Many states have adopted or
are considering similar legislative proposals, some of which extend beyond the
Medicaid program, to prohibit the payment or receipt of remuneration for the
referral of patients and physician self-referrals regardless of the source of
payment for the care. These laws and regulations are complex and limited
21
judicial or regulatory interpretation exists. We do not believe our
arrangements are in violation of these prohibitions. We cannot assure you,
however, that governmental officials charged with responsibility for enforcing
the provisions of these prohibitions will not assert that one or more of our
arrangements are in violation of such provisions.
The Balanced Budget Act also includes a number of antifraud and abuse
provisions. The Balanced Budget Act contains additional civil monetary
penalties for violations of the antikickback amendments discussed above and
imposes an affirmative duty on providers to ensure that they do not employ or
contract with persons excluded from the Medicare program. The Balanced Budget
Act also provides a minimum ten-year period for exclusion from participation in
federal healthcare programs for persons or entities convicted of a prior
healthcare offense.
The Federal Health Insurance Portability and Accountability Act of 1996,
commonly known as "HIPAA," signed into law on August 21, 1996, amended, among
other things, Title XI of the U.S. Code (42 U.S.C. (S)1301 et seq.) to broaden
the scope of fraud and abuse laws to include all health plans, whether or not
they are reimbursed under federal programs. In addition, HIPAA also mandates
the adoption of regulations aimed at standardizing transaction formats and
billing codes for documenting medical services, dealing with claims submissions
and protecting the privacy and security of individually identifiable health
information. HIPAA regulations that standardize transactions and code sets
became final in the fourth quarter of 2000. These regulations do not require
healthcare providers to submit claims electronically, but require standard
formatting for those that do. We currently submit our claims electronically and
will continue to do so. We will be required to comply with HIPAA transaction
and code set standards by October 2003.
Final HIPAA privacy regulations were published in December 2000. These
privacy regulations apply to "protected health information," which is defined
generally as individually identifiable health information transmitted or
maintained in any form or medium, excluding certain education records and
student medical records. The privacy regulations seek to limit the use and
disclosure of most paper and oral communications, as well as those in
electronic form, regarding an individual's past, present or future physical or
mental health or condition, or relating to the provision of healthcare to the
individual or payment for that healthcare, if the individual can or may be
identified by such information. HIPAA provides for the imposition of civil or
criminal penalties if protected health information is improperly disclosed. We
must comply with the privacy regulations by April 2003.
HIPAA's security regulations have not yet been finalized. The proposed
security regulations specify administrative procedures, physical safeguards and
technical services and mechanisms designed to ensure the privacy of protected
health information. We will be required to comply with the security regulations
26 months after the regulations become final.
We are currently evaluating the impact of compliance with HIPAA regulations,
but we have not completed our analysis or finalized the estimated costs of
compliance. We cannot assure you that our compliance with the HIPAA regulations
will not have an adverse affect on our financial position, results of
operations or cash flows.
We believe that the regulatory environment surrounding the long-term care
industry has intensified, particularly for large for-profit, multi-facility
providers like us. In the State of Florida, for example, a new statute requires
the State to revoke, absent sufficient mitigating factors, all licenses of
commonly controlled facilities even if only one facility has serious regulatory
deficiencies. The federal government has imposed extensive enforcement
policies, resulting in a significant increase in the number of inspections,
citations of regulatory deficiencies and other regulatory sanctions including
terminations from the Medicare and Medicaid programs, bars on Medicare and
Medicaid payments for new admissions and civil monetary penalties. Such
sanctions can have a material adverse effect on our results of operations,
liquidity and financial position. We vigorously contest such sanctions where
appropriate, and in several cases have obtained injunctions preventing
imposition of these
22
regulatory sanctions. While we generally have been successful to date in
contesting these sanctions, these cases involve significant legal expense and
the time of management and we cannot assure you that we will be successful in
the future.
Certificates of Need and State Licensing. Certificate of need, or CON,
regulations control the development and expansion of healthcare services and
facilities in certain states. Certain states also require regulatory approval
prior to certain changes in ownership of a nursing center or hospital. Certain
states that do not have CON programs may have other laws or regulations that
limit or restrict the development or expansion of healthcare facilities. We
operate nursing centers in 23 states and hospitals in 12 states that require
state approval for the expansion of our facilities and services under CON
programs. To the extent that CONs or other similar approvals are required for
expansion of the operations of our nursing centers or hospitals, either through
facility acquisitions, expansion or provision of new services or other changes,
such expansion could be affected adversely by the failure or inability to
obtain the necessary approvals, changes in the standards applicable to such
approvals or possible delays and expenses associated with obtaining such
approvals.
We are required to obtain state licenses to operate each of our nursing
centers and hospitals and to ensure their participation in government programs.
Once a nursing center or hospital becomes licensed and operational, it must
continue to comply with federal, state and local licensing requirements in
addition to local building and life-safety codes. All of our nursing centers
and hospitals have the necessary licenses.
Health Services Division
The development and operation of nursing centers and the provision of
healthcare services are subject to federal, state and local laws relating to
the adequacy of medical care, equipment, personnel, operating policies, fire
prevention, rate-setting and compliance with building codes and environmental
laws. Nursing centers are subject to periodic inspection by governmental and
other authorities to assure continued compliance with various standards,
continued licensing under state law, certification under the Medicare and
Medicaid programs and continued participation in the Veterans Administration
program. The failure to obtain, retain or renew any required regulatory
approvals or licenses could adversely affect nursing center operations.
Medicare and Medicaid and other Federal Regulation. The nursing centers
operated and managed by the health services division are licensed either on an
annual or bi-annual basis and generally are certified annually for
participation in Medicare and Medicaid programs through various regulatory
agencies that determine compliance with federal, state and local laws. These
legal requirements relate to the quality of the nursing care provided, the
qualifications of the administrative personnel and nursing staff, the adequacy
of the physical plant and equipment and continuing compliance with the laws and
regulations governing the operation of nursing centers. Federal regulations
affect the survey process for nursing centers and the authority of state survey
agencies and the Centers for Medicare and Medicaid Services ("CMS") to impose
sanctions on facilities based upon noncompliance with certain requirements.
Available sanctions include, but are not limited to, imposition of civil
monetary penalties, temporary suspension of payment for new admissions,
appointment of a temporary manager, suspension of payment for eligible patients
and suspension or decertification from participation in the Medicare and
Medicaid programs.
We believe that substantially all of our nursing centers are in substantial
compliance with applicable Medicare and Medicaid requirements of participation.
In the ordinary course of business, however, the nursing centers receive
statements of deficiencies from regulatory agencies. In response, the health
services division implements plans of correction to address the alleged
deficiencies. In most instances, the regulatory agency will accept the
facility's plan of correction and place the nursing center back into compliance
with regulatory requirements. In some cases or upon repeat violations, the
regulatory agency may take a number of adverse actions against the nursing
center. These adverse actions may include the imposition of fines, temporary
suspension of admission of new patients to the nursing center, decertification
from participation in the Medicaid and/or Medicare programs and, in extreme
circumstances, revocation of the nursing center's license.
23
The health services division also is subject to federal and state laws that
govern financial and other arrangements between healthcare providers. These
laws often prohibit certain direct and indirect payments or fee-splitting
arrangements between healthcare providers that are designed to induce or
encourage the referral of patients to, or the recommendation of, a particular
provider for medical products and services. Such laws include the antikickback
amendments discussed above. These provisions prohibit, among other things, the
offer, payment, solicitation or receipt of any form of remuneration in return
for the referral of Medicare and Medicaid patients. In addition, some states
restrict certain business relationships between physicians and pharmacies, and
many states prohibit business corporations from providing, or holding
themselves out as a provider of, medical care. Possible sanctions for violation
of any of these restrictions or prohibitions include loss of licensure or
eligibility to participate in reimbursement programs as well as civil and
criminal penalties. These laws vary from state to state.
In certain circumstances, federal law mandates that conviction for certain
abusive or fraudulent behavior with respect to one nursing center may subject
other facilities under common control or ownership to disqualification from
participation in the Medicare and Medicaid programs. In addition, some
regulations provide that all nursing centers under common control or ownership
within a state are subject to delicensure if any one or more of such facilities
are delicensed.
Hospital Division
Medicare and Medicaid and other Federal Regulation. The hospital division
is subject to various federal and state regulations. In order to receive
Medicare reimbursement, each hospital must meet the applicable conditions of
participation set forth by the U.S. Department of Health and Human Services
relating to the type of hospital, its equipment, personnel and standard of
medical care, as well as comply with state and local laws and regulations. We
have developed a management system to facilitate our compliance with the
various standards and requirements. Each hospital employs a person who is
responsible for an ongoing quality assessment and improvement program.
Hospitals undergo periodic on-site Medicare certification surveys, which
generally are limited if the hospital is accredited by the Joint Commission on
Accreditation of Health Care Organizations. As of December 31, 2001, all of the
hospitals operated by the hospital division were certified as Medicare
providers and 52 of such hospitals also were certified by their respective
state Medicaid programs. A loss of certification could affect adversely a
hospital's ability to receive payments from the Medicare and Medicaid programs.
Since 1983, Medicare has reimbursed general short-term acute care hospitals
under a prospective payment system. Under the hospital prospective payment
system, Medicare inpatient costs are reimbursed based upon a fixed payment
amount per discharge using diagnosis related groups. The diagnosis-related
group payment under the hospital prospective payment system is based upon the
national average cost of treating a Medicare patient's condition. Although the
average length of stay varies for each diagnosis related group, the average
stay for all Medicare patients subject to the hospital prospective payment
system is approximately six days. An additional outlier payment is made for
patients with higher treatment costs. Outlier payments are only designed to
cover marginal costs. Accordingly, the hospital prospective payment system
creates an economic incentive for general short-term acute care hospitals to
discharge medically complex Medicare patients as soon as clinically possible.
Hospitals that are certified by Medicare as general long-term acute care
hospitals are excluded from the hospital prospective payment system. We believe
that the incentive for short-term acute care hospitals to discharge medically
complex patients as soon as clinically possible creates a substantial referral
source for our long-term acute care hospitals.
The Social Security Amendments of 1983 excluded certain hospitals, including
general long-term acute care hospitals, from the hospital prospective payment
system. A general long-term acute care hospital is defined as a hospital that
has an average length of stay greater than 25 days. Inpatient operating costs
for general long-term acute care hospitals are reimbursed under the cost-based
reimbursement system, subject to a computed target rate per discharge for
inpatient operating costs established by TEFRA. As discussed below, the
Balanced Budget Act made significant changes to TEFRA's provisions.
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Prior to the Balanced Budget Act, Medicare operating costs per discharge in
excess of the computed target rate were reimbursed at the rate of 50% of the
excess, up to 10% of the computed target rate. Hospitals whose operating costs
were lower than the computed target rate were reimbursed their actual costs
plus an incentive. For cost report periods beginning on or after October 1,
1997, the Balanced Budget Act reduced the incentive payments to an amount equal
to 15% of the difference between the actual costs and the computed target rate,
but not to exceed 2% of the computed target rate. Costs in excess of the
computed target rate are still being reimbursed at the rate of 50% of the
excess, up to 10% of the computed target rate, but the threshold to qualify for
such payments was raised from 100% to 110% of the computed target rate.
Since the adoption of the Balanced Budget Act, a new provider will no longer
receive unlimited cost-based reimbursement for its first few years in
operation. Instead, for the first two years, it will be paid the lower of its
costs or 110% of the median of TEFRA's computed target rate for 1996 adjusted
for inflation. During this two-year period, new providers are not eligible to
receive TEFRA relief or incentive payments discussed in the previous paragraph.
As of December 31, 2001, all of our long-term acute care hospitals were
subject to TEFRA's computed target rate provisions. The reduction in TEFRA's
incentive payments has had a material adverse effect on our hospital division's
operating results. These reductions, which began between May 1, 1998 and
September 1, 1998 with respect to our hospitals, are expected to have a
material adverse impact on hospital division revenues in the future and may
impact adversely our ability to develop additional free-standing, long-term
acute care hospitals.
We also operate four general acute care hospitals that are subject to the
short-term acute care hospital prospective payment system and are not subject
to TEFRA's computed target rate provisions.
Medicare and Medicaid reimbursements generally are determined from annual
cost reports that we file, which are subject to audit by the respective agency
administering the programs. We believe that adequate provisions for loss have
been recorded to reflect any adjustments that could result from audits of these
cost reports.
Federal regulations provide that admission to and utilization of hospitals
by Medicare and Medicaid patients must be reviewed by peer review organizations
in order to ensure efficient utilization of hospitals and services. A peer
review organization may conduct such review either prospectively or
retroactively and may, as appropriate, recommend denial of payments for
services provided to a patient. The review is subject to administrative and
judicial appeal. Each of the hospitals operated by our hospital division
employs a clinical professional to administer the hospital's integrated quality
assurance and improvement program, including its utilization review program.
Peer review organization denials have not had a material adverse effect on the
hospital division's operating results.
The antikickback amendments discussed above prohibit certain business
practices and relationships that might affect the provision and cost of
healthcare services reimbursable under federal healthcare programs. Sanctions
for violating these amendments include criminal and civil penalties and
exclusion from federal healthcare programs. Pursuant to the Medicare and
Medicaid Patient and Program Protection Act of 1987, the U.S. Department of
Health and Human Services and the Office of the Inspector General specified
certain safe harbors that describe conduct and business relationships
permissible under the antikickback amendments. These safe harbor regulations
have resulted in more aggressive enforcement of the antikickback amendments by
the U.S. Department of Health and Human Services and the Office of the
Inspector General.
Section 1877 of the Social Security Act, commonly known as "Stark I," states
that a physician who has a financial relationship with a clinical laboratory
generally is prohibited from referring patients to that laboratory. The Omnibus
Budget Reconciliation Act of 1993 contains provisions, commonly known as "Stark
II," amending Section 1877 to expand greatly the scope of Stark I. Effective
January 1995, Stark II broadened the referral limitations of Stark I to
include, among other designated health services, inpatient and outpatient
hospital
25
services. Under Stark I and Stark II, a "financial relationship" is defined as
an ownership interest or a compensation arrangement. If such a financial
relationship exists, the entity generally is prohibited from claiming payment
for such services under the Medicare or Medicaid programs. Compensation
arrangements generally are exempted from Stark I and Stark II if, among other
things, the compensation to be paid is set in advance, does not exceed fair
market value and is not determined in a manner that takes into account the
volume or value of any referrals or other business generated between the
parties. These laws and regulations, however, are complex and the industry has
the benefit of limited judicial or regulatory interpretation. We believe that
business practices of providers and financial relationships between providers
have become subject to increased scrutiny as healthcare reform efforts continue
on the federal and state levels.
The pharmacy operations within the hospital division are subject to
regulation by the various states in which business is conducted as well as by
the federal government. The pharmacies are regulated under the Food, Drug and
Cosmetic Act and the Prescription Drug Marketing Act, which are administered by
the U.S. Food and Drug Administration. Under the Comprehensive Drug Abuse
Prevention and Control Act of 1970, which is administered by the United States
Drug Enforcement Administration, dispensers of controlled substances must
register with the Drug Enforcement Administration, file reports of inventories
and transactions and provide adequate security measures. Failure to comply with
such requirements could result in civil or criminal penalties.
Joint Commission on Accreditation of Health Care Organizations. Hospitals
receive accreditation from the Joint Commission on Accreditation of Health Care
Organizations, a nationwide commission that establishes standards relating to
the physical plant, administration, quality of patient care and operation of
medical staffs of hospitals. Generally, hospitals and certain other healthcare
facilities are required to have been in operation at least six months in order
to be eligible for accreditation by the Joint Commission. After conducting
on-site surveys, the Joint Commission awards accreditation for up to three
years to hospitals found to be in substantial compliance with Joint Commission
standards. Accredited hospitals are periodically resurveyed, at the option of
the Joint Commission, upon a major change in facilities or organization and
after merger or consolidation. As of December 31, 2001, all of the hospitals
operated by the hospital division were accredited by the Joint Commission. The
hospital division intends to seek and obtain Joint Commission accreditation for
any additional facilities it may purchase or lease and convert into long-term
acute care hospitals. We do not believe that the failure to obtain Joint
Commission accreditation at any hospital would have a material adverse effect
on the hospital division's results of operations.
Regulatory Changes
The Balanced Budget Act contained extensive changes to the Medicare and
Medicaid programs intended to reduce the projected amount of increase in
payments under those programs over a five year period. Virtually all spending
reductions were derived from reimbursements to providers and changes in program
components. The Balanced Budget Act has affected adversely the revenues in both
of our operating divisions.
The Balanced Budget Act established PPS for nursing centers for cost
reporting periods beginning on or after July 1, 1998. All of our nursing
centers adopted PPS on July 1, 1998. During the first three years, the per diem
rates for nursing centers were based on a blend of facility-specific costs and
federal rates. Effective July 1, 2001, the per diem rates were based solely on
federal rates. The payments received under PPS cover all services for Medicare
patients including all ancillary services, such as respiratory therapy,
physical therapy, occupational therapy, speech therapy and certain covered
pharmaceuticals.
The Balanced Budget Act also reduced payments made to our hospitals by
reducing TEFRA incentive payments, allowable costs for capital expenditures and
bad debts, and payments for services to patients transferred from a general
acute care hospital. The reductions in allowable costs for capital expenditures
became effective October 1, 1997. The reductions in the TEFRA incentive
payments and allowable costs for bad debts became effective between May 1, 1998
and September 1, 1998. The reductions in payments for services to
26
patients transferred from a general acute care hospital became effective
October 1, 1998. These reductions have had a material adverse impact on
hospital revenues. In addition, these reductions also may affect adversely the
hospital division's ability to develop or acquire additional free-standing,
long-term acute care hospitals in the future.
Under PPS, the volume of ancillary services provided per patient day to
nursing center patients also has declined dramatically. Medicare reimbursements
to nursing centers under PPS include substantially all services provided to
patients, including ancillary services. Prior to the implementation of PPS, the
costs of such services were reimbursed under cost-based reimbursement rules.
The decline in the demand for ancillary services since the implementation of
PPS is mostly attributable to efforts by nursing centers to reduce operating
costs. As a result, many nursing centers have elected to provide ancillary
services to their patients through internal staff. In response to PPS and a
significant decline in the demand for ancillary services, we realigned our
former ancillary services division in 1999 by integrating its physical
rehabilitation, speech and occupational therapy businesses into the health
services division and assigning its institutional pharmacy business to the
hospital division. Our respiratory therapy and other ancillary businesses were
discontinued.
Since November 1999, various legislative and regulatory actions have
provided a measure of relief from the impact of the Balanced Budget Act. In
November 1999, the Balance Budget Refinement Act (the "BBRA") was enacted.
Effective April 1, 2000, the BBRA (a) implemented a 20% upward adjustment in
the payment rates for the care of higher acuity patients, effective until the
enactment of a revised Resource Utilization Grouping payment system and (b)
allowed nursing centers to transition more rapidly to the federal payment
rates. The BBRA also imposed a two-year moratorium on certain therapy
limitations for skilled nursing center patients covered under Medicare Part B.
Effective October 1, 2000, the BBRA increased all PPS payment categories by 4%
through September 30, 2002.
In April 2000, CMS published a proposed rule which set forth updates to the
Resource Utilization Grouping payment rates used under PPS for nursing centers.
On July 31, 2000, CMS issued a final rule that indefinitely postponed any
refinements to the Resource Utilization Grouping categories used under PPS. As
a result, the 20% upward adjustment for certain higher acuity Resource
Utilization Grouping categories set forth in the BBRA was automatically
extended until the Resource Utilization Grouping refinements are enacted. On
July 31, 2001, CMS issued another final rule which did not establish such
refinements, and accordingly, the 20% adjustment will remain in place until the
Resource Utilization Grouping categories are refined.
In December 2000, the Medicare, Medicaid, and State Child Health Insurance
Program Benefits Improvement and Protection Act of 2000 ("BIPA") was enacted to
provide up to $35 billion in additional funding to the Medicare and Medicaid
programs over the next five years. Under BIPA, the nursing component for each
Resource Utilization Grouping category was increased by 16.66% over the
existing rates for skilled nursing care for the period April 1, 2001 through
September 30, 2002. BIPA also provided some relief from scheduled reductions to
the annual inflation adjustments to the Resource Utilization Grouping payment
rates through September 2002.
In addition, BIPA slightly increased payments for inpatient services and
TEFRA incentive payments for long-term acute care hospitals. Allowable costs
for bad debts also were increased by 15%. Both of these provisions became
effective for cost reporting periods beginning on or after September 1, 2001.
Despite the recent legislation and regulatory actions discussed above,
Medicare revenues recorded under PPS in our health services division are less
than the cost-based reimbursement we received before the enactment of the
Balanced Budget Act. In addition, the recent legislation did not impact
materially the reductions in Medicare revenues received by our hospitals as a
result of the Balanced Budget Act. Furthermore, we cannot assure you that the
increased revenues from the BBRA or BIPA will continue after September 30, 2002.
27
There continues to be legislative and regulatory proposals that would impose
more limitations on government and private payments to providers of healthcare
services. Congress has directed the Secretary of the U.S. Department of Health
and Human Services to develop a prospective payment system applicable
specifically to long-term acute care hospitals by October 1, 2001. The new
prospective payment system would be effective for cost report periods beginning
on or after October 1, 2002. This payment system would not impact us until
September 1, 2003. As of February 28, 2002, the Secretary had not proposed such
a prospective payment system. Congress has further directed that if the
Secretary is unable to implement a prospective payment system specific to
long-term acute care hospitals by October 1, 2002, the Secretary shall instead
implement, as of such date, a prospective payment system for long-term acute
care hospitals based upon existing hospital diagnosis-related groups modified
where feasible to account for resource use of long-term acute care hospital
patients. We cannot predict the content or timing of such regulations.
By repealing the Boren Amendment, the Balanced Budget Act eased existing
impediments on the ability of states to reduce their Medicaid reimbursement
levels. Many states are considering or have enacted measures that are designed
to reduce their Medicaid expenditures and to make certain changes to private
healthcare insurance. Some states also are considering regulatory changes that
include a moratorium on the designation of additional long-term acute care
hospitals. Additionally, regulatory changes in the Medicaid reimbursement
system applicable to the hospital division also are being considered. There
also are legislative proposals including cost caps and the establishment of
Medicaid prospective payment systems for nursing centers.
We could be adversely affected by the continuing efforts of governmental and
private third-party payors to contain healthcare costs. We cannot assure you
that payments under governmental and private third-party payor programs will
remain at levels comparable to present levels or will be sufficient to cover
the costs allocable to patients eligible for reimbursement pursuant to such
programs. In addition, we cannot assure you that the facilities we operate, or
the provision of services and supplies by us, will meet the requirements for
participation in such programs.
We cannot assure you that future healthcare legislation or other changes in
the administration or interpretation of governmental healthcare programs will
not have a material adverse effect on our results of operations, liquidity or
financial position.
CORPORATE INTEGRITY AGREEMENT
We have entered into a Corporate Integrity Agreement with the Office of
Inspector General of the U.S. Department of Health and Human Services to
promote our compliance with the requirements of Medicare, Medicaid and all
other federal healthcare programs. Under the Corporate Integrity Agreement, we
are implementing a comprehensive internal quality improvement program and a
system of internal financial controls in our nursing centers, hospitals and
regional and corporate offices. We have retained sufficient flexibility under
the Corporate Integrity Agreement to design and implement the agreement's
requirements to enable us to focus our efforts on developing improved systems
and processes for providing quality care. Our failure to comply with the
material terms of the agreement could lead to suspension or exclusion from
further participation in federal healthcare programs. We believe that many of
the requirements of the Corporate Integrity Agreement are necessary to achieve
our patient care objectives and are similar to the procedures used by other
healthcare providers to comply with existing laws and regulations.
The Corporate Integrity Agreement became effective on April 20, 2001 and
applies to us and our managed entities. The Corporate Integrity Agreement also
will apply to newly acquired facilities after a phase-in period of six months.
As required by the Corporate Integrity Agreement, we have engaged the Long
Term Care Institute, Inc. to monitor and evaluate our quality improvement
program and report its findings to the Office of the Inspector General.
28
The Corporate Integrity Agreement includes compliance requirements which
obligate us to:
. Adopt and implement written standards on federal healthcare program
requirements with respect to financial and quality of care issues.
. Conduct training each year for all employees to promote compliance with
federal healthcare requirements. Every employee will undergo a minimum of
two hours of general compliance training annually. We also will provide
annually at least two hours of specific training, tailored to issues
affecting employees with certain job responsibilities, as well as a
minimum of two hours of training for care-giving employees focused on
quality care. In addition, we will continue to operate our internal
compliance hotline.
. Put in place a comprehensive internal quality improvement program, which
will include establishing committees at the facility, regional and
corporate levels to review quality-related data, direct quality
improvement activities and implement and monitor corrective action plans.
We focus on integrating compliance responsibilities with operational
functions. We recognize that our compliance with applicable laws and
regulations depends on individual employee action as well as our
operations. The Long Term Care Institute, Inc. has assisted in program
development and will evaluate its integrity and effectiveness for the
Office of the Inspector General.
. Enhance our current system of internal financial controls to promote
compliance with federal healthcare program requirements on billing and
related financial issues, including a variety of internal audit and
compliance reviews. We have retained an independent review organization to
evaluate the integrity and effectiveness of our internal systems. The
independent review organization will report annually its findings to the
Office of the Inspector General.
. Notify the Inspector General within 30 days of our discovery of any
ongoing investigation or legal proceeding conducted or brought by a
governmental entity or its agents involving any allegation that we have
committed a crime or engaged in a fraudulent activity, and within 30 days
of our determination that we have received a substantial overpayment
relating to any federal healthcare program or any other matter that a
reasonable person would consider a potential violation of the federal
fraud and abuse laws or other criminal or civil laws related to any
federal healthcare program.
. Submit annual reports to the Inspector General demonstrating compliance
with the terms of the Corporate Integrity Agreement, including the
findings of our internal audit and review program. We submitted an
implementation report to the Office of Inspector General in August 2001.
The Corporate Integrity Agreement contains standard penalty provisions for
breach, which include stipulated cash penalties ranging from $1,000 per day to
$2,500 per day for each day we are in breach of the agreement. If we fail to
remedy our breach in the time specified in the agreement, we can be excluded
from participation in federal heal